Chapter 3

Macro-Economic
Concepts

Introduction
Macroeconomics deals with the economy as a
whole. Macroeconomics focuses on the
determinants of total national income, deals with
aggregates such as aggregate consumption and
investment, and looks at the overall level of
prices instead of individual prices.
Macroeconomics is the study of the structure
and performance of national economies and of
the policies that governments use to try to affect
economic performance.

The Components of the Macroeconomy

Macroeconomics focuses on four groups. To see
the big picture, it is helpful to divide the
participants in the economy into four broad
groups:
(1) households,
(2) firms,
(3) the government, and
(4) the rest of the world.

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The Components of the Macroeconomy

The Circular Flow of
Payments
Households receive income from firms
and the government, purchase goods
and services from firms, and pay taxes
to the government. They also purchase
foreign-made goods and services
(imports). Firms receive payments from
households and the government for
goods and services; they pay wages,
dividends, interest, and rents to
households and taxes to the
government. The government receives
taxes from firms and households, pays
firms and households for goods and
servicesincluding wages to
government workersand pays interest
and transfers to households. Finally,
people in other countries purchase
goods and services produced
domestically (exports).
Note: Although not shown in this
diagram, firms and governments also
purchase imports.

The Circular Flow Diagram

Macroeconomic Concerns

Three of the major concerns of

macroeconomics are:
Inflation
Output growth
Unemployment

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Macro Economic Concepts

1.
2.
3.
4.
5.

National Income / Output

Business Cycle
Inflation
Monetary policy
Fiscal Policy

Fundamental concepts of Macro-economics

National income or national product is defined as
the total market value of all the final goods and
services produced in an economy in a given
period of time.
National income consists of a collection of
different types of goods and services.
Since these goods are measured in different
physical units it is not possible to add them
together. Thus we cannot state national income is
so many millions of meter cloth. Therefore, there
is no way except to reduce them to a common
measure.
This common measure is money.

Basic concepts in National Income

Gross Domestic Product (GDP)
GDP is the money value of all final goods and
services produced in the domestic territory of a
country during an accounting year, regardless who
owns the production.
GDP can be estimated at constant prices and
current prices.
If the domestic product is estimated on the basis of
the prevailing prices it is called gross domestic
product at current prices (nominal GDP).
If GDP is measured on the basis of some fixed
price, that is price prevailing at a point of time or in
some base year it is known as GDP at constant
price (Real GDP).

Basic concepts in National Income

Net Domestic Product
A part of is therefore, set aside in the form of
depreciation allowance. When the depreciation
allowance is subtracted from gross domestic product
we get net domestic product.
NDP = GDP - Depreciation

Basic concepts in National Income

Gross National Product
Gross national product is defined as the sum of the
gross domestic product and net factor incomes from
abroad.
It takes into account the incomes which the residents
get from rest of the world and at the same time it
excludes those incomes which arise from the economic
activities within the country but have to paid out to the
non-residents operating in the country.
Gross National Product = Gross Domestic Product +
Net Factor Income from abroad
It can be derived by subtracting depreciation allowance
from GNP.
NNP = GNP Depreciation
NNP = NDP + Net factor income from abroad

Basic concepts in National Income

Personal Income and Disposable Income
Personal income may be defined as the current
income or persons or households from all services.
All personal income is not at the disposal to be spent
on consumption.
Individuals may have to pay personal direct taxes to
the government.
DPI = Personal Income Personal Direct Taxes
The disposable personal income may be spent fully or
individuals may save. What remains after saving is
called the personal outlay.
Disposable outlay = Disposable income - Savings

BUSINESS CYCLE
The business cycle or economic cycle refers to the
fluctuations of economic activity about its long term growth
trend.
The cycle involves shifts over time between periods of
relatively rapid growth of output (recovery and prosperity),
and periods of relative stagnation or decline contraction or
recession.
These fluctuations are often measured using the real gross
domestic product.
Despite being named cycles, these fluctuations in economic
growth and decline do not follow a purely mechanical or
predictable periodic pattern.

