Macro Economics


What is ‘Macroeconomics’

Macroeconomics is a branch of the economics field that studies how the aggregate economy behaves. In macroeconomics, a variety of economy-wide phenomena is thoroughly examined such as, inflation, price levels, rate of growth, national income, gross domestic product and changes in unemployment.

It focuses on trends in the economy and how the economy moves as a whole.

BREAKING DOWN ‘Macroeconomics’

Macroeconomics differs from microeconomics, which focuses on smaller factors that affect choices made by individuals and companies. Factors studied in both microeconomics and macroeconomics typically have an influence on one another. For example, the unemployment level in the economy as a whole has an effect on the supply of workers from which a company can hire. Macroeconomics, in its most basic sense, is the branch of economics that deals with the structure, performance, behavior and decision-making of the whole, or aggregate, economy, instead of focusing on individual markets.

The Study of Macroeconomics

Those working in the field of macroeconomics study aggregated indicators such as unemployment rates, GDP and price indices, and then analyze how different sectors of the economy relate to one another to understand how the economy functions. Macroeconomists develop models explaining relationships between a variety of factors such as consumption, inflation, savings, investments, international trade and finance, national income and output. Contrarily, microeconomics analyzes how individual agents act, namely consumers and corporations, and studies how these agents’ behavior affects quantities and prices in certain markets. Such macroeconomic models, and what the models forecast, are used by government entities to aid in the construction and evaluation of economic policy.

Specific Areas of Research

Macroeconomics is a rather broad field, but two specific areas of research are representative of this discipline. One area involves the process of understanding the causation and consequences of short-term fluctuations in national income, also known as the business cycle. The other area involves the process by which macroeconomics attempts to understand the factors that determine long-term economic growth, or increases in the national income.

Development of Macroeconomics:

Modern macroeconomics started with the major concern for unemploy­ment that dominated thinking in the developed industrial world in the 1920s and 1930s. The theoretical breakthrough was attributed to Keynes and is often called the Keynesian revolution.

While there is no doubt that there was a Keynesian revolution and that Keynes was the leading economist of us generation, it is worth knowing that he was not alone in contributing to our understanding of the subject. Many economists in the 1930s had important contributions to make on the subject.

The origin of macroeconomics can be traced back to the mercantilist writers who were concerned with the problem of economic growth of a country. Though they wrongly thought that the greater the gold and silver possessed by a country, the richer it could be. They also thought that the country could have economic prosperity only if it had a favourable balance of trade. But the first theoretical macroeconomic model can be seen in the writings of Physiocrats.

The Tableau Economique developed by Quesnay in 18th century France gave a circular flow model of total product among three classes of people. Quesnay’s tableau gave the idea of circular flow product and income which was later emphasised by Keynes. The Physiocrats thought that the economic growth depended on the net product produced by the agricultural sector.

According to the Physiocrats, the agricultural sector was the only productive sector in the economy capable of producing a surplus. They thought that industry and trade are unproductive, incapable of generating a surplus.

The next step in the development of macroeconomics was taken by classical economists such as Adam Smith, David Ricardo, Robert Malthus, J. B. Say etc. The classical economists investigated the real relations of production in bourgeois society. Classical economists also believed in the Say’s law of markets.

The idea of classical economists are summarised in the classical model of income and employment. They believed that in a free enterprise economy, each economic unit would try to maximise its own interest and there was a harmony of individual interests. A basic result of the classical economics is that, given the flexibility of wages and prices, a competitive market would automatically operate at full employment level of output and employment.

That is the economic forces would always be generated to ensure that the demand for labour would always equal its supply. So long as there is un­employment money wages and prices would fall, output would increase and I he additional supply of output creates its own demand (Say’s law) and there can be no overproduction.

In this way, full employment would be automatically reached and there could be no involuntary unemployment. The economy could temporarily deviate from full employment level but market forces would operate to restore the full employment equilibrium.

The Great Depression of the 1930s in all the capitalist countries of the world rudely shattered the belief of the self-correcting mechanism of the capitalist economic system as propounded by the classical economists. In his book, “The General Theory of Employment. Interest and Money” published in 1936, Keynes vehemently criticised the postulates of the classical theory and provided a new theory of employment and income. Modern macroeconomic theory is largely based on the idea of Keynes work.

