Unit-V Business Economics K.

Rakshit

Macroeconomics
National Income:
National income means the value of goods and services produced by a country during a
nancial year. Thus, it is the net result of all economic activities of any country during a
period of one year and is valued in terms of money. National income is an uncertain term
and is often used interchangeably with the national dividend, national output, and national
expenditure. The National Income is the total amount of income accruing to a country from
economic activities in a years time. It includes payments made to all resources either in the
form of wages, interest, rent and pro ts. The progress of a country can be determined by
the growth of the national income of the country.

Common measures of National Income:

There are mainly four measures of National Income i.e., GNP (Gross National Product),
GDP (Gross Domestic Product), NDP (Net Domestic Product), NNP (Net National Product).
These are some of the ways that help determine a nation’s nancial position.

GNP (Gross National Product):

Gross National Product is the total market value of the nal goods and services produced
by a nation’s economy during a speci c period of time (usually a year), computed before
the allowance is made for the depreciation or consumption of capital used in the process
of production.

GNP is commonly calculated by taking the sum of personal consumption expenditures,

private domestic investment, government expenditure, net exports and any income earned
by residents from overseas investments, minus income earned within the domestic
economy by foreign residents. Net exports represent the di erence between what a
country exports minus any imports of goods and services.

GNP = GDP + Net factor income from abroad

Or

GNP = C + I + G + X + Z

Where C is consumption, I is investment, G is government, X is net exports, Z is net

income earned by domestic residents from overseas investment minus net income earned
by foreign residents from overseas investments minus net income earned by foreign
residents from domestic investments.

GDP (Gross Domestic Product):

Gross domestic product (GDP) is the total monetary or market value of all the nished
goods and services produced within a country’s borders in a speci c time period. As a
broad measure of overall domestic production, it functions as a comprehensive scorecard
of a given country’s economic health.

Though GDP is typically calculated on an annual basis, it is sometimes calculated on a

quarterly basis as well. In the U.S., for example, the government releases an annualized
GDP estimate for each scal quarter and also for the calendar year. The individual data
sets included in this report are given in real terms, so the data is adjusted for price
changes and is, therefore, net of in ation.

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Unit-V Business Economics K. Rakshit

The calculation of a country’s GDP encompasses all private and public consumption,
government outlays, investments, additions to private inventories, paid-in construction
costs, and the foreign balance of trade. (Exports are added to the value and imports are
subtracted). If the opposite situation occurs—if the amount that domestic consumers
spend on foreign products is greater than the total sum of what domestic producers are
able to sell to foreign consumers—it is called a trade de cit. In this situation, the GDP of a
country tends to decrease.

There are two types to calculate GDP; the expenditure approach and the income
approach.

(i) Expenditure Approach: The expenditure approach, also known as the spending
approach, calculates spending by the di erent groups that participate in the economy.
The U.S. GDP is primarily measured based on the expenditure approach. This
approach can be calculated using the following formula:

GDP = C + G + I + NX
Where C = Consumption;

G = Government Spending;

I = Investments

NX = Net Exports

All of these activities contribute to the GDP of a country. Consumption refers to private
consumption expenditures or consumer spending. Consumers spend money to acquire
goods and services, such as groceries and haircuts. Consumer spending is the biggest
component of GDP, accounting for more than two-thirds of the U.S. GDP.

(ii) Income Approach: The income approach represents a kind of middle ground between
the two other approaches to calculating GDP. The income approach calculates the
income earned by all the factors of production in an economy, including the wages paid
to labour, the rent earned by land, the return on capital in the form of interest, and
corporate pro ts.

The income approach factors in some adjustments for those items that are not
considered payments made to aspects of production. For one, some taxes—such as
sales tax and property taxes—are classi ed as indirect business taxes. In addition,
depreciation—a reserve that businesses set aside to account for replacing equipment
that tends to wear down with use—is also added to the national income. All of this
together constitutes a nation’s income.

GDP = Total National Income + Sales Taxes + Depreciation + Net Foreign Factor
Income
Total National Income = The sum of all wages, rent, interest and pro ts.

Sales Taxes = Consumer taxes imposed by the government on the sales of goods and
services.

Depreciation = Cost allocated to a tangible asset over its useful life.

Net Foreign Factor Income = The di erence between the total income that a country’s
citizens and companies generate in foreign countries versus the total income foreign
citizens and companies generate in the domestic country.

NDP (Net Domestic Product):

Net domestic product (NDP) is an annual measure of the economic output of a nation that
is calculated by subtracting depreciation from Gross Domestic Product (GDP).

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Unit-V Business Economics K. Rakshit

NDP accounts for capital that has been consumed over the year in the form of housing,
vehicle, or machinery deterioration. The depreciation is often referred to as capital
consumption allowance and represents the amount needed to replace those depreciated
assets.

