Compiled Notes for Macroeconomics

Most of the content and all images used are from the book “Principles of Economics” by Gregory Mankiw.

Lecture 18

In contrast to microeconomics, macroeconomics studies economy-wide phenomena such as inflation, unemployment, and economic growth. It attempts to explain how economic changes affect households, firms, and markets simultaneously.

How do we measure the performance of an economy? Two measures that come to mind are per capita income and life expectancy.

The main actors in any economy are consumers, workers, and employers. Each person is a consumer and furthermore, they may be a worker or an employer.
In addition to the 7 principles we studied at the beginning of microeconomics, there are 3 that are relevant to macroeconomics.

  1. A country’s standard of living depends on its ability to produce goods and services.
    Productivity is the amount of goods and services produced from each hour of a worker’s time.

  2. Prices rise when the government prints too much money.
    Inflation is an increase in the overall level of prices in the economy. In the long run, the growth in quantity of money causes inflation. The value of the money falls.

  3. Society faces a short-run trade-off between inflation and unemployment.
    This is shown in the Phillips curve (which we shall not study).

Macroeconomics is the analysis of the backdrop of economic conditions against which firms/consumers make decisions.
The measures we use are per capita income and life expectancy. It is seen that both of them vary very widely across countries. We also sometimes use the total market value of a nation’s production - its Gross Domestic Product (GDP).

What makes countries that contribute more to the global economy different?

Lecture 19

Here, we mention some major events since the start of the millennium:

  • The dotcom bubble which peaked on March 10, 2000. NASDAQ reached 5123.5 points and quickly lost about three-quarters of its value.
  • 9/11 attacks on the World Trade Center and the Pentagon and the ensuing war on Afghanistan.
  • US invasion of Iraq (launched on March 20, 2003).
  • 2007/8 global financial crises - began with the collapse of Lehman Brothers on September 15, 2008. This is also known as the subprime crisis.
  • The euro crises (in October 2009) when Greece revealed a “black hole” in its budget, that is, deficits larger than previously known.
  • Outbreak of Syrian Civil War on January 26, 2011, which began with peaceful protests in Damascus.
  • Outbreak of the Ebola epidemic in West Africa in December 2013, when a 2 year old boy died in Guinea.
  • 2015 outbreak of MERS in South Korea.
  • Massive flow of refugees from Syria, Iraq, and Eritrea towards Europe in Summer 2015 (60 million in 2014 alone). This is the highest ever recorded to leave their home country.
  • Chinese stock market plunges 30% in June/July 2014 after rising 75% since the previous October.
  • The price of oil fell sharply in 2015/16 falling below $30 per barrel before recovering slightly. This mainly affected Russia, Venezuela, and Saudi Arabia.
  • Human wave of migrants from Syria, Libya, Iraq, Pakistan, Afghanistan, and others to the safe havens of Europe, which caused a crisis.
  • On June 23, 2016, Brexit happened and Britain voted (narrowly) to leave the European Union. The migrants to Britain were a contributing factor.
  • On November 8, 2016, Donald Trump won the elections with promises having an impact on globalization.
  • On September 3, 2017, North Korea conducted its 6th nuclear tests. There was a “war of words” between Trump and Kim Jong-un.
  • Trump’s China-related trade tariffs caused a trade war.
  • For India, bank recapitalization and GST (a unified task structure) were major. Liberalization made our borders porous, opening us to the global economy.

What is the difference between Ghana, India, and South Korea? The difference between the first two is due to the physical and human capital, whereas that between the latter two is attributed to knowledge.

Macroeconomic events arise from the interaction of many people trying to maximize their own welfare - firms, consumers, the government, forex dealers, FII, MNCs, RBI, etc.

Lecture 20

More often though, to measure the performance of an economy, we use the Gross Domestic Product (GDP). It measures two things – the total income of everyone in the country and the total expenditure on the economy’s output of goods and services. This is because both of these quantities are equal – an economy’s income is the same as its expenditure. This is made clear by the circular flow diagram we studied earlier.

GDP is the market value of all final goods and services produced within a country in a given period of time.

  • We use market prices to measure the amount people are paying for different goods.
  • GDP attempts to include all goods and services. If someone is renting out a house, then the tenant’s expenditure/landlord’s income will be counted. But even if someone owns the house they are staying in, we try to include it in the GDP by estimating its rental value. Some products, such as vegetables grown and consumed at home, illegally sold drugs, etc that never enter the market place, are difficult to include in the GDP however.
  • GDP includes both tangible goods (food, clothing) and intangible services (haircuts, housecleaning).
  • GDP includes goods and services currently produced, we do not include transactions involving items produced in the past.
  • GDP measures the production within the geographical confines of a country. If an Indian citizen works temporarily in Canada, then their production is considered in Canada’s GDP. If a Canadian citizen owns a factory in India, then the production of the factory is part of India’s GDP.
  • The GDP measures the value of production within a specific interval, usually a quarter (three months) or a year.

Intermediate goods are goods used up entirely in the production of final goods.
Value added is the dollar value of an industry’s sales minus the value of the intermediate goods used in production.

The difference between the GDP calculated using the income and expenditure methods is called statistical discrepancy (it arises due to imperfect data sources).

There are several transactions that have nothing to do with final goods. As a result, we exclude things like stocks/bonds (securities), social security, unemployment compensation (government transfer payments), individual gifts, corporate gifts (private transfer payments) etc. We also exclude the transfer of second-hand goods (we have already made the purchase and it has been included in the value), household production, and legal/illegal underground transactions.
That is, we only want to count the sales of final goods that occur through the market.

