ECO121 PPTs

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CHAPTER 1
Introduction to Macroeconomics
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Macroeconomics 3 rd ed.
What is Economics?
Economics is the science of wealth.
Adam Smith
Economics is the study of mankind in the ordinary business

of life; it examines that part of individual and social action
which is most closely connected with the attainment, and
with the use of the material requisites of well being.
Alfred Marshall
Economics is the science which studies human behavior as a

relationship between ends and scarce means which have
alternative uses.
John Robbins
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Why do people
economise?
Human wants, desires and
aspirations are endless.
Resources are limited and
scarce.
People are of optimising
nature.
People behave on the basis of
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demonstration effect.
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What is
Macroeconomics?
Macroeconomics is the
study of the behaviour of
the economy as a whole.
It examines the overall
level of a nations output,
employment, prices, and
foreign trade.
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P. A.
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What is
Macroeconomics?
Macroeconomics is essentially the study of
the behaviour and performance of the
economy as a whole. More importantly, it
studies the relationship and interaction
between the factors or forces that
determine the level and growth of
national output and employment,
general price level, and the balance of
payments positions of an economy.

Origin and growth of
Macroeconomics
Mercantilists of 16th century had used
macro approach to some extent but not in a
systematic way.
Foundation of Macroeconomics is literally laid
down by the British economist John Maynard
Keynes (1883-1946).
In the 19th century, Karl Marx used macro
approach to economic analysis of the society.
Post-Kynsian development of theories
established Macroeconomics as a subject.

Basic assumption of microeconomics
and macroeconomics
Optimizing behavior of the consumers, producers

and resource owners of resources is analyzed at
the individual level in Microeconomics.
All studies of the individual decision makers
constitute the subject matter of Microeconomics.
Microeconomics studies aggregate consumption,
production, price level, employment at the
national and international level.
Countrys balance of payments position is the
subject matter of Microeconomics.

Microeconomics Vs.
Macroeconomics
Microeconomics analyses individual decision
making units like personal demand & supply, firms
etc. whereas
Macroeconomics is concerned with economic
aggregates like national income, total employment,
balance of payments. (study of aggregates)
Microeconomics assumes all the macro variables to
be given whereas macroeconomics treats them as
variables.
Machlups View on Micro-Macro Distinction
Narrow/broad
Micro-Macro Paradoxes
Cash holding : Cash holding on individual
level does not affect stock of money at
economy level.
Saving and investment : Personal
returns/profits does not affect savings and
investment of national income/economy
Profit and wages : Microeconomics
assumes distribution of profit and wages
among employers and wage-earners but
macroeconomics considers a large number
of factors for TMH
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Limitations of Classical/traditional
Microeconomics
According to classical school of thought, if
market forces of demand and supply are
allowed to work freely, then
i. there will always be full employment in
the long run, and unemployment, if
any, will be a short-run phenomenon;
ii. there will be neither over-production
nor under-production at the aggregate
level; and
iii. the economy will always be in
equilibrium in the long run.

Limitations of Classical/traditional
Microeconomics
Ignores the structural changes

Aggregates are not a reality but
a picture or approximation of
reality
Some economists consider
macroeconomics only as an
intellectual attraction without
much practical use
The Keynesian
Revolution
The level of output and employment in an
economy is determined by the aggregate
demand given the resources.
The unemployment in any country is caused

by lack of aggregate demand and economic
fluctuations are caused by demand deficiency.
The demand deficiency can be removed

through compensatory government spending.

Problems of developing
countries
Developing countries face
economic challenges on a large
scale. Poverty, low literacy rates,
poor investments in both human
capital and domestic capital poor
nutrition etc. Sub-Sahara African
economies face the challenges
facing developing countries to
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stimulate domestic savings.
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Traditional microeconomic theory
and problems of developing nations
Traditional assumptions do not
resolve the structural problems.
Law of demand and supply are
not effective in mitigating vicious
circle of poverty.
Investment multiplier theory do
not determine the level of
employment
Circular flow in a two sector
model
In a two sector economy,
there are business firms
which produce goods and
services. The other sector is
households which supplies
their factors services to the
firms and also buy, goods and
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services produced by them.
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Macroeconomics 3rd
Circular flow in two
sector model

Circular flow of income in three
sector model
This includes household

sector, producing sector
and government sector. It
will study a circular flow
income in these sectors
excluding rest of the world
i.e. closed economy
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Macroeconomics 3rd
sector model
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Macroeconomics 3rd
sector model
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Macroeconomics 3rd
Circular flow of income in four
sector model
In real life, only four-sector economy
exists.The four-sector economy is
composed of following sectors, i.e.:
(i)Household sector,
(ii)Business sector,
(iii)The government, and
(iv)Transaction withrest of the
worldor foreign sector or external
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Macroeconomics 3rd
Circular flow of income in four
sector model
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Macroeconomics 3rd
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CHAPTER 4
Measurement of
National Income
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Introduction
National income is the single most important macro
variable that represents the economy as a whole.
The level of national income determines the level of

all other macroeconomic variablesaggregate
consumption, savings and investment, employment
and the price level.
The importance of national income accounting lies in

the fact that the performance and behaviour of an
economy are studied on the basis of the performance
of its macroeconomic variables.

National Income
In general sense of the term, national
income refers to the aggregate
money value of all final goods and
services resulting from the economic
activities of the people of a country
over a period of one year.

Economic Production
Economic production refers to the production of
those goods and services which are meant for
sale and have market value, and those goods
and services which are produced and provided
jointly to the people by the government and
public organisations, for which people pay
indirectly through tax payment.
All marketable production is economic

production but all economic production is not
marketable.
Non Economic Production
Non-economic production includes the production of
goods and services that are not meant to be sold, nor
is there any market for them, nor do they have a
market price.
To this category belong mainly the following services:

i. Services rendered to self
ii. Services provided to the family members
iii. Services provided by the neighbours to each other
These services are not included in the measurement

of the national income.

Intermediate and Final
Goods
Intermediate goods- The goods that flow from
one stage to another in the process of production
of a good, with their form changing.
Final goods- The goods that reach the final

stage of production and flow to their ultimate
consumers/ users.
The need for distinction between the

intermediate and final products arises because of
the problem of double counting.

Intermediate and Final
Services
The classification of services under
the intermediate and final product
categories depends on the purpose
of their use.
When used for production purpose,

these services are treated as
intermediate products and when
used for private consumption, they
28are treated as final products.
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Transfer Payments
Transfer payments are the payments
made by people to the people, and
by people to the government,
without corresponding transfer of
goods and services or addition to the
total output.
Transfer payments are not taken into

account while counting the national
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Consumer and Producer
Goods
Consumer goods- The goods and
services that are consumed by the people
to directly satisfy their needs and yield
utility to the consumer.
Producer goods- The category of final

products which are used for enhancing the
production capacity of the national
economy with the purpose of increasing
the flow of income in the future.
Gross Domestic Product
(GDP)
The Gross Domestic Product (GDP) can be
defined as the sum of market value of all final
goods and services produced in a country during
a specific period of time, generally one year.
It includes income earned by the foreigners in

the country and excludes income earned abroad
by the residents.
The market value of domestic product is obtained

at both constant and current prices.

Gross National Product
(GNP)
The concept of GNP includes the income of
the resident nationals which they receive
abroad, and excludes the incomes generated
locally but accruing to the non-nationals.
GNP = Market value of domestically produced goods and services

plus incomes earned by the residents of a country in foreign
countries minus incomes earned by the foreigners in the country.
GDP = Market value of goods and services produced by the residents in the
country
plus incomes earned in the country by the foreigners
minus incomes received by residents of a country from abroad.

Net National Product (NNP)
The NNP is the measure of national
income which is available for
consumption and net investment to
the society.
It the actual measure of national

income.
The NNP divided by the population of

the country gives the per capita
Personal Income (PI)
Personal income (PI) can be defined
as the sum of all kinds of incomes
received by the individuals from all
sources of incomes.
The sum of personal incomes is not

(where UDP = undistributed company profits; SPU = surplus of public
exactly the= rentals
undertakings; RPP same asproperties
of public NNP.and PI excludes items not
included in NNP)

Disposable Income and Private
Income
Disposable income- refers to personal
income of the income earners against which
they do not have any legally enforceable
payment obligations.
Private income-Broadly, all personal

incomes are private incomes. However, the
term private income is used in contrast to
public income.

