Macro Economics

Lecture-1

Introduction to Macro Economics

 Learning Outcome

 To understand the meaning of Macro economics

 To understand the scope of Macro economics
 To understand the importance of Macro economics
 Micro economics

Microeconomics is the study of how individual

households and firms make decisions and how they
interact with one another in markets.
 Macro Economics

According to Shapiro
“ Macro Economics deals with the functioning of the
economy as a Whole”
It studies the behavior of economic aggregates
such as aggregate income, consumption,
investment, and the overall level of prices.
Major Concerns of Macro Economics
Aggregate Demand

Aggregate Supply

Saving

Inflation/Deflation

Economic growth

Unemployment

Trade Cycle

International Trade

Economic Planning (Fiscal

policy/Monetary Policy)
 Importance of Macro Economics

 It explains the working of the economy as a whole.

 It examines the aggregate behaviour of
Economics
Macro entities like firms, households
and the government.
It is very useful to the planner for preparing economic
plans for the country's development.
 Its knowledge is indispensable for the policy-makers
for formulating macro-economic policies such as
monetary policy,fiscal policy, industrial policy,
exchange rate policy, income policy, etc.

 It explains economic dynamism intricate

interrelationship among macroeconomic
and
such as price level, income, output and employment.
variable,
 Scope of Macro Economics

Macro economics studies the concept of national

income, its methods and measurement.

Macro economics studies the problems related to

employment and unemployment.

Macro economics studies functions of money and

theories relating to it. Banks and other financial
institutions are also a part of its study.
Macro economics also studies trade among different
countries. Theory of international trade, tariff,
protection etc. are subjects of great significance to
macro economics.
 What is the Difference Between Micro
economics and Macro Economics?
 Why to study macro economics?
National Income
 Learning objective

Tounderstand various concepts of national

income, like GDP, GNP and NNP.
To understand the different methods of
measuring national income.
National income is defined as the money value of all
the final goods and services produced in an economy
during an accounting period of time, generally one
year.
Accounting Year= 1st April-31st March
 Concepts of National Income

• Gross Domestic Product (GDP)

• Gross National Product (GNP)
• Net Domestic Product (NDP)
• Net National Product (NNP)
• Per Capita Income
• Disposable Income
 Gross Domestic Product
 Gross Domestic Product (GDP): GDP is the sum of money values
of all final goods and services produced by the factors of
production located within the domestic territories of a country
during an accounting year. It exclude all output produced
abroad by domestically owned factors of Production ( land,labor
and capital)
GDP= C+I+G+(X-M)
C=consumption I= Investment G= Government expenditure
and X-M= Net export
 Gross National Product
Gross National Product (GNP): GNP is the aggregate
final output value of citizens and businesses of an
economy goods & services within country and from
abroad in a year.
GNP may be defined as the sum of Gross Domestic
Product and Net Factor Income from Abroad (NFIA).
GNP = GDP + NFIA
GNP = C+I+G+(X-M)+NFIA
 Net Factor Income from Abroad: difference between income
received from abroad for rendering factor services and income
paid towards services rendered by foreign nationals in the
domestic territory of a country
 Net Domestic Product and Net
National Product
 Net Domestic Product
Net domestic product (NDP) is an annual measure of the economic output of a nation that
is adjusted to account for depreciation and is calculated by subtracting depreciation from
the gross domestic product (GDP)

= GDP-Depreciation of a country capital goods( ie Capital consumed over the year in the
form of housing,vehicle or machinary deterioration
 Net National Product (NNP)
 = GDP–Depreciation +NFIA Or =GNP–Depreciation
Thus NNP is the actual addition to a year’s wealth and is the sum of consumption
expenditure, government expenditure, net foreign expenditure, and investment, less
depreciation, plus net income earned from abroad.

= C+I+G+(X–M)–Depreciation + NFIA
 NNP at Factor Cost is the sum total of income earned by all the people of the nation,
within the national boundaries or abroad

 It is also called National Income.

 NNP at Factor Cost = NNP at Market Prices –Indirect Taxes+ Subsidies

 ?

Why should a manager monitor GDP growth?

