UNIT V NATIANAL INCOME ANALYSIS

National income analysis – Theories of income – output and employment –

classical – Keynesian theory – theory of trade cycles – concept and causes of
trade cycles- measures to control trade cycles – macro-economic policy –
monetary and fiscal – theories of inflation – causes and control of inflation

DEFINITION OF NATIONAL INCOME

The definitions of national income can be grouped into two classes: One, the
traditional definitions advanced by Marshall, Pigou and Fisher; and two, modern
definitions.

The Marshallian Definition:

According to Marshall: “The labour and capital of a country acting on its natural
resources produce annually a certain net aggregate of commodities, material and
immaterial including services of all kinds. This is the true net annual income or
revenue of the country or national dividend.” In this definition, the word ‘net’ refers to
deductions from the gross national income in respect of depreciation and wearing
out of machines. And to this, must be added income from abroad.

It’s Defects:
Though the definition advanced by Marshall is simple and comprehensive, yet it
suffers from a number of limitations. First, in the present day world, so varied and
numerous are the goods and services produced that it is very difficult to have a
correct estimation of them.

Consequently, the national income cannot be calculated correctly. Second, there

always exists the fear of the mistake of double counting, and hence the national
income cannot be correctly estimated. Double counting means that a particular
commodity or service like raw material or labour, etc. might get included in the
national income twice or more than twice.

For example, a peasant sells wheat worth K.20000 to a flour mill which sells wheat
flour to the wholesaler and the wholesaler sells it to the retailer who, in turn, sells it
to the customers. If each time, this wheat or its flour is taken into consideration, it
will work out to K.80000, whereas, in actuality, there is only an increase of K.20000 in
the national income.

Third, it is again not possible to have a correct estimation of national income

because many of the commodities produced are not marketed and the producer
either keeps the produce for self-consumption or exchanges it for other
commodities. It generally happens in an agriculture- oriented country like Malawi or
India. Thus the volume of national income is underestimated.
Modern Definitions:
From the modern point of view, Simon Kuznets has defined national income as “the
net output of commodities and services flowing during the year from the country’s
productive system in the hands of the ultimate consumers.”

On the other hand, in one of the reports of United Nations, national income has been
defined on the basis of the systems of estimating national income, as net national
product, as addition to the shares of different factors, and as net national
expenditure in a country in a year’s time. In practice, while estimating national
income, any of these three definitions may be adopted, because the same national
income would be derived, if different items were correctly included in the estimate.

IMPORTANCE OF NATIONAL INCOME ANALYSIS

1. For the Economy:
National income data are of great importance for the economy of a country. These
days the national income data are regarded as accounts of the economy, which are
known as social accounts.

These refer to net national income and net national expenditure, which ultimately
equal each other. Social accounts tell us how the aggregates of a nation’s income,
output and product result from the income of different individuals, products of
industries and transactions of international trade.

Their main constituents are inter-related and each particular account can be used to
verify the correctness of any other account Based very much on social accounts.

2. National Policies:
National income data form the basis of national policies such as employment policy
because these figures enable us to know the direction in which the industrial output,
investment and savings’ etc. change, and proper measures can be adopted to bring
the economy to the right path.

3. Economic Planning:
In the present age of planning, the national data are of great importance. For
economic planning, it is essential that the data pertaining to a country’s gross
income, output, saving and consumption from different sources should be available.

Without these, planning is not possible. Similarly, the economists propound short-run
as well long-run economic models or long-run investment models in which the
national income data are very widely used.

4. Economic Models:
Economists build short-run and long-run economic models in which the national
income data are widely used.

5. For Research:
The national income data are also made use of by the research scholars of
economics, they make use of the various data of the country’s input, output, income,
saving, consumption, investment employment, etc., which are obtained from social
accounts.

6. Per-Capita Income:
National income data are significant for a country’s per capita income which reflects
the economic welfare of the country. The higher the per capita income, the higher the
economic welfare and vice versa.

7. Distribution of Income:
National income statistics enable us to know about the distribution of income in the
country. From the data pertaining to wages, rent, interest and profits we learn of the
disparities in the incomes of different sections of the society.

Similarly, the regional distribution of income is revealed it is only on the basis of

these that the government can adopt measures to remove the inequalities in income
distribution and to restore regional equilibrium. With a view to removing these
personal and regional disequilibria, the decisions to levy more taxes and increase
public expenditure also rest on national income statistics.

TWO IMPORTANT THEORIES OF INCOME AND EMPLOYMENT | MICRO

ECONOMICS
Two important theories of income and employments are: 1. Classical Theory of
Income and Employment, 2. Keynesian Theory of Income and Employment!

1. CLASSICAL THEORY OF INCOME AND EMPLOYMENT:

The theory is ascribed to early Classical economists like Adam Smith, Ricardo, and
Malthus and neo-classical like Marshall, Pigou and Robbins.

