BA103: Introductory

Macroeconomics
Unit 1: Basics of
Macroeconomics and National
Income Accounting
Abel, Bernanke and Croushore
(2014, 8th Edition), Chapter - 1,
Chapter - 2
And any 12th Class CBSE Textbook
for Macroeconomics
Question: What is Economics?
Answer: We know resources (Land, capital, Labor etc.)
are scarce but they have many alternative uses.
Economics is the study of how economy’s scarce
resources can be used efficiently and rationally to
maximize the economic gains.
Or
We can simply say that Economics is the study of
efficient allocation of economy’s scarce resources
to generate maximum possible returns.
Note: Efficient means less distortion or less
wastage or generating maximum possible returns
or welfare.
 Branches of Economics
There are broadly two branches of Economics: 1.
Microeconomics and 2. Macroeconomics
1. Microeconomics: Micro means small. Micro-
economics is the study of economic
activities/problems/policies at the micro level/small level.
For example: at the level of a firm, an individual
household, an industry etc.
2. Macroeconomics: Macro means large.
Macroeconomics is the study of economic
activities/problems/policies at the level of
aggregate/national economy. For example: study of
national income, GDP, unemployment, inflation etc.
Note: Economic activity means consumption, Investment,
production, distribution or Income generation etc.
 Central Problem of an Economy
An economic problem generally means the
problem of making choices that occurs
because of the scarcity of resources. Causes of
Economic Problem:
1. Scarcity of Resources: Resources like
labour, land, and capital are insufficient as
compared to the demand. Therefore, the
economy cannot provide everything that people
want.
2. Unlimited Human Wants: People’s wants
are unlimited and keep multiplying, therefore,
cannot be satisfied because of limited resources.
3. Resources have alternative uses:
Resources being scarce, the same resources are
 Central Problem of an Economy
(Cont..)
An economy faces three types of Economic/Central
problems:
1. What to Produce: A country cannot produce all
goods because it has limited resources. It has to
decide what goods and services should be
produced. Example: a farmer having a piece of land
has to decide whether to grow wheat or rice.
Government has to decide whether to allocate
funds, for the production of defense goods or
consumer goods, and if both, then in what
proportion.
2. How to Produce: This problem refers to the choice
of technique of production. It arises when there is
 Central Problem of an Economy
(Cont..)
…….. (a) Labour intensive technique(greater use of
labour) and Capital intensive technique(greater use
of machines). Labour intensive technique promotes
employment whereas capital intensive technique
promotes efficiency and growth.
3. For whom to produce: The society cannot satisfy
all the wants of all the people. Therefore, it has to
decide who should get how much of the total
output of goods and services. Society has to make
choice of whether luxury goods (for rich) or normal
goods (for everyone) have to be produced and if
both, then in what proportion. This distribution
or proportion directly relates to the purchasing
The major issues that Macroeconomists
address include the following:
1. What determines a nation’s long-run economic
growth?
2. What causes a nation’s economic activity/nation’s
GDP to fluctuate?
3. What causes unemployment?
4. What causes prices to rise i.e. inflation?
5. How does being part of a global economic system
affect nations’ economies?
6. Can and how government policies be used to
improve a nation’s economic performance?
7. What policies central bank should follow?
 Different sectors of the
Economy
Broadly there can be four sectors in the economy: 1.
Household/Consumption sector 2. Firm/Production
sector 3. Government Sector 4. Rest of the world.
1. Two sector economy: Household sector and Firm
sector
2. Three sector economy: Household sector, Firm
sector and Government sector
3. Four sector economy: Household sector, Firm
sector, Government sector and Rest of the world
Note: A closed economy is defined by two sector or
three sector economy whereas an open economy is
defined by four sector economy.
 There can be one more sector apart from the ones
listed above i.e. financial sector etc.
 Circular Flow Model/Diagram
 Circular flow model/diagram, also known as circular flow
of income/money, is a basic model used in economics to
show how an economy functions. It says economy works
in a never-stopping circular motion.
 Primarily, it looks at the way money, goods and services
move between different sectors of the economy.
 The figure at the slide no. 11 represents the circular flow
of money/income for a two sector (basic) economy,
consisting of Household and Firm Sector:
1) Household sector provide factors of production/factor
services (land, labor, capital, entrepreneur) to the Firm
sector. Firm sector in turn provides factor income (rent,
wage, interest, profit) to the household sector.
2) Firm sector provides goods and services to the
household sector for consumption. Household sector….
 Circular Flow Model/Diagram
………. in turn provide money to the firm sector as
payments for the purchase of goods and services.
 Thus, initially money flows from firm sector to household
sector as payments for the purchase of factors of
production. Then money flows back to firm sector as
payments for the purchase of goods and services by
household sector.
 Since the process of consumption and production never
stops, the circular flow of money/income between the
firm sector and the household sector never stops.
 Broadly, circular flows are of two types: 1. Real flows (refer
to the flow of goods and services, and factors of production
