Economic Theory

1. Economic Theory • An economic theory is a set of ideas about the economy that has been organized in a logical framework. Most economic theories are developed in terms of an economic model. • Economic model is a simplified description of some aspect of the economy, usually expressed in mathematical form.

2. Economic Policy • Set of instruction to control the performance of the economy. • There are two types of macro economic policies • Fiscal Policy • Monetary Policy

3. Economic Analysis • Positive Analysis • Normative Analysis

4. Positive Analysis • A positive analysis of an economic policy examines the economic consequences of a policy but doesn't address the question of whether those consequences are desirable. • e.g. if a tax is imposed on a good its price will tend to rise.

5. Normative Analysis • A normative analysis of policy tries to determine whether a certain policy should be used. • e.g. a tax should be imposed on tobacco to discourage smoking

6. Classical Versus Keynesians Classical Approach • Adam Smith (1776) • Published book Wealth of Nation. • Concept of invisible hand Keynesian Approach • Great Depression (1936) • John Maynard Keynes • General theory of Employment, Interest and Money

7. The Classical Approach • The invisible hand of Economics: General welfare will be maximized (not the distribution of wealth) if: • there are free markets; • individuals act in their own best interest.

8. The Classical Approach (continued) • To maintain markets’ equilibrium– the quantities demanded and supplied are equal: • Markets must function without impediments. • Wages and prices should be flexible.

9. The Classical Approach (continued) • Thus, according to the classical approach, the government should have a limited role in the economy.

10. The Keynesian Approach • Keynes (1936) assumed that wages and prices adjust slowly. • Thus, markets could be out of equilibrium for long periods of time and unemployment can persist.

11. The Keynesian Approach (continued) • Therefore, according to the Keynesian approach, governments can take actions to alleviate unemployment.

12. The Keynesian Approach (continued) • The government can purchase goods and services, thus increasing the demand for output and reducing unemployment. • Newly generated incomes would be spent and would raise employment even further.

13. Evolution of the Classical-Keynesian Debate • After stagflation – high unemployment and high inflation – of the 1970s, a modernized classical approach reappeared. • Substantial communication and cross-pollination is taking place between the classical and the Keynesian approaches.

14. Unified Approach to Macroeconomics • Individuals, firms and the government interact in goods, asset and labour markets. • The macroeconomic analysis is based on the analysis of individual behaviour.

15. The Unified Approach (continued) • Keynesian and classical economists agree that in the long run prices and wages adjust to equilibrium levels. • The basic model will be used either with classical or Keynesian assumptions aboutflexibility of wages and prices in the short run.

16. The Measurement and Structure of the National Economy

17. National Income Accounts • The national income accounts are an accounting framework used in measuring current economic activity.

18. Approaches of Measurement • Product Approach (excluding output used in intermediate stage of production). • Income Approach (income received by the producer of output) • Expenditure Approach (amount of spending by the ultimate purchaser of the output).

19. Product Approach • The product approach measures economic activity by adding the market values of goods and services produced, excluding any goods and services used up in intermediate stages of production. • Concept of value added (value of output minus value of input)

20. Income Approach • The income approach measures economic activity by adding all income received by producers of output • Rent, are the income from from property received by house hold • Interest, Private business pay to house hold • Wages, received by workers.It is largest component of National Income • Profit, received by owners of firm

21. Expenditure Approach • The expenditure approach measures activity by adding the amount spent by all ultimate users of output.

22. The Expenditure Approach to Measuring GDP • The expenditure approach measures GDP as total spending on final goods and services produced within a nation during a specified period of time. • Total spending on goods and services includes: • Consumption (C) • Investment (I) • Government Expenditure (G) • Net Export (NX)

23. Consumption • Consumption is spending by domestic households on final goods and services, including those produced abroad. • Consumption expenditures are grouped into three categories: • Consumer durables (car, television, mobile) • Nondurable goods (food, cloth, fuel) • Services (Education, Health care, Financial Services)

24. Investment • Investment includes both spending for new capital goods, called fixed investment, and increases in firms' inventory holdings, called inventory investment. • Fixed investment in turn has two major components: • Business Investment • Residential Investment

25. Government Expenditure • Government expenditure include any spending by the government for a currently produced good or service. • It also include the transfer payment (benefit) to the individuals of the country.

26. Net Export • Net exports are exports minus imports. • If exports are greater than imports NX >0. • If exports are less than imports NX<0.

27. Income-Expenditure Identity • Y = GDP = total production (or output) = total income = total expenditure; Y = C + I + G + NX.

28. Fundamental Identity of NationalIncome Accounting total production=total income=total expenditure

30. Gross Domestic Product • Gross domestic product used to measure the over all economic activity of a country. • GDP is calculate by using the following approaches: • Product approach • Expenditure approach • Income approach

31. Product Approach • A nation's gross domestic product (GDP) as the market value of final goods and servicesnewly produced within a nation during a fixed period of time.

