Economics II: Macroeconomics

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Circular Flow and National Income

The circular flow of income links households, firms, government, and the foreign sector, with injections (investment, government spending, exports) and leakages (savings, taxes, imports).
Gross domestic product (GDP): the market value of final goods and services produced within a country in a period. Three approaches: output (value added), income, and expenditure: Y = C + I + G + (X − M). GNI adds net income from abroad.
Nominal and real GDP: real GDP = nominal GDP ÷ GDP deflator × 100. GDP per capita and its limits as a measure of wellbeing (omits the informal economy, distribution, environmental damage, and non-market work).
Economic growth: the increase in real GDP; sources include labour, capital, technology, and institutions.
Business cycle: expansion, peak, contraction (recession), and trough; indicators such as the index of industrial production.

Aggregate Demand and Supply

Aggregate demand (AD) = C + I + G + (X − M); aggregate supply (AS) shows the output firms will produce at each price level (short run and long run). Shifts in AD or AS change the price level and output. Demand-pull and cost-push inflation, and stagflation (stagnation with inflation).

Keynesian Analysis

Keynes (1936) argued that output depends on aggregate demand in the short run.

Consumption function C = a + bY, where b is the marginal propensity to consume (MPC); savings S = Y − C.
Multiplier: k = 1 ÷ (1 − MPC) = 1 ÷ MPS. Example: if MPC = 0.8, k = 5, so an increase in investment of 100 raises income by up to 500 in the simple model. Leakages through taxes and imports reduce the multiplier.
Equilibrium income: where planned expenditure equals output, or where injections equal leakages.
Inflationary and deflationary gaps.

Money and Banking

Functions of money: medium of exchange, unit of account, store of value, standard of deferred payment. Money supply (M1, M2, broad money) and money demand (transactions, precautionary, speculative).
Commercial banks accept deposits and create credit (the money multiplier = 1 ÷ reserve ratio in a simple model).
The Central Bank of Sri Lanka (CBSL), established in 1950, has the objectives of domestic price stability and financial system stability (CBSL, n.d.). Its tools include the policy interest rate (in recent years an overnight policy rate), open market operations, the statutory reserve requirement, and the exchange-rate regime. The CBSL also issues currency and regulates banks.
Monetary policy: tightening (higher interest rates) reduces inflation but slows growth; easing does the opposite. Transmission occurs through interest rates, credit, exchange rates, and expectations.

Inflation and Unemployment

Inflation is a sustained rise in the general price level. Inflation rate = (CPI this year − CPI last year) ÷ CPI last year × 100. The Consumer Price Index (CPI) measures the cost of a basket of goods; limitations include substitution bias and quality changes. In Sri Lanka, the CPI is compiled by the Department of Census and Statistics (DCS, n.d.).
Causes: demand-pull, cost-push, money supply growth, imported inflation, and expectations. Effects: redistribution, uncertainty, loss of competitiveness, and shoe-leather and menu costs. Hyperinflation is extreme.
Unemployment: frictional, structural, cyclical, seasonal, and disguised unemployment; unemployment rate = unemployed ÷ labour force × 100. In developing economies underemployment and informal work are important.
Phillips curve: the short-run trade-off between inflation and unemployment.

Fiscal Policy

Government budget: revenue (taxes, non-tax revenue, grants) and expenditure (recurrent and capital); budget deficit and public debt.
Taxes: direct (income tax, corporate tax) and indirect (VAT, excise duties, customs duties); principles of taxation (equity, certainty, convenience, economy); progressive, proportional, and regressive taxes.
Fiscal policy: expansionary (higher spending, lower taxes) or contractionary; automatic stabilizers; crowding out; the debt burden and sustainability.
Combining policies: monetary, fiscal, and structural policies pursue macroeconomic objectives: stable prices, full employment, growth, a sustainable balance of payments, and equitable distribution.

Common Mistakes

Treating inflation as a rise in a single price.
Using the multiplier without stating the assumptions.
Ignoring the time lags and side effects of policies.

CHAPTER 15