The main result of the Keynesian theory is that the level of real national income and, therefore, employment, is determined largely by the level of aggregate demand. This is very different from the classical theory where supply creates its own demand. In the Keynesian theory, it is the demand which determines how much is to be supplied.

He argued that if firms find that they are producing more than is being demanded, they will observe an involuntary increase in their inventories of unsold goods and will so rectify this by cutting back on production and laying-off workers. National income will then fall until the value of what is produced is equal to the value of aggregate demand.

If firms find that they are not producing enough to satisfy demand, they will experience an unwanted fall in their inventories and so will attempt to increase production and hire more workers.

There will be one level of national income at which the aggregate demand is equal to the total value of production. This is called the equilibrium level of income. An important point to remember is that, in the Keynesian theory, the equilibrium level of income is not necessarily a full employment income. Even in equilibrium, some amount of involuntary unemployment may be present in the economy.

This is the reason he called his theory a general theory and he regarded the classical theory as a ‘special case’ where the equilibrium and full employment level of income coincide. Another contribution of Keynes is to break the classical dichotomy and to integrate the price theory with the monetary theory. He showed how all the variables — real and monetary — were simultaneously determined in an economic system in which the money was used both as a medium of exchange and as a store of value.

Keynes’s theory has policy implications which are different from the classical theory. Classical economists do not like government intervention in the economy and they think that the government is likely to make things worse by intervening. Thus, they favour monetary policy. On the other hand, Keynes was not in favour of monetary policy. He saw an useful role for the government and recommended the use of fiscal policy for full employment and economic stability.

The influence of Keynes in the development of modern macroeconomics is really profound. Much of the modern macroeconomics is based on Keynes’ work and has been developed by post-Keynesian economists such as Hicks. Hansen, Modigliani, Tobin etc. Post-Keynesian economists have refined and developed some of the ideas introduced by Keynes.

In the post-Keynesian period, macroeconomics have developed in two directions. One school of thought believes that markets work best if left to itself; the other believes that government intervention can significantly improve the performance of the economy. In the 1960s, the debate on these questions involved monetarists on the one side and Keynesians on the other.

In the 1970s, the debate on the same issues brought to the fore a new group — the new classical macroeconomists who, by and large, replaced the monetarists in keeping up the argument against active government intervention to improve economic performance. The new classical macroeconomics remains influential even today. On the other side, the new Keynesians — mostly trained in the Keynesian tradition — are moving beyond it. They do not believe that markets clear all the time but seek to understand and explain why markets may fail.


Macroeconomic Variables

The description and forecasting of macroeconomics require statistics on macroeconomic variables. The most prominent of these variables is the GDP, inflation, interest rates, and unemployment, but there are many others. The Gross Domestic Product (GDP) is the total value of all goods and services produced in one year within the country. GDP also measures total income, since the payments for the total production must go to someone, usually to the producers of those goods and services. For 2015, the GDP for the United States was slightly more than $18 trillion.

Because the measure of GDP depends on payment for the product or service, only those products and services are measured. Activities where legal payments were not made were not reported, so they are not part of the GDP. This includes the domestic services by a stay-at-home spouse and illegal activities by criminals. It also does not include labor paid for under the table.

In major economies, most of these unreported items are only a small fraction of the total GDP, but in many poor countries, unreported payments can constitute a major share of the economy.

Another key macroeconomic variable related to GDP is GDP per capita, which is the amount of GDP per person, found by dividing total GDP by the number of people in the country. This provides a rough estimation of the average income per person, which is useful for comparing living standards. The average global GDP per capita is slightly more than $10,000. In 2015, the GDP per capita ranges from a low of $277.10 USD for Burundi to more than 99,717.70 USD for Luxembourg. The world averages about $10,000 USD. The GDP per capita for the United States was $56,115.70.

Employment and unemployment ratesare also significant macroeconomic variables, especially since they can have a major impact on political elections. Unemployment rises when businesses reduce their production, usually when the economy enters a recession. The unemployment rate falls when the economy is growing. If the economy grows too fast, shortages may increase, leading to higher prices.

Another key macroeconomic variable is inflation, which can result when the supply of money exceeds the demand for money, which occurs when the supply of money increases faster than the economy. People and businesses are negatively impacted by short-run inflation, but over the long term, the economy adapts to the greater supply of money, causing higher wages and prices.

