MODULE : 1

INTRODUCTION TO MICRO & MACRO ECONOMICS

MANAGERIAL ECONOMICS
Introduction to Economics
“Economics is a social science, to study how
people (individual, households, firms, and
nations) maximize their gains from their limited
resources and opportunities”

1. Wants are unlimited

2. Resources are limited
3. Everybody tries to satisfy their maximum
wants by using these limited resources
Therefore, Economics is study of such
concepts, theories, tools and techniques, which
help in satisfying maximum wants from these
limited resources.

For ex: Economics studies how households

allocate their limited income between various
goods and services they consume so that they
are to maximize their total satisfaction.
Basic Assumptions in Economics

• Ceteris Paribus

• Rationality
Ceteris Paribus:

Ceteris paribus is a Latin phrase, literally

translated in English as “with other things
(being) the same” or “all other things being
equal

This assumption is applied to all economic

analysis to create an environment where casual
relationship between two variables is to be
studied.
For ex:
we want analyze the effect of the price of a
commodity on its demand. A part from price,
there can be a host of other factors like income of
the consumer, price of the related commodities,
etc. that may affect the demand for that
commodity. If we assume all the other factors
constant at a particular point of time, it would be
easier to find the effect of price on the quantity
demanded of commodity.
Rationality:
Economist makes assumptions that people act rationally.
This means that consumers and producers measure and
compare the costs and benefits of a decision before going
ahead.

For ex:
Whether eating at home is cheaper than going to a
restaurant; whether to train the existing workers or recruit
new workers for the newly opened unit of the firm, and so
on.
Types of Economic Analysis
Economic analysis can be divided into the following
categories:

1. Micro and Macro

2. Positive and Normative
3. Short run and long run
4. Partial and General Equilibrium
MICRO AND MACRO

Micro economics (“micro” meaning small) looks at the

smaller picture of the economy and is the study of the
behavior of small economic units.
Such as that of an individual consumer, a seller, or a
product. It focuses on the basic theories of demand and
supply in individual markets and deals with how individual
businesses will decide how much of something to produce
and at what price to sell it.
Macro economics (“macro” meaning large) is
that branch of economic analysis that deals with
the study of aggregates( as a whole). In macro
analysis we study the industry as a unit, and not
the firm. In macroeconomics we talk about
aggregate demand and aggregate supply,
national income, employment, inflation etc.
POSITIVE AND NORMATIVE

Positive statements are factual by nature; normative

statements involve some degree of value judgment,
and cannot be verified by empirical study of logic.
For ex:
1. The distribution of income in India is unequal.
2. The distribution of income in India should be equal.

The first statement is a positive one, while the second is

a normative one. Normative statements often imply a
recommendation, as in the above example, that
income should be redistributed.
Positive economics establishes a relationship
between cause and effect. It is “what is” in
economic matters.

Normative economics is concerned with

questions involving value judgments. It is “what
ought to be” in economic matters.
SHORT RUN AND LONG RUN

A Short run is a time period not enough for

consumers and producers to adjust completely to
any new situation

A long run is a “planning horizon” in which

consumers and producers can adjust any new
situation.
PARTIAL AND GENERAL EQUILIBRIUM

Equilibrium is the state of balance that can occur in a

model

Partial Equilibrium analysis studies the internal

outcome of any policy action in a single market only; this
means that the effects are examined only in the
market(s) which is directly affected, and not on other
markets

General Equilibrium analysis explains economic

phenomena in an economy as a whole.
For Ex:
If the price of fuel goes up, the fares of public
commuting vehicles would go up; this may put a
pressure on firms to hike the conveyance allowance
given to the workers. In sharp contrast to this, under
partial equilibrium analysis, a petroleum company would
hike the price of petrol without considering its possible
effects on the price of the other commodities whereas
general equilibrium analysis would propose that the
equilibrium price of fuel cannot be determined in
isolation and would need to incorporate a host of several
other variables.
BUSINESS
Business the word business in its literal sense
means the state of being busy. It is associated
with, an activity with which one can be busy
about. But in the economic sense, the word
business means human activities which are
performed with the objectives of earning
profits
Primary objective of every business is to maximize its
profit

Resources (like Money, Machines, Men and Material) of

every business are limited

Business involve risk and uncertainty

Therefore, crux of business is decision making and

forward planning for earning the maximum profit by
using these limited resources.
Introduction to Managerial Economics
• Managerial economics is the study of economic theories, logic
and tools of economic analysis that are used in the process of
business decision making

• Economic theories and techniques of economic analysis are applied

to analyze business problems, evaluate business options and
opportunities with a view to arriving at an appropriate business
decision.

• Managerial economics is thus constituted of that part of

economic knowledge, logic, theories and analytical tools that
are used for rational business decision-making.

• Managerial economics is a means to an end to managers in any

business, in terms of finding the most efficient way of allocating
scare organizational resources and reaching stated objectives.
Definition of Managerial Economics

“Managerial economics is concerned with the application of

economic concepts and economics to the problem of formulating
rational decision making.”
Mansfield

“Managerial Economics is the integration of economic theory with

business practice for the purpose of facilitating decision-making and
forward planning by management.”
Spencer and Siegelman

“Managerial economics is the application of economic principles and

methodologies to the decision-making process within the firm and
organization.”
Douglas
ME provides link between traditional economics and decision
sciences for managerial decision making

Managerial
Economics

Traditional
Economics

Optimal solution
to business
Decision
problems Problem

Decision Sciences
(Tools &
Techniques of
Analysis)
Characteristics of Managerial
Economics

1. Micro Economic in Character

2. Normative Economics
3. Use theory of firm
4. Prescriptive nature
5. Pragmatic and applied approach
6. It is both conceptual and metrical
7. Adequate importance to Macro-Economics
Micro-economics in character: Managerial economics is
Micro-Economic in character as it is only concerned with
smaller units of the economy. It studies the problem of
particular business firm or industry not as a whole business
economy.
Normative Economics: Managerial economics belong to
normative economics rather than positive economics,
which is concerned with what management, should do
under particular circumstances. It determines the goal of
the enterprises and then develops the way to achieve these
goals.
Use theory of firm: Managerial Economics uses only those
economic concepts and principles which are related with
the theory of firm i.e. demand and supply analysis, cost and
revenue analysis, determination of price and quantity,
profit maximization, etc.
Prescriptive nature: As it is prescriptive in nature it states
“what should be done”. It is an applied discipline of
Economic theory which suggests how economic principles
are applied to policy formulation, decision-making and
forward planning.

