UNIT 4 MACRO ECONOMICS UNIT 5 AGGREGATE SUPPLY AND

ROLE OF MONEY

RECAP

• As for now we learned various aspects of micro economics

– Demand

– Supply

– Cost of production

– Pricing strategies…. Etc

We know turn our attention to macro economics.

MACRO ECONOMICS

• Macro economics- (macro means large). – It is the branch of economic analysis that deals

with the study of aggregates namely with the performance, structure and behavior of economy as a whole.

– So we would know discuss • Aggregate demand

• Aggregate supply

• National income

• General price structure

• Movement of economic activity

CIRCULAR FLOW OF ECONOMIC ACTIVITIES AND INCOME

• The crux of macro economic theory is based on the circular flow of income

– The basis of this flow is the economic interdependence of consumers and sellers.

– Between whom the circular flow of production of goods and services, income and expenditure takes place.

– Let as start with simple models.

TWO SECTOR ECONOMY

• It is the simplest form

• The circular flow of economic activities and income assumes that there are only two players in the economy – Namely consumer (household)

– Firms(producer)

• There is no government intervention in economic activities .

• The country neither imports goods and services nor exports anything.

TWO SECTOR MODEL

CONSUMPTION EXPENDITURE

FIRMS

FACTOR PAYMENTS

HOUSE HOLDS FINANCIAL MARKETS

SAVINGS

INVETMENSTS

Goods/ services

..CONTD

• HOUSEHOLD – Set of individuals who live together and take joint

decisions about consumption of goods and services.

• FIRM – It is used to describe the basic selling unit of

consumption

– It provides consumers with goods and services.

• How the house hold and firm interdependence…….* (money flow between them)

..contd

• SAVINGS

– It is the with drawl of money from the circular flow

• INVESTMENTS

– It is the injection of money in circular flow.

• The with drawl of money should be equal to injection of money for the circular flow to continue undisturbed.

• In other words planned saving = planned investment

MATHEMETICAL EXPRESSION

• In such a simple two sector economy the value of output produced (Y) is equal to value of output sold (O).

• The total income is used either for purpose of consumption or for investment.

• Since the value of output sold is equal to the sum of consumption expenditure and investment expenditure

…contd

• Y = O= E • Y= C+S

• THUS

– E= C+I

– C+S= C+I Y= INCOME E= EXPENDITURE O= OUTPUT C= CONSUMPTION EXPENDITURE I= INVESTMENT EXPENDITURE

FOUR SECTOR ECONOMY

GOVERNMENT

FINANCIAL MARKET

FOREIGN NATIONS

FIRMS HOUSE HOLDS

EXPORTS IMPORTS

TAXES

REMITTANCES FOR PURCHASES

CONSUMPTION EXPENDITURE

FACTOR PAYMENTS

FOUR SECTOR ECONOMY

SAVINGS INVESTMENTS

FOUR SECTOR ECONOMY

• The two sector model has been introduced to help you understand the more complex real life situation.

• Every economy actually has two more sectors besides the consumers and producers – Government and external sector

• The development of basic infrastructure like roads, electricity, communication and security is essential for growth of a system.

..contd • These facilities are created by government

therefore total expenditure in an economy will not only consist of C+ I but also of government expenditure (G) – TOTAL EXPENDITURE = C+I+G

• At the same time government receives revenue from different sources such as taxes , interest on loans and profit on investments. – Y= C+S+T

• Since in equilibrium expenditure is equal to the income earned – C+I+G = C+S+T

…CONTD

• The every economy interacts with other economies through international trade – Flow of capital, other inputs, technology, services

and people.

• The households, firms and government interact with the foreign country through exports and imports of goods and services capital investments …etc – Hence there is a fourth sector in the economy known

as external markets

…contd

• In a circular flow that occurs in an open economy with 4 sectors the national income is measured by aggregate expenditure that includes

– Consumption expenditure, government expenditure and net of exports (X-M)

– X- exports M- Imports

– Y= C+I+G+(X-M)

MACROECONOMIC VARIABLES

• In the circular flow of income we had referred to terms like

– Aggregate consumption and expenditure

– Savings and investments

• Here we are going to study the importance of macro environment from the perspective of an individual firm.

AGGREGATE DEMAND AND AGGREGATE SUPPLY

• Aggregate demand – The sum of demand for all the goods and services

by all consumers for a given period of time may be termed as aggregate demand.

– Aggregate demand refers to aggregate expenditure made by the society as a whole.

– The aggregate demand (AD) consists of 2 components • Aggregate demand for consumer goods(C)

• Aggregate demand for capital goods (I)

• AD= C+I

…CONTD

• Aggregate supply

– It refers to the supply of all goods and services in the economy for a given period of time.

– Aggregate supply consists of supply of consumer goods where capital comes from savings (s) hence.

– AS = C+S

C+S= C+I = Y (AS= AD)

AS=C+S AD=C+I

E* C

E

I

XAXIS – INCOME YAXIS - EXPENDITURE

Y

EXP

END

ITU

RE

INCOME

GRAPH - INFERENCE

• The aggregate supply curve (AS) starts from origin because unless there is some income there can be no supply.

