# Managerial Economics - Overview

A close interrelationship between management and economics had led to the development of managerial economics. Economic analysis is required for various concepts such as demand, profit, cost, and competition. In this way, managerial economics is considered as economics applied to “problems of choice’’ or alternatives and allocation of scarce resources by the firms.

Managerial economics is a discipline that combines economic theory with managerial practice. It helps in covering the gap between the problems of logic and the problems of policy. The subject offers powerful tools and techniques for managerial policy making.

## Managerial Economics − Definition

To quote Mansfield, “Managerial economics is concerned with the application of economic concepts and economic analysis to the problems of formulating rational managerial decisions.

Spencer and Siegelman have defined the subject as “the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management.”

## Micro, Macro, and Managerial Economics Relationship

Microeconomics studies the actions of individual consumers and firms; managerial economics is an applied specialty of this branch. Macroeconomics deals with the performance, structure, and behavior of an economy as a whole. Managerial economics applies microeconomic theories and techniques to management decisions. It is more limited in scope as compared to microeconomics. Macroeconomists study aggregate indicators such as GDP, unemployment rates to understand the functions of the whole economy.

Microeconomics and managerial economics both encourage the use of quantitative methods to analyze economic data. Businesses have finite human and financial resources; managerial economic principles can aid management decisions in allocating these resources efficiently. Macroeconomics models and their estimates are used by the government to assist in the development of economic policy.

## Nature and Scope of Managerial Economics

The most important function in managerial economics is decision-making. It involves the complete course of selecting the most suitable action from two or more alternatives. The primary function is to make the most profitable use of resources which are limited such as labor, capital, land etc. A manager is very careful while taking decisions as the future is uncertain; he ensures that the best possible plans are made in the most effective manner to achieve the desired objective which is profit maximization.

• Economic theory and economic analysis are used to solve the problems of managerial economics.

• Economics basically comprises of two main divisions namely Micro economics and Macro economics.

• Managerial economics covers both macroeconomics as well as microeconomics, as both are equally important for decision making and business analysis.

• Macroeconomics deals with the study of entire economy. It considers all the factors such as government policies, business cycles, national income, etc.

• Microeconomics includes the analysis of small individual units of economy such as individual firms, individual industry, or a single individual consumer.

All the economic theories, tools, and concepts are covered under the scope of managerial economics to analyze the business environment. The scope of managerial economics is a continual process, as it is a developing science. Demand analysis and forecasting, profit management, and capital management are also considered under the scope of managerial economics.

### Demand Analysis and Forecasting

Demand analysis and forecasting involves huge amount of decision-making! Demand estimation is an integral part of decision making, an assessment of future sales helps in strengthening the market position and maximizing profit. In managerial economics, demand analysis and forecasting holds a very important place.

### Profit Management

Success of a firm depends on its primary measure and that is profit. Firms are operated to earn long term profit which is generally the reward for risk taking. Appropriate planning and measuring profit is the most important and challenging area of managerial economics.

### Capital Management

Capital management involves planning and controlling of expenses. There are many problems related to capital investments which involve considerable amount of time and labor. Cost of capital and rate of return are important factors of capital management.

### Demand for Managerial Economics

The demand for this subject has increased post liberalization and globalization period primarily because of increasing use of economic logic, concepts, tools and theories in the decision making process of large multinationals.

Also, this can be attributed to increasing demand for professionally trained management personnel, who can leverage limited resources available to them and maximize returns with efficiency and effectiveness.

## Role in Managerial Decision Making

Managerial economics leverages economic concepts and decision science techniques to solve managerial problems. It provides optimal solutions to managerial decision making issues.

Business firms are a combination of manpower, financial, and physical resources which help in making managerial decisions. Societies can be classified into two main categories − production and consumption. Firms are the economic entities and are on the production side, whereas consumers are on the consumption side.

The performances of firms get analyzed in the framework of an economic model. The economic model of a firm is called the theory of the firm. Business decisions include many vital decisions like whether a firm should undertake research and development program, should a company launch a new product, etc.

Business decisions made by the managers are very important for the success and failure of a firm. Complexity in the business world continuously grows making the role of a manager or a decision maker of an organisation more challenging! The impact of goods production, marketing, and technological changes highly contribute to the complexity of the business environment.

