Macroeconomics

Session 1
Introduction and overview, data concepts

Today’s class gives an overview of what this course offers.

It also introduces you to
• Basics of economic thinking broadly and briefly
• The issues macroeconomists study
• Some important concepts in macroeconomic analysis
• Macroeconomic data
Economics

• Origin: Greek words oikos (house) and nomos (laws)

• Laws or rules related to house/ households
• Mankiw: “…households and economies have much in common.”
• Choice of LA321
• Textbook definitions
• Adam Smith: an inquiry into the nature and causes of the wealth of nations
• Marshall: study of man in the ordinary business of life
• Robbins: a science which studies human behavior as a relationship between ends and scarce
means (limited resources to satisfy unlimited wants)
 Decision making
• People face trade-offs
• This course and, say, some other course; guns and butter
• Efficiency: getting maximum benefit from the scarce resources; Equity: whether the benefits are
uniformly distributed in the society
• There is always an opportunity cost
• Cost of the opportunity forgone/ next best alternative
• Studying and being in the job market
• People are rational
• People purposefully do the best they can to achieve their objectives
• Marginal benefits and marginal costs, airline pricing
• People respond to incentives
• Attendance policy at IIT
• Tax policies
Markets: how people interact
• Trade can make everyone better off
• Competition and efficiency
• Comparative advantage
• Markets and economic activity
• Command economy (centrally planned economy): government owns and directs the means
of production – land, labor, capital – or, the scarce resources. Also decides how the output
will be divided among different goods and services. E.g., Soviet Union and Eastern Europe
• Market economy (laissez-faire): individuals and firms, in other words market forces of
demand and supply, decide. The “invisible hand” guides! E.g., United States
• Mixed economy: India
• Market failure: markets can fail
• Markets may not always allocate the resources efficiently
• Externality (an individual’s action may influence well-being of another) and market power (an
economic agent can unduly influence the prices) may lead to market failures
• Hence, we need the government to enforce rules and maintain institutions
 Economy as a whole
• Output, prices, and unemployment
• Why do we bother so much about economic growth?
• Standard of living depends upon ability to produce goods and services
• Productivity is an important determinant of standard of living; cross-country studies indicate
that a substantial amount of variation in the living standards can be attributed to the
differences in countries’ productivity
• Persistent inflation is generally not believed to be good for an economy
• Imposes different costs on society
• Onion prices have led to changes in the government
• In the short run, there may be trade-off between inflation and unemployment (high inflation
boosts demand)
Three problems of economic organization

• What commodities are produced and in what quantities?

• Guns and butter
• How to produce these goods?
• Inputs and technology
• For whom are the goods produced?
• Dividing the national product among different households
Market economy: the economic functions of government

• Why do we need government intervention?

• Three main functions:
• Efficiency: promoting competition,
• Equity: tax and expenditure; redistributive policy
• Macro stability and growth: growth promotion, unemployment, inflation
• The role of government
The economic functions of the government: examples

failure of market economy government intervention current examples of govt. policy

Inefficiency
monopoly encourage competition antitrust laws, deregulation
externalities intervene in markets antipollution laws, taxes on tobacco
build lighthouses, subsidise scientific
public goods encourage beneficial activities research
Inequality
unacceptable inequalities of income progressive taxation of income and
and wealth redistribute income wealth, income support programs
Macroeconomic problems
monetary policies (changes in money
business cycles (high inflation and stabilise through macroeconomic supply and interest rates), fiscal
unemployment) policies policy (taxes and spending programs)
invest in education, raise national
slow economic growth stimulate growth savings by reducing budget deficit
 Microeconomics and Macroeconomics

• Micro: study of how households and firms make decisions and how they interact in markets; concerned
with individuals
• Macro: study of economy-wide aggregate phenomena; concerned with the operation of economy as a
whole
• inflation, unemployment, and output (growth)
• Linkage: macro is aggregation of micro
• impact of tax cut on output: depends on how households respond to the tax cut
• Distinctions: each field has its own tools, methods, and set of models; address different questions
• In macroecon, policies take time lag to be effective.

In micro, long-run supply curves are relatively more elastic, but in macro, aggregate supply is just the opposite.
Positive and normative analyses

• High unemployment causes hike in crime rates (scientist)

• The government should create more jobs to reduce unemployment (policy-maker)
• Positive: describe how the world is; descriptive
• Normative: make a claim about how the world ought to be; prescriptive
• We can confirm or refute the former by examining evidence (scientific)
• The latter cannot be judged just using data (value judgments); May involve ethics, religion,
philosophy, fairness, etc. There are often no right or wrong answers to these.
 Economic methodology

• Like other fields of study, economics has its own language and way of thinking: supply, demand,
elasticity, comparative advantage, consumer surplus, monopoly, regression
• Scientists: devise theories, collect data, and analyze these data to verify or refute the theories
• The fall of an apple from tree “motivated Newton to develop a theory of gravity that applies
not only to an apple falling to the earth but to any two objects in the universe. Subsequent
testing of Newton’s theory has shown that it works well in many circumstances”
• Similar interplay between theory and observation also occurs in economics
Economic methodology
• Consider the assertion that high inflation arises because the government prints too much money
• To examine the above, one can collect and analyze data on prices and money from different
countries
• A strong correlation between money growth and inflation might indicate that the assertion is
true
• However, unlike science, experiments are often difficult in economics
• For example, a physicist studying gravity can drop many objects in the lab but an economist
may not be able (or allowed) to manipulate a nation’s monetary policy simply to generate
useful data
• Role of assumptions
Economic models

• The economy consists of many people engaged in different activities like buying, selling,
manufacturing, etc.
• Circular flow diagram presents a visual model of the economy
• The economy has two types of decision makers—households and firms
• Firms produce goods and services using factor inputs (or factors of production)
• The factor inputs are land, labor, capital and organization
• Households own the factors of production and consume the goods and services that the firms
produce
The circular flow diagram

• Households and firms interact in two types of markets

• Product market
• It is the markets for goods and services.
• Households are buyers and firms are sellers: households buy the output of goods and
services that firms produce.
• Factor market
• It is the market for the factors of production.
• Households are sellers and firms are buyers: households provide firms the inputs that the
firms use to produce goods and services.
The circular flow diagram
Why do we need to study macroeconomics?

• Have you read today’s newspapers?

• The macroeconomy affects society’s wellbeing. E.g. unemployment leads to rise in crime rates.
Rise in interest rates reduces investment.
• The macroeconomy affects your wellbeing. E.g. rising unemployment accompanies falling real
wage growth. Inflation also hurts.
• The macroeconomy affects politics. E.g. demonetisation, recession
What is macroeconomics?
Macroeconomics is the study of the behavior of the economy as a whole and the policy measures that
the government uses to influence it.
Utilizes measures including total output, rates of unemployment and inflation, and exchange rates.

