mb0025 | Cost Of Living | Inflation

1. Define Managerial Economics and discuss its importance and functions.

- Managerial economics sometimes referred to as business economics, is a branch of economics that applies microeconomic analysis to decision methods of businesses or other management units. As such, it bridges economic theory and economics in practice. It draws heavily from quantitative techniques such as regression analysis and correlation. If there is a unifying theme that runs through most of managerial economics it is the attempt to optimize business decisions given the firm's objectives and given constraints imposed by scarcity, for example through the use of operations research and programming. The importance of managerial economics is apply economical theories to find solutions to day to day problems faced by a firm. - It gives guidance for identification of key variables in decision making. - It helps the business executives to understand the various intricacies of business and managerial problems and to take right decisions at the right time. - It provides the necessary conceptual, technical skills, toolbox of analysis and techniques of thinking and instruments like elasticity of demand and supply, cost and revenue, income and expenditure, profit and volume of production etc to solve various business problems. - It is both a science and art in the context of globalisation, privatisation, liberalisation and marketization and highly competitive dynamic economy. It helps in identifying various business and managerial problems their causes and consequences and suggests various programs and policies to overcome them. - It helps the business executives to become much more responsive. realistic and competent to face the ever changing challenges in the modern business world. - It helps in optimum use of scarce resources of a firm to maximise profits. - It also helps in achieving other objectives a firm like attaining industry leadership, market share expansion and social responsibilities etc. - It helps a firm forecasting the most important economic variables like demand, supply, cost, revenue, price, sales and profit etc formulate sound business policies. - It also helps in understanding the various external factors and forces which effect the decision making of affirm. The two important functions of managerial economics are 1 Decision making 2 Forward Planning. Decision-making essentially is process of selecting the best out of many alternative opportunities or course of action that are open to management. Decision making is management function. Decision making is routine affair in any business unit. Hence it is apart of business

activity. It is a basic function of a managerial economist. In the day-to-day business he has to make numerous decisions. Sometimes the manager takes the decision himself sometimes in collaboration and consultations with others. Some decisions are taken on the spot and other taken after careful thinking. Some decisions are major and complex while others minor and simple. Some decisions are taken in the absence of any information. Some decisions are taken in the background of certainty, known factors and information. The choices made by the business executives are difficult, crucial. And far reaching consequences. The basic aim of taking a decision is to select the best course of action which maximises the economic benefits and minimises the use of scarce resources. Any slight delay in making a decision can cause considerable economical and financial damage to the firm. So right decisions at the right time is of great benefit to the firm. Forward planning implies planning in advance for the future. It is associated with deciding the future course of action of a firm. It is prepared on the basis of past and current experiences of a firm. It is prepared in the background of uncertain and unpredictable environment and guess work. Future events and happenings cannot be predicted accurately. The success or failure of the future plan depends on a number of factors and forces which are unknown in nature. Much of economic activity is forward looking Every time we build a new factory, add to the stocks of inputs, trucks, computer or improvements in R&D our intension is to enhance the future of the firm. Growing firms devote a significant share of their current output to net capital formation to bolster future economic output.

that is it measures the relationship as the ratio of percentage changes between quantity demanded of a good and changes in its price. It is a measure of how consumers react to a change in price. the total revenue of producers falls to zero. the percentage change in quantity is equal to that in price. Hence. and elastic demand means that consumers are sensitive to the price at which a product is sold and will not buy it if the price rises by what they consider too much. the price elasticity of demand is a measure of the sensitivity of quantity demanded to changes in price. Inelastic demand means a producer can raise prices without much hurting demand for its product. and very elastic if consumers will only pay a certain price. any increase in the price. when the price is raised. Elasticity of demand is defined as the measure of responsiveness in the quantity demanded for a commodity as a result of change in price of the same commodity. In other words. In simpler words. when the price is raised. the percentage change in quantity demanded is greater than that in price. the percentage change in quantity demanded is smaller than that in price. it is percentage change in quantity demanded by the percentage change in price of the same commodity. Hence. In economics and business studies. and vice versa. The different degrees of price elasticity are:When the price elasticity of demand for a good is inelastic (|Ed| < 1). When the price elasticity of demand for a good is unit elastic (or unitary elastic) (|Ed| = 1). demand for a product can be said to be very inelastic if consumers will pay almost any price for the product. for the product. and vice versa. The demand curve is a horizontal . When the price elasticity of demand for a good is elastic (|Ed| > 1).2. Hence. When the price elasticity of demand for a good is perfectly elastic (Ed is undefined). . What is elasticity of demand? Explain the different degree of price elasticity With suitable examples. It is measured as elasticity. the total revenue of producers falls. or a narrow range of prices. no matter how small. the total revenue of producers rises. will cause demand for the good to drop to zero. when the price is raised.

