[As per the Revised Syllabus of Courses of Bachelor of Management Studies (BMS),B.Com. – Financial Markets (BFM), B.Com. – Investment Management (BIM)

andB.Com. – Banking & Insurance (BBI) Programme at Semester IV

with effect from the Academic Year 2017-18]

Dr. D. M. MITHANIProfessor,

Executive Development CenterUUM, Malaysia

Formerly Reader,Department of Commerce,

University of Mumbai.

Dr. GAIKAR VILAS BHAUM.A. (Economics), M.A. (Political Science),B.Ed, GDC&A, UGC-NET, M.Phil., Ph.D.,

Ph.D. Guide in Business Economics, University of Mumbai.

Assistant Professor,Department of Economics,

Smt. CHM. College,Ulhasnagar - 421 003, Dist. Thane.

(Affiliated to the University of Mumbai)Maharashtra, India.

BUSINESSBUSINESSBUSINESSBUSINESSBUSINESSECONOMICS-IIECONOMICS-IIECONOMICS-IIECONOMICS-IIECONOMICS-II

ISO 9001 : 2008 CERTIFIED

© D.M. MITHANINo part of this publication shall be reproduced, stored in a retrieval system, or transmitted in any form or by any means,electronic, mechanical, photocopying, recording and/or otherwise without the prior written permission of the author andthe publisher.

FIRST EDITION : 2018

Published by : Mrs. Meena Pandey for Himalaya Publishing House Pvt. Ltd.,“Ramdoot”, Dr. Bhalerao Marg, Girgaon, Mumbai - 400 004.Phone: 022-23860170/23863863; Fax: 022-23877178E-mail: himpub@vsnl.com; Website: www.himpub.com

Branch Offices :

New Delhi : “Pooja Apartments”, 4-B, Murari Lal Street, Ansari Road, Darya Ganj,New Delhi - 110 002. Phones: 011-23270392, 23278631; Fax: 011-23256286

Nagpur : Kundanlal Chandak Industrial Estate, Ghat Road, Nagpur - 440 018.Phones: 0712-2738731, 3296733; Telefax: 0712-2721215

Bengaluru : Plot No. 91-33, 2nd Main Road, Seshadripuram, Behind Nataraja Theatre, Bengaluru - 560 020.Phones: 080-41138821; Mobile: 09379847017, 09379847005

Hyderabad : No. 3-4-184, Lingampally, Besides Raghavendra Swamy Matham, Kachiguda,Hyderabad - 500 027. Phones: 040-27560041, 27550139; Mobile: 09390905282

Chennai : New No. 48/2, Old No. 28/2,Ground Floor, Sarangapani Street, T. Nagar, Chennai - 600 012.Mobile: 09380460419

Pune : First Floor, “Laksha” Apartment, No. 527, Mehunpura, Shaniwarpeth, (Near Prabhat Theatre),Pune - 411 030. Phones: 020-24496323, 24496333; Mobile: 09370579333

Lucknow : House No. 731, Shekhupura Colony, Near B.D. Convent School, Vikas Nagar, Aliganj,Lucknow - 226 022. Mobile: 09307501549

Ahmedabad : 114, “SHAIL”, 1st Floor, Opp. Madhu Sudan House, C.G. Road, Navrang Pura,Ahmedabad - 380 009. Phone: 079-26560126; Mobile: 09377088847

Ernakulam : 39/176 (New No. 60/251), 1st Floor, Karikkamuri Road, Ernakulam, Kochi - 682 011, Kerala.Phones: 0484-2378012, 2378016; Mobile: 09344199799

Bhubaneswar : Plot No. 214/1342/1589, Budheswari Colony, Behind Durga Mandap, Laxmisagar,Bhubaneswar - 751 006. Phone: 0674-2575129; Mobile: 09338746007

Kolkata : 108/4, Beliaghata Main Road, Near ID Hospital, Opp. SBI Bank, Kolkata - 700 010.Phone: 033-32449649; Mobile: 09883055590, 07439040301

DTP by : Sudhakar Shetty

Printed at : Rose Fine Arts, Mumbai, on behalf of HPH.

