MACRO ECO

WHAT IS MACRO ECO?

Micro eco deals with behaviour of individuals. Macro eco is concerned with the behaviour of aggregates. Micro economists generally conclude that markets work well. Macro economists observe that important prices in the economy often seem sticky. Micro eco foundation for macro eco.

THE ROOTS OF MACRO ECONOMICS Classical Models Classical or Market clearing Model Recessions were self-correcting. The Keynesian Revolution Employment is determined by aggregate demand for goods and services. Government intervention to affect the level of output and employment.

MACRO ECONOMIC CONCERS Growth Business Cycles Inflation Unemployment GOVERNMENT IN THE MACROECONOM Three kinds of policy that the governments use to influence the macro economy are: Fiscal Policy--tax and expenditure decisions. Monetary Policy Central banks to determine the quantity of money in the economy. Growth or Supply-side policies Most economists opine the govt., policy should be to stimulate the aggregate supply, i.e., to stimulate the output and income.

THE COMPONENTS OF THE MACROECO Macro economics focuses on four groups: 1.Households and (2) Firms, which together compose the private sector, 3. The government (public sector), and 4. The rest of the world (the international sector). I. THE CIRCULAR FLOW CONCEPT II. THE THREE MARKET ARENAS: 1. Goods-and-services market. 2. Labour market. 3. Money/Financial market a critical variable in the money market is the interest rate.

NATIONAL INCOME ACCOUNTING NI is the most comprehensive measure of the level of the aggregate economic activity in an economy. Def: NI is the aggregate of money value of the annual flow of final goods and services in the national economy during a given period. NI is also called National Product. The flow of NI begins when prodn units combine capital and labour and turn out goods and services. This is called GNP. GNP.. Value added(intermediate good). Prodn units distribute money incomes in the form of wages, rent, interest and profit which is called GNI.

We have three kinds of NI estimates: NI as net aggregate output NI as sum of distributive shares NI as aggregate value of final products. APPROACHES TO MEASUREMENT OF NI Measurement of NI involves the measurement of the size of the circular flow. Prodn creates income, income generates spending and spending induces prodn. So, NI can be measured either at the Prodn stage, Product approach, or Income approach, or Expenditure approach. These three approaches yield identical NI results.

The concepts of GDP, GNP,NNP,GNI, Nominal and Real GDP,etc., GDP: GDP is the total market value of a countrys output. GDP may be calculated by Expenditure Approach or Income Approach. Under Expenditure Approach GDP= C+I+G+(EX--IM) GNP: GNP is the total market value of all final goods and services produced in an economy including net factor income from abroad during a period of time. Under Expenditure approach GNP=C+Ig+G+(EXIM)+NFIA. Under Income approach GNP= Compensation of Employees+Operating surplus+Mixed income of self employed+Net Indirect Taxes+Consumption of Fixed Capital+NFIA.

NNP (Net National Product): NNP= GNP-- Depreciation. NATIONAL INCOME (NI): NI is the total of all income payments received by the factors of production. NI= NNP+Indirect biz taxes subsidies. NI is the sum of eight income items, viz., Compensation of employees+ Proprietors income + Rental Income + Corporate profits + Net interest + Indirect taxes less subsidies + Net biz transfer payments + Surplus of govt. enterprises.

NOMINAL Vs. REAL GDP Nominal GDP= GDP measured in current money value, i.e., all components of GDP valued at current values. Nominal GDP may be misleading when GDPs of two or more years are compared. Real GDP: Nominal GDP adjusted for price changes is called Real GDP.

PERSONAL INCOME NI does not represent the total income that individuals actually receive. Personal Income= NNP at factor cost Undistributed profits Corporate taxes + Transfer payments. DISPOSABLE INCOME Disposable Income = Personal Income Personal taxes. PI = DI + T DI = C + S So, PI = C+S+T.

Session - 10
LONG-RUN AND SHORT-RUN CONCERN GROWTH, PRODUCTIVITY, UNEMPLOY-MENT AND INFLATION GROWTH AND PRODUCTIVITY: Output growth Per capita output growth Output per worker is not the same as output per person. Output per worker is larger than output per person, and it is called productivity. Capital Labour and Capital and output quality of labour and capital.

