Introduction to

Macroeconomics

Macroeconomics
is the branch of economics studying the behavior of
the aggregate economy – at the regional, national or
international level.
While microeconomics is concerned primarily with
the decisions made by an individual within the usual
economic constraints of scarcity, macroeconomics
(Greek makro = ‘big) is the field of study that is
concerned with the indicators that reflect the
performance of the broader economy- gross
domestic product, inflation levels, unemployment,
growth rate, fiscal deficit etc.
If you are trying to gain a better appreciation of the
macroeconomics problems of the Indian economy
that get covered in newspapers and TV channels,
this post should help you get the basic principles of
macroeconomics.

What is macroeconomics?
The aim of studying macroeconomics is to
understand how an economy works, and identifying
the levers that can be pulled to put the overall
economy on the right path of growth. The system
that is a result of different economic agents coming
into contact is much more complex than the sum of
its independent and often disjoint parts.
Moreover, it is strictly “non-experimental” as we do
not have the luxury of conducting controlled
experiments like in the field of science. We can just
wait and observe the effects of broader policy
measures with a certain level of accuracy and a tinge
of hope.
It usually deals with goals that are conflicting;
ensuring growth, taming inflation, full employment
and fair income distribution at the same time!

Introduction to
Macroeconomics – Basic
concepts
  Currency
Before the advent of money and modern
economic systems, barter was prevalent to
facilitate the exchange of goods and services.
Money has many advantages over the barter
system and serves multiple functions: it is faster,
convenient, holds value over time and both
parties are not obligated to want what the other
is offering ensuring freedom of choice through a
neutral medium of exchange.
There is no scope for confusion as everyone
knows the current value of one unit of a
currency (atleast they think they know!).
Interest rate is the cost of borrowing money,
which in turn is dependent upon the current
demand of money in the economy.
An exchange rate signifies the rate at which one
currency will be exchanged for another. The two
primary types of exchange rate systems are –
fixed and floating. In fixed rate systems, the
participating countries agree upon the relative value
of their currencies and maintain the same rate by
buying/selling their foreign reserves in the case of
demand fluctuations for their currency.
Fixed exchange rate system was mostly prevalent in
the 19th and 20th centuries, and currencies were
backed by gold in the good old days (now it is not
the case, read about fiat money). In floating
exchange rate systems, the value of the currency is
determined by the market forces, just like any other
good.
 Inflation
Simply put, inflation is the erosion in value of a
currency, as its buying capacity diminishes over
time. Alternatively, it can also be defined as a
significant increase in the prices of
goods/services in an economy for considerable
time duration. Consumer Price Index (CPI) and
Wholesale Price Index (WPI) are the measures
of inflation used in India.
There is no broad consensus upon the right rate
of inflation in the economy, but majority believe
that a slightly positive rate of inflation signifies
growth and is best for the economy.
Wild variation in inflation is the major source of
headache for economists and can lead to a
variety of problems in the economy: the saving
sentiment of the populace erodes due to
uncertainty in the value of deposits and the
long-term investments may dry up due to
significant risk associated with final returns.

 Business cycles
Business cycles are the patterns of expansions &
contractions in the economy. During a phase of
expansion, gross domestic product (GDP) rises
and the unemployment rate falls. While
recession has found its place in the pop culture
 and now usually means any downturn in the
economy, the definition of recession usually
requires the real GDP to decline for two
consecutive quarters.
There is no set consensus among the economists
as to what decides the extent of these cycles, and
the role government should play in influencing
these cycles. Lowering taxes and increasing
spending usually provide the required stimulus
to the economy during downturns. Some see
this cycles as totally irregular phenomenon,
while some believe that overall technological
throughput of the economy drive these cycles.

 Unemployment
: Good rate of employment within an economy is
important for a couple of reasons – unemployed
workforce is pure wasted potential, plus it leads
to lowering in consumer spending as they’ve got
nothing to spend!
There are three sub-categories of unemployment:
 Cyclical unemployment: Result of business cycles,
not harmful to the economy in general
 Frictional unemployment: Result of lags in
information dissemination and imperfect
matching of jobs and skilled workers
 Structural unemployment: Result of workers not
being equipped for the jobs that are available,
can be detrimental to the economy
 While a very low rate of unemployment is desirable,
absolute zero unemployment is neither desirable
nor practically possible. The general relationship
that exists between inflation and employment –
higher the rate of employment, higher is the rate of
inflation. Balancing it all does require some serious
effort after all.

