Production function

From Wikipedia, the free encyclopedia

Graph of Total, Average, and Marginal Product

In microeconomics and macroeconomics, a production function is a function that specifies the output of a firm, an industry, or an entire economy for all combinations of inputs. This function is an assumed technological relationship, based on the current state of engineeringknowledge; it does not represent the result of economic choices, but rather is an externally given entity that influences economic decision-making. Almost all economic theories presuppose a production function, either on the firm level or the aggregate level. In this sense, the production function is one of the key concepts of mainstream neoclassical theories. Some non-mainstream economists, however, reject the very concept of an aggregate production function.[1][2]

Contents
[hide]

1 Concept of production functions 2 Specifying the production function 3 Production function as a graph 4 Stages of production 5 Shifting a production function 6 Homogeneous and homothetic production functions 7 Aggregate production functions 8 Criticisms of production functions

o o o

8.1 On the concept of capital 8.2 On the empirical relevance 8.3 Natural resources

9 See also 10 References 11 Further references and external links

[edit]Concept

of production functions

In micro-economics, a production function is a function that specifies the output of a firm for all combinations of inputs. A meta-production function (sometimes metaproduction function) compares the practice of the existing entities converting inputs into output to determine the most efficient practice production function of the existing entities, whether the most efficient feasible practice production or the most efficient actual practice production.[3]clarification needed In either case, the maximum output of a technologically-determined production process is amathematical function of one or more inputs. Put another way, given the set of all technically feasible combinations of output and inputs, only the combinations encompassing a maximum output for a specified set of inputs would constitute the production function. Alternatively, a production function can be defined as the specification of the minimum input requirements needed to produce designated quantities of output, given available technology. It is usually presumed that unique production functions can be constructed for every production technology. By assuming that the maximum output technologically possible from a given set of inputs is achieved, economists using a production function in analysis are abstracting from the engineering and managerial problems inherently associated with a particular production process. The engineering and managerial problems of technical efficiency are assumed to be solved, so that analysis can focus on the problems of allocative efficiency. The firm is assumed to be making allocative choices concerning how much of each input factor to

use and how much output to produce, given the cost (purchase price) of each factor, the selling price of the output, and the technological determinants represented by the production function. A decision frame in which one or more inputs are held constant may be used; for example, (physical) capital may be assumed to be fixed (constant) in the short run, and labour and possibly other inputs such as raw materials variable, while in the long run, the quantities of both capital and the other factors that may be chosen by the firm are variable. In the long run, the firm may even have a choice of technologies, represented by various possible production functions. The relationship of output to inputs is non-monetary; that is, a production function relates physical inputs to physical outputs, and prices and costs are not reflected in the function. But the production function is not a full model of the production process: it deliberately abstracts from inherent aspects of physical production processes that some would argue are essential, including error, entropy or waste. Moreover, production functions do not ordinarily model the business processes, either, ignoring the role of management. (For a primer on the fundamental elements of microeconomic production theory, see production theory basics). The primary purpose of the production function is to address allocative efficiency in the use of factor inputs in production and the resulting distribution of income to those factors. Under certain assumptions, the production function can be used to derive a marginal product for each factor, which implies an ideal division of the income generated from output into an income due to each input factor of production.i

[edit]Specifying

the production function

A production function can be expressed in a functional form as the right side of

Q = f(X1,X2,X3,...,Xn)
where:

Q = quantity of output X1,X2,X3,...,Xn = quantities of factor inputs (such as capital, labour, land or raw materials).
If Q is not a matrix (i.e. a scalar, a vector, or even a diagonal matrix), then this form does not encompass joint production, which is a production process that has multiple co-products. On the other hand, if f maps from Rn to Rk then it is a joint production function expressing the determination of k different types of output based on the joint usage of the specified quantities of the n inputs. One formulation, unlikely to be relevant in practice, is as a linear function:

Q = a + bX1 + cX2 + dX3 + ...

where a,b,c, and d are parameters that are determined empirically. Another is as a Cobb-Douglas production function:

The Leontief production function applies to situations in which inputs must be used in fixed proportions; starting from those proportions, if usage of one input is increased without another being increased, output will not change. This production function is given by

Other forms include the constant elasticity of substitution production function (CES), which is a generalized form of the Cobb-Douglas function, and the quadratic production function. The best form of the equation to use and the values of the parameters (a,b,c,...) vary from company to company and industry to industry. In a short run production function at least one of the X's (inputs) is fixed. In the long run all factor inputs are variable at the discretion of management.

[edit]Production

function as a graph

Quadratic Production Function

Any of these equations can be plotted on a graph. A typical (quadratic) production function is shown in the following diagram under the assumption of a single variable input (or fixed ratios of inputs so the can be treated as a single variable). All points above the production function are unobtainable with current technology, all points below are technically feasible, and all points on the function show the maximum quantity of output obtainable at the specified level of usage of the input. From the origin, through points A, B, and C, the production function is rising, indicating that as additional units of inputs are used, the quantity of output also increases. Beyond point C, the employment of additional units of inputs produces no additional output (in fact, total output starts to decline); the variable input is being used too intensively. With too much variable input use relative to the available fixed inputs, the company is experiencing negative marginal returns to variable inputs, and diminishing total returns. In the diagram this is illustrated by the negative marginal physical product curve (MPP) beyond point Z, and the declining production function beyond point C. From the origin to point A, the firm is experiencing increasing returns to variable inputs: As additional inputs are employed, output increases at an increasing rate. Both marginal physical product (MPP, the derivative of the production function) and average physical product (APP, the ratio of output to the variable input) are rising. The inflection point A defines the point beyond which there are diminishing marginal returns, as can be seen from the declining MPP curve beyond point X. From point A to point C, the firm is experiencing positive but decreasing marginal returns to the variable input. As additional units of the input are employed, output increases but at a decreasing rate. Point B is the point beyond which there are diminishing average returns, as shown by the declining slope of the average physical product curve (APP) beyond point Y. Point B is just tangent to the steepest ray from the origin hence the average physical product is at a maximum. Beyond point B, mathematical necessity requires that the marginal curve must be below the average curve (See production theory basics for further explanation.).

[edit]Stages

of production

To simplify the interpretation of a production function, it is common to divide its range into 3 stages. In Stage 1 (from the origin to point B) the variable input is being used with increasing output per unit, the latter reaching a maximum at point B (since the average physical product is at its maximum at that point). Because the output per unit of the variable input is improving throughout stage 1, a price-taking firm will always operate beyond this stage. In Stage 2, output increases at a decreasing rate, and the average and marginal physical product are declining. However, the average product of fixed inputs (not shown) is still rising,

because output is rising while fixed input usage is constant. In this stage, the employment of additional variable inputs increases the output per unit of fixed input but decreases the output per unit of the variable input. The optimum input/output combination for the price-taking firm will be in stage 2, although a firm facing a downward-sloped demand curve might find it most profitable to operate in Stage 1. In Stage 3, too much variable input is being used relative to the available fixed inputs: variable inputs are over-utilized in the sense that their presence on the margin obstructs the production process rather than enhancing it. The output per unit of both the fixed and the variable input declines throughout this stage. At the boundary between stage 2 and stage 3, the highest possible output is being obtained from the fixed input.

[edit]Shifting

a production function

By definition, in the long run the firm can change its scale of operations by adjusting the level of inputs that are fixed in the short run, thereby shifting the production function upward as plotted against the variable input. If fixed inputs are lumpy, adjustments to the scale of operations may be more significant than what is required to merely balance production capacity with demand. For example, you may only need to increase production by a million units per year to keep up with demand, but the production equipment upgrades that are available may involve increasing productive capacity by 2 million units per year.

Shifting a Production Function

If a firm is operating at a profit-maximizing level in stage one, it might, in the long run, choose to reduce its scale of operations (by selling capital equipment). By reducing the amount of

fixed capital inputs, the production function will shift down. The beginning of stage 2 shifts from B1 to B2. The (unchanged) profit-maximizing output level will now be in stage 2.

CobbDouglas production function

From Wikipedia, the free encyclopedia

A two-input CobbDouglas production function

In economics, the CobbDouglas functional form of production functions is widely used to represent the relationship of an output to inputs. Similar functions were originally used by Knut Wicksell (18511926), while the Cobb-Douglas form was developed and tested against statistical evidence by Charles Cobb and Paul Douglas during 19001947.
Contents
[hide]

1 Formulation 2 History 3 Difficulties and criticisms

3.1 Dimensional analysis

3.2 Lack of microfoundations

4 Some applications 5 Various representations of the production function

5.1 Translog (transcendental logarithmic) production function

6 Derived from a CES function 7 See also 8 References 9 External links

[edit]Formulation
In its most standard form for production of a single good with two factors, the function is

where:

Y = total production (the monetary value of all goods produced in a year) L = labor input K = capital input A = total factor productivity and are the output elasticities of labor and capital, respectively. These values are constants determined by available technology.

Output elasticity measures the responsiveness of output to a change in levels of either labor or capital used in production, ceteris paribus. For example if = 0.15, a 1% increase in labor would lead to approximately a 0.15% increase in output. Further, if: + = 1, the production function has constant returns to scale: Doubling capital K and labour L will also double output Y. If + < 1, returns to scale are decreasing, and if +>1 returns to scale are increasing. Assuming perfect competition and + = 1, and can be shown to be labor and capital's share of output.

Cobb and Douglas were influenced by statistical evidence that appeared to show that labor and capital shares of total output were constant over time in developed countries; they explained this by statistical fitting least-squares regression of their production function. There is now doubt over whether constancy over time exists.