UNEMPLOYMENT Recession (symptom-unemployment) Depression Measuring Unemployment and its cost Labour force = employed + unemployed. Unemployment rate = Unemployed/ employed+unemployed. The cost of unemployment can be categorised into three types: Frictional unemployment Structural unemployment Cyclical unemployment

THE BENEFITS OF RECESSION It slows down the inflation Survivor is the fittest Decreases imports and improves the nations BoP. INFLATION Inflation is an increase in the overall price level. Deflation is opposite of this. Some people lose and some gain from inflation. Inflation over a long period is referred to as sustained inflation.

THE COSTS OF INFLATION It cuts into peoples purchasing power. Inflation changes the Distribution of Income: The people living on fixed incomes are severely affected. Effects on Debtors and Creditors: Real interest rate. Increased Investment Risk and Slower Economic Growth.

11: AGGREGATE EXPENDITURE AND EQUILIBRIUM OUTPUT

Consumption & Savings Functions, The Keynesian Cross & The Multiplier and Its Significance: Three main concerns of macroeconomists are: the level of GDP, the overall price level, and the level of employment. AGGR. OUTPUT AND AGGR. INCOME (Y) Aggr. Output: The total quantity of goods and services produced (or supplied) in an economy in a given period, is referred to as aggregate output.

Aggr. Income: The total income received by all factors of production in a given period. Aggr. Output (Income) Y: A combined term used to denote the exact equality between aggr. Output and aggr. Income. Y= GDP = Aggr. Output (Income) Output includes the production of services, consumer goods, and investment goods. Note: GDP can be measured by Expenditure method or Income method. Aggr. output means Aggr. Expenditure, i.e., GDP.

When output (expenditure) increases, additional income (by way of wage, inte-rest, profits, etc.,) is generated, and vice-versa. INCOME, CONSUMPTION, AND SAVINGS (Y, C, and S) Assuming a simple world with no govt. and a closed economy, a household can only buy goods and services (consumption) and/or save. Saving = Income Consumption That is, S = Y C.

SPENDING BEHAVIOUR: Macroeconomics is the study of behaviour (of households and firms) i.e., spending by households (consumption), and spending by firms (investments, which is nothing but the savings of the households) The amount of aggr. Consumption in the economy depends on a no. of factors/det-erminants. Some of them are: 1. Household income 2. Household wealth 3. Interest rates 4. Households expectations about the future. These four factors work together to determine the spending and saving behavior of households.

Keynes, in his book General Theory, argued that people with more income tend to consume more than people with less income. The relationship between consumption and income is called a Consumption Function. (Diagram on: Consumption fn. for a household) the curve intersect C axis above zero, which means that even at an income of zero, consumption is +ve.

 Macro economics is concerned with aggr. Consumption. +ve relationship exists between aggr. Consumption (C) and aggr. Income (Y), same as in case of individual household (this is the micro economic foundation to macro economics). Assuming aggr. Consumption lie along a st. line, the following can be written: C = a + bY Where, Y= aggr. Output (income) C = aggr. Consuption a = Constant (consumption even at zero income) b = Slope of the line = ^C / ^Y. (Diagram on: An aggregate consumption fn) the upward slope indicates that higher levels of income lead to higher levels of consumption spending.

 MPC (Marginal Propensity to Consume): MPC = ^C / ^Y. MPS (Marginal Propensity to Save): MPS is the fraction of a change in income that is saved. MPS = ^S / ^Y. MPC + MPS = 1. Because C is the aggr. Consumption and Y is the aggr. Income, it implies that the MPC is societys MPC out of National Income and that the MPS is societys MPS out of National income. Solve Problem on C and S.

SAVINGS (S): Where C fn is above the 45 line, C>Y and so S = -ve. Where C fn crosses the 45 line, C = Y and so, S = 0. Where C fn is below the 45 line, C<Y, and so S = +ve. Note: Slope of the saving fn is ^S / ^Y, which is equal to MPS.

