Part 1: INTRODUCTION TO ECONOMICS

Chapter # 1: Micro Economics

Economics is the study of how people choose to use their scarce resources. Resources include the time, talent, land,
building, equipment and other tools and the knowledge of how to combine them to create useful products/services.

In short economics includes the study of labor, land and investments, of money, income and production, and taxes
and govt expenditure.

Microeconomics starts by thinking about how individual make decisions. Macroeconomics considered aggregate
outcomes.

Why study Economics

 Economics effect every one: Economics is about choice and is heart of all decision making. Thus, economics
is applicable in a wide range of fields including business, finance, administration, law, local & national govt etc.
are all faced making choices where resources are scarce.
 Intellectual discipline develops a valuable skill: Economics is valuable for its method of analysis. The
economists use in constructing models, analyzing arguments and testing empirical prediction.
 Helpful in getting Job: Economics open new horizon of Jobs.

Microeconomics: Microeconomics deal with smaller issues i.e consumer behavior, market behavior, cost of
business, competition among firms and imperfections in markets called market failure. It also discusses labor market,
issues such as distribution of income and wealth in an economy, as well as environmental concerns, poverty and
corporate mergers etc.

Macroeconomics: Macroeconomics deals with larger issues such as inflation, unemployment, economic growth
and measurement of these factors. This look at wide economic phenomena such as GDP, GNP, effect of
increase/decrease in import/export etc.

Microeconomics takes bottom-up approach to analyzing economy while macroeconomics takes top-down
approach.

Demand and Supply: demand and supply is one of the most fundamental concept of economics and backbone of
economy. Demand refers to how much quantity of a product/service is desired by the buyers. The quantity
demanded is the amount of a product people are willing to buy at a certain price. The relationship b/w price and
quantity demanded is called demand relationship.

Supply represents how can the market can offer. The quantity supplied refers to the amount of a certain good
producers are willing to supply when receiving a certain price. The correlation b/w price and supplied
product/services is known as supply relationship.

The relationship b/w demand and supply underlie the forces behind the allocation of resources.

The Law of Demand: The law of demand states that other factors being constant (cetris peribus), price and
quantity demand of any good and service are inversely related to each other. When the price of a product increases,
the demand for the same product will fall. Law of demand explains consumer choice behavior when the price
changes. In the market, assuming other factors affecting demand being constant, when the price of a good rises, it
leads to a fall in the demand of that good. This is the natural consumer choice behavior. This happens because a
consumer hesitates to spend more for the good with the fear of going out of cash.
The above diagram shows the demand curve which is downward sloping. Clearly when the price of the commodity
increases from price p3 to p2, then its quantity demand comes down from Q3 to Q2 and then to Q3 and vice versa.

The Law of Supply: Law of supply states that other factors remaining constant, price and quantity supplied of a
good are directly related to each other. In other words, when the price paid by buyers for a good rises, then suppliers
increase the supply of that good in the market. Law of supply depicts the producer behavior at the time of changes
in the prices of goods and services. When the price of a good rises, the supplier increases the supply to earn a profit
because of higher prices.

The above diagram shows the supply curve that is upward sloping (positive relation between the price and the
quantity supplied). When the price of the good was at P3, suppliers were supplying Q3 quantity. As the price starts
rising, the quantity supplied also starts rising.

Time and supply: Unlike the demand relationship, the supply relationship is a factor of time. The time is important
to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So, it is important
to determine whether a price change that is caused by the demand will be temporary or permanently.

Equilibrium: When supply and demand are equal (i.e. when the supply function and demand function intersect)
the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the
amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone
(individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are
selling all the goods that they have produced and consumers are getting all the goods that they are demanding.

In the real market place equilibrium, can only ever be reached in theory, so the prices of goods and services are constantly changing in relation
to fluctuations in demand and supply.
Disequilibrium: Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.
 Excess Supply: If the price is set too high, excess supply will be created within the economy and there will be
allocative inefficiency.

At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1, however, the quantity that the
consumers want to consume is at Q1, a quantity much less than Q2. Because Q2 is greater than Q1, too much is being produced
and too little is being consumed. The suppliers are trying to produce more goods, which they hope to sell to increase profits, but
those consuming the goods will find the product less attractive and purchase less because the price is too high.

 Excess Demand: Excess demand is created when price is set below the equilibrium price. Because the price is
so low, too many consumers want the good while producers are not making enough of it.

In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2. Conversely, the quantity of goods
that producers are willing to produce at this price is Q1. Thus, there are too few goods being produced to satisfy the wants
(demand) of the consumers. However, as consumers have to compete with one other to buy the good at this price, the demand
will push the price up, making suppliers want to supply more and bringing the price closer to its equilibrium.

Shifts vs. Movement: For economics, the "movements" and "shifts" in relation to the supply and demand curves
represent very different market phenomena:

 Movements: A movement refers to a change along a curve.

On the demand curve, a movement denotes a change in both price and quantity demanded from one point to
another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a
movement along the demand curve will occur when the price of the good changes and the quantity demanded
changes in accordance to the original demand relationship. In other words, a movement occurs when a change
in the quantity demanded is caused only by a change in price, and vice versa.
Movement along the supply curve means that the supply relationship remains consistent. Therefore, a movement
along the supply curve will occur when the price of the good changes and the quantity supplied changes in
accordance to the original supply relationship. In other words, a movement occurs when a change in quantity
supplied is caused only by a change in price, and vice versa.

 Shifts
A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even though
price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of beer demanded
increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in the demand curve imply
that the original demand relationship has changed, meaning that quantity demand is affected by a factor other
than price. A shift in the demand relationship would occur if, for instance, beer suddenly became the only type
of alcohol available for consumption.

Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2, then there
would be a shift in the supply of beer. A shift in the supply curve implies that the original supply curve has
changed, meaning that the quantity supplied is effected by a factor other than price. A shift in the supply curve
would occur if, for instance, a natural disaster caused a mass shortage of hops; beer manufacturers would be
forced to supply less beer for the same price.
Elasticity and Inelasticity: Inelasticity and elasticity of demand refer to the degree to which supply and demand
respond to a change in another factor, such as price, income level or substitute availability. If the change in demand
for a given product corresponds closely to a change in one of these factors, the demand is considered to be elastic.
If the change in demand for a given product does not correspond closely to a change in one of these factors, the
demand is considered to be inelastic.
Elasticity: Elasticity varies from product to product because some products may be more essential to the
consumer than others. Demand for products that are considered necessities is less sensitive to price changes
because consumers will continue buying these products despite price increases. On the other hand, an increase
in price of a good or service that is far less of a necessity will prevent consumers because the opportunity cost
of buying the product will become too high.
A good or service is considered highly elastic if even a slight change in price leads to a sharp change in the
quantity demanded or supplied. For example, if the price of Coke rises, people may readily switch over to Pepsi.
An inelastic good or service is one in which large changes in price produce only modest changes in the quantity
demanded or supplied, if any at all. These goods tend to be more of a necessity to the consumer in his or her
daily life, such as gasoline. To determine the elasticity of the supply or demand of something, we can use this
simple equation:
Elasticity = (% change in quantity / % change in price)
If the elasticity is greater than or equal to 1, the curve is elastic. If it is less than one, the curve is said to be inelastic.
The demand curve has a negative slope. If a large drop in the quantity demanded is accompanied by only a small increase in price,
the demand curve will appear looks flatter, or more horizontal. People would rather stop consuming this product or switch to
some alternative rather than pay a higher price. A flatter curve means that the good or service in question is quite elastic.
Factors Affecting Demand Elasticity
There are three main factors that influence a good’s price elasticity of demand:
1. Availability of Substitutes: The more good substitutes there are, the more elastic the demand will be. For
example, if the price of a cup of coffee went up by $0.25, consumers might replace it with a cup of strong tea.
This means that coffee is an elastic good because a small increase in price will cause a large decrease in
demand.
While a specific product within an industry can be elastic due to the availability of substitutes, an entire industry
itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few (if any)
substitutes.

2. Necessity: If something is needed for survival or comfort, people will continue to pay higher prices for it. For
example, people need to get to work or drive for any number of reasons. Therefore, even if the price of gas
doubles or even triples, people will still need to fill up their tanks.

3. Time: If the price of cigarettes goes up $2 per pack, a smoker with very few available substitutes will most likely
continue buying his or her daily cigarettes. This means that tobacco is inelastic because the change in price will
not have a significant influence on the quantity demanded. However, if that smoker finds that he or she cannot
afford to spend the extra $2 per day and begins to kick the habit over a period of time, the price elasticity of
cigarettes for that consumer becomes elastic in the long run.

Income Elasticity of Demand

Income elasticity of demand is the amount of income available to spend on goods and services. This also affects
demand since it regulates how much people can spend in general. Thus, if the price of a car goes up from $25,000
to $30,000 and income stays the same, the consumer is forced to reduce his or her demand for that car. If there is
an increase in price and no change in the amount of income available to spend on the good, there will be an elastic
reaction in demand: demand will be sensitive to a change in price if there is no change in income. If there is an
increase in income, demand in general tends to increase as well. The degree to which an increase in income will
cause an increase in demand is called the “income elasticity of demand,” which can be expressed in the following
equation.

If EDy is greater than 1, demand for the item is considered to have a high income elasticity. If EDy is less than 1,
demand is considered to be income inelastic. Luxury items usually have higher income elasticity because when
people have a higher income, they don't have to forfeit as much to buy these luxury items. consider a luxury good:
vacation travel. Bob has just received a $10,000 increase in his salary, giving him a total of $80,000 per year. With this new
higher purchasing power, he decides that he can now afford to go on vacation twice a year instead of his previous once a year.
With the following equation, we can calculate income demand elasticity:

Income elasticity of demand for Bob's air travel is 7, which is highly elastic.
With some goods and services, we may notice a decrease in demand as income increases. These cases often involve
goods and services considered of inferior quality that will be dropped by a consumer who receives a salary increase.
Products for which the demand decreases as income increases have an income elasticity of less than zero. Products
that witness no change in demand despite a change in income usually have an income elasticity of zero.
If the percentage change in quantity demanded is greater than the percentage change in income, then the demand is said to be
income elastic, or very responsive to changes in demander’s incomes. If the percentage change in the quantity demanded is less
than the percentage change in income, then the demand is said to be income inelastic. If the income elasticity of demand is
positive, the good must be normal good, and if the income elasticity of demand is negative the good must be inferior good.

If the percentage change in quantity demanded of good ‘X’ is greater than the percentage change in price of good ‘Y’ then the
demand for good ‘X’ is cross-price elastic w.r.t good ‘Y’ or very responsive to changes in the price of good ‘Y’. If the percentage
change in quantity demanded of good ‘X’ is less than the percentage change in price of good ‘Y’ then the demand for good ‘X’ is
cross-price inelastic w.r.t good ‘Y’ or not very responsive to changes in the price of good ‘Y’. if the cross-price elasticity of demand
is positive, the good X and Y must be substitutes, but if cross-price elasticity of demand is negative then the good X and Y must
be complement.

Consumer Preferences
Consumer make decisions by allocating their scarce income across all possible goods to obtain the greatest
satisfaction. Consumer choice is a theory that relates preferences for consumption goods/services to consumption
expenditures and ultimately to consumer demand curves. The link b/w personal preferences, consumption and the
demand curve is one of the most closely studied relations in economics. Consumer choice theory is a way of analyzing
how consumers may achieve equilibrium b/w preferences and expenditures by maximizing utility as subject to
consumer budget constraints.

Solution to the problem of mapping consumer choices is ‘Indifference Curve’. For individual an assumption of constant prices and
fixed income gives you above diagram. The consumer can choose any point on or below budget constraint line BC. In other words,
the amount spent on both goods together is less than or equal to the income of the consumer. The costumer will choose
indifference curve within his budget constraints. Every point on 13 is outside his budget constraints.

Substitute effect
The substitution effect is the economic understanding that as prices rise or income decreases consumers will replace
more expensive items with less costly alternatives. The substitute effect is the effect observed with changes in
relative price of goods. This affects the movement along the curve.
These curves can be used to predict the effect of changes to the budget constraints. The graph above shows the effect of price
increase for goods ‘Y’. If the price of ‘Y’ increases, the budget constraint will pivot from BC2 to BC1. Notice that because price of
good ‘X’ doesn’t change, the consumer can still buy the same amount of good ‘X’ however, if consumer choose to buy good ‘Y’
he will buy less quantity because price has increased.

Income effect
The income effect refers to the change in the demand for a product or service caused by a change in consumers'
disposable income, which is the portion of somebody's income that is available for spending on non-essentials or
saving. The income effect is the phenomena observed through changes in purchasing power. It reveals the change
in quantity demanded brought by a change in real income as long as the price remain constant. Changing the income
will create a parallel shift of the budget constraints. Increasing the income will shift the budget constraint right since
more of both can be bought, and decreasing income will shift it left.

Depending upon the indifference curves, as income increases, the amount purchased of goods can increase, decrease or stay the
same.

The concept of Market equilibrium

Changes in Market Demand and equilibrium Price

The demand curve may shift to the right (Increase) for several reasons.
 A rise in the price of a substitute or a fall in the price of a complement.
 An increase in consumer’s income or their wealth.
 Changing consumer tastes and preferences in favor of the product.
 A fall in interest rate.
 General rise in consumer confidence and optimism.