What are the major objectives of macroeconomic policy?

Macroeconomics is concerned with issues, objectives and policies that

affect the whole economy. All economic analysis that refers to aggregates
is macro. The UK unemployment rate, the UK inflation rate, the rate of
economic growth in the UK; these are all UK aggregates and therefore
macro issues.

The four major objectives are:

1. Full employment
2. Price stability
3. A high, but sustainable, rate of economic growth
4. Keeping the balance of payments in equilibrium.

In this Learn-It, we will look at the way in which these objectives are
measured. In the next, we shall look at why these objectives are important,
their relative importance and how successful recent governments have
been in achieving these goals. Finally we will look at the difficulties that
governments have in trying to achieve all the objectives at once.

How are these objectives measured?

1. Full employment, or low unemployment.

The claimant count is the older, more out-of-date, measure of

unemployment used in the UK. Those counted must be out of work,
physically able to work and looking for it, and actually claiming benefit.
For a more realistic count, and for international comparisons, the ILO
(International Labour Organisation) measure is used. This includes the
young unemployed who are not always eligible to claim, married women
who can't claim if their husband is earning enough, and those who claim
sickness and invalidity benefits. Many only slightly inconvenienced
unemployed workers are paid these benefits rather than swell the claimant
count of unemployment.

Note the issue of active and inactive members of the population of

working age. Only those who are active are included in the working
population (or labour force), which is defined as all those who are
employed or registered unemployed. But some of the inactive are in this
category by choice, for instance, students and those who retire early.

At the moment in the UK, the level of employment is the highest ever
(nearly 28 million workers). But one should note the significant difference
in the numbers employed in manufacturing compared with the services
(approximately 4 million against nearly 18 million).

2. Price stability

Inflation is usually defined as a sustained rise in the general level of

prices. Technically, it is measured as the annual rate of change of
the Retail Price Index (RPI), often referred to as the headline rate of
inflation. For prices to be stable, therefore, the inflation rate should be
zero. Generally, governments are happy if they can keep the inflation rate
down to a low percentage. For an explanation of how the RPI is
formulated, see the topic called 'Unemployment and inflation'. The UK
government prefers to target the underlying rate of inflation, or the
annual percentage change in the RPIX. This is the same as the RPI except
housing costs are removed in the shape of mortgage interest payments. It
makes sense for the government to use this measure because the weapon
they use to control inflation, interest rates, directly affects the RPI itself.

Other less popular measures include the RPIY, which takes RPIX a stage
further by also taking out the effects of indirect taxation (e.g. VAT), and
the consumer price index, which is often used when making international
comparisons.
The inflation rates based on these measures for the whole of 1999 were:
RPI, 1.5%; RPIX, 2.2% and RPIY, 1.6%. Another important statistic is
that of average earnings growth. Most economists believe that the growth
in wages directly affects the price level. The 4.6% figure for 1999 is
reasonably low historically (certainly compared with the early 90s), but
there are fears that it will have picked up during 2000. At the time of
writing it was too early to get figures for the whole of 2000. This is
something that you should look up yourself.

3. High (but sustainable) economic growth

Economic growth tends to be measured interms of the rate of change

of real GDP (Gross Domestic Product). When the word real
accompanies any statistic, it means that the effects of inflation have been
removed. GDP is a measure of the annual output (or income, or
expenditure) of an economy. Sometimes GNP (Gross National
Product) is used, which is very similar to GDP. The only difference is that
income earned from assets held abroad is added and the income earned by
foreigners who have assets in the UK is taken away (officially called net
property income from abroad). Growth figures are published quarterly,
both in terms of the change quarter on quarter and as annual percentage
changes.

UK real GDP growth was 1.8% in 1999, which is lower than the mid-90s,
but much better than the recession of the early 90s. Remember that many
economists were predicting 1999 to be a year of recession, so the final
figure is really quite reasonable. Note also that there is a big difference
between the growth rates of the manufacturing sector (-0.4%) and the
service sector (2.8%). The service sector has been healthy for years,
whereas the manufacturing sector, some would argue, has barely recovered
from the recession of the early 90s.

