Professional Documents
Culture Documents
Dr Hiranmoy Roy
Economic Theories
Pattern of Trade, Impact of Trade Barriers Govt. policies to pursue Growth in Developing Countries, Efficient use of resources, Full employment, Price stability, Fair dist. of income Classical Theories Depression of 1930s Classical theory had the difficulty of explaining Depression.
3
Economic Theories
J. M. Keynes began to develop alternative theories Birth of Keynesian theories But it also had trouble as unemployment and inflation began to rise together Stagflation Post Keynesian Development Critique of Keynes three main developments after Keynes
4
Economic Theories
Monetarism, Supply side Economics, Neo Classical Economics: Rational Expectation Theory Milton Friedman Monetarist Criticized Keynes He argued Monetary Policy is the prime engine in causing fluctuations in eco. Activity through Agg. Demand
5
Economic Theories
Keynes view that monetary policy ineffective to bring eco. Stability was criticized by Friedman In fact, he said the monetary policy contributed to almost all recessions There are differences between Keynes and Monetarists in two issues (i) Relationship between money supply and inflation (ii) Role of Govt. in the economy
6
Economic Theories
Monetarist led by Friedman Inflation is always and everywhere a monetary phenomenon Inflation is caused by rapid expansion of money supply Keynes and his followers activist role of Govt. Keynes lay stress on adoption of discretionary fiscal and monetary policy
7
Economic Theories
Keynes believed that expansion of money supply does not always cause inflation This depends on possibility of expansion of output When eco. Is in depression increase in money supply is likely to lead in large expansion of output and prevent price rise Monetarist opposed to the fiscal policy, budget deficit and pub. debt
8
Economic Theories
They argued that reducing taxes and public expenditure so that role of Govt. in the economy is reduced
Economic Theories
Supply Side Economics: In 1970s problem of stagflation appeared high inflation accompanied by high unemployment Keynes proposition of fluctuation in agg. dd. Responsible for either high unemployment or high inflation could not explain stagflation This led some economists to believe that problem was on the supply side eco. activity
10
Economic Theories
Keynesian theories were incapable of solving Keynesian expansionary fiscal and monetary measures taken to raise agg dd. to remove stagflation or high unemployment , it accelerated further. On the other hand if steps were taken to lower agg dd to lower inflation rate it would further increased already high unemployment rate
11
Economic Theories
Supply side economists mentioned that it was supply shocks, by reducing oil prices and increase in oil prices that caused the problem of stagflation Contraction in supply due to supply shocks , given the agg dd curve price level and inflation could rise on the one hand and agg output could fall giving rise to unemployment
12
Economic Theories
Supply side advocates expansion in money supply increase in employment opp., incentives to work, save and invest more were required to be promoted Increase in agg supply given the agg dd curve will lead to increase in employment on the one hand and reduction in inflation on the other
13
Economic Theories
According to them high rate of tax serves as disincentive to work New Keynesians thus emphasize both fiscal and monetary policies to attain eco. Stability To encourage more saving work and investment , they advocated reducing prevailing high rates of income tax This will not only cause employment to rise but also lower rate of inflation
14
Economic Theories
Laffer Curve When rate of a tax increases from zero upward Govt. revenue from it initially increases, but after a point further hike in rate of tax brings about decrease in revenue for the Govt. So lowering of tax rate not only increase N.I and employment but also reduce Govt. budget deficit
15
Economic Theories
New Classical Macro economics: Rational Expectation Theory : A New Macro theory put forward which is opposed to Keynesian Macro theory According to this new classical macro economic theory consumers, workers and producers behave rationally to promote their interests and welfare.
