1

Economics Reading Materials

Basics of Macro Economics

Basics of Macro Economics

• An Overview of Macro Economics

• National Income
• Interest Rates, Savings, and Investments
• Unemployment and Inflation
• Fiscal policy

Macro Economics

Economics is best defined as the study of scarcity, better yet, the study of how a limited
number of resources can satisfy an unlimited number of wants in an economy. Economics
answers the who? and what? questions in a society who will receive the goods, and what they
will receive. One who studies the field of economics is called an economist.

Before we delve into the field of economics, we must differentiate between the two primary
types of economics: Macro Economics (the study of one or more whole economies) and
microeconomics (the study of behaviours of firms, businesses, and individuals and their
decisions involving scarcity). While both fields deal directly with economics, they have obvious
contrasts.

Macro Economics

Macro Economics (from the Greek prefix macro- meaning "large" and economics) is a
branch of economics dealing with the performance, structure, behavior, and decision-
making of an economy as a whole, rather than individual markets. This includes national,
regional, and global economies. With microeconomics, Macro Economics is one of the two
most general fields in economics.

Objective of Marco Economics

Broadly, the objective of macroeconomic policies is to maximize the level of national

income, providing economic growth to raise the utility and standard of living of
participants in the economy. The major objectives are:

www.bankingnewsbd.com, Email: bankingnewsbd@gmail.com

 2

Sustainability - a rate of growth which allows an increase in living standards without

undue structural and environmental difficulties. 'Economic growth' will be studied later on
in this book.

Full employment - where those who are able and willing to have a job can get one, given
that there will be a certain amount of frictional, seasonal and structural unemployment
(referred to as the natural rate of unemployment).

Price stability - when prices remain largely stable, and there is not rapid inflation or
deflation. Price stability is not necessarily the same as zero inflation, but instead steady
levels of low-moderate inflation is often regarded as ideal. It is worth noting that prices of
some goods and services often fall as a result of productivity improvements during periods
of inflation, as inflation is only a measure of general price levels. However, inflation is a
good measure of 'price stability'. Zero inflation is often undesirable in an economy.
("Internal Balance" is used to describe a level of economic activity that results in full
employment with no inflation.)

Increasing Productivity - more output per unit of labour per hour. Also, since labour is but
one of many inputs to produce goods and services, it could also be described as output
per unit of factor inputs per hour.

Business cycle

The term business cycle (or economic cycle) refers to economy-wide fluctuations in
production, trade and economic activity in general over several months or years in an
economy organized on free-enterprise principles.

The business cycle is the pattern of expansion, contraction and recovery in the economy.
Generally speaking, the business cycle is measured and tracked in terms of GDP and
unemployment GDP rises and unemployment shrinks during expansion phases, while
reversing in periods of recession. Wherever one starts in the cycle, the economy is
observed to go through four periods expansion, peak, contraction and trough.

www.bankingnewsbd.com, Email: bankingnewsbd@gmail.com

 3

Aggregate Demand/AD

Aggregate demand is the sum of spending by consumers, Businesses, and Government and
it depends on the level of prices, as well as on monerary policy, fiscal policy, and other
factors;

aggregate demand (AD) is the total demand for final goods and services in the economy
(Y) at a given time and price level. It is the amount of goods and services in the economy
that will be purchased at all possible price levels.[2] This is the demand for the gross
domestic product of a country when inventory levels are static. It is often called effective
demand, though at other times this term is distinguished.

Aggregate Supply

Aggregate Supply refers to the total quantity of goods and services that the nation's
businesses willingly produce and sell in a given period. Aggregate Supply depends upon
the price level, the productive capacity of the economy, and the level of costs.

National Income

Circular Flow

The circular flow diagram (also called the circular flow model) is perhaps the simplest
diagram/model of economics to understand. In essence, the circular flow diagram displays
the relationship of resources and money between firms and households. Every adult and
even most children can understand its basic structure from personal experience. Firms
employ workers, who spend their income on goods produced by the firms. This money
(income spent by workers which turns into revenue by firms) is then used to compensate
the workers and buy raw materials to make the goods. This is the basic structure behind
the circular flow diagram (seen below.)