## Steps for Decision-Making

The steps for decision making like problem description, objective determination, discovering alternatives, forecasting consequences are described below −

### Define the Problem

What is the problem and how does it influence managerial objectives are the main questions. Decisions are usually made in the firm’s planning process. Managerial decisions are at times not very well defined and thus are sometimes source of a problem.

### Determine the Objective

The goal of an organization or decision maker is very important. In practice, there may be many problems while setting the objectives of a firm related to profit maximization and benefit cost analysis. Are the future benefits worth the present capital? Should a firm make an investment for higher profits for over 8 to 10 years? These are the questions asked before determining the objectives of a firm.

### Discover the Alternatives

For a sound decision framework, there are many questions which are needed to be answered such as − What are the alternatives? What factors are under the decision maker’s control? What variables constrain the choice of options? The manager needs to carefully formulate all such questions in order to weigh the attractive alternatives.

### Forecast the Consequences

Forecasting or predicting the consequences of each alternative should be considered. Conditions could change by applying each alternative action so it is crucial to decide which alternative action to use when outcomes are uncertain.

### Make a Choice

Once all the analysis and scrutinizing is completed, the preferred course of action is selected. This step of the process is said to occupy the lion’s share in analysis. In this step, the objectives and outcomes are directly quantifiable. It all depends on how the decision maker puts the problem, how he formalizes the objectives, considers the appropriate alternatives, and finds out the most preferable course of action.

## Sensitivity Analysis

Sensitivity analysis helps us in determining the strong features of the optimal choice of action. It helps us to know how the optimal decision changes, if conditions related to the solution are altered. Thus, it proves that the optimal solution chosen should be based on the objective and well structured. Sensitivity analysis reflects how an optimal solution is affected, if the important factors vary or are altered.

Managerial economics is competent enough for serving the purposes in decision making. It focuses on the theory of the firm which considers profit maximization as the main objective. The theory of the firm was developed in the nineteenth century by French and English economists. Theory of the firm emphasizes on optimum utilization of resources, cost control, and profits in a single time period. Theory of the firm approach, with its focus on optimization, is relevant for small farms and producers.

# Economic Analysis & Optimizations

Economic analysis is the most crucial phase in managerial economics. A manager has to collect and study the economic data of the environment in which a firm operates. He has to conduct a detailed statistical analysis in order to do research on industrial markets. The research may comprise of information regarding tax rates, products, competitor’s pricing strategies, etc., which may be useful for managerial decision-making.

Optimization techniques are very crucial activities in managerial decision-making process. According to the objective of the firm, the manager tries to make the most effective decision out of all the alternatives available. Though the optimal decisions differ from company to company, the objective of optimization technique is to obtain a condition under which the marginal revenue is equal to the marginal cost.

The first step in presenting optimization techniques is to examine the methods to express economic relationship. Now let’s have a look at the methods of expressing economic relationship −

• Equations, graphs, and tables are extensively used for expressing economic relationships.

• Graphs and tables are used for simple relationships and equations are used for complex relationships.

• Expressing relationships through equations is very useful in economics as it allows the usage of powerful differential technique, in order to determine the optimal solution of the problem.

Now suppose, we have total revenue equation −

TR = 100Q − 10Q2

Substituting values for quantity sold, we generate the total revenue schedule of the firm −

100Q − 10Q2 TR
100(0) − 10(0)2 $0 100(1) − 10(1)2$90
100(2) − 10(2)2 $160 100(3) − 10(3)2$210
100(4) − 10(4)2 $240 100(5) − 10(5)2$250

## Transfer Pricing

Transfer Pricing relates to international transactions performed between related parties and covers all sorts of transactions.

The most common being distributorship, R&D, marketing, manufacturing, loans, management fees, and IP licensing.

All intercompany transactions must be regulated in accordance with applicable law and comply with the "arm's length" principle which requires holding an updated transfer pricing study and an intercompany agreement based upon the study.

Some corporations perform their intercompany transactions based upon previously issued studies or an ill advice they have received, to work at a “cost plus X%”. This is not sufficient, such a decision has to be supported in terms of methodology and the amount of overhead by a proper transfer pricing study and it has to be updated each financial year.