16
Economic Theories
On the basis of their rational expectation they made quick adjustments in their behaviour Producers and consumers collect every information to determine their behaviour People make a correct relationship between eco. Event and Govt. policies on the one hand and results that follow from that Correct prediction from Govt. policies and changes in eco. environment
17
Economic Theories
E.g., when Govt. makes a deficit budget they will expect that interest rates will rise. So to they will attempt to take loans now when rate of int. is less than paying higher int. rates in future A sharp contrast of Keynesian theory and Rational expectations theory is that according to Keynesian theory deficit in Govt. budget will leads to increase in agg dd and will promote pvt investment
18
Economic Theories
On the other hand according to Rational expectations theory, budget deficit will cause rate of interest to rise which will discourage pvt investment Thus increase in agg dd as result of budget deficit is offset by decrease in pvt investment so that N.I., output and employment remains unaffected
19
Economic Theories
Similarly If RBI increases money supply , consumers, workers and producers expect rationally price level will rise . On the basis of their rational expectations, workers will get their wages raised , landlord raise their rents, bankers and lenders raise their interest and producers will raise the profit margins
20
Economic Theories
As a result of adjustments by various persons, the effect of expansion in money supply on these persons will get cancelled. So according to rational expectation theorists since the consumers, workers and producers themselves make adjustment to save them from adverse effect s of economic events and policies there is no need for the Govt. to intervene in the eco through proper macro eco policy
21
Economic Theories
Thus like Friedman and other monetarists the supporters of rational expectations theory opposed to the activists role by the Govt. However Conservative Govt. (US) of the 1980s gradually become disillusioned with Monetarism and returned to modern version of classical eco management Neo- Classical economics. Like classical eco it stresses the role of free markets in delivering the best possible eco growth
22
Economic Theories
Following three important theories popular in economics Classical / Neo- classical, Keynesian theory, Monetarist theory Classical refers to the works done by a group of economists in the 18th and 19th centuries. Much of these work subsequently been updated by modern economists and they are generally termed as neo-classical economists
23
Economic Theories
We look in to works of classical economists what they believed and proposed Beliefs, Theories, AS & AD policies, Virtual Economy Policies Neo-Classical Theory: Beliefs Malthus Population growth depress eco growth then diminishing returns would cause further problems for growth
24
Economic Theories
They believed Govt. should not intervene to correct this as it would only make things worse so only way to encourage growth is to allow free trade and free markets. This approach is known as laissez-faire approach This approach places total reliance on markets and anything that prevent markets clearing properly should be done away with.
25
Economic Theories
Neo-Classical Theories: Revolved mainly around the role of markets in the economy If markets work freely and nothing prevents their working then the economy would prosper Role of Govt. is to ensure the free workings of markets using supply side policies The main theory to justify this view is Free Market Theory, Says Law, Quantity Theory of Money
26
Economic Theories
Free Market Theory Eco left itself tend to full employment equilibrium Unemployment (a surplus of labour) fall in wages increased dd for labor - equilib restored at full employment Initially hig h wage results in unemp l( a b in diag) . This causes wage rate to fall and unempl in the eco is voluntary unempl
27
Economic Theories
Similarly if there is discrepancy between savings and investment the equilibrium would change in the market. This would require free and flexible market Increase in inv Increased dd for money Increased Rate of int. Increased Savings equilib is restored Compared to Keynesian macro theory of income and employment classical theory is more relevant to the conditions of prevailing in developing countries
28
Economic Theories
And the theory highlight those factors which govern income and employment in these countries While Keynesian theory emphasizes the role of effective dd in the determination of income and employment, classical economists believed that in a free market eco there is always tendency toward the establishment of full employment and sufficient dd for output
29
Economic Theories
Classical theory of employment and output is based on the following two basic notions: Says Law, Wage Price Flexibility Says Law: Jean Baptiste Say early nineteenth century Supply Creates its Own Demand Assumptions: (i) Any increase in goods and services (supply) will lead to an increase in expenditure to buy those goods and services (dd) (ii) There will not be any shortage of dd full employment if there is any unemployment it would simply be temporary Greater production leads to more income and which creates market for goods and deficiency in dd is not a problem
30
Economic Theories
Income which is not spent on con goods will be saved and will be reinvested. Thus inv equals saving Thus leakage caused by saving in income flow is made up by the inv expenditure J. M Keynes bitterly criticized the classical theory of automatic full employment
31
Economic Theories
