MACROECONOMICS

 In its briefest description, macroeconomics is the

study of the economy’s total output, employment and
the price level.
 Prior to the 1930s, economists concentrated their
attention almost exclusively on the area of
microeconomics.
 Economists believed boom and depression are
unavoidable and economy has a self-correcting
mechanism.
 The Great Depression of the 1930s and the
contribution of J M Keynes led to the origin of
macroeconomics.
 Macroeconomics
 The term ‘Macroeconomics’ applies to
the study of relations between broad
economic aggregates – R G D Allen.
 Macroeconomic Theory is the theory of
income, employment, prices and
money – J M Culbertson.
 Macroeconomics is that part of
economics which studies the overall
averages and aggregates of the
system – K E Boulding.
 Macroeconomics
 It is the study of the forces or factors that
determine the levels of aggregate production,
employment, prices in an economy and their rates
of change over time – G Ackley.
 The basic emphasis or essence is that
macroeconomics deals with the functioning of the
economy as a whole.
 In short, macroeconomics attempts to deal with the
truly “big” issues of economic life – full employment
or unemployment, capacity or undercapacity
production, a satisfactory or unsatisfactory rate of
growth, inflation or price level stability.
 Macroeconomics - Scope
 Macroeconomics examines changes in total national
production and consumption, averages of the prices
of broad groups of goods and services, and the
employment of workers in the economy.
 Macro economists seek to explain the causes of
economic fluctuations and to suggest policies that
will make the fluctuations less abrupt, with the aim
of preventing excessive unemployment and rapid
price increases.
 In studying aggregate production in the economy
and its fluctuations, macroeconomists seek to
uncover the basic influences that cause national
production to increase
Macroeconomics – Central Issue
 A major task of macroeconomics is
the explanation of what determines
the economy’s aggregate output of
goods and services.
 In any time period, output may be
equal to what can be produced with
full utilization of the economy’s
resources or may be less than that.
 The question of measurement comes
under National Income Accounting.
IMPORTANCE OF MACROECONOMICS
1. It helps to understand the functioning of a complicated modern economic
system. It describes how the economy as a whole functions and how the level
of national income and employment is determined on the basis of aggregate
demand and aggregate supply.
2. It helps to achieve the goal of economic growth, higher level of GDP and
higher level of employment. It analyses the forces which determine economic
growth of a country and explains how to reach the highest state of economic
growth and sustain it.
3. It helps to bring stability in price level and analyses fluctuations in business
activities. It suggests policy measures to control Inflation and deflation.
4. It explains factors which determine balance of payments. At the same time, it
identifies causes of deficit in balance of payments and suggests remedial
measures.
5. It helps to solve economic problems like poverty, unemployment, business
cycles, etc., whose solution is possible at macro level only, i.e., at the level of
whole economy.
6. With detailed knowledge of functioning of an economy at macro level, it has
been possible to formulate correct economic policies and also coordinate
international economic policies.
 NATIONAL INCOME AND PRODUCT
ACCOUNTS (NIPA)
 During the 1930s, Simon Kuznets helped to
create a system for measuring National
Income.
 The National Income and Product Accounts
(NIPA) are the official system used for
measuring economic activity in product and
input markets in the USA.
 NIPA not only measures economic activity
but also how households, business firms and
governments affect the flow of expenditure
and income in product and input markets.
 MEASURING AGGREGATE OUTPUT:
GROSS DOMESTIC PRODUCT (GDP)

 GDP – the cornerstone of NIPA

 GDP – the market value of final goods
and services produced by workers and
other resources located within the borders
of a nation over a period of one year.
 Market value
 Final goods and services
 Within the borders
 During an year
 MEASURING AGGREGATE OUTPUT:
GROSS DOMESTIC PRODUCT (GDP)

 GDP = Total value added in a nation

 = market value of all
products – market value of
intermediate products.
 Nominal GDP = at current prices.
 Real GDP = at constant prices.
HOW GOOD IS GDP AS A MEASURE OF
NATIONAL WELL-BEING?
What are its Limitations?

 Non-Market production.
 The value of leisure.
 Cost of environmental damage.
 The underground economy/parallel
economy.
 Distribution of GDP
GDP Measurement

Two major approaches:

Expenditure and Income.
 Expenditure Components of GDP

Consumption Expenditure (C)

 Purchase of both durable and non-durable
goods and services by people.
 Personal consumption expenditure in the US
typically account for 2/3rd or more of GDP. A
reduction in consumer spending, therefore,
can spell trouble for the economy.
 It excludes investment made on new houses.
 Expenditure Components of GDP

Investment Expenditure (I)

 Investment is the purchase of final products
by business firms for use in production or
additions to inventories and the purchase of
new homes by households.
 Gross private domestic investment includes
purchases of new machinery, equipment and
structures by businesses, purchases of new
homes by households and change in
business inventories during the year
 Expenditure Components of GDP

Investment Expenditure (I)

 Reduction in business inventories = negative
investment.
 It includes only investments within the
borders of the country.
 Net Domestic Private Investment = Gross
Domestic Private Investment – Depreciation.
 GPDI accounts for 12% to15% of US GDP
 Expenditure Components of GDP
Government Expenditure (G)
 Government purchases include expenditure on final
products of business firms, and all input costs,
including labour costs incurred by all levels of the
Government.
 Government produces valuables, goods and
services – national defense, education, law and
order, etc. They are indirectly valued.
 It does not include transfer payments (social security
pensions, welfare payments and subsidies).
 Government Exp. accounts for about 20% of GDP in
the US.
 Expenditure Components of GDP

Net Exports (NE)

 Excess of expenditure on exports over imports.
 Net exports account for a negative share of GDP in the US

 GDP = C + I + G + NE = Aggregate Expenditure.

 Aggregate Production will always be equal to Aggregate
Expenditure
 Aggregate Expenditure represents
Aggregate Demand
 GDP COMPOSITION OF INDIA:
EXPENDITURE APPROACH
Expenditure Approach 2005/06 2009/10 2014/15
(at 2004/05 prices) (Rs. Billion)
Private Consumption (C) 20833.09 28453.03 60642.47
% to total 58.80 59.39 56.97
Government Expenditure (G) 3860.07 5517.02 11578.10
% to total 10.89 11.52 10.88
Gross Fixed Capital Formation 10817.91 15944.75 31919.73
(GFCF) (I)
% to total 30.53 33.28 29.99
Change in Stocks (%) 2.86 2.99 1.54
Valuables (%) 1.14 1.97 1.58
Exports 7174.24 9990.30 24343.50
% to total 20.25 20.85 24.43
Net Exports (X – M) (%) -3.18 -7.0 -1.37
Total 35432.44 47908.47 58136.64
 Income Components of GDP
 GDP is also gross domestic income. The total income
generated from production of final products = the
value of those products.
when aggregate expenditure is valued at base year
market prices, aggregate expenditure measures real
GDP.
 Real GDP = Aggregate Real Income.
1. Compensation of Employees: Accounts for about 60% of the
GDP each year in the US.
2. Net Interest: It excludes interest paid by the government.
3. Rental Income
4. Profits
• Indirect business taxes
• Consumption of fixed capital (CFC)
Other Measures of Aggregate Expenditure and
Income

 GNP: The market value of final output

produced annually by all labour and property
supplied by a nation’s households, no matter
where those resources are employed.

 GNP = GDP + Foreign sources of income of

Indian households – Income earned by
foreigners in India.
 Other Measures of Aggregate Expenditure
and Income

 Net National product (NNP) = GNP – CFC

 National Income (NI) = GNP – CFC – Indirect
Taxes
 Personal Income (PI) = NI – Corporate
Income Taxes – Corporate Profits – Social
Security Contributions + Personal Interest
Income + Personal Dividend Payments +
Payments Received through Government
Transfers and Business Transfers.
 Disposable PI = PI – Personal Taxes
 GDP and GNP in India

Year At Current At Constant

Prices Prices
GDP 2005/06 Rs.36933.69 Rs.35432.44
billion billion (2004/05)
2014/15 Rs.125412.08 Rs.106439.83
billion billion (2010/11)
GNP 2005/06 Rs.33643.87 Rs.32281.77
billion billion (2004/05)
2014/15 Rs.123839.08 Rs.105131.63
billion billion (2010/11)
National Output: Expenditure and Income Flows

Pers
Compensation of employees
onal Disposable
C Rents
National Inco Income
Interest
Net Income me
Gross Dividends
National
G National Proprietors income
Product
Product Corporate income taxes
Undistributed corporate profits
I Indirect business taxes
Personal taxes

Capital consumption
allowance Social security contributions

Investment Expenditures
BUSINESSES GOVERNMENT HOUSEHOLDS

Transfer of payments
Government purchases of goods and services Personal Saving

Personal consumption expenditures

Circular Flow of Expenditure and Income
In je c tio n s o f S p e n d in g A g g re g a te e x p e n d itu re L e a k a g e s o f s p e n d in g
I = In v e s tm e n t GDP = C + I + G + NE S = S a v in g
G = G o v e rn m e n t p u rc h a se s T = N e t ta x e s
E = E x p o rt p u rc h a se s M = Im p o rts
G
+
+
I
+ NE

C o n s u m p tio n C

Government Purchases
A g g re g a te
E x p e n d itu re

Imports
Investment

Exports
H o u s e h o ld s F in a n c ia l G o v ern m e n t In te rn a tio n a l B u s in e s s F ir m s
S y ste m T ra d e

Net Taxes = Taxes – Transfers

Saving

N e t F o re ig n In flo w o f S a v in g s

D is p o s a b le
In c o m e
A g g re g a te
In c o m e

A g g re g a te in c o m e
GDP = C + S + T
NATIONAL INCOME ACCOUNTING (NIA) IN
INDIA: EVOLUTION AND STATUS
 The regular national income accounting system was
initiated in the mid-1960s.

 The first systematic work was done by VKRV Rao,

which constituted the basis for post-independence
work on national income estimation in India.

 The first official estimates of national income were

produced for the entire Indian union by the National
Income Committee appointed in 1949 under the
chairmanship of P C Mahalnobis with D R Gadgil
and VKRV Rao as members.
 NATIONAL INCOME ACCOUNTING (NIA) IN
INDIA: EVOLUTION AND STATUS
 The first report of National Income Committee was published in 1951.

 Simon Kuznets (NBER), J R N Stone (Cambridge University) and J B

D Derksen (UN) offered suggestions.

 Estimates of national income (up to 1967), estimates of national product

(1967-1974) and known as National Accounts Statistics (from 1975
onwards).

 GDP series at constant prices was prepared by CSO.

 Earlier the base year was selected to coincide with the decennial census
periods (1970/71, 1980/81).
 NATIONAL INCOME ACCOUNTING (NIA) IN
INDIA: EVOLUTION AND STATUS
 This was done because the CSO was depending on the
population census figures to estimate the size of the
workforce which, when multiplied by the estimated value
added per worker, gave GDP originating in segments of
various unorganized sectors.

 Henceforth, CSO would revise the base year every five years
to capture the rapidly changing structural features of the
economy. The NSSO employment and unemployment surveys
will be used, in addition to census. For 1993-94, the
workforce estimates of NSSO (1993-94) was used.
 ESTIMATION PROCEDURE OF PRODUCT
ACCOUNTS
 A complex set of methods is employed by the CSO to measure
GDP generated in each of the sectors.
 Production, expenditure and income approaches are adopted,
the criterion being essentially the nature of data availability.
 In certain cases like labour-intensive kutcha construction
undertaken with the use of freely available materials like leaves,
reeds, mud, etc. expenditure method is used.
 The sectors, which are amenable to the production approach
are: agriculture and allied activities, forestry and logging,
fishing, mining and quarrying, and registered manufacturing.
 In respect of the following sectors, income method or some
variant of it is adopted: unregistered manufacturing, electricity,
gas, water supply, transport, storage and communications,
trade, hotels and restaurants, real estate, dwelling and other
business services.
 Business Cycles, Unemployment and Economic
Growth

• Business Cycle is the term used to describe the fluctuations in

aggregate production as measured by the ups and downs of
real GDP.
• The fluctuations, although not subject to easy predictability or
regularity, can be readily identified.
• A recession is usually defined as a period in which output,
income and employment decline nationally over a period of six
months.
• There will be wide spread contraction of economic activity.
• Real GDP, industrial production, and personal income usually
decline, while unemployment increases.
 Business Cycles, Unemployment and Economic
Growth
Boom
Real GDP (per year)

Depression
Recovery or expansion

Recession or contraction

Time

• Almost all recessions are preceded by a decline in stock market prices, but
not all declines in stock market prices are followed by a recession.
 Unemployment
• Labour Force: People > 15 years of age either employed or
actively seeking a job.

• Unemployment Rate: The ratio of number of people classified

as unemployed to the total labour force.

• Unemployed Person: One > 15 years of age who is available for

work and has actively sought employment during the previous
four weeks.

• Discouraged Worker: Who leaves the labour force after

unsuccessfully searching for a job for a certain period.
 Unemployment
• Frictional Unemployment
• Structural Unemployment
• Cyclical Unemployment: characterized by Layoffs?
• Disguised Unemployment
• Natural rate of unemployment: % of labour force that can
normally be expected to be unemployed for reasons other
than cyclical fluctuations in real GDP.
• Full Employment: Actual rate of unemployment = Natural rate
of unemployment.
• Potential real GDP: Level of real GDP that would prevail if the
economy achieved the natural rate of employment over a
period of one year.
• Over heated economy: Actual rate of unemployment < natural
rate of unemployment
 What factors determine Natural rate of
Unemployment?
• Composition of labour force in terms of age groups.
• Changes in the structure of domestic demand.
• Rapid changes in technology.
• Number of two income earners in families.
• Tendencies towards moving in and out of the labour
force.
• As of 1994, natural rate of unemployment in the US
economy was in the range of 5.5% to 6.0%.
• Unemployment rates in India as of 2012/13, 2013/14
and 2014/15 were 11.3%, 9.8% and 10.8%,
respectively.
 Potential Real GDP

1. Potential real GDP is not the economy’s “capacity”

output.
2. It is not easy to measure potential real GDP.
3. Potential real GDP grows over time.

Potential real GDP is the benchmark used in

macroeconomics to gauge the performance of the
economy.
 Economic Growth
• Measured by the annual percentage increase in the level of
real GDP/GNP.
Sources of Economic Growth
1. The productive resources available to the nation.
2. The quality of productive resources available to the nation.
3. Improvements in technology.
4. Improvements in the efficiency with which available inputs
are used.
 Price Level and Inflation
 Price Level: an indicator of how high or low prices are in a
certain year compared to a base year.
 Price index: a number used to measure the price level.
 Inflation: the rate of upward movement in the price level for
an aggregate of goods and services.
 Pure Inflation: prices of all goods rise by the same
percentage over the year.
 Deflation, Dis-inflation and Deceleration.
 Deflation: rate of downward movement in the price level
 GDP Deflator: the ratio of nominal GDP to real GDP
(multiplied by 100).
 It is an index of the average of prices implicitly used to deflate
nominal GDP.
 Price Level and Inflation
 GDP Deflator = (Nominal GDP/Real GDP)*100

 GDP Deflator (for 1999/00) = (1761932/1148442)*100

= 153.42

 GDP Deflator (for 2000/01) = (1917724/1198685)*100

= 159.99
 Nominal Income and Real Income

 Nominal Wages and Real Wages

 Nominal Interest and Real Interest

 Price Level and Inflation
 Creeping inflation and Hyper inflation.
 In 1922, the annual rate of inflation in Germany was
more than 5000%.
 In 1985, the rate of inflation in Bolivia was 11749%.
 An item, which cost 50 cents at the beginning of the
year, cost more than $ 5000 at the end of the year.
 In 1989, in some months, in Argentina, the inflation
rate was more than 12000%.
 Headline inflation and Core inflation: The former is
overall inflation whereas the latter excludes changes
in the prices of food and fuel, which are considered
to be volatile and prone to inflationary spikes.
 Inflation Measurement

 Annual rates of inflation are measured by the

percentage change in a price index (CPI) from one
year to the next.
 CPI is the price index most commonly used to
measure the impact of inflation on households.
 CPI is actually a weighted average of a number of
component price indices.
 Rate of inflation (for 2017) =
CPI in 2017 – CPI in 2016 * 100
CPI in 2016
 Inflation Measurement in India
 Price indices are measures of price movements of a basket
of goods and services at different levels of aggregation.
 They measure the differences in average prices over time
and/or across geographical areas.
 WPI and CPI – two major types of prices compiled and used
in most countries.
 In India, the official inflation rate is measured by WPI
compiled on a weekly basis by the office of the E.A, Ministry
of Industry.
 CPI is compiled on a monthly basis for the following:-
 Industrial Workers
 Agricultural Labourers
 Rural Labourers
 Urban Non-Manual Employees
 Of the four, CPI – IW is the one most frequently used.
 Annual Average Inflation by Major
Heads in WPI (2004/05 base year)
Commodities Weight 2008/09 2009/10 2010/11 2011/12