Pragmatic and Applied approach: Managerial economics

is pragmatic, which deals with the things in a real &
sensible way rather than being influenced by fixed
theories. It tries to solve the problems in day-to-day
functioning of the firm and avoid difficult and abstract
issues of economic theory.
It is both Conceptual and Metrical: It takes help
of conceptual framework to understand &
analyze the decision problem and takes the help
of quantitative techniques to measure the
impact of different factors & policies.

Adequate importance to Macro-Economics:

Managerial Economics takes the help of Macro-
Economic since it provides intelligent and
understanding of environment in which the
business of firm must operate.
Scope of Managerial Economics
The scope of managerial economics comprehends all
those economic concepts, theories and tools of
analysis, which can be use to analyze the business
environment and to find solution to practical business
problems.
Scope of Managerial Economics

Environmental
Operational or
or External
Internal Issues Issues
●
Demand Analysis & ●
Issues related to
Forecasting
●
Cost and Production Macro Variables
Analysis ●
Issues related to
●
Pricing decision policies & foreign Trade
Practices
●
Profit Management
●
Issues related to
●
Capital Management Government Policies
Operational or Internal Issues
Demand analysis and forecasting: -. A major part of managerial
decision–making depends on accurate estimates of demand. A
forecast of future sales as a guide to management for preparing
production schedules and employing resources. It will help
management to maintain or strengthen its market position and
profit-base.

Cost and production analysis: - Cost estimates are most useful

for management decision. The different factors that cause
variations in cost estimates should be given due consideration for
planning purposes. The chief topics covered under cost and
production analysis are: cost concepts and classifications, cost-
output relationships, economies and diseconomies of scale,
production.
Pricing decision, policies and practices: - As price gives
income to the firm, it constitutes as the most important
field of managerial economics. The various aspects that
are dealt under it cover the price determination in various
market forms, pricing policies, pricing method,
differential pricing, productive and price forecasting.

Profit management: - The chief purpose of a business

firm is to earn the maximum profit. There is always an
element of uncertainty about profits because of variation
in costs and revenues. The important aspects covered
under this area are: nature and measurement of profit,
profit policies and techniques of profit planning like
break-even analysis.
Capital management: - The problems relating to firm’s
capital investments are perhaps the most complex and
troublesome. Capital management implies planning and
control of capital expenditure because it involves a large
sum and moreover the problems in disposing the capital
assets of are so complex that they require considerable
time and labor. The main topics dealt with under capital
management are cost of capital, rate of return and
selection of projects.
 Environmental or External Issues

Issues related to Macro Variables: Firm Planning to set up a new unit or expand
existing size would like to ask, what is the general trend in economy? What would
be the consumption level? Will it be profitable to expand the business? These
questions are answered on the basis of prevailing micro variables in the country.

Issues related to Foreign Trade: Firm dealing in exports and imports would be
interested in knowing the trends in international trade, prices, exchange rates and
prospects in the international market. Answers to such problem are obtained
through study of international trade.

Issues related to Government Policies: As each firm has to operate their business
under government rules and regulations. Therefore, it becomes important to
understand the government policies, which can affect the interest of the firm.
Roles and Responsibilities of
Managerial Economist
Roles of Managerial Economist
1. Helping in decision-making
a. Thinking function
b. Selection function
2. Helping in forward planning
3. Administrative role
4. Economic intelligence
5. Participation in debates
6. Specific Roles:
c. Sales forecasting
d. Industrial market research
e. Analysis of competitors
f. Pricing decision
g. Production schedule
h. Investment analysis
i. Public relation
j. Social objectives
Helping in Decision-making: Mostly the business
decisions are taken in uncertain environment. The function
of the managerial economist is to assure that correct
decisions are taken on proper time. These functions are
mainly divided into two categories-

A. Thinking Function: This is identification of area of

decision-making, determination of essential facts and
search of alternative decisions.
B. Selection Function: After the analysis of the problem,
development of different alternatives and collection of
required facts, the managerial economist should select the
most appropriate alternative according to the situation of
the firm.
Helping in forward planning: The managerial economist
help the management in the forward planning for the
operation of the firm. He prepared a long-term plan by
utilizing the resources of the firm. Practically, if there is
any mistake, he revised it by making necessary
correction.

Administrative Role: A Managerial economist is an

important executive of a concern. It is desired that he
should give suggestion to the management regarding
improvement in the organizational structure, proper co-
ordination between rights and duties, developing
effecting communication system and the optimum
utilization of the resources of the firm
Economic Intelligence: Another important role of a
Managerial economist is to provide useful economic
intelligence to the management of the firm such as, nature
and price of the products of the rival firms, tax rates,
custom duties etc., Though such information are always
available in various journals, newspaper, magazines and
government ordinances, yet their proper analysis is the
function of the managerial economist.

Participation in Debates: The role of a qualified

Managerial economist is take participate in government
and public general debates. Due to this both government
and the society are benefited by their practical experience
and ideas. Actually such participation not only gives public
recognition to one’s own organization but also bring
contact of subject specialists from various countries.
Specific Roles: Alexander, K.J.W and Kemp, A.G: revealed by a survey
in U.K.; according to which some specific roles performed by
Managerial Economist are following:

A. Sales Forecasting : An economist have to make sales forecasting

based on the past sales data and current performance, that how much
sale of a particular product will take place in future and what will be
the trend. So that other departments of the business can make
arrangements accordingly.

B. Industrial Market Research: An economist have to make a research

about the buyers like-what are the taste and preferences of the
buyers, what are the distribution channels available etc, so that
business can plan accordingly.

C. Analysis of Competitors: An economist have to find out that how

many competitors are present in the market, at what price they are
selling their products, what promotional strategies are they adopting,
what are the views of customers about their product.
D. Pricing Decision: An economist has to decide the
pricing strategy for its product. For that it has to be
studied that under what type of market is business
working, what are the prices of competitors, how much
price elastic is product, etc.

E. Production Schedule: An economist has to plan the

production as per the demand forecasted. He has to
arrange factors of production like men. machine, money
and material. Study about the availability of these factors
in the market etc.

F. Investment Analysis: An economist, by using different

analytical techniques like Capital budgeting, takes
decision that in which project investment should be made
out of various available projects.
G. Public Relation: An economist has to work for
maintaining good public relation, so that he can get
feedback from market about the product.

