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CHAPTER VI – NATIONAL INCOME, UNEMPLOYMENT, BUSINESS CYCLE,

POLICY, BEP AND MAXIMIZATION

The Role of Profit in an Economy

Profit is the surplus revenue after a firm has paid all its costs. Profit can be seen as the
monetary reward to shareholders and owners of a business. In a capitalist economy, profit
plays an important role in creating incentives for business and entrepreneurs. For an
incumbent firm, the reward of higher profit will encourage them to try and cut costs and
develop new products. If an industry is profitable, it will encourage new firms to enter. If a
firm becomes unprofitable, it will either have to adapt and change or close down. This profit
motive can help increase efficiency, provide greater choice for consumers and allocate
resources according to consumer preferences.

However, profit can have a downside. To increase profits, firms may take action which
cause market failure. For example, an asset stripper could buy a failing firm – selling off its
assets and then make workers redundant. Alternatively, a firm may increase profits by
finding ways around environmental regulation and cause more pollution. Also, a firm may
seek short-run profit maximisation and under-invest in the long-term.
Behavioural economists argue that economics can often over-emphasise the role of profit.
For example, individuals are motivated by many factors other than profit, such as pride in
work, desire to work in bigger company, be successful and attachment to ideas – even if
unprofitable.

Importance of profit
1. Investment in Research
& Development. Higher
profit enables a firm to spend
more on research and
development. This can lead to
better technology, lower costs
and dynamic efficiency. This
profit is particularly
important for some industries
such as oil exploration, drug
research and car
manufacturing – which
require significant risky
investment to develop.
Without this profit and investment, the economy will stagnate and lose international
competitiveness, leading to job losses in some sectors.
This is a graph showing dynamic efficiency – a fall in long-run average costs due to
investment in more productive
technology. Without supernormal
profit, this investment may not
occur.
2. Reward for Shareholders
Shareholders are given dividends.
Higher profit leads to higher
dividends and encourages people to
buy shares. Shareholders are an
important source of finance for
firms. Profit is important to be able
to remunerate shareholders. It is
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the hope of future profit that enables firms to raise finance from shareholders to finance
expansion.

Low profit may make a firm the target of a takeover bid. If a firm appears to be under-
performing, shareholders may feel they are better off selling to a firm wishing to take them
over.

3. High Profit should attract new firms into the industry

If the price of oil is high then it will become more profitable. These profits should encourage
firms to develop new oil fields. With mobile Apps becoming more profitable, it will encourage
more firms to enter.

The role of profit in competitive markets

In this example, a price of P2 gives supernormal
profit (AR>ATC). However, if the market is
perfectly competitive, this profit encourages more
firms to enter. Supply increases and price falls
until normal profit is made (at P1 where
AR=ATC).
In the long-run profit returns to a normal profit
level.
4. Risk Bearing Economies
Profit can be saved and provide insurance for an
unexpected downturn, such as recession or rapid appreciation in the exchange rate. This is
important for volatile industries, like luxury products. Luxury goods may be very profitable
in boom years, but make a loss in recession.

5. Tax Revenues
Governments charge corporation tax on company profits and
this provides several billion pounds of tax revenue per year.
In the UK the corporation tax rate is 19%. Company profit
levels in the US. This shows the dip in profit during the
recession, but sharp rise after.

Profit and wages

In theory, higher profit should enable higher wages for all workers.

Median wages in US
However, this graph shows that rising profit levels do not necessarily lead to higher median
wages.

6. The incentive effect

Higher profit acts as an incentive for entrepreneurs to set up a business. Without the reward
of profit, there would be less investment and fewer people willing to take risks. In a
command economy, there is no profit incentive but this can easily lead to a lack of
incentives.

Evaluation of the Importance of Profit

 Though profit plays an important role in an economy, it is worth bearing in mind.

 Pursuit of profit may damage the environment
 Higher profit may lead to greater inequality in society. It depends whether firms
have monopoly/monopsony power.
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 The pursuit of short-term profit can encourage risk-taking and reckless

behaviour. For example, commercial banks took more risks in the 1990s and early
2000s; this contributed to the credit crunch.
 Firms may pursue other objectives apart from profit-maximisation. These objectives
can include growth maximisation, cultural/social objectives, sales
maximisation, Profit satisficing. see: objectives of firms

Difference Between Profit Maximization and Wealth Maximization

Financial Management is concerned with the proper utilization of funds in such a manner
that it will increase the value plus earnings of the firm. Wherever funds are involved,
financial management is there. There are two paramount objectives of the Financial
Management: Profit Maximization and Wealth Maximization. Profit Maximization as its
name signifies refers that the profit of the firm should be increased while Wealth
Maximization, aims at accelerating the worth of the entity.

Profit maximization is the primary objective of the concern because of profit act as the
measure of efficiency. On the other hand, wealth maximization aim at increasing the value of
the stakeholders.

There is always a conflict regarding which one is more important between the two. So, in this
article, you will find the significant differences between Profit Maximization and Wealth
Maximization, in tabular form.

Comparison Chart

BASIS FOR
PROFIT MAXIMIZATION WEALTH MAXIMIZATION
COMPARISON

Concept The main objective of a The ultimate goal of the

concern is to earn a larger concern is to improve the
amount of profit. market value of its shares.

Emphasizes on Achieving short term Achieving long term objectives.

objectives.

Consideration of Risks No Yes

and Uncertainty

Advantage Acts as a yardstick for Gaining a large market share.

computing the operational
efficiency of the entity.

Recognition of Time No Yes

Pattern of Returns

Definition of Profit Maximization

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Profit Maximization is the capability of the firm in producing maximum output with the
limited input, or it uses minimum input for producing stated output. It is termed as the
foremost objective of the company.

It has been traditionally recommended that the apparent motive of any business
organisation is to earn a profit, it is essential for the success, survival, and growth of the
company. Profit is a long term objective, but it has a short-term perspective i.e. one financial
year.

Profit can be calculated by deducting total cost from total revenue. Through profit
maximization, a firm can be able to ascertain the input-output levels, which gives the highest
amount of profit. Therefore, the finance officer of an organisation should take his decision in
the direction of maximizing profit although it is not the only objective of the company.

Definition of Wealth Maximization

Wealth maximizsation is the ability of a company to increase the market value of its common
stock over time. The market value of the firm is based on many factors like their goodwill,
sales, services, quality of products, etc.

It is the versatile goal of the company and highly recommended criterion for evaluating the
performance of a business organisation. This will help the firm to increase their share in the
market, attain leadership, maintain consumer satisfaction and many other benefits are also
there.

It has been universally accepted that the fundamental goal of the business enterprise is to
increase the wealth of its shareholders, as they are the owners of the undertaking, and they
buy the shares of the company with the expectation that it will give some return after a
period. This states that the financial decisions of the firm should be taken in such a manner
that will increase the Net Present Worth of the company’s profit. The value is based on two
factors:

1. Rate of Earning per share

2. Capitalization Rate

Key Differences Between Profit Maximization and Wealth Maximization

The fundamental differences between profit maximization and wealth maximization is

explained in points below:

1. The process through which the company is capable of increasing earning capacity
known as Profit Maximization. On the other hand, the ability of the company in
increasing the value of its stock in the market is known as wealth maximization.
2. Profit maximization is a short term objective of the firm while the long-term objective
is Wealth Maximization.
3. Profit Maximization ignores risk and uncertainty. Unlike Wealth Maximization, which
considers both.
4. Profit Maximization avoids time value of money, but Wealth Maximization recognises
it.
5. Profit Maximization is necessary for the survival and growth of the enterprise.
Conversely, Wealth Maximization accelerates the growth rate of the enterprise and
aims at attaining the maximum market share of the economy.
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Conclusion

There is always a contradiction between Profit Maximization and Wealth Maximization. We

cannot say that which one is better, but we can discuss which is more important for a
company. Profit is the basic requirement of any entity. Otherwise, it will lose its capital and
cannot be able to survive in the long run. But, as we all know, the risk is always associated
with profit or in the simple language profit is directly proportional to risk and the higher the
profit, the higher will be the risk involved with it. So, for gaining the larger amount of profit a
finance manager has to take such decision which will give a boost to the profitability of the
enterprise.

In the short run, the risk factor can be neglected, but in the long-term, the entity cannot
ignore the uncertainty. Shareholders are investing their money in the company with the hope
of getting good returns and if they see that nothing is done to increase their wealth. They will
invest somewhere else. If the finance manager takes reckless decisions regarding risky
investments, shareholders will lose their trust in that company and sell out the shares which
will adversely effect on the reputation of the company and ultimately the market value of the
shares will fall.

Therefore, it can be said that for day to day decision making, Profit Maximization can be
taken into consideration as a sole parameter but when it comes to decisions which will
directly affect the interest of the shareholders, then Wealth Maximization should be
exclusively considered.

BREAK-EVEN ANALYSIS

A break-even analysis is an economic tool which is used to determine the cost structure of a
company or the number of units needs to be sold to cover the cost. Break-even is a
circumstance where a company neither makes a profit nor loss, but recovers all the money
spent.
Break-even analysis is used to examine the relation between the fixed cost, variable cost, and
revenue. Usually, an organization with low fixed cost will have a low break-even point of sale.

Importance of Break-Even Analysis:

 Manages the Size of Units to be Sold- With the help of break-even analysis, the
company or the owner comes to know how much units need to be sold to cover the
cost. The variable cost and the selling price of an individual product and the total cost
are required to evaluate the break-even analysis.
 Budgeting and Setting Targets- Since a company or the owner know at which point
a company can break-even, it makes it easy for them to fix a goal and set a budget for
the firm accordingly. This analysis can also be practised in establishing a realistic
target for a company.
 Manage the Margin of Safety- In financial breakdown, the sales of a company tends
to decrease. The break-even analysis helps the company to decide the least number of
sales required to make profits. With the margin of safety report, the management can
execute a high business decision.
 Monitors and Controls Cost- Companies profit margin can be affected by the fixed
and variable cost; therefore, with break-even analysis, the management can detect if
any effects are changing the cost.
 Helps Design Pricing Strategy- Break-even point can be affected if there is any
change in the pricing of a product. For example, if the selling price is raised, the
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quantity of the product to be sold to break -even will be reduced. Similarly, if the
selling price is reduced, a company needs to sell extra to break-even.

Components of Break-Even Analysis:

 Fixed Cost- These costs are also known as an overhead cost. These costs materialize
once the financial activity of a business starts. The fixed price includes taxes, salaries,
rent, depreciation cost, labour cost, interest, energy cost etc.
 Variable Cost- This cost fluctuates, and will decrease or increase according to the
volume of the production. This cost includes packaging cost, cost of raw material, fuel,
and other material related to production.

Uses of Break-Even Analysis:

 New Business- For a new venture, break-even analysis is essential. It guides the

management with pricing strategy and be practical about the cost. This analysis also
gives an idea if the new business is productive.
 Manufacture New Product- If an existing company is going to launch a new product,
they still have to focus on break-even analysis before starting, and see if the product
adds necessary expenditure to the company.
 Change in Business Model- Break-even analysis works even if there is a change in
any business model, like shifting from retail business to wholesale business. This
analysis will help the company to determine if the selling price of a product needs
change.

Break-Even Analysis Formula

Break-Even Point = Fixed Cost / Price Per Cost
– Variable Cost
Example of Break-Even Analysis
Company X sells a pen. The company first
determined that the fixed costs of Company X are
a lease, property tax, salaries, which make a sum
of ₹1,00,000. The variable cost linked with
manufacturing one pen is ₹2 per unit. So, the pen
is sold at a premium price of ₹10.
Therefore, to determine the break-even point of
Company X premium pen will be:
Break-Even Point = Fixed Cost / Price Per Cost
– Variable Cost
= ₹1,00,000 / (₹12 – ₹2) = 10,000
Therefore, given the variable costs, fixed costs, and the selling price of the pen, Company X
would need to sell 10,000 units of pens to break even.

