Introduction to

Macroeconomics

Dr.Leena A. Kaushal
 Learning Objectives
• To understand what macroeconomics is about

• Representing the macro economy by the

circular flow of income

• Using the circular flow of income to measure

national income/output
 Introduction to Macroeconomics
• Microeconomics examines the behavior of individual
decision-making units—business firms and households.

• Macroeconomics deals with the economy as a whole; it

examines the behavior of economic aggregates such as
aggregate income, consumption, investment, and the overall
level of prices.

– Aggregate behavior refers to the behavior of all households and

firms together
 The Roots of Macroeconomics
• The Great Depression was a period of severe
economic contraction and high unemployment that
began in 1929 and continued throughout the 1930s.
• Classical economists applied microeconomic
models to economy-wide problems.
• However, simple classical models failed to explain
the prolonged existence of high unemployment
during the Great Depression.
• This provided the impetus for the development of
macroeconomics.
 The Roots of Macroeconomics
• In 1936, John Maynard Keynes published The General
Theory of Employment, Interest, and Money.

• Keynes believed governments could intervene in the

economy and affect the level of output and employment.

• During periods of low private demand, the government

can stimulate aggregate demand to lift the economy out
of recession.
• Govt’s role ‘Fine-tuning’ -Walter Heller

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 Recent Macroeconomic History
• Proposed link between Unemployment and
Inflation – A.W.H Phillips

• The use of Keynesian policy to fine-tune the

economy in the 1960s, led to disillusionment in
the 1970s and early 1980s.

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Phillips Curve
Recent Macroeconomic History

• Stagflation occurs when there is persistent

high inflation combined with high
unemployment and stagnant demand in a
country's economy.
 Macroeconomic Concerns
• Three of the major concerns of
macroeconomics are:
– Inflation
– Output growth
– Unemployment

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 Inflation and Deflation
• Inflation is an increase in the overall price level.

• Hyperinflation is a period of very rapid increases in the

overall price level.
• Hyperinflations are rare, but have been used to study the costs
and consequences of even moderate inflation.

• Deflation is a decrease in the overall price level.

• Prolonged periods of deflation can be just as damaging for the
economy as sustained inflation.

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 Output Growth:
Short Run and Long Run
• The business cycle is the cycle of short-term ups and downs
in the economy.

 The main measure of how an economy is doing is

aggregate output.

 Aggregate output is the total quantity of goods and

services produced in an economy in a given period.

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The Business Cycle
 Output Growth:
Short Run and Long Run

• 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.

• Policy makers attempt :

• smooth fluctuations in output during a business cycle

• to increase the growth rate of output in the long-run.

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 Unemployment
• The unemployment rate:
• %of the labor force that is unemployed.
• A key indicator of the economy’s health

• The existence of unemployment seems to imply

that the aggregate labor market is not in
equilibrium.

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Unemployment Rate in India averaged 7.32 percent from
1983 until 2013

9.40 percent in 2009

4.90 percent in 2013

Currently 3.5%

Source: The Ministry of Labour and Employment, India.

Government in the Macroeconomy

• There are three kinds of policy that the

governments use to influence the macro
economy:
1. Fiscal policy: taxes and spending.

2. Monetary policy: regulate Money supply

3. Growth or supply-side policies: focus on stimulating

aggregate supply instead of aggregate demand.

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 Supply Side Policies
• Entrepreneurship
The government needs to encourage entrepreneurs to start new businesses by lowering
the marginal tax rate
Reduction in corporate taxes during initial years or if they don’t cross a minimum
revenue during the initial years.

• Competition and Efficiency

The government will need to increase competition between firms and increase the
overall efficiency of the economy.
They could do this through the removal of monopolies, by privatizing certain industries,
freeing up trade (through the reduction or elimination of trade barriers) and by
implementing inward investment policies.

• Education
Better education and training to improve skills will improve labor productivity.
 The Circular Flow of Income
• The economy can be viewed as a system
where there are actions and interactions
between
– Households
– Firms
– Government
– Financial institutions
– Foreign sector.
 The analogy of a hot water system
• If we think of the economy as a central heating
system that pumps hot water around a house, then
the use of government policy can be viewed as the
thermostat.
• If it is too cold:
– action : make things warmer,
• If it is too warm :
• action :cool things down.
• Policy making at the macro level is mainly
about influencing the circular flow of income.
 The Circular Flow of Income

• The circular flow diagram shows:

– the income received
– payments made by each sector

• Everyone’s expenditure is someone else’s receipt.

• Every transaction must have two sides of the
economy.
 Government policy
• An important aspect of macroeconomics!!
– take measures to try and influence parts of
CFOI to achieve certain goals.

– Economic growth
– Low unemployment
– Targeting inflation
– Trade balance
Circular Flow of Income
 Injections and Leakages
• Injections addn to the circular flow of
income.
– investment (I)
– government spending (G)
– exports (X).

