BUSINESS ECONOMICS

UNIT I NATURE AND SCOPE OF ECONOMIC ISSUES 10

Micro and Macro economic variables – law of demand, elasticity, demand
forecasting-diminishing marginal utility-consumer surplus, break even -point -
perfect and imperfect competition – market equilibrium. Role of economic
planning-Indian economic planning
UNIT II ANALYSIS OF MACRO ECONOMICS 15
National income-Determination of national income – circular flow of income -
Keynesian perspective -consumption, savings, investment, multiplier,
accelerator – business cycle.
UNIT III ANALYSIS OF MONEY MARKET 10
Demand and supply of money – money market equilibrium – the role of
money - monetary policy –Indian perspectives.
UNIT IV INFLATION AND ECONOMIC POLICIES 10
Analysis of inflation and unemployment, Fiscal policy, EXIM policy – balance
of payments, exchange rate - the role of economic policies – Indian experiences.
UNIT V ANALYSIS OF EXTERNAL SECTOR 15
International trade – trade multiplier – linkage model – free trade and
protection – analysis of performance of Indian economy in external sector-
Broad perspective of liberalization, privatization and globalization

TEXT BOOKS
1. Paul A .Samuelson and William D.Nordhaus, “Economics”, 18th Edition,
Tata McGraw – Hill Publishing Company Ltd., 2006.
REFERENCES
1. Dwivedi, “Macro Economics”, 2nd Edition, Tata McGraw – Hill Publishing
Company Ltd.,2007.
2. KA Chrystal, RG Lipsey , “Economics for Business and Management”, 2th
Edition, Oxford University Press New York, 2007.
3. Maheswari, “Managerial Economics”, 2th Edition, Prentice Hall of India Pvt.
Ltd., 2005.
4. Mankiw, “Principles of Macroeconomics”, 4th Edition, Cengage Learning
India Pvt. Ltd.,2007.
BUSINESS ECONOMICS
1
 UNIT I
Meaning of Economics:

Economics can be called as social science dealing with economics problem and

man’s economic behavior. It deals with economic behavior of man in society in

respect of consumption, production; distribution etc. economics can be called

as an unending science.

Example:

For e.g. most of us want to lead an exciting life i.e. life full of excitements,

adventures etc. but unluckily we do not always have the resources necessary to

do everything we want to do. Therefore choices have to be made or in the

words of economists “individuals have to decide-----“how to allocate scarce

resources in the most effective ways”.

Economics can be studied under two heads:

1) Micro Economics

2) Macro Economics

Micro Economics:

It has been defined as that branch where the unit of study is an individual, firm

or household. It studies how individual make their choices about what to

produce, how to produce, and for whom to produce, and what price to charge.

It is also known as the price theory is the main source of concepts and

analytical tools for managerial decision making.

Various micro-economic concepts such as demand, supply, elasticity of

demand and supply, marginal cost, various market forms, etc. are of great

significance to managerial economics.

2
Macro Economics:

It’s not only individuals and forms who are faced with having to make choices.

Governments face many such problems.

For e.g.

How much to spend on health

How much to spend on services

How much should go in to providing social security benefits.

Following are the various economic concepts which are useful for managers for

decision making:

• Price elasticity of demand

• Income elasticity of demand

• Cost and output relationship

• Opportunity cost

• Multiplier

• Propensity to consume

• Marginal revenue product

• Production function

• Demand theory

• Theory of firm—price, output and investment decisions

• Money and banking

• Public finance and fiscal and monetary policy

• National income and • Theory of international trade

CONCEPT OF ECONOMICS IN DECISION MAKING

Meaning of decision making:

3
Decision making may be defined as the process of selecting the suitable action

from among several alternative courses of action.

The problem of decision making arises whenever a number of alternatives are

available. Such as:

What should be the price of the product?

What should be the size of the plant to be installed?

How many workers should be employed?

What kind of training should be imparted to them?

What is the optimal level of inventories of finished products, raw material,

spare parts, etc.?

Therefore we can say that the problem of decision making arises due to the

scarcity of resources. We have unlimited wants and the means to satisfy those

wants are limited, with the satisfaction of one want, another arises, and here

arises the problem of decision making.

The main reasons behind uncertainty and risks are uncertain behavior of the

market forces which are as follows:

The demand and supply

Changing business environment

Government policies

External influence on the domestic market

Social and political changes

Economic problem

Meaning of Economic problem:

4
To know the meaning of the term economic problem we have to put together

the four characteristics i.e.

Human wants are unlimited.

Human wants vary in their intensity.

The means or resources are relatively limited.

There are alternative uses of the limited resources.

Therefore economic problem can be called as the problem related to the

unlimited wants with limited resources. Problem arises due to this unlimited

wants only. Resources used to satisfy one want cannot be used to satisfy the

other want – it means that every man begins to face the problem of

economizing his means.

The problem of economy is how to use the relatively limited resources with

alternative uses in the face of unlimited wants.

NATURE AND SCOPE OF MANAGERIAL ECONOMICS

Scope of Managerial Economics

ME deals with Demand analysis, Forecasting, Production function, Cost

analysis, Inventory Management, Advertising, Pricing System, Resource

allocation etc.

Following aspects are to be taken into account while knowing the scope of ME:

1. Demand analysis and forecasting:

Unless and until knowing the demand for a product how can we think of

producing that product. Therefore demand analysis is something which is

necessary for the production function to happen. Demand analysis helps in

analyzing the various types of demand which enables the manager to arrive at

reasonable estimates of demand for product of his company. Managers not

5
only assess the current demand but he has to take into account the future

demand also.

2. Production function:

Conversion of inputs into outputs is known as production function. With

limited resources we have to make the alternative uses of this limited resource.

Factor of production called as inputs is combined in a particular way to get the

maximum output. When the price of input rises the firm is forced to work out a

combination of inputs to ensure the least cost combination.

3. Cost analysis:

Cost analysis is helpful in understanding the cost of a particular product. It

takes into account all the costs incurred while producing a particular product.

Under cost analysis we will take into account determinants of costs, method of

estimating costs, the relationship between cost and output, the forecast of the

cost, profit, these terms are very vital to any firm or business.

4. Inventory Management:

What do you mean by the term inventory? Well the actual meaning of the term

inventory is stock. It refers to stock of raw materials which a firm keeps. Now

here the question arises how much of the inventory is ideal stock. Both the high

inventory and low inventory is not good for the firm. Managerial economics

will use such methods as ABC Analysis, simple simulation exercises, and some

mathematical models, to minimize inventory cost. It also helps in inventory

controlling.

5. Advertising:

6
Advertising is a promotional activity. In advertising while the copy,

illustrations, etc., are the responsibility of those who get it ready for the press,

the problem of cost, the methods of determining the total advertisement costs

and budget, the measuring of the economic effects of advertising ---- are the

problems of the manager.

There’s a vast difference between producing a product and marketing it.

It is through advertising only that the message about the product should reach

the consumer before he thinks to buy it.

Advertising forms the integral part of decision making and forward planning.

6. Pricing system:

Here pricing refers to the pricing of a product. As you all know that pricing

system as a concept was developed by economics and it is widely used in

managerial economics. Pricing is also one of the central functions of an

enterprise. While pricing commodity the cost of production has to be taken into

account, but a complete knowledge of the price system is quite essential to

determine the price. It is also important to understand how product has to be

priced under different kinds of competition, for different markets.

Pricing = cost plus pricing and the policies of the enterprise

Now it is clear that the price system touches the several aspects of managerial

economics and helps managers to take valid and profitable decisions.

7. Resource allocation:

Resources are allocated according to the needs only to achieve the level of

optimization.

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As we all know that we have scarce resources, and unlimited needs. We have

to make the alternate use of the available resources. For the allocation of the

resources various advanced tools such as linear programming are used to

arrive at the best course of action.

NATURE OF MANAGERIAL ECONOMICS

• Managerial economics aims at providing help in decision making by firms. It

is heavily dependent on microeconomic theory. The various concepts of micro

economics used frequently in managerial economics

Elasticity of demand

Marginal cost

Marginal revenue

Market structures and their significance in pricing policies.

• Macro economy is used to identify the level of demand at some future point

in time, based on the relationship between the level of national income and the

demand for a particular product. It is the level of national income only that the

level of various products depends.

In managerial economics macro economics indicates the relationship between

(a) the magnitude of investment and the level of national income, (b) the level

of national income and the level of employment, (c) the level of consumption

and the level of national income.

• In managerial economics emphasis is laid on those prepositions which are

likely to be useful to management.

8
 DEMAND ANALYSIS

“Demand for a product is the desire for that product backed by willingness as

well as ability to pay for it. It is always defined with reference to a particular

time, place, price and given values of other variables on which it depends.”

Demand for product implies:

a) Desires to acquire it,

b) Willingness to pay for it, and

c) Ability to pay for it.

For example:

 A poor man’s desires to stay in a five-star hotel room and his willingness

to pay rent for that room is not ‘demand’, because he lacks the necessary

purchasing power; so it is merely his wishful thinking.

 Similarly, a miser’s desire for and his ability to pay for a car is not

‘demand’, because he does not have the necessary willingness to pay for

a car.

 One may also come across a well-established person who processes both

the willingness and the ability to pay for higher education. But he has

really no desire to have it, he pays the fees for a regular cause, and

eventually does not attend his classes. Thus, in an economics sense, he

does not have a ‘demand’ for higher education degree/diploma.

TYPES OF DEMAND

Till now we have that may specify demand in the form of a function. Much of

this specification and its form depend on the nature of demand itself – its type

9
and determinants. From this standpoint, we can talk about a few other distinct

concepts of demand:

i) Direct and Derived Demands

Direct demand refers to demand for goods meant for final consumption; it is

the demand for consumers’ goods like food items, readymade garments and

houses. By contrast, derived demand refers to demand for goods which are

needed for further production; it is the demand for producers’ goods like

industrial raw materials, machine tools and equipments. Thus the demand for

an input or what is called a factor of production is a derived demand; its

demand depends on the demand for output where the input enters. In fact, the

quantity of demand for the final output as well as the degree of

substituability/complementarty between inputs would determine the derived

demand for a given input.

For example, the demand for gas in a fertilizer plant depends on the amount of

fertilizer to be produced and substitutability between gas and coal as the basis

for fertilizer production. However, the direct demand for a product is not

contingent upon the demand for other products.

ii) Domestic and Industrial Demands

The example of the refrigerator can be restated to distinguish between the

demand for domestic consumption and the demand for industrial use. In case

of certain industrial raw materials which are also used for domestic purpose,

this distinction is very meaningful.

For example, coal has both domestic and industrial demand, and the

distinction is important from the standpoint of pricing and distribution of coal.

iii) Autonomous and Induced Demand

10
When the demand for a product is tied to the purchase of some parent product,

its demand is called induced or derived.

For example, the demand for cement is induced by (derived from) the demand

for housing. As stated above, the demand for all producers’ goods is derived or

induced. In addition, even in the realm of consumers’ goods, we may think of

induced demand. Consider the complementary items like tea and sugar, bread

and butter etc. The demand for butter (sugar) may be induced by the purchase

of bread (tea). Autonomous demand, on the other hand, is not derived or

induced. Unless a product is totally independent of the use of other products, it

is difficult to talk about autonomous demand. In the present world of

dependence, there is hardly any autonomous demand. Nobody today

consumes just a single commodity; everybody consumes a bundle of

commodities. Even then, all direct demand may be loosely called autonomous.

iv) Perishable and Durable Goods’ Demands

Both consumers’ goods and producers’ goods are further classified into

perishable/non-durable/single-use goods and durable/non-

perishable/repeated-use goods. The former refers to final output like bread or

raw material like cement which can be used only once. The latter refers to

items like shirt, car or a machine which can be used repeatedly. In other words,

we can classify goods into several categories: single-use consumer goods,

single-use producer goods, durable-use consumer goods and durable-use

producer’s goods.

This distinction is useful because durable products present more complicated

problems of demand analysis than perishable products. Non-durable items are

meant for meeting immediate (current) demand, but durable items are

11
designed to meet current as well as future demand as they are used over a

period of time. So, when durable items are purchased, they are considered to

be an addition to stock of assets or wealth. Because of continuous use, such

assets like furniture or washing machine, suffer depreciation and thus call for

replacement. Thus durable goods demand has two varieties – replacement of

old products and expansion of total stock. Such demands fluctuate with

business conditions, speculation and price expectations. Real wealth effect

influences demand for consumer durables.

v) New and Replacement Demands

This distinction follows readily from the previous one. If the purchase or

acquisition of an item is meant as an addition to stock, it is a new demand. If

the purchase of an item is meant for maintaining the old stock of capital/asset,

it is replacement demand. Such replacement expenditure is to overcome

depreciation in the existing stock.

Producers’ goods like machines. The demand for spare parts of a machine is

replacement demand, but the demand for the latest model of a particular

machine (say, the latest generation computer) is anew demand. In course of

preventive maintenance and breakdown maintenance, the engineer and his

crew often express their replacement demand, but when a new process or a

new technique or anew product is to be introduced, there is always a new

demand.

You may now argue that replacement demand is induced by the quantity and

quality of the existing stock, whereas the new demand is of an autonomous

type. However, such a distinction is more of degree than of kind. For example,

when demonstration effect operates, a new demand may also be an induced

12
demand. You may buy a new VCR, because your neighbor has recently bought

one. Yours is a new purchase, yet it is induced by your neighbor’s

demonstration.

vi) Final and Intermediate Demands

This distinction is again based on the type of goods- final or intermediate. The

demand for semi-finished products, industrial raw materials and similar

intermediate goods are all derived demands, i.e., induced by the demand for

final goods. In the context of input-output models, such distinction is often

employed.

vii) Individual and Market Demands

This distinction is often employed by the economist to study the size of the

buyers’ demand, individual as well as collective. A market is visited by

different consumers, consumer differences depending on factors like income,

age, sex etc. They all react differently to the prevailing market price of a

commodity. For example, when the price is very high, a low-income buyer may

not buy anything, though a high income buyer may buy something. In such a

case, we may distinguish between the demand of an individual buyer and that

of the market which is the market which is the aggregate of individuals.

You may note that both individual and market demand schedules (and hence

curves, when plotted) obey the law of demand. But the purchasing capacity

varies between individuals. For example, A is a high income consumer, B is a

middle-income consumer and C is in the low-income group. This information

13
is useful for personalized service or target-group-planning as a part of sales

strategy formulation.

viii) Total Market and Segmented Market Demands

This distinction is made mostly on the same lines as above. Different individual

buyers together may represent a given market segment; and several market

segments together may represent the total market. For example, the Hindustan

Machine Tools may compute the demand for its watches in the home and

foreign markets separately; and then aggregate them together to estimate the

total market demand for its HMT watches. This distinction takes care of

different patterns of buying behavior and consumers’ preferences in different

segments of the market. Such market segments may be defined in terms of

criteria like location, age, sex, income, nationality, and so on

x) Company and Industry Demands

An industry is the aggregate of firms (companies). Thus the Company’s

demand is similar to an individual demand, whereas the industry’s demand is

similar to aggregated total demand. You may examine this distinction from the

standpoint of both output and input.

For example, you may think of the demand for cement produced by the

Cement Corporation of India (i.e., a company’s demand), or the demand for

cement produced by all cement manufacturing units including the CCI (i.e., an

industry’s demand). Similarly, there may be demand for engineers by a single

firm or demand for engineers by the industry as a whole, which is an example

of demand for an input. You can appreciate that the determinants of a

company’s demand may not always be the same as those of an industry’s. The

14
inter-firm differences with regard to technology, product quality, financial

position, market (demand) share, market leadership and competitiveness---- all

these are possible explanatory factors. In fact, a clear understanding of the

relation between company and industry demands necessitates an

understanding of different market structures.

What determines demand?

 There are a number of factors which influence housework demand for a

commodity.

(I) Price of the commodity,

(ii) Prices of other related commodities,

(iii) Level of income of the household,

(iv) Tastes and preferences of consumers,

(v) Size and composition of population,

(vi) Distribution of income,

Demand and supply analysis

Economics may appear to be the study of complicated tables and charts,

statistics and numbers, but, more specifically, it is the study of what constitutes

rational human behavior in the endeavor to fulfill needs and wants.

As an individual, for example, you face the problem of having only limited

resources with which to fulfill your wants and needs, as a result, you must

make certain choices with your money. You'll probably spend part of your

money on rent, electricity and food. Then you might use the rest to go to the

movies and/or buy a new pair of jeans. Economists are interested in the choices

you make, and inquire into why, for instance, you might choose to spend your

15
money on a new DVD player instead of replacing your old TV. They would

want to know whether you would still buy a carton of cigarettes if prices

increased by $2 per pack. The underlying essence of economics is trying to

understand how both individuals and nations behave in response to certain

material constraints.

We can say, therefore, that economics, often referred to as the "dismal science",

is a study of certain aspects of society. Adam Smith (1723 - 1790), the "father of

modern economics" and author of the famous book "An Inquiry into the

Nature and Causes of the Wealth of Nations", spawned the discipline of

economics by trying to understand why some nations prospered while others

lagged behind in poverty. Others after him also explored how a nation's

allocation of resources affects its wealth.

To study these things, economics makes the assumption that human beings

will aim to fulfill their self-interests. It also assumes that individuals are

rational in their efforts to fulfill their unlimited wants and needs. Economics,

therefore, is a social science, which examines people behaving according to

their self-interests.

Market
(1) demand(2)
for potatoes
(3) (monthly)
(4)

Price Babu’s Latha's Total

(per kg) demand demand market
(kg) (kg) demand
(tonnes:
000s)

A 20 28 16 700
B 40 15 11 500
C 60 5 9 350
D 80 1 7 200
E 100 0 6 100 16
 Market demand for potatoes (monthly)
E Point Price Market demand
100 (per kg) (tonnes 000s)
A 20 700
D
80 B 40 500
Price (per kg)

C 60 350
C D 80 200
60 E 100 100

B
40

A
20
Demand
0
0 100 200 300 400 500 600 700 800

Quantity (tonnes: 000s)

The definition set out at the turn of the twentieth century by Alfred Marshall,

author of "The Principles Of Economics" (1890), reflects the complexity

underlying economics: "Thus it is on one side the study of wealth; and on the

other, and more important side, a part of the study of man."

Supply and demand

17
Supply and demand is perhaps one of the most fundamental concepts of

economics and it is the backbone of a market economy. Demand refers to how

much (quantity) of a product or service is desired by buyers. The quantity

demanded is the amount of a product people are willing to buy at a certain

price; the relationship between price and quantity demanded is known as the

demand relationship. Supply represents how much the market can offer. The

quantity supplied refers to the amount of a certain good producers are willing

to supply when receiving a certain price. The correlation between price and

Price of Farmer X's Total Market

potatoes supply supply
(per kg) (tonnes) (tonnes:
000s)

a 20 50 100

b 40 70 200

c 60 100 350

d 80 120 530

e 100 130 700

how much of a good or service is supplied to the market is known as the

supply relationship. Price, therefore, is a reflection of supply and demand.

Market supply of potatoes (monthly)

100 e
Supply
d P Q
80
a 20 100
b 40 200
Price ( per kg)

c c 60 350
60
d 80 530
e 100 700
b
40

a
20

0
0 100 200 300 400 500 600 700 800
Quantity (tonnes: 000s)

18
 Law of Demand

A microeconomic law that states that, all other factors being equal, as the price

of a good or service increases, consumer demand for the good or service will

decrease and vice versa.

This law summarizes the

effect price changes have on

consumer behavior. For

example, a consumer will

purchase more pizzas if the

price of pizza falls. The

opposite is true if the price of

pizza increases.

A, B and C are points on the demand curve. Each point on the curve reflects a

direct correlation between quantities demanded (Q) and price (P). So, at point

A, the quantity demanded will be Q1 and the price will be P1, and so on. The

demand relationship curve illustrates the negative relationship between price

and quantity demanded. The higher the price of a good the lower the quantity

demanded (A), and the lower the price, the more the good will be in

demand (C).

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 B. The Law of Supply

Like the law of demand,

the law of supply

demonstrates the

quantities that will be

sold at a certain price. But

unlike the law of

demand, the supply

relationship shows an

upward slope. This

means that the higher the

price, the higher the quantity supplied. Producers supply more at a higher

price because selling a higher quantity at higher price increases revenue

A, B and C are points on the supply curve. Each point on the curve reflects a

direct correlation between quantity supplied (Q) and price (P). At point B, the

quantity supplied will be Q2 and the price will be P2, and so on.

Time and Supply

Unlike the demand relationship, however, the supply relationship is a factor of

time. Time is important to supply because suppliers must, but cannot always,

react quickly to a change in demand or price. So it is important to try and

determine whether a price change that is caused by demand will be temporary

or permanent.

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Let's say there's a sudden increase in the demand and price for umbrellas in an

unexpected rainy season; suppliers may simply accommodate demand by

using their production equipment more intensively. If, however, there is a

climate change, and the population will need umbrellas year-round, the change

in demand and price will be expected to be long term; suppliers will have to

change their equipment and production facilities in order to meet the long-

term levels of demand.

C. Supply and Demand Relationship

Now that we know the laws of supply and demand, let's turn to an example to

show how supply and demand affect price.

Imagine that a special edition CD of your favorite band is released for $20.

Because the record company's previous analysis showed that consumers will

not demand CDs at a price higher than $20, only ten CDs were released

because the opportunity cost is too high for suppliers to produce more. If,

however, the ten CDs are demanded by 20 people, the price will subsequently

21
rise because, according to the demand relationship, as demand increases, so

does the price. Consequently, the rise in price should prompt more CDs to be

supplied as the supply relationship shows that the higher the price, the higher

the quantity supplied.

If, however, there are 30 CDs produced and demand is still at 20, the price will

not be pushed up because the supply more than accommodates demand. In

fact after the 20 consumers have been satisfied with their CD purchases, the

price of the leftover CDs may drop as CD producers attempt to sell the

remaining ten CDs. The lower price will then make the CD more available to

people who had previously decided that the opportunity cost of buying the CD

at $20 was too high.

D. Equilibrium

When supply and demand are equal (i.e. when the supply function and

demand function intersect) the economy is said to be at equilibrium. At this

point, the allocation of goods is at its most efficient because the amount of

goods being supplied is exactly the same as the amount of goods being

demanded. Thus, everyone (individuals, firms, or countries) is satisfied with

the current economic condition. At the given price, suppliers are selling all the

goods that they have produced and consumers are getting all the goods that

they are demanding.

As you can see on the chart, equilibrium occurs at the intersection of the

demand and supply curve, which indicates no allocative inefficiency. At this

point, the price of the goods will be P* and the quantity will be Q*. These

figures are referred to as equilibrium price and quantity.

In the real market place equilibrium can only ever be reached in theory, so the

22
prices of goods and services are constantly changing in relation to fluctuations

in demand and supply.

E. Disequilibrium

Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.

1. Excess Supply

If the price is set too high, excess supply will be created within the economy

and there will be allocative inefficiency.

At price P1 the quantity of goods that the producers wish to supply is indicated

by Q2. At P1, however, the quantity that the consumers want to consume is at

Q1, a quantity much less than Q2. Because Q2 is greater than Q1, too much is

being produced and too little is being consumed. The suppliers are trying to

produce more goods, which they hope to sell to increase profits, but those

consuming the goods will find the product less attractive and purchase less

because the price is too high.

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2. Excess Demand

Excess demand is created when price is set below the equilibrium price.

Because the price is so low, too many consumers want the good

while producers are not making enough of it.

In this situation, at price P1, the quantity of goods demanded by consumers at

this price is Q2. Conversely, the quantity of goods that producers are willing to

produce at this price is Q1. Thus, there are too few goods being produced to

satisfy the wants (demand) of the consumers. However, as consumers have to

compete with one other to buy the good at this price, the demand will push the

price up, making suppliers want to supply more and bringing the price closer

to its equilibrium.

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 F. Shifts vs. Movement

For economics, the “movements” and “shifts” in relation to the supply and

demand curves represent very different market phenomena:

1. Movements

A movement refers to a

change along a curve. On

the demand curve, a

movement denotes a

change in both price and

quantity demanded from

one point to another on

the curve. The movement implies that the demand relationship remains

consistent. Therefore, a movement along the demand curve will occur when

the price of the good changes and the quantity demanded changes in

accordance to the original demand relationship. In other words, a movement

occurs when a change in the quantity demanded is caused

25
Only by a change in price, and vice versa. Like a movement along the demand

curve, a movement along the supply curve means that the supply relationship

remains consistent. Therefore, a movement along the supply

curve will occur when the price of the good changes and the quantity supplied

changes in accordance to the original supply relationship. In other words, a

movement occurs when a change in quantity supplied is caused only by a

change in price, and vice versa.

2. Shifts

A shift in a demand or supply curve

occurs when a good's quantity

demanded or supplied changes even

though price remains the same. For

instance, if the price for a bottle

of beer was $2 and the quantity of beer

demanded increased from Q1 to Q2,

then there would be a shift in the

demand for beer. Shifts in the demand curve imply that the original demand

relationship has changed, meaning that quantity demand is affected by a factor

other than price. A shift in the demand relationship would occur if, for

instance, beer suddenly became the only type of alcohol available for

consumption.

Conversely, if the price for a bottle of beer was $2 and the quantity supplied

decreased from Q1 to Q2, then there would be a shift in the supply of beer.

26
 Like a shift in the

demand curve, a shift in

the supply curve

implies that the original

supply curve has

changed, meaning

that the quantity

supplied is effected by a

factor other than price.

A shift in the supply curve would occur if, for instance, a natural disaster

caused a mass shortage of hops; beer manufacturers would be forced to supply

less beer for the same price.

The degree to which a demand or supply curve reacts to a change in price is

the curve's elasticity. Elasticity varies among products because some

products may be more essential to the consumer. Products that are necessities

are more insensitive to price changes because consumers would continue

buying these products despite price increases. Conversely, a price increase of a

good or service that is considered less of a necessity will deter more consumers

because the opportunity cost of buying the product will become too high.

A good or service is considered to be highly elastic if a slight change in price

leads to a sharp change in the quantity demanded or supplied. Usually these

kinds of products are readily available in the market and a person may not

necessarily need them in his or her daily life. On the other hand, an inelastic

good or service is one in which changes in price witness only modest changes

27
in the quantity demanded or supplied, if any at all. These goods tend to be

things that are more of a necessity to the consumer in his or her daily life.

To determine the elasticity of the supply or demand curves, we can use this

simple equation:

Elasticity = (% change in quantity / % change in price)

If elasticity is greater than or

equal to one, the curve is

considered to be elastic. If it is

less than one, the curve is said to

be inelastic.

As we mentioned previously, the

demand curve is a negative slope, and if there is a large decrease in the

quantity demanded with a small increase in price, the demand curve looks

flatter, or more horizontal. This flatter curve means that the good or service in

question is elastic.

Meanwhile, inelastic demand

is represented with a much

more upright curve as

quantity changes little with a

large movement in price.

28
Elasticity of supply works similarly. If a change in price results in a big change

in the amount supplied, the supply curve appears flatter and is considered

elastic. Elasticity in this case would be greater than or equal to one.

On the other hand, if a big change in price only results in a minor change in the

quantity supplied, the supply curve is steeper and its elasticity would be less

than one.

A. Factors Affecting Demand Elasticity

There are three main factors that influence a demand's price elasticity:

1. The

availability of substitutes –

29
This is probably the most important factor influencing the elasticity of a good

or service. In general, the more substitutes, the more elastic the demand will

be. For example, if the price of a cup of coffee went up by $0.25, consumers

could replace their morning caffeine with a cup of tea. This means that coffee is

an elastic good because a raise in price will cause a large decrease in demand as

consumers start buying more tea instead of coffee.

However, if the price of caffeine were to go up as a whole, we would probably

see little change in the consumption of coffee or tea because there are few

substitutes for caffeine. Most people are not willing to give up their morning

cup of caffeine no matter what the price. We would say, therefore, that caffeine

is an inelastic product because of its lack of substitutes. Thus, while a product

within an industry is elastic due to the availability of substitutes, the industry

itself tends to be inelastic. Usually, unique goods such as diamonds are

inelastic because they have few if any substitutes.

2. Amount of income available to spend on the good –

This factor affecting demand elasticity refers to the total a person can spend on

a particular good or service. Thus, if the price of a can of Coke goes up from

$0.50 to $1 and income stays the same, the income that is available to spend on

coke, which is $2, is now enough for only two rather than four cans of Coke. In

other words, the consumer is forced to reduce his or her demand of Coke. Thus

if there is an increase in price and no change in the amount of income available

to spend on the good, there will be an elastic reaction in demand; demand will

be sensitive to a change in price if there is no change in income.

30
3. Time - The third influential factor is time. If the price of cigarettes goes up $2

per pack, a smoker with very few available substitutes will most likely

continue buying his or her daily cigarettes. This means that tobacco is inelastic

because the change in price will not have a significant influence on the quantity

demanded. However, if that smoker finds that he or she cannot afford to

spend the extra $2 per day and begins to kick the habit over a period of time,

the price elasticity of cigarettes for that consumer becomes elastic in the long

run.

B. Income Elasticity of Demand

In the second factor outlined above, we saw that if price increases while income

stays the same, demand will decrease. It follows, then, that if there is an

increase in income, demand tends to increase as well. The degree to which an

increase in income will cause an increase in demand is called income elasticity

of demand, which can be expressed in the following equation:

If EDy is greater than one, demand for the item is considered to have

high income elasticity. If however EDy is less than one, demand is considered

31
to be income inelastic. Luxury items usually have higher income elasticity

because when people have a higher income, they don't have to forfeit as much

to buy these luxury items.

Let's look at an example of a luxury good: air travel.

Babu has just received a $10,000 increase in his salary, giving him a total of

$80,000 per annum. With this higher purchasing power, he decides that he can

now afford air travel twice a year instead of his previous once a year. With the

following equation we can calculate income demand elasticity:

Income elasticity of demand for Babu's air travel is seven - highly elastic.

With some goods and services, we may actually notice a decrease in demand as

income increases. These are considered goods and services of inferior quality

that will be dropped by a consumer who receives a salary increase. An example

may be the increase in the demand of DVDs as opposed to video cassettes,

which are generally considered to be of lower quality. Products for which the

demand decreases as income increases have an income elasticity of less than

zero. Products that witness no change in demand despite a change in income

usually have an income elasticity of zero - these goods and services are

considered necessities.

UTILITY

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We have already seen that the focus of economics is to understand the problem

of scarcity: the problem of fulfilling the unlimited wants of humankind with

limited and/or scarce resources. Because of scarcity, economies need to allocate

their resources efficiently. Underlying the laws of demand and supply is the

concept of utility, which represents the advantage or fulfillment a person

receives from consuming a good or service. Utility, then, explains how

individuals and economies aim to gain optimal satisfaction in dealing with

scarcity.

Utility is an abstract concept rather than a concrete, observable quantity. The

units to which we assign an “amount” of utility, therefore, are arbitrary,

representing a relative value. Total utility is the aggregate sum of satisfaction

or benefit that an individual gains from consuming a given amount of goods or

services in an economy. The amount of a person's total utility corresponds to

the person's level of consumption. Usually, the more the person consumes, the

larger his or her total utility will be. Marginal utility is the additional

satisfaction, or amount of utility, gained from each extra unit of consumption.

Although total utility usually increases as more of a good is consumed,

marginal utility usually decreases with each additional increase in the

Consumption of a good.

This decrease demonstrates the law of diminishing marginal utility. Because

there is a certain threshold of satisfaction, the consumer will no longer receive

the same pleasure from consumption once that threshold is crossed. In other

33
words, total utility will increase at a slower pace as an individual increases the

quantity consumed.

Take, for example, a chocolate bar. Let's say that after eating one Chocolate bar

your sweet tooth has been satisfied. Your marginal utility (and total utility)

after eating one chocolate bar will be quite high. But if you eat more chocolate

bars, the pleasure of each additional chocolate bar will be less than the pleasure

you received from eating the one before - probably because you are starting to

feel full or you have had too many sweets for one day.

This table shows that total utility will increase at a much slower rate as

marginal utility diminishes with each additional bar. Notice how the first

chocolate bar gives a total utility of 70 but the next three chocolate bars

together increase total utility by only 18 additional units.

The law of diminishing marginal utility helps economists understand the law

of demand and the negative sloping demand curve. The less of something you

have, the more satisfaction you gain from each additional unit you consume;

the marginal utility you gain from that product is therefore higher, giving you

34
a higher willingness to pay more for it. Prices are lower at a higher quantity

demanded because your additional satisfaction diminishes as you demand

more.

In order to determine what a consumer's utility and total utility are, economists

turn to consumer demand theory, which studies consumer behavior and

satisfaction. Economists assume the consumer is rational and will thus

maximize his or her total utility by purchasing a combination of different

products rather than more of one particular product. Thus, instead of spending

all of your money on three chocolate bars, which has a total utility of 85, you

should instead purchase the one chocolate bar, which has a utility of 70, and

perhaps a glass of milk, which has a utility of 50. This combination will give

you a maximized total utility of 120 but at the same cost as the three chocolate

bars.

DEMAND FORECASTING

 Demand Forecasting is the activity of estimating the quantity of a

product or service that consumers will purchase.

 Demand forecasting involves techniques including both informal

methods, such as educated guesses, and quantitative methods, such as

the use of historical sales data or current data from test markets.

 Demand forecasting may be used in making pricing decisions, in

assessing future capacity requirements, or in making decisions on

whether to enter a new market.

35
Necessity for forecasting demand

Stock effects:

 lack of availability.

 Demand is also untapped when sales for an item are decreased due to a

poor display location, or because the desired sizes are no longer

available.

 For example, when a consumer electronics retailer does not display a

particular flat-screen TV, sales for that model are typically lower than the

sales for models on display.

 And in fashion retailing, once the stock level of a particular sweater falls

to the point where standard sizes are no longer available, sales of that

item are diminished.

Market response effects

 The effect of market events that are within and beyond a retailer’s

control.

 Demand for an item will likely rise if a competitor increases the price or

if you promote the item in your weekly circular.

 The resulting sales increase reflects a change in demand as a result of

consumers responding to stimuli that potentially drive additional sales.

 Regardless of the stimuli, these forces need to be factored into planning

and managed within the demand forecast

36
LAW OF DIMINISHING MARGINAL UTILITY

A law of economics stating that as a person increases consumption of a

product - while keeping consumption of other products constant

[Ceteris paribus (meaning: other factors are constant)] - there is a decline in the

marginal utility that person derives from consuming each additional unit of

that product.

For example, say you go to a Hotel and the first plate of food you eat is

very good. On a scale of ten you would give it a ten. Now your hunger has

been somewhat tamed, but you get another full plate of food.

Since you're not as hungry, your enjoyment rates at a seven at best. Most

people would stop before their utility drops even more, but say you go back to

eat a third full plate of food and your utility drops even more to a three.

If you kept eating, you would eventually reach a point at which your

eating makes you sick, providing dissatisfaction, or 'dis-utility'.

CONSUMER SURPLUS

An economic measure of consumer satisfaction, which is calculated by

analyzing the difference between what consumers are willing to pay for a good

or service relative to its market price.

A consumer surplus occurs when the consumer is willing to pay more

for a given product than the current market price.

Consumers always like to feel like they are getting a good deal on the

goods and services they buy and consumer surplus is simply an economic

measure of this satisfaction.

For example, assume a consumer goes out shopping for a CD player and he or

she is willing to spend $250. When this individual finds that the player is on

37
sale for $150, economists would say that this person has a consumer surplus of

$100.

