MACROECONOMIC MODELS

Prof. Seema Sharma

Department of Management Studies
IIT Delhi-110016
Classical School
 Classical School: Important Tenets
• The Classical School of economic theory: Adam Smith's monumental work - The
Wealth of Nations (1776) The book identified land, labor, and capital as the
factors of production and the major contributors to a nation's wealth.

• According to Adam Smith, free markets can regulate themselves. And

this self-regulating market system automatically satisfies the economic needs of
the population. Adam Smith proposed the idea of an “invisible hand”
and stated that in a free market, people act in their own self-interest
which causes prices to rise or fall. The pursuit of people’s self-interests
produces the greatest benefit for society as a whole. Classical economists stated
that the Demand and Supply will always return to equilibrium. But
classical economists did not address how long it would take to reach
equilibrium. This problem was highlighted by the Great Depression of
20s.
 Classical Macroeconomic Model
❑ Money is neutral
(Just a medium of exchange)
❑ Laissez Faire Policy
❑ Say’s Law
❑ Long run
❑ Flexible interest rates
❑ Flexible prices
❑ Flexible wages
 According to
classicals, money
P2 is neutral. So
increase in MS
P1
has a direct
relationship with
Prices. An
P0 increase in MS
will increase the
prices but not the
output as we are
operating at full
employment.

Full Employment Output

 The Great Depression: Failure of Classical Model

▪ In late 20s, the postulate of flexible prices and wages could not work.
According to Classical theory, the downward adjustments in the
wages can on

one hand create incentive for the investors to

invest more,

and on the other hand, the real wage rate can be

kept stable by reducing the prices.
▪ Reduction in wages led to decline in AD levels and plunged the
economy in deeper depression upto end 30s.

▪ The bad condition of the economy with high unemployment rate

required aggressive Govt. intervention but was not possible due to
Laissez faire policy. Later some measures were taken but failed to
revive the economy.
 Failure of Classical Economists to deal with Depression
turned Great Depression
• Market correction a long-term phenomenon. In this process people suffer
destitution with extreme poverty and no means to support their lives.
• Stock market crash of 1929 (, the decade of 20s saw tremendous growth,
spending was high; production was high; but gradually with rise in prices, demand
started slowing down; overproduction leads to downturn of the business cycle.
People were taking loans to invest in stock market to make quick money. The stock
market was overvalued but the real economy was not growing.)
• Collapse of world trade due to the Smoot-Hawley Tariff
(USA increased tariff rates to protect its industries but retaliation by other
countries dropped its exports and further setback to industries.
• Bank failures and collapse of money supply
• Government policies
(Flexibility of wages played havoc)
New Deal: Roosevelt’s Response to Depression
 Keynesian Model
• John Maynard Keynes's magnum opus, The General Theory of Employment, Interest and
Money, published in 1936.
• Classical model was supply side model as they said Supply creates its own demand. But
Keynes argued that Aggregate demand, instead of Aggregate Supply, determines the
overall level of economic activity.
• Inadequate aggregate demand could lead to prolonged periods of high Unemployment.
• He advocated that the use of Fiscal and monetary policies can mitigate the adverse effects
of economic recessions and Depressions.
• Keynes was deeply critical of the British government's austerity measures during the Great
Depression. He believed that budget deficits were a good thing.
• At the height of the Great Depression, in 1933, Keynes published The Means to Prosperity,
which contained specific policy recommendations for tackling unemployment in a global
recession, chiefly counter-cyclical public spending.
• The Means to Prosperity contains one of the first mentions of the Multiplier Effect. While it
was addressed chiefly to the British Government, it also contained advice for other nations
affected by the global recession.
• A copy was sent to the newly elected President Franklin D. Roosevelt and other world
leaders. The work was taken seriously by both the American and British governments.
 Keynesian Model: Assumptions

• No Laissez Faire Policy

• Short Run
• Money is not neutral
• Supply is generally greater
than Demand
• Less than full employment

Full Employment Output

The General Theory of Employment, Interest and Money (1936)

Effective Demand: Economy generally operates at less than full employment

(Involuntary unemployment). There is indirect relationship between MS and Price
level as when MS increases, it increases output also apart from prices. Government
must behave as investor to revive the economy in bad times.
 Keynesian Model
In the state of equilibrium in the
economy:
AD= AS
E=Y
C+I = C+S
AD: Aggregate Demand
AS: Aggregate Supply

E: Total Expenditure, Y: Total Income

C = Consumption, I: Investment, S: Savings

If E < Y , N
Y
If E > Y Y , N
When money supply increases, E>Y, hence output and employment increases.
Consumption Function
(i) State of Equilibrium (Centre of gravity)

(ii) A shift in AD will lead to higher income levels.

