Um19mb504 Unit V 1576908336217

Managerial
Economics
(UM19MB504)
Unit V :
Macroeconomic Business
Environment
PES University
Managerial
Economics
(UM19MB504)
Session 34:
National Income Accounting; Aggregate Supply
and Demand
PES University
National Income Accounting
• The national accounts provide a comprehensive, conceptual and

accounting framework for analyzing and evaluating the performance
of an economy.
• As the national accounts are designed to account for all economic
transactions, their compilation is a major exercise, which draws
information from several diverse data sources.
PES University - MBA - Managerial Economics (UM19MB504) 3

National Income Accounting: Data Sources
• The sources consist of data generated as a byproduct of public

administration system, such as land records, collection of direct and
indirect taxes, as well as data collected directly through censuses and
sample surveys conducted by official agencies of the Central and
State Governments.
• For certain newly emerging activities such as software, information
available from selective nonofficial sources is used in the compilation
of national accounts statistics (NAS).

National Income Accounting: Historical
Perspective
• In the 1930s it was impossible for macroeconomics to exist in the

form we know it today because many aggregate concepts had not yet
been formulated, or were lacking rigour.
• In the mid-1930s, two Keynesians, Simon Kuznets and Richard Stone,
began to develop this terminology.
• They developed national income accounting – a set of rules and
definitions for measuring economic activity in the aggregate
economy – that is, in the economy as a whole.

National Income Accounting: Historical
Perspective
• Recognizing the need for providing estimates of national income on a
regular basis, the Government of India set up an Expert Committee in
1949 known as "National Income Committee“ under the
chairmanship of Prof. P. C. Mahalanobis with Prof. D. R. Gadgil and
Prof. V. K. R. V. Rao as members, to make recommendations on the
following three issues:
a) the compilation of estimates of national income,
b) the improvement of the statistical data on which the estimates were
to be based and
c) to suggest measures to promote research in the field of national
income.
GDP, GNP, NDP, and NNP
• Gross domestic product (GDP) is the total market value of all final goods
and services produced in an economy in a one-year period. It is the
single most-used economic measure.
• Gross national product (GNP) is the value of final goods and services
produced by domestically owned factors of production within a given
period.
• Net domestic product (NDP) is equal to GDP minus the capital
consumption allowances, a measure of depreciation. It is the total value
of production minus the value of the amount of capital used up in producing
that output.
• Net national product (NNP) refers to gross national product, i.e. the total
market value of all final goods and services produced by the factors of
production of a country during a given time period, minus depreciation.

Calculating GDP
• Calculating GDP requires adding together million of goods and

services.
• All goods and services produced by an economy must be weighted,
that is, each good and service must be multiplied by its price.
• Once quantities of a particular good or service are multiplied by its
price, we arrive at a value measure of the good or service.
• Finally, all the value measures are added to calculate that year’s
GDP.
• GDP does not measure total transactions in the economy. It counts
final output but not intermediate goods.

GDP Measures Final Output
• GDP does not measure total transactions in the economy. It counts

final output but not intermediate goods.
• Final output – goods and services purchased for final use.
Intermediate products are used as inputs in the production of some
other product.
• Counting the sale of final goods and intermediate products would
result in double and triple counting.
• There are two ways of eliminating intermediate goods. The first is to
calculate only final sales. A second way is to follow the value added
approach.

Calculating GDP: Some Examples
• Selling your car to a neighbor does not add to GDP.

• Selling your car to a used car dealer who sells your car to someone else for a
higher price, does add to GDP. The value added is the dealer's services.
• Selling a stock or bond does not add to GDP. The stock broker's
commission for the sales does add to GDP.
• Pension payments, welfare payments, employment insurance benefits, and
other government transfer payments are not included in GDP.
• The work of unpaid house spouses does not appear in GDP calculations.

Expenditure Approach and Income Approach
• Two different approaches are used to calculate GDP.

• In theory, the amount spent for goods and services should be equal
to the income paid to produce the goods and services, and other
costs associated with those goods and services.
• Calculating GDP by adding up expenditures is called the expenditure
approach, and computing GDP by examining income for resources
(sometimes referred to as gross domestic income, or GDI), is known
as the resource cost/income approach.

