COURSE OUTLINE

Course Title Macro Economics

Course Code 203
No of credits 3
Department BBA-II (CBCS 2022)
Course Leader DEEPSHIKHA GANDHI
Faculty Ms. Deepshikha Gandhi, Ms. Monika
Email ID deepshikha.gandhi-ext@bvp.edu.in

1. COURSE OBJECTIVES

1) To study the behaviour and working of the economy as a whole.

2) To study the relationship among broad aggregates.

3) To apply economic reasoning to problem of business and public policy.

2. COURSE CONTENT (INCLUDE THE UNIVERSITY SYLLABUS)

1. Module I : Basic Concept Of Macro Economics

2. Module II : National Income Accounting
3. Module III : Theory of income and employment
4. Module IV : Money
5. Module V : Macroeconomic policies

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 3. COURSE LEARNING OUTCOMES

At the successful completion of the course, the learner will be able to,

LO1. Acquaint with the concept of macroeconomics.

LO2. Determine the linkages between major economic variables.

LO3 .Understanding the concept of business cycle, inflation, deflation.

LO4. Acquaint with the Macro Economic Policies.

4. COURSE TEACHING AND LEARNING ACTIVITIES

1. Discussion on latest various economic and financial statistics of Indian economy like GDP, HDI,
inflation rate, Bank rate, CRR, SLR, Repo rate, Per Capita Income
2. Case Studies on Economic Development, HDI, Developing Countries, US Recession, Monetary Policy
3. Discussion on latest economic issues from newspaper (The economic Times)
4. Debate and Group Discussion among student on various topics like unemployment, inflation, recession,
demonetization in Indian context, also international economic situations like Great Depression (1930),
Recession in USA (2008), Greek crisis, Chinese currency devaluation & its impact on International
Business, Make in India & its impact on Indian Economy, Brexit & its impact on European Union etc.
5. Quiz on latest economic issues, current affairs on Business affairs.
6. Presentation by students on various Macroeconomic issues and discussion on it elaborately.

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 5. EVALUATION CRITERIAN & WEIGHTAGE
Learning
Assessment Weightage outcome
method Description (100) (Aligned
with the
course)
Continuous Evaluation System (CES)
CES (All the 3 CES are mandatory to get a weightage of 10% marks (best 10%
of of 2 i.e. 5% each) or else it will be calculated as 3.33% marks for
each CES attempted.
5%+5%=
Case Study Case Study on practical Macroeconomic problems like Economic 10% LO-1 &
(CES 1) Development, HDI and Economic Policies in India (All 3 CES LO-2
(CES 1 will be conducted from Unit 1-2 and after conducting more attempted)
than 10 classes) 3.33%+3.3
3%=6.66%
QUIZ QUIZ evaluating recall of the course learning and current economic (Only 2CES LO 1 &
(CES 2) issues. This quiz will be with 30 Multiple Choice Questions (MCQ) attempted) LO 3
with fixed time of 50 mins. 3.33%
(CES 2 will be conducted from Unit 2-3 and after conducting more (Only 1CES
than 20 classes) attempted)

Presentation To make the student confident to give presentation using PPT/Viva LO3&
(CES 3) on various economic and business issues. LO 4
(CES 3 will be conducted from Unit 4-5 after completion of
30classes)
Students with attendance of 75% and above will be awarded with 10
Attendance marks or else it will be marked as “O” Zero. Students need to check 10%
their attendance regularly on ERP.

Internal • 3 Questions will be of conceptual recall carrying 4marks to 10% LO 1, LO

exam I answer in 300 words, 2 & LO3
• 3 questions will be of Theoretical concept carrying 8 marks
Internal
each to answer in 500 words
exam II
• 3 Analytical/short case study/Essay type questions to test
analytical and comprehensive skill which carries 12 marks
need to be answer in 700 words.
This will cover first 3units (Module I, II & III) in Internal Exam-I 10% LO 1, LO
&last 3 units (Module III, IV & V) in Internal Exam II. 2 & LO 4

End Term It will be based on conceptual questions, situation specific, LO 1, LO

Exam application oriented questions and short case studies, end term exams 60% 2, LO 3
will cover both pre mid-term and post mid-term course coverage. & LO 4

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 6. ESSENTIAL READINGS
Text Book Macroeconimics: Theory & Policy by D.N. Dwivedi (TATA
Mc-Graw Hill Educations)
Reference Books 1. Macroecomics: Theories & Policy by H.L. Ahuja (S.
Chand Publications)
2. SumanKalyanChakraborty, Macroeconomics, Himalya
Publishing House
3. G.S. Gupta, Macroeconomics, Theory and Application,
3rd Edition.
4. William A. McEachern, A. Indra, Macro ECON – A
South Asian Perspective, Principles of
Macroeconomics, CENGAGAE Learning

Internet Sources 1. www.economist.com

2. www.indiainbusiness.nic.in
3. www.indiabix.com
4. www.bbc.com
5. www.moneyweek.com
6. www.economictimes.indiatimes.com
7. www.economywatch.com
Newspapers, News Channel & journal 1. The Economic Times Newspaper
2. NDTV Profit News Channel
3. The Economic Journal
4. The Indian Economic Journal
5. Arthashastra: Indian Journal of Economics & Research

MOOC COURSES • Macroeconomics (SWAYAM)

Macroeconomics - Course (swayam2.ac.in)
• Professional Certificate in Macroeconomics (edX)
Macroeconomics Professional Certificate | edX
• Oxford Diploma in The Economy of India
The Indian economy - 2 textbooks (FREE!) | Udemy
• Country Level Economics: Policies, Institutions and
Macroeconomic Performance
Country Level Economics: Policies, Institutions, and
Macroeconomic Performance | Coursera

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 8. LIST OF TOPICS/ MODULES:

Topic/ Module Contents/ Concepts

• Macroeconomics- definition & nature, Scope

Module I: Basic Concept Of Macro • Importance, Limitations,
• Paradoxes,
Economics • Macroeconomic variables.

• Circular flow of income: four sector model

Module II: National Income • Contribution of Various sectors in India in generation of
Accounting National Income,
• Composition of national income and occupational structure.
• National income accounting,
• Methods to calculate national income,
• Stock and flow concept,
• Gross domestic product(GDP),
• Gross national product(GNP),
• Net domestic product(NDP),
• Net national product(NNP),
• Personal and Personal disposable income;
• Classical theory of income and employment,
• Say’s law of market
• Keynesian theory of income and employment
• Components of aggregate demand,
Module III : Theory of income and • Components of Aggregate supply
• Investment Multiplier,
employment

• Functions of money,
• Quantity theory of money,
• Determination of money supply and demand,
• Quantity Theory of Money
• Business cycle & Inflation & Deflation:
Module IV: Money • Business cycle-nature,
• Features/Characteristics- Prosperity/Boom – Recession,
Depression, Revival/Recovery
• Inflation: Meaning ,
• Demand and supply side factors,
• Causes & control,
• Deflation: Meaning , causes & control,

5

Module V: Macroeconomic policies
• Macro economic policy:
• Monetary policy,
• Objectives and instruments of monetary policy
• Fiscal policy
• Objectives and instruments of fiscal policy.

9. SESSION PLAN:

Module I: Basic concept of Macroeconomics

Session Topic Refrences Learning Outcome
• Introduction to the subject, Macro Text Book To develop a basic understanding of the
Economics Page No. 56- subject macroeconomics.
1 • Course Outline Discussion 59 (LO1)
• Evaluation Criteria (CES
Activities) Course
Outline
• Definition, Nature &Scope of Text Book Appreciate and realize the need for
2 Macro Economics Page No. 7-8 studying macroeconomics (LO 1)
Text Book
• Importance & Limitation of Macro Page No. 19- Realize the importance &limitations of
3 Economics 24 macroeconomics (LO1)
• Paradoxes of Macroeconomics Text Book
Page No. 13
Text Book Interpret and analyze the forces that
• Macro-Economic Quantitative
4 Page No. 9 shape economic status (LO1 & LO2)
Variables
Page No. 26-
34
Text Book Interpret and analyze the forces that
• Macro-Economic Quantitative
5 Page No. 9 shape economic status (LO1 &LO2)
Variables
PPT NOTES
PPT NOTES Understand how Countries are divided
6 • Macroeconomic qualitative Internet according to their status of Economic
variables sources Development ( LO2 & LO4)

Course Pack Practical Application in solving

• CES 1: Case Study
7 Macroeconomic issues of India (LO5,
LO6, LO7 & LO8)
8 Revision on Unit 1 Classroom LO1, LO2
(Discussion/written class test) discussion
MODULE II: National Income Accounting

• Contribution of Various sectors in Text Book Interpret Data on GDP and contribution
9 India’s GDP Page No.75-76 from three sectors (LO5, LO7 & L08)

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 10 • Classroom discussion on reason Discussion LO2
for difference in contribution of
various sectors in GDP
• Composition of national income Text Book Interpret Data on GDP and contribution
11 • Occupational structure Course Pack from three sectors (LO5, LO7 & L08)

Text Book Understand how income of Indian

• National income accounting
12 Page No. 55- Economy is measured and its
• Measures of National Income 57 importance and policy making (LO4,
Accounting
LO7)
• Circular flow of income (four Text Book Understand the role of household,
13 sector model ) Page No. 52- firms, government and international
• Stock and flow concept 53 market in an economic system. (LO2)

• Methods to calculate national Text Book 66- Describe the value added method, factor
income 76 income method and expenditure
14 • Value Added method of measurement of national
• Income Method income. (LO1, LO6)
• Expenditure Method
• Gross domestic product(GDP), Text Book 77-
• Gross national product(GNP), 78 Understand the measurement of
• Net domestic product(NDP), National Income and its significance
15 • Net national product(NNP), Ppt notes (LO2, LO4 & LO7)
• Personal and Personal disposable
income
Text Book 61- Knowledge about Central Institution
• Functions of Central Statistical
16 65 providing data, its interpretation ans
Organization.
research in Macroeconomics. (LO5,
Ppt by team 2 LO7)
IT software Recollect all the basic knowledge and
• CES 2: Moodle Test
based test with understanding gained on
(MCQ based on
17 30 Multiple Macroeconomic indicators, Economic
Module 1 & 2)
choice Development Indicators, HDI, National
questions Income. (LO
• Revision Of Unit 2(Written Test/ Recollect all the knowledge gained on
18 Oral Test/ Quiz) various concepts of National Income.

MODULE III: Theory Of Income and Employment

Text Book 94- To understand the view point of

• Assumptions of Classical Theory
95 economist JB Say (LO2)
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 • Say’s Law of Market Text Book 95- To understand the view point of
21 • CES-3 (PPT Presentation) 96 PPT by economist JB Say (LO2)
team 1 and 2
Explain how total spending in the
22 • Objectives of Keynes theory of Text Book economy changes with income
Income & Employment 337 – 350 Ppt Determine the national income
• CES-3 (PPT Presentation) by team 3 equilibrium using the basic model
Describe the aggregate demand curve.
• Simple Model of Keynesian
23 Text Book 97- Analyze shifts of the aggregate supply
Theory Of Income and
104 curve. (LO1, LO2)
Employment
• Components of Aggregate Text Book Understand how equilibrium National
24 Demand 108 Income, Aggregate Demand and
• Equilibrium income Text Book Aggregate Supply is determined.
114-118 (LO3 & LO7)
Text Book Analyze in what propensity people
• Keynes psychological law of
25 109-112 consume and save and understand the
consumption,
Keynesian Theory on Consumption
• APC & MPC (LO3 & LO7)
Text Book Understand how Investment can
• Changes in equilibrium,
26 123-126 multiply the National Income with the
• Investment Multiplier
Ppt by team 4 help of Keynesian theory explanation
• CES-3 (PPT Presentation) (LO 3& LO7)
27 • Revision Of Unit 3 (Oral Test/ Remember and revise the concepts
Quiz) taught in this unit (LO3, LO7)
Module IV: Money

• Functions of money, Text Book and Explain the role of consumption.

28 • Determination of money, PPT notes (LO 1 & LO 2)
• Supply and demand

• Quantity Theory of Money Ppt by team 5 Understand the basic functions and
29 • CES-3 (PPT Presentation) interpretation of Saving (LO 2 & LO3)

• Functions of Central Bank Notes, Course Comprehend the importance of RBI in

30 • CES-3 (PPT Presentation) Pack stabilizing Indian Economy (LO5, LO7
Ppt by team 6 & LO8)

8

• Business cycle
• nature, Features/Characteristics
31 • Recession, Depression, PPT
Revival/Recovery
• US & Global Recession
• US Sub Prime Crisis
• Inflation & Deflation:
• Inflation: Meaning ,
32 • Demand and supply side factors
• CES-3 (PPT Presentation)
• Causes & Control,
• Deflation: Meaning,
33 • Causes & control.
• Current Economic situation
• Revision Of Unit 4(Written Test/
Oral Test/ Quiz)
34 • CES-3 (PPT Presentation)
MODULE V : Macro Economic Policies
• Monetary Policy
• Quantitative Instruments
35
• Bank Rate
• CRR & SLR
• Repo Rate & Reverse Repo Rate
• Qualitative instruments
36 • How Monetary policy works
• CES-3 (PPT Presentation)
• Fiscal Policy
37
• Direct Tax
• Indirect Tax
• How Fiscal Policy works
38
• CES-3 (PPT Presentation)
Text Book
Page No. 451- Identify the different phases of business
453 cycle and correlate with the recent ups
and down of economies like US
Notes, Recession and Greek Recession. ( LO5,
Course Pack LO6, LO7 & LO 8)
& Class
Discussion
Text Book Understand how inflation is measured
Page No. 510- and its impact on the economy. Also
520 analyze various measures adopted to
control inflation (LO6 & LO 7)
PPT by team 7
Comprehend and Analyze various
Text Book reasons for instability in the economy
Page No. 526- and control Money supply in the
533 economy (LO1, LO5, LO6 & LO8)
Recollect all the knowledge on Money
PPT by team 8 supply & Business Cycle and how it
effect the economy (LO45, L6 & LO8)
Text Book Interrelate with current economic
Page No. 631- situation and comprehend how these
637 monetary policies are used in
646-650 controlling Money supply in the
economy
PPT Notes & (LO3, LO7)
Class
Discussion
PPT & Class Discuss the relevance and application of
Discussion monetary policy ( LOI 6, LO7 & LO8)
Ppt by team 9
Text Book Discuss the evolution of fiscal policy
Page No. 656- (LOI 2, LO6 & LO8)
658
PPT & Class Discuss the fiscal impact of the budget.
Discussion ( LO 2 , LO 7 & LO8)
Ppt by team 10
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 • Revision Of Unit 6(Oral Test/ PPT & Class Remember the concepts taught in above
39 Quiz) Discussion sessions. ( LO 2 & LO 7)
• CES-3 (PPT Presentation) Ppt by team 11
• Previous year paper discussion ERP Question Remember the concepts taught in above
40 • CES-3 (PPT Presentation) BANK sessions and appreciate the importance
Ppt by team 12 of Macro Economics as a function (
LO1, LO2, LO3 & LO4)

10. Topics of PPT Presentation (CES- 3)

• HDI (Human Development Index) as an indicator of Economic Development
• Developing Economies- the growing economies in the world
• The changing dynamics of India’s sectorial contribution to GDP
• Great Depression of 1930 (American Depression)
• US Recession of 2008: its causes and effect on World Economy
• RBI & its role in stabilization of the Indian Economy
• Impact of GST as a measure of Fiscal Policy
• Economic Impact of Global Crude Oil Prices
• US-China Trade War and its impact on International Market
• Brexit & its impact on European Union
• Chinese currency devaluation: Objectives and Consequences in International Trade
• Demonetization in India in 2016 and its impact on Indian Economy
• Make in India- Increasing contribution to GDP of Secondary Sector & Employment
generation
• Effect of Covid’19 on Indian Economy
• Budget 2022 and its impact on different sectors of Indian Economy

11. Contact Details:

Ms. Monika
Name of the Instructor:
Ms. Deepshikha Gandhi
Ms. Gandhi (dshikharun@gmail.com),
Email:
Ms.Monika (monika2job@gmail.com),
Teaching Venue: Assigned classroom as per time table
Website: www.bvimr.com
Office Hours: 9:00 am to 5:00 pm
www.bvimrcampus.com
Online Links:
www.bvimr.com

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 BRIEF PROFILES
OF THE
SUBJECT FACULTY

11
Ms. Deepshikha Gandhi
deepshikha.gandhi-ext@bvp.edu.in
Ms. Deepshikha Gandhi is an Assistant professor (visiting faculty) at BVIMR, New Delhi. She
is working as an Assistant Professor since year 2011. Her subject areas are Accounting,
Economics, Marketing, Business, Statistics etc. She has been qualified UGC-NET. She is a Post-
graduate in Commerce. Apart from this, she has also completed her Bachelor’s in Education in the
year 2018. She has passed IELTS (International English language testing system) exam also in
2018 with 8 bands. Furthermore, she has attended many Conferences at National and International
level.

Ms. Monika
Monika2job@gmail.com
Ms. Monika has more than 7 years experience in academic teaching and human resource. Participated
in various webinars. workshops, FDPs and conferences. Has done MBA, M.com, B.Ed. and
pursuing Ph.D. in management.

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 Module I
Basic Concept Of Macro
Economics

13
MACROECONOMICS DEFINITION:
Macroeconomics is the branch of economics that studies the behavior and performance of an
economy as a whole. It focuses on the aggregate changes in the economy such as
unemployment, growth rate, gross domestic product and inflation.

Macroeconomics analyzes all aggregate indicators and the macroeconomic factors that
influence the economy. Government and corporations use macroeconomic models to help in
formulating of economic policies and strategies.

1.2.DIFFERENCE BETWEEN MICROECONOMICS & MCEOECONOMICS

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 1.3. NATURE & SCOPE OF MACROECONOMICS:

Macroeconomics is the study of aggregates or averages covering the entire economy, such as total
employment, national income, national output, total investment, total consumption, total savings,
aggregate supply, aggregate demand, and general price level, wage level, and cost structure.

Macroeconomics is also known as the theory of income and employment, or income analysis. It is
concerned with the problems of unemployment, economic fluctuations, inflation or deflation,
international trade and economic growth. It is the study of the causes of unemployment, and the
various determinants of employment.

1.3.1. NATURE OF MACROECONOMICS:

I.) DETERMINATION OF NATIONAL INCOME AND EMPLOYMENT:

• Macro-economics deals with aggregate demand and aggregate supply that determines the
equilibrium level of income and employment in the economy.
• The level of aggregate demand determines the level of income and employment.
• Macroeconomics also deals with the problem of unemployment due to lack of aggregate
demand. Moreover, it studies the economic fluctuations and business cycles.

II.) DETERMINATION OF GENERAL PRICE LEVEL:

• Macroeconomics studies the general level of price in an economy.
• It also studies the problem of inflation and deflation.

III.) ECONOMIC GROWTH AND DEVELOPMENT:

• Macroeconomics deals with economic growth and development.
• It studies various factors that contribute to economic growth and development.

IV.) DISTRIBUTION OF FACTORS OF PRODUCTION:

• Macroeconomics also deals with various factors of production and their relative share in
the total production or total national income

1.3.2. SCOPE MACROECONOMICS:

Macroeconomics is an essential field of study for economists. Government, financial bodies and
researchers analyze the general national issues and economic well being of a nation. It mainly
covers the measure fundamentals which are macroeconomic theories and macroeconomic policies.
Here the Macroeconomic theories involve economic growth and development, the theory of
national income, money, international trade, employment, and general price level. In contrast,
macroeconomic policies cover fiscal and monetary policies. The study of problems like
unemployment in India or the general price level or the problem of balance of payment(BOP) is a
part of the macroeconomic study because it relates to the economy as a whole.

15
 • Macroeconomic Theories:
It is understood that the Government is the regulating body of a nation. It considers the various
aspects which are critical and have a direct impact on the lives of the citizens.

There are six theories under the scope of macroeconomics:

1. Theory of Economic Growth and Development:
• The growth of an economy also comes under the study of macroeconomics. The resources
and capabilities of an economy are evaluated based on the scope of macroeconomics. It
schemes the increase in the level of national income, output, and the environment level.
They have a direct impact on the economic development of an economy.

2. Theory of Money:
• Macroeconomics assesses the impact of the reserve bank in the economy, the inflow and
outflow of capital, and its effects on job rates. The frequent change in the value of money
caused due to inflation and deflation diversely affect the economy of a nation adversely.
They can be aggravated by taking monetary, fiscal policies and direct control measures for
the economy as a whole.

3. Theory of National Income:

• It includes different topics related to the measurement of national income, including
revenue, spending, and budgeting. As a macroeconomic study, it is vital for assessing the
overall performance of the economy in terms of national income. At the onset of the Great
Depression of the 1930s, it was essential to investigate the triggers of general
underproduction and general unemployment. This led to the creation of data on national
income. It helps to forecast the level of economic activity. It also helps in understanding
the income distribution among various classes of citizens.

4. Theory of International Trade:

• It is an area of study that focuses on the export and import of products or services. In brief,
it points out the effect on the economy through cross-border commerce and customs duty.

5. Theory of Employment:
• This scope of macroeconomics assists in determining the level of unemployment. It also
determines the conditions that lead to such conditions of unemployment. Hence, this affects
the production supply, consumer demand, consumption, and expenditure behavior.

6. Theory of General Price Level:

• The most significant of these is the study of commodity prices and how specific price rates
fluctuate due to inflation or deflation.

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7. Macroeconomic Policies:
• The RBI and the Government of India together function to imply the macroeconomic
policies, for the nation’s improvement and development. It is classified into the following
two sections:
a. Fiscal policy:
• It refers to how the expenditure meets over the deficit income which explains itself as a
form of budget decision under macroeconomics.
b. Monetary policies:
• The Reserve Bank is establishing monetary policy in coordination with the Government.
These policies are measures taken to maintain economic stability and growth in the country
by regulating the different interest rates.

As a method of economic analysis macroeconomics is of much theoretical and practical

importance.

(i) To Understand the Working of the Economy:

• The study of macroeconomic variables is indispensable for understanding the working of
the economy. Our main economic problems are related to the behaviour of total income,
output, employment and the general price level in the economy.

(ii) In National Income:

• The study of macroeconomics is very important for evaluating the overall performance of
the economy in terms of national income. With the advent of the Great Depression of the
1930s, it became necessary to analyze the causes of general overproduction and general
unemployment.

iii) In Economic Growth:

• The economics of growth is also a study in macroeconomics. It is on the basis of
macroeconomics that the resources and capabilities of an economy are evaluated. Plans for
the overall increase in national income, output, and employment are framed and
implemented so as to raise the level of economic development of the economy as a whole.

13.3. Importance of Macroeconomics:

• It helps us understand the functioning of a complicated modern economic system. It

describes how the economy as a whole functions and how the level of national income and
employment is determined on the basis of aggregate demand and aggregate supply.
• It helps to achieve the goal of economic growth, a higher GDP level, and higher level of
employment. It analyses the forces which determine economic growth of a country and
explains how to reach the highest state of economic growth and sustain it.
• It helps to bring stability in price level and analyses fluctuations in business activities. It
suggests policy measures to control inflation and deflation.

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 • It explains factors which determine balance of payments. At the same time, it identifies
causes of deficit in balance of payments and suggests remedial measures.
• It helps to solve economic problems like poverty, unemployment, inflation, deflation etc.,
whose solution is possible at macro level only (in other words, at the level of the whole
economy).
• With a detailed knowledge of the functioning of an economy at macro level, it has been
possible to formulate correct economic policies and also coordinate international economic
policies.
• Last but not least, macroeconomic theory has saved us from the dangers of application of
microeconomic theory to the problems that require us to look at the economy as a whole.

1.3.3. Limitation of Macroeconomics:

1. Excessive Generalization:
As hinted above, generalization of individual observation to the system as a whole may lead to
erratic inferences about the system as a whole. For instance, a loss incurred by one firm in an
industry does not necessarily imply losses to all other firms in it. Likewise, hospitality shown by
one Indian does not imply that each and every Indian will show the gesture.

2. Obsession of Aggregative Approaches:

Excessive thinking in terms of lumping the individual units together may lead to erratic inferences.
Individual units possess individualistic traits. They are non-homogeneous in character. One can’t
add up two apples and three oranges to make any meaningful aggregate.

3. Fallacy of Deductive Inferences:

Inferences deduced about individual units from the aggregative tendency may not always be true
in respect of individual units as well. For instance, a general rise in prices may not affect all the
sections of the community in the same manner. A consumer suffers from rising price level while a
producer benefits from it.

4. Inconsistency between Overall and Individual Changes:

A hike in prices of industrial output and a fall in prices of the agricultural products may offset each
other to lead to no rise in the general price level. On the basis of stability of the general price level,
one who believes that no policy change is called for in the circumstances would certainly
jeopardize the cultivators’ interests.

5. Problems of Measurement of Aggregates:

In many cases measurement of aggregates involves serious problems.

To conclude, macroeconomic analysis, by itself, may not provide a true picture of an economy. It
may appear like the top surface of an ocean appearing calm and unruffled from above yet
harbouring quite a few storms underneath. To locate the trouble spots, it is microeconomic analysis
that is called for.

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1.3.6. PARADOX OF MACROECONOMICS:
Macroeconomics Paradoxes are referred as those situations where the facts hold true at the micro
level (i.e. in terms of Individual economic unit) but do not hold true at the macro level (i.e. in terms
of aggregate units). They are also known as ‘Micro-Macro paradoxes’.
Some examples are as follows:
• 1. The paradox of thrift:
An increase in the propensity to save will reduce output. One or even many individuals
may increase the proportion of their income that they save and do not spend. However if the
majority of the population of an economy do so, overall consumption will fall, reducing output.
This may even lead to a fall in the absolute level of savings if the economy shrinks, so that an
increase in desired saving leads to a fall in actual saving.
• 2. Paradox of Unemployment:
It is said if an individual takes up an employment at a lower-wage rate then the employment level
may increase. However, if all the labours accept employment at a lower-wage rate then over all
employment level may infact decrease.
• 3. Paradox of Cash withdrawl:
If an individual decides to withdraw funds from bank, then it will not harm the workings of the
bank. However, if all the individuals decide to withdraw their funds from bank then this will result
in bank failure.
• 5. Paradox of Plenty:
For a farmer it is common sense that he has to produce the maximum output possible. but if in an
economy everybody has good crops, then there may be a problem of plenty. as a result prices can
crash.
• 6. The paradox of costs:
This holds that a decrease in real wages will not increase the profits of firms and will instead lead
to a fall in employment. One firm can achieve higher profits by reducing its wage bill. However,
if all firms attempt to do the same, consumption will fall at the macro level, reducing sales, and
from there the rate of profits.
• 7. The paradox of public deficits:
Theory shows that an increase in the government’s deficit can increase firm profitability. The
extent of this will vary depending on the impact of a higher deficit on the balance of trade in an
open economy. It also may not hold in the longer term, as a boost to profits in the short-term
may reduce the incentives for firms to restructure or prevent weaker firms going bust, thereby
hampering structural change. But it remains a possibility.
• 8. The paradox of profit-led demand:
This idea suggests that if overall real wages in an economy are reduced to reduce prices, this can
lead to a boost to demand via net exports as the country becomes more competitive internationally.
However if all countries try to do the same, global consumption will fall, reducing demand and
output. It is impossible for all countries to become more competitive against each other, since the
world economy is a closed system. While one country can benefit from real wage reductions, other
things being equal, the world economy as a whole cannot. A good example of this paradox is the
Eurozone since 2000, with Germany as the economy reducing wages to increase
the competitiveness of its exports.

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 1.4. MACROECONOMIC VARIABLES:

Economic reports and indicators are those often-voluminous statistics put out by government
agencies, non-profit organizations and even private companies. They provide measurements for
evaluating the health of our economy, the latest business cycles and how consumers are spending
and generally faring. Various economic indicators are released daily, weekly, monthly and/or
quarterly.

While it is important to keep a pulse on the economy, few analysts or economists wade through
all of these massive volumes of data.

Here's a primer on 10 of the most common and vital economic indicators. Even if you don't follow
these reports yourself, it is helpful to know where the "experts" are drawing their opinions from.
If you do peruse these reports, remember that data can change rapidly, and that broad trends are
not judged by one isolated economic data point.

i. National Income and GDP

ii. Unemployment
iii. Growth Rate
iv. Inflation
v. International Trade
vi. Balance of Payment
vii. Monetary & Fiscal Policy
viii. Interest Rate
ix. Stock Market
x. Business Cycle
xi. Exchange Rate

i. NATIONAL INCOME AND GDP:

GDP refers to the monetary value of all the finished goods and services produced within a country's
borders in a specific time period, though GDP is usually calculated on an annual basis.
It includes all of private and public consumption, government outlays, investments and exports
less imports that occur within a defined territory. The gross domestic product (GDP) is one the
primary indicators used to gauge the health of a country's economy.

National Income is the total 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. It gives correct picture of the economy and purchasing power
of people in the country.
As of 2021, India was estimated to reach a GDP (gross domestic product) per capita of just
over 11.9 thousand U.S. dollars, whereas the average national income per capita stood at
approximately 10.56 thousand U.S. dollars.