## Dual Pricing

In simple words, different prices offered for the same product in different markets is dual pricing. Different prices for same product are basically known as dual pricing. The objective of dual pricing is to enter different markets or a new market with one product offering lower prices in foreign county.

There are industry specific laws or norms which are needed to be followed for dual pricing. Dual pricing strategy does not involve arbitrage. It is quite commonly followed in developing countries where local citizens are offered the same products at a lower price for which foreigners are paid more.

Airline Industry could be considered as a prime example of Dual Pricing. Companies offer lower prices if tickets are booked well in advance. The demand of this category of customers is elastic and varies inversely with price.

As the time passes the flight fares start increasing to get high prices from the customers whose demands are inelastic. This is how companies charge different fare for the same flight tickets. The differentiating factor here is the time of booking and not nationality.

## Price Effect

Price effect is the change in demand in accordance to the change in price, other things remaining constant. Other things include − Taste and preference of the consumer, income of the consumer, price of other goods which are assumed to be constant. Following is the formula for price effect −

Price Effect =
Proportionate change in quantity demanded of X / Proportionate change in price of X

Price effect is the summation of two effects, substitution effect and income effect

Price effect = Substitution effect − Income effect

## Substitution Effect

In this effect the consumer is compelled to choose a product that is less expensive so that his satisfaction is maximized, as the normal income of the consumer is fixed. It can be explained with the below examples −

• Consumers will buy less expensive foods such as vegetables over meat.

• Consumers could buy less amount of meat to keep expenses in control.

## Income Effect

Change in demand of goods based on the change in consumer’s discretionary income. Income effect comprises of two types of commodities or products −

Normal goods − If there is a price fall, demand increases as real income increases and vice versa.

Inferior goods − In case of inferior goods, demand increases due to an increase in the real income.

# Investment Under Certainty

Capital Budgeting is the process by which the firm decides which long-term investments to make. Capital Budgeting projects, i.e., potential long-term investments, are expected to generate cash flows over several years.

Capital Budgeting also explains the decisions in which all the incomes and expenditures are covered. These decisions involve all inflows and outflows of funds of an undertaking for a particular period of time.

Capital Budgeting techniques under certainty can be divided into the following two groups −

Non Discounted Cash Flow

• Pay Back Period
• Accounting Rate of Return (ARR)

Discounted Cash Flow

• Net Present Value (NPV)
• Profitability Index (PI)
• Internal Rate of Return (IRR)

The payback period (PBP) is the traditional method of capital budgeting. It is the simplest and perhaps the most widely used quantitative method for appraising capital expenditure decision; i.e. it is the number of years required to recover the original cash outlay invested in a project.

## Non-Discounted Cash Flow

Non-discounted cash flow techniques are also known as traditional techniques.

### Pay Back Period

Payback period is one of the traditional methods of budgeting. It is widely used as quantitative method and is the simplest method in capital expenditure decision. Payback period helps in analyzing the number of years required to recover the original cash outlay invested in a particular project. The formula widely used to calculate payback period is −

PBP =
Initial Investment / Constant annual cash inflow

PBP is a cost effective and easy to calculate method. It is simple to use and does not require much of the time for calculation. It is more helpful for short term earnings.

### Accounting Rate of Return (ARR)

The ARR is the ratio after tax profit divided by the average investment. ARR is also known as return on investment method (ROI). Following formula is usually used to calculate ARR −

ARR =
Average annual profit after tax / Average investment
×
100

The average profits after tax are obtained by adding up the profit after tax for each year and dividing the result by the number of years.

ARR is simple to use and as it is based on accounting information, it is easily available. ARR is usually used as a performance evaluation measure and not as a decision making tool as it does not use cash flow information.

## Discounted Cash Flow Techniques

Discounted cash flow techniques consider time value of money and are therefore also known as modern techniques.

### Net Present Value (NPV)

The net present value is one of the discounted cash flow techniques. It is the difference between the present value of future cash inflows and the present value of the initial outlay, discounted at the firm’s cost of capital. It recognizes the cash flow streams at different time intervals and can be computed only when they are expressed in terms of common denominator (present value). Present value is calculated by determining an appropriate discount rate. NPV is calculated with the help of equation.

