Module 5: Business Environment and Economy Performance 10 Hours

5.1 Nature, Scope, Structure of Indian Business Environment – Internal and

External Environment.
5.2 Political and Legal Environment, Economic Environment.
5.3 Socio – Cultural Environment, Global Environment Macro-economic
aggregates .
5.4 circular flow of macroeconomic activity – National income determination
– Aggregate demand and supply – Macroeconomic equilibrium –
Components of aggregate demand and national income .
5.5 Multiplier effect.

5.1 Nature, Scope, Structure of Indian Business Environment – Internal and External
Environment, political and Legal Environment, Economic Environment,Socio – Cultural
Environment, Global Environment

Meaning of Business Environment

Business environment refers to the surrounding or factors which affect the operations of the
business. It refers to the area where the business exists. It consists of several factors that
affect the functioning, growth, profitability and even continuation of the business.  Factors
that constitute a business environment are customers, suppliers, competitors, investors,
technology, economic conditions, government, etc. These all factors affect the success or
failure of any business and bring several opportunities, threats, and challenges to it.

The business environment is a dynamic concept as it comprises of several factors which

keep on changing continuously. It can be broadly classified into two different categories:
Internal environment and External environment. Internal environment includes all those
factors which are internal to organisation and are under its control. These factors provide
strengths and weaknesses to the organization. Internal environment consists of physical
resources, plan and policies, corporate culture, vision and objectives, human resources, and
organization culture. Whereas the external environment includes all those factors which are
external to the organization and are not under its control. The external environment brings
opportunities or threats to the business. It includes factors like customers, suppliers,
competitors, society, technology, economic, political, and cultural environment.

Proper understanding of the business environment helps in framing better strategies as per
business opportunities and enhances the overall performance. Scope of Business
Environment is explained in points given below:
Identifies Business Opportunities and Threats
Business environment helps business in identification of various opportunities and threats.
When business is able to detect market opportunities timely, they can easily take
advantages of such opportunity at earliest. They can earn maximum returns by availing such
opportunity before the competitors. By proper interaction between business and its
environment all threats can be easily detected. It will enable business in taking corrective
measures timely.

Helps In Planning And Policy Formulation

Proper understanding of business environment helps in formulating better policies and
strategies. It conveys all current information regarding market conditions to business. All
opportunities and threats are scanned through the study of the business environment.
Businessmen are properly aware of environment and thereby take all decisions according to
it. Their entire plan can be changed effectively and efficiently through environmental
awareness.

Provides Useful Resources

Business depends on the environment in which they operate for several resources. Business
environment supplies several inputs like raw materials, capital and labour which are used by
the business for its operations. These inputs are converted into goods and services for
satisfying the needs of the market. Without proper supply of inputs, business cannot
continue its operations. It is fully dependent upon environment for taking inputs and
delivering the required goods or services.

Improves Performance
Business environment has an effective role in accelerating the overall performance of
business organisations. Through continuous environmental awareness, managers update
their knowledge and skills. Environmental study serves as the medium of educating
management. Monitoring of environment provides qualitative information which helps in
developing strategic thinking. It enables managers to adopt suitable management practices
to control and improve the performance of business.

Helps In Coping With Rapid Changes

Factors which constitute business environment are dynamic in nature. They keep on
changing continuously from time to time. These changes include changes in customer’s
preferences, fashion, technology, economic conditions etc.

Proper understanding of the business environment helps business in detecting all these
frequently occuring changes easily. It enables them in dealing with these changes efficiently
by taking appropriate actions at right time. Managers through continuous monitoring of
environment are sensitive to such changes and respond effectively.

Enhances Business Image

Business through proper understanding of its environment are able to improve its public
image. They are more responsive and sensitive to the environmental needs through proper
knowledge of business environment. Study of environment provides them information for
making realistic plans and implementing them effectively. Businesses are able to provide
better service and serve the interest of entire society. People are happy with the business
and develop confidence towards it. This enables in developing a better image in market.

Assist In Facing Competition

Business environment communicates all details about competitors in market to business.
Awareness regarding the actions and strategies of competitors is crucial for every business
for meeting competition effectively. It helps business in formulating plans and policies in
accordance with the competitor’s actions. Businesses are able to face challenges and
competition in market through systematic planning in an efficient way.

Nature of Business Environment

Nature of Business Environment

Complex
Business environment is complex in nature. It consists of several factors, conditions and
events which directly influence the functioning of business. These factors influence the
productivity and profitability of business. It is quite difficult to understand how a particular
factor affects the operations of business. Different factors affect differently the performance
of business. 

Dynamic
Business environment is a dynamic concept and keeps on changing continuously. Various
factors which constitute business environment are always changing from time to time.
These changes are in terms of changes in customer preferences, technological
improvements, new competitor’s entry etc. These ever changing factors bring changes in
character and shape of business environment making it dynamic.
Interdependence
Factors of business environment are dependent on each other. Business environment
include economic, social, legal, technological and political factors. Changes in any one of the
factors will bring changes in several other factors. Like countries having better economy are
able to enhance their technology by incurring sufficient expenditure on research and
development.