They believe that:

(i) An economy, as a whole, always functions at the level of full employment:
Full employment of labour and other resources. Full employment level of output of
goods and services is the largest output that the economy is capable of producing
when all its resources are fully employed. Full employment is regarded as a normal
situation, yet there could be a temporary unemployment.

If at all there is unemployment, it must be a temporary one and it will be cured

automatically through free play of economic forces. Classical believe that aggregate
supply would always be at full employment level which is based on two assumptions,
namely Say’s Law of Market and Wage-price flexibility as explained below.

(ii) Supply creates its own demand:

Classical theory of employment is based on ‘Say’s Law of market’ which states that
‘supply creates its own demand’. This implies that supply creates a matching
demand for it with the result that the whole of output is sold out. So, there is no
deficiency in aggregate demand and hence no possibility of over-production and
unemployment. Thus, equilibrium level of income and employment is established
only at the level of full employment.

(iii) Flexible system of prices, interest rates and wages:

(a) Price mechanism automatically brings equilibrium between demand and supply
in the market, (b) Flexibility of interest rates brings about equality between savings
and investment, (c) Flexibility of wage rates brings about full employment
equilibrium. As a result, the aggregate supply is always at full employment level of
output.

2. KEYNESIAN THEORY OF INCOME AND EMPLOYMENT:

(a) Criticism against Classical Theory:
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.

(b) 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.

Salient points of his theory are:

(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 Demand increases, level of output will go up by
increasing employment 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.

MEANING OF TRADE CYCLE:

A trade cycle refers to fluctuations in economic activities specially in employment,
output and income, prices, profits etc. It has been defined differently by different
economists. According to Mitchell, “Business cycles are of fluctuations in the
economic activities of organized communities. The adjective ‘business’ restricts the
concept of fluctuations in activities which are systematically conducted on
commercial basis. The noun ‘cycle’ bars out fluctuations which do not occur with a
measure of regularity”.

According to Keynes, “A trade cycle is composed of periods of good trade

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

Features of a Trade Cycle:

1. A business cycle is synchronic. When cyclical fluctuations start in one sector it
spreads to other sectors.

2. In a trade cycle, a period of prosperity is followed by a period of depression. Hence

trade cycle is a wave like movement.
3. Business cycle is recurrent and rhythmic; prosperity is followed by depression and
vice versa.

4. A trade cycle is cumulative and self-reinforcing. Each phase feeds on itself and
creates further movement in the same direction.

5. A trade cycle is asymmetrical. The prosperity phase is slow and gradual and the
phase of depression is rapid.

6. The business cycle is not periodical. Some trade cycles last for three or four years,
while others last for six or eight or even more years.

7. The impact of a trade cycle is differential. It affects different industries in different

ways.

8. A trade cycle is international in character. Through international trade, booms and

depressions in one country are passed to other countries.

Phases of a Trade Cycle:

Generally, a trade cycle is composed of four phases – depression, recovery,
prosperity and recession.

Depression:
During depression, the level of economic activity is extremely low. Real income
production, employment, prices, profit etc. are falling. There are idle resources. Price
is low leading to a fall in profit, interest and wages. All the sections of the people
suffer. During this phase, there will be pessimism leading to closing down of
business firms.

Recovery:
Recovery denotes the turning point of business cycle from depression to prosperity.
In this phase, there is a slow rise in output, employment, income and price. Demand
for commodities go up. There is increase in investment, bank loans and advances.
Pessimism gives way to optimism. The process of revival and recovery becomes
cumulative and leads to prosperity.

Prosperity:

It is a state of affairs in which real income and employment are high. There are no
idle resources. There is no wastage of materials. There is rise in wages, prices,
profits and interest. Demand for bank loans increases. There is optimism
everywhere. There is a general uptrend in business community.

However, these boom conditions cannot last long because the forces of expansion
are very weak. There are bottlenecks and shortages. There may be scarcity of labour,
raw material and other factors of production. Banks may stop their loans. These
conditions lead to recession.

Recession:

When the entrepreneurs realize their mistakes, they reduce investment, employment
and production. Then fall in employment leads to fall in income, expenditure, prices
and profits. Optimism gives way to pessimism. Banks reduce their loans and
advances. Business expansion stops. This state of recession ends in depression.

THEORIES OF TRADE CYCLE:

Many theories have been put forward from time to time to explain the phenomenon
of trade cycles. These theories can be classified into non-monetary and monetary
theories.

(A) NON-MONETARY THEORIES OF TRADE CYCLE:

1. Sunspot Theory or Climatic Theory:
It is the oldest theory of trade cycle. It is associated with W.S. Jevons and later on
developed by H. C. Moore. According to this theory, the spot that appears on the sun
influences the climatic conditions. When the spot appears, it will affect rainfall and
hence agricultural crops.

When there is crop failure, that will result in depression. On the other hand, if the spot
appears on the sun, rainfall is good leading to prosperity. Thus, the variations in
climate are so regular that depression is followed by prosperity.

