MB1102 MANAGERIAL ECONOMICS

UNIT IV PERFORMANCE OF AN ECONOMY – MACRO ECONOMICS

Macro – economic aggregates – circular flow of macroeconomic activity –National income
determination – Aggregate demand and supply – Macroeconomic equilibrium –
Components of aggregate demand and national income – multiplier effect – Demand side
management – Fiscal policy in theory.

Macro Economics-
Macro economics is the study of aggregate economic behaviour of the economy as a
whole. Macro economics deals with the output, (total volume of goods and services produced)
levels of employment and unemployment, average prices of goods and services. It also deals
with the economic growth of the country, trade relationship with other countries and the
exchange values of the currency in the international market.
The major factors influencing these outcomes are international market forces like
population growth, consumption behaviour of the country, external forces like, natural
calamities, political instability and policy related changes such as tax policy, government
expenditure (budget) money supply and various other economic policies of the country.
Therefore it is essential to know the aggregate demand and aggregate supply of the country.

Objectives of Economic Policies:

The major macro level economic policies framed by the government of India to achieve the
objectives are:
1. To achieve national level full employment
2. To stabilize the price fluctuations in the market
3. To achieve overall economic growth
4. To develop regions economically
5. To improve the standard of living of the people
6. To reduce income inequalities
7. To control monopoly market structure
8. To avoid cyclical fluctuations in various economic activities of the country
9. To improve the Balance of Payment of the country
10. To bring social justice in various aspects.

Circular flow of macroeconomic activity

The circular flow model demonstrates how money moves through society. Money flows
from producers to workers as wages and flows back to producers as payment for products. In
short, an economy is an endless circular flow of money.
That is the basic form of the model, but actual money flows are more complicated.
Economists have added in more factors to better depict complex modern economies. These
factors are the components of a nation's gross domestic product (GDP) or national income. For
that reason, the model is also referred to as the circular flow of income model.
Understanding the Circular Flow Model
The basic purpose of the circular flow model is to understand how money moves within
an economy. It breaks the economy down into two primary players: households and
corporations. It separates the markets that these participants operate in as markets for goods and
services and the markets for the factors of production.
The circular flow model starts with the household sector that engages in consumption
spending (C) and the business sector that produces the goods.
Two more sectors are also included in the circular flow of income: the government
sector and the foreign trade sector. The government injects money into the circle through
government spending (G) on programs such as Social Security and the National Park Service.
Money also flows into the circle through exports (X), which bring in cash from foreign buyers.
In addition, businesses that invest (I) money to purchase capital stocks contribute to the flow of
money into the economy.
Outflows of Cash
Just as money is injected into the economy, money is withdrawn or leaked through
various means as well. Taxes (T) imposed by the government reduce the flow of income.
Money paid to foreign companies for imports (M) also constitutes a leakage. Savings (S) by
businesses that otherwise would have been put to use are a decrease in the circular flow of an
economy’s income.
A government calculates its gross national income by tracking all of these injections into
the circular flow of income and the withdrawals from it.
Adding Up the Factors
The circular flow of income for a nation is said to be balanced when withdrawals equal
injections. That is:
 The level of injections is the sum of government spending (G), exports (X), and
investments (I).
 The level of leakage or withdrawals is the sum of taxation (T), imports (M), and savings
(S).
When G + X + I is greater than T + M + S, the level of national income (GDP) will increase.
When the total leakage is greater than the total injected into the circular flow, national income
will decrease.
Calculating Gross Domestic Product (GDP)
GDP is calculated as consumer spending plus government spending plus business investment
plus the sum of exports minus imports. It is represented as GDP = C + G + I + (X – M).
If businesses decided to produce less, it would lead to a reduction in household spending and
cause a decrease in GDP. Or, if households decided to spend less, it would lead to a reduction in
business production, also causing a decrease in GDP.
GDP is often an indicator of the financial health of an economy. A common, though not official,
definition of a recession is two consecutive quarters of declining GDP. When this happens,
governments and central banks adjust fiscal and monetary policy to boost growth.
Keynesian economics, for example, believes that spending leads to economic growth, so a
central bank might cut interest rates, making money cheaper, so that individuals will buy more
goods, such as houses and cars, increasing overall spending. As consumer spending increases,
companies increase output and hire more workers to meet the increase in demand. The increase
in employed people means more wages and, therefore, more people spending in the economy,
leading producers to increase output again, continuing the cycle.
https://www.investopedia.com/terms/circular-flow-of-income.asp#:~:text=The%20circular
%20flow%20model%20demonstrates%20how%20money%20moves%20from
%20producers,money%20on%20products%20and%20services.

