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 foreign nationals in the domestic territory of a
country.
 Net Domestic Product and
Net National Product
 Net Domestic Product

= GDP-Depreciation
 Net National Product (NNP)

= GDP–Depreciation +NFIA

Or =GNP–Depreciation

Thus NNP is the actual addition to a year’s wealth and is the sum of consumption
expenditure, government expenditure, net foreign expenditure, and investment, less
depreciation, plus net income earned from abroad.

= C+I+G+(X–M)–Depreciation + NFIA

 NNP at Factor Cost is the sum total of income earned by all the people of the nation,
within the national boundaries or abroad

 It is also called National Income.

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

 ?

Why should a manager monitor GDP growth?

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

 Personal income is the total income received by the

individuals of a country from all sources before direct taxes
in one year.
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 (or Output) 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 provided by this sector. Public administration and
defence and other services also form part of it.
 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 (C.S –O.S)

 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.

2. Net Value Added at Market Price

3. Net Value Added at Factor Cost

 Estimating Value Added

Item Producing Value of Cost of Value Added

Enterprise Output (Rs) Intermediate
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.

 Product (or Output) 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.
 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
• Net factor income
 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 calculating national income at factor cost
• 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. mother’s services to the family.
 Expenditure method

• One man’s income is another man’s 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

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 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 country’s economic

health.

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

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

A measure of economic welfare.

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

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

poverty in a country.

Helps in comparing the situations of economic growth in two different

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

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
 Circular Flow of Income
(Two Sector Economy)
(Wages, Rent, Interest and Profits)
Factor Payments
(Y)
Factor Inputs

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

Goods and
Services (O)

Consumption
expenditure
(C)

In the equilibrium 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
 Circular Flow of Income
(Four Sector Economy)
The third sector is Government (G)
• Government Spending
– On provision of public utility goods and services.
– Provides salaries to the households
– Pays to firms for purchases of goods and services
• Government Revenue
– Households and 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
 Circular Flow of Income
(Four Sector Economy)
Government
(G)
Taxes
Taxes
Factor
Payments Remittances
for purchases
Factor Inputs
Salaries

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

Foreign Nations Exports

Exports (X-M) (X)
(X)
National Income=C+I+G+(X-M)
 Circular Flow of Income
(Four Sector Economy)

• National income includes expenditures on consumption investment,

government and net of exports (X-M)

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

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

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

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

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

I+G+X =S+T+M

• Therefore, W=J

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

Mention two important leakages in the circular
flow of national income.
Mention two important injections in the circular
flow of national income
Difference between the 2 and 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 economy’s 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 equilibrium77

in the goods market is achieved
The circular flow model with government in classical theory

78
The supply side of the real sector

the economy’s total supply of goods and services/ total income is

determined by,
•the economy’s 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

available technology: the form of the production function

79
 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 economy’s 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 )
MPL
1 As more labor is
MPL added, MPL 
1

Slope of the production

MPL
function equals MPL
1
L
labor
82
 Reasons for the diminishing Returns

1. Technology is given.
2. The economy’s supplies of capital and labor are fixed at

K K and L L

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 firm hires labor
up to the point where MPL
= W/P
Real
wage

MPL, Labor
demand

Units of labor, L
Quantity of 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
• Supplied sided theory 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 constraint—risk, 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. Say’s 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 don’t 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 your103
eye on the MPC in the following slides.
 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
• Consumption Function
• Autonomous consumption
• Types of Investment

109
 Learning Outcome

In this unit students have learnt about the

Classical Model (Say’s 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.

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 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)

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 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

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 Consumption Function

• 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
Y= income
Gottheil - Principles of Economics, 4e 115
• In economics, the consumption function is a single
mathematical function used to express consumer
spending. It was developed by John Maynard
Keynes and detailed most famously in his book The
General Theory of Employment, Interest, and
Money. The function is used to calculate the
amount of total consumption in an economy. It is
made up of autonomous consumption that is not
influenced by current income and induced
consumption that is influenced by the economy's
income level. This function can be written in a
variety of ways, an example being . This is probably
the most simplistic form of the consumption
function.
Gottheil - Principles of Economics, 4e 116
• The simple consumption function is shown as :
• C= C0 + C1Y
where
• C = total consumption,
• c0 = autonomous consumption (c0 > 0),
• c1 is the marginal propensity to consume (i.e the
induced consumption) (0 < c1 < 1), and
• Y = disposable income (income after government
intervention – benefits, taxes and transfer
payments – or Y + (G – T)).