The outward shift in the demand curves causes a movement (expansion) along the supply curve and a rise in the equilibrium price
and quantity. Firms in the market will sell more at a higher price and therefore receive more in total revenue. The reverse effects
will occur when there is an inward shift of demand. A shift in the demand curve doesn’t cause a shift in the supply curve.
Equilibrium means state of equality or state of change/w market demand & supply.
 Changes in Market Supply and equilibrium Price

A supply curve may shift outwards if

 A fall in the costs of production
 A govt subsidy to producers that reduces their costs.
 Favorable climate conditions (higher agriculture production)
 A fall in the price of substitute in production
 An improvement in production technology leading to higher/efficient productivity.
 The entry of new supplier leads to increase in total market supply.

The outward shift of the supply curve increase the supply available in the market at each price within a given demand curve,
there is a fall in the market equilibrium price P1 to P3 and rise in quantity demanded Q1 to Q3. Shift in supply cause expansion
along the demand curve. A shift in the supply does not cause a shift in demand curve instead we move along the demand curve
to the new equilibrium position.

The Production Function

The production function is a mathematical expression which relates the quantity of factors inputs to the quantity of
outputs that result.
 Total production is simply the total output that is generated from the factor of production employed by business such
as land, labor, capital, machinery etc.
 Average product is the total output divided by the number of units of the variable factors of production employed.
 Marginal product is the change in the total product when an additional unit of the variable factor of production is
employed.

The short Run Production Function

The short run is a time period where at least one factor of production is in fixed supply. Normally we assume quantity
of capital inputs i.e plant and machinery is fixed and that production can be altered by changing variable inputs such
as labor, raw materials and energy.
In the short run, the law of diminishing returns states that as more units of a variable input are added to fixed
amounts of land and capital, the change in total output will first rise and then fall. D iminishing returns to labor
occurs when marginal product of labor starts to fall. This means that total output will be increasing at a
decreasing rate

Capital Input Labor Input Total Output Marginal Product Average Product of Labor
20 1 5 5
20 2 16 11 8
20 3 30 14 10
20 4 56 26 14
20 5 85 28 17
20 6 114 29 19
20 7 140 26 20
20 8 160 20 20
20 9 171 11 19
20 10 180 9 18
What might cause marginal product to fall?
One explanation is that, beyond a certain point, new workers will not have as much capital equipment to work
with so it becomes diluted among a larger workforce I.e., there is less capital per worker.
In the following numerical example above, we assume that there is a fixed supply of capital (capital = 20 units) to
which extra units of labor are added to the production process.
 Initially, marginal product is rising – e.g. the 4th worker adds 26 to output and the 5th worker adds 28 and the 6th
worker increases output by 29.
 Marginal product then starts to fall. The 7th worker supplies 26 units and the 8th worker just 20 added units. At this
point production demonstrates diminishing returns.
 Total output will continue to rise as long as marginal product is positive
 Average product will rise if marginal product greater than average product

Opportunity Cost: represent the benefits an individual, investor or business misses out on when choosing one
alternative over another e.g If the government build a new road, then that money can’t be used for alternative
spending plans, such as education and healthcare.

Sunk Cost: A sunk cost is a cost that has already been incurred and cannot be recovered. Sunk costs are excluded
from future business decisions because the cost will be the same regardless of the outcome of a decision. Sunk
cost is barrier to exit. A firm which has incurred high sunk cost will have difficulties in deciding to exit from market.

Marginal Cost (MC):

The marginal cost of production is the change in total cost that comes from making or producing one additional item.
The purpose of analyzing MC is to determine at what point an organization can achieve economies of scale in short
run. It is derived by dividing the ‘change in total cost (or variable cost) by change in output’. It explains the law of
supply and upward sloping supply curve. MC reflects the law of diminishing marginal returns. When plotted on a
graph, MC traces out a U-shaped pattern. A profit maximizing firm compares the marginal revenue received from
output sold with the marginal cost of producing it.
o If Marginal Revenue = to MC, the firm produces profit maximizing output quantity
o If MR < MC firm can boost profit by increasing production
o If MR > MC firm can boost profit by decreasing production.

The Marginal Cost Curve:

The marginal cost curve, the graphical relation between marginal cost and output, is U-shaped. Marginal cost is
relatively high (negative slope) at small quantities of output, then as production increases, it declines (positive slope),
reaches a minimum value, then rises once again.

This U shape is directly attributable to increasing, then decreasing marginal returns (and the law of diminishing
marginal returns). As marginal product (and marginal returns) increases for relatively small output quantities,
marginal cost declines. Then as marginal product (and marginal returns) decreases with the law of diminishing
marginal returns for relatively large output quantities, marginal cost increases.

SHORT RUN MARGINAL COST CURVE (SRMC)

Slope and Total Cost (TC):

MC is a slope of the TC Curve. Because the TC Curve is parallel to the total variable cost curve, MC is also slope of
the total variable cost curve. A marginal is always the slope of the total curve.
o If TC Curve has a positive slope (upward sloping) then MC is positive
o If TC Curve has a positive and increasingly steeper slope, then MC is positive and rising
o If TC Curve has a positive and decreasingly steeper slope, then MC is positive and but falling
Long Run Marginal Cost Curve (LRMCC)
LRMCC shows for each unit of output the added total cost incurred in the long run, when all factors of production
are variable so as to minimize long run average total cost. LRMC increase in total cost associated with an increase of
one unit of output when all inputs are variable. LRMCC tends to be flatter than SRMCC due to increased input
flexibility as to cost minimization.

The LRMCC intersect the LRACC at minimum point of he later. When long run, marginal cost is below long run average
cost, long run average cost are falling (as to additional units of output). When long run, marginal cost is above long
run average cost, long run average cost are rising. LRMC equals SRMC at the least LRAC level of production LRMCC
is the slope of the LR total cost function.

Average Cost Curve (ACC)

o When the MC curve is above the ACC the Average curve is rising.
o When the MC curve is below an ACC the Average curve is falling
o Average Variable Cost AVC = Total variable cost / quantity produced
o Average Fixes Cost AFC = Fixed cost / quantity
o Average Total Cost ATC = Total cost / quantity

Average Fixed Cost (AFC) refers to fix cost per unit of output. AFC begin to fall with the increase in the number of
units/output produced.
Average Variable Cost (AVC) refers to variable expenses per unit of output. When output increase, the AVC
decrease in the beginning, reaches a minimum and then increase because when firm start using its full capacity to
produce output AVC decreases but when firm want to produce more than the full capacity then it will use less
efficient machinery/labor, this result in rise in AVC. The shape of the AVCC is like flat U-shaped. It shows that when
the output is increased, there is a steady fall in the AVC due to increasing return to variable factors.