PLANNED INVESTMENT (I): Investment by whom? Investment by firms. Aggr. Savings of households = Aggr. Investments by firms. Investment in what? Investment in capital stock, i.e., investment in something (assets) that are used to generate revenue in future. Inventory (stock) is part of investment ( stock includes inputs like raw materials, work-in-progress and finished products or final products). Such investment in stock is part of working capital of the firm. Working capital is part of capital of the firm. Note: The assumption is that Planned Investments (I) fixed. It does not change when income changes.

PLANNED AGGR. EXPENDITURE (AE) Pl. AE = Consumption + Planned Investment AE = C + I. EQUILIBRIUM AGGR. OUTPUT (INCOME) How an economy achieves equilibrium? At equilibrium, there is no tendency for change. For ex: in micro economics, price does not change at equilibrium demand and supply.

 In macro economics, equilibrium in the goods market is that point at which Planned AE = Aggr. Output (Aggreegate Income). Aggr. Output = Y Planned Aggr. Exp = AE = C + I. So, Equilibrium: Y = AE, or Y = C + I. This equilibrium is true only if Planned Investment Actual Investment are equal. Suppose Aggr. Output (Y) is greater than Planned AE: Y>C+I When output is greater than planned spending, there is unplanned inventory investment. Firms planned to sell more of their goods than they actually sold for the year. Suppose, AE > Y, then ?

THE MULTIPLIER How does the equilibrium level output change when planned investment changes? Output changes by a multiple of the change in planned investment. This multiple is called the multiplier. The multiplier is defined as the ratio of the change in the equilibrium level of output to a change in some independent (autonomous) variable. [ an autonomous variable is a variable that is assumed not to depend on the state of the economy]. In this case, Planned Investment (I) is considered as an independent /autonomous variable.

 Example: Planned Investment is Rs.10,000 Cr. Suppose, I increases to Rs.20,000 Cr; an increase in I of Rs.10,000 Cr will cause a disequilibrium with planned AE greater than aggr. output by Rs.10,000 Cr. Firms immediately see unplanned reductions in their stocks and, as a result, they begin to increase output. Then how to re-establish equilibrium?

 Why doesnt the multiplier process go on forever?. The answer is Only a fraction of increased income is consumed (spent) in each round. Succes-sive increases in income become smaller and smaller in each round of multiplier process, due to leakage as saving, until equilibrium is restored. The size of the multiplier depends on the slope (MPC) of the planned AE line. The steeper the slope of this line is, the greater the change in output (income, Y) for a given change in investment.

THE MULTIPLIER EQUATION There is a way to determine the size of the multiplier without using graphic analysis. When the I increases, AE increases, and AE>Y. So, there is an unplanned inventory reduction, and firms respond by increasing output (income, Y). This leads to a second round of increases and so on. The equilibrium can be restored on when S=I.

 As income (output,Y) rises, C rises and S also rises. The increase in income required to restore equilibrium must be a multiple of the increase in planned investment. MPS = ^S / ^Y. Because ^S must be equal to ^I for equilibrium to be restored, we can substitute ^I for ^S and solve.

MPS = ^I / ^Y Therefore, ^Y = ^I / MPS. Or ^Y = ^I X 1/MPS. So, ^Y is equal to 1/MPS times of ^I. Therefore, the Multiplier is 1/MPS. Also, MPS + MPC = 1. So, MPS = 1 MPC. Therefore, the Multiplier is 1 / 1--MPC.

Session 12: THE GOVT. AND THE FISCAL POLICY

Govt. can effect the macro economy through two policy channels: FISCAL POLICY and MONETARY POLICY. Fiscal Policy refers to the govt.s spending and taxing behaviour, i.e., its budget policy. Fiscal policy is generally divided into three categories: 1. Policies concerning govt. purchases of goods and services, 2. Polices concerning taxes, and 3. Policies concerning transfer payments to households. Monetary policy refers to the behaviour of the nations central bank, concerning nations money supply.