Phases of business cycle

Inflation
Inflation is defined as a sustained increase in the price
level or a sustained fall in the value of money.
To quantify the amount of inflation in the economy,
indicators such as the Wholesale Price Index, the
Consumer Price Index are used. It measures the
changes in prices that have occurred between the
base year and the current year.

Creeping Inflation
There is moderate rise in prices of 2-3 per cent per
annum in creeping inflation. It is generally considered
good for a growing economy. Mildly rising prices result
in faster growth of output in that they raise the profit
margins of firms and encourage them to produce more.
Creeping inflation does not severely distort relative
prices nor does it destabilize price expectations. A
single digit inflation is also considered as moderate
inflation which most countries have come to put up
with.

Galloping Inflation
Prices rise at double or treble digit rates per annum (20100%). It tends to distort relative prices and results in
disquieting changes in distribution of purchasing power
of different groups of income earners.

Hyper Inflation
Hyper inflation or run-away inflation is of a severe type
in which prices rise a thousand or a million or even a
billion per cent per year. It seriously cripples the
economy. Prices and money supply rise alarmingly.
Germany experienced hyper inflation during 1920-23. It
is generally a result of war, political revolution or some
other catastrophic event.

Causes of Inflation
On the demand side, the major inflationary factors are:
Money supply Demand Pull Theory
Disposable income and consumer expenditures
Reduction in direct or indirect taxation
Depreciation in exchange rate

Business outlays Cost Push Theory

Rising imported raw materials costs
Rising labour costs
Higher indirect taxes imposed by govt.

It is the cumulative effect of all or most of these factors that

the aggregate demand function in an economy shifts upwards,
resulting in inflation in prices.

MONETARY POLICY

What is Monetary Policy?

Monetary policy is the process by which the monetary
authority of a country controls the supply of money,
often targeting a rate of interest for the purpose of
promoting economic growth and stability.
The term monetary policy refers to actions taken by
central banks to affect monetary magnitudes or other
financial conditions.
Monetary Policy operates on monetary magnitudes or
variables such as money supply, interest rates and
availability of credit.
Monetary Policy ultimately operates through its
influence on expenditure flows in the economy.
In other words affects liquidity and by affecting liquidity,
and thus credit, it affects total demand in the economy.

Credit Policy
Central Bank (RBI) may directly affect the money supply
to control its growth.
It might act indirectly to affect cost and availability of
credit in the economy.
In modern times the bulk of money in developed
economies consists of bank deposits rather than
currencies and coins.
RBI today guide monetary developments with instruments
that control over deposit creation and influence general
financial conditions.
Credit policy is concerned with changes in the supply of
credit.
Central Bank administers both the Credit and Monetary
policy

Aims of Monetary policy

MP is a part of general economic policy of the govt.
MP contributes to the achievement of the goals of economic
policy.
Objective of MP are:
Reasonable Price Stability
Full employment
Stable exchange rate
Economic growth
Greater equality in distribution of
income & wealth
Financial stability

Price Stability: The Dominant Objective

Price stability does not mean complete year-to-year
price stability which is difficult to attain.
Price stability refers to the long run average stability of
prices.
Price stability involves avoidance of both inflationary
and deflationary pressures.
Price Stability contributes improvements in the standard
of living of people.
Price stability leads to interest rate stability, and
exchange rate stability (via export import stability).
It contributes to the overall financial stability of the
economy.

Instruments of Monetary Policy

Variations in Reserve Ratios

Bank Rate (Discount Rate)
Open Market Operations (OMOs)
Other Instruments Repo, Reverse Repo, SLR

Variations in Cash Reserve Ratio (CRR)

Banks are required to maintain a certain percentage of
their deposits in the form of reserves or balances with the
RBI
It is called Cash Reserve Ratio or CRR
Since reserves are high-powered money or base money,
by varying CRR, RBI can reduce or add to the banks
required reserves and thus affect banks ability to lend.

Bank Rate
Bank rate is the rate of interest charged by the central
bank for providing funds or loans to the banking system.
Funds are provided either through lending directly or
buying commercial bills and treasury bills.
Raising Bank Rate raises cost of borrowing by
commercial banks, causing reduction in credit volume to
the banks, and decline in money supply.
Variation in Bank Rate has an effect on the domestic
interest rate, especially the short term rates.
Market regards the increase in Bank rate as the official
signal for beginning of a tight money situation.

