MicroEconomics - ITM University

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Macroeconomics
Table of Content
1.
eBook
Introduction to
Macroeconomics
1.1
Introduction
1.2
Meaning
1.3
Origin and
1.4
Scope of Macroeconomics
12
1.5
Meaning
13
1.6
Relationship between
1. 7
Distinguish
1.8
Importance of Macroeconomics
16
1. 9
Limitations of Macroeconomics
17
1.10
Macroeconomic Indicators
18
1.11
Chapter Summary
20
2.
of Macroeconomics
Growth of Macroeconomics
and
Definition of Microeconomics
between
Microeconomics and
Micro and
Macroeconomics
14
Macroeconomics
15
Measurement of National Income
21
2.1
Introduction
22
2.2
C i r c u l a r Flow of Income
23
2.3
National Income
27
2.4
Concepts of National Income
28
2.5
30
2.6
Difficulties in the
33
2.7
Chapter Summary
3.
35
Money
36
3.1
Introduction
37
3.2
Evolution of Money
38
3.3
Definition of Money
39
3 .4
Functions of Money
40
3.5
Importance of Money
41
3.6
Role of Money in
3.7
Money S u p p l y
43
3.8
Money M u l t i p l i e r
46
3.9
Factors Determining
3.10
Demand
3.11
Chapter Summary
Economic Development of the Developing
Countries
Money S u p p l y
49
for Money
www.itmuniversityonline.org
42
50
53
Page 2
Macroeconomics
Table of Content
4.
eBook
Banking
54
4.1
Introduction
55
4.2
Definition of Banking
56
4.3
Classification of Banks
56
4.4
Functions of Commercial
4. 5
Role of Commercial
4.6
Central
4. 7
Functions of Central
4.8
Methods of Credit
4. 9
Impact of IT Revolution
4.10
Chapter Summary
5.
Bank
Banks in
58
Economic Development
61
Bank
62
Bank
63
Control
65
in
Banking
Industry
67
69
Macroeconomic Policies:
Monetary and
Fiscal
Policy
70
5.1
Introduction
5.2
Meaning
5.3
Objectives of Macroeconomic Policy
5.4
Definition and
5. 5
Objectives of Monetary Policy
76
5. 6
Instruments of Monetary
77
5. 7
Limitation and
5.8
Meaning
5. 9
Instruments of Fiscal
5.10
Types of Fiscal
5.11
Limitations of Fiscal
5.12
Chapter Summary
6.
Inflation and
71
and
Definition of Macroeconomic Policy
Meaning of Monetary
73
Policy
75
Policy
Effectiveness of Monetary
of Fiscal
72
Policy
79
Policy
80
Policy
81
Policy
82
Policy
83
84
85
Unemployment
86
6.1
Introduction
6.2
Definition and
6. 3
Types of Inflation
87
6.4
causes and
91
6. 5
Inflation
6.6
Definition and
6. 7
Types of Unemployment
6.8
Full Employment
102
6. 9
Cost of Unemployment
102
6.10
Unemployment in India
103
87
Meaning of Inflation
Measures of Inflation
96
in India
98
Meaning of Unemployment
99
Page 3
Macroeconomics
Table of Content
6.11
7.
eBook
Chapter Summary
Economic Growth and
104
105
Instability
7.1
Introduction
106
7.2
Meaning
107
7. 3
Factors of Economic Grow th
107
7.4
Theories of Economic Growth
111
7.5
Economic Instability
118
7.6
Definition and
7. 7
Phases of Business Cycle
7.8
Causes of Business Cycle
7. 9
Global
7.10
Chapter Summary
8.
of Economic Growth
Meaning
118
of Business Cycle
119
121
Fluctuations
122
Recession 2008-2009
Government and
123
Macroeconomy
124
8.1
Introduction
125
8.2
Public Finance
126
8.3
Public Expenditure
126
8.4
Public Revenue
129
8.5
Classification of Taxes
130
8.6
Principles or Canons of a Good Tax System
131
8.7
Deficit Financing
133
8.8
Role of Government in Different Economies
134
8.9
Chapter Summary
137
International Trade
138
9.1
Introduction
139
9.2
Meaning
9.3
Theories of International Trade
141
9.4
Terms of Trade
144
9.5
Classification of Terms of Trade
146
9.6
Free Trade
148
9.7
Forms of Trade Restrictions
149
9.8
Chapter Summary
152
9.
and
140
Definition of International Trade
Page 4
Macroeconomics
Table of Content
eBook
10. Balance of Payments
153
10.1
Introduction
154
10.2
Meaning
10.3
Purpose of Balance of Payments Accounting
155
10.4
Balance of Payments Accounts
156
10.5
Features of Balance of Payments
157
10.6
Disequilibrium
158
10. 7
Types of BOP D i s e q u i l i b r i u m
158
10.8
causes of D i s e q u i l i b r i u m
160
10.9
Effects of Ad verse Ba la nee of Payments
162
10.10
Measures to Correct Adverse Balance of Payments
162
10.11
Advantages of Balance
164
10.12
Chapter Summary
of Balance of Payments
(BOP)
155
in Balance of Payments
in Balance of Payments
of Payments
165
Page
I n t r o d u c t i o n to
Macroeconomics
Macroeconomics
01.
Introduction to
1.1
The
Macroeconomics
eBook
Introduction
economy
have
direct
inquisitive to
quest
for
of every
or
country
indirect
impact
know why and
answers
is
related
how
to
not
on
it
always
its
stable
smooth
happens.
economic
The
and
there
are
functioning.
various
factors
Individuals
are
always
study of macroeconomics w i l l end
fluctuations
and
its
impact
on
you
that
and
your
your
country.
Macroeconomics,
great
which
depression
of
is an
the
imperative
1930s.
part of economic science,
Prior
to
that,
economic
was evolved
science
was
after the
limited
to
microeconomics only.
Macroeconomics evolved
John
Maynard
Interest
and
as a separate
Keynes'
Money.
revolutionary
This
branch
book,
chapter
will
in
the year
The
1936,
General
help
you
with
Theory
the
of
understand
publication
Employment,
the
basis
macroeconomics.
After reading this chapter,
you
will
be able to:
Define macroeconomics
Discuss the o r i g i n and growth of macroeconomics
Distinguish
State the importance and
Identify the indicators of macroeconomics
between microeconomics and
of
macroeconomics
limitations of macroeconomics
Page 7
of
Macroeconomics
01.
Introduction to
1.2
The
Macroeconomics
eBook
M e a n i n g of M a c r o e c o n o m i c s
word
macro
is
derived
Macroeconomics
is
"Looking
forest
at
the
the
larger
whole.
It
in
Macroeconomics
determination
how
of
d i se q u i l i b r i u m
the
and
economic growth.
are
output,
determined
balances
macroeconomics
have
in
with
macroeconomics,
few
defined
words.
the
'makros',
as
can
also
which
whole.
describe
means
famous
the
old
real
of
what
the
level
and
factors
that
forecasting
country,
large.
saying,
essence
of
and
of
system,
the
overall
affect
them.
national
identification
as a
of
income,
causes
of
balance of payments.
determine the fiscal
According
is
price
are
the
macroeconomics
economy
attention
general
with
is to
behavior of the economic
the
and
primarily
role of macroeconomics
economists
economy
trees"
in the balance of trade and
major
concerned
the
word
analysis of the
total
concerned
The
Various
the
trade
of
Greek
way.
country
is
the
than
is the study and
studies
employment
view
rather
macroeconomics in a lucid
Macroeconomics
from
as
to
M.
H.
whole
focused
on
and
policies,
tried
to
confine
Spencer
or
large
such
monetary
all
policies,
aspects
of
"Macroeconomics
is
segments
problems
as
of
the
it.
In
level
of
unemployment, the rate of inflation, the nation's total output and other matters
of economy-wide significance."
P.
A.
Samuelson
economy
as
contributed
whole.
It
that,
"Macroeconomics
examines
the
overall
is
the
level
study
of
of
behavior
nation's
of
output,
employment, prices and foreign trade."
According
to
Kenneth
relationships
and
Macroeconomics..
aggregates
national
of
Boulding,
behavior
deals
these
income,
E.
not
not
of
aggregates
with
quantities . . .
with
"Macroeconomics
individual
not
individual
with
prices
is
of
quantities
with
study
economic
individual
but
the
as
price
nature,
quantities . . .
such,
incomes,
the
of the
but
levels,
but
with
not
i n d i v i d u a l output but with the national output."
Page 8
with
the
with
Macroeconomics
0 1 . Introduction to Macroeconomics
eBook
1 . 3 O r i g i n a n d Growth of Macroeconomics
As
mentioned
earlier,
the
economist John
Maynard
Keynes
on
brought
the
part
of
foundation
Keynes
paradigm
other
shift
of
macroeconomics
was
laid
down
by
British
( 1883 - 1946 ).
in
the field
economists,
if
of economics
their
study
contributions
but
toward
it
will
be
impartial
macroeconomics
are
ignored.
Macroeconomics has shown

after
the
Keynesian
categorized
revolution,
Classical
Classical
into
revolution.
three
The
origin
segments-the
and
revolution and
growth
classical
of
continued
macroeconomics
macroeconomics,
the
even
can
be
Keynesian
Macroeconomics
to
of
thoughts
classical
allowed
to work freely
be
equilibrium
in
before the Keynesian
and the post-Keynesian developments.
school
According
its start
underproduction.
was
contributed
macroeconomics,
if
(without government
in
the
long-run.
The country w i l l
there is any unemployment,
be
Mill,
market
forces
intervention),
There
Malthus,
will
be
of
Pigou,
demand
and
and
Ricardo.
supply
are
then the economy will always

neither
overproduction,
in a state of full employment
it will only
The great depression of 1 9 3 0 s proved
by
nor
in the l ong- run and
if
remain so for a short time.
classical theory wrong
because d u r i n g
that period,
there was large scale unemployment in most of the free-market industrial economies.
The
Keynesian
Revolution
The downfall of classical

observed
that
during
investment, and
macroeconomics gave rise to the
the
period
of
depression,
of
was
fall
revolution.
in
Keynes'
prices,
profits,
he concluded
that the
employment.
This problem of depression gave another view

problem
there
Keynesian
economic
fluctuation
can
be
point to Keynes and
handled
only
by
the
government's
direct
intervention.
H i g h l i g h t s of the Keynesian
revolution are:
Keynes' theory focused on the employment, growth, and
According
caused
to
the
Keynesian
theory,
unemployment
and
stability.
economic
fluctuations
by change in the aggregate d e m a n d .
Page 9
are
Macroeconomics
Unemployment
is
caused
due
eBook
to
lack
of
aggregate
demand
and
economic
fluctuations are caused due to the shortage of d e m a n d .
Demand
shortage can
Keynesian
economics
be removed
showed
signs
post-Keynesian development in
The
The
of
failure
during
the
1970s.
After
its
failure,
macroeconomics started.
Post-Keynesian Development
failure of Keynesian
evolution
of
the
economics
post-Keynesian
rise to various thoughts and
by compensatory government s p e n d i n g .
raised
doubts
development.
on
The
its applicability
post-Keynesian
and
this
led
to the
development
gave
revolutions:
Monetarism: A Counter Revolution
This
led
revolution was
by
Milton
Friedman.
national output,
Milton
price level,
monetary
demand
Keynes by sharing
in
further added
system
According
bringing
Keynesian
is the main
theory
failed
to
predict
unemployment.
the view
point that monetary
economic stability.
Monetarists argued
policy
is
that the
reason that causes a c h a n g e in aggregate
to
monetarists,
an
depression
inflation
The group
is
also
was
monetary
countries, especially the United
i n the economy.
was
that the great
but was the effect of rig id
rate of money supply
There
him,
known as monetarists and
and creates fluctuations in the economy.
Bank of the affected
supply
to
rate of employment, and
policy of a country
group
market
instrument
by a group of economists
According
Friedman criticized
an effective
The
initiated
the
suggested
not
policy
caused
adopted
due to a
free
by the Central
States of America.
cause
of
rapid
expansion
that there should
of
money
be a stable growth
in the economy.
endless
debate
between
monetarism
and
Keynesianism
and
the
topic of debate was 'what determines the aggregate d e m a n d . '
Neo-classical
Keynesian
'radicalists',
Macroeconomics
theory
in
the
was
countered
1980s.
Their
by
different
macroeconomic
group
of
proposition
economists
is
known
as
classical macroeconomics.
Page
10
called
neo
Macroeconomics
01.
Introduction to Macroeconomics
According
events
to
and
radicalists,
eBook
individuals
accordingly,
make
make
quick
rational
adjustments
expectations
in
their
about
behavior.
economic
The
rational
expectation of i n d i v i d u a l s is on the basis of information available to them and

expectations
are
always
correct,
which
helps
in
maintaining
stability
their
in
the
economy.
For example,
a
to
rise
in
avail
directly
the
when
the government
interest
rates and
makes deficit
as a result,
the opportunities of current

impacts the
interest
low
they
budgets,
individuals
w i l l try to take more
interest
rates.
The
will
expect
loans,
so as
behavior of individuals
rates with their immediate rise.
Supply-side Economics
Supply-side
economics
was
contributed
by
Arthur
Laffer.
an alternative to the Keynesian theory of employment and
Keynesian
changing
economists
employment
emphasized
on
and
In
output.
the
role
of
contrast,
shift
It
attempted
to
provide
output.
in
aggregate
supply-siders
demand
emphasized
on
in
the
role of shift in the aggregate s u p p l y curve.
For
example,
(rightward
decline
shift
in
rise in output and
in
the
the
tax
supply
rate
curve
causes
indicates
rightward
increase
shift
in
in
the
supply),
supply
which
curve
leads
to
employment.
Supply-side economics considers fiscal
policy
as the
main
instrument,
which
helps
in economic management.
Neo-Keynesianism
Contrary to
working
According
the classical
for
to
their
own
them,
group,
Neo-Keynesians argued
interest,
information
the
market
problems
is
and
not
cost
that
in
always
of
spite of i n d i v i d u a l s
simple
changing
and
lucid.
prices
cause
fluctuations in output and employment.
Page
11
Macroeconomics
01.
Introduction to
Macroeconomics
eBook
1 . 4 Scope of Macroeconomics
The
scope
of
macroeconomics
income,
employment,
trade.
is
It
money,
represented
in
Theory of National
National
of
the
general
Fig.
Fig.
income that
the
price
effect
levels,
of
economic
economic
resources
growth,
and
on
national
international
1.4a.
1 . 4 a : Scope of Macroeconomics
income
income of the country
country.
discusses
is the
Macroeconomics
best measure to estimate the growth and
studies
provide a base to national
different
concepts
and
elements
of
downfall
national
income accounting.
Theory of Employment
Macroeconomics
studies
Macroeconomics also
saving,
investments,
employment
indicates
the
problems
studies factors,
etc.,
that
of
such as,
unemployment
aggregate demand,
determines
the
better business prospects and
level
of
in
the
supply,
economy.
consumption,
employment.
Growing
vice versa.
Theory of Money
Macroeconomics
includes
Macroeconomics also
the
study
of
money
studies the functioning
and
different
of the Central
theories
Bank and
associated
with
commercial
Page
it.
banks.
12
Macroeconomics
01.
Introduction to
Monetary
studied
policy
adopted
by
the
eBook
Central
Bank
to
control
economic
instability
is
also
under macroeconomics.
Theory of General
Macroeconomics
scenarios.
and
Macroeconomics
Price
studies
Levels
the
Macroeconomics
changes
studies
in
the
variables,
aggregate
such
as
price
levels
inflation,
under
deflation,
different
their
effects
control measures.
Theory of Economic Growth
Macroeconomics studies problems

real income.
related
to
economic growth
or
increase
in
per capita
It also includes the study of the government's fiscal policy.
Theory of International Trade
The
main
focus
Consequently,
of
every
international
country
trade
is
to
achieve
constitutes
the
balance
most
of
payments
important
part
in
equilibrium.
the
study
of
macroeconomics.
1.5
M e a n i n g and
Microeconomics
consumer,
Kenneth
is
the
Definition of Microeconomics
study
individual d e m a n d ,
E.
particular
Boulding
of
economics
an
individual firm, and
has defined
household,
at
individual
price,
such
as
individual
i n d i v i d u a l worker.
microeconomics as,
individual
level,
"The study of particular firm,
wage,
income,
"Microeconomics
studies
industry
and
particular
commodity."
According
to
Roy
J.
making of firms and

in the
Ruffin,
individuals in a market setting;
the
economic
decision
it is study of the economy
small."
Page 13
Macroeconomics
01.
Introduction to
Macroeconomics
eBook
1 . 6 R e l a t i o n s h i p between Microeconomics a n d
Macroeconomics
Both micro and
macro analysis,
complement each other.

opposition
you
are
between
only
are equally
Prof. Sameulson
micro and
half educated
important
has also observed
macro economics.
if you
in the study of economics,
understand
Both
one
that,
"There is
are absolutely
while
being
as they
really no
vital.
ignorant
of
And
the
other."
Fig.
Micro and
1.6a:
Relationship between
macroeconomics are
the two is explained
below
Microeconomic Analysis
paid
in
the
economy;
provided
the
the
relationship
between
in a concise way:
Depends on
is able to
sale of
heavy
Macroeconomic Analysis
influenced
to the workers depends on
quantity of goods a firm
Macroeconomics
incomplete without each other;
Microeconomic decisions are always

wages
Micro and
sell
by
macroeconomic factors.
the wages actually
prevailing
For example,
in the
market.
in the market depends upon the supply of money
goods d e p e n d s on
the
interest
rate
and
the facilities
by commercial banks to the customers.
The
Page
14
Macroeconomics
01.
Introduction to
Macroeconomics
eBook
Study of Macroeconomics Demands for the Study of Microeconomics
The
study
of
microeconomic
the
collection
of
the
analysis
study
of
is
important
individual
units
for
is
macroeconomic
actually
the
study
analysis
of
because
economy
as
whole.
Individuals
form
a society
that
in
and
order
to
different
study
be
concluded
an
industry, different firms must be studied.
1 . 7 D i s t i n g u i s h between
The
main
differences
between
firms collectively
society,
individuals
Micro and
microeconomics
form
an
must
industry.
be
Thus,
studied
and
it
to
can
study
Macroeconomics
and
macroeconomics
are
mentioned
below:
Objectives
The
main
related
objectives
to
of microeconomics
optimum
macroeconomics
allocation
is to deal with
of
are
problems
related
instabilities.
Differences in the
Level of Aggregation
studies the
studies the aggregates

under
and
macroeconomics.
Similarly,
as well as,
levels.
Differences in the
individual
the
law
of
the
An
economy;
individual
industry-related
to
problems
price
levels,
studied
studied
are
of
macroeconomics
problems are
are
problems that
problems
objective
general
whereas,
firm's
study
main
to unemployment,
of the
significant factors,
demand
remain constant. Thus,
supply,
and
studied
under
at
micro,
Methods of Study
assuming the other factors,
In contrast,
prices
However,
there are various other
Microeconomics studies only

example,
units
of economic variables.
microeconomics
macro
determine
resources.
and other economic
Microeconomics
to
studies
the
such as taste,
by assuming
relationship
habits,
other t h i n g s are e q u a l .
between
income, and
demand
and
studies aggregates,
aggregate consumption,
of one economic variable
on
the
and
so on.
other.
such as aggregate demand,
It also
Thus,
analysis.
aggregate
explains the dependence and
macroeconomic
study
is
known
impact
as Quasi
general e q u i l i b r i u m analysis.
by
preferences, of customers
microeconomic study is known as partial e q u i l i b r i u m
macroeconomics
price
For
Page
15
Macroeconomics
01.
Introduction to
Macroeconomics
eBook
Paradoxes
There
are
favorable
Prof.
some
for
paradoxes
an
individual
such
Boulding,
For
example,
will
not
bank,
be
if an
harmful
found
can
be
macro
to
withdraws
anybody
of the
and
unfavorable
paradoxes are called
individual
the functioning
in
but
if
to
the
activities.
society,
The
as
activities
whole.
that
are
According
to
macroeconomic paradoxes.
all
all
micro
his
the
or
her
money
depositors
from
withdraw
commercial
all
their
bank,
money
it
from
bank w i l l fail.
Different Assumptions
Microeconomics
and
Microeconomics
that
total
there
assumes
output
and
that
there
expenditure
is
are
full
are
based
on
employment
fixed.
Whereas,
two
in
the
different
country.
According
macroeconomics
to
Prof.
behavior
of
Patinkin
economic
Differences Relating
and
Prof. Clower,
assumes
assumes
that
variables
in
microeconomics deals with the study of
equilibrium
position,
whereas,
macro
level.
affect
the
For
macroeconomics
position.
to Change
There are various economic units that may change at
not
also
Differences
deals with the behavior of economic aggregates in d i se q u i l i b r i u m
at
It
assumptions.
is o p t i m u m allocation of resources in the country.
Analytical
the
macroeconomics
example,
population,
the
due
to
increasing
the
micro
level
but
number of members
nullifying
effect
created
in
by
remain
many
families
unchanged
families
where
may
family
members are declining.
1 . 8 Importance of Macroeconomics
With
growing
mesmerizing
complexities
study
of
understanding
whole
challenges,
science that everyone wants to
Understand the
The
and
Functioning of an
an
economy,
the
individual
economy.
The
as
units
study of just
learn and
has
emerged
as
understand.
Economy
whole,
alone,
is
one
individual
the study of macroeconomics is of vital
macroeconomics
very
cannot
units can
complex
conclude
mislead
phenomenon
the
and
functioning
the economy;
of
by
the
therefore,
importance.
Page
16
Macroeconomics
01.
Introduction to Macroeconomics
eBook
Study of Important Issues
Macroeconomics is the study of issues that are vitally

nation.
lots
of
Macroeconomic
suffering
and
these issues and
Accelerating
is
always
pain
with
such
them.
brings prosperity
as
unemployment,
The
study
of
poverty
and
macroeconomics
of the
inflation,
helps
in
bring
resolving
in the economy.
Economic Growth
Economic growth
It
problems,
important for the well-being
is aspired
matter
Macroeconomics
of
studies
by every economy as
concern,
if
the factors
the
it
brings a lot of prosperity
economic
responsible
for
growth
the
of
slow
country
with
is
itself.
declining.
economic growth
and
tries
to find out the best way to accelerate economic growth.
Understanding of Business Cycles
The study
of
its
of macroeconomics
fluctuations.
government
in
The
adopting
helps
in
understanding
fiscal and
understanding
of
different
monetary
the
business cycle and
phases
policies,
of
business
which could
cycle
the causes
helped
m i n i m i z e the
the
affect of
business cycle fluctuations.
Formulation of Policies
Macroeconomics
best
monetary
has
and
always
fiscal
expansionary fiscal and

Depending
been
policies.
monetary
on the situation,
helping
hand
to
the
During
recession,
government
the
formulating
government
policies to save the country from
the government
in
keeps on taking
tries
to
the
adopt
its worst effects.
the best measures through
its effective policies.
Decision-making
Understanding
decision
the
maker.
economy
as
Macroeconomics
whole
helps
gives
the
larger
individuals
view
as
well
and
as
confidence
the
firms
to
to
the
take
effective decisions.
1 . 9 Limitations of M a c r o e c o n o m i c s
Despite
kept
various
in mind
advantages,
macroeconomics
before formulating
any
also
has
some
limitations
that
must
Page
17
business decision-making.
be
Macroeconomics
01.
Introduction to
Macroeconomics
eBook
The disadvantages of macroeconomics:
Macroeconomics
is dependent on the sum
total of i n d i v i d u a l
units,
which
may
not
provide accurate results.
Macroeconomics
ignores
structural
changes
due
to
which
the
conclusions
drawn
from the analysis can be misleading.
Macroeconomics
deals
with
national
aggregates.
According
to
K.
E.
Boulding,
"aggregates are not a reality but a picture or approximation of reality."
According
make
to
the
Prof.
Boulding,
results
macroeconomics
meaningless.
He
studies
illustrated
his
heterogeneous
points
with
units,
the
which
help
of
an
example:
6 apples+
7 apples=
13 a p p l e s (meaningful aggregate)
6 a p p l e s + 7 oranges =
6 apples+
7 houses=
Macroeconomics
has
13 fruits ( m e a n i n g f u l aggregate)
meaningless aggregate
limited
applications ,
theoretical significance, without any use in
as
most
of
the
models
have
only
practical life.
1 . 1 0 Macroeconomic Indicators
Macroeconomic indicators specify the present status of the economy. They are published
by
the
government
from
time-to-time.
These
indicators
help
in
the
prediction
of
the
future performance of the economy.
Gross domestic
product,
consumer
index,
price
inflation,
exchange
interest
rate,
rate,
balance
employment and
of
payments,
and
unemployment
fiscal
and
rates,
monetary
policies are the most important indicators of macroeconomics.
Gross
Domestic Product
Gross
Domestic
produced
country.
by
Product
normal
(GDP)
residents,
is
as
the
well
money
as,
value
of
non-residents
all
in
final
goods
the domestic
and
services
territory
of a
GDP does not include net factor income from abraod.
Inflation
Inflation
time.
is a considerable and
According
persistent
rise
in the general
price
level over a period
of
to A. C. Pigou, "Inflation exists when money income is expanding
more than in proportion to increase
in earning
activity."
Page 18
Macroeconomics
01.
Introduction to
Macroeconomics
eBook
There are two major causes of inflation:
The
first
demand
The
cause
is
demand-pull
for goods and
second
cause
are pushed
inflation,
which
is
caused
due
to
the
pull
in
services in excess to t h e i r total s u p p l y .
is cost-push
inflation,
which
refers to a situation where
prices
up as a result of rise in the cost of production.
Interest Rate
Interest
Interest
rate
is
rate
The interest
charge,
is the leading
rates can
levied
by
indicator,
be classified
lenders
on
the
amount
given
to
the
borrowers.
which shows the flow of investment.
into:
Nominal rate of interest does not take into account the effects of inflation.
Real rate of interest takes into account the effects of inflation.
unemployment
The
employment
well
the economy
and
unemployment
is d o i n g .
answer the following
The
rates
are
the
indicators
knowledge of employment and
to
understand
unemployment
how
rates will
questions:
How many jobs are being
formed>
How many jobs are being
destructed?
What percentage of the workforce is working
How
many
best
people
are
actually
actively?
employed
and
how
many
are
cl aiming
unemployment>
Balance of Payments
Balance of payments
the
that
payments going
records
the world
For
all
economic
balance
current account and
Fiscal
abroad.
Policy and
policy
of
between the amount
In other words,
transactions
for a particular period,
preparing
Fiscal
represents the ratio
payments
balance of payments
between
usually,
received
the
resident of a
from abroad
and
refers to a statement
nation
and
the
rest
of
a year.
account
economic
transactions
are
categorized
into
capital account.
Monetary Policy
includes
the
national economic goals.
government
Monetary
policy
which regulate and control the demand
policies
of
taxation
and
expenditure
includes the authorities,
and
such as
to
achieve
Central
supply of money.
Page
19
Bank,
Macroeconomics
eBook
1 . 1 1 Chapter Summary
Macroeconomics is the study and analysis of behavior of the economic system as a

whole.
It studies how total output, the general price level, and overall employment
in a country are determined;
The
foundation
Maynard
and what are the factors which affect them.
of macroeconomics
Keynes
(1883-1946)
Employment, Interest and
in
was
laid
down
his revolutionary
by
the
book,
British
The
classical
General
John
Theory
of
Money.
The origin and growth of macroeconomics can be categorized

the
economist
macroeconomics,
the
Keynesian
revolution
into three segments,
and
the
post-Keynesian
developments.
The
scope
national
of
macroeconomics
income, employment,
discusses
money,
the
general
effect
price
of
economic
levels,
resources
economic growth,
on
and
international trade.
Microeconomics
consumer,
According
is
the
study
i n d i v i d u a l demand,
to
Prof.
macro economics.
Gross
domestic
rates,
consumer
"There
is
price
individual
really
Both are absolutely vital.
product,
at
i n d i v i d u a l firm, and
Sameulson,
understand one while being
of economics
And
level,
such
as
individual
individual worker.
no
opposition
you are only
between
micro
half educated
if you
ignorant of the other."
inflation,
index,
interest
exchange
rate,
rate,
employment
balance
of
and
payments,
unemployment
and
fiscal
monetary policies are the most important indicators of macroeconomics.
and
Page 20
and
M e a s u r e m e n t of
National Income
Macroeconomics
02.
eBook
2 . 1 Introduction
National
income is the most
status of the
Simon
Kuznets,
income
helped
'economy
as a
whole'
indicator of macroeconomics,
on
in
economy
the
to
1930s.
measure
By
developed
introducing
and
as it
represents the
its own.
an American economist,
accounting
the
important
compare
the concept and

this
its
concept
and
performances
practice of national
practice,
through
'Kuznets'
scorecard
known as 'national income'.
National
income
policies, and
accounting
making
After reading
helps
in
measuring
the
standard
of
living,
formulating
international comparisons.
this chapter,
you will be able to:
E x p l a i n the circular flow of income
Define national income
List and
Describe the methods of measuring
Identify and
describe the concepts of national
income
national income
list the difficulties in the measurement of national
www. itmu niversityonline.o rg
income
Page 22
Macroeconomics
02.
Measurement of National
Income
eBook
2 . 2 Circular Flow of Income