 Per Capital Income and Personal
Income
 Per capita income is the average income of the people of a country in a particular
year.
National Income
Per Capita Income = Total Population

 Personal income is the total income received by the

individuals of a country from all sources before direct taxes
in one year in the form of wages,rent,interest & profit.
Personal Income = National Income –Undistributed Corporate
Profits/Retained Earnings– Corporate Taxes – Social Security
Contributions + Transfer Payments/Gifts+ Interest on Public Debt

 Personal Disposable Income is the income which can be

spent on consumption by individuals and families.
Personal Disposable Income = Personal Income – Personal Taxes

Disposal income (DI)=Consumption (c) + Saving (S)

 Measurement of Gross Domestic Product In
Current Prices & Constant Prices

 Nominal GDP = National income estimated at the prevailing prices is

called nominal GDP. In many application of macro economics is not
considered a measure of growth & walfare,

 Real GDP=National income measured on the basis of some fixed price,

say price prevailing at a particular point of time, or by taking a base
year, is known as national income at constant prices, or Real GDP

Nominal GDP
GDP Deflator x100
= Real GDP
deflator

 GDP deflator measures the change in prices between the base year and the
current year
 GDP deflator is the ratio of nominal GDP in a year to real GDP of that year
Measuring GDP Deflator

Nominal GDP
GDP Deflator x100
= Real GDP
deflator
 Ch 2 Learning
Objectives
 To explain the circular flow of economic activity
and income:

Two- Sector Model

Three- Sector Model
Four- Sector Model
 Injections and
Leakages in
the circular
flow of
economic activity.
Circular Flow of Income
Two Sector Model
Circular Flow of Economic Activities and
Income
The simple model of the circular flow assumes two players

Firms

• Produce and supply the goods and services.

• Require various factors of production to produce these goods and services.

Households

• Include a set of individuals living in the same house

• Take joint decision about the consumption of goods and services.

• Provide services in terms of factor inputs to the firms

• Get paid for these services by firms which households spend

on consumption.
• Money flows from firms to households as factor payments and from
households to firms as expenditure on goods and services.
• It is a circular flow of money or income
 Circular Flow of Income
(Two Sector Economy)
(Wages, Rent, Interest and Profits)
Factor Payments
(Y)
Factor Inputs

Financial
Households Savings Market Investment Firms
(S) (I)

Goods and
Services (O)

Consumption
expenditure
(C)

In the equilibrium
 Circular Flow of Income
(Four Sector Economy)
The third sector is Government (G)
• Government Spending
– On provision of public utility goods and services.
– Provides salaries to the households
– Pays to firms for purchases of goods and services
• Government Revenue
– Households and firmspay various taxes and other
payments and provide factor inputs to the government.
– Government borrows from the financial market to fill revenue gap.
The fourth sector is the external sector
• Imports (M): Outflow of income occurs when the domestic firms buy
goods and services from foreign ones.
• Exports (X): Inflow of income takes place when foreign firms
buy
 Circular Flow of Income
(Four Sector Economy)
Government
(G)
Taxe
Taxe Factor s
s Payments Remittances
for purchases
Factor Inputs
Salaries

Savings
(S) Financial Market Firms
Households Investment
(I)
Imports Imports
Goods (M)
(M) (O)
Consumption
Expenditure

Exports Foreign Nations Exports

(X-M) (X)
(X)
National Income=C+I+G+(X-M)
 Circular Flow of Income
(Four Sector Economy)
• National income includes expenditures on consumption
investment, government and net of exports (X-M)

National Income=C+I+G+(X-M)

• Since national income can either be consumed, or saved, or paid as tax to the
government:

C+I+G+(X-M)=C+S+T

I+G+(X-M) =S+T

• Sum of private investment and expenditure on net exports is equal to the sum
of savings and tax revenue. Thus:

I+G+X =S+T+M

• Therefore, W=J

• At equilibrium, total injections are equal to total withdrawals.

Mention two important leakages in the
circular flow of national income.
Mention two important injections in the
circular flow of national income
 Difference between the 2 and 4 sector model.
Uses of National Income Data

National income is the most dependable indicator of a country’s economic

health.

Difference between GDP and GNP indicates the contribution of net income
earned abroad

Necessary for Economic planning: useful aid in judging which sectors should
be given more emphasis

A measure of economic welfare.

• higher aggregate production implies more and more goods and services being available to people

Helps in determining the regional disparities, income inequality and level of

poverty in a country.