PREFACEWe are pleased to present the book on “Business Economics-II” for Second Year BMS,

BBI, BIM and BFM, Semester IV, University of Mumbai with effect from the Academic Year2017-18.

This book is designated to enable the students to understand the subject with its deepness.The book will also cater to the needs of all those desiring to make a mark in the field of BusinessEconomics.

The work in the present book is very simple presentation of the facts and figures based onknowledge and learning.

This book is also useful for students appearing for the professional and competitive examinations.The book covers the various topics such as in Unit-I: Introduction to Macroeconomic Data

and Theory Money: has covered Macroeconomics, Circular Flow of Aggregate Income and Expenditure,The Measurement of National Product, Short Run Economic Fluctuations, The Keynesian Principleof Effective Demand, Unit-II Includes Money Supply, Demand for Money, Money and Prices,Inflation, Monetary Policy. Unit-III consists of Role of a Government, Fiscal Policy, Instrumentsof Fiscal Policy, and Union Budget. The last Unit-IV focuses on open economy: Theory and issuesof international trade includes the Basis of International Trade, Foreign Investment, Balance ofPayments, Foreign Exchange and Foreign Exchange Market.

The present book has strong capacity to understand the terminologies and concepts givenin the syllabus with the latest data statistics. The book is written in a very simple and lucid mannerto understand with simplicity.

We take this opportunity to express our deep sense of gratitude to thank Hon. Mr. K.N.Pandey, Director, Himalaya Publishing House Pvt. Ltd., Mumbai. We also offer our sincere thanksto Mr. S.K. Srivastava and the entire team for bringing the book in time.

Any suggestions from the faculties of Economics and Business Economics as well as readersand the students are welcome to improve the further editions of the book.

December, 2017 AUTHORS

SYLLABUS

MODULES AT A GLANCE

Sr. No. Modules No. ofLectures

1 Introduction to Macroeconomic Data and Theory 15

2 Money, Inflation and Monetary Policy 15

3 Constituents of Fiscal Policy 15

4 Open Economy: Theory and Issues of International Trade 15

Total 60

Sr. No. Modules/Units

1 INTRODUCTION TO MACROECONOMIC DATA AND THEORY

Macroeconomics: Meaning, Scope and Importance.

Circular Flow of Aggregate Income and Expenditure: Closed and Open Economy Models.

The Measurement of National Product: Meaning and Importance – Conventional and GreenGNP and NNP Concepts – Relationship between National Income and Economic Welfare.

Short-run Economic Fluctuations: Features and Phases of Trade Cycles.

The Keynesian Principle of Effective Demand: Aggregate Demand and Aggregate Supply– Consumption Function – Investment Function – Effects of Investment Multiplier on Changesin Income and Output.

2 MONEY, INFLATION AND MONETARY POLICY

Money Supply: Determinants of Money Supply – Factors Influencing Velocity of Circulationof Money.

Demand for Money: Classical and Keynesian Approaches and Keynes’s Liquidity PreferenceTheory of Interest.

Money and Prices: Quantity Theory of Money – Fisher’s Equation of Exchange – CambridgeCash Balance Approach.

Inflation: Demand-pull Inflation and Cost-push Inflation – Effects of Inflation – Natureof Inflation in a Developing Economy.

Monetary Policy: Meaning, Objectives and Instruments, Inflation Targeting.

3 CONSTITUENTS OF FISCAL POLICY

Role of a Government to Provide Public Goods – Principles of Sound and Functional Finance.

Fiscal Policy: Meaning, Objectives – Contra Cyclical Fiscal Policy and Discretionary FiscalPolicy.

Instruments of Fiscal Policy: Canons of Taxation – Factors Influencing Incidence of Taxation– Effects of Taxation – Significance of Public Expenditure – Social Security Contributions– Low Income Support and Social Insurance Programmes – Public Debt – Types, PublicDebt and Fiscal Solvency, Burden of Debt Finance.