Examines the economy in the short and long run

Short run: movements in the business cycle
Long run: economic growth

Macroeconomics: aggregates individual markets → look at markets as a whole

AD and AS
Issues include unemployment, economic growth
Inflation
 Leading schools of thought
Classical (Smith, Ricardo, Mill, Say etc.)
• Goods and services are valued at the cost it took to create them (labour theory of value)
• Full employment, focus on long run, prices flexible
• Laissez faire, economy is self regulating, markets clear itself, government spending harmful
• Supply creates its own demand (Say’s law)
Keynesian
• Market is not self sustaining, Role of government intervention to stimulate economy
• Unemployment, focus on short run, prices sticky
• Aggregate demand determines output changes
• Supply does not create its own demand, consumer income does
Neoclassical (Walras, Jevons, Menger, Marshall, Solow etc.)
• Demand-supply interactions determine prices
• Marginal revolution: optimization subject to constraints, general equilibrium
• Laissez faire: free market economy, no role of state intervention in market failure
Monetarists (Friedman)
• Inflation is almost always a monetary phenomenon
 Important issues in macroeconomics
• Why do some countries grow, and some others can’t?
• Why does the cost of living keep rising?
• Why are millions of people unemployed, even when the economy is booming?
• What causes recessions? Can the government do anything to combat recessions? Should it?
• How would the government’s policies affect macroeconomic variables?
• What is the government budget deficit? How does it affect the economy?
• Why does the country have such a trade deficit?
• Why are so many countries poor? What policies might help them grow out of poverty?
So we have Macroeconomics in three models
• Study of macroeconomics is grounded in three models, each appropriate for a
particular time period:

✓ Very Long Run Model: domain of growth theory → focuses on

growth of the production capacity of the economy

✓ Long Run Model: a snapshot of the very long run model, in which
capital and technology are largely fixed
• Level of capital & technology determine level of potential output
• Output is fixed, but prices determined by changes in Aggregate
Demand (AD)

✓ Short Run Model: business cycle theories

• Changes in AD determine how much of the productive capacity is
used and the level of output and unemployment
• Prices are fixed in this period, but output is variable
Very Long Run Growth
• Figure 1-1a-b illustrate growth of
income per person in the U.S. over last
century → growth of 2-3% per year

• Growth theory examines how the

accumulation of inputs and
improvements in technology lead to
increased standards of living

• Rate of saving is a significant

determinant of future well being and
economic growth.
The Long Run Model (classical)
• In the long run, the Aggregate Supply
(AS) curve is vertical (under the
assumption that all factors are fully
employed in production) and pegged
at the potential level of output. Prices
are flexible.
• Output is determined by the supply
side of the economy and its productive
capacity.

• The price level is determined by the

level of demand relative to the
productive capacity of the economy.

• Conclusion: high rates of inflation

are always due to changes in AD
in the long run.
The Short Run Model (Keynesian)
• Short run fluctuations in output are largely due to changes in AD
• The AS curve is flat (horizontal) in the short run due to fixed/rigid prices, so
changes in output are due to changes in AD

• Changes in AD in the short run

constitute phases of the business
cycle
• In the short run, AD determines
output, and thus unemployment
Prices: flexible vs. sticky
• Market clearing: An assumption that prices are flexible and adjust to equate
supply and demand.
• In the short run, many prices are sticky – adjust sluggishly in response to
changes in supply or demand. For example,
• many labor contracts fix the nominal wage for a year or longer
• many magazine publishers change prices only once every 3-4 years

• The economy’s behavior depends partly on whether prices are sticky or

flexible:
• If prices are sticky, then demand won’t always equal supply. This helps
explain
• unemployment (excess supply of labor)
• why firms cannot always sell all the goods they produce
• Long run: prices flexible, markets clear, economy behaves very differently
Macroeconomics 2
Macroeconomic data, GDP concepts

• Some important concepts in macroeconomic analysis

• National Income Accounting
• Y=C+I+G+NX
• Macroeconomic data
• GDP
• CPI, WPI
• Unemployment rate, interest rate, exchange rate
National Income Accounting
• Why do we study the national income accounts?
1. National income accounting provides formal structure for macro theory models
2. Introduces statistics that characterize the economy

• Output is defined in two ways

1. Production side: output = payments to workers (wages), capital (interest and
dividends)
2. Demand side: output = purchases by different sectors of the economy

• Output typically measured as GDP = value of all final goods and services produced
within a country over a particular period of time
Production function
• The production side of the economy transforms inputs (labor, capital) into
output (GDP)
• Inputs = factors of production
• Payments to these factors = factor payments

• The relationship between inputs and outputs defined by the production

function → Y=NaK1-a
where Y = output, N = labor, K = capital
• “Output is a function of labor and capital,” where the functional form can be
defined in various ways
• E.g. corn = f (land, labor, seed, machines)
Components of demand
Aggregate demand for domestic output is made up of four components:
1. Consumption spending by households (C)
2. Investment spending by firms (I)
3. Government spending (G)
4. Foreign demand for our net exports (NX= Exports – Imports)

The fundamental national income accounting identity is

Y = C + I + G + NX

The above identity presents the expenditure components of GDP.

Consumption
• Consumption refers to the purchases of goods and services by
the household sector

• Includes spending on durable (ex. Cars), non-durable (ex.

Food), and services (ex. Medical services)

• Consumption is the primary component of demand

• Typically accounts for ~60% of total demand in India

• Consumption as a share of GDP varies by country

Government
• Government purchases of goods and services include national defense expenditures
and salaries of government employees

• Government also makes transfer payments = payments made to people without

their providing a current service in exchange, e.g., Social Security payments, old-age
pensions, food and housing support for BPL people

• Transfer payments are NOT included in GDP since they are not part of current production
Investment
• Investment = additions to the physical stock of capital (i.e. building
machinery, construction of factories, additions to firms’ inventories)

• In the national income accounts, investment associated with business

sector’s adding to the physical stock of capital, including inventories
• Household’s building up of inventories is considered consumption, although new
home constructions considered part of I, not C

• Gross investment included in GDP measure, which is net investment

plus depreciation
Net exports
• Accounts for domestic purchases of foreign goods (imports)
and foreign purchases of domestic goods (exports) → NX =
Exports – Imports

• Subtract imports from GDP since accounting for total demand for
domestic production

• NX can be >, <, or = 0

• U.S. net exports has been negative since the 1980s →

trade deficit
GDP: The circular flow diagram

42
 Measuring GDP
• Expenditure equals income because every rupee spent by a buyer becomes income to the seller.

• Expenditure approach
• GDP = C + I + G + NX, NX = Exports – Imports
• Definition: Total expenditure on domestically-produced final goods and services.

• Production (value added) approach

• Consider a farmer who produces wheat. Suppose it costs him Rs 0 to produce wheat. The farmer
sells the wheat to a flour industry for Rs 5. The industry sells it to a bakery shop for Rs 10. Finally,
a consumer buys it for Rs 15
• GDP = sum of the value added in the three stages of production
• GDP = (5-0) + (10-5) + (15-10) = 15

• Income approach
• Definition: Total income earned by domestically-located factors of production.
 GDP: formal definition
• Gross Domestic Product = total value of final goods and services currently produced
within a country over a period of time.
• Final goods and services → NO DOUBLE COUNTING
• Goods and services
• currently (in the time period being considered) produced & excludes transactions involving
used/ intermediate goods.
• produced within a country, regardless of the ownership/nationality of the producing firm
• GDP does not include transfer payments (e.g. social security transfers)
Nominal vs. real GDP
• NGDP is the value of output in a given period of time measured in current rupees
• RGDP is the value of output in constant rupees → scaled by a base year price, so that any
change in GDP is due to change in production, not prices

• NGDP in 2007 is the sum of the value of all outputs measured in 2007 dollars
whereas if PB is the price in the base year for good i, RGDP in 2007 is:
N N
NGDP2007 =  Pi
2007 2007
* Qi vs. RGDP2007 =  Pi B * Qi2007
i =1 i =1

Changes in nominal GDP can be due to changes in prices or changes in quantities of

output produced.
Changes in real GDP can only be due to changes in quantities, because real GDP is
constructed using constant base-year prices.
 Real and Nominal GDP

Our interest lies in

measuring the effect
that is not due to
changes in the prices.
Hence, we use real
GDP.
Real GDP is the
value of goods
and services
produced this
year and valued
at the prices
prevailing in the
base year (last
year, for example)