Helps in comparing the situations of economic growth in two different

countries.
 Summary
 GDP is the sum of money values of all final goods and services produced within
the domestic territories of a country during an accounting year. It can be
measured at current or constant prices.
 GNP is the aggregate final output of citizens and businesses of an economy in
one year. NNP is GNP less depreciation.
 The average income of the people of a country in a particular year is per capita
income for that year.
 National income can be measured by product method, income method and
expenditure method.
 National income accounting data are of utmost importance for the economy of
any country; such data reveal the aggregate production of the economy and
also help to determine the total expenditure and total income of that country.
 Difficulties in measuring national income include multiple counting, exclusion of
non market transacted services, self consumption of output, inflation or
deflation, confusion about informal sector, etc.
 National income is considered as a measure of economic welfare. As national
income rises, the aggregate production of goods and services rises. Therefore,
there is a positive relation between increase in national income and welfare.
 Learning Objective

• In this topic we will discuss about how nations

decide their Income, Output and Employment level
on the basis of the following theories
• Classical theory
• Keynes Theory

72
 Classical Theory

• Full employment is a natural phenomena.

• In a case of unemployment , demand for labor is
less than their supply. Due to low demand, money
wages of the laborers will fall. Low wage rate, in its
turn, will raise the demand for laborers. As a
consequence, unemployment is removed and full
employment is restored.

73
Keynesian Thought on income, output
and employment
• According to Keynes- there is not always full
employment in a developed economy as a matter
of fact there can be unemployment in the economy.
• The main reason for the unemployment is the is
deficiency of aggregate demand.
• Unemployment can be removed by increasing the
aggregate demand in the economy.

97
• According to classical thought the problem of
unemployment can be solve by lowering the wage
rate,
• According to Keynes the problem of unemployment
can be solved by increasing the aggregate demand.

98
 Absence of
Involuntary
Unemployment
• Voluntary unemployment
• Frictional unemployment
• Seasonal unemployment
• Technical unemployment
• Disguised unemployment

74
??????????????
 Questions

• Meaning of Full employment

• Different types of unemployment(cyclical, seasonal,
voluntary and Involuntary)

75
Investment
 Investment

• Meaning
• Different types of investment
• Factors affecting investment
 Learning outcome

• By studying this student will come to know about

the concept of investment and about the factors
affecting investment decisions.
• Will be able to know the importance of ROI and
MEC in determining the level of investment.
 Investment

• Investment in general sense means using or

spending money on acquiring physical or financial
assets and skills that yield a return over time.
• Investment conceptually refers to addition made to
the physical stock of capital
 Difference between capital and
Investment
• Capital is a stock concept
• It refers to capital accumulated over a period
of time
• Investment is a flow concept
• It is measured per unit of time, generally one year.
 Quiz

1. Net addition to existing capital stock is called?

2. Why investment is important?
 Types of investment

• Induced investment
• Autonomous investment
• Gross and Net investment
• Financial and real investment
• Planned and unplanned investment
 Autonomous Investment

• Investment which does not change with

the changes in income level.
• Even if the income is low, the
Investment
autonomous,remains the same.
• Investment made on houses, roads, public buildings
and other parts of Infrastructure etc.
 Induced Investment

• Investment which changes with the changes in the

income level.
• Induced Investment is positively related to
the income level.
 Financial Investment

• Investment made in buying financial instruments

such as new shares, bonds, securities, etc.
• Money invested for buying of new shares and
bonds as well as debentures have a positive impact
on employment level, production and economic
growth.
 Real Investment

• Investment made in new plant and equipment,

construction of public utilities like schools, roads
and railways, etc.
• Real investment has a direct impact on employment
generation, economic growth, etc.
 Planned Investment

• Investment made with a plan in several sectors of

the economy with specific objectives.
• Intended Investment because an investor while
making investment make a concrete plan of his
investment.
 Unplanned Investment

• Investment done without any planning is called as

an Unplanned or Unintended Investment.
• In unplanned type of investment, investors make
investment randomly without making any concrete
plans.
 Gross Investment

• The total amount of money spent for creation of

new capital assets like Plant and Machinery, Factory
Building, etc.
• It is the total expenditure made on new capital
assets in a period
 Net Investment

• Net Investment is Gross Investment less (minus)

Capital Consumption (Depreciation) during a period
of time, usually a year.
• A part of the investment is meant for depreciation
of the capital asset or for replacing a worn-out
capital asset.
 Quiz

• Investment made by government and departmental

undertakings is called ?
• Which investment does not depend upon
changes in national income ?
• Which investment varies with changes in the
level of national income ?
• Why is planned investment necessary?
 Factors affecting investment

• Size of the market

• Expectations of costs and prices in the future
• Change in income
• Taxation
• Technology
• Existing stock of capital asset
• Change in ROI
• Population
• Expected increase in Aggregate Income
• Political Climate
• Foreign Trade
• Price level
 Quiz

