Module 1 Introduction to Macro Economics and National Income

Macro Economics for Business Decisions 2017

1 Anil Kumar K Y Asst Professor Department of Commerce Post Graduation SIMS

Module 1

Introduction to Macro Economics and National Income

Economics:

Economics is a science that analyzes production, distribution and consumption of goods and

services or wealth.

Branches of economics:

1. Micro economics

2. Macro economics

Micro economics

Micro economics is a branch of economics that studies the behavior of the how individuals,

households and firm make decision to allocate limited resources.

For ex; micro economics studies only the employment in a firm or in industry. It is not

concerned with aggregate employment in the whole economy. In brief micro economic studies

the individual economic units.

Macroeconomic:

Macro economics is a branch of economics that studies the economic behavior not of an

individual but the economic system as a whole. It studies the overall conditions of the economy

such as total consumption, total national income, aggregate supply and demand, general price

level.

Instead of studying the income employment, output of a particular firm or industry. In macro

economics we are studying aggregates like total income, total employment, total output in the

economy.



Difference between micro economics and macro economics

Sl

no

Micro economics Macro economics

1 The branch of economics that’s studies the

behavior individual economy.

The branch of economic that’s studies

the behavior of whole economy.

2 It deals with individual Economy

variables.

It deals with aggregate economics

variable

3 It deals with individual income, individual

price & individual output

It deals with aggregate like national

income general price level, national

output.

4 Central problem is price determination &

allocation of resources

Central problem is determination of

level of income & employment.

5 Main tools of micro economics is demand

& supply of a particular commodity

Main tool of macroeconomic is

aggregate demand & supply of

economics.

6 It is based on unrealistic assumption that is

full employment

It assumes under employment.

7 It focus on issues that affect individual &

company

It will focus on issues that affect whole

economy

8 In micro economics each individuals

economic agents thinks about its own

welfare

In macroeconomic agents a thinks

about welfare

9 It focus on price analysis

It focus on income analysis

10 The word micro delivered from Greek

word Mikros which means small

The word macro delivered from Greek

word Makros which means large



Goals /objectives of Macro economics

1. Economic growth

2. Full employment

3. Economic efficiency

4. Price stability

5. Economic security

6. Equal distribution of income

7. Balance of trade

8. Raising the standard of living

9. Rapid industrialization

10. Elimination of wasteful competition

Resources of macro economics

1. Land

2. Labour

3. Capital

4. Entrepreneurship

Concepts of Macro economics

1. Output and Income

2. Unemployment

3. Inflation and deflation

4. Economic growth

5. International economics

6. Business cycle



Importance of Macro economics

1. It helps to understand the problem faced by various countries

2. Helps to understand the functioning of economic system

3. It helps in formulation of economic policies

4. It assists in dealing with the problem of allocation of goods and services

5. It helps in analysing the effects of inflation and deflation

6. It helps to analyse the GDP and economic growth of the nation

7. Easy understanding of micro economics

8. Helps in international comparisons

9. Helps in understanding business cycle

10. Helps in understanding importance of saving, Investment

11. It helps in equal distribution of income

12. It helps in stabilize the price of goods and services

Economic system

It is a system of production, distribution, consumption of goods and services in a society. It

composed of people, Institution, rules and relationships.

The Three types of economics:

1) Capitalism/ free market

2) Socialism

3) Mixed economy

1. Capitalistic or Capitalism: (free market)

It’s a system of economic organization in which the factors of production are owned, manage

and control by private individual and product takes place for private profit.

Every individual is free to start any business are choose any occupation with the limits of law.

Eg: united states, Canada, France, US, UK, Germany, Spain, Mexico…



Features of capitalistic:

1. Private property

2. Factors of production are owned by private individuals

3. Profit motive

4. Law of inheritance

5. Economic freedom

6. Indirect role of government

7. Consumer sovergenity

8. No social welfare

9. Existence of perfect competition

Merits:

1. Optimum utilization of resources

2. Variety of products

3. Efficient production of goods and services

4. Economic freedom

5. Consumer sovergenity

6. Right to have private property

7. Technological development

8. Higher standard of living

9. Higher rate of economic growth

10. Limited role of government

Demerits:

1. Inequality in distribution of income and wealth

2. Monopoly market

3. Class conflict

4. No social welfare

5. Labor exploitation

6. Wasteful competition

7. Creates unemployment

8. Misallocation of resources.



2. Socialistic economy:

Under socialistic economy the factor of production that is land, labor, money, organization has

owned manage, control by state / government. They carried business for social welfare.

E.g.: China

Merits:

1. Equal distribution of income and wealth

2. Social welfare

3. Absence of exploitation


5. Wastages avoided

6. Absence of trade cycle

Demerits:

1. Absence of consumer sovergenity

2. No occupation freedom

3. Administration burden

4. Reduction in efficiency of state entrepreneur

5. Loss of Liberty

6. Wastage of resources

3. Mixed economy:

It refers to the all the factors of production like land, labor, money, organization are owned,

managed, and controlled by both private individuals and government. Business carried over for

profit and social welfare.

Definition:-

According to samual son “mixed economy is that economy in which the public and

private sector exercise economic control”.

E.g.: India.



Merits:


2. Variety of products

3. Economic freedom or freedom of choice

4. Consumer sovergenity is protective

5. Technological development

6. Higher standard of living

7. Higher rate of economic growth

8. Equal distribution of income and wealth

9. Co-existence of private and public sector

10. Private property is allow

11. Price mechanism and control price

12. Reduction in economic inequalities.

Demerits:

1. Lack of co-ordination

2. No freedom of private sector

3. In efficient public sector

4. Government interference

5. Corruption

National Income:

National income is the total net value of all goods and services produced within a nation over a

specified period of time. It represents sum of wages, profits, rents, interests and pension

payments of citizens of a nation.

Concepts of national income:

1. Gross domestic product (GDP):

Gross domestic product (GDP) is the total market value of all final goods and services

produced within a country in a year. It does not include income earned from abroad.

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



Where C = consumption

I = Investment

G = Government expenditure

(X-M) = Exports minus Imports

2. Gross National product (GNP):

Gross National product (GNP) is the total market value of all final goods and services

produced within a country in a year plus net factor income earned from abroad.

GNP = C + I + G + (X-M) + NFIA

Where C = consumption

I = Investment

G = Government expenditure

(X-M) = Exports minus Imports

NFIA = Net factor income from abroad

3. Net National Product (NNP):

NNP is the market value of goods and services produced within a country and net factor

income from abroad minus Depreciation.

NNP = GNP - Depreciation

4. Personal Income (PI):

PI is the sum of all incomes actually earned by the individuals and households in a country

during one year. It is the amount available to them for spending, paying taxes, and saving

purpose.

5. Disposable income (DPI):

From personal income if we deduct personal taxes like income taxes, personal property taxes

etc.. What remains is called disposable income.

It is a part of personal income which is left after the payment of personal direct taxes.

DPI = PI – Personal direct taxes

It is the amount available for spending and saving purpose not for paying taxes.

DPI = consumption + savings



6. Per capital income :

Per capital income refers to the average income per head of population.

It is calculated by dividing national income by total population.

Per capital income = national income / total population

Methods of measuring national income:

1. Value added method/ output method:

In this method, only value added by each producing unit at various stages of production is

taken into account for the estimation of national income.

Value added by the manufacture is the difference between value of output produced and value

of inputs used.

This can be better understood by the following example:

stages Industry Selling price

(value of

output)

Cost price

(value of

input)

Value added

(output-input)

1 A

(wood seller)

80 00 80

2 B

(manufactures

of chairs)

150 80 70

3 C

(dealers in

chairs)

250 150 100

Total 480 230 250

2. Income method:

According to this method national income obtained by adding up of incomes of all individuals

in the country.

National income is calculated by adding all the incomes earned in the form of rent, wages,

salaries, interest on capital, profit from business, income of self employed people.



In India this method is used in service sectors like:

a. Transport, communication

b. Electricity, gas and water supply

c. Banking. Finance and insurance

d. Real estate

e. Public administration and defense

3. Expenditure method:

In this method National income is calculated by adding up of all the expenditure made on

goods and services during a year.

If we add the total expenditure incurred by all individuals, households, business units and the

government in a year then we get total national income of the country.

The following expenditures to be added to calculate National income

a. Expenditure by individuals and households on goods and services denoted by C

b. Expenditure by private business peoples on capital goods denoted by I

c. Government expenditure i.e. government purchase denoted by G

d. Expenditure made by foreigners on goods and services denoted by (X-M)

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

Difficulties involved in measurement of national income:

1. Difficulty in defining the Nation:

National income of a country does not mean only income earned within a country. It also

includes the income earned from abroad.

