Allmacroeconomicsppts 130321114704 Phpapp02

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
Macroeconomics deals with the economy
as a whole. It studies the behaviour 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
Macro Economics entities like firms,
households
and the government.
It is very useful to the planner for
preparing economic plans for the country's
development.
It is helpful in international comparison.
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 and

intricate interrelationship among
macroeconomic variable, such as price
level, income, output and employment.
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.
Study of problems relating to economic
growth or increase in per capita real
income forms part of macro economics
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?
What is the subject matter of Macro
economics?
Do you think study of Macro Economic
aggregates is useful for an individual
firm? Justify your answer with appropriate
example.
National Income
Lecture Plan
Introduction to National Income

Concepts of National Income
Real and Nominal GDP
Methods for Measuring National Income
Uses of National Income Data
Difficulties in Measurement of National
Income
Learning objective
To understand various concepts of national

income, like GDP, GNP and NNP.
To understand the different methods of
measuring national income.
To understand the importance of national
income calculations.
To understand the difficulties involved in
the calculation of 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 within the domestic territories of a country
during an accounting year.
GDP= C+I+G+(X-M)
GDP at market price: includes the final value of
goods and services also includes indirect taxes and
excludes the subsidies given by the government.
GDP at factor cost is the money value of final
goods and services based on the cost involved in the
process of production.
Gross Domestic Product at factor cost
= GDP at Market Prices Indirect Taxes+ Subsidies
Gross National Product
Gross National Product (GNP): GNP is
the aggregate final output of citizens and
businesses of an economy 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
Net Domestic Product and
Net National Product
Net Domestic Product
= GDP-Depreciation
Net National Product (NNP)
= GDPDepreciation +NFIA
Or =GNPDepreciation
Thus NNP is the actual addition to a years 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+(XM)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.
Personal Income = National Income Undistributed Corporate Profits
Corporate Taxes Social Security Contributions + Transfer Payments
+ 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
Real GDP and Nominal GDP
Nominal GDP = National income estimated at the prevailing prices is

called nominal GDP.
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 is the ratio of nominal GDP in a year to real GDP of

that year
GDP deflator measures the change in prices between the base
year and the current year.
?
How far national income of a

country a measure of welfare?
?
What is the Difference between

GDP and GNP?
Whether unemployment allowance
from the government is to be
included in the national income. Why
or Why not?
Will the transfer payment be a
part of personal income or not?
GDP and Economic
Well-Being
GDP is the best single measure of the

economic well-being of a society.
GDP per person tells us the income and
expenditure of the average person in the
economy.
GDP and Economic
Well-Being
Higher GDP per person indicates a higher

standard of living.
GDP is not a perfect measure of the
happiness or quality of life, however.
GDP and Economic
Well-Being
Some things that contribute to well-being are

not included in GDP.
The value of leisure.
The value of a clean environment.
The value of almost all activity that takes
place outside of markets, such as the value
of the time parents spend with their
children and the value of volunteer work.
Methods of measuring national income
Product (or Output) Method

Income Method
Expenditure Method
Product method is also called Value Added Method
or Industrial Origin Method
The market value of all the goods and services

produced in the country by all the firms across all
industries are added up together.
Steps of Value Added or Product Method:
Step 1 : Identification and Classification of

Producing Enterprises
a) Primary Sector: refers to that sector

wherein goods are produced by
exploiting natural resources
b). Secondary Sector: This sector is also
called manufacturing sector. Enterprises of
this sector transform one type of good into
another type.
c) Tertiary Sector: provides services and so is

called service sector. It includes trade,
hotels, transport and communication,
financing, insurance. Service alone are
Step 2: Estimation of Value Added
Value added is the difference between

value of output of an enterprise and the
value of its intermediate consumption
(non-factor inputs).
Value added = Value of output- Value of

non-factor input
Value of Output= Sales + Change in stock

Value added may be of the following
kinds:
1. Gross Value added at Market Price:

Gross value added is the difference
between value of output and
intermediate goods. Gross domestic
value added is equal to gross
domestic product at market price.
Estimating Value Added
Item Value of Cost of Value

