Semester 2

Introduction
to
Economic Analysis
- Dr Vighneswara Swamy
Dr. Vighneswra Swamy 1

What is economics?
Economics is the science that deals with the behaviour of people,
individuals, households, firms and the government concerned with the
production, distribution, and consumption of goods and services, or the
material welfare of humankind.
In simple terms, Economics is the study of how society manages its scarce
resources.
First ever recorded document on economics is from Kautilya in the form of
Arthashastra during 3 B.C.
Alfred Marshal was the first to use the term Economics in 1922.
DR. VIGHNESWRA SWAMY 2
What is Macroeconomics?
Macroeconomics is the study of the behavior of the
economy as a whole.
It concerns the business cycles that lead to
unemployment and inflation, as well as the longer-
term trends in output and living standards.

Microeconomics vs Macroeconomics
Microeconomics Macroeconomics
Microeconomics is the study of decision Macroeconomics is the study of nationwide
making by individual households and phenomena, such as inflation,
individual firms, and how they interact in unemployment, and economic growth.
specific markets.
Usefulness of Microeconomics: Usefulness of Macroeconomics:

Determination of demand pattern Income and employment determination
Determination of the pattern of supply Price level
Pricing Business cycles
Policies for improvement of resource allocation Balance of payments
Solution to the problems of micro-units Government policies
Interrelations between markets

Macroeconomics Objectives
The major objectives are:
Economic growth
Full employment
Price stability
1-5 SWAMY
DR. VIGHNESWRA
Macroeconomic Goals
The goal of economic growth
The goal of low unemployment
The goal of low inflation
Price stability
International trade with export and import equilibrium
and exchange rate stability

Scope of Macroeconomics
Macroeconomics involves the study of economic aggregates of
nation/s:
◦ Economic growth
◦ Employment
◦ Inflation
◦ Aggregate demand and aggregate supply
◦ Economic policies – fiscal and monetary
◦ International trade – exports and imports
◦ Money supply
◦ Interest rate trends
The Power of Economic Analysis
Economic analysis is used in all decision making.
Economic analysis is a tool that can aid all decision

making.
The economic way of thinking provides a framework for

analyzing solutions to economic problems.

Macroeconomic Policy Instruments
A policy instrument is an economic variable under the control of
government that can affect one or more of the macroeconomic goals
1. Fiscal Policy
Fiscal policy is the use of government expenditures and taxes to affect
aggregate demand and aggregate supply.
2. Monetary Policy
Monetary policy involves the use of interest rates to control the level
and rate of growth of aggregate demand in the economy.
Components of
Macroeconomy
Macroeconomics focuses on
four broad groups:
1. households
2. firms
3. the government
4. the rest of the world
Market Arenas of Macroeconomy
Macroeconomics focuses on
three broad market arenas:
1. the goods-and-services market
2. the labor market
3. the money (financial) market

Macroeconomic Concepts
Output National Business Employment Price International
and Income Cycle Stability trade
Growth
Output, Gross Domestic Depression, Unemployment, Inflation, Exports and
Aggregate Product (GDP), Recession, Labor force, Deflation, Imports,
output, Nominal income, Expansion Unemployment Price Trade
Economic Real income, rate stability Imbalances:
growth, Gross National surplus and
Productivity Income, deficits,
growth, Real and Exchange Rate
Nominal
measures,
GDP and Human
Welfare
GDP and related concepts
Gross Domestic Gross National Net National Nominal GDP Real GDP
Product (GDP) Product (GNP) Product (NNP)
GDP is the market GNP is the total NNP is the total Nominal GDP is Real gross domestic
value of all final value of goods value of goods GDP evaluated at product (GDP) is an
goods and services produced and produced and current market inflation-adjusted
produced within a services provided by services provided in prices. measure that reflects
country in a given a country during one a country during one the value of all goods
time period. year, equal to the year, after and services produced
gross domestic depreciation of by an economy in a
product plus the net capital goods has given year, expressed
income from foreign been allowed for. in base-year prices,
investments. and is often referred
to as "constant-price,"
"inflation-corrected"
GDP or "constant
dollar GDP."
Importance of GDP
1. Gross Domestic Product (GDP) is the widely used measure of an
economy's output or production.
2. It represents the total dollar value of all goods and services
produced over a specific time period; you can think of it as the
size of the economy.
3. It has become widely used as a reference point for the health of
national and global economies.
4. When GDP is growing, especially if inflation is not a problem,
workers and businesses are generally better off than when it is
not.

GDP and its Importance
Gross Domestic Product
Gross National Product
Nominal GDP
Real GDP
Potential (real) GDP

Major issues in Macroeconomics
1. What determines a nation’s long-run economic growth?
2. What causes a nation’s economic activity to fluctuate?
3. What causes unemployment?
4. What causes prices to rise?
5. How does global economic system affect nations’
economies?
6. How do the government policies help improve economic
performance?

The Role of Macroeconomists
Macroeconomic Macroeconomic Macroeconomic research Data
forecasting analysis development
To predict future To analyze and To understand the structure of Macroeconomists
economic trends - interpret events the economy in general – forms use data to assess
has some success as they happen – the basis for macroeconomic the state of the
in the short run. helps both analysis and forecasting. economy, make
In the long run private sector forecasts, analyze
too many factors and public To develop theories: policy
are highly policymaking. Economic theory: a set of ideas alternatives, and
uncertain. about the economy to be test theories.
organized in a logical framework.
Economic model: a simplified
description of some aspects of
the economy.
Keywords
Economics
Economic analysis
Macroeconomics
Production
Economic output
Economic growth
Prices
Income
Employment
Gross Domestic Product

Measuring
National
Output/Oncome
Circular Flow of Macroeconomic Activity
•The Circular Flow of Economic Activity refers to an economy
that is an enormous, constant cycle, with money, products,
and energy flowing back and forth.
•Economic Interdependence is an important feature of an

economy in which businesses, households, and the
government depend on each other in order for the
economy to run smoothly.
2
The Circular-Flow Diagram
Revenue Market for Spending
Goods
Goods & Goods &
Services sold
and Services
Services
bought
Firms Households
Inputs for Labor, land,

production Market for and capital
Factors
Wages, rent, of Production Income
and interest
Two Sector Model
4
Three Sector Model
5
Four Sector
Model
6
The Circular Flow Adding
the Rest of World
7
Measuring Economic Output
Output defined in two ways:
1. Production side: output = payments to workers (wages), capital
(interest and dividends)
2. Demand side: output = purchases by different sectors of the
economy
Output is typically measured as Gross Domestic Product (GDP). It is

the value of all final goods and services produced within a country
over a particular period of time.
8
Gross Domestic Product (GDP)
Gross Domestic Gross National Net National Net Domestic
Product (GDP) Product (GNP) Product (NNP) Product (NDP)
GDP is the market GNP is the total value NNP is the total NDP is the GDP
value of all final of goods produced value of goods minus
goods and services and services provided produced and depreciation.
produced within a by a country during services provided in
country in a given one year, equal to the a country during
time period. gross domestic one year, after
product plus the net depreciation of
income from foreign capital goods has
investments. been allowed for.
9
Measuring GDP
GDP is the value of final goods and services currently produced
within a country over a period of time.
1. Final goods and services (NO DOUBLE COUNTING): Ex. Would not include the full price
of a car AND the tires bought by the manufacturer for the car → tires = intermediate goods
2. Goods and services currently (in the time period being considered) produced & excludes
transactions involving used goods. Ex. Include the construction of new homes in current
GDP, but not the sale of existing homes.
3. Goods and services produced within a country, regardless of the ownership/nationality
of the producing firm. Ex. Include the sale of a car produced by a Japanese car
manufacturer located in the U.S. in U.S. GDP
10
What Is Counted and Not Counted in GDP?
1. GDP includes all items produced in the economy and sold
legally in markets.
2. GDP excludes services that are produced and consumed at
home and that never enter the marketplace.
3. Caring labor, the work that is normally produced by women.
4. Because GDP does not count it, it diminishes its importance.
5. GDP also excludes black market items, such as illegal drugs.
11
The Components of GDP
GDP (Y ) is the sum of the following:
 Consumption (C)
 Investment (I)
 Government Purchases (G)
 Net Exports (NX)=X-M
Y = C + I + G + (X-M)
12
Problems of GDP Measurement
Three major criticisms of the GDP measure:
1. Omits non-market goods and services. Ex. Work of stay-at-home mothers
and fathers not included in GDP
2. No accounting for “bads” such as crime and pollution. Ex. Crime is a
detriment to society, but there is no subtraction from GDP to account for it
3. No correction for quality improvements. Ex. Technological improvements
are beneficial to the economy, but nothing is added to GDP to account for
them
The Human Development Index (HDI) is a statistical tool used to measure a country's overall
achievement in its social and economic dimensions. The social and economic dimensions of a
country are based on the health of people, their level of education attainment and their standard of
living.
13
Gross National Net National Gross National Personal Disposable
Product (GNP) Product (NNP) Income (GNI) Income (PI) Personal
Income (DPI)
GNP is the total NNP is the total GNI is the GNP PI is the total DPI is equal to
market value of all value of goods converted into income of Personal income
final goods and produced and dollars using an households minus personal
services produced services provided average of income taxes. The
within a given in a country currency amount that
period by factors during one year, exchange rates households have
of production after over several to spend or save.
owned by a depreciation of years adjusted for
country’s citizens, capital goods has rates of inflation.
regardless of been allowed for.
where the output
is produced
14
Calculating GDP: Expenditure Approach
A method of computing GDP that measures the total amount spent on all final goods and
services during a given period.
The four main categories of expenditure:
1. Personal consumption expenditures (C): household spending on consumer goods
2. Gross private domestic investment (I): spending by firms and households on new
capital, that is, plant, equipment, inventory, and new residential structures
3. Government consumption and gross investment (G)
4. Net exports (EX - IM): net spending by the rest of the world, or exports (EX) minus
imports (IM)
GDP = C + I + G + (EX  IM)

15
Calculating GDP: Income Approach
A method of computing GDP that measures the income—wages, rents, interest, and
profits—received by all factors of production in producing final goods and services.
National Income: The total income earned by the factors of production owned by a
country’s citizens.
Compensation of Employees: Includes wages, salaries, and various supplements.
Proprietors’ Income: The income of unincorporated businesses.
Rental Income: The income received by property owners in the form of rent.
Corporate Profits: The income of corporations.
Net Interest: The interest paid by business
Indirect Taxes minus Subsidies, Net Business Transfer Payments, Surplus of Government
Enterprises 16
Calculating GDP: Product approach
The product approach of national income accounting measures the addition of value to
the raw material (intermediate goods) by a firm, during its productive activities. The
concept of value addition is essential to the practice of producing final goods with the
help of raw materials. It is calculated as the difference between value of output and value
of intermediate consumption. Intermediate consumption refers to the value of raw
materials used in the production process.
Value Added = Value of Output – Intermediate Consumption
Example: let us suppose that a baker needs only flour to produce bread. He purchases
flour as inputs worth Rs. 500 from the miller and then by virtue of its productive
activities, converts the flour into bread and sells the bread for Rs. 700. Now, in this
example, the flour purchased by the baker is his intermediate consumption, and the
bread that he produced is the final output. The value added, in this case, is = Value of
Output - Intermediate Consumption. = Rs. 700 – Rs 500 = Rs. 200
17
The Production Function
The production function is the relationship between inputs and output (Y)
Production function is used to study two sources of output growth:
◦ Increases in inputs (N, K)
◦ Increases in productivity (technology)
The production function is
𝑌 = 𝑓 𝐾, 𝑁 ∗ 𝐴
Where Y is th output, K and N are the inputs, and A is the technology.
Assumption: An increase in A = increase in productivity leads to output increases for
given level of inputs N and K.
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Growth Accounting Equation
Transform the production function into growth rate form to show the relationship
between input growth and output growth
The growth accounting equation is:
Y N K A
 (1  )    
Y    N 
K
 A
Nshare Ngrowth Kshare Kgrowth tech . progress
Growth rates of K and N are weighted by their respective income shares, so that
each input contributes an amount equal to the product of the input’s growth rate
and their share of income to output growth
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Examples
If   0.25, (1  )  0.75 , the growth rates of N and K are 1.2% and 3% respectively, and the rate of
technological progress is 1.5%, then output growth is:
Y
 (0.75  1.2%)  (0.25  3%)  1.5%  3.15%
Y
Since labor share is greater than capital share, a 1% point increase in labor increases output by more
than a 1% point increase in capital.
Suppose the growth rate of capital doubles from 3% to 6%. What is the growth rate of output?
Y
 (0.75  1.2%)  (0.25  6%)  1.5%  3.9%
Y
Output increases by less than a percentage point after a 3% point increase in the growth rate of capital
If the growth rate of labor doubled to 2.4% instead, output growth would increase from 3.15% to
4.05%
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Components of GDP, 2017: The Expenditure Approach
Billions of Dollars Percentage of GDP
1. Personal consumption expenditures (C) 10,089.1 70.8
Durable goods 1,035.0 7.3
Nondurable goods 2,220.2 15.6
Services 6,833.9 47.9
2. Gross private domestic investment (l) 1,628.8 11.4
Nonresidential 1,388.8 9.7
Residential 361.0 2.5
Change in business inventories 120.9 0.8
3. Government consumption and gross investment (G) 2,930.7 20.5
Federal 1,144.8 8.0
State and local 1,786.9 12.5
4. Net exports (EX – IM) -392.4 - 2.8
Exports (EX) 1,564.2 11.0
Imports (IM) 1,956.6 13.7
Gross Domestic Product 14,256.3 100.0
Note: Numbers may not add exactly because of rounding.
21
Components of National Income, 2017:
The Income Approach
Billions of Percentage of National
Dollars Income
National income 12,280.0 100.0

Compensation of employees 7,783.5 63.4
Proprietors’ income 1,041.0 8.5
Rental income 268.1 2.2
Corporate profits 1,308.9 10.7
Net interest 788.2 6.4
Indirect taxes minus subsidies 964.3 7.9
Net business transfer payments 134.1 1.1
Surplus of government enterprises -8.1 -0.1
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GDP, GNP, NNP, and National Income, 2017
USD bns
GDP 14,256.3
Plus: Receipts of factor income from the rest of the world +589.4
Less: Payments of factor income to the rest of the world -484.5
Equals: GNP 14,361.2

Less: Depreciation -1,864.0
Equals: Net national product (NNP) 12,497.2
Less: Statistical discrepancy -217.3
Equals: National income 12,280.0
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GDP at Market GDP at Factor NNP at Factor NDP at Factor
Price Cost Cost Cost
Gross domestic The Gross Domestic Net national product Net Domestic
product at market Product at factor cost at factor cost is the product of factor
prices is the sum of is the sum of net aggregate payments cost or domestic
the gross values value added by all made to the factors income is the income
added of all resident the producers in the of production. earned by all the
producers at market domestic territory of factors of production
prices, plus taxes less the country and within the domestic
subsidies on imports. consumption of fixed territory of a country
capital during an during a year in the
accounting year. form of wages,
interest, profit and
rent etc.
24
Nominal GDP vs. Real GDP
Nominal GDP Real GDP
Nominal GDP is GDP evaluated at current Real gross domestic product (GDP) is an inflation-adjusted measure that
market prices. reflects the value of all goods and services produced by an economy in a
given year, expressed in base-year prices, and is often referred to as
NGDP in 2017 is the sum of the value of all "constant-price," "inflation-corrected" GDP or "constant dollar GDP.“
outputs measured in 2017 dollars:
RGDP is the value of output in constant dollars → scaled by a based
𝑵 year price, so that any change in GDP is due to change in production, not
prices
𝑵𝑮𝑫𝑷𝟐𝟎𝟏𝟕 = 𝑷𝟐𝟎𝟏𝟕
𝒊 ∗ 𝑸𝟐𝟎𝟏𝟕
𝒊 If 𝑃𝐵 is the price in the base year for good i, RGDP in 2017 is:
𝒊=𝟏 𝑵
𝑵𝑮𝑫𝑷𝟐𝟎𝟏𝟕 = 𝑷𝑩 𝒊 ∗ 𝑸 𝟐𝟎𝟏𝟕
𝒊
𝒊=𝟏
25
Nominal GDP vs. Real GDP
Real GDP is corrected for the effects of inflation.
◦ It is found by multiplying output bought at a constant price level.
If Real GDP has increased then output has increased.
Calculating Real GDP (base year 2001):

2001 ($1 per hot dog x 100 hot dogs) + ($2 per hamburger x 50 hamburgers) = $200
GDP Deflator
GDP deflator is the ratio of NGDP in a given year to RGDP of that year
◦ The GDP deflator is one measure of the overall price level.
◦ Since GDP deflator is based on a calculation involving all goods produced in the economy, it is
a widely based price index that is frequently used to measure inflation
◦ Measures the change in prices between the base year and the current year
Ex. If NGDP in 2012 is $6.25 and RGDP in 2012 is $3.50, then the GDP deflator
for 2012 is $6.25/$3.50 = 1.79  prices have increased by 79% since the base
year
Nominal GDP
GDP deflator =  100
Real GDP
27
An Example:
GDP Inflation
Nominal GDP Real GDP
Deflator Rate
2015 $46,200 $46,200 100.0 n.a.
2016 51,400 50,000 102.8 2.8%
2017 58,300 52,000 112.1 9.1%
28
Real GDP and the Price Level
29
Measuring Economic Growth Rate
For an economy to experience continued prosperity GDP must grow at a
faster rate than the population.
GDP growth can be determined using the rate of change formula:
Current GDP – Previous GDP x 100
Previous GDP
Real Economic Growth Rate is the rate at which a nation's Gross Domestic
product (GDP) changes/grows from one year to another.
Why Do We Measure Economic
Growth?
The economic growth rate is the percentage change
in the quantity of goods and services produced from
one year to the next.
We measure economic growth so that we can make:
1. economic welfare comparisons
2. business cycle forecasts
3. international welfare comparisons
31
Economic Welfare Comparisons
1. Economic welfare measures the nation’s overall state of economic
wellbeing.
2. Real GDP is not a perfect measure of economic welfare for seven
reasons:
a) Quality improvements tend to be neglected in calculating real GDP.
b) Real GDP does not include household production.
c) Real GDP, as measured, omits the underground economy.
d) Health and life expectancy are not directly included in real GDP.
e) Leisure time, a valuable component of an individual’s welfare, is not included in real GDP.
f) Environmental damage is not deducted from real GDP.
g) Political freedom and social justice are not included in real GDP.
32
Business Cycle Forecasts
1. Real GDP is used to measure business cycle
fluctuations.
2. These fluctuations are probably accurately timed

but the changes in real GDP probably overstate the
changes in total production and people’s welfare
caused by business cycles.
33
International Comparisons
1. Real GDP is used to compare economic welfare in one
country with that in another.
2. Two special problems arise in making these
comparisons.
a)Real GDP of one country must be converted into the same
currency units as the real GDP of the other country, so an
exchange rate must be used.
b)The same prices should be used to value the goods and
services in the countries being compared, but often are not.
34
Changes in GDP
The level of output (income and expenditures) is The level of output (income and expenditures) is
changed if there is a change in AGGREGATE DEMAND. changed if there is a change in AGGREGATE SUPPLY.
35
CPI vs. GDP Deflator
CPI GDP Deflator
1. Prices of Capital Goods Excluded Included
2. Prices of Imported Included Excluded
Consumer Goods
3. The basket of goods Fixed Changes every year
36
Aggregate Output
Aggregate Output is another term for Gross Domestic Product (GDP). It's
the total value of goods and services produced in an economy and is usually
measured during a fiscal year. GDP represents the output of goods and
services at market prices. The term domestic means it's a measurement of
output from within a country' borders. Therefore, the measurement
inherently excludes net income from abroad.
There are two main criticisms of GDP:
•One is its preoccupation with indiscriminate consumption and production.
•The second is its exclusion of the lost value of depleted natural resources
and unpaid costs of environmental harm while including as a positive factor
in its calculations the cost of damage caused by pollution.
37
Aggregate Income
Aggregate income refers to the total amount of all income earned in an
economy within a given period of time.
This basis is one way to estimate, or determine, the gross domestic product.
Aggregate income does not factor in the affect of taxes or inflation on the
income.
Generally, the more income a country earns overall, the more prosperous
the country is considered to be.
Although GDP itself is measured on a fiscal basis, aggregate income is
calculated on a quarterly basis.
38
Human Development Index (HDI)
The Human Development Index (HDI) is a summary measure of average
achievement in key dimensions of human development: a long and healthy
life, being knowledgeable and have a decent standard of living.
The HDI is the geometric mean of normalized indices for each of the three
dimensions.
39
Human Development Index Trends, 1990-2017
HDI rank Country Human Development Index (HDI)
1990 2000 2010 2012 2014 2015 2016 2017
1 Norway 0.850 0.917 0.942 0.942 0.946 0.948 0.951 0.953
13 US 0.860 0.885 0.914 0.918 0.918 0.920 0.922 0.924
130 India 0.427 0.493 0.581 0.600 0.618 0.627 0.636 0.640
189 Niger 0.210 0.252 0.318 0.336 0.345 0.347 0.351 0.354
40
Gross National Happiness Index
The Gross National Happiness Index is a single number index developed
from 33 indicators categorized under nine domains. The GNH Index is
constructed based upon a robust multidimensional methodology known
as the Alkire-Foster method
The concept implies that sustainable development should take a
holistic approach towards notions of progress and give equal
importance to non-economic aspects of wellbeing.
The concept of GNH has often been explained by its four pillars: good
governance, sustainable socio-economic development, cultural
preservation, and environmental conservation.
41
Economic Growth vs
Economic Development
Economic Growth Economic Development
Economic Growth is a narrower Economic development is a normative
concept than economic development. concept i.e. it applies in the context of
It is an increase in a country's real level people's sense of morality
of national output which can be
caused by an increase in the quality of
resources.
The most accurate method of measuring development is the Human
Development Index which takes into account the literacy rates & life expectancy
which affect productivity and could lead to Economic Growth.
42
The Implication of Economic Growth
The benefits of economic growth include:
◦Higher average incomes
◦Lower unemployment
◦Lower government borrowing
◦Improved public services
◦Money can be spent on protecting the environment
◦Investment
◦Increased research and development
43
Keywords
Expenditure Approach
Income Approach
Product Approach
Nominal GDP
Real GDP
GDP Deflator
Economic Growth Rate
Aggregate Output
Aggregate income
Human Development Index (HDI)
Gross National Happiness Index
44
Aggregate Demand and
Aggregate Supply:
Classical and Keynesian Approach
1
Macroeconomics in Three Models
Study of macroeconomics is grounded in three models, each appropriate for a particular time period
Very Long Run Model Long Run Model Short Run Model
1. Domain of growth 1. A snapshot of the very long run model, in 1. Business cycle theories
theory. which capital and technology are largely 2. Changes in AD determine how
fixed. much of the productive capacity
2. It focuses on growth 2. Level of capital & technology determine is used and the level of output
of the production level of potential output and unemployment
capacity of the 3. Output is fixed, but prices determined by 3. Prices are fixed in this period,
economy changes in Aggregate Demand (AD) but output is variable
2
The Long Run Model
In the long run, the Aggregate Supply
(AS) curve is vertical and pegged at
the potential level of output
1. Output is determined by the supply side
of the economy and its productive
capacity
2. The price level is determined by the level
of demand relative to the productive
capacity of the economy
Hence, high rates of inflation are
always due to changes in AD in the
long run
3
The Short Run Model
Short run fluctuations in output
are largely due to changes in AD
The AS curve is flat in the short run
due to fixed/rigid prices, so changes in
output are due to changes in AD
Changes in AD in the short run
constitute phases of the business
cycle
In the short run, AD determines
output, and thus unemployment
4
Aggregate Supply and Demand Model
The AS/AD model is the basic macroeconomic tool for studying output
fluctuations and the determination of the price level and the inflation rate.
A model of the overall economy that we can use to understand long-term
output growth, business cycles, etc.
The AS/AS model an be used to explain how the economy deviates from a
path of smooth growth over time, and to explore the consequences of
government policies intended to reduce unemployment and output
fluctuations, and maintain stable prices
5
Aggregate Supply and Aggregate Demand
Aggregate supply Aggregate Demand
Aggregate supply (AS) curve describes, for Aggregate demand (AD) curve shows the
each given price level, the quantity of output combinations of the price level and the level
firms are willing to supply. of output at which the goods and money
markets are simultaneously in equilibrium.
AS is upward sloping since firms are willing
to supply more output at higher prices Downward sloping since higher prices
reduce the value of the money supply, which
reduces the demand for output
Intersection of AS and AD curves determines the equilibrium level of output and price level
6
Aggregate Demand (Y) includes:
Aggregate demand is the total demand for goods and services by everyone in
the economy. Aggregate Demand = C + I + G + (X – M). It shows the relationship
between Real GNP and the Price Level
Consumption (C) Investment (I) Government Net exports
spending (G) (XIM)
Demand by Demand by Demand by foreigners Demand by the
people for business firms for our goods and government for
consumer goods for equipment services goods and
and buildings, services, as well
and demand by as government
people for investment
housing spending
7
Consumption Investment Government Net Exports
spending
Largest component of Investments in physical Government spending Net exports =
aggregate demand capital are about 1/6 of accounts for about 1/6 exports – imports
(about 2/3 of total) aggregate demand of aggregate demand The level of net
Durable goods: autos, Physical capital is the Includes payments to exports depends on
furniture, and major equipment and structures government workers, Current domestic
appliances firms use in production government purchases income (-)
Nondurable goods: do and houses that people of goods and services, Current foreign
not last as long as live in gross government income (+)
durables The total amount of investment in physical
Services: consumed physical capital in an capital
immediately economy is its capital We assume government
Housing is not stock spending is chosen
considered a durable Financial investment is exogenously, and not
good, but rather an NOT included; only explained by the AD-AS
investment good, which investment in physical model.
will be discussed later. capital 8
The Two-Way Relationship Between
Output and the Price Level
Aggregate Demand Curve
Price Real
Level GDP
Aggregate Supply Curve
9
Aggregate Demand
Aggregate Demand refers to
the quantity demanded of
goods and services, or the
quantity demanded of the Real
GDP, at various price levels.
Aggregate demand tells us the
total amount of goods and
services being purchased
10
Aggregate Demand (AD) Curve
The aggregate demand curve plots the
total demand for GDP as a function of the
price level.
The aggregate-demand curve shows
combinations of the price level and output
that are consistent with equilibrium in the
goods market and money market
The price level refers to the average of all
prices in the economy, as measured by a
price index.
AD Curve
The price level is a key
endogenous variable.
An inverse relationship exists
between aggregate demand
and the price level.
Any point along the AD curve
is one for which both the
goods and money markets are
in equilibrium.
12
AD Curve Shifters
An increase in Causes this curve In this direction
to shift
Future income AD Right
Wealth AD Right
Future consumption AD Right
Profits AD Right
Business optimism AD Right
Foreign income AD Right
Government spending AD Right
Money supply AD Right
13
Factors That Shift the
Aggregate Demand
Curve
14
AD Curve Shifters..
An increase in Causes this curve In this direction
to shift
Taxes AD Left
Real interest rate AD Left
ATM costs or other Variables AD Left
that increase money demand
15
Effect of Money supply on AD curve
Decrease in Money Supply causes Increase in Money Supply causes
AD curve to shift to Left AD curve to shift to Left
Price level
Price level
AD' AD
Output (Y) Output (Y)

16
16
Aggregate Supply
Aggregate supply is the economy’s total production
of goods and services
Economists distinguish between short- and long-run
aggregate supply
LRAS is fixed at full employment
In the short-run, output increases with the price
level, as producers are incentivized to offer more for
sale
17
Aggregate Supply
Price AS
Level
AS is the production
of all the firms in
the economy
Real domestic output (GDPR) 18

Aggregate Supply (AS) curve
In the short run, the
relationship between
output and the price level is
positive.
In the long run, the
economy is at full
employment, so increases
in the price level have no
effect on output
19
What factors cause change in
Aggregate Supply?
Changes that Cause an Increase Changes that Cause a Decrease
in AS in AS
1. Discovery of new raw 1. Depletion of raw materials
materials 2. Decreased Competition
2. Increased Competition 3. Increase in Trade Barriers
3. Reduce Trade Barriers 4. Increase in business
4. Reduce business regulation regulation
5. Decrease Business Taxes 5. Taxes increase
6. Reduction to input prices 6. Input prices increase
20
AS Curve Shifters
An increase in Causes this In this
curve to shift direction
Productivity LRAS Right
SRAS Right
Labor force LRAS Right
SRAS Right
21
AS Curve Shifters ..
An increase in Causes this In this
curve to shift direction
Capital stock LRAS Left
SRAS Left
Expected price level SRAS Left
Costs of producing Output SRAS Left
22
23
Long-Run Aggregate Supply Short-Run Aggregate Supply (SRAS)
(LRAS)
Price level and the amount produced Price level and the amount produced in the short
in the long run: run:
1. Full employment: when capital 1. The amount of capital in the economy is fixed in
and labor are fully utilized; the the short run, so SRAS cannot be adjusted
unemployment rate = the natural 2. Producers are reluctant to increase prices when
rate of unemployment (reflecting demand increases, so higher demand leads to
normal job turnover) increased output
2. Full-employment output: the 3. If prices throughout the economy rise (because
output produced when the of inflation), a firm might think increased
economy is at full employment demand for its product means demand for its
3. Full-employment output is not product has increased, instead of realizing that it
affected by the price level, so the should raise its prices
long-run aggregate supply curve is 4. The firm is fooled into producing too much
vertical
24
Long-Run Aggregate Supply (LRAS)
Long Run
The classical aggregate supply curve is the
AS
supply curve for the long run—when the
economy is at full employment.
The level of full- employment output does not
depend on the level of prices, but on supply
factors—capital, labor and technology. This is
why the classical AS curve is vertical.
Because input prices are completely flexible in
the long-run, changes in price-level do not
change firms’ real profits and therefore do not
change firms’ level of output. This means that
the LRAS is vertical at the economy’s level of full
employment
25
Why LRAS is Vertical?
YN determined by the P LRAS
economy’s stocks of labor,
capital, and natural
resources, and on the level
P2
of technology.
P1
An increase in P does not
affect any of these, so it
does not affect YN. Y
YN
26
Long Run
Combined with the aggregate AS
demand curve, the intersection of
the classical AS curve and the AD
curve determines the price level
and the full-employment level of
output.
The position of the AD curve
depends on the level of taxes,
government spending, and the
supply of money.
An increase in aggregate demand
does not change the level of output in
the economy but only the level of
prices.
The main result from the classical

model is that, in the long run, output
is determined solely by the supply of
capital and labor—not by changes in
demand.
28
Short-Run Aggregate Supply (SRAS)
1. The quantity supplied of all
goods and services at different
price levels.
2. The Short Run Aggregate Supply
Curve is upward sloping.
3. It indicates a positive
relationship between the price
level and the real GDP (output).
29
The Keynesian AS curve is relatively
flat because, in the short run, firms
adjust output more than they adjust
prices.
Since an increase in demand is met

mostly by an increase in output, we
say that aggregate demand primarily
determines the level of output in the
short run.
30
The level of output where the
Keynesian AS curve intersects the
aggregate demand curve need not be
the full-employment level of output.
Output may exceed the level of full

employment when demand is very
high, and fall short of full employment
when demand is very low.
31
Short-Run Aggregate
Supply (SRAS)
The SRAS curve is upward sloping
The quantity supplied of all goods
and services at different price levels.
The Short Run Aggregate Supply
Curve is upward sloping.
It indicates a positive relationship
between the price level and the real
GDP (output).
32
Three Theories of SRAS
1. The Sticky-Wage 2. The Sticky-Price Theory 3. The Misperceptions Theory
Theory
Imperfection: Imperfection: Imperfection:
Nominal wages are sticky Many prices are sticky in the  Firms may confuse changes in P with
in the short run, they short run. changes
adjust sluggishly. 1. Due to menu costs, the costs in the relative price of the products they
 Due to labor contracts, of adjusting prices. sell.
social norms 2. Examples: cost of printing  If P rises above PE, a firm sees its price
Firms and workers set the new menus, the time rise before realizing all prices are rising.
nominal wage in advance required to change price  The firm may believe its relative price is
based on PE, the price tags rising, and may increase output and
level they expect to Firms set sticky prices in employment.
prevail. advance based So, an increase in P can cause an increase in
on PE. Y, making the SRAS curve upward-sloping.
33
Shifts in LRAS and SRAS
Any change in the
endowments of the
factors of production
will cause both to shift.
Ex. technology
34
AS and AD in the Long Run
In the LR, AS curve moves to the right at a slow, but
steady pace
Movements in AD over long periods can be large or
small, depending largely on movements in money
supply
Figure shows a set of AS/AD curves for the period 1970-
2000
Movements in AS slightly higher after 1990
Big shifts in AD between 1970 and 1980
Prices increase when AD moves out more than AS
Output determined by AS, while prices determined by
the relative shifts in AS and AD
35
Factors that Affect Aggregate Supply
1. Supply Shocks 2. Resource Price 3. Changes in 4. Capacity Increase
Changes Expectations for Inflation
Adverse supply shocks shift AS to Changes in the short If suppliers expect goods to A rightward or an increase
the left, i.e., a decrease in the AS run resource prices can sell at much higher prices in in AS implies an increase in
curve. Usually, a huge rise in oil alter the Short Run the future, they will be less productive capacity of the
prices can cause a supply shock. Aggregate Supply willing to sell in the current economy. You can think of
Natural catastrophes or hikes in curve. Unless the price period. As a result, the Short this as an outward shift in
taxes can also shift AS to the left. changes reflect Run Aggregate Supply will the production possibility
It is either a leftward shift in the differences in long- shift to the left. curve. An increase in the
short run AS curve (the one on term supply, the Long quality and quantity of the
the left) or by the leftward shift in Run Aggregate Supply factors of production or
the vertical long-run AS curve. is not affected. technological advancements
However, the long run AS curve is or any increase in
best suited for natural disasters or productivity can cause the
setbacks in the economy, such as outward shift.
corrupt governments.
36
Macroeconomic Equilibrium
Equilibrium is where aggregate demand is equal to
aggregate supply
AS and AD intersect at point E in Figure.
Equilibrium: AS = AD
Significant changes in either aggregate demand or
aggregate supply will have important effects on price,
unemployment, and inflation.
If equilibrium exceeds the economy's potential, it
called an 'inflationary gap'.
On the other hand, if it dips below the economy's
potential, it's called a 'recessionary gap'.
37
Changes in Equilibrium
38
Short-Run Equilibrium
Short-run macroeconomic
equilibrium occurs when
the quantity of real GDP
demanded equals the
quantity of real GDP
supplied at the point of
intersection of the AD
curve and the SAS curve.
39
The Long-Run Equilibrium
Long-run
macroeconomic
equilibrium
occurs when
real GDP equals
potential GDP—
when the
economy is on
its LAS curve.
40
From the Short Run to the Long Run
Economy in the Short Run Adjusting to the Long Run
41
From Short-run to Long-run Equilibrium
As firms compete for labor and raw
materials, wages and prices will tend
to rise over time.
This will cause the Keynesian
aggregate supply curve to shift
upward.
This situation will continue as long as
output exceeds potential.
42
From Short-run to Long-run Equilibrium
The Keynesian aggregate supply will
keep rising upward until it intersects
the aggregate demand curve at full
employment.
Adjustments in wages and prices

eventually take the economy from
short-run Keynesian equilibrium to
long-run classical equilibrium.
43
Adjustment to Long-Run Equilibrium in Aggregate
Supply and Demand Analysis
44
Positive
Demand Shock
45
Negative
Demand Shocks
46
Increase in AD due to an Increase in
Money Supply(MS)
Shifts in either the AS or AD schedule result in a
change in the equilibrium level of prices and
output
Increase in AD → increase in P and Y
Decrease in AD → decrease in P and Y
Increase in AS → decrease in P and increase in Y
Decrease in AS → increase in P and decrease in Y
47
Increase in AS due to an Increase in
Money Supply(MS)
The amount of the increase/decrease
in P and Y after a shift in either
aggregate supply or aggregate
demand depends on:
The slope of the AS curve
The slope of the AD curve
The extent of the shift of AS/AD
48
The Classical Model of Macroeconomics
1. The first attempt to explain inflation, output, income, employment, consumption, saving and
investment.
2. The classical economists include: Smith, Ricardo, Malthus, and Say
3. The Classical model of macroeconomics is the polar opposite of the extreme Keynesian
model.
4. It analyses the economy when wages and prices are fully flexible.
5. In this model, the economy is always at its potential level.
6. Excess demand or supply are rapidly eliminated by wage or price changes so that potential
output is quickly restored.
7. Monetary and fiscal policy affect prices but have no impact on output.
8. In the short-run before wages and prices have adjusted, the Keynesian position is relevant
whilst the classical model is relevant to the long-run.
49
Assumptions of Classical Model
1. Pure Competition Exists
2. Wages and Prices are Flexible
3. Self Interest
4. People don’t have money illusion- they understand nominal vs. real value.
5. Problems in the economy are temporary and will correct themselves.
50
Classical Model: Real GDP
Real GDP is Supply Determined.
The equilibrium Price fluctuates when the ad curve shifts
J.B. Say’s Law