2. Lack of statistical data:

The up to date, accurate, adequate and reliable data regarding the value and volume of goods

and services produced are not available in backward countries.

3. Absence of proper records:

Many people due to illiteracy, ignorance and indifferent attitudes do not have the habit of

keeping proper accounting data on production, income and expenditures.



4. Existence of non monetary transactions:

The national income must be calculated in monetary terms. There are certain non monetary

transactions which are not included in the value of a product for e, g, unpaid personal service

of House wife.

In our country all the goods and services produced are not exchanged for money, part of goods

and services may be bartered or consumed at home by producers themselves. The exclusion of

such value of goods would give us a wrong picture of the national income.

5. Absence of occupational specialization:

Many people are engaged in more than one occupation for earning their livelihood. Many

people work as part time workers and such they do not give complete information about

sources of their income.

For e.g. an individual may be working as a clerk in a government office but he may be getting

some additional income from his own farm and small grocery shop. It becomes difficult to

collect information about their income under such circumstances.

6. Danger of double counting:

While calculating National income we have to take into account the value of final goods and

services but many times the value of intermediate goods is included in the national income.

For e.g. the value of oil or oil seeds taken into account and not the value of both.

7. Existence of illegal earnings:

There is huge volume of incomes earned through illegal activities like gambling, smuggling,

black marketing, adulteration etc.. but these items cannot be included in calculation of national

income.

8. Treatment of profits from foreign firms:

Profit from foreign firms is treated as income of parent country or income of Host country.

9. Imperfect instrument to measure national income:

Value of goods and services measured in terms of money. But the values of money itself

change due to inflation or deflation.



10. Incomes earned through lottery, dowry, pensions, unemployment relief, etc should be

excluded from the calculation of national income because the above items are gratis.

11. Goods kept for self consumption:

The values of these goods are to be included in the calculation of national income.

12. Existence of non market transactions:

Many people stitch their own clothes, grow vegetables in their own gardens the value of such

activities does not enter the market transactions and hence are not included in the national

income estimates.

13. Existence of different methods to calculate depreciation charges:

14. Coverage of commodities and services:

Value of all unpaid work on account of love, affection, mercy, kindness friendship etc should

be excluded in the calculation of national income.

Model questions

1. Explain the significance of macro economics in business decisions? OR Explain the

interface of macro economics with business and Industry.

2. Explain the difference between Micro Economics and Macro Economics.

3. What are various economic systems? Explain the essential features of each one of

them. Which economic system do you prefer and why?

4. “Free market economy enables better allocation of resources, promotes innovation

and injects dynamism in the industry”. Substantiate this statement highlighting the

significance of free market economy.

5. What is national Income? What are the methods of measuring national income? OR

Critically examine the different approaches advocated for measuring the national

Income.

6. Explain the difficulties encountered in computation of N.I.? OR Enumerate the

difficulties which an underdeveloped economy faces in the calculation of national

income.

7. Define national income. Explain the variables included in national income.

8. Distinguish between GNP and NNP.



Module 2

Consumption, Savings and Investment

CONSUMPTION

It means the satisfaction of Human wants by using goods and services. In other words

Consumption is not only related with using of commodities but the use of utilities contain in

goods and services in order to satisfy wants.

For e.g.: when we eat food its utility is completely destroyed but at the same time our want is

satisfied distribution of utility does not mean consumption of commodity.

For e.g.: If a house catches fire and its utility is destroyed. It’s not means that it is consumption

because Human wants are not satisfied.

Hence, consumption means distribution of utilities in satisfaction of wants. Consumption

depends upon Income symbolically it is represented as c = f(y)

Where c = consumption

Y = income

F = functional relationship

Here, Income (y) is independent variable and consumption (c) is dependent variable.

Consumption function is also known as propensity to consume. It shows the relationship

between Income and Consumption.

Keynes psychological law of Consumption

1. The law states that when Income increases consumption also increases but it increases not as fast

as income. (This shows that people fails to spend on consumption the full amount of increased

income. If Income increases they save more than what they spent).

2. The increased income divided between Consumption and saving. It means a part of increased

income is spent on consumption and the remaining is saved.

3. As income increases both consumption and saving increases in different proportion.



Properties of consumption behaviour of communities

1. The level of consumption is directly related the level of income c = f(y)

2. With the rise in level of income , the consumption level also increases but at a decreasing rate

C<Y

3. As the level of income increases both consumption and savings increases

Y = C+S

Keynes consumption function is explained with the help of following table.

Income

(Y)

Consumption

(C)

Savings

(S)

APC

(C/Y)

MPC

C/Y

0 50 -50 0 0

100 100 0 1 0.5

200 150 50 0.75 0.5

300 200 100 0.66 0.5

Consumption expenditure increases with, increase in income

When income is 0 people spend their past savings on consumption

When income is 100 crs consumption expanses is also 100crs

After this stage income is increased by 100 crs and consumption increased by 50 crs. This

implies that increase in consumption is less than increase in income. The same data is shown in

fig below.



In the diagram “OX” axis represents the level of income and “OY” axis represent the level of

consumption.

‘C’ is consumption expenditure curve. ‘c’ curve slope upward from left to right in the diagram

which shows income increases the consumption expenditure also increases.

At the point ‘B’ consumption equals to income and there is 0 savings. B is called breakeven

point.

Left to the point of ‘B’ the consumption line (C) is above the income line (y).

It indicates negative savings.

Right to the point of ‘B’ the consumption line (c) is below the income line (y). It indicates

positive savings.

Properties of Consumption Function

Keynes has developed two concepts to analyze the consumption function .they are

1. Average propensity to consume (APC)

2. Marginal propensity to consume (MPC)



I. APC

The average propensity to consume explains the relationship between total consumption

and total income at a certain period of time.

In other words, APC explains what percentage of income spent on consumption of goods and

services. We can drive APC by dividing consumption expenditure by total income.

APC = Total consumption/Total income or APC = C/Y

For instance the income of the community is 2000 crs and consumption expenditure is 1500crs

the average propensity to consume is

APC = 1500/2000

= 0.75 or 75%

This shows that out of the income of Rs.2000 crs 75% will be used for consumption purpose.

II. MPC

The concept of MPC is very important in macro economics J.M Keynes has defined MPC

“as the relationship between changes in consumption and changes in income”

In other words, the ratio of changes in consumption to the changes in income. It may be derived

by dividing changes in consumption by changes in income.

MPC = Changes in consumption/Changes in income

Or

MPC = C /Y

Suppose total income increases from Rs. 10000crs to Rs. 20000crs and the total consumption

increases from Rs. 8000crs to Rs. 15000crs then,

MPC = 7000/10000

= 0.7

Income

( Y )

Consumption

( C )

APC

( C/Y )

0 40 -

100 100 1

200 150 0.75

300 200 0.66



Factors influencing consumption function

A. Subjective factors:

1. Motive of precautions

2. Religious belief of the people towards spending

3. The motive of enterprise

4. The motive of forecasting

B. Objective factors

1. Real income

2. Distribution of income

3. Expectation change in price

4. Change in the fiscal policy

5. Change in the rate of interest

6. Availability of goods

7. Credit facilities

8. Stock of liquid assets

9. Consumer indebtness

10. Demographic factors

11. High living standards

12. Windfall gains

Income Consumption C Y MPC

0 40 - - -

100 100 60 100 0.6

200 150 50 100 0.5

300 200 50 100 0.5



Measures to Increase consumption spending

1) Redistribution of Income

(By taxing the rich class progressively and by providing subsidies to the poor people)

2) Wage and income policy

(A long run increasing wage rate policy can help in raising the consumption expenditure) i.e.

increase in the level of wages and salaries of labor class.

3) Extension of credit facilities

(Consumer credit and hire purchase schemes in the sale of durable consumer goods leads to

increase in consumer expenditure)

4) Publicity, advertisement to increase sales and consumptions

(A constant publicity through advertisement and sales influences the psychology of consumer

and they may induced to spend more)

5) Tax reduction

6) Lower rate of interest

7) Availability of goods at cheaper rate

Types of consumption

1) Physical consumption

2) Conspicuous consumption

3) Risk averse consumption

Physical consumption: physical consumption is all about buying and using goods and services.

This type of consumption leads to physiological well being.

Conspicuous consumption: buying expensive items to display wealth and income rather than to

fulfill the real needs of the consumer.

Risk averse consumption: buying and using the goods and services in order to reduce the risk

.ex: healthcare products, banking services, insurance etc..



Saving:

Saving is a part of income which is not spent on consumption.

It is defined as the excess of income over consumption.

According to Keynes “saving is the amount left over when the cost of a person’s consumer

expenditure is subtracted from the amount of income that he or she earns in a given period of

time”.

