Microeconomics:

study of how households and firms make decisions and

how these decision-makers interact in the marketplace
Pursue own interests (profit /utility optimization)

Macroeconomics: focuses on the behavior of an economy

as a whole
Eg. what are the factors that determine an economys
capacity to produce goods and services
Why some countries experience rapid growth in
incomes over while others seem to be trapped in
poverty?
Causes of economic recessions and booms
Causes of inflation

 Three statistic(s) that economists and policymakers

use most often
Gross domestic product (GDP)
tells us the nations total income and the total
expenditure on its output of goods and services

Consumer price index (CPI)

measures the level of prices.

Unemployment rate tells us the fraction of workers

who are unemployed

The Circular Flow

In every transaction, the buyers expenditure becomes the sellers

income.
Thus, the sum of all expenditure equals the sum of all income.

GDP
1.Total expenditure on domestically-produced final goods and services
2.Total income earned by domestically-located factors of production

 Gross domestic product (GDP)

= the market value of all final goods
and services produced within an
economy in a given period of time

Real vs. Nominal GDP

GDP = value of all final goods and services produced.

Eg. GDP = (Price of Apples Quantity of Apples) + (Price

of Oranges Quantity of Oranges)

Nominal GDP measures these values using current

prices.

Can we use Nominal GDP to measure economic well

being of a country?

Changes in nominal GDP can be due to:

changes in prices
changes in quantities of output produced

If all prices doubled without any change in quantities,

nominal GDP would double

it would be misleading to say that the economys ability

to satisfy demands has doubled, because the quantity of
every good produced remains same

 Real GDP measures GDP using the prices of a base

year
value of goods and services measured using a
constant set of prices

Real GDP shows what would have happened to

expenditure on output if quantities had changed but
prices had not.

Changes in real GDP can only be due to changes in

quantities,
because real GDP is constructed using constant baseyear prices.

how real GDP is computed

Suppose we want to compare output in 2009 with output in
subsequent years

Choose a set of prices, called base-year prices = prices that

prevailed in 2009

Real GDP (2009)

= (2009 Price of Apples 2009 Quantity of Apples)+ (2009
Price of Oranges 2009 Quantity of Oranges)

Real GDP (2010)

= (2009 Price of Apples 2010 Quantity of Apples)
+ (2009 Price of Oranges 2010 Quantity of Oranges).

2002

2003

2004

good A

30

900

31

1,000

36

1,050

good B

100

192

102

200

100

205

Compute nominal GDP in each year

Compute real GDP in each year
using 2002 as the base year.

Nominal GDP multiply Ps & Qs from same

year

2002: 46, 200 = 30 900 + 100 192

2003: 51, 400
2004: 58, 300

Real GDP

multiply each years Qs by 2002 Ps

2002: 46, 200

2003: 50, 000
2004: 52, 000 = 30 1050 + 100 205

GDP Deflator
One measure of the price level is
the GDP Deflator, defined as

Nominal GDP
GDP deflator = 100
Real GDP
reflects whats happening to the overall level of prices in the economy.

Nom.
GDP

GDP
Real GDP
deflator

Inflation
rate

2002

46,200

46,200

100.0

2003

51,400

50,000

102.8

2.8%

2004

58,300

52,000

112.1

9.1%

Using GDP deflator to compute the

inflation rate

Understanding the GDP deflator

Example with 3 goods
For good i = 1, 2, 3
Pit = the market price of good i in month t
Qit = the quantity of good i produced in
month t
NGDPt = Nominal GDP in month t
RGDPt = Real GDP in month t

Understanding the GDP deflator

NGDPt
P1tQ1t P2tQ2t P3tQ3t
GDP deflator 100
100
RGDPt
RGDPt

Q1t
Q2t
Q 3t
100
P1t
P2t
P3t
RGDP
RGDPt
RGDP
t
t
The GDP deflator is a weighted average of prices.
The weight on each price reflects that goods relative
importance in RGDP.
Note that the weights change over time.

Measuring Cost of Living: CPI

Rs x today cannot buy as much as it did twenty years
ago.

The cost (price) of almost everything has gone up.

increase in the overall level of prices is called inflation
CPI is one measure of Cost of Living

1. Survey consumers to determine composition of the

typical consumers basket of goods.

2. Every month, collect data on prices of all items in the

basket; compute cost of basket

3. CPI in any month equals

Cost of basket in that month

100
Cost of basket in base period

 suppose that the typical consumer buys 5 apples and

2 oranges every month.