The frequency and scope of such replacements can vary by type of capital asset.
Machinery that is put to regular use may need parts replaced regularly until the entire piece
of equipment is no longer usable. While that may take many years, barring unexpected
damage or defects, there is a cycle of equipment failure and replacement. Part of the
machinery in a factory’s production line may need to be replaced while another set of
similar machines continues to function within the same factory. The acquisition of the
replacement machinery would be factored into the depreciation aspect of the NPI.

NDP = GDP - Depreciation

Where,
NDP = Net domestic product
GDP = Gross domestic product
Depreciation = Depreciation of capital assets such as equipment, vehicles, housing, and
more
NNP (Net National Product):
Net national product (NNP) is the monetary value of nished goods and services produced
by a country's citizens, overseas and domestically, in a given period. It is the equivalent of
gross national product (GNP), the total value of a nation's annual output, minus the amount
of GNP required to purchase new goods to maintain existing stock, otherwise known as
depreciation.

NNP is often examined on an annual basis as a way to measure a nation's success in

continuing minimum production standards. It can be a useful method to keep track of an
economy as it takes into account all its citizens, regardless of where they make their
money, and acknowledges the fact that capital must be spent to keep production
standards high.

The NNP can be extrapolated from the GNP by subtracting the depreciation of any assets.
The depreciation gure is determined by assessing the loss of the value of assets
attributed to normal use and ageing.

NNP= MVFG+MVFS – Depreciation

Where,

MVFG is the Market Value of Finished Goods

MVFS is the Market Value of Services

Alternatively, NNP can be calculated by

NNP= GNP- Depreciation

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

• Product Method

• Income Method

• Expenditure Method

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 Unit-V Business Economics K. Rakshit

Product Method:
This is also known as the inventory method or commodity service method. In this method
we nd the market value of all nal goods and services produced in a country during a
given period of time, The entire output of nal goods and services are multiplied by their
respective market prices to nd out the gross national product.

NI= (P1 Q1 + P2Q2 + ... PnQn) - Depreciation - Indirect taxes + Net income from
abroad
Where NI = National Income, P- Price of the good or service, Q= Quantity of good or
service produced 1,2... n are the various goods and services produced.

The values of raw material, intermediary goods etc., should not be included. Only nal
goods should be taken into account.

Here we nd out the value-added in the di erent sectors like Agriculture, Government
Professionals, Industry and service sectors. Hence it is also called the "Value-added
method.

• National income based on output data is calculated by adding the sum of ‘values added
by each rm in each industry. Industrial activity is conventionally classi ed according to
the Standard Industrial Classi cation.

• Value added is the di erence between the nal value of the product and the cost of the
inputs of raw materials and components, i.e. it is the rise in value of the product caused
by the activities of the rm itself.

Income Method:
In this method, the incomes earned by all factors of production are aggregated to arrive at
the national income of a country. The four factors of production receive incomes in the
form of wages, rent, interest and pro ts. This is also National Income at factor cost.

MI= W+I+R+P+ Net income from abroad.

N= National Income

N= Wages,

I= Interest,

R=Rent,

P= Pro ts

This method gives us National Income according to distributive shares, (the most
"important income share is that of labour.)

• Undistributed pro ts of companies are included in the accounts as they have ber earned
in the accounting period. It makes no di erence what the rm does with the pro ts
subsequently.

• The residual error refers to a sum that is added to balance the accounts. Each approach
to calculating national income involves thousands of gures collected from a variety of
sources. It is not surprising that the totals are not, in practice, equal The residual error
appears in the income accounts purely for the convenience of presentation.

Expenditure Method:

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 Unit-V Business Economics K. Rakshit

In this method, we add the personal consumption expenditure of households expenditure

of the rms, Government purchase of goods and services, net exports plus net income
from abroad.

NI= EH+ EF + EG+ Net exports + Net income from abroad

Here national income= Private nal consumption expenditure + Government na
consumption expenditure + net domestic capital formation + net exports +net income from
abroad.

EH = Expenditure of households

EP = Expenditure of Firms

En = Expenditure of Government

Care should be taken to include spending or expenditure made on nal goods and
services only.

Some other concepts:

Per Capita Income:
Per capita income is a measure of the amount of money earned per person in a nation or
geographic region. Per capita income can be used to determine the average per-person
income for an area and to evaluate the standard of living and quality of life of the
population. Per capita income for a nation is calculated by dividing the country's national
income by its population.

Per Capita Income = National Income / Total Population

Personal Income:
Personal income refers to all income collectively received by all individuals or households
in a country. Personal income includes compensation from a number of sources, including
salaries, wages, and bonuses received from employment or self-employment, dividends
and distributions received from investments, rental receipts from real estate investments,
and pro t-sharing from businesses.

Personal income has a signi cant e ect on consumer consumption. As consumer

spending drives much of the economy, national statistical organizations, economists, and
analysts track personal income on a quarterly or annual basis.

