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Macro Economics PPT

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Macro Economics PPT

  1. 1. Macro Economics
  2. 2. Lecture-1 Introduction to Macro Economics
  3. 3. Learning Outcome To understand the meaning of Macro economics To understand the scope of Macro economics To understand the importance of Macro economics
  4. 4. Micro economics Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets.
  5. 5. Macro Economics According to Shapiro “ Macro Economics deals with the functioning of the economy as a Whole”
  6. 6. Macroeconomics deals with the economy as a whole. It studies the behaviour of economic aggregates such as aggregate income, consumption, investment, and the overall level of prices.
  7. 7. Major Concerns of Macro Economics Aggregate Demand Aggregate Supply Saving Inflation/Deflation Economic growth Unemployment Trade Cycle International Trade Economic Planning (Fiscal policy/Monetary Policy)
  8. 8. Importance of Macro Economics It explains the working of the economy as a whole. It examines the aggregate behaviour of Macro Economics entities like firms, households and the government. It is very useful to the planner for preparing economic plans for the country's development. It is helpful in international comparison.
  9. 9. Its knowledge is indispensable for the policy-makers for formulating macro-economic policies such as monetary policy, fiscal policy, industrial policy, exchange rate policy, income policy, etc. It explains economic dynamism and intricate interrelationship among macroeconomic variable, such as price level, income, output and employment.
  10. 10. Scope of Macro Economics Macro economics studies the concept of national income, its methods and measurement. Macro economics studies the problems related to employment and unemployment. Macro economics studies functions of money and theories relating to it. Banks and other financial institutions are also a part of its study.
  11. 11. Study of problems relating to economic growth or increase in per capita real income forms part of macro economics Macro economics also studies trade among different countries. Theory of international trade, tariff, protection etc. are subjects of great significance to macro economics.
  12. 12.  What is the Difference Between Micro economics and Macro Economics?  Why to study macro economics?  What is the subject matter of Macro economics?  Do you think study of Macro Economic aggregates is useful for an individual firm? Justify your answer with appropriate example.
  13. 13. National Income
  14. 14. Lecture Plan Introduction to National Income Concepts of National Income Real and Nominal GDP Methods for Measuring National Income Uses of National Income Data Difficulties in Measurement of National Income
  15. 15. Learning objective To understand various concepts of national income, like GDP, GNP and NNP. To understand the different methods of measuring national income. To understand the importance of national income calculations. To understand the difficulties involved in the calculation of national income.
  16. 16. National income is defined as the money value of all the final goods and services produced in an economy during an accounting period of time, generally one year. Accounting Year= 1st April-31st March
  17. 17. Concepts of National Income • Gross Domestic Product (GDP) • Gross National Product (GNP) • Net Domestic Product (NDP) • Net National Product (NNP) • Per Capita Income • Disposable Income
  18. 18. Gross Domestic Product  Gross Domestic Product (GDP): GDP is the sum of money values of all final goods and services produced within the domestic territories of a country during an accounting year. GDP= C+I+G+(X-M)  GDP at market price: includes the final value of goods and services also includes indirect taxes and excludes the subsidies given by the government.  GDP at factor cost is the money value of final goods and services based on the cost involved in the process of production. Gross Domestic Product at factor cost = GDP at Market Prices –Indirect Taxes+ Subsidies
  19. 19. Gross National Product Gross National Product (GNP): GNP is the aggregate final output of citizens and businesses of an economy in a year. GNP may be defined as the sum of Gross Domestic Product and Net Factor Income from Abroad (NFIA). GNP = GDP + NFIA GNP = C+I+G+(X-M)+NFIA Net Factor Income from Abroad: difference between income received from abroad for rendering factor services and income paid towards services rendered by foreign nationals in the domestic territory of a country.
  20. 20. Net Domestic Product and Net National Product  Net Domestic Product = GDP-Depreciation  Net National Product (NNP) = GDP–Depreciation +NFIA Or =GNP–Depreciation Thus NNP is the actual addition to a year’s wealth and is the sum of consumption expenditure, government expenditure, net foreign expenditure, and investment, less depreciation, plus net income earned from abroad. = C+I+G+(X–M)–Depreciation + NFIA  NNP at Factor Cost is the sum total of income earned by all the people of the nation, within the national boundaries or abroad  It is also called National Income.  NNP at Factor Cost = NNP at Market Prices –Indirect Taxes+ Subsidies
  21. 21. ? Why should a manager monitor GDP growth?
  22. 22. Per Capital Income and Personal Income Personal income is the total income received by the individuals of a country from all sources before direct taxes in one year. Personal Income = National Income –Undistributed Corporate Profits – Corporate Taxes – Social Security Contributions + Transfer Payments + Interest on Public Debt Personal Disposable Income is the income which can be spent on consumption by individuals and families. Personal Disposable Income = Personal Income – Personal Taxes PopulationTotal IncomeNational =IncomeCapitaPer  Per capita income is the average income of the people of a country in a particular year.
  23. 23. Real GDP and Nominal GDP  Nominal GDP = National income estimated at the prevailing prices is called nominal GDP.  Real GDP=National income measured on the basis of some fixed price, say price prevailing at a particular point of time, or by taking a base year, is known as national income at constant prices, or Real GDP 100 deflatorGDPReal GDPNominal =DeflatorGDP x GDP deflator is the ratio of nominal GDP in a year to real GDP of that year GDP deflator measures the change in prices between the base year and the current year.
  24. 24. ? How far national income of a country a measure of welfare?
  25. 25. ?  What is the Difference between GDP and GNP?  Whether unemployment allowance from the government is to be included in the national income. Why or Why not?  Will the transfer payment be a part of personal income or not?
  26. 26. GDP and Economic Well-Being  GDP is the best single measure of the economic well-being of a society.  GDP per person tells us the income and expenditure of the average person in the economy.
  27. 27. GDP and Economic Well-Being  Higher GDP per person indicates a higher standard of living.  GDP is not a perfect measure of the happiness or quality of life, however.
  28. 28. GDP and Economic Well-Being  Some things that contribute to well-being are not included in GDP. The value of leisure. The value of a clean environment. The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work.
  29. 29. Methods of measuring national income Product (or Output) Method Income Method Expenditure Method
  30. 30. Product (or Output) Method  Product method is also called Value Added Method or Industrial Origin Method  The market value of all the goods and services produced in the country by all the firms across all industries are added up together.
  31. 31. Steps of Value Added or Product Method: Step 1 : Identification and Classification of Producing Enterprises a) Primary Sector: refers to that sector wherein goods are produced by exploiting natural resources
  32. 32. b). Secondary Sector: This sector is also called manufacturing sector. Enterprises of this sector transform one type of good into another type. c) Tertiary Sector: provides services and so is called service sector. It includes trade, hotels, transport and communication, financing, insurance. Service alone are provided by this sector. Public administration and defense and other services also form part of it.
  33. 33. Step 2: Estimation of Value Added • Value added is the difference between value of output of an enterprise and the value of its intermediate consumption (non-factor inputs). • Value added = Value of output- Value of non-factor input • Value of Output= Sales + Change in stock (C.S –O.S)
  34. 34. Value added may be of the following kinds: 1. Gross Value added at Market Price: Gross value added is the difference between value of output and intermediate goods. Gross domestic value added is equal to gross domestic product at market price. 2. Net Value Added at Market Price 3. Net Value Added at Factor Cost
  35. 35. Estimating Value Added Item Producing Enterprise Value of Output (Rs) Cost of Intermediate Goods Value Added Farmer 600 200 400 Flour Mill 800 600 200 Baker 1000 800 200 Shopkeeper 1200 1000 200 Total 3600 2600 1000
  36. 36. Limitations of Product Method  Problem of Double Counting: – unclear distinction between a final and an intermediate product.  Not Applicable to Tertiary Sector: – This method is useful only when output can be measured in physical terms  Exclusion of Non Marketed Products – E.g. outcome of hobby or self consumption  Self Consumption of Output – Producer may consume a part of his production.
  37. 37. Product (or Output) Method  The market value of all the goods and services produced in the country by all the firms across all industries are added up together.  Process – The economy is divided on basis of industries, such as agriculture, fishing, mining and quarrying, large scale manufacturing, small scale manufacturing, electricity, gas, etc. – The physical units of output are interpreted in money terms – The total values added up. (GDP at market price) – The indirect taxes are subtracted and the subsidies are added. (GDP at factor cost) – Net value is calculated by subtracting depreciation from the total value (NDP at factor cost).