46
Shortcomings of GDP
• There are four major criticisms of the GDP measure:
1. Omits non-market goods and services (e.g. home-made food,
housewife’s work, leisure)
2. No accounting for ‘bads’ such as environmental degradation or crime
rates
3. No correction for product quality improvements
4. Omits black economy or underground economy

• Despite these drawbacks, GDP is still considered one of the best economic indicators
for estimating growth in an economy.
• To know about criticisms of GDP as a measure of wellbeing in detail, read the two articles put up in the Dropbox folder.
 India’s GDP

Y= C+I+G+NX
GDP = Private consumption +
GFCF + Public consumption +
(Exports – Imports)

Source: Key Economic Indicators 17 May 2021 https://eaindustry.nic.in/Key_Economic_Indicators/Key_Macro_Economic_Indicators.pdf

GDP and the underground (black) economy

• GDP includes all items produced in the economy and sold legally in
markets
• GDP excludes most items that are produced and consumed at home; such
items do not enter the marketplace
• GDP excludes items produced and sold illicitly, such as illegal drugs
• In the US, the size of the black economy or underground economy is
estimated to be between 6 and 20 per cent.
• Bolivia and Zimbabwe: nearly two-third of their GDP
• India: 17-25 per cent (Chaudhuri et al. 2005)

49
Value Added Method: GDP = GVA

GDP= GVA = output – intermediate consumption.

GDP= GVA at basic prices + taxes on products – subsidies on

products

GVA = GDP + subsidies on products – taxes on products

GVA shows the production side of the economy. GVA is the grand total of all
revenues, from final sales and (net) subsidies, which are incomes into businesses.
Those incomes are then used to cover expenses (wages & salaries, dividends),
savings (profits, depreciation), and (indirect) taxes.
 Value Added Method: GVA in India

Source: Key Economic Indicators 17 May 2021 https://eaindustry.nic.in/Key_Economic_Indicators/Key_Macro_Economic_Indicators.pdf

Major changes brought into GDP data revisions in India

• India's National Accounts Statistics (NAS) is one of the most massive statistical exercises undertaken
in the world using more than 3000 data sources and surveys.
• In January 2015, CSO introduced a new series of National Accounts Statistics with 2011-12 as the
base year, replacing the old series with 2004-05 as the base year.

• Introduction of GVA at basic prices and GDP at market prices.

In the revised series, as is the practice internationally, industry-wise estimates are presented
as Gross Value Added (GVA) at basic prices, while "GDP at market prices" will be referred to
as "GDP". GVA at basic prices can be referred to as GVA at producer price and GDP at market
price as GDP at buyer price.
• Basic Price + Product tax – Product Subsidy = Market Price
Basic prices exclude any taxes on products the producer receives from the purchaser and
passes on to the government (E.g. GST or Sales Tax or Services Tax) but include any subsidies
the producer receives from government and uses to lower the prices charged to purchasers.
In simple terms, basic price is the subsidized price without tax.
Major changes brought into GDP data revisions in India

• Improvements in coverage of sectors: This refers to the use of MCA21 e-governance data for a
comprehensive set of over 5.5 lakh companies instead of the RBI sample study of around 4,500
companies.
• Methodological changes in the informal sector: different weights to different categories of
workers such as owners, hired workers and helpers.
• Recent data sources such as NSSO Employment-Unemployment Survey 2011-12, Unincorporated
Enterprise Survey 2010-11, Household Consumer Expenditure Survey 2011-12 etc. have been
used in the estimation.
GVA: Production vs product taxes/subsidies

Production Taxes
e.g. Land Revenues, Stamps and Registration fees and Tax on profession etc.
Production Subsidies
e.g. Subsidies to Railways, Input subsidies to farmers, Subsidies to village and small
industries, Administrative subsidies to corporations or cooperatives, etc.
Product Taxes
e.g. Excise Tax, Sales tax, Service Tax and Import and Export duties etc.
Product Subsidies
e.g. Food, Petroleum and fertilizer subsidies, Interest subsidies given to farmers,
households etc. through banks, Subsidies for providing insurance to households at lower
rates etc.

Product taxes or subsidies are paid or received on per unit of product.

GDP and NDP: gross and net
Gross and Net
• Capital wears out or depreciates while it is being used to produce output. Net means net of depreciation,
depreciation is wear and tear of the capital stock in an economy
• Thus, Net = Gross – depreciation
• Net Domestic Product = GDP – depreciation
• Net National Product= GNP – depreciation
GDP at factor cost and GDP at market price
GDP at FC = GDP at MP – (Indirect taxes + subsidies)

Factor cost and market price

In the presence of government intervention (indirect taxes or subsidies), market value does not equal value added.
Cigarettes (taxes)
If the market price is Rs 20, tax is Rs 2
GDP at MP = Rs 20, GDP at FC = 18
 GNP vs. GDP
• Gross National Product (GNP): Total income earned by the nation’s factors of production, regardless of
where the producer is located. GNP= GDP + Net Factor Incomes from Abroad
• GDP: Total income earned by domestically-located factors of production, regardless of nationality.
(GNP – GDP) = (factor payments from abroad) – (factor payments to abroad)
GDP and GNP differ on location of the economic activity, and ownership (domestic vs. foreign) of the
factors of production
 GDP=GNP-NFIA

• From the perspective of India, factor payments from abroad includes things like
• wages earned by Indian citizens working abroad
• profits earned by India-owned businesses located abroad
• income (interest, dividends, rent, etc.) generated from the foreign assets owned by Indian
citizens
• Factor payments to abroad includes things like
• wages earned by foreign workers in India.
• profits earned by foreign-owned businesses located in India.
• income (interest, dividends, rent, etc.) that foreigners earn on Indian assets
 Discussion question:

In your country, which would you want to be bigger, GDP, or GNP?

Why?

It’s a subjective issue though.

It’s better to have GNP > GDP, because it means our nation’s income is greater than the value of
what we are producing domestically.
If, instead, GDP > GNP, then a portion of the income generated in our country is going to people in
other countries, so there’s less income left over for us to enjoy.
 (GNP – GDP) as a percentage of GDP
selected countries, 2005
Philippines 9.2%
In Panama, GNP In the Philippines, GNP is 9.2% bigger
is 7.3% smaller Bangladesh 5.1 than its GDP. This means that the
than GDP. It income earned by the citizens of the
means 7.3% of U.K. 2.2 Philippines is 9.2% larger than the
all the income value of production occurring within
generated in U.S.A. 0.3 the country’s borders.
Panama is taken
away and paid to Mexico -1.8
foreigners.
Russia -2.5
Question: Why
El Salvador -3.4 might GNP
exceed GDP in
Argentina -5.4 the Philippines,
and vice versa in
Indonesia -6.5 Panama?

Panama -7.3
sources: World Development Indicators, World Bank and Bureau of Economic Analysis, U.S. Department of Commerce
• Reasons why GNP may exceed GDP:
• Country has done a lot of lending or investment overseas and is earning lots of income from
these foreign investments (income on nationally-owned capital located abroad).
• A significant number of citizens have left the country to work overseas (their income is
counted in GNP, not GDP).

• Reasons why GDP may exceed GNP:

• Country has done a lot of borrowing from abroad, or foreigners have done a lot of investment
in the country (income earned by foreign-owned domestically-located capital). This is most
likely why Panama’s GDP > GNP.
• Country has a large immigrant labor force
Inflation and prices
Pt − Pt −1
• Inflation, , is the rate of change of prices: t =
Pt −1

• Additionally, Pt = Pt −1 + ( Pt −1 * ) , or today’s price equals last

year’s price, adjusted for inflation

• If  > 0, prices are increasing over time → inflation

• If  < 0, prices are decreasing over time → deflation
• Inflation rate is the rate of growth in the general price level in an economy.

