Private & Confidential

Study Material – Managerial Economics

Unit – I – Demand & Supply Analysis
Study of Economics Involves –

o Unlimited Wants and Desires of Human Beings

o Scarce Resources to Fulfil
o Optimum Utilization of Scarce Resources (Efficiency and Effectiveness)

➢ Though many believe that economics is driven purely by money or capital, in

reality, it is much more expansive in nature.

The study of economics is subcategorized into –

❑ Microeconomics
❑ Macroeconomics
Microeconomics is the study of economics at the individual or business level, how
individual people or businesses behave given scarcity and government intervention.
• Microeconomics includes concepts such as supply and demand, price
elasticity, quantity demanded, and quantity supplied.
Macroeconomics is the study of the performance and structure of the whole
economy rather than individual markets.
• Macroeconomics includes concepts such as inflation, international trade,
unemployment, and national consumption and production.
DEMAND & SUPPLY Analysis
The importance of demand analysis in business decisions is as follows –
o Sales forecasting
o Pricing Decisions
o Marketing Decisions
o Production Decisions
o Financial Decisions

Determinants of Demand
❑ Price of a Product or Service
❑ Income - The income-demand relationship can be analyzed by grouping
goods into four categories, namely,
▪ Essential Consumer Goods
▪ Inferior Goods,
▪ Normal Goods,
 ▪ Luxury Goods.

❑ Tastes and Preferences of Consumers

❑ Price of Related Goods – Substitutes, Complementary Goods
❑ Expectations of Consumers:
❑ Effect of Advertisements
❑ Distribution of Income in the Society:
❑ Growth of Population:
❑ Government Policy:
❑ Seasonal Factors

Demand Function
INDIVIDUAL Demand Function

Dx = f (Px, Pr, Y, T, F)
Where,
Dx = Demand for Commodity X , Px = Price of the given Commodity X
Pr = Prices of Related Goods; Y = Income of the Consumer;
T = Tastes and Preferences; F = Expectation of Change in Price in future.

Market Demand Function

D = f(P , P , Y, T, F, P , S, D)
x x r D
Where,
Dx = Market demand of commodity x; Px = Price of given commodity x;
Pr = Prices of Related Goods; Y = Income of the consumers ; T = Tastes and
Preferences; F = Expectation of Change in Price in future;
PD = Size and Composition of population; S = Season and Weather; D = Distribution
of Income.

Law of Demand

“Higher the price, Lower the Demand and Lower the Price Higher the Demand ,
other things remaining constant “

Assumptions to Law of Demand

• There is no change in the tastes and preferences of the consumer;
• The income of the consumer remains constant;
• There is no change in customs;
• The commodity to be used should not confer distinction on the consumer;
• There should not be any substitutes of the commodity;
 • There should not be any change in the prices of other products;
• There should not be any change in the quality of the product; and
• The habits of the consumers should remain unchanged.
➢ Given these conditions, the law of demand operates. If there is change even
in one of these conditions, it will stop operating.

Exceptions to Law of Demand

❑ War
❑ Depression
❑ Goods Having Prestige Value: Veblen Effect
❑ Giffen Goods
❑ Speculation
❑ Using Price as an Index of Quality
❑ Ignorance Effect
❑ Necessities of Life
Demand Curve – Why Does it Slope Downwards
▪ Income effect
▪ Substitution effect
▪ Law of Diminishing Marginal Utility
▪ New Consumers
▪ Multiple Use of Commodity
Demand Curve – Movement and Shift
Movement along the demand curve depicts the change in both the factors - the price
and quantity demanded, from one point to another.
Other things remain unchanged when there is a change in the quantity demanded
due to the change in the price of the product or service, results in the movement of
the demand curve.
The movement along the curve can be in any of the two directions –

▪ Upward Movement: Indicates contraction of demand, in essence, a fall in

demand is observed due to price rise.
▪ Downward Movement: It shows expansion in demand, i.e. demand for the
product or service goes up because of the fall in prices

➢ Hence, more quantity of a good is demanded at low prices, while when the
prices are high, the demand tends to decrease.

Demand Curve – Shift

The Important Non Price Determinants which cause the Shift in the Demand Curve
are as follows –

Income of the Buyers

Consumers Tastes and

Preferences

Expectation of Future Price,

Supply , needs etc.