NPV = Present value of cash inflows − Initial investment.

NPV is considered as the most appropriate measure of profitability. It considers all the years of cash flow, and recognizes the time value for money. It is an absolute measure of profitability that means it gives output in terms of absolute amount. The NPVs of the projects can be added together which is not possible in other methods.

## Profitability Index (PI)

Profitability index method is also known as benefit cost ratio as numerator measures benefits and denominator measures cost like the NPV approach. It is the ratio obtained by dividing the present value of future cash inflows by the present value of cash outlays. Mathematically it is defined as −

PI =
Present value of cash inflow / Initial cash outlay

In a capital rationing situation, PI is a better evaluation method as compared to NPV method. It considers the time value of money along cash flows generated by the project.

Present Cash Value
Year Cash Flows @ 5% Discount @ 10% Discount
0 $-10,000.00$ -10,000.00 $-10,000.00 1$ 2,000.00 $1,905.00$ 1,818.00
2 $2,000.00$ 1,814.00 $1,653.00 3$ 2,000.00 $1,728.00$ 1,503.00
4 $2,000.00$ 1,645.00 $1,366.00 5$ 5,000.00 $3,918.00$ 3,105.00
Total $1,010.00$ -555.00
Profitability Index (5%) =
$11010 /$10000
= 1.101
Profitability Index (10%) =
$9445 /$10000
= .9445

## Internal Rate of Return (IRR)

Internal rate of return is also known as yield on investment. IRR depends entirely on the initial outlay of the projects which are evaluated. It is the compound annual rate of return that the firm earns, if it invests in the project and receives the given cash inflows. Mathematically IRR is determined by the following equation −

IRR = T t=1
Ct / (1 + r)t
− 1c0

Where,

R = The internal rate of return

Ct = Cash inflows at t period

C0 = Initial investment

Example −

Internal Rate of Return
Opening Balance -100,000
Year 1 Cash Flow 110000
Year 2 Cash Flow 113000
Year 3 Cash Flow 117000
Year 4 Cash Flow 120000
Year 5 Cash Flow 122000
Proceeds from Sale 1100000
IRR 9.14%

IRR considers the total cash flows generated by a project over the life of the project. It measures profitability of the projects in percentage and can be easily compared with the opportunity cost of capital. It also considers the time value of money.

# Investment Under Uncertainty

Macroeconomics is a part of economic study which analyzes the economy as a whole. It is the average of the entire economy and does not study any individual unit or a firm. It studies the national income, total employment, aggregate demand and supply etc.

## Nature of Macroeconomics

Macroeconomics is basically known as theory of income. It is concerned with the problems of economic fluctuations, unemployment, inflation or deflation and economic growth. It deals with the aggregates of all quantities not with individual price levels or outputs but with national output.

As per G. Ackley, Macroeconomics concerns itself with such variables −

• Aggregate volume of the output of an economy
• Extent to which resources are employed
• Size of the national income
• General price level

## Scope of Macroeconomics

Macroeconomics is much of theoretical and practical importance. Following are the points covered under the scope of macroeconomics −

### Working of the Economy

The study of macroeconomics is crucial to understand the working of an economy. Economic problems are mainly related to the employment, behavior of total income and general price in the economy. Macroeconomics help in making the elimination process more understandable.

### In Economy Policies

Macroeconomics is very useful in an economic policy. Underdeveloped economies face innumerable problems related to overpopulation, inflation, balance of payments etc. The main responsibilities of government are controlling the overpopulation, prices, volume of trade etc.

Following are the economic problems where macroeconomics study are useful −

• In national income
• In unemployment
• In economic growth
• In monetary problems

### Understanding the Behavior of Individual Units

The demand for individual products depends upon aggregate demand in the economy therefore understanding the behavior of individual units is very important in macroeconomics. Firstly, to solve the problem of deficiency in demand of individual products, understanding the causes of fall in aggregate demand is required. Similarly to know the reasons for increase in costs of a particular firm or industry, it is first required to understand the average cost conditions of the whole economy. Thus, the study of individual units is not possible without macroeconomics.

Macroeconomics enhances our knowledge of the functioning of an economy by studying the behavior of national income, output, savings, and consumptions.