Producing Output (Rs) Intermedia Added
Enterprise te Goods
Farmer 600 200 400
Flour Mill 800 600 200
Baker 1000 800 200
Shopkeeper 1200 1000 200
Total 3600 2600 1000
Limitations of Product Method
Problem of Double Counting:
unclear distinction between a final and an intermediate
product.
Not Applicable to Tertiary Sector:
This method is useful only when output can be measured
in physical terms
Exclusion of Non Marketed Products
E.g. outcome of hobby or self consumption
Self Consumption of Output
Producer may consume a part of his production.
The market value of all the goods and services produced
in the country by all the firms across all industries are
added up together.
Process
The economy is divided on basis of industries, such as agriculture,
fishing, mining and quarrying, large scale manufacturing, small
scale manufacturing, electricity, gas, etc.
The physical units of output are interpreted in money terms
The total values added up. (GDP at market price)
The indirect taxes are subtracted and the subsidies are added.
(GDP at factor cost)
Net value is calculated by subtracting depreciation from the total
value (NDP at factor cost).
Limitations of Product Method
Problem of Double Counting:
unclear distinction between a final and an intermediate
product.
Not Applicable to Tertiary Sector:
This method is useful only when output can be measured
in physical terms
Exclusion of Non Marketed Products
E.g. outcome of hobby or self consumption
Self Consumption of Output
Producer may consume a part of his production.
Income Method
The net income received by all citizens of a country in a particular year,
i.e. total of net rents, net wages, net interest and net profits. (GDP at
factor cost).
It is the income earned by the factors of production of a country.
Add the money sent by the citizens of the nation from abroad and
deduct the payments made to foreign nationals (individuals and firms)
(GNP at factor cost) or Gross National Income (GNI).
Process:
Economy is divided on basis of income groups, such as wage/salary
earners, rent earners, profit earners etc.
Income of all the groups is added, including income from abroad and
undistributed profits.
The income earned by foreigners and transfer payments made in
the year are subtracted.
GNI = Rent + Wage + Interest +Profit + Net Income from Abroad- Transfer
payments
Step-I
Identification and classification of

producing enterprises
Primary Sector
Secondary Sector
Tertiary sector
Step-II
Classification of factor income

Factor income: a factor income refers to
income earned by a person as a reward
for rendering his factor services.
Factor income are only earned incomes. It
does not include that income which is not
earned.
Step-II
National income= sum of all the factor

incomes
Classification of factor
incomes
Compensation of employees: wages and
salaries, payment in kind, employers
contribution to social security schemes,
pension on retirement.
Operating surplus: it is the income from
the property and entrepreurship.
E.g.Rent, interest, profit etc
Mixed income= it refers to the income of
the self employed persons using their
labor land capital
Precautions while estimating
factor income
Transfer payment
Income from illegal activities
Sale proceeds of second hand goods
The sale proceeds of shares and bonds are not
included in national income
Windfall gains should not be included.
Imputed rent of owner houses is included in NI
Indirect taxes like sales tax excise duty tend to
increase the market price of goods and services.
These are included in the estimation of national
income at market prices but are not added while
Income tax is paid out of compensation of
employees. It should not be added
separately in the estimation of national
income.
Limitations of Income Method
Exclusion of non monetary income: Ignores the non-

monetized section of economic activities.
Exclusion of Non Marketed Services: People undertake
a particular activity that are difficult to ascertain in money
value. E.g. mothers services to the family.
Expenditure method
One mans income is another mans

expenditure
Therefore national income can be arrived
at by adding the total expenditure of
individual and business firms during a
year
Expenditure or outlay on final products
takes place in three ways
50
Expenditure method
Expenditure or outlay on final products takes

place in three ways
Expenditure by consumers on goods and
services( Consumption Expenditure)
Expenditure by entrepreneurs on capital or
investment goods (Investment Expenditure)
Expenditure by government on consumption
and capital goods (Government Expenditure)
Net Exports
51
Expenditure method
The formula for this method is
Y = C + I + G +(X-M)
Here Y stands for total expenditure

C stands for consumption expenditure
I stands for investment expenditure
G stands for Government expenditure
(X-M) Difference between exports and
imports
52
Limitations
Neglects Barter System

Ignores over consumption
Affected by Inflation
53
Difficulties in the computation
of National Income
In backward economies like India, particularly in the rural sector, the
cultivators and small producers are illiterate and they do not keep books of
account. This is a serious difficulty in the calculation of national income
Avoidance of double counting becomes complicated
Existence of Non-monetized sector is dominant
The village money lenders maintain absolute secrecy of their transactions
54
Uses of National Income Data
National income is the most dependable indicator of a countrys 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.
??????????????
?
Consider an economy that produces only

three types of goods: A, B and C. In the
base year (a few year ago), the
production and price data were as
follows:
Fruit Quantity Price
A 3,ooo $2
B 6,000 $3
C 8,000 $4
In the current year the production and
price data are given as follows
Fruit Quantity Price
A 4,000 $3
B 14,000 $2
C 32,000 $4
Find the nominal GDP and real GDP.
Find the GDP deflator for the current year
and the base year. By what percentage
does the price level change from base
year to current year?
Circular Flow of Income
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 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
(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 Y=C+S=C+I=E=O

