business economics

ANAND ENGINEERING COLLEGE BCA PROGRAM BE IIIrd SEM UNIT - III

Syllabus: Macro Economic Concerns Inflation, Unemployment, Trade-Cycles, Circular Flow upto Four Sector Economy, Government in the Macro Economy: Fiscal Policy, Monetary Policy, Measuring National Income and Output.

Inflation is a macroeconomic concept referring to an increase (decrease) in the absolute price level over some defined time period. An increase in the price of all goods has the effect of reducing the purchasing power of money and money incomes and thus must be taken into account when planning future economic activity.

Meaning and DefinitionInflation is normally associated with high prices which causes decline in the purchasing power or the value of money. Inflation refers to the substantial and rapid increase in the general price level. Inflation is primarily a monetary phenomenon. Prices keep on rising due to excess supply of money and lower production of exchangeable goods.

According to Crowther,” Inflation is a state in which the value of money is falling i.e. prices are rising.”

According to Pigou, “Inflation takes place when money income is expanding relatively to the output of work done by productive agents for whom it is the payment.”

Features of Inflation: Following are the main features of inflation:1. Inflation is always accompanied by a rise in the price level, It is a process of uninterrupted

increase in prices.2. Inflation is a monetary phenomenon and it is generally caused by excessive money supply.3. It is an economic phenomenon as it originates in the economic system and is the result of action

and interaction of economic forces.4. Inflation is a dynamic process as observed over the long period.5. A cyclical movement of prices is not inflation.6. Pure inflation starts after full employment.7. Inflation may be demand-pull or cost-push.8. Excess demand in relation to the supply of everything is the essence of inflation.

Types of InflationA. According to Rate of Rise in Price: i) Creeping Inflation: When the rise in

prices is very slow like that of snail or creeper, it is called creeping inflation. In terms of speed, a sustained rise in prices of annual increase of less than 3 percent per annum is characterized as creeping inflation. Such an increase in prices is regarded safe and essential for economic growth.

ii) Walking Inflation: When rise in prices is more than as compared to creeping inflation, there exists walking inflation in

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the economy. Roughly, when prices rise by more than ten percent and within a range of 30 to 40 percent within a decade, or 3 to 4 percent a year, walking inflation is the outcome.

iii) Running Inflation: When the movement of prices accelerates rapidly, running inflation emerges. Running inflation may record more than 100 percent rise in prices over a decade. Thus when prices rise by more than 10 percent a year, running inflation occurs.

iv) Galloping Inflation/Hyperinflation: In the case of hyperinflation prices rise every moment, and there is no limit to the height to which prices might rise, therefore, it is difficult to measure its magnitude, as price rise by fits and starts. If, within a year, the prices rise by 100 percent, it is a case of hyperinflation or galloping inflation.

B. According to Government’s Reactioni) Open Inflation: When the government does not attempt to prevent a price rise. Inflation is

said to be open. Thus, inflation is open when prices rise without any interruption.ii) Repressed Inflation: When the government interrupts a price rise, there is repressed or

suppressed inflation. The essential characteristic of repressed inflation is that it seeks to prevent distribution based on controls.

C. According to Keynesian ViewKeynesian economic theory proposes that changes in money supply do not directly affect prices, and that visible inflation is the result of pressures in the economy expressing themselves in prices. The supply of money is a major, but not only the cause of inflation. Types of inflation are as follows:

i) Demand-Pull Inflation: It is caused by increase in aggregate demand due to increased private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since, the excess demand and favourable market conditions will stimulate investment and expansion.

ii) Cost-Push Inflation: It is also called “supply shock inflation” is caused by a drop in aggregate supply. This may be due to a natural disaster, or increased prices of inputs. For example, s sudden decrease in the supply of, oil leading to increased oil prices, can cause cost-push inflation.

iii) Built-in Inflation: It is induced by adaptive expectations, and is often linked to the “price-wage spiral”. It involves workers trying to keep their wages up with prices, and firms passing these higher labour cost on to their customers as higher prices, leading to a ‘vicious circle’.