GOVERNMENT AND THE MACRO ECONOMY While analysing consumption function of households ( in Session 11, i.e., AE and Equilibrium Output), the existence of govt. and tax was ignored and the assumption made was that households had only two options, i.e., Consumption or Saving. But when the role of govt. is taken into account, we see that as income (output, Y) flows towards households, the govt. collects net taxes (taxes less transfer payments) from households. So, the income ultimately left with households is called disposable of after-tax income (Yd).

 Yd = Y T Yd = C + S Then, Y T = C + S Adding T on both sides Y = C + S + T. Because govt. spends money on goods and services, planned AE is the sum of C by households, planned investments by firms (I), and govt. purchases of goods and services (G). So, AE = C + I + G. A govt.s budget deficit is the difference between what it spends (G) and what it collects in taxes (T) in a given period, and vice versa.

TAXES AND THE CONSUMPTION fn. In case of households, where the govt. and taxes were assumed to be absent, aggr. Consumption (C) depends on aggr. Income (output, Y). The Consumption fn was: C = a + bY. Since govt. is added to the economy, the above C fn needs to be modified. The disposable income (Yd) should be substituted to Y: C = a + bYd. = a + b(Y T).

EQUILIBRIUM OUTPUT In an economy, where there is no govt., equilibrium occurs where, Y = AE. But, when govt. is added to the economy, govt. also consumes goods and services. So, C fn is Equilibrium condition: Y = C + I + G. The situation of the economy, without govt., applies here also: If Output (income,Y) exceeds planned AE, i.e., C+I+G, there will be an unplanned increase in inventories, i.e., actual investment exceeds planned investments, and vice versa.

The Leakages/Injections Approach to Equilibrium: The govt. takes out net taxes (T) from the flow of income a leakage. Households save (S) some of their income a leakage from the flow of income. The planned spending injections are: Govt. purchases (G) and planned invest-ment (I). If S + T = I + G, there is equilibrium. Therefore, Leakages/injections approach to equilibrium = S + T = I + G. Even if we use the original Y = AE, we can obtain the above equilibrium. Y = AE, C+S+T=C+I+G So, S + T = I + G.

FISCAL POLICY & MULTIPLIER EFFECTS Govt. can control G and T. So, govt. is able to change the equilibrium level of output (income, Y). Following THREE multipliers work in fiscal policy of the govt.: I. Govt. Spending multiplier II. Tax multiplier III. Balanced Budget multiplier.

I. Govt. Spending Multiplier: Suppose, presently there is equilibrium in the economy but there is a significant level of unemployment also. So, the govt. wants to increase output (Y) without changing the present tax structure (T). So, the only option to the govt. is to spend for purchases of goods and services (G). So, the govt. must borrow. Therefore, the borrowing = G T. The increased govt. spending will throw the economy out of equilibrium.

When the govt. spends, AE > Y (output). Inventories will be lower than planned, and so firms have to increase output. An increase in G has the same impact on the equilibrium level of output/income (Y) as an increase in I. So, the equation of G multiplier is the same as the equation for the multiplier for a change in planned Investment (^I). So, G multiplier = 1 / MPS. (Here, autonomous variable is G instead of I).

THE TAX MULTIPLIER A tax cut increases disposable income (Yd) which is likely to increase AE, which will lead to decrease in inventories, which, in turn, will lead to a rise in output (income, Y), causing a second-round increase in C and so on. The tax multiplier the ration of change in the equilibrium level of output (Y) to a change in taxes differ from G multiplier because: W hen G increases, there is direct impact on AE, i.e., AE increases as much as increase in G. When taxes are cut, there is no direct impact on AE. Taxes only have effect on households Yd, which influences households C.

When taxes are cut, the initial increase in planned AE is only MPC times the change in taxes*. Because a tax decrease will cause an increase in C and output (Y, income), and a tax increase will cause a reduction in C (and Y), there is inverse ratio. So, the tax multiplier is a ve multiplier. Tax multiplier = -- *MPC X 1/ MPS = -- MPC / MPS.

