CH : 2 MACROECONOMIC ENVIRONMENT : MAJOR ISSUES

Jaimin Chhapia (124221) Krishna Shah(124232) Krupali Patel (124233) Kunal Shah(124235) Aarti Poddar (124201)

INTRODUCTION
Having discussed the nature and scope of business environment. Major macroeconomic issues considered while taking business decisions. The important macroeconomic issues :

Rate economic growth of the country Magnitude of employment generation in the economy Foreign exchange rate of the national currency Balance of payments situations of the country

ECONOMIC GROWTH

Meaning

Economic growth has been defined in two ways:

First

It is defined as increase in an economys real national income or gross national product (GNP).

Second

Second and better way to define is to do so in terms of per capita income.

ECONOMIC GROWTH & ECONOMIC

DEVELOPMENT

Since 1970 s

Necessary to distinguish between economic growth & Economic development. Two Views :

Traditional View

In this view share of agriculture in both national product and employment of labor force declines and that of industries and services increases.

C.P. Kindelberger writes, Economic growth means more output and economic development implies both more output and changes in the technical and institutional arrangements by which it is produced

Thus according to this view economic development implies growth plus structural change.

Modern View The problems of poverty, unemployment and income inequality further worsened instead of getting reduced during the process of growth in the fifties and sixties in the developing countries.

Thus due to failure of traditional strategies of development in solving the problems of poverty, unemployment and inequality..

This led to view that economic development should not be judged on the basis of growth in GNP alone.

POVERTY AND ECONOMIC GROWTH

Despite

significant economic growth achieved during the last half a century, there still prevails widespread poverty in developing countries.

Drastic

changes in seventies.

India

declined during nineties.

TOTAL FACTOR PRODUCTIVITY & ECONOMIC GROWTH

Y=AF(L,K,N)
Where, Y=GDP A=Total factor productivity L=Quantity of labor input K=Size of capital stock N=Quantity of natural resources

Now in studies of growth N=constant & Human capital (H) is added Y=AF(L,K,H)

ECONOMIC GROWTH
Economic Growth = Growth rate of supply of resources + rate of increase in total factor productivity % GDP = % TFP + 0.70(% L) + 0.30(% K)

Where GDP= Change in GDP TFP=Change in Total Factor Productivity L=Increase in the quantity of labor K=Increase in the capital stock

ARE NATURAL RESOURCES A LIMIT TO GROWTH???

Economic Growth living standards Club of Rome Non-renewable natural resources restricts the economic growth 2 saving factors

1)

Technological Progress 2) Discovery & Use of the substitute resources

ASIAN TIGERS & ECONOMIC GROWTH

Hong Kong, Singapore, South Korea, Taiwan Per capita GDP growth rate is 5.7 to 6.8 & they claim Special Tricks Economists like Alwyn Young say that no special tricksIts just increase in inputs like labor, human capital etc & increase in TFP Outward-looking economic strategy (promotion of exports to generate growth) & lissez-faire free market policies China & India too have registered a higher growth rate & have become the two fastest growing economies of the world.

INFLATION & ITS MEASUREMENT

Persistent rise in general price level Measured by % change in WPI & CPI It makes the rich richer & the poor poorer

Pt - Pt-1

Pt-1 Where Pt=Price level of the current year & Pt-1=Price level of the previous year

Similarly can be found out by the CPI where price of a basket of goods is taken in account

WHAT CAUSES INFLATION??

Quantity Theory of Money Demand-pull Inflation : Keyness View Cause of Inflation : Monetarists View Cost-Push Factor

1. 2. 3.

EMPLOYMENT AND UNEMPLOYMENT

An important macroeconomic issue is what determines the level of employment in the economy and what causes involuntary unemployment. Involuntary unemployment is defined as the situation when in the country there are a large number of workers who are willing to work at the current wage rates but are unable to get employment. In times of depression, the level of employment declines very low with the result that a large number of persons become involuntarily unemployed.

SAYS LAW AND EMPLOYMENT

According to Says Law, there is always enough expenditure or aggregate demand to purchase the total output produces with full-employment or resources. In other words, in their theory, the classical economists neglected the problem of deficiency of demand for purchasing goods produces at fullemployment level of resources. Even if deficiency of demand arises, according to them, prices and wages would change in such a way that real production, employment and income will not decline.

Says Law is based on the fact that every production of goods also creates incomes for the factors of production equal to the value of goods produced by them. Income earned by the factors are spent on purchasing goods produces. Supply creates its own demand, as a result, the problem of general overproduction and unemployment of resources do not arise.

According to classical economists, savings by the individual are automatically spent on investment or capital goods. Therefore, since saving becomes another form of expenditure (that is, investment expenditure), in classical theory the whole income is spent, partly on consumption and partly on investment. That is why, there is no reason for any leakage in the income stream and therefore supply creates its own demand.

