Macroeconomics for Managers

Venkatesh Athreya
 What is macroeconomics about?
• Macroeconomics is concerned with such issues as :

Output of an economy as a whole

Growth of output over time
Employment
Prices and their trends – Inflation
Distribution of Output
Poverty
International Trade and Capital Flows
Environment
 Evolution of Macroeconomics
• Confining ourselves to the modern period, modern
mainstream macroeconomics evolved in the home of
the first modern capitalist economy Britain
• Its best exponents were Adam Smith and David Ricardo
• Their main concern was with the long term prospects
for a capitalist economy
• Thus, the main focus was on growth and on distribution
• From the middle of the 19th century, the focus of
Economics in the Anglo Saxon world shifted to
microeconomic issues such as the efficient allocation of
scarce resources. (Why did this happen?)
 The Keynesian Revolution
• Though the capitalist economies of Europe and
North America experienced alternating periods of
expansion and contraction, mainstream economics
did not concern itself with the analysis of such
fluctuations or the question of what determines the
level of output or unemployment
• Things changed with the Russian Revolution of 1917
and the possibility of an alternative economic
arrangement that seemed to ensure full
employment and economic growth
 The Keynesian Revolution
• Following the first world war (1914 -1918) , there was a
brief boom in the mid late 1920s but the Great
Depression came in 1929. It caused massive
unemployment and widespread distress for almost a
decade, though technically it is dated from 1929 to
1933
• The crisis in mainstream economic theory which had no
explanation for such a phenomenon was addressed by
John Maynard Keynes in his book General Theory
• Keynes saw Investment as the key variable. He
focussed on the issues of uncertainty, imperfect
foresight and the role of expectations in determining
Investment and hence output and employment
 The Keynesian Revolution
• Like Marx had done much earlier, Keynes rejected
the so-called Say’s Law which claimed that supply
creates its own demand
• Keynes laid stress on the psychological element in
the determination of Investment. He spoke of the
“animal spirits” of capitalists in this context.
• Keynes also proposed the concept of the
consumption function which argued that income
was the main determinant of consumption.
• He was able to demonstrate through his model that
capitalism can stay for long periods at equilibrium
while unemployment remains considerable.
A simple model of the macroeconomy

• Any economic model has endogenous variables,

exogenous variables, behavioral assumptions and
equilibrium conditions
• Start with an economy consisting only of
households and businesses.
• Total demand in the economy consists of two
components: Consumption demand C and
Investment demand I
• Let us assume that Consumption is a function of
income and that the relationship is C= a + bY where
Y is income, a>0 and 0<b<1
 A simple model of the macroeconomy
• Investment denoted by I is assumed to be exogenously
given, based on the “animal spirits “ of capitalists.
• Income (=Output = Aggregate Supply of Goods and
Services) can be either consumed or saved:
Y =C+S
• Aggregate Demand = C + I
• Equilibrium requires that Aggregate Demand equals
Aggregate Supply. Thus, at equilibrium,
C + I = C + S, or in other words, I = S
• S = Y – C = Y – (a +bY) = I
• Thus, Y at equilibrium = (I + a) / (1 –b)
 ‘Paradox of Thrift’
• In the consumption function, we have two parameters, ‘a’
and ‘b’. The first is the autonomous component of
consumption, meaning that it is independent of the level
of income. The second is the marginal propensity to
consume (b = dC/dY)
• The equilibrium level of income can be seen to be positively
associated with ‘b’. Higher the value of b, higher is the
equilibrium level of income. This runs counter to the idea
that thrift is a good thing!
• Also note that if Investment is higher by an amount dI,
income at equilibrium will be higher by dI/(1-b).
• 1/(1-b) is called the Keynesian income multiplier
 Government and Foreign Trade
If one brings in government and foreign trade, then one can see
things in the following manner:
• Government expenditure G adds to total demand and so do
exports X which constitute the demand of the rest of the world
for the goods and services of our economy. So aggregate
demand becomes not just (C + I) but C + I + G + X .
• On the other hand, savings, taxes and imports cause reduction
in the demand for the domestic output of goods and services
• More generally, I, G and X constitute additions to demand
(Injections) but S, T and M are subtractions (Leakages).
Equilibrium requires that the sum of injections match the sum
of leakages so that the situation remains the same, and equality
between aggregate supply and aggregate demand holds.
 Some policy implications
Thus, in a model with foreign trade and government, we have the
equilibrium condition: I + G + X = S + T + M This has the policy
implication that government expenditure can help increase aggregate
demand in the economy and thus help reduce unemployment and
boost output.