  38. 38. Limitations of Product Method  Problem of Double Counting: – unclear distinction between a final and an intermediate product.  Not Applicable to Tertiary Sector: – This method is useful only when output can be measured in physical terms  Exclusion of Non Marketed Products – E.g. outcome of hobby or self consumption  Self Consumption of Output – Producer may consume a part of his production.
  39. 39. Income Method  The net income received by all citizens of a country in a particular year, i.e. total of net rents, net wages, net interest and net profits. (GDP at factor cost).  It is the income earned by the factors of production of a country.  Add the money sent by the citizens of the nation from abroad and deduct the payments made to foreign nationals (individuals and firms) (GNP at factor cost) or Gross National Income (GNI). Process: • Economy is divided on basis of income groups, such as wage/salary earners, rent earners, profit earners etc. • Income of all the groups is added, including income from abroad and undistributed profits. • The income earned by foreigners and transfer payments made in the year are subtracted. GNI = Rent + Wage + Interest +Profit + Net Income from Abroad- Transfer payments
  40. 40. Step-I • Identification and classification of producing enterprises Primary Sector Secondary Sector Tertiary sector
  41. 41. Step-II • Classification of factor income • Factor income: a factor income refers to income earned by a person as a reward for rendering his factor services. • Factor income are only earned incomes. It does not include that income which is not earned.
  42. 42. Step-II • National income= sum of all the factor incomes
  43. 43. Classification of factor incomes • Compensation of employees: wages and salaries, payment in kind, employers contribution to social security schemes, pension on retirement. • Operating surplus: it is the income from the property and entrepreurship. E.g. Rent, interest, profit etc • Mixed income= it refers to the income of the self employed persons using their labor land capital • Net factor income
  44. 44. Precautions while estimating factor income • Transfer payment • Income from illegal activities • Sale proceeds of second hand goods • The sale proceeds of shares and bonds are not included in national income • Windfall gains should not be included. • Imputed rent of owner houses is included in NI • Indirect taxes like sales tax excise duty tend to increase the market price of goods and services. These are included in the estimation of national income at market prices but are not added while calculating national income at factor cost
  45. 45. • Income tax is paid out of compensation of employees. It should not be added separately in the estimation of national income.
  46. 46. Limitations of Income Method Exclusion of non monetary income: Ignores the non- monetized section of economic activities. Exclusion of Non Marketed Services: People undertake a particular activity that are difficult to ascertain in money value. E.g. mother’s services to the family.
  47. 47. Expenditure method • One man’s income is another man’s expenditure • Therefore national income can be arrived at by adding the total expenditure of individual and business firms during a year • Expenditure or outlay on final products takes place in three ways 50
  48. 48. Expenditure method Expenditure or outlay on final products takes place in three ways Expenditure by consumers on goods and services( Consumption Expenditure) Expenditure by entrepreneurs on capital or investment goods (Investment Expenditure) Expenditure by government on consumption and capital goods (Government Expenditure) Net Exports 51
  49. 49. Expenditure method The formula for this method is Y = C + I + G +(X-M) • Here Y stands for total expenditure • C stands for consumption expenditure • I stands for investment expenditure • G stands for Government expenditure • (X-M) Difference between exports and imports 52
  50. 50. Limitations Neglects Barter System Ignores over consumption Affected by Inflation 53
  51. 51. Difficulties in the computation of National Income In backward economies like India, particularly in the rural sector, the cultivators and small producers are illiterate and they do not keep books of account. This is a serious difficulty in the calculation of national income Avoidance of double counting becomes complicated Existence of Non-monetized sector is dominant The village money lenders maintain absolute secrecy of their transactions 54
  52. 52. Uses of National Income Data National income is the most dependable indicator of a country’s economic health. Difference between GDP and GNP indicates the contribution of net income earned abroad Necessary for Economic planning: useful aid in judging which sectors should be given more emphasis A measure of economic welfare. • higher aggregate production implies more and more goods and services being available to people Helps in determining the regional disparities, income inequality and level of poverty in a country. Helps in comparing the situations of economic growth in two different countries.
  53. 53. Summary  GDP is the sum of money values of all final goods and services produced within the domestic territories of a country during an accounting year. It can be measured at current or constant prices.  GNP is the aggregate final output of citizens and businesses of an economy in one year. NNP is GNP less depreciation.  The average income of the people of a country in a particular year is per capita income for that year.  National income can be measured by product method, income method and expenditure method.  National income accounting data are of utmost importance for the economy of any country; such data reveal the aggregate production of the economy and also help to determine the total expenditure and total income of that country.  Difficulties in measuring national income include multiple counting, exclusion of non market transacted services, self consumption of output, inflation or deflation, confusion about informal sector, etc.  National income is considered as a measure of economic welfare. As national income rises, the aggregate production of goods and services rises. Therefore, there is a positive relation between increase in national income and welfare.
  54. 54. ??????????????
  55. 55. ? Consider an economy that produces only three types of goods: A, B and C. In the base year (a few year ago), the production and price data were as follows: Fruit Quantity Price A 3,ooo $2 B 6,000 $ 3 C 8,000 $ 4
  56. 56. In the current year the production and price data are given as follows Fruit Quantity Price A 4,000 $ 3 B 14,000 $ 2 C 32,000 $4
  57. 57. Find the nominal GDP and real GDP. Find the GDP deflator for the current year and the base year. By what percentage does the price level change from base year to current year?
  58. 58. Circular Flow of Income
  59. 59. Learning Objectives To explain the circular flow of economic activity and income: Two- Sector Model Three- Sector Model Four- Sector Model Injections and Leakages in the circular flow of economic activity.
  60. 60. Circular Flow of Economic Activities and Income The simple model of the circular flow assumes two players Firms • Produce and supply the goods and services. • Require various factors of production to produce these goods and services. Households • Include a set of individuals living in the same house • Take joint decision about the consumption of goods and services. • Provide services in terms of factor inputs to the firms • Get paid for these services by firms which households spend on consumption. • Money flows from firms to households as factor payments and from households to firms as expenditure on goods and services. • It is a circular flow of money or income
  61. 61. Circular Flow of Income (Two Sector Economy) (Wages, Rent, Interest and Profits) Factor Payments (Y) Consumption expenditure (C) In the equilibrium Y=C+S=C+I=E=O FirmsHouseholds Goods and Services (O) Factor Inputs Financial Market Investment (I) Savings (S)
  62. 62. Circular Flow of Economic Activities and Income • Value of output produced (Y) = value of output sold (O) • Value of output sold = Sum of consumption expenditure (C) and investment expenditure (I). Y=O=C+I=E……(1) • Income is either consumed or saved (S). Y=C+S………….(2) C+I=Y=C+S………(3) • Therefore: I = S…………(4) • Savings are withdrawal of money from the circular flow • Investment is injection of money into the circular flow • For equilibrium savings should be equal to investments • Hence Y=O=E
  63. 63. Circular Flow of Income (Four Sector Economy) The third sector is Government (G) • Government Spending – On provision of public utility goods and services. – Provides salaries to the households – Pays to firms for purchases of goods and services • Government Revenue – Households and firms pay various taxes and other payments and provide factor inputs to the government. – Government borrows from the financial market to fill revenue gap. The fourth sector is the external sector • Imports (M): Outflow of income occurs when the domestic firms buy goods and services from foreign ones. • Exports (X): Inflow of income takes place when foreign firms buy goods and services from domestic ones
  64. 64. Circular Flow of Income (Four Sector Economy) Government (G) Remittances for purchases Foreign Nations (X-M) Salaries Taxes Taxes Consumption Expenditure Financial Market Investment (I) Savings (S) FirmsHouseholds Factor Inputs Goods (O) Factor Payments Imports (M) Imports (M) Exports (X) Exports (X) National Income=C+I+G+(X-M)
  65. 65. Circular Flow of Income (Four Sector Economy) • National income includes expenditures on consumption investment, government and net of exports (X-M) National Income=C+I+G+(X-M) • Since national income can either be consumed, or saved, or paid as tax to the government: C+I+G+(X-M)=C+S+T I+G+(X-M) =S+T • Sum of private investment and expenditure on net exports is equal to the sum of savings and tax revenue. Thus: I+G+X =S+T+M • Therefore, W=J • At equilibrium, total injections are equal to total withdrawals.
  66. 66. Mention two important leakages in the circular flow of national income. Mention two important injections in the circular flow of national income Difference between the 2 and 3 sector model.