neither increases nor decreases in price affect the quantity demanded (no matter what the price.99 for it. An example of a perfectly inelastic good is a human heart for someone who needs a transplant. yet everyone will pay £9. a person will pay for one heart but only one. A banknote is the classic example of a perfectly elastic good. changes in the price do not affect the quantity demanded for the good. no matter how low the price is). . The demand curve is a vertical straight line. this violates the law of demand.01 for a £10 note. nobody would buy more than the exact amount of hearts demanded. nobody would pay £10. When the price elasticity of demand for a good is perfectly inelastic (Ed = 0).straight line.

Under the approach the potential buyers are directly contacted. d. Growth curve approach According to this the rate of growth and the ultimate level of demand for the new product are estimated on the basis of the pattern of growth of established products f. say super markets or big bazaars in big cities. which are also big marketing centres.3 Suppose your manufacturing company planning to release a new product into market. Substitute approach. The product may be offered for through in one supermarket and the estimate of sales obtained may be blown up to arrive at estimated demand for the product. Vicarious approach . the demand conditions of the old product can be taken as a basis for forecasting the demand for the new product.. Evolutionary approach The demand for the new product may be considered as an outgrowth of an existing product. These are finally looked up to forecast the demand for the new product. or through the use of samples of the new product and their responses are found out. If the new product developed serves as the substitute for the existing product the demand of the new product can be worked out on the basis of a market share. c. For e. Thus when a new product is evolved from the old product. Offer the new product for sale in a sample market. The growths of demand for all the products have to be worked out on the basis of intelligent forecast for independent variables that influence the demand for the substitutes. Opinion Poll approach. b.g. After that a portion of the market can be sliced out for the new product. e. Explain the various methods forecasting for a new product In this scenario what we have to be aware of is that it is quite different from forecasting demand for established products a. Sales experience approach. Demand for the Tata Indica which is a modified version of the old indica can most effectively be projected based on the sales of the old indica.

These methods are not mutually exclusive. This helps in making a more efficient estimation of future demands. about the different varieties of the product already available in the market.A firm will survey consumers’ reactions to a new product indirectly through getting in touch with some specialized and informed dealers who have good knowledge about the market. . the consumers’ preferences etc.

and number of buyers. this raises the equilibrium price from P1 to the higher P2. If the demand decreases. In the diagram. Explain the changes in market equilibrium and effects to shifts in supply and demand Equilibrium is simply a state of the world where economic forces are balanced and in the absence of external influences the (equilibrium) values of economic variables will not change. Increased demand can be represented on the graph as the curve being shifted outward. Market equilibrium. as from the initial curve D1 to the new curve D2. and the quantity will decrease. This is an effect of demand changing. The increase in demand could also come from changing tastes and fads. A movement along the curve is described as a "change in the quantity demanded" to distinguish it from a "change in demand. More people wanting coffee is an example.When consumers increase the quantity demanded at a given price. and decreases to D1. represented as shifts in the respective curves. a greater quantity is demanded. Comparative statics of such a shift traces the effects from the initial equilibrium to the new equilibrium Demand curve shifts . then the opposite happens: an inward shift of the curve. Define the term equilibrium. refers to a condition where a market price is established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. for example. If the demand starts at D2. This raises the equilibrium quantity from Q1 to the higher Q2." that is. the price will decrease. complementary and substitute price changes. At each point. a greater amount is demanded (when . market expectations. there has been an increase in demand which has caused an increase in (equilibrium) quantity. Practical uses of supply and demand analysis often center on the different variables that change equilibrium price and quantity. price and demand are different. a shift of the curve. This would cause the entire demand curve to shift changing the equilibrium price and quantity. incomes. The quantity supplied at each price is the same as before the demand shift (at both Q1 and Q2). it is referred to as an increase in demand. The equilibrium quantity.4. At each price point. This price is often called the equilibrium price or market clearing price and will tend not to change unless demand or supply change. In the example above. It is the point at which quantity demanded and quantities supplied are equal.