Circular Flow of Economic Activities
and Income
Value of output produced (Y) = value of output sold (O)
Value of output sold = Sum of consumption expenditure (C) and investment
expenditure (I).
Y=O=C+I=E(1)
Income is either consumed or saved (S).
Y=C+S.(2)
C+I=Y=C+S(3)
Therefore: I = S(4)
Savings are withdrawal of money from the circular flow
Investment is injection of money into the circular flow
For equilibrium savings should be equal to investments
Hence Y=O=E
(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 firms pay 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
goods and services from domestic ones
Governme
nt (G)
Taxe
Taxe
Factor s
s Remittance
Payment
s s for
Factor purchases
Salarie
Inputs
s
Savings
Househol (S) Financial Firms
Market Investme
ds nt
(I) Import
Import Good
s s
s (M)
(M) (O) Consumpti
on
Expenditur
e
Foreign Export
Export Nations s
s (X-M) (X)
(X)National Income=C+I+G+(X-M)
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 3 sector
model.
The classical model of
Income output and
employment
71
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
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
The classical macro model (Assumpations)
Laissez faire policy
Equality between saving and investment
Closed economy
Flexibility of prices, wage and rate of interest.
Rational man
Perfect competition
Constant technology
Law of diminishing returns
76
The real economy.
The supply side of the real economy

factors determining the economys total supply of
goods and services i.e.
how are labor, land and capital owners
compensated
The demand side of the real economy
factors determining the demand for goods and
services, by households, firms and the govt.
Equilibrium
what ensures that total supply = total demand; how
equilibrium in the goods market is achieved
77
The circular flow model with government in
classical theory
78
The supply side of the real sector
the economys total supply of goods and

services/ total income is determined by,
the economys supply of inputs/factors of
production
available technology
factors of production:
K = capital,
tools, machines, and structures used in production
L = labor,
the physical and mental efforts of workers
N = land,
All non-renewable resources
79
available technology: the form of the production
Determination of income and
employment
According to classical economists income
and employment is determined by
production function and equilibrium of
demand for and supply of labor.
80
The production function and its
properties:
represented as Y = F (K, L), N being fixed is
ignored
shows how much output (Y ) the economy can
produce from K units of capital and L units of
labor.
F reflects the economys level of technology
technological progress affects F.
In short period capital and technology remains
constant and employment can be increased by
increasing labor only and the result is
diminishing returns to output.
81
Diminishing marginal returns and the
production function
Y
output
F (K ,L)
MP
1 L As more labor
MP is added, MPL

1 L
Slope of the
MP
L production function
1 equals MPL
L
labo
r 82
Reasons for the diminishing Returns
1. Technology is given.
2. The economys supplies of capital and labor are
fixed at
K K and LL
Output is determined by the fixed factor supplies

and the fixed state of technology:
Y F (K , L)
83
How factor prices are determined - labor
Factor markets are assumed to be competitive.

Hence, factor prices are determined by supply
and demand of factor services.
Supply of each factor=Demand for factor inputs
84
Demand for labor
Demand for labor is diminishing function

of wage. It means , with rise in wage rate
demand for labor falls and with fall in
wage rate demand for labor rises.
W= MRP=PxMPP
W/p=MPP
85
Supply of labor
Supply of labor therefore increases with

rise in real wage and falls with fall in
wage rate.
86
MPL and the demand for labor the
demand curve is the same as the MPL
curve
Units of
output Each
Each firm
firm hires
hires
labor
labor
up
up to
to the
the point
point
where
where MPL
MPL = = W/P
W/P
Real
wag
e
MPL,
Labor
demand
Units of labor,
Quantity of L
labor
demanded
87
Says law of market
Supply creates its own demand

Barter system
Monetary system
88
Flexibility of wages
(Equilibrium in factor market)
Demand and supply of labor through
wage rate determines the equilibrium
89
Flexibility in Rate of interest
and Equilibrium in money
market
I=f(r)
S=f(r)
In money market
S=I
(I-investment, S-Saving)
in this way there is equilibrium in the
aggregate demand and supply.
90
Flexibility of prices level or
equilibrium in money market
Aggregate demand=Aggregate supply
MV=PT
M-money supply
V-velocity of money
P-price level
T-trade transactions
P=f(Money supply)
91
Questions
Meaning of Laissez faire