  67. 67. 71 The classical model of Income output and employment
  68. 68. Learning Objective • In this topic we will discuss about how nations decide their Income, Output and Employment level on the basis of the following theories • Classical theory • Keynes Theory 72
  69. 69. Classical Theory • Full employment is a natural phenomena. • In a case of unemployment , demand for labor is less than their supply. Due to low demand, money wages of the laborers will fall. Low wage rate, in its turn, will raise the demand for laborers. As a consequence, unemployment is removed and full employment is restored. 73
  70. 70. Absence of Involuntary Unemployment • Voluntary unemployment • Frictional unemployment • Seasonal unemployment • Technical unemployment • Disguised unemployment 74
  71. 71. Questions • Meaning of Full employment • Different types of unemployment(cyclical, seasonal, voluntary and Involuntary) 75
  72. 72. 76 The classical macro model (Assumptions) •Laissez faire policy •Equality between saving and investment •Closed economy •Flexibility of prices, wage and rate of interest. •Rational man •Perfect competition •Constant technology •Law of diminishing returns
  73. 73. 77 The real economy. The supply side of the real economy • factors determining the economy’s total supply of goods and services – i.e. • how are labor, land and capital owners compensated The demand side of the real economy • factors determining the demand for goods and services, by households, firms and the govt. Equilibrium • what ensures that total supply = total demand; how equilibrium in the goods market is achieved
  74. 74. 78 The circular flow model with government in classical theory
  75. 75. 79 The supply side of the real sector the economy’s total supply of goods and services/ total income is determined by, •the economy’s supply of inputs/factors of production •available technology factors of production: K = capital, tools, machines, and structures used in production L = labor, the physical and mental efforts of workers N = land, All non-renewable resources available technology: the form of the production function
  76. 76. Determination of income and employment • According to classical economists income and employment is determined by production function and equilibrium of demand for and supply of labor. 80
  77. 77. 81 The production function and its properties: • represented as Y = F (K, L), N being fixed is ignored • shows how much output (Y ) the economy can produce from K units of capital and L units of labor. • F reflects the economy’s level of technology – technological progress affects F. • In short period capital and technology remains constant and employment can be increased by increasing labor only and the result is diminishing returns to output.
  78. 78. 82 Y output Diminishing marginal returns and the production function L labor F K L( , ) 1 MPL 1 MPL 1 MPL As more labor is added, MPL  Slope of the production function equals MPL
  79. 79. 83 Reasons for the diminishing Returns 1. Technology is given. 2. The economy’s supplies of capital and labor are fixed at and K K L L Output is determined by the fixed factor supplies and the fixed state of technology: , ( )Y F K L
  80. 80. 84 How factor prices are determined - labor Factor markets are assumed to be competitive. Hence, factor prices are determined by supply and demand of factor services. Supply of each factor=Demand for factor inputs
  81. 81. Demand for labor • Demand for labor is diminishing function of wage. It means , with rise in wage rate demand for labor falls and with fall in wage rate demand for labor rises. • W= MRP=PxMPP • W/p=MPP 85
  82. 82. Supply of labor • Supply of labor therefore increases with rise in real wage and falls with fall in wage rate. 86
  83. 83. 87 MPL and the demand for labor – the demand curve is the same as the MPL curve Each firm hires labor up to the point where MPL = W/P Units of output Units of labor, L MPL, Labor demand Real wage Quantity of labor demanded
  84. 84. Says law of market Supply creates its own demand • Barter system • Monetary system 88
  85. 85. Flexibility of wages (Equilibrium in factor market) • Demand and supply of labor through wage rate determines the equilibrium 89
  86. 86. Flexibility in Rate of interest and Equilibrium in money market • I=f(r) • S=f(r) • In money market • S=I • (I-investment, S-Saving) • in this way there is equilibrium in the aggregate demand and supply. 90
  87. 87. Flexibility of prices level or equilibrium in money market • Aggregate demand=Aggregate supply MV=PT M-money supply V-velocity of money P-price level T-trade transactions P=f(Money supply) 91
  88. 88. Questions • Meaning of Laissez faire • Demand for Labor and supply of labor • Real Wages Vs Nominal wages • Investment and saving function 92
  89. 89. Points to remember in Classical Model • Y=f(Employment) • Demand for labor=(w/p) • Supply of labor =(w/p) • S=f(r) • I= f(r) • MV=PT 93
  90. 90. Criticism • Says law not applicable in current scenario • Employment can not increased by wage cut • Possibility of underemplymentgn • Absence of automatic adjustment • Ignores the role of short run peroid • Equality between saving and investment • Rejection of laissez policy • Supplied sided theory 94
  91. 91. Keynesian Theory of Income , output and employment 95
  92. 92. The General Theory 1. If the consumer is an economic optimizer, he/she must be unable to buy the goods they planned to buy because of some kind of constraint—risk, convention, social institutions, cash, or ...? a) According to the classical model, the consumer has insatiable wants. b) The money value of the incomes received must be equal to the value of the output produced. c) So how can unsold goods pile up in warehouses, causing firms to lay off workers? 96
  93. 93. Keynesian Thought on income, output and employment • According to Keynes- there is not always full employment in a developed economy as a matter of fact there can be unemployment in the economy. • The main reason for the unemployment is the is deficiency of aggregate demand. • Unemployment can be removed by increasing the aggregate demand in the economy. 97
  94. 94. • According to classical thought the problem of unemployment can be solve by lowering the wage rate, • According to Keynes the problem of unemployment can be solved by increasing the aggregate demand. 98
  95. 95. Assumptions or postulates of Keynesian Model • Closed economy • Diminishing marginal productivity • Labor is the only factor of production • No time lag • Saving and investment • Two sector model of the goods market in the economy (no government sector, no foreign trade). 99
  96. 96. 100
  97. 97. 2. Say’s Law cannot hold. (“Supply creates its own demand.”) a) If spending constraints are in effect, then there will be a difference between (unlimited) demand and “effective demand”. b) Actual (effective) demand will usually be “deficient” to purchase total output. c) Effective Demand(AD=AS) d) Aggregate Demand e) Aggregate Supply 101
  98. 98. Therefore, consumption depends primarily upon income, not interest rates. – C  C(r), but rather C = C(Y) – “People don’t change their standard of living simply because the interest rate changes a few points.” – ‘The fundamental psychological law, upon which we are entitled to depend with great confidence . . . is that men are disposed, as a rule and on average, to increase their consumption as their income increases, but not by as much as the increase in their income’ 102
  99. 99. • The Consumption Function: the key to Keynes • Consumption depends on the level of DISPOSABLE INCOME (disposable personal income = income - taxes = Y - T) • Some consumption is autonomous (= “independent” of DPI): it may depend on other factors such as wealth or stock values. (even at zero income, Bill Gates would consume something) • The consumption function proposed by Keynes is: • C = C0 + Cy ( Y - T) • C0 = Autonomous consumption • Cy = Marginal propensity to consume • The marginal propensity to consume plays a central role in the Keynesian system. Keep your eye on the MPC in the following slides. 103
  100. 100. Questions • Consumption Function • Marginal Propensity to consume • Average Propensity to consume 104
  101. 101. The Keynesian system: Planned and actual investment • Investment has three components: • Plant and equipment -- drill presses, factory buildings, etc. • Residential investment -- new housing construction • Inventory investment -- Change in Business Inventories • The first two are consciously planned (although plans can change, and typically do during a recession); • inventory investment can be unplanned -- if a store fails to sell what it had expected to, it winds up with more inventory than it had expected. • Stores with unplanned inventory investment will cut back on orders -- resulting in reduced production at the factory, layoffs and recession. 105
  102. 102. • The same can be explained with the help of regression line. • The Keynesian model: National income identity and equilibrium • The National income identity is: • Y = C + I + G + NX • The Keynesian equilibrium equation is: • Y = C0 + Cy ( Y - T) + Ip + G + NX • Notice that C has been replaced by the consumption function, and investment by planned investment. 106
  103. 103. State of Equilibrium 107
  104. 104. Keynes model in nutshell 108
  105. 105. Questions • Meaning of full employment • Underemployment • Consumption Function • Autonomous consumption • Types of Investment 109
  106. 106. Learning Outcome In this unit students have learnt about the Classical Model (Say’s law, income and output determination) Keynsian model( Effective demand, Psychological law of consumption, Investment, and output determination) 110
  107. 107. Consumption and Investment
  108. 108. LEARNING OBJECTIVE • To understand the basic of consumption. • To understand the different types of consumption. • To understand the equation of consumption. Gottheil - Principles of Economics, 4e 112
  109. 109. Keynesian theory of income • Simple economy model- two sector model ( household, firms sector) • Closed economy model- three sector model ( household, firms and government sector) • Open economy model- four sector model ( household, firms , government and foreign sector) Gottheil - Principles of Economics, 4e 113
  110. 110. Consumption function • The amount of money people spend out of national income on the purchase of the goods and services for the direct satisfaction of their wants is called aggregate consumption expenditure or consumption. Example: Total income of economy- 5000 cr. people spend -4000 cr. on goods and service Gottheil - Principles of Economics, 4e 114
