MACRO ECONOMICS

B.COM

UNIT-I

MACRO ECONOMICS
Renowned Economist Prof. Alfred Marshall has defined Economics which
studies human behaviour in ordinary business of life.
"In macro economics we study the ordinary business of life' in the aggregate,
i.e. we look at the behaviour of economy as a whole."

For the first time in 1933 Prof. Ragner Frish of Oslo University divided the study
of Economics in two parts :
1. Micro Economics : In micro economies various economic activities of small or
individual units are studied and analysed. In micro economics, economic problems
are studied oh individual basis like-consumption problem of a consumer or price
determination problem of a single firm. It is also known as 'Price Theory'.
2. Macro Economics : It studies the whole economic system. In Macro economics
total consumption of whole economy, general price level, total employment, national
income etc. are studied. Macro economics is known as Theory of Income and
Employment'.

CLASSICAL, NEO-CLASSICAL AND KEYNESIAN CONCEPT OF MACRO

ECONOMICS
(1) Classical Concept of Macro Economics : Adam Smith, J.S. Mill, J.B.Say and
Ricardo are considered classical economists. According to classical view in an

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independent capitalist economy, full employment is a normal phenomenon. If there
is unemployment in such economies, it is only temporary phenomenon, because
economic power during unemployment situations change themselves in such a way
that unemployment is removed by itself.
(2) Neo-classical concept of Macro Economics : Prof. Marshall and Pigou are
main exponents of neo-classical economists. Prof Marshall and his followers
considered the assumptions of full employment, production and income,
concentrated on relative price determination and distribution of factors of production
on the basis of their alternative uses.
(3) Keynesian Concept of Macro Economics : Credit goes to Lord J. M. Keynes
of England for refuting the concept of full employment given by classical
economists and presenting the important theory of Employment and Income
determination in his landmark book General Theory of Employment, Interest and
Money in 1936. Keynes had proved that economy can be in equlibrium below full
employment level. The reason for this according to Keynes is low aggregate demand
in relation to aggregate supply. He said that in order to increase aggregate demand
government has to incrase its expenditure under fiscal policy.

MEANING AND DEFINITIONS OF MACRO ECONOMICS

The word 'Macro' is derived from the word 'Makros' of Greek which means 'large or
big'. Therefore, macro is related with aggregates. So, Macro economics studies
groups related to the economy as a whole like—National Income, National Savings,
Total employment, Total productions and General price level.
Some definitions of Macro Economics are :
According to Prof. Boulding, "Macro Economic theory is that part of economics
which studies the overall average and aggregates of the system".
Gardner Ackley has defined Macro Economics as "Macro Economics concerns with
such variables as the aggregate volume of the output of an economy with the extent
to which its resources are employed, with the size of national income and with the
general price level."

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According to Prof. Shapiro, "Macro economics deals with the functioning of the
economics as a whole."
The appropriate definition of Macro Economics is :
"Macro Economics is that branch of economic analysis which studies the aggregates
of the whole economy along with their behaviour and mutual relations."

CHARACTERISTICS OF MACRO ECONOMICS

(1) Variable Macro Units : In macro economics aggregates like National Income,
Total output, Total employment, Normal price levels are variable.
(2) Related to Whole Economy : Only the effects of aggregate decisions on the
whole economy are studied in macro economics.
(3) Aggregate Quantitatives : Aggregate quantities are not the totals of micro units.
Micro and macro quantities are decided separately.
(4) Interdependence: Micro level changes does not affect other units but Macro
level aggregates are so interdependent that change in one variable will affect the
equilibrium of the economy. For e.g. If a country increases its investment then
multiplier effect will increase National Income which in turn will cause changes in
total employment, consumption, foreign trade etc.
(5) Comparative Study : Macro Economics explains any subject in a comparative
manner. For eg. It compares the National Income, National Savings, National
Investment, Total employment of two periods.
(6) Income Theory: It is also called Income theory because it studies how National
Income is determined, why it fluctuates.
(7) Employment Theory: Since increase in employment of labour increases
National Income and the factors determining income determines the full
employment. Therefore, it is called 'Employment theory' also.
(8) Complement to Micro Economics : It is complementary in nature because it
verifies the facts of micro analysis.
(9) Macro Economic Variable: Macro Economic variables are those which are
related to the whole economy. For e.g. National saving and Investment, Gross

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National Product, National Income, Total Employment, Aggregate Demand and
Aggregate supply.
(10) Tools of Macro Economics : The tools of macro economics are, (i) Fiscal
Policy, (ii) Monetary Policy, (iii) Income Policy.

SCOPE OF MACRO ECONOMICS

Macro Economics studies following topics :
(i) Theory of National Income : Macro Economics studies the concept various
factors, various measures of measuring national income.
(11) Theory of Employment: It studies the various factors determining employment
like-Effective Demand, Aggregate supply, Total consumption, Total investment,
Total saving, Multiplier etc. In short, it studies the problem of employment and
unemployment.
(iii) Theory of Supply of Money: It studies the various factors affecting supply of
money and their influences on the economy.
(iv) Theory of General Price-level: This theory studies the Wholesale Price Index,
change in general price level viz inflation and deflation.
(v) Theory of International Trade: It studies the trade relations between various
countries, quantity of foreign trade, determination of exchange rates, terms of trade
etc.
(vi) Theory of Economic Growth: Macro economics studies the economic growth
i.e. the problems related to increase in per capita real income. It studies the
economic development process of less developed countries. It also studies the
monetery and fiscal policies of the government.
(vii) Macro theory of Distribution: Macro economics tells how National Income is
distributed among various factors of production like what is the portion of labour,
capital, land and entrepreneurs.
Scope of Macro Economics is shown in the following way : Scope of Macro
Economics
Theory Theory Theory Theory Theory Theory Macro
ofNI of Emp- of Supply of General of Inter- of theory

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 loyment of Money Price-level national Economic of Dis-
Trade Growth tribution

Difference between Micro and Macro Economics

Points of Difference Micro Economics Macro Economics
1. Study It studies individual economic It studies the economy as a
2. Assumptions units. Based on the whole. Based on the
3. Central Problem assumption of full assumption of less than full
4. Paradoxes employment. Price employment. Determination
determination. The facts of output and employment.
which are true in individual Group behaviour works for
level may not be true at the whole economy.
aggregate level.
SBPD Publications Economics
5. Use of Technique
6. Objective
7. Nature
It studies price determination on the basis of assumption 'other things remaining the
same' and 'partial equilibrium analysis'. It's aim is to study the theories, problems
and policies regarding efficient allocation of factors.
It's analysis is simple.
It studies the changes on aggregate price and output levels on the basis of analysis of
general equilibrium.
It's aim is to study the principles, problems related to the full employment and
growth of factors of production.
It's analysis is complex.

KINDS OF MACRO ECONOMIC ANALYSIS

(1) Macro Static : It studies the whole economy under equilibrium static condition.
It does not try to explain how economic reached that specific point or equilibrium.
Economic world always goes on changing and various aggregates establish new

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equilibriums through their action or reaction. The study of these various equilibrium
situations is called macro economic static analysis.
Following Keynes' equation shows Macro Statics :
or, Total Income = Total Consumption Expenditure + Total Investment Above
equation explains that in an economy Total Income should be equal
to Total consumption expenditure and Total investment expenditure. But it says
nothing about the fact that how economy reached that point where total income, total
consumption expenditure and total investment expenditure have become equal.
Therefore in Macro static analysis time and the process of change are not discussed.
Fig (1) shows Macro Static equation.
In the Figure C is the consumption curve which indicates how much society spend
on consumption at each level of income. C + I curve shows the expenditure on both
consumption and investment. 45° Angle line Y = C +1 is total income and total
expenditure line. Economy will be in equilibrium when National Income is OY
because National Income is equal to consumption expenditure and investment
expenditure only at this level.
(2) Comparative Macro Static: Economic system always changes, it never remains
static. These changes in economy cause new equilibrium points on different levels.
Comparative macro static undertakes the comparative study of various equilibrium
points. In short, in this system we compare only the two different situations of
equilibrium not the path by which economy has moved from one equilibrium to
other.
In fig (2) initial income is OY. Suppose that investment increases by Al thereby
equilibrium income increases by AY and and the previous equilibrium point was OY
which increases OYr Similarly due to change in I i.e., Al economy shifts to new
equilibrium point Yr Therefore, in comparative macro static, in order to get a new
equilibrium point economy has to pass through this path of adjustment.
(3) Macro Dynamics : The contribution of Tinbergen, Hicks, Boulding, Samuelson,
Robertson and Harod is rema-rkable in the field of Macro dynamics. It is a new
event in growth economics. In it

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AY Income the changes in consumption, investment are analysed and their
adjustments are explained. In short, Macro dynamics state that how economy has
reached from one equilibrium point to other.
Fig (3) explains Macro Dynamics. In Primarily equilibrium situation income is OY.
When investment I increases by Al, income increases by AY and equilibrium
income Y shifts to Yr Now the question is, how total income Y shifts to Y1 level. In
the figure C + I curve is primary total expenditure. It is total of consumption and
Fig*3 investment expenditure. When investment is incrased by Al then total
expenditure curve C + I shifts upward to C +1 + Al and income expenditure
equilibrium changes from M to M r Macro dynamic equilibrium is shown by the line
joining points MNPQRSTM r

DEFECTS AND LIMITATIONS OF MACRO DYNAMICS

(1) Fallacy of Composition : Summation of individual units behaviour does not
indicate total economic behaviour. If it is supposed so it will create confusion
because it is not necessary that whatever is true for individual unit may be true for
the whole economy. For example :
Savings of Individual and Society : Savings is virtue for an individual but when all
people will start saving their money then it will be curse, because larger saving will
cause reduction in the demands of consumer goods which will result continuous
decrease in production, employment and income.
(2) Apprehension of Bank deposit: If one individual withdraws money from the
bank, there is no problem. But if all depositors start withdrawing the money banks
will fail.
(3) Paradox of Quantity of Money : It is good to increase quantity of money for an
individual but if there is increase in money in circulation in the economy will cause
inflation which is not feasible.
(4) Individual Unit is Ignored : Macro economics pays attention to the economy as
a whole and ignores the individual units and small groups which are crucial in
constructing an economy.

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(5) Difficulties in Measure of Aggregates: In the formation of economic groups are
used which are of different nature and their unit of measurement are also different.
For e.g. 2 quintals wheat and 2 meter clothes cannot be added. We use money as a
measure of value to know their prices but the value of money is always changing.
Therefore, it is difficult to measure aggregates.
(6) Aggregate Variables need not be Significant: It is also possible that aggregate
variables which make an economy are significant. For e.g. National Income is the
total of individual incomes. But increase in National Income does not always mean
that every individual's income has increased. It may be possible that due to increase
in the incomes of rich people National income has increased which is not so much
important from the point of economy.
(7) Not Practical : Whole analysis of macro economics only creates theoretical
models which have less practical benefit in policy making.

SIGNIFICANCE OF MACRO ECONOMICS

(1) Importance in Complex Economy: When individual units combine an economy
is formed, therefore, the economic behaviour of those units affect the whole
economy. In order to understand on economy it is essential to study and analyse
various economic units individually.
(2) Importance in Economic Policy Formulation : General economic analysis
helps in formulation of feasible economic policies. According to Boulding,
"Macro Economics is very important from the point of view of economic policy
because the economic policy of the government is not only for an individual but for
the whole economy. In fact from the economic point of view state is a group of
individuals, therefore, they should be studied from general point of view."
(3) Study of Economic Development: Macro economics study economic
development and evaluate the resources and capacities for economic development of
an economy. Then the planning for growth in National Income, output and
employment are made and implemented.

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(4) Analysis of Monetary Problem: Macro economics helps in analysing the
monetary problems. The fluctuations in value of money have adverse effect on the
economy which can be controlled through monetary policy, fiscal policy.
(5) Keynes Theory of Employment: Keynes Theory of Employment is macro
economics which states that deficiency in aggregate demand causes unemployment
in the country. In order to remove unemployment it is necessary to increase total
consumption and total expenditure. Macro economics is important as it studies the
causes, effects and measures of general unemployment.
(6) Useful for Micro Economics Study : Whatever economic principles are
propounded in the micro economics are tested with the help of macro economics.
For e.g. Law of Diminishing Marginal Utility was established only when it has been
tested through group behaviours of different people.

MUTUAL DEPENDENCE OF MICRO AND MACRO ECONOMICS

Micro and Macro economic analysis are not mutually contradictory but they are
complementary to each other. It is fallacy to understand them independent of each
other. There are many situations in any economy when :
(a) micro economic analysis are needed for macro economic analysis.
(b) In order to understand Micro economic problems macro economic analysis are
required.
(1) Need of Micro Economic Analysis in Macro Economic Analysis:
(1) If an economist wants to study whole economy then he will have to study
individual firms, families and industries because it is not possible to get full
information without understanding the forms of individual units.
(ii) When we plan for the whole economy then we will have to take into
consideration individual firms and industries. When Planning Commission in India
prepares Five Year Plan for the whole nation it takes into account of the aims of
various departments and organisations.

(2) Macro Analysis is helpful in understanding Micro Economic Problems :

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(i) Individual seller increases his stock only when he sees increasing general
employment, demand and prices.
(ii) A firm takes decision about the wages of its labourers. It is a problem of micro
analysis but while deciding this firm will also take into consideration the wage rates
of other firms and National wage policy. Therefore, in order to solve micro problem;
macro economics help is required.
(iii) If a firm determines the price of its product it has to pay attention to prices of
the products of other firms.
(iv) If a firm determines its output quantity then it keeps in view the aggregate
demand and employment situation in the economy.
(3) Non-existence of mutual independence between Micro and Macro
Economics : In spite of above mentioned mutual dependence, there are many
economic problems which are not applicable to individuals and many individual
problems which are not applicable to the whole economy. For example, Savings is a
virtue from an individual point of view but if all individuals of the nation start
saving then it will be curse for the economy. In full employment economy, firm can
increase its production by luring the factors of production of other firms, but whole
industry cannot do it. An individual country's import may be more or less of its
export but when whole world is taken into consideration all country's exports are
equal to all country's import. There are so many examples which show that whatever
is right for an individual may not be justified for the whole economy. So it can be
said that micro and macro economics are not interdependent, separate study of both
is essential.
Conclusion : Therefore, it can be concluded that there should be proper co-
ordination between micro and macro economics. There is not strong demarcation
between the two. Both should come under the general theory of economy. So it can
be said that both are complementry to each other. According to Samuelson, "In fact,
Micro and Macro economics are not contradictory. Both are very essential. You are
half educated if you understand one and are ignorant of the other."

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MAJOR MACRO ECONOMIC ISSUES or WHY A SEPARATE STUDY OF
MACRO ECONOMICS ?
Now the question arises why a separate study of aggregates of the economy ? Is it
not possible that through those formulated laws of Economics which state the
bahaviours of individual units will explain total consumption, total savings, total
investment and the behaviour of aggregates of the whole economy ? Is it not
possible that by adding, multiplying or taking out averages of conclusions of
individual firms we can get the variables of macro economics like total national
income, total employment, price level. It can be said that no its not possible because
whatever is right for an individual may not be right for the whole group. It may
create confusions.
Macro economics as a special branch of economics is required because :
(a) To understand working of an economy : Some complex economic problems
like inflation, imbalance in Balance of Payment, overpopulation can not be solved
through individually. There economic policy can be formulated through macro
economics.
(b) Growth and Development: The evaluation of resources and capacities of any
economy is done on the basis of macro economics. The planning and
implementation of total increase in National income, employment and output are
done so that the level of economic development of the whole economy can increase.
Economic Growth should not be achieved by excessive exploitation of natural
resources and pollution because it will hamper the productive capacity of future
generation. Sustainable Development is an emerging problem of macro economics.
(3) In National Income : In order to evaluate National income, study of Macro
Economics is essential. After the Great Depression of 1930 it is necessary to analyse
the reasons of general over production and general unemployment. Assessment of
National Income helps in guessing economic activities and distribution of income.
(4) Business Cycle: Economic activities are always fluctuating which is a macro
event covering all units of the economy. Sometimes it becomes global phenomenon
like the Great Depression of 1930. In reality the cyclical movement is a great macro
economic problem for which government has to formulate such policies which help

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in minimizing the effects of business cycles and the pace of economic growth can be
stabilized.
(5) In Monetary Problems : Macro economics help in analysing and understanding
monetary problems. The changes in supply of money, inflation, deflation have
adverse effects on the economy as a whole. It can be checked through monetary
policy, fiscal policy and direct actions. Exchange rate is a parameter which affects
the whole level of economic activities. Favourable exchange rate is good sign of
increase in the value of domestic currency.
It can be concluded that if we want to understand the working of the whole economy
then a separate and specific macro economic analysis is required.

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 NATIONAL INCOME ACCOUNTING
We know that macro economics is related with the study of production, aggregate
income, employment etc. The problem of macro economics is evaluation of
aggregate output of goods and services. Therefore, it is essential for students of
economics to study National Income Accounts and methods of preparing those
accounts.

MEANING OF NATIONAL INCOME ACCOUNTS

Every country keeps the systematic accounts of its national income is known as
National Income Accounts. National Income Accounts is like a commercial accounts
which have double entries system. Systematic accounts of National Income's data
related to (i) Production, (ii) Distribution, (iii) Consumption is called National
Income Accounts.
For e.g. Data of production and income, Indian agriculture, industry manufacturing,
transport, banking and expenditure on private consumption, investment, government
expenditure, net export are called National Income Accounts and in India it is called
National Account Statistics.

NATIONAL INCOME ACCOUNTING OR SOCIAL ACCOUNTING

National Income accounting refers to such statistical accounting which expresses the
income output and social and political arithmetic in such a way that interrelation
between the various sectors of economy are easily understood.
In this National Income Accounting method data of various economic units and
sectors are expressed in Metrics form which helps in understanding the
interdependence of various sectors. It studies the flow process of economy. It studies
the factor service's contributions in production process as 'Inflow' and it explains
how income reaches from producers to factors in the form of wages, interest, rent
and profit under 'Outflow'. In other words, National Accounting measure the level of
economic activities on the one side and it clears the interrelations of various
economic activities like production, consumption and investment.
Some important defintions of Nation Income Accounting are as follows.

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Franc John says, "National Income Accounting is that method through which
aggregate economic activities are understood and measured."
According to Paul Studenski, "National Income Accounting Analysis is a method of
determining complex nature, quantity and interrelations of financial activities."
In other words, "National Income Accounting presents the statistical explanation of
economic activities of various sectors and informs about their interrelations and
provides the structure of their analysis."

CHARACTERISTICS OF NATIONAL INCOME ACCOUNTING

(1) Division of Transactions : National Income Accounting studies only productive
activities like : production sector, family sector, government sector and rest world
sector.
(2) Double Entry System : Accounts for various sectors are prepared on the basis of
Double Entry System.
(3) Establishment of Accounting Relations : On the basis of Accounts of various
sectors accounting relations are established.
(4) Analysis of Interrelations: On the basis of interrelations of the works of various
sectors analysis is done.
Other Characteristics
1. It provides a framework for analysis of an economy on the basis of interrelations
and flows.
2. It is a method of determining the nature, quantity and interrelations of complex
financial transactions.
3. It includes only those transactions which are related to the flows of goods and
services in current year.

Difference between National Income and National Income Accounts

National Income
1. National Income is the measurement of the money value of goods and services
produced in a country during a year.
2. National income is the indicator of National's prosperity.

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3. National income measures the present achievement of an economy. It ignores the
interrelations of various sectors.
National Income Accounts
1. National Income Accounts is table and statistical statement of National Income.
2. National Income Accounts states about the completed works of various sectors of
the economy.
3. National Income Accounts states and analyse the interrelations of various sectors
of an economy.

GROWTH OF NATIONAL INCOME ACCOUNTS

National Income Accounts emerged in 17 th Century. Sir William Petty in his book
"Political Arithmetic" (1676) had mentioned that "National Income of a country is
the sum of the prices of the production by labour."
Sir Gregoryning King is called the Father of National Income. He had prepared the
expected per capita income, expenditure and savings for every social and economic
class.
Although during 18th and 19th century attempts were made to correctly define
National Income in England, France and other countries but only during 20 th century
scientific development of National Income Accounts took place in European
countries.
Simon Kuznets, for the first time during Second World War developed National
Income Accounting System in a proper way. After the end of Second World War
this system started developing rapidly. In 1947 U.S.A, England,
Australia, Canada, Ireland, Netherland have developed and started using Interrelated
National Income Accounting System in a large scale.
Till 1960 U.N.O. developed such National Income Accounting System which is very
much helpful in comparative study of economic activities of various country quite
easily. This is known as 'Standard National Accounts System (SNAS)'

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GROWTH OF NATIONAL ACCOUNTS SYSTEM IN INDIA
Although in our country many attempts had been made before Independence to
estimate the National Income and per capita income but the methodical approach on
the government level started only after 1947. In 1949 the government constituted a
National Income Committee. In 1950 the government established 'National Sample
Survey Organisation (NSSO)'. This organisation had been given task of collecting
data of National Income and per capita income. One "Central Statistical
Organisation" was also established. This organisation is publishing 'White Paper on
National Income' every year which is also known as National Accounts Statistics.

CLASSIFICATION OF NATIONAL INCOME ACCOUNTS

National Income Accounts classify an economy into the following sectors :
(1) Production Sector: It includes all those individuals and organisations which are
engaged in productive activities. They are known as 'firm sector'. This sector gets
factor services from household sector and produces goods and services. Main
function of this sector is production.
(2) Household Sector Accounts : Household sector is that sector which sells its
services to factors of production viz. land, capital, loan and labour. It creates income
in the form of rent, interest, wages and profits through which it purchases goods and
services from production sector.
(3) Government Sector Accounts: Government sector is that sector which includes
sales and purchase by the government. Government sector works as producers and
consumers both. When the government sector purchases the services of factors like
education, health, internal and external security for aggregate consumption it is
called production sector.
(4) Rest of the World Sector: This sector includes the transactions with other
countries. Net factor income and exports to foreign country and import from foreign
nations are included in this sector.
(5) Capital Sector Account: This sector includes savings from all sectors and
investments done in all sectors. In Capital Sector Account savings of household

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sector, government sector, producer sector along with domestic savings and foreign
investments are included.

IMPORTANCE OF NATIONAL INCOME ACCOUNTING

National Income Accounting of a nation reflects the present condition of the
economy and presents an analysis format for improving the economic health. The
importance of National Income Accounting are as follows :
(1) Significant in Transaction Classification: Innumerable transactions are found
in economic activities of a country which are related to payment and incomes from
sale and purchase, payment of taxes from import and export. Social Accounting is a
broader term than national income accounting and it classifies various transaction in
an appropriate way and presents them in a consolidated form and we get information
of National Income, expenditure, savings, consumption expenditure, production
expenditure, government expenditure, foreign payments, foreign earnings separately.
(2) Importance in Understanding Economic Structure : Social Accounting help
in understanding economic structure. It does not gives information regarding
National Income only but it also provides information regarding shape and
dependence of consumption, production, taxation, level of savings, dependence on
foreign trade of the economy.
(3) Knowledge of Interrelationship of Different Sectors : It helps in knowing the
interrelations of different sectors. It also helps in the evaluation ol relative
contributions of production sector, financial sector in the rest of the world's
economy.
(4) Comparative study: Social Accounting helps in comparative study of various
countries and future of upcoming events related to economic conditions. The
progress or downfall of economy is seen in social accounting. We can know the long
run path of the economy.
(5) Significance for Trade Unions: National Income Accounting is very important
for Trade Unions. It gives information about the contribution of labour in National
Income and what share of National Income is given as payment to labour and
employees.

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(6) Measure of Economic Growth : National Income is symbol of the level of
economic development and welfare of an economy. It is helpful in determination of
the trend of production, consumption and capital formation during a particular time
period. It is helpful in measuring and comparing the levels of economic activities in
two different time-periods.
(7) Helpful in Economic Planning: It is very helpful in economic planning. It
provides information to Planning Commission about the quantity of factors of
production available for plan period, what aims should be determined for various
sectors, what should be the size of plan, what should be the rate of growth, which
sector should be given priority etc.
(8) Record of Basic Economic Activities: National Income Accounting makes it
possible to keep the records of basic economic activities like production,
consumption and capital formation of the economy.
(9) Knowledge of Structural Changes : National Income Statistics provides
information regarding structural changes and distribution of income, pattern of
consumption and standard of living of people.
(10) Importance for Researchers: Social Accounting helps the researchers by
providing the information regarding the data collection for study and analysis of
economic activities.
In short National Income or Social Accounting is indicator of economic activities
and an important tool of economic planning.

DIFFICULTIES OF SOCIAL OR NATIONAL INCOME ACCOUNTING

The difficulties in Social or National Income Accounting are :
(1) Difficulty in Measurement: When National Income Accounting is done then all
types of incomes and payments are measured in terms of money, but there are so
many goods and services which cannot be measured in terms of money like the
services of housewives done for their family members, teaching of own children by
a teacher etc. are economic transaction but not marketed, their values cannot be
ascertained in monetary terms create difficulty in preparing social accounting.

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(2) Double Counting : The major problem in social accounting is double counting
because the difference between intermediate and final good is relative. good is
intermediary or final depends on its use. For e.g. cloth is intermediary good for
Readymade factory but for the consumer it is final good. Similarly flour s
intermediary good for a Bakery but it is final good for the consumer.
(3) Capital Depreciation : The depreciation cost of capital goods is estimated in
monetary term and subtracted from the production. Now the question is how can
depreciation of a capital good be estimated. For e.g. if a capital good's estimated age
is 60 years then it will be very difficult to find its current depreciation value. Along
with it if capital good's price goes on changing every year then it will be more
difficult.
(4) Public Services : One more problem is regarding the calculation of public
services. These services include police, army, health, education etc. Similarly, it is
very difficult to include the contributions of multipurpose river valley projects
because it is. very difficult to measure the various benefits of such project in
monetary terms.
(5) Inventory Adjustment: In National Income Accounting there is need of
evaluation of inventories, correct inventory adjustment is required which is very
difficult. Firms register their inventories according to principal cost not according to
their substitution cost. In reality when prices rise then there is profit in inventory
price but when prices fall then there is loss in inventory price. It is very difficult to
adjust these changes in inventories.
(6) Incomplete Accounts: National Income Accounting does not take into account
of transfer of capital, sale and purchase of old goods, gifts from foreign aid and
grants etc.
(7) Other Difficulties : One practical difficulty in National Income Accounting is
the reliability of data because data found from government sector, production sector
and household sector are not reliable and their interrelations are not properly
analysed.

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 CONCEPT OF GDP AND NATIONAL INCOME
In order to understand the levels of economic activities of an economy, the concepts
of Gross Domestic Product and National Income are very important.
GROSS DOMESTIC PRODUCT (GDP)
Gross Domestic Product is the market value of all final goods and services produced
in the domestic territory of a country during an accounting year. It can be defined as
Gross Value Added by all units of production under domestic territory during an
accounting year.
In order to understand the concept of GDP we will have to understand following
three concepts :
(1) Value Addition
(2) Final Goods
(3) Domestic Territory.
1. Value Addition : While calculating GDP we include the value addition by a firm
not its production price. Value addition means at every stage of production how
much price is increased by firm. In short, when some inputs changed into output it is
called value addition.
For e.g. suppose that one firm purchase flour of? 2,400 and makes bread of it and
sells it at ? 3,200. In such a situation
Value Addition Price of breads - Price of flour
=
800 = ' 3,200 2,400
So the value addition is the difference between production price and intermediary
goods. Therefore,
Value Addition = Cost of production - Intermediary Consumption Expenditure
Therefore, value addition or production are same thing. Therefore GDP can be
defined as :
"Gross Domestic Product is the sum total of the values of the final goods and
services produced within the domestic territory of a country during an accouting
year."

20
2. Final Goods : The goods which are purchased by consumers for consumption and
by producers for investment are known as final goods. These goods are not further
manufactured or sold. For e.g. Bread, butter or biscuits.
Any good is final or intermediary. It depends upon its use. For e.g. Milk may be
intermediary good for a sweet maker but it is final good for any family.
Intermediate goods are not included in calculation of National Income. Only the
value of final goods are added in National Income. The reason is very clear that the
price of intermediate goods is included are the price of find good. If the intermediate
goods prices are included then the problem of double counting will arise.
The Principal Difference between Final and Intermediate Goods
Intermediate Goods
These goods are used as raw materials for producing other goods. These goods are
resold for earning profit.
These goods are not ready for final consumption.
These goods are not included in the estimation of National Income.
Final Goods
1. These goods are not used as raw materials.
2. These goods are not resold for earning profits.
3. These goods are ready for final consumption.
4. These goods are included in the estimation of National Income.
3. Domestic Territory : The concept of domestic territory are different from the
concept of geographical boundaries. Domestic territory includes :
(a) Political boundaries including water boundaries.
(b) Ships and aviation by nation in different countries. For e.g. Air India aeroplanes
connecting different countries.
(c) Fishermen's boat, oil and natural gas, machinery and equipments installed in
oceans for drilling and production.
(d) Embassies, commercial embassies and army camps in different countries but
embassies of other countries situated in India are not included in domestic territory.
Therefore, in domestic territory we include political area, territorial ocean, airways
and water boats of fishermen and embassies in other countries.

21
It has to be noted that when the production of goods and services has been described
as market price of final goods, then Gross Domestic Product is written as Gross
Domestic Product at Market price or GDP Mp.

Now the various concepts of Gross Domestic Product and National Income are:
(i) Gross Domestic Product at Market Price
(ii) Net Domestic Product (hi) Gross National Product
(iv) Net National Product at Market Price
(v) National Income or National Income at Factor cost
(vi) Personal Income
(vii) Disposable Income
(viii) Gross Domestic Product at Factor Cost (GDP FC) or Gross Domestic Income
(ix) Gross National Product at Factor Cost (GNP rc) or Gross National Income (GNI).

I. GROSS DOMESTIC PRODUCT AT MARKET PRICE (GDP^)

Gross Domestic Product is the monetary price of all goods and services produced
during a year.
Production is a continuous process in various areas of an economy in which sugar,
clothes, steel, insecticides, wheats etc. goods and government publication, insurance,
transport etc. services are being manufactured. The sum total of the market prices of
various goods and services is called Gross Domestic Product.
Example 1: Suppose there are three commodities in an economy: Wheat, Sugar and
Iron, In year 2016-17 the production of these three commodities are respectively
2,000 quintal, 1,000 quintal and 3,000 Ton. The prices of these three commodities
are ? 300, ? 500, and ? 700. Then GDP will be calculated in the following way:
Table I: Gross Domestic Product (Year 2016-17)
Commodity Quantity (Units) Price Per Unit in ? Gross Money Price
1. Wheat 2,000 300 6,00,000
2. Sugar 1,000 500 5,00,000
3. Iron 3,000 700 21,00,000
G.D.P. 32,00,000

22
It is clear that GDP of the economy is ? 32,00,000
But in reality in an economy thousand types of goods and services are there whose
gross market price can be known in the above way.
Since it is calculated on market price it is called GDP at market price. Formula
GDPMP =
P(0)P(S)
Where P - Price unit, O = goods, S = Services
In Gross Domestic Product the production of private and public sector both are
included. It can be represented as :
GDPMP = Cp + Cg + Ip + Ig
Where
Cp = The production of goods and services in the private sector Cg = The production
of goods and services in the public sector (government sector)
Ip = The production of goods and services in the private sector
Ig = The production of goods and services in public or government sector

II. NET DOMESTIC PRODUCT AT MARKET PRICE (NDP^)

It is common experience that during production of capital goods like machines,
equipments, instruments, tractors, buildings of factories depreciate. After a certain
time period these capital goods have to be substituted, therefore, a part of total
production has to be kept separate for depreciation. Therefore we get Net Domestic
Product at Market price after subtracting the depreciation from Gross Domestic
Product at market price.
Formula :

23
 CONCEPT OF CIRCULAR FLOW OF INCOME
Real Flow Circular flow of income is very important to understand the structure and
measurement of National Income.
CONCEPT OF CIRCULAR FLOW OF INCOME
Production is possible through the mutual co-operation of various factors of
production. The persons engaged in production get reward as the owner of the
factors of production. For e.g. : Rent for land, wages for labour, interest to capital
and profit to entrepreneur. On the other hand, firms produce goods and services
through these factors of production.
Owners of factors of production not only the supplier of factors but they themselves
are consumers also. Therefore, the income accrued to factors of production are spent
on consumption. In this way business firms get income through the sale of goods
and services, and which they again spend on factors of production to reproduce.
In this way flow of income is circular. Due to flow of goods and services under
production process income is generated. Production generates income, income
generates expenditure and that expenditure leads to production and production
generates income.
In this way under production process the explanation of generated income can be
explained as circular flow of income. For e.g.
Production -» Income -» Expenditure -> Production -> Income
In this way the continuous flow of income and expenditure is called circular flow of
Income. It has neither beginning nor end.
R.G. Lipse has defined it, "The circular flow of income is the flow of payments and
receipts between domestic firms and domestic hold."
PRINCIPLES OR REASONS OF CIRCULAR FLOW OF INCOME
The circular flow of income is based on the following two principles :
(1) In any exchange process, the seller or producer gets that much money which
consumer or purchaser spends i.e. the amount spent by purchaser and received by
sellers are equal.