Demand for Labor and supply of labor
Real Wages Vs Nominal wages
Investment and saving function
92
Points to remember in
Classical Model
Y=f(Employment)
Demand for labor=(w/p)
Supply of labor =(w/p)
S=f(r)
I= f(r)
MV=PT
93
Criticism
Says law not applicable in current

scenario
Employment can not increased by wage
cut
Possibility of underemplymentgn
Absence of automatic adjustment
Ignores the role of short run peroid
Equality between saving and investment
Rejection of laissez policy 94
Keynesian Theory of Income ,
output and employment
95
The General Theory
1. If the consumer is an economic optimizer,

he/she must be unable to buy the goods they
planned to buy because of some kind of
constraintrisk, convention, social institutions,
cash, or ...?
a) According to the classical model, the consumer has
insatiable wants.
b) The money value of the incomes received must be
equal to the value of the output produced.
c) So how can unsold goods pile up in warehouses,
causing firms to lay off workers?
96
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
Assumptions or postulates of
Keynesian Model
Closed economy
Diminishing marginal productivity
Labor is the only factor of production
No time lag
Saving and investment
Two sector model of the goods market in
the economy (no government sector, no
foreign trade).
99
100
2. Says Law cannot hold. (Supply creates
its own demand.)
a) If spending constraints are in effect, then
there will be a difference between
(unlimited) demand and effective
demand.
b) Actual (effective) demand will usually be
deficient to purchase total output.
c) Effective Demand(AD=AS)
d) Aggregate Demand
e) Aggregate Supply 101
Therefore, consumption depends primarily upon income,
not interest rates.
C C(r), but rather C = C(Y)
People dont change their standard of living simply because the
interest rate changes a few points.
The fundamental psychological law, upon which we are entitled to
depend with great confidence . . . is that men are disposed, as a rule
and on average, to increase their consumption as their income
increases, but not by as much as the increase in their income
102
The Consumption Function: the key to Keynes
Consumption depends on the level of DISPOSABLE INCOME (disposable
personal income = income - taxes = Y - T)
Some consumption is autonomous (= independent of DPI): it may
depend on other factors such as wealth or stock values. (even at zero
income, Bill Gates would consume something)
The consumption function proposed by Keynes is:
C = C0 + Cy ( Y - T)
C0 = Autonomous consumption
Cy = Marginal propensity to consume
The marginal propensity to consume plays a central role in the

Keynesian system. Keep your eye on the MPC in the following slides.
103
Questions
Consumption Function
Marginal Propensity to consume
Average Propensity to consume
104
The Keynesian system: Planned and actual
investment
Investment has three components:

Plant and equipment -- drill presses, factory buildings, etc.
Residential investment -- new housing construction
Inventory investment -- Change in Business Inventories
The first two are consciously planned (although plans can change, and
typically do during a recession);
inventory investment can be unplanned -- if a store fails to sell what it had
expected to, it winds up with more inventory than it had expected.
Stores with unplanned inventory investment will cut back on orders --
resulting in reduced production at the factory, layoffs and recession.
105
The same can be explained with the help of regression line.
The Keynesian model: National income identity and equilibrium
The National income identity is:
Y = C + I + G + NX
The Keynesian equilibrium equation is:
Y = C0 + Cy ( Y - T) + Ip + G + NX
Notice that C has been replaced by the consumption function, and

investment by planned investment.
106
State of Equilibrium
107
Keynes model in nutshell
108
Questions
Meaning of full employment

Underemployment
Autonomous consumption
Types of Investment
109
Learning Outcome
In this unit students have learnt about the

Classical Model (Says law, income and
output determination)
Keynsian model( Effective demand,
Psychological law of consumption,
Investment, and output determination)
110
Consumption and
Investment
LEARNING OBJECTIVE
To understand the basic of

consumption.
To understand the different types of
consumption.
To understand the equation of
consumption.
Gottheil - Principles of Economics, 4e 112

Keynesian theory of income
Simple economy model- two sector model

( household, firms sector)
Closed economy model- three sector
model
( household, firms and government
sector)
Open economy model- four sector model
( household, firms , government and
foreign sector)
Consumption function
The amount of money people spend out

of national income on the purchase of the
goods and services for the direct
satisfaction of their wants is called
aggregate consumption expenditure or
consumption.
Example: Total income of economy- 5000
cr.
people spend -4000 cr. on goods and
service
The most important function of

consumption is income .
It means consumption is a function of
(determined by ) income.
Relationship between consumption and
income-
C= f (Y)
Where, C= consumption
f= function
Ineconomics, theconsumption
functionis a single mathematical
function used to expressconsumer
spending. It was developed byJohn
Maynard Keynesand detailed most
famously in his bookThe General Theory
of Employment, Interest, and Money. The
function is used to calculate the amount
of totalconsumptionin aneconomy. It is
made up ofautonomous
consumptionthat is not influenced by
current income andinduced
consumptionthat is influenced by the
economy's
Gottheil - Principlesincome level.
of Economics, 4e This function 116
The simple consumption function is
shown as :
C= C0 + C1Y
where
C= total consumption,
c0= autonomous consumption (c0> 0),
c1is themarginal propensity to consume
(i.e the induced consumption) (0 <c1<
1), and
Y= disposable income (income after
government intervention benefits, taxes 117
Gottheil - Principles of Economics, 4e
Induced consumptionis
consumption expenditure by
households on goods and services
that varies with income. Such
consumption is
consideredinducedby income when
expenditure on these consumables
varies as income changes. Induced
consumption contrasts with
autonomous consumption, which is
expenditures that do not vary with
income.
Definition of 'Autonomous
Consumption
The minimum level of consumption that