Break-Even Chart:
Break-Even charts are being used in recent years by the managerial economists, company
executives and government agencies in order to find out the break-even point. In the break-
even charts, the concepts like total fixed cost, total variable cost, and the total cost and total
revenue are shown separately. The break even chart shows the extent of profit or loss to the
firm at different levels of activity. The following Fig. 1 illustrates the typical break-even chart.
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In this diagram output is shown on the horizontal axis and costs and revenue on vertical
axis. Total revenue (TR) curve is shown as linear, as it is assumed that the price is constant,
irrespective of the output. This assumption is appropriate only if the firm is operating under
perfectly competitive conditions. Linearity of the total cost (TC) curve results from the
assumption of constant variable cost.
It should also be noted that the TR curve is drawn as a straight line through the origin (i.e.,
every unit of the output contributes a constant amount to total revenue), while the TC curve
is a straight line originating from the vertical axis because total cost comprises constant /
fixed cost plus variable cost which rise linearly. In the figure, В is the break-even point at OQ
level of output.
In the preparation of the break-even chart we have to take the following
considerations:
(a) Selection of the approach
(b) Output measurement
(c) Total cost curve
(d) Total revenue curve
(e) Break-even point and
(f) Margin of safety.
Meaning and Causes of Inflation
Demand-Pull Inflation, Cost-push inflation, Supply-side inflation Open Inflation, Repressed
Inflation, Hyper-Inflation, are the different types of inflation. Increase in public spending,
hoarding, tax reductions, price rise in international markets are the causes of inflation. These
factors lead to rising prices. Also, increasing demands causes higher prices which leads to
Inflation. In this article, we will discuss the meaning of inflation and what causes it.

What is Inflation?

According to many classical writers, inflation is a situation when too much money chases too
few goods and services. Inflation is measured by the Consumer Price Index(CPI).
Therefore, there is an imbalance between the money supply and the Gross Domestic Product
(GDP). There are many types of inflation like demand-pull inflation, cost-push inflation, supply-
side inflation. But Inflation can be divided into two broad types:
1. Open inflation – when the price level in an economy rises continuously and
2. Repressed inflation – when the economy suffers from inflation without any apparent
rise in prices.
According to Keynes, inflation is an imbalance between the aggregate demand and aggregate
supply of goods and services. Therefore, if the aggregate demand exceeds the aggregate supply,
then the prices keep rising.                                                                                        
Causes of Inflation
 Primary Causes
 Increase in Public Spending
 Deficit Financing of Government Spending
 Increased Velocity of Circulation
 Population Growth
 Hoarding
 Genuine Shortage
 Exports
 Trade Unions
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 Tax Reduction
 The imposition of Indirect Taxes
 Price-rise in the International Markets
Having understood the inflation meaning, let’s take a quick look at the factors that cause
inflation.
Primary Causes
In an economy, when the demand for a commodity exceeds its supply, then the excess demand
pushes the price up. On the other hand, when the factor prices increase, the cost of production
rises too. This leads to an increase in the price level as well.
Increase in Public Spending
In any modern economy, Government spending is an important element of the total spending.
It is also an important determinant of aggregate demand.
Usually, in lesser developed economies, the Govt. spending increases which invariably creates
inflationary pressure on the economy.
Deficit Financing of Government Spending
There are times when the spending of Government increases beyond what taxation can finance.
Therefore, in order to incur the extra expenditure, the Government resorts to deficit financing.
For example, it prints more money and spends it. This, in turn, adds to inflationary pressure.
Increased Velocity of Circulation
In an economy, the total use of money = the money supply by the Government x the velocity of
circulation of money.
When an economy is going through a booming phase, people tend to spend money at a faster
rate increasing the velocity of circulation of money.
Population Growth
As the population grows, it increases the total demand in the market. Further, excessive
demand creates inflation.
Hoarding
Hoarders are people or entities who stockpile commodities and do not release them to the
market. Therefore, there is an artificially created demand excess in the economy. This also
leads to inflation.
Genuine Shortage
It is possible that at certain times, the factors of production are short in supply. This affects
production. Therefore, supply is less than the demand, leading to an increase in prices and
inflation.
Exports
In an economy, the total production must fulfill the domestic as well as foreign demand. If it
fails to meet these demands, then exports create inflation in the domestic economy.
Trade Unions
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Trade union work in favor of the employees. As the prices increase, these unions demand an
increase in wages for workers. This invariably increases the cost of production and leads to a
further increase in prices.
Tax Reduction
While taxes are known to increase with time, sometimes, Governments reduce taxes to gain
popularity among people. The people are happy because they have more money in their hands.
However, if the rate of production does not increase with a corresponding rate, then the excess
cash in hand leads to inflation.
The imposition of Indirect Taxes
Taxes are the primary source of revenue for a Government. Sometimes, Governments impose
indirect taxes like excise duty, VAT, etc. on businesses.
As these indirect taxes increase the total cost for the manufacturers and/or sellers, they
increase the price of the product to have a minimal impact on their profits.
Price-rise in the International Markets
Some products require to import commodities or factors of production from the international
markets like the United States. If these markets raise prices of these commodities or factors of
production, then the overall production cost in India increases too. This leads to inflation in the
domestic market.
Non-economic Reasons
There are several non-economic factors which can cause inflation in an economy. For example,
if there is a flood, then crops are destroyed. This reduces the supply of agricultural products
leading to an increase in the prices of the commodities.
Investment in Gold, Real estate, stocks, mutual funds, and other assets are some of the ways to
deal with Inflation.

Q1. What is Inflation?

Answer: Inflation is a situation when too much money is chasing too few goods and services in
an economy. Hence, an imbalance exists between the GDP and the total money supply.
As per Keynes, inflation is an imbalance between the aggregate demand and aggregate supply
of goods and services. If the aggregate demand is more than the aggregate supply, prices
rise, leading to inflation.
Q2. What are the causes of inflation?
Answer: If the demand for a commodity exceeds its supply, then the excess demand increases
the price of the commodity. Also, if the price of the factors of production increases, the price of
the commodity increases too. The common causes that led to inflation are:
 Primary Causes
 Increase in Public Spending
 Deficit Financing
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 Increased Velocity of Circulation

 Population Growth
 Hoarding
 Genuine Shortage
 Exports
 Tax Reduction
 Imposition of Indirect Taxes
 Price-rise in the International Markets
 Non-economic Reasons
Impacts of Inflation
Inflation is not necessarily bad for the economy. For example, creeping inflation can generate
good effects on the overall economy of a country. In this article, we will look at the favourable
and unfavourable impacts of inflation.
Favourable Impacts of Inflation
The favourable impacts of inflation are as follows:
Higher Profits
Inflation, usually, benefits the producers of products. They experience better profits since they
can sell their products at higher prices.
Better Investment Returns
During inflation, investors and entrepreneurs receive added incentives for investing in
productive activities. Therefore, they receive better returns.
Increase in Production
Once the producers receive the right investment, they create more goods and services. Hence,
inflation leads to an increase in production of products/services.
More Employment and Better Income
Since production increases, there is an increased demand for the various factors of production,
including manpower. Therefore, employment and income increases during inflation.
Shareholders can earn a good income
If a company earns higher profits, which is possible during inflation, it can declare dividends to
its shareholders. Thus, the shareholders can experience a rise in their dividend income during
inflationary periods.
Benefits to Borrowers
During inflation, the purchasing power of money decreases. Therefore, if the borrower is paying
a rate of interest which is less than the inflation rate, then he gains in the process. This is
because the real value of the money that the borrower returns is actually less than that of the
money borrowed.

The unfavourable impacts of inflation are as follows:

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Fixed-Income Groups experience a fall in income

The true income of an individual is the purchasing power of his money income. In other
words,Real Income =\frac {\text{Money Income}}{\text{Price
Level}}RealIncome=Price LevelMoney Income.
For people belonging to the fixed-income group like salaried individuals, pensioners, etc. this
means that they will experience a fall in real income. In other words, their purchasing power
will reduce.

Inequality in Income Distribution Increases

During inflation, businessmen and entrepreneurs experience an increase in profits. On the

other hand, people belonging to the fixed-income groups experience a decline in their real
income. Hence, the inequality in income distribution becomes acute during this period.

Upsets the Planning Process

During inflation, the prices of goods, raw materials, and factor services increase. Therefore, the
Government has to spend more money to complete any investment project taken up during the
planning period.

If the Government fails to raise more financial resources through savings or taxation, then it
upsets the entire planning process.

Speculative Investment Increases

Let’s say that the price levels are rising at a very fast rate. People are unsure about how much
the prices will rise in the next few weeks or months. In such cases, many people start
speculative investments.

For example, they might start purchasing shares, gems, land, etc. just for speculative purposes.
This is done with the objective of earning quick profits. Such investments do not help in
creating productive capital in the economy.

Harmful Effects on Capital Accumulation

Let’s say that rising prices become chronic in an economy. During such periods, people start
preferring goods to money since the real value of money will fall in the future. Also, people start
preferring immediate consumption to consumption in the future.

Therefore, the general desire to save starts reducing. As the willingness and ability to save
reduces, the amount of funds available for further investment reduces too. Therefore, the
overall impact on the capital accumulation of the economy is negative since capital
accumulation in an economy depends on the growth of investment.

Lenders face Losses

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Under favourable impacts of inflation, we mentioned that borrowers benefit from inflation.
Therefore, lenders stand a chance of losing during such periods. This is because they receive an
amount having lower purchasing power than the amount loaned.

Negative Impact on Export Income

Since the prices of raw materials and factors of production increase, the prices of export items
also increase during inflation. Hence, their demand in the foreign markets might fall which
leads to a fall in the export income of the country.

Q1. What are the favourable impacts of inflation on the economy?

Answer: Inflation favourably impacts the economy in the following ways:

 Higher Profits since producers can sell at higher prices

 Better Investment Returns since investors and entrepreneurs receive incentives for
investing in productive activities

 Increase in Production

 More Employment and Better Income

 Shareholders can earn a good income since companies book more profits and tend to
share it with their shareholders via dividends

 Benefits to Borrowers – The real value of the money returned is less than that of the
money borrowed

Q2. What are the unfavourable impacts of inflation on the economy?

Answer: Inflation unfavourably impacts the economy in the following ways:

 Fixed-Income Groups experience a fall in income including salaried employees,

pensioners, etc.

 Inequality in Income Distribution Increases

 Upsets the Planning Process

 Speculative Investment Increases

 Harmful Effects on Capital Accumulation

 Lenders face Losses

 Negative Impact on Export Income

Effects of Inflation on Production and Distribution of Wealth

Inflation affects different aspects of the economy. In this article, we will explore the effects of
inflation on production activities and the distribution of wealth.
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Effects of Inflation on Production

Inflation has the following effects on production activities:

 Inflation may or may not result in an increase in production

 As long as the economy does not reach the full employment stage, inflation has a
favorable effect on production

 Usually, as the price level increases, profits increase too

 During inflation, businessmen tend to raise the prices of their products to earn better
profits

 However, if the wages and production costs start rising rapidly, then this favorable
effect of inflation does not last long

 If the inflation in an economy is of the cost-push type, then the inflationary situation
usually leads to a fall in production

 There is no direct correlation between prices and output

Effects of Inflation on the Distribution of Wealth

Inflation has the following effects on the distribution of wealth:

 Usually, during inflation, most people experience a rise in their income levels

 Some people might gain at the cost of others. As the sellers will be able to sell the
goods at a higher rate to its customers due to inflation.

 A certain set of people gain because their money income rises faster than the prices

 A different set of people lose because prices rise faster than their incomes during
inflation

Effects of Inflation on Different Categories of People

Let’s look at how inflation affects different categories of people.

Debtors and Creditors

 During inflation, borrowers tend to gain. Hence, lenders tend to lose.

 Borrowers gain because they repay less in real terms as compared to when they had
borrowed the money

 Lenders lose because when they receive repayment of their debts, the real value of
their money declines by the amount of increase in the price levels

 In other terms, a borrower receives ‘dear rupees’ but pays back ‘cheap rupees’.

