THEORIES OF PROFIT

Profit Maximisation Theory:

In the neoclassical theory of the firm, the main objective of a business firm is profit
maximisation. The firm maximises its profits when it satisfies the two rules:

(i) MC = MR and,

(ii) MC curve cuts the MR curve from below.

Maximum profits refer to pure profits which are a surplus above the average cost of
production. It is the amount left with the entrepreneur after he has made payments to all
factors of production, including his wages of management. In other words, it is a residual
income over and above his normal profits.

The profit maximisation condition of the firm can be expressed as:

Maximise π (Q)

Where π (Q)=R (Q)-C (Q)

Where π (Q) is profit, R (Q) is revenue, C (Q) are costs, and Q are the units of output sold.

The two marginal rules and the profit maximisation condition stated above are applicable both
to a perfectly competitive firm and to a monopoly firm.

Assumptions:
The profit maximisation theory is based on the following assumptions:

1. The objective of the firm is to maximise its profits where profits are the difference between
the firm’s revenue and costs.

2. The entrepreneur is the sole owner of the firm.

3. Tastes and habits of consumers are given and constant.

4. Techniques of production are given.

5. The firm produces a single, perfectly divisible and standardised commodity.

6. The firm has complete knowledge about the amount of output which can be sold at each
price.

7. The firm’s own demand and costs are known with certainty.

8. New firms can enter the industry only in the long run. Entry of firms in the short run is not
possible.

9. The firm maximises its profits over some time-horizon.

10. Profits are maximised both in the short run and the long run.

Given these assumptions, the profit maximising model of firm can be shown under perfect com-
petition and monopoly.
1. Profit Maximisation under Perfect Competition Firm:

Under perfect competition, the firm is one among a large number of producers. It cannot
influence the market price of the product. It is the price-taker and quantity-adjuster. It can only
decide about the output to be sold at the market price. Therefore, under conditions of perfect
competition, the MR curve of a firm coincides with its AR curve.

The MR curve is horizontal to the X-axis because the price is set by the market and the firm sells
its output at that price. The firm is thus in equilibrium when MC= MR= AR (Price). The
equilibrium of the profit maximisation firm under perfect competition is shown in Figure 1
where the MC curve cuts the MR curve first at point A.

It satisfies the condition of MC = MR, but it is not a point of maximum profits because after
point A, the MC curve is below the MR curve. It does not pay the firm to produce the minimum
output when it can earn larger profits by producing beyond OM.

It will, however, stop further production when it reaches the OM level of output where the firm
satisfies both conditions of equilibrium. If it has any plans to produce more than OM1 it will be
including losses, for the marginal cost exceeds the marginal revenue after the equilibrium point
B. Thus the firm maximises its profits at M1 B price at the output level OM1.

2. Profit Maximisation under Monopoly Firm:

There being one seller of the product under monopoly, the monopoly firm is the industry itself.
Therefore, the demand curve for its product is downward sloping to the right, given the tastes
and incomes of its customers. It is a price-maker which can set the price to its maximum
advantage. But it does not mean that the firm can set both price and output. It can do either of
the two things.

If the firm selects its output level, its price is determined by the market demand for its product.
Or, if it sets the price for its product, its output is determined by what the consumers will take
at that price. In any situation, the ultimate aim of the monopoly firm is to maximise its profits.
The conditions for equilibrium of the monopoly firm are:

(1) MC = MR<AR (Price), and

Criticisms of the Profit Maximisation Theory:

The profit maximisation theory has been severely criticised by economists on the following
grounds:

1. Profits Uncertain:

The principle of profit maximisation assumes that firms are certain about the levels of their
maximum profits. But profits are most uncertain for they accrue from the difference between
the receipt of revenues and incurring of costs in the future. It is, therefore, not possible for
firms to maximise their profits under conditions of uncertainty.

2. No Relevance to Internal Organisation:

This objective of the firm bears little or no direct relevance to the internal organisation of firms.
For instance, some managers incur expenditures apparently in excess of those that would
maximise wealth or profits of the owners of the firm. They are observed to emphasize growth
of total assets of the firm and its sales as objectives of managerial actions.

