National income accounting NOTES FOR ALL UNIVERSITIES MAINLY FOR ECONOMICS HONOURS COURSE AND CLASS XI , XII CBSE COURSE BY SOURAV SIR'S CLASSES 9836793076

SOURAV SIR’S CLASSES {98367 93076 }

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MACROECONOMICS

BY

SOURAV SIR’S CLASSES

INTRODUCTION

The purpose of this topic is to study how the gross national product is measuring the economic

activity of a nation. The concept is defined and explained. The components are analyzed in the

expenditure and the income approach, and the two are reconciled. Adjustments for inflation are

presented. The concept is compared to other measures of economic welfare.

NATIONAL INCOME ACCOUNTING

National income accounting is used to determine the level of economic activity of a country.

Two methods are used and the results reconciled: the expenditure approach sums what has been

purchased during the year and the income approach sums what has been earned during the year.

Just as firms need to know how well they are doing, so does a country.

National income accounting provides the statistics to determine if the

economy is encountering difficulties.

GROSS NATIONAL PRODUCT

The gross national product is the sum total of all final goods and services produced by the people

of one country in one year. The GNP is a flow concept. It can be calculated with either the

expenditure approach or the income approach. The GNP excludes intermediate goods, second

hand sales as well as financial transactions. The GNP is a money amount and must be adjusted

for changes in the value of money.

The goal of gross national product is to measure the physical activity of a

nation by adding all the different types of productions: production of cars,

production of computers, etc... But adding cars and computers does not make

much sense. Therefore, the prices of these goods are summed.

GROSS DOMESTIC PRODUCT

The gross domestic product is the sum of all the final goods and services produced by the

residents of a country in one year. Summing the production of residents (rather than nationals as

in GNP) gives often a more accurate picture of the level of activity in a country.

The difference between GDP and GNP is net unilateral transfers and

factor income of foreigners.

Countries which have many foreign firms operating within their territory,

have a gross domestic product larger than the gross national product. On the


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contrary, countries, such as the United States or Japan, which have firms

operating in foreign countries, have a gross domestic product smaller than

the gross national product (the net factor income from foreigners is negative).

INTERMEDIATE GOODS

Intermediate goods are goods which are made part of some final good. For instance, tires are

intermediate goods when they are part of a car. Tires are final goods when they are sold

separately as replacement parts. Incorporating intermediate goods to form a final good adds

value to that good.

Almost all metals and crude oil are part of intermediate goods: they are not

counted separately, but as part of the final good in which they are

incorporated. Tires purchased by customers to replace used tires are final

consumption; but, not the tires installed on new cars: these are intermediate

goods.

VALUE ADDED

GNP can be calculated by adding up all the value added from the intermediate goods (the result

is exactly the same). Countries with tax systems based on value added taxes prefer this method.

The work performed to assemble a car from its many components (such as

windshield, tires, motor, and so on), is the value added in a car assembly

plant. Such a value added can also be calculated by taking the difference

between the selling price and the costs of all material and goods used in the

product sold.

EXPENDITURE APPROACH

GDP can be calculated as the sum of all expenditures: personal consumption expenditure (C),

gross private domestic investment (Ig), government purchases (G), and net exports (Xn).

GDP = C + Ig + G + Xn.

The expenditure approach sums all that is purchased: in a sense, it is

equivalent to the income approach because purchases are only possible if

income is present.

PERSONAL CONSUMPTION EXPENDITURE

Personal consumption expenditure is what households buy (except houses). It is made of

durables (cars, appliances), nondurables (clothing, food) and services (haircuts, doctor visits,

airline tickets). A convention is made on nondurables to be all items which last less than a year,

including clothing. Nondurables expenditure is the most stable component of personal

consumption expenditure.


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People buy all kinds of goods and services. Services are, for example,

transportation, communication, banking and insurance. Durable goods

include furniture, appliances, equipment, cars, etc.. Nondurable goods are all

items which would normally be consumed within a year: food, fuel,

stationary, and by convention also clothing.

GROSS PRIVATE DOMESTIC INVESTMENT

Gross private domestic investment is made of 1) new construction, 2) new capital (machines,

trucks and equipment), and 3) changes in inventory. It excludes investment made by government

and investment made outside the country. New construction includes all forms of new building,

be it for rental purpose or for private residential purpose. Changes in inventory captures the

goods produced in one year and sold in future years.

When a company builds a plant and installs machinery and equipment: that is

an investment, i.e. an increase in capital. By convention, a private house is

considered an investment. The reason is that a private house may later be

rented and it is not possible to know for which purpose, rental or private use,

a house is built in the first place.

CAPITAL CONSUMPTION ALLOWANCE

Capital consumption allowance is the part of new capital produced during one year, which is

needed to replace the capital used up during that year. It is also known as depreciation. Capital

consumption allowance (CCA) is equal to the difference between gross investment (Ig) and net

investment (In):

CCA = Ig - In.

All machines and equipment used to produce other goods, are subject to

some wear and tear. Part of capital goods production must be devoted to

replace this wear and tear. Otherwise, the productive capacity of a nation

would be depleted. This replacement of the capital used is capital

consumption allowance.

NET INVESTMENT

Net private domestic investment is equal to gross private domestic investment less capital

consumption allowance. It is the most sensitive component of GDP. When it is negative it

implies that the capital stock is being depleted and production has to be decreasing. Economic

growth is implied in a positive net private domestic investment.

The productive capacity of a nation will increase only if net investment is

positive. This can easily be verified at the level of a single plant: the number

of new machines installed in any given year must be greater than the

machines that have been used up during that year.


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GOVERNMENT PURCHASES

Government purchases combine all goods and services bought by all forms of government: form

paper clips to bridges and hospitals. This does not include government payment for work or any

transfer payment.

As a single entity, the government is the largest purchaser in a nation. It buys

all kinds of products: from hospitals and bridges, to paper and pens (so we

can fill out all these forms). It also spends large sums on services such as

those provided by firemen and policemen.

NET EXPORTS

Net exports is the difference between total exports and total imports. It is equal to the trade or

merchandise balance of payments. When imports exceed exports (and the balance of payments is

in deficit), the amount shown as net exports is negative.

American exports, such as computers, airplanes and various crops, are all

items produced which are sold to foreigners. Imports, on the contrary, are

items produced by foreigners on which Americans spend some of their

income.

INCOME APPROACH

The income approach sums all income derived from productive activities.

If we compare a nation to a business, the income approach would be an

allocation of the funds generated from the sales of one year (net of costs of

intermediate goods), to the various expenses and retained profit.

NET NATIONAL PRODUCT

Net national product (NNP) is equal to gross national product minus capital consumption

allowance:

NNP = GNP-CCA.

Net domestic product is likewise

NDP = GDP - CCA

(As above, the difference between NNP and NDP is net factor income

and unilateral transfers to foreigners.)

The production which has been devoted to maintaining our stock of means of

production, that is the capital consumption allowance, must be deducted to

see what new consumption and income occurred during the year.


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NATIONAL INCOME

National income (NI) is equal to net national product minus indirect business taxes:

NI = NNP - (ind business taxes)

National income is also equal to the sum of salaries, rent, interest, profit and proprietors' income.

National income is the sum of all forms of gross income, similar to the gross

salary appearing in a paycheck of an employee, that is before various taxes

and other deductions are taken out.

INDIRECT BUSINESS TAXES

Indirect business taxes are all the various sales and excise taxes.

Sales taxes are the largest part of indirect business taxes. These sales taxes

are paid as an addition to the price when a purchase is made. They are passed

on to the government by the business that collects them. Thus, these moneys

are not part of what is distributed by the firm in the form of income.

PERSONAL INCOME

Personal income (PI) equals national income net of transfer payments. Transfer payments added

to national income are: social security and pension payments, welfare and unemployment

payments. Transfer payments deducted from national income are: social security contributions,

undistributed corporate profits and corporate income taxes.

TRANSFER PAYMENTS

Transfer payments are additions and subtractions to national income to obtain personal income.

Additions include social security retirement payments, unemployment benefits and welfare

payments. Subtractions include social security contributions, corporate income taxes and

undistributed corporate profits.

Transfer payments are payments which are not connected to any productive

activity. The typical example of a transfer payment is social security:

contributions to social security are collected from all those who work and are

passed on to those who are retired.

DISPOSABLE INCOME

Disposable income (DI) equals personal income less personal income taxes. Disposable income

is distributed between personal consumption expenditure and saving.

Disposable income can readily be seen in the paycheck an employee receives

from the employer. From the gross salary various amounts have been taken

out: taxes and various transfer payments. On the national level, it is just

about the same.


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REAL GDP

Real GDP is GDP adjusted for inflation (or change in value of money). The unadjusted GDP is

known as nominal or current GDP. The adjustment consists in dividing current GDP by a price

index (also known as a deflator).

GNP adjusted for inflation is said to be real in the same way as what a

paycheck can buy in various goods and services, is the real purchasing power

of that salary.

PRICE INDEX

A price index is constructed by taking the weighted average of the prices of a basket of goods in

a given year divided by the weighted average of the prices of the same basket in a base year. A

well known price index is the consumer price index or CPI.

The consumer price index is simply an average of prices reported by various

consumers from different markets during a telephone survey conducted

periodically. Such an average of prices is adequately portraying the presence

of any inflation.

National Income Accounting

National Income Accounting is the methodology used in measuring the total output and income

of the economy. To begin to measure the output of the U.S. economy we must understand the

definition of what we call the Gross Domestic Product. The Gross Domestic Product (GDP) is

the value of all the final goods and services produced in the domestic economy in a given

year.

Certain words in this definition were italicized to give emphasis to key components of how the

GDP is measured. Since the GDP measures the value of the goods and services produced it is

important to note that the GDP is measured in dollars, NOT in units of output. Measuring the

GDP in dollars allows us to aggregate or add up the output across very diverse types of goods

and services. If the GDP were measured in units of output, for example, how do you add up 10

automobiles and two bushels of wheat? What does the sum of those two outputs equal? Can you

imagine trying to do that with hundreds of thousands of goods and services and keeping it all in

units of output? Fortunately, the GDP is measured in dollars, so if the 10 automobiles are valued

at $25,000 each and the two bushels of wheat are valued at $10.00 dollars each, then the GDP is

equal to $250,020. Measuring the GDP in dollars allows us to easily aggregate the value of a

very disparate output.