The main beneficiary of inflation is the government, since the government can create more money before it has an impact on prices. Often, crooked governments will print massive amounts of money to enrich government employees and policymakers and to pay government bills. For instance, the annual inflation rate in Zimbabwe exceeded 231,000,000% in 2008, when it was reported that some people were using Zimbabwean dollars as toilet paper. In fact, Zimbabwe issued a $100 trillion bill, which is the highest denomination ever issued for any currency.

This type of hyperinflation causes people to trade the hyperinflated currency for more stable currency of other countries, such as the American dollar. The currency exchanges are made as quickly as possible, before the currency falls even further in value, which can happen in hours. If the currency cannot be exchanged, then purchases are made as soon as possible, since the maximum real value can be received by immediately exchanging the hyperinflated currency for something else, whether it be other currencies or for goods and services.

Another important variable is interest rates, which is the cost of credit, the cost of borrowing money. Although there are many types of interest rates, the prime rate, which is the interest rate that a sound business qualifies for, is often published in the newspapers. Central banks have significant control over the interest rate, since they can set interest rates for other banks and they can also control the money supply. A greater supply of moneyleads to lower interest rates, while a contraction of the money supply has the opposite effect. When the interest rate set by the central bank is already near 0 or even 0, then the central bank may turn to what is called quantitative easing, where money is created and placed within the economy by buying longer-term government debt from primary dealers of the central bank.

Interest rates affect not only how much consumers will borrow, but it will also affect how much businesses will borrow, especially since businesses will only borrow if they can invest the money for a higher expected return than the interest rate on the borrowed funds.

So, if a business project is expected to return 10%, a business will borrow if the interest rate on the loan is 6% but not if it is 12%, since the business can earn a net 4% in the 1st case, but lose 2% in the 2nd.


What is Macroeconomics?
• Macroeconomics is a branch of economics which studies the economy as a whole. It deals with the performance, structure and behavior of economy at national or regional level.
• It studies about aggregated indicators such as GDP, Unemployment Rates and Price Indices to understand how the whole economy functions.
• It develops models that explain the relationship between such factors as National Income, Output, Consumption, Unemployment, Inflation, Savings, Investment, International Trade and International Finance.

Vital Process of an Economy
By Vital Process we mean process without which an economy cannot exist. There are three vital process of an economy:
1. Production
2. Consumption
3. Investment

A. Production

• In economy the word production includes not only the making of various goods but also the services. For all of us services are also as essential as the goods. In fact, some of the goods cannot be used unless the services are not provided such as Television or Radio cannot be used unless the services of artists or technicians are provided. Thus production includes the goods made and the services provided in an economy.
• There are some services which are provided by family members to themselves or to one another like cooking and washing clothes, cleaning the house, ironing clothes, polishing shoes and so on.
• Such services are also a part of production but when it comes to measurement of the value of these services, problems arise about getting the required data of the quantity and value of these services. As such, in practical estimates, these services are left out of production.
• Similarly, all leisure time, activities such as growing fruits, flowers and vegetables in garden are also excluded from production for the same reason.

B. Consumption
• It is defined as an activity concerned with using up of goods and services for direct satisfaction of wants. In other words, consumption is an act of satisfying one’s wants.
• Consumption also includes consumption of both goods and services. For Example: we consume food, clothes, furniture etc. We use services of tailors, barbers, washerman, repairers, tutors ect.
• Consumption activity takes place as soon as we buy these goods and services. In other words, by consumption we mean acquiring of goods and services for consumption.
• All purchases by households, with an exception of purchase of a house, are consumption purchases.

C. Investment
• Whatever is produced during a year is not generally acquired for consumption in that year and is kept for future use in order to acquire more monetary amount or benefits.
• Goods lying with production units as raw materials in the process of production to satisfy the demands are also investment which will bear the result in future.
• Investment in fixed capitals by production units like machines, equipments, vehicles, buildings etc. during the year which are also known as durable use goods. Such components are meant to production of goods which may or may not be used in the same year and are kept for future use are also known as investment.
• During a particular year the goods are exceeding the production because of investment in various levels.

Production, consumption and investment processes are interrelated in the following manner
• First, production is the source of consumption and investment. If there is no production there would be no consumption and investment. Given production, if there is more consumption less would be available for investment.
• Second, consumption provides motivation for production and investment. If there is no need for consumption, there is no need to invest and produce.
• Third, investment determines the level of production. The more we invest, the more we can produce.
• Fourth, saving is the major source of financing investment. More saving means more investment which in turn means more production leading to more consumption and investment.