Uncertain
Factors which constitute business environment are uncertain. It is quite difficult to predict
several future conditions because no one knows what is going to happen in nature. These
factors changes too frequently like changes in fashion, technology, demand and economic
conditions.

Relativity
Business environment is relative in nature which means that it changes from one place to
another and from one country to another. Economic conditions In Canada are different from
those in India. Similarly, demand for women’s shalwar kameez is high in India than in U.S.A.  

System Approach
Business environment is a systematic approach which facilitates business in its functioning.
Business is a system which manufactures the products and services. It satisfies the wants of
customers by taking several inputs like raw materials, capital, labour etc. from environment
and delivering the required goods and services.

Social Responsibility Approach

Social responsibility is another important characteristic of business environment. According
to this, business exists for serving various members of society. These include shareholders,
employees, customers, government etc. and every business should consider their interest
while operating.

Following are Two types of business environment:

Primarily the types of business environment are classified under two categories;

1. Internal Business Environment

2. External Business environment

Internal Business Environment

As the name suggests, the internal business environment includes physical assets, human,
financial and marketing resources, technological supports, the management etc. Financial
resources represent the financial capabilities of the organization, while physical resources
are an indicator of physical assets which include machinery, production plant, and buildings
etc which convert the input into output.

Human resources are a very crucial factor in the internal business environment. The
managerial decisions are taken by human resources while technological resources represent
the technical knowledge which is used in the manufacturing of goods and services. Internal
environment consists of the factors which are controllable and which can be changed
according to the requirements of the external environment. There’s been a drastic change in
the internal environment in the last decade or so. The contemporary work environment
does not help the employees to be more productive and the Internet is your organization
that suffers.

That is the reason why organizations have started to adopt a more flexible way of working
by making necessary changes in the internal environment. Write from given liberty of
wearing informal clothes at the workplace to having Gyms and even work from home
facilities, the internal environment has become more employee friendly rather than work
friendly because organizations have realized that the true potential lies in the human
factor. Google is the benchmark of one of the best companies providing the best internal
environment to their employees.

External Environment :

The external environment is relatively watched compared to the internal business

environment. It is composed of various organizations institutions and other forces which
operate beyond the control of the organization. It is further classified into external micro
and external macro environment.

External Micro Business Environment: Microbusiness forces have a major impact on

the operations of a business. For example, suppliers have a huge impact on the pricing of
the products. Also, a competitive firm will start a price war in an industry which is relatively
small but if the rival firm is a big one then the competitive firm will hesitate to initiate the
price war. Following are important factors of micro external environment:

A) Suppliers of Inputs :

This is a very important part of the external type of business environment which include
supplier of its inputs such as components and raw materials. For the smooth functioning of
an organization, it is very essential that the inputs such as raw material should be regular. If
the supply of the same is not certain then it is recommended that organization should have
a large stock of raw materials so that the process is continued uninterrupted. This will result
in an increase in the cost of production and a reduction in profit margin or the customers
will have to bear the increased price.

Many of the organizations have adapted to set up a phone production plant for procuring of
raw materials. Similarly, energy is also an important input in the business of manufacturing.
Many industries have adapted to set up their own power generating plants so as to ensure
an uninterrupted supply of electricity for their businesses. However small organizations
cannot adopt the strategies and have to depend on external sources for the supply of these
inputs.

It is not recommended to depend on a single supplier for any of these inputs because of
there is any destruction due to workers strike or lockout or similar things on the supplier’s
end, then it will affect the production work of the organization negatively. Hence to reduce
the risk and uncertainty it is advised that organizations go ahead with multiple suppliers.

B) Customers :

The entity who buys products or uses services of the organization in exchange for money is
called a customer. They form an important part of the external environment and of the
business because all of the profits depend on customers.

It is necessary that your organization focuses on sales and to cater the customers
via customer service which are two important factors for customer satisfaction. An
organization may have different kinds of customers. For example, Audi cars we
have individual customers, government, companies, institutions etc. Although all of them
are separate entities and the deals with them will be on different levels all of them can be
classified as customers for the organization.

The organization will always be in competition with rival firms to get more customers
thereby to increase the market share of the organization. It does so by increasing
the demand in the market by spending on advertisements and promotions. The
usual strategy of most of the organization is to get new customers and retain the old ones.

A part of retaining customers is giving more customer satisfaction. Recently customer

satisfaction has become of Paramount importance because of the fact that customers are
provided with multiple options for buying the products. If a customer is not satisfied with a
certain product or service we can always opt for competitive one it was not the case about
half a century ago.

C) Marketing Intermediaries :

Marketing intermediaries play a very important role in distributing and sometimes of selling

the products to the final buyers. These include merchants and agents which
are distribution firms, retailers, wholesalers etc. They are responsible for transporting of
goods from the production site to the destination and to the final customer.

Organizations can take help of different agencies such as market

research consultancies, advertising agencies, management consultancies, which help the
organizations in promoting targeting and selling the products to the correct markets.
Therefore marketing is considered an important link between customers and organizations.