Circular Flow of Economic Activity

The Circular flow of economic activity refers to the endless cycle of how money and capital
flow through an economy. Although money moves through the economy in a far more complex
way, the circular flow model effectively summarizes it in a simple manner. A model is an
invaluable tool for economists looking to understand an economy better. Despite how one cannot
make informed decisions purely based on data from the model, at the very least, it can be used to
identify aspects of the economy that require examination.
Although the model is commonly illustrated with four components, the most basic variation is
the two-sector circular flow model. It comprises two aspects: companies, and households and
depicts the flow of capital between the two entities. The process is mainly captured in how
companies pay wages, interest, and profits to households in exchange for the use of their factors
of production. Production factors are the elements that are incorporated into the production of
goods and services. These elements are labor, land, capital, and entrepreneurship. Labor is the
work that people typically contribute to the production process, but in modernized economies,
that work is often conducted by automated machinery. The factor of labor is usually measured in
the work hours that individuals put into producing a good or service. The second production
factor of the land refers to the grounds on which a good or service is produced. This would
traditionally relate to the land on which a factory operates. In contemporary industries, though,
the importance of land is declining as the rise of online businesses is increasing.
Furthermore, capital is liquid assets that producers use in the production process. It usually refers
to money that can be financially or economically invested in growing the company. Finally,
entrepreneurship is the production factor that brings the previous three together. It is the act of an
individual who willingly takes on risks and invests their time and effort into building a business.
Entrepreneurship cannot be distinctly defined due to the lack of structure commonly associated
with it. Although, entrepreneurs are typically characterized as innovative people with a high
tolerance for risk.
While other circular flow models include production factors as a single component between
households and companies, the traditional two-sector model already has it within households and
companies. Households usually own the factors of labor and entrepreneurship, while companies
hold the factors of land and capital. The two-sector flow model looks as follow:

Households offer companies the production factors like labor and entrepreneurship that
they inherently have in exchange for money in salaries and wages. Companies use the production
factors they receive from households to produce goods and services they sell to households for
money. Companies can use this income to grow, and households can purchase these goods and
services to develop or satisfy their needs.
Circular Flow Model with Government
The circular flow model with government simply extends to include the governmental
component. The government refers to any sovereign entity that rules an economy as the central
power. When the governmental aspect is added to the model, it is referred to as the three-sector
flow model. As the central authority, the government naturally plays a key role in the
functioning of any economy, which calls for its presence in the flow model. In its capacity, it is
obligated to provide public services to both companies and households with the funds it raises
via tax collection from citizens and businesses.
The circular flow model can further illustrate the events where money and capital leave the
system in the form of leakages, or enter the system as injections. Leakages occur when money is
spent outside the system. In practical terms, if the model represents a country's economy,
leakages would be when households spend money outside the country, such as importing an
exclusive product from another country. This is captured as money that leaks out of the system
and is not generally regarded as a positive thing. The only benefit of importation is consumer
satisfaction. Beyond that, the economy is just worse off.