Wage-Price Flexibility: The amount of production depends not only on agg dd or exp but also on prices of products. Inequality in saving and investment may cause deficiency in agg exp even then over production and unemployment would not arise This is because they thought deficiency would be made by changes in price level Due to increase in savings expenditure declines, it will then affect the prices of the products
32
Economic Theories
At lower prices all products will be sold and so there is no overproduction and unemployment Thus increased savings will bring down the prices of products and not the amount of production and employment Now a question arises to what extent the sellers of the product will tolerate the decline in prices
33
Economic Theories
However to make their prices profitable they will have to reduces the prices of factors such as labourers With fall in wages all workers will get employment but if labourer do not work at lower wages, this is voluntary unemployment according to classical economists According to classical economists involuntary unemployment is not possible in a free market economy, all those who are willing to work at the existing wage rate will get employment
34
Economic Theories
During great depression of 1929-33 Pigou suggested cut in wage rates in order to remove huge widespread unemployment prevailed at that time Keynes criticized Pigous view in his General Theory Supply may not create its entire dd Income earned by different factors of production are equal to the value of the output produced this do not mean that whole income will be spent on goods and services If inv is not equal to desired savings then agg dd will not be equal to agg supply, producers will unable to sell whole output and so profit will be less, they will reduce production which will give rise to involuntary unemployment
35
Economic Theories
In a capitalist eco agg dd is the sum of con dd and inv dd. But in a free market capitalist eco persons who save is different from those who invest. Inv depends on marginal eff. Of capital Keynes also explained that equality between savings and investment can not be brought about by changes in interest rate as savings depends on income. But classical economists ignored changes in income due to their assumption of full employment
36
Economic Theories
Quantity Theory of Money Neo- Classical theory: Agg Supply (AS) and Agg dd (AD): The classicals have complete faith in markets they believed eco would always settle automatically the full emp. Equilib. in the long run However there may be slightly different reaction in the short run as the eco adjusted to its new long run equilib. This can be explained with AD and AS analysis (diagram)
37
Economic Theories
Neo-Classical Theory Policies: Classical view eco is self adjusting, there is no need to actively intervene in the eco Intervention may simply destabilizing and inflationary. The key to long term growth is thus ensure free markets with no imperfections (through supply side policies) Control the growth of the money supply to ensure low inflation
38
Economic Theories
Supply Side Policies: Supply side policies can be used to correct market imperfections. If level of agg supply increases then Says law predicts that dd will also increase This will only be non-inflationary way to get increase in output (Diagram). Money Supply Policies: Open market operation, Funding, Monetary Base Control, Interest Rate Control
39
Economic Theories
Keynesians: Theories The Labor Market, Money Market, The Multiplier, Keynesian Inflation Theory The Labor Market Did not have same faith in market as classical. Wages would be sticky downwards Workers are not happy about wage cuts and would resist, this would mean ages will not fall enough to clear the market and unemployment would linger (Diagram) Demand deficit unemployment
40
Economic Theories
Keynesian Theory Introduction: Much of J.M. Keyneses works took place at the time of Great Depression of 1930s Assumptions: (i) Market did not automatically lead to full employment equilibrium (ii) The Level of output (N.I.) would adjust between leakages and injections Imbalance between leakages and injections (increase in Govt. exp) extra agg dd more employment more income leakages (tax, savings, and imports). If leakages and injectins are equal than equilib restored, this is Multiplier Effect.
41
Economic Theories
Money market: Classical economists believed that savings to be increased to invest more. Keynes argued that savings would mean people to spend less This would mean a decrease in agg dd This would make things worse and firms would be even less inclined to invest as demand for product decreasing Inv depends on business expectation
42
Economic Theories
The Multiplier: Keynesian View of Inflation: Keynes rejected quantity theory of money. Increase in money supply will lead to inflation Increase in M may lead to decrease in V. Alternatively increase in M may lead to decrease in T (transaction) Keynes termed inflation is more likely to be cost push.
43
Economic Theories
Keynesian AS & AD: He argued that economy would settle at any equilibrium level of income at any time, it is duty of Govt. to use appropriate policies to ensure that equilibrium is good one for economy Reflationary policy to boost agg dd As agg dd increases so does output and employ which leads to inflation
44
Economic Theories
Keynesian Policies: Demand management Policies adjusting the level of dd so that eco arrives at full employment If there is shortfall of dd (deflationary gap), Govt. need to reflate the eco. If there is excess dd Govt. need to deflate the eco Demand for Money and Keynesian Liquidity Theory of Interest:
45
Economic Theories
Criticism of L.P. Theory of Interest: He ignored the real factors (like productivity of capital, thriftiness or saving) in the determination of interest rates He assumed rate of interest depends on demand for investment funds. Demand for capital (investment funds) depends on MEC. Reflationary Policies: (Ref.)