• Consumption curve(C) starts from origin. Irrespective of income level there will be some consumption.

• E is the equilibrium

• OE = EXPENDITURE OY= INCOME.

STOCKS AND FLOWS • Before determine the national income it is

necessary to understand the difference between stocks and flows.

• Stock – It may be defined as economic variable which has

been accumulated at a specific point of time. • Examples – money ,assets and wealth

• Flow – It includes the variables with increase (inflows) and

decrease (outflows) the stock • Example – income, consumption, saving and investment

over a period of time

….contd

• Mathematically a stock can be seen as an accumulation or integration of flows over time, with outflows subtracted from the stock.

• Stock

– Inventory

• Incoming goods(inflow)/outgoing goods (outflow)

– Bank balance

• Deposits / with drawls

INTERMEDIATE AND FINAL GOODS

• INTERMEDIATE GOODS

– It is also known as producer goods because they are used as inputs in the production of other goods

– They include partly finished goods or raw materials

– In the production process intermediate goods either become part of the final product.

…contd

• FINAL GOODS

– This goods are ultimately finished goods

– They are not used for production of another good.

– This goods are demanded by the final consumer .

Example – SAIL – PRODUCING STEEL

IT IS A FINISHED GOOD BUT ACT AS A INTERMEDIATE GOOD FOR AUTOMOBILES

CAPITAL FORMATION

• When we refer to an individual – it is investment.

• But when we talk in terms of country – it is capital formation.

• The process of saving is converted into investment is known as capital formation

• It is defined as the enlargement of capital stock.

..contd

• FIXED CAPITAL STOCK – It includes equipment, buildings and machinery used

in the production of goods and services

• GROSS PRIVATE INVESTMENT – It is the business spending on equipment, residential

structures and inventories

– It is the net investment + depreciation

• GROSS CAPITAL FORMATION(GCF) – It refers to the aggregate of additional to fixed assets

(fixed capital formation)

…contd

• Rate of capital formation is the measure of growth of an economy because it determines the volume of investment in future.

• The higher the rate of capital formulation higher is the increase in production of goods and services and hence higher is the economic growth of the economy.

EMPLOYMENT • This is the another very important macro variable

that affects the national economy. • Employment

– It is defined as a where a person who is willing and capable to work in a productive activity is engaged for certain number of hours per week.

• The population of any country is divided into working population and dependents.

• People under the age group (21- 60) are under working population and remaining as dependent.

• Every country tries to achieve full employment so that maximum economic growth with maximum social welfare can be achieved

GOVERNMENT EXPENDITURE AND REVENUE

• Government expenditure takes may forms – It includes spending on capital goods and

infrastructure(road, power, communication)

– Spending on defense goods, education, public health civil administration, police, subsidies on various goods.

– Procurement of certain items of mass communication and so on.

– All government expenditure is included in national output.

.. contd • Another type of expenditure known as

transfer payments

– It is refers to payments made to certain sections of the society as a social welfare measures.

– It is an exchange of purchasing power from one group of people to another.

• It includes unemployment compensation , retirement pensions etc.

• Since the receivers of such payments (such as old, handicapped) do not contribute to national output therefore such payment refers toa s transfer payments

CONCEPTS OF NATIONAL INCOME

“ National income or product is the final figure you arrive at when you apply the measuring rod of money to the diverse apples, oranges, battleships and machines that any society produces with its land, labor and capital resources.”

PAUL A.SAMUELSON

…CONTD

• One of the most important concepts in all economic systems is that of national income

• It is used to measure the economic performance of an economy as a whole.

• Measures of national income and output are used to estimate the value of goods and services produced in an economy.

• Calculation of national income requires adding together all final goods and services produced in a country in a given year.

DEFINITION – NATIONAL INCOME

“National income is defined as the money value of all the final goods and services produced in an economy during an accounting period of time, generally one year”

COMMON MEASURES OF NATIONAL INCOME

• GDP (Gross Domestic Product)

• GNP (Gross National Product)

• NDP (Net Domestic Product)

• NNP (Net National Product)

GDP

“GDP is the sum of money values of all final goods and services produced with in the domestic territories of a country during an accounting year”

• It includes income from exports and payments made on imports during the year.

• It does not include the earnings of nationals working abroad as also of the foreign nationals working in our country.

…contd • Many domestic companies which have their

branches or subsidiaries in foreign countries . • As also subsidiaries and branches of foreign

companies in your home country. • The outputs produced by all business are not

included in the GDP of the country. • GDP measures the final output not the

intermediate goods. • It also excludes items produced in previous years. GDP = C+I+G+(X-M) C= CONSUMPTION EXPENDITURE I= INVESTMENT X= EXPORT I=IMPORT G= GOVERNMENT EXPENDITURE

GDP AT FACTOR COST/GDP AT MARKET PRICE

• GDP is the money value of goods and services.

• Money flows in an economy in a circular manner from producers to consumers and back from consumers to producers.

• So goods and services can be converted in monetary terms in two ways – By using the market value of goods and services.

– By using payments for factor inputs.

• The values of GDP whether estimated at market price or at factor cost must be identical to each other. (market price= factor cost)

…contd

• But in real life market value of goods and services is actually not the same as the cost involved in their production.