SETTING A PRICE

 Psychology of Pricing:

Pricing can involve a complicated decision-making process on the part of

the consumer, and there is plenty of research on the marketing and psychology

of how consumers perceive price.

Pricing Methods

It is a mix of quantitative and qualitative factors. If you’ve created a

brand new, unique product, you should be able to charge a premium price, but

if you’re entering a competitive industry, you’ll have to keep the price in line

with the going rate or perhaps even offer a discount to get customers to switch

to your company.

 Cost-based pricing", is which calls for figuring out how much it will cost

to produce one unit of an item and setting the price to that amount plus a

predetermined profit margin. This approach is frowned upon since it

allows competitors who can make the product for less than you to easily

undercut you on price.

 “Price-based costing" encourages business owners to "start with the price

that consumers are willing to pay (when they have competitive

alternatives) and cut down costs to meet that price." That way if you

encounter new competition, you can lower your price and still turn a

profit.

MONOPOLIES, OLIGOPOLIES AND PERFECT COMPETITION

38
 Market Structure and Perfect Competitive Firm

Market structure – identifies how a market is made up in terms of:

 The number of firms in the industry

 The nature of the product produced

 The degree of power each firm has

 The degree to which the firm can influence price

 Profit levels

 Firms’ behaviour – pricing strategies, non-price competition, output

levels

 The extent of barriers to entry

 The impact on efficiency

Types of Market

For any particular market, we ask

How many buyers and sellers are there in the market?

Is each seller offering a standardized product, more or less indistinguishable

from that offered by other sellers?

Are there any barriers to entry or exit, or can outsiders easily enter and leave

this market?

 Four basic types of market

 Perfect competition

 Monopoly

 Monopolistic competition

 Oligopoly

39
 Market Structure

Perfect Pure
Competition Monopoly

Monopolistic Competition Oligopoly Duopoly Monopoly

The further right on the scale, the greater

the degree of monopoly power exercised by
the firm.

Part II. The Three Requirements of Perfect Competition

 Large numbers of buyers and sellers

 Each buys or sells only a tiny fraction of the total quantity in the market

 Sellers offer a standardized product

 Sellers can easily enter into or exit from market

 Significant barriers to entry and exit can completely change the

environment in which trading takes place .

i. A Large Number of Buyers and Sellers

 In perfect competition, there must be many buyers and sellers

 How many?

 Number must be so large that no individual decision maker can

significantly affect price of the product by changing quantity it buys or

sells

40
ii. Selling Standardized Products

 Buyers do not perceive significant differences between products of one

seller and another

 For instance, buyers of wheat do not prefer one farmer’s wheat over

another

iii. Easy Entry into and Exit from the Market

 Easy Entry

 no significant barriers to discourage new entrants

 any firm wishing to enter can do business on the same terms as firms

that are already there

 Easy exit

A firm suffering a long-run loss must be able to sell off its plant and equipment

and leave the industry for good, without obstacles

In many markets there are significant barriers to entry

Legal barriers

Existing sellers have an important advantage that new entrants can not

duplicate

Brand loyalty

Cost advantage of existing firms from significant economies of scale

Price Taker

 A firm in a perfectly competitive market is said to be a price taker

because the price of the product is determined by market supply and

demand, and the individual firm can do nothing to change that price.

 Both buyers and sellers are price takers.

 A price taker is a firm or individual who takes the market price as given.

41
 In most markets, households are price takers – they accept the price

offered in stores.

 A retail store is not a price taker but a price maker.

The Necessary Conditions for Perfect Competition

 The number of firms is large.

 Large means that what one firm does has no bearing on what other firms

do.

 Any one firm's output is tiny when compared with the total market.

There are no barriers to entry.

 Barriers to entry are social, political, or economic impediments that

prevent other firms from entering the market.

 Barriers sometimes take the form of patents granted to produce a certain

good.

 Technology may prevent some firms from entering the market.

 Social forces such as bankers only lending to certain people may create

barriers.

The firms' products are identical.

 This requirement means that each firm's output is indistinguishable from

any competitor's product.

There is complete information.

 Firms and consumers know all there is to know about the market –

prices, products, and available technology.

 Any technological breakthrough would be instantly known to all in the

market.

42
A perfectly competitive firm’s demand schedule is perfectly elastic even

though the demand curve for the market is downward sloping.

The result is that the individual firm perceives the demand curve for its

product as being perfectly horizontal

Market Demand versus Individual Firm Demand Curve

Market Firm
Price Market supply Price
$10 $10
8 8 Individual firm
6 6 demand
4 Market 4
2 demand 2
0 0
1,000 3,000 Quantity 10 20 30 Quantity

MONOPOLY

Pure monopoly – where only one producer exists in the industry

In reality, rarely exists – always some form of substitute available!

Monopoly exists therefore where one firm dominates the market

Firms may be investigated for examples of monopoly power when market

share exceeds 25%

Monopoly

Monopoly power – refers to cases where firms influence the market in some

way through their behaviour – determined by the degree of concentration in

the industry

43
  Influencing prices

 Influencing output

 straight barriers to entry

Origins of monopoly:

Natural monopoly – usually on a network or grid… wasteful to duplicate!

Geographical factors – where a country or climate is the only source of supply

of a raw material…quite rare. However, consider a single grocery store in a

isolated village…

 Government created monopolies – now sold off!

 Through growth of the firm

 Through amalgamation, merger or takeover

 Through acquiring patent or license

 Through legal means – Royal charter, nationalisation, wholly owned plc

Monopolistic Competition

Monopolistic Competition is

characterized by:

 A large number of firms

 Easy entry

 Differentiated products, because

each firm’s product is slightly

different, each firm is kind of a

mini-monopoly—the only

producer of that specific product.

 This allows the firm to be a price maker.

44
The firm’s demand curve is downward sloping and depending on the

differentiation of the firm’s product, it may be fairly inelastic.

Oligopoly

Oligopoly is a market structure in which there are a few interdependent firms.

There are often significant barriers to entry.

Oligopoly is characterized by:

 Few firms—more than one, but few enough so each firm alone can affect

the market.

 Entry is more difficult, but can occur.

 The firms are interdependent—each is affected by what others do.

The demand curve is downward sloping for each firm.

Demand for Various Markets

Competition among Consumers

Monopsony

45
A market structure in which there is a single buyer (e.g., rural area granary)

Oligopsony

A market structure in which there are only a few buyers (e.g., tobacco market)

Monopsonistic competition

A market structure in which there are many buyers offering differentiated

conditions to sellers (e.g., toy manufacturers)

DEMAND FORECASTING

NEED FOR DEMAND FORECASTING

Business managers, depending upon their functional area, need various

forecasts. They need to forecast demand, supply, price, profit, costs,

investment, and what have you. In this unit, we are concerned with only

demand forecasting. The reason is, the concepts and techniques of demand

forecasting discussed here can be applied anywhere.

The question may arise:

Why have we chosen demand forecasting as a model?

What is the use of demand forecasting?

The significance of demand or sales forecasting in the context of business

policy decisions can hardly be overemphasized. Sales constitute the primary

source of revenue for the corporate unit and reduction for sales gives rise to

most of the costs incurred by the fir.

Thus sales forecasts are needed for production planning, inventory planning,

and profit planning and so on. Production itself requires the support of men,

materials, machines, money and finance, which will have to be arranged.

46
Thus, manpower planning, replacement or new investment planning,

working capital management and financial planning—all depend on sales

forecasts.

Thus demand forecasting is crucial for corporate planning. The survival and

growth of a corporate unit has to be planned, and for this sales forecasting is

the most crucial activity.

There is no choice between forecasting and no-forecasting. The choice exists

only with regard to concepts and techniques of forecasting that we employ. It

must be noted that the purpose of forecasting in general is not to provide an

exact future data with perfect precision, the purpose is just to bring out the

range of possibilities concerning the future under a given set of assumptions.

In other words, it is not the ‘actual future’ but the ‘likely future’ that we build

up through forecasts. Such forecasts do not eliminate, but only help you to

reduce the degree of risk and uncertainties of the future. Forecasting is a step

towards that kind of ‘gursstimation’; it is some sort of an approximation to

reality. If the likely state comes close to the actual state, it means that the

forecast is dependable.

A sales forecast is meant to guide business policy decision. Without

forecasting, forward planning by a corporate unit will be directionless.

STEPS IN DEMAND FORECASTING

47
Demand or sales forecasting is a scientific exercise. It has to go through a

number of steps. At each step, you have to make critical considerations. Such

considerations are categorically listed below:

1) Nature of forecast:

To begin with, you should be clear about the uses of forecast data- how it is

related to forward planning and corporate planning by the firm. Depending

upon its use, you have to choose the type of forecasts: short-run or long-run,

active or passive, conditional or non-conditional etc.

2) Nature of product:

The next important consideration is the nature of product for which you are

attempting a demand forecast. You have to examine carefully whether the

product is consumer goods or producer goods, perishable or durable, final or

intermediate demand, new demand or replacement demand type etc. A couple

of examples may illustrate the importance of this factor. The demand for

intermediate goods like basic chemicals is derived from the final demand for

finished goods like detergents. While forecasting the demand for basic

chemicals, it becomes essential to analyse the nature of demand for detergents.

Promoting sales through advertising or price competition is much less

important in the case of intermediate goods compared to final goods. The

elasticity of demand for intermediate goods depends on their relative

importance in the price of the final product.

Time factor is a crucial determinant in demand forecasting. Perishable

commodities such as fresh vegetables and fruits can be sold over a limited

period of time. Here skilful demand forecasting is needed to avoid waste. If

there are storage facilities, then buyers can adjust their demand according to

48
availability, price and income. The time taken for such adjustment varies from

product to product. Goods of daily necessities that are bought more frequently

will lead to quicker adjustments. Whereas in case of expensive equipment

which is worn out and replaced after a long period of time, adaptation of

demand will be spread over a longer duration of time.

3) Determinants of demand:

Once you have identified the nature of product for which you are to build a

forecast, your next task is to locate clearly the determinants of demand for the

product. Depending on the nature of product and nature of forecasts, different

determinants will assume different degree of importance in different demand

functions. In the preceding unit, you have been exposed to a number of price-

income factors or determinants-own price, related price, own income-

disposable and discretionary, related income, advertisement, price expectation

etc. In addition, it is important to consider socio-psychological determinants,

specially demographic, sociological and psychological factors affecting

demand. Without considering these factors, long-run demand forecasting is not

possible.

Such factors are particularly important for long-run active forecasts. The size of

population, the age-composition, the location of household unit, the sex-

composition-all these exercise influence on demand in. varying degrees. If

more babies are born, more will be the demand for toys; if more youngsters

marry, more will be the demand for furniture; if more old people survive, more

will be the demand for sticks. In the same way buyers’ psychology-his need,

social status, ego, demonstration effect etc. –also effect demand. While

forecasting, you cannot neglect these factors.

49
4) Analysis of factors &determinants:

Identifying the determinants alone would not do, their analysis is also

important for demand forecasting. In an analysis of statistical demand

function, it is customary to classify the explanatory factors into (a) trend

factors, which affect demand over long-run, (b) cyclical factors whose effects

on demand are periodic in nature, (c) seasonal factors, which are a little more

certain compared to cyclical factors, because there is some regularly with

regard to their occurrence, and (d) random factors which create disturbance

because they are erratic in nature; their operation and effects are not very

orderly.

An analysis of factors is specially important depending upon whether it is the

aggregate demand in the economy or the industry’s demand or the company’s

demand or the consumers; demand which is being predicted. Also, for a long-

run demand forecast, trend factors are important; but for a short-run demand

forecast, cyclical and seasonal factors are important.

5) Choice of techniques:

This is a very important step. You have to choose a particular technique from

among various techniques of demand forecasting. Subsequently, you will be

exposed to all such techniques, statistical or otherwise. You will find that

different techniques may be appropriate for forecasting demand for different

products depending upon their nature. In some cases, it may be possible to use

more than one technique. However, the choice of technique has to be logical

and appropriate; for it is a very critical choice. Much of the accuracy and

relevance of the forecast data depends accuracy required, reference period of

50
the forecast, complexity of the relationship postulated in the demand function,

available time for forecasting exercise, size of cost budget for the forecast etc.

6) Testing accuracy:

This is the final step in demand forecasting. There are various methods for

testing statistical accuracy in a given forecast. Some of them are simple and

inexpensive, others quite complex and difficult. This stating is needed to

avoid/reduce the margin of error and thereby improve its validity for practical

decision-making purpose. Subsequently you will be exposed briefly to some of

these methods and their uses.

BREAKEVEN ANALYSIS

51
 Breakeven Analysis in the context of Production planning addresses the

decision of whether to make or buy a product.

 Making the product involves two cost elements:

– Fixed costs such as machine renting cost and operation expenses

– Variable costs such as raw material cost

 Buying the product involves only one cost element, the selling price.

However, the price may either be constant or variable based on the

quantity.

Breakeven Point = Fixed Costs

(Unit Selling Price - Variable Costs)

Cost Buy Cost (BC) = pQ

Making is better

Make Cost (MC) = FC + vQ

Buying is better
Variable cost: vQ

Fixed Cost: FC

Savings : S = BC – MC = pQ – FC – vQ
Breakeven: S = 0, pQ = FC + vQ
Quantity (Q)
Q’

ECONOMIC PLANNING

52
Meaning and Need for Planning:

The 20th century was an era of planning. Almost every country had some sort

of planning. In socialist countries, planning is almost a religion. Even in

countries like the U.S.A. and the U.K. with a capitalistic system, they have

partial planning. The 19th century State was a Laissez faire state. It followed a

policy of non –intervention in economic affairs. But the modern State is a

Welfare State. The two World Wars, the Great Depression of 1930s and the

success of planning in former Soviet Russia have underlined the need for

planning. Planning is a gift of former Soviet Russia to the world.

For, it was the first country to practice economic planning on a national scale.

According to Lionel Robbins, “strictly speaking, all economic life involves

planning…. To plan is to act with a purpose, to choose and choice is the

essence of economic activity”.

In the words of Barbara Wootten, “Planning may be defined as the conscious

and deliberate choice of economic priorities by some public authorities”. Many

economists today agree that planning is an organized,

conscious and continuous attempt to select the basic available alternatives to

achieve specific goals. Planning involves the economizing of scarce resources.

Most of the underdeveloped countries of the world became independent only

fifty or sixty years back and most of them were poor at that time. So it became

the main business of the Governments of the newly emergent nations to

provide food, clothing and shelter to their people. For that, first of all, they had

to increase their national income. Since most of them were agricultural

countries, they had to evolve some programmes for agricultural development.

Not only that, they had to industrialize their economies. And they had to

53
provide more jobs to their people. That means, they had to do something for

expanding employment opportunities. Further, as most of them were wedded

to some kind of socialism, they had to reduce inequalities of income and

wealth. All these things, the poor countries attempted to do by means of

economic planning.

Laissez faire policy is a luxury for modern governments. So they have economic

plans. In the developed nations of the world, they plan for economic stability.

But in the underdeveloped nations, they plan for economic growth and

development.

Another main reason for the emergence of planning in underdeveloped

countries is the failure of the market mechanism. The capitalist economy is

basically a market economy and price mechanism works through the market

system. The price system is a basic institution of capitalism. The allocation of

resources and distribution of rewards are done through the price system. All

decisions of the businessmen, farmers, industrialists and so on are guided by

the profit motive. If the market is perfect, price system is good. But if there is

monopoly and other types of imperfect competition, the market system fails.

And it calls for government intervention by way of planning.

The dispute between planning and Laissez faire is essentially about efficiency.

The case against Laissez faire rests on the following grounds:

1. Under Laissez faire, income is not fairly distributed. As a consequence, less

important and less urgent goods are produced for the wealthy people while the

poor lack basic goods like education, health, housing, good food and ordinary

54
comforts. Under such a situation, the State can control economic activity by

means of planning and reduce inequalities of income and wealth.

2. The market economy is a victim of trade cycles. And there will be alternating

periods of prosperity and depression. And during depression, there will be bad

trade, falling prices and mass unemployment. So there is need for state

intervention. By means of proper planning, the State can control trade cycles as

they did in the case of former Soviet Russia. During the latter half of the 20th

century, planning was popular in many underdeveloped countries, in addition

to former Soviet Russia and Eastern European countries. It does not mean that

they believed in complete central planning. The central issue in planning is not

whether there shall be planning but what form it shall take. The debate, in fact,

centered on whether the State shall operate through the price system or by

getting rid of it.

Problems of Planning in backward countries

Planning is much more necessary and much more difficult to execute in

backward than in advanced countries. First of all, “planning requires a strong,

competent and incorrupt administration”.But most of the economically

backward nations have weak, incompetent and corrupt administration.

Further, they have democratic planning. So they cannot do things in a quick

manner as was done in former Soviet Russia. They have to go slow. And

agriculture is the main stay of their economies. Since agriculture depends upon

natural factors which are uncertain, there is a lot of uncertainty about their

agricultural programmes. Over–population and

low capital formation are some other important problems of planning in

underdeveloped nations.

55
Characteristics of Economic Planning

In a planned economy, major economic decisions such as what and how much

is to be produced, when and where it is to be produced and to whom it is to be

allocated will be determined by a central authority such as the State, through

the Planning Commission.

And the Government will have the powers of implementation. Before the Plan

is drawn up, a detailed survey of all available resources – physical resources,

financial resources and human resources – has to be made. For example, in the

former Soviet Russia, after the Revolution in 1917, there was War Communism

between 1918 – 1921. And there was New Economic Policy (NEP) from 1921 to

1924. And from 1924, the Government made a detailed survey of all available

resources and only in 1928, it implemented its First Five Year Plan. After the

survey of resources, the objectives of planning will be determined. For

example, one of the long term objectives of Soviet Planning was that Soviet

Russia should catch up with the production levels of the leading capitalist

nation of the world, namely U.S.A., in steel, coal and electricity. Keeping in

mind, the objectives of the Five Year Plan, the physical targets will be fixed.

And ways and means of mobilizing financial resources will be explored. The

Plan will also spell out the details in which the fruits of planning will be

distributed in a fair and just manner.

The nature of planning is determined by the type of economic system –

capitalism, socialism, mixed economy - in which it is practiced.

There will be partial planning in a capitalist economy, (e.g., U.K.) but a socialist

economy is a totally planned economy (e.g., Former Soviet Russia). In a mixed

56
economy like India, both public sector and private sector play important roles

in economic planning.

Usually, the period of a Plan is five years. The Plan has to be drawn in advance.

It is done by the Planning Commission in India. A plan will be of a definite size

and it will fix the targets for the Plan period and it will also indicate the ways

by which the financial resources are to be mobilized for the Plan.

The first step in drawing up a Plan is to determine a growth target for an

economy over the Plan period. The planners then divide the economy into a

number of sectors such as agriculture, industry and service sector. The

planners will fix the physical targets for the sectors and also decide how much

investment must be made in each sector to achieve the targets. Then they will

decide the right type of investment projects and production techniques. As the

UDCs are poor, labour-intensive techniques will expand employment

opportunities. But some heavy industries like steel have to be capital –

intensive. The success or failure of a Plan depends upon the choices that are

made.

Types of Planning

1. Centralized Planning :

In a socialist economy (eg. Former Soviet Russia), there was centralized

planning; it was planning by direction. In a socialist state, most of the means of

production are owned by the State. All basic economic decisions such as

whether priority is to be given for industrialization or for development of

agriculture ; if it is decided to give importance to industrialisation, whether to

57
give importance to basic and heavy industries or for consumer goods

industries will be made by the central authority.

2. Planning by Inducement:

In a democracy, Planning is done by inducement. For example, ours is a mixed

economy where there is a public sector and a private sector. The government

has to persuade the industries in the private sector to fulfil the goals of the Plan

through inducements such as tax concessions and by providing incentives.

3. Indicative planning – In this type of planning, the government invites

representatives of industry, and business and discuss with them in advance

what it proposes to do in the Plan under question and indicates to them its

priorities and goals. Then the Plan is formulated after detailed discussions with

varied interests. Planning in France is a good example of indicative planning.

After we embraced liberalization and privatization policies in 1991, even

Indian planning, in a way, has become indicative planning.

Economic plans can also be divided into midterm plans, shorterm plans and

perspective plans. Our Five Year Plans are in fact, midterm plans. Short term

plans are Annual Plans. During the period of implementation, Five Year Plans

operated by dividing them into Annual Plans. Perspective Plans are long term

plans and the period ranges from 20 to 25 years. The Five Year Plans are

formulated by taking into account the long term objectives of the Perspective

Plan.

Rolling Plan :

Unlike the Five Year Plan with fixed targets, in the case of the rolling plan, at

the end of each year, targets will be fixed by adding one more year to the Plan.

That is, without fixed targets for all the five years, depending upon the

58
performance of the Plan in the current year, targets will be fixed for one more

year. Like this, it will go on a continuous basis. That is the idea behind the

rolling plan.

A great advantage of centralized planning is that plans can be implemented

with great speed and targets and goals can be achieved. For example, by means

of planning, former Soviet Russia transformed its economy, which was

predominantly agricultural into a predominantly industrial nation, within a

short span of 12 years. But a demerit of centralized planning is that as the State

enjoys a considerable degree of monopoly, in the absence of competition, it is

rather difficult to test the productive efficiency of state owned units. Under

planning by inducement (democratic planning), though there is a good deal of

freedom for people, because of the procedures and delays associated with the

democratic process and because of Parliamentary democracy, there will be a lot

of delay in the implementation of programmes and economic growth will be

slow.

Evolution and Objectives of Planning in India

The National Planning Commission was set up in India in 1950. A major

function of the Planning Commission was to “formulate a plan for the most

effective and balanced utilization of the country’s resources”. The Planning

Commission formulated the First Five Year Plan for the period (1951–56). Since

then, we completed nine Five Year Plans and we are now in the midst of Tenth

Five Year Plan (2002–2007).

Objectives of Planning in India

The central objective of planning in India is to raise the standard of living of the

people. Our Five Year Plans aim at increasing output. At the same time, they

59
aim at reducing inequalities of income and wealth and providing equal

opportunities for all. Growth with social justice is our basic goal.

The major objectives of developmental planning in India may

be listed as follows:

1.To raise the national income. This is known as Growth Objective;

2.To increase investment to a certain level within a given time ;

3.To reduce inequalities in the distribution of income and wealth

and to reduce concentration of economic power over resources ;

4.To expand employment opportunities ; and

5.To remove bottlenecks in agriculture, manufacturing industry

(especially capital goods) and the balance of payments.

In the agricultural sector, the main objective was increasing agricultural

productivity and attaining self–sufficiency in foodgrains. In the industrial

sector, the emphasis was on basic and heavy industries. In the foreign trade

sector, the emphasis was on having a ‘viable balance of payments position’.

The strategy adopted in Indian Planning is often referred to as ‘Mahalanobis

strategy’. In this strategy, emphasis was laid on rapid industrialization with

priority for basic and heavy industries.

Though achieving regional balance is mentioned in our plans, we have not

succeeded much in reducing regional imbalances. In agriculture, there are

surplus states and deficit states, with reference to foodgrains. In manufacturing

industry, there are advanced regions and backward regions. Not only that,

industrial growth is concentrated in and around Mumbai, Kolkata and

Chennai. Our Five Year Plans pay attention to the problems of poverty and

60
unemployment. The average Indian is among the poorest of the world. So, our

Plans want to remove poverty and improve the lot of the common man and the

weaker sections like SC/STs, OBCs, women and children. The standard of

living depends upon per capita consumption and per capita consumption

depends upon per capita income. And this in turn depends upon employment.

So our plans have looked at employment as an integral part of the problem of

the removal of poverty.

In the rural sector, there is concentration of land in the hands of a few persons

even today. In spite of our land reform programmes, nearly 50 percent of

agricultural land is owned by 10 percent of the population. And Green

Revolution has helped largely big landlords. Even the ownership of industrial

assets is concentrated. Of course, the basic causes of poverty in India are low

agricultural productivity and rapid growth of population resulting in low

savings and disguised unemployment. The Government has not succeeded

much in solving the problems of rural unemployment and underemployment

by giving support to cottage and small scale industries.

There is an urban bias in Indian Planning. Agriculture did not receive enough

funds in the past. But we cannot say the planners have neglected agriculture.

India began the process of planned economic development five decades back.

The First Five Year (1951-56) stated that the purpose of planning in India was

to initiate “ a process of development which will raise living standards and

open out to the people new opportunities for a richer and more varied life”.

The Second Five Year Plan (1956-61) aimed at rapid industrialization with

particular emphasis on the development of basic and heavy industries. It was

61
during the Second Plan period, the Government embraced the goal of

democratic socialism.

The Third Five Year Plan aimed at self – reliant and self – generating economy.

After the Third Plan, we had a “Plan Holiday”. The Fourth Plan did not

commence immediately after the Third Plan. We had three Annual Plans (1966-

69).

The Fourth Five Year Plan (1969 – 74) had two basic objectives:

1. Growth with stability, and

2. Progressive achievement of self-reliance.

The Fifth Plan (1974-79) focused on growth with social justice. The slogan

during the period was Garibi Hatao (Removal ofPoverty). So, the two main

objectives of the Fifth Plan were removal of poverty and attainment of self–

reliance. When Janata Party was in power at Centre, it formulated the Sixth

Plan (1978 – 83). But when the Congress came back to power, it discarded it

and formulated a new sixth Five Year Plan (1980 – 85). It aimed at a direct

attack on poverty by creating conditions for an expanding economy.

The Seventh Five Year Plan (1985-90) emphasized on accelerating agricultural

growth in foodgrains production, increasing employment opportunities and

raising productivity in all sectors. When the final version of the Eighth plan

(1992 – 97) was formulated, there were major changes in our economic policy

marked by liberalization, privatization and globalization. The Eighth Plan 1992

– 97 reflected these changes and aimed at accelerating economic growth and

improving the quality of life of the common man.

62
The main objectives of Planning in India may be grouped under four heads:

Growth, modernization, self–reliance and social justice.

Growth

In the first 30 years of planning, the trend rate of growth of national income

was 3.5 percent. Eminent economist Raj Krishna called it the Hindu rate of

growth. Agricultural production increased at an average rate of 2.7 percent and

industrial production at 6.1 percent. And per capita income increased at the

trend rate of 1.3 percent. Though these rates appear rather small, we must

remember that throughout the British period, for almost a century, there was

stagnation in the Indian economy. For example, in the undivided India from

1901 – 46, the trend growth rate of the national income was only 1.2 percent. So

one of the achievements of planning in Indian economy is that it has overcome

stagnation and we have had a slow

but steady economic growth.

Table 5.1Growth Rates of National Income(in percentage)

63
First plan (1951-1956)

The first Indian Prime Minister, Jawaharlal Nehru presented the first five-year

plan to the Parliament of India on December 8, 1951. The total plan budget of

206.8 billion INR (23.6 billion USD in the 1950 exchange rate) was allocated to

seven broad areas: irrigation and energy (27.2 percent), agriculture and

community development (17.4 percent), transport and communications (24

percent), industry (8.4 percent), social services (16.64 percent), land

rehabilitation 4.1 percent), and other (2.5 percent).

The target growth rate was 2.1 percent annual gross domestic product (GDP)

growth; the achieved growth rate was 3.6 percent. During the first five-year

plan the net domestic product went up by 15 percent. The monsoons were

good and there were relatively high crop yields, boosting exchange reserves

and per capita income, which went up 8 percent. Lower increase of per capita

income as compared to national income was due to rapid population growth.

Many irrigation projects were initiated during this period, including the

Bhakra Dam, Hirakud Dam, and Mettur Dam in South India. The World

Health Organization, with the Indian government, addressed children's health

and reduced infant mortality, contributing to population growth.

At the end of the plan period in 1956, five Indian Institutes of Technology (IITs)

were started as major technical institutions. University Grant Commission was

set up to take care of funding and take measures to strengthen the higher

education in the country.

Contracts were signed to start five steel plants; however these plants did not

come into existence until the middle of the next five-year plan.

Second plan (1956-1961)

64
The second five-year plan focused on industry, especially heavy industry.

Domestic production of industrial products was encouraged, particularly in the

development of the public sector. The plan followed the Mahalanobis model,

an economic development model developed by the Indian statistician Prasanta

Chandra Mahalanobis in 1953. The plan attempted to determine the optimal

allocation of investment between productive sectors in order to maximise long-

run economic growth .

Hydroelectric power projects and five steel mills at Bhilai, Durgapur, and

Jamshedpur were established. Coal production was increased. More railway

lines were added in the north east.

The Atomic Energy Commission was formed in 1957 with Homi J. Bhabha as

the first chairman. The Tata Institute of Fundamental Research was established

as a research institute. In 1957 a talent search and scholarship program was

begun to find talented young students to train for work in nuclear power.

Third plan (1961-1966)

The third plan stressed on agriculture and improving production of rice, but

the brief Sino-Indian War in 1962 exposed weaknesses in the economy and

shifted the focus towards defense. In 1965-1966, the Green Revolution in India

advanced agriculture. The war led to inflation and the priority was shifted to

price stabilization. The construction of dams continued. Many cement and

fertilizer plants were also built. Punjab begun producing an abundance of

wheat.

Many primary schools were started in rural areas. In an effort to bring

democracy to the grassroot level, Panchayat elections were started and the

states were given more development responsibilities.

65
State electricity boards and state secondary education boards were formed.

States were made responsible for secondary and higher education. State road

transportation corporations were formed and local road building became a

state responsibility.Gross Domestic Product rate during this duration was

lower at 2.7% due to 1962 Sino-Indian War and Indo-Pakistani War of 1965.

Fourth plan (1969-1974)

At this time Indira Gandhi was the Prime Minister. The Indira Gandhi

government nationalized 19 major Indian banks. In addition, the situation in

East Pakistan (now independent Bangladesh) was becoming dire as the Indo-

Pakistani War of 1971 and Bangladesh Liberation War took place.

Funds earmarked for the industrial development had to be used for the war

effort. India also performed the Smiling Buddha underground nuclear test in

1974, partially in response to the United States deployment of the Seventh Fleet

in the Bay of Bengal to warn India against attacking West Pakistan and

widening the war.

Fifth plan (1974-1979)

Stress was laid on employment, poverty alleviation, and justice. The plan also

focused on self-reliance in agricultural production and defense. In 1978 the

newly elected Morarji Desai government rejected the plan. Electricity Supply

Act was enacted in 1975, which enabled the Central Government to enter into

power generation and transmission.

Sixth plan (1980-1985)

Called the Janata government plan, the sixth plan marked a reversal of the

Nehruvian model.

66
When Rajiv Gandhi was elected as the prime minister, the young prime

minister aimed for rapid industrial development, especially in the area of

information technology. Progress was slow, however, partly because of caution

on the part of labor and communist leaders.

The Indian national highway system was introduced for the first time and

many roads were widened to accommodate the increasing traffic. Tourism also

expanded.

The sixth plan also marked the beginning of economic liberalization. Price

controls were eliminated and ration shops were closed. This led to an increase

in food prices and an increased cost of living.

Family planning also was expanded in order to prevent overpopulation. In

contrast to China's harshly-enforced one-child policy, Indian policy did not

rely on the threat of force. More prosperous areas of India adopted family

planning more rapidly than less prosperous areas, which continued to have a

high birth rate.

Seventh plan (1985-1989)

The Seventh Plan marked the comeback of the Congress Party to power. The

plan lay stress on improving the productivity level of industries by

upgradation of technology.

Period between 1989-91

1989-91 was a period of political instability in India and hence no five year plan

was implemented. Between 1990 and 1992, there were only Annual Plans. In

1991, India faced a crisis in Foreign Exchange (Forex) reserves, left with

reserves of only about $1 billion (US). Thus, under pressure, the country took

the risk of reforming the socialist economy. P.V. Narasimha Rao)(28 June 1921

67
– 23 December 2004) also called Father of Indian Economic Reforms was the

twelfth Prime Minister of the Republic of India and head of Congress Party,

and led one of the most important administrations in India's modern history

overseeing a major economic transformation and several incidents affecting

national security. At that time Dr. Manmohan Singh (currently, Prime Minister

of India) launched India's free market reforms that brought the nearly

bankrupt nation back from the edge. It was the beginning of privatization and

liberalization in India.

Eighth plan (1992-1997)

Modernization of industries was a major highlight of the Eighth Plan. Under

this plan, the gradual opening of the Indian economy was undertaken to

correct the burgeoning deficit and foreign debt. Meanwhile India became a

member of the World Trade Organization on 1 January 1995.This plan can be

termed as Rao and Man Mohan model of Economic development. The major

objectives included, containing population growth, poverty education,

employment generation, strengthening the infrastructure, Institutional

building, Human Resource development, Involvement of Panchayat raj,

Nagarapalikas, N.G.OSand Decentralization and people’s participation. Energy

was given priority with 26.6% of the outlay. An average annual growth rate of

6.7%against the target 5.6% was achieved.

Ninth plan (1997-2002)

During the Ninth Plan period, the growth rate was 5.35 per cent, a percentage

point lower than the target GDP growth of 6.5 per cent.

Tenth plan (2002-2007)

 The main objectives of the 10th Five-Year Plan were:

68
  Reduction of poverty ratio by 5 percentage points by 2007;

 Providing gainful and high-quality employment at least to the addition

to the labour force;

 All children in india in school by 2003; all children to complete 5 years of

schooling by 2007;

 Reduction in gender gaps in literacy and wage rates by at least 50% by

2007;

 Reduction in the decadal rate of population growth between 2001 and

2011 to 16.2%;

 Increase in Literacy Rates to 75 per cent within the Tenth Plan period

(2002-3 to 2006-7);

 Reduction of Infant mortality rate (IMR) to 45 per 1000 live births by

2007 and to 28 by 2012;

 Reduction of Maternal Mortality Ratio (MMR) to 2 per 1000 live births by

2007 and to 1 by 2012;

 Increase in forest and tree cover to 25 per cent by 2007 and 33 per cent by

2012;

 All villages to have sustained access to potable drinking water within the

Plan period;

 Cleaning of all major polluted rivers by 2007 and other notified stretches

by 2012;

 Economic Growth further accelerated during this period and crosses

over 8% by 2006.

Eleventh plan (2007-2012)

The eleventh plan has the following objectives:

69
  Income & Poverty

 Accelerate GDP growth from 8% to 10% and then maintain at 10% in the

12th Plan in order to double per capita income by 2016-17

 Increase agricultural GDP growth rate to 4% per year to ensure a broader

spread of benefits

 Create 70 million new work opportunities.

 Reduce educated unemployment to below 5%.

 Raise real wage rate of unskilled workers by 20 percent.

 Reduce the headcount ratio of consumption poverty by 10 percentage

points.

Education

 Reduce dropout rates of children from elementary school from 52.2% in

2003-04 to 20% by 2011-12

 Develop minimum standards of educational attainment in elementary

school, and by regular testing monitor effectiveness of education to

ensure quality

 Increase literacy rate for persons of age 7 years or more to 85%

 Lower gender gap in literacy to 10 percentage points

 Increase the percentage of each cohort going to higher education from

the present 10% to 15% by the end of the plan

Health

 Reduce infant mortality rate to 28 and maternal mortality ratio to 1 per

1000 live births

 Reduce Total Fertility Rate to 2.1

70
  Provide clean drinking water for all by 2009 and ensure that there are no

slip-backs

 Reduce malnutrition among children of age group 0-3 to half its present

level

 Reduce anaemia among women and girls by 50% by the end of the plan

Women and Children

 Raise the sex ratio for age group 0-6 to 935 by 2011-12 and to 950 by 2016-

17

 Ensure that at least 33 percent of the direct and indirect beneficiaries of

all government schemes are women and girl children

 Ensure that all children enjoy a safe childhood, without any compulsion

to work

Infrastructure

 Ensure electricity connection to all villages and BPL households by 2009

and round-the-clock power.