Therefore, we measure the GDP as the sum of the

  • national income:
    • compensation of employees
    • proprietor’s income
    • corporate profits
    • net interest
    • rental income
  • depreciation
  • indirect taxes minus subsidies
  • net factor payments to the rest of the world

Gross private domestic investment consists of

  • the creation of capital goods such as factories/machines that can yield production (and thus consumption). This also includes changes in business inventories and repairs made to machines and buildings.
  • producer durables or capital goods (life span more than three years)
  • fixed investments (purchases by a business of newly produced producer durables or capital goods)
  • inventory investments (changes in stocks of finished goods and goods in process, as well as changes in raw materials)

Lecture 21

The GDP can be looked at as either the total expenditure on domestically produced final goods/services or the total income earned by domestically located factors of production.
We can calculate the GDP in three different ways: output (the sum of value added in each sector), income, and expenditure.
The expenditure components of GDP are consumption, investment, government spending, and net exports.

  • Consumption \(\text{C}\) is the value of all goods and services purchased by households. It comprises of
    • durable consumer goods (life span more than three years),
    • non-durable consumer goods (life span at most three years), and
    • services (mental or physical help). This does not include purchase of new housing. Education is usually included in this section too.
  • Investment \(\text{I}\) includes
    • business fixed investment (spending on plant and equipment that firms will use to produce the other goods/services),
    • residential fixed investment (spending on housing units/structures by consumers and landlords), and
    • inventory investment (the change in the value of all firms’ inventories).
      The purchase of new housing is the one housheold expense that is categorized as investment instead of consumption. Investment is basically spending on new capital. This investment is not the same as the usual financial usage of the word.
  • Government purchases \(\text{G}\) includes all government spending on goods and services. It includes salaries of government workers and spending on public works. It excludes transfer payments (like unemployment insurance payments) because they are not in exchange for currently produced goods and services. Transfer payments can be thought of as negative taxes.
  • Net exports \(\text{NX}\) is equal to \(\text{EX}-\text{IM}\), where \(\text{EX}\) is the value of total exports (foreign purchases of domestic goods) and \(\text{IM}\) is the value of total imports (domestic purchases of foreign goods).

An important identity is:

\[\text{Y} = \text{C} + \text{I} + \text{G} + \text{NX},\]

where \(\text{Y}\) is the value of total output (GDP). The expression on the right is the total expenditure.

A stock is a quantity measured at a point of time. For example, a person’s wealth and the government’s debt are stocks.
A flow is a quantity measured per unit time. For example, a person’s annual savings and GDP are flow measures.

Price is the common unit using which we can measure other expenditures.

GDP is essentially an aggregate of price\(\times\)quantity.
The nominal GDP is the result when we use the price and quantity belonging to the same year.
The real GDP is the result when we fix a certain base year and use the price of that base year (we use the quantity of the year we are calculating the GDP of).
Since real GDP is not affected by changes in prices, it reflects the economy’s production of goods and services.

GDP can also be seen as the net value added across firms – we do not count the final goods because that would be double counting. This is the calculating of GDP using the output method that we mentioned earlier.

Lecture 22

Some more rules for computing GDP are:

  • To compute the total value of goods/services, the national income uses market prices.
  • As mentioned earlier, used goods are not used in the calculation of GDP.
  • How do we treat inventories? This depends on whether the goods are sold or if they spoil. If the goods are sold, then their value is included in the GDP. If they spoil, the GDP remains unchanged.
  • Some goods are not sold in the market. So, we use their imputed prices instead (recall the example of a house someone owns and lives in).
  • Intermediate goods are not counted in the GDP, only final goods are.

Now, the calculation of real GDP fixes a certain base year. This is not good because prices may change drastically over periods of time and it is misleading to use the values from 10-15 years ago. Therefore, we shift the base year prices once in a while (every 5-10 years).

Lecture 23

We tend to overestimate the rate of inflation and underestimate the rate of real economic growth when we consider the fact that earlier, people did not have modern conveniences.
As a result, to compensate for the shift in base year prices, we chain weight to average the prices.

The GDP deflator or implicit price deflator is the ratio of the nominal GDP to the real GDP. It gives a measure of the price of output relative to its price in the base year. It reflects the level of prices in the economy (and not quantities).
Observe that the GDP deflator is equal to \(1\) in the base year.

Inflation is used to describe a situation where the economy’s price level is increasing. The inflation rate is the percentage change from one period to the next. It can be calculated as the percentage change of the GDP deflator.

We must take inflation into account when calculating the GDP. Further, it becomes difficult to compare different countries since the degree of inflation is different in different countries.

Some problems in comparing GDPs are:

  • GDP is understated due to the informal sector.
  • Household scale economies are not taken into account.
  • Exchange rates to convert the GNP in local currency to USD is based on relative prices of internationally traded goods.
  • In developing countries, many cheap, labour-intensive, unstandardized goods and services have no impact on the exchange rate as they are not traded.
  • The price of foreign exchange is less than the equilibrium/market clearing price due to import barriers, restrictions on access to foreign currency, export subsidies, or state trading.
  • Resistant services such as healthcare and government administration which comprise more than 10% of most countries’ expenditures distort cross-national comparisons.

The (real and nominal) per capita GDPs are of interest and per capita growth should be looked at as well.

To resolve the problems in comparing GDP, we look at purchasing power parity. How much does a particular product cost in dollars in different countries? For example, a Starbucks grande latte costs $9.83 in Oslo but $2.80 in New Delhi.
We want a dollar to have the same purchasing power in any country.

Lecture 24

The GDP is the output produced within some geographic location. The GNI/GNP (Gross National Income/Product) is the output produced by the citizens of a geographic region. This value must be remitted back to the country. It is the total income earned by permanent residents of the country (nationals).

\[\text{GNP} = \text{GDP} + \text{Factor payments from abroad} - \text{Factor payments to abroad}\]

The Net Domestic Product (NDP) is equal to \(\text{GDP}-\text{Depreciation}\) and the Net National Product (NNP) is equal to \(\text{GNP}-\text{Depreciation}\).
Depreciation is called “consumption of fixed capital”. It is the cost of producing the output of the economy.

