CP 102 UNIT 4

Q.1. Introduction of macroeconomics.

Ans: Macroeconomics is the branch of economics studying the behavior of the aggregate
economy – at the regional, national or international level.
While microeconomics is concerned primarily with the decisions made by an individual
within the usual economic constraints of scarcity, macroeconomics (Greek makro = ‘big) is
the field of study that is concerned with the indicators that reflect the performance of the
broader economy- gross domestic product, inflation levels, unemployment, growth rate,
fiscal deficit etc.
If you are trying to gain a better appreciation of the macroeconomics problems of the
Indian economy that get covered in newspapers and TV channels, this post should help
you get the basic principles of macroeconomics.
What is macroeconomics?
The aim of studying macroeconomics is to understand how an economy works, and
identifying the levers that can be pulled to put the overall economy on the right path of
growth. The system that is a result of different economic agents coming into contact is
much more complex than the sum of its independent and often disjoint parts.
Moreover, it is strictly “non-experimental” as we do not have the luxury of conducting
controlled experiments like in the field of science. We can just wait and observe the effects
of broader policy measures with a certain level of accuracy and a tinge of hope.
It usually deals with goals that are conflicting; ensuring growth, taming inflation, full
employment and fair income distribution at the same time!

Introduction to Macroeconomics – Basic concepts

 Currency
Before the advent of money and modern economic systems, barter was prevalent to
facilitate the exchange of goods and services. Money has many advantages over the
barter system and serves multiple functions: it is faster, convenient, holds value over
time and both parties are not obligated to want what the other is offering ensuring
freedom of choice through a neutral medium of exchange.
There is no scope for confusion as everyone knows the current value of one unit of a
currency (atleast they think they know!). Interest rate is the cost of borrowing money,
which in turn is dependent upon the current demand of money in the economy.
An exchange rate signifies the rate at which one currency will be exchanged for another.
The two primary types of exchange rate systems are – fixed and floating. In fixed rate
systems, the participating countries agree upon the relative value of their currencies and
maintain the same rate by buying/selling their foreign reserves in the case of demand
fluctuations for their currency.
Fixed exchange rate system was mostly prevalent in the 19th and 20th centuries, and
currencies were backed by gold in the good old days (now it is not the case, read about fiat
money). In floating exchange rate systems, the value of the currency is determined by the
market forces, just like any other good.
 Inflation
 Simply put, inflation is the erosion in value of a currency, as its buying capacity
diminishes over time. Alternatively, it can also be defined as a significant increase in
the prices of goods/services in an economy for considerable time duration. Consumer
Price Index (CPI) and Wholesale Price Index (WPI) are the measures of inflation used
in India.
There is no broad consensus upon the right rate of inflation in the economy, but
majority believe that a slightly positive rate of inflation signifies growth and is best for
the economy.
Wild variation in inflation is the major source of headache for economists and can lead
to a variety of problems in the economy: the saving sentiment of the populace erodes
due to uncertainty in the value of deposits and the long-term investments may dry up
due to significant risk associated with final returns.
 Business cycles
Business cycles are the patterns of expansions & contractions in the economy. During
a phase of expansion, gross domestic product (GDP) rises and the unemployment rate
falls. While recession has found its place in the pop culture and now usually means any
downturn in the economy, the definition of recession usually requires the real GDP to
decline for two consecutive quarters.
There is no set consensus among the economists as to what decides the extent of these
cycles, and the role government should play in influencing these cycles. Lowering
taxes and increasing spending usually provide the required stimulus to the economy
during downturns. Some see this cycles as totally irregular phenomenon, while some
believe that overall technological throughput of the economy drive these cycles.
 Unemployment
: Good rate of employment within an economy is important for a couple of reasons –
unemployed workforce is pure wasted potential, plus it leads to lowering in consumer
spending as they’ve got nothing to spend!
There are three sub-categories of unemployment:
 Cyclical unemployment: Result of business cycles, not harmful to the economy in
general
 Frictional unemployment: Result of lags in information dissemination and imperfect
matching of jobs and skilled workers
 Structural unemployment: Result of workers not being equipped for the jobs that are
available, can be detrimental to the economy
While a very low rate of unemployment is desirable, absolute zero unemployment is
neither desirable nor practically possible. The general relationship that exists between
inflation and employment – higher the rate of employment, higher is the rate of inflation.
Balancing it all does require some serious effort after all.

Economic growth
Gross Domestic Product: What is GDP?
GDP full-form: Gross domestic product. GDP is the total value of the final goods/services
produced in an economy and is the most commonly employed measure of a country’s
economic capacity. GDP in effect is a measure of ‘value added’, the value added is more if
an entity produces more output with every unit of available input.
‘Real GDP’ measures economic output after adjusting for price changes, i.e. inflation or
deflation. The ultimate goal of any economic growth is to translate into a higher standard
of living, and measuring GDP per capita is an approximate way to do that. A sweet side
effect: it serves as a barometer to gauge the success (or lack thereof) of major economic
policy changes.
There are some drawbacks to the use of GDP though: –
 The GDP calculations exclude any form of unpaid/illegal activity. In a country like
India where a significant portion of economy is “underground”, the real GDP can be
grossly underestimated.
 It fails to take into account the losses that happen due to natural or man-made
disasters, but the rebuilding activity after a war or a natural disaster will cause the
GDP figures to shoot up.
 It also fails to capture the improvements in quality of life due to increased affordability
of goods over time;also ignores transactions where no money comes into picture
(think of NGOs) and does not take into account the value of all assets in the economy.
 The sustainability factor also does not come into picture as the high GDP can be a
result of over-utilizing the nation’s natural resources.
 Last but not the least, it does not take into account the distribution of wealth (a few
wealthy individuals can hold a very significant amount of money in an economy). It is
generally measured through Gini coefficient. For instance, “Gini” tells that the income
distribution is fairly skewed (screwed?) in South Africa whereas Scandinavian
countries are egalitarian havens.

A gap exists between the potential GDP that an economy could generate through optimum
utilization of labor and capital, and the actual GDP that is generated which is called
the output gap.

International Trade
Liberalization, Privatization and Globalization are the factors which have been responsible
for the spurt in economic activity in India for the past two decades. Without international
trade, the world suddenly becomes a very large and disconnected place.
The consumers have to compromise on the available choices (getting a landline
connection before 90’s was a luxury in India and a thriving black market for regular
commodities was the norm). Specialization is the backbone of all modern economic
activity, and a nation can maximize its welfare (and that of the world) by making goods
which it produces most efficiently—competitive advantage.
Balance of payment tracks the financial flow, the components being the flow of
goods/services and/or the investments. To make the payments exactly balanced with a
trading nation, the earnings from selling goods/services and the return on investments
should be equal to the spending on goods/services and the outgoing investment income.
While we are increasingly moving towards free international trade, the governments can
introduce barriers to trading which can come in various forms such as tariffs or quotas,
primarily to save local industries from foreign competition as a temporary measure or to
impose sanctions on a trading partner.
Tariffs cause the imported goods/services to be artificially expensive as compared to the
domestically produced goods. Similarly subsidies can be provided to the local
manufacturers which artificially make local goods/services cheaper as compared to the
foreign counterparts.

Macroeconomic policy
The macroeconomic policy of a nation is implemented with two
levers: fiscal and monetary.
 The money supply in the economy can be altered through several means by the central
bank. The usual action is to increase the money supply by offering bonds which lowers
interest rates, or selling bonds to take some money out of circulation. Inflation is
another beast that has to be tamed while ensuring a steady and high growth rate in the
economy.
When the interest rates are already near zero, the conventional approaches do not
work. Quantitative easing is an unconventional technique which was adopted by the
US Federal Reserve to stimulate the economy which was in doldrums due to the
worldwide financial crisis. In QE the government purchases assets from private
institutions, commercial banks etc.,instead of the usual government bonds.
 Fiscal policy involves governments’ lawful tinkering of balance sheets, i.e. decisions
related to changes in revenue and expenditure to take hold of the overall economy. Let
us take the case of a nation which is currently in a state of recession. If the tax rates are
lowered, people have more disposable income which will fuel the economic activity.
Another way is to increase spending, say by initiating an infrastructure project. This
will create jobs, lowers the unemployment rate and boosts consumer spending which
will be a positive stimulus for the overall economy.
Generally, monetary intervention is preferred over fiscal as the average lag in the case of
implementing monetary policies is far lesser than fiscal; a central bank is involved for
implementing monetary policies which is usually a strong non-political institution.

Macroeconomic schools of thought

 Classical economics is a school of thought that’s generally regarded as the first school
of economic thought and is widely associated with Adam Smith, the father of modern
economics. The central idea behind the ideology is that markets work best when they
are left alone and role of the government be as minimal as possible. The ‘invisible
hand’ in the free markets automatically assigns resources to places where they are
best utilized.
 Neo-classical economics is hinged on the premise of rationality in behavior, and that
the consumers are looking for maximum “utility” and the firms are looking for
 maximum profits. This fundamental conflict gives rise to the current demand and
supply theory.
 Keynesian economics derives its roots from the ideas of the British economist John
Maynard Keynes (widely regarded as the most important economist of the
20th century). It is a theory which relies on government intervention to manipulate
aggregate demand through changes in fiscal policy.It also posits that free markets
rarely move towards full-employment equilibrium.
 Monetarist economics is a school of thought largely attributed to the contributions of
Milton Friedman. The central belief is: The role of the government is to control
inflation through manipulating money supply. They believe that attempts to manage
demand in an artificial way (the Keynesian way) can be destabilizing to the overall
economy and can lead to inflation.

Through tracking major macro-economic indicators, an investor can expect to make better
investing decisions, a salaried individual can plan savings/investments in a better way and
a businessmen can take more informed decisions about raw materials or labor.
The knowledge of macroeconomics is an important tool in the arsenal of every individual,
and the future might lie dormant in the government’s stance on a few key policies.
1. Nature of Macroeconomics:

Macroeconomics is the study of aggregates or averages covering the entire economy, such
as total employment, national income, national output, total investment, total
consumption, total savings, aggregate supply, aggregate demand, and general price level,
wage level, and cost structure.
In other words, it is aggregative economics which examines the interrelations among the
various aggregates, their determination and causes of fluctuations in them. Thus in the
words of Professor Ackley, “Macroeconomics deals with economic affairs in the large, it
concerns the overall dimensions of economic life. It looks at the total size and shape and
functioning of the “elephant” of economic experience, rather than working of articulation
or dimensions of the individual parts. It studies the character of the forest, independently
of the trees which compose it.”
Macroeconomics is also known as the theory of income and employment, or simply
income analysis. It is concerned with the problems of unemployment, economic
fluctuations, inflation or deflation, international trade and economic growth. It is the study
of the causes of unemployment, and the various determinants of employment.
In the field of business cycles, it concerns itself with the effect of investment on total
output, total income, and aggregate employment. In the monetary sphere, it studies the
effect of the total quantity of money on the general price level.
In international trade, the problems of balance of payments and foreign aid fall within the
purview of macroeconomic analysis. Above all, macroeconomic theory discusses the
problems of determination of the total income of a country and causes of its fluctuations.
Finally, it studies the factors that retard growth and those which bring the economy on the
path of economic development.
The obverse of macroeconomics is microeconomics. Microeconomics is the study of the
economic actions of individuals and small groups of individuals. The “study of particular
firms, particular households, individual prices, wages, incomes, individual industries,
particular commodities.” But macroeconomics “deals with aggregates of these quantities;
not with individual incomes but with the national income, not with individual prices but
with the price levels, not with individual output but with the national output.”
Microeconomics, according to Ackley, “deals with the division of total output among
industries, products, and firms, and the allocation of resources among competing uses. It
considers problems of income distribution. Its interest is in relative prices of particular
goods and services.”
Macroeconomics, on the other hand, “concerns itself with such variables as the aggregate
volume of the output of an economy, with the extent to which its resources are employed,
with the size of the national income, with the ‘general price level’.”
Both microeconomics and macroeconomics involve the study of aggregates. But
aggregation in microeconomics is different from that in macroeconomics. In
microeconomics the interrelationships of individual households, individual firms and
individual industries to each other deal with aggregation.
“The concept of ‘industry’, for example, aggregates numerous firms or even products.
Consumer demand for shoes is an aggregate of the demands of many households, and the
supply of shoes is an aggregate of the production of many firms.
The demand and supply of labour in a locality are clearly aggregate concepts.” “However,
the aggregates of microeconomic theory,” according to Professor Bilas, “do not deal with
the behaviour of the billions of dollars of consumer expenditures, business investments,
and government expenditures. These are in the realm of microeconomics.”
Thus the scope of microeconomics to aggregates relates to the economy as a whole,
“together with sub-aggregates which (a) cross product and industry lines (such as the
total production of consumer goods, or total production of capital goods), and which (b)
add up to an aggregate for the whole economy (as total production of consumer goods and
of capital goods add up to total production of the economy; or as total wage income and
property income add up to national income).” Thus microeconomics uses aggregates
relating to individual households, firms and industries, while macroeconomics uses
aggregates which relate them to the “economy wide total”.
Scope and Importance of Macroeconomics:
As a method of economic analysis macroeconomics is of much theoretical and practical
importance.
(1) To Understand the Working of the Economy:
The study of macroeconomic variables is indispensable for understanding the working of
the economy. Our main economic problems are related to the behaviour of total income,
output, employment and the general price level in the economy.
These variables are statistically measurable, thereby facilitating the possibilities of
analysing the effects on the functioning of the economy. As Tinbergen observes,
macroeconomic concepts help in “making the elimination process understandable and
transparent”. For instance, one may not agree on the best method of measuring different
prices, but the general price level is helpful in understanding the nature of the economy.
(2) In Economic Policies:
Macroeconomics is extremely useful from the point of view of economic policy. Modern
governments, especially of the underdeveloped economies, are confronted with
innumerable national problems. They are the problems of overpopulation, inflation,
balance of payments, general underproduction, etc.
The main responsibility of these governments rests in the regulation and control of
overpopulation, general prices, general volume of trade, general outputs, etc. Tinbergen
says: “Working with macroeconomic concepts is a bare necessity in order to contribute to
the solutions of the great problems of our times.” No government can solve these
problems in terms of individual behaviour. Let us analyse the use of macroeconomic study
in the solution of certain complex economic problems.
(i) In General Unemployment:
The Keynesian theory of employment is an exercise in macroeconomics. The general level
of employment in an economy depends upon effective demand which in turn depends on
aggregate demand and aggregate supply functions.
Unemployment is thus caused by deficiency of effective demand. In order to eliminate it,
effective demand should be raised by increasing total investment, total output, total
income and total consumption. Thus, macroeconomics has special significance in studying
the causes, effects and remedies of general unemployment.
(ii) In National Income:
The study of macroeconomics is very important for evaluating the overall performance of
the economy in terms of national income. With the advent of the Great Depression of the
1930s, it became necessary to analyse the causes of general overproduction and general
unemployment.
This led to the construction of the data on national income. National income data help in
forecasting the level of economic activity and to understand the distribution of income
among different groups of people in the economy.
(iii) In Economic Growth:
The economics of growth is also a study in macroeconomics. It is on the basis of
macroeconomics that the resources and capabilities of an economy are evaluated. Plans
for the overall increase in national income, output, and employment are framed and
implemented so as to raise the level of economic development of the economy as a whole.
iv) In Monetary Problems:
It is in terms of macroeconomics that monetary problems can be analysed and understood
properly. Frequent changes in the value of money, inflation or deflation, affect the
economy adversely. They can be counteracted by adopting monetary, fiscal and direct
control measures for the economy as a whole.
(v) In Business Cycles:
Further macroeconomics as an approach to economic problems started after the Great
Depression. Thus its importance lies in analysing the causes of economic fluctuations and
in providing remedies.
(3) For Understanding the Behaviour of Individual Units:
For understanding the behaviour of individual units, the study of macroeconomics is
imperative. Demand for individual products depends upon aggregate demand in the
economy. Unless the causes of deficiency in aggregate demand are analysed, it is not
possible to understand fully the reasons for a fall in the demand of individual products.
The reasons for increase in costs of a particular firm or industry cannot be analysed
without knowing the average cost conditions of the whole economy. Thus, the study of
individual units is not possible without macroeconomics.
Conclusion:
We may conclude that macroeconomics enriches our knowledge of the functioning of an
economy by studying the behaviour of national income, output, investment, saving and
consumption. Moreover, it throws much light in solving the problems of unemployment,
inflation, economic instability and economic growth.
Limitations of Macroeconomics:
There are, however, certain limitations of macroeconomic analysis. Mostly, these stem
from attempts to yield macroeconomic generalisations from individual experiences.
(1) Fallacy of Composition:
In Macroeconomic analysis the “fallacy of composition” is involved, i.e., aggregate
economic behaviour is the sum total of individual activities. But what is true of individuals
is not necessarily true of the economy as a whole.
For instance, savings are a private virtue but a public vice. If total savings in the economy
increase, they may initiate a depression unless they are invested. Again, if an individual
depositor withdraws his money from the bank there is no ganger. But if all depositors do
this simultaneously, there will be a run on the banks and the banking system will be
adversely affected.
(2) To Regard the Aggregates as Homogeneous:
The main defect in macro analysis is that it regards the aggregates as homogeneous
without caring about their internal composition and structure. The average wage in a
country is the sum total of wages in all occupations, i.e., wages of clerks, typists, teachers,
nurses, etc.
But the volume of aggregate employment depends on the relative structure of wages
rather than on the average wage. If, for instance, wages of nurses increase but of typists
fall, the average may remain unchanged. But if the employment of nurses falls a little and
of typists rises much, aggregate employment would increase.
(3) Aggregate Variables may not be Important Necessarily:
The aggregate variables which form the economic system may not be of much significance.
For instance, the national income of a country is the total of all individual incomes. A rise
in national income does not mean that individual incomes have risen.
The increase in national income might be the result of the increase in the incomes of a few
rich people in the country. Thus a rise in the national income of this type has little
significance from the point of view of the community.
Prof. Boulding calls these three difficulties as “macroeconomic paradoxes” which are true
when applied to a single individual but which are untrue when applied to the economic
system as a whole.
(4) Indiscriminate Use of Macroeconomics Misleading:
An indiscriminate and uncritical use of macroeconomics in analysing the problems of the
real world can often be misleading. For instance, if the policy measures needed to achieve
and maintain full employment in the economy are applied to structural unemployment in
individual firms and industries, they become irrelevant. Similarly, measures aimed at
controlling general prices cannot be applied with much advantage for controlling prices of
individual products.
(5) Statistical and Conceptual Difficulties:
The measurement of macroeconomic concepts involves a number of statistical and
conceptual difficulties. These problems relate to the aggregation of microeconomic
variables. If individual units are almost similar, aggregation does not present much
difficulty. But if microeconomic variables relate to dissimilar individual units, their
aggregation into one macroeconomic variable may be wrong and dangerous.
2. Difference between Microeconomics and Macroeconomics:

The difference between microeconomics and macroeconomics can be made on the

following counts. The word micro has been derived from the Greek word mikros which
means small. Microeconomics is the study of economic actions of individuals and small
groups of individuals. It includes particular households, particular firms, particular
industries, particular commodities and individual prices.
Macroeconomics is also derived from the Greek word makros which means large. It “deals
with aggregates of these quantities, not with individual incomes but with the national
income, not with individual prices but with the price levels, not with individual output but
with the national output.”
The objective of microeconomics on demand side is to maximize utility whereas on the
supply side is to minimize profits at minimum cost. On the other hand, the main objectives
of macroeconomics are full employment, price stability, economic growth and favourable
balance of payments.
The basis of microeconomics is the price mechanism which operates with the help of
demand and supply forces. These forces help to determine the equilibrium price in the
market. On the other hand, the basis of macroeconomics is national income, output and
employment which are determined by aggregate demand and aggregate supply.
Microeconomics is based on different assumptions concerned with rational behaviour of
individuals. Moreover the phrase ceteris paribus is used to explain the economic laws. On
the other hand, macroeconomics bases its assumptions on such variables as the aggregate
volume of output of an economy, with the extent to which its resources are employed,
with the size of the national income and with the general price level.
Microeconomics is based on partial equilibrium analysis which helps to explain the
equilibrium conditions of an individual, a firm, an industry and a factor. On the other hand,
macroeconomics is based on general equilibrium analysis which is an extensive study of a
number of economic variables, their interrelations and interdependences for
understanding the working of the economic system as a whole.
In microeconomics, the study of equilibrium conditions are analysed at a particular
period. But it does not explain the time element. Therefore, microeconomics is considered
as a static analysis. On the other hand, macroeconomics is based on time-lags, rates of
change, and past and expected values of the variables. This rough division between micro
and macroeconomics is not rigid, for the parts affect the whole and the whole affects the
parts.
3. Dependence of Microeconomic Theory on Macroeconomics:

Take for instance, when aggregate demand rises during a period of prosperity, the
demand for individual products also rises. If this increase in demand is due to a reduction
in the rate of interest, the demand for ‘ different types of capital goods will go up. This will
lead to an increase in the demand for the particular types of labour needed for the capital
goods industry. If the supply of such labour is less elastic, its wage rate will rise.
The rise in wage rate is made possible by increase in profits as a consequence of increased
demand for capital goods. Thus, a macroeconomic change brings about changes in the
values of microeconomic variables in the demands for particular goods, in the wage rates
of particular industries, in the profits of particular firms and industries, and in the
employment position of different groups of workers.
Similarly, the overall size of income, output, employment, costs, etc. in the economy affects
the composition of individual incomes, outputs, employment, and costs of individual firms
and industries. To take another instance, when total output falls in a period of depression,
the output of capital goods falls more than that of consumer goods. Profits, wages
employment decline more rapidly in capital goods industries than in the consumer goods
industries.
4. Dependence of Macroeconomics on Microeconomic Theory:

On the other hand, macroeconomic theory is also dependent on microeconomic analysis.

The total is made up of the parts. National income is the sum of the incomes of individuals,
households, firms and industries. Total savings, total investment and total consumption
are the result of the saving, investment and consumption decisions of individual
industries, firms, households and persons.
The general price level is the average of all prices of individual goods and services.
Similarly, the output of the economy is the sum of the output of all the individual
producing units. Thus, “the aggregates and averages that are studied in macroeconomics
are nothing but aggregates and averages of the individual quantities which are studied in
microeconomics.”
Let us take a few concrete examples of this macro dependence on microeconomics. If the
economy concentrates all its resources in producing only agricultural commodities, the
total output of the economy will decline because the other sectors of the economy will be
neglected.
The total level of output, income and employment in the economy also depends upon
income distribution. If there is unequal distribution of income so that income is
concentrated in the hands of a few rich, it will tend to reduce the demand for consumer
goods.
Profits, investment and output will decline, unemployment will spread and ultimately the
economy will be faced with depression. Thus, both macro and micro approaches to
economic problems are interrelated and interdependent.
Importance of Macroeconomics:
1. It helps to understand the functioning of a complicated modern economic system. It
describes how the economy as a whole functions and how the level of national income and
employment is determined on the basis of aggregate demand and aggregate supply.
2. It helps to achieve the goal of economic growth, higher level of GDP and higher level of
employment. It analyses the forces which determine economic growth of a country and
explains how to reach the highest state of economic growth and sustain it.
3. It helps to bring stability in price level and analyses fluctuations in business activities. It
suggests policy measures to control Inflation and deflation.
4. It explains factors which determine balance of payment. At the same time, it identifies
causes of deficit in balance of payment and suggests remedial measures.
5. It helps to solve economic problems like poverty, unemployment, business cycles, etc.,
whose solution is possible at macro level only, i.e., at the level of whole economy.
6. With detailed knowledge of functioning of an economy at macro level, it has been
possible to formulate correct economic policies and also coordinate international
economic policies.
7. Last but not the least, is that macroeconomic theory has saved us from the dangers of
application of microeconomic theory to the problems of the economy as a whole.
Macro Economics deals with
Economic policy - is the deliberate attempt to generate increases in economic welfare.
Since the late 1920s, when many advanced economies were on the brink of complete
collapse, economists have recognised that there is a role for government in steering a
macro-economy towards increased economic welfare.

Unemployment - there are a number of types of unemployment, defined in terms of cause

and severity. Cyclical unemployment exists when individuals lose their jobs as a result of a
downturn in aggregate demand (AD). If the decline in aggregate demand is persistent, and
the unemployment long-term, it is called either demand deficient, general,
or Keynesian unemployment.

Inflation - inflation and deflation arise from changes in either the demand side or supply
side of the macro-economy. Demand pull inflation usually occurs when there is an
increase in aggregate monetary demand caused by an increase in one or more of the
components of aggregate demand (AD), but where aggregate supply (AS) is slow to adjust.
Poverty - the alleviation of poverty is increasingly seen as a fundamental economic
objective. Poverty creates many economic costs in terms of the opportunity cost of lost
output, the cost of welfare provision, and the private and external costs associated with
exclusion from normal economic activity. These costs include the costs of unemployment,
crime, and poor health.

Q.2. Concept of GDP & GNP. How to calculate GDP & GNP.
Ans: Concept of National Income
National income means the value of goods and services produced by a country during
a financial year. Thus, it is the net result of all economic activities of any country during a
period of one year and is valued in terms of money. National income is an uncertain term
and is often used interchangeably with the national dividend, national output, and
national expenditure. We can understand this concept by understanding the national income
definition.
Concept of National Income
The National Income is the total amount of income accruing to a country from economic
activities in a years time. It includes payments made to all resources either in the form
of wages, interest, rent, and profits.
The progress of a country can be determined by the growth of the national income of the
country
National Income Definition
There are two National Income Definition
 Traditional Definition
 Modern Definition

Source: freepik.com
Traditional Definition
According to Marshall: “The labor and capital of a country acting on its natural
resources produce annually a certain net aggregate of commodities, material and immaterial
including services of all kinds. This is the true net annual income or revenue of the country
or national dividend.”
The definition as laid down by Marshall is being criticized on the following grounds.
Due to the varied category of goods and services, a correct estimation is very difficult.
There is a chance of double counting, hence National Income cannot be estimated correctly.
For example, a product runs in the supply from the producer to distributor
to wholesaler to retailer and then to the ultimate consumer. If on every movement
commodity is taken into consideration then the value of National Income increases.
Also, one other reason is that there are products which are produced but not marketed.
For example, In an agriculture-oriented country like India, there are commodities which
though produced but are kept for self-consumption or exchanged with other commodities.
Thus there can be an underestimation of National Income.
Read more about Income and Expenditure Method here in detail
Simon Kuznets defines national income as “the net output of commodities and services
flowing during the year from the country’s productive system in the hands of the
ultimate consumers.”
Following are the Modern National Income definition
 GDP
 GNP
Gross Domestic Product
The total value of goods produced and services rendered within a country during a year is
its Gross Domestic Product.
Further, GDP is calculated at market price and is defined as GDP at market prices. Different
constituents of GDP are:
1. Wages and salaries
2. Rent
3. Interest
4. Undistributed profits
5. Mixed-income
6. Direct taxes
7. Dividend
8. Depreciation
Gross National Product
For calculation of GNP, we need to collect and assess the data from all productive activities,
such as agricultural produce, wood, minerals, commodities, the contributions to production
by transport, communications, insurance companies, professions such (as lawyers, doctors,
teachers, etc). at market prices.
It also includes net income arising in a country from abroad. Four main constituents of GNP
are:
1. Consumer goods and services
2. Gross private domestic income
3. Goods produced or services rendered
4. Income arising from abroad.
GDP and GNP on the basis of Market Price and Factor Cost
a) Market Price
The Actual transacted price including indirect taxes such as GST, Customs duty etc. Such
taxes tend to raise the prices of goods and services in the economy.
b) Factor Cost
It Includes the cost of factors of production e.g. interest on capital, wages to labor, rent for
land profit to the stakeholders. Thus services provided by service providers and goods sold
by the producer is equal to revenue price.
Alternatively,
Revenue Price (or Factor Cost) = Market Price (net of) Net Indirect Taxes
Net Indirect Taxes = Indirect Taxes Net of Subsidies received
Hence,
Factor Cost shall be equal to
(Market Price) LESS (Indirect Taxes ADD Subsidies)
Net Domestic Product
The net output of the country’s economy during a year is its NDP. During the year a country’s
capital assets are subject to wear and tear due to its use or can become obsolete.
Hence, we deduct a percentage of such investment from the GDP to arrive at NDP.
So NDP=GDP at factor cost LESS Depreciation.
The Accumulation of all factors of income earned by residents of a country and includes
income earned from the county as well as from abroad.
Thus, National Income at Factor Cost shall be equal to
NNP at Market Price LESS (Indirect Taxes ADD Subsidies)
Question on National Income
Q. Enumerate the various methods of measuring National Income?
Ans. There are various methods for measuring National Income:
1. Gross Domestic Product (GDP)
2. Gross National Product (GNP)
3. Net National Product (NNP)
4. Net Domestic Product (NDP)
5. National Income at Factor Cost (NIFC)
6. Transfer Payments
7. Personal Income
8. Disposable Personal Income

GDP & GNP

Gross domestic product (GDP) is the value of a nation's finished domestic goods and
services during a specific time period. The gross national product (GNP) is the value of all
finished goods and services owned by a country's residents over a period of time.
Both GDP and GNP are two of the most commonly used measures of a country's economy,
both of which represent the total market value of all goods and services produced over a
defined period.
There are differences between how each one defines the scope of the economy. While GDP
limits its interpretation of the economy to the geographical borders of the country, GNP
extends it to include the net overseas economic activities performed by its nationals.
Simply put, GNP is a superset of GDP.
 Gross domestic product and gross national product are both metrics used to
measure a country's economic output.
 GDP measures the value of goods and services produced within a country's borders,
while GNP measures the value of goods and services produced by a country's
citizens domestically and abroad.
 GDP is an important figure because it shows whether an economy is growing or
contracting.
 GDP is the most commonly used by global economies. The United States abandoned
the use of GNP in1991, adopting GDP as its measure to compare itself with other
economies.
Gross Domestic Product
Gross domestic product is the most basic indicator used to measure the overall health and
size of a country's economy. It is the overall market value of the goods and services
produced domestically by a country. GDP is an important figure because it gives an idea of
whether the economy is growing or contracting.

The United States uses GDP as its key economic metric and has since 1991; it replaced
GNP to measure economic activity because GDP was the most common measure used
internationally.
Calculating GDP includes adding together private consumption or consumer spending,
government spending, capital spending by businesses, and net exports—exports minus
imports. Here's a brief overview of each component:
 Consumption: The value of the consumption of goods and services acquired and
consumed by the country’s households. This accounts for the largest part of GDP
 Government Spending: All consumption, investment, and payments made by the
government for current use
 Capital Spending by Businesses: Spending on purchases of fixed assets and unsold
stock by private businesses
 Net Exports: Represents the country’s balance of trade (BOT), where a positive
number bumps up the GDP as country exports more than it imports, and vice versa
Because it is subject to pressures from inflation, GDP can be broken up into two
categories—real and nominal. A country's real GDP is the economic output after inflation
is factored in, while nominal GDP is the output that does not take inflation into account.
Nominal GDP is usually higher than real GDP because inflation is a positive number. It is
used to compare different quarters in a year. The GDPs of two or more years, though, are
compared using real GDP.
GDP can be used to compare the performance of two or more economies, acting as a key
input for making investment decisions in a country. It also helps government draft policies
to drive local economic growth.
When the GDP rises, it means the economy is growing. Conversely, if it drops, the economy
shrinks and may be in trouble. But if the economy grows to the point where inflation
builds up, a country may reach its full production capacity. Central banks will then step in,
tightening their monetary policies to slow down growth. When interest rates rise,
consumer and corporate confidence drops. During these periods, monetary policy is eased
to stimulate growth.
To draw a parallel, if a family earns $75,000 a year, their spending should ideally remain
within their earnings range. It is possible that the family’s spending may overshoot their
earnings once in a while, like while buying a house or a car on loan, but then it returns to
the limits over a period of time. Longer periods of negative GDP, which indicates more
spending than production, can cause big damage to the economy. It leads to jobs loses
businesses closures and idle productive capacity.
Gross National Product
Gross national product is another metric used to measure a country's economic output.
Where GDP looks at the value of goods and services produced within a country's borders,
GNP is the market value of goods and services produced by all citizens of a country—both
domestically and abroad.
While GDP is an indicator of the local/national economy, GNP represents how its nationals
are contributing to the country's economy. It factors in citizenship but overlooks location.
For that reason, it's important to note that GNP does not include the output of foreign
residents.
For example, a Canadian NFL player who sends his income home to Canada, or a German
investor who transfers the dividend income generated from her shareholdings to
Germany, will both be excluded from GNP. On the other hand, if a U.S.-based news
reporter is sent to South Korea and sends her Korean earnings home, or a U.S.-based
airline generates income from its overseas operations, they both contribute positively to
the country's GNP.
GNP can be calculated by adding consumption, government spending, capital spending by
businesses, and net exports (exports minus imports) and net income by domestic
residents and businesses from overseas investments. This figure is then subtracted from
the net income earned by foreign residents and businesses from domestic investment.
Examples of GDP and GNP
A quick look at the absolute GDP and GNP numbers of a particular country over the past
two years indicate they mostly move in sync. There is a nominal difference between GDP
and GNP figures of a particular country depending upon how the economic activities of the
nation are spread across domestically or globally.
(All Figures in Billions of USD)

