Unit – V

Macro Economics: National Income – Business

Cycles – Fiscal Policy – Monetary Policy.

Macro Economics:
Appropriate decision making is the strength of
business. Success in business depends on proper and
correct decision making. Location, scale of operation,
quantum of resources to be employed, marketing etc., are
some of the important problems calling for decisions in
business where macroeconomics may be applied for
better results.

Macro-Economic Analysis
Macroeconomics is concerned with the study of
aggregate economic variables. It is concerned with the
whole economy and studies the level and the growth of
national income, the levels of employment, the level of
private and government spending, the balance of
payments, the consumption & the investment, saving
functions and oscillations in business cycles.
The objective of macroeconomics is to maintain
macro equilibrium of the economy. According to Edwin
Mansfield, ‘Macroeconomics deals with the behavior of
aggregates like gross national product and the level of
employment.

National Income:
The total income of the nation is called national
income. In real terms, national income is the flow of
goods and services produced in the economy in a
particular period—a year.
Modern economy is a money economy. Thus,
national income of the country is expressed in money
terms.
A National Sample Survey has therefore defined
national income as “The money measures of the net
aggregate of all commodities and services accruing to the
inhabitants of community during a specific period.”

Different Concepts of National Income:

1. Gross National Income or Product (GNP):

Gross National Product has been defined as the total
market value of all final goods and services produced in a
year. It is the money value of all the final goods and
services which the labour and capital of a country
working on its natural resources have produced in a year.
It includes not only the part of the production which is
brought to the market for sale but also that part of the
produce which is kept for self consumption.

2. Net National Product or (NNP):

Net National Product (NNP) refers to the value of the
net output of the economy during the year. It is obtained
by deducting the value of depreciation or replacement
allowance of the capital assets from the GNP.
To put it symbolically:
NNP = GNP – D
where D = depreciation allowances.

This value is measured at current prices, while GNP

is expressed at the current market price. Net National
Product, in-fact, is the value of total consumption plus the
value of net investment of the community. It is the sum
total of net values added by each producer in the
productive process of an economy during one year period.
3. Gross Domestic Product (GDP):
Gross Domestic Product is the money value of all goods
and services produced annually within the territorial
limits of the country.
Gross Domestic Income includes:
(i) Wages and salaries,
(ii) Rents, including imputed house rents,
(iii) Interest,
(iv) Dividends,
(v) Undistributed corporate profits, including
surpluses of public undertakings,
(vi) Mixed incomes consisting of profits of
unincorporated firms, self-employed persons, partnership
etc., and
(vii) Direct taxes.
4. Per Capita Income:
Per capita income refers to the average income of an
individual in a particular year. It denotes the income
received by an individual during a certain year in a
country. In order to find per capita income of a country in
a certain year, we divide the national income of that
country by the population of that country in that year e.g.,
 Per-Capita Income = National Income of India in
2002/Population of India in 2002
It is clear that a country having high national income
and less population will have higher per capita income.
The concept of per capita income helps us in estimating
the standard of living of different nations and it also
serves as an index of economic development.

5. Personal Income:
Personal income is the aggregate income received by
the individuals of a country from all sources before
payment of direct taxes in one year. It is derived from
national income by deducting undistributed corporate
profits, profit taxes and employee’s contributions to social
security schemes.

6. Disposable Income or Personal Disposable Income:

Disposable income or personal disposable income is
the actual income which can be spend on consumption
because it is the income that accrues before direct taxes
have actually been paid. Therefore, in order to obtain the
disposable income, direct taxes are deducted from
personal income. Thus,
 Disposable Income = Personal Income — Direct Taxes
But it should be remembered while calculating this
income that the whole of the disposable income is not
spend on consumption and a part of it is saved. Therefore,
the disposable income is divided into consumption
expenditure and saving. Thus,
Disposable Income = Consumption Expenditure + Savings
The concept of Disposable Income is very useful in
computing the real purchasing power of the country. It
also gives us an information regarding the personal
consumption pattern. It refers to that part of the personal
income which is actually available to the consumers. It
can be obtained by deducting the amount of personal
taxes, fines etc., from personal income. It is at the
disposal of the consumers to save or consume or to use it
in any way they like.

