Economics for Business

Analyze the boundary condition.

Studying Analysis of contemporary

Economics economic condition.

Comprehend the words and

signals of policymakers and factor
them into managerial decision-
making.
• The chances of a soft
landing are likely to
diminish. No one knows
whether this process will
lead to a recession or, if
so, how significant that
recession would be. (Sept 2022)
• As inflation in systemically important
AEs turned out to be persistent rather
than transitory, the third shock
emanated in the form of aggressive
tightening of monetary policy by the US
Fed, and subsequent unrelenting
appreciation of the US dollar. Spillovers
to EMEs, and to India, were in the form
of capital outflows, depreciation
pressures on currencies, reserve losses
and imported inflation. (November 19, 2022 )
Data around you
 • The study of individual choice under scarcity and
Microeconomics its implications for the behavior of prices and
quantities in individual markets

• The study of the performance of national

Macroeconomics economies, and of the policies that governments
use to try to improve that performance
• In what way, we can quantify the
size of the economy and how an
economy is performing ?
 Gross
Domestic The market value of the final

Product goods and services produced in

a country during a given period

(GDP)
Income and Expenditure
• Gross Domestic Product (GDP) measures
total income of everyone in the economy.
• GDP also measures total expenditure on the economy’s output of
g&s.
For the economy as a whole,
income equals expenditure
because every Rupee a buyer spends
is a Rupee of income for the seller.
The Circular-Flow Diagram
• a simple depiction of the macroeconomy
• illustrates GDP as spending, revenue,
factor payments, and income
• Preliminaries:
• Factors of production are inputs like labor, land, capital, and natural
resources.
• Factor payments are payments to the factors of production (e.g., wages,
rent).
The Circular-Flow Diagram

Households:
§ own the factors of production,
sell/rent them to firms for income
§ buy and consume goods & services

Firms Households

Firms:
§ buy/hire factors of production,
use them to produce goods
and services
§ sell goods & services
The Circular-Flow Diagram

Revenue (=GDP) Spending (=GDP)

Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income (=GDP)
profit (=GDP)
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services
produced within a country
in a given period of time.

Goods are valued at their market prices, so:

§ All goods measured in the same units
(e.g., dollars in the U.S.)
§ Things that don’t have a market value are
excluded, e.g., housework you do for yourself.
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services
produced within a country
in a given period of time.

Final goods: intended for the end user

Intermediate goods: used as components
or ingredients in the production of other goods
GDP only includes final goods—they already
embody the value of the intermediate goods
used in their production.
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services
produced within a country
in a given period of time.

GDP includes tangible goods

(like DVDs, mountain bikes, beer)
and intangible services
(dry cleaning, concerts, cell phone service).
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services
produced within a country
in a given period of time.

GDP measures the value of production that occurs

within a country’s borders, whether done by its own
citizens or by foreigners located there.
Gross Domestic Product (GDP) Is…

…the market value of all final goods & services

produced within a country
in a given period of time.

GDP includes currently produced goods,

not goods produced in the past.
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services
produced within a country
in a given period of time.

Usually a year or a quarter (3 months)

The expenditure components of GDP

• consumption, C
• investment, I
• government spending, G
• net exports, NX
An important identity:
The Components of GDP

• Recall: GDP is total spending.

• Four components:
• Consumption (C)
• Investment (I)
• Government Purchases (G)
• Net Exports (NX)
• These components add up to GDP (denoted Y):

Y = C + I + G + NX
 • Definition: The value of all goods and
services bought by households, including:
• Durable goods
last a long time.
Consumption Examples: cars, home appliances
• Nondurable goods
(C) last a short time.
Examples: food, clothing
• Services
are intangible/non-physical items or activities,
purchased by consumers.
Examples: dry cleaning, air travel, concerts
Investment (I)
• Spending on capital, a physical asset used in future production
• Includes:
• Business fixed investment—Spending on plant and equipment
• Residential fixed investment—Spending by consumers and landlords on
housing units
• Inventory investment—The change in the value of all firms’ inventories
Investment (I)
• is total spending on goods that will be used in the future to produce
more goods.
• includes spending on
• capital equipment (e.g., machines, tools)
• structures (factories, office buildings, houses)
• inventories (goods produced but not yet sold)

Note: “Investment” does not

mean the purchase of financial
assets like stocks and bonds.
Government Spending (G)
• G includes all government spending on goods and services.
• Purchases of trains and installation of subway rail.
• Services provided by a Park Ranger to visitors of national parks.
• G excludes transfer payments
(e.g., unemployment insurance payments) because they do not
represent spending on goods and services.
Net Exports (NX)
• NX = exports – imports
• Exports: the value of g&s (goods and services) sold to other countries
• Imports: the value of g&s purchased from other countries
• Hence, NX equals net spending from abroad on our g&s.
• Notice: The trade deficit (NX < 0) does not reduce GDP. Instead, imports
are subtracted to removed them from domestic spending.
An expenditure-output puzzle?