Modern
economy
has
accepted
money
as
medium
of
exchange
and
hurdles of the barter system. The flow of money is never unidirectional;

economic
transactions,
which
understand the economy, you
maintain
continuous
need to understand
two-way
consumption.
involving
These
monetary
activities can
inflow
or
outflow.
outflow of goods from the business and
Economists
have
given
simplified
be
completed
For
the
it is the result of
flow.
In
order
to
how and why the money flows.
The functioning of any economy comprises three major activities,

and
removed
only
example,
with
production, exchange,
the
purchase
of
help
of transactions
goods
includes
the
inflow of money into the business.
models
to
help
understand
the
flow
of money
in
the
economy. These models, also known as circular flow models of economy, are d i v i d e d
into three categories:
Two-sector model
Three-sector model
Four-sector model
Two-sector
Circular
flow
Model
in
two-sector
model
includes
households and
business
firms.
Fig.2.2a
provides a pictorial representation of this model.
P
d
y
\c.e.t;
f'llem for Goods and sef'I
Flow of GOOds and 5er,,1c.e'i
Fig.
2.2a: Circular Flow in a Two-sector Model
Page 23
Macroeconomics
02.
In the upper loop of this model,

to
business
firms.
In
land,
exchange
for
eBook
labor, capital, and enterprise flow from

that,
factor
payments
(wages,
rent,
households
interest,
and
profits) flow from business firms to households.
In
the
lower
loop
of
this
model,
money
flows
from
households
to
business
firms,
in
exchange for goods and services sold to them by the business firms.
It can
have
be observed
created
that the economic activities
circular
flow.
This
circular
activity is dependent on each other and
between
flow
is
business firms and
never-ending
none of the activities have end
households
process,
as
every
points.
Circular flow of money with saving and investment
The
two-sector
income on
and
model
goods and
expenditure.
was
based
services;
What
will
on
the
therefore,
happen
to
assumption
there was
that
no
the circular flow
households
difference
of money,
spend
between
all
the
if households
income
save a
fraction of their income in the financial market?
Fig.
2.2b w i l l
help to understand the impact of saving on the circular flow of money.
factors Payments
'4\la
es
g
Rent, Interest
'
Savings
ror,i:s
Investments
fJ(
Pendfture on Goods and
Fig.
('l\c.e.S>
se
2. 2b: Circular Flow with Saving and
their
Investments
Page 24
Macroeconomics
02.
When
households
services decline,
decline
hiring
save
fraction
consequently,
in the money
fewer
or
by
of
eBook
their
money,
the flow of money
receipts,
workers
Income
their
the
layoff
on
goods
into the business w i l l decline.
business firms will try to
following
expenditure
policy
and
With the
reduce their factor payments
for existing
workers.
As
by
result,
the income of the households will d i m i n i s h .
Thus,
saving
reduces the flow
in the economy's total
However,
savings by
of income and
in
the
business,
households w i l l show their n e g l i g i b l e effect on
institutions,
causing
a fall
income.
flow through the financial market.

financial
expenditure
Households deposit and
insurance companies,
savings of households come
and
into the financial
if they
invest their savings in various
stock markets.
market and
the economy,
It
is assumed
there are
no
that all the
inter-households
borrowings.
Business
firms,
financial
in
market.
households
In
Three-sector
model.
you
the form
the
capital
business
financial
government
purchases
goods
2.2c,
their
firms
goods
are
market.
requirement,
indirectly
The
effect
borrow
borrowing
caused
from
the
due
to
the
money
of
household
by the borrowing of business from the financial market.
the
education,
borrowings from
in
in
plays
infrastructure,
Fig.
way,
government
government
In
meet
Model
add
The
to
this
deposited
savings is nullified
When
order
it
etc.
into
a major
and
The
two-sector
role
in
services
major
model,
taxation,
and
they
source
of
it
becomes
spending,
also
and
spend
government
on
three-sector
borrowings.
capital
finance
is
The
goods,
taxes
and
the financial market.
is clear that a part of the
of direct taxes.
Similarly,
households' income
firms
have
to
pay
is given to the government
direct
and
spent
on
indirect
taxes to the
government.
part
of
transfer
the
revenue
payments.
goods and
households
collected
Another
part
services from firms.

and
business
the
of the
Thus,
firms
government to households and
by
and
government
revenue
on
on
is
one side,
the
is
used
wages,
by the government
money flows from
other
salaries,
side,
money
to
and
purchase
the government to
flows
back
from
business firms.
Page 25
the
Macroeconomics
02.
eBook
financial
M,uket
Fig.
2.2c:
Circular
Flow in a Three-sector Model
Four-sector Model
When
foreign
model.
The
countries
four-sector
are
added
model
in
explains
three-sector
the
money
model,
supply
in
it
becomes
an
open
four-sector
economy,
that
is,
an economy that is open for trade relations with other countries.
Foreign countries interact with a domestic country
by
importing
services.
the
foreign
country,
foreign
When
it
is
goods
known
country
by
and
as
the
services
exports
and
domestic
are
when
country,
want to balance their trade by making
In
the circular flow analysis,
countries
for
the
import
it
and
sold
goods
it
is
and
known
country
services
as
exporting
are
imports.
by
goods and
the
domestic
purchased
from
Generally,
the
countries
t h e i r exports equivalent to their imports.
is assumed
export
to
and
of
that only
goods
and
business firms
services.
It
interact with
is
also
foreign
assumed
that
h o u s e h o l d s export o n l y manpower to foreign countries.
In
Fig.
firms
2.2d, the circular flow of money, with
receive
money
business
firms
country.
Another
whereby,
pay
for
the
money
two-way
households
to
exports
foreign
flow
export
is
by
them
countries,
created
manpower
remittance in the form of direct and
done
respect to foreign trade is visible.
for
between
to
the
in
imports
foreign
received
households
foreign
country.
and
country
by
the
foreign
and
Business
Similarly,
domestic
countries,
get
foreign
indirect taxes.
Page 26
Macroeconomics
02.
Income
eBook
Fig. 2.2d: Circular Flow in a Four-sector
2.3
Model
National Income
National
income
resulting
from
year.
refers
the
of final
the
economic
In simple words,
of the country.
to
aggregate
activities
of the
and
value
people
of
all
final
of a country,
national income is the summation of all the
In the words of Brooman,
goods
money
services
produced
national
by
income
labor and
is,
goods
over
services,
period
of one
incomes of the people
"the sum
wealth
and
of a
of total
nation
value
during
period of one year."
National
income
macroeconomic
in
reality,
how
to
it
is
variables.
a
identify
economic
accounting
very
is
utmost
National
complex
productive
production,
of
what
It
involves
non-productive
method
as
income accounting
task.
and
important,
should
be
it
may
various
for
the
appear
to
conceptual
activity,
used
studies
what
national
is
performance
be
very
easy
problems,
economic
such
and
income accounting,
of
but
as,
non
and
so on.
In
order
to
understand
understand
national
income
the various concepts of national
and
the
problems
associated
with
it,
income.
Page 27
first
Macroeconomics
02.
eBook
2 . 4 Concepts of N a t i o n a l I n c o m e
The various concepts of national
Final Goods and
Final
goods
are
intermediate
processing
For
goods
sale
is
are
the
purchased
goods
that
of
as
In t h i s case,
intermediate
It
consumers
purchased
for
for
the
the
final
purpose
use
and
of further
as final goods after processing.
used
income of the country.
by
are
raw
material
becomes a part of various
actual consumers.
The
are
steel
it
that
are resold
example,
processing,
Intermediate Goods
goods
and
income are:
steel
goods
is
by
various
final goods
that are
is an
is
not
industries
ready
for
and
sale
after
to the
intermediate good.
included
while
because they are already
calculating
included
in
the
national
the calculation
of
final goods.
Net Factor Income from Abroad
Residents
profit)
of
from
the
abroad
home country
rendered
by
home
for
country
earn
rendering
factor
income
factor services
in
(wages,
rent,
other countries.
becomes a source of income to the foreign country,
them
in
the
domestic
between the two incomes is
(NFIA)
territory
known as Net
of
the
home
interest,
and
Similarly,
the
for the services
country.
The
Factor Income from Abroad
difference
(NFIA).
Gross Domestic Product ( G D P )
Gross
domestic
services
year.
produced
within
is
the
the
sum
of
domestic
money
value
territories
It does not include net factor income from
of
of
a
all
the
country
final
in
an
goods
and
accounting
abroad.
= C + I +G + X n
GDP
C =
product
Private consumption expenditure
I = Gross private investment

G = Government expenditure
Xn =
Net exports
Gross domestic
product can
GDP
price
at
market
indirect taxes and
is the
be calculated
value
of goods
exclude subsidies).
services at factor cost
at market
and
services
GDP at factor cost
(includes subsidies and
price as well as at factor cost.

at
market
price
(includes
is the value of goods and
excludes indirect taxes).
Page 28
Macroeconomics
02.
Conceptually,
GDP at
value of goods and

their
production.
To
GDPMP
get
Income
market
eBook
price and
services is nothing
But
gross
in
reality
factor cost are same,
the
market
but the total of factor payments involved
there
domestic
because
exists
product
at
difference
factor
cost,
you
between
will
have
and
GDPFc
to
in
subtract
indirect taxes and add s u b s i d i e s to gross domestic product at market price.
GDPFc
Indirect
- Indirect taxes + Subsidies
GDPMP
tax
services
is
subtracted
goes
to
the
from
GDPM,
government
in
because
the
form
part
of
of the
taxes.
value of goods
Subsidies
are
and
added
because government pays subsidies to the producers of a particular commodity, so

that they can sell it at a lower price.
Gross National
Product ( G N P )
Gross national
product
When you add
NFIA in gross domestic product, it becomes gross national product.
GNPMP
GDP
GDPMP
GNPMP
Net Domestic
M P +
is a wider concept as compared
Net Factor Income from Abroad
- Net factor income from abroad
Product ( N O P ) and
Net National
to gross domestic product.
{NFIA)
(NFIA)
Product ( N N P )
Gross domestic product and gross national
product do not provide a true picture of
the
in
economy
NDP
and
as
NNP
they
ignore
provide
true
depreciation
picture
subtracting depreciation from GDP and
NOP
GDP
NNP
G N P - Depreciation
of
their
the
GNP,
calculation.
economy
as
they
On
the
are
other
side,
calculated
by
respectively.
- Depreciation
Or
NNP
GDP - Depreciation
Net National
Net
national
prices.
and
Product at Market Price
product
at
market
price
is also
known
as
national
It is the value of the current output of goods and
is obtained
NNPMP
+ NFIA
income at
market
services at market prices
by deducting depreciation from G N P at market price.
GNPMP
- Depreciation
Page 29
Macroeconomics
02.
Measurement of N a t i o n a l
Net National
Income
eBook
Product at Factor Cost
Net national product at factor cost is also known as national income at factor cost.
It refers to the total of a l l factor payments received
NNP,c
=
=
NNP,c
N N P M o - Indirect taxes
NDP,c
Personal
Personal
+ Subsidies
+ NFIA
Income
income does
security
by factors of production.
not
contributions,
contrary,
the
include
corporate
incomes
that
incomes which
income
are
tax,
received
are
and
but
not
received,
undistributed
not
earned,
such
as
profit.
such
as
social
On
the
transfer
payments.
Personal
income
National
income
Social
Corporate income tax - Undistributed profits
contribution
+ Transfer payments
Disposable Income
Disposable income refers to personal

legally
enforceable
fines, and
for
payment
penalties imposed
Disposable income
2.5
security
income against which
obligations,
like
income
income owners are not
tax,
government
loans,
by legal authorities.
Personal income - Personal taxes
Measurement of N a t i o n a l I n c o m e
There are three methods used
Value added
Income method
Expenditure method
Value Added
Value added
in the measurement of national income:
method
Method
method
income is estimated
is also called output or production method.
In this method,
by taking the contribution (or value a d d e d ) made by each
national
producing
enterprise to production in the domestic territory of a country in an accounting year.
Page 30
Macroeconomics
02.
For
estimating
divided
national
into
various
manufacturing
After d i v i d i n g
you
within
is
derive
by
to obtain
the
Gross
become
part
Now,
as
method,
primary
first,
the
sector,
economy
secondary
is
or
the
Net Value Added at
industry.
However,
Factor Cost
there are several steps
of a country.
the
services
The
value
quantity
of
produced
by
of goods and
goods
and
various enterprises
services
services
or
value of
produced
by
its market price.
enterprises
of a sector,
the value of output
of that
be derived.
intermediate
added
NVA,c,
multiplying
deducting
such
the value of output of all
particular sector can
GVAMP
sectors,
into different sectors,
domestic territory
obtained
By adding
counting,
value
for each enterprise and
particular enterprise with
Now,
the
have to calculate value of goods and
the
output
eBook
tertiary or service sector.
the economy
that need to be followed
First,
under
industrial
sector, and
is estimated
(NVA,c)
income
Income
Value
at
Market
consumption
of finished
goods at
intermediate consumption
from
later
Price
the
value
stage,
is deducted
which
(GVAMP),
of
thus,
from
output.
to
As
avoid
is
calculated
intermediate
the
problem
by
goods
of d o u b l e
value of output.
Value of output - Intermediate consumption
deduct
depreciation
from
GVAMe
to
get
Net
Value
Added
at
Market
Price
(NVAMp).
NVAMP
Now,
= GVAMP - Depreciation
make
excise
an
duties
adjustment
to
the
for
the
government
payment
minus
of
indirect
subsidies
from
the adjustment, the Net Value Added at Factor Cost
NVA,c
After
the
(sales
tax,
custom
government).
(NVA,c) w i l l
After
duty,
making
be derived.
NVAMP - Net indirect taxes
adding
economy,
taxes
the
Net
Value
Added
at
Factor
Cost
(NVA,c)
Net Domestic Product at Factor Cost ( N D P , c ) will
of
all
the
sectors
be derived.
Page 3 1
in
an
Macroeconomics
02.
Finally,
add
net
factor
income
Income
from
eBook
abroad
to
get
national
income
or
Net
National
Product at Factor Cost ( N N P , c ) ,
National
Income
In t h i s
Method
method,
country.
= NDP,c + Net Factor Income from Abroad
income or NNP,c
The
national
following
income
steps
is obtained
are
by adding
followed
to
the
incomes of all
estimate
national
i n d i v i d u a l s of a
income
under
this
method:
identify
First,
the
productive
enterprises
and
classify
them
into
various
industrial
sectors, such as agriculture, fishing, forestry, etc.
Second,
classify the factor payments into the following
Compensation of employees
Rent and
Interest
Profits
royalty
measure
Third,
all
enterprises b e l o n g i n g
Fourth,
by
domestic
groups:
factor
to an
summing
factor
up
income,
payments
and
add
all
out
by
the
factor
payments
of
all
the
obtain
the
industrial sector.
the
income
which
is
also
paid
known
as
all
net
industrial
domestic
sectors,
product
at
factor
cost
(NDP,c),
Finally,
called
by adding
national
NNP,c
In
The following
abroad
to
NDP,c,
derive
NNP,c,
which
is also
+ NFIA
method,
national
services d u r i n g
income
is
estimated
on
goods
adding
and
services
by
to obtain at national
individual
private consumption expenditure and
by
all
expenditures
made
a year.
types of expenditure are added
Expenditure
final
from
Method
expenditure
on goods and
income
income.
NDP,c
Expenditure
net factor
and
income:
households.
is represented
It
is
known
by C.
Page 32
as
Macroeconomics
02.
Expenditure
by
Income
government
on
goods
final consumption expenditure and
Expenditure
known
as
capital
gross
formation
goods
into
two
and
services.
is represented
and
domestic capital
is divided
the second
on
eBook
parts,
the
by
is,
known
productive
denoted
first
is
as
government
by G.
inventories
formation
It
by
I.
enterprises.
Gross domestic
gross fixed
capital
It
is
capital
formation
and
is, addition to the stocks or inventories of goods.
Net exports denoted
by (X - M)
X = Exports
M = Imports
All
above-mentioned
Market
Price
expenditures are added

After
(GDPMP)
that,
and
depreciation
Domestic Product at Market Price ( N D P M P )
GDPMP
NDPMP
G D P M P - Depreciation
To
N D P a: ,
get
net
you
get Gross
is
deducted
Domestic
from
Product
GDPM,
and
at
Net
is obtained.
(X - M)
indirect
taxes
(indirect
taxes
minus
subsidies)
are
subtracted
from
NDPMP
Finally,
Net
Factor
Income
from
Abroad
is
(NFIA}
added
to
get
N N P a:
or
national
income.
NNPFc
GDPMP
Depreciation
Net
indirect
taxes
Net
Factor
Income
from
Abroad
2.6 Difficulties in t h e Measurement of N a t i o n a l Income

The difficulties faced
in the measurement of national income are:
Non-monetary Transactions
The
treatment
national
of
income.
generated
non-monetary
For
is added
the
country
house
maid
is
biggest
is
paid
for
for the estimation of national income.
the work is managed

of
example,
transactions
by the family
declines.
In
this
members.
case,
the
At
this
services
ambiguity
her
while
services
and
calculating
the
income
However, when the maid quits
point of time,
remain
the
the
same
national
but
the
income
national
income is affected.
Page 33
Macroeconomics
02.
Income Generated
National
income
whether the
where
they
eBook
by Foreign Firms
measurement
income of foreign
are
Income
located
or
faces
problems
firms should
whether
it
related
to
foreign
be a part of national
should
be
the
part
of
firms.
The
problem
is
income of the country
national
income
of
the
country who owns that firm.
Difficulties
in
the
Measurement
of
National
Income
in
Developing
and
Underdeveloped Countries
Developing
and
underdeveloped
measurement of national
Inadequate
countries
face
the
following
difficulties
in
the
income:
availability
of statistics
in
the
country
is
the
major
constraint
in
the
measurement of national income.
In
underdeveloped
countries,
there
exist
large
non-monetized
sectors that
make
national income calculation difficult.
Illiteracy and
ignorance of public are the two major hurdles for calculating
National
Income.
There
are
always
people engaged
Problem
problems
in
collecting
information
regarding
the
income
of
to
difficulty
in
in more than one activity.
of d o u b l e counting
is
very common,
which
is
caused
due
identifying distinction between intermediate and final goods.
Inefficiency of the machineries for the collection of statistical data is also the major
drawback in calculating
national income.
Page 34
Macroeconomics
02.
Income
eBook
2 . 7 Chapter S u m m a r y
The
functioning
of
any
economy
comprises
three
major
activities,
production,
exchange, and consumption.
Circular flow models of economy and can

o
Two-sector model
Three-sector model
Four-sector model
National
income
refers
services
resulting
from
period
to
the
the
be categorized as:
aggregate
economic
money
activities
value
of the
of
people
all
of
final
a
goods
country
and
over a
of one year.
Gross domestic product, gross national

product,
personal
income,
and
product,
disposable
net domestic product,
income
are
the
important
net
national
concepts
of
national income.
The
three
method,
methods
for
measuring
income method, and
national
income
of a
country
are
value
expenditure method.
Page 35
added
Money
Macroeconomics
03.
Money
eBook
3 . 1 Introduction
When
the
thought
of
buying
something
strikes
person,
the
first
question
they
ask
Before
the
themselves is, "Do I have sufficient money to buy it?"
Similarly,
everyone
uses
development of money,
needed.
and
the
desires
people would
increasing
a great discovery
Now,
and
With the
money,
demand
for
barter,
it,
and
thinks
about
it.
in order to obtain goods and
of goods and
services,
the need
services they
for money was felt
in the form of 'money' took place.
study of money
is not just confined
s u p p l y of money determines the actual
to an
individual
buying.
Aggregate demand
position of the economy and
helps
in
major financial decisions.
After reading t h i s chapter,
you
will
be able to:
Explain
barter system
Define money
Explain the functions of money
Identify the importance of money
Describe the concept of money s u p p l y and demand
for money
Page 37
taking
Macroeconomics
03.
Money
eBook
3 . 2 Evolution of Money
In
the
early
decades,
money
was
not
used
as
medium
of
exchange.
commodities or services was made only through the barter system.
Exchange
of
Barter is a system of
exchange by which goods or services are directly exchanged for other goods or services,
without using
money as a m e d i u m
of exchange.
For example,
exchange of wheat
for
rice or some services.
However,
the
barter system
lots of difficulties
of goods faced
of value,
These
was
not as simple
in their operation.
problems,
The two
as
it
seems.
The
people who were
such as double coincidence of wants,
problem of subdivision of goods, and
major drawbacks
led
to
the
evolution
barter economy
involved
faced
in the exchange
lack of common measure
lack of store of value.
of
money.
Since
then,
money
has
taken
many forms.
Commodity Money
Initially,
various commodities,
used
money.
and
as
such
as
sea
These commodities faced
shells,
bows,
arrows,
animal
skin,
various difficulties as a medium
etc.,
were
of exchange
this led to the evolution of metallic money.
Metallic Money
Precious
metals,
commodities,
as
gold
and
silver,
metals were much easier to
Crowther said
they
such
replaced
handle.
With
commodity
money,
as
unlike
reference to metallic money,
G.
that, "they are easily handled and stored, they do not deteriorate,
have just the
right degree
of scarcity
and
they
can
be
relied
upon
neither
were
precious
to increase nor to d i m i n i s h in quantity except gradually."
Metals,
like gold
and
silver,
were
used
as
money
not
only
because they
but due to their scarcity.
Paper Money
With
the
development
its
of
value.
money,
After
that,
it
was
realized
precious
that
metals
scarcity
were
of
important
than
replaced
Gradually,
paper money took the form of bank notes that were issued
money
by
paper
is
more
money.
by a l l commercial
banks and eventually, the Central Bank took monopoly over the issue of bank notes.
Page 38
Macroeconomics
03.
Money
eBook
Bank Deposit Money

Bank deposit is the
cheques can
money that the public hold with commercial
be d r a w n .
In
India,
bank deposit
money
has
banks and
become an
against which
important
part
of
the total money supply.
Plastic Money
Plastic money
made
and
of
is the most modern form
plastic,
succeeded
commonly
in making
called
of money.
debit
cards and
It includes money in the form of cards

credit
cards.
Plastic
life easier for people who do not want to
hold
money
cash
in
has
tried
hand and
visit banks continuously to make any kind of payments.
3 . 3 Definition of M o n e y
Different definitions of money are given
about different aspects of money.
which
is widely accepted
by various economists and
According
to
D.
H.
Robertson,
each
definition
money
is,
talks
"Anything
as payments for goods or in discharge of any
kinds of
business obligations."
Crowther
contributed
that,
"Money
can
be
defined
as
anything
that
is
generally
acceptable as a means of exchange and that at the same time act as a measure
and store of value."
According
exchange
to
for
Milton
goods
Friedman,
and
but as an object that
"Money
services
is
whatever
accepted
represents a temporary
not
as
abode
is
an
of
generally
object
to
accepted
be
purchasing
consumed
power
used for buying still other goods and services."
in
Page 39
to
be
Macroeconomics
03.
Money
eBook
3 . 4 F u n c t i o n s of Money
The four major functions of money are displayed
in
Fig. 3.4a.
Medium
of
Exchange
Functions
of
Money
Fig. 3.4a:
Functions of Money
Medium of Exchange
The
As
most
important function
discussed
earlier,
barter
of money
system
is
that
faced
the
it can
be used
difficulty
as a medium
of d o u b l e
of exchange.
coincidence
of wants
but the evolution of money helped the economy get rid of that problem.
For example,
received
X can
sell goods to Y at
some
pre-decided
price and
Y can
use the
money
from X to buy another commodity.
Measure of Value
In
barter
system,
there was
difficult to decide which
selling
Now,
people
common
measure
two quantities and
the problem of barter system

services.
no
can
by acting
measure
of value,
due
commodities should
to
which
be traded.
it
was
Money
always
solved
as a yardstick to measure the value of goods and
the
worth
of goods
on
the
basis
of their
respective
prices.
Page 40
Macroeconomics
03.
Money
eBook
Standard of Deferred
Payments
Deferred
payments that are made
payments are
of deferred
payments because its value
in
the future.
is more or less
Money acts as a standard
stable.
All credit transactions are
possible only due to the existence of money.
During
deflation,
non-profitable to
the
value
of money
the debtors.
increases,
Similarly,
which is profitable to debtors and
during
which
is
inflation,
profitable
to
the
creditors and
the value of money
decreases,
non-profitable to the creditors.
Store of Value
Money
is the
wealth.
most
Anything
liquid
can
be
and
now,
most
acceptable
time without difficulty and

of value and
the
suitable asset
as
money,
deterioration.
paper money in
if
it
Previously,
that
can
can
be
gold
be
stored
stored
and
for
in
the
long
silver were used
form
of
period
of
as a store
banks has taken their place.
3 . 5 Importance of Money
Money
plays a vital
role
in the modern
economy.
The following
roles
of money
highlight
its importance:
Promotes Saving
The
existence of money
economy
Financial
and
has
become
institutions
opportunities, as
has
promoted
the
accept
cause
small
the savings,
of existence
savings
as well
as,
of various
of
investments
financial
individuals
and
in
the
institutions.
provide
loan
per the requirement of individuals.
Promotes Division of Labor
In
the
and
best
barter
services
to
system,
exchange
people were
fulfill
all
their
was difficult
more focused
desires
on
on
their
and
to
avoid
becoming
own
and
the
exchange of goods
self-reliant.
They
thus,
overlooked
they
tried
their
the
importance of divis ion of labor.
With
and
the
tried
evolution
to
of
money,
specialize
in
the
people
realized
production
of
the
goods
importance
that
they
of d i v i s i o n
could
of
labor
produce
more
effectively at lowest cost.
Page 4 1
Macroeconomics
03.
Money
eBook
Promotes Trade
Barter system
of
goods
system,
faced
and
various difficulties
services.
by facilitating
Money
has
exchange and
and
always
overcome
created
all
by promoting
the
problems
difficulties
in
of
exchange
the
barter
trade in the economy.
Maximum Satisfaction to Consumers
Money
provides
purchasing
purchase a n y t h i n g
rational
buying
to
consumers,
by
giving
at anytime as per their requirements.
decisions
This gives them a feeling
powers
by
comparing
two
of h a p p i n e s s and
products
them
the
right
to
Now, consumers can take
through
their
money
value.
satisfaction.
Important to Producers
Money
profit
helps
at
producers
different
to
compare
levels of output.
their
expenditure
Producers
pay
with
income
remuneration
form of money, which motivates them to work effectively and
3.6
Role
of
Money
Economic
rn
to
and
find
workers
in
out
the
efficiently.
Development
of
the
Developing Countries
Money
and
has
always
played
major
role
in
the
economic
development
of the
developing
underdeveloped countries of the world.
Assistance to
Non-monetized Sectors
A major part of underdeveloped

sectors.
their
The
and
developing
countries is covered
biggest drawback of the non-monetized
survival.
Introduction
of
requirements of the modern
money
industrial
has
helped
sector and
with
sector is that they
the
non-monetized
has helped
in
raising
non-monetized
produce only for

sector
meet
the
the output of the
economy.
Promotes
Money
affected
has
Productivity
always
the
promoted
productivity
services leads to an
of
specialization
the
economy.
and
Increase
increase in the income and
division
in
standard
of
labor,
the
which
production
has
of
positively
goods
of living of the people.
Page 42
and
Macroeconomics
03.
Money
eBook
Promotes Investment
According
savings.
to
It
is the
t h i s reason,
In
of
modern
economy,
of
investment
The
economic
government
development
supports
is
not dependent on
the industries that do
investments may exceed
countries,
investments.
level
households who do savings and
sometimes,
developing
the
the
level
investments.
of
For
savings.
can
be achieved
increased
rate
of
by
increasing
return,
by
the
creating
rate
new
money.
Helpful
In
in
Fast Yielding
developing
situations.
(flood
inflation,
countries,
If the
control,
Projects
newly
anti-soil
rather it will
newly
created
erosion
lead
created
money
is
measures,
money
used
does
for
not
always
investment
irrigation
work,
in
etc.),
create
fast
then
inflationary
yielding
there
projects
will
be
no
the country toward economic development.
3 . 7 Money Supply
Money
supply
is
the total
Money
supply
helps
in
money
supply
assists
in
amount
the
of money available
determination
retaining
price
of
price
stability
in
an
level
and
the
economy,
and
at
interest
economic
a specific time.
rate.
Growth
development
of
of the
country.
While
conducting
by the Central
an
economic analysis,
it
is assumed
that
money
supply
is determined
B a n k and government of a country.
Components of Money Supply
Money supply
includes two components:
Components of Money
Supply
Demand Deposits with the