Repo Rate
Whenever the banks have any shortage of funds they
can borrow it from RBI. Repo rate is the rate at which
our banks borrow rupees from RBI. A reduction in the
repo rate will help banks to get money at a cheaper
rate. When the repo rate increases borrowing from RBI
becomes more expensive.
Its a short term measure.

Reverse Repo Rate

Reverse Repo rate is the rate at which Reserve Bank of
India (RBI) borrows money from banks. Banks are
always happy to lend money to RBI since their money
are in safe hands with a good interest. An increase in
Reverse repo rate can cause the banks to transfer more
funds to RBI due to this attractive interest rates. It can
cause the money to be drawn out of the banking
system.

Statutory Liquidity Ratio (S.L.R)

Statutory Liquidity Ratio is the amount of liquid assets, such
as cash, precious metals or other short-term securities, that
a financial institution must maintain in its reserves. The
statutory liquidity ratio is a term most commonly used in
India.
The SLR is commonly used to contain inflation and fuel
growth, by increasing or decreasing it respectively. This
counter acts by decreasing or increasing the money supply in
the system respectively

Open Market Operations (OMOs)

OMOs involve buying (outright or temporary) and selling
of govt. securities by the central bank, from or to the
public and banks.
In times of inflation, RBI sells securities to mop up the
excess money in the market. Similarly, to increase the
supply of money, RBI purchases securities.

Due to this fine tuning of RBI using its tools of CRR, Bank
Rate, Repo Rate and Reverse Repo rate our banks
adjust their lending or investment rates for common
man. Thus altering the money supply in the country.

FISCAL POLICY

Fiscal Policy
The word fisc means state treasury and fiscal policy refers to
policy concerning the use of state treasury or the govt.
finances
to
achieve
the
macroeconomic
goals.
any decision to change the level, composition or timing of
govt. expenditure or to vary the burden, the structure or
frequency of the tax payment is fiscal policy.
The two main instruments of fiscal policy are government
expenditure and taxation.

Fiscal Policy & Macroeconomic Goals

Economic Growth: By creating conditions for increase in
savings & investment.
Employment: By encouraging the use of labourabsorbing technology
Stabilization: fight with depressionary trends and
booming (overheating) indications in the economy
Economic Equality: By reducing the income and wealth gaps
between the rich and poor.
Price Stability: employed to contain inflationary and
deflationary tendencies in the economy.

Fiscal Policy
Aggregate demand, which is the total demand for goods
and services in the economy, depends on three main
variables - consumption, private investment and
government spending.
When the government increases its expenditure then it
spurs the aggregate demand in the economy.
A higher aggregate demand in turn will stimulate output,
growth and employment.
Whereas if the government lowers its spending then it
decreases the aggregate demand and hence slows down
the growth of the economy.

Fiscal Policy Fundamentals

When the government makes use of its revenue and
expenditure programmes and affects the aggregate level of
demand for goods and services in the economy, then this
action is essentially known as fiscal policy. (Union Budget)
Related to fiscal policy are deficits and surpluses. When
the governments expenditure exceeds its revenue, then
there is a fiscal deficit and the opposite of this is known is
fiscal surplus.

Fiscal Policy Fundamentals

Renowned economist Keynes believed that taxes and
expenditure decisions, that is fiscal policy, should be used
to stabilize the economy.
Government should cut taxes and increase spending to
bring the economy out of a slump, this kind of a policy
action is known is expansionary fiscal policy.
On the other hand, government should increase taxes and
cut expenditure to bring the economy out of inflationary
pressure, that is, it should follow a contractionary fiscal
policy.
Thus Government can affect the level of output, overall
price level and interest rates by determining the level of
money supply in the economy.

Taxation
Meaning : Non quid pro quo transfer of
private income to public coffers
Classified into
Direct taxes - Corporate tax, Div. Distribution
Tax, Personal Income Tax, Fringe Benefit taxes,
Banking Cash Transaction Tax.
Indirect taxes - Central Sales Tax, Customs,
Service Tax, excise duty.