among different sectors of the economy) and 2. Money
Flows (refer to the flow of money across different sectors
of the economy). Money flows are reciprocal of real
 Circular Flow Model/Diagram
 The outer circle in the figure below represents Money
flows and the inner circle represents the Real flows.
 Circular Flow Model/Diagram
 In general, economy is characterised by having all five
sectors: household, firm, Govt, financial and rest of the
world. The circular flow of income of a five sector
economy is represented at the slide no 13.
 The introduction of govt, financial and rest of the world
sector allow use to understand the role of injections and
leakages in the circular flow of income.
 Injections are addition to the income stream i.e. they lead
to an increase in economy’s income flows. For example;
investment (I), govt purchase expenditure (G), exports
(X) and transfer payments by govt (TR).
 Leakages, on the other hand, are withdrawals from the
income stream i.e. they lead to an decrease in
economy’s income flows. For example; saving (S), tax
(T) and import (IM).
The circular flow of an economy is balanced when the total
injections (I+G+X+TR) equal the total leakages (S+T+IM).
If injections overweight leakages, the country’s national
income will grow. If injections are below leakages, the
country’s national income will fall.
 National Income Accounting
 National income is a measure of total economic
activities in an economy during an accounting year.
 National income is defined as the sum total of factor
incomes generated by normal residents of a country,
within its domestic territory or outside, during an
accounting year.
 Question: Who are normal residents of a country?
Answer: A normal resident is said to be the one who
ordinarily resides in the country concerned (generally for
more than one year) and whose centre of economic
interest (consumption/investment/Spending/Earning) lies
in that country on a significant scale.
 Note: 1. Normal residents include both individuals as
well as the institutions. 2. Foreign citizen living in India
for a period of more than one year (other than those……
 National Income Accounting
………for studies or travelling or medical treatment) are
also part of normal residents of India. 3. Indians working
within domestic territory of India (located outside India) are
also part of normal residents of India. 4. Normal residents
do not include the officials, diplomats and members of
armed forces of a foreign country posted in our country
and international organizations such as IMF, WHO, UNO
located in our country. However, Indians working in these
organization is part of Normal resident.
 Question: What is domestic territory a country?
Answer: Domestic territory of a country includes – (a)
Territory lying within the geographical territory including
territorial water of a country (b) Ships and aircrafts
operated by residence of the country across different
parts of the world. (c) Embassies, consulates and
military establishment of the country located abroad.
 National Income Accounting
 Domestic Income: It is defined as the sum total of
factor income generated within domestic territory of a
country during an accounting year.
 Difference between national income and domestic
income: National income includes factor income
generated by normal residents of a country, within its
domestic territory or outside during an accounting year
whereas domestic income only includes factor income
generated within domestic territory of a country during
an accounting year, no matter whether it is generated by
normal residents of the country or by non-residents.
 There are three approaches/methods to measure
national income/domestic income: 1. Production
approach 2. Income approach 3. Expenditure approach
 All three approaches leads to the same answer. This…..
 National Income Accounting
…..is because over any specified time period, following is
true in the economy: total production = total income
generated = total expenditure incurred.
Reason: (A). The market value of production must be equal
to the amount buyers have spent to buy them, which implies
total production value = total expenditure incurred ------- (1)
Also expenditure by one person is income for the other
person, which implies total expenditure incurred = total
income generated -----(2). Combining (1) and (2), we get
Total production = total income = total expenditure
(B) Whenever output is produced & sold, its production is
counted in product approach, its sale is counted in
expenditure approach and funds received by seller is
counted in income approach. So all produce same answer.
 National Income Accounting
 Since all approaches produce same result, national
income is also called national product or national
expenditure of the economy. Similarly, domestic income
is also called domestic product or domestic expenditure
of the economy.
1. Production Approach/Method: This approach is also
called value added approach or product approach. This
approach first calculates gross domestic product at market
price (GDPMP).
According to this method, GDPMP is defined as the total
market value of final goods and services newly produced
within the domestic territory of a country during an
accounting year.
Or It is defined as the total value addition within the
domestic territory of a country during an accounting year.
 National Income Accounting
 Therefore, the first way to calculate GDPMP is to add
market value of all the final goods and services newly
producing within the domestic territory of a country during
an accounting year.
 And the second way to calculate GDPMP is to calculate
total value addition in the economy within the domestic
territory of a country during an accounting year.
GDPMP = total value addition
= Value of output – intermediate consumption