Personal income = National Income - undistributed corporate pro ts - corporate taxes -

social security contributions + Transfer Payments + Interest on public debt

Disposable Income:
Disposable income, also known as disposable personal income (DPI), is the amount of
money that an individual or household has to spend or save after income taxes have been
deducted. At the macro level, disposable personal income is closely monitored as one of
the key economic indicators used to gauge the overall state of the economy.

Disposable income = personal income - personal taxes

Uses of National Income:

National income measures the overall health of the economy. The uses of national income
analysis are :

• For economic planning

• To calculate per capita income

• To understand the distribution of income

• To compare standards of living in di erent countries. 

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 Unit-V Business Economics K. Rakshit

• To measure the rate of growth of a country. 

• To estimate In ationary and de ationary pressures

Di culties of National Income:

Six major di culties faced in the measurement of national income are as follows:

1. Problems of de nition;

2. Lack of adequate data;

3. Non-availability of reliable information;

4. Choice of method;

5. Lack of di erentiation in the economic functioning;

6. Double counting.

In ation:
• In ation is a phase of a rapid rise in prices arising under conditions of full employment.
It can lead to no further rise in incomes and employment in the economy. In other
words, in ation is generally associated with rapidly rising prices which causes a decline
in the purchasing power of money. A persistent increase in the general price level or a
persistent decline in the real income of people is known as in ation.

• According to Coulborn “In ation is a situation of too much money chasing too few
goods”. According to Crowther “In ation is a state in which the value of money is falling,
that is prices are rising.”

Money Supply and In ation:

• Money and Price in ation have a cause and e ect relationship. And often price In ation
succeeds money in ation.

• Increasing the money supply faster than the growth in real output will cause in ation.
The reason is that there is more money chasing the same number of goods. Therefore,
the increase in monetary demand causes rms to put up prices.

• If the money supply increases at the same rate as real output, then prices will stay the
same.

Some Common Terms:

Headline In ation:
Headline in ation is the raw in ation gure reported through the Consumer Price Index
(CPI) that is released monthly by the Bureau of Labor Statistics. The CPI calculates the
cost to purchase a xed basket of goods, as a way of determining how much in ation is
occurring in the broad economy. The CPI uses a base year and indexes the current year's
prices according to the base year's values.

Hyperin ation:
• Hyperin ation is a term to describe rapid, excessive, and out-of-control general price
increases in an economy. While in ation is a measure of the pace of rising prices for
goods and services, hyperin ation is rapidly rising in ation, typically measuring more
than 50% per month. In comparison, the US in ation rate has been averaged about 2%
per year since 2011.

• Although hyperin ation is a rare event for developed economies, it has occurred many
times throughout history in countries such as China, Germany, Russia, Hungary, and
Argentina.

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 Unit-V Business Economics K. Rakshit

Stag ation:
• Stag ation is characterized by slow economic growth and relatively high unemployment
—or economic stagnation—which is at the same time accompanied by rising prices (i.e.
in ation). Stag ation can be alternatively de ned as a period of in ation combined with
a decline in the gross domestic product (GDP).

• Stag ation refers to an economy that is experiencing a simultaneous increase in in ation

and stagnation of economic output.

Suppressed In ation:
• Suppressed in ation describes a situation in which, at existing wages and prices, the
aggregate demands for current output and labour services exceed the corresponding
aggregate supplies. Suppressed in ation involves non-wage and non-price rationing. In
suppressed in ation, purchases of goods and labour services are rationed.

• In ation becomes suppressed or repressed when the government and the monetary
authorities do not allow the prices to rise to a high level. For many reasons, they take
measures to control the spending of the larger incomes through various methods, such
as price control and rationing of consumption in respect of some essential goods,
control of investment expenditures and others.

Disin ation:
• Disin ation is a temporary slowing of the pace of price in ation and is used to describe
instances when the in ation rate has reduced marginally over the short term.

• Disin ation is commonly used by the Federal Reserve (Fed) to describe a period of
slowing in ation. Unlike in ation and de ation, which refer to the direction of prices,
disin ation refers to the rate of change in the rate of in ation. Disin ation is not
considered problematic because prices do not actually drop, and disin ation does not
usually signal the onset of a slowing economy.

De ation:
• De ation is a general decline in prices for goods and services, typically associated with
a contraction in the supply of money and credit in the economy. During de ation, the
purchasing power of currency rises over time.

• De ation causes the nominal costs of capital, labor, goods, and services to fall, though
their relative prices may be unchanged. De ation has been a popular concern among
economists for decades. On its face, de ation bene ts consumers because they can
purchase more goods and services with the same nominal income over time.

The Pain of In ation and De ation:

Both in ation and de ation can pose problems for the economy.

• Here are two examples: in ation discourages people from holding onto cash because
cash loses value over time if the overall price level is rising. That is, the amount of goods
and services you can buy with a given amount of cash falls. In extreme cases, people
stop holding cash altogether and turn to barter.

