BMS AND A & F MACRO

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Page 1(A & F),(BMS) MACRO/MANAGERIAL ECONOMICSII

MACRO ECONOMICS :

Macroeconomics is concerned with the nature, relationships and behaviour of such

aggregate quantities and averages as national income, total consumption, savings and investment,total employment, general price level, aggregate expenditure and aggregate supply of goods and

services. As macroeconomics deals with aggregate quantities of the economy as a whole, it is also

called as aggregative economics.

Theories of National Income, consumption, saving and investment, theory of employment,

theories of economic growth, business cycles and stabilization policies, theories of money supply

and demand and theory of foreign trade broadly constitute the subject matter of macroeconomics.

Macroeconomic theories seek to answer questions such as how is the level of National Income of a

country determined? What determines the levels of overall economic activities in a country? What

determines the level of total employment? How is the general level of price determined? etc.

The main justification for macroeconomics lies in the need for generalising the behaviour of

and relationships between economic aggregates. To study the system as a whole and to explain the

behaviour of aggregate quantities and the relationship between them is extremely difficult.

Macroeconomic approach has made it possible. It ignores the details pertaining to the individual

economic agents and quantities and compresses the unmanageable economic facts to a manageable

size and makes them capable of interpretation. Macroeconomic theories are used in formulating

public policies. They provide clarity to the macroeconomic concepts and quantities and bring out

the relationship between macro variables of the economy in the form of models or equations.

Study of macroeconomics is limited to only aggregates. It cannot be applied to explain the

behaviour of individual components of the economic system and the individual quantities. Secondly,

it ignores the structural changes in constituent elements of the aggregate. Hence conclusions drawn

from the analysis of aggregates may involve error of judgement and may be misleading.

CIRCULAR FLOW OF INCOME

An economy can be defined as an integrated system of production, exchange and

consumption. In carrying out these economic activities, people are involved in making transactions-

they buy and sell goods and services. Economic transactions generate two kinds of flows :

i) Real flow i.e. the flow of goods and services, and

ii) Money flow.

Real and Money flows go in opposite direction in a circular fashion. The goods flow

consists of (a) factor flow, i.e., flow of factor services, and (b) product flow, i.e., flow of goods and

services. In a monetized economy, the flow of factor services generates money flows in the form of

factor payments which take the form of income flows. The factor payments and expenditure on

consumer goods and services take the form of expenditure flows. Both income and expenditure

flow in a circular fashion in opposite direction. The magnitude of these flows determines the size of

national income. To present the flows of income and expenditure, the economy is divided into four

sectors i.e. household sector, business sector, the firms, government sector and foreign sector.

These are combined to make the following three models for the purpose of showing the circularflows.

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i) Two sector model including the household and business sectors;

ii) Three sector model including the household, business and government sectors

iii) Four sector model including the household, business, government and the foreign sectors.

Circular flows of income and expenditure

Two sector model without Saving :-

The two sector model consists of only household and firm sectors representing a private

closed economy in which there is no government and no foreign trade. It is therefore unrealistic but

provides a starting point to analyze the circular flows.

The households are assumed to possess certain specific features : -the households are the owners of all factors of production

their total income consists of wages, rent, interest and profits

they are the consumer of all the consumer goods and services

they save a part of their income and supply finance to the firms.

The business firms are assumed to have the following features and functions : -

they own no resources of their own

they hire and use the factors of production from the households

they produce and sell goods and services to the households

they do not save, i.e. there is no corporate saving.

The working of a Two sector economy and the circular flows of incomes and expenditure areillustrated in the following figure.

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There are two sectors i.e. households and firms. They divide the diagram in two parts. The

upper half represents the factor market and the lower half represents the commodity market. Both

the markets generate two kinds of flows- real and money flows. In the factor market, factors ofproduction flows from households to firms. This makes the real flow shown by a continuous arrow.

There is another real flow of factor incomes (wages, interest, rent and profits) which flows from

firms to households.

In the commodity market (lower half) the goods and services produced by the firms flow

from the firms to the households. The payment made by the households for the goods and services

creates money flow.