20
Please refer to the First Advance Estimates of National Income, 2021-22
(Posted On: 07 JAN 2022 5:30PM by PIB Delhi)
https://pib.gov.in/PressReleasePage.aspx?PRID=1788380

The Gross Domestic Product (GDP) in India was worth 2622.98 billion US dollars in 2020,
according to official data from the World Bank. The GDP value of India represents 2.32 percent
of the world economy

ii. UNEMPLOYMENT:
Unemployment Rate (UR) is the ratio of number of unemployed persons/person-days to the
number of persons/person-days in labour force. Three sets of estimates of unemployment rates are
obtained based on the estimates of unemployment obtained by the three different approaches used
for classification of the activity statuses of persons.

Unemployment represents that ratio of labor force which fails to get employment.

The unemployment rate is a key indicator of the economy’s health.

The existence of unemployment seems to imply that the aggregate labor market is not in
equilibrium.

Unemployment rate is the number of unemployed people as a percentage of the labour force, where
the latter consists of the unemployed plus those in paid or self-employment.

21
 Total No. of Unemployed Population
Unemployment Rate= --------------------------------------------------- * 100
Total Labour Force

unemployed, a person must want to work and be actively looking for a job (but have not
yet found one)

labor force consists of those who are employed and those who are unemployed

unemployment rate is equal to the number of unemployed people divided by the labor
force.

India's Unemployment Rate increased to 3.52 % in Dec 2017, from the previously reported number
of 3.51 % in Dec 2016. India's Unemployment Rate is updated yearly, available from Dec 1991 to
Dec 2017, with an average rate of 3.81 %. The data reached an all-time high of 4.43 % in Dec
2002 and a record low of 3.41 % in Dec 2014. The data is reported by reported by World Bank.

In the latest reports, India's Population reached 1,316.00 million people in Mar 2018. The country's
Labour Force Participation Rate dropped to 53.79 % in Dec 2017.

22
• Unemployment Rate in India decreased to 6.50 percent in January from 9.10 percent in
December of 2020. (source: Centre for Monitoring Indian Economy)
• In India, the unemployment rate is estimated by directly interviewing a large sample of
randomly selected households. Centre for Monitoring Indian Economy Consumer
Pyramids panel of households includes over 174,405 households including over 522,000
members who are over 15 years old.

23
 iii. Growth Rate:
The annualized GDP growth rate is a measure of the increase or decrease of the GDP from one
year to the next. Understanding this measurement is a way of knowing whether the general
economy for the country (or other chosen location) is getting better, worse or staying stable over
time. GDP figures are generally made available on a quarterly basis. To calculate the “annualized”
GDP growth rate specifically, use data for the full year, not just a selected quarter.

This figure is always called the “growth” rate and uses a single formula, regardless of whether the
GDP is increasing or decreasing. If the value of the GDP increases from one year to the next, the
formula will produce a positive result. If the result is negative, the value is dropping, and you can
say that there has been “negative growth” over the selected time period.

24
India's GDP grows at 8.2 per cent in 2018-19 Q1. As per RBI, India's economic growth is expected
to accelerate to 7.4 percent in the current fiscal year that began in April.

India’s real GDP in the ongoing financial year 2020-21 is seen contracting by 7.7 per cent from
a growth rate of 4.2 per cent in 2019-20, according to the first advance estimates of GDP released
by the Ministry of Statistics & Programme Implementation (MoSPI). The contraction in the
economy is mainly on account of the impact of the coronavirus (COVID-19) pandemic.

25
 iv. INFLATION:
A expansion in demand or the money supply (demand-pull inflation) or by autonomous increases
in costs (cost-push inflation)

Inflation is the rate at which the general level of prices for goods and services is rising and,
consequently, the purchasing power of currency is falling.

A sustained, rapid increase in prices, as measured by some broad index (such as Consumer Price
Index) over months or years, and mirrored in the correspondingly decreasing purchasing power of
the currency.

When prices rise for energy, food, commodities, and other goods and services, the
entire economy is affected. Rising prices, known as inflation, impact the cost of living, the cost of
doing business, borrowing money, mortgages, corporate and government bond yields, and every
other facet of the economy.

• Inflation is an increase in the overall price level.

• Hyperinflation is a period of very rapid increases in the overall price level. Hyperinflations
is a rare phenomenon.
• Deflation is a decrease in the overall price level. Prolonged periods of deflation can be just
as damaging for the economy as sustained inflation.

Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running
smoothly.
Inflation rates in India are usually quoted as changes in the Wholesale Price Index(WPI), for all
commodities. Many developing countries use changes in the consumer price index (CPI) as their
central measure of inflation.

26
The WPI, where prices are quoted from wholesalers, is constructed by Office of Economic Affairs,
Ministry of Commerce and Industries.

In the case of CPI (prices quoted from retailers), there are several indices to measure it: CPI for
industrial labours (CPI-IL), agricultural labourers (CPI-AL) and rural labours (CPI-RL) besides
an all India CPI.

Retail price inflation in India jumped to 5.03 percent in February of 2021 from 4.06 percent in
January, above market forecasts of 4.83 percent. It is the highest reading in 3 months. Food
inflation accelerated to 3.87 percent from 1.89 percent which was the lowest since May of 2019.
Cost of pulses jumped 12.54 percent while vegetables fell at a slower 6.24 percent. Cost of clothing
and footwear also accelerated (4.21 percent vs 3.82 percent) while prices eased for miscellaneous
(6.82 percent vs 6.49 percent); pan, tobacco and intoxicants (10.7 percent vs 10.87 percent);
housing (3.23 percent vs 3.25 percent); and fuel and light (3.53 percent vs 3.87 percent)

v. International trade:
International trade is the exchange of goods and services between countries. This type of trade
gives rise to a world economy, in which prices, or supply and demand , affect and are affected by
global events.

27
International trade allows to expand markets for both goods and services that otherwise may not
have been available to all. It is the reason why you can pick between a Japanese, German or
American car.

As a result of international trade, the market contains greater competition and therefore more
competitive prices, which brings a cheaper product home to the consumer.

India’s overall exports (Merchandise and Services combined) in April-February2020-21* are

estimated to be USD 439.64Billion, exhibiting a negative growth of (-) 10.14per cent over the
same period last year. Overall imports in April-February 2020-21* are estimated to be USD
447.44Billion, exhibiting a negative growth of (-) 20.83per cent over the same period last year.

vi. Balance Of Payments (BOP):

The balance of payments (BOP) of a country is the record of all economic transactions between
the residents of a country and the rest of the world in a particular period (over a quarter of a year
or more commonly over a year).
These transactions are made by individuals, firms and government bodies. Thus the balance of
payments includes all external visible and non-visible transactions of a country during a given
period, usually a year.
It represents a summation of country's current demand and supply of the claims on foreign
currencies and of foreign claims on its currency.

28
Components of Balance of Payments:
(1) Current Account;
(2) Capital Account
(1) Current Account: Current account refers to an account which records all the transactions
relating to export and import of goods and services and unilateral transfers during a given period
of time. Current account contains the receipts and payments relating to all the transactions of
visible items, invisible items and unilateral transfers.

Components of Current Account:

The main components of Current Account are:
1. Export and Import of Goods (Merchandise Transactions or Visible Trade)
2. Export and Import of Services (Invisible Trade)
3. Unilateral or Unrequited Transfers to and from abroad(One sided Transactions)
4. Income receipts and payments to and from abroad.

29
BoP during April-September 2020-21 (H1 of 2020-21)
• India recorded a current account surplus of 3.1 per cent of GDP in H1of 2020-21 as
against a deficit of 1.6 per cent in H1 of 2019-20 on the back of a sharp contraction in the
trade deficit.
• Net invisible receipts were lower in H1 of 2020-21, mainly due to decline in net private
transfer receipts.
• Net FDI inflows at US$ 23.8 billion in H1of 2020-21 were higher than US$ 21.3 billion
in H1of 2019-20.
• Portfolio investment recorded a net inflow of US$ 7.6 billion in H1of 2020-21, almost at
the same level as a year ago.
• In H1 of 2020-21, there was an accretion of US$ 51.4 billion to the foreign exchange
reserves (on a BoP basis).

vii. Monetary Policy :

Monetary policy is the process by which the monetary authority of a currency controls
the supply of money, often targeting an inflation rate or interest rate to ensure price stability and
general trust in the currency.
The RBI is the main body that controls the monetary policy in India. They control the flow of
money into the market through various instruments of monetary policy. This helps the RBI
control the inflation and liquidity in the economy.
Further goals of a monetary policy are usually to contribute to economic growth and stability, to
low unemployment, and to predictable exchange rates with other currencies.

30
 viii. Fiscal Policy:
Fiscal policy is the means by which a government adjusts its spending levels and tax rates to
monitor and influence a nation's economy.
It is the sister strategy to monetary policy through which a central bank influences a nation's
money supply. These two policies are used in various combinations to direct a country's
economic goals.

Objectives of Fiscal Policy are given below:

1. To maintain and achieve full employment.
2. To stabilize the price level.
3. To stabilize the growth rate of the economy.
4. To maintain equilibrium in the Balance of Payments.
5. To promote the economic development of underdeveloped countries.

ix. INTEREST RATE:

An interest rate is the rate at which interest is paid by borrowers (debtors) for the use of money
that they borrow from lenders (creditors). Specifically, the interest rate is
a percentage of principal paid a certain number of times per period for all periods during the total
term of the loan or credit.
Many different interest rates in the economy vary by duration and degree of risk.

x. Stock Market:
A stock market or equity market is the aggregation of buyers and sellers (a loose network of
economic transactions, not a physical facility or discrete entity) of stocks (also called shares);
these may include securities listed on a stock exchange as well as those only traded privately.
History has shown that the price of stocks and other assets is an important part of the dynamics
of economic activity, and can influence or be an indicator of social mood.

An economy where the stock market is on the rise is considered to be an up-and-coming

economy. In fact, the stock market is often considered the primary indicator of a country's
economic strength and development.

xi. BUSINESS CYCLE

The term business cycle (or economic cycle or boom–bust cycle) refers to fluctuations in
aggregate production, trade and activity over several months or years in a market economy.
The business cycle is the downward and upward movement of levels of gross domestic product
(GDP) and refers to the period of expansions and contractions in the level of economic activities
(business fluctuations) around its long-term growth trend.

These fluctuations occur around a long-term growth trend, and typically involve shifts over time
between periods of relatively rapid economic growth (an expansion or boom), and periods of
relative stagnation or decline (a contraction or recession).

31
 xii. Exchange Rate
The Exchange Rate between two currencies is the rate at which one currency will be exchanged
for another.
It is also regarded as the value of one country’s currency in terms of another currency. governs
the terms on which international trade and investment take place.

Nominal Exchange Rate is the rate at which money of different countries can be exchanged for
one another
Real Exchange Rate is the rate at which the goods and services produced in different countries
can be exchanged for one another

xiii. Per Capita Income:

Per capita income (PCI) or average incomemeasures the average income earned per personin
a given area (city, region, country, etc.) in a specified year.

It is calculated by dividing the area's total income by its total population. Per capita income,
also known as income per person, is the mean income of the people in an economic unit such as
a country or city. It is calculated by taking a measure of all sources of income in the aggregate
(such as GDP or Gross national income) and dividing it by the total population.

1.5.ECONOMIC DEVELOPMENT:
Economic development is the process by which emerging economies become advanced
economies. In other words, the process by which countries with low living standards become
32
nations with high living standards. During the development, there is a population shift from
agriculture to industry, and then to services.

A longer average life expectancy, for example, is one of the results of economic development.
Improved productivity, higher literacy rates, and better public education, are also consequences.

1.5.1. Economic growth Vs Economic development:

Economic growth
• Economic growth is all about expanding GDP, i.e., making the size of the economy
bigger. GDP stands for gross domestic product.
• GDP is the sum of all economic activity in a nation over a specific period. It is the net value
of all the products and services that an economy produces.

Economic development
• Development, on the other hand, looks at a much wider range of statistic than simply GDP
or GDP per capita. GDP per capita is GDP divided by the total population.
• Economic development looks at how the citizens of a country are affected. Apart from their
living standards, it also looks at the freedom they have to enjoy those living standards.

World Patterns in Economic Development Type of Region Examples:

1. Developed Economies:
e.g. Europe, North America, Japan, Australia.
2. Developing Economies:
e.g. South East Asian countries like China, India, South and Central America: Brazil,
Mexico North African countries: Egypt
3. Least Developed Economies:
e.g. Many African countries like Zambia, Somalia, Ethiopia and Some countries in Asia
like Bangladesh

33
 1.5.2. INDICATORS OF ECONOMIC DEVELOPMENT:
The extent to which a country has developed may be assessed by considering a range of narrow
and broad indicators, including per capita income, life expectancy, education, and the extent of
poverty.

1. The Human Development Index (HDI)

The HDI was introduced in 1990 as part of the United Nations Development Programme
(UNDP) to provide a means of measuring economic development in three broad areas - per capita
income, heath and education. The HDI tracks changes in the level of development of countries
over time.
Each year, the UNDP produces a development report, which provides an update of changes during
the year, along with a report on a special theme, such as global warming and development, and
migration and development.

The HDI is a composite statistic calculated from the:

• Life expectancy index

• Education index
• Mean years of schooling index
• Expected years of schooling index
• Income index

Countries are ranked based on their score and split into categories that suggest how well developed
they are.

THE MAIN FEATURES :

• A scale from 0 (no development) to 1 (complete development).

• An index, which is based on three equally weighted components:
• Longevity, measured by life expectancy at birth
• Knowledge, measured by adult literacy and number of years children are enrolled
at school
• Standard of living, measured by real GDP per capita at purchasing power parity
What the figures mean:
• An index of 0 – 0.49 means low development - for example, Nigeria was 0.42 in 2010.
• An index of 0.5 – 0.69 means medium development – for example, Indonesia was 0.6. 3.
• An index of 0.7 to 0.79 means high development – for example, Romania was 0.76. 4.
• Above 0.8 means very high development – Finland was 0.87 in 2010.

34
The HDI is a very useful means of comparing the level of development of countries. GDP per
capita alone is clearly too narrow an indicator of economic development and fails to indicate other
aspects of development, such as enrolment in school and longevity. Hence, the HDI is a broader
and more encompassing indicator of development than GDP, though GDP still provides one third
of the index.

Human Development Report published in 2010 was calculated combining three dimensions:

• 1) A long Life (Life Expectancy at birth)

• 2) Education Index (Mean year of schooling and Expected Year of Schooling)
• 3) A decent Standard of Living ( GNI Per Capita )

1) Life Expectancy Index (LEI) = LE-20

85-20
(LEI is 1 when Life Expectancy at Birth is 85 and 0 when Life Expectancy at Birth is 20)

2) Education Index (EI) = MYSI + EYSI

2
Where, 2.1) Mean Year of Schooling Index (MYSI) = MYS
15
(15 is the projected maximum of this indicator of 2025)
2.2) Expected Year of Schooling Index (EYSI)= EYS
18
(18 is equivalent to achieving a Master’s degree in most countries)

3) Income Index (II) = In (GNIPC )- In (100)

In (75000)-In (100)
(II is 1 when GNI per capita is $75000 and 0 when GNI per Capita is $100)

Finally, the HDI is the geometric mean of the previous three normalized indices:
HDI= 3√LEI * EI* II

Evaluation of the HDI

• Despite the widespread use of the HDI there are a number of criticisms that can be made,
including:

35
• The HDI index is for a single country, and as such does not distinguish between different
rates of development within a country, such as between urban and traditional rural
communities.
• Critics argue that the equal weighting between the three main components is rather
arbitrary.
• Development is largely about freedom, but the index does not directly measures this. For
example, access to the internet might be regarded by many as a freedom which improves
the quality of people's lives.
• As with the narrow measure of living standards, GDP per capita, there is no indication of
the distribution of income.
• In addition, the HDI excludes many aspects of economic and social life that could be
regarded as contributing to or constraining development, such as crime, corruption,
poverty, deprivation, and negative externalities.
• GDP is calculated in terms of purchasing power parity, and the value can change.
2. GNP per capita :
• GNP is the total market value of all final goods and services produced by a country in one
year. It is a measure of economic activity, or how much is produced in a country. The more
that a country produces per person , the more "developed" it is assumed to be.
• Which country produces more (has a higher GNP), India or Switzerland? Which is more
"developed"?
• The GNP of India is $336 billion and the GNP of Switzerland is $288 billion. India
produces more than does Switzerland, but everybody would agree that Switzerland is more
economically advanced. Why?
• The answer is population. the population of India is 988 million and the population of
Switzerland is 7 million. Therefore we must compare GNP PER CAPITA. To calculate
GNP per capita (or income per person) we divide the GNP by the population. The GNP per
capita of Switzerland is $40,630 and the GNP per capita of India is $ 340.
3. Population Growth :
• In general, poorer countries have more rapid rates of population growth. Compare the
following maps to verify that this general trend is true.
• Many countries experienced both rapid population growth and negative changes in real per
capita GDP. But still others had relatively rapid population growth, yet they had a rapid
increase in per capita GDP. Clearly, there is more to achieving gains in per capita income
than a simple slowing in population growth. But the challenge raised at the beginning of
this section remains: Can the world continue to feed a population that is growing
exponentially?

36
 • Larger population size is generally associated with lower labour productivity in
agriculture, i.e. the classic situation of diminishing returns. The evidence is drawn from
Bangladesh, northern India, Africa and pre-industrial Europe.
4. Occupational Structure of the Labor Force
• Economic geographers divide economic activities into primary activities, secondary
activities, and tertiary activities.
• PRIMARY ACTIVITIES are those that directly remove resources from the earth.
Generally they include AGRICULTURE, MINING, fishing, and lumbering.
• SECONDARY ACTIVITIES involve converting resources into finished products. These
are the MANUFACTURING activities.
• TERTIARY ACTIVITIES comprise the SERVICE sector of the economy. The tertiary
activities include retailing, transportation, education, banking, etc.
• As countries develop the occupational structure of the labor force changes. In LDCs most
people are engaged in primary activities. In high income countries like the United states
most people are involved with the tertiary sector.

5. Urbanization
Urbanization is the percentage of a country's population who live in urban areas. Urban areas
generally means in towns and cities of 2,500 or more people. Currently just less than half of the
worlds population live in urban areas. Generally as countries develop urbanization increases.
Note the high urbanization found in the more leveloped countries and in South America.
6. Consumption per capita
Consumption per person is a good indicator of development. The richer a country is, the more its
citizens consume. This map shows the energy consumption patterns for the world. Similar maps
could be made for "televisions per capita" or "cars per capita".
One consequence of consumption is pollution. Carbon dioxide (CO2) is emitted when fossil fuels
are used. Scientists are studying the connection between CO2 build up in the atmosphere ant global
warming. this chart shows CO2 emissions for various countries
7. Infrastructure:
A country's infrastructure is defined by our author as "the foundations of a society: urban centers,
transport networks, communications, energy distribution systems, farms, factories, mines, and
such facilities as schools, hospitals, postal services, and police and armed forces." (textbook page
G-7).

37
This map shows the state of development of the transportation system as a measure of its length
per area of land. The darker the color the more developed is the transportation system and hence,
a greater the degree of economic development is assumed.
8. Social Conditions:
There are many other measures of economic development. Many refer to the social conditions of
a country. Crude Birth and Death rates (per 1000) can be used as an overall measure of the state of
healthcare and education in a country, though these numbers do not give a full picture of a nation’s
situation. Here is a short list.

Infant mortality rate

Infant mortality rate is the number of infants dying before reaching one year of age per 1,000 live
births in a given year.

Literacy rate

The rate, or percentage, of people who are able to read is a useful indicator of the state of education
within a country.

High female literacy rates generally correspond with an increase in the knowledge of contraception
and a falling birth rate.

Life expectancy

This simple statistic can be used as an indicator of the:

❖ healthcare quality in a country or province

❖ level of sanitation
❖ provision of care for the elderly

9. Physical Quality of Life Index:

Physical Quality of Life Index is a common indicator of development. It is computed from life
expectancy at birth, infant mortality rate and literacy rate of a country. If people live longer and
are literate, PQLI value will be high.
It is measured in scale of 1 to 100. PQLI is a common indicator of development. It is computed
from life expectancy at birth, infant mortality rate and a literacy rate of a country. If people live
longer and are literate, PQLI value will be high. PQLI is measured on a scale of 1 to 100. If its
value crosses 50, the country is supposed to be advanced and if the value lies below 50 the nations
are supposed to be developing. PQLI as an index was developed by Morris D Morris, which
measures only personal facts.

38
 CLASS ACTIVITIES
• CLASS ASSIGNMENT 1: Discussion on Macroeconomic Indicators after studying
the ECONOMIC SURVEY OF INDIA (2021-22)

Statistical-Appendix-in-English.pdf (indiabudget.gov.in)

• CASE STUDY 1: Case Study: Exchange rates

Towards the end of 2009 the pound fell to a six month low of 1.0628 Euros. Figures released by
the UK government suggested that demand was still low in the country. The pound was also under
downward pressure because of the low value of the interest rate. A recent report suggested these
would remain at their historic low of 0.5% until 2014. Business confidence in general remained
frail and there was concern over when the UK economy would start to recover from its negative
growth. There was huge excess capacity in the UK. In addition the government had a huge deficit
which was expected to cause problems with cutbacks and tax increases in the future.

Questions :
1. Explain what determines the value of a currency.
2. Analyze why the pound might have fallen so low towards the end of 2009.
3. Analyze the possible effects on the UK economy of a fall in the value of the currency.

• CASE STUDY 2: Case Study: The growth of free trade in Asia

At the start of 2010 a new free trade area was established incorporating China and the six founding
members of the Association of South East Asian Nations (ASEAN). These countries are Brunei,
Indonesia, Malaysia, Philippines, Singapore, and Thailand. The aim is to eliminate 90% of
imported goods. This deal created the largest trade area in the world, with nearly 1.9bn people.
Although there are undoubted gains there have also been warnings from South East Asia that some
industries are not ready to compete with China and that jobs will be lost.

Questions:
1. What is a free trade area?
2. Outline the potential advantages and disadvantages of joining this area for the member countries.
3. What factors determine the extent to which industries within a country gain or lose?

39
 • CASE STUDY 3: Case Study: China targeting 8% growth in 2010

At the beginning of 2010 the Chinese government announced that it was targeting 8% growth for
the economy again, despite the global recession. The target had been 8% for a number of years
and the government had always met it. About 9% growth is expected in 2010 thanks to huge
government fiscal and monetary stimulus measures. The Chinese economy is the third largest in
the world. Forecasts for economic growth made by the International Monetary Fund for 2010
included China 9.2%, UK 0.9%, Japan 1.7%, US 1.5% and India 6.4%. However government
officials in China recognized that growth was not guaranteed. China relies heavily on exports and
so is vulnerable to economic change elsewhere in the world.

Questions:
1. Why is economic growth often important to governments?
2. 8% is relatively fast economic growth. Why does China set such as high target?
3. Why is China predicted to grow faster than many other economies?
4. What types of fiscal and monetary stimulus might have been used to help the economy grow?
5. Why does the reliance on exports make Chinese growth vulnerable to changes in other
economies?
6. Could the government make the economy less reliant on exports?

• CASE STUDY 4: Case Study: Greek economy

In 2010 the Greek government had to inform the European Commission on how it would control
its budget deficit and improve the performance of its economy. The government’s debt is so high
that agencies assessing the creditworthiness of the government downgraded it (which would mean
more interest has to be paid to raise finance). Proposals were likely to include a 10% cut in
government spending.

Questions:
1. Outline two possible economic objectives of the Greek government.
2. Explain why the government’s budget deficit might be in a large deficit.
3. What would the effect on aggregate demand be if the government cut public spending by 10%?
4. What actions can the government take to increase national income growth in Greece?
5. If the Greek economy is in recession what would you expect to be the effect on:
a) Inflation?
b) Unemployment?
c) Imports?

Explain your answers.

40
 • RESEARCH PAPER 1: FINANCE AND INEQUALITY: A STUDY OF INDIAN
STATES
Finance and inequality: a study of Indian states: Applied Economics: Vol 44, No 34
(tandfonline.com)

• RESEARCH PAPER 2: Indian Economy Amid COVID-19 Lockdown: A Prespective

https://pdfs.semanticscholar.org/f496/f1e11d2d35ba1c652e7fb3bd41d25ac5eda6.pdf

• RESEARCH PAPER 3: Human Development: Beyond the HDI

https://www.econstor.eu/bitstream/10419/98277/1/cdp916.pdf

41
 MODULE II

NATIONAL INCOME
ACCOUNTING

42
 National income accounting
National income accounting refers to the government bookkeeping system that measures the health
of an economy, projected growth, economic activity, and development during a certain period of
time. It helps in assessing the performance of an economy and the flow of money in an economy.

The national income equation represents the relationship between national income and the
economy’s expense, along with other attributes, as shown in the following equation:

Y=C+I+G+(X-M)
Where:
• Y – National income
• C – Personal consumption expenditure
• I – Private investment
• G – Government spending
• X – Exports
• M – Imports

1.5.3. Importance of National Income Accounting

• The statistics provided by national income accounting can be used to simplify the
procedures and techniques used to measure the aggregate input and output of an economy.
• The data provided is used to frame government economic policies, and it also helps in
recognizing the systemic changes happening in the economy.
• National income accounting provides information on the trend of economic activity level.
Various social and economic phenomena can be explained through the data, which helps
the policymakers in framing better economic policies.
• Central banks can use the national income accounting statistics to vary the rate of interest
and set or revise the monetary policy.
• The data on GDP, investments, and expenditures also helps the government to frame or
modify policies regarding infrastructure spending and tax rates.
• The national income accounting data also shows the contribution of different sectors,
relative to each other, towards economic growth.

1.5.4. CIRCULAR FLOW OF INCOME IN A FOUR SECTOR ECONOMY:

• The circular flow model in four sector economy provides a realistic picture of the circular
flow in an economy. Four sector model studies the circular flow in an open economy which
comprises of the household sector, business sector, government sector, and foreign sector.

43
 The four-sector economy is composed of following sectors, i.e.:
• (i) Household sector,
• (ii) Business sector,
• (iii) The government, and
• (iv) Transaction with ‘rest of the world’ or foreign sector or external sector.

HOUSEHOLDS:
Households spend their income on:
• (i) Payment for goods and services purchased from firms;
• (ii) Tax payments to government;
• (iii) Payments for imports.

FIRMS:
• Firms receive revenue from households, government and the foreign sector for sale of their
goods and services. Firms also receive subsidies from the government.
Firm makes payments for:
• (i) Factor services to households;
• (ii) Taxes to the government;
• (iii) Imports to the foreign sector.

GOVERNMENT:
• Government receives revenue from firms, households and the foreign sector for sale of
goods and services, taxes, fees, etc. Government makes factor payments to households and
also spends money on transfer payments and subsidies.

FOREIGN SECTOR:
• firms, households and government for export of goods and services. It makes payments
for import of goods and services from firms and the government. It also makes payment
for the factor services to the households.
• The foreign sector has an important role in the economy. When the domestic business firms
export goods and services to the foreign markets, injections are made into the circular flow
model.
• On the other hand, when the domestic households, firms or the government imports
something from the foreign sector, leakage occurs in the circular flow model.
• In four-sector economy, goods and services available for the economy’s purchase include
those that are produced domestically (Y) and those that are imported (M). Thus, goods and
services available for domestic purchase is Y+M. Expenditure for the entire economy
include domestic expenditure (C+I+G) and foreign made goods (Export) = X.

44
Thus:
Y = C + I + G + (X – M)
Where, C = Consumption expenditure
I = Investment spending
G = Government spending
X = Total Exports
M = Total Imports
X – M = Net Exports

The circular flow of income in four sector economy can be explained by the flowing diagram:

From the viewpoint of the circular flow of income, each sector has dual roles to play in the
economy; while a sector receives certain payments from other sectors, it pays back to those sectors
as well. The circular flow of income in different sectors can be expressed as follows:

HOUSEHOLD SECTOR:
• RECEIPTS: The household sector receives factor income in the form of rent, wages,
interest, and profit from the business sector. It also receives transfer payments from the
government sector.

45
 • PAYMENTS: The income of the household sector flows into the business sector,
government sector and capital markets in the form of consumption expenditure, taxes and
savings respectively.

BUSINESS SECTOR:

• RECEIPTS: The principal receipts of the business sector constitute of income from the
sale of goods and services, income from exports, subsidies from the government sector,
and borrowings from the capital market.
• PAYMENTS: Factor payments, import payments, and savings constitute the principal
payments from the business sector to the household sector, government sector, foreign
sector and the capital market.

GOVERNMENT SECTOR:

• RECEIPTS: The major source of income for the government sector include the taxes paid
by household and business sector. Besides this, it also receives interests and dividends for
the investments made.
• PAYMENTS: The government sectors make payments to different sectors in the form of
transfer payments, subsidies, grants, etc. It pays to the business sector in return for the
goods purchased, makes transfer payments like pension funds, scholarships, etc. to the
household sector. If the government receipts are greater than the expenses, the surplus goes
to capital market. In case of cash deficit, the government borrows from the capital market
to maintain a balance in the economy.

FOREIGN SECTOR:

• RECEIPTS: The foreign sector receives income from the business sector in return for the
goods and services imported by the latter.
• PAYMENTS: Foreign sectors need to make payment to the business sector from where
imports have been made.
• If exports exceed imports, the economy has a surplus balance of payment. In case exports
exceed imports, the economy faces a deficit balance of payment. Depending on the trade
policies, the economy tries to maintain a balance between imports and exports.