• Under conditions would you go for

investment
what

• How can taxation decision effect

investment decision?
 Learning outcome

• To understand how change in investment will

affect change in income
• To understand how MPC and MPS affects
the working of the multiplier
MONEY
 LEARNING OBJECTIVES

 To understand the economics definition of money;

 To understand the various concepts of money;
 To understand how money can be used for
different purposes;
 To understand what are the important factors
that affect the demand for money
 MONEY
MEANING AND DEFINITION
 Meaning
 In general, money means currency notes
and coins.
 However, in economics, the term
used
moneyfor much is wider sense and is defined
differently by different economists.
 Conceptually, money can be defined as
commodity that is generally accepted as
any
a medium of exchange and measure of value.
MONEY
FUNCTIONS
 Functions of Money
 The following couplet brings out the major functions
of money:
“Money is a matter of functions four:
A medium, a measure, a standard, a store”

 Kinley classified the functions of money into following

three categories:
 Primary and Main Functions
 Secondary and Subsidiary Functions
 Contingent Functions
 Functions of Money

 Primary Functions:
 Medium of Exchange
 Measure of Value

 Secondary Functions:
 Standard of Deferred Payments
 Store of Value
 Functions of Money

 Contingent Functions:
 Basis of Credit Creation
 Maximum Satisfaction
 Distribution of National Income
 Increase in the Liquidity of Capital
 Bearer of option
 QUESTIONS
 Money can be defined as any commodity
that is generally accepted as
a
.
 What are the secondary functions
of money?
MONEY
CONCEPTS
 CONCEPTS OF MONEY

 Money has been used since time

immemorial. It has only been changing form
over time.
 Since its evolution money took
forms as:
several
 Commodity Money
 Metallic Money
 Paper Money
 Bank Deposits
 Near Money
 CONCEPTS OF MONEY

 Commodity Money:
 Under this, the people used
commodities or animals as money.
 Demerits:
 Commodities are not homogeneous
 Supply of commodities could abruptly
be change.
 Hoarding was not possible
 Lack of portability
 CONCEPTS OF MONEY
 Metallic Money:
 It was introduced to meet the difficulties of
commodity money. Different metals, such as
iron, gold, brass, silver, copper, etc. were
used to make coins.
 Demerits:
 Supply of these coins could not always be
adjusted to their demand.
 Very heavy.
 Continuous use of metal coins resulted in
lot of depreciation.
 CONCEPTS OF MONEY
 Paper Money:
 In past traders, used to deposit their
metallic money with money lenders and obtain
certificate of deposit. These certificates were
used as money. Thus, this led to the origin of
paper money.
 These days the paper money is issued only by
the Central Bank of the country.
 Initially, the paper money was convertible into
gold or gold coins, but these days it is
inconvertible in all countries of the world.
 CONCEPTS OF MONEY
 Paper Money:
 Merits:
 Not an expensive system of currency
 Supply can easily be adjusted
according to the need
 Easily transferrable
 Demerits:
 Always a possibility of excessive supply of paper
money which leads to inflation in the economy
and fall in the value of the currency.
 CONCEPTS OF MONEY
 Bank Deposits:
 There are three types of bank deposits:
 Current Account Deposits
 Saving Deposits
 Time Deposits
 Current A/C deposits are widely referred to as demand
deposits which are also known as ‘bank money’ and
‘credit money’.
 Conventional approach included only demand deposits
in the definition of money but Chicago approach treats
saving and time deposits as close substitute to demand
deposits.
 CONCEPTS OF MONEY
 Near Money:
 Near money refers to those promissory notes
which can be easily converted into money, but
can not be used as money to buy goods and
services.
 Near money includes treasury bills, bonds,
securities, fixed deposits in banks, insurance
policies, etc.
 Thus, compared to paper money near money is
less liquid.
 FIAT PAPER MONEY
 Fiat Paper Money: This means most coin and paper
currencies that are used throughout the world are fiat
money. This includes the U.S. dollar, the British pound, the
Indian rupee, and the euro.