However, this theory is not accepted today. Trade cycle is a complex phenomenon
and it cannot be associated with climatic conditions. If this theory is correct, then
industrialised countries should be free from cyclical fluctuations. But it is the
advanced, industrialised countries which are affected by trade cycles.

2. Psychological Theory:
This theory was developed by A.C. Pigou. He emphasized the role of psychological
factor in the generation of trade cycles. According to Pigou, the main cause for trade
cycle is optimism and pessimism among business people and bankers. During the
period of good trade, entrepreneurs become optimistic which would lead to increase
in production.

The feeling of optimism is spread to others. Hence investments are increased

beyond limits and there is over production, which results in losses. Entrepreneurs
become pessimistic and reduce their investment and production. Thus, fluctuations
are due to optimism leading to prosperity and pessimism resulting depression.
Though there is an element of truth in this theory, this theory is unable to explain the
occurrence of boom and starting of revival. Further this theory fails to explain the
periodicity of trade cycle.

3. Overinvestment Theory:
Arthur Spiethoff and D.H. Robertson have developed the over investment theory. It is
based on Say’s law of markets. It believes that over production in one sector leads to
over production in other sectors. Suppose, there is over production and excess
supply in one sector, that will result in fall in price and income of the people
employed in that sector. Fall in income will lead to a decline in demand for goods
and services produced by other sectors. This will create over production in other
sectors.

Spiethoff has pointed out that over investment is the cause for trade cycle. Over
investment is due to indivisibility of investment and excess supply of bank credit. He
gives the example of a railway company which lays down one more track to avoid
traffic congestion. But this may result in excess capacity because the additional
traffic may not be sufficient to utilise the second track fully.

Over investment and overproduction are encouraged by monetary factors. If the

banking system places more money in the hands of entrepreneurs, prices will
increase. The rise in prices may induce the entrepreneurs to increase their
investments leading to over-investment. Thus Prof. Robertson has successfully
combined real and monetary factors to explain business cycle.

This theory is realistic in the sense that it considers over investment as the cause of
trade cycle. But it has failed to explain revival.

4. Over-Saving or Under Consumption Theory:

This theory is the oldest explanation of the cyclical fluctuations. This theory has
been formulated by Malthus, Marx and Hobson. According to this theory, depression
is due to over-saving. In the modern society, there is great inequalities of income.
Rich people have large income but their marginal propensity to consume is less.

Hence they save and invest which results in an increase in the volume of goods. This
causes a general glut in the market. At the same time, as majority of the people are
poor, they have low propensity to consume. Therefore, consumption will not increase.
Increase in the supply of goods and decline in the demand create under
consumption and hence over production.

This theory is not free from criticism. This theory explains only the turning point from
prosperity to depression. It does not say anything about recovery. This theory
assumes that the amount saved would be automatically invested. But this is not true.
It pays too much attention on saving and too little on others.
5. Keynes’ Theory of Trade Cycles:
Keynes doesn’t develop a complete and pure theory of trade cycles. According to
Keynes, effective demand is composed of consumption and investment expenditure.
It is effective demand which determines the level of income and employment.

Therefore, changes in total expenditure i.e., consumption and investment

expenditures, affect effective demand and this will bring about fluctuation in
economic activity. Keynes believes that consumption expenditure is stable and it is
the fluctuation in investment expenditure which is responsible for changes in output,
income and employment.

Investment depends on rate of interest and marginal efficiency of capital. Since rate
of interest is more or less stable, marginal efficiency of capital determines
investment. Marginal efficiency of capital depends on two factors – prospective
yield and supply price of the capital asset. An increase in MEC will create more
employment, output and income leading to prosperity. On the other hand, a decline in
MEC leads to unemployment and fall in income and output. It results in depression.

During the period of expansion businessmen are optimistic. MEC is rapidly

increasing and rate of interest is sticky. So entrepreneurs undertake new investment.
The process of expansion goes on till the boom is reached. As the process of
expansion continues, cost of production increases, due to scarcity of factors of
production. This will lead to a fall in MEC. Further, price of the product falls due to
abundant supply leading to a decline in profits.

This leads to depression. As time passes, existing machinery becomes worn out and
has to be replaced. Surplus stocks of goods are exhausted. As there is a fall in price
of raw-materials and equipment, costs fall. Wages also go down. MEC increases
leading to recovery. Keynes states that, “Trade cycle can be described and analyzed
in terms of the fluctuations of the marginal efficiency of capital relatively to the rate
of interest”.

The merit of Keynes’ theory lies in explaining the turning points-the lower and upper
turning points of a trade cycle. The earlier economists considered the changes in the
amount of credit given by banking system to be responsible for cyclical fluctuations.
But for Keynes, the change in consumption function with its effect on MEC is
responsible for trade cycle. Keynes, thus, has given a satisfactory explanation of the
turning points of the trade cycle, “Keynes consumption function filled a serious gap
and corrected a serious error in the previous theory of the business cycle”. (Metzler).