AVC

Average Total Cost (ATC) refers to both fixed and variable per unit of output. When output increase, like AVC the
AFC also decrease in the beginning, reaches a minimum and then increase.

Production Cost:
The following elements are included in the cost of production:

Purchase of machinery, installment of machinery, wages, rent, interest on capital, wear & tear of machinery &
building, advertisement expense, insurance charge, taxes, cost of production etc.

Production cost: material cost, rent, wage, interest.

Selling Cost: Transportation, marketing etc
Sundry Cost: Insurance, taxes etc.
 Chapter # 2: Macro Economics
National Income: The total net value of all goods and services produced within a nation over a specified period
representing the sum of wages, profits, rents, interest and pension payments to residents of the nation. There are
03 main approaches.
i. Output or value added approach: The total value of all final goods & Services, can be found by adding up the total of
outputs produced at different stages. This method is to avoid double-counting or over-estimation of GNP.
ii. Expenditure Approach: this refers to all those spending or currently produced final good & services only. 03 agencies
buy goods/services i.e
o Household or private consumption expenditure ‘C’
o Firms or Investment expenditure ‘I’
o Government consumption expenditure ‘G’
While calculating GNP, we added Exports (X) and deduct Imports (M). GNP at Market Price = C + I + G + X - M

iii. Income Approach: this ties to measure the total flow of income earned by the factor owners.

Factors Affecting National Income

 Factor of Production
o Land: Resources like Coal, Iron Timber etc.
o Capital: determined by Investments and factors like probability, political stability etc.
o Labor & Entrepreneur: Quality of Human Resources.
 Technology: The development in technology is affected by the level of inventions and innovation on
Production
 Government: favorable, regulations, law & order, environment
 Political Stability: wars, social unrest will discourage investment.

Uses of National Income Statistics

 Standard of living: Per capita GNP allows to compare standard of living with other nations
 Policy Formulation: Assisting Govt for policy formulation.
 International Comparison: assisting to compare rate of growth & development
 Business Decision: level of development of different industries & sectors, help to plan production level.

Inflation: Sustained increase in general price leading to fall in purchasing power and value of money.
Deflation: When the rate of inflation is negative i.e General price level is falling and value of money is increasing.
Hyperinflation: is very high and accelerating inflation. It quickly erodes the real value of the local currency, as the
prices of all goods increase. This leads to political & social instability. Drastic action is required to stabilize economy.

The Main Couse of Inflation: If supplier/manufacturer of product/services increase its prices or Govt rise value
added tax. There are two main causes of inflation. The first occurs when demand-pull conditions drive
widespread price increases. The second cause of inflation results from cost-push factors.

Demand-pull Inflation: Demand pull inflation occurs when there is full employment of resources and aggregate
demand is increasing at a time when short run aggregate supply in inelastic. Possible cause of demand pull includes:
 Depreciation of exchange rate which increase the price of imports and reduces the foreign prices of exports.
 Higher demand from fiscal stimulus e.g a reduction in taxes or higher govt spending. If direct tax are
reduced, consumer will have more disposable income Causing demand to rise.
 Monetary stimulus e.g a fall in interest rate may increase to much demand like demand raise for loans.
 Faster economic growth in country, providing boost to exports. Export provide extra flow of income and
spending in the country.
Cost Push Inflation: Cost push inflation occurs when firms responded to rising cost, by increasing prices to protect
their profit margins. There are many reasons, some are as follows
 An increase in prices of raw materials and other components use in production process may be because of
oil prices, copper prices agriculture products etc.
  Rising labor cost: wage cost often rise when unemployment is low, skilled worker are scarce leads to higher
wages.
 Higher indirect taxes e.g a rise in specific duty on fuel. Cost push inflation illustrated by inward shift of the
short run aggregated supply curve. The fall in SRAS causes a contraction of national output together with
rise in the level of prices.
Inflation can be reduced by policies such as:
 Fiscal policy: Govt can reduce its spending, welfare payments, it can choose to increase direct tax which
tighten the policy.
 Monetary Policy: A tighten monetary policy involves higher interest rate to reduce consumer and
investment spending.
 Supply side Economic policy: include those that seek to increase productivity, competition and innovation
all of which can maintain lower prices.

UMEMPLOYMENT: (Govt can reduce unemployment by increasing spending and reducing taxes, known as fiscal policy)
 Frictional Unemployment is a type of unemployment that arises when workers are searching for new jobs
or are transitioning from one job to another. It is part of natural unemployment and hence is present even
when the economy is considered at full employment.
 Structural Unemployment occurs when people are made jobless because of capital-labor substitution which
reduces the demand for labor in an industry, or when there is a long run decline in demand which causes
redundancies and worker lay-offs. Structural unemployment exists where there is a mismatch between
their skills and the requirements of the new job opportunities.
 Cyclical Unemployment is a voluntary or ‘demand deficient’ unemployment due to lack of aggregate
demand. This is also known as “Keynesian”. When there is a recession we see rising employment because
plant closure and worker lay-offs.
 Voluntary and Involuntary Unemployment: voluntary unemployment when a worker choose not to accept
a job at the going wage rate and Involuntary unemployment occurs when a worker is willing to accept the
job at the going rate but cannot get offer.

EXCHANGE RATE: An exchange rate is the price of a nation’s currency in terms of another currency. It is
important channel of monetary policy. A significant appreciation of the domestic currency makes
domestic goods expensive relative to foreign goods. Exchange rate prices can be expressed in different
ways:
 Spot Exchange Rate: The actual exchange rate for a currency at current market price, determine by forex
on a minute by minute basis. The spot rate is sometimes called the benchmark rate, straightforward rate
or outright rate.
 Forward Exchange Rate: It involves the delivery of currency at some time in future at an agreed rate.
Companies avail this facility to reduce exchange rate uncertainty.
 Bi-Literal Exchange Rate: This is simply the rate at which one currency can be traded against another.
 Effective Exchange Rate Index (EER): is the weight index of rupees’ value against a basket of international
currencies the weights used are determined by the proportion of trade b/w Pakistan and each country.
 Real Exchange Rate: This measures the ratio of domestic price indices b/w two countries. A rise in the real
exchange rate implies a worsening of international competitiveness for a country.

BALANCE OF PAYMENT: The balance of payments (BOP), also known as balance of international
payments, summarizes all transactions that a country's individuals, companies and government bodies
complete with individuals, companies and government bodies outside the country. These transactions
consist of imports and exports of goods, services and capital, as well as transfer payments such as foreign
aid and remittances. If import is > than Export = Trade Balance deficit or vice versa. The balance of
payments divides transactions in two accounts: the current account and the capital account.
Imbalances: Countries with deficit in their current account will build up increasing debt and foreign ownership of
their assets. Typical types of Deficit are:
o A Visible Trade Deficit: where a nation is importing more than exporting.
o An Overall current account deficit
o A basic Deficit which is the current account plus foreign direct investment but excluding other elements of the capital
account like short term loans and the reserve account.