Data Sources: WorldBank DataBank / CEIC Data / Trading Economics

For instance, many American businesses, entrepreneurs, service providers, and
individuals who operate across the globe have helped the nation secure a positive net
inflow from the overseas economic activities and assets. This bumps up U.S. GNP, making
it higher than the GDP of the U.S. for the years 2016 and 2017.
Greece, which is going through a long-running financial problem owing to a debt crisis,
also has higher GNP than GDP. This indicates its citizens producing and contributing more
through their overseas operations—a net addition contributing to the higher GNP. Amid
the economic crisis in Greece, not many foreigners may be operating in a country which
may limit its GDP.
Other nations like China, the U.K., India, and Israel have lower GNP compared to
corresponding GDP figures. This indicates these nations are seeing a net overall outflow
from the country. Citizens and businesses of these countries operating overseas are
generating lesser income compared to the income generated by the foreign citizens and
businesses operating in these countries.
The percentage figures in the table above (GNP/GDP-%), which represents GNP as a
percentage of GDP, indicates that the absolute difference between the two figures remains
confined within a range of plus or minus 2 percent. It can be inferred that irrespective of
one figure being higher than the other, the difference is minimal.
Gross national product (GNP) is the value of all goods and services made by a country's
residents and businesses, regardless of production location. GNP counts the investments
made by U.S. residents and businesses—both inside and outside the country—and
computes the value of all products manufactured by domestic companies, regardless of
where they are made.
GNP doesn't count any income earned in the United States by foreign residents or
businesses, and excludes products manufactured in the United States by overseas firms.
GNP Formula
The formula to calculate the components of GNP is Y = C + I + G + X + Z.
That stands for GNP = Consumption + Investment + Government + X (net exports) + Z (net
income earned by domestic residents from overseas investments minus net income
earned by foreign residents from domestic investments).
GNP vs. GDP
U.S. GNP says a lot about the financial well being of Americans and U.S.-based
multinational corporations, but it doesn't give much insight into the health of the U.S.
economy. For that, you should use gross domestic product (real or nominal)—measures
production inside of a country, no matter who makes it. GNP is the same as GDP + Z. That
means GNP is a more accurate measure of a country's income than its production.
Examples of GNP vs. GDP
The output of a Toyota plant in Kentucky isn't included in GNP, although it's counted in
GDP, because the revenue from the sales of Toyota vehicles goes to Japan, even though the
products are made and sold in the United States. It is included in GDP because it adds to
the health of the U.S. economy by creating jobs for Kentucky residents, who use their
wages to buy local goods and services.
Similarly, the shoes made in a Nike plant in Korea will be counted in U.S. GNP, but not GDP,
because the profits from those shoes will boost Nike's earnings and stock prices,
contributing to higher national income. It doesn't stimulate economic growth in the United
States because those manufacturing jobs were outsourced. It's Korean workers who will
boost their country's economy and GDP by buying local goods and services.
These examples show why GNP is not as commonly used as GDP as a measure of a
country's economy. It gives a slightly inaccurate picture of how domestic resources are
used. For instance, if there were a severe drought in the United States, GNP would be
higher than GDP because the foreign holdings of U.S. residents would be unaffected by the
drought, unlike the U.S. investments of foreign workers.
GNP is also affected by changes in a country's currency exchange rates. If the dollar
weakens, then the foreign holdings of U.S. residents become worth more, boosting GNP.
 But that may not accurately reflect the state of the U.S. economy. A weaker dollar can
eventually boost GDP because it makes exports cheaper, which increases sales and
production.
GNP per Capita
GNP per capita is a measurement of GNP divided by the number of people in the country.
That makes it possible to compare the GNP of countries with different population sizes.
GNP by Country
The World Bank has replaced GNP with gross national income (GNI). So that GNI can
compared more fairly between nations with widely different populations and standards of
living, the World Bank uses GNI per capita.
The World Bank also uses the purchasing power parity (PPP) method, which excludes the
impact of exchange rates. Instead, it values each nation's output by what it would be worth
in the United States.
The CIA Factbook doesn't measure GNP; it only uses GDP. The Factbook notes that in
many emerging markets, such as Mexico, money made by residents overseas are sent back
to their country. This income can be a significant factor in boosting economic growth and
would be counted in GNP, but it isn't counted in GDP—which may cause the economic
power of these economies to be understated.
ARTICLE TABLE OF CONTENTSSkip to section
 GNP Formula
 GNP vs. GDP
 Examples of GNP vs. GDP
 GNP per Capita
 GNP by Country
GNP and GDP both reflect the national output and income of an economy. The main
difference is that GNP (Gross National Product) takes into account net income receipts
from abroad.
 GDP (Gross Domestic Product) is a measure of (national income = national output =
national expenditure) produced in a particular country.
 GNP = GDP + net property income from abroad. This net income from abroad includes
dividends, interest and profit.
 GNP includes the value of all goods and services produced by nationals – whether in the
country or not.
Example of GNP
If a Japanese multinational produces cars in the UK, this production will be counted
towards UK GDP. However, if the Japanese firm sends £50m in profits back to
shareholders in Japan, then this outflow of profit is subtracted from GNP. UK nationals
don’t benefit from this profit which is sent back to Japan.
 If a UK firm makes a profit from insurance companies located abroad, then if this profit is
returned to UK nationals, then this net income from overseas assets will be added to UK
GNP.
Note, if a Japanese firm invests in the UK, it will still lead to higher GNP, as some national
workers will see higher wages. However, the increase in GNP will not be as high as GDP.
 If a county has similar inflows and outflows of income from assets, then GNP and GDP will
be very similar.
 However, if a country has many multinationals who repatriate income from local
production, then GNP will be lower than GDP.
For example, Luxembourg has a GDP of $87,400 but a GNP of only $45,360.
A country like Ireland has received significant foreign investment. Therefore for Ireland,
there is a net outflow of income from the profits of these multinationals. Therefore, Irish
GNP is lower than GDP.

GNI
GNI (Gross National Income) is based on a similar principle to GNP. The World Bank
defines GNI as
“GNI is the sum of value added by all resident producers plus any product taxes (minus
subsidies) not included in the valuation of output plus net receipts of primary income
(compensation of employees and property income) from abroad.” (World Bank)
The World Bank now use GNI rather than GNP.
UK GNI
from: pdf ONS (1995)
This shows a small net income from abroad, so the GNI £715,028m is greater than GDP
(£713,980)
Gross Domestic Product
The Gross domestic Product (GDP) is the market value of all final goods and services
produced within a country in a given period of time. The GDP is the officially recognized
totals. The following equation is used to calculate the GDP:
GDP=C+I+G+(X−M)GDP=C+I+G+(X−M)
Written out, the equation for calculating GDP is:
GDP = private consumption + gross investment + government investment + government
spending + (exports – imports).
For the gross domestic product, “gross” means that the GDP measures production
regardless of the various uses to which the product can be put. Production can be used for
immediate consumption, for investment into fixed assets or inventories, or for replacing
fixed assets that have depreciated. “Domestic” means that the measurement of GDP
contains only products from within its borders.
Nominal GDP
The nominal GDP is the value of all the final goods and services that an economy produced
during a given year. It is calculated by using the prices that are current in the year in
which the output is produced. In economics, a nominal value is expressed in monetary
terms. For example, a nominal value can change due to shifts in quantity and price. The
nominal GDP takes into account all of the changes that occurred for all goods and services
produced during a given year. If prices change from one period to the next and the output
does not change, the nominal GDP would change even though the output remained
constant.
Nominal GDP: This image shows the nominal GDP for a given year in the United States.
Real GDP
The real GDP is the total value of all of the final goods and services that an economy
produces during a given year, accounting for inflation. It is calculated using the prices of a
selected base year. To calculate Real GDP, you must determine how much GDP has been
changed by inflation since the base year, and divide out the inflation each year. Real GDP,
therefore, accounts for the fact that if prices change but output doesn’t, nominal GDP
would change.
Real GDP Growth: This graph shows the real GDP growth over a specific period of time.
In economics, real value is not influenced by changes in price, it is only impacted by
changes in quantity. Real values measure the purchasing power net of any price changes
over time. The real GDP determines the purchasing power net of price changes for a given
year. Real GDP accounts for inflation and deflation. It transforms the money-value
measure, nominal GDP, into an index for quantity of total output.
The GDP Deflator
The GDP deflator is a price index that measures inflation or deflation in an economy by
calculating a ratio of nominal GDP to real GDP.
LEARNING OBJECTIVES
Explain how the calculation of the GDP deflator can measure inflation
KEY TAKEAWAYS
Key Points
 The GDP deflator is a measure of price inflation. It is calculated by dividing Nominal
GDP by Real GDP and then multiplying by 100. (Based on the formula).
 Nominal GDP is the market value of goods and services produced in an economy,
unadjusted for inflation. Real GDP is nominal GDP, adjusted for inflation to reflect
changes in real output.
 Trends in the GDP deflator are similar to changes in the Consumer Price Index, which
is a different way of measuring inflation.
Key Terms
 GDP deflator: A measure of the level of prices of all new, domestically produced,
final goods and services in an economy. It is calculated by computing the ratio of
nominal GDP to the real measure of GDP.
 real GDP: A macroeconomic measure of the value of the economy’s output adjusted
for price changes (inflation or deflation).
 nominal GDP: A macroeconomic measure of the value of the economy’s output that
is not adjusted for inflation.
The GDP deflator (implicit price deflator for GDP) is a measure of the level of prices of all
new, domestically produced, final goods and services in an economy. It is a price index
that measures price inflation or deflation, and is calculated using nominal GDP and real
GDP.
Nominal GDP versus Real GDP
Nominal GDP, or unadjusted GDP, is the market value of all final goods produced in a
geographical region, usually a country. That market value depends on the quantities of
goods and services produced and their respective prices. Therefore, if prices change from
one period to the next but actual output does not, nominal GDP would also change even
though output remained constant.
In contrast, real gross domestic product accounts for price changes that may have
occurred due to inflation. In other words, real GDP is nominal GDP adjusted for inflation. If
prices change from one period to the next but actual output does not, real GDP would be
remain the same. Real GDP reflects changes in real production. If there is no inflation or
deflation, nominal GDP will be the same as real GDP.
Calculating the GDP Deflator
The GDP deflator is calculated by dividing nominal GDP by real GDP and multiplying by
100.

GDP Deflator Equation: The GDP deflator measures price inflation in an economy. It is
calculated by dividing nominal GDP by real GDP and multiplying by 100.
Consider a numeric example: if nominal GDP is $100,000, and real GDP is $45,000, then
the GDP deflator will be 222 (GDP deflator = $100,000/$45,000 * 100 = 222.22).
In the U.S., GDP and GDP deflator are calculated by the U.S. Bureau of Economic Analysis.
Relationship between GDP Deflator and CPI
Like the Consumer Price Index (CPI), the GDP deflator is a measure of price
inflation/deflation with respect to a specific base year. Similar to the CPI, the GDP deflator
of the base year itself is equal to 100. Unlike the CPI, the GDP deflator is not based on a
fixed basket of goods and services; the “basket” for the GDP deflator is allowed to change
from year to year with people’s consumption and investment patterns. However, trends in
the GDP deflator will be similar to trends in the CPI.

Q.3. Inflations- Concept, Causes and its Impact.

Ans: Inflation and unemployment are the two most talked-about words in the
contemporary society.
These two are the big problems that plague all the economies.
Almost everyone is sure that he knows what inflation exactly is, but it remains a source of
great deal of confusion because it is difficult to define it unambiguously.
1. Meaning of Inflation:
Inflation is often defined in terms of its supposed causes. Inflation exists when money
supply exceeds available goods and services. Or inflation is attributed to budget deficit
financing. A deficit budget may be financed by the additional money creation. But the
situation of monetary expansion or budget deficit may not cause price level to rise. Hence
the difficulty of defining ‘inflation’.
Inflation may be defined as ‘a sustained upward trend in the general level of prices’ and
not the price of only one or two goods. G. Ackley defined inflation as ‘a persistent and
appreciable rise in the general level or average of prices’. In other words, inflation is a
state of rising prices, but not high prices.
It is not high prices but rising price level that constitute inflation. It constitutes, thus, an
overall increase in price level. It can, thus, be viewed as the devaluing of the worth of
money. In other words, inflation reduces the purchasing power of money. A unit of money
now buys less. Inflation can also be seen as a recurring phenomenon.
While measuring inflation, we take into account a large number of goods and services
used by the people of a country and then calculate average increase in the prices of those
goods and services over a period of time. A small rise in prices or a sudden rise in prices is
not inflation since they may reflect the short term workings of the market.
It is to be pointed out here that inflation is a state of disequilibrium when there occurs a
sustained rise in price level. It is inflation if the prices of most goods go up. Such rate of
increases in prices may be both slow and rapid. However, it is difficult to detect whether
there is an upward trend in prices and whether this trend is sustained. That is why
inflation is difficult to define in an unambiguous sense.
Let’s measure inflation rate. Suppose, in December 2007, the consumer price index was
193.6 and, in December 2008, it was 223.8. Thus, the inflation rate during the last one year
was
223.8- 193.6/ 193.6 x 100 = 15.6
As inflation is a state of rising prices, deflation may be defined as a state of falling prices
but not fall in prices. Deflation is, thus, the opposite of inflation, i.e., a rise in the value of
money or purchasing power of money. Disinflation is a slowing down of the rate of
inflation.
2. Types of Inflation:
As the nature of inflation is not uniform in an economy for all the time, it is wise to distin-
guish between different types of inflation. Such analysis is useful to study the distribu-
tional and other effects of inflation as well as to recommend anti-inflationary policies.
Inflation may be caused by a variety of factors. Its intensity or pace may be different at
different times. It may also be classified in accordance with the reactions of the
government toward inflation.
Thus, one may observe different types of inflation in the contemporary society:
A. On the Basis of Causes:
(i) Currency inflation:
This type of inflation is caused by the printing of currency notes.
(ii) Credit inflation:
Being profit-making institutions, commercial banks sanction more loans and advances to
the public than what the economy needs. Such credit expansion leads to a rise in price
level.
(iii) Deficit-induced inflation:
The budget of the government reflects a deficit when expenditure exceeds revenue. To
meet this gap, the government may ask the central bank to print additional money. Since
pumping of additional money is required to meet the budget deficit, any price rise may the
be called the deficit-induced inflation.
(iv) Demand-pull inflation:
An increase in aggregate demand over the available output leads to a rise in the price
level. Such inflation is called demand-pull inflation (henceforth DPI). But why does
aggregate demand rise? Classical economists attribute this rise in aggregate demand to
money supply. If the supply of money in an economy exceeds the available goods and
services, DPI appears. It has been described by Coulborn as a situation of “too much
money chasing too few goods.”

Keynesians hold a different argument. They argue that there can be an autonomous
increase in aggregate demand or spending, such as a rise in consumption demand or
investment or government spending or a tax cut or a net increase in exports (i.e., C + I + G
+ X – M) with no increase in money supply. This would prompt upward adjustment in
price. Thus, DPI is caused by monetary factors (classical adjustment) and non-monetary
factors (Keynesian argument).
DPI can be explained in terms of Fig. 4.2, where we measure output on the horizontal axis
and price level on the vertical axis. In Range 1, total spending is too short of full
employment output, YF. There is little or no rise in the price level. As demand now rises,
output will rise. The economy enters Range 2, where output approaches towards full
employment situation. Note that in this region price level begins to rise. Ultimately, the
economy reaches full employment situation, i.e., Range 3, where output does not rise but
price level is pulled upward. This is demand-pull inflation. The essence of this type of in-
flation is that “too much spending chasing too few goods.”
(v) Cost-push inflation:
Inflation in an economy may arise from the overall increase in the cost of production. This
type of inflation is known as cost-push inflation (henceforth CPI). Cost of production may
rise due to an increase in the prices of raw materials, wages, etc. Often trade unions are
blamed for wage rise since wage rate is not completely market-determinded. Higher wage
means high cost of production. Prices of commodities are thereby increased.
A wage-price spiral comes into operation. But, at the same time, firms are to be blamed
also for the price rise since they simply raise prices to expand their profit margins. Thus,
we have two important variants of CPI wage-push inflation and profit-push inflation.
Anyway, CPI stems from the leftward shift of the aggregate supply curve:

B. On the Basis of Speed or Intensity:

(i) Creeping or Mild Inflation:

If the speed of upward thrust in prices is slow but small then we have creeping inflation.
What speed of annual price rise is a creeping one has not been stated by the economists.
To some, a creeping or mild inflation is one when annual price rise varies between 2 p.c.
and 3 p.c. If a rate of price rise is kept at this level, it is considered to be helpful for
economic development. Others argue that if annual price rise goes slightly beyond 3 p.c.
mark, still then it is considered to be of no danger.
(ii) Walking Inflation:
If the rate of annual price increase lies between 3 p.c. and 4 p.c., then we have a situation
of walking inflation. When mild inflation is allowed to fan out, walking inflation appears.
These two types of inflation may be described as ‘moderate inflation’.
Often, one-digit inflation rate is called ‘moderate inflation’ which is not only predictable,
but also keep people’s faith on the monetary system of the country. Peoples’ confidence
get lost once moderately maintained rate of inflation goes out of control and the economy
is then caught with the galloping inflation.
(iii) Galloping and Hyperinflation:
Walking inflation may be converted into running inflation. Running inflation is dangerous.
If it is not controlled, it may ultimately be converted to galloping or hyperinflation. It is an
extreme form of inflation when an economy gets shattered.”Inflation in the double or
triple digit range of 20, 100 or 200 p.c. a year is labelled “galloping inflation”.
(iv) Government’s Reaction to Inflation:
Inflationary situation may be open or suppressed. Because of anti-inflationary policies
pursued by the government, inflation may not be an embarrassing one. For instance,
increase in income leads to an increase in consumption spending which pulls the price
level up.
If the consumption spending is countered by the government via price control and
rationing device, the inflationary situation may be called a suppressed one. Once the
government curbs are lifted, the suppressed inflation becomes open inflation. Open
inflation may then result in hyperinflation.

