Factors affecting demand for money

The quantity of money people hold depends on: 1) The price level 2) The interest rate 3) Real
GDP 4) Financial innovation
The Price Level
Nominal money is the quantity of money measured in dollars. y The quantity of nominal
money demanded is proportional to the price level. y If price increases by 10%, people will hold
10% more of money to buy the same bundle of goods. For example, if you spent $20 to buy a
cup of tea and a toast before, now you need to hold $2 more to buy the same bundle
Real Money
Real money is the quantity of money measured in constant dollars. y Real money is equal to
nominal money divided by price level. Real money measure what it will buy. y In the above
example, real money = $22/1.1 = $20. The quantity of real money demanded is independent of
the price level.
The Interest Rate
The opportunity cost of holding money is the interest rate a person could earn on assets they
could hold instead of money. Higher interest rate (higher opportunity cost) causes lower
money demand.
Real GDP
Money holdings depend upon planned spending. The quantity of money demanded in the
economy as a whole depends on Real GDP. y Higher income leads to higher expenditure.
People hold more money to finance the higher volume of expenditure
Financial Innovation
Changing technologies affect the quantity of money held. These include: Daily interest
checking deposits, Automatic transfers between checking and savings deposits, Automatic teller
machines, Credit cards. In general, the above innovation reduces the demand for money
Nominal Inflation
If people think that there will be an opportunity to purchase an asset in the immediate future at a
very low cost, they will also prefer to hold money.
International Factors
Usually when we discuss the demand for money, we're implicitly talking about the demand for a
particularly nation's money. Since Canadian money is a substitute for American money,
international factors will influence the demand for money. Following factors can cause the
demand for a currency to rise:

1.

An increase in the demand of that country's goods abroad.

2.

An increase in the demand for domestic investment by foreigners.

3.
4.

The belief that the value of the currency will rise in the future.
A central banking wanting to increase its holdings of that currency.
Demand for Money Wrap Up
The demand for money is not at all constant. There are quite a few factors which influence the
demand for money.
Factors Which Increase the Demand for Money

1.
2.
3.
4.
5.
6.
7.
8.
9.

A reduction in the interest rate.

A rise in the demand for consumer spending.
A rise in uncertainty about the future and future opportunities.
A rise in transaction costs to buy and sell stocks and bonds.
A rise in inflation causes a rise in the nominal money demand but real money demand
stays constant.
A rise in the demand for a country's goods abroad.
A rise in the demand for domestic investment by foreigners.
A rise in the belief of the future value of the currency.
A rise in the demand for a currency by central banks (both domestic and foreign).

Factors affects money supply in India

Determinants of Money Supply:
There are two theories of the determination of the money supply. According to the first view, the
money supply is determined exogenously by the central bank. The second view holds that the
money supply is determined endogenously by changes in the economic activity which affects
peoples desire to hold currency relative to deposits, the rate of interest, etc.
Thus the determinants of money supply are both exogenous and endogenous which can be
described broadly as: the minimum cash reserve ratio, the level of bank reserves, and the desire
of the people to hold currency relative to deposits. The last two determinants together are called
the monetary base or the high powered money.
1. The Required Reserve Ratio:

The required reserve ratio (or the minimum cash reserve ratio or the reserve deposit ratio) is an
important determinant of the money supply. An increase in the required reserve ratio reduces the
supply of money with commercial banks and a decrease in required reserve ratio increases the
money supply.The RR1 is the ratio of cash to current and time deposit liabilities which is
determined by law. Every commercial bank is required to keep a certain percentage of these
liabilities in the form of deposits with the central bank of the country. But notes or cash held by
commercial banks in their tills are not included in the minimum required reserve ratio.
In India the statutory liquidity ratio (SLR) has been fixed by law as an additional measure to
determine the money supply. The SLR is called secondary reserve ratio in other countries while
the required reserve ratio is referred to as the primary ratio. The raising of the SLR has the
effect of reducing the money supply with commercial banks for lending purposes, and the
lowering of the SLR tends in increase the money supply with banks for advances.
Open market operations refer to the purchase and sale of government securities and other types
of assets like bills, securities, bonds, etc., both government and private in the open market.
When the central bank buys or sells securities in the open market, the level of bank reserves
expands or contracts.
The purchase of securities by the central bank is paid for with cheques to the holders of
securities who, in turn, deposit them in commercial banks thereby increasing the level of bank
reserves. The opposite is the case when the central bank sells securities to the public and banks
who make payments to the central bank through cash and cheques thereby reducing the level of
bank reserves.
The discount rate policy affects the money supply by influencing the cost and supply of bank
credit to commercial banks. The discount rate, known as the bank rate in India, is the interest
rate at which commercial banks borrow from the central bank. A high discount rate means that
commercial banks get less amount by selling securities to the central bank. The commercial
banks, in turn, raise their lending rates to the public thereby making advances dearer for them.
Thus there will be contraction of credit and the level of commercial bank reserves. Opposite is
the case when the bank rate is lowered. It tends to expand credit and the consequent bank
reserves.
It should be noted that commercial bank reserves are affected significantly only when open
market operations and discount rate policy supplement each other. Otherwise, their effectiveness
as determinants of bank reserves and consequently of money supply is limited.

2. Publics Desire to Hold Currency and Deposits:

Peoples desire to hold currency (or cash) relative to deposits in commercial banks also
determines the money supply. If people are in the habit of keeping less in cash and more in
deposits with the commercial banks, the money supply will be large. This is because banks can
create more money with larger deposits. On the contrary, if people do not have banking habits
and prefers to keep their money holdings in cash, credit creation by banks will be less and the
money supply will be at a low level.
High Powered Money and the Money Multiplier:
The current practice is to explain the determinants of the money supply in terms of the monetary
base or high-powered money. High-powered money is the sum of commercial bank reserves and
currency (notes and coins) held by the public. High-powered money is the base for the
expansion of bank deposits and creation of the money supply. The supply of money varies
directly with changes in the monetary base, and inversely with the currency and reserve ratios.
3.