In calculating India’s GDP, there are three categories:

  • Category A: The annual figures of commodity-wise output and prices and values of different types of input or input-output proportions are known.
    We use the product approach. Aggregate the commodity-wise price-output multiplications to get the gross value of output and then deduct the total value of input.
    This consists of agriculture, registered manufacturing, construction, forestry and logging, mining and quarrying, and fishing.
  • Category B: The actual figures of all types of factor earnings reported in the annual accounts of difference companies or undertakings are published on a regular basis and known.
    We use the income approach. Aggregate the actual figures of employee compensation, interest, rent, and operating surplus or profits relating to each organization.
    This consists of public administration and defence, railways, water transport, banking and insurance, communication, electricity, air transport, and real estate.
  • Category C: The estimates of working force derived from the decennial population census data and the estimates of average productivity of labour derived from data is shown by periodic sample surveys.
    We use the income approach. Interpolate/extrapolate the decennial data and periodic estimates of average productivity are carried forward/backward by certain indicators. We then derive the year-to-year estimates of workers and their average productivity, and multiply to arrive at the estimate of value added.
    This consists of trade, hotels, and restaurants, unregistered manufacturing, ownership of dwellings, unorganized road and water transport, gas and water supply, storage, and other services.

Lecture 25

Inflation measures the general increase in level of prices. How do we measure cost of living/inflation?

We usually use the Wholesale Price Index (WPI) or Consumer Price Index (CPI) to measure the level of prices or inflation. It consolidates the prices of several goods and services into a single index that measures the overall level of prices. To do this reliably, some options are:

  • Compute the average of all prices. This treats all goods and services equally, which need not be the case. For example, food should have a higher weightage than clothing.
  • Take a the ratio of weighted averages of the prices while also considering a certain base year. For example, if we buy \(5\) apples and \(2\) oranges and take the base year as \(2011\), we can calculate
\[\text{WPI} = \frac{5\times\text{current price of apples} + 2\times\text{current price of oranges}}{5\times\text{2011 price of apples} + 2\times\text{2011 price of oranges}}\]

On top of this, we assign a weight to each sector, taking into account its share in the market.
The CPI can be calculated as:

  1. Fix the basket and determine which prices are important to the average consumer.
  2. Find the prices of each of the goods in the basket at each point in time.
  3. Compute the basket’s cost.
  4. Choose a base year and compute the cost. Compute the index as the ratio of the basket costs between the two times.

The inflation rate can be measured as the percentage change of CPI or WPI.

The WPI is used to provide estimates of inflation at the wholesale transaction level for the economy as a whole. This allows the government to check for inflation, in essential commodities in particular. It is used as a deflator for many sectors of the economy, including estimating GDP. It is also used for indexation in business contracts. Global investors track the WPI as a key macro indicator for their investment decisions.

We assign less weight to food items that are more volatile over time. As a result, core manufactured products have high weightage. According to purists, core inflation using only manufactured products carries significance as a more accurate predictor in the long term. This weeds out transitory components such as food and energy. An alternate methods is the trimmed-mean method, which strips the most volatile items off the index each month.

In any index,

  • What base year do we choose? The year should be somewhat normal/stable with respect to economic activities and their prices. We should have reliable data and the year should be as recent as possible. The base year for closely related economic indicators should not be wildly different.
  • What choice of sample commodity do we choose? We should sample over different varieties of each commodity. Including all these varieties in the index is neither desirable nor feasible. We choose one or two popular varieties consumed by the index population. This popularity is based on family budget data, market intelligence, etc.
  • Which price do we choose? We should choose that price which is charged to the consumer, including excise duty, sales tax, etc and excluding rebates.

In the field, price supervisors check the veracity of prices quoted by the price collectors by making spot visits. We further scrutinize in case

  • the variation is more than 10% for a non-seasonal item.
  • the variation is more than 50% for a seasonal item.
  • the variation is more than 3 points in the item level index wrt the previous month.

Producer Price Index (PPI) measures the price of a typical basket of goods bought by firms, not consumers.

Lecture 26

The HSBC Purchasing Manager Index (PMI) measures the factory production based on the monthly responses of purchasing executives in around 500 manufacturing companies. A value over 50 means expansion and a value under 50 means contraction.

Now, should we use the WPI or the GDP deflator?
The GDP deflator measures the prices of all goods produced, whereas the WPI measures only the prices of goods/services bought by consumers. In particular, an increase in the price of goods bought by firms/government shows up in the former but not the latter. Also, imported goods are not part of the GDP and do not show up in the GDP deflator. Lastly, the WPI assigns fixed weights to the prices of different goods whereas the GDP deflator assigns changing weights (a fixed basket of goods v. a changing basket of goods).

We use two indices in general, the Laspeyres index (which works with a fixed basket of goods) and the Paasche index (which works with a changing basket of goods).
The Laspeyres price index is equal to

\[P = \frac{\sum p_t q_0}{\sum p_0 q_0} \times 100\]

and the Paasche price index is equal to

\[P = \frac{\sum p_t q_t}{\sum p_0 q_t} \times 100,\]

where \(P\) is the price index, \(p_t\) is the current price, \(q_t\) is the quantity used in the current period, \(p_0\) is the price of the base period, and \(q_0\) is the quantity used in the base period.

Laspeyres requires quantity data from only the base period, which allows a more meaningful comparison because changes in the index can be attributed to changes in price, but may overweight goods whose prices increase and does not reflect changes in buying patterns over time.
Paasche reflects current buying habits because it uses current quantities, but it requires quantity data from the current year, which may be difficult to obtain. It is difficult to attribute changes in the index to price changes alone and tends to overweight goods whose prices have declined. The prices need to be recomputed each year.
Fischer’s ideal index is equal to the geometric mean of these two indices.

When the prices of different goods are changing differently, the Laspeyres index tends to overstate the increase in cost of living. This is because it does not take into account that consumers can replace more expensive items with less expensive items.
Conversely, the Paasche index tends to understate the increase in cost of living. While it takes the substitution effect into account, but does not take into account the decrease in the consumers’ welfare resulting from this substitution (because we take a fixed basket of goods). This issue is known as substitution bias.