What Is Inflation?
To put it simply, inflation is the long term rise in the prices of goods and services caused
by the devaluation of currency. While there are advantages to inflation which I will
discuss later in this article, I want to first focus on some of the negative aspects of
inflation.
Inflationary problems arise when we experience unexpected inflation which is not
adequately matched by a rise in people’s incomes. If incomes do not increase along with
the prices of goods, everyone’s purchasing power has been effectively reduced, which
can in turn lead to a slowing or stagnant economy. Moreover, excessive inflation can also
wreak havoc on retirement savings as it reduces the purchasing power of the money that
savers and investors have squirreled away.

Causes of Inflation
So what exactly causes inflation in an economy? There is not a single, agreed-upon
answer, but there are a variety of theories, all of which play some role in inflation:

1. The Money Supply

Inflation is primarily caused by an increase in the money supply that outpaces economic
growth.
Ever since industrialized nations moved away from the gold standard during the past
century, the value of money is determined by the amount of currency that is in
circulation and the public’s perception of the value of that money. When the Federal
Reserve decides to put more money into circulation at a rate higher than the economy’s
growth rate, the value of money can fall because of the changing public perception of the
value of the underlying currency. As a result, this devaluation will force prices to rise due
to the fact that each unit of currency is now worth less.
One way of looking at the money supply effect on inflation is the same way collectors
value items. The rarer a specific item is, the more valuable it must be. The same logic
works for currency; the less currency there is in the money supply, the more valuable
that currency will be. When a government decides to print new currency, they
essentially water down the value of the money already in circulation. A more
macroeconomic way of looking at the negative effects of an increased money supply is
that there will be more dollars chasing the same amount of goods in an economy, which
will inevitably lead to increased demand and therefore higher prices.

2. The National Debt

We all know that high national debt in the U.S. is a bad thing, but did you know that it can
actually drive inflation to higher levels over time? The reason for this is that as a
country’s debt increases, the government has two options: they can either raise taxes or
print more money to pay off the debt.
A rise in taxes will cause businesses to react by raising their prices to offset the
increased corporate tax rate. Alternatively, should the government choose the latter
option, printing more money will lead directly to an increase in the money supply, which
will in turn lead to the devaluation of the currency and increased prices (as discussed
above).

3. Demand-Pull Effect
The demand-pull effect states that as wages increase within an economic system (often
the case in a growing economy with low unemployment), people will have more money
to spend on consumer goods. This increase in liquidity and demand for consumer goods
results in an increase in demand for products. As a result of the increased demand,
companies will raise prices to the level the consumer will bear in order to balance supply
and demand.
An example would be a huge increase in consumer demand for a product or service that
the public determines to be cheap. For instance, when hourly wages increase, many
people may determine to undertake home improvement projects. This increased demand
for home improvement goods and services will result in price increases by house-
painters, electricians, and other general contractors in order to offset the increased
demand. This will in turn drive up prices across the board.

4. Cost-Push Effect
Another factor in driving up prices of consumer goods and services is explained by an
economic theory known as the cost-push effect. Essentially, this theory states that when
companies are faced with increased input costs like raw goods and materials or wages,
they will preserve their profitability by passing this increased cost of production onto
the consumer in the form of higher prices.
A simple example would be an increase in milk prices, which would undoubtedly drive
up the price of a cappuccino at your local Starbucks since each cup of coffee is now more
expensive for Starbucks to make.

5. Exchange Rates
Inflation can be made worse by our increasing exposure to foreign marketplaces. In
America, we function on a basis of the value of the dollar. On a day-to-day basis, we as
consumers may not care what the exchange rates between our foreign trade partners
are, but in an increasingly global economy, exchange rates are one of the most important
factors in determining our rate of inflation.
When the exchange rate suffers such that the U.S. currency has become less valuable
relative to foreign currency, this makes foreign commodities and goods more expensive
to American consumers while simultaneously making U.S. goods, services, and exports
cheaper to consumers overseas.
This exchange rate differential between our economy and that of our trade partners can
stimulate the sales and profitability of American corporations by increasing their
profitability and competitiveness in overseas markets. But it also has the simultaneous
effect of making imported goods (which make up the majority of consumer products in
America), more expensive to consumers in the United States.

The Good Aspects of Inflation

In a fact that is surprising to most people, economists generally argue that some inflation
is a good thing. A healthy rate of inflation is considered to be approximately 2-3% per
year. The goal is for inflation (which is measured by the Consumer Price Index, or CPI) to
outpace the growth of the underlying economy (measured by Gross Domestic Product, or
GDP) by a small amount per year.
A healthy rate of inflation is considered a positive because it results in increasing wages
and corporate profitability and keeps capital flowing in a presumably growing economy.
As long as things are moving in relative unison, inflation will not be detrimental.
Another way of looking at small amounts of inflation is that it encourages consumption.
For example, if you wanted to buy a specific item, and knew that the price of it would rise
by 2-3% in a year, you would be encouraged to buy it now. Thus, inflation can encourage
consumption which can in turn further stimulate the economy and create more jobs.

10 Strategies to Combat Inflation’s Effects on Your Retirement

The single most important consideration that inflation introduces into your financial
planning process is: Factoring for inflation, how much will I really need to retire?
What is your savings goal? Many people have set an arbitrary goal of $1 million to retire.
But how much will $1 million be worth when you retire?
If you are planning to retire in 2050, a rate of inflation approximating 3% per year will
result in $1 million dollars having the purchasing power of $325,000 of today’s dollars.
How long will $325,000 carry you? If your current cost of living is around $50,000 a year,
you can see that $1 million will only carry you through about 6 years in retirement
assuming you do not have supplemental sources of income.
So, what can be done to combat inflation’s detrimental effects on savings and adjust your
portfolio for inflation? Contrary to public belief or opinion, we aren’t helpless in
combating the role inflation can play in our lives. Many strategies can act as a hedge
against inflation, but these techniques must be employed strategically and effectively in
order to take advantage of their benefits. Ten of the best ways to combat inflation are as
follows:
1. Spend money on long-term investments.
We all love to save. But when it comes to long-term investments, sometimes spending
money now can allow you to benefit from inflation down the road. As an example, let’s
say you are looking to take out a mortgage to purchase a home and economists project
significant inflation over the next 50 years. When you consider you can repay the
mortgage down the line with inflated dollars that are worth less than they are now, then
you are using inflation to your benefit. Other areas where you can take advantage of
inflation include home improvement projects, capital expenditures for a business, or
other major investments.
2. Invest in commodities.
Commodities, like oil, have an inherent worth that is resilient to inflation. Unlike money,
commodities will always remain in demand and can act as an excellent hedge against
inflation. For most of us, however, purchasing commodities in the open marketplace is
probably too much of a daunting task. In that case, you can consider investing in
commodity-based Exchange Traded Funds (ETFs) through Zacks Invest. These will offer
the liquidity of stocks with the inflation hedging power of commodity investment. Just be
careful of and watch out for the problems of ETFs.
3. Invest in gold and precious metals.
Gold, silver, and other precious metals, like commodities, have an inherent value that
allows them to remain immune to inflation. In fact, gold used to be the preferred form of
currency before the move to paper currency took place. With that said, even precious
metals are liable to being a part of speculative bubbles.
4. Invest in real estate.
Real estate has also historically offered an inflationary hedge. The old saying goes: “land
is the one thing they aren’t making any more of.” Investing in real estate provides a real
asset. In addition, rental property, which can be purchased easily through Roofstock, can
offer the landlord the option of increasing rent prices over time to keep pace with
inflation. Plus, there’s the added alternative of the ability to sell the real assets in the
open market for what normally amounts to a return that generally keeps pace with or
outstrips inflation. However, just like with precious metals, we all know that real estate
bubbles can and do exist.
5. Consider TIPS.
Treasury Inflation Protected Securities (TIPS) are guaranteed to return your original
investment along with whatever inflation was during the lifetime of the TIPS. But TIPS
do not offer the opportunity for significant capital appreciation, and therefore should
only make up a portion of your personal investment portfolio allocation.
6. Stick with equities.
Although investing in bonds may feel safer, historically, bonds have failed to outpace
inflation, and have at times been crushed during hyper-inflationary periods. Over the
long term, the only source of inflation-beating returns has been the stock market.
Equities have historically beat bonds because of the ability of corporations to pass price
increases along to their consumers, resulting in higher income and returns for both the
company and its investors.
Pro tip: Ally Invest is offering up to $3,500 and free trades for 90 days when you open
and fund a trading account.
7. Consider dividend-paying stocks.
Exhaustive research by Wharton School of Business economist Jeremy Siegel reveals that
large-cap, dividend paying stocks have provided an inflation-adjusted 7% per year
return in every period greater than 20 years since 1800. If you have the investment risk
tolerance for the volatility and a time horizon of greater than 20 years until retirement,
consider dividend-paying securities. Dividend stocks offer a hedge against inflation
because dividends normally increase on an annual basis at a rate which outpaces that of
inflation. This almost guarantees stock price appreciation at a similar pace, while
offering the further benefit of compounding when dividends are reinvested.
8. Save More.
The fact is that you are probably going to need a lot more money for retirement than you
think you will. There are two ways to get to your new benchmark: Save more, or invest
more aggressively. Saving more is probably the easiest and most proactive thing you can
do to ensure your ability to fund a comfortable retirement. If you are saving $250 a
month, could you save $500 a month if you ate out a few less times and carpooled to
work? What if you started using the Acorns app, which rounds up all your purchases,
investing the difference? Chances are, you could and this will help protect you from
future inflation. See some of these planning strategies for how much to save for
retirement based on age.
9. Invest in collectibles.
Who would have believed the return on investment you could have gotten from the
purchase of a Mark McGwire rookie card during his first year in Major League Baseball,
or a Limited-Edition G.I. Joe in its original packaging? Buying and selling collectibles can
actually offer great inflation-adjusted returns, while also being a fun and interesting
hobby.
10. Become a patron of the arts.
The strategic acquisition of photography, paintings, sculptures and other art can often
provide inflation-beating returns, though certainly not always. My suggestion would be
to find the best of both worlds, a valuable piece of fine art that you truly appreciate and
will not be in a hurry to sell.
1. Demand-pull inflation
If the economy is at or close to full employment, then an increase in AD leads to an
increase in the price level. As firms reach full capacity, they respond by putting up prices
leading to inflation. Also, near full employment with labour shortages, workers can get
higher wages which increase their spending power.

AD can increase due to an increase in any of its components C+I+G+X-M

We tend to get demand-pull inflation if economic growth is above the long-run trend rate
of growth. The long-run trend rate of economic growth is the average sustainable rate of
growth and is determined by the growth in productivity.
Example of demand-pull inflation in the UK

In the 1980s, the UK experienced rapid

economic growth. The government cut interest rates and also cut taxes. House prices rose
by up to 30% -fuelling a positive wealth effect and a rise in consumer confidence. This
increased confidence led to higher spending, lower saving and an increase in borrowing.
However, the rate of economic growth reached 5% a year – well above the UK’s long-run
trend rate of 2.5 %. The result was a rise in inflation as firms could not meet demand. It
also led to a current account deficit. You can read more about demand-pull inflation at
the Lawson Boom of the 1980s.
2. Cost-push inflation
If there is an increase in the costs of firms, then businesses will pass this on to consumers.
There will be a shift to the left in the AS.

Cost-push inflation can be caused by many factors

1. Rising wages
If trades unions can present a united front then they can bargain for higher wages. Rising
wages are a key cause of cost push inflation because wages are the most significant cost
for many firms. (higher wages may also contribute to rising demand)
2. Import prices
One-third of all goods are imported in the UK. If there is a devaluation, then import prices
will become more expensive leading to an increase in inflation. A devaluation /
depreciation means the Pound is worth less. Therefore we have to pay more to buy the
same imported goods.
In 2011/12, the UK experienced a rise in cost-push inflation, partly due to the
depreciation of the Pound against the Euro. (also due to higher taxes)
3. Raw material prices
The best example is the price of oil. If the oil price increase by 20% then this will have a
significant impact on most goods in the economy and this will lead to cost-push inflation.
E.g., in 1974 there was a spike in the price of oil causing a period of high inflation around
the world.
 Source: World
Bank. In 2008, we had a smaller spike in oil prices causing a rise in inflation – just before
the great recession of 2008/09
4. Profit push inflation
When firms push up prices to get higher rates of inflation. This is more likely to occur
during strong economic growth.
5. Declining productivity
If firms become less productive and allow costs to rise, this invariably leads to higher
prices.
6. Higher taxes
If the government put up taxes, such as VAT and Excise duty, this will lead to higher prices,
and therefore CPI will increase. However, these tax rises are likely to be one-off increases.
There is even a measure of inflation (CPI-CT) which ignores the effect of temporary tax
rises/decreases.
CPI-CT is less volatile because it ignores the effect of taxes. In 2010, some of the UK CPI
inflation was due to rising taxes.
What else could cause inflation?
1. Rising house prices
Rising house prices do not directly cause inflation, but they can cause a positive wealth
effect and encourage consumer-led economic growth. This can indirectly cause demand-
pull inflation.
2. Printing more money
If the Central Bank prints more money, you would expect to see a rise in inflation. This is
because the money supply plays an important role in determining prices. If there is more
money chasing the same amount of goods, then prices will rise. Hyperinflation is usually
caused by an extreme increase in the money supply.
However, in exceptional circumstances – such as liquidity trap/recession, it is possible to
increase the money supply without causing inflation. This is because, in recession, an
increase in the money supply may just be saved, e.g. banks don’t increase lending but just
keep more bank reserves.
See: The link between money supply and inflation
Inflation expectations
Once inflation sets in it is difficult to reduce inflation. For example, higher prices will cause
workers to demand higher wages causing a wage-price spiral. Therefore, expectations of
inflation are important. If people expect high inflation, it tends to be self-serving.
The attitude of the monetary authorities is important; for example, if there was an
increase in AD and the monetary authorities accommodated this by increasing the money
supply then there would be a rise in the price level.
Q.4. Business Under Inflationary Situations.
Ans: Effects of Inflation on Businesses
When we think of inflation we usually think of how it affects us as consumers. But the
effects of inflation are wide ranging, including not only individuals but also businesses and
even countries. Consumers and businesses alike have to deal with the impact of inflation,
both good and bad. Here are some ways in which inflation affects businesses:
1. Consumer Purchasing