H. Social Objectives: An economist to fulfill its role for

society has to ensure better availability of goods at fair
prices in proper quality, provide employment, and avoid
unfair & anti-social practices.
Responsibilities of Managerial
Economist

A Managerial economist plays a very significant role in

decision-making and forward planning. But, to serve
his role successfully, he must thoroughly recognize his
responsibilities, some of which are following:-

1. To increase the profitability of the firm

2. To make accurate and successful forecast
3. To maintain relations with experts
4. To aware availability of resources
5. To simplify the decision making process
6. Responsibility to minimize risk.
To increase the profitability of the Firm: An economist
has a responsibility to earn profit for the firm by taking
right decision about investment, production, sale and
market research.

To make Accurate and Successful Forecast: It is a

responsibility of an economist to make successful
research and use past data to find out the expected sales
in future and the trend in sales.

To maintain relations with Experts: The important

responsibility of a managerial economist is to provide
solution to complex business problems, for this purpose
he must establish and maintain the relations with such
experts of different fields who can provide their service
to the firm as and when required.
To aware availability of Resources: A managerial economist should
be aware of locations and situations of the specific markets, by which
he should be able to provide the resources of firm’s operation quickly
at reasonable price.

To Simplifying the decision making process: The management has to

take many decisions in its day-today functioning. It is the main
responsibility of a managerial economist to make the decision making
process as simple as possible so that quick and correct decision could
be taken promptly.

Responsibility to minimize risk: Minimizing risk is another

responsibility to the economist. It can be done by minimizing future
uncertainty by knowing about all the prospective facts present in the
market. To minimize risk successful forecasting and right decisions are
needed.
 Basic Economic Principles
or
Five Fundamental Principles
BASIC ECONOMIC PRINCIPLES
Economic theory offers a variety of concepts and analytical tools
which can be of considerable assistance to the managers in his
decision making practice. These principles are helpful for managers
in solving their business related problems.
Following are the basic economic principles for decision making

1. Opportunity cost
2. Incremental principle
3. Principle of time perspective
4. Discounting principle
5. Equi-marginal principle
Opportunity cost Principle

• The opportunity cost of any alternative is

defined as the cost of not selecting the “next-
best” alternative.

• The opportunity cost of availing an

opportunity is the expected income foregone
from the second best opportunity of using the
resources.
Example:

Suppose, a firm has 100 million at its disposal and there are
only three alternatives uses the expected annual return
from the three alternative uses of finance are:

To expand the size of the business Rs. 20 million

Setting up new production unit Rs. 18 million
Buying share in another firm Rs. 16 million

All the other thing being same (Ceteris Paribus), rational

decision-making suggest to invest the money in alternative
1. This implies that manager has to sacrifice the annual
return of Rs.18 million expected from alternative 2.
In economic terms, 18 million is an annual opportunity
cost of an annual income of Rs. 20 million

The difference between actual earning and opportunity

cost is called economic gain or economic profit.
 
INCREMENTAL PRINCIPLE

It is related to the marginal cost and marginal revenue,

for economic theory. Incremental concept involves
estimating the impact of decision alternatives on costs
and revenue, emphasizing the changes in total cost and
total revenue resulting from changes in prices, products,
procedures, investments or whatever may be at stake in
decisions.
The two basic components if incremental reasoning is:

• Incremental cost

• Incremental revenue
The incremental principle may be stated as under:

“A decision is obviously a profitable one if –

1. It increases revenue more than cost

2. It decreases some costs to a greater extent than it
increases others
3. It increases some revenues more than it decreases
others and,
4. It reduces cost more than revenue”.
Example:
 
Suppose a new order is estimated to bring in an additional revenue of Rs.
5000/-. The cost estimated as under:
Material Rs. 2,000
Labor Rs. 1,500
Overhead (allocated at 120% of labor cost) Rs. 1,800
Selling & Administrative expenses Rs. 700
(Allocated at 20% of labor and material cost) _________
Full cost Rs. 6000
 
The order appears to be unprofitable.
However, suppose there is idle capacity which can be utilized to execute this
order. If the order adds only Rs. 500 of overhead (that is, the added cost of
heat, power and light, the added wear and tear on machinery, the added cost
of supervision, and so on) only Rs. 1000 by the way of labor cost because some
idle workers already on the payroll will be deployed without added pay, no
extra selling & distribution cost, the incremental cost of accepting the order
will be:

Material Rs. 2,000

Labor Rs. 1,000
Overhead Rs. 500

___________
Total Incremental cost Rs. 3, 500

While it appeared in the first instance that the order will result in a loss
of Rs. 1000, it now appear that it will lead to an additional of Rs.
1,500/- (Rs. 5000 –Rs. 3500) to profit

 
 PRINCIPLE OF TIME PRESPECTIVE

Managerial economists are also concerned with

the short run and the long run effects of
decisions on revenues as well as costs.

The very important problem in decision making

is to maintain the right balance between the
long run and short run considerations
Example:

Suppose there is a firm with temporary idle capacity. An

order for 5000 units comes to management’s attention.
The customer is willing to pay Rs.4/- per unit for the whole
lot but not more. The short run incremental cost (ignoring
the fixed cost) is only Rs.3/- per unit. Therefore, the
contribution to overhead and profit is Rs. 1/- per unit (Rs.
5000/- for the lot)
Analysis:

For the above example the following long run repercussion of the order
is to be taken into account:

• If the management commits itself with too much of business at

lower price or with a small contribution it will not have sufficient
capacity to take up business with higher contributions.
• If the other customers come to know about this low price, they may
demand a similar low price. Such customers may complain of being
treated unfairly and feel discriminated against.

In the above example it is therefore important to give due

consideration to the time perspective “a decision should be taken into
account both the short run and long run effects on revenue and costs
and maintain the right balance between long run and short rum
perspective”.
DISCOUNTING PRINCIPLE
One of the fundamental ideas in Economics is that a rupee
tomorrow is worth less than a rupee today. Suppose a person is
offered a choice to make between a gift of Rs.100/- next year.
Naturally he will choose Rs.100/- today. This is true for two
reasons –

• The future is uncertain and there may be uncertainty in

getting Rs. 100/- if the present opportunity is not availed of

• Even if he is sure to receive the gift in future, today’s Rs.

100/- can be invested so as to earn interest say as 8% so
that one year after Rs.100/ will become 108.
EQUI-MARGINAL PRINCIPLE
This rule has a name: it is the Equi-marginal Principle. The idea is to make
two things equal "at the margin" -- in this case, to make the marginal
productivity of labor equal on the two fields. 