3. No Perfect Knowledge:

The profit maximisation hypothesis is based on the assumption that all firms have perfect
knowledge not only about their own costs and revenues but also of other firms. But, in reality,
firms do not possess sufficient and accurate knowledge about the conditions under which they
operate.
At the most, they may have a knowledge about their own costs of production, but they can
never be definite about the market demand curve. They always operate under conditions of
uncertainty and the profit-maximisation theory is weak in that it assumes that firms are certain
about everything.

4. Empirical Evidence Vague:

The empirical evidence on profit maximisation is vague. Most firms do not rank profits as the
major goal. The working of modem firms is so complex that they do not think merely about
profit maximisation. Their main problems are of control and management.

The function of managing these firms is performed by managers and shareholders rather than
by the entrepreneurs. They are more interested in their emoluments and dividends. Since there
is substantial separation of ownership from control in modern firms, they are not operated so
as to maximise profits.

5. Firms do not bother about MC and MR:

It is asserted that the real world firms do not bother about the calculation of marginal revenue
and marginal cost. Most of them are not even aware of the two terms. Others do not know the
demand and marginal revenue curves faced by them. Still others do not possess adequate
information about their cost structure.

Empirical evidence by Hall and Hitch shows that businessmen have not heard of marginal cost
and marginal revenue. After all, they are not greedy calculating machines. As aptly put by C.J.
Hawkins: “To argue that all firms aim to do nothing else but maximise profits has not better
basis in logic or intuition as to argue that all students aim only to maximise examination marks”.

6. Principle of Average-Cost Maximises Profits:

Hall and Hitch found that firms do not apply the rule of equality of MC and MR to maximise
short run profits. Rather, they aim at the maximisation of profits in the long run. For this, they
do not apply the marginalistic rule but they fix their prices on the average cost principle.
According to this principle, price equals AVC +AFC + profit margin (usually 10%). Thus the main
aim of the profit maximising firm is to set a price on the average cost principle and sell its
output at that price.

7. Static Theory:

The neo-classical theory of the firm is static in nature. The theory does not tell the duration of
either the short period or the long period. The time-horizon of the neo-classical firm consists of
identical and independent time periods. Decisions are considered as temporally independent.
This is a serious weakness of the profit maximisation theory. In fact, decisions are ”temporally
inter- dependent. It means that decisions in any one period are affected by decisions in past
periods which will, in turn, influence the future decisions of the firm. This inter-dependence has
been ignored by the neo-classical theory of the firm.

8. Not applicable to Oligopoly Firm:

As a matter of fact, the profit-maximisation objective has been retained for the perfectly
competitive, or monopolistic, or monopolistic competitive firm in economic theory. But it has
been abandoned in the case of the oligopoly firm because of the criticisms leveled against it.
Hence the different objectives that have been put forth by economists in the theory’ of the firm
relate to the oligopoly or duopoly firm.

9. Varied Objectives:

The basis of the difference between the objectives of the neo-classical firm and the modem
corporation arises from the fact that the profit maximisation objective relates to the
entrepreneurial behaviour while modem corporations are motivated by different objectives
because of the separate roles of shareholders and managers.
 Baumol's Theory of Sales Revenue Maximisation

Prof. Baumol, in his book 'Business behaviour, Value and Growth' has propounded a theory of
Sales Maximisation. Main aim of a firm is to maximise sales. By sales he meant total revenue
earned by the sale of goods. That is why this goal is also referred to as Sales Maximisation Goal.
According to this theory, once profits reach acceptable levels, the goal of the firms become
maximisation of sales revenue rather than maximisation of profits.

In the words of Baumoul, 'The sales maximisation goal says that managers of firms seek to
maximise their sales revenue subject to the constraint of earning a satisfactory profits. "

The above definition maintains that when the profits of firms reach a level considered
satisfactory by the shareholders then the efforts of the managers are directed to maximise
revenue by promoting sales instead of maximising profit. While studying this theory. K must be
kept in view that firms do not Ignore profit altogether. They do aspire to attain a general level
of profit. But once an acceptable level of profit is obtained their goal shifts to sales
maximisation in place of profit maximisation.

