NASEER SHAHZADA economypk@yahoo

1. Introduction to Macroeconomics NASEER SHAHZADAeconomypk@yahoo.com NASEER SHAHZADA

2. Contents • National Income Accounting • Aggregate Demand and Aggregate Supply • Macroeconomic Equilibrium • Money and Banking • Integration of Goods and Money Markets (IS-LM) • Fiscal and Monetary Policies • Business Cycles • Inflation and Unemployment • International Trade and Balance of Payments NASEER SHAHZADA

3. Why to study Macroeconomics? • To understand the functioning of an economy • What causes fluctuations in demand? • What leads to instability in interest rates, prices (inflation rates), exchange rates? • To understand the direction of govt. policies • To take a decision on timing of fresh investments, takeovers, enter new markets, etc. • To get best return on investment NASEER SHAHZADA

4. Macroeconomic – An Introduction • Macroeconomics – study of the behavior and performance of the economy as a whole • Study of factors or forces determining the level and growth of macroeconomic aggregates • Macroeconomic aggregates (macroeconomic variables) – output, income, employment, price level, balance of payment positions, etc. • Aggregate behaviorrefers to the behavior of all households and firms together. NASEER SHAHZADA

5. Concepts in Macroeconomic Analysis Stock and Flow Variables • Stock: quantity of a variable at a point in time Eg: Capital stock, money supply, unemployment level, foreign exchange reserve, etc. • Flow:quantity expressed for a period of time Eg: GDP, inflation, exports, consumption, etc. NASEER SHAHZADA

6. Concepts in Macroeconomic Analysis Aggregate Demand and Aggregate Supply • Aggregate Demand:sum of demands for all consumer goods and services and for capital goods Sum of consumption, investment, government expenditure and net export. • Aggregate Supply:sum of the supplies of all consumer goods and services and of capital goods The amount of output the economy can produce given the resources and technology available NASEER SHAHZADA

7. The Roots of Macroeconomics • The Great Depressionwas a period of severe economic contraction and high unemployment that began in 1929 and continued throughout the 1930s. • A recession is a period during which aggregate output declines. Two consecutive quarters of decrease in output signal a recession. • A prolonged and deep recession becomes a depression. NASEER SHAHZADA

8. The Roots of Macroeconomics • Classical economists applied microeconomic models, or “market clearing” models, to economy-wide problems • Main argument: ‘Supply creates its own demand’- Say’s law • No intervention by the government (Laissez faire). Economy should be left to market forces (‘invisible hand’) • The failure of classical models to explain the prolonged existence of high unemployment during the Great Depression led to the development of macroeconomics NASEER SHAHZADA

9. The Roots of Macroeconomics • In 1936, John Maynard Keynes published The General Theory of Employment, Interest, and Money. • Keynes arguments: • The level of output and employment in an economy is determined by the aggregate demand (AD) • Governmentscould intervene in the economy and affect the level of output and employment • Two important objectives of macroeconomic policies: (a) Sustained growth in GDP, and (b) Price stability NASEER SHAHZADA

10. Functions of an Economy • An economy is a complex arrangements of many different buyers and sellers – households, businesses, government, and the rest of the world – and of their interactions with each other • An economy employs various resources to produce a variety of goods and services for domestic and world consumption, and provides income for the resources NASEER SHAHZADA

11. The Components of the Macro Economy • An economy can be pictured as a schematic of closely linked sectors – households, businesses, financial institutions, governments, and foreigners • A change in one sector’s transaction with another sector will trigger changes in the entire schematic • The circular flow of income and output diagramshows the income received and payments made by each sector of the economy NASEER SHAHZADA

12. Labor, land, capital, entrepreneurship Inputs for production Goods & Services sold Spending Revenue Two-sectors Circular Flow Wages, rent, interest, profit Income Factor Market Households Financial Sector Business/ Firms Saving Investment Goods & Services bought Product Market NASEER SHAHZADA

13. Three-sectors Circular Flow Factor Market Wages, rent, interest, profit Direct taxes Direct/Indirect taxes Households Government Business/ Firms Govt. expenditure (G) Govt. expenditure (G) Financial Market Saving = Investment (S=I) Product Market Consumption Spending (C) NASEER SHAHZADA

