1. The document discusses key macroeconomic concepts including aggregate demand, aggregate supply, and the circular flow of income in a basic two-sector economy consisting of households and firms. 2. It then expands the model to a four-sector economy, adding the government and external sectors and their interactions. 3. Key macroeconomic variables are defined including national income, consumption, investment, savings, capital formation and employment.

1. UNIT 4 MACRO ECONOMICS
UNIT 5 AGGREGATE SUPPLY AND
ROLE OF MONEY

2. RECAP
• As for now we learned various aspects of
micro economics
– Demand
– Supply
– Cost of production
– Pricing strategies…. Etc
We know turn our attention to macro economics.

3. MACRO ECONOMICS
• Macro economics- (macro means large).
– It is the branch of economic analysis that deals
with the study of aggregates namely with the
performance, structure and behavior of economy
as a whole.
– So we would know discuss
• Aggregate demand
• Aggregate supply
• National income
• General price structure
• Movement of economic activity

4. CIRCULAR FLOW OF ECONOMIC
ACTIVITIES AND INCOME
• The crux of macro economic theory is based
on the circular flow of income
– The basis of this flow is the economic
interdependence of consumers and sellers.
– Between whom the circular flow of production of
goods and services, income and expenditure
takes place.
– Let as start with simple models.

5. TWO SECTOR ECONOMY
• It is the simplest form
• The circular flow of economic activities and
income assumes that there are only two players
in the economy
– Namely consumer (household)
– Firms(producer)
• There is no government intervention in
economic activities .
• The country neither imports goods and services
nor exports anything.

6. TWO SECTOR MODEL
CONSUMPTION
EXPENDITURE
SAVINGS
FINANCIAL
HOUSE HOLDS MARKETS FIRMS
INVETME
NSTS
Goods/ services
FACTOR
PAYMENTS

7. ..CONTD
• HOUSEHOLD
– Set of individuals who live together and take joint
decisions about consumption of goods and
services.
• FIRM
– It is used to describe the basic selling unit of
consumption
– It provides consumers with goods and services.
• How the house hold and firm
interdependence…….* (money flow between
them)

8. ..contd
• SAVINGS
– It is the with drawl of money from the circular flow
• INVESTMENTS
– It is the injection of money in circular flow.
• The with drawl of money should be equal to
injection of money for the circular flow to
continue undisturbed.
• In other words planned saving = planned
investment

9. MATHEMETICAL EXPRESSION
• In such a simple two sector economy the
value of output produced (Y) is equal to value
of output sold (O).
• The total income is used either for purpose of
consumption or for investment.
• Since the value of output sold is equal to the
sum of consumption expenditure and
investment expenditure

10. …contd
• Y = O= E
• Y= C+S
• THUS
– E= C+I
– C+S= C+I
Y= INCOME E= EXPENDITURE O= OUTPUT
C= CONSUMPTION EXPENDITURE
I= INVESTMENT EXPENDITURE

11. FOUR SECTOR ECONOMY

12. FOUR SECTOR ECONOMY
REMITTANCES FOR
PURCHASES
TAXES
GOVERNMENT
FACTOR PAYMENTS
SAVINGS INVESTME
FINANCIAL NTS FIRMS
HOUSE HOLDS
MARKET
CONSUMPTION
EXPENDITURE
FOREIGN NATIONS
EXPORTS IMPORTS

13. FOUR SECTOR ECONOMY
• The two sector model has been introduced to
help you understand the more complex real
life situation.
• Every economy actually has two more sectors
besides the consumers and producers
– Government and external sector
• The development of basic infrastructure like
roads, electricity, communication and
security is essential for growth of a system.

14. ..contd
• These facilities are created by government
therefore total expenditure in an economy will
not only consist of C+ I but also of government
expenditure (G)
– TOTAL EXPENDITURE = C+I+G
• At the same time government receives revenue
from different sources such as taxes , interest on
loans and profit on investments.
– Y= C+S+T
• Since in equilibrium expenditure is equal to the
income earned
– C+I+G = C+S+T

15. …CONTD
• The every economy interacts with other
economies through international trade
– Flow of capital, other inputs, technology, services
and people.
• The households, firms and government interact
with the foreign country through exports and
imports of goods and services capital investments
…etc
– Hence there is a fourth sector in the economy known
as external markets

16. …contd
• In a circular flow that occurs in an open
economy with 4 sectors the national income is
measured by aggregate expenditure that
includes
– Consumption expenditure, government
expenditure and net of exports (X-M)
– X- exports M- Imports
– Y= C+I+G+(X-M)

17. MACROECONOMIC VARIABLES
• In the circular flow of income we had referred
to terms like
– Aggregate consumption and expenditure
– Savings and investments
• Here we are going to study the importance of
macro environment from the perspective of
an individual firm.

18. AGGREGATE DEMAND AND
AGGREGATE SUPPLY
• Aggregate demand
– The sum of demand for all the goods and services
by all consumers for a given period of time may be
termed as aggregate demand.
– Aggregate demand refers to aggregate
expenditure made by the society as a whole.
– The aggregate demand (AD) consists of 2
components
• Aggregate demand for consumer goods(C)
• Aggregate demand for capital goods (I)
• AD= C+I

19. …CONTD
• Aggregate supply
– It refers to the supply of all goods and services in
the economy for a given period of time.
– Aggregate supply consists of supply of consumer
goods where capital comes from savings (s)
hence.
– AS = C+S
C+S= C+I = Y (AS= AD)

20. XAXIS – INCOME
YAXIS - EXPENDITURE
AS=C+S AD=C+I
E* C
E
EXPENDITURE
I
Y
INCOME

21. GRAPH - INFERENCE
• The aggregate supply curve (AS) starts from
origin because unless there is some income
there can be no supply.
• Consumption curve(C) starts from origin.
Irrespective of income level there will be some
consumption.
• E is the equilibrium
• OE = EXPENDITURE OY= INCOME.