Bond and Debenture Holders

 Debenture and Bond Holders earn fixed income on their investments

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 Therefore, when the price levels rise, they suffer a reduction in real income

 Beneficiaries of life insurance programs also suffer badly because the real value of

their savings deteriorates

Investors

During inflation, businesses have an opportunity to earn good profits. Therefore, people who
invest in shares during inflation tend to gain. As the businesses earn higher profits, they
usually distribute the profit among investor and shareholders too.

Salaried People and Wage-earners

During inflation, people earning a fixed income face a lot of damage because the rate of increase
in wages is always behind the rate of increase in prices.

Therefore, inflation results in a drop in the real purchasing power of people earning a fixed
income. Hence, people earning a flexible income tend to gain during inflationary periods.

Profit Earners, Speculators, and Black Marketeers

 During inflation, the profit-earners gain

 Businessmen also raise the prices of their products and earn bigger profits

 Speculators gain by inflation, especially when the prices of factors of production

increase too

 Black marketeers tend to gain since the price of products increases with time
Q1. What are the effects of inflation on production activities?

Answer: Inflation may or may not result in an increase in production. Also, inflation has a
positive impact on production as long as the economy does not reach full employment stage.
Further, if the wages and production costs start rising rapidly, then it negatively impacts
production activities

Control Of Inflation
For any economy, inflation is a complex phenomenon. While moderate inflation is usually good
for an economy, if it goes beyond it, then it can cause a disastrous situation for the economy. In
this article, we will look at the fiscal policy and monetary measures to control inflation that the
Government undertakes.
Measures to Control Inflation
The government takes different measures to control inflation of different types as explained
below:
Demand Pull Inflation Control
In order to control the demand-pull inflation, the Government undertakes some monetary
measures and incorporates certain changes to the fiscal policy.
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Monetary Measures
One of the commonly used measures to control inflation is controlling the money supply in the
economy. If the Government decreases the supply of money, then the demand will fall, leading
to a fall in prices.
Therefore, the Government may decide to withdraw certain paper notes and/or coins
from circulation. This decreases the money supply.
It is important to note that a major portion of the money supply lies with banks in the form of
deposits or bank credit.
Therefore, by reducing the bank’s rate of lending (amount of money offered as credit), the
Government can considerably reduce the supply of money in the economy.
In order to do so, the Central Bank of a country (RBI in India) increases the bank rate and
reserve requirements leading to a reduction in the lending activities of banks.
Further, the Central Bank also starts issuing Government securities to commercial banks.
Therefore, these banks spent a significant portion of their money on purchasing these
securities and reduce the credit supply to the general public.
Fiscal Policy Measures to Control Inflation
Apart from the monetary measures, the Government also uses fiscal measures to control
inflation. A country’s fiscal policy has two essential components – Government revenue
and expenditure.
Therefore, the Government can change the tax rates to
increase its revenue or manage its expenditure better.
Typically, when the aggregate demand exceeds the
aggregate supply, an inflationary gap arises. Therefore, the
Government can take these fiscal measures to control
inflation:
1. Take steps to decrease the overall Government expenditure and transfer payments
2. Increase the rate of taxes causing individuals to decrease their total expenditure,
leading to a decrease in demand and a drop in the money supply in the economy.
The government can also use a combination of the two to obtain a reasonable control over
inflation.
Cost-Push Inflation Control
In order to control cost-push inflation, the Government uses direct control measures. These
include steps like freezing the wages of workers, putting upper limits on the prices of important
inputs like electricity, coal, steel, etc.
While these steps can control the extent of inflation, it is not a good ploy for the long-term. At
the end of the day, identifying the cause of inflation is the best way to control it.
Some other measures to control inflation
These are:
 16

 Increasing imports to augment the supplies of commodities in the domestic market

 Increasing domestic production, etc.
Q1. What are some primary measures that the government takes to control inflation?
Answer: Primarily, the government uses monetary and fiscal measures to control inflation.
Under monetary measures, it takes various steps to control the supply of money in the
economy which invariably leads to a decrease in demand and thus, control over inflation.
Under fiscal measures, the government tries to decrease its expenditure and increase its
revenue.

Definition and Functions of Money

In order to understand the fundamentals of economics, it is imperative to have a good
understanding of money. In this article, we will look at the definition of money from an
economics perspective and also the various functions of money.
Definition of Money
Money, in simple terms, is a medium of exchange. It is instrumental in the exchange of goods
and/or services.
Further, money is the most liquid assets among all our assets. It also has general acceptability
as a means of payment along with its liquid nature.
Usually, the Central Bank or Government of a country creates and issues money. Also called
cash money, this is a legal tender and hence there is a legal compulsion on citizens to accept it.
Credit money is another form of money which the banks create through loan transactions.
Functions of Money
There are many static and dynamic functions of money as follows:
Static Functions of Money
These functions are:
 A medium of Exchange – In an exchange economy, money plays an intermediary role.
It makes the exchange system smooth and convenient.
 A measure of Value – The value of a product or service is determined on the basis of
the money needed for its possession. This helps in making the exchange a mutually
profitable activity.
 The Standard of Deferred Payments – Money plays an important role in lending and
borrowing. Money is taken as a loan and repaid after a time-gap.
 Store of Value – You can store the purchasing power of money and keep a part of it
for future use – monetary savings. You can use your current income for current
consumption as well as future consumption through savings.
Learn more about Quantity Theory of Money here in detail.
Dynamic Functions of Money:
These functions are:
 17

 Money can activate idle resources and put them into productive channels.
 Therefore, it helps in increasing output, employment, and also income levels.
 Further, it helps in converting savings into investments.
 The creation of new money governments of modern economies can spend more than
what they earn.
Value of Money
The value of money simply implies its exchange value. It means the number/amount of goods
and/or services that you can obtain in exchange for a single unit of money.
Further, the value of money is inversely proportional to the price of goods/services. Therefore, if
the price level increases, the value of money decreases and vice-versa.
Forms of Money
We can classify the total money supply of an economy into two broad groups – Cash Money and
Credit Money, including all other financial assets. The degree of money-ness of different assets
is different.
The Components of Money Supply
The components of the money supply are as follows:
 Paper Money and Coins – The Central Bank or Government issues these as Currency.
Further, they have a 100% acceptance as a means of payment. The acceptance is based
on a ‘promise to pay the bearer’ gold and/or foreign exchange in return.
 Demand Deposit – A bank has a legal obligation to pay money on demand. The
money-ness is highest in currency and demand deposits.
 Near Money or Money Substitute – A commonly used Near Money is a bank cheque.
many people accept it as a means of payment. However, there is no legal compulsion
behind their acceptance.
 Term deposit – This is less liquid than a demand deposit as the individual cannot use
it before a fixed period of time.
 Other Financial Assets – Many non-banking financial intermediaries issue these
assets.
Solved Question on Functions of Money
Q1. What are the static functions of money?
Answer: The static functions of money are:
1. Money works as a medium of exchange
2. It helps to measure the value of a good or service
3. Money plays an important role in lending and borrowing
4. A person can store the purchasing power of money
 18

What is Stagflation?
Stagflation is a seemingly contradictory condition described by slow economic growth and
relatively high unemployment, or economic stagnation, which is at the same time
accompanied by rising prices (i.e. inflation). Stagflation can also be alternatively defined as a
period of inflation combined with a decline in gross domestic product (GDP).
KEY TAKEAWAYS

 Stagflation refers to an economy that is experiencing a simultaneous increase in

inflation and stagnation of economic output.
 Stagflation was first recognized during the 1970's, where many developed economies
experienced rapid inflation and high unemployment as a result of an oil shock.
 Prevailing economic theory at the time could not easily explain how stagflation could
occur.
 Since the 1970's, rising price levels during periods of slow or negative economic
growth have become somewhat of the norm rather than an exceptional situation.

What Is the Business Cycle?

The business cycle is the natural rise and fall of economic growth that occurs over time. The
cycle is a useful tool for analyzing the economy. It can also help you make better financial
decisions.
Features of Business Cycles
No business in any economy has a straight trajectory. They all have periods of economic
expansion and periods of contraction. The environment of the economy is very dynamic and it
has a significant effect on the business firms. These business cycles all have some common
characteristics. So let us learn about the features of business cycles.

Business Cycle

The business cycle is the natural expansion and contraction of the production and output of
goods and services that happens over a period of time. It can be said to be the economic rise
and fall of a firm in the economy.

It is most importantly a tool to understand the economic conditions of the firm and the
economy in general. The firm can use this analysis to make necessary changes to their policies.

One thing to understand that business cycles are a natural phenomenon that occurs over time.
Every firm will go through the cycles. No firm can have a constant growth or decline over its life
cycle. There are always ups and downs in the economic activities of the firm.

Features of Business Cycles

The four different phases of business cycles are –

expansion, peak, depression, and recovery. While all
these phases have their own unique characteristics,
 19

there are some features that are common to all the phases. Let us take a look at these features
of business cycles.

 Phases of Business Cycles

 Causes of Business Cycles
 Importance of Business Cycles

1] Occur Periodically
As we saw, these phases occur from time to time. However they do not occur in for specific
times, their time periods will vary according to the industries and the economic conditions.
Their duration may vary from anywhere between two to ten or even twelve years.
Even the intensity of the phases will be different. For example, the firm may see tremendous
growth followed by a shallow short-lived depression phase.

2] They are Synchronic

Another one of the features of business cycles is that they are synchronic. Business cycles are
not limited to one firm or one industry. They originate in the free economy and are pervasive in
nature.
A disturbance in one industry quickly spreads to all the other industries and finally affects the
economy as a whole. For example, a recession in the steel industry will set off a chain reaction
until there is a recession in the entire economy.

3] All Sectors are Affected

All major sectors of the economy will face the adverse effects of a business cycle. Some
industries like the capital goods industry, consumer goods industry may be disproportionately
affected.
So the investment and the consumption of capital goods and durable consumer goods face the
maximum brunt of the cyclic fluctuations. Non-durable goods do not face such problems
generally.

4] Complex Phenomenon
Business cycles are a very complex and dynamic phenomenon. They do not have any
uniformity. There are no set causes for business cycles as well. So it is nearly impossible to
predict or prepare for these business cycles.

5] Affect all Departments

Trade cycles are not only limited to the output of goods and services. It has an effect on all
other variables as well such as employment, the rate of interest, price levels, investment activity
etc.

6] International in Character
Trade cycles are contagious. They do not limit themselves to one country or one economy. Once
they start in one country they will spread to other countries and economies via trade relations
and international trade practices.
We have an actual example of this when the Great Depression of 1929 in the USA, later on, had
an adverse effect on the entire global economy. So in an integrated global economy like today’s
the effects of a trade cycle spread far and wide.
Q: The length of each phase of a business cycle is ____?
 20

a. Indefinite
b. Definite
c. Fixed
d. None of the above
Ans: The correct answer is A. The phases of a trade cycle do not display any regularity or
uniformity. We cannot determine the length, duration or intensity of each phase. This is one of
the important features of business cycles.
Importance of Business Cycles
As we know, the performance of a firm is never the same over an extended period of time. There
are always ups and downs in the economic activity and output of a firm. These cyclic phases
are known as business cycles or trade cycles. Let us learn a little more about the importance
of business cycles.
Importance of Business Cycles
Every company must go through their share of ups and downs. And each trading cycle is
characterized by its own unique features. There are four basic phases – expansion, peak,
trough/depression, and recovery. A firm must always identify which phase it is currently in. It
must also always be prepared for a sudden change in the cycles since these cycles are
impossible to predict. Let us see the importance of business cycles and their relevance for
firms.