• Suppose a firm:
• produces $10 million worth of final goods today and puts
all 10 million in inventory
• Then, tomorrow sells only $9 million worth

• Does this violate the expenditure = output identity?

 Why output = expenditure

Unsold output goes into inventory and is counted as “inventory

investment” . . whether or not the inventory buildup was intentional.

In effect, we are assuming that firms purchase their unsold output.

 If a firm produce extra output
(says Parle-G) without hiring any
more labor, then how Income is
equal to expenditure ?
The Profit will increase. Since the
Firms are owned by Households
only, so Income increase.
GNP versus GDP
• Gross national product (GNP):
Total income earned by the nation’s factors of production, regardless of
where located.
• Gross domestic product (GDP):
Total income earned by domestically located factors of production,
regardless of nationality.
• GNP – GDP = factor payments from abroad
minus factor payments to abroad
• Examples of factor payments: wages, profits, rent, interest and dividends
on assets
In simple words

• If Tesla make an
automobile in India,
the value addition of
this output into Indian
GDP is same as would
that automobile is
produced by TATA in
India.
• In calculating Indian GNP, Tesla’s profit on Indian production will be
subtracted from final output.
• So, Tesla’s production in India does not factor into US GDP at all.
But profits Tesla earn in India will be part of US GNP.
Depreciation
• Net National Product ( NNP) = GNP – Depreciation of Capital

“Theoretically Preferable … It suffer, however, from the serious obstacle that there is no satisfactory
operational definition of the consumption of fixed capital.”--- U.S. Commerce Department, 1947.
31/07/23 Abhishek Rohit 35
Net Trade as % of GDP 10
China India

Net trade in goods and services as percent of 6

GDP
4

Axis Title
0

20

20

20

20

20

20

20

20

20

20
00

02

04

06

08

10

12

14

16

18
-2

-4

-6

-8
 Nominal GDP vs. Real GDP
(Base year: 2010)

7/31/23 41
 • GDP is the value of all final goods and
services produced.
Real vs. • nominal GDP measures these values using
nominal GDP current prices.
• real GDP measure these values using the
prices of a base year.
 • Changes in nominal GDP can be due to:
• changes in prices.
Real GDP • changes in quantities of output produced.
controls for • Changes in real GDP can only be due to
changes in quantities,
inflation because real GDP is constructed using
constant base-year prices.
NOW YOU TRY
Real and nominal GDP

2019: 2020: 2020: 2021: 2021:

2019: P
Q P Q P Q
Good A $30 900 $31 1,000 $36 1,050

Good B $100 192 $102 200 $100 205

• Compute nominal GDP in each year.

• Compute real GDP in each year, using 2019 as
the base year.
NOW YOU TRY
Real and nominal GDP, answers

Nominal GDP multiply Ps and Qs from the same year

2019: $46,200 = $30 × 900 + $100 × 192
2020: $51,400
2021: $58,300

2020

2019

Real GDP multiply each year’s Qs by 2019 Ps

2019: $46,200
2020: $50,000 = $30 × 1000 + $100 × 200
2021: $52,000 = $30 × 1050 + $100 × 205
GDP deflator
• Inflation rate: the percentage increase in the overall level of prices.
• One measure of the price level: GDP deflator
• Definition:

Nominal GDP
GDP deflator = 100 ´
Real GDP
NOW YOU TRY
GDP deflator and the inflation rate

GDP Inflation
Nominal GDP Real GDP Deflator Rate
2019 $46,200 $46,200 n.a.
2020 51,400 50,000
2021 58,300 52,000

• Use your previous answers to compute the GDP

deflator in each year.
• Use the GDP deflator to compute the inflation rate
from 2019 to 2020 and from 2020 to 2020.
NOW YOU TRY
GDP deflator and the inflation rate, answers
GDP Inflation
Nominal GDP Real GDP Deflator Rate
2019 $46,200 $46,200 100 n.a.
2020 51,400 50,000 102.8 2.8%
2021 58,300 52,000 112.1 9.0%

2020 Inflation Rate =

( 2020 GDP delfator
- 2019 GDP deflator )
× 100
2019 GDP deflator
31/07/23 49
• https://economictimes.indiatimes.com/news/economy/indicators/ind
ia-would-become-5-trillion-economy-by-2026-27-cea-v-anantha-
nageswaran/articleshow/92205688.cms
How the CPI is constructed
1. Survey consumers to determine composition of the typical
consumer’s “basket” of goods
2. Collect data on prices of all items in the basket; compute cost of
basket
3. CPI in any month equals