Method of Payment:
The method of payment being used in the economy also determines the currency component of
the money supply. If most of the payments are made in cash, greater proportion of currency to
money supply is needed. If the payments are generally made through cheques, the proportion of
currency to money supply will be lowered.

4. The Price level:

Price level also affects the requirements of currency considerably. Higher the price level larger
the amount of currency required, and lower the price level, smaller the amount of currency
required to carry out the given volume of transactions.
5. Banking Habits:
If the public has confidence in the bank money and has banking habits, the currency
requirements will be less. But, if the people have less banking habits, the transactions will be
conducted with currency and more currency is required.
6. Distribution of Income:
Distribution of income also influences the currency requirements. If tie i distribution of income
is in favour of the rich, greater proportion of currency of higher denominations is required. On

the other hand, if the distribution is in favour of the poor, a larger proportion of currency should]
be of low denominations.
7. Other Factors:
The money supply is a function not only of the high-powered money determined by the
monetary authorities, but of interest rates, income and other factors. The latter factors change
the proportion of money balances that the public holds as cash. Changes in business activity can
change the behaviour of banks and the public and thus affect the money supply. Hence the
money supply is not only an exogenous controllable item but also an endogenously determined
item.
Limitations of Monetary Policy:
1. The time lag: the time taken in checking out the policy action, its implementation and working
time. Its divided into two parts:
i)
Inside tag or preparatory lag:
a) Identifying nature of probability
b) Identifying sources of probability
c) Choice of appropriate policy action
d) Implementation of policy action
ii)
Outside lag or response lag:
The time taken by households and the firms to react in response to the policy action taken by the
monetary authorities. This lag is long.
2. Problems in forecasting
Reliable assessment of magnitude of the problem recession or inflation as it helps in
determining the appropriate policy measures.
3. Non-Banking financial intermediaries:
Structural change reduces effectiveness of monetary policy. Although financial
intermediaries cannot create credit thro the process of credit multiplier, their huge share in the
financial operations reduces the effectiveness of monetary policy.
4. Under development of money & capital market
Effectiveness of monetary policy is less developed countries is reduced considerably
because of the under developed character of their money and capital markets.
5. Large Non-monetized Sector:
There is a large non-monetized sector which hinders the success of monetary policy in such
countries. People mostly live in rural areas where barter is practised. Consequently, monetary
policy fails to influence this large segment of the economy.

6. High Liquidity:
The majority of commercial banks possess high liquidity so that they are not influenced by the
credit policy of the central bank. This also makes monetary policy less effective.
7. Foreign Banks:
In almost every underdeveloped country foreign owned commercial banks exist. They also
render monetary policy less effective by selling foreign assets and drawing money from their
head officers when the central bank of the country is following a tight monetary policy.
8. Small Bank Money:
Monetary policy is also not successful in such countries because bank money comprises a small
proportion of the total money supply in the country. As a result, the central bank is not in a
position to control credit effectively.
9. Money not deposited with Banks:
The well-to-do people do not deposit money with banks but use it in buying jewellery, gold, real
estate, in speculation, in conspicuous consumption, etc. Such activities encourage inflationary
pressures because they lie outside the control of the monetary authority.
10. Existence of Black Money:
The existence of black money in the economy limits the working of the monetary policy. The
black money is not recorded since the borrowers and lenders keep their transactions secret.
Consequently the supply and demand of money also not remain as desired by the monetary
policy. In the words of V. Pandit, Black money is rightly regarded as a threat to the official
money credit policy mechanism to manage demand and price in several sectors of the economy.
11. Not Proper Implementation of the Monetary Policy:
Successful application of monetary policy is not merely a question of availability of instruments
of credit control. It is also a question of judgement with regard to timing and the degree of
restraint employed or relaxation allowed.
However, past experience shows that Reserve Banks credit restrictions have always fallen short
of the required extent of restraint. The Bank has adopted a hesitant attitude in the field of
monetary control.
In short, the monetary policy of the Reserve Bank suffers from many limitations. It requires
improvements in many directions.

On account of these limitations of monetary policy in an under-developed country, economists

advocate the use of fiscal policy along-with it.

Laffer Curve
What is the 'Laffer Curve'
The Laffer curve, invented by Arthur Laffer, shows the relationship between tax rates and tax
revenue collected by governments. The chart below shows the Laffer Curve:

The curve suggests that, as taxes increase from low levels, tax revenue collected by the
government also increases. It also shows that tax rates increasing after a certain point (T*)
would cause people not to work as hard or not at all, thereby reducing tax revenue. Eventually,
if tax rates reached 100% (the far right of the curve), then all people would choose not to work
because everything they earned would go to the government.
Governments would like to be at point T*, because it is the point at which the government
collects maximum amount of tax revenue while people continue to work hard.
The economic effect recognizes the positive impact that lower tax rates have on work, output,
and employment, which provide incentives to increase these activities.
Importantly, the Laffer Curve does not say whether a tax cut will raise or lower revenues, nor
does it predict that any and all tax rate reductions would necessarily bring in more total
revenues. Instead it says that tax rate reductions will always result in a smaller loss in revenues
than one would have expected when relying only on the static estimates of the previous tax
base. This also means that the higher the starting tax rate, the more dramatic the supply-side
stimulus will be from cutting the tax rate. It is possible that this economic effect will swamp the
arithmetic effect, causing an actual increase in tax revenue.