Likewise, higher levels of investment and of exports will be associated

with higher levels of equilibrium income . Correspondingly, higher
imports or taxes will be associated with lower levels of income at
equilibrium.

A given increase in G will lead to an increase of 1/(1-b) times in

equilibrium income, but the same increase in T will reduce the
equilibrium level of income only by b times. (WHY?) In the net,
equilibrium income will increase by the amount of increase of
government expenditure. This is called the balanced budget
multiplier theorem.
 Making Investment an endogenous variable
• Suppose we relax the assumption that investment is exogenously
given. Then the equilibrium value of investment too becomes an
endogenous variable to be determined in the model.
• An important argument in Economics is that investment in an
economy depends on the rate of interest: I = I (r) where r is the rate
of interest.
• The argument is that the opportunity cost of investment of a sum of
money in any project is the interest income that could have been
obtained if the money was lent out.
• If one discounts the stream of future annual flows of income from a
project using the prevailing interest rate, one gets the discounted net
present value of the project. If this is higher than the investment
outlay, the project will be seen as viable. One may therefore expect
investment to be negatively associated with the interest rate.
• Keynes was very skeptical of the influence of the rate of interest on
investment
 Interest Rate and the Demand for Money
• A question arises: What determines the rate of interest? Keynesian
economics linked the interest rate with the demand for and supply of
money.
• Economists speak of three motives for holding cash. There is the demand
for transactions purposes, since receipts and payments are not always
synchronous for most people. There is also the precautionary motive for
holding money, just in case some emergency arises. Both these depend
primarily on income.
• Keynes proposed a third component called the speculative demand for
money arising from it being an asset and not just a medium of exchange.
People hold money as one item in their portfolio of assets. Keynes argued
that money held for this purpose would be a function of expectations
concerning interest rates. He hypothesised that, at very low rates of
interest, people would simply hold on to money since they would expect
the interest rate to rise.
• Based on these considerations, one can build a model of simultaneous
determination of the equilibrium levels of both Income and the rate of
interest
 Real Sector Equilibrium
Let Y denote Income, I denote the rate of interest, i the level of
Investment and S the level of Savings. Then we have:
Investment I = f( i, Y) , Savings S = F( i, Y), I =S in equilibrium
These two equations can be brought together to give us pairs of
values of (Y, i) that make investment and savings equal. This is known
as conditions for equilibrium in the real sector. The locus of such pairs
of (Y, i) gives us the curve called the IS curve, meaning that along this
curve, Investment equals Saving. The IS curve will be NEGATIVELY
SLOPED, since a higher interest rate will be associated with a lower
level of investment and therefore a lower level of income at
equilibrium.
 Money Market Equilibrium
Demand for Money M = d(i, Y)

Supply of Money = M*, given exogenously

At equilibrium, M = M*

These two equations can be brought together to give us pairs of values

(Y, i) that ensure equilibrium in the money market. The locus of such

pairs of(Y,i) give us the LM curve along which demand for money

equals supply of money. The LM curve will be POSITIVELY SLOPED

since at higher levels of income, the demand for money will be higher

thus implying a higher rate of interest at equilibrium.

IS – LM Model of Macroeconomic Equilibrium

• The intersection of the IS and the LM curves will

yield a unique pair of values of Income (Y) and the
rate of interest (i) that is consistent with
simultaneous equilibrium in both the real sector
and the money market.

• This is called the IS –LM model and is associated

with two economists Hicks and Hansen

• This model is in many respects different from the

original theory proposed by Keynes
Going from S=I to the IS curve
Going from Md/P = Ms/P to the
LM curve
 Macroeconomic equilibrium and policy
Interest rate i

The intersection of IS and LM

represents the simultaneous
LM equilibrium on the goods and
the money market…
…For a given value of
government spending G, taxes
T, money supply M and prices
P
i*

IS

Y* Income, Output Y