D) Competition :

Absolute Monopoly is a concept which is long gone from the market. Competition is
prevalent and seen in every sector of business. Organizations compete with each other and
not only to get customers but also a lot of other aspects. Although the majority competition
is on price there is a non-price competition in advertising sponsoring in the event or even
and recruiting the best talents in the market.
A well known famous example of recruiting the best talent is that of Steve Jobs recruiting
John Sculley an executive from Pepsi. To get John onboard Steve Jobs sad the famous line,
‘Do you want to sell sugar water for the rest of your life or do you want to come with me
and change the world?’ Google is known to pay millions of dollars to get the best of the
talent.

Competition can also be seen in terms of CSR activities. Following the footsteps of Coca-Cola
Pepsi has started save water campaign which estimates about 30 million tones of water will
be saved because of manufacturing process changes of Pepsi.

Intense competition can also be seen in the procurement of raw materials from the
suppliers. Since the sources of raw materials are limited businesses often compete with
each other. Competition is not only limited itself to your competitors but the global
competition is also on the rise. With globalization, global competition and price wars not
only disturb the economy is but also customers. For example, an organization in the United
States will compete with an organization from Japan or China or India.

E) Public :

These are a very important part of external microenvironment in the type of business
environment. Any group which has interest or impact on the ability of the organization to
achieve its objective is termed as public.

Associations of citizens, local groups, consumer protection organizations, environmentalists,

Women Associations, Media, groups of youth are few of the important examples of the
public which have an impact on the organization. Environmentalists have a huge impact on
the working of the organizations which pollute the environment. Many citizen groups
actively campaign against cigarette manufacturers and alcohol manufacturers for
manufacturing in a false way to lure more and more youth. Hence public as an important
aspect which can make or break the organization.

2) External Macro Business Environment :

The microenvironment factors are the environmental forces which are faced by the
organization and determine the opportunities to exploit in order to promote its business
and also present a threat so that it can put restrictions on the expansion of Business and its
related activities.

The macro environment has both negative and positive aspects to it. A very crucial part of
macro environmental forces is that they cannot be controlled by the management of the
organization and because of its own controllability the firm or the organization has to adjust
itself in order to adapt to these external macro forces.

It is further classified into different types of business environment which will be discussed as
follows:
A) Economic Environment:

The economy that exists around the industry which is common for the business, as well as
its competition, is termed as economic environment. There can be different phases of the
economy like growth or decline which can impact the working of the organization.
The economic environment is largely affected by the government of the respective country
and it may present opportunities and threats are restrictions to the industries.

The framework within which the businesses have to work is provided by the economic
system. Largely there are two factors which affect the economic system that is the public
sector and the private sector. While Public sector is largely government influenced, Private
sector is with private firms and investors. Foreign exchange also forms an important part of
the economic environment. The fluctuations in the currency on a global scale can affect the
economies of different countries drastically. Also, import-export forms another important
aspect of the economic environment. For a positive economic environment, it is desired that
the exports of a country should be more than the imports.

B) Social and Cultural Business Environment:

While we saw that Customers and Public affect Microenvironment of the organization, their
social and Cultural aspects affect the macro environment. This is true especially in case of
multinational firms which bring the culture from their own country in the countries of
businesses. The organizations have to understand the cultural aspects and social aspects of
the country that the business is being done in.

The products of businesses can have a large impact on society. For example, there are
cultural dimensions in Asian countries which prevent them from eating certain foods. Care
should be taken by the organization was introducing the food options and they should be
customized for the customers in the local areas. For example, McDonald’s has customized
their menu for Asian markets because of the religious factors by the communities from the
Middle East and Asian countries.

Beef is not accepted in the Asian market and countries like India while pork is not accepted
in Middle Eastern countries. Hence McDonald’s and KFC and other food chains had to come
up with customized menu options respecting the local and cultural barriers. New concept
code social responsiveness has been developed by management science.

The ability of the organizations to get its businesses to the social environment in a way that
is mutually beneficial to both society and the organization is called social responsiveness.
Social responsibility and social responsiveness are a part of Business ethics. It is essential
that every business does its mode of operation within ethical limits.

C) Political and Legal Environment:

Each and every business is closely related to the government in the operating country. The
political influence of the government affects business to a large scale in a positive or
negative way. It is very important to take the political and legal nature into consideration for
operating any business. Businesses come in constant clashes with these two and get
affected from time to time.

For example, Facebook has always come under the constant radar over its data leaks in the
US and abroad. Going to the data leaks, many countries have banned Facebook in their
countries. A similar threat is eminent with Google which is why Google search engine is
banned in China. Because of social media rumors spread what is here and fast the news and
that is why curbing social media has become an important aspect in every country.

That is the reason why new and new laws are emerging to control social media and make it
safer and secure for the people. On the other hand, there are policies which affect
companies and businesses in a positive way.

For example in 2017, there was a demonetization in India as a part of the war against black
money. Due to the immediate and overnight Ban of currency, digital currency grew in a
proliferative way. Thus the political and legal aspect proved to be a boon for many
businesses.

D) Technological Environment:

Technology is evolving by leaps and bounds and is it is essential for the businesses to keep in
touch with the ever growing technology to update them and be in the race. New technology
is now being used for the production of goods and services.