• GDP at market price includes indirect taxes and excludes subsidies given by the government.

• GDP at factor cost would include transfer payments which do not contribute to national income – GDP at factor cost = GDP at market prices –

indirect taxes + subsidies

GROSS NATIONAL PRODUCT (GNP)

• GNP is the aggregate final output of citizens and businesses of an economy in a year.

• The difference between GNP and GDP arises because of the fact that a part of any country’s total output is produced by factors which are actually owned by other nations.

GNP = GDP +NFIA

GNP = C+I+G+(X-M)+NFIA

GDP – GROSS DOMESTIC PRODUCT

NFIA – NET FACTOR INCOME FROM ABROAD

NFIA

“Net factor income from abroad (NFIA) is the difference between income received from abroad for rendering factor services and income paid towards services rendered by foreign nationals in the domestic territory of a country”

NET DOMESTIC PRODUCT AND NET NATIONAL PRODUCT (NNP)

• While calculating GDP or GNP we ignore depreciation of assets or capital consumption.

• In reality the process of production uses up a certain amount of fixed capital by way of wear and tear by a process termed as depreciation.

• In order to arrive at NDP or NNP we deduct depreciation from GDP or GNP.

…..CONTD

• NDP = GDP – DEPRECIATION

• NNP= GDP – DEPRECIATION +NFIA

• NNP = C+I+G+(X-M)-DEPRECIATION + NFIA

NNP AT FACTOR COST (NATIONAL INCOME)

“Net national product at factor cost is the net output of an economy evaluated at factor prices or it is the sum total of all income earned by all the people of nation with in the national boundaries or abroad.”

NNP AT FACTOR COST = NNP AT MARKET PRICES - INDIRECT TAXES +SUBSIDIES

REAL AND NOMINAL NATIONAL INCOME

• National income is obtained by multiplying the output of goods and services by their prices.

• Which price should use in this calculation…?

• There are two practices – We may use either current or constant prices.

• All the different concepts of national income GDP , GNP, NNP can be expressed in terms of current price or constant price.

…contd

• Current prices are the prices prevailing in the year in which national income is calculated.

• The national income is estimated at the prevailing prices it is called national income at current prices or nominal national income or money national income.

..contd • The national income is measured on the basis

of some fixed price

– Say price prevailing at a particular point of time or by taking a base year it is known as national income at constant prices or real national income.

WHY WE NEED 2 VALUES OF NATIONAL INCOME

• MARKET PRICE OF PRODUCT X = 100 (2010)

• MARKET PRICE OF PRODUCT Y = 150 (2011)

• QTY PRODUCED AT BOTH YEARS – 100

• NOMINAL NATIONAL INCOME (2010)- 10000

• NOMINAL NATIONAL INCOME (2011)- 15000

• The difference between the national is due to inflation.

REAL GDP

• Real GDP = NOMINAL GDP / GDP deflator.

• Real GDP measures changes in the physical output in an economy between different time periods by valuing all goods in the two periods at the same prices.

• GDP deflator as the ratio of nominal GDP in a year to real GDP of that year

• GDP deflator measures the change in prices between the base year and the current year.

PER CAPITA INCOME (PCI)

• The average income of the people of a country in a particular year is called per capita income.

• In simple words it is income per head of a country for a year.

• Per capita income can be arrived at dividing national income by total population of the country.

…contd

• Per capita income = National income /

total population

• Per capita income is calculated on the basis of national income therefore it can be referred to as per capita NNP or per capita GNP or per capita GDP.

PERSONAL DISPOSABLE INCOME

• Personal income – It is the total income received by the individuals of a

country from all sources before direct taxes in one year.

– It is derived from national income by deducting undistributed corporate profits, profit taxes and employees contributions to social security schemes.

– It is gross income of households before payment of personal taxes.

– It also includes transfer payments received by households

PERSONAL INCOME

• Personal income = national income – undistributed corporate profits – corporate taxes –social security contributions + transfer payments + interest on public debt

… contd

• The entire amount of personal income cannot be spent by the house hold on consumption and saving because direct taxes to be paid out of this income.

• Disposable income or personal disposable income means the actual income which is available to be spent on consumption by individuals and families.

PERSONAL DISPOSABLE INCOME

• PERSONAL DISPOSABLE INCOME = PERSONAL INCOME – PERSON AL TAXES

• Personal disposable income includes income earned by individuals in any form say

– Salary, bonus, incentives, fringe benefits and other allowances dividend etc.

MEASUREMENT OF NATIONAL INCOME

• National income is nothing but the measurement of aggregate production in an economy during a definite time period.

• The circular flow enables to look at national income in three ways

– Flow of production goods and services

– Flow of income

– Flow of expenditure on goods and services.

PRODUCT METHOD

• As per the product method of estimating national income also called as national income by industry of origin.

• The market value of all the goods and services produced in the country by all the firms across all industries are added up together.