Methods of Calculating National Income

The national income of a country can be measured by
three alternative methods: (i) Product Method (ii) Income
Method, and (iii) Expenditure Method.
1. Product Method:
In this method, national income is measured as a flow
of goods and services. We calculate money value of all
final goods and services produced in an economy during a
year. Final goods here refer to those goods which are
directly consumed and not used in further production
process.
Goods which are further used in production process
are called intermediate goods. In the value of final goods,
value of intermediate goods is already included therefore
we do not count value of intermediate goods in national
income otherwise there will be double counting of value
of goods.
To avoid the problem of double counting we can use
the value-addition method in which not the whole value
of a commodity but value-addition (i.e. value of final
good value of intermediate good) at each stage of
production is calculated and these are summed up to
arrive at GDP.
The money value is calculated at market prices so
sum-total is the GDP at market prices. GDP at market
price can be converted into by methods discussed earlier.
2. Income Method:
Under this method, national income is measured as a
flow of factor incomes. There are generally four factors of
production labour, capital, land and entrepreneurship.
Labour gets wages and salaries, capital gets interest, land
gets rent and entrepreneurship gets profit as their
remuneration.
Besides, there are some self-employed persons who
employ their own labour and capital such as doctors,
advocates, CAs, etc. Their income is called mixed
income. The sum-total of all these factor incomes is called
NDP at factor costs.
3. Expenditure Method:
In this method, national income is measured as a flow
of expenditure. GDP is sum-total of private consumption
expenditure. Government consumption expenditure, gross
capital formation (Government and private) and net
exports (Export-Import).

Difficulties of National Income Calculations:

1. Types of Goods and Services:
The kinds of goods and services which should be
included in national income pose a problem. Goods and
services having money value are included in the national
income but there are goods and services which may have
no corresponding flow of money payments. Services
which are performed for love, kindness and mercy and not
for money have an economic value but have no money
value.
The difficulty is whether these services should be
included in national income and how to measure their
money value, e.g., a paid maid servant’s services are
included in the national income but later when she
marries the master, she is not paid any more, though she
continues to perform the services. There is, thus, a
reduction in the national income.
2. Problems of Double Counting:
Another difficulty is of double counting usually
associated with the inventory method. Double counting
implies the possibility of a commodity like raw material
or labour being included in national income more than
once, e.g., a farmer sells maize worth rupees two hundred
to a mill-owner, the mill owner further sells the maize
flour to a wholesale dealer, who further sells it to
consumer; if we calculate it at every stage, its money
value will increase to eight hundred rupees but actually
the increase in national income has been to the extent of
two hundred rupees only.
3. Excluded Market Transactions:
Certain transactions that take place in the market are
excluded from the computation of national income
because they violate the general rule for the recognition of
income—the good or service must be currently produced
and must use up currently available scarce resources.
Many transactions are such that represent merely the
transfer of wealth (or claims to wealth) or the exchange of
commodities produced in some previous accounting
period.
4. Problem of Imputed Values:
There are certain goods and services which do not
appear in or cannot be brought to the market. In such
cases we have to impute values to them. It means to give
or to fix their values, in case they had been brought to the
market. The procedure although very logical yet is beset
with number of practical difficulties because the task of
imputing or fixing values is not easy. But, values, once
they are imputed or fixed are included in the national
income accounts.
5. Inventory Adjustments:
Inventory adjustments i.e., changes in the stock of
capital goods or final products are also to be taken into
account while computing national income. If a jute mill
adds to its inventory of jute products during the year, it
represents an increase in output and must, therefore, be
included in GNP. The difference between the officially
published figures and the figures obtained from the
business accounting data calls for inventory valuation
adjustment. On account of the change in the physical
volume of inventories and the change in the prices at
which these inventories are valued by business units,
inventory valuation adjustment becomes essential.
6. Depreciation:
Depreciation implies a reduction in the value of
capital stock or capital goods due to wear and tear,
constant use etc. During the process of production the
wear and tear or capital consumption occurs, resulting in,
at the same time, a decline in the relative efficiency of the
plant and equipment on account of obsolescence.
However, the problem of correctly estimating
depreciation is equally a difficult task e.g., a machine may
be used more intensively in one year than the other. But
the rate of depreciation remains the same, though it
should differ between two years. Again, the depreciation
of similar equipment may differ between two business
units.
Business Cycle (or) Trade Cycle:
The different phases and fluctuations that an
economy goes through over time, such as periods of
booms (expansions) and economic recessions
(contractions), are collectively known as the business
cycle. With these booms and recessions come concurrent
increases and decreases in an economy’s production
output levels for goods and services. Sometimes the
business cycle is also referred to as the trade cycle or the
economic cycle.
One entire business cycle is the completion of an
expansion and a contraction sequentially. An expansion
takes place when the economy is growing; a contraction
happens when the economy goes into decline (otherwise
known as a recession). Business cycles can be quantified
based on increases and decreases in the gross domestic
product (GDP) as well as in the GDP after it has been
adjusted for inflation.
Numerous factors have considerably influenced the
business cycle, including technology, fiscal/regulatory
policy, demographic shifts, oil price spikes, and more.
Business Cycle Phases
The Business Cycle Graph

