Principles of Macroeconomics-I: Complete Study

Guide
Based on DU Syllabus, Previous Year Papers (2023-2025), and Core Textbooks

Table of Contents
1. Unit I: Introduction to Macroeconomics
2. Unit II: National Income Accounting
3. Unit III: Determination of GDP
4. Unit IV: Open Economy with Government
5. Unit V: Money in Modern Economy
6. High-Priority Question Bank
7. Formula Sheet
8. Diagram Reference

Unit I: Introduction to Macroeconomics

Key Concepts
1. Macroeconomics vs Microeconomics
Macroeconomics: Study of economy as a whole
Focus on aggregates: GDP, inflation, unemployment
Policy implications: Fiscal and monetary policy
2. Major Macroeconomic Issues
Economic Growth: Long-term increase in productive capacity
Business Cycles: Short-term fluctuations around trend
Unemployment: Involuntary idleness of resources
Inflation: Persistent rise in general price level
Balance of Payments: External sector equilibrium
3. Business Cycle Phases
Expansion: Economy grows above trend
Peak: Maximum growth rate
Contraction/Recession: Economy slows down
Trough: Lowest point of cycle
Important Questions & Solutions
Q1. What is the difference between the classical and Keynesian approaches to
macroeconomics? (8 marks)
Solution:
Classical Approach:
Markets self-correct through price flexibility
Say's Law: "Supply creates its own demand"
Government intervention unnecessary
Focus on long-run equilibrium
Keynesian Approach:
Markets may fail due to sticky prices/wages
Demand-side focus for short-run fluctuations
Active government intervention required
Involuntary unemployment possible
Q2. Explain the concept of business cycle with diagram. (10 marks)
Solution:
Business cycle represents recurrent fluctuations in economic activity with four phases:
1. Trough: Lowest point, high unemployment
2. Recovery/Expansion: GDP rising, employment increasing
3. Peak: Highest point, full employment
4. Recession/Contraction: GDP falling, unemployment rising
[Diagram would show a wave-like pattern around a trend line]

Unit II: National Income Accounting

Key Concepts
1. Basic Definitions
GDP: Market value of final goods/services produced within domestic territory
GNP: Market value of final goods/services produced by nationals anywhere
NDP: GDP minus depreciation
NNP: GNP minus depreciation
2. Important Relationships
GNP = GDP + NFIA (Net Factor Income from Abroad)
NNP_FC = GDP_MP - Depreciation - Net Indirect Taxes + NFIA
 GDP_MP = GDP_FC + Net Indirect Taxes
Net Indirect Taxes = Indirect Taxes - Subsidies

3. Methods of Measurement
Value Added Method: Sum of value added by all sectors
Income Method: Sum of factor incomes (wages, rent, interest, profit)
Expenditure Method: Sum of final expenditures (C + I + G + NX)

Important Questions & Solutions

Q1. Calculate GDP at MP from the following data: (10 marks)
NDP at MP = ₹12,000 Cr
Depreciation = ₹9,654 Cr
Net Indirect Taxes = ₹5,678 Cr
NFIA = -₹250 Cr
Solution:

GDP_MP = NDP_MP + Depreciation

GDP_MP = 12,000 + 9,654 = ₹21,654 Cr

Q2. Explain the limitations of GDP as a measure of economic welfare. (10 marks)
Solution:
1. Non-market activities excluded: Housework, volunteer services
2. Income distribution ignored: GDP doesn't show inequality
3. Environmental costs: Pollution, resource depletion not considered
4. Quality improvements: Better products at same price not captured
5. Underground economy: Black market activities excluded
6. Leisure time: More free time not reflected in GDP
Q3. Distinguish between nominal and real GDP. (8 marks)
Solution:
Nominal GDP: GDP at current market prices
Real GDP: GDP at constant prices (base year)
GDP Deflator = (Nominal GDP/Real GDP) × 100
Real GDP removes inflation effects, better for comparisons
Unit III: Determination of GDP

Key Concepts
1. Consumption Function
C = a + bY_d
where: a = autonomous consumption
b = MPC (marginal propensity to consume)
Y_d = disposable income

2. Savings Function
S = -a + (1-b)Y_d
where: (1-b) = MPS (marginal propensity to save)
MPC + MPS = 1

3. Investment Multiplier
k = 1/(1-MPC) = 1/MPS
ΔY = k × ΔI

4. Equilibrium Condition
Y = C + I + G (closed economy)
Y = AD (aggregate demand)

Important Questions & Solutions

Q1. Given C = 0.6Y, I = ₹1,000 Cr, G = ₹2,000 Cr, find: (15 marks)
(a) Equilibrium income (b) Government expenditure multiplier
Solution:
(a) Equilibrium Income:

Y = C + I + G
Y = 0.6Y + 1,000 + 2,000
Y - 0.6Y = 3,000
0.4Y = 3,000
Y = 3,000/0.4 = ₹7,500 Cr

(b) Government Expenditure Multiplier:

MPC = 0.6
k_G = 1/(1-MPC) = 1/(1-0.6) = 1/0.4 = 2.5

Q2. Explain the Paradox of Thrift with suitable diagram. (10 marks)
Solution:
Paradox of Thrift: When everyone tries to save more simultaneously, total income falls.
Mechanism:
1. Increased saving → Reduced consumption
2. Reduced consumption → Lower aggregate demand
3. Lower aggregate demand → Fall in equilibrium income
4. Fall in income → Actual savings may decrease
Policy Implication: Individual virtue (saving) becomes collective vice during recession.
Q3. Derive the investment multiplier and explain its working. (12 marks)
Solution:
Derivation:

Y = C + I + G
C = a + bY
Y = a + bY + I + G
Y - bY = a + I + G
Y(1-b) = a + I + G
Y = (a + I + G)/(1-b)

For change in investment:

ΔY = ΔI/(1-b) = ΔI/(1-MPC) = ΔI/MPS

Therefore: k = ΔY/ΔI = 1/(1-MPC) = 1/MPS

Working:
Initial increase in investment → Higher income for factor owners
Higher income → Higher consumption (MPC × ΔY)
Higher consumption → Further income increase
Process continues with diminishing effect
Total effect = k × ΔI

Unit IV: Open Economy with Government

Key Concepts
1. Open Economy Identity
Y = C + I + G + (X - M)
where: X = Exports, M = Imports

2. Open Economy Multiplier

 k_open = 1/[1 - MPC(1-t) + m]
where: t = tax rate, m = marginal propensity to import

3. Fiscal Policy Tools

Government Expenditure (G): Direct impact on AD
Taxes (T): Indirect impact through disposable income
Transfer Payments (TR): Increase disposable income
4. Tax Multiplier
k_T = -MPC/(1-MPC) = -MPC/MPS

5. Balanced Budget Multiplier

k_BB = k_G + k_T = 1/(1-MPC) + (-MPC)/(1-MPC) = 1

Important Questions & Solutions

Q1. Derive equilibrium income in an open economy with proportional income tax. (12 marks)
Solution:

Y = C + I + G + (X - M)
C = a + b(Y - tY) = a + bY(1-t)
M = m₀ + mY
X = X₀ (autonomous)

Substituting:
Y = a + bY(1-t) + I + G + X₀ - m₀ - mY
Y = a + bY(1-t) + I + G + (X₀ - m₀) - mY
Y[1 - b(1-t) + m] = a + I + G + (X₀ - m₀)

Y = [a + I + G + (X₀ - m₀)]/[1 - b(1-t) + m]

Multiplier: k = 1/[1 - b(1-t) + m]

Q2. Explain the concept of balanced budget multiplier. (10 marks)

Solution:
Definition: When government expenditure and taxes increase by same amount.
Formula: k_BB = 1
Proof:

ΔY = k_G × ΔG + k_T × ΔT
When ΔG = ΔT:
ΔY = [1/(1-MPC)] × ΔG + [-MPC/(1-MPC)] × ΔG
 ΔY = ΔG × [1/(1-MPC) - MPC/(1-MPC)]
ΔY = ΔG × [(1-MPC)/(1-MPC)] = ΔG × 1 = ΔG

Intuition: Direct effect of G exceeds indirect negative effect of T.

Unit V: Money in Modern Economy

Key Concepts
1. Functions of Money
Medium of Exchange: Eliminates barter problems
Store of Value: Preserve purchasing power
Unit of Account: Common measure of value
Standard of Deferred Payment: Future payments
2. Money Supply Measures in India
M₁ = Currency + Demand Deposits
M₂ = M₁ + Savings Deposits with Post Office
M₃ = M₁ + Time Deposits with Banks
M₄ = M₃ + Total Deposits with Post Office

3. Demand for Money (Keynes)

Transaction Motive: For daily transactions
Precautionary Motive: For emergencies
Speculative Motive: For bond speculation
4. Money Market Equilibrium
M_d = M_s
where: M_d = L(Y, i)

5. Credit Creation
Money Multiplier = 1/LRR
Total Credit = Initial Deposit × (1/LRR)

Important Questions & Solutions

Q1. Calculate credit creation if initial deposit = ₹1,000 Cr and LRR = 10%. (8 marks)
Solution:

Money Multiplier = 1/LRR = 1/0.10 = 10

Total Credit Created = Initial Deposit × Multiplier
 Total Credit = 1,000 × 10 = ₹10,000 Cr
Additional Credit = 10,000 - 1,000 = ₹9,000 Cr

Q2. Explain liquidity preference theory of interest rate. (12 marks)