The GDP includes the value of the final goods and services produced in a given year so as not to

double or triple count the value of intermediate goods that are used in the production of a final

product. If we produce an automobile in a given year, we only count the value of the automobile


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as a final product. We do not count the value of the glass in the windshield and the value of the

rubber in the tires (both of which may have also been produced in that same year) and then count

the value of the automobile also. If we did, the value of the windshield and the tires would be

counted twice. Therefore, the GDP counts only the value of the final goods and services

produced in a given year.

The fact that the GDP measures the value of the output in the domestic economy means that it

includes the value of all of the final goods and services produced within the borders of the

domestic economy, no matter who owns the factors of production. In other words, if a foreign

company is producing a good within the borders of the United States, it is counted as part of the

US GDP.

Notice in the definition of the GDP that the words in a given year were also italicized. This is to

give emphasis to the notion that the GDP in any given year does NOT include the value of

everything that is bought and sold in that year. It only includes the final goods and services that

were produced in that year. Many items are bought and sold as used items each year, but they

were included in the GDP of the year in which they were produced and NOT in subsequent years

when they are bought and sold as used items. It will be useful here to mention what happens to

the value of an item that is produced in a given year, but does not sell in the year in which it is

produced. At the end of the year it is included in inventories for that year and is thereby included

in that year’s GDP as will be seen when we discuss how to calculate GDP using the

Expenditures Approach.

There are two different ways to actually calculate the GDP. The GDP can be determined

either by adding up all that is spent to buy this year’s output (the expenditures approach)

or by summing up all the incomes derived from the production of this year’s output (the

income approach).

Section 02: The Expenditures Approach

The expenditures approach to the GDP recognizes that there are four possible uses for the output

of an economy in any given year. The output can be purchased by private households, by

businesses, by the government, or by the foreign sector.

The total payment made by households on consumption goods and services is called

consumption expenditures (C).

Firms, however, do not sell all of their output to households. Some of what they produce is

purchased by other firms. The purchase of new plants, equipment, buildings, new homes, and

additions to inventories is called investment expenditures (I). Note that is a significantly different

definition of investment than the common use of the term. In the national income accounts,

buying a stock, or an antique car, or precious gems, or a piece of art is NOT investment.


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Government purchases of finished products of businesses and all direct purchases of resources

are called government expenditures (G).

The expenditure by the rest of the world on goods and services produced by domestic firms

(exports) minus the US expenditures on goods and services produced by the rest of the world

(imports) is called net exports (NX).

The National Income Accounting Identity

Y = C + I + G + NX

Where Y is the GDP (the total output or income of the economy).

Example

Personal Consumption 3,657

Depreciation 400

Wages 3,254

Indirect Business Taxes 500

Interest 530

Domestic Investment 741

Government Expenditures 1,098

Rental Income 17

Corporate Profits 341

Exports 673

Net Foreign Factor Income 20

Proprietor’s Income 403

Imports 704


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Let me demonstrate calculating the GDP using the Expenditures Approach with the above

hypothetical data:

Y = C + I + G + NX

Y = 3,657 + 741 + 1,098 + (673 – 704)

Y = 3,657 + 741 + 1,098 – 31

Y = 5,465

Think About It: Calculating GDP with the Expenditures Approach

Calculate the GDP using the Expenditures Approach by using the actual 2009 data below to do

so.

2009 National Income Accounting Data provided by the US Government

Household Consumption 10,001.30

Corporate Profits 1,066.60

Investment Expenditures 1,589.20

Indirect Business Taxes 1,001.10

Depreciation 1,861.10

Government Expenditures 2,914.90

Net Foreign Factor Income 146.20

Net Exports -386.40

Wages 7,954.70

Proprietor’s Income 1,030.70

Rents 292.70

Interest Income 765.90

ANSWER


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Did you get an answer of $14,119? If not, review the example above and go back and redo this problem

solving it in the same way. Close (X)

Section 03: The Income Approach

The Income Approach to calculating the GDP recognizes that the total expenditures on the

economy’s output in any given year must equal the total income generated by the production of

that same output. Adding up what is spent on purchasing the output of the economy in a given

year (the expenditures approach) has to equal the sum of all of the incomes that are generated in

producing that output in a given year (the income approach). If you think about the total income

earned in a given year by the factors of production, you must go back to the payments made to

those factors we discussed previously. Remember that labor is paid a wage, land is paid rent,

capital is paid interest, and the entrepreneur is paid a profit. In the case of the entrepreneur, the

National Income Accounts recognize that there are two types of entrepreneurs in our economy,

and they each earn a different type of profit. One type of entrepreneur starts up his own business

and he will earn what is called proprietor’s income. Another type of entrepreneur (remember:

an entrepreneur is a risk taker) invests in someone else’s business, and he earns a profit that is

called corporate profit. So, we will now define “National Income” as the sum of these five

payments made to the four factors of production:

National Income = Compensation to Employees (Wages) + Rents + Interest + Proprietor’s

Income + Corporate Profits

To go from National Income to GDP you must add in the value of production that is never

received as income by a factor of production. This is done by adding Indirect Business Taxes

(sometimes called sales taxes), Depreciation (the value of the capital that is used up by producing

the output of the economy), and Net Foreign Factor Income (NFFI) to National Income. The

NFFI is the difference between factor payments received from the foreign sector by US citizens

and factor payments made to foreign citizens for US production. Each of these payments hovers

around 3% of GDP, but since NFFI is the difference between the two they tend to cancel each

other out and NFFI is usually a very small number, less than 1% of GDP.

The final Income Approach to the GDP is therefore given by:

Y = National Income + Indirect Business Taxes + Depreciation + NFFI

Where, again, Y equals GDP.

Another important measure which is sometime calculated in the National Income Accounts is the

called the Net Domestic Product and it is equal to: NDP = GDP – Depreciation

Example

I will demonstrate calculating the GDP using the Income Approach with the hypothetical date

given earlier:


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National Income = Compensation to Employees (Wages) + Rents + Interest + Proprietor’s

Income + Corporate Profits

National Income = 3,254 + 17 + 530 + 403 + 341 = 4,545

Y = National Income + Indirect Business Taxes + Depreciation + NFFI

Y = 4,545 + 500 + 400 + 20 = 5,465

This is the same value for the GDP received when calculating it using the Expenditures

Approach.

Think About It: Calculating GDP with the Income Approach

Calculate the GDP for the United States using the Income Approach and the actual data for 2009

given to you earlier in this lesson.

ANSWER

Important Side Note: When using the actual data for a large economy like the United States, the

Expenditures Approach and the Income Approach do not yield exactly the same value. However, it turns

out to be close and within what the government refers to as a “statistical discrepancy.”

Section 04: Measuring Changes in GDP over Time

The GDP is often used to measure the growth in an economy over time. If the GDP is rising, we

assume the economy is growing; if the GDP is falling, the economy is shrinking and presumably

is in the midst of an economic downturn. Since the GDP measures the value of the final goods

and services produced in the domestic economy in a given year, however, the GDP can rise

from one year to the next for one of three reasons: either because the economy has produced

more from one year to the next, because the value of the product has gone up from year to year,

or both. Since the value is measured in dollar prices, the GDP would go up from one year to the

next, even if you produced exactly the same amount of output in both years but the prices of the

products were to rise. It is therefore important to distinguish between what is called the Nominal

GDP and what is called the Real GDP.

The Nominal GDP measures the value of the output of final goods and services using current

dollar prices. It is the value of a given year’s output using the dollar prices that prevailed in that

given year (referred to as current dollar prices).

The Real GDP measures the value of the output of final goods and services using constant dollar

prices. It is the value of a given year’s output using the dollar prices that prevailed in a previous

year, called the base year (referred to as constant dollar prices).


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As an example to illustrate the dramatic difference between the nominal and real GDP’s in two

different years, consider the fact that the Nominal GDP in the United States in 1960 was 513

billion dollars. In 1990, the US Nominal GDP was 5.757 trillion dollars. Do you think that the

US economy really expanded by over 10 times in 30 years? Surely there was growth in the

United States between 1960 and 1990, but we did not produce over 10 times as much output in

1990 as in 1960. Part of that seeming growth can be accounted for because prices went up during

that 30 year period, so it would be interesting to know what the GDP in 1990 would be

calculated to be if the prices in 1990 had been the same as they were in 1960. This would give us

a measure called the Real GDP. The Real GDP in 1990 (using 1960 prices as the base year) was

approximately 804 Billion Dollars. So we can see, in real terms, the economy did not even

double between these two years, whereas in nominal terms it appeared to go up by over ten

times! This should illustrate the importance of looking at the real GDP when calculating growth

in an economy, so as not to be misled into thinking an economy is growing when it is actually

just experiencing large increases in prices.

Price Indices and GDP Growth

Inflation is an upward movement in the average level of prices and deflation is a downward

movement in the average level of prices. The price level is measured by a price index—the

average level of prices in one period relative to their average level in an earlier period. The two

most common price indices are called the Consumer Price Index (CPI) and the GDP Deflator.

We will discuss the CPI in a future lesson.

GDP Price Index

The GDP Deflator includes all of the items (C,I,G, and NX) included in the GDP. When

comparing the value of the GDP from year to year, we use the GDP Deflator to make a valid

comparison, i.e. one that takes into account the changes in prices that have occurred in the

economy between the two years.

In order to calculate Real GDP, we use the GDP Deflator. For example, let’s assume we have a

very simple economy that only produces three products: pineapples, snorkels, and beach

umbrellas. The prices and outputs of these items in the current and base years are as follows:

Current Period Base Period

ITEM Output Price Expenditures Price Expenditures

Pineapples 4,240 $1.30 $5,512 $1.00 $4,240

Snorkels 5,000 $10.00 $50,000 $8.00 $40,000

Umbrellas 1,060 $100.00 $106,000 $100.00 $106,000


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The Nominal GDP will be the value of the current year’s output using the current year’s prices:

Nominal GDP in the Current Period = (4,240 X $1.30) + (5,000 X $10.00) + (1,060 X $100.00)

= $156,512

The Real GDP will be the value of the current year’s output using the base year’s prices:

Real GDP in the Current Period = (4,240 X $1.00) + (5,000 X $8.00) + (1,060 X

$100.00) = $150,240

GDP Deflator = (Nominal GDP/Real GDP) X 100

($156,512 / $150,240) X 100 = 104.175

Notice that the GDP Deflator is equal to the Nominal GDP divided by the Real GDP and

multiplied times 100.

