S. CHAND & COMPANY PVT. LTD. (An ISO 9001 : 2008 Company)

RAM NAGAR, NEW DELHI - 110 055

Dr. Abha MittalAssociate Professor

Maharaja Agrasen CollegeDelhi University

Delhi ExecutiveIndian Economic Association

MACRO ECONOMICS

For the Students of B.Com. (Hons.) Delhi University, Annual and Semester Examination

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© 2012, Dr. Abha MittalAll rights reserved. No part of this publication may be reproduced or copied in any material form (including photo copying or storing it in any medium in form of graphics, electronic or mechanical means and whether or not transient or incidental to some other use of this publication) without written permission of the copyright owner. Any breach of this will entail legal action and prosecution without further notice.Jurisdiction : All disputes with respect to this publication shall be subject to the jurisdiction of the Courts, tribunals and forums of New Delhi, India only.First Edition 2012Second Revised Edition 2014ISBN : 81-219-4003-6 Code : 08A 246printed in india

By Rajendra Ravindra Printers Pvt. Ltd., 7361, Ram Nagar, New Delhi -110 055 and published by S. Chand & Company Pvt. Ltd., 7361, Ram Nagar, New Delhi -110 055.

DEDICATED

TOMY FATHER

PREFACE

It gives us immense pleasure to present the book, Macroeconomics, broadly covers the Syllabus of Economics (Hons.) & B.Com. (Hons.) of Delhi University and all other Indian Universities.

It is aimed at catering to the needs of both students as well as teachers.

The book has been structured in five units which covers all the topics of syllabus.

In addition to this, the book also has some important numericals, Multiplier, Budget Surplus, Large Open Economy and examination papers. The book also includes many graphs and diagrams which provides clear concept of Macroeconomics.

The book has been written keeping in mind the curriculam requirements from academic perspective as well as intended at true knowledge addition for the students.

I shall always be obliged to all the readers who appreciate our intentions mainfested in the form of this book. Suggestions will be received with gratitude.

At last but not the least I am thankful to S.Chand & Company Pvt. Ltd. for the faith they have shown in me.

Author

Disclaimer : While the author of this book has made every effort to avoid any mistake or omission and has used her skill, expertise and knowledge to the best of their capacity to provide accurate and updated information. The author and S. Chand do not give any representation or warranty with respect to the accuracy or completeness of the contents of this publication and are selling this publication on the condition and understanding that they shall not be made liable in any manner whatsoever. S.Chand and the author expressly disclaim all and any liability/responsibility to any person, whether a purchaser or reader of this publication or not, in respect of anything and everything forming part of the contents of this publication. S. Chand shall not be responsible for any errors, omissions or damages arising out of the use of the information contained in this publication.Further, the appearance of the personal name, location, place and incidence, if any; in the illustrations used herein is purely coincidental and work of imagination. Thus, the same should in no manner be termed as defamatory to any individual.

(v)

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ACknowlEdgEmEnt

I wish to record my sincere thanks for the continued encouragement and support which I received from:

1. Dr. Sunil Sondhi, Principal Maharaja Agrasen College2. Dr. Bhim Singh, Principal, Kirori Mal College3. Prof. Bhanumurthi Head of the Depratment, Commerce4. Mr. N.S. Mittal (Former Chairman, Elected Member and Central Government

Nominee on the Central Council of the Institute of Company Secretaries), my father-in-law

5. Dr. Kishan Kumar (Reader Rajdhani College)6. Dr. Bharat Singh (Satyawati College)7. Dr. Sangya Ranjan (Satyawati College)8. Dr. Ramji Narayan (P.G.DAV College)9. Dr. Poonam Tyagi (Kalindi College) 10. All employees of S.Chand & Company Ltd. who helped in the publication of the

book.