22. STOCKS AND FLOWS
• Before determine the national income it is
necessary to understand the difference between
stocks and flows.
• Stock
– It may be defined as economic variable which has
been accumulated at a specific point of time.
• Examples – money ,assets and wealth
• Flow
– It includes the variables with increase (inflows) and
decrease (outflows) the stock
• Example – income, consumption, saving and investment
over a period of time

23. ….contd
• Mathematically a stock can be seen as an
accumulation or integration of flows over
time, with outflows subtracted from the
stock.
• Stock
– Inventory
• Incoming goods(inflow)/outgoing goods (outflow)
– Bank balance
• Deposits / with drawls

24. INTERMEDIATE AND FINAL GOODS
• INTERMEDIATE GOODS
– It is also known as producer goods because they
are used as inputs in the production of other
goods
– They include partly finished goods or raw
materials
– In the production process intermediate goods
either become part of the final product.

25. …contd
• FINAL GOODS
– This goods are ultimately finished goods
– They are not used for production of another good.
– This goods are demanded by the final consumer .
Example – SAIL – PRODUCING STEEL
IT IS A FINISHED GOOD BUT ACT AS A
INTERMEDIATE GOOD FOR AUTOMOBILES

26. CAPITAL FORMATION
• When we refer to an individual – it is
investment.
• But when we talk in terms of country – it is
capital formation.
• The process of saving is converted into
investment is known as capital formation
• It is defined as the enlargement of capital
stock.

27. ..contd
• FIXED CAPITAL STOCK
– It includes equipment, buildings and machinery used
in the production of goods and services
• GROSS PRIVATE INVESTMENT
– It is the business spending on equipment, residential
structures and inventories
– It is the net investment + depreciation
• GROSS CAPITAL FORMATION(GCF)
– It refers to the aggregate of additional to fixed assets
(fixed capital formation)

28. …contd
• Rate of capital formation is the measure of
growth of an economy because it determines
the volume of investment in future.
• The higher the rate of capital formulation
higher is the increase in production of goods
and services and hence higher is the
economic growth of the economy.

29. EMPLOYMENT
• This is the another very important macro variable
that affects the national economy.
• Employment
– It is defined as a where a person who is willing and
capable to work in a productive activity is engaged
for certain number of hours per week.
• The population of any country is divided into
working population and dependents.
• People under the age group (21- 60) are under
working population and remaining as dependent.
• Every country tries to achieve full employment
so that maximum economic growth with
maximum social welfare can be achieved

30. GOVERNMENT EXPENDITURE AND
REVENUE
• Government expenditure takes may forms
– It includes spending on capital goods and
infrastructure(road, power, communication)
– Spending on defense goods, education, public
health civil administration, police, subsidies on
various goods.
– Procurement of certain items of mass
communication and so on.
– All government expenditure is included in national
output.

31. .. contd
• Another type of expenditure known as
transfer payments
– It is refers to payments made to certain sections of
the society as a social welfare measures.
– It is an exchange of purchasing power from one
group of people to another.
• It includes unemployment compensation , retirement
pensions etc.
• Since the receivers of such payments (such as old,
handicapped) do not contribute to national output
therefore such payment refers toa s transfer payments

32. CONCEPTS OF NATIONAL INCOME
“ National income or product is the final figure
you arrive at when you apply the measuring
rod of money to the diverse apples, oranges,
battleships and machines that any society
produces with its land, labor and capital
resources.”
PAUL A.SAMUELSON

33. …CONTD
• One of the most important concepts in all
economic systems is that of national income
• It is used to measure the economic performance
of an economy as a whole.
• Measures of national income and output are
used to estimate the value of goods and services
produced in an economy.
• Calculation of national income requires adding
together all final goods and services produced in
a country in a given year.

34. DEFINITION – NATIONAL INCOME
“National income is defined as the money
value of all the final goods and services
produced in an economy during an
accounting period of time, generally one
year”

35. COMMON MEASURES OF NATIONAL
INCOME
• GDP (Gross Domestic Product)
• GNP (Gross National Product)
• NDP (Net Domestic Product)
• NNP (Net National Product)

36. GDP
“GDP is the sum of money values of all final
goods and services produced with in the
domestic territories of a country during an
accounting year”
• It includes income from exports and payments
made on imports during the year.
• It does not include the earnings of nationals
working abroad as also of the foreign
nationals working in our country.