• How do we measure prices?

• For the macroeconomic policymaking, we need a measure of overall prices (price index)
• 3 most commonly used price indexes are CPI, PPI, and the GDP deflator. WPI is the PPI in India.
 GDP deflator is a price index
• GDP deflator is the ratio of Nominal GDP in a given year to Real GDP of that year

• GDP deflator is based on a calculation involving all final goods produced

in the economy and is a widely based price index that is frequently used
to measure inflation.

• Measures the change in prices between the base year and the
current year

• Ex. If NGDP in 2012 is Rs 6.25 and RGDP in 2012 is Rs 3.50, then the GDP
deflator for 2012 is Rs 6.25/ Rs 3.50 = 1.79 → prices have increased by 79%
since the base year
 Understanding the GDP deflator

Example with 3 goods

For good i = 1, 2, 3
Pit = the market price of good i in month t
NGDPt
Qit = the quantity of good i produced in month t GDP deflatort = 100𝑥
RGDPt
NGDPt = Nominal GDP in month t
  Q1t   Q2t   Q3t  
RGDPt = Real GDP in month t = 100x    P1t +   P2t +   P3t 

  RGDPt   RGDPt   RGDPt  

P1t Q 1t + P2t Q 2t + P3t Q 3t

= 100𝑥
RGDPt

The GDP deflator is a weighted sum of prices (as the weights do not all sum to 1). The weight on each
price reflects that good’s relative importance in GDP. Note that the weights change over time.
Price index: CPI
• Consumer Price Index measures the cost of buying a fixed basket of goods and
services representative of the purchases of consumers

• Measure of the cost of living for the average household

• CPI differs from GDP deflator in four ways:

1. CPI measures prices of a more limited basket of goods and services (only
household goods and services)
2. Prices of capital goods (if produced domestically) are included in the GDP deflator
but are not considered in CPI.
3. The bundle of goods in the consumer basket for CPI is fixed, while that of the GDP
deflator varies.
4. CPI includes prices of imported goods, while GDP deflator only considers those
goods produced within the country.
Price index: CPI
According to the 2016 Monetary Policy Agreement of the Reserve Bank of India and the Government
of India, the Consumer Price Index is the inflation targeting variable for RBI.

In India, CPI is a Laspeyres index.

Laspeyres Index: [Laspeyres, 1871]. It’s a weighted aggregate price index in which the weight for each
item is its base period quantity.

p01 =
 pq1 0
100
p q0 0

Where p1= price of goods in period 1 (later period), p0= price of goods in base period (base year), q0=
quantity of goods produced in the base period (base year)
 Weighted Price Indices
• Laspeyres Index: [Laspeyres, 1871]. A weighted aggregate price index in
which the weight for each item is its base period quantity.

p01 =
 pq 1 0
100
p q 0 0
• Paasche Index: [Paasche, 1874]. A weighted aggregate price index in
which the weight for each item is its current period quantity.

p01 =
 pq 1 1
100
p q 0 1
• Fisher’s ideal index: It is the geometric mean of the Laspeyre’s and
Paasche’s index numbers.
P01 =
 p q   p q 100
1 0 1 1

pq pq
0 0 0 1

• Dorbish & Bowley index: It is the arithmetic average of Laspeyre’s and

Paasche’s index.  p1q0  p1q1 +
p01 =
 p0 q 0 p q 0 1
100
2
 An example
ITEMS PRICE PRODUCTION PRICE PRODUCTION

( p0 ) (q0 ) ( p1 ) (q1 ) ( p1q0 ) ( p0 q0 ) ( p1q1 ) ( p0 q1 )

Dal 15 500 20 600 10000 7500 12000 9000
Chawal 18 590 23 640 13570 10620 14720 11520
Sabji 22 450 24 500 10800 9900 12000 11000
TOTAL 34370 28020 38720 31520

1. Laspeyres index: p01=

 pq
100 =
34370
1 0
100 = 122.66
p q 28020
0 0

2. Paasche’s Index : p =
 pq
100 =
38720
1 1
100 = 122.84
p q
01
31520
0 1

3. Fisher’s Ideal Index

P01 =
 p q   p q 100=
1 0 1 1 34370 38720
 100 = 122.69
pq pq 0 0 0 1 28020 31520
 Calculation of CPI
current year current year weighted price
item base year price price index weights index
=(240/150)x100=
food 150 240 160 4 640
apparel 300 420 140 3 420
medical care 250 200 80 1 80
transport 160 180 112.5 2 225
sums 492.5 10 1365

Simple CPI = Total of current year indices / number of items = 492.5/4= 123.125
Weighted CPI = Total of weighted CPI for goods / total weights = 1365/10= 136.5

Inflation =[(CPI current year – CPI previous year)/ CPI previous year] x 100%

Change in value of money = [(Base year index / CPI) – 1] x 100%

Simple CPI:
The general price level or costs have increased by 23.1 per cent (123.1- 100) from the base year to the current year.
Understanding the CPI
Example with 3 goods
Et
For good i = 1, 2, 3
CPI in month t =
Ci = the amount of good i in the CPI’s basket Eb
Pit = the price of good i in month t
P1t C1 + P2t C2 + P3t C3
Et = the cost of the CPI basket in month t
=
Eb = the cost of the basket in the base period Eb
 C1   C2   C3 
=   P1t +   P2t +   P3t
 Eb   Eb   Eb 
The CPI is a weighted sum of prices as the weights do not all sum to 1. It’s not a weighted
average.
The weight on each price reflects that good’s relative importance in the CPI’s basket. Note that
the weights remain fixed over time.
Reasons why the CPI may overstate inflation
Substitution bias:
The CPI uses fixed weights, so it cannot reflect consumers’ ability to substitute toward goods
whose relative prices have fallen.
Introduction of new goods:
The introduction of new goods makes consumers better off and, in effect, increases the real value
of the rupee. But it does not reduce the CPI, because the CPI uses fixed weights.
Unmeasured changes in quality:
Product quality improvements increase the value of the rupee, but are often not fully measured.
Steps of a price index calculation in India
• Fix the Basket: Determine what prices are most important to the typical consumer.
• The CSO/Labour Bureau identifies a market basket of goods and services the typical consumer buys.
• The LB conducts consumer surveys to set the weights for the prices of those goods and services.
• Find the Prices: Find the prices of each of the goods and services in the basket for each point in
time.
• Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods
and services at different times.
• Compute the inflation rate: The inflation rate is the percentage change in the price index from
the preceding period
• Choose a Base Year and Compute the Index:
▫ Designate one year as the base year, making it the benchmark against which other years are compared.
▫ Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying
by 100.
Base year must be a ‘normal year’, without any economic abnormalities or supply or demand shocks
such as due to natural calamities like droughts or floods causing agricultural output shock, or oil
price shocks due to say OPEC cartel’s embargo etc.
 How can you deflate a value?
• It is a technique used to make allowances for the effect of changing price values. It is used to measure
the purchasing power of money.
• Deflated value = (current value / price index of the current year) x 100. It can also be found thus:
Deflated value = current value x (base price p0 / current price p1).
• Example: Let’s calculate the deflated value (Real GDP) for every year with 2011 as the base year.

year GDP CPI Deflated value

2011 80 100 (80/100)*100=80
2012 108 120 (108/120)*100=90
2013 125 125 100
2014 147 140 105
2015 216 180 120
2016 230 200 115
 Producer Price Index

• PPI measures the cost of buying a fixed basket of goods and services representative of a firm
• Captures the cost of production for a typical firm
• Market basket includes raw materials and semi-finished goods
• PPI is constructed from prices at an earlier stage of the distribution process than the CPI
• PPI signals changes to come in the CPI and is thus closely watched by policymakers
• Over long periods of time, the two measures yield similar values and trends for inflation
 OPTIONAL
WPI, CPI in India
WPI has 3 components, manufacturing (chemical, metal, food), primary (food, non-food, mineral),
and fuel (oil, electricity, coal). The WPI index basket of the present 2011-12 series has a total of 697
items including 117 items for Primary Articles, 16 items for Fuel & Power and 564 items for
Manufactured Products.)