Author9810047562

According to the New Revised Syllabus of Delhi University B.com. (H) Annual and Semester Mode 2012-13

Unit 1 1. Topic to be done : 1.5 Rest Topics are deleted

2. Chapter 2 Deleted 3. Chapter 3, 4, 5 not deleted

Unit 2 Chapter 7 : 7.10 and 7.11 are deleted

Chapter 11 : 11.12.2 and 11.13 are deleted

Unit 3 Chapter 12 : Diagram 12.5 is deleted

Chapter 13 : 13.4 and 13.11 are deleted

Chapter 14 : 14.3, 14.4 and 14.5 are deleted

Chapter 15 : 15.8 and 15.9 are deleted

Unit 4 Chapter 16 : 16.7 and 16.8 are deleted

Chapter 17 : 17.4.1, 17.6, 17.7 and 17.8 are deleted

Chapter 18 : 18.11, 18.12 , 18.13 and 18.14 are deleted

Unit 5 Chapter 21 : deleted

UNIT 1

1. NATIONAL INCOME ACCOUNTING → Do only 1.5 3–13

1.1 Gross Domestic Product → Deleted 3 1.2 National Income and its related aggregates → Deleted 5 1.3 Difference between Nominal GNP and Real GNP → Deleted 8 1.4 Relationship between unemployment and real GDP : Okun’s Law → Deleted 8 1.5 TheCircularflow 9 1.6 Stockandflowvariables→ Deleted 11

2. EQUILIBRIUM OUTPUT AND EMPLOYMENT →Not in the Revised Syllabus Deleted 14–25

2.1 Mercantilist view 14 2.2 Classical View – Adam Smith, J.B. Say etc. 14 2.3 Classical theory of income, output and employment determination 14 2.4 Shift in Production Function 21 2.5 Supply Determined Nature of Output and Employment 21 2.6 Derivation of Classical Aggregate Supply Curve 23 2.7 Factors which do not affect output and employment in the Classical Model 24 2.8 In case of Stock Market or Auction Market 24

3. COMPONENTS OF GROSS DOMESTIC PRODUCT → Do All from 3.1 to 3.4 26–29

3.1 Consumption 26 3.2 Investment: Investment refers to the addition to the stock of capital goods 27 3.3 Government expenditure/purchases 28 3.4 NetExport(NX) 29

4. NEO-CLASSICAL THEORY OF DISTRIBUTION OF NATIONAL INCOME (AMONG FACTORS OF PRODUCTION) → Do All from 4.1 to 4.4 30–35

4.1 Introduction 30 4.2 Determination of Factor Price 31

Contents

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4.3 Demand for factor 32 4.4 How is National income distributed among the factors of production? 34

5. CLASSICAL MODEL OF DETERMINATION OF EQUILIBRIUM IN THE GOODS MARKET AND THE MONEY MARKET → Do All from 5.1 to 5.4 36–44

5.1 Goods Market 36 5.2 Money/Financial Market 37 5.3 Effect of Fiscal Policy on Savings and Investment 40 5.4 Effects of changes in Investment Demand 41

UNIT 2

6. KEYNESIAN MODEL OF INCOME DETERMINATION 47–58

6.1 Derivation of saving function 47 6.2 Equilibrium Level of Income Determination in the short-run given by

Keynes 49 6.3 Alternative Approach : S and I Approach 51 6.4 Change In Equilibrium Level of Income 54

7. MULTIPLIER → 7.10 and 7.11 deleted 59–78

7.1 InvestmentMultiplier 59 7.2 Multiplier in 3 Sector Model (NX = 0) 60 7.3 Tax Multiplier 61 7.4 Transfer Payment Multiplier 62 7.5 The Multiplier 62 7.6 Effects of a Change in Fiscal Policy 67 7.7 Effectsofachangeinfiscalpolicyontheequilibriumlevelofincome 68 7.8 Implications or Role of Fiscal Policy 71 7.9 BalancedBudgetMultiplier(BBM) 71 7.10 Government Budget → Deleted 73 7.11 Full-Employment Budget Surplus (BS*) → Deleted 75

8. THE IS-LM MODEL 79–90

8.1 Introduction 79 8.2 The Goods market and the IS curve 80 8.3 The money market and the LM curve 84 8.4 Equilibrium in the goods and money market 88

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9. SHIFTS AND SLOPE OF IS AND LM CURVE 91–108

9.1 ShiftsinIS/PositionofIScurve 91 9.2 SlopeofIScurve 92 9.3 ShiftinLM/positionofLMcurve 95 9.4 SlopeofLMCurve 96 9.5 EffectofshiftinISontheequilibrium 98 9.6 DerivationofADcurve 100 9.7 IS-LMModelintheShortRunandLongRun 103 9.8 ShiftsinAggregateDemandCurve 352 9.8.1 EffectofmonetarypolicyonADCurve 352 9.8.2 EffectoffiscalpolicyonADCurve 353