Browse more Topics

under Business Cycles

 Phases of Business
Cycles
 Features of
Business Cycles
 Causes of Business
Cycles

1] Help Frame
Appropriate Policies
A business cycle will affect all the sectors of an economy. Similarly, it will also affect all sectors
of a firm as well. Right from demand to supply to the cost of production every aspect will
depend on the phase of the business cycle. So the firm must be able to correctly identify its
current phase. This will help them frame appropriate business and trade policies. For example,
if the firm is going through expansion it will be the correct time for aggressive investment
policies or an expansion in the workforce.

2] Strategic Business Decisions

The business cycle of a firm will also have a huge impact on their business decisions. Managers
and entrepreneurs take strategic business decisions based on the phases of the trade cycle. A
business cannot be stagnant it must constantly keep updating to stay with the times. So
different phases of the cycle demand different actions from the firm.
So if the economy is going through an expansion the management can make the strategic
decision to expand the business or increase their output levels. But if the firm is in a trough
then spending must be reined in and policies should be formed accordingly. Management may
even decide to shut down some product lines temporarily or even permanently. Such important
business decisions will depend on the trade cycle.
 21

3] Greatly Affect Cyclic Businesses

Changes in the economy affect all firms but not uniformly. There are certain businesses that
are more vulnerable to a change in the phase of a trade cycle. Such firms have to keep a very
close look at the changes in the economy at all times.  Some examples are the fashion industry,
electronics industry, food and beverage industry, real estate industry etc.
For such firms when the economy is in a boom, they must capitalize. Because a depression in
the economy will affect them the most. So this is one of the main importance of business cycles.

4] Entry and Exit from Market

For the success of a product launch, the phase of the trade cycle for its introduction is a very
important factor. It is much harder for a new product to survive a sluggish economy that is
moving towards a depression. Even the prices, sales policy, promotions of the new product will
depend on the phases of the business cycle.
And on the other hand, if a product has to exit the market, again the conditions must be
studied. If the economy is coming out of a depression and seeing a revival then perhaps the exit
can be delayed. This is another importance of business cycles.
Solved Question on Importance of Business Cycles
Q: A firm should look to expand its workforce during a contraction phase. True or False?
Ans: The given statement is False. During contraction, the supply of goods is more than the
demand. Increasing the workforce will only add to the already high production cost. The
workforce may be added during the Expansion
phase to keep up with demand and increase
profitability.
Causes of Business Cycles
The cyclic pattern of changes that occurs in the
economy is caused by many factors in
combination. There are internal factors within
the economy that may be causing these changes.
And there are also external factors which may
lead to a boom or bust of an economy. Let us
take a look at all the causes of business cycles.
Internal Causes of Business Cycles
These endogenous factors can cause changes in the phases of the firm and the economy in
general. Let us take a look at the internal causes of business cycles.

1] Changes in Demand
Keynes economists believe that a change in demand causes a change in the economic activities.
When the demand in an economy increases the firms start producing more goods to meet the
demand.
There is more output, more employment, more income, and higher profits. This will lead to a
boom in the economy. But excessive demand may also cause inflation.
On the other hand, if the demand falls, so does the economic activity. This may lead to a bust,
which if it continues for a longer period of time may even lead to depression in the economy.

2] Fluctuations in Investments
Just as fluctuations in demand, fluctuations in investment is one of the main causes of
business cycles. The investments will fluctuate on the basis of a lot of factors such as the rate
of interest in the economy, entrepreneurial interest, profit expectation, etc.
 22

An increase in investment will lead to an increase in economic activities and cause expansion.
A decrease in investment will have the opposite effect and may cause a trough or even
depression

3] Macroeconomic Policies
The monetary policies and the economic policies of a nation will also result in changes in the
phases of a business cycle. So if the monetary policies are looking to expand economic activities
by promoting investment, then the economy booms. On the other hand, if there is an increase
in taxes or interest rates we will see a slowdown or a recession in the economy.

4] Supply of Money
There is another belief that says that business cycles are purely monetary phenomena. So
changes in the money supply will bring about the trade cycles. An increase of money in the
market will cause growth and expansion.
But too much money supply may also cause inflation which is adverse. And the decrease in the
supply of money will initiate a recession in the economy.
External Causes of Business Cycles

1] Wars
During times of wars and unrest, the economic resources are put to use to make special goods
like weapons, arms, and other such war goods. The focus shifts from consumer products and
capital goods. This will lead to a fall in income, employment, and economic activity. So the
economy will face a downturn during war times.
And later post-war the focus will be on rebuilding. Infrastructure needs to be reconstructed
(houses, roads, bridges, etc). This will help the economy pick up again as progress is being
made. Economic activity will increase as effective demand will increase.

2] Technology Shocks
Some exciting and new technology is always a boost to the economy. New technology will mean
new investment, increased employment, and subsequently higher incomes and profits. For
example, the invention of the modern mobile phone was the reason for a huge boost in the
telecom industry.

3] Natural Factors
Natural disasters like floods, droughts, hurricanes, etc can cause damage to the crops and
huge losses to the agricultural sector. Shortage of food will cause a surge in prices and high
inflation. Capital goods may see a reduction in demand as well.

4] Population Expansion
If the population growth is out of control that might be a problem for the economy. Basically of
the population growth is higher than the economic growth the total savings of an economy will
start dwindling. Then the investments will reduce as well and the economy will face depression
or a slow down.
Solved Question on Causes of Business Cycles
Q: A rapid increase in interest rates causes

a. Expansion
b. Peak
c. Contraction
d. Trough
 23

Ans: The correct answer is C. Recession or Contraction is caused by a sharp increase in

interest rates, which will contract the credit and cause companies to slow down on expansion
activities.
Phases of Business Cycles
Do you remember the global economic crisis of 2008-2009 that started in the USA? Stock
markets across the world saw sharp declines and the global economy was jolted. Many MNC’s
and banks shut down overnight. This crisis was actually the depression phase of a business
cycle. Let us learn more about the phases of business cycles.
Business Cycles
If you see back in history you will notice every country has at some point been through an
economic crisis of their own. In fact, there are ups and downs in the economic history of every
single economy and nation in the world. These cyclic fluctuations in economic activity are what
we call business cycles or trade cycles.
So there are good phases of business cycles with economic growth and expansion of the
economy, a rise in GDP etc. And there are slowdowns and negative phases of business cycles
with rising unemployment, high inflation, low GDP, negative growth etc. These phases are
cyclic in nature and occur periodically in every economy.
Phases of Business Cycles
1] Expansion or Boom
This phase is characterized by an
increase in output and employment.
There is also an increase in the
demand in the market,
capital expenditure, sales and
subsequently an increase in income
and profits. This cycle will
continue till there is hundred
percent utilization of
available resources.
And the production level will be at the maximum capacity. The unemployment rates will be zero
with the exception of voluntary unemployment and frictional or structural employment (which
is temporary).
In this phase both the prices and cost increase at a somewhat faster rate. But generally, the
public enjoy prosperity and a higher standard of living. The growth rate will eventually
deaccelerate as the economy approaches its peak.

2] Peak 
As the name suggests this is the highest point of all the phases of business cycles. At this point
the output is maximum, and the involuntary unemployment is basically zero. As the economy
goes through expansion, inputs become rarer. Their demands increase and so does their prices.
This leads to an increase in the price of consumer goods as well. Income does not see a
proportional increase. So consumers have to review their expenses and cut back on their
consumption.
Aggregate demand in the market will stagnate. This will mark the end of the expansion phase.
The growth of the economy stabilizes at the peak for a short period. Then it goes in the reverse
direction.

3] Contraction 
 24

At the peak of an economy, demand is stagnant. Then very soon, demand starts falling in
certain sections of the economy. This is the start of the contraction phase of the trade cycle,
which is the opposite of the expansion phase.
Even the investment levels and employment levels decrease along with the demand. Now there
is a mismatch between demand and supply in the market. Once producers become aware of the
shift in the economy they start disinvesting, scaling back operations, canceling orders for goods
and labor etc.
This will start a domino effect. Now producers of capital goods and raw materials will also start
canceling orders and holding off investment.
At this turning point in the economy, the prices of the goods also fall. Income levels decreases
which decrease consumer spending as well. The outlook about the economy is pessimistic and
we will see a contraction in economic activities across all sectors. We call this phase recession

4] Depression 
Depression is the lowest of the phases of business cycles. It is a severe form of recession. In this
phase, we will see a negative growth rate in the economy. There is a continuous decrease in
demand.
The companies that cannot dispose of their stocks keep reducing the prices. Some companies
will be forced to shut down due to mounting losses. This will adversely affect employment rates.
The capital and money market also suffer greatly. The interest rate is at its lowest. After this
phase, the economy will recover by additional investments, and the business cycle will
continue.
Solved Example on Phases of Business Cycles
Q: The process of recovery is initially felt in the ____ market.

a. Capital Goods
b. Capital
c. Labor
d. None of the above
Ans: The correct option is C. After the through comes the recovery phase. Investors take
advantage of the lower costs and start to invest again. Unemployment causes a lowering in
wage rates, and investors take advantage of this. So the reversal will be first felt in the labor
market.

Workers and Employment

What is meant by the ‘employment’ and what is its connection with the term ‘work’? Is there a
difference between the two? This chapter focusses, in length, on the economic definition of
work, worker, labour force, workforce, and employment. Let us dive right in.
Economic Definition of Work
To understand the issues of employment, let us first understand the relevance of ‘work’. Work
helps us to earn a living. But more importantly, work gives us a sense of worth to be able to do
something and lends meaning to our being. It is our way of contributing to the national
income of the country.
By that definition, a ‘worker’ is one who is bound by a contractual agreement or one who gets
rewards from working or is self-employed. There can be different types of workers defined on
the basis of certain parameters.

Unemployment and Employment Generation

 25

Types of Workers

 Hired Worker: These are workers who are employed by others (employers) and receive
a salary/wage as compensation for work. Hired workers may again be of two types:

 Casual Worker: These are workers who are engaged by employers on a temporary
basis for some specific work. They are not permanent and do not receive any social
security or other work benefits. Example: Construction workers are contracted only for
specific projects and not hired permanently. Seasonal workers such as those engaged on
the farm only during the harvest season are also classified as casual workers.

 Regular Salaried Worker: These are workers hired by employers on a permanent basis
and are paid regular salaries/wages for their work. Example: Chartered accountants,
teachers, sports trainers at a sports club.

 Self-Employed: The other set of workers are those who are not employed by some
employer but who own and work for their own enterprise. Example: Proprietors, business
persons.
In the urban areas, in India, 41% workers are self-employed and 59% are hired. In rural areas,
54% are self-employed and 46% are hired. The percentage of self-employed persons is more in
the rural areas as the workers there are usually engaged in working on their own farms.
Contrarily, in the urban areas, workers tend to be employed in factories or offices in larger
proportion than their rural counterparts.

Employment: Definition and Important Terminologies

The term ‘employment’ refers to the state of being employed. It is the relationship between an
employer and employee, usually. Employment for people varies in the sense that some of them
are employed for the entire year, while the others are employed for only some portion of the
year.

Worker and Workforce

All the persons in a country who are

engaged in productive activities i.e. in
activities that contribute to the
national product of the country
constitute workforce. Statistics on the
workforce reveal that 70% of the
workforce is constituted in rural areas,
while only 30% belong to the urban areas.
Out of the rural workforce, only 26% are
female workers.

In the urban areas, the figure drops to 14%. The overall female percentage of the workforce is
30%, while the remaining 70% is constituted by males. It is important to note the formula for
the workforce participation ratio:

Participation Ratio = (Total Workforce/ Total Population) x 100

 26

Note that the workforce discussed earlier is different from another concept called labour force.
It refers to the number of workers willing and able to offer their labour at a wage rate. This is
nothing but labour supply. It refers to the work workers are willing and able to do at a given
wage rate.

The participation rate in rural areas is 41% and higher than that in urban areas (35% only).
The overall participation rate in the country stands at a low figure of slightly over 39%. This
means that even while more people may be working, only a small chunk is engaged in
productive activity. Even then, the participation rate is higher in rural areas. Even the female
participation rate is higher in rural than urban areas.