4. Balance of payments in equilibrium

This is a very big topic in itself. Look at the topic called 'The balance of
payments' for much more detail. Briefly, this records all flows of money
into, and out of, the UK over a given time period (usually a year). It is split
into two: the Current Account and the Capital and Financial
Accounts (formerly the capital account, although examiners do still accept
this name).
Probably the most important is the current account because this records
how well the UK is doing in terms of its exports of goods and services
relative to its imports. If the UK is to 'pay its way' in the world over the
long term, then it needs to keep earning enough foreign currency from its
exports to pay for its imports. If this is not the case, the current account
will be in deficit.

Japan has the largest current account surplus in the world. Although a
surplus sounds better then a deficit, both can be bad. Japan's surplus forces
other countries in the world to have deficits. In fact, while Japan's surplus
is the biggest in the world, the USA's deficit is the biggest in the world.
This is not a coincidence! The UK tends to be in deficit, although the
current account was in surplus a couple of years ago, mainly due to our
strength in the service sector.

Scope and Importance of

Macroeconomics:
As a method of economic analysis
macroeconomics is of much theoretical and
practical importance.

(1) To Understand the Working of the

Economy:
The study of macroeconomic variables is
indispensable for understanding the working of
the economy. Our main economic problems are
related to the behaviour of total income,
output, employment and the general price level
in the economy.

These variables are statistically measurable,

thereby facilitating the possibilities of
analysing the effects on the functioning of the
economy. As Tinbergen observes,
macroeconomic concepts help in “making the
elimination process understandable and
transparent”. For instance, one may not agree
on the best method of measuring different
prices, but the general price level is helpful in
understanding the nature of the economy.

(2) In Economic Policies:

Macroeconomics is extremely useful from the
point of view of economic policy. Modern
governments, especially of the underdeveloped
economies, are confronted with innumerable
national problems. They are the problems of
overpopulation, inflation, balance of payments,
general underproduction, etc.

The main responsibility of these governments

rests in the regulation and control of
overpopulation, general prices, general volume
of trade, general outputs, etc. Tinbergen says:
“Working with macroeconomic concepts is a
bare necessity in order to contribute to the
solutions of the great problems of our times.”
No government can solve these problems in
terms of individual behaviour. Let us analyse
the use of macroeconomic study in the solution
of certain complex economic problems.

(i) In General Unemployment:

The Keynesian theory of employment is an
exercise in macroeconomics. The general level
of employment in an economy depends upon
effective demand which in turn depends on
aggregate demand and aggregate supply
functions.

Unemployment is thus caused by deficiency of

effective demand. In order to eliminate it,
effective demand should be raised by
increasing total investment, total output, total
income and total consumption. Thus,
macroeconomics has special significance in
studying the causes, effects and remedies of
general unemployment.

(ii) In National Income:

The study of macroeconomics is very important
for evaluating the overall performance of the
economy in terms of national income. With the
advent of the Great Depression of the 1930s, it
became necessary to analyse the causes of
general overproduction and general
unemployment.
This led to the construction of the data on
national income. National income data help in
forecasting the level of economic activity and to
understand the distribution of income among
different groups of people in the economy.

(iii) In Economic Growth:

The economics of growth is also a study in
macroeconomics. It is on the basis of
macroeconomics that the resources and
capabilities of an economy are evaluated. Plans
for the overall increase in national income,
output, and employment are framed and
implemented so as to raise the level of
economic development of the economy as a
whole.

(iv) In Monetary Problems:

It is in terms of macroeconomics that monetary
problems can be analysed and understood
properly. Frequent changes in the value of
money, inflation or deflation, affect the
economy adversely. They can be counteracted
by adopting monetary, fiscal and direct control
measures for the economy as a whole.

(v) In Business Cycles:

Further macroeconomics as an approach to
economic problems started after the Great
Depression. Thus its importance lies in
analysing the causes of economic fluctuations
and in providing remedies.

(3) For Understanding the Behaviour of

Individual Units:
For understanding the behaviour of individual
units, the study of macroeconomics is
imperative. Demand for individual products
depends upon aggregate demand in the
economy. Unless the causes of deficiency in
aggregate demand are analysed, it is not
possible to understand fully the reasons for a
fall in the demand of individual products.