1.5.5. MEASUREMENT OF NATONAL INCOME:

46
Concepts of National Income:
There are a number of concepts pertaining to national income and methods of measurement
relating to them.

(A) Gross Domestic Product (GDP):

GDP is the total value of goods and services produced within the country during a year. This is

calculated at market prices and is known as GDP at market prices. Dernberg defines GDP at market
price as “the market value of the output of final goods and services produced in the domestic
territory of a country during an accounting year.”

There are three different ways to measure GDP:

1. Product Method,
2. Income Method and
3. Expenditure Method.

These three methods of calculating GDP yield the same result because National Product = National
Income = National Expenditure.

1. The Product Method:

Another method of measuring GNP is by value added. In calculating GNP, the money value of
final goods and services produced at current prices during a year is taken into account. This is

one of the ways to avoid double counting. But it is difficult to distinguish properly between a

final product and an intermediate product.

For instance, raw materials, semi-finished products, fuels and services, etc. are sold as inputs by
one industry to the other. They may be final goods for one industry and intermediate for others.

So, to avoid duplication, the value of intermediate products used in manufacturing final products
must be subtracted from the value of total output of each industry in the economy.

Thus, the difference between the value of material outputs and inputs at each stage of production

is called the value added. If all such differences are added up for all industries in the economy,

47
we arrive at the GNP by value added. GNP by value added = Gross value added + net income

from abroad. Its calculation is shown in Tables 1, 2 and 3.

Table 1 is constructed on the supposition that the entire economy for purposes of total production
consists of three sectors. They are agriculture, manufacturing, and others, consisting of the

tertiary sector.

Out of the value of total output of each sector is deducted the value of its intermediate purchases

(or primary inputs) to arrive at the value added for the entire economy. Thus the value of total

output of the entire economy as per Table 1, is Rs. 155 crores and the value of its primary inputs
comes to Rs. 80 crores. Thus the GDP by value added is Rs. 75 crores (Rs. 155 minus Rs. 80

crores).

The total value added equals the value of gross domestic product of the economy. Out of this
value added, the major portion goes in the form wages and salaries, rent, interest and profits, a

small portion goes to the government as indirect taxes and the remaining amount is meant for

depreciation. This is shown in Table 3.

48
Thus we find that the total gross value added of an economy equals the value of its gross

domestic product. If depreciation is deducted from the gross value added, we have net value
added which comes to Rs. 67 crores (Rs. 75 minus Rs. 8 crores).

This is nothing but net domestic product at market prices. Again, if indirect taxes (Rs. 7 crores)

are deducted from the net domestic product of Rs. 67 crores, we get Rs. 60 crores as the net
value added at factor cost which is equivalent to net domestic product at factor cost. This is
illustrated in Table 2.

Net value added at factor cost is equal to the net domestic product at factor cost, as given by the
total of items 1 to 4 of Table 2 (Rs. 45+3+4+8 crores=Rs. 60 crores). By adding indirect taxes
(Rs 7 crores) and depreciation (Rs 8 crores), we get gross value added or GDP which comes to

Rs 75 crores.

49
If we add net income received from abroad to the gross value added, this gives -us, gross

national income. Suppose net income from abroad is Rs. 5 crores. Then the gross national
income is Rs. 80 crores (Rs. 75 crores + Rs. 5 crores) as shown in Table 3.

2. The Income Method:

The people of a country who produce GDP during a year receive incomes from their work. Thus

GDP by income method is the sum of all factor incomes: Wages and Salaries (compensation of
employees) + Rent + Interest + Profit.

3. Expenditure Method:

This method focuses on goods and services produced within the country during one year.

GDP by expenditure method includes:

(1) Consumer expenditure on services and durable and non-durable goods (C),

50
(2) Investment in fixed capital such as residential and non-residential building, machinery, and

inventories (I),

(3) Government expenditure on final goods and services (G),

(4) Export of goods and services produced by the people of country (X),

(5) Less imports (M). That part of consumption, investment and government expenditure which is
spent on imports is subtracted from GDP. Similarly, any imported component, such as raw

materials, which is used in the manufacture of export goods, is also excluded.

Thus GDP by expenditure method at market prices = C+ I + G + (X – M), where (X-M) is net
export which can be positive or negative.

(B) GDP at Factor Cost:

GDP at factor cost is the sum of net value added by all producers within the country. Since the net

value added gets distributed as income to the owners of factors of production, GDP is the sum of

domestic factor incomes and fixed capital consumption (or depreciation).

Thus GDP at Factor Cost = Net value added + Depreciation.

GDP at factor cost includes:

(i) Compensation of employees i.e., wages, salaries, etc.

(ii) Operating surplus which is the business profit of both incorporated and unincorporated firms.

[Operating Surplus = Gross Value Added at Factor Cost—Compensation of Employees—

Depreciation]

(iii) Mixed Income of Self- employed.

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Conceptually, GDP at factor cost and GDP at market price must be identical/This is because the

factor cost (payments to factors) of producing goods must equal the final value of goods and
services at market prices. However, the market value of goods and services is different from the

earnings of the factors of production.

In GDP at market price are included indirect taxes and are excluded subsidies by the government.
Therefore, in order to arrive at GDP at factor cost, indirect taxes are subtracted and subsidies are
added to GDP at market price.

Thus, GDP at Factor Cost = GDP at Market Price – Indirect Taxes + Subsidies.

(C) Net Domestic Product (NDP):

NDP is the value of net output of the economy during the year. Some of the country’s capital

equipment wears out or becomes obsolete each year during the production process. The value of
this capital consumption is some percentage of gross investment which is deducted from GDP.

Thus Net Domestic Product = GDP at Factor Cost – Depreciation.

(D) Nominal and Real GDP:

When GDP is measured on the basis of current price, it is called GDP at current prices or nominal

GDP. On the other hand, when GDP is calculated on the basis of fixed prices in some year, it is

called GDP at constant prices or real GDP.

Nominal GDP is the value of goods and services produced in a year and measured in terms of
rupees (money) at current (market) prices. In comparing one year with another, we are faced with

the problem that the rupee is not a stable measure of purchasing power. GDP may rise a great deal
in a year, not because the economy has been growing rapidly but because of rise in prices (or

inflation).

52
On the contrary, GDP may increase as a result of fall in prices in a year but actually it may be less

as compared to the last year. In both 5 cases, GDP does not show the real state of the economy. To
rectify the underestimation and overestimation of GDP, we need a measure that adjusts for rising

and falling prices.

This can be done by measuring GDP at constant prices which is called real GDP. To find out the
real GDP, a base year is chosen when the general price level is normal, i.e., it is neither too high
nor too low. The prices are set to 100 (or 1) in the base year.

(F) Gross National Product (GNP):

GNP is the total measure of the flow of goods and services at market value resulting from current

production during a year in a country, including net income from abroad.

GNP includes four types of final goods and services:

(1) Consumers’ goods and services to satisfy the immediate wants of the people;

(2) Gross private domestic investment in capital goods consisting of fixed capital formation,
residential construction and inventories of finished and unfinished goods;

(3) Goods and services produced by the government; and

(4) Net exports of goods and services, i.e., the difference between value of exports and imports of
goods and services, known as net income from abroad.

In this concept of GNP, there are certain factors that have to be taken into consideration: First,
GNP is the measure of money, in which all kinds of goods and services produced in a country

during one year are measured in terms of money at current prices and then added together.

But in this manner, due to an increase or decrease in the prices, the GNP shows a rise or decline,

which may not be real. To guard against erring on this account, a particular year (say for instance

53
1990-91) when prices be normal, is taken as the base year and the GNP is adjusted in accordance

with the index number for that year. This will be known as GNP at 1990-91 prices or at constant
prices.

Second, in estimating GNP of the economy, the market price of only the final products should be

taken into account. Many of the products pass through a number of stages before they are
ultimately purchased by consumers.

If those products were counted at every stage, they would be included many a time in the national

product. Consequently, the GNP would increase too much. To avoid double counting, therefore,
only the final products and not the intermediary goods should be taken into account.

Third, goods and services rendered free of charge are not included in the GNP, because it is not

possible to have a correct estimate of their market price. For example, the bringing up of a child
by the mother, imparting instructions to his son by a teacher, recitals to his friends by a musician,

etc.

Fourth, the transactions which do not arise from the produce of current year or which do not

contribute in any way to production are not included in the GNP. The sale and purchase of old

goods, and of shares, bonds and assets of existing companies are not included in GNP because

these do not make any addition to the national product, and the goods are simply transferred.

Fifth, the payments received under social security, e.g., unemployment insurance allowance, old

age pension, and interest on public loans are also not included in GNP, because the recipients do
not provide any service in lieu of them. But the depreciation of machines, plants and other capital

goods is not deducted from GNP.

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Sixth, the profits earned or losses incurred on account of changes in capital assets as a result of

fluctuations in market prices are not included in the GNP if they are not responsible for current
production or economic activity.

For example, if the price of a house or a piece of land increases due to inflation, the profit earned

by selling it will not be a part of GNP. But if, during the current year, a portion of a house is
constructed a new, the increase in the value of the house (after subtracting the cost of the newly
constructed portion) will be included in the GNP. Similarly, variations in the value of assets, that

can be ascertained beforehand and are insured against flood or fire, are not included in the GNP.

Last, the income earned through illegal activities is not included in the GNP. Although the goods

sold in the black market are priced and fulfill the needs of the people, but as they are not useful

from the social point of view, the income received from their sale and purchase is always excluded
from the GNP.

There are two main reasons for this. One, it is not known whether these things were produced

during the current year or the preceding years. Two, many of these goods are foreign made and

smuggled and hence not included in the GNP.

Three Approaches to GNP:

After having studied the fundamental constituents of GNP, it is essential to know how it is
estimated. Three approaches are employed for this purpose. One, the income method to GNP; two,

the expenditure method to GNP and three, the value added method to GNP. Since gross income

equals gross expenditure, GNP estimated by all these methods would be the same with appropriate
adjustments.

1. Income Method to GNP:

The income method to GNP consists of the remuneration paid in terms of money to the factors of

production annually in a country.

55
Thus GNP is the sum total of the following items:

(i) Wages and salaries:

Under this head are included all forms of wages and salaries earned through productive activities

by workers and entrepreneurs. It includes all sums received or deposited during a year by way of
all types of contributions like overtime, commission, provident fund, insurance, etc.

(ii) Rents:
Total rent includes the rents of land, shop, house, factory, etc. and the estimated rents of all such

assets as are used by the owners themselves.

(iii) Interest:

Under interest comes the income by way of interest received by the individual of a country from

different sources. To this is added, the estimated interest on that private capital which is invested
and not borrowed by the businessman in his personal business. But the interest received on

governmental loans has to be excluded, because it is a mere transfer of national income.

(iv) Dividends:

Dividends earned by the shareholders from companies are included in the GNP.

(v) Undistributed corporate profits:

Profits which are not distributed by companies and are retained by them are included in the GNP.

(vi) Mixed incomes:

These include profits of unincorporated business, self-employed persons and partnerships. They
form part of GNP.

(vii) Direct taxes:

Taxes levied on individuals, corporations and other businesses are included in the GNP.

56
(viii) Indirect taxes:

The government levies a number of indirect taxes, like excise duties and sales tax.

These taxes are included in the price of commodities. But revenue from these goes to the
government treasury and not to the factors of production. Therefore, the income due to such taxes

is added to the GNP.

(ix) Depreciation:

Every corporation makes allowance for expenditure on wearing out and depreciation of machines,

plants and other capital equipment. Since this sum also is not a part of the income received by the
factors of production, it is, therefore, also included in the GNP.

(x) Net income earned from abroad:

This is the difference between the value of exports of goods and services and the value of imports
of goods and services. If this difference is positive, it is added to the GNP and if it is negative, it

is deducted from the GNP.

Thus GNP according to the Income Method = Wages and Salaries + Rents + Interest +

Dividends + Undistributed Corporate Profits + Mixed Income + Direct Taxes + Indirect

Taxes + Depreciation + Net Income from abroad.

2. Expenditure Method to GNP:

From the expenditure view point, GNP is the sum total of expenditure incurred on goods and

services during one year in a country.

It includes the following items:

(i) Private consumption expenditure:

It includes all types of expenditure on personal consumption by the individuals of a country. It

comprises expenses on durable goods like watch, bicycle, radio, etc., expenditure on single-used

57
consumers’ goods like milk, bread, ghee, clothes, etc., as also the expenditure incurred on services

of all kinds like fees for school, doctor, lawyer and transport. All these are taken as final goods.

(ii) Gross domestic private investment:

Under this comes the expenditure incurred by private enterprise on new investment and on

replacement of old capital. It includes expenditure on house construction, factory- buildings, and
all types of machinery, plants and capital equipment.

In particular, the increase or decrease in inventory is added to or subtracted from it. The inventory

includes produced but unsold manufactured and semi-manufactured goods during the year and the
stocks of raw materials, which have to be accounted for in GNP. It does not take into account the

financial exchange of shares and stocks because their sale and purchase is not real investment. But

depreciation is added.

(iii) Net foreign investment:

It means the difference between exports and imports or export surplus. Every country exports to

or imports from certain foreign countries. The imported goods are not produced within the country

and hence cannot be included in national income, but the exported goods are manufactured within

the country. Therefore, the difference of value between exports (X) and imports (M), whether

positive or negative, is included in the GNP.

(iv) Government expenditure on goods and services:

The expenditure incurred by the government on goods and services is a part of the GNP. Central,

state or local governments spend a lot on their employees, police and army. To run the offices, the
governments have also to spend on contingencies which include paper, pen, pencil and various
types of stationery, cloth, furniture, cars, etc.

58
It also includes the expenditure on government enterprises. But expenditure on transfer payments

is not added, because these payments are not made in exchange for goods and services produced
during the current year.

Thus GNP according to the Expenditure Method=Private Consumption Expenditure (C) + Gross

Domestic Private Investment (I) + Net Foreign Investment (X-M) + Government Expenditure on
Goods and Services (G) = C+ I + (X-M) + G.

As already pointed out above, GNP estimated by either the income or the expenditure method

would work out to be the same, if all the items are correctly calculated.

3. Value Added Method to GNP:

Another method of measuring GNP is by value added. In calculating GNP, the money value of

final goods and services produced at current prices during a year is taken into account. This is one
of the ways to avoid double counting. But it is difficult to distinguish properly between a final

product and an intermediate product.

For instance, raw materials, semi-finished products, fuels and services, etc. are sold as inputs by

one industry to the other. They may be final goods for one industry and intermediate for others.

So, to avoid duplication, the value of intermediate products used in manufacturing final products

must be subtracted from the value of total output of each industry in the economy.

Thus, the difference between the value of material outputs and inputs at each stage of production

is called the value added. If all such differences are added up for all industries in the economy, we
arrive at the GNP by value added. GNP by value added = Gross value added + net income from

abroad.

59
(G) GNP at Market Prices:
When we multiply the total output produced in one year by their market prices prevalent during

that year in a country, we get the Gross National Product at market prices. Thus, GNP at market
prices means the gross value of final goods and services produced annually in a country plus net
income from abroad. It includes the gross value of output of all items from (1) to (4) mentioned

under GNP. GNP at Market Prices = GDP at Market Prices + Net Income from Abroad.

(H) GNP at Factor Cost:

GNP at factor cost is the sum of the money value of the income produced by and accruing to the

various factors of production in one year in a country. It includes all items mentioned above under
income method to GNP less indirect taxes.

GNP at market prices always includes indirect taxes levied by the government on goods which

raise their prices. But GNP at factor cost is the income which the factors of production receive in

return for their services alone. It is the cost of production.

Thus GNP at market prices is always higher than GNP at factor cost. Therefore, in order to arrive
at GNP at factor cost, we deduct indirect taxes from GNP at market prices. Again, it often happens
that the cost of production of a commodity to the producer is higher than a price of a similar
commodity in the market.

In order to protect such producers, the government helps them by granting monetary help in the
form of a subsidy equal to the difference between the market price and the cost of production of

the commodity. As a result, the price of the commodity to the producer is reduced and equals the
market price of similar commodity.

For example if the market price of rice is Rs. 3 per kg but it costs the producers in certain areas

Rs. 3.50. The government gives a subsidy of 50 paisa per kg to them in order to meet their cost of

60
production. Thus in order to arrive at GNP at factor cost, subsidies are added to GNP at market

prices.

GNP at Factor Cost = GNP at Market Prices – Indirect Taxes + Subsidies.

(I) Net National Product (NNP):

NNP includes the value of total output of consumption goods and investment goods. But the
process of production uses up a certain amount of fixed capital. Some fixed equipment wears out,
its other components are damaged or destroyed, and still others are rendered obsolete through

technological changes.

All this process is termed depreciation or capital consumption allowance. In order to arrive at NNP,

we deduct depreciation from GNP. The word ‘net’ refers to the exclusion of that part of total output

which represents depreciation. So NNP = GNP—Depreciation.

(J) NNP at Market Prices:

Net National Product at market prices is the net value of final goods and services evaluated at

market prices in the course of one year in a country. If we deduct depreciation from GNP at market
prices, we get NNP at market prices.

So NNP at Market Prices = GNP at Market Prices—Depreciation.

(K) NNP at Factor Cost:

Net National Product at factor cost is the net output evaluated at factor prices. It includes income

earned by factors of production through participation in the production process such as wages and
salaries, rents, profits, etc. It is also called National Income. This measure differs from NNP at
market prices in that indirect taxes are deducted and subsidies are added to NNP at market prices

in order to arrive at NNP at factor cost. Thus

NNP at Factor Cost = NNP at Market Prices – Indirect taxes+ Subsidies

61
= GNP at Market Prices – Depreciation – Indirect taxes + Subsidies.

= National Income.

Normally, NNP at market prices is higher than NNP at factor cost because indirect taxes exceed
government subsidies. However, NNP at market prices can be less than NNP at factor cost when

government subsidies exceed indirect taxes.

(L) Domestic Income:

Income generated (or earned) by factors of production within the country from its own resources
is called domestic income or domestic product.

Domestic income includes:

(i) Wages and salaries, (ii) rents, including imputed house rents, (iii) interest, (iv) dividends, (v)
undistributed corporate profits, including surpluses of public undertakings, (vi) mixed incomes

consisting of profits of unincorporated firms, self- employed persons, partnerships, etc., and (vii)

direct taxes.

Since domestic income does not include income earned from abroad, it can also be shown as:

Domestic Income = National Income-Net income earned from abroad. Thus the difference between

domestic income f and national income is the net income earned from abroad. If we add net income
from abroad to domestic income, we get national income, i.e., National Income = Domestic Income

+ Net income earned from abroad.

But the net national income earned from abroad may be positive or negative. If exports exceed
import, net income earned from abroad is positive. In this case, national income is greater than
domestic income. On the other hand, when imports exceed exports, net income earned from abroad

is negative and domestic income is greater than national income.

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(M) Private Income:
Private income is income obtained by private individuals from any source, productive or otherwise,

and the retained income of corporations. It can be arrived at from NNP at Factor Cost by making
certain additions and deductions.

The additions include transfer payments such as pensions, unemployment allowances, sickness
and other social security benefits, gifts and remittances from abroad, windfall gains from lotteries

or from horse racing, and interest on public debt. The deductions include income from government

departments as well as surpluses from public undertakings, and employees’ contribution to social

security schemes like provident funds, life insurance, etc.

Thus Private Income = National Income (or NNP at Factor Cost) + Transfer Payments + Interest

on Public Debt — Social Security — Profits and Surpluses of Public Undertakings.

(N) Personal Income:

Personal income is the total income received by the individuals of a country from all sources before

payment of direct taxes in one year. Personal income is never equal to the national income, because
the former includes the transfer payments whereas they are not included in national income.

Personal income is derived from national income by deducting undistributed corporate profits,

profit taxes, and employees’ contributions to social security schemes. These three components are
excluded from national income because they do reach individuals.

But business and government transfer payments, and transfer payments from abroad in the form

of gifts and remittances, windfall gains, and interest on public debt which are a source of income
for individuals are added to national income. Thus Personal Income = National Income –

Undistributed Corporate Profits – Profit Taxes – Social Security Contribution + Transfer Payments

+ Interest on Public Debt.

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Personal income differs from private income in that it is less than the latter because it excludes

undistributed corporate profits.

Thus Personal Income = Private Income – Undistributed Corporate Profits – Profit Taxes.

(O) Disposable Income:

Disposable income or personal disposable income means the actual income which can be spent on
consumption by individuals and families. The whole of the personal income cannot be spent on
consumption, because it is the income that accrues before direct taxes have actually been paid.

Therefore, in order to obtain disposable income, direct taxes are deducted from personal income.
Thus Disposable Income=Personal Income – Direct Taxes.

But the whole of disposable income is not spent on consumption and a part of it is saved. Therefore,

disposable income is divided into consumption expenditure and savings. Thus Disposable Income
= Consumption Expenditure + Savings.

If disposable income is to be deduced from national income, we deduct indirect taxes plus
subsidies, direct taxes on personal and on business, social security payments, undistributed

corporate profits or business savings from it and add transfer payments and net income from abroad
to it.

Thus Disposable Income = National Income – Business Savings – Indirect Taxes + Subsidies –

Direct Taxes on Persons – Direct Taxes on Business – Social Security Payments + Transfer

Payments + Net Income from abroad.

(P) Real Income:

Real income is national income expressed in terms of a general level of prices of a particular year

taken as base. National income is the value of goods and services produced as expressed in terms

of money at current prices. But it does not indicate the real state of the economy.

64
It is possible that the net national product of goods and services this year might have been less than

that of the last year, but owing to an increase in prices, NNP might be higher this year. On the
contrary, it is also possible that NNP might have increased but the price level might have fallen,

as a result national income would appear to be less than that of the last year. In both the situations,
the national income does not depict the real state of the country. To rectify such a mistake, the

concept of real income has been evolved.

In order to find out the real income of a country, a particular year is taken as the base year when

the general price level is neither too high nor too low and the price level for that year is assumed
to be 100. Now the general level of prices of the given year for which the national income (real)

is to be determined is assessed in accordance with the prices of the base year. For this purpose the
following formula is employed.

Real NNP = NNP for the Current Year x Base Year Index (=100) / Current Year Index

Suppose 1990-91 is the base year and the national income for 1999-2000 is Rs. 20,000 crores and

the index number for this year is 250. Hence, Real National Income for 1999-2000 will be = 20000

x 100/250 = Rs. 8000 crores. This is also known as national income at constant prices.

(Q) Per Capita Income:

The average income of the people of a country in a particular year is called Per Capita Income for
that year. This concept also refers to the measurement of income at current prices and at constant
prices. For instance, in order to find out the per capita income for 2001, at current prices, the

national income of a country is divided by the population of the country in that year.

• We can find the per capita income of a country if we know the NNP and total population.
• e.g. (NNP/ total Population) = per capita income

65
CASE STUDY 5: China's development could be advanced considerably if the government
and the people abandoned their unhealthy fixation on the rise of gross domestic product.

A recent edition of The South China Morning Post carried a feature expressing the point in a
particularly enlightening fashion.

What's so great about rapid economic growth anyway?

For the princely sum of 14,500 yuan (HK$16,800), the magazine's Beijing correspondent joined
30 or so mainlanders for a gruelling 10day, five-country coach tour of Europe.

Watching cultures collide - even at second hand - is always illuminating. No doubt the speed at
which the tourists swept past the architectural and artistic glories of Paris, pausing only to snap
the obligatory photographic record of their presence before heading off for an orgy of handbag
shopping, would have raised some supercilious French eyebrows.

But equally, for their part the visitors were taken aback by the leisurely pace of life in Europe,
where the locals linger over coffee, prohibit bus drivers from working more than 12 hours a day,
and even stop their cars for pedestrians.

"With a pace like that, how can their economies keep growing?" the Chinese guide asks. "Only
when you have diligent, hardworking people will the nation's economy grow."

It's a theme that recurred constantly as the group tore around Europe, with the visitors marvelling
at the willingness of French workers to go on strike, and at how many years the Italians take to
build a new highway. "If this were China, it would be done in six months," one says. "That's the
only way to keep the economy growing."

What's remarkable here is not that the Chinese tourists found Europe slow-moving - Americans
have been saying the same for decades - but that their automatic assumption that fast growth is
the best, indeed the only, measure of a country's economic success.

This begs the question: what's so great about rapid growth anyway?

That might sound like a dumb thing to ask, but the more you think about it, the more the question
makes sense.

The growth our tourists were talking about was in gross domestic product (GDP), which
measures the final value of all goods and services produced by an economy.

66
GDP was developed in the US during the Great Depression, and came into its own during the
second world-war as a measure of how many guns, ships and planes the US economy was able to
produce. It has been the standard measure of economic strength ever since.

But GDP measures quantity, not quality. In other words, although it says a great deal about how
much stuff you can churn out, it tells you very little about the state of your economic
development.

For example, GDP counts all investment as positive, whether or not that investment turns out to
be productive in the longer run.

So if a country pours resources into building pyramids, its GDP will rise sharply while they are
under construction. But considering that pyramids, once complete, add nothing to the economy
(except maybe generating tourist revenues four millennia later), it is difficult to claim that their
construction furthers economic progress.

This consideration is especially important for China. Although the country's leaders aren't
building pyramids, they may be doing the modern equivalent: building hundreds of expensive
airports, high-speed rail lines and glittering financial centres that can never hope to generate a
return on the investment involved. These projects add to GDP growth in the short term but do
nothing to advance economic development.

Similarly, GDP fails to account for the costs of environmental damage. All production is
regarded as positive, even if the pollution it causes reduces the productive capacity of the
agricultural sector and pushes up health care costs.

Again, this is important for China. A few years ago, the State Environmental Protection
Administration did try to factor pollution costs into the country's GDP figures. But when it found
that including environmental costs would have reduced growth by at least a third, the attempt
was quickly discontinued. That shouldn't have been too surprising given that maintaining high
headline GDP growth has become an obsession with China's leaders, who tout rapid growth as
the justification for their authoritarian rule.

And as our travellers' comments show, their message resonates strongly with China's people, or
at least those rich enough to take package tours round Europe.

But unfortunately the GDP measure by which both China's government and its travelling classes
set such store is a deeply flawed measure of true economic progress.

67
As Simon Kuznets, the US economist who originally developed the idea of gross domestic
product, warned: "Distinctions must be kept in mind between quantity and quality of growth,
between its costs and return, and between the short and the long run. Goals for more growth
should specify more growth of what, and for what."

It's a message China and its leaders would do well to heed.

That's not to say China should immediately embrace a European lifestyle - heaven forbid - but it
does mean that the country's economic development could be advanced considerably if only its
government and people were to abandon their unhealthy fixation on the rapid growth of GDP.

1. Summarize the arguments for slowing down the rapid growth of GDP?
2. To what extent do you agree with these arguments?
3. Explain the counter arguments in favour of increasing the level of a country's GDP.

RESEARCH PAPER
Decomposing the Macroeconomic Effects of Natural Disasters: A National Income
Accounting Perspective
https://www.sciencedirect.com/science/article/pii/S0921800916315300

68
 Module III:
THEORY
OF
INCOME AND EMPLOYMENT

69
3.1. CLASSICAL POSTULATES
(Assumptions of Classical Economist on Income and Employment)
The classical macroeconomic structure is built upon the writings of famous classical economists
like Adam Smith, David Ricardo, J.B. Say, T.R. Malthus, A.C. Pigou, Irving Fisher to mention the
greatest few. Their scattered writings, when put together, produce a systematic and coherent
macroeconomic framework. To understand this framework, one needs to bear in mind the basic
postulates/ assumptions that classical economists built around their macroeconomic conclusions.
These are, broadly, as under.

1.1.1. Full Employment :

Classical economists believed that there will always be full employment (or, near full employment)
in the economy – full employment not only of labour but also of other major resources such as
land, capital and other factors of production. In case of labour, for instance, they held the view that
all labour will normally find employment in a free enterprise capitalist economy with ‘flexible
labour market’ (explained below). However, such full employment does not mean that temporary
unemployment (i.e., unemployment for a temporarily short period) will not exist. But
unemployment of relatively longer period or what Keynes later termed ‘involuntary
unemployment’ is totally ruled out by the classicals. For instance, temporary unemployment may
occur due to maladjustment between demand and supply of resources in a capitalist economy or
frictions in the economy – workers changing jobs, locations, etc. – or change in the structure of
the economy such as old industries shutting down and new ones coming up or unemployment that
occurs during business cycles (recessions or depression). Full employment will, then, occur only
in the long run. So, long run perspective is implicit in all these postulates. The classicals generally
ignore short run problems however serious they may be. In the long run, total demand for labour
will always be equal to total supply of labour and total output (of goods and services) will be at its
full potential level.

1.1.2. Wage-Price Flexibility:

Classical economists postulated that in the capitalist system, wages as also prices (including
interest rates) are flexible and not rigid. This means that these rates are capable of moving upward
and downward under normal pressures of demand and supply in their respective markets. In other

70
words, the demand and supply curves are fairly responsive to prices and wages – or, to say the
same thing, demand and supply curves are price-elastic (as also wage-elastic). In the case of wage
rate flexibility, it is argued that, this is always in the interest of both the employers and workers.
Employers gain from wage rate reduction because this reduces their wage cost and hence increases
their profit margin. They will, therefore, be tempted to employ more workers and thereby increase
output. Workers will gain in terms of increased employment of labour force (though not in terms
of wage rate or wage per worker). Wage rate rise, similarly, works in opposite direction. On the
other hand, workers will respond by increasing their supply when wage rate is higher and decrease
their supply when wage rate is lower. These outcomes are, in fact, based on explanations, at the
micro level from both employer’s and worker’s normal decision behaviour. The implication is that
in case of any deviations from equilibrium occurring anywhere in the economic system, wage price
flexibility will ensure that such deviations will soon disappear and the economy will eventually
return to the equilibrium position.