Sales + Change in Stock Consumption of intermediate

goods and services
(Closing Stock –
Opening Stock)
 National Income Accounting
Question: What is the difference between Intermediate
goods and services and final goods and services?
Answer: Intermediate goods and services are those goods
and services which are used in the production of other goods
and services. They include value of non-factor inputs (all
inputs other than factors inputs of land, labor, capital and
entrepreneurship) used in the production process. Primarily, it
includes value of raw material used in the production process.
For example: (a) Wheat that is produced and then used to produce
flour in the same year is an intermediate goods. (b) Similarly flour that
is produced and then used to produce bread in the same year is an
intermediate goods. (c) An truck company that delivers flour to the
bakery provides intermediate services.
 Final goods are those goods and services which have
crossed all the production processes and are ready for final
(end) consumption. For example: bread produced by …...
 National Income Accounting
…...bakery for our consumption is a final good. If you take a
bus ride from office to home, it is a final service.
Problems/Precautions with product approach:
a) Some goods and services (such as service of housewives or
service of a doctor in his own family or growing vegetable in your
own garden) are not sold in formal markets and therefore their
accurate market values are not available. Because of this
reason, they are simply ignored in the calculation of GDP.
b) Transactions in underground economy (or shadow economy)
are excluded in the calculation of GDP simply because it is
difficult to measure their market value.
c) Value of the sale and purchase of second hand goods is not
included in value added. Because, value of second hand goods
is already accounted for during the year they were produced.
d) Commission earned on account of the sale and purchase of
second hand goods is included in the estimation of value ……
 National Income Accounting
…...added or calculation of GDP. Because commission is reward
for the services rendered.
e) Imputed (estimated) value of production for self-consumption
is taken into account. Because these goods are like those
produced for the market and has the market value. E.g wheat
produced and consumed by the farming families themselves.
f) Value of intermediate goods are not included in the estimation
of value added. Because value of intermediate goods are
reflected in the value of final goods.
g) Imputed (estimated) rent on owner occupied/self occupied
house is also taken into account. Because all houses have rental
value, no matter whether they are self-occupied or rented.
h) The product method of estimating national income/GDP might
lead to the problem of double counting. The problem arises
when the value of certain item is counted more than once. This
happen when we fail to draw distinction between final goods and
intermediate goods.
 National Income Accounting
There are two ways to avoid problem of double counting:
(i) Consider only the value of final goods and services produced
within domestic territory of the country to calculate GDP Or
(ii) Calculate value addition by each producing unit within the
domestic territory. Then take sum total of value added by all the
producing units within the domestic territory to calculate GDP Or
Calculate total value addition within the domestic territory by
taking the difference between total value of output (by all
producing units) and total intermediate consumption (by all
producing units).
 Once we have calculated gross domestic product at
market price (GDPMP), we can calculate net domestic
product at market price (NDPMP) as
NDPMP = GDPMP – Depreciation
 National Income Accounting
 Given NDPMP, net domestic product at factor cost
(NDPFC) is given by
NDPFC = NDPMP – net indirect taxes
where net indirect tax = indirect tax – subsidy
 Given NDPFC, net national product/national income at
factor cost (NNPFC) is given by
NNPFC = NDPFC + net factor income from abroad (NFIA)
where net factor income from abroad (NFIA) = factor
income earned by our residents from abroad – factor
income earned by non-residents/foreigners in our
domestic territory.