Public
Fig. 3.7a: Components of Money Supply
Page 43
Macroeconomics
03.
Money
eBook
Currency with the P u b l i c
Currency with the public in India
is calculated
issued
the following
Currency notes in circulation
The number of rupee notes and coins in circulation
Small coins in circulation
To deduce the total currency
with the
deducted
the
from
because
cash
the
value
of
reserves with
by
by a d d i n g
R.B.I.
public,
cash
above-mentioned
banks
cannot
items:
be
used
reserves with
items.
This
for making
banks
need
deduction
to
is
be
done
payments of goods
or any other services.
Demand
Demand
Deposits with the P u b l i c
deposit
withdrawn
medium
with
through
the
public
cheque.
of exchange and
is
Thus,
can
be
the
bank
demand
money
that
deposits
broadly classified
with
can
be
the
into demand
deposited
public
act
deposits and
and
as
time
deposits.
Demand
of time.
deposits are deposits that can

On
the other hand,
after a specified
be withdrawn against cheques at any
time deposits are deposits that can
point
be withdrawn only
period of time.
Measures of Money Supply
Reserve
Bank
of
India
has
adopted
four
concepts
or
measures
to
analyze
the
money
s u p p l y of the country:
Money Supply
M,
or Narrow
Money Supply
M,
Money Supply
M, or Broad
Money Supply
M.
Money
Money
Money Supply M1 or Narrow Money
Narrow money
M1
is composed of the following
C + D D +
items:
OD
Where,
C = Currency with
DD
= Demand
public
deposits by the public in the commercial and
cooperative banks
Page 44
Macroeconomics
03.
Money
O D =
eBook
other deposits
Money Supply
held
by the public with
R.B.I.
The M, concept is broader than
M1
and
is composed of the following
items:
= C + DD + OD + SD
M2
or
M2
M1
+ SD
Where,
C = Currency with
public
DD =
Demand
O D =
Other deposits held
S D = Saving
deposits by the p u b l i c in the commercial and

R.B.I.
deposits with the post office saving
Money Supply M 3
Broad
by the p u b l i c with
or Broad
money is composed
cooperative banks
banks
Money
of the following
items:
= C + DD + OD + TD
M,
or
M,
= M l +
TD
Where,
C = Currency with
public
DD =
Demand
O D =
Other deposits held
TD
deposits by the p u b l i c in the commercial and
= Time deposits with
Money Supply
The
measure
M3
R.B.l.
banks
M4
of money
the post office saving
M4
by the p u b l i c with
cooperative banks
includes all the
items of
M, and
also,
the total
deposits with
organization.
+ Total deposits with post office saving organization
Page 45
Macroeconomics
03.
Money
eBook
3 . 8 Money M u l t i p l i e r
Money
multiplier
increase in
high
is
the
extent
powered
to
money.
which
money
supply
is expanded
as
an
Money m u l t i p l i e r theory can be explained
effect
of the
with the help
of M , concept of money s u p p l y .
Here, the M , concept is denoted
M = Cp
by 'M'. T h u s :
Where,
M = Total money s u p p l y with public
C, = Currency with the p u b l i c
D = Demand deposits held
The
two
powered
most
important
money, and
High
Powered
High
powered
government;
held
it
by the p u b l i c
determinants
of
above-mentioned
money
supply
are
(i)
high
( i i ) money multiplier.
Money
money
includes
is denoted
by the public,
by
currency
'H'.
Some
notes
issued
by
the
part of the currency
whereas, the remaining
Central
issued
part of currency issued
by
is held
Bank
Central
and
the
Bank
is
by commercial
banks as reserve.
High
powered
money
is
banks as reserve. Thus,
Cp
the
sum
of currency
high powered
held
by
public
and
the
currency
held
money can be represented as:
Where,
H = H i g h powered
c,
= Currency held
R = C u r r e n c y held
money
by p u b l i c
by banks as reserve
Page 46
by
Macroeconomics
03.
Money
Money
eBook
Multiplier
Money m u l t i p l i e r can be expressed as:
m =
M / H or M =
H.m
Where,
m = Money multiplier
M = Money supply
H = H i g h p o w e r e d money (Currency issued
It
can
Money
now
be
concluded
multiplier can
help
that
in
money
by Central Bank)
supply
predicting
is
determined
the extent to which
by
the
money
multiplier.
money will change with the
change in the amount of h i g h powered money.
Money m u l t i p l i e r in a real-life situation is explained with the h e l p of an example.
Example 0 1 :
Assume that a l l commercial
banks keep
10
percent of their deposits as reserve and
rest
90 percent they lend.
A commercial bank named
X Bank receives deposit of < 1 0 , 0 0 0 .
10 percent of the deposit, which is < 1 0 0 0 as reserve and
Bank
1,000
Loans
9,000
Table 3.Sa:
X Bank has two types of liabilities,
('CJ
Assets
Reserve
Now,
rest <9,000 it w i l l lend.
(t')
Liabilities
It means that it w i l l keep
Deposits
10,000
X Bank
that is,
reserve and
loans and
one asset
in the
form of deposits.
The creation
that
of money
borrower
account
in
will
not
borrows <9,000
another
commercial
stop
with
from
bank
a single transaction
B a n k to
named
of X
buy goods from

Bank.
In
this
Bank.
Now,
person
example,
who
the
assume
has an
seller
deposit the amount received from the sale of goods in Y Bank.
Page 47
will
Macroeconomics
03.
In
Money
this
eBook
transaction,
Bank
will
keep
900
as
reserves
and
8,100
for
the
purpose
of
lending.
Y Bank
('!
Liabilities
Reserve
900
Loans
8,100
('!
Assets
Deposits
9,000
Table 3.Sb: Y Bank
If,
again,
this
process
continues
and
{8,100
are
deposited
in
bank,
then
it
creates
reserve o f { 8 1 0 and grants loans o f { 7 , 2 9 0 .
z Bank
(')
Liabilities
Reserve
810
Loans
7,290
(')
Assets
Deposits
8,100
Table 3.Sc: z Bank
This
process continues and
The
total
following
amount
each t i m e ,
created
in
the
money is created.
aforementioned
example
Lending
o f X Bank
{9,000
(+)
Lending
o f Y Bank
{8, 100
(+)
Lending
ofZ
{7,290
Bank
-------------
-------------
-------------
-------------
-------------
-------------
in
the
the
of
money
money.
creation
In
of banks, you
{1,00,000
money supply
Table 3.Sd: Total
lending
calculated
{10,000
(+)
Total
amount
be
manner:
O r i g i n a l deposit
Although
can
the
continue
aforementioned
w i l l find
process can
Money Supply
forever,
example,
if
it
you
will
not
keep
create an
on
infinite
calculating
the
that { 1 0 , 0 0 0 of reserves w i l l create { 1 , 0 0 , 0 0 0 of money.
Page 48
Macroeconomics
03.
Money
Thus,
eBook
you
reserves
can
conclude
is called
that
the
amount
money
generated
with
each
rupee
of
money multiplier.
3.9 Factors D e t e r m i n i n g
According
of
to R . B . I . , the following
M o n e y Supply
factors determine money s u p p l y .
Government Borrowings
Government
induce
borrows
R.B.I.
creation
of
to
new
from
create
banking
new
currencies
system
currencies
by
Central
to
that
finance
directly
Bank
to
their
deficit
affects
finance
the
budget,
money
government
which
may
supply.
deficit
The
budget
is
known as monetization of deficit.
In
1999,
an
Act of
Fiscal
according
to
which
the
government
Recently,
bonds
to
Responsibility
government
the
banks.
Budget
deficit
This
the government deficit was
Act
Management
budget
can
stopped
largely
be
financed
government
financed
(FRBM)
through
borrowing
by commercial
was
passed
selling
from
of
R.B.I.
banks through
the
selling of b o n d s .
Private Sector Borrowings
Private
sector
the money
may
supply with
commercial
bank's
banks by making
Foreign
borrow
from
the public.
credit
supply.
the
banking
However,
Central
changes in the cash
in
the
money supply.
not
Central
Bank
which
can
also
increase
Bank has complete control over the
can
control
the
liquidity
of
commercial
reserve ratio.
foreign
When
have
exchange
there
enough
assets
is deficit
foreign
in
the
exchange
held
rupee flows
into the
reserves of the
by
R.B.I.
can
also
Balance Of Payments
to
pay
deficit, the country will have to dispose foreign
Thus,
institutions,
Exchange Assets
Variation
does
also
for
its
Central
(BOPs)
imports,
reserves in
bring
then
change
and
to
in
the
the country
control
BOPs
return for rupee currency.
Bank ( R . B . I . ) ,
which
will
result
in
the
contraction of money s u p p l y .
Government Currency
Government
and
small
currency
coins
with
Liability
liability
the
with
public)
the
public
affects
the
(holdings
money
of one
supply
in
rupee
the
notes,
economy.
rupee coins
The
the government liabilities with the public, the higher w i l l be the money s u p p l y .
Page 49
higher
Macroeconomics
03.
Money
eBook
3 . 1 0 D e m a n d for M o n e y
Demand
for money
is
of interest,
prices, and
There
various
are
approach,
and
Fisher's
an
important
national
for
macroeconomics,
demand
approach,
Keynes' theory of demand
in
as
it
determines the
rate
income of the economy.
approaches
income
issue
of
money,
Cash-balance
such
approach
as
Fisher's
transaction
of Cambridge
economists,
for money.
Fisher's Transaction Approach

This
approach
approach,
and
the
there
lays
stress
exists
on
a direct
the
relationship
level of price of goods and
According
money
to
in
Fisher,
"Other
circulation
exchange
function
between
of
money.
quantity
According
of money
in
an
to
this
economy
services sold.
things
increases,
remaining
the
price
unchanged,
level
also
as
the
quantity
increases
of
in
direct
simple
truism.
proportion and the value of money decreases and vice versa."
Fisher's transaction approach equation can
MV
be expressed
as:
PT
Where,
M = Quantity of money in circulation
V = Transaction velocity of circulation
P = Average
T = Total
price
number of transactions
Fisher's Income Approach

Fisher's
transaction
approach
was
criticized
on
the
grounds
of
being
T h i s drawback of Fisher's transaction approach gave rise to Fisher's income approach.
Fisher's
income approach
transaction
version
of
whereas,
velocity
Fisher's
the
of
introduces the concept of income
circulation.
equation
income
version
includes
T,
of Fisher's
includes o n l y final goods to avoid
Specifically,
that
you
is,
equation
all
can
velocity of money
conclude
goods,
excludes
the
that
instead
of
transactions
intermediate
intermediate
and
final,
goods
double counting.
Page SO
and
Macroeconomics
03.
Money
eBook
The income version of quantity theory of money is written as shown
MV
below:
PY
P = MV
I Y
Where,
M = Quantity of money
V = Income velocity of money
P = Average price
Y =
Real
national
level of final goods and
services
income
Cambridge Cash-balance Approach
The
equation
was
stated
by
Cambridge
different from
Irving
Fisher.
According
them,
price
to
transactional purposes and
Cambridge cash
level
is
economists,
affected
not by total
balance approach can
only
Marshall
by
the
and
cash
that
MV as suggested earlier by
be expressed
in
Pigou,
people
form
hold
for
Fisher.
as:
kPY
Where,
Ma
= Demand
k =
for money
Proportion of n o m i n a l income (PY) that people want to hold
P = Average price
Y =
Real
national
level of currently produced
goods and
as cash
balances
services
income
Keynes' Theory of Demand for Money
According
to Keynes,
money
The Transaction
The
transaction
is demanded
Demand for
demand
for
to fulfill three motives:
Money
money
relates
day-to-day transactions of i n d i v i d u a l s and
Precautionary
holding
of cash
to
fulfill
the current
business firms.
Demand for Money
Precautionary demand
contingencies.
to
for
money
relates to
Risk is always attached
the
holding
of cash
to every i n d i v i d u a l and
balance for future
business firms,
Page 5 1
none
Macroeconomics
03.
Money
of
eBook
these
two
can
avoid
that
risk.
However,
contingency to m i n i m i z e the effect of risk and
Speculative
It
Demand for
relates to the
conditions,
holding
they
can
keep
some
money
for
uncertainties.
Money
of money
to
take advantage of future change
in
market
like change in interest rates. The speculative demand for money can
represented
the
be
through Fig. 3 . 1 0 a .
--------
r'
--------!--------
r"
- - - - - - - } - - - - - - - - - - - - - ' ..,.::_
E'
ls
..
'
'
LP
'
'
Speculative Demand for Money
Fig. 3 . l O a : Speculative Demand for Money
Fig.
to
3.10a
interest
represents the movement of speculative demand

rate.
decreases and
As the interest
rate
increases,
the demand
for money in
relation
for speculative money
vice versa.
Page 52
Macroeconomics
03.
Money
eBook
Barter is a system
of exchange by which goods or services are directly exchanged
for other goods or services without using money as a medium of exchange.
D.
H.
Robertson
defines
money
as,
"Anything
which
is
widely
accepted
as
payments for goods or in discharge of any k i n d s of business obligations."
Money includes four functions-a medium, a measure, a standard, and a store.
Currency
with
public
and
deposits
with
p u b l i c are
the
two
components
of money
supply.
Reserve
Bank
of
India
has
adopted
four
concepts
or
measures
to
analyze
the
money s u p p l y of the country:
Money S u p p l y M l or Narrow Money
Money S u p p l y M2
Money S u p p l y M3 or Broad
Money S u p p l y M4
Demand
for money
is an
important
rate of interest, prices, and
Money
issue
in
macroeconomics as
it determines the
national income of the economy.
Page 53
Banking
Macroeconomics
04.
Banking
eBook
4 . 1 Introduction
The need
for borrowing
money. This need
The financial
Banking
lending came into existence with the introduction and
has resulted
system
is the
and
most
in the evolution of a huge industry,
plays a major
important
role
part
has become the backbone of every
of trade, production, and
In
this
chapter,
you
financial
system
of every
individual, organization, and
Commercial banks play a major role in
known as banking.
in the economic development of every
of the
promoting
use of
country
country.
and
thus,
industry.
savings, allocation of funds,
promotion
investment.
will
closer view of the banking
study
about
the
functioning
of
banks,
which
will
give
industry.
After reading this chapter, you w i l l
be able to:
Define banking
Classify different banks
List the functions of a commercial bank
Discuss the role of commercial banks in economic development
Define Central Bank
List the functions of Central Bank
Discuss the methods of credit control
Page 55
you
Macroeconomics
04.
Banking
eBook
4 . 2 Definition of B a n k i n g
The following
definitions clearly explain the meaning
According
to
for
deposits and
bank
Prof Sayers,
"Ordinary
bank deposits
one person or corporation

of exchange,
banking
for
government bond,
business consists
cash;
to another, giving
the secured
of b a n k i n g :
transferring
of changing
bank
cash
deposits
from
bank deposits in exchange for bills

promises of businessmen to
repay
and so forth."
In
the
such
words
of Kinley,
advances
safely
made;
of
"A
money
and
to
when not required
Bank
or
which
by them
is
an
other
establishment
means
individuals
of
which
payments
entrust
as
money
makes to
may
or
be
individuals
required
means
and
of
payment
commercial
banks and
for use."
4.3 Classification of Banks

Banking
institutions can
be
broadly classified
into two categories,
cooperative banks.
Fig. 4.3a:
4.3.1 Commercial
Commercial
who
banks
have e n o u g h
banks
also
given
in
Banks
are
to
provide
Classification of Banks
banks
that
spare and
various
consideration
of
accept
give
types
deposits
loans to
of financial
payments
in
the
in
the
form
those who are
services
form
of
to
in
of
need
customers.
discount,
money
of
it.
These
interest,
from
Commercial
services
commission,
fees.
those
Page 56
are
and
Macroeconomics
04.
Banking
Commercial
eBook
banks are classified
Private sector ban ks
Public sector banks
Regional
Foreign
into four types:
rural banks
banks
Private Sector Banks
Private sector banks are banks where majority stake

shareholders
and
not
by
the
government.
private-sector banks are functioning
During
the
ignoring
sector.
post
rural
independence
and
agricultural
This problem
led
in
period,
sectors,
Since
(more t h a n
the
beginning
50%)
of
is held
the
by
banking
private
system,
India.
it
was
as
identified
those
banks
that
private
sector
were controlled
by
banks
the
were
industrial
to the emergence of p u b l i c sector banks in I n d i a .
Public Sector Banks
Public
sector
government.
took
over
July
1,
India
the
banks
started
Imperial
Rural
regional
rural areas.
RRBs
are
were
rural
Bank
of
India
and
banks were established
Regional
set
up
Regional
Foreign
Banks
on
rural
the
banks
Rural
banks are
(RRBs)
(more
than
in the year 1 9 5 5 ,
converted
banks
banks having
in
by M.
it
into
the
50%)
when
State
is
held
by
the
the government
Bank
of
India
in
emphasized
have
been
of
the
reach of the
banking
system
in
on the agricultural sector.
Narasimham
Working
Group
in
In I n d i a ,
the
in
India was "Prathama Grameen
registered
and
incorporated
outside the
Bank"
home country
home country.
present
since
the
British
period.
Some
of the
foreign
their branches in I n d i a are:
CitiBank
Deutsche Bank
year
Narasimham.
Bank established
banks that are
India
to expand
recommendations
have branches or offices in the
Foreign
stake
Banks
The first
and
majority
public sector b a n k i n g
1 9 7 5 . The group was headed
Foreign
where
1955.
Regional
The
banks
Page 57
Macroeconomics
04.
Banking
eBook
H S B C Bank
JP Morgan Chase B a n k
Standard
Chartered
Bank
4.3. 2 Cooperative Banks

One
of
the
important
bank comprises
voluntary
far as the method

banks.
In
segments
India,
of
members
Indian
who
banking
cater
of business is concerned,
cooperative
banking
to
is
cooperative
financial
cooperative
started
in
banks.
needs on
cooperative
mutual
basis.
As
banks are s i m i l a r to commercial
1904,
with
the
passing
of
the
Cooperative Societies Act.
Cooperative banks are classified
Rural credit societies
Urban credit societies
Rural
credit
societies
into two categories:
provide agricultural
credit,
whereas,
urban
credit
societies
provide
non-ag ricu ltu ral credit.
4.4 F u n c t i o n s of C o m m e r c i a l
The functions of commercial
Bank
banks are classified
Fig. 4.4a:
into four broad
Functions of Commercial
categories.
Banks
Page 58
Macroeconomics
04.
Banking
4.4.1
The
eBook
Primary Functions
primary
function
of a
commercial
bank
is
system. The primary functions of commercial

1.
Accepting
The
from
most
the
to
assist
the
functioning
of the
banking
banks are:
Deposits
important function
public
is
required
of the
for
bank
the
is accepting
smooth
and
deposits.
continuous
Accepting
functioning
deposits
of
banks.
Banks accept deposits from the p u b l i c in various forms:
Demand
Deposits
Demand
saved
deposits
in
are
also
demand
depositor/customer,
deposits
without
useful to businessmen,
demand
deposits
known
current
can
any
be
prior
account
deposits.
withdrawn
notice.
any
Demand
The
be
used
short
by
period
banks
for
deposits
of time.
No
lending
interest
amount
time
as their payments are always uncertain.
cannot
deposits are for a very
as
by
the
are
most
The funds of
purpose,
as
these
is given on demand
deposits.
Fixed
Fixed
of
Deposits
deposit accounts are created
time.
deposit
the
The depositor/customer
before
other
person
the
end
deposits,
holding
fixed
of
the
higher
for a specified,
cannot
withdraw
pre-decided
interest
deposits
can
fixed
rate
take
is
the
amount
period.
paid
loan
pre-decided,
on
against
In
the
the
fixed
from
period
a
fixed
comparison
fixed
with
deposits.
security
of those
deposits.
Saving
These
Deposits
accounts
are
usually
those who want short-term
time
but
contrary
to
by
people
having
fixed
salaries
or
savings.
S i m i l a r to demand deposits,
any
maintained
the amount of saving
this,
banks
have
put
deposits can
be withdrawn
certain
restrictions
on
maximum
on
the
frequency of cash withdrawal.
Savings
deposit
withdrawal
at
account
one
time
also
and
puts
from
restrictions
one
deposit.
the
The
main
aim
limit
of
restrictions is to encourage savings.
Page 59
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these
Macroeconomics
04.
Banking
2.
eBook
Advancing
Another
important
who are in
Loans
need
function
of money.
of a
commercial
bank
is
to
dispense
loans
to
people
Commercial bank provides loans in the following ways:
Overdraft
Overdraft is a facility
deposited
in
withdrawn;
the
provided
bank.
by
b a n k s to withdraw
Banks
this amount has to
charge
be repaid
interest
more than the amount

on
the
extra
w i t h i n a short period
amount
of time.
Cash-credit loans
In
cash-credit
can
loans,
the
from
the
withdraw
borrower
bank.
is given
The
a credit
credit
limit
limit
up
to which
sanctioned
by
he/she
the
bank
depends on the credit worthiness of the borrower.
Demand loans
Demand
loan
borrowers.
is
the
These
lump
loans
sum
can
be
amount
of
loan
provided
recalled
by
banks
at
by
any
point
interest rate is charged on the entire amount of the approved
Short-term
Short-term
against
bank
to
the
of time.
demand
The
loan.
loans
loans are personal
security.
Car
loans
loans that are given for a short
and
housing
loans
are
examples
the
transfer
period
of
of time
short-term
loans.
3.
Transferring of Money
bank
provides
the
safest
one place to another.
4.
and
cheapest
Banks pass on
means
for
of
money
peoples' funds through cheques and
from
drafts.
Discounting of B i l l s of Exchange
A commercial
bank
Bill
discounting
bill
of exchange
credit
amount
facility
the
discounted
rate.
from
providing
is
signed
after
procedure,
Apart
provides
availed
by
the
certain
seller
the
the
sells
functions
facility
when
buyer.
period
the
bill
of
The
bill
seller
bill
of time.
of
discussed
discounting
sells goods
is an
To
exchange
above,
to
the
on
credit
order to the
get
rid
to
the
seller
of the
and
buyer,
money
commercial
commercial
banks
of goods.
to
draws
pay
the
realization
banks
have
at
started
various other services to its customers.
Page 60
Macroeconomics
04.
Banking
eBook
4.4.2 Agency
Functions
Agency functions of commercial banks are:
Banks
collect
cheques,
bills
of
exchange,
drafts,
and
dividends
on
behalf of the
customers.
Banks purchase and sell securities on behalf of their customers.
B a n k transfer funds from one place to another.
Banks pay loan installments, insurance premium, and
income tax on behalf of their
customers.
4.4.3 General Utility Functions
Banks
perform
general
utility
functions,
for
example,
they
provide
locker
facilities
to
customers for the safe custody of their valuables.
In addition,
banks
issue
letters of credit,
perform
merchant
banking
functions, and
deal
in foreign exchange.
4.4.4 Resultative Functions
Banking
passing
functions
those
also
savings
involve
into
resultative
productive
functions,
channels,
such
helping
the
as
mobilizing
rural
areas,
of
and
savings,
assisting
the weaker sections of society.
4.5
Role of C o m m e r c i a l Banks in
E c o n o m i c Development
Commercial banks contribute in the development of the economy in the following ways:
Promote Savings
There
are
require
various
safe
promote savings
best
interest
reasons
place
by
rate
and
for which
a
providing
and
people
reasonable
various
liquidity
of
save
return
deposits
asset.
It
on
their
To
been
save
savings.
schemes with
has
commercial banks encourage thrift habits among
money.
the
observed
money,
people
Commercial
facility
that
banks
to choose
the
only
the
existence
of
people.
Mobilization of Savings
Commercial
and
the
banks act as a l i n k between the people who have surplus funds for deposits
people
whose
deficit
purpose of production and
funds
compel
them
to
use
the
outsiders'
funds
for
investment.
Page 6 1
the
Macroeconomics
04.
Banking
eBook
Commercial
banks
mobilize
the
productive investment to create
savings
done
by
the
household
sector
and
put
it
into
real wealth.
Promotion of Production
Deposits
of
new
in commercial
currency
by
banks,
the
promote production and
apart from cash
Reserve
policy
refers
sound
banking
effectively and
India.
This
credit
creation
can
be
used
to
to
the
Policy
policy
through
country controls the s u p p l y of money,
of
are as important as the issuing
investment in the economy.
Implementation of Monetary
Monetary
Bank
reserves,
system
smoothly.
helps
government
availability of money, and
the
A monetary
which
Central
Bank
policy will
to
or
Central
B a n k of a
rate of interest.
implement
monetary
policy
be effective only with the cooperation of
commercial banks.
Productive
Flow of Funds
Commercial
banks
flowing
speculative
into
also
make
sure
activities
that
can
funds
harm
flow
the
into
productive
economy
and
can
channels.
also
Funds
hamper
their
growth.
Implementation of Government Policies
Government
implements
requirements
government
of
in
the
and
amends
country.
implementing
policies
Commercial
policies
for
banks
related
to
the
the
play
development
a
major
development
and
role
in
as
per
the
helping
the
of different
sectors of
the economy.
4.6 Central
Central
banks,
and
Bank
the
rivals.
In
holds a special
main
economic
aim
the
position
of central
stability
India,
the Federal
Bank
bank
in the country,
Central
Bank
is
in
the
is
not to
which
Reserve
banking
earn
is why
structure of a country.
profit.
It
also
the Central
Bank of India
aims to
Bank does
(R.B.J.)
and
in
Unlike other
bring
not
the
financial
have any
U.S.,
Reserve.
Page 62
it
is
Macroeconomics
04.
In
Banking
India,
eBook
R.B.I.
is
an
apex
institution
promoter of the financial system.