Critics have pointed out the weakness of Keynes’ theory. Firstly, according to Keynes
the main cause for trade cycle is the fluctuations in MEC. But the term marginal
efficiency of capital is vague. MEC depends on the expectations of the entrepreneur
about future. In this sense, it is similar to that of Pigou’s psychological theory. He
has ignored real factors.

Secondly, Keynes assumes that rate of interest is stable. But rate of interest does
play an important role in decision making process of entrepreneurs.

Thirdly, Keynes does not explain periodicity of trade cycle. In a period of recession
and depression, according to Keynes, rate of interest should be high due to strong
liquidity preference. But, during this period, rate of interest is very low. Similarly
during boom, rate of interest should be low because of weak liquidity preference; but
actually the rate of interest is high.

6. Schumpeter’s Innovation Theory:

Joseph A. Schumpeter has developed innovation theory of trade cycles. An
innovation includes the discovery of a new product, opening of a new market,
reorganization of an industry and development of a new method of production.
These innovations may reduce the cost of production and may shift the demand
curve. Thus innovations may bring about changes in economic conditions.

Suppose, at the full employment level, an innovation in the form of a new product
has been introduced. Innovation is financed by bank loans. As there is full
employment already, factors of production have to be withdrawn from others to
manufacture the new product. Hence, due to competition for factors of production
costs may go up, leading to an increase in price.

When the new product becomes successful, other entrepreneurs will also produce
similar products. This will result in cumulative expansion and prosperity. When the
innovation is adopted by many, supernormal profits will be competed away. Firms
incurring losses will go out of business. Employment, output and income fall
resulting in depression.

Schumpeter’s theory has been criticised on the following grounds.

Firstly, Schumpter’s theory is based on two assumptions viz., full employment and
that innovation is being financed by banks. But full employment is an unrealistic
assumption, as no country in the world has achieved full employment. Further
innovation is usually financed by the promoters and not by banks. Secondly,
innovation is not the only cause of business cycle. There are many other causes
which have not been analysed by Schumpter.

(B) MONETARY THEORIES OF TRADE CYCLES:

1. Over-Investment Theory:
Prof. Von Hayek in his books on “Monetary Theory and Trade Cycle” and “Prices and
Production” has developed a theory of trade cycle. He has distinguished between
equilibrium or natural rate of interest and market rate of interest. Market rate of
interest is one at which demand for and supply of money are equal.

Equilibrium rate of interest is one at which savings are equal to investment. If both
equilibrium rate of interest and market rate of interest are equal, there will be
stability in the economy. If equilibrium rate of interest is higher than market rate of
interest there will be prosperity and vice versa.

For instance, if the market rate of interest is lower than equilibrium rate of interest
due to increase in money supply, investment will go up. The demand for capital
goods will increase leading to a rise in price of these goods. As a result, there will be
a diversion of resources from consumption goods industries to capital goods
industries. Employment and income of the factors of production in capital goods
industries will increase.

This will increase the demand for consumption goods. There will be competition for
factors of production between capital goods and consumption good industries.
Factor prices go up. Cost of production increases. At this time, banks will decide to
reduce credit expansion. This will lead to rise in market rate of interest above the
equilibrium rate of interest. Investment will fall; production declines leading to
depression.

Hayek’s theory has certain weaknesses:

1. It is not easy to transfer resources from capital goods industries to consumer
goods industries and vice versa.

2. This theory does not explain all the phases of trade cycle.

3. It gives too much importance to rate of interest in determining investment. It has

neglected other factors determining investment.

4. Hayek has suggested that the volume of money supply should be kept neutral to
solve the problem of cyclical fluctuations. But this concept of neutrality of money is
based on old quantity theory of money which has lost its validity.

2. Hawtrey’s Monetary Theory:

Prof. Hawtrey considers trade cycle to be a purely monetary phenomenon. According
to him non-monetary factors like wars, strike, floods, drought may cause only
temporary depression. Hawtrey believes that expansion and contraction of money
are the basic causes of trade cycle. Money supply changes due to changes in rates
of interest.

When rate of interest is reduced by banks, entrepreneurs will borrow more and invest.
This causes an increase in money supply and rise in price leading to expansion. On
the other hand, an increase in the rate of interest will lead to reduction in borrowing,
investment, prices and business activity and hence depression.

Hawtrey believes that trade cycle is nothing but small scale replica of inflation and
deflation. An increase in money supply will lead to boom and vice versa, a decrease
in money supply will result in depression.

Banks will give more loans to traders and merchants by lowering the rate of interest.
Merchants place more orders which induce the entrepreneurs to increase production
by employing more labourers. This results in increase in employment and income
leading to an increase in demand for goods. Thus the phase of expansion starts.

Business expands; factors of production are fully employed; price increases further,
resulting in boom conditions. At this time, the banks call off loans from the
borrowers. In order to repay the loans, the borrowers sell their stocks. This sudden
disposal of goods leads to fall in prices and liquidation of marginal firms. Banks will
further contract credit.