Note: Depreciation is also known as the ‘consumption

 National Income Accounting
An example of product method: Find out (i) Value added by firm
A and B (ii) Gross value added or Gross domestic product at Factor
cost
 National Income Accounting
2. Expenditure Approach/Method: This approach first
calculates gross domestic product at market price (GDP MP).
According to this method, GDPMP is defined as the total
spending on final goods and services newly produced
within the domestic territory of a country during an
accounting year.
GDPMP = total spending = C + I + G + NX
(i) Consumption Expenditure (C), also known as
personal/private consumption expenditure, is spending by
domestic households on final goods and services, including
those produced abroad. It is generally the largest
component of total expenditure in any country.
(ii) Investment Expenditure (I), also known as gross
domestic capital formation, is defined as the sum of gross
 National Income Accounting
where (a) gross domestic fixed capital formation (also
known as gross domestic fixed investment)
is the expenditure incurred on acquiring new capital goods
or fixed assets by domestic private sector or businesses,
known as business fixed investment
plus expenditure by government in the construction of fixed
assets or on infrastructure such as roads, railway, bridges
etc, known as public or government fixed investment
plus expenditure by household in the construction of new
house or purchase of new house, known as residential
investment

And (b) inventory investment is defined as the change in

stock, given by closing stock minus opening stock.
 National Income Accounting
(iii) Government purchase expenditure (G): It includes
govt purchase of final goods and services which include
any expenditure by the govt for a currently produced good
or service, foreign or domestic.
(iv) Net exports (NX): Net exports are exports minus
imports. Exports are sell of domestically produced goods
and services in foreign country. Imports are purchase of
foreign goods and services by domestic residences.
Note: Exports are added to total spending because they
represents spending by foreigners on domestically produced
goods and services. Imports are subtracted because C, I and G by
definition include imported goods and services. Subtracting imports
ensures that total spending, C+I+G+NX, reflects spending only on
domestically produced goods and services or goods and services
produced within the domestic territory of the country.
 National Income Accounting
It is the total spending on domestically produced goods and
services (GDPMP) which reflects the level of overall economic
activity in the country. A higher GDPMP represents a higher
level of income/employment generation in the country or
high economic growth of the country.
Problems/precautions with expenditure approach:
a) Not all the expenditure done by government involves purchase
of currently produced goods and services. Transfer payments, a
category that includes government payments for social security
and medical benefits, unemployment allowances, old age pension,
other welfare payments and so on, are payments by government
that are not made in exchange for current goods and services i.e.
they do not cause any value addition in the economy. As a result,
they are not counted in ‘G’ and hence they are not counted in the
calculation of GDP.
 National Income Accounting
b) For similar reason, interest payments on the national debt
are not counted as part of ‘G’.
c) Only final expenditure is to be taken into account to avoid the
problem of double counting. Final expenditure is to be
interpreted as expenditure on final goods and services.
d) Expenditure on second hand goods is not be include
because value of second hand goods has already been
accounted during the year of their production (when these were
initially produced and purchased by the final users)
e) Expenditure on shares and bonds is not be included in total
expenditure and hence not counted in the GDP calculation, as
these are mere paper claims and are not related to the
production of final goods and services. Such expenditure does
not cause any value addition in the economy.
f) Imputed (estimated) value of expenditure on goods produced
for self-consumption should be taken into account as the………..
 National Income Accounting
…….consumption expenditure, as these goods are reflected in
the estimation of GDP. Also imputed (estimated) rent on owner
occupied houses should be taken into account.
Once we have calculated GDPMP using expenditure
approach, other values can be calculated by applying
the formula presented at slide no 23 and 24
 National Income Accounting
An example of Expenditure approach: Using following
data, find GDPMP and NDPFC.
 National Income Accounting
3. Income Approach/Method: This approach directly
calculates net domestic product at factor cost (NDP FC).
NDPFC = total factor income generated = Compensation
to employees + Operating surplus + Mixed income
(i) Compensation to employees = Salary & wages +
Payments in kind (such as accommodation) + Employer’s
contribution in social securities (for example employer’s
contribution in PPF, pension funds, health/life insurance
etc.)
(ii) Operating surplus = Rent + Profit + Interest + Royalty