Price of Related Goods (

Substitutes)

Demand Curve – Reasons of Shift

❑ Change In Prices of a Substitute Goods

❑ Change In Price of a Complementary Goods
❑ Changes in the Income of Consumers
❑ Effects of Advertising and Marketing
❑ Interest Rates and Demand

Elasticity of Demand

• Elasticity of Demand refers to how sensitive the demand for a good is to

changes in other economic variables, such as the prices and consumer
income.
• Elasticity of Demand is calculated by taking the percentage change in quantity
of a good demanded and dividing it by a percent change in another economic
variable ( Could be Price, Income, Type of Goods – Substitutes ,
Complimentary etc.)
➢ A higher Demand Elasticity for a particular economic variable means
that consumers are more responsive to changes in this variable, such
as price or income.
TYPES of Demand Elasticity
Classified on the basis of –
❑ Source
❑ Degree
According to the SOURCE of the change, the following types of elasticity of
demand can be mentioned –

• Price Elasticity of Demand

▪ Cross Elasticity of Demand (the elasticity in relation to the change of the
price of other goods and services)
▪ Income Elasticity of Demand
▪ Advertisement Elasticity of Demand (the elasticity in relation to the
advertisement expenditure)

According to the DEGREE of the change in the demand, the elasticity can be
classified in:
o Perfectly Elastic
o Relatively Elastic
o Unit Elasticity
o Relatively Inelastic
o Perfectly Inelastic

▪ Perfectly Elastic Demand – Ed = ∞

▪ Perfectly Inelastic Demand – Ed= 0
▪ Unitary Elastic Demand – Ed = 1

▪ Relatively elastic demand: The elasticity is between - 1 and ∞

▪ Relatively inelastic demand: The elasticity is between 0 and 1.

Price Elasticity
The price elasticity of demand is the proportional change in the quantity demanded,
relative to the proportional change in the price of the good.

➢ Price elasticity of demand = Percentage change in quantity demanded /

Percentage change in price

Cross Elasticity

The cross elasticity of demand is the proportional change in the quantity demanded,
relative to the proportional change in the price of another good.
➢ Cross elasticity of demand
= Percentage change in quantity demanded / percentage change in price of another
good
= ΔQ1/Q1 / ΔP2/P2

Income Elasticity

The income elasticity of the demand is defined as the proportional change in

the quantity demanded, divided the proportional change in the income.
▪ The income elasticity of demand is the proportional change in the quantity
demanded, relative to the proportional change in the income.
▪ Income elasticity of demand
= Percentage change in quantity demanded / percentage change in the income
= ΔQ/Q / ΔI/I

Measurement of Elasticity

It’s not enough to know about the Various types of Elasticity .In real managerial use
we need to measure it. There are 4 Methods of measuring Elasticity of Demand –

▪ Total Outlay Method

▪ Proportionate Method
▪ Geometric or Point Method
▪ Arc Method

Supply Analysis

Supply and demand is perhaps one of the most fundamental concepts of

economics and it is the backbone of a market economy.
➢ Demand refers to how much (quantity) of a product or service is desired by
buyers. The quantity demanded is the amount of a product people are willing
to buy at a certain price; the relationship between price and quantity
demanded is known as the demand relationship.
Supply represents how much the market can offer. The quantity supplied refers
to the amount of a certain good producers are willing to supply when receiving a
certain price.
➢ The correlation between price and how much of a good or service is supplied
to the market is known as the supply relationship.
Price, therefore, reflects supply and demand.

The Law of Supply

Like the law of demand, the law of supply demonstrates the quantities that will be
sold at a certain price. But unlike the law of demand, the supply relationship shows
an upward slope.
 ➢ This means that the higher the price, the higher the quantity supplied.
Producers supply more at a higher price because selling a higher
quantity at a higher price increases revenue.
➢ Law of Demand is – vely sloped showing that with Increase in Prices
Demand comes down and just the Opposite of that is the Behavior of
Supply curve , its +vely sloped showing that with Increase in Prices the
Suppliers would tend to supply more to create more revenue/profits

Determinants of Supply

Price of a Given Commodity

Price of Other Goods

Price of Factors of Production (

Inputs)

State of Technology

Govt. Policy ( Taxation Policy )