Thus the period of contraction starts making the producers reduce their output. The
process of contraction becomes cumulative leading to depression. When the
economy is at the level of depression, banks have excess reserves. Therefore, banks
will lend at a low rate of interest which makes the entrepreneurs to borrow more.
Thus revival starts, becomes cumulative and leads to boom.

Hawtrey’s theory has been criticised on many grounds:

1. Hawtrey’s theory is considered to be an incomplete theory as it does not take into
account the non-monetary factors which cause trade cycles.

2. It is wrong to say that banks alone cause business cycle. Credit expansion and
contraction do not lead to boom and depression. But they are accentuated by bank
credit.

3. The theory exaggerates the importance of bank credit as a means of financing

development. In recent years, all firms resort to plough back of profits for expansion.

4. Mere contraction of bank credit will not lead to depression if marginal efficiency of
capital is high. Businessmen will undertake investment in-spite of high rate of
interest if they feel that the future prospects are bright.

5. Rate of interest does not determine the level of borrowing and investment. A high
rate of interest will not prevent the people to borrow. Therefore, it may be stated that
banking system cannot originate a trade cycle. Expansion and contraction of credit
may be a supplementary cause but not the main and sole cause of trade cycle
CAUSES OF THE TRADE CYCLE

The business cycle is caused by the forces of supply and demand, the availability
of capital, and expectations about the future. Here's what causes each of the four
phases of the boom and bust cycle.

Expansion:

When consumers are confident, they buy now. They know there will be future income
from better jobs, higher home values and increasing stock prices.  As demand
increases, businesses hire new workers.

The increase in consumer income, further stimulates demand. A little healthy

inflation can trigger demand by spurring shoppers to buy now before prices go up. 

A healthy expansion can suddenly turns into a dangerous peak. It happens when
there's too much money chasing too few goods. It can either cause price inflation or
an asset bubble.

Peak: 

If demand outstrips supply, then the economy can overheat. Investors and
businesses compete to outperform the market, taking on more risk to gain some
extra return. This combination of excess demand, and the creation of risky
derivatives, created the housing bubble in 2005.

You can always recognize a peak by two things: First, the media says that the
expansion will never end. Second, it seems everyone and his brother is making tons
of money from whatever the asset bubble is.

Contraction: 

A contraction causes a recession. Three types of events trigger a contraction.

They are a rapid increase in interest rates, a financial crisis, or runaway inflation. Fear
and panic replace confidence. Investors sell stocks, and buy bonds, gold, and the U.S.
dollar. Consumers lose their jobs, sell their homes, and stop buying anything but
necessities. Businesses lay off workers, and hoard cash.

 Trough: 

Consumers must regain confidence before the economy can enter a new expansion
phase. That often requires intervention with monetary or fiscal policy. In an ideal
world, they work together. That, unfortunately, doesn't occur often enough.

MEASURES TO CONTROL BUSINESS CYCLE OR TRADE CYCLE SYSTEM

Now it is believed that one of the main responsibilities of the government is to

formulate policies and take steps for consistent economic development and control
of fluctuations in business. The government takes fiscal and monetary measures to
achieve desirable changes in the economic activities on aggregate level. When fiscal
and monetary policies are used to control business cycle theses are then called
counter cyclical policies.

1 Fiscal Policy

Fiscal policy refers to all the decisions and measures of the government to change
its taxes and expenditures.

During the boom and inflationary situation, government may increase its taxes and
reduce public expenditures; this creates budget surplus and control inflation. On the
other hand during recession government cuts down its taxes and increases its
expenditures on public works. It creates deficit in budget which help government to
eliminate recession. When there is prosperity without inflation, government usually
keeps its budget balanced which causes no inflation in the economy.

Modern economists think that fiscal policy is the most important and effective for
controlling trade cycles in the economy. This policy is only successful if it is adopted
rationally and according to the needs of the economy.

 2 Monetary Policies

 Monetary policy refers to all the measure of central bank to change the supply of
money. The excess supply of money is a cause of inflation in the economy where as
insufficient supply of money cause deflation. A careful management of credit and
interest is very helpful ‘in controlling trade cycle in the economy. During the period of
prosperity and inflation, central bank takes measures to reduce the supply of money.
On the contrary in depression increase in supply of money yields desired results.

Monetary policy is very effective in controlling inflation, because it can help in

reducing credit advanced by commercial banks. During the period of recession its
effectiveness is controversial. During depression consumer and business become
more pessimistic and their expectations about future are disappointing, therefore
they are not willing to borrow from banks

3 International Measures

As the business cycles are of international in nature. Whenever a business cycle

appears in a country, due to its trade relations with other countries, these usually
spread to other countries. Therefore, it is necessary to take measures on
international level to control trade cycles. For example, if there is depression in USA
or Japan, the economy of Pakistan and other countries is bound to suffer due to
heavy economic reliance on these two countries. In these circumstances all the
countries should take corrective measures for the revival of the big economies. This
may be done by increasing imports from these countries. Other measure may
include reconsidering the rules and regulation of trade and making them favorable
with these countries.