OBJECTIVE OF MACROECONOMICS POLICY: The four-major objective are discussed below.

1. Full Employment or Low Employment: Full employment is an economic situation in which all available labor
resources are being used in the most efficient way possible. Full employment embodies the highest amount
of skilled and unskilled labor that can be employed within an economy at any given time. For realistic count,
International Labor Organization (ILO) measured is used. This includes the young unemployed, who are not
always eligible to claim, married woman who can’t claim if their husbands is earning enough and those who
claim sickness and invalidity benefits.
2. Price Stability: is in an economy means that the general price level in an economy does not change much
over time. In other words, prices neither go up or down; there is no significant degree of inflation or
deflation. Inflation is usually defined as a sustained rise in general level of price, it is measured as the annual
rate of change of the Retail price index (RPI). To be price stable inflation rate should be zero. (RPIX same as
RPI except housing cost are removed in the shape of mortgage interest payment).
3. High (but sustainable) Economic Growth: economic growth tends to be measured in terms of the rate of
change of real GDP. GDP is a measure of annual output of an economy.
4. Balance of Payment in Equilibrium: This records al flows of money into, and out of, the country. It is split
into two: Current Account and the Capital and Financial Accounts. Current Account is most important
because this records how well the country is doing in terms of its exports of goods/services relative to its
imports.
Macroeconomics Policies in Practices: Some of the most widely used policy instrument are:
I. Fiscal Policy: consist of Govt expenditures and taxation. Fiscal policy effects total spending and influences
real GFP and inflation.
II. Monetary Policy: Monetary policy controlled by SBP, this policy determines the money supply. Changes in
money supply move interest rate and effect spending in sector such as investment, housing, net exports.
III. International/Foreign Economic Policy: Such as trade policies, exchange rate setting, and monetary & fiscal
policies attempt to keep imports in line with exports and to stabilize exchange rate.
IV. Income policies: are Govt attempts to moderate inflation by direct steps by verbal persuasion or official
wage or price control.

MARGINAL ANALYSIS: is an examination of the consequences of benefits of an activity compared to the

additional/subtraction of costs/input incurred by that same activity. Companies use marginal analysis as
a decision-making tool to help them maximize their potential profits.
MARGINAL BENEFIT: Marginal benefit is an economic term that refers to the additional satisfaction created
by consumption of one more unit of good/services. Marginal benefit usually decreases as consumption of
goods/services increases, this is called “The Law of Diminishing Marginal Utility”
Marginal Cost: is the change in total cost that arise when quantity produced change by one unit. That is,
it is the cost of producing one more unit of goods/services. In long run all cost are marginal.
Consumer Surplus: is a measure of the welfare that people gain from the consumption of goods/services
or a measure of the benefits they derive from the exchange of goods. CS is the difference b/w the price
that a consumer is prepared to pay and the actual price.
Consumer Surplus and Price Elasticity of Demand: When the demand for a good/service is perfectly elastic,
consumer surplus is zero because the price that people pay matches precisely the price they willing to pay. This is
not happened in competitive market. In contrast, when demand is perfectly inelastic, consumer surplus is infinite.
Demand is totally invariant to a price change means whatever the price, the quantity demanded remains the same.
Price Discrimination and Consumer Surplus: If business can identify a group of consumer willing to pay higher
price for the same product, the seller may engage in price discrimination, aim is to take advantage of consumer
surplus to extract money form purchaser for extra revenue.
Producer Surplus: Producer surplus is a measure of producer welfare. It is measured as the difference b/w what
producer are willing and able to supply a good for and the price they receive.
Dead Weight Loss: also, known as excess burden or allocative inefficiency. DWL is a loss of economic efficiency
that can occur when equilibrium for a good /service is not Pareto optimal. In other words, people who would have
more marginal benefit that marginal cost are not buying the product, or people who have more a marginal cost than
marginal benefit buying the product.
Over Production: In economics, Overproduction, oversupply, or excess of supply refer to excess of supply over
demand of production being offered in the market. This leads to lower prices and/or unsold goods along with the
possibility of unemployment. OP is attributed as due to previous overinvestment; creation of excess productive
capacity refers to excess production over consumption.
Underproduction: refers to excess of demand over its supply. This leads to higher price & goods sold quickly.

TYPE OF COMPETITION
 Perfect competition:
o There are no barriers to entry into or exit out of the market. There are very many firms in the market -
too many to measure. This is a result of having no barriers to entry.
o Firms produce homogeneous, identical, units of output that are not branded.
o There are assumed to be no externalities, that is no external costs or benefits to third parties not involved
in the transaction.
o No single firm can influence the market price, or market conditions. The single firm is said to be a price
taker, taking its price from the whole industry. The single firm will not increase its price independently
given that it will not sell any goods at all. Neither will the rational producer lower price below the market
price given that it can sell all it produces at the market price.
o Knowledge is freely available to all participants, which means that risk-taking is minimal and the role of
the entrepreneur is limited.
o Firms can only make normal profits in the long run, although they can make abnormal (super-normal)
profits in the short run.
 Oligopoly: Few larger suppliers, degree of concertation is very high.
o Few firms selling similar products.
o Each firm produces branded products
o Significant entry berries which allows firms to make supernormal profit in long run.
o Interdependency b/w competing firms.
o When one firm has a dominant position, Oligopoly experience price leadership.
 Monopoly: controls selling side of market Four characteristics of monopoly are
o Single firm selling all output in the market
o Unique product
o Restriction entry into and exit out of the industry and more often not.
o Specialized information about production techniques.
  Monopolistic Competition: is a middle ground b/w monopoly and perfect competition.
o Larger number of firms
o Similar but not identical products sold by all firms
o Barriers to entry and exit in a monopolistic competitive industry are low, and the decisions of
any one firm do not directly affect those of its competitors.
o In short run.

Chapter # 3: Theory, Data and Forecasting

Cross-sectional data, which means a number of different observations on one variable taken in different places at
the same point in time.

Time series data. This involves surve on one variable at successive points in time.

A logarithmic scale: is a scale of measurement using the logarithm of a physical quantity instead of the quantity
itself. It is useful when percentage of data is more important than absolute changes. When data is graphed on the
logarithmic scale, equal distances indicate equal percentage changes. Also, with a log scale a straight line indicates
a constant rate of growth.