THE BALANCED BUDGET MULTIPLIER If the govt. decides to pay for its extra-spending by increasing taxes by the same amount, the govt.s budget deficit will not change. The govt.s extra-spending increases output, i.e., income,Y) proportionately. But the C by households falls by MPC times the tax amount. The net result in the beginning is that govt. spending rises, say, Rs.10,000 cr. (output, Y increases by same amount) but consumption spending by households (C) falls by Rs.10,000 cr. X MPC. AE increases by Rs.10,000 cr Rs.10,000 X MPC. Balanced budget multiplier = 1.

economy? What is money? The forces that determine the supply of money. How banks create money? Central bank of the nation. MONEY Money is anything that is generally accepted as a medium of exchange. Money is a means of payment, a store of value, and a unit of account.

Session 13: THE CENTRAL BANK, MONEY SUPPLY AND THE RESERVE SYSTEM How money market works in the macro

A means of payment / medium of exchange: Money is vital to the working of a market economy. The alternative to a monetary economy is barter. A store of value: Money is an asset that can be used to trans-port purchasing power from one time period to another. It comes in convenient denominations and is portable. Because money is also a means of payment, it is easily exchanged for goods at all times. The main disadvantage of money a store of value is that the value of money falls when the prices of goods and services rise.

A UNIT OF ACCOUNT: Money, as a standard unit, provides a consistent way of quoting prices. Commodity and Fiat Monies: Commodity money Example: Gold. Fiat money token money (currency bills and coins). Fiat money is intrinsically worthless. The govt. declares its paper money to be legal tender. The govt. declares that its money must be accepted in settlement of debts. Govt. does this by fiat i.e., unquestionable order. Hence, it is known as fiat money.

 The govt. promises the public that it will not print excess paper money that looses its value. Expanding the supply of currency so rapidly that it looses its value has been a problem throughout history and is known as currency debasement.

MEASURING THE SUPPLY OF MONEY The two most common measures of money are: 1) M1: Transactions money, and M2: Broad money. M1: Transactions money: Money that can be directly used for transact-ions are M1. This includes currency bills and coins held outside of banks, demand deposits,travellers cheques and other chequable deposits. M1 is the most widely used measure of the money supply.

M2: Broad money: If we add near monies close substitutes to M1, we get M2, called broad money because it includes not-quite-monies such as savings accounts, money market accounts, and other near monies. Beyond M2: Many financial instruments resemble money and so, some economists advocate to include them as part of money supply, e.g., credit cards the credits already availed under credit cards constitute a part of money supply.

THE CREATION OF MONEY Banks are required to keep a portion of their deposits either in cash or with central bank (Reserve Bank), for various reasons. Banks usually make loans up to the point where they can no longer do so because of the reserve requirement restrictions. The difference between a banks actual reserve and its required reserve, is its excess reserves. Excess reserves = Actual reserves Required reserves.

THE MONEY MULTIPLIER An increase in bank reserves leads to a greater than proportionate increase in money supply. The relationship between the final change in deposits and the change in reserves that caused this change, is called the money multiplier, if there is no leakage. Money multiplier = 1 / Required reserve ratio

Session-14: THE DEMAND FOR MONEY, EQUILIBRIUM INTEREST RATE AND MONETARY POLICY

 How interest rate ( r ) is determined in the macro economy? How the central bank affects the interest rate through monetary policy? Firms and the govt. borrow funds by issuing bonds, and they interest to firms and households (the lenders) that purchase these bonds. The demand for money (by households) The factors that determine the demand for money are key issues in macro economics. The issues are: How much money households wish to hold in cash and how much in interest-bearing securities, such as bonds?

THE TOTAL DEMAND FOR MONEY The total quantity of money demanded in the economy is the sum of the demand for bank account balances and cash by both households and firms. The quantity of money demanded at any moment depends on the opportunity cost of holding money, a cost determined by the interest rate. Households and firms hold their liquid assets both in the form of cash and interest-earning form.

TRANSACTIONS VOLUME AND THE PRICE LEVEL The total demand for money in the economy depends on the total rupee volume of transactions made. The total rupee volume of transactions in the economy depends on the aggr. Output (income, Y). A rise in Y, i.e., real GDP, means there is economic activity and so more money is demanded. [Graph]. The average amount of each transaction depends on prices, or on the price levels.

