Basics of Macroeconomics Training Course Material for e-Library on System of National Accounts March 2009 Module-I: PP1

2 Topics To Be Covered Introduction Circular flow of income and expenditure Measuring economy Macroeconomic objectives Macroeconomic policy –Monetary policy –Fiscal policy

3 Introduction People have unlimited wants and needs The wants and needs are satisfied by consuming goods and services (commodities) Commodities are produced by using resources Income gets generated to owners of resources who get income (factor) shares in the process of production of goods and services

4 Introduction (Contd.) The resources are factors of production Resource Factor Income (Factor) share Natural Land Rent Human Labour Salaries/Wages Financial Capital Interest Managerial skill Enterprise Profit /Loss Produced M&E Depreciation

5 INPUTS: RESOURCES /FACTORS OF PRODUCTION PRODUCTION PROCESS OUTPUT: GOODS AND SERVICES INTERMEDIATE USE and FINAL USE DISTRIBUTION CONSUMPTION Economic Activities

6 Key Economic Issues Scarce resources in relation to unlimited wants and needs How nations use their scarce resources - results in future development Scarcity is the gap between human desires and available resources. Scarcity forces people to make economic choices.

7 Opportunity Costs The Opportunity Cost of using resources for a certain purpose is the benefit given up by not using them in an alternative way It is what is given up in order to get something else

8 Key Economic Problems WHAT goods and services to produce? HOW to produce those goods and services? Labour intensive? Capital intensive? WHO should get the goods and services produced? Rich? Poor who works hard?

9 Two Complementary Ways of Viewing the Economy Microeconomics is the behavior in the economy of –individual markets (eg. for wheat, coal) –individual decision makers (eg. firms, households) Macroeconomics is the study of aggregate economic behavior. National, global economies and choices –Total economy output –Unemployment –Productivity –Inflation

10 Circular Flow of Income and Expenditure The concept of a circularity in economic relations is a critical one. It helps to understand how the separate parts of the economy are related to each other in a system of mutual interaction. Circular flow of Income and Expenditure is a simplified model for understanding of economic relations.

11 The Circular Flow of Income & Expenditure Producers Consumers Factor Markets Goods Markets Consumption Expenditure Sales receipt Wages, rent, and profit Income Goods & Services sold Goods & Services bought Labor, land, and capital Inputs for production

12 The Circular Flow of Income & Expenditure (Contd.) Two kinds of markets: Goods markets: Goods and services that are produced by firms are sold in these markets. Factor markets: The services of factors of production (land, labour, and capital) are sold in these markets The interactions involve flows going in two directions: Flows in goods and services, called real flows. Flows of payments for these goods and services, called money flows

13 Govtern- ment Households Consumption Income Govt. Expenditure Financial Market Saving Investment Rest of the World Imports Exports Circular Flow of Income and Expenditure [Showing also Leakages: Saving, Taxes, Imports; and Injections: Investment, Govt. Expenditure, Exports] Taxes Firms

14 The Circular Flow 1.Three Markets a) Labor Market b) Goods Market c) Financial Market 2.Four Economic Agents a) Households b) Firms/Businesses c) Government d) Rest of the World The Circular Flow of Income & Expenditure (Contd.)

15 The Circular Flow of Income & Expenditure (Contd.) Firms produce goods and services, they create through factor payments the incomes for households Households buy consumption goods and services, so there is consumption coming out of Households box Government collects taxes in order to cover its expenditure

16 The Circular Flow of Income & Expenditure (Contd.) Households devote part of their income (after tax) to savings, which flows into capital/financial market that in turn makes investment for businesses There are several leakages from and injections to the flow around the main circuit

17 The Circular Flow of Income & Expenditure (Contd.) Leakages and Injections Leakages: [Out from the Households] –Saving –Taxes –Imports Injections: [In to the Firms] –Investment –Government Expenditure –Exports

18 Final Demand of Goods / Services Y = C + G + I + X- M Where, C is Household Final Consumption Expenditure G is Government Final Consumption Expenditure I is Gross Domestic Investment X is exports M is Imports

19 Consumption Consumption is the value of goods and services bought by people It is a large part of aggregate demand (??) The economic performance of the country can be judged by the level and dynamics of consumption Three categories of consumption: Spending for consumer durables Spending for consumer non-durables Spending for consumer services

20 Saving People save, avoiding to consume all their income, is called Personal Saving People deposit Saving in bank accounts or in bonds, shares and other financial instruments (Financial Saving). It can also be invested in acquiring Houses (Physical Assets) Consumption is the key determinant (complementary) for the amount of Personal Saving. Domestic Saving = Personal Saving + Business Saving + Public/ Government Saving

21 Investment is the net value of machinery, equipment, plants, and buildings/sheds that are acquired by business firms for production purposes. All spending by business firms for acquiring new machinery and equipment and business plants/ structures. All changes in business inventories of raw materials, semi-finished goods, and finished goods. All spending by households for acquiring newly constructed residential housing Investment

22 Government Consumption Expenditure on Goods and Services (G) (a) Central government (i) Defense (ii) Non-defense (b) State government (c) Local Bodies Net Exports (X-M) (a) Exports (b) Imports

23 Measuring the Flow of Income and Expenditure There are three possible ways of measuring the flow of income Each of the ways looks at a different part of circular flow All three should give the same results

24 Measuring the Flow of Income and Expenditure (Contd.) Three approaches of measuring circular flow: Production Approach: total amount of goods and services produced in one year. Expenditure Approach : total amount of households final consumption expenditure, government final consumption expenditure, gross investments and net exports in one year. Income Approach : total incomes earned by the factors of production involved in the production of goods and services in one year.

25 Objectives of Governments Macroeconomic Policy Full employment Keep low inflation Economic growth Equitable distribution of income Low government budget, deficit and international debt

26 Policy Instruments Fiscal PoliciesMonetary Policy Government income Interest rates Money in circulation Government expenditure How to Achieve These Objectives?

27 Fiscal Policy Fiscal policy : Government spending and Taxation (government income) decisions. Government can affect aggregate demand by: –Purchasing more or fewer goods and services. –Increasing or reducing taxes. –Changing the level of income transfer. Fiscal policy: –Expansionary –Contractionary

28 Fiscal Policy (Contd.) Expansionary fiscal policy: Increase in government spending Reduction in Taxes Contractionary fiscal policy: Reduction in government spending Increase in Taxes

29 Fiscal Policy (Contd.) Tax regime, as a Fiscal measure, influences Consumption Investment Government Spending Fiscal Policy also does influence Education, Health, Poverty Reduction, Welfare Reforms, Investment, Regional Imbalances, Promotion of Enterprise, etc.

30 Reduction of Taxes The government increases the disposable income of the households by reducing taxes. Disposable income is the after-tax income of consumers or personal income less personal taxes.

31 Tax Cuts and Investment A tax cut may also be an effective mechanism for increasing investment spending. Tax cuts have been used to stimulate the economy.

32 Transfer Payments Increasing transfer payments such as – social security – welfare benefits – unemployment benefits – and veterans benefits Often stimulate the economy

33 Monetary Policy Influences the level of economic activity through –changes of the amount of money in circulation (Money Supply) –short-term interest rates Central bank controls countrys monetary conditions through –Money in circulation –Interest rates

34 How do Interest Rates affect Consumption, Saving & Investment Interest RatesBorrowing Individuals Firms ConsumptionInvestment SavingInterest Rates Consumption

35 How do Interest Rates affect Export and Import Prices Interest RatesExchange Rates Appreciation Import price down Depreciation Import price up Export price up Export price down

36 THANKS