In the model, firms and households interact with one another in both the product market
(or goods market) and the factors of production market (or factors market). The product
market, as mentioned in the name, is where all products made by businesses/firms are
exchanged. The factors of production market is where inputs such as land, labour, capital,

www.bankingnewsbd.com, Email: bankingnewsbd@gmail.com

 4

and other resources are exchanged. Households earn money by selling their resources
(most often labor) to businesses in the factor market. In return, households receive
income. The price of the resources the businesses purchase (labor from households) are
the costs. From the resources provided by households, businesses produce goods, which
are then sold in the product market. Households use their incomes to purchase these
goods in the product market. In return for the goods, businesses bring in revenue. While
this may seem like a lot of information, it is actually quite logical. Even though the graph
itself is extremely simple to most people, it is important to have it completely memorized.
Know the names of each market and the actions that occur in each. For high school and
college students, the circular flow diagram is a common theme on many tests. It should
result in easy points for those of you that have it memorized.

Gross Domestic Product

Gross Domestic Product (or GDP for short) is often used to measure and compare the
economic outputs of various countries around the world. It allows us to compare the total
output level of one country to the total output level of another country very easily.
Economists use GDP to understand patterns and relationships between economies around
the world and throughout history. Economically, GDP is best defined as an economy's cash
value of all final goods and services produced in a year. Essentially, GDP measures both
income and expenditure. A higher GDP means more output from an economy and typically
a stronger economy.here are multiple components to GDP, all of which are listed below.

Consumption Includes everyday purchases by households on good and services. This may
include things such as toys, groceries, or new cars. Consumption is often
abbreviated/represented with a C.

Investment The purchase of goods that will be used in the future to make other goods.
Capital is the main part of investment, but it also includes the purchase of new houses.
Investment is abbreviated/represented with an I.

Government Spending As the name suggests, this includes spending by the government.
Examples of government spending would be buying new jets from Boeing or paying
government employees. This does not include government transfer payments from
programs such as Social Security or Medicare/Medicaid. Government spending is
abbreviated/represented as a G.

www.bankingnewsbd.com, Email: bankingnewsbd@gmail.com

 5

Net Exports As described in Lesson 4.2, net exports for an economy are the number of
exports minus the number of imports in the economy. Net exports are typically
abbreviated as NX, as mentioned earlier.

Equattion
With the four components listed above, we can formulate an equation regarding GDP. For
the formula (and abbreviation on a lot of graphs) we may denote GDP as Y. Thus, our
equation looks like the following:
Y = C + I + G +NX
Or
Y = C + I + G + Exports Imports

Gross National Product

GNP at market price is sum total of all the goods and services produced in a country
during a year and net income from abroad. GNP is the sum of Gross Domestic Product at
Market Price and Net Factor Income from abroad.

Difference from GDP

While GDP bases production levels on geography, GNP bases production level on
ownership. GDP describes the output of goods and services within a country while GNP
portrays the output of goods and services of a country residents and companies.
Theoretically, if overseas expansion never occurred and all companies in an economy were
owned by that economy's residents, the GNP and GDP of a country would be equal.
However, this is not the case. Both GDP and GNP have their applications through the
world of economics.

Approaches to GNP

There are three different approaches to GNP, namely income approach, expenditure
approach and product approach.

www.bankingnewsbd.com, Email: bankingnewsbd@gmail.com

 6

Income Approch

In income approach, we find the different categories of Income namely;

(1) Wages and salaries
(2) Rents
(3) Interest
(4) Dividends
(5) Undistributed corporate profits
(6) Mixed incomes
(7) Direct taxes
(8) Indirect taxes
(9) Depreciation
(10) Net income from abroad.

Expenditure approach

In expenditure approach, we find the different categories of expenditure namely,

(1) Private consumption expenditure
(2) Gross domestic private income
(3) Net foreign income
(4) Government expenditure on goods and services.

Product approach

In product approach, we find the following categories of output. (1) Final market value of
goods and services (2) Less cost of intermediate goods.
The following factors are to be considered while calculating the GNP: 1. Only those goods
and services which can be measured by Money.
2. Market price of final goods and services alone will be considered.
3. Services which are done free of cost are not considered.
4. Productions done in current year alone are considered.
5. Illegal activities are not included.