24
(2) Goods and services from sellers to purchasers flow in one direction but the
money payments for these goods and services flow in opposite direction, i.e. from
purchasers to sellers.
The flow of income is shown in the following chart:
ORIGIN OF INCOME FLOW AND ITS CHANGING NATURE
In the initial stage of economic development production process was easy but
gradually with economic development complex division of labour, development of
financial organisations, interference of state and problems of international trade have
increase the economic complexities. The interrelationship between various factors of
production have given birth to circular flow of income. Generally, income is earned
in money form therefore, Income Flow and Money Flow are the same.
(1) Real Goods Flow: Real Goods Flow is prevalent in a traditional economy. In
goods flow, goods and services are exchanged mutually and use of money is not
present.
Real goods flow means that the flow of services of factors of production from the
domestic sector (Family) is towards firms or productive sector and the flow of goods
produced by firms is towards domestic sector. The Real Goods flow is shown in
above Fig. 1.
Fig. 1. shows that the factors of production like labour and capital, enterprise and
land are provided by domestic sector to production sector. Therefore, the flow of
factors of production is from domestic sector to productive sector. Firms produce
goods and services from these factors of production. Firms provide goods and
services to the domestic sector for factors of production. Therefore the flow of goods
and services are from firms to family.
(2) Money Flow - Two Sector Economy: Money is used in every economy. In this
way in the circular flow of economic activities other flow is also there which is
called money or income flow. These days domestic sector does not exchange goods
or services in barter system but they get money for the factors of production and use
this money to purchase goods and service.
Money flow means that flow in which factors of production get interest, profit,
wages and rent for their services in the form of money given by firms to them. Thus

25
the flow of money is from firms to domestic sectors. On the contrary, by firms in the
form of prices of produced goods and services with the help of factors of production
i.e. in the form of consumption expenditure, money flows from domestic sectors to
firms.
It is clear from the Figure 2.
(i) Domestic sector provides factors of production like land, labour, capital to firms
and for firms provides them income in the form of rent, wage and interest. It is an
aspect of money flow.
(ii) The income recieved by domestic sector is again spent on purchase of goods and
services of firms. In this way the income earned by domestic sector again returns to
firms. It is the another aspect of money flow.
In this way in an econ-
omy flow of money from domestic sector to firms and from firms to domestic sector
is called Money or Income flow.
Money flow is continuous till domestic sector spends its whole income on purchase
of goods and services and the firms whatever get returns the domestic sector for their
services.
It is explained in the following Table I which is based on the assumption that the
amount paid to factors of production will be equal to present production price and
domestic sector spends its whole income on the purchase of produced goods and
services.
Table I
Production , Total Income, Total Expenditure (In ?)
Total Production Income of Factors of Domestic Expenditure
GNP Production GNE
GNI
5,000 1,500 Wage 3,500 Expd. on goods
1,000 Interest 1,500 Expd. on
services
750 Rent
1,750 Profit

26
5,000 5,000 5,000
It is clear from the above table :
(i) GNP of one year is ? 5,000
(ii) From GNP wage is ? 1,500, interest ? 1,000 and rent is ? 750 and remaining ?
1,750 is the profit. Therefore, the income of domestic sector is also ? 5,000 (GNI).
(iii) Since domestic sector spends its whole income on purchase of goods and
services. Therefore, annual expenditure (GNE) of domestic sector is also ? 5,000
which firms will get again as sale receipts.
Therefore, it is clear from income flow that GNP, GNI and GNE of an economy are
equal. It is shown in the Figure 3.
Assumptions :
Above model is based on some assumptions :
(i) People spend their whole income, savings and investment is zero.
(ii) Firms spend their income on payment of factors of production.
(iii) There is no existence of the government.
(iv) Goods and services are neither exported nor imported. There is complete
absence of foreign trade. Now we try to make the model more useful by removing
the assumptions one by one.
(3) Inclusion of Savings and Investment and Income Flow or Two Sector Model
In general, family and "firm save a part of their income, this saving is kept by taking
out money from money flow. It shrinks the money flow. Therefore, savings is a
leakage in money flow.
Now this saving is not kept but becomes available in capital market for advancing
loans. Industrial firms takes loan from capital market for investment. Investment is
exact opposite of savings. Savings shrinks money flow but investment expands. If
savings of families and firms returns into money flow in the form of investment of
firms then the stability of money flow is maintained and the stability of price and
economic activity is also maintained.
In other words, till the savings and investment in the capital market are equal, the
circular flow of money keeps on going without any hindrance.

27
Therefore, in a simple two sector model the condition of equilibrium is the condition
of stability in the economy i.e.
S = I Saving = Investment
According to Fig 4. :
(i) The savings from (family) domestic sector comes to capital market, similarly, the
savings of business sector also come to capital market through various financial
institutions.
(ii) In this way business firms take loans from the savings of capital market. In this
way, savings flows from capital market to business firms.
In a free capitalistic economy investment is done by firms and industries. Savings is
mainly done by households and there is no guarantee that savings will be always
equal to investment. Therefore, it is certain that there is certainty of fluctuations in
income, employment and production.
(a) Suppose I < S then money flow will reduce in the economy. Therefore, the
demand for final goods will reduce and prices will fall.
(b) If I > S then it is possible that if past saving is included in money flow or new
money comes into circulation then money flow will increase and demand for
commodities will increase and prices will rise.
Conditions for the steady or Constant level of Income. Flow is that investment
should be equal to savings.
/. The equilibrium condition
S= IorC + S = C + I
Where, S = Saving
C = Consumption I = Investment (4) Three Sector Circular Flow Model
Now suppose that there are three sectors in an economy, i.e., Family, Firm and the
Government. In this model the government activities influences income flow.
Government activities is distributed in two parts i.e., Government Revenue and
Government Income.
(a) Government Revenue: Government gets revenue from various sources. The
main source of government revenue is tax. There are two main sources of revenue :
(i) Personal Tax (Tx)

28
(ii) Corporation Tax (Ta) or Taxes on firms.
Total revenue accrued to the government through taxes are shown as : T = T, + T
1 a
(b) Government Expenditure : Government spends income earned through taxes
can be divided in four parts :
(i) People of domestic sector like government administration, army etc. who provide
their services and Government gives them return (Gx).
(ii) When Government purchases goods produced by firms, then it pays to producers
(G2).
(iii) Government gives domestic sector as old age pension, unemployment
allowance, scholarships in the form of Transfer payments (G 3).
(iv) For industrial development and growth in production, government provides
subsidy (G4). Therefore, total expenditure of the government is expressed by the
following formula :
G = G1 + G2 + G, + G4 If (a) If Tax revenue (T) and Government expenditure G are
equal, i.e., T = G then the budget will be balanced.
(b) If Tax revenue is greater than Government expenditure, i.e., T > G then it will be
surplus budget. It will slow the income flow and Government sector will save and
this savings will come in market.
(c) If the Tax revenue is less than the government expenditure, i.e., T < G then it will
be deficit budget. In such a situation Government has to take loan from the capital
market. It will affect income flow positively.
In a three sector economy, the circular flow of income is shown in the following
Figure 5 :
Fig. 5: Three Sector Circular Flow Model It is clear from the above figure that in an
economy :
(a) Firms pay to domestic sectors for their factor services and domestic sectors pay
for purchased goods and services.
(b) Savings of Household sector is deposited in capital sector from there they are
invested in firms.

29
(c) Government gets revenue from taxes on to Household sectors and firms.
Government pays this income back to domestic sector and firms by purchasing their
goods and services.
(d) If Government saves it comes to capital market and in the situation of deficit,
government borrows from the capital market.
(e) Government gives subsidies to firms as a result of which money flows towards
firms.
(f) Government pays old age pensions as transfer payments which causes money
flow from Government sector to domestic sector.
In this way income flow continues in three sector economy.
Conditions of Equilibrium : Since in three sector economy government revenue
and expenditure also increases, therefore, the condition of equilibrium will be :
C+S+T=C+I+G
Where C = Consumption, S = Saving, T = Tax revenue, I = Investment, G =
Government expenditure
(5) Fourth Sector Circular Flow Model
We have studied upto now about a closed economy in which there is no export and
import from rest of the world. Now we analyse open economy. Therefore, one other
sector Foreign or Rest of the world sector circular flow is included. Nowadays
economy is an open economy.
These economies import and export some goods. When an economy pays for the
import from rest of the world then money inflow is from the economy to the rest of
the world. On the other hand, when a country exports to rest of the world then other
countries pay that country. In this way, the money inflow is from the rest of the
world to this country. These exports and imports in the country are done by
producing firms with rest of the world. Sometimes government also import and
export goods. The circular flow of money in an open economy is shown in fig 6.
It is clear from the Fig 6 that in an open economy due to contact with rest of the
world some more connections of income flow are added which causes expansion of
circular flow of income.

30
It is clear from the figure that four sector economy other than family, firm and
government transactions, this country transacts with rest of the world sector also.
Therefore, there are five pillars of income flow of an open economy :
(i) Household Sector (Domestic Sector)
(ii) Business Firm
(iii) Government Sector
(iv) Rest of the world Sector
(v) Capital Market
When, Rest of the world sector is included then export and import will also affect
circular flow of income. Due to import there is leakage in circular flow of income
and in export in injects money in circular flow of money. Therefore :
(1) If exports are equal to imports then circular flow of money is equal.
(2) If income from exports are greater than expenditure on imports then circular flow
of money will increase.
(3) On the contrary, if income earned from exports are less than expenditure on
imports then circular flow of money will decrease.
In this way, it is clear that the portion of income which reaches foreign country
while paying for imports, that again inflows in the economy in the form of export
income.
Y = Income, C = Consumption Expenditure, I = Investment Expenditure, G =
Government Expenditure, (X - M) = Net Export
IMPORTANCE OF WITHDRAWALS AND INJECTIONS IN THE
CIRCULAR FLOW OF INCOME
In order to maintain the equilibrium in circular flow of income withdrawals and
injections has great importance. In order to study its importance, it is necessary to
study withdrawals and injections of income.
(1) Withdrawals of Income : Withdrawals means that income which is saved and
not sent back to income flow. If factors of production does not spend their income
on produced goods and services of the country then it is called withdrawals of
income. Similarly, the firms earn income by selling goods and services, do not spend

31
them on purchasing the services of factors of production and keep with them as
undistributed profit then it is also leakage or withdrawals of income.
In the words of Lipsey, 'Withdrawal of income is that part of income which is not
spend back in circular flow of income.'
Withdrawals have contracting effect on National Income.
(2) Injection of Income : 'Injection of income is increase in the income which is
done in other way from outside circular flow.'
For example: If firms pay factors of production through bank loans then it will be
called injection to income because in such a situation firms are not using income
from circular flow to purchase extra services of factors of production.
Injection have expansion effect on National Income. Injections = Withdrawals
For equilibrium in the economy injection and withdrawals should be equal.
The main sources of injection and withdrawals are :
(1) Two Sector Economy
Withdrawal = Savings (S) Injection = Investment (I)
(2) Three Sector Economy
Withdrawal = Savings + Tax
Injection = Investment + Government Expenditure
(3) Four Sector Economy
Withdrawal = Savings + Tax (T) + Import (M)
Injection = Investment I + Govt. Expenditure (G) + Export Therefore, the condition
of equilibrium in four Sector economy will be :
C+S+T+M=C+I+G+X
IMPORTANCE OF CIRCULAR INCOME FLOWS
From economic analysis point of view circular flow of income is very important,
which is clear from the following points :
(i) Estimation of National Income : In estimation of National Income Study of
circular flow of money is very important.
(ii) Knowledge of Working of Economy: It indicates whether economy is working
smoothly or not.

32
(iii) Importance of Monetary Policy: From the point of bringing equality between
saving and investment circular flow of income clarifies the importance of monetary
policy.
(iv) Importance of Fiscal Policy : It indicates the importance of fiscal policies to
maintain the equilibrium in the economy through circular flow of income.
(v) Study of Problem of imbalance: Circular flow of income studies the causes of
imbalances and their remedies.
(vi) Theory of Income and Employment propounded.
(vii) It is a basis of international commercial policies.
(viii) It indicates triple identity of production, income and expenditure. Circular flow
indicates:
Production = Income = Expenditure
(ix) Other Importance:
(a) Many concepts like GDP, GNP, NNP and NI and the relations among them can
be easily analysed.
(b) By analysing circular flow we can develop National Income identities and can
develop models on the basis of identities.
(c) In an open economy net flow from foreign sector throws light on foreign
exchange situation.
LIMITATIONS, SHORTCOMINGS OR CRITICISMS OF CIRCULAR
FLOW OF MONEY
The circular flow of income model has three limitations which are important for
developed and underdeveloped nations. They are following :
(1) Mutual Transactions: When various firms transact productive goods among
themselves without using money then it is out of the circular flow of income and
definitely it is difficult to know the Monetary value of income. Therefore, by
including that, it is difficult to know the circular flow of income.
(2) Non-Monetary Transactions: In some areas of underdeveloped countries
money is not used in some transactions. In such a situation the circular flow of
income has no importance because it is not affected by non-monetary transactions.

33
(3) Goods for Self-consumption : Some portion of production which is used for
self-consumption is also out of circular flow of income.

IMPORTANT ECONOMIC IDENTITIES

Important Identities related to National Product
Circular flow of income indicates how goods and services are flowing among
various sectors only but it also indicates the identities among the various concepts,
which are as follow : Important Identities of Two Sector Model
(1) Gross National Product (GNP) or National Income (Y) can be written as various
components of Aggregate Demand i.e. Consumption Demand (C) and Investment
demand (I)._
(2) Second Important Identity (Saving) : GNP is the payment to various factors of
production which will be their consumption income or disposable income.
Therefore, one part is consumed and the rest will be saved.
...(2)
GNP or Y = C + S
Conclusion from identity (1) and (2) is
C + I=Y = C + S
...(3)
Left side of Identity (3) indicates the components of demand and right side indicates
the distribution of income.
This identity expresses the fact that Y = C + I on the one side and on the other it
indicates Y = C + S
By adjusting the Identity (3) we can find the relation between Investment and Saving
by subtracting C from both sides of Identity (3), we can get...(4)
Therefore in a two sector model I and S are mutual identities which express that
savings is equal to investment.

34
NATIONAL INCOME : DEFINITION, MEASUREMENT AND
AGGREGATES
In the history of economic thoughts the concept of National Income is very old.
Adam Smith had presented important views in Wealth of Nation but he has not
presented any clear definitions or concept in the context of National Income or
National Dividend. The concept of National Income is developed during 20th
century.
National Income means "the sum total of the prices of goods and services produced
during a year."
DEFINITIONS OF NATIONAL INCOME
(1) Definitions by Neo-classical Economists: It includes the definitions of Prof.
Marshall, Pigou and Fisher.
(2) Modern Definitions : It includes definitions of Prof. Simon Kuznets,
Samuelson, Bowley and Robertson, Paul Students.

(I) Definitions by Neo-classical Economists:

"The labour and capital of the country, acting on its natural resources, produce
annually a certain net aggregate of commodities material and immaterial, including
services of all kinds. This is the true net annual income or revenue or national
dividend of the country."

Characteristics of Definition of Marshall

1. National Income is accounted on annual basis.
2. Depreciation should be subtracted from total production.
3. Net income from abroad should be added.
4. Those service should not be included in National Income which he does free of
cost for his family and friends.
5. Similarly dividend from personal property and general property should not be
included. In short:
Net National Income : (Annual production of goods and services + Net income
from foreign investment-Cost of raw material-Depreciation)

35
Criticisms of Marshall's Definition
Although Marshall's definition is simple and broad but there are some practical
difficulties which are as follows:
1. Problems of Correct Estimation : It is very difficult to assess the various
producers and consumer goods and their varieties.
2. Fear of Double Counting: Marshall is of the view that there is fear of double
counting in assessment of National Income. For e.g. one portion of agriculture
produce he keeps for his family and the goods whose monetary value
is difficult to assess. Therefore, correct counting of National Income is not possible.
Pigou's Definition : Pigou included only those goods and services in accounting of
National Income which can be measured in money. In this way Pigou's definition is
different from Marshall's definition. According to Pigou 'National Income is that
part of the objective income of a community including income earned in foreign
countries, which can be measured in money.'
is difficult to assess. Therefore, correct counting of National Income is not possible.
Pigou's Definition : Pigou included only those goods and services in accounting of
National Income which can be measured in money. In this way Pigou's definition is
different from Marshall's definition. According to Pigou 'National Income is that
part of the objective income of a community including income earned in foreign
countries, which can be measured in money.'
NI = Monetary Income + Income from Foreign Investment
Characteristics of Pigou's Definition: Pigou's has stressed on two points in the
definition of National Income :
(i) Income from Foreign Investment: Except the output of the country income
from investment in foreign countries has to be included in National Income.
(ii) Measuring Rod of Money : Only those goods and services should be included
in National Income which can be measured in money.
Criticisms of Pigou's Definition: Prof. Pigou's definition is criticised on the
following grounds:

36
(i) Narrow and Paradoxical : Prof. Pigeu's view are very narrow and paradoxical.
For e.g. if a person pays ? 100/month to his maid for her services, then the services
of that maid will be included in National Income because the price of service is paid
in money. If that person marries with that maid then his service will not be included
in National Income because she is not getting any payment in money form. Now it is
clear that the services of maid are the same but sometimes it is included in National
Income or sometimes not.
(ii) Applicable to only Monetary Economy: This definition is applicable only in
monetary economy but where barter system prevails, there is no place for this
definition. According to Fisher:
"The national dividend or income constitutes solely of services as received by
ultimate consumers whether from their material or from human environment."
Clearing the concept of consumption Fisher said "In this way piano or overcoal
which is made for me this year, is not the income of this year but that is increase in
capital. Only those services, which I get from the use of these commodities is annual
income.
Explanation of the Definition
Fisher's definition is made clear through this example. Suppose a motor car is
prepared worth Rs 10,000 in 2017. Now according to Marshall and Pigou, whole Rs
10,000 will be included in the National Income of 2017 but Prof. Fisher does not
include Rs 10,000 in National Income of 2017. According to him only the used
value of motor car should be included in National Income of 2017. Suppose the life
of motor car is 10 years, then in National Income of 2017 only Rs 1,000 should be
added not Rs 10,000.

Characteristics of Fisher's Definition :

(i) Fisher has presented the definition of National Income on the basis of
'consumption', but Marshall and Pigou has made production on the basis of National
Income.
(ii) Fisher's definition is more closer to 'economic welfare' because consumption is
directly related with welfare. Welfare is not increased only with production.
(iii) Fisher's definition is scientific and reasonable.

37
Criticisms : Fisher's definition is more scientific than Marshall because according to
Fisher only value consumption goods included in National Income but there are
many defects in it from practical point of view.
(i) Wider Scope for Consumption : It is very difficult to know the total quantity of
consumption because the area of net consumption is greater than the area of net
production goods produced by a person is used by thousands of persons of the
society.
(ii) Durable Consumer's Goods : It is difficult to assess the life span of durable
goods because life of any good depends on the care and way of using the
commodity.
(iii) Transfer of Goods: Goods can be transferred. Durable goods purchased by
initial owner may be sold to second or third person. Then it becomes difficult to
know the manufacturing date.
Which is Suitable Definition ?
Although all three definitions have their own merits and demerits. But if one had to
say the best among the three then its answer can be given in the context of its
objectives that National dividend is used for which purpose. While calculating
National income if our aim is to assess economic welfare for some years, then
Fisher's definition is the best because according to Fisher National Income includes
only those goods and services which are used by residents of a nation on a particular
year. Fisher's definition is more useful in such a situation when we have to know
that one country gets war goods for some years, for that it is necessary to know how
much goods can be saved and how much can be consumed.
But our aim is to know during peace time which causes are affecting economic
welfare. Then Marshall's and Pigou's definitions will be more appropriate because
economic welfare is associated with total consumption.

38
(II) Modern Definitions:
Some modern economists have denned National Income in the following way :
(1) National Income Committee defined : "A national income estimate measures
the volume of commodities and services turned out during a given period counted
without duplication."
Criticism : This definition is very broad so it is very difficult to measure National
Income practically.
(2) Simon Kuznets : "National Income is the net output of commodities and
services flowing during the year from the country's productive system into the hands
of ultimate consumers or into net additions to the countryTstock of capital goods."
Criticism : This definition is not practical because it is difficult to know that how
much part of net production is transferred to stock and how much is consumed.
(3) Samuelson : "This (National Income) is a name which we give to the monetary
measurement in annual speed of goods and services in an economy."
We can conclude on the basis of above definitions that:
'National income of a country is generally the sum total of goods and services
produced in a country from which the depreciation is subtracted and net income
from abroad is added.'
It is clear from the definition that:
(i) NI is the income of a definite period or one year of country.
(ii) It is the money value of goods and services.
(iii) Depreciation is subtracted from it.
(iv) Net foreign income from abroad is added in it.
In this way from the National Income of a country consumption expenditure (C),
total investment expenditure (I), Government expenditure (G) and Net foreign
income from abroad (X - M) is added and Depreciation (D) is subtracted.
It has been said earlier that production creates circular flow of income, expenditure
and economic activities. Production creates income, income creates expenditure and
expenditure creates production. In this way National Income of a country can be
measured in three alternative methods :
(a) In the form of goods and services flow.

39
(b) In the form of income flow.
(c) In the form of expenditure flow.
The three methods of measuring NI is shown below :
National Income

It Expenditure

National Income (C) Expenditure Method

Fig.l
In Fig. (A) NI is shown in the flow of goods and services i.e. this flow expresses that
how much net increase has taken place in various productive areas of economy. This
method of measuring income is called value added or product method.
In Fig (B) NI is shown as flow of expenditure viz. It shows that how various sectors
consume NI. This flow divided economy in two sectors : Household and firm. This
method is called expenditure method.
Now, it is clear that NI accounting is done at three levels : (i) Productive level, (ii)
Income level, (iii) Expenditure level.
Now it is clear that there are three methods of measuring NI :
(i) Value Added Method or Product Method.
(ii) Income Method or Factor Income in the Production.
(iii) Expenditure Method.
(iv) Fourth method is by combining production method and income method is
Production Accounting and Income Accounting System.
(v) Social Accounting Method.
(I) PRODUCT METHOD OR VALUE ADDED METHOD According to this
method the sum total of prices of goods and serives produced in a country is called
NI. Production does not mean Census of producers but Net production.
Net Production is found after subtracting the depreciation from Total Production.
For e.g. If grain worth ?160 is produced 160 and its substitution cost is ?50. Then
Net production will be ?110.
According to Prof. Shoop this total is also called Final Production Total. Since in
this method the flow of goods and services is counted. Therefore, this method is

40
called 'Flow of Goods and Services Methods'. This accounting process is the total of
income of various groups. Therefore it is called National Income by Industrial
Origin.
Definition : Product Method or Value Added Method is that method which
estimates the contribution of every factor of production is domestic territory during
an accounting year and measures National Income.
Steps in Estimating National Income through production or value added
method :
First Step : Identification and classification productive enterprises. It is classified in
3 sectors.
(i) Primary Sector : It includes agriculture, forestry, fishery, dairy etc.
(ii) Secondary Sector: It includes manufacturing, electricity, water, gas etc.
(iii) Tertiary Sector : Transport, Telecommunication, trade, public administration,
bank, insurance are included in this sector.
In every sector production is multiplied by its price to get production price. In other
words, in product method or value added method prices of all final goods and
services are calculated. This Money value is called Gross National Product. Since it
is calculated at market price it is called GNP at Market price.
Suppose production in Agriculture, Industry and Service sector are 400, 300, 200
units. Whose market value is ?30, ?24, ?15 per unit then GNP will be calculated in
the following way:
Table I: Gross National Product
Explanation Quantity Price Price
1. Money value of Total 400 30 12,000
Product in Agriculture
2. Money Value of 300 24 7,200
Total Product in Industry
3. Money Value of Total 200 15 3,000
Product in Service Sector
GNP at market Price Rs 22,200
SBPD Publications Economics

41
Formula,
GDPMp = P(Q)xP(S)
Where, P = Per Unit Market Price
Q = Material Goods
S = Services Second Step: Measurement of Value of output: There are two methods :
(i) Final Product Method
(ii) Value Added Method.
(i) Final Product Method: In GNP all final goods and services are included. Final
goods are those which consumers pruchase for their final consumption. In order to
find the value of final goods and services we subtract the prices of intermediary
goods and services.
Example 1: Bread is the final good sold to the consumer. Suppose its price is Rs
3600, only this price will be included in National product. In order to prepare bread
suppose the price of used wheat is Rs 1,600, price of maida is Rs 2,400 and the price
of bread made by bakery is Rs 3,200 i.e. X 1,600 + 2,400 + 3,200 = Rs 7,200 in the
price of intermediary goods which will be deducted from the price of total product
(1,600 + 2,400 + 3,200 + 3,600 = Rs 10,800)
.'. The price of Final Product = Total Product Price - Price of Intermediary Goods
i.e. 3,600 = 10,800 - 7,200
(ii) Value Added Method : The other method of Product method is value added
method. In this method every firm increases the prices due to production process.
The total of its value indicates National product. Value added means at every stage
of production how much value is added to the price of good by every firm.
Value added method is that method which measures the contribution of every
producer in domestic territory.
Example 2.
Table II: Value-Added Approach
Stage of Production Value of Cost of Value Added
Output Intermediate
1. Wheat 1,600 — 1,600
2. Wheat Flour (Maida) 2,400 1,600 800

42
3. Bread (Bakery) 3,200 2,400 800
4. Scale of Bread 3,600 3,200 400
Total 10,800 7,200 3,600
It is clear from the above table that:
(a) Farmer has not to spend while producing wheat, he works himself and there is no
expenditure on seed and fertilizer, so he kept the price ?1600 for wheat.

43
 NATIONAL INCOME AND ECONOMIC WELFARE
RELATIONSHIP BETWEEN NATIONAL INCOME AND ECONOMIC
WELFARE
We have studied that National Income or National Product is the monetary value of
those goods and services which are produced in an economy during a year. The flow
of goods and services becomes the basis of present consumption and future
production. Generally, it is believed that welfare of people depends on their
consumption level. Therefore, it is said that as National income increases, people's
consumption also increases and there welfare also increases but the relation between
National Income and economic welfare is not so simple. Therefore, we will have to
study in detail.
WHAT IS ECONOMIC WELFARE ? Pigou has accepted money as a base and
divided total welfare in two parts : (i) Economic welfare (ii) Non-economic welfare.
According to Pigou, "Economic Welfare, is that part of social welfare, that can be
brought directly or indirectly into relation with the measuring rod of money."
Therefore, only one part of social welfare is called economic welfare. It is that part
which can be related to money in any form. Rest part of the social welfare, which
cannot be measured with money is called non-economic welfare. Happiness, feeling
of love etc. are examples of non-economic welfare. But in many situations it is
difficult to say which welfare is economic or which one is non-economic.
DEFFERENT APPROACHES REGARDING RELATIONSHIP BETWEEN
NATIONAL INCOME AND ECONOMIC WELFARE
National Income and Economic Welfare are closely related. This relation will be
discussed under following different approaches :
(i) Prof. Pigou's Approach, (2) Prof. Keynes' Approach, (4) Prof. Samuelson's
Approach, (3) Nodals & Tobin's Approach, (4) Index of Overseas Development
Committee.
(1) Pigou's Approach : Prof. Pigou in his book 'Economic Welfare' has studied the
relation between National Income and Economic Welfare under following heads:
(a) Change in magnitude of National Income and Economic Welfare.
(b) Change in distribution of National Income and Economic Welfare.

44
(c) Stability of National Income and Economic Welfare.
(a) Change in Magnitude of National Income and Economic Welfare: Generally,
'Change in magnitude of National Income and Economic welfare has direct relation
i.e., if GNP increases then it means that economic welfare of the country is
increasing. Increase in National Income means that available quantity of goods and
services has increased and when it happens, it has good effect on economic welfare.
On the contrary, when the size of National Income reduces then the quantity of
consumption goods and services decreases and thereby economic welfare
diminishes. But Prof. Pigou is of the view that 'It is not necessary that increase in
National Income is always accompanied with increase in economic welfare. It can
decrease instead of increasing i.e., it has some exceptions also. The reason due to
which economic welfare does not increase with the increase in National Income are
following :
(i) Proportion of Poor : Economic welfare will increase only when with the
increase in National Income the income of poor will not decrease.
(ii) Good Changes in Tastes: If people spend their increased income on good things
the economic welfare will increase, but if the increased income is spend on drugs,
gambling etc. then economic welfare will decrease.
(iii) Mode of Production: If National Income increases due to improvement in
techniques of production or new invention then economic welfare will increase. If
National Income is increased by increasing the working hours and by appointing
women and children for work then the sacrifice of leisure and contentment will
reduce economic welfare.
(iv) Composition of Production : Economic welfare will increase when per capita
income of the people is high and population is stable.
(v) Proper Utilization of Natural Resources: When natural resources of a country
are used judiciously and economically then economic welfare increases. On the
contrary, if natural resources are wasted then economic welfare decreases.
(vi) Increase in Prices : If National income means Monetary National Income at
current price then it is not the right indicator of economic welfare. Its reason is that
economic welfare is related with the quantity of goods and services not with the

45
changes in monetary price which is possible due to changes in current prices when
prices rise without the increase in quantities of goods and services will not increase
economic welfare.
(b) Change in Distribution of National Income and Economic Welfare: Change
in distribution of National Income means transfer of income from a particular class
of people to the people of other classes. In the society, generally there are two
clases:
(i) Rich class, (ii) Poor class.
Therefore, there will be two directions of distribution of income :
(a) Transfer of income from Rich to Poor.
(b) Transfer of income from Poor to rich.
If income is transferred in favour of poor, the equality in the distribution of income
will increase, and if it is in favour of rich inequality in distribution of income will
increase.
How National Income is redistributed in favour of poor ?
National Income redistribution in the favour of poor can be done in the following
ways:
(i) Directly it can be done through taking some purchasing power from rich and
transferred them to poor.
(ii) Indirectly there will be two methods of transferring purchasing power.
(a) Production pattern should be rectified in such a way that commodities consumed
by poor become cheaper and the commodities consumed by rich become costly. The
result will be majority of poor of the country will get more satisfaction with having
more goods from their income.
(b) Through rationing or other measures rich are forced not to consume the goods
consumed by poor. It will lead more availability of goods and services for the
consumption by poor and this will increase economic welfare.
(i) Economic welfare depends on that part of income which is used for consumption,
not on the whole income. Therefore, the portion of income of rich which are not
used for consumption should be given to poor who are deprived of necessary
consumption due to low income, will increase economic welfare.

46
(ii) According to Prof. Pigou : It is said on the basis of Diminishing Marginal
Utility that if same portion of income of rich are taken then the loss in economic
welfare is less than the welfare which poor get through that income.
(iii) Lack of Training : Due to lack of training poor people will not get more
satisfaction from increased income.
Above logics are not very important because it will lead more exploitation of poor
people by rich. It is true that poor people live in such environment that their
behaviour and interests can not be changed drastically but environment can be
changed.
Good education, employment opportunities and other facilities which leads more
production, will create a new hope in poor. Gradually they will modify their
behaviour, adopt good morals and their education will teach them how they will get
maximum satisfaction from their increased income.
(c) Stability of NI and Economic Welfare : Economic welfare of the country
depends on stability of National Income. When National Income changes frequently,
then economic welfare decreases because the years when income increases people
become extravagant and when the income is less people spend less. In this way it is
clear that stability of National Income increases economic welfare because from
long term point of view people have same income.
According to Prof. Pigou, "The reason which make less changeable the
consumption of the society, increases the welfare subject to no change in National
Income and distribution of income should not be against poor."
Here important point is that it is not essential that all the components of National
Income should have same fluctuations. If the fluctuations are more in poor's income
then it will be reason for loss of economic welfare. Reason being that the effect of
working oflaw of diminishing marginal utility is more for poor than rich.
So it is clear that any reason which reduces the instability of that National Income
which accrue to poor class, although it increases the Changeability of that portion
accrued to rich, increases the economic welfare, Ceteris Paribus.

47
(2) Keynesian Approach: Famous Economist of 20th Century Prof. J. M. Keynes
has propounded the Modern Theory of Employment in his book, 'The General
Theory of Employment, Interest and Money' 1936.
According to Lord Keynes, In a capitalist developed economy full employment
situation is not a normal situation. In reality, unemployment is found in every
economy. Therefore, unemployment can be removed only through government
interference.
Keynes has based his Employment Theory on the quantity of National Income.
"Increase in National Income increases economic welfare by increasing employment
and on the contrary when National Income falls, economic welfare decreases by fall
in employment and production."
(3) Prof Samuelson's Approach: Prof. P. A. Samuelson in his new article (Net
Economic Welfare—NEW) propounded a new concept of Net Economic Welfare.
According to him National Income is not the satisfactory measurement of economic
welfare. He is of the opinion that in order to know the correct measure of economic
welfare we have to adjust some additions and subtraction in GNP.
The items which are added in GNP:
(i) The price of satisfaction gained during leisure hours because this satisfaction is
equal to the satisfaction gained through consumption of goods and services.
(ii) Non-marketed Personal Services like services of housewives. Items to be
subtracted from GNP:
(i) Due to production of modern industries air, water and noise pollution is created, it
hampers the economic welfare.
(ii) Wasteful and non-profitable expenditure like expenditure on maintenance of law
and order, defence are called Regrettable costs but economists have taken them as
Regrettable Necessities which does not increase economic welfare.
In short, Gross National Product and Net Economic Welfare can be stated
as :
Real GNP - Depreciation + Value of Leisure + Non-Marketed Activities -
Environmental Pollution + Regrettable costs = Net Economic Welfare

48
This concept is considered more apt because neither value of leisure is not included
in GNP and nor air or water pollution, crime and inconvenience due to urbanization
is subtracted. Due to difficulty in measurement this concept has not been
popularized.
4. Nodal & Tobin's Approach : William Nodal and James Tobin has presented the
view (Measure of Economic welfare) MEW. According to this view economic
welfare depends not on the level of production but on the level of consumption.
Higher the level of consumption in one year higher will be the economic welfare.
In order to measure Net Economic Welfare Nodal & Tobin have recommended some
items to add and some to subtract which are :
(a) The items to be subtracted from consumption are :
(i) In public sector expenditure on army, security, police, roads and bridges repair.
(ii) Expenditure on durable goods like T. V., scooter, furniture etc.
(iii) Social costs of pollution and polluted atmosphere.
(b) The items to added in consumption are :
(i) Monetary value of annual satisfaction from durable goods.
(ii) Expected price of products for self-consumption.
(iii) Estimated price of satisfaction from rest.
But it is difficult to collect information of consumption and it is also difficult to
measure loss and profit from atmosphere in terms of money.
WHICH IS THE BEST MEASURE OF ECONOMIC WELFARE ?
Most of the economist of the view that inspite of so many limitations, till now
National Income concept is the satisfactory measure of National Income. According
to Prof. R. G. Lipsey :
"Whatever changes there may be in future in the measures of economic welfare they
can not fully replace Gross National Product."