37. …contd
• Many domestic companies which have their
branches or subsidiaries in foreign countries .
• As also subsidiaries and branches of foreign
companies in your home country.
• The outputs produced by all business are not
included in the GDP of the country.
• GDP measures the final output not the
intermediate goods.
• It also excludes items produced in previous years.
GDP = C+I+G+(X-M)
C= CONSUMPTION EXPENDITURE
I= INVESTMENT X= EXPORT I=IMPORT
G= GOVERNMENT EXPENDITURE

38. GDP AT FACTOR COST/GDP AT
MARKET PRICE
• GDP is the money value of goods and services.
• Money flows in an economy in a circular manner
from producers to consumers and back from
consumers to producers.
• So goods and services can be converted in
monetary terms in two ways
– By using the market value of goods and services.
– By using payments for factor inputs.
• The values of GDP whether estimated at market
price or at factor cost must be identical to each
other. (market price= factor cost)

39. …contd
• But in real life market value of goods and
services is actually not the same as the cost
involved in their production.
• GDP at market price includes indirect taxes
and excludes subsidies given by the
government.
• GDP at factor cost would include transfer
payments which do not contribute to national
income
– GDP at factor cost = GDP at market prices –
indirect taxes + subsidies

40. GROSS NATIONAL PRODUCT (GNP)
• GNP is the aggregate final output of citizens
and businesses of an economy in a year.
• The difference between GNP and GDP arises
because of the fact that a part of any
country’s total output is produced by factors
which are actually owned by other nations.

41. GNP = GDP +NFIA
GNP = C+I+G+(X-M)+NFIA
GDP – GROSS DOMESTIC PRODUCT
NFIA – NET FACTOR INCOME FROM ABROAD

42. NFIA
“Net factor income from abroad (NFIA) is the
difference between income received from
abroad for rendering factor services and
income paid towards services rendered by
foreign nationals in the domestic territory of
a country”

43. NET DOMESTIC PRODUCT AND NET
NATIONAL PRODUCT (NNP)
• While calculating GDP or GNP we ignore
depreciation of assets or capital
consumption.
• In reality the process of production uses up a
certain amount of fixed capital by way of wear
and tear by a process termed as depreciation.
• In order to arrive at NDP or NNP we deduct
depreciation from GDP or GNP.

44. …..CONTD
• NDP = GDP – DEPRECIATION
• NNP= GDP – DEPRECIATION +NFIA
• NNP = C+I+G+(X-M)-DEPRECIATION + NFIA

45. NNP AT FACTOR COST (NATIONAL
INCOME)
“Net national product at factor cost is the net
output of an economy evaluated at factor
prices or it is the sum total of all income
earned by all the people of nation with in the
national boundaries or abroad.”
NNP AT FACTOR COST = NNP AT MARKET PRICES
- INDIRECT TAXES +SUBSIDIES

46. REAL AND NOMINAL NATIONAL
INCOME
• National income is obtained by multiplying
the output of goods and services by their
prices.
• Which price should use in this calculation…?
• There are two practices
– We may use either current or constant prices.
• All the different concepts of national income
GDP , GNP, NNP can be expressed in terms of
current price or constant price.

47. …contd
• Current prices are the prices prevailing in the
year in which national income is calculated.
• The national income is estimated at the
prevailing prices it is called national income
at current prices or nominal national income
or money national income.

48. ..contd
• The national income is measured on the basis
of some fixed price
– Say price prevailing at a particular point of time
or by taking a base year it is known as national
income at constant prices or real national
income.

49. WHY WE NEED 2 VALUES OF
NATIONAL INCOME
• MARKET PRICE OF PRODUCT X = 100 (2010)
• MARKET PRICE OF PRODUCT Y = 150 (2011)
• QTY PRODUCED AT BOTH YEARS – 100
• NOMINAL NATIONAL INCOME (2010)- 10000
• NOMINAL NATIONAL INCOME (2011)- 15000
• The difference between the national is due to
inflation.

50. REAL GDP
• Real GDP = NOMINAL GDP / GDP deflator.
• Real GDP measures changes in the physical output in
an economy between different time periods by valuing
all goods in the two periods at the same prices.
• GDP deflator as the ratio of nominal GDP in a year to
real GDP of that year
• GDP deflator measures the change in prices between
the base year and the current year.

51. PER CAPITA INCOME (PCI)
• The average income of the people of a
country in a particular year is called per
capita income.
• In simple words it is income per head of a
country for a year.
• Per capita income can be arrived at dividing
national income by total population of the
country.

52. …contd
• Per capita income = National income /
total population
• Per capita income is calculated on the basis of
national income therefore it can be referred to
as per capita NNP or per capita GNP or per
capita GDP.

53. PERSONAL DISPOSABLE INCOME
• Personal income
– It is the total income received by the individuals of a
country from all sources before direct taxes in one
year.
– It is derived from national income by deducting
undistributed corporate profits, profit taxes and
employees contributions to social security schemes.
– It is gross income of households before payment of
personal taxes.
– It also includes transfer payments received by
households

54. PERSONAL INCOME
• Personal income = national income –
undistributed corporate profits – corporate
taxes –social security contributions + transfer
payments + interest on public debt

55. … contd
• The entire amount of personal income cannot
be spent by the house hold on consumption
and saving because direct taxes to be paid out
of this income.
• Disposable income or personal disposable
income means the actual income which is
available to be spent on consumption by
individuals and families.

56. PERSONAL DISPOSABLE INCOME
• PERSONAL DISPOSABLE INCOME =
PERSONAL INCOME – PERSON AL TAXES
• Personal disposable income includes income
earned by individuals in any form say
– Salary, bonus, incentives, fringe benefits and
other allowances dividend etc.

57. MEASUREMENT OF NATIONAL
INCOME
• National income is nothing but the
measurement of aggregate production in an
economy during a definite time period.
• The circular flow enables to look at national
income in three ways
– Flow of production goods and services
– Flow of income
– Flow of expenditure on goods and services.

58. PRODUCT METHOD
• As per the product method of estimating
national income also called as national income
by industry of origin.
• The market value of all the goods and
services produced in the country by all the
firms across all industries are added up
together.