Use of machines to standardize processes is now the regular way of doing things because it
reduces the cost as well as enhances productivity. The use of latest technology also gives
the organization a competitive advantage over the competition due to which it gets a better
market share. Has globalization has increased the organizations now compete with each
other in international markets for the sale of their products which is why they have to
standardize themselves according to the international standards.

Right from manufacturing after sales, many aspects of the organization depend on
technology which is why Technology plays a vital role in conducting the business. While in
some industries technological advancement is helpful not every industry will agree with the
same. For example, sales are an aspect where technological aid is necessary for Technology
cannot entirely replace it.

E) Demographic environment:

As the name suggests demography includes the growth of the population and the size of the
population along with life expectancy of the people, the distribution of population among
rural and urban settings and technological skills and education levels of the people.

These factors have an important impact on the functioning of organizations since many
workers are recruited from external sources; demographic factors are considered an
important aspect. The skills of the workers of the organization affect and determine how
well the organization can achieve its targets.

The businesses we have to adjust the requirements so as to adapt themselves to the

requirements of the labor forces. For example, having a labor welfare programme or child
care services for their employees. The demographic environment impacts the supply and
demand equality in any business.

The organizations get their labor force from external sources. The technical education skills
of employees are important for the functioning of the organization which is where the
demographic environment comes into the picture. Demography also comes into the picture
when foreign investors look to make the investment. For example, India is considered as
one of the largest English speaking countries in the world which is to its advantage and that
is why the global economies like the US and UK prefer to outsource work to India other than
China which is cheaper but English is not a language of choice over there.

The growth rate of the population age and even the composition of the population
determine the demand of the goods and services for a particular population. When the
population of a country is growing its child population will be on the higher side why the
stable population will have a geriatric population in higher side. This means that
organization will have to plan their offerings accordingly.

For example, while China is the most populous country in the world, the growth rate of
population in India is the highest in the world. On the other hand, in countries like Japan
and Norway, the population is growing negatively. Which means that requirement for
products related to infants and childcare will be on higher demand in India well mortuaries
and geriatric requirements will be higher in Japan or Norway?

F) Natural Environment:

The natural environment is the ultimate external environment which affects the business.
Availability of natural resources and the setting up of business depends largely on the
natural environment. It is desirable that the natural environment is to be kept relatively
unharmed.

Natural resources include geographical and economic resources like oil reserves, mineral
reserves, water and forest resources, weather and climate, conditions, availability and
facilities of Port, connectivity to other countries and development of the surrounding areas.
For example availability of minerals influences certain industries in that area.

An area with high mineral content will always attract raw material manufacturing companies
steel producing in industries. On the other hand of forest resources are abundant it with
attracting pharmaceutical industries and their plants, an area where agricultural resources
on the higher side, it attracts food industries. Besides this weather and climate conditions
are also an important aspect for the business.
It will not matter how cheap is the land if there are no resources surrounding it. For
example, most of the Middle East is desert and no industry can be set up over there which is
why even though the land rates a relatively cheap no industry is set up over there. On the
other hand, Africa is abundant in forest reserves but due to political factors industries
refrain from setting up over there.

5.2. Macro-economic aggregates:

Macroeconomic Aggregates and Policies
Economic factors at the national level, influencing the economic condition of the country
can be stated as macroeconomic aggregates. These are

1. Savings of the economy

2. Investment
3. Economic Growth
4. Capital formation
5. Capital output ratio
6. Population growth
7. Growth of foreign trade
8. Balance of payments
9. Foreign debt
10. Exchange rate stability
11. Employment level
12. Capital inflow
13. Per capita income as an indicator of economic development.
1. Savings of the economy
In most of the developed countries, savings of the people form a major part of investment
in the country. Savings can be there only when the income level of the people is higher and
the people are living above the poverty level. In India, savings are on an average only 9% of
the total Gross Domestic Product. As against this, in developed countries, they are nearly 28
to 30% of GDP.

When there are low savings, there is little scope for investment and also whatever little
savings are made, they do not reach the organized sector. They get fretted away in
conspicuous consumption (for example, the purchase of jewels in the rural economy).
Instead, if such savings are invested in corporate securities, they promote more investment.
Hence, the financial services in our country are unable to play a major role due to poor
savings.
2. Investment
The growth of the economy depends on the extent of investment made in the country.
Investments must generate more production and they should promote a balanced growth
of all the sectors in the economy. In some countries, investment may be made in those
sectors which have favorable factors and they will create a thrust in the economy leading to
the growth in other sectors. Thus, more production in agriculture will create conditions for
growth in industrial sector and service sector. Investment can be done both by public and
private sectors.
The government should play a role in promoting more investment by granting incentives
and facilities so that more promoters and investors enter the market. A stable government
with a steady economic policy will also promote investment. A proper climate for
investment should be created in the country through the promotion of capital
market, money market, financial institutions with various financial services.
Investment as a percentage of GDP should be sufficient so that the desired growth is
achieved in all the sectors of the economy.

