Principles of Business Decisions

Module 1: Basic Issues studied in Macro Economics

1. Define Economics
Economics is the study of the processes by which the relatively scarce productive
resources are allocated for production, distribution and consumption of goods and
services to satisfy the competing unlimited wants of human beings in a society.

2. Differentiate between Macro and Micro economics

Micro Economics Macro Economics

• Basically the study of the behaviour • Is the study of the overall economic
of different individuals and phenomena or the economy as a
organizations within an economic whole, rather than its individual
system. parts.
• Examines how the individual units • We study the behaviour of the large
(consumers or firms) make economic aggregates, such as, the
decisions as to how to efficiently overall levels of output, total
allocate their scarce resources. consumption, total saving and total
investment and also how these
aggregates shift over time.

Basic Issues studied Basic Issues studied

Price mechanism National income concepts
Demand – maximize utility Aggregate savings and Investment
Supply – maximize profit Full employment, economic growth,
price stability

3. Circular flow of Economy :

An economy can be defined as an integral system of production, exchange and consumption.
In carrying out these economic activities people are engaged in making transactions- they buy
and sell goods and services. Economic transactions are generally of two kinds of flow (1)
flow of goods and services (2) flow of money. Products and money flow in the opposite
direction in a circular fashion.

Circular Flow in a two sector model

Two sector model is a simplified economy and it consists of only two economic sectors-
Household and Firms (Business).
Assumptions
i) There are only two sectors in the economy, the household and the firms.

ii) Household are the owners of the factors of production (land, labour, capital,
entrepreneurship) and supply factor services to the firms.

iii) Firms hire factor services from households and pay factor payments in the form of wages,
rent, interest.

iv) Households spend their entire income on consumption, there are no savings at all.

v) Firms sell all that is produced to the households and do not maintain any inventory.

vi) There is no government or foreign trade nor any inflow or outflow of goods and services
from any other source.

The circular flow can be subdivided into two components:

i) Real flow
ii) Money flow.

i) Real flow :
Real flow of income implies the flow of factor services from the household sector to the
producing sector and the corresponding flow of goods and services from the producing sector
to the household sector.
● Household ( as the owners of the factors of production ) supplies factors of production
to the producers.
● Producers supply goods and services to the households.

ii) Money flow:

Money flow refers to the flow of factor income rent, interest, profit and wages from the
producing sector to the household sector as monetary reward for their factor services.

 The households spend their income on the goods and services produced by the
producing sector .
 Accordingly, money flows back to the producing sector as household expenditure as
shown in the flowchart.

4. National Income concept

The performance of an economy is studied in the macroeconomic variable of national
income and its related concepts of gross domestic product, gross national product,
aggregate consumption and saving, level of employment etc. It help to assess the
standard of living of the people and also to formulate policies.

Measurement and concepts in national income computation

A. Gross Domestic Product

● GDP is the sum of the market value of all final goods and services produced in an
economy during a specific period of time.
● GDP helps calculate the total output produced by an economy within a specific time
period, usually being a year.
• GDP is a number that expresses the worth of the output of a country in local
currency.
• GDP tries to capture all final goods and services as long as they are produced within
the country by any national, thereby assuring that the final monetary value of
everything that is created in a country is represented in the GDP.
 ● Domestic territory in terms of economics refers to the geographical territory which is
administered by a government within which the persons, goods, and capital are
circulated freely.
● GDP calculation is rather important as growth rate is a good indicator to the economic
growth of a nation.
● The items should be calculated at market price or value.
● All items included should be final goods that have passed the boundary of production.
● Items like intermediate goods and non-economic activities are excluded, for example:
sale of second hand or used goods, and household work are exempt from GDP
calculation.

GDP calculation:

In the simplest of forms, it would be something like

GDP = ( Price of item A x Quantity of item A) + ( Price of item B x Quantity of item B) +
( Price of ite, C + Quantity of item C) and on and on for every good and service produced
within the country.

Real GDP vs Nominal GDP:

● Nominal GDP, also known as unadjusted GDP, is the measure of value of all products
manufactured in a nation as per the current market price. So, nominal will contain all
the changes in the market prices owing to inflation and depletion for the current year.
Therefore, the market value changes depending upon the change in respective prices
and quantity of production of those specific commodities.