Cost of basket in that month

100 ´
Cost of basket in base period
 NOW YOU TRY:
Compute the CPI
Basket: 20 pizzas, 10 compact discs

prices: For each year, compute

pizza CDs § the cost of the basket
2002 Rs10 Rs15 § the CPI (use 2002 as the
2003 Rs11 Rs15 base year)
2004 Rs12 Rs16 § the inflation rate from the
2005 Rs13 Rs15 preceding year
 NOW YOU TRY:
Answers to CPI exercise
Cost of Inflation
basket CPI rate
2002 Rs350 100.0 n.a.
2003 370 105.7 5.7%
2004 400 114.3 8.1%
2005 410 117.1 2.5%
 Prices of capital goods:

• included in GDP deflator (if produced

domestically)

CPI vs. GDP

• excluded from CPI

Deflator
Prices of imported consumer goods:

• included in CPI
• excluded from GDP deflator

The basket of goods:

• CPI: fixed
• GDP deflator: changes every quarter/year
What the weights
of CPI signify ?
It is the share of expenditure of that item
to total expenditure.
Consumer Item Rural Urban
Price Index Food and beverages 54.18 36.29

Pan, tobacco and

• CPI is a measure that 3.26 1.36
intoxicants
examines the weighted
average of prices of a Clothing and
7.36 5.57
basket of consumer goods footwear
and services.
• The recent series of CPI Housing 21.67
provides a measure of
Urban, Rural and Combined Fuel and light 7.94 5.58
CPI.
• The components and their
Miscellaneous 27.26 29.53
respective weight in CPI
basket is: (Base Year 2012)
CPI Index
Wholesale Price Index
• Wholesale Price Index (WPI) measures the average change in
the prices of commodities for bulk sale at the level of early
stage of transactions

• The index basket of the WPI covers commodities falling under

the three major groups namely Primary Articles, Fuel and Power
and Manufactured products.
Comparative
Major Group/
Statement of Group
Weights No. of Items
Weights, Number
of 2004-05 2011-12 2004-05 2011-12

Items for WPI ALL

100 100 676 697
2004-05 vs 2011- COMMODITIES

12 Base year PRIMARY

ARTICLES
20.12 22.62 102 117

FUEL&POWER 14.91 13.15 19 16

MANUFACTURED
64.97 64.23 555 564
PRODUCTS

62
How are weights decided ?
• The weight of an item in the WPI basket is based on the net traded value
of the item in the base year i.e. 2011-12.
• Net traded value represents the total transactions of each product in the
economy during the base year.
• However, the weight assigned to crude petroleum is based on the value of
domestic production only as crude petroleum is not directly traded in the
market and its derivatives ( petroleum products ) are assigned due weight
based on net traded value.
• WPI reflects the change in average prices for bulk sale of
commodities at the first stage of transaction while CPI reflects
the average change in prices at retail level paid by the
consumer.
 They differ in terms of their weighting
pattern. First, food has a larger weight in CPI.

Divergence
Second, the fuel group has a much higher
between weight in the WPI than the CPIs. As a result,
movement in international crude prices has a
WPI and greater bearing on WPI than on the CPIs.

CPI Third, services are not covered under WPI

while they are, to different degrees, covered
under CPIs. Consequently, service price
inflation has a greater influence on CPIs.
CPI VS WPI
• Another way to analyze inflation data is by looking at “core inflation,” which is generally a
chosen measure of inflation that excludes the more volatile categories, such as food and
energy prices.
• The main argument here is that the central bank should be responding to the
movements in permanent components of the price level rather than temporary
deviations.
 An interest rate is the cost
of borrowing, or the price
Measuring paid for the rental of funds
Interest
Rates Interest rates are returns
for holding debt securities,
such as bonds
Real Versus Nominal Interest Rates

• A nominal interest rate makes no allowance for

inflation
• The real interest rate is the amount of extra
purchasing power a lender must be paid for the rental
of his/her money.
- Real interest rate represents effective rate of interest
on loan after controlling for inflation.
 Real Versus Nominal Interest Rates

• The Fisher equation:

i = nominal interest rate
r = nominal interest rate
πe = expected inflation

i = r + πe

or r = i - πe
Real Versus Nominal Interest Rates (cont d)

• Example: For a one-year loan with a 4%

nominal interest rate (i=4%) and you expect
the inflation to be 6% in a year ( pe=6%),
then:

r = 4% - 6% = -2%

• When the real interest rate is low, there are

greater incentives to borrow and invest, but
fewer incentives to lend.
• A borrows Rs 10,000 from B at 5%
nominal returns while inflation in
the economy is 10%.