 It is a kind of inconvertible paper money issued by the

state under emergency conditions. That’s why, it is also
known as emergency money.
 Government issued it in limited quantity.
 German Mark issued during World War I and the entire
paper money during World War II were a sort of fiat
money.
 QUESTIONS
 What are the demerits of
commodity money?
 What do you mean by near money?
 How paper money into
come existence?
 What do you mean by fiat
money?
 MONEY
FACTORS AFFECTING DEMAND FOR MONEY
 FACTORS AFFECTING DEMAND FOR MONEY

 The demand for money is affected by

several factors, including the level of income,
and inflation
interest rates, as well as uncertainty about the
future.
 The way in which these factors affect demand for
money is usually explained in terms of the three
motives for demanding money:
 transaction motive,
 precautionary motive, and
 speculative motive.
 TRANSACTION MOTIVE
 The transactions motive for demanding money
arises from the fact that most transactions involve
an exchange of money.
 Because it is necessary to have money available for
transactions, money will be demanded. The total
number of transactions made in an economy tends
to increase over time as income rises.
 Hence, as income or GDP rises, the transactions
demand for money also rises.
 PRECAUTIONARY MOTIVE
 People often demand money as a precaution
against an uncertain future.
 Unexpected expenses, such as medical or car
repair bills, often require immediate
payment.
 The need to have money available in such
situations is referred to as the precautionary
motive for demanding money.
 SPECULATIVE MOTIVE
 Money, like other stores of value, is an asset. The
demand for an asset depends on both its rate of return
and its opportunity cost.
 Typically, money holdings provide no rate of return and
often depreciate in value due to inflation.
 The opportunity cost of holding money is the interest
rate that can be earned by lending or investing one's
money holdings. The speculative motive for demanding
money arises in situations where holding money is
perceived to be less risky than the alternative of lending
the money or investing it in some other
 SPECULATIVE MOTIVE
 For example, if a stock market crash seemed imminent, the
speculative motive for demanding money would come into
play; those expecting the market to crash would sell their
stocks and hold the proceeds as money.
 The presence of a speculative motive for demanding money
is also affected by expectations of future interest rates and
inflation.
 If interest rates are expected to rise, the opportunity cost of
holding money will become greater, which in turn
diminishes the speculative motive for demanding money.
Similarly, expectations of higher inflation presage a greater
depreciation in the purchasing power of money and
therefore lessen the speculative motive for demanding
money.
MONEY
MEASURES OF MONEY
 SUPPLY OF MONEY
 Modern form of money is simply pieces of paper or numbers in a
ledger.
 Earlier money was in the form of coins, composed of gold, silver
and copper ,etc. Value of the coins was based on the value of the
metals they contained.
 System of paper money was introduced based on the gold
standard or silver standard or some combination of the two, to
ensure people’s faith in the system.
 The gold standard broke down in 1930 in UK, in USA it lasted till
1971
 This piece of paper is just like a promissory note issued by a
relevant authority.
 A currency issued by the government is called a fiduciary issue
(based on trust and confidence).
 SUPPLY OF MONEY
• In India the Reserve Bank of India is responsible for money
supply and control.
• India followed the proportional reserve system until 1956,
whereby a reserve of gold, silver, government securities and
foreign securities was maintained, of which gold and or foreign
securities were at least 40% of total reserves.
• In 1956 this was replaced by fixed minimum reserve system in
which reserve worth Rs. 400 crore including gold worth Rs.
115 crores was kept, which was reduced to Rs. 200 crore
including gold worth Rs. 115 crores in 1957.
• Thus practically Indian currency is nonconvertible in any
precious metal and is a fiat money that is declared by state to
be a legal tender. Under this system any number of notes can
be printed as per needs of the economy.
 MONEY SUPPLY AGGREGATES
• Narrow money includes only very liquid assets like currency, i.e. notes and
coins in the hands of public and demand deposits in the banks
• Broad money includes a set of less liquid assets like term deposits with banks
M1: Currency with public, i.e. coins and notes + demand deposits of public with
banks. It is also known as Narrow Money
M2: M1 + Post office savings deposits
M3: M2 + Time deposits of the public with banks+ “Other” deposits with RBI. It is
also known as Broad Money.
M4: M3 + All other deposits with Post office
M0: Currency in circulation+ Bankers’ deposits with RBI+ “Other” deposits with RBI.
It is also called Reserve Money.
Now RBI calculates only three of the above measures, i.e. M0, M1, and M3.