Sectors of the Economy

Based on the engagement of workers in different kinds of employment, the economy can be

broadly divided into three sectors:

 Primary: Constitutes agriculture and allied activities. The Primary sector continues to

employ the maximum number of workers in our country, even though the number has
dropped over the years.

 Secondary: Mainly includes the manufacturing activities, along with electricity, gas,

water supply, and construction. Workers have shifted from agriculture to other forms of
productive activity. This is also followed by rural to urban migration. A country’s
transformation in employment from agriculture to secondary and tertiary sectors is
called structural transformation.

 Tertiary: Comprises the service sector i.e. transport and communication,

banking, insurance, trade, storage, etc.
Solved Example for You

Question: What is worker -population ratio and what is its significance?

Answer: Worker -population ratio is the ratio of the workers who are contributing to productive
activities in a country to its total population. The population figure is the total number of people
residing in a country at a point of time. It is useful to give an idea about the employment
situation of a country. It indicates what proportion of the population is actually contributing to
the production of goods and services in the country. The ratio is usually multiplied by 100 for
percentage values.

Unemployment and Employment Generation

Did you know India has one amongst the highest unemployment rates in Asia? In 2017 it was
at 3.4%. One of the most crucial concerns of any economy is unemployment. This lesson
elaborates on the concept and calculation of unemployment rate, its causes and how it differs
in rural and urban India.
 Unemployment: Definition and Calculation
Unemployment is a regularly used term and normally refers to those who are ‘out of work’. In
strictly economic terms, the unemployed include all those who are able and willing to work but
cannot find work. This includes the pool of persons who seek work through employment
 27

exchanges, friends, relatives and other contacts and express their willingness to get employed,
owing to the lack of work. Economists define an unemployed person as one who is unable to get
work for even one hour during half a day.
The three major sources of official data on employment in India include:
1. The National Sample Survey Organization
2. Census of India
3. Directorate General of Employment and Training Data of Registration with
Employment Exchanges
We use the following formula to calculate it:

Unemployment Rate = (No. of Unemployed Persons / Total Labourforce) x 100

Here, labour force refers to all those persons willing and able to engage in productive activity
or work.

Types of Unemployment

Rural Unemployment

India has roughly 70% of its population living in rural areas. Agriculture forms the mainstay of
the rural population. But, not enough employment is available for all those living in the rural
areas. This leads to unemployment, which can take three forms open, seasonal and disguised.

Open Unemployment

This refers to the situation in rural areas where people who are willing and actually able to
work cannot find any work.

Disguised Unemployment

This particularly plagues the Indian agrarian scenario. In this case, more workers than
required are engaged on the farm, where not all of them are actually productively contributing
to creating output. Thus, the marginal physical productivity of many workers is zero. This
happens when almost the entire family engages in farm production.

Seasonal Unemployment

The case with this is that workers remain out of work for a particular season. For example,
workers hired only for the harvest season remain unemployed for the remaining part of the
year. Or, if the industry itself is seasonal, workers naturally remain unemployed during the off-
season.

Urban Unemployment
 28

The unemployed in the urban areas have increased considerably over the years. Normally, the
number of the urban unemployed is registered with unemployment exchange boards. It can
also take various forms, as under-

Industrial Unemployment

Those illiterate persons who are willing and able to work in factories or industries in urban
areas but cannot find work fall in this category. As rural-urban migration increases, urban
unemployment also does.

Educated Unemployment

The most horrifying kind of unemployment is when the educated youth are unable to find
appropriate jobs to suit their qualifications. With an improvement in education over time,
skilled workers have increased in number but the number of available jobs has not increased
correspondingly. This causes educated unemployment.

Technological Unemployment

This type of unemployment takes place every time technology upgrades and the existing
workforce are unable to cope with the new technology. If the skills required to meet the new
technology do not match the existing skill-sets of the employed workers and they cannot adapt,
they become unemployed. Upgradation is a natural process, with cyclical obsolescence as one
set of technology becomes irrelevant and gets
replaced by another.

Causes of Unemployment

To be able to deal with the problem of

unemployment, it is now necessary for you to
understand its causes in a country like ours. A slow
rate of economic growth would mean that the
national output is not increasing by much. It
indicates that not enough jobs are being created to
absorb the workers able and willing to work. Put
simply, labour supply far exceeds existing job
opportunities.

Another reason particular to India is its population growth rate. The number of people
looking for jobs has multiplied manifold over the years as the population growth rate has
soared high. The rising population proves to be a burden on the number of jobs that can
actually be created in an economy with its limited resources. The recent population
explosion is a contributing factor to decreased employment in the country.

Over-dependence on technology, domestic or foreign, has led to technological unemployment.

This is because of less requirement of manual labour to accomplish tasks with greater
dependence on machines and technology.

The lack of adequate fund-allocation and financial resources to curb unemployment is also

leading it to rise. Proper governmental programs targeting the unemployed population, if not
 29

well-implemented, harm the employment situation of the country. Lack of committed support
to deal with the job crisis causes employment to fall.

Employment Generation

The government has a key role to play in employment generation in the country. In fact, it must
persevere to increase the employment levels of the country. In the light of this, governments in
the past have acted to deal with unemployment in India. The National Rural Employment
Guarantee Act (NREGA) was passed in 2005. The NREGA seeks to provide 100 days of
guaranteed wage employment to rural households willing to perform unskilled manual work. It
makes special provisions for women and for the distance within which the job must be available
to job-seekers for convenience.

State and federal governments, over the years, have played a key role in enacting other social
security programmes, providing unemployment allowances and conducting training
programmes and encouraging on-the-job training to absorb more skilled labour into jobs.

The government has also strived to provide direct employment in government departments and
offices at various positions and levels. It also helps in indirect employment through the
production of goods and services that aid the ability of the private sector to invite more job
applicants and create opportunities. One of the main allied objectives of these policy
programmes is the idea of poverty alleviation, with other emphases on health, nutrition, a
standard of living, education, road-building, infrastructure and rural development.

Criticisms of the Unemployment Rate

Despite the care taken in calculating unemployment, there are three common criticisms of
the survey that are said to give misleading information about the true unemployment
situation. These criticisms are:

1. The survey does not count discouraged workers as unemployed. Discouraged workers

are individuals who indicate that they currently want a job, have looked for work in
the last 12 months, are available for work, and are not currently looking for work
either because they believe that no work is available in their line of work or area, they
had previously been unable to find work, they lack necessary schooling, training,
skills or experience, employers think they are too young or old, or they face some
other type of discrimination. In other words, they have given up looking for work
because they could not find a job or thought that they could not find a job. Many
people think that discouraged workers are the "hard-core" unemployed. Because the
unemployment rate does not include discouraged workers, it tends
to understate unemployment.
2. The survey does not account for hidden unemployment. Hidden unemployment
includes those who are working part-time but wish to have a full-time job and those
who are grossly overqualified for their positions, the underemployed. This omission
also makes the unemployment rate seem lower than it otherwise would be. Failure to
account for hidden unemployment understates the unemployment problem.
3. The surveyor does not check the accuracy of the response to an active job search. To
be unemployed, a survey respondent must only "say" that he has actively sought
work. The respondent may state, for example, that he has called several potential
employers or gone on a job interview when in fact he has not done so. When people lie
about their job search behavior, they are classified as unemployed instead of not in
the labor force. This effect tends to overstate the unemployment rate.
 30

Long-term unemployment vs. Short-term unemployment

Unemployment that lasts longer than 27 weeks even if the individual has sought
employment in the last four weeks is called long-term unemployment. Its effects are far
worse than short-term unemployment for obvious reasons, and the following are noted as
some of its effects.

 A huge 56% of the long-term unemployed reported a decrease in their income.

 It seems that financial problems are not the only effects of long-term unemployment
as 46% of those in such a state reported experiencing strained family relationships.
The figure is relatively higher than the 39% percent who weren’t unemployed for as
long.
 Another 43% of the long-term unemployed reported a significant effect on their ability
to achieve their career goals.
 Sadly, long-term unemployment led to 38% of these individuals to lose their self-
respect and 24% to seek professional help.

Costs of Unemployment. (Why is Full employment desirable?)

1. GDP Gap & Okun 's Law. When the economy fails to provide enough jobs for all who are
able and willing to work, potential production of goods and services is lost for ever. (In the
PPF diagram, one is then producing within the PPF and not on it.)
GDP gap = actual GDP - potential GDP .
Arthur Okun stated that for every 1% that the actual unemployment rate exceeds the natural
rate, a 2.5% GDP gap occurs. If the unemployment rate is 7.4% and the natural rate is
estimated to be 6% then GDP gap is 1.4 x 2.5 = 3.5%.
The inability to produce at the potential means firms lose the opportunity to earn more
profits if the economy were operating at full employment. Government loses tax revenues
from income tax, profit tax and indirect consumption taxes if the economy were operating at
full employment with higher personal incomes, profits and consumption level. For employed
workers, this can means a loss of additional incomes due to bonuses and dividends if the
economy were producing more outputs.

2. Personal loss. For the unemployed this means a loss in personal income. Even if he
receives some form of unemployment benefits this still means a reduction in personal
income. On top of that a loss in self-esteem and possible more strained relationships with
friends and family members.

Other non-economic costs are increase in suicide, homicides, cardiovascular mortality,

mental illness, crime and vandalism and social unrest.
To address these problems, government will have to spend more not only on unemployment
benefits alone but also more on healthcare, social service, and police.

3. Unequal burden of unemployment. The burden of unemployment are heavier on the

young adults less than 25 years old, female workers, unskilled labours, ethnic minorities
and people in rural areas.

4. People who have been unemployed for a long time, loss skills and motivation. Long term
unemployment concentrated among ethnic groups and in certain regions can lead to social
and political unrest. On the other hand, more government spending on healthcare, social
service and police can create new jobs in the economy. Over all, the long-run costs of
unemployment exceed benefits.

Measures to deal with Unemployment.

 31

1. Frictional Unemployment. This is basically a problem of imperfect information in the

labour market. Government can help by creating job centers and website to advertise job
vacancy, to help in job placement and to improve job search skill like resume writing and
interview tips. These job centers can also organize job fares by bringing together firms at
especially employment depressed regions. However, these centers may also encourage more
frictional unemployment because they lower the cost of searching for job and may encourage
more people to seek better positions.
A more controversial measure is to reduce the length a person can receive unemployment
benefit and increase the conditions for a person to qualify for unemployment benefits. These
measures can provide the incentive to increase the intensity of job search and the likelihood
of accepting a job offer.

2. Structural Unemployment. This usually involves supply-side policies that attempt to

shift the aggregate supply of labour to the right. As mentioned before the problems with
structural unemployment lie in a skill being obsolete and immobility of labour. The supply-
side policies can take (a) market orientated approach, (b) interventionist approach or (c) a
combination of both market orientated and interventionist approach. With the market
orientated approach, government can set up job counseling programme to encourage people
to adopt a more willing attitude towards retraining, to practice life-long learning to constantly
upgrade or expand their skills, and if necessary accept a reduction in wages. Many people
probably will deem the interventionist approach as more active because government provides
retraining programmes, support life-long learning that upgrade or expand one's marketable
skills, and sets up incentives for firms to set up in areas with high unemployment. A more
successful measure probably will have to have components of both market orientated and
interventionist approach. All these measures can increase labour mobility. It was reported
(late 2001) that in Germany some of the unemployed were trained to become rock/pop-
singers. In the regional setting, job centers like above may help, and government can
provide grants for firms to set up new industries in the affected areas. However, placing an IT
industry in a ex-mining town where most people knew only mining all their lives will not
solve the problem of structural unemployment.

3. Cyclical Unemployment. Keynesians believe that an appropriate injection into the

economy by the government via fiscal and/or monetary policies can close the demand-
deficient gap. Monetarist are more skeptical about this recommendation and believe that
government should provide a stable macroeconomic conditions to help the economy grows
out of recession. 