3. Economic Growth
The increase in physical production in all the three sectors of the economy namely,
agriculture, industry and service is referred as economic growth. An increase in economic
growth need not bring an increase in economic development. Because, the increased
production may be consumed by the increased population. Hence, the increase in
production experienced in all the 3 sectors should be sufficient not only to cater to the
needs of population but also provide some surplus for the economy to grow. The financial
services have to play a supportive role in channelizing the savings and investment so that
growth is achieved overall.
4. Capital Formation
When a company earns profits, it may plough back a part of its profits in the business which
expands its capital. In this way, capital formation takes place. For capital formation, a
reduction in consumption is very essential. If all the production is consumed, without
allowing any savings for ploughing back, capital formation will become nil. Thus, capital
formation is a kind of sacrifice the producer has to make by ploughing back his profit. But,
this will be done when the prospects of earning more profits are bright. Financial services
can play a major role by attracting the savings or the profit earned by the companies for a
beneficial investment.

5. Capital-output ratio
The amount of capital required for an output is dealt in the capital-output ratio. The
significance of this ratio is the quantum of capital needed for generating the required
output. If lesser capital is generating more output, it reflects a healthy capital-output ratio.
This is possible when the technological growth is at its peak in the country. With more
technology, lesser capital is utilized and more output is obtained. With a higher amount of
investment, the capital-output ratio is bound to bring in more benefits to the economy. The
difference between an under developed and a developed country is this — a developed
country consumes less capital but brings out more output, while an under developed
country consumes more capital and turns out lesser output due to poor technology. We can
very well experience this in our agriculture.
6. Population Growth
Increase in population may retard the economic growth of a country, if the increased
population is not put to use for productive purposes. But unfortunately, the productive
force in the increasing population is of lesser percentage, while the consumption force is of
a higher percentage. There are countries which regard ‘population’ as a human resource,
contributing for capital so that they are responsible for increasing the Gross Domestic
Product of the country. China is an example wherein the productivity of human labor is very
high.

Skill formation and creation of more skilled labor contribute more to the service sector. Of
the 3 sectors in an economy, it is the service sector which contributes more to the economy
and the development of human resources enables a country to earn more national income.
Of late, the export of services is gaining ground and in this context, India has earned more
than 15% of its export earnings in the IT industry by exporting software. Financial services
require more human touch and it is here that a trained person in financial service
contributes more to the economy.

7. Growth of Foreign Trade

Export forms a major part of any developed economy. Most of the countries which have
developed rapidly have given due importance to foreign trade. The promotion of foreign
trade requires the active support of financial services. Banks provide export
finance. Factoring and forfaiting companies finance the exporter. Leasing companies provide
equipment, while a merchant banker finances an exporter in foreign exchange to import
capital equipment. In this way, every aspect of financial service promotes foreign trade
which in turn plays a crucial role in the development of the economy.
8. Balance of Payments
The receipts and payments of a country from abroad are represented by the balance of
payments statement. If the receipts are more and the payment is less, the country
experiences a favorable balance of payments position. But sometimes, it may face a reverse
situation, with more payments and less receipts, leading to unfavorable balance of
payments. When a country borrows heavily and combines it with a heavy imports, it is
bound to experience adverse balance of payments position. It can overcome the situation
only by increasing its exports and repaying its foreign loans.
The financial services in the country can help the nation from coming out of its adverse
balance of payments situation. They can raise more foreign loan or attract more foreign
savings and invest them in profitable ventures so that they can provide a better return to
the foreign investors. Thus, the financial services can act as a bridge between the foreign
investor on the one hand and the domestic producer on the other.

9. Foreign Debt
Financial services help the economy in mobilizing foreign debt. Such debts can be obtained
in the global financial market at a competitive rate of interest. Normally, the credit rating of
the country is taken into consideration before extending any foreign loan. The past
performance of the country in the repayment of the foreign loan is yet another factor that
decides the interest rate for the loan.

If the foreign debt is utilized for unproductive purposes or is not properly invested, then the
chances of the country raising more loan in the foreign financial market will be dim. Hence,
raising foreign debts at a competitive rate of interest and putting them for proper use is
another important factor and the financial services ensure that the returns commensurate
with the interest rate on the foreign debts.

10. Exchange rate stability

When a country continuously borrows in the foreign market, followed by heavy imports,
then it will experience a decline in its currency value in relation to foreign currency. For
example, if India has an exchange rate of 1 US Dollar = Rs. 68, after the imports and foreign
debts, its exchange rate may slide to 1 US Dollar = Rs. 80. This slide will affect India, as we
have to pay more for our debts which are now 25% more than what they were at the time
of ow borrowing. Due to this, India’s foreign debt burden will increase. The financial services
can reduce this by two methods. First, they can find out methods to reduce our supply of
currency in the Foreign exchange market, thereby push up the exchange rate in favor of
India.

Secondly, the financial services themselves can export services (invisible trade) by way of
Banking, Insurance, etc., and earn foreign exchange by which the debt burden can be
reduced. This will also increase our currency value. If exchange rate stability is not
maintained, it will affect our foreign trade prospects and thereby exchange earnings.