The relationship between saving and income is called saving function.

S = Y – C

Saving = Income – consumption

Saving is dependent on Income, where saving(s) is an dependent variable and Income (y) is an

Independent variable.

Symbolically Y = f(S)

Saving – Income Relationship:

If Income (y) increases saving (s) also increases

If Income (y) decreases savings (s) also decreases

When Income (y) is zero, consumption cannot be zero, consumer will have to borrow or

use their past savings. Therefore when Income is zero Saving is Negative

As income increases saving also increases finally S=0 and then S>0

The saving function is explained with the help of following table:

Income

(y)

Consumption

(C)

Savings

(s)

Remarks

0 50 -50 S < 0 (Negative)

100 125 -25

200 200 0 S = 0

300 275 25

S > 0 (positive) 400 350 50

500 425 75



As shown in table when income increases savings also increases. When income is zero saving is

negative because people spend out their past savings on consumption. A rise in income to Rs.

100 is not enough to meet the consumption expenditure of Rs. 125 at this stage -25 is the saving.

When income increases to 200 consumption is also increases to 200 at this stage S = 0 after this

sage income increased by 100 and consumption increased by 75 remaining 25 is saving.

Therefore rise in the level of income leads to rise in the level of savings

The diagram represents relationship between income and savings.

The saving curve slopes upward from left to right

The saving line intersects the income line at point B which is called BEP because at this

point income and consumption are equal.

Left to the point of B, consumption is more than income indicating that saving is negative

Whereas right to the point of B, income is more than consumption indicating that positive

savings.



Concepts of Propensity to save:

1. Average propensity to consume (APS)

2. Marginal propensity to consume (MPS)

Average propensity to consume (APS)

It is the % of income saves at given level of income. In other words it is a relationship between

savings and income.

It is calculated by dividing savings by Income.

APS = savings / Income OR S / Y

For instance if the disposable income is 100 crore and expenditure is 80 crore om consumption

of goods and services then savings will be 20 crore

The APS will be 20 / 100 = 0.2 or 20%

The APS can also be calculated by subtracting APC from 1

APS = 1 – APC

APC = Consumption / Income

80 / 100 = 0.8

Therefore APS = 1 – APC

APS = 1 – 0.8 = 0.2 or 20%

Marginal propensity to consume (MPS)

MPS is the ratio of changes in savings to changes in income. The following formula is used to

find out MPS

MPS = changes in savings / changes in income

OR

MPS = S / Y



Suppose income increases from 1000 crore to 2000 crores, consumption increases from 800

crores to 1600 crores. Then savings would be go up from 200 crores to 400 crores.

In this case MPS would be

MPS = S / Y

MPS = 200 / 1000

MPS = 0.2 or 20%

It is also calculated by subtracting MPC from 1

MPS = 1 – MPC

Therefore MPC = C / Y

MPC = 800 /1000 = 0.8

MPS = 1- MPC

MPS = 1- 0.8

MPS = 0.2 or 20%

Schedule for APS and MPS

Income

(Y)

Consumption (C) Savings

(S)

APS ( S/Y) MPS (S / Y)

1000 1100 -100 -0.1 -

2000 2000 0 0 -

3000 2600 400 0.13 0.4

4000 3100 900 0.22 0.5

5000 3400 1600 0.32 0.7

6000 3600 2400 0.4 0.8

7000 3700 3300 0.47 0.9



Paradox of Thrift [Savings]

According to Keynes an act of saving of one individual would reduce the savings capacity of

other further he says that an Increase in Individual savings does not lead to an Increase is the

community savings.

The Paradox of Thrift explains that an attempt to Increase an Individuals savings would lead to a

decrease in total savings of the community. This is because of the simple reason that “One man’s

expenditure is another man’s Income”.

An Increase is savings of one person leads to decline in Income & savings of other another

person.

Eg: Assume everybody receives 10000 of Income .They save 50% [5000] and spent the rest

[5000]. This means everybody is spending Rs.5000 which supports demand for products which

creates jobs & generates tax revenue for the Govt.

Now assume that everybody decides to save more, they start saving Rs.7500 of their Rs.2500

which leads to a drop in the demand for goods & services lay off workers &lowest tax revenue

with the Govt.

Let us understand this concept with the help of diagram.



In this diagram initial saving curve is S, S suppose the people decide to increase their savings

then i.e. A E, savings curve shifts upward from SS to S1S1

INVESTMENT:

MEANING OF INVESTMENT:

Investment refers to the expenditure incurred by individual and business on purchase of new

plant and machinery the building of the house, factories, schools, construction of roads etc……..

TYPES OF INVESTMENT:

1. Induced Investment

2. Autonomous Investment

3. Financial Investment

4. Real Investment

5. Planed Investment

6. Unplanned Investment

7. Gross Investment

8. Net Investment

1. INDUCED INVESTMENT:

Investment which varies with the changes in the level of national income is called induced

investment. The larger the national income the higher is the investment and vice versa



In the above figure the investment curve high is slot upward from left to right. It indicates that

the level of income raises from OY to OY as a result the level of investment rises from OI1 to

OI2

2. AUTONOMOUS INVESTMENT:

The investment which is not influenced by national income is called autonomous investment

It is influenced by many basic factors such as increase in population changes in technology, rate

of interest etc…….

In the above figure autonomous investment curve I it’s a horizontal straight line it indicates that

when national income is OY, the investment is 10 bullion if the national income increases to

OY1 the investment remains 10 bullions

3. FINICIAL INVESTMENT:

Investment made in buying financial investment such as new shares, bonus, securities

The money used for buying old shares old bonus, old securities cannot be considered as financial

investment it’s considered as transfer of financial assets from one person to another person.

Investment made in new plant and equipment construction of public utility like school, roads and

railways it’s considered as real investment.

5. PLANNED INVESTMENT:

Investment made a plan in several of economy is called planned investment.



6. UNPLANNED INVESTMENT:

Investment done without any planned is called unplanned investment

7. GROSS INVESTMENT:

It is the total amount of money spent on new capital assets like plant and machinery, factory,

building etc……..

8. NET INVESTMENT:

It is gross investment minus depreciation during a period of time.

MARGINAL EFFICIENCY OF CAPITAL:-

According to JM Keynes marginal efficiency of capital is the rate of return expected on new

capital asset over its lifetime.

A businessman while investing in new capital asset examines the expected rate of return [profit]

during its life time against the cost of capital asset. if the expected rate of profit is greater than

the replacement cost of the asset the business man will invest the money in the project. if

expected rate of profit is less than the replacement cost of the assets then the investor not going

to invest.

MEC:-

* Expected rate of return [profit] on capital assets > replacement cost of the assets – invest

*If expected rate of return [profit]< replacement cost of assets – Don’t invest

EXAMPLE:-

If a business man spent Rs 10,000 on the purchase of machinery

The NCF return of the machine expected to Rs 1000 p.a

The marginal efficiency of capital [MEC] will be= 10%

The following formula is used to know the expected income though out the life span of capital

assets.

SP= R+R2+--------- Rn



Hence:-SP=Supply price of the new capital assets

R1+R2+-----------Rn =Return on yearly basis

SCHEDULE:-According to T.N Keynes as the stock of capital increases in the economy the

marginal efficiency of capital goes on diminishing

INVESTMENT MEC

20

25

40

70

100

10

9

7

5

2



In the above diagram the MEC curve is stop downward from left to right when stock of capital

is 20 million , the marginal efficiency of capital is 10% while the capital stock of 100 billion it

declines to 2 percent.

Factors Affecting MEC

1. SHORT RUN FACTORS:

a. Cost of capital: If cheap capital is available for investment there the investment opportunity

becomes more attractive.

b. Demand for the product: Increase in demand for the product leads to increase in investment

and vice versa.

c. Liquid assets : If entrepreneur are holding large volume of liquid assets they can take

advantage of investment opportunities the MEC will be high and vice versa

d. Sudden changes in income: if profits the MEC will be high and move investment in the country

go up on the other hand MEC falls with decrease in income

e. Current rate of investment: If in a particular industry much investment as already MEC will be

low

f. Wave of optimism and pessimism: If the business man have optimistic about future then MEC

will be high and if they are pessimistic about future then MEC will be low

2. LONG RUN FACTORS:-

a. Rate of population growth: If the rate of population growth is high then the demand of various

goods will increases so it will increase the MEC decrease in population discourage investment

and reduced the MEC

b. Technological advancement: Invention and technological improvement encourages investment

in the various project and increase marginal efficiency of capital

c. Rate of taxes : If government imposes the taxes on goods it will increase the cost of production

and reduce the profit so the fall in profit leads to fall in rate of investment

d. The quantity of capital goods : If the capital of goods are already in the large quantity to meet

the demand of the market then it will not be beneficial for the investors to invest the money in

the project so in search cases MEC will be low

e. Foreign trade: If the demand for export increases then the producer has to be increase the

investment and vice versa

f. Government interference: If the government interference in the private business and impose

some restriction then people will hesitate to invest and MEC falls on the other hands if it

encourage the private business then MEC will be increase.