All 100.00 8.05 3.80 9.55 9.11

Primary 20.12 11.05 12.66 18.41 9.91

Fuel & Power 14.91 11.57 -2.11 12.24 13.67

Manufactured 64.97 6.16 2.22 5.46 7.58

products
 WPI: Composition and Demerits

 The government revised the base year of WPI from 2004/05

to 2011/12 from April 2017.
 WPI inflation measures the average change in the prices of
commodities for bulk sale at the level of early stage
transactions pertaining to four sectors, namely, agriculture,
mining, manufacturing and electricity.
 The share of these four sectors in GDP at current prices was
41.4% in 2011/12. The basket of the WPI covers commodities
under 3 major groups: primary articles, fuel & power, and
manufactured products. The prices tracked are ex-factory
prices for manuf. Good, mandi prices for agri goods, and ex-
mines prices for minerals.
 The latest WPI series consists of altogether 697 articles/items
comprising 117 ‘primary articles’, 16 items of ‘fuel, power, light
and lubricants’, and 564 ‘manufactured products’.
 WPI: Composition and Demerits
 Weight given to each commodity covered in the WPI basket is
based on the value of production adjusted for net imports.
 WPI takes care of price movements of only commodity-
producing sectors, viz., primary and secondary sectors of the
economy. Thus, WPI does not cover services.
 The need for a service sector index in India is warranted by the
growing dominance of the sector in the economy.
 In the new WPI series (2011/12), significant improvement in
terms of concept, coverage and methodology has been made.
The item basket has been revised with inclusion of new items
and exclusion of old ones to capture the structural changes that
have occurred in the economy.
 In the updated WPI basket, the number of items has been
increased and special efforts have been made to enhance the
number of price quotations across the major groups to ensure
comprehensive coverage & representativeness.
Change in Reporting of Inflation
 At present the WPI for all commodities including manufactured
products is released on a monthly basis.
 The higher frequency weekly reporting was prone to more statistical
‘noise’ and sometimes provided a misleading picture, so the trade-off
was between the more frequent and less reliable data and less
frequent but more reliable data.
 International practice of reporting CPI inflation is also on a monthly
basis.
 In view of the above, the CCEA in its meeting on 24th January 2012,
agreed to discontinue the weekly release of WPI for commodities
under the groups ‘primary articles’ and fuel & power’ with immediate
effect.
 The last weekly WPI for the week ending 14 January 2012 was
released on 27 January 2012.
 WPI
 Inflation rate calculated on the basis of the movement of the Wholesale Price
Index (WPI) is an important measure to monitor the dynamic movement of
prices.
 As WPI captures price movements in a most comprehensive way, it is widely
used by Government, banks, industry and business circles.
 Important monetary and fiscal policy changes are often linked to WPI
movements. Similarly, the movement of WPI serves as an important
determinant, in formulation of trade, fiscal and other economic policies by the
Government of India.
 The WPI indices are also used for the purpose of escalation clauses in the
supply of raw materials, machinery and construction work.
 The Office of the Economic Adviser in the Department of Industrial Policy and
Promotion, Ministry of Commerce & Industry is responsible for compiling WPI
and releasing it.
 The Office published for the first time, the index number of wholesale prices,
with base week ended August 19, 1939= 100, from the week commencing
January 10, 1942. Since 1947 the index is being published regularly.
 Comparative Statement of Weights
assigned to Product Groups
Major Group 1970/71 1981/82 1993/94 2004/05 2011/12

All 100.00 100.00 100.00 100.00 100.00

Primary articles 41.67 32.30 22.02 20.12 22.62

- Food articles 29.80 17.39 15.40 14.34 -----

- Non food 10.62 10.08 6.14 4.26 -----

articles
-Minerals 1.25 4.82 0.49 1.52 -----

Fuel & power 8.46 10.66 14.23 14.91 13.15

Manufactured 49.87 57.04 63.75 64.97 64.23

products
 New Series of CPI Numbers
 The CSO has taken initiative for compilation of new series of urban, rural and
combined (urban + rural) CPI at State/UT/all India level with increased scope and
coverage
 CPI (rural and CPI (urban) would be compiled for each State/UT as well as at All
India level.
 Weighting diagrams have ben derived from the results of NSSO 61 st round of
CES (2004/05)
 In urban areas, all cities/towns having population (2001 population Census) more
than 9 lakh and all State/UT capitals not covered therein were selected
purposively.
 In rural areas, with a view to having a manageable workload and considering that
the CPI (rural) would provide the price changes for the entire rural population of
the country, a total of 1183 villages have been selected at all India level.
 The CSO has also decided to bring out a national CPI by merging CPI (urban)
and CPI (rural) with appropriate weights , as derived from NSS 61 st round of
Consumer Expenditure Survey (2004/05) data.
 INFLATION RATES BASED ON
DIFFERENT PRICE INDICES
Year WPI CPI - CPI-IW CPI -AL CPI-RL
combined

2012/13 6.9 10.2 10.4 10.0 10.2

2013/14 5.2 9.5 9.7 11.6 11.5

2014/15 1.2 5.9 6.3 6.6 6.9

2015/16 -3.7 4.9 5.6 4.4 4.6

2016/17 1.7 4.5 4.1 4.2 4.2

Source: DIPP for WPI; CSO for CPI-Combined, and Labour Bureau
for CPI (IW), CPI (AL), and CPI (RL).
 Recent Measures for Containing
(Food) Inflation
 Increased allocation for Price Stabilization Fund in the budget 2017-18
to check volatility of prices of essential 117 Prices and Inflation
commodities, in particular of pulses.
 Government has approved creation of a dynamic buffer of up to 20 lakh
tonnes of pulses for appropriate market intervention against which buffer
of around 18.75 lakh tonnes has already been built.
 Subsidized un-milled pulses from the buffer stock were offered to
States/Agencies for direct distribution to public
 at a reasonable rate.
 States/UTs have been empowered to impose stock limits in respect of
pulses, onion, edible oils and edible oil seeds under the Essential
Commodities Act.
 Export of all pulses is banned except kabuli channa and up to 10,000
MTs of organic pulses and lentils.
 Recent Measures for Containing
(Food) Inflation
 Import of pulses is allowed at zero import duty except for Tur where import duty of
10% has been imposed due to its bumper production in 2016-17.
 SEBI banned new contracts in Chana to dampen speculative activities.
 Announced higher Minimum Support Prices so as to incentivize production and
thereby enhance availability of food items which may help moderate prices.
 Export of edible oils was allowed only in branded consumer packs of up to 5 kg
with a minimum export price (MEP) of USD 900 per MT. This restriction has
recently been liberalized.
 MEP of USD 360 was imposed on potato till December 2016.
 Reduced import duty on potatoes, wheat and palm oil.
 Imposed 20 per cent duty on export of sugar.
 Imposed stock-holding and turn-over limit on sugar till 28.10.2017 to check
speculative tendencies and possible hoarding behaviour.
 Recently allowed duty free import of 500,000 tonnes of raw sugar to enhance
domestic availability.
 AGGREGATE DEMAND
AND AGGREGATE SUPPLY
Prof M H Bala Subrahmanya
Department of Management Studies
Indian Institute of Science
BANGALORE -560012
 Aggregate Demand
• Aggregate demand and aggregate supply help us to
understand how changes in the economy result in
expansions or contractions.
• Aggregate Demand
– It is the relationship between aggregate quantity demanded
and the economy’s price level.
– The amount of final products that buyers will purchase at a
given price level is called the aggregate quantity
demanded.
– Aggregate demand curve depicts the relationship between
aggregate quantity demanded and price level.
 Aggregate Demand

Price Level (index number)

Real GDP
(output of final products in billions of base year rupees)

• It is different from a market demand curve.

• It describes a relationship between an index of prices and
an aggregate of final products demanded in a nation
instead of a relationship between the price and the
quantity of a single good.
 Aggregate Demand
• Downward Slope: A decrease in the price level
will increase the willingness and ability of
buyers to purchase the products included in real
GDP.
• Three factors are responsible: -
1. Real wealth effect
2. Real interest rate effect
3. Foreign trade effect
• A change in Aggregate Quantity Demanded
implies a movement along the AD Curve.
Why the Aggregate-Demand Curve Is
Downward Sloping?
• The AD is not downward sloping for the reasons a
demand curve in microeconomics is downward sloping
(substitution and income effects)
• If P falls the value of money increases, people are then
holding excess cash balances so they either spend it or
lend it:
– The Price Level and Consumption: The Wealth Effect
– The Price Level and Investment: The Interest Rate Effect
– The Price Level and Net Exports: The Foreign Trade Effect
 The Wealth Effect

• The Price Level and Consumption: The Wealth

Effect
– A decrease in the price level increases the value of
money in one’s portfolio and makes consumers feel
more wealthy, which in turn encourages them to spend
more.
– This increase in consumer spending means larger
quantities of goods and services demanded.
– P↓ → VofM↑ → wealth↑ → spend it → C↑ →AD↑
 The Interest Rate Effect

• The Price Level and Investment: The Interest

Rate Effect
– A lower price level increases the value of cash
holdings and wealth, people lend more, this reduces
the interest rate, which encourages greater spending on
investment goods.
– This increase in investment spending means a larger
quantity of goods and services demanded.
– P↓ → VofM↑ → wealth↑ → lend it → SLF↑ → r↓ → I↑
→ AD↑
 The Exchange Rate Effect

• The Price Level and Net Exports: The Foreign

Trade Effect
– A lower domestic price level implies domestic goods
becoming less expensive relative to foreign goods,
which would prompt domestic residents to substitute
domestic goods for imported goods. The decrease in
the price of domestic goods also increases the quantity
of domestic exports demanded globally, other things
remaining the same. The result is an increase in Net
Exports (NX).
– P↓ → X↑ M↓ → NX↑ → AD↑
 Shifts in the Aggregate-Demand Curve
• The downward slope of the aggregate demand curve shows
that a fall in the price level raises the overall quantity of goods
and services demanded.
• Many other factors, however, affect the quantity of goods and
services demanded at any given price level. When one of these
other factors changes, the aggregate demand curve shifts.
• Shifts arise from autonomous increases (not related to P or Q)
– Consumption – consumer confidence
– Investment – business confidence
– Government Purchases – Military, Medicare
– (X-M) Net Exports ↑
 Changes in Aggregate Demand (AD)
• Change in AD and change in aggregate quantity demanded.
• A change in AD implies a movement of the entire demand curve.
• Due to factors other than the price level.
Price Level (index number)

Price Level (index number)

Initial AD New AD

New AD Initial AD

Real GDP
(output of final products in billions of base year rupees)
 Factors Influencing Changes in Aggregate
Demand
Changes that can cause an Changes that can cause a
increase in aggregate demand decrease in aggregate demand
• A decrease in real interest • An increase in real interest
rates. rates.
• An increase in the quantity of • A decrease in the quantity of
money in circulation. money in circulation.
• A decrease in the international • An increase in the international
value of the Rupee. value of the Rupee.
• An increase in the general • A decrease in the general level
level of wealth. of wealth.
• An increase in government • A decrease in government
purchases. purchases
 Factors Influencing Changes in Aggregate
Demand
Changes that can cause an Changes that can cause a
increase in aggregate demand decrease in aggregate demand

• A decrease in tax rates. • An increase in tax rates.

• An increase in government • A decrease in government
transfers. transfers.
• Improved expectations about • Deteriorating expectations
the future. about the future.
• Higher income and • Lower income and worsening
improvements in economic economic conditions in foreign
conditions in foreign nations. nations.
 Aggregate Supply (AS)

-AS is a relationship between price level and aggregate quantity

supplied.
- Aggregate quantity supplied is the quantity of final products
(measured by real GDP) that will be supplied by producers at a given
price level .
- Aggregate Supply curve shows the aggregate quantity supplied for
each possible price level over a given period
 Aggregate Supply (AS)

Price Level
(index number)

Potential real Real GDP

GDP
 Aggregate Supply (AS)

-An upward sloping AS curve implies that an increase in the

price level will increase the aggregate of the final products,
measured by real GDP, that domestic business firms will
produce.
 Segments of AS curve

Price Level 3

2
Segment 1

Real GDP
 Segments of AS curve

Segment 1- The economy is operating well below

its potential.
Segment 2 - The economy is close to full
employment.
Segment 3 – The economy is overheated.
Changes in Aggregate Quantity Supplied occur due to changes in the price level.
-Changes in AS
-Due to factors other than the price level.
-Changes in the Quantity or Productivity of Inputs affect AS.
Impact of an increase in input prices
on Aggregate Supply

New Aggregate Supply

Price level
(index number)

Initial Aggregate Supply

Potential real GDP

Real GDP
Impact of a Decrease in input prices
on Aggregate Supply

Price Level Initial Aggregate

Supply
(index
number)
New Aggregate Supply

Real GDP
Potential real GDP
 An Increase in Aggregate Supply
Resulting from an Increase in the
Quantity or Productivity of Inputs
Initial Aggregate Supply

Price Level
(index
number)

New Aggregate Supply

New potential real GDP Real GDP

Initial Potential real GDP
 A decrease in Aggregate Supply
Resulting from a Decrease in the
Quantity or Productivity of Inputs
New Aggregate Supply

Price level
(index
number ) Initial Aggregate Supply

Initial Potential real Real GDP

New Potential real GDP
GDP
 Macroeconomic Equilibrium

 Macroeconomic equilibrium is attained when the

aggregate quantity demanded equals the aggregate
quantity supplied.
 When a macroeconomic equilibrium exists, there may be
shortages in some product markets and surpluses in other
product markets.
 In the aggregate, however, there is neither upward nor
downward pressure on the price level or the level of real
GDP once macroeconomic equilibrium is attained.
Impact of a decrease in AD

Decrease

Initial AD
Price Level

New
AD AD2 AD1

Rs 5000 billion Real GDP

Recessionary (Potential Real GDP)
GDP gap
Impact of an increase in AD

Increase
AS

New
AD

Initial AD

AD2
Price Level

AD1

(Potential Real GDP) Real GDP

Inflationary
GDP gap
 Demand – Pull Inflation
• is inflation caused by increases in AD.
• Impact of changes in AD will vary with the extent of
capacity utilization in an economy.
AS
AS
Price Level

Price Level
AD2 AD2

AD1 AD1

REAL GDP
 Impact of changes in AS

Decrease Increase

AS2
AS1 AS1
Price Level

Price Level
AD
AD
AS2

REAL GDP
 Cost Push – Inflation

 Cost-push inflation is caused by continuous decreases in

aggregate supply.
 Recessions can be caused by a decrease in AD.
 A decrease in AD can cause both excessive
unemployment and some downward pressure on the price
level.
 A decrease in AS in likely to be accompanied by both
inflation and excessive unemployment.
 Inflation can be explained by either increases in AD or
decreases AS.
 Both demand-pull and cost-push inflation can occur, and
sometimes both occur simultaneously.
 CAUSAL FACTORS

 Demand-Pull
– Increase in income & wealth
– Easy money (monetary stimulus)
– Institutional factors
– Higher fiscal stimulus from the government
– Faster economic growth in other countries
 Cost-Push
– A rise in Component costs/labour costs
– A fall in the exchange rate
– Supply constraints
– Infrastructural bottlenecks
– Droughts, wars & other natural calamities
– Increase in indirect taxes and/or administered prices
HOW TO TACKLE INFLATION?

