Module 4: Session 9 & 10

Is the Business Cycle Avoidable?

 Since, post-1945 to 1970s business cycle disappeared

 Era of Demand Management

 1970s to late 1990s fluctuations due to supply side factors

 Oil shocks and dot.com boom

 Credit-led housing boom - Followed by collapse

 Need for Demand Management

 What is Multiplier Model?

 Explains how output is determined in the short run.

 Each Rs. change in exogenous expenditure leads more than 1 Rs.

Change (or a multiplied change) in GDP.

 The key assumptions –

 underlying are wages and prices are fixed
 Unemployed Resources in the economy

For Simplicity,

 we are ignoring the role of monetary policy,

 Assume financial market does not react to economic changeand

 no international Trade and Finance

Multiplier Model or Simple Keynesian Model

It tells us how
investment
and
consumption
spending
interact with
income to
determine
national
output.
 Meaning of Equilibrium
• An equilibrium is a situation where different forces at work are
balance
• Suppose, if you see ball rolling down a hill, the ball is not in
equilibrium. It is in disequilibrium
• When the ball comes to the rest in a valley, at the bottom of the hill
forces operating on the ball are in balance. Therefore, an
equilibrium
• Similarly, in macroeconomics equilibrium level of output is one
where the different forces of spending and output (supply) are in
balance
• At previous graph the point E is equilibrium.
• At point E and only at point E, does desired spending C+I equals
actual output
• At any other point, the business will find either producing too much
or too little, hence will want to get at point E.
 The Multiplier
• The multiplier is impact of Rs. 1 or $1 change in
exogenous expenditure on total output
• In this simple model where expenditure = C+I,
• In other words, multiplier = ΔY/ΔI
• Equilibrium condition-
 Y = C +Io
 Now, C = a+bYd
 Hence, Y = a+b(Y-T) +Io
 Y =(a-bT)/(1-b) + Io /(1-b)
 Y = a/(1-b) – bT/(1-b)+ Io /(1-b)
 ΔY/ΔI = 1/(1-b)
0 < b <1, Hence, 1/(1-b) > 1
What is the economic logic behind value of multiplier >1?
 Changes in Equilibrium Income
Multiplier is ΔY/ΔI = 1/(1-b)
• How it operates:
• pd1: ΔI= ΔE = ΔYd → ΔC=b ΔYd → Δ2C = b2 ΔYd →Δ3C = b3ΔYd
→….
• Total Increase in Expenditure or aggregate demand: ΔE +ΔC + Δ2C
+ Δ3C ……..
• Or, total increase in income, ΔY= ΔE+b ΔYd+ b2 ΔYd+ b3ΔYd…..

• As ΔI = ΔE = ΔYd

• We can write, ΔY = (1+b+b2+b3……). ΔI

• Or, ΔY = [1/(1-b)]. ΔI
Similarity and Dissimilarity
between Keynesian Cross
or Multiplier with AS-AD
model

Key assumption
is prices and
wages are fixed.
 Tax Multiplier

• Condition for a equilibrium level of Income,

Y = E = C+I+G,
I, G are autonomous expenditure so given, So is T
Y is endogenous variable,
C = a + b Yd = a + bY – bT,
So, Y = a + bY – bT +I + G
So equilibrium income Ȳ = (a-bT +I +G)/(1-b)
1/(1-b) is autonomous expenditure multiplier
(a-bT +I +G) is autonomous expenditure
ΔY/ΔT = – b/(1-b)
Why Tax Multiplier is negative?
How Tax Multiplier Operates:
pd1: ΔT= ΔYd → ΔC=b ΔYd → Δ2C = b2 ΔYd →Δ3C = b3ΔYd
→….
Total decline in Expenditure or aggregate demand: -ΔC - Δ2C -
Δ3C ……..
Or, total decline in income, ΔY = - b ΔT - b2 ΔT - b3ΔT…….
= -bΔT (1+ b + b2…………..)
= -bΔT/(1-b)
So, ΔY/ ΔT = -b/(1-b)

If we introduce Government Expenditure

for increase in Govt. Expenditure the increase in income is

ΔY = [1/(1-b)]. ΔG Govt. Expenditure Multiplier

If Fiscal Deficit is zero, what is the value of Multiplier ?