Baumol raised serious questions on the validity of profit maximisation as an objective of the
firm. He stressed that in competitive markets, firms would rather aim at maximising revenue,
through maximisation of sales. According to him, sales volumes, and not profit volumes,
determine market leadership in competition. He further stressed that in large organisations,
management is separate from owners. Hence there would always be a dichotomy of managers'
goals and owners' goals. Manager's salary and other benefits are largely linked with sales
volumes, rather than profits.

Baumol hypothesised that managers often attach their personal prestige to the company's
revenue or sales; therefore they would rather attempt to maximise the firm's total revenue,
instead of profits. Moreover, sales volumes are better indicator of firm's position in the market,
and growing sales strengthen the competitive spirit of the firm. Since operations of the firm are
in the hands of managers, and managers' performance is measured in terms of achieving sales
targets, therefore it follows that management is more interested in maximising sales, with a
constraint of minimum profit. Hence the objective is not to maximise profit, but to maximise
sales revenue, along with which, firms need to maintain a minimum level of profit to keep
shareholder satisfied. This minimum level of profit is regarded as the profit constraint.

However, empirical evidence to support above arguments of Baumol is not sufficient to draw
any definite conclusion. Whatever research has been done is based on inadequate data; hence
the results are inconclusive.

Arguments in favour of Maximisation of Sales Goal

Following arguments are given in favour of maximisation of sales goal:

i. More Realistic: Goal of maximisation of sales is a more realistic goal- In fact, firms accord
more importance to the goal of sales maximisation than profit maximisation. It is so because
success of a firm is generally judged from its total sales. According to Ferguson and Krupps,
'Among the various alternatives advanced, Baumoul’s thesis has great advantage — it raises the
other models in the direction of reality and plausibility while still permitting a rather general
theoretical analysis."

ii. More Practical: Revenue maximisation thesis of Baumol is more practical. It is so because
goal of revenue (Sales) maximisation leads to more production which, in turn, leads to fall in
price. As a result, consumers' welfare is promoted. They also endorse this goal of the firms.

iii. More Availability of Loans: At the time of sanctioning loan to a firm, financial institutions
mainly consider its sales. Prospects of loans are bright for such firms as have large total sales.

iv. Strong Position in the Market: Maximum sales of a firm symbolize its strong position in the
market. Sales of a firm will be large only in that situation when consumers like its production,
firm has more competitive power and has been expanding. All these features are indicative of
the progress of the firm.

v. More Advantageous to the Managers: It is more to the advantage of the managers that the
firm should aim at sates maximisation. This way their credibility enhances in the market.
Maximum sales is a reflection of the competence of the managers It has a favorable effect on
their wages. Firm is in a position to offer higher wages to the employees. Consequently,
employer-employee relations become more cordial. II is the constant endeavour of the
managers to maximize the sales of the firm after attaining a given level of profit.

Organizational slack

It can be defined as the excess capacity maintained. by an organization.1 This can be created
by an organization consciously. as well as unconsciously. Slack can be said to exist when
resources. are ordinarily not being completely utilized, employees are being paid.

Ownership and control

The so-called "divorce between ownership and control" happens when the owners of a
business do not control the day-to-day decisions made in the business. For example, the
majority of shareholders in public companies are not involved in any way with operational
decision-making by the companies in which they have invested. See also the principal agent
problem. Key decisions might cover areas such as product pricing, capital investment projects
and marketing budgets.
 Unit 5
Gross Domestic Product (GDP): What Is GDP Of India And How To Calculate It?

Gross Domestic Product, or GDP, is the macroeconomic factor that determines a country's
economic efficiency and capacity. GDP is associated with most of the socio-economic aspects,
such as unemployment, poverty, the status of women, and the literacy rate. An increasing GDP
means most of these factors are positively impacted.

What Is Gross Domestic Product (GDP)? :

GDP is the gross valuation of all the goods and services generated within a country's borders for
a specific period, typically one financial year. You can identify a country's development and
economic progress from its GDP.

The percentage growth of GDP over a quarter is taken as a standard growth of the economy. As
per the reports by International Monetary Fund, India is among the top 10 countries in the
world based on the nominal GDP in 2023.

How To Calculate GDP?

There are three methods to calculate GDP. They use different formulas, but the results are
pretty much the same.

Expenditure Method

This approach takes into consideration the total expenditure incurred by all individuals in one
economy for goods and services. The formula to calculate GDP is –

GDP = C + I + G+ NX
Here, C denotes consumption expenditure, I denotes investment, G is for government
expenditure, and NX signifies net exports.