1. Expansion or Boom
In the graph above, the curve above the trend line
represents the expansion phase of the business cycle. The
periods of expansion (economic growth where real output
increases) follow a period of recessions. The booms
characterize fast economic growth, which tends to
be inflationary and unsustainable. During this expansion
period employment, investment income, wages,
profits, demand, and supply are high. The movement of
the money supply is typically continuous and
uninterrupted.
2. Peak
The peak is the second stage of the trade cycle. This
stage is the maximum growth the economy can achieve,
and there are no further signs of economic growth
according to economic indicators. At this point, prices
also hit their maximum level. The end of the peak marks
the beginning of the contraction of the economy.
3. Recession
The peaks are expansions or booms, and the troughs
are recessions. The period of recessions is often
characterized by high unemployment, negative economic
growth, low sales due to reduced consumer demand,
income stagnation or even decrease, and real output
fall. Cyclical unemployment typically increases during a
recession. If rapid expansion takes place, then the
economy can heat up, and the rate of inflation could rise.
4. Depression
In the recession becomes more severe, and the
economy continues to fall below the trend line, then the
economy enters a depression period. Economic activity
and growth continue to decline. Additionally,
unemployment increases, production decreases further,
consumer confidence fails, and both trade and investment
decline. There are more bankruptcies, and both business
and consumers alike find themselves struggling to receive
credit.
5. Trough
The trough is the lowest point in the economy. All
indicators of good economic health are at their lowest
now. The economic growth rate is negative. This should
be the end of the depression and the beginning of the
recovery phase.
6. Recovery
The recovery phase of the business cycle marks the
beginning of improvement in the economy. Economic
activity starts to pick up again. Investment, employment,
confidence, spending, and prices begin to increase as the
economy begins to grow. This happens as low prices help
to fuel higher levels of demand and concurrently
production and employment levels begin to increase.
Factors that Affect the Trade Cycle
1. Natural Factors
The business cycle may change due to natural factors,
for example, during periods of heavy or unexpected
rainfall; agricultural productivity may be affected. A lack
of rainfall could result in a shortage of raw material, and
therefore, industrial production is also affected. This
shortage can affect the whole economy, particularly those
that rely on agriculture as their main component of the
Gross Domestic Product (GDP).
2. Wars
During a war, economic growth can slow down
because of uncertainty in the market and loss of business
confidence and consumer confidence. This loss of
confidence reduces spending and investment in the
economy.
3. Political Factors
In developing countries, often there is political
instability. The new government formulates new policies
and abandons the policies of previous governments. This
kind of political climate creates uncertainty in the
economy and causes business confidence and investment
to fall.
4. The Supply of Money
Unplanned changes in the supply of money can cause
business fluctuation in an economy. An increase in the
supply of money leads to the expansion in aggregate