• Money Multiplier = M3 / M0
• Monetization = M1 / GDP
• Monetary Deepening = M3 / GDP
 QUESTIONS
 What is the precautionary motive
for demand of money?
 What is the transaction motive
for demand of money?
 What is the speculative motive
for demand of money?
 What are the broad and
narrow definitions of money?
Thank You
Inflation
 Lecture Plan

• Inflation
• Causes of Inflation
• Inflation and Decision Making
• Measuring Inflation
• Inflation and Employment
• Control of Inflation
 Objectives
• To explore the realms of inflation and its different frontiers.
• To delve into concepts like wage price spiral, hyperinflation
and inflationary gap.
• To understand various measures of inflation and their role in
decision making.
• Toanalyze the reasons behind inflation, its impact on
the economy and the measures to curb it.
 Inflation
• Coulborn: it is a state of “too much money chasing too few goods”.
• Two broad categories:
– price inflation (generally called as inflation)
– money inflation.
– Money inflation is increase in the amount of currency in circulation. Which
may be due to:
• Deficit financing : direct cause is printing of additional currency on
demand of the government to meet its needs.
• Additional money supply through foreign exchange inflows in the form
of capital, such as foreign direct investment and foreign institutional
investment, tourism and other incomes from abroad.
Price inflation is a persistent increase in the general price level or a
persistent decline in the real income of people, i.e. decline in
value of money.
 Concepts of Inflation
• Headline Inflation: measure of the total inflation within an economy

– affected by the areas of the market which may sudden

experience
inflationary spikes such as food or energy.
• Hyperinflation: prices increase at such a speed that the value of money erodes
drastically

– This is also known as galloping inflation or runaway inflation.

• Stagflation: a typical situation when stagnation and inflation coexist.

• Disinflation: a process of keeping a check on price rise by deliberate attempts.

• Deflation: a state when prices fall persistently; just opposite to inflation

• Inflationary Gap (Keynes): Excess of anticipated expenditure over available

output at base price

– When money income exceeds the supply of goods and services, a gap is
 Wage Price Spiral

Wages chase prices and prices chase wages, thus create a wage
price spiral.

•When prices rise,

demand workers Prices Rise
nominal) wages
higherto protect
money their (or
real wages. This raises the costs Cost of
faced by their employers. production
rises Cost of
•To protect the real value of profits living rises
producers pass the higher costs
onto consumers in the form of
higher prices. Wages rise
•Workers (who are also consumers
demand for higher money wages.
 Causes of Inflation
• Demand Pull Inflation: when aggregate demand increases due to any reason, and supply of
output is unable to match this increased demand; i.e demand pulls prices up.
– Increase in money supply/ Increase in disposable income
– Increase in aggregate spending
– Increase in population of the country
• Cost Push Inflation: An increase in price of any of the inputs will increase the cost of
production; i.e. prices pushed up by cost.

• Low Increase in Supply: if supply falls short of demand, prices will increase.

– Obsolete technology/Deficient machinery

– Scarcity of resources

– Natural calamities/ Industrial disputes/ external aggressions

• Built in Inflation: Built in inflation is a type of inflation that has resulted from past events and
persists in the present.

– It is also known as hangover inflation.

 Inflation and Decision Making
• Impact on Consumers

– increase in any price upsets the home budget.

• Impact on Producers (or Suppliers)

– Producers as sellers are benefited by inflation;

• higher the prices, higher are their profits.

– when as buyers of raw material, they are
adversely affected by inflation.

Impact on Government:

– Government has to take the economy to higher levels of growth by encouraging production and
investment,
– At the other end, has to see that taxpayers’ money is not eroded by hyperinflation.

– Thus government has to act as the balancing force between consumers and sellers.
 Measuring Inflation
• A price index is a numerical measure designed to compare how the prices of
some class of goods and/or services, taken as a whole, differ between time
periods or geographical locations. (prices of the base year are assumed
to
be equal to 100.)

Current Year's Price

100

Base Year's Price

Price Index =

• The most common term used to denote inflation is inflation rate, which is
Current Year's
annual rate of increase of prices.
Inflation Rate
Index
 Measuring Inflation
• Producer Price Index (PPI): measures average changes in prices received by domestic
producers for their output.

• Wholesale Price Index (WPI): measures wholesale prices of a wide variety of goods (including
consumer and capital goods.

– USA has replaced WPI with PPI

• Consumer Price Index (CPI): measures the price of a selection of goods purchased by a typical
consumer.

– CPI differs from PPI in that price subsidy, profits, and taxes may cause the amount
received by the producer to differ from what the consumer paid.

• Cost of Living Indices (COLI): used to adjust fixed incomes and contractual incomes to
maintain the real value of such incomes.

– wage indexation is based on such indices.