# Circular Flow Model of Economy

Circular flow model is the basic economic model and it describes the flow of money and products throughout the economy in a very simplified manner. This model divides the market into two categories −

• Market of goods and services
• Market for factor of production

The circular flow diagram displays the relationship of resources and money between firms and households. Every adult individual understands its basic structure from personal experience. Firms employ workers, who spend their income on goods produced by the firms. This money is then used to compensate the workers and buy raw materials to make the goods. This is the basic structure behind the circular flow diagram. Let’s have a look at the following diagram −

In the above model, we can see that the firms and the households interact with each other in both product market as well as factor of production market. The product market is the market where all the products by the firms are exchanged and factors of production market is where inputs such as land, labor, capital and resources are exchanged. Households sell their resources to the businesses in the factor market to earn money. The prices of the resources, the businesses purchase are “costs”. Business produces goods utilizing the resources provided by the households, which are then sold in the product market. Households use their incomes to purchase these goods in the product market. In return for the goods, businesses bring in revenue.

# National Income & Measurement

## Definition of National Income

The total net value of all goods and services produced within a nation over a specified period of time, representing the sum of wages, profits, rents, interest, and pension payments to residents of the nation.

## Measures of National Income

For the purpose of measurement and analysis, national income can be viewed as an aggregate of various component flows. The most comprehensive measure of aggregate income which is widely known is Gross National Product at market prices.

### Gross and Net Concept

Gross emphasizes that no allowance for capital consumption has been made or that depreciation has yet to be deducted. Net indicates that provision for capital consumption has already been made or that depreciation has already been deducted.

### National and Domestic Concepts

The term national denotes that the aggregate under consideration represents the total income which accrues to the normal residents of a country due to their participation in world production during the current year.

It is also possible to measure the value of the total output or income originating within the specified geographical boundary of a country known as domestic territory. The resulting measure is called "domestic product".

### Market Prices and Factor Costs

The valuation of the national product at market prices indicates the total amount actually paid by the final buyers while the valuation of national product at factor cost is a measure of the total amount earned by the factors of production for their contribution to the final output.

GNP at market price = GNP at factor cost + indirect taxes - Subsidies.

NNP at market price = NNP at factor cost + indirect taxes - Subsidies

### Gross National Product and Gross Domestic Product

For some purposes we need to find the total income generated from production within the territorial boundaries of an economy irrespective of whether it belongs to the inhabitants of that nation or not. Such an income is known as Gross Domestic Product (GDP) and found as −

GDP = GNP - Nnet Factor Income From Abroad

### Net National Product

The NNP is an alternative and closely related measure of the national income. It differs from GNP in only one respect. GNP is the sum of final products. It includes consumption of goods, gross investment, government expenditures on goods and services, and net exports.

GNP = NNP − Depreciation

NNP includes net private investment while GNP includes gross private domestic investment.

### Personal Income

Personal income is calculated by subtracting from national income those types of incomes which are earned but not received and adding those types which are received but not currently earned.

Personal Income = NNP at Factor Cost − Undistributed Profits − Corporate Taxes + Transfer Payments

### Disposable Income

Disposable income is the total income that actually remains with individuals to dispose off as they wish. It differs from personal income by the amount of direct taxes paid by individuals.

Disposable Income = Personal Income − Personal taxes

The concept of value added is a useful device to find out the exact amount that is added at each stage of production to the value of the final product. Value added can be defined as the difference between the value of output produced by that firm and the total expenditure incurred by it on the materials and intermediate products purchased from other business firms.

## Methods of Measuring National Income

Let’s have a look at the following ways of measuring national income −

### Product Approach

In product approach, national income is measured as a flow of goods and services. Value of money for all final goods and services is produced in an economy during a year. Final goods are those goods which are directly consumed and not used in further production process. In our economy product approach benefits various sectors like forestry, agriculture, mining etc to estimate gross and net value.

### Income Approach

In income approach, national income is measured as a flow of factor incomes. Income received by basic factors like labor, capital, land and entrepreneurship are summed up. This approach is also called as income distributed approach.