  111. 111. Consumption Function • The most important function of consumption is income . • It means consumption is a function of (determined by ) income. Relationship between consumption and income- C= f (Y) Where, C= consumption f= function Y= incomeGottheil - Principles of Economics, 4e 115
  112. 112. • In economics, the consumption function is a single mathematical function used to express consumer spending. It was developed by John Maynard Keynes and detailed most famously in his book The General Theory of Employment, Interest, and Money. The function is used to calculate the amount of total consumption in an economy. It is made up of autonomous consumption that is not influenced by current income and induced consumption that is influenced by the economy's income level. This function can be written in a variety of ways, an example being . This is probably the most simplistic form of the consumption function.Gottheil - Principles of Economics, 4e 116
  113. 113. • The simple consumption function is shown as : • C= C0 + C1Y where • C = total consumption, • c0 = autonomous consumption (c0 > 0), • c1 is the marginal propensity to consume (i.e the induced consumption) (0 < c1 < 1), and • Y = disposable income (income after government intervention – benefits, taxes and transfer payments – or Y + (G – T)). Gottheil - Principles of Economics, 4e 117
  114. 114. • Induced consumption is consumption expenditure by households on goods and services that varies with income. Such consumption is considered induced by income when expenditure on these consumables varies as income changes. Induced consumption contrasts with autonomous consumption, which is expenditures that do not vary with income. • For example, expenditure on a consumable that is considered a normal good would be considered to be induced. Gottheil - Principles of Economics, 4e 118
  115. 115. Definition of 'Autonomous Consumption • The minimum level of consumption that would still exist even if a consumer had absolutely no income. This contrasts with discretionary consumption, which is used for non-essential items. When combined with discretionary income, a person's autonomous consumption determines his or her real income, or real wages Gottheil - Principles of Economics, 4e 119
  116. 116. • Certain bills and expenses are deemed to be autonomous (or independent), such as electricity, food and rent, because these expenses cannot ever be entirely eliminated whether you have money or not. Even in the worst-case financial scenario, you would still need to eat and have a place to live. If a consumer's income were to disappear for a time, he or she would have to dip into savings or increase debt in order to pay these expenses, which is also known as being in a "dissaving mode Gottheil - Principles of Economics, 4e 120
  117. 117. Average Propensity To Consume • The average propensity to consume (APC) refers to the percentage of income that is spent on goods and services rather than on savings. One can determine the percentage of income spent by dividing the average household consumption (what is spent) by the average household income (what is earned). The inverse of the average propensity to consume is the average propensity to save (APS) Gottheil - Principles of Economics, 4e 121
  118. 118. AVERAGE PROPENSITY TO CONSUME • Economic periods where consumers are spending can boost the economy: more goods are purchased (high demand for goods and services); keeping more people employed and more businesses open. Periods where the tendency to save is increased can have a negative effect on the economy as people purchase fewer goods and services (low demand for goods and services), resulting in fewer jobs and increased business closures. Gottheil - Principles of Economics, 4e 122
  119. 119. APC • The average propensity to consume is the ratio of consumption to income. It can be expressed as under. • For example, if total income is Rs 500 crores and total consumption is Rs 200 crores, then: Gottheil - Principles of Economics, 4e 123 Y C APC  4.0 500 200 orAPC 
  120. 120. MARGINAL PROPENSITY TO CONSUME(MPC) Definition of 'Marginal Propensity To Consume - MPC' • A component of Keynesian theory, MPC represents the proportion of an aggregate raise in pay that is spent on the consumption of goods and services, as opposed to being saved. Gottheil - Principles of Economics, 4e 124
  121. 121. MPC • The ratio of change in consumption to change in income is known as marginal propensity to consume. Symbolically, change (Δ) in the income is denoted as ΔY (read as delta Y) and change in consumption as Δ C. Hence, Gottheil - Principles of Economics, 4e 125 Y C MPC   
  122. 122. Example Suppose you receive a bonus with your paycheck, and it's $500 on top of your normal annual earnings. You suddenly have $500 more in income than you did before. If you decide to spend $400 of this marginal increase in income on a new business suit, your marginal propensity to consume will be 0.8 ($400 divided by $500). Gottheil - Principles of Economics, 4e 126
  123. 123. Characteristics of MPC • It is always positive • MPC is greater than zero but less than one. • The value of MPC always greater than zero because Option expenditure must increase with the increase in income, less than one, because the total increase in income is not consumed a part of it is saved. Thus this characteristic can be symbolically stated as 0<MPC<I where MPC is always positive but less than one Gottheil - Principles of Economics, 4e 127
  124. 124. • MPC of the poor class is higher • Constant MPC in the long run • Falling MPC in the short run • MPC can be greater than one in case of abnormal conditions. Gottheil - Principles of Economics, 4e 128
  125. 125. Causes of the fall in MPC with the increase in Income • Fulfilment of basic and important needs • Constant habits in the short period • Consumption expenditure and level of income in the past • Uncertainty of future Gottheil - Principles of Economics, 4e 129
  126. 126. • Relation between APC and MPC • APC and MPC are closely related to each other. • (1) APC refers to the ratio of absolute consumption absolute income at a particular point of time. On the other hand MP represents the ratio of change in consumption to change in income; MPC is the rate of change in APC. • (2) As income rises both APC and MPC declines, but I lie decline in MPC is more than the decline in APC, as income falls both APC and MPC rises but APC rises at a slower, rate than MPC. • (3) MPC is useful in short-period where as APC is useful in long period. In the short period there is no change in MPC and MPC<APC. In the long period APC=MPC. Gottheil - Principles of Economics, 4e 130
  127. 127. RELATION BETWEEN MPC AND APC • S+C=Y S + C = Y S / Y+ C/ Y = Y/ Y =1 MPS+ MPC=1 MPS=1-MPC Gottheil - Principles of Economics, 4e 131
  128. 128. Question- The consumption function shows the relationship between consumption and…… (1) Savings (2) Income (3) Demand (4) Supply Question- which of the following represents the consumption function? (1) C=f (Y) (2) Y= f (C) (3) C=f (1/Y) (4) C= f (C/Y) Gottheil - Principles of Economics, 4e 132
  129. 129. TABLE OF PROPENSITY TO CONSUME INCOME CONSUMPTION SAVING (RS CR.) 0 10 -10 100 100 0 200 190 10 300 280 20 400 370 30 500 460 40 Gottheil - Principles of Economics, 4e 133
  131. 131. FEATURES OF PROPENSITY TO CONSUME • Psychological concept • Unequal propensity to consume • Income and employment depend on propensity to consume • Consumption in the short run • Long run consumption function Gottheil - Principles of Economics, 4e 135
  132. 132. DETRMINANTS OF PROPENSITY TO CONSUME • It is of two types (1)Subjective factors (2)Objective factors Gottheil - Principles of Economics, 4e 136
  133. 133. Subjective factors (i) individual factors • Farsightedness-future is uncertain • Economic independence • Occupational motive • Miserliness- niggardly by nature • Status in the society • Precautionary motive Gottheil - Principles of Economics, 4e 137
  134. 134. (ii) Business factors • Extension of business • Liquidity preference • Modernization-save more to install new machines Gottheil - Principles of Economics, 4e 138
  135. 135. Objective factors • Change in money income • Change in real income • Change in distribution of income • Financial policy of the corporations • Change in expectations • Fiscal policy • Change in the rate of interest • Wages • Liquid assets.Gottheil - Principles of Economics, 4e 139
  136. 136. • Social security • Attraction of new products • Credit facilities • Change in fashion • Change in population • Demonstration effect
  137. 137. PROPENSITY TO SAVE/SAVING FUNCTION • The relationship between the change in income and the change in saving is the propensity to save. • We can also express propensity to save in two different ways. These are the following: a) The average propensity to save (APS), and b) The marginal propensity to save (MPS). Gottheil - Principles of Economics, 4e 141
  138. 138. The Average Propensity to Save (APS) • The average propensity to save is the ratio of total savings to total income. Thus, where, S = saving and Y = income. The Marginal Propensity to Save (MPS) Marginal propensity to save is the ratio of change in saving to change in income. Gottheil - Principles of Economics, 4e 142 Y S APS 
  139. 139. Gottheil - Principles of Economics, 4e 143 Y S MPS    We know that MPC + MPS = 1. Therefore, MPS = 1- MPC or Y C MPS   1
  141. 141. • Question- if the MPC is 0.7, what is the marginal propensity to save in a two-sector model? • Question- if MPS=0.3,it means that a 100 rs rise in disposable income leads to ………… rise in consumption. • Question-…………represents the pr0portion of each income level that a household will spend on consumption. Gottheil - Principles of Economics, 4e 145
  142. 142. CONSUMPTION FUNCTION:C= 1000 + 0.8Y) DISPOSA BLE INCOME AUTONO MUS CONSUMP TION INDUCED TOTAL SAVINGS APC APS 3000 1000 4000 1000 5000 1000 6000 1000 7000 1000 8000 1000 9000 1000 Gottheil - Principles of Economics, 4e 146
  143. 143. Investment
  144. 144. Investment • Meaning • Different types of investment • Factors affecting investment • Concept of multiplier • Types of multiplier • Uses of multiplier • Limitations of multiplier
  145. 145. Learning outcome • By studying this student will come to know about the concept of investment and about the factors affecting investment decisions. • Will be able to know the importance of ROI and MEC in determining the level of investment.