Monetary policy
Fiscal policy
Administrative measures
Other macro-economic policies such as:
Trade policy, and
Industrial policy can also play a role.
LABOUR MARKET IN INDIAN
ECONOMY
MACROECONOMICS
 OCCUPATIONAL STRUCTURE OF LABOUR
FORCE
• It defines the composition of labour force in terms
of employment in agriculture, industry and services.
• With economic development and changes in
economic structure, the occupational structure of
labour force is likely to undergo a change.
• Agriculture  Industry  Services
• However, the shift from agriculture to industry and
from industry to services will not be as sharp and
decisive as in the economic structure.
 Dimensions of Labour Sector in India
1. Population  Labour force  Workforce
2. Worker-Population Ratio (WPR)
3. Workforce employed in Agriculture, Industry &
Services
4. Workforce employed in organized and unorganized
sectors
5. Workforce employed in Public Sector Vs Private Sector
6. Types of employment: Self-employed, Salaried &
Casual workers
 Population, Labour and Workforce in Indian
Economy (Million)
1983/84 1993/94 1999/00 2004/05 Growth per annum (%)
1983- 1993/94- 1999/00-
1993/94 1999/00 2004/05

Population 718.10 893.68 1005.05 1092.83 2.11 1.98 1.69

Labour force 263.82 334.20 364.88 419.65 2.28 1.47 2.84

(36.74) (37.40) (36.31) (45.86)

Workforce 239.49 313.93 338.19 384.91 2.61 1.25 2.62

(33.35) (35.13) (33.65) (35.22)

Unemployment 9.22 6.06 7.31 8.28

rate (%)

No of unemployed 24.34 20.27 26.68 34.74

 Worker-Population Ratio for Urban,
Rural and All India (for every 1000)
Year Urban India Rural India All India

Male Female Total Male Female Total Male Female Total

1977/78 508 156 341 552 331 444 543 297 423

1983/84 512 151 340 547 340 445 538 216 420

1987/88 506 152 337 539 323 434 531 285 412

1993/94 521 155 347 553 328 444 545 286 420

1999/00 518 139 337 531 299 417 527 259 397

2004/05 549 166 365 546 327 439 547 287 420
 Sectoral Employment Shares in India
(%)
Sector 1983 1993/94 1999/00 2004/05 2011/12 2017/18

Agriculture 65.42 61.03 56.64 52.06 48.9 44.1

Industry 14.83 15.92 17.58 19.45 24.3 24.8

Service 19.74 23.06 25.78 28.47 26.9 31.1

Total 100.00 100.00 100.00 100.00 100.00 100.00

 Shares of Organized and Unorganized
Sectors in Employment (Millions)
1983 1993/94 1999/00 2004/05 2011/12 2017/18

Total workforce 239.49 313.93 338.19 384.91 474.2 465.1

(Million)
Organized sector 24.01 27.38 27.96 26.46 34.8 42.8
(10.03) (8.72) (8.27) (6.87) (7.34) (9.20)
Unorganized sector 215.48 286.55 310.23 358.45 439.4 422.30
(89.97) (91.28) (91.73) (93.54) (92.66) (90.80)
CARG 1983-1993/94 1993/94-2011/12 2011/12-
2017/18
Organized sector 1.32 1.34 3.51

Unorganized sector 2.89 2.40 -0.66

 Composition of Organized Sector:
Public and Private Sectors (Millions)
Sector 1977 1981 1985 1988 1991 1995 2000 2005 2012

Public 13.77 15.48 17.27 18.32 19.06 19.47 19.31 18.01 17.61

Private 6.87 7.40 7.31 7.39 7.67 8.06 8.65 8.45 11.97

Total 20.64 22.88 24.58 25.71 26.73 27.53 27.96 26.46 29.58

CARG 1977-1991 1991-2012

Public 2.35 -0.38

Private 0.79 2.14

Total 1.86 0.48

 Sectoral Shares in Public and Private
Organized Sectors (Lakhs)
Sector 1977 1985 1991 1995 2000 2005 2012
Agriculture Public 3.66 4.98 5.56 5.39 5.14 4.96 4.73
Private 8.38 8.07 8.91 8.94 9.31 9.83 9.24
Total 12.04 13.05 14.47 14.33 14.45 14.79 13.97
Industry Public 35.55 46.41 49.05 48.71 44.93 39.15 37.97
Private 44.14 46.43 46.58 48.66 52.64 46.66 58.44
Total 79.69 92.84 95.63 97.37 97.57 85.81 96.41
Service Public 98.46 121.31 135.97 140.55 143.07 135.95 133.39
Private 16.18 18.59 20.92 22.62 24.81 28.03 51.72
Total 114.64 139.9 156.89 163.17 167.88 163.98 185.11
CARG 1977-1991 1991-2012
Agriculture 1.32 -0.17
Industry 1.31 0.04
Service 2.27 0.79
 TYPES OF EMPLOYMENT: 2004/05-
2017/18 (% shares)
Type of employment 2004/05 2011/12 2017/18

Self-employed 56.9 52.2 52.2

Regular salaried/ 14.3 17.9 22.9
wage employee

Casual workers 28.8 29.9 24.9

Total 100.00 100.00 100.00
 CHANGING OCCUPATIONAL STRUCTURE OF LABOUR FORCE IN INDIA

Sector  Agriculture Industry Services Total

Year
1901 71.70 12.60 15.70 100.00
1951 72.10 10.70 17.20 100.00
1961 71.80 12.20 16.00 100.00
1971 72.20 11.20 16.70 100.00
1981 68.80 13.50 17.70 100.00
1991 66.80 12.70 20.50 100.00
1999/00 56.70 17.50 25.80 100.00
2011 49.26 23.11 27.53 100.00
2012 47.00 24.36 28.64 100.00
2013 46.43 24.43 29.14 100.00
2014 45.78 24.53 29.69 100.00
2015 45.16 24.58 30.26 100.00
2016 44.52 24.71 30.77 100.00
2017 43.94 24.85 31.21 100.00
2018 43.33 24.95 31.72 100.00
2019 41.39 25.37 33.24 100.00
2020 44.30 23.93 31.76 100.00
2021 43.96 25.34 30.70 100.00
 CHANGING ECONOMIC
STRTCURE OF INDIA
SECTOR  AGRICULTURE INDUSTRY SERVICES TOTAL
YEAR
1950/51 64.64 14.82 20.54 100.00
1960/61 60.12 18.52 21.36 100.00
1970/71 53.06 22.16 24.78 100.00
1980/81 46.63 23.83 29.54 100.00
1990/91 40.67 24.97 34.36 100.00
2000/01 31.95 25.13 42.92 100.00
2010/11 22.43 28.89 48.68 100.00
2020/21 18.61 27.81 53.58 100.00
India’s Macro Economic Crisis 1991:
Causes, Dimensions and Outcomes
 India’s Macro Economic Crisis – 1991
• For any Economy, its performance has two dimensions: Internal and
External
• Internal Performance: GDP and Inflation

• External Performance: Trade Balance, particularly Exports

• But for a Government the issues are different:

• Internally, its fiscal management, and externally, the BOP

-----------------------------------------------------------------------------------------------------
1. What are the issues involved in Government fiscal management ?
2. Why Government Fiscal Management important ?
3. What are the components of BOP?
4. Why BOP is important?
 Government Financial Management
1. Revenue Receipts = Tax Revenue + Non-Tax Revenue
A. Tax Revenue = Corp. Inc. Tax + Per. Inc. Tax + Indirect Taxes
B. Non-Tax Revenue = Fine, Fees, Interest, Receipts, etc.
2. Revenue Expenditure = A. Interest Payments
B. Subsidies
C. Wages + Salaries
D. Defense Expenditure., etc.
3. Capital Expenditure = Economic Services
Loans to State Government
4. Capital Receipts = A. Repayment of Loans by State Governments,
Disinvestments in PSUs, Grants, etc.
B. Small Savings, P.F., etc.

Revenue Deficit =2–1 Budget Deficit = (2+3) – (1+4)

Fiscal Deficit = (2+3) – (1+4A) Primary Deficit = [(2-2A) + 3] – [1+4A]
= Fiscal Deficit – Interest Payments
 Trends in Fiscal, Revenue and Budget Deficits
1980-81 to 1990-91 (Rs. Crore & % to GDP)
Sl 1980-81 1982-83 1984-85 1986-87 1988-89 1990-91
No
1 Total Revenue 12484 17507 23549 32950 43592 54995
(9.18) (9.83) (10.18) (11.25) (11.01) (10.27)
2 Revenue Expenditure 13261 18761 27047 40726 54107 73557
(9.75) (10.53) (11.69) (13.90) (13.67) (13.74)
3 Total Expenditure 21371 28273 41336 60425 75600 100884
(15.71) (15.87) (17.87) (20.63) (19.10) (18.84)
4 Fiscal Deficit 8887 10766 17786 27476 30923 44650
(6.53) (6.04) (7.69) (9.38) (7.81) (8.34)
5 Revenue Deficit 777 1254 3498 7776 10514 18562
(0.57) (0.70) (1.51) (2.65) (2.66) (3.47)
6 Budget Deficit 2577 1655 3746 8261 5642 11347
(1.89) (0.93) (1.62) (2.82) (1.43) (2.12)
 External Sector
• Exports (1) Current Account Balance =
• Imports (2) 3 + 4
• Exports – Imports = Capital Account :
Trade Balance (3) * Foreign Investment
• Invisibles (Current) : (4) * NRI Deposits
* Foreign Travel * Official Assistance
* Insurance * Bilateral Arrangements
* Interest Payment * Commercial borrowings
* Remittances (Private) Net IMF Credit
Change in Gross Reserves
 Principal Imports
Sl 1980-81 1990-91
No ($ million) ($ million)
1 Food and live animals chiefly for food (excl. cashew 481 NA
raw) (3.03)
2 Raw materials and intermediate manufactures 12341 NA
(77.76)
of which:
2.1 Petroleum, oil and lubricants 6656 6028
(41.94) (25.03)

2.2 Fertilizers and chemical products 1884 NA

(11.87)

2.3 Iron and Steel 1078 1178

(6.79) (4.89)
3 Capital Goods 2416 5833
(15.22) (24.22)
4 Others (Unclassified) 631 NA
(3.97)
5 Total 15869 24075
 Principal Imports ($ Million)
Sl. No. Import Items 2000-01 2019-20
1. Food and live animals:
1.1 Cereals and cereal 20 324
preparations
2 Raw materials and
Intermediate manufactures:
of which
-POL 15650 (30.44) 130550 (27.50)
-Chemical elements and 338 28260
compounds
-Iron & steel 781 (1.52) 10734 (2.26)
3 Capital Goods 5534 (10.76) 68543 (14.44)
4 Total Imports 51413 (100.00) 474709 (100.00)
Source: Economic Survey 2022
 Balance of Payments (BOP)
Sl. No. Items 1990/91 1995/96 2016/17
(US $ Million) (US $ Million) (US $ Million)
1 Imports 27915 35904 392580
2 Exports 18477 26855 280138
3 Trade Balance (2-1) -9438 -9049 -112442
4 Invisibles (net) -242 5680 97147
5 Current Account Balance -9680 -3369 -15296
6 Capital Account
6.1 Foreign Investment (net) 103 4807 43224
6.2 Loans 5533 3035
a.External assistance (net) 2204 1518 2013
b.Commercial borrowings (net) 3329 1517 -6102

6.3 Banking (net) 682 -334 -16616

6.4 Rupee Debt Service -1193 -983 --
6.5 Other capital (net) 1931 1977 7495
7 Capital Account Balance (6.1 to 6.5) 7188 9156 36482
8 Overall Balance (5+7) -2492 +5787 +21550
9 Monetary movement
a.IMF transactions (net) +1214 -1143
b.Increase (-) or decrease (+) in Reserves +1278 -4644 -21550
10 Total (9a + 9b) +2492 -5787 -21550
 BALANCE OF PAYMENTS
Sl. No Items 2017-18 (US$ M) 2019-20 (US$ M) 2020-21 (US$ M)
1 Imports 469006 477937 398452
2 Exports 308970 320431 296300
3 Trade balance -160036 -157506 -102152
4 Invisibles (net) 111319 132850 126065
5 Current Account Balance -48717 -24656 23912
6 Capital Account
6.1 Foreign Investment (net) 30286 43013 43955
6.2 Loans
a.External assistance (net) 2944 3751 11167
b.Commercial borrowings (net) 13717 21935 -4264
6.3 Banking (net) 16190 -5315 -21067
6.4 Rupee Debt Service -75 -69 -64
6.5 Other capital (net) 6213 18462 -2143
7 Capital Account Balance (6.1 to 6.5) 92292 84154 63374
8 Overall Balance (5+7) 43574 59498 87286
9 Monetary movement
a.IMF transactions (net)
b.Increase (-) or decrease (+) in Reserves -43574 -59498 -87286
10 Total (9a + 9b) -4574 -59498 -87286
 India’s Macro Economic Crisis – 1991
1. Growing Fiscal Deficit and accelerating inflation.
2. Dwindling Foreign Exchange Reserves and external payments crisis
Growing Fiscal Deficit and Inflation
- Expansionary fiscal policy of centre and states in the late 1980s led
to excess demand pressures.
- The average Fiscal Deficit (of Centre + States) went up from 7.99 %
in the early 80s to 9.63 % of GDP in the late 1980s
- Investment expenditure exceeded savings.
- Investment as % of GDP declined but the decline in government
savings was even faster.
- Excess demand of govt. has been met from three sources:
domestic borrowing, foreign borrowing and borrowing from RBI
 INDIA’S MACRO ECONOMIC CRISIS 1991
Growing Fiscal Deficit and Inflation

- In those years, domestic borrowing financed 70% of Government

financed capital formation and excess consumption.
- Rest from RBI and foreign borrowings.
- A large part of domestic borrowing from banking through SLR
[38.5%].
- In an open economy, excess of expenditure over domestic
borrowing would spill over into a balance of payments deficit.
- In India's case this was not possible because BOP was already
strained.
- Domestic and foreign borrowings are alternatives for financing
domestic investment.
- Either increase FB or increase domestic savings or reduce
domestic investment.
 INDIA’S MACRO ECONOMIC CRISIS 1991
Growing Fiscal Deficit and Inflation

• The other source is borrowing from RBI.

• This is directly related to expansion of money supply and
consequently, inflation.
• The monetized deficit rose from 1.6% of GDP in 1988/89
to 2.8% in 1990/91.
• There was a consistent increase in fiscal deficit, which was
Rs.446500 million in 1990/91, forming 8.34% of the GDP.
• Total fiscal deficit of centre and states = 10% of GDP.
• Inflation rate began to accelerate and was at its peak at
16.7% in August 1991.
 INDIA’S MACRO ECONOMIC CRISIS 1991
External Payments Crisis

• Sharp rise in POL imports during Sep-March, 1990/91 from

April-August,
• 1990-91: from $287 million per month to $671 million per
month.
• Annexation of Kuwait by Iraq led to a sharp rise in world oil
prices.
• Spot purchases of POL made to prevent shortages, which were
costly.
• Indian workers employed in Kuwait airlifted.
• Their remittances ceased to flow in.
• UN trade embargo on Iraq led to cessation of exports to Iraq
and Kuwait
 INDIA’S MACRO ECONOMIC CRISIS 1991
External Payments Crisis

• Short term credits began to dry up, causing further strain on

BOP.
• India’s credit rating was lowered by International Credit Rating
Agencies.
• External commercial (Medium Term) loans dried up.
• Outflow of NRI deposits.
• Foreign Currency assets declined to about US $ 1.1 billion at the
end of June 1991 – barely sufficient to finance two weeks’
imports.
• A default of payments for the first time in the country’s history
had become a serious possibility in June 1991.
 INDIA’S MACRO ECONOMIC CRISIS 1991
Policy Response
• Emergency action to prevent a default:
• Government leased 20 tonnes of gold out of its stock to SBI for sale
abroad, with an option to repurchase at the end of six months – May
1991.
• Government allowed RBI to ship 47 tonnes of gold to the Bank of
England in July 1991 to raise $ 600 million.
• Exchange rate of Rupee adjusted.(through devaluation – twice)
• Borrowing from IMF + IBRD through various facilities.
• Short term Measures:
• Almost blanket ban on imports – import compression.
• Reduction in capital expenditure.
• Rise in interest rates.
• Long Term Measures:
- To impart inherent competitive strength to the industrial economy, a
programme of structural reforms of trade, industrial and public sector
policies initiated.
 KEY MACROECONOMIC
INDICATORS: 2015/16-2020/21
Data category Unit 2015/16 2016/17 2017/18 2018/19 2020/21
GDP Growth rate % 8.0 8.2 7.2 6.1 -7.7
Gross Savings % of GDP 31.1 30.3 30.5 30.1 NA
GCF -do- 32.1 30.9 32.2 32.2 NA
PCI (at current Rs. 94797/- 104659/- 114958/- 126521/- 126968/-
prices)
Food grains MT 251.5 275.1 285.0 283.4 144.5
IIP % 3.3 4.6 4.0 3.8 -15.5
Electricity Gen. % 5.6 4.7 4.0 3.5 -4.6
WPI % -3.7 1.7 3.0 4.3 -0.1
CPI (combined) % 4.9 4.5 3.6 3.4 6.6
Export Growth % -15.5 5.2 10.0 8.8 -15.7
Import Growth % -15.0 0.9 21.1 10.4 -29.1
CAB % of GDP -1.1 -0.6 -1.9 -2.6 3.1
Gross Fiscal Deficit % of GDP 3.9 3.5 3.5 3.4 3.5

Revenue Deficit % of GDP 2.5 2.1 2.6 2.3 2.7

Source: Economic Survey
GLOBAL ECONOMIC CRISIS AND
INDIAN ECONOMY
MG 202: MACROECONOMICS
 INTRODUCTION
• Global economy experienced a macroeconomic crisis in
2008/09 manifested in the form of a decline in (i) world
economic growth, (ii) global FDI inflows & (iii) global export
growth.
• This has affected several industrialized as well as emerging
economies all over the world.
• How has the global economic crisis affected Indian
economy and its growth? Why?
• How has the global economic crisis affected Indian SMEs?
Why?
• What lessons can be learnt from the crisis?
 Global Economic Crisis
• What is an economic crisis?
• What causes an economic crisis?
• Why economies in one corner of
the globe should worry about an
economic crisis emerging in
another corner of the world?
 GLOBALIZATION?
• Perfect globalization would mean perfect
movement of factor inputs and factor output
between economies.
FACTOR INPUTS FACTOR OUTPUT
Land Labour Capital Entrepreneurship Technology Goods & Services
1. FDI laws have been substantially liberalized 2. Trade has been
since 1990 across a growing number of substantially
developing & erstwhile socialistic countries liberalized since 1990,
particularly after WTO
in 1995

3. Cross-national convergence of consumer demand

4. ICT Revolution
 Global Economic Growth
during 2005-2011
Economic 2005 2006 2007 2008 2009 2010 2011
variable

World GDP
Growth (%)
4.7 5.3 5.2 3.1 -0.7 4.9 3.7

FDI Inflows 973 1381 1865 1513 1198 1309 1524

(US$ (41.93) (35.05) (-18.87) (-20.82) (9.27) (16.65)
Billion)/
Growth (%)
World 12087 13523 15201 16862 13150 15756 18255
Exports in (11.88) (12.41) (10.93) (-22.01) (19.82) (15.86)
US$ billion/
Growth (%)
Sources: World Bank & WTO
 Global GDP Growth & Export Growth
Variable Mean Std. Minimum Maximum Number of
Deviation Countries
GDP 2008 3.856 4.18 -17.7 21.2 141