THE EQUILIBRIUM INTEREST RATE How is interest rate determined in the economy? The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy. The following factors influence the interest rate: * Supply and demand in the money market. * Change in the money supply. * Increases in Y and shifts in demand for money. [Graph].

Session-15: MONEY, THE INTEREST RATE AND OUTPUT

The goods market and money markets depend on each other. By analysing the two markets together, the values of Y and the r (interest rate) that are consistent with the existence of equili-brium, can be determined. The simultaneous study of both markets also reveals how fiscal policy affects the money market and how monetary policy affects the goods market.

The key questions in this module (session) are: How open market purchases of govt. securities (by central bank) affect the equilibrium level of national output and income (Y) ? How fiscal policy measures (such as tax cuts) affect interest rates ( r ) and invest-ment spending (I) ? [ The answers follow in the next few slides]

THE LINKS BETWEEN THE GOODS MARKET AND THE MONEY MARKET Link -1: Income (Y) and the demand for money: An increase in output (Y), with the interest rate held constant, leads to an increase in demand for money. Link 2: Planned investment spending (I) and the interest rate (r): The higher the interest rate is, the lower the level of planned I spending. Note: The interest rate ( r ) is determined in the money market whereas I is determined in the goods market. But they are inter-linked.

INVESTMENT, THE INTEREST RATE, AND THE GOODS MARKET The decision to invest in a project depends on whether the expected profits from the project justify the costs. Normally, a big cost of an investment project is the interest rate. [ Note that the capital is borrowed and interest/dividend is to be paid to the fundproviders]. When r rises, I reduces, and vice versa. [Graph].

Planned I depends on the r. So, a change in r will lead to a change in AE, i.e., C + I + G as well. This will lead to change in output (Y) and thus equilibrium is dislocated. [Graph]. The money market affects the level of r, which, in turn, affects I in goods market. So, there is a different level of equilibrium level of Y for every possible level of r.

MONEY DEMAND (Md), AGGR. OUTPUT (Y), AND THE MONEY MARKET How goods market affects the money market? What will happen to r when there is an increase in Y? The increase in Y will cause the money demand curve to shift to the right ( r remaining the same). [Graph] So, the equilibrium level of the r is not exclusively in the money market but changes in Y (in goods market) shift the Md curve and causes change in r.

COMBINING THE GOODS MARKET AND THE MONEY MARKET What are the effects on the economy if changes in both fiscal and monetary policy take place? EXPANSIONARY POLICY EFFECTS Any govt. policy aimed at stimulating (increase) aggr. Output (income, Y) is said to be expansionary. This fiscal policy is an increase in G or a reduction in T aimed at increasing Y. An expansionary monetary policy is an increase in Ms aimed at increasing Y.

Though the impact of cut in T is smaller than the impact of an increase in G, both have a multiplier effect on the equilibrium level of Y. Planned I depends on r. When G increases, Y increases and the Md increases. The resulting disequilibrium, i.e., Md > Ms causes the r to rise. So, the increase in G increases both Y and r.

The side effect of increase in r : A higher r cause I to decline. Since AE = C + I + G, decrease in I works against increase in G. This tendency of increase in G resulting in reduction in private I spending is called the Crowding-out effect. Y still rises (due to increase in G), but the multiplier effect of the increase in G is lowered because of the higher rs negative effect on I.

The multiplier of G depends on the assumption: If the central bank expands the Ms to accommodate the increase in G, the multi-plier will be larger. r will not increase. Without a higher r, there will no Crowding-out. I depends on factors other than r, and I may at times quite insensitive to increase in r. If planned I does not fall when r rises, there is Crowding out effect. G^ Y^ Md^ r^ I v.

Expansionary Monetary Policy: An increase in the Money Supply What happens when the central bank decides to increase the supply of money through open market operations? The quantity of Ms will be greater than the amount households want to hold, the equi-brium r falls. Ms^ r v I^ Y^ Md^. As Md ^, again r increases. Monetary policy can be effective only if I reacts to ^r.