[edit]History
Paul Douglas explains that his first formulation of the CobbDouglas production function was developed in 1927, when seeking a functional form to relate estimates he had calculated for workers and capital, he spoke with mathematician and colleague Charles Cobb who suggested a function of the form Y

= bLkC1 k previously used by Knut Wicksell . Estimating this using least

squares, he obtained a result for the marginal productivity of labour (k) to 0.75$ --- which was subsequently confirmed by the National Bureau of Economic Research to be %74.1. Later work in the 1940s prompted them to allow for the exponents on C and L vary, resulting in estimates that subsequently proved to be very close to improved measure of productivity developed at that time.[1] A major criticism at the time was that estimates of the production function, although seemingly accurate, were based on such sparse data that it was hard to give them much credibility. Douglas' remarked "I must admit I was discouraged by this criticism and thought of giving up the effort, but there was something which told me I should hold on."[1] The breakthrough came in using US censusdata, which was cross sectional and provided a large number of observations. Douglas presented the results of these findings, along with those for other countries, at his 1947 address as president of the American Economic Association. Shortly afterwards, Douglas went into politics and was stricken by ill health --- resulting in little further development on his side. However, two decades later, his production function was widely used, being adopted by economists such as Paul Samuelson and Solow.[1] The CobbDouglas production function is especially notable for being the first time an aggregate or economy-wide production function had been developed, estimated, and the presented to the profession for analysis; it marked a landmark change in how economists approachedmacroeconomics.[2]

[edit]Difficulties

and criticisms
analysis

[edit]Dimensional

The CobbDouglas model is criticized by some Austrian economists such as William Barnett II on the basis of dimensional analysis. They argue it does not having meaningful or economically reasonable units of measurement unless

+ = 1.[3] However, other economists in reply to

Barnett have argued that the units used are not fundamentally more unnatural than other units commonly used in physics such a log temperature or distance squared.[4]

[edit]Lack

of microfoundations

The CobbDouglas production function was not developed on the basis of any knowledge of engineering, technology, or management of the production process. It was instead developed because it had attractive mathematical characteristics, such as diminishing marginal returns to either factor of production and the property that expenditure on any given input is a constant fraction of total cost. Crucially, there are no microfoundations for it. In the modern era, economists try to build models up from individual agents acting, rather than imposing a functional form on an entire economy. However, many modern authors have developed models which give Cobb Douglas production function from the micro level; many New Keynesian models, for example.[5] It is nevertheless a mathematical mistake to assume that just because the Cobb Douglas function applies at the micro-level, it also always applies at the macro-level. Similarly, it is not necessarily the case that a macro CobbDouglas applies at the disaggregated level. An early microfoundation of the aggregate CobbDouglas technology based on linear activities is derived in Houthakker (1955).[6]

Leontief production function

From Wikipedia, the free encyclopedia

In economics, the Leontief production function or fixed proportions production function is a production function that implies the factors of production will be used in fixed (technologically pre-determined) proportions, as there is no substitutability between factors. It was named after Wassily Leontief and represents a limiting case of the constant elasticity of substitution production function. The function is of the form

where q is the quantity of output produced, z1 and z2 are the utilised quantities of input 1 and input 2 respectively, and a and b are technologically determined constants.

[edit]Example
Suppose that the intermediate goods "tires" and "steering wheels" are used in the production of automobiles (for simplicity of the example, to the exclusion of anything else). Then in the above

formulaq refers to the number of automobiles produced, z1 refers to the number of tires used, and z2 refers to the number of steering wheels used. Then the Leontief production function is Number of cars = Min{ times the number of tires, 1 times the number of steering wheels}.

SHORT-RUN PRODUCTION ANALYSIS:

An analysis of the production decision made by a firm in the short run, with the ultimate goal of explaining the law of supply and the upward-sloping supply curve. The central feature of this short-run production analysis is the law of diminishing marginal returns, which results in the short run when larger amounts of a variable input, like labor, are added to a fixed input, like capital. A contrasting analysis is long-run production analysis. The analysis of short-run production sets the stage to better understand the supply-side of the market. How producers respond to price depends, in part, on their ability to combine inputs to produce output. This ability is guided by the law of diminishing marginal returns, which states that the productivity of a variable input declines as more is added to a fixed input. If productivity declines, then more of the variable input is needed as thequantity produced increases. This results in an increase in production cost, which means producers need to receive a higher price. The connection between higher price and more production is essence of thelaw of supply.

Two Runs: Short and Long

The first step in the analysis of short-run production is a distinction between the short run and the long run. This distinction is intertwined with the distinction between fixed and variable inputs. Short Run: The short run is a period of time in which at least one input used for production and under the control of the producer is variable and at least one input is fixed.

Long Run: The long run is a period of time in which at all inputs used for production and under the control of the producer are variable.

The difference between short run and long run depends on the particular production activity. For some producers, the short run lasts a few days. For others, the short run can last for decades.

Two Inputs: Fixed and Variable

The analysis of short-run production assumes that at least one input in the production process is fixed and at least one is variable. As already noted, the fixed and variable inputs are intertwined with the notion of short run and long run.

Fixed Input: A fixed input is an input used in production and under the control of the producer that does not change during the time period of analysis (the short run).

Variable Input: A variable input is an input used in production and under the control of the producer that does change during the time period of analysis (the short run).

The variable input used by most producers is more often than not labor. The fixed input for most production operations is usually capital. The presumption is that the size of a firm's workforce can be adjusted more quickly that the size of the factory or building, the amount of equipment, and other capital. Note that the phrase "under the control of the producer" is included in the specifications of short run, long run, fixed input, and variable input. The reason is that short-run production analysis is most concerned with how producers adjust the inputs under the control in response to changing prices. Any production activity invariably includes inputs (fixed and variable) that are beyond the control of the producer, including government laws and regulations, social customs and institutions, weather, and the forces of nature. These other variables are certainly worthy of consideration, but are not fundamental to explaining and understanding the basic principles of market supply

Three Returns: Increasing, Decreasing, and Negative

The addition of a variable input (like labor) to a fixed input (like capital) can have one of three basic results. First, production might increase at a increasing rate. Second, production might increase at a decreasing rate. Third, production might actually decrease. These three alternatives are technically termed increasing marginal returns, decreasing marginal returns, and negative marginal returns. Increasing Marginal Returns: This occurs if each additional unit of a variable input added to a fixed input causes incremental production to increase. For example, the one worker contributes 10 units of output to production, the next worker contributes another 12 units, and the subsequent worker contributes 14 units. With increasing marginal returns, each worker contributes more to production that the previous worker.

Decreasing Marginal Returns: This occurs if each additional unit of a variable input added to a fixed input causes incremental production to decrease. For example, the one worker contributes 10 units of output to production, the next worker contributes another 8 units, and the subsequent worker contributes only 6 units. With decreasing marginal returns, each worker contributes less to production that the previous worker.

Negative Marginal Returns: This results if the addition of a variable input added to a fixed input actually causes the total production to decline. For example, if 10 workers produce a total of 100 units of output, and 11 workers produce a total of 99 units, then the eleventh worker is said to have negative marginal returns.

Most short-run production involves increasing marginal returns with the addition of the first few units of a variable input. This inevitably gives way to decreasing marginal returns. While negative marginal returns are somewhat rare, they do eventually result if too many units of a variable input are added.

One Law
The inevitability of decreasing marginal returns is captured by the most important economic principle in short-run production analysis--the law of diminishing marginal returns. The Law of Diminishing Marginal Returns: This law states that as more and more of a variable input is added to a fixed input in short-run production, then the marginal product (that is, the marginal returns) of the variable input eventually declines.

While most short-run production is likely to see increasing marginal returns, eventually, inevitably, most certainly, decreasing marginal returns occur. The law of diminishing marginal returns means that increased production of a good requires more and more of the variable input. For example, the first 50 units of production can be had with only 5 workers. However, the next 50 units might required an additional 10 workers. With more the variable input needed, the cost of production rises. And as the production cost rises, the price that producers need to receive also increases. Hence, a higher price corresponds with a larger quantity, which is the law of supply. The positive law of supply connection between price and quantity, as such, can be traced to the law of diminishing marginal returns.

Three Curves

Three Product Curves

This graph presents the three "product" curves that form the foundation of short-run production analysis. This particular set of curves depict the hourly production of Waldo's Super Deluxe TexMex Gargantuan Tacos (with sour cream and jalapeno peppers) for different quantities of labor, the variable input. The fixed input is the building, cooking and preparation equipment, cash register, tables, chairs, and other capital that comprise Waldo's TexMex Taco World restaurant. Total Product Curve: The curve labeled TP is the total product curve, the total number of TexMex Gargantuan Tacos produced per hour for a given amount of labor. If Waldo (the owner of Waldo's TexMex Taco World) hires more employees, he can expect a greater production of TexMex Gargantuan Tacos until he reaches peak production at 7 and 8 workers. Click the [TP] button to highlight this curve.

Marginal Product Curve: The MP curve is the marginal product curve, and the one that is key to the study of short-run production. The MP curve indicates how the total production of TexMex Gargantuan Tacos changes when an extra worker is hired. For example, hiring a fifth worker means that Waldo's TexMex Taco World can produce an additional 10 TexMex Gargantuan Tacos per hour. Most important, the marginal product declines after the second worker is hired, which is the law of diminishing marginal returns, the driving principle in the study of short-run production. Click the [MP] button to highlight this curve.

Average Product Curve: The average product curve, labeled AP, indicates the average number of TexMex Gargantuan Tacos produced by Waldo's workers. If, for example, Waldo has a staff of 7, then each produces about 17 TexMex Gargantuan Tacos per hour--on average. Click the [AP] button to highlight this curve.

Three Stages

Three Production Stages

Short-run production exhibits three distinct stages reflected by the shapes and slopes of the three product curves--total product, marginal product, and average product. Stage I: The first stage is increasing marginal returns and is characterized by the increasingly steeper positive slope of the total product curve, the positive slope of the marginal product curve, and the positive slope of the average product curve. Moreover, the marginal product curve reaches a peak at the end of Stage I.

Stage II: The second stage is decreasing marginal returns and is reflected in the positive but flattening slope of the total product curve and the negative slope of the marginal product curve. Moreover, the average product reaches a peak and is equal to marginal product in this stage. The marginal product curve intersects the horizontal quantity axis at the end of Stage II.

Stage III: The third and last stage is negative marginal returns illustrated by the negative value of marginal product and the negative slope of the total product curve. Average product is positive, but the average product curve has a negative slope.

One Step
This analysis of short-run production is but the first step in a brisk walk toward a better understanding market supply. Further steps include the cost of short-run production, especially marginal cost, and the market structure in which a firm operates, such as perfect competition ormonopoly. Production Cost: An understanding of market supply builds on the short-run production analysis and the key role played by the law of diminishing marginal returns. Because the productivity of the variable input decreases, a larger quantity is needed as production increases. This larger quantity, however, entails greater production cost, as reflected in a positively-sloped marginal cost curve.

Market Structure: The market supply also depends on the structure of the market, especially the degree of competition and the resultingmarket control of each firm. Competitive markets, with limited control over the price, tend to produce output by equating price and marginal cost. Because marginal cost increases with production, so too does price. However, less competitive markets, with greater market control by

the participating firms, need not equate price and marginal cost. As such, a higher price might not correspond with a larger quantity.

RETURNS TO SCALE:
Changes in production the occur when all resources are proportionately changed in the long run. Returns to scale come in three forms--increasing, decreasing, or constant based on whether the changes in production are proportionally more than, less than, or equal to the proportional changes in inputs. Returns to scale are the guiding principle for long-run production, playing a similar role that the law of diminishing marginal returns plays for short-run production. Returns to scale answer the question: If labor, capital, and other inputs ALL increase by the same proportion (say 10 percent) does output increase by more than, less than, or equal to this proportion (more than 10 percent, less than 10 percent, or exactly 10 percent)? The answer indicates that returns to scale can take one of three forms: increasing returns to scale, decreasing returns to scale, and constant returns to scale. Increasing Returns to Scale: This occurs if a proportional increase in all inputs under the control of a firm results in a greater than proportional increase in production. In other words, a 10 percent increase in labor, capital, and other inputs, results in a production increase that is greater than 10 percent.