MULTIPLIER:-

The theory of multiplier has occupied a very important place in the modern theory on income

and employment. It has become an effective instrument to explain the process of income

generation in an economy when the volume of investment changes.

The original concept of multiplier as been developed by professor “F.A KHAN” in the year

1931. He made a successful attempt to analyze the effect of an increase in investment on the

level of employment. Hence, khan multiplier as been described as “employment multiplier”.

Lord Keynes on the lines of employment multiplier as systematically developed a new

multiplier. Which is known popularly described as investment multipliers. Which show the

effect of increase in investment on the level of income

The concept of investment multiplier:-

It is believed that an initial increment in investment leads to a greater increases in income.

Multiplier explains the relationship between increases in investment due to increases in income.

Multiplier (k) = changes in Income / changes in Investment

OR K = Y /I

The working of multiplier can be explained in the following manner

For example:-

If an income increases for Rs 1,00,000 to Rs 2,00,000 then the investment increased from Rs

10,000 to Rs 20,000.

Multiplier (k) = Changes in income = ΔY

Changes in investment ΔI

= 1, 00,000

10,000

= 10 Times.

The formula to calculate the size of multiplier is as follows:-





From the above explanation it is clear that:-

1) Higher the value of MPC, Higher the value of k and vice versa.

2) When MPS = 0 and MPC = 1 there will be 100% increase in income.

Working of the multiplier and the process of income generation: -

Assumption:-

1) MPC = 0.5

2) Investment of Rs 10crore will generate income of 20crore.

The multiplier process is based on 1 principle that 1 man’s expenditure is another man’s income

from the above table it is clear that as the move from 1 round to another the initial investment

gives raise to dwindling series of successive increment in income.

Rounds Investment Income Consumption Savings

1 10 10 5 5

2 - 5 2.5 2.5

3 - 2.5 1.25 1.25

4 - 1.25 0.62 0.62

5 - 0.62 0.31 0.31

20 10 10



OX axis represents income and OY axis represents consumption and savings. C+S is aggregate

supply curve and C+I is aggregate demand curve. Aggregate demand curve interests aggregate

supply curve at the point of E. E point is equilibrium Y is equilibrium investment.

New increase in investment that is EA leads to aggregate demand curve goes upward. it interests

at E1 and Y1 is equilibrium income.

From the above diagram it is understand that initial changes in investment leads to greater

increase in income.

Assumption / limitation of multiplier:-

1) Availability of consumer goods & services :-

Multiplier works satisfactory if the volume of goods & service on which the income spent are

available in plenty otherwise people have unable to spend their income on consumption.

Consequently MPC falls leading to decline in the volume of "k".

2) No changes in the value of MPC:-

In the process of income generation the MPC should be constant. If there is any change in the

size of MPC then the value of "k" also changes.

3) No time gap between receipt of income & it's consumption:-

If there is a gap between receipt of income, and its consumption, the full value of ‘k’ can’t be

realized.

4) Existence of less than full employment conditions:-

If the economy is working at full employment level in that case there is scope for further

increase in output, income, and employment.

5) No net investment:-

In order to get the full value of 'k' there should be a net increase in investment. Increase in

investment in one sector of economy should not be offset by decrease in investment in another

sector.



6) Maintenance of investment :-

In order to achieve a high level of multiplier it's necessary that the increment in invested are be

repeated in regular time intervals.

7) Closed economy :-

Working of the multiplier depend upon the fast whether economy is closed or open multiplier

works at closed economy.

8) Non-existence of international trade :-

Absence of international trade helps to achieve higher value of 'k' more imports over exports act

as a leakage in the process of income generation.

9) Constant prices :-

It assumes that there is no changes in the prices of commodities, if it goes up, consumption

will be go down and the value of multiplier will be affected.

10) It is based on number of assumptions :-

Like MPC should be constant, less than full employment conditions, constant prices,

absence of foreign trade, closed economy etc....

11) Complete absence government activities:-

Like taxation, government expenditure, etc.....

Significance of multiplier :-

1) It describes how income is generated in an economic system.

2) It helps in framing full employment policy.

3) Removes depression through government investment.

4) It helps to analyze the business cycle.

5) Importance in investment.

6) It indicating improvement in public investment.



7) It brings equality between saving and investment.

8) Important tool for analyzing impact of taxation, foreign trade, etc....

Classical Theory of Employment

This theory is based on “Law of Market” which states that supply creates its own demand.

For this theory French economist J.B SAY formulated a law which is known as say’s law of

market.

According to him supply creates its own demand, its means that production of goods will create

demand for them. According to their views under perfect competition unemployment will be

temporary and after some time it will disappear. Classical economists assume full employment

in the free market economic system.

Meaning of full employment

Full employment is a situation in which all eligible people who want to work can find

employment at prevailing wage rate.

Assumptions

1. Existence of free market economy.

2. Exist perfect completion.

3. Absence of govt intervention.

4. Money is a medium of exchange.

5. Closed economy.

6. No International trade.

7. Wages and price are flexible.

The Supply of labor depends on the wage rate Sn=f(w/p), where

Sn=supply of labor

W/p=wage rate



When the D&S curves intersect at a point E is called full employment level that time real wage

rate is w/p0, if the wage rate is increased from w/p0 to w/p2 the supply of labor will be more

than demand of labor. Which creates involuntary employment that leads to competition among

workers for work, they will be willing to accept a lower wage rate, consequentially the wage rate

decrease from w/p2 to w/p0.

If the wage rates decreased from w/p0 to w/p1, the demand for the labor will be, more than its

supply. Competitions by employer for workers will increase the wage rate from w/p1 to w/p0.

Limitations

1. Supply does not create its own demand, presence govt intervention.

2. Assumption of perfect competition.

3. Role of money -money is demanded for transaction motive as well as speculative motive.



Keynes General Theory of Employment

Keynes states that the equilibrium level of income and employment will be where

Aggregate Demand = Aggregate supply

Keynes proved that the supply cannot create its own demand. If at any time aggregate demand

falls then unemployment takes place.

Aggregate Demand

Aggregate Demand is the amount of consumption and amount of investment expenditure at each

level of income.

There are 2 components of Aggregate Demand

1. Consumption Expenditure (c)

2. Investment Expenditure (I)

Aggregate Demand can be expressed as, Y=C+I

Aggregate Supply

Aggregate Supply is equal to National Income in others Words, National Income is equal to the

price of Goods and Services produced in the country so

Aggregate Supply = Consumption + Savings

Assumptions

1. No Changes in Technology and Efficiency of labour

2. No Foreign Trade

3. No Govt Interference

4. No charges in method of production



Determination of Level Of Income and Employment

Y C S I AD(C+I) AS(C+S) REMARKS

0 40 -40 40 80 0

AD>AS

(excess demand)

100 120 -20 40 160 100

200 200 0 40 240 200

300 280 20 40 320 300

400 360 40 40 400 400 Full Employment

500 440 60 40 480 500 AD<AS



Model Questions

1. Outline the linkages among Savings, consumption and Investment. OR what is

consumption function. What is its impact on saving and investment?

2. What are the sources of savings in India? Suggest measures for raising the rate of savings.

3. What is marginal propensity to consume? Suggests the measures to improve it.

4. Discuss the concept of MPC and MPS with the help of numerical example and the grapg

5. Explain the paradox of thrift.

6. Explain the concept of Multiplier.

7. Define multiplier. Bring out the significance and limitations of multiplier.

8. Explain critically the classical theory of income and employment

9. Explain the Keynes General theory of Income and employment.

10. Explain the concept of MEC and factors affecting MEC.



Module 3 and 4

Inflation, RBI, Fiscal Policy, Monetary policy, Business Cycle, Economic Growth

Inflation:

Inflation is the rise in the general price level of goods and services in an economy over a period

of time. The increase in price level leads to decrease in purchasing power of currency.

