Concepts of Macroeconomics (Part - 1) - Macroeconomics | Macro Economics - B Com PDF Download

BASIC CONCEPTS OF MACROECONOMICS

Economic Models
Models are theories that summarize the relationship among economic variables. Models are useful because they help us to dispense with irrelevant details and to focus on important economic relations more clearly.

A model is a description of reality with some simplification. To simplify analysis each model makes some assumptions which must be explicitly stated when a model is formulated.
A model may be expressed in terms of equations or diagrams. Of course, a model can also be expressed verbally. However, diagrams and equations are the most convenient method of expressing relationship among economic variables.

Models have two kinds of variables
1. Exogenous variables

• They come from outside the model
• They are inputs into the model.  

2. Endogenous variables 
Endogenous variables come from inside the model - they are the output of the model. In other words, exogenous variables are fixed at the moment they enter the model, whereas endogenous variables are determined within the model. The purpose of a model is to show how the exogenous variables affect the endogenous variables.

Example:
Let us see how we can develop a model for bread. We assume that the quantity of bread demanded, Q_d, depends on the price of bread, P_b and on aggregate income Y. This relationship is expressed in the equation Q_d = D (P_b, Y) where D denotes the demand function.

Similarly, we assume that the quantity of bread supplied, Q_s, depends on the price of bread, P_b, and on the price of flour, P_f, since flour is used to make bread. The relationship is expressed as Q_s = S (P_b, P_f), whereas S denotes the supply function. Finally, we assume that the price of bread adjusts to equilibrate demand and supply which implies Q_d = Q_s.

These three equations compose a model of the market for bread. Economic relationships involved in a model may be of different types:

1. Firstly, the relations could be behavioural.

Example: Consider the saving function
S = S(Y), which states that saving (S) is a function of income (Y).

2. Secondly, relationship between the variables could be technical. The technical relationships follow from technological considerations.

Example: Consider the production function Y = F (K, L) which states that total output (Y) produced is a function of total capital employed (K) and total labour employed (L). This relationship is determined by the technological consideration underlying the production process. Hence it is a technical relationship.

3. Thirdly, the relationship may be definitional. Such relationships follow from the very definitions of the variables.

Example: If Y_m represent money income, Y_r represents real income and P represents price level, then Y_m = Y_r х P represents a definitional equation.
A model must be complete. Mathematically, this means that number of equations should be equal to the number of Variables. For example, in our demand and supply model for bread, we have three unknowns and three equations. Hence the model is determinate. 

In the Simple Keynesian Model of income determination we have three equations:
(i) C = C(Y) (Consumption function)
(ii) I = I (Investment function)
(iii) Y = C + I (Equilibrium condition)
Hence the model is determinate. We need to distinguish between variables and parameters in a model.
The parameters are constants in relation to the variables in a model. 

Example: In a simple linear consumption function: C = a + bY, C and Y are variables while a and b are parameters. When any of the parameters changes the consumption function shifts its position.

FLEXIBLE VERSUS STICKY PRICES

• One crucial assumption of macroeconomic models are the adjustment of wages and prices. Economists normally presume that the price of a good adjusts to equilibrate demand and supply, they assume that, at the going price, suppliers have sold all they want and demanders have bought all they want.
• This assumption is called Market clearing. For answering most questions, economists use market-clearing models. But the assumption of continuous market clearing is not entirely realistic. For markets to clear continuously, prices must adjust instantly to changes in demand and supply. However, many wages and prices adjust sluggishly.
• Many labour contracts often set wages for longer years. Many firms leave their product prices unchanged for long periods of time. Although market clearing models assume that all prices and wages are flexible, in real world, we know, prices and wages are not so flexible.
• The apparent stickiness of prices does not make market-clearing models useless. They might not describe the economy at every instant, but they do describe the equilibrium toward which the economy slowly moves. Thus most macro-economists believe that market-clearing models are a good approximation to reality, especially in dealing with long-period issues. Prices and wages are flexible in the long-run.

However, for studying short-run issues, the assumption of price flexibility is less useful. Over short periods, many prices are fixed. Thus, many economists believe that price stickiness is a better assumption for studying short-run issues.

MONETARIST AND KEYNESIAN
The Keynesian View
Keynesian macro-economists are those who advocate detailed intervention to ‘fine tune’ the economy in the neighbourhood of full employment and low inflation. They seek to control inflation by direct controls of wages and prices and to reduce unemployment by stimulating aggregate demand, using monetary and fiscal policy.
They would use discretion to stimulate the economy in a depression or to hold the economy in a boom. They are not in favour of announcing policy change beforehand, so as to deter speculation. They modify their policy in the light of current and best-available forecasts. The intellectual leaders of this group are F. Modigliani, J. Tobin and many others in British universities.

The Monetarist View: Monetarists prefer the government to have policies towards a limited number of macroeconomic variables such as money supply, government expenditure, taxes, etc. They advocate the adoption of fixed rules for the behavior of these variables. 