This deflator tells us that there has been 4.175% inflation over the period from the base year to

the current year. Note that if the prices had been the same in the base year and in the current

year, the Nominal and the Real GDP would have been the same in the current year and the

deflator would have equaled 100. A deflator of 100 indicates NO inflation between the two

periods. A deflator greater than 100 indicates inflation and a deflator less than 100 indicates

deflation (a decline in the average price level from one year to the next).

Is the GDP a Good Measure of Economic Output and Welfare?

Several examples of items not included in the official GDP statistics have caused some to

suggest that the GDP is a poor measure of the economy’s total output. In other words, some final

goods and services produced in the economy are not counted as part of the GDP. The suggestion,

therefore, is that the official GDP reported in any given year seriously under-represents the total

value of all final goods and services produced in the economy in that year. Consider the

following examples:

Underground Economy—most goods and services that are illegal or produced “under the table”

are not counted in the GDP. This could be anything from illegal drugs to you building a deck on

your neighbor’s house and him rebuilding your engine in exchange.

Household Services—if you hire a maid to come in and clean your house, it is counted as part of

the GDP, but if you clean your house yourself, it is not counted as part of the GDP. Most

household production is not counted as part of the GDP, even though a final good or service is

produced.

Additionally, some suggest the GDP is a poor measure of social welfare. For example, you could

have two countries with exactly the same GDP and population, which might lead you to believe

that both countries are equally well off. In Country A, however, the workers may labor for 70

hours per week, while in Country B they may labor for only 40 hours per week. Or Country A


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may be a dirty and polluted place to live, while Country B may be a pristine, pleasant place to

live. As long as we value things like leisure time and clean living conditions, the GDP alone will

not tell us how well off a population is.

The Circular Flow

The first model that we will consider is called the Circular Flow Model of the Economy. In its simplest

form we will assume that the economy is composed of only two markets: a factor or resource market and

a product market. The key result of this model is the fact that the flow of income is equal to the

expenditures on goods and services (the output of the economy). Income flows through the Factor Market

and is represented on the top of the Circular Flow Model. Households supply the factors of production in

exchange for income. The factors of production are Land, Labor, Capital, and Entrepreneurship. These

factors of production are purchased (or rented in the case of labor) by businesses through a factor market.

But households do not provide these factors for free. Households are paid for the factors of production

and the payments to Land, Labor, Capital, and Entrepreneurship are called Rent, Wages, Interest, and

Profit, respectively.

What do businesses do with these factors, and what do households do with these incomes? That

is represented by the bottom half of the circular flow. Businesses use the factors or resources to

produce an output, generally described as goods and services, to be sold in product markets.

Households use their income to make expenditures in these product markets as they purchase

goods and services. These expenditures become the source of revenue for businesses that allow

them to employ the resources necessary to produce their output. As the name of the model

suggests, the income generated on the top of the circular flow is exactly sufficient to produce the

expenditures necessary to buy all of the output of goods and services on the bottom of the

circular flow.


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Students will often note that the model does not account for the banking sector, the government,

foreign trade, etc., suggesting that the model is too simplistic to represent the real economy. Each

of these objections could be handled by the circular flow model, but the model would just get

more complicated. Remember the more the model resembles the true economy, the more you are

trying to navigate an unfamiliar city with an enormously detailed map!

Economic Models

What is a model? A model is a simplified representation of a complex idea or entity. A model

airplane is a scaled version of a real airplane, but the model is not necessarily an exact replica of

a real airplane. The model gives us a good idea of reality without all of the complexity.

Economic models are similar in that they are generally a simplified version of a complex reality.

This idea of simplification gives us the primary reason for why economists use models.

Consider the example of a map. Think of a road map as a model. If you were unfamiliar with Los

Angeles and were planning to go there on a trip, how would you feel if I gave you a map of Los

Angeles exactly the size of Los Angeles? Would it be helpful to you? No, it would not. If you do

not know LA, a map the size of the city would be just as confusing for you as having no map at

all. You need the map to be scaled down. The actual economy is much too grand to be studied in

detail. We must model the economy to be able to make sense of it. As we study various

economic models, it is not helpful for you to think,“But that isn’t the way it is in real life!”

Generally, economists recognize that they are making simplifying assumptions that are not

always true to life, but studying a model that is scaled down is infinitely easier than studying the

real thing.


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MONEY

Money

This lesson introduces us to the role of money in our economy, the American Banking system

(including the Federal Reserve System of the United States), and the use of monetary policy to

manipulate price levels and employment in the US economy.

Section 01: The Functions of Money

Money fulfills three primary functions in our economy: It is a medium of exchange, it is a

measure of value, and it is a store of value. Let’s consider each of these functions in turn.

Medium of Exchange

Money is the means by which we purchase goods and services. If there were no money, we

might suppose that we would exchange goods and services directly for each other in a barter

system. It does not take much imagination to see how money is useful to facilitate exchanges that

would be difficult by barter. Imagine taking a pig into and shoe store and trying to exchange it

for a pair of tennis shoes. This situation is fraught with all sorts of difficulties. What if the owner

of the tennis shoes does not happen to want a pig or any portion of a pig? What about the fact

that the pig might be worth 5 pairs of tennis shoes and you only want one pair? Is it reasonable

that the shoe store owner can accept only 1/5 of a pig for a pair of tennis shoes? How would he

be able to do this? Money facilitates the exchange, because everyone is willing to accept money

as a medium of exchange for whatever it is that one might want to buy or sell. It is also very

easily divisible to the scale of what is being exchanged.

Measure of Value

Money is also a measure of value and acts as a yardstick for measuring the relative worth of

heterogeneous goods. It might be difficult to know off the top of your head that a pig is worth ten

pairs of tennis shoes, but money makes this easy to measure. If a grown pig can be sold for $300

and a pair of tennis shoes can be sold for $60, then we can say that a pig is worth 5 pairs of

tennis shoes. Money makes this calculation possible because it is a measure of value. How much

regular gasoline could you trade for a pound of roast beef? The answer to that question might not

be obvious to you at first blush. Let’s say that you were told, however, that sliced roast beef at


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the Deli counter at Broulim’s Grocery Store is $7.00 a pound and that regular gasoline at the

Maverick Gas Station in Rexburg ID is $3.50 a gallon. Now you would know that you could get

two gallons of regular gasoline for one pound of roast beef, and money as a measure of value

provides you with the answer!

Store of Value

Money is a store of value because it is a liquid (or spendable) source of wealth. Some people

choose to hold on to money as an asset, just like they might have a home, a painting, or a

diamond ring. Money has an advantage over other assets because it is very liquid. The liquidity

of an asset refers to how quickly the asset can be turned into cash, and since money is already

cash, it is the most liquid asset possible! This is probably the reason that so many people hold

onto cash as a store of value, as will be seen when we talk about the components of the money

supply.

Section 02: The Money Supply

There are two widely used definitions of the money supply. One is a more narrow definition and

the other is a broader definition. We will look at both.

M1

The first definition of the money supply is called M1. M1 consists of currency and coins in the

hands of the non-bank public, traveler’s checks, and checkable deposits. Currency and coins

constitutes about 50% of M1 and checkable deposits make up the other 50%. Traveler’s checks

make up far less than 1% of M1. As of April, 2011, M1 was $1,900,900,000,000, or nearly two

trillion US dollars.

M2

The second definition of the money supply is called M2. M2 is a broader and less liquid

definition of the money supply. While M1 constitutes money that is either cash or readily

changed to cash, M2 includes more types of money and specifically parts of the money supply

that are harder to turn into cash. M2 consists of M1, Savings Deposits, Small Time Deposits

($100,000 or less), and Money Market Mutual Funds. M1 makes up about 21% of M2, Savings

Deposits account for 61% of M2, Small Time Deposits make up 10% of M2, and Money Market

Mutual Funds constitute approximately 8% of M2. As of April 2011, M2 was 8,946,100,000,000

or nearly nine trillion US dollars.

Section 03: Demand for Money

Given our explanations of the functions of money, it will not be surprising that there are two

different types of demand for money. The first is called the transactions demand and the second

is called the asset demand.


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Transactions Demand

On a daily basis people need money on hand for the things that they routinely buy. You have to

get a haircut or stop by the store on the way home from work to pick up some milk. You have

transactions that you need to conduct, and therefore you have a demand for money. The

transactions demand for money is using money as a medium of exchange. Notice in the graph

below that the Transactions Demand for Money (DMT) is denoted as a vertical line when

graphed against the interest rate. The demand for money as a medium of exchange is

independent of the interest rate, because when you are on your way home from work and need to

pick up milk, the interest rate does not affect how much milk you buy.

Asset Demand

Some people hold money as a financial asset just like stocks and bonds. Holding money as a

liquid asset is using money as a store of value. Consider a person who has a portfolio of

investments. Perhaps he owns some stocks, bonds, jewelry, artwork, a home, a savings account

at his credit union, and has $5,000 in a fireproof box hidden in his basement. In an emergency,

the cash is the most liquid asset that the person has, and is far more spendable than a painting or

a piece of jewelry that might take weeks to turn into cash. The liquidity of cash is the advantage

of holding cash. The disadvantage of holding money as an asset is that there is very little or no

return on this asset.

The cost of holding money as an asset is the foregone interest rate and there is an inverse

relationship between the interest rate and the asset demand for money. This inverse relationship

is illustrated in the graph below as a downward sloping asset demand for money (DMA). The

total demand of money (DM) is just the sum of the transactions demand and the asset demand,

and has the same downward slope as the asset demand.


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Section 04: The Money Market

We will make a simplifying assumption that the supply of money is set by Federal Reserve

policy, and is therefore shown graphically as a vertical line.

Adjustments to a Decrease in the Supply of Money — When the supply of money decreases

(shifts to the left) the interest rate goes up.