Causes for inflation:

I. Demand side causes:

1. Increase in money supply

2. Increase in disposable income

3. Increase in exports

4. Existence of Black money

5. Increase in private consumption expenditure

6. Increase in population growth

7. High rates of indirect taxes

8. Reduction in the rates of direct taxes

9. Reduction in the level of savings

10. Expansion of credit

II. Supply side causes:

1. Shortage in the supply of goods

2. Hoarding by traders

3. Hoarding by consumers

4. Industrial disputes

5. Natural calamities

6. War

7. Increase in price of inputs



Measures to control Inflation:

I. Monetary Measures

1. Credit control

a. Increase in bank rate

b. Increase in SLR and CRR

c. Sale of Government securities in open market

d. Restrictions on bank credit

e. Regulations of consumers credit

2. Demonetization of currency

(Demonetize currency of higher denomination- this method is adopted when there is

abundance of black money in the country)

3. Issue of new currency

(Issue of new currency in the place of old currency- under this system one new note is

exchanged for a number of notes of old currency)

II. Fiscal measures

1. Reduction in unnecessary expenditure

2. Increases in taxes

3. Increases in savings

4. Surplus budget(collect more revenue and spend less)

5. Stop repayment of public debt

III. Other measures

1. To increase production

2. Price control

3. Rational wage policy

4. Rationing

5. Control speculative and gambling activities

6. Overvaluation of currency



Types of Inflation:

1. Demand pull inflation:

It occurs when total demand for goods and services in an economy exceeds the available

supply. So the prices for the goods and services rise in a market.

2. Cost pull inflation:

Increase in cost of production leads to increase in price of goods and services in an

economy.

3. Stagflation:

Fall in output and employment level, increases the price of goods and services in an

economy.

4. Hyper inflation:

Hyper inflation caused mainly by excessive deficit financing (financed by printing more

money) by a Government

5. Open inflation:

Price of the goods and services increases due to economic trends of spending products and

services.

6. Suppressed inflation:

Existing inflation disguised by government price controls and other interferences in an

economy such a s subsidies. Such suppression can only be temporary.

7. Galloping Inflation:

Very rapid inflation which is almost impossible to control.

8. Creeping inflation:

Where the inflation of a nation increases gradually, but continually over time.



Deflation: (opposite to Inflation)

Deflation is the fall in the general price level of goods and services in an economy over a period

of time. According to Prof Crowther “deflation is that state of economy where the value of

money is rising or the prices are falling”.

Measures to control Deflation:

1. Reduction in taxes

2. Redistribution of income

3. Credit expansion

4. Repayment of public debt

5. Deficit financing

6. Reduction in interest rates

7. Regulation of production

8. Subsidies

Monetary policy:

Monetary policy is the process by which the monetary authority of a country (RBI) controls the

supply of money.

Objectives of Monetary policy/ objectives of Central bank as the control of credit:

1. Neutral monetary policy

2. Price stability

3. Exchange rate stability

4. Controls of business cycles

5. Full employment

6. Rapid economic growth

7. Equilibrium in balance of payment

(Payments of imports equal to export earnings)

8. Monetary equilibrium

(Balance between demand for money and supply of money)

9. Developing banking habits

10. Capital formation



RBI functions:

Functions of RBI

Central banking functions Developmental functions Other functions

1) Monopoly of note issue

2) Banker to the Govt

3) Banker’s banker

4) Lender to last resort

5) Clearing house

6) Leader of money market

7) Controller of credit

8) Custodian of foreign

exchange reserves

1) Agricultural finance

2) Industrial finance

1) Research functions

2) Special functions

1. Monopoly of note issue:

RBI has the sole right to issue currency notes of all denominations of Rs. 10, 20,

50,100,200, 500, 2000 in the country. RBI follows the minimum reserve system while

issuing currency notes 1956. It has to maintain reserve of gold, silver, and foreign

exchange against issue of currency notes.

2. Banker to the Government:

RBI acts as a banker, agent and advisor to the government. The RBI receives deposits

from Government and advances loans to it. It receives and makes all payments on behalf

of Government. It transfers govt fund from one place to another, one account to another

account. Act as a agent between IMF and World Bank. It gives useful advice to the

government on important economic matters such as monetary policy, planning and

budgeting, foreign exchange rate policy etc..

3. Banker’s bank:

The activities of all commercial banks are controlled and managed by the RBI. The

regulation of banks may be related to their licensing, branch expansions, liquidity of

assets, maintaining reserves etc..



4. Lender to last resort:

The RBI helps the commercial banks in times of their financial crises. When commercial

banks are not able to get financial assistance from any source RBI comes to their rescue.

5. Clearing house:

The RBI act as a clearing house for transfer and settlement of mutual claims of the

commercial banks. It is easy for commercial banks to settle each other’s debts or transfer

of funds from one bank to another bank through the RBI.

6. Leader of money market:

RBI is the leader of money market in the country. It controls the activities of different

components of the money market such as commercial banks, financial institutions etc..

7. Controller of credit:

The important functions of RBI is the control of credit. For this purpose , it uses various

credit control measures such as bank rate, open market operations, variable reserve ratio,

selective credit controls etc..

8. Custodian of foreign exchange rates:

The RBI act as custodian of foreign exchange reserves. It is required to maintain serves

like gold, silver and foreign exchanges to back the issue of currency notes and to meet

international payments.

9. Agricultural finance:

Te RBI has been extending finance assistance to the cooperative institutions for the

development of agriculture. For this purpose it has set up an agricultural credit

department.

10. Industrial finance:

The RBI provides credit facilities to both small scale and medium scale industries through

SFC, IFCI, IDBI, ICICI etc…it also established National industrial credit fund in 1964 to

provide financial assistance to large scale industries.



11. Research functions:

The RBI collects and publishes information relating to agriculture, industrial, financial

sectors of the economy, exports and imports, banking, trends in money and capital

markets, price trends etc..

12. Special functions:

a. Conducts special debates and seminars on various subjects

b. Provides training facilities to bank staff

c. Maintaining regular contacts with various financial institutions

d. Suggests remedies for the problems of poverty, unemployment, inflation, deflation etc..

Explain the measures of control imposed by RBI to regulate the Monetary System in India.

OR What are the Quantitative and Qualitative credit control measures of RBI?

The various methods imposed by RBI to control Credit creation power of commercial banks can

be classified into two groups. i.e. quantitative and qualitative controls.

Quantitative controls are designed to regulate the volume of credit created by commercial banks.

Qualitative or selective measures are designed to regulate the flow of credit in specific uses.

Quantitative controls Qualitative or selective measures

1) Bank Rate policy:

2) Open market operations:

3) Variable cash reserve ratio:

a. CRR

b. SLR

c. Repo rate

d. Reserve repo rate

1) Margin requirements:

2) Regulation of consumer credit:

3) Credit Rationing:

4) Moral Suasion:

5) Control through directives

6) Direct action:

7) Publicity:



I Quantitative methods:

1. Bank Rate policy:

Bank rate is the rate at which RBI lends money to the commercial banks. It is also called as

discounted rate. A change in the bank rate affects the credit creation power of the RBI.

During the period of Inflation, there will be excess money supply. In order to control money

supply bank rate is used as a instrument. An increase in bank rate leads to increase in rates of

interests, Increase in rate of interest leads to increase in cost of borrowing and decrease in

demand for credit finally decrease in demand for credit leads to decrease in money supply.

During the period of deflation, there will be shortage of money supply, an decrease in bank rate

leads to decrease in rate of interest, decrease in rate of interest leads to decrease in cost of

borrowings and increase in demand for credit, increase in demand for credit leads to increase in

money supply.

2. Open market operations:

Open market operation refers to the sale and purchase of securities by the central bank to

commercial banks.

During the period of inflation, central bank will sell the securities to commercial bank in order to

control credit creation and money supply

During the period of deflation, central bank will buy the securities from commercial banks to

increase the credit creation and money supply in the economy.

3. Variable cash reserve ratio:

Variable cash reserve ratio refers to percentage of bank deposits that the commercial banks are

required to keep in the form of cash.

The reserve bank of India imposes mainly 2 types of reserve ratio. Viz. CRR and SLR

(a) Cash reserve ratio:

The CRR refers to that portion of the aggregate demand deposits which the commercial banks

are required to keep with RBI



A rise in CRR leads to decline in the credit creation power of the commercial banks and fall in

CRR leads to increase in the credit creation power of the RBI

(b) Statutory liquidity ratio:

The SLR refers to that portion of the aggregate demand deposits which the commercial banks

are required to keep with themselves in a liquid form.

A rise in SLR leads to decline in the credit creation power of the commercial banks and fall in

SLR leads to increase in the credit creation power of the RBI

(c) Repo rate: Repo rate is the rate at which RBI lends money to the commercial banks

(d) Reverse repo rate: RRR is the rate at which RBI borrows money from the commercial banks.

II Qualitative methods:

1. Margin requirements:

Margin is the difference between the loan value and the market value of the securities offered by

borrowers against loan.

A rise in Margin result in to decrease in credit creation and money supply in the economy and

decrease in margin leads to increase in credit creation and money supply in the economy.