However, the Laffer Curve does not say that all tax cuts pay for themselves as many people
claim. What is true is that tax rate cuts will always lead to more growth, employment, and
income for citizens, which are desirable outcomes leading to greater prosperity and opportunity.
There is, after all, more to fiscal policy than simply maximizing government revenue.
Supply-side economics is a macroeconomic theory which argues that economic growth can be
most effectively created by investing in capital, and by lowering barriers on the production of
goods and services. According to supply-side economics, consumers will then benefit from a
greater supply of goods and services at lower prices; furthermore, the investment and expansion
of businesses will increase the demand for employees and therefore create jobs.
The Laffer curve illustrates a central theory of supply-side economics, that lowering tax rates
may generate more government revenue than would otherwise be expected at the lower tax rate
because moving off of a prohibitively high tax system could generate more economic activity,
which would lead to increased opportunities for tax revenues. However, the Laffer curve only
measures the rate of taxation, not tax incidence, which is a stronger predictor of whether a tax
code change is stimulative or dampening. In addition, studies have shown that tax cuts done in
the US in the past several decades seldom recoup revenue losses and have minimal impact on
GDP growth.

Relationship between monetary policy and fiscal policy

Ideally, a countrys economy is controlled by two types of economic measures
fiscal and monetary. While the fiscal policy is framed and implemented by the
government with regulation of its spending and collection of revenue, the monetary
policy is controlled by the central bank of the country (in India, it is Reserve Bank of
India).
These policies may be designed and implemented for the expansion or contraction
of the economy. Policy measures aimed to increase the gross domestic product
(GDP) and the economic growth are called expansionary. The measures taken to
check the inflationary trends in the economy are the contractionary measures.
Conceptually, when demand is low in the economy, the government can step in
and increase its spending to stimulate demand. It may also lower taxes to increase
disposable income for people. It is, therefore, the manipulation of the level of
aggregate demand in the economy is to achieve economic objectives of price
stability, full employment, and economic growth.
Monetary policy, on the other hand, is the process by which the monetary authority
of a country (RBI, in case of India) controls the supply of money by adopting
different quantitative or qualitative measures. These steps include bringing
changes in key policy rates often targeting correction in rate of interest, cash
reserve ratio (CRR) and statutory liquidity ratio (SLR) to leave more/less disposable
funds with financial institutions to influence outcomes like economic growth,
inflation, exchange rates with other currencies and unemployment.

Both the fiscal and monetary policies have to be framed and implemented
coherently to attain a set of objectives oriented towards the growth and stability of
the economy. However, in India for the past two decades, the mismatch between
the fiscal and monetary policies has remained a major concern. Unsustainable
fiscal deficits and public debt levels created the spectre of fiscal dominance,
leading to high and volatile inflation and elevated risk on government debt. An
unfavourable exchange rate dynamic linked to weak fiscal and monetary policy
credibility has been the key factor in the destabilized capital outflows.
Relationship between monetary policy and fiscal policy
Fiscal policy generally refers to the governments choice regarding the use of taxation and government
spending to regulate the aggregate level of economic activity. In the same vein, the use of fiscal policy
entails changes in the level or composition of government spending or taxation, and hence in the
governments financial position. Key variables that policy makers focus on include government deficits
and debt, as well as tax and expenditure levels.
Monetary policy refers to the central banks control of the availability of credit in the economy to
achieve the broad objectives of economic policy. Control can be exerted through the monetary system by
operating on such aggregates as the money supply, the level and structure of interest rates, and other
conditions affecting credit in the economy. The most important objective of central bankers is price
stability, but there can be others such as promoting economic development and growth, exchange rate
stability and safeguarding the balance of external payments, and maintaining financial stability. Key
variables in this policy area include interest rates, money and credit supply, and the exchange rate.
While monetary and fiscal policy are implemented by two different bodies, these policies are far from
independent. A change in one will influence the effectiveness of the other and thereby the overall impact
of any policy change. That is why it is crucial to pursue a consistent monetary-fiscal policy mix and
coordinate these (and other) policies as much as possible to avoid tensions or inconsistencies. This policy
mix is a key component of the IMFs macroeconomic policy advice and of IMF-supported economic
adjustment programs, together with external, structural, and financial sector policies.
How does fiscal policy affect monetary policy and thus the central banks? There are both direct and
indirect channels. Starting with the first category, there are a number of ways in which fiscal policy may
impinge on monetary policy. First and foremost, an expansionary fiscal policy may result in excessive
fiscal deficits, which may create a strong temptation for governments to resort to the printing press (i.e.,
monetary financing by the central bank) to finance the deficits. An expansionary fiscal policy, then, leads
to an expansionary monetary policy, fueling inflationary pressures, causing a possible real appreciation
of the currency and hence balance of payments difficulties, potentially even resulting in a currency
(and/or banking) crisis.

But even if governments finance their deficits in a non-monetary way, that is, through the markets, there
may be cause for concern, specifically about crowding out: if governments take up (too) much funding in
the markets, the result may be too little or too expensive credit for the private sector. This may harm
economic development and growth, which would certainly be a concern of central bankers. On the
external side, there is the risk that too much dependence on foreign funding of domestic debt results in
exchange rate and/or balance-of-payments risks, which again would be worrying to central banks.