would still exist even if a consumer had
absolutely no income. This contrasts with
discretionary consumption, which isused
for non-essential items. When combined
with discretionary income,a person's
autonomous consumption determines his
or her real income, or real wages

Certain bills and expenses are deemed
to be autonomous (or independent),
such as electricity, food and rent,
becausethese expensescannotever be
entirely eliminated whether you have
money or not. Even in the worst-case
financial scenario, you would still need
toeat and have a place to live.If a
consumer's income were to disappear
for a time, he or she would have to dip
into savings or increase debt in order to
pay these expenses, which is also
known as being in a "dissaving mode
Average Propensity To Consume
The average propensity to consume

(APC) refers to the percentage of
income that is spent on goods and
services rather than on savings. One
can determine the percentage of
income spent by dividingthe average
household consumption (what is spent)
by the average householdincome (what
is earned). The inverse of the average
propensity to consume is the average
AVERAGE PROPENSITY TO
CONSUME
Economic periods where consumers are
spending can boost the economy: more
goods are purchased (high demand for
goods and services); keeping more
people employed and more businesses
open. Periods where the tendency to
save is increased can have a negative
effect on the economy as people
purchase fewer goods and services
(low demand for goods and services),
resulting in fewer jobs and increased
business closures.
APC
The average propensity to consume is

the ratio of consumption to income. It
can be expressed as under.
C
APC
Y
For example, if total income is Rs 500
crores and total consumption is Rs 200
crores, then: 200
APC or 0.4
500
MARGINAL PROPENSITY TO
CONSUME(MPC)
Definition of 'Marginal Propensity To
Consume - MPC'
A component of Keynesian theory, MPC
represents the proportion of an aggregate
raise in pay that is spent on the
consumption of goods and services, as
opposed to being saved.

MPC
The ratio of change in consumption to

change in income is known as marginal
propensity to consume. Symbolically,
change () in the income is denoted as
Y (read as delta Y) and change in
consumption as C. Hence,
C
MPC
Y

Example
Suppose youreceive a bonus with your
paycheck, and it's$500 on top of your
normal annual earnings. You suddenly
have $500 more in income than you did
before. If you decide to spend $400 of
this marginal increase in income on a
new business suit, your marginal
propensity to consume will be 0.8 ($400
divided by $500).

Characteristics of MPC
It is always positive
MPC is greater than zero but
less than one.
The value of MPC always greater
than zero because Option
expenditure must increase with the
increase in income, less than one,
because the total increase in income
is not consumed a part of it is
saved. Thus this characteristic can 127
Gottheil - Principles of Economics, 4e
MPC of the poor class is higher
Constant MPC in the long run
Falling MPC in the short run
MPC can be greater than one in
case of abnormal conditions.

Causes of the fall in MPC with the
increase in Income
Fulfilment of basic and important

needs
Constant habits in the short
period
Consumption expenditure and
level of income in the past
Uncertainty of future
Relation between APC and MPC
APC and MPC are closely related to each other.
(1) APC refers to the ratio of absolute
consumption absolute income at a particular
point of time. On the other hand MP represents
the ratio of change in consumption to change in
income; MPC is the rate of change in APC.
(2) As income rises both APC and MPC declines,
but I lie decline in MPC is more than the decline
in APC, as income falls both APC and MPC rises
but APC rises at a slower, rate than MPC.
(3) MPC is useful in short-period where as APC is
useful in long period. In the short period there is
no change in MPC and MPC<APC. In the long
Gottheil
period - Principles
APC=MPC. of Economics, 4e 130
RELATION BETWEEN MPC AND
APC
S+C=Y
S+ C= Y
S/ Y+ C/ Y = Y/ Y =1
MPS+ MPC=1
MPS=1-MPC

Question- The consumption function shows
the relationship between consumption
and
(1)Savings (2) Income (3) Demand (4)
Supply
Question- which of the following represents
the consumption function?
(2)C=f (Y) (2) Y= f (C) (3) C=f (1/Y)
(4) C= f (C/Y)
TABLE OF PROPENSITY TO
CONSUME
INCOME CONSUMPTION SAVING (RS CR.)
0 10 -10
100 100 0
200 190 10
300 280 20
400 370 30
500 460 40