GDP 2009 -0.819 5.28 -18.0 13.8 141

GDP 2010 4.243 4.07 -7.9 27 139

GDP 2011 3.911 3.84 -10.5 20.7 135

Export 2008 4.418 11.08 -21.1 84.4 130

Export 2009 -6.554 9.62 -34.7 19.7 129

Export 2010 9.909 12.06 -42.3 57.8 127

Export 2011 8.367 8.88 -6.3 47.7 112

Source: World Bank

Correlation between GDP Growth &
Export Growth
Correlation between Correlation coefficient
variables
GDP & Exports (2008) 0.39*
GDP & Exports (2009) 0.48*

GDP & Exports (2010) 0.34*

GDP & Exports (2011) 0.40*

Number of observations 111

*Significant at 0.00 level
 GDP Growth across Economies - 2009
Range of GDP Growth Number of Countries

>-20 to -10 6

>-10 to 0 73

Sub-total 79 (56.03%)

>0 to +10 61

>+10 to +20 1

Total Number of Countries 141 (100.00%)

 Export Growth Across Economies -
2009
Range of Export Growth Number of Countries
>-40 to -30 1
>-30 to -20 7
>-20 to -10 42
>-10 to 0 52
Sub-total 102 (79.07%)
>0 to +10 21
>+10 to +20 6
Total Number of Countries 129 (100.00%)
 Global Economic Crisis & Indian
Economy
• There are three possible channels through
which global economic crisis, at any time, can
be transmitted to Indian economy:
1. Financial markets which include the banking
sector, equity markets (which are directly
affected by FII flows), ECBs that drive corporate
investments, FDI, and remittances.
2. Trade flows.
3. Exchange rates.
 Financial Market Developments
• The first transmission was through financial markets.
• Given prudent regulations and a proactive regulator, the Indian banking sector
has remained more or less unaffected, at least, directly, by the global crisis.
• The banking sector as a whole maintained a healthy balance sheet.
• The Non-Performing Assets as a percentage of Gross Advances, in fact,
declined steadily from 5.2% in 2004/05 to 2.2% in 2008/09.
• However indirect impact was considerable. The liquidity squeeze in global
markets forced Indian banks and companies to shift their credit demand from
external sources to the domestic banking sector. As a result, short-term lending
rates shot up abnormally.
• FIIs saw a strong reversal flows: Against a net inflow of US$ 20.3 billion in
2007/08, there was a net outflow of US$ 15 billion from India during 2008/09.
As a consequence, equity markets lost >60% of their index value.
• Primary market got reduced considerably: Between 2007/08 & 2008/09, fund
collection through primary market (IPOs) declined by 63%.
 Financial Market Developments
• ECBs went up from US$ 9 billion in 2004/05 to US$ 30.3 billion in 2007/08,
registering a threefold increase over four years. But ECBs fell drastically to
US$ 18 billion in 2008/09.
• FDI inflows declined, though not to the same extent.
• Remittances, which are another source of inward foreign capital flows,
declined by 0.5% in the third quarter of 2008/09 on a YOY basis. It declined
further by 29% in the last quarter compared to the previous year.
• The combined effect of declined flow of FDI, ECBs, and remittances together
with the massive outflow of FII led to a deterioration of India’s capital
account in 2008/09. For the first time, after a long period, capital account
component of India’s BOP became negative.
• The second transmission was through the steep decline in India’s exports.
• The third transmission was through the exchange rate of Indian Rupee.
 Exchange Rate of the Rupee &
Foreign Exchange Reserves

Year Exchange Rate (Rupee Vs US Dollar) Reserves (US $ Million)

March 2008 40.35 309723

March 2009 51.22 251985

March 2010 45.49 279057

March 2011 44.99 304818

Source: RBI
 Policy Measures taken in India to
counter the impact of Global Crisis
• Both Fiscal and monetary policies were used to counter the emerging ill-effects of
global economic crisis.
• Three fiscal stimulus packages – one each in the months of December 2008;
January 2009 and March 2009 – were announced, aggregating to Rs.1060.50
billion or US $ 21 billion ( about 2% of the GDP).
• These packages comprised government spending on infrastructure, reduction in
indirect taxes, and some assistance to EOUs.
• To prop up domestic demand, excise duty was gradually slashed from 14% in
December 2008 to 8% in March 2009 on all products except petroleum products.
• Monetary Policy became expansionary from October 2008. RBI focus shifted from
inflation to growth.
• CRR brought down from 9% in October 2008 to 5% in January 2009. This led to an
injection of US$ 32.7 billion.
• Repo rate was slashed from 9% in October 2008 to 4.75% in April 2009.
• Reverse repo rates were cut from 6% in November 2008 to 3.25% in March 2009.
• As of April 2009, a cumulative amount of about US$ 80 billion was pumped into
the system by the RBI.
 India’s Economic Growth
during 2005 to 2011
Economic 2005/06 2006/0 2007/08 2008/0 2009/10 2010/1 2011/1
variable 7 9 1 2
GDP
Growth (%) 9.3 9.3 9.8 3.9 8.5 8.1 8.1

Industrial ---- 12.9 15.5 2.5 5.3 8.2 2.9

Growth (%)
Count
(IIP) 1999 2000 2001 2003 2004 2005 2006 2007 2008 2009 2010 2011
ry
FDIWorld
Inflows 8.96
3 4.8 22.82
2.7 3.8 34.83
4.9 4.741.87 37.75 3.1 34.85
5.3 5.2 -0.7 4.9 46.8
3.7
(US$ (48%) (146%) (53%) (20%) (-10%) (-8%) (34%)
Billion)/
Growth (%)

Total 26.4 20.4 5.9 14.6 -4.8 22.7 15.3

Export
Growth (%)

Sources: Ministry of Finance, CSO, DIPP & RBI

 Industrial Growth in India (%)
Variable 2006/07 2007/08 2008/09 2009/10
No of factories 144710 146385 155321 158877
(3.25) (1.16) (6.10) (2.29)
Fixed capital 7151.31 8451.32 10559.66 13513.24
(Rs. Billion) (17.83) (18.18) (24.95) (27.97)
Employment 10328434 10452535 11327485 11792814
(No of persons) (13.35) (1.20) (8.37) (4.11)
Net Value 3957.25 4815.93 5277.66 5820.24
Added (26.89) (21.70) (9.59) (10.28)
(Rs. Billion)

Source: CSO
 Did Global Economic Crisis affect
India adversely?
1. Organized sector employed 28.18 million persons in 2008/09
(grew by 2.3% over 2007/08) & 28.71 million persons in 2009/10
(grew by 1.9% over 2008/09).
2. Organized sector employment increased in both Public and Private
Sectors. The former accounted for >62% of the total in 2009/10.
3. Organized sector employed <8% of the total workforce.
A. FDI stocks accounted for 0.5% (1990), 3.7% (2000) & 9.9% (2008)
of the GDP.
B. FDI inflows accounted for 6.01% (2007/08); 7.84% (2008/09) &
5.99% (2009/10) of the GFCF, respectively.
I. Current receipts (Exports + Invisible receipts) accounted for 25.4%
(2007/08), 29.1% (2008/09) & 25.4% (2009/10) of the GDP.
II. Current receipts grew by 26% (2007/08), 9% (2008/09), -2.7%
(2009/10) & 28% (2010/11), respectively.
 Growth of GDP [C+I+G+(X-M)] (%)
(at 2004/05 prices)

Year C I G X M GDP
2006/07 8.5 13.4 3.8 20.4 21.5 9.3

2007/08 9.4 18.1 9.6 5.9 10.2 9.8

2008/09 7.2 -5.2 10.4 14.6 22.7 3.9

2009/10 7.4 17.3 13.9 -4.7 -2.1 8.5

2010/11 8.6 15.2 5.9 19.7 15.8 10.5

Source: Economic Survey 2012/13

 GDP = C + I G + (X-M)
(At constant prices & in Rs. Billion)

Year Consumption Investment Government Net Total GDP

Expenditure Expenditure Expenditure Exports

2006/07
22599 12312 4006 -1447 37470
(60.31) (32.86) (10.69) (-3.86) (100.00)
2007/08
24714 14307 4389 -1963 41447
(59.63) (34.52) (10.59) (-4.74) (100.00)
2008/09
26496 14809 4845 -3152 42998
(61.62) (34.44) (11.27) (-7.33) (100.00)
2009/10
28417 15809 5537 -3347 4641
(61.22) (34.06) (11.93) (-7.21) (100.00)
2010/11
30721 16994 5972 -3162 50525
(60.80) (33.63) (11.82) (-6.26) (100.00)
Source: RBI
Small & Medium Enterprises (SMEs)
• SMEs occupy a place of strategic significance in
Indian economy due to their considerable
contribution to employment, manufacturing value
added (MVA), GDP and exports.
• A dominant sector in terms of exports and the
second largest employer.
• They contributed 45.6% (IP) & 7.2% (GDP), 45.2%
(IP) & 8% (GDP), 44.9% (IP) & 8.7% (GDP) in
2006/07, 2007/08 & 2008/09, respectively.
• It is important to examine what kind of impact
that global crisis had on Indian SMEs.
 SME Sector Growth during 2005/06 - 2010/11:
Units, Employment, Production, Investment & Exports
Year No of SMEs Investment Production Employment Exports
(Lakhs) (Rs. Crore) (Rs. Crore) (Lakh persons) (Rs. Crore)
2005/06 123.42 188113 497842 (15.83) 294.91 (4.37) 150242 (20.76)
(4.07) (5.27)
2006/07 261.01 500758 709398 (42.49) 594.61 (101.62) 182538 (21.50)
(111.48) (166.20)
2007/08 272.79 558190 790398 (11.47) 626.34 (5.34) 202017 (10.67)
(4.51) (11.47)
2008/09 285.16 621753 880805 (11.39) 659.35 (5.35) N.A.
(4.53) (11.39)
2009/10 298.08 693835 982919 (11.59) 695.38 (5.47) N.A.
(4.53) (11.59)
2010/11 311.50 N.A. 1095758 732.20 (5.29) N.A.
(4.50) (11.48)
Note: Figures in brackets represent growth in percentage over the previous year.
Source: Ministry of MSMEs
12/01/2023
 Distribution of MSMEs based on Number of EM-II filed
Year Micro Small Medium Total
2007/08 156051 17777 491 174319
(89.52) (10.19) (0.28) (100.00)

2008/09 171031* 18757* 690* 193077

(88.58) (9.71) (0.36) (100.00)

2009/10 186126* 23999* 1412* 213894

(87.00) (11.22) (0.66) (100.00)

2010/11 204064* 29101* 1260* 237263

(86.00) (12.26) (0.59) (100.00)

2011/12 242606* 34192* 2939* 282496

(85.88) (12.10) (1.04) (100.00)

*Provisional, since bifurcated figures from some of the States/UTs are awaited.
Source: Ministry of MSMEs

12/01/2023
 Fourth MSME Census: 2006/07: Highlights
1. Total No of Enterprises 15.64 lakh 100.00%

2A.Manufacturing Enterprises 10.49 67.10

2B. Repair & Maintenance 2.52 16.13
2C. Services 2.62 16.78

3A. No power needed 3.79 24.25

3B. Coal 0.25 1.59
3C. Oil 0.53 3.40
3D. LPG/CNG 0.07 0.42
3E. Electricity 10.49 67.07
3F. Others 0.51 3.28

4A. Proprietary 14.09 90.0

4B. Partnership 0.63 4.01
4C. Private/Public limited/cooperatives/others 0.92 5.91

5A. Micro Enterprises 14.85 94.94

5B. Small Enterprises 0.76 4.89
5C. Medium Enterprises 0.03 0.17

Source: Ministry of MSMEs

12/01/2023
 Fourth MSME Census: 2006/07: Highlights
5. Employment (lakh persons) Total 93.09 100.00%
A. Micro 65.34 70.19
B. Small 23.43 25.17
C. Medium 4.32 4.64

6. Fixed Assets (Rs. Crore) Total 449198 100.00%

A. Micro 169538 37.75
B. Small 223503 49.76
C. Medium 56097 12.49

7. Gross Output (Rs. Crore) Total 707510 100.00%

A. Micro 312973 44.24
B. Small 318794 45.06
C. Medium 75743 10.71

8A. No of Exporting Units 47,000 <4.5% of MUs

8B. Total Exports (Rs. Crore) 67,914 9.6%
9A. No Finance (Lakh units) 13.64 87.23
9B. Finance through institutional sources 1.70 10.87
9C. Finance through non-institutional sources 0.16 1.05
9D. Finance through both 9B & 9C 0.13 0.84
12/01/2023 Source: Ministry of MSMEs
 Conclusions
• Global economic crisis was all-pervading affecting a large number of front-line
economies across the world.
• The crisis was manifested in the form of declined GDP growth, declined export growth
and declined foreign investments.
• Global crisis did affect Indian economy in 2008/09 & 2009/10 through three channels,
namely, financial markets, trade flows and exchange rates.
• Government of India promptly responded by resorting to expansionary monetary
policy as well as expansionary fiscal policy.
• Indian economy could recover from the global shock in 2010/11.
• But three factors would explain why India could escape the ill-effects of the global
economic crisis with minimum repercussions:
1. Limited, though growing, integration with the global economy.
2. Prompt Fiscal & Monetary Policy responses from the government.
3. Domestic market base of unorganized sector and to some extent, organized sector
as well.
 Conclusions
• SMEs have very limited exposure to the external
market, and therefore, could survive and grow in
the midst of the crisis.
• It is necessary to develop the domestic market in
terms of infrastructure, finance, technology, and
human resources to have greater vibrancy and as
a means of external shock absorber in the future.
• A strong & growing domestic market can act as a
buffer to absorb such external shocks.
THANK YOU
 Macroeconomic Equilibrium: The Classical
Model
• The economists of the 19th century and early 20th century are
called classical economists.
• The term “classical” was coined by Karl Marx – who used it to
cover the theories of David Ricardo, James Mill and their
predecessors.
• Keynes extended the term to include “the followers of
Ricardo, those who adopted and perfected the theory of the
Ricardian economics, including J S Mill, Marshall, Edgeworth
and Pigou”.
• All economists who wrote on macroeconomic issues prior to
1936 are classical economists.
• Keynes chose to contrast the ideas he presented in the General
Theory with the prevailing ideas by labeling those prevailing
ideas as classical.
Macroeconomic Equilibrium: The Classical
Model
• This is now the generally accepted meaning of “classical”
in its application to macroeconomic theory.
• Following the appearance of Keynes’ General Theory,
macroeconomic theory was neatly divided into two parts –
Classical and Keynesian.
• The essence of classical economic thinking: the
economy will always operate at full-employment level.
• The economy has an inherent self-correcting mechanism,
which would bring back the economy to the full-
employment level, even if deviations occur from time to
time.
 Two Basic Notions
1. Under spending – that is, level of spending insufficient
to purchase a full-employment output – was most
unlikely to occur.