Another reason is that, according to classical theory, it is the rate of interest which makes investment equal to saving. When saving of the people increases, rate of interest declines. As a result, the demand for investment increases and in this way investment expenditure becomes equal to the increases savings. In other words, it is changes in the rate of interest due to which the withdrawal of some money from the income stream as a result of savings automatically comes back to it in the form of investment expenditure and therefore income flow continues unchanged and supply goes on creating its own demand.

FLEXIBILITY IN PRICES AND WAGES AND FULL EMPLOYMENT: THE VIEW OF CLASSICAL ECONOMISTS
According to Classical Economists, if changes in rate of interest somehow fail to bring about equality between savings and investment and as a result deficiency of aggregate demand or expenditure arises, even then the problem of overproduction and involuntarily unemployment will not arise. This is because they thought that the deficiency in aggregate demand would be made up by change sin the price level.

When, due to the increase in savings by the people, the expenditure of the people declines, therefore, it will affect the prices of products. As a result, aggregate expenditure or demand will fall and therefore, the prices of products would declines and at reduced prices their quantity demanded will increase. Therefore, all the quantity of goods produced will be sold out at lower prices.

Thus, Classical economists thought that a freemarket capitalist economy works in a self-correcting manner and when aggregate expenditure on goods or aggregate demand for them declines, then various sellers and producers will reduce prices of their products so as to avoid the excessive accumulation of stocks of goods with them. Hence, according to them, when aggregate demand declines due to investment expenditure falling short of saving, the prices of products will decline, the level of production and employment remaining unaffected.

VOLUNTARILY UNEMPLOYMENT
If some workers do not want to work at the lower wages, they will not get any job or employment and therefore will remain unemployed. But, according to classical economists, those workers who do not want to work at lower wages and does remain unemployed are only voluntarily unemployed. This voluntarily unemployment is not real unemployment. According to the classical thought, it is involuntarily unemployment which is not possible in a free market capitalist economy.

J.M. KEYNES
During the period 1929-33, Keynes challenges the classical theory and put forward a new theory of income and employment. He brought about a basic change in economic thought regarding the determination of income and employment. Therefore, it is often said that Keynes brought about a revolution in economic theory. Keynes made a genuine break and a basic departure from the Classical economics. His macroeconomic theory is therefore called Keynesian revolution or New Economics.

KEYNES ON EMPLOYMENT AND

UNEMPLOYMENT Keynes challenged the correctness of Says law that supply creates its own demand. According to him, if aggregate demand is not sufficient to purchase the entire supply of goods then the producers would be unable to sell their whole output. As a result, their inventories of goods will increase beyond their desired level. This will cause the producers to reduce their level of production giving rise to unemployment in the economy.

Keynes showed that there was no guarantee that investment expenditure by entrepreneurs would be equal to the desired savings by people. While savings are done by individuals and households, investment expenditure is made by entrepreneurs. Saving depend on various subjective factors such as willingness to save for old age, for periods of sickness and unemployment, for education and marriage of their children, for amassing wealth to leave behind a large estate etc.

Apart from this, savings also depends on level of prices, rate of inflation, rate of interest, taxation policy of the government, distribution of income, and wealth in the society and expectations of future income. Investment by the entrepreneurs are determined by rate of interest and expected rate of profits in the short run and progress in technology, growth in population in long run. As a result, problem of demand deficiency arises which causes involuntarily unemployment.

Keynes also challenged the classical viewpoint regarding the impact of all-round cut in money wages on output and employment of labor. According to him, while in case of the analysis of process and output determination of an individual industry, it is justified to assume that a cut in wages by the industry would not significantly affect the demand for the product of that industry because most of the demand for the product of that industry comes from the workers and persons employed in other industries.

Keynes explained that the level employment was determined by aggregate demand and aggregate supply. He showed that equilibrium level of income and employment could well be established at less than full-employment level of national income. Thus, according to him, lack of aggregate demand can cause involuntarily unemployment of labor and unutilized productive capacity.

EMPLOYMENT STRATEGIES TO REDUCE UNEMPLOYMENT

IN ORDER TO REDUCE UNEMPLOYMENT PROBLEM IN INDIA FOLLOWING MEASURES SHOULD BE ADOPTED :

Use of Labour-Intensive Technology :

In order to generate employment both the rural and urban sectors must adopt these steps. The decline in employment elasticity of output growth is due to the increasing trend in capital intensity in organised sector as well as agriculture. Due to enhancement of technology the employment elasticity of growth of agricultural output has to discourage use of capital intensive technology So there must be proper trade off between employment and growth of outputs

ACCELERATING INVESTMENT IN AGRICULTURE:

Due to shortfall in investment or capital formation in agriculture the unemployment problem is faced. Both the public and private sector investment in agriculture has declined. So this problem could be overcomed by investing in infrastructure which operates through backward and forward linkages. Government has announced to furnish more credit to farmers at lower than market rates of intrest which will lead to growth of agricultural sector.

LABOUR INTENSIVE INDUSTRIAL GROWTH:

For solving employment problems in the urban areas organized industrial sector must absorb sufficient number of workers. The cause for failure is capital intensive technology imported from abroad which tries to improve competitiveness to face imported commodities. Also factor- price distortions like cheap capital and relatively higher wages of workers is the cause for such issue. Capital has become cheaper due to liberal fiscal consessions which leads to use of capital intensive technology so there must be proper trade off between employment and output.