Suppose, for a financial year, total consumption expenditure is Rs.75,000, total investment
spending on capital assets is Rs.80,000, the government spent a total of Rs.1,50,000 for
economic growth, and net export was Rs.1,00,000.

So, GDP = 75,000 + 80,000 + 1,50,000 + 1,00,000 = 4,05,000

Hence, as per the expenditure method, GDP is Rs.4,05,000 for a financial year.

Output Method

You can use this approach to determine the market value of all the services and products
produced within a country. This method helps eliminate any difference in GDP measurement
due to price level fluctuations.

The formula for GDP calculation as per output method is –

GDP = Real GDP (GDP at constant prices) – Taxes + Subsidies

Suppose, the real GDP of a country for a financial year is Rs.8,00,000, and it has collected taxes
of Rs.3,00,000 and given subsidies of Rs.1,50,000.

Hence, GDP = 8,00,000 - 3,00,000 + 1,50,000 = 3,50,000

So, the GDP as per the output method is Rs.3,50,000 for one financial year.

Income Method
Lastly, there is the income method. As the name suggests, this approach considers the gross
income earned by various factors of production, like capital and labour, within the boundaries
of a country. This is a sum of expenditure made by companies on their workforce. GDP
calculated based on this approach is known as GDI or Gross Domestic Income.

The formula is-

GDP as per Income Method/GDI = GDP at factor cost + Taxes – Subsidies

Suppose, the total GDP at factor cost is Rs.6,00,000 for a financial year. The total amount of
taxes and subsidies are Rs.1,00,000 and Rs.50,000, respectively.

Hence, GDP as per Income Method/GDI = 6,00,000 + 1,00,000 - Rs.50,000 = 6,50,000

Hence, GDI for that financial year is Rs.6,50,000.

What Are The Limitations Of GDP?

GDP is an important indicator of a nation’s economic growth and development, but it has its
flaws. Here are some of the limitations of GDP:

GDP does not include non-market transactions that positively impact productivity, such as
domestic, voluntary, or other participations. Also, it doesn't take into account goods produced
for private consumption.

India is one of those countries where unequal income distribution is a prime discrepancy in
its economy. GDP doesn’t reflect that.

You cannot determine the standard of living of a country from its GDP. India is the best
example of it. It has a high GDP but a relatively low standard of living.

Most importantly, GDP doesn't reflect how industries affect the environment and social well-
being. The government launched Green Gross Domestic Product or Green GDP to address this
issue.
Various factors affect the GDP growth of India. These factors include consumer demand,
investment, infrastructure, workforce and others. Every year the Economic Survey is tabled
right before the Union Budget that provides data on the GDP growth of India for the upcoming
fiscal year along with the economic scenario of the prevailing year.

What is Gross National Product?

Gross national product (GNP) refers to the total value of all the goods and services produced by
the residents and businesses of a country, irrespective of the location of production.

GNP takes into account the investments made by the businesses and residents of the country,
living both inside and outside the country. It also takes into account the value of the products
produced by the industries of the domestic origin.

GNP does not take into consideration the incomes earned by the foreign nationals in the
country or any products produced by a foreign company in the manufacturing units in the
country.

For calculating GNP, only the final goods and services are considered. Intermediate goods are
avoided as it leads to double counting.

To calculate the GNP for a nation, the following factors are considered:

Consumption expenditure

Investment

Government expenditure

Net exports (Total exports minus total imports)

Net income (Income earned by residents in foreign countries minus income earned by
foreigners in the country)
The mathematical formula for calculating GNP is expressed as follows:

Y=C+I+G+X+Z

Or

GNP = Consumption expenditure + Investment + Government expenditure + Net exports + Net

income

GNP considers the manufacturing of goods like equipment, machinery, agricultural products,
vehicles as well as some services like consulting, education, and health care.

The cost of providing the services is not calculated separately as it is included in the price of the
final products.

GNP per capita is used for the calculation of GNP on a country-to-country comparison, while it
becomes problematic when a citizen holds a dual citizenship. In that case, their income is
contributed as GNP for each of the respective countries, which leads to double counting.