India Act,
that
acts
as
It was established
guide,
in
1935,
regulator,
u n d e r the
controller,
Reserve
and
Bank of
1934.
The functions of R . B . I .
in the country but
are
not
only
confined
regulating
the credit
it also promotes economic development and
According
to the Preamble of R . B . I . Act,
regulate
the
securing
monetary
issue
credit system
to
of
bank
notes
stability
in
India
for
and
keeping
of
money
supply
price stability.
the objective of Reserve
and
and
Bank of I n d i a
reserves
generally to operate
with
the
is,
"to
view
currency
to
and
of the country to its advantage."
4.7 F u n c t i o n s of Central Bank

The functions of Central
Bank are:
Note Issuing Agency
The
over
Central
the
Bank
supply
has
of
monopoly
the
denominations are issued
Earlier
against
some
the
countries
currency
the form of gold
and
to
issue
currency
in
paper
the
notes
economy.
to
the
In
public and
India,
bank
exercise
notes
of
control
all
the
by the R . B . I .
use
to
issued
partly
keep
by
reserves
the
country.
in the form
in
the
The
form
of gold
percentage
of foreign exchange,
of
and
foreign
reserves
was decided
exchange
kept
partly
by the
in
law and
was subject to c h a n g e by the government.
Banker to the Government
The Central
government
Central
Bank acts as a banker to the government,

and
Bank also
by
making
and
receiving
provides short-term
by keeping
payments
on
all the balances of the
behalf
loans to the government and
of
the
government.
directly or indirectly
discounts government treasury b i l l s .
Central
Bank can even
to currency and
act as a fiscal agent to the government
by g i v i n g
advices
related
finance.
Banker's Bank
The Central
Bank acts as a banker's bank,
Central Bank is the custodian of cash
in the following ways:

reserves for commercial
banks.
Page 63
Macroeconomics
04.
Banking
eBook
Central
Bank is the lender of the last resort for commercial
Central
Bank acts as a bank of settlement,
clearance, and
banks.
transfers for commercial
banks.
All commercial
reserves
with
banks are required

Central
Bank.
to keep certain a percentage of their deposits as cash
These
reserves
help
the
Central
Bank
in
expanding
and
contracting credit in the economy.
Credit Controller
The
most
important objective of the
root cause of economic instability
Central
Bank
is
to
maintain
economic
stability.
The
is the change in aggregate demand, which depends on
the money s u p p l y .
It
is
the
responsibility
concerning
controlling
inflation,
the
money
credit,
the
the
supply,
the
Central
of
Central
Central
so
that
Bank
B a n k will
Bank
to
stability
can
can
control
restrict credit
give
guidance
be
maintained
inflation
supply
to
and
and
other
during
commercial
in
the
banks
economy.
instabilities.
deflation,
it
will
By
During
expand
credit.
Lender of the
It
is the
Last Resort
responsibility of the Central
banks
in all emergency situations.
When
there
to
this
is
an
situation.
overflow of demand
In
Bank. That is why,
that
case,
The
most
important
The
Central
function
Bank can
by fulfilling
the
value
of
help
Indian
in
of the
Central
maintaining
Rate of the
manages
dollars through
banks
a well-managed
will
take assistance
bank will fall

from
the
prey
Central
Bank
is to
agricultural
promote economic development.

and
industrial
development
national
currency.
For
in
the
their credit needs.
Manages Exchange
Bank
even
requirement of commercial
the Central Bank is known as the lender of the last resort.
Central
for cash,
commercial
Promote
country,
Bank to meet the credit
the
National Currency
exchange
currency
rate
depreciates,
of
the
R.B.l.
can
intervene
by
example,
increasing
supply
its reserves.
when
Page 64
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Macroeconomics
04.
It
Banking
is
the
eBook
responsibility
of
Central
Bank
to
prevent
the
depreciation
and
appreciation
of
national currency.
4.8 Methods of Credit Control

Credit
control
means
regulation
responsible for controlling
In
India,
R.B.I.
has
of
credit
by
been
authorized
to
control
The
Central
Bank
is
credit
and
to
speed
up
the
pace
of
m i n i m i z e price changes in the country.
Broadly, there are two methods of credit control:
Quantitative
Bank.
the v o l u m e of credit in the country.
economic development as well as to control and
4.8.1
Central
Quantitative and
Qualitative.
Methods of Credit Control
The quantitative methods of credit control are:

Bank
Bank
Rate
rate
is
significant
achieve
economic
country
provides
method
stability.
loans
to
It
of credit
is
the
commercial
control
control
inflation
commercial
banks
in
the economy,
to
increase
banks.
changing
By
interest
reduces the money supply in the market,

high
rates.
Similarly,
the economy
during
recession,
Bank
at
used
rate
Central
their
is
minimum
can affect the credit creation capacity of commercial
To
that
which
the
the
Central
Central
rate,
Bank to
Bank
of
Central
Bank
banks.
This
bank
increase
as customers avoid
Central
the
bank
increases the
rates.
by
in
taking
Bank decreases the
rate,
the
which
interest
loans from
bank
forces
rates
banks at
rate and
helps
become stable.
Open Market Operations
Open
market
treasury
bills
operations
by the Central
through commercial
credit and
Cash
The
the
banks.
the
Bank.
sale
and
The Central
purchase
of
government
Bank carries out open
Sale of securities by the
Central
securities
and
market operations
B a n k leads to contraction of
purchase of securities by the Central B a n k leads to expansion of credit.
Reserve
Central
Ratio
Bank
has to
percentage of that
most
include
keep
reserve
with
is
percentage of commercial
known as cash
important tool for the Central
it a certain
reserve
ratio.
Bank to contract or expand
Cash
bank deposits,
reserve
ratio
credit.
Page 65
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Macroeconomics
04.
Banking
When
when
the
eBook
Central
Bank
wants
to
it wants to expand credit,
4.8. 2 Qualitative
it
contract
credit,
lowers the cash
it
raises
reserve
the
cash
reserve
ratio
and
ratio.
Methods of Credit Control
The qualitative methods of credit control are:

Marginal
Requirements
Margin
the
is
difference
Commercial
banks
give
while g i v i n g
loans.
The
between
loans
the
market
against
Central
Bank
stock
value
and
of a
security
securities
and
increases or decreases the
and
the
keep
loan
certain
marginal
amount.
margins
requirement,
as per the requirement of the economy.
Credit Rationing
In
the
method
advances'
of
credit
of commercial
rationing,
banks.
The
Central
Central
Bank
Bank
puts
also
ceiling
ensures
on
that
the
'loans
commercial
and
banks
do not cross that ceiling.
Direct Control
The
Central
Bank
may
take
direct
action
against
commercial
banks
in
the
following
ways:
The
Central
Bank
may
refuse
to
provide
rediscounting
facilities
to
commercial
banks whose credit is not appropriate, as per monetary policy.
The
Central
excess
than
Bank
their
may
also
capital
above the b a n k rate from
refuse
and
to
give
reserves.
credit
The
banks that demand
to
Central
banks
Bank
whose
may
borrowings
charge
over
loans more than the prescribed
are
and
limit.
Moral Suasion
Moral
suasion
contract credit,
is
request
by
the
Central
Bank
to
the
commercial
banks,
to
expand
as per the requirements of the economy.
Page 66
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Macroeconomics
04.
Banking
eBook
4.9 Impact of IT Revolution i n B a n k i n g Industry

In
1991,
to an
IT
India opened
revolution
in
its doors to
the country
liberalization, globalization,
and
gradually,
Indian
and
privatization.
This led
banks whole-heartedly
adopted
technological advancements.
Banks
started
country.
The
computerized
Indian
inter-connectivity
banking
sector
that is, customer satisfaction,
Automated
country.
quick
Teller
machines
Electronic
money.
IT
milestone-mobile
in
the
confirmed
(ATM)
banking
Smart
with
all
their
branches
technology
and
throughout
their
ultimate
the
goal,
a positive response.
provided
transactions
banking
banking.
flourished
across
sector
easy
helped
was
access
customers
on
phones made
to
the
life
money
in
boom
everywhere
releasing
and
and
then
came
more accessible and
quick,
in
the
receiving
another
in
terms
of b a n k i n g .
These advancements can

Fig.
4.9a
compared
and
Fig.
be easily
4.9b,
summarized from the data
represents
the
growth
of
published
electronic
banking
by the R . B . I .
transactions,
to paper transactions in the recent years.
Representation of Electronic
Transactions Volume In Total
......
Electronic::
-__
---__
--
--
__
--
W041
ioo,
ioo&-01
l007'
08
--
200'!10
io10-11
io11-u
NoU)
Fig. 4.9a:
Source:
Volume of Electronic
Banking Transaction
R.B.I.
Page 67
as
Macroeconomics
04.
Banking
eBook
Representation of Electronic
Transactions Value In Total
Paper
Electronic
'"'
'"'
'"'
'"'
'"'
'"'
'"'
'"'
20(),0-0!
200!-06
200607
'
200708
WOll-09
200910
2010-11
201112
,.,,..
Nov i l )
Fig. 4.9b:
Source:
The
Value of Electronic Banking Transaction
R.B.I.
major
reports
problem
of
banking,
R.B.l.
that the
The
banking
major
industry
complaints
in 2 0 1 0 - 1 1 , were from
faced
(more
was
than
technology
70
defects,
percent)
as
against
per the
electronic
urban areas.
El Number of complaints received
80000
78000-
76000
74000
72000
7000068000
6600064000
Fig. 4.9c:
Source:
In
Number of Complaints Received
R.B.I.
recent
Whatever
years,
growth
India
rate
t h a t is,
rural sector and
India's
move
toward
has
shown
India
tremendous
achieved
urban sector do
growth
gap between urban and
has
and
is
not go
improvement
partial
because
in
the
the
banking
two
sectors
industry.
of
hand-in-hand.
modernization
can
be
successful
only
if
it
bridges
rural areas.
India,
Page 68
the
Macroeconomics
04.
Banking
eBook
Banking
institutions are broadly classified
Commercial
regional
banks
rural
Commercial
Central
main
be
banks, and
banks
play
promotion of trade,
can
further
foreign
a
aim
of
role
production, and
Centra
Bank
classified
private
banks,
public
banks,
to
in
promoting
savings,
allocation
of
funds,
investment.
position
is
into
cooperative banks.
banks.
major
Bank holds a special
into commercial and
in the
bring
banking
financial
structure of a country and
and
economic
stability
in
the
the
country.
In I n d i a ,
promoter
R.B.!.
is an
of the
financial
B a n k of India Act,
Credit
control
apex
institution that acts as a guide,

system.
It
was
established
in
regulator,
1935
controller and
under
the
Reserve
1934.
methods
are
classified
into
quantitative
methods
and
qualitative
methods.
Page 69
Macroeconomic
Policies:
Monetary a n d
Fiscal Policy
Macroeconomics
05.
Monetary and
Fiscal
Policy
eBook
5 . 1 Introduction
The world
has
free market
has created
faced
mechanism.
a solution,
Macroeconomic
achieving
various economic
full
Thus,
problems and
to overcome the
also witnessed
problems and
failure,
failures,
due
to the
the government
in the form of macroeconomic policies.
policies
help
employment,
the
government
controlling
attain
inflation,
the
main
maintaining
objectives,
balance
of
such
as,
payments
e q u i l i b r i u m , and stabilizing exchange rates.
To
achieve
the
macroeconomic
these
two
most
aforementioned
objectives,
policies-monetary
powerful
policy
economic
tools,
and
the
government
fiscal
which
policy.
help
in
This
introduced
chapter
controlling
and
two
will
major
introduce
managing
economy.
After reading this chapter, you w i l l
be able to:
Define macroeconomic policy, fiscal policy, and monetary policy
List the objectives of macroeconomic policy, monetary policy, and fiscal policy
Explain the instruments of monetary policy and fiscal policy
Discuss the limitations of monetary and fiscal policy
Page 7 1
the
Macroeconomics
05.
5 . 2 M e a n i n g and
Macroeconomic
regulate
policy
Monetary and
the
is
set
of
planned
an
actions
macroeconomic variables to achieve
words
attempt
of
Brooks
by
the
Policy
eBook
Definition of Macroeconomic Policy
as price stability, economic growth,
In
Fiscal
and
and
Evans,
authorities
undertaken
predetermined
direct,
control
and
macroeconomic goals,
such
employment.
"Macroeconomic
to
to
achieve
policy
particular
can
be
target
thought
levels
of
as
of
certain
and
working
major economic aggregates."
Macroeconomic
to
problems
improve their living
Solving
existed
since the
time
countries
conditions-the o n l y difference
macroeconomic
problems
through
started
thinking
lies in the solution to the problem.
macroeconomic policies
is
an
idea
of
recent
origin.
Before
the
principle
great
of
free
depression
market
of
1930s,
mechanism
macroeconomic
and
the
problems
interference
of
were
the
solved
on
government
the
was
minimal.
The
great
and
Keynes,
economic
depression
founder
management.
War period,
Some
the
(1929
of
1933)
shattered
macroeconomics,
Keynes' view got
the
principle
displayed
recognized
of free
the
and
role
of
admired
market
the
mechanism
government
during
in
the post-World
as it was of great importance for the renewal of war-ravaged economies.
economists
believe
that
countries
adopted
macroeconomic
policies
to
get
rid
of
the constant shocks of economic c h a n g e s .
It
must
but
is,
be
proved
noted
two
policy.
major
The
effective
in
Keynesian
ineffective d u r i n g
monetarism,
The
that
led
by
Milton
instruments
question
achieving
controversial and
that
the
macroeconomic
1960s and
was
then evolved
based
a new
on
fiscal
measures
school of thought,
that
Friedman.
of
macroeconomic
arises
is
whether
macroeconomic
the discussion
policy
is
goals?
policies
fiscal
The
are
policy
fiscal
or
answer
to
policy
monetary
this
and
monetary
policy
question
is
is
more
always
never e n d i n g .
Page 72
Macroeconomics
05.
Monetary and
Fiscal
Policy
eBook
5 . 3 Objectives of Macroeconomic Policy

Price Stability
One
of the
currency.
most
important
T h i s goal
can
be
goals
of an
achieved
economy
by
is
stabilizing
to
the
bring
stability
prices,
as
in
the
prices and
value
of
its
value of the
currency are inversely proportional to each other.
Other reasons to maintain
price stability
in the economy are:
Price instability can create problems in
Deflation
toward
increases
the
level
of
production and
unemployment,
distribution.
which
may
lead
the
economy
depression.
Inflation destroys the economic welfare of the community.
Price
instability
can
disturb
the
economic
relationship
within
and
outside
the
country.
Price
stability
measured
Full
only
concerned
with
the
stability
of
average
price
level
as
by the wholesale price index or consumer's price index.
Employment
Keynes was the

economy.
and
is
are
first
economist who emphasized
on
maintaining
fu l l
employment
in
the
Full employment denotes a state of affairs, where all those who are fit to work
prepared
capacities and
According
to
to
work at
training and
Keynes,
the
prevailing
are earning
full employment
rates
of wages,
get jobs
according
to
their
income.
is defined
as, "a situation
in which aggregate
employment is inelastic in response to the increase in the effective demand."
After the economy

follow a stable
has
reached
full employment,
the monetary authority
price policy, so that full employment can
be maintained
is supposed
in the long
to
run.
Exchange Rate Stability
When
the
currency,
The
value
of
one
country's
it is known as exchange
monetary authority aims at
currency
is
expressed
in
terms
of
another
country's
rate or the external value of money.
maintaining
exchange
rate
equilibrium
for the following
reasons:
To
maintain
international
on
large sea le.
confidence
and
to
maintain
smooth
international
Page 73
trade
Macroeconomics
05.
Speculators take
and
Monetary and
advantage
of the
Fiscal
exchange
rate
Policy
eBook
instability.
other undesirable effects, exchange rate stability should
Exchange
rate
stability
can
also
help
in
maintaining
To
avoid
speculation
be maintained.
equilibrium
in
the
balance
of
payments.
Greater Equality in Incomes

It
has
which
the
been
observed
that
makes the country
poor
becomes
wealth
socially
poorer.
This
is
concentrated
unjust.
creates
in
the
hands
As a result of this,
feeling
the
of exploitation
of only
rich
at
few
individuals,
become
the
richer and
lower
section
of
the society.
So,
one
of
the
major
aims
of
macroeconomic
policy
is
to
maintain
equality
in
the
incomes of the society.
Objectives of India's Macroeconomic Policy

In
India,
macroeconomic
commission.
policy
is
prepared
The objectives of macroeconomic
objectives of macroeconomic
by
ministry
policy are
policy are summarized
of
revived
finance
from
and
planning
time to time.
The
below:
Target growth
rate of 5 to 6 percent per annum
Eradic.ating economic disparity and poverty
Managing and controlling
inflation, price
instability
and balance of payments disequtlibnurn
Fig. 5.3a: Objectives of India's Macroeconomic Policy
The
objectives
targets
are
not
keep
met
on
changing,
always.
You
as
can
per
the
have
requirement
view
of
the
of
the
data
economy
related
to
and
the
objectives
achieved:
Indian
growth
reached
rate
9 percent
till
1970s
was
to
percent,
which
increased
in
1980s
in 2007.
Page 74
and
Macroeconomics
05.
Macroeconomic
Policies:
Monetary and
Employment rate was 1 to
Economic disparity,
Price level has continuously increased.
Inflation rate was more than
instead
5.4 Definition a n d
Monetary
policy
refers
1.5
to
Fiscal
Policy
eBook
percent per a n n u m .
of d e c l i n i n g ,
10
has increased.
percent
in 2008.
M e a n i n g of Monetary Policy
the
policy
through
which
the
government
or
Central
Bank
of
the country controls t h e :
S u p p l y of money
Availability of money
Cost of money or rate of interest
The following
definition explains the meaning
According
G.
K.
by
the
to
undertaken
Shaw,
"By
Monetary
monetary
of monetary policy more clearly:

policy,
authorities
to
we
mean
change
the
any
conscious
quality,
action
availability
or
cost (rate of interest) of money."
In
the words of D.
and
composition
C.
of
Aston,
"Monetary
aggregate
Policy
demand
by
involves the
the
influence
manipulation
of
on
the
interest
level
rates
and the availability of credit."
The
scope
of
transactions
monetary
and
policy
is
macroeconomic
through the use of monetary
extended
variables
to
and
the
entire
can
be
area
that
altered
by
involves
monetary
economic
authorities
policy instruments.
The scope of monetary policy depends upon two factors:
The
level of monetization
The
level of development of the financial market
For the
monetary
policy
to
be
in the economy
successful,
all
transactions
should
take
place
with
money
as a medium of exchange.
Some
instruments
through
should
capital
of
monetary
market.
So,
it
policy,
is
such
necessary
as
bank
that
rate
the
and
cash
financial
reserve
market
of
ratio,
the
country
be well developed.
work
Page 75
Macroeconomics
05.
Monetary and
Fiscal
Policy
eBook
5 . 5 Objectives of M o n e t a ry Policy
The
objectives
of
monetary
objectives, as discussed
policy
are
almost
similar
to
the
macroeconomic
policy
above. They are:
Neutrality of Money
According
to
this,
money
supply
instability
in
the
supply
of
in
the
money
economy
is
the
should
major
be
cause
kept
of
constant,
disturbance
as
and
fluctuations in the economy.
Changes
and
in
the money
'production
and
supply
can
cause
consumption',
imbalance
which
may
between
result
in
' s u p p l y and
price
demand'
fluctuations
and
unemployment.
Neutrality
constant
of
in
fundamental
money
all
the
also
adds
that
situations.
changes
(such
it
is
Money
as
not
supply
population,
Stabilization of
In
the
for
be
supply
slightly
to
be
changed
techniques,
kept
when
innovations,
the working of the economy.
Price
economy,
deflation,
can
productive
etc.) or other important changes are affecting
necessary
price
whereas,
instability
price
attracts
stability
problems
liberalizes
in
the
the
form
of
economy
inflation
from
and
economic
fluctuations.
Price
stabilization
value and
Price
helps
standard of deferred
stabilization
income
money
among
also
various
to
easily
perform
their functions,
such
as
store
of
distributions
of
national
payments.
ensures
that
segments
of
there
the
are
equitable
society.
It
also
promotes
the
economic
welfare of the country.
Stabilization of
Fluctuations
country,
in
which
Exchange Rate
the
exchange
causes
rates
speculation
directly
in
prices
exchange rates are required for the smooth
affect
and
the
exports
foreign
and
exchange
imports
market.
of the
Stable
performance of international trade and
stable international economic relations.
Recently,
in
the
rupee displayed
months
of
June
and
wide fluctuations. The
July,
2013,
the
rupee crossed all
exchange
its
rate
of
dollar
to
previous exchange rate
Page 76
Macroeconomics
05.
records
by
fluctuation
Full
One
hitting
Monetary and
60.25
per
dollar
has adversely affected
Fiscal
on
June
Policy
27,
eBook
2013.
This
exchange
rate
employment.
Full
the imports of the country.
Employment
of
the
major
employment
prepared
to
objectives
denotes
work
at
of
situation
the
monetary
where
prevailing
all
rates
policy
those
of
is
who
wages,
full
are
get
fit
jobs
to
work
and
according
to
are
their
capabilities.
Economic Growth
Economic growth
of a country
of
living
of
may
spread
the
be defined
over a long
people.
must be coupled
Mere
as the continual
period
of time,
maintenance
with a h i g h standard
of
increase
which
full
in
aims at
real
national
raising
employment
is
income
the standard
not
enough;
it
of l i v i n g .
5.6 Instruments of Monetary Policy

The
instruments of monetary
change
according
supply and
Paul
to
the
policy
economic
refer to all economic variables that Central

condition,
with
the
aim
to
control
and
Bank can
regulate
the
demand for money and availability of credit.
Samuelson
and
William
Nordhaus
termed
the
broadly
be
instruments
as,
"The
Nuts
and
Bolts of Monetary Policy."
The
instruments
shown
of
monetary
policy
can
classified
into
the
following,
in Fig. 5 .6a.
Fig. 5.6a:
Instruments of Monetary Policy
Page 77
as
Macroeconomics
05.
Monetary and
Fiscal
Policy
eBook
Quantitative Measures of Credit Control
The quantitative methods of credit control are:

Bank Rate
The
the
rate,
at
which
Central
b i l l s of exchange
rate is an
Bank
presented
important method
lends
by
money
the
to
the
commercial
of credit control,
used
commercial
banks,
is
banks and
known
by Central
Bank,
as
rediscounts
bank
rate.
Bank
to achieve economic
stability.
By
changing
commercial
the
bank
banks,
inflation and
rate,
which can
Market Operations
Open
Market
Operations
treasury bills
In
can
affect
the
credit
creation
capacity
of
h e l p the economy find a way out of the major problems of
include
by the Central
it
sells
Bank wants to
and
Bank
recession.
Open
circulation,
Central
Bank.
government
increase
the
money
sale
and
purchase
When the Central
securities
supply
in
and
government
Bank wants to
treasury
circulation,
of
it
bills.
buys
securities
and
reduce the money
However,
when
back government
in
Central
securities
bonds.
the
year
1922,
the
U.S.
Federal
Reserve
System
was
the
first
entity
to
use
open
market operations.
Cash
Reserve
Commercial
Bank as
the
Ratio
banks
reserve,
most
have to
which
important
maintain
is known as cas h
tool
of the
Bank wants to contract credit,

expand
credit,
Qualitative
some
Central
it
it lowers the cash
percentage of their deposits with
reserve
ratio. Cash
Bank to contract
raises the cash
reserve
reserve
or expand
ratio
ratio
the
is an easy and
credit. When
rate and
Central
when
Central
it wants to
reserve ratio rate.
Measure of Credit Control
The qualitative methods of credit control are:

Marginal
Requirements
Commercial
giving
banks give loans against
loans.
security
and
requirement
Marginal
the
implies
requirement
borrowed
less
fixes different marginal
stock and
is
amount
credit
against
the
difference
against
the
securities and
that
keep certain
between
security.
securities
and
vice
the
margin while
market
Increase
versa.
In
value
in
marginal
India,
requirements for different users.
of
Page 78
R.B.l.
Macroeconomics
05.
Central
Bank
increases
of the economy.
marginal
or
Monetary and
decreases
For example,
the
to control
Fiscal
marginal
Policy
eBook
requirement,
the excess demand,
as
per
R.B.I.
the
requirement
generally
raises the
requirement.
Credit Rationing
Credit
rationing
banks,
d u e to
method
which
is
adopted
banks give
when
loans to
there
priority
is
shortage
(financially
of
credit
strong)
available
sectors.
with
As a result,
the priority sector is affected.
To get
and
rid
of the above-mentioned
advances
provided
by
problem,
commercial
the Central
banks
Central Bank also ensures that commercial
for the
B a n k puts a ceiling
'developed
and
on the
large-scale'
loans
firms.
banks do no cross that ceiling.
Direct Control
Central Bank may take direct action against commercial banks in the following ways:
Central
Bank
may
refuse
to
provide
rediscounting
facilities
to
those
commercial
banks whose credit is not appropriate as per monetary policy.
Central
Bank
excess
than
above
the
prescribed
may
their
bank
also
refuse to
capital
rate
and
from
give credit to those
reserves.
those
The
banks
Central
who
banks whose
Bank
demand
borrowings are
may
charge
over
and
loans
more
than
the
limit.
Moral Suasion
Moral
suasion
is a
contract credit,
Central
Bank
method,
as
request
per the
when
Central
monetary and
the
Bank
The most
to
the
Central
Bank,
to the commercial
requirements of the economy.
other
holds
methods
various
show
This
ineffective
meetings
with
banks,
method
results.
In
commercial
to expand
is adopted
the
banks,
moral
to
or
by the
suasion
decide
on
credit matters.
5 . 7 Limitation a n d
The Time
by
Effectiveness of Monetary Policy
Lag
important limitation of monetary policy is the time lag
prepare
plan
of
action
implementation. Time lag
for
the
monetary
policy
is of two types-inside lag and
and
between
the
time
the time taken

taken
for
outside lag.
Page 79
its
Macroeconomics
05.
Inside
lag
refers to the t i m e
the correct policy and
Outside lag
Monetary and
lag
in
identifying
Fiscal
and
Policy
assessing
eBook
the
problems and
choosing
its implementation.
refers to the t i m e taken
by
firms and
the households for the
implementation
of the monetary policy.
Problems in
Forecasting
Inappropriate
year
2008,
forecasting
due
action could
to
the
major
wrong
drawback
forecasting,
growth
in
the
Financial
non-banking
recession
monetary
financial
of
credit
through
credit
policy
is not able to show effective results.
Underdeveloped
less
monetary
was
policy
not
formulation.
predicted;
In
the
therefore,
no
Intermediaries
ineffectiveness
In
for
be taken in terms of monetary policy.
Growth of Non-banking
Rapid
is
policy.
multiplier
These
financial
due
their
and
Money and Capital
developed
countries,
the
the
intermediaries
to
the
biggest
intermediaries
huge
share
in
are
the
cause
unable
market;
to
for
the
create
monetary
Market
effectiveness
non-monetized
is
sector,
of
which
monetary
dominance
of
has
character in
money and capital market of the country.
policy
inculcated
is
an
less
due
to
the
underdeveloped
5 . 8 M e a n i n g of Fiscal Policy
The
word
'fisc'
means treasury
of a
kingdom
or state
and
fiscal
policy
"a
policy
is
the
utilization
of state treasury to attain macroeconomic goals.
According
to
government
desirable
Arthur
uses
effects
Smithies,
its
and
fiscal
expenditure
avoid
policy
and
undesirable
is,
revenue
effects
under
programmes
on
the
which
to
national
the
produce
income,
production and employment."
In
simple
words,
fiscal
policy
the government for achieving
is
the
policy
related
to
expenditure,
a set of definite objectives.
Taxes,
revenue,
and
debt
p u b l i c expenditure, and
p u b l i c debts are the instruments of fiscal policy.
of
Page 80
Macroeconomics
05.
Objectives of Fiscal
The
objectives
Monetary and
Fiscal
Policy
eBook
Policy
of fiscal
policy
are
similar
to
the
objectives
of
macroeconomic
policies.
These objectives are:
Full employment
Economic stability
Economic growth
Equality
in the distribution of income and
5.9 Instruments of Fiscal
wealth
Policy
Budgetary Policy
Budgetary
the plan
When
policy
is
an
important
in which the government
the
expenditure
more t h a n revenue,
is
less
instrument
keep
than
of
fiscal
its budget
revenue,
it
is
in
policy.
Budgetary
policy
refers
to
balance-neither s u r p l u s nor deficit.
surplus
budget.
When
expenditure
is
it is a deficit b u d g e t .
Government Expenditure
Government expenditure is the spending
by the government on the following
Purchase of goods and
services
Payment of wages and
salaries to public servants
Public investments
Infrastructure development
Transfer payments
The effect of government expenditure depends on
its source of financing.
government expenditure directly affects the aggregate demand

control
and
items:
An
can
be
on
the
increase
in
major tool to
inflation.
Taxation
Tax
is
the
transfer
income they earn.
Direct
tax
of
funds
from
the
Taxes are classified

includes
taxes
on
people
to
the
into direct and

personal
government,
basis
and
Indirect tax includes taxes on production and
the
indirect taxes.
corporate
income,
wealth,
property.
of
sales of goods and
services.
Page 8 1
and
Macroeconomics
05.
Monetary and
Fiscal
Policy
eBook
Public Borrowings
P u b l i c borrowing
Internal
includes internal and external
borrowings are of two types:
Borrowings from
Borrowings from the Central
External
p u b l i c by means of government bonds and treasury
Foreign governments
Organizations like World
Market borrowings
5 . 1 0 Types of Fiscal
is
no
problems.
tackle
exclusive
with
Bank and
fiscal
policy
varied
economic
Compensatory fiscal
Discretionary fiscal
policy,
fall
tax
revenue.
For
Fund
(IMF)
can
provide
solution
policies suggested
differently.
Fiscal
to
all
the
economic
by various economists to
policies
can
be
classified
into
policy
Fiscal
the government
GDP,
an
Any
automatic
change
example,
policy
policy
Automatic Stabilization
and
Monetary
major heads:
policy.
that
problems,
Automatic stabilization fiscal
in
International
Policy
this
Bank
There are different types of fiscal
the following
In
bills
borrowings include borrowings from:
There
borrowings of the government.
with
in
the
Policy
links
its
fiscal
adjustment
the
GDP
increase
is
policy
to
made
in
automatically
in
GDP,
tax
the
the
GDP.
In
response to
government
brings
revenue
the
rise
expenditure
and
adjustments
increases
in
and
the
fiscal
government
expenditure decreases.
Compensatory Fiscal
In
this
deficit
policy,
the
budgeting.
budgeting
Policy
government
Surplus
is adopted
takes
budgeting
as per the
is
adopted
to fight against depression
Compensatory measures are taken

time,
compensatory
to
action
fight
in
the
against
form
of
inflation
surplus
and
deficit
in the economy.
by the government that can
be altered
from time-to
requirement of the economy.
and
Page 82
Macroeconomics
05.
Compensatory
measures
spending.
compensatory
cause an
This
increase in
Discretionary
a l so
measure
Fiscal
reducing
can
increase
the
the
Policy
tax
terms of expenditure and
makes
is one
in
and
government
and
pattern of its expenditure, and
aggregate
planned
policy
which
the government makes
changes
in
the
the size and
includes the following
levels and
Change
in
the size and
Change
in
the government expenditure financing
Change
in
the methods of deficit financing
limitations of fiscal
Narrow
fiscal
of taxation,
the
abolishing
of old
ones)
method
unorganized
is required
for effective fiscal
policy.
implementation of fiscal policy creates problems.
money
market
can
create
problem
in
the
execution
of
policy.
Dominance of non-monetized
Corruption and
sector in the underdeveloped
or developing
economy
policy ineffective.
inefficiency
in
administration can
be a major drawback or hurdle
the success of the fiscal policy.
size
policy are:
correct forecasting
makes the fiscal
in
Policy
between execution and

and
changes
pattern of government expenditure
L i m i t a t i o n s of Fiscal
Time lag
can
discretionary changes:
the tax rates (implementation of new taxes and
which
composition of p u b l i c debt.
in
A reliable and
demand,
impromptu
pattern
Change
government
in the profits of the producer.
The
increasing
taxation system.
The
5.11
eBook
Policy
policy
include
price level and an u p s w i n g
Fiscal
can
Monetary and
Tax evasion
habits of the people can
prove fiscal
policy wrong.
Page 83
in
Macroeconomics
05.
Monetary and
Fiscal
Policy
eBook
5 . 1 2 Chapter S u m m a r y
Macroeconomic policy
regulate
goals,
is a set of planned actions undertaken to direct, control, and
macroeconomic
variable
to
achieve
the
predetermined
macroeconomic
such as price stability, economic growth, and employment.
Monetary policy and fiscal policy are two major macroeconomic policies.
Monetary policy refers to the policy through which the government or Central Bank
of
the
country
controls,
supply
of
money,
availability
of
money,
and
cost
of
money.
Instruments
of
monetary
policy
are
classified
into
quantitative
and
qualitative
measures.
Fiscal
policy
is
the
policy
related
to
expenditure,
revenue,
and
debt
of
the
government for achieving a set of definite objectives.
Budgetary
policy, government expenditure, taxation, and
p u b l i c borrowing
are the
instruments of fiscal policy.
The
three
types
of
fiscal
policies
are
automatic
stabilization
fiscal
policy,
compensatory fiscal policy, discretionary fiscal policy.
Page 84
Inflation and
Unemployment
Macroeconomics
06. Inflation and
Unemployment
eBook
6 . 1 Introduction
Inflation and
the world
is taken
over
have suffered
period
rate of
of
time
inflation
formulators,
closely
from
the same problem very frequently.
more seriously since the early
Growing
policy
unemployment are the two major concerns of the economy.
related
scenario;
and
therefore,
After reading
and
is
seen
and
most
of
associated
politicians.
have
it
its
in
1970s.
gained
The
A persistent
the
developing
problems
problems
great
rise
of
importance
have
in
The problem of inflation

in the general
and
been
inflation
the
All countries in
developed
noticed
and
price
countries.
by economists,
unemployment
current
world
you will
be able to:
Define
List the types of inflation
E x p l a i n the causes of inflation
Identify the measures to control inflation
Discuss inflation
Define unemployment
E x p l a i n the types of unemployment
State the concept of full employment
Describe cost of unemployment
Discuss unemployment in India
inflation
in India
are
economic
needs detailed discussion.
this chapter,
level
Page 86
Macroeconomics
06.
Inflation and
Unemployment
6.2 Definition a n d
According
to
Pigou,
eBook
M e a n i n g of Inflation
"Inflation
exists
when
money
income
is
expanding
more
than in proportion to increase in earning activity."
Ackley
recently
general
of
to
the
economic
goods
inflation
more,
as,
"A
persistent
and
appreciable
rise
in
the
to Samuelson, "Inflation denotes a rise in the general level of price."
According
means
inflation
level or average of prices."
According
level
defined
is an
and
services
increase
inflation
"Inflation
available
in
means
an
rise
economy."
in
The
the
general
simple
price
meaning
of
in the prices of all the commodities for which a consumer pays.
reduces
when the
glossary,
the
purchasing
prices were
less.
Now,
power
prices
of the
have
consumer.
increased,
Consumers
therefore,
It
purchased
consumers can
either purchase less or pay more to buy the same quantity.
6.3 Types of Inflation