Understanding the Circular Flow Model

The idea of circular flow was first introduced by economist Richard Cantillon in the 18 th century
and then progressively developed by Quesnay, Marx, Keynes, and many other economists. It is
one of the most basic concepts in macroeconomics.
How an economy runs can be simplified as two cycles flowing in opposite directions. One is
goods and services flowing from businesses to individuals, and individuals provide resources for
production (labor force) back to the businesses.
In the other direction, money flows from individuals to businesses as consumer expenditures on
goods and services and flows back to individuals as personal income (wages, dividends, etc.) for
the labor force provided. This is the most basic circular flow model of an economy. In reality,
there are more parties participating in a more complex structure of circular flows.
Circular Flow Models with Sectors
Two-Sector Model
The model described above is the two-sector model, which is the most basic model containing
only two sectors: individuals or households and businesses. In the two-sector model, it is
assumed that households spend all their incomes as consumer expenditures and purchase the
goods and services produced by businesses. Thus, there are no taxes, savings, or investments that
are associated with other sectors.
Three-Sector Model
In the three-sector model, the government is added to the two-sector model. In this model,
money flows from households and businesses to the government in the form of taxes. The
government pays back in the form of government expenditures through subsidies, benefit
programs, public services, etc.
Four-Sector Model
The four-sector model contains the foreign sector, which is also known as the overseas sector or
external sector. The overseas sector turns a closed economy into an open economy. It is
connected to the other sectors through two flows of money: foreign trade (imports and exports)
and foreign exchange (inflow and outflow of capital). Like the other sectors, each flow of money
is paired with a flow of a factor of production or goods and services.
Five-Sector Model
The fifth sector – the financial sector – is added to complete the circular flow model. It includes
banks and other institutions that provide borrowing and lending services to the other sectors.
Savings and investments are assumed in the five-sector model, which flow from other sectors
with residual cash into the financial institutions, then out to the sectors that need money. As long
as lending (injection) is equal to borrowing (leakage), the circular flow reaches an equilibrium
and can continue forever.
Implications of the Circular Flow Model
As a fundamental concept of macroeconomics, the circular flow model has been widely applied
in different studies, with significant impacts on the understanding of economics. Four examples
are listed below to show the significance of the model.
1. Measurement of national income: The sectors in the circular flow model are the
components of the calculation of national income. The expenditure approach calculates a
nation’s GDP as the sum of the household consumption expenditures, private domestic
investment, government consumption and investment expenditures, and net exports
(GDP = C + I + G + [X-M]).
2. Knowledge of interdependence: The circular flow model underpins the knowledge of
interdependence between sectors in an economic system. The activities and money flows
cannot take place without interaction with another sector.
3. Unending nature of economic activities: Money and economic resources flow in cycles
indefinitely with an equilibrium of aggregate income and expenditures.
4. Injections and leakages: The circular flow of an economy is balanced when the total
injections equal the leakages. If injections overweight leakages, the country’s national
income will grow. If injections are below leakages, the national income will decrease.

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National income determination

 The purpose of national income accounting is to obtain some measure of the performance
of the aggregate economy. The major concepts used in the national income calculation are Gross
Domestic Product (GDP), Gross National Product (GNP), Net National Product (NNP), personal
income and Disposable income.
Gross Domestic Product is the total market value of all final goods and services
currently produced within the domestic territory of a country in a year. It measures the market
value of annual output of goods and services currently produced and counted only once to avoid
double counting. It includes only final goods and services. It includes the value of goods and
services produced within the domestic territory of a country by nationals and non nationals.

Gross National Product is the market value of all final goods and services produced in a year.
GNP includes net factor income from abroad.

GNP = GDP + Net factor income from abroad (income received by Indian’s abroad – income
paid to foreign nationals working in India)
Net National Product at market price is the market value of all final goods and services after
providing for depreciation.

NNP = GNP – Depreciation

Depreciation means fall in the value of fixed capital due to wear and tear.
NNP at factor cost is called as National Income:
National income is the sum of the wages, rent, interest and profits paid to factors for their
contribution to the production of goods and services in a year.

Nnp = Nnp (Market Price) – Indirect Tax + Subsidies

Personal income (PI) is the sum of all incomes earned by all individuals / households
during a given year. Certain incomes are received but not earned such as old age pension etc.,

Pi = Ni – Social Security Contribution – Corporate Income Tax – Undistributed Corporate

Profits + Transfer Payments.
Disposable income is calculated by deducting the personal taxes like income tax, personal
property tax from the personal income (PI).
Disposable Income = Personal Income – Personal Taxes = Consumption + Saving
Supernumerary income: the expenditure to meet necessary living costs deducted from
disposable consumer income is called as supernumerary income.

The economy is divided into different sectors such as agriculture, fisheries, mining,
construction, manufacturing, trade, transport, communication and other services. The gross
production is found out by adding up the net values of all the production that has taken place in
these sectors during a given year. This method helps to understand the importance of various
sectors of the economy.

Approaches To Calculate National Income:

The Income Approach:
The income of individuals from employment and business, the profits of the firms and
public sector earnings are taken into consideration.
National Income is the income of individuals + self employment + profits of firms and
public corporate bodies + rent + interest (transfer payments, scholarships, pensions are not
included) this includes the sum of the income earned by individuals from various input factors
such as rent of land, wages and salaries of employees, interest on capital, profits of entrepreneurs
and income of self employed people. This method indicates the income distribution among
various income groups of people.