● Real GDP is the value of all goods and services produced at constant price. To
calculate this, one needs to consider the prices of a selected base year. Using real
GDP one can compare the economic growth from one year to another in terms of
production of goods and services as opposed to the market value of these goods and
services.
GDP Deflater
• The Gross Domestic Product (GDP) deflator is a measure of general price inflation. It
is calculated by dividing nominal GDP by real GDP and then multiplying by 100.
Nominal GDP is the market value of goods and services produced in an economy,
unadjusted for inflation (It is the GDP measured at current prices). Real GDP is
nominal GDP, adjusted for inflation to reflect changes in real output (It is the GDP
measured at constant prices).
• GDP Deflator = Nominal GDP x 100
Real GDP

5.Gross National Product (GNP)

• GNP = Market value of domestically produced goods and services + income earned
by the national of the country in any foreign country – income earned by the
foreigners in the country
• Net National Income(NNP)= GNP – depreciation
• NNP is the measure of national income which is available for consumption and net
investment for the society. It is the actual measure of national income. NNP divided
by the population gives the per capita income of the country.

Methods of calculating national income

1. Output method - the monetary or market value of all the goods and services produced
within the borders of the country GDP (as per output method) = Real GDP (GDP at
constant prices) – Taxes + Subsidies. (GDP at Market Price)

2. Expenditure method - the total expenditure incurred by all entities on goods and
services within the domestic boundaries of a country.
 GDP (as per expenditure method) = C + I + G + (X-IM)
C: Consumption expenditure,
I: Investment expenditure,
G: Government spending and
(X-IM): Exports minus imports, that is, net exports

3. Income method - the total income earned by the factors of production, that is, labour
and capital within the domestic boundaries of a country.

GDP (as per income method) = GDP at factor cost

(wages+rent+profit+interest) + Taxes – Subsidies

5. Inflation
Inflation is the decline of purchasing power of given currency over time. It’s a quantitative
economic measure of a rate of change in prices of selected goods and services over a period
of time. Inflation indicates how much the average price has changed for the selected basket of
goods and services. It is expressed as a percentage. Increase in inflation indicates a decrease
in the purchasing price of the economy. There are three types of inflation.

THREE TYPES OF INLFATION

 DEMAND – PULL INFLATION
 COST – PUSH INFLATION
 BUILT – IN INFLATION

DEMAND – PULL INFLATION: It occurs when the demand for goods or services is higher
when compared to the production capacity. The difference between demand and supply
(shortage) result in price appreciation.

COST – PUSH INFLATION: It occurs when the cost of production increases. Increase in
prices of the inputs (labour, raw materials, etc.) increases the price of the product.

BUILT – IN INFLATION: Expectation of future inflations results in Built-in Inflation. A rise

in prices results in higher wages to afford the increased cost of living. Therefore, high wages
result in increased cost of production, which in turn has an impact on product pricing. The
circle hence continues.
Main causes of Inflation
 Monetary Policy: It determines the supply of currency in the market. Excess supply
of money leads to inflation. Hence decreasing the value of the currency.
 Fiscal Policy: It monitors the borrowing and spending of the economy. Higher
borrowings (debt), result in increased taxes and additional currency printing to repay
the debt.
 Demand - pull Inflation: Increases in prices due to the gap between the demand
(higher) and supply (lower).
 Cost-push Inflation: Higher prices of goods and services due to increased cost of
production.
 Exchange Rates: Exposure to foreign markets are based on the dollar value.
Fluctuations in the exchange rate have an impact on the rate of inflation.

The effects of a rise in the Inflation rate

A rise in an inflation rate can cause more than a fall in purchase power.
 Inflation could lead to economic growth as it can be a sign of rising demand.
 Inflation could further lead to an increase in costs due to workers demand to increase
wages to meet inflation. This might increase unemployment as companies will have to
lay off workers to keep up with the costs.
 Domestic products might become less competitive if inflation within the country is
higher. It can weaken the currency of the country.

SAVING
Savings refer to money you put aside for future use rather than spending it immediately. It’s
the portion of income not spent on current expenditures. Because a person does not know
what will happen in the future, money should be saved to pay for unexpected events or
emergencies. Without savings, unexpected events can become large financial burdens.
Therefore, savings help an individual or family become financially secure.

INVESTMENT
An investment is an asset or item acquired with the goal of generating income or
appreciation. Appreciation refers to an increase in the value of an asset over time. When an
individual purchases a good as an investment, the intent is not to consume the good but rather
to use it in the future to create wealth.