1.1.3. Absence of Money:

Illusion According to this postulate, there is complete absence of money illusion in the economy.
All groups of people in the economy – the workers, employers, savers, investors, etc., are
completely free from money illusion. For instance, if workers are influenced by the money value
(or, nominal value) of their wage rate and not by their real value (or real wage rate), we say workers
are guided by the money illusion. If, instead, workers are only guided by real wage rate, they are
said to be free from money illusion. Accordingly, if workers are willing to supply more working
hours/days at higher real wages and not high money wages, we say there is no money illusion in
the labour market. Similarly, if savers are guided by the real rate of interest (money rate of interest
minus the rate of inflation) they are said to be not suffering from any money illusion. Also, another
related assumption is that money is neutral – it does not affect any other price like interest rate.
Needless to say that this particular assumption of the classicals also holds a key position and frees
them from many complications which the laterday economists notably Keynes and his followers
incorporated in their analytical framework

71
 Classical Theory of Income and Employment:

Old classical economists like Adam Smith, Ricardo, J. B. Say, J. S. Mill, and N. Senior believe in
laissez faire policy (no government intervention in any economic activities) developed the
classical theory of employment. This theory states that full employment is a normal feature of a
capitalist economy. The classical theory of employment rules out the possibility of unemployment
in a free market economy. The economy would always be in a full employment equilibrium.
The classical theory of employment is based on the following assumptions:
• The Say’s law of market;
• Flexibility (‫ )مرونة‬of the interest rates;
• Flexibility of the wage rates.

According to Say’s Law of Market, “The supply creates its own demand”. It is an automatic
mechanism which establishes equilibrium between aggregate demand and aggregate supply.
The implication of the classical system is that there will never be a possibility of over- production
or under- production in the economy.

During the Great Depression of 1930s, the Classical Theory of Employment failed miserably.
Prof. J. M. Keynes developed a new theory of employment in his book “General Theory of
Employment, Interest and Money” published in 1936.

72
Keynesian theory of employment is based on the concept of effective demand. Keynes states that
demand creates its own supply.

Effective demand means the level of income where aggregate demand and aggregate supply are
equal.

Prof. J. M. Keynes used the approach of aggregate demand and aggregate supply for the
determination of full employment equilibrium.

1.2. SAY’S LAW OF DEMAND (Supply creates its own Demand)

Say’s law of market is the core of the classical theory of employment. There cannot be general
overproduction and the problem of redundancy in the economy. Conversely, if there is general
overproduction in the economy and then some labourers may be asked to leave their jobs there
may be the problem of unemployment in the economy sometime.

In the long run the economy will automatically tend toward full employment. In Say’s words, “It
is production which creates market for goods. A product is no sooner created then it, from that
instant, affords a market for other products to the full extent of its own value. Nothing is more
favourable to the demand of one product, than the supply of another.”

In an exchange economy whatever is produced represents the demand for another product because
whatever is produced is easily sold.

Whenever additional production takes place in the economy, necessary purchasing power is also
generated at the same time to absorb the additional supply; hence, there is no scope of supply
exceeding demand and causing unemployment. This law was the basis of their assumption of full
employment in the economy which rested on the plea that income is spent automatically at a rate
which will always keep the resources fully employed.

Savings, according to classical economist are just another form of spending; all income, they
believed, is partly spent on consumption and partly on investment. There is no ground to fear a
break in the flow of income stream in the economy. Hence there cannot be any general over-
production or unemployment.

The classical economists always assumed a state of employment in the economy. The normal
situation in an economy, according to them was full employment equilibrium. Less than full
employment, they believed, was an abnormal situation. Classical always held that there are no
lapses from full employment equilibrium and even if there are any, there is always a tendency to

73
return to full employment. This belief of the classical economists was based on the views of a
French economist, J.B. Say (1767-1832).

In his analysis of the market mechanism, J.B. Say noted down: “…a product is no sooner created,
than it from that instant, affords a market for other products to the full extent of its value. When
the producer has put the finishing hand to his product, he is most anxious to sell it immediately,
lest the value should vanish in his hands. Nor is he less anxious to dispose of the money he may
get for it; for the value of money is also perishable. But the only way of getting rid of money is the
purchase of some product or other. Thus, the mere circumstance of the creation of one product
immediately opens a vent for other products.”

Briefly stated, it means that “supply creates its own demand”. He asserted that there cannot be
any general over-production or general unemployment in the economy as whatever is produced is
automatically consumed. In other words, every producer who brings goods lo the market does so
only to exchange them for other goods.

Say believed that people did not work for its own sake but to obtain other goods and services that
go to satisfy their wants. To be employed simply meant to work in a field or to start a shop and to
sell one’s own product in the market. The organisation of the economy was simple under which
people spent on tools and consumer goods. Saving and investment were not separate processes.

1.2.1. The significant facts of this definition are as follows:

1. Production Creates Market Demand for Goods

When producers obtain the various inputs to be used in the production process they generate the
necessary income. For instance, producers give wages to labourers for producing goods. The
labourers will purchase the goods from the market for their own use. This in turn causes the
demand for goods produced. In this way, supply creates its own demand.

2. Barter System as its Basis

In its original form, the law is applicable to a barter economy where goods are ultimately sold for
goods. Therefore, whatever is produced is ultimately consumed in the economy. In the other
words, people produce goods for their own use to sustain their consumption levels. Say’s law, in
a very broad way, is as Prof. Hansen has said “a description of a free exchange economy. So
conceived it illuminates the truth that the main source of demand is the flow of factor income
generated from the process of production itself. Thus the existence of money does not alter the
basic low.

74
 3. General Over Production Impossible

If the production process is continued under normal conditions, then there will be no difficulty for
the producers to sell their products in the market. According to Say, work being unpleasant no
person will work to make a product unless he wants to exchange it for some other product which
he desires. Therefore, the very act of supplying goods implies a demand for them. In such a
condition there cannot be general over production for the reason supply of goods will not exceed
demand as a whole. But a particular good may be over produced for the reason that producer the
producer incorrectly estimates the quantity of the product which others want. But this is a
temporary phenomenon, for the excess production of a particular product can be corrected in time
by reducing its producing.

4. Saving Investment Equality

Income accruing to the factor owners in the form of rent, wages and interest is not spent on
consumption but some proportion out it is saved which is automatically invested for further
production. Therefore, investment in production is a saving which helps to create demand for
goods in the market. Further, saving – investment equality is maintained to avoid general over
production.

1.3. Aggregate Demand :

The total demand for goods and services in an economy in a year’s time is called aggregate
demand. It is expressed in terms of total expenditure of the community.
Goods and services are demanded for two purposes- (1) Consumption, and (2) Investment.
Consumption is of two types: private (household) consumption and public (government)
consumption. Similarly, investment is also of two types: private (household) investment and public
(government) investment.

Aggregate Demand (AD) = Consumption Demand (C) + Investment Demand (I)

AD = C + I
Y=C+I
1.3.1. Aggregate Demand Schedule:

The aggregate demand schedule can be drawn by aggregating- aggregate consumption (C) and
aggregate investment (I) at different levels of income.

Consumption depends on income (Y), propensity to consume (c) and many other factors.

C = a + cY

75
Relationship between Income and Consumption:

(SR ‘000 Crores)

Income & Consumption
Income Consumption
0 20 60

10 25 40
20 30
30 35 20
40 40
0
50 45
0 10 20 30 40 50 60
60 50

Aggregate Investment:
It is of two types- autonomous investment and induced investment.

Autonomous Investment: It is that expenditure on capital formation which is undertaken

independently of the level of income.

Induced Investment: It is expenditure both on fixed assets and on the stocks that are required if
the economy is to be able to produce a bigger output as aggregate demand rises.
Here, we assume that only investment expenditure that is incurred in the economy is in the form
of autonomous investment.
(SR ‘000 Crores)
Income & Autonomous Investment
Income Investment
25
0 20
10 20 20
20 20 15
30 20 10
40 20 5
50 20 0
60 20 0 10 20 30 40 50 60

Aggregate demand schedule can be derived by adding consumption schedule and investment
schedule.

76
 Income Consum Invest Aggregate Consumption (C)
(Y) ption ment Demand Investment (I)
(C) (I) (AD = C + I) Aggregate Demand (AD = C + I)
80
0 20 20 40
10 25 20 45 60
20 30 20 50 40
30 35 20 55
20
40 40 20 60
50 45 20 65 0
60 50 20 70 0 10 20 30 40 50 60

3.3.2. Components of Aggregate Demand:

There are four major components of aggregate demand-

1. Household consumption expenditure (C);
2. Government final consumption expenditure (G);
3. Private and public investment expenditure (I); and
4. Net export (X-M)

Symbolically,
AD = C + I + G + (X-M)

1.4. Aggregate Supply:

It refers to the money value of all goods and services produced in a country in a year’s time. It, in
fact, refers to the national income of a country because it is the money value of all goods and
services produced in a year’s time.
Aggregate Supply = Domestic Product = Total Factor Incomes = National Income
Aggregate Supply (AS) = Consumption (C) + Saving (S)
Y=C+S

1.4.1. Aggregate Supply Schedule:

Aggregate supply schedule can be formed by aggregating consumption expenditure and savings at
different levels of income.

77
 Income Consum Saving Aggregate Aggregate Supply (AS = C + S)
(Y) ption (C) s (S) Supply (AS
= C + S) 80
0 20 -20 0
60
10 25 -15 10
20 30 -10 20 40
30 35 -5 30
40 40 0 40 20
50 45 5 50
0
60 50 10 60
0 10 20 30 40 50 60 70
70 55 15 70

Determination of Equilibrium:
Determination equilibrium of an economy can be studied by two approaches:
1. As equality of aggregate demand and aggregate supply; and
2. As equality of saving and investment.

AS and AD Approach:
Equilibrium level of income is determined where aggregate demand curve cuts aggregate supply.
In other words, the level of income will be in equilibrium where aggregate demand is equal to
aggregate supply

Example:

(SR ’000 Million)

Aggregate Demand (AD= C+I)
Income Aggregate Aggregate
(Y) Demand Supply Aggregate Supply (AS= C+S)
(AD= C+I) (AS= C+S) 120
0 40 0
10 45 10 100
20 50 20 80
30 55 30
40 60 40 60
50 65 50
40
60 70 60
70 75 70 20
80 80 80
90 85 90 0
100 90 100 0 10 20 30 40 50 60 70 80 90 100

If Aggregate Demand is not equal to Aggregate Supply:

Aggregate Demand (AD) Aggregate Supply (AS)
=

78
 If AD > AS If AD < AS
↓ ↓
Increase in employment of factor services Decrease in employment of factor services
↓
Increase in the level of output of goods and Decrease in the level of output of goods and
services services
↓ ↓
Ultimately AD = AS Ultimately AD = AS

Alternative Approach to Equilibrium (Saving and Investment Approach):

Since, AD is:
Y = C + I, ……………………………………… (1)

And,

AS is:
Y = C + S, ………………………………………(2)

By putting together equations (1) and (2), we get

C+I=C+S
Hence,
I=S

i.e., aggregate investment equals aggregate saving in the economy.

Diagrammatic Presentation:

79
 Income Consum Saving Investment
Saving (S) Investment (I)
(Y) ption (S) (I)
(C) 40
0 20 -20 20 30
10 25 -15 20
20 30 -10 20 20
30 35 -5 20 10
40 40 0 20
50 45 5 20 0
0 10 20 30 40 50 60 70 80 90 100
60 50 10 20 -10
70 55 15 20
-20
80 60 20 20
90 65 25 20 -30
100 70 30 20

Equilibrium level of employment (or income) is determined by the intersection of the aggregate
demand and aggregate supply schedule.

The classical economists held the view that this equilibrium level of employment would be full
employment level. There will be no involuntary unemployment either of labour or of capital. If
there were to be any unemployment resources, wage rates and interest rates would move.
Movement in the wage rates and interest rates would serve to bring full employment in the
economy.

Prof. J. M. Keynes did not agree with this view of the classical economists. He gave three types of
equilibrium situations:
1. Equilibrium at full employment level;
2. Equilibrium at less than full employment level;
3. Equilibrium at more than full employment level;

Equilibrium at full employment level: this will obtain when the equality of AD and AS occurs at
a level where at the available resources are gainfully employed.

Equilibrium at less than full employment level (Deflationary gap): this will occur when the
aggregate demand is not sufficient to absorb all those who seek employment. Clearly, there will
be involuntary unemployment in the economy. This would have been caused by deficient demand.

Equilibrium at more than full employment level (Inflationary gap): this will occur when the
available resources in the economy are not sufficient to meet the aggregate demand for goods and
services. Clearly, this situation is caused by excess demand in the economy.

80
Causes of Excess Demand (Inflationary gap) and Deficient Demand (Deflationary gap):
Causes
Of Excess Demand Of Deficient Demand
• Government expenditure > • Government expenditure <
Government revenue Government revenue
• Increase in autonomous investment • Cut in autonomous investment
• Surplus on balance of payments • Deficits in balance of payments
• Increase in capital formation • Cut in capital formation

Effects of Excess Demand:

In case of excess demand, the planned aggregate expenditure is more than the planned aggregate
output. All the available resources are already fully employed. Therefore, there is no chance to
increase the level of employment further.
Likewise, since no additional resources are available, it will not be possible either to increase the
level of output.
But, in case, there is already full employment in the economy large aggregate expenditure in the
economy would result in a rise in the general price level. Thus, excess demand has a general
inflationary potential and that is why excess demand is known as inflationary gap.

Effects of Deficient Demand:

In case of deficient demand, the planned aggregate expenditure is less than the planned aggregate
output. In this case, there will be tendency to curtail the employment.
Since the aggregate output cannot be absorbed by the aggregate expenditure, the surplus
availability of output will result in a fall in the general price level. Thus, deficient demand has a
general deflationary potential and that is why it is also known as deflationary gap.

81
Measures to Correct Deficient Demand:
1. Fiscal policy:
• Reduction in tax rates; and
• Increase in government expenditure.
2. Monetary policy:
• Reduction in bank rate;
• Reduction in reserve ratios; and
• Purchase of government securities.
3. Export promotion:

Measures to Correct Excess Demand:

1. Fiscal policy:
• Rise in tax rates; and
• Decrease in government expenditure.
2. Monetary policy:
• Rise in bank rate;
• Increase in reserve ratios; and
• Sale of government securities.
3. Import promotion:

3.4. KEYNESIAN THEORY OF INCOME AND EMPLOYMENT:

Keynes criticised the Classical theory stating that the assumptions on which the theory is based
are wrong and impractical. For example, (i) In real world situation, an economy often does not
function at the level of full employment; rather it generally functions at less than full employment
level, (ii) Supply cannot create its equivalent demand on its own and, therefore, there is every
possibility of general over-production and unemployment, (iii) Similarly, prices, wages and
interest rates may not be flexible due to presence of monopolies and trade unions. The Great
Depression of 1929-33 fully shattered the Classical myth of full employment. It was at such a
crucial time that Keynes developed his alternative theory of income and employment as detailed
in the following pages.

Keynesian Theory:
With this background, Keynes, a British Economist, propounded his own theory and in 1936,
brought out his famous book “General Theory of Income, Interest and Money” which brought
about a revolution in economic thought. This led to the emergence of Macroeconomics as a
separate branch of economics.

82
(i) An economy can be in equilibrium even at less than full employment level:

Economic system does not ensure automatic equality between ‘aggregate demand’ and ‘aggregate
supply at full employment’ as believed by Classical. He proved that an economy could be in
equilibrium even at less than full employment level. This is the basic difference between Classical
Theory and Keynesian Theory.

(ii) Demand creates its own supply:

Aggregate demand for goods and services directly determines the level of output, income and
employment. If AD increases, level of output will go up by increasing emplo3mient of resources
to meet increased demand and as a result income will also go up. Thus, demand creates its own
supply.

(iii) Equilibrium level of income and employment is determined by aggregate demand

and aggregate supply:
But this does not mean level of full employment. The equilibrium level of income maybe at below
or above the level of full employment .In reality, an economy operates very often at less than full
employment equilibrium. Since in the short run, aggregate supply does not change, it, therefore,
changes in aggregate demand which brings about changes in income and employment.

This is the gist of Keynesian approach. The core issue of macroeconomics is the determination of
level of income, employment and output. According to this theory, in an economy income and
employment are in equilibrium at that level at which Aggregate Demand = Aggregate Supply.

Mind, Keynesian theory is supposed to apply under short run and perfect competition. Thus, in
Keynesian framework, this determination depends mainly on the level of aggregate demand
because during short run aggregate supply is constant with respect to given price. Let us, therefore,
first of all clearly understand the concepts of aggregate demand and aggregate supply.

3. Theory & Determination of Income and Employment

(Classical and Keynesian Theory)

Points to be remembered:
• Employment : A situation when a person is able and willing to take up a job and gets
employed.
• Full Employment: A situation where all those workers who are able and willing to work
get employment.

83
• Under Employment: A situation when people are engaged in jobs but they do not get
these jobs according to their capabilities, efficiency and qualifications.
• Unemployment : A situation when a person is willing to work but does not get opportunity
to work.
• Involuntary Unemployment: A situation when the workers are willing to work under any
conditions and at any wage rate but they fail to get employment.
• Voluntary Unemployment: When the economy offers employment opportunities to the
workers, but they themselves are not willing to take up jobs because the employment
conditions such as wage rate, location, promotional avenues, physical environment,
attitude of the employer, etc., do not suit them.
• Cyclical Unemployment: It is caused by slackness in business conditions. During
depression, investment activities get discouraged. Contraction in business activities renders
large numbers of workers unemployed.
• Technological Unemployment: It is generally found in the advanced countries. The main
cause of this unemployment is the introduction of the new technology.
• Frictional Unemployment: It is a temporary unemployment which exists during the
period of the transfer of labor from one occupation to another.
• Structural Unemployment: It is the result of the backwardness and underdevelopment of
an economy.
• Disguised Unemployment : When more workers are engaged in a work than actually
required to work, it is called disguised unemployment.
• Equilibrium level of employment : level of employment where aggregate demand equals
aggregate supply.
• Full employment level : the level of employment where all the available supply of labour
is gainfully employed.
• Excess demand: when aggregate demand exceeds aggregate supply at full employment
level.
• Deficient demand: when aggregate demand falls short of aggregate supply at full
employment level.
• Inflationary gap : it occurs as an excess of anticipated expenditure over available output
at full employment level.
84
• Deflationary gap: it occurs as an excess of available aggregate output over anticipated
aggregate expenditure.
• Ex- ante saving : Ex- ante saving is what the savers plan (or intend) to save at different
levels of income in an economy. It is also known as intended saving or planned saving.
• Ex- post saving : It refers to actual or realized saving in an economy during a year.
• Ex- ante Investment : Ex- ante investment is what the investors plan (or intend) to invest
at different levels of income in an economy. It is also known as intended investment or
planned investment.
• Ex- post investment : It refers to actual or realized investment in an economy during a
year.

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 3.5. PROPERTIES OR TECHNICAL ATTRIBUTES OF THE CONSUMPTION
FUNCTION
The consumption function has two technical attributes or properties:

(A) THE AVERAGE PROPENSITY TO CONSUME,

(B) THE MARGINAL PROPENSITY TO CONSUME

3.5.1. THE AVERAGE PROPENSITY TO CONSUME(APC):

"The average propensity to consume may be defined as the ratio of consumption expenditure to
any particular level of income." It is found by dividing consumption expenditure by income, or
APC=C/Y. The APC at various Income levels is shown in column 3 of below Table 1.1
The APC declines as the income increases because the proportion of income spent on consumption
decreases. But reverse is the case with APS (average propensity to save) which increases with
increase in income .

Thus, APS=1− APC

Diagrammatically, the average propensity to consume is anyone point on the C curve. In Figure
8.2 panel (A), point R measures the APC of the C curve which is OC'/OY'. The flattening of the C
curve to the right shows declining APC.

3.5.2. THE MARGINAL PROPENSITY TO CONSUME (MPC):

"The marginal propensity to consume may be defined as the ratio of the change in consumption to
the change in income or as the rate of change in the average propensity to consume as income
changes." It can be found by dividing change in consumption by a change in income, or

MPC= ∆C/∆Y. The MPC is constant at all levels of income as shown in column 5 of Table II. It
is 0.83 or 83 per cent because the ratio of change in consumption to change in income is
∆C /∆Y=50/60. Just like APC, The marginal propensity to save can be derived from the MPC_by
the formula 1 − MPC. It is 0.17 in the illustration

Diagrammatically/, the marginal propensity to consume is measured by the gradient or slope of

the C curve. This is shown in figure 8.2 panel (B) by NQ/RQ where NQ is change in consumption
(∆C) and RQ is change in income (∆Y), or C' C”/ Y' Y".

SIGNIFICANCE OF MPC:

The MPC is the rate of change in, the APC. When income increases, the MPC falls but more than
the APC. Conversely, when income falls, the MPC and APC rises but at a slower rate than the
income. The concept of MPC is of an important concern in Keynes analysis which pertains to the
short-run only while the APC is useful in the long-run analysis. The Post Keynesian economists

86
have come to the conclusion that, over the long-run APC and MPC are equal and approximate 0.9.
MPC is given more importance in the Keynesian analysis. Its value is assumed to be positive and
less than unity which means that when income increases the whole of it is not spent on
consumption proportion and never becomes zero i.e. 0 C/ Y 1which is of great analytical
significance. It not only explains that the consumption is an increasing function of income and but
also that it increases by less than the increment of income.

3.5.3. KEYNES'S PSYCHOLOGICAL LAW OF CONSUMPTION:

Keynes propounded the fundamental Psychological Law of consumption: Statement of Law: ”The
fundamental psychological law upon which we are entitled to depend with great confidence both
a prior from our knowledge of human nature and from the detailed facts of experience, is that men
are disposed as a rule and on "the average to increase their consumption as their income increases
but not by as much as the increase in their income." The law implies that there is a tendency on
the part of the people to spend on consumption less than the full increment of income.”

Propositions of the Law:

This law has three related propositions:
1) When income increases, consumption expenditure also increases but by a smaller amount.
2) The 'increased income will be divided in some proportion between consumption expenditure
and saving.
3) Increase in income always leads to an increase in both consumption and saving, it is unlikely to
lead either to fall in consumption or saving than before.
Further, Keynes put forward a psychological law of consumption, according to which, as income
increases consumption increases but not by as much as the increase in income.

In other words, marginal propensity to consume is less than one.

1 > ∆C/∆Y > 0

The Keynes’ consumption function can be expressed in the following form:

C = a + bYd
where C is consumption expenditure and Yd is the real disposable income which equals gross
national income minus taxes, a and b are constants, where a is the intercept term, that is, the amount
of consumption expenditure at zero level of income. Thus, a is autonomous consumption. The
parameter b is the marginal propensity to consume (MPC) which measures the increase in
consumption spending in response to per unit increase in disposable income.

Thus, MPC = ∆C/∆Y

87
It is evident from Fig. 9.1 and 9.3 the behaviour of consumption expenditure as perceived by
Keynes implies that marginal propensity to consume (MPC) which is measured by the slope of
consumption function curve CC at a point is less than average propensity to consume (APC) which
is measured by the slope of the line joining a point on the consumption function curve CC to the
origin (that is, MPC < APC).

This is because as income rises consumption does not increase proportionately and as income falls
consumption does not fall proportionately as people seek to protect their earlier consumption
standards. This can be seen from Fig. 9.3 the slope of consumption function curve CC’ measuring
MPC and the slopes of lines OA and OB which give the APC(i. e C/Y ) at points A and B
respectively are falling whereas slope of the linear consumption function CC’ remains constant.

88
In Fig. 9.3 we have shown a linear consumption function with an intercept term. In this form of
linear consumption function, though marginal propensity to consume (AC/AF) is constant, average
propensity to consume (C/F) is declining with the increase in income as indicated by the slopes of
the lines OA and OB at levels of income F, and F2 respectively.
The straight line OB drawn from the origin indicating average propensity to consume at higher
income level F2 has a relatively less slope than the straight line OA drawn from the origin to point/t
at lower income level Fr The decline in average propensity to consume as the income increases
implies that the proportion of income that is saved increases with the increase in national income
of the country.
This result also follows from the studies of family budgets of various families at different income
levels. The fraction of income spent on consumption by the rich families is lower than that of the
poor families. In other words, the rich families save a higher proportion of their income as
compared to the poor families.

The assumption of diminishing average propensity to consume is a significant part of Keynesian

theory of income and employment. This implies that as income increases, a progressively larger
proportion of national income would be saved. Therefore, to achieve and maintain equilibrium at
full-employment level of income, increasing proportion of national income is needed to be
invested.

If sufficient investment opportunities are not available, the economy would then run into trouble
and in that case it would not be possible to maintain full-employment because aggregate demand
will fall short of full-employment output.

89
On the basis of this increasing proportion of saving with the increase in income and, consequently,
the emergence of the problem of demand deficiency, some Keynesian economists based the theory
of secular stagnation on the declining propensity to consume.

3.6. INVESTMENT MULTIPLIER

Keynes concept of investment multiplier shows relationship between investment and income.
According to him an initial increase in investment creates larger increase in final aggregate income.
This multiplier effect works through increase in consumption expenditure. Investment multiplier
is thus a ratio of an increment in final income to an initial increment in investment.

∆Y
K=

∆I

where K = Coefficient of multiplier

Keynes believed that an initial increment in investment increases the final income by many times.
Multiplier expresses the relationship between an initial increment in investment and the resulting
increase in aggregate income.

∆ I = Increase in initial investment

∆ Y = Increase in national income

By rearranging, it can be written as ∆ Y = K ∆ I

Thus, when there is an increment of investment, income will increase by an amount which is K
times the increment of investment. The value of multiplier coefficient is determined by the
marginal propensity to consume (MPC). Thus,

K=

1 - MPC

90
If as a result of the investment of Rs. 100 crores, the national income increases by Rs. 300 crores,
multiplier is equal to 3. If as a result of investment of Rs. 100 crores, total national income
increases by Rs. 400 crores, multiplier is 4. The multiplier is, therefore, the ratio of increment in
income to the increment in investment. If ∆I stands for increment in investment and ∆Y stands for
the resultant increase in income, then multiplier is equal to the ratio of increment in income (∆K)
to the increment in investment (∆I).

Therefore k = ∆Y/∆I where k stands for multiplier.

If ∆Y stands for increase in income, ∆l stands for increase in investment and MPC for
marginal propensity to consume, we can write the equation (i) above as follows:

6.1.3.Multiplier and MPC:

There exists a direct relationship between MPC and the value of multiplier. Higher the MPC, more

will be the value of multiplier, arid vice-versa. The concept of multiplier is based on the fact that
one person’s expenditure is another person’s income.

When investment is increased, it also increases the income of the people. People spend a part of
this increased income on consumption. However, the amount of increased income spent on
consumption depends on the value of MPC.

The algebraic relation between Multiplier and MPC can be derived in the following manner:
We know, at equilibrium, income (Y) is the sum total of consumption (C) and investment (I).

Y=C+I

Similarly, any change in income (∆Y) will also be equal to (∆C + ∆I).

91
∆Y = ∆C + ∆I

Dividing both sides by ∆Y, we get

Working of Multiplier:
The working of multiplier is based on the fact that ‘One person’s expenditure is another person’s
income’. When an additional investment is made, then income increases many times more than
the increase in investment. Let us understand this with the help of an example:

Suppose, an additional investment of Rs 100 crores (AI) is made to construct a flyover. This extra
investment will generate an extra income of Rs100 crores in the first round. But this is not the end

of the story

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If MPC is assumed to be 0.90, then recipients of this additional income will spend 90% of Rs 100

crores, i.e. Rs 90 crores as consumption expenditure and the remaining amount will be saved. It
will increase the income by Rs 90 crores in the second round.

In the next round, 90% of the additional income of Rs 90 crores, i.e. Rs 81 crores will be spent on

consumption and the remaining amount will be saved.

This multiplier process will go on and the consumption expenditure in every round will be 0.90

times of the additional income received from the previous round. The multiplier process is shown

in Table below:

Thus, an initial investment of Rs 100 crores leads to a total increase of Rs 1,000 crores in the
income. As a result, Multiplier (K) = ∆Y/∆I= 1,000/100 = 10

3.6.2. Diagrammatic Presentation of Multiplier:

The multiplier can also be shown graphically using the AD and AS approach. In Fig. 8.7, income

is taken on the X-axis and aggregate demand on the Y-axis. Suppose, the initial equilibrium is
determined at point E where AD curve intersects the AS curve. The equilibrium level of income

93
is OY. Now, suppose that the investment increases by ∆I / so that the new aggregate demand curve

(AD1) intersects the aggregate supply curve (AS) at point ‘F’.