Importance of GNP

GNP is considered as an important economic indicator by economists. It is used by them for

finding solutions to the economic issues such as poverty and inflation.

When income is calculated on the basis of per person irrespective of the location, GNP becomes
a much more reliable factor than GDP.

The information obtained from GNP is used for analysing the BoP (Balance of Payments). In
some countries or unions, such as the European Union, economists use GNI or gross national
income.
Drawbacks of GNP

The following are some drawbacks of GNP:

The foreign exchange rate fluctuates. Therefore, it impacts the calculation.

It does not help in determining whether an economy is actually growing or shrinking.

Concept of Consumption, Saving and Investment

Economic development of a country refers to an increase in the standard of living of its people
coupled with a sustained growth rate. Today we are going to discuss in brief about the concepts
of consumption, savings and investment and also line out the relationship between these three
variables according to the classical system.

The main hypothesis of Keynes suggested that our disposable income which can be arrived at
by deducing tax liabilities from gross income influences our level of real consumption. Further
explanation on this is

C = f (Y) where C stands for consumption and Y stands for disposable income.

Keynes also held the view that people tend to enhance their consumption level along with a
rise in their disposable income.

However, the increase in disposable income is greater than the increase in consumption. This
hypothesis can be termed as our marginal propensity to consume and indicates a positive
correlation between these two variables.

This, if our income increases by one unit, our marginal propensity to consume increases by 0.8
units. Hence the remaining 0.2 units are used for savings.
Y = C + S where Y stands for disposable income, C stands for consumption and S stands for
savings.

It is also imperative to note here that propensity to consume and desire to consume are not
similar in nature as the former means effective consumption.

Both objective and subjective factors influence our consumption function. Tax policy, interest
rate, windfall profit or loss and holding of assets are some objective functions whereas
subjective ones relate to motives of foresight, precaution, avarice, and improvement amongst
individuals.

Savings

In plain words, savings refer to the excess of disposable income over consumption expenditure.

From a national level, the unconsumed part of the entire nation’s income comprising of all its
members can be termed as National Savings.

Total domestic savings, on the other hand, can be defined as the summation of savings of the
government, the business sector, and households.

Some of the biggest determinants of savings are

Income, as saving income ratio holds a proportionate relation with the rise in income. People
also have a tendency of saving the excess part of their income but not the entire bulk.

Distribution of income as the savings process is helped to a great extent by inequality of

income distribution. Our desire to showcase a superior standard of living in comparison to our
neighbors often steers us towards purchasing expensive goods which in turn declines the level
of savings.

Psychological or subjective factors such as savings to safeguard ourselves from future

insecurity and uncertainty. The ultimate attitude of people is driven towards savings by their
farsightedness. This, in turn, boosts them up to enjoy a better standard of living both for
themselves and their loved ones.
 Prevalent financial instruments and rate of interest as a higher rate motivates greater
savings.

Investment

Definition of Investment is:

Change in capital stocks or inventories pertaining to a business venture between two

different periods or

Production of fresh capital goods such as plants and equipment.

Relation Between Savings and Investment In Classical System

According to this theory, Savings (S) gets equated with Investment (I) automatically which
otherwise alters the interest rate. If savings exceeds investment, the excess supply of funds
brings down the rate of interest.

This, in turn, reduces savings and increases investment for maintaining equilibrium.

However, this law of the market holds good when the entire amount of savings is invested.

Inflation Meaning – Types, Causes in Economy

Inflation is an economic indicator that indicates the rate of rising prices of goods and services in
the economy. Ultimately it shows the decrease in the buying power of the rupee. It is measured
as a percentage.

This quantitative economic measures the rate of change in prices of selected goods and services
over a period of time. Inflation indicates how much the average price has changed for the
selected basket of goods and services. It is expressed as a percentage. Increase in inflation
indicates a decrease in the purchasing power of the economy.

This percentage indicates the increase or decrease from the previous period. Inflation can be a
cause of concern as the value of money keeps decreasing as inflation rises.

Different Types of Inflation in Economy

The three types of Inflation are Demand-Pull, Cost-Push and Built-in inflation.

Demand-pull Inflation: It occurs when the demand for goods or services is higher when
compared to the production capacity. The difference between demand and supply (shortage)
result in price appreciation.