46
Economic Theories
Deflationary Policy: (Ref.) Monetarists Theory- Introduction: Monetarism is very close to classical school of thought (Friedman 1960s, 1970s) Stagflation Stagnation and Inflation Monetarists work revolve round role of expectation in determining inflation Monetarists Belief: Re -evaluated QTM and argued increase in money supply would lead to inflation substantial empirical evidence
47
Economic Theories
Expectation adjust so quickly that policy change will immediately be taken by people No short term adjustment Rational Expectation School Inflation is always and every where a monetary phenomenon Monetarists Theory: QTM: Expectation Augmented Philips Curve (Diagram)
48
Economic Theories
Monetarists AS & AD: Short Run, Long Run (Diagram Ref.) Monetarists Policies: Limited their view on Inflation, policy is on inflation only They believed if inflation is controlled stability and growth of the economy will be maintained. The key policy is to control money supply to control inflation and do not intervene to reduce unemployment The only way to change natural rate is through Supply Side policies
49
Economic Theories
Supply Side policies: Non Inflationary increase in capacity (supply) to reduce unemployment (Diagram Ref.) Money Supply Policies: (Ref.)
50
Depreciation Accounting
Depreciation, Characteristics of Depreciation, Various Depreciation Methods Business acquires an asset to be used for more than one year, it appears in the balance sheet as a fixed asset These assets are expected to be used by the business for a number of years this is called the Useful Economic Life (UEL) At the end of the assets UEL, it may have some residual value
51
Depreciation Accounting
During the UEL, the value at which the asset appears in the balance sheet is gradually reduced until it is equal to the residual value at the end of the UEL. This reduction is called depreciation. For accountants, depreciation is an allocation process, not a valuation process. It is important, therefore, for analysis to differentiate between accounting depreciation and economic depreciation.
52
Depreciation Accounting
Income is defined as the amount that can be distributed during the period without impairing the productive capacity of the firm. The cash flows generated by an asset over its life, therefore, cannot be considered income until a provision is made for its replacement. These cash flows must be reduced by the amount required to replace the asset to determine the earnings generated by that asset.
53
Depreciation Accounting
This is underlying principle of economic depreciation The periodic depreciation expense, therefore, segregates a portion of cash flows for reinvestment, preserving that sum from distribution as dividends and taxes.
54
Depreciation Accounting
Suppose an asset costs $240 and is expected to generate net cash flows of $100 per year over its three year life, Over the life of the asset, income equals $60 ($300-$240) as $240 is required to replace the asset As financial statement report income annually, it is necessary to determine how much income (how much depreciation) to report each year.
55
Depreciation Accounting
This requires the allocation of a portion of the multi-period return to each period. Depreciation is an application of the matching concept. It aims to match the cost of buying the asset to the revenue or other benefits generated by its use it as a measure of the use or wearing out of the asset over time
56
Depreciation Accounting
There are many methods that may be used to calculate depreciation. Ideally, the method chosen should be the one which most closely matches the cost to the pattern of benefits obtained Characteristics of Depreciation: Depreciation is a reduction in the book value of fixed assets (with exception of land)
57
Depreciation Accounting
It reduces the book value of the asset but not its market value The reduction in the book value of an asset is permanent, gradual and of continuing nature it is not possible to restore it to its original cost It is a continuing process because the value is reduced either with the use of the asset or with a passage of time.
58
Depreciation Accounting
It takes place gradually unless there is a quick physical deterioration or obsolescence It is not the process of valuation of asset; it is process of allocation of cost of the asset
The term depreciation is used only for tangible fixed assets. This term is not used in the case of wasting and fictitious assets such as depletion of natural resources and amortization of goodwill, respectively
59
Depreciation Accounting
Depreciation has several meanings in literature. However, all different technical meanings However, all the different technical meanings attached to the word depreciation are basically variants of the following four concepts
60
Depreciation Accounting
Decrease in Value: The value of one asset is in someway computed at two different dates, and the value at the later date subtracted from the value at the earlier date is known as the depreciation. This is the generally implied meaning of depreciation. Amortized Cost: This is the accounting concept of depreciation in which the cost of an asset which is considered an operating expense is apportioned among the years of its useful life
61
Depreciation Accounting
Difference in Value between an Existing Old Asset and a Hypothetical New Asset Taken as a Standard of Comparison: This is the appraisal concept of depreciation and the appraisal depreciation means the value inferiority at some particular date
62
Depreciation Accounting
Impaired Serviceableness: With the passage of time equipments and machines are often unable to hold as close tolerances as when they were new. Similarly, owing to decay or corrosion, the strength of structures maybe impaired such impaired functional efficiency is also termed as depreciation there may be several other common reasons for Decrease in value besides impaired serviceableness
63
Depreciation Accounting
Depreciation Methods Annuity or Sinking Fund Depreciation: From an economic perspective, the income reported each year should reflects the rate of return earned by the asset (Table 3.1) The asset just described generates a return of 12% over its three year of life. To report for each year requires the pattern of depreciation (as shown in the Table 3.1)
64
Depreciation Accounting
This pattern, with the amount of depreciation increasing every year, is known as annuity or sinking fund depreciation. Straight Line Depreciation: Given the same asset and the pattern of constant cash flows shown in Table 3.1, the revenues (cash flows of $100) generated by the asset are the same each year, the income shows each year should also be the same.