11. Employment Level

Another macroeconomic aggregate influenced by financial services is the level of
employment. With more financial services such as leasing, hire purchase finance, housing
finance, insurance, etc., the level of employment opportunity in the country is bound to
increase. This will create more demand and other industries will also expand. Thus, the
country can reach the level of full employment.
12. Capital Inflow
The capital market in the country can attract more capital from abroad, leading to capital
inflow. This will take place only when the return on capital is much higher or the interest
rate offered is higher than what is prevailing in the domestic country. Financial services play
an active role in attracting capital by selling various products and services. India, by selling
American Deposit Receipt (ADR) and Global Deposit Receipt (GDR) could attract more
foreign funds. Similarly, SBI could mobilize more funds through India Resurgent Bonds and
Millennium Deposit Receipts.

13. Per capita Income as an indicator of economic development

When the national income of the country increases, due to increased production and
services, the benefit goes to the population in the form of per capita income which is an
indicator of the economic development of the country. Financial services can increase the
per capita income by providing various types of loans and encouraging self employment
schemes. They can also help in the mobilization of the savings by providing various sources
of investment.

The mobilization of savings and channelizing them in productive investment are bound to
improve the economy and thereby the national income and per capita income. The financial
services form a part of service sector and their activities will have a direct impact on the
population and the economy.

5.4 circular flow of macroeconomic activity:

 The circular flow of economic activity is a model showing the basic economic
relationships within a market economy.
 It illustrates the balance between injections and leakages in an economy. Half of
the model includes injections, and half of the model includes leakages.
 The circular flow model shows where money goes and what it's exchanged for.
 The model includes households, businesses and governments & foreign sector.
  In the circular flow of the economy, money is used to purchase goods and services.
Goods and services flow through the economy in one direction while money flows
in the opposite direction.

Circular flow of macro economic activity in Two sector economy:

Circular flow of macro economic activity in Three sector economy:

 The inclusion of Govt. sector makes the model more realistic as govt. plays an
important role in the economy
  The Govt. raises its revenue from many sources & its main source of revenue is
Taxes like:
1) Taxes levied on the household sector
2) Taxes levied on the firms
 It has to incur expenditure on many heads like expenditure on administration,
defence, development, subsidies etc.

Circular flow of Four sectors models:

 In four sector economy, besides the household, firms & the Govt, the fourth sector
is the foreign sector
 When a country imports goods & services, the expenditure incurred by the
residents of domestic country leads to an outflow of income & thus to a decrease
in the circular flow of income
 When a country exports goods & services, expenditure incurred by the residents of
foreign country leads to an inflow of income & thus leads to an increase in the
circular flow of income.
 When exports are less than its imports, there is a foreign trade deficit or an
unfavourable balance of trade
 When exports are greater than its imports, there is a foreign trade surplus or a
favourable balance of trade.
National income determination: Aggregate demand and supply

Definition of National Income

The total net value of all goods and services produced within a nation over a specified
period of time, representing the sum of wages, profits, rents, interest, and pension
payments to residents of the nation.

Measures of National Income

For the purpose of measurement and analysis, national income can be viewed as an
aggregate of various component flows. The most comprehensive measure of aggregate
income which is widely known is Gross National Product at market prices.

Gross and Net Concept

Gross emphasizes that no allowance for capital consumption has been made or that
depreciation has yet to be deducted. Net indicates that provision for capital consumption
has already been made or that depreciation has already been deducted.
National and Domestic Concepts
The term national denotes that the aggregate under consideration represents the total
income which accrues to the normal residents of a country due to their participation in
world production during the current year.
It is also possible to measure the value of the total output or income originating within the
specified geographical boundary of a country known as domestic territory. The resulting
measure is called "domestic product".
Market Prices and Factor Costs
The valuation of the national product at market prices indicates the total amount actually
paid by the final buyers while the valuation of national product at factor cost is a measure of
the total amount earned by the factors of production for their contribution to the final
output.
GNP at market price = GNP at factor cost + indirect taxes - Subsidies.
NNP at market price = NNP at factor cost + indirect taxes - Subsidies
Gross National Product and Gross Domestic Product
For some purposes we need to find the total income generated from production within the
territorial boundaries of an economy irrespective of whether it belongs to the inhabitants of
that nation or not. Such an income is known as Gross Domestic Product (GDP) and found as
−
GDP = GNP - Nnet Factor Income From Abroad
Net Factor Income from Abroad = Factor Income Received From Abroad - Factor Income
Paid Abroad
Net National Product
The NNP is an alternative and closely related measure of the national income. It differs from
GNP in only one respect. GNP is the sum of final products. It includes consumption of goods,
gross investment, government expenditures on goods and services, and net exports.
GNP = NNP − Depreciation
NNP includes net private investment while GNP includes gross private domestic investment.
Personal Income
Personal income is calculated by subtracting from national income those types of incomes
which are earned but not received and adding those types which are received but not
currently earned.
Personal Income = NNP at Factor Cost − Undistributed Profits − Corporate Taxes + Transfer
Payments.