Scatter diagrams: Data can also be presented in the form of a scatter diagram. This is the most analytical type of
chart. Its purpose is to show the relationship between two different variables, such as the price of flour and
the quantities of flour sold.
 Part 6: MONEY
Money is anything that can be traded for goods and/or services and this characteristic of it makes the exchange of
goods and: easy, it promotes specialization.
Why Credit Cards and Cheques cannot be counted as Money
Simply writing a cheque or carrying out a credit card transaction does not increase the money supply. It is when the
money has been realized does the transaction fully occur.
Outstanding cheques mean that the transaction was not fully carried out and for this reason cheques cannot be
counted as money. Credit cards are short-term loan that the card holder takes from the issuer which is repaid when
the bill has been received. Thus, credit cards also cannot be counted as money.

Functions of Money
 Money is medium of exchange.
 Money is value measure. Just as we measure length in meters, weight in grams and time in seconds we to have
a measure of the value of money.
 Money can also be used as a store value. This function recognizes that money can be stored and accumulated
over time. Money also does not have the risks associated with assets like jewelry, property, the owner can be
confident that it will realize its monetary value in the future.
 Money is to serve as a means of deferred payments. Most of the transactions are made on credit in this modem
world. In this case, sellers are unlikely to accept promises to pay in the future which are expressed in terms of
goods other than money. They cannot estimate how much of the product they will require in exchange and if
they would face the risk involved in selling them. Sellers usually accept promises to pay expressed in terms of
money because they know they can use money to buy the goods or service they want.

The Quantity theory of Money seeks to explain the factors that determine the general price level in a country.
The theory states that the price level is directly determined by the supply of money. There are two versions of this
theory. ‘The Transaction approach’ and ‘The cash Balance approach’.

 The Fisher’s Transaction approach: MV=PT

M is Total supply of money, V is velocity of circulation of money,
P is general price level, T is the total transaction in physical goods.

In an economy, the total value of all goods sold during any period (PT) must be equal to the quantity of money spent
during the period (MV). Fisher assumes that
o At full employment, total physical transactions ‘T’ in an economy will be a constant.
o The velocity of circulation remains constant in short run because it largely depends on the spending habits of the
employee.
When these two assumption are made the Equation of Exchange becomes The Quantity Theory of Money which
shows that there is an exact, proportional relationship b/w money supply and price level.

 The Cash Balance approach: π=kR/M…………………………eq(1)

π= The purchasing power of money
k= the proportion of income that people like to hold in the form of money
R= The volume of real income, M= The stock of supply of money in the country
This equation shows that purchasing power of money or the value of money (π) varies directly with k or R and inversely with M.

Since π is the reciprocal of the general price level; that is π=1/P, the equation, π=kR/M can be expressed alternatively
as 1/P=kR/M……………………..Eq (2) OR M=kRP……………………Eq(3)

If we multiply the volume of real income (R) by the general price level (P), we have the money national income (Y) Therefore,
M=KY……………………….Eq(4) where Y is the country’s total money income.
We can also write Eq(3) in terms of the general price level P=M/kR………………….Eq(5)
This equation implies that the price level (P) varies inversely with k or R and directly with M. in the Cash Balance Approach k was
more significant than M for explaining changes in the purchasing power/value of money. This means that value of money depends
upon demand of the people to hold money.
Implication of the Quantity theory: Looking at equation 3, if k is held constant, the price will move in proportion
with the money supply. A stable money supply will create stability in prices, if money supply grows fiercely, so will
the price or vice versa. The quantity theory is evident during the period of hyperinflation.
The Liquidity preferences theory: Keynes’s theory states that the interest rate adjusted to bring money supply and
money demand into balance. He stated that saving money does not yield interest. Interest is acquired a result of
parting with liquidity. According to Keynes there are three motives which determine a person’s demand for liquidity.
I. The Transaction Motive: to carry out basic transaction, the higher the income the higher the demand for liquidity
II. The precautionary motive: for unforeseen circumstances
III. The speculative motive: If decrease in price of bond, interest rate fall.

Keynes stated that there is an inverse relation between the speculative demand for money and the rate of interest.
Keynes expressed the speculative demand for money as M2 = L2 (r)
Where L2 is the speculative demand for money and r is the rate of interest.
He also expressed that M = M1 + M2
Where M is total liquid money, M1 is transactions plus precautionary motives and M2 is the speculative motive.

The Portfolio Management Theory

The modern portfolio theory is an investment theory which, aims at maximizing portfolio expected return and
minimizing portfolio risk by selecting the proportions of various assets.

The theory suggests that it is important to compare price changes of every asset with the other assets in the portfolio,
rather than selecting assets individually from the investment portfolio. It also assumes that investors are risk-averse
which means that if there are two portfolios within the same expected return, an investor would tend to choose the
one which is less risky. Thus, if a higher amount of expected return is offered, the investor take a higher risk to get
it. The investor is rational, he will invest in the portfolio, the more favorable risk-expected return profile.

Part 7: DEMAND & SUPPLY OF MONEY

The demand for money can be explained as the total amount of wealth in an economy that everyone
wishes to hold in the form of money. There is an inverse relationship b/w money and bonds it means rise
in demand for money with a fall in demand of bonds. The three important services that provided by money
balance.
1. The Transaction Motive: Most transaction need money. Costumers use money to pay for goods/services.
Firm use money to pass to employees for paying labor charges. Money balance that are held to finance such
flows are called transaction balance.
2. The Precautionary Motive: Many reasons for spending arise out of the blue, such as car repairs if it breaks
down unexpectedly, or if you need to make an unplanned trip to visit a sick relative. As a precaution against
cash crises, when receipts are abnormally low or disbursements are abnormally high, firms and individuals
carry money balances. The precautionary money balances provide a safety net against uncertainty about
the timing of cash flows.
3. The Speculative Motive: The characteristics of money mean that it can be held as an asset. A certain
amount of money can be held by firms and individuals to provide a “cushion” against the uncertainty
inherent in fluctuating prices of other financial assets.