Corporate Retained earnings Dividends

income tax or Reserves or
Undistributed profits
 National Income Accounting
(iii) Mixed Income: income of self-employed person using
their own labor, land & capital to produce goods and
services.
Problems/precautions with Income approach:
National Income Accounting
 National Income Accounting

Once we have calculated NDPFC using income

approach, GDPMP can be calculated by adding
depreciation and net indirect tax in to it. Other values
can also be calculated by applying the formula
presented at slide no 23 and 24.
 National Income Accounting
An example of Income approach: Using following data,
find NDPFC, GDPMP and GNPMP
Question: Can the current system of national income
accounting (which we just studied) be called ideal?
The answer is no. Because under the current system of
national income accounting, national income/GDP is
estimated with no regard to (i) environmental pollution and
(ii) exploitation of natural resources.
If national income/GDP increases along with increase in
environmental pollution, the quality of life would be far less
than the one indicated by national income/GDP index.
Likewise, if national income/GDP increases along with
excessive exploitation of the natural resources (so
excessive that it reduces the availability of resources for
the future generations), the increase in national
income/GDP would only be misleading as it cannot be
sustained in the years to come.
Therefore, an ideal national income accounting system
must consider the cost of environmental pollution and the
cost of national resource exploitation while estimating the
national income/GDP.
In other words, it can be said that national income/GDP
index should reflect not only the total economic activity in
the economy but also the cost of environmental pollution
and cost of national resource exploitation. Estimation of
national income/GDP that accounts for these parameters
is called Green GDP.
Emphasis on the concept of green GDP is a part of
achieving the goals of sustainable development.
One more Question: Does GDP represents welfare
of the society? (Do some research. Homework)
Private Sector and Government
Sector Income
 The income of the private sector, known as private
disposable income, measures the amount of income the
private sector has available to spend and save. It is given
by following equation.
Private disposable income = Y + NFIA + TR + INT – T
where
Y = Gross domestic product (GDP)
NFIA = Net factor income from abroad
TR = Transfers payments received from government
INT = Interest payment on government debt
T = Taxes
 Income of government sector = T
Private Saving, Government Saving
and National Saving
 Private Saving (Spvt)
= Private disposable income – consumption
= (Y + NFIA + TR + INT – T) – C
 Government Saving (Sgovt)/Government Budget Surplus
= Government total income – government total spending
= T – (G+TR+INT)
 National Saving (S) = Private Saving (Spvt) + Government
Saving (Sgovt)
S = Spvt + Sgovt
= (Y + NFIA + TR + INT – T) – C + T – (TR+INT+G)
Question: What is the use of an economy’s private saving?
Answer: An economy’s private saving is used in three ways:
(i) To finance private investment (I): Firms borrow from
private savers (through banks) to finance their business
fixed investment and inventory investment.
(ii) To finance government budget deficit: when government
runs a budget deficit, it borrows from the private savers to
cover the difference between the total spending and total
receipts.
(iii)To finance current account balance: If the country’s
current account is in surplus, that means what foreigners’
are receiving from our country is less than the payments
they need to make to the country. In this case, country’s
private savers will buy more of foreign assets or lend to
foreigners to provide them domestic currency to make
payment for the difference.
 Relating saving and wealth
 National Wealth: National wealth is the total wealth of the
residents of a country. It has two parts
(i) Country’s domestic physical assets (such as stock of
capital goods and land) and
(ii) Country’s net foreign assets, defined as the difference
between country’s foreign assets (foreign stock, bonds,
factories etc. owned by domestic residents) minus
country’s foreign liabilities (domestic stock, bonds,
factories etc. owned by foreign residents).
 National wealth of the country can change in two ways
overtime.
(A) If the value of existing assets or liabilities that make up
national wealth changes. For example; an increase in the
market value of country’s physical assets increases national
wealth. The depreciation of physical assets, which …………..
 Relating saving and wealth
……….corresponds to a drop in the value of those assets,
reduces national wealth.
(B) The second way that national wealth can change is
through national saving. Keeping everything constant, one
unit increase in national saving will lead to one unit
increase in national wealth. This is because national saving
is either used for building up of assets or reducing liabilities
of the country, both of which leads to one for one increase in
the national wealth.
 Real GDP and Nominal GDP
 Nominal variables: when economic variables are measured
in terms of current market values or at current price levels
or in terms of monetary units. Examples of nominal
variables are nominal wage, nominal GDP, nominal income,
current market value of national wealth etc.
 Real variables: when economic variables are measured at
constant prices or at base year prices. Real variables are
expressed in terms of volume/quantity of goods and
services. Examples of real variables are real wage, real
GDP, real income, real expenditure etc.
 Relation between the two: in general
Nominal variable (N) = Real variable (R) ᵡ Current price
level (P), where Real variable measures the quantity/volume
(Q) of goods and services.
 Real GDP and Nominal GDP
 What is Nominal GDP? Nominal GDP is the GDP or Value
of output that is measured at current market prices. It
shows the monetary value of economy’s final output
measured at current market prices.
 What is Real GDP? Real GDP is a GDP or Value of output
that is measured at constant prices or base year prices.
Real GDP measures the physical quantity of economy’s
final output using the base year prices.
 Whenever we want to compare values of an economic
variable, say GDP, at two different points in time, we focus
on the real GDP not on the nominal GDP. This is because
if nominal GDP i.e. current market value of the goods and