As new goods are introduced, consumers have more choice so the dollar is worth more.
Some quality change may be unmeasured. If the quality of a good deteriorates while its price remains the same, the value of a dollar is dropping.

Therefore, it is difficult to compare WPI (Laspeyres) and the GDP deflator (Paasche), since they are both bad in their own ways. They follow similar trends.

We can compare today’s prices with that of a different year’s as

\[\text{Amount in today's dollars} = \text{Amount in other year's dollars} \times \frac{\text{Price level today}}{\text{Price level in other year}}.\]

When we perform the above correction, we are said to index the amount for inflation. Approximately, when we put our money in a bank, the real interest rate is equal to the nominal interest rate minus the inflation rate.

Unemployment rate is the statistic that measures the percentage of people who want to work but do not have jobs, reflecting the performance of the economy.

Labor force is the sum of the employed and unemployed, and the unemployment rate is the percentage of the labor force that is unemployed. The labor force participation rate is the percentage of the adult population that is in the labor force.
The average rate of unemployment around which the economy fluctuates is called the natural rate of unemployment. It is the rate of unemployment towards which the economy gravitates. It should be noted that natural does not mean desirable.

Lecture 27

We have \(L = E + U\), where \(L\) is the labor force, \(E\) is the number of employed workers, and \(U\) is the number of unemployed workers.
The unemployment rate is \(U/L\). The rate of job separation (severance rate) is denoted \(s\) and the rate of job finding as \(f\).
Then, the number of people finding jobs is \(fU\) and the number of people losing jobs is \(sE\). In steady state, \(fU = sE\). Equivalently,

\[\frac{U}{L} = \frac{s}{s+f}.\]

Any policy aimed at lowering the natural rate of unemployment should either reduce the rate of job separation \(s\) or increase the rate of job finding \(f\).

The two main reasons for unemployment are job search and wage rigidity.
Job search is the process of matching workers with appropriate jobs.

Efficiency-wage theories propose another cause of wage rigidity. They claim that high wages make workers more productive. There are four theories related to this:

  • An increase in wage allows workers to get a more nutritious diet, which increases productivity. They can pay more than the equilibrium wage to maintain a healthy workforce. This is mostly relevant in developing countries.
  • Higher wage increases the workers’ incentive to stay with the firm, which decreases hiring/training costs.
  • The average quality of a firm’s workforce depends on the wage it pays to its employees. If a firm decreases its wage, the best employees may take jobs elsewhere, leaving the firm with inferior employees - this is called the adverse selection problem.
  • A high wage improves worker effort. The firm cannot monitor its employees. This is known as the moral hazard problem. The higher the wage, the greater the cost to the worker being fired.

When MNCs pay more wage than the equilibrium rate, the market is not cleared. Since the supply of labour is fixed, a higher supply means lower demand. This results in unemployment.

It was observed that most spells of unemployment are short, but most unemployment observed at any given time is long-term.
The unemployment caused by the time it takes workers to search for a job is called frictional unemployment. Economists call a change in the composition of demand among industries or regions a sectoral shift.
Since sectoral shifts are always occurring, there is always frictional unemployment. In an attempt to reduce frictional unemployment, some policies inadvertently increase it instead. An example of this is unemployment insurance. In this, workers collect a fraction of their wages for a certain period after losing their jobs. This decreases the incentive to find a new job. While economists agree that eliminating this will reduce the amount of unemployment, they disagree on whether it will enhance economic well-being.

Wage rigidity is the failure of wages to adjust until labour supply equals the labour demand. The unemployment resulting from wage rigidity and job rationing is called structural unemployment. Workers are unemployed not because they cannot find a job that complements their skills, but because the labor supply is greater than the labor demand. This is the case because the real wage is stuck above the equilibrium level. This is the result of a minimum wage law above the equilibrium wage. It should be noted that efficiency-wage theories claim that even in the presence of a minimum wage or a surplus of workers, firms should set their wage far above the equilibrium wage.

In job search, people are searching for jobs that suit their skills to open up, whereas in the above example, people are waiting for jobs to open up.

Globalization is a major cause for increased competition around the world. Developing countries provide cheap labour so many companies relocate their manufacturing plants to these nations. So, workers who were previously involved in manufacturing may become unemployed.

Lecture 28

In 1914, Ford started paying $5 per day to workers (against the prevailing $2 or $3 wage). According to Ford, this is in fact “the finest cost cutting move” he has ever made. The increase in wage increases the firm’s productivity. Absenteeism fell by 75% and shop floor costs fell as well.

  • Cyclical unemployment - This refers to the year-to-year fluctuations around its natural rate, which is associated with the short-run ups and downs of economic activity.
  • Disguised unemployment
  • Structural unemployment
  • Seasonal unemployment - people may be hired only in summers
  • Frictional unemployment
  • Hidden unemployment - people not registered in the official statistics, underemployed people, and skilled people in low-skilled jobs.

Some workers, known as discouraged workers claim to be unemployed but are not really trying to find a job.

A union is a worker association that bargains with workers over wages, benefits, and working conditions. The process by which unions and firms agree on the terms of employment is referred to as collective bargaining. If an agreement is not reached, a union can withdraw labour, resulting in a strike. Union workers usually earn about 10 to 20 percent more than similar workers who are not in unions. Unions just serve as an antidote against any market power that the firms that hire workers may possess.
When the wage increases due to union activity, there is a decrease in demand for labour. This causes a conflict between “insiders”, who are the union workers that gain from the increased wages, and the “outsiders”, who do not get the union jobs. Workers not in unions bear some of the cost as well. Even if the unions have this adverse effect of pushing wages above the equilibrium level and causing unemployment, the advantage is that firms have a happy and productive workforce.

The negative relationship between unemployment and GDP is called Okun’s law. It is defined as

\[\text{\% change in real GDP} = \text{Relation between real GDP and unemployment} - 2\times\text{change in unemployment rate}.\]

Okun obtained the above by running a linear regression on the data.