Expenditure Approach
• The expenditure approach utilizes four main components:

• Consumption (C) - These are personal consumption expenditures. They are typically broken
down into the following categories: durable goods, non-durable goods, and services.
• Investment (I) - This is gross private investment; it is generally broken down into fixed
investment and changes in business inventories.
• Government (G) - This category includes government spending on items that are "consumed" in
the current period, such as office supplies and gasoline; and also capital goods, such as
highways, missiles, and dams. Note that transfer payments are not included in GDP, as they are
not part of current production.
• Net Exports - This is calculated by subtracting a nations imports (M)from exports (X). Imports
are goods and services produced outside the country and consumed within, and exports are
goods and services produced domestically and sold to foreigners. Note that this number may be
negative, which has occurred in the U.S. for the last several years. Net exports for the U.S. were
minus $606 billion during calendar year 2004 (as per Bureau of Economic Analysis, U.S.
Department of Commerce June 29, 2005 press release).
• GDP = C + I + G + (X - M)

Resource Cost/Income Approach
• To calculate Gross Domestic Income (GDI), first consider how revenues received for
products and services are used:
• Pay for the labor used (wages + income of self-employed proprietors) , Pay for the
use of fixed resources, such as land and buildings (rent), Pay a return to capital
employed (interest), Pay for the replenishment of raw material used.
• Remaining revenues go to business owners as a residual cash flow, which is used to
replenish capital (depreciation), or it becomes a business profit. So with the
resource cost/income approach, GDP (or GDI) is calculated as wages, rent, interest
and cash flow paid to business owners or organizers of production.
• GDP by resource cost/income approach = wages + self-employment income + Rent +
Interest + profits + indirect business taxes + depreciation + net income of foreigners.
• GDI = wages + self-employment income + Rent + Interest + profits + indirect
business taxes + depreciation + net income of foreigners

Nominal GDP and Real GDP
• Nominal GDP measures the value of output in a given period in the

prices of that period, or, as it is sometimes put, in current prices.
Nominal GDP changes from year to year for two reasons. The first
reason is that the physical output of goods changes. The second is
that market prices change.
• Real GDP measures changes in physical output in the country
between different time periods by valuing all goods produced in
the two periods at the same price or in constant prices.

GDP Deflator
• The calculation of real GDP gives us a useful measure of inflation

known as the GDP deflator. The GDP deflator is the ratio of nominal
GDP in a given year to real GDP of that year.
• Unlike the Consumer Price Index (CPI), the GDP deflator is not based
on a fixed basket of goods and services. Since the GDP deflator is
based on calculation involving all the goods produced in the economy,
it is widely based price index that is frequently used to measure
inflation.

Personal Disposable Income
• Personal income (PI) is national income plus net transfer payments

from government minus amounts attributed but not received.
PI = NI + transfer payments from government - corporate retained
earnings - corporate income taxes – employment taxes (CPP, EI)
• Personal disposable income is the level of income available for
spending and saving by households in the country.

GDP Estimates by Industry: Agriculture and
Allied Sector
• Agriculture: value of crop outputs, value of livestock products, inputs of

agriculture including livestock (seed, chemical fertilizers, feed of
livestock, pesticides, insecticides, diesel oil etc.)
• Forestry: consumption of firewood from NSS Consumer Expenditure
Surveys, and others from budget documents of the State Forest
Departments.
• Fishing
• Mining and Quarrying

GDP Estimates by Industry: Manufacturing
and Services
• Unregistered manufacturing • Banking and insurance
• Electricity, Gas, and Water Supply • Real estate, ownership of dwellings, legal
(Public and Private Sector) and business services
• Construction • Renting of machinery and equipment
without operator
• Trade, hotels, and restaurants
• Computer and related activities in the
• Transport by means other than railways private sector
and storage
• Legal activities
• Storage and Warehousing
• Accounting, book keeping, and related
• Private communication services activities in the private sector
• Courier services • Research and development activities
• Activities of cable operators • Education services

The GDP Debate: Over Back
Series Data
https://www.youtube.com/watch?v=mecyr8waGTI

Managerial
Economics
(UM19MB504)
Session 35:
Unemployment
PES University
Unemployment
• An Unemployed person is defined as one who is not employed and who

has actively looked for work during the previous 4 weeks.
• A person not looking for work, either because he/she does not want a job
or has given up is classified as not in labour force.
• Total Labour force = Employed labour force + Unemployed labour
force
• Unemployment Rate is the ratio of number of unemployed people to the
total number of people in the Labour force.

The Unemployment pool
Unemployment occurs due to the below factors :

• The person may be a new entrant into the labor force or may be a
reentrant.
• The person may quit a job in order to look for other employment
and may register as unemployed while searching.
• The person may be laid off.
• The worker may lose a job, either by being fired or because the firm
closes down.

Reduction in Unemployment pool
• A person may be hired into a new job.