Supply creates its own demand.
Producing goods generates the demand to purchase other goods.
Desired expenditures equal actual expenditures.
Say’s law states that whatever aggregate output is produced will be demanded.
Because the interest rate adjust so that desired aggregate expenditures equal
actual output.
51
Assumptions of Say’s Law of Markets
Perfectly competitive market
Flexible Prices
Money- a veil
No Hoarding
State is neutral
Unlimited Opportunities for labour and capital
The large extent of market
Long period
Production according to consumer’s preference
52
Explanation of Say’s Law of Markets
Barter Economy: Monetary Economy:
In barter economy when a producer In such economies money acts as a
brings product to market for sale medium of exchange: Classicals.
this is done to get other goods in So seller sells his product in market,
exchange from market. So supply gets money in return and buys other
always represents demand for other goods and services with it. The value
goods of demand so created will be equal
So every seller is a buyer also. Supply to value of supply.
creates its own demand in barter.
53
Explanation of Say’s Law of Markets
Monetary Economy with savings: In real life people do not spend their
entire income on goods and services. They do saving also. As a result
aggregate demand in the economy falls to the extent of savings
effected.
However, classicals held the view that this law still applies despite of
savings in the economy. Because people convert their savings into
investment. As a result AD= C plus I.
If due to certain reasons, savings is more than investment, then rate of
interest will change in such a manner that saving will become equal to
investment. Concluding, Say’s law applies to monetary economy also.
54
Implications of Say’s Law
1. General overproduction is impossible
2. General unemployment is impossible
3. Partial over production and partial unemployment are possible.
4. Use of unemployed resources pay for itself
5. Automatic adjustment
6. Equality between saving and investment
7. Possibility of unlimited output and growth of capital
8. Money is but a veil
9. Policy implications
10. Say’s own observations
11. Quantity theory of money and Say’s law 55
Criticism of Say’s Law
1. General over production is possible
2. General unemployment is possible
3. Lack of automatic adjustment
4. Say’s law is not logical
5. Equality between saving and investment
6. Money is not merely medium of exchange
7. Need for state interference
8. Trade Cycles
9. Long term equilibrium
10. Under employment equilibrium is possible 56
Keynesian Short Run Aggregate Supply
John Maynard Keynes argued that wages were
not as flexible as the classical model
suggested, due to labor unions and contracts.
In addition since the 1930’s the minimum
wage sets a floor below which wages can’t
drop.
Therefore, changes in AD do not necessarily
change price as the classical economist argued.
According to Keynes, any change in aggregate
demand will change Real GDP, thus output is
demand determined.
Price level doesn’t change
57
Keynesian Short Run Aggregate Supply
The horizontal portion of the supply curve is where there is high
unemployment and unused capacity.
A leftward shift reduces real GDP creating unemployment.
Keynes argues that capitalism may not be self regulating, as the
classical economists suggest.
Once an economy is in recession, it needs increases in AD to move
toward full employment.
58
Modern Keynesian Analysis:
Short Run Aggregate Supply (SRAS)
Modern Keynesians agree that
prices are not completely “sticky”
there is some price adjustment.
The result is an SRAS curve that
slopes upward
Price and RGDP can increase
together.
SRAS can exceed full employment
(LRAS)
59
Equilibrium in the AD-AS Model Intersection of the AD and LRAS curves.
Intersection of the AD and SRAS curves.
Determination of output and price level in the Determination of output and price level in the
short run; output may differ from full- long run; output must equal full-employment
employment output output
60
Monetary Policy & the AD-AS Model
The economy is in recession when AD
intersects SRAS at less than full
employment.
An increase in the money supply starts
the process back toward long-run
equilibrium.
If the economy is in a recession, the
Central Bank can shift the AD curve to
the right by increasing the money
supply, restoring full-employment
equilibrium with a higher price level
61
Monetary Policy & the AD-AS Model
If the Fed uses expansionary
policy when the economy is at
full employment, the result is
temporarily higher output and
much higher prices
62
Fiscal Policy & the AD-AS Model
Fiscal policy refers to the government’s decisions regarding levels of
taxation and government spending
The government can increase aggregate demand by reducing taxes

or increasing government spending, and vice-versa
If in recession, the government might cut taxes or increase

government spending to attempt to restore full employment
63
Fiscal Policy & the AD-AS Model
When the economy is in
recession, government
might try to shift back
toward long-run
equilibrium though the
manipulation of
aggregate demand
64
AS and the Price Adjustment Mechanism
AS curve describes the
price adjustment
mechanism within the
economy
The AS curve is defined
by the equation:
Pt 1  Pt [1   (Y  Y * )]
where
Pt+1 is the price level
next period
Pt is the price level
today
Y* is potential output
5-65
Pt 1  Pt [1   (Y  Y * )]
If output is above potential (Y>Y*),
prices increase, higher next period
If output is below potential (Y<Y*),
prices fall, lower next period
Prices continue to rise/fall over time
until Y=Y*
◦ Today’s price equals tomorrow’s if
output equals potential (ignoring price
expectations)
The difference between GDP and potential
GDP, Y-Y*, is called the output gap
5-66
Pt 1  Pt [1   (Y  Y * )]
Upward shifting horizontal lines in
Figure (a) and (b) correspond to
successive snapshots of equation.
Beginning with the horizontal black

line at time t=0, at Y>Y*, price
higher (AS shifting up) by t=1
Process continues until Y=Y*
5-67
Pt 1  Pt [1   (Y  Y * )]
Upward shifting horizontal lines in
Figures (a) and (b)correspond to
successive snapshots of the above
equation.
Beginning with the horizontal black
line at time t=0, at Y>Y*, price
higher (AS shifting up) by t=1
Process continues until Y=Y*
5-68
AD Curve and Shifts in AD
• AD shows the combination of the price
level and level of output at which the
goods and money markets are
simultaneously in equilibrium
Shifts in AD due to:

1. Policy measures (changes in G, T, and MS)
2. Consumer and investor confidence
• Figure shows an outward shift in AD

resulting from an increase in the
money supply
5-69
AD Relationship Between Output and Prices
Key to the AD relationship between output and prices is the dependency of
AD on real money supply
◦ Real money supply = value of money provided by the central bank and the banking
system
◦ Real money supply is written as M , where M is the nominal money supply, and P is
P
the price level
◦ M AND M
  r  I  AD   r  I  AD
P P
For a given level of M , high prices result in low MP OR high prices mean that
the value of the number of available dollars is low and thus a high P = low
level of AD
5-70
AD and the Money Market
For the moment, ignore the goods market and focus on the money market
and the determination of AD
The quantity theory of money offers a simple explanation of the link
between the money market and AD
◦ The total number of dollars spent in a year, NGDP, is P*Y
◦ The total number of times the average dollar changes hands in a year is the velocity of
money, V
◦ The central bank provides M dollars
 The fundamental equation underlying the quantity theory of money is

the quantity equation: M  V  P  Y
5-71
AD and the Money Market
M V  P  Y
If the velocity of money is assumed constant, equation (2)
becomes M  V  P  Y, and is an equation for the AD curve
For a given level of M, an increase in Y must be offset by a
decrease in P, and vice versa
◦ Inverse relationship between Y and P as illustrated by downward sloping
AD curve
An increase in M shifts the AD curve upward for any value of Y
5-72
Changes in the Money Stock and AD
• An increase in the nominal money stock
shifts the AD schedule up in proportion to
the increase in nominal money
– SupposeM 0 corresponds to AD and the
economy is operating at P0 and Y0
– If money stock increases by 10% to M   1.1M

, 0
AD shifts to AD’  the value of P corresponding
to Y0 must be P’ = 1.1P0
M  1.1M 0 M 0
 
– Therefore P 1.1P0  real money balances
P0
and Y are unchanged
5-73
AD Policy & the Keynesian Supply Curve
• Figure shows the AD schedule
and the Keynesian supply
schedule
– Initial equilibrium is at point E (AS
= AD)
– Suppose an aggregate demand
policy increases AD to AD’

 G,  T ,  M S 
The new equilibrium point, E’, corresponds
to the same price level, and a higher level of
output (employment is also likely to
increase)
5-74
AD Policy & the Classical Supply Curve
• In the classical case, AS schedule is
vertical at FE level of output
– Unlike the Keynesian case, the price
level is not given, but depends upon the
interaction between AS and AD
• Suppose AD increases to AD’
– Spending increases to E’ BUT firms can
not obtain the N required to meet the
increased demand
– Firms hire more workers & wages and
costs of production rise  firms must
charge higher price
– Move up AS and AD curves to E’’
where AS = AD’
5-75
AD Policy & the Classical Supply Curve
• The increase in price from the
increase in AD reduces the real
money stock,   MP  , and
leads to a reduction in spending
• The economy only moves up AD
until prices have risen enough,
and M/P has fallen enough, to
reduce total spending to a level
consistent with full employment
 this is true at E’’, where AD = AS
5-76
Supply Side Economics
Supply side economics focuses on AS as the driver in the economy
Supply side policies are those that encourage growth in potential
output  shift AS to right
◦ Such policy measures include:
◦ Removing unnecessary regulation
◦ Maintaining efficient legal system
◦ Encouraging technological progress
Politicians use the term supply side economics in reference to the
idea that cutting taxes will increase AS enough that tax collections
will actually increase, rather than fall
5-77
• Cutting tax rates has an impact on both
AS and AD
– AD shifts to AD’ due to increase in
disposable income
• Shift is relatively large compared to
that of the AS
– AS shifts to AS’ as the incentive to work
increases
• In short run, move to E’: GDP increases,
tax revenues fall proportionately less than
tax cut (AD effect)
• In the LR, moves to E’’: GDP is higher,
but by a small amount, tax collections fall
as the deficit rises, and prices rise (AS
effect)
5-78
Supply side policies are useful, despite previous example
◦ Only supply side policies can permanently increase output
◦ Demand side policies are useful for short run results
Many economists support cutting taxes for the incentive
effect, but with a simultaneous reduction in government
spending
◦ Tax collections fall, but the reduction in government spending
minimizes the impact on the deficit
5-79
Keywords
Aggregate supply Classical Aggregate Keynesian Short Run
Supply Curve Aggregate Supply
Aggregate demand Keynesian aggregate Supply Side Economics
supply curve
Macroeconomic Price Adjustment Say’s Law of Markets
equilibrium Mechanism
Classical Supply Curve
80
Determination of
Equilibrium Income
- Keynesian Approach
1
Keynesian Income Determination Models
Private sector Public sector International
1. Consumption 1. Government 1. Imports,
demand expenditure exports, net
2. Investment 2. Government taxes exports
Demand 3. Monetary policy
3. Supply & demand manipulation of
for money money supply
2
Psychological Law of Consumption
1. J.M. Keynes, in his book ‘General Theory’ analyzed the consumption behavior of the
community on the basis of human psychology. He propounded a law which is known as
Psychological Law of Consumption.
2. "The household sector spends a major part of its income on the purchase of consumer
goods and services such as food, clothing, medicines, shelter etc., for personal
satisfaction. The expenditure on consumption (C) is the largest component of aggregate
expenditure. Whatever is not consumed out of disposable income is by definition called
saving (S)".
3. Formula: Disposable Income = Consumption + Saving i.e. I=C+S
4. According to Keynes, the level of consumption in a community depends upon the level of
disposable income. As income increases, consumption also increases but it increases not
as fast as income i.e., it increases at a diminishing rate. This relationship between
consumption and disposable income is called consumption function. 3
Properties of Consumption Behavior
(i) The level of consumption is directly functionally related to the
level of disposable income. C = f(y)
(ii) With the rise in the level of income, the consumption level
also rises, but at a decreasing rate. ΔC < Δy
(iii) As the level of income increases, the households devote a

part of the increase saving. ΔY = ΔC + ΔS
4
Consumption Function
Consumption (C)is a major component of Aggregate Demand (AD) and accounts for about
70% of AD
Fluctuations in C are proportionately smaller than the fluctuations in GDP
Consumption is relatively stable.
Consumption determines output and income, on the other hand, output and income also
determine consumption.
If C is consumption and Y is income, the consumption function is,
 C  C  cY where C  0 and 0  c 1
The intercept of equation is the level of consumption when income is zero → this is greater than zero since there is a
subsistence level of consumption
The slope of equation (4) is known as the marginal propensity to consume (MPC) → the increase in consumption per
unit increase in income 5
Consumption (C)is a major component of Aggregate
Demand (AD) and accounts for about 70% of AD
Fluctuations in C are proportionately smaller than the
fluctuations in GDP
Consumption is relatively stable.
Consumption determines output and income, on the other
hand, output and income also determine consumption.
6
The Consumption Function
The intercept of equation
is the level of consumption
when income is zero →
C = a + bY
this is greater than zero
since there is a
subsistence level of
consumption Income
Autonomous MPC
The slope of equation is
known as the marginal Consumption
propensity to consume Induced
(MPC) → the increase in
consumption per unit Consumption
increase in income.
7
Calculate C for each level of National Income (Y)
Y Ca MPC C
100 50 0.50 100
200 60 0.60 180
300 70 0.70 280
400 80 0.80 400
500 90 0.90 540
C
C ===aaa+++bYbY= 80
bY 60
70
==+100
..60
.80
50
90 70++(400)
(200)
(300) =(500)
=400
180
.5 (100)
.90 280= 100
= 540
8
45˚ line: at any point
on the 45˚line
consumption exactly
equals income and the
households have zero
saving.
MPC is the slope of
the consumption
function, which
measures the change
in consumption per
unit change in income.
9
The Consumption Function
DC
Real Consumption
MPC 
DY 3200 C
2400 DC
  .80
3000 800
DY
1000 4000
Real Disposable Income
10
Consumption
Function
C = a + b(Yd)
Consumption = autonomous consumption +
the MPC * (disposable income)
Example:
C = 100 + .75 (Yd)
If Aut. Cons. = 100, and Yd=1000
Then,
C = 100 + .75 (1000) = 100 + 750 = 850
Autonomous Consumption (Ā) is the
portion of consumption that is not related
to income (it is the amount of Cons. when
income is 0).
11
Nonlinear Consumption Function
There is some consumption expenditure
even when income is zero.
When consumption fails to increase at a
stable rate in response to rise in income,
the consumption curve becomes non-
linear.
In real life, the marginal propensity to
consume does not remain constant at all
levels of income.
It is possible that the MPC of an economy
may decline as the level of its income
increases. This happens because when
basic needs are satisfied, an increase in
income will reduce MPC and increase
MPS. In such a case, the consumption
function curve becomes non-linear.
12
Autonomous and Induced Consumption
Autonomous consumption Induced consumption
1. Autonomous consumption 1. Induced consumption ‘c’
expenditure 𝐶 occurs when describes consumption
income levels are zero. Such expenditure by households on
consumption does not vary with goods and services which varies
changes in income. with income.
2. If income levels are actually zero, 2. Consumption is considered

this consumption is financed by induced by income.
borrowing or using up savings.
13
Consumption, AD, and
Autonomous Spending
14
Marginal Propensity to Consume (MPC)
The marginal propensity to consume (MPC) is the extra amount that people consume
when they receive an extra unit of income.
 𝑴𝑷𝑪 = ∆𝑪 ∆𝒀
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑪𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 ∆𝑪
Also, 𝑴𝑷𝑪 = =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑫𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝑰𝒏𝒐𝒎𝒆 ∆𝑫𝑰
MPC is the first derivation of consumption function.
Induced consumption can be described by formula: 𝑪𝑰 = 𝑴𝑷𝑪 × 𝒀
15
Marginal Propensity to Consume
Total Change in Consumption Change in MPC
Income Income (C) Consumption
(Y)
0 500
1000 1000 1400 900 0.90
2000 1000 2200 800 0.80
3000 1000 2900 700 0.70
4000 1000 3500 600 0.60
5000 1000 4000 500 0.50
16
The Nation’s Marginal Propensity to Consume
According to
Simon Kuznets,
MPC tends to
remain fairly
constant
regardless of
the absolute
level of national
income.
17
Determinants of Consumption
Determinants of Consumption are:
1. Current disposable income: it is the central 4. Interest rate
factor determining a nation's consumption. 5. Inflation
2. Permanent income: it is the level of income 6. Expectations
that households would receive when 7. The Level of Economic
temporary influences are removed. Activity
3. Wealth: it is the net value of tangible and 8. The Stock of Capital
financial items owned by a nation or person at 9. Capacity Utilization
a point of time. 10.The Cost of Capital Goods
11.Technological Change
12.Public Policy
18
Saving
Saving is that part of national income not spent on consumption.
Saving equals income minus consumption.
If, Y = C + S
then, S = Y – C
C S DC DS
 1  1
Y Y DY DY
19
The Marginal Propensity to Save
The marginal propensity to save is defined as the fraction of an extra
unit of income that goes to extra saving.
DS
MPS 
DY
MPC + MPS = 1 because the part of each unit of income that is not consumed
is necessarily saved.
MPC = 1– MPS MPS = 1 – MPC

20
Saving Function
Like consumption, saving is also the function of income:
S = f(Y)
If autonomous consumption exists then autonomous saving

exists as well and saving function is: S = -CA + MPS x Y
Saving is a source for investment.

21
Savings Function - derivation
Savings function = flip side of consumption function, what
you don't spend you save
C = a +bY
Y=C+S
Y = a + bY + S
Y - a - bY = S
-a + (1 - b)Y = S
S = -a + (1-b)Y
22
Savings Function
- derivation C = a + bY
graphical Consumption
Savings
S = -a + (1-b)Y
-a
23
The Consumption and Saving Function
C, S The saving
function is the
mirror image of
C = f(Y) the
consumption
function.
CA S = f(Y) It shows the

relationship
45˚ between the
0 level of saving
YE Y
-CA and income.
24
An Illustration
Lets assume that your income increases by $100. We
observe that you increase your consumption by $80. What
is your MPC?
DC 80
MPC    .80
DY 100
DS 20
MPS    .20
DY 100
25
Consumption and Saving
Break-Even Income is the entire income that the households
plan to spend.
Average Propensity to Consume (APC) is the proportion of
total income consumed.
Average Propensity to Save (APS) is the proportion of total
income saved
Consumption Saving
APC = Income APS = Income
26
Consumption and Saving..
Marginal Propensity to Consume (MPC) is the proportion of change
in income spent
Marginal Propensity to Save (MPS) is the proportion of change in
income saved
MPC + MPS = 1
Change in Saving
MPS = Change in Income
Change in Consumption
MPC =
Change in Income
27
Consumption and Saving Schedules
(1) (4) (5) (6) (7)
Level of Average Average Marginal Marginal
Output (2) Propensity Propensity Propensity Propensity
And Consump- (3) to Consume to Save to Consume to Save
Income tion Saving (S) (APC) (APS) (MPC) (MPS)
(GDP=DI) (C) (1-2) (2)/(1) (3)/(1) Δ(2)/Δ(1) Δ(3)/Δ(1)
(1) $370 $375 $-5 1.01 -.01

.75 .25
(2) 390 390 0 1.00 .00
.75 .25
(3) 410 405 5 .99 .01
.75 .25
(4) 430 420 10 .98 .02
.75 .25
(5) 450 435 15 .97 .03
.75 .25
(6) 470 450 20 .96 .04
.75 .25
(7) 490 465 25 .95 .05
.75 .25
(8) 510 480 30 .94 .06
.75 .25
(9) 530 495 35 .93 .07
.75 .25
(10) 550 510 40 .93 .07
28
Consumption and Consumption and Saving Schedules
Saving Schedules 500
Consumption (billions of dollars)

C
475
450
425
Saving $5 Billion Consumption
Schedule
400
375
Dissaving $5 Billion
45°
370 390 410 430 450 470 490 510 530 550
(billions of dollars)
Disposable Income (billions of dollars)
50
Dissaving Saving Schedule
Saving
25 $5 Billion
S
Saving $5 Billion
0
370 390 410 430 450 470 490 510 530 550
29
Investment
Investment plays two roles in macroeconomics:
1. It can have a major impact on AD (real output and
employment)
2. It leads to capital accumulation (it increases the
nation's potential output and promotes economic
growth in the long run)
30
Investment Function
I
In the short-run it is
I2
reasonable to assume
I2 that investment is
I1
I1 independent of
national income.
0 Y
Investment Function
To assume I is fixed, or given, at all levels of Y means we
have an investment function like this:
I=I
Y
32
Consumption and Investment
Functions
C, I
C + I = CA + MPC . Y + I
C = CA + MPC . Y
I
I
0 Y 33
Equilibrium National Income
If the level of output is Y1
at this level of output the C, I
C+I spending line is above
45˚line, so planned C + I = CA + MPC . Y + I
spending is greater than
E Consumption and
planned output.
investment determine
This means that consumers
would be buying more output
goods than the businesses
were producing. Thus
45˚
spending disequilibrium
leads to a change in 0 Y1 YE Y2 Y
output.
34
Equilibrium Income
and Output
1. Equilibrium occurs where
Y=AD, which is illustrated
by the 45° line point E
2. The arrows show how the
economy reaches
equilibrium
◦ At any level of output
below Y0, firms’
inventories decline, and
they increase production
◦ At any level of output
above Y0, firms’
inventories increase, and
they decrease production
35
The Formula for Equilibrium Output
Can solve for the equilibrium level of output, Y0, algebraically:
◦ The equilibrium condition is Y = AD
◦ Substituting 𝑨𝑫 = Ā + 𝒄𝒀 yields Y  A  cY
◦ Solve for Y to find the equilibrium level of output:
Y  cY  A
Y (1  c)  A
1
Y0  A
(1  c)
36
The Formula for Equilibrium Output
Equation shows the level of output as a Y  cY  A
function of the MPC and A Y (1  c)  A
◦ Frequently we are interested in knowing how a change in some
1
component of autonomous spending would change output Y0  A
◦ Relate changes in output to changes in autonomous spending (1  c)
through DY 
1
DA
(1  c )
◦ Ex. If the MPC = 0.9, then 1/(1-c) = 10  an increase in government

spending by $1 billion results in an increase in output by $10 billion
◦ Recipients of increased government spending increase their own
spending, the recipients of that spending increase their spending and so
on
37
Saving and Investment Determine Output
Equilibrium occurs when desired saving S, I
of households equals the desired
investment of businesses.
When desired saving and desired
investment are not equal, output will
tent to adjust up or down.
S = f (Y)
At output level Y2 families are saving
more than businesses are willing to go
on investing. Firms will have too few E
I
customers and large inventories of
unsold goods than they want. Then, 0
businesses will cut back production and
lay off workers. This move output Y1 YE Y2 Y
gradually downward and economy
returns to equilibrium YE. -
38
Investment
Classification of Investment:
1. Induced Investment
2. Autonomous investment
3. Private Investment
4. Public Investment
5. Gross Investment
6. Net Investment
7. Intended/Ex-ante/Planned/voluntary Investment
8. Unintended/Ex-post/Unplanned/Involuntary Investment
39
Investment Demand
Instability of investment
1. Durability
2. Irregularity of innovation
3. Variability of profits
4. Variability of expectations
Consumption and Saving tend to be more stable than
investment
27-40
40
Investment Demand Curve
The investment
demand curve is
a curve that
shows the
quantity of
investment
demanded at
each interest
rate with all
other
determinant of
investment
unchanged.
41
Shift in the Investment Demand Curve
1. Acquisition, maintenance, and operating costs
2. Business taxes
3. Technological change
4. Stock of capital goods on hand
5. Planned inventory changes
6. Expectations
42
Induced Investment
The Induced Investment is a capital
investment that is influenced by the shifts in Y
the economy. These investments are made
Investment
with the intention to generate profit out of
such investments. When the investment I
increases due to an increase in profit and
production, it is known as induced
investment.So it is income or profit elastic.
Prof Kieser says, “ When an increase in
investment is due to increase in current level
of income and production, it is known as Income X
I
induced investment.
Prof Kurihara says that at very low levels of
income this investment may be negative.
Autonomous investment
It is independent of level of
income or output. It is made with Y
the aim of introducing new
techniques, new inventions etc.
Investment
Such investment is made for
I
economic development or
defence sector of the country. I
o Income X
Private and Public Investment
Private Investment Public Investment
1. Made by private individuals 1. It is made by the government
with the aim of profits. of the country.
2. Depends on MEC and rate of 2. Objective: Welfare of people,
interest defence of country and
3. If MEC is greater than R more economic development.
investment will be made. 3. Not profit induced
Otherwise no investment.
Also known as induced
investment
45
Components of Investment
46
Gross and Net Investment
Gross Investment Net Investment
1. The total expenditure 1. It is that investment as a
incurred on capital goods at result of which there is
any given time in a economy increase in capital stock.
2. GI= Net I+ Replacement I 2. Net investment is investment
3. Peterson says, “ Replacement that enlarges economy’s stock
investment is that of real capital assets thereby
investment which maintains adding to productive capacity.
intact a given stock of capital.
47
Gross and Net Investment
48
Ex-ante and Ex-post Investment
Ex-ante Investment Ex-post Investment
1. It is made voluntarily, 1. It is done involuntarily by
according to definite plan, to investors. Many a times due
achieve a given objective. sudden fall in demand the
2. Such investment is generally stocks may plummet. So
done by government to investment in such stocks is
achieve the target of against will of investor.
employment generation of
economic growth.
49
Propensity to Invest ( I/Y)
Average Propensity to Marginal Propensity to
Invest Invest
It is the ratio of total investment to It is the ratio of change in
total income. investment to change in income
API=I/Y If income increases by INR10 crore

and as a result investment increases
by 5 crore, then MPI=5/10=.5
50
The Marginal Efficiency of Capital (MEC)
1. The Marginal Efficiency of Capital (MEC) is
that rate of discount which would equate
the price of a fixed capital asset with its
present discounted value of expected
income.
2. Marginal efficiency capital (MEC) is a
Keynesian concept
3. MEC refers to the expected profitability
of a capital asset.
4. MEC may be defined as the highest rate
of return over cost expected from the
marginal or additional unit of a capital
asset. 51
Determinants of induced investment
In private sector, inducement to invest is influenced by two determinants-
MEC and rate of interest
1. MEC: It stands for expected rate of profitability when one more unit of
capital is employed. MEC depends upon two factors- Prospective yield and
supply price
2. Prospective yield: PY is calculated by aggregating net income of every year
of a machine through out its life time. To estimate net income, cost is
deducted from annual output of machine.
3. Supply Price: It is the cost of the machine. But not the cost of existing
machine but that of a brand new machine.
Determinants of induced investment
1. MEC can be found by deducting supply price from PY. As
supply remains fixed, so MEC is more influenced by PY which
is uncertain.
2. Rate of Interest: “Interest is the reward for parting with
liquidity” Keynes. Higher the rate of interest, greater will be
the keenness on the part of people to part with liquidity. LP
also affects rate of interest.
3. Greater the LP, higher will b the rate of interest.
Investment and MEC
1. Every entrepreneur compares Y
MEC with rate of interest while
making investment.
MEC & rate of interest

R MEC=R
R
2. He will make investment if E
MEC is greater than rate of
interest.
MEC
3. If they are equal, it will be
breakeven point. O Investment x
Other Determinants of Investment Demand
1. Expectations
2. The level of economic activity
3. The stock of capital
4. Capacity utilization
5. The cost of capital goods
6. Other factor costs
7. Technological change
8. Public policy
55
Factors affecting investment
Technological Advancement and innovation
Discovery of natural resources
Government policies
Foreign trade
Political Environment
Expectations
Rate of population growth
Territorial Expansion
The price level
The market structure
Availability of finance
Conditions in the labour market
Aggregate Demand
Measures to stimulate Investment
PRIVATE INVESTMENT PUBLIC INVESTMENT
1. Reduction in rate of interest 1. Taxation
2. Reduction in taxes 2. Loans
3. Increase in govt. expenditure 3. Deficit financing
4. Price support policy
5. Promotion of research
6. Pump pricing
Investment Volatility
58
Investment and Aggregate Demand
A
8
Price level
Interest rate (%)
6 C D
1.0
ΔI=$50
ΔAD=$100
ID
AD1 AD2
$950 $1,000 $8,000 $8,100
Investment per year (billions of base year $) Real GDP per year (billions of base year $)
59
Investment and Economic Growth
1. Investment adds to the capital stock
2. An increase in capital stock leads to an outward shift of
the PPC
3. This allows more consumption
4. The long run AS curve also shifts to the right
5. The increase in investment also affects aggregate
demand
60
Key Takeaways
1. The quantity of investment demanded in any period is negatively
related to the interest rate. This relationship is illustrated by the
investment demand curve.
2. A change in the interest rate causes a movement along the
investment demand curve. A change in any other determinant of
investment causes a shift of the curve.
3. The other determinants of investment include expectations, the
level of economic activity, the stock of capital, the capacity
utilization rate, the cost of capital goods, other factor costs,
technological change, and public policy.
61
Keywords
Economics
Economic analysis
Macroeconomics
Production
Economic output
Economic growth
Prices
Income
Employment
Gross Domestic Product
62
Product Market
1
Coverage
1. The concept of multiplier
2. Assumptions of multiplier
3. Importance of multiplier
4. Simple multiplier
5. Two sector and three sector model
6. Types of the multiplier
7. The Government Sector
8. Investment multiplier
9. Foreign trade multiplier
10. Balanced budget multiplier
11. The multiplier in the presence of tax 2
The Concept of Multiplier
1. The concept of multiplier was first of all developed by F.A. Kahn in the early 1930s. But
Keynes later further refined it.
2. Whereas Kahn’s multiplier is known as ’employment multiplier’, Keynes’s multiplier is
known as investment or income multiplier.
3. The essence of multiplier is that total increase in income, output or employment is
manifold the original increase in investment.
4. A $1 increase in autonomous spending, in general, increases GDP by much more than $1.
For example, if investment equal to Rs. 100 crores is made, then the income will not rise
by Rs. 100 crores only but a multiple of it.
5. We call the number 1/(1 – mpc) the multiplier, as it describes the amount by which that
initial $1 is multiplied as it changes hands, and is spent again and again
3
The Concept of Multiplier
1. The multiplier model gives numerical answers about the effect of changes in
aggregate expenditures on aggregate output.
2. A dollar injected into the economy (i.e. investment) has an impact beyond the
initial expenditures. The dollar continues to be spent multiplying its impact on
the economy.
3. The number of times it circulates through the economy is known as THE
MULTIPLIER.
𝟏 𝟏
𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 = =
𝟏 − 𝑴𝑷𝑪 𝑴𝑷𝑺
4
Assumptions of The Multiplier model
1. The multiplier model assumes that the price level remains constant - and then
explores specific questions about expenditures.
2. The marginal propensity to consume (MPC) remains constant throughout as the
income increases in various rounds of consumption expenditure.
3. There is no any time-lag between the increase in investment and the resultant
increment in income.
4. There exists an excess capacity in the consumer goods industries so that when the
demand for them increases, more amounts of consumer goods can be produced to
meet this demand. If there is no excess capacity in consumer goods industries, the
increase in demand as a result of some original increase in investment will bring
about rise in prices rather than increases in real income, output and employment.
5
The Multiplier
• Effect of an increase in
autonomous spending on the
equilibrium level of output:
– The initial equilibrium is at
point E, with income at Y0
– If autonomous spending
increases, the AD curve shifts
up by A , and income
increases to Y’
– The new equilibrium is at E’
with income at 
Y0  Y0  Y0
10-6
The Multiplier
By how much does a $1
increase in
autonomous spending
raise the equilibrium
level of income? 
The answer is not $1
◦ Out of an additional
dollar in income, $c is
consumed
◦ Output increases to
meet increased
expenditure; change in
output = (1+c)
◦ Expansion in output and
income results in further
increases 7
The Multiplier
If we write out the successive rounds of increased spending, starting
with the initial increase in autonomous demand, we have:
AD  A  cA  c 2 A  c 3A  ...
 A (1  c  c 2  c 3  ...)
◦ This is a geometric series, where c < 1, that simplifies to: AD  1
A  Y0
(1  c)
◦ Multiplier = amount by which equilibrium output changes when autonomous

aggregate demand increases by 1 unit
◦ The general definition of the multiplier is Y 1
 
A (1  c )
8
10-8
The Multiplier Equation
The multiplier equation tells us that income equals the multiplier
times autonomous expenditures.
Y = (multiplier) x (autonomous expenditures)
The multiplier equation is a useful way to determine the level of
income in the multiplier model.
The multiplier is a number that reveals how much income will
change in response to a change in autonomous expenditures.
Multiplier = 1/(1 – mpc)
9
The Multiplier Equation
As the mpc increases, the multiplier increases:
mpc Multiplier = mpc Multiplier =

1/(1-mpc) 1/(1-mpc)
0.5 2.0 0.8 5
0.6 2.5 0.9 10
0.75 4.0 0.95 20
10
Types of the Multiplier
1. Employment Multiplier: Kahn’s Employment Multiplier is a ratio of a change in total
employment to the changes in income.
2. Price Multiplier: refers to the ratio of the ultimate increase in the general price level
to the initial increase in prices (on account of the increased money supply).
3. Consumption Multiplier: the consumption multiplier tells us by how much the
consumption of wage goods in the economy will have to go down, if a given increase
in investment has to be self- financing, whereas the Keynesian multiplier tells us by
how much savings will have to go up if a given increase in investment has to be self-
financing
4. Investment Multiplier: refers to the concept that any increase in public or private
investment spending has a more than proportionate positive impact on aggregate
income and the general economy.
5. Income Multiplier: refers to the increase in final income arising from any new
injection of spending.
11
The Multipliers
Y = 1/(1-b) I
Y = 1/(1-b) G
}The Spending Multipliers
Y = -b/(1-b) T
} The Policy Multipliers
12
The Multiplier Process
1. The multiplier process amplifies changes in autonomous
expenditures.
2. What forces are operating to ensure that the income level we
determined is actually the equilibrium income level.
3. When expenditures do not equal current output, business people
change planned production:
1. Which changes income, which changes expenditures,
2. Which changes production, which changes income,
13
The Multiplier Effect
Change in Real GDP
Multiplier =
Initial Change in Spending
The Multiplier and the Marginal Propensities

1 1
Multiplier = -or- Multiplier =
1 - MPC MPS
One person’s spending becomes another’s income…..

