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Concepts In Macroeconomics

In order to understand the nature of macroeconomics, we must be well-versed with its basic concepts and methodology. A systematic exposition of these concepts helps us to provide a definite shape to the macroeconomic theory. Various basic concepts related to macroeconomic theory may be summaries as flows:

Macroeconomic Variables

As observed above, macroeconomic deals with the behavior of aggregates of economic variables. An economic variable is a magnitude whose value may change. Important variables in macroeconomics are gross national product, national income, consumption expenditure, investment expenditure, total money supply, general price level and overall employment. Some of these variables are ‘stocks’ and some are ‘flows’.

1.    Stock and Flow

A stock variable is a quantity measured at a specific point of time. For example, the money supply is a stock variable, a definite amount on a specific date.

It is a certain amount at a specifies point of time. In stating stock variable, both the amount and time must be clearly specified.

In contrast, a flow variable is a quantity which can only be measured in terms of specific period of time. In studying flow variables, it is important to be specific about the time period in question. For example, it is meaningless to say that Mr. X’S income is Rs. 9,000, since it is not clear whether his income is Rs. 9,000 per month or per year. An income of Rs. 9,000 per month is quite different from an income of Rs. 9,000 per year. All the flow variables are thus rates over some specified time period.

Thus, stock variables have a time reference with them, while flow variables have a time dimension.

The distinction between stock and flow variables is of particular importance in the study of macroeconomics. For example, we often confuse money and income. The former is a stock variable, the latter a flow variable. income may increase even when the stock of money is constant. Similarly, we often conduce personal saving or saving and personal savings or savings. Personal saving. the difference between disposable personal income and personal consumption expenditure, is a flow variable. Personal savings, the sum of current and past savings, is stock variable. As saving occurs, savings increase.

2. Ratio Variable

In macroeconomic analysis, we also use ‘ratio’ variables. The variable sin this category express the relationship between two flows, two stocks. or of stock-flows at a certain point of time.
The ratio between saving and income (S/Y) or ratio between consumption and income (C/Y) described as average propensity to save and average propensity to consume respectively are the flow ratio variables.

Liquidity is a ratio between two stocks, viz., liquid assets and total assets. Some variables like income-velocity of circulation of money may be expressed as a ratio of the flow of money transactions to the stock of money.

Functional Relationships

As already observed, a variable may be either a stock or a flow variable may be either a stock or a flow variable. We also speak of the dependent and independent variables. A variable is said to be a dependent variable if its value in some unique way with the variation in the value of some other independent variables.

The relationship between dependent variable (C) and independent variable (Y) can be symbolically expressed as C = f(Y). C being consumption expenditure and Y is income and ‘f’ indicating ‘function of . The symbolic expression C = f (Y) is read “C is a function of Y”. It means that there is some unspecified relationship between the values of the variables C and Y-dependent and independent variables. That is, for some value of Y such a relationship specifies corresponding value of C. Such a functional relationship is summarized in the flowing table:

Functional Relationship between Income and Consumption

Y (income in Rs.)  1,000  1,500  2,000  2,500
 C (consumption expenditure in Rs.)  900  1, 300  1, 600 1, 850

This states that when Y = 1, 000, then C = f (1,000) = 900,. Similarly, the value of C which corresponds to Y = 1, 500 is Rs. 1,300, etc. Basically, then, C= f(Y) is a symbol which represents such a table of values.

Likewise, in macroeconomics we speak of a direct functional relation between output (Q) and employment (N). This relationship is expressed as:

Q = f(N)

where Q being the output and N indicates employment.

In microeconomics, we often speak of demand function of the form Qd = f (P) which states that Qd, the quantity demanded of some commodity, depends on P. the price of the item. But as we know, the demand for a particular commodity does not depend only on the price of that commodity. IN fact, it depends on the values of variables other than the price. For example, it may depend on the level of customer’s income, Y, and on the price. For example, it may depend on the level of consumer’s income, Y, and on the prices of other related commodities. PR. This is a multivariate demand function which is written symbolically as Qd = f (P,Y,PR) meaning that the value of Qd depends in some way on the values of each of some unspecified number of variables.

Thus, the functional relationship may not simply be restricted to two variables. It may involve a number of variables. In economics, we study the relationship that exists between or among the various variables of an economic system. These relationships between two or more variable can be expressed mathematically.