Some problems in GDP measurement are:

  • Illegal activities
  • Tax avoidance (4-5% of earning population paying tax)
  • Hoarding assets - gold for example
    The above three are primarily in developing countries like India.
  • Non-market transactions like a barter system in villages and payments to domestic servants. If a chef cooks food for his family, it is not counted, but it is if he cooks it for a customer at his restaurant. The value added to the raw ingredients is left out of the GDP.
  • Negative externalities - for example, degrading the soil results in the growth of the fertilizer industry.
  • It does not take depletion of natural resources into account.
  • It does not talk about the distribution of income.
  • It does not measure changes in happiness. For example, higher GDP does not mean better education, but it does mean that the government can afford better education.
  • Growth and development are different. For example, a large fraction of India’s GDP is in healthcare, but people’s health has not significantly improved.

Lecture 29

The financial system is the group of institutions that helps match the savings of one person with the investments of another.
Financial markets are institutions through which savers can directly provide funds to borrowers. For example,

  • The bond market. A bond is a certificate of indebtedness. When someone purchases a bond, they receive some interest on it regularly, until the loan is repaid at the date of maturity. Bonds that never mature are said to be a perpetuity. Income taxes are not paid on municipal bonds, which are bonds issued by the local/state government.
  • The stock market. A stock is a claim to partial ownership in a firm. When someone purchases a stock, they receive part of the profits. These tend to be higher risk and higher reward than bonds.

Financial intermediaries are institutions through which savers can indirectly provide funds to borrowers. The two main ones are

  • banks, which take in deposits from people who want to save and loan it to people who want to borrow, and
  • mutual funds, which are institutions that sell shares to the public and use the proceeds to buy selections (portfolios) of stocks and bonds.

Private savings refers to the portion of a household’s income that is not used for consumption or paying taxes.
Public savings refer to the tax revenues minus the government spendings.
National savings is the sum of the private savings and public savings. This is equal to

\[(\text{Y} - \text{T} - \text{C}) + (\text{T} - \text{G}) = \text{Y} - \text{C} - \text{G},\]

where \(\text{Y}\) is the yearly income, \(\text{T}\) is the taxes paid minus the amount it pays back in transfer payments, \(\text{C}\) is the consumption, and \(\text{G}\) is the government purchases. This is the portion of the national income that is used for neither consumption nor government purchases.
Consider a closed economy with \(\text{NX} = 0\). Then the GDP is equal to \(\text{C} + \text{I} + \text{G}\), so the investment is equal to the national savings.

The budget surplus is the excess of tax revenue over government purchases (this is equal to the public savings). The budget deficit is the opposite (the negative of the public savings).

Investment is the purchase of new capital – it is not just the purchase of stocks and bonds! It is anything that will give future returns.

The supply of loanable funds comes from savings and the demand for loanable funds comes from investment. Households with extra income can loan it out to earn interest. Public savings, if positive, add to national savings and the supply of loanable funds.
An increase in interest rate makes saving more attractive, which increases the quantity of loanable funds supplied. This reduces the demand for loanable funds, however. As in microeconomics, the interest rate adjusts to equate supply and demand.
Incentives to encourage savings (a policy to shield some savings from taxation for example) increase the supply of loanable funds, which reduces the equilibrium interest rate and increases the equilibrium quantity of loanable funds. A government budget deficit would do the opposite.
Investment incentives (an investment tax credit for example) raise the equilibrium interest rate and reduce the equilibrium quantity of loanable funds.
A budget deficit causes a fall in the supply of loanable funds, which raises the equilibrium interest rate. The government borrows to finance its deficit, leaving less funds available for investment. This is known as crowding out, and reduces the economy’s growth rate and future standards of living.
A budget surplus would do the opposite.
It should be noted that the interest rate we are talking about above is the real rate, which is the nominal interest rate corrected for inflation.

Lecture 30

Money is the stock of assets that can be readily used to make actions. The stock of money is made of the rupees in the hands of the public. The three main uses of money are to serve as a

  • store of value: It is a way to transfer purchasing power from the present to the future.
  • unit of account: It can be used to measure economic transactions and debts.
  • medium of exchange: It is used to buy goods and services, as a legal tender from the government.

In a system without money, we can either be completely self-sufficient, or use a barter economy. The latter requires a “double coincidence of wants” - each person has something that the other wants. Nowadays, this is highly unlikely with the huge variety in goods.
Money allows for more indirect transactions. Liquidity refers to the ease with which an asset can be converted to the economy’s medium of exchange. For example, money is the most liquid asset, stocks and bonds are still relatively liquid (but less so than money), and an antique painting is less liquid.

Fiat money is money by declaration. It has no intrinsic value. For example, rupee or dollar.
Commodity money on the other hand does have intrinsic value and can be used for some purpose. For example, gold or tobacco. When we use gold as money, the economy is said to be on a gold standard.

There is a general shift from commodity money to Fiat money, primarily because the latter is much more standardized.

The money supply or money stock refers to the amount of money available in the economy. It includes both currency (the paper bills and coins in the hands of the public) and demand deposits (balances in savings accounts that depositors can access on demand).
If most sellers accept cheques, assets in savings accounts are as convenient as currency.

Lecture 31

In a fractional reserve banking system, banks keep a fraction of deposits as reserves and the rest to make loans. The RBI sets reserve requirements, which are regulations on the minimum amount of reserves that banks must hold against deposits. Banks may hold more than this minimum amount. The reserve ratio \(R\) is the fraction of deposits that banks hold as reserves, which is the total reserves as a percentage of total deposits.

A T-account is a simplified accounting statement that shows a bank’s assets and liabilities (reserves and loans are assets, whereas deposits are liabilities). It is also sometimes called a balance account.

There are three cases we shall analyze:

  • No banking system: The public holds all the money in the form of currency. This is the money supply as well.
  • 100% reserve banking system: The bank holds all the money in the form of reserves, so \(R\) is 100%. Banks do not affect the size of the money supply in a 100% reserve banking system.
  • Fractional reserve banking system: The bank loans out all but \(R\)% of the deposits. The banks create money by loaning it out. The borrower gets a certain amount of money as both an asset and a liability (debt). So, this sort of system creates money, but not wealth.