This is the most obvious impact to businesses. Rapidly rising

prices will cause consumers to (as Samuel Goldwyn famously said) “stay away in droves”.
There are ways for businesses to plan for inflation to reduce the chances of revenue loss.
Gradually increasing prices will prevent a sudden price hike, and if your competitors don’t
respond similarly, they’ll have to increase their own prices suddenly, which will cause
“sticker shock” for their consumers causing them to look for more affordable alternatives.
Another sneakier option that businesses often resort to, is to shrink the package size while
keeping the price the same. This is sort of “stealth inflation” because most consumers
won’t notice the quantity change because they are more focused on price.
2. Inventory Costs
Rapidly rising prices not only affect the price consumers pay, they also affect the cost
businesses have to pay for materials and inventory. When replacement inventory costs
more than the inventory you just sold, it can lead to inventory shortages. In the highly
inflationary 1970’s rising inventory costs led many U.S. companies to adopt the Japanese
model of Just in Time inventory management (JIT) as opposed to “Just in Case” inventory
management, so they wouldn’t have to stock so much inventory. Toyota is said to have
been one of the first to use JIT. “Toyota started with just-in-time inventory controls in the
1970s and it took more than 15 years to perfect. Toyota sends off orders for parts only when
it receives new orders from customers.” This requires precise timing and reliable inventory
channels since a single delay could halt production altogether.
JIT allows companies to stock less inventory, thus saving on carrying costs but even the
most prudent business management may not be able to overcome the effects of high
inflation. JIT is also useful in times of Deflation when prices are falling, as happens
frequently in the electronics industry. In that case you do not want to carry inventory in
stock which if held too long, you might have to sell at or below cost.
3. Price Changes
 When service and product prices fluctuate, businesses have to
spend money printing new menus or changing price tags to list the correct prices. These
costs are called ‘menu costs’, and they affect brick and mortar businesses most heavily.
Imagine the labor involved in going through Walmart and changing all the price tags! And
then imagine having to do that every day. In an effort to reduce the labor involved in
changing prices in the 1970’s large department stores stopped putting tags on individual
items and only put them on shelves instead.
Hyperinflation can make matters even worse. The (German) Weimar Republic is perhaps
the quintessential example of hyperinflation. In the book “Paper Money” by Adam Smith
he says:
“Prices rose not just by the day, but by the hour — or even the minute. If you had your
morning coffee in a café, and you preferred drinking two cups rather than one, it was
cheaper to order both cups at the same time.”
If businesses can’t predict their costs in advance and so they also don’t know how much
they will have to charge, they spend more and more printing and reprinting items. Over
time, the menu costs add up. To avoid this issue, highly variable items will simply be listed
as “Market Price” and you will have to ask the server what the going price is. In addition to
the cost of changing price tags, if the rate of inflation is widely variable (compared to
steadily increasing) it makes projecting costs and profit margins even more difficult and
thus larger expansion projects are put on hold simply due to uncertainty, which slows the
economy, eventually stifling it altogether see Zimbabwe hyperinflation.
In times of hyperinflation, people rush out to spend their money before it loses value, so
inventory turns over rapidly this is called the Velocity of Money.
4. Borrowing
Early in the inflation cycle, banks are actively expanding their loan portfolio as the easy
money policies of the government kick the economy into overdrive. During this artificial
“boom” many businesses succumb to the lure of easy money and think that getting a
business loan is a good idea. They figure that because inflation rates are rising, the cost (in
purchasing power) of paying the loan back will be less than the value of the loan taken out.
However, as is the case with any debt, companies must be smart about how much they
take out and for what, because even cheaper money won’t bail them out if profits didn’t
increase from the new business venture or expansion. Plus, like all games of “musical
chairs” eventually the music stops and someone is left without a seat.
Later in the inflation cycle, businesses will find it harder to take out a loan, because banks
and other financial institutions view a business with a low cash flow as a risk, since it’ll be
harder to pay back the borrowed funds. At this point, in order to protect themselves
against the impact of inflation, lenders increase interest rates to cover not only the cost of
the depreciating value of the money, but also the cost of increased market uncertainty.
This lack of borrowing power will reduce the liquidity of many enterprises who rely on
credit to fund inventory or operations, and may lead to insolvency, or reduce the ability of
businesses to invest in growth. As problems in the economy snowball, lenders become
more cautious and eventually all credit dries up, so even good credit risks are unable to
obtain financing.
At this point, people like Warren Buffett (who have wisely stockpiled cash) swoop in and
make offers to the cash starved organizations that they “can’t refuse”, primarily because
they have no other choice. For instance, in 2008 in the depths of the Great Recession,
Buffett’s Berkshire Hathaway loaned GE $3 Billion dollars (actually they purchased $3b
worth of preferred stock) under terms that no individual investor could have received. GE
needed the cash infusion due to problems with its financing unit, GE Capital. And GE was
desperate for funding after Bear Stearns and Lehman Brothers went belly up. According to
a USA Today article, “Berkshire, based in Omaha, Neb., is buying $3 billion of preferred
shares of GE, which carry a 10 percent dividend. The terms are similar to those Buffett struck
with Goldman Sachs. Berkshire also has the option to buy $3 billion worth of GE common
shares for $22.25 each at any time over five years. GE’s shares closed at $24.50
Wednesday.” Five years later, at the end of 2013 those shares were trading at about $28,
so Buffet could buy them at $22.25 and immediately turn around and sell them at $28.
5. Investment

For businesses hit hard by high inflation, upgrading outdated

electronics and equipment becomes nigh impossible. The office might benefit from a new
computer, and a remodel might appeal to customers, but those kinds of upgrades aren’t
going to be possible. Not only are profits low, but high inflation makes even normal,
everyday costs expensive.
High inflation stymies major investment. When inflation rises materially above the federal
target, investor confidence in the economy is reduced. This causes punitive interest rates
on loans as investors seek a return on their investments. This is because they want
compensation for the increased risk of lending money. In the long term, this reduces
business growth preventing businesses from taking advantage of market opportunities.
6. Employee Wages
One of the major costs of doing business for most companies is employee wages. Typically,
employees suffer more than companies due to inflation. Remember back to the example of
Weimar Germany when prices were going up hourly. Now imagine what would happen if
employees didn’t get wage increases except for once a year. Very quickly that employee
would quit coming to work. The same thing happens on a lesser scale when inflation is
lower. For simplicity sake, suppose an employee is earning $10 per hour. If inflation is 5%
per year, something that he could buy for one hour’s labor in January will cost him $10.50
in December, but he hasn’t gotten his raise yet, so in effect if prices rise rapidly the
employee is always a year behind. Over time, that employee will start to struggle
financially, because their dollar counts for less than it once did. This happens even when
the inflation rate is low, but when it’s high, this phenomenon is even more pronounced.
In addition, inflation gives businesses an opportunity to reduce the cost of employee
wages. Employees won’t agree to a pay cut, but by increasing employee wages by a rate
lower than the inflation rate businesses can lower their employee wages expenses.
7. Foreign Exchange

As inflation occurs, the purchasing power of the dollar falls,

relative to other currencies. If the dollar falls in value, costs for international purchases
increase. With supply chains in today’s increasingly globalised world spanning many
countries, purchases of raw materials and component parts often need to be made in
foreign currencies. A weaker dollar increases the cost in dollars for each unit purchased.
With complex supply chains, it is often impossible to switch to domestic suppliers in the
short term, making increased costs unavoidable.
On the flip side, a weaker dollar, increases demand for goods from overseas consumers,
because it becomes relatively less expensive to purchase finished goods from countries
with weaker currencies rather than from countries with relatively stronger currencies.
This may alleviate the impact of foreign expenses, or, depending on the scale of the
depreciation in the dollar, may prove a net benefit to the business. A lot depends on the
ratio of foreign sales to foreign raw materials costs. In other words if your income is in one
currency and your expenses are in another, the direction of the currency value changes
can have either a strong negative or positive effect. Most companies in this situation use
currency hedging to protect against adverse currency fluctuations.

Q.5. Monetary Policy.

Ans: Monetary policy is the policy adopted by the monetary authority of a country that
controls either the interest rate payable on very short-term borrowing or
the money supply, often targeting inflation or the interest rate to ensure price stability
and general trust in the currency.
Monetary policy is a central bank's actions and communications that manage the money
supply. That includes credit, cash, checks, and money market mutual funds. The most
important of these forms of money is credit. It includes loans, bonds, and mortgages.

Monetary policy increases liquidity to create economic growth. It reduces liquidity to

prevent inflation. Central banks use interest rates, bank reserve requirements, and the
amount of government bonds that banks must hold. All these tools affect how much banks
can lend. The volume of loans affects the money supply.

Three Objectives of Monetary Policy

Central banks have three monetary policy objectives. The most import is to
manage inflation. The secondary objective is to reduce unemployment, but only
after controlling inflation. The third objective is to promote moderate long-term interest
rates.

The U.S. Federal Reserve, like many other central banks, has specific targets
for these objectives. It wants the core inflation rate to be between 2% and 2.5%. It seeks
an unemployment rate below 6.5%. Beyond that, it prefers a natural rate of
unemployment of between 4.7% and 5.8%. The Fed's overall goal is healthy economic
growth. That's a 2% to 3% annual increase in the nation's gross domestic product.

Types of Monetary Policy

Central banks use contractionary monetary policy to reduce inflation. They reduce the
money supply by restricting the amount of money banks can lend. The banks charge a
higher interest rate, making loans more expensive. Fewer businesses and individuals
borrow, slowing growth.

Central banks use expansionary monetary policy to lower unemployment and

avoid recession. They increase liquidity by giving banks more money to lend. Banks lower
interest rates, making loans cheaper. Businesses borrow more to buy equipment, hire
employees, and expand their operations. Individuals borrow more to buy more homes,
cars, and appliances. That increases demand and spurs economic growth.

Monetary Policy Versus Fiscal Policy

Ideally, monetary policy should work hand-in-glove with the national government's fiscal
policy. It rarely works this way. Government leaders get re-elected for reducing taxes or
increasing spending. As a result, they adopt expansionary fiscal policy. To avoid inflation
in this situation, the Fed is forced to use restrictive monetary policy.

For example, during the Great Recession, Republicans in Congress became concerned
about the U.S. debt. It exceeded the benchmark debt-to-GDP ratio of 100%. As a result,
fiscal policy became contractionary just when it needed to be expansionary. To
compensate, the Fed injected massive amounts of money into the economy
with quantitative easing.

Monetary Policy Tools

All central banks have three tools of monetary policy in common. First, they all use open
market operations. They buy and sell government bonds and other securities from
member banks. This changes the reserve amount the banks have on hand. A higher
reserve means banks can lend less. That's contractionary policy. In the United States, the
Fed sells Treasurys to member banks.

The second tool is the reserve requirement. The central banks tell their members how
much of their money they must have on reserve each night. If it weren't for the reserve
requirement, banks would lend 100% of deposits. Not everyone needs all their money
each day, so it is safe for the banks to lend most of it out. That way, they have enough cash
on hand to meet most demands for redemption.

When a central bank wants to restrict liquidity, it raises the reserve requirement. That
gives banks less money to lend. When it wants to expand liquidity, it lowers the
requirement. That gives members banks more money to lend. Central banks rarely change
the reserve requirement because it requires a lot of paperwork for the members.

The third tool is the discount rate. That's how it much a central banks charges members to
borrow funds from its discount window. It raises the discount rate to discourage banks
from borrowing. That reduces liquidity and slows the economy. It lowers the discount rate
to encourage borrowing. That increases liquidity and boosts growth.

In the United States, the Federal Open Market Committee sets the discount rate a half-
point higher than the fed funds rate. The Fed prefers banks to borrow from each other.

Most central banks have many more tools. They work together to manage bank reserves.

For example, the Fed has two other major tools. Its most well-known is the fed funds rate.
This is the interest rate that banks charge each other to store their excess cash overnight.
The target for this rate is set at the FOMC meetings. The fed funds rate impacts all
other interest rates, including bank loan rates and mortgage rates.

The Fed, as well as many other central banks, also uses inflation targeting. It clearly sets
expectations that the banks want some inflation. The Fed’s inflation goal is 2% for the core
inflation rate. That encourages people to stock up now since they know prices are rising
later. It stimulates demand and economic growth.
When inflation is lower than the core, the Fed is likely to lower the fed funds rate. When
inflation is at the target or above, the Fed will raise its rate.

The Federal Reserve created many new tools to deal with the 2008 financial crisis. These
included the Commercial Paper Funding Facility and the Term Auction Lending Facility. It
stopped using most of them once the crisis ended.
What is Monetary Policy?
Monetary policy consists of the process of drafting, announcing, and implementing the
plan of actions taken by the central bank, currency board, or other competent monetary
authority of a country that controls the quantity of money in an economy and the channels
by which new money is supplied. Monetary policy consists of management of money
supply and interest rates, aimed at achieving macroeconomic objectives such as
controlling inflation, consumption, growth, and liquidity. These are achieved by actions
such as modifying the interest rate, buying or selling government bonds, regulating
foreign exchange rates, and changing the amount of money banks are required to maintain
as reserves. Some view the role of the International Monetary Fund as this.
KEY TAKEAWAYS

 Monetary policy is how a central bank or other agency governs the supply of money
and interest rates in an economy in order to influence output, employment, and
prices.
 Monetary policy can be broadly classified as either expansionary or contractionary.
 Monetary policy tools include open market operations, direct lending to banks, bank
reserve requirements, unconventional emergency lending programs, and managing
market expectations (subject to the central bank's credibility).
Volume 75%

Types of Monetary Policies

At a broad level, monetary policies are categorized as expansionary or contractionary.
If a country is facing a high unemployment rate during a slowdown or a recession, the
monetary authority can opt for an expansionary policy aimed at increasing economic
growth and expanding economic activity. As a part of expansionary monetary policy, the
monetary authority often lowers the interest rates through various measures that
make money saving relatively unfavorable and promotes spending. It leads to an
increased money supply in the market, with the hope of boosting investment
and consumer spending. Lower interest rates mean that businesses and individuals can
take loans on convenient terms to expand productive activities and spend more on big
ticket consumer goods. An example of this expansionary approach is the low to zero
interest rates maintained by many leading economies across the globe since the 2008
financial crisis. (For related reading, see "What Are Some Examples of Expansionary
Monetary Policy?")
However, increased money supply can lead to higher inflation, raising the cost of living
and cost of doing business. Contractionary monetary policy, by increasing interest rates
and slowing the growth of the money supply, aims to bring down inflation. This can slow
economic growth and increase unemployment, but is often required to tame inflation. In
the early 1980s when inflation hit record highs and was hovering in the double digit range
of around 15 percent, the Federal Reserve raised its benchmark interest rate to a record
20 percent. Though the high rates resulted in a recession, it managed to bring back the
inflation to the desired range of 3 to 4 percent over the next few years.
Tools to Implement Monetary Policy
Central banks use a number of tools to shape and implement monetary policy.
First is the buying and selling of short term bonds on the open market using newly created
bank reserves. This is known as open market operations. Open market operations
traditionally target short term interest rates such as the federal funds rate. The central
bank adds money into the banking system by buying assets (or removes in by selling
assets), and banks respond by loaning the money more easily at lower rates (or more
dearly, at higher rates), until the central bank's interest rate target is met. Open market
operations can also target specific increases in the money supply in order to get the banks
to loan funds more easily, by purchasing a specified quantity of assets; this is known as
quantitative easing.
The second option used by monetary authorities is to change the interest rates and/or the
required collateral that the central bank demands for emergency direct loans to banks in
its role as lender-of-last-resort. In the U.S. this rate is known as the discount rate. Charging
higher rates and requiring more collateral, will mean that banks have to be more cautious
with their own lending or risk failure and is an example of contractionary monetary
policy. Conversely, lending to banks at lower rates and at looser collateral requirements
will enable banks to make riskier loans at lower rates and run with lower reserves, and is
expansionary.
Authorities also use a third option, the reserve requirements, which refer to the funds that
banks must retain as a proportion of the deposits made by their customers in order to
ensure that they are able to meet their liabilities. Lowering this reserve requirement
releases more capital for the banks to offer loans or to buy other assets. Increasing the
reserve requirement has a reverse effect, curtailing bank lending and slowing growth of
the money supply.
In addition to the standard expansionary and contractionary monetary policies,
unconventional monetary policy has also gained tremendous popularity in recent times.
During periods of extreme economic crisis, like the financial crisis of 2008, the U.S. Fed
loaded its balance sheet with trillions of dollars in treasury notes and mortgage-backed
securities by introducing news lending and asset purchase programs that combined
aspects of discount lending, open market operations, and quantitative easing. Monetary
authorities of other leading economies across the globe followed suit, with the Bank of
England, the European Central Bank and the Bank of Japan pursuing similar policies.
Lastly, in addition to direct influence over the money supply and bank lending
environment, central banks have a powerful tool in their ability to shape market
expectations by their public announcements about the central bank's own future policies.
Central banks statements and policy announcements move markets, and investors who
guess right about what the central banks will do can profit handsomely. Some central
bankers choose to be deliberately opaque to market participants in the belief that this will
maximize the effectiveness of monetary policy shifts by making them unpredictable and
not "baked-in" to market prices in advance. Others choose the opposite: to be more open
and predictable in the hopes that they can shape and stabilize market expectations in
order to curb volatile market swings that can result from unexpected policy shifts.
However, the policy announcements are effective only to the extent of the credibility of
the authority which is responsible for drafting, announcing, and implementing the
necessary measures. In an ideal world, such monetary authorities should work completely
independent of influence from the government, political pressure, or any other policy-
making authorities. In reality, governments across the globe may have varying levels of
interference with the monetary authority’s working. It may vary from the government,
judiciary, or political parties having a role limited to only appointing the key members of
the authority, or may extend to forcing them to announce populist measures (to influence
an approaching election for example). If a central bank announces a particular policy to
put curbs on increasing inflation, the inflation may continue to remain high if common
public have no or little trust in the authority. While making investment decisions based on
the announced monetary policy, one should also consider the credibility of the authority.

Q.6. Fiscal Policy.

Ans: Fiscal policy is the means by which a government adjusts its spending levels and tax
rates to monitor and influence a nation's economy. It is the sister strategy to monetary
policy through which a central bank influences a nation's money supply. These two
policies are used in various combinations to direct a country's economic goals. Here's a
look at how fiscal policy works, how it must be monitored, and how its implementation
may affect different people in an economy.
Before the Great Depression, which lasted from October 29, 1929, to the onset of
America's entry into World War II, the government's approach to the economy
was laissez-faire. Following World War II, it was determined that the government had to
take a proactive role in the economy to regulate unemployment, business cycles, inflation,
and the cost of money. By using a mix of monetary and fiscal policies (depending on the
political orientations and the philosophies of those in power at a particular time, one
policy may dominate over another), governments can control economic phenomena.
KEY TAKEAWAYS

 Fiscal policy is the means by which a government adjusts its spending levels and tax
rates to monitor and influence a nation's economy.
 It is the sister strategy to monetary policy through which a central bank influences a
nation's money supply.
  Using a mix of monetary and fiscal policies, governments can control economic
phenomena.
Fiscal policy, measures employed by governments to stabilize the economy, specifically
by manipulating the levels and allocations of taxes and government expenditures. Fiscal
measures are frequently used in tandem with monetary policy to achieve certain goals.