iv) Semi-inflation: According to Keynes, so long as there are unemployed resources, the general price level will not rise as output increases. But a large increase in aggregate expenditure will face shortages of supplies of some factors which may not be substitutable. This may lead to increase in costs, and prices start rising. This is known as semi-inflation or bottleneck inflation.

v) True Inflation: According to Keynes, when the economy reaches the level of full employment, any increase in aggregate expenditure will raise the price level in the same proportion. This is because it is not possible to increase the supply of factors of production and hence of output after the level of full employment. This is called true inflation.

vi) Mark-up Inflation: It is closely related to the price-push problem. Modern labour organizations possess substantial monopoly power. They set prices and wages on the basis of mark-up over cost and relative-incomes. Firms possessing monopoly power have control over the prices charged by them. So, they have administered prices which increase their profit margin. This sets-off an inflationary rise in prices. Similarly when strong trade unions are successful in raising the wages of workers, this contributes to inflation.

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Causes of InflationWhen the prices of goods and services increase and value of money falls or when the quantity of money in circulation increases more than the increase in output the value of money falls and prices of goods increase then this situation is known as inflation. But inflation does not occur by itself. Some of the factors that cause inflation can be summed as under:

A. Factors Causing Increase in Demand

i) Increase in Public Expenditure: An increase in public expenditure during the time of war or for developmental planning increase the demand for goods and services in economy and finally result in increase in prices of goods and services causing inflation.

ii) Increase in Private Expenditure: An increase in private expenditure, consumption expenditure as well as investment expenditure is an important cause of emergence of excess demand in the economy. When business conditions are good private entrepreneurs start investing more and more funds in new business, giving rise to increase in the demand for the service of factor of production.

iii) Increase in Exports: An increase in the foreign demand for the country’s products resources the stock of commodities available for home consumption. It is evident that when more and more of commodities are exported to other countries, less and less are available for domestic consumption. This causes shortage of goods in the country and results in inflation because when demand is more and supply is less the prices go up.

iv) Reduction in Taxation: Reduction in taxation is also an important cause of emergence of increase in demand. When government reduces tax it results to an increase in purchasing power of the public and then it is in the position to demand more goods and services for private consumption and results to an increase in prices causing inflation.

v) Repayment of Past Internal Debts: When the government repays its past debts to the public it results in an increase of purchasing power of the public which is used by it for buying more goods and services for consumption purpose. This leads to increase in demand and prices tend to go up.

vi) Rapid Growth of Population: A rapid growth in population results in pushing up the level of aggregate effective demand for goods and services in a country. This acts as an inflationary force and tends to raise the prices to higher level.

B. Factors Causing Decrease in Supplyi) Shortage in Supplies of Factors of Production: Occasionally the economy of a country

faces or is met with shortage of such factors as labour, capital, equipment, raw material, etc. These shortages are bound to reduce the production of goods and services for consumption purposes. This results in an increase in prices and inflation as the demand is high and supply is less.

ii) Hoarding by the Traders: At the time of shortages and rising prices, there is a tendency on the part of traders and merchants to hoard essential commodities for profit purposes. The stocks of essential goods often go underground during the period of inflation and rising prices, causing further scarcity of goods in the market.

iii) Hoarding by Consumers: The individual customers also hoard essential commodities to avoid payment of higher prices in future. They also hoard essential commodities to ensure uninterrupted availability for private consumption. This leads to an increase in demand and shortage of goods thus resulting in increase in prices and cause inflation in the economy of the country.

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Effects of InflationA. Effects on Production: The adverse effects of inflation on production are discussed below:i) 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.

ii) Changes in the System of Transaction: Inflation leads to changes in transaction pattern of producers. They hold a smaller stock of real money holding against unexpected contingencies then before. They devote more time and attention to convert money into inventories or other financial or real assets.

iii) Reduction in Production: Inflation adversely affects the volume of production because the expectation of rising prices along with rising costs inputs brings uncertainty. This reduces production.

iv) Fall in Quality: Continuous rise in prices creates a seller’s market. In such situation, producers produce and sell sub-standard commodities in order to earn higher profits.

v) Hoarding and Black-marketing: To earn more profit from rising prices, producers board stocks of their commodities. Consequently an artificial scarcity of commodities is created in the market. Then the producers sell their products in black market which increases inflationary pressures.