Nominal and Real GNP
The GNP estimated at current prices
is called nominal GNP and GNP
estimated at constant prices in a
chosen year is called real income.
Real GNP gives national income

estimates free from distortion caused
by inflation or deflation.

The GNP Deflator
The GNP deflator is essentially an
adjustment factor used to convert
nominal GNP into real GNP.
The
Or formula for converting nominal
,
GNP of a year into real GNP

GNP Implicit Deflator
GNP implicit deflator is the ratio of
nominal GNP to real GNP.
The GNP implicit deflator can be used

for:
(a)To construct price index number, and
(b)To measure the rate of change in prices
Methods of Measuring National
Income
Net Product Method or the Value
Added Method
Factor Income Method, and
Expenditure Method

Net Product Method
This method consists of three stages-
i. Estimating the gross value of domestic
output in the various branches of
production;
ii. Determining the cost of material and
services used and also the depreciation
of physical assets; and
iii. Deducting these costs and depreciation
from gross value to obtain the net
value of domestic output.
Value Added Method
In the net product method, the problem of
double counting is often confronted. Value
added method is used to avoid double counting.
For estimating value added-

i. Identifying the production units and classifying
them under different industrial activities.
ii. Estimating net value added by each production unit
in each industrial sector.
iii. Adding up the total value added of each final
product to arrive at GDP.

Factor Income Method
In this method, the national income is treated to
be equal to all the incomes accruing to the basic
factors of production used in producing the
national products.
In modern economy, the national income is

considered to be comprised of three components:
i. Labour incomes,
ii. Capital incomes, and
iii. Mixed incomes.

Expenditure Method
The expenditure method, also known as
the final product method, measures
national income at the final expenditure
stage.
In order to estimate the aggregate

expenditure, any of the following two
methods may be followed:
i. Income Disposal Method
ii. Product Disposal Method
Treatment of Net Income from
Abroad
In estimating the national income,
net incomes from abroad are added
to GDP and net losses are subtracted
from GDP to arrive at the national
income figure of an open economy.
GDP adjusted for net income from

abroad is called Gross National
Income (GNI).
Double Entry System of
Accounting
A double entry accounting system is one in
which both receipts and payments are recorded-
receipts on credit side and payments on debit
side of the account.
Another aspect of the double accounting system

is that the account of a person need not
balance.
In this system, many types of accounts can be

imagined and operated.
Double Entry System of Accounting
(Contd.)
In national income accounting system,
the main types of transactions and their
accounting include the following:
i. Private Consumption,
ii. Government consumption,
iii. Investment (savings converted into capital),
iv. Government taxes and spending,
v. Inventories, and
vi. Net of foreign transactions (exports and
imports).

History of National Income
Measurement in India
In the pre-independence phase, the first attempt ever to measure
national income of India was made by Dadabhai Naoroji in 1867-
68.
The first systematic attempt to estimate Indias national income

was made by Prof. V.K.R.V. Rao for the year 1925-29 and again for
the year 1931-32.
In the post-independence phase, the first official estimate of

Indias national income was made in 1949 by the Ministry of
Commerce, Government of India.
Since 1967, the task of estimating national income has been

assigned to the Central Statistical Organisation (CSO).

Sectoral Classification of
Economy
Primary sector, including agriculture and
allied activities, forestry, fishing, mining and
quarrying;
Secondary sector, including

manufacturing industries, and
Tertiary sector or service sector, including

banking, insurance, transport and
communication, trade and commerce.
Income
(i) Production Method is used to
estimate income or domestic product of
the following production sectors:
i. Private Consumption,
ii. Government consumption,
iii. Investment (savings converted into capital),
iv. Government taxes and spending,
v. Inventories, and
vi. Net of foreign transactions (exports and
imports).

Income (Contd.)
(ii) Income method is used for estimating
domestic income of the following sectors:
i. Unregistered manufacturing,
ii. Gas, electricity and water supply,
iii. Banking and insurance,
iv. Transportation, communication and storage,
v. Real estate, ownership of dwellings and business
services,
vi. Trade, hotels and restaurants,
vii.Public administration and defense,
viii.Other services.

Income (Contd.)
In India, as per expenditure method, the
sectoral accounting of GDP, follows the
following classification of the national
income:
i. Private final consumption expenditure including
expenditure.
ii. Government final consumption expenditure
iii. Gross fixed capital formation including
construction, machinery and equipments,
iv. Change in stocks, and
v. Net export of goods and services.

Methods of Measuring National Income
Aggregates
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Methods of Measuring National Income
Aggregates (Contd.)
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Estimates of Indias GNP, NNP and Per
Capita Income at Factor Cost
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Annual Growth Rate of Indias GNP, NNP and
Per Capita NNP (At Factor Cost)
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Annual Growth Rate (%) of Indias GNP, NNP
and Per Capita NNP-2000-01 to 2007-08
(All at Factor Cost)
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CHAPTER 5
The Classical Theory of
Output and
Employment
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The Classical Postulates
There is always full employment
The economy is always in the state
of equilibrium
Money does not matter

Says Law: The Foundation of
Classical Macroeconomics
Says law states that supply
creates its own demand or
supply calls forth its own demand.
This law can be explained in the

context of both a barter system and
a monetised economy.

Two Major Conclusions of Says Law
1. No general overproduction or
underproduction
2. No unemployment under classical
system
Classical economists did not rule out the existence of

voluntary and frictional unemployment in the state of full
employment.

Classical Theory of Employment: A
Formal Model of Says Law
1. Aggregate production function, and
2. Labour supply and labour demand
functions.

The Classical Production Function
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Labour Supply Curve
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Labour Demand Curve
Labour demand function can be
expressed as:
In order to derive one needs to

derive the MPPL curve.
A simple and practical method of

measuring MPPL is:
Output and Marginal Productivity of Labour
Derivation of Total Production (TP) and

MPPL Curves
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Derivation of Labour Demand Curve
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Determination of Employment and Real Output
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The Collapse of the Classical
Economics
The Great Depression proved that the very basic postulates
of the classical economics were fundamentally wrong.
The industrial economies suffered a long-run disequilibrium

and a prolonged state of involuntary unemployment.
There was supply of capital but there was no sufficient

demand for capital.
The classical theory had no answer to these predicaments of

the 1930s. This marked the collapse of the classical
economics.

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CHAPTER 6
Keynesian Theory of Income
Determination: A Simple
Economy Model
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Introduction
The two-sector model includes only households and
firm sector.
While classical economists had emphasized the role

of supply, Keynes emphasized, in contrast, the role of
demand in the determination of output and
employment.
Throughout the Keynesian theory of income

determination, prices are assumed to remain
constant even if aggregate demand and aggregate
supply change.

Derivation of the Aggregate Supply Curve
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The Aggregate Demand Function:
Two-sector Model
In a simple two-sector economy,
aggregate demand (AD) consists of:
i. Aggregate demand for consumer
goods (C), and
ii. Aggregate demand for investment
goods (I).
Thus, in a simple economy,
The short-run aggregate demand

The Consumption Function
A consumption function is a functional
statement of relationship between the
consumption expenditure and its
determinants.
The consumption expenditure is a positive

function of income.
The most general form of consumption

function is,

The Linear Aggregate Consumption
Function
The linear aggregate consumption

function:

Average Propensity to
Consume

Saving Function
The saving function states the
relationship between income and
saving.
Saving is also the function of

disposable income. That is,
Since, Y=C+S, savings can be

defined as,
The Saving Function
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Aggregate Demand Function
Aggregate demand function

is,
Consumption function is,
The Aggregate Demand Function
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Income Determination in Simple
Economy Model
Assumptions:
i. There are only two sectors in an economy.
ii. Aggregate demand (AD) equals C+I.
iii. There is no tax and no government expenditure.
iv. The two-sector economy is a closed economy.
v. In the business sector, there is no corporate
savings or retained earnings.
vi. All prices, including factor prices, remain
constant.
vii.The supply of capital and technology are given.