59. PRODUCT METHOD - STEPS
• THE ECONOMY IS DIVIDED ON THE BASIS OF INDUSTRIES
STEP 1 • EXAMPLE – AGRICULTURE, MINING, POWER ETC
• THE PHYSICAL UNITS OF OUTPUT ARE THEN INYER)PRETED IN MONEY
STEP 2 TERMS (MARKET PRICE OF ALL PRODUCTS
• THE TOTAL VALUES OBTAINED ARE ADDED UP
STEP 3
• THEI INDIRECT TAXES ARE SUBTRACTED AND SUBSIDIES ARE ADDED THIS
STEP 4 GIVES GDP /GNP (ACCORDING TO DATA WE USED)
• THE NET VALUE IS CALCULATED BY SUBTRACTING DEPRECIATION FROM
STEP 5 THE TOTAL VALUE THUS OBTAINED IN ORDER TO ARRIVE AT NNP

60. EXAMPLE
• If a manufacturer sells a laptop to a retailer for
Rs 25000
• And the retailer sells it to the consumer at Rs
30000.
• How much has the laptop contributed GDP ? Is it
30000?...................
• No …. If we do that it would be double counting
• Instead we would either count the final value or
the value added at each stage.
• So the product method calculated by
– Final product method
– Value added method

61. ….contd
• Final product method
– According to this method the total value of final
goods and services produced in a country during a
year is calculated at market prices.
– To find out GDP the data of all productive
activities are collected and accessed in market
prices.
– No intermediaries goods are taken into account

62. ..contd
• Value added method
– It measures the contribution of each producing
enterprise of the economy.
– The difference between the values of material
outputs and inputs at each stage of production is
the value added.
– If all such differences are added up for all
industries in the economy we arrive at GDP.

63. LIMITATIONS OF PRODUCT METHOD
• Problem of double counting.
• Not applicable to tertiary sector.
– This cannot be applied to service sector.
• Exclusion of non marketed products

64. INCOME METHOD/NATIONAL INCOME
BY DISTRIBUTIVE SHARES
• According to income method it is net income
received by all citizens of a country in a
particular year that is added up.
– That is total of net rents, net wages, net interest
and net profits.

65. INCOME METHOD- STEPS
• THE ECONOMY IS DIVIDED ON BASIS OF INCOME GROUPS
• EXAMPLE- PROFIT EARNERS, WAGE/SALARY EARNERS,
STEP 1 RENT EARNERS ETC.
• INCOME OF EACH OF THESE GROUPS IS CALCULATED
STEP 2
• INCOME OF ALL EARNERS IS ADDED INCLUDING INCOME
FROM ABROAD AND UNDIATRIBUTED PROFITS
STEP 3

66. GNP AT FACTOR COST
• GNP AT FACTOR COST
= RENT + WAGE + INTEREST + PROFIT + OTHER
INCOME + (INCOME FROM ABROAD - PAYMENTS
MADE TO FOREIGNERS ) – TRANSFER PAYMENTS

67. LIMITATIONAS OF INCOME METHOD
• Exclusion of non monetary income
– Example= ignores non monetized section of the
economic activities such as farmer and family
working in own field./kirana shops.
• Exclusion of non marketed services
– House wife and mother services

68. EXPENDITURE METHOD
• According to this method the total
expenditure incurred by the society in a
particular year is added together to get that
year’s national income.
• The expenditure includes
– Personal consumption expenditure
– Net domestic investment
– Government expenditure on goods and services
– Net foreign investments

69. …contd
• Consumption expenditure
– Consumption is the largest and most important of
the flows.
– When individual receives income they can spend it
on domestic goods/foreign goods and services.
– They pay taxes and save the rest
– Personal consumption expenditure refers to
payments by households for goods and services

70. ….contd
• Investment expenditure
– This divided into 3 major categories
• Capital spending
– Purchas of new materials and equipments by firms
• Residential construction
– Construction of housing units
• Inventory investment
– Unsold portion of output

71. ..contd
• Government expenditure
– Government payments for goods and services
– Investment in equipments and structures
• Net exports
– Spending on imports is subtracted from total
expenditure on exports.
– exports to foreign nations are added to total
expenditure.

72. LIMITATIONS – EXPENDITURE METHOD
• Neglects barter system
• Ignores owns consumption
• Affected by inflation

73. USES OF NATIONAL INCOME DATA
• It is necessary for economic planning
• It is indicator of economic growth
• It is help in comparing the situations of
economic growth in two different countries.
• It is used to determining the regional
disparities.
• It is considered as a measure of economic
welfare.

74. DIFFICULTIES IN MEASUREMENT OF
NATIONAL INCOME
• Non monetized transaction.
• Unorganized sector.
• Multiple source of earnings.
• Categorization of goods and services.
• Inadequate data.