By combining the goods and money flows we get a circular flow. In reality, there are

leakages from and additions to the circular flows of income and expenditure. They are also called as

withdrawals and injections. A withdrawal is the amount that is set aside by the households and firms

and is not spent on the domestically produced goods and services over a period of time. On theother hand, an injection is the amount that is spent by households and firms in addition to their

incomes generated within the regular economy.

The Two sector model with savings :-

Household do save a part of their income for investment. The financial sector is constituted

of a large variety of institutions involved in collecting household savings and passing it on to the

business sector. The financial sector includes only banks and financial intermediaries like insurance

companies, industrial finance corporations, which accept deposits from the households and invest it

in the business sector in the form of loans and advances. It is explained in the following figure.

With the inclusion of the financial

sector, the households incomes (Y)

is divided into two parts :

consumption expenditure and

savings (S). As shown in the

following figure, C and S take

different routes to reach the

business sector. The consumption

expenditure (C) flows directly to the

firms, whereas savings (S) are

routed through the financial sector

as the banks and FIs use the

deposits to buy shares and

debentures of the firms which is

investment (I). In the final analysis

the entire money income generated

by the firms flows back to the firms

which flows back again to the

households as factor payments.

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Three sector model :-

It depicts a more realistic economy. It includes the government which plays an importantrole in the economy. The economic role of the government has increased tremendously during the

post War II period. Here we will include only three fiscal variables to the circular flows, viz. direct

taxes, government spending on goods and services and transfer payments. These variables

have different kinds of effects on the income and expenditure flows. As seen in the figure below, a

part of the household income is claimed by the government in the form of direct taxes. Similarly, a

part of the firms income is taxed away in the form of corporate income tax. The firms pass on to

the government the indirect taxes also which is collected from the households. The government

spends a part of its tax revenue on wages, salaries and transfer payments to the households and a

part of it on purchases from the firms and payments of subsidies. Thus, the money that flows from

the households and the firms to the government in the form of taxes, flows back to these sectors in

the form of government expenditure.

Four sector model : Model with the foreign sector :-

The Four sector model is formed by adding foreign sector to the three sector model. It

consists of two kinds of international transactions : foreign trade i.e. exports and imports of goods

and services and inflow and outflow of capital. For simplicity we make following assumptions : -the

external sector consists only of exports and imports of goods and services

-the export and import of goods and non-labour services are made only by the firms

-the households export only labour

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The circular flow is explained in the following figure

The lower part is the circular flows of money in respect of foreign trade.

Exports (X) make goods and services flow out of the country and make money (foreign

exchange) flow into the country in the form of receipts from export. This is in fact, flow of foreign

incomes into the economy. Exports (X) represent injections into the economy. Similarly, imports

(M) make inflow of goods and services and flow of money (foreign exchange) out of the country.

This is flow of expenditure out of the economy. Imports (M) represent withdrawals from the

circular flows.

So far as the effect of foreign trade on the magnitude of the overall circular flows is

concerned, it depends on the trade balance i.e. X-M. If X > M, it means inflow of foreign income is

greater than the outflow of income, or there is a net gain from foreign trade. The net gain increases

the magnitude of circular flows of income and expenditure. If X < M it decreases the magnitude of

circular flows.

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NATIONAL INCOME :-

National Income of a country can be defined as the total market value of all final goods and

services produced in the economy during a given year.

The net output of commodities and services following during year from the countrys

productive system in the hands of the ultimate consumers. - SIMON KUZNET

National income is that part of objective income of the community, including of course

income derived from abroad which can be measured in money. - A.C.PIGOU

NATIONAL INCOME = NATIONAL PRODUCT = NATIONAL EXPENDITURE

i) It is the sum of value of all final goods and services produced in a year

ii) It is the sum of all incomes accruing to factors of production in a year

iii) It is the sum of consumers expenditure , net investment expenditure and government

expenditure on goods and services.

Concepts of National Income :-

1. GROSS DOMESTIC PRODUCT(GDP) :-

Gross domestic product is the money value of all final goods and services produced within

the domestic territory of a country during a yearGDP=(P*Q)

where,GDP=Gross Domestic ProductP=Price of goods and serviceQ=Quantity of goods and servicedenotes the summation of all values.

According to expenditure approach, GDP is the sum of consumption, investment, governmentexpenditure, net foreign exports of a country during a year.