The prices tracked are ex- factory price for manufactured products, mandi price for agricultural
commodities and ex-mines prices for minerals. Weights given to each commodity covered in the
WPI basket is based on the value of production adjusted for net imports. WPI basket does not cover
services. WPI data are published by Economic Advisor, Ministry of Commerce and Industry.

CPI considers prices of commodities like food, beverage, tobacco, miscellaneous (health, education,
recreation), housing, fuel and light, clothing+bedding+footwear.

From February 2011, the CPI UNME (Urban Non-Manual Employee) released by CSO has been
replaced by CPI (urban),CPI (rural) and CPI (combined). CPI is used in calculation of Dearness
Allowance which forms an integral part of salary of a Government Employee. Base year to calculate
CPI is 2012=100. Data publisher: Central Statistical Office.
 OPTIONAL
Core inflation
Core Inflation is nothing but Headline Inflation (WPI) minus inflation that is contributed by food and energy
commodities which are highly volatile.

Food and fuel prices may go up in the short run due to some agriculture sector shock or petrol/oil price hike.
However, over the long term, they tend to revert back to their normal trend growth. On the other hand, prices of
other commodities do not fluctuate as regularly as food and fuel – as such increase in their prices could be taken
relatively to be much more of a permanent nature.

Since component food and energy prices are highly volatile, headline inflation may not give an accurate picture of
how an economy is behaving. Responding to headline inflation might therefore sometimes be inappropriate as it
generates excessive variability in the unemployment rate – variability that would be much more subdued when
policy responds to core inflation.

While temporary changes (like seasonal variation in fruits and vegetable prices) would reverse and might not
warrant attention, permanent changes would require standard remedies involving monetary and fiscal policies.
Research has shown that headline inflation tends to revert strongly towards core inflation once the temporary
fluctuation in food and energy sector stabilizes.
Unemployment
• The unemployment rate measures the fraction of the workforce that is
out of work and looking for a job or expecting a recall from a layoff
• Important indicator of well-being of an economy/households
• Optimal unemployment rates differ from country to country
• Optimal unemployment rate is linked to the potential level of output for a
given economy
Unemployment
statistics
in India

Source: Key Economic Indicators 17 May 2021

https://eaindustry.nic.in/Key_Economic_Indicators/Key_Macro_Economic_Indicators.pdf

Refer to the Key Economic Indicators Reading

in Dropbox
Unemployment
statistics
in India -II

Source: Key Economic Indicators 17 May 2021 https://eaindustry.nic.in/Key_Economic_Indicators/Key_Macro_Economic_Indicators.pdf Refer to the Economic Indicators Reading in
Dropbox
Interest rates
• Interest rate = rate of payment on a loan or other investment over and above the
principal repayment in terms of an annual percentage
• Cost of borrowing money OR benefit of lending money
• Nominal interest rate = return on an investment in current rupees
• Real interest rate = return on an investment, adjusted for inflation, i.e. the inflation has
been filtered out
• If R is the nominal interest rate, and r is the real interest rate, then we can define the
nominal rate as:
R=r+
Exchange rate
• Each country has its own currency in which prices are quoted
• In the U.S. prices are quoted in U.S. dollars, while in Canada prices are quoted in Canadian dollars and
most of Europe uses the euro
• Exchange rate = the price of a foreign currency
• Ex. 1 British pound is worth U.S. $1.38 (July 2, 2021)

• Floating exchange rate → price of a currency is determined by supply and demand

• Fixed exchange rate → price of a currency is fixed

• We’ll discuss it in the open economy module of this course.

Macroeconomics

Money demand and money supply, role of central bank and monetary policy
Inflation and hyperinflation

Learning objectives: we will discuss

What’s money, its functions and types, how it’s controlled and measured
Classical view: Quantity theory of money
Seigniorage, inflation and interest rates
Nominal interest rate, the money demand and supply
Theories of money demand
Role of central bank, and monetary policy
Monetary policy in India, Demonetization 2016
Inflation, Hyperinflation
 Introduction to Money

Obsidian: a hard, dark, glasslike volcanic rock formed by the rapid solidification of lava without crystallization.
Wampum: small cylindrical beads traditionally made by some North American Indian peoples from shells, strung together and worn as decoration or used as money.
 What is money? Why does anyone want it?
The moment you get out of this room and buy something, or deposit in or withdraw some money, you
do influence the money demand and money supply in your small little way.

Money is the stock of assets that can be readily used to make transactions. It is a widely used means of
payment or any asset that can be easily converted into a widely used means of payment with little loss
in value.

Old rhyme: “Money is a matter of functions four, a medium, a measure, a standard and a store”

Inflation rate = the percentage increase in the average level of prices.

Price = amount of money required to buy a good.
Because prices are defined in terms of money, we need to consider the nature of money, the supply of money, and how it is controlled. Demand for money refers to the
stock of assets held as cash, checking accounts, and closely related assets, specifically not generic wealth or income.
 The Functions of Money
Old rhyme: “Money is a matter of functions four, a medium, a measure, a standard and a store”

1. Medium of exchange
• We use it to pay for goods and services when we buy those.
• It eliminates the need for a “double coincidence of wants” (barter system) and waiting (time cost)

2. Store of value

Money is an asset that transfers purchasing power from the present to the future. Money retains its value over time,
so you need not spend all your money as soon as you receive it. Money can be hoarded.

Other assets also serve this function. Money is the most liquid of all assets but loses value so much during
hyperinflation and ceases to function (e.g. Venezuela, Zimbabwe).

3. Unit of account

It is the common unit by which everyone quotes and measures prices and values. Value of goods, services and assets
can be expressed in money. Money allows for comparing respective value of different goods, services and assets.

4. Standard of deferred payment or obligations

Money units are used in long term transactions (e.g. loans)

Additional properties of money for being a medium of exchange

It must be divisible—that is, easily divided into usable quantities or fractions. A Rs 100
note, for example, is equal to five Rs 20 notes. If something costs Rs 30, you don’t have to
tear up a Rs 50 note; you can pay with three Rs 10 notes.
You can’t divide cattle or stones!

It must be portable—easy to carry; it can’t be too heavy or bulky.

It must be storable and durable. It can’t fall apart or wear out after a few uses.
It must be difficult to counterfeit. It won’t have much value if people can make their own.

There are two types of money, (i) fiat money, (ii) commodity money.
 1. Fiat money
• It has no intrinsic value, i.e. it has no value as a commodity.
• It has nominal value or face value.
• It is the paper money decreed by governments as legal tender (so it can be accepted as legal payment for
debts) and people have faith in it that it retains value over time. Fiat means diktat or government order.
Example: the paper currency or notes we use
 Fiat money: Legal tender
‘Legal tender’ is the money that is recognized by the law of the land, as valid for payment of debt. It must be
accepted for discharge of debt. The RBI Act of 1934, which gives the central bank the sole right to issue bank notes,
states that “Every bank note shall be legal tender at any place in India in payment for the amount expressed therein”.