B. Distributional Effects: Inflation redistributes income, because prices of all factors do not rise in the same proportion. Its adverse effects can be explained as follows:

i) Debtors and Creditors: Debtors generally gain and creditors lose during inflation. Gain accrues to a debtor because he repays loans at a time when the purchasing power of money is lower than when it was borrowed. The creditor, on the other hand, is a loser during inflation, since her receives less in goods and services than he would have received in times of low prices.

ii) Business Community: Inflation is welcomed by businessmen because they stand to profit by rising prices. They find that the value of their inventories and stock of goods is rising in money terms. The business community, therefore, gets supernormal profit during periods of inflation, and those profits continue to increase as long as prices rise.

iii) Fixed Income Group: Inflation hits wage earners and salaried people very hard. Among these people are employees, pensioners and persons living on past savings.

iv) Investors: Those who invest in debentures and fixed interest bearing securities, bonds, etc. lose during inflation. However, investors in equities benefit because more dividend is yielded on account of high profits made by joint-stock companies during inflation.

v) Farmers: Farmers are benefited during inflation because of two factors:a)The prices of farm products increase, andb) Increase in the cost of production lags behind the rise in the prices.

Measures to Check InflationA. Monetary Measures: Monetary measure aim at reducing money income.i) Credit Control: The central bank of country adopts a number of methods to control the

quantity and quality of credit. For this purpose, it raises the bank rates, sells securities in the open market, raises the reserved ratio and adopts a number of selective credit control measures, such as raising margin requirements and regulating consumer credit.

ii) Demonetization of Currency: One of the monetary measures is to demonetize currency of higher denomination. Such a measure is usually adopted when there is abundance of black money in the country.

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iii) Issue of New Currency: Under this system, one new note is exchanged for a number of notes of the old currency. Such a measure is usually adopted when there is an excessive issue of notes and there is hyperinflation in the country. It is a very effective measure. But is inequitable for it hurts the small depositors the most.

B. Fiscal Measures: These are highly effective for controlling government expenditure, personal consumption expenditure and private and public investment.

i) Reduction in Unnecessary Expenditure: The government should reduce unnecessary expenditure on non-developmental activities in order to curb inflation. This will also put a check on private expenditure which is dependent upon government demand for goods and services.

ii) Increase in Taxes: To cut personal consumption expenditure, the rates of personal, corporate and commodity taxes should be raised and even new taxes should be levied, but the rates of taxes should not be as high as to discourage saving, investment and production.

iii) Increase in Savings: Another measure is to increase savings on the part of the people. This will tend to reduce disposal income with the people.

iv) Surplus Budgets: The government should give up deficit financing and instead have surplus budgets. It means collecting more in revenues and spending more.

v) Public Debt: The government shall stop repayment of public debt and postpone it so some future dates till inflationary pressures are controlled. Instead government should borrow more to reduce money supply with public.

C. Other Measures: The other types of measures are those which aim at increasing aggregate supply and reducing aggregate demand directly.

i) To Increase Production: The following measures should be adopted to increase production:a) Increase production of essential consumer goods like food, clothing, kerosene oil, sugar,

vegetable oils etc.b) Raw material of such products may be imported to increase production of essential

commodities.c) Efforts should be made to increase productivity.d) All possible help in form of latest technology, raw materials, financial help, subsidies, etc.

should be provided to different consumer goods sectors to increase production.ii) Rational Wage Policy: Under hyperinflation there is a wage-price spiral. To control this, the

government should freeze wages, incomes, profits, dividends, bonus, etc.iii) Price Control: Price control is another measure of direct control to check inflation. Price

control means fixing an upper limit for the prices of essential consumer goods. They are the maximum prices fixed by law and anybody charging more than these prices is punished by law.

iv) Rationing: Rationing aims at distributing consumption of scare goods so as to make them available to a large number of consumers. It is applied to essential consumer goods such as wheat, rice, sugar, kerosene oil, etc. It is meant to stabilize the prices of necessities and assure distributive justice.