What is meant by national income?

National income measures the monetary value of the flow of output of goods and services produced in an economy over a period of time.

The national income of a country can be measured by three alternative methods: (i) Product Method (ii) Income Method, and (iii) Expenditure Method.

1. Product Method:

In this method, national income is measured as a flow of goods and services. We calculate money value of all final goods and services produced in an economy during a year. Final goods here refer to those goods which are directly consumed and not used in further production process.

Goods which are further used in production process are called intermediate goods. In the value of final goods, value of intermediate goods is already included therefore we do not count value of intermediate goods in national income otherwise there will be double counting of value of goods.

To avoid the problem of double counting we can use the value-addition method in which not the whole value of a commodity but value-addition (i.e. value of final good value of intermediate good) at each stage of production is calculated and these are summed up to arrive at GDP.

The money value is calculated at market prices so sum-total is the GDP at market prices. GDP at market price can be converted into by methods discussed earlier.

2. Income Method:

Under this method, national income is measured as a flow of factor incomes. There are generally four factors of production labour, capital, land and entrepreneurship. Labour gets wages and salaries, capital gets interest, land gets rent and entrepreneurship gets profit as their remuneration.

Besides, there are some self-employed persons who employ their own labour and capital such as doctors, advocates, CAs, etc. Their income is called mixed income. The sum-total of all these factor incomes is called NDP at factor costs.

3. Expenditure Method:

In this method, national income is measured as a flow of expenditure. GDP is sum-total of private consumption expenditure. Government consumption expenditure, gross capital formation (Government and private) and net exports (Export-Import).


Four Components of Aggregate Demand

Any increase in any of the four components of aggregate demand leads to an increase or shift in the aggregate demand curve as seen in the diagram above.

AD = C + I + G + (X-M)

Components of Aggregate DemandIncrease in the Aggregate Demand Curve

1. Consumption

This is made by households, and sometimes consumption accounts for the larger portion of aggregate demand. An increase in consumption shifts the AD curve to the right.

Factors that Affect Consumption

1. Consumer Confidence

If consumers are confident about their future income, job stability, and the economy is growing and stable, spending is likely to increase. However, any job insecurity and uncertainty over income is likely to delay spending. An increase in consumer confidence shifts AD to the right.

2. Interest Rates

Lower interest rates tend to increase consumption because consumers purchase larger goods on credit. If interest rates are low, then it’s cheaper to borrow. Consumers mostly borrow to buy houses, which is one of the biggest purchases and lower interest rates means lower mortgage payments so that households can spend more on other goods. Some Economists argue that lower interest rates also make saving less attractive, but there is no real evidence. So, lower interest rates increase Aggregate Demand.

3. Consumer Debt

If a consumer has a lot of debt, he is unlikely to buy more since he would have to pay his debt off first. Low consumer debt increases consumption and aggregate demand.

4. Wealth

Wealth is assets held by a household, such as property or stocks. An increase in property is likely increase to consumption.

2. Investment

Investment, second of the four components of aggregate demand, is spending by firms on capital, not households. However, investment is also the most volatile component of AD. An increase in investment shifts AD to the right in the short run and helps improve the quality and quantity of factors of production in the long run.

Factors that Affect Investment

1. Interest Rates

Firms borrow from banks to make large capital intensive purchases, and if the interest rate decreases, it becomes cheaper for firms to invest and provides incentive for firms to take risk.

2. Business Confidence

If firms are confident about the economy and its future growth, they are more likely to invest in capital, new projects and buildings/machinery.

3. Investment Policy

If governments provide incentives such as tax breaks, subsidies, loans at lower interest rates then investment can increase. However, corruption and bureaucracy deters investment.

4. National Income

As firms increase output, they would need to invest in new machines. This relationship is known as The Accelerator. The assumption behind the accelerator is that firms will want to main a fixed capital to output ratio, meaning that if a factory uses one machine to produce 1000 goods, and the firms needs to produce 3000 goods more, then the firm will buy 3 more machines.

3. Government Spending

Government spending forms a large total of aggregate demand, and an increase in government spending shifts aggregate demand to the right. This spending is categorized into transfer payments and capital spending. Transfer payments include pensions and unemployment benefits and capital spending is on things like roads, schools and hospitals. Governments spend to increase the consumption of health services, education and to re-distribute income. They may also spend to increase aggregate demand.