4. Disequilibrium Unemployment. For real-wage unemployment, government can work to

reduce nominal minimum wage so to reduce the real wage rate. However, this is unpopular
and puts the burden on workers with lower incomes. A government can also increase money
supply so that the price level increases and lets inflation to reduce the real wage rate. This
will of course incompatible with the objective of keeping inflation low and stable. A more
effective measure is for government to dilute and break the bargaining power of labour union
to raise wages.

5. Seasonal Unemployment.This is not a big worry to many governments because

unemployment rate is often adjusted for this seasonal factor. A government can reduce the
influx problem of school and college graduate leavers on the economy by providing job fares
that target this group of job seekers. For tourism related industry, a training scheme can be
 32

set up to expand the skills of people affected. For example, a ski instructor can be trained to
become a bird-watcher guide or guide to hikers in the summer.

NB: The high unemployment rate in Europe in the late 90s was believed to be caused by
inflexible employment structure (high minimum wage, difficult to fire employee, etc).

Trade Cycle: 4 Phases of Trade Cycle

The four important features of Trade Cycle are (i) Recovery, (ii) Boom, (iii) Recession,

and (iv) Depression!

The trades cycle or business cycle are cyclical fluctuations of an economy. A full trade cycle

has got four phases: (i) Recovery, (ii) Boom, (iii) Recession, and (iv) depression. The upward

phase of a trade cycle or prosperity is divided into two stages—recovery and boom, and the

downward phase of a trade cycle is also divided into two stages—recession and depression.

Phases of Trade Cycle:

The phases of trade cycle are explained with a diagram:

(1) Recovery:
In the early period of recovery, entrepreneurs
increase the level of investment which in turn
increases employment and income. Employment
increases purchasing power and this leads to an
increase in demand for consumer goods.

As a result, demand for goods will press upon

their supply and it shall, thereby, lead to a rise
in prices. The demand for consumer’s goods
shall encourage the demand for producer’s
goods.

The rise in prices shall depend upon the gestation period of investment. The longer the
period of investment, the higher shall be the price rise. The rise of prices shall bring about a
change in the distribution of income. Rent, wages, interest do not rise in the same proportion
as prices.

Consequently, the margin of profit improves. The wholesale prices rise more than retail
prices. The prices of raw materials rise more than the prices of semi-finished goods and the
prices of semi-finished goods use more than the prices of finished goods.

(2) Boom:
The rate of investment increases still further. Owing to the spread of a wave of optimism in
business, the level of production increases and the boom gathers momentum. More
investment is possible only through credit creation. During a period of boom, the economy
surpasses the level of full employment and enters a stage of over full employment.

(3) Recession:
 33

The orders for raw materials are reduced on the onset of a recession. The rate of investment
in producers’ goods industries and housing construction declines. Liquidity preference rises
in society and owing to a contraction of money supply, the prices falls. A wave of pessimism
spreads in business and those markets which were sometime before sellers markets become
buyer’s markets now.

(4) Depression:
The main feature of a depression is a general fall in economic activity. Production,
employment and income decline. The prices fall and the main factor responsible for it is, a
fall in the purchasing power.

The distribution of national income changes. As the costs are rigid in nature, the margin of
profit declines. Machines are not used to their full capacity in factories, because effective
demand is much less. The prices of finished goods fall less than the prices of raw materials

Boom

 A boom occurs when real national output is rising at a rate faster than the trend rate
of growth. Some of the characteristics of a boom include:
 A fast growth of consumption helped by rising real incomes, strong confidence and a
surge in house prices and share prices
 A pick up in demand for capital goods as businesses invest in extra capacity to
meet strong demand and to make higher profits
 More jobs created and falling unemployment and higher real wages
 High demand for imports which may cause the economy to run a larger trade
deficit because it cannot supply all of the goods and services that consumers are
buying
 Government tax revenues will be rising as people earn and spend more and
companies are making larger profits – this gives the government money to increase
spending in areas such as education, the environment, health and transport
 An increase in inflationary pressures if the economy overheats and has a positive
output gap

Slowdown

 A slowdown occurs when the rate of growth decelerates – but national output is still
rising
 If the economy grows without falling into recession, this is called a soft-landing

Recession

A recession means a fall in the level of real national output i.e. a period when growth is
negative, leading to a contraction in employment, incomes and profits.

A simple definition:

 A fall in real GDP for two consecutive quarters i.e. six months

A more detailed definition:

 A recession is a significant decline in economic activity spread across the

economy, lasting more than a few months, normally visible in real GDP, real income,
employment, industrial production, and retail sales.
 34

There are many symptoms of a recession – here is a selection of key indicators:

1. A fall in purchases of components and raw materials (i.e. intermediate products)

2. Rising unemployment and fewer job vacancies available for people looking for work
3. A rise in the number of business failures and businesses announcing lower profits
and investment
4. A decline in consumer and business confidence
5. A contraction in consumer spending & a rise in the percentage of income saved
6. A drop in the value of exports and imports of goods and services
7. Large price discounts offered by businesses in a bid to sell their excess stocks
8. Heavy de-stocking as businesses look to cut back when demand is weak – causes
lower output
9. Government tax revenues are falling and welfare benefit spending is rising
10.The budget (fiscal) deficit is rising quickly

Recovery

 This occurs when real GDP picks up from the trough reached at the low point of the
recession.
 The state of business confidence plays a key role here. Any recovery might be subdued
if businesses anticipate that it will be temporary or weak in scale.
 A recovery might follow a deliberate attempt to stimulate demand. In the UK we have
seen

1. Cuts in interest rates – the policy interest rate fell to 0.5% in the Autumn of 2008
and they have stayed at this low level since then
2. A rise in government borrowing
3. A policy of quantitative easing (QE) by the Bank of England to pump more money
into the banking system in a bid to increase the supply of loans – now worth more
than £375 billion.

Why is GDP growth difficult to forecast?

When economists make forecasts about the future path for an economy they have to accept
the inevitability of forecast errors. No macroeconomic model can hope to cope with the
fluctuations and volatility of indicators such as inflation, exchange rates and global
commodity prices.

 Uncertain business confidence levels

 Fluctuations in exchange rate
 External events e.g. volatile oil and gas prices
 Uncertain reactions to macro policy changes
 Rate of business job creation hard to forecast

The Circular Flow of Economic Activity

The below mentioned article provides an overview on the Circular Flow of Economic Activity.
After reading this article you will learn about: 1. Introduction to the Circular Flow of
Economic Activity 2. The Circular Flow in a Two-Sector Economy 3. The Circular Flow in a
Three-Sector Economy 4. The Circular Flow in a Four-Sector Economy.

Introduction to the Circular Flow of Economic Activity:

 35

The all pervasive economic problem is that of scarcity which is solved by three institutions
(or decision-making agents) of an economy. They are households (or individuals), firms and
government. They are actively engaged in three economic activities of production,
consumption and exchange of goods and services. These decision-makers act and react in
such a manner that all economic activities move in a circular flow.

First, we discuss their nature and role in decision-making.

Households:
Households are consumers. They may be single-individuals or group of consumers taking a
joint decision regarding consumption. They may also be families. Their ultimate aim is to
satisfy the wants of their members with their limited budgets.

Households are the owners of factors of production—land, labour, capital and

entrepreneurial ability. They sell the services of these factors and receive income in return in
the form of rent, wages, and interest and profit respectively.

Firms:
The term firm is used interchangeably with the term producer in economics. The decision to
manufacture goods and services is taken by a firm. For this purpose, it employs factors of
production and makes payments to their owners. Just as household’s consumer goods and
services to satisfy their wants, similarly firms produce goods and services to make a profit.

The term ‘firm’ includes joint stock companies like DCM, TISCO etc., public enterprises like
IOC, STC, etc., partnership concerns, cooperative societies, and even small and big trading
shops which do not manufacture the commodities they sell.

Government:
The government plays a key role in all types of economic systems—capitalist, socialist and
mixed. In a capitalist economy, the government does not interfere. It simply establishes and
protects property rights. It sets standards for weights and measures, and the monetary
system.

In a socialist economy, the role of the government is very extensive. It owns and regulates the
entire production and consumption processes of the economy, and fixes prices of goods and
services. In a mixed economy, the government strengthens the market system.

It removes its defects by regulating the activities of the private sector and by providing
incentives to it. The government also uses resources to produce goods and services itself
which are sold to households and firms. These decision-making agents take economic
decisions to produce goods and services and to exchange them in order to consume them for
satisfying the wants of the whole economy.
 36

Production, consumption and exchange are the three main activities of the economy.
Consumption and production are flows which operate simultaneously and are interrelated
and interdependent. Production leads to consumption and consumption necessitates
production.

In other words, production is a means (beginning) and consumption is the end of all
economic activities. Both production and consumption, in turn, depend upon exchange.
Thus these two flows are interrelated and interdependent through exchange.

The Circular Flow in a Two-Sector Economy:

In a simplified economy with only two types of economic agents, households or consumers
and business firms, the circular flow of economic activity is shown in Figure 10. Consumers
and firms are linked through the product market where goods and services are sold. They
are also linked through the factor market where the factors of production are sold and
bought.

Consumers and firms have a dual role, and exchange with one another in two distinct
ways:
(1) Consumers or households own all the
factors of production, that is, land, labour,
capital and entrepreneurship, which are also
called productive resources. They sell them to
firms for producing goods and services.
In the diagram, the sale of goods and services
by firms to consumers in the product market is
shown in the lower portion of the inner circle
from left to right; and the sale of their services
to firms by households or consumers in the
factor market is shown in the upper portion of
the inner circle from right to left. These are the
real flows of goods and services from firms to consumers which are linked with productive
resources from consumers to firms through the medium of exchange or barter.

(2) In a modem economy, exchange takes place through financial flows which move in the
reverse direction to the “real” flows. The purchase of goods and services in the product
market by consumers is their consumption expenditure which becomes the revenue of the
firms and is shown in the outer circle of the lower portion from right to left in the diagram.

The expenditure of firms in buying productive resources in the factor market from the
consumers becomes the incomes of households, which is shown in the outer circle of the
upper portion from left to right in the diagram.
 37

The Circular Flow in a Three-Sector Economy:

So far we have been working on the circular flow of a two-sector model of an economy. To
this we add the government sector so as to make it a three-sector closed model of circular
flow of economic activity. For this, we add taxes and government purchases (or expenditure)
in our presentation.

Taxes are outflows from the circular flow and government purchases are inflows into the
circular flow. The circular flow in a three-sector economy is illustrated in Figure 11.

First, take the circular flow between the household sector and the government sector. Taxes
in the form of personal income tax and commodity taxes paid by the household sector are
outflows (or leakages) from the circular flow. But the government purchases the services of
the households, makes transfer payments in the form of old age pensions, unemployment
relief, sickness benefit, etc., and also spends on them to provide certain social services like
education, health, housing, water, parks and other facilities.

All such expenditures by the government are inflows (injections) into the circular flow. Next
take the circular flow between the business sector and the government sector. All types of
taxes paid by the business sector to the government are leakages from the circular flow.

On the other hand, the government purchases all its requirements of goods of all types from
the business sector, gives subsidies and makes transfer payments to firms in order to
encourage their production. These government expenditures are injections into the circular
flow.

Now we take the household, business and government sectors together to show their inflows
and outflows in the circular flow. As already noted, taxes are a leakage from the circular
flow. They tend to reduce consumption and saving of the household sector. Reduced
consumption, in turn, reduces the sales and incomes of the firms.

On the other hand, taxes on business firms tend to reduce their investment and production.
The government offsets these leakages by making purchases from the business sector and
buying services of the household sector
equal to the amount of taxes. Thus inflows
(injections) equal outflows (leakages) in the
circular flow.

Figure 11 shows that taxes flow out of the

household and business sectors and go to
the government. The government
 38

purchases goods from firms and also factors of production from households. Thus
government purchases of goods and services are an injection in the circular flow and taxes
are leakages in the circular flow.