Algebraic expression under expenditure approach is,

GDP=C+I+G+(X-M)

Where,

C=ConsumptionI=InvestmentG=Government expenditure(X-M)=Export minus import

GDP includes the following types of final goods and services. They are:

Consumer goods and services.Gross private domestic investment in capital goods.

Government expenditure. Exports and imports.

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2. GROSS NATIONAL PRODUCT (GNP) :-

Its the sum of money value of goods and services produced by a nation during a given

year. It is the sum of money worth of consumption , investment , govt. purchases of goods andservices and net export.

GNP can be expressed as the following equation:

GNP=GDP+NFIA (Net Factor Income from Abroad)or

GNP=C+I+G+(X-M)+NFIA

Hence, GNP includes the following:

Consumer goods and services.Gross private domestic investment in capital goods.Government expenditure.Net exports (exports-imports).Net factor income from abroad.

3. NET NATIONAL PRODUCT(NNP) :-

Net National Product is the market value of all final goods and services after allowing for

depreciation. It is also called National Income at market price. When charges for depreciation are

deducted from the gross national product, we get it. Thus,

NNP=GNP - Depreciation

or,

NNP=C + I + G + (X - M) + NFIA - Depreciation

4. NET DOMESTIC PRODUCT(NDP) :-

Net Domestic Product is the market value of all final goods and services after allowing for

depreciation. It is also called National Income at market price. When charges for depreciation are

deducted from the gross domestic product, we get it. Thus,

NDP=GDP - Depreciation

So National income as per follows ,

NI=NNP + Subsidies - Interest Taxes

or,

NI=GNP - Depreciation + Subsidies - Indirect Taxes

or,

NI=C + G + I + (X - M) + NFIA - Depreciation - Indirect Taxes + Subsidies

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5. PERSONAL INCOME (PI) :-

Personal Income i s the total money income received by individuals and households of a countryfrom all possible sources before direct taxes. Therefore, personal income can be expressed as

follows:

PI=NI + Transfer Payments + Dividend + Net Income From Abroad

6. DISPOSABLE INCOME (DI) :-

The income left after the payment of direct taxes from personal income is called Disposable

Income. Disposable income means actual income which can be spent on consumption by

individuals and families. Thus, it can be expressed as:

DI=PI-Direct Taxes

From consumption approach,

DI=Consumption Expenditure + Savings

7. PER CAPITA INCOME (PCI) :-

Per Capita Income of a country is derived by dividing the national income of the country by the

total population of a country. Thus,

PCI=Total National Income/Total National Population

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PRINCIPLE OF EFFECTIVE DEMAND

J.M.Keynes published his book , The general theory of employment, interest and money in1936. Keynesian theory is demand oriented , its explain about effective demand as a factor to

determine the level of income.

EFFECTIVE DEMAND :

The level of income and output in an economy is determined by the level of employment.

The level of employment is determined by the level of effective demand. Effective demand is

reveled by the total expenditure.

Total expenditure = Total output = Total Income

Effective Demand = National output = National income = National expenditure

= Aggregate expenditure on consumption goods = Aggregate

expenditure on Investment goods .

= Consumption + Investment

As income increases consumption also increases but in a lesser proportion. He gap between

income and consumption must be used to increase investment this will lead to increase in

employment.

Higher the effective demand higher the volume of employment and vise versa

Hence; Effective Demand = C + I + G

Where C = consumption expenditure of household

I = Investment expenditure of private enterprises

G = Govt. Expenditure on consumption and investment goods

FACTORS OF DETERMINING EFFECTIVE DEMAND :

1. AGGREGATE SUPPLY FUNCTION:

The factor of production like land , labour , capital and entrepreneur must be paid for thereuse in production process. The entrepreneur will be induced to produce that output and provide

that particular level of employment , only if he gets sales proceeds high enough to cover the total

cost of production.

The Aggregate supply price is the minimum amount of sales proceeds required by the

entrepreneurs to provide that level of employment and output.

The Aggregate supply function refers to a schedule indicating that various minimum amount

of proceeds required by all entrepreneurs at various level of employment, as the amount of proceeds

increases , grater employment will be offered to the workers.