• Someone laid off may be recalled to his or her employer.
• An unemployed person may stop looking for a job and thus, by
definition, leave the labour force.

Unemployment - Types
• Two types of Unemployment exist :
• Natural /Frictional Unemployment
• Cyclical Unemployment

Natural Rate of Unemployment
• The natural rate of unemployment is the rate of unemployment arising

from normal labor market frictions that exist when the labor market is in
equilibrium.
• It is the amount of unemployment associated with the full-employment
level of employment and the corresponding full-employment
(or potential) level of output
• Natural rate of Unemployment is also called Frictional Rate of
unemployment - this occurs because of Labour markets not being
“Friction – less”

Natural Rate of Unemployment - Causes
• Natural Employment consists of “search” unemployment and “wait”

unemployment for workers who are searching and waiting to take up
jobs in the near future
• It implies that Labour Market is not perfect or instantaneous , i.e., there
is “Friction” in matching workers to the job.
Causes :
• Change of jobs, relocation/mobility
• First-time job seekers
• Layoffs

Cyclical Rate of Unemployment
• Cyclical unemployment is unemployment in excess of frictional

unemployment: It occurs when output is below its full-employment
level.
• This unemployment occurs during recessions and depressions.
• In a recession, there is a decline in the real output caused by decrease
in aggregate demand leading to higher than normal rate of
unemployment.
• Cyclical unemployment is thus also called “deficient demand
unemployment”.

Natural Rate of Unemployment – Determinants
• Natural rate of Unemployment is a function of duration and frequency

of Unemployment
• Duration of Unemployment depends on Cyclical factors and
Structural factors
• Structural Factors :
• Organization of the labour markets ( includes presence of Employment agencies,
youth services)
• Demographics of labour force
• Ability and desire of the unemployed to keep looking for a better job ( also a
function of unemployment benefits)

Natural Rate of Unemployment – Determinants
• Frequency of Unemployment is the average number of times, per

period, that workers become unemployed. This is a function of
• Variability of the demand for labor across different firms in the
economy
• Rate at which new workers enter the labor force, since new potential
workers start out as unemployed
• Natural rate of unemployment varies as the determinants
change over time

Costs of Cyclical Unemployment
1. Loss of output as a result of not being at full employment

• Empirical relation between unemployment and output over the
business cycle, as given by Okun’s law, states that 1 extra
percentage of unemployment costs 2 percent of GDP
2. The costs of unemployment are borne very unevenly- There are large
distributional consequences. In other words, the costs of a recession
are borne disproportionately by those individuals who lose their jobs
3. Society stands to lost out on tax revenue with an increase in
unemployment

Unemployment in India
• Unemployment in India statistics has traditionally been collected,
compiled and disseminated once every five years by the Ministry of
Labour and Employment (MLE), primarily from sample studies
conducted by the National Sample Survey Office.
• In 2016, Centre for Monitoring Indian Economy – a non-government
entity based in Mumbai, started sampling and publishing monthly
unemployment in India statistics.
• As of September 2018, according to the Indian government, India had 31
million jobless people.

NSSO Surveys
• The National Sample Survey Office (NSSO) has been the key
governmental agency in India at the national and state levels to study
employment, unemployment and unemployment rates through sample
surveys.
• It does not report employment or unemployment results every quarter
nor every year, but generally only once every 5 years.
• The last three officially released NSSO survey and report on employment
and unemployment were completed in 2004–2005, in 2009–2010, and
2011–2012.
• There was no NSSO survey between 2012 and 2017, and a new survey
was initiated in 2017–2018. This report has not been officially released.

Labour Bureau Reports
• The Indian Labour Bureau, in addition to the NSSO surveys, has

published indirect annual compilations of unemployment data by
each state government's labour department reports.
• Those reports derived from the Annual Survey of Industries (ASI),
Occupational Wage Surveys, and Working Class Family Income and
Expenditure Surveys and other regular and ad-hoc field surveys and
studies on India published by third parties.

Managerial
Economics
(UM19MB504)
Session 36:
Inflation
PES University
Inflation
• Inflation is a rise in the general level of prices of goods and services in

an economy over a period of time.
• When the price level rises, each unit of currency buys fewer goods
and services.
• A chief measure of price inflation is the inflation rate.
• When Prices rise the Value of Money falls.

Inflation Rate

Stages of Inflation
1
• Creeping Inflation (0 % – 3 %)
2
• Walking Inflation (4 % – 7 %)
3
• Running Inflation (08 % – 20 %)
4
• Hyper Inflation (20 % and above)

Inflation Measures
• Inflation is measured by price index changes.