• Service Price Index (SPI): With the growing importance of service sector across the world,
many countries have started developing services price indices (SPI).
 Control of Inflation

• Inflation erodes the value of money and discourages

savings
• But zero inflation is undesirable
• Need to control inflation
– monetary policy measures (proposed by those who
believed money supply is the major culprit)
– fiscal policy measures (proposed by Keynes and his
followers).
– Other measures
• The government has to adopt an appropriate
combination of these measures after thorough
examination of the causes of inflation
 Monetary Policy Measures

• Increasing the discount rate: The central bank

rediscounts the eligible papers offered by commercial
banks. This is also called bank rate.
• Higher reserve ratios:
• Cash Reserve Ratio (CRR)
• Statutory Liquid Ratio (SLR)

• Open market operations: directly sell government

securities to public and restrain their disposable income
• Selective credit control: discourages consumption but
not investment
 Fiscal Policy Measures
The government may reduce public expenditure or increase public
revenue to keep a check on inflation
• Reducing public expenditure

• When government spends on activities like health, transport,

communication, etc., income of individuals increases; this in
turn increases the aggregate demand.
– Therefore the reverse will also be true.

• Increasing public revenue

– Major source of government revenue is various types of taxes
– Increase in income tax leaves less of disposable income in the hands
of
consumers
`
 Learning Outcomes:

1. Meaning and Scope of monetary policy;

2. Instruments of monetary policy;

3. Role of Monetary in achieving

Policy macroeconomic goals;

4. Effectiveness and limitations of monetary policy.

 “Monetary policy refers to the action taken
by the monetary authorities to control and
regulate the demand for and supply of money
with a given purpose.”
 Scope of Monetary Policy:

The scope of monetary policy depends, by

and large, on two factors:

i. The level of monetization of the economy, and

ii. The level of development of the financial market

 INSTRUMENTS OF MONETARY
POLICY
General Credit Control Selective Credit Control
Measures Measures
1. Bank Rate 1. Credit Rationing
2. CRR 2. Change in Lending
3. Open Market Margins
Operations 3. Moral Suasion
4. SLR 4. Direct Controls
5. Repo Rate (Repurchase
operation rate)
 General Measures:

1. Bank Rate Policy:

• The rate at which central bank lends money to the

commercial bank and rediscounts the bills of
exchange presented by commercial banks is termed
as bank rate
• The central bank can change this rate- increase or
decrease- depending on whether it wants
expand or reduce the flow of credit to from
commercial banks. the

• Current Bank rate (Dec, 2012): 9.00 %

 Limitations of BR as a Weapon of Credit Control

1. Nowadays, commercial banks are not dependent

only on financial support from central bank, which
makes change in rate ineffective.

2. With the growth of credit institutions and financial

intermediaries, capital market has widened and
share of banking credit has declined.
 2. Cash Reserve Ratio:

• Also termed as Statutory Reserve Ratio (SRR)

• It is the percentage of total deposits which

commercial banks are required to maintain in the
form of cash reserve with the central bank.

• Objective of CRR is to prevent shortage of cash for

meeting the cash demand by depositors.
• By changing CRR, the central bank can change
the money supply overnight

• When contractionary monetary policy is to

be adopted , then the central bank raises the CRR

• When expansionary monetary policy is to be adopted

then central bank cuts down the CRR

• Current CRR is 4.75 %

3. Open Market Operations

Open Market Operations is the sale and purchase

of government securities and Treasury Bills by the
central bank the country.
of
WHAT ARE TREASURY BILLS?
• In India, Treasury Bills are short-term promissory
notes issued by the Government of India through
the RBI.

• There are two kinds of Treasury Bills:

a) 91- Day Bill : are issued by the RBI on behalf of the

government at fixed discount rate of 4.6 %. The
RBI provides rediscounting facility within 14 days
of issue at an additional rediscounting fees.
b) 182- Day Bill: introduced in 1986, are sold by
auction to residents of India for a minimum value
of Rs 1,00,000.

• The auction bid is invited every fortnight and the

‘discount rate’ is decided on the basis of auction
rate.
• When central bank decides to pump money into
circulation, it buys back the government securities,
bills and bonds

• When it decides to reduce money in circulation, it

sells the government bonds and securities.
 How the sale of government bonds affects the
supply of credit?

1. Purchase of govt. securities reduces deposits with

commercial banks and their cash reserves which
leads to decreased credit creation capacity of the
banks.
• When commercial banks themselves decide to buy
the govt. bonds and securities, their cash reserves
go down which further reduces credit creation
capacity of the commercial banks.
 How the sale of government bonds affects
the demand of credit?

1. Central banks sells the government bonds them

at a reduced price, i.e., at a price less than their
denominated price.