10. SHIFTS IN AGGREGATE DEMAND AND AGGREGATE SUPPLY 109–117

10.1 Determinationofequilibriumpriceandoutput 109 10.2 Effect of an increase in the Nominal Money Supply/OR (Expansion ary monetary policy) 110 10.3 Aggregate Supply (AS) Curve 112 10.4 Shifts in the AS curve 113 10.5 Shifts in the AD curve 114

11. MONETARY AND FISCAL POLICY AND ITS EFFECT ON THE GOODS AND THE MONEY MARKET → 11.12.2 to 11.13 are deleted 118–139

11.1 Introduction 118 11.2 Fiscal Policy Multiplier 118 11.3 MonetaryPolicyMultiplier 119 11.4 Monetary Policy - Effect of expansionary monetary policy on the income level and interest rate 120 11.5 Liquidity Trap (For Understanding not in the Syllabus) 122 11.6 Liquidity Trap and LM curve 124 11.7 Crowding Out 125 11.8 ImportanceofCrowdingOut 129 11.9 ExpansionaryMonetaryPolicyanditseffectonInterestRate 129 11.10 Effectiveness of Fiscal Policy under different assumptions 131 11.11 Choice of Fiscal or Monetary Policy 132 11.12 MonetizingBudgetDeficit:Fiscalexpansiontoprevent crowding out – Monetary accommodation 132 11.12.2 Policy Mix → Deleted 11.13 Effect of Cutting Tax Rates in the Classical Case: The Supply-side Economics/Voodoo Economics → Deleted 135

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UNIT 3

12. UNEMPLOYMENT → Diagram 12.5 is deleted 143–154

12.1 Introduction 143 12.2 Definition 143 12.3 Characteristics of Unemployment 143 12.4 Cost of Unemployment 144 12.5 Natural Rate of Unemployment (NRU) 144 12.6 Determinants/Determination of NRU 145 12.7 Reasons of the Rising NRU 148 12.8 Reasons/Causes of Unemployment 148 12.9 Causes of Wage Rigidity → Diagram is deleted 150 12.10 Efficiency-wagetheories 152 12.11 Impact of Minimum Wage 152 12.12 Solutions to Minimum wage 152 12.13 Methods for Reducing NRU 153

13. PHILLIPS CURVE AND AS CURVE → 13.4 and 13.11 are deleted 155–178

13.1 Derivation of wage unemployment relationship from the Phillips curve 155 13.2 Derivation of AS curve from Phillips curve/Properties of AS curve 156 13.3 EffectofMonetaryExpansionontheAScurve 159 13.4 The Supply Shocks → Deleted 162 13.5 Aggregate Supply and Phillips Curve 164 13.6 The Phillips Curve 165 13.7 ModernPhillipsCurveorExpectations-AugmentedPhillipsCurve 169 13.8 Expectations-Augmented Dynamic short run Aggregate Supply Curves or short run expectations augmented AS curve (SRAS) 171 13.9 LongRunVerticalASCurve(LRAS) 174 13.10 Difference between Expectations Augmented Phillips curve and Rational Expectation Model 177 13.11 Causes of wage-Stickiness → Deleted 177

14. DYNAMIC AGGREGATE DEMAND → 14.3, 14.4 and 14.5 are deleted 179–189

14.1 DerivationofDADequation 179 14.2 DeterminationofInflationRateAndOutput/RelationshipBetween

InflationRateAndOutputLevel 182 14.3 Fiscalexpansionanditseffectsoninflationandoutput–

Adjustmentprocessoffiscalexpansion→Deleted 184

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14.4 Monetary Expansion → Deleted 186 14.5 Overshooting → Deleted 188 14.6 Stagflation 188

15. INFLATION → 15.8 and 15.9 are Deleted 190–203

15.1 Introduction 190 15.2 InterestRatesandInflation:TheFisherEquation 190 15.3 CostofDisinflation:SacrificeRatio 193 15.4 Strategies/MethodstoReduceInflation/Disinflation: 194

or HowtoendaHyperinflation 194 15.5 ComparisonofGradualistandColdTurkey 197 15.6 ReasonofChoiceofColdTurkey:Credibility 197 15.7 CostsofInflation 198 15.8 Solution of Inflation → Deleted 200 15.9 Is a little Inflation Good For the Economy → Deleted 203