services changes overtime, you cannot tell when whether
this change is happening as a result of changes in the
quantities of goods and services produced or changes in
the prices of goods and services.
 Real GDP and Nominal GDP
 The use of Real GDP (i.e. GDP calculated at the base year
prices) helps us remove the effects of price changes and
thereby tell us how much of increase in GDP overtime can
be attributed to an increase in economy’s production of
goods and services.
 Consider an numerical example which gives production and price
data for an economy that produces two types of goods: computers
and bicycles. The data are presented for two different years.
 Real GDP and Nominal GDP
 Nominal GDP in year 1 = market value of GDP/production
in year 1 = (5*1200 + 200*200) = $46000
 Nominal GDP in year 2 = market value of GDP/production
in year 2 = (10*600 + 250*240) = $66,000
 We note that from year 1 to year 2, nominal GDP has
increased by 43.5% [=((66000-46000)/46000)*100]
 This 43.5% increase in nominal GDP reflects changes in
both production of output and prices.
 The question is: How much of the this 43.5% increase in
nominal output/GDP is attributable to an increase in
economy’s production of goods and services?
 For this, we need to measure value of production each year
by using the prices from some base year i.e. we need to
calculate real GDP in both the years.
 Real GDP and Nominal GDP
 Suppose the base year is year 1. So real GDP in year 1 =
value of production in year 1 at year 1 prices = 5*1200 +
200*200 = $46000
 Real GDP in year 2 = value of production in year 2 at year
1 prices = 10*1200 + 250*200 = $62000.
 We note that from year 1 to year 2, real GDP has increased
by 34.8% [=((62000-46000)/46000)*100]
 This implies that out of 43.5% increase in nominal GDP
from year 1 to year 2, 34.8% increase comes from an
increase in economy’s production of goods and services.
 In fact, countries focus on real GDP growth rate not
nominal GDP growth rate. And data which is realised by
government on quarterly/annual basis is the real GDP
growth rate data. This is because, as explained above, it is
real GDP growth rate which represents the actual value…...
 Real GDP and Nominal GDP
…...addition in the economy overtime or which represents
increase in GDP overtime due to the production of goods &
services or which represents overtime increase in level of
economic activity in the country or which represents the how
bigger the economy has become overtime.
An exercise: Continue with previous numerical example. Say
base year is year 2. Calculate real GDP in year 1, real GDP in
year 2 and real GDP growth rate from year 1 to year 2.
Solution:
Real GDP in year 1 = value of production in year 1 at year 2 prices
= 5*600 + 200*240 = $51000
Real GDP in year 2 = value of production in year 2 at year 2 prices
= 10*600 + 250*240 = $66000
Percentage growth of real GDP/ real GDP growth rate from year 1
to year 2 = [((66000-51000)/51000)*100] = 29.4%
 Price Indexes and Inflation
 So far we have seen how to calculate the portion of the
change in nominal GDP due to a change in quantities of
goods and services produced (or due to a change in the
production of goods and services). Now we turn our
attention to the change in prices by using price indexes.
 A price index is a measure of the average level of prices
for some specified set of goods and services, relative to
their prices in a specified base year.
There are basically three types of price index:
1) GDP Deflator: the GDP deflator is a price index that
measures the overall level of prices of goods and services
included in GDP and is defined by the following formula
GDP deflator = (Nominal GDP/Real GDP) ᵡ 100
Assuming base year is year 1. In year 1, we note that both
nominal GDP and real GDP are equal to $46000. So ………...
 Price Indexes and Inflation
…..the GDP deflator in year 1 is 100. This result implies that
GDP deflator will always equal 100 in the base year.
In year 2, nominal GDP is $66000 and real GDP is $62000,
so the GDP deflator in year 2 = (66000/62000)*100 = 106.5
 We note that GDP deflator in year 2 is 6.5% higher than
GDP deflator in year 1. Thus the overall level of prices, as
measured by the GDP deflator, is 6.5% higher in year 2 as
compared to year 1.
2) The Consumer Price Index (CPI): GDP deflator measures
the average price level of goods and services included in
GDP. The consumer price index, however, measures the
average price level of consumer goods and services. For
example; food, clothing, housing, fuel etc.
It is calculated monthly (while GDP deflator is calculated
quarterly).
 Price Indexes and Inflation
More specifically, CPI measures the average price level of
some specified set of consumer goods and services, relative
to their prices in a specified base year.
In India, CPI is calculated separately for rural areas and urban
areas (CPIrural and CPIurban). Combining the two, we get overall
CPI for the economy as a whole. Currently, the base year of
CPI in India is 2012. That means consumer price index (CPI)
for 2012 is 100.
3) Wholesale Price index (WPI): it measures the average
price level of specified set of goods sold in the wholesale
market (before they reach to the consumers), relative to their
prices in the specified base year.
In India, WPI is calculated monthly. Currently, the base year
of WPI in India is 2011-12. That means wholesale price index
(WPI) for 2011-12 is 100.
 Price Indexes and Inflation
Calculating Inflation: Inflation is defined as increase in
the general price level overtime and it is calculated by taking
percentage change in the price index. Formula for inflation (π)
in period t is given by
πt = ᵡ 100
where
Price indext = price index in period t and Price indext-1 = price
index in period t-1
 Price index could be GDP deflator, CPI and WPI.
(a) If we use GDP deflator as price index in the above formula, we
get inflation rate by GDP deflator.
(b) If we use CPI as price index in the above formula, we get
inflation rate by CPI or CPI inflation.
(c) If we use WPI as price index in the above formula, we get
inflation rate by WPI or WPI inflation.
 Price Indexes and Inflation
Example: Suppose CPI in 2019 is 130 and CPI in 2020 is 140.
So inflation rate in 2020 = [(140-130)/130]*100 = 7.7% app.
This implies that overall prices of consumer goods and services
in 2020 are 7.7% higher as compare to 2019. Or you can say
overall prices of consumer goods and services have increased
by 7.7% in 2020 as compare to 2019.

