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We have so far talked about the national income, price level, rate f interest etc. in an ad hoc manner – without investigating the forces that govern their values. The basic objective of macroeconomics is to develop theoretical tools, called models, capable of describing the processes which determine the values of these variables. Specifically, the models attempt to provide theoretical explanation to questions such as what causes periods of slow growth or recessions in the economy, or increment in the price level, or a rise in unemployment. It is difficult to account for all the variables at the same time. Thus, when we concentrate on the determination of a particular variable, we must hold the values of all other variables constant. This is a stylisation typical of almost any theoretical exercise and is called the assumption of ceteris paribus, which literally means ‘other things remaining equal’. You can think of the procedure as follows – in order to solve for the values of two variables x and y from two equations, we solve for one variable, say x, in terms of y from one equation first, and then
substitute this value into the other equation to obtain the complete solution. We apply the same method in the analysis of the macroeconomic system.
EX ANTE AND EX POST
In the chapter on National Income Accounting, we have come across terms like consumption, investment, or the total output of final goods and services in an economy (GDP). These terms have dual connotations. In Chapter 2 they were used in the accounting sense – denoting actual values of these items as measured by the activities within the economy in a certain year. We call these actual or accounting values ex post measures of these items. These terms, however, can be used with a different connotation. Consumption may denote not what people have actually consumed in a given year, but what they had planned to consume during the same period. Similarly, investment can mean the amount a producer plans to add to her inventory. It may be different from what she ends up doing. Suppose the producer plans to add Rs 100 worth goods to her stock by the
end of the year. Her planned investment is, therefore, Rs 100 in that year. However, due to an unforeseen upsurge of demand for her goods in the market the volume of her sales exceeds what she had planned to sell and, to meet this extra demand, she has to sell goods worth Rs 30 from her stock. Therefore, at the end of the year, her inventory goes up by Rs (100 – 30) = Rs 70 only. Her planned investment is Rs 100 whereas her actual, or ex post, investment is Rs 70 only. We call the planned values of the variables – consumption, investment or output of final goods – their ex ante measures. In a theoretical model of the economy the ex ante values of these variables should be our primary concern. If anybody wants to predict what the equilibrium value of the final goods, output or GDP will be it is important for her to know what quantities of the final goods people plan to demand or supply. We must, therefore, learn about the determinants of the ex ante values of consumption, investment or aggregate output of the economy.
1. What is marginal propensity to consume? How is it related to marginal propensity to save?
2. What is the difference between ex ante investment and ex post investment?
3. What do you understand by ‘parametric shift of a line’? How does a line shift when its (i) slope decreases, and (ii) its intercept increases?
4. What is ‘effective demand’? How will you derive the autonomous expenditure multiplier when price of final goods and the rate of interest are given?
5. Measure the level of ex-ante aggregate demand when autonomous investment and consumption expenditure (A) is Rs 50 crores, and MPS is 0.2 and level of income (Y) is Rs 4000 crores. State whether the economy is in equilibrium or not (cite reasons).
6. Explain ‘Paradox of Thrift’.
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