UNIT 4

16. EXCHANGE RATE → 16.7, 16.8 are deleted 207–224

16.1 Types of Exchange Rate 207 16.2 Relation between Real and Nominal Exchange Rate/

Computation of RER 208 16.3 TypesofEconomy 209 16.4 National Income Accounts Identity 210 16.5 Relationbetweenfinancialmarketandgoodsmarketinanopen economy/Relationship between Net foreign investment and trade balance 212 16.6 Real Exchange Rate (RER) and the Trade Balance 213 16.7 Changes in Economic Policy and its impact on Real Exchange Rate → Deleted 214 16.8 Effect on RER if Investment at Home Increases → Deleted 216 16.9 NetCapitalOutflowor,shapeofnetforeigninvestment(NFI) in open economy and closed economy 217 16.10 Determination of trade balance in a small open economy 218 16.11 Effect of increase in investment on the trade balance 223

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17. LARGE OPEN ECONOMY CASE → 17.4.1, 17.6, 17.7, 17.8 are deleted 226–240

17.1 Introduction 226 17.2 Determination of real interest rate and real exchange rate in a large open economy with the help of saving and investment curve 227 17.3 Short run Equilibrium/Model in Large Open Economy OR

DeterminationofCF,NXandERwiththehelpofIS–IMmodel 229 17.4 Trade policies in a large open economy 231 17.4.1 Expansionary fiscal policy with the help of S and I curve → deleted 232 17.4.2 Expansionary fiscal policy with the help of IS – LM model 233 17.5 Expansionary monetary policy with help of IS-LM model (in large open economy) 235 17.6 Shift in Investment Demand in large open economy → deleted 236 17.7 Restrictive Trade Policies in Large open economy → deleted 237 17.8 Shifts in Net Capital outflow/Net foreign investment in 239

large open economy → deleted

18. MUNDELL FLEMING MODEL → 18.11, 18.12, 18.13, 18.14 is deleted 241–259

18.1 Introduction 241 18.2 Fixed exchange rate or pegged exchange rate 241 18.3 Flexible/floatingexchangerate 242 18.4 Mundell-Fleming Model: Small open economy case 242 18.5 Working of Fixed ER in Mundell-Fleming Model (in small open economy)withPricelevelfixed 247 18.6 Effect of Different Policies in small open economy in case of Mundell Fleming Model 248 18.7 Expansionaryfiscalpolicyunderfloatingexchangerate 248 18.8 Expansionary Fiscal Policy Under Fixed Exchange Rate (with Price levelfixed) 249 18.9 Expansionarymonetarypolicyunderfloatingexchangerate 251 18.10 Expansionary Monetary Policy Under Fixed ER with Price level Fixed 252 18.11 Restrictive trade policy under floating exchange rate → deleted 252 18.12 Restrictive Trade Policy Under Fixed ER → deleted 254 18.13 International Interest Rate Differentials → deleted 254 18.14 Mundell-Fleming model and economic implications of Interest rate differentials → deleted 255 18.15 Derivation of Aggregate Demand Curve with help of Mundell-Fleming Model and Change in price 257 18.16 Aggregate Supply and Aggregate Demand in case of Mundell-Fleming Model with change in price 258

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UNIT 5

19. MONEY SUPPLY 263–269

19.1 Introduction 263 19.2 Measuresofmoneysupply/Htheoryofmoneysupply/High powered money supply/Determinants of money supply 264 19.3 CreditCreationbyBanks 265 19.4 InstrumentsofMonetaryPolicy 268