• De ation can cause the reverse problem. If the price level is falling, cash gains value
over time. In other words, the amount of goods and services you can buy with a given
amount of cash increases. So holding on to it can become more attractive than
investing in new factories and other productive assets. This can deepen a recession.

Demand-Pull In ation:

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 Unit-V Business Economics K. Rakshit

• Demand-pull in ation is the upward pressure on prices that follows a shortage in supply,
a condition that economists describe as "too many dollars chasing too few goods.”

• A low unemployment rate is unquestionably good in general, but it can cause in ation
because more people have more disposable income. Increased government spending is
good for the economy, too, but it can lead to scarcity in some goods and in ation will
follow.

• The term demand-pull in ation usually describes a widespread phenomenon. That is

when consumer demand outpaces the available supply of many types of consumer
goods, demand-pull in ation sets in, forcing an overall increase in the cost of living.

• For example, Demand for many models of cars goes through the roof, but the
manufacturers literally can't make them fast enough. The prices of the most popular
models rise, and bargains are rare. The result is an increase in the average price of a
new car.

Five causes for demand-pull in ation:

1. A growing economy: When consumers feel con dent, they spend more and take on
more debt. This leads to a steady increase in demand, which means higher prices.  

2. Increasing export demand: A sudden rise in exports forces an undervaluation of the

currencies involved.

3. Government spending: When the government spends more freely, prices go up.

4. In ation expectations: Companies may increase their prices in expectation of in ation

in the near future.

5. More money in the system: An expansion of the money supply with too few goods to
buy makes prices increase.

Cost-Push In ation:
• Cost-push in ation occurs when overall prices increase (in ation) due to increases in the
cost of wages and raw materials. Higher costs of production can decrease the
aggregate supply (the amount of total production) in the economy. Since the demand for
goods hasn't changed, the price increases from production are passed onto consumers
creating cost-push in ation.

• The most common cause of cost-push in ation starts with an increase in the cost of
production, which may be expected or unexpected. For example, the cost of raw
materials or inventory used in production might increase, leading to higher costs.

• For example, The Organization of the Petroleum Exporting Countries (OPEC) is

a cartel that consists of 13 member countries that both produce and export oil. In the
early 1970s, due to geopolitical events, OPEC imposed an oil embargo on the United
States and other countries. OPEC banned oil exports to targeted countries and also
imposed oil production cuts.

• What followed was a supply shock and a quadrupling of the price of oil from
approximately $3 to $12 per barrel. Cost-push in ation ensued since there was no
increase in demand for the commodity. The impact of the supply cut led to a surge in
gas prices as well as higher production costs for companies that used petroleum
products. 

Causes of Cost-Push In ation:

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 Unit-V Business Economics K. Rakshit

1. Higher Price of Commodities. A rise in the price of oil would lead to higher petrol
prices and higher transport costs. All rms would see some rise in costs. As the most
important commodity, higher oil prices often lead to cost-push in ation (e.g. 1970s,
2008, 2010-11)

2. Imported In ation. A devaluation will increase the domestic price of imports.

Therefore, after a devaluation, we often get an increase in in ation due to rising cost
of imports.

3. Higher Wages. Wages are one of the main costs facing rms. Rising wages will push
up prices as rms have to pay higher costs (higher wages may also cause rising
demand)

4. Higher Taxes. Higher VAT and Excise duties will increase the prices of goods. This
price increase will be a temporary increase.

5. Pro t-push in ation. If rms gain increased monopoly power, they are in a position
to push up prices to make more pro t

6. Higher Food Prices. In western economies, food is a smaller % of overall spending,

but in developing countries, it plays a bigger role.

The Wage-Price Spiral:

• The wage-price spiral is a macroeconomic theory used to explain the cause-and-e ect
relationship between rising wages and rising prices, or in ation. The wage-price spiral
suggests that rising wages increase disposable income raising the demand for goods
and causing prices to rise. Rising prices increase demand for higher wages, which leads
to higher production costs and further upward pressure on prices creating a conceptual
spiral.

• The wage-price spiral is an economic term that describes the phenomenon of price
increases as a result of higher wages. When workers receive a wage hike, they demand
more goods and services and this, in turn, causes prices to rise. The wage increase
e ectively increases general business expenses that are passed on to the consumer in
the form of higher prices.

• It is essentially a perpetual loop or cycle of consistent price increases. The wage-price

spiral re ects the causes and consequences of in ation, and it is, therefore,
characteristic of Keynesian economic theory. It is also known as the "cost-push" origin
of in ation. Another cause of in ation is known as "demand-pull" in ation, which
monetary theorists believe originates with the money supply.

How a Wage-price Spiral Begins:

• A wage-price spiral is caused by the e ect of supply and demand on aggregate prices.
People who earn more than the cost of living select an allocation mix between savings
and consumer spending. As wages increase, so too does a consumer's propensity to
both save and consume.