The Expenditure Approach:

In this approach national income is calculated by using the expenditure of individuals,
private, government and foreign sectors. i.e. the sum of all the expenditure made on goods and
services during a year. i.e.
National Income = Expenditure of Individuals + Govt. + Private Firms + Foreigners
GDP = C + I + G + (X-M)
Where,
C = expenditure on consumer goods and services by individuals and households
I = expenditure by private business enterprises on capital goods
G = government expenditure on goods and services (government purchase)
X-M = exports – imports

The Output Approach:

In this approach we measure the value of output produced by firms and other
organization in a particular time period. i.e. the National Income = income from agriculture +
fishery + forestry + construction + transportation + manufacturing + tourism + water + energy …
GDP At Market Price + Subsidies –Taxes
GNP At Factor Cost + Net Income From Abroad

Factors Determining National Income:

1. Quantity of goods and services produced by the country. Higher the quantity of production,
higher shall be the national income.
2. Quality of products and services produced in the country will also determine the national
income of a country.
3. Innovation of more technical skills will improve the productivity which will reflect on national
income of the country.
4. Political stability strengthens the national income of an economy.

Difficulties in the Calculation of National Income:

1. Any income earned abroad have to be included
2. To avoid double counting, value added method should be considered
3. Services rendered free of charges are not to be included
4. Capital gains, transfer payments are not to be included
5. Changes in price level will also affect the calculation
6. Value of military services will not be taken into consideration.

Problems in Measuring National Income In India:

1. Non monetized sector: there are number of sectors in which the wages and salaries are
provided in kind, not in monetary measures.
2. Illiteracy: due to higher illiteracy rate the results may be biased.
3. Lack of occupational specification: we have difficulty in classifying the nature of the job
existing in India.
4. Unorganized productive activities: people involved in unorganized productive activities are
not fully covered in the calculation of national income.
5. Lack of adequate statistical data: Inadequate data leads to approximation of the calculation.
6. Self consumption: Farm products kept for self consumption are not considered for the
national income calculation.
7. Unpaid Services: services of house wives are not reckoned as national income.

Uses of National Income Estimates:

1. National income is a measure of economic growth
2. National income is an indicator of success or failure of planning
3. Useful in estimating per capita income
4. Useful in assessing the performance of different production sectors
5. Useful in measuring inequalities in the distribution of income
6. Useful in measuring standard of living
7. Useful in revealing the consumption behaviour of the society
8. Useful in measuring the level and pattern of investment
9. Makes international comparisons possible
Difficulties of Comparing National Income:
It is difficult to compare the national income of a country with others due to the
difference in population size, working hours of labour force, currency values in the market,
consumption pattern of general public, cultural difference and inflationary pressure of the
country. Even with all the above mentioned difficulties the GDP is the major economic indicator
of an economy.

Economic aggregates
Aggregate demand and supply
Aggregate demand: The total quantity of output demanded at prevailing price levels in a given
time period, ceteris paribus.
Aggregate supply: The total quantity of the output the producers are willing and able to supply
at prevailing price levels in a given time period.

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Understanding Aggregate Demand

Aggregate demand is a macroeconomic term that represents the total demand for goods
and services at any given price level in a given period. Aggregate demand over the long term
equals gross domestic product (GDP) because the two metrics are calculated in the same way.
GDP represents the total amount of goods and services produced in an economy while aggregate
demand is the demand or desire for those goods. As a result of the same calculation methods, the
aggregate demand and GDP increase or decrease together.
Technically speaking, aggregate demand only equals GDP in the long run after adjusting
for the price level. This is because short-run aggregate demand measures total output for a single
nominal price level whereby nominal is not adjusted for inflation. Other variations in
calculations can occur depending on the methodologies used and the various components.
Aggregate demand consists of all consumer goods, capital goods (factories and equipment),
exports, imports, and government spending programs. The variables are all considered equal as
long as they trade at the same market value.
Drawbacks of Aggregate Demand
While aggregate demand is helpful in determining the overall strength of consumers and
businesses in an economy, it does have limits. Since aggregate demand is measured by market
values, it only represents total output at a given price level and does not necessarily represent the
quality of life or standard of living in a society.
Also, aggregate demand measures many different economic transactions between millions of
individuals and for different purposes. As a result, it can become difficult to determine the
causality of demand and run a regression analysis, which is used to determine how many
variables or factors influence demand and to what extent.
Aggregate Demand Curve
If you were to represent aggregate demand graphically, the aggregate amount of goods and
services demanded would be placed on the horizontal X-axis, and the overall price level of the
entire basket of goods and services would be represented on the vertical Y-axis.
The aggregate demand curve, like most typical demand curves, slopes downward from left to
right. Demand increases or decreases along the curve as prices for goods and services either
increase or decrease. Also, the curve can shift due to changes in the money supply, or increases
and decreases in tax rates.