Goals/ Objectives of a Firm

Supply Function
Out of the Above determinants of Supply the Own Price of the Commodity, Prices of
Inputs, technology used in Production are 3 most Important Factors of Supply
Function.
QXS = S ( Px, F1,F2……………..Fm )
Qxs = Quantity Supplied of the Commodity X
Px = Price
F1,F2 ………. Fm = Input Costs to produce commodity X
S = State of technology

Shift Of Supply Curve

The amount of commodity that the producers or suppliers are willing to offer at the
marketplace can change even in cases when factors other than price of the
commodity change. Such non-price factors can be cost of factors of production,
tax rate, state of technology, natural factors, etc.

When quantity of the commodity supplied changes due to change in non-price

factors, the supply curve does not extend or contract but shifts entirely.

o For an instance, introduction of improved technology in industries helps in

reducing cost of production and induces production of more units of
commodity at same price. As a result, quantity of commodity supplied
increases, but price of the commodity remains as it is.

Shift in supply curve can also be of two types –

• Rightward shift occurs in supply curve when quantity of supplied commodity
increases at same price due to favorable changes in non-price factors of
production of commodity.
• Leftward shift occurs when quantity of supplied commodity decreases at the
same price.
Reasons for Rightward shift of supply curve

▪ Improvement in technology
▪ Decrease in tax
▪ Decrease in cost of factor of production
▪ Favorable weather condition
▪ Seller’s expectation of fall in price in future

Reasons for Leftward shift of supply curve

▪ Use of old or outdated technology
▪ Increase in tax
▪ Increase in cost of factor of production
▪ Unfavorable weather condition
▪ Seller’s expectation of rise in price in future
Market Equilibrium

Market equilibrium is an economic state when the demand and supply curves
intersect, and suppliers produce the exact amount of goods and services
consumers are willing and able to consume.

➢ Essentially, this is the point where quantity demanded and quantity

supplied is equal at a given time and price.
 ➢ There is no surplus or shortage in this situation and the market would be
considered stable.

In other words, consumers are willing and able to purchase all of the products
that suppliers are willing and able to produce. Everyone wins.

UNIT – II – Production & Cost Analysis

Production Analysis
The Supply of Product primarily depends upon its cost of Production. Cost of
production depends upon the following 2 Aspects –

❑ Physical Relationship between Inputs and Output

❑ Prices of Inputs
• The Physical Relationship between INPUT & Output forms the Subject matter
of “THEORY of Production”
➢ “The Theory of Production relates to the Physical Laws Governing Production
of Goods.
Definition of Production

The processes and methods used to transform

❖ Tangible Inputs (raw materials, semi-finished goods, subassemblies) and

❖ Intangible inputs (ideas, information, knowledge)

into goods or services.

Resources are used in this process to create an output that is suitable for use
or has Exchange Value.

Production Function

Mathematically, such a basic relationship between inputs and outputs may be

expressed as:
Q = f ( L, C, N )

Where Q = Quantity of output , L = Labor, C = Capital, N = Land.

Hence, the Level of Output (Q), depends on the Quantities of different inputs (L,
C, N) available to the firm.
➢ In the simplest case, where there are only two inputs, labor (L) and capital (C)
and one output (Q), the production function becomes.

Q = f (L, C)

Product Concepts

There are three concepts relating to production of a commodity –

❑ Total Product denoted as (TP)

❑ Average Product denoted as (AP)
❑ Marginal Product denoted as ( MP )

❑ Total Product (TP)

TP refers to the total quantity of output of a commodity at a particular level of
employment of an input, say labour, when the employment of all other inputs is
unchanged.

❑ Average Product (AP)

AP is the output per unit of a variable input, say labour. It can be obtained by dividing
TP by the number of units of a variable factor.

❑ Marginal Product (MP)

MP is defined as increase or decrease in TP resulted due to addition of one extra
unit of labour, keeping all other inputs unchanged
Law of Diminishing Returns
Law of Diminishing Returns occupies an important place in economic theory.

o Keeping other factors fixed, the law explains the production function with one
factor variable. In the short run when output of a commodity is sought to be
increased, the law of variable proportions comes into operation.

Therefore, when the number of one factor is increased or decreased, while other
factors are constant, the proportion between the factors is altered.