4. Net Exports

Imports are foreign goods bought by consumers domestically, and exports are domestic goods bought abroad. Net exports is the difference between exports and imports, and this component can be net imports too, if imports are greater than exports. An increase in net exports shifts aggregate demand to the right. The exchange rate and trade policy affects net exports.


Five Macroeconomic Goals

1. Non-Inflationary Growth

In other words, this is stable and sustainable economic growth and development that is “real” (non-inflationary) over the long-term. Economic growth in an economy is an outward shift in its Production Possibility Curve (PPC). Another way to define growth is the increase in a country’s total output or Gross Domestic Product (GDP). The objective of the central bank and government would be an increase in economic growth without a rise in the rate of inflation.

2. Low Inflation

Inflation is the sustained increase of the price level. The rate of inflation is the change in inflation over a period. Central banks would like to keep the growth of the rate at which prices increase at low rates. As inflation rises, every dollar you own buys a smaller percentage of a good or service.For example, the U.S. Federal Reserve targets the inflation rate at roughly 2%.

3. Low Unemployment or Full Employment

Full employment occurs when the labor force (this counts as people who are actively seeking jobs or are already employed) is fully employed in productive work. A person is considered to be unemployed if he doesn’t currently doesn’t have a job and is actively searching for one. A lower rate of unemployment means that productivity in the economy is higher. This objective simply means that as many people who want to be employed are employed, so the economy is running at or near full productivity.

4. Equilibrium in Balance of Payments

Equilibrium in Balance of Payments means that a country’s exports or imports should not be much larger than its imports or exports. Having a large balance of payments deficit or surplus is not beneficial for the economy.

5. Fair Distribution of Income

fair or equitable distribution of income means that the gap between the rich and the poor is not too large. Fair or equitable doesn’t mean equal, but fair is a relative concept. What could be fair to one person, may not be fair to another. The government doesn’t want all the wealth concentrated with a small group of people.



An aggregate market s a model that shows the price levels in a country and the levels of production. In other words, it examines supply and demand from a macro level. The model was created in the 1970s, when a more general and flexible study of nations was needed to create accurate growth predictions and predict sudden changes, like severe inflation or rapid unemployment. The aggregate market is made of two distinct parts: the aggregate demand and the aggregate supply.

Aggregate Demand

Aggregate demand is made out of four macroeconomic parts: household, business, government and foreign. Household demands include most private consumption and the individual demand for a variety of services, including things like insurance and debt. Business demand relates to the needs for supplies and services that businesses use in their own operations, and government demand is similar but focused on the public sector. Foreign demand refers primarily to exports that profit businesses within the nation.

Aggregate Supply

Aggregate supply is a measurement of real production, or how many goods are actually being produced to meet the demand. This is typically divided into long-run and short-run examinations. The long run look shows how many goods are being produced from the perspective of years, while the short run shows how supply has spiked or fallen within a much shorter framework, typically only one year. Together they show a useful picture of the nation’s supply growth.


The purpose of aggregate market studies is to compare the aggregate demand and supply. In a perfect system the two would be in equilibrium. In other words, all real production would exactly meet the demand in the four sectors. But equilibrium is never reached in a constantly changing system, although economies that are close to equilibrium tend to be the most stable and most successful. A retreat from equilibrium typically indicates a macroeconomic problem.


Differences between the GDP Deflator and CPI

To measure changes in the overall price level in an economy, policy makers and economists monitor a number of different economic indicators. The two most important ones are the GDP deflator and the Consumer Price Index (CPI). Even though they usually show similar results, there are two important differences between the GDP deflator and CPI that can cause them to diverge: (1) they reflect a different set of prices and (2) they weigh prices differently.

1) They Reflect a Different Set of Prices

The GDP deflator measures the price level of all goods and services that are produced within the economy (i.e. domestically). Meanwhile, the Consumer Price Index measures the price level of all goods and services that are bought by consumers within the economy. That means, the GDP deflator does not include changes in the price of imported goods, while the CPI does not account for changes in the price of exported goods. In addition to that, the CPI represents a fraction of all domestically produced goods and services, because it exclusively focuses on consumer goods. 