75. MONEY SUPPLY AND INFLATION

76. DEMAND AND SUPPLY OF MONEY
• The value of money is governed by the forces of
demand and supply.
• Money is in demand because all the
commodities which have utility are available in
exchange for money.
• Functions of money:
– Medium of exchange
– Measure of value
– Store of value
• It can be saved for future with convenience

77. DEMAND FOR MONEY
• Economist have proposed many theories to
explain the demand for money the some of
theories are
– Quantity theory of money
– Cash balance approach
– Income expenditure approach
• Keynes has identified three basic motives of
people to hold money
– Transaction motive
• Income motive(consumers) and business motive(producers)
– Precautionary motive
– Speculative motive

78. ..contd
• Money may be demanded as flow
(transaction motive) as well as stock
(precautionary motive).
• Money as a flow is that which is in circulation.
• Where as total money supply at any point of
time will consist of money in circulation as
well as in stock(various form of savings and
deposits)

79. SUPPLY OF MONEY
• Modern form of money is simply pieces of paper
or numbers in a ledger.
• The piece of paper is as much worth as it can get
you things you wanted.
• It is like a promissory note issued by a relevant
authority (RBI on behalf of Indian government)
• As long as the trust with the government the
piece of paper continues to be valuable.
• Such a currency is called as fiduciary issue(based
on trust and confidence)

80. HISTORY OF EVOLUTION OF MONEY
• Earlier money was in the form of coins,
generally composed of precious metals such
as gold, silver and copper.
• The value of coins was roughly based on the
value of the metals.
• Such a monetary system caused wear and tear
of metal and it was difficult to carry huge
amount of money fro one place to another.
• Support of paper money introduced.

81. … contd
• The paper money in different countries was
based on the gold standard or silver standard or
combination of two.
• This meant that you could take some paper
money to the government which would exchange
it for some gold/silver based on the exchange
rate it set.
• India followed the proportional reserve system
up to 1956. (gold and foreign securities were at
least 40% of total reserve)

82. ..contd
• In 1956 this was replaced by fixed minimum reserve
system.
• Practically Indian currency is non convertible in any
precious metal and fiat money that is declared.
• Fiat money
– Under this system any number of notes can be printed as
per needs of the economy.
• The success of this system is depends upon people
faith in the government.
• In India RBI is responsible for money supply and
control

83. CONCEPTS OF MONEY SUPPLY
• Normally money supply is expressed in the
form of two broad measures
– Narrow money
• It includes only very liquid assets like currency
• Example – notes and coins in the hands of public and
demand deposits in the bank
– Broad money
• It includes set of less liquid assets term deposits with
banks.

84. QUANTITY THEORY OF MONEY
• Economist believe that value of money varies
inversely with its quantity.
• The theory asserts that any given percentage
increase and decrease in the quantity of money
will lead to the same percentage decrease or
increase in the general price level.
• Initially the theory was based on the following
– MV = PT
– P = MV/T
• P= GENERAL PRICE LEVEL T= TRANSACTION VOLUME OF
GOODS AND SERVICES M= SUPPLY OF CURRENCY V=
VELOCITY WITH WHICH MONEY CIRCULATES(SPEED MONEY
MOVE FROM ONE HAND TO ANOTHER)

85. EXAMPLE
• Suppose you spent Rs 1000 on 5 commodities
• Thus the money is distributed among five
sellers.
• Each one of whom spends his/her share on
certain other goods.
• Thus the initial sum of Rs 1000 multiplies the
number of times it change hands.

86. …contd
• Over the years the definition of quantity of
money has developed as inclusive of all
money in circulation including currency and
debit.
• The formula for general price level has
emerged.
– P= (MV + M’ V’)/T
– M’ = CREDIT MONEY (CHEQUES) V’= VELOCITY OF
CREDIT MONEY

87. VALUE OF MONEY
• Money is good with limited supply and
unlimited demand.
• Therefore the law of market applies to money
as well.
• As long as people want money it will remain
valuable.
• If money cannot buy anything it is just a
useless piece of paper.

88. ..contd
• Whenever the government changes the size
and design of different denominations the old
currency losses value.
• The sufficient time is given to people to
convert their old money into new currency
through bank( this is what happened in
Europe when countries switched over to
euro)

89. EXAMPLE
• Link between value of money and price of goods
and services.
• 1 kg of orange is sold for Rs 50
• It means Rs 50 = 1 kg
• If 1 kg of orange is available for Rs 60
– What will happen.
• Value of money has declined in terms of oranges
because oranges are expensive now.
• Value of money and price of goods move in
opposite direction.
• Higher price = lower value of money

90. ..contd
• How prices of oranges went up.
– Supply on money increases people have more money
in hand. So demand of oranges increases but supply
remain constant price will go up.
– Supply of goods decreases. Demand same
– Demand for goods increases supply remains same it
will increases price.
• Money supply and price are very tightly
integrated.
• Increase in supply of money is direct cause of
price rise.

91. INFLATION

92. INFLATION
• Inflation is a situation of persistently rising
prices.
• It is also a situation of persistently rising
money supply.
• Inflation is a sate of “ too much money
chasing two few goods”.
• In simple words it can be said that inflation
implies an upward movement in the average
level of prices.

93. …contd
• It is seen as a situation in which volume of
purchasing power (money in hands of
consumers) is persistently more than the
goods and services available to consumers.
• DEFINITION
– Inflation can be defined as persistent increase in
general price level or a persistent decline in real
income of people i.e. decline in value of money.

94. ..contd
• According to the above definition inflation
means things getting more expensive.
• A one time rise in prices due to some external
factor like
– Natural calamity , new tax new wage and salary
structure
• May not be termed as inflation because it will be
automatically corrected.

95. CATEGORISE OF INFLATION
• Economists categorize inflation into two broad
categories
– Price inflation and money inflation
• The price inflation and money inflation have
cause and effect relationship.
• Price inflation is the effect of money inflation.
• When money supply increases persistently it
causes a price inflation too.

96. HOW MONEY CIRCULATION
INCREASES
• Printing of additional currency on demand of
the government to meet its need of
expenditure.
• Other sources of additional money supply are
foreign exchange inflows in the form of
capital such as FDI and FII tourism and other
incomes from abroad.