4 Economic Reforms

The developing economies like Pakistan usually face the situation of recession. One
major cause of such a recessionary situation is back ward structure of the economy.
In this situation government should take bold step to introduce reforms in the
economy. These reforms may include

1. Changes in the taxation system

2. Agriculture reforms

 Policies favorable for industrial growth.

 Removal of Administrative inefficiencies, etc.

 5 Planning

Market forces of demand and supply have failed to best allocate the scarce
resources. Due to the wastage of already scares resources the business fluctuations
have become the order of the day. In this situation it is desirable for the government
to interfere in economic decision making. Appropriate planning may help a country
to get out of depression or maintain the situation of prosperity.

6 Investment Friendly Environments

When a country becomes politically unstable it becomes very difficult for it to

maintain prosperity. In this situation investors stop new investment due to
uncertainty. The journey towards recession sets in fast. In this situation it is very
important to build up their confidence and make investment friendly environment in
the country. This will help to stop recession and achieve prosperity. Thus political
stability is an important factor of economic stability

WHAT IS THE DEFINITION OF MACROECONOMIC POLICY?

Definition: Macro Policy is policy which affects the whole country [or region]. It is
concerned with monetary, fiscal, trade and exchange rate conditions as well as with
economic growth, inflation and national employment levels.

THE FOUR MAJOR OBJECTIVES OF MACROECONOMIC

1. Full employment, or low unemployment.

The claimant count is the older, more out-of-date, measure of unemployment used in
the UK. Those counted must be out of work, physically able to work and looking for it,
and actually claiming benefit.

For a more realistic count, and for international comparisons, the ILO (International
Labour Organisation) measure is used. This includes the young unemployed who
are not always eligible to claim, married women who can't claim if their husband is
earning enough, and those who claim sickness and invalidity benefits. Many only
slightly inconvenienced unemployed workers are paid these benefits rather than
swell the claimant count of unemployment.

Note the issue of active and inactive members of the population of working age.
Only those who are active are included in the working population (or labour force),
which is defined as all those who are employed or registered unemployed. But some
of the inactive are in this category by choice, for instance, students and those who
retire early.

At the moment in the UK, the level of employment is the highest ever (nearly 28
million workers). But one should note the significant difference in the numbers
employed in manufacturing compared with the services (approximately 4 million
against nearly 18 million).

2. Price stability

Inflation is usually defined as a sustained rise in the general level of prices.

Technically, it is measured as the annual rate of change of the Retail Price Index
(RPI), often referred to as the headline rate of inflation. For prices to be stable,
therefore, the inflation rate should be zero. Generally, governments are happy if they
can keep the inflation rate down to a low percentage. For an explanation of how the
RPI is formulated, see the topic called 'Unemployment and inflation'. The UK
government prefers to target the underlying rate of inflation, or the annual
percentage change in the RPIX. This is the same as the RPI except housing costs are
removed in the shape of mortgage interest payments. It makes sense for the
government to use this measure because the weapon they use to control inflation,
interest rates, directly affects the RPI itself.

Other less popular measures include the RPIY, which takes RPIX a stage further by
also taking out the effects of indirect taxation (e.g. VAT), and the consumer price
index, which is often used when making international comparisons.

The inflation rates based on these measures for the whole of 1999 were: RPI, 1.5%;
RPIX, 2.2% and RPIY, 1.6%. Another important statistic is that of average earnings
growth. Most economists believe that the growth in wages directly affects the price
level. The 4.6% figure for 1999 is reasonably low historically (certainly compared with
the early 90s), but there are fears that it will have picked up during 2000. At the time
of writing it was too early to get figures for the whole of 2000. This is something that
you should look up yourself.

3. High (but sustainable) economic growth

Economic growth tends to be measured interms of the rate of change of real GDP
(Gross Domestic Product). When the word real accompanies any statistic, it means
that the effects of inflation have been removed. GDP is a measure of the annual
output (or income, or expenditure) of an economy. Sometimes GNP (Gross National
Product) is used, which is very similar to GDP. The only difference is that income
earned from assets held abroad is added and the income earned by foreigners who
have assets in the UK is taken away (officially called net property income from
abroad). Growth figures are published quarterly, both in terms of the change quarter
on quarter and as annual percentage changes.

UK real GDP growth was 1.8% in 1999, which is lower than the mid-90s, but much
better than the recession of the early 90s. Remember that many economists were
predicting 1999 to be a year of recession, so the final figure is really quite reasonable.
Note also that there is a big difference between the growth rates of the
manufacturing sector (-0.4%) and the service sector (2.8%). The service sector has
been healthy for years, whereas the manufacturing sector, some would argue, has
barely recovered from the recession of the early 90s.

4. Balance of payments in equilibrium

This is a very big topic in itself. Look at the topic called 'The balance of payments' for
much more detail. Briefly, this records all flows of money into, and out of, the UK
over a given time period (usually a year). It is split into two: the Current Account and
the Capital and Financial Accounts (formerly the capital account, although
examiners do still accept this name).