Balanced Budget Multiplier, ΔY̅/ΔG + ΔY̅/ΔT = 1

 Multiplier in Open Economy
• Condition for a equilibrium level of Income,
Y = E = C+I+G +X - M,
I, G, X are autonomous expenditure so given, So is T
Y is endogenous variable, Import Function, M = n + mY
C = a + b Yd = a + bY – bT, m is marginal propensity to import,
M = n + mY, n is average propensity to import

So, Y = a + bY – bT +I + G + X -n - mY
So equilibrium income Y = (a-bT +I +G +X -n)/(1-b+m)
1/(1-b+m) is autonomous expenditure multiplier
(a-bT +I +G +X -n) is autonomous expenditure

So, ΔY/ΔT = – b/(1-b+m ) Tax Multiplier

ΔY/ΔI = 1/(1-b+m) Autonomous Investment Multiplier
ΔY/ΔG = 1/(1-b+m) Govt. Expenditure Multiplier
ΔY/ΔX = 1/(1-b+m) Export Multiplier
 Home Task
Suppose, it is Simple Keynesian Economy or Keynesian cross
Economy (not closed). The GDP of this economy is Rs. 30 lakh crores.
Consumption, Investment and Gov expenditure are of Rs. 10 lakh crores
each. For an increase of Rs. 1 lakh in GDP, Rs. 30 thousand consumption
increases.

Case1: Suppose Government increases its expenditure (in domestic

economy) by 1 lakh crores by borrowing this amount from the external
market. But the exchange rate remains unchanged. What will be the impact
on GDP?

Case2: Suppose Government increases its expenditure (in domestic

economy) by 1 lakh crores by borrowing 50 thousand crores from the
domestic market and remaining 50 thousand crores by imposing tax on
household. (exchange rate remains unchanged.) What will be the impact on
GDP?
Government Accounts
 Budget Structure…1

Revenue Account Capital Account

Receipt Expenditure
Receipt Expenditure
Tax Developmental Mkt. loans Developmental
Ext. Debt
Non-Tax Small Savings
Non-Developmental
Provident fund Non-Developmental
Contri. by PSU Interest Payment
Interest Receipt Defence Exp.
Fiscal Service Organs of State
Fiscal Services
Gen. Services Admin. Services

Social & Comm services Subsidy to FCI

Social Security, Welfare Pension
Econ Services Subsidy to FCI
Ext. Grants Grants to UT
 What is Revenue Deficit?
• Revenue Deficit = Revenue Receipts – Revenue Expenditure

• Revenue Receipts = Tax receipts +Non-Tax Receipt (interest, dividend

from PSUs, fees, Stamp duties, external grants)

• Revenue Expenditure = Cost of running Govt. (Govt. Consumption Expenditure) +

Interest + Subsidies Cost

• Govt. Consumption expenditure includes expenditures on salaries and administration for

the normal running of dept. (like defense, police, postal, economic, social, other general
services and central plan)
Transfer Payment includes expenditure on subsidies, interest payment,
pensions.
• Revenue Expenditure can also divided into
• Development
• Non-Development Expenditure
 Net Capital Expenditure
• Net Capital Expenditure = Capital Expenditure - Capital Receipt

• Capital Expenditure as Expenditure on acquisition of assets of material

and permanent character
= Expenditure on public infrastructure, (i.e. roads, structures &
equipment used in Govt.), Govt. investment in shares, loans to
PSUs.
• This can also be divided into Development and Non-Development

• Capital Receipt = Non-debt receipt +debt receipt

• Non-debt Receipt = Loans and Advance recovery, Proceeds from

PSUs Disinvestment etc.
• Debt Receipt = Public Borrowing
 Various Concepts of Deficits…

• What is Fiscal Deficit?

• Fiscal Deficit = Revenue Deficit + Capital Expenditures
- Non-debt Receipt
It measures how much the Govt. has to borrow

• Primary Deficit = Fiscal Deficit – interest payment

• Monetised Deficit = Fiscal Deficit – Govt. borrowing

 Tax Receipts…1
• Direct or Income Tax & Indirect Tax

• Direct Tax two kind

– Personal income and corporate income
• Indirect Tax:
Tariff or customs duty
Goods And Service Tax (GST)
Excise Duty only in 5 products including petrol-
VAT Diesel and Alcohol
 Tax Receipts…2
• Personal income is proportional tax on Income

• Corporate income is proportional tax on profit

• Tariff or customs duty is proportional tax on value of imported Goods

• Goods and Service Tax (Tax collected at each stage of value addition)

• Excise Duty is proportional tax on the value of produced goods at the

factory gate.

• VAT is Tax collected at each stage of value addition in producing Goods

Thank You