Cost-push Inflation: It occurs when the cost of production increases. Increase in prices of the
inputs (labour, raw materials, etc.) increases the price of the product.

Built-in Inflation: Expectation of future inflations results in Built-in Inflation. A rise in prices
results in higher wages to afford the increased cost of living. Therefore, high wages result in
increased cost of production, which in turn has an impact on product pricing. The circle hence
continues.

What are the Main Causes of Inflation?

Monetary Policy: It determines the supply of currency in the market. Excess supply of money
leads to inflation. Hence decreasing the value of the currency.

Fiscal Policy: It monitors the borrowing and spending of the economy. Higher borrowings
(debt), result in increased taxes and additional currency printing to repay the debt.

Demand-pull Inflation: Increases in prices due to the gap between the demand (higher) and
supply (lower).

Cost-push Inflation: Higher prices of goods and services due to increased cost of production.

Exchange Rates: Exposure to foreign markets are based on the dollar value. Fluctuations in
the exchange rate have an impact on the rate of inflation.
How Do We Prevent Inflation?

To prevent inflation, the primary strategy is to change the monetary policy by adjusting the
interest rates. Higher interest rates decrease the demand in the economy. This results in lower
economic growth and therefore, lower inflation. Other ways to prevent inflation are:

Controlling the money supply can also help in preventing inflation.

Higher Income Tax rate can reduce the spending, and hence resulting in lesser demand and
inflationary pressures.

Introducing policies to increase the efficiency and competitiveness of the economy helps in
reducing the long term costs.

What are the Effects of a Rise in the Inflation Rate?

A rise in an inflation rate can cause more than a fall in purchase power.

Inflation could lead to economic growth as it can be a sign of rising demand.

Inflation could further lead to an increase in costs due to workers demand to increase wages
to meet inflation. This might increase unemployment as companies will have to lay off workers
to keep up with the costs.

Domestic products might become less competitive if inflation within the country is higher. It
can weaken the currency of the country.

Definition of Trade Cycle

A trade cycle is composed of periods of Good Trade, characterized by rising prices and low
unemployment percentages, shifting with periods of bad trade characterized by falling prices and
high unemployment percentages.

Keynes
Features of Trade Cycle
The characteristics or features of the trade cycle are

1. Movement in Economic Activity : A trade cycle is a wave-like movement in economic

activity showing an upward trend and a downward trend in the economy.
2. Periodical : Trade cycles occur periodically but they do not show the same regularity.
3. Different Phases : Trade cycles have different phases such as Prosperity, Recession,
Depression and Recovery.
4. Different Types : There are minor and major trade cycles. Minor trade cycles operate for
3-4 years, while major trade cycles operate for 4-8 years or more. Though trade cycles
differ in timing, they have a common pattern of sequential phases.
5. Duration : The duration of trade cycles may vary from a minimum of 2 years to a
maximum of 12 years.
6. Dynamic : Business cycles cause changes in all sectors of the economy. Fluctuations
occur not only in production and income but also in other variables like employment,
investment, consumption, rate of interest, price level, etc.
7. Phases are Cumulative : Expansion and contraction in a trade cycle are cumulative, in
effect, i.e. increasing or decreasing progressively.
8. Uncertainty to businessmen : There is uncertainty in the economy, especially for the
businessmen as profits fluctuate more than any other type of income.
9. International Nature : Trade Cycles are international in character. For e.g. Great
Depression of 1930s.

Types of Trade Cycle

Dynamic forces operating in a capitalist economy create various kinds of economic fluctuations.
These fluctuations can be classified as follows

1. Short-Time Cycle : This trade cycle occur for a short period of time. It is also known as
minor cycles. It lasts for about 3-4 years.
2. Secular Trends : This trade cycle occurs for a long period of time and is known as Long
term cycle. It lasts for about 4-8 years or more. It is also known as major cycle.
3. Seasonal Fluctuations : This refers to trade cycles, which take place due to seasonal
changes in the economy. For e.g. failure of monsoon can cause a downtrend in the
economy which may be followed by a good monsoon and up to trend.
4. Irregular or Random Fluctuations : These trade cycles are unpredictable and occur
during a period of strikes, war, etc., causing a shock to the economic system.
5. Cyclic Fluctuation : These fluctuations are wave-like changes in economic activity
caused by recurring phases of expansion and contraction. There is an upswing from a
trough (low point) to peak and downswing from the peak to trough caused due to
economic changes in demand, or supply or various other factors.
Monetary Policy vs Fiscal Policy Differences