Example
For instance, there are two factors of production viz., land and labor. Land is a fixed
factor whereas labor is a variable factor. Now, suppose we have a land measuring 5
hectares. We grow wheat on it with the help of variable factor i.e., labor.

• Accordingly, the proportion between land and labor will be 1: 5

• If the number of laborers is increased to 2, the new proportion between labor
and land will be 2: 5
Due to change in the proportion of factors there will also emerge a change in total
output at different rates.
➢ This tendency in the theory of production called the Law of Variable
Proportion
Returns to a Factor
In the long run all factors of production are variable. No factor is fixed.
Accordingly, the scale of production can be changed by changing the quantity of all
factors of production.

“The term returns to scale refers to the changes in output as all factors change by
the same proportion.”
Returns to scale relates to the behavior of total output as all inputs are varied and is
a long run concept

In the long run, output can be increased by increasing all factors in the same
proportion. Generally, laws of returns to scale refer to an increase in output due
to increase in all factors in the same proportion. Such an increase is called
returns to scale. We shall be discussing the Returns of Scale wrt to change in
Labor and Capital Inputs.

Returns to Scale are of 3 Types –

o Increasing Returns to Scale

o Constant Returns to Scale
o Decreasing Returns to Scale

What is an Isoquant?

The term "isoquant," broken down in Latin, means “equal quantity,” with “iso”
meaning equal and “quant” meaning quantity. Essentially, the curve represents a
consistent amount of output. The isoquant is known, alternatively, as an equal
product curve or a production indifference curve

➢ Isoquants represent how different combinations of Labor & Capital can

produce same Quantity

The returns to scale can be shown diagrammatically on an expansion path “by the
distance between successive ‘multiple-level-of-output” isoquants, that is, isoquants
that show levels of output which are multiples of some base level of output, e.g., 100,
200, 300, etc.”

COST Analysis
Analysis of cost is important in the study of managerial economics because it
provides a basis for two important decisions made by managers:

(a) whether to produce or not and

(b) how much to produce when a decision is taken to produce.

- In Economics, cost of production has a special meaning. It is all the payments

or expenditures necessary to obtain the factors of production of Land , labor,
 capital and management required to produce a commodity. It represents
money costs which we want to incur to acquire the factors of production.
-
In an Industry the Important Elements of Cost is as follows –

o Purchase of raw material, Installation of plant and machinery, Wages of labor,

Rent of Building,

Cost Types
❑ Based on Nature of the Cost (Economic Cost)

▪ Fixed Cost - It is the cost of Fixed inputs used in Production. These Costs do
not vary with the change in the Volume of Production.

▪ Variable Cost - It is the cost of Inputs used in Production. These change with
change in the Volume of Production.

▪ Semi Variable Cost - It refers to the costs which are Partly Fixed and Partly
Variable. For Eg – Administrative Cost , Maintenance Cost etc.

▪ Total Cost - Refers to the Total Cost of Production – Fixed Cost ( FC ) +

Variable Cost

▪ Marginal Cost - Refers to the Cost of Producing one extra unit of a Product

MCn = TCn – TCn-1

❑ Based on Behavior of Cost

▪ Direct Cost - Costs which are Easily Traceable

▪ Indirect Cost - refers to the cost which are Indirect and not easily Traceable
▪ Explicit or Accounting Cost – Refers to the Payment made in Monetary
Terms by the Firm to the Owners of Factor services required for Production
▪ Implicit or Economic Cost – Refers to the Estimated Value of all the Inputs
owned and put to use for Production by a Firm