Adjustments to an Increase in the Supply of Money — When the supply of money increases

(shifts to the right) the interest rate goes down.

Adjustments to a Decrease in the Demand for Money — When the demand for money

decreases (shifts to the left) the interest rate falls.

Adjustments to an Increase in the Demand for Money — When the demand for money

increases (shifts to the right) the interest rate goes up.

The above four statements can be easily illustrated by shifts in the graph above, but can you see the

logical economic argument behind each? Let’s illustrate with the first statement and then you work

through the similar logic on the other three.


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What would happen if there were a decrease in the Supply of Money from SM to SM’? If you

stay at the old interest rate of i˳ when the supply of money falls, then the demand for money will

exceed the supply of money. What would you do if you were running a bank and more people

came in demanded money than there were coming in and supplying money? Wouldn’t your

natural reaction be to increase the interest rate in the hope that the higher interest rate would

decrease the demand for money? Remember that at a higher interest rate, the asset demand for

money will be less. As the interest rate goes up, the demand for money and the supply of money

will eventually come into equilibrium again at a higher interest rate, say i*. You can use similar

logic to analyze each of the other three scenarios.

Return to the course in I-Learn and complete the activity that corresponds with this material.

Section 05: Why are there so many interest rates?

Our previous discussion referred to the interest rate as though there was only one in the

economy. The reality is that there are many interest rates. The interest rate on your credit card is

different than the interest rate for a car loan, which is different than the rate you might be

charged on a home loan. Let’s consider four factors that will influence the interest in any given

situation.

1. Term or maturity

1. Shorter term loans have a lower i

2. Longer term loans have a higher i

2. Risk

1. Riskier loans have a higher i

2. Safer loans have a lower i

3. Liquidity

1. Liquid loans have a lower i

2. Illiquid loans have a higher i

4. Administrative Costs

1. Loans that have a high cost to administer have a higher i

2. Loans that have a low cost to administer have a lower i


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Banking is a Business

Bankers provide services and attempt to make a profit for their owners. The Balance Sheet of a

Commercial Bank looks much like the balance sheet of any other business. Assets are items the

bank owns and Liabilities are items the bank owes. Assets minus liabilities equal the net worth of

the bank. It may seem counterintuitive, but the liabilities of the banks are its deposits, and the

assets of the bank are the loans that it has issued. Remember that a liability is something that the

bank owes; when you deposit money into your account, the bank owes you that money. An asset

is something that the bank owns; when the bank lends you money, it owns that loan, and you

owe the bank the amount of the loan. Banks like to make loans, because it is one of the primary

ways that they make money. Charging interest on the loan is one of the most profitable activities

for any commercial bank.

Reserves are the funds or assets that banks hold in the form of cash, or on deposit with the

central bank. Why would a bank hold reserves in the vault when they could be lending that

money out and earning interest? The bank has to have enough money on hand for day to day

operations. If someone comes into the bank and wants to withdraw $1,000 from her savings

account, it would not look good if the bank had to say, “Sorry, we don’t have $1,000 right now.

Could you come back later today?” They want to always have enough money on hand to do their

daily business, so even though money in the vault is “sterile” in the sense that it does not earn

any interest for the bank, it still is a good business practice to have money available to meet

customer needs.

The other important reason that banks keep money in reserve is that they are legally required to

do so. The percentage of the deposits that must be kept in reserve is called the reserve ratio.

We’ll talk a lot about that in the next section and in our later discussion of monetary policy.

Fractional Reserve Banking

Our modern banking system is known as fractional reserve banking. “Fractional reserve” refers

to the fact that, at any given point in time, the bank has in reserve only a fraction of its total

deposits. This system was developed as early as the middle ages to allow banks to invest money

(or make loans) for a profit. If banks were forced to keep all of their deposits in reserve in the

vault, then the bank would be no more than a storage unit for customers’ money. Not only could

they not make any money, but they would not be able to pay interest to their depositors. In fact,

in order to operate, they would have to charge customers a fee for accepting their deposits.

In this system, the Federal Reserve sets legal reserve requirements as a means of controlling the

money supply. An illustration will help you see how the reserve requirement is used to control

the money supply, and also how the commercial banking system of the United States “creates”

money.

In this example, we are going to consider the actions of a fictional bank called The Last National

Bank (LNB) which has a legal reserve requirement of 10%. This bank’s initial balance sheet is

shown below:


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The Last National Bank: Balance Sheet 1

Assets Liabilities

Reserves: $1,000 Deposits: $1,000

Notice that this bank has liabilities of $1,000, the total of its deposits. If the bank initially takes

this deposit and puts it in the vault, then it also has assets of $1,000 in the form on cash

reserves. If the reserve requirement is 10% then the LNB is only legally required to keep $100 in

reserve. What should the bank do with the other $900? Well, don’t forget that this bank has to

make a profit just like any other business, so it needs to do something with the $900 that will

bring in more money than what it is paying to the depositor in interest. The bank could invest the

$900, or lend it and charge more interest than what it is paying to the depositor. In either of these

two scenarios the result will be the same, but we will look at the case where the bank lends out

the money. After the loan is made, the balance sheet of the LNB looks like the following:

The Last National Bank: Balance Sheet 2

Assets Liabilities

Reserves: $1,000 Deposits: $1,000

Loans: $900

Let’s say that the person who borrows the $900 buys an item from someone, who then deposits

the $900 in his bank, The Second to the Last National Bank (SLNB). The balance sheet for the

SLNB is illustrated below. Notice that deposit is a liability to the bank and, at least initially, we

are showing the entire deposit as being held in reserve as cash vault, which is an asset to the

bank.

The Second to the Last National Bank: Balance Sheet 1

Assets Liabilities

Reserves: $900 Deposits: $900

The SLNB does not have to keep $900 in reserves, however. Because the legal reserve ratio is

10%, SLNB can lend out $810. If the SLNB has $900 in deposits and $900 in “actual” reserves

with a 10% reserve ratio, they have what is call “excess” reserves of $810. The “required”

reserves would be $90, and they can lend out all of their excess reserves. After making such a

loan, the new balance sheet for the SLND would look like the following:


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The Second to the Last National Bank: Balance Sheet 2

Assets Liabilities

Reserves: $900 Deposits: $900

Loans: $810

Notice what has happened to the money supply as a result of this fractional reserve banking

system. Remember that the money supply includes cash in the hands of the non-bank public plus

demand deposits at commercial banks. When the original deposit is made at the LNB, the money

supply is $1,000. When the LNB lends $900 the, money supply immediately goes up to

$1,900. Even if the person who borrowed the $900 just kept the money in his pocket this would

be true. The money supply expands, however, when the $900 is deposited into the SLNB and

they make an $810 loan off that deposit. Now the money supply is $1,000 + $900 + $810 =

$2,710. When the $810 is deposited into another bank and they lend out 90% of that deposit the

money supply continues to grow. The commercial banking system is essentially “creating”

money. The maximum amount of money supply expansion that can exist in the banking system

is equal to:

Total Potential Money Expansion = Excess Reserves x 1/rr

where “rr” is the legal Required Reserve Ratio. “1/rr” is referred to as the simple money

multiplier. “rr” is the Bank’s Required Reserves divided by the Bank’s Liabilities. In our

example rr = 0.10 so 1/rr = 10. Since the initial excess reserves of the LNB were equal to $900,

the total potential money expansion would be equal to $900 x 10 = $9,000.

Notice: the total potential money expansion is equal to excess reserves times 1/rr. This is the

potential, because you will only get this amount of money expansion under two critical

conditions: First, the bank must keep only the minimum amount of reserves on hand and lend out

all of their excess reserves, and second, the total amount of each loan in the expansion process

must be deposited into another bank. If the reserve ratio is 10% but a bank decides to keep 15%

instead, you do not reach the full potential of expansion. This would be true because the bank is

keeping excess reserves. Also, if a person borrows $900 dollars but deposits less than that

amount in his bank, and keeps some in cash hidden under his mattress, you will not have the full

potential money expansion. This would be true because the excess reserves of one bank are not

all becoming deposits in another bank.

Summary

1. Banks can create money because of the fractional reserve banking system.

2. The Federal Reserve controls the ability of banks to expand the money supply by setting the

reserve ratio.

3. Commercial banks hold reserves as cash and do one of two things with their excess reserves:

Lend them out or invest them in government securities.


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4. In both cases, the excess reserves of one bank become the deposits of another bank.

5. The total potential expansion of the money supply will be equal to excess reserves times 1/rr.

6. The Fed uses the reserve ratio as one of the tools of Monetary Policy.

Return to the course in I-Learn and complete the activity that corresponds with this material.

Section 03: Monetary Policy

The Federal Reserve has control over the three primary instruments of monetary policy:

1. Open-market Operations

2. Reserve Requirements

3. Discount Rate (note the difference between this and the Federal Funds Rate)

Open Market Operations

Open Market Operations refers to the buying and selling of government bonds by the Federal

Open Market Committee. When the FOMC decides to buy bonds they take bonds out of the

hands of the public and put cash into the hands of the public. If the Fed were to buy a bond from

you, you would give the Fed the bond and they would give you cash. Since bonds are not part of

the money supply but cash is, the money supply would immediately increase by the amount of

the cash that you are given. The cash would have formerly been in a Fed vault and therefore

would not have been part of M1. If you take that cash and deposit it in a bank, bank excess

reserves go up and the potential increase in the money supply grows through the money creation

process described in the previous section. For example, if the reserve requirement were 5%, the

multiplier would be 20—if the Fed buys $2 billion in bonds, the money supply will go up by $40

billion.

If the Fed were to sell bonds, you would give the Fed cash and they would give you bonds. The

cash that was formerly in your hands (or in your bank account) was part of M1, but as soon as

the Fed gives you a bond and you give the Fed your money the money, supply immediately

falls. If you take the money to pay for the bond out of your bank account, excess reserves will

fall and the money contracts by a multiple of the reduction in excess reserves. Think of the

opposite of money creation—in fact, it is sometimes called destroying money. For example, if

the reserve requirement were 10%, then the multiplier would be 10 and if the Fed sells $1 billion

in bonds, the money supply decreases by $10 billion.