 Ensure all-weather road connection to all habitation with population

1000 and above (500 in hilly and tribal areas) by 2009, and ensure

coverage of all significant habitation by 2015

 Connect every village by telephone by November 2007 and provide

broadband connectivity to all villages by 2012

 Provide homestead sites to all by 2012 and step up the pace of house

construction for rural poor to cover all the poor by 2016-17

Environment

 Increase forest and tree cover by 5 percentage points.

 Attain WHO standards of air quality in all major cities by 2011-12.

71
 Treat all urban waste water by 2011-12 to clean river waters.

 Increase energy efficiency by 20 percentage points by 2016-17.

72
73
 ANALYSIS OF MACRO ECONOMICS
UNIT II

NATIONAL INCOME ACCOUNTS

What is National Income Accounting?

National income accounting is a term which is applied to the description of

the various types of economic activities that are taking place in the

community in a certain institutional framework. In national income

accounting, we are concerned with statistical classification of the economic

activity so that we are able to understand easily and clearly the operation

of the economy as a whole. In national income accounting the following

distinctions are drawn between:

(a) forms of economic activity, namely, production, consumption, and

accumulation of wealth;

(b) sectors or institutional division of the economy; and

(c) types of transactions, such as sales and purchases of goods and

services, gifts, taxes, and other current transfers.

In national income accounting, a transactor is supposed to keep a set of

three accounts in which transactions are recorded:

(i) In the first account, incomes and outgoings relating a productive

activity of the transactor are brought together. The difference between

the two shows the profit or gain.

 (ii) The second account seeks to show how this profit and any other

income that accrues to the transactor are allocated to different uses.

The excess of income over outlay is saving.

(iii) The third account shows how this saving and any other capital

funds are used to finance the capital expenditure or to give loans to

other transactors.

Since in an economy, there are numerous transactors, therefore, they are

grouped into sectors. In a sector, accounts of a same type are consolidated.

The ‘sector accounts’ form the units in a system of national income

accounting.

Comparison of National Income Accounting and Individual Income

Accounting:

(a) Double entry book-keeping: Both national income accounting system

and individual income accounting system are based on the method of

double-entry book-keeping. For example, under individual income

accounting, a cash sale is recorded as a debit in Cash Account and as a

credit in Sales Account. Whereas, in national income accounting, the cash

transactions are not separately presented. Cash balances are recorded in

the capital transaction account. The difference is that the national income

accounting does not record the second entry in detail.

(b) Individual vs. collective individuals: Individual income accounts or

private accounts relate to an individual businessman or a corporate firm.

Whereas, the national income accounts are closely related to all the

businessmen or corporate firms in the community.

(c) Profit and loss account: Individual income accounts are usually

presented in the form of a Profit and Loss Account or Income Statement

which shows the flow of income and its allocation during a year. The

Balance Sheet shows the stock of assets and liabilities at the end of the

year. The Profit and Loss Account of a private businessman resembles in

national income accounting to what is called the Appropriation Account.

The only difference is that in private accounting, the profit often includes

some elements of costs such as depreciation on plant and machinery and

fees paid to the directors of the company. On the other hand, in national

income accounting, these incomes are shown net. There is no counterpart

at all of a Balance Sheet in national income accounting since there is a great

difficulty in collecting such a huge bank of data accurately and completely

especially on uniform basis.

Income Statement of a Typical Firm

For the year ended on December 31, 2005

Debits Rs. Credits Rs.

By Cost of Sales:
To Sales Account
1,250,000 Wages 750,000
(50,000 units @ Rs.
25) Rent 150,000

Interest 150,000
 Profit (residual) 200,000
Total 1,250,000 Total 1,250,000

National Product Account 2004-05 (Millions of rupees)

Flow of Product Rs. Flow of Earning Rs.

Costs or Earnings:
Final Output

12,500 Wages 7,500

(500 million units @ Rs.

25) Rent 1,500

Interest 1,500

Profit 2,000

Total 12,500 Total 12,500

Uses of National Income Accounting:

(a) Clear picture of the economy: The national income accounts or social

accounts give a clear picture of the economy regarding the GDP, national

income, per capita income, saving ratio, production, consumption,

disposable income, capital expenditure, etc. It gives a clear view of the

health of the economy and the way in which it functions. It also gives a

view on the living standard of the people.

(b) Promotion of efficiency and stability of the economy: To foster the

economic growth, any government has to see what she has achieved in the

past and what has to be done in the future. For this purpose, the

preparation of national income accounts is quite inevitable for the

promotion of economic efficiency and stability. It helps the government to

set the national priorities, such as education, inflation, unemployment,

defence, social development, and industrialisation, etc., in long-term and

medium-term planning. It also helps the planner to set the economic

objectives to be achieved in the near future. Thus it serves the purpose of

planning and controlling tool for public administrators.

(c) Measurement of economic welfare: Measurement of economic

welfare is another purpose of the preparation of social accounts. Through

social accounting, we can know at a glace to what extent the masses are

better off than at the time when planning started.

(d) Interrelationship of different sectors of the economy: Through the

study of national income accounts, the reader is in a position to inter-relate

different sectors of the economy. For example, through the study of

national income accounts, we can know that Pakistan’s industrial sector is

largely dependant on agriculture sector, because most of the raw materials

like cotton, silk, leather, sugarcane, milk, poultry, etc. are supplied from

agriculture.

(e) Monetary, fiscal and trade policies: The national income accounts are

very essential for the statesmen, governments, and politicians, because

they help them to efficiently formulate different economic policies,

including monetary policy, fiscal policy and trade policy. In the absence of

national income accounts, the economic planning would be disastrous.

Gross National Product (GNP):

GNP is the basic national income accounting measure of the total output or

aggregate supply of goods and services. It has been defined as the total

value of all final goods and services produced in a country during a year.

GNP is a ‘flow’ variable, which measures the quantity of final goods and

services produced during a year. For calculating GNP accurately, all

goods and services produced in any given year must be counted once, but

not more than once.

Approaches of Measuring GNP/GDP:

The primary purpose of national accounts is to provide a coherent and

comprehensive picture of the economy. To be concise, these estimates tend

to answer questions such as:

(a) What is the output of the economy, its size its composition, and its

uses? And

(b) What is the economic process by which this output is produced

and distributed? These questions are addressed below in relation to

estimation of GDP/GNP and final uses of the GNP.

The gross national product (GNP) is the market value of all final goods

and services, produced in the economy during a year. GNP is measured in

Rupee terms rather than in physical units of output. Gross domestic

product (GDP) is a better idea to visualize domestic production in the

economy. GDP may be derived in three ways or in combination of them.

(i) Production Approach: It measures the contribution to output made

by each producer. It is obtained by deducting from the total value of its

output the value of goods and services it has purchased from other

producers and used up in producing its own output, i.e.:

VA = value of output – value of intermediate consumption.

Total value added by all producers equals GDP.

(ii) Income/Cost Approach: In this approach, consideration is given to

the costs incurred by the producer within his own operation, the income

paid out to employees, indirect taxes, consumption of fixed capital, and the

operating surplus. All these add up to value added.

(iii) Expenditure Approach: This approach looks at the final uses of the

output for private consumption, government consumption, capital

formation and net of imports & exports. According this approach, GDP is

the sum of following four major components:

 Personal consumption expenditure on goods and services,

 Gross private domestic investment,

 Government expenditure on goods and services, and

 Net export to the rest of the world.

The concepts of expenditure approach and cost approach have been

illustrated in the following diagram of circular flow of a simplified two-

sector economy:
In the above diagram, the upper loop represents the ‘expenditure’ side of

the economy. Through this loop, all the products flow from business

sector to household sector. Each year the nation consumes a wide variety

of final goods and services: goods such as bread, apples, computers,

automobiles, etc.; and services such as haircuts, health, taxis, airlines, etc.

But we include only the value of those products that are bought and

consumed by the consumers. In our ‘two-sector economy’ illustration, we

have excluded the investment expenditure, government expenditure and

taxes from GDP calculation.

The lower loop represents the ‘cost or revenue’ side of the economy.

Through this loop, all the costs of doing business flow. These costs include

wages paid to labour, rent paid to land, profits paid to capital, and so

forth. But these business costs are revenues that are received by

households in exchange of supplying factors of production to the business

sector.
Precautions in Measuring GNP/GDP / Problems in National Income

Measurement / Dangers of National Income Accounts:

The federal statisticians and economists have to be very careful in

measuring GDP or preparing national income accounts. The following

precautionary measures should be taken:

(a) Reliable source of data: All the data for national accounts are

collected from different sources, including surveys, income tax returns,

retail sales statistics, and employment data. Inaccurate or incomplete data

can severely damage the integrity of the national accounts. The

economists have to be very careful in collection and selection of national

income accounting data.

(b) Difficulties of Measuring Some Services in Money Terms: National

Income of a country is always measured in money terms, but there are

some goods and services, which cannot be measured, in monetary terms.

Such goods include, the services of the housewife, housemaid and the

singing as a hobby by an individual. Exclusion of these services from the

national income, underestimate the national income account.

(c) Illegal Activities in the Economy/The Growth of “Black Economy”:

The “Black Economy” refers to that part of economic activity, which is

undeclared and therefore unrecorded for tax purposes and is therefore

deemed to be ‘illegal’. Many illegal activities in the economy generally

escape both the law and measurement in the national income. Such illegal

activities include, smuggling, drug trafficking and all parallel market

transactions. Since such activities are outlawed, income earned, through

them are not captured in the national income, thus, under estimating the

national income account.

(d) Danger of double counting: While measuring GDP, we have to

distinguish between the three forms of goods:

(i) Final product: A final product is one that is produced and sold for

consumption or investment.

(ii) Intermediate good: Intermediate goods are semi-finished goods or

goods-in-process.

(iii) Raw material: Raw materials are unfinished and unprocessed goods.

To avoid double or multiple counting, it is necessary to add the value of

only those goods which have reached their final stage of production,

i.e., final goods, and to not add the value of intermediate goods and

raw materials, which are already included in the value of final goods.

GDP, therefore, includes bread but not wheat, cars but not steal.

(e) Problem of Including All Inventory Change in GNP: Firms generally

record inventories at their original cost rather than at replacement costs.

When prices rise, there are gains in the book value of inventories but when

prices fall, there are losses. So, the book value of inventories overstates or

understates the actual inventories. Thus, for correct computation of GNP,

inventory evaluation is required. This is achieved when a negative

valuation of inventory is made for inventory gains and a positive valuation

is made for losses.

(f) Problem of Price Instability: Since national income is measured in

money terms, fluctuation in the general price level will render unstable the

measuring rod of money for national income. When prices are rising, the

national income figures are rising even though production might have

gone down. On the other hand, when prices are falling, GNP is declining

even though the production might have gone up. To solve this problem,

economist and statisticians have introduced the concept of real income.

(g) Exclusion of Capital Gain or Losses from GNP: Capital gain or losses

accruing to property owners by increase or decrease in the market value of

their asset are not included in GNP computation because such changes do

not result from current economic activities. Such exclusions underestimate

or overestimate the GNP.

(h) Value added: ‘Value added’ is the difference between a firm’s sales

and its purchases of materials and services from other firms. In calculating

GDP earnings or value added to a firm, the statistician includes all costs

that go to factors other than businesses and excludes all payments made to

other businesses. Hence business costs in the form of wages, salaries,

interest payments, and dividends are included in value added, but

purchases of wheat or steel or electricity are excluded from value added.

The following table illustrates the concept of value addition in GDP:

Table 1

Bread Receipts, Costs, and Value Added

Rupees Per be idle

(1) (2) (3)

Value
Cost of
Stages of Added
Sales Intermediat
Production (wages,
Receipts e
profit, etc.)
Materials
(1 – 2)

Wheat 2.00 0 2.00

Flour 5.50 2.00 3.50

Baked 7.25 5.50 1.75

dough

Delivered 10.00 7.25 2.75

bread

Total 24.75 14.75 10.00

(I) Non-productive transactions are excluded from GDP: The non-

productive transactions are excluded from GDP measurement. There are

two types of non-productive transactions:

(i) Purely financial transactions: Purely financial transactions are:

 All public transfer payments, which do not add to the current flow

of goods such as social security payments, relief payments,

etc.
 All private financial transactions, such as receipt of money by a

student from his father, etc.

 Buying and selling of marketable securities, which make no

contribution to current production.

(II) Sale proceeds of second-hand goods.

Difference between GDP and GNP:

GDP is the most widely used measure of national output in Pakistan.

Another concept is widely cited, i.e., GNP. GNP is the total output

produced with labour or capital owned by Pakistani residents, while GDP

is the output produced with labour and capital located inside Pakistan.

For example, some of Pakistani GDP is produced in Honda plants that are

owned by Japanese corporations. The profits from these plants are

included in Pakistani GDP but not in Pakistani GNP. Similarly, when a

Pakistani university lecturer flies to Japan to give a paid lecture on

‘economies of under-developed countries’, that lecturer’s salary would be

included in Japanese GDP and in Pakistani GNP.

Net National Product (NNP):

Net national product (NNP) or national income at market price can be

obtained by deducting depreciation from GNP. NNP is a sounder measure

of a nation’s output than GNP, but most of the economists work with

GNP. This is so because depreciation is not easier to estimate. Whereas

the gross investment can be estimated fairly-accurately.

NNP equals the total final output produced within a nation during a year,

where output includes net investment or gross investment less

depreciation. Therefore, NNP is equals to:

NNP = GNP – Depreciation

It is the net market value of all the final goods and services produced in a

country during a year. It is obtained by subtracting the amount of

depreciation of existing capital from the market value of all the final goods

and services. For a continuous flow of money payments it is necessary

that a certain amount of money should be set aside from the GNP for

meeting the necessary expenditure of wear and tear, deterioration and

obsolescence of the capital and ‘it should remain intact’.

In the above definition, the phrase ‘maintaining capital intact’ is meant to

make good the physical deterioration which has taken place in the capital

equipment while creating income during a given period. This can only be

made by setting aside a certain amount of money every year from the

annual gross income so that when the income creating equipment becomes

obsolete, a new capital equipment may be created out. If the depreciation

allowance is not set aside every year, the flow of income would not remain

intact. It will decline gradually and the whole country will become poor.

National Income or National Income at Factor Cost:

National income (NI) or national income at factor cost is the aggregate

earnings of all the factors of production (i.e., land, labour, capital, &

organisation), which arise from the current production of goods and

services by the nation’s economy. The major components of national

income are:

(i) Compensation of employees (i.e., wages, salaries, commission,

bonus, etc.);

(ii) Proprietors income (profits of sole proprietorship, partnership,

and joint stock companies);

(iii) Net income from rentals and royalties; and

(iv) Net interest (excess of interest payments of the domestic business

system over its interest receipts and net interest received from

abroad).

National income can be calculated as follows:

National Income = NNP – Indirect Taxes + Subsidies

Personal Income:

Personal Income is the total income which is actually received by all

individuals or households during a given year in a country. Personal

income is always less than NI because NI is the sum total of all incomes

earned, whereas, the personal income is the current income received by

persons from all sources. It should be noted here that all the income items

which are included in NI are not paid to individuals or households as

income. For instance, the earnings of corporation include dividends,

undistributed profits and corporate taxes. The individuals only receive

dividends. Corporate taxes are paid to government, and the undistributed

profits are retained by firms. There are certain income items paid to

individuals, but not included in the national income, commonly known as

‘transfer payments’. Transfer payments include old age benefits, pension,

unemployment allowance, interest on national debt, relief payments, etc.

Personal income can be measured as follows:

Personal Income = NI at Factor Cost – Contributions to Social Insurance

– Corporate Income Taxes – Retained Corporate Earnings + Transfer

Payments

Disposable Income:

Disposable income is that income which is left with the individuals after

paying taxes to the government. The individuals can spend this amount as

they please. However, they can spend in categorically two ways, i.e.,

either they can spend on consumption goods, or they can save. Therefore,

the disposable personal income is equal to:

Disposable Income = Personal Income – Personal Taxes

or

Disposable Income = Consumption + Saving

Details of National Income Accounts:

It is very important to take a brief tour of major components or particulars

of national accounts or product accounts. In this way, we can thoroughly

understand the concept of GDP/GNP:

(a) GDP Deflator: The problem of changing prices is one of the problems

economists have to solve when they use money as their measuring rod.

Clearly, we want a measure of the nation’s output and income that uses an

invariant yardstick. This problem can be solved by using ‘price index’,

which is a measure of the average price of a bundle of goods. The price

index is used to remove inflation from GDP or to deflate the GDP, that is
why, it is also called ‘GDP deflator’. The function of GDP deflator is to

convert the ‘nominal GDP’ or the ‘GDP at current prices’ to ‘real GDP’.

The formula of real GDP is as follows:

Real GDP = Nominal GDP

GDP Deflator

or

Q =
PQ
P
Nominal GDP or PQ represents the total money value of final goods

and services produced in a given year, where the values in terms of the

market prices of each year. Real GDP or Q removes price changes from

nominal GDP and calculate GDP in constant prices. And the GDP

deflator or P is defined as the price of GDP.

Example:

A country produces 100,000 litres of coconut oil during the year 2005 at a

price of Rs. 25 per litre. During the year 2006, she produces 110,000 litres

of coconut oil at a price of Rs. 27 per litre. Calculate nominal GDP, GDP

deflator and real GDP (using 2005 as base year).

Solution:

Nominal GDP:
 Price × Quantity
Price Quantity
Year PQ
P Q
Nominal GDP
2005 25 100,000 2,500,000
2006 27 110,000 2,970,000

Hence, during 2006, the nominal GDP grew by 18.8%.

GDP Deflator:

P1 = Current year price ÷ Base year price = Rs. 25 ÷ Rs. 25 = 1

P2 = Current year price ÷ Base year price = Rs. 27 ÷ Rs. 25 =

1.08

Real GDP:

Real GDP
Nominal GDP GDP Deflator
Year (PQ/P)
PQ P
Q
2005 2,500,000 1 2,500,000
2006 2,970,000 1.08 2,750,000

Hence, during 2006, the real GDP grew by 10%.

(b) Investment and Capital Formation: Investment consists of the

additions to the nation’s capital stock of buildings, equipment, and

inventories during a year. Investment involves sacrifice of current

consumption to increase future consumption. Instead of eating more

pizzas now, people build new pizza ovens to make it possible to produce

more pizza for future consumption.

To economists, investment means production of durable capital goods.

In common usage, investment often denotes using money to buy shares

 from stock exchange or to open a saving account in a bank. In

economic terms, purchasing shares or government bonds or opening

bank accounts is not an investment. The real investment is that only

when production of physical capital goods takes place.

Investment can be further categorised as:

(i) Gross investment: Gross investment includes all the machines,

factories, and houses built during a year – even though some were bought

to replace some old capital goods. Gross investment is not adjusted for

depreciation, which measures the amount of capital that has been used up

in a year.

(ii) Net investment: Gross investment does not adjust the deaths of

capital goods; it only takes care of the births of capital. However, the net

investment takes into account the births as well as deaths of capital goods.

In other words, net investment is adjusted for depreciation. Therefore, the

net investment plays a vital role in estimating national income:

Net Investment = Gross Investment – Depreciation

(c) Government Expenditure: Government expenditures include buying

goods like from roads to missiles, and paying wages like those of marine

colonels and street sweepers. In fact, it is the third great category of flow

of products. It involves all the expenditures incurred on running the state.

However, it does not mean that GDP includes all the government

expenditures including ‘government transfer payments’. The government

transfer payments, which include payments to individuals that are not

made in exchange for goods and services supplied, are excluded from

GDP measurement. Such transfers payments include expenditures on

pensions, old-age benefits, unemployment allowances, veterans’ benefits,

and disability payments. One peculiar government transfer payment is

‘interest on national debts’. This is a return on debt incurred to pay for

past wars or government programmes and is not a payment for current

government goods and services. Therefore, the interests are excluded

from GDP calculations.

(d) Net Exports: ‘Net exports’ is the difference between exports and

imports of goods and services. Pakistan is facing negative net export

situation since her birth, except for few years. The biggest reason is that

Pakistan is a developing nation and consistently importing capital goods

and final consumption goods from developed countries at much higher

prices. Whereas, we export raw materials and intermediate goods at lower

prices, which have less demand due to their poor quality or because of

availability of much cheaper substitute goods in the market.

CIRCULAR FLOW OF INCOME

The amount of income generated in a given economy within a period of

time (national income) can be viewed from three perspectives. These

are:

Income,
Product, and
 Expenditure.
The above assertion implies that we can view national income as either

the total sum of all income received within a particular period (income);

the total good and services produced within a particular period

(product) or total expenditure on goods and services within a given

period (expenditure). Whichever approach is used, the value we get is

the same.

The circular flow of income and product is used to show

diagrammatically, the equivalence between the income approach and

the product approach in measuring gross national product (GNP).

In analysing the circular flow of income, there are three scenarios:

1. A simple and closed economy with no government and external

transactions, i.e., two-sector economy;

2. A mixed and open economy with savings, investment and

government activity, i.e., three-sector economy; and

3. A mixed and open economy with savings, investment,

government activity and external trade, i.e., four-sector economy.

1. Circular Flow of Income in a Two-Sector Economy:

According to circular flow of income in a two-sector economy, there are

only two sectors of the economy, i.e., household sector and business sector.

Government does not exist at all, therefore, there is no public expenditure,

no taxes, no subsidies, no social security contribution, etc. The economy is

a closed one, having no international trade relations. Now we will discuss

each of the two sectors:

(i) Household Sector: The household sector is the sole buyer of goods

and services, and the sole supplier of factors of production, i.e., land,

labour, capital and organisation. It spends its entire income on the

purchase of goods and services produced by the business sector. Since the

household sector spends the whole income on the purchase of goods and

services, therefore, there are no savings and investments. The household

sector receives income from business sector by providing the factors of

production owned by it.

(ii) Business Sector: The business sector is the sole producer and supplier

of goods and services. The business sector generates its revenue by selling

goods and services to the household sector. It hires the factors of

production, i.e., land, labour, capital and organisation, owned by the

household sector. The business sector sells the entire output to

households. Therefore, there is no existence of inventories. In a two-sector

economy, production and sales are thus equal. So long as the household

sector continues spending the entire income in purchasing the goods and

services from the business sector, there will be a circular flow of income

and production. The circular flow of income and production operates at

the same level and tends to perpetuate itself. The basic identities of the

two-sector economy are as under:

Y=C
Where Y is Income

C is Consumption

Circular Flow of Income in a Two-Sector Economy (Saving Economy):

In a two-sector macro-economy, if there is saving by the household sector

out of its income, the goods of the business sector will remain unsold by

the amount of savings. Production will be reduced and so the income of

the households will fall. In case the savings of the households is loaned to

the business sector for capital expansion, then the gap created in income

flow will be filled by investment. Through investment, the equilibrium

level between income and output is maintained at the original level. It is

illustrated in the following figure:

The equilibrium condition for two-sector economy with saving is as

follows:

Y=C+S or Y=C+I or C+S=C+I or

S=I

Where Y is Income

C is Consumption

S is Saving

I is Investment
When saving and investment are added to the circular flow, there are two

paths by which funds can travel on their way from households to product

markets. One path is direct, via consumption expenditures. The other is

indirect, via saving, financial markets, and investment.

Savings:

On the average, households spend less each year than they receive in

income. The portion of household income that is not used to buy goods

and services or to pay taxes is termed ‘Saving’. Since there is no

government in a two-sector economy, therefore, there are no taxes in this

economy.

The most familiar form of saving is the use of part of a household’s income

to make deposits in bank accounts or to buy stocks, bonds, or other

financial instruments, rather than to buy goods and services. However,

economists take a broader view of saving. They also consider households

to be saving when they repay debts. Debt repayments are a form of saving

because they, too, are income that is not devoted to consumption or taxes.

Investment:

Whereas households, on the average, spend less each year than they

receive in income, business firms, on the average, spend more each year

than they receive from the sale of their products. They do so because, in

addition to paying for the productive resources they need to carry out

production at its current level, they desire to undertake investment.

Investment includes all spending that is directed toward increasing the

economy’s stock of capital.

Financial Market:

As we have seen, households tend to spend less each year than they

receive in income, whereas firms tend to spend more than they receive

from the sale of their products. The economy contains a special set of

institutions whose function is to channel the flow of funds from

households, as savers, to firms, as borrowers. These are known as

‘financial markets’. Financial markets are pictured in the center of the

circular-flow diagram in the above figure.

Banks are among the most familiar and important institutions found in

financial markets. Banks, together with insurance companies, pension

funds, mutual funds, and certain other institutions, are termed ‘financial

intermediaries’, because their role is to gather funds from savers and

channel them to borrowers in the form of loans.

2. Circular Flow of Income in a Three-Sector Economy:

We have so far discussed the two-sector economy consisting of household

sector and business sectors. Under three-sector economy, the additional

sector is the government. Two-sector economy is a hypothetical economy,

whereas the three-sector economy is much more realistic. The inclusion of

the government sector is very essential in measuring national income. The

government levies taxes on households and on business sector, purchases

goods and services from business sector, and attain factors of production

from household sector. The following figure illustrates three-sector

economy:

In the above diagram, in one direction, the household sector is supplying

factors of production to the factor market. Business sector demands the

factors of production from factor market. Inputs are used by the business

sector, which produces goods and services that are purchased back by the

households and the government. Personal income after tax or disposable

income that is received by households from business sector and

government sector is used to purchase goods and services and makes up

consumption expenditure (or C). The money spent in the product market

is the market value of final goods and services (or GDP). That money goes

to business sector that pays it back in the form of wages, rent, profits and

interests.

Total spending on goods and services is known as ‘aggregate demand’. The

total market value of output produced and sold is also known as ‘aggregate

supply’. To measure aggregate demand in a closed economy, we simply

add consumption spending (C), investment spending (I) and government

spending (G). Therefore:

Y=C+I+G

Where Y is Income,

C is Consumption,

I is Investment, and

G is Government Spending.

Note that government spending (G) includes its buying of labour from

factor market, buying of goods and services from product market, and

transfer payments to the household sector. Transfer payments are

payments the government makes in return for no service, for example,

welfare payments, unemployment compensation, pension, etc. The

government collects its money in the form of tax, which makes up most of

the government revenue. But the government does not always balance

their budgets. The government always tends to spend more than it takes

in as taxes. The federal government almost always runs a deficit. The

government deficit must be financed by borrowing in financial markets.

Usually this borrowing takes the form of sales of government bonds and

other securities to the public or to financial intermediaries. Over time,

repeated government borrowing adds to the domestic debt. The ‘debt’ is a

stock that reflects the accumulation of annual ‘deficits’, which are flows.

When the public sector as a whole runs a budget surplus, the direction of

the arrow is reversed. Governments pay off old borrowing at a faster rate

than the rate at which new borrowing occurs, thereby creating a net flow

of funds into financial markets.

3. Circular Flow of Income in a Four-Sector Economy:

Two-sector economy and three-sector economy are briefly discussed in

previous sections. These are hypothetical economies. In real life, only

four-sector economy exists. The four-sector economy is composed of

following sectors, i.e.:

(i) Household sector,

(ii) Business sector,

(iii) The government, and

(iv) Transaction with ‘rest of the world’ or foreign sector or

external sector.

The household sector, business sector and the government sector have

already been defined in the previous sections. The foreign sector includes

everyone and everything (households, businesses, and governments)

beyond the boundaries of the domestic economy. It buys exports produced

by the domestic economy and produces imports purchased by the

domestic economy, which are commonly combined into net exports

(exports minus imports). The inclusion of fourth sector, i.e., foreign sector

or transaction with ‘rest of the world’ makes the national income accounting

more purposeful and realistic. With the inclusion of this sector, the

economy becomes an open economy. The transaction with ‘rest of the

world’ involves import and export of goods and services, and new foreign

investment. It is illustrated in the following figure.

In four-sector economy, goods and services available for the economy’s

purchase include those that are produced domestically (Y) and those

that are imported (M). Thus, goods and services available for domestic

purchase is Y+M. Expenditure for the entire economy include domestic

expenditure (C+I+G) and foreign made goods (Export) = X. Thus:

Y+M=C+I+G+X
Y = C + I + G + (X – M)
Where, C = Consumption expenditure
I = Investment spending
G = Government spending
X = Total Exports
M = Total Imports
X–M = Net Exports
Economy Leakages and Injections
Leakages: When households engage in savings and purchase of goods

and services from abroad, we experience temporary withdrawal of

funds from circulation. Therefore, leakages in the circular flow are

savings, taxes and imports

Injection: On the other hand, when we sell abroad (export) we receive

income. More so when foreigners invest in our country the level of

income will also increase. These two activities are injection into the

income stream. Therefore, injections are investment, government

spending and exports.

Total Leakages = Total Injections

C + I + G + (X-M) = C + S + Net Taxes

 S + Net Taxes + Imports = I + G + Exports

S = I + (G – NT) + (X – M)

One way of thinking about the circular flow of income is to imagine a

water tank. Investment, government spending and spending by foreigners

is injected into the tank, and savings, taxes and spending on imports leak

out. The injections and the withdrawals are equal to each other so the level

in the tank is stable, or as economists like to say in equilibrium.

If injections are greater than

withdrawals or leakages then

the level in the tank will rise. If

withdrawals are greater than

injections then the level in the

tank falls. If planned (I+G) is

equal to planned (S+T), so that

injections is equal to leakages

and total spending is equal to total income and total demand is equal to

total supply. Then we have a ‘stable economy’. If leakages are higher than

injections i.e., planned savings plus taxes are greater than planned

investment plus government spending (S+T > I+G), economy contracts

resulting in inventory accumulation, too little spending and drop in prices.

If injections are higher than leakages, i.e., planned investment plus

government spending are greater than planned saving plus taxes (I+G >

S+T), economy expands resulting in more goods and services produced,

and higher prices.

 THEORY OF EMPLOYMENT

TYPES OF UNEMPLOYMENT

(a) Structural Unemployment: It is also known as Marxian

unemployment or long-term unemployment. It is due to slower growth of

capital stock in the country. The entire labour force cannot be absorbed in

productive employment, because there are not enough instruments of

production to employ them.

(b) Seasonal Unemployment: Seasonal unemployment arises because of

the seasonal character of a particular productive activity so that people

become unemployed during the slack season. Occupations relating to

agriculture, sugar mills, rice mills, ice factories and tourism are seasonal.

(c) Frictional Unemployment: It arises when the labour force is

temporarily out of work because of perfect mobility on the part of the

labour. In a growing and dynamic economy, in which some industries are

declining and others are rising and in which people are free to work

wherever they wish, some volume of frictional unemployment is bound to

exist. This is so because it takes some time for the unemployed labour to

learn new trades or to shift to new places, where there is a demand for

labour. Thus, frictional unemployment exists when there is unsatisfied

demand for labour, but the unemployed workers are either not fit for the

jobs in question or not in the right place to meet this demand.

(d) Cyclical Unemployment: It is also known as Keynesian

unemployment. It is due to deficiency of aggregate effective demand. It

occurs when business depression occurs. During the times of depression,

business activity is at low ebb and unemployment increases. Some people

are thrown out of employment altogether and others are only partially

employed. This type of unemployment is due to the fact that the total

effective demand of the community is not sufficient to absorb the entire

productive of goods that can be produced with the available stock of

capital. When the businessmen cannot sell their goods and services, their

profit expectations are not fulfilled. So the entrepreneurs reduce their

output and some factors of production become unemployed.

(e) Disguised Unemployment: Disguised unemployment is the most

widespread type of unemployment in under-developed countries. In

under-developed countries, the stock of capital does not grow fast. The

capital stock has not been growing at a rate fast enough to keep pace with

the growth of population, the country’s capacity to offer productive

employment to the new entrants to the labour market has been severely

limited. This manifests itself generally in two ways:

(i) the prevalence of large-scale unemployment in the urban areas; and

(ii) in the form of growing numbers engaged in agriculture, resulting in

‘disguised unemployment’.

In disguised unemployment, there is an existence of a very backward

agricultural economy. People are engaged in production with an

extremely low or zero marginal productivity. Since the employment

opportunities in non-agricultural sector are not sufficient, therefore, most

of the workers are bound to work in agricultural sector. This gives rise to

the concept of ‘disguised unemployment’, in which people are unwillingly

engaged in occupations, where their marginal productivity is very low.

THEORIES OF EMPLOYMENT

The theories of employment are broadly classified into two:

(a) Classical theory of employment

(b) Keynesian theory of employment.

The classical theory assumed the prevalence of full employment. The

‘Great Depression’ of 1929 to 1934, engulfing the entire world in

widespread unemployment, low output and low national income, for

about five years, upset the classical theorists. This gives rise to Keynesian

theory of employment.

Classical Theory of Employment:

The term ‘classical economists’ was firstly used by Karl Marx to describe

economic thought of Ricardo and his predecessors including Adam Smith.

However, by ‘classical economists’, Keynes meant the followers of David

Ricardo including John Stuart Mill, Alfred Marshal and Pigou. According

to Keynes, the term ‘classical economics’ refers to the traditional or orthodox

principles of economics, which had come to be accepted, by and large, by

the well known economists by then. Being the follower of Marshal,

Keynes had himself accepted and taught these classical principles. But he

repudiated the doctrine of laissez-faire. The two broad features of classical

theory of employment were:

(a) The assumption of full employment of labour and other productive

resources, and

(b) The flexibility of prices and wages to bring about the full employment

(a) Full employment:

According to classical economists, the labour and the other resources are

always fully employed. Moreover, the general over-production and

general unemployment are assumed to be impossible. If there is any

unemployment in the country, it is assumed to be temporary or abnormal.

According to classical views of employment, the unemployment cannot be

persisted for a long time, and there is always a tendency of full

employment in the country. According to classical economists, the reasons

for unemployment are:

(i) Intervention by the government or private monopoly,

(ii) Wrong calculation by entrepreneurs and inaccurate decisions, and

(iii) Artificial resistance.

The economy is assumed to be self-adjusting and perfectly competitive

economy. It is the economy in which the relative values of goods and

services are determined by the general relations of demand and supply.

The pricing system serves as the planning mechanism.

(b) Flexibility of prices and wages:

The second assumption of full employment theory is the flexibility of

prices and wages. It is the flexibility of prices and wages which

automatically brings about full employment. If there is general over-

production resulting in depression and unemployment, prices would fall

as a result of which demand would increase, prices would rise and

productive activity will be stimulated and unemployment would tend to

disappear. Similarly, the unemployment could be cured by cutting down

wages which would increase the demand for labour and would stimulate

activity. Thus, if the prices and wages are allowed to move freely,

unemployment would disappear and full employment level would be

restored. Further, the classical economists treated money as mere

exchange medium. They ignored its role in affecting income, output and

employment.

Say’s Law:
1. Say’s Law is the foundation of classical economics. Assumption of

full employment as a normal condition of a free market economy is

justified by classical economists by a law known as ‘Say’s Law of

Markets’.

2. It was the theory on the basis of which classical economists thought

that general over-production and general unemployment are not

possible.

3. According to the French economist J. B. Say, supply creates its own

demand. According to him, it is production which creates market

for goods. More of production, more of creating demand for other

goods. There can be no problem of over-production.