PRODUCT METHOD - STEPS

STEP 1

• THE ECONOMY IS DIVIDED ON THE BASIS OF INDUSTRIES

• EXAMPLE – AGRICULTURE, MINING, POWER ETC

STEP 2 • THE PHYSICAL UNITS OF OUTPUT ARE THEN INYER)PRETED IN MONEY

TERMS (MARKET PRICE OF ALL PRODUCTS

STEP 3 • THE TOTAL VALUES OBTAINED ARE ADDED UP

STEP 4 • THEI INDIRECT TAXES ARE SUBTRACTED AND SUBSIDIES ARE ADDED THIS

GIVES GDP /GNP (ACCORDING TO DATA WE USED)

STEP 5 • THE NET VALUE IS CALCULATED BY SUBTRACTING DEPRECIATION FROM

THE TOTAL VALUE THUS OBTAINED IN ORDER TO ARRIVE AT NNP

EXAMPLE • If a manufacturer sells a laptop to a retailer for

Rs 25000 • And the retailer sells it to the consumer at Rs

30000. • How much has the laptop contributed GDP ? Is it

30000?................... • No …. If we do that it would be double counting • Instead we would either count the final value or

the value added at each stage. • So the product method calculated by

– Final product method – Value added method

….contd

• Final product method

– According to this method the total value of final goods and services produced in a country during a year is calculated at market prices.

– To find out GDP the data of all productive activities are collected and accessed in market prices.

– No intermediaries goods are taken into account

..contd

• Value added method

– It measures the contribution of each producing enterprise of the economy.

– The difference between the values of material outputs and inputs at each stage of production is the value added.

– If all such differences are added up for all industries in the economy we arrive at GDP.

LIMITATIONS OF PRODUCT METHOD

• Problem of double counting.

• Not applicable to tertiary sector.

– This cannot be applied to service sector.

• Exclusion of non marketed products

INCOME METHOD/NATIONAL INCOME BY DISTRIBUTIVE SHARES

• According to income method it is net income received by all citizens of a country in a particular year that is added up.

– That is total of net rents, net wages, net interest and net profits.

INCOME METHOD- STEPS

STEP 1

• THE ECONOMY IS DIVIDED ON BASIS OF INCOME GROUPS

• EXAMPLE- PROFIT EARNERS, WAGE/SALARY EARNERS, RENT EARNERS ETC.

STEP 2 • INCOME OF EACH OF THESE GROUPS IS CALCULATED

STEP 3 • INCOME OF ALL EARNERS IS ADDED INCLUDING INCOME

FROM ABROAD AND UNDIATRIBUTED PROFITS

GNP AT FACTOR COST

• GNP AT FACTOR COST

= RENT + WAGE + INTEREST + PROFIT + OTHER INCOME + (INCOME FROM ABROAD - PAYMENTS MADE TO FOREIGNERS ) – TRANSFER PAYMENTS

LIMITATIONAS OF INCOME METHOD

• Exclusion of non monetary income

– Example= ignores non monetized section of the economic activities such as farmer and family working in own field./kirana shops.

• Exclusion of non marketed services

– House wife and mother services

EXPENDITURE METHOD

• According to this method the total expenditure incurred by the society in a particular year is added together to get that year’s national income.

• The expenditure includes

– Personal consumption expenditure

– Net domestic investment

– Government expenditure on goods and services

– Net foreign investments

…contd

• Consumption expenditure

– Consumption is the largest and most important of the flows.

– When individual receives income they can spend it on domestic goods/foreign goods and services.

– They pay taxes and save the rest

– Personal consumption expenditure refers to payments by households for goods and services

….contd

• Investment expenditure

– This divided into 3 major categories

• Capital spending – Purchas of new materials and equipments by firms

• Residential construction – Construction of housing units

• Inventory investment – Unsold portion of output

..contd

• Government expenditure

– Government payments for goods and services

– Investment in equipments and structures

• Net exports

– Spending on imports is subtracted from total expenditure on exports.

– exports to foreign nations are added to total expenditure.

LIMITATIONS – EXPENDITURE METHOD

• Neglects barter system

• Ignores owns consumption

• Affected by inflation

USES OF NATIONAL INCOME DATA

• It is necessary for economic planning

• It is indicator of economic growth

• It is help in comparing the situations of economic growth in two different countries.

• It is used to determining the regional disparities.

• It is considered as a measure of economic welfare.

DIFFICULTIES IN MEASUREMENT OF NATIONAL INCOME

• Non monetized transaction.

• Unorganized sector.

• Multiple source of earnings.

• Categorization of goods and services.

• Inadequate data.

MONEY SUPPLY AND INFLATION

DEMAND AND SUPPLY OF MONEY

• The value of money is governed by the forces of demand and supply.

• Money is in demand because all the commodities which have utility are available in exchange for money.

• Functions of money: – Medium of exchange

– Measure of value

– Store of value • It can be saved for future with convenience

DEMAND FOR MONEY

• Economist have proposed many theories to explain the demand for money the some of theories are – Quantity theory of money

– Cash balance approach

– Income expenditure approach

• Keynes has identified three basic motives of people to hold money – Transaction motive

• Income motive(consumers) and business motive(producers)

– Precautionary motive

– Speculative motive

..contd

• Money may be demanded as flow (transaction motive) as well as stock (precautionary motive).

• Money as a flow is that which is in circulation.