Fiscal policy is how Congress and other elected officials influence the economy using
spending and taxation. It is used in conjunction with the monetary policy implemented
by central banks, and it influences the economy using the money supply and interest rates.

The objective of fiscal policy is to create healthy economic growth. Ideally, the economy
should grow between 2–3% a year, unemployment will be at its natural rate of 4.7–5.8%,
and inflation will be at its target rate of 2%. The business cycle will be in the expansion
phase.

Expansionary Fiscal Policy

There are two types of fiscal policy. The most widely-used is expansionary, which
stimulates economic growth. Congress uses it to end the contraction phase of the business
cycle when voters are clamoring for relief from a recession. The government either spends
more, cuts taxes, or both. The idea is to put more money into consumers' hands, so they
spend more. The increased demand forces businesses to add jobs to increase supply.

Politicians debate about which works better. Advocates of supply-side economics prefer
tax cuts because they say it frees up businesses to hire more workers to pursue business
ventures. Advocates of demand-side economics say additional spending is more effective
than tax cuts. Examples include public works projects, unemployment benefits, and food
stamps. The money goes into the pockets of consumers, who go right out and buy the
things businesses produce.

An expansionary fiscal policy is impossible for state and local governments because they
are mandated to keep a balanced budget. If they haven't created a surplus during the
boom times, they must cut spending to match lower tax revenue during a recession. That
makes the contraction worse. Fortunately, the federal government has no such
constraints; it's free to use expansionary policy whenever it's needed. Unfortunately, it
also means Congress created budget deficits even during economic booms—despite a
national debt ceiling.
As a result, the critical debt-to-gross domestic product ratio has exceeded 100%.

Contractionary Fiscal Policy

The second type of fiscal policy is contractionary fiscal policy, which is rarely used. Its
goal is to slow economic growth and stamp out inflation. The long-term impact of inflation
can damage the standard of living as much as a recession. The tools of contractionary
fiscal policy are used in reverse. Taxes are increased, and spending is cut. You can imagine
how wildly unpopular this is among voters. Only lame duck politicians could afford to
implement contractionary policy.

Tools

The first tool is taxation. That includes income, capital gains from investments, property,
and sales. Taxes provide the income that funds the government. The downside of taxes is
that whatever or whoever is taxed has less income to spend on themselves, which is why
taxes are unpopular.

The second tool is government spending—which includes subsidies, welfare programs,

public works projects, and government salaries. Whoever receives the funds has more
money to spend, which increases demand and economic growth.

The federal government is losing its ability to use discretionary fiscal policy because each
year more of the budget must go to mandated programs. As the population ages, the costs
of Medicare, Medicaid, and Social Security are rising. Changing the mandatory
budget requires an Act of Congress, and that takes a long time. One exception was
the American Recovery and Economic Stimulus Act. Congress passed it quickly to stop
the Great Recession.

Fiscal Policy vs. Monetary Policy

Monetary policy is the process by which a nation changes the money supply. The country’s
monetary authority increases supply with expansionary monetary policy and decreases it
with contractionary monetary policy. It has many tools it can use, but it primarily relies on
raising or lowering the fed funds rate. This benchmark rates then guides all others.

When interest rates are high, the money supply contracts, the economy cools down, and
inflation is prevented. When interest rates are low, the money supply expands, the
economy heats up, and a recession is usually avoided.

Monetary policy works faster than fiscal policy. The Fed votes to raise or lower rates at its
regular Federal Open Market Committee meeting but may take about six months for the
impact of the rate cut to percolate throughout the economy. Lawmakers should coordinate
fiscal policy with monetary policy, but they usually don't because their fiscal policy
reflects the priorities of individual lawmakers. They focus on the needs of their
constituencies.

These local needs often overrule national economic priorities, and as a result, fiscal policy
often runs counter to what the economy needs. Central banks are forced to use monetary
policy to offset poorly planned fiscal policy.
 Current Budget Spending

Congress outlines U.S. fiscal policy priorities in each year's federal budget. By far, the
largest portion of budget spending is mandatory, which means that existing laws dictate
how much will be spent. Most of this is for Social Security, Medicare, and Medicaid
entitlement programs. The remaining portion of spending is discretionary, and more than
half of this goes toward defense. The current fiscal policy has created the massive U.S. debt
level.

History

Until the Great Depression, most fiscal policies followed the laissez-faire economic theory.
Politicians believed that they must not interfere with capitalism in a free market economy,
but Franklin D. Roosevelt (FDR) changed that by promising a New Deal to end the
Depression. He followed the Keynesian economic theory, which said government spending
could end the Depression by stimulating consumer demand. He exemplified expansionary
fiscal policy by spending to build roads, bridges, and dams. The federal government hired
millions, putting people back to work, and they spent their income on personal goods,
driving demand.

FDR ended the Depression in 1934 when the economy grew 10.8%. It then increased by
8.9% in 1935 and 12.9% in 1936. But in 1937, FDR worried about balancing the budget.
He used contractionary fiscal policy, and cut government spending, and in 1938, the
economy decreased by 3.3%.

In 1939, FDR renewed an expansionary fiscal policy to gear up American involvement in

World War II. He spent 30 times more in 1943 on the war than he did in 1933 on the New
Deal. That aggressive level of expansionary fiscal policy ended the Depression for good.

Learning Outcomes:

Q.1. Understanding the tools and techniques incorporated in monetary policy for
controlling inflation.
Ans:
Inflation is generally controlled by the Central Bank and/or the government. The main
policy used is monetary policy – set by Central Banks. However, in theory, there are a
variety of tools to control inflation including:
1. Monetary policy – Setting interest rates. Higher interest rates reduce demand, leading to
lower economic growth and lower inflation
2. Control of money supply – Monetarists argue there is a close link between the money
supply and inflation, therefore controlling money supply can control inflation.
3. Supply-side policies – policies to increase competitiveness and efficiency of the economy,
putting downward pressure on long-term costs.
4. Fiscal policy – a higher rate of income tax could reduce spending and inflationary
pressures.
5. Wage controls. Trying to control wages could, in theory, help to reduce inflationary
pressures. However, apart from the 1970s, it has been rarely used.
Monetary Policy
In a period of rapid economic growth, demand in the economy could be growing faster
than its capacity to meet it. This leads to inflationary pressures as firms respond to
shortages by putting up the price. We can term this demand-pull inflation. Therefore,
reducing the growth of aggregate demand (AD) should reduce inflationary pressures.
The Central bank could increase interest rates. Higher rates make borrowing more
expensive and saving more attractive. This should lead to lower growth in consumer
spending and investment. See more on higher interest rates

A higher interest rate should also lead to a higher exchange rate, which helps to reduce
inflationary pressure by
 Making imports cheaper.
 Reducing demand for exports and
 Increasing incentive for exporters to cut costs.
Interest rates were increased in the late 1980s / 1990 to try and control the rise in
inflation
Inflation target

UK inflation
target set in 1998.
As part of monetary policy, many countries have an inflation target (e.g. UK inflation
target of 2%). The argument is that if people believe the inflation target is credible, then it
will help to lower inflation expectations. If inflation expectations are low, it becomes
easier to control inflation.
 Countries have also made Central Bank independent in setting monetary policy. The
argument is that an independent Central Bank will be free from political pressures to set
low-interest rates before an election.
Fiscal Policy
The government can increase taxes (such as income tax and VAT) and cut spending. This
improves the budget situation and helps to reduce demand in the economy.
Both these policies reduce inflation by reducing the growth of Aggregate Demand. If
economic growth is rapid, reducing the growth of AD can reduce inflationary pressures
without causing a recession.
If a country had high inflation and negative growth, then reducing aggregate demand
would be more unpalatable as reducing inflation would lead to lower output and higher
unemployment. They could still reduce inflation, but, it would be much more damaging to
the economy.
Other Policies to Reduce Inflation
Wage Control
If inflation is caused by wage inflation (e.g. powerful unions bargaining for higher real
wages), then limiting wage growth can help to moderate inflation. Lower wage growth
helps to reduce cost-push inflation and helps to moderate demand-pull inflation.
However, as the UK discovered in the 1970s, it can be difficult to control inflation through
incomes policies, especially if the unions are powerful.
Monetarism
Monetarism seeks to control inflation by controlling the money supply. Monetarists
believe there is a strong link between the money supply and inflation. If you can control
the growth of the money supply, then you should be able to bring inflation under control.
Monetarists would stress policies such as:
 Higher interest rates (tightening monetary policy)
 Reducing budget deficit (deflationary fiscal policy)
 Control of money being created by the government
However, in practice, the link between money supply and inflation is less strong.
Supply Side Policies
Often inflation is caused by persistent uncompetitiveness and rising costs. Supply-side
policies may enable the economy to become more competitive and help to moderate
inflationary pressures. For example, more flexible labour markets may help reduce
inflationary pressure.
However, supply-side policies can take a long time, and cannot deal with inflation caused
by rising demand.
Ways To Reduce Hyperinflation – change currency
In a period of hyperinflation, conventional policies may be unsuitable. Expectations of
future inflation may be hard to change. When people have lost confidence in a currency, it
may be necessary to introduce a new currency or use another like the dollar
(e.g. Zimbabwe hyperinflation).
Ways to Reduce Cost-Push Inflation
Cost-push inflation (e.g. rising oil prices can lead to inflation and lower growth. This is the
worst of both worlds and is more difficult to control without leading to lower growth
Objectives of the Monetary Policy of India
1. Price Stability: Price Stability implies promoting economic development with
considerable emphasis on price stability. The centre of focus is to facilitate the
environment which is favourable to the architecture that enables the developmental
projects to run swiftly while also maintaining reasonable price stability.
2. Controlled Expansion Of Bank Credit: One of the important functions of RBI is the
controlled expansion of bank credit and money supply with special attention to seasonal
requirement for credit without affecting the output.
3. Promotion of Fixed Investment: The aim here is to increase the productivity of
investment by restraining non essential fixed investment.
4. Restriction of Inventories: Overfilling of stocks and products becoming outdated due
to excess of stock often results is sickness of the unit. To avoid this problem the central
monetary authority carries out this essential function of restricting the inventories. The
main objective of this policy is to avoid over-stocking and idle money in the organization
5. Promotion of Exports and Food Procurement Operations: Monetary policy pays
special attention in order to boost exports and facilitate the trade. It is an independent
objective of monetary policy.
6. Desired Distribution of Credit: Monetary authority has control over the decisions
regarding the allocation of credit to priority sector and small borrowers. This policy
decides over the specified percentage of credit that is to be allocated to priority sector and
small borrowers.
7. Equitable Distribution of Credit: The policy of Reserve Bank aims equitable
distribution to all sectors of the economy and all social and economic class of people
8. To Promote Efficiency: It is another essential aspect where the central banks pay a lot
of attention. It tries to increase the efficiency in the financial system and tries to
incorporate structural changes such as deregulating interest rates, ease operational
constraints in the credit delivery system, to introduce new money market instruments etc.
9. Reducing the Rigidity: RBI tries to bring about the flexibilities in the operations which
provide a considerable autonomy. It encourages more competitive environment and
diversification. It maintains its control over financial system whenever and wherever
necessary to maintain the discipline and prudence in operations of the financial system.
Conclusion:
So it can be conclude that the implementation of the monetary policy plays a very
prominent role in the development of a country. It’s a kind of double edge sword, if money
is not available in the market as the requirement of the economy, the investors will suffer
(investment will decline in the economy) and on the other hand if the money is supplied
more than its requirement then the poor section of the country will suffer because the
prices of essential commodities will start rising.
Broadly, instruments or techniques of monetary policy can be divided into two
categories:
(A) Quantitative or General Methods.
(B) Qualitative or Selective Methods
A. Quantitative or General Methods:
1. Bank Rate or Discount Rate:
Bank rate refers to that rate at which a central bank is ready to lend money to commercial
banks or to discount bills of specified types.
Thus by changing the bank rate, the credit and further money supply can be affected. In
other words, rise in bank rate increases rate of interest and fall in bank rate lowers rate of
interest.
During the course of inflation, monetary authority raises the bank rate to curb inflation.
Higher bank rate will check the expansion of credit of commercial banks. They will be left
with less resources which would restrict the credit creating capacity of the bank. On the
contrary, during depression, bank rate is lowered, business community will prefer to have
more and more loans to pull the economy out of depression. Therefore, bank rate or
discount rate can be used in both types of situation i.e. inflation and depression.
2. Open Market Operations:
By open market operations, we mean the sale or purchase of securities. As is known that
the credit creating capacity of the commercial banks depend on the cash reserves of the
banks. In this way, the monetary authority (Central Bank) controls the credit by affecting
the base of the credit-creation by the commercial banks. If the credit is to be decreased in
the country, the central bank begins to sell securities in the open market.
This will result to reduce money supply with the public as they will withdraw their money
with the commercial banks to purchase the securities. The cash reserves will tend to
diminish. This happens in the period of inflation. During depression when prices are
falling, the central bank purchases securities resulting in expansion of credit and
aggregate demand,
3. Variable Reserve Ratio:
The commercial banks have to keep given percentage as cash-reserve with the central
bank. In lieu of that cash ratio, it allows commercial banks to contract or expand its credit
facility. If the central bank wants to contract credit (during inflation period) it raises the
cash reserve ratio.
As a result, commercial banks are left with less amount of deposits. Their favour to credit
is curtailed. If there is depression in the economy, the reserve ratio is reduced to raise the
credit creating capacity of commercial banks. Therefore, variable reserve ratio can be used
to affect commercial banks to raise or reduce their credit creation capacity.
4. Change of Liquidity:
According to this method, every bank is required to keep a certain proportion of its
deposits as cash with it. When the central bank wants to contract credit, it raises its
liquidity ratio and vice versa.
B. Qualitative or Selective Methods:
1. Change in Marginal Requirements:
Under this method, the central bank effects a change in the marginal requirement to
control and release funds. When the central bank feels that prices are rising on account of
stock-piling of some commodities by the traders, then the central bank controls credit by
raising the marginal requirements. (Marginal requirement is the difference between the
market value of the assets and its maximum loan value). Let us suppose, a borrower
pledged goods worth Rs. 1000 as security with a bank and gets a loan amounting to Rs.
800.
Thus marginal requirement is Rs. 200 or 20 percent. If this margin is raised, the borrower
will have to pledge goods of greater value to secure loan of a given amount. This would
reduce money supply and inflation would be curtailed. Similarly, in case of depression,
central bank reduces margin requirement. This will in turn raise the credit creating
capacity of the commercial banks. Therefore, margin requirement is a significant tool in
the hands of central authority during inflation and depression.
2. Regulation of consumer credit:
During inflation, this method is followed to control excess spending of the consumers.
Generally the hire purchase facilities or installment methods are used to reduce to the
minimum to curb the expenditure on consumption. On the contrary, during depression
period, more credit facilities are allowed so that consumer may spend more and more to
pull the economy out of depression.
3. Direct Action:
This method is adopted when some commercial banks do not co-operate with the central
bank in controlling the credit. Thus, central bank takes direct action against the defaulter.
The central bank may take direct action in a number of ways as under.
(i) It may refuse rediscount facilities to those banks who are not following its directions.
(ii) It may follow similar policy with the bank seeking accommodation in excess of its
capital and reserves.
(iii) It may change rates over and above the bank rate.
(iv) Any other strict restrictions on the defaulter institution.
4. Rationing of the credit:
Under this method, the central bank fixes a limit for the credit facilities to commercial
banks. Being the lender of the last resort, central bank rations the available credit among
the applicants.
Generally, rationing of credit is done by the following four ways.
(i) Central bank can refuse loan to any bank.
(ii) Central bank can reduce the amount of loans given to the banks.
(iii) Central bank can fix quota of the credit.
(iv) Central bank can determine the limit of the credit granted to a particular industry or
trade.
5. Moral Persuasion or Advice:
In the recent years, the central bank has used moral suasion also as a tool of credit control.
Moral suasion is a general term describing a variety of informal methods used by the
central bank to persuade commercial banks to behave in a particular manner. Moral
suasion takes the form of Directive and Publicity.
In-fact, moral persuasion is a sort of advice. There is no element of compulsion in it. The
central bank focuses on the dangerous consequences of the credit expansion and seeks
their co-operation. The effectiveness of this method depends on the prestige enjoyed by
the central bank on the degree of co-operation extended by the commercial banks.
6. Publicity:
Publicity is also another qualitative technique. It means to force them to follow only that
credit policy which is in the interest of the economy. The publicity generally takes the
form of periodicals and journals. The banks are not kept informed about the type of
monetary policy, the central bank regards goods for the economy. Therefore, the main aim
of this method is to bring the banking community under the pressure of public opinion.

Q.2.Understanding the impact of inflations on different groups of economic agents

and public.
Ans: Some of the major effects of inflation are as follows: 1. Effects on Redistribution
of Income and Wealth 2. Effects on Production 3. Other Effects!
Inflation affects different people differently. This is because of the fall in the value of
money. When price rises or the value of money falls, some groups of the society gain, some
lose and some stand in-between. Broadly speaking, there are two economic groups in
every society, the fixed income group and the flexible income group.