20. INVESTMENT SPENDING 270–281

20.1 Introduction 270 20.2 The supply of stock of capital 270 20.3 Firm’s Demand for the desired capital stock 271 20.4 Relation between the desired capital stock (K*), rental cost of capital (rc) and the output level (Y) or the effect of increase in GNP on desired capital stock. 273 20.5 Shift in MPk Curve 273 20.6 Effect of Monetary Policy on the Desired Capital Stock 273 20.7 The Stock Market/Tobin’s Q theory of investment 274 20.8 BusinessfixedInvestment 276 20.9 CreditRationing 277 20.10 Irreversibility and the Timing of Investment Decision 277 20.11 Taxes and investment 277 20.12 Residential investment 278 20.13 Taxtreatmentofhousing/EffectoftaxandInflationonHousing 279 20.14 Inventory investment 280 20.15 Inventory Investment and the Accelerator Model 280 20.16 Types of Inventories 281 20.17 Role of Business Cycle in Inventories 281 20.18 ‘Just-in-Time’ Inventory Management 281 20.19 InvestmentandAggregateSupply(AS) 281 20.20 Investment around the World 281 Question For Review

21. DEMAND FOR MONEY → Deleted 282–285

21.1 Introduction 282

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21.2 Classical View 282 21.3 Neo-Classical Theory/Cambridge version 283 21.4 Keynesian concept of demand for money/liquidity preference theory of demand for money 283

22. TRANSACTION THEORIES OF MONEY DEMAND 286–298

22.1 Baumol-Tobin Model of Cash Management/Baumol-Tobin treatment of Transaction Demand for Money 286 22.2 PortfoliotheoriesofMoneyDemand 291 22.3 James Tobin Portfolio approach to demand for money/Recent developments in the Keynesian approach to the theory of demandformoney 291 22.4 DemandforMoney 293 22.5 DemandforMoneyatDifferentInterestRates 294 22.6 ModelExplainedwiththehelpofSubstitutionandIncomeEffect 295 22.7 Effectofchangesintheriskinessofbondsonthedemandformoney 296 22.8 Modernquantitytheoryofmoneyordemandformoney 297 SOME IMPORTANT NUMERICALS 299–311 MULTIPLIER 312–317 BUDGET SURPLUS 318–321 LARGE OPEN ECONOMY 322–326 EXAMINATION PAPERS 2006-2013 327–355v B.Com.(Hons.) 2006-07v B.Com. (Hons.) 2007-08v B.Com. 2007-2008v B.Com.(Hons.)2008-09v B.Com.(Hons.)2009-10 v B.Com. (Hons.) 2010-11v B.Com. (Hons.) 2011-12v B.Com. (Hons.) 2012-13APPENDIX — Continuation of chapter 9 (Unit 2) shifts in AD curve 9.8.1, 9.8.2 356–357

BIBLIOGRAPHY 358

ERRATA 359

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UNIT - 1

1. National Income Accounting2. Equilibrium Output and Employment3. Components of Gross Domestic Product4. Neo-Classical Theory of Distribution of National Income (Among Factors

of Production)5. Classical Model of Determination of Equilibrium in the Goods Market

and the Money Market

Macroeconomics2

Chapter

1 National IncomeAccounting

Statistics which the economists and the policy makers use often to quantify the performance of the economy are: 1. Gross Domestic Product (GDP): It measures the total income and total expenditure

of the Nation on its output of goods and services during an accounting year. 2. Consumers Price Index (CPI): It measures the level of prices.1

3. Unemployment Rate: It tells us about the fraction of workers who are unemployed.2

1.1 GROSS DOMESTIC PRODUCT GDPisthemarketvalueofallfinalgoodsandservicesproducedinaneconomyina given period of time.There are two ways to view GDP : (a) It is the total income generated in the economy. (b) It is the total expenditure on the economy’s output of goods and services, which

the economy produces. As the GDP measures both the economy’s income and expenditure on its output, it is used to measure the economic performance. This is because for the economy as a whole, income should be equal to the expenditure because every transaction has both a buyer and a seller, for example, when Jony construct Hank’s house for ` 2000, that is an income to Jony and expenditure by Hank.

GDP = Price × number of units produced1. Assume: The economy produces 3 goods A, B, C Where PA → Price of good A

1. CPI = Sum of (current year prices × base year’s quantity)

Sum of (base year prices × current year’s quantity)

P01 = 1 0

1100P Q

P Q0

Σ×

Σ

2. Unemployment Rate = Number of Labour Unemployed ×100

Labour Force Where Labour Force = Number of Employed + Number of Unemployed

3

Macroeconomics4 PB → Price of good B PC → Price of good C QA, QB, QC → Quantity of goods A, B, C produced respectively

Then: GDP = PAQA + PBQB + PCQC

GDP can be increased either by increasing the price or by increasing the quantity.