An out-ward or right-ward shift in demand increases both equilibrium price and quantity The demand curve "shifts" because a non-price determinant of demand has changed.” If either of these conditions does not hold.there is a shift from D1 to D2). Graphically the shift is due to a change in the x-intercept. A shift in the demand curve due to a change in a non-price determinant of demand will result in the market's being in a non-equilibrium state. If the demand curve shifts in. Two assumptions are necessary for the validity of the standard model. First.the answers to issues concerning when. that supply is "constrained by a fixed resource. there will be a surplus . whether and how a new equilibrium will be established are issues that are addressed by stochastic models economic dynamics.at the new market price quantity supplied will exceed quantity demanded. If the demand curve shifts out the result will be a shortage . that supply and demand are independent and second.at the new market price quantity demanded will exceed quantity supplied. The process by which a new equilibrium is established is not the province of comparative statics . then the Marshallian model cannot be sustained Supply curve shifts - .

Otherwise stated. The supply curve can also move inward or outward.An out-ward or right-ward shift in supply reduces equilibrium price but increases quantity When the suppliers' costs change for a given output. If the quantity supplied decreases at a given price. producers will be willing to supply more wheat at every price and this shifts the supply curve S1 outward. The equilibrium quantity increases from Q1 to Q2 as the quantity demanded extends at the new lower prices. For example. assume that someone invents a better way of growing wheat so that the cost of growing a given quantity of wheat decreases. there are three possible movements. and the equilibrium quantity will decrease. to S2—an increase in supply. the equilibrium price will increase. If the supply curve starts at S2. and shifts inward to S1. The equilibrium quantity. This increase in supply causes the equilibrium price to decrease from P1 to P2. The quantity demanded at each price is the same as before the supply shift (at both Q1 and Q2). the supply curve shifts in the same direction. . the price and the quantity move in opposite directions. In a supply curve shift. When there is a change in supply or demand. This is an effect of supply changing. demand contracts. price and supply changed. the opposite happens. The demand curve can move inward or outward.

which are not as clear cut regarding their effects on a business's bottom-line value. It has been described as expressing "the basic relationship between scarcity and choice The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently Thus. With these expenses. lost time. the time and effort that an owner puts into the maintenance of the company rather than working on expansion. swag. These are intangible costs that are not easily accounted for.5. This contrasts with lesstangible expenses such as goodwill amortization. Opportunity cost is a key concept in economics because it implies the choice between desirable. pleasure or any other benefit that provides utility should also be considered opportunity costs The actual cost of a project represents the true total and final costs accrued during the process of completing all work during the pre-determined period of time allocated for all schedule . opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone. It is a calculating factor used in mixed markets which favor social change in favor of purely individualistic economics. A business expense that is easily identified and accounted for. it is easy to see the source of the cash outflow and the business activities to which the expense is attributed. rent or lease costs. For example. and the cost of materials that go into the production of goods. Good examples of explicit costs would be items such as wage expense. excluding cash. Explicit costs represent clear. Give a brief description of (a) Implicit and Explicit cost Implicit cost that is represented by lost opportunity in the use of a company's own resources. (b) Actual and opportunity cost Opportunity cost or economic opportunity loss is the value of the next best alternative forgone as the result of making a decision Opportunity cost analysis is an important part of a company's decision-making processes but is not treated as an actual cost in any financial statement The next best thing that a person can engage in is referred to as the opportunity cost of doing the best thing and ignoring the next best thing to be done. obvious cash outflows from a business that reduce its bottom-line profitability. yet mutually exclusive results.

but not limited to. . The term actual cost can also be referred to as actual costs of work performed (AWCP). and also all costs including indirect costs.activities as well as for all work breakdown structured components. Actual costs are primarily made up of a number of specific items including. cost in direct labour hours. when possible. should be thoroughly itemized in detail throughout the project as opposed to merely compiled at the end as it is easier to accurately itemize costs when it is done as the expenditures occur. direct costs alone. Actual costs.