People belonging to the first group lose and those belonging to the second group gain. The
reason is that the price movements in the case of different goods, services, assets, etc. are
not uniform. When there is inflation, most prices are rising, but the rates of increase of
individual prices differ much. Prices of some goods and services rise faster, of others
slowly and of still others remain unchanged. We discuss below the effects of inflation on
redistribution of income and wealth, production, and on the society as a whole.

1. Effects on Redistribution of Income and Wealth:

There are two ways to measure the effects of inflation on the redistribution of income and
wealth in a society. First, on the basis of the change in the real value of such factor incomes
as wages, salaries, rents, interest, dividends and profits.

Second, on the basis of the size distribution of income over time as a result of inflation, i.e.
whether the incomes of the rich have increased and that of the middle and poor classes
have declined with inflation. Inflation brings about shifts in the distribution of real income
from those whose money incomes are relatively inflexible to those whose money incomes
are relatively flexible.

The poor and middle classes suffer because their wages and salaries are more or less fixed
but the prices of commodities continue to rise. They become more impoverished. On the
other hand, businessmen, industrialists, traders, real estate holders, speculators, and
others with variable incomes gain during rising prices.

The latter category of persons becomes rich at the cost of the former group. There is
unjustified transfer of income and wealth from the poor to the rich. As a result, the rich
roll in wealth and indulge in conspicuous consumption, while the poor and middle classes
live in abject misery and poverty.

But which income group of society gains or losses from inflation depends on who
anticipates inflation and who does not. Those who correctly anticipate inflation, they can
adjust their present earnings, buying, borrowing, and lending activities against the loss of
income and wealth due to inflation.

They, therefore, do not get hurt by the inflation. Failure to anticipate inflation correctly
leads to redistribution of income and wealth. In practice, all persons are unable to
anticipate and predict the rate of inflation correctly so that they cannot adjust their
economic behaviour accordingly. As a result, some persons gain while others lose. The net
result is redistribution of income and wealth.

The effects of inflation on different groups of society are discussed below:

(1) Debtors and Creditors:
During periods of rising prices, debtors gain and creditors lose. When prices rise, the value
of money falls. Though debtors return the same amount of money, but they pay less in
terms of goods and services. This is because the value of money is less than when they
borrowed the money. Thus the burden of the debt is reduced and debtors gain.

On the other hand, creditors lose. Although they get back the same amount of money
which they lent, they receive less in real terms because the value of money falls. Thus
inflation brings about a redistribution of real wealth in favour of debtors at the cost of
creditors.

(2) Salaried Persons:

Salaried workers such as clerks, teachers, and other white collar persons lose when there
is inflation. The reason is that their salaries are slow to adjust when prices are rising.

(3) Wage Earners:

Wage earners may gain or lose depending upon the speed with which their wages adjust
to rising prices. If their unions are strong, they may get their wages linked to the cost of
living index. In this way, they may be able to protect themselves from the bad effects of
inflation.

But the problem is that there is often a time lag between the raising of wages by
employees and the rise in prices. So workers lose because by the time wages are raised,
the cost of living index may have increased further. But where the unions have entered
into contractual wages for a fixed period, the workers lose when prices continue to rise
during the period of contract. On the whole, the wage earners are in the same position as
the white collar persons.
(4) Fixed Income Group:
The recipients of transfer payments such as pensions, unemployment insurance, social
security, etc. and recipients of interest and rent live on fixed incomes. Pensioners get fixed
pensions. Similarly the rentier class consisting of interest and rent receivers get fixed
payments.

The same is the case with the holders of fixed interest bearing securities, debentures and
deposits. Among these groups, the recipients of transfer payments belong to the lower
income group and the rentier class to the upper income group. Inflation redistributes
income from these two groups toward the middle income group comprising traders and
businessmen.

(5) Equity Holders or Investors:

Persons who hold shares or stocks of companies gain during inflation. For when prices are
rising, business activities expand which increase profits of companies. As profits increase,
dividends on equities also increase at a faster rate than prices. But those who invest in
debentures, securities, bonds, etc. which carry a fixed interest rate lose during inflation
because they receive a fixed sum while the purchasing power is falling.

(6) Businessmen:
Businessmen of all types, such as producers, traders and real estate holders gain during
periods of rising prices. Take producers first. When prices are rising, the value of their
inventories (goods in stock) rise in the same proportion. So they profit more when they
sell their stored commodities.

The same is the case with traders in the short run. But producers profit more in another
way. Their costs do not rise to the extent of the rise in the prices of their goods. This is
because prices of raw materials and other inputs and wages do not rise immediately to the
level of the price rise. The holders of real estate’s also profit during inflation because the
prices of landed property increase much faster than the general price level.

(7) Agriculturists:
Agriculturists are of three types, landlords, peasant proprietors, and landless agricultural
workers. Landlords lose during rising prices because they get fixed rents. But peasant
proprietors who own and cultivate their farms gain. Prices of farm products increase more
than the cost of production.

For prices of inputs and land revenue do not rise to the same extent as the rise in the
prices of farm products. On the other hand, the landless agricultural workers are hit hard
by rising prices. Their wages are not raised by the farm owners, because trade unionism is
absent among them. But the prices of consumer goods rise rapidly. So landless agricultural
workers are losers.
(8) Government:
The government as a debtor gains at the expense of households who are its principal
creditors. This is because interest rates on government bonds are fixed and are not raised
to offset expected rise in prices. The government, in turn, levies less taxes to service and
retire its debt.

With inflation, even the real value of taxes is reduced. Thus redistribution of wealth in
favour of the government accrues as a benefit to the tax-payers. Since the tax-payers of the
government are high-income groups, they are also the creditors of the government
because it is they who hold government bonds.

As creditors, the real value of their assets decline and as tax-payers, the real value of their
liabilities also declines during inflation. The extent to which they will be gainers or losers
on the whole is a very complicated calculation.

Conclusion:
Thus inflation redistributes income from wage earners and fixed income groups to profit
recipients, and from creditors to debtors. So far as wealth redistributions are concerned,
the very poor and the very rich are more likely to lose than middle income groups.

This is because the poor hold what little wealth they have in monetary form and has few
debts, whereas the very rich hold a substantial part of their wealth in bonds and have
relatively few debts. On the other hand, the middle income groups are likely to be heavily
in debt and hold some wealth in common stocks as well as in real assets.

2. Effects on Production:
When prices start rising production is encouraged. Producers earn wind-fall profits in the
future. They invest more in anticipation of higher profits in the future. This tends to
increase employment, production and income. But this is only possible up to the full
employment level.

Further increase in investment beyond this level will lead to severe inflationary pressures
within the economy because prices rise more than production as the resources are fully
employed. So inflation adversely affects production after the level of full employment.

The adverse effects of inflation on production are discussed below:

(1) Misallocation of Resources:
Inflation causes misallocation of resources when producers divert resources from the
production of essential to non-essential goods from which they expect higher profits.

(2) Changes in the System of Transactions:

Inflation leads to changes in transactions pattern of producers. They hold a smaller stock
of real money holdings against unexpected contingencies than before. They devote more
time and attention to converting money into inventories or other financial or real assets. It
means that time and energy are diverted from the production of goods and services and
some resources are used wastefully.

(3) Reduction in Production:

Inflation adversely affects the volume of production because the expectation of rising
prices along-with rising costs of inputs bring uncertainty. This reduces production.

(4) Fall in Quality:

Continuous rise in prices creates a seller’s market. In such a situation, producers produce
and sell sub-standard commodities in order to earn higher profits. They also indulge in
adulteration of commodities.

(5) Hoarding and Black marketing:

To profit more from rising prices, producers hoard stocks of their commodities.
Consequently, an artificial scarcity of commodities is created in the market. Then the
producers sell their products in the black market which increases inflationary pressures.

(6) Reduction in Saving:

When prices rise rapidly, the propensity to save declines because more money is needed
to buy goods and services than before. Reduced saving adversely affects investment and
capital formation. As a result, production is hindered.

(7) Hinders Foreign Capital:

Inflation hinders the inflow of foreign capital because the rising costs of materials and
other inputs make foreign investment less profitable.

(8) Encourages Speculation:

Rapidly rising prices create uncertainty among producers who indulge in speculative
activities in order to make quick profits. Instead of engaging themselves in productive
activities, they speculate in various types of raw materials required in production.

3. Other Effects:
Inflation leads to a number of other effects which are discussed as under:
(1) Government:
Inflation affects the government in various ways. It helps the government in financing its
activities through inflationary finance. As the money incomes of the people increase,
government collects that in the form of taxes on incomes and commodities. So the
revenues of the government increase during rising prices.

Moreover, the real burden of the public debt decreases when prices are rising. But the
government expenses also increase with rising production costs of public projects and
enterprises and increase in administrative expenses as prices and wages rise. On the
whole, the government gains under inflation because rising wages and profits spread an
illusion of prosperity within the country.
(2) Balance of Payments:
Inflation involves the sacrificing of the advantages of international specialisation and
division of labour. It affects adversely the balance of payments of a country. When prices
rise more rapidly in the home country than in foreign countries, domestic products
become costlier compared to foreign products.

This tends to increase imports and reduce exports, thereby making the balance of
payments unfavourable for the country. This happens only when the country follows a
fixed exchange rate policy. But there is no adverse impact on the balance of payments if
the country is on the flexible exchange rate system.

(3) Exchange Rate:

When prices rise more rapidly in the home country than in foreign countries, it lowers the
exchange rate in relation to foreign currencies.

(4) Collapse of the Monetary System:

If hyperinflation persists and the value of money continues to fall many times in a day, it
ultimately leads to the collapse of the monetary system, as happened in Germany after
World War I.

(5) Social:
Inflation is socially harmful. By widening the gulf between the rich and the poor, rising
prices create discontentment among the masses. Pressed by the rising cost of living,
workers resort to strikes which lead to loss in production. Lured by profits, people resort
to hoarding, black marketing, adulteration, manufacture of substandard commodities,
speculation, etc. Corruption spreads in every walk of life. All this reduces the efficiency of
the economy.

(6) Political:
Rising prices also encourage agitations and protests by political parties opposed to the
government. And if they gather momentum and become unhandy they may bring the
downfall of the government. Many governments have been sacrificed at the altar of
inflation.

Major Effects of Inflation and Deflation on Economy

1. Effects on Production:
Keynes felt that as long as there were unemployed resources in the economy a moderate
or a mild dose of inflation might be in order; because this would lead to waves of optimism
inducing businessmen to invest more.

But this cannot go on forever because the limit is set by full employment ceiling, after
which the prices start rising and moderate inflation starts assuming the nature of hyper-
inflation which, in turn, has disastrous consequences on production.
It distorts the smooth functioning of price mechanism, hinders capital formation,
stimulates speculative activities and hoarding, leads to misallocation of productive
resources.

In short, inflation invites business to seek profits via manipulation of markets rather than
via efficient production.

2. Effects on Distribution:
Inflation has the effect of redistributing income because prices of all factors do not rise in
the same proportion. Entrepreneurs stand to gain more than wage earners or fixed
income groups. Speculators, hoarders, black marketers and smugglers stand to gain on
account of windfall profits.

Changes in the value of money also result in the redistribution of wealth partly because
during inflation there is no uniform rise in prices and partly because debts are expressed
in terms of money. Inflation is a kind of hidden tax, steeply regressive in character and in
effects. This redistribution of wealth as a result of inflation puts more burden on those
groups of the economy which are least able to bear it.

3. Debtors and Creditors:

Debtors borrow from creditors to pay the latter along with the rate of interest at some
future date. Changes in the price level affect them differently at different times. During
inflation when the prices rise (and the real value of money goes down), the debtors pay
back less in real terms than what they had borrowed, and thus, to that extent they are
gainers. On the other hand, the creditors get less in terms of goods and services than what
they had lent and stand to lose to that extent. During the period of deflation, however,
when prices fall (and the real value of money rises), creditors stand to gain and debtors
lose.

4. The Entrepreneurs:
When prices rise, producers, traders speculators and entrepreneurs stand to gain on
account of windfall profits because prices rise at a faster rate than cost of production,
besides, there is time-lag between the two. Moreover, they gain because the prices of their
inventories (stock) go up.

Again, they generally being borrowers of money for business purposes, stand to gain. On
the other hand, falling prices heavily reduce the profits on account of the fact that wages
fail to fall along with the fall in the prices. Entrepreneurs, therefore, react to it by
curtailing the volume of production and hence employment goes down generating a full-
fledged depression.

5. Investors:
Different kinds of investors are affected differently by inflation and deflation. One can
invest in bonds and debentures which yield a fixed rate of interest income or one can
invest in real estate or equities (shares) whose returns (dividends) rise and fall with
profits earned by the companies concerned. When prices rise, the returns on equities go
up on account of the rise in profits, while the bonds and debenture-holders gain nothing as
their incomes remain fixed.

On the other hand, equity-holders will lose during depression on account of a fall in the
price level, while the debenture- and bond-holders gain. To the extent investors are able
to diversify their investment, they can protect themselves from the effects of the
fluctuation in prices.

6. Farmers:
Farmers gain during inflation. The prices of farm products go up and the cost incurred by
them (like interest and taxes) either remain constant or do not increase much, at any rate
i.e., costs lag behind prices received by the farmers. In India, during war and post-war
period, farmers were able to pay-off their old debts on account of high prices of their
products because of inflation. Moreover, farmers are generally debtors and have to pay
less in real terms, while the land revenue and taxes etc., do not rise much. Thus, farmers
stand to gain during periods of inflation.

7. Wage Earners:
Wage-earners generally suffer during inflation, despite the fact that they obtain a wage
rise according to a rise in the cost of living index. However, wages do not rise as much as
the rise in prices of those commodities, which the workers consume. Further, there is a lag
between a rise in the price level and a rise in wages. If the workers are organized, they
may not suffer much during inflation but if they are unorganized like the agricultural
labourers, they may suffer more, as they may not find it easy to get their wages increased.
Similarly, in deflation the real value of the money wages received by them increases and
they may gain a little.

8. Middle Class and Salaried Persons:

The hardest hit are the persons who receive fixed incomes, usually called the middle class.
Persons who live on past savings, fixed interest or rent, pensioners, government
employees, teachers etc., suffer during periods of rising prices as their incomes remain
fixed. Kemmerer remarked: “The middle class, however, which by hard work and thrift
has built up a fund of saving to educate its children and to provide a livelihood for times of
sickness and for old age, finds itself in a desperate situation in a time of serious inflation.”
During deflation, however, middle class is able to get some relief on account of falling
prices and rising value of money.

9. Government:
In a mixed economy, the public sector is affected by fluctuations in price level. As prices
rise, the government has to spend more on goods and services including raw materials for
carrying through their project. Estimates are revised and taxes are raised. On the other
hand, when prices fall, the government sector or the public sector has to incur less costs.
10. Public Moral:
Inflation results in arbitrary redistribution of wealth favoring businessmen and debtors
and hurting consumers, creditors, petty shopkeepers, small investors and fixed income
earners. This lowers the public moral. The ethical standards and the public moral had
fallen to miserably low levels during the period of hyper-inflation in Germany.