• If the minimum wage of an economy increased, for example, it would cause consumers
within the economy to purchase more products, which would increase demand. The
rise in aggregate demand and the increased wage burden causes businesses to
increase the prices of products and services. Although wages are higher the increase in
prices causes workers to demand even higher salaries. If higher wages are granted, a
spiral where prices subsequently increase may occur repeating the cycle until wage
levels can no longer be supported.

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 Unit-V Business Economics K. Rakshit

Measuring In ation:
• The most common method to measure in ation is to construct a price index. A price
index is a normalized average of price relatives for a given class of goods or services in
a given region, during a given interval of time. It is a statistic designed to help to
compare how these price relatives, taken as a whole, di er between time periods or
geographical locations.

• Price indices have several potential uses. For particularly broad indices, the index can
be said to measure the economy's general price level or a cost of living. More narrow
price indices can help producers with business plans and pricing. Sometimes, they can
be useful in helping to guide investment.

• Price Index = (Current Year’s price / Base Year’s Price) x 100

Wholesale Price Index:

• A wholesale price index (WPI) is an index that measures and tracks the changes in the
price of goods in the stages before the retail level. This refers to goods that are sold in
bulk and traded between entities or businesses (instead of between consumers).
Usually expressed as a ratio or percentage, the WPI shows the included goods' average
price change; it is often seen as one indicator of a country's level of in ation.

• Wholesale price indexes (WPIs) are reported monthly in order to show the average price
changes of goods. The total costs of the goods being considered in one year are then
compared with the total costs of goods in the base year. The total prices for the base
year are equal to 100 on the scale. Prices from another year are compared to that total
and expressed as a percentage of change.

Consumer Price Index:

• The Consumer Price Index (CPI) is a measure that examines the weighted average of
prices of a basket of consumer goods and services, such as transportation, food, and
medical care. It is calculated by taking price changes for each item in the predetermined
basket of goods and averaging them. Changes in the CPI are used to assess price
changes associated with the cost of living. The CPI is one of the most frequently used
statistics for identifying periods of in ation or de ation.

• The CPI is what is used to measure these average changes in prices over time that
consumers pay for goods and services. Essentially, the index attempts to quantify the
aggregate price level in an economy and thus measure the purchasing power of a
country's unit of currency. The weighted average of the prices of goods and services
that approximates an individual's consumption patterns is used to calculate CPI.

Measures to Check In ation:

The e ects of in ation are economically unsound, politically dangerous, socially disastrous
and morally indefensible. It generates inequalities of wealth; it paralyses the machinery of
wealth production and even as a source of revenue it soon gets dried up. It is therefore,
obvious that in ation is a serious disease that needs to be e ectively controlled before it is
too late.

The subject of controlled in ation can be viewed from two angles: the general controls and
the speci c controls. The general control is concerned principally with currency and credit
xing. Various measures can be adopted to control in ation. These measures can be
grouped into three categories:

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 Unit-V Business Economics K. Rakshit

A. Monetary Measures: These are adopted by the central bank (RBI) of the country.
Following are the monetary measures that help in controlling the in ationary situation.

1. Making Note Issue Policy Strict: The central bank should adopt strict note issue
policies so that it may not issue additional money. For making the note issue more
stringent, the gold or foreign exchange reserve should be enhanced. If there is no
provision of keeping reserve, it should be started. Adoption of such measures makes
note issue system a di cult one. These measures also check the in ationary
situation.

2. Issue of New Currency: When in ation reaches to an uncontrollable situation, the

government issues new currency and squeeze old currency out of circulation. These
measures are also called demonetization. It is an unusual method of controlling
in ation.

3. Control on Credit Money: To controll in ation, it is essential to control credit money

also. For this purpose the central bank of the country adopts the following
measures:

i) Increase in Bank Rate: Bank rate is the rate of which the central bank
rediscounts the bills of commercial bank or at which it extends nancial
accommodation to the commercial banks. If there is much expansion of credit in
the banking system, in such cases to control credit central bank increases bank
rate. Increase in bank rate will check rising in ationary situation

ii) Open Market Operations: Another method to check in ation is that the central
bank of the country resorts to selling government securities to the public and the
banks. When the public and the banks purchase the securities, they have to make
payments for these securities to the central bank. The result is that the cash
moves from the commercial banks to the central bank. This reduces commercial
bank ability to create credit

iii) High Reserve Requirement: The central bank in order to reduce the money
supply in the economy increases the limit of the reserve requirement of
commercial banks. This method prevents the commercial bank from forming a
basis for further credit expansion

B. Fiscal Measures: The following scal measures could be adopted by the government
for combating in ation:

1. Taxation: During in ation, e orts should be made to reduce the size of disposable
income in the hands of the public. This can be done either by imposing new taxes
on by increasing the existing rates of taxation. This will leave less money supply with
the public

2. Government Expenditure: To control in ation, the government should reduce its

expenditure, especially unproductive expenditure. Any drastic cut in government
expenditure to curb the in ationary situation may land the economy in a slump.