• Where as total money supply at any point of time will consist of money in circulation as well as in stock(various form of savings and deposits)

SUPPLY OF MONEY

• Modern form of money is simply pieces of paper or numbers in a ledger.

• The piece of paper is as much worth as it can get you things you wanted.

• It is like a promissory note issued by a relevant authority (RBI on behalf of Indian government)

• As long as the trust with the government the piece of paper continues to be valuable.

• Such a currency is called as fiduciary issue(based on trust and confidence)

HISTORY OF EVOLUTION OF MONEY

• Earlier money was in the form of coins, generally composed of precious metals such as gold, silver and copper.

• The value of coins was roughly based on the value of the metals.

• Such a monetary system caused wear and tear of metal and it was difficult to carry huge amount of money fro one place to another.

• Support of paper money introduced.

… contd

• The paper money in different countries was based on the gold standard or silver standard or combination of two.

• This meant that you could take some paper money to the government which would exchange it for some gold/silver based on the exchange rate it set.

• India followed the proportional reserve system up to 1956. (gold and foreign securities were at least 40% of total reserve)

..contd

• In 1956 this was replaced by fixed minimum reserve system.

• Practically Indian currency is non convertible in any precious metal and fiat money that is declared.

• Fiat money – Under this system any number of notes can be printed as

per needs of the economy.

• The success of this system is depends upon people faith in the government.

• In India RBI is responsible for money supply and control

CONCEPTS OF MONEY SUPPLY

• Normally money supply is expressed in the form of two broad measures

– Narrow money

• It includes only very liquid assets like currency

• Example – notes and coins in the hands of public and demand deposits in the bank

– Broad money

• It includes set of less liquid assets term deposits with banks.

QUANTITY THEORY OF MONEY • Economist believe that value of money varies

inversely with its quantity.

• The theory asserts that any given percentage increase and decrease in the quantity of money will lead to the same percentage decrease or increase in the general price level.

• Initially the theory was based on the following – MV = PT

– P = MV/T • P= GENERAL PRICE LEVEL T= TRANSACTION VOLUME OF

GOODS AND SERVICES M= SUPPLY OF CURRENCY V= VELOCITY WITH WHICH MONEY CIRCULATES(SPEED MONEY MOVE FROM ONE HAND TO ANOTHER)

EXAMPLE

• Suppose you spent Rs 1000 on 5 commodities

• Thus the money is distributed among five sellers.

• Each one of whom spends his/her share on certain other goods.

• Thus the initial sum of Rs 1000 multiplies the number of times it change hands.

…contd

• Over the years the definition of quantity of money has developed as inclusive of all money in circulation including currency and debit.

• The formula for general price level has emerged. – P= (MV + M’ V’)/T

– M’ = CREDIT MONEY (CHEQUES) V’= VELOCITY OF CREDIT MONEY

VALUE OF MONEY

• Money is good with limited supply and unlimited demand.

• Therefore the law of market applies to money as well.

• As long as people want money it will remain valuable.

• If money cannot buy anything it is just a useless piece of paper.

..contd

• Whenever the government changes the size and design of different denominations the old currency losses value.

• The sufficient time is given to people to convert their old money into new currency through bank( this is what happened in Europe when countries switched over to euro)

EXAMPLE

• Link between value of money and price of goods and services.

• 1 kg of orange is sold for Rs 50

• It means Rs 50 = 1 kg

• If 1 kg of orange is available for Rs 60 – What will happen.

• Value of money has declined in terms of oranges because oranges are expensive now.

• Value of money and price of goods move in opposite direction.

• Higher price = lower value of money

..contd

• How prices of oranges went up. – Supply on money increases people have more money

in hand. So demand of oranges increases but supply remain constant price will go up.

– Supply of goods decreases. Demand same – Demand for goods increases supply remains same it

will increases price.

• Money supply and price are very tightly integrated.

• Increase in supply of money is direct cause of price rise.

INFLATION

INFLATION

• Inflation is a situation of persistently rising prices.

• It is also a situation of persistently rising money supply.

• Inflation is a sate of “ too much money chasing two few goods”.

• In simple words it can be said that inflation implies an upward movement in the average level of prices.

…contd

• It is seen as a situation in which volume of purchasing power (money in hands of consumers) is persistently more than the goods and services available to consumers.

• DEFINITION – Inflation can be defined as persistent increase in

general price level or a persistent decline in real income of people i.e. decline in value of money.

..contd

• According to the above definition inflation means things getting more expensive.

• A one time rise in prices due to some external factor like

– Natural calamity , new tax new wage and salary structure

• May not be termed as inflation because it will be automatically corrected.

CATEGORISE OF INFLATION

• Economists categorize inflation into two broad categories

– Price inflation and money inflation

• The price inflation and money inflation have cause and effect relationship.

• Price inflation is the effect of money inflation.

• When money supply increases persistently it causes a price inflation too.

HOW MONEY CIRCULATION INCREASES

• Printing of additional currency on demand of the government to meet its need of expenditure.

• Other sources of additional money supply are foreign exchange inflows in the form of capital such as FDI and FII tourism and other incomes from abroad.

HEADLINE INFLATION

• It is measure of total inflation within an economy and is affected by areas of the market which may experience sudden inflationary spikes, such as food or energy.

