Microeconomics: study of how households and firms make decisions andhow these decision-makers interact in the marketplacePursue own interests (profit /utility optimization)

Macroeconomics: focuses on the behavior of an economy as a wholeEg. what are the factors that determine an economys capacity to produce goods and servicesWhy some countries experience rapid growth in incomes over while others seem to be trapped in poverty?Causes of economic recessions and boomsCauses of inflation

Three statistic(s) that economists and policymakers use most oftenGross domestic product (GDP)tells us the nations total income and the total expenditure on its output of goods and services

Consumer price index (CPI) measures the level of prices.

Unemployment rate tells us the fraction of workers who are unemployed

The Circular Flow

In every transaction, the buyers expenditure becomes the sellers income.Thus, the sum of all expenditure equals the sum of all income.

GDP Total expenditure on domestically-produced final goods and servicesTotal income earned by domestically-located factors of production

Gross domestic product (GDP) = the market value of all final goods and services produced within an economy in a given period of time

Real vs. Nominal GDPGDP = value of all final goods and services produced.

Eg. GDP = (Price of Apples Quantity of Apples) + (Price of Oranges Quantity of Oranges)

Nominal GDP measures these values using current prices. Can we use Nominal GDP to measure economic well being of a country?

Changes in nominal GDP can be due to:changes in prices changes in quantities of output produced

If all prices doubled without any change in quantities, nominal GDP would double

it would be misleading to say that the economys ability to satisfy demands has doubled, because the quantity of every good produced remains same

Real GDP measures GDP using the prices of a base yearvalue of goods and services measured using a constant set of prices

Real GDP shows what would have happened to expenditure on output if quantities had changed but prices had not.

Changes in real GDP can only be due to changes in quantities,because real GDP is constructed using constant base-year prices.

how real GDP is computedSuppose we want to compare output in 2009 with output in subsequent years

Choose a set of prices, called base-year prices = prices that prevailed in 2009

Real GDP (2009) = (2009 Price of Apples 2009 Quantity of Apples)+ (2009 Price of Oranges 2009 Quantity of Oranges)

Real GDP (2010) = (2009 Price of Apples 2010 Quantity of Apples)+ (2009 Price of Oranges 2010 Quantity of Oranges).

Compute nominal GDP in each yearCompute real GDP in each year using 2002 as the base year.

200220032004PQPQPQgood A30900311,000361,050good B100192102200100205

Nominal GDP multiply Ps & Qs from same year 2002: 46, 200 = 30 900 + 100 192 2003: 51, 400 2004: 58, 300Real GDP multiply each years Qs by 2002 Ps 2002: 46, 200 2003: 50, 000 2004: 52, 000 = 30 1050 + 100 205

GDP DeflatorOne measure of the price level is the GDP Deflator, defined as

reflects whats happening to the overall level of prices in the economy.

Using GDP deflator to compute the inflation rate

Nom. GDPReal GDPGDP deflatorInflation rate200246,20046,200100.0200351,40050,000102.82.8%200458,30052,000112.19.1%

Understanding the GDP deflatorExample with 3 goods For good i = 1, 2, 3Pit = the market price of good i in month tQit = the quantity of good i produced in month tNGDPt = Nominal GDP in month tRGDPt = Real GDP in month t

Understanding the GDP deflatorThe GDP deflator is a weighted average of prices. The weight on each price reflects that goods relative importance in RGDP. Note that the weights change over time.

Measuring Cost of Living: CPIRs x today cannot buy as much as it did twenty years ago.

The cost (price) of almost everything has gone up.

increase in the overall level of prices is called inflation

CPI is one measure of Cost of Living

Survey consumers to determine composition of the typical consumers basket of goods.Every month, collect data on prices of all items in the basket; compute cost of basketCPI in any month equals

suppose that the typical consumer buys 5 apples and 2 oranges every month.

Then the basket consists of 5 apples and 2 oranges

CPI with 2009 base year=(5 Current Price of Apples + 2 Current Price of Oranges) /(5 2009 Price of Apples + 2 2009 Price of Oranges)

The basket contains 20 pizzas and 10 compact discs. prices:pizzaCD20021015200311152004121620051315For each year, computethe cost of the basketthe CPI (use 2002 as the base year)the price change from the preceding year

cost of price chbasket CPI 2002350100.02003 370105.75.7%2004 400114.38.1%2005 410117.12.5%

Understanding the CPIExample with 3 goods For good i = 1, 2, 3Ci = the amount of good i in the CPIs basketPit = the price of good i in month tEt = the cost of the CPI basket in month tEb = the cost of the basket in the base period

Understanding the CPIThe CPI is a weighted average of prices. The weight on each price reflects that goods relative importance in the CPIs basket. Note that the weights remain fixed over time.