❑ Based on Decision Making

▪ Opportunity Cost – Refers to the Cost of the next Best Alternative use that is
sacrificed in order to pursue the chosen option
▪ Sunk Cost – It is a Cost which cannot be Altered by the current Business
Activity. For Eg – Cost of Purchase of Machinery
▪ Replacement Cost – the cost of Replacing an Asset , Plant Machinery,
Equipment etc.
 ▪ Imputed Cost – Hypothetical Costs which are considered for Decision
Making Purposes and do not involve actual Cash Flow
▪ Real Cost – Refers to all efforts and sacrifices made by Owners of Factors of
Production in Production of a Commodity
▪ Social Cost – Refers to the Cost of Hardship that Society has to bear due to
the Operations of Business Activity
Cost Types – Analytical Cost Concepts
o Fixed Costs (FC) - The costs which don’t vary with changing output. Fixed
costs might include the cost of building a factory, insurance and legal bills.
Even if your output changes or you don’t produce anything, your fixed costs
stay the same.
o Variable Costs (VC) - Costs which depend on the output produced. For
example, if you produce more cars, you must use more raw materials such as
metal. This is a variable cost.
o Total cost represents the value of the total resource requirement to produce
goods and services. It refers to the total outlays of money expenditure, both
explicit and implicit, on the resources used to produce a given level of output.
It includes both fixed and variable costs. The total cost for a given output is
given by the cost function.
o Average cost: Average cost (AC) is obtained by dividing the total cost (TC)
by the total output (Q),

Cost Function

Cost function is a mathematical formula used to show how production expenses

will change at different output levels. In other words, it estimates the total cost of
production given a specific quantity produced.

➢ Management uses this model to run different production scenarios and help
predict what the total cost would be to produce a product at different levels of
output. The cost function equation is expressed as –

C(x)= FC + V(x)

- where C equals total production cost, FC is total fixed costs, V is variable cost
and x is the number of units.

Short and Long Run Costs

Short-run and long-run cost concepts are related to variable and fixed costs
respectively, and often marked in economic analysis interchangeably.
o Short-run is a period during which the physical capacity of the firm
remains fixed. Any increase in output during this period is possible only by
using the existing physical capacity more extensively. So short run cost is
 that which varies with output when the plant and capital equipment in
constant.
o Long run costs are those, which vary with output when all inputs are variable
including plant and capital equipment. Long-run cost analysis helps to take
investment decisions – Plant Size, Multiple Locations, Change in Technology
etc.
• Long-run costs, on the other hand, are the costs which are incurred on the
fixed assets like plant, building, machinery, etc. Such costs have long-run
implication in the sense that these are not used up in the single batch of
production.
UNIT III – Markets
A set up where two or more parties engage in exchange of goods, services and
information is called a market. Important types of Markets are

o Perfect competition – Many firms, freedom of entry, homogeneous

product, normal profit.

o Monopoly – One firm dominates the market, barriers to entry, possibly

supernormal profit.

o Oligopoly – An industry dominated by a few firms

o Monopolistic competition – Freedom of entry and exit, but firms have

differentiated products. Likelihood of normal profits in the long term.

Perfect Competition
❖ Key Features of Perfect Competition
In order to attain perfect competition, several factors need to be met. The following
list outlines some of the main factors: -

▪ Knowledge is available to all buyers and sellers, and no individual has

control over the prices.
▪ Buyers and sellers have no barriers to enter or leave the market.
▪ Buyers and sellers want to maximize profit.
▪ There is large no. of buyers & sellers to take control of the market.
▪ All goods are homogeneous (Similar)
▪ Entry and Exit from the Industry is Free for the Firms

Advantages of Perfect Competition

Perfect Competition brings in the most efficiencies –

▪ Allocative Efficient - This is because P = MC

▪ Productive Efficient - This is because firms produce at the lowest point on the
AC
▪ Competition between firms will call for increased efficiency
▪ Resources will not be wasted through advertising because products are
homogenous
▪ Normal profit means consumers are getting the lowest price.
▪ This also leads to greater equality in society

MONOPOLY
Monopoly is said to Exist when One Producer is the Sole Producer /Seller of a
Product which has no Close Substitutes.

Literally also it means One Seller - ‘Mono’ means One & Poly means ‘Seller’.

Monopoly exists if the Following 3 Conditions are met –

▪ There is a Single Producer or Seller of a Product

▪ There are no close Substitutes for the Product
▪ There are Strong Barriers to the Entry of a New Firm

Characteristics of Monopoly
▪ Price Discrimination
A monopolist may charge different prices for his product from different sets of
consumers at the same time. It is known as ‘Price Discrimination’.

▪ Price Maker
In case of monopoly, firm and industry are one and the same thing. So, firm has
complete control over the industry output. As a result, monopolist is a price-maker
and fixes its own price. It can influence the market price by changing the supply of
the product.