Probably the most important is the current account because this records how well
the UK is doing in terms of its exports of goods and services relative to its imports. If
the UK is to 'pay its way' in the world over the long term, then it needs to keep earning
enough foreign currency from its exports to pay for its imports. If this is not the case,
the current account will be in deficit.

Japan has the largest current account surplus in the world. Although a surplus
sounds better then a deficit, both can be bad. Japan's surplus forces other countries
in the world to have deficits. In fact, while Japan's surplus is the biggest in the world,
the USA's deficit is the biggest in the world. This is not a coincidence! The UK tends
to be in deficit, although the current account was in surplus a couple of years ago,
mainly due to our strength in the service sector.
TOP 3 THEORIES OF INFLATION
Different economists have presented different theories on inflation. The economists
who have provided the theories of inflation are broadly categorized into two labels,
namely, monetarists and structuralists.

Monetarists associated inflation to the monetary causes and suggested monetary

measures to control it.

On the other hand, structuralists believed that the inflation occurs because of the
unbalanced economic system and they used both monetary and fiscal measures
together for sorting out economic problems.

There are three main theories of inflation, which are shown in Figure-3:

MARKET-POWER THEORY OF INFLATION:

In an economy, when a single or a group of sellers together decide a new price that
is different from the competitive price, then the price is termed as market-power
price. Such groups keep prices at the level at which they can earn maximum profit
without any concern for the purchasing power of consumers.

For example, in the past few years, the prices of onion were very- high in India. The
soaring price of onions was the result of the group action of onion producers. In
such a situation, people in middle and low income groups reduced the consumption
of onions. However, onion producers earned high profits from higher income group.

According to the advanced version of market power theory of inflation, oligopolists

can increase the price to any level even if the demand does not rise. This hike in
price levels occurs due to increase in wages (because of trade unions) in the
oligopolistic industry.

The increase in wages is compensated with the hike in prices of products. With
increase in the income of individuals, their purchasing power also increases, which
further results in inflation.
Apart from this, some economists concluded that fiscal and monetary policies are
not applicable in practical situations as these policies are not able to control rise in
prices levels. These policies would work only when prices rise due to an increase in
demand.

Moreover, these policies cannot be applied to oligopolistic rise in prices, which is due
to increase in the cost of production. Monetary policy can reduce the rate of inflation
by raising the interest rate and regulating the credit flow in the market. However, it
would have no effect on the oligopolistic price as the cost is transferred to the prices
of goods and services.

CONVENTIONAL DEMAND-PULL INFLATION:

The market power theory of inflation represents one extreme end of inflation.
According to this theory inflation exists even when there is no excess in demand. On
the other end, the conventional demand-pull theorists believed that the only cause of
inflation is the excess of aggregate demand over aggregate supply.

In full employment equilibrium condition, when demand increases, inflation becomes

unavoidable. In addition, in full employment condition, the economy reaches to its
maximum production capacity. At this point, the supply of goods and services
cannot be increased further while the demand of products and services increases
rapidly. Due to this imbalance between demand and supply, inflation takes place in
the economy.

STRUCTURAL THEORIES OF INFLATION:

Apart from the two extreme ends mentioned in the above, there is a middle group of
economists called structural economists. According to structural theory of inflation,
market power is one of the factors that cause inflation, but it is not the only factor.
The supporters of structural theories believed that the inflation arises due to
structural maladjustments in the county or some of the institutional features of
business environment.

They have provided two types of theories to explain the causes of inflation, which
are shown in Figure-4:
Mark-up Theory:
Mark-up theory of inflation was proposed by Prof Gardner Ackley. According to him,
inflation cannot occur alone by demand and cost factors, but it is the cumulative
effect of demand-pull and cost-push activities. Demand-pull inflation refers to the
inflation that occurs due to excess of aggregate demand, which further results in the
increases in price level. The increase in prices levels stimulates production, but
increases demand for factors of production. Consequently, the cost and price both
increases.

In some cases, wages also increase without rise in the excess demand of products.
This results in fall in supply at increased level of prices as to compensate the
increase in wages with the prices of products. The shortage of products in the
market would result in the further increase of prices.

Therefore, Prof. Gardner has provided a model of mark-up inflation in which both the
factors, demand cost, are determined. Increase in demand results in the increase of
prices of products as the customers spend more on products.

On the other the goods are sold to businesses instead of customers, then the cost of
production increases. As a result, the prices of products also increase. Similarly, a
rise in wages results in increase in cost of production, which would further increase
the prices of products.

So according to Prof Gardner, inflation occurs due to excess of demand or increases

in wage rates; therefore, both monetary and fiscal policies should be used to control
inflation. Though, these two policies are not adequate to control inflation.

Bottle-Neck Inflation:
Bottle-neck inflation was introduced by Prof Otto Eckstein. According to him, the
direct relationship between wages and prices of products is the main cause of
inflation. In other words, inflation takes place when there is a simultaneous increase
in wages and prices of products. However, he believed that wage push or market-
power theories alone are not able to provide a clear explanation of inflation.