Legal tender can be limited or unlimited in character. In India, coins function as limited legal tender. Therefore, 50
paise coins can be offered as legal tender for dues up to ₹10 and smaller coins for dues up to ₹1. Currency notes are
unlimited legal tender and can be offered as payment for dues of any size.

So, does this mean an autowallah is obliged to accept your new ₹2,000 note for a short hop? Not necessarily! If you
are yet to get into the auto, the autowallah can turn you down despite it being legal tender. But once you make the
trip, and you have incurred a debt, he cannot refuse to take your ₹2,000 note. And he certainly cannot sue you to
recover that debt.

India’s Nov 2016 Demonetisation cancelled the legal tender status of old Rs 500 and Rs 1000 notes. The cancellation
of the legal tender status is important because paper money derives all its value from the Government’s recognition
of it. It’s fiat money.
https://www.youtube.com/watch?v=jjdZM-X9mv8
 Tomorrow, if the Government declares gold to be completely worthless, will it put us Indian
citizens into such a tizzy? You can guess that it probably will not!

Citizens will probably ignore the government and continue to hoard gold. This is because our
tendency to view gold as something of great value does not come from any government diktat; it
comes from tradition.

But for a piece of paper to function as a medium of exchange and store of value, it needs to enjoy
unquestioning acceptance from the public. This can only be ensured by declaring such paper
currency notes as ‘legal tender’ through a fiat, with the RBI or the Centre promising to ‘pay the
bearer’ an equivalent sum if the currency note is presented to them.

All our wealth, the scriptures tell us, are pure illusion (maya). Well, paper currency is maya too.
Without a government fiat to make it legal tender, it is just a piece of paper.

Talk about ‘money illusion’

Source: “All you wanted to know about legal tender”, Aarati Krishnan, The Hindu Business Line https://www.thehindubusinessline.com/opinion/columns/all-you-wanted-to-know-about-legal-tender/article9345780.ece
 2. Commodity money
Commodity money has intrinsic value, so there is substantial value in alternative uses. It has also face value.
It is easily standardized.

Shortcomings: heavy and uneasy to transport from one place to another, sometimes not divisible.
Examples: cattle, salt, spices, conch shells, precious metals in ancient history; gold coins, cigarettes in P.O.W.
camps in WW-II

Remember the 1994 film The Shawshank Redemption starring Tim Robbins and Morgan Freeman? Watch
Cigarettes as currency.
To know more about use of cigarettes as money in camps for Allied POWs in Germany during WWII, read R.
A. Radford, The Economic Organisation of a P.O.W. Camp, Economica, Nov., 1945, pp. 189-201.

Use of mobile phone airtime as money in some African countries viz. Côte d’Ivoire, Egypt, Ghana and
Uganda, Nigeria.
 Gresham's law: Bad money drives out good
• Let’s assume there is no legal tender laws in place, and we have two types of money or coins which are of same
face value or nominal value, gold coins and copper coins.
• Now, one money (i.e. gold coins) has face value as well as intrinsic value or commodity value. The other coins have
less precious and valuable base metal. In many cases, they are debased, i.e. there is less than the officially specified
amount of base metal in those coins.
• In such a case and with no legal tender laws in place, the gold coins which have both intrinsic value and face value
will be driven out of circulation and will be hoarded by people who may use it as store of value or convert to other
use.
• The coins which are debased or those without intrinsic value will be more in circulation.
• This is called Gresham's law that says "bad money drives out good". Bad money here is the coins or currency that is
overvalued.
• So bad money is one for which both nominal/ face value and intrinsic/ commodity value are different. Nominal
value will be much more than the intrinsic value in case of bad money.
• The situation is the opposite for good money which is undervalued. In case of good money, nominal value and
intrinsic value do not differ. People appreciate this fact and do not circulate good money in the economy.
Gresham’s law is now almost irrelevant by
standardisation of cash money in
circulation and the possibility of
exchanging damaged or soiled banknotes
and coins at face value.

Example from India – coins with face value

below the value of scrap metal
Sharp practice of melting coins, BBC 2007
Which of these are money?

a. Currency a - yes
b. Cheques b - no, not the cheques
themselves, but the funds in
c. Deposits in checking accounts checking accounts are money.
(“demand deposits”) c - yes (see b)
d - no, credit cards are a means
d. Credit cards of deferring payment.
e. Certificates of deposit e - CDs are a store of value, and
(“time deposits”) they are measured in money
units. They are not readily
spendable, though.
 Money stock aggregates in India
Monetary base or Reserve Money aka M0 = currency in circulation + Bankers’ deposits with RBI +
Other deposits with RBI
Monetary base or Reserve Money aka M0 = Net RBI credit to the Government + RBI credit to the
commercial sector + RBI’s claims on banks + RBI’s net foreign assets + Government’s currency liabilities
to the public – RBI’s net non-monetary liabilities

M1= Currency with public + Demand deposits with the Banking system (non-interest earning checking
accounts of individuals in banks, current account, saving account, traveler checks) + Other deposits
with RBI
M1 comprises those claims that can be used directly, instantly, and without restrictions → LIQUID
An asset if it can immediately, conveniently, and cheaply be used for making payments.
M2= M1 + Savings deposits of post office savings banks
M2 includes M1, plus some less liquid assets (ex. savings accounts and money market funds)

https://www.rbi.org.in/scripts/Data_MSupply.aspx link for India’s periodic money supply data

For definitions of different money stock components, refer to
https://m.rbi.org.in/Scripts/PublicationsView.aspx?id=9455
 Money stock aggregates in India

M3= M1 + Time deposits with the banking system

= Currency with public + Demand deposits with the Banks + Time deposits with Banks + Other deposits with
RBI
= Net bank credit to the Government + Bank credit to the commercial sector + Net foreign exchange assets
of the banking sector + Government’s currency liabilities to the public – Net non-monetary liabilities of the
banking sector
M3 aka Broad Money is considered as money supply.
M4= M3 + All deposits with post office savings banks (excluding National Savings Certificates).

As liquidity of an asset decreases, the interest yield increases.

A typical economic tradeoff: in order to get more liquidity, asset holders have to sacrifice yield
 Cryptocurrency (e.g. Bitcoin ₿)
According to the US Library of Congress, an
"absolute ban" on trading or using
Bitcoin is a cryptocurrency, a digital
cryptocurrencies applies in nine countries:
asset designed to work as a medium
Algeria, Bolivia, Egypt, Iraq, Morocco, Nepal,
of exchange that uses cryptography
Pakistan, Vietnam, and the United Arab Emirates.
(practice and study of techniques for
An "implicit ban" applies in another 15 countries,
secure communication in the
which include Bahrain, Bangladesh, China,
presence of third parties called
Colombia, the Dominican Republic, Indonesia,
adversaries) to control its
Kuwait, Lesotho, Lithuania, Macau, Oman, Qatar,
Saudi Arabia and Taiwan.

Bitcoin (₿) is a cryptocurrency invented in 2008 by an unknown person or group of people using the
name Satoshi Nakamoto. The currency began use in 2009 when its implementation was released
as open-source software.
Bitcoin is a decentralized digital currency, without a central bank or single administrator, that can be
sent from user to user on the peer-to-peer bitcoin network without the need for intermediaries and
transaction costs. Transactions are verified by network nodes through cryptography and recorded in a
public distributed ledger called a blockchain. Bitcoins are created as a reward for a process known
as mining. They can be exchanged for other currencies, products, and services.