14
The Multiplier Tabular and Graphical Views
Effect (1)
(2)
Change in
Change in Consumption
(3)
Change in
Saving
Income (MPC = .75) (MPC = .25)
Increase in Investment of $5 $ 5.00 $ 3.75 $ 1.25
Second Round 3.75 2.81 .94
Third Round 2.81 2.11 .70
Fourth Round 2.11 1.58 .53
Fifth Round 1.58 1.19 .39
All other rounds 4.75 3.56 1.19
Total $ 20.00 $ 15.00 $ 5.00
$20.00
$4.75
15.25
$1.58
13.67
$2.11
11.56
$2.81
8.75
ΔI=
$5 billion $3.75
5.00
$5.00
1 2 3 4 5 All
Rounds of Spending 15
The Multiplier Effect
The MPC and the Multiplier
MPC Multiplier
.9 10
.8 5
Multiplier = 1/(1 – mpc)
.75 4
.67 3
.5 2
16
Simple Spending Multiplier
A Simple Spending Multiplier is the factor by which real GDP
demanded changes for a given initial change in spending.
𝟏
Simple Spending Multiplier =
𝟏−𝑴𝑷𝑪
The Simple Spending Multiplier provides a shortcut to the total

change in real GDP demanded.
17
Employment Multiplier
The original idea of Employment Multiplier was given by R. F. Kahn
Employment Multiplier studies the effect of changes in employment
on changes in income as per which the changes in income happens
to be greater than the initial change in employment
Algebraically, ∆𝒀 = 𝑲𝒆 ∗ ∆𝑬
ΔY stands for change in income
Ke stands for Employment Multiplier
ΔE stands for initial change in Employment
18
Investment Multiplier
The concept of ‘Investment Multiplier’ is an important contribution of Prof. J.M. Keynes.
An initial increment in investment increases the final income by many times. The Investment
Multiplier expresses the relationship between an initial increment in investment and the
resulting increase in aggregate income.
The larger an investment's multiplier, the more efficient it is at creating and distributing
wealth throughout an economy.
Multiplier (k) is the ratio of increase in national income (∆Y) due to an increase in investment
(∆I). K= ∆Y/∆I
Suppose an additional investment (∆I) of RS 1,000 crores in an economy generates an
additional income (∆Y) of Rs 4,000 crores. The value of multiplier (k), in this case will be: k
=4,000/1,000 = 4. It means, income increased 4 times with a single increase in investment.
19
The Keynesian investment multiplier model shows that an increase in
investment will increase output by a multiplied amount – by an
amount greater than itself.
The multiplier is the number by which the change in investment
must be multiplied in order to determine the resulting change in
total output.
The size of the multiplier k depends upon how large the MPC is.
Y Y 1 1 1
k    
I Y  C 1  C 1  MPC MPS
Y
C, I C + I2
E2 I2 = I1 + ΔI
C +I1
E1 ΔY = k . ΔI
ΔI Y
k 
I
45˚
0 Y1 ΔY Y2 Y
Income Multiplier
Income Multiplier is the ratio of the change in equilibrium GDP to
the change in initial spending or autonomous spending.
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝒒𝒖𝒊𝒍𝒊𝒃𝒓𝒊𝒖𝒎 𝑮𝑫𝑷
𝑰𝒏𝒄𝒐𝒎𝒆 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑨𝒖𝒕𝒐𝒏𝒐𝒎𝒐𝒖𝒔 𝑺𝒑𝒆𝒏𝒅𝒊𝒏𝒈
∆𝒀
𝑰𝒏𝒄𝒐𝒎𝒆 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 =
∆𝑨𝑪
Income multiplier refers to the change in income of GDP of the
economy owing to any injection or spending made.
22
Money Multiplier
The Money Multiplier measures how much the money supply
increases in response to a change in the monetary base.
∆𝑴𝒐𝒏𝒆𝒚 𝑺𝒖𝒑𝒑𝒍𝒚
𝑴𝒐𝒏𝒆𝒚 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 =
∆𝑴𝒐𝒏𝒆𝒕𝒂𝒓𝒚 𝑩𝒂𝒔𝒆
The multiplier may vary across countries, and will also vary depending
on what measures of money are considered.
For example, consider M3 (Broad Money) as a measure of Money
supply, and M0 as a measure of the monetary base.
If a $1 increase in M0 by the federal reserve causes M2 to increase by
$10, then the money multiplier is 10/1=10.
23
The Multiplier for Government Expenditure
The government affects the level of equilibrium output in two ways:
 Government expenditures (component of AD)
 Taxes and transfers
In the standard theory, an increase in government expenditure has the multiplier
effect
Since the change in consumption is Δc = Δy−Δg, therefore
24
Y = C + I + G, where C = a + b(Y – T)
1.: Y = a + b(Y – T) + I + G
1.: Y = a + bY – bT + I + G
Suppose T changes by T, causing Y to change by Y.
The new equilibrium is:
2.: Y + Y = a + b(Y + Y) - b(T + T) + I + G

2.: Y + Y = a + bY + bY - bT -bT + I + G
25
The Government Sector –
Expenditure multiplier effect
Government purchases are said to have a multiplier effect on aggregate
demand.
Each dollar spent by the government can raise the aggregate demand for goods
and services by more than a dollar.
If the MPC = 3/4, then the multiplier will be:
 Multiplier = 1/(1 – 3/4) = 4
In this case, a $20 billion increase in government spending generates $80 billion
of increased demand for goods and services.
Y = 1/(1-b) G
26
The MPC and the Tax Multiplier
As with the spending multiplier, the multiple that relates Y
to T is dependent on the MPC= “b” in the equation
C = a + b(Y – T)
We can actually calculate an expression in the form of
Y = (some multiplier)T.
27
The Government Sector – Taxes
multiplier effect
1. When the government cuts personal income taxes, it increases households’
take-home pay.
2. Households save some of this additional income.
3. Households also spend some of it on consumer goods.
4. Increased household spending shifts the aggregate-demand curve to the
right.
5. The size of the shift in aggregate demand resulting from a tax change is
affected by the multiplier and crowding-out effects.
6. It is also determined by the households’ perceptions about the permanency
of the tax change.
Y = -mpc/(1-mpc) T
28
Suppose we increase G by 100 and increase T by 100.
If b = 0.80, what will the net change in Y?
YG = 1/(1-mpc) G YT = -mpc/(1-mpc) T

1/(1-mpc) = 1/(1-0.80) = 5 -mpc/(1-mpc) = -0.80/(1-0.80) = -4
G = 100 T = 100
YG = 5 (100) = 500 YT = -4 (100) = -400
Y = YG + YT = 500 -400 = 100

29
The Government Sector Multiplier Effect
Price
Level
2. . . . but the multiplier

effect can amplify the
shift in aggregate
demand.
$20 billion
AD3
AD2
Aggregate demand, AD1
0 Quantity of
1. An increase in government purchases Output
of $20 billion initially increases aggregate
30
demand by $20 billion . . .
Foreign Trade Multiplier
The foreign trade multiplier (also called the export multiplier) operates like the
investment multiplier of Keynes.
The Concept of foreign trade multiplier was given by Mr. Leighton.
Foreign trade multiplier is defined as the amount by which the national
income of a country will be raised by a unit increase in domestic investment
on exports.
As exports increase, there is an increase in the income of all persons
associated with export industries. These in turn create demand for goods. But
this is dependant upon their marginal propensity to save (MPS) and the
marginal propensity to import (MPM). The smaller these two marginal
propensities are, the larger will be the value of multiplier and vice versa.
31
The foreign trade multiplier is based on the following:
1. There is full employment in the domestic economy
2. There is a direct link between domestic and foreign country in exporting and
importing goods and the country is small with no foreign country
3. It is on a fixed exchange rate system The multiplier is based on instantaneous
process without time lag and the domestic Investment (Id) remains invariable
4. There is no accelerator and the analysis is applicable to only two countries
5. There are no tariff barriers and exchange controls
6. The government expenditure is constant
32
The formula to calculate the foreign trade multiplier (Kf) is
𝟏
𝑲𝒇 =
(𝑴𝑷𝑺+𝑴𝑷𝑴)
∆𝑺
Where MPS is Marginal Propensity to Save (𝑴𝑷𝑺 = )
∆𝒀
∆𝑴
MPM is Marginal Propensity to Import (𝑴𝑷𝑴 = )
∆𝒀
33
The value of MPS = 0.25, and the value of MPM = 0.15
𝟏 𝟏 𝟏
𝑲𝒇 = = = = 𝟐. 𝟓
(𝑴𝑷𝑺 + 𝑴𝑷𝑴) (𝟎. 𝟐𝟓 + 𝟎. 𝟏𝟓) 𝟎. 𝟒𝟎
∆𝒀 = 𝑲𝒇 ∗ ∆𝑿
If exports increase by 200 i.e. from 300 to 500; ∆𝑿 = 𝟎 ∆𝑰 = 𝟎
∆𝒀 = 𝟐. 𝟓 ∗ 𝟐𝟎𝟎 = 𝟓𝟎𝟎 If Y0=1000
𝒀𝟏 = 𝒀𝟎 + ∆𝒀 = 𝟏𝟎𝟎𝟎 + 𝟓𝟎𝟎 = 𝟏𝟓𝟎𝟎
∆𝑺 = 𝑺∆𝒀 = 𝟎. 𝟐𝟓 ∗ 𝟓𝟎𝟎 = 𝟏𝟐𝟓
∆𝑴 = 𝒎∆𝒀 + 𝟎. 𝟏𝟓 ∗ 𝟓𝟎𝟎 = 𝟕𝟓
34
At the point of changed equilibrium level of national
income:
∆𝑰 + ∆𝑿 = ∆𝑺 + ∆𝑴 Therefore 𝟎 + 𝟐𝟎𝟎 = 𝟏𝟐𝟓 + 𝟕𝟓 = 𝟐𝟎𝟎
Generally, K=4 in the closed economy and Kf=2.5 in the open
economy
𝑲𝒇 < 𝑲
Because of two leakages i.e. savings and imports
35
Balanced Budget Multiplier
Balanced Budget Multiplier is the ratio of the change in aggregate output (GDP)
to a change in government spending, which is matched by an equal change in
taxes.
This is termed a balanced-budget multiplier because the change in spending is
matched by the change in taxes and thus the government's budget deficit or
surplus is neither increased nor decreased.
If the government had a balanced budget before the changes, then it has one
after the changes.
The balanced budget multiplier is important in understanding the way
governments manage the economy.
36
Balanced Budget Multiplier
∆Y = ∆T = ∆G Then, ∆Y/ ∆G = ∆Y/ ∆T = 1
The value of BBM (symbolised by KB) is unity. It can also be expressed in
the following way:
𝐾𝐵 = 𝐾𝐺 + 𝐾𝑇
𝟏 𝑴𝑷𝑪 𝟏−𝑴𝑷𝑪 𝟏−𝑴𝑷𝑪
𝑲𝑩 = − = = =𝟏
𝑴𝑷𝑺 𝑴𝑷𝑺 𝑴𝑷𝑺 𝟏−𝑴𝑷𝑪
MPS=1-MPC
Since KG is positive and KT is negative, the net effect of balanced budget is not neutral.
Income changes by an amount equal to a change in government expenditure and tax
receipt. So the value of BBM must be 1. Since KT is one less than KG, a balanced
budget must have a value of one.
37
The Fiscal Multiplier
The fiscal multiplier is consistent with the standard Keynesian multiplier theory. In
the standard theory, an increase in government expenditure has the multiplier effect
The change in consumption is proportional to the change in the government deficit.
38
The Tax Multiplier
The Tax multiplier is the change in income 1. TM is negative when a tax
resulting from a unit increase in Tax. increase reduces C, which reduces
Y  MPC income
 1. TM is greater than 1 when a
T 1  MPC change in taxes has a multiplier
effect on income.
If MPC = 0.8, then the tax multiplier 1. TM is smaller than the
equals government spending multiplier
Y  0.8  0.8 when consumers save the fraction
   4 (1-MPC) of a tax cut, so the initial
T 1  0.8 0.2 boost in spending from a tax cut is
smaller than from an equal
increase in G
39
The Circular Flow Model and the Multiplier
Process
1. The circular flow model provides the intuition behind the multiplier process.
2. Expenditures are injections into the circular flow.
3. The mpc measures the percentage of expenditures that get injected back into the
economy each round of the circular flow. But there are withdrawals.
4. Economists use the term the marginal propensity of save (mps) to represent the
percentage of income flow that is withdrawn from the economy for each round of the
circular flow.
5. By definition: mpc + mps = 1
6. Alternatively expressed: mps = 1 - mpc
multiplier = 1/mps
40
The Circular Flow Model and the Multiplier Process
41
Limitations of Multiplier Model
1. The Multiplier Model Is Not a Complete Model of the Economy
2. On the surface, the multiplier model makes a lot of intuitive sense.
3. Surface sense can often be misleading.
4. The multiplier model does not determine income from scratch.
5. At best, it can estimate the directions and rough sizes of autonomous
demand or supply shifts.
6. The multiplier model leads people to overemphasize the aggregate
expenditure shifts that would occur in response to a shift in autonomous
expenditures.
42
Keywords
The concept of Multiplier
Assumptions of Multiplier
Simple multiplier
Two sector and three sector model
Investment multiplier
Foreign trade multiplier
Balanced Budget multiplier
43
Money Market
1
Coverage
1. What is money?
2. The evolution of money and forms- Barter, Commodity money, Paper money, Bank
deposits.
3. The functions of money (a) Money as a medium of exchange (b) Money as a measure of
value (c) Money as a store of value (d) The standard of Deferred payments.
4. The determinants of demand for money
5. The supply of money
6. The sources of money supply
7. Central bank and high powered money
8. Measurement of high powered money
9. Purpose of measuring money supply
DR. VIGHNESWARA SWAMY 2
Coverage..
10. The Keynesian demand for money function (a)The transaction demand for
money(b) the Precautionary demand for money (c) The speculative demand for
money
11. The Keynesian theory of interest rate,
12. Components of the money supply- M1, M2, M3 and M4
13. Measurement of the money supply
14. Implications of the money supply
15. Money Multiplier Approach
16. Role of Banking systems and creation of money

Coverage…
17. Determinants of the money supply
18. How the interest rate is determined?
19. Real Vs. Nominal interest rates
20. Liquidity
21. How do changes in money supply affect the economy?
22. Negative Interest rates and its implications on an economy.

What is money?
1. Money is primarily a medium of exchange or means of exchange
2. Money is the stock of assets that can be readily used to make
transactions.
3. Money is whatever is accepted in exchange
4. There is no commonly acceptable definition of money
Two procedures of Definition:
◦ 1. Nominalist - Attaches labels to real world objects.
◦ 2. Empiricist - Attaches labels to concepts and then search for the corresponding
real world entity.

Money Functions
Medium of exchange Unit of account Standard of Store of value
Deferred
Payment
1. A medium of exchange. Money 1. Money is the basic unit for 1. Acts as a standard 1. Money can be
is used to pay for goods and measuring economic value of deferred used to hold
services, and enables us to 2. This simplifies payment. wealth
avoid the “double coincidence comparisons of prices, 2. Money is used in 2. Most people use
of wants” required in a barter wages, and incomes long-term money only as a
economy. 3. The unit-of-account transactions; you store of value for
function is closely linked might borrow $100 a short period and
with the medium-of- from a friend, for for small
exchange function example, and amounts, because
4. But countries with very promise to pay him it earns less
high inflation may use a back $105 at a later interest than
different unit of account, date. money in the
so they don't have to bank
constantly change prices

The Evolution of Money
Crypto-
Paper currency
Coins
Gold, Silver and
Metals Copper coins
Commodity
Money
Cattle, Salt, Cowry,
Barter yarn balls, skeins
and fabrics
the exchange
of merchandise
for
merchandise
The Four Different Types of Money
Commodity Fiat Money Fiduciary Money Commercial Bank
Money Money
Its value is defined Fiat money gets its value Fiduciary money depends for commercial bank
by the intrinsic from a government order its value on the confidence money is created
value of the (i.e. fiat). The word fiat that it will be generally through what we call
commodity itself. means the “command of the accepted as a medium of fractional reserve
In other words, sovereign”. That means, the exchange. Unlike fiat money, it banking.
the commodity government declares fiat is not declared legal tender by Fractional reserve
itself becomes the money to be legal tender, the government, which means banking describes a
money. It has which requires all people people are not required by law process where
intrinsic value. and firms within the country to accept it as a means of commercial banks give
to accept it as a means of payment. Instead, the issuer out loans worth more
payment. It has no intrinsic of fiduciary money promises than the value of the
value. Example: the paper to exchange it back for a actual currency they
currency we use commodity or fiat money hold.
Other Types of Money
Fractional Representative Coins Paper Money
Money Money
It is a hybrid type It represents a claim Metals of particular Paper money doesn’t have any
of money which is on commodity and it weight are stamped intrinsic value, as a fiat money,
partly backed by a can be redeemed for into coins. There are it is approved by government
commodity and that commodity at a various precious order to be treated as legal
has a fiat money bank. It is a token or metals like gold, tender through which value
transaction paper money that silver, bronze, exchange can happen.
purpose. If the can be exchanged for copper whose coins Governments print the paper
commodity loses a fixed quantity of a are already used in money according to the
its value then commodity. Its value human history. The requirements which are tightly
Fractional money depends on the minting of coins is controlled as it can affect the
converts into Fiat commodity it backs. controlled by the economy of the country.
money. state.
Commodity Money

Commodity Money

Commodity Money
Cow Salt Cowry

Ancient Coins

Gold, Silver, and Copper

Paper Money

Indian
Currency

Approaches of Money
Conventional Chicago Approach Gurley and Shaw Central Banking or
Approach Approach Redcliffe Approach
In this approach money is Influenced by Nobel Laureate This approach says money This approach also
defined on the basis of Friedman. should include all includes credit in the
its functions. “ Money is “Money is temporary abode of instruments which are close definition of money. So
what money does.” purchasing power.” substitute of each other. credit extended by NBFI
Geoffrey Crowther says, In monetary economy, every So Money= Currency+ DD including unorganized
“ Money can be defined transaction has two aspects: +TD +Saving Bank Deposit institutions is also
as anything that is sale and purchase. It is +Shares +Bonds +…….. included in definition of
generally acceptable as a essential to hold purchasing Credit instruments issued by money.
means of exchange and power in terms of money till financial intermediaries – Money= Currency+
at the same time acts as such time the transaction is banking and no-banking and DD+ TD+ Saving
a measure and store of performed. thrift societies like LIC, Saving Deposit+ Shares+
value.” Money= Currency+ Demand Bank etc. have high quality of Bonds+ Securities+
Money= Notes +coins Deposit+ Time Deposit liquidity. Hence, these should Credit from
+ Demand Deposits This definition has widened the be also included in money.
unorganized sector
scope of the concept of money
Characteristics of Money
1. General acceptability
2. Voluntary Acceptability
3. Medium of Exchange
4. Money is a mean not an end
5. Government control
6. Liquidity: Separation of money from other assets is its
superiority in liquidity
7. Money is not a veil
Functions of Money
Primary Secondary Static and
Contingent Functions
Functions Functions Dynamic
function
1. Medium of 1. Standard of 1. Basis of Credit Creation 1. Static Functions
Exchange Deferred 2. Maximum Satisfaction 2. Dynamic
2. Measure of Payments 3. Distribution of National functions
Value 2. Store of Value Income
3. Transfer of 4. Bearer of option
value 5. Guarantee of Solvency
6. Increase in the liquidity
of capital

Demand for Money
Demand for money refers to the stock of assets held as cash, checking
accounts, and closely related assets, specifically not generic wealth or
income
Keynes suggested three different motives:
1. The transactions motive. We wish to avoid having to cash in another asset every
time we make a purchase. (Imagine what a nuisance that would be!)
2. The precautionary motive. “Just in case.” We never know our spending plans
exactly; it pays to keep a little extra money around in case the urge for a hot fudge
sundae hits at a time when your stockbroker is playing golf and cannot liquidate any
of your assets.
3. The speculative motive. While money doesn’t have a very high return, it is less
risky than other assets. Speculative demand for money is actually demand for a safe
asset. DR. VIGHNESWARA SWAMY 21
The Demand for Money
The demand for money is the quantity of monetary assets people
want to hold in their portfolios
Money demand depends on expected return, risk, and liquidity
Money is the most liquid asset
Money pays a low return
People's money-holding decisions depend on how much they value
liquidity against the low return on money

Md = $YL(i)
(-)
d Demand for money
M
$Y Nominal income
L(i ) The liquidity demand for
Money is a function of i
(-) Md is inversely related to i
Empirical research has settled four key points about money demand:
1. When the real interest rate increases, the demand for real money balances falls.
2. When income increases, money demand also increases.
3. It takes time for money demand to fully adjust to changes in income and the interest
rate.
4. If the price level doubles, so will nominal money demand. Real money demand will be
unaffected; there is no money illusion.
High inflation can also induce people to hold less money. With sufficiently high rates of
inflation, people may not wish to hold financial assets at all, holding food, other goods
(especially gold) and foreign money instead. This phenomenon is known as flight out of
(domestic) money.

Theories of Money Demand
Classical Theory of Keynesian Theory of Portfolio Theories of Money Transactions Theories of
Money Demand Money Demand Demand Money Demand
According to the a more realistic money They emphasize the role of money as a They emphasize the role of
quantity theory of demand function, store of value; people hold money as a money as a medium of
money, where the demand for part of their portfolio of assets. Key exchange; they
(M/P)d = kY real money balances insight: money offers a different risk and acknowledge
where k is a constant depends on return than other assets. Money offers a that money is a dominated
measuring how i and Y: (M/P)d = L(i, Y). safe nominal return, while other asset and stress that people
much people want to investments may fall in both real and hold money, unlike other
hold for every dollar nominal terms. assets, to make purchases.
of income. (M/P)d= L (rs, rb, EP, W), where rs is the They explain why people
expected return in the stock market, rb hold narrow measures of
is the expected return on bonds, EP is money like currency or
the expected inflation rate, and W is checking accounts.
real wealth

Macroeconomic Determinants of Money Demand
Determinant’s increase Causes Money Demand to
Price level Rise proportionately
Real Income Rise less than proportionately
Real Interest Rate Fall
Expected Inflation Fall
Nominal Interest Rate Rise
Wealth Rise
Liquidity of alternate assets Fall
Efficiency of Payment Technologies Fall
The Money Demand Function
The money demand function
◦Md = PL(Y, i ) (Eq.1)
◦ Md is nominal money demand (aggregate)
◦ P is the price level
◦ L is the money demand function
◦ Y is real income or output
◦ i is the nominal interest rate on nonmonetary assets
◦ As discussed above, nominal money demand is proportional to the price
level
◦ A rise in Y increases money demand; a rise in i reduces money demand
The Money Demand Function..
We can write the nominal rate of interest as the following:
i = r + πe
I = nominal interest rate
r = expected real rate of interest
πe = expected inflation rate
Then we rewrite the Money demand function as:
Md = PL (Y, r + πe)


Equilibrium

The Relationship

Importance of Money
Direct Importance Indirect Importance
1. In consumption 1. Freedom from barter
2. In production 2. Solution of Central Economic problems
3. In exchange 3. Basis of Credit
4. In trade 4. Index of Economic Development
5. In distribution 5. Increase in mobility of capital
6. In public finance 6. Measure of social welfare
7. Capital formation 7. National and international unity

Disadvantages of Money
Economic Social
1.Instability of value 1. Encourages
2.Trade cycles materialism
3.Over- Capitalization 2. Tendency of
4.Economic wastage Exploitation
5.Unequal distribution of wealth 3. Increase in immoral
6.Problem of black money tendencies
The Income Velocity of Money
The income velocity of money is defined as the number of times the stock
of money is turned over, or reused each year to finance all of the purchases
that occur.
If people purchased INR 1,000,000 of goods and services in a particular
year, and the (nominal) money supply were INR 1,000,000,
 Then, the velocity of money would be equal to 1; meaning each INR would be used an
average of one time.
If people purchased INR 1,000,000 of goods and services in a particular
period, and the (nominal) money supply were INR 500,000,
 Then, the velocity of money would be equal to INR 1,000,000 / INR 500,000 =2;
meaning each dollar would be used an average of two times.
The Income Velocity of Money..
The income velocity of money is defined as: P´ Y Y
V = =
M M P
The quantity theory of money uses this definition to explain how and why the price
level and the money stock are connected:
M´V = P´Y
The classical incarnation of this theory assumes that both V and Y are fixed and,
based on those assumptions, argues that any change in the money supply will cause
a proportional change in the price level.

Equation of Exchange
The Equation of Exchange addresses the relationship between money and price level, and
between money and nominal GDP.
The equation simply states: MxV=PxY

Where M = the money supply, usually the M1
V = the velocity of money
P = the price level
Y = real output, or real GDP.
Velocity is the number of times the average dollar is spent to buy final goods and services in a
given year. Velocity can be calculated by using V = (P x Y ) / M
This equation demonstrates a direct relationship between price and money supply. If V and Y are
constant, a certain percentage change in money supply will cause a same amount of change in the
price level.
Money Supply
The money supply is the quantity of money available in the economy.
Definition: The total stock of money circulating in an economy is the
money supply. The circulating money involves the currency, printed
notes, money in the deposit accounts and in the form of other liquid
assets.
Valuation and analysis of the money supply help the economist and
policy makers to frame the policy or to alter the existing policy of
increasing or reducing the supply of money. The valuation is important
as it ultimately affects the business cycle and thereby affects the
economy.
Money Supply..
The money supply depends on the:
1. monetary base
2. currency-deposit ratio
3. reserve ratio
The Central Bank of a country can control the money supply

with:
1. Open market operations
2. The reserve requirement
3. The discount rate
4. Interest on reserves

A Model of the Money Supply
1. Monetary base, B = C + R
(controlled by the central bank; C=currency; R=Reserves)
2. Reserve-deposit ratio, rr = R/D
(depends on regulations & bank policies; rr=reserve ratio; D=Deposits )
3. Currency-deposit ratio, cr = C/D

(depends on households’ preferences)

Money Supply India

Statement on Money Supply - India
Year-on-year
(Amount in ₹ billion) 2018 2018 October 27, 2017 October 26, 2018
Mar 31 Oct 26 Amount % Amount %
M3 139625.9 144262.4 7504.1 6.1 13109.3 10.0
Components (i+ii+iii+iv)
i) Currency with the Public 17597.1 18751.3 -1536.5 -9.0 3265.7 21.1
ii) Demand Deposits with Banks 14837.1 13503.2 2133.3 20.5 964.5 7.7
iii) Time Deposits with Banks 106952.6 111762.1 6842.0 7.1 8858.1 8.6
iv) `Other ' Deposits with Reserve Bank 239.1 245.8 65.2 40.9 21.0 9.3
Sources (i+ii+iii+iv-v)
i) Net Bank Credit to Government Sector (a+b) 40014.0 42930.4 3029.6 8.1 2637.3 6.5
a) Reserve Bank 4759.6 6510.7 -1549.8 - 1587.9
b) Other Banks 35254.4 36419.8 4579.4 14.9 1049.4 3.0
ii) Bank Credit to Commercial Sector (a+b) 92137.2 96234.7 5099.2 6.4 11678.2 13.8
a) Reserve Bank 140.3 92.3 8.2 10.5
b) Other Banks 91996.9 96142.4 5091.0 6.4 11667.8 13.8
iii) Net Foreign Exchange Assets of Banking Sector 29223.0 29949.7 862.3 3.3 2723.0 10.0
iv) Government's Currency Liabilities to the Public 256.5 257.0 20.2 8.6 1.6 0.6
v) Banking Sector's Net Non-Monetary Liabilities 22004.8 25109.4 1507.3 7.7 3930.8 18.6
of which : Net Non-Monetary Liabilities of R.B.I. 9069.9 11492.6 -203.0 -2.2 2609.3 29.4

Money Supply Measures
Reserve Money (M0) Narrow Money M2 Broad Money (M3) M4
(narrowest money) (M1)
= Currency in circulation Currency with the M1 + Savings M1+ Time deposits M3 + All
+ Bankers’ deposits with public + deposits of with the deposits with
the RBI + ‘Other’ deposits Demand deposits post office banking system post
with the RBI with the savings banks = Net bank credit to the office savings
= Net RBI credit to the banking system + Government + Bank banks (excluding
Government + RBI credit ‘Other’ deposits credit to the National Savings
to the commercial sector + with the RBI. commercial sector + Certificates).
RBI’s claims on banks + Net foreign exchange
RBI’s net foreign assets + assets of the banking
Government’s sector + Government’s
currency liabilities to the currency liabilities to
public – RBI’s net non- the public – Net non-
monetary liabilities monetary liabilities
of the banking sector
New Monetary Aggregates
NM1 NM2 NM3
= Currency with the = NM1 = NM2
public + Short-term time + Long-term time
+ Demand deposits deposits deposits
with the banking of residents of residents
system (including and up + Call/Term
+ ‘Other’ deposits with to the contractual funding from
the RBI. maturity of financial
one year). institutions.
The Money Supply Process
(Model to explain the size and variability of money supply)

Why Is Money Supply Important?
1. Affects price levels
2. Affects interest rates
3. Affects growth rate
4. Affects exchange rates
5. M1=currency + deposits

What is the Monetary Base?
Essentially, it is the liabilities of the Central Bank (RBI in the case
of India)
Monetary Base= currency in circulation+ reserves (B=C+R)
Federal currency in circulation is a liability (to the non-bank
public)
Cash kept in banks is called vault cash and is counted as part of
reserves.
Bank reserves are assets held by banks that they can collect from
the fed but… DR. VIGHNESWARA SWAMY 47
Currency Deposit Ratio
The currency deposit ratio shows the amount of currency
that people hold as a proportion of aggregate deposits.
An increase in cash deposit ratio leads to a decrease in
money multiplier.
An increase in deposit rates will induce depositors to
deposit more, thereby leading to a decrease in Cash to
Aggregate Deposit ratio. This will in turn lead to a rise in
Money Multiplier.
Broad Money to Reserve Money
Definition: It is a measure of money multiplier. Money multiplier shows
the mechanism by which reserve money creates money supply in the
economy. It is dependent on two variables: (i) currency deposit ratio and
(ii) reserve deposit ratio.
M3 is a measure of broad money and includes currency with the public
and deposits. The Reserve Money factor shows the reserve money and
includes required reserve and the excess reserves of the banking system.
If the reserve requirement as stipulated by the RBI increases, the Reserve
Money value will increase and the multiplier will fall. Similarly, if banks
keep more money as excess reserves, it will have an adverse effect on the
money multiplier.
Two Types of Money
Ordinary Money
High Powered Money (H)
(M)
Ordinary money (M) is High powered money (H) is the
referred to as currency money produced by the RBI and
plus demand deposits: the government of India (small
M = C + dd. coins including one rupee notes)
held by the public and banks.
High Powered Money
High powered money or powerful money is the currency that has
been issued by the Government and Reserve Bank of India.
Some portion of this currency is kept along with the public while rest
is kept as funds in Reserve Bank.
H=C+R
Where H = High Powered Money
C = Currency with the public (Paper money + coins)
R = Government and bank deposits with RBI
Components of High Powered Money
The important components of high powered money:
1. Currency with the public
2. Other Deposits with RBI
3. Cash with Banks
4. Banker’s Deposits with RBI.
High powered Money (H) includes currency with Public (C), important
reserves of Commercial banks and other reserve (ER).
Thus, H = C + RR + ER
Supply of money (M) includes bank deposits (D) and currency with public (C).
Thus, M = C + D
Sources of High Powered Money
Claims of Reserve Net Foreign Exchange Assets of Government’s Currency Net Non-Monetary
Bank of India Reserve Bank Liabilities to the Public Liabilities of
Reserve Bank
Reserve Bank also It is the work of Reserve Bank to Finance Ministry of the Indian The non-monetary
provides loans to the make arrangement for foreign Government is responsible for liability of Reserve
government. This loan is exchange funds. When, Reserve printing one rupee note and Bank is in the form of
in the form of Bank purchases foreign securities by also for coinage. This function is capital introduced in
investment in paying the money of the country, done through the government national fund and
government securities then the quantity of foreign for completing money related statutory fund. Its
by the Reserve Bank. exchange increases which increases responsibilities towards the main items are-Paid-
After deducting the high powered money. On the public. Thus with the increase in up Capital, Reserve
deposits of government contrary, when Reserve Bank sells these liabilities, quantity of Fund, Provided Fund
from quantity of loan of foreign securities, then the quantity supply of money will increase and pension fund of
Reserve Bank quantity of of foreign exchange with the central and the quantity of High the employees of
net bank credit to bank of the country decreases. It Powered money will also Reserve Bank of
government is results decrease in high powered increase. India.
calculated. money.

High Powered Money and the Money Multiplier
The current practice is to explain the determinants of the money
supply in terms of the monetary base or high powered money.
High-powered money is the sum of commercial bank reserves and
currency (notes and coins) held by the public.
High powered money is the base for the expansion of bank deposits
and creation of the money supply.
The supply of money varies directly with changes in the monetary
base, and inversely with the currency and reserve ratios.

Money Multiplier
It is the relationship between monetary base and money supply in
economy. The amount of money that banks generate with each unit (Rs
in case of India) of money.
The money multiplier is the reciprocal of the reserve ratio. The money
multiplier is the ratio of deposits to reserves in the banking system.
The Money Multiplier, m is the increase in the money supply resulting

from a one-dollar increase in the monetary base.
Money Multiplier..
Solving for the money supply:
where
where m is the Money Multiplier

Illustration:
• Suppose households decide to hold more of their money as currency and less in the
form of demand deposits.
1. Determine impact on money supply.
2. Explain the intuition for your result
• Impact of an increase in the currency-deposit ratio Δcr > 0.
Then,
1. An increase in cr increases the denominator of m proportionally more than the
numerator. So m falls, causing M to fall.
2. If households deposit less of their money, then banks can’t make as many loans, so
the banking system won’t be able to create as much money.
Money Multiplier - Derivation
The money multiplier m is such that: M=Money Supply
Money Supply = m * Monetary Base m=Money Multiplier
BASE=Monetary Base
M = m * BASE C=Currency in circulation
D=Deposits
m = M/BASE R=Reserves
m = (C + D) / (C + R) RR=Reserve Ratio
ER=Excess Reserves
m = (C + D) / (C + RR + ER) RRR=Required Reserve Ratio
m = (C/D + 1) / (C/D + RR/D + ER/D)
m = (cu +1) / (cu + rrr + er)
M= [(cu +1) / (cu + rrr + er)] Base
The Money Multiplier; Money Supply and the Monetary Base

Determinants of Money Supply
Theory of Exogenous Theory of Endogenous Factors
Factors
According to this view, the According to this view, the money
money supply is determined supply is determined endogenously
exogenously by the central by changes in the economic activity
bank. which affect people's desire to hold
currency relative to deposits, the
rate of interest, etc.