For example: if the margin is 30% then commercial banks lend only 70% of the market value of

the securities. If it is raised to 40% then they can lend only 60% of the market value of the

securities.

2. Regulation of consumer credit:

Under this method consumers have to pay certain % of the price of the durable goods in the form

of down payment, the remaining part of the price of the goods finance d by the bank which is

repayable by consumer in Installments over a period of time.

If RBI wants to control the money supply then it will increase the down payment amount and

increase the interest rates on consumer credit and vice versa



3. Credit Rationing:

Rationing of credit is a system under which the central bank limits the total amount of loans and

advances or specific categories of loans and advances granted by commercial banks.

4. Moral Suasion:

It is a convincing action and request made by RBI to the commercial banks to follow the

monetary policy without making any deviations. It may in the form of request, appeal, and

convincing action by the RBI.

During the period of Inflation RBI request the commercial banks not to lend more credit to

speculative and non essential activities. During the period of deflation RBI request the

commercial banks to provide more credit.

5. Control through directives:

Central bank can exercise control over commercial banks through directives from time to time.

These directives may be in the form of oral or written orders, statements, warnings or even

threats.

6. Direct action:

When moral suasion and directives fails, the central bank make use of this method as a last

resort. It will take direct action against banks by imposing punishments like higher interest on

borrowings, stoppage of credit, delicensing of the banks and liquidation

7. Publicity:

Publicity includes publishing regularly the statements of commercial banks assets and liabilities,

reports on operations and activities of commercial banks, Money market, banking, public

finance, industry, agriculture etc.. This information give clues to commercial banks to formulate

their own polices.



Fiscal policy:

Fiscal policy refers to the policy of Government as regards taxation, public debt and public

expenditure with specific objectives in view. It defined as the government’s program of taxation,

expenditure and other financial operations to achieve national goals.

Objectives of Fiscal policy:

1. Full employment

2. Economic stability

3. Rapid economic growth

4. Price stability

5. Encourage investment

6. Reducing inequalities in income

7. Break the circle of poverty

8. Reducing unemployment and underemployment

9. Capital formation

10. Control inflation and deflation effects

11. Optimum allocation of resources

12. Increase standard of living

Components of fiscal policy:

1. Public revenue

2. Public expenditure

3. Public debt

4. Deficit financing – printing of fresh and new currency notes by government without

keeping any sort of gold reserve or foreign exchange reserves.

5. Budgetary policy

Fiscal tools:

1. Subsidies

2. Development rebates

3. Tax relief, tax concession, tax exemptions and tax holidays

4. Freight concessions 5. Relief expenditure, debt relief 6. Public work programs



“Fiscal policy regarding public revenue, public expenditure and public debt”


expenditure with specific objectives in view. It defined as the government’s program of taxation,

expenditure and other financial operations to achieve national goals.

1. Public revenue:

Public revenue refers to the income earned by the Government from both tax and non tax

revenues. A suitable tax policy is always regarded as an important technique in bringing

about economic stability. Because changes in the rates of taxes will cause change in the

level of disposable income and consumption expenditure of the people.

Generally government generates revenues through tax and non tax sources.

I. Tax revenues:

It refers to the revenues collected by the government in the form of taxes.

a. Income tax: it refers to taxes levied on income of individuals, HUF, partnership firms,

joint stock companies etc..

b. Corporate tax: it refers to the tax levied on the net profit of joint stock companies

c. Custom duties: it refers to the duties imposed on the goods imported into and exported

from India.

d. GST: goods and services taxes imposed on commodities produced in India and

services rendered.

II. Non tax revenues:

These are the several sources of non tax revenues of the central government. They are

a. Profits earned by industries and commercial enterprises owned by central government.

b. Profits earned by Indian railways

c. Profits earned by posts and telegram

d. Profits earned by RBI

e. Interest on loans and advances granted to local governments

f. Fees collected from educational institutions and health departments

g. Fines and penalties



2. Public expenditure:

public expenditures refers to the expenditures incurred by the government for the

promotion of economic and social welfare of the people. Public expenditure is broadly

classified into revenue expenditure and capital expenditure.

I. Revenue expenditure:

It refers to the expenditure incurred by government for the day to day administration

and for maintenance of social, economic, administration and defense services.

a. Civil expenditure:

It refers to administration expenditure of the government relating to maintenance of

law and order.

b. Expenditure on general services:

Expenditure incurred on the maintenance of law and order.

c. Expenditure on social service:

Expenditure incurred on providing social services like education, medical, housing

etc..

d. Expenditure on economic services:

Expenditure incurred on economic services like agriculture, industry, mining,

power, transportation and communication etc…

e. Defense expenditure: expenditure incurred on defense forces such as army, navy,

air force etc..

f. Grants to state and local governments:

g. Miscellaneous expenditure:

Subsidies to exporters, industries, relief to the peoples in times of flood, draughts

and natural calamities etc..

II. Capital expenditure:

It refers to the expenditure incurred by the government for creating permanent revenue

yielding assets. Such as development of industries, agriculture, transport and

communication, power plants etc..



3. Public Debts:

Public debt refers to the borrowings of the government to meet budget deficits. It is used

as an effective instrument of fiscal policy to control inflation and deflation.

Sources of public debts

Internal debt: it refers to money borrowed by the government of India from individuals

and institutions within country.

External debt: it refers to the borrowings of the government of India from foreign

countries and from international financial institutions.

Internal debt External debt

1. Borrowings from

commercial banks

2. Borrowings from RBI

3. Treasury bills

4. Issue of bonds

5. Market loans

1. Borrowings from international

financial institutions

2. Borrowings from foreign

governments

3. Borrowings from foreign banks,

individual and non financial

institution

Reasons for increasing in public expenditure:

1. Increase in developmental expenditures like agriculture, industry, mining, power,

transportation and communication etc…

2. Increase in social expenditures like education, medical, housing etc..

3. Increase in social expenditure like education, medical, housing etc..

4. Increase in defense expenditure

5. Increase grants to governments

6. Increase in civil expenditure

7. Increase in price level

8. Rapid growth of population

9. Increase in extra-ordinary expenditure on relief of people in times of draughts and floods.

Causes for increase in public debt:

1. To provide certain basic facilities such as education, medical facilities, house etc..

2. To meet fiscal emergencies like war, floods cyclone etc..

3. To control effects of business cycle

4. To undertake social welfare schemes



5. To import latest technology

6. To run state commercial enterprises, public sector industries

Business cycle/ Trade cycle:

Trade cycles are species of fluctuations in economic activities of organized communities. It

refers to a wave like fluctuations in aggregate economic activities particularly in national

income, employment and output.

Causes of business cycle:

1. Expansion and contraction on money supply

2. Over investment in capital goods

3. Under consumption and over savings

4. Innovations

5. Fluctuations in rate of interest

6. Wars

7. Population growth

8. Technological advancement

Phases of business cycle:

1. Depression :

Depression is the first phase of trade cycle when the economic activity is extremely low.

During depression all construction activities come to a more or less halting stage. Capital

goods industries suffer more than consumer goods industries. Producers suffer heavy

losses, purchasing power of consumers low.

Features:

a. A sharp reduction in output, trade activities

b. A sharp reduction income of the community

c. A fall in price of products

d. Decline in consumer expenditure

e. Increase in the level of unemployment



2. Recovery or revival:

After a period of depression, recovery starts. It is a period where economic activities

recover from shocks. Recovery is the turning point of economy from depression to

expansion. Recovery period helps the business people to restore the confidence and

creates the favorable climate for business activities. As result of these factors, business

people take more risks and invest more.

Features:

a. Increase in government expenditure

b. New innovations – developing new products and services, new marketing strategy

c. Changes in the production techniques

d. Investments in new regions

3. Prosperity or full employment:

This stage is also called as expansion, the prosperity stage is characterized by high level of

output and trade, high level of employment and income, large expansion of bank credit,

high demand , high level of purchasing power, consumer expenditure etc..

4. Boom or over full employment or inflation:

The prosperity phase does not stop at full employment. It gives the way to boom. Business

optimism stimulates further investment leading to rapid expansion in all business

activities. At this stage increased pressure in investment leads to increase in wages and

prices. No productive resources are facing unemployment at this stage saving must be

equal to investment.