 Inflation can be of two types: Headline Inflation and

Core Inflation. Find out the definition of the two and
the difference between the two. (Homework).
 Business Cycle
Question: What is Business Cycle?
Answer: Business cycle is a series of cycles of economic
expansions and contractions that an economy experiences
overtime repetitively.
In other words, business cycle represents cycle of
fluctuations in the GDP around its long-term natural level
that an economy experiences overtime repetitively.
 Business cycle is also known as Economic/Trade cycle.
There are four phases/stages of business cycle:
1) Expansion (Boom or Upswing): This is the first stage of
business cycle. In this stage, GDP grows at a healthy rate;
businesses are doing well; employment is rising; consumers’
confidence is high; investors’ confidence is high;
unemployment is low. Basically economy is moving up.
 Business Cycle
2) Peak (peak of expansion phase): This is the second
stage of business cycle. It occurs at the peak of expansion
phase, where GDP has reached its maximum point following
the expansionary phase.
3) Contraction (Recession or downswing): Peak stage is then
followed by the Contraction stage. This is a situation where
GDP has started falling; unemployment is rising; investors’
confidence is low; consumers’ confidence is low; Demand is
the economy is falling. Basically Economy is going down.
4) Trough (lowest point of contraction phase): This is the
last stage of a business cycle. It occurs at the lowest point of
contraction stage, where GDP has reached its lowest point
following the contractionary phase. This is the stage from
which a new business cycle, starting with expansion stage, is
likely to begin. (Refer the figure at the next slide)
 Business Cycle
Long Term
Peak Trend of
Real GDP
Real GDP

(II)
Peak
(III) Contraction
Contraction
(I)
Expansion
Expansion

Trough

Trough
(IV)

Time (t)
 Flow vs Stock Variable
 Flow Variables are those economic variables that are
measured per unit of time (for example, per quarter, or per
year). For instance, GDP, Income, Expenditure, Saving -
they are all measured per unit of time (for example, per
quarter, per month or per year) and hence are flow
variables.
 Stock Variables are those economic variables that are
defined at a point in time. For example, total amount of
money in your bank account as on 5th December 2022 or on
any other date, total wealth of the country as on 5th December
2022 or any other date.
 Positive vs Normative Analysis
 A positive analysis of an economic policy examines the
economic consequences of the policy but does not address
the question of whether those consequences are desirable.
 A normative analysis of an economic policy tries to
determine whether the policy should be used or not. It
involves value judgement, opinions and personal beliefs.
 For example: if an economist is asked to evaluate the effects
on the economy of a 5% reduction in the income tax, the
response involves a positive analysis. But if asked whether
the income tax should be reduced by 5%, the economist’s
response requires a normative analysis.
 Disagreements among macroeconomists may arise because
of the differences in normative conclusions, as the result of
differences in personal values and beliefs, and because of
differences in the positive analysis of the policy proposal.
 Nominal versus Real interest rate
 Nominal interest rate: it is the rate of return in terms of
monetary units. It is generally denoted by ‘i’. In other words, it
denotes the rate at which the nominal value of money is
rising.
 Real interest rate: it is the rate of return in terms of units of
goods. It is generally denoted by ‘r’. In other words, it
denotes the rate at which real value of money/purchasing
power of money is rising.
 Why this differentiation matter? Because it is the real interest
rate which tells you whether real value/purchasing power of
your money deposited into the bank is rising or falling.
If r > 0, that means real value/purchasing power of your money
deposited into the bank is rising and
if r < 0, that means real value/purchasing power of your money
deposited into the bank is falling.
 Nominal versus Real interest rate
 Therefore for a depositor/lender, all that matter is real interest
rate i.e. how much he/she will receive in real terms on their
deposits/lending. The depositor/lender would want real
interest rate as high as possible.
 Similarly for a borrower/investor, all that matter is real interest
rate i.e. how much he/she will have to pay in real terms on
their borrowings. The borrower/investor would want real
interest rate as low as possible.
 The approximate relationship between real interest rate (r)
and nominal interest rate (i) is given by following equation:
r i – πe (A)
where πe denote expected inflation/inflation expected for the
relevant period. Note: we make expectation about inflation at the
beginning of the period because actual inflation of the relevant
period is not known in advance.
 Nominal versus Real interest rate
 Eqn (A) in the previous slide implies that
If nominal interest rate (i) > expected inflation (πe), real interest
rate (r) > 0
If nominal interest rate (i) < expected inflation (πe), real interest
rate (r) < 0
Example showing the importance of real interest rate:
Suppose you have 200 rupees as money holding and the current
price level in the economy is 2. So, current purchasing power of
your money is = 200/2 = 100 units
Suppose you plan to deposit this money into the bank which pays
annual nominal interest rate (i) equal to 5%. Also suppose inflation
(π) over the period of deposit comes out to be 10%.
Given this, nominal value of your money after one year would be 210
rupees and price level after one year would be 2.2. So, purchasing
power of your money after one year is = 210/2.2 = 95.45 units.
 Nominal versus Real interest rate
 You can clearly note from the previous example that the
purchasing power of your money has fallen after one year i.e.
after one year, you are able to buy less units of goods using
the money you have.
 Why this happened? Because in this example, real interest
rate is negative. In this example, real interest rate (r) =
nominal interest rate (i) - inflation (π) = 5% - 10% = - 5% < 0
 The above example shows the importance of real interest
rate for a depositor/lender. To be specific, we can say that a
depositor/lender would always want to receive a positive real
interest rate (or a real interest rate as high as possible) as it
will ensure increase in purchasing power of his money.
 Similarly, in contrast, a borrower/investor would always prefer
to pay a negative real interest rate or a real interest rate as
low as possible as it will reduce his payment in real terms.
 Fiscal Policy and Monetary Policy
 There are two powerful tools of macroeconomic policy
available with every economy to influence economic
activity: Fiscal Policy and Monetary Policy.
 What is Fiscal Policy? Fiscal policy is a policy that
manages government spending and taxation to influence
aggregate demand in the economy.
 This policy is conducted by Government.
 There are two types of fiscal policy: 1. Expansionary fiscal
policy and 2. Contractionary fiscal policy.
1. Expansionary fiscal policy: A fiscal policy will be called
expansionary if it seeks increase the aggregate demand in
the economy by putting more money into hand of people. For
example; if government increases its spending (increase in G
or increase in TR) or decreases taxes (T) or both, then it is
putting more money into the hand of people i.e. businesses....
 Fiscal Policy and Monetary Policy
…..and consumers. So aggregate demand in the economy
will rise.
2. Contractionary fiscal policy: A fiscal policy will be called
contractionary if it seeks to decease the aggregate demand in
the economy by reducing the availability of money into hand
of people. For example; if government decreases its spending
(decrease in G or decrease in TR) or increases taxes (T) or
both, then it is reducing the availability of money into the hand
of people i.e. businesses and consumers. So aggregate
demand in the economy will fall.
 Question: Why is there need for increase or decrease the
aggregate demand in the economy?
a) To reduce/control inflation, we need to decrease aggregate
demand; b) to reduce unemployment or increase economic
growth, we need to increase aggregate demand.
 Fiscal Policy and Monetary Policy
 What is Monetary policy? Monetary policy is a policy that
manages/controls money supply and interests rates in the
economy.
 This policy is conducted by the central bank.
 What are the objectives of monetary policy? The primary
objective of monetary policy of any country is to control
inflation (i.e. achieving price stability) and promote
economic growth. The other objectives of monetary policy
are reducing volatility in the exchange rate and reducing
volatility in the financial markets.
 There are two types of monetary policy: 1. Expansionary
monetary policy and Contractionary monetary policy.
1. Expansionary monetary policy: A monetary policy will be
called expansionary if it seeks to increase money supply or
credit supply in the economy.
 Fiscal Policy and Monetary Policy
2. Contractionary monetary policy: A monetary policy will be
called contractionary if it seeks to decrease money supply or
credit supply in the economy.
 There are many instruments available with the central
bank, called monetary policy instruments, which can help in
increasing or decreasing the money supply in the economy.
These instruments will be discussed in the next Unit.
 Question: Why is there need for increase or decrease the
supply of money in the economy? Because of
Inflation? Reducing supply of money in the economy helps in
decreasing the inflation rate by decreasing the aggregate
demand in the economy.
Economic growth? Increasing supply of money in the economy
helps in improving economic growth or reducing unemployment
by increasing the aggregate demand in the economy.
 Balance of payment (BOP)
 Balance of payments (BOP) records all the transactions of
residents of a country with residents of rest of the world.
 BOP is sum of two accounts:

1. Current Account 2. Capital Account

1. Current Account: It records trade in goods and services,
and transfer payments between the home country and rest of
the world.
(Note: Trade in services also include freight, royalty payments,
interest payments, investment income such as dividend and profit
on your assets abroad. Examples of transfer payments: foreign
grants, foreign gift, foreign aids, remittances etc.
 This implies current account balance = net export of goods
[also known as trade balance or balance of trade] + net
export of services (invisibles) + net transfer payments.
 Balance of payment (BOP)
2. Capital Account: It records purchases and sales of assets
such as stocks, bonds, bank deposits, real estate etc. b/w
residents of a country with residents of rest of the world.
 This implies, Capital account balance = receipts on account
of sale of assets (abroad or domestic assets to foreigners) +
receipts on account of borrowing abroad – payment on
account of purchase of assets (abroad or domestic assets
from the foreigner) – payment on account of lending abroad.
 If capital account is in surplus, that means there is net capital
inflows in the economy and if capital account is in deficit, that
means there is net capital outflows from the economy.
Note: If any transaction causes foreign currency to come in, it
will be recorded as +ve item in the BOP. And if any transaction
causes foreign currency to move out of country, it will be
recorded –ve item in the BOP.
 Balance of payment (BOP)
 There is one more account, namely ‘Official Foreign
Exchange Reserve Account’. It represents assets held by
central bank other than domestic money which can used to
make international transactions such as dollar reserves, gold
reserves etc. Transactions in this account represents central
bank’s activity or intervention in the foreign exchange market.
 If BOP is in deficit i.e. BOP < 0, that means outflow of foreign
currency from the economy is more than inflow of foreign
currency. This deficit will be financed by central bank and
hence there will be fall in country’s foreign exchange reserves.
 If BOP is in surplus i.e. BOP > 0, that means inflow of foreign
currency in the economy is more than outflow of foreign
currency. This surplus will be absorbed by central bank and
hence there will be increase in country’s foreign exchange
reserves.
 Balance of payment (BOP)
 The discussion in the previous slide implies that external
account must balance i.e. current account balance + capital
account balance + transaction in country’s official foreign
exchange reserve account must be zero.
Note: Increase in official foreign exchange reserves is
considered as –ve item as this would mean fall in the supply of
foreign currency available in the market. With same logic,
decrease in official foreign exchange reserves is considered as
+ve item as this would mean increase in the supply of foreign
currency available in the market.
 Classical vs Keynesian
 The two major schools of thought in macroeconomics are:
1. Classical school of thought or Classical economics
and 2. Keynesian school of thought or Keynesian
economics. [There are other schools of thought as well for
example, Monetarists, New Classical, New Keynesians etc.
These will be discussed in coming semesters]
1. Classical school of thought:
 Classical thought started in late 18th century and was
originated by an economist- Adam Smith.
 Adam Smith through his book ‘Wealth of Nations’ in 1776
proposed the concept of “invisible hand”.
 The idea of invisible hand is that, if there are free markets
and individuals act in their own self-interests, overall
economy will work well or the general welfare of the
economy will be maximized.
 Classical vs Keynesian
 The validity of the idea of Adam Smith’s “invisible hand”
depends on two key assumptions:
a) All the markets in the economy (labor, goods, financial etc.)
must work freely without any intervention or impediment.
b) Wages and prices must adjust rapidly enough to maintain
equilibrium (a situation where quantity demanded equals
quantity supplied) in all the markets. In other words, wages and
prices should be fully flexible.
 Classical economics/approach builds on the idea of
‘invisible hand’ and its key assumptions.
 Thus, according to classical approach, because markets
are free, and wages and prices are fully flexible; economy
will self-regulate/correct itself and hence economy will
always work at the equilibrium i.e. at the full employment.
This means there is no need for government intervention
in the economy.
 Classical vs Keynesian
 As the economy always works at full employment, as per
classical approach, any change in fiscal policy or monetary
policy will have no impact on economy’s output or we can
say these polices will be ineffective.
 This school of thought dominated till 1930s.
 Other major Classical thinkers are David Ricardo,
Thomas.R.Malthus and John Stuart Mill.
 According to Classical economists, supply creates its own
demand (Say’s law) i.e. output is supply determined. In
particular, they believe in supply side economics.
2. Keynesian school of thought:
 This school of thought was originated by an Economist-
John Maynard Keynes through his book ‘General Theory of
Employment, Interest and Money’ in 1936.
 Classical vs Keynesian
 As per Keynesians, what Classical are saying may be true
in the long run but not in short run. No one has seen the
long run and we will all die in long run. So it is the short run
which matters most for the economy.
 Keynesians as opposed to Classical economists believe
that wages and prices are not fully flexible in short run; in
fact they are fixed or adjust slowly in the short run (though
they may be fully flexible in the long run).
 So, there is no self-correcting mechanism working in
the economy in the short run. Hence, there is no reason
to believe that economy will work at full employment in
the short run. This means there may be some
unemployment in the economy at any given point in time.
Keynesians strongly favour the need for government
intervention or Fiscal policy when economy is in crisis.
 Classical vs Keynesian
 Keynesian approach is a demand side approach because
they believe that demand creates its own supply. In other
words, as per Keynesians, output is demand determined.
 These ideas dominated only till 1970s. In 1970s, major
economies of the world faced a situation of stagflation-
(stagnation + high inflation) because of sharp rise in crude
Oil price worldwide. [Note: Stagnation means GDP is either
declining or flat or growing slowly].
 Keynesian thoughts failed to explain this situation of
stagflation (both in terms of its source; also in terms of
policy response).
 Note: 1). When there is negative output/GDP growth rate
for two consecutive quarters, it is called Recession. In
simple words, when there is a fall in GDP/output overtime.
2) And a prolonged recession is called Depression.
 Homework
1. Practice numerical problems related to
national income accounting and Balance of
payment from any 12th class Macroeconomics
textbook based on the CBSE syllabus.
2. Also solve back questions of Chapter-1 and
Chapter - 2 of Abel, Bernanke and Croushore.
 Syllabus
Unit I: Basics of Macroeconomics and National Income
Accounting: Definition of Macroeconomics, Central
Problem of an Economy, Circular Flows:
Injections/Withdrawals, National Income Accounting, Real
vs Nominal GDP, Business cycle, Price indices and
measurement of inflation, Fiscal policy and Monetary
Policy, Balance of Payments Account, Classical vs
Keynesian debate.
Readings:
1)Abel, Bernanke and Croushore (2014, 8 th Edition),
Chapter – 1 and Chapter – 2 (for section 2.3, refer the
class notes only).
2)12th class CBSE textbook on Macroeconomics for
national income accounting, balance of payment and
circular flows.
3)Class notes/PPT.
 Syllabus (Conti..)
Unit II : Money and Inflation: Concept of Money:
Functional and Descriptive, Money Demand, Money
Supply: Credit Creation and High Powered Money, Inflation:
Quantity Theory of Money, Economic Effects and Social
Costs of Inflation, Cost Push and Demand Pull Inflation,
Keynesian Liquidity Preference Theory, Determination of
Rate of Interest.
Readings:
1)N. Gregory Mankiw (8th Edition, 2013), Chapter - 4 and
Chapter - 5
2)O. Blanchard (7th Global Edition, 2017), Chapter - 4 (4.1
and 4.2 only)
3)Mishkin (7th Edition, 2004), Chapter-22 (521-524).
4)Class notes/PPT
 Syllabus (Conti..)
Unit III: Product/Goods Market: Classical and
Keynesian Perspectives, Keynesian model of income
determination, Multipliers, Inflationary and Deflationary
Gap, Paradox of Thrift.
Readings:
1)Dornbusch, Fischer and Startz (6th or 11th Edition)
Chapter - 3 or Chapter - 9.
2)Class notes/PPT