  146. 146. Investment • Investment in general sense means using or spending money on acquiring physical or financial assets and skills that yield a return over time. • Investment conceptually refers to addition made to the physical stock of capital
  147. 147. Difference between capital and Investment • Capital is a stock concept • It refers to capital accumulated over a period of time • Investment is a flow concept • It is measured per unit of time, generally one year.
  148. 148. Propensity to Invest • An increase in income directly related to an increase investment. The ratio in which income changes to change in investment is called propensity to invest PI = I / Y Average Propensity to Consume API = I / Y Marginal Propensity to Consume= $I /$Y
  149. 149. Quiz 1. Net addition to existing capital stock is called? 2. Why investment is important? 3. Ratio of change in investment to change in income is called? 4. Ratio of consumption to income is called?
  150. 150. Types of investment • Induced investment • Autonomous investment • Gross and Net investment • Financial and real investment • Planned and unplanned investment
  151. 151. Autonomous Investment • Investment which does not change with the changes in income level. • Even if the income is low, the autonomous, Investment remains the same. • Investment made on houses, roads, public buildings and other parts of Infrastructure etc.
  152. 152. Induced Investment • Investment which changes with the changes in the income level. • Induced Investment is positively related to the income level.
  153. 153. Financial Investment • Investment made in buying financial instruments such as new shares, bonds, securities, etc. • Money invested for buying of new shares and bonds as well as debentures have a positive impact on employment level, production and economic growth.
  154. 154. Real Investment • Investment made in new plant and equipment, construction of public utilities like schools, roads and railways, etc. • Real investment has a direct impact on employment generation, economic growth, etc.
  155. 155. Planned Investment • Investment made with a plan in several sectors of the economy with specific objectives. • Intended Investment because an investor while making investment make a concrete plan of his investment.
  156. 156. Unplanned Investment • Investment done without any planning is called as an Unplanned or Unintended Investment. • In unplanned type of investment, investors make investment randomly without making any concrete plans.
  157. 157. Gross Investment • The total amount of money spent for creation of new capital assets like Plant and Machinery, Factory Building, etc. • It is the total expenditure made on new capital assets in a period
  158. 158. Net Investment • Net Investment is Gross Investment less (minus) Capital Consumption (Depreciation) during a period of time, usually a year. • A part of the investment is meant for depreciation of the capital asset or for replacing a worn-out capital asset.
  159. 159. Quiz • Investment made by government and departmental undertakings is called ? • Which investment does not depend upon changes in national income ? • Which investment varies with changes in the level of national income ? • Why is planned investment necessary?
  160. 160. Factors affecting investment • Size of the market • Expectations of costs and prices in the future • Change in income • Taxation • Technology • Existing stock of capital asset • Change in ROI • Population
  161. 161. • Expected increase in Aggregate Income • Political Climate • Foreign Trade • Price level
  162. 162. Profitability of investment depends upon • MEC • Rate of Interest
  163. 163. MEC • It refers to productivity of capital. It may be defined as the highest rate of return over cost accruing from an additional unit of capital asset. • Also it refers to the yield expected from a new unit of capital.
  164. 164. MEC • MEC can be calculated by deducting from the total income of the capital assets its cost. • Suppose the price of a machine is 20000, the duration of the machine is 10 years. during the 10 years it is expected to yield an income of 40000. the total profits= 40000-20000=20000 (over a period of 10 years) • Average profits= 20000/10= 2000 • MEC= 2000/20000*100= 10%
  165. 165. MEC depends upon 1. Prospective yield from the capital asset 2. The supply price of the capital asset.
  166. 166. Prospective yield • Prospective yield of an asset is the aggregate net return from it during its whole life. • In order to determine Prospective yield annual return of the capital is worked out. • Aggregate of annual return expected from a capital asset over its life-time, is called Prospective yield • Changes in the price prices likely to change Prospective yield
  167. 167. Prospective yield • Prospective yield can be expressed as • Py= Q1+Q2+Q3+Q4+…………..+Qn • Q1, Q2, Q3, Q4,…………..,Qn ( net revenue received in the first, second, third and fourth year)
  168. 168. Supply price • The other factor affecting the MEC is the is its supply price. ( is also known as replacement Cost) • A capital asset actually remains operative more than one year.
  169. 169. Supply price • Py1= SP (1+m) SP- supply price, m= MEC, py prospective yield SP= Py1/ (1+m) Py2= Py1( 1+m) {Py1= SP (1+m)} Py2= SP( 1+m)2 SP= py2/ (1+m)2 SP= py1/ (1+m)+ py2/(1+m)2+……. SP= py/ (1+m)n
  170. 170. MEC and Investment • Generally it is experienced that as the amount of investment goes on increasing, MEC of capital goes on decreasing Investment MEC 50 12% 100 10% 150 8% 200 6%
  171. 171. Relationship between MEC and ROI Relationship of MEC & ROI Effect on Investment MEC > ROI Favorable MEC= ROI Neutral MEC<ROI Unfavorable
  172. 172. Quiz • Under what conditions would you go for investment? • Productivity of capital is referred to as ? • How can taxation decision effect investment decision?
  173. 173. Multiplier
  174. 174. Learning outcome • To understand how change in investment will affect change in income • To understand how MPC and MPS affects the working of the multiplier
  175. 175. In Economics: It is a change in Income (∆Y) as a result of change in Investment (∆I). The number of times Income exceeds Investment is called Multiplier (K).
  176. 176. Change in Investment (∆I) Change in Income (∆Y) Change in Consumption (∆C) Change in Income (∆Y)
  177. 177. This Concept is given by Keynes; and it defines the Relationship between Income and Investment; so, its also known as Investment Multiplier.
  178. 178. Types of Multiplier: • Employment Multiplier K1 = N2 N1 N2 – Total Employment N1 – Primary Employment • Foreign Trade Multiplier Kf = ∆Y ∆E Y – Change in Total Income E – Change in Export Income
  179. 179. Size of Multiplier: • MPC • MPS • Larger the MPC, Larger the Multiplier • Larger the MPS, Smaller the Multiplier
  180. 180. Relationship with MPC: K = ∆Y ∆I Y = C + I ∆Y = ∆C + ∆I ∆I = ∆Y - ∆C K = ∆Y ∆Y - ∆C
  181. 181. ∆Y K = ∆Y ∆Y - ∆C ∆Y ∆Y MPC = ∆C ∆Y 1 1 - ∆C ∆Y K = 1 1 - MPC
  182. 182. Relationship with MPS: MPS = ∆S ∆Y ∆Y = ∆C + ∆I (Ag. Demand) ∆Y = ∆C + ∆S (Ag. Supply) Dividing by ∆Y ∆Y K = ∆Y ∆S ∆Y ∆C + ∆S = ∆C + ∆I => ∆I = ∆S K = ∆Y => K = ∆Y ∆I ∆S 1 1 ∆S = MPS ∆Y
  183. 183. • Larger the MPC, Larger the Multiplier ( direct relationship between MPC and K) • Larger the MPS, Smaller the Multiplier (inverse relationship between MPS and K)
  184. 184. QUIZ • What is the importance of multiplier? • Who gave the concept of multiplier? • What is the difference between foreign trade multiplier and investment multiplier? • How is multiplier related to MPC and MPS?