If government purchase exceeds net taxes then the government will incur a deficit equal to
the difference between the two, i.e., government expenditure and taxes. The government
finances its deficit by borrowing from the capital market which receives funds from the
household sector in the form of saving.

On the other hand, if net taxes exceed government purchases the government will have a
budget surplus. In this case, the government reduces the public debt and supplies funds to
the capital market which are received by the business sector.

The Circular Flow in a Four-Sector Economy:

So far the circular flow has been shown in the case of a closed economy. But the actual
economy is an open one where foreign trade plays an important role. Exports are an injection
or inflows into the circular flow of money. On the other hand, imports are leakages from the
circular flow.

They are expenditure s incurred by the household sector to purchase goods from foreign
countries. These exports and imports in the circular flow are shown in Figure 12.

Take the inflows and outflows of the household, business and government sectors in relation
to the foreign sector. The household sector buys goods imported from abroad and makes
payment for them which is a leakage from the circular flow of money. The householders’ ma
receives transfer payments from the foreign sector for the services rendered by them in
foreign countries.

On the other hand, the business sector exports goods to foreign countries and its receipts
are an injection in the circular flow or money. Similarly, there are many services rendered by
business firms to foreign countries such as shipping, insurance, banking, etc. for which they
receive payments from abroad.

They also receive royalties, interests,

dividends, profits, etc. for investments made in
foreign countries. On the other hand, the
business sector makes payments to the foreign
sector for imports о capital goods, machinery,
 39

raw materials, consumer goods, and services from abroad. These are the leakages from the
circular flow of money.

Like the business sector, modern governments also export and import goods and services,
and lend to and borrow from foreign countries. For all exports of goods, the government
receives payments from abroad.

Similarly, the government receives payments from foreigners when they visit the country as
tourists and for receiving education, etc., and also when the government provides shipping,
insurance and banking services to foreigners through the state-owned agencies.

It also receives royalties, interests, dividends, etc. for investments made abroad. These are
injections into the circular flow of money. On the other hand, the leakages are payments
made to foreigners for the purchase of goods and services.

Figure 12 shows the circular flow of money of the four sector open economy with saving,
taxes and imports shown as leakages from the circular flow on the right hand side of figure,
and investment, government purchases and exports as injections into the circular flow, on
the left side of the figure.

Further, imports, exports and transfer payments have been shown to arise from the three
domestic sectors—the household, the business and the government. These outflows and
inflows ass through the foreign sector which is also called the “Balance of Payments Sectors”.

Monetary Policy vs. Fiscal Policy: An Overview

Monetary policy and fiscal policy refer to the two most widely recognized tools used to
influence a nation's economic activity. Monetary policy is primarily concerned with the
management of interest rates and the total supply of money in circulation and is generally
carried out by central banks, such as the U.S. Federal Reserve.1 Fiscal policy is a collective
term for the taxing and spending actions of governments. In the United States, the national
fiscal policy is determined by the executive and legislative branches of the government. 

KEY TAKEAWAYS

 Both monetary and fiscal policy are maroeconomic tools used to manage or stimulate
the economy.
 Monetary policy addresses interest rates and the supply of money in circulation, and
it is generally managed by a central bank.
 Fiscal policy addresses taxation and government spending, and it is generally
determined by government legislation.
 Monetary policy and fiscal policy together have great influence over a nation's
economy, its businesses, and its consumers.
2

Monetary Policy
Central banks typically have used monetary policy to either stimulate an economy or to
check its growth. By incentivizing individuals and businesses to borrow and spend, the
 40

monetary policy aims to spur economic activity. Conversely, by restricting spending and
incentivizing savings, monetary policy can act as a brake on inflation and other issues
associated with an overheated economy.

The Federal Reserve, also known as the "Fed," frequently has used three different policy tools
to influence the economy: open market operations, changing reserve requirements for banks
and setting the discount rate. Open market operations are carried out on a daily basis when
the Fed buys and sells U.S. government bonds to either inject money into the economy or
pull money out of circulation.3 By setting the reserve ratio, or the percentage of deposits that
banks are required to keep in reserve, the Fed directly influences the amount of money
created when banks make loans. The Fed also can target changes in the discount rate (the
interest rate it charges on loans it makes to financial institutions), which is intended to
impact short-term interest rates across the entire economy.

Monetary policy is more of a blunt tool in terms of expanding and contracting the money
supply to influence inflation and growth and it has less impact on the real economy. For
example, the Fed was aggressive during the Great Depression. Its actions prevented deflation
and economic collapse but did not generate significant economic growth to reverse the lost
output and jobs.

Expansionary monetary policy can have limited effects on growth by increasing asset prices
and lowering the costs of borrowing, making companies more profitable.

 Monetary policy seeks to spark economic activity, while fiscal policy seeks to address either
total spending, the total composition of spending, or both.

Monetary Policy

 Monetary policy involves influencing the supply and demand for money through
interest rates and other monetary tools.
 Monetary policy is usually conducted by the Central Bank, e.g. UK – Bank of England,
US – Federal Reserve.
 The target of Monetary policy is to achieve low inflation (and usually promote
economic growth)
 The main tool of monetary policy is changing interest rates. For example, if the
Central Bank feel the economy is growing too quickly and inflation is increasing, then
they will increase interest rates to reduce demand in the economy.
 41

 In some circumstances, Central Banks may use other tools than just interest rates.
For example, in the great recession 2008-12, Central Banks in UK and US pursued
quantitative easing. This involved increasing the money supply to increase demand.
Fiscal Policy
Generally speaking, the aim of most government fiscal policies is to target the total level of
spending, the total composition of spending, or both in an economy. 2 The two most widely
used means of affecting fiscal policy are changes in government spending policies or in
government tax policies.

If a government believes there is not enough business activity in an economy, it can increase
the amount of money it spends, often referred to as stimulus spending. If there are not
enough tax receipts to pay for the spending increases, governments borrow money by issuing
debt securities such as government bonds and, in the process, accumulate debt. This is
referred to as deficit spending.

In comparing the two, fiscal policy generally has a greater impact on consumers than monetary
policy, as it can lead to increased employment and income.
By increasing taxes, governments pull money out of the economy and slow business activity.
Typically, fiscal policy is used when the government seeks to stimulate the economy. It might
lower taxes or offer tax rebates in an effort to encourage economic growth. Influencing
economic outcomes via fiscal policy is one of the core tenets of Keynesian economics.

When a government spends money or changes tax policy, it must choose where to spend or
what to tax. In doing so, government fiscal policy can target specific communities, industries,
investments, or commodities to either favor or discourage production—sometimes, its actions
are based on considerations that are not entirely economic. For this reason, fiscal policy
often is hotly debated among economists and political observers.

Essentially, it is targeting aggregate demand. Companies also benefit as they see increased

revenues. However, if the economy is near full capacity, expansionary fiscal policy risks
sparking inflation. This inflation eats away at the margins of certain corporations in
competitive industries that may not be able to easily pass on costs to customers; it also eats
away at the funds of people on a fixed income.

Fiscal Policy

 Fiscal policy relates to the impact of government spending and tax on aggregate
demand and the economy.
 42

 Expansionary fiscal policy is an attempt to increase aggregate demand and will involve
higher government spending and lower taxes.
 Expansionary fiscal policy will lead to a larger budget deficit.
 Deflationary fiscal policy is an attempt to reduce aggregate demand and will involve
lower spending and higher taxes.
 This deflationary fiscal policy will help reduce a budget deficit.

The Bottom Line

Both fiscal and monetary policy play a large role in managing the economy and both have
direct and indirect impacts on personal and household finances. Fiscal policy involves tax
and spending decisions set by the government, and will impact individuals' tax bill or provide
them with employment from government projects. Monetary policy is set by the central bank
and can boost consumer spending through lower interest rates that make borrowing cheaper
on everything from credit cards to mortgages.

CONCEPT OF NATIONAL INCOME

National income means the value of goods and services produced by a country during
a financial year. Thus, it is the net result of all economic activities of any country during a
period of one year and is valued in terms of money. National income is an uncertain term and
is often used interchangeably with the national dividend, national output, and
national expenditure. We can understand this concept by understanding the national income
definition.

Concept of National Income

The National Income is the total amount of income accruing to a country from economic

activities in a years time. It includes payments made to all resources either in the form
of wages, interest, rent, and profits. The progress of a country can be determined by
the growth of the national income of the country
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National Income Definition

There are two National Income Definition

 Traditional Definition

 Modern Definition

Traditional Definition

According to Marshall: “The labor and capital of a country acting on its natural

resources produce annually a certain net aggregate of commodities, material and immaterial
including services of all kinds. This is the true net annual income or revenue of the country or
national dividend.”

The definition as laid down by Marshall is being criticized on the following grounds.
Due to the varied category of goods and services, a correct estimation is very difficult.
There is a chance of double counting, hence National Income cannot be estimated correctly.

For example, a product runs in the supply from the producer to distributor
to wholesaler to retailer and then to the ultimate consumer. If on every movement commodity
is taken into consideration then the value of National Income increases.

Also, one other reason is that there are products which are produced but not marketed.

For example, In an agriculture-oriented country like India, there are commodities which
though produced but are kept for self-consumption or exchanged with other commodities. Thus
there can be an underestimation of National Income.

Simon Kuznets defines national income as “the net output of commodities and services flowing
during the year from the country’s productive system in the hands of the ultimate consumers.”

Following are the Modern National Income definition

 GDP

 GNP

Gross Domestic Product

The total value of goods produced and services rendered within a country during a year is
its Gross Domestic Product.
Further, GDP is calculated at market price and is defined as GDP at market prices. Different
constituents of GDP are:

1. Wages and salaries

2. Rent
3. Interest
4. Undistributed profits
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5. Mixed-income
6. Direct taxes
7. Dividend
8. Depreciation

Gross National Product

For calculation of GNP, we need to collect and assess the data from all productive activities,
such as agricultural produce, wood, minerals, commodities, the contributions to production by
transport, communications, insurance companies, professions such (as lawyers, doctors,
teachers, etc). at market prices. It also includes net income arising in a country from abroad.
Four main constituents of GNP are:

1. Consumer goods and services

2. Gross private domestic income

3. Goods produced or services rendered

4. Income arising from abroad.

GDP and GNP on the basis of Market Price and Factor Cost

a) Market Price

The Actual transacted price including indirect taxes such as GST, Customs duty etc. Such
taxes tend to raise the prices of goods and services in the economy.

b) Factor Cost

It Includes the cost of factors of production e.g. interest on capital, wages to labor, rent for land
profit to the stakeholders. Thus services provided by service providers and goods sold by the
producer is equal to revenue price.

Alternatively,
Revenue Price (or Factor Cost) = Market Price (net of) Net Indirect Taxes
Net Indirect Taxes = Indirect Taxes Net of Subsidies received
Hence,
Factor Cost  shall be equal to
(Market Price) LESS (Indirect Taxes ADD Subsidies)

Net Domestic Product

The net output of the country’s economy during a year is its NDP. During the year a country’s
capital assets are subject to wear and tear due to its use or can become obsolete.
Hence, we deduct a percentage of such investment from the GDP to arrive at NDP.
So NDP=GDP at factor cost LESS Depreciation.
The Accumulation of all factors of income earned by residents of a country and includes income
earned from the county as well as from abroad.
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Thus, National Income at Factor Cost  shall be equal to

NNP at Market Price LESS (Indirect Taxes ADD Subsidies)
Question on National Income
Q. Enumerate the various methods of measuring National Income?
Ans. There are various methods for measuring National Income:

1. Gross Domestic Product (GDP)

2. Gross National Product (GNP)
3. Net National Product (NNP)
4. Net Domestic Product (NDP)
5. National Income at Factor Cost (NIFC)
6. Transfer Payments
7. Personal Income
8. Disposable Personal Income

Measurement of National Income

National income is the value of the aggregate output of the different sectors during a certain
time period. In other words, it is the flow of goods and services produced in an economy in a
particular year. Thus, the measurement of National Income becomes important.