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Trade Cycles (Business Cycles)The term Trade Cycle(Business Cycle) refers to fluctuations in economic activity that occurs in a more or less regular time sequence in all capitalist societies. The volume of economic activity in a community is shown by various indicators, viz, the volume of employment, price level, output and income. When these indicators are plotted on a chart, the graph looks like a wave. This shows that economic activity rises and falls in a regular manner. Each, movement, the rise and fall taken together, is called a Trade Cycle and Business Cycle.`According to Keynes, “A trade cycle is composed of periods of good trade characterized by rising prices and low unemployment percentages altering with periods of bad trait characterized by falling prices and high unemployment percentages.”

Characteristics of Trade Cycle: Various characteristics of trade cycle are as follows:1. Recurring Fluctuation: Business cycles are characterized by fluctuation which occurs

periodically in a free rhythm. This implies that the recurrence of expansion and contraction has no fixed or invariable period.

2. Period of Business Cycle is Longer than a Year: A typical business cycle completes itself in a period of 3 to 4 years. A business cycle in its character is distinct from seasonal fluctuations in economic activity which take place within the period of a calendar year.

3. Presence of the Crisis: According to Keynes, an important characteristic of the business cycle is the phenomenon of crisis. This implies that the peak and the trough are uneven.

4. Synchronic: Business cycles are synchronic. That is, they do not cause changes in any single industry or sector but are of all embracing character. It occurs simultaneously in all the sectors of economy. Recession passes from one industry to another and chain reaction continues till the whole economy is in grip of recession.

5. Consumption of Non-Durable Goods and Services: An important feature of business cycles is that consumption of non-durable goods and services does not vary much during different phases of business cycles.

6. Inventories of Goods: The immediate impact of depression and expansion is on the inventories of goods. When depression sets in, the inventories start accumulating beyond the desired level. This leads to cut in production of goods.

7. International in Character: Business cycles are international in character. That is, once started in one country they spread to other countries through trade relations between them.

Phases of Trade Cycle:1. Prosperity or Expansion: This stage is

characterized by increase production high capital investment in basic industries and expansion of the bank credit, high prices, high profits and full employment. There is general feeling of optimism between industrialist and businessman. Once the process gets a momentum, all economic variables like output, employment, investment, consumption, profits and prices start rising collectively.

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2. Peak: The growth eventually slows down and reached the peak. The peak phase is generally characterized by slackening in the expansion rate, the highest level of prosperity and downward slide in the economic activities from the peak.

3. Recession: The recession is normally characterized by liquidation in the stock market, strains in the banking system and some liquidation of bank loans, some fall in prices, a sharp reduction in demand for capital equipments and abandoning of relatively new projects.

4. Depression: It is the protective period in which business activities in the country is far below the normal. It is characterized by sharp deduction of production, mass unemployment, low employment, falling prices, falling profits, low wages, contraction of credit, a high rate of business failures and an atmosphere of all round negativity.

5. Trough: It is a phase of depression during which the down-trend in the economy slows down and eventually stops and the economic activities once again register an upward movement. Trout is the period of most severe strain on the economy.

6. Recovery: It implies increase in business activity after the lowest point of depression has been reached. The entrepreneur began to feel that the economic situation was after all no so bad. This leads to improvement in business activities. The industrial production picks up slowly and gradually. The volume of employment also increases.