The money multiplier is the amount of money the banking system generates with each dollar of reserves. It is equal to \(1/R\). If the money a borrower takes is deposited back in another bank, and so on, the total amount of money that arises from one unit is \(1/R\) units.

The control over the money supply is called the monetary policy. In India, it is conducted by a partially independent institution called the Reserve Bank of India (RBI).
The monetary policy is a traditionally bi-annual policy statement through which the RBI targets a key set of indicators to ensure price stability.
At times of recession, the policy involves the adoption of tools to increase the money supply and lower interest rate, thus stimulating the aggregate demand in the economy.
At times of inflation, it seeks to contract aggregate spending by tightening the money supply or raising the rate of return The three tools it uses to do so are:

  • Open-Market Operations (OMOs): The purchase and sale of Indian government bonds by the RBI. To increase money supply, they buy bonds, paying with new dollars, which are deposited in banks increasing reserves, which banks use to make loans causing money supply to expand.
    To reduce money supply, they sell government bonds, taking dollars out of circulation and the process works in reserve. Open-market sales of bonds take rupees out of the hands of the public, thus reducing the quantity of money in circulation.
    These are easy to conduct and are the RBI’s monetary policy tool of choice.

Lecture 32

  • Reserve Requirements:
    • Cash reserve ratio (CRR): The minimum percentage of deposits to be maintained by banks in the form of liquid cash (it is currently 3%).
    • Statutory Liquid Ratio (SLR): The minimum percentage of deposits to be maintained by banks in the form of liquid cash, gold, or other securities (it is currently 18%).

    To increase the money supply, the RBI reduces reserve requirements. Banks make more loans from each rupee of reserves, which increases the money multiplier and so money supply.
    To reduce the money supply, the CRR is raised and the process works in reverse.
    The RBI rarely uses this because frequent changes would disrupt the banking system.

The reverse repo rate is what the banks get when they deposit their excess funds in the RBI for short periods. Basis points are often mentioned in monetary policy reviews. 1% is equivalent to 100 basis points. For example, if the reverse repo rate is 7.75% and the RBI increases it by 25 basis points, the new rate is 8%. It is currently 3.35%.

  • The discount rate or bank rate is the rate of interest which a central bank charges on its loans and advances to commercial banks (loans). It is currently 4.25%.
    Repo rate is the rate at which commercial banks borrow money (short-term funds) from the RBI by selling their securities. It is currently 4%.
    The reverse repo rate is the rate of interest offered by the RBI when banks deposit their surplus funds with it for short periods. When banks have surplus funds but no lending/investment options, they must deposit these funds with the RBI, which they earn interest on. Discount lending is used to provide extra liquidity when financial institutions are in trouble.

    Banks are mandated to invest a quarter of their deposit/borrowings inflows into government securities. Only the excess over this mandated investment can be used to borrow funds from repo window. The banks’ core borrowing usually comes from deposits, so RBI is a “lender of last resort”.

    The RBI raises the repo rate to increase the overall cost of funds in the banking system. Higher costs keeps the check on demand for funds. As demand slows, so does the demand pull inflation. In a tight liquidity scenario, the repo rate acts as the base rate at which banks can borrow funds.
    If funds are not very available and banks are unable to borrow at the repo rate, they may have to increase deposit rates to attract depositors.
    There is a trade-off between inflation and growth.

    To raise the bank rate, the RBI sells government bonds.

If households hold more money as currency (so banks have fewer reserves) or banks hold more as reserves, money supply falls. The RBI can compensate for this.

When people suspect that their banks are in trouble, a run on banks occurs where people go to withdraw their funds, holding more currency and less deposits. Under fractional-reserve banking, they do not have enough reserves to pay off all the depositors, so banks may have to close. Therefore, banks may make fewer loans and hold more reserves to satisfy depositors. These increase \(R\), reverse the process of money creation, and cause the money supply to fall.

Money demand refers to how much wealth people want to hold in liquid form. It depends on \(P\), the price level (CPI or GDP deflator). An increase in \(P\) reduces the value of money, so more money is required to buy goods and services. The quantity of money demanded is negatively related to the value of money and positively related to \(P\), other things equal.

Nominal variables are measured in monetary units, whereas real variables are measured in physical units (for example, nominal GDP and real GDP). A relative price is the price of one good with respect to the other (it is a real variable).
The real wage is equal to the ratio of the nominal wage to the price level.
Classical dichotomy is the theoretical separation between nominal and real variables. Hume and classical economists claim that monetary developments affect nominal variables and not real variables. This is referred to as monetary neutrality. It is widely believed that these do hold in the long run.

Lecture 33

A quantity equation attempts to link the money supplied to the number of transactions made. The quantity theory of money gives the quantity equation

\[MV = PT,\]

where \(M\) is the quantity of money supplied, \(V\) is the transaction velocity of money, which is the number of times a rupee exchanges hands, \(P\) is the price of a typical transaction (the number of rupees exchanged), and \(T\) is the number of transactions made in a year. The right side of the equation looks from the perspective of transactions, whereas the left looks from the perspective of money used to make transactions.
However, it is very difficult to measure \(T\), so we replace the number of transactions \(T\) with the total output of the economy \(Y\) (real GDP). The more the economy produces, the more goods are bought and sold. They are technically not the same, for example because second-hand goods should be counted in \(T\) but are not in \(Y\).
\(V\) in this new equation \(MV = PY\) is called the income velocity of money. When using the quantity equation, we usually assume that \(V\) is constant.
Observe that since \(Y\) is the amount of output and \(P\) is the price of one unit of output, \(PY\) is just the nominal GDP.
\(M/P\) is referred to as the real money balance, which measures the purchasing power of a stock of money.
If the real GDP is constant, the inflation rate is equal to the money growth rate and if it is growing, the inflation rate is less than the money growth rate.