2. Even if a deficiency of total spending were to arise,

price-wage (including interest rate) adjustments would
occur quite quickly so as to ensure that the decline in
total spending would not entail declines in real output,
employment and real incomes.
 Fundamental to Classical Economists’
Thinking: Say’s Law of Markets
• The very act of producing goods generates an amount of income
exactly equal to the value of goods produced.
• That is, the production of any output would automatically
provide the wherewithal to take that output off the market.
• Supply creates its own demand.
• Say’s “Law of Markets” guarantees that there will be sufficient
consumption spending for its successful disposal.
• Even if AD changes, wage-price flexibility will ensure that the
economy bounces back to the level of full employment.
• The key to the Classical Model is the assumption that prices and
quantities in all markets are flexible.
• Classical economists presumed that price flexibility would
eliminate all surpluses or shortages in markets and that markets
were competitive enough to adjust to changes in economic
conditions.
 The Classical Model: The Effect of a
Decrease in Aggregate Demand
Initial Aggregate
Supply

New aggregate supply after

decreases in nominal wages
and other input prices
E1
Price Level (index number)

E2

O Potential Real GDP

Real GDP (billions of base year
dollars)

A decrease in Real GDP falls As As a result of Real GDP

aggregate below potential unemployment declines in increases until
demand occurs real GDP as increases, nominal wages full
for an the economy nominal wages and input prices, employment is
economy at moves from E1 and other input aggregate restored
full to E prices fall supply increases
employment
 The Classical Model: The Effect of an
Increase in Aggregate Demand
New aggregate supply after
increases in nominal wages
and other input prices

Initial aggregate supply

E2

E
Price Level (index number)

E1
New aggregate demand

Initial aggregate demand

O Potential Real GDP

Real GDP (billions of base year
dollars)

An increase in Real GDP Increase in As nominal Decrease in

aggregate increases nominal wages wages and input real GDP and
demand occurs below potential and other input prices rise, there employment
for an real GDP as prices as a is a decrease in until point E2
economy at the economy result of aggregate is reached
full moves from E1 shortages supply
employment to E
 The Classical Long-Run AS Curve
• According to classical economists, equilibrium real
GDP can deviate from potential real GDP only
temporarily.
• Any recessionary or inflationary GDP gaps are
eliminated quickly through changes in AS that
eliminate the discrepancy between equilibrium and
potential real GDP.
• In the long run, equilibrium real GDP would equal
potential real GDP if all prices were flexible.
• The long run AS curve would be a vertical line
corresponding to potential (full-employment) real
GDP.
The Classical Long-Run AS Curve
Long Run AS Curve
Price Level

Potential Real GDP Real GDP

 Macroeconomic Growth in the
Classical Model
• Outward shifts of the long-run supply curve imply growth in potential
and equilibrium real GDP on average over time.
• Increases in AD contribute to short-term economic growth because
they give confidence to businesses to make investments that expand
the economy’s productive capacity.
• Annual shifts in AD therefore exert an influence on the year to year
performance of the economy.
• The growth of an economy, however, ultimately depends on the
expansion of its productive capacity and is therefore a supply-side
phenomenon.
• Growth in AD can prevent recession and give a fillip to economic
growth but the real engine of economic growth is an outward-shifting
long-run AS curve.
 The Quantity Theory of Money
• The starting point for the classical quantity theory
of money is the equation of exchange, which is an
identity relating the volume of transactions at
current prices to the stock of money times the
turnover rate of each rupee.
• The turnover rate for money, which measures the
average number of times each rupee is used in
transactions during the period, is called the velocity
of money.
• Fisher’s equation of exchange
 The Quantity Theory of Money
• The equation of exchange focuses on income transactions
• MV = PT
where M = quantity of money in circulation
V = velocity of circulation of money
P = average price level
and T = volume of transactions
• V = PT/M
• Under these conditions, the price level varies
1. Directly as the quantity of money in circulation (M)
2. Directly as the velocity of its circulation (V)
3. Inversely as the volume of trade done by it (T)
 The Quantity Theory of Money
• The first of the three referred above is worth
emphasis because it constitutes the “quantity theory
of money”.
• Real output (or transactions) is supply determined.
• According to Fischer, velocity was determined by
institutional factors and could be regarded as fixed for
the short run.
• Quantity of money is exogenously controlled by the
monetary policy authority.
 The Quantity Theory of Money
• If velocity is a pre-determined constant and the
volume of output is fixed from the supply side, the
equation of exchange expresses a relationship of
proportionality between the exogenously given money
stock and the price level:
MV = PT or P = (V/T) M
• A doubling of M doubles P or a 10 % increase in M
leads to a 10 % increase in P.
• The basic result of the quantity theory of money: the
quantity of money determines the price level.
 The Cambridge Approach to the Quantity
Theory
• The Cambridge approach, named after Cambridge University,
the academic home of its originators Alfred Marshall and A C
Pigou, also demonstrated a proportional relationship between
the exogenous quantity of money and the aggregate price
level.
• Marshall’s focus was on the individual’s decision on the
optimal amount of money to hold.
• Money holding provides convenience for transactions as well
as security. But as Pigou noted, “currency held in the hand
yields no income”.
• Therefore, money will be held only so far as convenience and
security outweigh the interest income foregone.
 The Cambridge Approach to the Quantity
Theory
• According to Marshall and other Cambridge economists, the
demand for money would be a proportion of income.
• Cambridge equation , Md = kPy
Money demand (Md) is assumed to be a proportion (k) of
nominal income, the price level (P) times the level of real
income (y).
• The proportion of income that would be optimal to hold in the
form of money (k) is assumed to be relatively stable in the
short run, depending on the payment habits of the society.
 The Cambridge Approach to the Quantity
Theory
• In equilibrium, the exogenous stock of money (M) must equal
the quantity of money demanded
M = Md = kPy
where k is fixed in the short run and real output (y) is
determined by supply conditions.
• Therefore, Cambridge equation also reduces to a proportional
relationship between the price level and money stock.
• Cambridge version represents a step toward more modern
monetary theories?
• The quantity theory of money provides the link in the classical
system between money and prices; an excess supply of money
leads to increased demand for commodities and upward
pressure on the price level.
 The Cambridge Approach to the Quantity
Theory
• The quantity theory was thus the implicit theory of the AD for output within
the classical system.
• The quantity theory can be used to construct a classical AD curve.
P
Aggregate Price Level

Yd (M = 400)

Yd (M = 300)

Y
Output
Let value of V = 4, M =300, MV = 1200
If M = 400, MV = 1600
•An increase in money stock shifts the AD curve to the right
 The Cambridge Approach to the Quantity Theory

P3
Aggregate Price Level

Y (M3)
P2
Y (M2)

P1 Y (M1)

Y
Y1 = Y2 = Y3

• The classical theory of AD is termed an implicit theory.

• It does not either focus on the components of AD or explain the factors
that determine the AD level.
• If money demand exceeds money supply, there will be a spillover to the
commodity market as individuals try to reduce their expenditure on
commodities.
 The Classical Theory of the Interest Rate

• The equilibrium interest rate in the classical theory was the

rate at which the amount of funds that individuals desired to
lend was just equal to the amount others desired to borrow.
• Borrowing consists of selling a standard bond, a promise to
pay certain amounts in the future.
• Lending consists of buying such bonds.
• A standard bond is a perpetuity, a bond that pays a perpetual
stream of interest payments with no return of principal.
• The rate of interest measures the return to holding bonds and
equivalently the cost of the borrowing.
• The interest rate depends on the factors that determine the
levels of bond supply (borrowing) and bond demand (lending).
 The Classical Theory of the Interest Rate
• Suppliers of bonds: Firms, which financed all investment
expenditures by the sale of bonds and the government, which
might sell bonds to finance spending in excess of tax revenues.
• The level of the government deficit as well as the portion of
the deficit that government might choose to finance by selling
bonds to the public are exogenous policy variables.
• The level of business investment was a function of the
expected profitability of investment projects and the rate of
interest.
• As interest rate declines, investments will increase.
• Demand for bonds: - Individual savers purchase the goods.
Act of saving = Act of foregoing current consumption to have
a command over goods in a future period. There is a trade off
between current consumption and future consumption.
 The Classical Theory of the Interest Rate
• As interest rate increases, the terms of the trade-off become more
favourable. Individuals would save more at higher rates of interest.
• In normal times, classical assumption was that saving was a demand
for bonds.
P

S = Supply of loanable funds

ro
Interest Rate

I + (g-t)

I = Demand for loanable funds

Y
S = I + (g-t) S, I, g-t
Loanable Funds

Interest rate determination in the classical system

 Autonomous decline in Investment Demand
P

? I

ro B
Interest Rate

r1
Io
A
I1

Y
S1 = I1 So = Io

• When investment declines, S exceeds I at the

prevailing interest rate. This puts a downward
pressure on interest rate. As the rate of interest
declines, two adjustments occur.
 Autonomous decline in Investment Demand

I. Savings decline, and thus consumption

increases. The amount of this decline in saving
and the equal increase in current consumption
demand is given by the distance marked A (in
the previous figure).
II. Investment is somewhat revived by the decline
in the interest rate. This interest rate induced
increase in investment is measured by the
distance B (in the previous figure).

Equilibrium is restored at interest rate r1 where S

=I
 Classical Macroeconomics: Conclusions
• Central Assertion: Supply creates its own demand and
economy operates always at full employment, thanks to its
self-correcting mechanism.
• Classical economists stressed the self-adjusting tendencies of
the economy, which bring back the economy to full-
employment, even if there are aberrations.
• The first of these self-stabilizing mechanism consists of freely
flexible prices and money wages, which keep changes in
aggregate demand from affecting output.
• The second set of stabilizers is the interest rate, which brings
equality between savings and investment.
• Flexibility of prices and wages as well as interest rate is
crucial to the full-employment properties of the classical
system.
 Classical Macroeconomics: Conclusions
• The inherent stability of the private sector led classical
economists to propagate non-intervention by the government
in economic activities.
• A second central feature of the classical system is the
dichotomy between the factors determining real and nominal
variables.
• In the classical theory, real (supply side) factors determine
real variables. Output and employment depend primarily on
population, technology and capital formation.
• Money is a veil determining nominal values in which
quantities are measured, but monetary factors do not play a
role in determining these real quantities.
 THE GREAT DEPRESSION OF
THE 1930s IN THE USA
 The Great Depression was a global financial crisis that consumed most of the
developed world throughout the 1930s.
 While the first real indications of its onset can be seen at the end of 1929,
most countries did not feel its true effects until 1930 or later.
 Its effects varied from country to country when it ended but signs of recovery
were seen in the late 1930s, with things looking up for most economies in the
1940s (with the onset of II WW).
 Though the Wall Street Crash which took place in October 1929 is often
seen as an interchangeable term for the Great Depression, this event is simply
one of the causes emanating from the US, which led to the longest and
deepest worldwide recession of the 20th century.
 But there were many other factors at play that resulted in a more far-reaching
crisis.
 CAUSES OF THE GREAT
DEPRESSION
1. Overproduction
2. Uneven incomes
3. Wall Street Crash
4. Weak banking system
5. European recession
6. President Herbert Hoover’s failures
7. The gold standard
 Branch Banking Unit Banking
A bank that is connected to one or more other banks in
Single, usually small bank that provides financial
an area or outside of it. Provides all the usual financial
About services to its local community. Does not have other
services but is backed and ultimately controlled by a
bank branches elsewhere.
larger financial institution.

Typically very resilient, able to withstand local recessions

Extremely prone to failure when local economy
Stability (e.g., a bad harvest season in a farming community)
struggles.
thanks to the backing of other branches.

Operational Freedom Less More

Restricted or prohibited for most of U.S. history. Allowed Preferred form of banking for most of U.S. history,
Legal History in all 50 states following the Riegle-Neal Interstate despite its tendency to fail. Proponents were wary of
Banking and Branching Efficiency Act of 1994. branch banking's concentration of power and money.

Loans and advances are based on merit, irrespective of Loans and advances can be influenced by authority
Loans and advances
the status . and power.
Financial resources Larger financial resources in each branch. Larger financial resources in one branch
Delay in Decision-making as they have to depend on the Time is saved as Decision-making is in the same
Decision-making
head office. branch.

Funds are allocated in one branch and no support of

Funds are transferred from one branch to another.
other branches. During financial crisis, unit bank has
Funds Underutilisation of funds by a branch would lead to
to close down. Hence lead to regional imbalances or no
regional imbalances
balanced growth
Cost of supervision High Less
Concentration of power in the hands of few people Yes No
Division of labour is possible and hence specialisation Specialisation not possible due to lack of trained staff
Specialisation
possible and knowledge
Competition High competition with the branches Less competition within the bank
Profits Shared by the bank with its branches Used for the development of the bank
Specialised knowledge of the local borrowers Not possible and hence bad debits are high Possible and less risk of bad debts
Distribution of Capital Proper distribution of capital and power. No proper distribution of capital and power.
Rate of interest is uniformed and specified by the head Rate of interest is not uniformed as the bank has own
Rate of interest
office or based on instructions from RBI. policies and rates.
Deposits and assets are diversified, scattered and hence Deposits and assets are not diversified and are at one
Deposits and assets
risk is spread at various places. place, hence risk is not spread.
 The Great Depression: What Happened?
How?
 The Great Depression hit the US economy suddenly and
unexpectedly.
 In early 1929 the US economy was operating at full
employment (with an unemployment rate of only 3.2%).
 In October 1929, stock market crashed, the value of
corporate stocks plunged to 2/3rd of the value that
prevailed early in the year.
 Banks failed, thousands of firms in the building industry
were forced out of business.
 Massive decline in AD
 The Great Depression: What Happened?
How?
 As a result of bank failures, supply of money in
circulation was sharply reduced by the monetary
authorities.
 As a result, spending declined.
 Interest rates remained high as the supply of loanable
funds dried up.
 By 1933 one out of every four workers was unemployed
and real GDP was only 70% of its 1929 value. Classical
self-correcting mechanism failed to restore full
employment.
Using AD-AS Analysis to understand the
Great Depression of the 1930s

AS 1929

AS 1933

14.6
AD 1933

AD 1929

11.2

Potential Real GDP Real GDP

 The Great Depression: What Happened?
How?
 For most of the 1930s the economy stagnated in
equilibrium at well below potential real GDP.
 By 1933, quantity of money in circulation declined by
20% of the amount available in 1929.
 Several policy blunders were made.
 Tariff was imposed to protect US industry from foreign
competition.
 The tariff had the opposite effect: It deprived the US
market for European goods and recession spread to
Europe.
 The Great Depression: What Happened?
How?
 European demand for US goods declined, which
contributed to a further decline in AD in US, thus further
reducing real GDP and the price level.
 J M Keynes developed his model of macroeconomic
equilibrium during this period, which offered a unique
solution to the problem of an economy stagnating in
equilibrium at a level of real GDP below full
employment.
 Keynes reasoned: If the G component of GDP were
increased without increasing taxes, AD would increase so
that the economy could move toward full employment.
 The Great Depression: What Happened?
How?
 Reductions in AD may never reduce the PL enough to get
to points on the long-run AS curve.

 “In the long-run we are all dead”- J M Keynes

 Recessions often require short-run actions to increase AD

because the long-run self-correcting mechanism of the
economy does not work well in the downward direction.
 THE NEW DEAL
 The New Deal was the set of federal programs launched by President
Franklin D. Roosevelt after taking office in 1933, in response to the
calamity of the Great Depression.
 It had four major goals and achievements:
1. Economic Recovery: The New Deal stabilized the banks and
cleaned up the financial mess left over from the Stock Market crash
of 1929. It stabilized prices for industry and agriculture, and it aided
bankrupt state and local governments. And it injected a huge amount
of federal spending to bolster aggregate incomes and demand.
2. Job Creation: One in four Americans was out of work by 1933. The
New Deal created a number of special agencies that provided jobs for
millions of workers and wages that saved millions more in their
desperate families. It also recognized the rights of workers to
organize in unions.
 THE NEW DEAL
3. Investment in Public Works: The New Deal built hundreds of
thousands of highways, bridges, hospitals, schools, theatres, libraries, city
halls, homes, post offices, airports, and parks across America—most of
which are still in use today.
4. Civic Uplift: The New Deal touched every state, city, and town,
improving the lives of ordinary people and reshaping the public sphere.
New Dealers and the men and women who worked on New Deal
programs believed they were not only serving their families and
communities, but building the foundation for a great and caring society.
- In less than a decade, the New Deal changed the face of America and
laid the foundation for success in World War II and the prosperity of the
post-war era – the greatest and fairest epoch in American history.
Keynesian Theory of Employment:
Introduction
 Keynesian theory of employment contrasts sharply with
the classical position.
 Its conclusion is that capitalism simply does not contain
any mechanisms capable of guaranteeing full employment.
 An economy may attain equilibrium with considerable
unemployment or substantial inflation.
 Unemployment and inflation occur due to the failure of
certain fundamental economic decisions to synchronize
completely (in particular S and I).
 Product prices and wages tend to be downwardly
inflexible.
 Extended and costly periods of recession will prevail
before significant declines in prices and wages occur.
Unlinking of Saving and Investment Plans
 Keynesian theory rejects Say’s Law by questioning the
ability of rate of interest to equalize S with I.
 The classical contention that investors would invest when
households increase their rates of saving – is questionable.
 Savers and investors are two different groups which plan
their actions for different reasons and are largely unrelated
to the rate of interest.
 Much of the motives for savings have nothing to do with
the rate of interest.
 It is possible, according to Keynesians, to pose a situation
where savings is inversely related to the rate of interest.
 Why business firms invest?
 Interest rate, no doubt, is a factor to be considered while
formulating investment plans.
Unlinking of Saving and Investment Plans
 But it is not the most important one.
 Rate of profit is the crucial determinant of investment.
 During downswing of the business cycle, profit
expectations will be bleak and therefore, investments will
be low despite substantial reductions in interest rate.
 Current saving is not the only source of funds for financing
investment.
 Two other sources:
 Accumulated money balances of households.

 Commercial banks.

 Also, it is wrong to assume that all current saving will

come in to the money market.
 Households may add some of their current saving to their
money balances.
 Current saving may also be used to pay back bank loans.
 Price – Wage Flexibility
 Keynesians argue that prices and wages are not as flexible
as to ensure the restoration of full employment, as and
when total spending declines.
 Price system of capitalism has not been perfectly
competitive. It is riddled by market imperfections.
 Monopolistic producers have the ability to resist falling
product prices even when demand declines.
 In resource markets, labour unions are strong enough to
prevent wage cuts.
 Therefore, in practise, price-wage flexibility cannot be
expected to offset the unemployment effects of a decline in
total spending.
 Price – Wage Flexibility
 Even if we assume price-wage to decline, it may not reduce
unemployment.
 A decline in prices and consequently in wages will reduce
money incomes and therefore general spending.
 In such a situation, employers in general will not go for
more investments by recruiting more labour.
 A single firm may absorb more labour at a lower wage rate
than at a higher wage rate.
 But this reasoning is not applicable to the whole economy,
to general wage cuts.
 Because wages are a major source of income in the
economy. General wage cuts will lead to decline in incomes
and general demand for both products and labour.
 As a result, employer will hire little or no additional labour
after general wage cuts.
Classical and Keynes: AS – AD Restatement

 According to Classical economists, with perfectly flexible

prices and wages, there would be no change in real
rewards and therefore the production.
 Price flexibility provides an automatic, built in mechanism
which constantly pushes the capitalist economy towards
full employment.
 Therefore, government macroeconomic policies are
unnecessary.
 To Keynes, price inflexibility will make unemployment to
persist for extended periods.
 Active macroeconomic policies of demand management
by government are essential to prevent recession and
depression.
 Classical Approach
AS

A B
P
AD1

P1 C
AD2

O Q
Keynesian Approach

P AS

AD1

AD2

O
Q2 Q1
Keynesian Theory
 John Maynard Keynes
 The General Theory of Employment, Interest and Money – written
by J M Keynes during the Great Depression – (February 1936)
explained what classical economics could not: perpetual
unemployment and a stagnating economy.
 The most depressing part of the Great Depression was that it
seemed without end.
 Keynes’ theory explained how this phenomenon could occur and
offered a solution in the form of increased government spending.
 Keynes studied economics at Cambridge University under Alfred
Marshall, whom he later lovingly described as an absurd old man.
 Ironically, this man who sold champagne at discounted prices to
support its consumption was born the year Karl Marx died. Both
were revolutionary economists, but while Marx viewed capital with
despair, Keynes – even in its blackest hour – looked for
explanation, hope, and a cure. And he found them.
 Keynesian Theory of Employment

 Basic Proposition: The equilibrium level of income and output

depends on the economy’s aggregate spending

 What determines aggregate spending ?