EXHIBIT 1 THE INDIVIDUALS MARGINAL PROPENSITY TO
CONSUME
134
FEATURES OF PROPENSITY TO
CONSUME
Psychological concept
Unequal propensity to consume
Income and employment
depend on propensity to
consume
Consumption in the short run
Long run consumption function

DETRMINANTS OF
PROPENSITY TO CONSUME
It is of two types
(1)Subjective factors
(2)Objective factors

Subjective factors
(i) individual factors
()Farsightedness-future is uncertain
()Economic independence
()Occupational motive
()Miserliness- niggardly by nature
()Status in the society
()Precautionary motive
(ii) Business factors
Extension of business
Liquidity preference
Modernization-save more to install new
machines

Objective factors
Change in money income

Change in real income
Change in distribution of income
Financial policy of the corporations
Change in expectations
Fiscal policy
Change in the rate of interest
Wages
Gottheil
Liquid assets.
- Principles of Economics, 4e 139
Social security
Attraction of new products
Credit facilities
Change in fashion
Change in population
Demonstration effect
PROPENSITY TO SAVE/SAVING
FUNCTION
The relationship between the change in

income and the change in saving is the
propensity to save.
We can also express propensity to save in
two different ways. These are the
following:
a) The average propensity to save (APS),
and
b) The marginal propensity to save (MPS).
The Average Propensity to Save (APS)
The average propensity to save is the
ratio of total savings to total income.
Thus, S
APS
Y
where, S = saving and Y = income.

The Marginal Propensity to Save
(MPS) Marginal propensity to save is the
ratio of change in saving to change in
S
MPS
Y
We know that MPC + MPS = 1. Therefore, MPS = 1- MPC or
C
MPS 1
Y

RELATION BETWEEN SAVING AND
CONSUMPTION
Y=C+ S
WHERE Y =DISPOSABLE INCOME
C= CONSUMPTION
S= SAVINGS
AND C= C0+ C1Y
APC+APS=1

Question- if the MPC is 0.7, what is
the marginal propensity to save in a
two-sector model?
Question- if MPS=0.3,it means that a
100 rs rise in disposable income leads
to rise in consumption.
Question-represents the
pr0portion of each income level that
a household will spend on
consumption.
CONSUMPTION FUNCTION:C= 1000 + 0.8Y)
DISPO AUTON CONSU TOTAL SAVIN APC APS

SABLE OMUS MPTION GS
INCOM INDUCE
D
E
3000 1000
4000 1000
5000 1000
6000 1000
7000 1000
8000 1000
9000 1000

Investment
Investment
Meaning
Different types of investment
Factors affecting investment
Concept of multiplier
Types of multiplier
Uses of multiplier
Limitations of multiplier
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.
Propensity to Invest
An increase in income directly related to

an increase investment. The ratio in
which income changes to change in
investment is called propensity to invest
PI = I / Y
Average Propensity to Consume
API = I / Y
Marginal Propensity to Consume= $I /$Y
Quiz
1. Net addition to existing capital stock is

called?
2. Why investment is important?
3. Ratio of change in investment to change
in income is called?
4. Ratio of consumption to income is
called?
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
autonomous, Investment 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
Profitability of investment
depends upon
MEC
Rate of Interest
MEC
It refers to productivity of capital. It may

be defined as the highest rate of return
over cost accruing from an additional unit
of capital asset.
Also it refers to the yield expected from
a
new unit of capital.
MEC
MEC can be calculated by deducting

from the total income of the capital
assets its cost.
Suppose the price of a machine is 20000,
the duration of the machine is 10 years.
during the 10 years it is expected to
yield an income of 40000. the total
profits= 40000-20000=20000 (over a
period of 10 years)
Average profits= 20000/10= 2000
MEC depends upon
1. Prospective yield from the capital asset

2. The supply price of the capital asset.
Prospective yield
Prospective yield of an asset is the

aggregate net return from it during its
whole life.
In order to determine Prospective yield
annual return of the capital is worked out.
Aggregate of annual return expected
from a capital asset over its life-time, is
called Prospective yield
Changes in the price prices likely to
change Prospective yield
Prospective yield
Prospective yield can be expressed as