This principle deals with the allocation of an available resource among the
alternative activities. According to this principle, an input should be
allocated that the value added by the last unit is the small in all cases. This
generalization is called the Equi-marginal principle.

Suppose, a firm has 100 units of labor at its disposal. The firm is engaged
in four activities which need labor services viz, A, B, C and D. it can
enhance any one of these activities by adding more labor but only at the
cost of other activities.
MACRO ECONOMICS

Concept, characteristics & scope of Macro economics

Circular flow of Income
National Income, GDP, GNP, Per capita income, methods of measuring
national income
Business Cycle & Business Policies
Introduction to Macro Economics
The term 'macro' denoted' large'. Macro-economics is not
the studies of individuals units, but all the units combined
together. It deals with the functioning of the economy as a
whole. Since it studies aggregate form of the economy, it is
also referred to as 'Aggregate' Economics and income
theory'. For example, macro-economic studies the big
aggregates like national income, national output, general
prices level, total employment, saving and investment,
Hence, Mc Connell observes :Here we study forest, not the
trees. It gives us a bird's eye view of the economy."
Definitions of Macro Economics
According to Edwin Mansfield, "Macro-economic deals with behavior of
economics aggregates such as gross national product and level of
employment".

According to Gardner Ackley "Macro-economic deals with the economic

affairs in large it concerns the overall dimension of economics life. It studies
the character of forest, independently of tree which composes it".

K. E. Bounding defines macro-economics in these words "macro-economics

is that part of economics which studies the overall averages and aggregates of
the system".

So we conclude that macro-economic deal not with individual’s quantities,

individual incomes, individual’s prices, individuals output but with aggregate
of these quantities, national income, price level and national output.
Difference between Micro and Macro
Economics
MICRO ECONOMICS MACRO ECONOMICS

1. It deals with an individual's economic 1. It deals with aggregate economic

behavior. behavior of the people in general.
2. It deals with the pricing of a 2. It deals with the general price level
particular commodity in an industry. in the economy, National income
3. It deals with the income of a
accounting, etc.
particular set of people.
3. Study of macro economics is
4. Study of micro economics is
important for resource utilization,
important for formulation of
public finance, and for taking economic policy of the whole
business decisions. nation.
5. The concepts of micro-economics are 4. The concepts of macro economics
independent concepts. are interdependent on one another.
6. These concepts have more 5. These concepts have more
theoretical value. practical value.
Characteristics of Macro Economics

The characteristics that describe a macro economy are

usually referred to as the key macroeconomic variables. The
following four variables are considered to be the most
important in gauging the state or health of an economy:

1. Aggregate Output Or Income,

2. The Unemployment Rate,
3. The Inflation Rate, And
4. The Interest Rate.
Aggregate Output or Income

An economy's overall economic activity is summarized by a measure of

aggregate output. As the production or output of goods and services
generates income, any aggregate output measure is closely associated
with an aggregate income measure. The GDP is a measure of all
currently produced goods and services valued at market prices.

Unemployment

The level of employment is the next crucial macroeconomic variable.

The employment level is often quoted in terms of the unemployment
rate. The unemployment rate itself is defined as the fraction of labor
force not working (but actively seeking employment).
Instead, it is defined as consisting of those working and those not
working but seeking work.
Inflation Rate

The inflation rate is defined as the rate of change in the price level. Most
economies face positive rates of inflation year after year. The price level, in
turn, is measured by a price index, which measures the level of prices of
goods and services at given time. The number of items included in a price
index varies depending on the objective of the index.

The Interest Rate

The concept of interest rates  used by economists is the same as the one
widely used by ordinary people. The interest rate is invariably quoted in
nominal terms—that is, it is not adjusted for inflation. Thus, the commonly
followed interest rate is actually the nominal interest rate. The nominal
interest rate has two key attributes—the duration of lending/borrowing
involved and the identity of the borrower.
Scope of Macro Economics
A branch of economics theory macro-economic covers the following
aspects:

Theory of income and employment:

Macro-economic studies what factors and how these factors

determine the level of income and employment. The level of
income and employment is determined by aggregate
demand. Aggregate demand is the sum of total consumption
demand and total investment demand. Hence, consumption
function and investment function are the important
components of macro-economics. The theory of business
cycle is also covered by macro-economics.
Theory of general prices level:

Macro-economics is concerned with how general

price level is determined. The main aspect of
general prices level is inflation. There are many
theories of inflation. Inflation, one of the grave
problems of preset world, is also an important
component of macro-economics. The theories of
money, banking and finance also fall under macro-
economics.
Theory of economic growth:

Growth economics or the theory of economic growth is

another important branch of macro-economics. Many
theories of economics growth have been developed .These
theory suggest the way to accelerate the rate of growth of the
economics. It is because economic growth is a prerequisite for
the improvement in the levels of living of people and
alleviation of poverty.
Modern theory of distribution:

National income is distributed among different

classes of people of a country in different ways.
Macro-economic studies what factors and how these
factors determine the relative share of different of
people national income.
CIRCULAR FLOW OF ECONOMIC ACTIVITIES AND
INCOME

The crux of macroeconomics theory is based on the

circular flow of income. The basis of this flow is the
economic interdependence of consumers and sellers,
between whom the circular flow of production of
goods and services, income and expenditure takes
place.

• Two Sector Economy

• Four Sector Economy
TWO SECTOR ECONOMY

The simplest form of circular flow of economic activities and income

features only consumers and firms.

On one side of the flow is consumer, who is an individual (like

you and me) who purchases goods and services for own
consumption, in order to derive satisfaction from them. A
household include a set of individuals who live together and take
joint decision about the consumption of goods and services.

On the other side there are firms who supply the varieties of
goods and services. The term “firm” is used to describe the basic
selling unit of consumption of goods and services.
The nature of interdependence is such that
consumer needs to pay the prices for these goods
and services and firms require various factor of
production to produce these goods and services.
Hence the households provide services in terms
of factor input to the firm and get paid for these
services, which they spend on consumption.

Thus the money and economic activities flowing

between firms and households create a circular
flow.
Household do not spend their entire money on consumption,
instead they save a part of their income for the future. When
household save, their consumption of goods and services would
decline to the extent of saving, and as a result money flow to the
business firms would decrease by the same extent.