Research produced by the University of Cambridge estimated that in 2017, there were 2.9 to 5.8 million unique users using a cryptocurrency wallet, most of them using bitcoin.

Total number of Bitcoins generated cannot exceed 21 million. Bitcoin has been criticized for its use in illegal transactions, the large amount of electricity used by miners, price
volatility, and thefts from exchanges. Some economists, including several Nobel laureates, have characterized it as a speculative bubble at various times. Bitcoin has also been used
as an investment, although several regulatory agencies have issued investor alerts about bitcoin.
 Motivation for Bitcoin: Why did it come into being?

i. Distrust of financial institutions

• Any noncash transaction requires a trusted third-party administrator—commonly
a bank or financial service provider.
• The system forces participants to trust financial institutions that are not always
trustworthy.
ii. Transaction costs
• Traditional payments are revocable, even on irrevocable services.
• Financial institutions act as an arbitrator between counterparties in disputed
claims.
• Arbitration costs are passed on to consumers.

Source: https://www.dallasfed.org/assets/documents/educate/classroom/bitcoin.pptx
 Primary concerns
i. Transaction security
Two levels of verification
Source is legitimate
Coins are legitimate
Public/private key verification ensures the legitimacy

ii. Double spends

If the money is just digital codes, why not copy and paste to make more money?
• Timestamps (Each transaction is packaged and publically recorded in the order it was carried
out.)
• Hashes (The time-stamped group of transactions are given a unique algorithmically derived
number)
• Block chain (Transactions are recorded in a community-built record of all transactions that acts as
a proof-of-work. Computers connected to the network accept the longest chain as accurate.)
 Where do Bitcoins come from?
• They’re mined.
• High-powered computers solve complicated math problems.
• Each time a problem is solved, the finder is paid a bounty.
• Mining bitcoins
• Miners solve complicated algorithms to find a solution called a hash.
• Finding a hash creates a block that is used to process transactions.
• Each new block is added to the block chain.
• Until there are 21 million bitcoins, miners are paid for finding a hash in new coin.
• After 21 million, miners will charge transaction fees for creating a new block.
• The amount paid per hash goes down by half about every 4 years.

Mining is a record-keeping service done through the use of computer processing power. Miners keep the blockchain consistent, complete, and unalterable by repeatedly
grouping newly broadcast transactions into a block, which is then broadcast to the network and verified by recipient nodes.
Owning bitcoins
Users create accounts called wallets.
Wallets are secured using passwords and contain the private keys used for transferring
bitcoins.

Spending bitcoins

Buyer enters the Buyer signs the

seller’s address and transaction with a Buyer broadcasts the
Seller provides an
the amount of the private key and transaction to all the
address to the buyer
payment to a announces the public Bitcoin network
transaction message key for verification
 Bitcoin security
• Computers accept the longest block chain, which inhibits hacking.
• Hackers would have to create a longer chain of fraudulent information faster than
the combined effort of all other computers.
• Public/private cryptography means individual bitcoins are secured when not
being transacted.
• Authentication → Public Key Crypto: Digital Signatures
• Am I paying the right person? Not some other impersonator?
• Integrity → Digital Signatures and Cryptographic Hash
• Is the coin double-spent?
• Can an attacker reverse or change transactions?
• Availability→ Broadcast messages to the P2P network
• Can I make a transaction anytime I want?
• Confidentiality→ Pseudonymity
• Are my transactions private? Anonymous?
Is cryptocurrency money?

Medium of exchange
Store of value
Unit of account
Standard of deferred payment
 El Salvador has adopted Bitcoin as legal tender
• El Salvador, a Spanish-speaking Central American country bordered with Honduras, Guatemala,
and the Pacific Ocean, has recently adopted Bitcoin as legal tender. Now, they have two currencies
in vogue: US Dollars and Bitcoin (BTC).
• 68 lakh population (as of 2021). President: Nayib Bukele. Capital: San Salvador.
• El Salvador (SLV) has problems like poverty, inequality, gang violence.

Map source: https://www.britannica.com/place/El-Salvador, 07.07.2021

 • Three key issues
• SLV will have a dual currency system with USD and BTC.
• Due to high volatility, BTC is not a particularly good store of value.
• Because of this, USD will remain as the currency for accounting and tax purposes.
• What does this mean for the different sectors in the economy?
• Households:
• Households in SLV can get BTC through mining, remittances or salaries. They can either use it for
consumption or save it. What will they do?
• GDP per capita is USD 3700/-. Around 30% of people in SLV live in poverty. As prices and goods will
remain denominated in USD, their tolerance for BTC volatility is minimal. As soon as they get BTC,
they will likely exchange it for USD through SLV public facility.

Source of this portion is a Twitter thread of Daniel Munevar, link: https://twitter.com/danielmunevar/status/1403196041583861760. I have edited the contents to suit our purposes.
 • Businesses:
• Businesses are in a similar position. Their credits, supplier bills (inc. imports) and taxes will
remain denominated in USD. Sure, they can pay those in BTC, but why take the risk of high
intraday volatility that can mess up their capacity to settle bills at the end of the month?
• So, just like households, every time they receive a BTC for a payment of a good or service, they
will proceed to exchange it for USD in order to protect themselves from volatility and meet
their bills (they might set some aside as a speculative investment).
• Government
• They will put in place incentives for households and business to exchange their BTC for USD
through a public facility. This sets up a system where the government is in a position to receive
a steady inflow of BTC matched by USD outflows.

• Why would they do that? You can not settle imports nor meet debt payments with BTC. For that you
need USD. The only scenario where SLV would want to structurally accumulate BTC is if they are
convinced the price will always go up in the long run.
Broad implications for SLV’s economy
• This is the desperate part of the play. SLV government seems to assume it can handle the short-term
volatility and profit from a never-ending long-term appreciation of BTC vs USD. It’s a risky play but if you
are already talking to the International Monetary Fund (IMF) for a loan, there is not much to lose.
• The nefarious part comes via the external sector. SLV is not a big exporter nor an attractive foreign direct
investment (FDI) destination. Introducing BTC does not change this situation. However, the new law does
allow SLV to sell potentially attractive money laundering services (at least initially).
• The new law effectively allows BTC holders to buy anything they want in SLV skirting anti-money-
laundering (AML) regulations. No matter where the money has come from, they (BTC holders) are free to
buy properties skirting banks and the financial system all together, as the BTC goes from wallet to wallet.
• So, if you are involved in some shady line of work, SLV gives you an easy way to launder your money.
Come in, buy stuff, selling after couple of months/years and then exchange it for USD through SLV public
facility.
• They can then take the USD out. Asked about the provenance of money by a foreign bank, they can show
the receipt of its origin: SLV public facility. Presto. Clean money. (This will likely work until SLV is flagged
internationally as AML risk)
Going forward… (lessons for other countries?)
• What's in it for SLV? This dynamic can start a real state boom with lots of new economic activity and
construction jobs. The constant inflow of non-resident BTC will allow the government to leverage
their own BTC play (under the assumption that it will always go up versus USD).

• The problem is that this is an implicit Balance of Payments ponzi scheme. The only way to keep the
show going is if the increase in value of BTC versus USD is large enough to offset clean USD
outflows. If this criterion is not met, i.e., if the value of BTC does not increase to a large enough
amount to compensate for the USD outflows, SLV will run out of USD. Bad money always drives
good money out. (Application of Gresham’s law!)