CONTRACTIONARY POLICY EFFECTS Any govt. policy that is aimed at reducing aggr. Output (Y) is said to be contraction-nary. This policy is used to slow down the economy to fight inflation. One way to fight inflation is to reduce AE. Contractionary Fiscal Policy: A decrease in G and an increase in T : G v or T^ Yv Md v r v I^. Contractionary Monetary Policy: A decrease in the Ms: Ms v r^ I v Y v Md v.

THE MACRO ECONOMIC POLICY MIX Fiscal and Monetary policy can be used simultaneously. Suppose, the govt. wants to increase Y without changing r ; it can do so by increasing both G and Ms by the appropriate amounts.

Session-16: AGGR. DEMAND, AGGR. SUPPLY AND INFLATION

In all the earlier sessions (chapters), price was considered to be fixed. In this session onwards, flexible prices are adopted to understand the macro economics better. Causes of Inflation is another point to study in this session.

THE AGGR. DEMAND CURVE As prices and wage rise, households and firms want to keep more money to spend. This results in increase in Md. Md is a function of three variables: r, Y and the price level, P. Md increases if Y and P increase and r declines.

Aggr. Demand Curve: Aggr. Demand is the total demand for goods and services in the economy. To derive the aggr. Demand curve, examine what happens to Y when P changes. Aggr. Demand curve is obtained in response to change in price level (ignoring fiscal policy variables G, T and Ms). Generally, an increase in the P increases the Md curve to the right [assuming Ms remaining the same Ms line is a vertical line]. [Graphs].

 AD falls when the P increases because the higher P level causes Md to rise. With Ms constant, r will rise to re-establish equilibrium in the money market. Other reasons for a downward-sloping AD curve: 1.The Consumption link 2. The Real Wealth Effect.

SHIFTS OF THE AD CURVE The AD curve is based on the assumption that the fiscal and monetary policy variables G, T and Ms are fixed. If any of these variables change, the AD curve will shift. An increase in Ms at a given P, shifts the AD curve to the right. An increase in G and decrease in T shifts the AD curve to the right.

THE AGGR. SUPPLY CURVE (A S Curve) A S is the total supply of goods and services in an economy. The A S curve shows the relationship between aggr. Output (Y) by all the firms in an economy and the overall price level (P). A S in the short-run: Capacity constrains: For ex: Fixed factors of production. [Graph].

SHIFTS OF SHORT-RUN A S CURVE Cost shocks A S curve shifting to left. Eco growth A S curve shifting to right. THE EQUILIBRIUM PRICE LEVEL The equilibrium P in the economy occurs at the point at which the AD curve and the A S curve intersect. [Graph]. THE LONG-RUN A S CURVE If wage rates and other costs fully adjust to changes in P in the long-run, then the long-run A S curve is vertical.

A D, A S AND MONETARY AND FISCAL POLICY An expansionary policy shifts the A D curve to the right and vice versa. As far as the A S curve is concerned, the direction of the shift of A S curve depends on where along the short-run A S curve the economy is, at the time of the change. [Graphs].

LONG-RUN A S AND POLICY EFFECTS If the A S curve is vertical in the long-run, which suggests that economy is working at full capacity (no idle capacity of factors of production to increase output), neither monetary policy nor fiscal policy has any effect on aggr. Output (Y) in the long run. So, any policy change effects only the price. The multiplier effect on a change in G on Y is zero. But, the length of long-run matters if it 3 to 6 months, policy change doesnt effect; if the long-run is 3 or 4 years, the policy change effects the Y.

CAUSES OF INFLATION Inflation is an increase in the overall price level. Anything that shifts AD curve to the right or the A S curve to the left causes inflation. If the inflation prolongs for long time, it is known as sustained inflation. Demand-pull Inflation Inflation initiated by an increase in A D is called demand-pull inflation. P rises (assuming aggr. Output either remains same or little increase) and leads to inflation

. Cost-push or supply-side Inflation When Cost of production of goods and services go up due to prices of raw materials and wages, etc., go up, the supply price goes up, and leads to inflation. For ex: If crude petrol price goes up, the prices of almost goods and services go up. Money and Inflation An increase in Ms can lead to an increase in the aggr. Price level.