Then the basket consists of 5 apples and 2 oranges

CPI with 2009 base year=
(5 Current Price of Apples + 2 Current Price of
Oranges) /
(5 2009 Price of Apples + 2 2009 Price of
Oranges)

The basket contains 20 pizzas and

10 compact discs.

prices:
2002
2003
2004
2005

pizza
10
11
12
13

CD
15
15
16
15

For each year,

compute
the cost of the
basket
the CPI (use 2002
as the base year)
the price change
from the preceding
year

cost of
basket
2002

350

price ch
CPI
100.0

2003

370

105.7

5.7%

2004

400

114.3

8.1%

2005

410

117.1

2.5%

CPI vs. GDP Deflator

GDP deflator measures the prices of all goods and services
produced, whereas the CPI measures the prices of only the
goods and services bought by consumers.
Thus, an increase in the price of goods bought only by
firms or the government will show up in the GDP
deflator but not in the CPI.

GDP deflator includes only those goods produced

domestically. Imported goods are not part of GDP and do
not show up in
the GDP deflator.
Eg. increase in the price of Toyota (made in Japan) and
sold in India affects the CPI, because the Toyota is bought
by consumers, but it does not affect the GDP deflator.

CPI vs. GDP Deflator

The basket of goods
CPI: fixed
GDP deflator: composition of goods changes every year

Implication
Suppose a major earthquake in North India affects tea
production.

The quantity of tea produced =0, and the price of tea remaining
in market becomes sky high.

Tea is no longer part of GDP, the increase in the price of tea

does not show up in the GDP deflator.

Since CPI is computed with a fixed basket of goods that includes

tea, the increase in the price of tea causes a substantial rise in
the CPI

CPI may overstate inflation

Substitution bias: The CPI uses fixed weights, so it cannot
reflect consumers ability to substitute toward goods whose
relative prices have fallen.
Thus CPI overstates the impact of the increase in tea

prices on consumers

Why do we care about GDP

how a person is doing economically

income is an indicator

When judging whether the economy is doing well or

poorly, it is natural to look at the total income that
everyone in the economy is earning.

GDP is a measure of how well the overall economy is

performing

GDP = market value of all final goods

and services produced within a
country in a given period of time
GDP IS THE MARKET VALUE . . .
GDP adds together different kinds of products and
services into a single measure of the value of economic
activity
OF ALL . . .
- Comprehensive measure
It includes all items produced in the economy and sold
legally in markets
Note: excludes most items that are produced and

consumed at home and, therefore, never enter the

marketplace
Vegetables you buy at the grocery store are
part of GDP; vegetables you grow in your garden are not

 FINAL . . .
- International Paper makes paper, which Hallmark
uses to make a greeting card
- the paper is an intermediate good, and the card is
final good.
- GDP includes only the value of final goods

Adding the market value of the paper to the market

value of the card would be double counting.

That is, it would (incorrectly) count the paper twice.

GOODS AND SERVICES . . .

GDP includes both tangible goods (food, clothing,
cars) &
intangible services (haircuts, doctor visits, music
concert)
PRODUCED . . .
GDP includes goods and services currently produced.
It does not include transactions involving items
produced in the past.
Eg. Tata produces and sells a new car, the value of
the car is included in GDP.
When one person sells a used car to another person,
the value of the used car is not included in GDP.

 WITHIN A COUNTRY . . .
GDP measures the value of production within the geographic
boundary of a country.

Indian citizen works temporarily in the US, his production is part

of US GDP.
- It is not part of Indias GDP
American citizen owns a car factory in Gujarat, the production of
his factory is not part of US GDP.
It is part of Indias GDP.
Items are included in a nations GDP if they are produced
domestically, regardless of the nationality of the producer

COMPONENTS OF GDP
Consider different types of expenditure:

Consumer having lunch at McD

TATA builds a car factory in Gujarat
Navy procures a submarine produced in India
Indian Railways buys a train from local manufacturer

GDP includes all of these various forms of spending

on

domestically produced goods and services

Some conventions
Important to understand the composition of GDP
among various types of spending
how the economy is using its scarce resources
Y =C + I + G + X-M
C: Consumption spending by households on goods
and services
- exception: purchases of new housing
I: Investment is the purchase of capital equipment,
inventories
- includes expenditure on new housing

 G: government purchases
- spending on goods and services by government

X-M (net exports)

purchases of domestically produced goods by foreigners

(exports) the domestic purchases of foreign goods

(imports).

A domestic firms sale to a buyer in another country increases

exports
IT services from TCS hired by British Telecom

imports of goods and services are produced abroad

Hence subtracted

Evaluation of GDP
GDP is not a perfect measure of well-being
GDP does not measure the health of children
but nations with larger GDP can afford better health care
for their children
GDP uses market prices to value goods and services, it

excludes the value of almost all activity that takes place

outside of markets.