  185. 185. Assumptions • Consumption is a function of current income • There is no time lag • There is no change in prices • The economy is closed unaffected by foreign influences • There is less than full employment level in the economy • The marginal propensity to consume is constant
  186. 186. Working of multiplier • Static Multiplier • Dynamic Multiplier • i. Forward Multiplier • Ii.Backward Multiplier
  187. 187. Importance of Multiplier • Income Generation • Full Employment • Public Investment • Trade Cycles • Inflation and deflation • State Intervention • Deficit finanicing
  188. 188. Leakages' of multiplier • Idle Saving • Imports • Debt cancellation • Purchase of old stocks • Hoarding • Taxes • High liquidity preference • Undistributed profits • Excess stock of capital goods
  189. 189. Relevance of multiplier to developing countries • Keynesian multiplier is based on following assumption • Involuntary unemployment • Industrialized economy • Excess capacity in consumption goods industries • Comparatively elastic supply of raw material and working capital
  190. 190. quiz • What are the limitations of the concept of multiplier? • How the concept of multiplier is useful for income generation? • What is the difference between static and dynamic multiplier?
  191. 191. MONEY
  192. 192.  To understand the economics definition of money;  To understand the various concepts of money;  To understand how money can be used for different purposes;  To understand how RBI measures the money supply  To understand what are the important factors that affect the demand for money LEARNING OBJECTIVES
  194. 194.  In general, money means currency notes and coins.  However, in economics, the term money is used for much wider sense and is defined differently by different economists.  Conceptually, money can be defined as any commodity that is generally accepted as a medium of exchange and measure of value. Meaning
  195. 195.  H. G. Johnson has classified the approaches to the definition of money under the following categories:  The Conventional Approach  The Chicago Approach  The Central Bank Approach  The Gurley-Shaw Approach Definition
  196. 196.  Most oldest and widely accepted approach.  Stresses mainly one the basic functions of money i.e. medium of exchange and measure of value.  Any commodity that functions as a medium of exchange and measure of value is money.  It includes barter system (Exchanging commodities for commodities)  However, this system had some problems. THE CONVENTIONAL APPROACH
  197. 197.  Coined by Milton Friedman and his associates in Chicago University.  They extended the conventional definition by adding the time deposits in it.  Thus money include (i) Currency, (ii) Demand Deposits, (iii) Time Deposits.  They included the time deposits for two reasons:  Time deposits have direct correlation with money supply and with GNP  Time deposits remain unavailable for transaction only THE CHICAGO APPROACH
  198. 198.  This approach is attributed to John G. Gurley and Edward S. Shaw.  They regarded the liquid assets held by financial intermediaries and liabilities of non-bank intermediaries as close substitute for money.  Intermediaries provide substitute for money as a store of value.  Thus, they gave wider definition of money based on liquidity which includes bonds, insurance reserves, pension funds, savings and loan shares. The Gurley-Shaw Approach
  199. 199.  The central banks take still a wider definition of money. They view all available means of payment and credit flows as money.  Thus, money supply constitutes currency plus all ‘realizable assets’ i.e. the assets which have perfect or near perfect liquidity.  Depending upon objectives of monetary policy and policy targets central banks make and use different measures of money supply, referred to as M1, M2, M3 and M4. The Central Bank Approach
  200. 200.  To conclude, money cannot be described on the basis of matter it is made of. It can be defined in terms of its functions:  ‘Any thing which is used for medium of exchange, measure of value, store of value and standard of deferred payments’. Conclusion:
  202. 202.  The following couplet brings out the major functions of money: “Money is a matter of functions four: A medium, a measure, a standard, a store”  Kinley classified the functions of money into following three categories:  Primary and Main Functions  Secondary and Subsidiary Functions  Contingent Functions Functions of Money
  203. 203.  Primary Functions:  Medium of Exchange  Measure of Value  Secondary Functions:  Standard of Deferred Payments  Store of Value Functions of Money
  204. 204.  Contingent Functions:  Basis of Credit Creation  Maximum Satisfaction  Distribution of National Income  Increase in the Liquidity of Capital  Bearer of option Functions of Money
  205. 205.  Money can be defined as any commodity that is generally accepted as a _______________.  What are the four approaches to money?  Chicago approach added which factor to money?  What are the secondary functions of money? QUESTIONS
  206. 206. MONEY CONCEPTS
  207. 207.  Money has been used since time immemorial. It has only been changing form over time.  Since its evolution money took several forms as:  Commodity Money  Metallic Money  Paper Money  Bank Deposits  Near Money CONCEPTS OF MONEY
  208. 208.  Commodity Money:  Under this, the people used commodities or animals as money.  Demerits:  Commodities are not homogeneous  Supply of commodities could be abruptly change.  Hoarding was not possible  Lack of portability CONCEPTS OF MONEY
  209. 209.  Metallic Money:  It was introduced to meet the difficulties of commodity money. Different metals, such as iron, gold, brass, silver, copper, etc. were used to make coins.  Demerits:  Supply of these coins could not always be adjusted to their demand.  Very heavy.  Continuous use of metal coins resulted in lot of depreciation. CONCEPTS OF MONEY
  210. 210.  Paper Money:  In past traders, used to deposit their metallic money with money lenders and obtain certificate of deposit. These certificates were used as money. Thus, this led to the origin of paper money.  These days the paper money is issued only by the Central Bank of the country.  Initially, the paper money was convertible into gold or gold coins, but these days it is inconvertible in all countries of the world. CONCEPTS OF MONEY
  211. 211.  Paper Money:  Merits:  Not an expensive system of currency  Supply can easily be adjusted according to the need  Easily transferrable  Demerits:  Always a possibility of excessive supply of paper money which leads to inflation in the economy and fall in the value of the currency. CONCEPTS OF MONEY
  212. 212.  Bank Deposits:  There are three types of bank deposits:  Current Account Deposits  Saving Deposits  Time Deposits  Current A/C deposits are widely referred to as demand deposits which are also known as ‘bank money’ and ‘credit money’.  Conventional approach included only demand deposits in the definition of money but Chicago approach treats saving and time deposits as close substitute to demand deposits. CONCEPTS OF MONEY
  213. 213.  Near Money:  Near money refers to those promissory notes which can be easily converted into money, but can not be used as money to buy goods and services.  Near money includes treasury bills, bonds, securities, fixed deposits in banks, insurance policies, etc.  Thus, compared to paper money near money is less liquid. CONCEPTS OF MONEY
  214. 214.  Fiat Paper Money:  It is a kind of inconvertible paper money issued by the state under emergency conditions. That’s why, it is also known as emergency money.  Fiat money is not backed up by any reserve.  Since this money is not backed up by any reserves, government issued it in limited quantity.  German Mark issued during World War I and the entire paper money during World War II were a sort of fiat money.  It is different from inconvertible paper money because the latter is backed up by a reserve fund. FIAT PAPER MONEY
  215. 215.  What are the demerits of commodity money?  What do you mean by near money?  How paper money come into existence?  What do you mean by fiat money? QUESTIONS
  217. 217.  The demand for money is affected by several factors, including the level of income, interest rates, and inflation as well as uncertainty about the future.  The way in which these factors affect demand for money is usually explained in terms of the three motives for demanding money:  transaction motive,  precautionary motive, and  speculative motive. FACTORS AFFECTING DEMAND FOR MONEY
  218. 218.  The transactions motive for demanding money arises from the fact that most transactions involve an exchange of money.  Because it is necessary to have money available for transactions, money will be demanded. The total number of transactions made in an economy tends to increase over time as income rises.  Hence, as income or GDP rises, the transactions demand for money also rises. TRANSACTION MOTIVE
  219. 219.  People often demand money as a precaution against an uncertain future.  Unexpected expenses, such as medical or car repair bills, often require immediate payment.  The need to have money available in such situations is referred to as the precautionary motive for demanding money. PRECAUTIONARY MOTIVE
  220. 220.  Money, like other stores of value, is an asset. The demand for an asset depends on both its rate of return and its opportunity cost.  Typically, money holdings provide no rate of return and often depreciate in value due to inflation.  The opportunity cost of holding money is the interest rate that can be earned by lending or investing one's money holdings. The speculative motive for demanding money arises in situations where holding money is perceived to be less risky than the alternative of lending the money or investing it in some other SPECULATIVE MOTIVE
  221. 221.  For example, if a stock market crash seemed imminent, the speculative motive for demanding money would come into play; those expecting the market to crash would sell their stocks and hold the proceeds as money.  The presence of a speculative motive for demanding money is also affected by expectations of future interest rates and inflation.  If interest rates are expected to rise, the opportunity cost of holding money will become greater, which in turn diminishes the speculative motive for demanding money. Similarly, expectations of higher inflation presage a greater depreciation in the purchasing power of money and therefore lessen the speculative motive for demanding money. SPECULATIVE MOTIVE
  223. 223. SUPPLY OF MONEY  Modern form of money is simply pieces of paper or numbers in a ledger.  Earlier money was in the form of coins, composed of gold, silver and copper ,etc. Value of the coins was based on the value of the metals they contained.  System of paper money was introduced based on the gold standard or silver standard or some combination of the two, to ensure people’s faith in the system.  The gold standard broke down in 1930 in UK, in USA it lasted till 1971  This piece of paper is just like a promissory note issued by a relevant authority.  A currency issued by the government is called a fiduciary issue (based on trust and confidence).