Net National Product (NNP)

In the process of production of goods and services, there will be some depreciation of
fixed capital also called as consumption of fixed capital, if the value of depreciation is

www.bankingnewsbd.com, Email: bankingnewsbd@gmail.com

 7

deducted from the value of gross national product in a year, we obtain the value of net
national product.

Interest Rates, Savings, and Investments

Interest Rate

An interest rate is the rate at which interest is paid by borrowers for the use of money
that they borrow from a lender. Specifically, the interest rate (I/m) is a percent of
principal (P) paid a certain amount of times (m) per period (usually quoted per annum).
For example, a small company borrows capital from a bank to buy new assets for its
business, and in return the lender receives interest at a predetermined interest rate for
deferring the use of funds and instead lending it to the borrower. Interest rates are
normally expressed as a percentage of the principal for a period of one year.

Nominal and Real

Like GDP, interest rates have nominal and real versions. The nominal interest rate is the
cost of a loan adjusted for inflation. Typically in a loan, banks will establish the estimated
inflation rate within the interest rate, thus giving the nominal interest rate. The nominal
interest rate, like nominal price, is the price we see on the price tag of the loan. Knowing
this, you can probably guess what the real interest rate is. The real interest rate is the
cost of the loan without the rate of inflation. The equation below is perhaps the simplest
equation in all of economics. It describes the relationship between the real interest rate,
nominal interest rate, and the inflation rate.
Real Interest Rate = Nominal Interest Rate Inflation
Or
Real IR = Nominal IR Inflation

Savings

Saving means different things to different people. To some it means putting money in the
bank. To others it means buying stocks or contributing to a pension plan. But to
economists, saving means only one thing consuming less in the present in order to
consume more in the future.

www.bankingnewsbd.com, Email: bankingnewsbd@gmail.com

 8

An easy way to understand the economist's view of saving and its importance for
economic growth os to consider an economy in which there is a single commodity, say,
corn. The amount of corn on hand at any point in time can either be consumed (literally
gobbled up) or saved. Any corn that is saved is immediately planted (invested), yielding
more corn in the future. Hence, saving adds to the stock of corn in the ground, or in
economic jargon, the stock of capital. The greater the stock of capital, the greater the
amount of future corn, which can, in turn, either be consumed or saved....

Investment

Although in general parlance investment may connote many types of economic activity,
economists normally use the term to describe the purchase of durable goods by
households, businesses, and governments. Private (non-governmental) investment is
commonly divided into three broad categories: residential investment, which accounts for
about a quarter of all private investment (25.7 percent in 1990); non-residential, or
business, fixed investment, which accounts for most of the remainder; and inventory
investment, which is small but volatile. Indeed, inventory investment is often negative (it
was in 1990, and in three years during the eighties). Business fixed investment, in turn, is
composed of equipment and non-residential structures. Equipment now makes up over
three-quarters of business investment.

Unemployment and Inflation

Unemployment

Unemployment is defined as a situation where someone of working age is not able to get
a job but would like to be in full time employment.

Note:If a Mother left work to bring up a child or if someone went into higher education,
they are not working but would not be classed as unemployed as they are not actively
seeking employment.

One grey area is voluntary unemployment. This occurs when the unemployed choose not
to take a job a the going wage rate (e.g. wrong job, benefits too high e.t.c) They could be
counted as unemployed because they are still seeking a job (they just don't want to take
one they are offered.

www.bankingnewsbd.com, Email: bankingnewsbd@gmail.com

 9

Types of Unemployment

Demand Deficient Unemployment-

Demand deficient unemployment occurs in a recession or period of very low growth. If

there is insufficient Aggregate Demand, firms will cut back on output. If they cut back on
output then they will employ less workers. Firms will either cut back on recruitment or
lay off workers. The deeper the recession, the more demand deficient unemployment there
will be. This is often the biggest cause of unemployment, especially in a downturn. This is
also known as cyclical unemployment referring to how unemployment increases during an
economic downturn. Diagram showing fall in AD and lower Output which leads to higher
unemployment

Structural Unemployment

This is unemployment due to inefficiencies in the labour market. It may occur due to a
mismatch of skills or geographical location. For example structural unemployment could
be due to:

• Occupational immobility-

There may be skilled jobs available, but many workers may not have the relevant
skills. Sometimes firms can struggle to recruit during periods of high
unemployment. This is due to the occupational immobility.