Decreasing Returns to Scale: This occurs if a proportional increase in all inputs under the control of a firm results in a less than proportional increase in production. In other words, a 10 percent increase in labor, capital, and other inputs, results in a production increase that is less than 10 percent.

Constant Returns to Scale: This occurs if a proportional increase in all inputs under the control of a firm results in an equal proportional increase in production. In other words, a 10 percent increase in labor, capital, and other inputs, results in an equal 10 percent increase in production.

Long-Run Stuffed Amigo Production

Suppose, for example, that The Wacky Willy Company employs 1,000 workers in a 5,000 square foot factory to produce 1 million Stuffed Amigos (those cute and cuddly armadillos, tarantulas, and lizards) each month. Returns to scale indicate what happens to production if the scale of operation expands to 2,000 workers in a 10,000 square foot factory--a doubling of the inputs.

If production increases to exactly 2 million Stuffed Amigos, twice the original quantity, then The Wacky Willy Company has constant returns to scale. If production increases by more than 2 million Stuffed Amigos, then The Wacky Willy Company has increasing returns to scale. And if production increases by less than 2 million Stuffed Amigos, then The Wacky Willy Company has decreasing returns to scale.

Economies and Diseconomies of Scale

Returns to scale are the flip slide of economies of scale and diseconomies of scale. However, whereas economies and diseconomies of scale focus on cost, returns to scale focus on production. Economies of scale indicate that long-run average cost decreases, which corresponds to increasing returns to scale in terms of production.

Diseconomies of scale indicate that long-run average cost increases, which corresponds to decreasing returns to scale in terms of output.

Constant returns to scale for production terms results when long-run average cost neither increases nor decreases.

The anticipated pattern for most production activities is that increasing returns to scale emerge for relatively small levels of production, which is then following be constant returns to scale and finally decreasing returns to scale. This pattern is represented by a U-shaped long-run average cost curve.

NOT Marginal Returns

Do not confuse increasing and decreasing returns to scale with increasing and decreasing marginal returns. While these phrases sound similar, they are quite different. Increasing and decreasing returns to scale relate to the long run in which all inputs under the control of the firm are variable. Increasing and decreasing marginal returns related to the short run in which one or more input is variable and one or more input is fixed. The existence of fixed inputs in the short run gives rise to increasing and decreasing marginal returns. In particular, decreasing marginal returns result because the capacity of the fixed input or inputs is being reached. However, in the long run, there are no fixed inputs, so no capacity constraint, so no marginal returns.

COST:
An alternative term for economic or opportunity cost, which is the highest valued alternative foregone in the pursuit of an activity. Opportunity cost is one of the most fundamental

concepts used in the study of economics, hence when the term cost is used in the study of economics without modification, it usually means economic or opportunity cost. Because economists like to economize on effort, the succinct term cost is also frequently used in lieu of opportunity cost or economic cost. In fact, whenever the term cost is used in economics, absent of any modifiers, it inevitably means economic or opportunity cost.

Starting With Scarcity

The ultimate source of cost is the pervasive problem of scarcity (unlimited wants and needs, but limited resources). Whenever limited resources are used to satisfy one want or need, an unlimited number of other wants and needs remain unsatisfied. Hence pursuing one activity means alternatives are not pursued. Herein lies the essence of cost. Doing one thing prevents doing another.

Cost Plus...
There are a seemingly endless number of modifiers that can be used with the term cost. Here is a lengthy, but necessarily incomplete list. Accounting Cost: An actual outlay or expense incurred in productionthat shows up a firm's accounting statements or records, which may or may not be an opportunity cost.

Average Cost: The opportunity cost incurred per unit in the production of a good, calculated by dividing the total cost of production by the quantity of output produced

Explicit Cost: An opportunity cost that involves a money payment and usually a market transaction.

External Cost: An opportunity that is not included in the market price of a good because it is not included in the supply price.

Fixed Cost: An opportunity that does not change with changes in the quantity of output produced.

Historical Cost: An accounting principle stating that expenses are recorded in terms of original or acquisition cost, which may or may not reflect opportunity cost or current market value.

Implicit Cost: An opportunity cost that does NOT involve a money payment or a market transaction.

Marginal Cost: The change in total opportunity cost resulting from a change in the quantity of output produced by a firm in the short run.

Production Cost: The opportunity cost of using labor, capital, land, and entrepreneurship in the production of goods and services.

Total Cost: The opportunity cost incurred by all of the factors of production used by a firm to produce a good or service, including wages paid to labor, rent paid for the land, interest paid to capital owners, and a normal profit paid to entrepreneurs.

Variable Cost: An opportunity cost that changes with changes in the quantity of output produced.

This is a modest list at best. Other terms contain the word "cost" include average variable cost, total variable cost, average fixed cost, total fixed cost, total factor cost, average factor cost, and marginal factor cost. Other "cost" terms pop up in the study of economics as attention is directed to specific topics and issues.

Circular flow of income

From Wikipedia, the free encyclopedia

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In this simplified image, the relationship between the decision-makers in the circular flow model is shown. Larger arrows show primary factors, whilst the red n ,.0p;smaller arrows show subsequent or secondary factors.

In economics, the terms circular flow of income or circular flow refer to a simple economic model which describes the reciprocal circulation of income between producers and consumers. [1][2] In the circular flow model, the inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively and provide each other with factors in order to facilitate the flow of income[1]. Firms provide consumers with goods and services in exchange for consumer expenditure and "factors of production" from households. More complete and realistic circular flow models are more complex. They would explicitly include the roles of government and financial markets, along with imports and exports. Human wants are unlimited and are of recurring nature therefore, production process remains a continuous and demanding process. In this process, household sector provides various factors of production such as land, labour, capital and enterprise to producers who produce by goods and services by co-ordinating them. Producers or business sector in return makes payments in the form of rent, wages, interest and profits to the household sector. Again household sector spends this income to fulfil its wants in the form of consumption expenditure. Business sector supplies them goods and services produced and gets income in return of it. Thus expenditure of one sector becomes the income of the other and supply of goods and services by one section of the community becomes demand for the other. This process is unending and forms the circular flow of income, expenditure and production.Reference- S.Dinesh Introduction to Macro Economics. A continuous flow of production, income and expenditure is known as circular flow of income. It is circular because it has neither any beginning nor an end. The circular flow of income involves two basic principles:- 1.In any exchange process, the seller or producer receives the same amount what buyer or consumer spends. 2.Goods and services flow in one direction and money payment to get these flow in return direction, causes a circular flow.

Circular flows are classified as: Real Flow and Money Flow. Real Flow- In a simple economy, the flow of factor services from households to firms an d corresponding flow of goods and services from firms to households s known to be as real flow. Assume a simple two sector economy- household and firm sectors, in which the households provides factor services to firms, which in return provides goods and services to them as a reward. Since there will be an exchange of goods and services between the two sectors in physical form without involving money, therefore, it is known as real flow. Money Flow- In a modern two sector economy, money acts as a medium of exchange between goods and factor services. Money flow of income refers to a monetary payment from firms to households for their factor services and in return monetary payments from households to firms against their goods and services. Household sector gets monetary reward for their services in the form of rent, wages, interest, and profit form firm sector and spends it for obtaining various types of goods to satisfy their wants. Money acts as a helping agent in such an exchange.

NATIONAL INCOME AND GROSS DOMESTIC PRODUCT:

National income (NI) is the total income earned by the citizens of the national economy resulting from their ownership of resources used in the production of final goods and services during a given period of time, usually one year. Gross domestic product (GDP) is the total market value of all final goods and services produced within the political boundaries of an economy during a given period of time, usually a year. Although national income is generated by the production of gross domestic product, the value of production does not entirely result in earned income. In other words, national income can be derived from gross domestic product after a few adjustments. The vast majority of domestic production is undertaken by factors of production owned by domestic citizens (national income is about 80 percent of gross domestic product). However, key differences do exist. The six main differences between gross domestic product and national income are (1) capital consumption adjustment, (2) indirect business taxes, (3) business transfer payments, (4) net foreign factor income, (5) government subsidies less surplus of government enterprises, and (6)statistical discrepancy. The following equation captures the relation between national income (NI) and gross domestic product (GDP): NI = GDP - Capital Consumption Adjustment - Indirect Business Taxes - Business Transfer Payments + Net Foreign Factor Income + Government Subsidies less Current Surplus of Government Enterprises - Statistical Discrepancy

Net Foreign Factor Income

Net foreign factor income is the difference between factor payments received from

the foreign sector by domestic citizens and factor payments made to foreign citizens for domestic production. This is, by the way, the key difference between gross DOMESTIC product and gross NATIONAL product. Net foreign factor income actually represents a two-part adjustment between gross domestic product and national income. A portion of the revenue received from producing DOMESTIC output is actually paid to foreign citizens. As such, factor payments made to foreign citizens for domestic production, much like the capital consumption adjustment and indirect business taxes, are revenue generated from gross DOMESTIC product that is not part of NATIONAL income received by domestic citizens. However, in a classic example of turn-about is fair play, a portion of the income earned by domestic citizens is the result of production that is part of gross domestic product for OTHER nations. These are factor payments received from the foreign sector by domestic citizens. They are added to factor payments generated by domestic production to obtain national income.

NATIONAL INCOME AND NET DOMESTIC PRODUCT:

National income (NI) is the total income earned by the citizens of the national economy resulting from their ownership of resources used in the production of final goods and services during a given period of time, usually one year. Net domestic product (NDP) is the total market value of all final goods and services produced within the political boundaries of an economy during a given period of time, usually a year, after adjusting for the depreciation of capital. Although national income is generated by the production of net domestic product, the value of production does not entirely result in earned income. In other words, national income can be derived from net domestic product after a few adjustments. The vast majority of domestic production is undertaken by factors of production owned by domestic citizens (national income is about 90 percent of net domestic product). However, key differences do exist. The five main differences between net domestic product and national income are (1) indirect business taxes, (2) business transfer payments, (3) net foreign factor income, (4) government subsidies less surplus of government enterprises, and (5) statistical discrepancy. The following equation captures the relation between national income (NI) and net domestic product (NDP): NI = NDP - Indirect Business Taxes - Business Transfer Payments + Net Foreign Factor Income + Government Subsidies less Current Surplus of Government Enterprises - Statistical Discrepancy