The Reserve Requirement

Within limits established by Congress, the Federal Reserve has the discretion to raise or lower

the legal reserve ratio for commercial banks. Recall that if the Fed reduces the reserve ratio, then

banks will have additional excess reserves that they can lend out, and the money supply may be

expanded by an amount equal to excess reserves times 1/rr. Increasing the reserve ratio will

reduce the amount of excess reserves that banks can lend out and will result in a contraction of

the money supply by an equivalent amount. Therefore, the ability to set the reserve ratio


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becomes an instrument of monetary policy to the extent that the reserve ratio effects the money

supply.

Discount Rate Policy

What would happen to a commercial bank that lends out so much money that they do not have

enough on hand to meet their required reserves? In other words, in our example of the LNB that

had required reserves of $100 and could lend out $900, what would happen if the bank made of

loan of $950 and found at the end of the day that they only had $50 in actual reserves? When

commercial banks are short on reserves, they can borrow from a Federal Reserve Bank. The

interest rate they are charged on such a loan is called the discount rate.

When the discount rate is low, the Fed encourages borrowing by member banks, which tends to

expand the money supply. If I lend out $50 dollars too many to a bank customer and charge him

6% interest, and the Fed sets the discount rate at 2%, it makes sense for me to just borrow the

$50 from the Fed to make up my required reserves. In effect, low discount rates encourage

commercial banks to loan out their required reserves and then borrow the reserves back from the

Fed. Obviously, the more loans that banks make, the higher the money supply, as discussed in

the section on money creation.

When the discount rate is high, the opposite is true. High discount rates discourage banks from borrowing

from the Fed, and banks will therefore be more cautious in making loans. As banks make fewer loans, the

money supply falls. Because the money supply rises or falls as the discount rate is lower or higher, the

discount rate becomes an instrument of monetary policy. The Feds ability to manipulate the discount rate

allows it to also manipulate the money supply.

Important Note: You should not confuse the Discount Rate with the Federal Funds Rate. The

discount rate is the interest rate that the Federal Reserve charges member banks when these

banks borrow money from the Fed. The Federal Funds Rate is the rate that one commercial bank

charges another commercial bank when banks borrow money from each other. The Federal

Funds Rate is sometimes called an overnight rate because banks usually borrow money from

each other for very short periods of time—sometimes just overnight.

.

Section 04: The Money Market Revisited

A decrease in the money supply would cause the interest rate to rise; an increase in the money

supply would lower the interest rate. The change in the interest rate as the Fed exercises

monetary policy will either increase investment and interest sensitive consumption (if the interest

rate falls) or decrease investment and interest sensitive consumption (if the interest rate

rises). Since investment and consumption are two components of Aggregate Demand, a change

in investment and consumption will either stimulate (if investment and consumption go up) or

contract (if investment and consumption go down) AD.


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Shifting AD to the right will expand the economy, causing inflation in the Intermediate or

Classical ranges of AS, while increasing output or GDP and lowering unemployment in the

Keynesian or Intermediate ranges of AS. Shifting AD to the left will contract the economy,

reducing inflation in the Intermediate or Classical ranges of AS and decreasing output or GDP,

while increasing unemployment in the Keynesian or Intermediate ranges of AS. Let’s review the

exact process:

Expansionary Monetary Policy

If the Fed thinks that unemployment is rising too sharply, it will follow an expansionary

monetary policy designed to stimulate output and reduce unemployment.

Think About It: Expansionary Monetary Policy

The following outlines the steps of expansionary monetary policy. Consider the following

questions before checking the answers by clicking in the word in parenthesis:

1. The Fed can increase excess reserves ),hich

2. increases the money supply which

3. decreases the interest rate), which

4. increases I and C which

5. increases AD (which

6. increases Real GDP, and decreases Unemployment and the Price Level

(


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Contractionary Monetary Policy

If the Fed thinks that Inflation is too high in the economy, they will follow a contractionary

monetary policy designed to reduce the price level.

Think About It: Contractionary Monetary Policy

The following outlines the steps of contractionary monetary policy. Consider the following

questions before checking the answers by clicking in the word in parenthesis:

1. The Fed can reduce excess reserves which

2. reduces the money supply (which

3. increases the interest rate (which

4. decreases the I and C), which

5. decreases AD which

6. decreases Real GDP, and increases Unemployment and the Price Level

Section 05: Summary

We can summarize the relationship between the money supply and AD as follows:


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1. Increases in the Money Supply lead to an increase in AD, because interest rates will fall.

2. Decreases in the Money Supply leads to a decrease in AD, because interest rates will rise.

We can summarize the relationship between the money supply and the Price Level as follows:

1. Increases in the Money Supply leads to increases in the Price Level.

2. Decreases in the Money Supply leads to decreases the Price Level.

Consumption Function

The Keynesian Consumption function expresses the level of consumer spending depending on

three items

Yd – disposable income

a – autonomous consumption (consumption when income is 0. (e.g. even with no income, you

may borrow to be able to buy food))

c – marginal propensity to consume (the % of extra income that is spent) Also known as induced

consumption.

Consumption Function formula

C = a + c Yd

This suggests Consumption is primarily determined by the level of disposable income (Yd).

Higher Yd, leads to higher consumer spending.

This model suggests that as income rises, consumer spending will rise. However, spending will

increase at a lower rate than income.

At low incomes, people will spend a high proportion of their income. The average propensity to

consume could be one or greater than one. This means people spend everything they have. When

you have low income, you don’t have the luxury of being able to save. You need to spend

everything you have on essentials.

However, as incomes rise, people can afford the luxury of saving a higher proportion of their

income. Therefore, as income rise, spending increases at a lower rate than disposable income.

People with high incomes have a lower average propensity to spend.

http://www.economicshelp.org/dictionary/a/autonomous-consumption.html


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Implications of Consumption Function

If you cut income tax for those on low income, they tend to have a higher marginal propensity to

consume this extra income. Therefore, there is a large increase in spending. People with high

incomes will tend to have a lower marginal propensity to consume. If they benefit from a tax cut,

they will save a greater proportion.

Shift in the Consumption Function

In this diagram, the consumption function has shifted to the right. (C1 to C2). This means

consumers are spending a smaller % of their income. This could be due to a fall in property

prices which decrease consumer confidence and lead to lower consumer spending.

Increased Marginal Propensity to Consume


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In this diagram, the consumption function has become steeper. This means the value of c (MPC)

has increased. Therefore, people are spending a higher % of income. This could be due to rising

confidence and easier availability of credit.

Limitations of Consumption Function

In the real world people are influenced by other factors

Life Cycle factors – e.g. students more likely to borrow and spend during university days.

Behavourial factors – e.g. people may be influenced by general optimism

Investment

· Economics definition: Investment is the addition to Capital Stock of the economy- e.g.

factories, machines, or any item that is used to produce other goods and services

· Note saving money in a bank is not investment in economic terminology

· The value of capital stock depreciates over time as it wears out and is used up, this is called

depreciation.

· Gross investment measures investment before depreciation.

· Net Investment measures gross investment less depreciation

Depreciation accounts for ¾ of gross investment

· Investment can be in either:

i) Physical Capital e.g. machines or

ii) Human Capital e.g better education to increase labour productivity

Marginal Efficiency of Capital

The rate of return for an investment project is known as the marginal efficiency of capital.

The cost of capital or investment is related to the rate of interest for 2 reasons:

1. The rate of interest shows the cost of borrowing money to fund investment

2. The alternative to investing is saving money in a bank, this is the opportunity cost of

investment.

If the rate of interest is 5% then only projects with a rate of return of greater than 5% will be

profitable.


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Factors which shift the Planned Investment schedule

1. A change in the cost of capital,

E.g. an increase in the cost of capital will lead to a fall in investment

2. Technological change,

If new technology is invented firms will want to invest more.

3. Expectations and business confidence.

Keynes believed this was very important. Keynes termed it “animal spirits”

4. Government Policy.

E.g. the govt could have tax breaks for firms to increase investment

5. Supply of finance.

If banks are more willing to lend money investment will be easier

Loanable Funds Theory

In an economy interest rate will be determined by the supply of finance (loanable funds) and the

demand for loanable funds

The supply of finance is the level of savings in the economy.

When people deposit money in banks these funds can be lent out to firms for investment in

physical capital

Higher interest rates will encourage people to save more

Saving will also be dependent upon incomes and confidence a change in these could shift the

supply curve.

A shift in the supply or demand curve will cause a change in the level of interest rate

An increase in demand for loanable fund will cause a shortage of funds this will cause interest

rates to rise and therefore this will encourage an increase in saving.

Determinants of Investment

Learning Objectives

1. Draw a hypothetical investment demand curve, and explain what it shows about the relationship

between investment and the interest rate.

2. Discuss the factors that can cause an investment demand curve to shift.


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We will see in this section that interest rates play a key role in the determination of the desired

stock of capital and thus of investment. Because investment is a process through which capital is

increased in one period for use in future periods, expectations play an important role in

investment as well.

Capital is one factor of production, along with labor and natural resources. A decision to invest is

a decision to use more capital in producing goods and services. Factors that affect firms’ choices

in the mix of capital, labor, and natural resources will affect investment as well.

We will also see in this section that public policy affects investment. Some investment is done by

government agencies as they add to the public stock of capital. In addition, the tax and regulatory

policies chosen by the public sector can affect the investment choices of private firms and

individuals.

Interest Rates and Investment

We often hear reports that low interest rates have stimulated housing construction or that high

rates have reduced it. Such reports imply a negative relationship between interest rates and

investment in residential structures. This relationship applies to all forms of investment: higher

interest rates tend to reduce the quantity of investment, while lower interest rates increase it.

To see the relationship between interest rates and investment, suppose you own a small factory

and are considering the installation of a solar energy collection system to heat your building. You

have determined that the cost of installing the system would be $10,000 and that the system

would lower your energy bills by $1,000 per year. To simplify the example, we shall suppose

that these savings will continue forever and that the system will never need repair or

maintenance. Thus, we need to consider only the $10,000 purchase price and the $1,000 annual

savings.

If the system is installed, it will be an addition to the capital stock and will therefore be counted

as investment. Should you purchase the system?