CPI vs. GDP DeflatorGDP deflator measures the prices of all goods and services produced, whereas the CPI measures the prices of only the goods and services bought by consumers.Thus, an increase in the price of goods bought only by firms or the government will show up in the GDP deflator but not in the CPI.

GDP deflator includes only those goods produced domestically. Imported goods are not part of GDP and do not show up inthe GDP deflator. Eg. increase in the price of Toyota (made in Japan) andsold in India affects the CPI, because the Toyota is bought by consumers, but it does not affect the GDP deflator.

CPI vs. GDP DeflatorThe basket of goodsCPI: fixedGDP deflator: composition of goods changes every year

ImplicationSuppose a major earthquake in North India affects tea production. The quantity of tea produced =0, and the price of tea remaining in market becomes sky high. Tea is no longer part of GDP, the increase in the price of tea does not show up in the GDP deflator. Since CPI is computed with a fixed basket of goods that includes tea, the increase in the price of tea causes a substantial rise in the CPI

CPI may overstate inflationSubstitution bias: The CPI uses fixed weights, so it cannot reflect consumers ability to substitute toward goods whose relative prices have fallen.Thus CPI overstates the impact of the increase in tea prices on consumers

Why do we care about GDPhow a person is doing economically income is an indicator

When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning.

GDP is a measure of how well the overall economy is performing

GDP = market value of all final goodsand services produced within acountry in a given period of timeGDP IS THE MARKET VALUE . . .GDP adds together different kinds of products and services into a single measure of the value of economic activity

OF ALL . . .- Comprehensive measure It includes all items produced in the economy and sold legally in markets

Note: excludes most items that are produced and consumed at home and, therefore, never enter the marketplaceVegetables you buy at the grocery store arepart of GDP; vegetables you grow in your garden are not

FINAL . . .- International Paper makes paper, which Hallmark uses to make a greeting card- the paper is an intermediate good, and the card is final good. - GDP includes only the value of final goods

Adding the market value of the paper to the market value of the card would be double counting.That is, it would (incorrectly) count the paper twice.

GOODS AND SERVICES . . .GDP includes both tangible goods (food, clothing, cars) & intangible services (haircuts, doctor visits, music concert)

PRODUCED . . .GDP includes goods and services currently produced. It does not include transactions involving items produced in the past. Eg. Tata produces and sells a new car, the value of the car is included in GDP. When one person sells a used car to another person, the value of the used car is not included in GDP.

WITHIN A COUNTRY . . .GDP measures the value of production within the geographic boundary of a country.

Indian citizen works temporarily in the US, his production is part of US GDP.- It is not part of Indias GDP

American citizen owns a car factory in Gujarat, the production of his factory is not part of US GDP. It is part of Indias GDP.

Items are included in a nations GDP if they are produced domestically, regardless of the nationality of the producer

COMPONENTS OF GDPConsider different types of expenditure:

Consumer having lunch at McDTATA builds a car factory in GujaratNavy procures a submarine produced in IndiaIndian Railways buys a train from local manufacturer

GDP includes all of these various forms of spending ondomestically produced goods and services

Some conventionsImportant to understand the composition of GDP among various types of spendinghow the economy is using its scarce resources

Y =C + I + G + X-M

C: Consumption spending by households on goodsand servicesexception: purchases of new housing

I: Investment is the purchase of capital equipment, inventories- includes expenditure on new housing

G: government purchases- spending on goods and services by government

X-M (net exports)purchases of domestically produced goods by foreigners (exports) the domestic purchases of foreign goods (imports).

A domestic firms sale to a buyer in another country increases exportsIT services from TCS hired by British Telecom

imports of goods and services are produced abroadHence subtracted

Evaluation of GDP GDP is not a perfect measure of well-being

GDP does not measure the health of childrenbut nations with larger GDP can afford better health care for their children

GDP uses market prices to value goods and services, it excludes the value of almost all activity that takes place outside of markets.