Indirect Business Taxes

Indirect business taxes is the official term used in the National Income and Product Accounts for sales taxes. These are termed INDIRECT taxes because the business sector has the DIRECT responsibility of paying these taxes to the government sector, but the business sector really acts as the "collection agency" for the government, collecting the taxes from thehousehold sector. The taxes are paid INDIRECTLY by the household sector. In general, sales taxes drive a wedge between the price buyers pay for production (demand price) and the price sellers receive for production (supply price). The demand price IS the market value of production measured by gross domestic product. The supply price is the opportunity cost of the resources used in production, which is factor payments and income earned by the factors (that is, national income). To the extent that sales taxes increase the demand price above the supply price, gross domestic product is greater than national income. For example, suppose Maurice Finklestein decides to buy a Wacky Willy Stuffed Amigo from the local MegaMart Discount Warehouse Super Center that carries a "shelf price" of $10. However, Maurice needs more than $10 to complete this purchase. The reason, of course, is that the local sales tax is 5 percent. Any purchase made at the MegaMart Discount Warehouse Super Center includes the "shelf price" plus 5 percent. His total expense is thus $10.50. This means that Maurice must obtain at least $10.50 worth of satisfactionfrom his Stuffed Amigo. If he receives less than $10.50, then he would not by this Stuffed Amigo. He would spend his $10.50 on a good that DID provide $10.50 worth of satisfaction. This is the essence of what gross domestic product seeks to measure. And from the expenditure approach to measuring GDP, this $10.50 would be included in its entirety. Now consider the income approach to measuring GDP. The income generated from the production of this Amigo is not $10.50, but only $10. The opportunity cost of using the four factors of production to supply this Stuffed Amigo is $10. To see why all that is needed is to ask the question: "What is the minimum price MegaMart Discount Warehouse Super Center excepts for this Stuffed Amigo WITHOUT SALES TAXES?" The answer, of course, is $10. This $10 covers production cost, which is another way of saying that the factors of production (labor, capital, land, and entrepreneurship) need a total of $10 in income to produce and supply this Stuffed Amigo. As such, the $10.50 revenue received by the MegaMart Discount Warehouse Super Center is divided in two ways. The first $10 is used to pay the factors of production, which is then included in national income. The remaining $0.50 is used to pay sales taxes. In the same way, gross domestic product includes the total revenue generated in production, which is then divided among national income and indirect business taxes.

Business Transfer Payments

Business transfer payments are subsidies, or gifts, made from the business sector to the household sector. While a portion of business transfer payments are, in fact, outright gifts to the household sector (such as student scholarships), a substantial portion results when unpaid debts are "written off." In effect, when the business sector "writes off" an unpaid debt, the are giving the household sector "free" goods. Suppose, for example, that Lisa Quirkenstone purchases a bunch of goods from the MegaMart Discount Warehouse Super Center using her MegaMart Discount Warehouse Super Center installment credit card, a common practice in the retail industry. In principle, Lisa would pay this debt off over time. However, what would happen if she turned out to be something of a deadbeat, who becomes unemployed and unable to pay off this debt? Try as they may, MegaMart Discount Warehouse Super Center, is unable to collect payment. After several years, they simply write off her debt as uncollectable. In essence, they have given Lisa the goods that she supposedly "purchased." She receives the goods, but MegaMart NEVER receives payment. This ends up being nothing more than a gift, just as if they had bought Lisa a bunch of birthday presents. Business transfer payments enter the National Income and Product Accounts much like the capital consumption adjustment. They are part of gross domestic product, but never make it to national income. Business transfer payments are included in the value of the final goods produced (after all, Lisa receives value from the goods that she "bought" MegaMart Discount Warehouse Super Center), but they are not included as factor payments (nor national income). Business transfer payments can be thought of as an extra cost tacked onto the price of goods, over and above factor payments, that compensates for bad debts incurred by the household sector.

Government Subsidies Less Surplus of Government Enterprises

Government subsidies are transfer payments from the government sector to the business sector. As transfer payments, government subsidies are NOT payments for current production. In essence they are government gifts to the business sector. They are then added to the pool of revenue that the business sector uses for factor payments (and thus national income). Because the business sector does NOT receive this revenue as the result of producing goods, it is part of national income but not part of gross domestic product. In the National Income and Product Accounts, government subsidies are adjusted by the current surplus of government enterprises. Government enterprises are productive activities that essentially operate like private sector businesses. One example is a city that sells electricity directly to consumers. This city-owned electric "company" operates like a privately owned electric company, with one primary difference--the "profit" received.

Because the term "profit" is reserved for use by private businesses, any revenue received by government enterprises over cost is termed government surplus. This surplus is generated from producing valuable output, and is part of gross domestic product. From a national income perspective, the surplus of government enterprises is important because, unlike private business profit, it is NOT officially earned by any factors of production. Rather than being paid out as national income to any productive factors, this surplus is returned to government treasuries.

FOREIGN TRADE:
The exchange of goods and services between the domestic sector of a given nation and its foreign sector (that is, other nations of the world). Also termed international trade when viewed from the perspective of the global economy, this exchange of production is comparable to any exchange, except that buyers and sellers are from different countries. Key insight from the study of foreign trade includes the law of comparative advantage and trade protection policies. Foreign trade arises when an economy exchanges of goods and services with its foreign sector. This includes goods and services produced in thedomestic economy of a nation and purchased by the foreign sector, what is termed exports, and goods and services produced in the foreign sector and purchased by the domestic economy, what is termed imports. Foreign trade is also termed international trade. The distinction between the two terms is based on perspective. International trade is viewed from the perspective of the global economy, in which each of the nations of the world are players in the exchange game. Foreign trade is viewed from the perspective of the domestic sector of a given economy. This foreign trade perspective takes a decidedly domestic, geocentric view, that is, "us" (the domestic sector) versus "them" (the foreign sector). The flow of trade between a given nation and its foreign sector is captured by net exports. Net exports are the difference between exports (goods and services produced by the domestic economy and purchased by the foreign sector) and imports (goods and services produced by the foreign sector and purchased by the domestic economy). In addition to highlighting the law of comparative advantage, viewing international trade from a domestic/foreign perspective enables a better understanding of the why and how of foreign trade policies designed to promote exports and/or restrict imports, and thus increase net exports. The key foreign trade policies are tariffs, import quotas, and export subsidies.

Domestic and Foreign

Let's first begin by distinguishing between two related terms, foreign and

domestic. Domestic: This is activity that takes place within the political boundaries of a given nation. Usually, not always but usually, this activity is undertaken by resources owned by citizens of the nation. The domestic sector, or domestic economy, includes producers, consumers, and even governments residing in the given nation.

Foreign: This is, in contrast, any activity that takes place beyond the political boundaries of a given nation, that is, activity in other nations. The foreign sector includes producers, consumers, and even governments from other nations.

Foreign trade is then the exchange of goods and services between the domestic economy and the foreign sector.

Exports and Imports

The direction of the exchange, that is, who does the buying and who does the selling, is generally categorized as either imports or exports. Imports are goods (or services) produced by the foreign sector and purchased by the domestic economy. These are goods (or services) that flow into the domestic economy in exchange for payment that flows out of the domestic economy and to the foreign sector.

Exports are goods (or services) produced by the domestic economy and purchased by the foreign sector. These are goods that flow out of the domestic economy in exchange for payment that flows from the foreign sector and to the domestic economy.

With goods and services flowing back and forth between the domestic economy and the foreign sector, a summary, or net, flow of activity is often useful. Net exports are the difference between exports and imports. This is the difference between goods flowing out of the domestic economy and goods flowing into the domestic economy.

Open and Closed

While most nations of the world engage in foreign trade, it is possible, at least in theory, for a domestic economy to have no foreign trade. This suggests two related notions a closed economy and an open economy. Closed Economy: A closed economy is an economy with no foreign trade, meaning that the economy is totally self sufficient. All goods consumed are produced within the domestic economy and all goods produced with in the

domestic economy and consumed domestically as well.

Open Economy: An open economy is an economy with that engages in foreign trade, meaning that some goods produced by their domestic economy are purchased by other nations and/or some goods purchased in the domestic economy are produced by other nations.

Domestic and Global

The term foreign trade implies one of two ways that the exchange of goods and services among different nations can be viewed. The most common way is from the perspective of the domestic economy. The other way is from the perspective of the global economy. The Domestic View: With this view, the focus is on foreign trade, the flow of trade between the domestic economy and the foreign sector. The domestic economy includes activity that occurs within the political boundaries of a particular nation. The foreign sector is then any and all activity that takes place beyond those political boundaries, activity that takes place in other nations. This view inevitably creates an "us" versus "them" perspective. This is the perspective a dedicated sports fan might take when rooting for the "home" team. Use of the term foreign trade reveals the domestic/foreign, us/them perspective.

The Global View: A broader view looks at every nation as but one among many players in the game of international trade, the flow of trade among nations. With this view each nation operates its own domestic economy and is simultaneously part of the foreign sector for every other nation. This is the perspective that an unbiased, objective umpire or referee should take when officiating a sporting event. Use of the term international trade emphasizes this notion of trade among nations.

Is one view right? Is the other view wrong? Is one view better than the other? Yes and no. And maybe. Like a lot that takes place in the study of economics, it all depends. For those who seek to isolate the basic principles of trade among nations, the global view makes the most sense. However, for those who seek to isolate the basic principles of domestic macroeconomic activity, the domestic view generally works better. While the domestic view distinguishes between imports and exports, the global view sees both as essentially two sides of the same coin. The import of one nation is the export of another. All imports are exports and all exports are imports. And while one nation might have more exports than imports, or more imports than exports, the global economy ALWAYS has a balance between exports and imports. Short of trading with another planet, net exports for the global economy are ALWAYS zero.

The Law of the Comparative Advantage

The key economic principle underlying foreign trade is the law of comparative advantage. This law states that every nation has a production activity that incurs a lower opportunity cost than that of another nation. This means that any given nation is bound to find some production that it can export as well as other production that it can import. How does this law work? First consider two related concepts. Absolute Advantage: A country is said to have an absolute advantage if it can, in general, produce more goods using fewer resources. An absolute advantage arises when a country is technically efficient or technologically superior.

Comparative Advantage: A country is said to have a comparative advantage if it can produce one good at a relatively lower opportunity cost than other goods, compared to the production in another country.

The law of comparative advantage works because EVERY nation has at least one good that it can produce at a relatively lower opportunity cost than that incurred by another nation. This is the key to foreign trade, because it also means that other nations can benefit by importing that good rather than producing it domestically. It's a win-win for exporters and importers.

The Balance of Trade

Tracking the flow of exports and imports, the foreign trade for a country, is commonly accomplished with the balance of trade. The balance of trade is the difference between the value of goods exported out of a country and the value of goods imported into the country. That is, it is the difference between exports and imports. The balance of trade is essentially another term for net exports, the difference between exports and imports. However, whereas the net exports phrase surfaces in most theoretical analyses of the macroeconomy, the balance of trade term tends to be more common in the official measurement of foreign trade. In fact, the balance of trade is actually one component of a more extensive set of international financial accounts termed the balance of payments. The balance of payments is the difference between all payments coming into a country and all payments going out of the country. Many of these payments are for exports and imports, but other payments are for capital assets or simply gifts between foreign and domestic citizens. In the same way that net exports can be either positive or negative, meaning exports exceed imports or imports exceed exports, the balance of trade can have either a surplus or deficit.