Features:

a. Higher output, income and employment

b. Increases in wages, prices, profits

c. Business people borrow more and invest

d. Higher purchasing power

e. It is a symptom of end of prosperity phase and beginning of recession



5. Recession:

It is the period where in the aggregate level of economic activities starts declining. There

is a slowing down of business activities. After reaching the peak point, demand for the

goods decline, over investment and production creates imbalance between supply and

demand

Features:

a. Unemployment

b. Fall in wages, income and profits

c. Fall in market price

d. Banks curtails credits

e. Decline in share price

f. Decline in investment, income and consumption



Measures to control business cycles:

I. Monetary measures:

When economy in moving in upward direction:

1. Restricting the issue of legal tender money

2. Putting restrictions to the expansion of bank credit

3. A rise in bank rate and lending rates

4. Increase in CRR and SLR

5. Open market sale of securities

6. Raising margin requirements

7. Making credit costly

When economy in moving in downward direction:

1. Cheap money policy

2. Reduce in bank rate and lending rates

3. Reduction in CRR and SLR

4. Purchase of securities in open market

5. Reducing marginal requirement

II. Fiscal measures:

During the period of boom:

a. Imposing high taxes

b. Price control measures

c. Government should adopt Surplus budget

d. Reduce public expenditure

During the period of depression:

a. Reduce tax rates, grant subsidies, tax concessions

b. deficit financing

c. increase the volume of public expenditure

d. adopt deficits budget

III. other measures:

a. during the period of boom, adopt price control policy

b. During the period of depression adopt price support policy.

c. Unemployment insurance schemes



Economic Growth

Meaning: It is an Increase in the capacity of an economy to produce goods and services

compared from one period to another.

An increase in the amount of goods and services produced per head of the population over a

period of time.

Increase in a country’s productive capacity as measured by comparing gross national product in

a year with the GNP in the previous year.

Definition: Economic growth is defined as “a positive change in the level of production of

goods and services by a country over certain period of time”.

Difference between economic growth and economic development

Sl No Economic Growth Economic Development

1 Economic growth is basically meant by

positive change in the real output of the

country in a particular span of time.

Economic development involves rise in

level of production in an economy along

with advancement of technology,

infrastructure development and

improvement in standard of living and so

on.

2 It is a narrow concept It is an broader concept

3 Economic growth is a single dimensional It is multidimensional phenomenon

4 Economic growth is a quantitative

concept

It is both quantitative and qualitative

concept.

5 Economic growth is short term process

It is a long term process.

6 Economic growth applies to advances

nations or rich nations or highly

developed nations

Economic development is associated with

developing or poor nations.

7 Economic growth applies for specific

period of time.

Economic development is a continuous

process



Problems of Economic Growth:

1. Misuse of resources due to market imperfections

2. Rapidly growing population

3. Lack of employment

4. Lack of innovation

5. Lack of advanced technology – difficulty in adopting western technology

6. Lack of adequate training facilities

7. Lack of financial recourses

8. Lack of infrastructure facilities

9. Adverse balance of payment – import is more than export

10. Political instability

11. Lack of forward planning

12. management problems

Factors Affecting Economic Growth

I. Economic Factors:

1. Natural resources:

Countries with abundant natural resources can develop its economy much faster when

compared to a country that is deficient in natural resources.

2. Capital formation:

Capital is life blood of all economic activities. Capital creation means creation of

capital goods or assets. Larger quantity of capital assets results into higher output and

vice versa.

3. Technological progress:

Adoption of new technology, changes in method of production, improvements results

into higher output and vice versa.

4. Division of labor:

It means right man in the right job. Division of labor and specialization leads to higher

output.

5. Economic stability:

It means absence of fluctuations in economic activities. Which result in to higher

output.



6. Population growth:

Increase in population leads to increase in output and vice versa.

7. Size of the market:

Expansion in the size of the market leads to increase in output and vice versa.

8. Removal of market imperfections:

Removal of market imperfections like low efficiency in productions, under and misuse

of resources, monopoly practices and price rigidity results into increase in output and

vice versa.

II. Non Economic factors:

1. Political stability

2. Social and cultural factors

3. Technical knowledge and education

4. Desire for development

5. Human resources

6. Corruption

III. International factors:

1. Foreign capital

2. Foreign trade

3. International co operation

Various policies towards economic stability:

1. Fiscal policy

2. Monetary policy

3. Floating exchange rates – in the event of negative demand or supply, the exchange rate

will fall

4. Flexible labor markets



Role of financial intermediaries in Economic Growth:

1. Serve as a agent of development in various areas like agriculture, industry and

international trade

2. Accelerate the growth of economy

3. Support for rapid industrialization

4. Provide additional employment opportunities

5. Development of backward areas

6. Take up rural development and agriculture

7. Financing housing and small scale industries

8. Provide technical and administrative assistance

9. Undertaking marketing research and surveys

10. Refinancing

11. Women development

12. Financing of those projects which are of great importance to economy.

Capital output ratio:

It means the ration of capital used to produce the desired level of output over a period of time.

This ratio has a tendency to be high when the capital is available at cheaper rates as compare to

other inputs.

It explains the relationship between changes in capital investment and corresponding changes in

output.

The capital output ratio of 2 types

1. Average capital output ratio

2. Marginal/incremental capital output ratio

Average capital output ratio

The average capital output ratio express the quantitative relationship between the stock of capital

available in a period of time and the output of that time.

Average capital o/p ratio = stock of capital / total output



Marginal/incremental capital output ratio

It express the relationship between the amount of increase in output or income (Y), resulting

from a given increase in the stock of capital (K)

ICOR = k / Y

Determinants of capital output ratio

1. Availability of natural resources

2. Amount of capital employed

3. Growth of population

4. Efficient use of capital equipments

5. Level of education

6. Impact of imports and exports

7. Industrialization and urbanization

Growth models

Economic growth models is been proposed by different economist on their own way that result

in economic growth under different perception.

1. Harrod-Domor model

2. Exogenous growth model

3. Surplus labor model

4. Harris-Tadoro model

Harrod-domor model

It is proposed by Sir.Roy Harrod of Britain and E.V Domor of USA.

According to this model a functional economic relationship in which the growth rate GDP(g)

depends directly on national saving ratio(s) and inversely related to the National capital output

ratio(k).

Therefore with this we can say that g=s/k



Exogenous growth model

This theory or Neo classical growth model of Robert Solow emphasis on the role of

technological change. unlike Harrod-Domor model, the saving rate will only determine the level

of income but not the rate of growth.

The sources of growth measurement obtained from this model highlights the relative

importance of capital formation or capital accumulation and technological change in economic

growth.

This study showed that technological change accounted for almost 90% of economic growth in

the late 19th and 20th century.

Surplus labor model

This model is proposed by ‘lewis- ranis-fei’. Economic models such as unbalanced growth,

Big-push model, etc. are only partial theories of economic growth that address specific issues.

But the surplus labour model takes into account, the peculiar economic situation in developing

countries like unemployment. Underemployment of resources and dualistic economic structure.

Here it is understood that the development process is triggered by existence of surplus labour

when compared with the availability of employment opportunities in the country.

This leads the HR to work for minimum wage or subsistence wage which intern results in no

savings, no investment, no capital formation there by leading to slow economic growth.

Harris- Tadoro model

This theory of rural-urban migration is usually studied in the context of

employment and unemployment in developing countries. In the Harris-Tadoro model the

purpose is to explain the serious urban unemployment problem in developing countries. The

applicability of this model depends on the development stage and economic success in the

developing country.



Model questions:

1. Discuss briefly the principal methods adopted by central bank to control credit. OR

Explain the measures of control imposed by RBI to regulate the monetary system in India.

OR

Explain the Tools of monetary policy OR

What factors have attribute to recent economic tsunami? Explain the techniques used by RBI

to overcome this problem. OR

Critically examine the process of commercial banks in creation of credit and their

limitations.

2. “Fiscal policy refers to the policy of the Government regarding public revenue, public

expenditure and public debt”. Elucidate.

3. Discuss the different stages of Inflation. Give a detailed description about the causes and the

various measures adopted by RBI to control Inflation.

4. What is business cycle? What are its phases? Explain the causes and Mechanism to

overcome the trade cycles.

5. Explain the various problems of Economic growth and economic development of India.

6. How do you differentiate between economic growth and economic development? Explain

the factors determining the economic growth.

7. Objectives of fiscal policy, monetary policy

8. Discuss the significance of monetary policy

9. Explain the role of Financial intermediaries in economic growth

10. Explain the functions of money.

11. Discuss the various policies towards economic stability.

12. Capital output ratio

13. Economic growth models



2 Marks Questions and Answers

Macroeconomic:

Macro economics is a branch of economics that studies the economic behavior not of an

individual but the economic system as a whole. It studies the overall conditions of the economy

such as total consumption, total national income, aggregate supply and demand, general price

level.

Instead of studying the income employment, output of a particular firm or industry. In macro

economics we are studying aggregates like total income, total employment, total output in the

economy.