In particular, GDP omits the value of goods and services

produced at home.
When a chef prepares a delicious meal and sells it at his
restaurant, the value of that meal is part of GDP
GDP excludes food cooked at home
Child care provided in day care centers is part of

GDP whereas child care by parents at home is not

 GDP excludes the quality of the environment

Suppose government eliminates all environmental
regulations.

Firms could then produce goods and services without

considering the pollution they create, and GDP might
rise.

Yet well-being would most likely fall.

The deterioration in the quality of air and water would
more than offset the gains from greater production
(increased GDP)

 GDP also says nothing about the distribution of

income.

A society in which100 people have annual incomes of

50,000 has GDP of 5 million and, GDP per person of
50,000.

So does a society in which 10 people earn 500,000 and

90 suffer with nothing at all

INTERNATIONAL DIFFERENCES IN GDP AND

THE QUALITY OF LIFE
Rich and poor countries have vastly different levels of GDP
per person.

If a large GDP leads to a higher standard of living, then we

should observe GDP to be strongly correlated with
measures of the quality of life.

In rich countries, (United States, Japan, and Germany),

people can expect to live longer, and almost all of the
population can read.

In poor countries, (Nigeria, Bangladesh, and Pakistan),

people typically have shorter life exp, and only about half
of the population is literate.

 Goods and services that are not sold in markets, such

as food produced and consumed at home, are not
included in GDP.

this might cause the numbers to be misleading in a

comparison of the economic wellbeing of the United
States and India

 In general, international data reveals:

Countries with low GDP per person tend to have more
infants with low birth weight, higher rates of infant
mortality, maternal mortality, higher rates of child
malnutrition, and less access to safe drinking water

GDP is closely associated with its

citizens standard of living.

exercise
Volvo raises the price of its cars.
Volvos are made in Sweden, the car is not
part of Indias GDP.

Indian consumers buy Volvos, and so the

car is part of the typical consumers
basket of goods.

Hence, a price increase in an imported

consumption good shows up in the
consumer price index but not in the GDP
deflator

 >75% of the oil we use is imported

As a result, oil and oil products comprise a much larger
share of consumer spending than they do of GDP.

When the price of oil rises, the consumer price index

rises by much more than does the GDP deflator.

 When you deposit your savings in a bank account, you

will earn interest on your deposit. Conversely, when
you borrow from a bank, you will pay interest at future
date.

Interest represents a payment in the future for a

transfer of money in the past.

interest rates always involve comparing amounts of

money at different points in time.

 Suppose you deposit 1000 in a bank account that pays

an annual interest rate of 10 %.

Inflation rate = 4%
Real interest rate
= Nominal interest rate (paid by bank) - Inflation rate
= 6%

 Goal: What factors cause fluctuations in national

income ?
what determines national income
A simple model where income is determined by

aggregate demand / expenditure

Why useful?
Identify the factors that affect national income
Tools that policymakers can use to influence

national income

Keynesian theory of National

income determination
Q. How national income is determined

Economys national income is determined largely by

expenditure of
households
businesses/ firms
and government

The more people want to spend, the more goods and

services firms can sell.

The more firms can sell, the more output they will
produce and the more workers they will choose to hire

 Distinction between actual and planned expenditure

Actual expenditure
= amount households, firms, and the government
spend on goods and services
= the economys GDP

Planned expenditure
= amount households, firms, and the government
would like to spend on goods and services

 Actual expenditure may differ from planned expenditure:

when firms sell less than what they had planned, their stock
of inventories increases

Leads to unplanned inventory investment

Note: increase in inventory is counted as inventory
investment
(investment: goods used for future use)

 conversely, when firms sell more than what they had

planned, their stock of inventories falls

Leads to unplanned changes (reduction) in inventory

Few definitions
Inventories are stocks of goods held to satisfy future
sales.

Inventory investment is the value of the change in total

inventories held in the economy during a given period.

Unplanned inventory investment occurs when actual

sales are more or less than businesses expected, leading
to unplanned changes in inventories.

Actual investment spending is the sum of planned

investment spending and unplanned inventory investment

Simple Keynesian Model

Simplest Model set up:
economy is closed (i.e. net exports =0)
Govt spends G
Govt collects lumpsum tax T
Exogenous variables: G, T, Iplanned

Consumption function
Without Tax: Aggregate C is function of aggregate income Y
C= f(Y) =C(Y)
As Y changes by 1 unit, how much will C change
Marginal Propensity to Consume (MPC)

With Tax: Aggregate C is function of aggregate disposable

income Y

C = f (Y-T) = C(Y-T)
Since T is exogenous, a one-unit increase in Y causes a oneunit increase in disposable income.
MPC = increase in consumption due to one-unit increase in disposable
income.