Balance of Trade Surplus: A surplus in the balance of trade arises if the value of exports exceeds the value of imports. In terms of "payments," this indicates that the domestic economy is receiving a net inflow of payments from the foreign sector. More payments coming in than going out means the domestic economy has more income that enhances the living standards of domestic residents. For this reason, a balance of trade surplus is also commonly termed a favorable balance of trade.

Balance of Trade Deficit: A deficit in the balance of trade arises if the value of imports exceeds the value of exports. In terms of "payments," this indicates that the domestic economy has a net outflow of payments to the foreign sector. Fewer payments coming in than going out means the domestic economy has less income and thus lower living standards. For this reason, a balance of trade deficit is also commonly termed a unfavorable balance of trade.

PESTEL analysis of the macro-environment

There are many factors in the macro-environment that will effect the decisions of the managers of any organisation. Tax changes, new laws, trade barriers, demographic change and government policy changes are all examples of macro change. To help analyse these factors managers can categorise them using the PESTEL model. This classification distinguishes between: Political factors. These refer to government policy such as the degree of intervention in the economy. What goods and services does a government want to provide? To what extent does it believe in subsidising firms? What are its priorities in terms of business support? Political decisions can impact on many vital areas for business such as the education of the workforce, the health of the nation and the quality of the infrastructure of the economy such as the road and rail system. Economic factors. These include interest rates, taxation changes, economic growth, inflation and exchange rates. As you will see throughout the "Foundations of Economics" book economic change can have a major impact on a firm's behaviour. For example: - higher interest rates may deter investment because it costs more to borrow - a strong currency may make exporting more difficult because it may raise the price in terms of foreign currency

- inflation may provoke higher wage demands from employees and raise costs - higher national income growth may boost demand for a firm's products Social factors. Changes in social trends can impact on the demand for a firm's products and the availability and willingness of individuals to work. In the UK, for example, the population has been ageing. This has increased the costs for firms who are committed to pension payments for their employees because their staff are living longer. It also means some firms such as Asda have started to recruit older employees to tap into this growing labour pool. The ageing population also has impact on demand: for example, demand for sheltered accommodation and medicines has increased whereas demand for toys is falling. Technological factors: new technologies create new products and new processes. MP3 players, computer games, online gambling and high definition TVs are all new markets created by technological advances. Online shopping, bar coding and computer aided design are all improvements to the way we do business as a result of better technology. Technology can reduce costs, improve quality and lead to innovation. These developments can benefit consumers as well as the organisations providing the products. Environmental factors: environmental factors include the weather and climate change. Changes in temperature can impact on many industries including farming, tourism and insurance. With major climate changes occurring due to global warming and with greater environmental awareness this external factor is becoming a significant issue for firms to consider. The growing desire to protect the environment is having an impact on many industries such as the travel and transportation industries (for example, more taxes being placed on air travel and the success of hybrid cars) and the general move towards more environmentally friendly products and processes is affecting demand patterns and creating business opportunities. Legal factors: these are related to the legal environment in which firms operate. In recent years in the UK there have been many significant legal

changes that have affected firms' behaviour. The introduction of age discrimination and disability discrimination legislation, an increase in the minimum wage and greater requirements for firms to recycle are examples of relatively recent laws that affect an organisation's actions. Legal changes can affect a firm's costs (e.g. if new systems and procedures have to be developed) and demand (e.g. if the law affects the likelihood of customers buying the good or using the service). Different categories of law include: consumer laws; these are designed to protect customers against unfair practices such as misleading descriptions of the product competition laws; these are aimed at protecting small firms against bullying by larger firms and ensuring customers are not exploited by firms with monopoly power employment laws; these cover areas such as redundancy, dismissal, working hours and minimum wages. They aim to protect employees against the abuse of power by managers health and safety legislation; these laws are aimed at ensuring the workplace is as safe as is reasonably practical. They cover issues such as training, reporting accidents and the appropriate provision of safety equipment Typical PESTEL factors to consider include:

Factor Political Economic Social Technological Environmental Legal

Could include: e.g. EU enlargement, the euro, international trade, taxation policy e.g. interest rates, exchange rates, national income, inflation, unemployment, Stock Market e.g. ageing population, attitudes to work, income distribution e.g. innovation, new product development, rate of technological obsolescence e.g. global warming, environmental issues e.g. competition law, health and safety, employment law

By using the PESTEL framework we can analyse the many different factors in a

firm's macro environment. In some cases particular issues may fit in several categories. For example, the creation of the Monetary Policy Committee by the Labour government in 1997 as a body that was independent of government but had the ability to set interest rates was a political decision but has economic consequences; meanwhile government economic policy can influence investment in technology via taxes and tax credits. If a factor can appear in several categories managers simply make a decision of where they think it best belongs. However, it is important not to just list PESTEL factors because this does not in itself tell managers very much. What managers need to do is to think about which factors are most likely to change and which ones will have the greatest impact on them i.e. each firm must identify the key factors in their own environment. For some such as pharmaceutical companies government regulation may be critical; for others, perhaps firms that have borrowed heavily, interest rate changes may be a huge issue. Managers must decide on the relative importance of various factors and one way of doing this is to rank or score the likelihood of a change occurring and also rate the impact if it did. The higher the likelihood of a change occurring and the greater the impact of any change the more significant this factor will be to the firm's planning. It is also important when using PESTEL analysis to consider the level at which it is applied. When analysing companies such as Sony, Chrysler, Coca Cola, BP and Disney it is important to remember that they have many different parts to their overall business - they include many different divisions and in some cases many different brands. Whilst it may be useful to consider the whole business when using PESTEL in that it may highlight some important factors, managers may want to narrow it down to a particular part of the business (e.g. a specific division of Sony); this may be more useful because it will focus on the factors relevant to that part of the business. They may also want to differentiate between factors which are very local, other which are national and those which are global. For example, a retailer undertaking PESTEL analysis may consider: Local factors such as planning permission and local economic growth rates National factors such as UK laws on retailer opening hours and trade descriptions legislation and UK interest rates Global factors such as the opening up of new markets making trade easier. The entry of Bulgaria and Rumania into the European Union might make it

easier to enter that market in terms of meeting the various regulations and provide new expansion opportunities. It might also change the labour force within the UK and recruitment opportunities. This version of PESTEL analysis is called LoNGPESTEL. This is illustrated below:

POLITICAL

LOCAL Provision of services by local council Local income Local population growth

ECONOMIC SOCIAL

TECHNOLOGICAL Improvements in local technologies e.g. availability of Digital TV ENVIRONMENTAL Local waste issues LEGAL Local licences/planning permission

NATIONAL GLOBAL UK government World trade policy on subsidies agreements e.g. further expansion of the EU UK interest rates Overseas economic growth Demographic Migration flows change (e.g. ageing population) UK wide technology International e.g. UK online technological services breakthroughs e.g. internet UK weather Global climate change UK law International agreements on human rights or environmental policy

In "Foundations of Economics" we focus on the economic environment. We examine issues such as the effect of interest rate changes, changes in exchange rates, changes in trade policy, government intervention in an economy via spending and taxation and economic growth rates. These can be incredibly important factors in a firm's macro-environment. The growth of China and India, for example, have had massive effects on many organisations. Firms can relocate production there to benefit from lower costs; these emerging markets are also providing enormous markets for firms to aim their products at. With a population of over 1 billion, for example, the Chinese market is not one you would want to ignore; at the same time Chinese producers should not be ignored either.

However, the relative importance of economic factors compared to other factors will depend on the particular position of a business. Exchange rate fluctuations may be critically important to a multinational but less significant to a local window cleaner. Rapid economic growth or economic decline may be very significant to a construction business that depends heavily on the level of income in the economy but may be slightly less significant to a milk producer whose product is less sensitive to income. So whilst the economy is important to all firms on both the supply side (e.g. unemployment levels affect the ease of recruitment) and demand side (e.g. income tax affects spending power) the relative importance of specific economic factors and the relative importance of the economy compared to, say, regulation or social trends will vary. Whilst we hope this book provides a good insight into the economy and the possible effects of economic change on a business these must be considered in the light of other macro and micro factors that influence a firms' decisions and success.

Investment multiplier is simply the multiplier effect of an injection of investment into an

economy. In general, a multiplier shows how a sum injected into an economy travels and generates more output. For example if you buy $100 worth of chips. Say the stallowner saves $10 and spends $90 on burgers. Then the burger stall owner saves 10% that is $9 and consumes the rest ($81) on cheese, and so on... Each $ receivedm 10% is saved (marginal propensity to save- MPS) and 90% consumed (marginal propensity to consume - MPC). This eventually results in 100/(1.9)=$1000 worth of expenditure in the economy. The multiplier=1/(1-MPC). The investment multiplier is simply teh same idea applied to an increase in investment as opposed to consumption above. Using consumptionjust makes it easier to understand; investment multiplier is just the same. Now, autonomous investment increases for many reasons. People might start believing that better times are ahead, hence prepare for the future. Another could be that more people decide to become entrepreneurs. Another could be government policies that make small loans available for SMEs. Another could be peace rather than war. ANother could be change in tarde reginme towards an open economy so people try to invext to export... hope that helped.

The Supply of Money

The supply of money is what gives each dollar its value. All things being equal, the greater the supply, the lesser the value. We can make the same conclusions about shares of stock. If a company announces a 2:1 split, what happens to the price? A 2:1

split just means that the company issues one share of stock for each share in existence thus creating two shares for every one in existence. If you own 100 shares today, you will have 200 shares after the split. Does that mean youll immediately double the value of your holdings? No, because the share price gets cut in half. In other words, if you double the number of shares, the price falls proportionately. Microsoft is currently trading for about $35 per share and has 9.38 billion shares outstanding. What would the company be worth if they increased the number of shares by a factor of 10,000? It would be nearly worthless. As with money, the more stock certificates there are in existence, the lower the value of each share. Money has value because of the relative availability. If money were as plentiful as grains of sand on all the worlds beaches, it would have no value. Just like sh ares of stock, money is similar in that it symbolizes a claim on assets. If you have a ten-dollar bill, it represents your claim to ten dollars worth of goods or services. However, if that ten-dollar bill represents such a small fraction of all bills in existence, it is virtually worthless. In a similar way, one grain of sand represents an insignificantly small portion of the beach and therefore has no value. At any time, the Fed can count the number of dollars in existence but that is easier said than done since that depends on what were willing to count as money. There are four basic definitions that the Fed uses to measure the supply of money called M1, M2, M3 and L. In fact, in the Federal Reserve booklet, The Federal Reserve System, Purposes & Functions, the Fed gives the following definition of money: "Anything that serves as a generally accepted medium of exchange, a standard of value, and a means of saving or storing purchasing power. In the United States, currency (the bulk of which is Federal Reserve notes) and funds in checking and similar accounts at depository institutions are examples of money ." While it's beyond the scope of this course to go into the various pros and cons of the different measures, they are listed here just to emphasize how difficult it is to give a precise definition of the supply of money: M1 is the base measurement of the money supply and includes cash in the hands of the public (currency and coins) plus demand deposits, tourist's checks from non-bank issuers, and other checkable deposits. M2 is equal to M1 plus savings deposits, money market accounts, overnight repurchase agreements issued by commercial banks, overnight Eurodollars, money market mutual funds, and time deposits less than $100,000. M3 equals M2 plus institutionally held money market funds, term repurchase agreements, term Eurodollars, and large time deposits. L,the fourth measure, is equal to M3 plus Treasury bills, commercial papers, banker's acceptances, and very liquid assets such as savings bonds. Almost all short-term, highly liquid assets will be included in this measure called L, which stands for liquidity. Regardless of how it is measured, an increase in the supply of money puts more

spending power in the hands of the consumers, which stimulates demand for goods and services. The Treasury must issue enough securities to provide the amount needed by the economy and the money supply is ultimately limited by the total amount of Treasury securities outstanding.