Measures to Control Trade CyclesCyclic fluctuations in business and economic activities adversely affect the process of economic development of an economy. Therefore, the government should take preventive and corrective measures to maintain stability in economic system. Two types of measures are adopted to control trade cycles:

A. Preventive Measures: The preventive measures aim at avoidance of the occurrence of business cycles and these are as follows:

i) To Reduce the Dependence of Agriculture on Nature: The dependence of agriculture on nature causes fluctuations in agricultural production and which in turn causes fluctuations in national income and employment particularly in under-developed countries. Therefore, the government should develop irrigation facilities and take other appropriate measure to reduce the dependence of agriculture on nature.

ii) Equilibrium between Demand and Supply: The government should maintain the balance between demand and supply of scare goods by imports and buffer stocks policy.

iii) Check on Speculation Activities: Speculation causes cyclic fluctuations. Therefore, there should be effective check on these activities. There should be check on black-marketing.

iv) Nationalization of Basic Industries: The nationalization of basic industries would help in maintaining equilibrium between demand and supply. It would also help in checking monopolies.

B. Corrective Measures: i) Monetary policy: Monetary policy refers to the control of money supply and cost of credit in

the economy. In other words, monetary policy means to use the various methods of credit control by the central bank in the economy.

ii) Fiscal policy: Fiscal policy refers to the management of public revenue, expenditure and public debt to achieve certain objectives. The government can control cyclic fluctuations by making appropriate changes in taxation, public expenditure and public debt policies, i.e fiscal policy.

iii) Direct Control: For the speedy and effective control of business cycle government should resort to direct physical controls. Direct control includes licensing, rationing of scare and essential goods, Rice and wage controls, export-import controls, exchange controls, control over black marketing, control of monopolies and restrictive trade practices, etc.

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iv) Automatic Stabilizers: The economists have suggested the introduction of a number of automatic stabilizers to deal with business cycle. One such device is the federal progressive income-tax. This tax is so devised that people in higher income brackets are taxed at a progressively higher rate than those in the lower brackets.

v) Ad-Spend Policy: As the economy slows down, firms slow down and cut their advertising budgets a means of boosting their own profitability. However, some major corporations and FMCG‘s believe, on contrary, in raising their advertising budgets significantly.

National Income and OutputNational income is the money value of all the final goods and services produced by a country during the period of one year. National income consists of a collection of different types of goods and services of different types. Since, these goods are measured in different physical units it is not possible to add them together. Therefore, there is no way except to reduce them to a common measure. The common measure is money.National income may be defined as the aggregate of income which arises from the current production of goods and services. The nation’s economy refers to the factors of production (i.e. labour and property) supplied by the normal residents of national territory.

According to Professor Fisher, “The national income consists solely of services received by ultimate consumers, whether from their material or from their human environment.”

According to Pigou, “National Income is that part of the objective income, of the community, including income derived from abroad, which can be measured in money.”

Concepts of National Income1. Gross and Net Concepts: Gross emphasizes that no allowance for capital consumption has been

made or that depreciation has yet to be deducted.Net indicates that provision for capital consumption has already been made or that depreciation has already been deducted. Thus, difference between the gross aggregate and net aggregate it depreciation.

2. National and Domestic Consumption: The term national denotes the total income which accrues to the normal residents of a country due to their participation in world production during the current year.As against this, it is also possible to measure the value of the total output or income originating within the specified geographical boundary of a country known as “domestic territory”. The resulting measure is called “domestic product”.

3. Market Prices and Factor Costs: Market prices indicates the total amount actually paid by the final buyers while the factor cost is a measure of the total amount earned by the factors of production for their contribution to the final output.

4. Gross Domestic Product (GDP): Gross domestic product is the money value of all final goods and services produced in the domestic territory of a country during an accounting year.

5. Net Domestic Product (NDP): While calculating GDP no provision is made for depreciation. Capital goods like machines equipments, tools, buildings, tractors, etc. get depreciated during the process of production. After sometime these capital goods need replacement. A part of capital is therefore, set aside in the form of depreciation allowance. When depreciation allowance is subtracted from gross domestic product gross domestic product we get net domestic product.

