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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
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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
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The Circular Flow
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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
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Gross domestic product (GDP) = the market value of all final
goods and services produced within an economy in a given period of
time
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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?
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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
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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.
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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).
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Compute nominal GDP in each yearCompute real GDP in each year
using 2002 as the base year.
200220032004PQPQPQgood A30900311,000361,050good
B100192102200100205
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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
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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.
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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%
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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
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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.
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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
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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
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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)
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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
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cost of price chbasket CPI 2002350100.02003 370105.75.7%2004
400114.38.1%2005 410117.12.5%
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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
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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.
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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.
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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
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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
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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
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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
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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.
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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.
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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
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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
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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
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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
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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
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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)
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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
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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.
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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
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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.
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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
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>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.
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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.
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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%
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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
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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
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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
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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)
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conversely, when firms sell more than what they had planned,
their stock of inventories falls
Leads to unplanned changes (reduction) in inventory
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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
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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
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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.
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*Elements of Simplest Keynesian Model: determinants of planned
expenditure
consumption function: planned investment:planned
expenditure:govt policy variables:
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PE = C( Y-T)+ Planned I+G
Actual expenditure = GDP = Y= C(Y-T) + Planned I + Unplanned I
+G
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*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
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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.
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How to graph the equilibrium condition?
Eqbm: Planned Expenditure (PE) = Actual Expenditure Since,
Actual expenditure = GDP = National income =Y
Therefore equilibrium: PE= AE=Y
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*Graphing the equilibrium conditionincome, output, Y
PEplannedexpenditure45
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*The equilibrium value of incomeKeynesian cross Diagram
income, output, Y PE, AEPE =AE=Y PE =C +IP +G
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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.
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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.
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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.
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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.
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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).
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*An increase in government purchasePE =Y so firms increase
output, and income rises to a new equilibrium.
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Solving for Yequilibrium conditionbecause I exogenous
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The government purchase multiplierExample: If MPC = 0.8,
thenDefinition: the increase in income resulting from a 1 unit
increase in G.
Govt purchase multiplier
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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
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Sum up changes in expenditure
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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.
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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
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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*******