For example, let’s say the price of a Boeing 747 Jumbo Jet increases. Since Boeing is a US company, this shows up in the US GDP. As a result, the GDP deflator increases. However, a Boeing 747 is certainly not part of the market basket bought by typical US consumers. Therefore, the price increase will not affect the CPI. Thus, the increase in the price of a Boeing 747 has an effect on the GDP deflator but no effect on CPI.

To give another example, assume the price of a Toyota Corolla (i.e. one of the best-selling cars in the US) increases. This has no effect on US GDP, because Toyota is a Japanese company. However, typical consumers in the United States buy Toyota Corollas, so the car is part of the typical basket of goods used to calculate CPI. Hence, the increase in the price of a Toyota Corolla has an effect on CPI but not on the GDP deflator.

2) They Weigh Prices Differently

The CPI weighs prices against a fixed basket of goods and services, whereas the GDP deflator examines all currently produced goods and services. As a result, the goods used to calculate the GDP deflator change dynamically, whereas the market basket used for calculating CPI must be updated periodically. This can lead to diverging results if the prices of goods represented in both indicators don’t change proportionally. In other words, when the prices of some goods increase or decrease more than others, the two indicators may react differently.

For example, let’s look at the prices of Ford trucks. Ford is an American company that sells its cars and trucks within the United States and abroad. As a matter of fact, Ford ranks in the top 10 for biggest US export companies (by asset value) and cars sold within the US at the same time. As a result, changes in the price of a Ford truck show up in both the GDP deflator and CPI. Ford Trucks are produced in the US and also bought by typical US consumers. However, if Ford Trucks are weighed more heavily in the GDP deflator than in the CPI market basket, the price increase will have a higher impact on the GDP deflator. This will cause the two indicators to diverge.

In a Nutshell

To measure the increase in the overall price level in an economy, policy makers and economists usually monitor both the GDP deflator as well as the Consumer Price Index (CPI). Even though the two indicators usually show similar results, there are two important differences between the GDP Deflator and CPI that can cause them to diverge. First, they reflect a different set of prices and second, they weigh prices differently.


What is a ‘Money Market’

The money market is where financial instruments with high liquidity and very short maturities are traded. It is used by participants as a means for borrowing and lending in the short term, with maturities that usually range from overnight to just under a year. Among the most common money market instruments are eurodollar deposits, negotiablecertificates of deposit (CDs), bankers acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase agreements (repos).

How are interest rates determined: the lender perspective

The logic behind interest rate calculations is pretty straightforward, and it generally boils down to perceived risk. When a lender gives you money in the form of a loan, they’re essentially betting that you’ll pay that money back. If it is a good bet that you’ll pay the money back, lenders are generally willing to accept a smaller rate on the loan. If, on the other hand, the lender believes that there is a relatively good chance that you won’t pay the loan back, they’ll want to charge a higher rate as compensation for accepting the increased risk associated with you as a borrower.

This underlying risk/reward logic isn’t just a factor in lending. It’s actually an important influence in economic systems and consumer decision-making – impacting everything from financial markets to international relations.

So how do lenders determine how much risk they should associate with a given borrower? In most cases, potential factors that lenders evaluate in determining an interest rate for a given borrower include:

  • Credit score: A credit score is a numeric representation of a borrower’s creditworthiness determined by a number of factors, including payment and default history on revolving debt obligations; history of collections, liens, or judgments; ratio of revolving debt to credit available; and recent credit activity.1
  • Loan to Value (LTV) ratio: The amount you’re borrowing divided by the value of the vehicle you’re purchasing. The lower this ratio, the less risk the lender is accepting, so providing a down payment to reduce the LTV of the loan can reduce the rate you’re charged by the lender.
  • Loan amount: In some cases, different loan amounts are associated with different levels of risk.
  • Debt ratio: The ratio of your monthly payment obligations (generally only revolving debt obligations) to your monthly income. Financing a vehicle will increase your monthly payment obligations, so the lender will want to make sure that your debt ratio will remain at an acceptable level after including the vehicle payment.

How are interest rates determined: the macroeconomic perspective

At the beginning of the article we stated that the answer to how interest rates are determined depends on who you ask – so, other than lenders, who else could we ask? Many economists study consumer lending rates, and most will tell you that, in addition to the micro-story about how rates are determined, there are a number of macroeconomic factors at work that move consumer lending rates in one direction or another.