The Demand for Money

Is there a limit on the demand for money? Could you ever have too much? While this may be the suggested meaning in the phrase demand for money it is not the way it is used by economists. When economists speak of the demand for money, they mean your desire to hold a given amount of money over a given time. There are three main reasons why people demand to hold money (1) to conduct basic transactions (2) for unexpected events, which is often called a precautionary motive, and (3) for speculation. The first reason, transactions, refers to basic transactions. These include money for food, transportation, tolls, and other miscellaneous known transactions throughout a given time period. For example, if you typically hold an average of $100 in your wallet each week to conduct transactions, that's your transactions demand for money. Precautionary money is held for unexpected transactions such as car repairs or medical bills, although does not need to be limited to serious expenses or needs. You could hold additional money to take advantage of a computer sale you expect to be happening soon. The speculation motive for holding money is a battle between cash and investments. Cash, by itself, earns no interest and can therefore be expensive to hold (due to the opportunity cost of foregone interest). However, if you think stock and bond prices are relatively low, you could generate a return on your money by putting cash into these investments thats the speculative motive for holding money. Conversely, if interest rates are high, you will want to hold as much cash as possible.

The Price of Money Interest Rates

As stated at the beginning of this course, the supply and demand for any product or service is what determines its value and money is no exception. We also stated earlier that banks regulate the flow of money from lenders to borrowers. Now it's time to apply the principles of supply and demand and see how they coincide with bank operations. If the bank desires more funds to loan, they must increase the interest rate (raise the bid) they pay for their products, such as Certificates of Deposit. As the price goes up, cash comes in. Likewise, if they have excess cash, they have more "sellers" of cash than "buyers." In other words, they have more lenders than borrowers so will likely lower rates to give consumers the incentive to borrow and lenders the disincentive to lend. Interest rates are therefore the price that people are willing to pay for the use of money. Specifically, interest is the price of current consumption. If you want to buy something now but do not have the money, you can borrow the funds from a bank. In exchange, you must pay back the money plus interest, which means there is something in the future you will not be able to purchase. You are effectively sacrificing that future good for another good today. Lenders are willing to sacrifice consumption of goods today in exchange for consumption of a higher amount (principal plus interest) of goods in the future. Economics is all about tradeoffs. Banks simply match lenders with

borrowers. How can we be sure there are not too many (or too few lenders) compared to the borrowers? By now you should understand that price acts to regulate the number of buyers and sellers. The price that regulates current consumption is the interest rate. How is that rate determined? Let's take a look at the mechanics. If you have money to lend, you can, for example, buy a bond. You give up cash today to buy the bond. While it may sound a little confusing, if you are a buyer of a bond, you are also a seller of cash. The seller of the bond uses that cash today in exchange for giving up more cash tomorrow. The seller of the bond is therefore the buyer of cash. Now you should have a better understanding what was meant when we said supply and demand are two sides of the same coin. Suppliers of bonds are demanders of cash and vice versa. If a lot of people want to borrow money relative to those who want to lend, then borrowers are trying to coax more cash out of the market. How do they create more sellers of cash? They do the same thing our desert tourists did when they wanted more water and raise their bid. As bond sellers raise the bid price of cash the interest rate more cash sellers (bond buyers) appear resulting in more cash emerging in the market. We could have also reached the same conclusion by looking at the effects on bond prices in the markets. As the bond sellers compete for bond sales in the market, they must do so by lowering the price of bonds. Lower bond prices attract new bond buyers (sellers of cash). As bond prices fall, interest rates rise. Remember, look at this situation as though you are either a buyer of cash or the seller of a bond. Either the price of cash goes up or the price of bonds goes down. Both result in higher interest rates. The reverse effects obviously hold true as well. If we assume that a lot of people want to lend money relative to those who want to borrow, then we have more people willing to sell cash than those willing to buy and the interest rate should fall. We can run through the mechanics again as a quick check. If you want to sell cash, you are effectively demanding the purchase of a bond. In order to sell cash, you must lower its price, which is the interest rate. Likewise you can view this as demanding a bond. How do you create more bond sellers? You raise the bid price of the bonds. As bond prices rise, interest rates fall. As lenders buy bonds, they compete in the markets and drive up the price of bonds, which makes the interest rates (bond yields) fall. Therefore, if there are excess people willing to lend, interest rates will fall. In other words, there are more sellers than buyers so they must bring down their price in order to attract buyers. Once all buyers of cash are equally matched with sellers, the market is cleared and the interest rate is stable. Just as any product or service's price is controlled by supply and demand, money is no exception. Money is a commodity and is subject to the same economic forces that establish price.

We should note that when people say "the" interest rate, they are generally talking about the short-term, risk-free rate on government treasuries, as there are many types of interest rates. Even within the government treasuries there are generally 90-day bills and 30-year notes with varying time frames in between. Regardless, any interest rate is the result of the current supply of money for that asset and the demand for it. What's the interest rate for credit cards? It is the price that equalizes the amount of money that banks are willing to supply for signature loans (loans that don't require collateral) and people's demand for that money. This should shed some light on consumers' willingness to spend ahead of their incomes and you hopefully now have at least a little different viewpoint if someone states that credit card rates are "outrageous." They are outrageous as a direct reflection of consumers insatiable appetite for spending today rather than tomorrow. Interest rates are the tie between buyers and sellers of cash. By adjusting interest rates, we can control the incentives to buyers and sellers and therefore adjust the amount of cash available for loans. But this brings up an interesting point. Rather than regulating the amount of cash available to consumers, why doesnt the government just print money for everybody thus making us better off? The answer, as shown in the next section, has to do with our economic forces of supply and demand.

Why Can't the Government Print Money and Make Everybody Wealthy?
We have seen that the value of everything is determined by its supply and demand for it. As we just found out, the same forces too determine the value of money. Many people wonder why the government can't just print money, deposit it into everybody's account, and make everybody wealthy. The reason is because there would be a large supply of money relative to the goods produced and the value of the dollar will fall. People who make such arguments for printing money as a means for creating wealth are confusing money with wealth. If you think about it, you really don't desire money for the sake of holding additional pieces of paper. You desire it to

purchase more things. The more things you are able to purchase, the wealthier you are. While most people associate more pieces of paper with the ability to purchase more things that is only true for an individual and not the group as a whole. The mistaken belief that what is true for an individual is also true for the whole is known as thefallacy of composition. I may get a better view if I stand during a football game, but will lose that advantage if everybody else stands too. If I stick a fluorescent orange styrofoam ball on my car antenna, I have an advantage of quickly locating my car in a crowded parking lot unless everyone else does the same thing. Likewise, you may be better off if you have more pieces of paper, but will lose the advantage if everybody has more too. Just because you own more pieces of paper does not necessarily mean you have more wealth. If the government doubled overnight everybody's checking account balances, stock portfolios and other forms of money discussed earlier, you may think you would be pretty happy. Because of your newly found wealth, you will certainly demand more things. You will want another car, boat, more clothes, jewelry, and certainly more vacations. But here's the catch: none of these additional items were produced overnight. As you (and everybody else) rush out to buy them, the prices get bid up in the process because there are now more buyers than sellers. As we said earlier, people have a certain demand for money, and everybody tries to get rid of the excess cash. However, as you try to get rid of your cash, it becomes somebody else's cash. Remember at the beginning of the course we showed several examples of where "lines of people" are formed when prices are too low. This is exactly what happens if the supply of money is increased. On a relative scale, there is more money than products so things appear a little cheap and people act accordingly and get in line to buy. The retailers cannot handle the excess demand so how do the get rid of the long lines of cash waiting outside their doors? They raise the prices to a point where they are in equilibrium and supply equals demand to a point where prices are exactly doubled. This phenomenon is often called the quantity theory of money. It states that a given money supply is spent over and over (called the velocity of money) on goods and services throughout the year. For example $1 can be spent on many items throughout the year, thus providing income to many people. The value of the number of products that dollar will buy is equal to Price * Quantity. In other words, $1 spent 10 times can support $10 worth of goods. This can be stated as: Money Supply * Velocity = Prices * Quantity, which can be written as: M*V=P*Q This is the formula behind the quantity theory of money. The velocity, V, of money is the rate at which people spend and is usually constant over fairly long periods of time. Likewise, the quantity, Q, of goods produced is fairly constant over a given time. Because V and Q are fairly constant, if the money supply, M, increases (left side of the equation), the only way the right side of the equation can balance is if prices, P, rise by an equal amount. In other words, if the money

supply doubles so too will all prices. So while the government does have the right and the ability to print more money, the economic forces of supply and demand prevent us from using printing presses to create true wealth. We can create more pieces of paper but youd find that you are no better off than before. The reason is that prices will be proportionately inflated by the amount of cash in the system. On our website, we feature this note worth 500 billion Yugoslavian dinars as a banner ad for this course. That's a 5 followed by 11 zeros! That's a lot of pieces of paper but it represented little value. Although, this currency is no longer, it was still nearly worthless when it was in existence. The Yugoslavian government used printing presses to pay off all its loans. The result was a lot of money without corresponding goods and services to back it up. The quantity theory of money states that the result will be inflation -- and that's why you see so many zeros. Lets take a closer look at the monetary phenomenon of inflation in the next section.

Liquidity preference
From Wikipedia, the free encyclopedia

This article is about liquidity preference in macroeconomic theory. For other uses, see Liquidity preference (Venture capital). In macroeconomic theory, Liquidity preference refers to the demand for money, considered as liquidity. The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money. The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds. Interest rates, he argues, cannot be a reward for saving as such because, if a person hoards his savings in cash, keeping it under his mattress say,

he will receive no interest, although he has nevertheless, refrained from consuming all his current income. Instead of a reward for saving, interest in the Keynesian analysis is a reward for parting with liquidity. According to Keynes, demand for liquidity is determined by three motives: 1. the transactions motive: people prefer to have liquidity to assure basic transactions, for their income is not constantly available. The amount of liquidity demanded is determined by the level of income: the higher the income, the more money demanded for carrying out increased spending. 2. the precautionary motive: people prefer to have liquidity in the case of social unexpected problems that need unusual costs. The amount of money demanded for this purpose increases as income increases. 3. speculative motive: people retain liquidity to speculate that bond prices will fall. When the interest rate decreases people demand more money to hold until the interest rate increases, which would drive down the price of an existing bond to keep its yield in line with the interest rate. Thus, the lower the interest rate, the more money demanded (and vice versa). The liquidity-preference relation can be represented graphically as a schedule of the money demanded at each different interest rate. The supply of money together with the liquiditypreference curve in theory interact to determine the interest rate at which the quantity of money demanded equals the quantity of money supplied (see IS/LM model).