Determinants of Money Supply..
The determinants of money supply are both
exogenous and endogenous which can be described
broadly as:
1. The minimum cash reserve ratio
2. The level of bank reserves
3. The desire of the people to hold currency relative to
deposits
The last two determinants together are called the monetary
base or the high powered money..
Determinants of Money Supply..
1. The 2. The Level of Bank 3. Public's 4. Other Factors
Required Reserves Desire to Hold
Reserve Ratio Currency and
(RRR) Deposits
An increase in the Commercial bank reserves consist If people are in The money supply is a function not
required reserve of reserves on deposits with the the habit of only of the high-powered money,
ratio reduces the central bank and currency in their keeping less in but of interest rates; income and
supply of money tills or vaults. cash and more other factors. These factors change
with commercial It is the central bank of the in deposits with the proportion of money balances
banks and a country that influences the the commercial that the public holds as cash.
decrease in reserves of commercial banks in banks, the money Changes in business activity can
required reserve order to determine the supply of supply will be change the behavior of banks and
ratio increases the money. large. the public and thus affect the
money supply. Excess reserves are the difference money supply. Hence the money
between total reserves (TR) and supply ,is not only an exogenous
required reserves (RR): ER=TR-RR. controllable item but also an
DR. VIGHNESWARA SWAMY endogenously determined item.62
How do changes in money supply affect
the economy?
Direct effect Indirect effect
Monetarist view: Money affects the economy via interest
Increase in money rates:
balances affects R affects Expenditure (C and I)
consumption Exchange Rates (and therefore X and M)
directly Property Prices
Bonds and Shares
Role of Banking Systems and Creation Of Money
1. Banks are both borrowers and lenders.
2. Banks take in deposits and use the money they borrow to make loans to
others.
3. Banks make a profit by charging a higher interest on the money they lend
out than they pay for the money they borrow.
4. Banks can be analyzed from the perspective of asset management and
liability management.
5. Asset management is how a bank handles its loans and other assets.
6. Liability management how a bank attracts deposits and how it pays for
them. DR. VIGHNESWARA SWAMY 64
How Banks Create Money?
First Step Second Step Third Step
1. The central bank 1. The bearer deposits 1. Banks lend a portion
creates money by the currency in a of their deposits
simply printing chequing account at keeping the balance as
currency and the bank. reserves.
exchanging it for 2. The bank holds your 2. Reserves are cash and
bonds. money and keeps deposits a bank keeps
2. Currency is a financial track of it until you on hand, or at the
asset to the bearer write a cheque. central bank, enough
and a liability to the to manage the normal
central bank. cash inflows and
outflows.
Banks’ Role in the Monetary System
No banks 100-percent- Fractional-reserve banking
reserve banking
Early periods of A system in which A system in which banks hold a fraction of
civilization when no banks hold all their deposits as reserves.
banks existed in deposits as reserves. Original deposit = $1000
+ First bank lending = $ 800
formal sense. Before a deposit: + Second bank lending = $ 640
With no banks, D=0; C=M + Third bank lending = $ 512
M=C+D After a deposit: + other lending…
Total money supply = (1/rr ) × $1,000. where rr = ratio of
D = 0 and M = C D=M; C=0 reserves to deposits In our example, rr = 0.2, so M = $5,000
D=Deposits 100%-reserve banking has
A fractional-reserve banking system creates
C=Currency no impact on size of
M=Money supply money supply. money, but it doesn’t create wealth:
Bank loans give borrowers some new money
and an equal amount of new debt.
The Instruments of Monetary Policy
Open Market Discount Rate or Reserve Interest on Reserves
Operations Repo Rate Requirements
The Central Bank’s The interest rate the Central bank’s The central bank pays
preferred method of central bank charges regulations that impose interest on bank
monetary control. on loans to banks a minimum reserve- reserves deposited
1. To increase the 1. To increase the deposit ratio. with it.
base, the central base, the central E.g. CRR and SLR in India 1. To reduce the
bank (RBI in India) bank could lower 1. To reduce the reserve-deposit
could buy the discount rate, reserve-deposit ratio, the Fed could
government encouraging ratio, the central pay a lower
bonds, paying with banks to borrow bank could reduce interest rate on
new Rupees. more reserves. reserve reserves.
requirements.
Interest Rates
1. Mean reverting (stationary)
2. Long term rates are less volatile than short term rates
3. Long term rates show more persistence than short term rates
4. High degree of persistence
5. Highly correlated with one another (long rates less correlated with
shorter rates)
6. Nominal Interest Rates tend to be Procyclical and lagging
7. Interest rates tend to be negatively correlated with changes in
money (in the short run)
8. Interest rates are highly correlated with Inflation rates (less so for
longer term rates)
Nominal vs. Real Interest Rate
Nominal Interest Rate Real Interest Rate
1. Nominal interest rate refers to the 1. The real interest rate is the rate of
interest rate before taking inflation into interest an investor, saver or lender
account receives (or expects to receive) after
2. Nominal Interest Rates tend to be allowing for inflation.
Procyclical and lagging 2. Real interest rate is adjusted for changes
3. Interest rates tend to be negatively in price level so it more accurately
correlated with changes in money (in the reflects the cost of borrowing
short run) 3. Ex ante real interest rate is adjusted for
4. Interest rates are highly correlated with expected changes in the price level
Inflation rates (less so for longer term 4. Ex post real interest rate is adjusted for
rates) actual changes in the price level

Neutral Vs. Effective Interest Rate
Neutral Rate of Interest Effective Interest Rate
• The natural rate of Interest  The effective interest rate is the
(NRI), sometimes called the interest rate that is actually earned
neutral rate of interest, is or paid on an investment, loan or
the interest rate that other financial product due to the
supports the economy at full result of compounding over a given
employment/maximum time period.
output while keeping  It is also called the effective annual
inflation constant. interest rate, the effective rate or
the annual equivalent rate.
How the Interest Rate is Determined?
1. Demand for Money 2. Supply of Money
Demand for money is determined by private Money supply is set by central bank
sector Causes of changes in money supply:
1. Transactions purposes 1. Banks can reduce their liquidity
- price level ratios
- income 2. Surplus in balance of payments
- interest rate (opportunity cost) 3. Govt. creates high-powered money
2. Precautionary purposes to finance a budget deficit
3. Speculative purposes 4. Govt. sells short-term Treasury bills
- expected change in price of bonds 5. Govt. buys long-term bonds and
- bond price inversely related to r sells short-term Treasury bills to
- hold money if bond prices are expected to fall increase liquidity
- hence: demand for money high when r is low
The Determination of the Interest Rates
i is determined by Money Demand (MD) & Money Supply
(MS)
1. Central bank changes i by changing MS
2. Central bank changes MS with open market operations
3. Buying bonds increases the MS and reduces i
4. Selling bonds decreases the MS and increases I
◦ Increases in Central Bank money (central bank buys bonds) decrease the
interest rate
◦ Decreases in Central Bank money (central bank sells bond) increase the
interest rate
Setting Interest Rates
What does the central bank take into account in setting interest
rates?
1. Forecasts of inflation
2. Spare productive capacity
3. Growth of retail sales
4. Trends in output growth relative to growth of
5. productive capacity
6. Growth of money supply
7. House price changes
8. Interest rate trends in USA, EU and japan
9. Exchange rate trends
Fisher Equation
i  ir   e
i = nominal interest rate
ir = real interest rate
 e = expected inflation rate
When the real interest rate is low,
there are greater incentives to borrow and fewer incentives to lend.
The real interest rate is a better indicator of the incentives to
borrow and lend.
Ex Ante. Vs. Ex Post Real Interest Rates
Ex Ante real interest rates are the rates investors expect based on anticipated
inflation rates
Ex Post real interest rates are the rates investors actually receive after the
fact.
The difference between the two depends on the accuracy of inflationary
expectations

Negative Interest Rates
Negative interest rates mean depositors pay money to save their money, a reversal of the
normal rules of economics.
Negative rates are the opposite—savers who do not want to spend their funds are willing to pay
borrowers to accept them.
In theory, nominal rates should never be negative because investors are better off holding
currency, which earns a zero nominal rate, instead.
In practice, holding large sums of currency incurs a convenience cost—it is bulky and can be lost
or stolen. Buying a safe or renting a security deposit box are examples of costs associated with
holding currency.
 Riskless negative rates can go at least low enough to equal the convenience cost of holding
currency.
 In countries with negative rates, banks instead pay to deposit reserves at their central bank
Some Potential Unintended Consequences of
Negative Rates?
1. Negative rates raise banks' operating costs. If those costs cannot be passed on to customers,
they would reduce bank profitability. So far, banks in countries with negative rates have not
charged their retail depositors negative rates.
2. If negative rates spread to safe, short-term securities, money market funds (MMFs) would be
unable to maintain a stable net asset value (i.e., would "break the buck"). Since MMFs are close
substitutes to bank deposits, it is unclear whether MMFs would still be attractive to investors in
that scenario.
3. Negative rates could raise unpredictable logistical issues. For example, existing financial
contracts or settlement systems might not envision a scenario where the lender would have to
pay the borrower.
4. Market participants would have the incentive to take actions just to avoid negative interest
rates, such as increasing cash holdings, prepaying bills, or delaying receipt of payments. Those
actions would use resources that represent a deadweight loss to the economy.

What sort of countries have negative rates?
1. Countries with ultra-low inflation or deflation, meaning
falling prices associated with weak economic growth
resort to negative interest rates.
2. The European Central Bank, which oversees monetary
policy for countries that use the euro, introduced
negative rates in 2014.
3. Japan’s central bank followed in January, announcing that
it would charge commercial banks a fee of 0.1 percent on
a portion of their reserves that they keep with it.
What is Liquidity?
1. Liquidity means how quickly you can get your hands on your cash. In simpler terms,
liquidity is to get your money whenever you need it.
2. The ability to trade immediately and at prices that are only affected by expected return
and risk considerations
1. Market liquidity: ability to transform financial assets into cash at current market prices
2. Balance sheet liquidity: cash holdings
3. Funding liquidity: ability to convert assets into cash
4. Macroeconomic liquidity: the availability of cash in the economy
Motives for Liquidity preference:

Liquidity preference of a particular individual depends upon several considerations. The desire for liquidity
arises because of three motives: (i) The transactions motive; (ii) The precautionary motive and; (iii) The
speculative motive.
Linking the Different Concepts of Liquidity

Keywords
1. Money
2. Commodity Money
3. Paper Money
4. Money Demand
5. Keynesian Money Demand Function
6. Money Supply – M1, M2, M3, M4
7. Central Bank
8. Ordinary Money
9. High Powered Money
10. Money Multiplier
11. Money Creation
12. Fractional Reserve Banking
13. Interest Rates
14. Real Vs. Nominal Interest Rates
15. Liquidity
16. Negative Interest Rates DR. VIGHNESWARA SWAMY 81
Price Stability
1
Coverage
1. Inflation Vs. deflation
2. Measures of inflation
3. Types of inflation
4. Low inflation
5. Galloping inflation
6. Hyperinflation
7. Threshold inflation
8. Demand-pull Vs. Cost-push inflation
9. Stagflation
10. Expected Vs. unexpected inflation
11. Core inflation Vs. Headline inflation,
2
Coverage..
11. The role of
government
and RBI to
control
inflation
12. Economic
impacts of
inflation
13. Is a little
inflation is
good for the
economy?
14. Price in the
AD-AS
framework
15. The Phillips
curve
16. Short run
Philips curve
and Long run
Philips curve.
3
Inflation
Inflation is a pervasive and general rise in the average price level.
Inflation is an increase in the average level of prices, and a price is the
rate at which money is exchanged for a good or service.
Inflation measures how much more expensive a set of goods and
services has become over a certain period, usually a year.
Deflation is a fall in the overall level of prices.
Rate of Inflation shows the rate of change of prices over time.
Rate of inflation is the percentage rate of change in a price index
Rate of inflation = (PI2 – PI1) / PI1
4
Deflation
Deflation is the opposite of inflation.
Deflation is the fall in prices. It occurs when the inflation rate falls below 0%. When this
happens, the nominal prices of goods are falling on average and the purchasing power of
money is increasing.
Deflationary Spiral is a situation where decreases in price lead to lower production, which
in turn leads to lower wages and demand, which leads to further decreases in price.
It is generally caused when an asset bubble bursts.
Deflation can turn a recession into a depression.
During the Great Depression of 1929, prices dropped 10 percent a year. Once deflation
starts, it is harder to stop than inflation.
5
Deflation ..
When deflation occurs, the general price level is falling and the purchasing
power of money is increasing.
Deflation is a more serious problem because it increases the real value of debt
and may worsen recessions.
Deflation discourages consumption because consumers know that if they wait
to make a purchase, the price will likely drop.
Deflation discourages borrowing and investment because the real value of the
money to be repaid will be higher than the real value of the money borrowed.
Deflation is caused by a fall in the general level of demand, and sometimes
due to a fall in the money supply.
6
Cause and Effect of Deflation
Causes Effects
Deflation is caused by a shift in Deflation is a more serious problem
the supply and demand curve for because it increases the real value of
goods and services. debt and may worsen recessions.
According to monetarist Deflation is good for lenders and
economists, therefore, deflation bad for borrowers: when loans are
is caused by a reduction in the paid back, the cash is worth more.
money supply, a reduction in the Thus, deflation discourages
velocity of money, or an increase borrowing, and by extension,
in the number of transactions consumption and investment today.
7
Theories explaining Inflation
The Classical Theory of Inflation The Quantity Theory of Money
1. The classical theory of money is 1. How the price level is determined
used to explain the long-run and why it might change over time
determinants of the price level is called the quantity theory of
and the inflation rate. money.
2. Inflation is an economy-wide 2. The quantity of money available in
phenomenon that concerns the the economy determines the value
value of the economy’s medium of of money.
exchange. 3. The primary cause of inflation is
3. When the overall price level rises, the growth in the quantity of
the value of money falls. money.
8
The Classical Dichotomy
Classical dichotomy is the the theoretical separation of nominal and real
variables
Hume and the classical economists suggested that monetary developments
affect nominal variables but not real variables.
If central bank doubles the money supply, Hume & classical thinkers contend
Nominal variables are variables measured in monetary units.
Real variables are variables measured in physical units.
All nominal variables – including prices – will double.
All real variables – including relative prices – will remain unchanged.
9
1. According to Hume and others, real economic variables do not
change with changes in the money supply.
◦ According to the classical dichotomy, different forces influence real and
nominal variables.
2. Changes in the money supply affect nominal variables but not real
variables.
10
The Neutrality of Money
Monetary neutrality: the proposition that changes in the money supply do not
affect real variables.
Doubling money supply causes all nominal prices to double; what happens to
relative prices?
Initially, relative price of cd in terms of pizza is
Most price of cd $15/cd
economists = = 1.5 pizzas per cd
believe the price of pizza $10/pizza
classical
dichotomy and The relative price
neutrality of  After nominal prices double, is unchanged.
money
describe the price of cd $30/cd
economy in = = 1.5 pizzas per cd
the long run price of pizza $20/pizza
11
The Neutrality of Money..
The irrelevance of monetary changes for real variables is called monetary
neutrality.
Neutrality of money is the idea that a change in the stock of money affects
only nominal variables in the economy such as prices, wages, and exchange
rates, with no effect on real variables, like employment, real GDP, and real
consumption.
Neutrality of money means that money is neutral in its effect on the fiscal
system. A variation in the money stock can have short-run forces on the
level of actual productivity, employment, rate of interest or the composition
of final productivity. The only lasting impact of a variation in the money
stock is to modify the normal price level.
12
Disinflation Around the World
13
Measures of inflation
Price index level
Expresses the level of prices of goods traded in economy at the same
time
Price index is calculated for particular market basket for examined
periods.
The change of price index level within time is the rate of inflation.
1. Consumer price index
2. Producer price indexes
3. Wholesale price indexes
4. Commodity price indexes
14
Prices
According to the classical model of the price level,
the real quantity of money is always at its long-run
equilibrium level.
Prices play three roles:

1. Convey Information
2. Give Incentives
3. Provide Working Capital
15
Real Variables: Nominal Variables:
Measured in physical units— Measured in money units, e.g.,
quantities and relative prices, for • nominal wage: Dollars per hour of
example: work.
• quantity of output produced • nominal interest rate: Dollars
• real wage: output earned per earned in future by lending one
hour of work dollar today.
• real interest rate: output • the price level: The amount of
earned in the future by lending dollars needed to buy a
one unit of output today representative basket of goods.
16
Real vs. Nominal Wage
The Real Wage is the wage rate divided by the price level.
Real Income is income divided by the price level.
An important relative price is the real wage:

W = nominal wage = price of labor, e.g., $15/hour
P = price level = price of gas, e.g., $5/unit of output
Real wage is the price of labor relative to the price

of output: W $15/hour
= = 3 units output per hour
P $5/unit of output
17
Illustration 1
If inflation is 12% and you get a 7% raise, what has
happened to your money income? real income?
Ans:
Your money income has increased by 7% but your
real income has decreased by 12-7= 5%
18
Illustration 2
If your income goes up from $30,000 to $35,000 and
inflation is 8%, are you better or worse off?
Ans:
Take the difference and divide by the original number
$5,000/$30,000 = 16.7%
You are better off because your real income has
increased by 16.7-8=8.7%
19
Price Mechanism
The adjustment of prices in response to changing market
conditions
Is any increase in prices inflationary? The answer is ‘NO’ –
Because some prices will always increase because of the
price mechanism.
20
Inflation and Indexation
•In counties where inflation rates are high and uncertain, long-term
borrowing using nominal debt becomes impossible: lenders are simply too
uncertain about the real value of the repayments they will receive
•Governments of such countries issue indexed debt
•An indexed debt is a bond indexed to the price level when either the
interest rate or the principle or both are adjusted for inflation
•The holder of the indexed bond will typically receive interest equal to the
stated real rate plus the actual inflation rate → risk reducing
•Some formal labor contracts include cost of living adjustment (COLA)
provisions
 Link increases in money wages to increases in the price level
21
Inflation and Indexation..
1. In case real material prices increase, firms pass these cost increases
on as higher prices of final goods
1. Consumer prices will increase
2. Under a system of wage indexation, wages will also rise this leads to
further price, materials-cost, and wage increases
3. Indexation in this example feeds an inflation spiral
2. Economists argue that the governments should adopt indexation on
a broad scale, including bonds and the tax system because:
 Inflation would be easier to live with
 Costs of unanticipated inflation would disappear
22
Price Index
Price index is a measure of relative price changes, consisting of a series of
numbers arranged so that a comparison between the values for any two
periods or places will show the average change in prices between periods
or the average difference in prices between places.
Price indexes were first developed to measure changes in the cost of living
in order to determine the wage increases necessary to maintain a constant
standard of living.
They continue to be used extensively to estimate changes in prices over
time and are also used to measure differences in costs among different
areas or countries.
23
Price Index..
The central problem of price-data collection is to gather a sample of prices
representative of the various price quotations for each of the commodities under
study. Sampling is almost always necessary.
Weighting is the next step is to combine the price relatives in such a way that the
movement of the whole group of prices from one period to another is accurately
described.
Adjusting For Biases is another problem of price index number construction that
cannot be completely resolved is the problem of quality change. In a dynamic
world, the qualities of goods are continually changing to such a degree that it is
doubtful whether anyone living in an industrialized economy buys many products
that are identical in physical and technical characteristics to those purchased by his
grandfather.
24
Price Indices
Price indices are tools used to measure price changes for a specific subset of goods and services.
Price indices are often normalized and compared to a base year.
The basket of goods determines which prices are being compared.
The most commonly used formula is the Laspeyres price index, which determines a basket of goods during a
base period, finds the price of this basket, and then compares that to the price of the same basket of goods in a
later period of time.
An alternate type of index, the Paasche index, finds a basket of goods in the current period, determines it’s
total price, and compares that price to what the current basket of goods would have cost in the base period.
The Consumer Price Index (CPI) and the Producer Price Index (PPI) are commonly used inflation indices. The CPI
reflects changes in the prices of goods and services typically purchased by consumers.
The PPI reflects changes in the revenue that producers receive for goods and services.
25
Consumer Price Index (CPI)
1. The CPI measures the price increases of a particular basket of goods and services.
As people’s tastes and preferences change, what goes into the basket will change
2. CPI is the most often used index
3. Measures the price of a selection of goods purchased by a "typical consumer".
4. It is a statistical time-series measure of a weighted average of prices of a specified
set of goods and services purchased by consumers.
5. It is a price index that tracks the prices of a specified basket of consumer goods and
services, providing a measure of inflation.
6. The CPI reflects changes in the prices of goods and services typically purchased by
consumers, and includes price changes in imported goods. The CPI is often used to
measure changes in the cost of living.
26
How to measure CPI?
(1) Selection of the Base Year (CPI = 100)
(2) Selection of CPI basket, Example of Consumer Basket, weightage (to measure
the importance of one item in the basket)
(3) Collection of data on prices
(4) Calculation of CPI
Weighted CPI
The rate of inflation is determined as:
27
Wholesale Price Index
Wholesale price index is a measure of changes in the prices
charged by manufacturers and wholesalers.
Wholesale price indexes measure the changes in commodity
prices at a selected stage or stages before goods reach the retail
level; the prices may be those charged by manufacturers to
wholesalers or by wholesalers to retailers or by some
combination of these and other distributors.
28
Measuring Wholesale Price Index
In the United States, the index measures the price movements of all commodities
flowing into primary markets of the United States—whether domestically produced or
imported.
Primary markets are those in which a good in a given stage of fabrication is first sold in
substantial quantities. Because primary markets include goods of all degrees of
fabrication, the same commodity is often priced at several stages of processing. Cotton,
for example, is priced in the form of raw cotton, cotton yarn, cotton gray goods, cotton
piece goods, and cotton clothing.
Price data used to construct the indexes are usually gathered from business firms by
mail, less frequently from trade journals and trade associations, and also from
government purchasing agents. Weights are generally based on relative sales volume.
Data from censuses of production (manufacturing, mining, agriculture, etc.) are used for
weights when they are available.
29
Producer Price Index
The PPI reflects changes in the revenue that producers receive in
return for goods and services.
The PPI, unlike the CPI, includes price changes for goods produced
within the US but exported abroad.
It also does not include sales and excise taxes, nor does it include
distribution costs.
While we often expect the CPI and PPI to show similar rates of
inflation, they measure two different sets of price changes.
30
Laspeyres Index
Laspeyres index, index proposed by German economist Étienne
Laspeyres (1834–1913) for measuring current prices or quantities in
relation to those of a selected base period.
A Laspeyres price index is computed by taking the ratio of the total
cost of purchasing a specified group of commodities at current prices
to the cost of that same group at base-period prices and multiplying
by 100.
The base-period index number is thus 100, and periods with higher
price levels have index numbers greater than 100.
31
Laspeyres Index..
The distinctive feature of the Laspeyres index is that it uses a group of commodities
purchased in the base period as the basis for comparison. In other words, in
computing the index, a commodity’s relative price (the ratio of the current price to
the base-period price) is weighted by the commodity’s relative importance to all
purchases during the base period.
The Laspeyres price index tends to overstate price increases because, as prices
change, consumers typically alter their purchasing decisions by selecting fewer
products with large price increases while buying more products that show low or no
price increases. If consumers can do this without reducing their total satisfaction, the
use of base-period commodity selections tends to overstate declines in the standard
of living. Similar to the price index, the Laspeyres quantity index uses base-period
prices to compare aggregate production levels in two periods.
32
Laspeyres Index..
Merit Demerit
1. The distinctive feature of the 1. The Laspeyres price index tends to overstate price
Laspeyres index is that it uses increases because, as prices change, consumers
a group of commodities typically alter their purchasing decisions by
purchased in the base period selecting fewer products with large price increases
as the basis for comparison. while buying more products that show low or no
2. In computing the index, a price increases.
commodity’s relative price 2. If consumers can do this without reducing their
(the ratio of the current price total satisfaction, the use of base-period
to the base-period price) is commodity selections tends to overstate declines
weighted by the commodity’s in the standard of living.
relative importance to all 3. Similar to the price index, the Laspeyres quantity
purchases during the base index uses base-period prices to compare
period. aggregate production levels in two periods. 33
Paasche Index
Paasche index, index developed by German economist Hermann Paasche for
measuring current price or quantity levels relative to those of a selected base
period.
It differs from the Laspeyres index in that it uses current-period weighting.
The index is a ratio that compares the total purchase cost of a specified bundle of
current-period commodities (commodities valued at current prices) with the value
of those same commodities at base-period prices; this ratio is multiplied by 100.
The Paasche price index tends to understate price increases, since it already
reflects some of the changes in consumption patterns that occur when consumers
respond to price increases—i.e., increased consumption of goods will indicate
reduced relative prices.
34
GDP Deflator
GDP Deflator is an adjustment for the impact of changes in prices on changes in nominal GDP.
GDP Deflator can be considered the most comprehensive measure of inflation since a wide array of goods
and services are included in its construction. But it may not reflect the full impact of inflation on consumer
welfare because it does not include imported goods and services that constitute a significant portion of what
people buy.
GDP Deflator is the ratio of the value of aggregate final output at current market prices (Nominal GDP) to its
value at the base year prices (Real GDP). In effect the basket of goods for the construction of this price index
includes all the final output produced within the geographic boundaries of the country.
GDP Deflator = Nominal GDP/ Real GDP
CPI and GDP Deflator measure the same thing, but there are a few key differences:
 (1) GDP Deflator includes only domestic goods and not anything that is imported. Whereas, CPI includes
anything bought by consumers including foreign goods.
 (2) GDP Deflator is a measure of the prices of all goods and services, while the CPI is a measure of only
goods bought by consumers.
35
Who Measures Inflation?
In the U.S. inflation is published monthly by the Bureau of Labor Statistics
In India, two Ministries – Ministry of Statistics and Programme
Implementation (MOSPI) and Ministry of Labour and Employment (MOLE)
are engaged in the construction of different CPIs for different
groups/sectors.
 In India, there is no single measure of inflation which captures economy-
wide inflationary pressures in the economy. It is the year on year
percentage change in wholesale price index (WPI), which is used as an
indicator of headline inflation.
Although there are four consumer price indices (CPIs), they are targeted
at different population groups and none of them captures economy-wide
inflationary pressures. CPI (Rural), CPI (Urban) and CPI (All India)
36
Types of Inflation
From the quantitative point of view
Creeping
Galloping inflation Hyperinflation
inflation
The slow but The rate of inflation It is inflation that is "out of control", a
steady increase in exceeds the rate of condition in which prices increase rapidly as a
prices. production growth, currency loses its value. Hyperinflation is over
The rate of inflation Galloping inflation is 100% per year. Prices as well as wages are
doesn’t exceed the from 10% to 100%. extremely erratic. Money have no value and
rate of production Money loose barter trade emerges (barter means the
growth. Creeping purchase power, exchange of good for good). Example:
inflation is < 10% people hold as little Germany after I.WW, Hungary after II.WW.,
money as possible. Zimbabwe, Venezuela
37
Types of Inflation..
Open
Suppressed inflation Hidden inflation
inflation
If economic If state authorities damp or even Government imposes strict controls
imbalance is stop the rise of price level by to curb price inflation, producers
accompanied with administrative means. Such are forced to sell the products at
rising price level. situation is followed by existence the prices required.
of scarce commodities, shadow Producers can not sell the
economy etc. commodity at higher prices to get
In such cases the provision of the profit, therefore, lower on the
basic necessities such as quality of products. This means
agricultural products is set by the that employers are selling lower
government by introducing price quality products at higher prices ->
controls on commodities inflation is hidden.
38
Types of Inflation..
Chronic Low Inflation Walking Inflation
Inflation
Chronic inflation Low inflation contributes towards Walking inflation is a type of strong, or
occurs when inflation economic stability – which pernicious, inflation is between 3-10 percent
steadily increases for encourages saving, investment, a year.
a long time economic growth, and helps It heats up economic growth too fast. People
maintain international start to buy more than they need, just to
competitiveness. avoid tomorrow's much higher prices.
Generally the governments target an This drives demand even further so that
inflation rate of around 2-4%. This suppliers can't keep up. More important,
moderate but low rate of inflation is neither can wages.
considered the best compromise As a result, common goods and services are
between avoiding the costs of priced out of the reach of most people.
inflation but also avoiding the costs
of deflation
39
Types of Inflation…
Wage Inflation Asset Inflation
Wage inflation is when workers' pay rises fasterAsset inflation occurs in any asset class
than the cost of living. This occurs in three when the asset prices experience high
situations. First, is when there is a shortage of
levels of price rise.
workers. Second, is when labor unions negotiate Good examples are housing, oil and
ever-higher wages. Third is when workers gold.
effectively control their own pay. It is generally overlooked by the central
banks and other inflation-watchers
Of course, everyone thinks their wage increases when the overall rate of inflation is low.
are justified. But higher wages are one element But the subprime mortgage crisis and
of cost-push inflation. That can drive up the subsequent global financial crisis
prices of a company's goods and services. demonstrated how damaging unchecked
asset inflation can be.
40
Demand-pull Inflation
 Demand-pull inflation occurs when aggregate
demand for goods and services in an
economy rises more rapidly than an
economy's productive capacity.
 One potential shock to aggregate demand
might come from a central bank that rapidly
increases the supply of money.
 The increase in money in the economy will
increase demand for goods and services from
D0 to D1.
 The economy's equilibrium moves from point
A to point B and prices will tend to rise,
resulting in inflation.
41
42
Cost-push Inflation
• Cost-push inflation, on the other hand, occurs
when prices of production process inputs
increase.
• Rapid wage increases or rising raw material
prices are common causes of this type of
inflation.
• The sharp rise in the price of imported oil during
the 1970s provides a typical example of cost-
push inflation (illustrated in Figure).
• Rising energy prices caused the cost of producing
and transporting goods to rise.
• Higher production costs led to a decrease in
aggregate supply (from S0 to S1) and an increase
in the overall price level because the equilibrium
point moved from point Z to point Y. 43
44
Causes of
Demand-pull Inflation Cost-push Inflation
1. Depreciating exchange rate 1. Component costs
2. Higher demand from a fiscal 2. Increasing oil prices
stimulus 3. Rising labour cost
3. Monetary stimulus to the economy 4. Expectations of inflation
4. Fast growth in other countries 5. Higher indirect taxes
5. Rising property prices 6. A fall in the exchange rate
6. Increasing consumer wealth 7. Monopoly employers/profit-
push inflation
45
Low inflation
Low Inflation is a phenomenon when the prices of goods and
services do not increase rapidly.
A low inflation is the rate of inflation that has been consistently
below the targeted rate of inflation by the central bank of the
country.
46
Core Inflation Vs. Headline Inflation
Core Inflation Headline Inflation
1. An inflation measure which excludes transitory or 1. Headline inflation is your general index like WPI (for
temporary price volatility as in the case of some India), CPI etc. that includes all the items used for
commodities such as food items, energy products etc. It measuring inflation.
reflects the inflation trend in an economy. 2. Headline inflation tends to revert strongly towards core
2. Core means, we should ignore food and fuel part. inflation over a time period making the case for core
3. Core inflation = Only WPI of Non-food manufacturing stronger.
industries= Headline WPI – (primary + fuel + food mfg.
industries)
4. A dynamic consumption basket is considered the basis
to obtain core inflation. Some goods and commodities
have extremely volatile price movements. Core inflation
is calculated using the Consumer Price Index (CPI) by
excluding such commodities.
5. Core inflation index excludes a certain items whose
prices are more volatile and hence may not represent a
true picture of the inflation.
47
Deflation Vs. Disinflation
Deflation Disinflation
1. Deflation is a sustained decrease in 1. Disinflation is a reduction in the rate of inflation
the price level 2. Disinflation is not the same as deflation, when
2. It is a decrease in the general price inflation drops below zero.
level, that is, in the nominal cost of 3. During periods of disinflation, the general price
goods and services. level is still increasing, but it is occurring slower
than before.
4. Disinflation can be illustrated as movements
along the short-run and long-run Phillips curves.
5. Disinflation can be caused by decreases in the
supply of money available in an economy. It can
also be caused by contractions in the business
cycle, otherwise known as recessions.
48
Inflation vs. Deflation vs. Disinflation
Assume the following annual
price levels as compared to Inflation Disinflation Deflation
the prices in 2012: As the economy Between 2013 and 2015, the rise in Between 2015
2012: 100% of 2012 prices moves through price levels slows down. Between and 2016, the
2012 to 2015, 2013 and 2014, the price level only price level does
2013: 104% of 2012 prices there is a increases by two percentage points, not increase, but
2014: 106% of 2012 prices continued which is lower than the four decreases by two
growth in the percentage point increase between percentage
2015: 107% of 2012 prices price level. This 2012 and 2013. The trend continues points. This is an
2016: 105% of 2012 prices is an example between 2014 and 2015, where there example of
of inflation; the is only a one percentage point deflation; the
price level is increase. This is an example of price rise of
continually disinflation; the overall price level is previous years has
rising. rising, but it is doing so at a slower reversed itself.
rate.
49
Stagflation
Stagflation occurs when economic growth is stagnant but there still is price inflation.
This seems contradictory, if not impossible.
Why would prices go up when there isn't enough demand to stoke economic
growth?
Stagflation occurs when the prices of goods rise while unemployment increases and
spending declines.
It happened in the 1970s when the United States abandoned the gold standard.
Once the dollar's value was no longer tied to gold, it plummeted. At the same time,
the price of gold skyrocketed.
Stagflation is also considered an unnatural phenomenon since inflation shouldn't
happen when an economy is weak.
50
Threshold Inflation
Threshold level of inflation can be described as that inflexion point
beyond which the output growth is not optimal.
Empirical studies have shown that at inflation rates higher than
threshold level, the output growth has retarded.
The threshold inflation rate is within 4 to 4.5 per cent for India.
Beyond this level, inflation is growth retarding.
51
Drivers of Inflation
1. Large and sequential supply side shocks
2. Oil price shocks
3. Wage growth
4. According to Quantity Theory too much money in the economy
causes inflation.
52
Causes of Inflation
Cost-push inflation Built-in inflation (or
Demand-pull inflation
(or supply-shock) Anticipated inflation)
Arises when aggregate demand in an It is a type of inflation It is induced by adaptive
economy outpaces aggregate supply. caused by large increases expectations, often linked to
It involves inflation rising as real gross in the cost of important the "price/wage spiral“
domestic product rises and goods or services where It involves workers trying to
unemployment falls. This is commonly no suitable alternative is keep their wages up with
described as "too much money chasing available. prices and then employers
too few goods". Possible causes of cost- passing higher costs on to
Possible causes of demand-pull inflation: push inflation: (i) consumers as higher prices as
(i) Excessive investment expenditures; (ii) Imperfect competition; (ii) part of a "vicious circle.“
Excessive growth of consumption Increased taxes; (iii) Rising Built-in inflation reflects
expenditures; (iii) Low-cost loans; (iv) Tax wages; (iv) Political events in the past, and so
cutting; (v) Augmentation of government incidents (like oil crises) might be seen as hangover
expenditures inflation.
53
Causes of Inflation
Short-run Long-run
1.Expectations 1.Too much money chasing too few
2.Excess demand goods
3.Supply shocks 2.“Inflation is always and everywhere
a monetary phenomenon…”
(Milton Friedman)
54
The Fisher Effect
Nominal Inflation Real interest
= +
interest rate rate rate
This relationship is called the Fisher effect