Q.3. Explain the economic indicators of national income and growth in an economy.
Ans: Economists and statisticians use several methods to track economic growth. The
most well-known and frequently tracked is the gross domestic product (GDP). Over time,
however, some economists have highlighted limitations and biases in the GDP calculation.
Organizations such as the Bureau of Labor Statistics (BLS) and the Organization for
Economic Co-operation and Development (OECD) also keep relative productivity metrics
to gauge economic potential. Some suggest measuring economic growth through increases
in the standard of living, although this can be tricky to quantify.
KEY TAKEAWAYS

 Different methods, such as Gross National Product (GNP) and Gross Domestic
Product (GDP) can be employed to assess economic growth.
 Gross Domestic Product measures the value of goods and services produced by a
nation.
 Gross National Product measures the value of goods and services produced by a
nation (GDP) and income from foreign investments.
 Some economists posit that total spending is a consequence of productive output.
 Although GDP is widely used, it, alone, does not indicate the health of an economy.
Why Is GDP So Important?
Gross Domestic Product
The gross domestic product is the logical extension of measuring economic growth in
terms of monetary expenditures. If a statistician wants to understand the productive
output of the steel industry, for example, he needs only to track the dollar value of all of
the steel that entered the market during a specific period.
Combine the outputs of all industries, measured in terms of dollars spent or invested, and
you get total production. At least that was the theory. Unfortunately, the tautology that
expenditures equal sold-production does not actually measure relative productivity. The
productive capacity of an economy does not grow because more dollars move around, an
economy becomes more productive because resources are used more efficiently. In other
words, economic growth needs to somehow measure the relationship between total
resource inputs and total economic outputs.
The OECD described GDP as suffering from a number of statistical problems. Its solution
was to use GDP to measure aggregate expenditures, which theoretically approximates the
contributions of labor and output, and to use multi-factor productivity (MFP) to show the
contribution of technical and organizational innovation.
Gross National Product
Those of a certain age may remember learning about the gross national product (GNP) as
an economic indicator. Economists use GNP mainly to learn about the total income of a
country's residents within a given period and how the residents use their income. GNP
measures the total income accruing to the population over a specified amount of time.
Unlike gross domestic product, it does not take into account income accruing to non-
residents within that country’s territory; like GDP, it is only a measure of productivity, and
it is not intended to be used as a measure of the welfare or happiness of a country.
The Bureau of Economic Analysis (BEA) used GNP as the primary indicator of US
economic health until 1991. In 1991, the BEA began using GDP, which was already being
used by the majority of other countries. The BEA cited an easier comparison of the United
States with other economies as a primary reason for the change. Although the BEA no
longer relies on GNP to monitor the performance of the US economy, it still provides GNP
figures, which it finds useful for analyzing the income of US residents.
There is little difference between GDP and GNP for the US, but the two measures can differ
significantly for some economies. For example, an economy that contained a high
proportion of foreign-owned factories would have a higher GDP than GNP. The income of
the factories would be included in GDP as it is produced within domestic borders.
However, it would not be included in GNP since it accrues to non-residents. Comparing
GDP and GNP is a useful way of comparing income produced in the country and income
flowing to its residents.
Productivity vs. Spending
The relationship between production and spending is a quintessential chicken-and-
egg debate in economics. Most economists agree that total spending, adjusted for inflation,
is a byproduct of productive output. They disagree, however, if increased spending is an
indication of growth.
Consider the following scenario: In 2017, the average American works 44 hours a week
being productive. Suppose there is no change in the number of workers or average
productivity through 2019. In the same year, Congress passes a law requiring all workers
to work 50 hours a week. The GDP in 2019 will almost certainly be larger than the GDP in
2017 and 2018. Does this constitute real economic growth?
Some would certainly say yes. After all, total output is what matters to those who focus on
expenditures. For those who care about productive efficiency and the standard of living,
this question does not have a clear answer. To bring it back to the OECD model, GDP
would be higher but MFP would be unchanged.
Reduced Unemployment Does Not Always Equal Positive Economic Growth
Suppose instead the world becomes mired in a third world war in 2020. Most of the
nation's resources are dedicated toward the war effort, such as producing tanks, ships,
ammunition, and transportation; and all of the unemployed are drafted into war service.
With an unlimited demand for war supplies and government financing, the standard
metrics of economic health would show progress. GDP would soar,
and unemployment would plummet.
Would anyone be better off? All of the produced goods would be destroyed soon after, and
high unemployment is not worse than high mortality rates. There would be no lasting
gains from that sort of economic growth.
OR
Net National Income:
Net national income, thus, is a crude index of measuring development on the ground that
it does not consider population growth of a country.
A faster growth of net national income in a year may be eaten away by a much faster
growth rate of population, thereby nothing is left for saving and capital accumulation.
Further, this index of net national income does not say anything of the standard of living of
the people. In spite of economic growth, the standard of living may be eroded because of
high growth of population, income inequality, etc.
Another limitation of this index of development is that it does not say anything about the
composition of goods and services produced. If ‘public bads’ (e.g., pollution) are produced
more, society’s welfare will decline. In this sense, how much national income figure
impinges ‘cost’ on the society following environmental pollution remains unaccounted.
Any economic activity say, use of natural resources for extracting our needs damages
environment. Since such is not deducted from the net national income figures, a good
measure of human welfare is denied.
Per Capita Income as a Growth Indicator :
Dividing GDP/GNP by the total population one gets per capita GDP/GNP. Conventionally,
per capita income is used as an index of development. Economic development involves
something more than economic growth. Economic development emphasises on the
qualitative aspects of economic expansion processes.
Anyway, this view says that increases in per capita income over a long period of time are
suggestive of economic development. Greater the income, higher the standard of living of
people, and lower the incidence of poverty and inequality. The only thing that has to be
taken into account is that the growth rate of per capita income should exceed the
country’s population growth—to have more growth and development.
However, the reality is not so simple as it has ‘been painted here. Although there may be a
positive association between high income and higher level of development and between
low income and a state of un-development, there are many reasons that suggest per capita
income is not an acceptable criterion of development.
In the first place, per capita income is a ‘crude’ index of measuring economic performance
of a nation as it throws no light on income distribution within countries. In other words,
per capita income does not necessarily indicate equity and justice.
If there is inequality in income distribution, then, in spite of a rise in per capita income, the
income gaps between the rich and the poor would be larger—rich would become richer
and the poor poorer. There are some countries in the world whose per capita incomes are
comparable with the high-income economies; but the majority of population live in abject
poverty.
This per capita income criterion speaks very little about economic development. To
measure the living standard of population, what one should know is the nature of
distribution of income in tandem with national per capita income—that is, how much of it
is shared between the rich and the poor.
Secondly, economic well-being is measure by income –higher the income, greater is the
living standard. However, per capita income figure does not give an idea about the
composition of goods and services produced in an economy. This means that whether
society produces more of consumer goods or capital goods or public goods like health,
education, etc., is not known from this conventional criterion of development. Further,
many human needs like security against crime and violence, political and cultural
freedoms, democracy, grassroots participation in decision-making process extend far
beyond economic well-being.
In this since, per capita income is an inadequate index of development. However,
consumption of these commodities increases human well-being. That is why modern
development economists describe the state of development/underdevelopment in terms
of accessibility of people to these goods that do not get reflected in per capita income. The
basic purpose of development is to enlarge people’s choices. Per capita income cannot
‘buy’ all pleasures of life (e.g. law and order, good governance, democracy, etc.)
Thirdly, per capita income does not reveal, naturally, a country’s economic and social
environment under which goods and services are produced in an economy. Whether such
goods and services that are marketed in an economy are the result of market economy, or
a planned economy, or the military economy, cannot be known from income figures. In
fact, the influence of the entire environment upon which per capita income is dependent
remains totally obscure. On the contrary, standard of living or the quality of life largely
depends on such environment.
Fourthly, growth measured by per capita income is good since such is equated with
progress, advancement, higher consumption, and a better quality of life. Thus, growth in
that sense is desirable. But can economies grow indefinitely? Answer is: There are ‘Limits
to’ Growth’ since economic growth is not compatible with environmental quality.
As per capita income grows, the economy’s productive base shrinks. Such depletion of
resources involves huge social cost —future generations get less resources to meet their
needs than the present generation. Attempt to have more economic growth through the
use of more resources and energy of an economy ultimately leads to environmental
degradation. Growth will then suffer—cost of damage to the environment is not deducted
from the per capita income. Growth in per capita income is not compatible with the
concept of sustainable development.
It is now clear that this traditional notion of per capita income as the criterion of
development reflects nothing but the differences in potentialities for development
between countries, distribution of income, poverty, state of unemployment, and
qualitative indicators of living standards. Above all, this conventional measure is
conspicuously silent on economic, social and political freedoms/ un-freedoms that a
country’s citizens experience.
Thus, the per capita income figure does not throw light on the holistic approach to
development. One may then conclude that this index is a ‘crude’ one; it may be a necessary
condition for nation’s economic and social uplift but not a sufficient condition. This is
because increase in income involves both costs and benefits. Costs arising out of economic
activities (e.g., pollution) do not get reflected in the per capita income figures.
In spite of these limitations of per capita income as an index of development, it is used
widely as a measure of growth. Per capita income figures of different nations are ‘used as a
starting point for classifying levels of development, and can certainly be used to identify
the need for development.’ The World Bank classifies different countries in accordance
with per capita income data. It ranks countries in four categories on the basis of per capita
income measured in U.S. dollars. Further, such data has the merit of devising policies to
close the gaps between different economies as far as practicable within a period of time.
Finally, since per capita income figure alone fails to capture the living standards, the
United Nations Development Programme (UNDP) has devised an index to measure the
standards of living. This index is most popularly known as Human Development Index
(HDI).
HDI takes into account
(i) per capita GDP,
(ii) life expectancy at birth, and
(iii) access to knowledge.
Since people- centred HDI is a “summary measure” of key human development outcomes,
the distinction between growth and development becomes clear. However, HDI
supplements per capita GDP (goods-centred) notion. Even then, ‘One does not have to
“rubbish” economic growth.’
Relationship between Economic Growth and Economic Development
Economic Growth:
The term economic growth refers to the quantitative aspect of economic progress of a
country. According to Paul Baron, “Economic growth may be defined as an increase over
time in per capita output of material goods.” In other words, growth of gross national
output or per capita output is an indicator of economic growth.
We know human wants are unlimited and they are increasing over time. Man is never
satisfied with what he has. However, our resources are very limited. Therefore, we should
try to satisfy our wants. Hence, we should try to increase the production of goods and
services. Thus, economic growth signifies the growth in the volume of goods and services.
It leads to:
(i) Increase in National Product:
Growth in the money value of goods and services are not sufficient for an economy. It
simple increases the price of goods and services. In fact, growth is considered in physical
terms. Thus, production of different goods and services must be increase in an economy.
(ii) Increase in Per capita output:
Under growth process, not only the total volume of production increases, but
simultaneously total population will also increase. Thus, per capital output will also
increase over time to maintain the same growth rate. It will help to solve the problem of
physical output of goods and services per capita in any economy.
How to attain growth:
Economic growth can be attained from the following methods:-
(a) To raise total output
(b) To check increase in population
(c) To ensure capital formulation
(d) To raise entrepreneurship.
Economic Development:
According to Promit Chowdhury, “Economic development is an increase in real output
goods and services that is sustained over a long period of time, measured in terms of value
added.” According to Meier and Bladwin, “Economic Development is a process whereby an
economy’s real national income increases over a long period of time.”
According to Prof. Todaro, “Economic development is a multi dimensional process
involving major changes in social structures, popular attitudes and national institutions as
well as the acceleration of economic growth, the reduction of inequality and the
eradication of absolute poverty”.
Economic development is a much broder concept than economic growth. In simple sense,
Economic development.
= Economic Growth + Standard of Living.
Hence, standard of living includes various things like safe drinking water, improve
sanitation systems, medical facilities, spread of primary education to improve literacy
rate, eradication of poverty, balanced transport networks, increase in employment
opportunities etc. Thus, the quality of life is the major indicator of economic development.
Therefore, increase in economic development is more necessary for an economy to
achieved the status of Developed Nation.

Q.4. Explain various methods for measuring national Income. Which one is the best.-
Justify.
Ans: 3 Important Methods for Measuring National Income
The national income of a country can be measured by three alternative methods: (i)
Product Method (ii) Income Method, and (iii) Expenditure Method.
1. Product Method:
In this method, national income is measured as a flow of goods and services. We calculate
money value of all final goods and services produced in an economy during a year. Final
goods here refer to those goods which are directly consumed and not used in further
production process.
Goods which are further used in production process are called intermediate goods. In the
value of final goods, value of intermediate goods is already included therefore we do not
count value of intermediate goods in national income otherwise there will be double
counting of value of goods.
To avoid the problem of double counting we can use the value-addition method in which
not the whole value of a commodity but value-addition (i.e. value of final good value of
intermediate good) at each stage of production is calculated and these are summed up to
arrive at GDP.
The money value is calculated at market prices so sum-total is the GDP at market prices.
GDP at market price can be converted into by methods discussed earlier.
2. Income Method:
Under this method, national income is measured as a flow of factor incomes. There are
generally four factors of production labour, capital, land and entrepreneurship. Labour
gets wages and salaries, capital gets interest, land gets rent and entrepreneurship gets
profit as their remuneration.
Besides, there are some self-employed persons who employ their own labour and capital
such as doctors, advocates, CAs, etc. Their income is called mixed income. The sum-total of
all these factor incomes is called NDP at factor costs.
3. Expenditure Method:
In this method, national income is measured as a flow of expenditure. GDP is sum-total of
private consumption expenditure. Government consumption expenditure, gross capital
formation (Government and private) and net exports (Export-Import).

Methods of Computing/Measuring National Income:

There are three methods of measuring national income of a country. They yield the
same result. These methods are:

(1) The Product Method.

(2) The Income Method.

(3) The Expenditure Method.

We now look at each of the three methods in turn.

(1) Product Method or Value Added Method:

Definition and Explanation:

Goods and services are counted in gross domestic product (GDP) at their market values.
The product approach defines a nation's gross product as that market value of goods and
services currently produced within a nation during a one year period of time.

The product approach measuring national income involves adding up the value of all the
final goods and services produced in the country during the year. Here we focus on
various sectors of the economy and add up all their production during the year. The main
sectors whose production value is added up are:

(i) agriculture (ii) manufacturing (iii) construction (iv) transport and communication (v)
banking (vi) administration and defense and (vii) distribution of income.

Precautions For Product Method or Value Added Method:

There are certain precautions which are to be taken to avoid miscalculation of national
income using this method. These in brief are:

(i) Problem of double counting: When we add up the value of output of various sectors,
we should be careful to avoid double counting. This pitfall can be avoided by either
counting (he final value of the output or by including the extra value that each firm adds to
an item.

(ii) Value addition in particular year: While calculating national income, the values of
goods added in the particular year in question are added up. The values which had
previously been added to the stocks of raw material and goods have to be ignored. GDP
thus includes only those goods, and services that are newly produced within the current
period.

(iii) Stock appreciation: Stock appreciation, if any, must be deducted from value added.
This is necessary as there is no real increase in output.

{iv) Production for self consumption: The production of goods for self consumption
should be counted while measuring national income. In this method, the production of
goods for self consumption should be valued at the prevailing market prices.

(2) Expenditure Method:

Definition and Explanation:

The expenditure approach measures national income as total spending on final goods
and services produced within nation during an year. The expenditure approach to
measuring national income is to add up all expenditures made for final goods and services
at current market prices by households, firms and government during a year. Total
aggregate final expenditure on final output thus is the sum of four broad categories of
expenditures:

(i) consumption (ii) investment (iii) government and (iv) Net export.
(i) Consumption expenditure (C): Consumption expenditure is the largest component of
national income. It includes expenditure on all goods and services produced and sold to
the final consumer during the year.

(ii) Investment expenditure (I): Investment is the use of today's resources to expand
tomorrow's production or consumption. Investment expenditure is expenditure incurred
on by business firms on (a) new plants, (b) adding to the stock of inventories and (c) on
newly constructed houses.

(iii) Government expenditure (G): It is the second largest component of national

income. It includes all government expenditure on currently produced goods and services
but excludes transfer payments while computing national income.

(iv) Net exports (X - M): Net exports are defined as total exports minus total imports.
National income calculated from the expenditure side is the sum of final consumption
expenditure, expenditure by business on plants, government spending and net exports.

NI = C + I +G + (X - M) Precautions

Precautions For Expenditure Method:

While estimating national income through expenditure method, the following precautions
should be taken:

(i) The expenditure on second hand goods should not be included as they do not
contribute to the current year's production of goods.

(ii) Similarly, expenditure on purchase of old shares and bonds is not included as these
also do not represent expenditure on currently produced goods and services.

(iii) Expenditure on transfer payments by government such as unemployment benefit, old

age pensions, interest on public debt should also not be included because no productive
service is rendered in exchange by recipients of these payments.

(3) Income Approach:

Income approach is another alternative way of computing national income, This method
seeks to measure national income at the phase of distribution. In the production process
of an economy, the factors of production are engaged by the enterprises. They are paid
money incomes for their participation in the production. The payments received by the
factors and paid by the enterprises are wages, rent, interest and profit. National income
thus may be defined as the sum of wages, rent, interest and profit received or occurred to
the factors of production in lieu of their services in the production of goods. Briefly,
national income is the sum of all income, wages, rents, interest and profit paid to the four
factors of production. The four categories of payments are briefly described below:

(i) Wages: It is the largest component of national income. It consists of wages and salaries
along with fringe benefits and unemployment insurance.

(ii) Rents: Rents are the income from properly received by households.

(iii) Interest: Interest is the income private businesses pay to households who have lent
the business money.

(iv) Profits: Profits are normally divided into two categories (a) profits of incorporated
businesses and (b) profits of unincorporated businesses (sold proprietorship,
partnerships and producers cooperatives).

Precautions For Income Approach:

While estimating national income through income method, the following precautions
should be undertaken.

(i) Transfer payments such as gifts, donations, scholarships, indirect taxes should not be
included in the estimation of national income.

(ii) Illegal money earned through smuggling and gambling should not be included.

{iii) Windfall gains such as prizes won, lotteries etc. is not be included in the estimation of
national income.

(iv) Receipts from the sale of financial assets such as shares, bonds should not be included
in measuring national income as they are not related to generation of income in the
current year production of goods.

Why Three Methods of Computing/Measuring National Income are Equal:

The three approaches used for measuring national income give the same result. The
reason is the market value of goods and services produced in a given period by definition
is equal to the amount that buyers must spend to purchase them. So the product approach
which measures market value of good and services produced and the expenditure
approach which measures spending should give the same measure of economic activity.

Now as regards the income approach, the sellers receipts must equal what the buyers
spend. The sellers receipts in turn equal the total income generated by the economic
activity. Thus, total expenditure must equal total income generated implying that the
expenditure and income approach must also produce the same result.