There is another, more direct channel of fiscal policy affecting central bankers and that is the impact of
indirect taxes on the price level and thus on inflation. If governments feel forced to resort to substantial
increases in indirect taxessales taxes, value added taxesrather than taxes on various forms of
income, this will have a direct impact on prices. The key concern here is that a one-off increase leads to a
wage-price spiral and therefore permanent (higher) inflation and inflationary expectations.
In addition to these direct relationships between fiscal and monetary policy, there is the more indirect
channel through expectations. Perceptions and expectations of large and on-going budget deficits and
resulting large borrowing requirements may trigger a lack of confidence in the economic prospects. This
may become a risk to the stability in financial markets. Such a lack of confidence in the sustainability of
the financial position of the government may become a potential destabilizing factor on bond and foreign
exchange markets, eventually even leading to the collapse of the monetary regime.
Impact of Fiscal Expansion
Conceivably, expansionary fiscal policy may at some stage become ineffective as a means to stimulate
demand and, similarly, fiscal contractions may turn out to be expansionary.1 When economic agents
realize that the government is borrowing too much for its own good, they will conclude that this can only
lead to higher taxation levels in the future, and they may decide to compensate for that already now by
saving more and consuming less. This so-called Ricardian equivalence means that the financial
behavior of economic agentson which central banks base their monetary policy decisionsdepends
on their perception of fiscal sustainability. It is therefore another example of how fiscal policy can
(indirectly) affect the effectiveness of monetary policy.
It should be noted that the impact of fiscal policy on central bank objectives is not automatically avoided
when the central bank is independent. Even when the central bank has independence, and hence is not
submitted to the fiscal needs of the government, the need to offset the impact of expansionary fiscal
policy on aggregate demand and inflation in the economy could prompt the central bank to tighten
monetary policy, by raising interest rates or reducing credit in the financial system. The resulting high
interest rates could depress economic activity, attract short-term and easily reversible capital in-flows
thereby adding to inflation and appreciation pressures on the currency, and eventually damaging
macroeconomic and financial stability. Severe budgetary problems may even lead to crises. There have
been a number of examples of such severe tensions in the past, in which large and growing fiscal deficits
in the absence of needed public sector reformsled to high real interest rates. This intensified the
governments debt-servicing costs, causing a buildup of shortterm and foreign currency-linked public
debt, thus increasing the sensitivity to interest rate, exchange rate, and rollover risks, which materialized
as foreign capital inflows that had helped to finance the debt were suddenly reversed.

Another area where monetary and fiscal policy come together is the development of financial markets.
Both finance ministries and central banks have a strong interest in financial market development because
(1) it is indispensable for economic development and growth; (2) it facilitates funding of deficits and
debt; and (3) it enables market-based operations by central banks. As part of financial market
development, it is important for the authorities to engage in a discussion with (potential) market
participants about market practices, conditions, and possible impediments.
The relationship between monetary policy and fiscal policy depends strongly on the development of
financial markets. The transition from a rudimentary financial ial system to a fully developed system can
be divided into four stages.2 In the undeveloped stage, there is no government debt outside the central
bank, and fiscal deficits are essentially accommodated by money creation. In the next stage, marketable
securities are introduced, but there is no secondary market and interest rates are inflexible. In the

transitional stage, a secondary market for government debt instruments exists, interest rates have become
more flexible, and central banks conduct more active and independent liquidity management. In the final
developed stage, medium-term debt instruments are offered through auctions, interest rates are fully
flexible, and central banks control liquidity in the markets through indirect and market-based instruments
(e.g., repos). In particular, in the latter two stages, good coordination between the governments financial
management (issuance of treasury bills, etc.) and the central banks monetary policy operations is
required.
The Role of Central Bankers
What can central banks do about fiscal policy? First of all, coordination is very important. Even if
central banks act on the short end and governments on the long end of the ket, their financial activities
should be coordinated. Second, communication is key as well. Central bankers expressing views on
budgetary policies have become regular features in the international financial press, often in the context
of presentations in Parliament and at presentation of reports on the economy. Of course, timing and
frequency are important elements, and governors are not expected to issue statements each day. The
effectiveness of the message will be affected by the stature and image of the governor and his or her
institution.
Transparency
Finally, incorporating transparency into monetary and fiscal policy is key to their effectiveness. In this
context, the IMF has developed two important international standards: the Code of Good Practices on
Transparency in Monetary and Financial Policies5 for central banks and supervisors, and the Code of
Good Practices on Fiscal Transparency for governments. These codes are important instruments to
support clarity in discussions on the necessary coordination between monetary and fiscal policy.

Managerial Economics and their relationship

Knowledge:

with Other Branches of

A useful method of throwing light on the nature and scope of managerial economics is to examine its
relationship with other disciplines. To classify the scope of a field of study is to discuss its relation to
other subjects. Managerial economics has a close linkage with other disciplines and fields of study. The
managerial economics integrates concepts and methods from these disciplines and bringing them to bear
on managerial problems.
i.)Managerial Economics and Economics:Managerial Economics has been described as economics
applied to decision making. It may be studied as a special branch of economics, bridging the gap
between pure economic theory and managerial practice. Economics has two main branchesmicroeconomics and macro-economics.
Micro-economics:Micro means small. It studies the behaviour of the individual units and small groups
of such units. It is a study of particular firms, particular households, individual prices, wages, incomes,
individual industries and particular commodities. Thus micro-economics gives a microscopic view of the
economy.
The micro-economic analysis may be undertaken at three levels:

(i) The equalisation of individual consumers and produces;(ii) The equalization of the single market;(iii)
The simultaneous equilibrium of all markets. The problems of scarcity and optimal or ideal allocation of
resources are the central problem in micro-economics. In price theory, demand concepts, elasticity of
demand, marginal cost marginal revenue, the short and long runs and theories of market structure are
sources of the elements of micro-economics which managerial economics draws upon. It also makes use
of well known models in price theory such as the model for monopoly price, the kinked demand theory
and the model of price discrimination.
Macro-economics:Macro means large. It deals with the behaviour of the large aggregates in the
economy. The large aggregates are total saving, total consumption, total income, total employment,
general price level, wage level, cost structure, etc. Thus macro-economics is aggregative economics.It
examines the interrelations among the various aggregates, and causes of fluctuations in them. Problems
of determination of total income, total employment and general price level are the central problems in
macro-economics
ii.)Managerial Economics and Theory of Decision Making: The theory of decision making is a
relatively new subject that has a significance for managerial economics. In the entire process of
management and in each of the management activities such as planning, organising, leading and
controlling, decision making is always essential. In fact, decision making is an integral part of todays
business management. A manager faces a number of problems connected with his/her business such as
production, inventory, cost, marketing, pricing, investment and personnel. Hence managerial economics
is economics applied in decision making. The theory of decision making recognises the multiplicity of
goals and the pervasiveness of uncertainty in the real world of management.

iii.)Managerial Economics and Operations Research: Mathematicians, statisticians, engineers and

others teamed up together and developed models and analytical tools which have since grown into a
specialised subject, known as operation research. The basic purpose of the approach is to develop a
scientific model of the system which may be utilised for policy making. Much of the development of
techniques and concepts such as Linear Programming, Dynamic Programming, Input-output Analysis,
Queueing Theory, Game Theory, Decision Theory and Symbolic Logic.Linear programming deals with
those programming problems where the relationship among the variables is linear. It is a useful tool for
the managerial economist for reducing transportation costs and allocating purchase amongst different
supplies and site depots. It is employed when the objective function is to maximise profit, output or
efficiency.
Dynamic programming helps in solving certain types of sequential decision problems. A sequential
decision problem is one in which a sequence of decision must be made with each decision affecting
future decision.
Input-output analysis is a technique for analysing inter-industry relation. It can be used by firms for
planning, co-ordination and mobilisation of resources.
Queueing is a particular application of the statistical decision theory. It is employed to get the optimum
solution. The theory may be applied to such problems as how to meet a given demand most economically
or how to minimise the waiting period or idle time.
The theory of games holds out the hope of solving certain problems concerning oligopolistic
interminacy.
When we apply the game theory, we have to consider the following:
(i) The players are the two firms;
(ii) They play the game in the market place;
(iii) Their strategies are their price or output decision; and
iv.)Managerial Economics and Statistics: Statistics is important to managerial economics. It provides
the basis for the empirical testing of theory. Statistics is important in providing the individual firm with
measures of the appropriate functional relationship involved in decision making. Statistics is a very
useful science for business executives because a business runs on estimates and probabilities. Suppose
forecasting has to be done. For this purpose, trend projections are used.
v.)Managerial Economics and Accounting: Managerial economics is closely related to accounting. It is
concerned with recording the financial operation of a business firm. A business is started with the main
aim of earning profit. Capital is invested it is employed for purchasing properties such as building,
furniture, etc and for meeting the current expenses of the business.Goods are bought and sold for cash
as well as credit. Cash is paid to credit sellers. It is received from credit buyers. Expenses are met and
incomes derived. This goes on the daily routine work of the business. The buying of goods, sale of goods,
payment of cash, receipt of cash and similar dealings are called business transactions. They are too
numerous to be kept in ones memory. This has given rise to the necessity of recording business
transaction in books. They are written in a set of books in a systematic manner so as to facilitate proper
study of their results.
There are three classes of accounts:
(i) Personal account,

(ii) Property accounts, and

(iii) Nominal accounts.
Management accounting provides the accounting data for taking business decisions. The accounting
techniques are very essential for the success of the firm because profit maximisation is the major
objective of the firm.
vi.)Managerial Economics and Mathematics: Mathematics is yet another important subject closely
related to managerial economics. For the derivation and exposition of economic analysis, we require a
set of mathematical tools. Mathematics has helped in the development of economic theories and now
mathematical economics has become a very important branch of the science of economics.
Mathematical approach to economic theories makes them more precise and logical. For the estimation
and prediction of economic factors for decision making and forward planning, the mathematical method
is very helpful. The important branches of mathematics generally used by a managerial economist are
geometry, algebra and calculus.

Managerial economics
Demand forecasting
Meaning: Forecasts are becoming the lifetime of business in a world, where the
tidal waves of change are sweeping the most established of structures, inherited by
human society. Commerce just happens to the one of the first casualties. Survival
in this age of economic predators, requires the tact, talent and technique of
predicting the future.Forecast is becoming the sign of survival and the language of
business. All requirements of the business sector need the technique of accurate
and practical reading into the future. Forecasts are, therefore, very essential
requirement for the survival of business. It is becoming increasingly important and
necessary for business to predict their future prospects in terms of sales, cost and
profits. The value of future sales is crucial as it affects costs profits, so the
prediction of future sales is the logical starting point of all business planning.

Procedure to Prepare Sales Forecast:

The industry forecast is based on surveys of consumers intention and analysis of statistical trends is
made available by trade associations or chamber of commerce. It can give indication to a firm regarding
tine direction in which the whole industry will be moving. The company derives its sales forecast by
assuming that it will win a certain market share.

All forecasts are built on one of the three information bases:

What people say?
What people do?

What people have done?

Types of Forecasting:
Forecasts can be broadly classified into:
(i) Passive Forecast and(ii) Active Forecast.
Under passive forecast prediction about future is based on the assumption that the firm does not change
the course of its action. Under active forecast, prediction is done under the condition of likely future
changes in the actions by the firms.