  224. 224. SUPPLY OF MONEY • In India the Reserve Bank of India is responsible for money supply and control. • India followed the proportional reserve system until 1956, whereby a reserve of gold, silver, government securities and foreign securities was maintained, of which gold and or foreign securities were at least 40% of total reserves. • In 1956 this was replaced by fixed minimum reserve system in which reserve worth Rs. 400 crore including gold worth Rs. 115 crores was kept, which was reduced to Rs. 200 crore including gold worth Rs. 115 crores in 1957. • Thus practically Indian currency is nonconvertible in any precious metal and is a fiat money that is declared by state to be a legal tender. Under this system any number of notes can be printed as per needs of the economy.
  225. 225. MONEY SUPPLY AGGREGATES • Narrow money includes only very liquid assets like currency, i.e. notes and coins in the hands of public and demand deposits in the banks • Broad money includes a set of less liquid assets like term deposits with banks M1: Currency with public, i.e. coins and notes + demand deposits of public with banks. It is also known as Narrow Money M2: M1 + Post office savings deposits M3: M2 + Time deposits of the public with banks+ “Other” deposits with RBI. It is also known as Broad Money. M4: M3 + All other deposits with Post office M0: Currency in circulation+ Bankers’ deposits with RBI+ “Other” deposits with RBI. It is also called Reserve Money. Now RBI calculates only three of the above measures, i.e. M0, M1, and M3. • Money Multiplier = M3 / M0 • Monetization = M1 / GDP • Monetary Deepening = M3 / GDP
  226. 226.  What is the precautionary motive for demand of money?  What is the transaction motive for demand of money?  What is the speculative motive for demand of money?  What are the broad and narrow definitions of money? QUESTIONS
  227. 227. Thank You
  228. 228. Inflation
  229. 229. Lecture Plan • Inflation • Causes of Inflation • Inflation and Decision Making • Measuring Inflation • Inflation and Employment • Control of Inflation
  230. 230. Objectives • To explore the realms of inflation and its different frontiers. • To delve into concepts like wage price spiral, hyperinflation and inflationary gap. • To understand various measures of inflation and their role in decision making. • To analyze the reasons behind inflation, its impact on the economy and the measures to curb it.
  231. 231. Inflation • Coulborn: it is a state of “too much money chasing too few goods”. • Two broad categories: – price inflation (generally called as inflation) – money inflation. – Money inflation is increase in the amount of currency in circulation. Which may be due to: • Deficit financing : direct cause is printing of additional currency on demand of the government to meet its needs. • Additional money supply through foreign exchange inflows in the form of capital, such as foreign direct investment and foreign institutional investment, tourism and other incomes from abroad. Price inflation is a persistent increase in the general price level or a persistent decline in the real income of people, i.e. decline in value of money.
  232. 232. Concepts of Inflation • Headline Inflation: measure of the total inflation within an economy – affected by the areas of the market which may experience sudden inflationary spikes such as food or energy. • Hyperinflation: prices increase at such a speed that the value of money erodes drastically – This is also known as galloping inflation or runaway inflation. • Stagflation: a typical situation when stagnation and inflation coexist. • Disinflation: a process of keeping a check on price rise by deliberate attempts. • Deflation: a state when prices fall persistently; just opposite to inflation • Inflationary Gap (Keynes): Excess of anticipated expenditure over available output at base price – When money income exceeds the supply of goods and services, a gap is
  233. 233. Wage Price Spiral Prices Rise Cost of living rises Wages rise Cost of production rises Wages chase prices and prices chase wages, thus create a wage price spiral. •When prices rise, workers demand higher money (or nominal) wages to protect their real wages. This raises the costs faced by their employers. • To protect the real value of profits producers pass the higher costs onto consumers in the form of higher prices. •Workers (who are also consumers demand for higher money wages.
  234. 234. Causes of Inflation • Demand Pull Inflation: when aggregate demand increases due to any reason, and supply of output is unable to match this increased demand; i.e demand pulls prices up. – Increase in money supply/ Increase in disposable income – Increase in aggregate spending – Increase in population of the country • Cost Push Inflation: An increase in price of any of the inputs will increase the cost of production; i.e. prices pushed up by cost. • Low Increase in Supply: if supply falls short of demand, prices will increase. – Obsolete technology/Deficient machinery – Scarcity of resources – Natural calamities/ Industrial disputes/ external aggressions • Built in Inflation: Built in inflation is a type of inflation that has resulted from past events and persists in the present. – It is also known as hangover inflation.
  235. 235. Inflation and Decision Making • Impact on Consumers – increase in any price upsets the home budget. • Impact on Producers (or Suppliers) – Producers as sellers are benefited by inflation; • higher the prices, higher are their profits. – when as buyers of raw material, they are adversely affected by inflation. Impact on Government: – Government has to take the economy to higher levels of growth by encouraging production and investment, – At the other end, has to see that taxpayers’ money is not eroded by hyperinflation. – Thus government has to act as the balancing force between consumers and sellers.
  236. 236. Measuring Inflation • A price index is a numerical measure designed to compare how the prices of some class of goods and/or services, taken as a whole, differ between time periods or geographical locations. (prices of the base year are assumed to be equal to 100.) Price Index = • The most common term used to denote inflation is inflation rate, which is annual rate of increase of prices. Inflation Rate 100 IndexsYear'Current IndexsYear'Current-Indexsyear'Last  100 PricesYear'Base PricesYear'Current 
  237. 237. Measuring Inflation • Producer Price Index (PPI): measures average changes in prices received by domestic producers for their output. • Wholesale Price Index (WPI): measures wholesale prices of a wide variety of goods (including consumer and capital goods. – USA has replaced WPI with PPI • Consumer Price Index (CPI): measures the price of a selection of goods purchased by a typical consumer. – CPI differs from PPI in that price subsidy, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. • Cost of Living Indices (COLI): used to adjust fixed incomes and contractual incomes to maintain the real value of such incomes. – wage indexation is based on such indices. • Service Price Index (SPI): With the growing importance of service sector across the world, many countries have started developing services price indices (SPI).
  238. 238. Control of Inflation • Inflation erodes the value of money and discourages savings • But zero inflation is undesirable • Need to control inflation – monetary policy measures (proposed by those who believed money supply is the major culprit) – fiscal policy measures (proposed by Keynes and his followers). – Other measures • The government has to adopt an appropriate combination of these measures after thorough examination of the causes of inflation
  239. 239. Monetary Policy Measures • Increasing the discount rate: The central bank rediscounts the eligible papers offered by commercial banks. This is also called bank rate. • Higher reserve ratios: • Cash Reserve Ratio (CRR) • Statutory Liquid Ratio (SLR) • Open market operations: directly sell government securities to public and restrain their disposable income • Selective credit control: discourages consumption but not investment
  240. 240. Fiscal Policy Measures The government may reduce public expenditure or increase public revenue to keep a check on inflation • Reducing public expenditure • When government spends on activities like health, transport, communication, etc., income of individuals increases; this in turn increases the aggregate demand. – Therefore the reverse will also be true. • Increasing public revenue – Major source of government revenue is various types of taxes – Increase in income tax leaves less of disposable income in the hands of consumers
  241. 241. `
  242. 242. Learning Outcomes: 1. Meaning and Scope of monetary policy; 2. Instruments of monetary policy; 3. Role of Monetary Policy in achieving macroeconomic goals; 4. Effectiveness and limitations of monetary policy.