Short Run Equilibrium in Monopoly

The Monopolist Firm Maximizes the Short Run Profits when he produces the Level of
Output at which –

▪ Short Run Marginal Cost is Equal to Short Run Marginal Revenue

( SMC = SMR ).This will be reached at the Intersection Point between SMC &
SMR
▪ Marginal Cost is Rising i.e., SMC Curve Cuts the SMR Curve from Below

▪ Once the Equilibrium or Optimum Level of Output is decided by the

Monopolist the Price needs to be set in Relation to the Demand.

▪ Important to Note here that a MONOPOLIST cannot determine PRICE

independently of the Market Demand

LONG Run Equilibrium in Monopoly

In the long run monopolist would make adjustment in the size of his plant. The
long-run average cost curve and its corresponding long-run marginal cost curve
portray the alternative plants, i.e., various plant sizes from which the firm has to
choose for operation in the long-run.
• The monopolist would choose that plant size which is most appropriate for a
particular level of demand. In the short run the monopolist adjusts the level of
output while working with a given existing plant.
 • His profit- maximizing output in the short run will be where only the short-run
marginal cost curve (i.e., marginal cost curve with the existing plant) is equal
to marginal revenue.
• But in the long run he can further increase his profits by adjusting the size of
the plant. So in the long run he will be in equilibrium at the level of output
where given marginal revenue curve cuts the long run marginal cost curve.

• Fixing output level at which marginal revenue is equal to long-run

marginal cost shows that the size of the plant has also been adjusted.

• That is, a plant size has been chosen which is most optimal for a given de-
mand for the product. It should be carefully noted that, in the long run, mar-
ginal revenue is also equal to short-run marginal cost.

In the long- run equilibrium, both the long-run marginal cost curve and short-
run marginal cost curve of the relevant plant intersect the marginal revenue
curve at the same point.
• Further, it is important to note that, in the long run, the firm will operate
at a point on the long- run average cost curve (LAC) at which the short-
run average cost is tangent to it.
• This is because it is only at such tangency point that short-run marginal
cost (SMC) of a plant equals the long-run marginal cost (LMC).

Price Discrimination Under Monopoly

Price discrimination means the practice of selling the same commodity at different
prices to different buyers. Under monopoly the producer usually restricts output and
sells it at a higher price, thereby making maximum profit.

o If the monopolist charges different prices from different customers for the
same commodity, it is called price discrimination or discriminating monopoly.

o The idea is to get from each customer whatever profits could be

squeezed out of him depending on his ability to pay and intensity of
demand. When a seller charges Rs.20 for a commodity from a customer
A and Rs.22 for the same commodity from customer B, he is practicing
price discrimination.

o Joan Robinson defines price discrimination as, “the act of selling the same
article produce under a single control at different prices”. Price discrimination
may also be defined as, “the sale of technically similar products at prices
which are not proportional to marginal cost”.
Types of Price Discrimination
• Personal discrimination
• Place discrimination
• Trade discrimination

Degrees of Price Discrimination

UNIT – IV – Macro Economics

It is that part of economic theory which studies the economy in its totality or
as a whole.
 • It studies does not individual economic units like a household, a firm or an
industry but the whole economic system. Macroeconomics is the study of
aggregates and averages of the entire economy.

➢ Aggregates like national income, total employment, aggregate savings and

investment, aggregate demand, aggregate supply, general price level, etc.

Here, we study how these aggregates and averages of the economy as a whole are
determined and what causes fluctuations in them. Having understood the
determinants, the aim is how to ensure the maximum level of income and
employment in a country.

In short, macroeconomics is the study of national aggregates or economy-wide

aggregates.

➢ In a way it is like study of economic - forest as distinguished from trees

that comprise the forest. Main tools of its analysis are aggregate demand and
aggregate supply.