The building blocks that determine the level of prices are:

  • The factors of production and production function, which determine \(Y\).
  • The money supply, which determines the nominal value \(PY\) of output (This is due to the assumption that \(V\) is unchanging).

The price level \(P\) is then the ratio of \(PY\) to \(Y\).
If both \(V\) and \(Y\) are fixed, then the percentage change in \(M\) is equal to the percentage change in \(P\).
Thus, quantity theory yields that the central bank, which controls money supply, ultimately controls the inflation rate as well. If the money supply is kept stable, the price level is stable.

\[(M/P)^d = kY.\]

The money demand function is similar to the demand function for a good. Since the demand for money balance should be equal to the supply, we get \(M/P = kY\), so the income velocity is \(1/k\). This shows the link between demand and velocity.
If we hold a lot of money for each rupee of income (\(k\) is large), \(V\) is small and money changes hands frequently. Similarly, if \(k\) is small, then \(V\) is large.
The factors of production and production function determine the level of output \(Y\). The money supply determines the nominal value of output \(PY\). The price level \(P\) is thus the ratio of the nominal value of output \(PY\) to the real value of output \(Y\).

The revenue raised by printing of money is called seigniorage. A government can finance its spending in three ways - raising revenue through taxes, borrowing from public by selling bonds, and printing money.
The government itself does not print money, it asks the RBI to print it instead.
Seigniorage causes an increase in money supply, which causes inflation. The printing of money to increase revenue is like imposing an inflation tax which is levied on the holders of money (old money becomes less valuable).

Some results of inflation are:

  • Shoeleather costs are resources wasted when inflation encourages people to reduce their money holdings. This includes the time and transactions costs of frequent bank withdrawals.
  • Menu costs are the costs of changing prices, such as printing new menus and mailing new catalogs.
  • Since firms don’t raise prices at the same time, relative prices can vary, which distorts resource allocation.
  • It complicates long-range planning and comparison of rupee amounts over time.
  • Nominal income grows faster than real income, and since taxes are based on nominal income and may not be adjusted for inflation, people pay more taxes even when their real incomes don’t rise.
  • When inflation is high, another side effect is that debtors can repay their debt with rupees that aren’t worth much. Inflation lower than expected transfers purchasing power from debtors to creditors. A high inflation situation tends to be variable and less predictable than low inflation, and arbitrary redistributions of wealth are frequent.

Hyperinflation is said to occur when the inflation rate exceeds 50% per month. When it occurs, bartering or commodity money becomes prevalent.
Why do banks print money in countries facing hyperinflation? This is due to fiscal policy, when the government has inadequate tax revenue to pay for its spending. To cover this deficit, it prints money. Due to delayed tax collection, real tax revenue drops as inflation rises, and fiscal problems worsen. The reliance on seigniorage worsens the situation.
It can be fixed by reducing government spending and increasing taxes.

The interest rate paid by the banks is called the nominal interest rate \(i\) and the increase in purchasing power the real interest rate \(r\). If \(\pi\) is the rate of inflation, we have \(i = r + \pi\). This is known as the Fisher effect.
Quantity theory together with the Fisher equation tell us how money growth influences nominal interest rate.

Suppose a borrower and lender agree on some nominal interest rate (they do not know the inflation rate over the period of the loan). The ex ante real interest rate is that expected by the borrower and lender when a loan is made, and the ex post real interest rate is that which is actually realized.
Let \(\pi\) denote the actual future inflation and \(\pi^e\) the expectation of future inflation. Then the ex ante real interest rate is \(i - \pi^e\) and the ex post rate is \(i - \pi\). Since the nominal interest rate cannot adjust to the actual inflation (because it is not know when the nominal interest rate is set), the modified Fisher effect says \(i = r + \pi^e\). The ex ante rate \(r\) is determined by the equilibirium in the market as described by the GE model.
The nominal interest rate is essentially the opportunity cost of holding money - it is what is given up by holding money instead of bonds.
The Fisher effect just says that an increase in inflation causes an equal increase in the nominal interest rate, so the real interest rate (wealth) is unchanged.

Lecture 34

In the long run, real GDP grows around 5% per year on average. In the short run however, it fluctuates around this trend. A recession is a period of falling real incomes and rising unemployment. A depression is a severe recession.

  • Economic fluctuations are irregular and unpredictable.
    These short-run economic fluctuations are often called business cycles. The name is somewhat leading since the fluctuations do not actually cycle, and are very unpredictable.
  • Most macroeconomic quantities fluctuate together.
    As a result, it does not matter too much which variable we use to monitor economic activity. It should be noted that while they fluctuate together, they do fluctuate by different amounts.
  • As output falls, unemployment rises.
    This makes sense because when firms produce less goods and services, they lay off workers, which increases the number of unemployed.

Explaining these fluctuations is difficult, and the theory of economic fluctuations is controversial. We usually use the model of aggregate demand and aggregate supply. This differs from classical long-run theories.
In the short run, changes in nominal variables (like \(\text{P}\)) can affect real variables (like \(\text{Y}\)).

The aggregate demand curve shows the quantity of all goods and services demanded in the economy (by households, firms, the government, and customers abroad) at a given price level (\(P\) on the vertical axis and \(Y\) on the horizontal).
The aggregate demand curve slopes downward. Why is this? If \(P\) rises,

  • \(\text{C}\) falls (the wealth effect). People can buy fewer goods and services with the money they hold, so real wealth is lower, people feel poorer, and \(\text{C}\) falls.
  • interest rate \(\text{I}\) rises (the interest rate effect). Wealth falls, so people are more hesitant to lend money, which increases interest rates.It discourages investment spending and decreases the demand for goods and services.
  • \(\text{NX}\) increases (the exchange rate effect). Interest rates rise, so foreign investors desire more Indian bonds, the Indian exchange rate appreciates, and \(\text{NX}\) increases.
    We may assume that \(G\) is fixed by the government policy.