Monetary policy and fiscal policy are crucial criteria that decide the fate of the economic status
of a nation. Both are important to maintaining equilibrium in the economy. Monetary policy,
created by the Federal Reserve, has the power to control the economy by contriving the money
input and rates of interest. It plays a vital role in achieving macroeconomic policy and is mainly
managed by the Central Bank.

On the other hand, fiscal policy was created to gain a specific goal using targeted tax income
and spending. Government legislation is the main factor that determines fiscal policy.

Monetary Policy

Monetary policy acts as a macroeconomic policy which is under the control of the Central Bank.
The Central Bank controls money input in the economy, impacting interest rates. This interest
rate is directly related to gaining different macroscopic goals.

These goals include inflation, consumption as well as growth and liquidity. Hence, monetary
policy plays a vital role in maintaining economic growth.

Money supply in the economy and rate of interest change are two critical parameters that
affect monetary policy. Different policy tools that affect the economy are:

Discount rate,

Reserve requirement,

Open market operations, and

Interest on reserves
Monetary policy stimulates people and firms to invest in various economic activities. Therefore,
it has an indirect impact on a country’s economy. As there is very less political interference in
monetary policy, it can be acted upon independently.

The main risk here is that if monetary policy becomes loose, it can inversely increase the money
supply and inordinately impacts inflation. It functions on the flow of money in the economy and
credit control. If we closely observe, monetary policy is highly complex.

Fiscal Policy

British economist John Maynard Keynes (1883-1946) gave the concept of fiscal policy. He stated
that the government is responsible for maintaining the business circle and regulating the
economic product.

According to Keynesian economics, aggregate demand is a key factor in handling the production
and development of the economy. Customers’ spending, different spending during investment,
the total expenditure of the government as well as total export value combine and form
aggregate demand.

In fiscal policy, government revenue collection and expenditure are used to affect the country’s
economic condition. This policy includes the aggregate supply of economic consumption and
employment. This also affects economic growth. There is a remarkable impact of changing
government spending and tax rates observed in fiscal policy. The government determines the
fiscal policy, which shows the direct effect on the economic condition of the country.

Two crucial policy tools that affect fiscal policy are:

Taxes, and

Public spending

The credit for a great impact on the economy goes to the tax and spending policies of the
federal government. It gives an idea about the money spent by one individual.
Two important types of fiscal policy:

Expansionary Fiscal Policy: In this policy, public expenditure increases, whereas the
government decreases taxes.

Contractionary Fiscal Policy: Here, public spending decreases with an increase in taxes by the
government.

In fiscal policy, the political influence is very high, affecting the equilibrium of economics. This
solid political dimension directly changes the tax rates.

Monetary Policy vs Fiscal Policy

The monetary policy is governed by the Central Bank of the country. On the other hand, fiscal
policy is directed by the Finance Ministry.

Monetary policy is performed for a long duration compared to fiscal policy, which is lost for
only one year.

Monetary policy plays an important role in maintaining price stability. On the other hand,
fiscal policy is responsible for giving a particular direction to the economy.

The political impact on monetary policy is absent. Conversely, there is a significant impact of
politics on fiscal policy.

The monetary policy specifically deals with financial management as well as borrowing.
Contrarily, fiscal policy comprises government revenue and spending.

The political impact on monetary policy is absent. Conversely, in fiscal policy, there is a major
impact of politics on policy.

Economic stability is the main focus of monetary policy compared to fiscal policy, which
focuses on the economy’s growth.

The economic status of a nation is directly dependent on the change in monetary policy. On
the other hand, fiscal policy gets updated every year.

Conclusion

The objective of monetary policy and fiscal policy is to keep the economy healthy. Both are put
together for growth and the steadiness of the economy. The main distinguishing factor
between them is that the Central Bank approves monetary policy. On the other hand, fiscal
policy is directed by the government of a country. Hence, monetary policy is crucial to achieving
macroeconomic policy.