• A Price index measures general level of prices with reference to a base
period
• The main prices indices used are as below :
• GDP deflator
• Consumer price Index
• Producer price index

GDP Deflator
• The calculation of real GDP gives us a useful measure of inflation

known as the GDP deflator. The GDP deflator is the ratio of nominal
GDP in a given year to real GDP of that year.
• Since the GDP deflator is based on calculation involving all the goods
produced in the economy, it is widely based price index that is
frequently used to measure inflation.

Consumer price Index
• The consumer price index (CPI) measures the cost of buying a fixed
basket of goods and services representative of the purchases of a
typical consumer
• CPI differs in three main ways from the GDP deflator :
• The deflator measures the prices of a much wider group of goods than the CPI
does.
• The CPI measures the cost of a given basket of goods, which is the same from
year to year. The goods and services included in the GDP deflator, however,
differs from year to year, depending on what is produced in the economy in each
year.
• The CPI directly includes prices of imports, whereas the deflator includes only
prices of goods produced in the Country.

Consumer price Index - Criticisms
• Substitution bias – Increase in prices of some goods will lead to

consumers replacing them with more affordable substitutes. However,
since CPI includes only a fixed basket, the increase in prices is
overstated
• Representation of Novelty – New products take a long time and a
consistent level of purchase before being introduced in CPI. As such, CPI
may not reflect the actual cost of living
• Effects of Quality Changes - The effects of quality changes cannot be
accurately represented because the quality is extremely hard to measure
• Lack of Individual Relevance - The consumer price index may not
accurately report the level of inflation experienced by an individual
because it measures the price level and inflation based on a typical
consumer

Producer price Index
• The Producer price index (PPI), also known as Wholesale Price Index
(WPI), is an index of prices of products that producers receive for
products at all stages of the production process, i.e., raw materials,
intermediate goods and finished goods.
• PPI detects price changes early in the Production process and is
therefore used as a leading indicator of future consumer prices.

Core Inflation
• Policymakers are interested in measuring ongoing inflationary

trends.
• The prices of some goods are very volatile, suggesting that price
changes are often temporary.
• For this reason policymakers focus on core inflation , which excludes
changes to food and energy prices.
• Core inflation measures are usually reported for CPI

Types of Inflation
1 • Demand Pull Inflation
2 • Cost Push Inflation

Causes of Demand Pull Inflation
• Increase in Money Supply • Increase in Income

• Increase in Black Marketing • Demonstration Effect
• Increase in Hoarding • Increase in Black money
• Repayment of Past Internal • Increase in Credit facilities
Debt
• Increase in Exports
• Deficit Financing

Causes of Cost Push Inflation
• Increase in cost of raw materials

• Shortage of Supplies
• Natural calamities
• Industrial Disputes
• Increase in Wages
• Increase in Transportation Cost
• Huge Expenditure on Advertisement

Cost of Inflation
• Cost of Inflation can be broken down into two categories :

• Costs due to Anticipated Inflation
• Costs due to Unanticipated Inflation
• Costs due to Anticipated Inflation:

• Menu Costs – Administrative costs associated with changing prices of various
goods and services
• Shoe- Leather costs – Costs associated with holding cash in banks (frequent
trips to banks) - Interest rates tend to rise with anticipated inflation resulting in
rise of opportunity costs of holding cash outside banks.

Cost of Inflation
• Costs due to Unanticipated Inflation:

• Arbitrary redistribution of Income – Workers, Sellers of products would lose
• Focus shifts away from productive jobs– Extreme levels of unanticipated
inflations causes individuals to shift away their focus from working on
productive jobs to profiting from inflation
• Reluctance to invest long term – Long term investments are as risky leading to
fall in such investments. As such, prospects for long term growth are diminished
• Debtors benefit at the expense of Creditors – Less “real” rate of return for
Creditors. Impact is most acutely felt on class of investors holding fixed income
securities as the main source of income.