From the view point of time span, forecasting may be classified into two, viz.,:
(i) Short term demand forecasting and (ii) long term demand forecasting. In a short run forecast, seasonal
patterns are of much importance. It may cover a period of three months, six months or one year. It is one
which provides information for tactical decisions.
Which period is chosen depends upon the nature of business. Such a forecast helps in preparing suitable
sales policy. Long term forecasts are helpful in suitable capital planning. It is one which provides
information for major strategic decisions. It helps in saving the wastages in material, man hours,
machine time and capacity. Planning of a new unit must start with an analysis of the long term demand
potential of the products of the firm.

There are basically two types of forecast, viz.,:

(i) External or national group of forecast, and (ii) Internal or company group forecast. External forecast
deals with trends in general business. It is usually prepared by a companys research wing or by outside
consultants. Internal forecast includes all those that are related to the operation of a particular enterprise
such as sales group, production group, and financial group. The structure of internal forecast includes
forecast of annual sales, forecast of products cost, forecast of operating profit, forecast of taxable
income, forecast of cash resources, forecast of the number of employees, etc.

At different levels forecasting may be classified into:

(i) Macro-level forecasting,
(ii) Industry- level forecasting,
(iii) Firm- level forecasting and
(iv) Product-line forecasting.

Macro-level forecasting is concerned with business conditions over the whole economy. It is measured
by an appropriate index of industrial production, national income or expenditure. Industry-level
forecasting is prepared by different trade associations.
Firm-level forecasting is related to an individual firm. It is most important from managerial view point.
Product-line forecasting helps the firm to decide which of the product or products should have priority in
the allocation of firms limited resources.Forecast may be classified into (i) general and (ii) specific. The
general forecast may generally be useful to the firm. Many firms require separate forecasts for specific
products and specific areas, for this general forecast is broken down into specific forecasts.

There are different forecasts for different types of products like:

(i) Forecasting demand for nondurable consumer goods,
(ii) Forecasting demand for durable consumer goods,
(iii) Forecasting demand for capital goods, and
(iv) Forecasting demand for new-products.

Non-Durable Consumer Goods:

These are also known as single-use consumer goods or perishable consumer goods. These vanish after
a single act of consumption. These include goods like food, milk, medicine, fruits, etc. Demand for these
goods depends upon household disposable income, price of the commodity and the related goods and
population and characteristics. Symbolically,
Dc =f(y, s, p, pr) where
Dc = the demand for commodity
= the household disposable income
s = population
p = price of the commodity
pr = price of its related goods

Durable Consumer Goods:

These goods can be consumed a number of times or repeatedly used without much loss to their utility.
These include goods like car, T.V., air-conditioners, furniture etc. After their long use, consumers have a
choice either these could be consumed in future or could be disposed of.

The choice depends upon the following factors:

(i) Whether a consumer will go for the replacement of a durable good or keep on using it after necessary
repairs depends upon his social status, level of money income, taste and fashion, etc. Replacement
demand tends to grow with increase in the stock of the commodity with the consumers. The firm can
estimate the average replacement cost with the help of life expectancy table.
(ii) Most consumer durables are consumed in common by the members of a family. For instance, T.V.,
refrigerator, etc. are used in common by households. Demand forecasts for goods commonly used should
take into account the number of households rather than the total size of population. While estimating the
number of households, the income of the household, the number of children and sex- composition, etc.
should be taken into account.
(iii) Demand for consumer durables depends upon the availability of allied facilities. For example, the
use of T.V., refrigerator needs regular supply of power, the use of car needs availability of fuel, etc.
While forecasting demand for consumer durables, the provision of allied services and their cost should
also be taken into account.
(iv) Demand for consumer durables is very much influenced by their prices and their credit facilities.
Consumer durables are very much sensitive to price changes. A small fall in their price may bring large
increase in demand.

Forecasting Demand for Capital Goods:

Capital goods are used for further production. The demand for capital good is a derived one. It will
depend upon the profitability of industries. The demand for capital goods is a case of derived demand. In
the case of particular capital goods, demand will depend on the specific markets they serve and the end
uses for which they are bought.
The demand for textile machinery will, for instance, be determined by the expansion of textile industry
in terms of new units and replacement of existing machinery. Estimation of new demand as well as
replacement demand is thus necessary.

Three types of data are required in estimating the demand for capital goods:
(a) The growth prospects of the user industries must be known,
(b) the norm of consumption of the capital goods per unit of each end-use product must be known, and
(c) the velocity of their use.

Forecasting Demand for New Products:

The methods of forecasting demand for new products are in many ways different from those for
established products. Since the product is new to the consumers, an intensive study of the product and its
likely impact upon other products of the same group provides a key to an intelligent projection of
demand.
Joel Dean has classified a number of possible approaches as follows:

(a) Evolutionary Approach:

It consists of projecting the demand for a new product as an outgrowth and evolution of an existing old
product.
(b) Substitute Approach:
According to this approach the new product is treated as a substitute for the existing product or service.
(c) Growth Curve Approach:
It estimates the rate of growth and potential demand for the new product as the basis of some growth
pattern of an established product.
(d) Opinion-Poll Approach:
Under this approach the demand is estimated by direct enquiries from the ultimate consumers.
(e) Sales Experience Approach:
According to this method the demand for the new product is estimated by offering the new product for
sale in a sample market.
(f) Vicarious Approach:
By this method, the consumers reactions for a new product are found out indirectly through the
specialised dealers who are able to judge the consumers needs, tastes and preferences.
The various steps involved in forecasting the demand for non-durable consumer goods are the following:
(a) First identify the variables affecting the demand for the product and express them in appropriate
forms, (b) gather relevant data or approximation to relevant data to represent the variables, and (c) use
methods of statistical analysis to determine the most probable relationship between the dependent and
independent variables.