49
NATIONAL INCOME AT CURRENT PRICES AND CONSTAT PRICES :
NOMINAL AND REAL INCOME AND LIMITATION OF GDP CONCEPT
National Income can be estimated in the following two ways :
1. National Income at Current Price : While estimating NI, produced goods and
services are multiplied with their price. Therefore,
NI = Price x Goods and Services
If National Product is multiplied with current price then it is called NI at current
price. Current price means the price of that year whose NI is estimated. For e.g., if
we are estimating NI of 2016-17 then we should take in account current price of
2016-17. Therefore when GDP is estimated on the basis of current price then it is
called GDP at current price.
Since market prices are changeable, NI can increase or decrease at current price
although the production of goods and services remain the same. If prices rise then NI
also rises at current price. If prices fall then NI falls at current price. Therefore, NI at
current price is not the real indicator of real progress of the country because with the
rise in price NI increases without the increase in real production and with the fall in
price NI decreases without the fall in real production.
2. Real National Income or National Income at Constant Price :
Constant price means any given price or prices of any given year. For e.g., When
India's NI was estimated on the basis of fixed price of 2004-05. Therefore when
GDP is estimated at a fixed price in a given year is called GDP at fixed price.
When fixed price is used then National Income is called real and the changes which
occur in NI is due to change in production, not due to change in prices. Therefore in
order to know real increase or decrease in NI it should be estimated on fixed prices.
Example : Suppose 3 goods wheat, cotton and sugar are produced in an economy
which is shown in an imaginary Table-I for year 2010-15.
(i) When Price Index of current year is less than the price index of base year and
production of goods and services remains the same.
(ii) When the production of current year is less than the base year but price index
remains the same :

50
DIFFERENCE BETWEEN NI AT CURRENT PRICE AND NI AT
CONSTANT PRICE
NI at Current Prices
1. NI at current price is the sum total of the prices of produced final goods and
services in a year.
2. Increase in NI at current price is called monetary increase.
3. Increase in NI at current price may be due to increase in production and price.
4. Increase in NI at current price is not the indicator of economic growth
NI at Constant Prices
1. NI at constant price is the sum total of the base year prices of final goods and
services produced in a year.
2. Increase in NI at fixed price is called real increase.
3. Increase in NI at fixed price may be only due to increase in production.
4. Increase in NI at fixed price is the indicator of economic growth.
IMPORTANCE OF NI AT CONSTANT PRICE
The importance of NI at constant price are as follows :
1. NI at constant price is more correct measure of economic development and real
development capacity of a country.
2. With the help of NI at fixed price we can measure the changes in the production
of goods and services year by year.
3.NI at fixed price is more useful in comparing the economic achievements of
various countries.
GNP DEFLATOR
GNP Deflator measures the average price of all those goods and services, by adding
which GNP is estimated. It can be calculated through this formula :
GNP Deflator =
Nominal GNP Real GNP
xlOO
LIMITATIONS OF GDP CONCEPT
To evaluate the economic activities of any economy. GDP is the most prevalent
measure. High level of economic activities of any economy is its high level GDP

51
which shows the high flow of goods and services. Other things remaining the same,
increase in the flow of goods and services indicates that people's economic welfare
is increasing. Still the concept of GDP has many limitations. Some of them are as
follows :
1. Non-Market Services: Some non-economic activities increase welfare but are not
included in NI estimation. Services of housewives, religious functions etc. affect the
welfare of people but not included in GNP.
2. Leisure : Leisure is an important factor to influence social welfare, but it is not
included in GNP. For e.g. More or less leisure enjoyed by people affects the total
production of the economy. But it is not included in GNP.
3. Nature of Production : In NI estimation different satisfaction level achieved by
different goods are not reflected. For e.g. expenditure on one Atom bomb or dam
constructed over a river increases NI in equal way but they provide satisfaction to
the society differently. Bomb does not increases welfare but dam increases.
4. Change in Consumption : Due to increase in income, consumption should
increase towards well-being then welfare will increase otherwise not. For e.g, If new
libraries (without fee) are established then interest for learning will increase. On the
contrary, if liquour houses are opened then bad habit will increase. In the first
situation with increase NI, economic welfare will increase but it will decrease in
second case.
5. Quality of Life: In GNP estimation quality of life is not included which indicates
social welfare. For e.g., The life in crowded city are full of stress, which cause
wastage of time, leads accidents, creates pollution thereby decreases social welfare.
But all these stress of city life are not included in NI. On the other hand, in less
crowded place people enjoy pollution free life in the lap of nature. Here quality of
life improves but it is not reflected in NI.
6. Externalities: Externalities are synonymous to external economies. It means in
present social and economic environment, some consumers have either to pay some
cost unnecessary or some have to enjoy something without any effort. Externalities
are such interdependence which are not exchanged, they can be reciprocal or one-
sided. Externalities also affect welfare both in positive or negative way. One

52
example of externality is getting pleasure of neighbour's garden. The other example
is pollution due to establishment of factory. First example increases the welfare but
other reduces it. These are mutual dependent, cannot be included in NI.
Due to above limitations GNP cannot be used as a measure of economic welfare.
Although some economists have tried to expand the definition of GNP so that
economic welfare can be measured. Some economists have tried this. Prof. Nordhus
and Prof. Tobin have made Measure of Economic Welfare—MEW in 1972 which
Prof. Samuelson says : Net Economic Welfare —NEW.
7. Other Limitations:
(a) Double Counting : There is fear of Double counting of any goods and service in
NI.
(b) Transfer Payment : There is difficulty in including pension, unemployment
allowance in NI.
(c) Public Services: In NI estimation it is very difficult to assess the public services
like police or army services.
Due to above limitations GD as index of economic welfare is a matter of great
concern.

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CONCEPTS OF ACTUAL GDP, POTENTIAL GDP AND AGGREGATE
EXPENDITURE
Actual GDP: Actual GDP shows the real level of production in an economy during
an Accounting year.
In short, through Real GDP we know that how economy is working every year in the
form of goods and services.
Potential GDP : It means that expected level of production of a country when all the
available resources of economy are fully utilized at normal level of utilization. From
factors of production we mean labour and capital etc. and their normal level of
utilization. Normal level means that level where resources are not either overutilized
or underutilized. For e.g., If working hour is decided 8 hours and a labour works
only 7 hours then it will be said that labour is underutilized.
On the contrary, if a labour works more than 8 hours daily then it will be called
overutihzation of the labour-. Potential GDP is also called 'Full employment level of
income' or 'High employment level of income'.
In short, Real or Actual GDP is the measure of a country's total output of a specified
period and potential GDP measures the potential production of the country when all
available resources are utilized at their normal utilization level. GROSS
DOMESTIC PRODUCT GAP OR GDP GAP
Definition : GDP Gap refers to the disparity between an economy actual total output
and its potential total output.
Example : Suppose in any economy Real GDP is ? 440 crore and Potential GDP is ?
425 crore then GDP Gap will be ? 15 crore.
GDP Gap : Positive, Negative and Zero
There will be three positions of GDP Gap
1. Positive Gap: If Real GDP is less than Potential GDP then GDP Gap is positive.
So Positive GDP Gap shows the less utilization of resources.
In such a situation producers produce less than their capacity. Due to less utilization
of production capacity there is less demand of labourers which leads to
unemployment and wages reduce. In short, the Positive Gap creates situation of
'Deflation' in the economy.

54
In the words of Lipsey and Crystal, 'Economic depression which is related with
positive GDP creates the situation of depression in the economy.'
2. Negative Gap: When Real GDP is greater than Potential GDP is called negative
GDP Gap.
Negative GDP Gap = Y > Y* = Excess utilization of resources
When real production is greater than potential production i.e., economy is producing
more than its capacity. It results in the demand pressure on factors of production.
Wages hike and accordingly, per unit cost of production increases. Per unit high cost
of production means high price level. Hike in price level increases wages all the
more. As a result high price level and high wage rates chases each other.
This GDP Gap is called 'Inflationary Gap'. Higher the higher will be the pressure of
inflation.
3. Zero Gap : When Real GDP and Potential GDP are equal then it is zero GDP
Gap.
Zero GDP Gap = Y = Y* = Full utilization of resources
In such a situation Real GDP is equal to Potential GDP. In such a situation the
capacity of economy is neither excessively used nor less used. This is the situation
of full employment. It is an ideal situation.
In the following table Potential Zero Gap and GDP Gap is shown :
In such a situation producers produce less than their capacity. Due to less utilization
of production capacity there is less demand of labourers which leads to
unemployment and wages reduce. In short, the Positive Gap creates situation of
'Deflation' in the economy.
In the words of Lipsey and Crystal, 'Economic depression which is related with
positive GDP creates the situation of depression in the economy.'
2. Negative Gap: When Real GDP is greater than Potential GDP is called negative
GDP Gap.
Negative GDP Gap = Y > Y* = Excess utilization of resources
When real production is greater than potential production i.e., economy is producing
more than its capacity. It results in the demand pressure on factors of production.
Wages hike and accordingly, per unit cost of production increases. Per unit high cost

55
of production means high price level. Hike in price level increases wages all the
more. As a result high price level and high wage rates chases each other.
This GDP Gap is called 'Inflationary Gap'. Higher the higher will be the pressure of
inflation.
3. Zero Gap : When Real GDP and Potential GDP are equal then it is zero GDP
Gap.
Zero GDP Gap = Y = Y* = Full utilization of resources
In such a situation Real GDP is equal to Potential GDP. In such a situation the
capacity of economy is neither excessively used nor less used. This is the situation
of full employment. It is an ideal situation.
In the following table Potential Zero Gap and GDP Gap is shown :
(1) In the above table in year 1 and 2, Negative GDP Gap is shown because
Potential GDP > Actual GDP. This is called Negative Gap or Depression Gap or
Deflationary Gap.
(2) In the year 3 and 4, Real GDP > Potential GDP. It is called 'Inflationary Gap'.
(3) In the year 5, Real GDP = Potential GDP. This is called Zero Gap or Ideal
situation.
While determining GDP we are not concerned with potential GDP but with Real
GDP.
AGGREGATE EXPENDITURE MODEL
A macro economic model presents the short term relations between Total
(Aggregate) expenditure and Real GDP. When it is supposed that prices are stable in
the economy. According to this model in any specific year GDP is determined by
Aggregate expenditure.
In short, In Economics, aggregate expenditure is a measure of National Income.
In this way, according to this theory balanced Real GDP is determined when
Aggregate expenditure and Aggregate output of any economy are equal. There are
two components of Aggregate expenditure in an economy :
(1) Demand for consumer goods which is called consumption demand or
consumption expenditure and

56
(2) Demand for capital goods which is called investment demand or investment
expenditure.
Consumption expenditure includes both private and public expenditure. In an open
economy the prices of imports and exports are also included.
In this way Aggregate expenditure is the sum total of investment, public expenditure
and Net export.
Here Aggregate expenditures of all the four sectors domestic, firms, Government
and the Rest of the world are discussed in determination of GDP.
(1) AE curve is upward sloping which shows that with the increase in GDP,
Aggregate expenditure of economy increases and with the decrease in GDP
Aggregate expenditure decreases.
(ii) Equality of AE and GDP is shown through 45° line. On 45° line is Aggregate
expenditure and Aggregate output is in equilibrium. Since Aggregate output is
perfectly elastic (GDP adjusts itself at every level of Aggregate expenditure).
Aggregate expenditure determines Real GDP.
MODELS RELATING AGGREGATE EXPENDITURES
Two models are related with Aggregate Demand which opines that NI is determined
by Aggregate Expenditure :
(i) Say's Law of Market
(ii) Keynesian theory of Aggregate Expenditure or Effective Demand.

57
 SAY'S LAW OF AGGREGATE EXPENDITURE OR SAY'S LAW OF
MARKET
Famous economist Prof. Jean Baptiste Say in his book 'Traite D' Economie
Politique'had propounded a short law of market. This law is called 'Say's Law of
Market'.
J.B. Say said that, 'Supply creates its own demand' due to which the problems of
overproduction and unemployment do not arise in the economy. If due to certain
reasons like overproduction labourers are removed then demand and supply becomes
equal in the economy.
According to J.B. Say : "It is Production which creates markets for goods. A product
is no sooner created than it, from that instant, affords a market for other products of
the full extent of own value. Nothing is more favourable to the demand of one
product than the supply of another."
In short, according to Say's Law generally, the situation of unemployment and
overproduction cannot be created in the economy because whatever is produced is
certainly consumed.
The summary of Say's Law is :
(1) Supply always creates its own demand.
(2) It is production which creates market for goods.
EXPLANATION OF THE LAW
The above statments means that market creates production. According to this view
main source of demand is the income earned through various factors of production
which emerges through prodution processs. Whenever new process of production is
started certain amount of produce is available and its demand incerases as a result
whatever is produced is automatically sold. According to Say:
"It is production which creates markets for goods".
The working of Say's Law in monetary economy is expressed as follow : It is clear
from the following example that there is production of (Total Aggregate Supply) ^
10 crore in the economy. As a result the incomes of factors of production will
increase by ^ 10 crore. They will spend whole ? 10 crore in purchasing total supply.
In this way demand will increase by 10 crore. Therefore, Aggregate (Total) supply

58
will creates its own demand. Due to Aggregate demand National Income will again
reach to producers and they will produce worth ? 10 crore next year. In this way the
circular flow will continue and there will be no general unemployment or
overproduction.
Working of Say's Law in Monetary Economy Fig.l
REASONS FOR OPERATION OF SAY'S LAW OF MARKET
There are two reasons for operation of Say's Law of Market:
(1) Flexible Rate of Interest: The above logic is based on this concept that all
incomes earned by factor owners are spent on pucrchase of those goods and services
which they have helped in producing. If some portion of their income are not spent
and saved is automatically invested. In this way saving and investment are always
equal. If there is some gap that is automatically adjusted through the rate of interest.
For example, If saving is more then rate of interest reduces. Lower rate of interest
induces more investment on the one hand and on the other discourages more
savings. Rate of interest will go on diminshing till all extra (surplus) savings are
invested. Therefore, surplus savings are automatically invested due to the process of
diminishing rate of interest. In this way the flexibility of rate of interest always
keeps savings and investnent equal.
(2) Flexible wages: Prof. Pigou has presented Say' Law in the context of Labour
Market. According to him this tendency is present in the economic system under free
competition that labour market will provide full employment itself. Due to rigidity
of wage structure and interference in the working system of free market economy
causes unemployment. In this context, here it is essential to mention that classical
economists consider price and wages fully flexible and accept that economy adjusts
itself at the level of full employment. While explaining Employment theory Pigou
based his theory on Say's Law and its working on Labour Market and established
classical view.
Pigou has based his theory on the assumption that if labour is ready to accept wages
equal to his marginal productivity then there will never be unemployment stuation in
the labour market.

59
To prove his conclusion Prof. Pigou has used a mathematical formula which is as
follow :
N = qY/W
where N = No. of working labourers W = Wage rate Y = National Income.
qY = ratio of National Income paid to labour as wages
Pigou is of the opinion that number of workers can always be increased by lowering
the wages. When the price of any good is very low then whole supply of that good
will be sold. Similalry when wage rate is very low all labourers will be employed.
IMPLICATIONS OF SAY'S LAW
or
MAIN POINTS OF SAY'S EMPLOYMENT THEORY
1. Every economy works at its full employment level.
2. Economy has self adjustment capacity. Therefore, whatever is produced is all
consumed.
3. Overproduction is impossible in a country because every surplus production
creates surplus purchasing power in the economy. Therefore Aggregate income is
equal to Aggregate expenditure.
4. Since overproduction is impossible then general unemployment is also
impossible.
5. Flexibility of rate of interest always keeps savings and investment equal.
6. Under perfect competition by cutting wages full employment can be established.
7. The situation of unemployment occurs only when wage rate, rate of interest and
other prices are static and Government and trade unions interfere in free working of
market forces.
Assumptions : The assumptions of this law are :
(1) Perfect Competition : There is perfect competition in labour and product
market.
(2) Tendency towards Full Employment: The tendency of achieving full
employment is always there in a free market economy, i.e. full employment is
general phenomenon.

60
(3) Laissez-Faire Policy : Government does not interfere in working of economic
powers.
(4) Closed Economy : Other assumption of this law is that there is no international
trade in the economy.
(5) Flexibility: The important concept of this Law is that wage rates and rates of
interest are flexible due to which it is possible for the economy to attain automatic
equilibrium.
(6) Limited Role of Money : The role of money in the economy is very limited, i.e.
it works only as a medium of exchange and does not affect original equilibrium of
the economy.
(7) No Hoarding : Other assumption of this law is that all income are automatically
spent on consumption and investment and there is no hoarding of money in the
economy.
(8) Wide Extent of Market: There is possibility of wide extent of market.
(9) Long Period: It is based on the assumption of long term full employment. There
can be overproduction of any good during short run but it will
automatically ends during long run.
The main concept of Say's Law is that 'Supply creates its own demand' practically
does not work in modern economies. As a result there will be no 'general
overproduction' and 'general unemployment' and this proved wrong during 1929-33
Worldwide Great Depression. Keynes has vehemently criticised these concepts in
his book 'General Theory'. Since Classical Theory of Employment is based on Say's
Law so its criticisms are similar to the criticisms of Say's Law.

61
 KEYNESIAN THEORY OF AGGREGATE EXPENDITURE :
EQUILIBRIUM NATIONAL INCOME
Famous economist of 20th Century Lord J.M. Keynes propounded the modern
theory of employment in his book, "The General Theory of Employment, Interest
and Money." According to Lord Keynes, full employment is not a normal situation
in a capitalist developed economy. In reality, every economy has unemployment.
Keynes' Theory came into existence during 1931 Worldwide Depression when
million workers were searching jobs as against the full employment assumptions of
classical economists. Interest rate was at the lowest level but investment was not
rising. That time Keynes analysed the factors which influence employment in
capitalistic economy in his famous book 'General Theory of Employment, Interest
and Money1. Keynes' analysis is a short term analysis.
EXPLANATION OF KEYNESIAN THEORY
Starting Point of Employment: Effective Demand
According to Employment Theory of Keynes in a capitalist economy, total
production or National Income depends on the level of employment because in the
short run other factors of production like capital, technology remains stable. The
level of employment depends on effective demand. Effective demand is that evel of
aggregate demand where it is equal to aggregate supply.
Effective demand means that level of demand in economy for which supply is
available and producers are not ready to increase production i.e., if production . ill
have to be increased then the level of demand will have to be increased. For Suppose
if 1 million people of a country are employed and aggregate supply price is Rs 200/-
Cr. and aggregate demand price for that period is Rs 200 Cr. Then Aggregate
demand will be equal to Aggregate supply. Therefore, Aggregate demand price of
Rs 200 crore is called Aggregate demand. Therefore, it is clean that effective
demand is that level of aggregate demand where it is equal to the aggregate supply.
In other words, effective demand is that point on aggregate demand ! urve where
aggregate price intersects it:
(1) Effective Demand is Representative of Aggregate Production : Since
Effective demand expresses that level of demand of economy whose supply s

62
available. Therefore, effective demand also indicates the price of total production or
value of aggregate output.
Effective Demand = National Production of Value of Aggregate Output
(2) Effective Demand is equal to National Income: The reason is that alue of
aggregate output and the income earned through the sale of products to producers
are the same. Therefore, effective demand is equal to aggregate output alongwith
National Income. Therefore, Effective Demand can be expressed as National Income
or Total income of factors of productions (wages + rent + interest
+ profit) or_
Effective Demand = Value of National Output = National Income
(3) Effective Demand (reflects) the Total Expenditure of Economy:
Income earned by factors of production are spent on purchasing the produced goods
and services of the economy. Therefore, on the one hand the effective demand is
equal to National Expenditure on consumption goods and on the other hand it is
equal to the National Expenditure on capital goods. Therefore, Effective Demand =
National Expenditure or Consumption + Investment = C + I
Effective Demand = National Production = National Income = National Expenditure
(C +1)
i.e. ED = NP = NI = NE
It is clear from the above discussion that:
(i) NI depends on level of employment (N)
Y = /XN)
(ii) Level of Employment (N) depends on Effective Demand (ED)
N = /(ED)
(iii) Effective Demand depends on Aggregate Demand Price and Aggregate Supply
Price :
ED = AD + AS
(iv) When Effective Demand increases employment, production and National
Income increases.
(v) When Effective Demand decreases employment, production and income
decreases.

63
(vi) Effective Demand is equal to the expenditure on purchase of consumer goods
and investment goods.
(vii) It can be said that employment depends on consumption and investment
expenditure.
(viii) If consumption remains constant and investment increases then employment
also increases.
(ix) Contrary to this if investment is stagnant and consumption increases then also
employment increases.
DETERMINANTS OF EMPLOYMENT THEORY
According to Marshall, price is determined by market forces of demand and supply.
But according to Keynes price is determined by the mutual equality of aggregate
demand and aggregate supply. There are two determining factors of Employment
theory of Keynes are :
(a) Aggregate Demand Function (b) Aggregate Supply Function.
(a) Aggregate Demand Function: Total demand of goods and services in an
economy is called Effective or Aggregate Demand. Commodities are demanded for
two purposes: (1) Consumption, (2) Investment Govt, and Household Demand for
consumption. Household's demand for consumer goods is called Private
consumption. Similarly, government's demand of goods and services like cement,
iron, banking, transport, recreation for supplying public goods is known as Public
Consumption. Private and Public consumption jointly creates consumption demand
of goods and services. The other important part of aggregate demand is investment
demand i.e., demand for capital goods. Investment demand is made by both private
and public sectors. The combined investment demand of private and public sector
comprises the total investment demand of the economy. Therefore aggregate
demand is :
Aggregate Demand = Consumption Demand + Investment Demand
When household and government demands goods and services then there IS money
expenditure on them. Therefore, Aggregate demand can be expressed AS Total
expenditure also.

64
Aggregate Demand = Total Expenditure = Consumption Expenditure + Investment
Expenditure.
Aggregate Demand can be understood from other perspective also. We know that
the expenditure of one person becomes income of the other person. On this basis it
can be said that an economy's total expenditure is its total income viz. Total
expenditure is the income of those firms who produce goods and services. Therefore,
in an economy total expenditure can be expressed as the income of the firms.
On the basis of above explanation Aggregate Demand or Aggregate Expenditure is
that amount of receipts of the firms which they get while selling their goods which
they produced with the help of labour.
If firms expect to earn more income then definitely will have to produce more by
employing more people. In this way the expected monetary income schedule got
from the sale of produced goods at different employment level is known as
Aggregate Demand Function. In other words, Aggregate demand or Total income or
Total expenditure increases or decreases according to employment level.
Aggregate Demand Schedule: For example, a schedule of income earned through
sale proceed at different level of employment is prepared i.e. known as Aggregate
Demand Schedule, it is shown in the following table : Table I: Aggregate Demand
Schedule
Level of Employment (in Cr. Expected Sale Proceed or
people) Aggregate Demand (In ? Cr.)
0 30
1 50
2 60
3 70
4 80
5 90
6 95

65
It is clear from the above schedule that:
(i) When employment is zero then also Aggregate demand is ? 30 crore. It means
that there is possibility that unemployed workers still spend ? 30 crore on their
consumption.
(ii) After that as soon as employment increase total expected sale proceeds also
increases. In other words, there is direct relation between employment and expected
sale proceeds or Aggregate demand. Aggregate demand is the function of
Employment level.
Aggregate Demand Curve: When aggregate demand schedule is presented is
presented through curve it is called aggregate demand curve.
In Fig. 1. AD is aggregate demand curve which is starting not from 0 but above 0
which proves that even when employment level is zero, consumption
expenditure is always there.
Aggregate demand curve AD is upward sloping which proves that when
employment increases aggregate demand or expected sale proceeds are also
increasing. In short:
(i) Total of consumption expenditure and investment expenditure is called Aggregate
demand.
(ii) The expenditure of one person is the income of the other therefore, total
expenditure of an economy expresses the aggregate income of the economy.
(iii) Therefore, Aggregate demand is that income obtained from expected ale
proceeds which firms expect to earn after selling the goods produced by labour.
(iv) Expected Income Schedule earned from the sale of product produced at different
levels of employment.
(v) As employment increases expected sale proceeds also increase i.e.
(b) Aggregate Supply Function: Now we discuss the other determinant of Effective
demand i.e. Aggregate Supply Function. In an economy total quantity of goods and
services available for consumption and expenditure is known as Aggregate Supply.
We know that the prices of final goods and services produced in an economy is
known as National Product. Therefore, all goods and services produced in an

66
economy are made available for consumption and investment then National Product
will be equal to National Income.
/. Aggregate Supply = National Product = National Income Income earned through
different factors of production is equal to the cost of production of goods and
services by firms at a definite level of employment.
Firms may maintain that level of employment to earn such income to make
payments of factors of production. In other words, in order to maintain the present
level of employment and production firms must get that minimum income from the
sale of produced goods and services. So, in order to maintain that definite level of
production and employment the required minimum sale proceeds is known as
'Aggregate Supply Price'.
Aggregate Supply Schedule: It shows the relationship between different levels of
employment and minimum sale proceeds :
Table II Aggregate Supply Schedule
Total Employment (InCr.) Total Cost of Production at a
given employment level or Total
Income (? Cr.)
0 0
1 30
2 45
3 60
4 75
5 90
6 105
The above table shows that with the increase in employment, Aggregate supply price
increases.
Aggregate supply curve is the graphical presentation of aggregate supply schedule.
In the figure on X-axis the different levels of employment presented producers are
shown and on the Y-axis the expected incomes at different levels of employment are
shown. Aggregate supply price has positive relation with the level of employment.
When the economy reaches the level of full employment then Aggre-gate Supply

67
becomes inelastic beca-use there is no possibility of increase in production after
attainment of full 1 2 3 4 5 employment. Employment
In short: Fi&2
(i) In an economy the available quantity of goods and services for consumption and
investment is called Aggregate Supply, GNP or National Income.
(ii) The income accrued to various factors of production is equal to the cost of
producing goods and services at certain level of employment.
(iii) Therefore, any firm will desire to get that money after selling the goods and
services which have been spent on producing them by definite number of labour. So,
Aggregate supply price is related with minimum sale proceed.

DETERMINANTS OF EFFECTIVE DEMAND

In Perfect competition situation employment will be determined at that level where
aggregate demand will be equal to aggregate supply. This level is called equilibrium
level or effective demand.
So,
(i) When total expected incomes of entrepreneurs i.e. aggregate demand is greater
than total cost and aggregate supply price, entrepreneurs get encouragement to
increase production and employment.
(ii) When expected sale proceeds are less than total cost then production and
employment decreases.
(iii) When expected sale proceeds or aggregate demand and aggregate supply are
equal then general level of employment is maintained. This is the equihbrium or the
point of effective demand which determines the employment level in the economy.
Determination of employment level is clear from the following table :

68
Table - III: Determination of Effective Demand In Crore ?
Expected Aggregate Aggregate Tendencies of
Employment Demand Supply Employment
Level Function Function
0 30 0 AD> AS
1 50 30 AD> AS
2 60 45 AD > AS
3 70 60 AD>AS
4 80 75 AD > AS
5 90 90 AD = AS
6 95 105 AD < AS
Diagrammatical Presentation of Equilibrium Level of Employment
Pring Fram
N,
Employment Fig. 3
N N2
(i) It is clear from the above table that when employment is zero then AD = ? 30
crores and AS = 0. The rea-son is that unemployed people also spend on
consumption.
(ii) Upto employment level 4 crore AD and AS both are increasing but AD > AS.
Therefore, production will be more and more employment will be there.
(iii) At the employment level of 5 crore AD = AS. This is the equilibrium point of
employment in the economy.
(iv) After the employment level of 5 crore when more labour is employed AD < AS.
Therefore, it is not feasible to employ people
more than 5 crore. It will be possible only when AD > AS.
(i) AS is aggregate supply curve and AD is aggregate demand curve which intersect
each other at point E. Therefore, at ON level of employment E is equilibrium point
of effective demand where revenue equals cost. The equality of AD and AS at E
indicates that at this point the expected income of producer will be highest.

69
(ii) At ONj employment level total receipts i.e. BNt is greater than total cost ANr
Due to more profit, employment level will be increased.
(iii) Similarly, ON2 level of employment is not feasible because here total cost DN 2
> total receipt CN2.
EFFECTIVE DEMAND NOT AT FULL EMPLOYMENT LEVEL It is not
necessary that equilibrium is always at full employment point. Equilibrium between
AD and AS is established before full employment which is said under full
employment equihbrium. Thus Keynes refuted the full employment assumption of
classical economists because according to Keynes unemployment to some extent is
always present in developed countries. Full employment is that last limit after which
increase in effective demand does not increases the level of production and
employment. In Fig (3) ON employment level is at point E of Effective Demand
which is less than full employment level ON 2. In order to get full employment level
aggregate demand has to be increased AD1 level as shown in Figure (3). In the figure
NN2 shows the quantity of unemployment.
According to Keynes deficiency in aggregate demand is the main reason of under
full employment equilibrium. The gap between income and consumption creates
(brings) deficiency in aggregate demand. Increase in income increases consumption
expenditure but in less proportion because Marginal Propensity to Consume is less
than one. If this gap is fulfilled by investment then full employment equilibrium will
be achieved but investment is low due to Marginal Efficiency of Capital. It leads to
underfull employment equilibrium.
RELATIVE IMPORTANCE OF AGGREGATE DEMAND FUNCTION AND
AGGREGATE SUPPLY FUNCTION
Aggregate Demand Function Main determinant of Employment:
Keynes had given more stress, on aggregate demand function than aggregate supply
function. Keynes had assumed fixed aggregate supply in short run. The reason
behind this is that change in aggregate supply depends on the factors like capital,
productivity of labour and technical factors. It is not possible to change these in the
short run. So, in the short run only Aggregate Demand Function can be changed. In
this way Keynes has given full concentration on Aggregate Demand Function and

70
assumed Aggregate Supply Function constant. Aggregate Demand Function is itself
influenced by two factors : 1. Propensity to consume 2. Inducement to invest
1. Consumption Demand and Propensity to Consume : The concept of propensity
to consume is very important in Keynes' Theory of income and employment. The
demand for consumer goods is a part of aggregate demand which depends on the
following two factors :
(i) Size of Income
(ii) The part of income spent on consumption goods.
In short propensity to consume expresses the relationship between aggregate income
and aggregate consumption.
Consumption demand depends upon the propensity to consume. Keynesian analysis
is based on 'Psychological Law of Consumption' which states that when aggregate
income increase total consumption also increases but not in the same extent as
income increases. According to Keynes :
"Generally people increases their consumption with the increase in their income but
this increase in consumption is less than the increase in income."
It is clear from it that with the increase in income consumption lages behind . Two
things can be done to minimize the gap between income and expenditure :
Either Consumption should be increased or Investment should be increased.
It should be noted that in the short run the gap between income and expenditure
cannot be reduced i.e. propensity to consume cannot be increased. Therefore,
Keynes suggested to increase the investment.
2. Investment Function or Inducement to Invest: In Keynes 'General Theory'
investment has great importance. According to Keynes investment always means
'real investment' which provides extra employment to people. Real investment
means establishment of new factories, construction of new buildings, increase in
transport facilities, increase in current capital, increase in stock of goods etc.
Factors influencing investments are :
(i) Marginal Efficiency of Capital (ii) Rate of interest.
(i) Marginal Efficiency of Capital (MEC) : MEC means maximum expected income
from new capital assets after deducting the cost. It indicates two things:

71
(a) We should keep in view the marginal unit or extra unit of capital asset.
(b) Cost of capital asset should be deducted from its expected income. In this way
the marginal productivity of capital depends on two factors :
(a) Expected income of capital asset
(b) Supply price of capital asset
Marginal efficiency of capital is the ratio of expected income of capital asset and
supply price of capital asset.
(ii) Rate of Interest: The second factor influencing the investment is rate of interest.
According to Keynes, 'Interest is the prize of parting with liquidity'. An individual
wants to keep his income in liquid form due to three motives :
(a) Transaction Motive, (b) Precautionary Motive, (c) Speculative Motive.
Keynes said that first two motives are somewhat static but third one is not static
because the habit of speculation depends on the attitude of creditors. According to
Keynes there are two determining factors of rate of interest:
(1) Habit of Speculation
(2) Quantity of Money
MEC and Rate of Interest: It is clear that investment rate is determined by
Marginal Efficiency of Capital and Rate of Interest. An investor while investing
compares the marginal efficiency of capital with rate of interest and investor invests
till marginal efficiency of capital is greater than the rate of interest. Then time comes
when MEC = Rate of interest and there investment stops.
Keynes's view is that the effect of MEC is greater than rate of interest on investment.
The reason of this is that marginal efficiently of capital depends on the attitude of
entrepreneurs. Due to optimism of entrepreneurs MEC increases rapidly then
increasing rate of interest can also not check the entrepreneurs from investing of
more capital.
Therefore, Pro. Keynes said :
"As you can take a horse to water but cannot force him to drink water. Similarly you
can attract entrepreneurs to invest more by lowering the rate of interest but you
cannot force them."

72
Therefore, only by lowering the rate of interest investment cannot be increased
because if hope of profit is low then people will not be ready to invest even if rate of
interest is zero. It means that there is very low possibility of increasing the
investment to fill gap created by depression.
Public Investment or Increase in Public Expenditure
It is clear that in the condition of depression, it is not possible to increase neither
consumption nor private investment to reduce the gap of income and expenditure. In
this situation only the government can do something to reduce depression and
unemployment. Government can spend on public works and thereby can increase
effective demand and employment.
Multiplier Effect: Multiplier effect has very important place in Keynes'
Employment Theory. Keynes believed that increase in investment leads to manyfold
increase in income. The relation of increase in investment and income is called
Multiplier (K) by Keynes.
Suppose : When Rs 1,000 Cr. is invested then income increases to Rs 4,000
4000
Cr. then Multiplier K = 4 - 1000
(Because income is 4 times greater than investment)
The size of K always depends on MPC. When MPC is more, K will be greater and
when MPC is less K will be lesser. In short, K is the derivative of marginal savings
habit.
Formula:
K=
1-MPC
MPS KEYNESIAN THEORY OF EMPLOYMENT SUMMARY
(1) Employment depends on effective demand.
(2) Effective demand is determined by AS and AD
(3) Aggregate Supply Function remains stable in the short run. Therefore, effective
demand is affected by aggregate demand function.
(4) Aggregate Demand Function is itself influenced by consumption and investment
expenditure.