An investment always concerns the outlay of some capital today—time, effort, money, or an
asset—in hopes of a greater payoff in the future than what was originally put in.

For example, an investor may purchase a monetary asset now with the idea that the asset will
provide income in the future or will later be sold at a higher price for a profit.
SAVINGS & INVESTMENT IN NATIONAL INCOME
According to the accounting concept in national income say’s
Saving = Investment
By definition, saving is income minus spending. Investment refers to physical investment, not
financial investment. That saving equal investment follows from the national income equals
national product identity.
Investment is determined by available savings in the economy. If there is an increase
in savings, then banks can lend more to firms to finance investment projects. In a simple
economic model, we can say the level of saving will equal the level of investment.
I.E saving must equal planned investment at equilibrium GDP in the private closed economy
because when this is so, spending and production will be the same, and there will be no
unplanned inventory, or GDP, changes. the decrease in the aggregate expenditures is
multiplied into a larger change in real GDP.

In this simple economic model with a closed economy there are three uses for GDP (the
goods and services it produces in a year). If Y is national income (GDP), then the three uses
of C consumption, I investment, and G government purchases can be expressed as:
Y=C+I+G

MONEY
Money is an economic unit that functions as a generally recognized medium of exchange for
transactional purposes in an economy. Money provides the service of reducing transaction
cost, namely the double coincidence of wants. Money originates in the form of a commodity,
having a physical property to be adopted by market participants as a medium of exchange.
Money can be: market-determined, officially issued legal tender or fiat moneys, money
substitutes and fiduciary media, and electronic cryptocurrencies.

FUNCTIONS OF MONEY:
(a) Primary Functions:
Refer to the basic or original functions of money. The primary functions of money include:
(1) Medium of Exchange:
Refers to a function of money in which money is considered as a mode of exchanging
goods. The medium of exchange function is considered as the main and unique function
of money as it has solved the main problem of barter system of double coincidence of
wants.
Double coincidence of wants refers to the condition when one person receives the
commodity provided by the other person in exchange. For example, a butcher would not get
the cloth unless the weaver does not require meat.
In such a case, it is essential that both the parties require goods that they are receiving from
each other. Therefore, it was difficult to obtain required goods. However, with the
introduction of money, goods are easily made available without dependence on any other
good.
This is due to the fact that money is generally acceptable throughout an economy. Apart from
this, money is also considered as medium of exchange as it is easily portable and divisible as
well as authenticated by the government.
(2) MEASURE OF VALUE:
Refers to a function of money that helps in determining the value of goods and
services. The value of all goods and services are expressed in terms of money. Money is
taken as
The common denominator while measuring the value of goods and services in monetary
terms.
The measure of value function of money has the following advantages:
1. Helps in comparing and calculating the exchange rates between two goods
2. Provides more meaningful accounting systems.
3. Helps in determining and comparing national income of different countries
4. Helps in comparing the cost incurred on production and distribution and the revenue
generated from the consumption of goods and services
(b) SECONDARY FUNCTIONS:
Refer to important functions of money that are obtained from primary functions.
The secondary functions of money are as follows:
(1) STORE OF VALUE:
Refers to a secondary function that has been derived from the medium of exchange
function of money. Generally, individuals store their wealth in the form of money.
Therefore, money acts as an asset that sustains value over a period of time.
 In barter system, there used to be only one transaction, which was a simultaneous sale and
purchase of goods and services. However, in money economy, the sale and purchase are
considered as two separate functions. It can be possible when money not only serves as a
medium of exchange, but also store of value. For example, salary drawn by an individual is
not spent simultaneously rather it is consumed gradually for purchasing different goods and
services.

(2) STANDARD OF DEFFERED PAYMENTS:

Refers to one of the most important functions of money. Deferred payments refer to
payments made on loans, salaries, pensions, insurance premium, interests, and rents.
The necessary condition for deferred payment is that the amount of repaid money
should be the same as it was at the time of purchase.
In barter system, it was not possible to find out whether the amount returned in the form of
commodity is same as it was at the time of purchase. For example, the price of one quintal
rice purchased today would not be same after one year. However, the standard of deferred
payment function of money is not free from limitations as the value of money has always
remained a subject of fluctuations due to inflation.
Different economists have given different viewpoints on money. They treated money as a
concept rather than a commodity. The definition of money has always been a controversial
issue. Therefore, a universally accepted definition of money has not been provided.