Since money is thus “taken out” of the circular flow, saving would
be considered as a component of “withdrawals”. If these savings
are kept with the household they will result in “leakages” in the
money flow.

But saving of households comes to the financial market, through

banks, financial institutions, insurance companies and stock
markets.
You would wonder as to what happen to
this saving in the financial market?

Firms, borrow this savings from the financial market

for their investment in capital goods. Thus the saving
of the household deposited in the financial market go
to firms as their investment expenditure, which is
termed as “injection”.

Saving is the withdrawal of money from the circular

flow, while investment is the injection of money into
the circular flow.
 Financial
Savings Market
Investment

Factor Payment

Land, Labor & Capital

In simple two sector economy, the value of output produced (Y) is equal to the
value of output sold (O). Thus, the total income is used either for the purpose
of consumption, or for investment. Since the value of output sold is equal to
the sum of consumption expenditure and investment expenditure, we can
state that:

Y=O=E
Y=C+S
E=C+I
Hence, C + S = C + I
Where,

• Y = income,
• E = Expenditure,
• O = Output,
• C = Consumption expenditure,
• I = Investment expenditure,
• S = Saving
 
FOUR SECTOR ECONOMY

The four sector model has been introduced

to help us understand the more complex
real life situation.
Every economy has actually two or more
sectors besides the consumers and
produces i.e. government and external
sector.
The development of basic infrastructure, like roads,
electricity, communication and security is essential for
growth of a system.

These facilities are created by government therefore

total expenditure in an economy will not only consist
of C + I but also of government expenditure (G).

At the same time government receive revenue from

different sources such as taxes, interest on loans and
profit on investment.
Thus there is a third dimension to the circular
flow of income, i.e. some money flowing
between firm and household is diverted to the
government in the form of taxes and other
payments, where as government contributes to
the generation of assets by the way of
expenditure in form of salaries to government
employees, infrastructure development and
public sector enterprises. Some amount of
saving also flow to government in the form of
government bond and securities.
Every economy interacts with other
economies through international trade, flow
of capital, other inputs, technology, services
and people. Thus households, firms and
government interacts with the foreign country
through exports and imports of goods and
services, capital investment, etc. hence there
is a fourth sector in the economy know as
external markets.
 
Taxes
GOVERNMENT Taxes
Remittance for
Salaries purchases or
Subsidiaries

HOUSEHOLD Financial FIRMS

S Market

Imports Imports

Exports FOREIGN Exports

NATION
Taxes
GOVERNMENT Taxes
Remittance for
Salaries purchases or
Subsidiaries
Factor Payment

Factor Inputs

HOUSEHOLD Financial FIRMS

S Market Investments
Savings

Consumption
Expenditure
Goods & Services

Imports Imports
Exports FOREIGN Exports
NATION
MACRO ECONOMIC VARIABLES

AGGREGATE DEMAND AND AGGREGATE SUPPLY

Aggregate demand is the total demand in terms of goods and

assets at a given price by all the people in an economy.
Aggregate demand consists of two components, aggregate
demand (AD) for consumer goods (C) and aggregate demand for
capital goods (I). Thus we can write the above equation as:
AD = C + I
Aggregate supply is the total national output produced and
supplied by all the factors of production in an economy.
Aggregate supply consists of supply of consumer goods and
capital goods.
 STOCKS AND FLOWS
For better understanding of national income determination it is necessary to
understand the difference between the concept of stock and flow.
Stock may be defined as any economic variable which has been accumulated
at a specific point of time, like money, assets and wealth.
Flow includes the variables which increases (inflows) and decreases (outflows)
the stock, like income, consumption, saving and investment over a period of
time.
Mathematically a stock can be seen as an accumulation and integration of
flows over time, with outflows subtracted from the stock. Thus, money supply
is a stock, while national income is a flow
Example
STOCK INFLOW OUTFLOW
INVENTORY INCOMING GOODS OUGOING GOODS
BANK BALANCE DEPOSITS WITHDRAWALS
POPULATION BIRTH + IMMIGRATION DEATH + EMIGRATION
 INTERMEDIATE AND FINAL
GOODS

Intermediate goods (and services) are items purchased

by firms for using them in production of some other
goods of utility.
Final goods are demanded by the final consumer for
using these goods as they are.
NOTE:
For the calculation of national income only final goods
are considered. While calculation of national income if
we add intermediate goods to final goods. We shall be
counting the same product for more than once, which
would give inflated figures of national income.
EMPLOYMENT

This is another important macro variable that affects the national

economy. Employment is defined in different respects; for
example in US it is defined as a contract between two party
agrees to work under term specified by another party.

Employment means where a person who is willing and capable to

work in a productive activity is engaged for certain number of
hours per week, whether working for self or someone else.

Every country tries to achieve a full employment so that

maximum economic growth with maximum social welfare can be
achieved.
GOVERNMENT EXPENDITURE AND
REVENUE
Government expenditure refers to outlay on national defense, road building
and maintenance, railways, national health, and free education and salary of
government employees.

All government current expenditure is included in national output.

There is another type of expenditure, known as transfer payments, which
refers to payments made to certain sections of society as a social welfare
measure. It is an exchange of purchasing power from one group of people to
another.

These include unemployment compensation, retirement pension, etc.

Since the receiver of such payments (such as old, unemployed,
handicapped and needy families) do not contribute to national output
therefore such payments are referred to as transfer payments and they
are not treated as a part of the government’s current output of goods and
services.
CONCEPTS OF NATIONAL INCOME

“National income or product is the final figure you arrive at

when you apply the measuring rod of money to the diverse
apples, oranges, battleship and machines that any society
produces with its land, labor and capital resources.”

- Paul A. Samuelson

National Income National Income Committee of India 1951

defines National Income as follows: “ A national income
estimate measures the volume of commodities and services
turned out during a given period counted without duplication.”
National income is defined as the money value of all
final goods and services produced in an economy
during an accounting period of time, generally one
year.

National income gives us a means to measure the

economic performance of an economy as a whole.

National income accounting is a set of rules and

definition for measuring economic activities in an
economy.
Some of the common measures of national income
are:

 GROSS DOMESTIC PRODUCT (GDP)

 GROSS NATIONAL PRODUCT (GNP)

 NET DOMESTIC PRODUCT (NDP)

 NET NATIONAL PRODUCT (NNP)

GROSS DOMESTIC PRODUCT (GDP)

GDP is the sum of money values of all final goods and services produced within
the domestic territories of a country during an accounting year.