Income and Output
Determination
According to the Keynesian theory of
income determination, the national
income equilibrium is determined
where:

Keynesian Model
The consumption function proposed by Keynes is:
C = C0 + Cy ( Y - T)
C0 = Autonomous consumption
Cy = Marginal propensity to consume
The marginal propensity to consume plays a central role
in the Keynesian system. Keep your eye on the MPC in the
following slides.
Propensity to Consume
Therefore, consumption depends primarily upon income,
not interest rates.
C C(r), but rather C = C(Y)
People dont change their standard of living simply because the
interest rate changes a few points.
The fundamental psychological law, upon which we are entitled to
depend with great confidence . . . is that men are disposed, as a rule
and on average, to increase their consumption as their income
increases, but not by as much as the increase in their income
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Propensity to consume
The MPC or Marginal Propensity to Consume refers to the
fraction of additional income which is spent by the
consumer.
It can be calculated as C/Y where C=Consumption and

Y= Income
Marginal propensity to save(MPS) can be calculated as 1-

MPC
The Average Propensity to Consume or APC can be
calculated as C/Y
Propensity to Consume
Propensity to Consume depends upon level of disposable
income, wealth in the form of stocks, bonds an financial
instruments, expectations of future Income and
consumption habits of the population.
The consumption function proposed by Keynes is:
C = C0 + Cy ( Y - T)
C0 = Autonomous consumption
Cy = Marginal propensity to consume
National Income Identity
The Keynesian model: National income identity and
equilibrium
The National income identity is:
Y = C + I + G + NX
The Keynesian equilibrium equation is:
Y = C0 + Cy ( Y - T) + Ip + G + NX
Notice that C has been replaced by the consumption
function, and investment by planned investment.
Planned and actual Investment
Investment has three components:

Plant and equipment -- drill presses, factory buildings,
etc.
Residential investment -- new housing construction
Inventory investment -- Change in Business
Inventories
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Planned and Actual
Investment
The first two are consciously planned (although plans can
change, and typically do during a recession);
inventory investment can be unplanned -- if a store fails to
sell what it had expected to, it winds up with more
inventory than it had expected.
Stores with unplanned inventory investment will cut back
on orders -- resulting in reduced production at the factory,
layoffs and recession.
NPV and IRR
Present Value refers to the current value of an expected
future stream of benefits by discounting them at a
particular rate.
It can be expressed by the formula: P=S/(1+r)n where
P=Present value, S=Future value, r=rate of interest and
n=time period.
Net Present Value can be calculated as Present Value-Initial
investment.
Internal Rate of Return or IRR refers to the rate of interest
where NPV=0.
MEC and MEI
The IRR is also known as Marginal Efficiency of Capital or
MEC.
In other words, Marginal Efficiency of Capital is the rate of
discount which which makes the discounted present value
of expected income stream equal to cost of capital.
The increase in demand for Capital goods beyond
production capacity leads to rise in price of capital goods
increasing the cost of investment leading to decrease in
MEC.
This relationship between the interest rate and total
investment is shown by the marginal Efficiency of
Investment or MEI.
Tobin Q
Tobin q is measured by the formula:
Market value of installed capital/Replacement cost of
installed capital
The same can be explained with the help of regression line.
The Keynesian model: National income identity and equilibrium
The National income identity is:
Y = C + I + G + NX
The Keynesian equilibrium equation is:
Y = C0 + Cy ( Y - T) + Ip + G + NX
Notice that C has been replaced by the consumption function, and
investment by planned investment.
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Formal Model of Income
Determination
1. AD-AS approach, and
2. S-I approach.

AD-AS Approach
Determination of
AD-AS approach Consumption
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Equilibrium of the National Income and Output: The
Two-Sector Model
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Macroeconomics 3rd ed.
The Saving-Investment Approach to
Income Determination
The equilibrium level of income can
also be determined by using only S
and I schedules. This is called the
saving-investment approach.
At equilibrium,

Income Determination: Saving and
Investment Approach
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Change in Aggregate Demand: An
Overview
An increase in aggregate spending makes
the aggregate demand schedule shift
upward.
As a result, the equilibrium point would shift

upward along the AS schedule causing an
increase in the national income.
Likewise, a fall in the aggregate spending

causes a fall in the national income.
Change in Investment and Multiplier
Increase in Investment Demand and National Income Determination

m=Y/ I, Since Y > I, multipler (m) is greater than 1. It
implies that when investment increases in an economy, national
income increases by more than the increase in investment.
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Working of Multiplier Process
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A Simple Model of Investment
Multiplier
Investment multiplier (m) = reciprocal

of MPS

What Determines the Value of
Multiplier?
The numerical value of the multiplier
is determined by numerical value of
MPC.

Static and Dynamic
Multiplier
The concept of static multiplier implies that
change in investment causes change in income
instantaneously. There is no time lag between
the change in investment and the change in
income.
The concept of dynamic multiplier recognises

the fact that the overall change in income as a
result of the change in investment is not
instantaneous. The process of change in
income involves a time lag.
Role of Multiplier in the two-sector
model
To assess the overall possible
increase in the national income due
to one-shot increase in investment
or due to a single injection of
investment, and
To plan economic growth of the

country.

Limitations of the Multiplier
1. Leakages from the income stream
i. Payment of the past debts
ii. Purchase of existing wealth
iii. Import of goods and services
2. Non-availability of consumer goods
and services
3. Full employment situation

Applicability of Multiplier Theory to
LDCs
V.K.R.V. Rao pointed out, an underdeveloped country is
characterised by:
i. a predominant agricultural sector,
ii. a vast disguised unemployment,
iii. low level of capital equipment,
iv. low level of technology and technical know how,
v. a small proportion of wage employment to the total,
vi. a vast non-monetised sector, and
vii.a vast sector producing for self-consumption.
Under these circumstances, the multiplier principle does

not work in the simple fashion visualised by Keynes
primarily for the industrialised economies.

The Paradox of Thrift
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MONEY
LEARNING OBJECTIVES
To understand the economics definition of
money;
To understand the various concepts of money;
To understand how money can be used for
different purposes;
To understand how RBI measures the money
supply
To understand what are the important factors
that affect the demand for money
MONEY
MEANING AND DEFINITION
Meaning
In general, money means
currency notes and coins.
However, in economics, the term
money is used for much wider
sense and is defined differently
by different economists.
Conceptually, money can be
defined as any commodity that is
generally accepted as a medium
of exchange and measure of
Definition
H. G. Johnson has classified the
approaches to the definition of
money under the following
categories:
The Conventional Approach

The Chicago Approach
The Central Bank Approach
The Gurley-Shaw Approach
THE CONVENTIONAL APPROACH
Most oldest and widely accepted

approach.
Stresses mainly one the basic
functions of money i.e. medium of
exchange and measure of value.
Any commodity that functions as
a medium of exchange and
measure of value is money.
It includes barter system
(Exchanging commodities for
commodities)
THE CHICAGO
APPROACH
Coined by Milton Friedman and his
associates in Chicago University.
They extended the conventional definition
by adding the time deposits in it.
Thus money include (i) Currency, (ii)
Demand Deposits, (iii) Time Deposits.
They included the time deposits for two
reasons:
Time deposits have direct correlation with
money supply and with GNP
Time deposits remain unavailable for
transaction only for a short period.
The Gurley-Shaw
Approach
This approach is attributed to John
G. Gurley and Edward S. Shaw.
They regarded the liquid assets held
by financial intermediaries and
liabilities of non-bank intermediaries
as close substitute for money.
Intermediaries provide substitute
for money as a store of value.
Thus, they gave wider definition of
money based on liquidity which
includes bonds, insurance reserves,
The Central Bank
Approach
The central banks take still a wider
definition of money. They view all
available means of payment and
credit flows as money.
Thus, money supply constitutes
currency plus all realizable assets
i.e. the assets which have perfect or
near perfect liquidity.
Depending upon objectives of
monetary policy and policy targets
central banks make and use
Conclusion:
To conclude, money cannot be
described on the basis of matter
it is made of. It can be defined in
terms of its functions:
Any thing which is used for
medium of exchange, measure of
value, store of value and
standard of deferred payments.
MONEY
FUNCTIONS
Functions of Money
The following couplet brings out the
major functions of money:
Money is a matter of functions four:
A medium, a measure, a standard, a
store
Kinley classified the functions of

