Macroeconomics

WHAT IS MACROECONOMICS?

Macroeconomics (from the Greek prefix makro- meaning "large" and economics) is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole rather than individual markets. This includes national, regional, and global economies.

Macroeconomists study aggregated indicators such as GDP, unemployment rates, national income, price indices, and the interrelations among the different sectors of the economy to better understand how the whole economy functions. Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade and international finance. In contrast, microeconomics is primarily focused on the actions of individual agents, such as firms and consumers, and how their behavior determines prices and quantities in specific markets.

Basic macroeconomic concepts:

Macroeconomics encompasses a variety of concepts and variables, but there are three central topics for macroeconomic research. Macroeconomic theories usually relate the phenomena of output, unemployment, and inflation. Outside of macroeconomic theory, these topics are also important to all economic agents including workers, consumers, and producers.

Output and income

National output is the total amount of everything a country produces in a given period of time. Everything that is produced and sold generates an equal amount of income. Therefore, output and income are usually considered equivalent and the two terms are often used interchangeably. Output can be measured as total income, or it can be viewed from the production side and measured as the total value of final goods and services or the sum of all value added in the economy.

Unemployment

The amount of unemployment in an economy is measured by the unemployment rate, i.e. the percentage of workers without jobs in the labor force. The unemployment rate in the labor force only includes workers actively looking for jobs. People who are retired, pursuing education, or discouraged from seeking work by a lack of job prospects are excluded.

Inflation and deflation

A general price increase across the entire economy is called inflation. When prices decrease, there is deflation. Economists measure these changes in prices with price indexes. Inflation can occur when an economy becomes overheated and grows too quickly. Similarly, a declining economy can lead to deflation.

TYPES OF INCOME

National Income:

The total amount of income accruing to a country from economic activities in a year’s time is known as national income. It includes payments made to all resources in the form of wages, interest, rent and profits. In other words, national income means the total value of goods and services produced annually in a country.

Concept of National Income: GDP, NDP, GNP, NNP

1. GDP (Gross Domestic Product)

The value of final goods and services produced inside the boundary of nation during one year.

GDP= Value of gross domestic output- value of intermediate consumption

2.NDP (Net Domestic Product)

It is the net form of GDP.

NDP= GDP – Depreciation

Depreciation is a decrease in an asset’s value caused by unfavorable market conditions.

3. GNP (Gross National Product)

Gross national product (GNP) is an estimate of total value of all the final products and services produced in a given period by the means of production owned by a country's residents

It is the GDP of a country added with its income from abroad.

GNP= GDP + Income from Abroad

Or,

GNP = GDP – Income from abroad

Income from abroad= trade balance + interest on External Loans+ Private Remittance

Private remittance= inflows and outflows on account of private transfer e.g. NRI

Trade balance = net outcome at the year-end of the total import and export.

Interest on external loans= balance of the inflow of interest payment (on money lend out of economy) – outflow of interest payment (on the money borrowed by the economy)

4. NNP or Net National Product

NNP= GNP – Depreciation

Or,

NNP= GDP+ income from abroad- depreciation

3 Important Methods for Measuring National Income

1.Income Method:

Under this method, national income is measured as flow of factor incomes. There are four factors of production labor, capital, land and entrepreneurship. Labor get wages and salaries, capital gets interest, land gets rent, entrepreneurship gets profit as their remuneration

Precautions For Income Method: While estimating national income through income method, the following precautions should be undertaken.

(i) Transfer payments such as gifts, donations, scholarships, and indirect taxes should not be included in the estimation of national income.

(ii) Illegal money earned through smuggling and gambling should not be included.

(iii) Windfall gains such as prizes won, lotteries etc. is not be included in the estimation of national income.

(iv) Receipts from the sale of financial assets such as shares, bonds should not be included in measuring national income, as they are not related to generation of income in the current year production of goods.

2.Product Method:

In this method national income is measured as a flow of goods and services. We calculate money value of all final goods and services produced in an economic during a year. Final goods here refer to those goods, which are directly consumed and not used in further production on process.