(3) MONEY ELIMINATES THE PROBLEM OF BARTER SYSTEM:

Money solves the problems that the barter system creates. Money serves as a medium of
exchange, which means that money acts as an intermediary between the buyer and the seller.
Instead of exchanging accounting services for shoes, the accountant now exchanges
accounting services for money. The accountant then uses this money to buy shoes. To serve
as a medium of exchange, people must widely accept money as a method of payment in the
markets for goods, labor, and financial capital.

(4) WORKS AS THE FIFTH FACTOR OF PRODUCTION:

However, money is not a factor of production because it is not directly involved in
producing a good or service. Instead, it facilitates the processes used in production by
enabling entrepreneurs and company owners to purchase capital goods or land or to pay
wages.

(5) ACCELERATES THE GROWTH OF PRODUCTION:

An initial increase in expenditure can lead to a larger increase in the quantity of goods
produced in an economy because spending by one household, business or the government is
income for another household, business or the government.

(6) LIFE BLOOD OF MODERN ECONOMY:

Whether we pull out paper bills or swipe a credit card, most of the transactions we engage
in daily use currency. Indeed, money is the lifeblood of economies around the world.
Currency refers to paper money or coins that are in circulation.
MONEY SUPPLY:
Q. What is money supply?
In economics, the money supply refers to all of the cash and currency in circulation within a
country. A country’s money supply has a significant effect on a country’s macroeconomic
profile, particularly in relation to interest rates, inflation, and the business cycle.
Q. How is money supply determined?
A central bank regulates the level of money supply within a country. Expansionary policies
involve the increase in money supply through measures such as open market operations,
where the central bank purchases short-term Treasuries with newly created money, thus
injecting money into circulation. Conversely, a contractionary policy would involve the
selling of Treasuries, removing money from circulating in the economy.
High Power Money (Reserve Money or Base Money) – High power money is the base of
money supply expansion in the economy.
High Power Money = C + OD + CR.
C = Currency with the public
OD = Other Deposits of the general public with the RBI (insignificant)
CR = Cash Reserves of banks which consists of (i.) Cash with banks themselves and (ii)
Bankers deposits with RBI.

Classical Theory of Inflation

The classical theory of inflation refers to the sustained price inflation to excessive growth in
the quantity of money in circulation. Therefore, sometimes it is also called the “quantity
theory of money” even though it is about inflation
This theory is concerned with the consequences of increase or decrease in the money supply
on aggregate price levels in the economy

Classical theory of inflation – Fisher

This theory explains how money supply is a major factor of the price level in an economy
and how money supply is the main cause of inflation in an economy.
As the quantity of money in an economy increases the price,££j aka inflation also tends to
rise
Value of money starts to fall therefore

MxV=PxT
Following are the assumptions made in the theory

1. Velocity remains constant

2. Volume of transactions remain constant
 3. Economy is at full employment
4. Price is a passive factor
5. It is a long run theory
6. Money is used only as a medium of exchange

 M = money supply
 V = Velocity of money
 P = average price level
 T = Volume of transactions
Let us take an example to understand this

Assume M = 200, V = 5, P = 1000, T = 1

When we take M x V we get
M x V = 200*5 = 1000 (the total money supply in an economy)

Similarly, when we take P x T, we get

P x T = 1000*1 = 1000(the total money demanded for transaction purpose)

Here, Assuming V and T to be constant, we can see a clear relation between money supply
and price level
So, money supply in an economy rises consequently the prices of goods and services also
rise. As a result of the value of money is bound to fall. This is what we call inflation.

Fisher effect

• The Fisher Effect is an economic theory that states that the nominal interest rate
is equal to the real interest rate plus expected inflation. This theory states that
people will demand a higher nominal interest rate to compensate for the expected
loss in purchasing power due to inflation. The Fisher Effect is used to help
predict how changes in inflation expectations will impact interest rates.

INTEREST RATE AND MONEY SUPPLY

• The supply of money in an economy is determined by the policies of the government

and the Central Bank of the country. It consists of coins, currency notes and bank
deposits. The supply of money is not affected by the Interest rate; hence, the supply of
money remains constant in the short period.
• In the long run it depends on the Demand and supply of savings – savings and
investment

The rate of interest in the economy is decided by the level of savings and investment