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AGGREGATE SUPPLY SHEDULE :

The level of employment is measured on the X axis & the minimum sales proceeds on the

Y axis. ASF represent the Aggregate Supply Function. It is Linear because we have assumed a

constant wage rate. If the wage rate is changing ASF will be non liner.

ASF curve slopes upwards to the right showing that minimum amount of proceeds

increases , volume of employment also increases. It will become vertical straight line (Perfectlyinelastic) at point F where the economy has full employment

2. AGGREGATE DEMAND FUNCTION:

Aggregate Demand refers to the total expenditure in the economy

The aggregate demand price is the maximum amount of sales proceeds expected by the

entrepreneur to provide that level of employment & Output. The ADF refers to the schedule

indicating various maximum amounts of proceeds expected by all entrepreneur at various levels of

employment

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Level of EmploymentN

Money WagesW

Aggregate Supply(N x W)

1 10 100

2 10 200

3 10 300

4 10 400

5 10 500

6 10 600


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AGGREGATE DEMAND SHEDULE :

When the increase in the level of employment , aggregate price also increases & Vise versa.

So there is positive correlation between ADF & Employment

The level of employment is measured on the X axis & the maximum sales proceeds on the

Y axis. ADF represent the Aggregate Demand Function. It is Linear it can also be non liner

depending upon the data. ADF curve slopes upwards to the right showing that maximum

amount of proceeds increases , volume of employment also increases.

EFFECTIVE DEMAND

The Effective Demand , level of Income and Employment is determined with the help of

ADF & ASF. The ASF represent the minimum cost and ADF represent the maximum receipts

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Level of Employment Aggregate Demand

1 100

2 200

3 300

4 400

5 500

6 600


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EFFECTIVE DEMAND

DiagramA represent a linear AD & AS Curves and Diagram B represent a Non- linear AD

& AS Curves. The ADF & ASF Curves intersect at E point which is Effective Demand.

1 ADF > ASF :

At that level cost are lesser than revenue and the entrepreneur are induced to provide more

employment till both are equal

2 ADF = ASF

This is the Equilibrium point at this point E, normal profit gained as the total sales proceeds

is equal to the total cost.

3 ADF < ASF

The total cost will be grater than the expected total revenue, hence entrepreneur will reduce

the employment as they would recover a loss.

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Level of Employment Aggregate Demand Aggregate Supply Comparison Change

1 175 100 AD > AS Increase



4 400 400 AD = AS Equal

5 475 500 AD < AS Decrease

6 550 600 AD


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Page14(A & F),(BMS) MACRO/MANAGERIAL ECONOMICSII

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Page15(A & F),(BMS) MACRO/MANAGERIAL ECONOMICSII

MONEY

Money is anything which is widely accepted in payment for good or in discharge of other

kinds of business obligation. Money is matter of four functions : Medium , Measure, Standard &

Store.

SUPPLY OF MONEY

Components of Money Supply

A. Traditional Approach :

1. Currency (Coins & Notes) 2. Demand Deposits

B. Modern Approach :

1. Currency (Coins & Notes) 2. Demand Deposits

3. Saving Deposits in Post Office 4. Time Deposits

5. Govt. Securities 6. Credit

RBIS New Measures of Money Supply :

Determinants Of Money Supply :

1. Monetary Base:

The monetary base consists of monetary Gold stock , Reserve assets such as govt. securities, Bonds,

Foreign exchange reserve with the central bank and the amt. of central banks credit. At present gold stock is

not consider as a part of monetary base.

2. Community Choice:

The amount of cash and demand deposits held by public also influence the supply of money. If the

people prefer to make check payment much more than cash payment , a given monetary base would be larger

and vice versa. The choice of community, per capita income, availability of banking facilities, if this factors aredeveloped the money supply would be larger and vise versa.

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ORIGINAL MEASURE REVISED MEASURE

M1= C + DD + OD M1= C + DD + OD

M2 = M1 + Saving Deposits with post

office saving banks

M2 = M1 + Saving Deposits with Bank

+ Term Deposits maturing within one

year

M3 = M1 + Time deposits of bank M3 = M2 + Term deposits over one year

maturity period

M4 = M3 + Total Deposits with post

Off.

M4 = Abolished


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