Components of Aggregate Demand

An economy’s aggregate demand is the sum of all individual demand curves from different
sectors of the economy. It is typically the sum of four components:

1. Government Spending (G)

Government spending (G) is the total amount of expenditure by the government on
infrastructure, investments, defense and military equipment, public sector facilities, healthcare
services, and government employees. It excludes the spending on transfer payments, such as
pension plans, subsidies, and aid transfers to other countries that are in need.
2. Consumption Spending (C)
Consumption spending (C) is the largest component of an economy’s aggregate demand, and it
refers to the total spending of individuals and households on goods and services in the economy.
Consumption spending depends on several factors, such as disposable income, per capita
income, debt, consumer expectations of future economic conditions, and interest rates.
An important point to note is that consumption spending does not include spending on residential
structures, which is accounted for in the investment spending component.
3. Investment Spending (I)
Investment spending (I) is the total expenditure on new capital goods and services such as
machinery, equipment, changes in inventories, investments in nonresidential structures, and
residential structures. Investment spending depends on factors such as interest rates (since they
determine the cost of borrowing), future expectations regarding the economy, and government
incentives (such as tax benefits or subsidies for investing in renewable energy).
4. Net Exports (X–M)
Exports are products that are produced by domestic producers and sold abroad, while imports are
products that are manufactured abroad and imported for domestic purchase.
It is important to remember that aggregate demand is the total demand for domestically produced
goods and services; therefore, exports are added to the aggregate demand, whereas imports are
subtracted. The measure of exports minus imports is called Net Exports, an important
determinant of aggregate demand.
Shifts in Aggregate Demand
The aggregate demand curve plots the demand for domestically produced goods and services at
all price levels. Real GDP measures the value of gross domestic product adjusted for inflation
and provides a more accurate picture of changes in domestic demand than nominal GDP.
The Aggregate Demand (AD) curve is downward sloping since higher price levels correspond to
lower demand for goods and services, which is in accordance with the Law of Demand.
Here are some of the reasons behind the downward slope of the AD curve:
1. Pigou’s Wealth Effect
Pigou’s Wealth Effect states that consumers are wealthier at lower price levels (assuming that
wages are constant). Disposable income is higher at lower price levels and allows consumers to
spend more on goods and services, increasing the demand for output.
2. Exchange Rate Effect
When the value of a country’s currency drops against other currencies, domestic goods become
relatively cheaper to foreigners, and imports become more expensive. Therefore, at lower price
levels, when domestic goods are cheaper compared to imported goods, the demand for exports is
higher, and it leads to an increase in aggregate demand.

Factors Influences Aggregate Demand

A variety of economic factors can affect the aggregate demand in an economy. Key ones
include:
 Interest Rates: Whether interest rates are rising or falling will affect decisions made by
consumers and businesses. Lower interest rates will lower the borrowing costs for big-
ticket items such as appliances, vehicles, and homes. Also, companies will be able to
borrow at lower rates, which tends to lead to capital spending increases. Conversely,
higher interest rates increase the cost of borrowing for consumers and companies. As a
 result, spending tends to decline or grow at a slower pace, depending on the extent of the
increase in rates.
 Income and Wealth: As household wealth increases, aggregate demand usually
increases as well. Conversely, a decline in wealth usually leads to lower aggregate
demand. Increases in personal savings will also lead to less demand for goods, which
tends to occur during recessions. When consumers are feeling good about the economy,
they tend to spend more leading to a decline in savings.
 Inflation Expectations: Consumers who feel that inflation will increase or prices will
rise, tend to make purchases now, which leads to rising aggregate demand. But if
consumers believe prices will fall in the future, aggregate demand tends to fall as well.
 Currency Exchange Rates: If the value of the U.S. dollar falls (or rises), foreign goods
will become more (or less expensive). Meanwhile, goods manufactured in the U.S. will
become cheaper (or more expensive) for foreign markets. Aggregate demand will,
therefore, increase (or decrease).