Union Budget: Structure – Deficit Concepts – Fiscal Responsibility and Budget ManagementAct.

4 OPEN ECONOMY: THEORY AND ISSUES OF INTERNATIONAL TRADE

The Basis of International Trade: Ricardo’s Theory of Comparative Cost Advantage –The Heckscher-Ohlin Theory of Factor Endowments – Terms of Trade – Meaning and Types,Factors Determining Terms of Trade – Gains from Trade – Free Trade versus Protection.Foreign Investment: Foreign Portfolio Investment – Benefits of Portfolio Capital Flows –Foreign Direct Investment – Merits of Foreign Direct Investment – Role of MultinationalCorporations.Balance of Payments: Structure – Types of Disequilibrium – Measures to Correct Disequilibriumin Balance of Payments.Foreign Exchange and Foreign Exchange Market: Spot and Forward Rate of Exchange– Hedging, Speculation and Arbitrage – Fixed and Flexible Exchange Rates – Managed Flexibility.

QUESTION PAPER PATTERN

Maximum Marks: 75

Questions to be Set: 05

Duration: 2 ½ Hours

All Questions are Compulsory Carrying 15 Marks each.

Question No. Particular s Marks

Q.1 Objective Questions 15 Marks(A) Sub-questions to be asked (10) and to be answered (any 08) 15 Marks(B) Sub-questions to be asked (10) and to be answered (any 07)(*Multiple Choice/True or False/Match the Columns/Fill in the Blanks)

Q.2 Full Length Question 15 MarksOR

Q.2 Full Length Question 15 Marks

Q.3 Full Length Question 15 MarksOR

Q.3 Full Length Question 15 Marks

Q.4 Full Length Question 15 MarksOR

Q.4 Full Length Question 15 Marks

Q.5 (A) Theory Questions 08 Marks(B) Theory Questions 07 MarksOR

Q.5 Short Notes 15 MarksTo be asked (05)To be answered (03)

Note: Theory question of 15 Marks may be divided into two sub-questions of 7/8 and 10/5 Marks.If the topic demands, instead of practical questiions, appropriate theory questiion may be asked.

CONTENTSUnit 1: Introduction to Macroeconomic Data and Theory

1. Macroeconomics: Meaning, Scope and Importance 1 – 62. Circular Flow of Aggregate Income and Expenditure 7 – 123. The Measures of National Product: National Income 13 – 224. Short-run Economic Fluctuations: Trade Cycles 23 – 275. The Keynesian Principle of Effective Demand 28 – 396. Consumption Function 40 – 447. Investment Function 45 – 508. Investment Multiplier 51 – 58

Unit 2: Money, Inflation and Monetary Policy

9. Money Supply 59 – 7110. Demand for Money 72 – 8311. Money and Prices 84 – 9512. Inflation 96 – 11813. Monetary Policy 119 – 131

Unit 3: Constituent of Fiscal Policy

14. Role of Government — Principles of Sound and Functional Finance 132 – 14315. Fiscal Policy 144 – 15116. Instrument of Fiscal Policy 152 – 15517. Incidence of Taxation 156 – 16118. Effect of Taxation 162 – 17119. Public Expenditure 172 – 18120. Public Debt 182 – 19121. Union Budget 2015-16 192 – 203

Unit 4: Open Economy: Theory and Issues of International Trade

22. The Basic of International Trade 204 – 21223. Heckscher-Ohlin Theory of Factor Endowments 213 – 22324. Terms of Trade 224 – 24425. Gains from Trade 245 – 25026. Free Trade vs. Protection 251 – 25927. Foreign Investment 260 – 26928. Balance of Payments 270 – 27629. 277 – 285Foreign Exchange and Foreign Exchange Markets

Model Question Paper 286 – 287

MMACROECONOMICS:MEANING, SCOPE AND

IMPORTANCE

1

- 1 -

1. MEANING OF MACROECONOMICS

Macroeconomics is the study of the aggregate behaviour of the economy as a whole. It isconcerned with the macroeconomic problems such as the growth of output and employment, nationalincome, the rates of inflation, the balance of payments, exchange rates, trade cycles, etc. In itsstudy, we examine the interrelationships and interaction among ,various aggregates, their determinantsand causation.