Precautions For Product Method: There are certain precautions, which are to be taken to avoid miscalculation of national income using this method. These in brief are:

(i) Problem of double counting: When we add up the value of output of various sectors, we should be careful to avoid double counting. This pitfall can be avoided by either counting (he final value of the output or by including the extra value that each firm adds to an item.

(ii) Value addition in particular year: While calculating national income, the values of goods added in the particular year in question are added up. The values that had previously been added to the stocks of raw material and goods have to be ignored. GDP thus includes only those goods, and services that are newly produced within the current period.

(iii) Stock appreciation: Stock appreciation, if any, must be deducted from value added. This is necessary as there is no real increase in output.

(iv) Production for self-consumption: The production of goods for self-consumption should be counted while measuring national income. In this method, the production of goods for self-consumption should be valued at the prevailing market prices.

3.Expendeture Method:

In this method national income is measured as a flow of expenditure. GDP is sum-total of private consumption expenditure. Government consumption expenditure gross capital formation (Government and Private) and net exports (Export-Import)

Precautions For Expenditure Method: While estimating national income through expenditure method, the following precautions should be taken:

(i) The expenditure on second hand goods should not be included, as they do not contribute to the current year's production of goods.

(ii) Similarly, expenditure on purchase of old shares and bonds is not included, as these also do not represent expenditure on currently produced goods and services.

(iii) Expenditure on transfer payments by government such as unemployment benefit, old age pensions, interest on public debt should also not be included because no productive service is rendered in exchange by recipients of these payments.

Personal Income:

Personal income refers to all of the income collectively received by all of the individuals or households in a country. Personal income includes compensation from a number of sources including salaries, wages and bonuses received from employment or self-employment; dividends and distributions received from investments; rental receipts from real estate investments and profit-sharing from businesses.

Disposal Income:

Disposable income, also known as disposable personal income (DPI), is the amount of money that households have available for spending and saving after income taxes has been accounted for. Disposable personal income is often monitored as one of the many key economic indicators used to gauge the overall state of the economy.

CIRCULAR FLOW OF INCOME

The circular flow of income or circular flow is a model of the economy in which the major exchanges are represented as flows of money, goods and services, etc. between economic agents. The flows of money and goods exchanges in a closed circuit and correspond in value, but run in the opposite direction. The circular flow analysis is the basis of national accounts and hence of macroeconomics.

Fig: Basic Diagram of the circular flow of income

Two sector model

In the basic circular flow of income, or two sector circular flow of income model, the state of equilibrium is defined as a situation in which there is no tendency for the levels of income (Y), expenditure (E) and output (O) to change, that is:

Y = E = O

Fig: Two sector circular flow of income

This means that the expenditure of buyers (households) becomes income for sellers (firms). The firms then spend this income on factors of production such as labor, capital and raw materials, "transferring" their income to the factor owners. The factor owners spend this income on goods, which leads to a circular flow of income.

This basic circular flow of income model consists of six assumptions:

1) The economy consists of two sectors: households and firms.

2) Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S).

3) All output (O) produced by firms is purchased by households through their expenditure (E).

4) There is no financial sector.

5) There is no government sector.

6) There is no foreign sector

Three sector model:

It includes household sector, producing sector and government sector. It will study a

circular flow income in these sectors excluding rest of the world i.e. closed economy income. Here flows from household sector and producing sector to government sector are in the form of taxes. The income received from the government sector flows to producing and household sector in the form of payments for government purchases of goods and services as well as payment of subsides and transfer payments. Every payment has a receipt in response of it by which aggregate expenditure of an economy becomes identical to aggregate income and makes this circular flow unending.

INFLATION

What is ‘Inflation’?

Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.

Different types of Inflation

Demand-pull Inflation

Demand-pull Inflation is asserted to arise when aggregate demand in an economy outpaces aggregate supply. This is commonly described as "too much money chasing too few goods". More accurately, it should be described as involving "too much money spent chasing too few goods", since only money that is spent on goods and services can cause inflation.