### Expenditure Approach

This method is known as the final product method. In this method, national income is measured as a flow of expenditure incurred by the society in a particular year. The expenditures are classified as personal consumption expenditure, net domestic investment, government expenditure on goods and services and net foreign investment.

These three approaches to the measurement of national income yield identical results. They provide three alternative methods of measuring essentially the same magnitude.

# National Income Determination

## Factors Determining the National Income

According to Keynes there are two major factors that determine the national income of an economy −

### Aggregate Supply

Aggregate supply comprises of consumer goods as well as producer goods. It is defined as total value of goods and services produced and supplied at a particular point of time. When goods and services produced at a particular point of time is multiplied by the respective prices of goods and services, it helps us in getting the total value of the national output. The formula for determining the aggregate national income is follows −

Aggregate Income = Consumption(C) + Saving (S)

Few factor prices such as wages, rents are rigid in the short run. When demand in an economy increases, firms also tend to increase production to some extent. However, along with the production, some factor prices and the amount of inputs needed to increase production also increase.

### Aggregate Demand

Aggregate demand is the effective aggregate expenditure of an economy in a particular time period. It is the effective demand which is equal to the actual expenditure. Aggregate demand involves concepts namely aggregate demand for consumer goods and aggregate demand for capital goods. Aggregate demand can be represented by the following formula −

As per Keynes theory of nation income, investment (I) remains constant throughout, while consumption (C) keeps changing, and thus consumption is the major determinant of income.

# Modern Theories of Economic Growth

## Definition of Economic Growth

Economic growth refers to an increase in the goods and services produced by an economy over a particular period of time. It is measured as a percentage increase in real gross domestic product which is GDP adjusted to inflation. GDP is the market value for all the final goods and services produced in an economy.

## Theories of Economic Growth

### The Classical Approach

Adam Smith laid emphasis on increasing returns as a source of economic growth. He focused on foreign trade to widen the market and raise productivity of trading countries. Trade enables a country to buy goods from abroad at a lower cost as compared to which they can be produced in the home country.

In modern growth theory, Lucas has strongly emphasized the role of increasing returns through direct foreign investment which encourages learning by doing through knowledge capital. In Southeast Asia, the newly industrialized countries (NICs) have achieved very high growth rates in the last two decades.

### The Neoclassical Approach

The neoclassical approach to economic growth has been divided into two sections −

• The first section is the competitive model of Walrasian equilibrium where markets play a very crucial role in allocating the resources effectively. To secure the optimal allocation of inputs and outputs, markets for labor, finance and capital have been used. This type of competitive paradigm was used by Solow to develop a growth model.

• The second section of the neoclassical model assumes that technology is given. Solow used the interpretation that technology in the production function is superficial. The point is that R&D investment and human capital through learning by doing were not explicitly recognized.

The neoclassical growth model developed by Solow fails to explain the fact of actual growth behavior. This failure is caused due to the model’s prediction that per capita output approaches a steady state path along which it grows at a rate that is given. This means that the long-term rate of national growth is determined outside the model and is independent of preferences and most aspects of the production function and policy measures.

### The Modern Approach

The modern approach to market comprises of several features. The new economy emerging today is spreading all over the world. It is a revolution in knowledge capital and information explosion. Following are the important key elements −

• Innovation theory by Schumpeter, inter firm and inter industry diffusion of knowledge.

• Increasing efficiency of the telecommunications and micro-computer industry.

• Global expansion of trade through modern externalities and networks.

Modern theory of economic growth focuses mainly on two channels of inducing growth through expenses spent on research and development on the core component of knowledge innovations. First channel is the impact on the available goods and services and the other one is the impact on the stock of knowledge phenomena.

Business cycles are the rhythmic fluctuations in the aggregate level of economic activity of a nation. Business cycle comprises of following phases −

• Depression
• Recovery
• Prosperity
• Inflation
• Recession

Business cycles occur because of reasons such as good or bad climatic conditions, under consumption or over consumption, strikes, war, floods, draughts, etc

### Schumpeter’s Theory of Innovation

According to Schumpeter, an innovation is defined as the development of a new product or introduction of a new product or a process of production, development of new market or a change in the market.