97. HEADLINE INFLATION
• It is measure of total inflation within an
economy and is affected by areas of the
market which may experience sudden
inflationary spikes, such as food or energy.
• Head line inflation may not present an
accurate picture of the current state of the
economy.

98. INFLATIONARY SPIKES
• It occur when a particular section of the
economy experiences a sudden price rise.
Possibly due to the external factors.

99. HYPER INFLATION
• In Hyper inflation prices increases at such a
speed that value of money erodes drastically
and the economy is trapped between rising
prices and wages.
• It is also known as galloping inflation or run
away inflation

100. STAGFLATION
• This is a typical situation when stagnation
and inflation co exist.
• Industrial production was at its lowest
accompanied by mounting prices
• India too has faced stagflation in the 1970’s.

101. SUPPRESED INFLATION
• It is a state when inflationary conditions exist
but the government makes such policies
which temporarily keep prices under check.
• When these checks are removed inflation
bursts out.
• Example – petrol & diesel prices in india

102. DIS INFLATION
• Disinflation is a process to bring down prices
moderately from a very high level.
• It is a process of keeping a check on price rise
by deliberate attempts.
– Example = government of India has set a target
to keep annual inflation below 5%.

103. DEFLATION
• It is a just opposite to inflation.
• It is a state when prices falls persistently.
• Deflation is accompanied by declined in money
income of people.
• When prices falls
– Revenue of sellers falls
– They would thus have less incentive to produce more
– This will result in fall in investment
– Fall in demand for factors of production.
– Fall in money income .

104. ..contd
• Therefore it is often said that if governments
have to make a choice between inflation and
deflation.
• ….what will they choose………?
• Inflation or deflation
– Inflation – because inflation is normally
accompanied by economic expansion.

105. INFLATIONARY GAP
• This term was coined by keynes to describe a
situation when there is an “ excess of anticipated
expenditure over available output at base
prices”.
• This is a gap between effective demand and
supply.
• When money in the hands of people exceeds the
supply of goods and services a gap is created
between demand and supply.
• The situation of price rise due to gap between
demand and supply is known as inflationary gap

106. WAGE PRICE SPIRAL
PRICES
WAGES WAGES
PRICES

107. “Wages chase prices and prices chase wages and
thus create a wage spiral”

108. EXAMPLE – WAGE PRICE SPIRAL
• Mr X is a business head of a consultancy firm.
– His company is known for concern for employees.
• Inflation rate is 5%
– This means a commodity which would be earlier
purchased for Rs 100 can now be purchased for Rs
105.
– Thus it means that consumers real income decreased
by 5%
• To compensate the loss in real income of
employee Mr X granting 5% wage hike.
– This naturally could mean 5% increase in cost of
production.

109. ..contd
• So two option for Mr X
– Either bear the enhanced cost /reduced profit margin
– Shift the burden on consumers by increasing the price
of his product.
• As a rational business man he would keep his
employees happy without eroding his own
profits and naturally would increase the prices.
• Now the chain is created his consumers have to
pay more so they will demand increase in their
incomes from their employers.
• Thus the wage price is created.

110. CAUSES OF INFLATION
• Excess money supply
• Demand pull inflation
• Cost push inflation
• Low increase in supply of goods

111. EXCESS MONEY SUPPLY
• The money inflation precedes price inflation is
known as monetarism.
• For a long period of time money supply was
accepted as the single most important cause
of inflation.

112. DEMAND FULL INFLATION
• Whenever the demand for any commodity
increases other things including supply
remaining the same the natural outcome is
increase in price of that commodity.
• Demand pulls prices up.
• When aggregate demand level increases due
to any reason and supply of output is unable
to match this increased demand that is
known as demand pull inflation

113. REASONS FOR DEMAND PULL
INFLATION
• Increase in money supply
• Increase in disposable income
• Increase in aggregate spending
• Increase in population of the country.

114. COST PUSH INFLATION
• Prices pushed up by the cost is known cost
push inflation.
• Increase in price of any inputs whether fixed
or variable will imply an increase in the cost
of production which may rise in the price of
the product.

115. DETERMINANTS WHICH RESTRAINS
SUPPLY
• Obsolete technology
– Poor technology will hamper supply.
• Deficient machinery
• Scarcity of resources.
• Natural calamities.
• Industrial disputes and external aggressions.
• Built in inflation.
– Built in inflation is a type off inflation that has
resulted from past events and persists in the
present.

116. INFLATION AND DECISION MAKING
• Impact on consumers.
• Impact on producers(or suppliers).
• Impact on government.
• Indexation.

117. IMPACT ON CONSUMERS
• The consumer makes a tentative budget
based on monthly income and expenses.
• Naturally expenses depend upon the prices of
the relevant goods.
• Increase in price of one commodity or a
number of commodities upsets the whole
budget.

118. EXAMPLE
• You have applied for home loan worth Rs 30
lakh.
• Then you find that house prices are swollen by
15% on account
– Due to increase in cement, iron and steel prices.
• You have will have to arrange for another Rs 4.5
lakh or you have to go for small house.
• You will repay this loan and the interest
– Thereupon reducing your monthly income.
• Thus increase in price of one commodity affects
your purchase decisions for many other things of
daily need.

119. IMPACT ON PRODUCERS
• Producers are affected in two ways
– When they are sellers they are benefited by
inflation
• Higher the prices higher are their profits.
– When they have to buy raw material , hire work
force , buy technology or machine they are
aversely affected by inflation.
• You have seen the creation of wage price spiral.