• Head line inflation may not present an accurate picture of the current state of the economy.

INFLATIONARY SPIKES

• It occur when a particular section of the economy experiences a sudden price rise. Possibly due to the external factors.

HYPER INFLATION

• In Hyper inflation prices increases at such a speed that value of money erodes drastically and the economy is trapped between rising prices and wages.

• It is also known as galloping inflation or run away inflation

STAGFLATION

• This is a typical situation when stagnation and inflation co exist.

• Industrial production was at its lowest accompanied by mounting prices

• India too has faced stagflation in the 1970’s.

SUPPRESED INFLATION

• It is a state when inflationary conditions exist but the government makes such policies which temporarily keep prices under check.

• When these checks are removed inflation bursts out.

• Example – petrol & diesel prices in india

DIS INFLATION

• Disinflation is a process to bring down prices moderately from a very high level.

• It is a process of keeping a check on price rise by deliberate attempts.

– Example = government of India has set a target to keep annual inflation below 5%.

DEFLATION

• It is a just opposite to inflation. • It is a state when prices falls persistently. • Deflation is accompanied by declined in money

income of people. • When prices falls

– Revenue of sellers falls – They would thus have less incentive to produce more – This will result in fall in investment – Fall in demand for factors of production. – Fall in money income .

..contd

• Therefore it is often said that if governments have to make a choice between inflation and deflation.

• ….what will they choose………?

• Inflation or deflation – Inflation – because inflation is normally

accompanied by economic expansion.

INFLATIONARY GAP

• This term was coined by keynes to describe a situation when there is an “ excess of anticipated expenditure over available output at base prices”.

• This is a gap between effective demand and supply.

• When money in the hands of people exceeds the supply of goods and services a gap is created between demand and supply.

• The situation of price rise due to gap between demand and supply is known as inflationary gap

WAGE PRICE SPIRAL

PRICES

WAGES

PRICES

WAGES

“Wages chase prices and prices chase wages and thus create a wage spiral”

EXAMPLE – WAGE PRICE SPIRAL

• Mr X is a business head of a consultancy firm. – His company is known for concern for employees.

• Inflation rate is 5% – This means a commodity which would be earlier

purchased for Rs 100 can now be purchased for Rs 105.

– Thus it means that consumers real income decreased by 5%

• To compensate the loss in real income of employee Mr X granting 5% wage hike. – This naturally could mean 5% increase in cost of

production.

..contd • So two option for Mr X

– Either bear the enhanced cost /reduced profit margin

– Shift the burden on consumers by increasing the price of his product.

• As a rational business man he would keep his employees happy without eroding his own profits and naturally would increase the prices.

• Now the chain is created his consumers have to pay more so they will demand increase in their incomes from their employers.

• Thus the wage price is created.

CAUSES OF INFLATION

• Excess money supply

• Demand pull inflation

• Cost push inflation

• Low increase in supply of goods

EXCESS MONEY SUPPLY

• The money inflation precedes price inflation is known as monetarism.

• For a long period of time money supply was accepted as the single most important cause of inflation.

DEMAND FULL INFLATION

• Whenever the demand for any commodity increases other things including supply remaining the same the natural outcome is increase in price of that commodity.

• Demand pulls prices up.

• When aggregate demand level increases due to any reason and supply of output is unable to match this increased demand that is known as demand pull inflation

REASONS FOR DEMAND PULL INFLATION

• Increase in money supply

• Increase in disposable income

• Increase in aggregate spending

• Increase in population of the country.

COST PUSH INFLATION

• Prices pushed up by the cost is known cost push inflation.

• Increase in price of any inputs whether fixed or variable will imply an increase in the cost of production which may rise in the price of the product.

DETERMINANTS WHICH RESTRAINS SUPPLY

• Obsolete technology – Poor technology will hamper supply.

• Deficient machinery

• Scarcity of resources.

• Natural calamities.

• Industrial disputes and external aggressions.

• Built in inflation. – Built in inflation is a type off inflation that has

resulted from past events and persists in the present.

INFLATION AND DECISION MAKING

• Impact on consumers.

• Impact on producers(or suppliers).

• Impact on government.

• Indexation.

IMPACT ON CONSUMERS

• The consumer makes a tentative budget based on monthly income and expenses.

• Naturally expenses depend upon the prices of the relevant goods.

• Increase in price of one commodity or a number of commodities upsets the whole budget.

EXAMPLE • You have applied for home loan worth Rs 30

lakh.

• Then you find that house prices are swollen by 15% on account – Due to increase in cement, iron and steel prices.

• You have will have to arrange for another Rs 4.5 lakh or you have to go for small house.

• You will repay this loan and the interest – Thereupon reducing your monthly income.

• Thus increase in price of one commodity affects your purchase decisions for many other things of daily need.

IMPACT ON PRODUCERS

• Producers are affected in two ways

– When they are sellers they are benefited by inflation

• Higher the prices higher are their profits.

– When they have to buy raw material , hire work force , buy technology or machine they are aversely affected by inflation.

• You have seen the creation of wage price spiral.

IMPACT ON GOVERNMENT

• Government is vested with the responsibility to take care of the interest of all the sections of the society.