Macroeconomic equilibrium
Macroeconomic equilibrium occurs when the quantity of real GDP demanded equals
the quantity of real GDP supplied at the point of intersection of the AD curve and the AS
curve. If the quantity of real GDP supplied exceeds the quantity demanded, inventories pile up
so that firms will cut production and prices.

Multiplier
In economics, a multiplier broadly refers to an economic factor that, when increased or
changed, causes increases or changes in many other related economic variables. In terms of
gross domestic product, the multiplier effect causes gains in total output to be greater than the
change in spending that caused it.
The term multiplier is usually used in reference to the relationship between government
spending and total national income. Multipliers are also used in explaining fractional reserve
banking, known as the deposit multiplier.
Explaining Multipliers
A multiplier is simply a factor that amplifies or increase the base value of something
else. A multiplier of 2x, for instance, would double the base figure. A multiplier of 0.5x, on the
other hand, would actually reduce the base figure by half. Many different multipliers exist in
finance and economics.
The Fiscal Multiplier
The fiscal multiplier: the fiscal multiplier measures the effect that increases in fiscal
spending will have on a nation's economic output, or gross domestic product (GDP).
The fiscal multiplier is the ratio of a country's additional national income to the initial
boost in spending or reduction in taxes that led to that extra income. For example, say that a
national government enacts a $1 billion fiscal stimulus and that its consumers' marginal
propensity to consume (MPC) is 0.75. Consumers who receive the initial $1 billion will save
$250 million and spend $750 million, effectively initiating another, smaller round of stimulus.
The recipients of that $750 million will spend $562.5 million, and so on.
The Investment Multiplier
The investment multiplier: The investment multiplier quantifies the additional positive
impact on aggregate income and the general economy generated from investment spending.
An investment multiplier similarly refers to the concept that any increase in public or
private investment has a more than proportionate positive impact on aggregate income and the
general economy. The multiplier attempts to quantify the additional effects of a policy beyond
those immediately measurable. The larger an investment's multiplier, the more efficient it is at
creating and distributing wealth throughout an economy.
The Earnings Multiplier
The earnings multiplier: The earnings multiplier relates a company's current stock
price to its per-share earnings.
The earnings multiplier frames a company's current stock price in terms of the
company's earnings per share (EPS) of stock. It presents the stock's market value as a function
of the company's earnings and is computed as price per share/earnings per share (commonly
called the earnings multiple).
The Equity Multiplier
Equity multiplier: The equity multiplier is a risk metric calculation of how much of a
company’s assets are financed by stock rather than debt.
The equity multiplier is a commonly used financial ratio calculated by dividing a
company's total asset value by total net equity. It is a measure of financial leverage. Companies
finance their operations with equity or debt, so a higher equity multiplier indicates that a larger
portion of asset financing is attributed to debt. The equity multiplier is thus a variation of
the debt ratio, in which the definition of debt financing includes all liabilities.
The money multiplier: how central bank reserves are amplified by commercial banks
The deposit multiplier: how fractional reserve banking can amplify deposits through new loans

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Multiplier effect
The multiplier effect refers to the effect on national income and product of an
exogenous increase in demand. For example, suppose that investment demand increases by
one. Firms then produce to meet this demand. That the national product has increased means that
the national income has increased.
The multiplier effect is an economic term, referring to the proportional amount of
increase, or decrease, in final income that results from an injection, or withdrawal, of capital.
In effect, Multipliers effects measure the impact that a change in economic activity—
like investment or spending—will have on the total economic output of something. This
amplified effect is known as the multiplier.