4. Say denies the possibility of the deficiency of aggregate demand.

5. The conceived Say’s Law describes an important fact about the

working of free-exchange of economy that the main source of

demand is the sum of incomes earned by the various productive

factors from the process of production itself. A new productive

process, by paying out income to its employed factors, generates

demand at the same time that it adds to supply. It is thus

production which creates market for goods, or supply creates its

own demand not only at the same time but also to an equal extent.

6. According to Say, the aggregate supply of commodities in the

economy would be exactly equal to aggregate demand. If there is

 any deficiency in the demand, it would be temporary and it would

be ultimately equal to aggregate supply. Therefore, the employment

of more resources will always be profitable and will take to the point

of full employment.

7. According to Say’s Law, there will always be a sufficient rate of total

spending so as to keep all resources fully employed. Most of the

income is spent on consumer goods and a par of it is saved.

8. The classical economists are of the view that all the savings are spent

automatically on investment goods. Savings and investments are

interchangeable words and are equal to each other.

9. Since saving is another form of spending, according to classical

theory, all income is spent partly for consumption and partly for

investment.

10. If there is any gap between saving and investment, the rate of

interest brings about equality between the two.

Basic Assumptions of Say’s Law:

(a) Perfectly competitive market and free exchange economy.

(b) Free flow of money incomes. All the savings must be

immediately invested and all the income must be immediately
spent.

(c) Savings are equal to investment and equality must bring about by
flexible interest rate.
 (d) No intervention of government in market operations, i.e., a laissez
faire economy, and there is no government expenditure, taxation
and subsidies.

(e) Market size is limited by the volume of production and aggregate

demand is equal to aggregate supply.

(f) It is a closed economy.

Criticism of Classical Theory:

1. Supply may not create its own demand when a part of the income is
saved. Aggregate demand is not always equal to aggregate supply.

2. Employment in a country cannot be increased by cutting general

wages.

3. There is no direct relationship between wages and employment.

4. Interest rate adjustments cannot solve savings-investment problem.

5. Classical economists have made the economy completely self-

adjusting and self-reliant. An economy is not so self-adjusting and
government intervention is unobvious.

6. Classical economists have made the wages and prices so much

flexible. In practical, wages and prices are not so flexible. It will
create chaos in the economy.

7. Money is not a mere medium of exchange. It has an essential role in

the economy.

8. The classical theory has failed to explain the occurrence of trade

cycles.

Keynesian Theory of Employment:

Keynes has strongly criticised the classical theory in his book ‘General

Theory of Employment, Interest and Money’. His theory of employment is

widely accepted by modern economists. Keynesian economics is also

known as ‘new economics’ and ‘economic revolution’. Keynes has invented

new tools and techniques of economic analysis such as consumption

function, multiplier, marginal efficiency of capital, liquidity preference,

effective demand, etc. In the short run, it is assumed by Keynes that

capital equipment, population, technical knowledge, and labour efficiency

remain constant. That is why, according to Keynesian theory, volume of

employment depends on the level of national income and output. Increase

in national income would mean increase in employment. The larger the

national income the larger the employment level and vice versa. That is

why, the theory of Keynes is known as ‘theory of employment’ and ‘theory of

income’.

Theory of Effective Demand:

According to Keynes, the level of employment in the short run depends on

aggregate effective demand for goods in the country. Greater the

aggregate effective demand, the greater will be the volume of employment

and vice versa. According to Keynes, the unemployment is the result of

deficiency of effective demand. Effective demand represents the total

money spent on consumption and investment. The equation is:

Effective demand = National Income (Y) = National Output

(O)

The deficiency of effective demand is due to the gap between income and

consumption. The gap can be filled up by increasing investment and

hence effective demand, in order to maintain employment at a high level.

According to Keynes, the level of employment in effective demand

depends on two factors:

(a) Aggregate supply function, and

(b) Aggregate demand function.

(a) Aggregate supply function:

1. According to Dillard, the minimum price or proceeds which will

induce employment on a given scale, is called the ‘aggregate supply
price’ of that amount of employment.

2. If the output does not fetch sufficient price so as to cover the cost,
the entrepreneurs will employ less number of workers.

3. Therefore, different numbers of workers will be employed at

different supply prices.

4. Thus, the aggregate supply price is a schedule of the minimum

amount of proceeds required to induce varying quantities of
employment.

5. We can have a corresponding aggregate supply price curve or

aggregate supply function, which slopes upward to right.

(b) Aggregate demand function:

 1. The essence of aggregate demand function is that the greater the
number of workers employed, the larger the output. That is, the
aggregate demand price increases as the amount of employment
increases, and vice versa.

2. The aggregate demand is different from the demand for a product.

The aggregate demand price represents the expected receipts when
a given volume of employment is offered to workers.

3. The aggregate demand curve or aggregate demand function

represents a schedule of the proceeds of the output produced by
different methods of employment.

Determination of Equilibrium Level of Employment:

1. In the above diagram, AS curve

shows the different total amounts

which all the entrepreneurs, taken

together, must receive to induce

them to employ a certain number

of men. If the entrepreneurs are

convinced to receive OC amount of

money, they will employ ON1

number of labour.

2. The AD curve shows the different total amounts which all the

entrepreneurs, taken together, expect to receive at different levels of

employment. If they employed ON1 level of employment, they

expect to receive ON amount of proceeds from the total output.

 3. At ON1 level of employment, the economy is not in equilibrium.

Because the total expected amount is greater than the total amount

paid:

OH > OC

4. The equilibrium level of employment is ON2, as at this point the

AD curve intersects the AS curve or the AD is just equal to AS. The

amount of proceeds, i.e., OM which entrepreneurs expect to receive

from providing ON2 number of jobs is just equal to the amount i.e.

OM which they must receive if the employment of that number of

workers is to be worthwhile for the entrepreneurs.

5. If the situation is such that the total amount of money expected to

be received from the sale of output exceeds the amount that is

considered necessary to receive, there will be competition among the

entrepreneurs to offer more employment and thus, the employment

will increase. On the left of N2, AD is greater than AS, i.e., the

amount expected to be received is greater than the amount

considered necessary, there will be competition amount

entrepreneurs to employ more labour.

6. Beyond the N2, the AD curve lies below AS curve, which means

that the amount expected by the entrepreneurs is less that the

amount they considered necessary to receive. Therefore, the

number of persons employed will be reduced in the economy.

7. The slope of AS curve, at first rises slowly and then after a point it

rises sharply. It means that at beginning as more and more men are

employed, the cost of output rises slowly. But as the amount

received by the entrepreneurs increases they employ more and more

men. As soon as the entrepreneurs start getting OT amount, they

will be prepared to employ all of the workers.

8. The AD curve, in the beginning, rises sharply, but it flattens

towards the end. This shows that in the beginning as more men are

employed, the entrepreneurs expect to get sharply increasing

amounts of money from the sale of the output. But after

employment has sufficiently increased, the expected receipts do not

rise sharply.

9. Effective demand is that aggregate demand price which becomes

‘effective’ because it is equal to aggregate supply price and thus

represents a position of short-run equilibrium.

10. Effective demand also represents the value of national output

because the value of national output is equal to the total amount of

money received by the entrepreneurs from the sale of goods and

services. The money received by the entrepreneurs from the sale of

goods is equal to the money spent by the people on these goods.

Hence the equation is:

Effective demand = National income

 = Value of national output

= National expenditure

= Expenditure on consumption goods +

Expenditure on investment goods

11. It is not necessary that the equilibrium level of employment is

always at full employment level. Equality between AD and AS does

not necessarily indicate the full employment level. It can be in

equilibrium at less that full employment or an under-employment

equilibrium.

12. Actually there is always some unemployment in the economy, even

in economically advanced countries.

13. According to Keynes, full employment is the level of employment

beyond which further increases in effective demand do not increase

output and employment.

14. At the point of intersection of AS and AD, the entrepreneurs are

maximising their profits. The profit will be reduced if volume of

employment is more or less that this point. Even if the point does

not represent full employment.

15. AD and AS will be equal at full employment only if the investment

demand is sufficient to cover the gap between the AS price and

consumption expenditure. The typical investment falls short of this

 gap. Hence the AD curve and AS curve will intersect at a point less

than full employment, unless there

is some external change.

16. In the above diagram, in this

situation of aggregate supply (AS),

ON’ number of men were seeking

employment, whereas only ON

number of men could secure

employment.

17. In this situation, the economy

has not yet reached the full employment level, and there are still

NN’ number of workers unemployed in the economy.

18. If the favourable circumstances push the economy and the AD

increases so much that the entrepreneurs now find it worthwhile to

employ ON’ men at the equilibrium point E’, where the economy is

in full employment level.

19. The situation in which the economy is in equilibrium at the level

of full employment is called the ‘optimum situation’.

20. The root cause of the under-employment equilibrium is the

deficiency of AD. This deficiency is due to the fact that there is a

gap between income and consumption. As income increases

consumption increases but not proportionately. If the investment is

 increased sufficiently to cover this gap, there can be full

employment. Hence the gap between income and consumption and

insufficiency of investment to this gap are responsible for under-

employment equilibrium.

Significance of Keynesian Theory:

1. Keynes has given a new approach, i.e., Macro-approach to the field of

economics. His theory has several names: theory of income and

employment, demand-side theory, consumption theory, and macro-

economic theory. In fact, he has brought about a revolution in economic

analysis, often known as ‘Keynesian Revolution’.

2. Keynes’ theory has completely demolished the idea of full-

employment and forwards the idea of under-employment equilibrium. He

states that employment level in the economy can only be increased by

increasing investment.

3. The new economic tools and techniques developed by Keynes have

enabled the today’s economists to draw correct conclusions on the

economic situation of a country. Such tools are consumption function,

multiplier, investment function, liquidity preference, etc.

4. Keynes has integrated the theory of money with the theory of value

and output.

5. Keynes has first time introduced a dynamic economic theory, in order

to depict more realistic situation of the economy.

6. He also states the reasons of excess or deficiency of aggregate

demand through inflationary and deflationary gap analysis.

7. Keynes’ theory is a general theory and therefore, can be applied to all

types of economic systems.

8. Keynes influenced on practical policies and criticised the policy of

surplus budget. He advocated deficit financing, if that sited the economic

situation in the country.

9. Keynes has emphasised on suitable fiscal policy as an instrument for

checking inflation and for increasing aggregate demand in a country. He

advocated extensive public work programmes as an integral part of

government programmes in all countries for expanding employment.

10. He advised several monetary controls for the central bank, which in

turn will act as the instrument of controlling cyclical fluctuations.

11. Keynesian theory has played a vital role in the economic development

of less-developed countries.

12. He rejected the theory of wage-cut as a means of promoting full-

employment.

13. Keynes’ theory has given rise to the importance of social accounting or

national income accounting.

Criticism on Keynes’ Theory:

1. According to Schumpeter, the Keynes theory is a depression theory,

which has limited applications.

2. Some socialist or communist economists had said that Keynes’

theory is dead if communism comes. However, even the socialist countries

have strived to raise their national income by using Keynesian theory.

3. Keynesian theory is not as much dynamic and it may more properly

be called comparative statics.

4. Keynesian theory has ignored microanalysis and is not helpful in

the solution of the problems of individual firms and consumers.

5. Keynes has not given any place to the accelerator principle.

6. It pays excessive attention to money in economic analysis.

Relevance of Keynes’ Theory to Less-Developed Countries (LDCs)

(Extended Criticism):

1. The Keynesian theory is primarily for fighting depression. The

assumptions on which Keynesian theory is based are:

(a) The multiplier, and

(b) Short-term analysis.

2. In the short-term analysis, Keynes assumes that capital equipment,

technology, organisation, labour and their efficiency remains

 constant. He thinks that the problems relating to employment in

developed countries arises only on account of the deficiency of

demand.

3. But the problem in case of LDCs is to increase capital equipment, to

improve technology and labour efficiency. Solving this problem will

take a long process; it cannot be solved in short-run.

4. The developing countries like Pakistan and India, the basic cause of

unemployment is low rate of savings and investment.

5. Most of the LDCs are agriculturists and the Keynesian approach is

industry-oriented. Therefore, increase in national income by deficit

spending will lead to increase in demand for food. This will raise

the prices of food grains. Therefore, heavy reliance on Keynesian

approach could mislead the economists, and can plunge the

economy into inflationary spiral.

6. The principle of multiplier does not much work in LDCs. Suppose

new investments are made in the country, increased investment will

lead to the establishment of new factories, workers will get

employed, income will increase, demand will increase, but it does

not guarantee the increase in the supply of goods because there is no

excess capacity, and the supply of productive factors is not elastic.

Increased income will be absorbed in high prices.

DETERMINATION OF NATIONAL INCOME

1. In the short run, the level of national income is determined by

aggregate demand and aggregate supply. The supply of goods and

services in a country depends on the production capacity of the

community. But during the short period the productive capacity

does not change.

2. If AD increases, output will also increase and the level of national

output (i.e., national income) will rise. On the other hand, if AD

decreases, the national output or national income will also decrease.

It follows that the equilibrium level of NI is determined by AD since

the aggregate capacity remains more or less the same during the

short run.

3. Thus, there are two components of effective demand:

(a) Consumption demand, and

(b) Investment demand.

4. Aggregate Demand = Consumption + Investment

i.e., AD = C + I

5. The consumption demand depends on propensity to consume and

income. At a given propensity to consume, as income increases, the

consumption demand will also increase.

6. In the above diagram the 45o line represents aggregate supply line

and it is also called ‘income line’. This income line shows two

things:

(a) Total output or aggregate supply (C + I), and

(b) National income.

7. In the above diagram, the curve C rises upward to the right which

means that as income increases consumption also increases. The

distance between income line and consumption line represents

saving. Thus, NI = C + S or Y = C + S.

8. One noteworthy thing about propensity to consume is that it

remains stable or constant during the short period. Because the

propensity to consume depends on the tastes and needs of the

people and these do not change in the short run.

9. Since consumption is more or less stable and cannot be varied,

therefore, variation in NI depends on variation in investment.

10. Investment is the second component of AD. Investment depends on

two things:

(a) Marginal efficiency of capital, and

(b) The rate of interest

11. The rate of interest is more or less stable, hence, change in

investment depends on the marginal efficiency of capital (MEC).

12. The MEC means expectations of profit from investment. In other

words, the expected rate of profit is called MEC.

13. The MEC depends on two factors:

(a) Replacement cost of capital goods, and

(b) Profit expectations of investors.

14. If we join the investment demand with the curve C of propensity to

consume, we get AD curve C + I in which C represents consumption

and I investment. The distance between propensity to consume

curve C and AD curve C + I is equal to investment.

 15. The level of NI will be determined at point at which the AD and AS

curves intersect each other. At this point AD and AS are in

equilibrium.

16. In the above diagram, the equilibrium level of income is OY. At this

point the AD curve and AS curve intersect each other.

17. If the income is more than OY, than total output or AS is greater

than AD (C + I), and the entire output cannot be sold out.

18. If the income is less than OY, then total output or AS is less than AD

(C + I), and the entire output will be sold out. In such a situation

there is a shortage of supply, but the output will be increased in

order to cover the shortage and the NI will also increase.

19. OY is the equilibrium level of income which is less than full

employment level, i.e., OYF. Whereas, the HF corresponds the

saving.

20. The economy will be in full employment level only when investment

demand increases so as to cover this saving. But there is no

guarantee that investment demand will exactly be equal to savings.

Equality of Saving and Investment:

1. There is another way of determining the equilibrium level of NI, i.e.,

through equality of savings and investment.

 2. Take the same diagram of AD and AS. At point E, the savings and

investment are equal to GE. At above the point the saving is more

than investment, and for income less than this point, the investment

is more than saving. Saving and investment are only equal at the

equilibrium level of income, and when they are not equal, the NI is

not in equilibrium.

3. When at a certain level of NI intended investment by the

entrepreneurs is more than intended savings by the people, this

would mean that AD is greater than total output or AS, i.e.,

I > S or AD > AS

This would induce the firms to increase production raising the level

of income and employment.

4. Hence, when at any level of NI, investment is greater than savings,

there will be a tendency for the NI to increase.

5. On contrary, when at any level of NI, the investment demand is less

than saving, it means that AD is less than AS. As a result of a

decline in national output, the national income will also reduce.

6. Saving is withdrawal of some money from the income stream. On

the other hand, investment is the injection of money into the income

stream. If the intended investment is more than intended saving, it

 means that more money has been injected in the economy. This

would increase the national income.

7. But when investment is just equal to saving, it would mean that as

much money has been put into income stream as has been taken out

of it. The result would be that the NI will neither increase nor

decrease, i.e., it would be in equilibrium. The determination of NI

by investment and saving is illustrated in the following diagram:

8. In the above diagram, the investment line (II curve) has been drawn

parallel to the X-axis. This is done on the assumption that in any

year, the entrepreneurs intend to invest a certain amount of money.

That is, we assume that investment does not change with income.
 9. The saving line (SS curve) shows intended saving at different levels

of income.

10. The saving line and investment line intersect each other at the

equilibrium point E, where the intended saving and the intended

investment are equal at OY level of income. Hence OY is the

equilibrium level of NI.

11. In the above diagram, there is no tendency for income to increase or

decrease.

12. If the income level is greater than OY, the amount of intended

investment is less than saving, as a result, the income will finally

decrease.

13. If the income level is less than OY, the amount of intended

investment is greater than intended saving, as a result, the income

will continue to increase to the equilibrium level.

Inflationary Gap:

Inflationary gap arises when consumption and investment spending

together are greater than the full employment GNP level. This means that
people are demanding more goods and services than can be produced. In

other words, the implication of inflationary gap is that national income,

output and employment cannot rise further. The only consequence of

increased demand is that the price level will increase. Or we may say that

there will be an inflationary gap if scheduled investment tends to be

greater than full employment saving. In a situation like this, more goods

will be demanded than the economic system can produce. The result will

be that price will begin to rise and an inflationary situation will emerge.

Thus, if full employment saving falls short of scheduled investment at full

employment (which means that peoples’ propensity to spend is higher

than the propensity to save), there will be an inflationary gap.

In the above diagram, C + I + G (consumption, investment and government

spending) line shows the total expenditure on demand in the economy. At

this level, Y is the real output, as shown by the intersection, point D, with
the 45o line. YF represents a full employment level on real output. Real

income of the economy, obviously cannot reach Y. At YF, total demand (C

+ I + G) exceeds total output, leaving a gap AB, which is the inflationary

gap in the Keynesian sense.

Deflationary Gap:

The deflationary or recessionary gap is the amount by which the aggregate

expenditure falls short of the full employment level of national income. It

causes a multiple decline in real NI.

In the above diagram, Y is the total output at full employment level. Let us

assume that the total demand is (C + I + G)’ which cuts the 45o line at B,

with real output Y’, AB then is the deflationary gap.

Consumption Function
Propensity to consume is also called consumption function. In the

Keynesian theory, we are concerned not with the consumption of an

individual consumer but with the sum total of consumption spending by

all the individuals. However, in generalizing the consumption behaviour

of the whole economy, we have to draw some useful conclusions from the

study of the behaviour of a normal consumer, which may be valid for all

consumers’ behaviour of the economy. Aggregate consumption depends

on consumption function or propensity to consume.

The economic term ‘consumption’ means the amount spent on consumption

at a given level of income. ‘Consumption function’ or ‘propensity to consume’

means the whole of the schedule showing consumption expenditure at

various levels of income. It tells us how consumption expenditure

increases as income increases. The consumption function or propensity to

consume, therefore, indicates a functional relationship between the

aggregates, viz., total consumption expenditure and the gross national

income. It is a schedule that expresses relationship between consumption

and disposable income.

According to Keynesian theory, following are the factors that influence

consumption:

(a) The real income of the individual,

(b) The past savings, and

(c) Rate of interest.

Average and Marginal Propensity to Consume

The average propensity to consume (apc) is a relationship between total

consumption and total income in a given period of time. In other words,

apc is the ratio of consumption to income. Thus:

apc = C
Y

Where C : Consumption

Y : Income

apc : Average propensity to consume

While, the marginal propensity to consume (mpc) measures the

incremental change in consumption as a result of a given increment in

income. In other words, mpc is the ratio of change in consumption to the

change in income.

mpc = ΔC
ΔY

Where ΔC : Incremental change in consumption

ΔY : Incremental change in income

mpc : Marginal propensity to consume

the normal relationship between income and consumption is that when

income increases, consumption also increases, but by less than the increase

in income. In other words, in normal circumstances, mpc is less than one.

It is drawn as a straight-line with a slope of less than one. This slope

indicates the percentage of additional disposable income that will be spent.

It is assumed that the whole additional income is not spent, i.e., a certain

amount is spent and the remainder is saved. This can be further explained

with the help of following table and diagram:

Income Consumptio Saving

n
100 75 25
120 90 30
140 105 35
180 135 45
220 165 55

In the above diagram, OL is the income line and OP is income

consumption curve. The income consumption line OP lies below the

income line OL. The mpc will be measured by the tangent of the angle

that income consumption curve makes with X-axis.

The curve as we have drawn turns out to be straight line rising from the

origin, which means that mpc is constant throughout. This, however, need

not be so and the curve may well become flatter as income rises, for as

more and more consumption needs have been satisfied, a greater share of

an increase in income than before may be saved. The dotted curve OM

represents such a relationship showing that as income rises, mpc becomes

smaller and smaller.

There is a level of disposable income (DI) at which the entire income is

spent and nothing is saved. This point is often known as ‘point of zero

savings’. Below this level of DI, the consumption expenditure will exceed

the DI. There may be cases in which the consumer has no income at all. In

such cases, the income consumption curve may not rise from the origin but

from farther left showing that when income is zero, consumption is not

zero and that the individual is living on his past savings.

Propensity to save:
In the above diagram, ON represents the saving-income curve. Savings at

a given level of income can also be read off from the distance between a

point on income-consumption curve and corresponding point on income

curve (See the figure of income-consumption relationship). The marginal

propensity to save (mps) can be measured by the slope of income-saving

curve ON. Marginal propensity to save (mps) is the increment in savings

caused by a given increment in income. The mps is always equal to one

minus mpc:
Keynes’ Law of Consumption:

Keynes propounded a law based on the analysis of consumption function.

This law is known as ‘Fundamental Law of Consumption’ or ‘Psychological

Law of Consumption’. It states that aggregate consumption is a function of

aggregate disposable income.

Propositions of the Law:

This law consists of three propositions:

(a) When aggregate income increases, consumption expenditure will

also increase but by a somewhat smaller amount.

(b) When income increases, the increment of income will be divided in

same proportion between saving and consumption. Consumption
and saving go side by side. What is not consumed is saved. Savings
is, thus, the complement of consumption.

(c) As income increases, both consumption spending and saving go

up. An increment in income is unlikely to lead either to less

spending or less savings than before. It will seldom happen that a

person may decrease his consumption or his savings when he has

got more income.

Assumptions:

(a) Habits of people regarding spending do not change or that the

propensity to consume remains the same or stable.

(b) The economic conditions remain normal. There is no hyper-

inflation or war or other abnormal conditions.

 (c) The economy is a free-market economy. There is no government

intervention.

(d) The important characteristic of the slope of consumption function

is that the marginal propensity to consume (mpc) will be less than

unity. This results in low-consumption and high-saving economy.

Implications:

According to Keynesian theory, the mpc is less than unity, which brings

out the following implications:

(a) Since consumption largely depends on income and consumption

function is more or less stable, it is necessary to increase investment

fill the gap of declining consumption as income increases. If this is

not done, the increased output will not be profitable.

(b) When the income increases, and the consumption are not

increased, there is a danger of over-production. The government

will have to step in to remedy the situation. Therefore, the policy of

laissez-faire will not work here.

(c) If the consumption is not increased, the marginal efficiency of

capital (MEC) will diminish. The demand for capital will also

diminish, and all the economic progress will come to a standstill.

(d) Keynes’ Law explains the turning points in the business cycle.

When the trade cycle has reached the highest point of prosperity,
 income has gone up. But since consumption does not

correspondingly go up, the downward cycle starts, for demand has

lagged behind. In the same manner, when the business cycle has

touched the lowest point, the cycle starts upwards, because

consumption cannot be diminished beyond a certain point. This is

due to the stability of mpc.

(e) Since the mpc is less than unity, this law explains the over-saving

gap. As income goes on increasing, consumption does not increase

as much. Hence saving process proceeds cumulatively and there

arises a danger of over-saving.

(f) This law also explains the unique nature of income generation. If

money is injected into the economic system, it will increase

consumption but to a smaller extent than increase in income. This

again is due to the fact that consumption does not increase along

with increase in income.

Factors Influencing Consumption Function:

There are certain factors affecting the propensity to consume in the long-

run:

1. Objective Factors:

(a) Distribution of income: It is generally observed that the average

and marginal propensities to consume of the poor are greater than

 those of the rich. This is because the poor has a lot of unsatisfied

wants and he is likely to seize every opportunity that comes his way

to satisfy them. On the other hand, the rich have already a high

standard of living and relatively less urgent wants remain to be

satisfied, so that in their case, an addition to their incomes is more

likely to be saved than spent on consumption.

(b) Fiscal policy: Fiscal policy of the government will also influence

the consumption behaviour of an economy. A reduction in taxation

will leave more post-tax incomes with the people and this will

stimulate higher expenditure on consumptions. Similarly, an

increase in taxes will depress consumption.

(c) Changes in business expectations: Business expectations by

affecting the incomes of certain classes of people affect consumption

function.

(d) Windfall gains and losses: The windfall losses and gains arising

out of changes in capital values affect the ‘saving brackets’ mostly

and not the spending sections. Hence, their influence on

consumption function is not so well marked.

(e) Liquidity preferences: Another factor is the people’s liquidity

preferences. If people prefer to keep their income in liquid ford,

consumption is reduced correspondingly.

(f) Substantial changes in the rate of interest.

2. Subjective Factors:

(a) Individual motives to save:

(i) Building of reserves for unforeseen contingencies as illness or

unemployment,

(ii) To provide for anticipated future needs such as daughter’s

wedding, son’s education, etc.

(iii) To enjoy an enlarged future income by investing funds out of

current income, etc.

(b) Business motives:

(i) The desire to expand business,

(ii) The desire to face emergencies successfully,

(iii) The desire to have successful management,

(iv) The desire to ensure sufficient financial provision against

depreciation and obsolescence.

Investment

Investment, in the theory of income and employment, means, an addition

to the nation’s stock of capital like the building of new factories, new
machines as well as any addition to the stock of finished goods or the

goods in the pipelines of production. Investment includes addition to

inventories as well as to fixed capital. Thus, investment does not mean

purchase of existing securities or titles, i.e., bonds, debentures, shares, etc.

Such transactions do not add to the existing capital but merely mean

change in ownership of the assets already in existence. They do not create

income and employment. Real investment means the purchase of new

factories, plants and machineries, because only newly constructed or

created assets create employment or generate income.

Types of Investment:

1. Gross and Net Investment: Net investment means gross investment

minus depreciation. In the theory of income and employment,

investment means net investment.

2. Ex-ante and Ex-poste Investment: Ex-ante investment is planned or

anticipated investment. Ex-post investment is actually realised

investment, or the investment which is not merely planned but

which is actually invested or implemented.

3. Private and Public Investment: Private investment is on private

account and public investment is by the State or local authorities.

The private investment is influenced by marginal efficiency of

capital (MEC) i.e., profit expectations and the rate of interest.

Therefore, the private investment is profit-elastic. In public

 investment, the profit motives do not enter into consideration. It is

undertaken for social good and not for private gain.

4. Autonomous and Induced Investment: Autonomous investment is

independent of income level, and depends on population growth

and technical progress. Such investment does not vary with the

level of income. In other words, it is income-inelastic. The influence

of change in income is not altogether ruled out. The examples of

autonomous investment are ‘long range’ investments in houses,

roads, public buildings and other forms of public investment. Such

investment is generally done by the State as necessitated by the

growth of population and facilitated by technical progress and not

as a result of change in NI. These investments are independent of

changes in income and are not governed by profit motive. They are

generally made by governments and local authorities for promoting

general welfare.

Induced investment varies with NI. Changes in NI bring about

changes in aggregate demand which in turn affects the volume of

investment. When NI increases, AD too increases, and investment

has to be undertaken to meet this increased demand. Thus induced

investment is income-elastic.

Investment is made by the people as a result of changes in income

level or consumption. It is also influenced by price changes, interest

changes, etc., which affect profit possibilities. It is undertaken for the

 sake of profit or income and it changes with a change in income.

Thus, induced investment is governed by profit motive.

Factors Affecting Investment:

1. Marginal Efficiency of Capital (MEC) or expected rate of profit:

MEC or expected rate of profit the most important factor affecting

private investment. If the business expectations are good or if the

MEC is high, more investment will be made. On the contrary, if

there is an economic depression in the country or there are bleak

prospects of profits, investment will be discouraged. Thus, the

fluctuations in investment are mainly caused by the fluctuations in

the MEC.

2. Rate of interest: The second important factor affecting investment is

rate of interest. The rate of interest does not quickly change; it is

more or less sticky or constant. Hence, the inducement to invest, by

and large, depends on the MEC. For a suitable investment

condition, the rate of return or profit must at least equal to rate of

interest. So long as the expected rate of return exceeds the rate of

interest, investment will continue to be made. In other words, the

MEC must never fall below the current rate of interest, if investment

is to be worthwhile.

3. Excess capacity: There are some other factors that affect investment.

Excess capacity is one of them. If a firm has already ‘excess capacity’

 and can easily handle increased future demand, it will not go in for

further investment in capital equipment.

4. Technological progress: Technological progress also affects current

level of investment. For instance, a new invention may render the

present capital stock of a firm obsolete and adversely affect its

ability to compete. In this case, further investment will be called for.

5. Political and security conditions: This factor has become one of the

major important factors that affect the investment, esp. with

reference to under-developed countries including Pakistan. Political

instability, poor security arrangements and society’s negative

attitude towards investment companies can badly damage the

investment environment, and the country can be suffered from

poverty and unemployment due to lack of investment. Countries

like Kenya, Zimbabwe, Sudan, etc. are the worst victims.

Investment-Demand Curve:

The investment-demand schedule is also known as MEC schedule. The

MEC schedule shows a functional relationship between MEC and the

amount of investment in a given type of capital asset at a particular period

of time for the whole economy.

 In the above diagram, the

marginal efficiency of

capital is represented by

MEC curve. It slopes

downward from left to

right which means that as

investment increased its

marginal efficiency goes

down.
Investment MEC /
(In Million Rate of Interest Investment at any time
US $) (In %)
depends on the rate of
200 10
250 9 interest prevailing at that
400 7 time. If the rate of interest is
750 5
1000 3 5%, the investment is US

$750 million, because, at this level, MEC is equal to the rate of interest. The

MEC represents the investor’s return and the rate of interest is his cost.

Obviously, the return on capital must at least be equal to the rate of

interest, which is its cost. Suppose the rate of interest goes down to 3%,

then it will become worthwhile to invest US $1,000 million. Thus, the MEC

and the rate of interest move together.

Position and Shape of MEC Curve: The elasticity of MEC determines the

extent to which the volume of investment would change consequent upon

changes in the rate of interest. If MEC is relatively interest-elastic, a little

fall in the rate of interest will result in a considerable expansion in the

volume of investment. On the other hand, if the MEC is relatively interest-

inelastic, then a considerable fall in the rate of interest may not lead to any

increase in the volume of investment.

Influence of Rate of Interest: The rate of interest along with the MEC

determines the volume of investment. If the rate of interest is higher than

the MEC, it will not be profitable to create a new physical asset. This is

because we assume that the aim of individual investor is to maximise the

money profits. Two courses of action are open to invest, either he can use

his money to crease additional physical assets, i.e., he can invest in the

Keynesian sense of the term, or else he can lend his money to others at a

certain rate of interest. Now, if MEC is lower than the current rate of

interest, it is more profitable to lend money rather than use it for creating

new assets. On the other hand, if MEC is higher than the rate of interest, it

is better to invest more. At the point, where MEC equals the current rate

of interest, we have the equilibrium level of investment.

 MULTIPLIER AND ACCELERATOR

THE MULTIPLIER:

Keynes’ Multiplier Theory gives great importance to increase in public

investment and government spending for raising the level of income and

employment. Both consumption and investment create employment. But

both have complementary relationship with one another. When

investment increases, consumption increases too and helps in creating

employment. It is only when the level of full employment has been

reached that investment and consumption become competitive instead of

being complementary; then increase in one will reduce the other, one will

be at the expense of the other.

Kahn’s Employment Multiplier:

Kahn’s Multiplier is known as Employment Multiplier, and Keynes’

Multiplier is known as Investment Multiplier. According to Kahn’s

Employment Multiplier, when government undertakes public works like

roads, railways, irrigation works then people get employment. This is

initial or primary employment. These people then spend their income on

consumption goods. As a result, demand for consumption goods

increases, which leads to increase in the output of concerned industries

which provides further employment to more people. But the process does
not end here. The entrepreneurs and workers in such industries, in which

investment has been made, also spend their newly obtained income which

results in increasing output and employment opportunities. In this way,

we see that the total employment so generated is many times more than

the primary employment.

Suppose the government employs 300,000 persons on public works and, as

a result of increase in consumer goods, 600,000 more persons get

employment in the concerned industries. In this way, 900,000 persons

have been able to get employment, that is, three times more people are

now employed. In other words, Kahn’s employment multiplier means

that by the government undertaking public works many more times total

employment is provided as compared with initial employment.

Keynes’ Income or Investment Multiplier:

Keynes’ income multiplier tells us that a given increase in investment

ultimately creates total income which is many times the initial increases in

income resulting from that investment. That is why it is called income

multiplier or investment multiplier. Income multiplier indicates how

many times the total income increases by a given initial investment.

Suppose Rs. 100 million are invested in public works and as a result there

is an increase of Rs. 300 million in income. In this case, income has been

increased 3 times, i.e., the multiplier is 3. If ΔI represents increase in

investment, ΔY indicates increase in income and K is the multiplier, then

the equation of multiplier is as follows:

----------------------------------- (i)

The multiplier is the numerical co-efficient showing how large an increase

in income will result from each increase in investment. The multiplier is

the number by which the change in investment must be multiplied in

order to get the resulting change in income. It is the ratio of change in

income to the change in investment. If an investment of Rs. 50 million

increases income by Rs. 150 million, the income multiplier is 3 and if Rs.

200 million, the multiplier is 4 and so on.

In the following multiplier equation, the relationship between income and

investment is determined through marginal propensity to consume:

------------------------------------(iii)

Where:

(mps: Marginal Propensity to Save)

Therefore, the third multiplier equation is:

--------------------------------------((iii)
It should be noted that the size of multiplier varies directly with the size of

mpc. When the mpc is high, the multiplier is high and when the mpc is

low, the multiplier is also low.

The multiplier works not only in money terms but also in real terms. In

other words, the increase in income takes place not only in the form of

money but in the form of goods and services.

Keynes multiplier theory is also very helpful in the determination of

national income. In his book, ‘General Theory of Employment, Interest and

Money’, he has contradicted the viewpoint of the classical economists. He

is of the opinion that if an economy operates at a level of equilibrium it is

not necessary that there should be a high level of employment in a

country. It is just possible that there may be millions of people

unemployed. So according to Keynes, if any country wishes to achieve

level of employment, it can only do so through the changes in the

magnitude of investment.