• At one end it is committed to take the economy to higher levels of growth by encouraging production and investment.

• At another end the government duty bound to see that taxpayer’s money is not eroded by hyperinflation.

..contd

• The government takes various measures which keep inflation in check.

• The economists prefer some minimum level of inflation (keynes sugested 2%).

• By using the monetary policy and fiscal policy the government achieve the economic growth

INDEXATION

• Indexation is the automatic linkage between monetary obligation and price levels.

• Indexation reduce the cost of inflation

• It apply to wages, interest and taxes.

• Example

– Employers are forced to index wages against prices so that gap between money income and real income may be minimized.

MEASURING - INFLATION

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

• Various measure of inflation are used for different purposes.

• All these measures are called as indices.

PRICE INDEX

• It is numerical measure designed to help compare how prices of some class of goods/services taken as whole differ between time periods or geographical locations.

• Price index reduces all distinct prices for the class of goods in question to a single number.

• Price index

= current year’s price/base year’s base

PRODUCER PRICE INDEX

• PPI measures average changes in prices received by domestic producers for their output.

• It measures the pressure being put on producers by the costs of their raw materials.

• This could be passed on to consumers as inflation.

WHOLE SALE PRICE INDEX

• When inflation is calculated on the basis of whole sale prices of a wide variety of goods it is called WPI.

• In India WPI is available on weekly basis.

• It is continuous to be most popular and most comprehensive measure of economy.

CONSUMER PRICE INDEX

• Consumer price index measures the price of a selection of goods purchased by a typical consumer.

• CPI are compiles in terms of general standards and guidelines set by the ILO.

• The commodity basket for these indices is derived on the basis of group specific consumer expenditure survey and weights to each commodity are proportionate to its expenditure.

…contd

• Different counties issue different categories of a CPI.

• In India 4 types of CPI are – CPI IW –(INDUSTRIAL WORKERS)

• Is the most well known of these indices as it is used for wage indexation in government and in the organized sectors

– CPI UNME –(URBAN AND NON MANUAL EMPLOYEES)

– CPI AL- (AGRICULTURE WORKERS)

– CPI RL – ( RURAL LABOURERS)

…contd

• Central statistical organization has initiated steps to compile CPI under two broad categories

– CPI (RURAL)

– CPI (URBAN)

COST OF LIVING INDICES

• Cost of living indices are used to adjust fixed incomes and contractual incomes to maintain the real value of such incomes.

SERVICE PRICE INDEX

• With the growing importance of service sector across the world many countries have started developing services price indices (SPI).

• Some agencies have focused exclusively on the prices of services provided to enterprises.

• In India office of economic adviser, ministry of commerce and industry started work on construction of this index numbers selected from – Services(transport, railways, air transport, port,

banking, post, telecommunication, business services and trade services)

INFLATION RATE

• The formula for calculating the inflation rate

last year’s index – current year’s index

Inflation rate=------------------------------------------x 100

current year’s index

INFLATION AND EMPLOYMENT

• A.W.H. PHILLIPS studied the relationship between unemployment and rate of changes in money wages.

• Phillips hypothesized that inflation shocks cause a short term change in behavior of firms and labor.

• Labors accept jobs at lower pay if they are unemployed and firms are more willing to hire due to low wages.

• As out come of this study phillips developed a curve which is known as phillips curve

PHILLIPS CURVE

• This curve widely used to explain the relation between unemployment and inflation.

• It is assumed that during inflation trade unions pressurize employers to raise money wages.

• Phillips postulated that the lower rate of unemployment the higher is the rate of change of wages.

• Its main implication is that since a particular level of unemployment in an economy will imply a particular rate of wage increase.

..contd

• The objectives of low unemployment and low rate of inflation may be inconsistent.

• Hence government mist choose between the feasible combinations of unemployment and inflation.

PHILLIPS CURVE

AN

NU

AL

PR

ISE

RIS

E %

∆

P/P

AN

NU

AL

WA

GE

RIS

E %

∆W

/W

UNEMPLOYMENT %

CURVE - INFERENCE

• X AXIS – UNEMPLOYMENT %

• Y AXIS – PERCANTAGE CHANGE IN PRICE

• Giving it a three dimensional effect wages are shown on the right hand side of vertical axis.

• The values corresponding to the curves are hypothetical.

• When inflation is zero unemployment is 6 percentage.

• When unemployment is 2% inflation is 4%.

• The curve shows the various combination of unemployment and inflation

..contd

• So the government may hence trade off between unemployment and inflation and choose the most appropriate combination as per the need of economy.

CONTROL OF INFLATION

• Inflation erodes the value of money and how it discourages savings.

• Zero level inflation is undesirable.

• Therefore governments do not try to reach zero inflation but still they try to control it.

• Various methods are advocated for controlling inflation – Monetary measures(control the money supply)

– Fiscal measures (proposed by keynes)

MONETARY MEASURES

• Under monetary measures the central bank of the country uses various methods of credit control to keep a check on inflation.

• To control inflation it is necessary that a curb is put on money supply.

• Some of the important measures adopted by central bank are – Increasing the discounting rate

– Higher reserve ratios

– Open market operations

– Selective credit control.