In the long run, money is neutral, so a change in the money growth
rate affects the inflation rate but not the real interest rate.
So, the nominal interest rate adjusts one-for-one with changes in the
inflation rate.
55
Money and Inflation in Ordinary Business Cycles
Annual M2 growth and the inflation rate of the GDP deflator for the U.S.
Inflation
is closely
linked to
M2
growth
56
Effects of Inflation
Redistribution Social Impact of
Impact on Economy Balance
Effect of Inflation Inflation
• Inflation affects recipients • Socially poor persons • Fall of real product bellow potential product
of fixed income firstly suffer from inflation • Changes in the structure of consumption
(nominal incomes remain more then rich (consumers are buying cheaper goods)
same but the real value of • In case of fixed currency exchange rate higher
income drop) exports are incited.
• Inflation affects the • Inflation deforms prices
purchasing power of • Inflation causes higher costs and makes economy
wages that don’t follow less efficient
the rise of prices • Creeping and anticipated inflation has positive
• Inflation causes effect on economy and stimulates economic
diminishing value of loans growth
and savings • High inflation and not anticipated inflation are
serious problems in economy.
57
How to Stop the inflation?
There are a number of methods which have been
suggested to stop inflation.
1. Managing the wages and prices – determined by state income
policy (authority can set wages ceiling)
2. Stimulating market competition – e.g. antimonopoly
regulations
3. Fiscal and monetary policy – e.g. central banks can affect
inflation to a significant extent through setting interest rates
58
Expected vs. Unexpected Inflation
1. Expected inflation 1. Unexpected inflation
1. Expected inflation is the 1. Unexpected inflation is the inflation experienced that
inflation that economic is above or below that which we expected.
agents expect in the future. 2. Unexpected inflation redistributes wealth from
2. Wage negotiations and creditors to debtors.
pricing adjustments in the 3. When unexpected inflation is higher than expected,
businesses can help solve the borrowers tend to benefit.
this problem of expected 4. When the unexpected inflation is lower than
inflation. expected, lenders tend to benefit.
3. Expected inflation can give 5. Unexpected inflation can give rise to inequality,
rise to menus costs and information asymmetry, and risk premium.
shoe-leather costs.
59
Costs of Inflation
Costs of extremely high inflation are generally vivid:
If prices rise rapidly enough, money stops being a useful
medium of exchange
Costs of low, expected inflation are difficult to see
Regardless, public has a distaste for it → becomes a policy issue
60
Costs of Inflation
The costs of inflation include:
1. Menu costs - a menu cost is the cost to a firm resulting from changing its prices.
2. Shoe leather costs - the cost of time and effort that people spend trying to counter-act
the effects of inflation, such as holding less cash and having to make additional trips to
the bank.
3. Loss of purchasing power - Money loses value with inflation, leading to a drop in the
purchasing power of an individual dollar. Unless wages increase with inflation, individuals’
purchasing power will also drop.
4. Redistribution of wealth.
5. Tax distortions: Inflation makes nominal income grow faster than real income. So,
inflation causes people to pay more taxes even when their real incomes don’t increase.
6. Other costs of high and/or unexpected inflation include the economic costs of hoarding
and social unrest.
61
Cost of Expected Inflation
1. Inflation Tax
2. Menu Cost -Increased price changing- Inflation causes firms to change their posted prices more often, the
logistics of which can be costly. This is sometimes referred to as menu costs in reference to restaurants having to
print new menus.
3. Inefficiency due to inflation variability
4. Increase in tax liability - Distortions in the way taxes are levied- The tax code doesn’t take into account inflation
so the way tax liabilities are assessed is altered from the economically efficient level.
5. Consumer inconvenience - Undertaking economic transactions in a world with changing price levels in
inconvenient and inefficient.
6. When inflation is expected, it has few distribution effects between borrowers and lenders. This is because the
inflation rate is built in to the nominal interest rate, which is the sum of the real interest rate and expected
inflation.
7. Reluctance to hold money- Holding money as cash doesn’t earn an interest rate, and with the presence of
inflation actually decreases in value over time. With inflation, people are reluctant to hold money and thus make
more frequent trips to the bank (this is sometimes referred to as shoe-leather costs)
62
The Inflation Tax
When tax revenue is inadequate and ability to borrow is limited, Govt. may
print money to pay for its spending.
Almost all hyperinflations start this way.
The revenue from printing money is the
inflation tax: printing money causes inflation, which is like a tax on
everyone who holds money.
In the U.S., the inflation tax today accounts for less than 3% of total revenue
Inflation is also called an arbitrary tax, because it lessens people’s
disposable income while effecting them randomly
63
Costs of Unexpected Inflation
1. Redistributions of wealth -
Creditors / Debtors and Employees (on contract) / Employers
2. Interference with long-term planning

Future purchasing power is uncertain
3. “Noise” in the price system

Information conveyed by prices becomes difficult to interpret
4. Shoe leather costs

Time and effort spent to minimize the effect of inflation
5. Distortions of the tax system

“Bracket creep” and future value of depreciation allowances
6. Other costs of high and/or unexpected inflation include the economic costs of hoarding and social
unrest. 64
Inflation Tax..
1. Independent central banks issue fiat money
2. Monetizing the debt
3. Seignorage
4. Inflation Tax
65
The Fisher Effect & the Inflation Tax
Nominal = Inflation + Real interest
interest rate rate rate
The inflation tax applies to people’s holdings of money, not their

holdings of wealth.
The Fisher effect: an increase in inflation causes an equal increase
in the nominal interest rate,
so the real interest rate (on wealth) is unchanged.
66
Costs of Unexpected Inflation..
6. Loss of returns:
6. creditors lose if π* > π
7. borrowers lose if π* < π
7. Loss of real income when income is fixed

8. Arbitrarily redistributes wealth among individuals- For example loan agreements
have an interest rate that has taken inflation into consideration. If inflation is higher than
expected, the borrower is better off because he/she is repaying the fixed loan with less
valuable dollars. The opposite situation is true if inflation is lower than expected.
9. Hurts individuals on fixed pensions and those bound by fixed contracts-
Similar to the borrower/lender example, unexpectedly high or low inflation can hurt one
party in a fixed long term contract or payment system, thereby discouraging their use.
67
Benefits of Inflation
Unexpectedly high inflation tends to transfer wealth from creditors to debtors and from
the rich to the poor.
Inflation is good for borrowers and bad for lenders because it reduces the value of the
money paid back to the lenders.
The inflation rate is built in to the nominal interest rate, which is the sum of the real
interest rate and expected inflation. When the inflation rate rises or falls unexpectedly,
wealth is redistributed between creditors and debtors.
Those with savings in the form of currency or bonds lose money from inflation. Those
with negative savings (debt) or savings in the form of stocks, however, are better off with
higher inflation.
Unexpected inflation often manifests as a wealth transfer from older individuals to
younger individuals.
68
Hyperinflation
Definition: Hyperinflation is a rapid and often uncontrollable currency devaluation causing
the prices of goods and services to skyrocket in a short period of time.
Although there is no precise threshold for hyper-inflation, normally it describes an inflation
rate that exceeds 50 percent.
Hyperinflation is usually caused by an extremely rapid growth in the money supply of an
economy. When the monetary and fiscal policy allow the issuance of “new” money to
accommodate for government spending, the money supply grows faster than the real
output of the economy, thus causing inflation.
Hyperinflation refers to a period of massive price rise.
Prices grow so rapidly that the payment system is damaged to the point of shutdown
Too much money has been printed → outward push of AD dominates all else in our
macroeconomic models 69
Hyperinflation
Hyper inflation is a fast decrease in the value of a currency that drastically
reduces the purchasing power of the currency marked by extreme price
increases of normal goods and services.
When π > 50% per month
All unexpected costs get larger
Delay in tax collection
Inflation psychology
Caused by excessive printing press
Cure required fiscal reform
70
Episodes of Hyperinflation
Country Period CPI Inflation % per year
Angola 1995-96 4,145
Peru 1988-90 5,050
Zimbabwe 2005-07 5,316
Nicaragua 1988 33,000
71
Hyperinflation in Germany
Date Price in marks
Price of a newspaper in January 1921 0.30
Germany, 1921-1923: May 1922 1
October 1922 8
February 1923 100
September 1923 1,000
October 1, 1923 2,000
October 15 20,000
October 29 1,000,000
November 9 15,000,000
Source: Mankiw, Macroeconomics, 5th ed., November 17 70,000,000
pp. 105-106
72
Hyperinflation
: very high
rates of
inflation →
around 1,000
percent per
annum
73
Why governments create hyperinflation?
When a government cannot raise taxes or sell bonds, it must
finance spending increases by printing money.
In theory, the solution to hyperinflation is simple: stop printing
money.
In the real world, this requires drastic and painful fiscal restraint.
74
The role of government and RBI to control inflation
The main policy tools to control inflation include:
1. Monetary policy – Setting interest rates. Higher interest rates reduce
demand, leading to lower economic growth and lower inflation
2. Control of money supply – Monetarists argue there is a close link between
the money supply and inflation, therefore controlling money supply can
control inflation.
3. Supply-side policies – policies to increase competitiveness and efficiency of
the economy, putting downward pressure on long-term costs.
4. Fiscal policy – a higher rate of income tax could reduce spending and
inflationary pressures.
5. Wage controls - Trying to control wages could, in theory, help to reduce
inflationary pressures. However, apart from the 1970s, rarely used.
75
Economic impacts of inflation
1. Inflation can cause unemployment when the uncertainty of inflation leads to
lower investment and lower economic growth in the long term.
2. Inflationary growth is unsustainable leading to a boom and bust economic cycle.
3. Inflation leads to decline in competitiveness and lower export demand, causing
unemployment in the export sector (especially in a fixed exchange rate).
4. There is no direct link between unemployment but often we see a trade-off e.g. in
a period of strong economic growth and falling unemployment, we see a rise in
inflation.
5. A period of high and volatile inflation discourages firms from investing. Because
inflation is high, firms are less certain investment will be profitable.
76
The Sacrifice Ratio
To reduce inflation, policymakers can contract aggregate
demand, causing unemployment to rise above the natural
rate.
The Sacrifice Ratio measures the percentage of a year’s real
GDP that must be foregone to reduce inflation by 1
percentage point.
A typical estimate of the ratio is 5.
77
The Sacrifice Ratio-An Illustration
To reduce inflation from 6 to 2 percent, must sacrifice 20
percent of one year’s GDP:
GDP loss = (inflation reduction) x (sacrifice ratio)
20 = 4 x 5
This loss could be incurred in one year or spread over several,
e.g., 5% loss for each of four years.
The cost of disinflation is lost GDP.
One could use Okun’s law to translate this cost into

unemployment.
78
Is a little inflation is good for the economy?
A little inflation (around 3-5%) is always considered as good for overall growth of economy. Some of
the reasons for the same are as following:
1. The consumer always expects the prices of goods to increase, so they spend more frequently,
which increases demand and provide profitability to the manufacturers.
2. A little inflation is a sign of growing and healthy economy.
3. Inflation always works as a lubricant for any shock to economy and help it to recover. For
example in a recession time cutting wages are considered more profitable than cutting jobs,
but the earlier is not accepted easier than the later, and as we know job cuts are always bad
for economy. But if there’s inflation in economy, employers just need to provide lesser raise
than inflation rate and no one would mind.
4. Inflation drives people to invest their money, instead of locking them up, because each day
reduces the purchasing power of money and it’s better to invest than loose purchasing
power.
5. Investment helps companies or government to raise money for growth easier.
79
Is a little inflation is good for the economy?
1. A small amount inflation reduces the natural rate of unemployment
2. It provides a necessary mechanism for lowering the real wages
without cutting the nominal wages.
80
The Phillips
Curve
In 1958 A.W. Phillips published a
study of wage behavior in the U.K.
between 1861 and 1957
The main findings are summarized
in Figure.
1. There is an inverse relationship
between the rate of
unemployment and the rate of
increase in money wages
2. From a policymaker’s
perspective, there is a trade-off
between wage inflation and
unemployment
81
The Phillips
Curve..
The curve sloped down from left to
right and seemed to offer policy
makers with a simple choice
- you have to accept inflation or
unemployment. You cannot lower
both.
The Phillips curve is a dynamic
representation of the economy; it
shows how quickly prices are rising
through time for a given rate of
unemployment.
The relationship between inflation
and unemployment depends upon
the time frame
82
The Phillips Curve..
The PC shows the rate of growth of wage inflation decreases with increases in
unemployment
◦ If Wt = wage this period
Wt+1 = wage next period Wt 1  Wt
gw = rate of wage inflation, then g w  (1)
Wt
If * represents the natural rate of unemployment, the simple PC is defined as:

gw   (    * ) (2)
where  measures the responsiveness of wages to unemployment
◦ Wages are falling when  > * and rising when  < *
◦ ( - *) is called the unemployment gap
83
Short-run Phillips curve
Short-run Phillips curve is a curve that shows
the relationship between the inflation rate
and the unemployment rate when the
natural unemployment rate and the
expected inflation rate remain constant.
In the Figure:
1. The natural unemployment rate is 6 percent.
2. The expected inflation rate is 3 percent a year.
3. This combination, at point B, provides the anchor
point for the short-run Phillips curve.
4. The short-run Phillips curve passes through points
A, B, and C and is the curve SRPC.
84
Aggregate Supply and the Short-Run Phillips Curve
The AS-AD model explains the negative relationship between unemployment and inflation
along the short-run Phillips curve.
The Short-run Phillips Curve is another way of looking at the upward-sloping aggregate
supply curve.
Both curves arise because the money wage rate is fixed in the short run.
So when the price level rises, the real wage rate falls.
And the quantity of labor employed increases.
Along the short-run Phillips curve, the rise in the price level means an increase in inflation.
The increase in quantity of labor employed means a decrease in the number unemployed
and a decrease in the unemployment rate.
So a movement along the AS curve is equivalent to a movement along the short-run
Phillips curve.
85
The Long-Run Phillips Curve
The long-run Phillips curve is a vertical line
that shows the relationship between
inflation and unemployment when the
economy is at full employment.
The long-run Phillips curve is a vertical line
at the natural unemployment rate.
In the long run, there is no unemployment-
inflation trade-off.
In the long run, the only unemployment rate
available is the natural unemployment rate,
but any inflation rate can occur.
86
Short-run and Long-
run Phillips Curve
In the Figure, If the natural
unemployment rate is 6
percent, the long-run Phillips
curve is LRPC.
1. If the expected inflation rate
is 3 percent a year, the short-
run Phillips curve is SRPC0.
2. If the expected inflation rate
is 7 percent a year, the short-
run Phillips curve is SRPC1.
87
Short-run and Long-run Phillips Curve
Long-run and Short-Run Phillips Curves
intersect when actual inflation is equal
to expected rate of inflation.
88
Long-run & Short-run Phillips Curves in terms of Output (Y)
89
The Natural Rate Hypothesis
The natural rate hypothesis is the proposition that
when the inflation rate changes, the unemployment
rate changes temporarily and eventually returns to
the natural unemployment rate.
The inflation rate is 3 percent a year and the
economy is at full employment, at point A. Then the
inflation rate increases.
In the short run, the increase in inflation brings a
decrease in the unemployment rate — a movement
along SRPC0 to point B.
Eventually, the higher inflation rate is expected and
the short-run Phillips curve shifts upward to SRPC1.
At the higher expected inflation rate,
unemployment returns to the natural
unemployment rate—the natural rate hypothesis.
90
Effect of Changes in the
Natural Unemployment Rate
The expected inflation rate is 3
percent a year.
The natural unemployment
rate is 6 percent.
The short-run Phillips curve is
SRPC0 and the long-run Phillips
curve is LRPC0.
A decrease in the natural
unemployment rate shifts the
two Phillips curves leftward to
LRPC1 and SRPC1.
91
Influencing Inflation and
Unemployment
Effects of Central Bank policy:
The economy starts at point A, with the unemployment
rate higher than the natural unemployment rate on
SRPC0.
The Fed increases the growth rate of real GDP and the
economy slides up along SRPC0.
If the Fed continues to increase the growth rate of
aggregate demand, the inflation rate rises and
unemployment falls below the natural rate.
With the inflation rate rising, the expected inflation rate
gradually rises and both inflation and unemployment
increase.
 The economy gradually moves to point B.
 With an expected inflation rate of 10 percent a year, the

short-run Phillips curve has shifted up to SRPC1.
92
Non-Accelerating Inflation Rate of
Unemployment (NAIRU).
NAIRU, a Keynesian explanation
which exists at the Long Run
Phillips Curve, is the rate of
unemployment at which
inflation will stabilise - in other
words, at this rate of
unemployment, prices will rise
at the same rate each year.
93
Does the trade-off still exist?
The unemployment between 1993 and
2008 fell to record lows, but inflation did
not rise, as predicted by the Phillips curve.
Many economists explain this by pointing
to the successful supply-side policies that
have been pursued over the last 20 years.
Supply-side policies: The effectiveness of
supply side policies has meant that the
economy can continue to expand without
inflation.
Indeed, many argue that the long run
Phillips Curve still exists, but that for the
UK it has shifted to the left.
94
Supply Shocks
1. A supply shock is a disturbance in
the economy whose first impact is a
shift in the AS curve
2. An adverse supply shock is one that
shifts AS inwards (as in Figure )
◦ As AS shifts to AS’, equilibrium shifts
from E to E’ and prices increase while
output falls
◦ The u at E’ forces wages and prices
down until return to E, but process is
slow
95
Supply Shocks..
After the shock:
1. Economy returns to the full employment level of
employment
2. Price level is the same as it was before the shock
3. Nominal wages are LOWER due to the increased u at
the onset of the shock
4. Real wages must also fall
W
w
P
where w is the real wage and W is the
nominal wage
96
Supply Shocks…
1. Figure also shows the impact of AD policy
after an adverse supply shock
2. Suppose G increases (to AD’):
 Economy could move to E* if increase
enough
 Such shifts = “accommodating
policies” (accommodate the fall in the
real wage at the existing nominal
wage)
 Added inflation, although reduce u
from AS shock
97
Using AD/AS to demonstrate the Phillips Curve effect
When the economy is at a stable
equilibrium, at Y. An increase in
government spending will shift AD from AD
to AD1, leading to a rise in income to Y1,
and a fall in unemployment, in the short
term.
However, households will successfully
predict the higher price level, and build
these expectations into their wage
bargaining.
As a result, wage costs rise and the AS
shifts up to AS1 and the economy now
moves back to Y, but with a higher price
level of P2. 98
Why is Phillips Curve so Important?
1. The Phillips curve focuses directly on two policy targets: the
inflation rate and the unemployment rate.
2. The aggregate supply curve shifts whenever the money wage rate
or potential GDP changes, but the short-run Phillips curve does
not shift unless either the natural unemployment rate or the
expected inflation rate change.
99
Linkage Among Money, Prices, and Interest Rates
• Changes in money
demand and supply
determine the price
level
• Changes in the price
level determine the
inflation rate
• The inflation rate
affects the interest
rate
• The nominal interest
rate affects the money
demand
100
Keywords
Inflation
Deflation Demand-pull and Cost-push inflation
Disinflation Expected and Unexpected inflation
Hyperinflation Consumer price index
Threshold inflation Phillips Curve
Stagflation Unemployment
Core inflation Natural employment
Headline Inflation Supply shocks
101
MCQ 1
Which of the following is caused by unexpected
inflation (as opposed to expected inflation)?
1. Menu costs
2. Uneven distribution of wealth between lenders and
borrower
102
MCQ 1
Which of the following is caused by unexpected
inflation (as opposed to expected inflation)?
1. Menu costs
2. Uneven distribution of wealth between lenders and
borrowers
103
MCQ 2
Who would most likely benefit from an
unexpected 10% inflation rate?
1. Alok who has INR 5000 in a savings account
2. Madhura, who has INR 5000 life insurance policy
3. Jagat, who loaned Angad INR 5000 last year
4. Ananya who borrowed INR 5000 last year
104
MCQ 2
Who would most likely benefit from an
unexpected 10% inflation rate?
1. Alok who has INR 5000 in a savings account
2. Madhura, who has INR 5000 life insurance policy
3. Jagat, who loaned Angad INR 5000 last year
4. Ananya who borrowed INR 5000 last year
105
Short Question 1
What does the foreign sector have to do
with inflation?
Ans:
If more money enters the country than
leaves, the money supply increases
106
Short Question 2
What is the equation of exchange?
Ans:
MV = PQ
107
Short Question 2
What is the equation of exchange?
Ans:
MV = PQ
108
Short Question 3
What determines the price level?
Ans:
MV/Q = P
109
Short Question 4
What can reduce the Inflation rate?
Ans:
Decrease M,
decrease V, and/or
increase Q
110
Short Question 5
Who influence the money supply?
Ans:
RBI in India
Fed in the U.S.
111
Short Question 6
Do you think government
mandated price controls work?
Ans:
NO, they simply alter the economic system.
112
Short Question 7
D you think businesses or
consumers can cause inflation?
Ans:
Maybe for a short time, but very quickly
prices will come down due to a lack of
buying pow.
113
Short Question 8
Is it easy to fight
demand pull inflation?
Ans:
YES, When we lower demand prices will
soon drop.
114
Short Question 9
What do you mean by supply side
inflation?
Ans:
It is the Inflation caused by reductions in
aggregate supply .
115
Short Question 10
How are savers effected by
inflation?
Ans:
With an inflation rate of 7% and an interest
rate of 6%, Assuming that there is no
increase in taxes, a saver is worse off by 1%
116
Short Question 11
What fiscal policies would you use to
bring down inflation?
Ans:
1. Cut government spending
2. Raise taxes to pay debt
3. Relax trade restrictions
4. Increase productivity
117
Short Question 12
How one can protect oneself from
hyperinflation?
Ans:
1. real estate
2. art
3. gold
118
Short Question 13
Do you think Inflation causes a fall
in Purchasing Power?
Ans: Inflation does not in itself reduce people’s

real purchasing power.
119
Business Cycles
and
Unemployment
1
Coverage
1. Features of Business Cycles- (a) Aggregate economic activity (b)
Expansions and contractions(c) Co-moments (d) Recurrent but not
periodic (e) Persistence.
2. Phases of business cycle (a) Boom (b) Peak (c) Recession/Contraction
(d) Through (e) Recovery.
3. Business cycle facts- (a) Direction (b) Timings.
4. Business cycle theories-Exogenous Vs. internal theories
5. Demand induced cycle
6. Monetary theories
2
Coverage
1.Political theories of business cycle
2.Real business cycle theories,
3.Supply shocks theory,
4.Can we predict the business cycle?
5.Types of unemployment
6.Okun's Law
7.Economic Impact of unemployment.
8.Can we eradicate unemployment completely?
3
Coverage..
1. Political
theories of
business cycle
2. Real business
cycle theories,
3. Supply shocks
theory,
4. Can we predict
the business
cycle?
5. Types of
unemployment
6. Okun's Law
7. Economic
Impact of
unemployment.
8. Can we
eradicate
unemployment
completely?
4
Business Cycle
A business cycle is a period of macroeconomic
expansion followed by a period of contraction.
Business cycle is the pattern of expansion and
contraction in economic activity about the path
of trend growth.
Trend path of GDP is the path GDP would take if
factors of production were fully utilized
Deviation of output from the trend is referred to
as the output gap
Output gap = actual output – potential output
Output gap measures the magnitude of cyclical
deviations of output from the potential level
5
Business Cycle..
A business
cycle is a
cycle of
fluctuations
in the Gross
Domestic
Product
(GDP) around
its long-term
natural
growth rate.
6
-8.00
-6.00
-4.00
-2.00
2.00
4.00
6.00
8.00
10.00
12.00
0.00
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
INDIA GDP Growth Rate
2001
2003
2005
2007
2009
2011
2013
7
2015
2017
-4.00
-2.00
0.00
2.00
4.00
6.00
1961 8.00
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
USA GDP Growth Rate
2001
2003
2005
2007
2009
2011
8
2013
2015
2017
Business Cycle…
It explains the expansion and contraction in economic activity that an
economy experiences over time. A business cycle is completed when it
goes through a single boom and a single contraction in sequence.
The time period to complete this sequence is called the length of the
business cycle.
A boom is characterized by a period of rapid economic growth
whereas a period of relatively stagnated economic growth is a
recession.
These are measured in terms of the growth of the real GDP, which is
inflation adjusted.
9
Business Cycle..
When an economy is expanding or growing, many people have jobs
and many goods and services are being produced and sold. At the
peak of the expansion, Gross Domestic Product is as high as it will go
for that particular business cycle.
During a period of contraction, more people are unemployed and
fewer goods and services are being produced and sold. Not all
contractions are equally severe.
A contraction that lasts for at least six months is called a recession.
A particularly severe and long contraction is called a depression.
10
Characteristics of the Business Cycle
The expansion phase is terminated by a peak of business cycle and contraction by a
through. These points are called the “turning points”.
One business cycle is defined as the period
during which the economy performs motion
between two consecutive turning points (e.g.
between the two troughs).
The duration, at which the economy passes
such a movement, is referred to a cycle period.
When we say that all recessions/expansions
“look similar”, we mean that there seem to be
consistent statistical relationships between
GDP and the behavior of other economic
variables.
 Correlation (procyclical, countercyclical)
 Timing (leading, coincident, lagging)
 Relative Volatility
11
Characteristics of the Business Cycle..
Business cycles can be characterized as fluctuations in economic
activity in the form of actual real output fluctuations around
potential output of the economy (i.e. the trend).
The difference between actual and potential output is known as a
gap (gap – a difference).
The business cycle occurs when economic activity speeds up or
slows down.
A business cycle is a swing in total national output, income and
employment, usually lasting for a period of 2 to 10 years, marked by
widespread expansion or contraction in many sectors of the
economy.
12
The Great Depression was
the most severe economic
contraction in the history of
the world. It permanently
changed the way economists
think.
13
Stages of the Business Cycle
#1 #3
#2 Peak
Expansion Recession
#4 #6
#5 Trough
Depression Recovery
14
#1 Expansion
The first stage in the business cycle is expansion. In this
stage, there is an increase in positive economic indicators
such as employment, income, output, wages, profits,
demand, and supply of goods and services.
Debtors are generally paying their debts on time, the
velocity of the money supply is high, and investment is high.
 This process continues until economic conditions become
favorable for expansion.
15
#2 Peak
The economy then reaches a saturation point, or peak, which is
the second stage of the business cycle.
The maximum limit of growth is attained at this stage.
The economic indicators do not grow further and are at their
highest.
Prices are at their peak.
This stage marks the reversal in the trend of economic growth.
Consumers tend to restructure their budget at this point.
16
#3 Recession
The recession is the stage that follows the peak phase.
The demand for goods and services starts declining rapidly and
steadily in this phase.
Producers do not notice the decrease in demand instantly and go
on producing, which creates a situation of excess supply in the
market.
Prices tend to fall.
All positive economic indicators such as income, output, wages,
etc. consequently start to fall.
17
#4 Depression
There is a commensurate rise in unemployment.
The growth in the economy continues to decline, and as
this falls below the steady growth line, the stage is called
depression.
18
#5 Trough
In depression stage, the economy’s growth rate becomes
negative.
There is further decline until the prices of factors, as well as the
demand and supply of goods and services, reach their lowest.
The economy eventually reaches the trough.
This is the lowest it can go. It is the negative saturation point
for an economy.
There is extensive depletion of national income and
expenditure.
19
#6 Recovery
In this phase, there is a turnaround from the trough and the economy starts recovering from the
negative growth rate.
Demand starts to pick up due to the lowest prices and consequently, supply starts reacting, too.
The economy develops a positive attitude towards investment and employment and hence,
production starts increasing.
Employment also begins to rise and due to the accumulated cash balances with the bankers,
lending also shows positive signals.
In this phase, depreciated capital is replaced by producers, leading to new investment in the
production process.
Recovery continues until the economy returns to steady growth levels. This completes one full
business cycle of boom and contraction. The extreme points are the peak and the trough.
20
Explanations by Two Schools of Thought
Keynesians Chicago School
 John Keynes explains the occurrence of  Economists like Finn E. Kydland and
business cycles as a result of fluctuations in Edward C. Prescott, associated with
aggregate demand, which bring the the Chicago School of Economics,
economy to short-term equilibriums that are challenge the Keynesian theories.
different from a full employment  They consider the fluctuations in the
equilibrium. growth of an economy not as a result
 Keynesian models do not necessarily of monetary shocks, but a result of
indicate periodic business cycles but imply technology shocks, such as
cyclical responses to shocks via multipliers. innovation.
 The extent of these fluctuations depends on  It is generally rejected by mainstream
the levels of investment, for it determines economists who follow the path of
the level of aggregate output. Keynes.
21
Factors Which Affect the Business Cycle
Investment in Interest Rates Consumer External Shocks
Businesses Expectations
1. The more money 1. Interest is the price 1. When people 1. External shocks
people invest in of borrowed are optimistic can be positive
businesses, the money. When about the or negative.
more money interest rates are future, they 2. An earthquake is
businesses have high, people spend more a negative
to grow. borrow less. money. external shock. It
2. Investment 2. Businesses borrow 2. Optimism affects the
affects the less too. affects the business cycle.
business cycle. 3. Interest rates affect business cycle.
the business cycle.
22
External Causes of Business Cycles
Wars: create contraction in the economic activity.
Post-war Period: the level of consumption and investment goes upward.
Scientific Development: increases income, employment and profit etc. and plays an
important part in the revival of economy.
Gold Discoveries: stimulate the volume of international trade and help in adjusting trade
deficit, loans etc. The rising income lead to expansion in economic activity.
Surplus, Exports and Foreign Aid: raise the level of consumption and investment spending
which helps in increasing output, income and employment level.
Weather: is an important factor which can cause economic activities. If in any year, weather
is good the output of agricultural sector will go upward.
Population Growth Rate: when it is higher than the economic growth rate, income level and
consumption expenditure and savings will be low 23
Three Types of Business Cycles
Short-term Medium-term Long-term
(Kitchin) cycle (Jouglar) cycle (Kondratiev) cycle
From 2 to 4 years, From 7 to 11 years, from 30 to 50
it results from the it refers to new years, it results
changes in business from the
business investment. technological
inventories. innovation.
24
Business Cycles as Shifts in AD
Business cycle generally occurs as a result of shifts in
the AD. Decline in the AD lowers output and as a result P AS
of downward shift in the AD curve, the gap between
QP
actual and potential GDP becomes greater during a
recession. AD
Characteristics of the recession: AD1
Consumers purchases decline and businesses react by
holding back production. Real GDP falls. Businesses
investment also falls. The demand for labor falls. The
prices of many commodities fall.
E
P
Wages are less likely to decline, but they tend rise less
rapidly. P1 E1
Business profit fall, because the demand for credit
falls, interest rates generally also falls. 0 Q1 Q
25
An Adverse Aggregate Demand Shock
An aggregate demand shock is a
change that shifts the aggregate
demand curve
The aggregate demand curve
shifts down and to the left
Short-run equilibrium occurs
where the aggregate demand
curve intersects the short-run
aggregate supply curve (at F);
output falls, price level is
unchanged
Long-run equilibrium occurs
where the aggregate demand
curve intersects the long-run
aggregate supply curve (at H);
output returns to its original
level, price level has fallen
26
An Adverse Aggregate Supply Shock
Classicals view aggregate supply shocks as the main
cause of fluctuations in output
An aggregate supply shock is a shift of the long-run
aggregate supply curve
Factors that cause aggregate supply shocks are
things like changes in productivity or labor supply
Initial long-run equilibrium at intersection of LRAS1
and AD, with full-employment output level 1
Aggregate supply shock reduces full-employment
output from 1 to 2, causing long-run aggregate
supply curve to shift left from LRAS1 to LRAS2
New equilibrium has lower output and higher
price level
So recession is accompanied by higher price level
27
Three Features of Business Cycles
Comovement Recurrent but not Persistence
periodic
1. Economic variables show 1. The business cycle is 1. The business cycle is
comovement--they have recurrent, but not persistent
regular and predictable periodic. 2. Declines are followed
patterns of behavior over the 2. Recurrent means the by further declines;
course of the business cycle. pattern of contraction- growth is followed by
2. The tendency of many trough-expansion-peak more growth
economic variables to move occurs again and again 3. Because of
together in a predictable way 3. Not being periodic persistence,
over the business cycle is means that it doesn't forecasting turning
called comovement. occur at regular, points is quite
predictable intervals important
28
Indicators of the Business Cycle
These indicators are divided into three main groups: leading indicators,
concurrent indicators and indicators delayed.
Leading Indicators Concurrent Indicators Delayed
indicators
The leading indicators we can Concurrent indicators help Delayed indicators
include in the stock market identifying the current phase mean decay of certain
indexes, the number of contracts of the business cycle, among cyclical phase. We can
(especially in sectors producing them we can include in e.g. examine the level
investment goods), the number the level of real GDP, of wages, retail sales
of building permits issued and unemployment rate, producer and consumer prices.
others. price index (PPI).
29
Business Cycle Facts: Direction & Timings
All business cycles have features in common
The cyclical behavior of economic variables--direction and
timing
Direction Timing
What direction does a variable move What is the timing of a variable's
relative to aggregate economic activity? movements relative to aggregate
 Procyclical: in the same direction economic activity?
 Countercyclical: in the opposite Leading: in advance
direction Coincident: at the same time
 Acyclical: with no clear pattern Lagging: after
30
Business Cycle Facts: Direction & Timings..
Direction Timing
1. A pro-cyclical variable moves in the 1. A leading variable’s turning points
same direction as aggregate occur before those of the business
economic activity. cycle.
2. A countercyclical variable moves in 2. A coincident variable’s turning
the opposite direction to aggregate points occur around the same time
economic activity. as those of the business cycle.
3. An acyclical variable does not 3. A lagging variable’s turning points
display a clear pattern over the occur later than those of the
business cycle. business cycle.
31
Business Cycle Facts
Macroeconomic Variable Direction Timing
Industrial Production Procyclical Coincident
Consumption Procyclical Coincident
Business Fixed Investment Procyclical Coincident
Residential Investment Procyclical Leading
Employment Procyclical Leading
Average Labor Productivity Procyclical Leading
Real Wages Procyclical Leading
Money Supply Procyclical Leading
Inflation Procyclical Lagging
Stock Prices Procyclical Leading
Nominal Interest Rates Procyclical Lagging
Real Interest Rates Acyclical --- 32
Cyclical Behavior of Variables
Cyclical behavior of key macroeconomic variables
◦ Procyclical
◦ Coincident: industrial production, consumption, business fixed investment,
employment
◦ Leading: residential investment, inventory investment, average labor productivity,
money growth, stock prices
◦ Lagging: inflation, nominal interest rates
◦ Timing not designated: government purchases, real wage
◦ Countercyclical: unemployment (timing is unclassified)
◦ Acyclical: real interest rates (timing is not designated)
◦ Volatility: durable goods production is more volatile than nondurable goods
and services; investment spending is more volatile than consumption
33
Business Cycle Fluctuations
What explains business cycle fluctuations?
◦TWO major components of business cycle theories
◦ A description of the shocks
◦ A model of how the economy responds to shocks
◦TWO major business cycle theories
◦ Classical theory
◦ Keynesian theory
◦Study both theories in aggregate demand-aggregate
supply (AD-AS) framework
34
Why should we know Business Cycle Facts?
1. Knowing the business cycle facts is useful for interpreting
economic data and evaluating the state of the economy.
2. They provide guidance and discipline for developing
economic theories of the business cycle – this is how the
theories are evaluated.
3. The facts also have important policy implications.
35
Business Cycle Theories
1. Keynesian theory is based on fluctuations in aggregate demand under the influence of fluctuations in
investment and consumption expenditures (employment is determined by the aggregate demand in the
short run).
2. Monetarist (monetary) theory explains the fluctuations of the economy through monetary illusion
caused by workers, respectively by their improper inflation expectations. Fluctuation causes in economic
activity have only monetarist (money) nature and are based on changes in the money supply.
3. Rational expectations theory justifies fluctuations in aggregate demand via misinterpretation of relative
prices development by economic entities. Economic fluctuations here are called “the equilibrium
business cycle”.
4. The theory of political business cycle is based on the assumption that the causes of fluctuations in
production represent interventionist actions of authorities, especially the use of the instruments of fiscal
and monetary policy.
5. The principle of the accelerator and multiplier. This theory is Keynesian approach with an emphasis on
capital expenditure. Acceleration principle is based on the relationship between the volume of output
produced and the capital required to produce products.
36
Business Cycle Theories..
External Theories Internal Neoclassical Keynesian Theories Political
Theories Theories Theories
The external theories The internal Neoclassical Keynesian theories Political
find the root of the theories look theories attribute fluctuations to theories of
business cycles in the for mechanism attribute the the economic system itself. business cycle
fluctuations of within the business cycle They think that the macro attribute
something outside economic to the economy is prone to fluctuations to
the economic system system itself expansion and extended business cycles, politicians who
(wars, revolutions, (self-generating contraction of with high levels of manipulate
elections, economic business money and unemployed resources for fiscal and
policy, migrations, cycles). credit. long period of time. They monetary
discoveries of new further hold that the policies in
lands and resources). government can stimulate order to be re-
the economy. elected.
37
Theory of Real Business Cycles
Theory of real business cycles focuses on the supply side of the economy.
The theory distinguishes between the initial impulse of expansion phase or
contraction phase of business cycle and business cycle inertia mechanism.
Business cycles are invoked by real external shocks. These are the factors
affecting particularly inputs productivity - technological change,
government spending, as well as climate change, etc.
The theory rejects the effects of changes in the nominal money supply
growth affecting the product.
Money is endogenous factor and its development adapts product
development and not vice versa.
38
Theory of Real Business Cycles..
This theory is an equilibrium business cycle theory.
The labor market is expected to exhibit only the existence of
voluntary unemployment.
 Product fluctuation is explained by changes in the volume of labor
employed.
 Supply of labor equals the labor demanded.
The economy operates at the level of potential output and
fluctuations in the economy mean the fluctuations of potential
output.
39
Labor Market
Employed: Currently working for pay
Unemployed: Out of who work, but actively looking
for work
Labor Force: Employed + Unemployed
Out of Labor Force: Out of who work, but not looking
for work
40
Unemployment
Unemployment and output are tightly linked – but
the link is not perfect
Unemployment is a lagging economic indicator
 Can be a mistaken guide to policy
 Rising GDP may be of little solace to those still without a job
Costs of unemployment not equally distributed
41
Unemployment - Definition
An unemployed person is any one who
is:
◦ Sixteen years old or older
◦ Out of who work
◦ Actively searching for work: he/she has made
specific efforts to find work during the
previous four weeks
42
Measuring Unemployment
43
Unemployment Rate
To find the Unemployment Rate, we use the following equation:
# 𝒐𝒇 𝒑𝒆𝒐𝒑𝒍𝒆 𝑼𝒏𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅
X 100
# 𝒐𝒇 𝒑𝒆𝒐𝒑𝒍𝒆 𝒊𝒏 𝒕𝒉𝒆 𝒄𝒊𝒗𝒊𝒍𝒊𝒂𝒏 𝑳𝒂𝒃𝒐𝒓 𝑭𝒐𝒓𝒄𝒆
For Example, if there are 7 million unemployed people. And there are 150 million people
in the civilian labor force, we have the following rate of Unemployment:
7 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
= .047 . 𝟎𝟒𝟕 𝑿 𝟏𝟎𝟎 = 𝟒. 𝟕% 𝑼𝒏𝒆𝒎𝒑𝒍𝒐𝒚𝒎𝒆𝒏𝒕
150 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
44
Duration of Unemployment
A spell of unemployment is a period in which an individual remains
continuously unemployed
The duration of unemployment is the average length of time a person
remains unemployed
45
Full Employment – a macroeconomic goal
Zero Unemployment is always impossible in a market economy.
But we strive for Full Employment where no cyclical unemployment exists
in the economy.
An unemployment rate of about 4-6 percent is normal during full
employment.
Full Employment means everyone who wants a job has a job.
But some of those people may be Underemployed meaning
they are working at a job below their skillset.
Example: An individual with a Master’s degree, unable to find
work in their field, and settling for a job at a brick kiln.
46
Types of Unemployment
1. Seasonal Unemployment
2. Cyclical Unemployment
3. Frictional Unemployment
4. Structural Unemployment
5. Technological Unemployment
6. Hidden Unemployment
47
#1. Seasonal Unemployment
Seasonal Unemployment: When industries slow or shut down
for a season of the year to make seasonal shifts in production
schedules and people lose their jobs.
◦ Examples: When people who sell Halloween costumes or
Christmas trees are out of a job because the holiday has
passed.
Seasonal unemployment: Unemployment due to seasonal
changes
◦ e.g., Tribhuvan, a ski instructor, loses his job when winter
ends.
48
#2. Cyclical Unemployment
Cyclical Unemployment:
Unemployment that goes up
during times of economic turmoil,
and goes down during times of
economic prosperity.
◦ Examples: A recession causes people
to save more and spend less, because
of this companies may slow down
production and lay off workers.
Unemployment due to labor lay-offs in a
recession
e.g., Vibhavari, an engineer, is let go as
her employer attempts to cut labor cost.
49
#3. Frictional Unemployment
Frictional unemployment: Unemployment due to
searching time for jobs and waiting time between jobs
e.g., Jay, just graduated from college, is looking for a

job that matches her qualifications
50
#4. Structural Unemployment
Structural unemployment: Unemployment due to
changes in the structure of the economy that result in a
loss of jobs in certain industries
e.g., Krishna, a farm laborer, lost his job due to mechanization.