Suppose that your business already has the $10,000 on hand. You are considering whether to use

the money for the solar energy system or for the purchase of a bond. Your decision to purchase

the system or the bond will depend on the interest rate you could earn on the bond.

Putting $10,000 into the solar energy system generates an effective income of $1,000 per year—

the saving the system will produce. That is a return of 10% per year. Suppose the bond yields a

12% annual interest. It thus generates interest income of $1,200 per year, enough to pay the

$1,000 in heating bills and have $200 left over. At an interest rate of 12%, the bond is the better

purchase. If, however, the interest rate on bonds were 8%, then the solar energy system would

yield a higher income than the bond. At interest rates below 10%, you will invest in the solar

energy system. At interest rates above 10%, you will buy a bond instead. At an interest rate of

precisely 10%, it is a toss-up.


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If you do not have the $10,000 on hand and would need to borrow the money to purchase the

solar energy system, the interest rate still governs your decision. At interest rates below 10%, it

makes sense to borrow the money and invest in the system. At interest rates above 10%, it does

not.

In effect, the interest rate represents the opportunity cost of putting funds into the solar energy

system rather than into a bond. The cost of putting the $10,000 into the system is the interest you

would forgo by not purchasing the bond.

At any one time, millions of investment choices hinge on the interest rate. Each decision to

invest will make sense at some interest rates but not at others. The higher the interest rate, the

fewer potential investments will be justified; the lower the interest rate, the greater the number

that will be justified. There is thus a negative relationship between the interest rate and the level

of investment.

"The Investment Demand Curve" shows an investment demand curve for the economy—a curve

that shows the quantity of investment demanded at each interest rate, with all other determinants

of investment unchanged. At an interest rate of 8%, the level of investment is $950 billion per

year at point A. At a lower interest rate of 6%, the investment demand curve shows that the

quantity of investment demanded will rise to $1,000 billion per year at point B. A reduction in

the interest rate thus causes a movement along the investment demand curve.

Figure The Investment Demand Curve

The investment demand curve shows the volume of investment spending per year at each interest

rate, assuming all other determinants of investment are unchanged. The curve shows that as the

http://catalog.flatworldknowledge.com/bookhub/23?e=rittenmacro-ch14_s02#rittenmacro-ch14_s02_s01_f01

http://images.flatworldknowledge.com/rittenmacro/rittenmacro-fig14_007.jpg


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interest rate falls, the level of investment per year rises. A reduction in the interest rate from 8%

to 6%, for example, would increase investment from $950 billion to $1,000 billion per year, all

other determinants of investment unchanged.

.

To make sense of the relationship between interest rates and investment, you must remember that

investment is an addition to capital, and that capital is something that has been produced in order

to produce other goods and services. A bond is not capital. The purchase of a bond is not an

investment. We can thus think of purchasing bonds as a financial investment—that is, as an

alternative to investment. The more attractive bonds are (i.e., the higher their interest rate), the

less attractive investment becomes. If we forget that investment is an addition to the capital stock

and that the purchase of a bond is not investment, we can fall into the following kind of error:

“Higher interest rates mean a greater return on bonds, so more people will purchase them. Higher

interest rates will therefore lead to greater investment.” That is a mistake, of course, because the

purchase of a bond is not an investment. Higher interest rates increase the opportunity cost of

using funds for investment. They reduce investment.

Other Determinants of Investment Demand

Perhaps the most important characteristic of the investment demand curve is not its negative

slope, but rather the fact that it shifts often. Although investment certainly responds to changes in

interest rates, changes in other factors appear to play a more important role in driving investment

choices.

This section examines eight additional determinants of investment demand: expectations, the

level of economic activity, the stock of capital, capacity utilization, the cost of capital goods,

other factor costs, technological change, and public policy. A change in any of these can shift the

investment demand curve.

Expectations

A change in the capital stock changes future production capacity. Therefore, plans to change the

capital stock depend crucially on expectations. A firm considers likely future sales; a student

weighs prospects in different occupations and their required educational and training levels. As

expectations change in a way that increases the expected return from investment, the investment

demand curve shifts to the right. Similarly, expectations of reduced profitability shift the

investment demand curve to the left.


35

The Level of Economic Activity

Firms need capital to produce goods and services. An increase in the level of production is likely

to boost demand for capital and thus lead to greater investment. Therefore, an increase in GDP is

likely to shift the investment demand curve to the right.

To the extent that an increase in GDP boosts investment, the multiplier effect of an initial change

in one or more components of aggregate demand will be enhanced. We have already seen that

the increase in production that occurs with an initial increase in aggregate demand will increase

household incomes, which will increase consumption, thus producing a further increase in

aggregate demand. If the increase also induces firms to increase their investment, this multiplier

effect will be even stronger.

The Stock of Capital

The quantity of capital already in use affects the level of investment in two ways. First, because

most investment replaces capital that has depreciated, a greater capital stock is likely to lead to

more investment; there will be more capital to replace. But second, a greater capital stock can

tend to reduce investment. That is because investment occurs to adjust the stock of capital to its

desired level. Given that desired level, the amount of investment needed to reach it will be lower

when the current capital stock is higher.

Suppose, for example, that real estate analysts expect that 100,000 homes will be needed in a

particular community by 2010. That will create a boom in construction—and thus in

investment—if the current number of houses is 50,000. But it will create hardly a ripple if there

are now 99,980 homes.

How will these conflicting effects of a larger capital stock sort themselves out? Because most

investment occurs to replace existing capital, a larger capital stock is likely to increase

investment. But that larger capital stock will certainly act to reduce net investment. The more

capital already in place, the less new capital will be required to reach a given level of capital that

may be desired.

Capacity Utilization

The capacity utilization rate measures the percentage of the capital stock in use. Because capital

generally requires downtime for maintenance and repairs, the measured capacity utilization rate

typically falls below 100%. For example, the average manufacturing capacity utilization rate was

79.7% for the period from 1972 to 2007. In November 2008 it stood at 72.3.

If a large percentage of the current capital stock is being utilized, firms are more likely to

increase investment than they would if a large percentage of the capital stock were sitting idle.

During recessions, the capacity utilization rate tends to fall. The fact that firms have more idle

capacity then depresses investment even further. During expansions, as the capacity utilization

rate rises, firms wanting to produce more often must increase investment to do so.


36

The Cost of Capital Goods

The demand curve for investment shows the quantity of investment at each interest rate, all other

things unchanged. A change in a variable held constant in drawing this curve shifts the curve.

One of those variables is the cost of capital goods themselves. If, for example, the construction

cost of new buildings rises, then the quantity of investment at any interest rate is likely to fall.

The investment demand curve thus shifts to the left.

The $10,000 cost of the solar energy system in the example given earlier certainly affects a

decision to purchase it. We saw that buying the system makes sense at interest rates below 10%

and does not make sense at interest rates above 10%. If the system costs $5,000, then the interest

return on the investment would be 20% (the annual saving of $1,000 divided by the $5,000 initial

cost), and the investment would be undertaken at any interest rate below 20%.

Other Factor Costs

Firms have a range of choices concerning how particular goods can be produced. A factory, for

example, might use a sophisticated capital facility and relatively few workers, or it might use

more workers and relatively less capital. The choice to use capital will be affected by the cost of

the capital goods and the interest rate, but it will also be affected by the cost of labor. As labor

costs rise, the demand for capital is likely to increase.

Our solar energy collector example suggests that energy costs influence the demand for capital as

well. The assumption that the system would save $1,000 per year in energy costs must have been

based on the prices of fuel oil, natural gas, and electricity. If these prices were higher, the savings

from the solar energy system would be greater, increasing the demand for this form of capital.

Technological Change

The implementation of new technology often requires new capital. Changes in technology can

thus increase the demand for capital. Advances in computer technology have encouraged

massive investments in computers. The development of fiber-optic technology for transmitting

signals has stimulated huge investments by telephone and cable television companies.

Public Policy

Public policy can have significant effects on the demand for capital. Such policies typically seek

to affect the cost of capital to firms. The Kennedy administration introduced two such strategies

in the early 1960s. One strategy, accelerated depreciation, allowed firms to depreciate capital

assets over a very short period of time. They could report artificially high production costs in the

first years of an asset’s life and thus report lower profits and pay lower taxes. Accelerated

depreciation did not change the actual rate at which assets depreciated, of course, but it cut tax

payments during the early years of the assets’ use and thus reduced the cost of holding capital.


37

The second strategy was the investment tax credit, which permitted a firm to reduce its tax

liability by a percentage of its investment during a period. A firm acquiring new capital could

subtract a fraction of its cost—10% under the Kennedy administration’s plan—from the taxes it

owed the government. In effect, the government “paid” 10% of the cost of any new capital; the

investment tax credit thus reduced the cost of capital for firms.

Though less direct, a third strategy for stimulating investment would be a reduction in taxes on

corporate profits (called the corporate income tax). Greater after-tax profits mean that firms can

retain a greater portion of any return on an investment.

A fourth measure to encourage greater capital accumulation is a capital gains tax rate that allows

gains on assets held during a certain period to be taxed at a different rate than other income.

When an asset such as a building is sold for more than its purchase price, the seller of the asset is

said to have realized a capital gain. Such a gain could be taxed as income under the personal

income tax. Alternatively, it could be taxed at a lower rate reserved exclusively for such gains. A

lower capital gains tax rate makes assets subject to the tax more attractive. It thus increases the

demand for capital. Congress reduced the capital gains tax rate from 28% to 20% in 1996 and

reduced the required holding period in 1998. The Jobs and Growth Tax Relief Reconciliation Act

of 2003 reduced the capital gains tax further to 15% and also reduced the tax rate on dividends

from 38% to 15%. A proposal to eliminate capital gains taxation for smaller firms was

considered but dropped before the stimulus bill of 2009 was enacted.

Accelerated depreciation, the investment tax credit, and lower taxes on corporate profits and

capital gains all increase the demand for private physical capital. Public policy can also affect the

demands for other forms of capital. The federal government subsidizes state and local

government production of transportation, education, and many other facilities to encourage

greater investment in public sector capital. For example, the federal government pays 90% of the

cost of investment by local government in new buses for public transportation.