money into following three categories:
Primary and Main Functions
Secondary and Subsidiary Functions
Contingent Functions
Functions of Money
Primary Functions:
Medium of Exchange
Measure of Value
Secondary Functions:
Standard of Deferred Payments
Store of Value
Functions of Money
Contingent Functions:
Basis of Credit Creation
Maximum Satisfaction
Distribution of National
Income
Increase in the Liquidity of
Capital
Bearer of option
QUESTIONS
Money can be defined as any
commodity that is generally
accepted as a _______________.
What are the four approaches
to money?
Chicago approach added
which factor to money?
What are the secondary
functions of money?
MONEY
CONCEPTS
CONCEPTS OF MONEY
Money has been used since
time immemorial. It has only
been changing form over time.
Since its evolution money took
several forms as:
Commodity Money
Metallic Money
Paper Money
Bank Deposits
Near Money
CONCEPTS OF MONEY
Commodity Money:
Under this, the people used

commodities or animals as
money.
Demerits:
Commodities are not
homogeneous
Supply of commodities could be
abruptly change.
Hoarding was not possible
CONCEPTS OF MONEY
Metallic Money:
It was introduced to meet the
difficulties of commodity money.
Different metals, such as iron, gold,
brass, silver, copper, etc. were used to
make coins.
Demerits:
Supply of these coins could not
always be adjusted to their demand.
Very heavy.
Continuous use of metal coins
resulted in lot of depreciation.
CONCEPTS OF MONEY
Paper Money:
In past traders, used to deposit
their metallic money with money
lenders and obtain certificate of
deposit. These certificates were
used as money. Thus, this led to
the origin of paper money.
These days the paper money is
issued only by the Central Bank of
the country.
Initially, the paper money was
convertible into gold or gold coins,
CONCEPTS OF MONEY
Paper Money:
Merits:
Not an expensive system of
currency
Supply can easily be adjusted
according to the need
Easily transferrable
Demerits:
Always a possibility of excessive
supply of paper money which leads
to inflation in the economy and fall
in the value of the currency.
CONCEPTS OF MONEY
Bank Deposits:
There are three types of bank deposits:
Current Account Deposits
Saving Deposits
Time Deposits
Current A/C deposits are widely referred
to as demand deposits which are also
known as bank money and credit
money.
Conventional approach included only
demand deposits in the definition of
money but Chicago approach treats
saving and time deposits as close
substitute to demand deposits.
CONCEPTS OF MONEY
Near Money:
Near money refers to those

promissory notes which can be
easily converted into money, but
can not be used as money to buy
goods and services.
Near money includes treasury bills,
bonds, securities, fixed deposits in
banks, insurance policies, etc.
Thus, compared to paper money
near money is less liquid.
FIAT PAPER MONEY
Fiat Paper Money:
It is a kind of inconvertible paper money
issued by the state under emergency
conditions. Thats why, it is also known
as emergency money.
Fiat money is not backed up by any
reserve.
Since this money is not backed up by any
reserves, government issued it in limited
quantity.
German Mark issued during World War I
and the entire paper money during
World War II were a sort of fiat money.
It is different from inconvertible paper
QUESTIONS
What are the demerits of
commodity money?
What do you mean by near
money?
How paper money come into
existence?
What do you mean by fiat
money?
The Government, the Central Bank
and Money
Money is a just a tool that does
three things
Serve as a unit of account
Serve as a medium of exchange
Serve as a store of value.
Lots of things could do these jobs,
some better than others
Cash is really good at most of these
things (but is it better at some things
than others)
Demand deposits (checking
accounts) are also obvious kinds of
money
Other liabilities might also work (but
how well and where should the line
be drawn separating money from
other kinds of debt?)
Does Money Matter? The Quantity
Theory of Money
Let V stand for the velocity of
money that is the total number of
times the money supply is spent in a
given year. In symbols
MxV = PxQ
Where
M is the money supply
P is the price level
Q is the quantity of goods transacted
Does Money Matter? The Quantity
Theory of Money (Continued)
Now suppose that
V is determined by things other than
prices or the aggregate level of
economic activity such as the
sophistication of the financial system.
Q is determined by real economic
factors such as the availability and
productivity of labor and other
resources.
In such an environment, the price
level would depend entirely on the
Since, as we will see, banks play a critical role in the
process of supplying money, lets start with brief
history of US banking
First Bank of the United States (1811-

1831)
Banking in the Jacksonian Era: The
Second National Bank (1816-1836)
State Banking (1836-1863)
National Bank Act (1863)
The Federal Reserve (1913)
Functions of the Central
Bank
Create money and control money
supply
Regulate and supervise financial
institutions
Provide banking services to the
Government
Provide banking services to private
financial institutions (for example,
check clearing and wire transfers).
Monitor economic conditions and
The Central bank Control of the
Money Supply: Basic Definitions.
C= the total stock of cash in the hands of the
public
D=the total amount of demand deposit liabilities
(money in checking accounts)
M=C+D (the money supply)
R=the amount of reserves the banks choose to
hold in Fed
Rr=required reserve ratiothe amount of
reserves the banks are required to hold as
proportion of demand deposits. That is, the
required reserves are Rr x D
Control of the Money Supply: A
Slightly Simplified Model
C = c x D, (where c is just some number
indicating what proportion of their total D
people want in the form of cash. For example,
demand deposit liabilities might be $)
R = Rr x D (the banks dont hold excess
reserves.
Put it all together and it means that
M = (1+c)R/Rr
In other words, the amount of money is controlled
by the reserves in the Fed
So, how can the cental bank control
reserves?
Most importantly by Open Market
Operations, which just means the
buying and selling of financial assets,
mostly Treasury Bonds, Bills and
Notes.
Example (assume c=.05 and
Rr=.10)
If total bank reserves were $300, calculate the
money supply
M = 1.05x300/.1 = $3,150
If the fed bought $100 M worth of bonds, what
happens to M?
When the Fed buys the bonds, the money ends up
as part of bank reserves. Thus the money supply
goes up by 1.05x100/.1 = $1,050 million.
Similarly if the Fed were to sell $100 M worth of
bonds, the money it is paid for the bonds comes out
of reserves and so M would fall by $1,050 million.
How does the monetary policy influence
interest rates? Demand and Supply Again.
Clearly, the Fed supplies money but it might seem