According to Keynes’ theory, there are two main methods of measuring

the equilibrium level of NI, i.e.:

(a) The AD-AS Approach, and

(b) The Saving Investment Approach

(a) AD-AS Approach:

For explaining the

determination of level of

income in a two-sector

economy, we assume an

economy in which there is

no international trade, no

government role and in

which corporations retain no earnings. In this simplest model of

economy, the level of income is determined at a point where the AD

intersects the AS.

In the above diagram, the national income is determined at the point

where AD curve (C+I) cuts the AS curve (C+S), i.e., at E. The multiplier

effect is also shown in this diagram. The curve C represents the mpc

which is assumed to be ½. That is why the slope of curve C is 0.5. Since

the AD curve (C + I) cuts the 45o angle line at E, OY1 is the level of income

determined. If now investment is increased to EH (ΔI) we can find out the

increase in income (ΔY). As a result of investment EH, the AD curve shifts

upwards to C + I’. This new AD curve cuts the AS curve (45 o angle line) at

F, so that OY2 income is determined. Thus, income increases by Y1Y2 as a

result of investment increase of EH, which (Y1Y2) is double of EH.

It is clear, therefore, that the multiplier is 2. It is also calculated as below:

(a) Saving-Investment Approach: In order to simplify the analysis of

income determination we imagine an economy (1) where there are no taxes

levied by the government, (2) the corporations retain no earnings, and (3)

there are no changes in the level of prices. The equilibrium level of NI is

determined at a point where planned or intended saving is equal to

planned or intended investment, or in other words, where the saving

intersect the investment. It is further explained with the help of following

diagram:

The above diagram shows the

multiplier effect of an increase

in investment on the

equilibrium level of income. SS

is the supply curve and II is the

investment curve showing the

total level of investment of OI.

These two curves intersect each

other at the equilibrium point E

where is income is OY1. If now there is a change in investment from

OI to OI’, i.e., an increase of II’, then the II curve will shift to the
 position of I’I’ and the two curves I’I’ and SS intersect each other at

the new equilibrium point E’, where the income is OY2. Now it is

clear that when mps is ½, an increase in investment by II’ (let say Rs.

10 million) has led to the increase in income by Y1Y2 (let say Rs. 30

million). Obviously the value of the multiplier is equal to 3.

Limitations of Multiplier:

(a) Efficiency of production: If the production system of the country

cannot cope with increased demand for consumption goods and make

them readily available, the incomes generated will not be spent as

visualised. As a result, the mpc may decline.

(b) Regular investment: The value of the multiplier will also depend on

regularly repeated investments. A steadily increasing investment is

essential to maintain the tempo of economic activity.

(c) Multiplier period: Successive doses of investment must be injected at

suitable intervals if the multiplier effect is not to be lost.

(d) Full employment ceiling: As soon as full employment of the idle

resources is achieved, further beneficial effect of the multiplier will

practically cease.

Leakages of Income Stream and Their Effect on the Multiplier:

As we know that as income increases, consumption does not increase to

the same extent or proportionately, because a part of the income is saved.

The part of the income that is saved is as if a leakage from the flow of

income stream. These leakages obstruct the growth of national income. In

the absence of these leakages, mpc would have been unity. The

consumption expenditure would have increased 100 per cent of the

increase in income and there would have been full employment. The

following are the principal leakages:

(a) Paying off debts: It generally happens that a person has to pay a debt

to a bank or to another person. A part of his income goes out in repaying

such debts and is not utilised either in consumption or in productive

activity. Income used to pay off debts disappears from the income stream.

If, however, the creditor uses this amount in buying consumer goods or in

some productive activity, then this sum will generate some income,

otherwise not.

(b) Idle cash balances: It is well known that people keep with them ready

cash which is neither used productively nor in purchasing consumer

goods. Keynes has mentioned three motives for holding ready cash for

liquidity preference, viz., transactions motive, precautionary motive and

speculative motive. This means that the re-spent part of income goes on

decreasing. In this way, a part of the initial expenditure leaks out of the

income stream.

(c) Imports: The part of the money spent by country for importing goods

also leaks out of the country’s income stream. It does not encourage or

support any business or industry in the country. This is specially so if the

imports do not help the trade and industry of the country or if they are not

used for export promotion. The net import is a leakage.

(d) Purchase of existing securities: Some people purchase securities

(saving certificates) from others and the seller of securities can hoard this

money. This money also leaks out of the income stream. This may also be

valid in case of purchase of shares, debentures, bonds, insurance policy, or

some other financial investment. If this invested money is not used in

productive areas, there will be a leakage in the income stream.

(e) Price inflation: Inflationary situation is also responsible for leakage.

In such a situation, investment does not help in generating employment or

increasing income. If there is already full employment in the country,

increase in investment, far from increasing demand for consumer goods, it

decreases it as a result of which employment in the consumer goods

industries contracts and demand for capital goods decreases. Whatever

increase in income there is, it is spent in high prices and it does not help in

creating income and employment.

As a result of leakages of income from the main income stream of the

country, the multiplier effect of the primary or initial investment in

increasing income is reduced. If somehow these leakages are plugged, the

multiplier effect of investment in generating income and employment

would increase. If they cannot be plugged altogether, they should be

reduced or the propensity to consume should be increased or propensity

to save should be reduced, otherwise the new investment will not have full

effect in increasing income and employment.

Importance of Multiplier:

Keynes’ principle of multiplier has a great role in removing the Great

Depression of 1929-34. These days governments are actively interfere in

the economic affairs of the community through multiplier. Its importance

is further explained as below:

1. The multiplier principle focuses on the importance of public

investment, which is the key to remove unemployment during the days of

depression. An investment of Rs. 1 million can create income and

employment worth many times, and can help the government to remove

unemployment from the country.

2. During the days of depression, the private entrepreneurs are

discouraged to invest in the economy. Therefore, to fill this gap, the

government comes forward and undertakes the investment in her own

hands. Hence, the demand for consumer goods increases and also the

level of NI and employment increases on account of the working of the

multiplier.

3. When the demand for goods increases and incomes rise owing to

government investment, the profit expectations of the entrepreneurs go up

and as a result the MEC rises.

4. When the government makes investment in public works to fight

depression and unemployment, private investment is encouraged on

account of the operation of the multiplier. The confidence of private

investors is restored, and hence helps in further removing the economic

depression of the country.

Assumptions of Multiplier:

The following certain essential conditions / assumptions for the operation

of multiplier:

1. The supply curve of output should be elastic. In other words, when

demand for certain goods or services increases, its supply can be

increased without much difficulty.

2. There is excess productive capacity in consumer goods industries, so

that the supply of goods can be easily increased when demand

increases.

3. The supply of raw materials and working capital should also be

elastic.

4. There should be ‘involuntary unemployment’. That is, there are

people who want work at the prevailing wage rate, but are not

getting it.

Criticism on Keynes’ Multiplier Theory:

Many economists including the classical economists and the economists

from third world countries have strongly criticise the Keynes’ Multiplier

Theory. It is explained in brief as below:

1. Keynes’ multiplier theory assumes that the supply of output, raw

materials and working capital is elastic, i.e., it can be increased

whenever required. But, according to critics, this condition cannot

be fulfilled in an under-developed country (UDC), where there is a

continuous vicious cycle of poverty. The whole economy is based

on agriculture, and there is a dearth of capital equipment, skill

labour and technology. The existing industries cannot fulfill the

increased demand. Moreover, the government is so poor to invest in

public works.

2. According to Keynes’ multiplier theory, there is excess productive

capacity in consumer goods industries. But according to critics,

there is a little excess productive capacity in poor countries;

therefore, this theory cannot be applied to UDCs.

3. Another condition of Keynes’ theory is that there should be

‘involuntary unemployment’. That is, there are people who want work

at the prevailing wage rate, but are not getting it. Whereas, in

UDCs, there is ‘disguised unemployment’, and most of the workers

are self-employed, therefore, this condition cannot be fulfilled in

such countries.
 4. According to critics, this theory can only be applied to economically

advanced and highly industrialised countries, and cannot be applied

to under-developed countries, which are pre-dominantly agricultural

countries. In UDCs, the heavy plant and machineries, and skilled

labour are not easily available and the supply cannot be increased

quickly.

THE ACCELERATOR:

The multiplier describes the relationship between investment and income,

i.e., the effect of investment on income. The multiplier concept is

concerned with original investment as a stimulus to consumption and

thereby to income and employment. But in this concept, we are not

concerned about the effect of income on investment. This effect is covered

by the ‘accelerator’. The term ‘accelerator’ should not be confused with the

accelerator in cars. It does not make the investment to grow faster and

faster.

The term ‘accelerator’ is associated with the name of J.M. Clark in the year

1914. it has been proved a powerful tool of economic analysis since then.

Keynes, astonishingly, has altogether ignored this concept. That is why,

the concept of accelerator is not considered the part of Keynesian theory.

According the principle of accelerator, when income increases, people’s

spending power increases; their consumption increases and consequently

the demand for consumer goods increases. In order to meet this enhanced

demand, investment must increase to raise the productive capacity of the

community. Initially, however, the increased demand will be met by over-

working the existing plants and machinery. All this leads to increase in

profits which will induce entrepreneurs to expand their plants by

increasing their investments. Thus a rise in income leads to a further

induced investment. The accelerator is the numerical value of the relation

between an increase in income and the resulting increase in investment.

(Figures in Rs. ‘000)

Required
Replacement Net Gross
Years Demand Stock of
Cost Investment Investment
Capital
5 1 machine
2007 500 machines 300 0 machine 300
1500
5 1 machine
2008 500 machines 300 0 machine 300
1500
8 1 machine
3 machines
2009 800 machines 300 1200
900
2400
10 1 machine
2 machines
2010 1000 machines 300 900
600
3000
10 1 machine
2011 1000 machines 300 0 machine 300
3000
8 1 machine – 2
2012 800 machines 300 machines – 300
2400 600
Cost per machine: Rs. 300,000 per machine
In the above example, suppose we are living in a world, where the only

commodity produced is cloth. Further suppose that to produce cloth Rs.

100,000, we require one machine worth Rs. 300,000, which means that the

value of the accelerator is 3 (i.e., the capital-output ratio is 1:3). That is, if

demand rises by Rs. 100,000, additional investment worth Rs. 300,000 takes

place. If the existing level of demand for cloth remains constant, let us say,

at Rs. 500,000, then to produce this much cloth we need five machines

worth Rs. 1.5 million. At the end of one year, let us suppose, that one

machine becomes useless as a result of wear and tear, so that at the end of

one year, a gross investment of Rs. 300,000 must take place to replace the

old machine in order that the stock of capital is capable of producing

output worth Rs. 500,000.

In the third period, i.e., the year 2009, demand rises to Rs. 800,000. To

produce output worth Rs. 800,000, we need 8 machines. But our previous

stock consisted of only 5 machines. Thus if we are to produce output

worth Rs. 800,000, we must install 3 new machines, worth Rs. 900,000. The

net investment for the year 2009 will be Rs. 900,000 and with the

replacement cost of one machine Rs. 300,000, our gross investment jumps

from Rs. 300,000 in the year 2008 to Rs. 1.2 million in the year 2009. A 60

per cent increase in demand led to a 400 per cent increase in gross

investment. Here we have a glimpse of the powerful destabilising role of

accelerator.

Assumptions of the Accelerator:

 1. Under the principle of accelerator, it is assumed that there is no

excess capacity existing in the consumer goods industries. No

machines are lying idle and shift working is not possible.

2. In capital goods industries, it has been assumed that there is an

existence of surplus capacity. If there is no excess capacity in capital

goods industries, increased demand for machines could not lead to

increase in the supply of machines.

3. Output is flexible. The machine-making industry or capital goods

industry can increase its output whenever desired.

4. The size of the accelerator does not remain constant over time. It

value will be affected by the businessmen’s calculations regarding

the profitability of installing new plants to make more machines on

the basis of their probable working life.

5. The demand for machines will remain stable in the future, although

the increase in demand has suddenly cropped up.

Business Cycles

Trade cycles refer to regular fluctuations in the level of national income. It

is a well-observed economic phenomenon, though it often occurs on a

generally upward growth path and has a variable time span, typically of

three years.
In trade cycles, there are upward swings and then downward swings in

business. The periods of business prosperity alternate with periods of

adversity. Every boom is followed by a slump, and vice versa. Thus, the

trade cycle simply means the whole course of trade or business activity

which passes through all phases of prosperity and adversity.

Several suggestions have been put forward as to the cause of cycles. The

most well known are developed by Samuelson, Hicks, Goodwin, Phillips

and Kalecki in the 1940s and 1950s, combine the multiplier with the

accelerator theory of investment. More recently, attention has been paid to

the effects of shocks to the economy from technology and taste changes.

Phases of Trade Cycles:

Typically economists

divide business cycles

into two main phases –

depression and recovery.

Boom and slump mark

the turning points of the

cycles:

(a) Depression: In this phase, the whole economy is in depression and the

business is at the lowest ebb. The general purchasing power of the

community is very low. The productive activity, both in the production of

consumer goods and the production of capital goods, is at a very low level.
Business settles down at a new equilibrium point with a low level of

prices, costs and profits. It may last for a number of years. Following are

the characteristics of depression:

(i) The volume of production and trade shrinks,

(ii) Unemployment increases,

(iii) Overall prices fall,

(iv) Profits and wages fall, thus, the income of the community falls to a
very low level,

(v) Aggregate expenditure and the effective demand come down,

(vi) There is a general contraction of credit and little opportunity to invest,

(vii) Stock markets show that prices of all shares and securities have fallen
to a very low level,

(viii)Interest rates decline all round,

(ix) Practically, all construction activity – whether in buildings or

machinery, comes to an end.

(b) Recovery: This phase is also known as ‘expansion’. The depression

period of trade cycle ends in the recovery period. The economic situation

has now become favourable. Money is cheap and so are the other

materials and the factors of production. Productive activity has been

increased. The entrepreneurs have now sufficient financial backing.

Constructional and allied industries are receiving orders and employing

more workers, thus creating more income and employment. This

stimulates further investment and production. The whole economy is

moving faster towards the boom.

(c) Boom: Boom or peak is the turning point of the trade cycle. It is the

highest point of economic recovery. The typical features of boom are as

follows:

(i) A large number of production and trade,

(ii) A high level of employment and job opportunities in sufficient

amount to permit a good deal of labour mobility,

(iii) Overall rising prices,

(iv) A rising structure of interest rates, so that a bullish tendency rules

stock exchanges,

(v) A large expansion of credit and borrowing,

(vi) High level of investment, i.e., manufacturing or machinery

(vii) A rise in wages and profits so that the community’s income rises, and

(viii) Operation of the economy at optimum capacity.

(d) Recession:

It is a sharp slow down in economic activity, but it is different from

depression or slump which is more severe and prolonged downturn.

Just as depression created the conditions of recovery, similarly, the boom

conditions generate their own checks. All idle factors have been employed
and further demand must raise their prices, but the quality is inferior. Less

efficient workers have to be taken on higher wages.

Rate of interest rises and so also of the necessary materials. The costs have

after all started the upward swing. They overtake prices ultimately and

the profit margins are first narrowed and then begin to disappear. The

boom conditions are almost at an end.

Then starts the downward course. Fearing that the era of profits has come

to a close, businessmen stop ordering further equipment and materials.

The prudent businessmen want to get out altogether and cuts down his

establishment ruthlessly. The government applies the axe mercilessly.

The bankers insist on repayment. The bottlenecks appear, stocks

accumulate. Desire for liquidity all round. This accentuates the

depression.

Theories of Trade Cycle:

(a) Climatic Theory: It is said that there are cycles of climate. For some

years the climate is favourable and then comes an unfavourable turn.

Changes in climate bring about changes in agricultural production. The

cycle of agricultural production results in a cycle of industrial activity, for

industry is deeply affected by the state of agricultural production.

One of the famous climatic theories is ‘Jevons’ Sunspot Theory’. According

to Stanley Jevon, spots appear on the face of the sun at regular intervals.

These spots affect the emission of heat from the sun, which, in turn,
conditions the degree of rainfall. The rain affects agriculture, which, in

turn, affects trade and industry. That is how trade cycles are caused.

(b) Psychological Theory: According to psychological theory of trade

cycle, there are moods of optimism alternating the moods of pessimism in

the economy, without any tangible basis. At some stage, people just think

that trade is good and that it is going to remain good. Business activity is

intensified and becomes feverish. Then, all of a sudden, people start

thinking that the period of prosperity has lasted long enough and

adversity is round the corner. Thus, although there was no valid reason

for depression to come about, but it is brought about by the people

themselves. It is all psychological.

(c) Under-Consumption Theory: According to under-consumption

theory, there is too much of saving during a boom and further additions to

saving reduce the level of consumption. A reduction in the level of

consumption, in the face of increasing productive capacity, must sooner or

later lead to the collapse of the boom. This theory is associated with the

names of J. A. Hobson and Major Douglas.

(d) Monetary Theory: R.G. Hawtrey was a firm believer in monetary

theory. According to him, variations in flows of money are the sole and

sufficient determinants of business activity and account for alternating

phases of prosperity and depression. When the business prospects are

good, the banks freely extent credit facilities. The businessmen go on

expanding their business, entering into further and further commitments

with the banks. A huge superstructure of credit is built up and this

superstructure can be maintained by cheap money conditions. But a point

reached, when banks think that they have gone a bit too far in the matter

of advances. Probably their reserve ratio fallen dangerously low. In self-

defence, they apply the brake, curb further expansion of credit, and begin

to recall advances. This sudden suspension of credit facilities proves a

bombshell in the business community. Businessmen have to sell their

stocks in order to repay. This general desire for liquidity depresses the

market, and may even led to bankruptcy for certain firms.

(e) Over-Investment Theory: According to over-investment theory,

fluctuations in the rate of investment are the main causes of trade cycles.

Investment becomes excessive during the boom. That investment during

the boom is borne out by the fact that investment goods industries expand

faster than consumption goods industries during the upward phase of the

cycle. During the depression, investment goods industries suffer more

than consumption goods industries.

(f) Keynes’ Theory: According to Keynes, the business cycle is a

rhythmic fluctuation in the overall level of income, output and

employment. According to him, fluctuations in economic activity are

caused by fluctuations in the rate of investment. And fluctuations in the

rate of investment are caused

mainly by fluctuations in the

marginal efficiency of capital. The

rate of interest, which is the other determinant of investment, is more or

less stable and does not play a significant role in cyclical fluctuations in

investment.

Fluctuations in MEC or the expected rate of profit on new investment are

due to:

(i) changes in the prospective yields, and

(ii) changes in the cost or supply price of the capital goods.

Towards the end of the boom, the decline in the prospective yields on

capital is due, in first instance, to the growing abundance of capital goods

which lowers the MEC. The turning point from expansion to contraction

is, thus, explained by the collapse of MEC. As investment falls, because of

the decline in MEC, income also falls. The multiplier works in reverse

direction.

Just as the collapse of MEC is the main cause of the upper turning point in

the trade cycle, similarly the lower turning point, i.e., change from

recession to recovery, is due to the revival of MEC. The interval, between

the upper turning point and the start of recovery, is conditioned by two

factors:

(i) the time necessary for wearing out of durable capital assets, and

(ii) the time required to absorb the excess stocks of goods left over from

the boom.
Policy for Trade Cycle:

(a) Monetary Policy: A country must always formulate and follow an

appropriate monetary policy so as to avoid the occurrence of booms

and slumps. Monetary policy embraces banking and credit policy

relating to loans and interest rates as well as the monetary standard

and public debt and its management. It influences the volume of

credit base and, through it the volume of bank credit and thus the

general level of prices and of economic activity. When boom

conditions are developing, bank rate is raised and thus credit is

contracted with the consequent brake upon the undue expansion of

business activity. In a depression, a policy of cheap money may be

adopted to stimulate business investment and thus assist recovery.

The bank credit policy involves two types of controls, i.e., the

qualitative and the quantitative. The quantitative control is aimed at

general tightening or easing of the credit system as the situation may

demand. It is exercised by influencing the reserves of the banks. The

qualitative or selective control seeks to regulate particular type of

credit. Its object is to stimulate, restrict or stabilise bank advances for

specific business schemes.

But there are limitations of monetary policy relating to bank rate and

open market operations. Its success will depend on how far certain

assumptions are true. For example, how far the various member of

the banking system are prepared to accept the lead given by the
 central bank; how far the banks can make their borrowers use their

credits for purposes for which such credits have actually been

created; further, how far monetary causes are responsible for the

economic fluctuations; and still further, and most important,

whether the business community will adjust their investment

exactly in accordance with the altered rates of interest.

(b) Fiscal Policy: Since public expenditure in all modern states constitutes

a fairly respectable proportion of the total national income, fiscal policy is

bound to affect the level of prices, production and employment,

irrespective of the fact whether this policy is deliberately aimed at this or

not. Fiscal policy consists of two elements, i.e., public spending or the

policy of public works, and appropriate taxation.

In a year of depression, that is, when private investment is at a low ebb,

the deficiency in investment will have to be made up by large capital

outlay by the state, and conversely, during the upward swing of the cycle,

the state will have considerably to cut down its spending programme.

Thus, during the depression years, the state must be ready to spend

beyond its current revenues. In other words, the state should be prepared

to have deficit budgets during depression. Conversely, there should be

surplus budgets during the years of prosperity. To put it another way,

instead of having balanced budgets every year, the state should aim at

budget-balancing over a series of years.

On the revenue side, rates and taxes should be lowered during depression,

while they should be raised during boom years. To stimulate business

investment during depression, not only the rates of taxes should be

lowered but also more liberal allowances for depreciation and

obsolescence, etc., should be granted.

Thus, fiscal policy, which is also known as the contra-cyclical management

of public finance, may be operated both through public revenues and

public expenditure.

(c) International Measures: So far we have discussed individual national

efforts at economic stabilisation. But trade cycle is an international

phenomenon and no country is hermetically scaled from the rest of the

world. In fact, this international aspect creates complications and makes

crisis control all the more difficult.

The measures which are suggested to be adopted on an international scale

are: International Production Control, International Buffer Stocks and

International Investment Control. International Production Control

envisages control of production and prices of the importance primary

products. The difficulties of such control are indeed formidable, notably

because agriculture in countries like India and Pakistan is usually carried

on a small scale and more as a mode of living than business, so that even

though it ceases to be profitable, it will be continued. But production

control, as far as possible, combined with buffer stocks to counteract

sudden changes in supply and demand, will go a long way in preventing

rise or fall in their prices, which give rise further to serious fluctuations in

the entire economy.

An international investment control for developing backward regions

would help in raising the standards of living of their people and thus

reduce the inequalities in the standard of living of different peoples. Such

reduction in those inequalities is bound to strengthen the forces of

stabilisation.
 ANALYSIS OF MONEY MARKET UNIT III

EVOLUTION OF MONEY:

Commodity Money - overcame the inconveniences that went with barter

system by using uncoined metals like gold, silver or copper. It had the

advantage of ease of transport and durability. New set of problems came

up with the use of uncoined metals such as adulteration (impurities in

content) and short weighing by unscrupulous traders.

Coinage solved the problem of adulteration and short weighing, with the

king's seal being stamped on the metals for authentication. However, some

more problems came up like storage, theft, costly and risky transport, and

so on.

IOU's tend to minimize risk in transport since coins were left to a

reputable person with "vault or safekeeping" means. IOU's ("I owe you")

were simply written on paper/receipt instead of going to the safe keeper to

transact.

Bank note involves the promise to pay a debt (IOU) which is evidenced by

a piece of paper backed by specie.

Specialized Bankers evolved because it was observed that not all people

who "deposited" their money were demanding payment at the same time.

Hence, there was no need to hold all the gold/silver pieces all the time. The

idea of lending out a portion of the entrusted money for a fee while

holding on to the rest for safe-keeping paved the way for fractional reserve
banking.

Electronic Funds Transfer System (EFTS)- Electronic money make use of

computer terminals for transactions and automated computer clearing

house that does away with a physical medium of exchange.

DEFINITION OF MONEY

Money serves as means of payment or temporary store of value.

Money is an asset which is anything that serves as a means to store value

over a period of time.

Economists have not really agreed on a single definition but they agree

that money supply refers to all things generally acceptable in payment of

debt (store of value) and as payment for goods and services (medium of

exchange) whatever its legal status may be.

FUNCTIONS OF MONEY

 Unit of account:

Money represents an item with which the values of all other goods and

services are expressed or quoted.

 Medium of exchange:

This means that money is an accepted means of payment for goods and

services.

 Store of value (and a standard of delayed payment:

Money can be kept today (i.e., stored) and spent at a later period. It also

implies that goods can be bought today and paid for at a later date

(deferred payment).
However inflation, may decreases the ability of money to act as a store of

value and deferred payment.

DEMAND FOR MONEY – Why to people hold money?

Transactions Demand for Money –

Arises from the need of households and firms to have money for the

regular payments of goods and services

Precautionary Demand for Money –

Households want extra money for emergency like paying bills for the

unexpected hospitalization of a family member.

Firms, likewise, will desire to extra cash to prepare themselves for

untoward events like labor strikes.

Speculative or Portfolio Allocation Motive –

The speculative demand stems from the preference of households and

firms to hold other assets that are "perfectly liquid and perfectly free from

risk of depreciation in terms of money" in order to "take advantage of

market movements."

Demand for money is primarily determined by the level of income and the

interest rate.

Other factors:

(a) Credit availability and affordability;

(b) Expectations on future income;

(c) Expectations on prices;

(d) Risk and expected returns on alternative assets; and

(e) Financial innovations that allow easy movement of funds from less

liquid to more liquid forms.

The Demand for Money by Individuals

Three factors influence money demand:

 Expected Return

The interest rate measures the opportunity cost of holding money rather

than interest-bearing bonds. A rise in the interest rate raises the cost of

holding money and causes money demand to fall.

 Risk

Holding money is risky. An unexpected increase in the prices of goods and

services could reduce the value of money in terms of the commodities

consumed. Changes in the risk of holding money need not cause

individuals to reduce their demand for money. Any change in the riskiness

of money causes an equal change in the riskiness of bonds.

 Liquidity

The main benefit of holding money comes from its liquidity.

Households and firms hold money because it is the easiest way of

financing their everyday purchases. A rise in the average value of

transactions carried out by household or firm causes its demand for money

to rise.

Supply of Money: How the Money Supply Is Determined

An economy’s money supply is controlled by its central bank.

The central bank: Directly regulates the amount of currency in existence

Indirectly controls the amount of checking deposits issued by private

banks

M1 consists of items used as medium of exchange such as currency or

coins in circulation and demand deposits.

M2 consists of M1, plus savings and small time deposits.

M3 refers to money supply, savings, and negotiable order of withdrawals

(NOW accounts), time deposits and deposit substitutes of money-

generating banks.

RM or reserve money represents liabilities of the Central Bank to the public

sector in the form of currency in circulation and to the banking sector in

the form of cash reserves.

Instruments of Monetary Control

Its primary objective is to maintain price stability and the convertibility of

the rupee.

It makes use of monetary instruments

Reserve requirement (rr),

Rediscount rate (iDR), and

Open market operations (OMO), among others, to control the supply of

money.

1. Reserve Requirement (rr) – what banks are required to keep in reserve

(in their vaults) the Central Bank(CB) lowers the reserve requirement if it

wants to engage in an expansionary monetary policy, that is, if it wants to

increase money supply in circulation. This is so because a decrease in

reserve requirement means that banks shall have more deposits available
for lending. On the other hand, if the CB wants to contract money supply,

perhaps to "mop out excess liquidity" in the economy, it will have to

increase the reserve requirement so that more deposits are kept in the

banks' vaults.

2. Rediscount rate is the rate of interest that the CB lends to banks.

The CB increases the rediscount rate if it wants to contract money supply

and decreases it if it wants to increase money supply. When there is an

increase in the rediscount rate, banks are discouraged from borrowing

funds from the CB since it is more expensive to borrow. Banks will

therefore have the tendency to increase their excess reserves to refrain

from having to make loans with CB.

3. Open market operations (OMO) – means the buying and selling of

government securities to the public by open market purchase, we refer to

the CB's buying of government securities (e.g., bonds) from private

individuals.

By open market sale, we mean the CB's selling of government securities

(e.g., bonds) to private individuals.

Thus, if the CB wants to expand money supply, it will engage in open

market purchase of bonds. This way, the CB releases money into the

economy in exchange for government securities.

On the other hand, if the CB thinks that there is too much money

circulating in the economy, and therefore needs to contract it, then the CB

will engage in an open market sale of government securities.

Monetary Equilibrium
Simplifying assumptions: that the price level (P) and the level of real

income (Y) are given or fixed.

This assumption will imply that the demand for money will be just a

function of the interest rate.

Money equilibrium
i

MS

Interest
Rate
E
i*

MD

M/P
M/P*
Stock of Money

Demand for real money balances increases as the interest rate decreases

since the opportunity cost of holding money is lower. Supply of money is

upward sloping which implies that as the interest rate increases, banks will

hold less reserves, thus increasing the money multiplier and consequently

raising money supply.

Demand for money (MD) is shown as a downward sloping curve that is

inversely proportional to the interest rate i. This means that as the interest
rate increases, the demand for real money balances decreases since the

opportunity cost of holding money is lower. The supply of money (MS) is

assumed to be an increasing function of the interest rate. In equilibrium,

MD = MS and the equilibrium interest rate (i*) and the stock of money

(M*/P) are determined at the point of intersection, E.

How do Banks “Create” Money?

It takes a system of banks and not just a single bank to create money.

“Money Creation“refers to the multiple expansions of deposits.

Simplifying assumptions:

 Depository institutions (e.g., banks) issue only transaction accounts;

 All banks face the same reserve requirement of eg. 10 percent

 Banks have no desire to hold excess reserves

 The public currency-deposit ratio is zero

 Initial amount of P1000 is deposited in bank A.

The Money Creation Process (figures in rupees)

Additional
Additional Required
Bank transaction Additional Reserves (rr =
Deposits received Loans Made 10%)

A 1,000 900 100

B 900 810 90
C 810 729 81
- - - -
- - - -
Total, first 3 banks 2,710 2,439 271
Other banks’ turn 7,290 6,561 729
Grand Total 10,000 9,000 1,000

Banks’ role in the money supply

The money supply equals currency plus demand (checking account)

deposits:

M = C + D

Since the money supply includes demand deposits, the banking system

plays an important role.

A few preliminaries

Reserves (R ): the portion of deposits that banks have not lent.

To a bank, liabilities include deposits; assets include reserves and

outstanding loans

100-percent-reserve banking: a system in which banks hold all deposits as

reserves.

Fractional-reserve banking: A system in which banks hold a fraction of

their deposits as reserves.

SCENARIO 1: No Banks

With no banks,

D = 0 and M = C = $1000.

SCENARIO 2: 100 Percent Reserve Banking

► Initially C = $1000, D = $0, M = $1000.

► Now suppose households deposit the $1000 at “First bank.”
 FIRSTBANK’S ► After the deposit,
balance sheet
C = $0,
Assets Liabilities D = $1000,
M = $1000.
reserves $1000 deposits $1000 ► 100% Reserve
Banking has no
impact on size of
money supply.

SCENARIO 3: Fractional-Reserve Banking

The money supply now equals $1800:

The depositor still has $1000 in demand deposits, But now the borrower

holds $800 in currency.

SCENARIO 3: Fractional-Reserve Banking

► Suppose banks hold 20% of deposits in reserve, making
loans with the rest.
► First bank will make $800 in loans.

The money supply

FIRSTBANK’S
now equals $1800:
balance sheet
The depositor still
Assets Liabilities has $1000 in
reserves $1000
reserves $200 deposits $1000 demand deposits,
loans $800 but now the
borrower holds $800
in currency.
SCENARIO 3: Fractional-Reserve Banking
Thus, in a fractional-reserve
banking system, banks create money.

The money supply

FIRSTBANK’S now equals $1800:
balance sheet
The depositor still
Assets Liabilities has $1000 in
reserves $200 deposits $1000 demand deposits,
loans $800 but now the
borrower holds $800
in currency.

SCENARIO 3: Fractional-Reserve Banking

► Suppose the borrower deposits the $800 in Second bank.
► Initially, Second bank's balance sheet is:

SECONDBANK’S ► But then Second

balance sheet bank will loan 80%
of this deposit
Assets Liabilities
and its balance
reserves
reserves $160
$800 deposits $800 sheet will look like
loans
loans $0
$640 this:
 SCENARIO 3: Fractional-Reserve Banking

► If this $640 is eventually deposited in Third bank,

► then Third bank will keep 20% of it in reserve, and
loan the rest out:

THIRDBANK’S
balance sheet
Assets Liabilities

reserves $128
deposits $640
loans $512

Finding the total amount of money:

Original deposit = $1000

+ First bank lending = $ 800

+ Second bank lending = $ 640

+ Third bank lending = $ 512

+ other lending…

Total money supply = (1/rr )  $1000

where rr = ratio of reserves to deposits

In our example, rr = 20%, so M = $5000

The fractional reserve system and the creation of money

A. Commercial banks are required to keep a reserve (cash) of about 12% of

their demand deposits (checking accounts) at their bank or on deposit

with the Federal Reserve (required reserves).

(Excess Reserves) may be loaned out even though they support deposits.

B. Money is created by these loans as long as the demand deposits (DD)

created by them stay within the banking system, that is, the money loaned

is redeposit as a DD into a bank within the system. The banks owe the

demand deposits created by the loans to each other. These inter-brain

debts are canceled with a bookkeeping entry. It should be pointed out that

the demand deposits created by such loans are spent, and goods

transferred, just as if the transaction involved currency.

C. Example: Bank A has $50,000 in demand deposits. A reserve

requirement of 10% would yield required reserves of .10 x $50,000 =

$5,000. If Bank A had $7,000 in reserve, it could loan up to $2,000 in the

form of demand deposits. Suppose Bank B does exactly the same with both

banks' customers depositing their DD in the other bank. Banks would

owe cashed checks to each other, would cancel interbank debts, and

money has been created.

D. The system works in reverse with money destroyed if reserves leave the

system.

E. Required reserves, reserves not loaned, and loans of cash (reserves)

represent a leakage which eventually stops money supply growth.

The monetary multiplier

A. An infusion of reserves into the system by the Treasury as directed by

the Federal Reserve can be loaned a number of times by the commercial

banking system. For example, the Federal Reserve may buy a $100

Treasury bond from Ms. A who deposits the Federal Reserve check

(reserves) into Bank A.

B. Bank A's new DD of $100 requires them to keep $10 (10%) in reserve

leaving $90 excess to loan to Mr. B who

deposits it in Bank B.

C. Bank B needs to keep only $9 ($90 x .1) in reserve and may loan out $81.

D. This process continues and as long as the demand deposits being

created by the loans stay within the commercial

banking system, interbank debts are canceled and money has been created

E. Monetary multiplier (M) sets the upper limit of the expansion

1. R = reserve requirement = 10% = .1

2. M = 1/R = 1/.1 = 10

F. In the above example the total amount of DD created beginning with

Bank A's $90 in excess reserves would equal Excess Reserves x M = $90 x

10 = $900. If the $100 infusion by the Federal Reserve is included, the

increase is 10 x 100 = $1,000.

THE QUANTITY THEORY OF MONEY

A. Represents the basic theory behind macroeconomics prior to the

Keynesian Revolution
B. Believed that changes in the money supply would only affect price and

not economic activity.

C. The equation of exchange

MV = PT

Money Supply X Velocity of Money = Average Price Level X Number of

Transactions

1. . Velocity of money is how often the money supply is spent.