..contd

• Increasing discount rate – Central bank rediscounts the eligible papers

offered by commercial banks.*(bank rate)

– In this way bank credit becomes costlier and commercial banks are forced to increase their lending rate

– Thus money become costlier to public

• Higher reserve ratios – CRR, SLR ,REPO, REVERSE REPO these rate are

increased by RBI

..contd

• Open market operations

– Central bank may directly sell government securities to general public and thus restrain their disposable income.

• Selective credit control

– Central bank advise commercial banks to go for selective credit control this discourages consumption but not investment

FISCAL MEASURES

• It include government revenue and government expenditure.

• Reducing public expenditure

– Important tools in the hands of government.

– When government spends money on various activities(health, transport etc) income of individuals increases thus turn increases the aggregate demand.

..contd

• Increasing public revenue – Major sources of government revenue from taxes

– When government wants to curb peoples spending it increases various taxes.

– Increases in income tax leaves less of disposable income in the hands of consumers.

• Increasing supply – Supply of goods to reduce the demand supply gap

– Increasing imports decreasing exports of the items which are short in supply.

BUSINESS CYCLE

BUSINESS CYCLE

• Business cycle is the periodic up and down movements in economic activities.

• The economic activities measured in terms of production, employment and income move in a cyclical manner over a period of time.

• This cyclical movement is characterized by alternative waves of expansion and contraction and is associated with alternate periods of prosperity and depression.

FEATURES OF BUSINESS CYCLES • Periodicity.

– These wavelike movements in income and employment occur at intervals 12- 16 years.

– The gap between two cycles is not regular or predictable with certainty.

• Synchronism. – It happens because of interdependence of various

sectors of the economy. – The contraction of economic activities in one sector

would lead to recession in many other areas.

• Self reinforcing. – Cyclical movements faced by one sector spreads to

other sectors in the economy – The upward swing of the cycle is reinforced for further

upward movement

PHASES OF BUSINESS CYCLE

• EXPANSION – All macro economic variables like output,

employment, income and consumption increase – At same time prices move up, money supply increases

• PEAK – This is highest point of growth – The stage beyond this no further expansion is possible

• CONTRACTION(RECESSION) – Slowing down process of all economic activities, – No demand of the product.

• TROUGH(DEPRESSION) – It termed as slump or depression – Lowest ebb of economic cycle

BUSINESS CYCLE

EXPANSION

PEAK

TROUGH

TIME UNIT (YEARS)C

GN

P %

• There are two turning points in the cycle one at peak when the economy tarts sliding down and the other at trough when the economy picks up momentum for another phase of growth.

EFFECTS OF BUSINESS CYCLE

• Effects during expansion

– Inflation

– Severe competition

• Effects during recession

– Excess inventory

– Retrenchment

CONTROLLING OF BUSINESS CYCLES

• Measures to business cycles can be categorized into – Preventive measures(proactive) – Curative measures(reactive)

• At firm level – Precautionary measures

• Investments • Inventory

– JIT STRATEGY

• Products – DIFFERENTIATION

• Pricing

– Curative measures

..contd • At government level

– Monetary measures

• Rediscount rates – During expansion --- increase rediscount rates(bank rates)

– During recession --- decrease rediscount rates

• Reserve ratios – During expansion --- Increase ratios

– During recession --- decrease ratios

• Open market operations – During expansion --- sells government securities

– During recession --- buys government securities

• Selective credit control – Credit may extend to certain areas and contracted to certain

areas

..contd

– FISCAL MEASURES

• Pubic expenditure – During recession governments normally use public

expenditure as a tool

• Public revenue – During expansion governments use public revenue items as

controlling device

CONCEPT OF MULTIPLIER AND ACCELERATOR

• MULTIPLIER

– The multiplier is often referred to as autonomous expenditure multiplier or investment multiplier.

– Before we dwell deeper into the concept of multiplier it is important to understand two more concept

• Marginal propensity to consume (MPC)

• Marginal propensity to save (MPS) – These two concepts are introduced by keynes.

MPC (MARGINAL PROPENSITY TO CONSUME)

• MPC

– It is the measure of effect of change in total income on the keenness of people to spend on consumer goods

– It is the change in consumption expenditure due to change in income

– MPC = d C / d Y C- CONSUMPTION Y-INCOME

MPS (MARGINAL PROPENSITY TO SAVE)

• MPS

– It is a measure of the effect of change in total income on the keenness of people to save.

– MPS = d S / d Y S- SAVINGS Y-INCOME

MULTIPLIER • The value of MPC lies between 0 and 1.

– It is assumed that Y increases C also increases but increase in C is less than increase in Y.

• Where MPS +MPC= 1 • There fore MPS = 1- MPC

• The multiplier measures the effect of certain

amount of capital investment on total employment /total income /total consumption – K= 1/(1-MPC) = 1/MPS (MULTIPLIER IS THE

RECIPROCAL OF MPS)

ACCELERATOR

• As per acceleration principle, changes in demand for consumer goods bring about wider changes in the production of appropriate capital goods.

• Accelerator measures the relationship between changes in investment due to change in national output or national income.

THE END

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