• Leakages lowers income flows

– saving (S)
– taxes (T)
– imports (M).
 Equilibrium in the Economy
Injections >leakages
CFOI Increases

Leakages > Injections

CFOI Increases

EQm I+G+X=S+T+M
National Income Accounting and the
Circular Flow of Income
• Gross Domestic Product (GDP) is a measure of the total
output produced by an economy.
– Expenditure method
– Income method
– Output method.
• National income accounting has a direct relationship to the
circular flow of income.
– The level of GDP indicates of the strength of the circular flow of
income.
– Due to the circular flow, the three methods of calculating GDP
should all produce the same measure.
Three measures of GDP
• (1) Expenditure Method

• Y=C+G+I+X–M

• GDPMP : prices you actually pay

• GDPFC :true cost of production

GDPFC = GDPMP - Indirect Taxes + Subsidies

 The First Thing we could understand is that GDP (FC) is GDP ( MP)
minus indirect taxes plus subsidies.
• Here we can figure out that the more is the subsidy, the more is
difference between the GDP(FC) & GDP (MP).
• We take following example to understand this.

• We suppose that in a particular year, GDP(FC) is Rs. 100. In the same

year Indirect Taxes are Rs. 25 while the subsidies are Rs. 20.
• So, we can arrive at GDP(MP) using the following equation:
• GDP(FC) = GDP(MP) -Indirect Taxes + Subsidies
• Rs. 100 = GDP(MP) – Rs. 25 + Rs. 20
• So, GDP (MP) = Rs. 100 + Rs. 25- Rs. 20 = Rs. 105
• If the Government tries to raise the subsidies, the Difference between
the GDP(FC) and GDP(MP) will increase.

• The opposite for Indirect taxes.

Components of Expenditure in UK
GDP
UK GDP, adjusted from market
prices to factor cost
 Three measures of GDP
• (2) Income Method:

• Y = Other Income + Corporate Profits +

Wages and Salaries

• Other Income primarily include rental and

interest income.
Components of Income in UK GDP
 Three measures of GDP
• (3) Output method

• The output method avoids double-counting

by totalling the value-added by each firm at
each state of the production process.
Three measures of UK GDP
 GDP and GDP per capita
• Gross Domestic Product-
– Income generated by an economy in a year.

• GDP per capita

– GDP divided by the country’s population
– indicator of the material standard of living in a
country.
 Economic Growth
• Economic growth
– change in GDP
– main concern for governments and policy
makers.

• High and sustained economic growth

– generating more and more income
– continual improvement of living standards.
UK Output and Trend GDP
 Output and Trend Growth of GDP
• GDP grows consistently over time ( positive trend)
– People are richer and enjoy improving living standards.

• GDP does not grow steadily.

– Fluctuates quite considerably around the trend path,
– The rate of economic growth is not constant in the short run.
– There is output fluctuation, such as booms and recessions.
 Open Economies
Openness can be seen in two ways:

• Trade of goods and services.

– Exports are injections

– Imports are leakages.

• Capital flows to and from the financial sector

– (Globalisation of financial markets)
• Foreign Direct Investment

• Portfolio Capital ( bonds and equities)

 What is stock and flow variable?
• Variable- measurable quantity

• Variable measured at a point in time

(stock)

• Variable measured over a period (flow).

 Differences
• Flow: are defined with a reference to a specific
period ( length of time), hours, months, year etc.
• It has a time dimension.
• National income ( during a year)
• Income of a person (week /month)
• Expenditure, savings, changes in money supply,
change in inventories, rent, profit etc. ( measured
over a period of time)
 Differences
• Stock: Stock is a quantity that is measured at a particular point of
time.
• Capital – stock variable
• On a particular date a country owns and commands stock of
machine, raw material, accessories etc.
• Eg: Wealth, foreign debt, loan, inventories, opening stock, money
supply, population etc.

• Still camera : records position at a point of time ( stock)

• Video camera: records position during particular period ( flow)
• Wealth is measured in dollars at a point in time and is
a stock variable.
• Saving is measured in dollars per unit time and is a flow variable.
Positive/Normative
• Positive economics is objective and fact based,
while normative economics is subjective and value
based.
• Positive economic statements do not have to be
correct, but they must be able to be tested and
proved or disproved.
• Normative economic statements are opinion based,
so they cannot be proved or disproved.
 For example:
• The statement "government should provide basic healthcare
to all citizens" is a normative economic statement. There is
no way to prove whether government "should" provide
healthcare; this statement is based on opinions about the
role of government in individuals' lives, the importance of
healthcare and who should pay for it.

• The statement, "government-provided healthcare increases

public expenditures" is a positive economic statement,
because it can be proved or disproved by examining
healthcare spending data in countries like Canada and
Britain where the government provides healthcare.
Thank you!