[edit]Criticisms
Murray Rothbard rejected Keynes' theory of liquidity preference. In his book America's Great Depression, Rothbard argued that interest rates are instead determined by time preference. Says Rothbard, "Increased hoarding can either come from funds formerly consumed, from funds formerly invested, or from a mixture of both that leaves the old consumption-investment proportion unchanged. Unless time preferences change, the last alternative will be the one adopted. Thus, the rate of interest depends solely on time preference, and not at all on "liquidity preference." In fact, if the increased hoards come mainly out of consumption, an increased demand for money will cause interest rates to fallbecause time preferences have fallen."[1]

Monetary policy

From Wikipedia, the free encyclopedia

This article may contain too much repetition or redundant language . Please help improve it by merging similar text or removing repeated statements. (September 2009)
Part of a series on Government

Public finance

Policies[show]

Fiscal policy[show]

Monetary policy[show]

Trade policy[show]

Revenue and Spending[show]

Optimum[show]

Reform[show]

Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.[1] [2] The official goals usually include relatively stable prices and

low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. It is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values. Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated borrowing.[3]
Contents
[hide]

1 Overview

1.1 Theory

2 History of monetary policy

o o

2.1 Trends in central banking 2.2 Developing countries

3 Types of monetary policy

o o o o o o

3.1 Inflation targeting 3.2 Price level targeting 3.3 Monetary aggregates 3.4 Fixed exchange rate 3.5 Gold standard 3.6 Policy of various nations

4 Monetary policy tools

o o o o o o

4.1 Monetary base 4.2 Reserve requirements 4.3 Discount window lending 4.4 Interest rates 4.5 Currency board 4.6 Unconventional monetary policy at the zero bound

5 See also 6 Notes and references

7 External links

[edit]Overview
Monetary policy rests on the relationship between the rates of interest in an economy, that is, the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard. A policy is referred to as contractionary if it reduces the size of the money supply or increases it only slowly, or if it raises the interest rate. An expansionary policy increases the size of the money supply more rapidly, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation. There are several monetary policy tools available to achieve these ends: increasing interest rates by fiat; reducing the monetary base; and increasing reserve requirements. All have the effect of contracting the money supply; and, if reversed, expand the money supply. Since the 1970s, monetary policy has generally been formed separately from fiscal policy. Even prior to the 1970s, theBretton Woods system still ensured that most nations would form the two policies separately. Within almost all modern nations, special institutions (such as the Federal Reserve System in the United States, the Bank of England, the European Central Bank, the People's Bank of China, and theBank of Japan) exist which have the task of executing the monetary policy and often independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system. The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds, or foreign currencies. All of these purchases or sales result in more or less base currency entering or leaving market circulation. Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific

exchange rate relative to some foreign currency or else relative to gold. For example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight; however, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies. The other primary means of conducting monetary policy include: (i) Discount window lending (lender of last resort); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) "Open mouth operations" (talking monetary policy with the market).

Types of monetary policy

In practice, to implement any type of monetary policy the main tool used is modifying the amount of base money in circulation. The monetary authority does this by buying or selling financial assets (usually government obligations). These open market operations change either the amount of money or its liquidity (if less liquid forms of money are bought or sold). The multiplier effect of fractional reserve banking amplifies the effects of these actions. Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate. The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.

Monetary Policy:

Target Market Variable: Interest rate on overnight debt Interest rate on overnight debt The growth in money supply The spot price of the currency

Long Term Objective:

Inflation Targeting

A given rate of change in the CPI

Price Level Targeting Monetary Aggregates Fixed Exchange Rate

A specific CPI number

A given rate of change in the CPI

The spot price of the currency

Gold Standard

The spot price of gold

Low inflation as measured by the gold price

Mixed Policy

Usually interest rates

Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking exactly the same variables (such as a harmonized consumer price index). [edit]Inflation

targeting

Main article: Inflation targeting Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, within a desired range. The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar. The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee. Changes to the interest rate target are made in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. For example, one simple method of inflation targeting called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and [18] the output gap. The rule was proposed by John B. Taylor of Stanford University. The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is currently used in Australia, Brazil, Canada, Chile, Colombia, the Czech Republic, Hungary, New Zealand, Norway, Iceland, India, Philippines, Poland, Sweden, South Africa, Turkey, and the United Kingdom. [edit]Price

level targeting

Price level targeting is similar to inflation targeting except that CPI growth in one year over or under the long term price level target is offset in subsequent years such that a targeted pricelevel is reached over time, e.g. five years, giving more certainty about future price increases to consumers. Under inflation targeting what happened in the immediate past years is not taken into account or adjusted for in the current and future years. [edit]Monetary

aggregates

In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc.). In the USA this approach to monetary policy was discontinued with the selection of Alan

Greenspan as Fed Chairman. This approach is also sometimes called monetarism. While most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary quantities. [edit]Fixed

exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation. Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate. Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.) Under a system of fixed exchange rates maintained by a currency board every unit of local currency must be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that the local monetary base does not inflate without being backed by hard currency and eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard (anchor) currency. Under dollarization, foreign currency (usually the US dollar, hence the term "dollarization") is used freely as the medium of exchange either exclusively or in parallel with local currency. This outcome can come about because the local population has lost all faith in the local currency, or it may also be a policy of the government (usually to rein in inflation and import credible monetary policy). These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, credit channels and other economic factors. See also: List of fixed currencies [edit]Gold

standard

Main article: Gold standard The gold standard is a system under which the price of the national currency is measured in units of gold bars and is kept constant by the government's promise to buy or sell gold at a

fixed price in terms of the base currency. The gold standard might be regarded as a special case of "fixed exchange rate" policy, or as a special type of commodity price level targeting. The minimal gold standard would be a long-term commitment to tighten monetary policy enough to prevent the price of gold from permanently rising above parity. A full gold standard would be a commitment to sell unlimited amounts of gold at parity and maintain a reserve of gold sufficient to redeem the entire monetary base. Today this type of monetary policy is no longer used by any country, although the gold [19] standard was widely used across the world between the mid-19th century through 1971. Its major advantages were simplicity and transparency. The gold standard was abandoned during the Great Depression, as countries sought to reinvigorate their economies by increasing their [20] money supply. The Bretton Woods system, which was a modified gold standard, replaced it in the aftermath of World War II. However, this system too broke down during the Nixon shock of 1971. The gold standard induces deflation, as the economy usually grows faster than the supply of gold. When an economy grows faster than its money supply, the same amount of money is used to execute a larger number of transactions. The only way to make this possible is to lower the nominal cost of each transaction, which means that prices of goods and services fall, and each unit of money increases in value. Absent precautionary measures, deflation would tend to increase the ratio of the real value of nominal debts to physical assets over time. For example, during deflation, nominal debt and the monthly nominal cost of a fixed-rate home mortgage stays the same, even while the dollar value of the house falls, and the value of the dollars required to pay the mortgage goes up. Mainstream economics considers such deflation to be a major disadvantage of the gold standard. Unsustainable (i.e. excessive) deflation can cause problems during recessions and financial crisislengthening the amount of time an economy spends in recession. William Jennings Bryan rose to national prominence when he built his historic (though unsuccessful) 1896 presidential campaign around the argument that deflation caused by the gold standard made it harder for everyday citizens to start new businesses, expand their farms, or build new homes.

Main Functions of rbi

Monetary Authority:

Formulates, implements and monitors the monetary policy. Objective: maintaining price stability and ensuring adequate flow of credit to productive sectors.

Regulator and supervisor of the financial system:

Prescribes broad parameters of banking operations within which the country''s banking and financial system functions. Objective: maintain public confidence in the system, protect depositors''

interest and provide cost -effective banking services to the public. Regulator and supervisor of the payment systems o Authorises setting up of payment systems o Lays down standards for operation of the payment system o Issues direction, calls for returns/information from payment system operators.

Manager of Foreign Exchange

Manages the Foreign Exchange Management Act, 1999. Objective: to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.

Issuer of currency:

Issues and exchanges or destroys currency and coins not fit for circulation. Objective: to give the public adequate quantity of supplies of currency notes and coins and in good quality.

Developmental role

Performs a wide range of promotional functions to support national objectives.

Related Functions

Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker. Banker to banks: maintains banking accounts of all scheduled banks

Fiscal policy has to decide on the size and pattern of flow of expenditure from the government to the economy and from the economy back to the government. So, in broad term fiscal policy refers to "that segment of national economic policy which is primarily concerned with the receipts and expenditure of central government." In other

words, fiscal policy refers to the policy of the government with regard to taxation, public expenditure and public borrowings. The importance of fiscal policy is high in underdeveloped countries. The state has to play active and important role. In a democratic society direct methods are not approved. So, the government has to depend on indirect methods of regulations. In this way, fiscal policy is a powerful weapon in the hands of government by means of which it can achieve the objectives of development.

Main Objectives of Fiscal Policy In India

The fiscal policy is designed to achive certain objectives as follows :-

1. Development by effective Mobilisation of Resources

The principal objective of fiscal policy is to ensure rapid economic growth and development. This objective of economic growth and development can be achieved by Mobilisation of Financial Resources. The central and the state governments in India have used fiscal policy to mobilise resources. The financial resources can be mobilised by :1. 2. 3. Taxation : Through effective fiscal policies, the government aims to mobilise resources by way of direct taxes as well as indirect taxes because most important source of resource mobilisation in India is taxation. Public Savings : The resources can be mobilised through public savings by reducing government expenditure and increasing surpluses of public sector enterprises. Private Savings : Through effective fiscal measures such as tax benefits, the government can raise resources from private sector and households. Resources can be mobilised through government borrowings by ways of treasury bills, issue of government bonds, etc., loans from domestic and foreign parties and by deficit financing.

2. Efficient allocation of Financial Resources

The central and state governments have tried to make efficient allocation of financial resources. These resources are allocated for Development Activities which includes expenditure on railways, infrastructure, etc. While Nondevelopment Activities includes expenditure on defence, interest payments, subsidies, etc. But generally the fiscal policy should ensure that the resources are allocated for generation of goods and services which are socially desirable. Therefore, India's fiscal policy is designed in such a manner so as to encourage production of desirable goods and discourage those goods which are socially undesirable.