➢ Since the subject matter of macroeconomics revolves around determination of

the level of income and employment, therefore, it is also known as ‘Theory of
Income and Employment”

Macroeconomics Objectives
 Full Employment ( Employment
Generation )

Price Stability ( Check Inflation )

Economic Growth

Balance of Payment Equilibrium

Social Objectives

Macro-Economic Instruments
There are 2 Policy Instruments through which the Govt. tackles
Macroeconomic Issues. They are –

Monetary Policy

Fiscal Policy

❑ Monetary Policy
Implemented by central banks, monetary policy is an action that influences money
supply and interest rates. The central bank/ MPC ( Monetary Policy Committee)
can set interest rate targets for direct results.
Money supply also affects the interest rate, with increased supply usually
lowering interest rates (negative correlation). As previously mentioned,
interest rates influence consumer consumption and investment.
❑ Fiscal Policy
The government implements fiscal policy through spending and taxes to guide the
macroeconomy. Government spending influences job creation and
infrastructure improvements, which, in turn, affects money in circulation.
Taxes affect consumer disposable income.
National Income and Its Aggregates

The important concepts of national income are:

Gross Domestic Product ( GDP)

Gross National Product ( GNP )

Net National Product at Market

Prices

Net National Product at Factor

Cost or National Income

Personal Income

Disposable Income
Methods of Measuring National Income
❑ INCOME Method

This method approaches National Income from Distribution Side. Under this method
National Income is Obtained by summing up the Incomes of All Individuals in the
Country.

❑ VALUE Added / PRODUCTION Method/OUTPUT Method

In this method contribution of Each and Every Enterprise to the generation of flow
of goods and services is measured. Under this Method Economy is divided into
Different Industrial and Agriculture Sectors.

NI or NNPFC = NDPFC + Net Factor Income from Abroad

❑ Expenditure Method

Expenditure Method arrives at National Income by adding up all Expenditures made

on Goods & Services. Income can be spent on Consumer Goods or capital Goods.
▪ Expenditures can be done by – Private Individuals, Households, Govt. &
Business Enterprises
▪ Expenditure are Done on Account of Import of Goods and Services from
Other Companies / Countries
UNIT – V – Inflation, Fiscal & Monetary Policy
Inflation is the rate at which the general level of prices for goods and services is
rising and, consequently, the purchasing power of currency is falling. Inflation Erodes
the Purchasing Power of Money.
For Eg – If a Commodities price in the last year was Rs. 100 & Inflation rate is 5% ,
then to buy the same commodity this year an individual will have to spend Rs.105.
Inflation means a general rise in the Price Levels. This s a Big Problem for the
Economies world over.

Inflation Types
On the basis of the rate of increase in price level we have three types of inflation –

❑ Creeping Inflation
It is also known as mild-inflation. It is not dangerous specially in an economy
where national income is also rising. There are some economists who regard a mild
increase in the price level as a necessary condition for economic growth.

❑ Galloping Inflation
If mild inflation is not checked and if it is allowed to go uncontrolled, it may assume
the character of the galloping inflation. It may have adverse effect on saving and
investment in the economy. Normally a Double-digit Inflation

❑ Hyper-Inflation
The final stage of inflation is hyper-inflation. It occurs when the Prices go out of
control and the monetary authorities find it beyond their resources to impose any
checks on it. At this stage, there is no limit to which the price level may rise.

Inflation types on the Basis of Causes –

❑ Currency inflation
This type of inflation is caused by excess printing of currency notes.
❑ Credit inflation
Being profit-making institutions, commercial banks sanction more loans and
advances to the public than what the economy needs. Such credit expansion
leads to a rise in price level.
❑ Deficit-induced inflation
The budget of the government reflects a deficit when expenditure exceeds revenue.
To meet this gap, the government may ask the central bank to print additional
money. Since pumping of additional money is required to meet the budget
deficit, any price rise may the be called the deficit-induced inflation.
❑ Demand-Pull inflation
An increase in aggregate demand over the available output leads to a rise in the
price level. Such inflation is called demand-pull inflation (henceforth DPI). But why
does aggregate demand rise?
- Economists attribute this rise in aggregate demand to money supply. If the
supply of money in an economy exceeds the available goods and services, DPI
appears. It has been described as a situation of “too much money chasing too few
goods
❑ Cost-Push inflation
Inflation in an economy may arise from the overall increase in the cost of production.
This type of inflation is known as cost-push inflation (henceforth CPI).
- Cost of production may rise due to an increase in the prices of raw materials,
wages, etc. Often trade unions are blamed for wage rise since wage rate is not
completely market- determined. Higher wage means high cost of production.
Prices of commodities are thereby increased.