The aggregate demand curve can shift due to

  • changes in consumption, due to a stock market boom/crash or tax hikes/cuts, etc.
  • changes in investment, due to firms buying new equipment or expectations changing.
  • changes in government spending.
  • changes in \(\text{NX}\), due to booms/recessions in countries that buy exports, or appreciation/depreciation from international speculation in the foreign exchange market.

If any of the above decrease, the curve shifts to the left (the quantity of goods/services demanded at a certain price level drops).

The aggregate supply curve shows the quantity of the total quantity of goods and services firms produce and sell at any given price level. It is upward sloping in the short run and vertical in the long run.
First, let us look at the long run.
In the long run, the real GDP depends on the supplies of labour, capital, natural resources, and available technology. Since these do not significantly change in the long run, the aggregate supply is constant and the curve is vertical. What could cause a shift of the long-run aggregate supply curve?

The natural rate of output (\(Y_N\)) is the amount of output the economy produces when unemployment is at its natural rate. It is determined by the economy’s stocks of labour, capital, natural resources, and level of technology, which remain somewhat constant in the long run (an increase in \(P\) does not affect any of these) – this is a consequence of classical dichotomy.

Lecture 35

Some factors that shift the long-run aggregate supply curve are

  • change in labour because of
    • immigration
    • retirement
    • government policies to reduce the natural unemployment rate
      An increase in labour would shift the curve to the right (more goods/services are produced).
  • change in capital because of
    • investment in equipment
    • higher education rate (human capital)
    • destruction of factories due to some natural disaster
      An increase in capital would shift the curve to the right.
  • changes in natural resources because of
    • discovery of new mineral deposits
    • reduction in supply of imported oils
    • changing weather patterns
      An increase in the availability of resources would shift the curve to the right. It should be noted that it can even shift due to the availability of resources abroad, events in the global oil market for example.
  • changes in technology because of productivity improvements from technological process. If they get more advanced, the curve shifts to the right.

In the long run, the aggregate supply curve gradually shifts to the right (due to technological progress) and so does the aggregate demand (due to an increase in money supply). The short-term occurrences should be viewed as deviations from this general trend of output growing and presence of inflation.

The short-run aggregate supply curve is upward sloping. An increase in the price level raises the amount of goods and services supplied. Three theories that attempt to explain this are:

  • According to the sticky-wage theory, nominal wages are sticky in the short run and adjust sluggishly.
    If the price level is greater than expected, the revenue is higher but not the labour cost. Production is profitable, so output and employment increase.
  • According to the sticky-price theory, prices are sticky in the short run and adjust sluggishly.
    This may be due to menu costs, which is the cost of adjusting prices. Suppose the price level is greater than expected. Then firms with menu costs wait to raise prices, so sales increase, and output and employment increase as well.
  • According to the misperceptions theory, firms may confuse changes in price level with changes in the relative price of the products they sell.
    If the price level increases more than expected, then a firm sees its own price rise before realizing that all prices are rising. So, thinking that its relative price is increasing, it may increase output and employment as well.

In all three theories, \(Y\) deviates from \(Y_N\) when \(P\) deviates from \(P_E\).

\[Y = Y_N + a(P-P_E),\]

where \(a > 0\) measures how much \(Y\) responds to changes in \(P\). The imperfections in these theories are only short-run, and the stickiness disappears in the long run.

If the expected price level \(P_E\) changes, the short-run aggregate supply curve shifts. If it rises, workers and firms set higher wages, so at a fixed \(P\), production is less profitable, \(Y\) falls, and the curve shifts to the left.

In the long-run, \(P_E = P\), \(Y = Y_N\), and the unemployment is at its natural rate.

Stagflation is a period of falling output and rising prices.

The theory of liquidity preference is a theory about the interest rate, denoted \(r\). It adjusts to balance supply and demand for money.
Money demand reflects how much wealth people want to hold in liquid form. Suppose there are only two types of assets - money (which is liquid but pays no interest), and bonds (which pay interest but are not as liquid). Then, money demand reflects the preference for liquidity, which is influenced by \(Y\), \(r\), and \(P\).

  • If \(Y\) rises, the money demand increases (people want to buy more goods and services).
  • If \(r\) rises, the money demand falls (the opportunity cost of holding money increases).
  • If \(P\) rises, the money demand increases (people need more money to buy the same amount of goods and services).

The money supply curve is vertical (it is fixed by the RBI). To change both the interest rate and shift the aggregate demand curve, the RBI conducts OMOs to change the money supply. Reducing the money supply increases \(r\), which in turn reduces the quantity of goods and services demanded.

Fiscal policies are undertaken by the government, and monetary policies by the central bank.

  • Expansionary fiscal policy increases \(G\) and/or decreases \(T\) (it shifts the aggregate demand curve to the right).
  • Contractionary fiscal policy decreases \(G\) and/or increases \(T\) (it shifts the aggregate demand curve to the left).

There are two effects that fiscal policy has:

  • The multiplier effect - additional shifts in aggregate demand that result when fiscal policy increases income and thus increases consumer spending.
    Marginal propensity to consume is the fraction of extra income that households consume rather than save. Using this, we can quantify the multiplier effect.
    We have

    \[\Delta Y = \Delta C + \Delta G = (MPC) \Delta Y + \Delta G = \frac{1}{1 - MPC} \Delta G.\]

    \(I\) and \(NX\) do not change. This multiplicative factor is the multiplier.

  • The crowding out effect - if a fiscal policy raises \(r\), then investment drops, and the net increase in aggregate demand drops. So, the actual aggregate demand shift may be less than the initial fiscal expansion.

People who believe that fiscal policy affects aggregate supply significantly are called supply-siders. These effects are usually more relevant in the long run.

It is desirable to have a relatively stable economy.

  • When GDP falls below its natural rate, expansionary monetary/fiscal policy should be implemented to avoid a recession.
  • When it goes above its natural rate, contractionary policy should be implemented to avoid (too much) inflation.
    Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into recession, without the policymakers actively taking any action.
    For example, in a recession, taxes fall automatically and government spending rises automatically (more people apply for public assistance).