 One of the determinants is consumption spending

 What determines consumption spending ?

 Real income of households provides the answer [i.e., real personal

disposable income]
 Consumption expenditures vary directly with disposable income

 As DI increases, consumers will spend part but not all of the

increase, choosing instead to save part of it
 Fundamental Psychological Law
“Men are disposed, as a rule and on the
average, to increase their consumption as
their income increases, but not by as
much as the increase in their income”.
 As income increases, consumers will spend
part but not all of the increase, choosing
instead to save some part of it.
 Therefore, the total increase in income will
be accounted for by the sum of the increase
in consumption expenditure and in the
increase in personal saving.
Fundamental Psychological Law

 The satisfaction of the immediate primary needs of a

man and his family is usually a stronger motive than the
motives toward accumulation.
 But the latter acquire effective sway when a margin of
comfort has been established.
 The absolute level of consumption varies directly with
the level of income and the fraction of income
consumed varies with the level of income.
 Consumption Function
 Relationship between consumption and income

 Can be represented by a 45 degree line – any point on this line is equi-

distant from the vertical and horizontal axes. This implies, at any time,
income must equal consumption plus savings (Figure 1).

 Break even level of income

 Savings and dis-saving

 Average Propensity to Consume [APC]

 Average Consumption – Income Relationship

 APC = C/Y
 C + S

280 Y = C + S

260

240
C
220

200

180
ΔC  15
160 K
ΔY  20
140
S = 20
120
ΔS  10
100
ΔC  30
80
ΔY  40 C = 140
60 S = -10

40 C = 80
C = 50
20 M
45o
Y
0 40 80 100 120 140 160
20 60 180 200 220 240 260 280

S
40

20 ΔY  40

Y
20 60 80 100 120 140 160 180 200 220 240 260 280
-20
S = -10 B
 Consumption Function
 Marginal Propensity to Consume [MPC]
 Ratio of change in consumption to change in income
 MPC = ΔC/ΔY
 MPC is positive but less than 1
 MPC is the same for any change in income
 Due to the above assumption C.F is a straight line
 APC is infinity at zero level of income and declines as income
rises. But APC is always greater than MPC
 C = Ca + cY
 APC = C/Y = Ca/Y + c

Saving Function:
Average Propensity to Save [APS]
Marginal Propensity to Save [MPS]
 Consumption and Saving Schedules

Income C S APC APS MPC MPS

0 20 -20 ? ? - -
40 50 -10 1.25 -0.25 0.75 0.25
80 80 0 1.0 0 0.75 0.25
160 140 20 0.875 0.125 0.75 0.25
200 170 30 0.85 0.15 0.75 0.25
 Determination of Equilibrium Level of
Income and Output
 Two Sector Economy: C + S = GNP = C + I

 Assumptions:
 All firms are non-corporate and therefore, no undistributed
profits
 No business transfer payments
 No interest payments

 GNP – Capital Consumption Allowance = NNP

 NNP = NI = PI = DPI

 DPI is either devoted to personal consumption expenditure

or personal saving
 Determination of Equilibrium Level of
Income and Output
 Since DPI = NI, personal saving (the amount of unconsumed
PI) must equal investment (the amount of unconsumed NNP)

 Then, we will have the following identities:

NNP = C + I
DPI = C + S

 Since NNP and DPI are identical in this economy in any time
period, we can refer to them interchangeably
Y=C+I
Y=C+S
and S = I
 Equilibrium Income and Output
 What determines the economy’s consumption and investment
expenditures ?

 DI is the sole determinant of consumption expenditure

 Suppose business people invest a total of $ 20 billion per time

period for additions to plant and equipment and change in
inventories

 This plan is independent of the levels of output

 That is, I = 20, irrespective of the level of output

 So, to arrive at aggregate expenditure or aggregate spending at

each level of output, we must add consumption and investment
functions
 Equilibrium Income and Output
 Given the aggregate spending function, we can define equilibrium
level of income as that level at which aggregate spending just equals
aggregate output.

 Suppose business people produce $ 160 billion goods.

 At this level of income, consumers will spend $ 140 billion and

business people will spend $ 20 billion (Figure 2).

 So plans of both sellers and buyers were realized.

 Amount of goods purchased = Amount of goods produced.

 Equilibrium may also be defined as that of level of output at which

planned saving equals planned investment.

 If saving and investment are equal, aggregate spending and aggregate

output are also equal.
 C + I

280

260 C + I

240
C
220

200 I = 20

180
S = 20 = I S = 30
160

140

I = 20
120

S = 10
100

80 C = 170
C = 140
60
C = 110

40

20
45o
Y
0
20 40 80 100 120 140 160 180 200 220 240 260 280

S, I

60

40 S
S = 20

20 I
I = 20 I = 20 S = 30
S = 10
Y
0
20 40 80 100 120 140 160 180 200 220 240 260 280
B
 Equilibrium Income and Output -
Equations
 Y = C + I, where C = Planned Consumption, I = Planned
Investment

 Solution of this equation identifies that level of output at

which planned spending by people on consumption out of the
income earned in producing that output will, when added to
the planned spending on investment, be just sufficient to
purchase the total amount of output actually produced

Our C = 20 + ¾ Y
I = 20
Y=C+I
= 20 + ¾ Y + 20
= 160
 Equilibrium Income and Output -
Equations
 Alternatively, equilibrium level of output is at that level where
S=I
S = -20 + ¼ Y
I = 20
-20 + ¼ Y = 20
Y = 160

 Therefore, output = C + I
160 = 20 + (3/4 * 160) + 20
Income = C + S
160 = 20 + (3/4 * 160) + [-20 + (¼ * 160)]
 Equilibrium Income and Output -
Equations
 Thus, if consumption function and investment function are
given, it is possible to illustrate why 160 is the only
equilibrium level of income and output.

 If output is more, deficient aggregate spending will force

business to cut down production.

 This in turn will cause income to fall and as fast as output.

 If aggregate spending is more than the aggregate output, the

excess spending will force business to produce more.

 As a result, output will go up to equate aggregate spending.

 What is MULTIPLIER EFFECT ?
 An increase of Investment by 10 million has resulted in an increase of
Aggregate Income by 40 million. This is due to the multiplier effect
(Figure 3).
Y=C+I
= Ca + cY + I
Y = 20 + ¾ Y + 20
Y = 40 + ¾ Y
Y - ¾ Y = 40
¼ Y = 40
Y = 160
Y = 20 + ¾ Y + 20 + 10
Y = 50 + ¾ Y
¼ Y = 50
Y = 200
ΔY = 40
ΔY/ ΔI = 40/10 = 4
 C + I

280

260

240 I  ΔI  30
220
S  30  I  ΔI
200 S = 40

180

160 I  ΔI  30

140
S = 20
120

100
ΔI  10 C = 200

80 C = 170
C = 140
60 I = 20

40

20
45o
Y
0
20 40 80 100 120 140 160 180 200 220 240 260 280

S, I

60
I  ΔI  30 S
40 I  ΔI  30 S  30  I  ΔI
I  ΔI
I
20
S = 40
S = 20
Y
0
20 40 80 100 120 140 160 180 200 220 240 260 280
B
 What is a MULTIPLIER ?
 The rate at which Aggregate Income increases as a result of
an initial increase in Investment.
 ΔY = ΔC + ΔI
= cΔY + ΔI
ΔY – cΔY = ΔI
ΔY (1-c) = ΔI
ΔY = (1/1-c)*ΔI
ΔY/ΔI = 1/1-c

 sΔY = ΔI
ΔY = (1/s)*ΔI
ΔY/ΔI = 1/s
 GOVERNMENT SPENDING AND
TAXATION
 Govt. policy with respect to spending and taxation is known as
FISCAL POLICY( F.P).

 Govt. can expand aggregate spending either by increasing exp. Or by

reducing taxes.

 Similarly, it can contract aggregate spending.

 The effect will depend upon how much Government injects in to the
stream and how much it with draws.

 If an economy is operating below FE equilibrium the Govt. should go

for expansionary F.P.

 If the economy is operating at F.E level and there is an upward

pressure on prices, the appropriate F.P is a contraction one.
 GOVERNMENT SPENDING AND
TAXATION

 F.P can have several objectives:-

- F.E. Equilibrium.
- Rapid eco. Growth.
- Equal distribution of income + wealth
- balanced regional development.

 If the need is expansionary FP, the alternative are Govt. exp↑ or

taxes ↓ or both

 How does the Govt. select the most effective alternative ?

 GOVERNMENT SPENDING AND
TAXATION

 Will there be any differences in the impact of an increase on

Govt. exp. as compared to an equivalent amount of decrease
in taxes ?

 Can Govt. expand income by increasing its purchases and at

the same time increase taxes by an equal amount ?

 What is the difference in the expansionary effect of an

increase in Govt. exp. and an equal increase in Govt. transfer
payments ?

 To understand these issues, the mechanics of FP have to be

understood
 First Fiscal Model: Including Net
Taxes and Govt. Purchases

 C + S + T = GNP = C + I + G
 Assumption: Government derives tax revenue only from personal
taxes, and NNP=NI=PI
Disposable Personal Income (Yd) = Y – T
C = Ca + c (Y – T)
= Ca + c Yd
 With this consumption function, with investment (I) assumes to be
entirely autonomous, and with fixed amounts of Govt. Purchases
and tax receipts assumed per time period, the equilibrium level of
income Y = Ca + c (Y – T) + I + G (Figure 4).
 If expressed in terms of S and I, equilibrium level of income and
output is found at that level of output at which
Planned Saving + T = Planned I + G
 C + I + G

280

260

240

220

200

180 S= 20 = I

160
ΔI  10
140 S + T = 45 =
I + G
120

100 C = 215

80
C = 140 C = 140
60

40

20
45o
Y
0
20 40 80 100 120 140 160 180 200 220 240 260 280

A
S,I,T,G

80

60 S + T = 45 = I + G
I + G
40
S
I S S = 45 = I + G
20

Y
0 20 40 80 100 120 140 160 180 200 220 240 260 280
B
 First Fiscal Model: Including Net
Taxes and Govt. Purchases

 Suppose, Govt. resorts to an autonomous Public Spending

(Rs 25 Crore) which is added to Private Spending (C + I) to
produce aggregate Spending Function

 Suppose, now Govt. decides to finance its expenditure by

taxation. What will be the impact on equilibrium ?

 Why an equivalent amount of taxes lead to a less reduction

in equilibrium income

 Balanced Budget Theorem or Unit Multiplier Theorem

 Second Fiscal Model: Including Gross Taxes,
Government Purchases and Transfer Payments
 R = Transfer Payments
C+S+T–R=Y=C+I+G
Yd = Y – T + R
Y = Ca + c (Y – T + R) + I + G
 For an increase in G, ΔY = 1/(1-c) * ΔG or ΔY/ ΔG = 1/(1-c)
 For an increase in R, ΔY = 1/(1-c) * c ΔR or ΔY/ ΔR = c/(1-c)
 For an increase in T, ΔY = 1/(1-c) * -c ΔT or ΔY/ ΔT = -c/(1-c)

 Regardless of the value of c (c<1), Govt. Transfers multiplier is one less

than Govt. Purchase Multiplier

 Apart from the change in sign, it is the same as tax multiplier

 As a result, the expansionary effect of G > R and G > T

 Expansionary effect of R = Contractionary effect of T

 Foreign Sector
 Y = C + I + G + (X – M)

 Gross imports must be subtracted from gross exports in

measuring GNP.

 C + Rpf + S + T = Y = C + I + G + (X – M ) (Figure 5).

Rpf = Personal transfer payments to foreigners.
If we assume Rpf = 0, then
C + S + T = Y = C + I + G + (X – M )
C+S+T+M=C+I+G+X
For, Ca=25, c=8/10, I=20, G=26, T=25, X=17, M=24, Y=?
C + I + G + (X – M)

280

260

240

220 (X – M) = -7

200
G = 26
180 (X – M) = 0 or X = 17 = M I = 20

160

140

120

100

C = 181
80

60

40

20
45o
Y
0
20 40 80 100 120 140 160 180 200 220 240 260 280

I,G,X,S,T,M

80 M = 24
I + G + X
60
I + G X = 17

40
T= 25 G = 26
I
20
S = 14
S I = 20
Y
0 20 40 80 100 120 140 160 180 200 220 240 260 280
B
 Equilibrium Level of Income + Output
 An economy’s income and output will rise as and when gross exports
rise or gross imports fall or when both occur

 Imports and exports thus affect the equilibrium level of income and
output

 In general, an economy’s gross exports depend on:

 Relative price level
 Tariff and trade policies
 Level of income in other countries
 Level of imports of the domestic economy, etc.

 Thus, a number of factors determining an economy’s exports are

external

 To simplify the model, we assume that exports are given at any point
of time
 Import Function
 Imports are also determined by a number of factors such as
trade policy, relative price level, income level etc.

 But imports, in general, are more determined by domestic

factors than anything else

 Therefore, we assume that other things remain the same and

imports are a function of income

 There is a linear relationship between income and imports

 M = Ma + mY
Ma = autonomous expenditures for imports
m = MPM = Δm/ ΔY
 Import Function
X, M

Ma
o b Y

Below ob, X > M

Above ob, X < M
• Any shift in the export function upwards will increase net
export balance or decrease net import balance at each level of
income, similar to ↓ import function
 Equilibrium Level of Income –
Equations
 Y = C + I + G + (X – M)
= Ca + cY + I + G + X – (Ma + mY)
= Ca + c(Y – T) + I + G + X – (Ma – mY)

 If G = 26, I = 20, X = 17, T = 25 (Figure 6).

M = Ma + mY = 2 + 1/10 Y
C = Ca + c(Y – T) = 25 + 8/10 (Y – 25)
Y = 25 + 8/10 (Y – 25) + 20 + 26 + 17 – (2 + 1/10 Y)
Y=?
Suppose X increases to 35?
C + I + G + (X – M)

290

280
X  ΔX - M  5

270
G = 26
260
S + T =51

250

240
I = 20
230 (X – M) = -
7

220
G = 26
210

C = 229
200 S + T =39

190 I = 20
C = 181
45
o
Y
0 190 200 210 220 230 240 250 260 270 280 290

I,G,X,S,T,M
ΔY  60
80
I  G  X  ΔX
70 ΔX  18 ΔX  18
I + G + X
60 M = 30
X = 17 X = 17
50 M = 24
I + G
40
G = 26 T = 25 G = 26
30
T = 25
20 I
S S = 26
10 I = 20 I = 20
S = 14
0 190 200 210 220 230 240 250 260 270 280 290 Y

B
 Foreign Trade Multiplier and
Changes in the Level of Income
 In an open economy, where imports depend on the level of income,
the overall expansionary effect of any increase in autonomous
spending will be dampened by some leakage for the purchase of
imports.

 Multiplier = 1/1 – (c - m)

 The greater the MPM, the lesser the multiplier effect

 If MPC = MPM, multiplier = 1

 If MPM = 0, multiplier will be ordinary multiplier

 In practise, MPM varies from country to country.

 It tends to be higher for trade oriented countries and vice versa

 Exports as a Function of Imports
 C+1+G↑

 M ↑ Exports of other countries ↑

 Income of other countries ↑ Imports ↑

 As a result, exports of the original country ↑

 This describes why income levels of different countries are

interdependent

 As nations become more and more closely linked through foreign

trade, we encounter “INTERNATIONAL PROPAGATION OF
BUSINESS CYCLES”
Keynesian Theory – How Far Practical?
 Keynesian models are based on certain assumptions. Will
they hold good ?

1. We assume that C.F is given. Both government expenditure

and taxation may bring out a change in MPC
 The expansionary effect of tax financed govt. expenditure
may be more if MPC goes up and vice versa
 Govt. expenditure through progressive income tax
 Govt. expenditure through GST

2. Impact on Investment Function

 A tax financed expenditure may reduce investment
expenditure. The resultant downward shift in the investment
function could offset the expansionary effect of the rise in
Govt. expenditure.
 Keynesian Theory – How Far
Practical
 If government expenditure is deficit financed, this too will have
adverse effects on investment function. If the expenditure is
financed by borrowings, this will add to the demand of private
investors for loanable funds and push up the Rate of Interest.
 Higher rate of interest will “crowd out” private investment by an
amount equal to the debt-financed increase in Govt. spending.
As a result, there will be no expansionary effect on aggregate
income.