120. IMPACT ON GOVERNMENT
• Government is vested with the responsibility
to take care of the interest of all the sections
of the society.
• At one end it is committed to take the
economy to higher levels of growth by
encouraging production and investment.
• At another end the government duty bound
to see that taxpayer’s money is not eroded
by hyperinflation.

121. ..contd
• The government takes various measures
which keep inflation in check.
• The economists prefer some minimum level
of inflation (keynes sugested 2%).
• By using the monetary policy and fiscal policy
the government achieve the economic
growth

122. INDEXATION
• Indexation is the automatic linkage between
monetary obligation and price levels.
• Indexation reduce the cost of inflation
• It apply to wages, interest and taxes.
• Example
– Employers are forced to index wages against
prices so that gap between money income and
real income may be minimized.

123. MEASURING - INFLATION
• The most common term used to denote
inflation is inflation rate which is actually
annual rate of increase of prices.
• Various measure of inflation are used for
different purposes.
• All these measures are called as indices.

124. PRICE INDEX
• It is numerical measure designed to help
compare how prices of some class of
goods/services taken as whole differ between
time periods or geographical locations.
• Price index reduces all distinct prices for the class
of goods in question to a single number.
• Price index
= current year’s price/base year’s base

125. PRODUCER PRICE INDEX
• PPI measures average changes in prices
received by domestic producers for their
output.
• It measures the pressure being put on
producers by the costs of their raw materials.
• This could be passed on to consumers as
inflation.

126. WHOLE SALE PRICE INDEX
• When inflation is calculated on the basis of
whole sale prices of a wide variety of goods it
is called WPI.
• In India WPI is available on weekly basis.
• It is continuous to be most popular and most
comprehensive measure of economy.

127. CONSUMER PRICE INDEX
• Consumer price index measures the price of a
selection of goods purchased by a typical
consumer.
• CPI are compiles in terms of general standards
and guidelines set by the ILO.
• The commodity basket for these indices is
derived on the basis of group specific
consumer expenditure survey and weights to
each commodity are proportionate to its
expenditure.

128. …contd
• Different counties issue different categories of
a CPI.
• In India 4 types of CPI are
– CPI IW –(INDUSTRIAL WORKERS)
• Is the most well known of these indices as it is used for
wage indexation in government and in the organized
sectors
– CPI UNME –(URBAN AND NON MANUAL
EMPLOYEES)
– CPI AL- (AGRICULTURE WORKERS)
– CPI RL – ( RURAL LABOURERS)

129. …contd
• Central statistical organization has initiated
steps to compile CPI under two broad
categories
– CPI (RURAL)
– CPI (URBAN)

130. COST OF LIVING INDICES
• Cost of living indices are used to adjust fixed
incomes and contractual incomes to maintain
the real value of such incomes.

131. SERVICE PRICE INDEX
• With the growing importance of service sector
across the world many countries have started
developing services price indices (SPI).
• Some agencies have focused exclusively on the
prices of services provided to enterprises.
• In India office of economic adviser, ministry of
commerce and industry started work on
construction of this index numbers selected from
– Services(transport, railways, air transport, port,
banking, post, telecommunication, business services
and trade services)

132. INFLATION RATE
• The formula for calculating the inflation rate
last year’s index – current year’s index
Inflation rate=------------------------------------------x 100
current year’s index

133. INFLATION AND EMPLOYMENT
• A.W.H. PHILLIPS studied the relationship
between unemployment and rate of changes in
money wages.
• Phillips hypothesized that inflation shocks cause
a short term change in behavior of firms and
labor.
• Labors accept jobs at lower pay if they are
unemployed and firms are more willing to hire
due to low wages.
• As out come of this study phillips developed a
curve which is known as phillips curve

134. PHILLIPS CURVE
• This curve widely used to explain the relation
between unemployment and inflation.
• It is assumed that during inflation trade unions
pressurize employers to raise money wages.
• Phillips postulated that the lower rate of
unemployment the higher is the rate of change
of wages.
• Its main implication is that since a particular
level of unemployment in an economy will imply
a particular rate of wage increase.

135. ..contd
• The objectives of low unemployment and low
rate of inflation may be inconsistent.
• Hence government mist choose between the
feasible combinations of unemployment and
inflation.

136. ANNUAL PRISE RISE % ∆P/P
UNEMPLOYMENT %
PHILLIPS CURVE
ANNUAL WAGE RISE % ∆W/W

137. CURVE - INFERENCE
• X AXIS – UNEMPLOYMENT %
• Y AXIS – PERCANTAGE CHANGE IN PRICE
• Giving it a three dimensional effect wages are shown
on the right hand side of vertical axis.
• The values corresponding to the curves are
hypothetical.
• When inflation is zero unemployment is 6 percentage.
• When unemployment is 2% inflation is 4%.
• The curve shows the various combination of
unemployment and inflation

138. ..contd
• So the government may hence trade off
between unemployment and inflation and
choose the most appropriate combination as
per the need of economy.

139. CONTROL OF INFLATION
• Inflation erodes the value of money and how
it discourages savings.
• Zero level inflation is undesirable.
• Therefore governments do not try to reach
zero inflation but still they try to control it.
• Various methods are advocated for controlling
inflation
– Monetary measures(control the money supply)
– Fiscal measures (proposed by keynes)

140. MONETARY MEASURES
• Under monetary measures the central bank of
the country uses various methods of credit
control to keep a check on inflation.
• To control inflation it is necessary that a curb is
put on money supply.
• Some of the important measures adopted by
central bank are
– Increasing the discounting rate
– Higher reserve ratios
– Open market operations
– Selective credit control.