Thus, the new equilibrium level of income is OY1. The income rises from OY to OY1, in response

to an initial increase in investment (∆I ). It is clear from the figure that the increase in income
(YY1 or ∆Y) is greater than increase in investment (∆I ). The value of multiplier is given by

K=∆Y/∆I

3.6.3. Algebraic Derivation of Multiplier:

The multiplier can be derived algebraically as follows:
Writing the equation for the equilibrium level of income we have

Y = C + I … (1)

As in the multiplier analysis we are concerned with changes in income induced by changes in
investment, rewriting the equation (1) in terms of changes in the variables we have

∆Y = ∆C + ∆I … (2)

94
In the simple Keynesian model of income determination, change in investment is considered to be
autonomous or independent of changes in income while changes in consumption are function of
changes in income.

In the consumption function,

C = a + bY

where a is a constant term, b is marginal propensity to consume which is also assumed to remain
constant. Therefore, change in consumption can occur only if there is change in income. Thus

This is the same formula of multiplier as obtained earlier. Note that the value of multiplier ∆Y/∆I
will remain constant as long as marginal propensity to consume remains the same.

3.7. Multiplier (investment, Government expenditure, lump sum tax, foreign trade:

Keynes’ investment multiplier is simple and static in which income depends upon consumption
and investment. It is called a two sector model. After Keynes, in order to make the multiplier more
practical, economists included a number of variables to construct many multipliers which are
called complex multipliers.

These are dynamic multiplier, government expenditure multiplier, tax multipliers, balanced

budget multiplier and foreign trade multiplier.

95
Keynes’ two sector model depends upon consumption and investment. By including government

expenditure and taxes, it becomes a three sector model. When exports and imports are included
in it, it becomes a four sector model. These sector models are discussed in the article on Income

Determination in a Closed and Open Economy.

The present article explains government expenditure multiplier, tax multipliers and Foreign

Trade multiplier.

CLASS ACTIVITIES

• CLASS ASSIGNMENT 1: The size of multiplier depends upon the marginal

propensity to consume of the community. The multiplier is the reciprocal of one minus
marginal propensity to consume. However, we can express multiplier in a simpler form.
As we know that saving is equal to income minus consumption, one minus marginal
propensity to consume will be equal to marginal propensity to save, that is, 1- MPC =
MPS. Therefore, multiplier is equal to 1/ 1- MPC =1/MPC.

Q.1. The size of multiplier depends on

(A) MPC
(B) MEC
(C) APC
(D) APS

Q.2. Formula for Multiplier =

(A) 1/1-MPC
(B) MPS/5
(C) 1-MPC
(D) MPS-1

Q.3. Savings is equal to :

(A) S= Y-C
(B) Y=C-S
(C) C= Y+ S
(D) 1& 2 both

Q.4. Marginal Propensity to Save is equal to:

(A) 1-MPC
(B) MPC

96
(C) APC
(D) APS

Q.5. in Keynes Theory aggregate supply curve is

(A) Rising Upwards
(B) Horizontal
(C) Vertical
(D) falling Downward

• CASE STUDY 1: Test of Keynesian Consumption Function: A Case Study of University

of the Punjab

(PDF) Test of Keynesian Consumption Function: A Case Study of University of the

Punjab | Sir Bilal and Management and Administrative Sciences Review ISSN: 2308-
1368 - Academia.edu

• RESEARCH PAPER 1: Aggregate Demand, Aggregate Supply and Economic Growth

https://www.researchgate.net/profile/Amitava-
Dutt/publication/24082599_Aggregate_Demand_Aggregate_Supply_and_Economic_Growth/link
s/0c96053b4720d6c488000000/Aggregate-Demand-Aggregate-Supply-and-Economic-
Growth.pdf

• RESEARCH PAPER 2: Money and Credit in a Keynesian Model of Income

Determination
https://www.econstor.eu/bitstream/10419/186916/1/wp242.pdf

97
 Module IV:

Money
• Functions of money,
• Quantity theory of money,
• Determination of money supply and demand,
• Quantity Theory of Money
• Business cycle & Inflation & Deflation:
• Business cycle-nature,
• Features/Characteristics- Prosperity/Boom – Recession, Depression, Revival/Recovery
• Inflation: Meaning ,
• Demand and supply side factors,
• Causes & control,
• Deflation: Meaning , causes & control,
• Phillips curve, Stagflation,
• Inflationary gap

98
 4.1. FUNCTIONS OF MONEY

Money is any good that is widely accepted in exchange of goods and services, as well as payment
of debts. Most people will confuse the definition of money with other things, like income, wealth,
and credit. Three functions of money are:

1. Medium of exchange: Money can be used for buying and selling goods and services. If there
were no money, goods would have to be exchanged through the process of barter (goods would be
traded for other goods in transactions arranged on the basis of mutual need). For example: If I raise
chickens and want to buy cows, I would have to find a person who is willing to sell his cows for
my chickens. Such arrangements are often difficult. But Money eliminates the need of the double
coincidence of wants.

2. Unit of account: Money is the common standard for measuring relative worth of goods and
service.

3. Store of value: Money is the most liquid asset (Liquidity measures how easily assets can be
spent to buy goods and services). Money’s value can be retained over time. It is a convenient way
to store wealth.

PRIMARY AND SECONDARY FUNCTIONS OF MONEY!

1. Primary Functions (Main or Basic Functions)

2. Secondary Functions (Subsidiary or Derivative Functions)

1. Primary Functions:

Primary Functions include the most important functions of money, which it must perform in every

country.

These are:

(i) Medium of Exchange:

Money, as a medium of exchange, means that it can be used to make payments for all transactions
of goods and services. It is the most essential function of money. Money has the quality of general
acceptability So, all exchanges take place in terms of money.

99
1. This function has removed the major difficulty of lack of double coincidence of wants and
inconveniences associated with the barter system.

2. Use of money allows purchase and sale to be conducted independently of one another.

3. This function of money facilitates trade and helps in conducting transactions in an economy.

4. Money has no power to satisfy human wants, but it commands power to purchase those things,
which have utility to satisfy human wants.

For, “How does money separate the acts of sale and purchase”, refer HOTS.

(ii) Measure of Value (Unit of Value):

Money as measure of value means that money works as a common denomination, in which values
of all goods and services are expressed.

1. By reducing the value of all goods and services to a single unit (i.e. price), it becomes very easy
to find out the exchange ratios between them and comparing their prices.

2. This function facilitates maintenance of business accounts, which would be otherwise

impossible.

3. Money helps in calculating relative prices of goods and services. Due to this reason, it is
regarded as a Unit of Account’. For instance, ‘Rupee’ is the unit of account in India, ‘Pound’ in
England and so on.

2. Secondary Functions:

These refer to those functions of money which are supplementary to the primary functions. These
functions are derived from primary functions and, therefore, they are also known as ‘Derivative
Functions’.

The major secondary functions are:

(i) Standard of Deferred Payments:
Money as a standard of deferred payments means that money acts as a ‘standard’ for payments,
which are to be made in future. Every day, millions of transactions take place in which payments
are not made immediately. Money encourages such transactions and helps in capital formation and
economic development of the economy.

4.2. DETERMINANTS OF THE SUPPLY OF MONEY

Main determinants of the supply of money are (a) monetary base and (b) the money multiplier.
These two broad determinants of money supply are, in turn, influenced by a number of other
factors. Various factors influencing the money supply are discussed below:

100
1. Monetary Base:

Magnitude of the monetary base (B) is the significant determinant of the size of money supply.
Money supply varies directly in relation to the changes in the monetary base.

Monetary base refers to the supply of funds available for use either as cash or reserves of the
central bank. Monetary base changes due to the policy of the government and is also influenced
by the value of money.

2. Money Multiplier:

Money multiplier (m) has positive influence upon the money supply. An increase in the size of m
will increase the money supply and vice versa.

3. Reserve Ratio:

Reserve ratio (r) is also an important determinant of money supply. The smaller cash-reserve ratio
enables greater expansion in the credit by the banks and thus increases the money supply and vice
versa.

Reserve ratio is often broken down into its two component parts; (a) excess reserve ratio which is
the ratio of excess reserves to the total deposits of the bank (re = ER/D); (b) required reserve ratio
which is the ratio of required reserves to the total deposits of the bank (rr = RR/D). Thus r = re +
rr. The rr ratio is legally fixed by the central bank and the re ratio depends on the market rate of
interest.

4. Currency Ratio:

Currency ratio (c) is a behavioral ratio representing the ratio of currency demand to the demand
deposits. The effect of the currency ratio on the money multiplier (m) cannot be clearly recognized
because enters both as a numerator and a denominator in the money multiplier expression (1 +
c/r(1 +t) + c). But, as long as the r ratio is less than unity, a rise in the c ratio must reduce the
multiplier.

5. Confidence in Bank Money:

General economic conditions affect the confidence of the public in bank money and, thereby,
influence the currency ratio (c) and the reserve ratio (r). During recession, confidence in bank
money is low and, as a result, c and r ratios rise. Conversely, during prosperity, c and r ratios tend
to be low when confidence in banks is high.

6. Time-Deposit Ratio:

Time-deposit ratio (t), which represents the ratio of time deposits to the demand deposits is a
behavioral parameter having negative effect on the money multiplier (m) and thus on the money
supply. A rise in t reduces m and thereby the supply of money decreases.

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7. Value of Money:

The value of money (1/P) in terms of other goods and services has positive influence on the
monetary base (B) and hence on the money stock.

8. Real Income:

Real income (Y) has a positive influence on the money multiplier and hence on the money supply.
A r se in real income will tend to increase the money multiplier and thus the money supply and
vice versa.

9. Interest Rate:

Interest rate has a positive effect on the money multiplier and hence on the money supply. A rise
in the interest rate will reduce the reserve ratio (r), which raises the money multiplier (m) and
hence increases the money supply and vice versa.

10. Monetary Policy:

Monetary policy has positive or negative influence on the money multiplier and hence on the
money supply, depending upon whether reserve requirements are lowered or raised. If reserve
requirements are raised, the value of reserve ratio (r) will rise reducing the money multiplier and
thus the money supply and vice versa.

11. Seasonal Factors:

Seasonal factors have negative effect on the money multiplier, and hence on the money stock.
During holiday periods, the currency ratio (c) will tend to rise, thus, reducing the money multiplier
and, thereby, the money supply.

1.1.QUANTITY THEORY OF MONEY (WITH DIAGRAM)

How is the general price level determined? Why does price level change? Classical or pre-
Keynesian economists answered all these questions in terms of quantity theory of money.

In its simplest form, it states that the general price level (P) in an economy is directly dependent
on the money supply (M);

P = f(M)

If M doubles, P will double. If M is reduced to half, P will decline by the same amount. This is the
essence of the quantity theory of money. Though the theory was first stated in 1586, it received its
full-fledged popularity at the hands of Irving Fisher in 1911. Later, an alternative approach was
given by a group of Cambridge economists. However, the basic conclusion of these two theories

Assumptions:
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The classical quantity theory of money is based on two fundamental assumptions: First is the
operation of Say’s Law of Market. Say’s law states that, “Supply creates its own demand.” This
means that the sum of values of all goods produced is equivalent to the sum of values of all goods
bought.

Thus, by definition, there cannot be deficiency of demand or under utilisation of resources. There
will always be full employment in the economy. Second is the assumption of full employment that
follows from the Say’s Law.

1. Quantity Theory of Money— Fisher’s Version:

Like the price of a commodity, value of money is determinded by the supply of money and demand
for money. In his theory of demand for money, Fisher attached emphasis on the use of money as
a medium of exchange. In other words, money is demanded for transaction purposes.

The transactions version of the quantity theory of money was provided by the American economist
Irving Fisher in his book- The Purchasing Power of Money (1911). According to Fisher, “Other
things remaining unchanged, as the quantity of money in circulation increases, the price level also
increases in direct proportion and the value of money decreases and vice versa”.

Fisher’s quantity theory is best explained with the help of his famous equation of exchange:
MV = PT or P = MV/T
Like other commodities, the value of money or the price level is also determined by the demand
and supply of money.

i. Supply of Money:
The supply of money consists of the quantity of money in existence (M) multiplied by the number
of times this money changes hands, i.e., the velocity of money (V). In Fisher’s equation, V is the
transactions velocity of money which means the average number of times a unit of money turns
over or changes hands to effectuate transactions during a period of time.
Thus, MV refers to the total volume of money in circulation during a period of time. Since money
is only to be used for transaction purposes, total supply of money also forms the total value of
money expenditures in all transactions in the economy during a period of time.

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ii. Demand for Money:
Money is demanded not for its own sake (i.e., for hoarding it), but for transaction purposes. The
demand for money is equal to the total market value of all goods and services transacted. It is
obtained by multiplying total amount of things (T) by average price level (P).
Thus, Fisher’s equation of exchange represents equality between the supply of money or the total
value of money expenditures in all transactions and the demand for money or the total value of all
items transacted.
Supply of money = Demand for Money
Or
Total value of money expenditures in all transactions = Total value of all items transacted
MV = PT
or
P = MV/T

Where,
M is the quantity of money
V is the transaction velocity
P is the price level.
T is the total goods and services transacted.
The equation of exchange is an identity equation, i.e., MV is identically equal to PT (or MV = PT).
It means that in the ex-post or factual sense, the equation must always be true. The equation states
the fact that the actual total value of all money expenditures (MV) always equals the actual total
value of all items sold (PT).
What is spent for purchases (MV) and what is received for sale (PT) are always equal; what
someone spends must be received by someone. In this sense, the equation of exchange is not a
theory but rather a truism.
Irving Fisher used the equation of exchange to develop the classical quantity theory of money, i.e.,
a causal relationship between the money supply and the price level. On the assumptions that, in
the long run, under full-employment conditions, total output (T) does not change and the
transactions velocity of money (V) is stable, Fisher was able to demonstrate a causal relationship
between money supply and price level.
In this way, Fisher concludes, “… the level of price varies directly with the quantity of money in
circulation provided the velocity of circulation of that money and the volume of trade which it is
obliged to perform are not changed”. Thus, the classical quantity theory of money states that V
and T being unchanged, changes in money cause direct and proportional changes in the price level.

104
Irving Fisher further extended the equation of exchange so as to include demand (bank) deposits
(M’) and their velocity, (V’) in the total supply of money.

Thus, the equation of exchange becomes:

Thus, according to Fisher, the level of general

prices (P) depends exclusively on five definite
factors:
(a) The volume of money in circulation (M);
(b) Its velocity of circulation (V) ;
(c) The volume of bank deposits (M’);
(d) Its velocity of circulation (V’); and
(e) The volume of trade (T).

The transactions approach to the quantity theory of

money maintains that, other things remaining the
same, i.e., if V, M’, V’, and T remain unchanged,
there exists a direct and proportional relation
between M and P; if the quantity of money is
doubled, the price level will also be doubled and the
value of money halved; if the quantity of money is
halved, the price level will also be halved and the
value of money doubled.

Example:
Fisher’s quantity theory of money can be explained with the help of an example. Suppose M = Rs.
1000. M’ = Rs. 500, V = 3, V’ = 2, T = 4000 goods.

105
Thus, when money supply in doubled, i.e., increases from Rs. 4000 to 8000, the price level is
doubled. i.e., from Re. 1 per good to Rs. 2 per good and the value of money is halved, i.e., from 1
to 1/2.

Thus, when money supply is halved, i.e., decreases from Rs. 4000 to 2000, the price level is halved,
i.e., from 1 to 1/2, and the value of money is doubled, i.e., from 1 to 2.

4.3. BUSINESS CYCLES

MEANING, PHASES, FEATURES AND THEORIES OF BUSINESS CYCLE

4.3.1. Meaning:

Many free enterprise capitalist countries such as USA and Great Britain have registered rapid
economic growth during the last two centuries. But economic growth in these countries has not

followed steady and smooth upward trend. There has been a long-run upward trend in Gross

National Product (GNP), but periodically there have been large short-run fluctuations in economic
activity, that is, changes in output, income, employment and prices around this long- term trend.

The period of high income, output and employment has been called the period of expansion,

upswing or prosperity, and the period of low income, output and employment has been described
as contraction, recession, downswing or depression. The economic history of the free market
106
capitalist countries has shown that the period of economic prosperity or expansion alternates with

the period of contraction or recession.

These alternating periods of expansion and contraction in economic activity has been called
business cycles. They are also known as trade cycles. J.M. Keynes writes, “A trade cycle is

composed of periods of good trade characterised by rising prices and low unemployment
percentages with periods of bad trade characterised by falling prices and high unemployment
percentages.”

4.3.2. Phases of Business Cycles:

Business cycles have shown distinct phases the study of which is useful to understand their
underlying causes. These phases nave been called by different names by different economists.

Generally, the following phases of business cycles have been distinguished:

1. Expansion (Boom, Upswing or Prosperity)

2. Peak (upper turning point)
3. Contraction (Downswing, Recession or Depression)
4. Trough (lower turning point)

The four phases of business cycles have been shown in Fig. 27.1 where we start from trough or

depression when the level of economic activity i.e., level of production and employment is at the

lowest level. With the revival of economic activity the economy moves into the expansion phase,
but due to the causes explained below, the expansion cannot continue indefinitely, and after
reaching peak, contraction or downswing starts. When the contraction gathers momentum, we have

a depression.

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The downswing continues till the lowest turning point which is also called trough is reached. In
this way cycle is complete. However, after remaining at the trough for some time the economy
revives and again the new cycle starts.

1) Expansion and Prosperity:

In its expansion phase, both output and employment increase till we have full-employment of

resources and production is at the highest possible level with the given productive resources. There
is no involuntary unemployment and whatever unemployment prevails is only of frictional and

structural types.

Thus, when expansion gathers momentum and we have prosperity, the gap between potential GNP

and actual GNP is zero, that is, the level of production is at the maximum production level. A good
amount of net investment is occurring and demand for durable consumer goods is also high. Prices
also generally rise during the expansion phase but due to high level of economic activity people

enjoy a high standard of living.

Then something may occur, whether banks start reducing credit or profit expectations change
adversely and businessmen become pessimistic about future state of the economy that bring an

end to the expansion or prosperity phase.

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As shall be explained below, economists differ regarding the possible causes of the end of

prosperity and start of downswing in economic activity. Monetarists have argued that contraction
in bank credit may cause downswing.

Keynes have argued that sudden collapse of expected rate of profit (which he calls marginal

efficiency of capital, MEC) caused by adverse changes in expectations of entrepreneurs lowers

investment in the economy. This fall in investment, according to him, causes downswing in
economic activity.

2) Contraction and Depression:

As stated above, expansion or prosperity is followed by contraction or depression. During

contraction, not only there is a fall in GNP but also level of employment is reduced. As a result,

involuntary unemployment appears on a large scale. Investment also decreases causing further fall
in consumption of goods and services.

At times of contraction or depression prices also generally fall due to fall in aggregate demand. A

significant feature of depression phase is the fall in rate of interest. With lower rate of interest
people’s demand for money holdings increases.

There is a lot of excess capacity as industries producing capital goods and consumer goods work

much below their capacity due to lack of demand. Capital goods and durable consumer goods
industries are especially hit hard during depression. Depression, it may be noted, occurs when
there is a severe contraction or recession of economic activities.

3) Trough and Revival:

There is a limit to which level of economic activity can fall. The lowest level of economic activity,

generally called trough, lasts for some time. Capital stock is allowed to depreciate without

replacement. The progress in technology makes the existing capital stock obsolete.

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If the banking system starts expanding credit or there is a spurt in investment activity due to the

emergence of scarcity of capital as a result of non-replacement of depreciated capital and also

because of new technology coming into existence requiring new types of marines and other capital

goods. The stimulation of investment brings about the revival or recovery of the economy.

The recovery is the turning point from depression into expansion. As investment rises, this causes
induced increase in consumption. As a result industries start producing more and excess capacity
is now put into full use due to the revival of aggregate demand. Employment of labour increases

and rate of unemployment falls. With this the cycle is complete.

4.3.3. Features of Business Cycles:

Though different business cycles differ in duration and intensity they have some common

features which we explain below:

1. Business cycles occur periodically. Though they do not show same regularity, they have some

distinct phases such as expansion, peak, contraction or depression and trough. Further the duration

of cycles varies a good deal from minimum of two years to a maximum of ten to twelve years.

2. Secondly, business cycles are Synchronic. That is, they do not cause changes in any single
industry or sector but are of all embracing character. For example, depression or contraction occurs

simultaneously in all industries or sectors of the economy. Recession passes from one industry to
another and chain reaction continues till the whole economy is in the grip of recession. Similar
process is at work in the expansion phase, prosperity spreads through various linkages of input-

output relations or demand relations between various industries, and sectors.

3. Thirdly, it has been observed that fluctuations occur not only in level of production but also

simultaneously in other variables such as employment, investment, consumption, rate of interest

and price level.

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4. Another important feature of business cycles is that investment and consumption of durable

consumer goods such as cars, houses, and refrigerators are affected most by the cyclical
fluctuations. As stressed by J.M. Keynes, investment is greatly volatile and unstable as it depends

on profit expectations of private entrepreneurs. These expectations of entrepreneurs change quite

often making investment quite unstable. Since consumption of durable consumer goods can be

deferred, it also fluctuates greatly during the course of business cycles.

5. An important feature of business cycles is that consumption of non-durable goods and services

does not vary much during different phases of business cycles. Past data of business cycles reveal
that households maintain a great stability in consumption of non-durable goods.

6. The immediate impact of depression and expansion is on the inventories of goods. When

depression sets in, the inventories start accumulating beyond the desired level. This leads to cut in
production of goods. On the contrary, when recovery starts, the inventories go below the desired

level. This encourages businessmen to place more orders for goods whose production picks up and

stimulates investment in capital goods.

7. Another important feature of business cycles is profits fluctuate more than any other type of

income. The occurrence of business cycles causes a lot of uncertainty for businessmen and makes

it difficult to forecast the economic conditions. During the depression period profits may even
become negative and many businesses go bankrupt. In a free market economy profits are justified
on the ground that they are necessary payments if the entrepreneurs are to be induced to bear

uncertainty.

8. Lastly, business cycles are international in character. That is, once started in one country they
spread to other countries through trade relations between them. For example, if there is a recession

in the USA, which is a large importer of goods from other countries, will cause a fall in demand

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for imports from other countries whose exports would be adversely affected causing recession in

them too. Depression of 1930s in USA and Great Britain engulfed the entire capital world.

1.5. INFLATION:

1.5.1. Meaning : Inflation is the decline of purchasing power of a given currency over time.
A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected
in the increase of an average price level of a basket of selected goods and services in an economy
over some period of time. The rise in the general level of prices, often expressed as a percentage,
means that a unit of currency effectively buys less than it did in prior periods.

1.5.2. Demand and supply side factors:

1.5.2.1.DEMAND SIDE INFLATION :

A rise in the prices which is caused due to increase in the demand for goods and services in the
economy is termed as Demand –side inflation which is also known as Demand-pull inflation.

What Demand-Pull Inflation?

When the supply of money in the economy increases, people have more money available which in
turn increases their purchasing power. As a result of which, demand for goods and services
increases. In response to rising demand, instead of increasing supply of goods and services, prices
are increased which causes reduction in demand but at the same time increase in the profits of the
sellers.

Example:- A seller selling a good for Rs 2 earns profit of Rs1000 by selling 500units of that good.
Experiencing the rising demand for good, he increases its price to Rs 4, as a result the demand falls
and now he sells only 300 units of good but still witnesses an increase in profit to Rs 1200. How
to reduce demand-pull inflation. The most effective way to reduce the demand-pull inflation is by
reducing the supply of money in the economy through monetary policy which will reduce the
purchasing power of the people and hence the demand will fall further reducing the prices of goods
and services. Now, after getting a clear understanding of demand side of inflation or Deman d-pull
inflation, the next we come up with is Supply side of inflation or Cost-push inflation.

1.5.2.2. SUPPLY SIDE OF INFLATION:

The rise in the prices which is caused due to reduction in the supply of goods and services in the
economy is called supply side of inflation which is also known as Cost-Push Inflation.

WHAT COST-PUSH INFLATION?

As the name suggests, when the cost of production of a good or service increases, it becomes
expensive for the producers to produce goods and services and as a result they transfer this burden
of rise in the cost of production to the customers by increasing the prices of goods and services.
Thus, causing inflation. Causes of Cost-Push Inflation.

The various causes which lead to cost-push inflation are-

• Increase in the prices of raw materials.

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• Increase in taxes like VAT and excise duties.
• Increasing the amount of wages and salaries to workers.

How to reduce Cost-Push Inflation?

• Providing better education and training to the workforce which increases the supply.
• Adopting measures to carry out cost-effective production

DIFFRENCE BETWEEN DEMAND- PULL & COST-PUSH INFLATION:

Demand pull inflation arises when the aggregate demand becomes more than the aggregate
supply in the economy. Cost pull inflation occurs when aggregate demand remains the same but
there is a decline in aggregate supply due to external factors that cause rise in price levels.
Let us look at some of the points of difference between demand pull inflation and cost push
inflation.

Demand Pull Inflation Cost Push Inflation

Definition

Inflation that occurs due to increase in Inflation that results from decline in aggregate supply
aggregate demand is referred to as demand pull due to external factors is referred to as cost push
inflation inflation.

Impact of aggregate demand

Increased aggregate demand results in demand In cost push inflation the aggregate demand remains
pull inflation the same.

Caused by

Rise in aggregate demand Rise in price of inputs like raw materials, labour, etc

What it represents

The beginning of price inflation The idea that inflation is difficult to stop, once it has
started

Causative Factors

Monetary factors and real factors Caused by business groups of society who respond to
rise in costs of the product

Prevalence

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 Demand pull inflation occurs in most Cost push inflation is not that relevant in current times
economies of the world

4.3.6. Causes & control:

Sometimes it happens that the policy makers misinterpret the supply side inflation which is
prevailing in the economy as demand side inflation and take measures to control it accordingly.
As we know that in demand side inflation, because of the increase in demand of the good its prices
rise and in order to control it the government, with the help of monetary policy, increases the
interest rates causing aggregate demand to fall. As a result of this action, the prices should fall, but
what happens is just the reverse reason being that the type of inflation in the economy is supply
sided in which price of good rise due to the scarcity of that good. Therefore increasing interest
rates will not reduce the inflation in the economy rather it will further increase.

4.3.6.1. Factors which causes Inflation (Factoring affecting Demand and Supply)

Factors which causes Inflation (Factoring affecting Demand and Supply)!

4.3.6.1.1. Factors Affecting Demand for Money:

Both Keynesians and monetarists believe that inflation is caused by increase in aggregate
demand.

They point toward the following factors which raise it:

1. Increase in Money Supply:

Inflation is caused by an increase in the supply of money which leads to increase in aggregate

demand. The higher the growth rate of the nominal money supply, the higher is the rate of
inflation. Modern quantity theorists do not believe that true inflation starts after the full
employment level. This view is realistic because all advanced countries are faced with high

levels of unemployment and high rates of inflation.

2. Increase in Disposable Income:

When the disposable income of the people increases, it raises their demand for goods and

services. Disposable income may increase with the rise in national income or reduction in taxes

or reduction in the saving of the people.

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3. Increase in Public Expenditure:

Government activities have been expanding much with the result that government expenditure has
also been increasing at a phenomenal rate, thereby raising aggregate demand for goods and

services. Governments of both developed and developing countries are providing more facilities
under public utilities and social services, and also nationalising industries and starting public

enterprises with the result that they help in increasing aggregate demand.

4. Increase in Consumer Spending:

The demand for goods and services increases when consumer expenditure increases. Consumers
may spend more due to conspicuous consumption or demonstration effect. They may also spend

more when they are given credit facilities to buy goods on hire-purchase and installment basis.

5. Cheap Monetary Policy:

Cheap monetary policy or the policy of credit expansion also leads to increase in the money supply

which raises the demand for goods and services in the economy. When credit expands, it raises the

money income of the borrowers which, in turn, raises aggregate demand relative to supply, thereby

leading to inflation. This is also known as credit-induced inflation.

6. Deficit Financing:

In order to meet its mounting expenses, the government resorts to deficit financing by borrowing
from the public and even by printing more notes. This raises aggregate demand in relation to
aggregate supply, thereby leading to inflationary rise in prices. This is also known as deficit-

induced inflation.

7. Expansion of the Private Sector:

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The expansion of the private sector also tends to raise the aggregate demand. For huge investments

increase employment and income, thereby creating more demand for goods and services. But it
takes time for the output to enter the market. This leads to rise in prices.

8. Black Money:

The existence of black money in all countries due to corruption, tax evasion etc. increases the
aggregate demand. People spend such unearned money extravagantly, thereby creating
unnecessary demand for commodities. This tends to raise the price level further.

9. Repayment of Public Debt:

Whenever the government repays its past internal debt to the public, it leads to increase in the

money supply with the public. This tends to raise the aggregate demand for goods and services

and to rise in prices.

10. Increase in Exports:

When the demand for domestically produced goods increases in foreign countries, this raises the

earnings of industries producing export commodities. These, in turn, create more demand for good

s and services within the economy, thereby leading to rise in the price level.

3.6.1.2. Factors Affecting Money Supply:

There are also certain factors which operate on the opposite side and tend to reduce the aggregate
supply.

Some of the factors are as follows:

1. Shortage of Factors of Production:

One of the important causes affecting the supplies of goods is the shortage of such factors as labour,
raw materials, power supply, capital, etc. They lead to excess capacity and reduction in industrial

production, thereby raising prices.