Forecasting Techniques:
Demand forecasting is a difficult exercise. Making estimates for future under the changing conditions is
a Herculean task. Consumers behaviour is the most unpredictable one because it is motivated and
influenced by a multiplicity of forces. There is no easy method or a simple formula which enables the
manager to predict the future.
Economists and statisticians have developed several methods of demand forecasting. Each of these
methods has its relative advantages and disadvantages. Selection of the right method is essential to make

demand forecasting accurate. In demand forecasting, a judicious combination of statistical skill and
rational judgement is needed.
Mathematical and statistical techniques are essential in classifying relationships and providing
techniques of analysis, but they are in no way an alternative for sound judgement. Sound judgement is a
prime requisite for good forecast.

The more commonly used methods of demand forecasting are discussed below:
The various methods of demand forecasting can be summarised in the form of a chart as shown
in Table 1.

1. Opinion Polling Method:

In this method, the opinion of the buyers, sales force and experts could be gathered to determine the
emerging trend in the market.
The opinion polling methods of demand forecasting are of three kinds:

(a) Consumers Survey Method or Survey of Buyers Intentions:

In this method, the consumers are directly approached to disclose their future purchase plans. I his is
done by interviewing all consumers or a selected group of consumers out of the relevant population. This
is the direct method of estimating demand in the short run. Here the burden of forecasting is shifted to
the buyer. The firm may go in for complete enumeration or for sample surveys. If the commodity under
consideration is an intermediate product then the industries using it as an end product are surveyed.
(i) Complete Enumeration Survey:
Under the Complete Enumeration Survey, the firm has to go for a door to door survey for the forecast
period by contacting all the households in the area. This method has an advantage of first hand, unbiased
information, yet it has its share of disadvantages also. The major limitation of this method is that it
requires lot of resources, manpower and time.
In this method, consumers may be reluctant to reveal their purchase plans due to personal privacy or
commercial secrecy. Moreover, at times the consumers may not express their opinion properly or may
deliberately misguide the investigators.

(ii) Sample Survey and Test Marketing:

Under this method some representative households are selected on random basis as samples and their
opinion is taken as the generalised opinion. This method is based on the basic assumption that the sample
truly represents the population. If the sample is the true representative, there is likely to be no significant
difference in the results obtained by the survey. Apart from that, this method is less tedious and less
costly.
A variant of sample survey technique is test marketing. Product testing essentially involves placing the
product with a number of users for a set period. Their reactions to the product are noted after a period of
time and an estimate of likely demand is made from the result. These are suitable for new products or for
radically modified old products for which no prior data exists. It is a more scientific method of
estimating likely demand because it stimulates a national launch in a closely defined geographical area.

(iii) End Use Method or Input-Output Method:

This method is quite useful for industries which are mainly producers goods. In this method, the sale of
the product under consideration is projected as the basis of demand survey of the industries using this
product as an intermediate product, that is, the demand for the final product is the end user demand of
the intermediate product used in the production of this final product.
The end user demand estimation of an intermediate product may involve many final good industries
using this product at home and abroad. It helps us to understand inter-industry relations. In input-output
accounting two matrices used are the transaction matrix and the input co-efficient matrix. The major
efforts required by this type are not in its operation but in the collection and presentation of data.

(b) Sales Force Opinion Method:

This is also known as collective opinion method. In this method, instead of consumers, the opinion of the
salesmen is sought. It is sometimes referred as the grass roots approach as it is a bottom-up method
that requires each sales person in the company to make an individual forecast for his or her particular
sales territory.
These individual forecasts are discussed and agreed with the sales manager. The composite of all
forecasts then constitutes the sales forecast for the organisation. The advantages of this method are that it
is easy and cheap. It does not involve any elaborate statistical treatment. The main merit of this method
lies in the collective wisdom of salesmen. This method is more useful in forecasting sales of new
products.

(c) Experts Opinion Method:

This method is also known as Delphi Technique of investigation. The Delphi method requires a panel
of experts, who are interrogated through a sequence of questionnaires in which the responses to one
questionnaire are used to produce the next questionnaire. Thus any information available to some experts
and not to others is passed on, enabling all the experts to have access to all the information for
forecasting.

2. Statistical Method:
Statistical methods have proved to be immensely useful in demand forecasting. In order to maintain
objectivity, that is, by consideration of all implications and viewing the problem from an external point
of view, the statistical methods are used.

The important statistical methods are:

(i) Trend Projection Method:
A firm existing for a long time will have its own data regarding sales for past years. Such data when
arranged chronologically yield what is referred to as time series. Time series shows the past sales with
effective demand for a particular product under normal conditions. Such data can be given in a tabular or
graphic form for further analysis. This is the most popular method among business firms, partly because
it is simple and inexpensive and partly because time series data often exhibit a persistent growth trend.
Seasonal variations refer to changes in the short run weather pattern or social habits. Cyclical variations
refer to the changes that occur in industry during depression and boom. Random variation refers to the
factors which are generally able such as wars, strikes, flood, famine and so on.When a forecast is made
the seasonal, cyclical and random variations are removed from the observed data. Thus only the secular
trend is left. This trend is then projected. Trend projection fits a trend line to a mathematical equation.

The trend can be estimated by using any one of the following methods:

(a) The Graphical Method,

(b) The Least Square Method.
a) Graphical Method:
This is the most simple technique to determine the trend. All values of output or sale for different years
are plotted on a graph and a smooth free hand curve is drawn passing through as many points as
possible. The direction of this free hand curveupward or downward shows the trend. A simple
illustration of this method is given in Table 2.