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• Induced consumption is consumption
expenditure by households on goods and
services that varies with income. Such
consumption is considered induced by
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.
• For example, expenditure on a consumable
that is considered a normal good would be
considered to be induced.
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 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 is used for non-essential items. When
combined with discretionary income, a person's
autonomous consumption determines his or her
real income, or real wages

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Gottheil - Principles of Economics, 4e
• Certain bills and expenses are deemed to be
autonomous (or independent), such as electricity,
food and rent, because these
expenses cannot ever be entirely eliminated
whether you have money or not. Even in the
worst-case financial scenario, you would still
need to eat 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

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Gottheil - Principles of Economics, 4e
 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 dividing the average household consumption
(what is spent) by the average household income
(what is earned). The inverse of the average
propensity to consume is the average propensity
to save (APS)
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Gottheil - Principles of Economics, 4e
 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.

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 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
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Gottheil - Principles of Economics, 4e
 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.

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 MPC

• The ratio of change in consumption to change in

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

C
MPC 
Y

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Gottheil - Principles of Economics, 4e
 Example
Suppose you receive 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).

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Gottheil - Principles of Economics, 4e
 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 be symbolically stated as
0<MPC<I where MPC is always positive but
less than one
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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.

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Gottheil - Principles of Economics, 4e
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

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Gottheil - Principles of Economics, 4e
• 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 period APC=MPC.

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RELATION BETWEEN MPC AND APC
• S+C=Y
S+ C= Y
S/ Y+ C/ Y = Y/ Y =1
MPS+ MPC=1
MPS=1-MPC

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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?
(1) C=f (Y) (2) Y= f (C) (3) C=f (1/Y)
(4) C= f (C/Y)

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Gottheil - Principles of Economics, 4e
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

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EXHIBIT 1 THE INDIVIDUAL’S 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

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Gottheil - Principles of Economics, 4e
 DETRMINANTS OF PROPENSITY TO
CONSUME
• It is of two types
(1)Subjective factors
(2)Objective factors

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Gottheil - Principles of Economics, 4e
 Subjective factors

(i) individual factors

• Farsightedness-future is uncertain
• Economic independence
• Occupational motive
• Miserliness- niggardly by nature
• Status in the society
• Precautionary motive
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Gottheil - Principles of Economics, 4e
(ii) Business factors
• Extension of business
• Liquidity preference
• Modernization-save more to install new machines

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Gottheil - Principles of Economics, 4e
 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).

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Gottheil - Principles of Economics, 4e
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 income.
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Gottheil - Principles of Economics, 4e
 S
MPS 
Y
We know that MPC + MPS = 1. Therefore, MPS = 1- MPC or

C
MPS  1 
Y

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Gottheil - Principles of Economics, 4e
 RELATION BETWEEN SAVING AND
CONSUMPTION
• Y=C+ S
• WHERE Y =DISPOSABLE INCOME
C= CONSUMPTION
S= SAVINGS
AND C= C0+ C1Y

APC+APS=1

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Gottheil - Principles of Economics, 4e
• 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.
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Gottheil - Principles of Economics, 4e
 CONSUMPTION FUNCTION:C= 1000 + 0.8Y)

DISPOSA AUTONO CONSUMP TOTAL SAVINGS APC APS

BLE MUS TION
INCOME INDUCED

3000 1000
4000 1000
5000 1000
6000 1000
7000 1000
8000 1000
9000 1000

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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= 2000/20000*100= 10%
 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 in Change in Change in Change in
Investment Income Consumption Income
(∆I) (∆Y) (∆C) (∆Y)
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

∆E

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

• Larger the MPS, Smaller the Multiplier

(inverse relationship between MPS and K)
 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
• Excess stock of capital goods
 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 exchange and measure of value.
 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 (Exchanging
commodities for commodities)
 However, this system had some problems.
 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:
 Time deposits have direct correlation with money
supply and with GNP
 Time deposits remain unavailable for transaction only
 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 includes bonds, insurance
reserves, pension funds, savings and loan shares.
 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 central banks make and use
different measures of money supply, referred to as
M1, M2, M3 and M4.
 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
value and standard of deferred
payments’.
MONEY
FUNCTIONS
 Functions of Money
 The following couplet brings out the major functions
of money:
“Money is a matter of functions four:
A medium, a measure, a standard, a store”

 Kinley classified the functions of money into following

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

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

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

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

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

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

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

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

• Inflation
• Causes of Inflation
• Inflation and Decision Making
• Measuring Inflation
• Inflation and Employment
• Control of Inflation
 Objectives
• To explore the realms of inflation and its different frontiers.
• To delve into concepts like wage price spiral, hyperinflation
and inflationary gap.
• To understand various measures of inflation and their role in
decision making.
• 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 services, a gap is
 Wage Price Spiral

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

•When prices rise, workers

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

• Cost Push Inflation: An increase in price of any of the inputs will increase the cost of
production; i.e. prices pushed up by cost.