Fig: Demand-pull Inflation

Cost Push Inflation

Cost-push inflation occurs when we experience rising prices due to higher costs of production and higher costs of raw materials. Cost-push inflation is determined by supply side factors (cost-push inflation is different to demand-pull inflation which occurs due to aggregate demand growing faster than aggregate supply)

Fig: Cost-push Inflation

What is Stagflation?

Stagflation refers to economic condition where economic growth is very slow or stagnant and prices are rising. The term stagflation was coined by British politician Iain Macleod, who used the phrase in his speech to parliament in 1965, when he said: “We now have the worst of both worlds - not just inflation on the one side or stagnation on the other. We have a sort of ‘stagflation’ situation.” The side effects of stagflation are increase in unemployment- accompanied by a rise in prices, or inflation. Stagflation occurs when the economy isn't growing but prices are going up. At international level, this happened during mid 1970s, when world oil prices rose dramatically, fuelling sharp inflation in developed countries.

What is Hyperinflation?

Hyperinflation is a situation where the price increases are too sharp. Hyperinflation often occurs when there is a large increase in the money supply, which is not supported by growth in Gross Domestic Product (GDP). Such a situation results in an imbalance in the supply and demand for the money. In this this remains unchecked; it results into sharp increase in prices and depreciation of the domestic currency.

How to Control Inflation:

Inflation can be reduced by policies that slow down the growth of AD and/or boost the rate of growth of aggregate supply (AS)

Fiscal policy:

Controlling aggregate demand is important if inflation is to be controlled. If the government believes that AD is too high, it may choose to ‘tighten fiscal policy’ by reducing its own spending on public and merit goods or welfare payments

It can choose to raise direct taxes, leading to a reduction in real disposable income

The consequence may be that demand and output are lower which has a negative effect on jobs and real economic growth in the short-term

Monetary policy:

A ‘tightening of monetary policy’ involves the central bank introducing a period of higher interest rates to reduce consumer and investment spending

Higher interest rates may cause the exchange rate to appreciate in value bringing about a fall in the cost of imported goods and services and also a fall in demand for exports (X)

Direct controls:

• A government might choose to introduce direct controls on some prices and wages

1) Public sector pay awards – the annual increase in government sector pay might be tightly controlled or even froze (this means a real wage decrease).

2) The prices of some utilities such as water bills are subject to regulatory control – if the price-capping regime changes, this can have a short-term effect on the rate of inflation.

UNEMPLOYMENT

What is ‘Unemployment’?

Unemployment is a phenomenon that occurs when a person who is actively searching for employment is unable to find work. Unemployment is often used as a measure of the health of the economy. The most frequently measure of unemployment is the unemployment rate, which is the number of unemployed people divided by the number of people in the labor force.

BREAKING DOWN 'Unemployment'

While the definition of unemployment is clear, economists divide unemployment into many different categories. The broadest two categories of unemployment are voluntary and involuntary unemployment. When unemployment is voluntary, it means that a person has left his job willingly in search of other employment. When it is involuntary, it means that a person has been fired or laid off and now must look for another job. Digging deeper, unemployment, both voluntary and involuntary, is broken down into six types.

Frictional Unemployment

Frictional unemployment arises when a person is in-between jobs. After a person leaves a company, it naturally takes time to find another job, making this type of unemployment short-lived. It is also the least problematic from an economic standpoint. Arizona, for example, has faced rising frictional unemployment in May of 2016, due to the fact that unemployment has been historically low for the state. Arizona citizens feel confident leaving their jobs with no safety net in search of better employment.

Cyclical Unemployment

Cyclical unemployment comes around due to the business cycle itself. Cyclical unemployment rises during recessionary periods and declines during periods of economic growth. For example, the number of weekly jobless claims in the United States has slowed in the month of June, as oil prices begin to rise and the economy starts to stabilize, adding jobs to the market.