Economic Models

An economic model is a set of relationships among a group of relationships among a group of economic variables. These relationships may represent the economy or one or more of its parts. A model may be expressed in words, tables, graphs and mathematical equations. A model contains a set of equation, each attempting to explains behaviors of one of the variables. Variables influence each other mutually. For example, consumption is influenced by income. But consumption being part of income determines the latter. Ins such a system the value of all variables will have to be determined simultaneously. This feature, too, is brought out explicitly by a model.

Once a model is constructed, one is in a position to study and predict the probable results of changes in variable and  parameters. The usefulness of a model is judges by the empirical results which it provides. If it helps us to understand reality. it is a “good” model. If the model leads to misunderstanding , it is inadequate and we seek alternative models.

Accounting and Theoretical Relationships

If a relationship is assumed to be true by its definition, it is said to be accounting relationship or an identity. In such relationships. the identical equality sign = (read: is identically equal to ) is often employed in place of the regular equal sing = although the latter is acceptable. It implies that identical relationship among the variables holds irrespective of the magnitudes of the variables.

A theoretical or behavioral relationship, on the other hand, specifies the manner in which a variable behaves in response to changes in other variables. This may involve either human behavior (such as the aggregate consumption patter in reaction output changes). Such behavioral or theoretical relationship may either be proved true or disproved through empirical investigation and testing.


Equilibrium means a state of balance. It may be referred to as a situation when opposing forces for change are in balance. Either important variable do to not change, or opposing variables offset each other. In other words, equilibrium is a situation that is characterized by a lack of tendency to change.

The fact that an equilibrium implies not tendency to change may tempt one to conclude that an equilibrium necessarily constitutes a desirable or ideal state of affairs, on the ground that only in the ideal state would there be a lack of motivation for change. Such a conclusion is unwarranted. Even though a certain equilibrium position may represent a desirable state and something to be striven for-such as a profit maximizing situation from the firm’s point o view-another equilibrium position may be quite undesirable and, therefore, something to be avoided, such as an under-employment equilibrium level of national income. The only warranted interpretation is that an equilibrium is a situation which, if attained, would tend to perpetuate itself, barring any changes in the external forces.

Ex-ante and Ex-post

Ex-ante and Ex-post are the Latin terms meaning ‘before-hand’ and ‘afterwards’ respectively. Generally, the use of these terms is made in the context of saving and investment.

In ex-ante sense, we refer to estimates to these variables at the beginning of a specific period. In ex-post sense, we refer to the magnitude of these variables at the end of a specific period. Saving and investment are always equal ex-post although the two are not necessarily equal ex-ante.

The understanding of above-mentioned concepts helps us to study macroeconomic theory in the right perspective. The basic macroeconomic problem of determination of income, output and employment can be better understood through the study of these concepts.

Nature of Macroeconomic Problem: Targets and Instruments

The issues that are discussed in macroeconomics are of two types. First, there are the things that really matter for their own sake. These are the things that affect living conditions and the state of the economic environment. living standards, unemployment, business cycles, and inflation are outcomes that matter. Almost everyone wants resign living standers, high employment and low unemployment, as well as avoidance of recession and inflation. These things are known s the targets of policy. ‘Good’ values of these variables are what the governments would like to achieves.

Fiscal and monetary policies (government speeding, taxes, interest rates and money supply) are not so much valued for their own sake; rather, they are the instruments of policy and are valued for the effect they have he targets. Instruments are the variables that the government can change directly in order to change the targets, which are the things that it would like to change.

The macroeconomic problem is to choose appropriate values of the policy instruments in order to achieve the best possible combination of the outcomes of the targets. This is a continually changing problem because the targets are perpetually being affected by shocks from various parts of the world economy.

Potential GDP and GDP GAP

GDP (gross domestic product), as we will explain fully inc hapter-2 below, refers to the value of total output actually produced in the economy during a year.

Here we need to distinguish between two related terms, viz. (i) actual GDP. and (ii) potential GDP.

Actual GDP represents what the economy does, in fact, produce.

Potential GDP measures what the economy could produce if all resources-land, labour and productive capacity-were fully employed at their normal levels of mutilation. This concept is also referred to as potential income or full-employment income.

Actual GDP during a year may not be equal to the potential output. Actual GDP may either fall short of potential GDP, or may exceed potential GDP. The difference between the actual GDP and the potential GDP is called GDP gap or output gap. GDP gap is measured as follows:

GDP gap = Y* - y

where Y* measures potential output, and Y measures actual output.

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