6 . 3 . 1 On the Basis of Speed
Creeping Inflation
In creeping
snail
or
growth
creeper.
of an
economy
During
inflation,
This
type
economy.
dynamic.
the
prices
peri od
rise at a slow
of
Creeping
An
feature
inflation,
People can
is
inflation
important
of creeping
the monetary system.
inflation
hold
rate over a longer period

very
has
of
safe
been
for
proved
creeping
people
an
economy,
to
inflation
continue
to
money as an asset
of time
be
is
have
as
good
that
faith
like that of a
it
for
it
is
and
shows
the
making
the
predictable.
confidence
in
because it works as a medium
of exchange.
Walking or Trotting Inflation

Walking
at
or trotting
which
below
prices
10
the
more at
increase.
percent,
between the
keeps
inflation
it
increase
is
in
profitability
less cost.
is a bit different from
When
known
the
of
moderate
as
price
or
low-cost
at
trotting
higher
produced
level
goods
inflation.
increase
prices of commodities and
producers
These
walking
creeping
or
It differs in the
annual
inflation.
There
inflation
is
and
can
be
motivates
sold
at
them
higher
rate
time
their cost of production.

to
rate
is
gap
T h i s gap
produce
prices d u r i n g
Page 87
Macroeconomics
06.
Inflation and
walking
inflation.
Unemployment
eBook
This type of inflation
it can easily c h a n g e into
running
is an alarming
stage for the government
because
inflation.
Running Inflation
When
as
prices
running
inflation.
therefore,
inflation
strong
increase
firms
Along
start
requires
with
losing
the
monetary and
Galloping
r a p i d l y at the
the
their
immediate
fiscal
rate from
prices
to
the inflation
range
and
Baumol
galloping
percent
products,
per a n n u m ,
their
attention
of
the
cost
and
government
it
also
is
increases,
worldwide.
and
the
termed
Running
formulation
of
policies.
Blinder,
"Galloping
of Sameulson
20,
100
inflation
or
200
and
However,
Nordhaus,
percent
is deep-rooted
type of inflation totally

purchasing
rate."
inflation
refers
they do
to
an
inflation
that
not mention at what
rate
is exceptionally h i g h .
words
of
final
20
competitiveness domestically
proceeds at an exceptionally high
the
of
to
Inflation
According
In
10
in
a year
"inflation
is
labeled
the economy,
shatters the monetary
in
the
as
double
galloping
or
triple
digit
inflation."
Once
it damages the economy
system
badly.
Such
because of the constant fall
in
the
power of money.
Hyper Inflation
Hyper
inflation
diverted
from
withdrawing
hope
of getting
protect
6 . 3 . 2 0 n the
firms.
and
activities
prices
goods
in
price
to
simply
speculative
from
future.
level
the
Savings
market
of
the
purchasing
power.
The
rate
of
explodes.
activities,
and
as
hoard
Resources
producers
those
households
invest their available savings into projects,
tend
goods
to
start
in
the
decline
and
such as real estate and
interest
also
increases,
get
as
gold,
there
is
borrowings.
Inflation
increases
inflation.
by
the
Basis of Inducement
inflation
workers
where
produced
higher
their
Wage-induced
induced
situation
already
more pressure on
When
productive
people prefer to
which
is
In
the
assuring
Ultimately,
this
due
to
increase
modern
higher
era,
wages
increases
the
and
cost
in
the
trade
wages
union
of
wants
simultaneously
of
production
labor,
to
is
secure
efficient
and
it
known
the
labor
general
price
as
wage
future
of the
productivity
level
of goods
services.
to
Page 88
Macroeconomics
06.
Inflation and
Unemployment
eBook
Profit-induced Inflation
Producers
increase the
prices
of goods
This is known as profit-induced
and
services just
to
increase their
rate
of
profit.
inflation.
Deficit-induced Inflation
Government
circulation
prints
in
an
extra
notes
economy,
to
which
finance
leads
to
the
deficit.
inflation.
This
This
is
increases
known
as
the
money
deficit-induced
inflation.
Currency Inflation
If there
is an
increase
is known as currency
in
the general
price
level d u e to the
increase
in
printed
money,
it
inflation.
Credit Inflation
When
price
increase
because of an expansion of b a n k credit
in an economy,
it
is termed
as credit inflation.
Internationally Generated Inflation
It
has
always
been
the
domestic fluctuations
increase d u e to
but
changes
subject
instead
in
of
argument
that
d u e to fluctuations
international
forces,
it
is
inflation
in
is
not
created
international forces.
known
as
because
When
internationally
of
prices
generated
inflation.
Sectoral
Inflation
When
increase
an
in
known as sectoral
price
is
restricted
to
particular
sector
of an
economy
only,
it
is
inflation.
6.3.3 On the Basis of Time

War Time Inflation
During
the
general
period
of war,
price level.
government
S u c h inflation
expenditure
increases,
which
leads
to
rise
in
is known as war time inflation.
Post War Inflation
There
and
is
continuous
increase
in
increase
demand.
generally, caused
due to
in
Post-war
the
inflation
repayment
price
in
an
takes
economy
due
to
continued
place after the end
of p u b l i c debt taken d u r i n g
shortages
of the war and
the war.
It
results
Page 89
is,
in an
Macroeconomics
06.
Inflation and
increase
Unemployment
in disposable
situation
leads to
eBook
income without any
rise in
increase
in the
level of production.
This entire
prices.
Peace Time Inflation
When there
known
as
peace
economies,
generally
is an
when
have
increase
time
in
the general
inflation.
government
This
t ype
expenditure
longer completion
periods.
between the generation of income and
6 . 3 . 4 0 n the
price
level
of
during
a normal
inflation
increases
on
Prices tend
can
be
period
seen
developmental
to
rise
of time,
in
it
is
developing
projects,
which
because of the gap created
the availability of final goods and
services.
Basis of Scope
Partial or Sporadic Inflation
This
full
type
of inflation
employment.
time,
it
is temporary
When
supply
is known as partial
in
of
nature and
commodity
inflation.
generally
cannot
be
arises
in
increased
As the name suggests,
it
is
an
economy
for
partial,
some
that
before
period
is,
of
it affects
o n l y a part of the economy.
True or Comprehensive Inflation
When
inflation
comes after full
comprehensive inflation.
6 . 3 . S O n the
employment
level
in
an
economy,
it
is
known
as true or
This type of inflation affects the entire economy.
Basis of Government Action
Open Inflation
When
prices
government,
no
steps
competing
the
it
to
as open
the
rise
in
an
inflation.
economy
Under
in
prices
and
an
effort
to
prices,
it
without
open
scarce
any
inflation,
resources
interruption
the
by
government
are
allocated
the
takes
among
Inflation
government
to
measures
can
marketing
known
correct
measures
economy
is
increase
industries.
Suppressed
When
continuously
due
control
control
to
makes
the
rise
inflation
suppressed
in
till
their
inflation
correct
is
effect
like
the
known
rise
as
continues.
hoarding,
in
prices
suppressed
Many
or
inflation.
problems
profiteering,
takes
arise
corruption,
etc.
Page 90
some
These
in
an
black
Macroeconomics
06.
Inflation and
Unemployment
eBook
6.4 Causes a n d M e a s u r e s of Inflation

6.4.1
A. C.
Causes of Inflation
L.
Day says that,
"there are two main ways in which an inflationary process
may be initiated. They are changes in demand conditions and changes in supply
conditions,
in
each
price shifts d u e to
either
for
Demand-pull Inflation
Cost-push Inflation
Prices
rise
supply
in
two
due
demand-pull
for
services."
According
and
to
this
definition,
supply.
is of two types:
Inflation
available
increases
or
interactions between the forces of demand
Analysis of causes of inflation
Demand-pull
goods
conditions-when
at
to
current
increase
inflation.
inflationary gap
in
prices
in
any
demand
or
when
factor
economy which
goods
the
of
Keynes explains that,
the
for
and
services
aggregate
demand.
exceeds
demand
Such
of
situation
their
an
is
total
economy
known
as
"Inflation arises when there occurs an
comes to exist when
aggregate demand
exceeds aggregate supply at full employment level of output."
D e m an d - p u l l
the
increase
the
economy
chasing
inflation
in
to
the
is,
generally,
money
supply
supply
goods
monetary
rapidly
and
in
services.
in
the
origin
because
economy
That
is
why
as
the
the
government
compared
phrase
to
"too
the
allows
ability
much
money
too few goods" is frequently u s ed .
y
AS
P,
.;
>
P,
AD,
P,
0.
P,
AD,
------- x
Aggregate Demand and Supply
Fig. 6.4. la:
of
D e m a n d - p u l l Inflation
Page 9 1
Macroeconomics
06.
Inflation and
Unemployment
In the above graph,
AS
represents the supply which
level of full employment,

the
which
level of full employment.
to AD, and
so on;
whereas,
equilibrium
AD,
At
to A D , ,
OY,
cannot
increases
supply
supply,
increase
firm
further
price level to P. and
Increase in
from AD 1
from
is
OP 1
at
but
demand
keeps on
The
to
OP2.
OY,
to
the
level
demand
Similarly,
OY,,
of
will
and
full
keep
when
the demand
equilibrium
employment,
moving
OY 1
increases
increases from
which
further
to OY2 and
and
means
this
will
P,
the
from
to
P,.
supply
increase
the
Inflation:
rate of inflation
is directly
related
increase in the supply of
to the growth
rate of money supply.
Disposable Income
people tend
more disposable
d u e to
from AD 1
Money Supply
Increase in
Generally,
increasing
to AD 2 supply also increases from
Inflation occurs when aggregate d e m a n d s increase due to

money.
but only t i l l the
so on.
Causes of Demand-pull
increasing
s u p p l y remains constant after full employment.
increases from
the
keeps on
is t i l l OY,. T h i s is because supply cannot increase beyond
In the above curve,
With the increase in demand

the
eBook
increase
to raise the demand
income
in
in t h e i r hands.
national
income,
for goods and
Disposable
reduction
in
services when they have
income of the
taxes,
reduction
people
in
increases
savings of the
people, etc.
Cheap Monetary Policy
Money
supply
increases
the
increases
money
due
income
to
o
f
the aggregate d e m a n d , which
Increase in
This
is
due
to
an
increase
the
monetary
borrower.
leads to
A
s
policy.
When
result,
credit
money
increases,
income
it
increases
inflation.
Expenditure
important
the
conditions,
Public
cheap
cause
outbreak
of
employment
in the demand
of
war
is
inflation.
or
due
created
for goods and
in
Often,
to
the
government
any
expenditure
developmental
economy,
services, when
which
project.
leads
to
increase
In
a
such
bigger
prices are already h i g h .
Deficit Financing
The expenditure
related
the government.
The government
to war or developmental
resolves this
project of an economy
problem
is met
by
by deficit financing, either
Page 92
Macroeconomics
06. Inflation and
by
Unemployment
borrowing
from the
eBook
public or
by
printing
more
notes.
d e m a n d , with respect to aggregate s u p p l y , thereby,
increases aggregate
leading to inflation.
Black Money
Generally,
results
in
people
the
tend
creation
to
of
evade
black
tends to increase the general
This
Increase in
When
the
and
money.
go
This
into
other
increases
illegal
aggregate
activities,
which
demand,
which
price level in an economy.
Exports
the demand
earnings
result,
taxes
of
for domestic goods
those
industries,
increases
which
in
produce
it speeds up demand for more goods and
foreign
countries,
commodities
for
it
increases
export.
As
services w i t h i n the country.
Cost-push Inflation
Cost-push
inflation
is
a situation
where
prices
instead
of being
pulled
up
by the factors
of demand are pushed up d u e to rise in the cost of production.
Other things remain the same;

is high.
Increased
the quantity of production is less if the cost of production
wage rates and
increased
prices of raw material force firms to reduce
the quantity of labor employed and to cut production at a given price level.
AS,
AS,
PJ
pl
l------,"'---+--1f..
AD
Y
1
Y1
Aggregate output
Fig. 6 . 4 . l b : Cost-push Inflation
In the above graph,
X axis shows the aggregate demand
and
supply,
whereas,
price
displayed on Y axis.
Page 93
is
Macroeconomics
06.
Inflation and
Unemployment
When wages
increase,
s u p p l y curve
shifts
Due to
the
reflected
shift
the
from
in
the
as inflation
supply
AS,
to
supply
eBook
curve
AS 2,
shifts
upward
whereas,
curve,
to
the
the demand
the e q u i l i b r i u m
left.
In
curve AD
also changes
the
above
graph,
remains constant.
from
P1
to
P2
and
is
because
in
in the economy.
Causes of Cost-push Inflation:
Wage-push Inflation
Increase
the
in
wages
modern
them
era,
is
said
trade
to
be the
unions
main
want
to
factor of wage-push
secure
h i g h e r wages. T h i s leads to increase
the
future
of
inflation
workers
in cost of production.
Thus,
by
assuring
to maximize
profits, the producers raise the prices of their products.
Profit-push Inflation
To
increase profits,
as cost-push
monopolists
inflation.
raise the
Prices can
also
prices of the commodities.
be
increased
by
This
hoarders and
is
known
speculators in
order to get tremendous profit margins.
Rise in
Raw Material
Increase
in
the
increases the
Prices
prices
overall
of
cost
raw
material
of production.
during
Burden
the
process
of this
consumers in the form of higher prices of final goods and
producers
on to consumers,
Lop-sided
If,
increment
production
is
passed
also
on
to
services.
Higher Taxes
Generally,
of
in
any
by
have to
raising
shift
the
burden
of taxes,
specifically
indirect
taxes
the prices of the goods.
Production
country,
rather
than
goods.
This, again,
emphasis
essential
is
consumer
given
on
the
products,
it
production
leads
to
of
luxurious
shortage
of
products,
consumer
causes inflation.
International Causes
When
the
countries
world
prices
of
the
rise
in
world.
market leads to
most
Often,
industrial
the
rise in the
countries,
increase
prices of all
in
the
related
their
prices
impacts
of
raw
final goods and
affect
all
the
in
the
material
services.
Page 94
Macroeconomics
06. Inflation and
Unemployment
6.4.2 Measures to Control
eBook
Inflation
The different measures that are adopted to control
inflation are:
Monetary Measures
Inflation
is
monetary
term.
The
reason
supply over the quantity of goods and

aim
at
minimizing
the
excess
supply
for
services.
of
Reducing
excess
the
quantity
money
from
of
an
legal
or
in
prices
in
an
is
excess
money
government authorities
economy.
The
following
are
inflation:
tender
economy
hike
Therefore,
money
some of the monetary measures that control

o
the
money
by
either
avoiding
by
issue
withdrawing
of
notes
in
the
large
quantities.
B a n k credits should
Increasing
Central Bank sells government securities in the open market operation.
There should
Rationing
Fiscal
be
restricted.
bank rate to avoid
further borrowings and
investments.
be regulation on consumer credit.
of credit.
Measures
Some of the fiscal
measures that are used to control inflation are:
Minimizing
the amount of p u b l i c expenditure.
Increasing
the rate of taxes.
Introducing
new taxes and
reformulating
the slabs of tax
rates
so
that more
people can come under the coverage of taxes.

o
Postponing
the repayment of debt to people for some
Controlling
the volume of deficit f i n a n c i n g .
Preparing
Making
Increasing
Suggesting
a surplus budget by
imports by
wage
control
order
to
control
control
inflation
Increase
demand
to
tariffs.
invest
their
money
in
involuntarily
government
securities.
means
the
hiked
by direct
measures taken
o
public authorities.
reducing
earners
Direct or Administrative
Direct
of time.
some schemes to encourage people to do more savings.
bonds and
period
Measures
government
prices.
takes
administrative
Governments
intervention
in
take
the working
some
measures
concrete
directly,
measures
of the economy.
in
to
Some direct
by modern governments are:
the
level
of
domestic
production
in
order
to
meet
the
increased
for goods.
Page 95
Macroeconomics
06. Inflation and
Unemployment
eBook
Prices s h o u l d
Speculative and
Appropriate income policy should
Control
because
of
it
be controlled
gambling
population
is
the population
activities should
is
possible to
directly by the government.
be adopted.
considered
keep
be controlled.
one
a check on
of
the
demand
most
important
for goods and
methods
services,
if
is controlled.
6 . 5 Inflation in I n d i a
In September 2013, the inflation
According
19 6 9 to 2 0 1 3 ) ,
An a l l - t i m e - h i g h
low
In
inflation
India,
recorded
to the report of Ministry of Commerce and
years (from
rate in I n d i a was
inflation
rate
rate recorded
the
main
inflation
-11.31
measure
of
Industry,
rate in India averaged
recorded
34.68
percent in
inflation
is
percent
May
the
at 6 .46
in
percent.
India,
in
the
last 44
7 . 7 2 percent.
September of 1974 and
1976.
Wholesale
Price
Index
(WP!).
The
WP! measures the price of wholesale goods of a representative basket.
In India, wholesale price index

o
Primary Articles ( 2 0 . 1
Fuel and
Manufactured
From
the
is categorized
into three groups:
percent of total weight)
Power (14 . 9 percent)
Primary
Products (65
Articles
percent)
Group,
Food
Articles
account
for
14.3
percent
of
total weight.
The key components of the Manufactured

o
Chemicals and
Chemical
Basic Metals, Alloys and
Machinery and
Textiles ( 7 . 3
Transport,
Products Group are:
products ( 1 2
percent of the total weight)
Metal Products ( 1 0 . 8
Machine Tools ( 8 . 9
percent)
percent)
percent)
E q u i p m e n t and
Parts
(5.2
percent)
Page 96
the
Macroeconomics
06.
Inflation and
Unemployment
eBook
INDLA INFLATION
RATE
-l CN"'i on C0"4utn91' Price ,nde
10
8
.
9.46
10
8.07
7 .74
'
769
7.56
7.23-
7.5
,-
7 .55
7.557.58
--
6.87
"'
7.45
-
7.28
7.247.18
6.62
6.46
,. ,
5.85
5.65
'
'
5.16
nn
Jan/12
Jul/12
Jan/13
Fig. 6.Sa:
Source:
India Inflation
20130514
20130614
2013-07-15
20130814
20130916
20131014
Country
India
India
India
India
India
India
Reference
Event
WPI Inflation
2013
Rate YOY
04-30
WPI Inflation
2013
Rate YOY
0531
WPI Inflation
2013
Rate YOY
0630
WPI Inflation
2013
Rate YOY
0731
WPI Inflation
2013
Rate YOY
0831
WPI Inflation
2013
Rate YOY
0930
Table 6.Sa:
Indian
In
Rate
http://www.tradingeconomics.com/india/inflation-cpi
Calendar
Source:
Jul/13
Previous
Actual
Consensus
Forecast
4.89%
5.96%
5.50%
NA
4.70%
4.89%
4.76%
4.58%
4.86%
4.7%
4.9%
4.5%
5.79%
4.88%
5.0%
5.01%
6.10%
5.79%
5.80%
5.62%
6.46%
6.10%
6.0%
5.94%
India Inflation
Rate
http://www.tradingeconomics.com/india/inflation-cp1
Inflation Speeds up to Seven-Month
September,
percent from
the
6.1
rate of h i g h speed
inflation
percent
rate
of
in August,
India,
reaching
is, generally, due to
High in September
based
its
on
monthly
highest
level
WP!,
since
increased
February
to
6. 5
2013.
The
higher prices for food.
Page 97
Macroeconomics
06.
Inflation and
The
index
percent),
for
Unemployment
food
rice ( 1 9
prices
increased
percent), and
eBook
by
18
percent
due
to
high
p r ic e s of vegetables
(89
fruits (14 percent).
Source: http://www.tradingeconomics.com/ articles/ 1 0 1 4 2 0 1 3 0 9 1 2 1 3 . ht m
Energy
costs
percent),
prices
The
increased
liquefied
increased
increased
to an
10
petroleum
to 2 . 0
percent
gas
(9
due
to
percent)
higher
and
prices
oil
(9
of
high-speed
percent).
diesel
Manufactured
(20
goods
percent.
inflation
increased
by
rate
rate of 4.84
in
the financial
percent
year
until
now
in the corresponding
was
5.64
percent,
compared
period of the previous year.
6 . 6 Definition a n d M e a n i n g of Unemployment
Unemployment means a lack of jobs,
the
current
wage
rate.
While
even for those who are able and
calculating
the
rate
of
u n d e r the age group of 15 to 65 or 70 are considered
From
the
measurement
point
of view,
between the 'full employment' and

From
the employment
policy
willing
unemployment
only
to work at
the
people
as labor force.
unemployment
may also
be explained
as the gap
the number of persons employed.
point of view,
therefore,
unemployment
is
measured
more
specifically, as follows:
Unemployment
Total
work
force
(Number
of
persons
employed
Frictionally unemployed)
The
work
years,
force
who
are
employment.
The term
of a
employed
unemployment
Unemployment
and
of
individuals
those
who
are
are
has a different meaning
for developed
has
employment
countries
consists
Work force does not include students,
different meaning
of
country
been
and
not
aptly
defined
by
meaningful
in
Prof.
as
the
the
unemployed
housewives,
age
group
but
are
and
in every country.
countries and developing
unemployment
between
P.C.
used
case
of
in
retired
15
to
65
search
of
p eo p l e .
Unemployment
has a
countries.
Mahalanobis
in
of
the
as,
advanced
household
"the
concepts
industrialized
enterprises
which
Page 98
Macroeconomics
06.
Inflation and
Unemployment
constitute an overwhelming
eBook
proportion of productive activities in rural areas, in
India and other underdeveloped countries.
self-employed
unemployed
in
person
the
sense
helping
in
the
which
household
this,
concept
enterprise
is
used
in
can
the
never
be
industrialized
countries." Therefore,
in the primary sector (agriculture), where farmers are seasonally
employed
an
and
getting
irregular
income,
the
traditional
concept
of
unemployment
seems vague.
6.7 Types of Unemployment

Unemployment is explained
broadly under the following
categories:
Seasonal Unemployment
Seasonal
time
unemployment
pattern
of
unemployment
through
particular
means
seasonal
changes."
is a very
S e a so n a l
common
type of unemployment.
employment.
the
According
unemployment
variations
in
their
unemployment takes
to
arising
activity
"Seasonal
particular
industries
in
labor
is
due to the
Beveridge,
brought
place when
It occurs
about
not
by
productive
climatic
in
certain
periods of the year.
Take
the
season.
case
of
an
umbrella
In the winter and
demand
for
labor
production,
which
summer seasons,
occupied
in
its
has
with a fall
production
high
demand
in the demand
also
goes
during
the
rainy
for umbrellas,
down,
and
the
seasonal
unemployment occurs.
Seasonal
unemployment
opportunities
for
those
occurs
employees
type of unemployment does not

seasonal
skills
hasn't
mainly
gone
actually
away
can
who
be
and
because
are
lack
unemployed
lead
it
of
to any
alternative
during
the
serious effects
resurfaces
controlled
of
in
through
Seasonal
unemployment
the
subsidiary
industries or through modernization of agriculture.
rather
employment
slack
season.
This
because demand
predictable
development
for
pattern.
projects
of
Frictional unemployment
Some
amount
have w i l l i n g l y
between
jobs.
of
unemployment
always
left their existing jobs and