2. . Number of transactions is real economic activity

3. . The equation is an identity

a. Dollars spent = dollars received

b. MV = Aggregate Demand and PT = Nominal GDP = C + I +

G + XN = GDP

4. . Classical theory stated that V was basically stable and that there

existed some natural level of growth for T.

a. This natural level was a function of individual and business

interaction.

b. V and T were essentially unalterable which meant changes in M

would change P and not the natural level of T.

c. Government should therefore refrain from interfering with market

activity by adjusting the money supply.

d. Came into disfavor in the 1930's with the popularity of Keynesian

economics which stated that real output could be changed by affecting

aggregate demand.

Monetarism
A. Monetarists believe that changes in the money supply are both a

necessary and sufficient condition to cause inflation.

B. If AD was low; increasing the money supply would only increase short-

run economic activity.

1. Eventually short-term expansion stops and increasing M only

adds to inflation.

2. Public anticipation stops the process from being repeated.

3. Monetarists believe that government involvement in the economy,

especially monetary intervention, increases the magnitude of the business

cycle.

C. Keynes believed changing the money supply would affect interest rates

which would affect investment which in turn would affect Real GDP

D. To some degree monetarism is an extension of classical economics. Its

advocates believe that a competitive market, free from government

interference, results in economic stability and a reasonable growth rate.

New classical economists

A. Lead by Milton Friedman, these economists revived the quantity

theory of money.

B. They rely on market forces and not government manipulation of

aggregate demand and the money supply to control economic activity.

C. This economic school of thought has much in common with those who

believe in rational expectations.

1. This recently formed school does not assume market participants

have perfect knowledge.

 2. Instead, it assumes market participants will learn from experience

and use current information to predict and adjust to the expected future.

3. The result is not the disequilibrium of Keynesian economics with

its inflationary and deflationary gaps but a constant equilibrium with

economic behavior adjusting to be compatible with different levels of

economic activity.

4. As with the classical school, the new classical school, monetarist,

and those believing in rationalist expectation feel government involvement

in economic activity is not beneficial.

MONETARY POLICY

Monetary policy is the process by which the government, central bank, or

monetary authority of a country controls (i) the supply of money, (ii)

availability of money, and (iii) cost of money or rate of interest, in order to

attain a set of objectives oriented towards the growth and stability of the

economy. Monetary theory provides insight into how to craft optimal

monetary policy.

Monetary policy is referred to as either being an expansionary policy, or a

contractionary policy, where an expansionary policy increases the total

supply of money in the economy, and a contractionary policy decreases

the total money supply. Expansionary policy is traditionally used to

combat unemployment in a recession by lowering interest rates, while

contractionary policy involves raising interest rates in order to combat

inflation. Monetary policy should be contrasted with fiscal policy, which

refers to government borrowing, spending and taxation.

Overview

Monetary policy rests on the relationship between the rates of interest in

an economy, that is the price at which money can be borrowed, and the

total supply of money. Monetary policy uses a variety of tools to control

one or both of these, to influence outcomes like economic growth,

inflation, exchange rates with other currencies and unemployment. Where

currency is under a monopoly of issuance, or where there is a regulated

system of issuing currency through banks which are tied to a central bank,

the monetary authority has the ability to alter the money supply and thus

influence the interest rate (in order to achieve policy goals). The beginning

of monetary policy as such comes from the late 19th century, where it was

used to maintain the gold standard.

There are several monetary policy tools available to achieve these ends:

increasing interest rates by fiat; reducing the monetary base; and

increasing reserve requirements. All have the effect of contracting the

money supply; and, if reversed, expand the money supply.

The primary tool of monetary policy is open market operations. This

entails managing the quantity of money in circulation through the buying

and selling of various credit instruments, foreign currencies or

commodities. All of these purchases or sales result in more or less base

currency entering or leaving market circulation.

The other primary means of conducting monetary policy include: (i)

Discount window lending (i.e. lender of last resort); (ii) Fractional deposit

lending (i.e. changes in the reserve requirement); (iii) Moral suasion (i.e.

cajoling certain market players to achieve specified outcomes); (iv) "Open

mouth operations" (i.e. talking monetary policy with the market).

The advancement of monetary policy as a pseudo scientific discipline has

been quite rapid in the last 150 years, and it has increased especially

rapidly in the last 50 years. Monetary policy has grown from simply

increasing the monetary supply enough to keep up with both population

growth and economic activity. It must now take into account such diverse

factors as:

Short term interest rates;

Long term interest rates;

Velocity of money through the economy;

Exchange rates;

Credit quality;

Bonds and equities (corporate ownership and debt);

Government versus private sector spending/savings;

International capital flows of money on large scales;

Financial derivatives such as options, swaps, futures contracts, etc.

MONEY SUPPLY, MONEY DEMAND, AND MONETARY

EQUILIBRIUM:
In the long run, the overall level of prices adjusts to the level at which the

demand for money equals the supply.

Money Supply, Money Demand, and

the Equilibrium Price Level
Value of Price
Money (1/P) Money supply
Level (P)
(High) 1 1 (Low)

3/4 1.33
value of money

price level
Equilibrium
1/2 2
Equilibrium

1/4 4
Money
demand
(Low) 0 (High)
Quantity fixed Quantity of
by the Fed Money

The Effects of Monetary Injection

Value of Price
Money (1/P) MS1 MS2
Level (P)
(High) 1 1. An increase 1 (Low)
in the money
supply...
3/4 1.33
2. ...decreases the
value of money ...

3. …and increases
the price level

A
1/2 2

B
1/4 4
Money
demand
(Low) 0 (High)
M1 M2 Quantity of
Money

Trends in central banking:

The central bank influences interest rates by expanding or contracting the

monetary base, which consists of currency in circulation and banks'

reserves on deposit at the central bank. The primary way that the central
bank can affect the monetary base is by open market operations or sales

and purchases of second hand government debt, or by changing the

reserve requirements. If the central bank wishes to lower interest rates, it

purchases government debt, thereby increasing the amount of cash in

circulation or crediting banks' reserve accounts. Alternatively, it can lower

the interest rate on discounts or overdrafts (loans to banks secured by

suitable collateral, specified by the central bank). If the interest rate on

such transactions is sufficiently low, commercial banks can borrow from

the central bank to meet reserve requirements and use the additional

liquidity to expand their balance sheets, increasing the credit available to

the economy. Lowering reserve requirements has a similar effect, freeing

up funds for banks to increase loans or buy other profitable assets.

A central bank can only operate a truly independent monetary policy

when the exchange rate is floating. If the exchange rate is pegged or

managed in any way, the central bank will have to purchase or sell foreign

exchange. These transactions in foreign exchange will have an effect on the

monetary base analogous to open market purchases and sales of

government debt; if the central bank buys foreign exchange, the monetary

base expands, and vice versa. But even in the case of a pure floating

exchange rate, central banks and monetary authorities can at best "lean

against the wind" in a world where capital is mobile.

Accordingly, the management of the exchange rate will influence domestic

monetary conditions. In order to maintain its monetary policy target, the

central bank will have to sterilize or offset its foreign exchange operations.
For example, if a central bank buys foreign exchange (to counteract

appreciation of the exchange rate), base money will increase. Therefore, to

sterilize that increase, the central bank must also sell government debt to

contract the monetary base by an equal amount. It follows that turbulent

activity in foreign exchange markets can cause a central bank to lose

control of domestic monetary policy when it is also managing the

exchange rate.

In the 1990s, central banks began adopting formal, public inflation targets

with the goal of making the outcomes, if not the process, of monetary

policy more transparent. In other words, a central bank may have an

inflation target of 2% for a given year, and if inflation turns out to be 5%,

then the central bank will typically have to submit an explanation.

Types of monetary policy:

In practice, all types of monetary policy involve modifying the amount of

base currency (M0) in circulation. This process of changing the liquidity of

base currency through the open sales and purchases of (government-

issued) debt and credit instruments is called open market operations.

Constant market transactions by the monetary authority modify the

supply of currency and this impacts other market variables such as short

term interest rates and the exchange rate.

The distinction between the various types of monetary policy lies

primarily with the set of instruments and target variables that are used by

the monetary authority to achieve their goals.

Monetary Target Market

Long Term Objective:
Policy: Variable:
 Inflation Interest rate on A given rate of change in the
Targeting overnight debt CPI
Price Level Interest rate on
A specific CPI number
Targeting overnight debt
Monetary The growth in money A given rate of change in the
Aggregates supply CPI
Fixed Exchange The spot price of the
The spot price of the currency
Rate currency
Low inflation as measured by
Gold Standard The spot price of gold
the gold price
Usually unemployment + CPI
Mixed Policy Usually interest rates
change

The different types of policy are also called monetary regimes, in parallel

to exchange rate regimes. A fixed exchange rate is also an exchange rate

regime; The Gold standard results in a relatively fixed regime towards the

currency of other countries on the gold standard and a floating regime

towards those that are not. Targeting inflation, the price level or other

monetary aggregates implies floating exchange rate unless the

management of the relevant foreign currencies is tracking the exact same

variables.

Monetary aggregates:

In the 1980s, several countries used an approach based on a constant

growth in the money supply. This approach was refined to include

different classes of money and credit (M0, M1 etc). This approach is also

sometimes called monetarism.

While most monetary policy focuses on a price signal of one form or

another, this approach is focused on monetary quantities.

Fixed exchange rate:

This policy is based on maintaining a fixed exchange rate with a foreign

currency. There are varying degrees of fixed exchange rates, which can be

ranked in relation to how rigid the fixed exchange rate is with the anchor

nation.

Under a system of fiat fixed rates, the local government or monetary

authority declares a fixed exchange rate but does not actively buy or sell

currency to maintain the rate. Instead, the rate is enforced by non-

convertibility measures (e.g. capital controls, import/export licenses, etc.).

In this case there is a black market exchange rate where the currency trades

at its market/unofficial rate.

Under a system of fixed-convertibility, currency is bought and sold by the

central bank or monetary authority on a daily basis to achieve the target

exchange rate. This target rate may be a fixed level or a fixed band within

which the exchange rate may fluctuate until the monetary authority

intervenes to buy or sell as necessary to maintain the exchange rate within

the band. (In this case, the fixed exchange rate with a fixed level can be

seen as a special case of the fixed exchange rate with bands where the

bands are set to zero.)

Under a system of fixed exchange rates maintained by a currency board

every unit of local currency must be backed by a unit of foreign currency

(correcting for the exchange rate). This ensures that the local monetary
base does not inflate without being backed by hard currency and

eliminates any worries about a run on the local currency by those wishing

to convert the local currency to the hard (anchor) currency.

Under dollarization, foreign currency (usually the US dollar, hence the

term "dollarisation") is used freely as the medium of exchange either

exclusively or in parallel with local currency. This outcome can come

about because the local population has lost all faith in the local currency,

or it may also be a policy of the government (usually to rein in inflation

and import credible monetary policy).

These policies often abdicate monetary policy to the foreign monetary

authority or government as monetary policy in the pegging nation must

align with monetary policy in the anchor nation to maintain the exchange

rate. The degree to which local monetary policy becomes dependent on the

anchor nation depends on factors such as capital mobility, openness, credit

channels and other economic factors.

Managed Float:

Officially, the Indian Rupee (INR) exchange rate is supposed to be 'market

determined'. In reality, the Reserve Bank of India (RBI) trades actively on

the INR/USD with the purpose of controlling the volatility of the Rupee -

US Dollar exchange rate - within a narrow bandwidth. (i.e. pegs it to the

US Dollar Other rates - like the INR/Pound or the INR/JPY - have

volatilities which reflect the volatilities of the US/Pound and the US/JPY

respectively.

The pegged exchange rate is accompanied by an elaborate system of

capital controls.

- On the current account, there are no currency conversion restrictions

hindering buying or selling foreign exchange (though trade barriers do

exist).

- On the capital account, "foreign institutional investors" have

convertibility to bring money in and out of the country and buy securities

(subject to an elaborate maze of quantitative restrictions).

- Local firms are able to take capital out of the country in order to expand

globally.

- Local households have quantitative restrictions (which are being relaxed

in recent times) in their ability to do global diversification. (Example while

local firms can buy real estate - individuals may not). However they are

able to purchase items (mainly consumer items - say a laptop) and services

reasonably freely (there are quantitative restrictions). Most of these

transactions happen through credit cards through the internet.

Owing to an enormous expansion of the current account and the capital

account, India is increasingly moving into de facto convertibility. However

- it still cannot be considered a fully convertible currency.

The INR is not a highly traded currency - beyond India. It is traded by way

of Forwards through inter bank transactions. ( again the US Dollar

exchange rate determines the INR / other Crosses exchange rate )

As any currency traded in the international market - the INR does trade at

a market determined premium / discount for the forward months.

Gold standard:

The gold standard is a system in which the price of the national currency

as measured in units of gold bars and is kept constant by the daily buying

and selling of base currency to other countries and nationals. (i.e. open

market operations, cf. above). The selling of gold is very important for

economic growth and stability.

The gold standard might be regarded as a special case of the "Fixed

Exchange Rate" policy. And the gold price might be regarded as a special

type of "Commodity Price Index".

Mixed policy

In practice, a mixed policy approach is most like "inflation targeting".

However some consideration is also given to other goals such as economic

growth, unemployment and asset bubbles.

This type of policy was used by the Federal Reserve in 1998.

Monetary policy tools:

Monetary base

Monetary policy can be implemented by changing the size of the monetary

base. This directly changes the total amount of money circulating in the

economy. A central bank can use open market operations to change the

monetary base. The central bank would buy/sell bonds in exchange for
hard currency. When the central bank disburses/collects this hard currency

payment, it alters the amount of currency in the economy, thus altering the

monetary base.

Reserve requirements

The monetary authority exerts regulatory control over banks. Monetary

policy can be implemented by changing the proportion of total assets that

banks must hold in reserve with the central bank. Banks only maintain a

small portion of their assets as cash available for immediate withdrawal;

the rest is invested in illiquid assets like mortgages and loans. By changing

the proportion of total assets to be held as liquid cash, the Federal Reserve

changes the availability of loanable funds. This acts as a change in the

money supply.

Discount window lending

Many central banks or finance ministries have the authority to lend funds

to financial institutions within their country. By calling in existing loans or

extending new loans, the monetary authority can directly change the size

of the money supply.

Interest rates

The contraction of the monetary supply can be achieved indirectly by

increasing the nominal interest rates. Monetary authorities in different

nations have differing levels of control of economy-wide interest rates. In

the United States, the Federal Reserve can set the discount rate, as well as

achieve the desired Federal funds rate by open market operations. This

rate has significant effect on other market interest rates, but there is no
perfect relationship. In the United States open market operations are a

relatively small part of the total volume in the bond market.

In other nations, the monetary authority may be able to mandate specific

interest rates on loans, savings accounts or other financial assets. By raising

the interest rate(s) under its control, a monetary authority can contract the

money supply, because higher interest rates encourage savings and

discourage borrowing. Both of these effects reduce the size of the money

supply.

Currency board

A currency board is a monetary arrangement which pegs the monetary

base of a country to that of an anchor nation. As such, it essentially

operates as a hard fixed exchange rate, whereby local currency in

circulation is backed by foreign currency from the anchor nation at a fixed

rate. Thus, to grow the local monetary base an equivalent amount of

foreign currency must be held in reserves with the currency board. This

limits the possibility for the local monetary authority to inflate or pursue

other objectives. The principal rationales behind a currency board are

three-fold:

(i) To import monetary credibility of the anchor nation;

(ii) To maintain a fixed exchange rate with the anchor nation;

(iii) To establish credibility with the exchange rate (the currency board

arrangement is the hardest form of fixed exchange rates outside of

dollarisation).

In theory, it is possible that a country may peg the local currency to more

than one foreign currency; although, in practice this has never happened

(and it would be a more complicated to run than a simple single-currency

currency board).

Monetary policy theory

It is important for policymakers to make credible announcements and

degrade interest rates as they are non- important and irrelevant in

regarding to monetary policies. If private agents (consumers and firms)

believe that policymakers are committed to lowering inflation, they will

anticipate future prices to be lower than otherwise (how those expectations

are formed is an entirely different matter; compare for instance rational

expectations with adaptive expectations). If an employee expects prices to

be high in the future, he or she will draw up a wage contract with a high

wage to match these prices. Hence, the expectation of lower wages is

reflected in wage-setting behaviour between employees and employers

(lower wages since prices are expected to be lower) and since wages are in

fact lower there is no demand pull inflation because employees are

receiving a smaller wage and there is no cost push inflation because

employers are paying out less in wages.

In order to achieve this low level of inflation, policymakers must have

credible announcements; that is, private agents must believe that these
announcements will reflect actual future policy. If an announcement about

low-level inflation targets is made but not believed by private agents,

wage-setting will anticipate high-level inflation and so wages will be

higher and inflation will rise. A high wage will increase a consumer's

demand (demand pull inflation) and a firm's costs (cost push inflation), so

inflation rises. Hence, if a policymaker's announcements regarding

monetary policy are not credible, policy will not have the desired effect.

If policymakers believe that private agents anticipate low inflation, they

have an incentive to adopt an expansionist monetary policy (where the

marginal benefit of increasing economic output outweighs the marginal

cost of inflation); however, assuming private agents have rational

expectations, they know that policymakers have this incentive. Hence,

private agents know that if they anticipate low inflation, an expansionist

policy will be adopted that causes a rise in inflation.

Consequently, (unless policymakers can make their announcement of low

inflation credible), private agents expect high inflation. This anticipation is

fulfilled through adaptive expectation (wage-setting behaviour); so, there

is higher inflation (without the benefit of increased output). Hence, unless

credible announcements can be made, expansionary monetary policy will

fail.

Announcements can be made credible in various ways. One is to establish

an independent central bank with low inflation targets (but no output

targets). Hence, private agents know that inflation will be low because it is

set by an independent body. Central banks can be given incentives to meet

their targets (for example, larger budgets, a wage bonus for the head of the

bank) in order to increase their reputation and signal a strong commitment

to a policy goal. Reputation is an important element in monetary policy

implementation. But the idea of reputation should not be confused with

commitment. While a central bank might have a favorable reputation due

to good performance in conducting monetary policy, the same central

bank might not have chosen any particular form of commitment (such as

targeting a certain range for inflation).

SPENDING MULTIPLIER
The multiplier effect refers to the idea that an initial spending rise can lead

to an even greater increase in national income. In other words, an initial

change in aggregate demand can cause a further change in aggregate

output for the economy.

The multiplier effect is a tool used by governments to restimulate

aggregate demand. This can be done in a period of recession or economic

uncertainty. The money invested by a government creates more jobs,

which in turn will mean more spending and so on.

For example: a company spends $1 million to build a factory. The money

does not disappear, but rather becomes wages to builders, revenue to

suppliers etc. The builders will have higher disposable income as a result,

so consumption, hence aggregate demand will rise as well. Say that all of

these workers combined spend $2 million dollars in total, since there was
an initial $1 million input which created a $2 million output, the multiplier

is 2.

Another example is when a tourist visits somewhere they need to buy the

plane ticket, catch a taxi from the airport to the hotel, book in at the hotel,

eat at the restaurant and go to the movies or tourist destination. The taxi

driver needs petrol (gasoline) for his cab, the hotel needs to hire the staff,

the restaurant needs attendants and chefs, and the movies and tourist

destinations need staff and cleaners.

It must be noted that the extent of the multiplier effect is dependent upon

the marginal propensity to consume and marginal propensity to import.

Also that the multiplier can work in reverse as well, so an initial fall in

spending can trigger further falls in aggregate output.

The basic formula for the economic multiplier, in macroeconomics, is ,

or the change in equilibrium GDP divided by the change in investment

(i.e. the initial increase in spending).

VELOCITY OF MONEY
The velocity of money is the average frequency with which a unit of

money is spent in a specific period of time. Velocity affects the amount of

economic activity associated with a given money supply. When the period

is understood, the velocity may be present as a pure number; otherwise it

should be given as a pure number over time. In the equation of exchange,

velocity of money is one of the key variables determining inflation.

If, for example, in a very small economy, a farmer and a mechanic, with

just $50 between them, buy goods and services from each other in just

three transactions over the course of a year

 Mechanic buys $40 of corn from farmer.

 Farmer spends $50 on tractor repair.

 Mechanic spends $10 on barn cats from farmer

Then $100 changed hands in course of a year, even though there is only

$50 in this little economy. That $100 level is possible because each dollar

was spent an average of twice a year, which is to say that the velocity was

2 / yr.

In practice, attempts to measure the velocity of money are usually indirect:

Where is the velocity of money for all transactions. is the nominal

value of aggregate transactions. is the total amount of money in

circulation on average in the economy.

A rise or fall in the velocity of money usually follows a rise or fall in the

interest rate. As applied to an economy expenditures on final output are of

interest, the relation may be written:

Where
 is the velocity for transactions counting towards national domestic

product. is national domestic product.

 INFLATION AND ECONOMIC POLICIES
UNIT IV

P.S.VENKATESWARAN

INFLATION AND UNEMPLOYMENT

Inflation is another important indicator of the economy. Inflation is the

continuing rise in the overall price level of an economy. Inflation, in large

part, guides government policy. Long-term inflation can be a major

problem. Inflation is almost always existent, the price level is constantly

rising, but in a sustained economy, the inflation rate is stable. There are

multiple indices for measuring inflation and none are completely up-to-

date and accurate, they give an accurate enough picture of inflation. These

indices allow us to adjust our production numbers. (Say we produce 1

trillion monetary units worth of stuff the first year and produce 1.5 trillion

the next, since the price level has risen and our production really hasn't,

we may only have really produced 1.2 trillion relative to the first year.) It is

important to distinguish between the real figures and nominal figures.

Inflation is the rise in price level and people set the prices, so the inflation

is caused by people thinking that raising prices will get them more of the

output. There are two types of inflation.

► Demand-pull inflation is inflation initiated by an increase in

aggregate demand.

► Cost-push, or supply-side, inflation is inflation caused by an

increase in costs.
1. DEMAND-PULL INFLATION

Demand-pull inflation is caused by great demand and a scarcity of

supply. When there is

scarcity, based on the laws of

supply and demand, prices

go up. People are willing to

pay more for a needed

product or needed labor.

Thus, prices go up and

workers' wages go up;

people are willing to charge

more for everything.

Demand-pull inflationary

markets are at full

employment.

Demand pull factors

- monetary factors

- Increase in

government spending,

given tax revenue

- Cut in tax rate without change in government expenditure

- Upward shift in investment function

- Downward shift in saving function

 - Upward shift in export function

- Downward shift in import function

2. COST-PUSH INFLATION

The second type is cost-push inflation. Unlike in demand-pull inflationary

economies, cost-push economies may not have surplus demand. However,

certain groups have the ability to force their own prices up, therefore

forcing those who buy their products to raise their own prices. Both of

these forces combine to form inflationary pressures on an economy. One is

often supplemented by the other. People also raise their prices to keep up

with the inflation they project will occur. However, the inflation is

unexpected sometimes and people struggle to catch up by setting their

prices higher.

Inflation has the effect of

moving wealth from those who

don't raise their prices to those

who do. If workers increase

their demands for payment,

they get more money, so they

can pay for the increased prices

of the companies. However, if

someone could not raise their prices, they lose wealth. Inflation can make it

hard for people to judge prices, as it's hard for them to constantly readjust

themselves to shifting price levels. When inflation goes out of control and

expectations of inflation rise, inflation can potentially wreck an economy.

Cost Push factors

- wage push

- Profit push

- Supply shock

Stagflation occurs when output is falling at the same time that prices are

rising.

- One possible cause

of stagflation is an

increase in costs.

Hyperinflation is

inflation of 100% or more.

Large inflation causes

people to spend their

money quickly and not

save it for future

investment (because that

money wouldn't be able

to buy much soon). This

kind of severe inflation can destroy confidence in the economy in general.

Inflation and unemployment are interrelated to each other. When a

country encourages rapid growth and unemployment goes down, this

could trigger massive inflation as a result of excess demand and cost-pull

as explained above. But if a country wants to cut down on inflation, the

cost is often the increase in unemployment and lack of growth.

Impact of Inflation:

 Distribution of income and wealth

 The rich get richer and poor get poorer

 Loss to fixed income earners

 Gains to profit earners

 Gains to the debtors

 Loss to the creditor

 Loss to wage earners

 Government

 Economic growth

 Employment

KEYNESIAN VIEW OF INFLATION

As opposed to the Classics, who view inflation as a problem of ever-

increasing money supply, Keynesians concentrate on the institutional

problems of people increasing their price levels. Keynesians argue that

firms raise wages to keep their workers happy. Firms then have to pay for

that and keep making a profit by subsequently raising the prices. This

causes an increase in both wages and prices and demands an increase of

money supply to keep the economy running. So, the government then
issues more and more money to keep up with inflation. This differs from

the classical model. Classics view changing money supply as affecting

inflation while Keynesians view inflation as the cause of changing money

supply.

► The key to the classical view of inflation was the Quantity Theory of

Money .

► This theory revolved around the Fisher Equation of Exchange :

MV = PT

where:

 M is the amount of money in circulation

 V is the velocity of circulation of that money

 P is the average price level and

 T is the number of transactions taking place

► He argued that increases in the money supply would not inevitably

lead to increases in inflation.

► Increasing M may instead lead to a decrease in V.

► In other words the average speed of circulation of money would fall.

► Alternatively, the increase in M may lead to an increased in T

(number of transactions), because as we have seen Keynes disputes

the assumption that the economy will find its own equilibrium.

► It may be in a position where there is insufficient demand for full-

employment equilibrium, and in that case increasing the money

 supply will fund extra demand and move the economy closer to full

employment.

► Keynesians tend to argue that inflation is more likely to be cost-push

inflation or demand-pull inflation.

EXPECTATIONS AND INFLATION

If every firm expects every other firm to raise prices by 10%, every firm

will raise prices by about 10%. This is how expectations can get “built into

the system.”

• In terms of the AD/AS diagram, an increase in inflationary

expectations shifts the AS curve to the left.

Money and Inflation:

An increase in G with the money

supply constant shifts the AD curve

from AD0 to AD1. This leads to an

increase in the interest rate and

crowding out of planned investment

If the Fed tries to prevent crowding, it

will increase the money supply and

the AD curve will shift farther and

 farther to the right. The result is a sustained inflation, possibly

hyperinflation.

Costs of Inflation: Almost everyone thinks inflation is evil, but it isn't

necessarily so. Inflation affects different people in different ways. It also

depends on whether inflation is anticipated or unanticipated. If the

inflation rate corresponds to what the majority of people are expecting

(anticipated inflation), then we can compensate and the cost isn't high. For

example, banks can vary their interest rates and workers can negotiate

contracts that include automatic wage hikes as the price level goes up.

Problems arise when there is unanticipated inflation:

• Creditors lose and debtors gain if the lender does not anticipate inflation

correctly. For those who borrow, this is similar to getting an interest-free

loan.

• Uncertainty about what will happen next makes corporations and

consumers less likely to spend. This hurts economic output in the long run.

• People living off a fixed-income, such as retirees, see a decline in their

purchasing power and, consequently, their standard of living.

• The entire economy must absorb reprising costs ("menu costs") as price

lists, labels, menus and more have to be updated.

• If the inflation rate is greater than that of other countries, domestic

products become less competitive.

People like to complain about prices going up, but they often ignore the

fact that wages should be rising as well. The question shouldn't be whether

inflation is rising, but whether it's rising at a quicker pace than your

wages. Finally, inflation is a sign that an economy is growing. In some

situations, little inflation (or even deflation) can be just as bad as high

inflation. The lack of inflation may be an indication that the economy is

weakening.

How Is It Measured?

Measuring inflation is a difficult problem for government statisticians. To

do this, a number of goods that are representative of the economy are put

together into what is referred to as a "market basket." The cost of this

basket is then compared over time. This results in a price index, which is

the cost of the market basket today as a percentage of the cost of that

identical basket in the starting year.

There are two main price indexes that measure inflation:

• Consumer Price Index (CPI) - A measure of price changes in consumer

goods and services such as gasoline, food, clothing and automobiles. The

CPI measures price change from the perspective of the purchaser.

• Producer Price Indexes (PPI) - A family of indexes that measure the

average change over time in selling prices by domestic producers of goods

and services. PPIs measure price change from the perspective of the seller.

INFLATION GAP
An inflationary gap is the amount by which the real Gross domestic

product exceeds potential GDP. The real GDP is also known as GDP

"adjusted for inflation", "constant prices" GDP because it measures the

aggregate output in a country's income accounts in a given year, expressed

in base-year prices. On the other hand, the potential GDP is the quantity of

real GDP when a country's economy is at full-employment.

When an initial increase in aggregate demand produces inflation (so called

demand-pull inflation) and real GDP increase, the price level and real GDP

are determined at the point where the new aggregate demand and the

short-run aggregate supply meet. This point is known as above full-

employment equilibrium, since the short-run aggregate supply is above

the long-term aggregate supply, i.e. above the aggregate supply at full

employment.

The gap created between real

GDP and potential GDP is the

consequence of inflation and

that is why it is called the

inflationary gap.

Obviously, this situation

cannot last forever, because

there is a shortage of labour.

The shortage of labour

produces the rise of wage rates,

which makes the short-run

aggregate supply decrease, until it reaches the full-employment level. The

short-run aggregate supply decrease makes an upward pressure on the

price level, consequently causing inflation. The once created gap between

real GDP and potential GDP was the sign of forthcoming inflation and that

is why it is called the inflationary gap.

Deflationary Gap:
Economic term describing the situation when Gross Domestic Product is

below its full-employment level. In theory, such a situation would lead to

the existence of unemployed resources, which should lead to falling prices

(deflation) for those resources as the unemployed ones compete in the

market.

• The output of the economy cannot exceed the maximum output of

YF.

• The difference between planned aggregate expenditure and

aggregate output at full capacity is sometimes referred to as an

inflationary gap.

DEFLATIONARY POLICIES

► Deflationary policies to dampen down the level of economic activity

might include:

= Reducing the level of government expenditure

= Increasing taxation (either direct or indirect) to discourage

spending

= Increasing interest rates to discourage saving

= Reducing money supply growth

 ► The first two policies would be considered contractionary fiscal

policies,

► The second two are contractionary monetary policies.

► The impact of them should be to reduce aggregate demand and

therefore the level of output.

► The diagram below shows this:

• The initial level of aggregate demand was inflationary – prices were

increasing rapidly.

• However, the deflationary policies have reduced demand to AD2

and thus reduced the level of inflation.

MEASURES TO CONTROL INFLATION

Monetary Measures
- Bank rate policy
- Variable reserve ratio
- Open market operation
- Statutory liquidity ration
- Moral suasion
- Selective credit controls
Fiscal Measures
- Cut down in public expenditure
- Tax policy
Price and Wage Control
- Price control
- Wage control
- Indexation

EMPLOYMENT

Unemployment is used as a major indicator of how well an economy is

doing, along with capacity utilization rate, a measure of how much we are

using our production potential compared to what is possible. A 4 or 5

percent unemployment rate and 85 percent capacity utilization rate are

roughly the target rates. These target numbers are numbers we try to

reach, but not exceed. Exceeding them, pushing the economy too fast,

would let the smallest mistake trigger a catastrophic collapse of the whole

economy (which is like what happened during the depression of the

1930's).

In the problem of unemployment, two type of unemployment exist:

cyclical and structural. Cyclical unemployment is caused by the

downturns and upturns of the ever-shifting economy. When economies go

down, business activity declines and people lose jobs. When economies

goes up, people get hired. Structural unemployment is caused by changes

in how the economy works. For example, industrialization initially caused

a massive loss of jobs, because machines replaced people. However, as

industrial employment declined, service employment increased. The U.S.

economy, for example, is an economy fueled primarily by workers that

provide services rather than manufacture things.

The Industrial Revolution, by moving people to fixed-wage jobs (you

never got 'fired' off of a farm in the old days, because if the year's

production was bad, you just reaped less crops), introduced these

economic situations. At first, unemployment in industrial societies meant

having nothing and to avoid starving to death, one had to find another job.

However, under the new economic systems. In pure capitalism, as earlier

stated, the government practiced laissez-faire and did not intefere in

economic activities. However, most modern economies are a melding of

capitalist and socialist ideas to form welfare capitalism, a system in which

governments significantly regulate the otherwise free market.

Governments try to maintain their economies at full employment, meaning

that anyone who wanted a job could have one. Full employment does not

mean that everyone had a job. There are a few people who voluntarily quit

their jobs and there are people who are not eligible to hold jobs (prison

inmates, etc.). The target level of full employment has been constantly

shifting, but the idea remains the same. This type of voluntary

unemployment is called frictional unemployment.

Unemployment is another area of debate between Classical and Keynesian

economists. Classical economists generally believe that unemployment is

the individual's problem, and those who are unemployed are not trying

hard enough. Thus, all unemployment is frictional unemployment.

Keynesian economists believe that society should always be able to offer

individuals jobs. Because of these discrepancies, the real unemployment

numbers may not be totally accurate. Some people are working, just not

officially registered anywhere, some are going off work for a while

because they feel like it. The unemployment figures may also not be

completely representative because they break down when the statistics are

shown for various demographic groups: gender, race, age, etc.

The Natural Rate of Unemployment

The Natural Rate

of Unemployment

is the rate of

Unemployment

when the Labour

market is in

equilibrium.

It is the difference

between those

who would like a job at the current wage rate and those who are willing

and able to take a job.

The Natural Rate of Unemployment will therefore include:

 Frictional unemployment

 Structural unemployment

E.g. a worker who is not able to get a job because he doesn’t have the right

skills.
Therefore the natural rate of unemployment is unemployment caused by

supply side factors rather than demand side factors. Monetarists argue that

the Natural Rate of Unemployment occurs when the Long Run Phillips

Curve crosses the x axis.

The Natural Rate of Unemployment is sometimes known as the

Non accelerating inflation rate of Unemployment NAIRU

This is because when unemployment is 4% there is no tendency for

inflation to increase.

In this example the Natural rate of unemployment is 4%. If the govt

increased AD there may be a temporary fall in unemployment but in the

Long Run it would return to the natural rate of 4% .

Sometimes the natural rate is known as the full employment level of

unemployment.

This is because even if the economy is operating at full capacity and there

is no demand deficient unemployment then there will still be some

unemployment caused by supply side factors.

What Determines the Natural Rate of Unemployment:

1. M. Freidman argued the Natural rate of unemployment would be

determined by institutional factors such as:

Availability of job information. A factor in determining frictional

unemployment

Skills and Education. The quality of Education and retraining schemes

will influence the level of occupational mobilities.

Degree of labour mobility

Flexibility of the labour market E.g. powerful trades unions may be able

to restrict the supply of labour to certain labour markets

Hysteresis. A rise in unemployment caused by a recession may cause the

natural rate of unemployment to increase. This is because when workers

are unemployed for a time period they become deskilled and demotivated

and are less able to get new jobs.

THE PHILLIPS CURVE

► A.W.Phillip 1958, London School of

Economics

► Relationship between

unemployment and the changes in

money wage rates in British

economy during the period 1861-

1957

► Phillips found inverse relationship between the rate of change in money

wages and rate of unemployment

► There exist tradeoff between the rate of unemployment and rate of

increase in money wages i.e. lower rate of unemployment can be

achieved only by allowing money wage rate to increase

When economists look at inflation and unemployment in the short term,

they see a rough inverse correlation between the two. When

unemployment is high, inflation is low and when inflation is high,

unemployment is low. This has presented a problem to regulators who

want to limit both. This relationship between inflation and unemployment

is the Phillips curve. The short term Phillips curve is a declining one.