Structural Unemployment

Structural unemployment comes about through technological advances, when people lose their jobs because their skills are outdated. Illinois, for example, after seeing increased unemployment rates in May of 2016, seeks to implement "structural reforms" that will give people new skills and therefore more job opportunities.

Seasonal Unemployment

The Seasonal Unemployment means the demand for a specific kind of work and workers change with the change in the season. Simply, the period when the demand for the manpower as well as the capital stock reduces because of a decreased demand in the economy at a particular point in time in a year causes the seasonal unemployment.

The seasonal unemployment is prevalent in those industries, which are engaged in seasonal production activities. Such as agricultural industry wherein the demand for workers is more during harvesting than is required in other months in a year. Similarly, in the case of a hotel industry, the demand for the catering staff as well as the housekeeping staff is more during the peak season as compared to the demand in the off-season.

Technological unemployment

Technological unemployment is the loss of jobs caused by technological change. Such change typically includes the introduction of laborsaving machines or more efficient processes. Just as horses employed, as prime movers were gradually made obsolete by the automobile, humans' jobs have also been affected throughout modern history.

Disguised Unemployment

Disguised Unemployment is a kind of unemployment in which there are people who are visibly employed but are actually unemployed. This situation is also known as Hidden Unemployment. In such a situation more people are engaged in a work than required.

For example:

1. In rural areas, this type of unemployment is generally found in agricultural sector like - in a family of 9 people all are engaged in the same agricultural plot. But if 4 people are with drawn from it there will be no reduction in output. So, these 4 people are actually disguisedly employed.

2. In urban areas, this type of unemployment can be seen mostly in service sectors such as in a family all members are engaged in one petty shop or a small business which can be managed by less number of persons.

Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts in a particular country or socio-economic context, or is easily converted to such a form. Money is any acceptable commodity that serves as a medium of exchange and a store of value

Money should be

1.Durable – needs to withstand everyday wear and tear

2.Portable – needs to be easily carried around

3.Widely accepted as a means of payment – everyone in the country must agree to accept it as a medium of exchange

4.Stable in value – must be worth the same over time

5. Easily divisible – 100 paisa= 1.00 taka

6. Difficult to counterfeit – maintains confidence in the currency

The following points highlight the top six functions of money.

(1). A Medium of Exchange: The only alternative to using money is to go back to the barter system. However, as a system of exchange the barter system would be highly impracticable today. For example, if the baker who supplied the green-grocer with bread had to take payment in onions and carrots, he may either not like these foodstuff or he may have sufficient stocks of them.

(2). A Measure of Value: Under the barter system, it is very difficult to measure the value of goods. For example, a horse may be valued as worth five cows or 100 quintals of wheat, or a Maruti car may be equivalent to 10 two- wheelers. Thus one of the disadvantages of the barter system is that any commodity or service has a series of exchange values. Money is the measuring rod of everything. By acting as a common denominator it permits everything to be priced, that is, valued in terms of money. Thus, people are enabled to compare different prices and thus see the relative values of different goods and services. This serves two basic purposes: (1) Households (consumers) can plan their expenditure and

(2) Business people can keep records of income and costs in order to work out their profit and loss figures.

(3). A Store of Value (Purchasing Power):

A major disadvantage of using commodities — such as wheat or salt or even animals like horses or cows — as money is that after a time they deteriorate and lose economic value. They are, thus, not at all satisfactory as a means of storing wealth. To realize the problems of saving in a barter economy let us consider a farmer. He wanted to save some wheat each week for future consumption. But this would be of no use to him in his old age because the ‘savings’ would have gone off.

Again, if a coal miner wanted to set aside a certain amount of coal each week for the same purpose, he would have problems of finding enough storage space for all his coal. By using money, such problems can be overcome and people are able to save for the future. Modern form of money (such as coins, notes and bank deposits) permits people to save their surplus income.