At a macroeconomic level, one of the most important factors in determining interest rates in automotive lending is the cost of funds2 to the lenders themselves – or, in other words, the amount they’re paying for the money they intend to lend to consumers. Automotive lenders aren’t necessarily banks or money houses with spare cash lying around that they lend to consumers. In many cases, they’re actually intermediaries that buy money in credit markets3 by selling bonds or other financial instruments and then lending the proceeds of these sales to consumers. Their business model is to profit on the margin between the rate they’re paying to borrow the money and the rate they’re charging consumers. The rates they charge consumers fluctuate on the basis of the rates they pay, and the rates they pay depend on the amount of capital available on these credit markets.

So what determines the availability of, and demand for, capital in credit markets? Broadly speaking, both the supply of capital available in credit markets and the demand for the available capital are a reflection of economic activity. In general, when the economy is doing well, various actors in the economy (individuals, corporations, banks, etc.) earn more money than they intend to spend, and rather than leave their spare cash in a bank account, they invest it in financial instruments likely to yield a return. Some of it makes its way into credit markets, increasing the supply of credit available and driving consumer lending rates down.4

The other half of the story is the demand for this capital. When the economy is doing well, people buy more merchandise, including cars. When demand for consumer goods increases, demand for credit increases, and consumer lending rates increase as a result. So in macroeconomic terms, the rates consumers are charged for automotive loans are the result of a balancing of credit market factors.5

What does all of this macroeconomic theory mean for the average borrower? Through 2014 and 2015, not a lot. Average new car loan rates for prime borrowers increased from 3.61% to 3.67% from Q1 2014 to Q1 2015.6 New car loan rates increased from 10.79% to 10.96% for subprime borrowers over the same period. In the near term, auto lending rates appear stable – probably an indication that, for the time being, credit supply and demand are near equilibrium. 


Demand and Supply of Labour (Explained With Diagram)

Although labour has certain peculiarities and cannot be regarded as a commodity, still wages are very largely determined by the interaction of the forces of demand and supply.

Demand for Labour:

The demand for labour is a derived demand. It is derived from demand for the commodities it helps to produce. The greater the consumers’ demand for the product, the greater the producers’ demand for the labour required in making it. Hence an expected increase in the demand for a commodity will increase the demand for the type of labour that produces this commodity.

The elasticity of demand for labour depends, therefore, on the elasticity of demand for its output. Demand for labour will generally be inelastic if their wages form only a small proportion of the total wages. The demand, on the other hand, will be elastic if the demand for the commodity it produces is elastic or if cheaper substitutes are available.

The demand for labour also depends on the prices of the co-operating factors. Suppose the machines are costly, as is the case in India, obviously more labour will be employed. The demand for labour will increase. Another factor that influences the demand for labour is the technical progress. In some cases, labour and machinery are used in a definite ratio. For instance, the introduction of automatic looms reduces the demand for labour.

After considering all relevant factors, e.g., demand for the products, technical conditions, and the prices of the co-operating factors, the wages are governed by one fundamental factor, viz., marginal productivity. Just as there is a demand price of commodities, so there is a demand price for labour.

The demand for labour, under typical circumstances of a modern community, comes from the employer who employs labour and other factors of production for making profits out of his business. The demand price of labour, therefore, is the wage that an employer is willing to pay for that particular kind of labour.

Suppose an entrepreneur employs workers one by one. After a point, the law of diminishing marginal returns will come into operation. Every additional worker employed will add to the total net production at a decreasing rate. The employer will naturally stop employing additional workers at the point at which the cost of employing a worker just equals the addition made by him to the value of the total net product.

Thus, the wages that he will pay to such a worker (the marginal unit of labour) will be equal to the value of this additional product or marginal productivity. But since all the workers may be assumed to be of the same grade, what is paid to the marginal worker will be paid to all the workers employed. This is all about the demand side of labour. Now let us consider the supply side.

Supply of Labour:

By the supply of labour, we mean the various numbers of workers of a given type of labour which would offer themselves for employment at various wage rates.

The supply of labour may be considered from two view-points?

(a) Supply of labour to the industry and

(b) Supply of labour to the entire economy.

For an industry, the supply of labour is elastic. Hence, if a given industry wants more labour, it can attract it from other industries by offering a higher wage. It can also work the existing labour force over-time. This in effect will mean an increase in supply. The supply of labour for the industry is subject to the law of supply, i.e., low wage, small supply and high wage, large supply. Hence, the supply curve of labour for an industry rises upwards from left to right.