Unemployment - Inflation Trade-off
Simple Phillips Curve
• In 1958 A. W. Phillips, a professor at the
London School of Economics, published
a comprehensive study of wage
behavior in the United Kingdom for the
years 1861– 1957.
• The Phillips curve, in the short run, is
an inverse relationship between the
rate of unemployment and the rate of
increase in money wages. The higher
the rate of unemployment, the lower
the rate of wage inflation. In other
words, there is a tradeoff between wage
inflation and unemployment

Inflation Augmented Phillips Curve
• The simple Phillips curve relationship fell apart
after the 1960s, both in Britain and in the
United States
Inflation and Unemployment in
• This failure led to the concept of an inflation- the United States
augmented Phillips curve:
• π = π e − h ( u − u N ),h > 0, where
• π is inflation ,
• π e is expected inflation,
• u is unemployment
• h is a fixed positive coefficient
• u N is the “natural rate of unemployment

Long Run Phillips Curve
• Phillips curve is vertical in the long
–run and corresponds to the natural
rate of unemployment
• The long – run Phillips curve is
vertical because whenever the
unemployment rate is pushed below
the natural rate, wages begin to rise
pushing up the costs. This leads to a
lower level of output which pushes
the unemployment back up to the
natural rate

Indian Inflation Rate: June-October, 2019
Source: MOSPI, GOI

Retail Inflation in India: September–October,
2019
Source: MOSPI, GOI

Managerial
Economics
(UM19MB504)
Session 37:
Economic Growth and Development
PES University
Economic Growth
• Economic growth can be defined as an increase in the capacity of an

economy to produce goods and services, compared from one period
of time to another.
• Economic growth can be measured in nominal terms, which include
inflation, or in real terms, which are adjusted for inflation.
• It is conventionally measured as the percent rate of increase in real
gross domestic product, or real GDP.
• The "rate of economic growth" refers to the annual rate of growth in
GDP between the first and the last year over a period of time.

The Importance of Economic Growth
• Economic growth is important because it is necessary ingredient for
both higher incomes and higher living standards.
• GDP is a measure of both output and income. Growth of output is
necessary for growth of income.
• Per capita GDP is the country’s GDP divided by its population.
Growth of per capita GDP means more goods and services per
person.
• In most cases higher levels of per capita GDP will mean that the in
general citizens of the country will have better diet, improved health,
access to medical services, a longer life expectancy, and greater
education opportunity.

Economic Development
• Economic development is the process by which the economic well-

being and quality of life of a nation, region or local community are
improved.
• Economic development is a policy intervention endeavor aiming to
improve the well-being of people – like the development of human
capital, literacy ratio, infrastructure, health, and general welfare of the
citizens. Economic growth is a phenomenon of market productivity
and rise in GDP.
• Economist Amartya Sen points out, "economic growth is one aspect of
the process of economic development".

Economic Development
• Economic development is –
1) Quantitative and qualitative changes in the economy.
2) Promoting the standard of living and economic health.
3) Human Development Index is one of the most popular method for
measuring economic development.
4) Modernization and industrialization plays important role for
economic development of a nation.

Some Indicators of Economic Development
• GDP per capita

• Life expectancy
• Literacy rates
• Measures of poverty
• Demographic indicators
• Disease indicators

Managerial
Economics
(UM19MB504)
Session 38:
Monetary and Fiscal Policy
PES University
Monetary Policy
• Monetary policy is an important economic tool which is used to

attain many macro-economic goals.
1) Monetary policy regulates the supply of money and availability of
credit in the economy.
2) It takes care of both the lending and borrowing rates of interest
of commercial banks.
3) It aims to maintain price stability, full employment, and
economic growth.
Reserve Bank of India (RBI) is responsible for formulating and
implementing monetary policy of India.
Monetary Policy in India
• The Monetary and Credit Policy is the policy statement, traditionally

announced twice a year (recently bi-monthly), through which the
Reserve Bank of India seeks to ensure price stability for the economy.
• These factors include - money supply, interest rates and the inflation.
In banking and economic terms money supply is referred to as M3 -
which indicates the level (stock) of legal currency in the economy.
• Besides, the RBI also announces norms for the banking and financial
sector and the institutions which are governed by it.

What are the objectives of the Monetary
Policy?
• The objectives are to maintain price stability and ensure adequate

flow of credit to the productive sectors of the economy.
• Stability for the national currency (after looking at prevailing
economic conditions), growth in employment and income are also
looked into. The monetary policy affects the real sector through long
and variable periods while the financial markets are also impacted
through short-term implications.

Instruments of Monetary Policy
• Bank Rate of Interest • Margin Requirements

• Cash Reserve Ratio • Deficit Financing
• Statutory Liquidity Ratio • Issue of New Currency
• Open market Operations • Credit Control

Bank Rate of Interest
• It is the interest rate which is fixed by the RBI to control the lending
capacity of Commercial banks.
• During Inflation , RBI increases the bank rate of interest due to which
borrowing power of commercial banks reduces which thereby reduces
the supply of money or credit in the economy.
• When Money supply reduces it reduces the purchasing power and
thereby curtailing consumption and lowering Prices.
• The current bank rate as fixed by the RBI is 5.40 %.