The reasons for increase in costs of a particular

firm or industry cannot be analysed without
knowing the average cost conditions of the
whole economy. Thus, the study of individual
units is not possible without macroeconomics.

Conclusion:
We may conclude that macroeconomics
enriches our knowledge of the functioning of
an economy by studying the behaviour of
national income, output, investment, saving
and consumption. Moreover, it throws much
light in solving the problems of unemployment,
inflation, economic instability and economic
growth.
Limitations of Macroeconomics:
There are, however, certain limitations of
macroeconomic analysis. Mostly, these stem
from attempts to yield macroeconomic
generalisations from individual experiences.

(1) Fallacy of Composition:

In Macroeconomic analysis the “fallacy of
composition” is involved, i.e., aggregate
economic behaviour is the sum total of
individual activities. But what is true of
individuals is not necessarily true of the
economy as a whole.

For instance, savings are a private virtue but a

public vice. If total savings in the economy
increase, they may initiate a depression unless
they are invested. Again, if an individual
depositor withdraws his money from the bank
there is no ganger. But if all depositors do this
simultaneously, there will be a run on the
banks and the banking system will be adversely
affected.
(2) To Regard the Aggregates as
Homogeneous:
The main defect in macro analysis is that it
regards the aggregates as homogeneous
without caring about their internal
composition and structure. The average wage
in a country is the sum total of wages in all
occupations, i.e., wages of clerks, typists,
teachers, nurses, etc.

But the volume of aggregate employment

depends on the relative structure of wages
rather than on the average wage. If, for
instance, wages of nurses increase but of
typists fall, the average may remain
unchanged. But if the employment of nurses
falls a little and of typists rises much, aggregate
employment would increase.

(3) Aggregate Variables may not be

Important Necessarily:
The aggregate variables which form the
economic system may not be of much
significance. For instance, the national income
of a country is the total of all individual
incomes. A rise in national income does not
mean that individual incomes have risen.

The increase in national income might be the

result of the increase in the incomes of a few
rich people in the country. Thus a rise in the
national income of this type has little
significance from the point of view of the
community.

Prof. Boulding calls these three difficulties as

“macroeconomic paradoxes” which are true
when applied to a single individual but which
are untrue when applied to the economic
system as a whole.

(4) Indiscriminate Use of

Macroeconomics Misleading:
An indiscriminate and uncritical use of
macroeconomics in analysing the problems of
the real world can often be misleading. For
instance, if the policy measures needed to
achieve and maintain full employment in the
economy are applied to structural
unemployment in individual firms and
industries, they become irrelevant. Similarly,
measures aimed at controlling general prices
cannot be applied with much advantage for
controlling prices of individual products.

(5) Statistical and Conceptual

Difficulties:
The measurement of macroeconomic
concepts involves a number of statistical
and conceptual difficulties. These
problems relate to the aggregation of
microeconomic variables. If individual
units are almost similar, aggregation
does not present much difficulty. But if
microeconomic variables relate to
dissimilar individual units, their
aggregation into one macroeconomic
variable may be wrong and dangerous.
Macroeconomic background

India is developing into an open-market economy. One of

the reforms in 1990 that accelerated economic growth of
the country was economic liberalization with reduced
controls on foreign trade and investments (CIA. The World
Factbook, 2010). India’s varied economy includes traditional
farming, modern agriculture, handicrafts, a wide range of
modern industries, and a multitude of services.

India exports petroleum products, precious stones,

machinery, iron and steel, chemicals, vehicles, apparel for
the total amount of $165 bln. The main export partners are
UAE (12.3%), US (11.7%), China (5.4%), Singapore (4.5%).

Products that are imported in India are crude oil, precious

stones, machinery, fertilizer, iron and steel, chemicals for the
total amount of $254 bln. Import partners are China
(10.8%), Saudi Arabia (6.9%), US (6.7%), UAE (6.7%), Iran
(4.2%) (CIA. The World Factbook, 2010).

During recent years, India’s economy has grown quite

quickly. “Since 1991 it has been among the top 10% of the
world’s countries in terms of economic growth” (The World
Bank, 2010).

Household and international demand for India’s services

stays strong what makes service sector the biggest in India’s
GDP for a very long time (see app.1). Interesting that this
sector, being a major source of economic growth, has only
one-third of the total work force. “India has capitalized on
its large educated English-speaking population to become a
major exporter of information technology services and
software workers” (CIA. The World Factbook, 2010).