Disposable Income
Disposable income is the total income that actually remains with individuals to dispose off
as they wish. It differs from personal income by the amount of direct taxes paid by
individuals.
Disposable Income = Personal Income − Personal taxes
Value Added
The concept of value added is a useful device to find out the exact amount that is added at
each stage of production to the value of the final product. Value added can be defined as
the difference between the value of output produced by that firm and the total expenditure
incurred by it on the materials and intermediate products purchased from other business
firms.

Methods of Measuring National Income

Let’s have a look at the following ways of measuring national income −

Product Approach
In product approach, national income is measured as a flow of goods and services. Value of
money for all final goods and services is produced in an economy during a year. Final goods
are those goods which are directly consumed and not used in further production process. In
our economy product approach benefits various sectors like forestry, agriculture, mining etc
to estimate gross and net value.
Income Approach
In income approach, national income is measured as a flow of factor incomes. Income
received by basic factors like labor, capital, land and entrepreneurship are summed up. This
approach is also called as income distributed approach.
Expenditure Approach
This method is known as the final product method. In this method, national income is
measured as a flow of expenditure incurred by the society in a particular year. The
expenditures are classified as personal consumption expenditure, net domestic investment,
government expenditure on goods and services and net foreign investment.
These three approaches to the measurement of national income yield identical results. They
provide three alternative methods of measuring essentially the same magnitude.

Factors Determining the National Income

According to Keynes there are two major factors that determine the national income of an
economy −
Aggregate Supply
Aggregate supply comprises of consumer goods as well as producer goods. It is defined as
total value of goods and services produced and supplied at a particular point of time. When
goods and services produced at a particular point of time is multiplied by the respective
prices of goods and services, it helps us in getting the total value of the national output. The
formula for determining the aggregate national income is follows −
Aggregate Income = Consumption(C) + Saving (S)
Few factor prices such as wages, rents are rigid in the short run. When demand in an
economy increases, firms also tend to increase production to some extent. However, along
with the production, some factor prices and the amount of inputs needed to increase
production also increase.
Aggregate Demand
Aggregate demand is the effective aggregate expenditure of an economy in a particular time
period. It is the effective demand which is equal to the actual expenditure. Aggregate
demand involves concepts namely aggregate demand for consumer goods and aggregate
demand for capital goods. Aggregate demand can be represented by the following formula
−
AD = C + I
As per Keynes theory of nation income, investment (I) remains constant throughout, while
consumption (C) keeps changing, and thus consumption is the major determinant of
income.

Components of aggregate demand

Aggregate Demand and its Components

 Consumption
 Investment or the total output of final commodities and services
. Consumption may indicate not what people have actually utilised in a year, but what they
had planned to utilise during the same period.
Similarly, investment means the amount a manufacturer plans to add to their catalogue
(inventory).
It may be distinct from what they end up doing. Suppose a manufacturer plans to
add ₹1,000 worth of commodities to their stockpile by the end of the year. The planned
investment is ₹1,000 in that year. However, due to an unpredicted increase of demand for
the commodities in the market, the volume of the sales shoots up from what they had
outlined to sell.
To meet this extra surplus demand, they have to sell commodities worth ₹300 from their
stockpile. Hence, at the end of the year, their catalogue increases by ₹(1,000 – 300) = ₹700.
Their outlined investment is ₹1,000, whereas the actual or ex-post investment would
be ₹700 only. We call the outlined values of the variables: utilisation, investment, or output
of final commodities their ex-post measures.
In simple words, ex-ante portrays what has been outlined, and ex-post portrays what has
actually happened. In order to comprehend the determination of earning, we need to know
the outlined values of distinct components of the average demand.

5–6 Marks Questions

Q.1 Explain the meaning and components of aggregate demand.

 Answer:

(a) Meaning ● Aggregated demand means the total demand for final goods
and services in an economy.
It is the total (final) expenditure of all the units of the economy,
i.e., households, firms, government, and the rest of the world.

(b) Following are the various components of aggregate demand:

Components of AD = C + I + G + (X – M)
aggregate demand

(a) Private (Household ● It comprises a household’s expenditure on the consumption of

consumption goods and services.
expenditure) (C)) ● These goods can be durable, semi-durable, or non-durable.
● Consumption of households depends upon their disposable
income and MPC.

(b) Investment ● It refers to the expenditure incurred by firms on the purchase
expenditure (I)) of capital goods like machines, plants, equipment, etc., to
increase the production capacity.
●  Investment decision depends upon the relative values of MEI
(Rate of return/Marginal efficiency of investment) and rate of
interest.

(c) Government ● It refers to expenditure incurred by the government on the

expenditure (G)) purchase of consumer goods and capital goods to satisfy the
collective wants of the society. Example: public parks, public
hospitals, roads, etc.
● Government expenditure depends upon the priorities of the
government.

(d) Net exports ● It is the difference between exports and imports.
(X – M) ● It reflects the net demand for a domestic product by the rest
of the world.
● Net exports depend upon many things like foreign trade policy,
foreign exchange rate, comparative prices,  quality, etc.
 

Q.2 Explain aggregate demand with the help of a hypothetical schedule.