14. Four-sectors Circular Flow External Sector Remittances Receipts from exports Export of services Payments for imports Wages, rent, interest, profit Direct taxes Direct/Indirect taxes Business/ Firms Households Government Govt. expenditure (G) Govt. expenditure (G) Saving = Investment (S=I) Consumption Spending (C) NASEER SHAHZADA

15. The Three Market Arenas • Households, firms, the government, and the rest of the world all interact in the goods-and-services, labor, and money markets. Who create demand and supply in these markets? NASEER SHAHZADA

16. Leakages and Injections • Leakage/Withdrawal: is the amount that is set aside by the households, firms, and governments and is not spent on the domestically produced goods and services over a period of time • They reduce the size of the circular flow Ex: savings, taxes, imports • Injection/Addition: is the amount spent by households and firms in addition to their regular incomes and receipts • Injections increase the size of the circular flow Ex: investments, govt. expenditures, exports NASEER SHAHZADA

17. National Income Accounting National Income – Concepts and Measurement NASEER SHAHZADA

18. Why National Income Accounting? • Provides common standards of measurement of the size of an economy • Helps to evaluate the economic condition of a country and to compare conditions across time and across countries NASEER SHAHZADA

19. National Income – Concepts Different concepts of NI - The Criteria (i) Items included in or excluded from the NI concept (ii) Method of estimating NI Gross Domestic Product (GDP) • The sum of market value of all final goods and services produced in a country during a specified period of time, generally one year. • Also called GDP at market prices(GDPMP) NASEER SHAHZADA

20. National Income – Concepts • Market values of final goods and services are taken • Includes netindirect taxes • Considers only final goods and services • Intermediate goods are excluded to avoid the problem of double-counting • Considers output produced in a year • The year of production, not the year of sale • Inventory as such is not included, but changes in inventory* is considered *Changes in inventory count output that is produced but not sold in a given year NASEER SHAHZADA

21. National Income – Concepts GDP at factor cost (GDPFC)is the sum of all factor payments (wages, interest, rent, profits and depreciation) GDPFC= GDPMP– Net indirect taxes (Net indirect taxes = Indirect taxes – Subsidies) Gross National Product (GNP) The concept of GNP is similar to GDP, but with a significant difference. NASEER SHAHZADA

22. GDP vs. GNP GDP measures the total value of goods and services that are produced within a country’s geographical borders • Example: An Indian MNC in China will actually contribute to Chinese GDP GNP measures the total value of all final goods and services that a country’s citizens produce regardless of where they produce them • Example: Profits of Indian MNCs earn in overseas market is included in India’s GNP GNP = GDP + NFIA (Net Factor Income from Abroad) (NFIA=income earned by residents abroad – income earned by non-residents from our country) NASEER SHAHZADA

23. National Income – Concepts Net National Product (NNP) • GNP included final consumer goods + capital goods • Depreciation:part of capital goods that is used up or consumed in the process of production • Usually covered under Gross Investment (Gross Investment = Net Investment + Replacement Investment/Depreciation) • NNP = GNP – Depreciation • NNPFC = NI (the actual measure of National Income) • Per Capita Income = (NNPFC = NI ) / Total Population NASEER SHAHZADA

24. National Income – Concepts Personal Income (PI) • The sum of all kinds of income received by the individuals from all sources of income • The share of NI actually received by the HH sector Personal Income (PI) = National Income (NI) Minus – Income earned but not received (undistributed corporate profits, social security contributions by the HHs (PF, pension funds), etc.) Plus + Income received but not earned now (transfer payments by business and govt. to HHs, dividend income, etc.) Disposable Personal Income (DPI):the income at the disposal of a person DPI = PI – Direct taxes NASEER SHAHZADA

25. National Income – Concepts Nominal and Real GNP • GNP is estimated at current and constantprices • Nominal GNP:market value of all final goods and services measured in current year prices • Real GNP:market value of all final goods and services measured in the price of a base year (constant prices) • Why do we estimate GNP at constant prices? • How to convert the nominal (current) values into real (constant) values? NASEER SHAHZADA