Financial crisis in the world caused industrial slowdown in

the beginning of 2008, which reflected on lower percentage
of economic growth in comparison to previous years (see
app.1). Nevertheless, financial crisis did not affect India that
much because of careful banking system and quite low
dependence on exports for growth. Therefore, India has still
second highest growth amongst world’s major economies.

One of the current challenges for India is to sustain this

growth and use the benefits of this growth in the most
efficient way. In order to maintain economic growth India
has to make certain reforms, such as improving
infrastructure, financial sector and dealing with some
limiting labor regulations and big monetary deficit (The
World Bank, 2010).

Infrastructure in India is one of the leading limitations for a

growth, or growth only in the certain areas. The
infrastructure of services sector that employs higher
educated people is developed more, while the one for other
sectors remains less developed. In order to speed up
development of export-oriented sectors and to take place
in a global supply chain, India needs investments in
infrastructure (around 3-4% of its GDP to sustain 8% growth
(The World Bank, 2010)). Certain amount of investments can
be attracted from the private sector and through private
public partnership. It is also important to maintain the
condition of already existing infrastructure.

One of the reasons of underdeveloped infrastructure as well

as other social projects is continuing financial deficit. Deficit
is a big challenge for India, throughout previous years it was
reduced; however, in 2008 due to the world’s financial crisis
it began to grow again (see app.1).

The situation on India’s labor market is very complex.

Majority of all the reforms and regulations are oriented on
already employed people. However, there are much more of
unemployed Indians than the ones with a job. Therefore,
one of the challenges that India has to overcome in order to
sustain and improve economic growth is to create better
labor conditions to reduce unemployment.

In India, large enterprises have grown faster than medium

and small companies due to the reforms in financial sector.
In contrary, other companies are not able to get new loans
for banking sector. This situation affects negatively
economic growth of the country since small and medium
enterprises are very important components of productivity
and overall growth.

Over the past decade, Indian government has really realized

the value of tourism industry toward the overall
development. India as a touristic destination has a great
potential since it attract various types of tourists from all
over the world. Tourism in India is the largest service sector
that contributes 6,23% to the national GDP and 8,78 of the
total employment (Wikipedia, 2010). The future expansion
of this sector is expected and it will be explained later on in
the long-term forecast.

Another sector that is developing quite successfully is

medical tourism. Today India leaves the countries that were
known to be preferred destinations for medical purposes,
such as Malaysia, Singapore and Thailand, behind. India is
negotiating with US the possibility of development and it
seems to be very appealing for Americans especially since
the costs for medical services became higher in US (The
Economic Times, 2010).

Analysis of the market economy

Market economy is relatively new for India. Country can

benefit from it by development of human capital, increasing
investments in human resources that will reduce such
problems as poverty, inequity and unemployment. In
addition, the situation of the infrastructure mentioned
earlier can be improved, it is easier to create entrepreneurial
environment in the country through established market
economy. Therefore, good economic liberalization will
benefit India in economic growth and development of
society.

However, there are some critics of market economy in India.

Some argue that due to economic liberalization the wealth
will be concentrated in the hands of few people out of the
whole society that will increase inequality and social
differences. In addition, social security will be worst since
before it was managed and controlled somehow by
government. As it was mentioned earlier, India now is just
developing into market economy and it definitely takes
times to see the results.

In the modern world of globalization, market of the third

world countries like India, has an opportunity to grow.
Therefore, it is important to understand that government is
no longer a dominant in this situation like it was before.
However, state can play a crucial role in these changes, it
needs to control how the market operates and that the
outcomes of this economy are directed in a right way.
Therefore, established market economy does not
necessarily mean complete elimination of government that
was always visible in India in economic, social and cultural
sectors.

Since the reforms of 1991, India has shown much better

results than during pre-reform period. GDP, overall export
and foreign exchange reserves grew significantly. India
became an attractive destination for foreign investments.
Reforms played big role in development of certain
industries in India. For instance, information technology
sector grew extensively, export and domestic sales of
software increased noticeably.