According to Prof. Ackley: “Macroeconomics deals with economic affairs ‘in the large’, itconcerns the overall dimensions of economic life.” In short, macroeconomics deals with the majoreconomic issues, problems and policies of the present times.

Macroeconomics is the study of the major economic “aggregates” or totals. National income, money,total investment, savings, unemployment, inflation, balance of payments, exchange rates, etc. are thecrucial economic aggregates.

Microeconomics is a fascinating subject and challenging too, because it takes an overview ofthe functioning and relationships in the whole economy by reducing complicated details to comprehensiveand manageable essentials. In macroeconomic analysis the behaviour of economic agents such asfirms, households and government is seen in total, disregarding details at the particular level, i.e.,micro level.

An individual consumer, particular market for a given commodity, operation of a firm, etc.are the subject matter of economics. Macroeconomics deals with the market for all goods as awhole. It is considered as the product or commodity market in general. Similarly, labour market istaken as a whole for the entire labour force in the economy. Likewise, financial market is taken asa whole which covers money market, capital market and all banking and” non-banking institutionstaken together.

There is no basic conflict between microeconomics and macroeconomics, because, the aggregateof the whole economy is composed by the sum of individual units and sub-markets. In microeconomics,we study the pricing of a particular commodity. In macroeconomics we study the price level.

Methodology of macroeconomics, however, differs from that of the microeconomics. Inmicroeconomic analysis, it is assumed that total output and the general price level of the economyare given; and then an explanation is provided for the determination of equilibrium price and

Unit 1: Introduction to Macroeconomic Data and Theory

2 BUSINESS ECONOMICS - II

output of an individual product. In macroeconomic analysis, we assume distribution of incomeand relative prices as given and seek to explain determination of total output/income and the generalprice level.

It must, however, be recognised that in reality changes in microeconomic variables carrytheir impact on the macroeconomic variables, and vice versa. Therefore, a complete understandingof economic science requires the study of both micro and macroeconomics.

Prior to Keynesian revolution in economic thinking in the 1930s, the classical economistshad concentrated more on microeconomic approach and macro behaviour was also described asmere summation of individual observations. Prof. J.M. Keynes in 1936 published The GeneralTheory of Employment, Interest and Money which revolutionised the whole economic thinking.He suggested that macro economic behaviour should be studied separately. Behaviour in total isquite different then what we may try to infer by summation of individual behaviour. He said that,for instance, saving is a private virtue but it is a public vice in a matured economy cause deficiencyof demand leading to depression.

Keynes prescribed macroeconomics as a policy-oriented science to deal with the problemslike unemployment, inflation etc. Economics of Keynes serves as the foundation centre for themodern economics.

It follows that the score of macroeconomics is confined with the behaviour of the economy intotal. It does not examine individual behaviour. It relates to the economy-wide total or aggregatesand problems of general nature. Its policies are general.

The subject matter of macroeconomics include the theory of income and employment, theoryof money and banking, theory of trade cycles and economic growth.

Macroeconomics deals with economic activity as a whole,The functioning of the economic system and the course of economic activity may be viewed

from the long-run and short-run point of view.In macroeconomic analysis, short-run is an immediate period and short span of time, covering

a year or a few years, at the most, During short-run economic activity is assumed to be under giventechnological conditions, given habits of people, given population, availability of labour force etc.Short-run changes are not dynamic and do not radically change the norm of economic activity.

Long run is a long span of time running over decades together. Long run involves dynamicchanges. The classical economists assumed long-run analysis. In their view long-run equilibriumis automatic and there is full employment level. The classical assumption of full employmentcondition was based on the Say’s law of market. (This we shall discuss in detail at later stage in thebook).

Keynes, however, asserted that we should adopt a short run analysis, because in the long-runwe are all dead. Short-run is more realistic. We should seek to solve our problem from short-runpoint of view.