Solution:
Keynes' Theory: Interest rate determined by demand and supply of money.
Components of Money Demand:
1. Transaction Demand: L₁ = f(Y) - increases with income
2. Precautionary Demand: L₂ = f(Y) - increases with income
3. Speculative Demand: L₃ = f(i) - decreases with interest rate
Total Money Demand: M_d = L₁ + L₂ + L₃ = L(Y, i)
Equilibrium: M_d = M_s determines interest rate
Q3. What is liquidity trap? Explain with diagram. (10 marks)
Solution:
Definition: Situation where interest rate is so low that further increase in money supply doesn't
reduce it.
Characteristics:
Interest rate near zero
Money demand becomes perfectly elastic
Monetary policy ineffective
People prefer cash over bonds
Policy Implication: Fiscal policy needed instead of monetary policy.

High-Priority Question Bank

Short Answer Questions (5-8 marks each)

1. GDP vs Social Welfare - Limitations of GDP as welfare measure
2. Paradox of Thrift - Individual saving vs collective impact
3. Open Economy Multiplier - Derivation and factors affecting
4. Functions of Money - Four main functions with examples
5. Business Cycle - Phases and characteristics
6. Circular Flow of Income - 4-sector model
7. Liquidity Preference - Keynes' theory of interest rate
8. Monetary Policy Tools - CRR, SLR, OMO, Repo Rate
 9. Balanced Budget Multiplier - Theory and numerical
10. Credit Creation - Process and limitations

Long Answer Questions (10-18 marks each)

1. National Income Calculation - All three methods with precautions
2. Consumption Function Analysis - MPC, APC, shifts, diagrams
3. Fiscal Policy Effects - Impact of G, T, TR changes
4. Open Economy Income Determination - Complete derivation
5. Money Market Equilibrium - Demand, supply, shifts
6. Investment Multiplier - Derivation, working, leakages
7. GDP Measurement - Problems and solutions
8. Macroeconomic Issues - Growth, unemployment, inflation
9. Central Bank Functions - Monetary policy implementation
10. Trade Feedback Effect - Open economy interactions

Formula Sheet

National Income Accounting

GNP = GDP + NFIA

NNP_FC = GDP_MP - Depreciation - Net Indirect Taxes + NFIA
GDP_MP = GDP_FC + Net Indirect Taxes
Value Added = Value of Output - Intermediate Consumption

GDP Determination

C = a + bY_d (Consumption Function)

S = -a + (1-b)Y_d (Savings Function)
k = 1/(1-MPC) = 1/MPS (Investment Multiplier)
Y = C + I + G + NX (Aggregate Demand)

Fiscal Policy

Tax Multiplier = -MPC/(1-MPC)

Transfer Multiplier = MPC/(1-MPC)
Balanced Budget Multiplier = 1
Budget Surplus = T - G - TR
Open Economy

k_open = 1/[1 - MPC(1-t) + m]

Trade Multiplier = 1/m
Output Gap = Actual GDP - Potential GDP

Money and Banking

MV = PY (Quantity Theory)
M_d = L(Y, i) (Money Demand)
Money Multiplier = 1/LRR
M₁ = Currency + Demand Deposits

Diagram Reference

Essential Diagrams to Practice

1. Business Cycle - Wave pattern around trend
2. Consumption Function - Linear upward sloping
3. Savings Function - Derived from consumption function
4. Investment-Saving Equilibrium - IS curve derivation
5. 45° Line Diagram - Keynesian cross for equilibrium income
6. Multiplier Process - Step-by-step income changes
7. Money Market Equilibrium - Money demand and supply curves
8. Liquidity Trap - Horizontal portion of money demand
9. Credit Creation Process - Banking system expansion
10. Circular Flow Models - 2, 3, and 4 sector economies

Exam Strategy Tips

Time Allocation (3 Hours = 180 minutes)

5 questions × 18 marks = 90 marks
36 minutes per question
Planning: 5 minutes
Writing: 30 minutes
Review: 1 minute
Question Selection Priority
1. Unit II & V (25 marks each) - Highest weightage
2. Unit III & IV (20-25 marks each) - Core concepts
3. Unit I (10-15 marks) - Basic theory

Answer Structure
1. Definition/Introduction (2-3 marks)
2. Main Content with Diagrams (12-14 marks)
3. Conclusion/Policy Implications (2 marks)

Important Note
This study guide consolidates syllabus-aligned topics, PYQ patterns, and textbook theories.
Practice numerical problems daily and draw diagrams for better understanding. Focus on
recent PYQ trends for optimal preparation.
Sources:
DU Syllabus (DSC-4: Principles of Macroeconomics-I)
Previous Year Papers (2023-2025)
Abel & Bernanke: Macroeconomics (10th Edition)
SOL Study Material (2023-24)
Dornbusch, Fischer & Startz: Macroeconomics (11th Edition)