26. National Income – Concepts GNP Deflator • An index of price changesfor goods and services included in GNP • Used to deflate the nominal GNP to eliminate the price effect to find real GNP for any year Real GNP = Nominal GNP / GNP Deflator GNP Deflator = Nominal GNP / Real GNP x 100 NASEER SHAHZADA

27. National Income Accounting NASEER SHAHZADA

28. National Income Measurement NASEER SHAHZADA

29. Measurement of NI - Methods • A complex process • Product flows (Real flows) and Money flows (factor payments and payments for goods and services) • Three approaches of measuring NI: • Product Approach • Factor Income Approach • Expenditure Approach NASEER SHAHZADA

30. Measurement of NI - Methods The Product Method • Also known as Output Method or Value Added Method • Either by valuing all the final goods and services during a year OR • By aggregating the values imparted (value added) to the intermediate products at each stage of production (to avoid Double Counting) (Value added is the difference between the value of output and the value of the intermediate goods used in the production of that output) NASEER SHAHZADA

31. Measurement of NI - Methods Method • Classification of output under various categories (15 sub-categories are currently used in India) • Computation of gross value of output of each category by multiplying the output of each category by their respective market prices and adding them together • OR by summing up the value added at each stage of production • This gives GDP at market prices NASEER SHAHZADA

32. Measurement of NI - Methods Product Method – An illustration NASEER SHAHZADA

33. Measurement of NI - Methods The Income Method • Also known as factor share method • Sum of the incomes accruing to the basic factors of production used in producing the national products Rent + wages + interests + profits + depreciation = GDP at factor cost Plus net income from abroad = GNP at factor cost NASEER SHAHZADA

34. Measurement of NI - Methods Factor Income Method – An illustration NASEER SHAHZADA

35. Measurement of NI - Methods The Expenditure Method • Measures NI at final expenditure stage • Excluded all expenditure on intermediate goods • Sum of all money spend by individuals, firms and government within a year = GDP at market prices (Y) =) Consumption (C) + Investment (I) + Government Expenditure (G) + Exports and factor income from abroad (X) - Imports and factor income paid abroad(M) Y = C + I + G + X - M NASEER SHAHZADA

36. Measurement of NI - Methods Expenditure Method – An illustration NASEER SHAHZADA

37. GDP Omissions There are three types of omissions in the measurement of GDP 1) Activities that are not part of GDP by definition Transfer payments & gifts received, second-hand sales (except brokerage), increase in share prices, etc.. 2) Items left out because of measurement problem All non-market transactions, unorganized sector, income through illegal means (black money), etc.. 3) Items related to the welfare of the people Quality of life, distribution of income, environmental damages, etc.. NASEER SHAHZADA

38. Problems of measuring GNP • Determining what is ‘final’ and what is not (problem of double counting) • Evaluation of non-marketed goods and services Example: - The goods and services produced and consumed at home, that never enter the market place • The services of housewives, women at HHs. • Many economic activities by unorganized sector • Black money, black market items, income from illegal activities and professions, etc. • Does not consider certain factors affecting people’s welfare (like income distribution, environmental damages) NASEER SHAHZADA

39. Exercise - 1 The following information is extracted from the National Income Accounts of an economy for the year 2008-09 Compute (a) the value of depreciation; (b) the value of net factor income from abroad; (c) the value of subsidies; (d) the value of NDP at factor cost; (e) the value of national income; (f) the value of personal income; and (g) the value of personal disposable income NASEER SHAHZADA

40. Exercise - 2 The following information is extracted from the National Income Accounts of an economy for the year 2008-09 Compute (a) the value of GNP at market price; (b) the value of NNP at market price; (c) the value of NDP at market prices; (d) the value of NDP at factor cost; (e) the value of GNP at factor cost; and (f) the value of personal disposable income NASEER SHAHZADA

41. References • Chapter 4 & 5, ‘Principles of Macroeconomics’ by Michael Melvin and William Boyes . • Chapters 1 & 2, ‘Macroeconomic Policy Environment’ by Shyamal Roy. • Chapter 2, ‘Macroeconomics’ by R. Dornbusch, S.Fischer, and R. Startz. • Chapter 2. Prof. A. HamidShahid • Chapter 2. Abel. Ben. bernanke NASEER SHAHZADA