73
(5) Consumption Expenditure is determined by (a) size of income and (b)
Inducement to consume the community.
(6) High consumption habit is very suitable for employment.
(7) Since consumption, expenditure is not 100% there investment is required.
(8) Investment depends on (a) MEC (b) Rate of Interest.
(9) Marginal Efficiency of capital itself is determined.
(a) Supply price of capital asset (b) Prospective yield of the capital.
(10) Rate of Interest is influenced by two factors : (a) Liquidity Preference (b)
Supply of money. Liquidity Preference is determined by three factors : (i)
Transaction Motive
(11) Precautionary Motive (hi) Speculative Motive
(11) The effect of Marginal Efficiency of capital is greater than Rate of Interest on
investment.
(12) Thus, it is clear that if we have to increase employment then consumption and
investment both should be increased.
Keynes General Theory (in Chart) Employment, Production & Income depends
on Effective Demand (depends on)
Aggregates Supply Function (Fixed in short run)
Aggregate Demand Function (depends on)
Fixed in short run
Marginal Efficiency of Capital
Consumption (depends on) Investment (depends on)

Quantity of Propensity to Consume

Income
Rate of Interest
Transaction Motive (Fixed in Short Run)
Future Supply Liquidity Quantity of
Price Preference Money
Income ofCaptial depends on

74
Precautionary Motive
Speculative Motive
Assumptions :
Keynes' Employment Theory is based on following assumptions (i) Keynes'
Employment Theory applies in short run.
(ii) Keynes' Employment Theory is based on the assumption of full employment
(iii) Capitalist Economy is closed economy.
(iv) When more units of labour are employed their marginal productivity goes on
diminishing.
(v) In short run among the factors of production only labour can be increased or
decreased.
(vi) Various economic factors can be co-ordinated without any delay.
(vii) Money is not only medium of exchange but also store of value.
(viii) Imperfect employment equilibrium is a general condition in the economy.
CRITICISMS OF THE KEYNESIAN THEORY
Keynesian Employment Theory had been criticised by many economists like:
Hayek, Nayak, Hazzlit & Lorence. They criticised the theory on the following
grounds:
(1) Perfect Competition: Keynesian economics is based on the unrealistic
assumption of perfect competition but we know in the real world perfect competition
is mere imagination.
(2) Problem of Unemployment: Keynes has not mentioned any full proof remedy
for unemployment. Keynesian Theory only removes cyclical unemployment, but
there are many more types of unemployment in the economy. For e.g., dynamic
unemployment, frictional unemployment etc. Keynesian economics theoretically
failed in solving them.
(3) General Theory : Keynes has named his theory as 'General Theory' but from
many points it is clear that it is a 'specific theory' not a General Theory which is
applicable under static situations in a closed economy under perfect competition.
Not only this, it is applicable only in developed economies not in underdeveloped
economies.

75
(4) Time Lag Ignored: Keynes has not given any weightage to time-lag in his
theory. He assumed that with the increase in income, consumption increases and due
to increased demand, investment increases. In reality, reaction of every economic
action takes some time. Therefore, Keynes theory is termed as the theory which
ignores time-lag.
(5) Short Time Theory : Keynes theory's major drawback is that it is short-run
theory and it concentrates in short-run policies and did not pay any attention on long
term economic development.
(6) One Sided Theory : Keynes assumed supply side fixed and neglected supply
side so it in one-sided theory.
(7) Wrong Concept of Propensity to Consume: Keynes theory is based on wrong
notion that consumption expenditure depends only on present income. According to
Friedman, consumption expenditure does not depend only present income but it also
depends on permanent income.
(8) Investment Function : Keynes stressed only on investment function in
determining employment because he assumed that in the short run marginal
propensity to consume is constant but now it is proved that in the short-run also
increase in marginal prosperity to consume affects unemployment positively.
(9) Rate of Interest: According to Keynes rate of interest is determined by the
process of money and demand and rate of interest is the outcome of the sacrifice of
liquidity preference. Therefore, rate of interest is only a monetary concept. But
according to Prof. Hicks, rate of interest is influenced by monetary and real factors
like scarcity and productivity of capital.
IMPORTANCE OF KEYNESIAN THEORY
Keynesian Employment theory had great influence on economic theory and practice
which are discussed below :
1. Theoretical Significance: Keynes' contribution in developing economic theory
are following:
(1) Keynes has revived the 'macro economics' propounded by Mercantalist
economist.
(2) Keynes has analysed the reasons due to which full employment can be achieved.

76
(3) Keynes has provided many effective tools of economic analysis like : propensity
to consume, propensity to save, investment process, liquidity preference, marginal
efficiency of capital.
(4) Keynes has contributed in development of monetary theory.
(5) Keynes has given a new direction to economic theory by recognising the
importance of investment in determining unemployment.
(6) Keynes helped in making dynamic economic analysis.
2. Practical Significance: The practical significance of Keynesian theory are :
(1) Keynes proved that government interference is not desirable but it is essential
too.
(2) Keynes has given very much importance to fiscal policy for full employment.
(3) Keynes has provided many practical suggestions for deficit financing.
(4) Due to Keynesian economic thought full employment policy has been main
policy of all nations.
(5) Keynes has laid so much stress on National Income, National consumption,
saving and National investment in his Employment theory that in modern age data
related to this fields are collected, published and started being used more and more.
Keynes has proved wrong the assumption of classical economist that full
employment can be achieved by cutting the wage rates.

77
 CONSUMPTION FUNCTION AND PSYCHOLOGICAL LAW OF
CONSUMPTION
It has been explained in Keynes' Employment Theory that level of employment and
income in any economy depends on Effective Demand and determined by Aggregate
Demand Function. In any Two Sector Model Economy Aggregate demand has two
parts :
(a) Consumption and (b) Investment.
We will explain Consumption Function and Psychological Law of Consumption
Function in this chapter.
MEANING OF CONSUMPTION
The part of National Income which is spent on goods and services is called
consumption and which is not consumed is called saving. The addition of
consumption and saving is called Income.
CONSUMPTION FUNCTION
Consumption expenditure depends on many factors like : income, price of the good,
fashion etc. Therefore, it can be said that consumption is the function of many
factors, viz, it depends on many factors.
Therefore, Keynes' opinion was that Aggregate consumption expenditure mainly
depends on income or it can be said that consumption is the function of income.
Definitions
According to Brooman, "Consumption Function shows that expenditure consumers
will wish to make on consumer's goods and services at each possible level of
income."
According to Peterson, "Consumption Function may be defined as a sehedule
showing amount that will be spent for consumer goods and services at different
income levels."
According to Keynes, how much consumption will increase with increase in income
depends on propensity to consume. Similarly, increase in saving with the increase in
income depends on propensity to save.

78
Keynes has used the term propensity to consume for 'Consumption Function'.
Therefore, the relationship between the change in consumption due to change in
income is called 'propensity to consume'.
DEFINITION OF PROPENSITY TO CONSUME
According to Prof. Kurihara, "Consumption (C) represents the amount of
consumer expenditure at a given level of income. Whereas the propensity to
consume C/Y is a schedule of consumption expenditure at a various level of
income."
According to F. S. Brooman, "Consumption Function shows what expenditure
consumers will wish to make on consumer goods and services at each possible level
of income."
Dillard says : "The schedule presenting the different quantities of consumption at
different levels of income is called propensity to consume schedule or in short
propensity to consume."
Schedule of the Propensity to Consume : The distribution which expresses the
functional relationship between total income and consumption expenditure at
various level of income is called "schedule of the propensity to consume". Such
schedule does not expresses the desire to consume only but it also says that what is
consumption at various levels of income or what is possibility of consumption. An
imaginary explanation is given below :
Table I: Propensity to Consume Possible Income Consumption
Income (Y) Consumption (C)
in Cr. ? in Cr. ?
0 200
100 250
200 300
300 350
400 400
500 450
600 500
700 550

79
 800 600
It is clear from the table :
(i) With every increase in income consumption is also increasing.
(ii) When income is zero then also people are spending ? 200 crore on consumption.
For this expenditure people are utilizing their previous saving. It is called Dis-
saving.
(iii) When income increases to ? 400 crores then consumption also increases to ? 400
crores. The point at which level of income and consumption are equal is known as
'Break Even Point.'
(iv) When increases above ? 400 crore then consumption is also increasing but
increase in consumption is less than increase in income. In other words, a part of
increasing income is not consumed, it is saved.
Propensity to Consume Curve or Consumptions curves
(1) AS is Aggregate supply curve which is 45° line expresses positive correlation
between Income (Y) and Consumption (C). As income increases, consumption
expenditure also increases in the same proportion. For e. g. when income is Rs 100
Cr. then consumption is also 100 crore. If income increases to Rs 200 crore then
consumption expenditure also increases to Rs 200 crore. Therefore, this line shows
the equality of Total income (Y) and Total Consumption Expenditure (C). It is an
imaginary line.
(2) CC curve is consumption curve which expresses the real consumption at various
levels. Consumption curve does not start from origin 0 because when income is zero,
as shown in Table I consumption is ? 200 Crore. The curve CC is rising from low to
high which proves that with the rise in income consumption also increases. At point
E income and consumption are equal because consumption curve CC is intersecting
aggregate supply curve AS. It is also called Break Even Point. Left side of point E
consumption curve CC is above aggregate supply curve AS. It shows that
consumption expenditure is greater than income, therefore saving is negative (- S).
Right to CC consumption curve is below the Aggregate supply curve AS which
makes it clear that consumption expenditure is less than income therefore, savings is
positive (+ S).

80
Conclusion : It is clear from the study of Consumption Function that Income /
Employment and consumption are related in the following ways :
(i) Consumption (C) increases with every increase in income (Y).
(ii) Theoretically Income (Y) may be zero but Consumption (C) will be always
positive. It means that even if income is zero, we must spent something on
consumption.
(iii) After a certain level of income, increase in consumption is less than increase in
income. The reason of this is that at higher level of income people start saving some
of part of their income. According to Keynes, this is due to Psychological Law of
Consumption.
FEATURES OF PROPENSITY TO CONSUME
(1) Psychological Concept: It is a psychological concept and affected by many
abstract factors like : fashion, interest, habit etc. These factors are stable in the short
run therefore, propensity to consume is stable in the short run.
(ii) Unequal Propensity to Consume : Propensity to consume of lower income
group is more than higher income group. The reason behind this is that poor people
have lower income so they spent their income on consumption but rich people have
higher income so they save some part of it.
(iii) Income and Employment depends upon Propensity to Consume: If propensity
to consume increases then production has to be increased which will increase
income and employment. On the contrary, if propensity to consume diminishes,
income and employment decreases.
(iv) Short Run Consumption Expenditure : Consumption expenditure in short run
depends on independent consumption expenditure and marginal propensity to
consume. Independent consumption means that consumption which a person has to
undertake in every situation even when income is zero. In short run consumption
expenditure increases less than increase in income.

81
KINDS OR TECHNICAL ATTRIBUTES OF THE CONSUMPTION
FUNCTION
The relationship between income and consumption can be measured in two ways or
Propensity to consume may be of two types :
(1) Average Propensity to Consume
(2) Marginal Propensity to Consume.
(1) Average Propensity to Consume (APC): The part of income which is spent on
consumption is known as Average Propensity to Consume. It is expressed as ratio of
Total Consumption to Total Income. Average Propensity to Consume can be known
for an individual consumer or all consumers. In macro economics it is calculated on
group basis.
Definitions:
Kurihara Defines, "Average propensity to consume is a ratio of consumption
expenditure at a certain level of income."
According to Peterson, "Average Propensity to consume is a ratio of consumption
and income at a certain level of income."
McConnell says, "The part of percentage of total definite income which is being
consumed is known as Average Propensity to Consume."
Income in? Consumption Expenditure in? APC
100 80 =0.8 100

200 120 120

=0.6 200
Diagrammatical Presentation: In the diagram Income is shown on OX axis and
consumption on OY axis. CC is the consumption curve which shows C
that at point S, APC = — = 0.8 and 120
at point T, APC = — = 0.6
As this curve is moving upward average propensity to consume is climinishing.
(2) Marginal Propensity to Consume (MPC) : Increase in consumption due to
small increase in income is known as Marginal Propensity to Consume, i.e., it
consumption in extra income.

82
Definition:
Prof. Keizer, "Marginal Propensity to consume shows the relationship between
increase or decrease in consumption due to increase or decrease in income."\
Peterson Defined, "Marginal Propensity to Consume means induced consumption
expenditure due to change in income."
McConnell says, "That proportion or part of change in income which is consumed is
known as Marginal Propensity to Consume."
j^p£ _ AC (change in consumption = AC' AY Change in income = AY)
For e.g. If income increase from ? 20 crore to ? 40 crore then
AY = 40 - 20 = ? 20 Crore. Due to change in income, consumption increases from ?
16 Crore to 7 24 Crore.
Then AC = 24 - 16 = ? 8 Crore
MPC = —= — =0.4 AY 20
Marginal Propensity to Consume is shown in the following table :
Table-Ill: MPC
Consumpti
Income AY Consumption • AC AC
MPC=-
20 — 16 8
40 40 -20 20 24 24 -16 = 8 = 0.4 20
=
60 60 -40 20 30 30 -24 = 6 4-
=
Diagrammatic Presentation: In the following diagram income is shown on OX
axis and consumption on OY axis. CC is the consumption curve. The Marginal
AC 8
Propensity to Consume from C to S is = — = 0.4
The Concept of
AY 20

83
Importance of Marginal Prope-nsity to Consume
Marginal Propensity to Consume has very much economic value. It states that when
income increases, how much is spent on consumption and how much is saved. It also
decides the quantity of investment.
RELATION BETWEEN MPC AND MPS
The value of marginal propensity to consume lies in between O and 1. It is less than
one and more than zero. It means that increment of income which is not consumed is
saved. Therefore, total of Marginal Propensity to Consume (MPC) and Marginal
Propensity to Save is equal to 1. If of the increase in income is spent on
consumption, then MPS will be =
PSYCHOLOGICAL LAW OF CONSUMPTION
Keynes has presented his Psychological Law of Consumption on the basis of
analysis of consumption activity. This law is the symbol general tendency of people
that when income increases consumption also increases but less than increase in
income. According to Prof. Keynes, 'The fundamental psychological law men are
disposed as a rule and on the average to increase their consumption as their income
increases but not by as the increase in their income."
This law is called propensity to consume.
This law can be stated as :
AC < AY i.e. change in consumption AC is less than AY i.e. Marginal propensity to
consume is always positive but less than unity.
Three Propositions: Prof. Keynes has divided in three prepositions related to
consumption.
(1) Less increase in total consumption than increase in total income:
When total income increases then total consumption also increases but less than
increase in income. The reason is that with the increase in income people's wants are
mostly satisfied. Therefore, there is no need to spend more on consumption.
(2) Distribution of increase in income in consumption and saving:
When income increases then this increase is distributed in a ratio among expenditure
and saving. When increase in expenditure is not equal to increase in income then
surplus income is definitely saved. That is why consumption and saving go jointly.

84
(3) Increase in consumption and saving due to increase in income:
When income increases, consumption and savings be th increase. A normal person
generally spends more on consumption when income increases, because with the
increase in income he wants to enjoy more comforts.
From Table IV we can make clear the above statements :
(i) Income is increasing at the rate of Rs 10 crore at each level but after a certain
point increase in consumption is at diminishing rate.
(ii) In every situation Rs 10 crore increase in income is being divided in some ratio
between consumption and saving. For e.g, when income increases Rs 30 crore to Rs
40 crore then out of increased income of Rs 10 crore Rs 48 crore goes to
consumption and Rs 2 crore in saving.
(iii) As income rises from Rs 30 crore to Rs 40,50 and Rs 60 crore then consumption
also increases from Rs 30 crore to Rs 38, 44 to Rs 48 crore and savings also
increases from zero to Rs 2,6 and Rs 12 crore. With the increase in income neither
consumption nor savings decreased.
Table IV: Propensity to Consumption
Income (Y) Consumption (C) Saving (S)
(in ? Crore) in Crore) in (? Crore)
0 10 -10
10 14 -4
20 22 -2
30 30 0
40 38 2
50 44 6
60 48 12
Diagrammatical presentation
The three prepositions are shown with the help of Figure 4.
In the above diagram, income is shown on OX-axis and savings and investment is
shown on OY-axis. CC is the Consumption Function curve and SS is propensity to
save and 45° line represents Income.

85
Preposition (1) : When income X increases from OY Q to OYt then consumption
also increases from CQY0 to CiYv Similarly when income increases to OY 2 from OYx
then consumption also increases from C^Y1 to C2Y2. In this way we see that increase
in consumption expenditure is less than increase in income.
Preposition (2): When income increases to OY x and OY2 then this increase is
divided in some ratio in between consumption C^Y^ C2Y2 and saving TlCl and
Preposition (3): SS shows the propensity to save. When income increases OYto
OYx then savings in SjYv Similarly when income increase OYl to OY2 then savings
also increases from SiYl to S2Y2. In this way increase in income brings increment in
both consumption and saving.
ASSUMPTIONS OF CONSUMPTION FUNCTION OR
PSYCHOLOGICAL LAW OF CONSUMPTION
This law is based on following assumptions :
(1) Psychological and Institutional Factors are Constant: It means that an
individual's consumption depends on his income only and other psychological and
institutional factors like : population, habit of human being, distribution of income,
price level, customs and tradition remain the same.
(2) Normal Conditions: Psychological Law of Consumption is applicable only in
normal situation. It means that war, revolution, inflation or depression do not affect
activities of economy.
(3) Independent Policy Economy : Keynes' Psychological Law of Consumption
Theory is applicable only in Laissez-faire economy where there is not government
interference.
Some Implications of the Fundamental Psychological Law or the Importance of
Consumption Function :
The importance of consumption function described by Keynes can be made clear
through the analysis of Psychological Law of Consumption. Consumption has
unique place in economic analysis. Prof. Hansen has called it 'An unique instrument'
and Prof. Harris has graded as TJnparallel discovery'. It's importance will be clear
from the following discussion :

86
(1) Special Significance in Investment: We know that consumption and investment
are two important parts of employment theory. Since consumption is stable in short
sun so if employment has to be increased then more attention will have to be paid on
investment. In simple words, since, consumption does not change with the increase
in income therefore, the difference in consumption is compensated by investment so
that employment and production may increase. Therefore, investment is short term
determinant.
(2) Helpful in Repudiating Say's Law of Market: Say's Law states that supply
creates its own demand so there is no possibility of overproduction and
unemployment. Keynes consumption function theory repudiates this law. According
to Keynes, Marginal propensity to consume being less than unity all earned income
is not spent. Therefore, situation of unemployment and overproduction emerges.
(3) Explanation of Tendency of Capital: It is helpful in explaining the diminishing
tendency of marginal productivity of capital when increase in consumption is less
than increase in income then total income decreases and market is flooded with
goods. As a result producers start decreasing production due to which demand for
capital goods diminishes in future and marginal productivity of capital starts
declining.
(4) Explanation of Business Cycles : Keynes's Theory of Marginal Propensity to
Consume is successful in explaining the high and low points of the trade-cycle.
According to Keynes's, analysis when Marginal Propensity to Consume is less than
unity is the cause of high turning i.e. from boom to depression. With the increase in
boom income also starts increasing but human being do not spend whole of
increased income on consumption or starts saving more. This increased tendency of
saving weakens the base of boom and at last becomes the cause of depression.
(5) Low rate of Income Generation : When Marginal Propensity to Consume is
less than unity, people do not spend their whole income on consumption which
results in new generated income's pace slowed down.
(6) Under Employment Equilibrium : Aca iing to Keynes equilibrium is
established on the level of effective demand but it is not necessary that this

87
equilibrium will be full employment equilibrium because consumer does not spend
his whole increased income on consumption.
(7) Possibility of General Unemployment: According to this law when income
increases consumption expenditure does not increase equal to increase in income. It
means that some Commodities are such whose purchasers are no one. Marginal
Propensity to consume being less than one indicates that whatever is produced is not
all consumed therefore, there is always possibility of overproduction and as a result
of it unemployment in always possible.
(8) Long Term Stagnation : Keynes' Marginal Propensity to Consume Theory
clears long-term stagnant depression. Due to stagnation in propensity to consume
opportunity to invest is limited and savings go on increasing. Therefore, a situation
comes in a developed economy, when the economy is not able to invest surplus
savings. This situation is called Long term stagnation.
(9) Inducement to Investment: We know that marginal propensity to consume is
more in underdeveloped economies, therefore, the opportunity to invest are greater
and it encourages investment.
(9) Need for Govt. Interference : There is gap between income and expenditure. In
order to rectify the national economy or to equalize expenditure and income
Government will have to interfere.
(11) Helpful in Formulation of Economic Policy : Keynes theory of marginal
propensity to consume is very helpful in establishing full employment and
formulating economic laws for economic stability. In condition of unemployment
Government has to adopt such policy to increase effective demand so that income
can be transferred from rich class to poor classes. Reason is that riches have high
propensity to consume. Therefore, when income comes to them after redistribution
then propensity to consume will increase which in turn will increase effective
demand and income.
FACTORS DETERMINING CONSUMPTION FUNCTION
There are many factors which determine propensity to consume because saving is
complementary to consumption. Therefore, the factors on which consumption

88
depends, they affect savings. Propensity to consume will be high or low depends on
following factors :
Table-V
Determining Factors of Propensity to Consume
Internal Factors External Factors (Objective)
(Subjective)
1. Precaution 1. Income
2. Foresight 2. Distribution of income
3. Profit 3. Price & Wage level
4. Improvement 4. Abnormal situations
5. Economic Independence 5. Business Policy of Corporation
6. Enterprise Aim 6. Unexpected Profit & Losses
7. Pride 7. Composition of Population
8. Avarice 8. Effect of Private Sector in expenditure
9. Enterprise 9. Fiscal Policy
10 Liquidity Preference 10. Rate of Interest
.
11 Improvement 11. Social Insurance & Life Insurance
.
12 Financial 12. Introduction of New Products
. Foresightedness
13. Loans & Instalment Facilities
14. Possibility and Income in Future
15. Development of Means of Transport
16. Availability of Goods & Services
17. Changes in Taste & Fashion of People
18. Approach towards Savings
19. Law of Dusenberry

89
Subjective Factors:
Factors which motivate people for savings are as follows :
1. Precaution : People try to save some part of their income for unseen
contingencies like illness and accidents.
(2) Foresight: Some social events like marriage, education which have to be done
certainly in future, people save same portion of income.
(3) Profit: In order to earn profit some people spend less and save more.
(4) Improvement: In order to improve their standard of living some people spend
more and save less.
(5) Economic Independence: Some people want to become independent
economically which help them during crisis.
(6) Enterprise Aim : People try to save for starting new enterprise or for speculative
purposes.
(7) Pride : Some people want to save for social prestige and respect of offsprings.
(8) Avarice : Some people are miser by nature and they save more and spend less.
Above reasons force human being to spend less. According to Prof. Keynes there are
some reasons which force people to consume are extravagance short sightedness,
enjoyment, generosity, ostentation.
Some factors which motivate companies, corporations and Government Institutions
to save more are as follow :
(9) Enterprise : The desire to expand business.
(10) Liquidity Preference : To hold money in liquid form for emergency.
(11) Improvement: Improvement for renewing the machinery and equipments.
(12) Financial Foresightedness: To safeguard future losses.
It is not possible to change these psychological factors in the short period, therefore,
consumption function is constant in short period. Keynes is of the opinion that
although propensity to consume is constant in the short period but it is not remain so
strongly. Due to change in fiscal policy, interest rates and rapid change in the price
of capital affects propensity to consume. Therefore, these factors affects
consumption during short period also.

90
Objective Factors:
(1) Income : Propensity to consume depends especially on income. When income
increases consumption also increases and income decreases consumption also
decrease. In the Fig. 5 increase in consumption due to increase in income and due to
increase in propensity to consume change in consumption is shown.
Fig. 5 shows the change in consumption due to change in income but no change in
propensity to consume.
In Fig. 6 change in consumption due to change in propensity to consume is shown
but there is no change in income.
(2) Distribution of Income: The way wealth is distributed in the society, propensity
to consume is also decided accordingly. Due to unequal distribution of wealth, the
saving capacity of rich people increases and it affects propensity to consume
adversely. The equal distribution of wealth enhances propensity to consume.
(3) Price and Wage Level: Due to rise in price-level real income decreases
therefore propensity to consume also decreases. Contrary to this, fall in price level
increases the real income and thereby propensity to consume. Similarly, increase in
wage-level increases propensity to consume and decrease in wage-level decreases
the propensity to consume.
(4) Abnormal Situations : Propensity to consume is affected by future events. If
there is possibility of war or other emergency then people will purchase more goods.
This will encourage consumption.
(5) Business Policy of Corporation : Propensity to consume depends on Dividend
of distribution policy of corporation and joint stock companies also. If companies
decide to keep more fund as reserve then they give less money to consumers as
dividend which results into less income and less consumption.
(6) Unexpected Profit and Losses : Unexpected profit and losses also affect
propensity to consume.
(7) Composition of Population : Savings is done mostly by people are above 35
years age. When the number of such people increases propensity to consume
reduces.

91
(8) Effect of Private Sector on Expenditure: Advertisement and arrival of
important commodities in the market influences the consumption level. But when
some of such goods are purchased through savings and other commodities are
purchased through instalment when loan is given at discounted rate propensity to
consume will increase.
(9) Fiscal Policy : Taxation policy and expenditure and loan policy of government
also affect consumption pattern. For e.g. Government can adopt progressive taxation
in its fiscal policy and help in equal distribution of wealth which encourages
consumption.
(10) Rate of Interest: Higher the rate of interest lower will be the propensity to
consume and tendency to save more.
(11) Social Insurance and Life Insurance: These days so many deductions are
done from salaries and wages, for e.g. Life insurance premium, contribution for
social security schemes, contribution in provident fund. Such schemes takes a large
part of income which otherwise can be spent on consumption.
(12) Introduction of New Products : Due to arrival of new products index of
consumption shifts upward. The attraction of new products changes the preferences
of the consumers can made them to stop their savings.
(13) Loans and Instalment Facilities: If people start getting commodities in
installments and loan facilities, propensity to consume increases.
(14) Possibility and Income in Future: Propensity to consume depends on
expectations of future income. If people expect more income in future then their
propensity to consume will be high.
(15) Development of Means of Transport : If means of transport are helpful in
importing goods then propensity to consume will increase, if they are used in exports
then propensity to consume will reduce.
(16) Availability of Goods & Services : When scarce goods become available in
abundance their demand will increase and propensity to consume will increase.
(17) Change in Tastes & Fashion of People : Propensity to consume changes due
to change in tastes and fashions of people.

92
(18) Approach towards Savings : When people will save more the propensity to
consume reduces.
(19) Law of Dusenberry: According to Prof. Dusenberry, People of lower class try
to imitate the consumption nature of high class. This is called 'Demonstration
Effect'. The country or society where demonstration effect is more, propensity to
consume is higher. Prof. Dusenberry also told that people when attain certain
standard of consumption level it is very difficult to lower down that standard.
Therefore, even during depression people try to maintain that level of consumption.
CRITICISM OF CONSUMPTION FUNCTION
(1) Wrong Use of Word Propensity : Prof. Hazlitt objected the use of word
'Propensity'. In reality 'Propensity' means inclination only but Keynes has used the
term 'Propensity' to define certain part of income. Along with it propensity to
consume does not represent the amount spend from the income. The money which is
spent on capital goods are not included in consumption. According to Hazlitt, "If a
doctor purchases a house and uses it as his house and office then that word
according to Keynes, how much will be propensity to consume and to investment."
2. Not applicable in Long run : This law is criticized that it is short run law but in
the long run due to change in psychological and institutional facts propensity to
consume differs.
3. Others : According to Prof. Garden Ackley, 'Keynes' propensity to consume is
neither an important example inductive logic nor analyses the deductive logic.
Prof. Keynes' Propensity to Consume Theory explains only quantitative perspective
and does not explain the qualitative effect on the society.
Prof. Keynes Theory does not explain the size of income, relation between income
and wealth and Black money.
Consumption and Saving constitute an important place in Keynes' Employment and
Income Theory. Saving and Investment jointly determine the level of employment
and income.

93
MEANING OF SAVING
When total expenditure is subtracted from Aggregate (Total) Income what we get as
remaining is called saving. Saving (s) is the difference between income (Y) and
consumption (C):
S = Y-C
This definition of saving is valid for both individual and society. Keynes always
mean savings of the society. Individual saving is not of any importance for him.
MEANING OF SAVING FUNCTION
According to Keynes saving is the function of income i.e. savings depend on
income. Saving function expresses the functional relationship between total income
and total saving i.e.
' S = F(Y)
Where,
S = Saving i.e. a dependent variable Y = Income i.e. an independent variable
There is direct relationship between saving and income. If income level is high then
there will be more saving. Contrary to this if income level is low then saving will be
low. This has been explained in the table shown below : Table I: Relationship
between Income and Saving
Income (Y) Consumption (C) Saving (S) APS=| AS
(DinCr. (2) (3) (3/1) = 4 MPS=- (5)
0 10 -10 — —
30 35 -5 — —
60 60 0 0 —
90 85 5 0.06 0.17
120 110 10 0.08 0.17
Column (3) of above Table shows that when income is zero or very low then people
don't save. When income is Rs 30 crore then consumption is Rs 35 crore i.e. more
than income but when income is Rs 60 crore consumption is also Rs 60 crore and
both income and consumption are equal and saving is zero. When income increases
by Rs 30 crore then saving increases by Rs 5 crore which shows that when income
increases then saving also increases but less than the increase in income.

94
The propensity to save is shown in Fig. 1.
In the diagram SS curve is the propensity to save curve. The saving is negative
below the point. A in saving function curve SS because people are not able to save
due to low income. Saving is zero at point A i.e., income and consumption are Fig. 1
equal at this point. Above point A saving increases with the increase in income. SS
curve is straight line because increase in income and saving are at definite rates.
KINDS OF PROPENSITY TO SAVE
Propensity to save are of two types :
(1) Average Propensity to Save or APS : APS expresses those ratio of income which
are saved. In other words, APS is ratio of saving and income which is expressed as
2. Marginal Propensity to Save or MPS : APS expresses that ratio of income
which is made by any society, Marginal Propensity to Save (MPS) expresses that
how much portion of additional consumable income can be saved. Therefore, MPS
is found by dividing change in consumption income by change in induced saving.
MPS =
Change in Saving Change in Income
or,
MPS =
AS AY
Example : If consumption income increases from Rs 100 crore to Rs 120 crore and
due to this saving increases by Rs 5 crore then MPS will be :
MPS= 0.25
Since, additional income is either consumed or saved, MPC + MPS will be one. or,
MPC + MPS = 1
It can be proved mathematically equation C + S + Y prove that any increase in
income i.e. AY will increase either consumption i.e. AC or will increase saving
i.e. AS
AC + AS = AY Dividing by Y both sides we get
AY +AY MPC + MPS =
MPS is shown is Fig. 3.

95
MPS is measured at a falling point. In Fig. 3 it is shown by AB/BC, where change in
AB is change in saving i.e., AS and in BC in the change in income i.e., AY.
This way APS and MPS are two different concepts. APS states the relationship
between Total Saving and Total Income and on the other hand MPS is related to
change in saving and change in income.
SAVING IS VIRTUE OR VICE OR PARADOX OF THRIFT
There is a controversy among the economists that saving is personal virtue or social
virtue or vice. We can study the different opinions on this topic under three different
heads:
(1) Classical Views, (2) Keynesian View, (3) Modern View.
(1) Classical Views : Classical economists describe the concept of saving from
micro point of view. They believe that saving is a great personal and social virtue.
They say that every wise man should save something for future emergencies. Future
of men are uncertain so for the safety in future and comfort : f life every individual
should save. According to them hard labour, maximum income, minimum
expenditure, maximum prudence are the best qualities of men. Therefore, classical
economists believe that saving is personal and social irtue.
2. Keynesian View: Keynes has analysed the concept of saving from macro point of
view. According to him saving is a social vice. When people increase their personal
saving then total caving decrease instead of increasing. It badly affects employment
and production.
According to Keynes saving depends on income and society's maximum saving is
possible only when National Income will increase. Since a person's expenditure is
other person's income, therefore some person save more, it means that other person's
income and expenditure are decreasing. As a result due to deficiency of effective
demand production, employment and income diminishes.
Therefore, Keynes has said that saving is a social vice. Keynes said that people
should aim at spending the income instead of saving because by spending we
increase the income of others, and this way we bring richness for all in the society.
The adverse effect more saving on income is shown in the above Fig. 4. It is clear
from the figure if saving in a society is S : Sx in a particular time and II or Saving

96
Investment remain the same then Total income reduces to Yx from Y and saving
reduces to Y1 Ej from YE. In this way due to increase in saving, income and
consumption reduces. Therefore, Keynes has told oversaving as social vice. This is
Paradox of Thrift. This Paradox of Thrift is due to following reasons :
(i) It says that what was an old quality is a modern vice. Classical economists say
that saving is always good. But it is clear from Fig. (4) that saving can be a social
vice. It is good to do personal saving but it is not necessary that whatever is right for
one person will be useful for the whole society.
(ii) It is paradox because social saving is total of personal saving. Therefore, if all
people will save more then the size of social saving will also increase but we see that
when all people will save more then income of others will reduce thereby saving will
automatically decrease.
(3) Modern View: Modern economists say that whether saving is a virtue or vice
depends on following situations :
(i) Underdeveloped countries : These countries face serious problem of economic
development. These countries are capital deficient. Due to lack of capital and saving
there is serious problem of unemployment. If these countries will have more saving
then there will be more capital formation. Therefore, Keynes concept does not
operate in underdeveloped countries. Saving is social virtue for these countries.
Increase in saving will check price rise and saving will be encouraged. Due to these
reasons in underdeveloped countries saving is encouraged so that those saving can
be invested and economic development can take place.
(ii) Use of Saving : Whether saving is virtue or vice it depends on its use. If saving
is used for accumulation of wealth then it is vice, if it is used for investment then is
virtue.
Conclusion : Whether saving is virtue or vice it depends upon the fact that for which
purpose it is used. So Keynesian view cannot be accepted because for country like
India saving is a virtue

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According to Keynes real level of employment depends on effective demand and
effective demand depends on consumption expenditure and investment expenditure.
Function remains stable during short run, therefore with the increase in income the
difference between income and consumption goes on increasing. In order to fulfill
this gap and to maintain the level of production and employment, it is essential that
the other component of effective demand i.e. investment expenditure should
increase. In reality, Investment expenditure is the important factor in determining the
level of income and employment.
CONCEPT OF INVESTMENT
In simple words, investment means purchasing present securities, bonds, land or
capital but Keynes has used the term investment in a different way : According to
Keynes a man can invest in two ways :
(i) Financial Investment: i.e. purchasing of old stocks and shares.
(ii) Real Investment : i.e. purchasing of new stocks and shares or construction of
new factories, buildings or bridges.
According to Keynes, due to financial investment money is transferred from one
person to another, there is no increase in employment. Such investments are
important only from individual point of view, not from social point of view.
Contrary to this, second type of investment is real investment. Real investment are
done to establish new factories and firms. Such investments increase total
investments and the demand for factors of production and employment also
increases. Increase in demands of factors and employment is that part of real
investment which is spent for constructing real capital. It includes three types of
expenses: construction of (a) New capital equipments and machines, (b) New
buildings, (c) Increase in stock.
In Keynesian economics, the term investment is used for 'real investment'.
Real Investment means increase in current capital goods which thereby increase
employment.
Definitions:
(i) Keynes : "Investment refers to the increment of capital equipment."