32. Market Value • Goods and services are counted in GDP at their market values that is, at the prices at which they are sold. Advantages: • It allows adding the production of different goods and services. Disadvantages: • Some useful goods and services are not sold in formal markets.

33. Market Value (Cont……) • Some nonmarket goods and services are partially incorporated in official GDP measures. An example is activities in the so-called underground economy. • The underground economy includes both legal activities (hidden from government record keepers to avoid payment of taxes) and illegal activities (drug dealing and gambling).

34. Newly Produced Goods and Services • As a measure of current economic activity, GDP includes only goods or services that are newly produced within the current period.

35. Final Goods and Services • Only the value of final goods and services include in the measurement of GDP. • Final goods also include capital goods and inventory investment.

36. GDP Versus GNP • Gross National Product is the market value of final goods and services newly produced by domestic factors of production during the current period, whereas GDP is production taking place within a country. GNP = GDP + NFP GDP = GNP - NFP

37. Net Factor of Payment • NFP is the income earned by the domestic factor of production from the rest of the world. • From the above definition, GDP = GNP – NFP • In developed economies GNP = GDP. • In Underdeveloped economies GNP > GDP.

38. Measures of National Income • Net National Product • Less: Capital Consumption Allowance • National Income at market price • National Income at factor cost • Personal Income • Personal Disposable Income

39. Private Disposable Income (PDI) • Private disposable income, measures the amount of income the private sector has available to spend. • Mathematically, PDI = Y + NFP + TR + INT - T Y = gross domestic product (GDP); NFP = net factor payments from abroad; TR = transfers received from the government; INT = interest payments on the government's debt; T = taxes.

40. Net Government Income (NGI) • Net government income equals taxes paid by the private sector, T, minus payments from the government to the private sector (transfers and interest payments on the government debt) • Mathematically, NGI = T – TR -INT

41. Saving • Private Saving: private saving is equal to private disposable income minus consumption. Spvt = (Y+NFP+TR+INT-T)-C • Government Saving: It is defined as net government income less government purchases of goods and services. Sgov = (T - TR - INT) - G.

42. National Saving • S = Spvt + Sgov • = (Y+NFP+TR+INT-T)-C + (T - TR - INT) - G. • S= I + CA • Uses of Spvt 1, Spvt is used to fund new capital (Investment) 2, Provide the resource to Govt needs to finance its budget deficit (-Sgov) 2, Foreign lending

43. Current Account (CA) • The current account balance equals payments received from abroad in exchange for currently produced goods and services (including factor services), minus the analogous payments made to foreigners by the domestic economy. • CA = NX + NFP • NX = X – M • NFP = Income from abroad – Payment made to abroad

44. National Wealth • The value of all assets own by a person or country. • Current assets – Current Liabilities • It is total wealth of the residents of a country, it consist two parts 1, Domestic physical assets (Stock of capital, goods, Land) 2,Net foreign assets= Countries foreign assets(foreign stock, bonds and factories own by domestic resident) minus its foreign liabilities (domestic physical and financial assets own by foreigners) Note: Domestic financial assets held by domestic residents are not part of National wealth.

45. National wealth can change in two ways. 1, Value of existing assets or liabilities that make up national wealth * Stock Prices • The wearing out or depreciation of physical assets which corresponded to a drop in the value of asset 2, National Saving • Increase in domestic stock of capital • Increase in stock of net foreign assets ( NX+NFP)

46. Nominal and Real GDP • Nominal GDP measure the current dollar value of the output of the country • Total output at current prices • Y= Pn X Qn Pn= new price, Qn= new Quantity • Real GDP measure output at base year or constant prices • Y = Pb X Qn Pb = Base year price

47. GDP deflator • The GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy • GDP deflator = nominal GDP / Real GDP • = Pn X Qn / Po X Qn • Real GDP = nominal GDP / GDP deflator • nominal GDP=Real GDP X GDP deflator

48. Consumer Price Index ( CPI) • Consumer Price Index • measures changes in the price level of a market basket of consumer goods and services purchased by households. The CPI in the Pakistan is defined by the ministry of finance as "a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

49. Calculation of Growth rate • Growth Rate = • (Current – Previous/ Previous) X100

50. Difference b/w CPI and GDP price Index • Three main differences are 1, GDP deflator measure prices of all goods & services produced where as CPI measure the prices of only goods & services bought by consumer. 2, GDP deflator shows the prices of all goods & services produced domestically, imported goods are not included in GDP deflator. CPI consider imported goods. 3, CPI is computed using fixed basket of goods. GDP deflator allows the basket of goods to change overtime as the composition of GDP deflator.