Understanding the Multiplier Effect

Generally, economists are most interested in how infusions of capital positively affect
income or growth. Many economists believe that capital investments of any kind—whether it be
at the governmental or corporate level—will have a broad snowball effect on various aspects of
economic activity.
 As its name suggests, the multiplier effect provides a numerical value or estimate of a
magnified expected increase in income per dollar of investment. In general, the multiplier used
in gauging the multiplier effect is calculated as follows:
The multiplier effect can be seen in several different types of scenarios and used by a
variety of different analysts when analyzing and estimating expectations for new capital
investments.
Example of the Multiplier Effect
For example, assume a company makes a $100,000 investment of capital to expand its
manufacturing facilities in order to produce more and sell more. After a year of production with
the new facilities operating at maximum capacity, the company’s income increases by
$200,000. This means that the multiplier effect was 2 ($200,000 / $100,000). Simply put, every
$1 of investment produced an extra $2 of income.
The Keynesian Multiplier
Famed British economist John Maynard Keynes formally introduced the concept of the
multiplier in his "The General Theory of Employment, Interest, and Money" in 1936.
During the depression of the 1930s Keynes understood that the classical thinking where
supply would create its own demand does not always work. He noted that in the Great
Depression the main problem was a lack of aggregate demand. He also noted that the
government spending could add to aggregate demand and that this fiscal stimulus would create
a “multiplier effect” through increases in consumer demand. Regardless of the type of
government spending, it will lead to cycles of economic prosperity and increased employment,
raising gross domestic product (GDP) by a larger amount of the increase. So $1 billion in
government spending will raise a country's GDP by more than the amount spent.

To summarize these concepts, we note that in a simple closed economy that aggregate demand
can be represented by the following expression:

Y=C+I+G
Where:
 Y = Aggregate demand
 C = Consumer demand
  I = Investment demand
 G = Government demand
Keynes also introduced the concept of the consumption function.
C=mY

Where:
 m= the marginal propensity to consume (MPC) with m<1 and for purposes of this
discussion we will assume is estimated at .75 indicating that when consumers receive
additional income, they spend 75% and save 25%. Investment demand was primary
determined by entrepreneurial spirits, interest rates (monetary policy) and current
business conditions while government demand was determined by the fiscal decisions
made by government
In this framework we can express aggregate demand as:
 Y= C + I + G = mY + I + G
Solving this expression for Y results in:
Y= (I+G) / (1-m)

Where the term 1/(1-m) is the Keynesian income “multiplier.” In our example with m=.75 the
multiplier is
1/(1-.75)=4
If Y falls due to a problem with Investment spending (i.e., business confidence) then the
government can step in to increase aggregate demand by increasing G. If m=.75 then the
multiplier is 4 indicating a 1 dollar increase in G, all other things being equal would result is an
increase in income of 4 dollars in Y.
This was the contribution Keynes made to the economic thinking of the time and was
fundamental then, and now, in the role of fiscal policy in getting the economy back to full
employment.

https://www.investopedia.com/ask/answers/09/keynesian-multiplier.asp
 Demand side management
DSM refers to initiatives and technologies that encourage consumers to optimise
their energy use. The benefits from DSM are potentially two-fold; first, consumers can reduce
their electricity bills by adjusting the timing and amount of electricity use.
Demand for electricity can sometimes fluctuate wildly because of sudden changes
in weather, a surge in economic growth, damage to lines, or other factors. In extreme
cases, sharp fluctuations can result in power blackouts. The transition to renewable
energy plays a role in these fluctuations too, because power demand may peak at a time
when the unpredictable supply of renewable energy is low. The new energy scenario calls
for an increasingly flexible energy grid.
Fortunately, utilities have a powerful tool to manage these peak-load demands,
enabling them to guarantee service and, increasingly, deliver savings for users. Demand
Side Management (DSM) is a strategy used by electricity utilities to control demand by
encouraging consumers to modify their level and pattern of electricity usage . A
Demand Side Management program typically takes place on the user’s premises and
includes monetary incentives to encourage consumers to buy energy-efficient equipment,
or lower prices if they agree to reduce usage during peak times of demand. It’s a win-win
situation: when customers agree to reduce their energy use at times when demand (and
therefore prices) are highest and shift their consumption to moments when energy is more
plentiful, the utility benefits from an even supply, and the customer from lower prices.