Measurement of National Income

There are three ways of measuring the National Income of a country. They are from the income
side, the output side and the expenditure side. Thus, we can classify these perspectives into the
following methods of measurement of National Income.

Methods of Measuring National Income

 Product Method

 Income Method

 Expenditure Method


1. Product Method

Under this method, we add the values of output produced or services rendered by the different
sectors of the economy during the year in order to calculate the National Income.
In this method, we include only the value added by each firm in the production process in the
output figure.
Hence, we use the value-added method. The value-added output of all the sectors of the
economy is the GNP at factor cost.
However, this method is unscientific as it adds the value of only those goods and services that
are sold in the market or are available for sale in the market

2. Income Method
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Under this method, we add all the incomes from employment and ownership of assets before
taxation received from all the production activities in an economy.
Thus, it is also the Factor Income method. We also need to add the undistributed profits of the
private sector and the trading surplus of the public sector corporations.
However, we need to exclude items not arising from productive activities such as sickness
benefits, interest on the national debt, etc.

3. Expenditure Method

This method measures the total domestic expenditure of the economy. It consists of two
elements, viz. Consumption expenditure and Investment expenditure.
Consumption expenditure includes consumption expenditure of the household sector on goods
and services and consumption outlays of the business sector and public authorities.
Investment expenditure refers to the expenditure on the making of fixed capital such as Plant
and Machinery, buildings, etc.

Difficulties in Measurement of National Income

Following are the difficulties in estimating the National Income

 Conceptual difficulties

 Statistical difficulties

A. Conceptual difficulties

1. It is difficult to calculate the value of some of the items such as services rendered for
free and goods that are to be sold but are used for self-consumption.

2. Sometimes, it becomes difficult to make a clear distinction between primary,

intermediate and final goods.

3. What price to choose to determine the monetary value of a National Product is always

a difficult question?

4. Whether to include the income of the foreign companies in the National Income or not
because they emit a major part of their income outside India?

B. Statistical difficulties

1. In case of changes in the price level, we need to use the Index numbers which have
their own inherent limitations.

2. Statistical figures are not always accurate as they are based on the sample surveys.
Also, all the data are not often available.

3. All the countries have different methods of estimating National Income. Thus, it is not
easily comparable.
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Questions on National Income

What is the usefulness of estimating the National Income?

Ans. The usefulness of estimating National Income is as follows:

1. It depicts the change in the production to output and also the effects of
the Government policies on the economy.
2. The National Income studies the relation between the input of one industry and the
output of the other.
3. It shows the income distribution among different economic units.
4. It also shows the change in the tastes and preferences of the consumers and thus,
helps the producers to decide what to produce and for whom to produce.
5. The quantum of the National Income of a country indicates its ability to pay its share
for international purposes, such as membership of IMF, World Bank or SAARC.

Concept of Consumption, Saving and Investment

Economic development of a country refers to an increase in the standard of living of its people
coupled with a sustained growth rate. Today we are going to discuss in brief about the concepts
of consumption, savings and investment and also line out the relationship between these
three variables according to the classical system. Consumption, Savings and Investment

Consumption

The main hypothesis of Keynes suggested that our disposable income which can be arrived at
by deducing tax liabilities from gross income influences our level of real consumption. Further
explanation on this is
C = f (Y) where C stands for consumption and Y stands for disposable income.
Keynes also held the view that people tend to enhance their consumption level along with a rise
in their disposable income.
However, the increase in disposable income is greater than the increase in consumption. This
hypothesis can be termed as our marginal propensity to consume and indicates a
positive correlation between these two variables.
This, if our income increases by one unit, our marginal propensity to consume increases by 0.8
units. Hence the remaining 0.2 units are used for savings.
Y = C + S where Y stands for disposable income, C stands for consumption and S stands for
savings.
It is also imperative to note here that propensity to consume and desire to consume are not
similar in nature as the former means effective consumption.
Both objective and subjective factors influence our consumption function. Tax policy, interest
rate, windfall profit or loss and holding of assets are some objective functions whereas
subjective ones relate to motives of foresight, precaution, avarice, and improvement amongst
individuals.

Savings

In plain words, savings refer to the excess of disposable income over consumption expenditure.
From a national level, the unconsumed part of the entire nation’s income comprising of all its
members can be termed as National Savings.
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Total domestic savings, on the other hand, can be defined as the summation of savings of the
government, the business sector, and households.

Some of the biggest determinants of savings are

 Income, as saving income ratio holds a proportionate relation with the rise in income.

People also have a tendency of saving the excess part of their income but not the entire
bulk.

 Distribution of income as the savings process is helped to a great extent by inequality

of income distribution. Our desire to showcase a superior standard of living in
comparison to our neighbors often steers us towards purchasing expensive goods which
in turn declines the level of savings.

 Psychological or subjective factors such as savings to safeguard ourselves from future

insecurity and uncertainty. The ultimate attitude of people is driven towards savings by
their farsightedness. This, in turn, boosts them up to enjoy a better standard of living
both for themselves and their loved ones.

 Prevalent financial instruments and rate of interest as a higher rate motivates greater
savings.

Investment

Definition of Investment is:

 Change in capital stocks or inventories pertaining to a business venture between two

different periods or

 Production of fresh capital goods such as plants and equipment.

Relation Between Savings and Investment In Classical System

According to this theory, Savings (S) gets equated with Investment (I) automatically which
otherwise alters the interest rate. If savings exceeds investment, the excess supply of funds
brings down the rate of interest.

This, in turn, reduces savings and increases investment for maintaining equilibrium.
However, this law of the market holds good when the entire amount of savings is invested.
Economic Growth
The expansion of an economy in order to produce more goods and services for a specific period
of time is known as economic growth. This is an outward shift of the possibilities for production
in an economy.
Economic Growth

There are different maximum possibilities of two goods when it employs all the available
resources fully when given the existing state of technology shown by Economic growth.
Measuring Economic Growth
There have been various methods proposed for measuring economic growth. One of those
methods includes measuring the overall capacity of a country to produce goods and services.
Also, the money value of GNP can change with the change in prices.
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Thus, it becomes necessary to measure economic growth using real income or constant rupees.
There can be an increase in GNP if it is followed by a higher rate of a growing population. This
may lead to no change or deterioration in the living standards of the people.
Thus, real GNP per capita is measured when real GNP is divided by the population. So, when
the numerator grows faster than the denominator, the real GNP for capita will increase. Along
with this, the quality of life will also improve.
Various Components of Economic Growth
There is various competition using which economic growth of a country is measured. These are
the size of a population, percentage of a population that forms labor, the number of labor hours
that are actually worked by labors, and labor productivity.
The size of the population helps when the demand is enlarged. Thus, it paves the way for
producing more quantity of output. Also, L/P which is a fraction of the population that forms
the labor force will be high when the productive capacity of an economy increases.
Also, the total number of labor hours is the length that the actual average labor has worked.
Thus, it has a direct impact on the economic growth rate. Also, labor productivity is said to
have a direct bearing on the GNP level. The more productive a labor will be, the more will be the
total output in the industry.
The Relation between Growth and Stability
Financial stability is a must for economic growth. Because a stable economy can help in
forming the capital due to the continuous flow of foreign income. Furthermore, stability in an
economy is necessary for a rapid rise in productivity. Also, when the prices are stable,
companies can make ‘easy’ profits.
Furthermore, they can repay their debt when the currency depreciates. Thus, there needs to be
an existence of the well managed financial institution. This can easily quicken economic
growth. So, this is done by mobilizing the savings for purposes like investments.
When the businesses are run in a capitalistic economy it is likely to have ups and downs. These
fluctuations that take the shape of a wave are known as the business cycle or trade cycle. There
are 4 phases through which trade cycles are passed. They are prosperity, recession, depression,
and recovery.
Economic Fluctuations
When the businesses are run in a capitalistic economy it is likely to have ups and downs. These
fluctuations that take the shape of a wave are known as the business cycle or trade cycle or
economic
Economic Fluctuations There are 4 phases
through which trade cycles are passed. They are
prosperity, recession, depression, and recovery. In
economic terms, these 4 stages are called
economic fluctuations.
Prosperity
The oxygen of any business or its prosperity is
profit. In a capitalist country like India when the
profits increases or inflates, businessman and
industrialists get the necessary incentive.
These incentives make them produce more and
thereby they invest more. So, more and more investments lead to more employment. Thus,
more income effectively means an increase in demand.
Recession
When there is excessive expansion, it leads to diseconomies to continue to large scale
production. Furthermore, it also leads to higher wages, rising costs, and any more shortages.
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This is termed as a recession in an economic cycle. When the demand for bank credits are rise
and high, the interest rates thus tends to increase. Thus, the profits at a lower level are also
diminished.
Depression
In this part of economic fluctuation, employment, income, and output begin to decline sharply.
Thus, it can also be seen in recessionary trends. Furthermore, the investments fall and the
enterprises are also discouraged. Thus, it leads to the pessimism that leads to deflation and
depression.
Recovery
Depression period does not continue forever. There is cooling down after a period of time. Thus,
in this period the improvement of trade begins. During this period, old debts are repaid, the
units which are weaker are liquidated, and many enterprises are reorganized.
Thus, in this time period, the unemployment rate is also gradually decreased. Also, this is the
time in which income is generated.
Anti-cyclical Policy
Government of a country takes drastic measures to control the cyclical fluctuations. Also,
through the contractionary or expansionary credit policies, the central bank controls the
business cycle. Thus, when there is a period of depression, the government should tax less and
spend more.
Additionally, the objective here is to increase the effective demand which is the buying power of
the people. While during the phase of prosperity, the government should tax more and spend
less. There is thinking by the socialists that the capitalist economy is the real reason behind the
cyclical fluctuations.
Thus, cyclical fluctuations are the outcomes of the capitalist economy. Here the main driving
force and motive is the profit. Thus, the problem can be solved if the system shifts from
capitalism to socialism.

Backwash Effects

Economic growth provides benefits and costs in the region in which it occurs. It has a
positive impact on nearby localities if jobs, population, and wealth spill over into these
communities. Alternatively, it has adverse effects on the nearby localities if growth in the
core region attracts people and economic activity away from these peripheral
areas. Spread refers to the situation where the positive impacts on nearby localities and
labor markets exceed the adverse impacts. Backwash occurs if the adverse effects dominate
and the level of economic activity in the peripheral communities’ declines.

A renewed interest in backwash effects was stimulated by the “new economic-growth

theory.” An enhanced role for innovative activity and increasing returns to scale in economic
development increase the competitive advantage of larger urban areas as the location for
economic activity. This growth in urban (core) areas may lead to a decline in rural
(peripheral) population and employment (a backwash effect) if rural-to-urban flows weaken
rural economies. Five types of flows contribute to backwash: Rural funds are invested in
urban areas to take advantage of entrepreneurial activities and relatively rapidly growing
markets for goods and services. Spending in rural trade and service markets declines owing
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to increased competition from urban businesses. Rural residents move to the expanding
urban areas for improved access to jobs and urban amenities. Rural firms in the innovative
stage of their life cycle move to urban areas to benefit from proximity to specialized services,
skilled labor, and expanding markets. And finally, political influence and government
spending may shift to the more rapidly growing core areas.

The adverse rural-to-urban flows occur in conjunction with the spill over of people, jobs, and
funds from the growing core to peripheral areas (spread effects). The size and geographical
extent of the beneficial and adverse forces on rural areas depend on the characteristics of the
rural and urban areas and the nature of rural-urban linkages. In general, the beneficial
forces are stronger for rural areas near urban cores, while the adverse flows dominate in
regions more peripheral to the growing urban areas. Thus, backwash is more likely in rural
areas outside of the rural-to-urban commuting zones.

The policy implications of backwash are that localities distant from urban growth centers will
likely be adversely affected by regional economic-development policies that focus on
innovation and entrepreneurial development in urban areas. These remote regions will need
to devise economic-development programs that emphasize competitive advantages specific to
their economies.