1.1.1 Rules for computing GDPI. In case of used Goods: As GDP measures only the value of currently produced goods

and services, sale of used goods is not included in GDP For example, when a painting is made and sold for ` 1000, ` 1000 are added to the

Nation’s GDP. But when a collector sells a rare painting for ` 1000, this ` 1000 will not be added

toGDPbecauseitreflectstransferofanasset.II. In case of Inventories: It will be treated like the sale of used goods. For example.Afirmfailstoselltheadditionalpastryproduced (a) If the pastry is spoilt: Neither the total expenditure nor the total income changes

becausenoonebuysthepastry.Asaresult,theprofitofthefirmwilldecreasebytheamountofwageswhichthefirmpaystothelabourandthereforeitdoesnot affect the GDP.

(b) If the pastry is put into inventory to be sold later:Ifthefirmsellsthegoodse.g. pastry out of inventory, then it will not affect the GDP because on the one hand there is spending by the consumers on the pastry and on the other hand there will beinventorydisinvestmentbythefirm.Thenegativespendingbythefirmwilloffset the positive expenditure by the consumers. Therefore, sale out of inventory does not affect the GDP.

III. Intermediate Goods and Value Added: Intermediate goods are those goods which helps in the process of further production. The value of Intermediate goods will not be included in GDP otherwise it will lead to double counting.

Value Added (VA) = Gross value of output – Value of Intermediate goods For Example, Mr. X sells meat to KFC for ` 100 Further, KFC sells hamburger to the consumer for ` 150 VA by Mr. X = ` 100 (Assume he bought no Intermediate goods) VA by KFC = ` 150 – ` 100 = ` 50 Total VA = ` 100 + ` 50 = ` 150 Thus, GDP will increase by ` 150 and not by ` 250IV. Goods that are not sold in the market: Housing Services, Government servants

providing services to the public. Since these services are not sold in the market, they have no market price. To include

these goods and services in the GDP, imputed value has to be found out. (a) In case of owner occupied house: If the house was rented out, it would have

National Income Accounting

earned a rent but since the owner is living in the house he is deprived of the rent which he would have earned. Therefore, market rent for the house if it were rented out is found out and then included in the GDP.

(b) In case of Government services: They are valued at their cost. The value of their output is measured by the wages paid to them.

1.1.2 Excluded in GDP (a) Imputed rent on cars, jewellery or other durable goods owned by the households. (b) Own account production, They are the goods produced and kept for self-

consumption. For example, Value of food cooked at home is not included in GDP but if it is cooked at restaurant it is included in GDP.

(c) Goods and services sold in the underground economy: For instance: illegal drug trade, smuggling, etc.

1.2 NATIONAL INCOME AND ITS RELATED AGGREGATES1

1.2.1 Gross National Product (GNP)

GNP = GDP + Net Factor Incomes from Abroad (NFIA)

where: NFIA=[FactorPaymentfromAbroad(wages,profitandrent)–FactorPaymentsto

abroad]1.2.2 Net National Product (NNP)

NNP = GNP – Depreciation

Depreciation consists of the amount of the economy’s stock of plants, equipment and residential structures that wears out in the process of production during the year. By subtracting depreciation from GNP, we obtain the net result of the economic activity because depreciation is a cost of producing the output of the economy. NDP differs from NNP due to NFIA.

1.2.3 National Income (NI)/Net National Product at Factor Cost (NNPFC)

MPNI = NNP – NIT NNPMP → NNP at market pricesNIT = Net indirect taxesIT = Indirect Business taxes e.g. Sales taxNIT = IT – Subsidies

Components of NI :

National income is dividedintofivecomponentsonthebasisofincomeearned.Theyare: (i) Compensation of Employees: It includes all the payments made by the resident

producerstotheiremployeesinformofwagesandthefringebenefitsearnedbythe workers like life insurance, pension, etc.

(ii) Proprietors income:Itistheincomeofthenon-corporatesmallfirmslikeretailstores, lawyers, self-practising doctors, etc.

1. Question : How are the alternative measures of income related?

5

Macro Economics

Publisher : SChand Publishing ISBN : 9788121940030 Author : Abha Mittal

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