Example: A widely advocated rule is that the money supply should grow at a certain fixed percentage rate per year.

Another rule widely advocated by them is that the government budget should be balanced over a period of four to five years. In any event, all policy interventions which do occur should be announced as far ahead as possible so as to enable people to take account of them in planning their own economic affairs.
The intellectual leader of this school is M. Friedman, R. Lucas and many others in the American universities.
We should not form the impression that the Keynesian/Monetarists division is one that follows neat political boundaries. Although there is some tendency for there to be an association between monetarism and Conservatism, and between Keynesianism and liberalism/socialism, that association is far from perfect. Monetarists range all the way from die hard libertarians to orthodox Marxists. Keynesians do not go quite so far to the right, but they do go a long way in that direction.

OKUN’S LAW
A relationship between real growth and changes in unemployment rate is known as Okun’s law. Okun’s law says that the unemployment rate declines when the growth is above the trend rate of 2.25 per cent. Specifically, for every percentage point of growth is real GDP above the trend rate that is sustained for a year, the unemployment rate declines by one-half percentage point.
This relationship is stated in equation; ∆u = - 0.5 (y - 2.25), where ∆u denotes the change in the unemployment rate, y is the growth rate of output. The use of the formula can be seen as: Suppose growth rate in a given year is 4.25 per cent. That would imply a reduction of unemployment rate of 1.0 percent [Δu= 0.5 (4.25 - 2.25)].

Fig. 2.1 shows the change (∆u) in unemployment rate on the vertical axis and the % ∆ in real GDP on the horizontal axis. Each point represents one year.

EX-POST AND EX-ANTE

• An economic concept can he defined either in ex-post or ex-ante sense. Ex-ante magnitudes refer to as planned or intended or desired magnitudes. They are determined by the decisions taken by different economic units.
  Example: In any year, different economic units plan to save some amount. The sum total of such planned savings is the total ex-ante saving of the economy.
• Ex-post concepts refer to actual magnitudes. Thus, ex-post national income refers to the actual national income of a country. Similarly, ex-post saving refers to the actual saving. Ex-post magnitudes can be measured only after they have occurred. There is, however, no guarantee that the ex-ante value of a variable will be necessarily equal to ex-post value.
  Thus, ex-ante saving may not be equal to ex-post saving, people may not be able to save what they plan or desire to save. If individuals succeed in realizing their saving plans, i.e. when each individual saves an amount which is equal to plan saving, their ex-ante total saving will be equal to ex-post total saving.
• Similarly, ex- ante total investment will be equal to ex-post total investment if all the investment plans are realized. Ex-ante values arc relevant for determining equilibrium values of different variables.
  Example: The equality of ex-ante savings and ex-ante investments determines the equilibrium level of income in the Keynesian model of income determination. Similarly, equilibrium price is determined by the equality of ex-ante demand and ex-ante supply and so on.

EQUALITY AND IDENTITY

• An equation represents a relationship between several variables which is true for some specific values of the variables but not true for all values. For example, let us consider the relation y = 2x + 5. It is not true for all possible values of x and y. But it is true for certain values of x and y only. An equation is characterized by “=” sign while an identity is denoted by “≡” sign.
• We can solve an equation and can determine the value of the variables for which the equation is satisfied. An equation represents a functional relationship. For example, suppose it is assumed that aggregate consumption depends on the level of Y of the economy. Then assume that the consumption is a linear function of income (Y). This equation can be written as C = a + bY where a and b are parameters.It represents an equation and not an identity. It can be tested. But an identity cannot be tested. It is always true by definition. Hypothesis about economic behaviours can be represented by an equation. But identities cannot represent a behavioural relationship.
• However, an identity is a relation between several variables which is true for all possible values. For example, when it is said that (x – y)² ≡ x² – 2xy + y² it is true for all possible values of x and y. Hence it is an identity. An identity is denoted by “≡” notation. An identity is always true by definition. An identity cannot be solved for determining the values of the variables since it is satisfied for all values of the variables.
  Example of an identity can be given from macroeconomics. Income be either consumed or saved.

Hence total income will always be equal to the sum of total consumption and total saving. It is true for all levels of income. Thus, it is an identity. We can write identity as Y ≡ C + S where Y is total income, C is total consumption and S is total savings. We cannot use this identity to determine the equilibrium level of income. An accounting relationship such as the equality between actual saving and actual investment represents an identity. An identity is a mere tautology and it explains nothing.