DETERMINANTS OF CONSUMPTION

1) Cost of Credit

If credit becomes difficult, mainly through expense of interest rates, some households may

postpone their credit financed purchases. There will be a reduction in consumption until

circumstances change, i.e. accumulate more savings, or a fall in interest rates

2) Assets

Most households appear to have target levels of assets/wealth at each stage of their life cycle. If

assets fall unexpectedly, households will increase their saving and reduce consumption. This

works in reverse for situations like a sudden increase in wealth.

http://en.wikipedia.org/wiki/households

http://en.wikipedia.org/wiki/saving

http://en.wikipedia.org/wiki/wealth


38

3) Disposable Income

Disposable income (income is often expressed as 'Y') is income after taxes. It is the amount of

total income that can be spent with reasonable freedom by the household. Thus, disposable

income is total income minus taxes (and sometimes also regarded as including other fixed

payments, such as mortgage repayments). It is that income which can be 'disposed of' with near

freedom.

4) Expectations

Individuals' attitudes to the functionality of the economy effects the level of aggregate

expenditure. For example, households increase purchases of consumer durables if they believe

interest rates will remain low or job security improves, etc. Expectations are the source of both

business and household economic indicators. Strictly speaking, an expectation is a leading

economic indicator, since it predicts changes in an economy and changes occur before

corresponding changes in the economy.

A leading indicator is an economic statistic that suggests transactions in the future. For

example, building permits suggest construction activity in the near term, and hence the hiring of

construction workers and purchases of building materials. Purchases of raw materials by

manufacturing industries ordinarily suggest a level of likely production. Increases in either

suggest increased activity; decreases suggest decreases in near-term activity. Stock prices fit this

category because high prices for corporate stocks create the impression of wealth that spurs

consumption.

A coinciding indicator ordinarily indicates activity at the time. It is often a defining

characteristic of the economy such as payroll or sales volume.

A lagging indicator is a statistic that ordinarily follows economic changes. Unemployment rates

are a prime example; decisions by most employers to hire workers follow increases in activity

and the parallel decision to lay off workers follows decreases in activity.

5) Taxation

A change in the level of taxation on income (income tax) will reduce the amount of disposable

income available. Because of this, C could fall. However, if an equal or greater sum were given

out in benefits to households, particularly to unemployed, then consumption could even rise. It is

important to note that an increase in taxation will not necessarily cause a contraction in

consumption. Further, if taxation and benefits were used to redistribute income/wealth from

richer to poorer households, consumption might rise. This is because less wealthy households are

more likely to spend a greater proportion of their disposable income than extremely rich

individuals.

http://en.wikipedia.org/wiki/consumer_durables

http://en.wikipedia.org/wiki/economic_indicators


39

The marginal propensity to consume is less than the average propensity to consume

because of errors in measuring permanent income. True or False? Explain your answer.

True because current income is not a good measure of permanent income. Increases in observed

current income levels in the economy are typically part permanent and part transitory. Permanent

increases in income affect consumption but transitory increases do not. Thus, even though

consumption will typically be a more or less constant fraction of permanent income and thus

vary in roughly the same proportion as permanent income, it will vary less than proportionally

with changes in current income because only a portion of changes in current income are typically

permanent. If consumption is a constant fraction of permanent income, the marginal propensity

to consume out of permanent income will equal the ratio of consumption to permanent income.

This ratio of consumption to permanent income is also the average propensity to consume out of

permanent income. The marginal propensity to consume out of current income, on the other

hand, will typically be less than the ratio of consumption to current income (or average

propensity to consume out of current income) as indicated by the Keynesian consumption

function

(1) C = a + b Y,

where C is consumption, Y is income, and b, the marginal propensity to consume, is less than the

ratio C/Y, which is in turn less than unity. Note that in the current-income consumption function

above, the average propensity to consume out of current income (C/Y) will fall as current income

increases.

The relationship between the current and permanent income consumption functions can be seen

from FIGURE 1.


40

The average level of both current and permanent income income is given by Yo. When current

income is above Yo, permanent income (denoted with a P superscript) is also above Yo, but by a

smaller amount. Consumption depends on permanent income according to the consumption

function

(2) C = kYp.

Consumption varies less than current income because permanent income varies less than current

income. As a result, the current-income consumption function, given by equation (1), is flatter

than the permanent-income consumption function, given by equation (2). The marginal

propensity to consume out of current income, which is equal to the slope b, is less than the

marginal (and average) propensity to consume out of permanent income, which is equal to the

slope k. The average propensity to consume out of current income is given by the slope of a line

(not shown in FIGURE 1) drawn from the point on the current income consumption line

associated with the amount of consumption to the origin. The slope of such a line will be smaller,

and the average propensity to consume will therefore be smaller, the greater the level of

consumption.

Zero time preference implies that consumption is the same in all years regardless of

income. True or False? Explain your answer.

False! Zero time preference would only lead to equal consumption in all years if the interest rate

were zero. In a two-period model, consumption will be the same in both years if the rate of time


41

preference equals the real rate of interest. Assume that the individual's two-period utility function

is of the time-separable form

U = U(C0) + [1/(1 + p)] U(C1)

where C0 and C1 are the levels of consumption in year 0 and year 1 respectively and p is the rate

of time preference. It can be shown that -(1 + p) is the slope of the individual's indifference

curves where they cross the 45 degree ray from the origin (along which C0 equals C1). If the

individual is endowed with incomes Y0 and Y1 in the two years and and can borrow and lend at

the constant real interest rate r, his two-period budget line will have a slope equal to -(1 + r). The

indifference curve and the budget line will therefore be tangent at the 45 degree ray from the

origin, and consumption will be the same in both years, when (1 + p) = (1 + r) ---that is, when p

= r. If p is zero but r is not zero, the positive r will result in the individual consuming less in year

0 than in year 1. This is shown in FIGURE 1 below.

Given zero time preference (p = 0), the slopes of all indifference curves where they cross the 45

degree ray from the origin are equal to -1. If the interest rate is positive, the slope of the

consumer's budget line will be steeper than -1. The individual will consume the combination C0

and C1 in the respective years. Since this combination is to the left of the 45 degree ray, more is

consumed in year 1 than in year 0.

For consumption to be the same in both years the interest rate would have to equal the rate of

time preference. Since the rate of time preference is the slope of the indifference curves where

they cross the 45 degree ray, equality of the rate of time preference with the rate of interest

would imply that the indifference curves and the budget line have the same slope along the 45

degree ray from the origin. Tangency of the two curves would then occur where consumption in

the two years is the same.


42

A permanent reduction of the fraction of unemployed individuals who find jobs each

period will result in a permanent increase in the unemployment rate. True or False?

Explain your answer.

Let U denote the total number of unemployed workers and E denote the number of workers who

are employed. The labour force is equal to the total number of workers whether they are

employed or unemployed---i.e.

(1) -- L = E + U

Let f be the fraction of the total number of unemployed workers who find jobs in each period and

s be the fraction of employed workers who lose (become separated from) their jobs each period.

When the unemployment rate is at an equilibrium level it will be neither increasing nor

decreasing, so the number of people losing their jobs will equal the number finding jobs:

(2) -- f U = s E

Rearranging equation (1) we obtain

(3) -- E = L - U

Substitution of equation (3) into equation (2) yields

(4) -- fU = sL - sU

Dividing both sides of this by L to express the equilibrium unemployment rate as U/L yields

(5) -- f (U/L) = s - s (U/L)

When we add [s (U/L)] to both sides of this equation we obtain

(6) -- (f + s) (U/L) = s

so that

(7) -- U/L = s/(f + s)

A permanent reduction in f will reduce the denominator of equation (7) and increase the

unemployment rate (U/L).


43

The payment of efficiency wages by some firms in the economy will result in an increase in

the country's unemployment rate. True or False? Explain your answer.

The payment of efficiency wages by a firm will enable it to select the best (i.e., most productive)

workers from the labour force in return for paying them higher wages than they could obtain

elsewhere. Workers who end up not being employed by efficiency wage firms will bid wages

down elsewhere until they too are employed. There will be no effect on the aggregate

unemployment rate. That is, everyone who wants a job at their reservation wage (the minimum

wage at which they will work) or higher will have one.

Unionization of workers causes unemployment. True or False? Explain your answer.

It will cause unemployment in the unionized industries in the sense that people willing to work in

those industries at the wages firms are forced by the union to pay will not be able to obtain jobs

in the unionized sector. But those individuals will still be able to find jobs in the non-unionized

sector as long as the wages in that sector do not fall below their reservation wage (in which case

they will choose not to work). Wages in the non-unionized sector will be bid down until

everyone who wants a job at the market wage has one. Unionization will not affect the

unemployment rate in the economy as a whole unless the entire economy is unionized. In this

latter case, workers squeezed out of the unionized sector by the union-engineered increase in the

wage rate will have no where else to go.

\

Types of Inflation

This article briefly explains different types of inflation in economics with examples, wherever

necessary. It is also supplemented with a hierarchical diagram to help readers summarize and

quickly assimilate their list.

Here are different types of inflation depicted and listed below.

The list is as follows:

1. Coverage or scope: a. Comprehensive or Economy-Wide Inflation, and

http://kalyan-city.blogspot.com/2011/06/what-is-inflation-meaning-definition.html


44

b. Sporadic Inflation.

2. Time of occurrence: a. War-Time Inflation,

b. Post-War Inflation, and

c. Peace-Time Inflation.

3. Government's reaction or control: a. Open Inflation, and

b. Suppressed or Repressed Inflation.

4. Rising prices: a. Creeping, Mild or Low Inflation,

b. Chronic or Secular Inflation,

c. Walking or Trotting Inflation,

d. Moderate Inflation,

e. Running Inflation,

f. Galloping or Jumping Inflation, and

g. Hyperinflation.

5. Different causes: a. Deficit Inflation,

b. Credit Inflation,

c. Scarcity Inflation,

d. Profit Inflation,

e. Pricing Power, Administered Price or Oligopolistic Inflation,

f. Tax Inflation,

g. Wage Inflation,

h. Build-In Inflation,

i. Development Inflation,

j. Fiscal Inflation,

k. Population Inflation,

l. Foreign Trade Induced Inflation:

i. Export-Boom Inflation, and

ii. Import Price-Hike Inflation.

m. Export-Boom Inflation,

n. Import Price-Hike Inflation,

o. Sectoral Inflation,

p. Demand-Pull or Excess Demand Inflation, and

q. Cost-Push (Supply-side) Inflation.