Therefore, it was proved that protectionism was not the way

to success. On the contrary, introduction of multinational
companies increased competition on the national market
and forced Indian enterprises to adopt world-class
infrastructure, quality processes, human resources practices,
and so forth (Murthy, 2004).
Apart from the positive economic results, market economy
benefited Indian society as well. It was noticed that poverty
decreased, literacy levels went up and people became more
motivated to receive education. Therefore, economic
reforms in India resulted in economic growth and social
development.

India’s competitive market structure

In 1947 when India regained its independence, they could

start controlling their own political, social and economic
situation, which had been impossible for more than 90
years. They established their own democracy and a
representative government, which had to conduct a good
and prosper economic plan for their growing population
that would have a beneficial and sustainable effect for the
society. More than five decades later, India has become the
12th largest economy, third largest growing economy in
Asia, behind Japan and China. Comparing to other countries
around the world, India have during the inflation kept their
interest rates manageable and their foreign exchange
reserves at a record level, which are more than $120 billion.
An important aspect of India’s market is that the export
have increased in the past two years, which is always
beneficial for the country, as you should have more export
then import, otherwise the country could experience a
deficit. One of the reasons for the increase in export is that
information technology service sector having been very
successful and has become the benchmark for the
economic development around the world. This is one of the
most significant reasons how India have done a tremendous
progress and starting to create a competitive position in the
global economy, but India has still a long way to go to have
a sustainable global position with its competitive
advantages. This is featured in what India has heredity from
socialism, which affects India’s capacity to become pioneers
in the global market. To be able to compete India has to
address these barriers to growth, or else they will miss their
opportunity to enter the modern world (McKern, 2005).

There are several reasons for their competitive market

structure to occur. The demographics of India is having a
huge impact on the market structure. Japan is one of the
examples of a country who is having an ageing population,
which will make it difficult for them to grow in the future.
On the other hand, in India, 35 % of its population is under
15 and this means that in the soon future they will be in the
workforce, which means they will be components of the
producing and consuming. This had a huge impact on the
perception of India for many multi international companies
and this explains the boom in BPO and the IT industry. BPO
stands for business process outsourcing, which is a broad
term referring to outsourcing in all the different technology
fields (Sharma, 2004).

India is being part of the BRIC countries and therefore it is

important to have a certain government intervention, when
it comes to keep a firm and sustainable economy in the
country and the educational and political sectors are very
important to keep improving and stable. This is based on
having an open and fair trade with foreign investment in the
country. The government must intervene to be able to make
progress in the society with education and developing jobs,
if that will be implemented in India they will be the leader in
growth over the next 50 years. Another reason for the
competitive advantage is the local entrepreneurship that is
being highly popular and have generated in a lot of revenue
and jobs for the country. Another reason why India is one of
the most competitive markets comparing to the other BRIC
countries are that India have used less of its capital and that
is also a reason why they haven’t had the same growth as
China has. However, China has experienced a very different
story, where countries have been investing in China. Many
of these local entrepreneurs in India could compete
globally, which have been proven that they have been
thriving on the market, like Infosys, Wipro and Biocom.
Another big industry next to the It industry is the
entertainment and media industry, which has the biggest
growth amongst the BRIC countries, with its annual growth
of 16.7 % and by 2011 it will be reaching $27 billion (The
Picky, n.d.).

Back to IT industry, more foreign companies are investing in

India or are planning to invest in India in the future. A
German software company called SAP, has announced that
they will invest $ 1 billion in India by 2010, as they see India
of one of the future long-term markets. This will create
more money in circulation in the market for India as SAP
has already a team of 4600 employees in Bangalore, which
makes it the largest research and development center
outside Germany (The Picky, n.d.).
This relates to that the economy of India for the moment is
booming and if they will improve the privatization and the
infrastructure in the country further, they will be able to
reach their target of a 10% GDP. A good prove of that the
market in India is becoming more competitive is that, per
capita income has almost doubled to $800 since 2000, this
is indicated in the middle-class where households have an
income between $4400 to $22000, this is about 13 million
households. With this expanding middle class, a high
demand for durable goods have been noticed on the
market, this has been proven significantly in the mobile
market, where more foreign companies like Vodafone wants
to be part of. The IT industry in India is the reason for the
competitive market structure and this could be improved
with more government intervention, by improving the
infrastructure and supporting privatization of companies,
which will create more entrepreneurs and thriving ideas that
will be able to compete with the rest of the global market
(David, 2007).