The firm aims at maximizing its sales revenue subject to a minimum profit constraint. Few assumptions of this model are. Critically examine Boumal’s static and dynamic models. . Boumal's model highlights that the primary objective of a firm is to maximize its sales rather than profit maximization. 1. Demand and cost curves of the firm are conventional in nature. 1. Dynamic Model: This model explains how changes in advertisement expenditure. 4. 2. 3. 2. 3. would affect the sales revenue of a firm under severe competitions. Boumal has developed two models: 1st is Static Model and 2nd is Dynamic model The Static Model: This model is based on the following assumptions. The demand curve of the firm slope downwards from left to right. It states that the goal of a firm is maximization of sales revenue subject to a minimum profit constraint.6. Prof. The average cost curve of the firm is U-shaped one. . Market price remains constant. The model is applicable to a particular time period and the model does not operate at different periods of time. Higher advertisement expenditure would certainly increase sales of a firm. a major determinant of demand.

company growth maintain price leadership desensitize customers to price discourage new entrants into the industry match competitors prices encourage the exit of marginal firms from the industry survival avoid government investigation or intervention . Determining what your objectives are is the first step in pricing. Stabilization of margin is basically a cost-plus approach in which the manager attempts to maintain the same margin regardless of changes in cost. forces and its own business objectives. Pricing objectives or goals give direction to the whole pricing process. nature of marketing etc. 3) consumer price elasticity and price points and 4) the resources you have available. a firm adopts different policies and methods to fix the price of its products. Pricing is considered as one of the basic and central problems of economic theory in a modern economy. pattern of distribution. When deciding on pricing objectives you must consider: 1) the overall financial. marketing. and strategic objectives of the company. Fixing prices are the most important aspect of managerial decision making because market price charged by the company affects the present and future production plans. Pricing policy refers to the policy of setting the price of the product or products and services by the management after taking into account of various internal and external factors. Pricing Policy basically depends on price theory that is the corner stone of economic theory. 2) the objectives of your product or brand. Some of the more common pricing objectives are: • • • • • • • • • • • • • • • • maximize long-run profit maximize short-run profit increase sales volume (quantity) increase monetary sales increase market share obtain a target rate of return on investment (ROI) obtain a target rate of return on sales stabilize market or stabilize market price: an objective to stabilize price means that the marketing manager attempts to keep prices stable in the marketplace and to compete on non-price considerations.1. What do you mean by pricing policy? Explain the various objective of pricing policy of a firm A detailed study of the market structure gives us information about the way in which prices are determined under different market conditions. in reality. However.

or product be perceived as “fair” by customers and potential customers create interest and excitement about a product discourage competitors from cutting prices use price to make the product “visible" build store traffic help prepare for the sale of the business (harvesting) social.• • • • • • • • • • obtain or maintain the loyalty and enthusiasm of distributors and other sales personnel enhance the image of the firm. ethical. brand. or ideological objectives get competitive advantage .

2. the price elasticity depends on the rival¡¦s reaction to change its price. The sellers are the price makers and not price takers. Because there are few participants in this type of market. government rules / regulations or ownership of scare resources. however. An oligopoly is a market form in which a market or industry is dominated by a small number of sellers (oligopolists). Strategic planning by oligopolists always involves taking into account the likely responses of the other market participants. the cost per unit of products decreases. is a simple form of Oligopoly in which only two firms dominate a market. where the market shares of four largest firms are measured (as a percentage) since they form the major portion of the market share. the barriers can be due to patents. and are influenced by.Pepsi and Coke. The decisions of one firm influence. An Oligopolist faces a downward sloping demand curve. Entry barriers for the other firms are high. Firms are interdependent for decision making. The features Oligopolistic Market are as follows: • • • • • • • • • It is a market dominated by a small number of participants who are able to collectively exert control over supply and market prices. The word is derived from the Greek oligo 'few' plus -opoly as in monopoly and duopoly.g. the decisions of other firms. Duopoly: . What is Oligopoly? Explain the features of Oligopoly markets. Cadbury and Schweppes.:. This causes oligopolistic markets and industries to be at the highest risk for collusion. The sellers can achieve economies of scale. Products can be homogenous (standardized) or heterogeneous (differentiated). There is high degree of market concentration. Few firms sell branded products which are close substitutes of each other. investment and output. in this method the firms takes into account the decisions/strategies of the competitors before deciding their strategies. since the few sellers mutually dominate the pricing decisions. The sellers can achieve supernormal profits in the long run. copyrights. since the four-firm concentration ratio is often used. thus ensuring higher profits. The firm uses Game Theory. since for the large producers as the level of production rises.A Duopoly. . The different forms of Oligopoly are: 1. e. each oligopolist is aware of the actions of the others.

Cartel: .When there is a formal agreement among the Oligopolist for a collusion (to increase prices and restrict production in the same way as a monopoly) with an objective to reduce risk and foster joint profit it is termed as Cartel. . 4. Oligopsony: . there are few buyers and large number of sellers.A market with a few sellers (oligopoly) and a few buyers (Oligopsony) is referred as Bilateral Oligopoly.In Oligopsony. The other characteristics are same as Oligopoly.2. Bilateral Oligopoly: . 3.