NDP = GDP – Depreciation

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6. Gross National Product (GNP): Gross national product is defined as the sum of the gross domestic product and net factor incomes from abroad. Thus in order to estimate the gross national product of India we have to add net factor income from abroad, i.e., income earned by Indian residents abroad minus income earned by non-residents in India to form the gross domestic product of India.GNP = GDP + NFIA(where NFIA is the net factor income from abroad)

7. Net National Product (NNP): It can be derived by subtracting depreciation allowance from GNP. It can also be found out by adding the net factor income from abroad to the net domestic product.

Factors Determining Size of National IncomeThe size of national income of a country is determined by the following factors:

1. Natural Resources: Nature supplies the main ingredients of wealth production. Countries having sufficient land, fertile soil, necessary minerals, like coal and iron, power resources, etc., have the necessary potential for a high national income. Countries having poor natural resources usually have low national income.

2. Labour: Labour is required for the production of wealth. The workers must be reasonably efficient. There must also be an adequate number of workers. From the standpoint of the per capita income of a country, under population is as bad as overpopulation. In an under populated country, the natural resources are inadequately utilized owing to lack of labour. In an overpopulated country, the per capita income is low because there are too many shares of total income.

3. Capital: Efficient production is impossible without up-to-date machinery and equipment. The national income of underdeveloped countries is low because of lack of capital. The rate of capital formation in a country should be high enough to promote rapid growth.

4. Social and Political Structure: Social and political institutions may retard economic development or accelerate it. In underdeveloped countries there exist many barriers to progress. For example, the cast system and the joint family system in India put obstacles upon enterprise and initiative.

Measuring National Income and OutputNational income can be measured through the following three methods:

1. Output and Production Method: This is also known as ‘Value Added Method’. This method approaches national income from the output side. According to this method, the economy is divided into different sectors such as agriculture, mining, manufacturing, small enterprise, commerce, transport, communication and other services. Then, the gross product is found out by adding up net value of all the production that has taken place in these sectors during a given year.

The aggregate or net values of production of all the industries and sectors of the economy plus the net income from abroad will give us the Gross National Product. By subtracting the total amount of depreciation from figure of gross national product, we get the net national product, or national income.

GNP = Money value of total good and services + income from abroadNI = GNP – Depreciation

2. Income Method: This method approached national income from the distribution side. In other words, this method measures the national income after it has been distributed and appears as income earned or received by individuals of the country. Thus, according to this method, national income is obtained by summing up of the incomes of all individuals in the country.

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National income is calculated by adding up the rent of land, wages and salaries of employees, interest on capital, profits of entrepreneurs and income of self employed people.

NI = Rent + wage + interest + profit + income from abroad

Only incomes earned by owners of primary factors of production are included in national income. Transfer incomes are excluded from national income. Thus, while wages of labourers will be included, pensions of retired workers will be excluded from the national income.

This method of estimating national income has the great advantage of indicating the distribution of national income among different income groups such as landlords, capitalists, workers, etc. Therefore, this is called national income by distributive shares.

Thus GNP according to Income Method = Wages and Salaries + Rent + Interest + Dividends + Undistributed Corporate Profits + Mixed Incomes + Direct Taxes + Indirect Taxes + Depreciation + Net Income from abroad.

3. Expenditure Method: This method is arrived at national income by adding up all the expenditures made on goods and services during a year. Income can be spent either on consumer goods or investment goods. Thus, we can get national income by summing up all consumption expenditure and investment expenditure made by all individuals as well as government of a country during a year.

GNI = Individual Expenditure + Government Expenditure

Hence the gross national product is found by adding up:i) What private individuals spend on consumer goods and services? This is called personal

consumption expenditure;ii) What private business spends on replacement, renewals, and new investment? This is called

gross domestic private investment;iii) What foreign countries spend on the goods and services of the national economy over the

above what this economy spends on the output of the foreign countries, i.e., export minus imports. This is called Net foreign investment; and

iv) What government spends on the purchase of goods and services, i.e., government purchases.

Thus GNP according to Expenditure Method = Private Consumption Expenditure(C) + Gross Domestic Private Investment (I) + Net Foreign Investment (X – M) + Government Expenditure on Goods and Services.

G = C + I + (X – M) + G

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