### Over − Investment Theory

Professor Hayek says, “primary cause of business cycles is monetary overestimate”. He says business cycles are caused by over investment and consequently by over production. When a bank charges rate of interest below the equilibrium rate, the business has to borrow more funds which leads to business fluctuations.

### Monetary Theory

According to Professor Hawtrey, all the changes in the business cycles take place due to monetary policies. According to him the flow in the monetary demand leads to prosperity or depression in the economy. Cyclical fluctuations are caused by expansion and contraction of bank credit. These conditions increase or decrease the flow of money in the economy.

## Stabilization Policies

Stabilization policies are also known as counter cycle policies. These policies try to counter the natural ups and downs of business cycles. Expansionary stabilization policies are useful to reduce unemployment during contraction and contractionary policies are used to reduce inflation during expansion.

## Instruments of Stabilization Policies

The flow chart of stablilization policies is described below:

### Monetary Policy

Monetary policy is employed by the government as an effective tool to promote economic stability and achieve certain predetermined objectives. It deals with the total money supply and its management in an economy. Objectives of monetary policy include exchange rate stability, price stability, full employment, rapid economic growth, etc.

### Fiscal Policy

Fiscal policy helps to formulate rational consumption policy and helps to increase savings. It raises the volume of investments and the standards of living. Fiscal policy creates more jobs, reduces economic inequalities and controls, inflation and deflation. Fiscal policy as an instrument to fight depression and create full employment conditions is much more effective as compared to monetary policy.

### Physical Policy

When monetary policy and fiscal policy are inadequate to control prices, government adapts physical policy. These policies can be introduced swiftly and thus the result is quite rapid. Theses controls are more discriminatory as compared to monetary policy. They tend to vary effectively in the intensity of the operation of control from time to time in various sectors.

# Inflation & ITS Control Measures

## Inflation

In economics, inflation means rise in the general level of prices of goods and services over a period of time in an economy. Inflation may affect the economy either in positive way or negative way.

## Causes of Inflation

The causes of inflation are as follows −

• Inflation may occur sometimes due to excessive bank credit or currency depreciation.

• It may be caused due to increase in demand in relation to supply of all types goods and services due to a rapid increase in population.

• Inflation also may be also be caused by a change in the value of production costs of goods.

• Export boom inflation also comes into existence when a considerable increase in exports may cause a shortage in the home country.

Inflation is also caused by decrease in supplies, consumer confidence, and corporate decisions to charge more.

## Measures to Control Inflation

There are many ways of controlling inflation in an economy −

### Monetary Measure

The most important method of controlling inflation is monetary policy of the Central Bank. Most central banks use high interest rates as a way to fight inflation. Following are the monetary measures used to control inflation −

• Bank Rate Policy − Bank rate policy is the most common tool against inflation. The increase in bank rate increases the cost of borrowings which reduces commercial banks borrowing from the central bank.

• Cash Reserve Ratio − To control inflation, the central bank needs to raise CRR which helps in reducing the lending capacity of the commercial banks.

• Open Market Operations − Open market operations mean the sale and purchase of government securities and bonds by the central bank.

### Fiscal Policy

Fiscal measures are another important set of measures to control inflation which include taxation, public borrowings, and government expenses. Some of the fiscal measures to control inflation are as follows −

• Increase in savings
• Increase in taxes
• Surplus budgets

### Wage and Price Controls

Wage and price controls help in controlling wages as the price increases. Price control and wage control is a short term measure but is successful; since in long run, it controls inflation along with rationing.

## Impact of Inflation on Managerial Decision Making

Inflation is of course the all too familiar problem of too much money (demand) chasing too few goods (supply), with the upshot of prices and expectations everywhere tending to rise higher and higher.

### The Role of a Manager

In these circumstance, a business manager has to take appropriate decisions and measures based on macro economic uncertainties like inflation and the occasional recession.

A true test of a business manager lies in delivering profitability ie., the extent to which he increases revenues and also reduces costs even during economic uncertainties.

In the current scenario, they are supposed to get faster solutions to the problems of coping with soaring prices (for example) by understanding the process of how inflation distorts the traditional functions of money along with recommendations.

### The Effect of Management

The bottom-line impact is that, Customers / clients reward efficient management with profits and penalize inefficient management with losses. Hence, it is advisable to be well prepared to tackle these areas.