In particular, GDP omits the value of goods and services produced at home. When a chef prepares a delicious meal and sells it at his restaurant, the value of that meal is part of GDPGDP excludes food cooked at home

Child care provided in day care centers is part of GDP whereas child care by parents at home is not

GDP excludes the quality of the environment

Suppose government eliminates all environmental regulations. Firms could then produce goods and services without considering the pollution they create, and GDP might rise.

Yet well-being would most likely fall. The deterioration in the quality of air and water would more than offset the gains from greater production (increased GDP)

GDP also says nothing about the distribution of income.

A society in which100 people have annual incomes of 50,000 has GDP of 5 million and, GDP per person of 50,000.

So does a society in which 10 people earn 500,000 and 90 suffer with nothing at all

INTERNATIONAL DIFFERENCES IN GDP AND THE QUALITY OF LIFERich and poor countries have vastly different levels of GDP per person.

If a large GDP leads to a higher standard of living, then we should observe GDP to be strongly correlated with measures of the quality of life.

In rich countries, (United States, Japan, and Germany), people can expect to live longer, and almost all of the population can read.

In poor countries, (Nigeria, Bangladesh, and Pakistan), people typically have shorter life exp, and only about half of the population is literate.

Goods and services that are not sold in markets, such as food produced and consumed at home, are not included in GDP.

this might cause the numbers to be misleading in a comparison of the economic wellbeing of the United States and India

In general, international data reveals:Countries with low GDP per person tend to have more infants with low birth weight, higher rates of infant mortality, maternal mortality, higher rates of child malnutrition, and less access to safe drinking water

GDP is closely associated with its citizens standard of living.

exerciseVolvo raises the price of its cars. Volvos are made in Sweden, the car is not part of Indias GDP. Indian consumers buy Volvos, and so the car is part of the typical consumers basket of goods.Hence, a price increase in an imported consumption good shows up in the consumer price index but not in the GDP deflator

>75% of the oil we use is importedAs a result, oil and oil products comprise a much larger share of consumer spending than they do of GDP. When the price of oil rises, the consumer price index rises by much more than does the GDP deflator.

When you deposit your savings in a bank account, you will earn interest on your deposit. Conversely, when you borrow from a bank, you will pay interest at future date.

Interest represents a payment in the future for a transfer of money in the past.

interest rates always involve comparing amounts of money at different points in time.

Suppose you deposit 1000 in a bank account that pays an annual interest rate of 10 %.

Inflation rate = 4%

Real interest rate = Nominal interest rate (paid by bank) - Inflation rate= 6%

Goal: What factors cause fluctuations in national income ?

what determines national incomeA simple model where income is determined by aggregate demand / expenditure

Why useful?Identify the factors that affect national incomeTools that policymakers can use to influence national income

Keynesian theory of National income determination Q. How national income is determined

Economys national income is determined largely by expenditure ofhouseholdsbusinesses/ firmsand government

The more people want to spend, the more goods and services firms can sell.

The more firms can sell, the more output they will produce and the more workers they will choose to hire

Distinction between actual and planned expenditure

Actual expenditure= amount households, firms, and the government spend on goods and services= the economys GDP

Planned expenditure = amount households, firms, and the government would like to spend on goods and services

Actual expenditure may differ from planned expenditure:

when firms sell less than what they had planned, their stock of inventories increases Leads to unplanned inventory investment

Note: increase in inventory is counted as inventory investment (investment: goods used for future use)

conversely, when firms sell more than what they had planned, their stock of inventories falls

Leads to unplanned changes (reduction) in inventory

Few definitions Inventories are stocks of goods held to satisfy future sales.

Inventory investment is the value of the change in total inventories held in the economy during a given period.

Unplanned inventory investment occurs when actual sales are more or less than businesses expected, leading to unplanned changes in inventories.

Actual investment spending is the sum of planned investment spending and unplanned inventory investment

Simple Keynesian Model

Simplest Model set up:

economy is closed (i.e. net exports =0)Govt spends GGovt collects lumpsum tax TExogenous variables: G, T, Iplanned

Consumption function Without Tax: Aggregate C is function of aggregate income Y C= f(Y) =C(Y)As Y changes by 1 unit, how much will C change Marginal Propensity to Consume (MPC)

With Tax: Aggregate C is function of aggregate disposable income YC = f (Y-T) = C(Y-T)

Since T is exogenous, a one-unit increase in Y causes a one-unit increase in disposable income.MPC = increase in consumption due to one-unit increase in disposable income.

