Macro-economics Concepts PDF

Macro-economics concepts National Income National income is defined as the money value of all the final goods and services produce in an economy during an accounting period of time, generally one year. According to Paul A Samuelson, “ National income or product is the final figure you arrive...

Macro-economics concepts National Income National income is defined as the money value of all the final goods and services produce in an economy during an accounting period of time, generally one year. According to Paul A Samuelson, “ National income or product is the final figure you arrive at when you apply the measuring rod of money of the diverse apples, oranges, battleships and machines that any society produces with its land, labor and capital resource. GDP (Gross domestic product) Gross domestic product (GDP) is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period. GDP=C+G+I+(X-M) C = consumption expenditure I = Investment G = Government expenditure X = Exports M = Imports Gross National Product (GNP) GNP is the aggregate final output of citizens and businesses of an economy in a year. Gross national product or GNP is a measure of the total value of all the finished goods and services that is produced by the citizens of a country irrespective of their geographic location. It calculates only the final or finished goods. GNP = C + I + G + X + NFIA Where C = Consumption I = Investment G = Government X = Net exports NFIA = Net factor income from abroad Net National Product (NNP) Nominal GDP: Net national product or NNP is Nominal GDP is the total value of all goods and services the total value of all goods and produced within a country's borders, measured using services that are produced in a current prices during the time the output is produced. country during a given period of It does not adjust for inflation, which means it can be time minus the depreciation. It misleading when comparing economic output over is represented as follows: different time periods. If prices rise due to inflation, nominal GDP will also rise, NNP = GNP – Depreciation even if the actual quantity of goods and services produced remains the same. Real GDP: Real GDP adjusts for inflation and reflects the value of all goods and services produced in an economy at constant prices. By using a base year’s prices, real GDP provides a more accurate representation of an economy’s true growth by showing the increase in actual output, rather than just the increase in prices. It allows for more meaningful comparisons over time and across different periods. Methods to measure national Income Income Method: This method calculates national income by summing up all incomes earned by individuals and businesses in the economy. Components: Wages and Salaries: Payments to employees for labor. Rent: Income from property and land. Interest: Earnings from investments and loans. Profits: Income from business enterprises. Mixed Income: Income earned by self-employed individuals, combining elements of wages, rent, and profit. Formula: National Income=Wages+Rent+Interest+Profits+Mixed Income+Net Factor Income from NI = W+R+I+P+M+NFIA Expenditure Method This method calculates national income by adding up all expenditures made in an economy. Components: Consumption (C): Total spending by households on goods and services. Investment (I): Expenditure on capital goods that will be used for future production. Government Spending (G): Total government expenditures on goods and services. Net Exports (X - M): The value of exports minus imports. Production (Output) Method This method measures national income by calculating the total value of goods and services produced in the economy. Components: Gross Value Added (GVA): The value of output minus the value of intermediate consumption. Net Factor Income from Abroad: The income residents earn from abroad minus the income foreigners earn from the domestic economy. National Income=∑ Value Added in All Sectors+Net Factor Income from Abroad Business Cycle  Stages of the Economic Cycle Expansion During expansion, the economy experiences relatively rapid growth, interest rates tend to be low, and production increases. The economic indicators associated with growth, such as employment and wages, corporate profits and output, aggregate demand, and the supply of goods and services, tend to show sustained uptrends through the expansionary stage. The flow of money through the economy remains healthy and the cost of money is cheap. However, the increase in the money supply may spur inflation during the economic growth phase. Peak The peak of a cycle is when growth hits its maximum rate. Prices and economic indicators may stabilize for a short period before reversing to the downside. Peak growth typically creates some imbalances in the economy that need to be corrected. As a result, businesses may start to reevaluate their budgets and spending when they believe that the economic cycle has reached its peak. Contraction A correction occurs when growth slows, employment falls, and prices stagnate. As demand decreases, businesses may not immediately adjust production levels, leading to oversaturated markets with surplus supply and a downward movement in prices. If the contraction continues, the recessionary environment may spiral into a depression. Trough The trough of the cycle is reached when the economy hits a low point, with supply and demand hitting bottom before recovery. The low point in the cycle represents a painful moment for the economy, with a widespread negative impact from stagnating spending and income. The low point provides an opportunity for individuals and businesses to reconfigure their finances in anticipation of a recovery. Effects of business cycle 1. Expansion Phase: Economic Growth: During an expansion, economic activity increases, leading to higher GDP growth. Businesses produce more goods and services, and consumer demand is strong. Employment: Job creation is robust, leading to lower unemployment rates. Wages tend to rise as labor markets tighten. Investment: Businesses are more likely to invest in new projects, capital, and infrastructure due to positive economic outlooks. Inflation: As demand increases, prices may rise, leading to moderate inflation. If unchecked, this can become problematic. Consumer Confidence: Consumer and business confidence are generally high, fueling further spending and investment. 2. Peak: Overheating: At the peak of the business cycle, the economy might experience overheating, where demand outstrips supply, leading to excessive inflation. Tight Labor Markets: Unemployment is at its lowest, which can lead to wage inflation as businesses compete for scarce labor. Interest Rates: Central banks may raise interest rates to control inflation, which can slow down borrowing and spending. 