Objectives of Macro economics

1) Economic growth

2) Full employment

3) Economic efficiency

4) Price stability

5) Economic security

Resources of macro economics

Land

Labour

Capital

Entrepreneurship

Economic system

It is a system of production, distribution, consumption of goods and services in a society. It

composed of people, Institution, rules and relationships.

Capitalistic or Capitalism: (free market)

It’s a system of economic organization in which the factors of production are owned, manage

and control by private individual and product takes place for private profit.



Socialistic economy:

Under socialistic economy the factor of production that is land, labor, money, organization has

owned manage, control by state / government. They carried business for social welfare.

Mixed economy:

It refers to the all the factors of production like land, labor, money, organization are owned,

managed, and controlled by both private individuals and government. Business carried over for

profit and social welfare.

National Income:

National income is the total net value of all goods and services produced within a nation over a

specified period of time. It represents sum of wages, profits, rents, interests and pension

payments of citizens of a nation.

Gross domestic product (GDP):

Gross domestic product (GDP) is the total market value of all final goods and services produced

within a country in a year. It does not include income earned from abroad.

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

Gross National product (GNP):

Gross National product (GNP) is the total market value of all final goods and services produced

within a country in a year plus net factor income earned from abroad.

GNP = C + I + G + (X-M) + NFIA

Net National Product (NNP):

NNP is the market value of goods and services produced within a country and net factor income

from abroad minus Depreciation.

NNP = GNP - Depreciation

Personal Income (PI):

PI is the sum of all incomes actually earned by the individuals and households in a country

during one year. It is the amount available to them for spending, paying taxes, and saving

purpose



Disposable income (DPI):

From personal income if we deduct personal taxes like income taxes, personal property taxes

etc.. What remains is called disposable income.

Per capital income:

Per capital income refers to the average income per head of population.

It is calculated by dividing national income by total population.

Per capital income = national income / total population

Consumption

It means the satisfaction of Human wants by using goods and services. In other words

Consumption is not only related with using of commodities but the use of utilities contain in

goods and services in order to satisfy wants

Consumption function

Consumption function is also known as propensity to consume. It shows the relationship

between Income and Consumption.

Average propensity to consume

The average propensity to consume explains the relationship between total consumption and

total income at a certain period of time.

In other words, APC explains what percentage of income spent on consumption of goods and

services. We can drive APC by dividing consumption expenditure by total income.

APC = Total consumption/Total income or APC = C/Y

Marginal propensity to consume

The concept of MPC is very important in macro economics J.M Keynes has defined MPC “as

the relationship between changes in consumption and changes in income”

In other words, the ratio of changes in consumption to the changes in income. It may be derived

by dividing changes in consumption by changes in income.

MPC = Changes in consumption/Changes in income

Or



MPC = C /Y

Physical consumption:

Physical consumption is all about buying and using goods and services. This type of

consumption leads to physiological well being.

Conspicuous consumption:

Buying expensive items to display wealth and income rather than to fulfill the real needs of the

consumer.

Risk averse consumption:

Buying and using the goods and services in order to reduce the risk .ex: healthcare products,

banking services, insurance etc..

Saving:

Saving is a part of income which is not spent on consumption.

It is defined as the excess of income over consumption.

According to Keynes “saving is the amount left over when the cost of a person’s consumer

expenditure is subtracted from the amount of income that he or she earns in a given period of

time”.

Average propensity to consume (APS)

It is the % of income saves at given level of income. In other words it is a relationship between

savings and income.

It is calculated by dividing savings by Income.

APS = savings / Income OR S / Y

Marginal propensity to consume (MPS)

MPS is the ratio of changes in savings to changes in income. The following formula is used to

find out MPS

MPS = changes in savings / changes in income

OR



MPS = S / Y

Paradox of Thrift [Savings]

The Paradox of Thrift explains that an attempt to Increase an Individuals savings would lead to

a decrease in total savings of the community. This is because of the simple reason that “One

man’s expenditure is another man’s Income”.

Induced Investment:

Investment which varies with the changes in the level of national income is called induced

investment. The larger the national income the higher is the investment and vice versa

Autonomous Investment:

The investment which is not influenced by national income is called autonomous investment

It is influenced by many basic factors such as increase in population changes in technology,

rate of interest etc…….

Marginal Efficiency of Capital:-

According to JM Keynes marginal efficiency of capital is the rate of return expected on new

capital asset over its lifetime.

Multiplier:-

It is believed that an initial increment in investment leads to a greater increases in income.

Multiplier explains the relationship between increases in investment due to increases in income

Multiplier (k) = changes in Income / changes in Investment

OR K = Y /I

Aggregate Demand

Aggregate Demand is the amount of consumption and amount of investment expenditure at

each level of income.

There are 2 components of Aggregate Demand

Consumption Expenditure (c) and Investment Expenditure (I)



Aggregate Demand can be expressed as, Y=C+I

Aggregate Supply

Aggregate Supply is equal to National Income in others Words, National Income is equal to the

price of Goods and Services produced in the country so

Aggregate Supply = Consumption + Savings

Inflation:

Inflation is the rise in the general price level of goods and services in an economy over a period

of time. The increase in price level leads to decrease in purchasing power of currency.

Deflation: (opposite to Inflation)

Deflation is the fall in the general price level of goods and services in an economy over a period

of time. According to Prof Crowther “deflation is that state of economy where the value of

money is rising or the prices are falling”.

Monetary policy:

Monetary policy is the process by which the monetary authority of a country (RBI) controls the

supply of money.

Formulated by RBI

Fiscal policy:


expenditure with specific objectives in view.

Formulated by Central Government

Cash reserve ratio:

The CRR refers to that portion of the aggregate demand deposits which the commercial banks

are required to keep with RBI



Statutory liquidity ratio:

The SLR refers to that portion of the aggregate demand deposits which the commercial banks

are required to keep with themselves in a liquid form.

Repo rate:

Repo rate is the rate at which RBI lends money to the commercial banks

Reverse repo rate:

RRR is the rate at which RBI borrows money from the commercial banks.

Business cycle/ Trade cycle:

Trade cycles are species of fluctuations in economic activities of organized communities. It

refers to a wave like fluctuations in aggregate economic activities particularly in national

income, employment and output.

Recession:

It is the period where in the aggregate level of economic activities starts declining. There is a

slowing down of business activities. After reaching the peak point, demand for the goods

decline, over investment and production creates imbalance between supply and demand

Economic Growth

It is an Increase in the capacity of an economy to produce goods and services compared from

one period to another.

An increase in the amount of goods and services produced per head of the population over a

period of time.

Capital output ratio:

It means the ration of capital used to produce the desired level of output over a period of time.

This ratio has a tendency to be high when the capital is available at cheaper rates as compare to

other inputs.



Average capital output ratio

The average capital output ratio express the quantitative relationship between the stock of

capital available in a period of time and the output of that time.

Average capital o/p ratio = stock of capital / total output

Marginal/incremental capital output ratio

It express the relationship between the amount of increase in output or income (Y), resulting

from a given increase in the stock of capital (K)

ICOR = k / Y

Tools of fiscal policy

a. Subsidies

b. Tax relief, tax concessions

c. Public work programs

d. Development rebate

Interest rate structure

Interest rate at which the banking sector lends to the borrower is called interests rate. It is

normally expressed as % rate over a period of one year

The relationship between maturity period and rate of interest rate is called interest rate

structure

Mention 4 wheels / drivers of economic growth

a. Capital

b. Technology

c. Human resource

d. Natural resources



What are financial assets? Give example.

An asset that derives the value because of contractual claim. In other words assets in the form of

stock, rights, certificates, bank balance etc.. as distinguished from tangible, physical assets. Ex:

stocks, bonds, bank deposits

Disguised unemployment

Disguised unemployment is a kind of unemployment in which some people look like being

employed but are actually not employed fully. This situation is also known as hidden

unemployment

Trading down

Customer point of view

Trading down means switching from an expensive or branded product to a lower priced, lower

quality product due to economic constraints

Company point of view

Trading down means offering a lower quality product by reducing the number of features in

order to reduce selling price.

Scarcity inflation:

Increase in the price of goods and services due to fall in production or artificial Hoarding.

Capital formation:

Capital formation means creation of capital goods or capital assets to increase the productivity.

Galloping inflation: or Hyper inflation

Under this inflation price rises every moment and there is no upper limit to the price rise.

Liquidity trap

The liquidity trap is a situation in which injections of cash into private banking system by a

central bank fail to decrease interest rate.



Production possibility frontier: (PPF)

A PPF shows the output combinations of two goods or services attainable when all resources

are fully and efficiently employed.

Selective credit control/ qualitative credit control

Qualitative or selective measures are designed to regulate the flow of credit in specific uses.

Documents

Module 1 Introduction to Macro Economics and National Income