(4). The Basis of Credit:

Money facilitates loans. Borrowers can use money to obtain goods and services when they are needed most. A newly married couple, for example, would need a lot of money to completely furnish a house at once. They are not required to wait for, say ten years, so as to be able to save enough money to buy costly items like cars, refrigerators, T.V. sets, etc.

(5). A Unit of Account:

An attribute of money is that it is used as a unit of account. The implication is that money is used to measure and record financial transactions as also the value of goods or services produced in a country over time. The money value of goods and services produced in an economy in an accounting year is called gross national product. According to J. R. Hicks, gross national product is a collection of goods and services reduced to a common basis by being measured in terms of money.

(6). A Standard of Postponed Payment:

This is an extension of the first function. Here again money is used as a medium of exchange, but this time the payment is spread over a period of time. Thus, when goods are bought on hire purchase, they are given to the buyer upon payment of a deposit, and he then pays the remaining amount in a number of installments.

The quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold. According to QTM, if the amount of money in an economy doubles, price levels also double, causing inflation (the percentage rate at which the level of prices is rising in an economy). The consumer therefore pays twice as much for the same amount of the good or service.

Another way to understand this theory is to recognize that money is like any other commodity: increases in its supply decrease marginal value (the buying capacity of one unit of currency). So an increase in money supply causes prices to rise (inflation) as they compensate for the decrease in money's marginal value.

The quantity theory of money states that the quantity of money is the main determinant of the price level or the value of money. Any change in the quantity of money produces an exactly proportionate change in the price level.

Proof:

In the words of Irving Fisher, “Other things remaining unchanged, as the quantity of money in circulation increases, the price level also increases in direct proportion and the value of money decreases and vice versa.” If the quantity of money is doubled, the price level will also double and the value of money will be one half. On the other hand, if one half reduces the quantity of money, one half will also reduce the price level and the value of money will be twice.

Fisher has explained his theory in terms of his equation of exchange:

PT=MV+ M’ V’

Where P = price level, or 1 IP = the value of money;

M = the total quantity of legal tender money;

V = the velocity of circulation of M;

M’ – the total quantity of credit money;

V’ = the velocity of circulation of M

T = the total amount of goods and services exchanged for money or transactions performed by money.

This equation equates the demand for money (PT) to supply of money (MV=M’V). The total volume of transactions multiplied by the price level (PT) represents the demand for money.

According to Fisher, PT is SPQ. In other words, price level (P) multiplied by quantity bought (Q) by the community (S) gives the total demand for money. This equals the total supply of money in the community consisting of the quantity of actual money M and its velocity of circulation V plus the total quantity of credit money M’ and its velocity of circulation V’. Thus the total value of purchases (PT) in a year is measured by MV+M’V’. Thus the equation of exchange is PT=MV+M’V’. In order to find out the effect of the quantity of money on the price level or the value of money, we write the equation as

P= MV+M’V’

Fisher points out the price level (P) (M+M’) provided the volume of tra remain unchanged. The truth of this proposition is evident from the fact that if M and M’ are doubled, while V, V and T remain constant, P is also doubled, but the value of money (1/P) is reduced to half.

Fisher’s quantity theory of money is explained with the help of Figure 65.1. (A) and (B). Panel A of the figure shows the effect of changes in the quantity of money on the price level. To begin with, when the quantity of money is M, the price level is P.

When the quantity of money is doubled to M₂, the price level is also doubled to P₂. Further, when the quantity of money is increased four-fold to M₄, the price level also increases by four times to P₄. This relationship is expressed by the curve P = f (M) from the origin at 45°.

In panel В of the figure, the inverse relation between the quantity of money and the value of money is depicted where the value of money is taken on the vertical axis. When the quantity of money is M₁ the value of money is HP. But with the doubling of the quantity of money to M₂, the value of money becomes one-half of what it was before, 1/P₂. And with the quantity of money increasing by four-fold to M₄, the value of money is reduced by 1/P₄. This inverse relationship between the quantity of money and the value of money is shown by downward sloping curve 1/P = f (M).