Session-17: THE LABOUR MARKET, UNEMPLOYMENT AND INFLATION in the labour Since labour is an input, what goes on
market affects the shape of A S curve. If wages and other input costs are comple-tely flexible and rise every time prices rise by the same percentage, the A S curve will be vertical. BASIC CONCEPTS Labour Force (LF) = Employed + Unemployed. Unemployment rate = U / LF. Frictional Unemployment Structural Unemployment. The latter two are desirable to some extent for healthy economic growth.

Note: In this session, we are concerned with Cyclical Unemployment i.e., the increase in unemployment that occurs during recessions and depressions. When the economy contracts (due to decrease in G or I ) the unemployment rises. The classical economists, earlier to Keynes, held the view that if the quantity of labour demanded and supplied are brought into equilibrium by adjusting wage rates, there cannot be persistent unemployment (except the frictional and structural unemployment). The above view is also held by several economists at present.

THE CLASSICAL VIEW OF LABOUR MARKET The classical economists assume the wage rate adjusts to equate the quantity of labour demanded with the quantity of labour supplied, implying U does not exist. The amount of labour that a firm hires depends on the value of the output that workers produce. The classical economists believed the market decides the equilibrium wage rate and employment, and there is nothing the govt. can do to make things better.

REASONS FOR UNEMPLOYMENT Sticky wages Efficiency wage theory Imperfect information Minimum wage laws The short-run relationship between the unemployment rate and Inflation U and inflation are two of the most important variables in macro economics. An increase in Y corresponds to a decrease in U. Thus, U and Y are negatively related. There is a negative relationship between the U rate and P. As the U declines, in response to the eco9nomys moving closer to maximum capacity output (Y), the overall P level rises more and more.

THE PHILLIPS CURVE According to this the higher the unemploy-ment rate is, the lower the rate of inflation. [Graph]. To lower the inflation rate, an U must be accepted, and to lower U rate, accept a higher inflation rate. This phenomena happened in 1950s and 60s and proved to be true. But the Phillips curve broke down (proved to be wrong) in the 1980s.

A S AND A D ANALYSIS AND THE PHILLIPS CURVE How there was a stability of the Phillips curve in the 1950s and 60s and lack of stability after that?

SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT The break-down of Phillips curve in 1970s does not mean that there is no trade-off between inflation and U. It simply means other factors affect inflation beside U. (just as demand increases as price increases due to increase in the income, i.e., income effect).

 Balance of payment (B o P). The Current Account. The Capital Account. THE OPEN-ECONOMY AND Planned A E Planned A E in an open economy = C + I + G + (Ex Im). Determining the Level of Imports Assume that the level of imports is a function of Y the citizens of the country import foreign goods and services when their Y increase. Im = mY, where m is a unknown co-efficient <1.

Session-19: BALANCE OF PAYMENT AND EXCHANGE RATES

THE OPEN-ECONOMY MULTIPLIER In an open-economy, a part of the income (Y) generated by G is spent on imports instead of domestically produced goods and services. To compute the multiplier, we need to know how much of the increased Y is used to increase domestic C. Then, MPC to consume domestic goods is (MPC MPM) So, Open-eco multiplier = 1 / 1 (MPC MPM)

EXCHANGE RATES Bretton-wood conference and fixed exchange rate. 1971 Floating exchange rate or marketdetermined exchange rate. The Equilibrium Exchange Rate The equilibrium exchange rate occurs at the point at which the quantity demanded of a foreign currency equals the quantity supplied (in the inter-national market).

FACTORS THAT AFFECT EXCHANGE RATES Purchasing power parity: The law of one price :- The theory that exchange rates will adjust so that the price of similar goods in different countries is the same, is known as the Purchasing power parity theory. Relative Interest Rates.

THE EFFECTS OF EXCHANGE RATES ON THE ECONOMY Exchange rate effects on imports, exports, and the real GDP: A depreciation of a countrys currency is likely to increase its GDP. Exchange rates and the Balance of Trade. BoT= Rs. Price of exports X quantity exported Rs. Price of imports X quantity imported.