Demand Side Management offers three considerable benefits:

 Firstly, it helps reduce market prices for electricity by freeing the utility from the
expense of building backup (and sometimes fossil-fueled) plants that are brought online
to cope with peak demand
 It reduces the costs of managing the electricity grid
 By smoothing out demand, it results in a more efficient and dependable electricity
network

https://corporate.enelx.com/en/question-and-answers/what-is-demand-side-management
Fiscal policy in theory
Fiscal policy is based on the theories of the British economist John Maynard Keynes,
whose Keynesian economics theorised that government changes in the levels of taxation and
government spending influence aggregate demand and the level of economic activity.
Fiscal policy is defined as the conscious attempt of the government to achieve certain
macro economic goals of policy by altering the volume and pattern of its revenue and
expenditures and the balance between them.
The major economic goals of fiscal policy are to maintain a high average level of
employment and business activity, to minimize fluctuations in employment activity, prevent
inflation and to produce and promote economic growth.
The fiscal policy is used to control inflation through making deliberate changes in
government revenue and expenditure to influence the level of output and prices. It is a budgetary
policy. Fiscal policy is the use of government taxes and spending to alter macroeconomic
outcomes of the country. During the great depression of the 1930s people were out of work, they
were unable to buy goods and services therefore government had to increase, to regulate
macroeconomic values and money supply.
The use of government spending and taxes to adjust aggregate demand is the essence of
fiscal policy. The simplest solution to the demand shortfall would be to increase government
spending. The government increases it’s spending through construction of tanks, schools,
highways.
This increased spending is a fiscal stimulus. Economic stability is a macro goal of the
fiscal policy of a country whether developed or developing. By economic stabilization it means;
controlling recession or depression and price stability.

Objectives of Fiscal Policy:

1. To maintain economic stability in the country
2. To bring Price stability
3. To achieve full employment
4. To provide social justice
5. To promote export and introduce import substitution
6. To mobilize more public revenue
7. To reallocate available resources
8. To achieve balanced regional growth.

Types of fiscal policy

There are two main types of fiscal policy: expansionary and contractionary.
Expansionary fiscal policy
Expansionary fiscal policy, designed to stimulate the economy, is most often used during a
recession, times of high unemployment or other low periods of the business cycle. It entails the
government spending more money, lowering taxes or both.
The goal of expansionary fiscal policy is to put more money in the hands of consumers so they
spend more to stimulate the economy. Explained in economic language, the goal of expansionary
fiscal policy is to bolster aggregate demand in cases when private demand has decreased.

Contractionary fiscal policy

Contractionary fiscal policy is used to slow economic growth, such as when inflation is growing
too rapidly. The opposite of expansionary fiscal policy, contractionary fiscal policy raises taxes
to cut spending. As consumers pay more taxes, they have less money to spend, and economic
stimulation and growth slow.
Under contractionary fiscal policies, the economy usually grows by no more than 3% per year.
Above this growth rate, negative economic consequences – such as inflation, asset bubbles,
increased unemployment and even recessions – may occur.

How fiscal policy affects businesses

Public and private companies experience direct effects of an economy’s fiscal policy – whether
in the form of spending or taxation. Fiscal policy can have the following effects on your small
business.
1. Investment opportunities
Businesses will see more investment opportunities related to government spending. This
commonly occurs during an expansionary fiscal policy, when more money is flowing into the
economy from the government and from other sources since taxation is also low. When a balance
between price and demand is met, then companies can expect to thrive and grow.
2. Slower growth
A contractionary fiscal policy may kick in to prevent inflation when that balance is broken and
demand – and prices – fall. Businesses typically rein in their growth due to rising taxes and take
measures to stay in the black with less money flowing through the economy.
3. Taxation changes
Depending on your company’s location, your business will face several levels of taxation:
including local, state and federal. Consider how your state and local government taxes your
company and how it interweaves with federal fiscal policy.
Fiscal policy also impacts the amount of taxation on future generations. Government spending
that leads to greater deficits means that taxation will eventually have to increase to pay interest.
Inversely, when the government runs on a surplus, taxes must eventually be lowered.

4. Unemployment rates
A major objective of fiscal policy is to minimize unemployment. For example, the government
can lower taxes to put more money back in consumers’ pockets. As such, consumers have more
money to spend and companies may face increased demand. With increased demand may come
additional production tasks for companies to complete, and businesses can respond by creating
more jobs and hiring more employees. With proper fiscal policy in place, a low unemployment
rate may gradually increase.

https://www.businessnewsdaily.com/3484-fiscal-policy.html