He is getting trained to be a security officer.
51
#5. Technological Unemployment
Technological:
There is no doubt that improvements in technology have reduced
the demand for labour. However, one may expect with some degree
of optimism that in the long run improvements in technology and
the resultant increases in productivity will create jobs by leading to
an expansion of the economy.
52
# 6. Hidden Unemployment
Hidden unemployment is sometimes known as disguised unemploy-
ment.
It can take several forms. For example, during a temporary fall in
demand, employers may retain on their payrolls a great number of
employees than they can provide work for.
53
#7. Residual Unemployment
There is always a residue of unemployment, due to frictional and sea-
sonal causes, which planners and policy-makers cannot reduce. In
addition there are some people who are not willing to work but get
their names registered with employment exchanges in order to receive
compensation from the government.
This classification also includes those people who are unable to work
because of physical or mental disabilities.
The existence of residual employment makes it difficult to suggest an
accurate definition of full employment.
Monetarists like Phelps and Friedman use the term natural rate of
unemployment which is consistent with price level stability.
54
#8. Chronic Unemployment
This type of unemployment is mainly seen in undeveloped
countries. When a country is suffering long term of
unemployment on a whole, then it is known as chronic
unemployment.
Some of the main reasons of chronic unemployment are,
1. Weak economic condition
2. Lack of developed resources
3. High population growth
4. Primitive state of technology
5. Low capital formation, etc.
55
Natural Rate of Unemployment
Natural Rate of Unemployment: Unemployment that occurs as a normal
functioning of the economy.
NRU =
Frictional Unemployment + Structural Unemployment
Usually 4 to 5 percent of the labor force is searching for jobs, waiting

between jobs, or getting trained for new jobs.
Unemployment rate above the natural rate is considered to be cyclical,

e.g., 7.5% – 5% = 2.5%
56
Determinants of the Natural Rate of
Unemployment
The determinants of duration and frequency of unemployment are the basic determinants
of the natural rate of unemployment
Duration Frequency
The duration of unemployment depends on cyclical The frequency of unemployment is the
factors and on the following structural characteristics average number of times per period that
of the labor market: workers become unemployed
1. The organization of the labor market, including Two basic determinants of the frequency of
the presence or absence of employment agencies, unemployment:
youth employment services, etc. 1. Variability of the demand for labor
2. The demographic makeup of the labor force across different firms in the economy
3. The ability and desire of the unemployed to keep 2. The rate at which new workers enter
looking for a better job, which depends in part on the labor force, since new potential
the availability of unemployment benefits workers begin as unemployed workers
57
Causes of Unemployment
1. Recession
2. Reduced demand for goods and services
3. Low wages
4. Automation and new technologies
5. Seasonal variation
58
Effects of Unemployment
1. Few tax revenues
2. High supply side cost
3. Enhanced welfare cost
4. Lower wages
5. Surplus labor
6. Enhanced demand for inferior goods
7. Goods and services on less demand
8. Elevated training cost
9. Lower living standards
10. Loss of depression and confidence 59
Economic Impact of Unemployment
1. Loss of income
2. Negative multiplier effects
3. Loss of national output
4. Fiscal costs
5. Social costs
60
Impact of Unemployment on Individual
1. Loss of 2. Loss of 3. Loss of 4. Sense of 5. Health
Income Status social Guilt Problems
contacts
Financial Erodes self- Social Failed Depression
insecurity. esteem. isolation. themselves.
Anxiety
Stress / Decline in Social life and Let down
Worry about self- leisure their family. Stress
bills. confidence. restricted by
limited Alcohol
Fear of finance. abuse
poverty.
61
The Costs of Unemployment
Unemployed persons suffer both from their income loss and from
the related social problems that long periods of unemployment
cause
Costs of cyclical unemployment:
1. Okun’s law tells us that every 1 point increase in unemployment reduces output by 2
% points
2. Distributional impact of unemployment may be more dire for some groups than others
(Ex. Teenagers vs. older workers)
3. In addition to lost output from unemployment, there is reduced tax revenues
Social costs of unemployment:

1. Include increased divorce rates, suicide rates, and depression
62
Okun’s Law
The greatest cost of unemployment = lost
production
This cost is large: a recession can easily cost 3-
5% of GDP and hundreds of billions of dollars
Okun’s law states that 1 extra point of
unemployment costs 2% of GDP
Costs borne unevenly, largely by those who
lose their jobs
Workers just entering the labor force and
teenagers are amongst the hardest hit
63
Okun’s Law..
Okun’s law states that 1 extra point of
unemployment costs 2% of GDP
Period Unemployment Real GDP
Rate (%) (trillions of 2005
Dollars)
A 5 10.2
B 6 10.0
C 7 9.8
64
Policies to Reduce Supply Side Unemployment
1. Education and training
2. Reduce the power of trades unions
3. Employment subsidies
4. Improve labour market flexibility
5. Improved geographical mobility
6. Reducing occupational immobility
7. Benefit and tax reforms
65
Measures to Eradicate Unemployment
• Ensuring political stability
• Enhancing the educational standards
• Control of population growth in the nation
• Launch of new empowerment programs
• Encouraging self-employment/ entrepreneurship
• Ensuring access to basic education
• Reducing the age of retirement
• Avoid Laziness
• Being creative, positive and competitive
• Being positive to stop unemployment.
66
Keywords
Business Cycles • Demand induced cycle
Boom • Okun's Law
• Supply shocks theory
Peak
• Real business cycle
Recession theory
Contraction • Political theories of
Through business cycle
Recovery.
Business cycle facts: (a) Direction (b) Timings
67
Monetary Policy
1
Coverage
1.Objectives of Monetary Policy
2. Instruments of Monetary Policy:
1. Open market operation
2. Bank rate
3. Cash reserve ratio
4. Statutory liquidity ratio
5. Repo rate
6. Reverse repo rate
2
Coverage..
9. Marginal standing facility
10.Liquidity Adjustment Facility
11.Market Stabilization Scheme
12.Easing Vs. Tightening of Monetary Policy
13.Expansionary and Contractionary Monetary Policy
14.The Impact of Monetary Policy
15.Impact of demonetization on Indian economy.
3
Monetary Policy
Monetary policy is the macroeconomic policy laid down by the
central bank.
Monetary policy is the management of money supply and interest
rates by central banks to control prices and employment.
It involves management of money supply and interest rate and is the
demand side economic policy used by the government of a country
to achieve macroeconomic objectives like inflation, consumption,
growth and liquidity.
4
Monetary Policy: Characteristics
Goals
Intermediate Monetary Instruments

Targets Policy
Objectives
Objectives of Monetary Policy
The following points highlight the six main objectives of
monetary policy in India:
1.High employment
2.Economic growth
3.Price stability
4.Interest-rate stability
5.Stability of financial markets
6.Stability in foreign exchange markets
6
What is Monetary Policy in India?
According to RBI:
Monetary policy refers to the use of monetary instruments
under the control of the central bank to regulate magnitudes
such as interest rates, money supply and availability of credit
with a view to achieving the ultimate objective of economic
policy.
In India, monetary policy of the Reserve Bank of India is
aimed at managing the quantity of money in order to meet
the requirements of different sectors of the economy and to
increase the pace of economic growth.
7
Monetary Framework in India
Monetary policy refers to the policy of the central
bank with regard to the use of monetary instruments
under its control to achieve the goals specified in the
Act.
The Reserve Bank of India (RBI) is vested with the
responsibility of conducting monetary policy. This
responsibility is explicitly mandated under the
Reserve Bank of India Act, 1934.
8
The Goal(s) of Monetary Policy in India
The primary objective of monetary policy is to maintain price stability
while keeping in mind the objective of growth. Price stability is a
necessary precondition to sustainable growth.
The amended RBI Act also provides for the inflation target to be set by the
Government of India, in consultation with the Reserve Bank, once in every
five years.
The Central Government has notified in the Official Gazette 4 per cent
Consumer Price Index (CPI) inflation as the target for the period from
August 5, 2016 to March 31, 2021 with the upper tolerance limit of 6 per
cent and the lower tolerance limit of 2 per cent.
9
The Monetary Policy Framework
1. The amended RBI Act provides the legislative mandate to the Reserve Bank to operate the
monetary policy framework.
2. The framework aims at setting the policy (repo) rate based on an assessment of the current and
evolving macroeconomic situation; and modulation of liquidity conditions to anchor money
market rates at or around the repo rate.
3. Repo rate changes transmit through the money market to the entire the financial system, which,
in turn, influences aggregate demand – a key determinant of inflation and growth.
4. Once the repo rate is announced, the operating framework designed by the Reserve Bank
envisages liquidity management on a day-to-day basis through appropriate actions, which aim at
anchoring the operating target – the weighted average call rate (WACR) – around the repo rate.
5. The operating framework is fine-tuned and revised depending on the evolving financial market
and monetary conditions, while ensuring consistency with the monetary policy stance.
10
Monetary Policy Committee (MPC)
Section 45ZB of the amended RBI Act, 1934 also provides for an empowered six-
member monetary policy committee (MPC) to be constituted by the Central
Government .
The MPC determines the policy interest rate required to achieve the inflation target.
The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating
the monetary policy. Views of key stakeholders in the economy, and analytical work of
the Reserve Bank contribute to the process for arriving at the decision on the policy
repo rate.
The Financial Markets Operations Department (FMOD) operationalises the monetary
policy, mainly through day-to-day liquidity management operations. The Financial
Markets Committee (FMC) meets daily to review the liquidity conditions so as to
ensure that the operating target of the weighted average call money rate (WACR).
11
Monetary Policy Committee (MPC)
The MPC is required to meet at least four times in a year.
The quorum for the meeting of the MPC is four members.
Each member of the MPC has one vote, and in the event of an
equality of votes, the Governor has a second or casting vote.
Once in every six months, the Reserve Bank is required to
publish a document called the Monetary Policy Report to
explain:
a) the sources of inflation; and
b) the forecast of inflation for 6-18 months ahead.
12
Instruments of Monetary Policy
1. Repo Rate 6. Bank Rate
2. Reverse Repo Rate 7. Cash Reserve Ratio (CRR)
3. Liquidity Adjustment Facility 8. Statutory Liquidity Ratio (SLR)
(LAF)
4. Marginal Standing Facility 9. Open Market Operations
(MSF) (OMOs)
5. Corridor 10. Market Stabilisation Scheme
(MSS)
13
#1. Repo Rate
Repo Rate: The (fixed) interest rate at which the Reserve
Bank provides overnight liquidity to banks against the
collateral of government and other approved securities
under the liquidity adjustment facility (LAF).
14
#2. Reverse Repo Rate
Reverse Repo Rate: The (fixed) interest rate at which the
Reserve Bank absorbs liquidity, on an overnight basis, from
banks against the collateral of eligible government securities
under the LAF.
15
#3. Liquidity Adjustment Facility (LAF)
Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well
as term repo auctions.
Progressively, the Reserve Bank has increased the proportion of
liquidity injected under fine-tuning variable rate repo auctions of range
of tenors.
The aim of term repo is to help develop the inter-bank term money
market, which in turn can set market based benchmarks for pricing of
loans and deposits, and hence improve transmission of monetary policy.
The Reserve Bank also conducts variable interest rate reverse repo
auctions, as necessitated under the market conditions.
16
#4. Marginal Standing Facility (MSF)
Marginal Standing Facility (MSF): A facility under which scheduled
commercial banks can borrow additional amount of overnight
money from the Reserve Bank by dipping into their Statutory
Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest.
 This provides a safety valve against unanticipated liquidity shocks to
the banking system.
17
#5. Corridor
Corridor: The MSF rate and reverse repo rate determine the corridor for the daily
movement in the weighted average call money rate.
An interest rate corridor or a policy corridor refers to the range within which the
operating target of the monetary policy - a short term interest rate, say the
weighted average call money market rate - moves around the policy rate
announced by the central bank.
The policy rate is set within a corridor charted by
◦ A standing collateralised marginal lending facility available throughout the
day at a rate higher than the Policy rate that provides the upper bound; and
◦ A standing uncollateralised deposit facility at a rate lower than the Policy rate
that provides the lower bound to the corridor.
18
#6. Bank Rate
Bank Rate: It is the rate at which the Reserve Bank is ready to buy or
rediscount bills of exchange or other commercial papers.
This rate has been aligned to the MSF rate and, therefore, changes
automatically as and when the MSF rate changes alongside policy repo rate
changes.
Bank rate is also called discount rate because
bank provide finance to the commercial bank
by rediscounting the bills of exchange.
When central bank raises the bank rate, the
commercial bank raises their lending rates, it
results in less borrowings and reduces money
supply in the economy.
19
#7. Cash Reserve Ratio (CRR)
Cash Reserve Ratio (CRR): The average daily balance that a bank is
required to maintain with the Reserve Bank as a share of such per
cent of its Net demand and time liabilities (NDTL) that the Reserve
Bank may notify from time to time in the Gazette of India.
Increase in the CRR leads to the contraction of credit
Decrease in the CRR leads to the expansion of credit and banks
tends to make more money available to borrowers.
20
#8. Statutory Liquidity Ratio (SLR)
Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is
required to maintain in safe and liquid assets, such as, unencumbered
government securities, cash and gold.
Changes in SLR often influence the availability of resources in the
banking system for lending to the private sector.
Increase in the SLR leads to the contraction of credit
Decrease in the SLR leads to the expansion of credit and banks tends
to make more money available to borrowers.
21
#9. Open Market Operations (OMOs)
Open Market Operations (OMOs): These include both, outright purchase and sale of
government securities, for injection and absorption of durable liquidity, respectively by
central bank of the country.
The sale of security by the central bank leads to contraction of credit and purchase there
of to credit expansion.
OMO is used to wipe out shortage/excess of Money in Money Market, to influence the
term and structure of interest rate and to stabilize the market for government securities.
When RBI sells securities in open market, commercial banks and public buy it. This reduces
the existing money supply as money gets transferred from the Commercial Banks to RBI.
When RBI buys securities from commercial banks in open market, commercial banks sell it
and get back the money they had invested in them, thereby increasing the existing money
supply.
22
#10. Market Stabilisation Scheme (MSS)
Market Stabilisation Scheme (MSS): This instrument for monetary
management was introduced in 2004.
Surplus liquidity of a more enduring nature arising from large capital
inflows is absorbed through sale of short-dated government
securities and treasury bills.
The cash so mobilised is held in a separate government account with
the Reserve Bank.
23
The Monetary Policy Process
1. The Monetary Policy Committee (MPC) constituted by the Central
Government under Section 45ZB determines the policy interest rate
required to achieve the inflation target.
2. The Reserve Bank’s Monetary Policy Department (MPD) assists the
MPC in formulating the monetary policy. Views of key stakeholders
in the economy, and analytical work of the Reserve Bank contribute
to the process for arriving at the decision on the policy repo rate.
3. The Financial Market Committee (FMC) meets daily to review the
liquidity conditions so as to ensure that the operating target of
monetary policy (weighted average lending rate) is kept close to the
policy repo rate.
24
Selective Credit Control
1. Rationing of credit
2. Margin Requirement
3. Variable interest rates
4. Regulation of consumer credit
5. Moral Suasion
25
Expansionary Monetary
Policy in a Recessionary Gap
1. If the central bank is combatting a
recessionary gap, it can increase the
money supply, which leads to a
change in aggregate demand from
AD1 to AD2.
2. The result is greater RGDP of a
higher price level.
3. The expansionary monetary policy
has moved the economy to the
natural rate (where RGDP 5
potential GDP).
26
Contractionary
Monetary Policy
in an Inflationary Gap
1. If the central bank is
combatting an inflationary
gap at E1, it can decrease
the money supply, which
would lead to a change
from AD1 to AD2.
2. The result is a lower RGDP
and a lower price level at
E2, and the economy moves
to the natural rate (where
RGDP 5 potential GDP).
27
Expansionary vs. Contractionary
monetary policy
Expansionary monetary policy is monetary policy that increases aggregate demand.
Contractionary monetary policy is monetary policy that reduces aggregate demand.
28
Expansionary Monetary Policy
At times of Recession and unemployment
Expansionary monetary
policy is monetary policy 1. OMO – buys
that increases aggregate securities Money supply Investment
demand. 2. CRR - reduced increases increases
Expansionary monetary
policy reduces the 3. Bank Rate -
interest rate by reduced
increasing the money
supply. This increases
investment spending Aggregate output
and consumer spending,
increases by a Aggregate
which in turn increases demand
aggregate demand and multiple of the
real GDP in the short increase in investment increases
run.
29
Expansionary
Monetary
Policy to Fight
a
Recessionary
Gap
30
Contractionary Monetary Policy
At times of Inflation
Contractionary
monetary policy is 1. OMO – sells
monetary policy that
Interest
securities Money supply
reduces aggregate
decreases
rate
demand. 2. CRR & SLR - raised
increases
Contractionary 3. Bank Rate -
monetary policy raises reduced
the interest rate by
reducing the money
supply.
This reduces
Aggregate Investment
investment spending Price level
and consumer demand declines expenditure
spending, which in turn
falls declines
reduces aggregate
demand and real GDP
in the short run. 31
Contraction
ary
Monetary
Policy to
Fight an
Inflationary
Gap
32
Monetary Policy and the Multiplier
33
Monetary Targeting
Flexible, transparent, accountable
Advantages
◦ Almost immediate signals help fix inflation expectations and produce less
inflation
◦ Almost immediate accountability
Disadvantages
◦ Must be a strong and reliable relationship between the goal variable and the
targeted monetary aggregate
◦ Relies on stable money – inflation relationship
34
Inflation Targeting
1. Inflation targeting occurs when the central bank sets an explicit target for
the inflation rate and sets monetary policy in order to hit that target.
2. Public announcement of medium-term numerical target for inflation
3. Institutional commitment to price stability as the primary, long-run goal of
monetary policy and a commitment to achieve the inflation goal
4. Information-inclusive approach in which many variables are used in
making decisions
5. Increased transparency of the strategy
6. Increased accountability of the central bank
35
Inflation Targeting
Advantages
◦ Does not rely on one variable to achieve target
◦ Easily understood
◦ Reduces potential of falling in time-inconsistency trap
◦ Stresses transparency and accountability
Disadvantages
◦ Delayed signaling
◦ Too much rigidity
◦ Potential for increased output fluctuations
◦ Low economic growth during disinflation
36
Implicit Nominal Anchor
Forward looking and preemptive
Advantages
◦ Uses many sources of information
◦ Avoids time-inconsistency problem
◦ Demonstrated success
Disadvantages
◦ Lack of transparency and accountability
◦ Strong dependence on the preferences, skills, and trustworthiness of
individuals in charge
◦ Inconsistent with democratic principles
37
Money,
Output,
and
Prices in
the Long
Run
Potential output
38
Monetary Neutrality
Why economists believe in monetary neutrality — that monetary
policy affects only the price level, not aggregate output, in the long
run
In the long run, changes in the money supply affect the aggregate
price level but not real GDP or the interest rate.
In fact, there is monetary neutrality: changes in the money supply
have no real effect on the economy. So monetary policy is ineffectual
in the long run.
39
The Long-Run Relationship Between Money and
Inflation
 The horizontal axis measures the
annual percent increase in a
country’s money supply between
1970 and 2007.
 The vertical axis measures the
annual percent increase in a
country’s aggregate price level
over the same period.
 Each point represents a specific
country.
 The scatter of points lies close to a
45-degree line, demonstrating
that in the long run increases in
the money supply lead to roughly
equal percent increases in the
aggregate price level.
40
Source: OECD.
Key words
1. Monetary policy
2. Open market operation
3. Bank rate
4. Cash reserve ratio
5. Statutory liquidity ratio
6. Repo rate
7. Reverse repo rate
8. Marginal standing facility
9. Liquidity Adjustment Facility
10.Market Stabilization Scheme
41
Fiscal Policy
1
Coverage
1. Fiscal Policy
2. Objectives of Fiscal Policy
3. Types of Fiscal Policy
4. Discretionary Vs. Non-discretionary Fiscal Policy
5. Expansionary Vs. Contractionary Fiscal Policy
6. Fiscal instruments-Taxes, Public expenditure, Public borrowings.
7. Tax structure- Direct and Indirect tax.
8. Impact of GST on the Indian economy.
2
Coverage..
9. Role of Fiscal Policy during inflation and deflation
10.Laffer curve
11.Fiscal Policy and stabilization
12.Types of deficits
13.Public debt
14.Crowding-out effect.
3
Fiscal Policy
•Fiscal policy is the use of government taxes and spending to alter
macroeconomic outcomes.
•It is the manipulation of government purchases, transfer payments,
taxes, and borrowing in order to positively influence the economy
•Keynes argued that fiscal policies may be necessary to bring about full
employment
•Post World War experiences showed that government stimulus
package can work
•Examples of Fiscal policies are (i) Government purchases; (ii) Transfer
payments; (iii) Taxes
4
Objectives of Fiscal Policy
Fiscal Policy is designed to:
1) Achieve full-employment
2) Control inflation
3) Encourage economic growth
5
Goal #1 of Fiscal Policy: raise potential GDP
Supply-side economics
 taxes entail welfare loss
  tax rates on K and L incomes  enhanced incentives to invest and work
Implication: growth of permanent GDP= supply side phenomenon
 tax rates to be lowered to favor growth
Yet most people think that tax elasticity of investment and work
effort is rather low. If this correct, then fiscal policy left with goal #2
6
Goal #2: GDP stabilization
If supply-side effects are not there or small, then goal of fiscal policy is:
stabilize GDP
when economy overheated, fiscal policy should simply cool it down (by
G and T)
when in recession, fiscal policy should sustain GDP by either T or G
In both cases, fiscal policy meant to affect aggregate demand (by shifting
AD curve)
◦ By how much? It depends on the multiplier
Big issue: does fiscal policy really stabilize GDP?
7
Fiscal Policy..
Fiscal Policy can
◦ boost the level of economic activity if there is a shortage of
demand which is causing a deflationary gap (reflationary policy).
◦ reduce the level of economic activity if too much demand in the
economy is causing an inflationary gap (deflationary policy).
◦ Be used to improve incentives, e.g. through income tax cuts, or
to improve the quality of resources, such as increased
government expenditure on health and education and subsidies
to key areas (supply-side policy).
8
Expansionary Fiscal Policy Contracationary Fiscal Policy
9
Expansionary Fiscal Policy
To stimulate the economy when unemployment is greater than the
natural rate
An increase in government purchases, decrease in net taxes, or some
combination of the two aimed at increasing aggregate demand
A typical Keynesian policy during recession is to use discretionary fiscal
policies to stimulate the economy to a full employment equilibrium
It seeks to stimulate production (and consumption)
Directly (expenditures ↑)
Indirectly (taxes ↓ to encourage household spending or investment
spending)
10
Expansionary Fiscal Policy..
Expansionary $5 billion Recessions
increase in Decrease AD
Fiscal policy is spending
used during a AS
recession to: Full $20 billion
Price level
1. Increase increase in
aggregate demand
government P1
spending
2. Decrease taxes
3. Combination of AD1
both AD2
4. Create a deficit $490 $510
Real GDP (billions) 11
Contractionary Fiscal Policy
A decrease in government purchases, increase in net taxes, or some
combination of the two aimed at reducing aggregate demand
A response to inflation (economy is operating above full employment and
prices are rising)
It is used to slow down the economy when inflation is more than desired
It leads to reduction in interest rates
It seeks to reduce production (and consumption)
◦ Directly (expenditures ↓)
◦ Indirectly (taxes ↑ to discourage household or investment spending)
A politically difficult phenomenon
12
Contractionary Fiscal Policy..
$3 billion initial
Used during demand- decrease in
spending
pull inflation AS
1. Decrease
government spending
Price level
Full $12 billion
2. Increase taxes P2
d c b decrease in
aggregate demand
3. Combination of both a
P1
4. Create a surplus
AD4
AD
AD3 5
$502 $510 $522

Real GDP (billions) 13
Discretionary Vs. Non-discretionary Fiscal Policy
Discretionary Automatic Stabilizers
1. Policymakers change tax policies 1. Implemented without any deliberate action
or spending programs in from policymakers
response to fluctuations in the 2. Found in the tax system and spending
business cycle (at their programs
discretion) 3. Taxes are linked to economic activity
2. Government policies that require a) Progressive income tax rates (individual
ongoing decisions by policy and corporate)
makers b) Payroll taxes
3. Discretionary policy often has c) Sales and excise taxes
limited impacts on the economy. 4. Recessions → automatic “tax cut”
5. Expansion → automatic “tax increase”
14
Automatic or Built-In Stabilizers
Tax System Spending
1. Taxes are linked to economic 1. Government spending responds
activity to the business cycle
a) Progressive income tax rates a) Unemployment insurance
(individual and corporate) benefits
b) Payroll taxes b) Welfare benefits
c) Sales and excise taxes c) School lunch programs
2. Recessions → automatic “tax d) Other income-support
cut” programs
3. Expansion → automatic “tax 2. Recessions → more spending
increase” 3. Expansion → less spending
15
Automatic or Built-in Stabilizers
Structural features of
government spending and
taxation smooth out
fluctuations in booms and
busts
Example of automatic
stabilizers are
(i) Unemployment
payments;
(ii) Welfare;
(Iii) Other govt. programs
16
Built-In Stability
T
Government expenditures, G,
Automatic stabilizers
 Taxes vary directly with GDP
and tax revenues, T

 Transfers vary inversely with
GDP Surplus
G
Reduces severity of business Deficit
fluctuations
Tax progressivity
◦ Progressive tax system
◦ Proportional tax system
◦ Regressive tax system
GDP1 GDP2 GDP3
Real domestic output, GDP
17
Discretionary Fiscal Policy
1. Do lag effects influence discretionary fiscal policies?
Answer: Yes, they weaken fiscal policies as a tool of economic
stabilization
2. Is there an effect of politics?
Answer: There is always the danger that politicians can use
discretionary fiscal policies to suit their short term political goals
18
Fiscal Policy Instruments
Taxes Subsidies Government Crowding
Expenditure Out
1. Can be targeted 1. Research and 1. Can be targeted: During periods of
2. Reduces overall development welfare for full employment
consumption 2. Activities corporations or for the government
3. Stabilize economy that provide the poor? can borrow
4. Can have positive 2. Public goods or money that
important impact externalities:
private goods? What otherwise would
on scale 'subsidize
offers highest be spent or
goods, not
bads' marginal benefits? invested
3. Investments in
human made vs.
natural
19
Government Expenditure
Government expenditure, also known as government spending, refers to the
resources a government allocates to achieve its strategic objectives and satisfy
the needs of the members of the nation.
Governments spend money on health care, education, Social Security benefits,
infrastructure and defence activities.
Annual government budgets specify the breakdown of funds for a fiscal year.
Total government expenditure includes federal government expenditure, as well
as state and local government expenditure.
Economists classify government expenditure into two main types: transfer
payments and purchase of services and goods.
20
Types of Government Expenditure
Government final Capital Expenditures or Fixed Capital Transfer payments
consumption Formation
expenditure
Current Expenditures Capital Expenditures or fixed capital Transfer payments -
or Government final formation (or government investment) - spending that does not
consumption government spending on goods and services involve transactions of
expenditure on goods intended to create future benefits, such goods and services, but
and services for current as infrastructure investment in transport instead represent
use to directly satisfy (roads, rail airports), health (water collection transfers of money, such
individual or collective and distribution, sewage systems, as social security
needs of the members communication (telephone, radio and tv) and payments, pensions and
of the community research spending (defence, space, genetics). unemployment benefit.
21
Public Expenditure
Public Expenditures
Government
Transfers (Tr)
Expenditures (G)
22
Public Expenditure..
Current expenditure Capital Expenditure
1. Current expenditure is expenditure on goods 1. Capital expenditure
and services consumed within the current measures the value of
year.
purchases of fixed assets,
2. Current expenditure includes final
consumption expenditure, property income i.e. those assets that are
paid, subsidies and other current transfers used repeatedly in
(e.g., social security, social assistance, production processes for
pensions and other welfare benefits). more than a year.
3. Goods And Services 2. The value is at full cost
4. Interest Payments
price.
5. Subsidies
6. Transfers 3. Sales of fixed assets are not
deducted.
23
Crowding Out Effect
Crowding out effect is a situation when increased interest rates lead to a
reduction in private investment spending such that it dampens the initial
increase of total investment spending.
When the government adopts an expansionary fiscal policy stance and
increases its spending to boost the economic activity, it leads to an increase in
interest rates. Increased interest rates affect private investment decisions. A
high magnitude of the crowding out effect may even lead to lesser income in
the economy.
With higher interest rates, the cost for funds to be invested increases and
affects their accessibility to debt financing mechanisms. This leads to lesser
investment ultimately and crowds out the impact of the initial rise in the total
investment spending.
24
Crowding Out Effect
16
The tendency of 14
Real interest rate (percent)

expansionary fiscal policy 12
Increase in
investment
to cause a decrease in 10
b c demand
planned investment or 8
planned consumption in 6
a
Crowding-out
the private sector; this 4 effect
ID2
decrease normally results 2
ID1
from the rise of interest 0 5 10 15 20 25 30 35 40
rates. Investment (billions of dollars)
25
Crowding Out Effect
 Private sector spending is
‘crowded-out’ by the
government’s deficit spending.
 The crowding out effect refers
to a situation of high
government expenditure
supported by high borrowing
causes decrease in private
expenditure. Or in other
words, when the government
is increasing its expenditure,
private expenditure comes
down.
26
The Crowding-Out Effect, Step by Step
27
Illustrating the Crowding-out Effect
Interest rates paid by private borrowers in a nation are a primary determinant of the
levels of savings, investment, and consumption. The market in which private interest
rates is illustrated is called the loanable funds market.
The Loanable Funds Market: A nation's loanable funds market represents

the money in commercial banks that is available to be loaned out to firms
and households to finance private investment and consumption.
• The price of loanable funds is the real interest rate
• The market shows relationships between real returns on savings and
real price of borrowing and the private sector's willingness to save and
invest.
• The supply curve represents household savings
 At higher interest rates, households save more
 At lower rates, households save less
• The demand curve represents investment