  243. 243. “Monetary policy refers to the action taken by the monetary authorities to control and regulate the demand for and supply of money with a given purpose.”
  244. 244. Scope of Monetary Policy: The scope of monetary policy depends, by and large, on two factors: i. The level of monetization of the economy, and ii. The level of development of the financial market
  245. 245. INSTRUMENTS OF MONETARY POLICY General Credit Control Measures 1. Bank Rate 2. CRR 3. Open Market Operations 4. SLR 5. Repo Rate (Repurchase operation rate) 6. Reverse Repo Rate Selective Credit Control Measures 1. Credit Rationing 2. Change in Lending Margins 3. Moral Suasion 4. Direct Controls
  246. 246. General Measures: 1. Bank Rate Policy: • The rate at which central bank lends money to the commercial bank and rediscounts the bills of exchange presented by commercial banks is termed as bank rate
  247. 247. • The central bank can change this rate- increase or decrease- depending on whether it wants to expand or reduce the flow of credit from the commercial banks. • Current Bank rate (Dec, 2012): 9.00 %
  248. 248. Limitations of BR as a Weapon of Credit Control 1. Nowadays, commercial banks are not dependent only on financial support from central bank, which makes change in rate ineffective. 2. With the growth of credit institutions and financial intermediaries, capital market has widened and share of banking credit has declined.
  249. 249. 2. Cash Reserve Ratio: • Also termed as Statutory Reserve Ratio (SRR) • It is the percentage of total deposits which commercial banks are required to maintain in the form of cash reserve with the central bank. • Objective of CRR is to prevent shortage of cash for meeting the cash demand by depositors.
  250. 250. • By changing CRR, the central bank can change the money supply overnight • When contractionary monetary policy is to be adopted , then the central bank raises the CRR • When expansionary monetary policy is to be adopted then central bank cuts down the CRR • Current CRR is 4.75 %
  251. 251. 3. Open Market Operations Open Market Operations is the sale and purchase of government securities and Treasury Bills by the central bank of the country.
  253. 253. • In India, Treasury Bills are short-term promissory notes issued by the Government of India through the RBI. • There are two kinds of Treasury Bills: a) 91- Day Bill : are issued by the RBI on behalf of the government at fixed discount rate of 4.6 %. The RBI provides rediscounting facility within 14 days of issue at an additional rediscounting fees.
  254. 254. b) 182- Day Bill: introduced in 1986, are sold by auction to residents of India for a minimum value of Rs 1,00,000. • The auction bid is invited every fortnight and the ‘discount rate’ is decided on the basis of auction rate.
  255. 255. • When central bank decides to pump money into circulation, it buys back the government securities, bills and bonds • When it decides to reduce money in circulation, it sells the government bonds and securities.
  256. 256. How the sale of government bonds affects the supply of credit? 1. Purchase of govt. securities reduces deposits with commercial banks and their cash reserves which leads to decreased credit creation capacity of the banks.
  257. 257. • When commercial banks themselves decide to buy the govt. bonds and securities, their cash reserves go down which further reduces credit creation capacity of the commercial banks.
  258. 258. How the sale of government bonds affects the demand of credit? 1. Central banks sells the government bonds them at a reduced price, i.e., at a price less than their denominated price. 2. Consequently, the actual rate of interest on the bonds goes up which causes an upward push in the overall interest rate structure
  259. 259. 3. The rise in the rate of interest reduces the demand for credit.
  260. 260. Effectiveness of OMO Under the following conditions, OMO do not work properly: 1. When commercial banks possess excess liquidity. 2. In UDC’s where banking system is not well developed and security capital markets are not interdependent, OMO have a limited effectiveness.
  261. 261. TIME FOR QUIZ
  262. 262. 1. What is meant by monetary policy? 2. What monetary measures have been used by the RBI to control inflation in the country? 3. How does the working of OMO affect the money supply in a country like India?
  263. 263. 4. Statutory Liquidity Ratio: • Under SLR, the commercial banks are required to maintain a certain percentage of their total daily demand and time deposits in the form of liquid assets.
  264. 264. • Liquid assets include: a) Excess reserves b) Unencumbered government securities, e.g. bonds of IDBI, NABARD, Development Banks, debentures of ports, trusts etc. c) Current account balance with other banks
  265. 265. 5. Repo rate: RBI buys securities from banks and thereby provides funds to the banks. The rate of interest at which the RBI lends money to the bank is the repo rate. 6. Reverse repo rate: is the rate at which the banks can buy securities or deposit money with the RBI
  266. 266. Quiz 1. What do you understand by SLR, Repo Rate, and Reverse repo rate 2. Current rates? 3. How increase and decrease in repo rate affects the credit creation?
  267. 267. 2. Selective Credit Control Measures: 1) Credit rationing 2) Change in Lending Margins 3) Moral Suasion 4) Direct Controls
  268. 268. Limitations and Effectiveness of Monetary Policy: 1. The Time Lag 2. Problems in Forecasting 3. Growth of Non-Banking Financial Intermediaries 4. Underdeveloped Money and Capital Markets
  269. 269. ? 1. Differentiate between general and selective credit control measures? 2. What are the factors that determine the effectiveness of monetary policy? 3. What monetary measures have been used by RBI in achieving the policy targets?
  270. 270. FISCAL POLICY Learning Objectives: 1. Meaning and scope of fiscal policy 2. Differentiate between financial instruments and target variables 3. Kinds of fiscal policy 4. Fiscal policy and macroeconomic goals
  271. 271. • The word ‘fisc’ means ‘state treasury’ and ‘fiscal policy’ refers to policy concerning the use of ‘state treasury’ or government finances to achieve certain macroeconomic goals.
  272. 272. Fiscal Instruments 1. Budgetary policy deficit or surplus budgeting 2. Government expenditure 3. Taxation 4. Public borrowings
  273. 273. Target Variables Variables which are sought to be changed through fiscal instruments are: 1. Private disposable incomes, 2. Private consumption expenditure, 3. Private savings and investment, 4. Exports and imports, and 5. Level and structure of prices
  274. 274. ? How Fiscal Instruments Affect Target Variables?
  275. 275. Kinds of Fiscal Policy 1. Automatic Stabilization Fiscal Policy, 2. Compensatory Fiscal Policy, and 3. Discretionary Fiscal Policy
  276. 276. Fiscal Policy and Macroeconomic Goals 1. Fiscal Policy for Economic Growth 2. Fiscal Policy for Employment 3. Fiscal Policy for stabilization 4. Fiscal Policy for Economic Equality
  277. 277. Crowding –Out and Crowding-In Controversy Crowding-Out refers to the adverse effect of high deficit spending by the government on private investment. Crowding-in means rise in the private investment due to deficit spending by the government.
  278. 278. ? 1. What is fiscal policy? 2. Differentiate between fiscal instruments and target variables? 3. Discuss the role of fiscal policy in achieving economic growth? 4. Fiscal policy is the most powerful tool of achieving macroeconomic goals. Discuss.
  279. 279. BALANCE OF PAYMENTS Learning Outcomes: 1. Meaning and purpose of BOP 2. Accounting methods of BOP 3. India’s position in BOP 4. Factors responsible for imbalance in BOP
  280. 280. • “BOP is statement of economic transactions of a country with the rest of the world over a period of time.” • It can also be defined as a statement of all economic transactions between the residents of a nation and the rest of the world during a period of time, usually one year.
  281. 281. Purpose of BOP • Yields necessary information on the strength and weakness of the country in international economic status. • By analyzing the BOP account, one can find the overall gains and losses from the international economic transactions.
  282. 282. • BOP statements give warning signals for future policy formulation.
  283. 283. BALANCE OF PAYMNETS ACCOUNTS Economic transactions of a country can be categorised as: 1. Current transactions 2. Capital transactions
  284. 284. Factors Responsible for Imbalance in BOP 1. Inflation 2. Business cycle 3. Structural changes 4. Short-term disequilibrium factors
  285. 285. ? 1. What is BOP? 2. What is disequilibrium in BOP 3. What are the major causes of disequilibrium in the BOP?