In a developing economy under planning, however, we consider short-run and long-run viewstogether. India’s Five Year Plans are short-run plans with annual set-up of budgetary expenditures.But, the planning as a whole has a long-term perspective for at least 15 years in view.

In cyclical behaviour of economic activity in a capitalist economy also we look into minorcycles and major cycles on long-term considerations. While, we may also see seasonal variationsin short-term view of the economic and business activity.

MACROECONOMICS: MEANING, SCOPE AND IMPORTANCE 3

We may have short-term budgetary policy for a year and a long-term fiscal policy covering anumber of years together.

2. SCOPE AND SUBJECT MATTER OF MACROECONOMICS

Macroeconomic theories provide explanation to inter-relationship and causation among differentmacroeconomic variables and issues relating to the aggregate economic behaviour and the associatedproblems.

Set of macro-theories differ from that of the micro-theories. The former deals with aggregates;while, the latter deal with individual units.

There are a number of macroeconomic theories. These are —Theory of income and employment — Classical and Keynesian.Theories of trade cycles:(a) Pure monetary theory of trade cycle.(b) Monetary over-investment theory.(c) Non-monetary over-investment theory.(d) Under-consumption theory.(e) Psychological theory.(f) Innovation theory.(g) Keynes’s marginal efficiency theory.(h) Hicks’s theory of trade cycle.Theories of economic growth, e.g., theory of big-push.Theories of inflation, e.g., Phillips curve hypothesis.Theory of fiscal policy, e.g., theory of balanced budget multiplies.Theory of monetary policy, e.g., quantity theory of money-monetarism.

As Prof. Demburg puts it: “Macroeconomics is first and foremost a policy science.”

Macroeconomics is a policy-oriented subject. It deals with a number of policies of macro nature to solvemany issues and problems.

Macroeconomic policies have macroeconomic goals to fulfill. Macroeconomic goals are:Price stability.Economic stability.Exchange rate stability.Attainment and maintenance of full employment.Economic growth.Economic justice.Improvement of common standard of living.Eradication of poverty.

4 BUSINESS ECONOMICS - II

There are a number of macroeconomic policies, such as:Monetary policy.Fiscal policy.Income policy.Trade policy.Industrial policy.Import-Export policy.Banking policy.Planning policy.

3. IMPORTANCE OF MACROECONOMICS

Macroeconomic studies have unique theoretical and practical significance.1. Macroeconomics provides an exploration to the Functioning of an Economy in general:

Using macroeconomic tools and technique of economic analysis one can understand the workingof the economic system in a better way.

2. Empirical Evidences: Macro-studies are based on empirical evidences of the theoreticalissues. Macroeconomics is more realistic.

3. Policy-orientation: Macroeconomics is a policy-oriented science. It suggests a brief policymeasures, such as fiscal policy, monetary policy, Income policy, etc. to deal with complex economicproblems like unemployment, poverty, inequality, inflation, etc. faced by the country in modemtimes.

As Prof. Demburg puts it: “The task of the policy-oriented macro-economist is to show howthese (macroeconomic tools) can be used to narrow the gaps between actual employment and fullemployment, between actual inflation and no inflation, and between the actual growth rate and thegrowth of potential output.”

4. National Income: Macroeconomics teaches the computation, use and application of nationalincome data. With the help of national income statistics and accounting one can understand andevaluate the growth performance of an economy oyer a period of time.

5. Income and Employment Theory and Monetary Theory: Economics of employmentand income and monetary economics are the major fields of macroeconomics which have utmostpractical relevance. Planning and policy making is not possible without the base of the understandingof these two fields.

6. Dynamic Science: Macroeconomics is a dynamic science. It studies and suggests solutionsto the issues and problems from the dynamic view point. It allows for changes. One can have abetter idea of a dynamic perspective in the real economic world in the light of macroeconomictools and mode of its general equilibrium analysis.