After analysis of inflationary situation, Prof Eckstein says that the inflation occurs
due to the boom in capital goods and wage-price spiral. In addition, he also
advocated that during inflation prices in every industry is higher, but few industries
show a very high price hike than rest of the industries.

These industries are termed as bottle-neck industries, which are responsible for
increase in prices of goods and services. In addition, Prof. Eckstein advocated that
concentration of demand for products of bottle industries results in inflation.

CAUSES OF INFLATION

Inflation means there is a sustained increase in the price level. The main causes of
inflation are either excess aggregate demand (economic growth too fast) or cost
push factors (supply-side factors).

SUMMARY OF MAIN CAUSES OF INFLATION

1. Demand-pull inflation – aggregate demand growing faster than aggregate

supply (growth too rapid)
2. Cost-push inflation – higher oil prices feeding through into higher costs
 3. Devaluation – increasing cost of imported goods, also boost to domestic
demand
4. Rising wages – higher wages increase firms costs and increase consumers’
disposable income to spend more.
5. Expectations of inflation – causes workers to demand wage increases and
firms to push up prices.

1. DEMAND-PULL INFLATION

If the economy is at or close to full employment, then an increase in AD leads to an

increase in the price level. As firms reach full capacity, they respond by putting up
prices leading to inflation. Also, near full employment with labour shortages, workers
can get higher wages which increase their spending power.

AD can increase due to an increase in any of its components C+I+G+X-M

We tend to get demand-pull inflation if economic growth is above the long-run trend
rate of growth. The long-run trend rate of economic growth is the average
sustainable rate of growth and is determined by the growth in productivity.

Example of demand-pull inflation in the UK

In the 1980s, the UK experienced rapid economic growth. The government cut
interest rates and also cut taxes. House prices rose by up to 30% -fuelling a positive
wealth effect and a rise in consumer confidence. This increased confidence led to
higher spending, lower saving and an increase in borrowing. However, the rate of
economic growth reached 5% a year – well above the UK’s long-run trend rate of 2.5
%. The result was a rise in inflation as firms could not meet demand. It also led to a
current account deficit. You can read more about demand-pull inflation at the
Lawson Boom of the 1980s.

2. COST-PUSH INFLATION

If there is an increase in the costs of firms, then businesses will pass this on to
consumers. There will be a shift to the left in the AS.
Cost-push inflation can be caused by many factors

a. Rising wages

If trades unions can present a united front then they can bargain for higher wages.
Rising wages are a key cause of cost push inflation because wages are the most
significant cost for many firms. (higher wages may also contribute to rising demand)

b. Import prices

One-third of all goods are imported in the UK. If there is a devaluation, then import
prices will become more expensive leading to an increase in inflation. A devaluation /
depreciation means the Pound is worth less. Therefore we have to pay more to buy
the same imported goods.
In 2011/12, the UK experienced a rise in cost-push inflation, partly due to the
depreciation of the Pound against the Euro. (also due to higher taxes)

c. Raw material prices

The best example is the price of oil. If the oil price increase by 20% then this will have
a significant impact on most goods in the economy and this will lead to cost-push
inflation. E.g., in 1974 there was a spike in the price of oil causing a period of high
inflation around the world.
Source: World Bank. In 2008, we had a smaller spike in oil prices causing a rise in
inflation – just before the great recession of 2008/09

d.    Profit push inflation

When firms push up prices to get higher rates of inflation. This is more likely to occur
during strong economic growth.

e.   Declining productivity

If firms become less productive and allow costs to rise, this invariably leads to higher
prices.

f. Higher taxes

If the government put up taxes, such as VAT and Excise duty, this will lead to higher
prices, and therefore CPI will increase. However, these tax rises are likely to be one-
off increases. There is even a measure of inflation (CPI-CT) which ignores the effect
of temporary tax rises/decreases.
CPI-CT is less volatile because it ignores the effect of taxes. In 2010, some of the UK
CPI inflation was due to rising taxes.

3. RISING HOUSE PRICES

Rising house prices do not directly cause inflation, but they can cause a positive
wealth effect and encourage consumer-led economic growth. This can indirectly
cause demand-pull inflation.

4. PRINTING MORE MONEY

If the Central Bank prints more money, you would expect to see a rise in inflation.
This is because the money supply plays an important role in determining prices. If
there is more money chasing the same amount of goods, then prices will rise.
Hyperinflation is usually caused by an extreme increase in the money supply.

However, in exceptional circumstances – such as liquidity trap/recession, it is

possible to increase the money supply without causing inflation. This is because, in
recession, an increase in the money supply may just be saved, e.g. banks don’t
increase lending but just keep more bank reserves.

MEASURES FOR CONTROLLING 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.

The different measures used for controlling inflation are shown in Figure-5:

The different measures (as shown in Figure-5) used for controlling inflation are
explained below.

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.

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:

Refers to one of the most widely used measure taken by the central bank to control
inflation.

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.

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 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.