unusual to talk about the demand for money.
But in fact it makes perfectly good sense. Money
is different than income or wealth. Bill Gates, for
example, has lots of income and wealth, but
maybe doesnt have much more money than you
or I.
In a simple world, the rate of interest is just the
opportunity cost of holding moneyas interest
rates go down, people are willing to hold more
money (that is, they demand more money).
The Picture
Interest rate
Money
Supply (Set
by Fed)
Demand for
Money
Equilibriu
m interest
rate
M
Players in the Money Supply Process
Central Bank
Banks (most important: depository banks;
also other financial intermediaries)
Depositors (households, firms)
Borrowers from banks (households, firms,
governments)
Behavior of each actor influences the
money supply.
Central Banks Balance
Sheet
CB Liabilities
Currency in circulationpaper money & coins
held by the nonfinancial sector (firms &
households)
Reservescommercial banks deposits at the
CB and vault cash (cash held in ATM machines
and branches of commercial banks). CB
requires banks to hold a minimum level of
reserves at the CB as a percentage of total
deposits required reserve ratio. But banks
may choose to hold excess reserves
MB = C + R
MB: Monetary Base
C: Currency in circulation
R: Reserves
Banks Create Deposit in a Fractional
Reserve System
When the CB injects 1 TL reserve into the
banking system through OMOs or disc.
loans, money supply increases by more
than 1 TL.
This is because the required reserve ratio
(RRR) is less than 100% of deposits. A
smaller RRR leads to a greater expansion
of the money supply for 1 TL injection.
First let us assume banks do not hold
excess reserves.
Deposit Creation: Single
Bank
When CB makes an open market purchase from
First National Bank (FNB), FNBs reserves
increase, securities decrease by 100 TL.
Since FNBs deposits dont change, this 100 TL
is excess reserve for FNB and it lends all of this
money to a firm. Opens a checking account for
the firm, loans and checkable deposits of FNB
increase by 100 TL.
When the borrower spends the credit, reserves
and checkable deposits disappear on FNBs T-
account.
When the firm X spends the credit, assuming
that nobody wants to keep extra cash, 100 TL
spent is deposited in a checking account at
another bank, Bank A. Then Bank As reserves
and checkable deposits increase by 100 TL.
Bank A must hold 10% required reserves, but
can lend the rest: 90 TL. When firm Y who
borrowed this 90 TL spends this loan, reserves
are deposited to another bank: Bank B.
Everytime new credit is creat ed, money
supply increases by: 100+90+81+72.9+.
= 100 (1+0.9+(0.9)2+(0.9)3+.)
=100.(1/10)
=1000 TL
As required reserve ratio(r) increases
(decreases), money multiplier 1/r
decreases (incr.) and money creation slows
down (accelerates).
INFLATION
Inflation
Coulborn: it is a state of too much money chasing too few
goods.
Two broad categories:
price inflation (generally called as inflation)
money inflation.
Money inflation is increase in the amount of currency in
circulation. Which may be due to:
Deficit financing : direct cause is printing of additional
currency on demand of the government to meet its
needs.
Additional money supply through foreign exchange
inflows in the form of capital, such as foreign direct
investment and foreign institutional investment,
tourism and other incomes from abroad.
Price inflation is a persistent increase in the general
price level or a persistent decline in the real
income of people, i.e. decline in value of money.
Concepts of Inflation
Headline Inflation: measure of the total inflation within an
economy
affected by the areas of the market which may experience
sudden inflationary spikes such as food or energy.
Hyperinflation: prices increase at such a speed that the
value of money erodes drastically
This is also known as galloping inflation or runaway
inflation.
Stagflation: a typical situation when stagnation and inflation
coexist.
Disinflation: a process of keeping a check on price rise by
deliberate attempts.
Deflation: a state when prices fall persistently; just opposite
to inflation
Inflationary Gap (Keynes): Excess of anticipated
expenditure over available output at base price
When money income exceeds the supply of goods and
services, a gap is created between demand and supply
What Rate of Price Rise is Inflation?
Some modern economists opine that only a
persistent, prolonged and sustained and a
considerable and appreciable rise in the general
price level can be called inflation.
However, Samuelson-Nordhaus define inflation as a

rise in the general level of prices is inflation.
It means that any rise in the general price level over

and above the base year level is inflation. This is the
concept of inflation which is generally used in the
analysis of price behaviour.

What is Desirable Rate of
Inflation?
In general, a moderate rate of inflation is
considered to be desirable and acceptable
because:
A moderate rate of inflation keeps the economic outlook

optimistic, promotes economic activity and prevents
economic stagnation.
It is helpful in the mobilization of resources by increasing

the overall rate of savings and investmentinflationary
financing has, in fact, been widely used to finance
economic growth of the underdeveloped countries.

What is Desirable Rate of Inflation?
(Contd.)
It is historically evident that, despite intermittent
deflation, the general price level has exhibited a rising
trend, and some increase in the general price level is
inevitable in a dynamic and progressive economy.
A price rise of 2-3 percent per annum in the developed and

4-5 percent per
annum in the developing economies is generally considered
as the desirable rate of inflation.

Demand Pull Inflation
Demand Pull Inflation caused by
monetary factors:
Demand Pull Inflation: when aggregate demand
increases due to any reason, and supply of output
is unable to match this increased demand; i.e
demand pulls prices up.
Increase in money supply/ Increase in disposable
income
Increase in aggregate spending
Increase in population of the country
Demand Pull Inflation caused by real factors:
A quick increase in consumption and investment along with an
extremely confident firms
A sudden increase in exports which might lead to a huge under-
valuation of your currency
A lot of government spending
The expectation that inflation will rise often leads to a rise in
inflation. Workers and firms will increase their prices to catch up
to inflation
Excessive monetary growth when they is too much money in the
system chasing too few goods. The price of a good will thus
increase
The Cost-Push inflation
In modern economy wages are not strictly market-

determined prices, but are administered prices
wages can rise even if there is no excess demand for
labour or even there is unemployment
If rate of increase in wage rate > rate of increase in

productivity, the wage cost per unit of output
increases
The employers now are less willing to supply goods at

the existing price level supply of goods
Fall in supply is not accompanied by a fall in demand

product prices rise & this rise continues till the original
W/P restored
Note: when W employers actually raise price

instead of lowering supply & raising prices as a
consequence. This is spontaneous inflation
Types of Cost Push Inflation
Wage -push inflation cost inflation stemming from
trade union pressure on wage rate
Profit - push inflation inflation caused by
monopolistic practices of the managers of firms who
increase prices even in the absence of increase in
demand or rising costs
Inflation if there is excess demand in some sectors
without no excess demand in other sectors
excess demand in some sectors P excess demand
for labour W here trade union in other sectors will
demand W . If this claim is granted W in these
sectors with no excess demand cost inflation
Wage Price Spiral
Wages chase prices and prices chase wages, thus
create a wage price spiral.
When prices rise, workers

Prices Rise
demand higher money (or
nominal) wages to protect
their real wages. This raises Cost of
the costs faced by their production rises
employers. Cost of
living rises
To protect the real value of
profits producers pass the Wages rise
higher costs onto
consumers in the form of
higher prices.
Workers (who are also
consumers demand for
Profit Push Inflation
When firms push up prices to get

higher rates of inflation.
Supply Shock Inflation
It refers to an unexpected event that
changes the supply of a product or
commodity, resulting in a sudden
change in its price.
Control of Inflation
Inflation erodes the value of money and
discourages savings
But zero inflation is undesirable
Need to control inflation
monetary policy measures (proposed by those
who believed money supply is the major
culprit)
fiscal policy measures (proposed by Keynes
and his followers).
Other measures
The government has to adopt an
appropriate combination of these
measures after thorough examination of
the causes of inflation
Monetary Policy
Measures
Increasing the discount rate: The central
bank rediscounts the eligible papers offered
by commercial banks. This is also called
bank rate.
Higher reserve ratios:
Cash Reserve Ratio (CRR)
Statutory Liquid Ratio (SLR)
Open market operations: directly sell
government securities to public and restrain
their disposable income
Selective credit control: discourages
consumption but not investment
Fiscal Policy Measures
The government may reduce public expenditure or
increase public revenue to keep a check on
inflation
Reducing public expenditure
When government spends on activities like
health, transport, communication, etc., income of
individuals increases; this in turn increases the
aggregate demand.
Therefore the reverse will also be true.
Increasing public revenue
Major source of government revenue is various types of
taxes
Increase in income tax leaves less of disposable income
in the hands of consumers
Price and Wage control
wage and price controls,economic policy measure
in which the government places a ceiling on wages and
prices to curb inflation. Also known as incomes policy.
Price controls:These are governmental restrictions

on the prices that can be charged for goods and
services in amarket. The intent behind implementing
such controls can stem from the desire to maintain
affordability ofstaple foodsand goods, to preventprice
gougingduring shortages, and to slow inflation, or,
alternatively, to insure a minimum income for providers
of certain goods or a minimum wage.
Price and Wage control
Wage Control: It is used to combat
inflation when wages tend to rise
much faster than the productivity.
Under this method, the govt. control
the wage rise directly by imposing a
ceiling on the wage income in both
private and public sector.
Indexation
It is a technique to adjust income
payments by means of aprice index,
in order to maintain thepurchasing
powerof the public afterinflation,
whileDeindexationrefers to the
unwinding ofindexation.
Phillips curve
ThePhillips curveis a historical inverse
relationship between the rate
ofunemploymentand the rate
ofinflationin an economy. Stated simply,
lower unemployment in an economy is
correlated with a higher rate ofinflation.
Short-run Phillips curve depicts the
inverse trade-off between inflation and
unemployment.
Short-run Phillips curve
Short-run Phillips curve
The long-run Phillips curve is a
vertical line at the natural rate of
unemployment, so inflation and
unemployment are unrelated in the
long run.
Business Cycle
Theories and Global
Recession
175
Learning Outcome
To understand the meaning of
Business cycle and its different
phases
To understand the notion of
various theories of Business
Cycle and its contribution in the
concept
TMH Copyright 2010
176
Macroeconomics 3rd
Introduction
The economic history of the world
economy is essentially the history of
business cycleseconomic ups and
downs, booms and slumps, prosperity and
depression.
However, since the Great Depression of