It includes income from exports and payments made on imports during the
year. However, it does not include the earning of nationals working abroad
as also of the foreign nationals working in our country.

If you look around, you would find any domestic companies which have their
branches or subsidiaries in foreign countries, as also subsidiaries are branches
of foreign companies in your home country.

The output produced by all these individuals and businesses are however
not included in the GDP of the country. This is done to avoid the incidence of
double counting since the incomes earned by subsidiary firms in different
countries are added to the income of the parent country
GROSS NATIONAL PRODUCT (GNP)

GNP is the aggregate final output of citizen and businesses of an economy

in a year.
The difference between GDP and GNP arises because of the fact that a part of
any country’s total output is produced by factors which are actually owned by
other nation(s). Thus, Net Factor Income from Abroad (NFIA) is the difference
between income received from abroad for rendering factor services and
income paid towards services rendered by foreign nationals in the domestic
territory of a country.
GNP is defined as the sum of Gross Domestic Product and Net Factor
Income from Abroad.
GNP = GDP + NFIA
Thus GNP of India would count goods and services produced by all Indians,
regardless of where they work.

NOTE: GNP will be less than GDP when a country makes more payment than
it receive from abroad.
NET DOMESTIC PRODUCT and NET NATIONAL PRODUCT

While calculating GDP and GNP we ignore depreciation of assets or capital

consumption; else they would not reveal complete flow of goods and services
through various sectors. But in reality the process of production uses up a
certain amount of fixed capital by way of wear and tear by a process termed
as depreciation, or capital consumption allowance.
In order to arrive at NDP and NNP, we deduct depreciation from GDP and
GNP. The word “net” refers to the exclusion of that part of total output which
represents depreciation, wear and tear and replacements during the year of
accounting.
 
Hence, NDP = GDP – Depreciation
And NNP = GDP – Depreciation + NFIA
Or NNP = GNP – Depreciation
 PER CAPITA INCOME

The average income of the people of a country in a particular

year is called per capita income.
Per capita income is income per head of a country for a year.

 
National Income
Per capita Income = ---------------------------
Total Population
PERSONAL DISPOSABLE INCOME

Personal income is the total income received by the individuals

of a country from all sources before direct taxes in one year.
 
Personal Disposable Income is the income which can be spent
on consumption by individuals and families.
 

Personal disposable Income = Personal Income – Personal

Taxes
 
MEASUREMENT OF NATIONAL INCOME

National income is nothing but the measurement of

aggregate production in an economy during a definite time
period.
There are three different ways of looking at the value of a
nation’s output, viz., Gross National Product (GNP), Gross
National Income (GNI) and Gross National Expenditure (GNE)
represented by Total Output, Total Income and Total
Expenditure respectively.
1. GNP is the sum of value added of all firms in same period that is the total
value of final goods and services produced. GNP is a monetary measure
because there is no other way of adding up different sorts of goods and
services produced except with their money value.

2. GNI values national output as a sum of total payments made to the

factors of production for their services in production or alternatively, the
earnings received by various factors.

3. GNE values national output by taking the value of expenditure on goods

and services produced (that is, aggregate expenditure on consumption
and investment).

The terms “Gross National Product, Gross National Income and Gross
National Expenditure” may be used synonymously. In principle, these three
variants will always be equal, that is GNP= GNI = GNE. However, in practice,
for some statistical data problem, this may not happen, and statistical
discrepancy may arise.
 
Based on these three ways there are three methods
of measuring national income

1. Product (or Output) Method

2. Income Method

3. Expenditure Method
PRODUCT (OR OUTPUT) METHOD

As per the product method of estimating

national income, also called national income
by Industry of Origin.

The product method adds up the market

value of all final goods and services produced
in the country by all firms across all industries.
This method involves the following steps:
1. The economy is divided on basis of industries, such as
agriculture, fishing, mining, large scale manufacturing, small
scale manufacturing, electricity, gas, etc.
2. The physical units of output are then interpreted in money
terms, i.e., by taking market price of all the products
3. The total values thus obtained are then added up.
4. The indirect taxes are subtracted and the subsidies are added.
This gives the GDP or GNP, as the case may be, depending
upon what data are being used.
5. The net value is calculated by subtracting depreciation from
the total value thus obtained, in order to arrive at NNP.

A word of caution to be repeated here is that goods produced in a

particular year and only in their final form are to be considered.
 
EXAMPLE: If a manufacturer sells a mobile phone to a
retailer for Rs. 3000 and the retailer sell it to the
consumer at Rs. 5000, how much has the mobile
contributed to GDP? Is it Rs. 8000? No. if we do that, it
would be double counting. Instead we would either
count the final value (Rs. 5000) or the value added at
each stage (Rs.3000 by the manufacturer and Rs.2000
by the retailer). The sum of all such values added by all
industries in the economy is known as Gross Value
Added (GVA) at basic prices.
Thus national income by Product Method can
be calculated in two ways:

• Final Product Method

• Value Added Method

Final Product Method
 
• According to this method, the total value of final goods
and services produced in a country during a year is
calculation and assessed at market price.
• Only the final goods and services of all these sectors are
included, and intermediary goods and services are not
taken into account. This avoids chance of double
counting.
• So in the previous example of mobile phone that we have
taken, we shall only consider Rs. 5000, which is the market
price for final consumer.
Value Added Method
 
• Another method of measuring national income is the value
added by each industry of the economy.
• The value added method measures the contribution of each
producing enterprise of the economy. The difference
between the values of material outputs and inputs at each
stage of production is the value added. If all such
differences are added up for all industries in the economy,
we arrive at GDP
• Like in the above example national income added by value
added method require calculating the value addition at
retailer level, i.e., Rs.3000 and again at final consumer level
i.e., Rs. 2000. Thus national income will be Rs. 5000.
LIMITATIONS OF PRODUCT METHOD

Problem of double counting:

 The greatest difficulty in calculating national income by the product method is
that of unclear distinction between a final and intermediate product. Hence,
the possibilities of double counting cannot be fully eliminated.

Not applicable to tertiary sector:

The method is useful only when output can be measured in physical terms.
Thus it cannot be applied to the service sector due to the absence of input
output relationship, which is the basis of this method.
 
Exclusion of Non Marketed products:
National income is always measured in money, but there are number of goods
and services which are difficult to assess in terms of money, e.g. painting as a
hobby by an individual. It has an opportunity cost in terms of time and
resources involved, but it does not go to the national income data
 
INCOME METHOD

According to the Income method, it is the net income received

by all citizen of the country in a particular year that is added up,
i.e., total rents, net wages, net interest and net profits.
However, income received in the form of transfer payment is
not included.