3. Balanced Budget: To control the in ationary situation, the government should

adopt the policy of the Balanced Budget because the de cit budget further
increases in ation in the economy. In case of an in ationary boon, the government
should also try to prepare a surplus budget

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 Unit-V Business Economics K. Rakshit

4. Increase in Savings: To provide a positive incentive to promote saving which will

reduce outlays and curb in ation, the government should have in its budgetary
policy incentives for savings also.

5. Increase in Public Debts: To check in ation, the government should also issue
debentures and bonds and encourage the public for its purchase. By issue of
debentures and bonds, the government can take back additional purchasing power.
The amount collected by the government through these sources should be utilized in
productive channels.

6. Control on Investment: During in ation, in anticipation of a future rise in prices,

traders and industrialists increase their investment activity. Such investment
increases the money supply in the market and this increase in money supply further
increases in ation. Hence, to check in ation, the government should control unusual
investments in the economy.

7. Overvaluation of Currency: An overvaluation of domestic currency in terms of

foreign currencies also serves as an anti-in ationary measure. This will discourage
exports and encourage imports, resulting in an increase in the domestic supply of
goods in the economy. This will check the rise in prices.

8. Income and Prices Policy: Another method to control in ation is to purchase a

policy of incomes and prices. The tendency for wages to rise beyond the marginal
product of labour has to be curbed by relating wages to productivity. Similarly, the
factorial incomes, in general, are to be related to their marginal product and an
excessive rise in factorial incomes has to be curbed. Close scrutiny on prices should
also be pursued. Thus, by controlling factor incomes and unwarranted price rises,
in ation can be cured.

9. Other Fiscal Controls: Other scal measures for the control of in ation are the
introduction of a rationing system, reducing exports, xing of the price of essential
commodities by the government and shifting of productive resources to the
production of more sensitive goods, etc.

C. Other measures: In addition to the above scal and monetary measures, the following
measures can be adopted for controlling in ation:

i) Increase in Production: By increasing production the in ationary pressure can be

reduced. An increase in production increases the supply of goods, which helps in
establishing prices.

ii) Price control and Rationing System: The government can control the rise in prices
by prohibiting any unwarranted price rises or by putting a ceiling on the prices of
selected commodities. The government can also impose price control along with
rationing of the commodities.

iii) Export-Import Control: By restricting exports and promoting imports, the

government can increase the supply of goods in the country. This helps in controlling
the rise in prices.

iv) Improvement of Distribution System: The public distribution system in the country
should be strengthened. So that the commodities are made available at reasonable
prices.

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 Unit-V Business Economics K. Rakshit

Business Cycles
• The economic history of nearly all countries point towards the fact that they have gone
through uctuations in economic activities i.e. there have been periods of prosperity
alternating with periods of economic downturns. These rhythmic uctuations in
aggregate economic activity that an economy experiences over a period of time are
called business cycles or trade cycles.

• A trade cycle is composed of periods of good trade characterised by rising prices and
low unemployment percentages, altering with periods of bad trade characterised by
falling prices and high unemployment percentages. In other words, the business cycle
refers to alternate expansion and contraction of overall business activity as manifested
in uctuations in measures of aggregate economic activity, such as gross national
product, employment and income.

• A noteworthy characteristic of these economic uctuations is that they are recurrent and
occur periodically. That is, they occur again and again but not always at regular
intervals, nor are they of the same length. It has been observed that some business
cycles have been long, lasting for several years while others have been short ending in
two to three years.

Phases of Business Cycle:

A typical business cycle has four distinct phases. These are:
1. Expansion (also called Boom or Upswing)

2. Peak or boom or Prosperity

3. Contraction (also called Downswing or Recession)

4. Trough or Depression

• The four phases of a business cycle are shown in the gure below. The broken line
(marked ‘trend’) represents the steady growth line or the growth of the economy when
there are no business cycles.

• The gure starts with ‘trough’ when the overall economic activities i.e. production and
employment, are at the lowest level. As production and employment expand, the
economy revives, and it moves into the expansion path. However, since expansion
cannot go on inde nitely, after reaching the ‘peak’, the economy starts contracting.

• The contraction or downturn continues till it reaches the lowest turning point i.e.
‘trough’. However, after remaining at this point for some time, the economy revives
again and a new cycle starts.

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 Unit-V Business Economics K. Rakshit

Expansion:
• The expansion phase is characterised by an increase in national output, employment,
aggregate demand, capital and consumer expenditure, sales, pro ts, rising stock prices
and bank credit. This state continues till there is full employment of resources and
production is at its maximum possible level using the available productive resources.
Involuntary unemployment is almost zero and whatever unemployment is there is either
frictional or structural.