 At higher interest rates, firms invest less
 At lower interest rates, firms invest more
28
Crowding-out Effect in the Loanable
Funds Market
When a government borrows in order to finance a budget deficit, it must increase
the interest rates on its bonds in order to attract more lenders.
• Higher rates on government debt will lead households to take their savings
out of private banks and lend it to government instead
• This causes the supply of loanable funds to decrease, leading to

higher borrowing costs in the private sector.
 Before the expansionary fiscal policy, the level investment was
Qpr.
 Higher interest rates on government bonds cause the supply of
loanable funds to decrease to S1.
 Less money in banks leads to higher interest rates. The quantity
funds demanded for private investment falls to Qp.
 Overall spending increases to Qg, but there is a decrease in
private investment of Qp-Qpr
Private sector spending is ‘crowded-out’ by the government’s deficit
spending. This means AD will not increase by as much as the spending
multiplier would predict. 29
Crowding-out Effect in the AD/AS Model
Let us say a government increases spending by $100
million, without raising taxes. This money must be
borrowed. Assume the multiplier is 4.
The fiscal policy should lead to an increase in AD of $400
million. However…
• If the government’s borrowing reduces the supply of
funds available to the private sector, then higher interest
rates might cause private investment to fall, therefore,
• The total increase in AD will be less than that which was
predicted by the multiplier.
 To reach full employment, AD would have to
increase to AD1.
 But due to crowding-out, it only increases to AD2.
A much larger stimulus would be needed than the multiplier
predicts, further increasing national debt!
30
Evaluating the Crowding-out Effect
During deep recessions: During mild recessions:
Crowding-out is unlikely to occur; private sector Crowding-out is more likely to occur; resources are close
investment is already deeply depressed. There is very to being fully-employed, and private sector spending is
little spending to crowd out, and government should be relatively high. Government will have to offer higher
able to borrow without raising interest rates by much rates to attract lenders, which could cause private
investment to fall
LRAS SRAS
LRAS PL
PL SRAS
Pfe
Pfe
P2
AD1
P2 AD1
AD2
$100 million
$500 million AD2
Y2 Yfe real GDP
Y2 Yfe real GDP
31
Fiscal Policy Lag Effects
1. Recognition lag
The time required to gather information about the current state of the
economy
2. Decision lag
The time required to take a decision after recognizing the current state of the
economy
3. Action lag
The time required between recognizing an economic problem and putting
policy into effect
4. Effect Time lag
The time it takes for a fiscal policy to affect the economy
32
Three Pillars of Keynesian Economics
1. Liquidity Trap:
A lack of borrowing keeps money bottled up in savings institutions. A
Keynesian solution to a liquidity trap is that Government borrows the
money that consumers and business do not borrow.
2. Balanced Budget Multiplier:
When the government taxes and spends the money there is a multiple
effect because of no savings
3. Paradox of thrift:
The more people save, the less will be demand, which leads to slow
growth
33
How fiscal policy affects business?
Businesses directly experience the effects of fiscal policy whether it's in the form
of spending or taxation.
Businesses can foresee investment opportunities from government spending as
well as private investment. This commonly happens during an expansionary policy,
when more money is flowing into the economy from the government and from
other sources since taxation is also low.
When a balance between price and demand are met, then businesses can expect
to thrive and grow.
A contractionary financial policy may kick in to prevent inflation when that
balance is broken and demand and prices fall. Businesses typically reign in their
growth due to rising taxes and take measures to stay in the black with less money
flowing through the economy.
34
How effective are fiscal policies?
Automatic or built-in stabilizers are more effective than are
discretionary fiscal policies
The stronger and more effective the automatic stabilizers
are, the less need there is for discretionary fiscal policies
35
Does fiscal policy really stabilize GDP?
Three possible reasons for why this may not be
the case
1. Political delays
2. Ricardian equivalence
3. Crowding out
36
Reasons why fiscal policy may not stabilize GDP?
Political delays Ricardian equivalence Crowding Out
‘Right’ fiscal policy Robert Barro Suppose G to counteract recession; expect
stance hardly If T temporary, effects on AD very large effect on AD (shift of AD)?
No, if other AD items ‘crowded out’
delivered when small How is G financed? Suppose G financed by
needed. Approval Why? DEF
takes time If tax cut is “temporary”, then people  DEF  price of T-bonds and interest rates
 I (private investment)
When tax cuts to would save additional income overall effect on AD dampened
sustain GDP obtain from tax cut, rather than By how much, it depends on how responsive
Parliament consume it investment and savings are to interest rates
With today’s high K mobility, only if large
approval, it may be If G has not been cut in parallel, I economy (e.g USA, Euroland or OECD) runs
too late expect taxes up tomorrow & a large DEF will it have an impact on world
save to meet future tax interest rates; unlikely to work for small
If approved and economies in isolation
obligations
implemented late, if G financed by T: T  C, effect on AD
risk of GDP de- Hence AD stays where it is dampened either
stabilization If Barro is right, changing tax rates If crowding out important, stabilizing role of
does not stabilize GDP fiscal policy may not be there
37
Ricardian Equivalence
Ricardian equivalence suggests that when a government tries to
stimulate an economy by increasing debt-financed government
spending, demand remains unchanged.
Aggregate Demand (AD) remains unchanged due to the fact that the
public saves its excess money to pay for expected future tax increases
that will be used to pay off the debt.
Ricardian Equivalence holds if taxation and government borrowing
both have the same effect on spending in the private sector.
Ricardian equivalence theory was developed by David Ricardo in the
19th century but was revised by Harvard professor Robert Barro into a
more elaborate version of the same concept.
38
Two arguments for Fiscal Policy
Efficiency Equity
Efficiency refers to the Equity refers to the
collective well being of distribution of well being
an economy. across individual in an
economy.
Can we use fiscal policy to
Can we use fiscal policy to
redistribute income in a “fair”
increase aggregate income?
way?
39
Fiscal Policy - Challenges
1. Political factors
2. Time lags
a) Time required to create and pass legislation
b) Time required to implement legislation
3. Supply side impacts
4. Forecasting difficulties
5. Monetary policies may reinforce or offset fiscal policies
40
Taxes
A tax may be defined as a "pecuniary burden laid upon
individuals or property owners to support the
government, a payment exacted by legislative
authority.”
A tax "is not a voluntary payment or donation, but an
enforced contribution, exacted pursuant to legislative
authority".
Taxes: Direct and Indirect
Direct Taxes are Income Tax; Corporation Tax; Property
Tax; Inheritance (Estate) Tax; Gift Tax.
Indirect Taxes are Goods and Services Tax; Customs Duty
41
Tax structure- Direct and Indirect tax
Direct Taxes Indirect Taxes
1. A Direct tax is a kind of charge, 1. An indirect tax is a tax collected by an
which is imposed directly on the intermediary (such as a retail store) from the
taxpayer and paid directly to the person who bears the ultimate economic
government by the persons (juristic burden of the tax (such as the customer).
or natural) on whom it is imposed. 2. An indirect tax is one that can be shifted by the
2. A direct tax is one that cannot be taxpayer to someone else.
shifted by the taxpayer to someone 3. An indirect tax may increase the price of a good
else. so that consumers are actually paying the tax
3. The some important direct taxes by paying more for the products.
imposed in India are as under: 4. The some important indirect taxes imposed in
Income Tax; Corporation Tax; India are as under: Goods and Services Tax;
Property Tax; Inheritance (Estate) Customs Duty
Tax; Gift Tax.
42
Nature of Taxes
Regressive
• % of income paid in taxes ↓ as income ↑
Progressive
• % of income paid in taxes ↑ as income ↑
Proportional
• % of income paid in taxes is fixed as income
changes
43
Benefits of GST
1 Reduction in Cascading of Taxes
Decrease in
2 Overall Reduction in Prices Inflation
3 Common National Market

Ease of Doing
4 Benefits to Small Taxpayers Business
5 Self-Regulating Tax System

Decrease in “Black”
Non-Intrusive Electronic Tax System Transactions
6
44
Benefits of GST ..
7 Simplified Tax Regime
More informed
8 Reduction in Multiplicity of Taxes consumer
9 Consumption Based Tax

Poorer States
10 Abolition of CST to Gain
11 Exports to be Zero Rated

Make in India
12 Protection of Domestic Ind. - IGST
45
Central Taxes
Multiple State Taxes Single Tax-GST
Tax Multiple State Tax Single Tax
Administrations Administrations
Administration
CEx/ST Act & Rules Multiple Acts & Rules
Uniform law
Procedures Multiple procedures
Computerized
uniform procedures
Pre-GST Indirect tax structure in India
GST
GST
CGST
CGST SGST/UTGST
SGST/UTGST IGST
IGST
GST Structure in India

Goods and Services Tax
“Goods and services tax” means any tax on supply of goods, or services or both
except taxes on the supply of the alcoholic liquor for human consumption. (w.e.f 1
July, 2017)
GST includes Central Excise duty, Duties of Excise (medicinal and toilet preparations),
Additional Duties of Excise (goods of special importance), Additional Duties of Excise
(textile and textile products), Additional Duties of Customs, Special Additional Duties
of Customs, Service Tax, and Central surcharges and cesses.
The State taxes subsumed under GST include State VAT, Entry Tax, Central Sales Tax,
Entertainment and Amusement Tax, Luxury Tax, Purchase Tax, Taxes on
advertisements.
GST have been categorised under four tax slabs, viz. 5%, 12%, 18%, and 28%.
47
Benefits of GST
1 Reduction in Cascading of Taxes
Decrease in
2 Overall Reduction in Prices Inflation
3 Common National Market

Ease of Doing
4 Benefits to Small Taxpayers Business
5 Self-Regulating Tax System

Decrease in “Black”
Non-Intrusive Electronic Tax System Transactions
6
48
Benefits of GST ..
7 Simplified Tax Regime
More informed
8 Reduction in Multiplicity of Taxes consumer
9 Consumption Based Tax

Poorer States
10 Abolition of CST to Gain
11 Exports to be Zero Rated

Make in India
12 Protection of Domestic Ind. - IGST
49
What is Laffer Curve?
The Laffer Curve describes the relationship between the tax rate and the tax
revenue it generates
The Laffer Curve implies there is an “optimal” tax rate, a tax rate that
maximizes tax revenue.
The Laffer curve is the graphical representation of the relationship
between tax rates and absolute revenue these rates generate for the
government.
The principle thought behind the Laffer curve is that a zero tax rate would
produce zero revenue and a 100% tax rate would also generate zero revenue,
as there would be no incentive to work. This means there must be an optimal
tax rate that will yield maximum revenue for the government.
The Laffer curve gets its name from economist Arthur Laffer
50
Laffer curve
A curve that shows that
starting from zero an
increase in taxes will
raise revenue but beyond
a point an increase will
lower revenues
51
Laffer Curve..
What is the case in India?
Although the current rate of taxes in India is considered moderate, it is felt that
lowering the tax rate will increase compliance further, particularly in the case of
individuals.
What is the case around the world?
A recent paper of the European Central Bank says that the US could increase tax
revenues by as much as 30% by raising labour taxes or tax on income and 6% by
raising capital income taxes or tax on business.
For a select 14 countries of the EU, the benefit from rate hike can be only 8% and 1%,
respectively.
The study notes that Denmark and Sweden are on the wrong side of the Laffer curve
for capital income taxation.
52
Measuring Fiscal Policy’s Effects
Effects are not limited to the initial dollar value of the change in
policy
The eventual effects may be larger or smaller, depending on:
1. Multiplier effect
2. Crowding-out effect
Fiscal operations
Fiscal operations are actions taken by the government to
implement budgetary policies, such as revenue and expenditure
measures, as well as issuance of public debt instruments and
public debt management.
53
Budget Lingo
Balanced budget
• Revenues = Expenditures
Budget deficit
• Revenues < Expenditures
Budget surplus
• Revenues > Expenditures
Government debt
• Sum of all deficits – Sum of all surpluses
54
Budget Glossary
Revenue Receipts:
The earnings made by the government which neither create liabilities or reduce assets
of the government. For example, receipts from tax collections, interest on investments,
dividend earnings and earnings from services provided.
Capital Receipts:
The earnings made by the government which creates liabilities (borrowing from the
public in form of PPF and small saving deposits, National Pension Scheme etc. ) or
reduce assets (divesting stake in a particular company, called disinvestment or
recovering loans made to state governments.)
Non-debt Capital Receipts
These are capital receipts which do not create debt for the government such as
recovery of loans made and selling a stake in a public company.
55
Budget Glossary..
Revenue expenditure:
It is the expenditure made by the government on a recurring basis such as
administrative expenses, interest payments on loan taken by the
government, pensions, subsidies etc.
Capital expenditure:
It is a productive, asset-creating (or liability reducing) long-period, non-
recurring expenditure of the government. For example; expenditure on
creating the infrastructure (roads, electricity dams etc.), loans made to
state governments and repayment of loans by the central government
(reducing liability).
56
Budget Glossary…
Gross Fiscal Deficit (GFD):
GFD of the government is the difference between the total expenditure incurred and the
total non-debt capital receipts (total receipts minus the earnings from borrowing) of the
government. GFD indicates the total borrowing requirements (incl. the need for interest
payments) of the government.
Revenue Deficit (RD):
RD is the difference between the revenue receipts and the revenue expenditure of the
central government. RD indicates the excess amount of expenditure by the government to
fund current consumption needs rather than for productive asset-creation.
Gross Primary Deficit (GPD):
GPD is the difference between the fiscal deficit of the current year and the interest
payments on the previous borrowings made by the government. GPD indicates how much
of the government borrowing is going to meet expenses other than interest payments.
57
Gross Budgetary Support
The government’s support to the Central plan is called Gross Budgetary Support.
The Central plan forms the annual expenditure of the government and is
incurred keeping the objectives of 5-year plans in mind.
Budgetary Support is earmarked for meeting the planned outlays of the Central
government during the financial year.
Plan outlays are incurred for development of heterogeneous sectors like
agriculture and allied activities, rural areas, irrigation and flood control, energy,
industry and minerals, transport, communications, science, technology and
environment, social services like education, mid day meal scheme, Sarva Shiksha
Abhiyan, health, housing, police, justice administration etc.
58
Fiscal Deficit
Fiscal Deficit is the difference between total revenue and total expenditure of the government.
Fiscal Deficit is an indication of the total borrowings needed by the government.
While calculating the total revenue, borrowings are not included.
The gross fiscal deficit (GFD) is the excess of total expenditure including loans net of recovery over
revenue receipts (including external grants) and non-debt capital receipts. The net fiscal deficit is the
gross fiscal deficit less net lending of the Central government.
Generally fiscal deficit takes place either due to revenue deficit or a major hike in capital expenditure.
Capital expenditure is incurred to create long-term assets such as factories, buildings and other
development.
A deficit is usually financed through borrowing from either the central bank of the country or raising
money from capital markets by issuing different instruments like treasury bills and bonds.
Fiscal consolidation is a policy aimed at reducing government deficits and debt accumulation.
59
Fiscal Deficit - classification
Gross Fiscal Deficit (GFD) Net Fiscal Deficit
The gross fiscal deficit (GFD) is The net fiscal deficit is the gross
the excess of total expenditure fiscal deficit less net lending of
including loans net of recovery the Central government.
over revenue receipts (including
external grants) and non-debt
capital receipts.
60
Deficit Types
Deficit Types
Revenue deficit = Fiscal deficit =

Primary deficit =
Total revenue Total expenditure – Total Fiscal deficit-Interest
expenditure – Total receipts excluding payments
revenue receipts borrowings
61
India - Budget at a Glance
India Budget at a Glance (In INR crore)
2016-2017 2017-2018 2017-2018 2018-2019
Actuals Budget Estimates Revised Estimates Budget Estimates
1Revenue Receipts 1374203 1515771 1505428 1725738
2. Tax Revenue 1101372 1227014 1269454 1480649
(Net to Centre)
3. Non-Tax Revenue 272831 288757 235974 245089
4Capital Receipts 600991 630964 712322 716475
5. Recovery of Loans 17630 11933 17473 12199
6. Other Receipts 47743 72500 100000 80000
7. Borrowings and Other Liabilities 535618 546531 594849 624276
8Total Receipts (1+4) 1975194 2146735 2217750 2442213
9Total Expenditure (10+13) 1975194 2146735 2217750 2442213
10On Revenue Account 1690584 1836934 1944305 2141772
of which
11Interest Payments 480714 523078 530843 575795
12Grants in Aid for creation
of capital assets 165733 195350 189245 195345
13On Capital Account 284610 309801 273445 300441
62
India Budget –Deficits at a Glance (In INR crore)
2016-2017 2017-2018 2017-2018 2018-2019
Actuals Budget Estimates Revised Estimates Budget Estimates
Revenue Deficit 316381 321163 438877 416034

-2.1 -1.9 -2.6 -2.2
Effective Revenue Deficit 150648 125813 249632 220689
-1 -0.7 -1.5 -1.2
Fiscal Deficit 535618 546531 594849 624276
-3.5 -3.2 -3.5 -3.3
Primary Deficit 54904 23453 64006 48481
-0.4 -0.1 -0.4 -0.3
63
India – Deficit Trends
 Gross Primary Deficit is Gross Fiscal Deficit
less interest payments.
 Net Primary Deficit is Net Fiscal Deficit minus
net interest payments.
 Net interest payment is interest paid minus
interest receipt.
 While fiscal deficit is the difference between
total revenue and expenditure, primary deficit
can be arrived by deducting interest payment
from fiscal deficit.
 Interest payment is the payment that a
government makes on its borrowings to the
creditors
64
Deficit
Deficit occurs when government spending (purchases &
transfers) exceeds tax receipts
Primary deficit is one of the parts of fiscal deficit.
While Fiscal Deficit is the difference between total
revenue and expenditure, Primary Deficit can be arrived
by deducting interest payment from fiscal deficit.
Interest payment is the payment that a government
makes on its borrowings to the creditors
65
Budget Deficit and Debt
• Budget deficit (DEF) = G + Ig + Tr + iD-1– T G = Govt purchases of goods and
• DEF goes up in recessions and down in booms services (for education, justices,
defense)
 Why? In recession: Tr and T (why?) Ig = public investment (for roads,
 Hence: in recession, DEF. The opposite during highways)
Tr = transfers (pensions, assistance
booms
to the poor). Tr  G or Ig: doesn’t
 Structural DEF computed as if GDP were at its have to do with provision of goods
potential and services
iD-1 = interest payments on
• Balanced budget: DEF=0, G + + Ig Tr + iD-1 = T
outstanding debt (another type of
• Primary deficit = (G + Ig + Tr – T) transfers)
T = indirect taxes (e.g. VAT) + direct
• Deficit is not debt: debt = sum of current and past
taxes (personal & corporate taxes) +
deficits social security contributions
66
India
Deficit Financing
67
Deficit
Deficit occurs when government spending (purchases &
transfers) exceeds tax receipts
Primary deficit is one of the parts of fiscal deficit.
While Fiscal Deficit is the difference between total
revenue and expenditure, Primary Deficit can be arrived
by deducting interest payment from fiscal deficit.
Interest payment is the payment that a government
makes on its borrowings to the creditors
68
Fiscal Consolidation
Fiscal consolidation is a process where government’s fiscal health is getting
improved and is indicated by reduced fiscal deficit.
Improved tax revenue realization and better aligned expenditure are the
components of fiscal consolidation as the fiscal deficit reaches at a
manageable level.
Fiscal consolidation is a reduction in the underlying fiscal deficit. It is not
aimed at eliminating fiscal debt
In India, fiscal consolidation or the fiscal roadmap for the centre is
expressed in terms of the budgetary targets (fiscal deficit and revenue
deficit) to be realized in successive budgets.
The Fiscal Responsibility and Budget Management (FRBM) Act gives the
targets for fiscal consolidation in India.
69
Fiscal Consolidation
Fiscal consolidation is a process where government’s fiscal health is getting
improved and is indicated by reduced fiscal deficit.
Improved tax revenue realization and better aligned expenditure are the
components of fiscal consolidation as the fiscal deficit reaches at a
manageable level.
Fiscal consolidation is a reduction in the underlying fiscal deficit. It is not
aimed at eliminating fiscal debt
In India, fiscal consolidation or the fiscal roadmap for the centre is
expressed in terms of the budgetary targets (fiscal deficit and revenue
deficit) to be realized in successive budgets. The Fiscal Responsibility and
Budget Management (FRBM) Act gives the targets for fiscal consolidation in
India.
70
What is FRBM Act?
The Fiscal Responsibility and Budget Management (FRBM) Act was enacted in
2003.
FRBM sets targets for the government to reduce fiscal deficits.
The targets were put off several times.
In May 2016, the government set up a committee under NK Singh to review the
FRBM Act.
The committee recommended that the government should target a fiscal deficit
of 3 per cent of the GDP in years up to March 31, 2020 cut it to 2.8 per cent in
2020-21 and to 2.5 percent.
71
Public Debt
Public debt are the external obligations of the government and
public sector agencies.
Public external debt is the external debt obligations of the public
sector.
Government debt (also known as public interest, public debt,
national debt and sovereign debt) is the debt owed by a
government.
By contrast, the annual "government deficit" refers to the difference
between government receipts and spending in a single year.
72
Role of Fiscal Policy during inflation
During Inflation the following is the Fiscal policy approach:
◦ Inflation can be reduced by policies that slow down the growth of Aggregate
Demand (AD) and/or boost the rate of growth of Aggregate Supply (AS).
◦ To control inflation there is a need to control aggregate demand. If the
government believes that AD is too high, it may choose to ‘tighten fiscal
policy’ by reducing its own spending on public and merit goods or welfare
payments
◦ It can choose to raise direct taxes, leading to a reduction in real disposable
income
◦ The consequence may be that demand and output are lower which has a
negative effect on jobs and real economic growth in the short-term.
73
Role of Fiscal Policy during deflation
During Deflation, the following Fiscal policy is adopted:
◦This involves increasing AD.
◦Therefore the government will increase spending (G)
and cut taxes (T).
◦Lower taxes will increase consumers spending because
they have more disposable income (C)
◦This will tend to worsen the government budget deficit,
and the government will need to increase borrowing.
74
Key words
Fiscal Policy
Discretionary Fiscal Policy Primary Deficit
Non-discretionary Fiscal Policy Revenue Deficit
Direct Tax Laffer Curve
Indirect Tax Crowding out effect
GST Public Debt
Budget
Budget Deficit
75
IS-LM Framework
1
Coverage
1. Product and Money Market Equilibrium
2. Hicks-Hansen Model: IS-LM analysis.
3. The slope of the IS curve
4. Shift in the IS curve
5. Shift of the LM curve
6. Monetary Policy and its impacts on the LM curve
7. Fiscal Policy and its impact on the IS curve
2
General Equilibrium of Product and
Money Market
IS - LM Framework – General Equilibrium of Product and Money
Market
IS-LM Framework is a macroeconomic tool that demonstrates the
relationship between interest rates and real output in the goods and
services market and the money market.
The intersection of the IS and LM curves is the "General Equilibrium"
where there is simultaneous equilibrium in both markets.
IS stands for Investment Saving & LM stands for Liquidity preference
Money supply .
3
IS-LM Model
The IS-LM (Investment Saving – Liquidity Preference Money Supply)
model is a macroeconomic model that graphically represents two
intersecting curves.
The investment/saving (IS) curve is a variation of the income-
expenditure model incorporating market interest rates (demand).
The liquidity preference/money supply equilibrium (LM) curve
represents the amount of money available for investing (supply).
Hicks (1949) is credited with the invention of the IS-LM.
Hicks labeled SI-LL which later Alvin Hansen relabeled as showing IS and
LM curves in 1949
4
IS-LM Model (Hicks-Hansen model)
IS-LM model is the core of short-run macroeconomics
The determination of output and interest rates in the short-run
The IS-LM model translates the General Theory of Keynes into neoclassical terms (often
called the neoclassic synthesis )
Developed by Keynes (1936)
Made famous by Hicks and Hansen
It was proposed by John Hicks in 1937 in a paper called “Mr Keynes and the "Classics":
A Suggested Interpretation” and enhanced by Alvin Hansen (hence it is also called the
Hicks-Hansen model).
Tool for macroeconomists during 1950s to 1970s
With rational expectations revolution, approach seemed to fall out of favour
Recent literature (McCallum, Rotemberg, Woodford, etc) has resurrected it
5
IS-LM Model
The model examines the combined equilibrium of
two markets :
◦The goods market, which is at equilibrium when
investments equal savings, hence IS.
◦The money market, which is at equilibrium when the
demand for liquidity equals money supply, hence LM.
◦Examining the joint equilibrium in these two markets
allows us to determine two variables : output Y and the
interest rate i.
6
IS-LM Model
IS-LM model is based on two fundamental assumptions:
1. All prices (including wages) are fixed.
2. There exists excess production capacity in the economy
This is a complete change in perspective compared to classical economics:
◦ The level of demand determines the level of output and employment.
◦ There can be an equilibrium level of involuntary unemployment.
Why can there be insufficient demand ?
◦ Criticism of Say’s law: Uncertainty can lead to precautionary saving rather
than consumption.
◦ Monetary criticism: the preference for liquidity can lead to under-
investment as savings are kept in the form of liquidity.
7
IS-LM Model
The IS-LM model has become the “standard model” in macroeconomics.
Its essential contribution (linked to that of Keynes) is this potential equilibrium
unemployment:
◦ Such a situation is impossible in earlier neoclassic models, as the price of labour (like all
prices) is assumed to adjust naturally until supply and demand for labour are balanced.
This is why IS-LM (1937!!) remains central to modern macroeconomics, and has
been extended to explain more markets/ variables:
◦ The AS-AD model adds inflation into the problem
◦ The Mundell-Fleming model deals with international trade
8
IS Curve and the Goods Market
The IS curve exhibits the combinations of interest rates Slopes downward
and levels of output such that planned spending equals r because
income
◦ It is derived in two steps: r I Y
1. Link between interest rates and investment
2. Link between investment demand and AD
Investment is no longer treated as exogenous, but
dependent upon interest rates (endogenous)
◦ Investment demand is lower the higher are interest
rates IS
1. Interest rates are the cost of borrowing money
2. Increased interest rates raise the price to firms Y
of borrowing for capital equipment  reduce
the quantity of investment demand 9
The IS Curve: Interest Rate and Aggregate Demand
Need to modify the AD function of the last chapter to reflect the new
planned investment spending schedule
AD  C  I  G  NX
 C  cT R  c(1  t )Y   ( I  bi)  G  NX
 A  c(1  t )Y  bi
An increase in i reduces AD for a given level of income

At any given level of i, can determine the equilibrium level of income
and output
A change in i will change the equilibrium
10
11-10
The IS curve
The IS curve shows all the combinations of interest rates i and outputs Y for which the goods market is in
equilibrium
It is based on the goods market equilibrium we have examined in the first two weeks
The Investment function The Savings function:
Is the sum of private investment (endogenous) Is obtained from the aggregate demand equation,
and public investment (exogenous) subtracting investment and consumption:
I g  I  i   G  T  S=Y-C-T

Here, the interest rate is the marginal S= -C0 +(1-c)(Y-T)
profitability of investment
11
The Investment-Saving (IS) Curve
IS curve: equilibrium in the goods market.
– As interest rates rise, output falls.
 Demand:
 Z = C(Y-T) + I(Y,i) + G
 Equilibrium:
 Y = C(Y-T) + I(Y,i) + G
 Movements along the IS curve: As interest rates rise, output falls.
 Shifts in the IS curve: As government spending increases, output increases for
any given interest rate.
12
Factors that Shift the IS Curve
A change in autonomous factors that is unrelated to
the interest rate
Changes in autonomous consumer expenditure
Changes in planned investment spending
unrelated to the interest rate
Changes in government spending
Changes in taxes
Changes in net exports unrelated to the interest
rate 13
Fiscal Policy and its impact on IS curve
An increase in taxes shifts the IS
curve to the left.
• Equilibrium in the goods market

implies that an increase in the
interest rate leads to a decrease in
output.
• Changes in factors that decrease the
demand for goods, given the interest
rate shift the IS curve to the left.
14
The Shift in the IS Curve
IS Curve: At lower interest rates, equilibrium IS Curves: An increase in government
output in the goods market is higher. spending shifts out the IS curve.
15
What will shift the IS curve to the Right?
When C, I, G, or NX increases (decreases), the IS curve shifts right (left).
16
The IS Curve: Why is it downward sloping?
r
Slopes downward because
r I Y
Recall that:
I+T=S+G
or
I(r) + T0 = S(Y) + G0
Differentiate implicitly with respect to Y and r:
IS ds
dr dY ()
Y   0
dY dI ( )
dr
17
The Slope of the IS Curve
The steepness of the IS curve depends on two things:
◦(i) Interest elasticity of investment
◦(ii) MPS, i.e., the slope of saving curve.
The slope of the curve is of significant interest to us because
it is a factor determining the relative effectiveness of
stabilisation policies, viz., monetary and fiscal policies
18
The LM Curve
The LM curve shows all the
combinations of interest rates i
and outputs Y for which the
money market is in equilibrium
Here, the interest rate i has a
monetary interpretation:
It is the opportunity cost of
money, in other words the
payment made for renouncing
liquidity (preference for liquidity)
19
The LM Curve and the Money Market
The LM curve shows combinations of interest rates and levels of output
such that money demand equals money supply  equilibrium in the
money market
The LM curve is derived in two steps:
1.Explain why money demand depends on interest rates and income
◦ Theory of real money balances, rather than nominal
2.Equate money demand with money supply, and find combinations of
income and interest rates that maintain equilibrium in the money market
◦ (i, Y) pairs meeting this criteria are points on a given LM curve
20
The Liquidity preference – Money supply
(LM) Curve
•LM curve: equilibrium in the money market.
– As output rises, interest rates rise.
• Demand for real balances: Md /P = Y L(i)
• Equilibrium in money market: Md=M
• LM Curve: M/P = Y L(i)
• Movements along the LM Curve: An increase in Y increases money demand, which
causes an increase in interest rates to maintain money market equilibrium.
• Shifts in the LM curve: An increase in money supply lowers interest rates at any given
level of output.
21
The LM Curve
Liquidity preference:
With a level of output Y, the level of interest i adjusts so that the demand for
money (given by the liquidity function L) equals the exogenous supply:
M
P
 L Y,i
 
 
M = Money supple (exogenous)
P = Level of prices (exogenous by assumption)
22
The LM Curve
There are two motives for demanding real money balances:
1. The transaction and precautionary motive L1(Y) : The money demanded in order to be able to transact
in the future (function of the level of output)
2. The speculation motive L2(i) : The money demanded for purposes of speculation (opportunity cost of
the interest rate). When interest is high, people don’t want to hold money, whereas when the rates are
low, money demanded increases.
23
Monetary Policy and its impacts on LM curve
Changes in the money supply
Autonomous changes in money demand
24
The Shift in the LM Curve
The Effects of a Monetary
Expansion
An increase in money leads the LM curve
to shift down.
 Equilibrium in financial markets
implies that, for a given real money
supply, an increase in the level of
income, which increases the demand
for money, leads to an increase in the
interest rate.
 An increase in the money supply shifts
the LM curve down; a decrease in the
money supply shifts the LM curve up. 25
The Shift in the LM Curve
LM Curve: At higher levels of output, equilibrium An increase in money supply shifts the LM Curve. At
in the money market implies higher interest rates. the current level of output, the interest rate required
to maintain equilibrium in the money market is lower.
26
The Shift in LM Curve: Increase in Money Supply
27
The Shift in LM Curve: Increase in Money Demand
28
The Supply of Money, Money Market
Equilibrium, and the LM Curve
Figure shows the
combinations of i and Y
such that demand for real
money balances exactly
matches available supply.
Assumption:
Real money supply is
M/P, where M and P are
assumed fixed
Point E1 is the equilibrium
point in the money
market
As Income increases to
Y2, interest rate moves to
i2. Then, the new
equilibrium moves to E2
29
What shifts the LM curve?
Money: Increasing Money Supply increases M/P causing the LM curve
to the right.
Prices: Increasing Prices causes real Money Balances to fall shifting LM

curve to the left.
Expected Inflation π e: Increasing expected inflation causes returns

on bonds (assets other than money) to increase making it less
attractive to hold cash. Causes LM curve to shift right!
30
The LM Curve: Hicks interpretation
r LM Curve (L=M): all
LM those combinations of
real interest rates and
income which bring the
money supply equal to
money demand.
31
The LM Curve slopes upwards?
If Y increases, transactions and
precautionary demand increase.
r LM
There will be excess demand in the r
money markets Ms
Interest rates will be driven upward
So Y r, and the LM Curve slopes Md(Y2)
upward.
Liquidity Preference is: L = L(Y,r)
r1 Md(Y1)
Money Supply is: Ms = M0 = M
r0 Md(Y0)
Ms = Md implies M = L(Y,r)  LM Curve
 L
dr
 Y   (  )  0
dY L ( ) M Y0 Y1 Y2 Y
r
32 32
The Slope of the LM Curve
The steeper the LM curve:
◦ The greater the responsiveness of the demand for money to income, as
measured by k
◦ The lower the responsiveness of the demand for money to the interest rate, h
These points can be confirmed by examining equation:
1 M
i   kY  
h P 
A given change in income has a larger effect on i, the larger is k and the smaller
is h
33
Equilibrium in goods and money market
 The IS-LM model shows that monetary
policy influences income by changing
the interest rate.
 The IS-LM model shows that an
increase in the money supply lowers
the interest rate, which stimulates
investment and thereby expands the
demand for goods and services.
 Assumptions:
 Price level is constant
 Firms willing to supply whatever
amount of output is demanded
at that price level
34
Changes in the Equilibrium Levels of
Income and the Interest Rate
The equilibrium levels of income
and the interest rate change when
either the IS or the LM curve shifts
Figure shows effects of an increase
in autonomous spending
 Shifts IS curve out by G ∆I if
autonomous investment is the source
of increased spending
 The resulting change in Y is smaller
than the change in autonomous
spending due to slope of LM curve
35
IS-LM Framework
McCallum and Nelson (1997) observe 6 limitations:
◦ 1. IS-LM analysis presumes a fixed, rigid price level
◦ 2. No distinction between real and nominal rates
◦ 3. Only 2 assets; money and bonds
◦ 4. Only short-run, no steady states
◦ 5. Capital stock fixed
◦ 6. Not derived using microfoundations => Lucas Critique
Rational Expectations revolution: Move away from IS-LM
(although equivalent expressions were still used!)
36
The IS-LM
The real and monetary sectors of the
r economy are resolved together.
LM
Money matters to real sector
outcomes.
There is no dichotomy (contrast).
r*
Assumptions:
Price level is constant
IS Firms willing to supply whatever
Y* amount of output is demanded at that
Y
price level
37
37
The IS-LM model
LM is a stock equilibrium (beginning of period).
IS is a flow equilibrium (end of period).
The model is an equilibrium of flows constrained by stocks. It is a
cash-flow equilibrium.
The time frame is long enough for full adjustment of real income and
interest, short enough so stocks do not change.
IS-LM equilibrium is not permanent. S>0 implies that wealth
(allocations) are increasing over time. Therefore LM is shifting due to
the stock of bonds. If net investment is positive, then the capital stock
grows.
38
The IS-LM Model
Equilibrium in the goods market
implies that an increase in the interest
rate leads to a decrease in output.
Equilibrium in financial markets
implies that an increase in output leads
to an increase in the interest rate.
When the IS curve intersects the LM
curve, both goods and financial
markets are in equilibrium.
39
Structure of the IS-LM Model
The IS-LM Model
Macroeconomic
equilibrium and policy
The intersection of IS and