98
(ii) Stonier and Hague: "By investment, we do not mean the purchase of existing
paper securities, bonds, debentures or equities but the purchase of new factories,
machines and the like."
(iii) Mrs. Joan Robinson: "Investment means making an addition to the stock of
goods in existence."
In short, Investment is expenditure on purchase of new factories which directly helps
to increase in production.
DIFFERENCE BETWEEN CAPITAL AND INVESTMENT
Capital means the total stock of capital goods but Investment means increase in total
stock of capital during one year period.
KINDS OR CLASSIFICATION OF INVESTMENT
Investments are of two types : (1) Induced Investment (2) Autonomous Investment.
1) Induced Investment
Induced investment is mainly induced by demand. When the demand for
consumption goods increases in the cou- Y ntry then it becomes inevitable to
increase the production to meet the demand. Production increases only when
investment increases. Investment creates supply and supply fulfills the demand. In
this way, first demand increases then investment increases being induced by
demand. Increase in investment increases supply and supply meets the increased
demand. For e.g. when demand for clothes increases then more investment is done
on the cloth making machines. It is an example of induced investment.
Induced investment depends on income. Therefore, induced investment is also called
the function of income Le.
I = F(Y)
It means that when income increases, induced investment also increases and when
income decreases induced investment decreases. It in shown in the above figure 1.
2) Autonomous Investment
Autonomous investment is not influenced by the level of income and rate of interest.
Government investment for public utilities for e.g. on the construction of rails, roads,
post office etc. are called autonomous investment. Such investment is called auton-
omous because it is not related with the level of incomes of the economy but it can

99
fluctuate due to change in financial allocation and government budget. In Fig. 2
Autonomous investment is shown which is constant at all income levels. At any
period total investment is summation of induced and autonomous investment But in
Keynesian analysis autonomous investment has been used because it had appeared
during 'Great Depression' of 1929-30.
DETERMINANTS OF INVESTMENT OR INDUCEMENT TO INVEST
Inducement to increases investment is called inducement to invest. It enables
us to know whether investor will invest or not. In private sectors, investor invest to
earn profits. Determinant of inducement to invest in private sectors are :
(i) Marginal Efficiency of Capital (MEC)
(ii) Rate of Interest.
Determinants of Investment or
Induced Investment
Prospective Yield Supply Price
(1) Marginal Efficiency of Capital (MEC)
Meaning: MEC is the expected rate of profit earned from any new capital.
Prospective yield from new investment may be called MEC.
Definitions of MEC :
(i) Prof. Fisher: "MEC is rate of return over cost from the additional unit of capital
invested."
(ii) Prof. Kurihara : "Marginal Efficiency of capital is the ratio between
prospective yield of additional capital goods and their supply price."
It is clear from above discussion that prospective yield from new investment is
called marginal efficiency of capital. "
MEC means prospective rate of profit. In other words, MEC means prospective rate
of profit in relation to its price when an additional unit of capital good is used.
For Example : Supply price of a machine is Rs 2,000. Machine works for one year,
after that it is not able to work. In one year prospective yield of this machine is ?
2,200, therefore, the profit on cost of machine will be : 2,200-2,000 = Rs 200
This profit is gained from the capital of Rs 2,000. Therefore, marginal efficiency
of capital (MEC) will be Rs 22. x100 = 10%. 2000

100
It is clear from the above example that MEC depends on (a) Prospective yield from
Rs 2,200 and (b) Supply price is Rs 2,000.
Determinants of MEC : There are two factors which determine Marginal
Efficiency of Capital:
(i) Prospective Yield, (ii) Supply Price.
(i) Prospective Yield : When investors invest in capital, they calculate that how
much net revenue will accrue to them with the consumption of that capital good. Net
Revenue is the difference between Gross Revenue earned from sale of produce
produced by that capital and Variable Costs like : raw materials, wages etc. It is also
called Net Revenue Flow.
Annual prospective yield of capital assets for expected life tenure can be known
through the following equation :
PY = Q1 + Q2 + Q3 + Q4 + ... + Qn Where PY = Prospective Yield,
Qj, Q2, Q3,... Qn = Yearly prospective yield Suppose : If the life of any machine is 3
years and prospective yield from that machine in 1st year Rs 1,750, 2nd year Rs
1,450, 3rd year ? 1,200 then its prospective yield will be :
PY= Q1 + Q2 + Q3
= 1,750 + 1,450 + 1,200 = Rs 4,400 (ii) Supply Price: The other factor affecting the
MEC of any capital goods is its supply price. Supply price does not mean the present
price of capital goods. But it means what will be the cost of installing same new
machine in place of the old one. Therefore, supply price of a capital good is also
called 'Replacement Cost.'
In this way, the ratio of the possibility of annual income with the use of any capital
goods and the price which has to be paid for purchasing that capital is called
'Marginal Efficiency of Capital.'
MEC formula can be determined in the following way :
ProspectiveYield(Y) or Supply Function
In order to express in prospective rate it is multiplied by 100.
MEC= x 100
On the basis of above formula, MEC is calculated at various supply prices and
prospective yields.

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Table-I MEC of Capital Good
Supply Price (P) Annual Income (Y) MEC
20,000 2,000 2,000x100 = 10%
20,000
20,000 1,600 1,600x100 = 8%
20,000
40,000 2,000 2,000x100 = 5%
40,000
The above table shows that with the decrease in prospective yield and increase in
supply price MEC reduces. Therefore every entrepreneur compares prospective yield
and supply price then invests. So
(i) If prospective yield is greater than of supply price of capital goods then
entrepreneur becomes ready to invest or not.
(ii) Greater the prospective yield investor expects greater profit and invests more.
(iii) In this way MEC is the ratio of prospective yield and supply price.
(2) Rate of Interest (r)
Other determining factor of investment is the rate of interest. Rate of interest is
determined by the demand and supply of money. The demand for money is hquidity
preference of people. People keep money in liquid form for three purposes:
(1) Transaction motive
(2) Precautionary motive
(3) Speculative motive.
According to Keynes, "Interest is the award for parting the money for a definite
period."
In the short period due to fixed supply of money, rate of interest depends mainly on
liquidity preference. Higher the liquidity preference higher will be the rate of
interest.

102
 THE EQUILIBRIUM VOLUME OF INVESTMENT
Or
INVESTMENT DECISION RULE

It is clear that investment depends on two factors : (i) MEC, (ii) Rate of Interest.
Since MEC and Rate of interest are two important determinants, therefore, investors
compare these two before new investment:
(i) When MEC > r, investors increase the investment.
(ii) When MEC < r, investors reduce the investment.
(iii) Therefore, the investment is decided at that point where MEC = r and that point
will be equilibrium point.
Example: Equilibrium point of investment is shown in the following Table II:
Table-ii
Investment Equilibrium Point
Price of Annual MEC Effect on
Capital Income Investment
5,000 200 4% 4% MEC= neutral
4,000 200 5% 4% MEC >r
Favourable
5,000 200 4% 5% MEC < r
unfavourable
It is clear from the above that new unit of capital which costs Rs 5,000 and Rs 200 is
the annual income then MEC = -r-rrr * 100 = 4%. In the above table :
(i) When MEC 4% is equal to rate of interest i.e. 4% then there is neutral effect on
investment.
(ii) When MEC is 5% and greater than rate of interest i.e. 4% then there is
favourable impact on investment.
(iii) When MEC is 4% and rate of interest is 5% then its impact is unfavourable on
investment.

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Diagrammatic Representation: This situation is depicted in Fig. 3 where
investment is shown on OX-axis and MEC and Rate of interest (r) is shown on OY-
axis:
(i) In the Fig. 3 Curve rr depicts the rate of interest curve and MEC.
(ii) Suppose r is fixed at Or, rr is showing fixed r.
(iii) When investment is 01 then MEC Pj Ij > rate of interest (r) S I 1. Therefore there
will be more investment. Investment will increase to O I. In this situation MEC and
rr are intersecting each other at P where MEC = r. Then there will be no inducement
to invest after this point.
(iv) If due to any reason investment become 0I2 then MEC TI2 < Rate of interest
P212. Therefore investors will have to incur loss and investment will decrease.
More Significance of MEC : Now question arises while determining investment
which is more important MEC or Rate of interest. Classical Economists believed
that Rate of interest is the determinant of investment but during Great Depression
when very Low rate of interests were not able to increase investment then Keynes
opined that:
'Investment depends more on psychological concept of MEC then Rate of interest.'
Therefore, more important determinant of investment is MEC.
TOTAL INVESTMENT THEORY AT A GLANCE
It is clear from above discussion that:
(i) Investment in economy depends on MEC and r. In other words, investment is the
function of MEC and r.
Mathematically I = F (MEC, r)
(ii) MEC itself is determined by prospective yield and supply price of capital.
(iii) When prospective yield of capital is greater than its supply price, investor is
induced to invest.
(iv) Investor at the time of investment compares the MEC and rate of interest and
invests only when MEC > r.
(v) The most effective factor determining investment is MEC.

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 MARGINAL EFFICIENCY OF CAPITAL
We have studied that according to Keynes, inducement to invest mainly depends on
two factors :
(a) Rate of Interest
(b) Marginal Efficiency of Capital or MEC
Among these two factors marginal efficiency of capital or MEC is comparatively
more effective component and if it is high, the inducement to invest will also be
high.
MEANING OF MARGINAL EFFICIENCY OF CAPITAL
The concept of MEC was first coined by Prof. Irving Fisher in 1930. He had given it
the name 'Rate of Return over Cost'. In general words, the meaning of marginal
efficiency of capital is:
'Expected role of profitability of New Investment'.
'Efficiency' word is used to express the rate of income. In this way MEC means the
income which is derived from the return by use of one additional unit of capital after
deducting the cost.
MEC depends on two factors:
(i) Prospective yield of capital asset
(ii) Supply price of capital asset.
(i) Prospective Yield of Capital Asset: Prospective yield means that total net return
expected from the asset over its life-time. Here 'Net' word is used because in order to
know Net income we have to subtract the present costs of assets from Total income.
If. we divide the total expected life of the new capital asset in various time periods,
we may refer to annual returns as a series of
annuities represented by Qi; Q2, Q3 ...... Qn. We will have to calculate the
discounted value of the return for all years to get prospective yield.
(ii) Supply Price of the Assets : Supply price means the cost of the asset not the
existing one but of the new units of asset. For e.g. the expenditure incurred to
establish new plant or machine is called supply price or cost of new investment. It is
also called 'Replacement Cost'.

105
Thus, MEC is the ratio of prospective yield of asset and supply price of the asset. In
the words of Prof. Kurihara :
"The ratio of prospective yield of capital and its supply price is Marginal Efficiency
of capital." MEC formula is:
DETERMINATION OF MEC IN THE FORM OF RATE OF DISCOUNT
It is worthnoting that the supply price of capital is its present cost, where,
prospective yield expresses the income yield in its life-time or in future.
Therefore, after knowing the supply price and prospective yield of capital asset
MEC can be estimated as equal to rate of discount which equates the values of both
these concept. In the words of Prof. Keynes :
"More Precisely, I define the MEC as being equal to that rate of discount which
would make the present value of the series of annuities given by the return expected
from the capital asset during its life just equal to its supply price."
The above definition expresses that 'MEC is that rate of discount' where prospective
yield and supply price of asset become equal. The definition will be more clear
through the following equation :
Suppose:
(i) Cr = is the supply price of assets.
(ii) Q1? Q2, Q3 etc. are Expected Annual Returns from the capital assets.
(iii) r is that rate of discount which equals the sum of discounted prospective yields
with the supply price of the capital costs.
In equation (1) there is problem of knowing MEC or r (Rate of discount) where
supply price C and series of returns are given Qv Q2, Q3,... Qn.
Example : Let us suppose that the prospective annual yields from the use of a new
capital asset whose life is 3 years only are as follows :
1st Year? 2,200 2nd Year ? 4,840 3rd Year ? 7,986
Suppose further that current supply price or replacement cost of capital asset is
12,000. MEC of capital will be known with the help of the following equation:
By solving the above equation it shows that unique rate of discount is 10% which
will equate the sum of the discounted values of prospective annual yields to the

106
current supply price of the capital asset. In such a equation the rate of discount or
MEC is 10%.
The equation will be solved in such a way :
It is clear that the Rate of discount 10% which equates the sum of the discounted
values of prospective yield to current supply price of capital asset i.e. Rs 12,000 =
Rs 12,000 It is clear from above discussion that:
1. Marginal Efficiency of Capital (MEC) is a ratio or a rate i.e. it is a percentage
rate.
2. MEC is a prospective rate which is under all future uncertainties.
3. MEC is a marginal rate which means that rate of return is used for one additional
unit of capital asset.
4. It is a Rate of discount, a unique rate of discount which equates the sum of
discounted values of the prospective annual yields to the current supply price of
capital asset.
5. Among the two factors influencing supply price and prospective yield, supply
price is fixed in short period because during short period the cost and price of assets
do not change.
6. Since supply price of capital asset is fixed in the short period, therefore MEC or
Rate of discount rises due to increase in prospective annual yield or decrease due fall
in prospective annual yield.
NATURE OF MEC
There is difference between Marginal Efficiency of Capital and Marginal
productivity of an economy. The marginal productivity of any capital asset is that
rate of prospective yield which accrues due to use of an additional unit of capital
asset. On the contrary, general marginal productivity of capital means prospective
income rate due to use of new unit of beneficial capital. In other words, general
marginal productivity means most useful capital assets highest marginal
productivity.
The nature of MEC is to diminish with every increase in capital investment.
According to Keynes:

107
'During any period, if investment is increased in certain capital assets, then
marginal productivity of capital has tendency to decrease with the increase.' It is
shown through the following capital investment demand schedule : "The schedule
which shows the marginal productivity of capital at various levels of capital
investment is called Investment. Demand Schedule." This schedule expresses the
functional relationshing between MEC and Investment i.e.
Investment Demand Schedule Diminishing MEC
Investment MEC%
10,000 12
12,000 10
14,000 8
16,000 6
18,000 4
20,000 2
According to this schedule when investment is Rs 10,000, MEC is 12% and when it
increases to 20,000, MEC reduces to 2%.
The position and shape of Investment demand Schedule is very important for
determining the level of investment and employment.
In figure 1 the MEC curve is downward sloping which proves that with the increase
in investment MEC falls. It is called 'Keynesian Theory of Diminishing Marginal
Efficiency of Capital'. .-. MEC = r
12 14 16 18 20 Investment (in thousand ) and investment I is the decreasing
function of Expenditure.
r = AD
WHY MARGINAL EFFICIENCY OF CAPITAL DIMINISHES ?
There are three reasons of diminishing MEC :
(1) Working of Law of Diminishing Marginal Utility: When with the other fixed
factors of production like land, labour, more units of capital are used then due to law
of diminishing marginal utility with every addition unit of capital gives
comparatively less return than the former. So MEC starts falling.

108
(2) Increase in Prices of Capital Goods: When the demand for capital goods
increases then its supply prices rise and prospective yield declines. In this way high
supply price results in declining MEC.
(3) Supply Effect of Final Goods : Y A When the use of capital assets increases
then the production of final goods also increase but it decreases the price of final
goods therefore, MEC starts declining.
SHIFTS IN MEC CURVE
Here it is important to note that if there is any change in prospective yield then
whole investment demand curve or MEC curve may shift upward or downward.
During prosperity, MEC shifts upward and during depression it shifts downward. It
is shown in the following figure:
(1) Prosperity Period : Suppose due to outbreak of war or other reasons the demand
for goods increases and producers hope to earn more profits. Therefore, MEC shifts
to MECi; which means that more investment will be done at fixed interest rates. It is
clear from the fig. (2) that when investment demand curve was MEC then at the rate
of interest PM the quantity of investment is OM but with the increase in profit
investment demand shifts to MEC and investment rises from OM to OM t at same
rate of interest PM or P x Mr
(2) Depression Period : During depression the hope of profit are less. So MEC
curve shifts left to MEC 2. Now there is less investment OM2 at same rate of interest
PM or P2M2.

THE EQUILIBRIUM VOLUME OF INVESTMENT INVESTMENT

DECISION RULE
Or
MEC AND RATE OF INTEREST
There are two determining factors of investment:
(a) MEC
(b) Rate of Interest.
Investors increase investment till MEC is greater than the rate of interest. On the
contrary, if MEC is low, investment is badly affected. Therefore, investors reduce

109
investment. It is clear that investment will be in equilibrium at that level where
interest rate and MEC will be equal.
FACTORS AFFECTING MEC
The factors which affect MEC can be divided in two groups : (1) Short Term
Factors
(a) Cost and Nature of Demand : If the costs are expected to rise or prices are
likely to fall and demand for a commodity is prove to decline in future, average
businessmen's expectation of return will fall and investment will be affected
adversely. On the contrary, investment will rise if investors expect fall in costs and
rise in prices and demand.
(b) Changes in Income: Sudden increase or fall in income due to profit or tax
concessions MEC increases and investment also and vice versa.
(c) Propensity to consume : Investment increases due to increase in demand for
consumption goods and thereby favourably affects MEC.
(d) Change in Liquid Assets: Investors increase investment if they have more liquid
assets, which he can invest according to need. But when assets are not liquid it is
difficult to invest.
(e) Taxation Policy : If heavy direct or indirect taxes are imposed, they affect
investment adversely and decreases MEC. On the contrary, rebates and subsidies
increases investment and MEC.
(f) Present Stock of Capital Goods : If present stock of capital stock is large the
MEC will be less.
(g) Present Investment Rate : If investment is more than before in any industry
then investors will be less eager to invest in that industry because it will badly affect
MEC. For e. g. If many sugar mills are being established in the country then new
investors will not come forward to invest in sugar mill.
(h) Present Income from Capital goods: If present income from capital goods is
rising sharply then investors will invest more and it will badly affect MEC.
(i) Production Capacity : The production capacity of present capital equipments
affect MEC. If any industry's equipment are not fully utilised then investor will not

110
invest more. But if machine is working on its full capacity then it will certainly
invest.
(j) Future Expectations: Future expectations of profit also affects present
investment and favourably affects MEC. If Entrepreneurs hope more profit in the
long run then MEC curve shifts upward.
(k) Volume of Total Investment: How much capital is already invested in different
production sectors also affect productivity of new capital.
(1) Waves of Optimism and Pessimism: MEC is also affected by optimism and
pessimism because optimism increases profit and pessimism decreases profit thereby
MEC is affected. (2) Long Term Factors
(a) Population: Increasing population favourably affects investment and MEC
because multiple investments are required to fulfill the requirements of increasing
population.
(b) Development of New Sectors : When the new sectors of country are developed
then major investments are incurred on agriculture, irrigation, industry, transport and
communication.
(c) Technical Development: When techniques of production are improved then
entrepreneurs are ready for new investments. For .e.g. When new invention occurs
then new and costly machines and equipments are installed in factories.
(d) General Conditions: If there is fear of war in future then political and social
instability will take place and affect MEC adversely. On the contrary in peaceful
atmosphere in the country will encourage investment and increase MEC.
(f) Economic Policy : Government Economic policy also affects MEC. If there is
situation of Nationalization in future MEC will be less.
(g) Long Term Investment Demand: If there is possibility of permanent increase in
demand for commodities then entrepreneurs will invest more and MEC will
increase.
(h) Change in Supply of Capital Equipment: If there is sufficient supply of capital
equipment then there will be no inducement to investment and MEC will be less, but
if present capital is fully utilized then it will positively affect investment and MEC.

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CRITICISM OF MEC
(1) Indefinite Meaning : Critics say that Keynes has not used the term MEC in a
definite sense, so it is difficult to understand it clearly. Prof Hazlitt has criticised
Keynes' concept of MEC and said :
'Keynes could had saved him from many ambiguities, uncertainities and bad
reasonings if he had not used the word MEC'
(a) Illogical: According to Keynes MEC affects future expectations but not rate of
interests. Keynes had firm belief there is strong relationship between MEC and
prospective yields but in fact there is not relationship between MEC and rate of
interest. It means that Keyneshad included Yate of interest' in static economics and
'MEC in dynamic economics. Prof Hazlitt is of the opinion that if we accept Keynes'
assumption then it will mean that prospective yield will affect entrepreneurs but not
creditors. It will be a great fallacy.
(3) Difficulty in Measurement: According to Keynes MEC is related to expected
profitability of capital but how we can measure expected profitability ? If MEC
keeps on changing and it will affect investment then MEC cannot be measured.
(4) Wrong Assumption of Perfect Competition : Keynes had accepted the concept
of perfect competition and ignored the concept of imperfect competition.
(5) Business Expectations and MEC: MEC depends on prospective yield.
Prospective yield expresses the future income expectations which are called business
expectations.
'Business Expectations are those expectations of changes in social and political
scenario which affect the accrued income from capital assets.'
Inspite of above criticisms the fact cannot be denied that the concept of MEC is an
important contribution of Keynes. This concept plays an important role in the
determination of investment.
Due to the instability and uncertainty long term expectations are more important
than short term expectations.
In capitalistic economy after a limit the tendency of falling profit rate is found in
long run. Keynes has given the name to this tendency as 'Long term stationary

112
depression'. It means that in the long run in the capitalistic economy the tendency of
MEC is falling:
Explanation :
According to Meire and Baldwin, 'Secular stagnation expresses such a situation in
capitalistic economy where the tendency of increase in net saving and decrease in
net investment is present in the situation of full employment'.
In the words of Prof. Richar G. Lipsy, 'The condition of Long term depression is
long term surplus prospective saving in comparison to prospective private
investment'
Keynes has explained that richer the economy, higher will be the difference between
potential and real development. As a result there defects will emerge in economic
system. In such rich economy not only MEC decreases but due to increase in
tendency of saving wealth the opportunity for new investment will not be attractive.
In other words, in capitalistic economy in the long run saving is greater than
investment and supply is greater than demand. As a result the problem
of'Overproduction' will arise. The fear of unemployment emerges, this situation can
be called 'Secular Stagnation.'
IS THE CONCEPT OF SECULAR STAGNATION NEW ?
The concept of Secular Stagnation is not new. In classical economics, it was named
The fall in rate of profit'. Economists like Adam Smith, Ricardo, J. S. Mill, Karl
Marx said that, as capitalistic economies will develop falling tendency of rate of
profit will be found. They said various reasons for falling profit.
Adam Smith said the reason for falling profit in developed country is availability of
capital in large amount.
Ricardo & Mill said, It is the result of natural misery because due to rise in
population, low quality levels will be used and production will fall.
Therefore, Keynes' view of Secular Stagnation is not new. Keynes has given it only
a new name i.e. The Diminishing MEC Keynes' views are similar to that of Adam
Smith and Karl Marx to some extent. Karl Marx has to say that it is the especiality of
capital that as more quantities of capital are used its return diminishes. Therefore,
the concept of secular stagnation of Keynes is not new.

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 INVESTMENT MULTIPLIER
Development of Concept: Multiplier is the indespensable part of Keynes'
Employment Theory. The concept of Multiplier was first used by R. F. Khan in his
Article 'The Relation of Home Investment to Unemployment' published in
'Economic' magazine in June 1931. Khan's multiplier is known as 'Employment
Multiplier. Keynes propounded 'Investment Multiplier' from the 'Employment
Multiplier of Khan.'
MEANING OF INVESTMENT MULTIPLIER
We know that main determinant of income is investment. Income increases with the
increase in investment and income decrease with the decrease in investment. Now,
we will try to know that how much income increases or decrease with the definite
increase or decrease in investment.
Keynes was of the view that "There is many times increase in income with the initial
increment investment."
According to Keynes, Ultimate increase in income due initial increase in investment
is Investment Multiplier. For e. g., If there is increase in investment by Rs 2 crore
and income increases by Rs 10 crore. Then investment multiplier will be 5. But if
increase in investment of Rs 2 crore leads increase in income by Rs 5 crore then
multiplier will be 2.5. Therefore the relation between initial increase in investment
and ultimate increase in income is known as 'Multiplier'. Keynes says that initial
increase in investment will change consumption which will be the reason of increase
in total income. It can be simply stated as follows : Change in Investment (Primary
Reason)
Change in Consumption
Change in Aggregate Income (Last Result) Keynes represented 'Investment
Multiplier' with 'K' Definitions:
(i) J. M. Keynes 'The General Theory': "Investment multiplier tells us that when
there is an increment of aggregate investment income will increase by an amount
which is 'K times the increment of investment."
(ii) Hansen: "Keynes' investment multiplier is the coefficient relating to an
increment of investment to an increment of income."

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In this way it is clear that multiplier is ratio of increase in income due to increase in
investment. Mathematically it can be expressed as : Formula of Multiplier:
In the following table the size of K is shown at various levels of MPC
SOME IMPORTANT CONCLUSIONS
(i) There is direct and straight relation between MPC and multiplier and there is
opposite relation between MPS and multiplier.
(ii) Generally MPC never be zero but when consumer saves his whole income then
MPC becomes zero and value of multiplier becomes one.
(iii) When MPC = 1 and whole income is spent then the value of multiplier is
infinity.
(iv) Generally value of multiplier is never one or infinity but it varies in between 1 to
WORKING OF THE MULTIPLIER AND INCOME PROPAGATION
Multiplier theory describes that cumulative effect due to change in investment which
affects income due to change in its consumption expenditure.
Multiplier Process
Due to change in investment, income changes which in turn brings changes in
consumption. The consumption expenditure of one person is the income of the other
person. Therefore, change in consumption brings changes in income. This process
continues till the consumption expenditure reduces to zero.
Income Expansion effect of multiplier is shown in the following table II.
Forward Action and Backward Action of Multiplier
Multiplier action is of two types. When increase in investment brings multiple
increase in income then it is called forward action of multiplier.
Contrary to this when decrease in investment brings multiple decreases in income
then it is called backward action of multiplier.
(a) Forward Action of Multiplier: It indicates the manifold increase in income due
to increase in investment.
Suppose : Initial investment in an economy is of Rs 100 crores and MPC is then
total income will increase by Rs 200 crore. In first initial investment of 2 ' Rs 100
crore income will increase by Rs 50 crore because income earners spend only 50%

115
of their income on consumption because MPC = In the second round the increase
will be Rs 25 crore (which - of ? 50 crore).
Similarly in the third round Rs 12.5 crore, fourth round Rs 6.25 crore, in fifth round
Rs 3.12 crore income will increase and at the end total increase in income will be Rs
100 crore i.e. double of principal investment. This process will take time. It is shown
in the Table II:
Table-II
Income expansion effect of increase of Rs 100 crore in Investment
(MPC = 0.5)
It is clear from the above table that after the initial investment of Rs 100 crore after a
certain period total income increases to Rs 200 crore and total saving will increase
by Rs 100 crore which is equal to initial investment. It proves that:
Diagrammatic Representation: It is assumed that MPC is 1/2 therefore multiplier
K will be 2.
In the diagram II is the investment
Y curve and SS is the saving curve, both
IS intersect each other at point E, therefore,
the equilibrium level of income is OM. (30) Suppose investment increases i. e. Al by
Rs (20) Crore so that investment curve shifts to. New Investment curve cuts saving
curve SS at point A where, the X equihbrium level of income is OM t we see that
when Al is Rs 10 crore then AY Expenditure in Rs 20 Crores increases by ? 20
crore. It is clear from Pig, 2 the diagram that income increases more
in comparison to increase in investment.
REVERSE WORKING OF MULTIPLIER
Multiplier is dual edged weapon. It works in reverse direction also. It means that if
there is deficiency in investment in the economy then income will reduce much
more than that. In such situation multiplier will start working in reverse direction.
CHARACTERISTICS OF MULTIPLIER Prof. McConnell and Wallac P.
Peterson explained the following important characteristics of multiplier:
1. Multiplier depends on MPC, higher the MPC higher will be the multiplier.

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2. There is inverse relationship between Marginal Propensity to Save (MPS) and
Multiplier.
3. Multiplier works in both directions viz. a small increase in investment brings
many times increase in National Income and a small decrease in investment
decreases the income manifold.
4. Size of Multiplier depends on the addition of leakages of income.
5. Multiplier works only when there is continuous and independent changes in the
economic system.
ASSUMPTIONS OF MULTIPLIER
Keynes' Multiplier works on certain assumptions which are as follows :
1. There is only autonomous investment in the economy and no induced investment.
2. MPC is constant.
3. There is no time lag in multiplier process viz. whenever there is increase or
decrease in investment in the economy there is immediately increase or decrease in
the income.
4. Consumption expenditure depends on current year's income.
5. There is less than full employment in the economy.
6. The supply of consumer goods is perfectly elastic.
7. The economy is closed, there is no foreign trade.
LIMITATIONS OF MULTIPLIER
Following are the limitations of Multiplier :
(1) Availability of Consumer Goods : The process of income expansion depends
on the availability of consumer goods. If due to increase in income, consumer goods
are in ample amount then multiplier will be high or not.
(2) Adequacy of Investment: In order to get high multiplier it is essential to have
continuous increase in investment.
(3) Multiplier Period: There is gap between income earning and spending of the
consumer. Higher the gap lesser will be the multiplier.
(4) Effect of Investment on Other Sectors : It is essential to keep in view while
studying the result of multiplier that there should not be adverse effect of investment
on other sectors of the economy otherwise the multiplier effect will be lesser.

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(5) Level of Full Employment : Multiplier will increase income and employment
only when there are idle resources in the economy. As soon as resources are fully
utilized, full employment will be established and increase in income through
multiplier will be checked, whatever be the MPC.
(6) Industrial Economy: In industrially developed economy, production depends on
demand very much. When demand increases production, income and employment
automatically increases, Extra expenditure on consumption is done mainly on
industrial goods. Therefore, multiplier works efficiently in industrial economy.
(7) Excess Capacity in Industry of Consumer Commodity: For working of
multiplier it is essential that there should be excess capacity in consumer goods
industry. In such situation increase in investment will increase the demand for
consumer goods and to fulfill this increased demand extra manpower will be
employed. As a result of it employment, production and income will increase. The
effect of multiplier will be clear.
(8) Elasticity of working Capital : In order to provide job to more manpower the
supply of other factors of production should be perfectly elastic.
LEAKAGES OF MULTIPLIER
There are many leakages in the income stream which slows down the expansion of
income. The leakages are :
(1) Savings : Whole increase of income can not be spend on consumption but some
part of it is saved so that the size of multiplier becomes limited. Therefore, savings is
the greatest leakage of income stream.
(2) Payment of Loans: Some portion of new increment of income goes in the
repayment of old loans and does not enters into the economy in the form of
expenditure, and units the size of multiplier.
(3) Idle Cash Reserve : If some part of the income is saved in the bank then
expenditure consumption reduces and size of multiplier also reduces.
(4) Imports : Expenditure on imports does not increase domestic income and
employment. Thus, the increased portion of income due to investment goes to
foreign which does not impact the consumption of domestic goods so it is an
important leakage.

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(5) Purchase of Old Shares, Stock and Securities: If new income created through
investment is spent on purchase of old shares, bonds and others securities viz. on
financial investment not on real investment then investment on consumption reduces
and size of multiplier reduces.
(6) Price Inflation : Due to price inflation a large portion of income is spent on
consumption rather than on increase in income and employment.
(7) Undistributed Profit of Companies : The leakage in multiplier is due to
undistributed profits which companies keep in Reserve Fund instead of distributing
among shareholders.
CRITICISMS OF MULTIPLIER
The concept of multiplier is criticised on the following ground :
(1) Constant Propensity to Consume : Multiplier theory assumes that MPC is
constant but in reality it is not constant when income changes, MPC also changes.
Keynes' Multiplier Theory expresses the simple curvilinear relationship between
income and consumption but in practical there is complex and non-curvihnear
relationship.
(2) Difficult Estimation : Prof. Hansen says that multiplier is a mathematical
technique and difficult to assess.
(3) Time Element Ignored: Keynes' multiplier is stationary or static and time
element is ignored.
(4) No Clear Explanation : Multiplier does not say about the time gap between
initial investment and final increase in income.
(5) Effect of Increase in Consumption Ignored: It studies the effect of increase of
investment on consumption but ignores the effect of increase in consumption on
investment.
(6) The Effect of Government Investment on Private Investment: If private
investment reduces due to public investment then the possibilities of employment
reduces and multiplier becomes useless.
(7) Other Criticisms : (i) This theory does not apply in underdeveloped countries.
(ii) Prof. Hazlitt says, There is no existence of multiplier.'
(iii) C = F (Y) cannot be proved through data.

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IMPORTANCE OF MULTIPLIER
Theoretical Importance
Explanation of income expansion Importance of Investment Equality between
Saving and Investment
Importance in Post Keynesian Economy
Practical Importance
1. Explanation of trade cycle
2. Helps in formulation of economic policies
3. Full Employment
4. Significance of Deficit Financing.
5. To end Depression
6. Control on Inflation
7. Easy to explain long term stagflation
Theoretical Significance of Multiplier
(1) Explanation of Income Expansion: Multiplier clears the process of income
expansion process of various economies.
(2) Importance of Investment: It clears the importance of multiplier. Initial
increase in investment leads manifold increase in income.
(3) Equality between Saving & Investment: Multiplier theory helps in establishing
equality between saving and investment. If investment is more
than saving then due to multiplier effect increase in income will be greater than
investment. Increase in income will increase saving and at last equality between
saving and investment will be established.
(4) Theoretical Significance of Post Keynesian Economy : Keynes Multiplier
concept has been used by economists like Harrod Domar, Hicks, Samuelson in
economic analysis. In analysing economic development and trade cycle multiplier is
used.
Applied Significance of Multiplier
(1) Explanation of Trade Cycle : Turning points of trade cycle can be explained
through multiplier. High income and low consumption leads to depression and when

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income decreases during depression then consumption does not reduces to that limit.
Therefore, economy increases towards boom.
(2) Helpful in Formulation of Economic Policies: It helps in formulation of
economic policies.
(3) Full Employment: This concept helps to formulate full employment policies and
states that investment should be increased to achieve full employment.
(4) Significance of Deficit Financing : According to multiplier theory during
depression in order to encourage private investment deficit financing is more
effective than cheap monetary policy to reduce the rate of interest.
(5) Helpful is Relieving from Depression : By increasing the initial investment
economy can be relieved from depression.
(6) Control on Inflation : Multiplier works in reverse direction also. In order to
control inflation government reduces investment which results decrease in income.
Consumption expenditure and prices start declining.
(7) Easy to Explains Long term Stagflation : Multiplier helps in understanding
long term stagflation. At the high level of incomes the gap between expenditure and
income increases.
PRACTICAL PROBLEMS AND SOLUTION
1. An economy wants to create extra income of? 8,000 crore. Explain how much
extra investment will be required
If MPS = (i) 0.5 (ii) 0.4
SBPD Publications Economics
Keynes Income or Investment multiplier is criticized because it is a static concept
and it is not related with the dynamic process of income creation. The concept of
multiplier does not tell us about the time lags between initial investment and last
increase in income.
It is worthnoting that Keynes had given three concepts of multiplier :
(i) Logical theory of multiplier which works continuously without time lag.
(ii) Periodic Analysis in which time lag affects consumption expenditure.
(iii) Comparative Static Theory but Keynes has given much stress on first concepts.