6. Expectation or predictability: a. Anticipated or Expected Inflation, and

b. Unanticipated or Unexpected Inflation.

Now let's discuss each type of inflation one by one.

The types of inflation based on coverage or scope:


45

1. Comprehensive Inflation: When the prices of all commodities rise in the entire

economy, it is known as Comprehensive Inflation. Economy-Wide Inflation is its another

name.

2. Sporadic Inflation: Time when prices of only a few commodities in some regions

(areas) rise, it is called Sporadic Inflation. It is sectional in nature. For example, increase

in food prices due to bad monsoon (winds that bring seasonal rains in India).

The types of inflation based on the time or period of occurrence:

1. War-Time Inflation: Inflation that takes place during the period of a warlike situation is

Wartime Inflation. During war, scant productive resources are all diverted and prioritized

to manufacture military goods and equipments. Overall it results in very limited supply

and extreme shortage (low availability) of resources (raw materials) to produce essential

commodities. Production and supply of needed goods slow down and can no longer meet

the soaring demand from people. Consequently, prices of necessary goods keep on rising

in the market, resulting in Wartime Inflation.

2. Post-War Inflation: Inflation that takes place soon after a war is a Post-War Inflation.

After the war, government controls are relaxed, resulting in a faster hike in prices than

what experienced during the war.

3. Peace-Time Inflation: When prices rise during the peace period, it is known as

Peacetime Inflation. It is due to enormous government expenditure or spending on capital

projects of a long gestation (development) time.

4. Open Inflation: When government does not attempt to restrict inflation, it is known as

an Open Inflation. In a free-market economy, where prices are allowed to take its course,

Open Inflation occurs.

5. Suppressed Inflation: When government prevents the price rise through price controls,

rationing, etc., it is known as Suppressed Inflation. Repressed Inflation is its another

name. However, when government removes its controls, it becomes Open Inflation. It

then leads to corruption, black marketing, artificial scarcity, etc.

The types of inflation based on the rising prices:

1. Creeping Inflation: When prices are gently rising, it is referred as Creeping Inflation. It

is the mildest form of inflation and also known as a Mild Inflation or Low Inflation.

According to R.P. Kent, when prices rise by not more than (i.e. Up to) 3% per annum

(year), it is called Creeping Inflation.

2. Chronic Inflation: If creeping inflation persists (continues to increase) for a longer

period, then it is often called as Chronic or Secular Inflation. Chronic-Creeping Inflation

can be either Continuous (which remains consistent without any downward movement)

or Intermittent (which occurs at regular intervals). It is named chronic because if an

inflation rate continues to grow for a longer period without any downturn, then it possibly

leads to Hyperinflation.

3. Walking Inflation: When the rate of rising prices is more than the Creeping Inflation, it

is known as Walking Inflation. Trotting Inflation is its another name. When prices rise by

more than 3%, but less than 10% per annum (i.e., between 3%, and 10% per annum), it is

called as Walking Inflation. According to some economists, we must take Walking


46

Inflation seriously as it gives a cautionary signal for the occurrence of Running inflation.

Furthermore, if, not checked in due time, it can eventually result in Galloping Inflation.

4. Moderate Inflation: Prof. Samuelson clubbed together concept of Creeping and

Walking inflation into Moderate Inflation. It happens when prices rise by less than 10%

per annum (single digit inflation rate). According to him, it is a stable inflation and not a

serious economic problem.

5. Running Inflation: A rapid acceleration in the rate of rising prices is called Running

Inflation. It occurs when prices rise by more than 10% in a year. Though economists have

not suggested a fixed range for measuring running inflation, we may consider a price

increase between 10% to 20% per annum (double-digit inflation rate) as a Running

Inflation.

6. Galloping Inflation: According to Prof. Samuelson, if prices rise by dual or triple digit

inflation rates like 30% or 400% or 999% yearly, then the situation can be termed as

Galloping Inflation. When prices rise by more than 20%, but less than 1000% per annum

(i.e. Between 20% to 1000% per annum), Galloping Inflation occurs. Jumping Inflation is

its another name. India has been witnessing it from second five-year plan period.

7. Hyperinflation refers to a situation where the prices rise at an alarming high rate. The

prices rise so fast that it becomes very difficult to measure its magnitude. However, in

quantitative terms, when prices rise above 1000% per annum (quadruple or four-digit

inflation rate), it is termed as Hyperinflation. During a worst-case scenario of

hyperinflation, the value of the national currency (money) of an affected country reduces

almost to zero. Paper money becomes worthless, and people start trading either in gold

and silver or sometimes even use the old barter system of commerce. Two worst

examples of hyperinflation recorded in the world history are of those experienced by

Hungary in the year 1946 and Zimbabwe during 2004-2009 under Robert Mugabe's

regime.

Following is a conceptual graph on Creeping, Walking, Running, Galloping, Hyperinflation, and

Moderate Inflation.


47

In the above figure,

1. X-axis represents the time in years or annum.

2. Y-axis implies percentage (%) increase or rise in price.

3. OA is a Creeping Inflation from 0 to 3%.

4. AB is a Walking Inflation from 3 to 10%.

5. BC is a Running Inflation from 10 to 20%.

6. CD is a Galloping Inflation from 20 to 1000%.

7. DE is a Hyperinflation from 1000% and above.

8. OB is an addition of OA and AB. It is a Moderate Inflation.

Note: Graph is not drawn to scale. It is roughly made only to get an understanding of how the

actual figure will appear if plotted to scale.

The types of inflation based on different or miscellaneous causes:

1. Deficit Inflation takes place due to deficit financing.

2. Credit Inflation occurs due to excessive bank credit or the money supply in the

economy.

3. Scarcity Inflation occurs due to hoarding. Hoarding is an excess accumulation of

necessary commodities by unscrupulous traders and black marketers. It is practiced to

create an artificial shortage of essential goods like food grains, kerosene, etc. With an

intention to sell them only at higher prices to make huge profits during Scarcity Inflation.

Though hoarding is an unfair trade practice and a punishable criminal offense still, some

crooked merchants often get themselves engaged in it.

4. Profit Inflation: When entrepreneurs are interested in boosting their profit margins,

prices rise.

5. Pricing Power Inflation: Usually, it is referred as Administered Price Inflation. It occurs

when industries and business houses increase the price of their goods and services with

an objective to boost their profit margins. It does not occur during a financial crisis and

economic depression, and not seen when there is a downturn in the economy. As

Oligopolies have an ability to set prices of their goods and services, it is also called as an

Oligopolistic Inflation.

6. Tax Inflation: Due to the rising indirect taxes, sellers charge high price to the

consumers.

7. Wage Inflation: If the rise in wages in not accompanied by an increase in output, prices

rise.

8. Build-In Inflation: Vicious cycle of Build-In Inflation gets induced by adaptive

expectations of workers or employees who try to keep their wages or salaries high in

anticipation of inflation. Employers and Organizations raise the prices of their respective

goods and services in anticipation of the workers or employees' demands. This overall

forms a vicious cycle of rising wages followed by an increase in general prices of


48

commodities. If this cycle continues, then it keeps on accumulating inflation at each

round turn and thereby results in a Build-In Inflation.

9. Development Inflation: During the process of the development of an economy, income

increases, causing an increase in demand and rise in prices.

10. Fiscal Inflation: It occurs due to excess government expenditure or spending when there

is a budget deficit.

11. Population Inflation: Prices rise due to a rapid increase in population.

12. Foreign Trade Induced Inflation: It has two categories, viz.,

a. Export-Boom Inflation, and

b. Import Price-Hike Inflation.

13. Export-Boom Inflation: Considerable increase in exports may cause a shortage at home

(within exporting country) and results in price rise (within exporting country).

14. Import Price-Hike Inflation: If a country imports goods from a foreign country and the

prices of these goods increases due to inflation abroad, then the prices of domestic

products using imported goods also rise. For example, India imports oil from Iran at $100

per barrel. Oil prices in the international market suddenly increase to $150 per barrel.

Now India to continue its oil imports from Iran has to pay $50 more per barrel to get the

same amount of crude oil. When the imported expensive oil reaches India, the Indian

consumers also have to pay more and bear the economic burden. Manufacturing and

transportation costs also increase due to hike in oil prices. It consequently, results in a

rise in the prices of domestic goods being manufactured and transported. It is the end-

consumer in India, who finally pays and experiences the ultimate pinch of Import Price-

Hike Inflation. If the oil prices in the international market fall, then the Import Price-Hike

Inflation also slows down, and vice-versa.

15. Sectoral Inflation: It occurs when there is a rise in the prices of goods and services

produced by certain sectors of the industries. For instance, if prices of the crude oil

increase, then it will also affect all other sectors or areas (like aviation, road

transportation, etc.) which are directly dependent on the oil industry. For example, if oil

prices hike, air ticket fares and road transportation cost will increase.

16. Demand-Pull Inflation: Inflation, which arises due to various factors like rising income,

exploding population, etc., leads to aggregate demand and exceeds aggregated supply,

and tends to raise prices of goods and services. Excess Demand Inflation is its another

name.

17. Cost-Push Inflation: When prices rise due to the growing cost of production of goods

and services, it is known as Cost-Push (Supply-side) Inflation. For example, if the wages

of workers get raised, then the unit cost of production also increases. As a result, the

prices of end products and services being manufactured and supplied are consequently,

hiked.

The types of inflation based on the expectation or predictability:

1. Anticipated Inflation: If the rate of inflation corresponds to what the majority of people

are either expecting or predicting, then is called Anticipated Inflation. Expected Inflation

is its another name.

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2. Unanticipated Inflation: If the rate of inflation corresponds to what the majority of

people are neither anticipating nor predicting, then is called Unanticipated Inflation.

Unexpected Inflation is its another name.

National income accounting NOTES FOR ALL UNIVERSITIES MAINLY FOR ECONOMICS HONOURS COURSE AND CLASS XI , XII CBSE COURSE BY SOURAV SIR'S CLASSES 9836793076

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