Unemployed
people
are
prevails
in
the
are searching
not
able
to
economy
among
workers
for new jobs-they are said
get
employment
instantly
who
to
be
due
to
Page 99
Macroeconomics
06.
Inflation and
frictions,
such
immobility
on
have either
who
Unemployment
as
the
left
lack
part
of
eBook
market
of workers.
information
Thus,
frictionally
their existing jobs w i l l i n g l y
have entered
into the
about
market for the
and
are
jobs
availability
unemployed
in
the
first time and
hunt
people
for
looking
and
are
perfect
those
better jobs,
who
or those
for jobs suitable to their
skills.
Frictional
unemployment
frictional
unemployment
According
to
well-suited
is
not
takes
should
economists
with
the
serious
unemployed
like
place
not
be
temporary
considered
Keynes
concept
problem
for
and
of full
because
a danger for
Lerner,
only.
the
"Frictional
employment;
those
period
it
persons
economy's
the
growth.
unemployment
(frictional
who
Therefore,
are
is
unemployment)
able
to
work
are
for frictional reasons for short period of time."
Structural Unemployment
Structural
a
unemployment occurs
country.
demand
"the
It
and
takes
supply
place
of
labor.
unemployment
change
of
demand
due
because of a change
to
According
arising
so
changes
in
great
to
in
the
it
the
be
of
structural
industries
may
structure of an economy of
conditions
Beveridge,
particular
that
in
or
regarded
certain
categories
unemployment
localities
as
of
means
through
affecting
the
main
economic structure of a country."
Lipsey
says,
"As economic growth
skilled
and
unskilled
goods
are
demanded.
readjustment
enough
on
the
so that severe
laborers
proceeds the
changes
These
economy.
as
changes
When
mix of required
do
the
impose
the
proportions
adjustment
does
in
the
same vein,
the
term
geographical
mobility
in
saying
the
locations as among
demands
occur
for
fast
industries and
is falling
faster than
that,
"The term
enduring
broadest
sense
employers and
'structural
unemployment'
limitations of worker mobility

to
include
mobility
industries and
as
among
as among
and occupations."
final
unemployment."
usually refers to the more serious and

using
which
not
pockets of unemployment occur in areas,
the supply, we speak of "structural
speaks
in
considerable
occupations in which the demand for factors of production
Ackley
inputs between
Page
100
skills
Macroeconomics
06.
Inflation and
Structural
able
to
eBook
unemployment occurs when
absorb
relocation
frictional
Unemployment
of
jobs
because
industries
leads
unemployment and
there are vacant jobs around
of
lack
to
structural
structural
of
adequate
skills
and
unemployment.
unemployment
but workers are
training.
The
not
Sometimes,
difference
between
is that frictional unemployment
is
of a shorter duration and occurs due to temporary factors.
Cyclical
Cyclical
Unemployment
unemployment
According
to
equilibrium
economy,
the
in
period."
According
caused
long
are
economic activity
business
classical
the
there
to
due
there
economists,
run.
But
in
are
general
"there
reality,
fluctuations
of
increases
and
employment
falling
"cyclical
deficiency
is
also
popularly
unemployment
of effective
demand
in
fluctuations
would
it
employment
unemployment
Keynes,
to
when
alternate
and
conditions
Cyclical
occurs
is
be
seen
prosperity
as
in
period
Keynesian
is
involuntary
in
the
in
downward
economy.
employment
and
opportunities
known
an
full
that
prosperity
in
capitalist
depression,
and
in
sluggish
depression
unemployment.
nature,
phase
and
of trade
cycle."
Steady growth line
Trough
Phases of business cycle
Fig. 6.7a:
is
Page 1 0 1
Macroeconomics
06.
Inflation and
6.8 Full
Full
Unemployment
Employment
employment takes
the existing
United
cannot
does
be
seasonal
there
place when
wage rate gets job.
Nations
not
eBook
(UN)
in
the
the
factors." As
by
an
economy
who
is
willing
to
work at
Full employment does not mean that everyone has jobs.
defines unemployment as,
increased
exceed
everybody
increase
minimum
in
"a
situation
effective
allowance
that
per the definition given
by
is unemployment in excess of frictional and
demand
must
UN,
in
be
which
and
made
employment
unemployment
for
frictional
unemployment occurs only
and
when
seasonal unemployment.
6 . 9 Cost of U n e m p l o y m e n t
It creates loss of output in an economy when a number of unemployed
increase due to a lack of adequate skills and
to an
individual,
Loss of output
According
to
as they
per labor.
lose their jobs. The loss of output can be measured
It adds cost
as:
= Per labor output x Number of unemployed persons
Okun's
unemployment
availability of capital
productive labors
law,
rate
"In
by
one
developed
economy,
percentage
unemployment rate, causes a 2.5
point
percent fall
recession that
above
in actual
the
GNP
raises
natural
below the
rate
Page
of
potential
output at full employment."
the
102
Macroeconomics
06. Inflation and
Unemployment
eBook
6 . 1 0 U n e m p l o y m e n t in I n d i a
The
rate
2010.
rate
of
unemployment
According
of
was
reduced
to the report of India
unemployment
is
7.6
percent
in
December
2010
3.8
percent
in
December
2011.
people actively looking
and
In
3.80
percent
Ministry of Labor,
percent.
9.4
to
Highest
the
India,
lowest
the
in
from
2011
from
9.40
percent
1 9 8 3 to 2 0 1 1 , the average
rate
of
unemployment
was
recorded
as
rate
of
unemployment
was
recorded
as
unemployment
rate counts
the
number of
for a job as a percentage of the labor force.
INOIA UNfAPLOY/11HT fl.ATE
-pofdo.L.lbn,a,
,.,
"
,.,
"
1.35
,,,
'
'
Jin/06
J1n/OI
Table 6. lOa:
Source:
Jin/10
J1nl12
'
India Unemployment Rate
www.tradingeconomics.com/MINISTRY OF LABOR AND EMPLOYMENT,
in
INDIA
Page
103
Macroeconomics
07.
Economic Growth and Instability
Apart
from
human
a i r and
life.
Land
water,
is
fertile
gifted
with
land
a
eBook
is an
vast
important
area
of
source of food-the
natural
resources,
basic
which
is
need
the
of
richest
source of raw materials for industries.
The
experience
essential
for
of developed
economic
sector is based
growth
and
discloses
the fact
development
that
industrial
of a country.
Growth
growth
of the
is
very
industrial
on the availability of raw materials in a country.
Labor as a Growth
If nature
countries
is the
Factor
mother of all
what extent
natural
depends
on
the
country.
Increase
life support
resources can
number
in
of
the
systems,
be exploited
hands
standard
that
of
can
living
and
be
of
labor
is
the father of a l l
goods and
put
to
work,
population
products.
services can
that
results
is,
in
be produced
population
the
To
growth
of
of
the
labor
force.
There
are
two
numerical
features
feature
of
feature of labor can
of
labor
as
labor
force
means
be developed
qualitative feature of labor
Capital as a Growth
The word
capital
means
physical
by g i v i n g
is called
of
them
production-number
or
natural
training
form
of
and
quality.
labor.
on advanced
The
The
quality
technologies.
The
' h u m a n capital'.
Factor
is used
in,
both, a narrow
sense and
means only those productive assets that directly

equipment,
machinery,
techniques
of
buildings,
production'.
etc.
Following
In
broad
are
three
a broad
sense.
produce goods and
sense,
capital
categories
In
narrow sense,
services,
consists of a l l
under
which
all
it
like tools,
'man-made
man-made
techniques are d i v i d e d :
Physical capital
Social overhead capital
H u m a n capital
Contribution of capital
time.
That
is
why,
in economic growth
early
economic
single-most
important factor
that
formation
capital
Hence,
it
can
be
is
only
concluded
in
increases the
development
economists
the economic growth
an
that
essential
growth
condition,
rate
productivity of labor per unit of

considered
of a country.
not
of saving
enough
and
capital
However,
for
this
economic
investment
is
as
proves
growth.
very
strong
indicator of capital formation.
Page
the
108
Macroeconomics
07.
Economic
Growth and
Human Capital
The
knowledge
capital
means
understand,
same
into
and
the
says,
level
their
human
human
and
discover
skills
new
is
people
methods
The mental and
called
have,
of
human
their
working
physical
capital.
ability
and
to
Human
think
and
converting
the
health of labor force may
natural
are
build
constitute
resources
the
social
active
the
are
economic
and
ultimate
passive
agents
Fredrick H.
who
basis
factors
accumulate
political
for
Harbison
wealth
of
of
production
capital,
organizations,
exploit
and
carry
national development."
and
natural
human
is
subject
researches
higher
developed
rate
it
to
and
reveal
countries is very
subject
is
to
increasing
subject
increasing
capital
to
are
subject
returns.
diminishing
returns .
to
According
returns,
Knowledge
diminishing
is
our
to
Alfred
man
most
(his
power
that
productivity
of increase
high
in
of developed
labor
and
because human
capital
countries
inputs.
capital formation
has
The
increased
at
rate of growth
a
of
in these countries has
physical capital formation.
Technology as a Growth
Factor
Frances Stewart defines technology as,

making,
physical
enables us to subdue nature and satisfy our wants."
because
been stronger than
is
nature
engine of production;
Statistical
resources
capital
"(While)
knowledge)
for
beings
important role in economic growth.
resources
beings
resources,
Marshall,
much
to
physical assets.
and
importantly,
returns
ability
"human
whereas
Most
in
knowledge
plays the most
Capital
forward
Factor
embedded
of
eBook
to the human capital.
nations.
natural
skills
productive
H u m a n capital
rightly
as a Growth
and
also be added
Instability
using,
and
doing
"all
useful
the skills,
things."
knowledge
Technology
and
includes
procedures
the
following
features:
Discovering
Designing
a new method of production
Designing
a system for the organization of work force,
Technical
and
a new product
progress
is
non-stop
effort
of
people
to
machinery, and
produ ce
large
production.
quantity
of goods
services from the available scarce resources.
Page
109
Macroeconomics
07.
Many
economists
technological
claim
progress.
that
the
They
reason
claim
eBook
for
that
economic
growth
technological
in
change
developed
and
countries
improvement
is
is
the
main reason for h i g h e r productivity that leads to economic growth.
Technological progress adds to economic growth
in the following definite ways:
Productivity of labor and capital per u n i t of time increases.
The waste of inputs and
Technological improvements save space.
raw materials reduces.
Government and Economic Growth
Government
plays
development.
Government's
growth
economy.
of
an
an
important
The
role
role
has
major
in
both
the
process
impacts,
contributions
that
of
is,
the
of
economic
positive and
government
growth
negative
in
the
and
in the
process
of
growth and development can be categorized a s :
Building of social overhead capital
Promotional roles
Social
overhead
gives
base
for
important
areas
economy.
The
defined
as 'all
capital
plays an
economic
in
which
social
important
growth.
the
role in the growth of an economy.
Building
government
overhead
capital
is
social
overhead
contributes
also
called
capital
significantly
'social
for
is
fact,
one
the
infrastructure'
man-made means of production that are used
In
of
the
growth
and
can
directly or indirectly
it
of
be
in the
process of production'.
In
brief,
the
building
making
government
essential
and
and
plays
an
adequate
maintaining
an
important
social
efficient
role
in
overhead
financial
the
growth
capital,
of
an
improving
infrastructure
system,
economy
by
infrastructure,
and
protecting
domestic industries from foreign competition.
To
sum
up,
economy
whether a government
depends
on
the
has a
government's
positive or
efficiency,
their effective implementation. An inefficient and
negative
suitability
role
in
the
of economic
growth
policies,
fraudulent administration can
Page
and
harm the
growth of an economy to a great extent.
of an
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Growth and
Instability
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7.4 Theories of Economic Growth

Having
described
the
growth are discussed

7.4.1
meaning
use
of
growth
accounting,
the
main
theories
of
here:
Harrod-Damar Model of Growth
Harrod-Damar growth
full employment and
period
theory
necessities
own
and
of
models.
of
model
is
an
additional
income theory.
output.
steady
R.
F.
economic
Though
their
The
of
Keynesian
Harrod-Damar model
Harrod
and
growth
models
study
in
E.
their
have
D.
separate
different
conclusions are the same to a large extent.
Damar
short-term
presents a complete
identified
writings
the
and
explanations,
Therefore,
analysi s
terms
developed
their
approach
their models are jointly
of
long
and
their
and
known
as
Harrod-Damar growth model.
Capital Accumulation and
Here,
Harrod
economic
and
Damar consider capital
growth.
accumulation
Economic Growth
has to
They
play
emphasize
two
roles.
accumulation as a key
that
First,
it
in
the
growth
generates
factor
of
income,
an
and
in the
process of
economy,
second
it
capital
increases
production capacity of the economy.
The
income
condition
generated
should
be
creates
fulfilled
steady economic growth
demand
every
in the long
for
year
run.
to
goods
and
maintain
services
full
This is the central
in
the
employment
economy.
and
to
This
achieve
idea of Harrod-Damar growth
model.
Harrod-Damar
growth
model
assumes
production
function
with
constant
coefficient of capital output.
kK
Where,
Y = Total
k =
production of a nation
Coefficient of capital/output
K = Total stock of capital
Page
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Any
increase in total
production
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(llY) must be equal to
k times.
11 Y = k /1 K
Where,
llY =
C h a n g e in total production
k = Capital/output ratio
llK
= Change in total stock of capital
Thus,
increase
in
stock
of
capital
(llK)
in
any
period
is
equal
to
investment
of
that
period.
/1Y
= kl
Where,
I =
investment
Another
important
assumption
of
this
proportionally constant of the national
theory
is
that
total
savings
of
an
economy
is
income.
sY
Where,
S =
total
savings of an economy
s = marginal
Finally,
the
per unit of time
propensity to save
model
of this
theory
savings eq u a l s to the p l a n n e d
proves
that
at
can
to
the
be achieved
By
Harrod-Domar
by following
increasing
both
equilibrium
level
of output,
planned
investment.
S = I =
According
the
growth
sY
model,
p l a n n ed
rate
of
growth
of an
economy
two ways:
marginal
propensity
to
save
and
the
total
stock
of
capital,
simultaneously.
By increasing
output/capital
ratio.
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Assumptions of the Harrod-Damar growth model are given
No change in marginal
No change in output/capital
No change in technology of production.
Initially, economy is in e q u i l i b r i u m .
There should
There
below:
propensity to consume.
ratio.
neither be government expenditure nor foreign trade in that period.
should
not
be
between savings and
time
gap
adjustment
between
demand
and
supply,
and
investments.
These assumptions are unrealistic
in
nature and
these unrealistic assumptions
make the
ratios
(such
economy unrealistic.
Criticism
The
major
criticism
capital/output
determined
deviated
ratio,
of
this
marginal
independently.
from
the
theory
path
is
that
propensity
If there
to
save,
growth
is a minute change
of e q u i l i b r i u m .
That
is
used
why,
in
this
in
this
rate
the
of
ratio,
model
is
model
labor,
are
all
the economy w i l l
be
also
etc.)
as
called
as 'Razor
edged' model.
7 .4.2 The Neo-Classical Theory of Growth

This theory was
propounded
by T o b i n ,
Solow,
Swan,
all together gave a joint name to this theory-The
This theory
is based
on some of the following
There is a perfect competition.
Factor payments are equal to their m a r g i n a l
Variation may or may not be found
There is full employment in an economy.
the
authors,
growth
R.
Nee-Classical
M.
model.
growth
Solow's growth
Thus,
the
and
Johnson.
revenue productivity.
in capital/output ratio.
theory
was
jointly
developed
Solow
to
model
given
be a
by
the
perfect
of growth
is
aforementioned
presentation of the
presented
here
the Nee-Classical model of growth.
They
Neo-Classical Growth Theory.
model was considered
newly
Phelps,
assumptions:
Though
Meade,
Page
113
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Macroeconomics
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Solow Model of Growth

For
clear
understanding
difference
between
of
Solow
assumptions
growth
of
the
model,
it
is
Harrod-Oomar
necessary
and
the
to
understand
Nee-Classical
the
growth
models.
Firstly,
is,
in
the
capital;
function,
whereas
in
function
the
in
complements
considered
Nee-Classical
in
Harrod-Dornar
of
each
other;
model,
model,
labor
whereas
there
are
is only
many
one factor,
factors
in
that
production
in
and
capital
Neo-Classical
are
considered
model,
labor
as
and
perfect
capital
are
as close substitutes of each other.
Harrod-Domar
model,
whereas in Nee-Classical Model,
Finally,
of Harrod-Domar model there
like labor, capital, and technology.
Secondly,
Thirdly,
production
in
Nee-Classical
competitive,
that
is,
it
is
assumed
it is assumed
model,
the
price of labor
and
capital/output
ratio
is
constant;
that capital/output ratio is varied.
factor
(PL)
that
and
commodity
price of capital
(PK)
market
are
equal
is
perfectly
to
marginal
revenue of productivity.
P L =
P K =
As
per
factors,
the
Solow
such
as
model,
stock
growth
of capital
rate
(Kl,
MRPL
MRPK = i
of
an
labor
economy
supply
(L),
depends
and
on
the
rate
technological
of
growth
progress
(T)
overtime.
The Solow model assumes constant

of production function.
As
f(K,L, T}
returns to
scale,
per t h i s assumption,
to increase in total stock and
increase
in
is called
Cobb-Douglas type
total output of nation
labor supply.
/iY
which
= /i K .
MPK
+ /!,. L .
MPL
Page
114
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Macroeconomics
07.
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Where,
MP"=
Marginal
MP,=
Marginal physical
Therefore,
equals
product of capital
product of labor
Neo-Classical
the
elasticity
physical
elasticity
of
output
of
growth
output
with
model
with
respect
to
suggests
respect
to
increase
in
that,
"economic
increase
labor
in
force,
growth
capital
given
stock,
the
rate
plus
level
of
technology."
When
there
to growth
is
introduction of t ec h n o l o g i ca l
in output denoted by l'IT/T can
/iY/Y
b ( /i K / K )
progress to
the
Nee-Classical
model,
it
leads
be written as:
+ ( 1 - b) /i l / L + /iT/T
Where,
Y =
National output
l'IY = Change in
b =
(1
national output
Elasticity of output
- b)
Elasticity of output with
respect to change in
labor,
stock of capital
K = Total stock of capital

l'IK = Change in total stock of capital
L =
Labor s u p p l y
I'l l =
Change in
labor supply
T = Technology
l'IT = Change in technology or technological progress
The
The
Long-run Steady State Growth
basics of Solow growth
model concludes that growth
rate of income
(l'IY/Y)
depends
on the following factors:
The
rate of increase in capital
The
rate of increase in
Change in technology (l'IT/T)
Marginal
But
here,
one
(l'IK/K)
labor (l'IL/L)
productivity of capital and
important
question
labor
arises:
how
the
long-run
steady
state
of
growth
attained?
Page
115
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Macroeconomics
07.
The
long-run
between
steady
growth
'consumption
and
rate
is
savings'
eBook
determined
and
by
the
'investment
equilibrium
and
savings'.
level
T his
of
is
balance
called
as
capital formation.
According
to the
Solow
model,
capita capital growth and
Assuming
a constant
a steady
state growth
rate
is achieved
when,
both,
per
per capita income are constant.
rate of depreciation,
d,
the net
increase
in the stock of capital can
be expressed as:
.Q.K = I = sY - dK
Increase
in
population
leads
to
increase
in
per
capita
capital.
By
dividing
the
above
equation by L, you derive the following equation, which gives you a steady growth rate:
.11. ( K / L )
s(Y / L ) - (d
+ n) ( K / L )
Where,
n = Population growth rate
The
steady
equation.
state
growth
in
per
capita
stock
of
capital
is
defined
through
the
above
It is more clearly explained through the below g r a p h :
Y/L
Y/L - f(K/L)
H
Y/E,
'.J'
- - - - - - - -
-----
Y/E,
o
-_;;.-.,..;,;_B
;:,
(d+n) K/L
Y/L
K/
K/
K/L
Per capita capital
Fig. 7.4.2a:
Determination of Steady State Output, Investment and Growth
Page
116
Macroeconomics
07.
In
Fig.
7.4.2a,
per capita
income
is
eBook
taken
on
the
vertical
axis and
capital-labor
ratio
is
taken on the horizontal axis. The Y/L = f(K/L) curve shows
per labor production function.
The s(Y/L) curve shows the trend
increase
in
per capita saving
with
in
income and
the (d
+ n) (K/L) l i n e shows simultaneous increase in saving and investment.
It is important to
note here, the curve s(Y/L) and the line (d
terms on the r i g h t - h a n d
7 .4.3
This
This
side.
Endogenous Growth Theory
theory
given
+ n)(K/L) represent the two
by
emerged
Paul
theory
Romer and
M.
is
to
overcome
Romer and
an
Robert
extension
E.
Robert
of
drawbacks
E.
of
Nee-Classical
theory.
This
theory
Lucas.
Solow
growth
Lucas to explain
how
model.
It
is
technological
an
attempt
made
progress and
by
Paul
production function excluding
Land T i s :
ak
Where,
a =
Marginal
k =
Capital
productivity
Capital accumulation can be expressed
as:
.6K = I =
sY
Where,
I = Investment
sY
Proportion of income saved
The equation can further be written as:
.6K
= I =
M.
economic growth
become endogenous-endogenous growth means self-sustained growth.
Simplified
is
s aK
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Economic Growth and
The growth capital can
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Instability
eBook
be expressed a s :
.6. K / K = s a
Capital
accumulation
is
subject
to
depreciation,
which
causes
decline
in
accumulated
stock of capital.
.6. K / K - d = .6.Y /Y - d = sa
Thus, the depreciation adjusted
growth
.6. K / K
rate can
= .6.Y /Y
- d
be written as:
= sa - d
Where,
d = Rate of depreciation
7.5
E c o n o m i c Instability
Economic
growth
growth
for
growth
and
create
unemployment.
stability
cycle
in
to
Sometimes,
economic
economists,
economic
Business
beneficial
g r a n t ed .
has troubled
During
is
regular
u p s and
instability.
to
No
and
companies
This instability
the economy,
economy;
statesmen,
instability,
helps
every
is
downs
other
bear
of real
problem
the general
losses
you
of
GDP
an
do
take
economic
interrupt
economic
economic
public t h a n
and
cannot
environment
that of business cycle.
cost-cutting,
which
leads
to
is generally known as business cycle.
understand
it
therefore,
the
important
to
different
phases
understand
the
of
economy.
different
To
phases
maintain
of
business
cycle.
7.6
Definition a n d
Different economists
each
M e a n i n g of Business Cycle
have defined
business
in
many different ways,
and
tried
to explain
phase of business cycle in detail.
According
to
J.
M.
characterized
by
Keynes,
rising
"A
trade
prices and
cycle
low
is
composed
unemployment
of
periods
of good
percentages,
trade
alternating
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07.
Economic
with
Growth and
periods
of
bad
Instability
trade
eBook
characterized
by
falling
prices
and
high
unemployment percentages."
Briefly
speaking,
trade cycle
economy,
followed
period
prosperity,
rate,
side
of
increase
of
gain,
value turns to
and
prices
high
there
there
go
is
phase of h i g h
high
On
is decline
in
the
rate
and
of
factors,
employment.
growth
decline
national
increase
contrary,
some
and
negative,
down
financial gain,
rate.
investment,
be
to a
by a phase of depression
per capita
fairly
depression,
financial
in
refers
in
in
growth
output,
higher
as
rate
Throughout
the
to
deflation.
regular
than
the
the
potential
employment at the
of
recession
output,
return
per
period,
unemployment
periodic
in
Throughout the
depression
business activities decline sharply,
leading
period
of national
the
prosperity
rate.
investment and
throughout
such
rate and
of
and
capita
rate
of
increases,
growth
and
recession creates the trade cycle.
7.7 Phases of Business Cycle

Basically,
there
depression,
but
are
only
here you
cycle is explained
two
will
phases
in
study about the
business
cycle,
intermediate
in detail through the following
that
is,
prosperity
stages as well.
The
and
business
diagram.
Steady growth line
Trough
Phases of busmess cycle
Fig. 7.7a:
Expansion
In
the
phase
production,
capita
of
expansion,
employment
output,
there
rate,
wholesale and
is
capital
retail
growth
in
some
formation,
factors
aggregate
prices, standard
of
of
the
demand,
living,
and
economy,
profits,
GDP.
Thus,
such
sales,
Page
per
growth
all these factors leads to the development of an economy.
as
119
in
Macroeconomics
07.
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Peak
There
is a slowdown
peak.
The
peak
in the growth of the expansion
phase
is
highest level of prosperity,
generally
described
and downward
as
p h a se and
reduction
reaches a point
in
the
expansion
known as
rate,
the
slide in the economic activities from the peak.
Recession
The
phase of recession starts when the decline in the growth
steady.
output,
In
businesses,
employment,
major
prices,
changes
and
have
reducing
taken
inventories,
Thus, the whole economy suffers from fear and
M. Y.
Lee
forest
says that,
fire,
once
place
way,
tends
to
because
which
often
of
rapid
lead
to
decline
in
downsizing.
frustration.
"A recession once started, tend
under
rate becomes very fast and
create
its
to
build
own
upon
draft
itself much
and
give
as
internal
impetus to its destructive a b i l i t y . "
Trough
Trough
down
is
the
and
getting
phase
stops
an
in
upward
depression.
This
unemployed
people,
in
manufacturing
severe tension
recovery.
course.
which
Subsequently,
movement.
depression
during
is
If
there
state
negative growth
is
of
the
the
an
down-trend
economic
acute
the
rate of GDP,
in
activities
recession,
economy
with
severe shortages,
plants, which are not fully utilized.
Trough
the
it
a
economy
once
may
and
is considered
again
turn
large
slows
start
into
number
a
of
excess capacity
to
be the most
Expansion
After completing
output,
due
depression
in an economy.
Recovery and
in
of
the trough
employment,
When
there
phase, when an economy
GDP,
aggregate
is a continuous
demand,
recovery,
records a steady and
prices,
growth
etc.;
rate
is
it
enters
more t h a n
rapid
the
growth
phase
steady.
the economy a g a i n enters the phase of expansion.
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07. Economic Growth and Instability
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7.8 Causes of Business Cycle Fluctuations

Following
are
the
causes
which
explain
why
there
are
business
fluctuations
in
an
economy.
Changes in Investment Spending
When
so
the economy
they
can
is
in
increase
their
new plants or buy new

and
generates
enough.
lead
the
rate
of
investment
businesses
in
capital
look forward
goods.
machinery to replace older ones. Firstly,
income,
If they cut
phase of expansion,
but
eventually
businesses
back on their capital
may
investments and
to
Companies
high
sales,
may
install
t h i s creates employment
decide
layoffs,
they
have
expanded
then eventually
it may
to recession.
Innovation and Imitation

When a business
innovates,
down or sales go u p .
If
other
firms
imitating
invest
the
in
takes hold
often
In each case,
the
same
innovator's
h e a v i l y to do
it
this,
in the industry,
profits increase and
industry
product,
and
creates competition
an
want
but
with
to
additional
in
differences.
booms
because costs go
the business develops.
participate
subtle
investment
in an economy
competition,
The
imitating
in an economy.
investments are pointless,
and
they
companies
After the
it
start
innovation
leads to decline
in
the growth of an economy.
Monetary Policy Decisions
Another possible cause of business cycle

policy.
When
acquired
'easy
easily.
money'
Easy
policies are
money
in
encourages
motivates
the economy for a short time.
increases
the
interest
borrowing
and
spending
rates,
is the
which
interest
effect,
the
rates that come u n d e r monetary
interest
private
sector
In d u e course,
leads
to
rates are
to
the
decrease
in
low
borrow
and
and
increased
the
loans can
invest,
demand
demand
for
be
which
for loans
loans.
As
sl o w down, the rate of growth of an economy declines.
External Shocks
Another
prices
important
of oil,
example,
wars,
Great
cause
and
Britain
of
business
international
discovered
oil
cycle
is
disputes.
in
the
external
Some
North
shocks,
shocks
Sea
in
such
drive
1970s,
as
the
which
increase
economy
led
to a
in
the
up,
for
boom
its economy.
Page
121
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Macroeconomics
07.
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7 . 9 G l o b a l Recession 2008 - 2009

The
Great
Recession
(which
officially
started
from
December
with a loss of 8 trillion d o l l a r s that were given as housing
2009 originated
Sub-prime
sub-prime
loans).
in
crisis
U.S.
was
and
caused
borrowers and
The
real
estate
boom
which
As
estate
result,
2006.
heavy
Due
the
to
losses
financial
real
the
and
due
period
led to an
by
decline
failed
to
pay
in
started
increased
up
estate
their
had
declining
loans.
crisis
number
residents (who
real
back
a financial
increased
prices declined
sharp
companies.
to
to the poor
the prices of houses,
was caused
2007 to J u n e 2 0 0 9 )
in
of
Global
known
prices,
loans.
This situation got worse with the
loans
record
to
the
of repaying
2007 due to a sharp d e c l i n e
the
This
2008-
s u b - p r i m e crisis.
home
a poor track
percent
50
as
granting
number of housing
to
recession
began
in
agents.
an
from
2008
sub-prime
had
in
their
borrowers
impact
on
the
bankruptcy of Lehman
peak
in
incurred
banks
and
Brothers in
September 2008.
The growth of the economy

create
employment
October 2 0 1 0 ,
did
required
to
in the summer of 2009
keep
pace
with
the
and
normal
16 months after recession, the economy still
was
growth
had
not that
of
strong
population.
to
In
5.4% fewer jobs than
it
before the recession started.
The unemployment during

in
stopped
poverty,
the
housing
family
and
loss
bubble
wealth.
The
of
and
the Great
health
the
impact
insurance
fall
of
Recession
in
the
the
for
stock
Great
led
both
to a drop
adults
market
Recession
in family
and
resulted
was
seen
children.
in
on
incomes,
The
a drastic
the
increase
explosion
decline
labor
market
their families.
in
Page
122
of
the
and
Macroeconomics
07.
eBook
Economic growth is generally defined as a sustained

output over a long
Land,
labor,
increase in
per capita national
period of time.
capital,
human
capital,
technology,
and
government
are
factors
affecting economic growth.
Three theories of economic growth are:

o
Harrod-Damar Model of Growth
Nee-Classical Theory of Growth
Endogenous Growth Theory
A trade cycle
and
low
unemployment
characterized
is composed
Expansion,
by falling
peak,
of periods of good
percentages,
prices and
recession,
trade characterized
alternating
with
by
periods
of
rising
prices
bad
trade
h i g h unemployment percentages.
trough, and
recovery are the five stages of a business
cycle.
The
Great
Recession
(which
officially started
from
December 2 0 0 7
began with a loss of 8 trillion dollars that were given as housing
to June
loans.
Page 1 2 3
2009)
Government and
Macroeconomy
I T M
Macroeconomics
08.
Government and
Macroeconomy
eBook
8 . 1 Introduction
The
government
involved
The
has
always
played
major
role
in
modern
industrial
economy.
It
is
in every sphere of economic development of the country.
primary
objective
of the
government
is
to
manage
the
economy
by
increasing
the
welfare of individuals.
The
government
regulations
of
government
individually
provides
the
law
makes
on
the
it
clear
are
of
lawful
controlled,
clear
basis
and
in
its
and
framework
practically
guidelines
preferences.
that
There
is
for
applied
every
no
every
to
business.
all
business
preferential
Rules
businesses.
deals
with
treatment
for
and
The
them
private
companies or for government companies.
Most
importantly,
increase the
level
the
government
of employment,
helps
and
to
increase
stabilize the
the
price.
rate
the government can adjust expenditure and
tax
can
money
are
the
down or speeding
This
chapter
supply
and
credit.
These
economic
According
of the economy,
control
of
measures
to
the
requirement
rates (fiscal
also
growth,
helpful
policy)
in
or it
slowing
up the growth of the economy.
introduces
the
helps in efficient functioning
tools
(revenue
and
expenditure)
of the
government,
of the economy.
you
will
be able to:
Define public expenditure
Explain the importance of p u b l i c expenditure
Classify p u b l i c expenditure
Define public revenue
Explain tax and
Explain deficit budget
Discuss the role of governments
its classification
in different economic systems
Page 1 2 5
which
Macroeconomics
08.
Government and
Macroeconomy
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8 . 2 P u b l i c Finance
Public finance
government
is made
(all
up of two words, 'public' and
sorts
of government-central,
'finance'.
state,
and
The word
local)
and
public
the
refers to
word
finance
refers to the means of monetary funds.
Thus,
public
government
also
finance
raises
formulates
is
its
public
fiscal
finance
is
study
resources
policies,
such as price stability,

of
the
of
to
finance
meet
which
to
its
should
economic growth,
expected
of the
change
government.
It
is
non-ending
expenditure.
be
to
adopted
achieve
time
to
time
study
The
etc.
according
to
of
how
government
certain
e q u a l distribution of income,
from
the
objectives,
Thus,
the
changes
role
in
the
of
the
economic environment.
The
important
state and
The
objective
of
public
between
different
state.
also
relief fund
0.
public
finance
is
to
improve
financial
transparency
local government of I n d i a .
scope
It
of
activities,
comprises
measures,
Eckstein defines
budgets
on
finance
the
consists
which
other
are
raising
regarded
activities
provident fund
necessary
as
performed
funds
essential
by
the
and
duties
or
their
allocation
functions
government,
such
of the
as
poor
schemes, etc.
p u b l i c finance as,
economy,
of
" P u b l i c finance
particularly
the
is the study
effect
on
the
of the effects of
achievement
of
the
major economic objects - growth, stability, equity, and efficiency."
There are two major branches of public finance:
P u b l i c expenditure
Public revenue
8.3
Public
P u b l i c Expenditure
expenditure
common
wants,
efficiently.
its own
In
is
expenditure
which
the
other words,
it
that
people
refers
in
to
is
incurred
their
by
individual
expenses
the
government
capacity
incurred
by
the
are
to
satisfy
unable
government,
to
those
satisfy
either for
maintenance or for the welfare of economy.
Page
126
Macroeconomics
08.
Government and
Macroeconomy
eBook
Importance of Public Expenditure
Public expenditure promotes development of an economy.
Public expenditure promotes trade and
Public expenditure promotes rural and
Public
doing
8.3.1
expenditure
this,
it
can
be
used
as a
helps the economy
in
commerce.
agricultural development.
lever
be improved
Classification of Public
Expenditure
of
different ways.
public
expenditure
is
increase
recovering
Distribution of income can
Classification
to
by
from
aggregate
demand,
and
by
recession.
public expenditure.
explained
by
different
Important classifications are explained
economists
in
their
own
below:
Revenue Account Expenditure and Capital Account Expenditure
Detailed
classification
between
revenue
expenditure
and
capital
expenditure
is
given
below:
Revenue Account Expenditure
Revenue
account
creation
of
any
expenditure
asset,
but
means
simply
expenditure
has
an
that
effect
on
does
the
not
result
money
in
the
balances
of
government.
Revenue
forces,
expenditure
is
administration,
current
or
consumption
p u b l i c welfare,
and
Capital Account
Capital
They
durable
are
capital
not
on
assets
frequent
formation.
on
defense
is incurred every year.
Expenditure
expenditures,
building
incurred
maintenance of government machinery.
This type of expenditure is very frequent which
expenditure
the other
(highways,
hand,
irrigation
expenditures.
Such
are
incurred
projects,
This expenditure
expenditures are
likely
on
m u l t i p u r p o se
machinery
is
made
to develop
the
and
for
dams,
and
equipment).
the
purpose
productive
of
capacity
of the nation.
Productive Expenditure and Unproductive
Classical economists classified
Expenditure
this on the basis of creation of productive capacity.
Productive Expenditure
Expenditure
incurred
for
agricultural development
the
development
increases
of
infrastructure,
productive capacity
government income. Therefore, they are classified
in
the
public
enterprises
nation and
or
increases
as productive expenditure.
Page 1 2 7
Macroeconomics
08. Government and
Unproductive
Expenditures
incurred
does
classified
Transfer
A.
C.
and
on
consumption,
expenditure
not
bring
on
income
law
to
such
and
the
as
order,
interest
in
payments,
which
government.
defense,
productive
These
types
asset
is
of expenses
civil
not
are
as unproductive expenditures.
Expenditure and
Pigou,
eBook
Expenditure
administration,
created,
Macroeconomy
British
Non-transfer Expenditure
economist,
classified
public
expenditure
as
transfer
expenditure
non-transfer expenditure.
Transfer
Transfer
there
its
is
Expenditure
expenditure
is
expenditure
no corresponding
expenditure
on
return.
transfer
incurred
Thus,
payments.
by
the
government
against
which
the government sector spends a portion