Cash Reserve Ratio
• CRR, or cash reserve ratio, refers to a portion of deposits (as cash)

which banks have to keep/maintain with the RBI.
• During Inflation, the RBI increases the CRR due to which commercial
banks have to keep a greater portion of their deposits with the RBI.
• This serves two purposes, a) it ensures that a portion of bank
deposits is totally risk-free and, b) it enables that RBI control
liquidity in the system, and thereby, inflation.
• The current CRR as fixed by the RBI is 4 per cent per annum.

Statutory Liquidity Ratio
• Banks are required to invest a portion of their deposits in government

securities as a part of their statutory liquidity ratio (SLR) requirements.
• If SLR increases the lending capacity of commercial banks decreases
thereby regulating the supply of money in the economy.
• The current statutory liquidity ratio is 19 per cent.

Open Market Operations
• It refers to the buying and selling of Govt. securities in the open

market .
• During inflation RBI sells securities in the open market which leads to
transfer of money to RBI.
• Thus money supply is controlled in the economy.

Margin Requirements
• During Inflation RBI fixes a high rate of margin on the securities kept
by the public for loans.
• If the margin increases the commercial banks will give less amount of
credit on the securities kept by the public thereby controlling
inflation.

Deficit Financing and Issue of New Currency
• It means printing of new currency notes by Reserve Bank of India.

• If more new notes are printed it will increase the supply of money thereby
increasing demand and prices.
• Thus during Inflation, RBI will stop printing new currency notes thereby
controlling inflation.
• During Inflation the RBI will issue new currency notes replacing many old
notes.
This will also reduce the supply of money in the economy.

Fiscal Policy
• Fiscal policy is defined as the conscious attempt of the government

to achieve certain macro-economic goals by changing the volume
and pattern of its revenue and expenditures and the balance
between them.
• It is a budgetary policy.
• Fiscal policy is the use of government taxes and spending to alter

macroeconomic outcomes of the country.

Instruments of Fiscal Policy
• Reduction of Govt. Expenditure • Maintaining Surplus Budget

• Increase in Taxation • Increase in Imports of Raw
materials
• Imposition of new Taxes
• Decrease in Exports
• Wage Control
• Increase in Productivity
• Rationing
• Provision of Subsidies
• Public Debt
• Use of Latest Technology
• Increase in savings
• Rational Industrial Policy

How is the Monetary Policy different from the
Fiscal Policy?
• The Monetary Policy regulates the supply of money and the cost and
availability of credit in the economy. It deals with both the lending and
borrowing rates of interest for commercial banks.
• The Monetary Policy aims to maintain price stability, full employment and
economic growth.
• The Monetary Policy is different from Fiscal Policy as the former brings
about a change in the economy by changing money supply and interest
rate, whereas fiscal policy is a broader tool with the government.
• The Fiscal Policy can be used to overcome recession and control inflation.
It may be defined as a deliberate change in government revenue and
expenditure to influence the level of national output and prices.

Managerial
Economics
(UM19MB504)
Session 39:
Business Cycle
PES University
Business Cycle
• The term ‘business cycles’ or ‘trade cycles’ in economics refers to the

wave-like fluctuations in the aggregate economic activity, particularly
in investments, in output, in income, and in employment.
• Mitchell defined ‘a trade cycle as a fluctuation in aggregate economic
activity’.
• According to Haberler, ‘the business cycle in the general sense may be
defined as an alternation of periods of prosperity and depression, of
good and bad trade’.

Phases of a Business Cycle
• Prosperity phase – expansion or the upswing.

• Recessionary phase – a turn from prosperity to depression (or upper
turning point)
• Depressionary phase – contraction or downswing.
• Revival or recovery phase – the turn from depression to prosperity
(or lower turning point).

Phases of a Business Cycle

Prosperity Phase
• Haberler defines prosperity as ‘ a state of affairs in which the real

income consumed, real income produced, level of employment are high
or rising, and there are no idle resources or unemployed workers or
very few of either’.

Characteristic Features of Prosperity Phase
• A high level of output and trade. • A rising structure of interest rate.

• A high level of effective demand. • A large expansion of bank credit.
• A high level of employment and • Overall business optimism.
income.
• Tendency of the economy to
• A high marginal efficiency of operate at almost full capacity
capital. along its production possibility
frontier.
• A price inflation.

Recessionary Phase
• A deep widespread downward movement of the business and

economic activity.