Factors affecting demand for money: Four factors that influence the quantity of money demanded.
1. The price level: Nominal GDP is equal to the product of nominal price of goods and services and their
quality. Nominal price level is the quantity of money measured in rupees, whereas real money is the
quantity of money measured in own rupees. Real money is:
Real Money = Nominal Money / Price Level
If at any interest rate, the nominal price of the goods and increase, the demand for money will also increase, or vice
versa Therefore the quantity of nominal money in demand is directly proportional to the price level. However, note
that the change in price level changes the demand for the nominal quantity of money but it does not have an impact
on the real quantity of money people plan to hold.
2. Real GDP: The increase in the total output results in real GDP growth; this in turn increases the demand for
money in the economy. The relationship between real GDP and quantity of money demanded is simple.
When the economy is growing, people get better incomes, thus at the same price level they can consume
more goods and services for which they require higher volume money, thus the demand for money
increases. Note that it is the real GDP growth that will increase the quantity of real money people plan to
hold.
3. The Nominal Interest Rate: The rise in the nominal interest rate decreases the quantity of money
demanded. Higher interest rates indicate higher return on the savings. Thus, the higher the opportunity
cost of earning interest incomes and forgoing expenditures on goods and services, the smaller is the
quantity of real money demanded. There is a zero interest on the currency we hold, so the opportunity cost
of keeping the currency is the nominal interest on savings accounts or saving bonds, T-bills or any interest-
bearing security. By holding money, you forgo the interest that you would have earned otherwise. Inflation
depreciates the value of money. If other things are held constant, the higher the expected inflation rate,
the higher is the nominal interest rate.
4. Financial Innovation: Technological advancements in banking and introduction of new financial products
have changed the quantity of money held by people. Money transactions have become convenient now
with the introduction of new facilities such as ATMs, credit and debit cards, online banking, automatic
transfers, etc. — the fact that people can now hold currency electronically, they tend to demand a greater
quantity of money. Thus, financial innovation has a short-term influence on the demand for money.
The demand for money is explained by the relationship between the nominal interest rate and the
quantity of money demanded. As discussed earlier, there is an inverse relationship between nominal
interest rates and the demand for money when all other factors remain the same. The increase in the
interest rate causes the demand for real money to fall.
MEASURES OF MONEY
I. Currency (paper money & coins) in public hand or which is present outside the Treasury, Federal Reserve
Bank, and the vaults of depository institutions.
II. Demand deposits or checking accounts in commercial banks. The depositor can withdraw these deposits or
transfer the funds to someone else at any time (usually by cheque) without any prior notice to the banks
and these deposits are generally interest free. These are called demand deposits by banks.
III. Traveler s cheques of non-bank issuers.
IV. It measures OCD, Other Checkable Deposits, consisting of negotiable order of withdrawal (NOW) and
automatic transfer service (ATS) accounts at depository institutions, demand deposits at thrift institutions,
and credit union share draft accounts. These share draft accounts cane be described as checking accounts
at federally insured credit unions that function like NOW accounts.
Both NOW and ATS accounts are very similar. These two accounts function as checking accounts and this is the
reason for the central bank to include this form of money in the Ml category. The funds in a NOW account can be
withdrawn by the holder by writing what is essentially, but not Legally, a cheque. NOWs, which are interest-bearing,
are currently available at commercial banks, saving and loans associations, and mutual funds. A relatively lower level
of liquidity is reflected by M2. It is thought of as the key economic indicator which is used to forecast inflation. Thus,
M2 measures the following:
I. M1
II. Interest-earning savings deposits and small-denomination deposits. The pass book deposits and many other
deposits.
III. Balances in both taxable and tax-exempt general purpose broker/dealer money market mutual funds.
IV. Resident foreign currency deposits with the scheduled banks
 V. Overnight (and continuing contract) repurchase agreements (repos).
VI. Money market deposit accounts.
Ml and M2 are both different from each other in way that savings and currency and checkable deposits are included
in M2. The emphasis Ml is on the medium-of-exchange function of money, whereas the of-value function of money
is also measured inM2.
M3 comprises the following components:
I. M2
II. Large denomination time deposits and term repo liabilities issued by financial institutions
III. Balances in both taxable and tax-exempt institution-only money market mutual funds

L includes the following:

I. M3
II. Non-bank public holdings of saving bonds.
III. Short-term treasury securities.
IV. Bankers’ acceptances and commercial paper.
V. Measure of money stock L is quite broad and encapsulates nearly all liquid assets.

Money Market equilibrium: occurs when the quantity of money demand equals the supply of money. In the short
run, the actions of banks and the central bank determine the quantity of money supplied. The central bank adjusts
the supply to conform to the interest rate target. In the long run, the interest rate is determined by the demand and
supply in the loanable funds market. In the long run, real GDP (which has direct influence on the quantity demanded
for money) is equal to potential GDP. The price level adjusts to make the quantity of money equal to the quantity of
money supplied. In the long run, the price level change is in direct proportion to the change in the quantity of money.

Creation of money: Banks create money by creating deposits for savers and by: to the borrowers. When a bank
makes a loan, the borrower spends the money. The sellers who receive the cash may deposit it in their banks. The
deposits which are in excess of the reserves (fractional deposits to be held by banks in the central bank as required
by law) create additional funds which can be lent out. This cycle may continue until the amount of excess reserves
available for lending are exhausted and become zero. Three factors limit the quantity of deposits that the banking
system can create.
1. The Monetary Base: also, called high power money. It is the amount of money in circulation. The monetary
base restrict the total quantity of money banks can supply.
2. Desired Reserves: Reserves are calculated in ratio to the deposits portion of a bank’s total deposits held in
reserves is called reserve ratio. The monetary base which includes notes and vault and the deposits it has
in the central bank are the bank’s ‘actual reserves. These reserves are used at the time when the bank has
to meet depositors’ demands and to make payments to other banks. However higher the desired reserve
ratio maintained by the banks, the smaller is the quantity of deposits and money that the banking system
can create from a given amount of monetary base.
3. Desired Currency Holding: Another factor that limits the money supply is the desire of idividuals to hold
money in the form of currency. When the total quantity of deposits increases, the amount of currency
people wish to hold also increases.
 Part 8: MONETARY POLICY
Monetary policy is the use of interest rates and the level of money supply to manage the economy. Interest rates
used to be set by the central bank. Monetary policy may be used either to expand (or reflate) the economy or
contract (or deflate) the economy.

Four Objectives of monetary (economic) policy:

 The maintenance of high and stable employment
 Reasonable stability of the price level
 Balance of payments (currency flow) equilibrium
 Economic growth

Role of Money: Monetary policy is based on the view that that the money supply, bank credit, and interest rate
influence the behavior of the real economy. MP concentrates on the control and management of one or more of
these influences. Thus, if monetary demand increase and price remain stable, it follows that output and employment
must increase. The objective of monetary policy is to create a stable financial environment.

Target Variable: The controls selected to achieve an economic objective take the form of a monetary variable which
is of importance, such as bank lending growth or money supply growth. This is referred to as a target variable. To
achieve a target, the Central Bank will not control it directly, but will use various monetary instruments or techniques
such as altering interest rates, open market operations, reserve ratios and directives.

The Central’s Bank Monetary Tools

Quantitative Instruments of Monetary policy:
 Direct Instruments: These are the direct controls on the financial prices (interest rate) or quantities
(deposits or credits) of financial institution.
Appeals in favor of direct instruments are as follows.
o These are reliable in controlling credit aggregates
o These are attractive to the Govt that wants to channel credit to meet specific objective.
o These may constitute the most effective approach in circumstances of undeveloped financial markets or
where central bank has inadequate techniques of indirect monetary control.