Table 2: Sales of Firm

Year

Sales(Rs.Crore)

1995

40

1996

50

1997

44

1998

60

1999

54

2000

62

In Fig. 1, AB is the trend line which has been drawn as free hand curve passing through the
various points representing actual sale values.

(b) Least Square Method:

Under the least square method, a trend line can be fitted to the time series data with the help of statistical
techniques such as least square regression. When the trend in sales over time is given by straight line, the
equation of this line is of the form: y = a + bx. Where a is the intercept and b shows the impact of the
independent variable. We have two variablesthe independent variable x and the dependent variable y.
The line of best fit establishes a kind of mathematical relationship between the two variables .v and y.
This is expressed by the regression on x.
In order to solve the equation v = a + bx, we have to make use of the following normal equations:
y = na + b X
xy =a x+b x2

(ii) Barometric Technique:

A barometer is an instrument of measuring change. This method is based on the notion that the future
can be predicted from certain happenings in the present. In other words, barometric techniques are
based on the idea that certain events of the present can be used to predict the directions of change in the
future. This is accomplished by the use of economic and statistical indicators which serve as barometers
of economic change.

(iii) Regression Analysis:

It attempts to assess the relationship between at least two variables (one or more independent and one
dependent), the purpose being to predict the value of the dependent variable from the specific value of
the independent variable. The basis of this prediction generally is historical data. This method starts from
the assumption that a basic relationship exists between two variables. An interactive statistical analysis
computer package is used to formulate the mathematical relationship which exists.
For example, one may build up the sales model as:
Quantum of Sales = a. price + b. advertising + c. price of the rival products + d. personal disposable
income +u
Where a, b, c, d are the constants which show the effect of corresponding variables as sales. The constant
u represents the effect of all the variables which have been left out in the equation but having effect on
sales. In the above equation, quantum of sales is the dependent variable and the variables on the right
hand side of the equation are independent variables. If the expected values of the independent variables
are substituted in the equation, the quantum of sales will then be forecasted.
The regression equation can also be written in a multiplicative form as given below:
Quantum of Sales = (Price) a + (Advertising)b+ (Price of the rival products)
income Y + u

+ (Personal disposable

In the above case, the exponent of each variable indicates the elasticities of the corresponding variable.
Stating the independent variables in terms of notation, the equation form is QS = P 8. Ao42 . R.83. Y2.68.
40

Then we can say that 1 per cent increase in price leads to 0.8 per cent change in quantum of
sales and so on.
(iv) Econometric Models:
Econometric models are an extension of the regression technique whereby a system of independ ent
regression equation is solved. The requirement for satisfactory use of the econometric model in
forecasting is under three heads: variables, equations and data.
The appropriate procedure in forecasting by econometric methods is model building. Econometrics
attempts to express economic theories in mathematical terms in such a way that they can be verified by
statistical methods and to measure the impact of one economic variable upon another so as to be able to
predict future events.

Criteria of a Good Forecasting Method:

There are thus, a good many ways to make a guess about future sales. They show contrast in cost,
flexibility and the adequate skills and sophistication. Therefore, there is a problem of choosing the best
method for a particular demand situation.
There are certain economic criteria of broader applicability. They are:
(i) Accuracy, (ii) Plausibility, (iii) Durability, (iv) Flexibility, (v) Availability, (vi) Economy, (vii)
Simplicity and (viii) Consistency.

(i) Accuracy:The forecast obtained must be accurate. How is an accurate forecast

possible? To obtain an accurate forecast, it is essential to check the accuracy of
past forecasts against present performance and of present forecasts against future
performance. Accuracy cannot be tested by precise measurement but buy
judgment.
(ii) Plausibility:The executive should have good understanding of the technique
chosen and they should have confidence in the techniques used. Understanding is
also needed for a proper interpretation of results. Plausibility requirements can
often improve the accuracy of results.
(iii) Durability: Unfortunately, a demand function fitted to past experience may
back cost very greatly and still fall apart in a short time as a forecaster. The
durability of the forecasting power of a demand function depends partly on the
reasonableness and simplicity of functions fitted, but primarily on the stability of
the understanding relationships measured in the past. Of course, the importance of
durability determines the allowable cost of the forecast.
(iv) Flexibility: Flexibility can be viewed as an alternative to generality. A long
lasting function could be set up in terms of basic natural forces and human
motives. Even though fundamental, it would nevertheless be hard to measure and
thus not very useful. A set of variables whose co-efficient could be adjusted from
time to time to meet changing conditions in more practical way to maintain intact
the routine procedure of forecasting.
(v) Availability: Immediate availability of data is a vital requirement and the
search for reasonable approximations to relevance in late data is a constant strain
on the forecasters patience. The techniques employed should be able to produce
meaningful results quickly. Delay in result will adversely affect the managerial
decisions.
(vi) Economy: Cost is a primary consideration which should be weighted against
the importance of the forecasts to the business operations. A question may arise:
How much money and managerial effort should be allocated to obtain a high level
of forecasting accuracy? The criterion here is the economic consideration.
(vii) Simplicity: Statistical and econometric models are certainly useful but they
are intolerably complex. To those executives who have a fear of mathematics,
these methods would appear to be Latin or Greek. The procedure should,
therefore, be simple and easy so that the management may appreciate and
understand why it has been adopted by the forecaster.
(viii) Consistency: The forecaster has to deal with various components which are
independent. If he does not make an adjustment in one component to bring it in
line with a forecast of another, he would achieve a whole which would appear
consistent.