This is a rough estimation of a short-term Phillips curve. As you can see,

inflation is inversely related to unemployment. The long-term Phillips

curve, however, is different. Economists have noted that in the long run,

there seems to be no correlation between inflation and unemployment.

Aggregate Demand, Aggregate Supply, and Monetary and Fiscal

Policy
• AD can shift to the right for a

number of reasons, including an

increase in the money supply, a

tax cut, or an increase in

government spending.

• Expansionary policy works well

when the economy is on the flat

portion of the AS curve, causing

little change in P relative to the

output increase.

• On the steep portion of the AS curve,

expansionary policy does not work well. The

multiplier is close to zero.

• When the economy is operating near full

capacity, an increase in AD will result in an

increase in the price level with little increase in

output.
Long-Run Aggregate Supply and Policy Effects:

• If the AS curve is

vertical in the long run,

neither monetary

policy nor fiscal policy

has any effect on

aggregate output.

• In the long run, the

multiplier effect of a

change in government

spending or taxes on

aggregate output is zero.

FISCAL POLICY
Fiscal policy is one concept strongly advocated by Keynes. After all,

Keynesian economists are those who support government regulation.

Fiscal policy, then, is government regulation of its own spending and taxes

to influence a country's economy. Fiscal policy works as government

spending and taxes can provide an initial shock to the economy that

triggers adjustments. Increasing taxes, for example, would cut down on

people's disposable income and slow the economy in an effort control it.

On the other hand, lowering taxes can give people more money to spend

and thus provide a boon to the economy. Increasing government

spending, too, can give suppliers an incentive to increase production and

thus increase income.

There are two types of fiscal policy, depending on what the goal is.

Expansionary fiscal policy means an increase in overall spending in the

economy is represented by an upward shift of the expenditures graph. On

the other hand, contractionary fiscal policy is represented by a downward

shift of the consumption graph. Using mathematical and graphical

analysis, it's possible to predict the affects of government fiscal policy. As

the graph of expenditures shifts up and down, we can find the point of

intersection with the production graph to find the new equilibrium

income.
Fiscal Policy Can Be Divided In Two Types

FISCAL
POLICY

Flexible policy Non-flexible

Policy

To cure Recession To Control Inflation Personal Income

taxes

Increase in Govt Raising Taxes to Transfer Payments

Expenditure Control Inflation

Reduction of taxes Disposing of Budget Corporate Income

Surplus taxes

Corporate Dividend
policy
 I) DISCRETIONARY (flexible) FISCAL POLICY FOR

STABILISATION

Fiscal policy is an important instrument to stabilises the economy, that is,

to overcome recession and control inflation in the economy. By

discretionary policy we mean deliberate change in the Government

expenditure and taxes to influence the level of national output and prices.

Fiscal policy generally aims at managing aggregate demand for goods and

services. To cure recession expansionary fiscal policy and to control

inflation contractionary fiscal policy is adopted.

A) Fiscal Policy to cure recession:

The recession occurs when aggregate demand decreases due to fall in

private investment. Private investment may fall when businessmen

become highly pessimistic about making profits in future, resulting in

decline in marginal efficiency of investment. A fall in private investment

expenditure, aggregate demand curve shifts down creating a deflationary

or recessionary gap.

There 2 fiscal methods to get the economy out of recession.

 Increase in Government Expenditure.

 Reduction of taxes.

i) Increase in Government Expenditure to Cure Recession:

This is the important tool to cure depression. Government may increases

expenditure by starting public works, such as buildings roads, dams, ports

telecommunication links, irrigation works electrification of new areas etc.

Government buys various types of goods and materials and employs

workers. The effect of this increase in expenditure is both direct and

indirect. The direct effect is the increase in incomes of those who sell

materials and supply labour for these projects. The output of these public

works also goes up together with the increase in incomes, and for those

who get more income they spend further on consumer goods depending

on their marginal propensity to consumer. This creates the multiplier. As

during the period of recession there exists excess capacity in the consumer

good industries, the increase in demand for them bring about expansion in

their output which further generates employment and incomes for the

unemployed workers and so the new income are spent and serpent further

and the process of multiplier goes on working till it exhausts itself.

ii) Reduction in Taxes to Overcome Recession: The reduction in taxes

increases the disposable income of the society and causes the increase in

consumption spending by the people. If tax reduction of Rs.200 crores is

made by the Finance Minister, it will lead to Rs.1520 crores in

consumption, assuming marginal propensity t6o consume is 0.75 or ¾.

Thus reduction in taxes will cause an upward shift in the consumption

function. It is worth nothing that reduction in taxes has only an indirect

effect on expansion and output through causing a rise in consumption

function. Like the increase in government expenditure, the increase in the

consumption achieved through reduction in tax will have a multiple effect

on increasing income, output and employment.

Example: -There is some instances in history of capitalist world, especially

USA when taxes were reduced to stimulate the economic. In 1964,the

President Kennedy reduce personal and business tax by about $12 billion

to give a boost to the American economy when there was high

unemployment and lower capacity utilization in American economy. This

tax cut was quiet successful in reducing unemployment substantially at

expanding national Income through full utilization of excess capacity.

Again, over the period 1981-84, president Reagan made a very large tax

reduction to get out of recession and to achieve expansion in National

Income to reduce unemployment. However, tax reduction by President

Reagan play a significant role for bringing about the recovery.

B) Fiscal Policy to Control inflation:

When due to large increases in consumption demand by the households or

investment expenditure by the entrepreneurs, or biggest budget deficit

caused by too large an increase in Government Expenditure, aggregate

demand increases beyond what the economy can potentially produce by

fully employing its given resources, it gives rise to the situation of excess

demand which results in inflationary pressures in the economy.

This inflationary situation can also arise if too large an increase in money

supply in the economy occurs. In these circumstances inflationary gap

occurs which tend to bring about rise in prices. If to check the emergence

of successful steps exceeds demands or close the inflationary gap are not

taken, the economy will experience a period a period of inflation or rising

prices. For the last few decades, both the developed and developing

countries of the world have faced problems of demand-pull inflation. Both

have faced an alternative way of looking at inflation is to view it from the

angles of business cycles.

After recovery from recession, when during upswing an economy finds

itself in conditions of boom and become overheated prices start rising

rapidly. Under such circumstances anti cyclical fiscal policy calls for

reduction in aggregate demand. Thus fiscal policy measures to control

inflation are

1) Reducing Government expenditure and;

2) Increasing tax

If in the beginning the government is having balanced budget, then

increasing taxes while keeping government expenditure constant will

yield budget surplus. The creation of budget surplus will cause downward

shift in aggregate demand curve and will therefore help in easing pressure

on prices. If there is a balanced budget to begin with and the government

reduces its expenditure, say on defense, subsidies transfer payments, while

keeping taxes constant, this will also create budget surplus and result in

removing excess demand in the economy.

i) Raising Taxes to Control Inflation: As an alternative to reduction in

Government expenditure, the taxes can be increased to reduce aggregate

demand .For these purpose especially personal direct taxes such as income

tax, wealth tax, corporate tax can be raised. The hike in taxes reduces the

disposable in the comes of the people and thereby force them to reduce

their consumption demand

ii) Disposal of Budget Surplus: the government either reduces its

expenditure or raises taxes to lower aggregate demand for goods and

services. Reduction in expenditure or hike in taxes results in decrease in

budget deficits {if occurring before such step} or in the emergency of the

budge serapes if the government was having balances budget prior to the

adoption of anti-inflationary fiscal policy measures. Assume that anti-

inflationary fiscal policy results in budget surplus. Anti-inflationary

impact of budget surplus depends to a good extent on hoe the government

disposes of this budget surplus.

There are two ways in which budget surplus can be disposed of: -

1) Reducing Or Retiring Public Debt: The budget surplus created by Anti-

inflationary policy can be use by the government pay back the outstanding

debt. However, using budget surplus for retiring public debt will weaken

its anti-inflationary effect. In plying of the debt of held by the public the

government will be returning the money to the public which it has

collected through taxes. Further, this will also add to the money supply

with public. General public will spend a part of the money so received,

which will raise consumption demand. Beside, retiring of public debt will

result in the expansion of money supply in the money market, which will

tend to lower the rate of interest. The lower rate of interest will stimulate

consumption and investment demand while anti-inflationary policy

requires that they should be reduced.

2) Impounding Public Debt: - To realize a large anti-inflationary effect of

budget surplus it is desirable to impound the surplus fund. The

impounding surplus fund means that they should be kept idle. Thus by

impounding the budget surplus, the government shall be withdrawing

some income or purchasing power from the income-expenditure stream

and thus will not create any inflationary pressure to offset the deflationary

impact of the budget. To conclude, the impounding of the budget surplus

is the better method of disposing of budget surplus than of paying of

public debt.

II) NON_DISCRETIONARY FISCAL POLICY: AUTOMATIC

STABILIZERS

There is an alternative to use of discretionary fiscal policy, which generally

involves the problem of, large in recognizing the problem of recession or

inflation and large of the taking appropriate action to tackle the problem.

In this Non-discretionary fiscal policy, the tax structure and expenditure

are so designed that taxes and government spending vary automatically

inappropriate direction with the changes in National Income. That is, these

taxes and expenditure pattern without any special deliberate action by the

government and parliament automatically raise aggregate demand in

times of recession and reduce aggregate demand in times of boom and

inflation and there by help in insuring economic stability. These fiscal

measures are therefore called automatic stabilizers or built-in stabilizers.

Since these automatic stabilizers do not require any fresh deliberate policy

action or legislation by the government, they represent non-discretionary

fiscal policy. Built-in-stability of tax revenue and government expenditure

of transfer payment of subsidies is created because they vary with national

income. These taxes and expenditure automatically bring about

appropriate change in aggregate demand and reduce the impact to

recession and inflation that might occur in an economy at sometimes. This

means that because of existence of this automatic or built-in-stabilizers

recession and inflation will be shorter and less intense than otherwise is

the case. Important automatic fiscal stabilizes compensation, welfare

benefits corporate dividends.

 Below are some taxes and revenue from which varies directly with

the change in national income:

1) Personal Income Taxes: -The tax rate structure is so designed that

revenue from these taxes directly varies with income. Moreover, personal

income taxes have progressive rates: The higher rates are changed are from

the upper income brackets. As a result, when national income increases

during expansion and inflation, increasing percentage op the people’s

income is paid to the government. Thus, through causing a decline in their

disposable income this taxes automatically reduce people’s consumption

and therefore aggregate demand. This decline n aggregate demand

because of imposition of progressive personal income tax tender’s to check

inflation from becoming more severe. On the other hand, when national

income decline’s at times of recession, the tax revenue declines as well

which prevent aggregate demand from falling by same proportion as the

decline in income.

2) Corporate Income Taxes: -Companies, or corporations as they are called

now, also pay a percentage of their profits as tax to the Government. Like
personal income taxes, corporate income tax rate is also generally higher at

higher levels of corporate profits. As recession and inflation affect

corporate taxes greatly, they have a powerful stabilizing effect on

aggregate demand; the revenue from them rises greatly during inflation

and boom which tends to reduce aggregate demand, and revenue from

them falls greatly during recession which tends to offset the decline in

aggregate.

3) Transfer payments: Unemployment compensation and welfare benefits:

When there is recession and as a result unemployment increases, the

Government has to spend more on compensation for unemployment and

other welfare programmes such as food stamps, rent-subsidies to farmers.

This hike in Government expenditures tends to make recession short-lived

and less intense. On the other hand, when at times of boom and inflation

national income increases and therefore unemployment falls, the

government curtails its programme of social benefit, which results in

lowering government expenditure. The smaller spending by the

government help to control inflation.

4) Corporate Dividend Policy: With economic fluctuation, corporate

profits also rise and fall. However, corporations do not so quickly increase

or reduce dividend in turn with fluctuation in profits and follow a fairly

stable dividend policy. This permit the individuals to spend more during

recession and spend less then would have the case if dividends were

lowered in time of recession and raised in condition of boom and inflation.

Thus, fairly stable dividends tend to cushion recession and curb inflation

by stabilizing consumption.

Limitations of fiscal policy

1. Formulation of an appropriate fiscal policy requires reliable

forecasting of the target variables, like GNP, consumption,

investment and its determinants, technological changes, and so on.

But no one has yet discovered a foolproof method of economic

forecasting.’

2. The Overall effect of changes in the policy instruments, like, changes

in government spending and taxation is determined by the rate of

dynamic multiplier. Forecasting the multiplier is in itself an

extremely difficult task and a time consuming process. Therefore, by

the time the full impact of one policy change is realized, economic

conditions change necessitating another change in the fiscal policy.

3. A decision and execution lag in case of discretionary fiscal policy

makes both working and efficacy of fiscal policy shrouded with

uncertainty.

4. Working and effectiveness of fiscal policy in underdeveloped

countries is severely limited by a) low levels of income, b) small

proportion of population in taxable income groups, c) existence of

large non - monetized sector, d) all pervasive corruption and

inefficiency in administration, especially in tax collection machinery.

5. Countries which are excessively dependent on fiscal policy for their

economic management, the governments are often forced to have

 recourse to internal and external borrowings and deficit financing.

Excessive borrowings take such countries close to debt trap and

deficit financing beyond the absorption capacity of the economy

accelerates the pace of inflation, which further creates other control

problems.

Evaluation / Criticism of Fiscal Policy

1. Disincentives of Tax Cuts. Increasing Taxes to reduce AD may

cause disincentives to work, if this occurs there will be a fall in

productivity and AS could fall. However higher taxes do not

necessarily reduce incentives to work if the income effect dominates.

2. Side Effects on Public Spending. Reduced govt spending to

Increase AD could adversely effect public services such as public

transport and education causing market failure and social

inefficiency.

3. Poor Information Fiscal policy will suffer if the govt has poor

information. E.g. If the govt believes there is going to be a recession,

they will increase AD, however if this forecast was wrong and the

economy grew too fast, the govt action would cause inflation.

4. Time Lags. If the govt plans to increase spending this can take along

time to filter into the economy and it may be too late.Spending plans

are only set once a year. There is also a delay in implementing any

changes to spending patterns.

5. Budget Deficit Expansionary fiscal policy (cutting taxes and

increasing G) will cause an increase in the budget deficit which has

many adverse effects.Higher budget deficit will require higher taxes

in the future and may cause crowding out (see below

6. Other Componenets of AD. If the governmentt uses fiscal policy its

effectiveness will also depend upon the other components of AD, for

example if consumer confidence is very low, reducing taxes may not

lead to an increase in consumer spending.

7. Depends on Multiplier And change in injections may be increased

by the multiplier effect, therefore the size of the multiplier will be

significant.

8. Crowding Out Increased Govt spending (G) to increased AD may

cause “Crowding out” Crowding out occurs when increased

government spending results in decreasing the size of the private

sector.

 For example if the govt increase spending it will have to increase

taxes or sell bonds and borrow money, both method reduce private

consumption or investment. If this occurs AD will not increase or

increase only very slowly.

 Also Classical economists argue that the govt is more inefficient in

spending money than the private sector therefore there will be a

decline in economic welfare

  Increased government borrowing can also put upward pressure on

interest rates. To borrow more money the interest rate on bonds may

have to rise, causing slower growth in the rest of the economy.

9. Monetarist Critique. Monetarists argue that in the LR AS is inelastic

therefore an increase in AD will only cause inflation to increase

Differences in the Effectiveness of Monetary and Fiscal Policies

When the economy is in a recession (when business and consumer

confidence is very low and perhaps where deflationary pressures are

taking hold) monetary policy may be ineffective in increasing current

national spending and income. The problems experienced by the Japanese

in trying to stimulate their economy through a zero-interest rate policy

might be mentioned here. In this case, fiscal policy might be more effective

in stimulating demand. Other economists disagree – they argue that short

term changes in monetary policy do impact quite quickly and strongly on

consumer and business behavior. Consider the way in which domestic

demand in both the United States and the UK has responded to the interest

rate cuts introduced in the wake of the terror attacks on the USA in the

autumn of 2001

However, there may be factors which make fiscal policy ineffective aside

from the usual crowding out phenomena. Future-oriented consumption

theories hold that individuals undo government fiscal policy through

changes in their own behavior – for example, if government spending and

borrowing rises, people may expect an increase in the tax burden in future

years, and therefore increase their current savings in anticipation of this.

BALANCE OF PAYMENTS
The World Economic Outlook (WEO, IMF October 2007) observed that the

recent expansionary phase in the global economy, with average growth of

5 per cent, was the longest since the early 1970s. The WEO update on

January 2008 has, however, revised these estimates based on new PPP

exchange rates from the 2005 international comparison programme (ICP).

There is considerable uncertainty in quantifying the downside risk to

global growth arising from the downturn in housing market and the sub-

prime mortgage market crisis in the United States.

Monetary policy actions by the United States and other developed

countries seem to have contained its immediate impact, though more

surprises in the next six months cannot be ruled out.

The Indian economy has been progressively globalizing since the initiation

of reforms. Trade, an important dimension of global integration, has risen

steadily as a proportion of GDP. Inward FDI has taken off and there is a

surge in outward investment from a very low base, with net FDI

continuing to grow at a good pace. The surge of capital flows in 2007-08 is

a third indicator that testifies to the growing influence of global

developments on the Indian economy.

Capital flows, as a proportion of GDP, have been on a clear uptrend

during this decade. They reached a high of 5.1 per cent of GDP in 2006-07

after a below trend attainment of 3.1 per cent in 2005-06. This is a natural
outcome of the improved investment climate and recognition of robust

macroeconomic fundamentals like high growth, relative price stability,

healthy financial sector and high returns on investment. Even as the

external environment remained conducive, the problem of managing a

more open capital account with increasing inflows and exchange rate

appreciation surfaced.

The current account has followed an inverted V shaped pattern during the

decade, rising to a surplus of over 2 per cent of GDP in 2003-04. Thereafter,

it has returned close to its post-1990s reform average, with a current

account deficit of 1.2 per cent in 2005-06 and 1.1 per cent of GDP in 2006-

07. The net result of these two trends has been a gradual rise in reserve

accumulation to over 5 per cent of GDP in 2006-07. With capital inflows

exceeding financing requirements, foreign exchange reserve accumulation

was of the order of US$ 15.1 billion in 2005-06 and US$ 36.6 billion in 2006-

07. Thus, the rupee faced upward pressure in the second half of 2006-07.

Despite this, the rupee depreciated by 2.2 per cent on an overall yearly

average basis. The excess of capital inflows has risen to 7.7 per cent of GDP

in the first half of 2007-08. Foreign exchange reserves increased by US$

91.6 billion to US$ 290.8 billion on

February 8, 2008.

Components of Capital Account

The composition of capital flows is also changing. Among the components

of capital inflows, foreign investment has been a relatively stable

component, fluctuating broadly between 1 per cent and 2 per cent of GDP
during this decade. However, it seems to have shifted to a higher plane

from 2003-04 with the average for 2003-04 to 2006-07 roughly double that

during 2000-01 to 2002-03. The relative stability of investment flows is

primarily due to steadily rising FDI. In contrast, debt flows have fluctuated

much more, with net outflows in the three years to 2003-04. The variations

in debt flows have been primarily due to lumpy repayments on

government guaranteed or related ECB. The ratio of debt flows to GDP

was on a down trend till 2003-04 and a rising trend from 2004-05. Debt

flows, primarily external commercial borrowings, shot up on a net basis in

2006-07 to a level of US$ 16.2 billion. The trend in net capital flows since

2003-04, therefore, seems to be broadly driven by the rising ratio of debt

flows.

The most welcome feature of increased capital flows is the 150 per cent

increase in net foreign direct investment inflows in 2006-07 to US$ 23

billion. The trend has continued in the current financial year with gross

FDI inflows reaching US$ 11.2 billion in the first six months. FDI inflows

were broad-based and spread across a range of economic activities like

financial services, manufacturing, banking services, information

technology services and construction. With FDI outflows also increasing

steadily over the last five years, overall net flows (FDI balance in Bop)

have grown at a slower rate.

The globalization of Indian enterprises and planting of the seeds for the

creation of Indian multinationals have taken place in the last few years.
Outward investment from India shot up to US$ 14.4 billion in 2006-07 from

less than US$ 2 billion in the period 2003-04. The trend continued in the

current year with outward investment of US$ 7.3 billion in April-

September 2007. Net FDI flows were, therefore, a modest US$ 3.9 billion

during this period. The proportion of payments to receipts under FDI into

India was in the range of 0.7 per cent to 0.4 per cent in 2005-06 and 2006-07,

respectively. This indicates the lasting and stable nature of FDI flows to

India.

Increased volatility in Asian and global financial markets in 2006-07

affected the flow of portfolio investment. Net portfolio flows became

negative in May-July 2006 (reflecting the slump in equity markets), picked

up momentum in August-November 2006, only to slow again in March

2007. Net flows were, therefore, only US$ 7.1 billion in 2006-07 compared

to US$ 12.1 billion in 2005-06. Euro equities, which were a relatively minor

component of portfolio flows (less than a billion US dollars in the period

1997-98 to 2004-05), rose to US$ 3.8 billion in 2006-07 constituting 54.3 per

cent of the total net portfolio flows. Net portfolio investment inflow was

US$ 18.3 billion in April-September 2007, more than double the inflow

during 2006-07. Underlying these were gross

Inflows of $ 83.4 billion and outflows of US$ 65.0 billion.

The rapid accretion of reserves and increased pressure on the rupee

necessitated raising the limit on the market stabilization fund. The

annualized return on the multi-currency, multi asset portfolio of the RBI

was 4.6 per cent in 2006-07, indicating that the effective fiscal cost of

sterilization may be 3.2 per cent. The fiscal costs of sterilization in 2007-08

are placed at Rs. 8,200 crore. The search for an appropriate policy mix for

balancing a relatively open capital account, monetary policy independence

and flexible exchange rate continues.

Current account components

The current account deficit (CAD) mirrors the saving-investment gap in

the national income accounts and thus constitutes net utilized foreign

savings. The challenge is to leverage foreign inflows (i.e. foreign savings

and investment) to promote growth without having the long-term

consequences of external payment imbalances. The distinction between

gross capital inflows and net inflows is useful. As the latter must equal the

CAD, there is no way in which net use of foreign saving can increase

without an increase in the CAD. The gross inflow can, however, increase to

the extent that it is offset by gross outflows in the form of build-up of

foreign exchange reserves, reduction in government external debt or

outward investment by entrepreneurs. Higher gross inflows have value

even if net flows do not increase to the same extent, as they can improve

competition in the real and financial sectors, improve the quality of

intermediation and the average productivity of investment, and thus raise

the growth rate of the economy. The challenge for policy is to maximize

these benefits while minimizing the costs of exchange rate management.

The rise and fall of the current account balance (as a ratio to GDP) during

this decade has been driven largely by the goods and services (G&S) trade
balance, with the two having virtually the same pattern. The surplus from

factor income including remittances, which fluctuated between 2 per cent

and 3 per cent of GDP, has helped moderate the substantial deficit on the

trade account. Both the trade (G&S) balance and the factor surplus

improved between 2000-01 and 2003-04 leading to an improvement of the

current account. Both reversed direction thereafter resulting in a declining

trend in the current account. The peak values of the three as a proportion

of GDP were -0.6 per cent, 2.9 per cent and 2.3 per cent. In the past two

years the current account deficit, trade (G&S) deficit and factor surplus

have averaged 1.15, 3.5 and 2.35 per cent of GDP, respectively. 1.51 The

trends in the goods and services trade deficit have in turn been largely

driven by the merchandise trade deficit since 2004-05. During 2000-01 to

2003-04 the merchandise trade deficit was around 2 per cent of GDP and

the rising services surplus resulted in an improving trend in the overall

G&S trade balance. From 2004-05 the merchandise trade balance has been

deteriorating and despite the continued rise in the services surplus, the

overall G&S balance had followed the deteriorating trend of the former.

Private transfer receipts (mainly remittances) shot up by 49.2 per cent in

2007-08 (April-September) over the first half of 2006-07 when they had

increased by 19.2 per cent. Investment income (net), which reflects the

servicing costs on the payments side and return on foreign currency assets

(FCA) on the receipts side, grew by 60 per cent in 2007-08 (April-

September) reflecting the burgeoning foreign exchange reserves. Net

invisible surplus grew by 35.2 per cent to reach US$ 31.7 billion in 2007-08
(April-September), equivalent of 6.1 per cent of GDP. Thus, higher

invisible surplus was able to moderate partly the higher and rising deficits

on trade account. CAD was, therefore, placed at US$ 10.7 billion in 2007-08

(April-September), equivalent of 2 per cent of GDP for the half year.

External trade

India’s greater integration with the world economy was reflected by the

trade openness indicator, the trade to GDP ratio, which increased from

22.5 per cent of GDP in 2000-01 to 34.8 per cent of GDP in 2006-07. If

services trade is included, the increase is higher at 48 per cent of GDP in

2006-07 from 29.2 per cent of GDP in 2000-01, reflecting greater degree of

openness.

1.54 India’s merchandise exports and imports (in US$, on customs basis)

grew by 22.6 per cent and 24.5 per cent respectively in 2006-07, recording

the lowest gap between growth rates after 2002-03. Petroleum products

(59.3 per cent) and engineering goods (38.1 per cent) were the fastest

growing exports. The perceptible increase in share of petroleum products

in total exports reflected India’s enhanced refining capacity and higher

POL prices. The rising share of engineering goods reflected improved

competitiveness. The value of POL imports increased by 30 per cent, with

volume increasing by 13.8 per cent and prices by 12.1 per cent in 2006-07.

Non-POL import growth at 22.2 per cent was due to the 29.4 per cent

growth of gold and silver and 21.4 per cent growth of non-POL non-

bullion imports needed to meet industrial demand. In the first nine

months of the current year, exports reached US$111 billion, nearly 70 per
cent of the year’s export target. During April-September 2007, the major

drivers of export growth were petroleum products, engineering goods and

gems and jewellery. Machinery and instruments, transport equipment and

manufactures of metals have sustained the growth of engineering exports.

There was a revival of the gems and jewellery sector with export growth at

20.4 per cent for April-September 2007, after a deceleration in 2006-07.

Imports grew by 25.9 per cent during April-December 2007 due to non-

POL imports growth of 31.9 per cent, implying strong industrial demand

by the manufacturing sector and for export activity. The merchandise

trade deficit in April-December 2007 at US$ 57.8 billion was very close to

the trade deficit of US$ 59.4 billion for 2006-07 (full year). Despite the large

overall trade deficit, there was a large (but declining) trade surplus with

the United States and UAE, and a small surplus with the United Kingdom

and Singapore (till 2006-07). The surplus with the first three has continued

in 2007-08. The largest trade deficits are with Saudi Arabia, China and

Switzerland. The trade deficit with China has increased further in April-

September 2007-08.

Balance of Payments Equilibrium

In a floating exchange rate the supply of currency will always equal the

demand for currency, and the balance of payments is 0.

Therefore if there is a deficit on the current account there will be a surplus

on the financial account.

If there was an increase in interest rates this would cause hot money flows

to enter into the UK, therefore there would be a surplus on the financial

account

The appreciation in the exchange rate would make exports less

competitive and imports more competitive therefore with less X and more

M there would be a deficit on the current account

Factors which cause a current account Deficit in the balance of Payments

Fixed Exchange Rate

If the currency is overvalued, imports will be cheaper and therefore there

will be a higher Q of imports. Exports will become uncompetitive and

therefore there will be a fall in the Quantity of exports.

Economic Growth

If there is an increase in AD and National Income increases, people will

have more disposable income to consume goods. If domestic producers

can not meet the domestic AD, consumers will have to imports goods from

abroad. In the UK we have a high Marginal propensity to imports mpm

because we do not have a comparative advantage in the production of

manufactured goods. Therefore if there is fast economic growth there

tends to be a big increase in imports.

Decline in Competitiveness.

IN the UK there has been a decline in the exporting manufacturing sector,

because it has struggled to compete with developing countries in the far

east. This has led to a persistent deficit in the balance of trade.

Higher inflation
This makes exports less competitive and imports more competitive.

However this factor may be offset by a decline in the value of sterling.

Recession in other countries.

If India’s main trading partners experience negative economic growth then

they will buy less of our exports, worsening the current account.

Borrowing money

If countries are borrowing money to invest e.g third world countries

Deterioration in the current account

This means that the value of exports has increased at a slower rate than the

value of imports. Therefore there could have been an increase in the deficit

or the surplus could have changed into a deficit

Policies to reduce a balance of Payments Deficit

1. Devaluation.

This involves lowering the value of the currency against others.

 If there is a devaluation in the currency the price of importing

French goods increases and therefore the quantity demanded falls.

 Exports will be cheaper in price for the French and will increase the

quantity of exports

 Therefore we would expect a devaluation to lead to an improvement

in the current account. However it does depend upon the elasticity

of demand for exports and imports.

The Marshall Learner Condition

This states that a devaluation will improve the balance on the current

account,

on the condition that the combined elasticity’s of demand for imports and

exports is greater than one.

· If (PED x + PED m > 1) then a devaluation will improve current account

· If (PED x + PED m > 1) then an appreciation will worsen current account

· This is because the effect on the current account depends on the total

value and not just the quantity of exports.

The J Curve effect:

In short term demand for imports and exports tends to be inelastic.

Therefore current account tends to get worse before it gets better.

· Another problem with devaluation is that it can lead to imported

inflation. This is a problem if it leads to cost push inflation. This means the

improvement in the current account might only be temporary.

2. Deflation

If govt reduces AD by raising interest rates or increasing taxes then people

will have less money to spend so they reduce consumption of imports.

· The UK has a high mpm therefore a reduction in AD improves the

current account significantly

· Deflationary policies will also put pressure on manufacturers to reduce

costs and this will lead to more competitive exports and so exports will

increase

· The success of this policy depends on the elasticity of demand for imports
· However this policy will conflict with other macroeconomic objectives

With lower AD, growth is likely to fall causing higher unemployment

3. Supply Side Policies

These can improve the competitiveness of the economy and exporters, but

this will take time to have effect

4. Protectionism

Increased tariffs of quotas will reduce imports and improve the current acc

However :

1) Protectionism leads to retaliation so exports will decrease

2) Domestic industries may become uncompetitive, because there is no

incentive.

EXIM POLICY.
The foreign trade of India is guided by the Export- Import policy of the

Government of India. Regulated by The Foreign Trade Development and

Regulation Act 1992. Exim policy contains various policy decisions with

respect to import and exports from the country. Exim Policy is prepared

and announced by the central government. Exim Policy of India aims to

developing export potential, improving export performance, encouraging

foreign trade and creating favorable balance of payment position.

General Objectives of Exim Policy:

To establish the framework for globalization to promote the

productivity competitiveness of Indian Industry.

To encourage the attainment of high and internationally accepted

standards of quality.
 To augment export by facilitating access to raw material,

intermediate, components, consumables and capital goods from the

international market.

To promote internationally competitive import substitution and self-

reliance.

Exim Policy of India 2004-2009

Hon. Shri Kamal Nath minister for commerce and industry has announced

on 31 st Aug 2004, India’s first Exim policy. The duration of the policy

from 1st t Sept. 2004 to 31st March 2009..It takes an integrated view of the

overall development of India’s foreign trade. Aim of the policy is to double

the global merchandise trade within the policy time period of 5 years.

Objectives of Exim Policy 2004-2009. \

To double our percentage of share of global merchandise trade

within the five year.

To act as an effective instrument of economic growth by giving a

thrust to employment generation.

Highlights of the New Foreign Trade Policy 2004-2009

Special Focus Initiatives: Semi-urban and Rural Area

Agriculture : Vishesh Krishi Upaj Yojana and Agri Export Zones

Handlooms and Handicrafts: Mark under Market Access Initiatives

Scheme and Proposed to start new SEZ.

Gems and Jewellery: Import of gold of 18 carat and above has been

permitted under the replenishment scheme been permitted under the

replenishment Leather and Footwear: Duty free import entitlement of

specified items shall be 5% of FOB value of exports during the preceding

year

Export Promotion Schemes Assistance to States for Infrastructure

Development of Exports [ASIDE] Exports

Market Access Initiative [MAI]

Marketing Development Assistance [MDA]

Towns of Export Excellence Towns of

Target plus Scheme.

Served from India Scheme

Service Export Promotion Council Service

Board of Trade: The role is to advising government on relevant issues

connected with Foreign Trade.

Implications of the Foreign Trade 2004-09.

Implications on Indian Economy: This policy propose to simplify

procedures and develop technology and infrastructure.

 Implications on Agriculture: Special Agricultural Produce Scheme

has been introduced for promoting the export of fruits, vegetables,

flowers, and their value added products.

Implications on Handlooms and Handicraft: Establishment of

Handicraft SEZ and Handicraft Export Promotion Council would

promote development of Handloom and Handicraft Industry.

Implications on Gem and Jewellery Sector: This is special thrust area

in this policy. Duty free imports of other inputs would give a further

boost to this sector to.

Implications on Leather and Footwear Industry: Duty free import as

a specified percentage of exports. – Exemption on customs duty on

equipment for effluent treatment plants would help promoting

export form this sector.

Implications on Service Industry: – An exclusive service promotion

council has been set up in order to map the opportunities for key

services in key market. Develop strategic market access programmes

like brand building in co-ordination with sectoral players and

recognize nodal bodies of the service industry.

Annual Supplement to Foreign Trade Policy 2004-09

Minister for Commerce and Industry, Government of India has announced

annual Supplement 2005, to the Foreign Trade Policy 2004-09 on the 8 th

April 2005.

Highlights of the Supplement

Inter State Trade Council: To engage the State Government in providing

an enabling environment for boosting international trade, by setting up an

Inter State Trade Council.

Removal of Export Cess: Proposed to abolish cess on export of all

agricultural and plantation commodities levied under various Commodity

Board Acts. Export Promotion Capital Goods Scheme (EPCG: This

scheme is extended to Agricultural sector, SSI sector, Retail Sectors in

order to promote exports from them.

Service Export: To upgrade infrastructure in the service related

companies.

Agri Export: Benefits under ‘Vishesh Krishi Upaj Yojana’ have been

extended to exports of poultry and dairy products in addition to export of

flowers, fruits, vegetables and their value added products

Package for Marine Sector: Duty free import of specified specialized

chemicals and flavoring oils as per a defined list shall be allowed to the

extent of 1% of FOB value of preceding financial years export.

Advance Licensing Scheme: The Scope of Advance License for annual

requirement has been extended to all categories of exporters having past

export performance

Duty Free Replenishment Certificate: Brass scrap, Additives, paper

board, and dye stuff have been removed from the list of items prescribed

for import under DFRC.

Procedural Simplification:
Proposed to simplify procedures and reduce the documentation

requirements so as to reduce the transaction cost of the exporters and

thereby increase their competitiveness.

EDI Initiatives: DGFT shall introduce an automated electronic system for

filing, retrieval and authentication of documents based on agreed

protocols and message exchange with other authorities such including

Customs and banks.

Negative List of Exports 2002-07

The negative list consists of goods, the import or export of which is ether

prohibited, restricted through licensing or otherwise to be canalized

through a designate government agency.. The negative list of exports, as

per the EXIM Policy 2002-07

Prohibited Items:

Which items completely banned from the exports.

All forms of wild animals including their parts and products.

 Special Chemicals as notified by the DGFT.

 Exotic birds as notified by the DGFT.

 Beef

 Sea Shells,

 as specified Human Skeleton.

 Peacock

 Tail Red sanders wood in any form.