Investment Multiplier
Investment Multiplier
 Increase in Increase in Increase in Increase in
Period
Investment Income Consumption Savings

1 100 100 (ΔY) 50 (100 x 0.5) 50

2 50 (bΔY) 25 25
3 25 (b2ΔY) 12.5 12.5
- - - -
- - - -
- - - -
- - - -
- - - -
Total = 100/(1-b)
Total increase in Income =
200 100 100
 Relationship between mpc and Investment Multiplier

Higher the mpc, larger will be the change in income.

mpc k = 1/(1-mpc)
1 1/0 = ∞
0.8 1/0.2 = 5
0.5 1/0.5 = 2
0 1=1

mpc of poor people is high hence, in depression, purchasing

power of poor people should be increased.
 Why monetary Policy ineffective during
Depression
❑Paradox of Thrift
People save more in recession which leads to
decline in AD and hence the economic growth.

❑Liquidity Trap
Monetary Policy ineffective to revive the economy.
Liquidity Trap
 Marginal Efficiency of Capital (MEC)

Keynes, also gave concept of Marginal Efficiency of Capital (MEC). Also known
as internal rate of return, it is the rate that would discount future income and cost
outlays such that the net present value was zero.

Keynes described the marginal efficiency of capital as:

“The marginal efficiency of capital is equal to that rate of discount which would make
the present value of the series of annuities given by the returns expected from the
capital asset during its life just equal to its supply price.” – J.M.Keynes, General Theory,
Chapter 11

This theory suggests investment will be influenced by:

1.The marginal efficiency of capital
2.The interest rates

Generally, a lower interest rate makes investment relatively more attractive. If interest rates were
2.5%, then firms would need an expected rate of return of at least 2.5% from their investment to
justify the investment. If the marginal efficiency of capital was lower than the interest
rate, the firm would be better off not investing, but saving the money.
A reduction in interest rates from 5% to 2% will increase investment from 100 to 150
as all projects with MEC more than 2% are also profitable.

However, in a liquidity trap, investments may be unresponsive to lower interest

rates.
 IRR vs. NPV
• NPV is in absolute measure. IRR is in relative measure.
• NPV is the net present value of the difference of the cash inflows and the cash
outflows. Whereas IRR is the discount rate that equates NPV of a project to zero.
• NPV method focuses on the actual expected absolute returns as it considers the
rate of interest. On the other hand, IRR determines the breakeven rate of discount.

IRR NPV

Here, C0 is the initial investment of the capital

Here, SP is the supply price of the capital asset.
asset or project.
R1,R2… Rn are the prospective yields; and i is the
R1,R2… Rn are the prospective yields; and r is
rate of discount.
the rate of interest.
 SP = 2200; r = 18
i = 20 r = 18
Year Monetray Value Discounted Value Discounted Value
1 900 750.00 762.71
2 800 555.56 677.97
3 700 405.09 593.22
4 600 289.35 508.47
5 498 200.00 422.03
2200.00 2964.41
NPV = (2964.41-2200)
NPV = 764
 SP = 2200; r = 18
i = 20 r = 18 r = 15
Year Monetray Value Discounted Value Discounted Value Discounted Value
1 900 750.00 762.71 782.61
2 800 555.56 677.97 695.65
3 700 405.09 593.22 608.70
4 600 289.35 508.47 521.74
5 498 200.00 422.03 433.04
2200.00 2964.41 3041.74
NPV = (2964.41-2200)
NPV=764

If r falls to 15%, a higher I would equate the returns to the Cost Price.
So Keynes said that AD is very important which further depends on two
things C & I. C depends on Income, and I depends on rate of interest & MEC
(marginal efficiency of capital). But he did not talk about goods market and
money market in the economy.
 Equilibrium in the Economy

Closed Economy Open Economy

1962, 1963
1936

1937
Keynesian sector Hicks & Hansen Mundell Fleming
Model three Sector Model Four Sector
Model
AD = AS
C+I = C+S C+I+G = C+S+T
C+I+G+(X-M)

IS-LM Model IS-LM-BP Model

Income and Employment
determination in the economy
General Equilibrium in General Equilibrium
the Economy in Goods in the Economy in
and Money Market Goods Market,
Money Market and
BOP
IS LM Analysis: GeneraL EQUILIBRIUM of Product and
Money Market

• Hicks and Hansen, in 1937, gave general equilibrium of goods

and money market in the economy.

• Goods Market (IS): Investment (I) and Saving (S)

• Money Market (LM): Demand for Money(L) and

Supply of Money (S)
 Product Market Equilibrium

AD = AS
Total spending = Total Income (in equilibrium)
C+I+G = C+S+T
Hence S = I (Desired S and I)
S = f(Y); positive relationship
I = f(r); negative relationship,
r: interest rate
IS curve shows combinations of r & Y where S & I are
equal.
Can also be explained with the help of I and S
curves as shown in next slide
Derivation of IS Curve

IS Curve: There is
negative relationship
between r and output.
Y = f(r)

Changes in Y caused
by changes in r are
reflected as
movements along the
IS curve. When
interest rates
decrease, spending
rises and as a result,
output increases as
well. When interest
rates increase,
spending falls and as
a result output
decreases as well.
Shifts in IS curve: Changes in Y due to factors other than r

Change Shift
Increase in investment right
Increase in Govt.
Spending Right
Increase in
consumption Right
Reduction in saving Right
Reduction in Taxes Right
Investment falls Left
increase in Savings Left
Increase in Taxes Left
Money market Equilibrium
LM
 L= LT+Ls
LT: Transactions demand for money
Ls: Speculative demand for money

LT =f(Y), positive relationship

Ls= f(r), negative relationship

M
Money Supply is assumed fixed as set by RBI in India and Federal
reserve in US
LM curve shows all combinations of r & Y at which demand for
money and supply of money is equal.
 Derivation of LM Curve

LM curve relates different income levels to various interest rates.