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2. Industrial Disputes:

In countries where trade unions are powerful, they also help in curtailing production. Trade unions
resort to strikes and if they happen to be unreasonable from the employers’ viewpoint and are

prolonged, they force the employers to declare lock-outs.

In both cases, industrial production falls, thereby reducing supplies of goods. If the unions succeed
in rising money wages of their members to a very high level than the productivity of labour, this
also tends to reduce production and supplies of goods. Thus they tend to raise prices.

3. Natural Calamities:
Drought or floods is a factor which adversely affects the supplies of agricultural products. The

latter, in turn, create shortages of food products and raw materials, thereby helping inflationary

pressures.

4. Artificial Scarcities:

Artificial scarcities are created by hoarders and speculators who indulge in black marketing. Thus

they are instrumental in reducing supplies of goods and raising their prices.

5. Increase in Exports:

When the country produces more goods for export than for domestic consumption, this creates

shortages of goods in the domestic market. This leads to inflation in the economy.

6. Lop-sided Production:

If the stress is on the production of comfort, luxury, or basic products to the neglect of essential
consumer goods in the country, this creates shortages or consumer goods. This again causes

inflation.

7. Law of Diminishing Returns:

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If industries in the country are using old machines and outmoded methods of production, the law

of diminishing returns operates. This raises cost per unit of production, thereby raising the prices
of products.

8. International Factors:

In modern times, inflation is a worldwide phenomenon. When prices rise in major industrial
countries, their effects spread to almost all countries with which they have trade relations. Often
the rise in the price of a basic raw material like petrol in the international market leads to rise in

the prices of all related commodities in a country.

3.6.2. Measures to control inflation:

Inflation is considered to be a complex situation for an economy. If inflation goes beyond a
moderate rate, it can create disastrous situations for an economy; therefore is should be under
control.

It is not easy to control inflation by using a particular measure or instrument.

The main aim of every measure is to reduce the inflow of cash in the economy or reduce the
liquidity in the market.

1. Monetary Measures:
The government of a country takes several measures and formulates policies to control economic
activities. Monetary policy is one of the most commonly used measures taken by the government
to control inflation.

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In monetary policy, the central bank increases rate of interest on borrowings for commercial
banks. As a result, commercial banks increase their rate of interests on credit for the public. In
such a situation, individuals prefer to save money instead of investing in new ventures.

This would reduce money supply in the market, which, in turn, controls inflation. Apart from
this, the central bank reduces the credit creation capacity of commercial banks to control
inflation.

The monetary policy of a country involves the following:

(a) Rise in Bank Rate:
The bank rate is the rate at which the commercial bank gets a rediscount on loans and advances
by the central bank. The increase in the bank rate results in the rise of rate of interest on loans for
the public. This leads to the reduction in total spending of individuals.

The main reasons for reduction in total expenditure of individuals are as follows;
(i) Making the borrowing of money costlier:
Refers to the fact that with the rise in the bank rate by the central bank increases the interest rate
on loans and advances by commercial banks. This makes the borrowing of money expensive for
general public.

Consequently, individuals postpone their investment plans and wait for fall in interest rates in
future. The reduction in investments results in the decreases in the total spending and helps in
controlling inflation.

(ii) Creating adverse situations for businesses:

Implies that increase in bank rate has a psychological impact on some of the businesspersons.
They consider this situation adverse for carrying out their business activities. Therefore, they
reduce their spending and investment.

(iii) Increasing the propensity to save:

Refers to one of the most important reason for reduction in total expenditure of individuals. It is
a well-known fact that individuals generally prefer to save money in inflationary conditions. As a
result, the total expenditure of individuals on consumption and investment decreases.

(b) Direct Control on Credit Creation:

Constitutes the major part of monetary policy.

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The central bank directly reduces the credit control capacity of commercial banks by using
the following methods:
(i) Performing Open Market Operations (OMO):
Refers to one of the important method used by the central bank to reduce the credit creation
capacity of commercial banks. The central bank issues government securities to commercial
banks and certain private businesses.

In this way, the cash with commercial banks would be spent on purchasing government
securities. As a result, commercial bank would reduce credit supply for the general public.

(ii) Changing Reserve Ratios:

Involves increase or decrease in reserve ratios by the central bank to reduce the credit creation
capacity of commercial banks. For example, when the central bank needs to reduce the credit
creation capacity of commercial banks, it increases Cash Reserve Ratio (CRR). As a result,
commercial banks need to keep a large amount of cash as reserve from their total deposits with
the central bank. This would further reduce the lending capacity of commercial banks.
Consequently, the investment by individuals in an economy would also reduce.

2. Fiscal Measures:
Apart from monetary policy, the government also uses fiscal measures to control inflation. The
two main components of fiscal policy are government revenue and government expenditure. In
fiscal policy, the government controls inflation either by reducing private spending or by
decreasing government expenditure, or by using both.

It reduces private spending by increasing taxes on private businesses. When private spending is
more, the government reduces its expenditure to control inflation. However, in present scenario,
reducing government expenditure is not possible because there may be certain on-going projects
for social welfare that cannot be postponed.

Besides this, the government expenditures are essential for other areas, such as defense, health,
education, and law and order. In such a case, reducing private spending is more preferable rather
than decreasing government expenditure. When the government reduces private spending by
increasing taxes, individuals decrease their total expenditure.

For example, if direct taxes on profits increase, the total disposable income would reduce. As a
result, the total spending of individuals decreases, which, in turn, reduces money supply in the

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market. Therefore, at the time of inflation, the government reduces its expenditure and increases
taxes for dropping private spending.

3. Price Control:
Another method for ceasing inflation is preventing any further rise in the prices of goods and
services. In this method, inflation is suppressed by price control, but cannot be controlled for the
long term. In such a case, the basic inflationary pressure in the economy is not exhibited in the
form of rise in prices for a short time. Such inflation is termed as suppressed inflation.

The historical evidences have shown that price control alone cannot control inflation, but only
reduces the extent of inflation. For example, at the time of wars, the government of different
countries imposed price controls to prevent any further rise in the prices. However, prices remain
at peak in different economies. This was because of the reason that inflation was persistent in
different economies, which caused sharp rise in prices. Therefore, it can be said inflation cannot
be ceased unless its cause is determined.

3.6.2.2.MEASURES TO CONYROL INFLATION:

1. Supply

The control over the money supply is an effective method to control inflation. The printing of new
notes must be stopped.

2. Compulsory Saving

The government may start schemes of compulsory savings to take from each person some portion
of his earnings. The purpose is to decrease the purchasing power of each person.

3. Credit Control

The central bank can control credit in order to control inflation. Money is needed to do business.
The limits of credit may be fixed by the government from time to time. The monetary authority
should act according to the credit ceiling approved by the state.

4. Monetary Reforms

The government can exchange old notes for new ones and large parts may be blocked. The same
rule can be applied to bank accounts. The people cannot take loans and they are completed to spend
money out of current income.
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5. Taxation Increase

The increase in taxes means part of the income of people will be transferred to the government.
The purchasing power of general public will decrease. There will be a low demand for goods and
services.

6. Public Debt

The government may arrange public debt during inflation. The central bank can arrange loans from
banks and the general public. The borrowing on the part of the government reduces the income of
people.

7. Surplus Budget

The government can prepare a surplus budget during inflation. The surplus budget means the
income is more as compared to expenses. Taxes are collected from the general public for the
purpose of decreasing general public income. The surplus budget is a step to control inflation.

8. Tariff Decrease

The decrease in tariff on importers encourages the importers to buy goods in large quantities from
other countries. The low rate permits import of goods at a low rate.

9. Check on Exports

The surplus goods may be exported, but the items which are short at the home market should not
be exported at any cost. The maintenance of a stable price level is a challenge for the government.

10. Over Valuation

The government can overvalue its money in terms of currencies of other countries. The holders of
overvalued money can buy more goods and services than before.

11. Control Over Investment

The investment can be controlled by means of a license. The government can decide about the
areas of investment. The developed sector may be discouraged.

12. Price Control

The government can introduce the price control of various commodities. It is a tool in the hands
of the government to control inflation.

13. Rationing

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The rationing of goods is another measure to control inflation. The supply of some items may be
short. The demand for goods is high. The government can fix the quota of goods available to the
general public.

14. Increase in Production

The increase in the production of goods is helpful to increases the supply of things in the market.
The increases in production can regulate the price level. The installation of new machines and
overhauling old machines can help to improve the supply of goods.

15. Wages Control

The government can control the wages of employees in the public and private sectors. The
purchasing power of people is increased. It helps to regulate the demand for goods and services.

3.7. Deflation:

3.7.1. Meaning:

Deflation is the persistent and considerable amount of reduction in the prices of goods and
services in an economy. The fall in prices should be persistent and should continue over
some time and not a few days or a week. Also, it should be a considerable fall and not just
a minor one to be termed as deflation.

3.7.2. Causes Deflation:

Deflation can be caused by a number of factors, all of which stem from a shift in the supply-
demand curve. The prices of all goods and services are heavily affected by a change in supply
and demand. If demand drops in relation to supply, prices have to drop accordingly. Likewise,
a change in the supply and demand of a national or single-market currency (such as the U.S.
dollar or the E.U. euro) plays an instrumental role in setting the prices of the country’s goods
and services.

Although there are many reasons why deflation may take place, the following causes seem to
play the largest roles:

I. Monetary policy

The monetary policy of the Central Bank plays a significant role in causing deflation. The
Central bank, at the insistence of the government, may reduce money supply in the market
and increase rates of interest to control an inflationary phase. It may also happen after
artificial infusion of money in the economy over long periods. Reduction in money supply
will result in lower cash in the hands of the people to spend. Production levels remain the
same, resulting in an over-supply in the market. It will lead to a fall in the prices of goods
and services.

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 II. Fall in demand

The overall demand in the economy may also continue to fall at the time of falling prices.
Buyers will expect prices to fall further and prefer to wait to buy. The demand does not
pick up even with a fall in prices, as the public expects of a further reduction in prices.
Such a vicious cycle is called a deflationary spiral.

III. Change in Capital Market Structures

When many different companies are selling the same goods or services, they typically lower
their prices as a means to compete. Often, the capital structure of the economy changes and
companies have easier access to debt and equity markets, which they can use to fund new
businesses or improve productivity.

There are multiple reasons why companies might have an easier time raising capital, such as
declining interest rates, changing banking policies, or a change in investors’ aversion to risk.
However, after they’ve utilized this new capital to increase productivity, businesses have to
reduce their prices to reflect the increased supply of products, which can result in deflation.

IV. Increased Productivity

Innovative solutions and new processes help increase efficiency, which ultimately leads to lower
prices. Although some innovations only affect the productivity of certain industries, others may
have a profound effect on the entire economy.

For example, after the Soviet Union collapsed in 1991, many of the countries that formed as a
result struggled to get back on track. In order to make a living, many citizens were willing to
work for very low prices, and as U.S. companies outsourced work to these countries, they were
able to significantly reduce their operating expenses and bolster productivity. Inevitably, this
increased the supply of goods while decreasing their cost, which led to a period of deflation near
the end of the 20th century.

V. Decrease in Currency Supply:

Currency supplies generally decrease due to actions taken by central banks, often with the
explicit aim of tamping down inflation. For instance, when the Federal Reserve was first created,
it considerably contracted the U.S. money supply. Unfortunately, it’s easy for currency supply
reductions to spiral out of control. For example, the Fed’s early moves caused severe deflation
during the early 1910s.

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Likewise, spending on credit is a fact of life in the modern economy. When creditors pull the
plug on lending money, consumers and businesses spend less, forcing sellers to lower their prices
to regain sales. This is why one of the Federal Reserve’s top priorities today is ensuring the
smooth functioning of credit markets.

VI. Austerity Measures:

Deflation can be the result of decreased governmental, business, or consumer spending, which
means government spending cuts can lead to periods of significant deflation. For example, when
Spain initiated austerity measures in 2010, preexisting deflation began to spiral out of control in
that country. To date, Spain and other “peripheral” European economies badly affected by the
sovereign debt crisis of the early 2010s contend with stagnant prices, high unemployment, and
persistently slow economic growth.

VII. Deflationary Spiral (Persistent Deflation):

Once deflation rears its ugly head, it can be very difficult to get the economy under control.
While the actual mechanics of persistent deflation are complicated, the crux is that true deflation
is self-reinforcing.

When consumers and businesses cut spending, business profits decrease, forcing them to reduce
wages and cut back on investment. This short-circuits spending in other sectors, as other
businesses and wage-earners have less money to spend. Short of a massive monetary
stimulus that can swing the pendulum too far in the other direction and precipitate runaway
inflation – which central banks try to avoid at all costs – there’s no easy way out of this cycle.

VIII. Innovation and technology

Implementation of new technology in the production process or innovation of a new

product, method, or idea may lead to increased production and efficiency in the economy.
Producers may experience a decrease in input costs due to economies of large scale
production. Passing the lower costs as well as increased supply may result in a fall in prices
in the marketplace.

3.7.3. Effects of Deflation

Deflation is like a terrible storm: The damage is often intense and takes far longer to repair than
the storm itself. Sadly, some nations never fully recover from the damage caused by deflation.
Hong Kong, for example, has yet to fully recover from the deflationary effects that gripped the
Asian economy in 2002.

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Deflation may have any of the following impacts on an economy:

1. Reduced Business Revenues

Businesses must significantly reduce the prices of their products in order to stay competitive. As
they reduce their prices, their revenues start to drop. Business revenues frequently fall and
recover, but deflationary cycles tend to repeat themselves multiple times.

Unfortunately, this means businesses need to increasingly cut their prices as the period of
deflation continues. Although these businesses operate with improved production efficiency,
their profit margins eventually drop, as savings from material costs are offset by reduced
revenues.

2. Wage Cutbacks & Layoffs

When revenues start to drop, companies need to find ways to reduce their expenses to meet their
bottom line. They can make these cuts by reducing wages and cutting positions. Understandably,
this exacerbates the cycle of inflation, as more would-be consumers have less to spend.

3. Changes in Customer Spending

The relationship between deflation and consumer spending is complex and often difficult to
predict. When the economy undergoes a period of deflation, customers often take advantage of
the substantially lower prices that result.

Initially, consumer spending may increase greatly. However, once businesses start looking for
ways to bolster their bottom line, consumers who have lost their jobs or taken pay cuts must start
reducing their spending as well. Of course, when they reduce their spending, the cycle of
deflation worsens.

4. Reduced Stake in Investments

When the economy goes through a series of deflation, investors tend to view cash as one of their
best possible investments. Investors watch their money grow simply by holding onto it.
Additionally, the interest rates investors earn often decrease significantly as central banks
attempt to fight deflation by reducing interest rates, which in turn reduces the amount of money
they have available for spending.

In the meantime, many other investments may yield a negative return or become highly volatile,
since investors are scared and companies aren’t posting profits. As investors pull out of stocks,
the stock market inevitably drops.

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5. Reduced Credit

When deflation rears its head, financial lenders quickly start to pull the plugs on many of their
lending operations for a variety of reasons. First of all, as assets such as houses decline in value,
customers cannot back their debt with the same collateral. In the event a borrower is unable to
make their debt obligations, the lenders will be unable to recover their full investment through
foreclosures or property seizures.

Also, lenders realize the financial position of borrowers is more likely to change as employers
start cutting their workforce. Central banks might try to reduce interest rates to encourage
customers to borrow and spend more, but many customers still won’t be eligible for loans.

3.7.4. MEASURES TO CONTROL DEFLATION:

Deflation can be controlled by adopting monetary and fiscal measures in just the opposite manner
to control inflation.

I. MONETARY POLICY MEASURES:

To control deflation, the central bank can increase the reserves of commercial banks through a
cheap money policy. They can do so by buying securities and reducing the interest rate. As a result,
their ability to extend credit facilities to borrowers increases. But the experience of the Great
Depression tells us that in a serious depression when there is pessimism among businessmen, the
success of such a policy is practically nil.

In such a situation, banks are helpless in bringing about a revival. Since business activity is almost
at a standstill, businessmen do not have any inclination to borrow to build up inventories even
when the rate of interest is very low. Rather, they want to reduce their inventories by repaying
loans already drawn from the banks.

Moreover, the question of borrowing for long-term capital needs does not arise during deflation
when the business activity is already at a very low level. The same is the case with consumers who
faced with unemployment and reduced incomes do not like to purchase any durable goods through
bank loans.

Thus all that the banks can do is to make credit available but they cannot force businessmen and
consumers to accept it. In the 1930s, very low interest rates and the piling up of unused reserves
with the banks did not have any significant impact on the depressed economies of the world. Thus
the success of monetary policy in controlling deflation is severely limited.

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 1. Currency Expansion

Deflation can be controlled though currency expansion. The central bank can issue new notes to
increase the supply of currency in the country. The new money is injected into the economy. The
people get more income. They spend more on goods and services. The demand increases, which
raises the level of production. In this way deflation is driven out of the economy and the rate of
growth can maintained.

2. Credit Expansion

Credit expansion is a method to control deflation. The central bank can ask commercial banks to
expand the volume of credit in the country. The rate of interest is lowered. The business activities
go up and the period of deflation comes to an end.

The Reserve bank of India and the commercial banks should implement a policy which results in
credit expansion to promote business and industry in the country. Bank credit should be made
easily available to the public and business concerns.

3. Low Bank Rate

Deflation may be controlled by lowering the bank rate. The central bank can lower the bank rate
to provide more funds to commercial banks. The lower bank rate is an indication for the banks that
there is less money supply in the economy. In order to meet the business requirements the banks
provide more loans. In case of need, they can get money from the central bank. The low bank rate
helps to combat deflation.

4. Low Reserve Ratio

The low reserve ratio is a tool to control the deflation. As per law commercial banks are bound to
deposit 5 % of their demand and time deposits with the central bank. The decrease in reserve ratio
encourages commercial banks to provide more loans. When there is shortage of funds, the banks
can borrow from central bank. The increasing rate of loan is another step to kill the evil forces of
deflation.

5. Consumer Credit

Deflation is controllable by means of consumer credit. The loans must be provided to consumers
for the purchase of household assets. The number of installments can be increased to provide relief
to the borrowers. In this way more money remains in the business. The additional money helps the
people to expand business activities. The consumer’s credit is one of the methods to eradicate the
germs of deflation.

II. FISCAL POLICY MEASURES:

Fiscal policy through increase in public expenditure and reduction in taxes tends to raise national
income, employment, output, and prices. An increase in public expenditure during deflation
increases the aggregate demand for goods and services and leads to a large increase in income
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via the multiplier process, while a reduction in taxes has the effect of raising disposable income
thereby increasing consumption and investment expenditures of the people.

The government should increase its expenditure through deficit budgeting and reduction in taxes.
The public expenditure includes expenditure on such public works as roads, canals, dams, parks,
schools, hospitals and other buildings, etc. and on such relief measures as unemployment
insurance, pensions, etc.

Expenditure on public works creates demand for the products of private construction industries
and helps in reviving them while expenditure on relief measures stimulates the demand for
consumer goods industries. Reduction in such taxes as corporate profits tax, income tax, and
excise taxes tends to leave more income for spending and investment.

Borrowing by the government to finance budget deficits utilises idle money lying with banks and
financial institutions for investment purposes. But the effectiveness of public expenditure
primarily depends upon the public works programme, its importance in the economic system, the
volume and nature of public works and their planning and timing.

1. Lowering the Taxation :

The government should change the taxation policy in such a way that the number and burden of
various taxes levied on commodities and services will become lowered. Then the prices of goods
and services will become reduced the previous one. This will lead to a tremendous increase the
purchasing power of the people. As a result, the demand for goods and services will increase. And
sufficient tax relief should be given to businessmen to encourage investment.

2.Repayment of Public Debt :

Government can increase the money in the economy by way of repaying the old public debts during
the times of deflation. This would result in an increase in the amount of currency in the economy
which helps to eradicate the deflation.

3. Initiatives to attract more investments :

Government should formulate and implement favorable trade policies which are investment
friendly. This will attract the attention of foreign institutional investors and domestic entrepreneurs
to set up their businesses in the economy. This entire scenario will definitely lower the deflation.

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 1.7. PHILLIPS CURVE:
The Phillips curve given by A.W. Phillips shows that there exist an inverse relationship between
the rate of unemployment and the rate of increase in nominal wages.

A lower rate of unemployment is associated with higher wage rate or inflation, and vice versa. In
other words, there is a tradeoff between wage inflation and unemployment.

Reason: during boom, demand for labour increases. Due to greater bargaining power of the trade
union, wage increases.

Thus, decrease in unemployment leads to increase in the wage (Fig. 13.6). But when wage
increases, the firms cost of production increases which leads to increase in price. Therefore it is
also called wage inflation, that is, decrease in unemployment leads to wage inflation. (Fig. 13.6)

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This show that there exists inverse relationship between the rate of unemployment and growth rate
of money wages.

The Phillips Curve shows that wages and prices adjust slowly to changes in AD due to
imperfections in the labour market.

e.g. Assume: Initially, the economy is in equilibrium with stable prices and unemployment at NRU
(U*) (Fig. 13.7)
If Money supply increases by 10%, with price level constant, real money supply (M/P) will
increase. This will lead to decrease in interest rate and thus increase in AD which in turn will lead
to an increase in both wages and prices by 10% so that the economy reaches back to the full
employment equilibrium level (U*) i.e. at NRU.

Thus, Phillips curve shows that when wage increases by 10%, unemployment rate will fall from
U* to U1. This will cause the wage rate to increase, but when wage increases, prices will also
increase and eventually the economy will return back to the full-employment level of output and
unemployment.

1.8. STAGFLATION:

Stagflation is defined as an economic phenomenon where there is high inflation along with rising
unemployment and relatively slow economic growth or recession. In this condition, there is a

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slowdown in the gross domestic product (GDP) and an increase in the prices of necessary
commodities. In other words, it is the economic scenario where there is co-existence of recession
and inflation side by side.

The reasons for these unfavorable conditions are the government’s failure to cope with inflation,
which tends towards unemployment. When the government’s policies backfire, it tends to create a
contradictory course of action in an economy. Various factors like supply shocks and poor
implementations of fiscal policies are the primary reasons for this phenomenon.

Stagflation is a combination of stagnant economic growth, high unemployment,

and high inflation. It's an unnatural situation because inflation is not supposed to occur in a weak
economy.

Causes

Stagflation occurs when the government or central banks expand the money supply at the same
time they constrain supply. The most common culprit is when the government prints currency. It
can also occur when a central bank's monetary policies create credit. Both increase the money
supply and create inflation.

At the same time, other policies slow growth. That happens if the government increases taxes. It
can also occur when the central bank raises interest rates. Both prevent companies from
producing more. When conflicting expansionary and contractionary policies occur, it can slow
growth while creating inflation.

In a normal market economy, slow growth prevents inflation. As a result, consumer demand drops
enough to keep prices from rising. Stagflation can only occur if government policies disrupt normal
market functioning.

Stagflation 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.
inflation). While many theories abound, the consensus is that stagflation occurs when money
supply is expanding while supply is being constrained. For example, if a government prints
currency, which would increase the money supply and create inflation, while raising taxes, which
would slow economic growth, then the end result would be stagflation.

Why Is Stagflation Bad?

Conceptually, stagflation is a contradiction as slow economic growth would likely lead to an
increase in unemployment but should not result in rising prices. This is why this phenomenon is
so dangerous. An increase in the unemployment level results in a decrease of consumers spending
power and, if you tack on runaway inflation, that means that what money they have is losing value
as time goes by. So, less money being worth less and less.

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What Is the Cure for Stagflation?
There is no definitive cure for stagflation but the consensus amongst economists is that
productivity has to be increased to the point where it would lead to higher growth without
additional inflation. This would then allow authorities to tighten monetary policy to reign in the
rampant inflation component of stagflation. That is easier said than done so the key to preventing
stagflation is to be extremely proactive in avoiding it.

1.9. INFLATIONATRY GAP:

An inflationary gap, also known as an expansionary gap, is the difference between the real GDP
and the full-employment real GDP. In fact, the real GDP outweighs the full employment real GDP
because an increase in the real GDP causes the general price level to rise in the long-term.
Inflationary gap is always related to a business-cycle expansion and arises when the equilibrium
level of an economy’s aggregate output is greater than the output that could be produced at full
employment.
Example
Saudi Arabia employs all its available resources and produces 11.6 barrels of oil per day. The
aggregate demand for oil is estimated at 5 barrels of oil per day because there is a growing
uncertainty over oil supplies, regional conflict and price hikes, which lower consumer confidence.
In this case, since the aggregate demand (real GDP) is lower than the full-employment real GDP,
there is no inflationary gap.
Conversely, if the aggregate demand for oil was 13.2 barrels of day, and consumer confidence was
high, there would be an inflationary gap of 1.6 barrels of oil per day because the aggregate demand
(real GDP) would be higher than the full-employment real GDP.

Therefore, when the full-employment real GDP is X, and the aggregate demand (real GDP) is X+1,
there is an inflationary gap that needs to be corrected with contractionary fiscal policy.

The concept of ‘inflationary gap’—introduced first by Keynes. This concept may be used to
measure the pressure of inflation.

Let us denote aggregate value of output at the full employment by Y f. This inflationary gap is
given by C + I + G + (X – M) > Yf. The consequence of such gap is price rise. Prices continue to
rise so long as this gap persists. Inflationary gap thus describes disequilibrium situation.
Inflationary gap is thus the result of excess demand. It may be defined as the excess of planned
levels of expenditure over the available output at base prices. An example will help us to clear the
meaning of the concept of inflationary gap.

Suppose, the aggregate value of output at current price is Rs. 600 crore. The government now takes
away output worth Rs. 100 crore for its own requirements, leaving thus Rs. 500 crore for civilian
consumption. National income analysis says that the value of aggregate money income equals the
net value of aggregate output.

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Here also the total money income of the people (Rs. 500 crore) is equal to the net value of aggregate
output (i.e., Rs. 600 crore – Rs. 100 crore = Rs. 500 crore). Thus, prices will remain stable since
aggregate expenditure is equal to aggregate output. Let us further assume that the money income
of the community is increased to Rs. 800 crore by creating additional purchasing power.

Let the government takes away Rs. 50 crore as taxes. A part of the increased income, say Rs. 100
crore, may now be saved. So the net disposal income available for spending becomes Rs. (800 –
50 – 100 =) 650 crore. Since the aggregate demand at old prices is Rs. 500 crore, an excess of Rs.
150 crore appears.

This excess represents inflationary gap that pulls up prices. If there is no corresponding increase
in aggregate output, prices will continue to rise until aggregate output becomes equal to aggregate
expenditure.

Keynes’ demand inflation is often couched in terms of the concept of inflationary gap. We now
graphically explain this gap with the help of the Keynesian cross that we use in connection with
the determination of equilibrium national income. In Fig. 11.5, aggregate expenditure is measured
on the vertical axis and national income or aggregate
output is measured on the horizontal axis.

Let us assume that Yf is the full employment level of

national income. If C + I + G + (X – M) is the aggregate
demand (AD) curve that cuts the 45° line at point A then
an equilibrium income is determinded at Yf. There will
not be any price rise since aggregate demand equals
aggregate supply. Now if the AD curve shifts up to AD’,
equilibrium output will not increase since output cannot
be increased beyond the full employment level.

In other words, because of full employment, output cannot increase to Y*. Thus at Y f level of full
employment output, there occurs an inflationary gap to the extent of AB. The vertical distance
between the aggregate demand and the 45° line at the full employment level of national income is
termed the inflationary gap. Or at full employment, there is an excess demand of AB that pulls up
prices.
To describe inflationary gap in a simple way, we use Fig. 11.6. In this figure, we weigh aggregate
demand (i.e., C + I + G + X-M) and aggregate supply. Since the former exceeds the latter, an
inflationary gap emerges.

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Inflationary gap can be eliminated/ minimized by using
monetary policy and or fiscal policy instruments. Under
the monetary policy, money supply is reduced and/or
interest rates are increased. This gap, however, can be
reduced either by reducing money income through
reduction in government expenditure, or by increasing
output of goods and services, or by increasing taxes.

If aggregate demand exceeds the aggregate value of

output at the full employment level, there will exist an
inflationary gap in the economy. Aggregate demand or
aggregate expenditure is composed of consumption
expenditure (C), investment expenditure (I), government
expenditure (G) and the trade balance or the value of
exports minus the value of imports (X – M).

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 CLASS ACTIVITIES
• CASE STUDY 1: A $550 Million Loaf of Bread?
If you were born within the last three decades in the United States, Canada, or many other countries
in the developed world, you probably have no real experience with a high rate of inflation. Inflation
is when most prices in an entire economy are rising. However, there is an extreme form of inflation
called hyperinflation. This occurred in Germany between 1921 and 1928, and more recently in
Zimbabwe between 2008 and 2009. In November 2008, Zimbabwe had an inflation rate of 79.6
billion percent. In contrast, in 2014, the United States had an average annual rate of inflation of
1.6%.
Zimbabwe’s inflation rate was so high it is difficult to comprehend, so let’s put it into context. It
is equivalent to price increases of 98% per day. This means that, from one day to the next, prices
essentially double. What is life like in an economy afflicted with hyperinflation? Most of you
reading this will have never experienced this phenomenon. The government adjusted prices for
commodities in Zimbabwean dollars several times each day. There was no desire to hold on to
currency since it lost value by the minute. The people there spent a great deal of time getting rid
of any cash they acquired by purchasing whatever food or other commodities they could find. At
one point, a loaf of bread cost 550 million Zimbabwean dollars. Teachers' salaries were in the
trillions a month; however, this was equivalent to only one U.S. dollar a day. At its height, it took
621,984,228 Zimbabwean dollars to purchase one U.S. dollar.
Government agencies had no money to pay their workers so they started printing money to pay
their bills rather than raising taxes. Rising prices caused the government to enact price controls on
private businesses, which led to shortages and the emergence of black markets. In 2009, the
country abandoned its currency and allowed people to use foreign currencies for purchases.