Py= Q1+Q2+Q3+Q4+..+Qn
Q1, Q2, Q3, Q4,..,Qn ( net
revenue received in the first, second,
third and fourth year)
Supply price
The other factor affecting the MEC is the

is its supply price. ( is also known as
replacement Cost)
A capital asset actually remains operative
more than one year.
Supply price
Py1= SP (1+m)
SP- supply price, m= MEC, py prospective
yield
SP= Py1/ (1+m)
Py2= Py1( 1+m) {Py1= SP (1+m)}
Py2= SP( 1+m)2
SP= py2/ (1+m)2
SP= py1/ (1+m)+ py2/(1+m)2+.
SP= py/ (1+m)n
MEC and Investment
Generally it is experienced that as the

amount of investment goes on
increasing, MEC of capital goes on
decreasing
Investment MEC
50 12%
100 10%
150 8%
200 6%
Relationship between MEC and
ROI
Relationship of MEC & ROI Effect on Investment
MEC > ROI Favorable

MEC= ROI Neutral
MEC<ROI Unfavorable
Quiz
Under what conditions would you go for

investment?
Productivity of capital is referred to as ?
How can taxation decision effect
investment decision?
Multiplier
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
In Economics:
It is a change in Income (Y) as a

result of change in Investment (I).
The number of times Income exceeds

Investment is called Multiplier (K).
Change
Change Change in Change
in
in Consumpt in
Investme
Income ion Income
nt
(Y) (C) (Y)
(I)
This Concept is given by Keynes;
and it defines the Relationship

between Income and Investment;
so, its also known as Investment

Multiplier.
Types of Multiplier:
Employment Multiplier K1 = N2
N1
N2 Total Employment
N1 Primary Employment
Foreign Trade Multiplier Kf = Y
Y Change in Total Income
E Change in Export Income

Size of Multiplier:
MPC
MPS
Larger the MPC, Larger the Multiplier
Larger the MPS, Smaller the Multiplier

Relationship with MPC:
K = Y
I
Y=C+I
Y = C + I I = Y - C
K = Y
Y - C
Y 1
K= Y 1 - C
Y - C Y
Y Y
MPC = C K= 1
Y 1 - MPC
Relationship with MPS:
MPS = S C + S = C + I
Y => I = S
Y = C + I (Ag. Demand)
Y = C + S (Ag. Supply) K = Y => K=

Y
Dividing by Y I
Y S
K= Y
S 1 1
S = MPS
Larger the MPC, Larger the
Multiplier
( direct relationship between MPC and
K)
Larger the MPS, Smaller the

Multiplier
QUIZ
What is the importance of multiplier?

Who gave the concept of multiplier?
What is the difference between
foreign trade multiplier and
investment multiplier?
How is multiplier related to MPC and
MPS?
Assumptions
Consumption is a function of current

income
There is no time lag
There is no change in prices
The economy is closed unaffected by
foreign influences
There is less than full employment
level in the economy
The marginal propensity to consume
is constant
Working of multiplier
Static Multiplier
Dynamic Multiplier
i. Forward Multiplier
Ii.Backward Multiplier
Importance of Multiplier
Income Generation
Full Employment
Public Investment
Trade Cycles
Inflation and deflation
State Intervention
Deficit finanicing
Leakages' of multiplier
Idle Saving
Imports
Debt cancellation
Purchase of old stocks
Hoarding
Taxes
High liquidity preference
Undistributed profits
Relevance of multiplier to
developing countries
Keynesian multiplier is based on
following assumption
Involuntary unemployment
Industrialized economy
Excess capacity in consumption goods
industries
Comparatively elastic supply of raw
material and working capital
quiz
What are the limitations of the

concept of multiplier?
How the concept of multiplier is useful
for income generation?
What is the difference between static
and dynamic 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 how RBI measures the money
supply
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
money is used for much wider
sense and is defined differently by
different economists.
Conceptually, money can be
defined as any commodity that is
generally accepted as a medium of
Definition
H. G. Johnson has classified the
approaches to the definition of
money under the following
categories:
The Conventional Approach

The Chicago Approach
The Central Bank Approach
The Gurley-Shaw Approach
THE CONVENTIONAL
APPROACH
Most oldest and widely accepted
approach.
Stresses mainly one the basic
functions of money i.e. medium of
exchange and measure of value.
Any commodity that functions as a
medium of exchange and measure
of value is money.
It includes barter system
THE CHICAGO
APPROACH
Coined by Milton Friedman and his
associates in Chicago University.
They extended the conventional
definition by adding the time
deposits in it.
Thus money include (i) Currency, (ii)
Demand Deposits, (iii) Time
Deposits.
They included the time deposits for
two reasons:
The Gurley-Shaw
Approach
This approach is attributed to John G.
Gurley and Edward S. Shaw.
They regarded the liquid assets held
by financial intermediaries and
liabilities of non-bank intermediaries
as close substitute for money.
Intermediaries provide substitute for
money as a store of value.
Thus, they gave wider definition of
money based on liquidity which
The Central Bank
Approach
The central banks take still a wider
definition of money. They view all
available means of payment and
credit flows as money.
Thus, money supply constitutes
currency plus all realizable assets
i.e. the assets which have perfect or
near perfect liquidity.
Depending upon objectives of
monetary policy and policy targets
Conclusion:
To conclude, money cannot