Transfer
payments
are
made
without
of
any
expectation of productive activity.
Government expenditure i n c l u d e s :
o
Subsidies
National old
Welfare
Interest payment
Unemployment allowance
The
benefits to weaker sections
government
expenditures,
These
age pension scheme
but
does
it
expenditures
not
get
anything
in
return
increases the welfare of society,

basically
lead
to
redistribution
from
the
especially
of
money
aforementioned
of priority sectors.
incomes
within
the
society.
Non-transfer Expenditure
Non-transfer
in
creation
expenditure
of
output
or
development as well as
is
expenditure
capital
incurred
formulation.
by
the
government
Non-transfer
non-development expenditure
that
expenditure
incurred
results
comprises
by the government
that results in creation of assets, directly or indirectly.
Following
o
are examples of non-transfer expenditures:
Infrastructure
of economic
nature,
such
as
transportation,
power,
irrigation
facility, etc.
o
Infrastructure of social
nature such as education,
health, and
public welfare.
Page
128
Macroeconomics
08.
Government and
Macroeconomy
Defense and
Civil administration
eBook
law and order
By i n c u r r i n g such expenditures, the government creates a healthy environment for

economic
income
activities.
in
form
of
For
the
taxes
growth
and
of
duties,
economy,
which
are
the
government
utilized
for
the
may
create
aforementioned
expenditures.
Development and
Non-development Expenditure
The following classification is given by modern economists:
Development Expenditure
All
those government
economy
are
termed
expenditures
as
that
development
promote
growth
expenditure.
For
and
development
example,
in
an
expenditure
on
infrastructure development, agricultural development, etc.
Non-development Expenditure
Unproductive
expenditures
are
of consumption
nature,
which
do
not
create
any
productive assets. This type of expenditure brings more income or more returns to
the government are termed as non-development expenditure.
Functional Classification
Public
expenditure
government
is
performs
classified
various
infrastructure development,
by
some
functions
and
economists
like
on
agriculture,
industrial development.
the
social
basis
of
functions.
welfare,
defense
Expenditures incurred
The
force,
on these
types of functions are called functional classification.
8.4 P u b l i c Revenue
The income earned
by the government from all sources is called
income. Tax is considered
Tax
is a compulsory
Dr.
Dalton
has
revenue
which
supplied
by
as the most important source of p u b l i c revenue.
payment
the expenditure incurred
defined
public revenue or public
imposed
on
the
income of people or companies,
to
meet
by the government for the common welfare of society.
public
includes
income
public enterprise,
revenue
in
from
different
taxes,
ways.
prices
revenue generated
from
In
of
narrow
goods
sense,
and
"public
services
administrative activities
Page 1 2 9
Macroeconomics
08.
Government and
such
as
which
fines,
fees
include
all
Macroeconomy
etc.,
the
and
gifts
income
of
eBook
and
the
grants."
In
government
broad
sense,
which
it
"public
may
have
receipts
during
given period of tim e. It also includes the loans which the government raises."
Significance of P u b l i c Revenue
On the basis of the following
The
welfare
revenue,
of
the
points,
people
significance of p u b l i c revenue can
of
other things being
an
economy
depends
on
the
be j u d g e d .
size
of
the
public
constant.
Prosperity of the country is measured
Raised
public revenue is distributed
by the size of public revenue.
among
the people of the country.
8 . 5 Classification of Taxes
Taxes are classified
Direct and
Specific and
Prag ressive,
on the following
basis:
Indirect Tax
Ad-valorem Tax
Proportional, and
Regressive Taxes
Direct and Indirect Tax
Direct Tax
Direct
taxes
completely
are
those
incurred
by
taxes
the
whose
person
burden
who
pays
cannot
it.
be
passed
For example,
to
others
income
tax,
and
is
wealth
tax, etc.
Indirect Taxes
Indirect
tax
taxes
are
those
taxes
whose
burden
payers do not bear the whole b u r d e n .
can
be
passed
on
to
others
For example, excise duty,
so
that
sales tax, etc.
Specific and Ad-valorem Tax
Specific Tax
A specific tax on
paid
tax
per
will
unit
vary
commodity
based
on
a commodity
of the
commodity,
according
and
not
is
on
to
the
physical attributes
the
based
on
particular qualities of commodity and
whatever
changes
value
of
in
sales
like weight,
the
the
or
The
quantity
output.
length,
Specific duties are comparatively simple and
price.
amount
of
output
Specific
volume,
of total
etc.,
taxes
or
specific
sales
are
is
of
imposed
of the commodities.
easy to evaluate and
manage.
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Macroeconomics
08.
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Macroeconomy
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Ad-valorem Taxes
'Advalorem' is a Latin word,

indirect
tax
is
levied
on
which means 'according
the
value
of
goods.
percentage of the value of the commodity.

goods.
Ad-valorem
volume and
Progressive,
taxes
result
in
to value'. Ad-valorem type of
Ad-valorem
tax
is
It is imposed according
increased
tax
revenue
with
tax
shown
as
to the value of
an
increase
in
price of goods. 'Sales tax India' is an ad-valorem tax.
Proportional, and
Regressive Taxes
Progressive Tax
In case of a progressive tax,
that
is,
current
income
tax
from
rate increases along
all
sources
system
in which more taxes are charged
tax
high
amount
amount
is collected
is
collected
from
from
of
tax
with an
payer.
increase in
Progressive
tax
tax
is
base,
tax
as the income of the taxpayer increases.
taxpayers
taxpayers who earn
who
less.
earn
The
more;
and
less
tax
I n d i a n government uses a
progressive tax system.
Proportional Tax
In case of proportional tax,

base
So,
on
in
which
this
it
is
method,
the constant tax
imposed.
the
tax
Here,
rate
tax
rate
increases
rate
is
with
is charged,
uniform
an
and
increase
whatever be the tax

tax
in
payable
the
tax
is
fixed.
base.
The
application of this tax rate depends on the income level of individuals.
Regressive Taxes
As opposed
increases.
to
progressive tax,
in
regressive tax the rate declines as the tax
base
So, the tax rate decreases for higher incomes.
8.6 P r i n c i p l e s or Canons of a Good Tax System

8.6.1
Basic Principles
Principle of Equality
According
the
to this principle, every
person's
people.
ability
Adam
to
Smith
pay.
person
Therefore
should
rich
pay tax to the government according
people
pay
more
tax
as
compared
to
to
poor
rightly said that, "every person should be taxed in proportion
to their respective abilities."
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08.
Government and
Macroeconomy
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Principle of Certainty
According
to the
principle
certain,
not
paid,
what time,
at
arbitrary.
of certainty,
The taxpayer
and
the
amount of tax
should
the detailed
have
paid
by
knowledge of
procedure of paying
tax
the
how
to
person
much
tax
should
be
has to
be
the government.
same time, the government is also certain about the revenue collected
At the
through tax.
Principle of Convenience
According
to this
payment should
ought to
be
principle,
not only
the amount of tax,
be convenient for the tax
levied
at
the
time or
in
payer.
the
but
According
manner
in
also the
mode and
timing
of
to Adam Smith, "every tax
which
it
is
most
likely to
be
convenient for the contributor to pay it."
Principle of Economy
According
the
to this
amount
contrived
of
principle,
tax
as both
possible over and
the cost
collected.
incurred
Adam
to take and
in collection of tax should
Smith
rightly
keep out of the
said
that,
be m i n i m u m than
"every
pockets of the
tax
has
to
be
people. As little as
above what it brings into the public treasury of the state."
8.6. 2 Other Principles

Productivity or
This
tax
principle
is
must earn
Fiscal Adequacy
also
called
sufficient
the
principle
of fiscal
adequacy.
According
revenue for the government treasury and
to
this
principle,
the government
need
not opt for deficit financing.
Elasticity of Taxation
This
principle suggests that taxation should
tax amount should

of the
time
government.
or
through
during
be elastic in
be capable of increasing
For
crisis,
example,
the
source
if
of
the
or decreasing,
government
tax
nature.
should
be
In other words,
according
requires
capable
more
of
to the
income
fetching
the total
requirement
during
war
more
amounts
various
different
increase in tax rate.
Diversity
According
sources
to
this
rather than
income tax,
principle,
government
concentrating
service tax,
on
one
should
collect
s i n g l e tax
taxes
source.
from
These
different
sources are
sales tax, excise tax, etc.
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132
Macroeconomics
08.
Government and
If the total
tax
amount
Macroeconomy
of tax
revenue
revenue from a n y source w i l l
eBook
comes
from
have little
different
sources,
impact on the total tax
then
any
decrease
in
revenue.
Simplicity
This
principle
difficult
due
to
suggests
understand
that
and
the
tax
system
administer.
to complication of tax system.
In
should
Problems
India,
of
not
be
complicated
interpretation
of late,
and
the government
as
it
becomes
dispute can
is
in the
arise
process of
simplifying the tax system.
8.7 Deficit F i n a n c i n g
Deficit
financing
expenditure.
more
than
financing
and,
In
refers
to
other words,
current
is inflation.
revenue
the
financial
deficit
and
financing
public
Deficit financing
It reduces its accumulated
It
It takes loans from
issues
new
in
between
India
in
public
refers to
borrowing.
results
therefore leads to increase in demand
The government uses the following
gap
The
increase in
for goods and
revenue
and
public
the expenditure which
major
money
drawback
supply
of
is
deficit
in an economy
services.
measures to overcome deficit:
cash
reserve from
RBI
currency
Reserve Bank of India
Objectives of Deficit Financing

The m a i n objectives of deficit financing
are explained
below.
Financing for War

Deficit financing
is used
This is a normal method
as a measure of financing
of raising
expenditure incurred
during
war time.
funds during war.
Remedy for Depression

In
developed
emerge
of the
countries,
deficit
depression
deficit financing
financing
period.
This
is
used
measure
is
as
also
measure
by
advocated
the
by
government
Prof.
Keynes
as a remedy for depression.
Page 133
to
for
Macroeconomics
08.
Government and
Macroeconomy
eBook
In
developing
financing
the
and
under
execution
developed
of
countries,
developmental
deficit
plans.
It
financing
promotes
the
becomes
essential
economic
growth
for
of a
country.
Mobilization of Idle
Deficit
financing
is
Resources
also
used
for
the efficient
allocation
of unutilized,
excess,
and
ideal
funds for productive purpose in an economy.
Granting Subsidies
In
developing
production
for
the
country
like
India,
the
government
of a particular type of commodity.
government,
which
purpose, deficit financing
cannot
be
met
Giving
with
the
gives
subsidies
subsidies
regular
to
is a very
income
of
encourage
the
expensive affair
people.
For
this
economy,
the
becomes very essential.
8 . 8 Role of Government in Different Economies

Socialist
Socialist
sources
Economy
economy
of
is
also
production,
the government.
of economy,
called
that
is,
All citizens
centrally
mines,
planned
factories,
in this economy
economy.
capital,
have equal
resources are allocated according
etc.
In
are
socialist
owned
rights and
by
benefits.
the
state
or
In this type
to the directions of public authorities.
In a socialist economy, the government takes decisions r e g a r d i n g :
Production
Allocation of resources
Employment
Pricing
Characteristics of Socialist
Following
As
Economy
are the characteristics of socialist economy:

it
is
welfare.
owned
and
controlled
Profit motive and
by
the
government,
self-interest are
not
the
primary
objective
important objectives
is
in this type of
economy.
Market forces do not play any role in the allocation of resources.
public
Page
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08.
Government and
Government
economy.
Macroeconomy
formulates
and
eBook
accomplishes
goals
and
objectives
O n l y the government can take decisions regarding
for
growth
of the
what to produce,
how
much to produce, and when to produce.
An
important
feature
of
the
socialist
Apart from this, even educational and
economy
is
equal
distribution
of
income.
other facilities are equally distributed
among
members.
The
government
guarantees
because of government's rigid
right
to
work
planning
but
choice
of
for economic and
occupation
is
restricted
social welfare.
Capitalist Economy
In
capitalist
There
is
no
capitalist
economy,
management
interference
economy.
implies a system
is
owned
by the government
Capitalist
economy
of economic freedom.
is
in
and
the
based
controlled
Smith,
government
in
year
1974,
on
the
principal
Capitalist economy
recommended
the
private
individuals.
management of current affairs under
economy. The main objective of this economy is to earn
Adam
by
of
laissez
is also called
faire,
which
free enterprise
profit.
following
four
major
functions
of
the
in the free enterprise economy:
National defense
Law and order and
Judiciary
Money supply
internal security
Characteristics of Capitalist Economy
Following are the characteristics of capitalist economy:
The
entire
individuals.
property
Their
factors
of
production
are
under
the
control
The owners of these factors of production are free to
of production
or
of
private
use these factors
in whichever manner they want.
primary
objective
is
profit
motive,
which
encourages
people
to
work
efficiently.
Entrepreneurs
are
free
to
take
any
business
they
want
or
engage
themselves
in
any economic activity.
In
the
capitalist
Common
methods
price cutting,
In
economy,
capitalist
to
face
there
is
tough
competition
in
competition
capitalist
among
economy
sellers
are
and
buyers.
advertisement,
sales promotion, discounts, etc.

economy,
there is a wide gap
there
is
inequality
in
the
distribution
of
income,
that
between the rich and the poor in the economy.
Page
135
is,
Macroeconomics
08.
Government and
Mixed
In
Macroeconomy
Economy
mixed
economy,
the
objective
merits of both the economies,

excludes
the demerits
economy
like
like self
equal
goods
eBook
and
of
both.
interest,
distribution
services
of
are
that
is,
to
develop
economy
motive,
income,
etc.,
social
controlled
by
system
in
socialist economy and
Mixed
profit
runs some important industries.
is
welfare,
the
use
of
some
etc.
there
should
be
capitalist economy w h i l e
appreciates
and
which,
some
features
of capitalist
features of socialist
Production
legislation,
that
and
is,
it
economy
consumption
government
Private enterprise has its own importance and
of
itself
is allowed
to play an important role in the mixed economy.
Characteristics of Mixed
Economy
Following are the characteristics of mixed economy:
The first important characteristic of mixed economy is that there is co-existence of

both the sectors-public sector and
In
mixed
Therefore,
economy,
it
must
the
prepare
private sector.
government
plans
has
for the
clear
and
development
definite
of
both
economic
private
and
goal.
public
sector enterprises.
In
mixed
imbalance.
economy,
Thus,
government
plays
positive
role
public sector enterprises are located
in
to
develop
backward
the
regional
regions for the
betterment of backward areas.
Dual
system
determined
of
pricing
exists
in
mixed
economy.
through the market forces of demand
prices of various products are determined
In
private
and supply;
sector,
and
prices
are
in p u b l i c sector,
by the public authorities.
Page
136
Macroeconomics
08.
Government and
Macroeconomy
eBook
8.9 Chapter S u m m a r y
Public finance
is the
effect
achievement
on
the
study of the
of
effects of budgets on
major
economic
economy,
objects-growth,
particularly
stability,
the
equity,
and efficiency.
Public expenditure and
public revenue are the two main
branches of p u b l i c finance.
Public expenditure can be used as a lever to increase aggregate d e m a n d .
The
income of the government
from
all
sources
is called
p u b l i c revenue or
public
income. The most important source of public revenue is tax.
Deficit financing
refers to
the financing
of gap
between
public
revenue and
public
expenditure.
There
are
three
mixed economy.
types
of
economies:
capitalist
economy,
socialist
economy
India is considered as a mixed economy.
Page 137
and
International
Trade
I T M
Macroeconomics
09.
Internationa
Trade
eBook
9 . 1 Introduction
International
in
modern
markets
trade
times.
and
has
been
Today,
almost
the
in
existence
nearly
same
15
since ancient
percent
percentage
of
of
national
domestic
imported.
In the case of developing countries, t h i s
Over
years,
the
policies and
international
country,
has
It
all
over
regarded
the
have
consumption
ratio is about 20
successfully
contributed
enormously
entered
is
met
foreign
by
world.
percent.
to
the
preparation
you
International
trade
of
country
consists
of
inflow
leads to movement of foreign exchange.
will
be able to:
Define international trade
Discuss theories of international trade
Describe terms of trade
Discuss free trade and
of
industrial growth.
make an attempt to explain the basics of international trade.
goods
as the most essential determinant of economic growth of
outflow of goods and services, which
This chapter w i l l
has grown
products
development of strategic structures for economic and
International trade is
a
trade
times.
form of trade
restrictions
Page
139
and
Macroeconomics
09.
International Trade
9 . 2 M e a n i n g and
International
trade
is
in
the
Definition of I n t e r n a t i o n a l Trade
the
s i m p l y refers to export
competition
eBook
and
trade
of
goods
import at an
market
and
or
services
international
makes
prices
across
level.
more
international
borders.
It
International trade increases
competitive,
which
leads
to
borders
or
availability of affordable products for the consumer.
International
territories
trade
of
is
exchange
countries.
In
most
of
goods,
countries,
services,
it
and
represents
capital
an
across
important
share
of
Gross
Domestic Product ( G D P ) .
Goods and
people.
fulfill
services are
Resources
maximum
resources.
country.
All
It
i m p o rt i n g
export
no
goods,
and
is
which
which
to
produce
population
services
from
of a l l
sufficient
of
that
other
countries,
it
country,
requires
countries
self-reliant.
are
are
in
not
Every
available
with
surplus quantity
it.
with
but
it
the
it and
satisfy
goods
every
and
services
country
be
cannot
wants of their
has
produced
produce.
to
limited
within
the
Similarly,
it
it has in excess q u a n t i t y .
has
In
of
cannot
what
country
which
quantity
services to other countries, which
country
goods,
the
purchase
sells some goods and
Generally,
of
goods
to
requirements
needed
wants
the
has
are
basic
to
rely
same
are
in
on
other
way,
high
countries
every
country
demand
for
can
outside the
country.
International
trade means
regulated
laws,
trade
rules,
and
between
regulations
two or more
of the
country
nations.
International trade
concerned.
Thus,
is
international
is more difficult than domestic trade.
Global
will
by
business
Policy
Forum
be exchanged
in each
predicted
internationally.
national economy w i l l
According
to
transaction
Murad,
has
Wasserman
between
"International
that
by
2030,
60
percent
It means that the contribution
of the
of the
world's
economy
rest of the world
be more than the contribution of the domestic economy.
and
Haltman,
residents
trade
of
is
"International
different
a
trade
countries."
between
trade
consists
According
nations."
to
Anatol
According
Eugeworth, "International trade means trade between nations."
of
Page 140
to
Macroeconomics
09.
Internationa
Trade
eBook
9 . 3 Theories of International Trade

Theories
of
goods and
9.3.1
international
Adam
of
is
produce all
and
specialized
those goods
import
country
is
other
goods
problems.
and
specialized. Therefore,
produce
the
question
'Why
countries
export
and
import
in detail below.
Smith's Theory of Absolute Advantage
production
country
answer
services?' These theories of international trade are explained
A country can
cost
trade
Cost
cost
of
it can
goods,
to
as
are demanded
of
production
production
it is concluded
that
inc lined
that
is
more
by Adam Smith
produce
in
its
less
of
these
production
for
but t h i s gives
those
in
goods
which
in
rise to
which
country
is
not
that it is beneficial for a country to
costs
of
people,
for goods
more efficiently
production
specialize
is
by
and
at
high
goods
low
to
in
cost of production;
the
country.
which
Thus,
it
has
absolute
between
two
countries
advantage of cost.
The
theory
can
be
of
absolute
equally
production
advantage
profitable
of at
only
gives
if
both
an
the
least one commodity and
idea
that
countries
exchange
have
absolute
absolute disadvantage
advantage
in the
in
production
the
of at
least one commodity.
Adam
Smith's theory
can
be explained
through a s i m p l e ,
hypothetical example
in
which
two countries and two commodities are taken.
Country
Wheat
Jute
India
40
80
Thailand
70
30
Table 9.3. la:
India
needs 40
man-hours
to
man-hours
produce
to
the
Per Quintal
Labor Cost (Man-hour)
produce one q u i n t a l of wheat,
same.
India
needs
80
man-hours
jute and Thailand
needs 30 man-hours to produce the same.
Therefore,
has
absolute
wheat
should
India
advantage
production
in
and
an
absolute
jute
advantage
production.
should
in
According
import jute and
whereas T h a i l a n d
wheat
to
Thailand
this
to
produce
production
example,
specializes
one
and
of
has
specializes
in
production and
import wheat.
70
quintal
Thailand
India
in jute
needs
Page
141
Macroeconomics
09.
International Trade
eBook
9.3. 2 Ricardian Theory of Comparative Advantage
Ricardian
trade
theory
between
of
comparative
two
production of both
countries
advantage
even
the commodities,
if
one
and
recommends
the
country
absolute
has
the other country
possibility
of
profitable
advantage
in
the
has absolute disadvantage
in
the production of both the commodities.
Ricardian
theory
advantage
in
gives
the
valid
production
point
of
goods;
countries would always be feasible and
The
Ricardian theory can
two countries and
can
the
hypothetical example in which again
Thailand
70
110
both
in
Per Quintal
is
wheat
specialize
in
wheat
production
production
the
industries
both stand
the conclusion
should
and
is,
India
because
in jute
it
to Thailand.
needs only
to
production
India
Thailand
in
as compared
(40/70)
India
100
has a
57.14
in T h a i l a n d .
less as compared
production
in
Labor Cost (Man-hours)
the goods more efficiently
they trade their surplus,
which
in
because its relative cost of jute
(80/40).
jute
they
Thus,
India
production.
have
has comparative
Assuming
comparative
India
advantage,
and
and
if
to g a i n .
would
specialize in wheat
specialize in jute production and
production and
import jute,
import wheat.
Heckscher-Ohlin Theory of Trade
theory
trade.
both
both the countries.
80
advantage
This
comparative
between
40
(110/70)
9.3.3
trade
India
has a comparative advantage
Thailand
profitable to
and
have
Jute
production
and
specialization
countries
Wheat
produce
Therefore,
as
Country
percent of the cost of wheat
Thailand
long
commodities are taken.
comparative advantage
Thailand
so
be clear t h r o u g h a simple,
Table 9 . 3 . 2 a :
India
that
is also
known as factor-endowment theory of trade or the
modern theory of
Heckscher-Ohlin theory of trade states that comparative advantage
production
is
made
clear,
exclusively
by
the
variations
in
the
in
the cost of
factor-endowment
nations.
Page
142
of
Macroeconomics
09.
Internationa
Factor-endowment
different
factor
Trade
eBook
consists
of
endowments,
two
crucial
that
is,
factors-labor
some
countries
and
capital.
have
plenty
All
of
countries
labor
and
have
some
countries have plenty of capital.
Theorems of Heckscher-Ohlin Theory of Trade

The Heckscher-Ohlin theory of trade can
Theorem
1:
A country
can
intensive
involves
specialize
of
2:
in
excess
use
o
f
the
export
resources,
its
limited
of those commodities
and
import
those
whose
production
commodities
whose
involves
production
resources.
Factor Price Equalization Theorem

trade
international
different
its
intensive
International
of
Trade Theorem
use
Theorem
be explained with the help of two theorems:
balances the factor
trade,
countries.
it
The
is
probably
second
prices
that
between
trading
prices of factors
theorem
of
of
Heckscher-Ohlin
countries.
production
suggests
In
the absence
are
that
different
in
international
trade eradicate the factor disparities.
Assumptions of Heckscher-Ohlin Theory of Trade

Heckscher-Ohlin
theory
two goods (X and
Y)
of trade
and
assumes
two factors-labor
model,
(L)
and
which
capital
has
two
countries
(K)-along
with
(A
and
B),
the following
assumptions:
Existence of perfect competition
in
markets
(product market and
factor market)
in
both the countries.
Labor factor and
capital
Y w i t h i n the country
factor have
but not
perfect
Labor factor and capital factor are
Factors of production are fully employed.
Production
There is neither transportation cost,
Production
(A and
the
industries
X and
homogenous of both the countries.
possibility curves are concave to the origin.
technology
intensive,
Demand
between
between the countries.
capital
mobility
for
nor any trade barrier.
commodity
and
commodity
is
labor
intensive
and
respectively.
conditions for
both the goods (X and Y)
are identical
in
both the countries
B).
Page 143
Macroeconomics
09. International Trade
eBook
9 . 4 Terms of Trade
The
theory
production
surplus
from
of
of
comparative
a
commodity
production,
foreign
advantage
trade
then
may
in
that
not
which
it
country
remain
suggests
has
will
the
that
if
any
comparative
have
benefit
same-it
may
country
advantage,
from
foreign
change.
The
from foreign trade to trading
countries depend
on the terms of trade.
In
may
as
general,
terms
of
trade
exported for per unit of imported
The
ratio
of terms
of trade
happens because an
imports.
is
increase
be
defined
the
specializes
quantity
of
and
the
exports
trade.
But,
changes
in
goods
in
that
its
benefit
benefits
must
be
goods.
highly
influenced
by
changes
in
in the value of domestic currency
the
exchange
rate.
This
increases the quantity of
It also makes exports less competitive.
Terms of trade
refers
to the
index
of
prices of a country's
export
that are
measured
in
relation to its import prices.
Index of Export Prices x