It may increase to Rs14 crore and Rs 1 crore constitutes the savings. there is no saving and investment. Further the income increases to Rs. It consists of three inter related propositions: 1. Increasing the volume of investment in an economy can only fill up the gap between income and Consumption. This law tells us that people fail to spend on consumption the full amount of increment in income. This law is also called the fundamental law of consumption. Generally it is observed that when income increases. it is impossible to raise the propensity to consume of the people so as to increase the national output. It is based upon his observations and conclusion derived from the study of consumption function. These three prepositions form Keynes psychological law of consumption. This savings create a gap between Income and Consumption. Factors determining consumption function . Suppose the total income of the community is 10 crore and the consumption expenditure is also Rs 10 crore. both consumption spending and saving will go up. When the aggregate income increases. This tendency is so deep rooted in people's habits. customs. The increased income is distributed over both spending and saving. expenditure on consumption will also increase but by a smaller amount. Then. State the psychological law of consumption. 3. which states that. Explain the various factors that affect consumption function and its importance.15 crore. when aggregate income increases. but not to the extent of Rs15 crore. consumption expenditure shall also increase but by a somewhat smaller amount". This gap is in conformity with Keynes Psychological law of consumption. and the psychological set up that it is difficult to change in the short run. This law may be considered as a rough indication of the actual macro behaviour of consumers in the short run. As income increases.3. consumption also increases. the wants of the people get satisfied and as such when income increases they save more than what they spend. In that case. As consumption expenditure progressively diminishes when income increases. 2. This is the fundamental principle upon which the Keynesian consumption function is based. income and employment. consumption also increases but by a less proportion than the increase in income. As income increases. Hence. a gap between income and expenditure arises.

generosity. The following are some of the important objective factors. 10. "We could also draw up a corresponding list of motives to consumption such as enjoyment. 2. In this case personal factors will not come into picture. Real income. he has also added a list of motives. They are the motives of precaution. ostentation and extravagance" Keynes. In addition to these factors. 1. calculation. They are 1. Liquid assets. Subjective Factors. Changes in expectations. Windfall (Sudden) gains and losses. II. Keynes has listed eight main motives. Changes in tastes and fashion. foresight. Objective factors Objective factors are those. pride and avarice. enterprise. Attitude towards thrift 11. which influence consumption function in the long run. the subjective factors are internal or endogenous in nature. independence. They mainly depend upon the personal decisions taken by the people. Price and wage level. 4. 3. Fiscal Policy. 6. Objective factors. . there are two factors. Distribution of national income. improvement. which compel people to refrain from current spending. Money income. 2. short sightedness. 1. 7. The level of consumer Indebtedness. which leads to consumption. 8. which influence consumption. miscalculation. 9. Subjective factors: Subjective factors basically underlie and determine the form of the consumption. which depends on merits and facts. 5.Broadly speaking.

Rate of interest. 15 demonstration effect. It is because of this. 14. Keynes places his reliance on investment for the purpose of increasing employment during depression. Thus. and 17 Installment buying. Business policies of corporations. 13. Social and life insurances. propensity to consume in the short period is generally stable. Changes in expectations.12. 16. . The objective factors generally remain unchanged in the short period. etc.

Monetary policy is contrasted with fiscal policy. (ii) availability of money. The Treaty makes clear that ensuring price stability is the most important contribution that monetary policy can make to achieve a favourable economic environment and a high level of employment. or monetary authority of a country controls (i) the supply of money. Article 105 (1). while contractionary policy involves raising interest rates in order to combat inflation. where an expansionary policy increases the total supply of money in the economy. It assigns overriding importance to price stability.To maintain price stability is the primary objective of the Eurosystem and of the single monetary policy for which it is responsible. spending and taxation. Monetary policy is the process by which the government. What is Monetary policy? Explain the general objectives and instruments of monetary policy. central bank. Objectives of the monetary policy. or a contractionary policy. the natural role of monetary policy in the economy is to maintain price stability (see scope of monetary policy). which refers to government borrowing. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates. This is laid down in the Treaty establishing the European Community. Monetary policy can affect real . Maintaining stable prices on a sustained basis is a crucial pre-condition for increasing economic welfare and the growth potential of an economy . the Eurosystem will also "support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community".4. "Without prejudice to the objective of price stability". These include a "high level of employment" and "sustainable and noninflationary growth". and (iii) cost of money or rate of interest. and a contractionary policy decreases the total money supply. The Treaty establishes a clear hierarchy of objectives for the Eurosystem. 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. These Treaty provisions reflect the broad consensus that   the benefits of price stability are substantial (see benefits of price stability). Monetary policy is referred to as either being an expansionary policy.