1930s had not repeated itself until 2008-
09, i.e., over a period of 80 yearsthe
longest period considered in the trade
cycle classifications.
177
What is Business Cycle?
According to Samuelson and Nordhaus, a
business cycle is a swing in total national
output, income, and employment, usually
lasting for a period of 2 to 10 years,
marked by a widespread expansion or
contraction in most sectors of the
economy.
178
Phases of Business Cycle
179
Theories of Business Cycle
1. Pure Monetary Theory
2. Monetary Over-investment Theory
3. Schumpeters Interaction Theory
4. MultiplierAcceleration Interaction
Theory
5. Hicksian Theory of Trade Cycle
180
The Pure Monetary Theory of
Business Cycle
According to this theory, the main
cause of business fluctuations is the
instability of the monetary and credit
system.
The main proponent of this theory,

Hawtrey, maintained that all changes
in the levels of economic activities
are caused by the changes in money
flows.
181
Criticism- Pure Monetary
Theory
Although monetary factors are certainly major
contributors to the business fluctuations, business
cycles are not a purely monetary phenomenon.
In spite of the fact that monetary factors play an

important role in accelerating the process of
expansion and contraction, they do not fully explain
the turning points.
Monetary theorists conviction that businessmen are

highly sensitive to the changes in the interest rates
is highly doubtful.
182
The Money Over-Investment
Theory
The monetary overinvestment theory emphasizes
the role of imbalance between the desired and actual
investments in economic fluctuations and the
imbalance between the investment in capital and
consumer goods industriesinvestment in the
former exceeding that in the latter.
F.A. Hayek, the pioneer of this theory, stresses that to

keep the economy in equilibrium, investment pattern
must correspond to the pattern of consumption.
So long as this equilibrium condition exists, the

whole economy would remain stable.
183
Criticism- Money Over-Investment
Theory
The overinvestment theory presumes that when
market rate of interest is lower than the natural or the
normal rate of interest due to, say, excess supply
funds, the new bank credit flows to the capital goods
industries. This would be true only under the condition
of full employment. But, business cycles have taken
place even when resources were not fully employed.
This theory emphasizes on the change in the interest

rate as the main determinant of investment. It ignores
many other important factors such as businessmens
own expectations, cost of capital equipment, etc.
184
Criticism- Money Over-Investment
Theory (Contd.)
The monetary over-investment
theory lays undue emphasis on the
imbalance between investment in
capital goods and consumer goods
industries. In a modern economy,
such imbalances are self-correcting
and do not create serious
depression.
185
Schumpeters Innovation Theory of
Trade Cycle
According to Joseph A. Schumpeter, business cycles are
almost exclusively the result of innovations in the
industrial and commercial organization.
By innovations he means such changes of the

combination of the factors of production as cannot be
effected by infinitesimal steps or variations on the
margin.
In his formulation of the business cycle theory,

Schumpeter has developed a model in two stages which
he calls as the first approximation and the second
approximation.
186
Criticism- Schumpeters Innovation
Theory of Trade Cycle
According to M.W. Lee, An objective
evaluation of Schumpeters theory of the
cycle is not only difficult but also unavailing
because much of his arguments is based on
sociological rather than economic factors.
Schumpeters theory is not basically different

from investment theory.
Schumpeters theory, like many other

theories, leaves out many other important
187 factors causing business fluctuations.
Multiplier-Accelerator Interaction Theory
of Business Cycle: Samuelsons Model
Samuelsons model shows how multiplier and
acceleration interact with one other to generate
additional income, consumption and investment
demands more than expected, and how economic
fluctuations take place.
In his analysis of interaction between multiplier
and accelerator, Samuelson assumes:
i. no excess production capacity,
ii. one-year lag in income and consumption;
iii. one-year lag in investment and consumer demand;
and
iv. no government activity and foreign trade.
188
Combinations of mpc (a) and accelerator
(b) cycles
189
Trade Cycle Patterns with Different
Combinations of mpc (a) and accelerator (b)
190
Trade Cycle Patterns with Different Combinations
of mpc (a) and accelerator (b) (Contd.)
191
Criticism- Samuelsons
Model
Samuelsons model is regarded by its critics as far
too simple to explain fully what actually happens
during the period of economic fluctuations since it
is developed on highly simplifying assumptions.
Samuelsons model leaves out or gives little

consideration to many other important factors
which might play an equally important role in
business cycles, cycles, e.g., the role of producers
expectations, changing business psychology,
changing consumer preferences, and such other
exogenous factors.
192
Criticism- Samuelsons Model
(Contd.)
It assumes constancy of capital-output
ratio whereas there is a great likelihood of
change in this ratio during the periods of
upswings and downswings.
It is alleged that many cyclic patterns

suggested by the model do not conform to
the world experience in its economic
history.
193
Hicksian Theory of Trade
Cycle
In his model, Hicks assumes an equilibrium rate of growth
in the model economy.
He assumes also that the autonomous investment
increases at a constant rate which always equals the rate
of increase in voluntary savings. The equilibrium growth
rate is determined by the rate of autonomous investment
and saving.
Hick assumes a Samuelson-type of consumption function,
Ct = aYt-1
Hicks distinguishes between autonomous and induced
investment function.
Hicks imagines ceiling and bottom for the upswing and
downswing.
194
Hicksian Trade Cycle
195
Criticism Hicksian Theory of Trade
Cycle
Hicksian theory does not provide sufficient
reasons for the linear consumption function
and a constant multiplier.
The assumption regarding the constancy of

multiplier under the dynamic conditions is
looked upon with skepticism.
Hicksian theory is regarded as a highly

abstract formulation which seems incapable
of explaining the phenomenon of economic
196 fluctuations in real life.
The Global Recession of
2008-09
Objective of the Study
To understand the concept of
Recession
To understand the relationship
between Recession and the Business
Cycle
Financial Crisis
Highlights
Over $1.5 trillion lost on toxic assets.
Near collapse of US mortgage industry
Investment banking disembowelled
Total government bailouts exceed

$2 trillion in US and Europe.
199
Highlights continued
US equity markets lose over $8 trillion in value
Global contagion. Worldwide recession.
Over 20 million jobs lost
3 years later US unemployment still

near 10%
200
The Global Recession The
Business Cycle of 2008-09
The global recession originated in the US
the richest and the strongest economy of the
world in the later half of 2008 and spread
to almost all major economies of the world.
The economic recession in the US was

caused by a financial crisis, widely known as
sub-prime crisis. The financial crisis in the US
was caused by the burst of the housing
boom.
201
The US Economic Recession and the
World Economy
IMF, WB and UN bodies have given their estimates
of impact of the US economic recession in terms
of:
Decline in global growth rate
Decline in world trade
The global loss of trade
Countries affected most by the Global Recession