100
Index of Import Prices
For example,
and
if over a given
period,
the
index
the index of import prices increases by
10
of export
percent,
prices
increases
by
20
percent
the terms of trade are:
120
x 100
110
=
109.09
This means that terms of trade have improved
by 9 . 0 9
When
100,
the
terms
of trade
when they fall
below
Now
question
here
the
increase
more
1 0 0 , they are said
arises,
'what
than
percent.
they
are
said
to
be
improving;
to be worsening.
are
the
factors
that
improve
or
worsen
terms
trade?'
and
Page
144
of
Macroeconomics
09.
Internationa
Trade
eBook
Improving Terms of Trade
If terms
can
of trade of a n y country
improve,
purchase more units of imported
trade
generates
profit
in
terms
it
means that
goods.
of
So
quantity
for
per unit of exports
potentially,
of
goods
an
that
increase
need
in
to
sold,
it
the terms of
be
exported
to
purchase a given quantity of imports.
If exports
hand,
if
are
more
prices
of
than
imports,
exports
are
it
is
called
relatively
favorable
lower
than
terms
the
of
trade.
imports,
On
it
is
the
other
termed
as
unfavorable terms of trade.
Worsening Terms of Trade
When
any
referred
country
exports
to as worsening
t h i s destiny
has
taken
more
goods
terms of trade.
place
with
to
purchase
According
many
given
to the
developing
quantity
imports,
Prebisch-Singer
countries
prices of goods with respect to the price of manufactured
of
given
the
it
is
hypothesis,
general
fall
in
price
of
goods.
India Terms of Trade
In
India,
imports.
Terms of Trade
(ToT)
refers to the
ratio
of price
of exports
to
the
Reserve Bank of India reported Terms of Trade in India.
INDLA TERl'\S Of TRADE
120
r 120
113
110
f- 1 1 0
100
f-
100
90
f-
90
f-
80
91
86
83
83
81
79
80
78
77
70
70
Jan/04
Jan/06
Fig
Source:
g.4a:
Jan/08
Jan/10
Jan/12
India Terms of Trade
http://wWIN.tradingeconomics.com/india/terms-of-t rade
Page 1 4 5
Macroeconomics
The above graph

to
113
2000
Index
until
eBook
shows that Terms of Trade
Points in 2 0 1 1 .
2011,
reaching
in
India
Terms of Trade of India
a highest of
113
Index
rose from
91
has averaged
Points
in
June
Index
90
Points
in
2010
Index Points from
2011
and
record
low
of 77 Index Points in June 2007.
9 . 5 Classification of Terms of Trade

Net Barter Terms of Trade
It
is
the
relation
most
common
between
T" as defined
prices
and
widely
used
of exports and
by Taussig and
measure
prices
of
of
terms
imports.
Viner may be expressed
of
The
trade.
net
It
refers
to
the
barter terms of trade
as:
x,
T =
"
M
p
Where,
T"
Net
barter terms of trade
x,
Prices of exports
M,
Prices of imports
Trends
of
terms
of
trade
can
be
found
out
by
comparing
the
prices
of
exports
imports of two different periods.
Gross Barter Terms of Trade
Taussig and Viner defined
another important measure of terms of trade as:
M,
T
xq
Where,
T,
= Gross
M,
x,
barter system
of trade
Quantity of imports
Quantity of exports
Page
146
and
Macroeconomics
09.
Internationa
Trade
eBook
Trade between two countries is said
to be balanced
when the net barter terms of trade
and the gross barter terms of trade is equal, that is:
X,
M,
- = -
M,
X,
Income Terms of Trade
A drawback of net
barter
terms of trade
perfectly competitive system
both
price and
that
of international
another concept of terms of trade

considers
is
use
pricing
restricted
to the conditions of
To overcome this variance,
that is,
income terms of trade.
Income terms of trade
index of imports.
T,
is
system.
has been suggested,
volume of exports.
value index of exports over value
its
refer
It may be expressed
to the
ratio
It
of
as:
Where,
T,
= Income terms of trade
x,
Prices of exports
x,
Quantity of exports
M,
Prices of imports
Single-factor Terms of Trade
Single-factor
terms
drawback of net
it
by
not
trade
is
another
barter terms of trade.
Kindleberger.
consider the
of
It
has been
change
in
pointed
efficiency
concept
'Monstrous
recommended
piece of jargon'
to
amend
is the
name
out that ratio of prices of exports and
and
so
it
ignores the
impact
on
the
given to
imports do
the growth
country.
major
Page
147
of the
Macroeconomics
Thus,
adjustment
measure improved
should
eBook
be
made
efficiency.
in
the
ratio
of
It may be expressed
prices
of
exports
and
imports
to
as:
x,
-x
E,
M,
Where,
E, = Improved efficiency of export sector
x,
M,
=
=
Prices of exports
Prices of imports
Double-factor Terms of Trade
This
is
factors
another concept
in
the
country
suggested
from
for further amendments
which
it
imports.
This
in
concept
the
is
improved
known
as
efficiency of
double-factor
terms of trade.
Where,
E,
Em
x,
M,
= Improved
= Improved
=
efficiency of export sector

efficiency of import sector
Prices of exports
Prices of i m p o rt s
9 . 6 Free Trade
Free trade means unrestricted
to a condition of international
international
trade
(such
and
free exchange of goods
trade when a l l
as tariffs,
quotas,
difference between domestic trade and
Free
trade
interference
policy
by
is
also
called
government
in
as
with other countries.
types of artificial and
etc.)
are
not
present.
It refers
unnatural controls on
Under
free
trade,
the
international trade disappears.
the
laissez-faire
international
trade.
policy,
Under
that
this
is,
the
policy,
policy
all
of
non
obstacles
Page
148
to
Macroeconomics
09.
Internationa
Trade
eBook
international trade are removed

allowed
to
take
their
natural
and
flow.
the
movements of goods between
Trade
is
advantageous
for
all
the countries are
partners
in
foreign
trade.
According
draws
to
Adam
no
therefore,
free
Smith,
distinction
neither
trade
between
imposes
is,
"that
system
domestic
additional
and
burdens
of
commercial
foreign
on
the
policy
which
commodities
latter,
nor
and,
grants
any
special favours to the former."
According
to
Jagdish
Bagwati,
tariffs, quotas, exchange
"Free
trade
policy
restrictions, taxes and
involves
complete
subsidies on
absence
of
production, factor
use and consumption."

Advantages of Free Trade
The advantages of free trade are:
The consequence of free trade
country
can
specialize
in
is equalization of factor prices.

the
production
of
those
goods
in
which
it
has
comparative advantage because of free trade.
Specialization
due
to
international
trade
facilitates
country
to
do
large
scale
production.
Introduction of new and
modern technology.
Criticism of Free Trade
Free trade is criticized
Cheap
Specialization
Dependence on other countries may prove critical
9.7
imported
by the government on the following
grounds:
goods may demolish domestic industries producing those goods.
because of trade may
result in unbalanced
growth of the economy.
in situations like war.
Forms of Trade Restrictions
Following are the important types of forms of trade restrictions:

Tariffs or Custom
This
may
is
the
follow
most
Duties
common
different
and
types
of
important
tariff
type
systems,
of
trade
such
as
restriction.
single
Different
column
countries
tariff
system,
conventional tariff system or preferential tariff system.
In
single
column
tariff
system,
consistent
treatment
is
given
to
import
of
goods,
irrespective of the origin of the country.
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149
Macroeconomics
09.
International Trade
In
conventional
countries,
tariff
eBook
system,
consistent
treatment
is
given
to
except to those countries with whom the domestic country
imports
from
has entered
all
into a
specific treaty.
In
preferential
treatment
When
system,
because of racial,
tariff
numbers,
tariff
duty
etc.),
is
it
referred
the value of commodities,
When a d u t y
and
to
is
protect
levied
the
on
from
some
political, or regional
imposed
is
imports
on
physical
units
to as spec ifi c duty,
it is referred
imported
producer
from
supports
its
countries
are
given
preferential
reasons.
of
commodity
(for
example,
whereas when tariff duty
tones,
is imposed
on
to as ad-valorem duty.
products to
incurring
increase
losses,
its
such
price
type
in the domestic country
of
duty
is
referred
to
as
compensatory tariff.
When
duty
any
country
is levied
on the
exported
products
by
subsidy,
then
the
countervailing
imports of such similar or substitute products in order to make sure
the protection o r i g i n a l l y intended.
Licenses
Some
countries
country
many
are
require
required
to
importers can also
country.
license
get
to
import
licenses
restrict the
Export licenses have been
to
or
export
import
goods.
foreign
Importers
goods.
Not
issuing
h i g h quantity of product or service
used
of
domestic
licenses
import
to
into that
to control trade with some countries.
Quantitative Restrictions
These
period.
in
restrictions
This
is
legally
because
prices of goods and
their
production.
country,
and
but the
Like
limit
quantity
it creates shortages
services.
tariff,
extra
the
Then,
quota
money
can
on
goods
in the
domestic
too
spent
of
be
to
imported
import countries,
producers
profitable
foreign
be
goods
raise
which
lead
producer
the
foreign
given
to a
their prices and
for the
benefit
during
rise
expand
of a domestic
government,
not the domestic government.
Quota
restricts the total amount of goods to
the imports of an
i n d i v i d u a l importer.
be imported,
while import
licensing
restricts
The quantitative restrictions are very common.
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09.
Internationa
Trade
eBook
Embargo
Sometimes
countries
because of political
ban
exports
reasons-this
and
imports
on
some
is known as embargo.
It
with some countries or any particular country is banned,
specified
group
is also observed
u s u a l l y for
political
of
products
that all trade

reasons.
Standards
Standards
are
Sometimes
laws,
countries
rules
create
or
regulations
health
and
that
safety
higher than those for commodities produced
countries
standards
for
use
to
restrict
imported
imports.
goods
that
are
in the domestic country.
Subsidies
The government
international
money
pay
to
motivate
this
shortage,
practice
domestic
costs
Exchange
involves
Though
Instead
and
its domestic producers so that they can compete with

of
imposing
producers
they
charge
for
less
tax
more
for
on
imports,
exports.
the
goods
the
Producers
government
use
produced
by
gives
this
money
them
than
to
the
producers.
Foreign
This
competitors.
production
foreign
pays subsidies to
control
system
but
under
Restrictions
now,
and
was
it
originally
has
exchange
restriction
been
used
more
control
on
and
the
to
used
sale
and
purchase
moderate
the
to
and
control
regulation
is
to
of
situation
restrict
release
foreign
of foreign
imports.
foreign
exchange.
exchange
The
exchange
general
on
basis of set priorities of imports of some goods.
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Macroeconomics
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9 . 8 Chapter S u m m a r y
International
trade
is
the
exchange
of
goods
or
services
along
international
borders.
Adam
Smith's
Advantage,
Theory
of
Absolute
Heckscher-Ohlin
Advantage,
Theory
of
Trade
Ricardian
is
the
Theory
three
of
Comparative
important
theories
of
trade.
Terms
of
trade
means
the
rate
at
which
country
exchanges
its
goods
for
the
goods of other countries.
Free trade is criticized

o
Cheap
by the government due to the following
imported
goods
may
destroy
local
industries
reasons:
manufacturing
those
goods.
o
Specialization
resulting
from
trade
may
lead
to
lopsided
growth
of
economy.
o
Dependence on other countries may prove fatal
in situations like war.
Some important forms of trade restricts are:

o
Tariffs or Custom
Licenses
Quantitative Restrictions
Embargo
Standards
Subsidies
Foreign
Exchange
Duties
Restrictions
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the
B a l a n c e of
Payments
Macroeconomics
10.
Balance of Payments
eBook
1 0 . 1 Introduction
In the globalized
world,
in the g l o b a l economy.
no country
is self-reliant and
Every country
country
goes
through
from what happens
has to rely on other countries for those goods and
services, which they cannot produce due to limited
When
fully protected
various
import
resources and
and
export
h i g h cost.
transactions,
it
becomes
important for the country to keep a systematic record of all transactions.
Balance of payment systematically records a l l the economic transactions for a particular

period
of time, generally a year.
The main
purpose of keeping
these
records
is to
the international economic position of the country.
After reading this chapter, you will be able to:
Define balance of payments
Identify the accounts associated with balance of payments
List the features of balance of payments
Describe the d i s e q u i l i b r i u m
Identify the causes of balance of payments
List the effects of balance of payments
in
balance of payments
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1 0 . 2 M e a n i n g of Balance of Payments ( B O P )
Balance
of
payments
refers
to
the
systematic
recording
any country with the other countries of the world
of a l l
economic
for a specific period,
transactions
u s u a l l y a year.
Every country has to enter into economic transactions with other countries.
transactions,
it
gets
receipts
and
makes
payments of a country is determined
According
record
payments
to
other
Due to these
countries.
by the difference of receipts and
of
Balance
of
payments.
to Kindleberger, "The balance of payments of a country is a systematic
of
all
economic
transactions
between
residents
its
and
residents
of
foreign countries."
'Systematic
record'
refers
to
double
entry
bookkeeping
system.
'Economic
transactions'
consist of all those transactions that involve the transfer of ownership of goods,
assets,
and
'resident'
money
refers
to
between
the
the
citizens
residents
of that
of a country
country
from
and
where
rest
of the
economic
world.
services,
The term
transactions
have
taken place.
10.3
The
Purpose of B a l a n c e of Payments Accounting
purpose
losses
arising
of
Balance
out
of
of
Payments
international
(BOP)
accounting
transactions
and
to
is
to
measure
correct
the
the
gains
and
trends,
which
are
nation,
which
are
detrimental for a nation's growth.
BOP accounts are made for the following
To
get
information
necessary to
To
find
out
evaluating
on
the
purposes:
strengths
and
weaknesses
of
know the international economic status.

the
overall
gains
and
losses
from
international
transactions
the past year's balance of payments accounts.
To alert the government at the right time for future policy formulation.
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155
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10.
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1 0 . 4 B a l a n c e of Payments Accounts
Balance of Payments
Accounts
Current Account
Fig.
Capital Account
10.4a: Types of Balance of Payments Accounts
Current Account
Current
account
transactions
import of goods and
Items of current
a re listed
contain
and
invisible
trade,
that
is,
export
and
services.
account
transactions
suggested
by
International
Monetary
Fund
(IMF)
below:
Transactions
Foreign travel
Transportation
Insurance premium
Banking
Investment income
Government (purchase and
All
visible
current
account
transactions
sale of goods and services)
have
two
Receivables are shown on the credit side and
counterparts,
that
is,
debit
and
credit.
payables are shown on the debit side.
Capital Account
Capital
account
includes a l l
types of short-term
and
long-term
international
movement
of capital.
Items of capital account transactions are listed
below:
Purchase and
sale of non-financial assets, for example,
Purchase and
sale of land
Cash balance held
Foreign direct investment.
lease.
by foreign ministry.
by foreigners for security against war or any other uncertainty.
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Portfolio investment.
Trade creditors.
Inflow and outflow of foreign exchange.
Balance of Trade
Every
country
export
some
imports
goods
some
and
between exports and
goods
services,
and
services
which
are
from
excess
imports of goods is called
rest
in
of
the
their
world,
country.
and
The
they
also
difference
balance of trade.
Trade s u r p l u s =
Trade deficit =
X > M
M > X
Where,
X =
Exports of goods
M = Imports of goods
10.5
Features of B a l a n c e of Payments
Features of balance of payments are discussed
BOP refers to a period, usually,
BOP
accounting
payments and
Total
credits
adopts
it is an a n n u a l statement.
a double
entry
credit side shows all
and
debits
in
the
below:
bookkeeping
system.
Debit
side
shows
all
should
always
be
of
the
world
and
payments
receipts.
balance
of
payments
statement
equal.
All
economic
systematically
transactions
The debit side and
BOP
be
one
country
and
the
rest
are
recorded.
may
between
in
credit side of BOP accounts are always balanced.
equilibrium
or
disequilibrium.
It
means
if
receipts
are equal, the BOP is in e q u i l i b r i u m .
BOP
is
in
surplus,
if
rece ipts
payments are more than
more
than
payments;
BOP
is
in
deficit,
receipts.
BOP consists of all transactions,
are
visible as well as invisible.
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10.6 Disequilibrium in
When there is a difference
the world,
it is called
Balance of Payments
between
receipts and
in
payments of a country with the
Disequilibrium
rest of
in balance of
payments is of two types:
Favorable balance of payment
Unfavorable balance of payment
Favorable Balance of Payment
When a country
receives
more
from
other countries than
what
it
pays,
the
balance
of
payments is known as favorable balance of payment.
BOP=R>P
Where,
BOP = Balance of payments

R = Receipt from abroad
P = Payments made abroad
Unfavorable
When
Balance of Payment
country
makes
more
payments
to
other
countries
than
what
it
receives,
the
balance of payments is known as unfavorable balance of payment.
BOP=P>R
Where,
BOP = Balance of payments
R = Receipt from abroad
P = Payments made abroad
1 0 . 7 Types of BOP D i s e q u i l i b r i u m
Cyclical
Disequilibrium
Cyclical d i s eq u i l i b r i u m
is
caused
by
fluctuations
in
the trade cycles.
It
is caused
by the
following factors:
Cyclical patterns of income
Different income elasticity
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Balance of Payments
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Different price elasticity
Changes
in
these
trade, which
factors
bring
changes
if prices
increase d u r i n g
will decrease the value of imports;

the
contrary,
if prices fall
the imports;
and can
Fluctuations
in
during
lead
and
during
to deficit
business cycle
prosperity
depression
the
terms of trade and
also
in
the growth
of
leads to a surplus or deficit in the balance of payments.
In any country,
On
in
in
lead
high
elasticity of demand
for imports
to surplus in the balance of payments.

high
elasticity
of demand
will
increase
balance of payment.
demand
reduces the demand
it can
depression,
have an
increases
prosperity,
impact on
for
national
imports
and
income.
low
High
national
income
national
income
during
for imports.
Secular Disequilibrium
Secular d i s eq u i l i b r i u m
occurs
economy,
capital
such
as
technological advancements,
due
to
long-run
formation,
and
deep-rooted
population
dynamic
growth,
changes
territorial
in
the
expansion,
innovations, etc.
The three stages of dynamic change or development of an economy are:

1.
In the first stage,

than
2.
In
imports are more than exports.
inflow of fund, which
the
second
stage,
inflow
which leads to surplus in

3.
In
the
which
third
and
equates
final
the
leads to deficit in
is more
of funds tends to
increase d u e to
increase
in
exports,
stage,
debit
It means outflow of fund
inflow
and
of
credit
funds
side
of
tends
to
eq u a l
the
outflow
balance
of
payments
various
technological
of funds,
account.
This
is
known as favorable balance of payment.
Technological
Technological
innovations
productive
Disequilibrium
of
occurs
production.
factors,
which
as
because
Technological
a
result,
of
changes
influence
the
affect
various
demand
items
inventions
for
in
goods
the
and
and
balance
of
payments.
Innovation
leads
to
promote exports, then
increase
in
it may lead
exports.
If
to d ec l i n e in
the
innovation
is
specially
designed
imports.
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Macroeconomics
10.
Balance of Payments
Structural
Structural
eBook
Disequilibrium
disequilibrium
takes
place
when
structural
economy bring c h a n g e in the forces of demand
and
changes
in
some
sectors
s u p p l y for export and
of
the
imports.
The structural change may be due to:
Exhaustion of some extensively used
Change in the structure of industries
Change in technology
Change in fashion
Change in consumer taste and
Such
The
changes
have a drastic
countries
which
are
preferences
impact
lagging
natural resources
on
the capacity
behind
in
of a country
technological
and
to
export and
industrial
import.
growth
find
it
difficult to face the foreign competition. T h i s may be due to their h i g h cost of production.
1 0 . 8 Causes of D i s e q u i l i b r i u m in B a l a n c e of Payments
Following
are various causes of d i s eq u i l i b r i u m
in the balance of payments:
Development Schemes
Huge
investment
cause
of
demand
in
the
disequilibrium
for
import
of developing
technological
development
in
balance
of capital
countries may
and
not
industrial
due
them
sufficient e n o u g h
not
high
of
increase
of
to
developing
On
in
they
All
Also,
this
are
leads
to
of
to
an
hand,
lagging
face
production
structural
important
countries,
the other
unable
quantity
is
these
because these countries are
production.
export.
countries
Moreover,
industrialization.
development;
cost
in
payments.
increases for
competition
is
to
schemes
the
exports
behind
in
international
produced
disequilibrium
in
by
the
Price-Cost Structure
Prices
increase
reduction
in
due
to
increase
exports.
Changes
quantity of exports and
Changes in Foreign
With
an
become
an
increase
costlier.
external
in
value
of
in
wage
rate,
price-cost
create d i s e q u i l i b r i u m
cost
of
raw
structure
material,
of
export
etc.,
which
industries
leads
affect
to
the
in the balance of payments.
Exchange Rates
the
This
in
external
makes
money
value
of money,
imports
balance of payments
declines,
imports
become
unfavorable.
become
In
costli er
cheaper
the
and
and
exports
same way,
exports
Page
when
become
160
Macroeconomics
10.
Balance of Payments
cheaper.
Therefore,
disequilibrium
Demonstration
increase
changes
the
rate
of
exchange
are
also
one
of
the
causes
of
Effect
has
great
countries want
in
in
in the balance of payments.
Demonstration
developed
eBook
imports
of
impact
to
the
follow
on
the
people.
According
to
lifestyle of developed
less-developed
countries
and
people
Nurkse,
countries.
creates
This
in
leads
d i s eq u i l i b r i u m
less
to an
in
the
International
Borrowing and
Borrowing
lending
the
and
balance
tends to
be
of
from
payments.
unfavorable,
Lending
other
Usually
while the
countries
the
is
also
balance
balance of
of
the
cause
payments
for
of
payments of the
the
the
borrowing
lending
country
in
country
tends to
be favorable.
Cyclical
During
Fluctuations
depression,
As a result,
exports fall
the declined
due to fall
in
the
incomes of people
exports of these countries
in
foreign
produce d i s eq u i l i b r i u m
countries.
in the balance
of payments of the domestic country.
Newly Independent Countries
These
on
countries
the
want
to
establishment
develop
international
of embassies,
business
missions,
etc.,
in
relations,
other
spend
countries.
heavy
This
amount
affects
the
balance of payments and creates d i s e q u i l i b r i u m .
Population Explosion
Population
cause
of
explosion
adverse
in
under-developed
balance
of
payments.
countries like India decreases exports and
Natural
Natural
and
developing
Increasing
countries
rate
of
is another
population
in
important
developing
increases imports.
Factors
causes,
production
in
such
as
country,
floods,
which
in
droughts,
turn
earthquakes,
reduces
the
exports
etc.,
and
adversely
increases
affect
the
imports.
This
makes the country's balance of payments unfavorable.
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10.
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1 0 . 9 Effects of Adverse B a l a n c e of Payments

Following
are the effects of adverse of balance of payments:
It results in
increase in economic dependency on foreign countries.
Economic dependence on other countries generally
The country's foreign exchange reserves are exhausted.
The country's economy is exploited.
Growth of economic development of the country decelerates.
International
interference
increases
political sphere, economic sphere,
in
the
social
leads to political dependence.
domestic
sphere,
country's
spheres,
such
as
etc.
1 0 . 1 0 Measures to Correct Adverse B a l a n c e of Payments

Adverse
balance
of
payments
can
be
corrected
through
monetary
measures
and
non-monetary measures.
Monetary Measures
Deflation
It
refers
to
reduced,
that
which
monetary
in
turn
policy
under which
reduces the
prices
and
the
money
the
in
the
prices of goods
income
of
payments can
people
a domestic country
tend
to
reduce
Central
quantitative methods.
increases
imports.
is
the
Thus,
exports,
adverse
and
fall
balance
in
of
be corrected through deflation.
Devaluation
When
the
regards
government
to
foreign
costlier and
the
in
of the country
incomes of the consumers.
Bank controls the money supply through qualitative and
Fall
supply
Exchange
When
in
currencies,
country
it
is
exports cheaper. Thus,
decreases
known
it
the
value
as devaluation.
of
This
the
currency
makes the
with
imports
leads to favorable balance of payment.
Depreciation
Depreciation
decline
of
of currency
the
rate
is
the
of exchange
result
of
one
of
forces
currency
supply of foreign currency exceeds
of demand
with
its demand
regard
in
the
and
to
supply.
It
means
another currency.
market,
it means that
the domestic currency depreciates in value.
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10.
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Exchange Control
The Central
Bank of the country controls the use of foreign exchange.
permission of Central
Bank,
Without the
no one can get the benefit of foreign exchange as this
is the only reserve that lies with Central Bank. Therefore,
imports can be restricted
and controlled through this method and d i se q u i l i b r i u m can be corrected.
Export
Promotion
Volume of exports can be increased

should
be given
by reducing
restrictions and duties.
Industries
special facilities to increase the volume of exports, which
helps to
correct the adverse balance of payments.
External
In
this
adverse
Debts
measure,
position
credit and
government
of
balance
secures
of
loans
payments.
from
Loans
foreign
from
countries
foreign
to
correct
countries
its
create
help the country correct the adverse balance of payments.
Non-monetary Measures
Discouraging Imports
To
correct
adverse
balance
of
payments,
imports
are
reduced
by
the
following
ways:
o
Levying
new
import duties
or
increasing
the existing
rate
of
import
duties.
This makes imports costlier a n d , thus fall in the quantity of imports improves
the adverse position of balance of payments.
Imports
are
reduced
imports
are
fixed
by
by
fixing
the
import
quotas.
government.
Quotas
Restriction
on
on
the
volume
imports
helps
of
in
correcting the adverse balance of payments.
Volume of imports can

domestic
country.
be reduced
This
method
by
is
producing a substitute of import in the
also
helpful
in
correcting
the
adverse
Other Measures
Encouragement to Foreign Investment
Foreign
investment
schemes and
can
be
encouraged
concessions schemes.
by
offering
different
Investment of a foreign
kinds
of
incentive
country constitutes a
credit item a n d , t h u s adverse balance of payments is corrected.
Page 1 6 3
Macroeconomics
10.
Balance of Payments
Attraction to
Foreign
Foreign Tourists
tourists
currency with
developing
eBook
should
them
be
attracted
to
that serves the same
recreation
parks
and
home
country
as
they
purpose as exports.
entertainment
bring
Government
programs
to
attract
foreign
is also
foreign
tourists.
Liberal
Industrial
Policy
Liberal industrial policy always encourages export and
import substitution, which is
helpful in correcting the adverse balance of payments.
1 0 . 1 1 Advantages of B a l a n c e of Payments
Following are the advantages of balance of payments:
Balance
of
payments
indicates
the
economic
situation
of the
country.
Developed
and economically-sound countries always have favorable balance of payment while

countries
having
unfavorable
balance of
payment are considered
as economically
sick.
Changes
that
occur
in
the
economy
at
different
periods
can
be
reflected
in
the
balance of payments position.
Balance
of
payments
indicates
the
level
of dependence
of
country
on
foreign
countries.
Balance of payments gives details of foreign
It also
reveals the
country.
In
the
country from
income earned
same
way,
its foreign
it
by the
reveals
inflows and outflows.

foreigners from
the
income
earned
their
by
investment
the
residents
Status of balance of payments helps in effective planning for future.
On
basis
of
the
of the
investment.
the
in
balance
of
payments
statistics,
policies
for foreign
trade
can
be
formulated.
Balance
of
payments
status
is
helpful
to
international
d e t e r m i n i n g the amount of financial help required
financial
institutions
by a country.
Page
164
in

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Measurement of National Income

Concepts of National Income

Measurement of National Income

Measurement of National Income

Economic Development of the Developing

Objectives of Macroeconomic Policy

Objectives of Monetary Policy

Definition of Macroeconomic Policy

Economic Growth and

Factors of Economic Grow th

Theories of Economic Growth

Phases of Business Cycle

Causes of Business Cycle

Principles or Canons of a Good Tax System

Role of Government in Different Economies

Theories of International Trade

Classification of Terms of Trade

Forms of Trade Restrictions

Definition of International Trade

10. Balance of Payments

Purpose of Balance of Payments Accounting

Balance of Payments Accounts

Features of Balance of Payments

Effects of Ad verse Ba la nee of Payments

Measures to Correct Adverse Balance of Payments

know why and

study of macroeconomics w i l l end

part of economic science,

After reading this chapter,

Discuss the o r i g i n and growth of macroeconomics

State the importance and

Identify the indicators of macroeconomics

between microeconomics and

determine the fiscal

behavior of the economic

in the balance of trade and

is the study and

employment, prices and foreign trade."

i n d i v i d u a l output but with the national output."

Macroeconomics has shown

before the Keynesian

and the post-Keynesian developments.

there is any unemployment,

then the economy will always

in a state of full employment

The great depression of 1 9 3 0 s proved

in the l ong- run and

remain so for a short time.

classical theory wrong

The downfall of classical

macroeconomics gave rise to the

This problem of depression gave another view

point to Keynes and

Keynes' theory focused on the employment, growth, and

by change in the aggregate d e m a n d .

fluctuations are caused due to the shortage of d e m a n d .

rise to various thoughts and

Monetarism: A Counter Revolution

point that monetary

reason that causes a c h a n g e in aggregate

countries, especially the United

that the great