Characteristic Features of Recessionary Phase
• The banking system and the • Income throughout the economy

people in general try to attain falls.
greater liquidity.
• Reduced income causes a
• Credit sharply contracts. decrease in aggregate
expenditure.
• Business expansion stops,
orders are cancelled and • General demand falls.
workers are laid off.
• Prices, profits, and business
• General drive to contract the declines.
scale of operations, leading to
increase in unemployment.

Depressionary Phase
• A prolonged period of declining business and economic activity.

Characteristic Features of a Depressionary
Phase
• Shrinkage in the volume of • Curtailment in consumption
output, trade, and transactions. expenditure and reduction in the
level of effective demand.
• Rise in the level of
unemployment. • Collapse of the marginal
efficiency of capital and decline in
• Price deflation. the investment demand function.
• Fall in the aggregate income of • Contraction of bank credit.
the community (especially
wages and profits).

Recovery Phase
• The revival or recovery phase refers to the lower turning point at

which an economy undergoes change from depression to prosperity.

Characteristic Features of a Recovery Phase
• With an improvement in • Induced investment will cause a

demand for capital goods, rise in employment and income.
recovery sets in.
• Increased income – will lead to a
• When the demand for rise in consumption – will push
consumption goods rises or up the demand – rise in prices,
when the capital stock profits, further investment,
increases, the demand for employment and income.
capital goods will rise and new
investment will be induced.

Causes of Business Cycle
• Exogenous factors: are those external to the economic system, for

example – war, innovation, population movement, territorial
development etc.
• Endogenous factors: are integral to the economic structure. They

are the forces which operate from within the economic system. For
example – volume of bank credit, liquidity preference behavior, the
price level, interest rate, elasticity of supply of production factors,
marginal propensity to consume, marginal efficiency of capital.

Important Business Cycle Theories
• Purely Monetary Theory

• Monetary Overinvestment Theory
• Non-monetary Overinvestment Theory
• Under-consumption Theory
• Psychological Theory
• Innovation Theory
• Marginal Efficiency of Capital Theory
• Hicks’ Theory

Purely Monetary Theory
• R. G. Hawtrey
• He describes that all changes in the level of economic activity are
nothing but reflections of changes in the flow of money.
• Causes of cyclical fluctuations were to be found in those factors that
produce expansions and contractions in the flow of money – money
supply.
• The main factors affecting the money supply is the credit creation by
the banking system.
• He points out that ‘when credit movements are accelerated, the period
of the cycle is shortened’.

Monetary Overinvestment Theory
• F. A. Hayek
• He describes that the monetary system brings about

overinvestment in the economy, causing crisis and
depression.
• Centers on the analysis of equilibrium between

production of capital goods and consumption goods.
• He believes that the failure of the banking system to

keep the supply of money neutral causes trade cycle.

Under-consumption or Over-saving Theory
• Thomas Robert Malthus, Karl Marx
• The root cause of a trade cycle is over-saving or under-

consumption which is due to the existing unequal
distribution of wealth in the community.
• During the course of economic prosperity – owners

share a larger part of increased income than the wage-
earners – inequality of income in the community
increases – large income recipients will consume a
portion of their income and save the rest – savings in
the economy will increase.

Psychological Theory
• John Stuart Mill, Arthur Cecil Pigou

• They have expounded a theory of trade cycle which
emphasises the importance of psychological factors.
• Trade cycles may be found in the waves of
‘overoptimism’ and ‘overpessimism’ in the business
community leading to the tendency of the heavy
goods industries to expand and contract by a
greater amount in relation to the consumer good
industries.
The Innovation Theory
• J. A. Schumpeter
• He regards innovations as the organising cause of trade
cycles.
• Inventions – discoveries of scientific novelties –
innovation – is the application of such inventions to
actual production.
• Schumpeter classifies innovation into five categories –
introduction of new type of goods, introduction of new
methods of production, opening of new markets,
discovering of new sources of raw materials, change in
the organisation of an industry, like the creation of a
monopoly, trust, or cartel, or breaking up of a
monopoly, cartel etc.

Marginal Efficiency of Capital (MEC) Theory
• John Maynard Keynes
• According to Keynes’, a trade cycle occurs due to the

fluctuations in the rate of changes in the marginal
efficiency of capital.
• ‘The trade cycle is best regarded as being

occasioned by a cyclical change in the marginal
efficiency of capital, though complicated and often
aggravated by associated changes in the other
significant short period variables of the economic
system’.
Managerial
Economics
(UM19MB504)
Session 40:
International Trade and
Interdependence
PES University
International Trade
• International trade is the exchange of goods and services among

nations.
• Imports – are goods and services purchased from others.
• Exports – are goods and services sold to other countries.
• The principal of economic interdependence is fundamental to
marketing in a global environment.