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Modern economists study multiplier in dynamic form. There is time lag in change in
income which occurs due to change in investment.
When investment is done initially then it takes tune to increase the income. During
this time lag some other changes may occur. For e. g., increase in investment,
increase in consumption expenditure etc. Its affects income also. In this way
multiplier takes care of short-term and long-term situation. Hansen is given it the
name 'True Multiplier'.
According to Hansen, Real Multiplier is not tautological because it is based on either
short term or long term behaviour'.
In short, modern economists by including time lag tried to clear that we achieve new
income equilibrium with the increase in investment. This concept of multiplier can
be called Active or Dynamic concept. Dynamic concept of multiplier states that
present consumption is based on previous period's income, it means that increase in
present income will lead increase in future consumption.
It is clear from above discussion that dynamic multiplier is :
(i) Present consumption (Ct) depends on previous income (Y ( _x) viz.
Ct-F(YtJ.
(ii) Future income (Y ( j) depends on present investment. It viz.
Y,+1 = F(I,)
(iii) Present Expenditure Et creates income for future (Y(+x) viz. Et = Y( +1 In this
way Keynes discussed the role of dynamic multiplier in income
expansion. It takes years to see the effect on income and consumption due to
investment. It is clear from the Table IV.
TABLE-IV
Time in Increase in Increase Increase in
(Months) Investment in Consumption income
AI AC (MPC = 0.5) (AY)
0 0 0 0
t+1 100 0 100
t+2 100 50 100 + 50
t+3 100 25 150 + 25

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 t+n 100 100 200
If we assume that every time duration is of 1 month and initial investment of? 100
crore takes 17 months time to create ? 200 crore income and if MPC is 0.5 then time
lag to complete multiplier process will be 17 months.
It is clear from the Table that with the investment of ? 100 income will increase by ?
100 crore in the 1st month (t + 1). Since MPC = 0.5 therefore ? 50 crore out of it
will be spent on consumption. In the 2nd month (t + 2) income will increase by ? 50
crore and out of which ? 25 crore will be spent on consumption.
In the 3rd month (t + 3) income will increase by ? 25 crore. This process will
continue till that period when in 17 months income will increase to ? 200 crore In
the Table (t + n) is indicator of 17 months. It can be expressed algebraically also :
Diagrammatic Representation: Dynamic multiplier is depicted in Fig. 3.
(i) C +1 is Aggregate demand function and 45° line is Aggregate supply function.
(ii) If we start in t0 time when income 0% is in equilibrium and if investment is
increase by A-I then in t time income increase equal to increased investment i.e. t0to
t. Increased investment is shown by new Aggregate demand function C +1 + AI.
(iii) But from t0 time consumption lags behind and still equal to E 0 but at YQ level
Aggregate demand increases to Y 01 from
(iv) In t + 1 time period new inves-tment increases the income to OYx and
consumption increases from t to Ex but at this level total demand is Y 1E1 which is
greater than Aggregate supply CE r During this period t + 2 income increases to OY 2
and consumption increases to E^.
(v) Income generation process will go till C+ I + AI Aggregate demand function will
not become equal to Aggregate Supply Function. 45° line at En in nth time period
and new level of income will be established.
(vi) The path from E Q to En is the dynamic path of income generation which
expresses the dynamic process of multiplier.
(viii) The lower part of diagram shows the expansion of multiplier process which
expresses income expansion Y 0 to Yn through E0En curve from t + 1 to t + 3 time
period.

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It can be concluded that in developed economy where all types rigidities and
uncertainties are present, there income from consumption lags behind, therefore,
income generation process remains slow.
MULTIPLIER THEORY TO DEVELOPING CONTINUE
Now the questions arises to which extent Keynes' multiplier theory works in
underdeveloped economies. Theoretically we can say Keynes's multiplier theory will
work rapidly in developing country like India, because Keynes' multiplier theory is
based on the size of MPC. Higher the MPC higher will be the multiplier. India being
a developing country, MPC is higher. But in underdeveloped countries Keynes'
multiplier will not work similar to the working of multiplier in developed countries.
Now we try to see that why multiplier does not work properly in developing country
like India ? For working of Multiplier Keynes has accepted following assumptions :
1. There is involuntary unemployment in the country.
2. Production is flexible viz. when the demand for goods and series increase its
supply can be increased without difficulty.
3. There is extra production capacity in industries.
4. Raw material and working capital is easily available to increase production.
Keynes' Multiplier theory works on only on the basis of above assumptions.
Since above assumptions are not fulfilled in developing countries, therefore, the
working of multiplier is difficult. We will explain above assumption one by one.
1. Voluntary Employment : In Keynesian Economics involuntary employment is a
part of industrial economy where most of income earners work to get wages and
production is does with the purpose of investment. Such involuntary unemployment
is prevalent in large scale in underdeveloped countries like India. In India,
agriculture is the main occupation, capital is lacking, old technique of production is
adopted and disguised unemployment is prevalent Disguised employment is used for
those who are engaged in agriculture and allied works but in reality they are
unemployed, if they are removed from those work, the production will not decrease.
Due to absence of involuntary unemployment the working of multiplier is affected in
underdeveloped countries. The workers are not available on working wage because

124
they don't realize that they are unemployed and secondly what the real income they
are getting, gives them satisfaction equal to working wage.
2. Flexible Production: Most of underdeveloped countries are agriculture based
where production is not flexible like industrial countries therefore, when prices rise,
production does not increase. In such economies uncertainities of rain, insufficiency
of fertilizer and seeds etc. do not allow to increase the production of foodgrains in
short-run. Not only these, raw material skilled labour are such difficulties which
check increasing the production of non-agriculture areas. The result is there is no
increase in production and employment with the initial increase in investment.
In underdeveloped countries production is mainly done for self consumption and not
for sale in market. Therefore whenever income increases MPC increases the demand
for self consumption goods which is partially fulfilled by consumer through self-
production. Therefore, increased demand is fulfilled by transferring the self-
consumption goods to the market. Therefore, when consumption increases,
employment does not increase in such economies.
3. Production Capacity : There is no extra production capacity in industries in
underdeveloped countries. If we study the supply curve of these countries then we
come to know that it increases, up to a limit with increase in effective demand and
after that it becomes parallel to X-axis i.e. with the increase in effective demand
production does not increases. It happens so because there is lack of capital
investment, Till there is extra capacity is available in machines, production
increases. After a limit that machine can not be used and new capital is not available
for new machine. Therefore, supply curve of each stage of economic development
becomes inelastic.
In the figure OP and KPj are the supply curves of two development situations. In
first stage O -> M when demand increases production increases. When demand was
OM prod-uction was OT2. Now suppose demand increases to OMj, Keynes'
multiplier works in O -> K region after that in KP region multiplier does not work.
"In this way in underdeveloped countries in order to increase production, raw
material and working capital can not increased easily."

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4. Scarcity of Raw Material: In underdeveloped countries there is scarcity of raw
material and working capital to increase the level of production.
In short, in underdeveloped country multiplier theory does not work in increase of
employment and production because in such countries investment is increased
through deficit financing which results in inflationary rise in prices in place of
increase in production and employment.

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 THEORY OF ACCELERATOR

Theory of Accelerator states that how much consumption changes with the initial
change in investment in the economy but theory does not make it clear that how
much investment changes with the change in consumption. This point is explained
by the theory of accelerator. The theory of accelerator states that if the demand for
consumer goods increases in the economy then for the production of consumer
goods the demand for factors of production will increase and which thereby increase
the investment. In this way accelerator explains the effect on investment due to
change in consumption.
Accelerator theory was first used by Prof. J. M. Klark in Economics in 1917 but
Economists like Prof. A. C. Pigou, Prof. Simon Kuznets, Robertson Harrod and
Samuelson had given it scientific form. This theory is not related with Keynes.
MEANING OF ACCELERATOR
Demand for capital goods is a derived demand i.e. the demand for capital goods
arises due to the demand for consumption goods whose production is based on
capital goods. In this way change in consumption goods demand has tendency to
change the demand of capital goods. The theory of acceleration is based on this fact.
'Theory of Acceleration states that if demand for consumption goods is changed then
how much the demand for capital goods will change."
As the demand for consumption goods increases, more capital in the form of
machine and equipment are required which raises the amount of investment. Along
with it, due to continuous use some machines are not workable which have to be
replaced with new one. The demand for capital goods is of two types :
(i) In order to maintain the given production level, new machines are required every
year for the replacement of old ones.
(ii) Since we want to increase the production of consumption goods for which we
need extra machines.
Therefore, there is possibility of rapid increase in investment due to increase in
consumption level. Such investment is called 'induced investment.'

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Therefore, accelerator is the ratio of change between consumption expenditure and
change in induced investment.
AI _ Change in Induced Investment AC"
Accelerator =
Change in Consumption Expenditure From the technical point of view value of
accelerator depends upon the capital output ratio and durability of capital goods.
Capital-output ratio shows the invested capital and as a result of which increase in
production. Suppose, there is a carpet factory which is working at its full production
capacity. If the demand for carpet increases by 2 carpets daily then we have to invest
on new
powerloom. If the price of a carpet is Rs 50 then the price of 2 carpets will be Rs
100. If the price a powerloom is Rs 200 and it can weave two carpets daily then it
means that in order to increase production of Rs 100, the investment of Rs 200 is
required i.e. the ratio of investment and output will 200 : 100 or 2 : 1. It means that
the capital of Rs 2 is required to produce Rs 1 output. This ratio will be called
accelerator or capital-output ratio.
In the theory of accelerator this technical concept of capital output ratio is assumed
stable.
When multiplier shows the changes in income and employment i.e., multiplier effect
shows the investment's effect on consumption and accelerator show the effect on
investment due to change in consumption viz. accelerator shows the dependence of
investment on consumption. Therefore, multiplier and accelerator theories are not
contradictory to each other but they are parallel theories affecting National Income.
In short,
(i) What changes occurred due to induced consumption ? —Multiplier
(ii) What changes occurred due to induced investment which is the result of induced
consumption ? —Accelerator
ASSUMPTIONS OF ACCELERATOR THEORY
Accelerator theory is based on following assumptions :
(1) All factors of production are easily available.
(2) There is no excess capacity in production units.

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(3) The supply of capital and entrepreneur is flexible.
(4) Due to increase in production net investment increases immediately.
(5) There is no difference between required capital stock and real capital stock.
(6) Capital-output ratio is stable.
(7) Increase in demand is permanent.
WORKING METHOD OF ACCELERATOR
Working of accelerator in explained through an example : Suppose 100 machines are
required to produce 1000 consumption goods. Now suppose that the age of every
machine is 10 years. After 10 years machine has to be substituted by new ones
which is called 'replacement demand of machines'. When demand for consumption
goods increases then some extra machines will be demanded alongwith replacement
demand of machines.
Change in consumption demand and working of accelerator is shown in the
following table:
Table -1: Working of Accelerator
Year Goods Demand for Replacement Extra New Accel-
1 2 Machines 3 Demand 4 Demand 5 Machine 6 erator 7
0 1,000 100 10 0 10 —
1 1,100 110 10 10 20 10
2 1,300 130 10 20 30 2.75
3 1,500 150 10 20 30 0
4 1,600 160 10 10 30 -Ve
Explanation : Working of accelerator can be clarified on following points :
(i) 0 Years : Suppose, demand for goods in 0 years is 1,000 which require 100
machines 10 machines will be replaced at the end of the year because 1/10 of
machine is damaged every year, Therefore 100 x ^ = 10 will be total demand of
new machines shown in (Column 4 + 6). The accelerator will not work in current
year because the demand for goods has not increased.
(ii) 1st Year : Now suppose the demand for goods increased from 1000 to 1100 i.e.
demand has increased 10%, in such a situation 10% machines will be required. In

129
this way the demand for total machines will increase to 20. Therefore, accelerator
will be calculated :

(iii) 2nd Year: In the 2nd year suppose the demand for goods increases to 1,300
from 1,100 for which 20 machines are required. Therefore, new demand for 20
machine + replacement demand for 10 machines, therefore total 30 machines will be
demanded. The value of accelerator will be :
Increase in demand for goods = (1,300 - 1,100) = 200
(iv) 3rd Year : In the third year the demand for goods increases to 1,500 from 1,300
then the demand for total machines will be 30.
(v) Open Economy: These economies are open economies and they have to depend
on foreign trade for a great extent. Generally, terms of trade are not against. For the
investment import of capital and machines will lead to leakages which makes the
accelerator effect zero.

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 DETERMINATION OF EQUILIBRIUM NATIONAL INCOME
Keynes' theory which is for short run and where quantity of capital, efficiency of
labour, technique of production remain stable. In such a situation employment and
level of income increases or decreases simultaneously and the factors determining
them are same. i. e. both are determined by Aggregate demand. In this chapter
National Income determination will be discussed under two headings.
EQUILIBRIUM LEVEL OF INCOME IN TWO SECTOR ECONOMY
First we study the equilibrium level of income in closed economy. It is also called
Two-sector Economy. In two sector economy only two sectors are there : Family
and business units where public expenditure and taxation are lacking. In such
economy equilibrium of income is explained on the basis of two thoughts:
(1) Equality of Aggregate Demand and Aggregate Supply
(2) Saving and Investment Equality.
(1) Equality of Aggregate Demand and Aggregate Supply : To study equilibrium
in a Two-sector economy we will first study aggregate demand and aggregate
supply.
(i) Aggregate Demand: Aggregate demand means total demand of goods and
services in the economy. There are two parts of Aggregate Demand :
(a) Demand for consumer goods i.e. consumption demand.
(b) The other type of demand is demand for capital goods which is called investment
demand. Therefore, By aggregate demand we mean that how much people and the
government are willing to pay on consumption and investment.
Total Demand = Consumption Demand + Investment Demand AD = C + I (i) So far
consumption demand is concerned it depends on propensity to consume and income.
If propensity to consume is given, then, as income increases, consumption demand
will also increase. In fig. (1) C shows the consumption demand.
(ii) The second part of Aggregate demand is Investment. Keynes assumed that
investment demand does not increases with increase in income i.e.
Keynes has assumed investment demand as Autonomous from income. In fig. (1) I
line represents Autonomous Investment Schedule i.e. whatever be the income,
investment remains the same.

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(iii) If we add this Investment demand I to consumption demand C then we get C +
I. Aggregate demand curve as shown in figure (1). Therefore, in income
determination analysis C + I curve shows Aggregate Demand.
(ii) Aggregate Supply: In an economy total available supply of goods and services
in economy for consumption and investment is called Aggregate supply. The
monetary value of all goods and services produced in an economy is called National
Production. In reality, National Product and National Income are the dual names of
one concept.
Total supply is shown by 45° line. As mentioned above that 45° line or Aggregate
supply curve shows two things :
(i) Aggregate supply of consumer goods and investment goods in the economy and
(ii) National Income in money terms.
45° line in the figure shows that produced income which is shown on X-axis can be
distributed in two types in the society. One part of it is consumed and other is saved.
Therefore 45° line represents
Y = C + S also For e.g. if Y = Rs 2,000 crore
Then C + S = Rs 2,000
EQUDLIBRIUM LEVEL OF INCOME
Now question arises where the equilibrium level of National income is established.
The answer of this question is that the equilibrium level of National Income will be
determined at that equilibrium point where the Aggregate demand C +1 and
Aggregate Supply C + S are equal to each other. It is shown in Fig. (3):
1. OX-axis National Income and an OY-axis consumption, saving and investment is
shown.
2. C + I curve is the 'point curve of consumption' and investment, which is called
Aggregate Demand Curve.
3. Aggregate Supply Curve is shown by Y = C + S or 45° curve.
4. Aggregate demand curve C + I cuts the Aggregate Supply Curve or 45° curve at
E. Therefore, equilibrium level of income is OY.

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It is clear from the above explanation that equilibrium level of income is OY and
Aggregate demand and aggregate supply will not be equal at any other level of
income.
(A) When Aggregate Supply is greater than Aggregate Demand (When AS AD).
This situation is shown in the above portion of the diagram where at OYj level of
income, Aggregate supply is YjF and Aggregate demand is Yfi and spendable
income is OYr At this level of income consumers will spent YjT income on
consumption and save TF. Due to increased income entre-pre-neurs will desire to
invest TG amount. If we add consumption and investment expenditure then we can
know Aggregate demand. For e.g. YtT + TG = Y:G i.e., Aggregate Demand
Function. In this situation Aggregate Supply is Y tF which is greater by GF from
demand YjG. Aggregate supply is equal to Tetal product but in this situation GF
extra production will be kept by entrepreneurs as unwanted stocks which they do not
want to keep, so they will reduce production. As a result, income
will decrease and income will be in equilibrium at OY.
(B) When Aggregate Demand is greater than Aggregate Supply (AD > AS)
The second situation of disequilibrium occurs when Aggregate demand is greater
than Aggregate Supply. This situation emerges when income level is at OY 2. At this
level of income Aggregate demand is Y 2K and Aggregate Supply is Y 2L.
Expenditurable income is OY2 which is equal to total supply or total production
Y2L. At this level of income consumers spend Y 2R income on commodities and save
RL but due to more Aggregate Demand investor is ready to invest RK income on
investment goods. In this way Total demands Y2K (Y2R + RK) which is greater than
total supply Y2L i.e. LK In such a situation investors will not be willing to spent on
stocks of goods but will increase production to fulfill extra demand which in turn
will increase income and equilibrium level of income will again established at OY.
It can be concluded that at the equilibrium level of income always AD = AS. Until
AD = AS, the level of National income will increase or decrease.
Equilibrium level of income by equality of saving and investment
Equilibrium level of income can also be explained through equilibrium of saving and
investment. It is seen in the above explanation that when Aggregate supply (C + S)

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and Aggregate demand (C +1) are equal, equilibrium of income is established. It is
concluded that saving is equal to investment. It can be expressed as :
C+S=C+IS=I
Diagrammatical Representation : In Fig. 3 (Previous) in lower portion of diagram
income is shown on OX-axis and savings and investment on OY-axis. I and S
respectively show investment and saving function. National income
equilibrium flow is that where C + I curve cuts C + S curve in above part of the
figure and in the lower part of figure it cut saving and investment curve. Thus, it is
proved that when Aggregate demand equals to Aggregate supply then savings and
investments are also equal. We can also say that National income is at equilibrium:
(i) When C + I curve cuts 45° Total Income curve
(ii) When S = I
Now, If the disequilibrium between saving and investment then how equilibrium
level can be reestablished ? We will study now.
(i) When saving is greater than Investment Le. (When S > I): If income level
increases to OYt then at this point saving is greater than investment. Here investment
is YtJ and savings YtH i. e. savings is more by JH than investment. The reason for
more saving is that consumption of people is less so Aggregate demand is less.
Therefore, entrepreneurs will keep stock and production will reduce. So income will
also redudue and equilibrium of income will be established at OY.
(ii) When Investment is greater than saving (When I > S): If income level
reduces to OY2 then investment becomes greater than saving. In the Fig. 3 saving is
Y2N at OY2 income level and investment is Y 2M i. e. saving YgN is lesser than
investment NM. Since Aggregate supply or production is less than Aggregate
demand, entrepreneurs will not keep stock and increase the quantity of production,
this will increase income and income level will again reach OY equilibrium level.
Therefore, equilibrium is there where
S=I
At equilibrium level of National Income, Aggregate Demand is equal to Aggregate
Supply and Saving is equal to Investment. Uptill now we have cleared two methods
of National Income determination. National Income will be at equilibrium where :

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(i) Aggregate Demand = Aggregate Supply
(ii) Saving = Investment
The point where Aggregate demand and Aggregate supply are equal or Savings and
Investment are equal are same point where National Income is in eqmTibrium. It is
clear from the following table :
Table : Equilibrium Level of Aggregate Demand and Income (In ? Cr.)
National Proposed Proposed Proposed AD AS Income
Income Consumption Saving Investment (C + I) (C + S) Tendency
(O (S) 0)
0 80 -80 160 240 > 0 Expansion
200 200 0 160 360 > 200 Expansion
400 320 80 160 480 > 400 Expansion
600 440 160 160 600 = 600 EquiMbrium
800 560 240 160 720 > 800 Contraction
1,000 680 320. 160 840 > 1,000 Contraction
It is clear from the above table that ? 600 crore is the equilibrium level of National
income where :
(i) AD = AS and
(ii) S = I which is ? 160 cr. We again take Fig. (3)
(i) In the diagram AD curve C + I and AS curve is shown ky 45° line or Y = C + S.
Both curves cut each other at point E. Therefore, equilibrium level of income is OY.
(ii) In lower fig. (3) SS is the saving curve and II is the investment curve which cut
each other at point E. Here also equilibrium level of income is OY.
It is clear that the concept of AD and AS and Saving-Investment make us to reach at
equilibrium point of National Income. Mathematical Presentation:
(i) AD & AS Approach : We know that National Income is in equilibrium when AD
= AS
Where, AD = C + I AS = Y
at equilibrium Y = C +1 Keynes' consumption function C is :
C = a + by
Where

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Consumption demand C is a constant a which is independent of income Y and is
equal to addition of finite portion of income (6Y). This b is MPC.
In consumption demand function a is constant which indicates that if income Y in
any year is equal to zero then also consumption will be equal to a. This consumption
is done by past saving suppose Investment la is autonomous investment which is not
dependent on income with consumption function.
C = a + by and Investment la is the equilibrium level in two sector economy can be
calculated as :
NATIONAL INCOME DETERMINATION: A THREE SECTOR CLOSED
ECONOMY MODEL
In two sector closed economy the role of Government is ignored, but fiscal policy of
the Government has an important role. Government decides the economic activities
of consumers and producers with the help of budgetary policy. Therefore, it is
important to study the various components of budgetary policy.
MAIN INSTRUMENTS OR TOOLS OF BUDGETARY POLICY
Budgetary Policy determines the economic condition of the economy, therefore,
following budgetary policy instruments are used :
(1) Balanced Budget, Deficit Budget and Surplus Budget
(2) Public Expenditure Policy
(a) Pump Priming Spending, (b) Compensatory Spending
(3) Public Revenue Policy
(4) Public Debt Policy.
1. Balanced, Deficit and Surplus Budget Policy:
(a) Balanced Budget : When government arranges it's expenditure according to
expected revenue or public expenditure is equal to public revenue. It is called
balanced budget.
If Government adopts the policy of maintaning the balanced budget continuously
then there is lesser change in the economic condition of the country because
government spends only that money which it gets from the public, which will
otherwise spent by people themselves.

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According to modern economists budget should not be balanced but according to
situation of country and time period it should be sometimes deficit on surplus
budget. Rarely budget is balanced. Not only this, some odd situation is created due
to balanced budget policy. For eg.
During depression when Government's revenue start falling then for balanced budget
either tax has to be increased or expenditure has to be reduced which will lead to
depression.
Contrary to this in the situation of inflation due to increase in government's revenue
either taxes will be reduced or government expenditure will increase and inflation
will be more intense.
(b) Deficit Budget: When public revenue is greater than public expenditure it is
called Deficit Budget.
In deficit budget government expenditure is more than government revenue viz. total
expenditure increases. Deficit is covered by printing new currency. Economic and
business activities of economy are expanded by deficit budget. As soon new money
comes in circulation then people start spending more on goods and services. In order
to meet the increased demand of goods and services investment increases in the
economy, which in turn increases the employment opportunities, income level
increases and more goods and services will be demanded and economy will be on
expansion path.
(c) Surplus Budget : When government arranges less expenditure in comparison to
expected revenue i.e. when public expenditure is lesser than public revenue then it is
called surplus budget.
Due to surplus budget one portion of total supply of money goes out of circulation. It
has contraction effect.
Surplus budget is made in those situations when government's aim is to reduce the
level of economic activities, for eg. during inflation. Without changing taxation total
expenditure can be directly decreased by reducing the public expenditure. In
addition to this, without increasing the government expenditure, surplus budget can
be made without inposing taxes..There are more difficulty in increasing the tax than
in reducing the expenditure.

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2. Public Expenditure Policy : It is very important part of budgetary policy. In
developed countries in order to remove depression and unemployment, the
government provides employment to people. Contrary to this, during inflation and
boom the government controls the price by doing heavy curtailment in its public
expenditure.
Public expenditure has two forms :
(a) Pump Priming Spending: Pump priming spending means those public
expenditure which are done to induce and revive economic activities so that new
purchasing power can be created and private investment will be encouraged. It is
assumed that such public expenditure done initially will create a continuous process
to remove situation of depression. As some water is put to start a tap or pump and
after that the tap gives water for long time like a continuous flowing stream.
Similarly if government undertakes some expenditure during depression then
economic life will flow smoothly.
In short, during depression when due to shortage future profit or deficiency of
marginal effeciency of capital, private investors do not invest then in order to revive
economic activities inflation is generated through pump priming.
Pump priming does not take place of private investment but done for encouraging
private investment. It is an ad-hoc remedy to control depression.
(b) Compensatory Spending : Compensatory spending is done by the government
when private sectors do not invest sufficient amout. In order to compensate the
deficit of private investment, public expenditure or investment may be of two types :
(i) Public Construction Works: Like expenditure on road construction, bridge and
canal construction.
(ii) Security Measures : For eg. Pension, unemployment insurance, economic
assistance to handicapped.
When government feels that the private investment is lacking then immediately
government should increase investment on public works and social security
measures. Public Expenditure should continue till private expenditure does not reach
its previous level.

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When the signs of recovery start appearing then gradually public expenditure should
be curtailed. When inflationary pressure becomes visible then private investment
should be reduced to minimum.
In this way through public expenditure policy economic stability can be maintaned
in the country.
In the developing countries :
(i) The Government through public expenditure increases industrialization,
agricultural production, export promotion, economic equilibrium and reduces
backwardness.
(ii) By heavy spending on social security government can remove economic
inequality.
(iii) By spending on economic and social infrastructure government can accelerate
the rate of economic development.
In this way the budgetary policy of public expenditure of the Government has great
impact on economic development and economic stability.
3. Public Revenue Policy: This instrument of budgetary policy includes those tools
which yield revenue for the government. While using the different sources of public
revenue, its effect on production, consumption, distribution, saving and investment
has to be taken care of since, tax is the most important source of revenue for the
government, there it has greatest contribution in public revenue.
Taxation has great role in both developed and developing countries, which is clear
from the following :
(i) The tax structure should be such which automatically check the fluctuation of the
economy.
(ii) Through taxation inflation can be controlled.
(iii) The Government can impose higher taxes on rich class and redistribute that
revenue to poors.
(iv) Through taxation the government can Control consumption and increase capital
formation. Along with it the Government can increase the quantity of consumption
good in ratio to increase in income.

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4. Public Debt Policy: The third important instrument of budgetary policy is Public
Debt Policy. Public debt are those debts which government gets from the public of
the country or foreign countries. The government has to pay interest on such loans
so these borrowings cannot be included in incomes.
Public debt help in increasing employment and modern development. For eg :
(i) During inflation government through internal borrowing can reduce the demand
for goods and services and can influence the prices. Countrary to this, during
depression by repaying the debt, the government can bring back normally in the
economy.
(ii) Inflation can be controlled through public debt.
(iii) Public debt can be used to check unnecessary consumption and for arranging
financial resources for development projects.
(iv) In developing countries the burden of public debt is lesser because with the
increase in National income debt can be repayed.
In this way the government tries to achieve the goal of economic development and
economic stability though budgetary policy by using public expenditure, taxation,
public debt and deficit financing
National Income Determination : A Three Sector Closed Economy Model We
have studied National Income determination in a simple economy where there is no
government interference. In order to make our analysis more authentic we will
include Government sector and study the effect of Government expenditure and
Taxation on National Income.
By including Government sector in two sector model of income determination three
sector model is created.
Now, we study the effect of government expenditure and taxation on demand and
income.
(I) Government Expenditure : First of all we take Government Expenditure. It is
based on all the above assumptions of two sector model. The determination of
income in the Government sector is :
In two sector model
Y=C+I

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Y = C + I + G Similarly by adding G in Saving and Investment equation
by adding (G)
(v S = I) Y-C = S)
Now we study through diagram (Fig. 1) the effects of Government expenditure on
National Income.
(i) The Government expenditure is a part of aggregate demand because increase in
government expenditure is similar to increase in investment because it injects extra
expenditure on the flow of income. Therefore, the flow of Government expenditure
is forceful like investment.
Now, we suppose that Government spends in a definite quantity i.e. government
expenditure is also autonomous of income. Therefore, in Fig. 1 Government
expenditure which is shown by G when added to C + I curve, we get parallel C + I +
G curve which shows the aggregate demand.
National Income Determination : A Three Sector Closed Economy Model | 167
(ii) National Income equilibrium level will be at that point where aggregate demand
C + I + G will be equal to or cut aggregate supply i.e. 45° line.
(iii) In the Fig. 1 C + I + G line cuts 45° line at point E where National Income OY E
level is determined.
(iv) It is clear from the diagram that government expenditure G which is equal to the
vertical distance between C + I curve and C + I + G curve is lesser than the increase
in income which is equal to Y AYE. The reason of this is activation of multiplier
which is equal to
It can be concluded that with the increase in Government Expenditure equilibrium
level of income increases.
It is clear from the above that equilibrium level of income is OY E. On other levels of
income, Aggregate Demand C + I + G and Aggregate Supply line 45° will not be
equal.
If income level is more than OY E, then aggregate supply will be greater than
aggregate demand. Therefore, production will be more than sale and producers will
have unsold goods, then they will reduce production which in turn will reduce
income and again income will be equilibrium at OY E.

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If income level is less than OYE, then aggregate supply will be less than aggregate
demand. As a result production will be less than sale, then producer will increase
production to meet the increased demand which will increase income and income
level will rise to OY E again.
It is clear from the above that OY E is equilibrium level of income.
(II) Explanation from Saving-Investment Approach: According to this approach
at the equilibrium level of income :
I+G=S
Here we assume that taxation = 0 I + G = S
In the lower part of Fig. 1 Investment and Government expenditure make I + G
Curve. Saving line is S (Z) which cuts. I + G curve at E where equilibrium level is
OYE.
It is clear that aggregate demand and aggregate supply approach and saving and
investment approach leads to similar National income equilibrium level.
TAXATION AND EQUILIBRIUM LEVEL OF NATIONAL INCOME
Now we study the effect of taxes on equilibrium level of income, assuming the
government expenditure constant. In the economy effects of taxation is experienced
in the form of lowering of consumption. When tax (T) is subtracted from the
personal Income (Y) we get disposable income (Y d).
Y-I
Taxation may be done in two ways :
(i) Lump-sum Tax
(ii) Proportion Tax
(1) Lump-Sum Tax: To make our analysis simple we assume that the Government
decides to collect extra Rs 1000 crore from public through lump-sum
tax. When the Government will impose Lump-sum Tax of Rs 1000 crore on the
public then public's disposable income will be reduced by the same amount. As
result people will consume less at every level of GNP and saving will also be less.
Since consumption is a part of Aggregate Demand therefore, Aggregate Demand
also decreases. As a result AD curve shifts rightside as a result the equilibrium level
of income reduces.

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It has to the noted that the quantity of consumption does not decreases in the same
quantity of imposition of tax, because due to taxation only a portion of consummable
income is being consumed and before taxation one portion of it was being saved.
Therefore, it is clear that due to lump-sum tax reduction in disposable income will
partially reduced consumption and partially saving.
Now question arises how much consumption will be reduced due to taxation.
Reduction in consumption quatity due to lump-sum tax will be equal to the product
of amount of taxation and marginal propensity to consume. If change in disposable
income or consumable income is AY and Taxation is T.
Marginal Propensity to Consume : MPC and decrease inconsumption due to lump-
sum tax is : (- AC) then
-AC = TMPC
T = AYa -AC = AY°.MPC
For e.g.: if lump-sum taxation is Rs 100 crore MPC = 0.75
Then decrease in consumption due to lump-sum tax- Rs 100 crore x 0.75 = Rs 75
crore
Contrary to that if lump-sum tax is reduced then increase in consumption will be
equal to the product of reduction in lump-sum tax and MPC.
AC = Yd.MPC
Now through Fig. 2 we study the effect of lump-sum taxation on consumption
function and equilibrium level of National Income.
In Fig. 2 (A) the effect of lump-sum taxation on consumption function has been
shown. When lump-sum tax is imposed then reduction in consumption be equal to
decrease of product of the amount of tax and MPC. This is the reason after
imposition of lump-sum taxation cousumption function curve C shifts to C1.
Now we analyse what will be the effect of lump-sum taxation on equilibrium level
of National Income. It is shown in Fig. 2 (B).
In Fig. 2 (i) When lump-sum tax is imposed then total expenditure reduces due
reduction in consummable income. As a result Total expenditure curve (C + I + G)
will shift downward C1 + I1 + G1 (Broken line).

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(ii) Due to downward shift of total expenditure curve (C +1 + G) equihbrium level of
income reduces to Y1 from Y0.
(iii) It has to be noted that decrease in the level of income (AY) is not equal to
collected tax amount but will be equal to its product.
The value of multiplier :
PROPORTIONAL INCOME TAX AND EQUILIBRIUM LEVEL OF
NATIONAL INCOME
Now we try to analyse if government imposes proprotional Income tax in place of
lump-sum tax then how will it affect consumption function curve and equilibrium
level of income.
As we know that under proportional tax if we pay 20% or 25% as tax. In this way
under proportional tax without keeping in view level of income, we collect as a
stable tax.
When Government impose lump-sum tax then the amount of tax equally makes our
disposable income as spendable expenditure and this decrease diminishes the money
amount of consumption and investment at each level. But under proportional income
tax at every level of income consumption does not reduce by equal amount but will
reduce proportionately. Therefore, due to proportional income tax consumption
function shifts downward night that amount of consumption reduces but decline in
income level is at previous level. It is shown in Fig. 3.
In Fig. 3 (A):
(i) C is the consumption function curve before imposition tax and after imposition of
proportional income tax. Consumption function curve becomes C.
(ii) The vertical distance between C C is equal to decrease in consumption due to
proportional tax.
(iii) Here it is worthnoting that under proportional tax reduction in consumption is
equal to the product of MPC and tax revenue.
In Fig. 3 (B) the effect of proportional income tax on equilibrium level of National
Income has been studied. In the Figure due to proportional income tax Aggregate
Demand curve C + I + G shifts downward to C +1' + G'.