demand. But an excessive increase in credit and money
can also set off inflation in the economy. On the other
hand, a decrease in the supply of money initiates a
recession in the economy.
5. Future Expectation
Expectations about future business is also a major
factor in the business cycle. When businesses are
optimistic about future expectations, it triggers an
expansion in business activities whereas pessimism about
profits in the future results in the contraction of business
activities.
Inflation:
In economics, inflation is a general increase in the
prices of goods and services in an economy. When the
general price level rises, each unit of currency buys fewer
goods and services; consequently, inflation corresponds to
a reduction in the purchasing power of money.
Economists, therefore, define inflation in terms of a
continuous rise in prices. Brooman defines it as “a
continuing increase in the general price level.” Shapiro
also defines inflation in a similar vein “as a persistent and
appreciable rise in the general level of prices.”
The Keynesian school believes inflation results from
economic pressures such as rising costs of production or
increases in aggregate demand. Specifically, they
distinguish between two broad types of inflation: cost-
push inflation and demand-pull inflation.
Causes of Inflation:
1. Cost-push inflation results from general increases
in the costs of the factors of production. These factors—
which include capital, land, labor, and entrepreneurship—
are the necessary inputs required to produce goods and
services. When the cost of these factors rise, producers
wishing to retain their profit margins must increase the
price of their goods and services. When these production
costs rise on an economy-wide level, it can lead to
increased consumer prices throughout the whole
economy, as producers pass on their increased costs to
consumers. Consumer prices, in effect, are thus pushed up
by production costs.
2. Demand-pull inflation results from an excess of
aggregate demand relative to aggregate supply. For
example, consider a popular product where demand for
the product outstrips supply. The price of the
product would increase. The theory in demand-pull
inflation is if aggregate demand exceeds aggregate
supply, prices will increase economy-wide.
However, it is essential to understand that a sustained
rise in prices may be of various magnitudes.
Accordingly, different names have been given to inflation
depending upon the rate of rise in prices.
Different Magnitude of Inflation:
1. Creeping Inflation: When the rise in prices is
very slow like that of a snail or creeper, it is called
creeping inflation. In terms of speed, a sustained
rise in prices of annual increase of less than 3 per
cent per annum is characterized as creeping
inflation. Such an increase in prices is regarded
safe and essential for economic growth.
2. Walking or Trotting Inflation: When prices rise
moderately and the annual inflation rate is a single
digit. In other words, the rate of rise in prices is in
the intermediate range of 3 to 7 percent per annum
or less than 10 per cent.
3. Running Inflation: When prices rise rapidly like
the running of a horse at a rate of speed of 10 to 20
per cent per annum, it is called running inflation.
Such Inflation affects the poor and middle classes
adversely.
 4. Hyper Inflation: When prices rise very fast at
double or triple digit rates from more than 20 to
100 per cent per annum or more, it is usually called
runway or galloping inflation.