• Prices and costs also tend to rise faster. Good amounts of net investment occur, and
demand for all types of goods and services rises. There is altogether increasing
prosperity and people enjoy a high standard of living due to high levels of consumer
spending, business con dence, production, factor incomes, pro ts and investment. The
growth rate eventually slows down and reaches its peak.

Peak:

• The term peak refers to the top or the highest point of the business cycle. In the later
stages of expansion, inputs are di cult to nd as they are short of their demand and
therefore input prices increase. Output prices also rise rapidly leading to increased cost
of living and greater strain on xed income earners. Consumers begin to review their
consumption expenditure on housing, durable goods etc. Actual demand stagnates.
This is the end of expansion and it occurs when economic growth has reached a point
where it will stabilize for a short time and then move in the reverse direction.

Contraction:
• The economy cannot continue to grow endlessly. As mentioned above, once the peak is
reached, an increase in demand is halted and starts decreasing in certain sectors.
During contraction, there is a fall in the levels of investment and employment. Producers
do not instantaneously recognise the pulse of the economy and continue anticipating
higher levels of demand, and therefore, maintain their existing levels of investment and
production. The consequence is a discrepancy or mismatch between demand and
supply.

• Supply far exceeds demand. Initially, this happens only in a few sectors and at a slow
pace but rapidly spreads to all sectors. Producers being aware of the fact that they have
indulged in excessive investment and overproduction, respond by holding back future
investment plans, cancellation and stoppage of orders for equipment and all types of
inputs including labour. This in turn generates a chain of reactions in the input markets
and producers of capital goods and raw materials, in turn, respond by cancelling and
curtailing their orders. This is the turning point and the beginning of a recession.

Trough and Depression:

• Depression is a severe form of recession and is characterized by extremely sluggish
economic activities. During this phase of the business cycle, the growth rate becomes
negative and the level of national income and expenditure declines rapidly. Demand for
products and services decreases, prices are at their lowest and decline rapidly forcing
rms to shut down several production facilities. Since companies are unable to sustain
their workforce, there is mounting unemployment which leaves the consumers with very
little disposable income.

• A typical feature of depression is the fall in the interest rate. With a lower rate of interest,
people’s demand for holding liquid money (i.e. in cash) increases. Despite lower interest
rates, the demand for credit declines because investors' con dence has fallen. Often, it

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 Unit-V Business Economics K. Rakshit

also happens that the availability of credit also falls due to possible banking or nancial
crisis. Industries, especially the capital and consumer durable goods industry, su er
from excess capacity. A large number of bankruptcies and liquidations signi cantly
reduce the magnitude of trade and commerce. At the depth of the depression, all
economic activities touch the bottom and the phase of a trough is reached.

Causes of Business Cycles:

Business Cycles may occur due to external causes or internal causes or a combination of
both. The 2001 recession was preceded by an absolute mania in dot-com and technology
stocks, while the 2007-09 recessions followed a period of unprecedented speculation in
the U.S. housing market.

Internal Causes:
The Internal causes or endogenous factors which may lead to boom or bust are:

Fluctuations in E ective Demand:

• Fluctuations in economic activities are due to uctuations in aggregate e ective
demand (E ective demand refers to the willingness and ability of consumers to
purchase goods at di erent prices). In a free market economy, where maximization of
pro ts is the aim of businesses, a higher level of aggregate demand will induce
businessmen to produce more. As a result, there will be more output, income and
employment.

• However, if aggregate demand outstrips aggregate supply, it causes in ation. As against

this, if the aggregate demand is low, there will be lesser output, income and
employment. Investors sell stocks, and buy safe-haven investments that traditionally do
not lose value, such as bonds, gold and the U.S. dollar. As companies lay o workers,
consumers lose their jobs and stop buying anything but necessities. That causes a
downward spiral.
Fluctuations in Investment:
• According to some economists, uctuations in investments are the prime cause of
business cycles. Investment spending is considered to be the most volatile component
of aggregate demand. Investments uctuate quite often because of changes in the pro t
expectations of entrepreneurs.

• New inventions may cause entrepreneurs to increase investments in projects which are
cost-e cient or more pro t inducing. Or investment may rise when the rate of interest is
low in the economy. Increases in investment shift the aggregate demand to the right,
leading to an economic expansion. Decreases in investment have the opposite e ect.
Variations in government spending:
• Fluctuations in government spending with its impact on aggregate economic activity
result in business uctuations. Government spending, especially during and after wars,
has destabilizing e ects on the economy.

Macroeconomics policies:
• Macroeconomic policies (monetary and scal policies) also cause business cycles.
Expansionary policies, such as increased government spending and/or tax cuts, are the
most common method of boosting aggregate demand. This results in booms.