2. Consequently, the actual rate of interest on the

bonds goes up which causes an upward push in
the overall interest rate structure
3. The rise in the rate of interest reduces the demand
for credit.
 Effectiveness of
OMO

Under the following conditions, OMO do not work

properly:

1. When commercial banks possess excess liquidity.

2. In UDC’s where banking system is not well

developed and security capital markets are not
interdependent, OMO have a limited
TIME FOR QUIZ
1. What is meant by monetary policy?

2. What monetary measures have been used by the

RBI to control inflation in the country?

3. How does the working of OMO affect the money

supply in a country like India?
4. Statutory Liquidity Ratio:

• Under SLR, the commercial banks are required to

maintain a certain percentage of their total daily
demand and time deposits in the form of liquid
assets.
• Liquid assets include:

a) Excess reserves

b) Unencumbered government securities, e.g. bonds

of IDBI, NABARD, Development Banks, debentures
of ports, trusts etc.

c) Current account balance with other banks

5. Repo rate: RBI buys securities from banks and
thereby provides funds to the banks. The rate of
interest at which the RBI lends money to the bank is
the repo rate.

6. Reverse repo rate: is the rate at which the banks

can buy securities or deposit money with the
RBI
 Quiz

1. What do you understand by SLR, Repo Rate, and

Reverse repo rate

2. Current rates?

3. How increase and decrease in repo rate affects

the credit creation?
2. Selective Credit Control Measures:

1) Credit rationing

2) Change in Lending Margins

3) Moral Suasion

4) Direct Controls
 Limitations and Effectiveness of Monetary Policy:

1. The Time Lag

2. Problems in Forecasting

3. Growth of Non-Banking Financial Intermediaries

4. Underdeveloped Money and Capital Markets

 ?

1. Differentiate between general and selective credit

control measures?

2. What are the factors that determine the

effectiveness of monetary policy?

3. What monetary measures have been used by RBI

in achieving the policy targets?
 FISCAL POLICY

Learning Objectives:
1. Meaning and scope of fiscal policy
2. Differentiate between financial instruments and
target variables
3. Kinds of fiscal policy
4. Fiscal policy and macroeconomic goals
• The word ‘fisc’ means ‘state treasury’ and ‘fiscal
policy’ refers to policy concerning the use of ‘state
treasury’ or government finances to achieve certain
macroeconomic goals.
Fiscal Instruments

1. Budgetary policy deficit or surplus budgeting

2. Government expenditure

3. Taxation

4. Public borrowings
Target Variables
Variables which are sought to be changed through
fiscal instruments are:

1. Private disposable incomes,

2. Private consumption expenditure,

3. Private savings and investment,

4. Exports and imports, and

5. Level and structure of prices

 ?
How Fiscal Instruments Affect Target Variables?
Kinds of Fiscal Policy

1. Automatic Stabilization Fiscal Policy,

2. Compensatory Fiscal Policy, and

3. Discretionary Fiscal Policy

 Fiscal Policy and Macroeconomic Goals

1. Fiscal Policy for Economic Growth

2. Fiscal Policy for Employment

3. Fiscal Policy for stabilization

4. Fiscal Policy for Economic Equality

Crowding –Out and Crowding-In Controversy

Crowding-Out refers to the adverse effect of high

deficit spending by the government on private
investment.

Crowding-in means rise in the private investment

due to deficit spending by the government.
 ?
1. What is fiscal policy?

2. Differentiate between fiscal instruments and

target variables?

3. Discuss the role of fiscal policy in achieving

economic growth?

4. Fiscal policy is the most powerful tool of achieving

macroeconomic goals. Discuss.
 BALANCE OF PAYMENTS

Learning Outcomes:
1. Meaning and purpose of BOP
2. Accounting methods of BOP
3. India’s position in BOP
4. Factors responsible for imbalance in BOP
• “BOP is statement of economic transactions of a
country with the rest of the world over a period of
time.”

• It can also be defined as a statement of all

economic transactions between the residents of a
nation and the rest of the world during a period of
time, usually one year.
Purpose of BOP

• Yields necessary information on the strength and

weakness of the country in international economic
status.

• By analyzing the BOP account, one can find the

overall gains and losses from the international
economic transactions.
• BOP statements give warning signals for future
policy formulation.
 BALANCE OF PAYMNETS ACCOUNTS

Economic transactions of a can be

country categorised as:

1. Current transactions

2. Capital transactions
 Factors Responsible for Imbalance in BOP
1. Inflation
2. Business cycle
3. Structural changes
4. Short-term disequilibrium factors
 ?
1. What is BOP?
2. What is disequilibrium in BOP
3. What are the major causes of disequilibrium in the
BOP?