• So, while this might work for a couple of years (domestic asset bubble), this is an enormous risk for
the people of El Salvador. You don't want to find out the hard way if you can pay food, medicine and
oil imports in BTC once your USD have dried out.
 Demand for money
• Imagine that a consumer has a certain amount of wealth, which is divided between
money and other assets.
• The other assets typically generate some type of income (e.g., interest income in the
case of bonds) but are much less liquid (spendable) than money. There is therefore a
trade-off: the more money the consumer holds in his portfolio, the more interest
income he foregoes; the less money he holds, the more interest income he makes, but
the less liquid is his portfolio.

• So, a consumer’s “money demand” refers to the fraction of his wealth he would like to
hold in the form of money (as opposed to less-liquid income-generating assets like
bonds).

DFS ch 16
Theories of the Demand for Money
The demand for money is the demand for real money balances → people hold money for its purchasing
power, for the amount of goods they can buy with it. Nominal money holdings do not matter.
Two implications:
1. Real money demand is unchanged when the price level increases, and all real variables, such as
the interest rate, real income, and real wealth, remain unchanged
2. Equivalently, nominal money demand increases in proportion to the increase in the price level,
given the real variables just specified
So, we are interested in a money demand function that tells us the demand for real balances, M/P, not
nominal balances, M.
Money illusion:

An individual is free from money illusion if a change in the level of prices, holding all real variables
constant, leaves the person’s real behavior, including real money demand, unchanged.

E.g., People interpret nominal wage or price changes as real changes. If prices and wages all go up
by 2%, there is no real change in purchasing power. People with money illusion think they are
richer in this case.
 The Demand for Money: Theory
Keynes postulated that people have three motives for holding money:
The transactions motive: people demand money because they use it in making regular payments
for transactions
The precautionary motive: people demand money to meet unforeseen contingencies
The speculative motive: people demand money to invest in assets as there are uncertainties about
the money value of other assets that an individual can hold.
Transaction and precautionary motives → mainly discussing M1 (mainly currency+DD)
Speculative motive → M3 (mainly currency+ DD+ Time deposits+ interest-earning mutual funds invested in
short-term assets etc.), as well as non-money assets

From DFS
These theories of money demand are based on a tradeoff between the benefits of holding more
money versus the opportunity costs of doing so (foregone interest).

Opportunity cost of holding money = the yield on other assets – the own interest rate.

Three types of theories

Transactions demand (Baumol- Tobin formula)
• stress on the function of money as a medium of exchange
Precautionary demand for money
• stresses on the function of money as a store of value
Portfolio theories of money demand
• stress on the function of money as a store of value
• posit that money demand depends on risk/return of money & alternative assets
 Transaction demand
The transaction demand for money arises when receipts and disbursements are not in
sync with each other
• Keep money on hand to make purchases between pay periods

Tradeoff between amount of interest an individual forgoes by holding money and costs of
holding a small amount of money
• Benefit of keeping small amounts of money on hand is interest earned on money
left in the bank
• Cost of keeping small amounts of money is the cost and inconvenience of making
trips to the bank to withdraw more

From DFS
Transaction Demand
In general:
Y
With starting income of Y, n trips to the bank → The average cash balance is . Each trip costs tc.
2n
→ The combined cost of trips plus forgone interest is:
(n  tc) + i  (Y 2n )
Choose n to minimize costs and compute the average money holdings → Baumol-Tobin formula for the demand
for money:
M tc  Y
=
P 2i
Implications:

1. Money demand decreases when interest rate increases and increases when transaction cost increases.
Money demand increases with increases in income but less than proportionately.

2. Money demand increases with spending and the cost of converting non-monetary assets to money.

3. The income elasticity of money demand is ½ and the interest elasticity of money demand is -1/2. Empirical
evidence supports the signs of the predictions but suggests the income elasticity is closer to 1 while the
interest elasticity is close to zero.
From DFS ch 16, Optional Appendix.
This formula is also used for determining optimal inventories of goods, not just money.
 Question: How do these factors affect money demand?

(a) Spread of Bank ATMs

(b) Wider usage of Internet banking

The spread of automatic teller machines reduces the cost of trips to the bank by reducing the time it takes
to withdraw money. Lower cost of trips to the bank increases the number of trips to the bank for
withdrawal and decreases money demand.

Similarly, with (b), a decrease in the cost of withdrawing money allows consumers to hold lower real money
balances relative to their spending, so they can keep more of their money in interest-bearing bank
accounts. Of course, they will need to make more trips to the bank now but doing so is less costly.
Financial Innovation, Near Money, and the Demise of the Monetary Aggregates

• Examples of financial innovation:

• many checking accounts now pay interest
• very easy to buy and sell assets
• mutual funds are baskets of stocks that are easy to redeem - just write a check
• Digital UPI cash outlets (PhonePe, Google Pay, Paytm, Google Tez etc.)
• Non-monetary assets having some of the liquidity of money are called near money.
• Money & near money are close substitutes and switching from one to the other is easy.
Financial Innovation, Near Money, and the Demise of the Monetary
Aggregates

The rise of near money makes money demand less stable and complicates monetary policy.

1993: the Fed switched from targeting monetary aggregates to targeting the Federal Funds rate.

This change may help explain why the U.S. economy was so stable during the rest of the 1990s.

Like the US, many countries such as India are nowadays targeting the policy rate (repo rate) instead of
targeting the monetary aggregates.
 The Precautionary Motive

The Baumol-Tobin model ignored uncertainty

People uncertain about the payments they might want or have to make → there is demand
for money for these uncertain events

The more money a person holds, the less likely he or she is to incur the costs of illiquidity (not having
money immediately available)
The more money a person holds, the more interest he/she will give up → similar tradeoff
encountered with transactions demand for money

• Technology and the structure of the financial system are important determinants of precautionary
demand

• Both transactions demand and precautionary demand for money emphasize the medium-of-
exchange function of money while the speculative demand for money rests on the store-of-value
function of money and concentrate on the role of money in an individual’s investment portfolio.

From DFS
 Speculative Demand for Money
Wealth held in specific assets → portfolio
Due to uncertainty, unwise to hold entire portfolio in a single risky asset → diversify asset
holdings

Money is a safe asset in that its nominal value is known with certainty.
Of course, when the inflation rate is uncertain, real value of money is uncertain too and money is no longer a
safe asset. Still, money can be treated as a relatively safer asset as equity uncertainties are so larger than
inflation uncertainty.

Demand for money depends upon the expected yields and riskiness of the yields on
other assets (James Tobin, 1958)
• Increased opportunity cost of holding money lowers money demand
• Increased riskiness of returns on other assets increases money demand

From DFS ch 16
Empirical Estimates
Four essential properties of money demand:
Demand for money balances responds negatively to the rate of interest.
Demand for money increases with the level of real income.
Short-run responsiveness of money demand to changes in interest rates and income is
considerably less than the long-run response. (the long-run responses are estimated to be about
5 times the size of the short-run responses)
Demand for nominal money balance is proportional to the price level. There is no money
illusion; in other words, the demand for money is a demand for real balances

From DFS
Inflation in India: 1950-2010
(Source: Gokarn 2010)

122
 Inflation: Quantity Theory of Money (QTM)
• It’s a classical theory of inflation.
• QTM links money supply to price level. MV=PY
• For this, we need to know what V is. V stands for velocity of circulation of money.

• Basic concept: the rate at which money circulates

• Definition: the number of times the average rupee note changes hands in a given time period
• Example: In 2007,
• Rs 500 billion in transactions
• money supply = Rs 100 billion
• The average rupee is used in five transactions in 2007
• So, velocity = 5
• In order for Rs 500 billion in transactions to occur when the money supply is only Rs 100b,
each rupee must be used, on average, in five transactions.