STATIC AND DYNAMIC ANALYSIS
When the variables involved refer to the same point in time (or period of time), then this analysis is known as Static analysis. On the other hand, if the variables involved refer to different points of time (or periods of time) then this analysis is called Dynamic analysis.
When we say that the quantity demanded during a period of time depends on price in that period of time, then this represents a static relationship. For example, if savings of the economy during a period of time depends on the level of income of that period, then this represents a static relationship.
On the other hand, if it is said that planned supply in any period depends on the price of the previous period, i.e. x_t = F(P_t-1) where x_t is planned supply in period t and P_t-1 is the price in the previous period, then this represents a dynamic relationship.
Suppose, we are considering a Simple Keynesian Model of income determination, in which there are three equations: consumption is a function of income, C = C(Y), then the investment function I = I̅₀ and the equilibrium condition where Expenditure equals income: Y = C + I. Solving these three equations give us equilibrium values of all these variables. This analysis is a static analysis; all the variables refer to the same period of time.
Further, the time element is not considered in the determination of equilibrium values of the variables. Similarly, the determination of equilibrium price by the equality of supply and demand is another example of static analysis.
Static analysis is concerned with the determination of equilibrium. However, it does not concern itself with the time it takes to reach an equilibrium or with the path to follow to reach the equilibrium. This is the concern of dynamic analysis.
The useful static analysis is known as Comparative statics.
In comparative static analysis one equilibrium position is compared with another equilibrium position. In static analysis there are several parameters which are assumed to be constant at a particular level. If any of these changes the equilibrium position will also change.
When we compare one equilibrium position with another corresponding to different values of the same parameter, we call it comparative static analysis. The Keynesian multiplier analysis is an example of comparative static analysis.
In the comparative static analysis one equilibrium position is compared with another equilibrium position without analyzing the process of movement. Such a process of analysis is unnecessary if the speed of adjustment is very quick. However, when the speed of adjustment is slow, we need dynamic- analysis to get a complete picture of the movement from one equilibrium to another.

Dynamic analysis is necessary for the following reasons:

1. Dynamic analysis is necessary to consider the stability of the system. An equilibrium is known as stable if any disturbance from the equilibrium brings the system back to equilibrium again.
Example: if we start from a disequilibrium position and then want to know whether the system moves towards equilibrium or not we require to analyse the time path of the relevant variable. This is known as dynamic analysis.

2. Since adjustment of one variable takes time to cause a change in another variable, there are lags in many functions. The presence of these lags requires dynamic analysis. Third, there are certain variables which depend on the rate of growth of other variables. Such problems require dynamic analysis.

STOCKS AND FLOWS
Stock and flow variables are an important distinction in macroeconomics. A variable has a time dimension. It is always measured over a period of time. A stock variable has no time dimension. It is measured at a given point in time. The stock variable is just a number, not a rate flow of so much per period. For example, the concepts like total money supply, total bank deposits, etc. are stock concepts whereas the concepts like national income, national output, total consumptions, etc. are flow concepts.
When we measure the national income we consider a period of time, namely one year. Thus national income is measured as a flow per year. Similarly, total investment, total saving, total consumption etc. are expressed as amount per year - so they are flow concepts. But the total supply of money is a stock concept which is measured on a particular point in time. Thus, flow variable must specify the period of time to which this flow refers.
If we talk about the income of an individual we must mention the time period of this income flow. If we say that the individual has an income of £ 10,000, it is meaningless because we have not mentioned the time period. If the time period is one month, it means something - that the individual is earning £ 10,000 per month or £ 1,20,000 per year. Thus, the time period of a flow variable is very important.
However, the stock variable is measured without any reference to time period. In economics we use both flow variables and stock variables and it takes a little practice to master these concepts. The main test is whether a time dimension is needed to give the variable meaning.
The distinction between stock and flow variables can be explained with the help of an example. The bathtub is a classic example used to illustrate stocks and flows. The amount of water in the tub is a stock: it is the quantity of water in the tub at a given point in time.
The amount of water coming out of the tap is a flow: it is the quantity of water added to the tub per unit of time. But the units with which we measure stocks and flows differ. We say that the bathtub contains 100 gallons of water, but that water is coming out of the tub through the tap at a rate of 5 gallons per minute.
Stocks and flows are often related. In the bathtub example, these relations are clear. The stock of water in the tub represents accumulated water, and the flow of water represents the change in the stock. When developing theories to explain economic variables, it is often useful to think about whether the variables arc stocks or flows and the relationships between them.

Here are more examples of stocks and flows that we study in macroeconomics:
(i) A consumer’s wealth is a stock; his income and expenditure are flows.
(ii) The amount of capital in an economy is a stock; the amount of investment is a flow.
Example: if K₀ is the stock of capital at the beginning of a year and if K₁ is the stock of capital at the end of the year then (K₁ – K₀) = I₀ is the flow of investment during the year.
(iii) The number of unemployed people in a given year is a stock; the number gaining their employment is a flow.
(iv) The government debt is a stock; the budget deficit is a flow. The ratio of two flow magnitudes having the same time dimension is a pure number without any time dimension.
Example: APC = c/y is the ratio of consumption flow to income flow and is also a pure number without any time dimension. Again, the derivative of a flow with respect to another flow is also a pure number without any time dimension. Thus, the marginal propensity to save, MPS = ∆S/∆Y has no time dimension ant is a pure number.