• Similarly, softening of interest rates, often motivated by political motives, leads to

in ationary e ects and a decline in unemployment rates. Anti-in ationary measures,

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 Unit-V Business Economics K. Rakshit

such as reduction in government spending, increase in taxes and interest rates cause
downward pressure on the aggregate demand and the economy slows down.

Money Supply:
• The Trade cycle is a purely monetary phenomenon. Unplanned changes in the supply of
money may cause business uctuation in an economy. An increase in the supply of
money causes expansion in aggregate demand and in economic activities.

• However, excessive increases in credit and money also set o in ation in the economy.
Capital is easily available, and therefore consumers and businesses alike can borrow at
low rates. This stimulates more demand, creating a virtuous circle of prosperity. On the
other hand, a decrease in the supply of money may reverse the process and initiate a
recession in the economy.
Psychological factors:
• Modern business activities are based on the anticipations of business community and
are a ected by waves of optimism or pessimism. Business uctuations are the outcome
of these psychological states of mind of businessmen.

• If entrepreneurs are optimistic about future market conditions, they make investments,
and as a result, the expansionary phase may begin. The opposite happens when
entrepreneurs are pessimistic about future market conditions. Investors tend to restrict
their investments. With reduced investments, employment, income and consumption
also take a downturn and the economy faces contraction in economic activities.

External Causes:
The External causes or exogenous factors which may lead to boom or bust are:

Wars:
• During war times, production of war goods, like weapons and arms etc., increases and
most of the resources of the country are diverted for their production. This a ects the
production of other goods - capital and consumer goods. Fall in production causes falls
in income, pro ts and employment. This creates a contraction in economic activity and
may trigger a downturn in the business cycle.

Post War Reconstruction:

• After the war, the country begins to reconstruct itself. Houses, roads, bridges etc. are
built and economic activity begins to pick up. All these activities push up e ective
demand due to which output, employment and income go up.

Technology shocks:
• Growing technology enables the production of new and better products and services.
These products generally require huge investments for new technology adoption. This
leads to expansion of employment, income and pro ts etc. and gives a boost to the
economy.

• For example, due to the advent of mobile phones, the telecom industry underwent a
boom and there was an expansion of production, employment, income and pro ts.
Natural Factors:
• Weather cycles cause uctuations in agricultural output which in turn cause instability in
the economies, especially those economies which are mainly agrarian. In the years
when there are draughts or excessive oods, agricultural output is badly a ected.

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 Unit-V Business Economics K. Rakshit

• With reduced agricultural output, the incomes of farmers fall and therefore they reduce
their demand for industrial goods. Reduced production of food products also pushes up
their prices and thus reduces the income available for buying industrial goods. Reduced
demand for industrial products may cause an industrial recession.

Population Growth:
• If the growth rate of the population is higher than the rate of economic growth, there will
be lesser savings in the economy. Fewer savings will reduce investment and as a result,
income and employment will also be less. With lesser employment and income, the
e ective demand will be less, and overall, there will be a slowdown in economic
activities.

Relevance of Business Cycles in Business Decision Making:

• Business cycles a ect all aspects of an economy. Understanding the business cycle is
important for businesses of all types as they a ect the demand for their products and in
turn, their pro ts which ultimately determines whether a business is successful or not.
Knowledge regarding business cycles and their inherent characteristics is important for
a businessman to frame appropriate policies.

• In contrast, a period of recession or depression reduces business opportunities and

pro ts. A pro t maximising rm has to consider the nature of the economic environment
while making business decisions, especially those related to forward planning.
• The stage of the business cycle is crucial while making managerial decisions regarding
expansion or downsizing. Businesses have to advantageously respond to the need to
alter production levels relative to demand.

• Di erent phases of the cycle require uctuating levels of input use, especially labour
input. Firms should exercise the capability to expand or rationalize production
operations so as to suit the stage of the business cycle. Business managers need to
work e ectively to arrive at sound strategic decisions in complex times across the
whole business cycle, managing through boom, downturn, recession and recovery.

• Economy-wide trends can have a signi cant impact on all types of businesses.
However, it should be kept in mind that business cycles do not a ect all sectors
uniformly. Some businesses are more vulnerable to changes in the business cycle than
others.

• Businesses whose fortunes are closely linked to the rate of economic growth are
referred to as "cyclical" businesses. These include fashion retailers, electrical goods,
house-builders, restaurants, advertising, overseas tour operators, construction and
other infrastructure rms. During a boom, such businesses see strong demand for their
products but during a slump, they usually su er a sharp drop in demand. It may also
happen that some businesses actually bene t from an economic downturn.

• Overcoming the e ects of economic downturns and recessions is one of the major
challenges of sustaining a business in the long term. The phase of the business cycle is
important for a new business to decide on entry into the market. The stage of the
business cycle is also an important determinant of the success of a new product launch.
Surviving the sluggish business cycles require businesses to plan and set policies with
respect to product, prices and promotion.

THE END.
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