Disadvantages of Direct Instruments

o Benefit both depositors and borrowers
o Selective credit control
o Direct controls encourage intermediation into non-controlled markets or abroad.

The primary Direct Instruments of monetary controls are:

a) Interest Rate: The Central bank is responsible for setting short term interest rates in order to keep
inflation within the Govt’s inflation target. If inflation is overshooting, interest rate will be raised
or vice versa.
b) Credit Ceilings and Direct Lending: The Central bank can prescribe credit ceilings, set credit/deposit
ratio, fix margin requirements and control the rate of return. The Central bank give two kind of
directive to a banker.
 Quantitative directives: concern with the amount of lending banks are allowed.
 Qualitative directives: concern with type of lending banks do/abandon of competition.

 Indirect Instruments: Discount rate, T-bills, Open market operations and reserve requirements.
o Reserve Requirements are the percentage of a commercial bank liabilities which they are required
to hold as reserves at the Central bank.
 o Open Market Operations: the purchase and sale of Treasury Bills to influence the price of gilts and
interest rates. AS gilts prices rise, interest rates fall and vice versa. OMO affect the cost and supply
of money in two ways:
 The central bank through its operations in the repo market can influence security prices and interest
rates. If it wishes to prevent interest rates from rising, it must prevent T-bill prices from falling. To
achieve this, it must purchase T-bills at the appropriate price in any amount and thereby prevent a
rise in interest rates. The Bank’s actions pump additional money into the financial markets and add
to money supply in the economy. The opposite approach of selling gilts will depress their price, raise
interest rates and take money out of the financial markets and economy. As well as impacting on
current interest rates, the Bank uses its OMO to influence expectations about future interest rate.
 The Bank's OMO have an additional effect on the cash reserves, operational balances at the Bank
and overall liquidity position of the country’s banks. If the Bank is buying securities, it pays the
sellers by cheque; the cheques are paid into the sellers‘ accounts at the banks and in due course
are presented through the clearing system to the Bank for payment. The Bank makes settlement by
crediting the banks’ accounts at the Bank, increasing their operational balances. The banks can use
this increase in their liquid assets as a basis for credit/deposit creation via the bank deposit
multiplier. If the Bank sells securities to the public, it has the opposite effect and leads to a
contraction in bank credit in the economy.

Short term interest rates: Fortnightly, the Central Bank raises short-term loans for the government by selling Treasury bills (T-
bill), issued by the central bank Treasury, which reduces the Bank’s liquidity. The counterparties are able to restore liquidity by
borrowing from the Bank but on its terms. The most important way this is done is through the sale of repos which are sale and
purchase agreements. A seller sells securities with a legal commitment to buy back the equivalent security on a specified date at
an agreed price. This is in effect a form of secured loan. The difference between the selling price and the buyback price represents
the interest.

Long-term interest rates: The Central bank also influences long-term interest rates by buying and selling long term government
securities (T-bill edged) on the Stock Exchange. The Bank uses these open market operations to influence the price of securities
and interest rates (as security prices rise, interest rates fall and vice versa) and to influence the money supply. The rate of interest
is the price which matches the supply of money with the demand for money. If the authorities wish to keep interest rates low
and there is a high demand for money then they will have to accept an increase in the money supply to meet the demand
Alternatively, if the authorities wish to restrict the money supply, they may be forced to accept a high rate of interest to cut of
some of the demand for money.

A Repo is a sale and repurchase” agreement: Party A sells securities to Party B with a legally binding agreement to purchase
equivalent securities from Party B for an agreed price at a specified future date.

The central bank uses Contractionary Monetary Policy to decrease consumption by reducing money supply in the economy,
which results in higher interest rates. This results in a fall in investment and consumption due to the high cost of borrowing and
inflation. The net exports also fall due to rising interest rates.
If the central bank considers that inflation is in danger of rising and perhaps going over its inflation target, then it may consider
increasing interest rates. Increasing interest rates will discourage people and firms from borrowing money and will also give
people who are indebted with mortgages less money to spend each month as their mortgage payments rise. The combination of
these effects will reduce the levels of consumption and investment. Since consumption and investment are two key components
of aggregate demand, increasing interest rates should result in reduced economic growth and increased unemployment. The
government or central bank can also try to cut the level of money supply growth to cut inflation. Therefore, a contractionary
policy with: Increasing interest rates and Reducing money supply

The central bank uses Expansionary Monetary Policy to increase investment and consumption by increasing money supply
which in return reduce interest rates. This will encourage people and firms to borrow more money. It will also give people who
have mortgages more money to spend each month as their mortgage payments fall. The combination of this affect will increase
the level of consumption and investment. consumption and investment are two of the key components of aggregate demand,
cutting interest rates should result in increased economic growth and reduce unemployment. As the business cycle expands,
wealth rises and people will invest more.
If the Central Bank Considers that inflation is falling and they will easily meet their inflation target, then they may consider cutting
interest rates down. if there is a danger of the economy suffering a downturn this will help reinforce this decision. Therefore,
expansionary policies are about: Cutting interest rates and Allowing money supply to increase.

Part 9: FISCAL POLICY

Fiscal policy is the use of the Govt budget to affect an economy. The fiscal policy is reflected in the federal
budget which is built on two primary objectives.
 To Finucane Govt activities.
 To achieve micro economic factor (such as GDP, unemployment e.t.c)
Two main component of budget are Tax revenues and outlays (Payments).

Types of Budget
 Actual Budget records the actual rupee expenditures, revenues and deficits in a specific time period.
 Structural budget calculates the government expenditures, revenues and deficits if the economy is
operating at potential output.
 Cyclical budget calculates the impact of business cycle on the budget. It measures the changes in revenues,
expenditures and deficits that arise when the economy is either in boom or recession. It can also be
obtained by measuring the different between the actual and structural budget.

The making of fiscal policy: Fiscal policy plays a vital role in shaping government expenditure taxation to alter the
business cycle and to maintain economic growth, keeping stable employment and inflation rate. Fiscal said to be
tight or contractionary when revenue is higher than spending (the government budget is in surplus) and
expansionary when spending is higher than revenue (the budget is in deficit). Suppose the economy in a particular
year is heading toward prolonged recession. The bank may try to use expansionary fiscal policy to encourage
investment. In a recession government, can run an expansionary fiscal policy, thus help output to its normal level
and to put unemployed workers back to work. During boom, when inflation is perceived to be a greater
unemployment, the government can run a budget surplus helping to slow down the economy. Such a countercyclical
policy budget that was balanced on average.

TO BE CONTINUE…….. please refer book