Price Index

Inflation is the Rate of Change of General Price Level during a period of time. Rate
of Inflation measures the cost of living in an Economy. To measure the Price Level
there are Indices to measure it which are as follows –

o Consumer Price Index (CPI)

o Wholesale Price Index (WPI)

Fiscal Policy
Fiscal Policy is the mechanism by means of which a government makes
adjustments to its planned spending and the imposed tax rates to monitor and
thus in turn influence the performance of a country’s economy.

It is implemented along with the monetary policy by means of which the central
bank of the nation influences the nation’s money supply. Together these policies go
hand in hand to direct a country’s economic goals.

General objectives of Fiscal Policy are given below: -

o To maintain and achieve full employment.

o To stabilize the price level.
o To stabilize the growth rate of the economy.
o To maintain equilibrium in the Balance of Payment
o To promote the economic development of underdeveloped states /
countries.
Fiscal Policy Instruments

Some of the major instruments of fiscal policy are as follows:

Budget
Taxation
Public Expenditure
Public Works
Public Debt

Monetary Policy

Monetary policy refers to the credit control measures adopted by the central bank of
a country (in Our Case the RBI / Monetary Policy Committee)

o Monetary policy is defined as a Policy “employing central bank’s control

of the supply of money as an instrument for achieving the objectives of
general economic policy.”
o It is also defined as “any conscious action undertaken by the monetary
authorities to change

- the quantity of money

- availability or cost of money.”

Objectives or Goals of Monetary Policy

There are 3 IMPORTANT Objectives of the Monetary Policy –

▪ Ensuring price stability, that is, containing inflation.

▪ To encourage economic growth.
▪ To ensure stability of exchange rate of the rupee, that is, exchange rate of
rupee with the US dollar, pound sterling and other foreign currencies.

There are two types of Monetary Policy: -

❑ Expansionary Monetary Policy (used to give Boost to the Economy )

• The money supply can be increased by buying the government bonds,
lowering the interest rates and the reserve ratio ( CRR & SLR ) .
 • By doing so, the consumer spending increases, the private sector borrowings
increases, unemployment reduces and the overall economy grows.
• Expansionary policy is also called as “easy monetary policy”.

❑ Contractionary Monetary Policy ( Used for Controlling INFLATION )

The Contractionary Monetary policy is applied when the inflation is a problem and
economy needs to be slow down by curtailing the supply of money.

• Inflation is characterized by increased money supply and increased consumer

spending.
• Thus, the Contractionary policy is adopted with an aim to decrease the money
supply and the spending's in the economy.
• This is primarily done by increasing the interest rates so that the borrowing
becomes expensive.

Main instruments of the monetary policy are: Cash Reserve Ratio, Statutory Liquidity
Ratio, Bank Rate, Repo Rate, Reverse Repo Rate, and Open Market Operations.
Monetary policy refers to the credit control measures adopted by the central bank of
a country. In case of Indian economy, RBI is the sole monetary authority which
decides the supply of money in the economy.
Instruments of Monetary Policy

The instruments of monetary policy are of two types: -

❑ Quantitative
❑ Qualitative

Quantitative
❑ Bank Rate Policy
❑ Open Market Operations
❑ Changes in Reserve Ratios

Qualitative
▪ Selective Credit Controls - Change in Margin Money, Moral
Suasion, Direct Action

Role of RBI in Indian Economy

The Reserve Bank of India (RBI) is India’s central bank and regulatory
organisation in charge of banking regulation. It belongs to the Indian
government’s Ministry of Finance.

• The Indian rupee is issued and distributed by it.

• It also oversees the country’s major payment networks and aims to further the
country’s economic growth.
• The RBI’s Bhartiya Reserve Bank Note Mudran division prints and mints
Indian banknotes and coins.
• To regulate India’s payment and settlement systems, the RBI formed the
National Payments Corporation of India as one of its specialised divisions.
• The Reserve Bank of India formed the Deposit Insurance and Credit
Guarantee Corporation as a specialised division to provide deposit
insurance and credit guarantee to all Indian banks.
• It also had full control of monetary policy until the Monetary Policy
Committee was constituted in 2016.

Functions of RBI
❑ Monetary Management
❑ Issuer of Currency
❑ Banker and debt manager of the Government
❑ Banker to Banks
❑ Financial Regulation and Supervision
❑ Developmental Role

___________________________ The END

___________________________________