• CASE STUDY 2: MONEY AND SOCIAL CONVENTIONS ON THE ISLAND OF

YAP

Question 1: Explain how money acts as store of value.

Question 2: What the function of money as a unit of exchange?

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 • CASE STUDY 3: MONEY INA POW CAMP

Question 1: What are the problems associated with barter system of money.
Question 2: Explain the functions of money.

• RESEARCH PAPER 1: The U.S. Subprime Mortgage Crisis: Causes, Effects and
Lessons

(PDF) The U.S. Subprime Mortgage Crisis: Causes, Effects and Lessons | Yama
Bakhtani - Academia.edu

• RESEARCH PAPER 2: Indian Monetary Policy in the Time of Inflation Targeting and
Demonetization
https://www.researchgate.net/profile/Rakesh-Mohan-
10/publication/328784923_Indian_Monetary_Policy_in_the_Time_of_Inflation_Targetin
g_and_Demonetization/links/5c72ba1f299bf1268d22b79f/Indian-Monetary-Policy-in-
the-Time-of-Inflation-Targeting-and-Demonetization.pdf

137
 Module V:
Macro Economic Policy

5.1.MACRO ECONOMIC POLICY:

5.1.1. Macroeconomic Policy Objectives:

The macroeconomic policy objectives are the following:

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(i) Full employment,

(ii) Price stability,

(iii) Economic growth,

(iv) Balance of payments equilibrium and exchange rate stability, and

(v) Social objectives.

(i) Full employment:

Performance of any government is judged in terms of goals of achieving full employment and
price stability. These two may be called the key indicators of health of an economy. In other words,
modern governments aim at reducing both unemployment and inflation rates.

Unemployment refers to involuntary idleness of mainly labour force and other productive
resources. Unemployment (of labour) is closely related to the economy’s aggregate output. Higher
the unemployment rate, greater the divergence between actual aggregate output (or GNP/CDP)
and potential output. So, one of the objectives of macroeconomic policy is to ensure full
employment.

The objective of full employment became uppermost amongst the policymakers in the era of Great
Depression when unemployment rate in all the countries except the then socialist country, the
USSR, rose to a great height. It may be noted here that a free enterprise capitalist economy always
exhibits full employment.

But, Keynes said that the goal of full employment may be a desirable one but impossible to
achieve. Full employment, thus, does not mean that nobody is unemployed. Even if 4 or 5 p.c. of
the total population remain unemployed, the country is said to be fully employed. Full
employment, though theoretically conceivable, is difficult to attain in a market-driven economy.
In view of this, full employment objective is often translated into ‘high employment’ objective.
This goal is desirable indeed, but ‘how high’ should it be? One author has given an answer in the
following way; “The goal for high employment should therefore be not to seek an unemployment
level of zero, but rather a level of above zero consistent with full employment at which the demand
for labour equals the supply of labour. This level is called the natural rate of unemployment.”

(ii) Price stability:

No longer the attainment of full employment is considered as a macroeconomic goal. The emphasis
has shifted to price stability. By price stability we must not mean an unchanging price level over
time. Not necessarily, price increase is unwelcome, particularly if it is restricted within a
reasonable limit. In other words, price fluctuations of a larger degree are always unwelcome.

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However, it is difficult again to define the permissible or reasonable rate of inflation. But sustained
increase in price level as well as a falling price level produce destabilising effects on the economy.
Therefore, one of the objectives of macroeconomic policy is to ensure (relative) price level
stability. This goal prevents not only economic fluctuations but also helps in the attainment of a
steady growth of an economy.

(iii) Economic growth:

Economic growth in a market economy is never steady. These economies experience ups and
downs in their performance. This objective became uppermost in the period following the World
War II (1939-45). Economists call such ups and downs in the economic performance as trade
cycle/business cycle. In the short run such fluctuations may exhibit depressions or prosperity
(boom).

One of the important benchmarks to measure the performance of an economy is the rate of increase
in output over a period of time. There are three major’ sources of economic growth, viz. (i) the
growth of the labour force, (ii) capital formation, and (iii) technological progress. A country seeks
to achieve higher economic growth over a long period so that the standards of living or the quality
of life of people, on an average, improve. It may be noted here that while talking about higher
economic growth, we take into account general, social and environmental factors so that the needs
of people of both present generations and future generations can be met.

However, promotion of higher economic growth is often hampered by short run fluctuations in
aggregate output. In other words, one finds a conflict between the objectives of economic growth
and economic stability (in prices). In view of this conflict, it is said that macroeconomic policy
should promote economic growth with reasonable price stability.

(iv) Balance of payments equilibrium and exchange rate stability:

From a macro- economic point of view, one can show that an international transaction differs from
domestic transaction in terms of (foreign) currency exchange. Over a period of time, all countries
aim at balanced flow of goods, services and assets into and out of the country. Whenever this
happens, total international monetary reserves are viewed as stable.

If a country’s exports exceed imports, it then experiences a balance of payments surplus or

accumulation of reserves, like gold and foreign currency. When the country loses reserves, it
experiences balance of payments deficit (or imports exceed exports). However, depletion of
reserves reflects the unhealthy performance of an economy and thus creates various problems.
That is why every country aims at building substantial volume of foreign exchange reserves.

(v) Social objectives:

The list of objectives that we have referred here is by no means an exhaustive one; one can add
more in the list. Even then we have incorporated the major ones.

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Macroeconomic policy is also used to attain some social ends or social welfare. This means that
income distribution needs to be more fair and equitable. In a capitalist market-based society some
people get more than others. In order to ensure social justice, policymakers use macroeconomic
policy instruments.

5.1.2. Macroeconomic Policy Instruments:

As our macroeconomic goals are not typically confined to “full employment”, “price stability”,
“rapid growth”, “BOP equilibrium and stability in foreign exchange rate”, so our macroeconomic
policy instruments include monetary policy, fiscal policy, income policy in a narrow sense. But,
in a broder sense, these instruments should include policies relating to labour, tariff, agriculture,
anti-monopoly and other relevant ones that influence the macroeconomic goals of a country.
Confining our attention in a restricted way we intend to consider two types of policy instruments
the two “giants of the industry” monetary (credit) policy and fiscal (budgetary) policy. These two
policies are employed toward altering aggregate demand so as to bring about a change in aggregate
output (GNP/GDP) and prices, wages and interest rates, etc., throughout the economy.

Monetary policy attempts to stabilise aggregate demand in the economy by influencing the
availability or price of money, i.e., the rate of interest, in an economy.

Monetary policy may be defined as a policy employing the central bank’s control of the supply of
money as an instrument for achieving the macroeconomic goals.

Fiscal policy, on the other hand, aims at influencing aggregate demand by altering tax-
expenditure-debt programme of the government. The credit for using this kind of fiscal policy in
the 1930s goes to J.M. Keynes who discredited the monetary policy as a means of attaining some
of the macro- economic goals—such as the goal of full employment.

As fiscal policy has come into scrutiny in terms of its effectiveness in achieving the desired
macroeconomic objectives, the same is true about the monetary policy. One can see several rounds
of ups and downs in the effectiveness of both these policy instruments consequent upon criticisms
and counter- criticisms in their theoretical foundations.

It may be pointed out here that as there are conflicts among different macroeconomic goals,
policymakers are in a dilemma in the sense that neither of the policies can achieve desired goals.
Hence the need for additional policy measures like income policy, price control, etc. Further, while
the objectives represent economic, social and political value judgements they do not normally enter
the mainstream economic analysis. Ultimately, policymakers and bureaucrats are blamed as
trouble shooters.

5.2.1. Monetary policy:

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Monetary policy is concerned with the changes in the supply of money and credit. It refers to the
policy measures undertaken by the government or the central bank to influence the availability,
cost and use of money and credit with the help of monetary techniques to achieve specific
objectives. Monetary policy aims at influencing the economic activity in the economy mainly
through two major variables, i.e., (a) money or credit supply, and (b) the rate of interest.

The techniques of monetary policy are the same as the techniques of credit control at the disposal
of the central bank. Various techniques of monetary policy, thus, include bank rate, open market
operations, variable cash reserve requirements, selective credit controls.

How does the Reserve Bank of India get its mandate to conduct monetary policy?
• The Reserve Bank of India (RBI) is vested with the responsibility of conducting monetary
policy. This responsibility is explicitly mandated under the Reserve Bank of India Act,
1934.
• Recently there were many changes in the way Monetary Policy of India is formed – with
the introduction of:
o Monetary Policy Framework (MPF),
o Monetary Policy Committee (MPC),
o and Monetary Policy Process (MPP).
2.C.1.4. What is the main goal of Monetary Policy of India?
I. Maintain price stability:
• The primary objective of monetary policy is to maintain price stability while keeping in
mind the objective of growth. Price stability is a necessary precondition for sustainable
growth.
• To maintain price stability, inflation needs to be controlled. The government of India sets
an inflation target for every five years. RBI has an important role in the consultation process
regarding inflation targeting. The current inflation-targeting framework in India is flexible
in nature.

II. Flexible Inflation Targeting Framework (FITF)

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 • Flexible Inflation Targeting Framework: Now there is a flexible inflation targeting
framework in India (after the 2016 amendment to the Reserve Bank of India (RBI) Act,
1934).
• Who sets the inflation target in India: The amended RBI Act provides for the inflation
target to be set by the Government of India, in consultation with the Reserve Bank, once
every five years
• Current Inflation Target: The Central Government has notified 4 per cent Consumer
Price Index (CPI) inflation as the target for the period from August 5, 2016, to March 31,
2021, with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per
cent.
• Factors that constitute a failure to achieve the inflation target:
o (1) the average inflation is more than the upper tolerance level of the inflation target
for any three consecutive quarters, OR
o (2) the average inflation is less than the lower tolerance level for any three
consecutive quarters.
The Monetary Policy Framework (MPF):

While the Government of India sets the Flexible Inflation Targeting Framework in India, it is
the Reserve Bank of India (RBI) which operates the Monetary Policy Framework of the country.
The amended RBI Act explicitly provides the legislative mandate to the Reserve Bank to operate
the monetary policy framework of the country.
The framework aims at setting the policy (repo) rate based on an assessment of the current and
evolving macroeconomic situation, and modulation of liquidity conditions to anchor money
market rates at or around the repo rate.

Note: Repo rate changes transmit through the money market to the entire financial system, which,
in turn, influences aggregate demand – a key determinant of inflation and growth.
Once the repo rate is announced, the operating framework designed by the Reserve Bank envisages
liquidity management on a day-to-day basis through appropriate actions, which aim at anchoring
the operating target – the weighted average call rate (WACR) – around the repo rate.

Monetary Policy Committee (MPC)

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 • Now in India, the policy interest rate required to achieve the inflation target is decided by
the Monetary Policy Committee (MPC). MPC is a six-member committee constituted by
the Central Government (Section 45ZB of the amended RBI Act, 1934).
• The MPC is required to meet at least four times a year. The quorum for the meeting of the
MPC is four members. Each member of the MPC has one vote, and in the event of an
equality of votes, the Governor has a second or casting vote.
• The resolution adopted by the MPC is published after the conclusion of every meeting of
the MPC. Once in every six months, the Reserve Bank is required to publish a document
called the Monetary Policy Report to explain: (1) the sources of inflation and(2) the
forecast of inflation for 6-18 months ahead.
. The Monetary Policy Process (MPP)
• The Monetary Policy Committee (MPC) determines the policy interest rate required to
achieve the inflation target.
• The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating
the monetary policy. Views of key stakeholders in the economy and analytical work of the
Reserve Bank contribute to the process of arriving at the decision on the policy repo rate.
• The Financial Markets Operations Department (FMOD) operationalises the monetary
policy, mainly through day-to-day liquidity management operations.
• The Financial Market Committee (FMC) meets daily to review the liquidity conditions so
as to ensure that the operating target of monetary policy (weighted average lending rate) is
kept close to the policy repo rate. This parameter is also known as the weighted average
call money rate (WACR).
Expansionary and Contractionary Monetary Policy
• We have already seen that monetary policy refers to the actions undertaken by a nation’s
central bank to control the money supply. Control of money supply helps to manage
inflation or deflation.
• The monetary policy can be expansionary or contractionary.
• An expansionary monetary policy is focused on expanding (increasing) the money supply
in an economy. An expansionary monetary policy is implemented by lowering key interest
rates thus increasing market liquidity.
• A contractionary monetary policy is focused on contracting (decreasing) the money supply
in an economy. A contractionary monetary policy is implemented by increasing key
interest rates thus reducing market liquidity.

5.2.1.1.Instruments of Monetary Policy

The instruments or methods of credit control or instruments of monetary policy are of two kinds:

A. Quantitative control
B. Qualitative control

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 A. QUANTITATIVE CONTROL:

The quantitative instruments are also known as general tools used by the RBI (Reserve Bank of
India). As the name suggests, these instruments are related to the quantity and volume of the
money. These instruments are designed to control the total volume/money of the bank credit in the
economy. These instruments are indirect in their nature and are used to influence the quantity of
credit in the economy.

i) Bank Rate Policy

The bank rate is the minimum rate at which the central bank lends money and rediscounts first-
class bills of exchange and securities held by commercial banks. When RBI gets a hint
that inflation is rising, it increases the bank interest rates so that commercial banks borrow less
money and the inflation stays under control.

Commercial banks also increase their lending rate to the public and business enterprises so that
people borrow less money, which will eventually help to control inflation.

On the other hand, when RBI reduces bank rates, that means borrowing for commercial banks will
become cheap and easier. This allows the commercial banks to lend money to borrowers on a
lower lending rate, which will further encourage borrowers and businessmen.

ii) Legal Reserve Ratios

The commercial banks have to keep a certain amount of reserve assets in the form of reserve cash.
Some portion of these cash reserves is their total assets in the form of cash.

To maintain liquidity and to control credit in the economy, the RBI also keeps a certain amount of
cash reserves. These reserve ratios are known as SLR (Statutory Liquidity Ratio) and CRR
(Cash Reserve Ratio).

(a) CASH RESERVE RATIO (CRR):

CRR refers to a certain percentage of commercial bank's net demand and time liability that
commercial banks have to maintain with the RBI at all times. In India, the CRR remains between
3-15 per cent by the law.

(b) STATUTORY LIQUIDITY RATIO (SLR):

SLR refers to a certain percentage of reserves to be maintained in the form of gold and foreign
securities. In India, SLR remains 25-40% by the law.

Any changes in SLR and CRR bring out the change in the position of commercial banks.

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 iii) Open Market Operations (OMO)
The sale and purchase of security in the long run/short run by the RBI in the money market is
known as open market operations. This is a popular instrument of the RBI's monetary policy.

To influence the term and structure of the interest rate and to stabilize the market for government
securities, etc., the RBI uses OMO, and this operation is also used to wipe out the shortage of
money in the money market.

If RBI sells securities in the money market, private and commercial banks and even individuals
buy it. This leads to a reduction in the existing money supply as money gets transferred from
commercial banks to the RBI. On the other hand, when RBI buys securities from the commercial
banks, the commercial banks that sell receive the amount they had invested in RBI before.

There are certain factors that affect OMOwhich include underdeveloped securities market, excess
reserves with the commercial banks, indebtedness of the commercial banks, etc.

iv) Repo Rate

A Repo rate is a rate at which commercial banks borrow money by selling their securities to the
RBI to maintain liquidity. Commercial banks sell their securities in case of a shortage of funds or
due to some statutory measures. It is one of the main instruments of the RBI to keep inflation under
control.

v) Reverse Repo Rate

Sometimes, the RBI borrows money from commercial banks when there is excess liquidity in the
market. In that case, commercial banks get benefits by receiving the interest on their holdings with
the RBI.

At the time of higher inflation in the country, RBI increases the reverse repo rate that encourages
banks to park more funds with the RBI, which will help it earn higher returns on excess funds.

B. QUALITATIVE METHODS:
Qualitative instruments are also known as selective instruments of the RBI's monetary policy.
These instruments are used for discriminating between various uses of credit; for example, they
can be used for favouring export over import or essential over non-essential credit supply. This
method has an influence on both borrowers and lenders.

Following are some selective tools of credit control used by the RBI:

i) Rationing of Credit
RBI fixes a credit amount to be granted for commercial banks. Credit is given by limiting the
amount available for each commercial bank. For certain purposes, the upper credit limit can be

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fixed, and banks have to stick to that limit. This helps in lowering the bank's credit exposure to
unwanted sectors. This instrument also controls the bill rediscounting.

ii) Regulation of Consumer Credit

In this instrument, consumers' credit supply is regulated through the instalment of sale and hire
purchase of consumer goods. Here, features like instalment amount, down payment, loan duration,
etc., are all fixed in advance, which helps to check the credit and inflation in the country.

iii) Change in Marginal Requirement

Margin is referred to the certain proportion of the loan amount that is not offered or financed by
the bank. Change in marginal can lead to change in the loan size. This instrument is used to
encourage the credit supply for the necessary sectors and avoid it for the unnecessary sectors. That
can be done by increasing the marginal of unnecessary sectors and reducing the marginal of other
needy sectors.

Suppose, RBI feels that more credit supply should be allotted to the agricultural sector, then RBI
will reduce the margin, and even 80-90% of the loan can be allotted.

iv) Moral Suasion

Moral suasion refers to the suggestions to commercial banks from the RBI that helps in restraining
credits in the inflationary period. RBI implies pressure on the Indian banking system without
taking any strict action for compliance with rules. Through monetary policy, commercial banks
get informed of the expectations of RBI. The RBI can issue directives, guidelines, suggestions for
commercial banks regarding reducing credit supply for speculative purposes under the moral
suasion.

v) Direct Credit Control: The Central Bank can direct Deposit Money Banks on the
maximum percentage or amount of loans (credit ceilings) to different economic sectors or
activities, interest rate caps, liquid asset ratio and issue credit guarantee to preferred loans. In this
way the available savings is allocated and investment directed in particular directions.

5.2.1.1. Role of Monetary Policy in Developing Countries:

The monetary policy in a developing economy will have to be quite different from that of a
developed economy mainly due to different economic conditions and requirements of the two
types of economies. A developed country may adopt full employment or price stabilisation or
exchange stability as a goal of the monetary policy.

But in a developing or underdeveloped country, economic growth is the primary and basic
necessity. Thus, in a developing economy the monetary policy should aim at promoting economic
growth. The monetary authority of a developing economy can play a vital role by adopting such a
monetary policy which creates conditions necessary for rapid economic growth.
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Monetary policy can serve the following developmental requirements of developing
economies:
1. Developmental Role:
In a developing economy, the monetary policy can play a significant role in accelerating economic
development by influencing the supply and uses of credit, controlling inflation, and maintaining
balance of payment.
Once development gains momentum, effective monetary policy can help in meeting the
requirements of expanding trade and population by providing elastic supply of credit.
2. Creation and Expansion of Financial Institutions:
The primary aim of the monetary policy in a developing economy must be to improve its currency
and credit system. More banks and financial institutions should be set up, particularly in those
areas which lack these facilities.
The extension of commercial banks and setting up of other financial institutions like saving banks,
cooperative saving societies, mutual societies, etc. will help in increasing credit facilities,
mobilising voluntary savings of the people, and channelising them into productive uses.
It is also the responsibility of the monetary authority to ensure that the funds of the institutions are
diverted into priority sectors or industries as per requirements of be development plan of the
country.
3. Effective Central Banking:
To meet the developmental needs the central bank of an underdeveloped country must function
effectively to control and regulate the volume of credit through various monetary instruments, like
bank rate, open market operations, cash-reserve ratio etc. Greater and more effective credit
controls will influence the allocation of resources by diverting savings from speculative and
unproductive activities to productive uses.
4. Integration of Organised and Unorganised Money Market:
Most underdeveloped countries are characterized by dual monetary system in which a small but
highly organised money market on the one hand and large but unorganised money market on the
other hand operate simultaneously.
The unorganised money market remains outside the control of the central bank. By adopting
effective measures, the monetary authority should integrate the unorganised and organised sectors
of the money market.
5. Developing Banking Habits:
The monetary authority of a less developed country should take appropriate measures to increase
the proportion of bank money in the total money supply of the country. This requires increase in

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the bank deposits by developing the banking habits of the people and popularising the use of credit
instruments (e.g, cheques, drafts, etc.).
6. Monetisation of Economy:
An underdeveloped country is also marked by the existence of large non-monetised sector. In this
sector, all transactions are made through barter system and changes in money supply and the rate
of interest do not influence the economic activity at all. The monetary authority should take
measures to monetise this non-monetised sector and bring it under its control.
7. Integrated Interest Rate Structure:
In an underdeveloped economy, there is absence of an integrated interest rate structure. There is
wide disparity of interest rates prevailing in the different sectors of the economy and these rates
do not respond to the changes in the bank rate, thus making the monetary policy ineffective.
The monetary authority should take effective steps to integrate the interest rate structure of the
economy. Moreover, a suitable interest rate structure should be developed which not only
encourages savings and investment in the country but also discourages speculative and
unproductive loans.
8. Debt Management:
Debt management is another function of monetary policy in a developing country. Debt
management aims at- (a) deciding proper timing and issuing of government bonds, (b) stabilising
their prices, and (c) minimising the cost of servicing public debt.
The monetary authority should conduct the debt management in such a manner that conditions are
created “in which public borrowing can increase from year to year and on a big scale without
giving any jolt to the system. And this must be on cheap rates to keep the burden of the debt low.”
However, the success of debt management requires the existence of a well- developed money and
capital market along with a variety of short- term and long-term securities.
9. Maintaining Equilibrium in Balance of Payments:
The monetary policy in a developing economy should also solve the problem of adverse balance
of payments. Such a problem generally arises in the initial stages of economic development when
the import of machinery, raw material, etc., increase considerably, but the export may not increase
to the same extent.
The monetary authority should adopt direct foreign exchange controls and other measures to
correct the adverse balance of payments.
10. Controlling Inflationary Pressures:
Developing economies are highly sensitive to inflationary pressures. Large expenditures on
developmental schemes increase aggregate demand. But, output of consumer’s goods does not
increase in the same proportion. This leads to inflationary rise in prices.

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Thus, the monetary policy in a developing economy should serve to control inflationary tendencies
by increasing savings by the people, checking expansion of credit by the banking system, and
discouraging deficit financing by the government.
11. Long-Term Loans for Industrial Development:
Monetary policy can promote industrial development in the underdeveloped countries by
promoting facilities of medium-term and long-term loans to tire manufacturing units. The
monetary authority should induce these banks to grant long-term loans to the industrial units by
providing rediscounting facilities. Other development financial institutions also provide long-term
productive loans.
12. Reforming Rural Credit System:
Rural credit system is defective and rural credit facilities are deficient in the under-developed
countries. Small cultivators are poor, have no finance of their own, and are largely dependent on
loans from village money lenders and traders who generally exploit the helplessness, ignorance
and necessity of these poor borrowers.
The monetary authority can play an important role in providing both short-term and long term
credit to the small arrangements, such as the establishment of cooperative credit societies,
agricultural banks etc.

This the Central Bank is able to do with the help of three instruments of monetary policy:
1. Open-market operations

2. Reserve requirements

3. Discount Rate.

I. Open-market Operations:
It is the deliberate sale and purchase of Government bonds by the Central Bank to the general
public.

Working:
(i) During inflation:
Objective:
Increase the interest rate by decreasing the money supply.

Central Bank achieves this objective by selling bonds to the public

Result:

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Public makes payment to the bank by withdrawing the amount from the commercial bank.

This will lead to a fall in the monetary base and thus decrease the money supply.

(ii) During deflation:

Objective:
Increase the money supply.

It therefore buys bonds from the public

Result:
Public deposit the money in the commercial bank.

The monetary base will increase and thus leading to an increase in the money supply.

II. Reserve Requirements:

Commercial banks have to maintain a minimum reserve-deposit ratio with the Central Bank.

Working:
If the Central Bank increases the Reserve-deposit ratio (rr), the money multiplier will decrease.

Reason:
Money multiplier =1 + cr/cr + rr

Result:
Money supply decreases.

Similarly if rr is lowered, money multiplier will increase and thus money supply will increase.

III. The Discount Rate:

(Commonly known as the Bank Rate)

It is the rate of interest at which the Central Bank gives loans to the Commercial banks.

When commercial banks are unable to meet the reserve requirements because of less reserves, it
borrows from the Central Bank.

Working:

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(i) If the Central Bank lends at low discount rate, the commercial banks can borrow more from
the Central Bank.

Result:
Monetary base and the money supply will increase.

(ii) Similarly, if discount rate is high, borrowing will be less. Both Monetary base and the money
supply will fall.

5.2.2. Fiscal policy :

Fiscal policy is prepared to ensure the economic growth of a country. The government of a country
takes responsibility for the well-being of the countrymen. That’s why every spending of the
government should be in the right order. And to do so, the government needs to collect taxes from
businesses and individuals of the country.
Fiscal policy is a policy adopted by the government of a country required in order to control the
finances and revenue of that country which includes various taxes on goods, services and person
i.e., revenue collection, which eventually affects spending levels and hence for this fiscal policy is
termed as sister policy of monetary policy.

5.2.2.1. Two Types of Fiscal Policy:

There are two types of fiscal policies. Both of these policies work well for the overall growth of
the economy. But the government uses one of them at times when one is required more than the
other.

I. Expansionary Fiscal Policy:

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This policy is quite popular among the people of the country because through this, consumers get
more money in their hands and as a result, their purchasing power increases drastically. The
government uses this in two ways. Either they spend more money on public works, provide
benefits to the unemployed, spend more on projects that are halted in between or they cut taxes so
that the individuals or businesses don’t need to pay much to the government. You may think which
one is more prudent! People who favor government spending prefer it over cutting taxes because
they believe that if the government spends more, the unfinished projects would be completed. On
the other hand, individuals who prefer cutting taxes talk about it because they believe that by
cutting taxes the government would be able to generate more cash into consumers’
hands. Expansionary policy isn’t easy to apply for state government because the state government
is always on the pressure to keep a budget that is balanced. As it becomes impossible at local
levels, expansionary fiscal policy should be mandated by the central government.

This is generally used to give a boost to the economy. Thus, it speeds up the growth rate of the
economy. Also, during the recession period when the growth in national income is not enough to
maintain the current living of the population.

So, a tax cut and an increase in government spending would boost economic growth and decrease the
unemployment rates. Although this is not a sustainable solution. Because this can lead to a budget
deficit. Thus, the government should use this with caution.

II. Contractionary Fiscal Policy:

Contractionary fiscal policy is just the opposite of the expansionary fiscal policy. That means the
objective of the contractionary policy is to slow down economic growth. But why the government
of a country would like to do that? The only reason for which contractionary fiscal policy can be
used is to flush out the inflation. However, it is the rarest thing and that’s why the government
doesn’t use contractionary policy at all. The nature of this sort of policy is just the opposite. In this
case, government spending is cut as much as possible and the rate of taxes is increased so that the
purchasing power of the consumer gets reduced. Taking away money from the hands of the
consumers can be dangerous because that means businesses will not be able to sell off goods and
services and as a result, the economy will take a sure-shot hit which only can be reversed by taking
the expansionary fiscal policy.

This involves cutting government spending or raising taxes. Thus, the tax revenue generated is more
than government spending. Also, it cuts on the aggregate demand in the economy. So, the economic
growth leading to the reduction in inflationary pressures of the economy.

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 III. Neutral Fiscal Policy
This policy implies a balance between government spending and Furthermore, it means that tax
revenue is fully used for government spending. Also, the overall budget outcome will have a neutral
effect on the level of economic activities.

5.2.2.2.Fiscal surplus and fiscal deficit:

Fiscal surplus and fiscal deficit are two important concepts of this policy. The idea behind
these two concepts is simple.

(I) Fiscal surplus: When the government spends less than it earns, then the

government creates a fiscal surplus. This concept sounds great, but normally

it’s very difficult to create a surplus in reality.

(II) Fiscal deficit: When the government spends more money than it earns, then it

is called a fiscal deficit. This concept is very much known to the public because

the media and newspapers talk a lot about it. When a government creates a fiscal

deficit, it needs to take the debt from external sources and then bear the cost (if

any). Fiscal deficit, as you can expect, is a much more common phenomenon

than a fiscal surplus.

5.2.2.3.Instruments of Fiscal Policy

There are major nstruments to the fiscal policies and they are

(i) Expenditure Policy

Government expenditure includes capital expenditure and revenue expenditure. Also, the government
budget is the most important instrument that embodies government expenditure policy. Furthermore,
the budget is also for financing the deficit. Thus, it fills the gal between income and government
spending.

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 (ii) Taxation Policy
The government generates its revenue by imposing both indirect taxes and direct taxes. Thus, it is
important for the government to follow a judicial system for taxation and impose correct tax rates.
This is because of two reasons. The higher the tax, the reduction in the purchasing power of the people.