65
Depreciation Accounting
Straight Line Depreciation with Declining Cash Flows: (Ref. Table 3.2) Straight Line Depreciation with Constant Cash Flows: (Ref. Table 3.3 same as table 3.1) Straight line depreciation is the dominant method in most of the countries and in United States The cost of plant and equipment is depreciated generally by the straight line method, over the estimated useful life of respective asset
66
Depreciation Accounting
The use of this method results in an increasing rate of return rather than the actual rate of return earned over the life of the asset Formula for Straight Line Depreciation Method: Depreciation in year i = 1/n (Original Cost Salvage) Where n = Depreciation Life
67
Depreciation Accounting
Accelerated Depreciation Method: The matching principle can also justify accelerated depreciation patterns, with higher depreciation charges in early years and smaller amounts in later years. Benefits (revenues) from an asset may be higher in early years, declining in later years as efficiency falls (the asset wears out). The depreciation should decline with benefits.
68
Depreciation Accounting
Even if revenues are constant over time, an asset requires maintenance and repairs over time, costs that tend to increase as the asset ages. Accelerated depreciation methods compensate for the rising trend of maintenance and repair costs so that total asset costs are level over the assets life.
69
Depreciation Accounting
Both the efficiency and maintenance of an asset are difficult to forecast, and, in any case accelerated depreciation methods are (like straight line) arbitrary procedures designed to yield the desired pattern of higher depreciation amounts in earlier years Accelerated methods have historically been used for tax reporting, here they are justified by the desire to promote capital investment
70
Depreciation Accounting
The two most common accelerated methods are the Sum-of- Years Digits (SYD) method and the family of declining- balance methods Exhibit 1 Accelerated Depreciation Method- Sum-Of-Years Digits Original Cost = $18000 Salvage Value = $3000 Depreciation life, n = 5 Year Rate(Original Cash Salvage value) Depreciation Expense (Ref. Table)
71
Depreciation Accounting
For Sum-of-Years Digits method Depreciation in Year i = (n-i+1)/SYD X (Original Cost Salvage Value) Where, SYD=n(n+1)/2. for e.g. n=5 SYD=15. Depreciation thus varies from year to year (as I varies) in reverse counting order of the years; that is the pattern is 5/15, 4/15, 3/15, 2/15 and 1/15 and is depicted as follows (Ref. Exhibit 2)
72
Depreciation Accounting
Impact of Depreciation Methods on Financial Statements: The choice of depreciation method impacts both the income statement and balance sheet; for capital-intensive companies, the impact can be significant. As depreciation is an allocation of past cash flows
73
Depreciation Accounting
Accelerated depreciation method, with higher depreciation expense in the early years of asset life, tens to depress both net income and stockholders equity when compared with the straight line method. As the percentage effect on net income is usually greater than the affect on net asset, return ratios tend to be lower when accelerated depreciation is used. Consequently these methods are considered more conservative
74
Depreciation Accounting
Depreciable lives and salvage value impact both depreciation expense and stated asset values. Sorter lives and lower salvage values are considered conservative in that they lead to higher depreciation expense Conservative depreciation practices also increase asset turnover ratio by decreasing the denominator of that ratio
75
Depreciation Accounting
Impact of Inflation on Depreciation: Historical cost based depreciation expense may be used to define income as long as the total expense over the assets life is enough to replace the asset after it has been utilized. If however the replacement cost of the asset increases, than depreciation expense based on the original cost will be insufficient.
76
Depreciation Accounting
Accelerated depreciation methods partially compensate for this inflation effect by shortening the tax recovery period Depreciating the asset over a shorter life serves similar purpose. A number of studies have been examined whether accelerated method compensates for depreciation and /or reflect economic depreciation.
77
79
80
85
88
91
93
94
96
106
107
113
117
119
124
125
129
131
132
136
138
140
147
157
167
169
170
173
179
185
187
189
190
191
192