4. CONCLUDING REMARKS

Macroeconomics has certain limitations. These limitations are due to macroeconomic paradoxesone may come across when attempts are made to yield macroeconomic generalisations from individual

MACROECONOMICS: MEANING, SCOPE AND IMPORTANCE 5

experiences. Macroeconomic paradox refer to phenomena which are true for economic systemsbut untrue in individual cases. Macroeconomic paradox appears as follows:

1. Macroeconomic variables aggregates are regarded as homogeneous whole despiteinternal heterogeneity

In macroeconomic analysis, macro variables are measured in total as a homogeneous components.In doing so, individual heterogeneity is not taken into account. However, macro components arehomogeneous whole comprising internal heterogeneity in its structure. For example, inflation ismeasured as a change in general price level through say, wholesale price index number. The relativeprice structure and changes in the relative prices of different goods are not recognised. But actuallythe change in price level is rejected due to changes in the relative prices, but only average price isconsidered in measuring the change.

2. Macroeconomic behaviour involves fallacy of Aggregation

Aggregate economic behaviour is formed by the sum total of individual, behaviour. But,what is true for an individual does not become necessarily true for the entire economy when takenas a whole. For instance, savings are a private virtue but a public vice. An individual when savesmore he becomes wealthy. But savings of all individuals together will ‘not make society merewealthy. Then, there is a paradox of thrift. It is a macroeconomic paradox.

3. Macroeconomics is concerned with general economic welfare

General welfare disregards individual welfare. For example, increase in national income doesnot necessarily imply an improvement in the welfare of a particular individual, even though nationalincome is supposed to reflect an aggregate of all individual incomes.

Beside these macroeconomic paradoxes or difficulties, a major limitation of macroeconomicanalysis lies in its indiscriminate use. Indiscriminate application of macroeconomic tools in analysingeconomic problems of the real world may sometimes lead us on the erroneous conclusions andwrong prescriptions. For example, check in merely supply-a monetary policy measure can be alrightfor controlling overall inflation, but it cannot be just applied with the same merit for regulation ofthe prices of selected commodities.

SUMMARY: KEY POINTS

Macroeconomics deals with economic affairs in aggregates.In macroeconomic analysis, distribution of income and relative price are assumed to be as given.Macroeconomics seeks to explain determination of total output/income and the general price level is theeconomyKeynes’s economic theory lies at the heart of Macroeconomic Analysis.Macroeconomics basically deals with computation, use and application of national income data.

MAJOR TERMS

1. Macroeconomics: Aggregative economic behaviour.2. Price level: Prices of goods in general measured through price index number.3. Dynamic Science: It follows/allows changes.4. Investment: Money spent by the firms in business.

6 BUSINESS ECONOMICS - II

A. DISCUSSION QUESTIONS

(Full length questions) [15 marks]

1. What is meant by Macroeconomics? Discuss its scope and importance.2. Write an explanatory note on meaning and significance of macroeconomic analysis.

B. ANSWER IN BRIEF QUESTIONS

[10 marks]1. Trace the scope of macroeconomics.2. Narrate the significance of macroeconomic analysis.

C. OBJECTIVE TEST

1. Give answer in one or two lines:

(a) Define maroeconomics.(b) What is the main purpose of macroeconomic study?

2. State whether the following statements are TRUE (T) or FALSE (F):

(1) Macroeconomics deals with economic affairs in the large. (T)(2) Macroeconomics deals with current issues in aggregates. (T)(3) Inflation is a crucial microeconomic problem. (F)(4) Macroeconomics disregards details at micro level. (T)(5) Term Macroeconomics was coined by Rayner Frisch. (T)

3. Fill in the Blanks:

(1) Macro implies a ________ part. [large](2) Term macroeconomics was coined by ________. [Ragner Frish](3) Macroeconomic views the working of an economy in ________. [general](4) Macroeconomic deals with ________ economic behaviour. [aggregative](5) The Greek word Makros means ________. [large]

4. Match the following items of Group I and II

Group I Group II

(1) Macroeconomics (A) Macroeconomics(2) Aggregative economic affair (B) Ragnar Frisch(3) Heart of Macroeconomics (C) Keynes’s General Theory

(D) Adam Smith

[Ans: (1) (B); (2) (A); (3) (C)]