The supply of labour for the entire economy depends on economic, social and political factors or institutional factors, e.g., attitude of women towards work, working age, school and college leaving age and possibilities of part-time employment for students, size and composition of the population and sex distribution, attitude to marriage, the size of the family, birth control, standard of medical facilities and sanitation, etc.

The supply of labour may be decreased by workers refusing to work for a time. This happens when labour is organised into trade unions. The workers may not accept wages offered by the employer if such wages do not ensure the maintenance of a standard of living to which they are accustomed.

But, as we shall see, it is only when higher wages are justified by higher marginal productivity that high wages will be paid. Thus, workers with low marginal productivity cannot demand high wages merely on the basis of their standard of living. On the whole, we might say that, the number of potential workers being given, the supply of labour may be defined as the schedule of units of labour at the prevailing rates of wages.

This depends on two factors:

(a) The number of workers who are willing and able to work at different wages;

(b) The number of working hours that each Worker is willing and able to put in at different wages.

In case the workers have no staying power and the only alternative to work is starvation, the supply of labour in general will be perfectly inelastic. This means that wages can he driven down. Over a short period, reduction in wages may not cause any reduction in the supply of labour. For any industry over a long period, the supply curve will slope upwards from left to right. In other words, supply will be somewhat elastic in the long run.

Backward Sloping Supply Curve of Labour:

While labour’s supply curve sloping upwards from left to right is the general rule, an exceptional case of labour’s supply curve may also be indicated (see Fig. 31.1) When the workers’ standard of living is low, they may be able to satisfy their wants with a small income and when they have made that much, they may prefer leisure to work. That is why it happens that, sometimes, increase in wages leads to a contraction of the supply of labour. This is represented by a backward-sloping supply curve as under.

For some time this particular individual is prepared to work long hours as the wage goes up (wage is represented on OY—axis in Fig. 31.1). But beyond OW wage, he will reduce rather than increase his working hours.

Backward Bending Supply Curve of Labour

Determination of Wages

However, this backward sloping Curve may sometimes be true of certain workers, the supply curve of labour to industry as a whole will normally slope upwards from left to right (as shows in Fig. 31.2)

Interaction of Demand and Supply:

We have now analysed the demand side as well as the supply side of labour. We shall now see how their interaction determines the wage level. This is shown in Fig. 31.2

Long-run Equilibrium Wage-rate

In this diagram, we have shown the wage determination of a particular type of labour for an industry. The curve SS represents supply of labour to the industry. DD is the demand curve for labour of that industry. Demand and supply curves intersect at E. Therefore, the wage rate OW (= NE) will be established. The equilibrium wage rate will change if the demand and/or supply conditions change.

Under competitive conditions, wage rate in the long run will be equal to both the marginal revenue product and the average revenue product. If the wage rate is less than the average revenue product, the firms would be earning supernormal profits. As a result, new firms will enter the industry and the demand for labour will increase which will push up the wage rate so as to be equal to average revenue product.

On the other hand, if the wage rate is above the average revenue product, the firms will be suffering losses. As a result, some firms will leave the industry and demand for labour will decrease which will force the wage-rate down. Fig. 31.2 shows the long-run equilibrium of the firms under perfect competition. This diagram shows that long-run equilibrium wage rate is OW. At wage rate OW, the firm is employing ON number of labour. This OW rate is equal to marginal revenue product (MRP) and average revenue product (ARP) at point E. The point E is the equilibrium position of the firm in the long run.

We have so far concerned ourselves with the problem of how wages in general are determined. But is there any general rate of wages?

If labour had been like any other commodity, it would also have been sold in the market at the same rate. But as you know, labour is peculiar in certain respects. Labourers differ in efficiency. They are less mobile than goods. Their supply cannot be increased to order and it is a most painful process to reduce I hem. If a day is lost, its labour is lost with it. For these and other reasons, a uniform rate of earnings for workers is not possible. There is thus no prevailing rate of wages similar to the prevailing rate of interest or prevailing price of a good.

All over the world, labour is spat up into a very large number of groups and sub-groups, each with a different level of wages. Even within the same group, the differences are ever so many. Consequently there cannot possibly be a general rate of wages. All that can be done is to and out an average rate which can be discovered by dividing the total amount paid to a given group of workers by the total number of workers in it. The fact is that the wages differ from occupation to occupation. Wages are relative.