3. Contraction (Recession) Phase: Economic Decline: GDP growth slows down or becomes negative, reflecting a reduction in economic activity. Unemployment: Businesses cut back on production and may lay off workers, leading to higher unemployment rates. Decreased Consumer Spending: With rising unemployment and uncertainty, consumer spending declines, further exacerbating the slowdown. Falling Investment: Business investment drops as firms become pessimistic about future demand. Deflationary Pressures: In some cases, prices may fall (deflation), especially if the recession is severe and prolonged. Government Intervention: Governments may increase spending and cut taxes to stimulate the economy, while central banks may lower interest rates to encourage borrowing and investment. Trough: Lowest Economic Activity: The trough represents the lowest point of economic activity, where GDP, employment, and investment are at their weakest. Stabilization: The economy begins to stabilize as the contraction phase ends, laying the groundwork for recovery. Policy Response: Fiscal and monetary policies implemented during the downturn may start to take effect, aiding the recovery process.  Measure to control business cycle Preventive measures Curative measures Monetary Policy: Interest Rates: Central banks raise rates during expansions to cool inflation and lower them during recessions to stimulate spending. Open Market Operations: Buying or selling government securities to adjust the money supply. Quantitative Easing: Injecting liquidity into the economy when traditional tools are insufficient. Reserve Requirements: Adjusting how much banks must hold in reserve to influence lending. Fiscal Policy: Government Spending: Increasing spending during recessions to boost demand; reducing it during expansions to prevent overheating. Taxation: Cutting taxes to stimulate the economy during downturns; raising taxes to cool it during booms. Automatic Stabilizers: Built-in mechanisms like progressive taxes and unemployment benefits that automatically respond to economic changes.  INFLATION Inflation is the rate at which the general level of prices for goods and services rises, leading to a decrease in the purchasing power of money. While a moderate level of inflation is normal in a growing economy, excessive inflation can have negative effects. Types of Inflation Demand-Pull Effect Demand-pull inflation occurs when an increase in the supply of money and credit stimulates the overall demand for goods and services to increase more rapidly than the economy's production capacity. This increases demand and leads to price rises. When people have more money, it leads to positive consumer sentiment. This, in turn, leads to higher spending, which pulls prices higher. It creates a demand-supply gap with higher demand and less flexible supply, which results in higher prices. Cost-Push Effect Cost-push inflation is a result of the increase in prices working through the production process inputs. When additions to the supply of money and credit are channeled into a commodity or other asset markets, costs for all kinds of intermediate goods rise. This is especially evident when there's a negative economic shock to the supply of key commodities. These developments lead to higher costs for the finished product or service and work their way into rising consumer prices. For instance, when the money supply is expanded, it creates a speculative boom in oil prices. This means that the cost of energy can rise and contribute to rising consumer prices, which is reflected in various measures of inflation. Built-In Inflation Built-in inflation is related to adaptive expectations or the idea that people expect current inflation rates to continue in the future. As the price of goods and services rises, people may expect a continuous rise in the future at a similar rate. As such, workers may demand more costs or wages to maintain their standard of living. Their increased wages result in a higher cost of goods and services, and this wage-price spiral continues as one factor induces the other and vice-versa.  Inflation measures Consumer Price Index (CPI) Producer Price Index (PPI): What It Measures: The CPI measures the average Definition: PPI measures the average change in change over time in the prices paid by consumers for a selling prices received by domestic producers for their market basket of consumer goods and services. output over time. Components: The CPI includes categories such as Components: It tracks prices at different stages of food, housing, clothing, transportation, healthcare, and production, including raw materials, intermediate education. goods, and finished products. Use: It's widely used to assess changes in the cost of Usage: PPI is an early indicator of inflationary trends living and to adjust wages, pensions, and other since it reflects price changes before they reach contracts for inflation. consumers. Wholesale Price Index (WPI): Definition: WPI measures the average change in prices Percent Inflation Rate of goods at the wholesale level, before they reach the = (Final CPI Index retail market. Value ÷ Initial CPI Components: WPI includes commodities like agricultural Value) x 100 products, metals, and fuels. Usage: Though less commonly used than CPI, WPI can provide insights into inflationary pressures in the production and distribution stages.  Weimar Republic Hyperinflation (1921-1923) Post-World War I: After losing World War I, Germany faced severe economic hardship. The Treaty of Versailles imposed heavy reparations on Germany, requiring payments in gold or foreign currency. Economic Instability: The German economy was already weakened by the war, and the reparations created additional financial pressure. The government began printing more money to meet its obligations, which led to a loss of confidence in the currency. Runaway Inflation: Prices soared at an unprecedented rate. By late 1923, prices were doubling every few days, and the currency became practically worthless. For example, in November 1923, a loaf of bread that cost 250 marks in January 1923 had risen to 200 billion marks by the end of the year. What is an Exchange Rate? An exchange rate is the rate at which one currency can be exchanged for another between nations or economic zones. It is used to determine the value of various currencies in relation to each other and is important in determining trade and capital flow dynamics. An exchange rate regime is a way a country or currency union's monetary authority manages its currency in relation to other currencies and the foreign exchange market. It determines how much a country's currency is worth in relation to other countries' currencies. There are several exchange rate regimes a country can choose from, including floating, fixed, and pegged: Floating: The currency is free to float. Fixed: The exchange rate is fixed to a base currency, like the US dollar, and the central bank backs the domestic currency with reserves of the base currency. This can limit the government's ability to use monetary and fiscal policies, and the central bank may run out of foreign exchange reserves if demand exceeds supply. Pegged: The currency is fixed to another currency using a hard peg. For example, a crawling peg adjusts the exchange rate to keep up with inflation or to prevent a run on reserves. An active crawl involves announcing the exchange rate in advance and making changes in stages to manipulate inflation expectations