Geetha Iyer

Meaning
Macroeconomics is study of the economy as a whole
It analyses the causes of major economic problems such as

high unemployment, rampant inflation, low wages, low economic growth and increasing trade deficits. It deals with short term fluctuations in output, employment and prices ( business cycles ) and the long term increase in output and standard of living ( economic growth ) . It helps us to understand the forces that have an impact on growth and business cycles.
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Goals of Macroeconomic Policy

1. Output : High level and rapid growth of output ( GDP ) 2. Employment : High level of employment with low level

of unemployment 3. Price Stability 4. Sustainable Balance Of Payments 5. Economic Growth

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Instruments of Macroeconomic Policy

Fiscal policy : refers to the policy of the government with

respect to its spending and mobilization of resources.

1. Government Expenditure 2. Transfer Payments 3. Taxation

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Instruments of Macroeconomic Policy

Monetary Policy: is formulated and implemented by the

Reserve Bank of India. It is used to influence the total quantity of money , interest rates and total volume of credit in the economy.

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Instruments of Macroeconomic Policy

International Trade Policy :

Trade policies refers to tariff and non- tariff trade regulations that limit or promote the imports and exports of a country.

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Instruments of Macroeconomic Policy

Exchange rate policy: refers to policies related to foreign

exchange management The foreign exchange rate is the rate at which a countrys currency can be exchanged with a foreign currency.

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Instruments of Macroeconomic Policy

Employment Policies : are aimed at generating

employment opportunities

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Instruments of Macroeconomic Policy

Prices and Income Policies: are used to influence the

working of the market economy

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National Income
National income represents the total income received by

labour, capital and land.

National income equals total compensation of labour,

rental income, net interest , income of proprietors and corporate profits.

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Factors Affecting the size of a National Income

1. Natural Resources: minerals, agricultural potential and

energy resources. 2. Human Resources: Large literate population capable and knowledgeable in wealth creating processes. 3. Capital resources : tools, plant & machinery, factories, mines , domestic dwellings, schools and colleges, roads, airports, railways, seaports and communication facilities. 4. Self- Sufficiency: Government should encourage entrepreneurial activities that increase self- sufficiency.
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Approaches to measure national income

1. Product Approach: National Income is measured by

calculating the total value of the final output of a country. All goods and services produced in the country comprise the final output. GDP = Consumption ( C ) + Gross private domestic investment ( I ) + Government Purchases ( P ) + Net exports ( X )
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Approaches to measure national income

2. Income Approach : The annual flow of factor earnings in the form of wages , rents , interest and profits accrued from labour, land , capital and organisation respectively are taken into account in the income approach. GDP = Compensation of labour ( Wages , Salaries ) + Corporate Profits + Depreciation + Net production Taxes
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Approaches to measure national income

3. Expenditure Approach : National Income is measured by

aggregating the flow of total expenditure on the final goods and services in an economy. Y=En+Eb+Eg Where E n , E b, E g denote the annual floe of expenditure by the households, business and government sectors respectively.

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Gross National Product

GNP is an alternative measure of national output. GNP is the total output produced with inputs owned by

the residents of a country. GNP is the income of all the factors irrespective of whether they are staying in the home country or abroad

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GDP vs GNP

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Difficulties in Measuring National Income

Non Market Production : Household production Imputed values : value of commodities consumed by the

farmers Underground Economic activities : illegal activities Side Effects and Economic Bads : Air & water pollution, Defense expenditure Leisure and Human Cost Double counting
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Uses of National Income Statistics

As an instrument of Economic Planning and Review As a means of indicating changes in countrys standard of

living To indicate changes in Economic Growth of a country As a means of comparing the economic performance of different countries

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Inflation
Inflation occurs when the general level of prices is rising.
Rate of inflation in year t = 100 * P (t) P( t-1)

P( t-1) Inflation is defined as the rate (%) at which the general price level of goods and services is rising, causing purchasing power to fall.

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Factors responsible for inflation

Inflation occurs when most prices are rising by some

degree across the whole economy. This is caused by four possible factors, each of which is related to basic economic principles of changes in supply and demand: Increase in the money supply. Decrease in the demand for money. Decrease in the aggregate supply of goods and services. Increase in the aggregate demand for goods and services.

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Types of Inflation
1. Low Inflation : is characterized by prices that rise slowly

and predictably and is single digit annual inflation rates 2. Galloping Inflation: Inflation in double digit or triple digit range of 20,100 or 200 percent per year is called galloping inflation or very high inflation 3. Hyperinflation :takes place when prices are rising a million or trillion percent per year.