Fractional reserve limits the amount of loans banks can make to the domestic economy and thus limit the supply of money. an interest rate or the exchange rate-in order to affect the goals which it does not control. Monetary policy guides the Central Bank’s supply of money in order to achieve the objectives of price stability (or low inflation rate). The assumption is that Deposit Money Banks generally maintain a stable relationship between their reserve holdings and the amount of credit they extend to the public. given that monetary policy can affect real activity in the shorter term. But ultimately it can only influence the price level in the economy. The Treaty provisions also imply that. In particular. the Eurosystem should also take into account the broader economic goals of the Community. Open Market Operations: The Central Bank buys or sells ((on behalf of the Fiscal Authorities (the Treasury)) securities to the banking and nonbanking public (that is in the open market). One such security is Treasury Bills. necessitate spending adjustments. it reduces the supply of reserves and when it buys (back) securities-by redeeming them-it increases the supply of reserves to the Deposit Money Banks. 2 . thus affecting the supply of money. some monetary variables which the Central Bank controls are adjusted-a monetary aggregate. The instruments of monetary policy used by the Central Bank depend on the level of development of the economy. full employment. The commonly used instruments are discussed below. Instruments of monetary policy. Reserve Requirement: The Central Bank may require Deposit Money Banks to hold a fraction (or a combination) of their deposit liabilities (reserves) as vault cash and or deposits with it. Lending by the Central Bank: The Central Bank sometimes provide credit to Deposit Money Banks. especially its financial sector. When the Central Bank sells securities. in the actual implementation of monetary policy decisions aimed at maintaining price stability. the ECB typically should avoid generating excessive fluctuations in output and employment if this is in line with the pursuit of its primary objective. thus affecting the level of reserves and hence the monetary base. To conduct monetary policy. and growth in aggregate income.activity only in the shorter term (see the transmission mechanism).Fiduciary or paper money is issued by the Central Bank on the basis of computation of estimated demand for cash. This is necessary because money is a medium of exchange and changes in its demand relative to supply.

The real exchange rate when misaligned affects the current account balance because of its impact on external competitiveness. Key elements of prudential guidelines remove some discretion from bank management and replace it with rules in decision making. Exchange Rate: The balance of payments can be in deficit or in surplus and each of these affect the monetary base. through the balance of payments and the real exchange rate. interest rate caps. which otherwise they may not do. In this way the available savings is allocated and investment directed in particular directions.Interest Rate: The Central Bank lends to financially sound Deposit Money Banks at a most favourable rate of interest. The others are quantitative instruments because they have numerical benchmarks. . persuade banks to follow certain paths such as credit restraint or expansion. the Central Bank ensures that the exchange rate is at levels that do not affect domestic money supply in undesired direction. the supply of savings (which affects the supply of reserves and monetary aggregate) and the supply of investment (which affects full employment and GDP). The MRR sets the floor for the interest rate regime in the money market (the nominal anchor rate) and thereby affects the supply of credit. Moral suasion and prudential guidelines are direct supervision or qualitative instruments. called the minimum rediscount rate (MRR). It can. Direct Credit Control: The Central Bank can direct Deposit Money Banks on the maximum percentage or amount of loans (credit ceilings) to different economic sectors or activities. liquid asset ratio and issue credit guarantee to preferred loans. By selling or buying foreign exchange. Prudential Guidelines: The Central Bank may in writing require the Deposit Money Banks to exercise particular care in their operations in order that specified outcomes are realized. and hence the money supply in one direction or the other. increased savings mobilization and promotion of exports through financial support. on the basis of their risk/return assessment. Moral Suasion: The Central Bank issues licenses or operating permit to Deposit Money Banks and also regulates the operation of the banking system. from this advantage.