*Elements of Simplest Keynesian Model: determinants of planned expenditure

consumption function: planned investment:planned expenditure:govt policy variables:

PE = C( Y-T)+ Planned I+G

Actual expenditure = GDP = Y= C(Y-T) + Planned I + Unplanned I +G

*Slope of PE line = MPCWith IP and G exogenous, the only component of (C+IP+G) that changes when income changes is consumption. A one-unit increase in income causes consumption, and therefore PE to increase by the MPC. income, output, Y PEplannedexpenditure

Notion of Equilibrium:

Assumption: the economy is in equilibrium when actual expenditure equals planned expenditurewhen plans have been realized, we have no reason to change what we are doingEqbm: actual expenditure (Y) = planned expenditure (PE)

Y= Actual Expenditure Actual Expenditure = C(Y-T)+ Planned I + Unplanned I +G

PE = C(Y-T)+ Planned I +G

Equilibrium when Unplanned I = 0In equilibrium, there is no unplanned inventory investment. Firms are selling everything they had intended to sell.

How to graph the equilibrium condition?

Eqbm: Planned Expenditure (PE) = Actual Expenditure Since, Actual expenditure = GDP = National income =Y

Therefore equilibrium: PE= AE=Y

*Graphing the equilibrium conditionincome, output, Y PEplannedexpenditure45

*The equilibrium value of incomeKeynesian cross Diagram

income, output, Y PE, AEPE =AE=Y PE =C +IP +G

How does the economy get to equilibrium?

Whenever an economy is not in equilibrium,- firms experience unplanned changes in inventories- this induces them to change production levels.- changes in production in turn influence total income and expenditureeconomy moves toward equilibrium

Note: inventories play an important role in the adjustment process.

suppose we consider GDP at a level greater than the equilibrium levelplanned expenditure < production = outputfirms are selling less than they are producingAccumulate unplanned inventoriesThis unplanned inventory accumulation induces firms to decrease production.

Suppose GDP is at a level lower than the equilibrium level, such as the level Y2. planned expenditure PE2 > productionY2. Firms meet the high level of sales by reducing their inventories.As firms see their stock of inventories do down, they increase production. GDP rises and the economy approaches the equilibrium.

SummaryKeynesian cross diagram shows how aggregate income Y is determined Aggregate demand determines aggregate income

So far, we have assumed IP ,G and T to be exogenous variables

Thus the aggregate income Y is determined for given levels of IP ,G and T

We can apply this model to show how income changes when these exogenous variables changes.

Comparative Static AnalysisIf the exogenous variable(s) change, then how does it affect national income?

Eg. How does a change in government purchase affect the economy ?

At any value of Y, an increase in G by the amount G causes an increase in PE by the same amount.

At Y1, PE > Ythere is an unplanned depletion of inventories, because people are buying more than firms are producing (PE > Y).

*An increase in government purchasePE =Y so firms increase output, and income rises to a new equilibrium.

Solving for Yequilibrium conditionbecause I exogenous

The government purchase multiplierExample: If MPC = 0.8, thenDefinition: the increase in income resulting from a 1 unit increase in G.

Govt purchase multiplier

Why the multiplier is greater than 1

Initially, the increase in G causes an equal increase in Y: Y = G.But Y C further Y further C further Y

Sum up changes in expenditure

Suppose the government spends an additional 100 million on defense. Then, the revenue of defense firms increase by 100 million, all of which becomes income of the workers and engineers and managers...

Hence, income rises 100 million (Y = 100 million = G ).

The people whose income rose by 100 million are also consumers, and they will spend the fraction MPC of this extra income.

If MPC = 0.8, so C rises by 80 million.

Suppose they spend 80 million on cars

Then, car manufacturers income increase by 80 million

What do they do with this extra income?

They spend the fraction MPC (0.8) of it, causing C = 64 million

Suppose they spend 64 million on food

Then, food producers income increase by 64 million

So far, the total impact on income is 100 million + 80 million + 64 million, which is much bigger than the governments initial increase in spending.

But this process continues, and the final impact on Y is 500 million (because the multiplier is 5).

Note: The larger the MPC, the larger the value of the multiplier.the larger the MPC, the more additional consumption takes place after each rise in income during the multiplier process.

**********Labour Bureau, Government ofIndia*******