141. ..contd
• Increasing discount rate
– Central bank rediscounts the eligible papers
offered by commercial banks.*(bank rate)
– In this way bank credit becomes costlier and
commercial banks are forced to increase their
lending rate
– Thus money become costlier to public
• Higher reserve ratios
– CRR, SLR ,REPO, REVERSE REPO these rate are
increased by RBI

142. ..contd
• Open market operations
– Central bank may directly sell government
securities to general public and thus restrain
their disposable income.
• Selective credit control
– Central bank advise commercial banks to go for
selective credit control this discourages
consumption but not investment

143. FISCAL MEASURES
• It include government revenue and
government expenditure.
• Reducing public expenditure
– Important tools in the hands of government.
– When government spends money on various
activities(health, transport etc) income of
individuals increases thus turn increases the
aggregate demand.

144. ..contd
• Increasing public revenue
– Major sources of government revenue from taxes
– When government wants to curb peoples spending it
increases various taxes.
– Increases in income tax leaves less of disposable
income in the hands of consumers.
• Increasing supply
– Supply of goods to reduce the demand supply gap
– Increasing imports decreasing exports of the items
which are short in supply.

145. BUSINESS CYCLE

146. BUSINESS CYCLE
• Business cycle is the periodic up and down
movements in economic activities.
• The economic activities measured in terms of
production, employment and income move in
a cyclical manner over a period of time.
• This cyclical movement is characterized by
alternative waves of expansion and
contraction and is associated with alternate
periods of prosperity and depression.

147. FEATURES OF BUSINESS CYCLES
• Periodicity.
– These wavelike movements in income and
employment occur at intervals 12- 16 years.
– The gap between two cycles is not regular or
predictable with certainty.
• Synchronism.
– It happens because of interdependence of various
sectors of the economy.
– The contraction of economic activities in one sector
would lead to recession in many other areas.
• Self reinforcing.
– Cyclical movements faced by one sector spreads to
other sectors in the economy
– The upward swing of the cycle is reinforced for further
upward movement

148. PHASES OF BUSINESS CYCLE
• EXPANSION
– All macro economic variables like output,
employment, income and consumption increase
– At same time prices move up, money supply increases
• PEAK
– This is highest point of growth
– The stage beyond this no further expansion is possible
• CONTRACTION(RECESSION)
– Slowing down process of all economic activities,
– No demand of the product.
• TROUGH(DEPRESSION)
– It termed as slump or depression
– Lowest ebb of economic cycle

149. BUSINESS CYCLE
PEAK
GNP %
EXPANSION
TROUGH
TIME UNIT
(YEARS)C

150. • There are two turning points in the cycle one
at peak when the economy tarts sliding down
and the other at trough when the economy
picks up momentum for another phase of
growth.

151. EFFECTS OF BUSINESS CYCLE
• Effects during expansion
– Inflation
– Severe competition
• Effects during recession
– Excess inventory
– Retrenchment

152. CONTROLLING OF BUSINESS CYCLES
• Measures to business cycles can be categorized
into
– Preventive measures(proactive)
– Curative measures(reactive)
• At firm level
– Precautionary measures
• Investments
• Inventory
– JIT STRATEGY
• Products
– DIFFERENTIATION
• Pricing
– Curative measures

153. ..contd
• At government level
– Monetary measures
• Rediscount rates
– During expansion --- increase rediscount rates(bank rates)
– During recession --- decrease rediscount rates
• Reserve ratios
– During expansion --- Increase ratios
– During recession --- decrease ratios
• Open market operations
– During expansion --- sells government securities
– During recession --- buys government securities
• Selective credit control
– Credit may extend to certain areas and contracted to certain
areas

154. ..contd
– FISCAL MEASURES
• Pubic expenditure
– During recession governments normally use public
expenditure as a tool
• Public revenue
– During expansion governments use public revenue items as
controlling device

155. CONCEPT OF MULTIPLIER AND
ACCELERATOR
• MULTIPLIER
– The multiplier is often referred to as autonomous
expenditure multiplier or investment multiplier.
– Before we dwell deeper into the concept of
multiplier it is important to understand two more
concept
• Marginal propensity to consume (MPC)
• Marginal propensity to save (MPS)
– These two concepts are introduced by keynes.

156. MPC (MARGINAL PROPENSITY TO
CONSUME)
• MPC
– It is the measure of effect of change in total
income on the keenness of people to spend on
consumer goods
– It is the change in consumption expenditure due
to change in income
– MPC = d C / d Y C- CONSUMPTION Y-INCOME

157. MPS (MARGINAL PROPENSITY TO
SAVE)
• MPS
– It is a measure of the effect of change in total
income on the keenness of people to save.
– MPS = d S / d Y S- SAVINGS Y-INCOME

158. MULTIPLIER
• The value of MPC lies between 0 and 1.
– It is assumed that Y increases C also increases but
increase in C is less than increase in Y.
• Where MPS +MPC= 1
• There fore MPS = 1- MPC
• The multiplier measures the effect of certain
amount of capital investment on total
employment /total income /total consumption
– K= 1/(1-MPC) = 1/MPS (MULTIPLIER IS THE
RECIPROCAL OF MPS)

159. ACCELERATOR
• As per acceleration principle, changes in
demand for consumer goods bring about
wider changes in the production of
appropriate capital goods.
• Accelerator measures the relationship
between changes in investment due to
change in national output or national
income.

160. THE END
ALL THE BEST