 Of course, if government expenditure is financed by an increase

in money supply, the impact will be different. But will the
Central Bank oblige ?

 Criticism of “Supply Side” Economists

 On balance, what are the merits of Keynesian theory ?

MG 202: Macroeconomics

Money and Its Functions

 Functions of Money
Money serves a number of functions and any definition
of money must consider all of its functions. Money
serves four major functions:
1. A medium of exchange: Money eliminates the need for
barter, the direct exchange of one item for another.
Barter requires the double coincidence of wants. Money
facilitates specialization and the division of labor in an
economy. It cuts down the transaction costs of trading.
2. A standard of value: Money provides a unit of account
that serves as a standard of the measure of value.
 Functions of Money
3. A standard of deferred payment
4. A store of value : Holding money as a store of value can
reduce the transaction costs involved with every day
business.
Money is anything that is generally accepted as payment
in exchange for goods or services. It also serves as a
standard of value, a standard of deferred payment and a
store of value.
Money is a matter of functions four;
A medium, a measure, a standard and a store.
 Types of Money
Commodity Money: In the early days of America-
tobacco, corn and other agro products were accepted as
payment for goods and services. Example: In ancient
Russia- furs were used as money; Zulus of South Africa-
used cattle as money; Gold and silver were most
commonly used as money by European and other nations
throughout their history.
Fiat Money: Money that is accepted as a medium of
exchange because of government decree rather than
because of its intrinsic value as a commodity. Paper money
was invented by the Chinese in the 13th century.
 Gresham’s Law
Gresham’s Law (named after Sir Thomas Gresham)
“Bad money drives good money out of circulation”
• Gresham argued that “good money” is driven out of
circulation by “bad money”. Good money has higher value
as a commodity than bad money.
- The bad ‘alloy’ coins drove the ‘good’ silver coins out of
circulation.
- Gresham observed that coins with a high content of gold
and silver were melted down for their precious metal or
were hoarded rather than being used in exchange
 Chequable Deposits
Chequable Deposits as a form of Money
Money deposited in bank accounts based on which one can
issue cheques for purchases and pay debts.
Chequable deposits are money.
Chequable deposit accounts are offered by various types of
specialized firms called depository institutions
Depository institutions mainly comprise commercial banks,
cooperative banks etc. Chequable deposits comprise
mainly demand deposits and savings deposits.
 What money is not?
Bonds are not money. What are bonds? Securities
issued by companies or Govt. representing the
promise to make periodic interest payments and to
repay the principal at a certain time.
Credit Cards are not money
Money is a stock rather than a flow. A stock is a
variable that can be measured only at a given point
in time.
 Measuring Money Stock
M1= Currency + account balances commonly used to pay for
goods + services
= Currency + travelers cheques + chequable deposits.
M2 = M1 + Near Monies
Near Monies are assets that are easily converted into money
because they can be liquidated at a low cost and little risk
of loss. Eg: Fixed deposits in banks.
M3 = M2 + Large denomination certificates of deposits.
M4 = Broad Money
 Definition of Money in India
• The RBI has a long tradition of compilation and dissemination of monetary statistics, since
July 1935. In India, the measures and definition of money stock have continuously evolved
since independence (1947).
• Working Groups were set up periodically to review and refine monetary aggregates.
• Three working groups were set up so far:
• First Working Group (FWG) on Money Supply (1961): The First Working Group 1961
(FWG) of RBI for the first time threw some light on the concept of money supply in India
emphasizing the role of money as a liquid asset and a medium of exchange.
• Second Working Group (SWG) (1977): SWG of RBI developed four measures of money
stock M1, M2, M3, and M4.
• Working Group on Money Supply: Analytics and Methodology Compilation (WGMS)
(1998) (Chairman: Dr Y V Reddy): with the advent of new financial institutions, the Third
Working Group (TWG) felt the need for a broader measure of money supply and redefined
financial institutions to include banking sector, insurance corporations, mutual funds, non-
banking financial companies (NBFCs) accepting deposits from the public and development
financial institutions (DFIs).
• Consequently, TWG broadened the scope of the measure of the money stock. RBI
compiles and publishes data on M1, M2, M3, and the M4 measure of money supply
fortnightly and uses M3 as the official measure of the money supply.
 Definition of Money in India
• Monetary statistics at present are compiled on a balance sheet
framework with data drawn from the banking sector and postal
authorities
• There is no unique definition of money either as a concept in
economic theory or as measured in practice.
• Money is a means of payment and thus a lubricant that facilitates
exchange.
• Money also acts as a store of value and a unit of account.
• Money can be defined for policy purposes as the set of liquid
financial assets, the variation in the stock of which could impact on
aggregate economic activity.
 Definition of Money in India
• Reserve Money = Currency in circulation + Bankers’
deposits with the RBI + ‘Other’ deposits with the RBI
• M1 = Currency with the public + Demand deposits with
the banking system + ‘Other’ deposits with the RBI
• M2 = M1 + Savings deposits of post office savings banks
• M3 = M1 + Time deposits with the banking system
• M4 = M3 + All deposits with post office savings banks
(excluding NSCs)
 March 31/ Currency with the Public Deposit Money of the M1 Post M2(9+10 Time M3 Total M4(13+1
reporting Public (5+8) Office ) Depo (9+12) Post 4)
Notes in Circulation of Cash Total Demand ‘Other’ Total Saving sits with Office
Fridays of
Circula- on (1+2+3- Deposits Dep osits (6+7) Bank Banks Depo
the tion(1) Rupee Small Hand 4) with with Depo sits
month/last Coins Coins with Banks Reserve sits
reporting (2) (2) Banks Bank (3)
Friday of the
month

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

2008-09 6,811.0 84.9 15.7 257.0 6,654.5 5,886.9 55.3 5,942.2 12,596.7 50.4 12,647.1 35,351.0 47,947.8 259.7 48,207.4

2009-10 7,882.8 97.0 15.7 320.6 7,674.9 7,179.7 38.1 7,217.8 14,892.7 50.4 14,943.1 41,134.3 56,027.0 259.7 56,286.7
2010-11 9,369.4 111.6 15.7 354.6 9,142.0 7,176.6 36.5 7,213.1 16,355.1 50.4 16,405.5 48,639.8 64,994.9 259.7 65,254.6

January 14, 9,144.4 108.1 15.7 350.8 8,917.3 6,441.2 29.1 6,470.3 15,387.7 50.4 15,438.1 46,701.7 62,089.4 259.7 62,349.1
2011
January 28, 9,125.1 109.1 15.7 368.4 8,881.5 6,650.2 133.3 6,783.5 15,665.1 50.4 15,715.5 46,894.8 62,559.8 259.7 62,819.5
2011
September 9,696.6 117.4 15.7 403.4 9,426.4 6,304.7 23.2 6,327.9 15,754.3 50.4 15,804.7 52,940.5 68,694.8 259.7 68,954.5
2011
October 2011 9,840.4 120.5 15.7 438.5 9,538.1 6,385.8 11.4 6,397.3 15,935.3 50.4 15,985.7 53,718.2 69,653.6 259.7 69,913.3
November
10,081.3 121.5 15.7 433.5 9,784.9 6,301.2 11.6 6,312.8 16,097.8 50.4 16,148.2 54,059.6 70,157.4 259.7 70,417.1
2011
 Demand for money
There are generally two types of demands for the money:
• Transaction Demand
• Money as an asset:
– Pre-cautionary motive
– Uncertainty about future prices and interest rates
– Speculative motive
Money Demand Curve
The demand for money is the relationship between the sums of money that
people willingly hold and the level of interest rates in the economy, other
things remaining the same.
A money demand curve shows a relationship between the level of interest rates
in the economy and the stock of money demanded at a given point in time.
Increased GDP leads to increase in money demand
 Money Demand Curves
I.R. I.R

MD2

MD3 MD1

Q of Money Demanded Q of Money Demanded

 Factors Affecting Money
Demand
ATM- Automatic Teller machines have brought down
the transaction demand for money
- Proliferation of Credit Cards.
- A decrease in the cost of converting near money
into money reduces the demand for money
- If bond prices are expected to rise, the demand for
money will decline and vice versa.
- Electronic transfers/Digital payments
- Prepaid Payment Instruments (PPI): Closed/Semi-
closed/Open.
Stock of Money, Money Demand
and Interest Rates
• IR IR
Original MS

New Money
Supply

8 10
New MD

7 8
Initial MD

600 700 500

Q of Money Demanded Q of Money Demanded
Money Stock
 Need to understand changes in
the Money Stock
• The demand for money and the available stock of money
exert an important influence on interest rates in the
economy.
• The impact of changes in the money stock on the economy
is complex because changes in interest rates are likely o
affect aggregate demand.
• C and I will go up as and when interest rates decline, as a
result, over long periods, changes in the national money
stock are likely to affect nominal GDP. As nominal GDP
changes, so does the demand for money.
Banking
Depository Institutions
 Those institutions that make loans and offer
chequable deposit and time deposit accounts
for use by households and business firms.
 They are members of a broad class of firms
that seek to make profits by linking savers
who supply loanable funds to investors and
other borrowers.
Financial Intermediaries
 Firms that specialise in borrowing funds
from savers and lending those funds to
investors and others.
 Examples of financial intermediaries
 Banks,mutual funds, insurance companies,
pension funds etc.
Banks
 The word “Bank” is derived from the Italian word for
bench which is banco.
 In the middle ages, gold and silver were used as money
in most European nations and for international trade.
 To avoid inconvenience and risk, most merchants
preferred to keep their money in a safe place.
 They usually left it with goldsmiths or money changers
who first placed it on benches so that it could be
examined and weighed. This practice evolved into what
is now known as banking.
How did Fractional Reserve Ratio
emerge?
 The gold smiths/money changers assessed the purity of gold or
coins before issuing depositors official receipts certifying the
deposits.
 The depositors paid a fee for the storage service.
 The deposit receipts soon began to circulate as a medium of
exchange, which reduced the transaction costs by avoiding the
inconvenience and risk of physically carrying these gold coins.
 The holders of these receipts could at any time go to the
goldsmiths and redeem the receipts for the stored gold.
 In effect, the receipts for the gold became paper currency.
How did FRR emerge?
 At first, the early bankers issued receipts for no more than the gold deposits
that they had in the vault.
 However some of the more astute goldsmiths observed that while receipts
were presented each day for redemption of gold, new deposits of gold more
than offset the decline from the outflow and resulted in the issuance of new
receipts.
 This means that the goldsmiths could either loan out a portion of the gold on
deposit for the use of others or issue more gold receipts than the actual gold
available in the vault.
 On any given day, the inflows and outflows of gold were predictable, and it
was rare for more than 25% of the gold receipts outstanding to end up as
net withdrawals on a given day. By making loans, the goldsmiths could add
to profits but would run little risk of being unable to meet the demand for
withdrawals.
 Thus the gold smiths actually created money.
Fractional Reserve Ratio
 Fractional Reserve Ratio = cash reserves
receipts from deposits
 It is the proportion of money that a financial
intermediary(bank) would hold in the form
of cash. This is important because it
determines the ability of a bank to create
money.
How banks make loans and create
chequable deposits?

 How can a modern banking system create

money?
 It is necessary to understand how a single
bank accepts deposits and makes loans to
understand how a bank creates money.
Balance Sheet of a Bank
 A bank’s operations can be classified by
looking at its Balance Sheet- A statement
of its assets and liabilities.
 Bank’s assets comprise property,cash and
debt owed to the bank which includes
loans and any marketable securities the
bank holds-treasury bills etc.
Balance Sheet of a Bank(contd)
 Net Worth = Assets – Liabilities
 Understand the relationship between a
banks’ assets, liabilities and its net worth.
Balance Sheet of a Bank
Balance Sheet of a Bank-End of Week 1 (no loans)

Liabilities + Net Worth

Assets
•Reserves
• Deposits 100,000

•Required
•Net worth 200,000
20,000
•Excess 80,000 Total 300,000
•Loans 0
•Property 2,00,000
•Total Assets 3,00,000
Required Reserve Ratio
 The minimum percentage of deposits that
a bank must hold in reserves to comply
with regulatory requirements.
Excess Reserves:
= Total reserves-Required Reserves
 Balance Sheet of a Bank
Balance Sheet of a Bank-End of Week 2

Liabilities + Net Worth

Assets
•Reserves
• Deposits 180,000

•Required
•Net worth 200,000
20,000
•Excess 80,000 Total 380,000
•Loans 80,000
•Property 2,00,000
Total Assets = 3,80,000
 Money Creation Process in Banks
Stage Bank New Reserves R.R. E.R. Chequable deposits that
acquired can be created
1 1 10 2 8 8

2 2 8 1.6 6.4 6.4

3 3 6.4 1.28 5.12 5.12

4 4 5.12 1.02 4.10 4.10
5 5 4.10 0.82 3.28 3.28
6 6 3.28 0.65 2.62 2.62
7 7 2.62 .052 2.10 2.10
8 8 2.10 .042 1.68 1.68

Total increase in money stock = 40,000

Multiplier
 M= ER = 8 = 40
(1-0.8) 0.2
 When the required reserve ratio is 0.2, each
rupee of excess reserves that enters the
banking system can support 5 times as much
new chequable deposits.
 Reserve multiplier = 1/RRR

(The maximum amount of money stock that can

be created from each rupee in the excess
reserve available to the banking system)
RM = 1/.2 = 5
Deposit Expansion vs Deposit
Contraction
 Deposit contraction = Loss in ER/RRR
 Why do banks keep more reserves in excess
of required reserves?
Interest Rate(in %)

Holding of excess
reserves
Cyclical Fluctuations in Demand
 Cyclical Fluctuations in bank demand for
excess reserves has important
implications for the money stock. More the
ER banks hold, lesser the chequable
deposits created and lesser the increase
in money stock and Vice versa
Macro 18
 Bank Portfolio Management

 The picture of bank deposit creation is highly

simplified. Banks must be concerned with both
liquidity and profitability.
 Banks must balance their desire for increased
profitability against the risk of default and the risk of
having assets that cant be easily converted into
reserves to meet unexpected withdrawals.
 To do this, most banks are careful to have a
diversified portfolio or mix of assets.
 Bank Portfolio Management

 Banks will make risky as well as secured

loans. Riskiest loans are those that are
made in exchange for unsecured promises
to pay.
 Secured loans are those lent with a
collateral (an asset a borrower pledges to
a lender in case of default).
 A car, bought on bank loan, is pledged as
collateral to the bank.
 Bank Portfolio Management
 Banks also make short-term loans to credit-
worthy businesses at lower interest rates than
they charge consumers.
 Prime rate: interest rate a bank charges its most
credit-worthy customers, usually large
corporations, for short-term loans of less than
one year.
 Mortgage: is a loan a bank makes to finance the
purchase of a house or other real estate, with
the asset secured by that loan as collateral.
 Government Securities
 Most banks carry 10% – 20% of their assets
in the form of govt. securities that can be sold
quickly at very low transaction costs to obtain
reserves when the bank needs them.
 Government securities are interest bearing
debts of the Government in the form of
Treasury bills, Treasury notes and Treasury
bonds.
 Interest earned on Government securities is
less than on loans. But their liquidity is worth
the loss in profitability to the bank.
 Government Securities

 Commercial banks typically hold about

20% of their assets in the form of highly
liquid govt. securities, often called
secondary reserves.

 Cash + Govt. securities = liquidity base of

banking system
Monetary Policy &
Its Instruments
 Central bank uses a variety of
techniques to control the excess
reserves available to the Depository
Institutions.
 The monetary base = currency in
circulation + total bank reserves
outstanding at any given time
 The central bank can vary the monetary base
by adjusting its liability and assets and by
regulating banks through control of reserve
requirements.
 By controlling the monetary base, the central
bank can exert a strong influence on the
equilibrium money stock.
 An increase in the monetary base through
increases in bank excess reserves will
increase the money stock only if the banks
choose to use those reserves to extend
credit, thereby creating new deposits.
 The three major instruments that are available
to the central bank to control the bank excess
reserves and thus, the monetary base are:-
 Required Reserve Ratio: the legally mandated
ratio of reserves to deposit for banks.
 Discount rate: the interest rate the Central bank

charges the member banks for loans.