• Geographical immobility

Jobs may be available in London, but, unemployed workers may not be able to
move there due to difficulties in getting housing e.t.c.

• Technological change

If an economy goes through technological change some industries will decline. This
is likely to lead to structural unemployment. For example, new technology (nuclear
power) could make coal mines close down leaving many coal miners unemployed.

www.bankingnewsbd.com, Email: bankingnewsbd@gmail.com

 10

Frictional unemployment

This occurs when workers are in between jobs e.g. school leavers take time to find work.
There is always likely to be some frictional unemployment in an economy as people take
time to find a job suited to their skills.

Voluntary Unemployment.

This occurs when workers choose not to take a job at the going wage rate. For example, if
benefits offer a similar take home page to wage tax, the unemployed may feel there is no
incentive to take a job.

Seasonal

Occurs when people are out of work during the off-season. This may include landscapers,
construction workers, and/or other outdoor jobs in cold winter climates. Often times,
workers involved in seasonal unemployment hold a different job during the off-season.

Disguised / Hidden unemployment

ften unemployment statistics don't include certain types of workers. For example, those
put on incapacity benefit may not be counted as unemployed, but, it may really be a type
of structural unemployment

In economic terms, the natural rate of unemployment is the minimum rate of unemployment
without an increase in the rate of inflation. This occurs when businesses are at the peak of the
expansion phase and the economy is in full long-run conditions. The natural rate of
unemployment includes frictional unemployment and structural unemployment only, which are
added together to equal the natural rate. Because structural and frictional unemployment always
exist, an economy can never have a 0% natural rate of unemployment. The natural rate of
unemployment in countries varies. In America, the natural rate is 5%.

Inflation

In economics, inflation is a rise in the general level of prices of goods and services in an
economy over a period of time. When the general price level rises, each unit of currency
buys fewer goods and services. Consequently, inflation reflects a reduction in the
purchasing power per unit of money a loss of real value in the medium of exchange and

www.bankingnewsbd.com, Email: bankingnewsbd@gmail.com

 11

unit of account within the economy. A chief measure of price inflation is the inflation
rate, the annualized percentage change in a general price index (normally the consumer
price index) over time.

Inflation's effects on an economy are various and can be simultaneously positive and
negative. Negative effects of inflation include an increase in the opportunity cost of
holding money, uncertainty over future inflation which may discourage investment and
savings, and if inflation is rapid enough, shortages of goods as consumers begin hoarding
out of concern that prices will increase in the future. Positive effects include ensuring that
central banks can adjust real interest rates (to mitigate recessions), and encouraging
investment in non-monetary capital projects.

Some economists maintain that high rates of inflation and hyperinflation are caused by an
excessive growth of the money supply, while others take the view that under the
conditions of a liquidity trap, large injections are "pushing on a string" and cannot cause
significantly higher inflation. Views on which factors determine low to moderate rates of
inflation are more varied. Low or moderate inflation may be attributed to fluctuations in
real demand for goods and services, or changes in available supplies such as during
scarcities, as well as to changes in the velocity of money supply measures; in particular
the MZM ("Money Zero Maturity") supply velocity. However, the consensus view is that a
long sustained period of inflation is caused by money supply growing faster than the rate
of economic growth.

Today, most economists favour a low and steady rate of inflation. Low (as opposed to zero
or negative) inflation reduces the severity of economic recessions by enabling the labour
market to adjust more quickly in a downturn, and reduces the risk that a liquidity trap
prevents monetary policy from stabilizing the economy. The task of keeping the rate of
inflation low and stable is usually given to monetary authorities. Generally, these
monetary authorities are the central banks that control monetary policy through the
setting of interest rates, through open market operations, and through the setting of
banking reserve requirements.

Fiscal Policy

Government spending policies that influence macroeconomic conditions. Through fiscal

policy, regulators attempt to improve unemployment rates, control inflation, stabilize

www.bankingnewsbd.com, Email: bankingnewsbd@gmail.com

 12

business cycles and influence interest rates in an effort to control the economy. Fiscal
policy is largely based on the ideas of British economist John Maynard Keynes (1883 -
1946), who believed governments could change economic performance by adjusting tax
rates and government spending.