This is the GDP at factor; now we add the money sent by the
citizens of the nation from abroad and deduct the payments
made to foreign nationals (individuals and firms) we get Gross
National Income (GNI)
 
Income method involves the following steps:

The economy is divided on the basis of income groups, such

as wages/salary earners, rent earners, profit earners, and so
on.
Income of each of these groups is calculated.
Income of all the earners is added, including income from
abroad and undistributed profits.
From (3), income earned by foreigners and transfer
payment made in the year are subtracted. In other words,

GNP at factor cost = Rent + Interest + Profits + other Income

+ (Income from Abroad – Payments made to foreigners) –
Transfer Payments.
LIMITATIONS OF INCOME METHOD

Exclusion of Non Monetary Income: The most significant limitation of this

method is that it ignores the non monetized sector of economic activities,
such as a farmer and family working in own field; a retailer running business
in own premises, and so on. All of these activities are economic in nature
and contribute to national income, but due to their non monetary nature,
they go unrecorded. Hence, the calculated value of national income is less
by this amount.
 
Exclusion of Non Marketed Services: There may be cases when people take
up a particular activity which is not economic in the strict sense, but have
opportunity cost and real cost implications. Example may be mother’s
services or housewife’s services. These services are not included in national
income as it is very difficult to count their true monetary value.
 
EXPENDITURE METHOD

We have seen that whatever is earned is spent either on

consumption or on investment. Therefore, it is possible to
calculate national income by expenditure method.

According to the expenditure method, the total expenditure

incurred by the society in a particular year is added together to
get the year’s national income; such expenditure includes
personal consumption expenditure, net domestic investment,
government expenditure on goods and services, and net foreign
investment.
 
This concept rests on the assumption that national income
equals national expenditure.

• Consumption expenditure: Consumption is the largest and

most important of the flows. When individuals receive
income, they can spend it on domestic goods or foreign
goods (durables and non durables) and services; they pay
taxes out of it and save the rest. Personal consumption
expenditure refers to payments by households for goods
and services.

• Investment Expenditure: This expenditure is divided into

three major categories: capital spending (purchase of new
materials and equipments by firms), residential
construction (construction of new housing units and
renovation of existing structures) and inventory investment
(unsold portion of output).
• Government Expenditure: Government
expenditure refers to government payments
for goods and services or investment in
equipments and structures.

• Net Exports: Spending on import is

subtracted from total expenditure on
exports, because such spending escapes the
system and does not add to domestic
production. Exports to foreign nations are
added to total expenditures.
USES OF NATIONAL INCOME DATA
 National income data is necessary for economic planning of
a country. Such data help in determining the output of each
sector and therefore are useful aid in judging which sector
should be given more emphasis.
 A sustained increase in national income of a country over
time is an indicator of economic growth.
 These data also help in comparing the situations of
economic growth in two different countries.
 These data also help in determining the regional disparities,
income inequality and level of poverty in a country, on the
basis of per capita income and inflation indices.
 National income is considered as a measure of economic
welfare.
Difficulties in the measurement of National Income

• Non Monetized Transactions:

There are numerous incidents of exchange of goods and services, like
services rendered out of love, courtesy or kindness, which have no
monetary payments as such. These services have economic value but no
money value. For ex: a businessman takes the help of his wife in
managing his business but does not pay her any salary.

• Unorganized Sector:
The unorganized sector of any economy, including unskilled labor,
domestic servants, and household production unit contributes
substantially to the national income, but mostly goes unrecorded. How
would you count the contribution of a road side tea shop? By income
method? Output Method? Expenditure method? Secondly, it is very
difficult to identify income of those who do not pay income tax.
Multiple Source of Earning:
A person may have multiple source of income, of which one may be the main
activity while the others may be executed on a part time basis. For ex: In India,
most of the small farmers cultivate only one crop a year, and in lean session
they work in unorganized sector. The latter goes unrecognized. Hence
multiple source of earning makes collection of data difficult.

Categorization of Goods and Services:

The validity of National Income accounting depends upon the belief that only
final goods and services are counted and intermediary goods are excluded. But
the problem in this is that there are many cases in which categorization are
not very clear.

Example: The computer bought by a student for personal use is a final

product, but the computer bought by the computer training institute is an
intermediary good, as the final product in its case is trained person. In such
cases there would either be incidence of double counting, or less than actual
counting.
Inadequate Data:
Lack on inadequate and reliable data is a major
hurdle to the measurement of national income of
underdeveloped countries. Often authentic data
may not be available from any proprietorship firms,
partnership or nonprofit organizations, which results
in inaccurate computation of national income.
BUSINESS CYCLES

Business cycle is a periodic up and down movements in

economic activities. It has been seen that economic activities
measured in terms of production, employment and income move
in a cyclical manner over a period of time. This cyclical movement
is characterized by alternative waves of expansion and
contraction, and is associated with alternate period of prosperity
and depression. Business cycles have three basic features or
characteristics:

1. Periodicity
2. Synchronism
3. Self reinforcing
 FEATURES OF BUSINESS CYCLES

Periodicity:

These wavelike movements in income and

employment occur at interval of 6 to 12 years. To
understand it further you should know that when an
economy continues to grow for certain period of time,
it is bound to slow down.
Synchronism:

Another very interesting feature of business cycle is that their

impact is all embracing i.e., large sections of the economy
experience the same phase. It happens because of
interdependence of various sectors of the economy.
For ex: Suppose, due to any reason aggregate demand of
electronic goods declines. What will be the effect? This will
result in closure of some of the units. This will, on the one
hand create unemployment of employees, and on the other
hand would result in reduction in demand for capital, raw
material, intermediary products, marketing agents,
advertisers and so on.
Thus contraction of economic activities in one sector would
lead recession in many other areas, and would thus create a
chain of less economic activities.
Self Reinforcing:

This is one of the most critical features of business

cycle. You have seen that due to interdependence of
various sector and economies, cyclical movements
faced by one sector spreads to other sectors in the
economy; those faced by one economy spread to
other economies as well. Therefore, upward swing of
the cycle is reinforced for further upward movement
and vice versa.
 