This will lead to a decrease in investment and production. Furthermore, the lower tax will leave more
money with people that lead to high spending and thus higher inflation.

(iii) Surplus and Debt Management

When the government receives more amount than it spends than it is known as surplus. Also, when
the spending is more than the income than it is known as a deficit. In order to fund the deficits, the
government needs to borrow from domestic or foreign sources.

5.2. Economic scenario analysis, Out of inflation & deflation , which is worst and why?

5.2.1. Why is deflation worse than inflation?

Small inflation, probably 2 to 4 percent, may not destabilize an economy. In short, it can even
boost economic growth. But when it comes to deflation, the reverse is the case. As prices fall
following a recession or economic downturn, deflation could creep in. Now when this happens,
interest rates can only be lowered to zero percent, and economic crisis may further deepen.
Demand for goods and services would reduce, the unemployment rate would increase, increase in
debt defaulters, and there will be a financial meltdown. Also, inflation could be dangerous too. But
experts fear deflation more than inflation for numerous reasons. One is that falling prices will
lower consumer spending, which would cripple economic growth.

So, these are the reasons deflation is worse than inflation. At least, with a little inflation, the
economy can still thrive. But having that same percentage of deflation could be bad news for the
economy. Anyway, let’s look at other valuable information about inflation and deflation to gain
more knowledge.

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 5.2.2. Comparison Chart:
BASIS FOR
INFLATION DEFLATION
COMPARISON

Meaning When the value of money decreases in Deflation is a situation, when the
the international market, then this value of money increases in the
situation is termed as inflation. international market.

Effects Increase in the general price level Decrease in the general price level

National income Does not declines Declines

Gold prices Falls Rises

Classification Demand pull inflation, cost push Debt deflation, money supply side
inflation, stagflation and deflation. deflation, credit deflation.

Good for Producers Consumers

Consequences Unequal distribution of income. Rise in the level of unemployment

Which is evil? A little bit of inflation is a symbol of Deflation is not good for an economy.
economic growth of the country.

5.2.3. Comparison between Inflation and Deflation!

Of the two—inflation and deflation—which is better than the other.

Of course, both are equally bad in their effects on the society. But inflation is the lesser evil. As
pointed out by Keynes, “Inflation is unjust, deflation is inexpedient. Of the two deflations is worse.
Inflation brings about rising prices and redistribution of income in favour of the better-off classes.

On the other hand, deflation leads to fall in output, employment and income. Of all the evils in a

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capitalist society, unemployment leading to poverty is the worst. We discuss below why Keynes

regarded inflation as unjust and deflation inexpedient.

Inflation is unjust because it widens the gulf between the rich and the poor. It makes the rich richer
at the cost of the poor. On the other hand, the poor are made poorer. The poor and low income

classes suffer because their wages and salaries do not rise to the extent prices rise.

It becomes difficult for them to make both ends meet with rising prices of consumer goods. On the

other hand, businessmen, traders, industrialists, real estate holders, speculators, etc. gain because

their profits and incomes increase much more than the rise in prices. So they are not affected by
the fall in purchasing power when prices are rising. Thus it leads to inequalities of income and

wealth.

When the government resorts to deficit financing to meet its rising expenditure during inflationary
pressures, it increases the demand for goods and services. This deprives the people of the use of

essential goods, thereby creating shortages and hardships for the common man.

Again, inflation is unjust because persons who save are losers in the long run. When prices are

rising, the value of money is falling. Since savers are mostly the low and middle income groups

who save for a variety of reasons, they are the losers. Their savings lying in deposits are reduced

automatically in real terms as inflationary pressures increase.

Inflation is unjust because it is socially harmful. People are lured to amass wealth by unscrupulous

means. They, therefore, resort to hoarding, black-marketing, adulteration, manufacture of sub-

standard commodities, speculation, etc. Corruption spreads in every walk of life. All this reduces

the efficiency of the economy.

Deflation, on the other hand, is inexpedient because it reduces national income, output and
employment. While inflation takes away half the bread of the poor, deflation impoverishes them

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by taking away the whole of it. Deflation leads to mass unemployment because fall in production,

prices and profits force producers and businessmen to close down their enterprises.

Deflation is also inexpedient because falling prices lead to depression. All economic activities are
stagnant. Factories are locked out. Trade and business are at a standstill. There is glut of

commodities in all types of markets for goods and services. Even a bumper agricultural crop brings
poverty to the peasantry. It is a situation of poverty in the midst of plenty.

Again, once the downward movement of prices begins, the economy plunges into a depression.

But the downward movement of the economy is much faster as compared to the upward movement
in a cycle. This makes depression of a much longer period. Consequently, people suffer a lot and

the economy also remains in a state of stagnation for long.

It is on these grounds that inflation is unjust and deflation is inexpedient. Keynes pointed out that,
“it is not necessary that we weigh one evil against the other. It is easier to agree that both are evils

to be shunned.” Still he preferred inflation as the lesser of the two evils.

This is because inflation increases national output, employment and income, whereas deflation

reduces national income and brings the economy backward to a state of depression. Again inflation

is better than deflation because when it occurs the economy is already in a situation of full

employment. On the other hand, there is always unemployment under deflation.

And unemployment leading to poverty are the two scourges of mankind. Again inflation is a lesser

evil than deflation. It redistributes income and wealth in favour of the rich. But deflation is a greater
evil. Though it redistributes income in favour of the low income groups, yet it fails to benefit them

because they are unemployed and have little income during deflation.

5.3. What is the current CRR & SLR ratio?

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New Policy Rates by RBI in Indian Banking (as on Apr 07, 2021):

• SLR Rate : 18.00%

• CRR : 3.50%
• MSF : 4.25%
• Repo Rate : 4.00%
• Reverse Repo Rate : 3.35%
• Bank Rate : 4.25%

New Lending/ Deposit Rates By RBI (as on Apr 07, 2021):

• Base Rate : 7.40% - 8.80%

• MCLR (Overnight) : 6.55% - 7.05%
• Savings Deposit Rate : 2.70% - 3.00%
• Term Deposit Rate > 1 Year : 4.90% - 5.50%

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5.3.3. Are this ratios appropriate for current condition of the country?

Monetary Policy formulated by the Reserve Bank of India in 2020 related to money matters of the
country. The policy also takes into account the distribution of credit among users as well as the
rate of interest on borrowing and lending. Since India is a developing country, the monetary policy
is significant in the promotion of economic growth. The monetary policy in India is formulated by
the Reserve Bank of India and relates to the monetary matters of the country. The policy involves
measures taken to control inflation, regulate supply of money and cost of credit in the economy.
The various instruments of monetary policy include variation in bank rates, other interest rates,
supply of currency, etc.

On 7th April 2021, RBI kept the Repo Rate unchanged at 4.00% and reverse repo rate at 3.35%.
In addition to that, the Marginal Standing facility rate and the bank rate stands at 4.25%. This has
been done to limit the damage caused to the economy by the second wave of Covid-19.

5.3.3.1. Key highlights of RBI monetary policy as announced on 7th April 2021, are:

• RBI keeps Repo Rate unchanged at 4.00%.

• Reverse repo rate also remains unchanged at 3.35%.
• CRR will remain 3.00%.
• MSF & Bank Rate remains unchanged at 4.25%.
• Projection for CPI Inflation has been revised to 5.1%.
• TLTRO scheme is being extended by 6 months, up to September 30, 2021 this will help in
maintaining liquidity.
• Real GDP growth for FY22 projected at 10.5%.
• RBI is indirectly expanding liquidity. It will be ensured the borrowing of Rs 22 lakh crore
by the Centre, states in FY22.
• NEFT, RTGS facility to be extended beyond banks.

The Reserve Bank of India (RBI), on Tuesday, kept the key indicative policy rates unchanged
while it cut the gross domestic product (GDP) forecast for the current financial year from 7.3
per cent to 6.5 per cent and raised the inflation forecast from 6.5 per cent to 7 per cent.

However, the RBI cut the Statutory Liquidity Ratio (SLR) by one percentage point from 24
per cent to 23 per cent which is expected to provide liquidity of around Rs.60,000 crore.

“Even as our growth is slowing in line with the rest of the world, our inflation continues to be
high…. the primary focus of monetary policy remains inflation control,” said D. Subbarao,
Governor, RBI, while addressing a press conference after meeting bankers as part of its first
quarter review of the Monetary Policy 2012-13.

In the present circumstances, said Dr. Subbarao, “lowering policy rates will only aggravate
inflationary impulses without necessarily stimulating growth.”

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The RBI left interest rates unchanged for the second straight review. It kept the Repo rate
unchanged at 8 per cent, and the Cash Reserve Ratio (CRR) at 4.75 per cent. Repo rate is the
rate at which banks borrow money from the central bank. CRR is the portion of deposits banks
have to keep with the central bank in cash.

This time around, markets and industry were almost certain that the RBI was unlikely to cut
rates.

The RBI had frontloaded the policy rate reduction in April last with a cut of 50 basis points.
Since then, the rates remained the same.

However, in a move to provide more liquidity in the system, the central bank has reduced the
Statutory Liquidity Ratio (SLR) from 24 per cent to 23 per cent with effect from August 11.
SLR is the amount of liquid assets or securities that commercial banks must maintain as
reserves other than the cash.
Liquidity conditions:
Liquidity conditions play an important role in the transmission of monetary policy signals.
“Although the liquidity situation has eased significantly in the recent period, the reduction of
SLR is expected to ensure that liquidity pressures do not constrain the flow of credit to the
productive sectors of the economy. This will allow banks to shift their portfolio in favour of
the private sector,” said Dr. Subbarao.

The RBI governor said that the monsoon had been deficient and uneven so far.

“This will have an adverse impact on food inflation. He also said that international crude
prices remained elevated, and, on top of that, the rupee depreciation had added to import
prices, putting upward pressure on domestic fuel prices.

“The adjustment in domestic prices of petroleum products to international price changes is

still incomplete. Going forward, the embedded risks of suppressed inflation could also impact
fuel prices in India.”

At current levels of current account and fiscal deficits, the economy faced the “twin deficit”
risk, said Dr. Subbarao. “Financing the fiscal deficit from domestic savings crowds out private
investment, thus lowering growth prospects. This, in turn, deters capital inflows, making it
more difficult to finance the current account deficit. Failure to narrow the twin deficits with

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appropriate policy actions will threaten both macro-economic stability and growth
sustainability.”
5.4.3.2. Key Policy Responses as of April 1, 2021

I. MONETARY POLICY BY RBI IN 2020-21:

Since March 2020, the Reserve Bank of India (RBI) reduced the repo and reverse repo rates by
115 and 155 basis points (bps) to 4.0 and 3.35 percent, respectively, and announced liquidity
measures across three measures comprising Long Term Repo Operations (LTROs), a cash reserve
ratio (CRR) cut of 100 bps, and an increase in marginal standing facility (MSF) to 3 percent of the
Statutory Liquidity Ratio (SLR) (now further extended to September 30, 2021) and open market
operations (including simultaneous purchases and sales of government securities), resulting in
cumulative liquidity injections of 5.9 percent of GDP through September. The RBI has provided
relief to both borrowers and lenders (through end-August) and the Securities and Exchange Board
of India (SEBI) temporarily relaxed the norms related to debt default on rated instruments and
reduced the required average market capitalization of public shareholding and minimum period of
listing. The implementation of the net stable funding ratio and the last stage of the phased-in
implementation of the capital conservation buffers were delayed by six months (on September 29
the delay was extended till April 2021). On April 1, the RBI created a facility to help with state
government's short-term liquidity needs, and relaxed export repatriation limits. Earlier, the RBI
introduced regulatory measures to promote credit flows to the retail sector and micro, small, and
medium enterprises (MSMEs) and provided regulatory forbearance on asset classification of loans
to MSMEs and real estate developers (later extended to loans from NBFCs). CRR maintenance
for all additional retail loans has been exempted, and the priority sector classification for bank
loans to NBFCs has been extended for on-lending for FY 2020/21. During April 17-20, the RBI,
along with additional monetary easing, announced:

(a) a TLTRO-2.0 (funds to be invested in investment grade bonds, commercial paper, and non-
convertible debentures of NBFCs);

(b) special refinance facilities for rural banks, housing finance companies, and small and medium-
sized enterprises;

(c) a temporary reduction of the Liquidity Coverage Ratio (LCR) and restriction on banks from
making dividend payouts;

(d) a standstill on asset classifications during the loan moratorium period with 10 percent
provisioning requirement, and an extension of the time period for resolution timeline of large
accounts under default by 90 days.

Furthermore, state’s Ways and Means Advance (WMA) limits have been increased by 60 percent
and now extended till March 2021. The RBI asked financial institutions to assess the impact on
their asset quality, liquidity, and other parameters from the COVID-19 shock and take immediate
contingency measures. On April 27, the RBI announced a special liquidity facility for mutual funds
(SLF-MF) and a fixed-rate 90-day repo operation for banks exclusively for meeting the liquidity
requirements of mutual funds, along with regulatory easing for liquidity support availed under the

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facility, later (April 30) extended to banks’ own deployed resources; and the SEBI reduced broker
turnover fees and filing fees on offer documents for public issue, rights issue and buyback of
shares. On May 13, the government announced measures targeting businesses:

(i) a collateral-free lending program with 100 percent guarantee,

(ii) subordinate debt for stressed MSMEs with partial guarantee, and
(iii) partial credit guarantee scheme for public sector banks on borrowings of non-bank
financial companies, housing finance companies (HFCs), and micro finance institutions.

The government also announced

(i) a Fund of Funds for equity infusion in MSMEs, and

(ii) a special purpose vehicle (SPV) to purchase short-term debt of the eligible non-bank
financial companies and housing finance companies, fully guaranteed by the
government and managed by a public sector bank.

On May 22, the RBI undertook further regulatory easing, including the increase in the large
exposure limit, relaxation of some of the norms for state government financing, credit support to
the exporters and importers and extension of the tenor of the small business refinancing facilities.
On June 4, the RBI extended the benefit under interest subvention and prompt repayment incentive
schemes for short-term agricultural loans until August 31, 2020. On June 12, the GST council
announced that it would halve the interest rate charged on overdue filings of small businesses. On
June 21, the RBI directed banks to assignment zero percent risk weight on the credit facilities
extended under the emergency credit line guarantee scheme. On August 6, RBI permitted banks
to restructure existing loans to MSMEs classified as ‘standard” (as of March 1, 2020) without a
downgrade in the asset classification. The restructuring of the borrower account is to be
implemented by March 31, 2021. Banks are required to maintain additional provision of five
percent over and above the provision already held by them for accounts restructured. The RBI also
announced a resolution plan for corporate and personal loans that were classified as ‘standard’ as
of March 1, 2020 but were stressed due to COVID-19. Resolution needs to be invoked by end-
December 2020 and the eligible loans continue to be classified as ‘standard’ until the
implementation of the resolution plan. Ten percent provisioning is required following the
implementation of the resolution plan. On August 31, banks are allowed to hold fresh acquisitions
of SLR securities acquired from September 1, 2020 under held-to-maturity up to an overall limit
of 22 per cent through March 31, 2021. On September 22, the Parliament adopted the amendment
to the Indian Bankruptcy Code (IBC), with no insolvency cases until December 25,2020. The
suspension of the IBC was later extended until end-March 2021. On October 9, the RBI announced
that the risk weights for new housing loans sanctioned until March 31, 2022 will not be linked to
the size of the loan, while they will remain linked to the LTV ratios; the maximum single
counterparty exposure limit for retail loans by banks was eased from 5 to 7.5 crore. The RBI
announced OMOs of state government securities on October 16. On-tap TLTROs up to three years
tenor for a total amount of up to ₹1,00,000 crore at a floating rate linked to the policy repo rate
were announced on October 21. The Government extended the Emergency Credit Line Guarantee
Scheme (ECLGS) for MSMEs first till November 30th, 2020, then March 31, 2021, and now till
September 30, 2021, while at the same time relaxing the eligibility criteria. The RBI has extended
the Liquidity Adjustment Facility and the Marginal Standing Facility to the regional rural banks
to improve their liquidity management since December 2020. On January 8, 2021, the RBI

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announced a phased resumption of operations under the revised liquidity management framework,
including variable rate reverse repo auction.

II. FISCALPOLICY MEASURE BY GOVERNMENT OF INDIA IN 2020-21:

India’s fiscal support measures can be divided into two broad categories: (i) above-the-line
measures which include government spending (about 3.2 percent of GDP, of which about 2.2
percent of GDP is expected to fall in the current fiscal year), foregone or deferred revenues (about
0.3 percent of GDP falling due within the current year) and expedited spending (about 0.3 percent
of GDP falling due within the current year); and (ii) below-the-line measures designed to support
businesses and shore up credit provision to several sectors (about 5.2 percent of GDP). In the early
stages of the pandemic response, above-the-line expenditure measures focused primarily on social
protection and healthcare. These include in-kind (food; cooking gas) and cash transfers to lower-
income households (1 percent of GDP); wage support and employment provision to low-wage
workers (0.5 percent of GDP); insurance coverage for workers in the healthcare sector; and
healthcare infrastructure (0.1 percent of GDP). The more recent measures that were announced in
October and November include additional public investment (higher capital expenditure by the
central government and interest-free loans to states, of about 0.2 percent of GDP) and support
schemes targeting certain sectors. The latter includes a Production Linked Incentive scheme
targeting 13 priority sectors and is expected to cost about 0.8 percent of GDP over 5 years, a higher
fertilizer subsidy allocation benefiting the agriculture sector (0.3 percent of GDP) and support for
urban housing construction (0.1 percent of GDP). Several measures to ease the tax compliance
burden across a range of sectors have also been announced, including postponing some tax-filing
and other compliance deadlines, and a reduction in the penalty interest rate for overdue GST
filings. Measures without an immediate direct bearing on the government’s deficit position aim to
provide credit support to businesses (1.9 percent of GDP), poor households, especially migrants
and farmers (1.6 percent of GDP), distressed electricity distribution companies (0.4 percent of
GDP), and targeted support for the agricultural sector (0.7 percent of GDP), as well as some
miscellaneous support measures (about 0.3 percent of GDP). Key elements of the business-support
package are various financial sector measures for micro, small, and medium-sized enterprises and
non-bank financial companies, whereas additional support to farmers will mainly be in the form
of providing concessional credit to farmers, as well as a credit facility for street vendors.
Agricultural sector support is mainly for infrastructure development. On February 1, the central
government budget for FY2021/22 was tabled in the parliament. The budget expanded spending
on health and wellbeing, including a provision for the country’s COVID-19 vaccination program
(350 billion Rs).

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5.5.Which trade cycle is prevailing in India at present?

First Quarter 2021

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The Economic Survey has stated that there should be a revival in growth in the second half of

2019-20.

The explanation for this assumption is that up-cycles in India’s GDP growth take 13 quarters,
while down-cycles take nine quarters. The survey points that since 2011-12, India’s GDP growth

hit its lowest quarterly GDP growth in the fourth quarter of 2012-13, at 4 per cent. There was a

gradual growth thereafter and, after 13 quarters, the economic growth increased to 9.4 per cent by
the first quarter of 2016-17.

After another 13 quarters, the economic growth has once again skid to 4.5 per cent in the second

quarter of 2019-20. This shows that the length of a typical business cycle in India is 13 quarters
and growth can bottom at these levels.

A study on business cycle measurement since 1996 by Pandey et al in 2018 indicates that when

GDP is accelerating, the business cycle on average is 12 quarters but, in a deceleration phase, the
business cycle on an average falls to nine quarters.

"A resurgence in growth is, accordingly, expected to begin in H2 of 2019-20," the survey states.

This surmise ties in with the study of financial cycles in the RBI working paper, ‘Does financial

cycle exist in India?’ by Harendra Behera and Saurabh Sharma. With the help of quarterly data on
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credit, equity prices, house prices and real exchange rate, the paper indicated that the trough of the

financial cycle that has been contracting since the 2008 peak is being formed now.

While the growth could remain bleak for a few more quarters, it could plateau here for a few
quarters, after which, there could be a recovery.

Much of the recent work on financial cycles has been focused on developed economies. What
about India? A new working paper by two Reserve Bank of India (RBI) economists shows that
there is a financial cycle in India as well. Harendra Behera and Saurabh Sharma build their case
using quarterly data on credit, equity prices, house prices and the real exchange rate from the first
quarter of 1960 to the fourth quarter of 2018.

They have first looked at the cycles in the individual variables, and then combined them to chart
out a financial cycle for India. Some of their findings are very similar to what Borio found in his
2012 analysis of developed economies. The length of the Indian financial cycle is greater than the
length of the business cycle. The expansionary phase of the financial cycle offers an early warning
signal about rising banking stress, as well as an economic slowdown in the future.

There are three other important findings. The financial cycle has become more prominent after the
financial liberalization of the 1990s. The amplitude of the Indian financial cycle is much larger in
the expansion phase than in the contraction phase. The role of house prices in the financial cycle
has increased since the mid-2000s. The bottom line: India has a financial cycle that stretches over
12 years on average, compared to the average business cycle of five years.

. Monetary and Fiscal policies with their implications on economy:

Let us start by referencing Aggregate Demand as a measure in the economy. Aggregate

demand (AD) is a macroeconomic concept representing the total demand for goods and services
in an economy. This value is often used as a measure of economic well-being or growth.

Both fiscal policy and monetary policy can impact aggregate demand because they can influence
the factors used to calculate it: consumer spending on goods and services, investment spending on
business capital goods, government spending on public goods and services, exports, and imports.

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 • Fiscal policy affects aggregate demand through changes in government spending and
taxation. Those factors influence employment and household income, which then impact
consumer spending and investment.

• Monetary policy impacts the money supply in an economy, which influences interest rates
and the inflation rate. It also impacts business expansion, net exports, employment, the cost
of debt, and the relative cost of consumption versus saving—all of which directly or
indirectly impact aggregate demand.

The aims of fiscal and monetary policy are similar. They could both be used to:

• Maintain positive economic growth (close to long-run trend rate of 2.5%)

• Aim for full employment
• Keep inflation low (inflation target of 2%)

The principal aim of fiscal and monetary policy is to reduce cyclical fluctuations in the economic
cycle. In recent years, governments have often relied on monetary policy to target low inflation.
However, in recessions, there are strong arguments for also using fiscal policy to achieve economic
recovery.

2.C.1.1. Fiscal policy involves changing government spending and taxation. It involves a shift
in the governments budget position. e.g. Expansionary fiscal policy involves tax cuts, higher
government spending and a bigger budget deficit. Government spending is a component of AD.

2.C.1.2. Monetary policy involves influencing the demand and supply of money, primarily
through the use of interest rates.

Monetary policy can also involve unorthodox policies such as open market operations and
quantitative easing.

Monetary policy is usually carried out by an independent Central Bank

2.C.2. Overview of monetary and fiscal policy

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Reducing Inflation

• To reduce inflationary pressures, the government or monetary authorities will try to reduce
the growth of AD.
• If we use fiscal policy, it will involve higher taxes, lower spending. The advantage of using
fiscal policy is that it will help to reduce the budget deficit.
• However, It can be difficult to cut public spending (or increases taxes) for political reasons.
This is why most economies have relied on monetary policy for the ‘fine-tuning’ of the
economy.

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 CLASS ACTIVITIES

• CLASS ASSIGNMENT 1: Discussion on Fiscal and Monetary Policy in India with

News Paper Article and Report on BUDGET 2022 and RBI Updated regulations and
revised rates and its impact on the Economy

• CASE STUDY 1: MONETARY POLICY

Predicting Federal Reserve Actions in an Era of Uncertainty
POLICY CONTEXT
In response to the 2008-09 financial crisis and subsequent recession, the Federal Reserve cut short-
term interest rates effectively to zero and lowered long-term rates through multiple large-scale
asset purchase programs (i.e., “quantitative easing”=QE). This unprecedented use of monetary
policy eased financial stress and improved rate-sensitive sectors of the economy. However, it also
created uncertainty around the effects of both QE and the Fed’s exit strategy.
Keybridge is an economic and public policy consulting firm. Keybridge’s clients across all sectors
have become increasingly concerned about the implications of Fed policies for their businesses.
Over the past several years, many questions have arisen. Would quantitative easing result in rapid
inflation? Would massive injections of liquidity create financial imbalances? When will the Fed
begin to unwind quantitative easing? Will the inevitable rise of interest rates stifle the housing
market recovery?
APPROACH
Keybridge’s economists provide a number of services to clients concerned with monetary policy
and how it might affect their businesses. Through regular correspondence, Keybridge has delivered
timely and insightful analysis and guidance to clients.
(1) Tracking the Federal Reserve: Keybridge closely follows the Fed’s public statements, meeting
minutes, and policy actions. Based on more than 30 years of experience, Keybridge’s economists
use their knowledge of the Fed’s inner workings and the overall macroeconomic environment to
help clients anticipate the Fed’s next moves.

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(2) Economic and Inflation Momentum Monitors: Keybridge publishes monthly leading
indicators on U.S. economic growth and inflation that provide clients with a 3 to 6 month outlook.
These tools help anticipate the economic environment the Fed will be operating under in the near
future.

RESULT
Keybridge’s analysis, forecasts, and strategic guidance have helped clients make smarter decisions
and mitigate risks. Global investors have gained greater understanding of the timing and magnitude
of interest rate movements that affect their investment returns. Chief Economists at Fortune 100
companies have garnered new insights that they have used to advise their executives on key
strategic decisions; and trade associations have used Keybridge’s views on monetary policy to help
shape their economic agenda.
Discuss
1. Discuss the case with reference to the importance of monetary policy.
2. What are the measures taken by Keybridge to mitigate the apprehensions regarding the
monetary policy?

• CASE STUDY 2: FISCAL POLICY

Navigating the Fiscal Cliff
POLICY CONTEXT
In late 2012, the U.S. was in the midst of an extended period of intense political partisanship.
Congress was in a stalemate on nearly every issue. In particular, fiscal policy came to a standstill.
By the end of the year, it became clear that Congress would be unable to agree on a budget.
Congress had previously mandated in 2011 that if a deal were unable to be reached, certain
automatic budget cuts and tax increases would be enacted on January 1, 2013. As it became known,
the “fiscal cliff,” included the expiration of the Bush tax cuts, the expiration of the payroll tax
holiday, and spending cuts across most federal agencies. Amidst a fragile economic recovery, such
sudden and substantial fiscal contraction would certainly have a significant impact on economic
growth. Clients were deeply concerned about whether the U.S. would indeed “go over the fiscal
cliff”, and if so, what it would mean for the U.S. economy.

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APPROACH
Keybridge is an economic and public policy consulting firm. Keybridge’s economists provide a
number of services to clients concerned with fiscal policy and how it might impact the U.S.
economy and their business. Through regular correspondence, Keybridge has delivered timely and
insightful analysis and guidance to clients.
(1) Political Analysis: Keybridge closely follows the latest movements in the Administration and
Congress to gauge the overall political climate, appetite for compromise, and balance of power on
fiscal policy issues. Based on more than 30 years of “inside the Beltway” experience, Keybridge’s
economists and policy experts sort through political theatre and noise to determine the range and
likelihood of political outcomes.
(2) Webinars: Shortly after the November 2012 election, Keybridge hosted a webinar to discuss
the election results and implications for fiscal policy. It identified the key political and economic
themes, handicapped a range of plausible fiscal policy scenarios, and discussed their potential
economic impacts.
RESULT
Keybridge’s advice on fiscal policy issues helped elucidate Washington politics and fiscal policy
outcomes for clients, which in turn helped them make more informed and strategic business
decisions. Global investors have gained greater understanding of the timing and magnitude of
fiscal policy actions (or inaction).
Questions:
1. Discuss the case with reference to the importance of fiscal policy.
2. What are the measures taken by Keybridge to mitigate the apprehensions regarding the
fiscal policy?

• RESEARCH PAPER 1: Fiscal Policy and Macroecomonic Stability in South Asian

Countries

https://www.researchgate.net/profile/Kashif-Munir-
7/publication/333775131_Fiscal_Policy_and_Macroecomonic_Stability_in_South_Asian_Countries/
links/5d480b1092851cd046a274ff/Fiscal-Policy-and-Macroecomonic-Stability-in-South-Asian-
Countries.pdf

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• RESEARCH PAPER 2: Fiscal policy, public debt and monetary policy in EMEs: an
overview
https://www.bis.org/publ/bppdf/bispap67.pdf#page=5

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 SAMPLE QUESTIONS FORMULTIPLE CHOICE QUESTIONS ON MOODLE

An increase in the marginal propensity to consume (MPC)

A. raises the value of the multiplier.
B. has no impact on the value of the multiplier.
C. rarely occurs because the MPC is set by congressional legislation.
D. lowers the value of the multiplier.

Which of the following would not cause a shift in the long-run aggregate supply curve?

A. All of these answers shift the long-run aggregate supply curve.

B. An increase in the available capital
C. An increase in the available labour
D. An increase in the available technology
E. An increase in price expectations

Stagflation occurs when the economy experiences

A. rising prices and rising output.

B. rising prices and falling output.
C. falling prices and falling output.
D. falling prices and rising output.

The initial effect of an increase in the money supply is to

A. increase the interest rate.

B. increase the price level.
C. decrease the price level.
D. decrease the interest rate.

A reasonable measure of the standard of living in a country is

A. real GDP per person.

B. nominal GDP per person.
C. real GDP.
D. the growth rate of nominal GDP per person.
E. nominal GDP.

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