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

– Obsolete technology/Deficient machinery

– Scarcity of resources

– Natural calamities/ Industrial disputes/ external aggressions

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

– It is also known as hangover inflation.

 Inflation and Decision Making

• Impact on Consumers

– increase in any price upsets the home budget.

• Impact on Producers (or Suppliers)

– Producers as sellers are benefited by inflation;

• higher the prices, higher are their profits.

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

Impact on Government:

– Government has to take the economy to higher levels of growth by encouraging production and
investment,

– At the other end, has to see that taxpayers’ money is not eroded by hyperinflation.

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

• The most common term used to denote inflation is inflation rate, which is
annual rate of increase of prices.

Last year's Index - Current Year' s Index

 100
Current Year' s Index
Inflation Rate
 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 Control Selective Credit Control
Measures 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
operation rate)
6. Reverse Repo Rate
 General Measures:

1. Bank Rate Policy:

• The rate at which central bank lends money to the

commercial bank and rediscounts the bills of
exchange presented by commercial banks is termed
as bank rate
• The central bank can change this rate- increase or
decrease- depending on whether it wants 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 has widened and
share of banking credit has declined.
 2. Cash Reserve Ratio:

• Also termed as Statutory Reserve Ratio (SRR)

• It is the percentage of total deposits which

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

• Objective of CRR is to prevent shortage of cash for

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

• When contractionary monetary policy is to be

adopted , then the central bank raises the CRR

• When expansionary monetary policy is to be adopted

then central bank cuts down the CRR

• Current CRR is 4.75 %

3. Open Market Operations

Open Market Operations is the sale and purchase

of government securities and Treasury Bills by the
central bank 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 issue at an additional rediscounting fees.
b) 182- Day Bill: introduced in 1986, are sold by
auction to residents of India for a minimum value
of Rs 1,00,000.

• The auction bid is invited every fortnight and the

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

• When it decides to reduce money in circulation, it

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

1. Purchase of govt. securities reduces deposits with

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

1. Central banks sells the government bonds them

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

2. Consequently, the actual rate of interest on the

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

Under the following conditions, OMO do not work

properly:

1. When commercial banks possess excess liquidity.

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

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

2. What monetary measures have been used by the

RBI to control inflation in the country?

3. How does the working of OMO affect the money

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

• Under SLR, the commercial banks are required to

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

a) Excess reserves

b) Unencumbered government securities, e.g. bonds

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

c) Current account balance with other banks

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

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

can buy securities or deposit money with the RBI
 Quiz

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

Reverse repo rate

2. Current rates?

3. How increase and decrease in repo rate affects

the credit creation?
2. Selective Credit Control Measures:

1) Credit rationing

2) Change in Lending Margins

3) Moral Suasion

4) Direct Controls
 Limitations and Effectiveness of Monetary Policy:

1. The Time Lag

2. Problems in Forecasting

3. Growth of Non-Banking Financial Intermediaries

4. Underdeveloped Money and Capital Markets

 ?

1. Differentiate between general and selective credit

control measures?

2. What are the factors that determine the

effectiveness of monetary policy?

3. What monetary measures have been used by RBI

in achieving the policy targets?
 FISCAL POLICY

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

1. Budgetary policy deficit or surplus budgeting

2. Government expenditure

3. Taxation

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

1. Private disposable incomes,

2. Private consumption expenditure,

3. Private savings and investment,

4. Exports and imports, and

5. Level and structure of prices

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

1. Automatic Stabilization Fiscal Policy,

2. Compensatory Fiscal Policy, and

3. Discretionary Fiscal Policy

 Fiscal Policy and Macroeconomic Goals

1. Fiscal Policy for Economic Growth

2. Fiscal Policy for Employment

3. Fiscal Policy for stabilization

4. Fiscal Policy for Economic Equality

Crowding –Out and Crowding-In Controversy

Crowding-Out refers to the adverse effect of high

deficit spending by the government on private
investment.

Crowding-in means rise in the private investment

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

2. Differentiate between fiscal instruments and

target variables?

3. Discuss the role of fiscal policy in achieving

economic growth?

4. Fiscal policy is the most powerful tool of achieving

macroeconomic goals. Discuss.
 BALANCE OF PAYMENTS

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

• It can also be defined as a statement of all

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

• Yields necessary information on the strength and

weakness of the country in international economic
status.

• By 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?