Shape and slope of LM Curve
 Shifts in LM curve
Change Shift
Increase in Money supply right

decrease in demand for money right

Decrease in Money supply Left

Increase in Demand for money Left

IS LM General Equilibrium
ISLM and Policy: Fiscal Policy and Monetary Policy

Govt. Expenditure, Taxation and Money Supply are policy variables.

 Expansionary Fiscal Policy: Crowding Out Effect

Public investment crowds out the private investment.

However, no Crowding Out if operating at Liquidity Trap
A monetary expansion (the rightward shift in LM) has no effect on equilibrium
interest rates or output. However, fiscal expansion (shift in IS ) leads to a higher
level of output with no change in interest rates. Since interest rates are
unchanged, there is no Crowding Out effect either.
 Expansionary Monetary Policy

Open Market Operations: The Central Bank buys bonds & increases the money supply.
This injection of liquidity lowers the interest rate in the money market. The reduced
interest rate induces increased investment, and equilibrium output consequently
increases. The LM curve shifts to the right and equilibrium output increases. Because of
the increased income demand for money increases (transactions), and this increases the
interest rate. The economy eventually settles down at a new simultaneous equilibrium.

MS ↑ ⇒ r↓ ⇒ I↑ ⇒Y↑ ⇒MD ↑ ⇒ Net reduction in r overall and higher income.

Simultaneous use of Expansionary Fiscal & Monetary Policy to
avoid Crowding Out
 Case of the 1990s boom in the US
In 1990-91 the US economy was in recession following a Global economic
slowdown. On election in 1992 Bill Clinton faced a considerable budget
deficit and an economy in some difficulties. In 1993 the Republican Congress
passed a deficit reduction package which increased taxes and reduced
Government spending. On the other hand, the newly appointed chairman of
the Federal Reserve employed expansionary monetary policy and kept
interest rates at a 30 year low. This low interest rate encouraged investment,
especially in the highly productive new technologies and induced a sustained
period of economic growth.
 Money Supply

M4: M3 + All deposits with post office savings banks (excluding National
Savings Certificates).
• Like other developed countries, since 1957

Reserve Bank of India follows Minimum Reserve

System of issuing currency. Under this system,

minimum reserves of Rs. 200 crores of gold and

other approved securities (such as dollars, pound

sterling, etc.) have to be kept and against this any

amount of currency can be issued depending on

the monetary requirements of the economy

 Money Supply
• In India, RBI uses four alternative measures of money supply viz., M1, M2, M3 and M4. M1 is
the most commonly used measure of money supply because its components are regarded
most liquid assets. Each measure is briefly explained below.
• (i) M1 = C + DD + OD. Here C denotes currency (paper notes and coins) held by public, DD
stands for demand deposits in banks and OD stands for other deposits in RBI. Demand
deposits are deposits which can be withdrawn at any time by the account holders. Current
account deposits are included in demand deposits.
• But savings account deposits are not included in DD because certain conditions are imposed
on the amount of withdrawals and number of withdrawals. OD stands for other deposits
with the RBI which includes demand deposits of public financial institutions, demand
deposits of foreign central banks and international financial institutions like IMF, World
Bank, etc.
• (ii) M2 = M1 (detailed above) + saving deposits with Post Office Saving Banks
• (ii) M3= M1 + Net Time-deposits of Banks
• (iii) M4 = M3 + Total deposits with Post Office Saving Organisation (excluding NSC)
Like other developed countries, since 1957 Reserve Bank of India follows

Minimum Reserve System of issuing currency. Under this system, minimum

reserves of Rs. 200 crores of gold and other approved securities (such as dollars,

pound sterling, etc.) have to be kept and against this any amount of currency can

be issued depending on the monetary requirements of the economy

 Demonetization in India
Evidence from Past
• The first instance was in 1946 and the second in 1978
when an ordinance was promulgated to phase out notes
with denomination of Rs 1,000, Rs 5,000 and Rs 10,000.
 Demonetisation in 2016
• Demonetisation is the act of withdrawing a currency unit of its status as
legal tender.
• Was a policy enacted by the GOI on 8 November 2016, ceasing the usage
of all 500 and 1,000 banknotes of the MG Series as legal tender in India
from 9 November 2016.
Benefits
Four measures started in 1977 by RBI.
Next Topics

• National Income Accounting

• Inflation