be described on the basis of
matter it is made of. It can
be defined in terms of its
functions:
Any thing which is used for
medium of exchange,
measure of value, store of
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
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 four approaches
to money?
Chicago approach added
which factor to money?
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
several forms as:
Commodity Money
Metallic Money
Paper Money
Bank Deposits
CONCEPTS OF MONEY
Commodity Money:
Under this, the people used
commodities or animals as
money.
Demerits:
Commodities are not
homogeneous
Supply of commodities could be
abruptly change.
Hoarding was not possible
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.
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
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
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:
It is a kind of inconvertible paper money

issued by the state under emergency
conditions. Thats why, it is also known
as emergency money.
Fiat money is not backed up by any
reserve.
Since this money is not backed up by any
reserves, government issued it in limited
quantity.
German Mark issued during World War I
and the entire paper money during World
QUESTIONS
What are the demerits of
commodity money?
What do you mean by near
money?
How paper money come into
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, interest rates, and inflation 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
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
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,
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 peoples 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
money?
What is the speculative
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.
To analyze 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 experience
sudden 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
Wage Price Spiral
Wages chase prices and prices chase wages, thus

create a wage price spiral.
When prices rise, workers

Prices Rise
demand higher money (or
nominal) wages to protect
their real wages. This raises Cost of
the costs faced by their production rises
employers. Cost of
living rises
To protect the real value of
profits producers pass the Wages rise
higher costs onto
consumers in the form of
higher prices.
Workers (who are also
consumers demand for
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 annual rate of increase of prices.
Last year' s Index - Current Year' s Index

100
Inflation Rate Current Year' s 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 Policy in achieving

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 Selective Credit
Control Measures Control Measures
1. Bank Rate 1. Credit Rationing
2. CRR 2. Change in Lending
Margins
3. Open Market
Operations 3. Moral Suasion
4. SLR 4. Direct Controls
5. Repo Rate
(Repurchase
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 to expand or reduce the
flow of credit from the commercial banks.
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
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

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
3. Open Market Operations
Open Market Operations is the sale and

purchase of government securities and
Treasury Bills by the central bank of the
country.
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
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
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 UDCs where banking system is not

well developed and security capital
markets are not interdependent, OMO
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. Indias 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 analysing 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 country can

be 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?

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Macro Economics

Introduction to Macro Economics

To understand the meaning of Macro

Microeconomics is the study of how

It explains economic dynamism and

Macro economics studies the concept of

Macro economics studies the problems related

Macro economics studies functions of money

Introduction to National Income

To understand various concepts of national

Gross Domestic Product (GDP)

Why should a manager monitor GDP

Personal income is the total income received by the

Nominal GDP = National income estimated at the prevailing prices is

GDP deflator is the ratio of nominal GDP in a year to real GDP of

How far national income of a

What is the Difference between

GDP is the best single measure of the

Higher GDP per person indicates a higher

Some things that contribute to well-being are

Product (or Output) Method

The market value of all the goods and services

Step 1 : Identification and Classification of

a) Primary Sector: refers to that sector

c) Tertiary Sector: provides services and so is

Value added is the difference between

Value added = Value of output- Value of

Value of Output= Sales + Change in stock

1. Gross Value added at Market Price:

Item Value of Cost of Value

Identification and classification of

Classification of factor income

National income= sum of all the factor

Exclusion of non monetary income: Ignores the non-

One mans income is another mans

Expenditure or outlay on final products takes

The formula for this method is

Here Y stands for total expenditure

Neglects Barter System

Avoidance of double counting becomes complicated

Existence of Non-monetized sector is dominant

The village money lenders maintain absolute secrecy of their transactions

National income is the most dependable indicator of a countrys economic

A measure of economic welfare.

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

Helps in comparing the situations of economic growth in two different

Consider an economy that produces only

To explain the circular flow of economic activity and

In the equilibrium Y=C+S=C+I=E=O

In this topic we will discuss about how

Full employment is a natural phenomena.

Meaning of Full employment

The supply side of the real economy

the economys total supply of goods and

Output is determined by the fixed factor supplies

Factor markets are assumed to be competitive.

Demand for labor is diminishing function

Supply of labor therefore increases with

Supply creates its own demand

Meaning of Laissez faire

Says law not applicable in current

1. If the consumer is an economic optimizer,

Cy = Marginal propensity to consume