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It is clear from the figure due to imposition of proportional income tax, national
income equilibrium level shifts to OYt from OYQ.
It is worthnoting that higher the rate of proportional income tax, lower the
consumption thereby ocurring the equilibrium level of National Income.

EFFECT OF TAX ON SAVING AND INVESTMENT

Effect of tax on Saving and Investment affects the equilibrium National Income in
the following way :
C+I+GC+S+T
C+I+G=C+S+T I+G=S+T
or
YYYY
I+G
National Income Fig. 4
It is clear from the above equation that when planned investment (T), Government
expenditure on goods and services (G) and planned savings (S), Deposits Tax (T) are
equal, I + G are inflow or injection and S + T outflow. When inflow and outflow are
equal, there is National income equilibrium. This is explained in the following
diagram:
(i) The equilibrium before tax is E where S and I + G cut each other and OY income
level is determined.
(ii) After imposition of tax S curve shifts leftward to S + T and makes new
equilibrium point at E with T + G which
NATIONAL INCOME DETERMINATION : A FOUR SECTOR OPEN
ECONOMY MODEL
Now we study real balanced GDP determination Four Sector Model including
family, firm, government and the remaining world. In Four Sector Economy or open
economy, balanced GDP is determined in the similar way as in Two-sector and
Three-sector Model. In short, in such economies balanced GDP is determined in the
following two ways :
1. Aggregate Expenditure = Aggregate Output

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2. Saving = Investment
AGGREGATE EXPENDITURE AND AGGREGATE OUTPUT APPROACH
According to this view balanced real GDP is determined at that point when
economy's Aggregate expenditure is equal to total National Income. We know that
Aggregate Expenditure = C + I + G + (X-M)
Now we discuss the effect of the expenditure of domestic firm, government and the
rest of world in determination of National Income. In Fig (1):
C + I + G + (X-
Real Income GDP (Y) Fig.l
AE = C +1 + G + (X - M) is shown by the curve. AE curve is upward sloping which
shows that Aggregate Expenditure of economy increases or decreases with increase
or decrease in GDP.
GDP is the total goods and services produced during a year. Since Total Product is
perfectly elastic therefore, it is equal to every level of AE. In the figure (1) the
equality of AE and total output is shown by 45° line.
At 45° Y = AE since total output (Y) is perfectly elastic therefore, total output
adjusts itself at every level of Aggregate Expenditure. In reality, it determines
balanced GDP.
Aggregate Income generated in the economy is total output. In other words, GDP
shows Y (Aggregate Income).
Therefore, Y = C + S + I + M since we have added (X - M) in AE function therefore
in Y i.e. Aggregate income import will not be included. Therefore,
Y = C + S + T AE = Y
AE = C + I + G + (X-M)
Y = C + S + T C + I + G + (X-M) = C + S + T
The relation between AE and GDP is shown in the following table :
GDP(Y) C = 10 + 75 I G X M X-M AE = C + I + G +
X-M
(1) (2) (3) (4) (5) (6) (7) (8)
0 0 80 20 40 0 40 140
40 40 80 20 40 10 30 170

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 80 70 80 20 40 20 20 190
300 235 80 20 40 75 -35 300
400 310 80 20 40 100 -50 350
600 460 80 20 40 150 -110 450
It is clear from the above table that:
(i) AE is related to GDP (Y) at every level. For e.g. when GDP increases
from 0 to 600 units and AE also increase 140 to 450 (Column 1 and 8)
(ii) upto 300 level of GDP AE > Y.
(iii) More expenditure increases output. Therefore, with the increase in expenditure,
production also increases. Here production is assumed total perfectly elastic
according to AE.
(iv) At the level of 300 GDP AE = Y. The economy is in equilibrium.
(v) Above 300 at any level of income AE < Y. Less expenditure will shift back the
output level to equilibrium level. Therefore it will be not in equilibrium
Fig. 3 position.
This fact is shown in Fig (3). In Fig (3):
(i) At point E equilibrium position is shown where AE = Y and OY is equil-ibrium
GDP.
(ii) At OY, GDP level AE is E and Aggregate Income (Y) is RY r Therefore AE is
greater than total product by RE r In such a situation more expenditure in comparison
to production increases the desired production level upto OY.
(iii) At OY2 level of GDP AE < Y. Here AE is less than Y by TE 2 quantity. Less
expenditure reduces the desired production level to OY r
It is clear that economy has equilibrium income only when AE = Y which is shown
in the figure by OYr
Savings (Leakages) = Investment (Injection) Approach
Now we study the determination of equilibrium income through Savings and
Investment Approach.
We have read earlier that Saving(s), Tax (T) and Export (X - M) is leakage from the
effect point of view and Investment (I), Government Expenditure (G) and Import
(M) are injection. For equilibrium, leakage and injection should be equal.

147
AE + C + I + G + (X-M) + Y = C + S + T At equilibrium,
AE = Y C + I + G + X-M = C + S + T I + G + X-M = S + T I + (X-M) = S + (T-G)
Where,
T-G = Budget Surplus S + (T - G) = Total saving of the economy I + (X - M) =
Investment and Net export In this way, equilibrium income in the economy will be
when total saving will be equal to total output created by investing the total saving.
Balanced Income is shown in the
Table II.
It is clear from the Table-II:
(i) At the income level of 300 Total saving i.e. Column 12 is equal to total property
(Column B) i.e. 45.
(ii) At the equilibrium level of income 300 is shown on Column (9) which AE = Y
Column (1).
(iii) Below or above 300 at any income level Total saving (S) of economy is not
equal to total investment (I).
In this way at equilibrium income 300
AE = GDP and at this level S = I is also.
SAVING AND INVESTMENT APPROACH FOR DETERMINATION OF
GDP
Saving and Investment Approach for determination of GDP is depicted in the
following Figure (4). In the figure :
(i) Sd is Total Saving line i.e. [S + (T - G)] and I + (X - M) is Total investment or
Capital formation line.
(ii) In the economy balanced GDP is determined at Ej, where S + (I - G) = I + (X-M)
i.e. S = I
(iii) On other levels of GDP, economy will not be in equilibrium. For e.g. at OYj
level in the economy Investment is greater than Savings. Contrary to this at OY 2
income level S is greater than investment. Therefore, at both levels of GDP economy
will be not in the equilibrium.
(iv) Therefore, it is clear that OY is the equilibrium National Income.
S + (T + G) = I + (X-M) Le. S = I

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Now it is worthnoting that through both the approaches i.e. Aggregate Expenditure
and Aggregate Output Approach and Aggregate Saving and Investment, equilibrium
income level is 300.
EQUILIBRIUM LEVEL OF INCOME AND FULL EMPLOYMENT LEVEL
OF INCOME
We have studied that equilibrium level of income in any economy is determined at
that point where (a) Aggregate Demand is equal to Aggregate supply or (b) Saving is
equal equal to investment.
But Keynes' view is that it is not always essential that equilibrium level of income
and employment are same. According to Keynes :
'Equilibrium level of income can be established at equilibrium level of employment
or below it'.
Classical economists assu-c med that an economy is always at full employment
level. The base of this assumption is Market Law of Prof. J. B. Say according to
which 'supply creates its own demand'. In such a situation all Classical Equilibrium
factors who
arejeady to work on current wage, have employment opportunity. In this
way in an economy, full employment situation is always present.
The Great Depression of 1930 proved wrong the classical notion when there was
unem-ployment in the whole world. Prof. Keynes was of the view that there may be
unemployment even when economy is in equilibrium which can be removed by
increasing the Ag-gregate Demand. For this equilibrium point has to be shifted
upward right. In Fig (5):
(i) According to economists equilibrium is always establ-ished at full employment
point. As shown in upper portion of figure (5) by ON 0 employment level.
(ii) But according to Keynes equilibrium can be established below full employment
level as show in figure by E r At point Ev Aggregate Demand Curve (C + 1) cutting
Aggregate Supply Curve (C + S). This is the equilibrium point but at this
equilibrium point NjN,, factors are unemployed which clears that income
equihbrium level is established before full employment level.

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(iii) Therefore NjN,, unemployed factors can get employment opportunities when
Aggregate demand is increased. It is shown by C + I + AI new Aggregate Demand
Curve.
(iv) Due to shift of Aggregate Demand Curve, equilibrium point shifts to E from E r
It is clear from the figure that equilibrium point E of classical school and equilibrium
point E1 of Keynes thought represent the same. In this situation equilibrium of
income and equlibrium of employment are same.

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CONCEPT OF MONEY IN MODERN ECONOMY

MEANING OF THE MONEY

English word money has been taken from Latin word TVIoneta'. Moneta is the other
name of Goddess of Rome 'Juno'. It is said that in ancient time this Goddess was
supposed as Goddess of Heaven and coins are minted in her temple. Therefore, the
money which is minted in Goddess Juno's temple, that also named 'Moneta' and
which changed to money later on. Some learned men say that the term 'money' is
derived from Latin word 'Pecunia'. 'Pecunia' word is made of word 'Pecus' and it is
meant for cattle. In ancient Rome cattle are used in the form of money and money
and cattle are used in same meaning. How money is originated, there is conflict
among economists.
WHAT IS MONEY ?
Money may be anything which is accepted as medium of exchange. It is broadly
used for payment of goods and services and repayment of loans. But it is not related
with the situation and respects of transacting people and anybody can give and take
this. Thus, money is that which is generally accepted and used as medium of
exchange and measure of value.
From the ancient time man is using money to remove the difficulties of barter
system. As economy is growing the form of money is changing. In short, the nature
of money is changing according to need of payment and medium of exchange. It is
shown is the following Table-I:
Table-I Development of Money
Stages Nature of Nature of Trade Money as a Medium of
Production and Exchange Exchange and Payment

1. Simple Simple Commodity Money

2. Start of Specialization Growth of trade but to Metal Money—coins
limited area. use
3. Growth of Specialization Trade and Exchange at Metal Money-Beginn-
national level. ing of Paper Money

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4. High Level of Specializa- National and Internati- Paper Money and Bank
tion onal Trade Money
5. Specialization and Auto- Large Amount, Large Importance of Bank Mo-
mation Maximum Prod- Trade and Commerce. ney, Use of Traveller's
duction cheque and Credit card.
Definition of money is categorized in two ways which is clear from the following
Table-II.
Table-H Various Definitions of Money
Base
1. Descriptive Definitions
2. Legal Definitions
3. General Accepted Definition Definition based on Nature of Money
This group includes those definitions which explain works of money. This group
includes definitions given by Crowther, Co-ulborn, Hartley, Prof. Thomas] etc.
Anything which is declared as money by the state is called Money. This group
includes Prof. Knapp's definition. It includes all those defintions which are based on
general acc-j eptance quality of money. It includes the definitions of Selig-man,
Crowther, Keynes and Kent.
Classical Definition: According to them
Money = Currency + Demand Deposit.
Chicago Approach: Money = Cu-rency + Demand deposists + Term Deposit.
Gurle and shaw's Approach: Money = Currency + Demand Depposit + Term deposit
+ Savings bank deposit + Share + Bonds
Central Bank Approach: Money = Currency + Demand deposit+Term
deposit+Savings Bank deposit + Share + Bonds + Securities + Credit from Uno-rga-
nised Sector._
(I) Definitions based on Nature of Money
It can be divided in three class :
(1) Descriptive or Functional Definitions: It includes those definitions which
describe functions of money. It is called descriptive or functional definitions. It
includes the definition of economist Prof. Hartley Withers, Coulborn, Thomas etc.

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(1) According to Coulborn: "Money may be defined as the means of valuation and
Payment".
(ii) Hartley Withers defines : "Money is what money does".
(iii) Prof. Thomas said: "It is a means to an end not for its own sake but as a means
of obtaining others articles or of commanding the services of others".
(2) Legal Definitions : The other opinion regarding money is that which is declared
as 'money' by the government, this view is propounded by Prof. Knapp of Germany
and British Economist Hawtrey.
According to Prof. Knapp : "Anything which is declared by the state as money
becomes money."
The defects of Prof. Knapp's definition are :
(i) Universal acceptance of money is the faith of public not the pressure of the
government because inspite of legal recognition when people's faith is not with the
money then that will not work as money.
(ii) Theoretically this definition is defective because according to theory of exchange
should be free and voluntary but if acceptance of money is mandatory announced by
the government then exchange work with this does not remain free and voluntary.
(3) Definitions based on Common Acceptance: This group includes all those
definitions which lays stress on common acceptance of Money. The main definitions
are:
(i) According to Seligman : "Money is one thing that has general acceptability.
(ii) According to Keynes : 'Money is that by the delivery of which debt contracts
and price contracts are discharged and in the shape of which a store of general
purchasing is held'.
(iii) According to Crowther: "Anything that is generally acceptable as a means of
exchange and at the same time as a measure and store of value".
(iv) According to Kent: "Money is anything which is commonly used and generally
accepted as a medium of exchange or as a standard of value".
Characteristics : From the analysis of generally accepted definition we get three
features of money :
(a) Money should be universally accepted.

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(b) The acceptance of money should be free and voluntary.
(c) Money should perform the function of medium and measure of value together.
Defects: The economists of this group have not included cheques, hundies and
exchange letters in money and said that they are not generally accepted as medium
of exchange.
(II) Definitions based on Viewpoint of Economists
(1) Classical Definition : According to Prof. Hicks traditional definitions of money
are based on the works of money. "Anything which is used as money is money".
Money is that which works as money.
Under classical definitions money includes paper notes, coins and currency and
demand deposits with banks. Demand Deposit is that deposit which can be
withdrawn anytime through cheque. Therefore, according to this approach :
Money = Currency + Demand Deposit
(2) Chicago Approach: This approach was propounded by Prof Friedman,
economist of'Chicago School of Economics.'
According to Milton Friedman : "Money is the temporary abode of Purchasing
power".
To work as temporary abode of purchasing power currency, demand deposit and
time deposit should also be included in money. Time deposite can be converted into
cash without any loss, discomfort and delay. Therefore according to this approach:
Money = Currency + Demand Deposit + Time Deposit
(3) Gurley and Shaw Approach: This approach was propounded by J.G. Gurley
and E.S.Shaw in his book 'Money in a Theory of Finance'. In this approach includes
non-banking financial intermediaries, debentures, savings deposit, shares, bonds
along with currency, demand deposit, time deposit.
Non-banking Financial Intermediaries : It includes savings, loan-committees, Life
Insurance Corporation, Savings bank etc are included.
According to this Approach :
Money = Currency + Demand Deposit + Time Deposit + Non-banking Finacial
Intermediaries - Debentures, Saving Bank Deposits, Shares and Bonds.

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(4) Central Banking or Redcliff Approach: According to this Approach 'Money
means loans given by various means'. According to this Approach money includes
loans issued by currency, Demand Deposit, Time deposit, Non-banking financial
intermediaries and unorganised institutions.
Money = Currency + Demand Deposit + Time Deposit + Non-banking Financial
Intermediaries - Debentures, Savings Bank Deposits, Shares, Bonds + Credit from
Unorganised Sectors.
According to this approach there is similarity between money and other financial
resources. Therefore total credit is included in money.
Suitable Definition of Money : 'Money is that which is independently and generally
accepted as a medium of exchange, measure of value, means of deferred payment
and store of value'.
Weintraub has defined money as : "Money may be defined as those liquid asset
which serve the nation as circulating media."
MAIN CHARACTERISTICS OF MONEY
(i) Money has general acceptance, people accept them as payment for transactions
and loans.
(ii) Money is accepted voluntarily.
(iii) Money has purchasing power.
(iv) Money is the medium of exchanging goods and services.
(v) Money is measure of value.
(vi) Money is used as store of value.
(vii) Money means not the end.
(viii) Money has liquidity and convertibility.
(ix) Money is not veil but an active factor.
FUNCTIONS OF MONEY
Generally money has four functions. Medium, Measure, Store and Standard.
Functions of money is shown is the following chart:
(I) TRADITIONAL OR STATIC FUNCTIONS OF MONEY
Static Functions of Money includes :

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(1) Primary Functions: (Which money has to do at every situation) These functions
are called original and essential functions also. They are :
(a) Medium of Exchange : Money works as a medium of sale and purchase of each
and every goods and services. Due to use of money the exchange works become
indirect. First goods and services are expressed in terms of money (which is called
'purchase') and then goods and services are acquired in lieu of money (which is
called 'sale'). Since money has quality of universal acceptance, therefore, it works as
mediater.
(b) Measure of Value : As we measure electricity in KW, temperature in degree etc.
in the same way prices or value of goods and services are expressed in terms of
money. For e.g.
1 Table price Rs 700
1 Pen price Rs 40
1 meter Cloth price Rs 50
1 Kg Potato price Rs 10
When the prices of all goods are expressed in terms of money then comparison of
the prices of two goods become easy.
The barter system had one difficulty that it was very tough to decide the exchange
ratio between various goods and services but when it started measuring through
money it become very easy.
Since value of money keeps on changing therefore money is not distinct measure of
value.
(2) Secondary Functions : (Which started after the development of economic life).
These functions help in primary function of money. They are called secondary or
derived functions also. They are :
(a) Standard of Deferred Payment: Today whole economy is based on credit i.e.
most of the transactions are done on loan. Money is the easy mean of deferred
payment. It has three qualities :
(i) Money has stability as compared to other commodities. Its value fluctuates less.
(ii) Money has general acceptance quality, therefore, it is required all the time.
(iii) Money has more durability than other good.

156
Due to its function of standard for deferred payment Money Market and Capital
Market have developed.
But as a standard of deferred payment it is not free from demerits because value of
money itself keeps on changing which is sometimes against the debtors or sometime
against the creditors.
(b) Store of value : Man wants to keep some part of his current income for
precautionary motive and unseen contingencies, but he should have satisfaction that
his savings are safe and he can use them anytime according to his needs. None other
than money are suitable for store of value because :
(i) utility of money never destroys
(ii) Always goods can be purchased with its help.
(iii) Money occupies less place.
(iv) Interest can be earn by depositing it to bank.
In present era this work of money occupies great importance because by storing the
wealth, money makes possible capital formation also which is the base of a country's
economic and industrial development.
Newlyn has called this function of money : "Asset function of Money".
(c) Transfer of Value : Transfer of value through money is very easy from one
person to other or from one place to other because it is a liquid property and has
general acceptance. For e.g. If a person wants to shift some other place then he can
sell his properties and purchase the same in other place.
(3) Contingent Functions: These functions are more prevalent in developed
economies :
(a) Distribution of National Income : In modern age production is collective i.e.
Land, labour, capital, enterpreneur all co-operate, therefore, all the factors of
production should get payment according to their contribution.
National Income is assessed in monetary terms and the price of each factor of
production is paid in money.
(b) Basis of Credit: Credit in modern time is the life of business. Banks create credit
on the basis of cash reserves i.e. Credit papers and bank notes are based on money.

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Today's money is nothing more than 'promise to pay'. It is printed on every currency
that:
"I promise to pay the Bearer.........."
(c) Maximum Satisfaction : A cousumer wants to use his income in such a way so
that he can get maximum satisfaction. Consumer can get maximum satisfaction only
when he spend on various goods in such a way that marginal utilities gained from all
goods will become equal to the ratio of the prices of those goods i.e.
Marginal Utility from A Price of A Marginal Utility from B ~ price of B
Only due to circulation of money every person gets the opportunity that he spends
his income in such a way that the marginal utility gained from all good is equal to
ratio of prices of those goods.
A producer also wants to use factors of production in such a way that his cost of
production may be minimum. For this he has to equalize the ratio of marginal
productivity of goods to the ratio of their prices.
Marginal Productivity of A Price of Factor A
Marginal Pr oductivity of B Price of Factor B
Such calculation is possible only in monetary economy, therefore, the use of factors
and income are possible only in such economies.
(d) Increase in Liquidity of Capital : Money is an important asset in which form
property is kept. In reality, all assets can be converted into money. For e.g. all land,
machinery, stock, share can be purchased and sold in terms of money. Therefore, it
is the money which provides liquidity to all assets.
Why above function are called contingent functions ?
In reality all four functions described by Prof. Kinley rise from primary functions of
money. For e.g. Distribution of social income is done through money because
money works as medium of exchange and measure of value also. In this way the
base of credit, liquidity of asset, maximum satisfaction of producer and consumer
also depends on measurement of price. Since above functions are based on medium
of exchange and measure of value. Therefore, it is justified to call them contingent
Functions.

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Miscellaneous Functions:
(a) Guarantee of Solvency : According to Kent money serves to make people
solvent, because a man can be solvent till then he is able to repay his loans and fulfill
his liablities.
(b) Bearer of Option: According to Prof. Graham money works as bearer of option.
The meaning of this function is the man who has money, can use it according to his
will. In reality, when man accumulates wealth, he has not any definite aims that
time, if it is there, it may change in future. Therefore, there is no difficulty in
accumulating wealth, because it can be used in purchasing any thing as it is bearer of
option.
(II) DYNAMIC FUNCTIONS OF MONEY
Paul Eizing has divided the functions of money in two parts : (a) Static Functions
(b) Dynamic Functions.
(a) Static Functions : The static functions of money are also called traditional,
fixed, technical and inactive functions. Such functions mean functions which help in
working of economy but do not help in creating speed. Main functions under these
functions include :
Medium of exchange, measure of value, store of value, transfer of wealth, standard
of deferred payment and activation of price mechanism.
(b) Dynamic Functions : Dynamic functions of money are those which speed up the
economy. Speeding up the economy means to bring stability in price level, increase
employment, income, production and trade. Along with it to provide liquidity to
capital and work on the basis of credit are dynamic functions. It is clear that money
is a dynamic power. During determing Government or Central Bank Policy to check
inflation and deflation money's dynamic function are considered.
Dynamic functions of money are :
(i) Money through prices brings situation of inflation and deflation.
(ii) Due to monetary economy the government can spend more than its income i.e.
Deficit financing is possible.
(iii) Due to money international trade has extended a lot. SDR facility given by IMF
is based on medium of money.

159
(iv) Full utilization of natural and human resources are possible through money
which results in increase in National Income.
(v) Through use of monetary policy the government can achieve the goals of
economic development and price stability.
IS CREDIT CARD A FORM OF MONEY ?
Credit card is not money because it is a type of credit. There is difference between
money and credit. Money is a financial asset of the bearer through which we can
purchase goods and services. Contrary to this credit card is a financial liability for
the bearer, because we are taking loans from the bank who has issued that credit
card. In this way credit card is a loan issued by bank. When we purchase some
commodity through credit card then shopowner gets the desired amount from that
bank which has issued credit card.
OTHER CONCEPTS OF MONEY
1. The Concept of Near Money : We know that assets are of two types :
(i) Real Assets : It includes material assets like land, buildings, table, chairs, metal
etc.
(ii) Financial Assets: These are not real assets but can claim real assets. They are of
two types :
(a) Liquid Financial Assets : It includes currency, coins, demand deposits of banks
etc. They are liquid in nature because it can be used as cash for the current purchase
of goods and services.
(b) Near Money : Near Money is that which has to be changed in cash before
purchasing goods and services. The examples of Near money are : Time deposit,
Hundies, Exchange bill, Bonds, Share, Debentures, Life Insurance Policy which can
be converted into money without losing time and money.
Difference between Money and Near Money
Base
1. Exchange
2. Liquility
3. Parts
4. Income

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Money
It is used directly to exchange goods and services.
Money is fully liquid.
Money includes coins, currency
and demand deposits of banks.
Income is not generated in the form of interest through money
Near Money
Near Money is used indirectly. First it is converted into money then it is used for
exchange. It is not fully liquid. It includes exchange papers, treasury bills, bond,
debenture, share, time deposits and Insurance Policies.
Near money generates incomes for the bearer.
2. Electronic Money or Digital Money : It means that money which is transacted
through electronic means. Generally computer network, internet or digital payment
is done. Electronic Fund Transfer or Credit Deposit are examples of Electronic
Money. It is the collective name of financial symbolic writing and technique.
3. Composite Money : Composite money is that which represent the average value
of various currencies of a group of nations. Euro is the best example. It is a joint
currency of European countries group. It is called 'Composite Money'.
4. Global Money : The currency which is accepted without hitch all over the world
as a medium of exchange is called 'Global Money'.
In International Market 'Dollar' is highly accepted and each nation's currency has its
transaction rate (exchange) with dollar and it is accepted by all nations as a medium
of exchange.
ROLE (IMPORTANCE) OF MONEY: IN CAPITALIST, SOCIALIST AND
MIXED ECONOMIES
In modern age, money is important in every aspect of life. Whether it is Economics
or Political Science, Sociology or Philosophy, Trade or Commerce, Science or
literature, Peace or War. Money is path-showing.
According to Crowther: "In every field of education every branch has its basic
innovation, for e.g. wheel in mechanics, fire in science, vote in political science,

161
similarly in business of economics and men money is the most useful innovation, on
which many facts are based."
In reality, without money our social, economic and political life will not work
smoothly.
According to Prof. A. C. L. Dey : "Money has become so important and worthwhile
that the study of functions of money has become important part of economics."
In all economic systems money is an important economic institution. So we will
study the importance and role of money under different economic system :
(1) Role of Money in Capitalistic Economy
(2) Role of Money in Socialistic Economy
(3) Role of Money in Mixed Economy
Role of Money in Capitalistic Role of Money in Role of Money in Mixed
Economy Socialistic Economy Economy
1. Solution of Central problems 1. Allocation of Resources 1. Formulation of Plans
2. Role of money in consumption 2. Distribution of Income 2. Economic Development
3. Role of Money in Exchange 3. Capital Formation 3. Expansion and
4. Role of Money in Distribution 4. International Trade Accounting of Public
5. Role of Money 5. Circular Flow of Money Sector
in Public Finance 4. Need of Foreign
Exchange
5. Sale & purchase of
Goods & Services
6. Money & Industrial Progress
7. Money & Trade facilities
8. Money & Economic Progress
9. Effect on Income, Production & Employment
6. Necessary for Economic Planning
6. Other Importance
ROLE (IMPORTANCE) OF MONEY IN CAPITALISTIC ECONOMY
In capitalistic economy there is private ownership on factors of production and
private entrepreneurship produce to earn maximum profit. Such economy is 'Money

162
Economy' where economic activities are done by 'Price Mechanism'. Since prices are
expressed in money, therefore in capitalistic economy money plays important role. It
is clear from the following :
1. Solution of Central Problems : The central problems of capitalistic economy, for
e.g.-what, how and for whom to produce is solved through money based price
mechanism.
(a) What to Produce ? : In a capitalistic economy consumers are ready to pay more
for those products which they like more. Therefore, producers produce those
commodities which consumers desire more to get maximum profit and every
producer uses his resources in a way to get maximum market price.
(b) How to Produce ? : The aim of every reducer is to earn maximum profit. The
difference between the price of commcty and cost of production is called profit. He
has to choose that combination of factors of production which gives maximum
production at minimum cost. If cost of production per unit labour is less than the
cost of production per unit capital then labour will be used more in place of capital.
(c) For Whom to Produce ? : It is related to distribution system. It is solved by
price system. People who have more income, they get more portion of National
Income. In simple words, people who have more income, they have more purchasing
power and they demand more goods and producers produce more those goods
demanded by them. Contrary to this, people with less income, demand less
commodities and producers produce according to their demand. Money is a centre
around which economic activities clusters.
Money has made all economic activities easy like consumption, production,
exchange, distribution and public finance.
2. Role of Money in Consumption :
(i) With the help of money consumer's dominance is maintained. He spends only
when he gets necessary commodities according to his desire.
(ii) Money helps in following the principle of Equi-Marginal utility, through which
consumer gets maximum satisfaction from his expenditure.

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(iii) Money has made exchange work easy as a result of which number and quantity
of goods available to consumer, along with this taste and preference of consumer is
also taken care of.
3. Role of Money in Exchange :
(i) Availability of Credit: Today for the production of goods and services money
and credit both are equally required. For large scale production units availability of
credit is the most important. We know that credit creation is possible only through
money. Credit market's importance for credit is utmost. The development of credit
market depends on money. According to Hawe :
"Money is inevitable need for the development of credit market." In this way in
capitalistic economy, money plays important role by assuring the availability of
credit.
(ii) Savings & Investment: The base of capitalist economy is capital or money. To
produce in large quantity, large amount of capital is require. Capital is gained
through money, which people invest in the form of savings somewhere. Small
savings are possible only through money and these small savings combine to take
form of capital.
(iii) Link between the Present and Future : Under capitalism independence of
entrepreneurship and consumption money establishes relationship between present
and future. Consumer gets opportunity to save some portion of his income due to
independence of consumption. Capital goods are produced through investment due
to savings and capital goods contributes in increment in the economy.
4. Role of Money in Distribution : Production is a collective process in the modern
time. The good produced are sold in the market for money and earned money
through wealth is distributed among factors of production. All these are possible
through money.
5. Role of Money in Public Finance : Due to continuous increase in government
works importance of public expenditure is increasing day by day. In order to meet
public expenditure the government receives income from various sources. No
Government can receive taxes, fees and fines from commodities because farmers,
carpenters, cobbler wish to pay in the form of grains, furniture and shoes

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respectively. Therefore, public revenue could be received in money form which is
impossible in the absence of money. In short, the amount of public expenditure is so
huge that it can be collected and spent in the form of money only.
6. Money and Industrial Progress: Money is the life-line for to encourage
industrialization. In the industrial age the success of industry depends on the
quantity of capital. Prof. Pigou has written :
"Industries in the modern age is covered with the veil of money."
7. Money and Trade Facilities: Business is done to earn profits. Therefore,
industrial units have to be selected, size of business has to established, various plans
have to be made to conduct those businesses. The relationship between cost and
income has to be verified. All the above works are not possible without money.
8. Money and Economic Progress : As barometer indicates the air pressure of place
and thermometer indicates the temperature of body, similarly, money is the indicator
of economic progress of any country. By studying the monetary history of any
country we can say that how much economic progress has been done because with
the increase in human wants monetary system also changes accordingly. In other
words, as man becomes wealthier his wants go on increasing and monetary system
also goes on changing accordingly. Therefore, Herbson has written in his book
'Growth of Present Capital' that monetary system of country is the indicator of
economic development of that country.
9. Effects on Income, Production and Employment : According to Keynes money
affects our economic activities like income, production and employment directly.
The level of production and employment can be increased with the help of money
and income of the society can be increased. Therefore, money is a dynamic factor.
Financial sector is the important area of the economy in which activities are
influenced by money. Money influences the investment by influencing the rate of
interest and in this affects the whole economic activities like income, production and
employment. Therefore, money is not only a veil.
It is clear from the above discussion that money's role is very important in
capitalistic economy. Marshall had said, "Money is that axis around which all
economic activities revolve."

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ROLE OF MONEY IN SOCIALIST ECONOMY
Socialist economy is that form of economic system in which factors of production
are governed by the state. All areas of the economy for e.g. -industry, agriculture,
transport, business are conducted by government employees. The main aim of
production is to increase the social welfare and its aim is not to earn profit. In such
economy central problem are not solved by price mechanism but done by Central
Planning Authority.
We will study the role of money in Socialist Economy in short:
(1) Allocation of Resources : In Socialist Economy Central Planning Authority has
to allocate factors of production in various activities. To allocate the resources in a
proper way money is required. Central Planning Authority decide that every
manager create productive goods and services in such a way so that average cost will
be minimum. Alongwith it every management select that scale of production in
which marginal cost should be equal to price because in such economy all resources
are under the control of the government. Therefore even raw material, machines and
other costs are sold at such costs which are equal to the marginal cost.
If the price of a commodity is more than its average cost then plant manager will
earn profit and if the price is below the average cost of production then loss will
occur. In the first situation the industry will expand and in the second situation
production of the industry has to be reduced and at last equilibrium will be
established by Trial and Error Method. It is shown in the following diagram (Fig. 1).
(i) DD is the demand curve and SS is the supply curve. Price mechanism has been
described with the help of demand curve and supply curve.
(ii) Suppose, Central Planning Authority initially decides the price of commodity
OPj which is higher than the equilibrium price OP3. At this high price consumer will
purchase only OMj quantity but production aim OM4 was already decided.
(iii) At end of initial counting producer will inform Central Planning Authority that
M1M4 extra amount of X is in the stock. In the 2nd term Central Planning Authority
will adopt the policy of price reduction in order to sell that extra quantity Ml M4 of X
as a result demand of that commodity will increase.