 Open Market Operations: the Central bank’s

purchases and sales of govt. securities, on

financial markets that will affect the amount of
excess reserves available to the banks.
 RRR
 An increase in RRR reduces the ability of
banks to create chequeable deposits,
through a reduction of excess reserves.
 Similarly, a reduction in RRR increases
the bank’s ability to create chequeable
deposits through an increase in the excess
deposits.
 Discount Rate
 Discount loans or advances by the Central
bank to the member banks accounts for hardly
2% of the total reserves of the banking system
(in the U.S).
 If banks can borrow from the central bank,
they can increase their excess reserves
thereby.
 Discount window is used to maintain
confidence in the banking system.
 Banks will borrow more at a lower rate than at
a higher rate.
 Open Market Operations
 Consists of daily sales and purchases of govt.
securities by the Central bank (CB).
 All OMO are conducted through the CB.
 Transactions are done between CB and
securities dealers (many of whom are banks)
who trade for their own accounts or
banks/business firms/ individuals who want to
buy and sell govt. securities.
 Any purchase of govt. securities by CB are
purchases of securities already outstanding
and held by the public. CB does not have the
authority to purchase new Treasury issues of
the govt. securities.
 OMO
 If CB decides to reduce its holdings of
government securities, it will sell them to
dealers that are also depository institutions.
 Sale of govt. securities will decrease the
monetary base and the potential for the
banks to create money
 Buying of govt. securities by the CB will
have the opposite effect.
 OMO
Why banks should buy/sell government
securities as required by the Central bank???
 Securities- Treasury bills, Treasury notes and bonds
 They have a certain maturity value. When they are sold at
a discount rate, the effective yield will increase.
 Similarly, when they are demanded at a higher rate,
effective yield will decrease.
 The CB holds such a large amount of the govt. securities
that it can influence the prices of treasury bills, notes and
bonds by selling or buying from its portfolio.
To increase the monetary base:
1. Decrease RRR
2. Decrease discount rate
3. Purchase securities in open market

Injection of excess reserves ->

Increase in loans extended ->
Multiple expansion of money stock
To decrease the monetary base:
1. Increase RRR
2. Increase discount rate
3. Sell securities in open market

Decrease in excess reserves ->

Decrease in loans extended ->
Multiple contraction of money
Stabilization & Monetary Policy
Stabilization & Monetary Policy
• Stabilization policies are the procedures
undertaken by government authorities to maintain
full employment and a reasonably stable price
level.

• Monetary policy consists of actions taken by

central banks to influence the money supply or
interest rates in attempts to stabilize the
economy.
• Banks will have a tendency to increase loans during
periods of economic expansion, when interest rates are
rising.
• During periods of economic expansion, expansion of credit
and money supply must be restrained to prevent inflation
from heating up.
• During periods of economic downturns, when interest rates
are falling, there is a normal tendency for banks to cut back
on loans and increase their holdings of excess reserves.
• If banks are allowed to create fewer Rupees of chequable
deposits, the resulting reduction in the availability of credits
and slowdown in the growth of the money stock could
decrease AD and turn an economic contraction into
recession.
• The central bank must attempt to stabilize AD in ways that
smooth out the swings of the business cycle through
influencing money supply.
Money Supply & Short term Macroeconomic
Equilibrium
• Monetary policy affects the economy daily
through it’s impact on investment spending,
household spending and international
transactions.
• Economic stabilization is an art, not a science.
• Unexpected changes in an economy can frustrate
the goals of the most carefully planned policies.
• There are two major policies, which are used to
stabilize an economy; Monetary policy & Fiscal
policy
Short-Term Impact of Monetary Policy
• The monetary policy transmission mechanism: Immediate
Effects

Change in excess Change in Change in

Change in
reserves to the supply of interest rates
Monetary Base
banking system money
 Initial New
Interest Supply of Interest
Money
rate Money rate Supply
(%) (%)
New Initial
Money Supply of
Supply Money

Demand Demand
for for
money money

Money stock (rupees) Money stock (rupees)

A. An increase in the money supply puts B. A decrease in the money supply puts
downward pressure on interest rates upward pressure on interest rates
Interest Rates and Aggregate Demand
• How changes in money supply affect AD ?
• Real interest rate is a major determinant of AD
• If monetary authorities can gauge the expected rate of
inflation, they can change nominal interest rate in such a
way that it results in a change in real interest rate.
• Rate of inflation remaining the same, a sharp increase in
nominal interest rate will lead to a raise in real interest
rate and vice versa.
• The component of AD that is likely to be most responsive
to changes in real interest rates is investment purchases,
including purchases of homes.
Interest Rates & Aggregate
Demand
• Lower real interest rates encourage increased
investment purchases while higher real interest
rates cause business firms to cut back their
planned investment expenditures.
• Of course, some consumer purchases are also
interest rate sensitive, particularly those that are
installment based purchases.
• To simplify, our focus is on investment
purchases.
Real Aggregate
AP Price
I.R. Investment purchases
After level
(%) Demand
Expansi
onary AD After
M.P. expansionary
M.P.
Initial
AP Initial
AD
Investment Real GDP Real GDP
goods per year

A. B. C.

Impact of Expansionary Monetary Policy on AD

Using Expansionary Monetary Policy to eliminate
a recessionary GDP Gap

Price level
AS

105 Impact of an expansionary

New AD
monetary policy on real GDP
100
and the price level
Initial AD
5000
4000 Real GDP

Recessionary GDP Potential Real

gap GDP
Expansionary Decrease in Real Increase in Increase in
Monetary Policy Interest Rates investment Aggregate
purchases Demand

Increase in
equilibrium
GDP and PL
How effective is Monetary Policy in
increasing AD
Unfortunately Monetary Policy is not an exact science and
it’s effectiveness depends on how responsive both banks
and investors are to changes in the monetary base and
the level of real interest rates.
The effectiveness of an expansionary monetary policy in
increasing aggregate demand depends on two factors:
• The willingness of the banking system to create new chequable
deposits by making loans using newly created excess reserves.
• The responsiveness of investment and other credit sensitive
purchases to declines in interest rates:
• Suppose banks respond positively to an expansionary
monetary policy, then it’s success will depend on the
responsiveness of investment purchases.
• In times of recession, the business outlook may be so gloomy
that banks may prefer to hold onto their excess reserves
rather than extend credit.
• If so, interest rates will not fall and demand for credit will not
go up.
• J.M. Keynes was quite pessimistic about the effectiveness of
monetary policy as a means of pulling an economy out of a
deep recession.
• Keynes argued that even if the central bank is
effective in increasing the equilibrium money
stock, in a deep recession, it’s effect on the
market rate of interest might be negligible.
• During deep recession, money is likely to be a
very attractive asset for households and
business compared to stocks and bonds.
• The increased money stock ends up being
held as currency or chequable deposits.
• As a result, there is little increase in the supply
of loanable funds and little downward pressure
on interest rates.
 To prevent inflationary gaps from occurring,
the Central Bank must engage in a
contractionary monetary policy as the economy
approaches full employment level.
 To do so, decrease the excess reserves available
to depository institutions.
 Monetary policy will be effective in preventing
an inflationary gap, if it can keep the Aggregate
Demand Curve from shifting outward.
Price
Level
AS
E2
125
110 E1

100 AD2
E
AD1

5000 5500
Real GDP

Inflationary GDP Gap Potential Real GDP

 If the monetary policy is successful, it will keep
the AD Curve from shifting outward (from
AD1 to AD2). If so, the economy will never
reach an equilibrium at E1 (in the figure).
 The objective of the Central Bank is to restrain
demand from increasing to the point where it
over heats the economy.
 In doing so, it hopes to engineer a ‘soft landing’
for the economy.
 However, precise information about Potential
Real GDP is difficult to obtain.

 Therefore, the Central Bank must be careful to

avoid ‘crashing’ the economy by tightening too
much in a way that causes a recession.
 Economists agree that monetary policy has the
potential to influence A.D.
 However, there is disagreement about the
mechanism through which monetary policy
affects A.D and macroeconomic equilibrium.
 In the short run, the major impact of the money
supply on Real GDP occurs through the
transmission mechanism discussed earlier.
 But in the long run, the impact depends on the
relationship between growth in the money
stock available, growth in Potential Real GDP,
and shifts in the demand curve for money.
 The long term objective of the monetary policy
is to adjust the growth in the transaction
demand for money.
 By doing this, the Central Bank ensures a stock
of money and a supply of credit that allow the
economy to expand without excessive inflation
or recession.
 The number of times per year, on average, a rupee
of the money stock is spent on final products.
 The income velocity of circulation =
V = Nominal GDP / M1
 V (2000-01) = 23558/3794 = 6.21
 V (2015/16) = 136820/26025 = 5.26
 V(2018/19) = 18816538/3701285 = 5.07
 On average, a rupee note was involved in six
transactions during 2000-01 whereas five times in
2015/16 as well as in 2018/19 in Indian economy.
 V = Nominal GDP / M1
(M1)V = Nominal GDP
Nominal GDP = (Price Level)(Real GDP) = PQ
Therefore,
MV = PQ
This is an identity. MV represents total rupee
expenditure and PQ total income receipts.
 The classical theory assumed velocity to be constant
and argued that in the long run, if growth of money
supply exceeds growth of Real GDP, it would cause
rapid inflation
 But ‘V’ is not constant.
 Year Velocity
2011/12 5.02
2012/13 5.24
2013/14 5.45
2014/15 5.43
2015/16 5.26
2016/17 4.52
 The variability of ‘V’ casts doubt on the applicability of
the Quantity Theory of Money.
 Real GDP grew by 6.89% whereas Narrow Money
grew by 9.18% per annum during 2011/12-2016/17.
Why does ‘V’ change ?
 The answer lies in shifts of the demand curve for
money in the economy.
 Velocity varies as the demand for money varies.
 There was a sharp increase in the Velocity from
1950s to 1980s, in the US, due to many financial
innovations. These innovations allowed the public to
economize on the money it held.
 This trend has been observed in the Indian context as
well.
 ‘V’ varies with interest rates.
 When interest rates go up, the opportunity cost
of holding money rises and individuals
economize on their money balances to take
advantage of higher yields.
 A lower demand for money will be associated
with an increase in velocity and vice-versa.
 Monetary policy operates with long and
sometimes unpredictable lags.
 An economy is like a ‘long locomotive’.
 The lags in the effects of monetary policy
makes its use more of an art than a science.
 However, the variability of velocity has not
rendered the Quantity Theory of Money
useless.
 MONETARISM is a theory of long term
macroeconomic equilibrium, based on the
equation of exchange, according to which shifts
in velocity are reasonably predictable.
 They believe that after adjusting for changes in
the rate of increase (or decrease) in velocity,
careful control of the equilibrium money stock
is necessary to stabilize the economy.
 Suppose, after adjusting for changes in ‘V’ if
money stock is not allowed to grow rapidly
enough to accommodate the growth in Real
GDP, monetary policy could cause a recession
and vice-versa.
 Economic contraction or recession can be
precipitated by inadequate monetary growth.
 Monetarists argue that in the long run, the
growth rate of money stock is the major factor
influencing the rate of inflation in the economy.
 If MV = PQ and Real GDP grows up by 3% per
year, MV must increase by no more than 3%
per year to prevent inflation in the long run.
 But in the meantime, if ‘V’ increases, ‘M’ needs
to increase by less than 3%.
 Monetarists argue that changes in ‘V’ are
predictable and therefore, money supply can
be changed so as to ensure stable price level
and economic growth.
MONETARY POLICY: AN
EMPIRICAL TREATMENT

Though the role of monetary policy in an

open economy is undisputed, there has
been considerable debate regarding its
core objective.
MONETRY POLICY
OBJECTIVES
 MP can have several objectives such as
sustained growth of real output, higher
productivity and employment, equitable
distribution of income and wealth, etc.
 However, cross-country experiences bring
out that maintaining low and stable order of
inflation should constitute the fundamental
objective of MP.
This is on account of two
important considerations
1. Empirically it is now clear that in the medium to long run,
inflation is associated with sustained growth in monetary
aggregates. This is brought out by the negative relationship
between inflation rate and economic growth on the one
hand and positive correlation between inflation rate and
variations in money supply across countries on the other.
2. Maintaining a stable and low rate of inflation is considered
best for ensuring efficiency and improving overall social
welfare.
Therefore, Central Banks across the world have been focusing their
strategies exclusively on price stability.
Money Demand Function in
India
 The demand for money is a critical
component in the formulation of monetary
policy
 A stable demand function for money is
perceived as a pre-requisite for the use of
monetary aggregates in the conduct of
policy.
EQUATION OF EXCHANGE
 The relationship among money, output and
prices can best be described by the well-
known equation of exchange
 MV=PY where
 M denotes money supply
 P denotes price of a unit of output
 Y denotes the amount of output, and
 V denotes the income velocity of money
Quantity Equation with Interest
Rate as an additional variable
 (M/P) = f(Yr , i) where M/P stand for real money balance,
Yr for real income and I for interest rate.
 This equation states that the quantity of real money
balance demanded is a function of real income and
interest rate.
 In India there have been several attempts over the years
to estimate the demand function for money.
 Most of the studies support the hypothesis that the demand function for
money is stable.
 This functional stability as distinguished from numerical stability does not,
however, preclude shifts in the parameters over a period of time.
MONETARY POLICY IN INDIA
 Monetary Policy (MP) is an arm of Economic Policy
(EP) and hence, the objectives of MP are no
different from the overall objectives of EP.
 Broadly, the three major objectives of EP in India
have been: (1) Growth, (2) Social justice, and (3)
Price Stability.
 Of the various objectives, price stability is the one
that can be pursued most effectively by monetary
policy - Rangarajan
MONETARY POLICY IN INDIA
 Price stability has gained more importance
following the opening up of the economy and
financial market deregulation in the recent
period.
 The expectations of future rate of inflation
constitute one of the prime determinants of
market based interest rates and exchange
rates.
Monetary Policy in India
 The RBI by virtue of its monopoly power of
supplying reserves to the economy is best placed
to ensure price stability through appropriate
conduct of MP.
 The preamble of the Reserve Bank of India Act,
1934 enjoins the Bank to conduct its operations
“with a view to securing monetary stability in India
and generally to operate the currency and credit
system of the country to its advantage”.
The RBI formulates and
administers MP in India
 The central bank attempts to ensure an adequate
level of liquidity to support the rate of economic
growth envisaged and to assist in the fullest
possible utilisation of resources without generating
inflationary pressures.
 The building up of the financial infrastructure has
constituted and will constitute in the foreseeable
future a major dimension to the developmental
monetary policy.
Monetary Policy in India
 The efficacy of MP can be judged by the single
criterion of inflation performance of the economy.
 However, considering the need for development
finance in a capital scarce economy, monetary
policy would need to be evaluated in an
integrated framework in terms of the inter-
relationship among money, output and prices.
 During 1951/52-1996/97, M3 expanded at 13.4%,
real GDP grew by 4.3%, inflation rate by 6.8%
and growth in bank credit by 14.7%
Monetary Policy in India
 The application of monetary policy instruments
has witnessed a distinct qualitative change over
time.
 The instruments available at the disposal of RBI
remained unchanged throughout the period but
their relative efficacy and the environment in
which they have been applied has undergone a
sea change, particularly in the 1990s.
Monetary Policy Instruments
can be classified into:
 General Instruments  Selective Instruments
Bank Rate and - Various directed
Interest Rates, CRR, credit programmes
OMO and refinance such as priority sector
facilities credit, export credit,
food credit, and
- Application of margins
in lending.
Monetary Policy in India
 During the pre-independence period, of the instruments,
the Bank rate was particularly important since it was the
signalling rate.
 The effectiveness of the Bank rate dwindled sharply with
the emergence of differential interest rates system in the
1960s.
 In the post-nationalisation phase, with increased
emphasis on priority sector lending and concessional
lending, the Bank rate lost much of its significance till the
announcement of resurrecting it was made in April 1997.
Monetary Policy in India
 The Bank Rate was changed nine times during
1951-74 and only thrice during 1975-96 despite the
substantial growth of financial sector and the
pressures on liquidity exerted at different points of
time during 1951-1996.
 The CRR and SLR increasingly became the active
policy instruments particularly since 1970s.
 The basic CRR was kept constant for 38 years
during 1935-72 while the SLR was changed only
once during 1949-69.
Monetary Policy in India
 Following the weakening of fiscal position of the Central
Government, the resources of the banking sector came to be
increasingly absorbed to support the market borrowing programme
of the Government on longer term basis at highly concessional rate
of interest through prescriptions of higher SLR.
 As these resources fell short of financing of fiscal deficit, the Central
Government took recourse to the RBI through the issue of ad hoc
Treasury Bills at relatively low rates of interest.
 These and other ‘statutory’ liabilities not only ‘crowded out’ the
private sector, the government securities market lost its depth
as the rates of interest and maturity period of securities
reflected the perceptions of the issuer (Government) rather
than those of the market and investors.
Monetary Policy in India
 As a result, OMO were rendered ineffective.
 The evolving situation led to gradual scaling up
of CRR and SLR to reach the unsustainable
level of 63.5 % in 1991 from only 23% in 1962.
 Even on the balance of 36.5%, there were pre-
emptions in terms of lending for priority sectors
up to 40% of net bank credit.
 With the result, credit for commercial sectors’
use tended to be limited.
Monetary Policy in India
 The first major attempt to ratinalise the system
and to improve the operating procedure of policy
arose from the recommendations of the
Committee to review the Working of the
Monetary system (the Chakravarthy Committee)
in 1985 followed by the Working Group on Money
Market (the Vaghul Committee) in 1987 and
finally, the committee on the Financial System
(the Narasimham Committee) in 1991.
Monetary Policy in India
 The new process thus set in has become
much more refined with market forces playing
more dominant role in influencing the balance
sheets of financial sector units.
 This has provided RBI the much needed
maneuverability in respect of monetary policy
instruments and considerable flexibility in
influencing market liquidity.
Monetary Policy in India
 MP has been activated since the early 1990s:
 Reduction in CRR
 Limiting automatic monetisation of fiscal deficit by
replacing ad hoc Treasury Bills with ways and means
advances at market related interest rates from April 1997
 Auction system of government securities
 Liberalizing interest rates and rationalizing concessional
credit and refinance facilities
 Re-vitalizing the Bank rate as a signaling instrument of
the stance of monetary policy, etc.