3. Reduction in inequalities of Income and Wealth

Fiscal policy aims at achieving equity or social justice by reducing income inequalities among different sections of the society. The direct taxes such as income tax are charged more on the rich people as compared to lower income groups. Indirect taxes are also more in the case of semi-luxury and luxury items, which are mostly consumed by the

upper middle class and the upper class. The government invests a significant proportion of its tax revenue in the implementation of Poverty Alleviation Programmes to improve the conditions of poor people in society.

4. Price Stability and Control of Inflation

One of the main objective of fiscal policy is to control inflation and stabilize price. Therefore, the government always aims to control the inflation by Reducing fiscal deficits, introducing tax savings schemes, Productive use of financial resources, etc.

5. Employment Generation
The government is making every possible effort to increase employment in the country through effective fiscal measure. Investment in infrastructure has resulted in direct and indirect employment. Lower taxes and duties on small-scale industrial (SSI) units encourage more investment and consequently generates more employment. Various rural employment programmes have been undertaken by the Government of India to solve problems in rural areas. Similarly, self employment scheme is taken to provide employment to technically qualified persons in the urban areas.

6. Balanced Regional Development

Another main objective of the fiscal policy is to bring about a balanced regional development. There are various incentives from the government for setting up projects in backward areas such as Cash subsidy, Concession in taxes and duties in the form of tax holidays, Finance at concessional interest rates, etc.

7. Reducing the Deficit in the Balance of Payment

Fiscal policy attempts to encourage more exports by way of fiscal measures like Exemption of income tax on export earnings, Exemption of central excise duties and customs, Exemption of sales tax and octroi, etc. The foreign exchange is also conserved by Providing fiscal benefits to import substitute industries, Imposing customs duties on imports, etc. The foreign exchange earned by way of exports and saved by way of import substitutes helps to solve balance of payments problem. In this way adverse balance of payment can be corrected either by imposing duties on imports or by giving subsidies to export.

8. Capital Formation

The objective of fiscal policy in India is also to increase the rate of capital formation so as to accelerate the rate of economic growth. An underdeveloped country is trapped in vicious (danger) circle of poverty mainly on account of capital deficiency. In order to increase the rate of capital formation, the fiscal policy must be efficiently designed to encourage savings and discourage and reduce spending.

9. Increasing National Income

The fiscal policy aims to increase the national income of a country. This is because fiscal policy facilitates the capital formation. This results in economic growth, which in turn increases the GDP, per capita income and national income of the country.

10. Development of Infrastructure

Government has placed emphasis on the infrastructure development for the purpose of achieving economic growth. The fiscal policy measure such as taxation generates revenue to the government. A part of the government's revenue is invested in the infrastructure development. Due to this, all sectors of the economy get a boost.

11. Foreign Exchange Earnings

Fiscal policy attempts to encourage more exports by way of Fiscal Measures like, exemption of income tax on export earnings, exemption of sales tax and octroi, etc. Foreign exchange provides fiscal benefits to import substitute industries. The foreign exchange earned by way of exports and saved by way of import substitutes helps to solve balance of payments problem.

Conclusion On Fiscal Policy

The objectives of fiscal policy such as economic development, price stability, social justice, etc. can be achieved only if the tools of policy like Public Expenditure, Taxation, Borrowing and deficit financing are effectively used. Though there are gaps in India's fiscal policy, there is also an urgent need for making India's fiscal policy a rationalised and growth oriented one. The success of fiscal policy depends upon taking timely measures and their effective administration during implementation.

Indian Money Market - Features

Every money is unique in nature. The money market in developed and developing countries differ markedly from each other in many senses. Indian money market is not an exception for this. Though it is not a developed money market, it is a leading money market among the developing countries.

Indian Money Market has the following major features or characteristics :1. Dichotomic Structure : It is a significant aspect of the Indian money market. It has a simultaneous existence of both the organized money market as well as unorganised money markets. The organized money market consists of RBI, all scheduled commercial banks and other recognized financial institutions. However, the unorganized part of the money market comprises domestic money lenders, indigenous bankers, trader, etc. The organized money market is in full control of the RBI. However, unorganized money market remains outside the RBI control. Thus both the organized and unorganized money market exists simultaneously. 2. Seasonality : The demand for money in Indian money market is of a seasonal nature. India being an agriculture predominant economy, the demand for money is generated from the agricultural operations. During the busy season i.e. between October and April more agricultural activities takes place leading to a higher demand for money. 3. Multiplicity of Interest Rates : In Indian money market, we have many levels of interest rates. They differ from bank to bank from period to period and even from borrower to borrower. Again in both organized and unorganized segment the interest rates differs. Thus there is an existence of many rates of interest in the Indian money market. 4. Lack of Organized Bill Market : In the Indian money market, the organized bill market is not prevalent. Though the RBI tried to introduce the Bill Market Scheme (1952) and then New Bill Market Scheme in 1970, still there is no properly organized bill market in India. 5. Absence of Integration : This is a very important feature of the Indian money market. At the same time it is divided among several segments or sections which are loosely connected with each other. There is a lack of coordination among these different components of the money market. RBI has full control over the components in the organized segment but it cannot control the components in the unorganized segment. 6. High Volatility in Call Money Market : The call money market is a market for very short term money. Here money is demanded at the call rate. Basically the demand for call money comes from the commercial banks. Institutions such as the GIC, LIC, etc suffer huge fluctuations and thus it has remained highly volatile.

7.

Limited Instruments : It is in fact a defect of the Indian money market. In our money market the supply of various instruments such as the Treasury Bills, Commercial Bills, Certificate of Deposits, Commercial Papers, etc. is very limited. In order to meet the varied requirements of borrowers and lenders, It is necessary to develop numerous instruments.

Drawbacks of Indian Money Market

Though the Indian money market is considered as the advanced money market among developing countries, it still suffers from many drawbacks ordefects. These defects limit the efficiency of our market.

Some of the important defects or drawbacks of indian money market are :1. Absence of Integration : The Indian money market is broadly divided into the Organized and Unorganized Sectors. The former comprises the legal financial institutions backed by the RBI. The unorganized statement of it includes various institutions such as indigenous bankers, village money lenders, traders, etc. There is lack of proper integration between these two segments. 2. Multiple rate of interest : In the Indian money market, especially the banks, there exists too many rates of interests. These rates vary for lending, borrowing, government activities, etc. Many rates of interests create confusion among the investors. 3. Insufficient Funds or Resources : The Indian economy with its seasonal structure faces frequent shortage of financial recourse. Lower income, lower savings, and lack of banking habits among people are some of the reasons for it. 4. Shortage of Investment Instruments : In the Indian money market, various investment instruments such as Treasury Bills, Commercial Bills, Certificate of Deposits, Commercial Papers, etc. are used. But taking into account the size of the population and market these instruments are inadequate. 5. Shortage of Commercial Bill : In India, as many banks keep large funds for liquidity purpose, the use of the commercial bills is very limited. Similarly since a large number of transactions are preferred in the cash form the scope for commercial bills are limited.

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Lack of Organized Banking System : In India even through we have a big network of commercial banks, still the banking system suffers from major weaknesses such as the NPA, huge losses, poor efficiency. The absence of the organized banking system is major problem for Indian money market.

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Less number of Dealers : There are poor number of dealers in the short-term assets who can act as mediators between the government and the banking system. The less number of dealers leads tc the slow contact between the end lender and end borrowers.

These are some of the major drawbacks of the Indian money market; many of these are also the features of our money market.

Recent Reforms in Indian Money Market

Indian Government appointed a committee under the chairmanship of Sukhamoy Chakravarty in 1984 to review the Indian monetary system. Later,Narayanan Vaghul working group and Narasimham Committee was also set up. As per the recommendations of these study groups and with the financial sector reforms initiated in the early 1990s, the government has adopted following major reforms in the Indian money market.

Reforms made in the Indian Money Market are:1. Deregulation of the Interest Rate : In recent period the government has adopted an interest rate policy of liberal nature. It lifted the ceiling rates of the call money market, short-term deposits, bills rediscounting, etc. Commercial banks are advised to see the interest rate change that takes place within the limit. There was a further deregulation of interest rates during the economic reforms. Currently interest rates are determined by the working of market forces except for a few regulations. 2. Money Market Mutual Fund (MMMFs) : In order to provide additional short-term investment revenue, the RBI encouraged and established the Money Market Mutual Funds (MMMFs) in April 1992. MMMFs are allowed to sell units to corporate and individuals. The upper limit of 50 crore investments has also been lifted. Financial institutions such as the IDBI and the UTI have set up such funds.

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Establishment of the DFI : The Discount and Finance House of India (DFHI) was set up in April 1988 to impart liquidity in the money market. It was set up jointly by the RBI, Public sector Banks and Financial Institutions. DFHI has played an important role in stabilizing the Indian money market.

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Liquidity Adjustment Facility (LAF) : Through the LAF, the RBI remains in the money market on a continue basis through the repo transaction. LAF adjusts liquidity in the market through absorption and or injection of financial resources.

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Electronic Transactions : In order to impart transparency and efficiency in the money market transaction the electronic dealing system has been started. It covers all deals in the money market. Similarly it is useful for the RBI to watchdog the money market.

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Establishment of the CCIL : The Clearing Corporation of India limited (CCIL) was set up in April 2001. The CCIL clears all transactions in government securities, and repose reported on the Negotiated Dealing System. Development of New Market Instruments : The government has consistently tried to introduce new short-term investment instruments. Examples: Treasury Bills of various duration, Commercial papers, Certificates of Deposits, MMMFs, etc. have been introduced in the Indian Money Market.

These are major reforms undertaken in the money market in India. Apart from these, the stamp duty reforms, floating rate bonds, etc. are some other prominent reforms in the money market in India. Thus, at the end we can conclude that the Indian money market is developing at a good speed.

The foreign exchange market (forex, FX, or currency market) is a global, worldwide-decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of [1] weekends. The foreign exchange market determines the relative values of different currencies. The foreign exchange market assists international trade and investment, by enabling currency conversion. For example, it permits a business in the United States to import goods from the United Kingdom and pay pound sterling, even though its income is in United States dollars. It also supports direct speculation in the value of currencies, and the carry trade, speculation on the change in interest [2] rates in two currencies. In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system. The foreign exchange market is unique because of its huge trading volume representing the largest asset class in the world leading to high liquidity; its geographical dispersion; its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday; the variety of factors that affect exchange rates; the low margins of relative profit compared with other markets of fixed income; and the use of leverage to enhance profit and loss margins and with respect to account size.

As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks. According to theBank for International [3] Settlements, as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007. Some firms specializing on foreign exchange market had put the average daily turnover in excess of US$4 [4] trillion. The $3.98 trillion break-down is as follows: $1.490 trillion in spot transactions $475 billion in outright forwards $1.765 trillion in foreign exchange swaps $43 billion currency swaps $207 billion in options and other products