SERVICE AND EMPLOYMENT GROWTH

Growth of service has a large employment potential. For eg. Software and BPOs. It must be noted that growth of such sector is dependent on industrial and agricultural growth in the economy.

EDUCATION, HEALTH & EMPLOYMENT GENERATION

Lastly expansion of education and health care not only promotes accumulation of human capital and thereby contributes to growth of output it will also generate a good deal of employment opportunities. Working of these sectors will provide employment of both skilled and unskilled persons.

BALANCE OF PAYMENTS :

The balance of payments is a systematic record of economic transactions of residents of a country with the rest of the world during a given period of time. It is prepared to measure various components of a countrys external and economic transactions. This helps to find out international economic position of a country which helps the Government in decision making on monetary and fiscal policies of a country.

BALANCE OF TRADE AND BALANCE OF PAYMENTS :

It refers to difference in values of imports and exports of commodities only. During a given period of time, the exports and imports may be exactly equal in which case balance of trade is said to be in balance. If value of exports exceeds the value of imports than it is regarded as export surplus. And if the value of its imports exceeds the value of exports it is regarded as deficit balance of trade.

BALANCE OF PAYMENTS ON CURRENT ACCOUNT :

Two types of balance of payments are distinguished- (a) Balance of payments on current account (b) Balance of payment on capital account. Balance of payment on current account is more comprehensive in scope than balance of trade. In not only includes imports and exports of a country which are visible items but also invisible items such as foreign travel ,insurance etc.

BALANCE OF PAYMENT ON CAPITAL ACCOUNT :

In balance of payments of capital account the important items are borrowings from foreign countries and lending funds to other countries. This takes two forms - (a) External assistance which means aid from foreign countries at concessional rates of intrest. (b) Commercial borrowings under which the Indian Government and the private sector borrow funds from world money markets at the market rates of intrest.( c )Short term debt which is incurred on short term borrowing on trade account. ( d ) In addition, non resident deposits made by NRIs. (e) and by investment done by foreign companies in India.

DISTINCTION BETWEEN CURRENT ACCOUNT AND CAPITAL ACCOUNT

The major diffrence is that current account deals with payment for currently produced goods and services on the other hand capital account deals with capital receipts and paymenst of debts and claims. The current account of balance paymenst has a direct effect on the level of income in a country where as capital account does not have any such direct effect on the level of income; it influences the volume of assets which a country holds.

DOES BALANCE OF THE PAYMENTS MUST ALWAYS BALANCE?

The individuals and business firms of an economy have to pay for the imports and if exports are not sufficient to pay the imports than how the balance of payment will be in balance? Here is a example, The balance of payments on current account of india has been in deficit for most the years. Deficit on current account implies that the residents are paying more on imports than the incomes they are earning from exports.

For the overall balance of payment to be in balance, this deficit in the current account of the balance of payments must be financed by selling capital assests such as shares. Both selling assests or by borrowing from abroad, foreign capital flows into the country as has been happening in the last several years in India. These foreign capital inflows are shown in the capital account of the balance of payments which must be in surplus to finance the deficit in the current account. Current account + capital account surplus = 0

CAPITAL FLOWS AND GLOBALIZATION

The globalization of the Indian economy has an important consequence with regard to capital flows into the economy. Suppose India faces given prices of its imports and a given demand for its exports. So, if domestic rate of interest is higher as compare to what exists abroad, then given the mobility of capital, capital will flow into Indian economy to a very large extent.

BP = NX ( Yd, Yf, R) + CF(If Id) BP= balance of payments, NX= net exports, CF= surplus ( Capital flows) An increase in the domestic income due to higher industrial growth or fall in real exchange rate of rupee will adversely affect the trade balance inflows.

FOREIGN EXCHANGE RATE

Exchange Rate is the value of national currency in terms of a foreign currency. Change in foreign exchange rate effect the price of exports and imports which is turn determine there volume and there by determine balance of payments of a country. In the long run the foreign exchange rate between the two currencies is determined by the purchasing powers of the two currencies in the domestic economies.

In the short run, the demand for imports and exports of goods and services, magnitude of capital flows between the countries effect demand for and supply of foreign exchange and there by determine the exchange rate between the currencies. The system of exchange rate in which the value of a currency is allowed to adjust freely or to float as determine by demand for and supply of foreign exchange is called as flexible exchange rate.

If foreign exchange rate instead of been determine by demand for and supply of foreign exchange is fixed by the govt. its is called the fixed exchange rate system. In a fixed exchange rate system the govt has to buy or sell foreign exchange in order to maintain the rate at the controlled level. However under the fixed exchange rate system the value of once currency can be changed.

A one time lowering of value of its currency in terms of foreign exchange by a country is called Devaluation. With the fixed rate exchange system if a country raises the value of its currency in terms of foreign currency, it is called Revaluation.