The two main tools of fiscal policy are government spending and taxes. Taxes are the
biggest source of revenue for the government and are collected on almost everything.
(Something I'm sure you are all well-aware of.) When taxes are increased, the government
brings in more revenue and the public has less spending money, or disposable income.
When taxes decrease, the opposite occurs. Government spending is the most common way
of influencing the economy. It allows the government to directly influence not only the
entire economy, but specific parts of the economy. When government spending is
increased, the economy is often stimulated. Although government spending is the easiest
way for the government to influence the economy, it comes at a price. Whether it is a
required increase in taxes or a growing government debt, the government must pay this
price at some point in time.

Policy Types

Expansionary Fiscal Policy

Typically during slow economic periods, the government will enact an expansionary fiscal
policy. Expansionary policy is the reduction of taxes and/or the increase of government
spending. By lowering taxes, the government enables citizens to have more income as they
now have to pay less of their income to taxes. With a greater income, citizens will often
spend more, thus stimulating the economy. An increase in government spending will also
stimulate the economy. The government can pump money into struggling sectors of the
economy, enabling growth and stability to return.

Governments typically use an expansionary policy during recessions and depressions. The
lower taxes and greater government spending enables more money to flow throughout the
economy. With a larger money flow in the economy, businesses can expand and hire more
people, further increasing the money flow. A historic example of major expansionary fiscal
policy actions is what occurred during the Great Depression in America. President
Roosevelt constantly lowered taxes and raised government spending (usually with a high
budget deficit) to stimulate the economy. While the long run effects of the policy are still

www.bankingnewsbd.com, Email: bankingnewsbd@gmail.com

 13

debated, the expansionary policy's actions had numerous positive short run effects on the
economy.

Contractionary Fiscal Policy

Often enacted during excessive economic growth, contraction fiscal policy allows the
government to slow down the economy. While it may seem crazy to slow the economy
down, it is often necessary. Excessive economic growth leads to high rates of inflation and
ultimately a decrease in purchasing power. As we saw chapters ago, high inflation can
destroy economies. The government not only oversees the economy to be sure it grows
quickly enough, but it also watches the economy to see that it does not grow too quickly.

posit of expansionary policy, contractionary policy is the increase in taxes and/or the
decrease of government spending. By increasing taxes and/or decreasing spending, the
government causes the money flow within the economy to decrease. Businesses will earn
fewer profits and ultimately choose to expand less or possibly not expand at all. This
creates a slow-down in the economy and brings the economic growth rate to a more
desirable level.

The purpose of Fiscal Policy

• Stimulate economic growth in a period of a recession.

• Keep inflation low
• basically, fiscal policy aims to stabilise economic growth, avoiding a boom and bust
economic cycle.

Expansionary (or loose) Fiscal Policy

• This involves increasing AD. (Aggregate Demand)

• Therefore the government will increase spending (G) and / or cut taxes (T). Lower taxes
will increase consumers spending because they have more disposable income (C)
• This will tend worsen the government budget deficit and the government will need to
increase borrowing.

www.bankingnewsbd.com, Email: bankingnewsbd@gmail.com

 14

Diagram showing effect of expansionary fiscal policy

Deflationary (or tight) Fiscal Policy

• This involves decreasing AD.

• Therefore the government will cut government spending (G) and / or increase taxes.
Higher taxes will reduce consumer spending (C)
• Tight fiscal policy will tend to cause an improvement in the government budget deficit.

Diagram showing the effect of tight fiscal policy

Evaluation of fiscal policy

The success of fiscal policy will depend on several factors, such as

1. It depends on the size of the multiplier. If the multiplier effect is large, then changes in
government spending will have a bigger effect on overall demand.
2. It depends on the state of the economy. Fiscal policy is most effective in a deep
recession where monetary policy is insufficient to boost demand. In a deep recession
(liquidity trap). Higher government spending will not cause crowding out because the
private sector saving has increased substantially
3. It depends on other factors in the economy. For example, if the government pursue
expansionary fiscal policy, but interest rates rise and the global economy is in a
recession, it may be insufficient to boost demand.

www.bankingnewsbd.com, Email: bankingnewsbd@gmail.com