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Sources of Inflation
1. Demand- pull inflation
2. Cost push inflation

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Demand Pull Inflation

Demand-pull inflation occurs when there is an increase in

aggregate demand, categorized by the four sections of the macroeconomy: households, businesses, governments and foreign buyers. When these four sectors concurrently want to purchase more output than the economy can produce, they compete to purchase limited amounts of goods and services. Buyers in essence bid prices up, again, causing inflation. This excessive demand, also referred to as too much money chasing too few goods, usually occurs in an expanding economy.

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Factors Pulling Prices Up

An increase in government purchases can increase aggregate

demand, thus pulling up prices. Another factor can be the depreciation of local exchange rates, which raises the price of imports and, for foreigners, reduces the price of exports. As a result, the purchasing of imports decreases while the buying of exports by foreigners increases, thereby raising the overall level of aggregate demand (we are assuming aggregate supply cannot keep up with aggregate demand as a result of full employment in the economy). Rapid overseas growth can also ignite an increase in demand as more exports are consumed by foreigners. Finally, if government reduces taxes, households are left with more disposable income in their pockets. This in turn leads to increased consumer spending, thus increasing aggregate demand and eventually causing demand-pull inflation. The results of reduced taxes can lead also to growing consumer confidence in the local economy, which further increases aggregate demand.
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Demand Pull Inflation

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Demand Pull Inflation

Looking again at the price-quantity graph, we can see the relationship

between aggregate supply and demand. If aggregate demand increases from AD1 to AD2, in the short run, this will not change (shift) aggregate supply, but cause a change in the quantity supplied as represented by a movement along the AS curve. The rationale behind this lack of shift in aggregate supply is that aggregate demand tends to react faster to changes in economic conditions than aggregate supply. As companies increase production due to increased demand, the cost to produce each additional output increases, as represented by the change from P1 to P2. The rationale behind this change is that companies would need to pay workers more money (e.g. overtime) and/or invest in additional equipment to keep up with demand, thereby increasing the cost of production. Demand-pull inflation can occur as companies to maintain profit levels, pass on the higher cost of production to consumers prices.
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Cost Push Inflation

Aggregate supply is the total volume of goods and services

produced by an economy at a given price level. When there is a decrease in the aggregate supply of goods and services stemming from an increase in the cost of production, we have cost-push inflation. Cost-push inflation basically means that prices have been pushed up by increases in costs of any of the four factors of production (labor, capital, land or entrepreneurship) when companies are already running at full production capacity. With higher production costs and productivity maximized, companies cannot maintain profit margins by producing the same amounts of goods and services. As a result, the increased costs are passed on to consumers, causing a rise in the general price level (inflation).
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Production Costs
A company may need to increases wages if laborers demand higher salaries

(due to increasing prices and thus cost of living) or if labor becomes more specialized. If the cost of labor, a factor of production, increases, the company has to allocate more resources to pay for the creation of its goods or services. Another factor that can cause increases in production costs is a rise in the price of raw materials. This could occur because of scarcity of raw materials, an increase in the cost of labor and/or an increase in the cost of importing raw materials and labor (if the they are overseas), which is caused by a depreciation in their home currency. The government may also increase taxes to cover higher fuel and energy costs, forcing companies to allocate more resources to paying taxes. To continue to maintain (or increase) profit margins, the company passes the increased costs of production on to the consumer, making retail prices higher. Along with increasing sales, increasing prices is a way for companies to constantly increase their bottom lines and essentially grow.
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Cost Push Inflation

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Cost Push Inflation

The graph below shows the level of output that can be

achieved at each price level. As production costs increase, aggregate supply decreases from AS1 to AS2 (given production is at full capacity), causing an increase in the price level from P1 to P2. The rationale behind this increase is that, for companies to maintain (or increase) profit margins, they will need to raise the retail price paid by consumers, thereby causing inflation.

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Measures to control inflation

1. Monetary measures
2. Fiscal measures 3. Other measures

a. Price control and rationing

b. Wage policy

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The Phillips Curve

Demonstrates the inverse relationship between unemployment rates and inflation rates Assuming a constant short-run AS curve:
Inflation rate Unemployment (when AD increases,

there is a upward pressure on prices and UE therefore decreases) Inflation rate Unemployment (when AD decreases, there is a downward pressure on prices and UE therefore increases) Thus, the relationship is inverse as shown by the graph below:
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The Phillips Curve

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Stagflation's Demise:
However, in the long term:

Due to great unemployment, workers accept lower wages, and firms' costs decrease Foreign competition also holds down wages and price hikes Input prices is a determinant of AS, therefore when input prices (wages) decrease, AS will shift to the right A component of laissez-faire economics is the theory that the economy will self-correct. However, the economy will suffer great unemployment in the process.

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