(a) Meaning ● Aggregate demand means the total demand for final goods
and services in an economy.
● It is the total (final) expenditure of all the units of an
economy, i.e., households, firms, government, and the rest of
the world.
● However, in case of a two sector model, we only consider the
 consumption expenditure of households and investment
expenditure of firms.

(b) Hypothetical Income (Y) Consumption (C) Investments (I) AD = C

schedule (in crore) (in crore) (in crore) +I
(in
crore)

0 40 20 60

100 120 20 140

200 200 20 220

300 280 20 300

400 360 20 380

(c) Explanation ● In the given schedule, it can be observed that:

● Even at zero levels of income, consumption of `40 crore and
investment of `20 crore prevail which are autonomous
consumption and autonomous investment. AD is a sum of
consumption and investment which is `60 crore.
● Every time with the increase in income by `100 crores, the
consumption is also increasing by `80 crore but investment
being autonomous remains the same at all the levels of
income. AD, which is the sum of C and I, also changes but after
zero levels, it fully depends upon the consumption
expenditure.
● So, with an increase in income, AD also increases, but the
rate of increase in AD is less than the rate of increase in
income.

5.5 Multiplier effect.

The multiplier formula denotes an effect that initiates because of increased investments
(from the government or corporate levels), causing the proportional increase in the
economy’s overall income. However, it is also observed that this phenomenon works in the
opposite direction (the decrease in income affects a reduction in total spending). Following
is the formula for the calculation of the multiplier effect: –

Multiplier (k) = Change in Real GDP (Y) / Change in Injections

For the calculation of the multiplier formula in economics, the formula used is

Multiplier (k) = 1 / MPS

Or
k = 1 / (1 – MPC)

Where,

 MPS = (1- MPC)

This formula shows the relation between the increase in the earning of the nation due to
the investments by the respective government or the corporates, if, there is a fixed pattern
of expenditure from the additional income.

This formula works on the premise that one person’s expenditure is the income for another
person apart from that portion which the earning person is saving. So, there is an
assumption that one person’s expenditure is another person’s income in the form of profit,
wages, salaries, etc. That person, in turn, spends it again, majorly on the consumption front.
This circle continues until the saving equals the amount injected into the economy.

Important Definitions

 GDP: GDP or Gross Domestic Product denotes the production of finished goods or
services for a specific period in market value terms. It indicates the commercial well-
being of the economy of a nation. It helps gauge the country’s economic condition
and is used heavily for national policymaking. 
 Real GDP: GDP could be of two types; Real GDP, and Nominal GDP. Inflation is the
difference between the real GDP and nominal GDP. The real GDP accounts for the
value of all goods and services produced at a constant price and does not consider
the effects of inflation. On the contrary, the nominal GDP does view the actual costs
of all the produced goods and services and the full impact of inflation in its
calculation. So, suppose the primary consideration is to evaluate the relative
production levels of the nation. In that case, real GDP turns out to be a winner
because it does not consider the inflationary prices and keeps the focus fixed on the
actual production.
  Injections: Injections are an addition to the total expenditures already happening in
the economy. These expenditures could come from any direction, be it from
corporations, government, export contributions, etc. A few examples to understand
it clearly would be the corporates investing in the company’s capital goods or taking
up expansion plans, the government taking up the infrastructure activities and or
spending on welfare schemes, or international companies purchasing goods from
domestic producers. All these would fall under the injections criteria.
 MPC: Marginal Propensity to Consume is an essential tenet of the multiplier
formula. It indicates the basic idea of consumption patterns that would remain
constant over the consumption series. For instance, let us assume the MPC is 0.8 or
80% of the earning, and in simple terminology, it reflects the spending behavior of
the person. If a person earns $100, around 80% or $80 would be spent on consumer
goods. It would save the remaining amount. Again, one person’s spending would
become the earning of another party, and that too would spend 80% of it on
consumer spending. This circle continues over time unless it reaches a negligible
amount. The formula of MPC is changed in the expenditure over the change in the
earning. (Change in Consumption / Change in the Earning)
 Marginal Propensity to Save: It speaks about a person’s savings when changes in
earnings. In other words, it is arrived at by deducting the income by marginal
propensity to spend. So, the formula for MPS would be: – Earning – Marginal
propensity to spend.

Examples of Multiplier Formula in Economics

Given below are the examples of multiplier formula.

Importance and Uses of Multiplier Formula in Economics

Even though the multiplier formula in economics has various limitations, it has a far-
reaching impact on the nation’s economic decisions and policy making. The following are
some noted uses and importance of the multiplier formula: –

 This formula has directly connected with investments in the economy and job
creation. The multiplier theory also states that pumping funds into the economy
would create a ripple-like effect in the economy’s cash flow; even a percentage of
the amount is being saved at every level.
 Multiplier provides that even if the small investment has been put in the system,
eventually, after some time, the invested figure would grow manifolds. That is
because it encourages the ruling government and public or private investors to
remain invested and increase investments in the market.
 Sound knowledge of this concept helps to judge and understand various business
cycles as it entails a fairly accurate understanding.

----------------------------------------------END OF MODULE 5------------------------------------------------------------