PHASES OF BUSINESS CYCLES

A typical business cycle can be studied in four phase:

 Expansion
 Peak
 Contraction (recession)
 Trough (depression), and two turning points
upward and downward
 peak

G’
Expansion
GNP %

contraction

G
trough

Tine unit (Years)

EXPANSION
 
As the term itself denotes, this is a phase when all macro
economic variables like output, employment, income and
consumption increase. At the same time, prices move up,
money supply increase, and the self reinforcing features of
business cycle pushes the economy upward.
 
PEAK
 
This is the highest point of growth; hence it is referred to as
peak or boom in a business cycle. This is the stage beyond
which no further expansion is possible, and it is that phase
which sees the downward turning point.
In reality a process of growth cannot continue indefinitely;
after some time it slows down and thus a turning point comes
in the economy.
CONTRACTION
 
Again you can understand from the term “contraction” that it
means the slowing down process of all economic activities. Let
us see what happens in this phase. There are workers who are
willing to work, but cannot, because no one is willing to hire
them; there are consumers who would like to spend, but cannot,
because their income has been reduced. As a result, there are
firm that would like to invest and produce and hire more
workers, but cannot, because there is not enough demand for
their product. When investment reduces, industrial production
slows down, thus increasing unemployment and reducing
income and consumption. This marks the onset of recession.
 
TROUGH
 
Also termed as slump or depression, this is the lowest ebb of
economic cycle. And it is also followed by the next turning point
in the cycle, when new growth process starts afresh.
 
Thus you can seen that there are two turning points in the
cycle, one at peak when the economy starts sliding down, and
the other at trough, when the economy picks up momentum
for another phase of growth.
EFFECTS OF BUSINESS CYCLES

EFFECTS DURING EXPANSION

Expansion is the phase of high growth coupled with large investments,

increase in employment, income and expenditure, but that is not all about it.
Expansion also comes along with inflation and competition.

Inflation
Inflation is the necessary evil that comes with expansion. Increase in
investment increases demand for capital, which forces more money supply in
the system, demand for factor inputs increases, hence their prices increase
which increases cost of production. So wages and prices of goods also
increase. So, we can say inflation is by product of growth and expansion,
therefore governments are busy controlling inflation during expansion phase.
Competition

Another effect of expansion is intensive competition; firm vie

for their share in the growth process and the only bad thing
about this situation is that firms resort to large amount of non
productive expenditure on advertisements and publicity.
Especially in monopolistic and oligopoly firms, where the
product differentiation is not generic or utility based, but is
more due to consumers’ preferences and biases, the
producers (or sellers) are forced to spend huge amount of
funds on such expenditures which do not add real value to the
product; thus the GNP may increase, but in money terms not
in the real terms.
EFFECTS DURING RECESSION

Recession is unwarranted and creates negative implications for the

economy; hence there is no doubt that it should be controlled. During this
phase, the basic problems that occur are that of unemployment,
excessive inventory, below capacity operations and liquidation of firms.
 
Excess Inventory
One of the most important reasons for recession is fall in aggregate
demand. Therefore, those firms which had produced in abundance during
expansion phase face the problem of maintaining unsold items. This
further dampens the spirit to investment. They not only have excess
inventory of unsold finished goods, but also of raw material and semi
finished goods which are in the production process. This creates
unemployment for suppliers of these goods.
Another problem is that inventory maintenance has a cost, which is in
addition to cost of production. Thus the problem of the firm further
aggravates.
Retrenchment

Firms employ more people if they increase production; in the

event of reduction in investment, the first axe falls on workers
and recession phase is marked by large scale retrenchment. You
would recall that with the news of a possible downswing of US
economy, many software majors in India have put recruitments
on hold and have also cut down workforce in the name of
rationalization.
CONTROLLING BUSINESS CYCLES

At Firm Level

Firms are the main victims of cycles; at the same time they are
one of the main players in the game. This dichotomy of roles
makes firm’s responsibility more critical and crucial. During
expansion firms gain, during recession they suffer; therefore
expansion is the desired phase for them and the recession is
the unwarranted phase. But the problem is that no one can
choose just one. Therefore the only therapy available to firms
is to take preventive measures.
 
Precautionary Measures
These include safe guards against swaying away the wave of
expansion, so that suffering during recession may be minimized

Investment: Firms should deter from investing huge amount of

funds in fixed assets. Financing pattern should be a balanced nix
of debt and equity.

Inventory: Firms should not create large inventory of raw

material or finished goods. Just in time strategy helps in such
cases.

Products: Firms should diversify in different markets and

different products, because in this way risk is also diversified.

Pricing: Flexibility should be the right strategy, so that during

recession prices may be adjusted to increase demand without
eating away the margins.
At Government Level

Since inflation is an important corollary of expansion,

measures to control inflation also help in controlling
business cycle.
The basic difference between the two is that while
controlling inflation government’s focus is only on
prices whereas in case of business cycles the focus is
on the stability in the economy.
 
Monetary Measures
Under monetary measures, the central bank of the country uses
various methods of credit control.

Rediscount rate: during expansion the central bank increases

the rediscount rate to curb money supply, whereas in recession
it reduces the rate to increase money supply.
Note: increase in money supply encourages people to spend
more and thus increases aggregate demand.
 
Reserve ratios: reserve ratios function in the same manner as
rediscount rate. Hence during expansion the ratio are increased
so that banks are left with less cash to be extended as credit,
while during recession the ratios are decreased so that bank can
extend easy credit.
Open market operations: during expansion, central bank sells
securities and thus takes away disposable income from people’s
hand. At the other extreme, during recession it buys securities to
give more in the hands of people for consumption.

Selective credit control: all the above methods are aimed at

controlling money supply in general without any segmentation,
either on the basis of use or amount. And you know that it may
not be always desirable to control credit at all levels. Therefore,
central banks have devised another method, known as selective
credit control. Actually this method is a very preventive tool,
through which credit may be extended to certain areas and
contracted other areas, thereby providing a safety cushion
against strong bouts of expansion and contraction in the
economy.
FISCAL MEASURES

Fiscal measures include managing public expenditure, public revenue and

public debt.
 
Public expenditure: Public expenditure is an important measure to recover
an economy from recession. When government spends money on various
activities like health, transport, communication, etc., income of individuals
increases; this in turn increases aggregate demand.

Public revenue: As increase in expenditure boosts aggregate demand,

increase in public revenue takes away portion of people’s money income and
thus bring down aggregate demand. So during recession it is desirable that
government reduces taxes.
 
During recession government normally use public expenditure as a tool,
while during expansion they use public revenue items as controlling device.