LM represents the
simultaneous equilibrium
on the goods and the
money market for a given
value of government
spending G, taxes T, money
supply M and prices P
41
IS-LM Model: The Effects of a Monetary Expansion
Monetary contraction, or monetary
tightening, refers to a decrease in the
money supply.
An increase in the money supply is
called monetary expansion.
Monetary policy does not affect the
IS curve, only the LM curve. For
example, an increase in the money
supply shifts the LM curve down.
Monetary expansion leads to higher
output and a lower interest rate.
42
The IS-LM Model: Changes in the Equilibrium
Levels of Income and the Interest Rate
The equilibrium levels of income and
the interest rate change when either
the IS or the LM curve shifts
The Figure shows effects of an increase
in autonomous spending
Shifts IS curve out by 𝒂𝑮 ∆𝑰 if
autonomous investment is the source of
increased spending
The resulting change in Y is smaller than
the change in autonomous spending
due to slope of LM curve.
43
The IS-LM Curve: Deriving
the AD Schedule
•The AD schedule maps out the IS-LM
equilibrium holding autonomous spending
and the nominal money supply constant
and allowing prices to vary
•Assume, prices increase from P1 to P2
–M/P decrease from M/P1 to M/P2  LM
decreases from LM1 to LM2
–Interest rates increase from i1 to i2, and
output falls from Y1 to Y2
–Corresponds to lower AD
44
The IS-LM Model: Macroeconomic equilibrium and policy
45
The IS-LM Model: Explaining the Liquidity Trap
46
IS-LM Model in the Long Run
47
IS-LM Model: Using a Policy Mix
The combination of monetary The Effects of Fiscal and Monetary Policy.
and fiscal polices is known as the
monetary-fiscal policy mix, or Shift of Shift of Movement Movement in
simply, the policy mix. IS LM of Output Interest Rate
Increase in taxes left none down down
Decrease in taxes right none up up
Increase in spending right none up up
Decrease in spending left none down down
Increase in money none down up down
Decrease in money none up down up
48
The IS-LM Model and the Facts
We can describe the basic mechanisms as below:
Consumers are likely to take some time to adjust their
consumption following a change in disposable income.
Firms are likely to take some time to adjust investment spending
following a change in their sales.
Firms are likely to take some time to adjust investment spending
following a change in the interest rate.
Firms are likely to take some time to adjust production following
a change in their sales.
49
IS-LM Model: Merits and Demerits
Advantages Disadvantages
1. This model is widely used and seen as useful in gaining an 1. This model ignores uncertainty –
understanding of macroeconomic theory even though disputed and that liquidity preference only
in some circles and considered to be imperfect . makes sense in the presence of
2. It is used in most college macroeconomics textbooks. uncertainty.
3. Most modern macroeconomists see the IS-LM model as being 2. A shift in the IS or LM curve will
at best a first approximation for understanding the real world. cause change in expectations,
4. IS-LM can be used to assess the impact of exogenous shocks on causing the other curve to shift.
the endogenous variables of the model (interest rates and
output)
5. One can also evaluate the effectiveness of the policy mix, i.e.
the combination of:
 Fiscal policy: changes to government spending and taxes
 Monetary policy: changes to money supply
50
Key words
Product Market
Money Market
Product and Money Market
Equilibrium
IS curve
LM curve
IS-LM Model
51
Open Economy
Framework:
International Trade
1
Coverage
1. International Vs. Domestic trade
2. The advantages of International trade
3. Theories of International Trade
4. Theory of Absolute and Comparative advantage
5. Protection
6. Issues related to tariff
7. WTO
2
International Trade
International Trade – is the cross-border import and
export of goods and services among the nations.
Imports – are goods and services purchased from other
countries.
Exports – are goods and services sold to other countries.
The underlying principle of international trade is the
economic interdependence.
International trade is guided by two important theories: (i)
Absolute advantage; (ii) Comparative advantage.
Absolute Advantage - a country has natural resources or talents that allow it to produce an item at the
lowest possible cost.
Comparative Advantage – is the value that a nation gains by selling what it produces most efficiently.
Better infrastructure, raw materials, and educated labor force.
3
International Trade
Advantages Examples
High-quality goods Electronics; scientific products; cars
Lower prices Clothing and textiles
Larger profits McDonalds, KFC
Higher employment China, India
Improved Standard of Living China, India
More purchasing options Developed nations like the U.S
4
Domestic vs. International Trade
Domestic Trade International Trade
1. A domestic trade is an internal trade 1. International trade or foreign trade
which is within the borders of a given on the other hand is any business
country. For example, all trading transaction that occurs between two
activities that go on within your or more countries across the border.
country are referred to as domestic 2. Involves use of largely foreign
trade. currencies.
2. Involves use of largely the local 3. Subjected to certain restrictions such
currency. as embargoes and quotas
3. Largely free from restrictions 4. World Trade Organization (WTO)
4. Not regulated by external bodies regulates
5
Theories of International Trade
Theory of Comparative Theory of Factor The Product Porter’s
Absolute Advantage Reciprocal Demand Endowment Life Cycle Theory of
Advantage Theory Theory Theory National
Diamond
Adam Smith David Ricardo John Stuart Mill (1806- Heckscher (1919) Raymond Vernon Michel Porter
(1776) Cost (1817) 1873) - Olin (1933) (1966) (1990)
differences The basic Reciprocal Demand Theory Theory: Focuses on the 1. Factor
govern prediction of states that within the The resource role of endowments
international Ricardo’s principle outer limits of terms of endowments are technological 2. Firm strategy,
movement of is that countries trade, the actual terms of the key innovation as a structure and
goods and will tend to export trade is determined by the determinants of key determinant rivalry
services those goods in relative strength of each comparative of trade patterns 3. Demand
Smith’s concept which their labor country’s demand for advantage. in manufactured conditions
of cost was productivity is other country’s product. goods. 4. Related and
founded upon the relatively high. Terms of trade is the ratio of an supporting
index of a country's export prices
labor theory of to an index of its import prices.
industries
value
6
Theory of Absolute Advantage
1. In a two nation, two product world, international specialization and
trade will be beneficial when one nation has absolute cost advantage in
one good and the other nation has absolute cost advantage in another
good.
2. A nation will import those goods in which it has absolute cost
disadvantage and export those goods in which it has absolute cost
advantage.
3. Free trade benefits a nation as a whole, but individuals may lose jobs
and incomes from the competition from foreign goods and services.
VIGHNESWARA SWAMY
Illustration for Absolute Advantage Principle
Consider world output possibilities in the absence of specialization.
Country Wine Cloth

United States 5 bottles 20 yards
United Kingdom 15 bottles 10 yards
US has absolute advantage in cloth production
UK has absolute advantage in wine production
VIGHNESWARA SWAMY
Comparative Advantage Principle
1. Even if a nation has an absolute cost advantage in the production of both goods, a
basis for mutually beneficial trade may still exist.
2. The less efficient country should specialize in and export the good in which it is
relatively less inefficient.
3. The more efficient country should specialize in and export that good in which it is
relatively more efficient (where its absolute advantage is greatest).
4. When nations follow the principle of comparative advantage, they gain. The reason is
that world output increases and each nation ends up with a higher standard of living
by consuming more goods and services than possible without specialization and
trade.
VIGHNESWARA SWAMY
Illustration for Comparative Advantage
Country Output perWine
labor hour
Cloth
United States 40 bottles 40 yards
Unite Kingdom 20 bottles 10 yards
According to Ricardo’s Comparative Advantage theory,
1. US should specialize in and export cloth where it has comparative advantage, and
2. UK should specialize in and export wine in which it has smaller absolute disadvantage.
VIGHNESWARA SWAMY
Protectionism
Countries use protectionist measures to shield a country’s markets from
intrusion by foreign competition and imports.
1. Maintain employment and reduce unemployment.
2. Increase of business size, and
3. Retaliation and bargaining.
4. Protection of the home market.
5. Need to keep money at home.
6. Encouragement of capital accumulation.
7. Maintenance of the standard of living and real wages.
8. Conservation of natural resources.
9. Protection of an infant industry
10. Industrialization of a low-wage nation
11. National defense
11
Trade barriers
Types:
1. Import duties
2. Import quotas
3. Import licenses
4. Tariffs
5. Export licenses
6. Subsidies
7. Non-tariff barriers to trade
8. Voluntary Export Restraints
12
Tariffs
A tariff is a tax on imports or exports.
Money collected under a tariff is called a duty or customs duty.
Tariffs are used by governments to generate revenue or to
protect domestic industries from competition.
Why impose tariff?
1. To discourage consumption
2. To raise revenue
3. To discourage imports
4. To protect domestic industries
13
Tariffs
Ad valorem Tariffs Specific Tariff Compound Tariff
Ad valorem tariffs are calculated as a fixed A specific tariff is a fixed Compound tariffs
percentage of the value of the imported amount of money that include both ad
good. The most common is an ad valorem does not vary with the valorem and a specific
tariff, which means that the customs duty is price of the good. component.
calculated as a percentage of the value of
the product. A per unit tax on imports For example, A country
charges Rs. 0.88 per
A value based tax on imports In some cases, both liter of some petroleum
the ad valorem and products plus 25
When the international price of a good rises specific tariffs are levied percent ad valorem.
or falls, so does the tariff. on the same product.
14
Tariffs..
Most Favored Nation (MFN) Tariff Preferential Tariff Bound Tariff (BND)
1. MFN tariffs are what countries 1. These agreements are 1. Bound tariffs are specific
promise to impose on imports reciprocal: all parties agree commitments made by
from other members of the WTO, to give each other the individual WTO member
unless the country is part of a benefits of lower tariffs. governments.
preferential trade agreement 2. Some agreements 2. The bound tariff is the
(such as a free trade area or specify that members will maximum MFN tariff level for a
customs union). receive a percentage given commodity line.
2. This means that, in practice, reduction from the MFN 3. When countries join the WTO
MFN rates are the highest (most tariff, but not necessarily or when WTO members
restrictive) that WTO members zero tariffs. negotiate tariff levels with each
charge one another. 3. Preferences therefore other during trade rounds, they
differ between partners make agreements about bound
and agreements. tariff rates, rather than actually
applied rates. 15
WTO
There are a number of ways of looking at
the WTO
It’s an organization for liberalizing trade.
It’s a forum for governments to negotiate
trade agreements. It’s a place for them to
settle trade disputes. It operates a system
of trade rules.
It’s a negotiating forum …
Geneva It’s a set of rules …
And it helps to settle disputes …
WTO
What is WTO?
A simple answer: “A global organization dealing with rules of trade between
nations”.
The World Trade Organisation (WTO)
Established on 1st January 1995
As a result of the Uruguay Round negotiations (1986-1994)
Located in Geneva, Switzerland
Members: 164 members (29 July 2016)
India is a member - 1 January 1995 (GATT: 8 July 1948)
What is the Predecessor of the WTO?
The General Agreement on Tariffs and Trade (GATT) 1947 -the first major effort to
establish international rules governing trade in goods. Though initially conceived as a
provisional legal instrument, it endured for almost 50 years.
Principles of the world trading
system under the WTO
1. Non discrimination- Most Favoured Nation (MFN) and National
Treatment obligations
2. Freer trade – negotiations aimed at lowering trade barriers
3. Predictability and transparency - binding commitments, restrictions on
the use of barriers to trade and transparent trade policies and regulatory
frameworks (e.g. transparency obligations in the major trade agreements
and the Trade Policy Review Mechanism)
4. The promotion of fair competition - MFN, national treatment and rules
against unfair trade practices (e.g. anti dumping)
5. Encouragement of development and economic reform
Organizational structure of the WTO
1. Ministerial Conference- The apex body for decision making (meets every 2 years).
Composition:-ministerial representatives.
2. General Council- performs the functions of the Conference between meetings and has specific
duties assigned to it by the WTO agreements. Composition:- governmental representatives.
3. The General Council also meets as the Dispute Settlement Body and the Trade Policy Review
Body.
4. Councils for Trade in Goods (oversees GATT), Trade in Services (oversees GATS) and TRIPS
which report to and assist the General Council. [GATT: General Agreement on Tariffs and Trade; GATS: General
Agreement on Tariffs and Services; TRIPS: Agreement on Trade-Related Aspects of Intellectual Property Rights]
5. Committees on special subjects, Committees functioning under the Councils and Committees
for the Plurilateral Agreements.
Membership- developed, developing, least developed countries and economies in transition.
Decision making is by consensus. If consensus is not possible decisions will be taken by a majority
vote.
Trade policy review mechanism
◦The trade policy review mechanism scrutinizes the trade
policy of each member state on a regular basis.
◦The report on the four major trading partners ( US, EU ,Japan
and Canada) are provided more frequently.
◦This review is expected to exercise discipline on the trade
policy of member states.
Key words
International trade
Domestic trade
Absolute advantage
Comparative Advantage
Protectionism
Tariffs
Barriers
WTO
21
Open Economy
Framework:
Foreign Exchange
1
Coverage..
1. Fixed exchange rate
2. Floating exchange rate
3. Managed floating exchange rate
4. Nominal exchange rate
5. Real exchange rate
6. Effective Exchange rate
7. Determination of Exchange Rate
8. Factors influencing exchange rate
9. Participants of Foreign Exchange Markets.
2
Introduction
Economies are linked through two broad channels
1. Trade
◦ Some of a country’s production is exported to foreign countries  increase
demand for domestically produced goods
◦ Some goods that are consumed or invested at home are produced abroad
and imported  a leakage from the circular flow of income
2. Finance
◦ Portfolio managers shop the world for the most attractive yields
◦ As international investors shift their assets around the world, they link
assets markets here and abroad  affect income, exchange rates, and the
ability of monetary policy to affect interest rates
◦ U.S. residents can hold U.S. assets OR assets in foreign countries
3
Exchange Rates
Exchange rate is the price of one currency in terms of
another
Ex. On 24th Jan 2019 you could buy 1 USD for INR 71.22 in
Indian currency → nominal exchange rate was e = 71.22
If a sandwich cost 2.39 USD, that is equivalent to
71.22(INR/USD)x2.39USD=USD 170.21
4
Nominal Exchange Rate
1. Relative price of two currencies
2. It is often expressed as number of units of local or home currency required to buy a unit
of foreign currency
3. We usually view Indian Rupee (INR) as our home currency and United States Dollar
(USD) as our foreign currency
local currency INR
4. Nominal or currency exchange rate (e) is
e 
foreign currency USD
5. If e increases, the value of INR (home currency) falls

6. If e decreases, the value of the INR (home currency) rises (nominal appreciation)
7. e and the value of INR are inversely related
8. e is often graphed as its inverse which is equal to the value of INR
VIGHNESWARA SWAMY
Nominal Exchange Rate
The nominal exchange rate is the price of one country’s
exchange rate in terms of another’s.
Example:
In India, if you want to buy a dollar, it costs 50 Rupees on the
market.
1. So, the nominal exchange for dollars is 1/50=.02 dollars
per rupee in India.
2. In the U.S, the nominal exchange rate for a rupee is 50
rupees to the dollar.
VIGHNESWARA SWAMY
The Real Exchange Rate
1. Measures the rate at which two countries’ goods trade against
each other
2. Makes use of the price levels in the two countries under
consideration
◦ PIND—overall price level in India (the home country)
◦ PUS—overall price level in the United States (the foreign country)
◦ Then Real Exchange Rate (re):
US
P
re  e  IND
P
VIGHNESWARA SWAMY
Real Exchange Rate
The real exchange rate is the purchasing power of a currency
relative to the purchasing power of other currencies.
Things cost different amounts in each country.
For example:
To take the Indian case, with INR 67 to 1USD.
A shirt in India may cost INR 670, while in the U.S it costs USD10.
Are you better off buying in India or in the U.S? To check, we have to calculate the real
exchange rate
VIGHNESWARA SWAMY
Real Exchange Rate
Formula:
[Bilateral Real ER= Nominal ER (Foreign Price /Domestic Price)]
EX r is the Real Exchange Rate
EX n is the nominal Exchange Rate
Pd is the Domestic Price
Pf is the Foreign Price
[Real E.R= 71.22 x (12USD/500INR)=1.70]
VIGHNESWARA SWAMY
Real Exchange Rate
From the previous example:
Consider the Indian case with INR 67 to 1USD. A shirt in India may cost INR
445, while in the U.S it costs USD12.
Are you better off buying in India or in the U.S?

To check, we have to calculate the real exchange rate.
EX r = [INR 67/1USD]x[USD12]/445
= [67]x[12] /445 = 1.80
That means 2 Indian shirts / 1 US shirt.
So, shirts are in real terms, twice as expensive in the U.S as they are in India.
VIGHNESWARA SWAMY
Real Exchange Rate
The RER between two currencies is the product of the
nominal exchange rate (the INR cost of a USD, for example)
and the ratio of prices between the two countries.
 Consider an example:
Nominal Exchange Rate (NER)=1USD=INR 71
Price of Big Mac in USA = USD 3.57
 Price of Big Mac in India = USD 2.51
RER = 71 (2.51/3.57)= 49.91
11
Real Effective Exchange Rate (REER)
Real Effective Exchange Rate (REER) is a measure of the trade-weighted average
exchange rate of a currency against a basket of currencies after adjusting for inflation
differentials with regard to the countries concerned and expressed as an index
number relative to a base year.
REER is also defined as the average of the bilateral Real Exchange Rates (RER)
between the country and each of its trading partners, weighted by the respective
trade shares of each partner.
Real Effective Exchange Rates are used for an array of purposes such as assessing the
equilibrium value of a currency, the change in price or cost competitiveness, the
drivers of trade flows, or incentives for reallocation production between the tradable
and the non-tradable sectors.
12
Real Effective Exchange Rate (REER)
𝑹𝑬𝑬𝑹𝑪𝒐𝒖𝒏𝒕𝒓𝒚 𝒊=
𝑵
= 𝑻𝒓𝒂𝒅𝒆 𝒘𝒆𝒊𝒈𝒉𝒕 𝑪𝒐𝒖𝒏𝒕𝒓𝒚 𝒋

𝒋=1
country j=1,2,...N are country i's trading partners, exchange rates in natural
logarithms (geometric averages)
13
Fixed Exchange Rates
In a fixed exchange rate system foreign central banks buy
and sell their currencies at a fixed price in terms of dollars
◦ Ensures that market prices equal to the fixed rates
No one will buy dollars for more than fixed rate since know that they can get
them for the fixed rate
No one will sell dollars for less than fixed rate since know can sell them for
the fixed rate
Foreign central banks hold reserves to sell when they have

to intervene in the foreign exchange market
◦ Intervention: the buying or selling of foreign exchange by the
central bank
14
Flexible Exchange Rates
In a flexible (floating) exchange rate system, central banks allow the
exchange rate to adjust to equate the supply and demand for foreign
currency
◦ Suppose the following:
◦ Exchange rate of the dollar against the yen is 0.86 cents per yen
Japanese exports to the U.S. increase
Americans must pay more yen to Japanese exporters
◦ Bank of Japan stands aside and allows the exchange rate to adjust
Exchange rate could increase to 0.90 cents per yen
Japanese goods more expensive in terms of dollars
Demand for Japanese goods by Americans declines
15
The Flexible Exchange Rate Regime:
1973-Present
Free Float
The largest number of countries, about 48, allow market forces to determine their currency’s value.
Managed Float
About 25 countries combine government intervention with market forces to set exchange rates.
Pegged to another currency

Such as the U.S. dollar or euro (through franc or mark).
No national currency
Some countries do not bother printing their own currency. For example, Ecuador, Panama, and El
Salvador have dollarized. Montenegro and San Marino use the euro.
The Flexible Exchange Rate Regime:
1973-Present ..
Currency Board: A legislative commitment to exchange domestic currency for a
specified foreign currency at a fixed ex rate.
Fixed Peg: The ex rate is fixed against a major currency. Active intervention
needed.
Crawling Peg: The ex rate is adjusted periodically in small amounts at a fixed,
preannounced rate. (Mexico pegged its Peso with USD)
Dollarization: The dollar circulates as the legal tender
The Determinants of Foreign Exchange Rates
VIGHNESWARA SWAMY
Forecasting Exchange Rates
1. Flow (BoP) Approach
2. Asset (Market) Approach
3. Portfolio Balance Approach
4. Efficient Markets Approach
5. Fundamental Approach
6. Technical Approach
7. Performance of the Forecasters
What is Foreign Exchange Market?
1. Foreign Exchange Market is a currency market where
money denominated in one currency is bought and sold
with money denominated in another currency.
2. It facilitates the conversion of one country’s currency into
another through the buying and selling of currencies.
3. It sets and quotes exchange rates and offers contracts to
manage foreign exchange exposure.
4. Essentially, foreign exchange market refers to the
organizational setting within which individuals, businesses,
governments, and banks buy and sell foreign currencies
and other debt instruments.
VIGHNESWARA SWAMY
Location of Forex Market
1. There is no physical location where traders get together to
exchange currencies.
2. Traders are located in the offices of major commercial banks
around the world and communicate using computer
terminals, telephones, telexes, and other information
channels.
3. Most trades happen by phone, telex, or SWIFT (Society for
Worldwide Interbank Financial Telecommunications)
4. The FX market is an over-the-counter market.
VIGHNESWARA SWAMY
Forex
Market
Structure
Participants
1. Central Banks
2. Commercial
Banks
3. Corporations
4. NBFCs
5. Exporters and
Importers
6. Retail Traders
VIGHNESWARA SWAMY
Facilitates
Exchange of
Currencies
Capital
Features
mobility 24 hour
of Forex
(Unrestricted market
Market
or Restricted)
Covered
interest
parity
relationship
VIGHNESWARA SWAMY
Forex Market Functions
1. The transfer of funds or purchasing power from one nation
and currency to another.
Demand for foreign currencies
-Import/expenditures abroad/investment abroad
Supply of foreign currencies
-Export/earnings from tourism/receipt of foreign investments
2. The credit function

3. Facilitates hedging and speculation
VIGHNESWARA SWAMY
Key words
Exchange rate
Nominal exchange rate
Real exchange rate
Effective exchange rate
Fixed exchange rate
Floating exchange rate
Managed float
25
Open Economy
Framework:
Balance of Payments
1
Coverage
1.Balance of Payments
2.Current Account
3.Capital Account
4.Financial account
5.The effects of Crude oil /Gold price on Current account.
2
Balance of Payments
Balance of Payments (BOP)—is an accounting
record of all the economic transactions
between the residents of one country and the
rest of the world.
The nations keep the record of BoP on an
annual basis. Some nations like U.S. keep the
record of BoP on quarterly basis.
The BoP is the statistical record of a country’s
international transactions over a certain period
of time presented in the form of double-entry
bookkeeping.
VIGHNESWARA SWAMY
BoP – RBI Definition
The Balance Of Payments of a country is a systematic
record of all economic transactions between the ‘residents’
of a country and the rest of the world.
It presents a classified record of all receipts on account of
goods exported, services rendered and capital received by
‘residents’ and payments made by them on account of
goods imported and services received from the capital
transferred to ‘non-residents’ or ‘foreigners’.” – Reserve
Bank of India (RBI)
VIGHNESWARA SWAMY
Visible and Invisible Items
1. Visible Items: 2. Invisible Items:
1.These include all types of physical
goods which are exported and 1.Invisible items of trade refer to all
imported. types of services like shipping,
2.These are called ‘visible items’ as they banking, insurance etc., which are
are made of some matter or material given and received.
and can be seen, touched and 2.These are called invisible items as
measured.
they cannot be seen, felt, touched
3.The movement of such items is open
and can be verified by the customs
or measured.
officials.
VIGHNESWARA SWAMY
Unilateral Transfers and Capital
Transfers
Unilateral Transfers: Capital Transfers:
Unilateral transfers include gifts, Capital transfers relate to
personal remittances and other capital receipts (through
‘one-way transactions’. borrowings or sale of assets)
Since these transactions do not and capital payments (through
involve any claim for repayment, capital repayments or purchase
they are also known as of assets).
unrequited transfers.
VIGHNESWARA SWAMY
Features of the BOP
BOP follows the accounting procedure of double-entry bookkeeping (debits &
credits).
A credit entry records an item or transaction that brings foreign exchange into
the country.
A debit entry represents a loss of foreign exchange.
BOP will always balance.
A BOP deficit (surplus) means that the debit entries exceed (are less than) the
credits. This imbalance applies only to a particular account or component of
the BOP.
BOP is a flow statement, not a stock statement.
7
Why is it useful to examine BOP?
The BOP provides detailed information about
the supply and demand of the country’s
currency.
◦ The trade statistics in the Current Account, show
the composition of trade – what a country imports
and what it exports?
◦ The Capital Account shows inflows and outflows of
capital in various categories.
Viewed over time, BOP data can shed light on
important developments in a country’s
comparative advantage and international
competitiveness.
8
Significance of BoP
The BoP is an important indicator of pressure on a country’s foreign
exchange rate .
The BOP helps to forecast a country’s market potential, especially in

the short run.
Changes in a country’s BOP may signal the imposition or removal of

controls over payment of dividends and interest, license fees, royalty
fees, or other cash disbursements to foreign firms or investors.
9
BoP Accounting
Current Account
The current account of the Capital Account
balance of payments refers Capital Account includes
to the monetary value of transactions that are purely
international flows
associated with transactions claims on financial assets
in goods, services, income (i.e. purchases or sales of
flows, and unilateral financial assets).
transfers.
10
Balance of Payment
Current Account Capital Account
1.Merchandize Trade balance: 1. Foreign Investment:
- Exports - FDI, FPI, ADRs, GDRs,
- Imports
2. Invisibles: 2. Loans:
- Services Balance: - External assistance
Transportation, - Commercial Borrowing
Military transactions, - Short Term Funds
Royalties, Software
3. Unilateral Transfers: 3. Banking Capital
- Government Grants - Foreign assets of banks
- Private Transfers or remittances - Foreign liabilities of ADs
- Others
4. Other Capital
5. Reserve Account
6. Statistical discrepancy 11
Reserve Account
Reserve Account Statistical Discrepancy
Reserve Account constitutes the Statistical Discrepancy account
changes in the reserves indicated includes the errors and
separately. omissions.
These are the assets that are

acceptable across the world for
settlements of international
transactions.
12
Different Accounts …. In short
Current Account a record of all international transactions for goods and services.
The current account combines the transactions of the trade
account and the services account.
Merchandise a record of all international transactions for goods only. Goods
Trade Account include physical items like autos, steel, food, clothes,
appliances, furniture, et. al.
Services Account a record of all international transactions for services only.
Services include transportation, insurance, hotel, restaurant,
legal services, consulting, et. al.
Financial a record of all international transactions for assets. Assets
Account include bonds, treasury bills, bank deposits, stocks, currency,
real estate, et. al.
13
Standard Presentation of India's Balance of Payments
(US$ Million)
Apr-Jun 2018 PR Jul-Sep 2018 P Apr-Sep 2018 P
Credit Debit Net Credit Debit Net Credit Debit Net
1 Current Account (1.A+1.B+1.C) 155692171613 -15921 160007 179098 -19091 315699 350711 -35012
1.A Goods and Services (1.A.a+1.A.b) 131563 158619 -27057 133493 163277 -29784 265055 321896 -56840
1.B Primary Income (1.B.1to1.B.3) 5327 11244 -5917 5623 14282 -8659 10950 25526 -14576
1.C Secondary Income (1.C.1+1.C.2) 18803 1750 17053 20891 1539 19352 39694 3289 36405
2 Capital Account (2.1+2.2) 111 94 17 75 96 -21 186 190 -4
3 Financial Account (3.1 to 3.5) 142502125807 16695 131048 112851 18198 273551 238658 34893
3.1 Direct Investment (3.1A+3.1B) 17313 7453 9860 14997 7126 7872 32310 14579 17732
3.1.B Direct Investment by India 276 3619 -3344 751 3071 -2320 1027 6690 -5663
3.5 Reserve assets 11338 0 11338 1868 0 1868 13206 0 13206
3 Total assets/liabilities 142502 125807 16695 131048 112851 18198 273551 238658 34893
4 Net errors and omissions 792 -792 914 914 123 123
P: Preliminary. PR: Partially Revised.
14
India's Current Account
(US$ Million)
Current Account
1 (1.A+1.B+1.C) 155692171613 -15921 160007 179098 -19091 315699 350711 -35012
1.A Goods and Services (1.A.a+1.A.b) 131563 158619 -27057 133493 163277 -29784 265055 321896 -56840
1.A.a Goods (1.A.a.1 to 1.A.a.3) 83389 129141 -45752 83399 133432 -50034 166788 262574 -95786
1.A.b Services (1.A.b.1 to 1.A.b.13) 48174 29478 18696 50094 29844 20250 98268 59322 38946
1.B Primary Income (1.B.1to1.B.3) 5327 11244 -5917 5623 14282 -8659 10950 25526 -14576
1.C Secondary Income (1.C.1+1.C.2) 18803 1750 17053 20891 1539 19352 39694 3289 36405
15
India Current
Account - Services
What services bring current account surplus to
India?
The detailed analysis of service component of
current account deficit shows that the largest
component of India’s services surplus comes
from IT industries.
Similarly, India is a net exporter of travel
meaning foreigners visiting India spend more
money than Indians visiting foreign countries.
India has to send abroad a significant amount
of money for use of intellectual property.
India is a net importer of recreational services
that include services in film, music industry and
so on. 16
What Factors cause a current account deficit?
1.A current account deficit occurs when the value of imports (of goods,
services and investment incomes) is greater than the value of exports.
2.Running a Current Account Deficit means that an economy is not
paying its way in the global economy.
3.There is a net outflow of demand and income from the circular flow of
income and spending.
4.Spending on imported goods and services exceeds the income from
exports.
5.Decreasing a current account deficit is not in the hands of home
country alone.
17
What factors cause a current account deficit?
1. Exchange Rate
2. Economic Growth
3. Decline in Competitiveness
4. Higher inflation
5. Poor productivity
6. Low levels of investment in real capital
7. Low levels of investment in human capital
18
India's Capital Account (US$ Million)
2 Capital Account (2.1+2.2) 111 94 17 75 96 -21 186 190 -4
Gross acquisitions (DR.)/disposals (CR.) of non-
produced nonfinancial assets
2.1 66 16 51 2 4 -2 68 20 49
2.2 Capital transfers 45 78 -33 72 92 -19 118 170 -53
2.2.1 General government 1 22 -22 0 21 -21 1 43 -43
2.2.1.1 Debt forgiveness
2.2.1.2 Other capital transfers 1 22 -22 0 21 -21 1 43 -43
Financial corporations, nonfinancial
2.2.2 corporations, households, and NPISHs 44 56 -12 72 71 2 117 127 -10
2.2.2.1 Debt forgiveness
Other capital transfers including migrants
2.2.2.2 transfers 44 56 -12 72 71 2 117 127 -10
19
Capital Flows and BoP
In addition to Currency Depreciation and Protectionism,
another way of monitoring and arresting the adverse
Balance of Payments (BoP) is controlling the capital flows
on account of transactions of financial assets.
VIGHNESWARA SWAMY
India's Financial Account
(US$ Million)
3 Financial Account (3.1 to 3.5) 142502 125807 16695 131048 112851 18198 273551 238658 34893
3.1 Direct Investment (3.1A+3.1B) 17313 7453 9860 14997 7126 7872 32310 14579 17732
3.2 Portfolio Investment 60453 68598 -8145 60388 62006 -1618 120841 130604 -9763
Financial derivatives (other than
3.3 reserves) and employee stock options 3631 5113 -1482 5623 4344 1278 9254 9458 -204
3.4 Other investment 49767 44643 5124 48172 39374 8798 97939 84017 13922
3.5 Reserve assets 11338 0 11338 1868 0 1868 13206 0 13206

21
Twin Deficit Identity
The Relationship between a Country’s Government Budget
Deficit and Its Current Account Deficit.
To understand this identity it will be helpful to take a much

more careful look at the national income identity.
VIGHNESWARA SWAMY
Tit-Bits
Difference between Current Account Deficit and Fiscal Deficit
Fiscal Deficit Current Account Deficit

Fiscal Deficit is a percentage of Current Account Deficit occurs
the nation's GDP and can be when the country's imports are
considered as an economic greater than the country's
event in which the government exports of goods, services and
expenditure exceeds its revenue transfers.
VIGHNESWARA SWAMY
Tit-Bits
Difference between Current Account Balance and Trade Balance
Current Account Balance Trade Balance

Total Exports – Total Imports Merchandize Exports –
= > 0 means surplus BoP Merchandize Imports
= < 0 means deficit BoP = > 0 means surplus BoT
= < 0 means deficit BoT
Indicates the competitiveness on

the manufacturing sector
VIGHNESWARA SWAMY
Tit-Bits
Difference between Current Account Balance and Trade Balance
Current Account Balance Trade Balance

Total Exports – Total Imports Merchandize Exports –
= > 0 means surplus BoP Merchandize Imports
= < 0 means deficit BoP = > 0 means surplus BoT
= < 0 means deficit BoT
Indicates the competitiveness on

the manufacturing sector
VIGHNESWARA SWAMY
Tit-Bits
Difference between BoT and BoP
BoT BoP
The difference between A system of accounts that
exports and imports of goods measures transactions of goods,
services, income and financial
assets between domestic
households, businesses, and
governments and residents of the
rest of the world during a specific
time period
VIGHNESWARA SWAMY
Globalization
Globalization
1. Globalization is a process of greater interdependence among countries and their
citizens.
2. OECD defines Globalization as a process of deeper economic integration
between countries and regions of the world.
3. For a common man, globalization means, residents of one country are more
likely to consume the products of other country, to invest in other country.
4. Globalization has two facets: (1) Globalization of Markets and (2) Globalization
of Production.
5. Globalization is also termed as the shrinkage of economic space.
VIGHNESWARA SWAMY
Globalization: Major Drivers
1. Emergence of global financial markets.
2. Emergence of the Euro as a global currency (beginning of 1999).
3. Trade liberalization (GATT and WTO) and economic integration
(EU, SAFTA)
4. Surge in privatization, public private participation (PPP)
5. Emergence of Multinational Corporations (MNCs) like GE,
Vodaphone, Toyota, Siemens, TATA, and others
VIGHNESWARA SWAMY
Waves of Globalization
1. First Wave of Globalization: 1870-1914
- Largely driven by European and American businesses
2. Second Wave of Globalization: 1945-1980
-Decline in trade barriers, specialization in manufacturing
3. Latest Wave of Globalization: 1980 onwards

- Outsourcing of technologies and labor
VIGHNESWARA SWAMY
Globalization of Finance
1. Rise in international financial instruments
2. International funds (mutual funds)
3. Emerging country funds
4. Hot money flows
VIGHNESWARA SWAMY
Tit-Bits
Difference Globalization of Markets and Globalization of Production
Globalization of Markets Globalization of Production

Globalization of markets refers to the fact The globalization of production refers to
that in many industries historically distinct the tendency among many firms to source
and separate national markets are merging goods and services from different locations
into one huge global marketplace. around the globe in an attempt to take
advantage of national differences in the
cost and quality of factors of production.
(labor, energy, land and capital)
VIGHNESWARA SWAMY
Key learnings
1. The merchandise trade balance measures exports minus imports of goods.
2. Net exports includes trade in services as well.
3. The current account includes net international factor income, taxes, and
transfers.
4. The current account is mirrored by an equal and opposite capital and financial
account measuring net asset transactions.
5. The net international investment position measures our current net claims on
the rest of the world.
6. The flow identity tells us that the current account reflects some combination of
personal saving, investment in plant and equipment, and the government deficit.
VIGHNESWARA SWAMY
Key words
Balance of Payments
Current Account
Capital Account
Financial Account
Current Account Deficit
Globalization
Financial integration
34

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Introduction

Dr. Vighneswra Swamy 1

DR. VIGHNESWRA SWAMY 3

Usefulness of Microeconomics: Usefulness of Macroeconomics:

DR. VIGHNESWRA SWAMY 4

DR. VIGHNESWRA SWAMY 6

Economic analysis is a tool that can aid all decision

The economic way of thinking provides a framework for

DR. VIGHNESWRA SWAMY 8

DR. VIGHNESWRA SWAMY 11

DR. VIGHNESWRA SWAMY 14

DR. VIGHNESWRA SWAMY 15

DR. VIGHNESWRA SWAMY 16

DR. VIGHNESWRA SWAMY 18

•Economic Interdependence is an important feature of an

Inputs for Labor, land,

Output is typically measured as Gross Domestic Product (GDP). It is

GDP = C + I + G + (EX  IM)

National income 12,280.0 100.0

Less: Payments of factor income to the rest of the world -484.5

Equals: GNP 14,361.2

Calculating Real GDP (base year 2001):

2016 51,400 50,000 102.8 2.8%

2017 58,300 52,000 112.1 9.1%

2. These fluctuations are probably accurately timed

Aggregate Supply Curve

Output (Y) Output (Y)

Real domestic output (GDPR) 18

The main result from the classical

Since an increase in demand is met

Output may exceed the level of full

Adjustments in wages and prices

J.B. Say’s Law

The government can increase aggregate demand by reducing taxes

If in recession, the government might cut taxes or increase

Beginning with the horizontal black

Shifts in AD due to:

• Figure shows an outward shift in AD

 The fundamental equation underlying the quantity theory of money is

– If money stock increases by 10% to M   1.1M

 this is true at E’’, where AD = AS

(iii) As the level of income increases, the households devote a

2. If income levels are actually zero, 2. Consumption is considered

MPC is the first derivation of consumption function.

Induced consumption can be described by formula: 𝑪𝑰 = 𝑴𝑷𝑪 × 𝒀

MPC = 1– MPS MPS = 1 – MPC

If autonomous consumption exists then autonomous saving

Saving is a source for investment.

CA S = f(Y) It shows the

(1) $370 $375 $-5 1.01 -.01

Saving Schedules 500

Consumption (billions of dollars)

◦ Ex. If the MPC = 0.9, then 1/(1-c) = 10  an increase in government

API=I/Y If income increases by INR10 crore

MEC & rate of interest

Discovery of natural resources

Rate of population growth

The price level

The market structure

Conditions in the labour market