Interdependence of Nations: Absolute
Advantage
• Absolute advantage is when a producer can produce a good or

service in greater quantity for the same cost, or the same quantity
at lower cost, than other producers.
• Absolute advantage can be the basis for large gains from trade
between producers of different goods with different absolute
advantages.
• By specialization, division of labor, and trade, producers with
different absolute advantages can always gain over producing in
isolation.

Interdependence of Nations: Comparative
Advantage
• Comparative advantage suggests that countries will engage in trade

with one another, exporting the goods that they have a relative
advantage in productivity.
• The theory was first introduced by David Ricardo in the year 1817.
• Absolute advantage refers to the uncontested superiority of a country
to produce a particular good better. Comparative advantage
introduces opportunity cost as a factor for analysis in choosing
between different options for production.

Government Involvement in International Trade
• Balance of Trade – the difference between exports and imports.

• Trade Surplus – nation exports more than imports.
• Trade Deficit – nation imports more than exports.
• Negative consequences of trade deficit – reduces a nations revenue.
More money leaves the country.
• Trade Barriers – When countries impose barriers to commercial
exchange between nations that is conducted on free market
principles, without restrictive regulations.

• Tariffs -- (sometimes called a duty) is a tax on imports. Revenue

producing tariffs first used around 1913 before income taxes.
Discourage trade or make prices/competition fairer, known as
protective tariff
• Quotas – limits either the quantity or the monetary value of a
product that may be imported.
• Embargos – a total ban on specific goods coming into and leaving a
country. Can impose an embargo for health reasons.

• Protectionism – economic policies to protect domestic industries.

Protectionism is the opposite of free trade.
Imposing tariffs and quotas is one method of practicing
protectionism.
• Subsidies – subsidizing domestic companies allowing them to be
more competitive

Trade Agreements
and Alliances
World Trade Organization

(WTO)
North American Free Trade

Agreement (NAFTA)
European Union (EU)

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Managerial

• The national accounts provide a comprehensive, conceptual and

PES University - MBA - Managerial Economics (UM19MB504) 3

• The sources consist of data generated as a byproduct of public

PES University - MBA - Managerial Economics (UM19MB504) 4

• In the 1930s it was impossible for macroeconomics to exist in the

PES University - MBA - Managerial Economics (UM19MB504) 5

PES University - MBA - Managerial Economics (UM19MB504) 7

• Calculating GDP requires adding together million of goods and

PES University - MBA - Managerial Economics (UM19MB504) 8

• GDP does not measure total transactions in the economy. It counts

PES University - MBA - Managerial Economics (UM19MB504) 9

• Selling your car to a neighbor does not add to GDP.

PES University - MBA - Managerial Economics (UM19MB504) 10

• Two different approaches are used to calculate GDP.

PES University - MBA - Managerial Economics (UM19MB504) 11

• The expenditure approach utilizes four main components:

PES University - MBA - Managerial Economics (UM19MB504) 12

PES University - MBA - Managerial Economics (UM19MB504) 13

• Nominal GDP measures the value of output in a given period in the

PES University - MBA - Managerial Economics (UM19MB504) 14

• The calculation of real GDP gives us a useful measure of inflation

PES University - MBA - Managerial Economics (UM19MB504) 15

• Personal income (PI) is national income plus net transfer payments

PES University - MBA - Managerial Economics (UM19MB504) 16

• Agriculture: value of crop outputs, value of livestock products, inputs of

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PES University - MBA - Managerial Economics (UM19MB504) 18

PES University - MBA - Managerial Economics (UM19MB504) 19

• An Unemployed person is defined as one who is not employed and who

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Unemployment occurs due to the below factors :

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• A person may be hired into a new job.

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• Two types of Unemployment exist :

• Natural /Frictional Unemployment

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• The natural rate of unemployment is the rate of unemployment arising

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• Natural Employment consists of “search” unemployment and “wait”

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• Cyclical unemployment is unemployment in excess of frictional

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• Natural rate of Unemployment is a function of duration and frequency

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• Frequency of Unemployment is the average number of times, per

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1. Loss of output as a result of not being at full employment

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PES University - MBA - Managerial Economics (UM19MB504) 31

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• The Indian Labour Bureau, in addition to the NSSO surveys, has

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• Inflation is a rise in the general level of prices of goods and services in

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