The term business cycle. (or economic cycle) refers to economy-wide fluctuations in production or economic activity over several months or years. due to government involvement..5. each reflecting differing levels of economic activity and the subsequent circumstances occurring during each respective stage. prices usually don't fall. These fluctuations occur around a long-term growth trend. Following the peak is a recession. and periods of relative stagnation or decline (contraction or recession) These fluctuations are often measured using the growth rate of real gross domestic product. Employment tends to increase (unemployment falls) and there is upward pressure placed on prices (inflation rises) as output rises. There is very little upward pressure on prices and in some cases there is downward pressure on prices (deflation). During this phase output actually decreases (the rate of growth becomes negative). . unemployment begins to rise and the inflationary pressure on prices fades In America. and typically involve shifts over time between periods of relatively rapid economic growth (expansion or boom. This is known as a trough and unemployment tends to be at its peak and production at it low point. What is a business cycle? Describe the different phases of a business cycle. The business cycle is identified and marked by the National Bureau of Economic Research (NEBR). or contraction. an independent economic "think tank". but the rate of inflation decreases). A peak is reached when the economy has produced the greatest amount of output. An expansion is where the economy is experiencing positive and increasing economic output. At this point employment is generally at or near its highest level (unemployment is at its lowest level: usually below the full employment rate of approximately 5%) and prices tend to rise more rapidly (inflation accelerates). The low point of the cycle occurs next.. Despite being termed cycles. most of these fluctuations in economic activity do not follow a mechanical or predictable periodic pattern A business cycle consists of four unique components.

each unit of currency buys fewer goods and services. Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply Views on which factors determine low to moderate rates of inflation are more varied. inflation is a rise in the general level of prices of goods and services in an economy over a period of time. the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth Today. as well as to growth in the money supply. A chief measure of price inflation is the inflation rate. Positive effects include a mitigation of economic recessions and debt relief by reducing the real level of debt. consequently. Low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn. inflation is also an erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy. the annualized percentage change in a general price index (normally the Consumer Price Index) over time Inflation can have positive and negative effects on an economy. Discuss different kinds of Inflation and the measures adopted to control it. Generally. and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Negative effects of inflation include loss in stability in the real value of money and other monetary items over time. through open market operations . In economics. However.6. uncertainty about future inflation may discourage investment and saving. and reduce the risk that a liquidity trap prevents monetary policy from stabilizing the economy.When the price level rises.and through the setting of banking reserve requirements Basic types of inflation . most mainstream economists favor a low steady rate of inflation. or changes in available supplies such as during scarcities. these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services. Define inflation.] The task of keeping the rate of inflation low and stable is usually given to monetary authorities.

Indexation makes inflation much less painful. A systematic institutional difference is between countries having or not having (partial or total) indexation of wages (and other income sources). As an indication only. with yearly price increases of three-digits percentage points and an explosive acceleration. some indications can be given as it follows. say.Different types of inflations can have widely different determinants. Controlling inflation A variety of methods have been used in attempts to control inflation.domestic costs. basing on their broadlydefined origins: 1. but normally keeps it at a higher level and increases the risk of a continous acceleration. Below zero. Both kinds can be stable or dangerously accelerate to enter in an hyperinflation condition. Moderate inflation can be differently defined around the world. 2. Around zero there is no inflation (price stability). the higher part of this range is already "high inflation". Hyperinflation is the most extreme inflation phenomenon. A transversal classification distiguish inflations. Most central banks are tasked with keeping the federal funds lending rate at a low level. and within a targeted low inflation range. a country faces deflation. Extremely high inflation could range anywhere between 50% and 100%. 3. as oil price increases or currency relative devaluation. somewhere from about 2% to 6% per .external sources. as wages. Still. one could consider an inflation as moderate when it ranges from 5% to 25-30%. There is no strictly binding definition of ranges of intensity in price increase. effects and remedies. Low inflation can be characterized from 1-2% to 5%. 30%-50% a year.domestic demand. given the different inflation histories. Monetary policy Today the primary tool for controlling inflation is monetary policy. High inflation is a situation of price increase of. normally to a target rate around 2% to 3% per annum. For some countries.