US, UK, Japan, Germany and Euro Area
The two least affected economies- China and India
202
Revival of the Global
Economy
Most developed and developing economies
affected by the global recession have
adopted economic stimulus schemes.
The stimulus packages aimed at

i. preventing further failure of banks and
companies and reviving the financial market,
ii. creating job opportunities for jobless, and
iii. generating additional income, with the
purpose of reviving plunging demand.
203
What Business Cycle Theory Applies
to Global Recession?
Over-investment theory of business
cycle appears to offer a reasonable
explanation to the global crisis.
204
Policy Measures to Control Business
Cycle
1.Fiscal policy
2.Monetary policy.
205
Relationship between public
expenditure and GDP, and between
tax and GDP:
1. Public expenditure and GDP
2. Taxation and GDP
3. Counter-cyclical fiscal policy:
Automatic and Discretionary
changes
206
Monetary Policy Measures
1. Open Market Operations
2. The Bank Rate or Repo Rate
3. The Cash Reserve Ratio (CRR)
And
. Selective Credit Control Measures
. Moral Suasion
207
Monetary Policy
Measures
Increasing the discount rate: The central
bank rediscounts the eligible papers offered
by commercial banks. This is also called
bank rate.
Higher reserve ratios:
Cash Reserve Ratio (CRR)
Statutory Liquid Ratio (SLR)
Open market operations: directly sell
government securities to public and restrain
their disposable income
Selective credit control: discourages
consumption but not investment
The government may reduce public expenditure or
increase public revenue to keep a check on
inflation
Reducing public expenditure
When government spends on activities like
health, transport, communication, etc., income of
individuals increases; this in turn increases the
aggregate demand.
Therefore the reverse will also be true.
Increasing public revenue
Major source of government revenue is various types of
taxes
Increase in income tax leaves less of disposable income
in the hands of consumers
`
Learning Outcomes:
1. Meaning and Scope of monetary policy;
2. Instruments of monetary policy;
3. Role of Monetary Policy in achieving

macroeconomic goals;
4. Effectiveness and limitations of

monetary policy.
Monetary policy refers to the
action taken by the monetary
authorities to control and
regulate the demand for and
supply of money with a given
purpose.
Scope of Monetary Policy:
The scope of monetary policy

depends, by and large, on two
factors:
i. The level of monetization of the
economy, and
ii. The level of development of the

financial market
INSTRUMENTS OF MONETARY
POLICY
General Credit Control Selective Credit

Measures
Control Measures
1. Bank Rate
2. CRR 1. Credit Rationing
3. Open Market 2. Change in Lending
Operations Margins
4. SLR
3. Moral Suasion
5. Repo Rate (Repurchase
operation rate) 4. Direct Controls
6. Reverse Repo Rate
General Measures:
1. Bank Rate Policy:

. The rate at which central bank lends
money to the commercial bank and
rediscounts the bills of exchange
presented by commercial banks is
termed as bank rate
The central bank can change this
rate- increase or decrease-
depending on whether it wants to
expand or reduce the flow of credit
from the commercial banks.
Current Bank rate (Dec, 2012):
9.00 %
Limitations of BR as a Weapon of Credit
Control
1. Nowadays, commercial banks are not dependent

only on financial support from central bank, which
makes change in rate ineffective.
2. With the growth of credit institutions and financial

intermediaries, capital market has widened and
share of banking credit has declined.
2. Cash Reserve Ratio:
Also termed as Statutory Reserve Ratio (SRR)
It is the percentage of total deposits which

commercial banks are required to maintain in
the form of cash reserve with the central
bank.
Objective of CRR is to prevent shortage of
cash for meeting the cash demand by
depositors.
By changing CRR, the central bank
can change the money supply
overnight
When contractionary monetary policy
is to be adopted , then the central
bank raises the CRR
When expansionary monetary policy
is to be adopted then central bank
3. Open Market Operations
Open Market Operations is the sale

and purchase of government
securities and Treasury Bills by the
central bank of the country.
WHAT ARE TREASURY BILLS?
In India, Treasury Bills are short-term
promissory notes issued by the
Government of India through the
RBI.
There are two kinds of Treasury Bills:
a) 91- Day Bill : are issued by the

RBI on behalf of the government at
fixed discount rate of 4.6 %. The
b) 182- Day Bill: introduced in 1986,
are sold by auction to residents of
India for a minimum value of Rs
1,00,000.
The auction bid is invited every
fortnight and the discount rate is
decided on the basis of auction rate.
When central bank decides to pump
money into circulation, it buys back
the government securities, bills and
bonds
When it decides to reduce money in
circulation, it sells the government
bonds and securities.
How the sale of government
bonds affects the supply of
credit?
1. Purchase of govt. securities reduces

deposits with commercial banks and
their cash reserves which leads to
decreased credit creation capacity of
the banks.
When commercial banks themselves
decide to buy the govt. bonds and
securities, their cash reserves go
down which further reduces credit
creation capacity of the commercial
banks.
How the sale of government
bonds affects the demand of
credit?
1. Central banks sells the government

bonds them at a reduced price, i.e.,
at a price less than their
denominated price.
2. Consequently, the actual rate of
3. The rise in the rate of interest
reduces the demand for credit.
Effectiveness of OMO
Under the following conditions, OMO

do not work properly:
1. When commercial banks possess

excess liquidity.
2. In UDCs where banking system is

not well developed and security
capital markets are not
TIME FOR QUIZ
1. What is meant by monetary policy?
2. What monetary measures have

been used by the RBI to control
inflation in the country?
3. How does the working of OMO

affect the money supply in a
country like India?
4. Statutory Liquidity Ratio:
Under SLR, the commercial banks
are required to maintain a certain
percentage of their total daily
demand and time deposits in the
form of liquid assets.
Liquid assets include:
a) Excess reserves
b) Unencumbered government
securities, e.g. bonds of IDBI,
NABARD, Development Banks,
debentures of ports, trusts etc.
c) Current account balance with other

banks
5. Repo rate: RBI buys securities
from banks and thereby provides
funds to the banks. The rate of
interest at which the RBI lends
money to the bank is the repo rate.
6. Reverse repo rate: is the rate at

which the banks can buy securities
or deposit money with the RBI
Quiz
1. What do you understand by SLR,

Repo Rate, and Reverse repo rate
2. Current rates?
3. How increase and decrease in repo

rate affects the credit creation?
2. Selective Credit Control
Measures:
1) Credit rationing
2) Change in Lending Margins
3) Moral Suasion
4) Direct Controls
Limitations and Effectiveness of
Monetary Policy:
1. The Time Lag

2. Problems in Forecasting
3. Growth of Non-Banking Financial

Intermediaries
4. Underdeveloped Money and Capital

Markets
?
1. Differentiate between general and

selective credit control measures?
2. What are the factors that determine
the effectiveness of monetary
policy?
3. What monetary measures have

been used by RBI in achieving the
FISCAL POLICY
Learning Objectives:
1. Meaning and scope of fiscal policy
2. Differentiate between financial
instruments and target variables
3. Kinds of fiscal policy
4. Fiscal policy and macroeconomic
goals
The word fisc means state
treasury and fiscal policy refers to
policy concerning the use of state
treasury or government finances to
achieve certain macroeconomic
goals.
Fiscal Instruments
1. Budgetary policy deficit or surplus
budgeting
2. Government expenditure
3. Taxation
4. Public borrowings
Target Variables
Variables which are sought to be
changed through fiscal instruments
are:
1. Private disposable incomes,
2. Private consumption expenditure,
3. Private savings and investment,
4. Exports and imports, and

?
How Fiscal Instruments Affect
Target Variables?
Kinds of Fiscal Policy
1. Automatic Stabilization Fiscal Policy,
2. Compensatory Fiscal Policy, and
3. Discretionary Fiscal Policy

Fiscal Policy and Macroeconomic
Goals
1. Fiscal Policy for Economic Growth

2. Fiscal Policy for Employment
3. Fiscal Policy for stabilization
4. Fiscal Policy for Economic Equality

Crowding Out and Crowding-In
Controversy
Crowding-Out refers to the

adverse effect of high deficit
spending by the government on
private investment.
Crowding-in means rise in the

private investment due to deficit
?
1. What is fiscal policy?
2. Differentiate between fiscal

instruments and target variables?
3. Discuss the role of fiscal policy in
achieving economic growth?
4. Fiscal policy is the most powerful

tool of achieving macroeconomic
The Balance of Payments
Learning Objectives
To understand the fundamental principles of
how countries measure international business
activity,
To understand the critical differences between
trade in merchandise and services
To understand how countries with different
government policies toward international trade
and investments, or different levels of economic
development, differ in their balance of
payments
Introduction
The measurement of all international

economic transactions between the
residents of a country and foreign
residents is called the balance of
payments (BOP)
The two major sub accounts of the
balance of payments are:
Current account
Capital account
Reserves
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Current Account
I.A. goods, services, and income:

1.Merchandise
2. Shipment and other transportation
3. Travel
4. Investment income
5. Other official
6. Other private
B. Unrequited transfers:
1. Private
2. Officials
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Capital Account
II.C. Capital excluding reserves

1. Direct investment
2. Portfolio investment
3.Other long-term, official
4. Other long- term, Private
5. Other short- term, official
6. Other short term, private
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Reserves
III. D. Reserves
1. Monetary gold
2. Special Drawing Rights
3. IMF reserve position
4. Foreign Exchange assets
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Reserve assets
Reserve assets consist of those external
assets that are readily available to and
controlled by monetary authorities for direct
financing of payments imbalances, for
indirectly regulating the magnitude of such
imbalances through intervention in exchange
markets to affect the currency exchange rate
and/or for other purposes.
The category of reserve assets in the IMF's
Balance of Payments Manual, Fifth Edition
(BPM5) comprises:
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Contd
- Monetary gold;
- Special drawing rights (SDRs);
- reserve position in the Fund;
- Foreign exchange assets (consisting
of currency and deposits and
securities); and
- Other claims.
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Balance of payment equilibrium
Occurs when surplus or deficit is

eliminated from the BOP
Causes for disequilibrium
1. National output and National
spending
2. Money supply
3. Exchange Rate
4. Interest rate
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Balance of Payment Equilibrium:
Equilibrium is that state of balance of payment over the

relevant time period which makes it possible to sustain an
open economy without severe unemployment on a continuing
basis.
In BOP equilibrium, we have to make certain assumptions for
the simplicity of our analysis. These assumptions are:
(a) A given supply curve,
(b) No change in price expectations,
(c) Internal capital flows depend on the level of the interest
rate at home and abroad,
(d) No accumulation of real capital.
It is evident that the balance of payments depends on both the
level of domestic economic activity and the level of domestic
interest rate.
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Types of BOP Equilibrium:
There are two types of BOP equilibrium, i.e., static

equilibrium and dynamic equilibrium:
(a) Static Equilibrium: The distinction between
static and dynamic equilibrium depends upon the time
period. In static equilibrium, exports equal imports
including exports and imports of services as well as
goods and the other items on the BOPs short term
capital, long term capital and monetary gold are on
balance, zero. Not only should the BOPs be in
equilibrium, but also national money incomes should
be in equilibrium vis--vis money incomes abroad. The
foreign exchange rate must also be in equilibrium.
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Types of BOP Equilibrium:

(b) Dynamic Equilibrium: The
condition of dynamic equilibrium for
short periods of time is that exports
and imports differ by the amount of
short-term capital movements and
gold (net) and there are no large
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Types and Causes of BOP Disequilibrium:
There are three main types of BOP Disequilibrium

which are discussed below:
(a) Cyclical disequilibrium,
(b) Secular disequilibrium, and
(c) Structural Disequilibrium.
(a) Cyclical Disequilibrium: Cyclical disequilibrium
occurs because of two reasons. First, two countries
may be passing through different paths of business
cycle. Second, the countries may be following the
same path but the income elasticities of demand or
price elasticities of demand are different.
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Types and Causes of BOP
Disequilibrium:
b) Secular Disequilibrium: The
secular or long-run disequilibrium in
BOP occur because of long-run and
deep seated changes in an economy
as it advances from one stage of
growth to another. (The current
account follows a varying pattern
from one state to another. In the
initial stages of development,
domestic investment exceeds
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Structural Disequilibrium
(c) Structural Disequilibrium: Structural disequilibrium can
be further bifurcated into:
(i) Structural Disequilibrium at Goods Level: Structural
disequilibrium at goods level occurs
when a change in demand or supply of exports or imports
alters a previously existing equilibrium, or when a change
occurs in the basic circumstances under which income is
earned or spent abroad, in both cases without the requisite
parallel changes elsewhere in the economy. (Suppose the
demand for Pakistani handicrafts falls off. The resources
engaged in the production of these handicrafts must shift to
some other line or the country must restrict imports,
otherwise the country will experience a structural
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General Measures to Correct BOP Disequilibrium:
To correct the different types of

disequilibrium in BOP the following
general measures are used:
(a) Exchange depreciation (price effect)
or devaluation (by government),
(b) Deflate the currency,
(c) Tariffs,
(d) Import quotas, and
(e) Export duties.
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(a) Exchange Depreciation (Price Effect) or Devaluation (by
Government):
Exchange depreciation means a reduction in the value of a

currency in terms of gold or other currencies under free
market conditions and coming about through a decline in
the demand for that currency in relation to the supply. This
is usually applied to floating exchange rates. The
purpose of this method is to depreciate the external
exchange value of the home currency, thus cheapening the
domestic goods for the foreigner. Whereas, under fixed-
parity system or fixed exchange rate, the reduction of
currency value in against the gold or other currencies is
official and not market based. This official reduction of
exchange rate is called devaluation. The purpose of both
depreciation and devaluation is to cheapen the domestic
goods and boost up the exports.
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(b) Deflate the Currency:
According to this method, the currency is
deflated. As the currency contracts, prices will
fall, which will stimulate exports and check
imports. But the method of deflation is also full of
dangers. If prices are forced down while costs,
which are proverbially rigid (especially as regards
wages in countries where trade unions are well
organised), do not follow suit, the country may
face a serious depression and unemployment.
Correcting the balance of payments, therefore,
once a disequilibrium has arisen is not an easy
matter.
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(c) Tariffs:
Tariff is a tax levied on imports. It is synonymous with
import duties or custom duties. Tariffs are used for two
different purposes;
- for revenue and
- for protection.
Revenue Tariffs are a source of government revenue
and Protective Tariffs are meant to maintain and
encourage those branches of home industry protected
by the duties.
Tariff duties are of four types:
(i) Ad Valorem Tariff: It is levied as a percentage
of the total value of the imported commodity.
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Tariffs:
(ii) Specific Duties: These are
levied per unit of the imported
commodity.
(iii) Compound Duties: These
are a mixture of above two.
(iv) Sliding Scale Duties:
These vary with the prices of
commodities imported.
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(d) Import Quotas:
As a protective device, import quotas are
alternative to tariffs. Under an import quota,
fixed amount of a commodity in volume or value
is allowed to be imported into the country
during a specified period of time. The major
objectives of import quotas are:
(i) to avoid foreign competition,
(ii) to provide greater administrative
flexibility,
(iii) to solve the problem of BOP and
BOT.
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(e) Export Duties:
When world prices are higher than
domestic prices, there is an incentive
to export. In such a situation, a
government may levy export duties.
Export duties are used to prevent
exports. The reason may be that
exported commodities are required
domestically.
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1

TMH Copyright 2010

Economics is the study of mankind in the ordinary business

Economics is the science which studies human behavior as a

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Optimizing behavior of the consumers, producers

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Ignores the structural changes

The unemployment in any country is caused

The demand deficiency can be removed

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This includes household

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The level of national income determines the level of

The importance of national income accounting lies in

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All marketable production is economic

To this category belong mainly the following services:

These services are not included in the measurement

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Final goods- The goods that reach the final

The need for distinction between the

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When used for production purpose,

Transfer payments are not taken into

Producer goods- The category of final

It includes income earned by the foreigners in

The market value of domestic product is obtained

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GNP = Market value of domestically produced goods and services

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It the actual measure of national

The NNP divided by the population of

The sum of personal incomes is not

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Private income-Broadly, all personal

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Real GNP gives national income

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The GNP implicit deflator can be used

39 TMH Copyright 2010

For estimating value added-

41 TMH Copyright 2010

In modern economy, the national income is

42 TMH Copyright 2010

In order to estimate the aggregate

GDP adjusted for net income from

Another aspect of the double accounting system

In this system, many types of accounts can be

46 TMH Copyright 2010

The first systematic attempt to estimate Indias national income

In the post-independence phase, the first official estimate of

Since 1967, the task of estimating national income has been

47 TMH Copyright 2010