Elements of Simplest Keynesian Model:

determinants of planned expenditure

consumption function:
govt policy variables:
planned investment:
planned expenditure:

 PE = C( Y-T)+ Planned I+G

Actual expenditure = GDP = Y
= C(Y-T) + Planned I + Unplanned I +G

PE
PE =C +IP
+G

planned
expenditure

MPC

income, output, Y
Slope of PE line = MPC
With IP and G exogenous, the only component of (C+IP+G) that changes
when income changes is consumption.
A one-unit increase in income causes consumption, and therefore PE to

Notion of Equilibrium:
Assumption: the economy is in equilibrium when actual

expenditure equals planned expenditure

when plans have been realized, we have no reason to change
what we are doing
Eqbm: actual expenditure (Y) = planned expenditure (PE)

Y= Actual Expenditure
Actual Expenditure = C(Y-T)+ Planned I + Unplanned I +G
PE = C(Y-T)+ Planned I +G
Equilibrium when Unplanned I = 0
In equilibrium, there is no unplanned inventory investment.
Firms are selling everything they had intended to sell.

 How to graph the equilibrium condition?

Eqbm:
Planned Expenditure (PE) = Actual Expenditure
Since, Actual expenditure = GDP = National income =Y
Therefore equilibrium: PE= AE=Y

Graphing the equilibrium condition

PE

PE =AE=Y

planned
expenditure

45
income, output, Y

The equilibrium value of income

Keynesian cross Diagram

PE, AE

PE =AE=Y
PE =C +IP
+G

income, output, Y

Equilibrium
income

How does the economy get to

equilibrium?
Whenever an economy is not in equilibrium,
- firms experience unplanned changes in inventories
- this induces them to change production levels.
- changes in production in turn influence total income
and
expenditure

- economy moves toward equilibrium

- Note: inventories play an important role in the
adjustment process.

 suppose we consider GDP at a level greater than the

equilibrium level

planned expenditure < production = output

firms are selling less than they are producing
Accumulate unplanned inventories
This unplanned inventory accumulation induces firms
to decrease production.

 Suppose GDP is at a level lower than the equilibrium

level, such as the level Y2.

planned expenditure PE2 > productionY2.

Firms meet the high level of sales by reducing their
inventories.

As firms see their stock of inventories do down, they

increase production.

GDP rises and the economy approaches the

equilibrium.

Summary
Keynesian cross diagram shows how aggregate income
Y is determined
Aggregate demand determines aggregate income

So far, we have assumed IP ,G and T to be exogenous

variables

Thus the aggregate income Y is determined for given

levels of IP ,G and T

We can apply this model to show how income changes

when these exogenous variables changes.

Comparative Static Analysis

If the exogenous variable(s) change, then how does it
affect national income?

Eg. How does a change in government purchase affect

the economy ?

At any value of Y, an increase in G by the amount G

causes an increase in PE by the same amount.

At Y1, PE > Y
there is an unplanned depletion of inventories,

because people are buying more than firms are

producing (PE > Y).

An increase in government purchase

P
E

=
Y

PE
At Y1,
there is an
unplanned drop in
inventory

PE =C +I
+G2
PE =C +I
+G1

G
so firms increase
output, and income
rises to a new
equilibrium.

Y
PE1 = Y1

PE2 = Y2

Solving for Y
equilibrium condition

because I exogenous

The government purchase multiplier

Definition: the increase in income resulting from a 1 unit
increase in G.
Govt purchase multiplier

Example: If MPC = 0.8, then

Why the multiplier is greater than 1

Initially, the increase in G causes an equal
increase in Y:

Y = G.

But Y C
further Y
further C
further Y

Sum up changes in expenditure

Y G MPC G MPC MPC G
MPC MPC MPC G ...

G MPC 1G MPC 2G MPC 3G ...

 Suppose the government spends an additional 100

million on defense.

Then, the revenue of defense firms increase by 100

million, all of which becomes income of the workers

and engineers and managers...

Hence, income rises 100 million (Y = 100 million =

G ).

The people whose income rose by 100 million are also

consumers, and they will spend the fraction MPC of
this extra income.

 If MPC = 0.8, so C rises by 80 million.

Suppose they spend 80 million on cars
Then, car manufacturers income increase by 80 million
What do they do with this extra income?
They spend the fraction MPC (0.8) of it, causing C = 64
million

Suppose they spend 64 million on food

Then, food producers income increase by 64 million

 So far, the total impact on income is 100 million + 80

million + 64 million, which is much bigger than the
governments initial increase in spending.

But this process continues, and the final impact on Y

is 500 million (because the multiplier is 5).

Note:
The larger the MPC, the larger the value of the
multiplier.
the larger the MPC, the more additional
consumption takes place after each rise in income
during the multiplier process.