Role of Fiscal Policy in Economic Development:

Fiscal policy refers to the use of government
spending and tax policies to influence economic
conditions, especially macro economic conditions,
including aggregate demand for goods and services,
employment, inflation and economic growth.
Fiscal policy is largely based on the ideas of British
Economist John Maynard Keynes (1883-1946), who
argued that economic recessions are due to a deficiency in
the consumer spending and business investment
components of aggregate demand. Keynes believed that
governments could stabilize the business cycle and
regulate economic output by adjusting spending and tax
policies to make up for the shortfalls of the private sector.
His theories were developed in response to the Great
Depression, which defied classical economics’
assumptions that economic swings were self-correcting.
Keynes’ ideas were highly influential and led to the New
Deal in the U.S., which involved massive spending on
public works projects and social welfare programs.
In Keynesian economics, aggregate demand or
spending is what drives the performance and growth of
the economy. Aggregate demand is made up of consumer
spending, business investment spending, net government
spending, and net exports. According to Keynesian
economists, the private-sector components of aggregate
demand are too variable and too dependent on
psychological and emotional factors to maintain sustained
growth in the economy.

1. Full Employment:
The first and foremost objective of fiscal policy in a
developing economy is to achieve and maintain full
employment in an economy. In such countries, even if full
employment is not achieved, the main motto is to avoid
unemployment and to achieve a state of near full
employment. Therefore, to reduce unemployment and
under-employment, the state should spend sufficiently on
social and economic overheads. These expenditures
would help to create more employment opportunities and
increase the productive efficiency of the economy.
2. Price Stability:
There is a general agreement that economic growth
and stability are joint objectives for underdeveloped
countries. In a developing country, economic instability is
manifested in the form of inflation. Prof. Nurkse believed
that “inflationary pressures are inherent in the process of
investment but the way to stop them is not to stop
investment. They can be controlled by various other ways
of which the chief is the powerful method of fiscal
policy.”
3. To Accelerate the Rate of Economic Growth:
Primarily, fiscal policy in a developing economy,
should aim at achieving an accelerated rate of economic
growth. But a high rate of economic growth cannot be
achieved and maintained without stability in the economy.
Therefore, fiscal measures such as taxation, public
borrowing and deficit financing etc. should be used
properly so that production, consumption and distribution
may not adversely affect. It should promote the economy
as a whole which in turn helps to raise national income
and per capita income.
4. Optimum Allocation of Resources:
Fiscal measures like taxation and public expenditure
programmes, can greatly affect the allocation of resources
in various occupations and sectors. As it is true, the
national income and per capita income of underdeveloped
countries is very low. In order to gear the economy, the
government can push the growth of social infrastructure
through fiscal measures. Public expenditure, subsidies and
incentives can favorably influence the allocation of
resources in the desired channels.
5. Equitable Distribution of Income and Wealth:
It is needless to emphasize the significance of
equitable distribution of income and wealth in a growing
economy. Generally, inequality in wealth persists in such
countries as in the early stages of growth, it concentrates
in few hands. It is also because private ownership
dominates the entire structure of the economy. Besides,
extreme inequalities create political and social
discontentment which further generate economic
instability. For this, suitable fiscal policy of the
government can be devised to bridge the gap between the
incomes of the different sections of the society.
6. Economic Stability:
Fiscal measures, to a larger extent, promote economic
stability in the face of short-run international cyclical
fluctuations. These fluctuations cause variations in terms
of trade, making the most favourable to the developed and
unfavorable to the developing economies. So, for the
purpose of bringing economic stability, fiscal methods
should incorporate built-in-flexibility in the budgetary
system so that income and expenditure of the government
may automatically provide compensatory effect on the
rise or fall of the nation’s income.
7. Capital Formation and Growth:
Capital assumes a central place in any development
activity in a country and fiscal policy can be adopted as a
crucial tool for the promotion of the highest possible rate
of capital formation. A newly developing economy is
encompassed by a ‘vicious circle of poverty’. Therefore, a
balanced growth is needed to breakdown the vicious
circle which is only feasible with higher rate of capital
formation. Once a country comes out of the clutches of
backwardness, it stimulates investment and encourages
capital formation.
8. To Encourage Investment:
Fiscal policy aims at the acceleration of the rate of
investment in the public as well as in private sectors of
the economy. Fiscal policy, in the first instance, should
encourage investment in public sector which in turn effect
to increase the volume of investment in private sector. In
other words, fiscal policy should aim at rapid economic
development and must encourage investment in those
channels which are considered most desirable from the
point of view of society.

Role of Monetary Policy in Economic Development:

Monetary Policy is the process by which the
monetary authority of a country, like the central bank or
currency board, controls the supply of money, often
targeting an inflation rate or interest rate to ensure price
stability and general trust in the currency.

Objectives or Goals of Monetary Policy:

1. Full Employment:
Full employment has been ranked among the
foremost objectives of monetary policy. It is an important
goal not only because unemployment leads to wastage of
potential output, but also because of the loss of social
standing and self-respect.
2. Price Stability:
One of the policy objectives of monetary policy is to
stabilize the price level. Both economists and laymen
favour this policy because fluctuation in prices bring
uncertainty and instability to the economy.
3. Economic Growth:
One of the most important objectives of monetary
policy in recent years has been the rapid economic growth
of an economy. Economic growth is defined as “the
process whereby the real per capita income of a country
increases over a long period of time.”
4. Balance of Payments:
Monetary policy in the form of interest rate policy
plays an important role in bridging the balance of
payments deficit. Under developed countries develop
serious balance of payments difficulties to fulfill the
planned targets of development. To establish
infrastructure like power, irrigation, transport, etc. and
directly productive activities like iron and steel,
chemicals, electrical, fertilizers, etc., underdeveloped
countries have to import capital equipment, machinery,
raw materials, spares and components thereby raising
their imports. But exports are almost stagnant. They are
high-price due to inflation. As a result, an imbalance is
created between imports and exports which lead to
disequilibrium in the balance in payments. Monetary
policy can help in narrowing the balance of payments
deficit through high rate of interest. A high interest rate
attracts the inflow of foreign investments and helps in
bridging the balance of payments gap.
5. To Create Banking and Financial Institutions:
One of the objectives of monetary policy in an
underdeveloped country is to create and develop banking
and financial institutions in order to encourage, mobilise
and channelise savings for capital formation. The
monetary authority should encourage the establishment of
branch banking in rural and urban areas. Such a policy
will help in monetizing the non-monetized sector and
encourage saving and investment for capital formation. It
should also organise and develop money an capital
market. These are essential for the success of a
development oriented monetary policy which also
includes debt management.
6. Debt Management:
Debt management is one of the important functions of
monetary policy in an underdeveloped country. It aims at
proper timing and issuing of government bonds,
stabilising their prices and minimising the cost of
servicing the public debt. The primary aim of debt
management is to create conditions in which public
borrowing can increase from year to year. Public
borrowing is essential in such countries in order to
finance development programmes and to control the
money supply. But public borrowing must be at cheap
rates. Low interest rates raise the price of government
bonds and make them more attractive to the public. They
also keep the burden of the debt low. Thus an appropriate
monetary policy, as outlined above, helps in controlling
inflation, bridging balance of payments gap, encouraging
capital formation and promoting economic growth.

Instruments of Monetary Policy:

The instruments of monetary policy are of two types: first,

quantitative, general or indirect; and second, qualitative,
selective or direct. They affect the level of aggregate
demand through the supply of money, cost of money and
availability of credit. Of the two types of instruments, the
first category includes bank rate variations, open market
operations and changing reserve requirements. They are
meant to regulate the overall level of credit in the
economy through commercial banks. The selective credit
controls aim at controlling specific types of credit. They
include changing margin requirements and regulation of
consumer credit. We discuss them as under:

1. Bank Rate Policy:

The bank rate is the minimum lending rate of the

central bank at which it rediscounts first class bills of
exchange and government securities held by the
commercial banks. When the central bank finds that
inflationary pressures have started emerging within the
economy, it raises the bank rate. Borrowing from the
central bank becomes costly and commercial banks
borrow less from it.

The commercial banks, in turn, raise their lending

rates to the business community and borrowers borrow
less from the commercial banks. There is contraction of
credit and prices are checked from rising further. On the
contrary, when prices are depressed, the central bank
lowers the bank rate.

2. Open Market Operations:

Open market operations refer to sale and purchase of

securities in the money market by the central bank. When
prices are rising and there is need to control them, the
central bank sells securities. The reserves of commercial
banks are reduced and they are not in a position to lend
more to the business community.

Further investment is discouraged and the rise in

prices is checked. Contrariwise, when recessionary forces
start in the economy, the central bank buys securities. The
reserves of commercial banks are raised. They lend more.
Investment, output, employment, income and demand rise
and fall in price is checked.

3. Changes in Reserve Ratios:

This weapon was suggested by Keynes in his Treatise

on Money and the USA was the first to adopt it as a
monetary device. Every bank is required by law to keep a
certain percentage of its total deposits in the form of a
reserve fund in its vaults and also a certain percentage
with the central bank.

When prices are rising, the central bank raises the

reserve ratio. Banks are required to keep more with the
central bank. Their reserves are reduced and they lend
less. The volume of investment, output and employment
are adversely affected. In the opposite case, when the
reserve ratio is lowered, the reserves of commercial banks
are raised. They lend more and the economic activity is
favourably affected.

4. Selective Credit Controls:

Selective credit controls are used to influence specific

types of credit for particular purposes. They usually take
the form of changing margin requirements to control
speculative activities within the economy. When there is
brisk speculative activity in the economy or in particular
sectors in certain commodities and prices start rising, the
central bank raises the margin requirement on them.

Conclusion:

For an effective anti-cyclical monetary policy, bank

rate, open market operations, reserve ratio and selective
control measures are required to be adopted
simultaneously. But it has been accepted by all monetary
theorists that (i) the success of monetary policy is nil in a
depression when business confidence is at its lowest ebb;
and (ii) it is successful against inflation. The monetarists
contend that as against fiscal policy, monetary policy
possesses greater flexibility and it can be implemented
rapidly.