TOOLS FOR MACROECONOMIC ANALYSIS

1. VARIABLES
Variables are quantities or magnitude which varies during a specified period of time under

consideration. In economics, variables are the indicators determining the country’s performance

in terms of its economy. These variables cover a wide variety of information that helps the

government make decisions to improve and solve problems in state affairs. Variables help us

determine the inflation and unemployment in the country, which helps the policymakers focus on

making the policies to improve the conditions of a country and avoid economic failure within the

system and make their work easier.

Variables can be divided into various forms or types, but for this course we will limit it to four

different forms or types. They are:

(a) Exogenous Variables: In economic models, an exogenous variable is one that exists outside

of the model. Factors outside of the economic model determine the value of exogenous variables.

Factors within the economic model don't affect exogenous variables, meaning that they're similar

to independent variables. Because exogenous variables exist outside of the economic model, the

model can't predict their value. They are also referred to as external variables. For example, in

an economic model studying the factors affecting consumer spending, variables such as

government policies, interest rates, or global economic conditions would be considered

exogenous variables

(b) Endogenous Variables: These are also known as internal variables. They are variables that

are determined within the model or system being studied. They are influenced by other variables

in the model. Endogenous variables are the outcome or result of the interactions and relationship
within the system. In the consumer spending example, variables such as household income,

consumer confidence, or personal savings rate would be considered endogenous variables.

(c) Dependent Variables: A dependent variable is the outcome or response being studied in an

experiment or investigation. It’s what researcher’s measure to determine the effect of changes in

the independent variable. In a cause-and-effect relationship, the dependent variable is presumed

to be influenced or caused by the independent variable.

(d) Independent Variables: An independent variable, often termed the predictor

or explanatory variable, is the variable manipulated or categorized in an

experiment to observe its effect on another variable, called the dependent

variable. It’s the presumed cause in a cause-and-effect relationship,

determining if changes in it produce changes in the observed outcome.

FUNCTIONS
A function is a mathematical relationship in which the values of a dependent variable are

determined by the values of one or more independent variables.

Functions with a single independent variable are called Univariate functions. There is a one to

one correspondence. Functions with more than one independent variable, are called

Multivariate functions. The independent variable is often designated by X. The dependent

variable is often designated by Y. For example, Y is function of X which means Y depends on X

or the value of Y is determined by the value of X. Mathematically one can write Y = f(X).
An important function which is extensively used in economics is a demand function which

expresses quantity demanded of a commodity is a function of its price, other factors being

held constant.

Thus, demand for a commodity X is described as under:

Dx = f (Px)

Where:

Dx is the quantity demanded of commodity X

Px is its price.

FUNCTIONAL RELATTIONSHIP BETWEEN VARIABLES

A functional relationship between two variables can be identified by testing whether each input

value leads to only one output value, and not more. In other words, if every input value entered

into the function produces a unique output value, then the relationship is a function.

1. Causal Relationship: A causal relationship exists when one variable in a data set has a

direct influence on another variable. Thus, one event triggers the occurrence of another

event. A causal relationship is also referred to as cause and effect.

2. Linear Relationship: A linear relationship refers to a direct correlation between an

independent variable and a dependent variable. When plotted on a graph, this

relationship creates a straight line. When you plot a linear relationship, the resulting
graph is a straight line. Example: Suppose a shoe factory increases its workforce (the

independent variable) by 10%. The corresponding change in production output (the dependent

variable) will also be proportional. There is also a linear relationship between height and weight.

3. Non- Linear Relationship: Nonlinearity occurs when there is not a straight-line or direct

relationship between an independent variable and a dependent variable. Instead, changes in

the output do not change in direct proportion to changes in any of the inputs. For example

there is a non- linear relationship between Age and Fertility rate

4. Positive or Direct Relationship: A positive correlation refers to a relationship

between two variables that tend to move in the same direction. When one variable
increases, the other also increases, and when one decreases, the other follows suit. Here
are some examples:

(a) Demand and Price: One of the most common positive correlations is
between demand and price. When the demand for a product increases, its price tends
to rise. Conversely, if demand decreases, the price tends to fall. For instance, when more
people want to buy a particular item (increased demand), sellers can charge higher
prices for it. This relationship is influenced by factors such as consumer preferences,
scarcity, and market dynamics.

(b)Consumer Spending and GDP: In macroeconomics, consumer spending and Gross

Domestic Product (GDP) often exhibit a positive correlation. When consumers spend
more on goods and services, it contributes to economic growth, leading to an increase
in GDP. Conversely, during economic downturns, reduced consumer spending can lead
to lower GDP growth

5. Negative or Inverse Relationship: In economics, a negative relationship refers to the situation

where two variables tend to move in opposite directions. Specifically, when one variable
increases, the other variable decreases, and vice versa. Example includes the relationship

between Inflation and Unemployment.

INDEX NUMBERS

An index number is a statistical measure designed to show changes in a variable or a group of

related variables over time. It is typically used to measure economic data such as prices,

quantities, or values in order to track economic performance, inflation, or productivity levels.

Index numbers provide a simple, easy-to-understand way to present the relative changes from

one period to another, making them crucial for economic analysis and decision-making.

Consider the Consumer Price Index (CPI), one of the most commonly referenced index numbers.

The CPI measures the average change over time in the prices paid by urban consumers for a

market basket of consumer goods and services. Assume that the base year (the year used for

comparison) has a CPI of 100. If the CPI in the following year rises to 105, this indicates that

there has been a 5% increase in the level of consumer prices — in other words, inflation —

compared to the base year.

To further illustrate, imagine the prices of a basket of goods and services that an average

consumer buys: food, housing, clothes, entertainment, and transportation. If these prices increase

overall, the CPI will rise, indicating inflation. Conversely, if the prices decline, the CPI will

drop, suggesting deflation.

Why Index Numbers Matter

Index numbers are essential tools for economists, policymakers, business analysts, and investors

for several reasons:

(a) Inflation Tracking: They are indispensable for measuring inflation, which affects

purchasing power and living standards. By analyzing trends in CPI, economists can understand

how inflation is evolving and propose monetary policies accordingly.

(b) Economic Policy: Governments use index numbers to formulate fiscal and monetary

policies. For example, adjustments to interest rates are often based on movements in key

economic indices.

(c) Business Planning: Businesses rely on index numbers such as the Producer Price Index (PPI)

for planning purposes. Changes in the PPI can signal changes in raw material costs, affecting

pricing strategies and profit margins.

(d) Contract Adjustment: Index numbers are used in cost-of-living adjustments for wages,

leases, and other contracts to maintain their real value over time.

(e) Historical Comparison: They allow economists to compare economic performance across

different periods, adjusting for the effects of inflation, and to analyze long-term trends.