Restricted Items:

Which items allowed for exports under special license issued by the DGFT.
  Dress materials, ready-made garments, fabrics or textile items with

imprints of excerpts or verses of the Holy Quran

 Horses – Kathiawadi, Marwari, and Manipuri breeds.

 Fresh and frozen silver prom frets of weight less than 300gm.

 Paddy (Rice in husk).Seaweeds of all types.

 Chemical Fertilizer all types.

Canalized Items:
Can be exported without an export license through designated State

Trading Enterprise through designated State Trading E

Freely Exportable Items: can be exported without an export license from

DGFT. However export of such items is subject to certain procedures or

conditions.
 INTERNATIONAL TRADE UNIT V

P.S.VENKATESWARAN

International trade is the exchange of goods and services across

international boundaries or territories. In most countries, it represents a

significant share of GDP.

Risks in international trade

The risks that exist in international trade can be divided into two major

groups:

Economic risks

• Risk of insolvency of the buyer,

• Risk of protracted default - the failure of the buyer to pay the amount

due within six months after the due date

• Risk of non-acceptance

• risk of Exchange rate

Political risks

• Risk of cancellation or non-renewal of export or import licenses

• War risks

• Risk of expropriation or confiscation of the importer's company

• Risk of the imposition of an import ban after the shipment of the

goods

• Transfer risk - imposition of exchange controls by the importer's

country or

foreign currency shortages.

If countries specialize in the production of certain goods and then trade

with other countries there will be an increase in economic welfare.

Countries will specialize in those goods where they have a comparative

advantage

Absolute Advantage:

This occurs when one country can produce a good with less resources than

another. E.G. if USA can produce cars with lower cost than the UK the

USA has an absolute advantage in producing cars.

Comparative Advantage:

A country has a comparative advantage over another in the production of

a good if it can produce it at a lower opportunity cost:

i.e. it has to forego less of other goods in order to produce it.

The Law of Comparative advantage

This states that trade can benefit all countries if they specialise in the goods

in which they have a comparative advantage.

INDIA’S FOREIGN TRADE

A. EXPORTS (including re-exports)

Exports during May, 2007 were valued at US $ 11861.28 million which was

18.07 % higher than the level of US $ 10045.99 million during May, 2006. In

rupee terms, exports touched Rs. 48371.98 crore, which was 6.04% higher

than the value of exports during May, 2006. Cumulative value of exports

for the period April-May, 2007 was US$ 22436.39 million (Rs. 92944.16
Crore) as against US$ 18639.50 million (Rs. 84243.20 Crore) during the

same period last year.

Export goods textile goods, gems and jewelry, engineering goods,

chemicals, leather manufactures, services
Main export partners US 18%, the People's Republic of China 8.9%, UAE
8.4%, UK 4.7%, Hong Kong 4.2% (2005)

B. IMPORTS
Imports during May, 2007 were valued at US $ 18077.81 million

representing an increase of 26.36 % over the level of imports valued at US

$ 14306.76 million in May, 2006. In Rupee terms, imports increased by

13.49 %. Cumulative value of imports for the period April-May, 2007 was

US$ 35713.14 million (Rs. 148053.58 Crore) as against US$ 26841.29 million

(Rs. 121304.73 Crore) during the same period last year

Import goods crude oil, machinery, gems, fertilizer, chemicals

Main import partners the People's Republic of China 7.2%, US 6.4%,
Belgium 5.1%, Singapore 4.7%, Australia 4.2%, Germany 4.2%, UK 4.1%

C.CRUDE OIL AND NON-OIL IMPORTS:

Oil imports during May, 2007 were valued at US $ 4740.29 million which

was 2.99% lower than oil imports valued at US $ 4886.44 million in the

corresponding period last year. Oil imports during April-May, 2007 were

valued at US$ 9165.20 million which was 1.01% higher than the oil imports

of US$ 9073.62 million in the corresponding period last year.

Non-oil imports during May, 2007 were estimated at US $ 13337.52 million

which was 41.58 % higher than growth on non oil imports of US$ 9420.32

million in May, 2006. Non-oil imports during April-May, 2007 were valued

at US$ 26547.94 million which was 49.42% higher than the level of such

imports valued at US$ 17767.67 million in April-May, 2006.

D. TRADE BALANCE

The trade deficit for April-May, 2007 was estimated at US $ 13276.75

million which was higher than the deficit at US $ 8201.79 million during

April-May, 2006.

Benefits of Free Trade.

1. The theory of comparative advantage.

This explains that by specialising in goods where countries have a lower

opportunity cost, there can be an increase in economic welfare for all

countries.

2. Reducing Tariff barriers leads to trade creation

Trade creation occurs when consumption switches from high cost

producers to low cost producers

 The removal of tariffs leads to lower prices for consumers and an

increase in consumer surplus

  Imports will increase

 The govt will lose tax revenue

 Domestic firms producing this good will sell less and lose producer

surplus

 However overall there will be an increase in economic welfare

 The magnitude of this increase depends upon the elasticity of

supply and demand. If demand elastic consumers will have a big

increase in welfare

3. Increased Exports.

As well as benefits for consumers importing goods, firms exporting goods

where the UK has a comparative advantage will also see a big

improvement in economic welfare. Lower tariffs on UK exports will enable

a higher quantity of exports boosting UK jobs and economic growth.

4. Economies of Scale:

If countries can specialise in certain goods they can benefit from economies

of scale and lower average costs, this is especially true in industries with

high fixed costs or that require high levels of investment. The benefits of

economies of scale will ultimately lead to lower prices for consumers.

5. Increased Competition.

With more trade domestic firms will face more competition from abroad

therefore there will be more incentives to cut costs and increase efficiency.

It may prevent domestic monopolies from charging too high prices.

6. Trade is an engine of growth.

World trade has increased by an average of 7% since the 1945, causing this

to be one of the big contributors to economic growth.

7. Make use of surplus raw materials

Middle Eastern counties such as Qatar are very rich in reserves of oil but

without trade there would be not much benefit in having so much oil.

Japan on the other hand has very few raw material without trade it would

be very poor.

8. Tariffs may encourage inefficiency

If an economy protects its domestic industry by increasing tariffs

industries may not have any incentives to cut costs.

THE FOREIGN ‘TRADE MULTIPLIER

Assume a closed economy – one that does not engage in international

trade: Y=C+I+G

Now, subtract C and G from both sides of the equation:

Y–C–G=I

• The left side of the equation is the total income in the economy after

paying for consumption and government purchases and is called

national saving, or just saving (S).

• Substituting S for Y - C - G, the equation can be written as: S = I

• Saving represents outflow or withdrawal some money from the

income flow, while investment is the injection of some money into

the income stream.

 • The level of national income is in equilibrium (that is, circular flow

of income is constant when outflow from the income stream in the

form of savings is equal to the injection of investment expenditure.

• In an open economy, the role of foreign trade, that is, exports and

imports of a country are also to be considered.

• Imports by consumers of a country represent the expenditure on

imported goods by the residents of the country and leads to the

leakage of some income from domestic economy.

Public saving is the amount of tax revenue that the government has left

after paying for its spending.

Public saving = (T – G)

Surplus and Deficit:

– If T > G, the government runs a budget surplus because it receives

more money than it spends.

– The surplus of T - G represents public saving.

– If G > T, the government runs a budget deficit because it spends more

money than it receives in tax revenue.

– Therefore, in addition to saving, imports are other from of leakage

that occurs in an open economy.

– On the other hand, exports represent expenditure by the people of

foreign countries on the goods produced in the domestic economy

and are, like domestic investment, injection into the income stream

of an open economy.
 – Therefore, equilibrium level of national income in an open economy

is determined at the level at which total leakage,

– Savings plus imports (S + M) equal total injection, that is, domestic

investment plus exports (I + A) into the income stream.

– Thus, in an open economy, national income is in equilibrium at the

level at which

S+M= I+X

– When a change in any of the above four variables occurs, then the

change on the left side of the above equation must equal the change

on the right side if the new equilibrium.

Hence

▲S+ ▲M= ▲I+ ▲X

Now, change in saving, ▲S = s. ▲Y

Where s = marginal propensity to save and

▲Y = change in national income.

Likewise, change in imports, ▲M= m. ▲Y

Where m marginal propensity to import.

Thus, rewriting equation (1) we have

s.▲Y + m.▲Y = ▲ I + ▲ X
It will be known from equation (2) that changes in either investment or

exports will cause income to increase by the multiple, 1 / s+m. Thus 1 / s+m

is the foreign trade multiplier which is generally denoted by K f

Thus, if exports increase by ▲X the national income will rise by

▲X.1 / s + m
i.e ▲x. K f
Graphic Representation of Foreign Trade Multiplier:

Assume that there is no investment; equilibrium level of national income

will therefore be determined by consumption (saving) and exports.

How the Foreign Trade Multiplier Works?

The foreign trade multiplier works in the same way as Keynes’ investment

multiplier.

When there is increase in exports, it will cause the increase in income of

the exporters and those employed in the export industries.

They will save some of the increase in their incomes and will spend a good

part of the increases in their incomes on consumer goods, both domestic

and imported ones.

While savings do not generate further income and represent leakage from

the income stream, expenditure on imports leads to the increase in the

incomes of the foreign countries from which goods are imported.

Thus expenditure on imports also represents a leakage from the income

stream as far as domestic economy is concerned. But the increased

expenditure on domestic goods as a result of increase in exports will go on

increasing incomes till the multiplier fully works out.

It may be noted that increase in exports of a country can occur due to

several reasons. There may be change in tastes or demand of the people of

foreign countries for goods of a country.

The exporters may meet the demand for exported goods by selling their

inventories and enjoy higher incomes. But in the next periods, they will

make efforts to increase the production of exported goods and employ

more workers. This will generate new income and employment in the

export industries. But the working of multiplier does not stop here.

Those employed in export industries will spend a good part of their

increased incomes on goods produced by other industries and in this way

increases in income, production and employment will spread in the whole

of the domestic economy.

LINKAGE MODEL

Ricardian model

The Ricardian model focuses on comparative advantage and is perhaps the

most important concept in international trade theory. In a Ricardian

model, countries specialize in producing what they produce best. Unlike

other models, the Ricardian framework predicts that countries will fully

specialize instead of producing a broad array of goods.

Country Pencil Pen

1 10 5
2 4 8
Heckscher-Ohlin model
The Heckscher-Ohlin model was produced as an alternative to the

Ricardian model of basic comparative advantage. The theory argues that

the pattern of international trade is determined by differences in usage

pattern. It predicts that countries will export those goods that make

intensive use of locally plentiful and will import goods that make intensive

use that are locally scarce.

Country scarce Excess

1 wheat rice
2 rice Sugar, Wheat
3 sugar Wheat, rice

EXCHANGE RATES
 The exchange rate is the rate at which one currency trades against

another on the foreign exchange market

 If the present exchange rate is £1=$1.42 this means that to go to America

you would get $142 for £100. Similarly if an American came to the UK he

would have to pay $142 to get £100. Although in real life, the dealer would

make a profit.
 Currencies are being continuously traded on the foreign exchange

markets, with the prices constantly changing as dealers adjust to changes

in supply and demand

 Currencies will also undergo long term changes depending on the state

of the comparative countries. E.G. in the 1920s the £ was worth $4.50 Since

the launch of the EURO in 1999 it has depreciated by 25% against the

dollar.

 Exchange rate index: This gives a measure of a currency against a basket

of currencies. It is expressed as an index, where the value of the index will

be 100 in the base year.

 The weight given to each currency depends upon the proportion of

transactions done with the country. For example in the Sterling exchange

rate index the highest weighting will be given to the Euro and then the

dollar

 Real Exchange Rate. This is the exchange rate after being adjusted for the

effects of inflation, it therefore more accurately reflects purchasing power

Factors which influence the exchange rate

1. Inflation

If inflation in the UK is lower than elsewhere, then UK exports will become

more competitive and there will be an increase in demand for £s. Also
foreign goods will be less competitive and so UK citizens will supply less

£s.

Therefore the rate of £ will increase from say £1=$1.4 to $1.5

2. Interest Rates

If UK interest rates rise relative to elsewhere it will become more attractive

to deposit money in the UK, Therefore demand for Sterling will rise. This

is known as “hot money flows”. Therefore the value of sterling £ will

appreciate

3. Speculation

If speculators believe the sterling will rise in the future They will demand

more now to be able to make a profit. This increase in demand will cause

the value to rise.

Therefore movements in the exchange rate do not always reflect economic

fundamentals, but are often driven by the sentiments of the financial

markets

4. Change in competitiveness

If British goods become more attractive and competitive this will also

cause the value of the ER to rise

5. Relative strength of other currencies

Between 1999 and 2001 the £ appreciated because the Euro was seen as a

weak currency

6. Balance of Payments

A large deficit on the current account means that the value of imports is

greater than the value of exports. If this is financed by a surplus on the

financial/ capital account then this is OK. But a country who struggles to

attract enough capital inflows will see depreciation in the currency. (For

example current account deficit in US of 7% of GDP is one reason for

depreciation of dollar in 2006)

The determination of the rate of exchanges in a free market

The rate of exchange is determined by supply and demand

When a UK citizen wishes to purchase goods from US, he supplies

pounds. The higher the exchange rate the more dollars he will get for a

pound

When a US citizen wishes to purchase UK goods they supply dollars and

demand pounds.

If you are going on holiday to the US it is best if there is an appreciation in

Sterling so that you get more dollars for your £.

Economic Effects of an Appreciation

Exports more expensive, therefore less UK exports will be demanded

Imports are cheaper; therefore more imports will be bought.

A fall in AD, causing lower growth

Lower inflation because:

import prices are cheaper

Lower AD

More incentives to cut costs

Fixed Exchange Rates:

Floating Exchange Rate: this is when the govt does not intervene in the

foreign exchange market but always market forces to determine the level

of a currency

Fixed Exchange Rate: This occurs when the govt seeks to keep the value of

a currency fixed against another currency

Exchange Rate Mechanism ERM. This was a semi fixed exchange rate

where EU countries sought to keep their currencies fixed within certain

bands against the D-Mark. The ERM was the forerunner of the Euro

Problems Facing Indian Economy

1. Inflation.

Fuelled by rising wages, property prices and food prices inflation in India

is an increasing problem. Inflation is currently between 6-7%. A record

98% of Indian firms report operating close to full capacity (2) with

economic growth of 9.2% per annum inflationary pressures is likely to

increase, especially with supply side constraints such as infrastructure. The

wholesale-price index (WPI), rose to an annualised 6.6% in Janu 2007.

2. Poor educational standards.

Although India has benefited from a high % of English speakers.

(important for call centre industry) there is still high levels of illiteracy

amongst the population. It is worse in rural areas and amongst women.

Over 50% of Indian women are illiterate

3. Poor Infrastructure.
Many Indians lack basic amenities lack access to running water. Indian

public services are creaking under the strain of bureaucracy and

inefficiency. Over 40% of Indian fruit rots before it reaches the market; this

is one example of the supply constraints and inefficiency’s facing the

Indian economy.

4. Balance of Payments deterioration.

Although India has built up large amounts of foreign currency reserves the

current account deficit has deteriorate in recent months. This deterioration

is a result of the overheating of the economy. Aggregate Supply cannot

meet Aggregate demand so consumers are sucking in imports. Excluding

workers remittances India’s current account deficit is approaching 5% of

GDP

5. High levels of debt.

Buoyed by a property boom the amount of lending in India has grown by

30% in the past year. However there are concerns about the risk of such

loans. If they are dependent on rising property prices it could be

problematic. Furthermore if inflation increases further it may force the RBI

to increase interest rates. If interest rates rise substantially it will leave

those indebted facing rising interest payments and potentially reducing

consumer spending in the future

6. Inequality has risen rather than decreased.

It is hoped that economic growth would help drag the Indian poor above

the poverty line. However so far economic growth has been highly uneven

benefiting the skilled and wealthy disproportionately. Many of India’s

rural poor are yet to receive any tangible benefit from the India’s economic

growth. More than 78 million homes do not have electricity. 33%

(268million) of the population live on less than $1 per day. Furthermore

with the spread of television in Indian villages the poor are increasingly

aware of the disparity between rich and poor. (3)

7. Large Budget Deficit.

India has one of the largest budget deficits in the developing world.

Excluding subsidies it amounts to nearly 8% of GDP. Although it is fallen a

little in the past year. It still allows little scope for increasing investment in

public services like health and education.

8. Rigid labour Laws.

As an example Firms employing more than 100 people cannot fire workers

without government permission. The effect of this is to discourage firms

from expanding to over 100 people. It also discourages foreign investment.

Trades Unions have an important political power base and governments

often shy away from tackling potentially politically sensitive labour laws.

LIBERALIZATION
In general, liberalization refers to a relaxation of previous government

restrictions, usually in areas of social or economic policy. Liberalization of

autocratic regimes may precede democratization.

Liberalization and privatization

Although economic liberalization is often associated with privatization, the

two can be quite separate processes. For example, the European Union has

liberalized gas and electricity markets, instituting a system of competition;

but some of the leading European energy companies (such as EDF and

Vattenfall) remain partially or completely in government ownership.

Liberalized and privatized public services may be dominated by just a few

big companies, particularly in sectors with high capital costs, or high sunk

cost, such as water, gas and electricity. In some cases they may remain

legal monopolies, at least for some part of the market (e.g. small

consumers).

Liberalization vs Democratization

There is a distinct difference between liberalization and democratization,

which are often thought to be the same concept. Liberalization can take

place without democratization, and deals with a combination of policy and

social change specialized to a certain issue such as the liberalization of

government-held property for private purchase, whereas democratization

is more politically specialized that can arise from a liberalization, but

works in a broader level of government. Liberalisation is the process

whereby the contribution into the promotion of trade.

PRIVATIZATION
Privatization is the incidence or process of transferring ownership of

business from the public sector (government) to the private sector

(business). In a broader sense, privatization refers to transfer of any

government function to the private sector including governmental

functions like revenue collection and law enforcement.

The term "Privatization" also has been used to describe two unrelated

transactions. The first is a buyout, by the majority owner, of all shares of a

public corporation or holding company's stock, privatizing a publicly

traded stock. The second is a demutualization of a mutual organization or

cooperative to form a joint stock company.

Types of privatization:

There are three main methods of privatization:

 Share issue privatization (SIP) - selling shares on the stock market

 Asset sale privatization - selling the entire firms or part of it to a

strategic investor, usually by auction or using Treuhand model

 Voucher privatization - shares of ownership are distributed to all

citizens, usually for free or at a very low price.

Share issue privatization is the most common type of privatization. Share

issue can broaden and deepen domestic capital markets, boosting liquidity

and potentially economic growth, but if the capital markets are

insufficiently developed it may be difficult to find enough buyers, and

transaction costs (e.g. underpricing required) may be higher. For this

reason, many governments elect for listings in the more developed and

liquid markets. Euronext, and the London, New York and Hong Kong

Stock Exchanges are popular because they are highly developed and

sophisticated.

As a result of higher political and currency risk deterring foreign investors,

asset sales are more common in developing countries.

Voucher privatization has mainly been used in the transition economies of

Central and Eastern Europe, such as Russia, Poland, the Czech Republic,

and Slovakia.
Asset sale privatizations is that bidders compete to offer the state the

highest price, creating revenues for the state to redistribute in addition to

new tax revenue. Voucher privatizations, on the other hand, would be a

genuine return of the assets into the hands of the general population, and

create a real sense of participation and inclusion. Vouchers, like all other

private property, could then be sold on if preferred by what companies are

offering.

Pro-privatization

Proponents of privatization believe that private market actors can more

efficiently deliver many goods or service than government due to free

market competition. In general, it is argued that over time this will lead to

lower prices, improved quality, more choices, less corruption, less red

tape, and quicker delivery. Many proponents do not argue that everything

should be privatized; the existence of problems such as market failures and

natural monopolies may limit this. However, a small minority thinks that

everything can be privatized, including the state itself.

The basic economic argument given for privatization is that governments

have few incentives to ensure that the enterprises they own are well run.

One problem is the lack of comparison in state monopolies. It is difficult to

know if an enterprise is efficient or not without competitors to compare

against. Another is that the central government administration, and the

voters who elect them, have difficulty evaluating the efficiency of

numerous and very different enterprises.

A private owner, often specializing and gaining great knowledge about a

certain industrial sector, can evaluate and then reward or punish the

management in much fewer enterprises much more efficiently. Also,

governments can raise money by taxation or simply printing money

should revenues be insufficient, unlike a private owner.

If there are both private and state owned enterprises competing against

each other, then the state owned may borrow money more cheaply from

the debt markets than private enterprises, since the state owned

enterprises are ultimately backed by the taxation and printing press power

of the state, gaining an unfair advantage.

Privatizing a non-profitable company which was state-owned may force

the company to raise prices in order to become profitable. However, this

would remove the need for the state to provide tax money in order to

cover the losses.

Performance. State-run industries tend to be bureaucratic. A political

government may only be motivated to improve a function when its poor

performance becomes politically sensitive, and such an improvement can

be reversed easily by another regime.

Improvements. Conversely, the government may put off improvements

due to political sensitivity and special interests — even in cases of

companies that are run well and better serve their customers' needs.

Corruption. A monopolized function is prone to corruption; decisions are

made primarily for political reasons, personal gain of the decision-maker

(i.e. "graft"), rather than economic ones. Corruption (or principal-agent

issues) during the privatization process - however - can result in

significant underpricing of the asset. This allows for more immediate and

efficient corrupt transfer of value - not just from ongoing cash flow, but

from the entire lifetime of the asset stream. Often such transfers are

difficult to reverse.

Accountability. Managers of privately owned companies are accountable

to their owners/shareholders and to the consumer and can only exist and

thrive where needs are met. Managers of publicly owned companies are

required to be more accountable to the broader community and to political

"stakeholders". This can reduce their ability to directly and specifically

serve the needs of their customers, and can bias investment decisions away

from otherwise profitable areas.

Civil-liberty concerns. A company controlled by the state may have access

to information or assets which may be used against dissidents or any

individuals who disagree with their policies.

Goals. A political government tends to run an industry or company for

political goals rather than economic ones.

Capital. Privately held companies can sometimes more easily raise

investment capital in the financial markets when such local markets exist

and are suitably liquid. While interest rates for private companies are often

higher than for government debt, this can serve as a useful constraint to

promote efficient investments by private companies, instead of cross-

subsidizing them with the overall credit-risk of the country. Investment

decisions are then governed by market interest rates. State-owned

industries have to compete with demands from other government

departments and special interests. In either case, for smaller markets,

political risk may add substantially to the cost of capital.

Security. Governments have had the tendency to "bail out" poorly run

businesses, often due to the sensitivity of job losses, when economically, it

may be better to let the business fold.

Lack of market discipline. Poorly managed state companies are insulated

from the same discipline as private companies, which could go bankrupt,

have their management removed, or be taken over by competitors. Private

companies are also able to take greater risks and then seek bankruptcy

protection against creditors if those risks turn sour.

Natural monopolies. The existence of natural monopolies does not mean

that these sectors must be state owned. Governments can enact or are

armed with anti-trust legislation and bodies to deal with anti-competitive

behavior of all companies public or private.

Concentration of wealth. Ownership of and profits from successful

enterprises tend to be dispersed and diversified -particularly in voucher

privatization. The availability of more investment vehicles stimulates

capital markets and promotes liquidity and job creation.

Political influence. Nationalized industries are prone to interference from

politicians for political or populist reasons. Examples include making an

industry buy supplies from local producers (when that may be more

expensive than buying from abroad), forcing an industry to freeze its

prices/fares to satisfy the electorate or control inflation, increasing its

staffing to reduce unemployment, or moving its operations to marginal

constituencies.

Profits. Corporations exist to generate profits for their shareholders.

Private companies make a profit by enticing consumers to buy their

products in preference to their competitors' (or by increasing primary

demand for their products, or by reducing costs). Private corporations

typically profit more if they serve the needs of their clients well.

Corporations of different sizes may target different market niches in order

to focus on marginal groups and satisfy their demand. A company with

good corporate governance will therefore be incentivized to meet the

needs of its customers efficiently.

Anti-privatization
Opponents of privatization dispute the claims concerning the alleged lack

of incentive for governments to ensure that the enterprises they own are

well run, on the basis of the idea that governments are proxy owners

answerable to the people. It is argued that a government which runs

nationalized enterprises poorly will lose public support and votes, while a

government which runs those enterprises well will gain public support

and votes. Thus, democratic governments do have an incentive to

maximize efficiency in nationalized companies, due to the pressure of

future elections.

Opponents of certain privatizations believe certain parts of the social

terrain should remain closed to market forces in order to protect them

from the unpredictability and ruthlessness of the market (such as private

prisons, basic health care, and basic education). Another view is that some

of the utilities which government provides benefit society at large and are

indirect and difficult to measure or unable to produce a profit, such as

defense. Still another is that natural monopolies are by definition not

subject to competition and better administrated by the state.

The controlling ethical issue in the anti-privatization perspective is the

need for responsible stewardship of social support missions. Market

interactions are all guided by self-interest, and successful actors in a

healthy market must be committed to charging the maximum price that

the market will bear. Privatization opponents believe that this model is not

compatible with government missions for social support, whose primary

aim is delivering affordability and quality of service to society.

Many privatization opponents also warn against the practice's inherent

tendency toward corruption. As many areas which the government could

provide are essentially profitless, the only way private companies could, to

any degree, operate them would be through contracts or block payments.

In these cases, the private firm's performance in a particular project would

be removed from their performance, and appropriation and dangerous

cost cutting measures might be taken to maximize profits.

Some would also point out that privatizing certain functions of

government might hamper coordination, and charge firms with

specialized and limited capabilities to perform functions which they are

not suited for. In rebuilding a war torn nation's infrastructure, for example,

a private firm would, in order to provide security, either have to hire

security, which would be both necessarily limited and complicate their

functions, or coordinate with government, which, due to a lack of

command structure shared between firm and government, might be

difficult. A government agency, on the other hand, would have the entire

military of a nation to draw upon for security, whose chain of command is

clearly defined. Opponents would say that this is a false assertion:

numerous books refer to poor organization between government

departments (for example the Hurricane Katrina incident).

Furthermore, opponents of privatization argue that it is undesirable to

transfer state-owned assets into private hands for the following reasons:

Performance. A democratically elected government is accountable to the

people through a legislature, Congress or Parliament, and is motivated to

safeguarding the assets of the nation. The profit motive may be

subordinated to social objectives.

Improvements. The government is motivated to performance

improvements as well run businesses contribute to the State's revenues.

Corruption. Government ministers and civil servants are bound to uphold

the highest ethical standards, and standards of probity are guaranteed

through codes of conduct and declarations of interest. However, the selling

process could lack transparency, allowing the purchaser and civil servants

controlling the sale to gain personally.

Accountability. The public does not have any control or oversight of

private companies.
Civil-liberty concerns. A democratically elected government is

accountable to the people through a parliament, and can intervene when

civil liberties are threatened.

Goals. The government may seek to use state companies as instruments to

further social goals for the benefit of the nation as a whole.

Capital. Governments can raise money in the financial markets most

cheaply to re-lend to state-owned enterprises.

Lack of market discipline. Governments have chosen to keep certain

companies/industries under public ownership because of their strategic

importance or sensitive nature.

Cuts in essential services. If a government-owned company providing an

essential service (such as the water supply) to all citizens is privatized, its

new owner(s) could lead to the abandoning of the social obligation to

those who are less able to pay, or to regions where this service is

unprofitable.

Natural monopolies. Privatization will not result in true competition if a

natural monopoly exists.

Concentration of wealth. Profits from successful enterprises end up in

private, often foreign, hands instead of being available for the common

good.

Political influence. Governments may more easily exert pressure on state-

owned firms to help implementing government policy.

Downsizing. Private companies often face a conflict between profitability

and service levels, and could over-react to short-term events. A state-

owned company might have a longer-term view, and thus be less likely to

cut back on maintenance or staff costs, training etc, to stem short term

losses. Many private companies have downsized while making record

profits.

Profit. Private companies do not have any goal other than to maximize

profits. A private company will serve the needs of those who are most

willing (and able) to pay, as opposed to the needs of the majority, and are

thus anti-democratic.

Privatisation and Poverty. It is acknowledged by many studies that there

are winners and losers with privatization. The number of losers —which

may add up to the size and severity of poverty—can be unexpectedly large

if the method and process of privatization and how it is implemented are

seriously flawed (e.g. lack of transparency leading to state-owned assets

being appropriated at minuscule amounts by those with political

connections, absence of regulatory institutions leading to transfer of

monopoly rents from public to private sector, improper design and

inadequate control of the privatization process leading to asset stripping.

PRIVATISED BUSINESS FIRMS IN INDIA

Maruti Udyog

BSNL

Delhi Airport

Mumbai Airport

Hyderabad International Airport

Bangalore International Airport

Cochin International Airport

Many others including sporting associations, airports, tv channels, etc

which were all originally government-run businesses, were privatised by

Prime Minister P. V. Narasimha Rao, which not only removed a financial

burden of the government, but also revolutionised business in India.

GLOBALIZATION
Globalization can be described as a process of blending or homogenization

by which the people of the world are unified into a single society and

function together. This process is a combination of economic,

technological, sociocultural and political forces. Globalization is often used

to refer to economic globalization, that is, integration of national

economies into the international economy through trade, foreign direct

investment, capital flows, migration, and the spread of technology.

Tom G. Palmer of the Cato Institute defines "globalization" as "the

diminution or elimination of state-enforced restrictions on exchanges

across borders and the increasingly integrated and complex global system

of production and exchange that has emerged as a result."

The term "internationalization" refers to the importance of international

trade, relations, treaties etc. International means between or among

nations.

Looking specifically at economic globalization, demonstrates that it can be

measured in different ways. These centers around the four main economic

flows that characterize globalization:

Goods and services, e.g. exports plus imports as a proportion of national

income or per capita of population

Labor/people, e.g. net migration rates; inward or outward migration

flows, weighted by population

Capital, e.g. inward or outward direct investment as a proportion of

national income or per head of population

Technology, e.g. international research & development flows; proportion

of populations (and rates of change thereof) using particular inventions

(especially 'factor-neutral' technological advances such as the telephone,

motorcar, broadband)

EFFECTS OF GLOBALIZATION
Globalization has various aspects which affect the world in several

different ways such as:

Industrial - emergence of worldwide production markets and broader

access to a range of foreign products for consumers and companies.

Particularly movement of material and goods between and within national

boundaries.

Financial - emergence of worldwide financial markets and better access to

external financing for borrowers. Simultaneous though not necessarily

purely globalist is the emergence of under or un-regulated foreign

exchange and speculative markets.

Economic - realization of a global common market, based on the freedom

of exchange of goods and capital.

Political - some use "globalization" to mean the creation of a world

government, or cartels of governments (e.g. WTO, World Bank, and IMF)

which regulate the relationships among governments and guarantees the

rights arising from social and economic globalization. Politically, the

United States has enjoyed a position of power among the world powers; in

part because of its strong and wealthy economy. With the influence of

globalization and with the help of The United States’ own economy, the

People's Republic of China has experienced some tremendous growth

within the past decade. If China continues to grow at the rate projected by

the trends, then it is very likely that in the next twenty years, there will be

a major reallocation of power among the world leaders. China will have

enough wealth, industry, and technology to rival the United States for the

position of leading world power.

Informational - increase in information flows between geographically

remote locations. Arguably this is a technological change with the advent

of fibre optic communications, satellites, and increased availability of

telephony and Internet.

Language - the most popular language is English.

About 75% of the world's mail, telexes, and cables are in English.

Approximately 60% of the world's radio programs are in English.

About 90% of all Internet traffic is using English.

Competition - Survival in the new global business market calls for

improved productivity and increased competition. Due to the market

became worldwide not specific area, there are many industries around the
world. Industries have to upgrade their products and use technology

skillfully for facing the competition and increasing their competitive.

Cultural - growth of cross-cultural contacts; advent of new categories of

consciousness and identities which embodies cultural diffusion, the desire

to increase one's standard of living and enjoy foreign products and ideas,

adopt new technology and practices, and participate in a "world culture".

Some bemoan the resulting consumerism and loss of languages.

Ecological- the advent of global environmental challenges that might be

solved with international cooperation, such as climate change, cross-

boundary water and air pollution, over-fishing of the ocean, and the

spread of invasive species. Since many factories are built in developing

countries with less environmental regulation, globalism and free trade

may increase pollution. On the other hand, economic development

historically required a "dirty" industrial stage, and it is argued that

developing countries should not, via regulation, be prohibited from

increasing their standard of living.

Social (International cultural exchange) - increased circulation by people

of all nations with fewer restrictions.

Spreading of multiculturalism, and better individual access to cultural

diversity (e.g. through the export of Hollywood and Bollywood movies).

Some consider such "imported" culture a danger, since it may supplant the

local culture, causing reduction in diversity or even assimilation. Others

consider multiculturalism to promote peace and understanding between

peoples.
Business

Globalization has had extensive impact on the world of business. In a

business environment marked by globalization, the world seems to shrink,

and other businesses halfway around the world can exert as great an

impact on a business as one right down the street. Internet access and e-

commerce have brought small-scale coops in Third World nations into the

same arena as thriving businesses in the industrialized world, and visions

of low-income workers handweaving rugs on primitive looms that

compete with rug dealers in major cities are not totally far-fetched.

Globalization has affected workforce demographics, as well. Today's

workforces are characterized by greater diversity in terms of age, gender,

ethnic and racial background, and a variety of other demographic factors.

In fact, management of diversity has become one of the primary issues of

21st-century business.

Trends such as outsourcing and offshoring are a direct offshoot of

globalization and have created a work environment in which cultural

diversity can be problematic. A U.S. company where punctuality is

important and meetings always start on time faces adjustments if it opens

an office in South America or France, where being 10 to 15 minutes late to

a meeting is considered acceptable: being on time is called 'British Time'

Sweatshops

It can be said that globalization is the door that opens up an otherwise

resource poor country to the international market. Where a country or

nation has little material or physical product harvested or mined from it

sown soil there is seen the opportunity by large corporations to take

advantage of the “export poverty” of such a nation. Where the majority of

the earliest occurrences of economic globalization are recorded as being

the expansion of businesses and corporate growth, in many poorer nations

globalization is actually the result of the foreign businesses investing in the

country to take advanatge of the lower wage rate: even though investing,

by increasing the Capital Stock of the country, increases their wage rate.

One example used by anti-globalization protestors is the use of

“Sweatshops” by manufacturers. According to Global Exchange these

“Sweat Shops” are widely used by sports shoe manufacturers and

mentions one company in particular – Nike. There are factories set up in

the poor countries where employees agree to work for low wages. Then if

labour laws alter in those countries and stricter rules govern the

manufacturing process the factories are closed down and relocated to

other nations with more liberal economic policies.

There are several agencies that have been set up worldwide specifically

designed to focus on anti-sweatshop campaigns and education of such.

“The Decent Working Conditions and Fair Competition Act” is a

legislation passed by the National Labor Committee in the USA. The

legislation now suggests that companies are legally obligated to respect

human and worker rights by prohibiting the import, sale, or export of

sweatshop goods. There are very strict standards set out by the

International Labor Organization and any violations shall be banned from

the US market.
Specifically, these core standards include no child labor, no forced labor,

freedom of association, right to organize and bargain collectively, as well

as the right to decent working conditions.

For example, in the area of digital media (animations, hosting chat rooms,

designing games), where it is often less glamourous than it may sound. In

the gaming industry, a Chinese Gold Market has been established.