whether express or implied. in the later part of the 20th century. Brazil. as deflationary conditions are seen as dangerous for the health of the economy. some countries reverted to a fixed exchange rate as part of an attempt to control inflation. as the value of the reference currency rises and falls. It can also be used as a means to control inflation. slowing the rise in the money supply). a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value.S. Gold standard . For instance. Fixed exchange rates Under a fixed exchange rate currency regime. Keynesians emphasize reducing aggregate demand during economic expansions and increasing demand during recessions to keep inflation stable. most countries around the world had currencies that were fixed to the US dollar. A low positive inflation is usually targeted. Argentina (19912002). This limited inflation in those countries. A fixed exchange rate is usually used to stabilize the value of a currency. and Chile). countries gradually turned to floating exchange rates. This policy of using a fixed exchange rate to control inflation was used in many countries in South America in the later part of the 20th century (e. Bolivia. some follow a symmetrical inflation target while others only control inflation when it rises above a target. However. Control of aggregate demand can be achieved using both monetary policy and fiscal policy (increased taxation or reduced government spending to reduce demand). a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability. such as gold). though they have different approaches. and using monetary policy to control inflation (increasing interest rates.annum. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations. Monetarists emphasize keeping the growth rate of money steady. Central banks such as the U. This essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to. However. vis-a-vis the currency it is pegged to. In addition. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation. Under the Bretton Woods agreement.g. There are a number of methods that have been suggested to control inflation. After the Bretton Woods agreement broke down in the early 1970s. so does the currency pegged to it. but also exposed them to the danger of speculative attacks.

there . They often have perverse effects. fungibility. Under this system all other major currencies were tied at fixed rates to the dollar. as were seen in some countries during the Great Depression. and ease of identification. However. their use in other contexts is far more mixed. which itself was tied to gold at the rate of $35 per ounce. However. Under a gold standard.The gold standard is a monetary system in which a region's common media of exchange are paper notes that are normally freely convertible into pre-set.] Wage and price controls Another method attempted in the past have been wage and price controls ("incomes policies"). Artificially low prices often cause rationing and shortages and discourage future investment. The standard specifies how the gold backing would be implemented. including the amount of specie per currency unit. silver certificate. winning the war being fought. Notable failures of their use include the 1972 imposition of wage and price controls by Richard Nixon. but is accepted by traders because it can be redeemed for the equivalent specie. The Bretton Woods system broke down in 1971. divisibility. only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime. fixed quantities of gold. For example. could be redeemed for an actual piece of silver. Wage and price controls have been successful in wartime environments in combination with rationing. they were not without their problems and critics. More successful examples include the Prices and Incomes Accord in Australia and the Wassenaar Agreement in the Netherlands. The usual economic analysis is that any product or service that is under-priced is overconsumed. In general wage and price controls are regarded as a temporary and exceptional measure. The currency itself has no innate value. A U. resulting in yet further shortages. Gold was a common form of representative money due to its rarity.S. causing most countries to switch to fiat money – money backed only by the laws of the country. Austrian economists strongly favor a return to a 100 percent gold standard.] Representative money and the gold standard were used to protect citizens from hyperinflation and other abuses of monetary policy. due to the distorted signals they send to the market. for example. if the official price of bread is too low. and that monetary policy would essentially be determined by gold mining. the long term rate of inflation (or deflation) would be determined by the growth rate of the supply of gold relative to total output] Critics argue that this will cause arbitrary fluctuations in the inflation rate. and so were partially abandoned via the international adoption of the Bretton Woods System. durability. which some believe contributed to the Great Depression. for example.

and (2) most cost-of-living indexes are not forward-looking. and too little investment in bread making by the market to satisfy future needs. employment contracts. thereby exacerbating the problem in the long term. and government entitlements (such as social security) are tied to a cost-of-living index. average wages have increased faster than most calculated cost-of-living indexes. reflecting the influence of rising productivity and worker bargaining power rather than simply living costs. whether labor or resources. The lower activity will place fewer demands on whatever commodities were driving inflation. while the recession prevents the kinds of distortions that controls cause when demand is high.will be too little bread at official prices. However. but instead compare current or historical data. in general the advice of economists is not to impose price controls but to liberalize prices by assuming that the economy will adjust and abandon unprofitable economic activity. Salaries are typically adjusted annually[ They may also be tied to a cost-of-living index that varies by geographic location if the employee moves. Temporary controls may complement a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment). In many countries. . This often produces a severe recession. typically to the consumer price index A cost-of-living allowance (COLA) adjusts salaries based on changes in a cost-of-living index. Cost-of-living allowance The real purchasing-power of fixed payments is eroded by inflation unless they are inflation-adjusted to keep their real values constant. Many economists and compensation analysts consider the idea of predetermined future "cost of living increases" to be misleading for two reasons: (1) For most recent periods in the industrialized world. as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed. and inflation will fall with total economic output. These negotiated increases in pay are colloquially referred to as cost-of-living adjustments or cost-of-living increases because of their similarity to increases tied to externally-determined indexes. Annual escalation clauses in employment contracts can specify retroactive or future percentage increases in worker pay which are not tied to any index. pension benefits.

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