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(iv) In the Figure when the price of the commodity reduced to OP 2 from OPt then
consumer will demand OM 4 quantity of the commodity then only OM 2 quantity is
sold. Therefore, Production Management Board will suggest to increase the supply
and along with it Board will increase the price of the commodity from OP 2 to OP3.
At point T the demand and supply of commodity X is equal.
(v) Therefore, the price of the commodity will be decided OP3 and OM3 amount of
commodity X will be produced in the economy.
(2) Distribution of Income : In Socialist Economy also in the absence of monetary
system equal distribution of commodity among the consumers will be impossible. In
reality ideal of Marx 'Each one have according to need' is impractical because there
is not any objective parameter to measure each person's requirement. Therefore even
in Socialist Economy, money is required to distribute the income of labourers. In the
absence of money, the income distribution in the form of goods and services will be
very difficult. After getting the income in the form of money, consumer will easily
get goods and services according to their need.
(3) Capital Formation: Large scale production is assumed as the base of economy
in the Socialist Economy also capital formation is required. In socialist economy
also have the resources of capital formation similar to capitalist economy. It includes
taxes imposed by the government, profit to public sector industries, taxes on
agriculture production, income from foreign countries. All are expressed in terms of
money. Therefore, money is very important for capital formation.
(4) International Trade: Socialist Economies do not undertake commodity trade by
establishing bilateral trades. Since they are members of World Bank and IMF, so in
international trade they pay in money.
(5) Circular Flow of Money: There is circular flow of money in Socialist Economy.
For e.g.: Productive units get capital for investment from state budget or grants or
loans from the state, so that they can purchase required resources and pay the
labourers, labourers spend their income on consumer goods. In this way in a
Socialistic Economy, money helps in circular flow of goods and services.
(6) Necessary For Economic Planning : In Socialist Economy Central Planning
Authority prepares plan in two parts :

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(i) Physical Plan : By such plans material Aims like : production, Real National
Income, employment are determined.
(ii) Financial Plan : In financial plans financial aims like : price determination,
income determination of factors of production, government loan, taxes, expenditure
etc. are decided in the form of money. Therefore, money olays important role.
It is clear from the above discussion that money has important place in Socialist
economy but money is not so important in socialist economy as it is important in
capitalist economy. We agree with G. N. Halm who says :
"Socialist Economy is always monetary economy and it will remain same in the
future also."
ROLE OF MONEY IN MIXED ECONOMY
Planned economy has two forms : (i) Socialist Economy, (ii) Mixed Economy . We
have already studied about Socialist Economy. Now we study Mixed Economy.
Mixed economy is that economy in which private sector & public sector both jointly
work for the economic development of the country. In such economy economic
problems in private sector are solved by price mechanism and production is done
with the aim of profit earning but they are under the control of the Government. In
such economy the role of money is following :
(i) Formulation of Plans : The size of plan depends on the availability of money.
Money helps in preparing the Government development schemes and their
implementation.
(ii) Economic Development: For economic development the real resources of the
country like-land, forest, mineral water, labour should be fully utilized. For further
utilization of resources money is required which is acquired through— savings,
taxes, loans etc. If total wealth acquired from these resources falls short then the help
of Deficit Financing is taken which is possible only through money.
(iii) Expansion and Accounting of Public Sector : With money the Government
establishes and expands industries in various areas especially in backward areas. The
cost and revenues of the goods and services produced by these industries are
assessed through money only.

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(iv) Need for Foreign Exchange: Every developing country has to arrange foreign
exchange in large amount for its economic development. For this, it is necessary to
gain foreign exchange in required amount and there should be stability in foreign
exchange rate. For this proper regulation of money is essential.
(v) Sale-Purchase of Goods and Services : The sale and purchase of goods and
services in internal and foreign market is possible only through money.
Other Significance
(i) The Government provides facilities to entrepreneurs in direct or indirect
way.
(ii) In non-monetised sector government opens Savings Bank, starts construction
work, establishes industries and thereby increases the movement of money to
develop exchange economy which is possible only through transaction of money.
(iii) Don Patinkon assumed money as consumer goods. According to him through
money people increases their utility and raise their standard of living.
(iv) Retarding Element: Money helps in economic development on the one hand
and creates problems also on the other. Large expansion of money leads inflation,
balance of payment problems. In order to check it the government controls excess
expansion of money.
SIGNIFICANCE OF MONEY IN NON-ECONOMIC SPHERE
(1) Money and Social Development: Money has important contribution towards the
development of social life. When labourer were paid in commodities then farmers
and labourer incur losses and in reality as they were the slave of zamindars and
landlords. They could not change place or job according to their desire. But when
they start getting wages in money then they became free to purchase anything. Many
institution like-dispensary, library, schools, research centres and many social welfare
institution which provide help to poor and disabled.
(2) Money and Political Freedom : Money has its own importance in political field
also:
(i) The Government of any country makes plan for development only when they
have sufficient capital which is possible only when money is available.

169
(ii) All types of taxes are paid in money so that every person is aware of his rights
and starts taking interest in political affairs to take care that public wealth would not
be misused. The statement of modern age is 'No taxation without representation'.
Only due to money democratic government has been started being set up.
(iii) Money and National & International Co-operation : Under monetary system
self-dependence is replaced by specialisation and exchange. People leaving for apart
meet each other for trade, opinions exchange, mutual relation strengthens, national
integrity increases, through use of money international co-operation encouraged and
mutual payment has become convenient through money.
(iv) Other Non-economic Significance : In non-economic sectors also money is
required. For e. g. :
(i) Money is required for charity, worship and donation.
(ii) People and commodities are recognised on the basis of money. To quote
Horrace:
"All things human and divine, renown honour and worth, at money's shine go
down."
EVILS OF MONEY
Although money is very important but it is not full flawless. Many statements are
given for money as :
(a) "Money which is a source of so many blessings of mankind becomes also unless
we control it, a source of peril and confusion." —Robertson
(b) "Money is a valuable through dangerous inventions."
(c) "Money is a good servant but a bad master."
1. Economic Evils of Money : Evils of money from economic point of view :
(a) Encouragement to Borrowing : Money encourages the habit of borrowing
because it helps in taking and repaying loan which encourages extravaganza.
(b) Over Capitalisation & Overproduction: When industrialist get loan easily then
this tendency encourages over capitalisation and overproduction in industry and
business and disrupts the economy.

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(c) Instability in Value of Money : Exchange rate of money keeps on changing.
The effects of this change fall differently on different classes, but the effects in total
are very uncertain hinders trade and industry.

Evils of Money
• Economic Evils
• Political Evils
• Social Evils Moral Evils
(i) Encourages materialism
(ii) Tendency of Exploitation. Encouragement to borrowing. Over capitalisation and
overproduction. Instability in value of money Inequality in distribution of wealth
Money is not real measure of sacrifice and content of human being. Emergence of
class-conflict
(vii) Inflation
(viii) Money becomes master from servant.
(d) Inequality in distribution of Wealth: Big industries are established due to
money which encouraged capitalism. It accumulates all factors of production in the
hands of industrialists in the hands of capitalists.
As production increases rich class become richer and poor become poorer. There is
great difference in incomes which leads to revolution.
(e) Money is not real measure of sacrifice and content of human being : Money
is not real measurement of human sacrifice and satisfaction because money and
purchasing power are not the same thing. It is possible that men have money but
they are not able to purchase goods and services. Due to expansion of money after
1st World War German Mark was in abundance but German people were not able to
purchase.
(f) Emergence of Class Struggle: Due to power of money in all capitalist economy
some people become more rich and some remain poor. It created two class-rich and
poor. There is always conflict between them and leads to strikes, lockout, picketing
etc.

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(g) Inflation : Under money system the Government sometimes spend more and to
fulfill this deficit new currency is printed. It leads to inflation in the country. Such
situation is seen mostly in developing country and more wealth is required for
success of economic planning.
(h) Money become Master from Servant : Money has become master from
servant. Money is useful only when it is like servant i.e. under control but when it is
out of control then it is very harmful.
2. Social Evils : Social evils of money are :
(a) Encourages Materialism: Growth of money encourages materialistic
tendencies.
(b) Tendency of Exploitation : In order to earn money people exploit others. It is a
social evil.
3. Moral Evils : To get money men have given up moral values and leads to bribing,
black marketing, burglary.
4. Political Evils : The reason of political evils is money. Change political parties
are due to lust of money.
IS MONEY IS ACTIVE INSTRUMENT OF ECONOMIC CHANGE ?
Now question arises is money a passive instrument ? There are two views :
1. Classical View : Classical economists of the view that money is only medium of
exchange. According to them money does not influence production, consumption
and exchange. Therefore, money has no importance in determination of real
production.
2. Modern Views: Modern economists consider money as active dynamic agent. For
e.g. Keynes was of the view that with the increase in quantity of money, rate of
interest decreases and investment increases. As a result production, employment and
National Income increases.
Prof. Friedman, monetary economist of the opinion that money has important role in
solving various economic problems. In this context importance of Monetary policy
is more stressed.

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 UNIT-II
MONEY SUPPLY: MONETARY AGGREGATES

MEANING & DEFINITION OF MONEY SUPPLY

Money supply means the total amount of legal tender money circulating in the
country. Legal tender money includes circulating notes and coins in the country
which is used as medium of exchange. In present time credit money or bank money
is also used as medium of exchange. Therefore, bank money is included in the
supply of money.
Definition : Money works in two ways :
(1) Medium of exchange (ii) Store of value.
In view of above dual works of money, the supply of money is also defined in two
ways :
(a) Narrow Approach of Money Supply : Money supply in the narrow sense
means all money in circulation which is used as medium of exchange and which is
universally accepted as payment for sale and purchase and repayment of loans.
In short money in narrow sense includes only liquid assets which are accepted in
repayments :
(i) Currency with Public (C): (i) Currency is issued by the Government of a
country or the Central Bank of a country. It is called Legal Tender Money because it
is generally accepted as medium of exchange and repayment of loans.
(ii) Demand Deposits of Bank (DD): Demand deposits deposited by public in
banks is also a part of money supply because they are easily accepted as means of
payment. In the narrow sense, the supply of money is expresssed by Mj in equation
form (Supply of Money) Ml = Currency (Notes + Coins) + Demand Deposits.
(b) Broad Approach to Money Supply: In the narrow sense of supply of money
has forgotten the store of value work of money in which money supply is described
as medium of exchange. But some economists like Milton Friedman said that 'The
store of value work is as important as exchange work.'

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He included Time deposits in money supply. According to him Time deposits can be
converted into demand deposits and cash in any time. Therefore, they should be also
included in the supply of money. It is called the broad approach of money supply.
This approach is called M8 in India. Supply of Money M = Currency + Demand
deposits + Time Deposits
Clearly, according to narrow approach savings and time deposit is not included in
money and according to broad approach it is included in the money.
REASONING IN FAVOUR OF ADDING SAVING AND TIME DEPOSIT
Since people generally change their time deposits in currency. So payment is not
done on the basis of time deposits, all banks include in money supply.
ITEMS EXCLUDED FROM MONEY SUPPLY
Following items are excluded from the supply of money of a country : (1) Available
cash with commercial banks is not included in Money Supply since they are the base
of public deposits or credit money.
(ii) In order to print paper money, some gold is kept as securities, it is not included
in supply of money because it is not in circulation.
(hi) Cash available with the Government and Central Bank is not included in supply
of money because demand based deposits are based on this funds.
DISTINCTION BETWEEN STOCK AND FLOW OF SUPPLY OF MONEY
Supply of money is studied in both form Stock and Flow. If supply of money is
studied in relation to any point of time then it is called the concept of 'Stock'. If it is
said that on certain date the supply of money is this, it is called Stock Concept but if
it is said during sometime period it is called Flow Concept. In order to know the
flow of money the stock of money with people during one year is multiplied by
average velocity of circulating money. Velocity of Money means that during a
certain period one unit of money moves at for which speed transactions from one
man to another. If stock of money is M and average speed is V then the supply of
money at certain period will be M x V = MV.
In short, inflow of money includes both stock of money and velocity of money.
DIFFERENT CONCEPTS OF MONEY SUPPLY
We will study two approaches related to supply of money :

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(1) Traditional view, (2) Friedman view, (3) Gurle & Shaw views, (4) Redcliff or
Banking view.
Above all views are discussed in Chapter 'Concept of Money in Modern Economy'.
Modern Views: According to modern view, Total supply of money includes
currency and demand deposits viz.
upply of Money = Currency (Coins + Notes) + Demand Deposits
MONETARY AGGREGATES AND MEASURES OF MONEY SUPPLY IN
INDIA
On the basis of'Second Working Group of Money Supply' Reserve Bank of India
calculates money supply on the basis of four components :

Now we study four components of money supply :

(1) Mj Narrow Concept of Supply of Money : The narrow concept of supply of
money i.e.M1 is very important for a developing country like India. Ml includes
following factors :
(a) Currency with Public (C) : Currency with public has important contribution in
supply of money. The factors included under it are :
(i) Notes in circulation, (ii) Rupee coins, (iii) Small coins.
Cash with banks is deducted from the total of notes in circulation, Rupee coins,
small coins. Therefore currency with the government - Notes in circulation + Rupee
coins + small coins - Cash with banks.
(b) Demand Deposits with Banks-(DD) : Demand deposits in banks refers to the
demand deposits of commercial and Co-operative banks. It is created through two
ways :
(i) Active and (ii) Passive.
Active deposits is created when people deposit cash in banks. It is also called High
Powered Money.
Passive deposits are created when bank collects money through giving loans.
(c) Other Deposits with Reserve Bank (OD) : Other deposits with Reserve Bank
include demand deposits of foreign governments, other Central Banks, IMF, World
Bank along with other deposits.

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In short,
Example 1. We will try to make clear the value of M1 with the imaginary numbers of
following table :
Table 1-A
Due amount of Mt an 1st April, 2017 in (Crore ?)
Ml (i + ii + iii)
(i) Currency with the public (C)
(ii) Demand Deposits with banks (DD)
(iii) Other Deposits with RBI (OD)
6,91,640 4,10,110 2,75,410 6,120
It is clear from the above that maximum amount of Mj is currency with the
government. On 1st April, 2017, in total due of M1 the share of C was 56.4%, DD
was 42.8%, OD was 0.8%, it is negligible.
Demand Deposits (DD) and other deposits (OD) (i + iii) with RBI is called Deposit
Money of Public.
(2) Mjj Concept of Supply of Money: By adding the savings deposits of post office
we get M2 i.e.
M2 = Mj + deposits with post office
Example 2. If Mx is Rs 6,91,640 crore and saving deposits of post office is
Rs 11,000 cr. then M2 will be :
M„ = Rs 6,91,640 cr. + Rs 11,000 cr. = Rs 7,02,640 cr.
(3) Mj, Broader Concept of Supply of Money : In broader concept of money
alongwith Mt (Currency with the public + Demand deposits with bank + other
deposits in RBI) banks' time deposits are also included.
M3 = Mj + Time deposits with banks
Example 3. If on 1st April, 2017 (imaginary) banks have Rs 18,11,427 cr. as time
deposits and M1 Rs 6,91,640 cr. then
M3 = Mj + Time deposits with bank
= Rs 6,91,640 + Rs 18,11,427 cr.= Rs 25,03,067 cr. M3 is called Broad Money or
comprehensive monetary resource. In India to indicate annual increase rate of money
supply generally increase rate of M 3 is used.

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(4) M4 Concept of the Supply of Money : M 4 is the broadest concept of supply of
money. In it except M3, total deposits of Post Office is included, whether these
savings are done through banks or other schemes.
M = M + Total deposits of Post Offices
In short, four concepts of money supply are as follows :
Mj = Currency with the public + Demand deposits + Other deposits with Reserve
Bank
Mg = Mj + Savings deposits of Post Office
Mg = Mj + Time deposits of bank
M4 = M3 + Total deposits with Post Office In India following factors are included in
money supply :
1. Currency, notes and coins with the public
2. Demand deposits and Time deposits" with Scheduled and Non-scheduled and
state government banks.
3. Amount of deposits with RBI.
4. Total deposits with Post Office.
Table 1-B
Relation between Mt, M^, Mg and M4 (Imaginary numbers)
Concept of Money
(1) Currency with Public + (2) Deposits with the bank + (3) Other Deposits with
bank
Supply of Money (Monetary liquidity, M,, M 2, M3, M4) has following importance :
1. Mt: It is the most liquid form of money. Only this part of money is used at any
point as medium of exchange. It is called supply of money to public.
2. Mj: It is less liquid than M r The reason of it is that savings deposits with post
office is less than demand deposits of the bank
3. M3 : It is less liquid in comparison to Mj and M 2. The reason is that it includes
fixed deposits of banks also which is less liquid than savings deposits of post office.
4. M4: In M4 in which total deposits with post office alongwith M 3. Therefore it is
less liquid than other money.

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It is clear from the above discussion that as we proceed from Ml to M2, M3, liquidity
of money goes on decreasing or we proceed from 'medium of exchange' form to
'store of value'. Various components of money supply are not equally important but
there is difference in their relative importance.
In India among the above components of money supply M 3 is the most important. It
is generally called Broad Money.
Numerical Examples:
1. Find the supply of money from the following data :
(i) Currency with the Govt. Rs 5,30,870 cr.
(ii) Demend Deposits with the Banks Rs 3,96,830 cr.
Solution : Money Supply = (i) + (ii) = 5,30,870 + 3,96, 830
= Rs 9,27,700 crore
2. Calculate the currency with the public from the following data :
(i) Cash with banks Rs 537 cr.
(ii) Notes in circulation Rs 5,202 cr.
(iii) Small coins Rs 222 cr.
(iv) Rupee coins Rs 342 cr.
Solution : Currency with the public = (ii) + (iii) + (iv)
= 5,202 + 222 + 342 = X 5,766 Cr.
3. Find Mv M2, M3 and M4:
In ? Cr.
(i) Currency with the Public 2,56,787
(ii) Deposits with the banks 1,85,779
(iii) Deposits in Savings accounts of Post Office 5,041
(iv) Time Deposits with Bank 12,15,844
(v) Total Deposits of Post Office 25,969
Solution : Rs Cr. Mj = (i) + (ii) = 2,56,787 + 1,85,779 = 4,42,566 M 2 = M1 + (iii) =
4,42,566 + 5,041 = 4,47,607 M 3 = M1 + (iv) = 4,42,566 + 12,15,844 = 16,58,410 M4
= M3 + (v) = 16, 58,410 + 25,969 = 16,84,379

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MONEY SUPPLY IN INDIA
Among the four measures of money supply used by Reserve Bank of India (RBI),
Mx and M3 is the most important.
By Mx the narrow meaning of money supply and by M3 broad meaning of money
supply is indicated. We will study the supply of narrow money M1 and broad money
M3 .
Supply of Narrow Money M1: In the Table-2 the supply of money from 1970-71 to
2012-13 is shown. The numbers of table shows that:
Table - 2 Increase in Mt Money Supply
(in ? Cr.)
Year Currency Demand Deposits Other deposits Total Supply
with Public with banks of RBI of Money
1970-71 4,367 2,910 44 j 7,321
1980-81 13,464 9,336 317 23,117
1991-92 61,231 52,855 885 1,14,971
2001-02 2,40,795 1,79,198 2,850 4,22,843
2010-11 9,14,200 7,17,660 3,650 16,35,510
2011 -1? 10,25,670 7,04,910 2,820 17,73,400
2012-13 11,08,790 6,92,280 1,420 18,02,540
(1) The currency with public in 1970-71 was Rs 4,367 cr. which increased to Rs
11,08,790 in 2012-13.
(2) So far the total supply of Money M t is concerned was Rs 7,321 in 1970-71,
increased to Rs 18,02,540 cr. in 2012-13. Currency with public, demand deposits
with the bank and other deposits with RBI has important contribution in supply of
money.
(3) During last 30 years the proportion of deposits with bank, has increased more
than currency with the public. In 1970-71 the contribution of currency in total supply
of money was 69.8% which reduced to 56% in 2012-13 Although there is sufficient
increase bank deposits during last 38 years but here also people use currency more
for exchange.

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GROWTH OF MONEY SUPPLY Mg AND ROLE OF INFLATION IN INDIA
IN RECENT YEARS
By adding the Time deposits of Banks in M1 we get the broad measure M 3 of money
supply. During last three decades there is important change in supply of money in
India i.e.the deposits have increased. Time deposits were Rs 3,637 cr. in 1970-71
which increased to Rs 62,97,860 cr. and demand deposits rised from Rs 2,910 cr. to
Rs 6,92,280cr. during the same period which is clear from Table-2 andTable-3.
Table - 3 Broad Measure of Money Supply Mg (in Rs Cr.)
Year Mi Deposits with Banks M3
(1) (2) (3) (2 + 3)
1970-71 7,321 3,637 10,958
1980-81 23,117 32,241 55,358
1990-91 92,892 1,72,936 2,65,828
2001-02 4,22,843 10,75,512 14,98,355
2010-11 16,35,510 48,63,980 69,99,490
2011-12 17,33,400 56,24,350 73,57,705
2012-13 18,02,540 62,97,860 81,00,400
In fact with the increase in time deposits banks' power to give loans increases and
due to credit creation by banks supply of money increases. The supply of money M 3
concept express the both works of money i.e.(i) Medium of exchange and (ii) Store
of value.
M1 & Mg as Percentage of GDP
It is clear from Table-4 that M3 has increased more than Ml during last years.
Table - 4 M1 & Mg as Percentage of GDP
Years Mi M3
2004-05 18.5 65.5
2005-06 19.3 66.1
2006-07 20.0 68.9
2007-08 20.1 72.8
2008-09 20.4 77.8
2012-13 22.0 84.0

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LATEST MEASURES OF MONEY SUPPLY OF RBI
A special committee under the Chairmanship of Sri Y. V. Reddy was formed by RBI
to study the changing economy's monetary form of economy due to changes occured
financial area. On the basis of recommendations of Reddy Committee RBI uses
following new measures of supply of Money.
(i) M0 = Currency in circulation + Deposits of banks with RBI + Other deposits with
RBI
(ii) Mj = Currency in circulation + Deposits with banks + Other deposits with RBI
(iii) M2 = Mj + Term deposits of banks + Certificates of deposits issued by banks +
One year maturity deposits of domestic citizens with banks
(iv) M3 = M2 + One year maturity deposits of domestic citizens with banks + Call
borrowings of banks from Financial Corporations. After analysing the new measures
of money supply of RBI following facts come forward:
(i) MQ is included as the base of money, it means that money which is created by
RBI.
(ii) The way of calculating M1 has not changed.
(iii) The measures of Mv M2 and M3 are presented serially according to diminishing
liquidity.
Mj is the most liquid.
M2 is lesser liquid than Mr
M3 is the lowest liquid money.
The Certificate of Deposits (CDs) issued by banks has been included in money for
the first time. The maturity period of CDs is either one year or more than one year
and banks pay relatively high rate of interest on them. New Concepts of Liquid
Resources
Working group of money supply of RBI has redefined the monetary concepts and
after that shown the new concepts of liquid assets of India which are as follow:
Lx = Mj + All deposits with Post Office (Except NSC)
L2 = Lx + Time deposits with financial institutions + Certificates of deposits issued
by financial institutions
L3 = L2 + Public deposits with Non-Banking Financial Companies (NBFC)

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In this way in liquid group financial and non-financial institutions are included.
FACTORS AFFECTING MONEY SUPPLY
Some important factors influencing money supply are :
(1) Monetary Policy of Central Bank : If Central Bank of a country adopts cheap
money policy then loans are available at less interest rate and supply of money
increases. On the contrary it adopts dear money policy then supply of money
decreases.
(2) Commercial Bank's Capacity or Policy of Credit Creation: Higher the cash
deoosits in bank higher will be the expansion of credit i.e. supply of money will
increase. On the contrary with less cash deposit, expansion of credit will be lesser.
(3) Government's Fiscal Policy: If the Government adopts the policy of Deficit
Financing then the supply of money will increase. On the contrary if the
Government adopts the policy of savings budget then money supply will reduce.
(4) Desire to hold Currency and Deposits: The desire of public to hold currency
and deposits decides the supply of money. If people keep less cash and keep more
deposits with commercial banks then the supply of money will increase and more
money will be created through loans. Contrary to this, if people have no banking
habit then they keep their savings with them in cash form then lesser. Credit will be
created by the bank and the supply of money will reduce.
(5) Velocity of Money : Supply of money is also influenced by velocity of money.
In a particular time period one unit of money can be used many times. Therefore,
single unit of money will work as more units. Suppose, in India one unit of money is
use 5 times for payment it means that one unit of money has worked as 5 units of
money. In economic terms, it will be said that velocity of circulation of money is 5.
Therefore, during a specific period the supply of money is estimated by multiplying
the quantity of money (M) with its velocity of circulation (V). Supply of Money = M
x V = MV
(6) Volume of High Powered Money : High power or reserve money includes :
(i) Currency with public (C)
(ii) Cash with banks (R)
(iii) Other deposits with RBI (OD)

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H = C + R + OD
Supply of money and High powered money are directly related i.e. with the increase
in High powered money, supply of money increases and vice-versa.
WHO SUPPLIES MONEY
In modern age money supply is done by the Government, Central Bank and
Commercial Banks. In India, the finance ministry of the Government issues one
rupee note and mints the coin. In India note-issue work is done by the Central Bank
i.e.Reserve Bank of India. Reserve Bank of India issues currency on the basis of
minimum Reserve System. Reserve Bank has to keep gold worth ? 200 cr. and
foreign securities in reserve fund out of which gold worth ? 115 cr. is essential.
Ideal Supply of Money
The supply of money has effect on total expenditure. It affects trade activities,
production and employment also. Now, the question arises that in the country in full
employment situation, without keeping any factor of production idle, how much
money is required. The supply of this money will be called ideal supply. Due to this
supply full utilisation of production capacity of the country becomes possible. If
supply of money is greater than ideal supply then prices will start rising in full
employment situation and inflationary situation will be created.
HIGH POWERED MONEY Meaning : High powered money H is related with the
government money (currency) issued by Central Bank or Reserve Bank of India
which is kept as reserve with commercial bank and notes and coins with the
Government. In this way the components of High Powered Money are :
(i) Currency with the public (C)
(ii) Reserve fund with the banks (R) which are :
(a) Cash Reserve with banks themselves.
(b) Deposits with Reserve Bank of India.
(iii) Other deposits (OD) With Central Bank in which deposits of Semi-Government
institutions are included.
In this way:

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DISTINCTION BETWEEN HIGH POWERED MONEY AND COMMON OR
NARROW MONEY
Narrow money (Mt) is defined earlier in the following way :
Mj = Currency with the public (C) + Demand deposits (DD) with the
commercial Banks + Other deposits (OD) with RBI. We can compare M t and H in
the following way :
Therefore, it is clear that in M1 and H both C and OD are included. Both factors are
similar. Main difference among them is that in Mv DD is included i.e. Demand
deposit and in H Cash Reserve R is included.
COMPONENTS OF HIGH POWERED MONEY
In a modern economy credit and supply of money is created on the monetary base of
High powered money which is expressed as following equation :
The components of H are :
(1) Currency with the Public (C) : The currency (C) is most important component
of High Powered Money. In the context of India, currency is issued by the RBI and
the Government of India the quantity of currency changes only in the long run,
therefore, in High powered money its role is not very important.
It is worthmentioning here that one part of issued currency is kept in banks by the
people. Therefore, if people are not habituated of banking then they will think it is
better to keep cash with themselves, then banks will create less credit and the supply
of money will be low.
(2) Cash Reserve with Banks : It is of two types :
(a) Required Reserve (RR) : Central Bank makes mandatory for all commercial
banks that a certain percent of their time deposits and demand deposits should be
kept as reserve with RBI. It is the legal minimum or Required Reserve. Required
Reserve decides the Required Reserve ratio (RRr) and the levels of deposits (D) of
the Commercial Banks i.e.
RR = RRr x D If Deposits are Rs 50 Lakh and RRr is 10% then
Required Reserve (RR) = 10% x 50 = Rs 5 Lakh. If RRr is reduced to 5% then RR
will be Rs 2.5 lakh. In this way Higher the RRr, banks will have to keep more
Required Reserve. In India it is called Cash Reserve Ratio.

184
(b) Excess Reserve (ER) : Cash more than Required Reserve available with
Commercial Banks is called Excess Reserve (ER). In short, the difference between
total Cash Reserve & Required Reserve is ER. ER = Total Cash Reserve - Required
Reserve. For e.g. if Total cash Reserve is Rs 50 Lakh.
Required Reserve is Rs 5 Lakh
Then
ER = 50 - 5 = Rs 45 Lakh
When Required Reserve is Rs 2.5 lakh
Then ER = 50 - 2.5 lakh = Rs 47.5 lakh
ER is used by depositors to get back their deposits and for the payment towards
other commercial banks.
To determine the quantity of High powered money ER is very important because
Excess Reserve affects the size of deposit liabilities, commercial banks gives loan
equal to their ER and ER is an important part of supply of money .
Central Bank of the country influences the reserves of commercial banks and
through open market operations and Bank rate policy determines the money supply.
Open market operations are related with sale and purchase of Government Securities
and other types of government and private assets like Hundies, Securities, Bonds in
the open markets. By open market operations Central Bank can increase or decrease
the capacities of credit creation and loan giving capacities of commercial banks. We
know the quantities of loan given by banks or credit creation depends on their cash
balances. When Central Bank desires that other banks don't give more loans then it
sells the securities in the market. When commercial banks will purchase the
securities from the Central Bank by paying through cheques then the cash balance of
banks will reduce and they will decrease giving advances. When Central Bank
wishes to check depression in the country, more loans should be provided for
encouraging the business then, Central Bank will buy back the bonds and securities
from commerical banks. When Central Bank will pay then cash will increase with
commercial banks and they will start giving more loans. As a result money and
credit will expand.

185
It is clear from the above that when Central Bank wants to contract credit through
reducing Excess Reserve then they sell securities in the open market and on the
contrary when they want to expand credit they purchase the securities.
Bank rate is that minimum rate at which Central Bank provides loan to Commercial
Banks. It is also called Discount rate. Bank rate policy affects supply of money by
ifluencing the cost and supply of credit of commercial banks. Due to change in Bank
rate, lending rate of commercial banks for providing loans to customers also changes
Le., cost of borrowing or credit from banks also changes. Change in interest rate
influences the quantity of credit taken from banks by businessmen, which causes
fluctuations in supply of money.
High Discount rate means if commercial banks take loans from RBI on its securities,
then it will have to pay more interest. As a result it will also charge more interest
rate from its customers, which makes its credit costly. It narrows the credit and
reserves of commercial banks. And when bank rate is reduced the opposite situations
emerge i.e. credit and reserves of commercial banks expand.
In short, when Central Bank increases Bank rate credit becomes dear, therefore,
credit contracts in the economy. Contrary to this, when Bank rate reduces, credit
expands.
(3) Other Deposits with Central Bank (OD): OD is the third component of High
powered money. It ihcludes Non-banking Institutions like Industrial Banks, Unit
Trust, Foreign Governments deposits money to Central bank. Since other deposits of
Central Bank also work as the base of multiple credit creation from banks, they are
also a component of High powered money. But their quantity is very low, so as a
source of change in High powered money they are not very important.
It is clear from the above discussion that OD is not very important component of
High powered money. In such a situation High Powered Money is divided among
currency with the public, Required reserve with Central bank and Excess Reserve,
supply of money changes in reverse ratio of C tRR & ER but supply of money
changes in direct ratio with change in High powered money as shown in Fig. (1).
(i) If supply of High powered money increases by AH the HS curve shifts t<HS1.

186
(ii) At point E High powered money's demand and supply are in equilibriun and
supply of money is OM.
(iii) When supply of High powered money increases and curve HS shifts to HS 1 then
money supply is OMx at new equilibrium point Ej . It increases AM i.e.OM to OM r
(iv) It is clear that when High powered money increase by AH then money supply
increase more i.e. AM which shows the effect of money multiplier.

SOURCES OF HIGH POWERED MONEY & CHANGES THEREIN

Sources of High Powered Money are analysed under the following heads : (1) Net
Bank Credit to the Government
(2) Bank Credit to the commercial sector
(3) Net Foreign Exchange Assets
(4) Government's Currency Liabilities to the Public
(5) Net Non-Monetary Liabilities of the Banking Sector.
(1) Net Bank Credit to the Government : Net credit given to the Government
through the banking sectors are of two types :
(a) Credit given by Reserve bank of India
(b) Credit given by other banks.
When the governments takes loans for meeting its financial liabilities then Reserve
Bank of India creates new money to give credit to the Government. In economics it
is called 'Deficit Financing".
In this way when the Government takes loans on the basis of its securities then bank
opens a Demand Deposits on the name of the Government equal to the values of
securities and creates credit money. It brings into existence a new purchasing power
in the country which in turn, leads to increase in demand for goods and services in
the country.
(2) Bank Credit to the Commercial Sector : The credit given to commercial
sectors are of two types : The effect of credit given by RBI will be similar to the
credit given by RBI to the Government. Secondly, the effect of credit given by
commercial bank will be similar to above analysis. By doing this commercial bank
will create credit.

187
(3) Net Foreign Exchange Assets: The supply of money in the country is affected
by net foreign exchange assets of banking system. These assets belong to RBI and
other banks. Suppose, any Indian exporter gets dollar by exporting his goods, which
comes in the country. Suppose that dollar is deposited in RBI. RBI gives Indian
currency in exchange of that dollar to the exporter. Therefore, whenever RBI or
other commercial banks get foreign exchanges or assets from other person or firms
then they have to pay Indian currency of same amount.
Similarly importers have to purchase foreign currencies to pay for imported goods. It
has two effects :
(i) Foreign exchange reduces from banking system.
(ii) The supply of money reduces in the country.
It is worthnoting here that when we discuss foreign exchange assets of banking
system then we have to know the differences between Net foreign exchange assets
and Net foreign exchange liabilities. In this way :
Net Foreign Exchange Assets = Net Foreign exchange of RBI + Net foreign
exchange assets of other banks.
Increase and decrease in Net Foreign Exchange Assets leads to increase and
decrease in money supply of the country. In other words, there is direct positive
relationship between Net Foreign Exchange Assets and Money Stocks M 3.
(4) Government's Currency Liabilities to the Public : Government of India prints
one rupee note and coins of 50 paise and 25 paise. All these demonstrates monetary
liability of the Government towards the public. In this way there is direct and
positive relationship between Governments' currency liabilities to the public and the
stock or supply of the money.
In order to know the wider supply of money in the country, all the above four
sources have to be added. But in order to know the wider money supply of the
country i.e. M we will have to subtract non-monetary liabilities.
(5) Net Non-Monetary Liabilities of the Banking Sector : Under this heading the
liabilities of RBI and other commercial banks are also included. Non-monetary
liabilities of RBI include :

188
(i) Paid-up capital, (ii) Reserve Fund, (iii) Pension Funds and Provident funds. In
this way in other banks' non-monetary funds include Reserve Funds and payable
bills, fixed capitals etc. but it is shown in negative form because if there is more
amount in this component then RBI has to depend less on creation of new reserve
money.
Therefore, according to this source the formula to know :
High Powered Money or Reserve money (H) = 1 + 2 + 3 + 4- 5
i.e.By adding above four components and subtracting the component 5 we get H i.e.
High Powered Money. In High Powered Money consists 80 to 95% of Net Bank
Credit given to the Government through RBI.
From the above analysis there are two ways of knowing Reserve Money or High
Powered Money:
(1) Addition of various components of reserve money (1 + 2 + 3 + 4).
(2) Addition of various components of money from (1) to (4) minus (5).
Reserve Money : (1 + 2 + 3 + 4) - 5.
USES AND IMPORTANCE OF HIGH POWERED MONEY
In modern economy the concept of High Powered Money (H) is very important and
useful.
1. Base Money : High powered money is the base of extension of bank deposits and
supply, therefore, it is called Base Money or Reserve Money.
2. Main Source of Change : Supply of money depends on High powered money. It
changes in which direction money supply changes in the same direction.
3. Money Multiplier: In the economy supply money is many more times than High
powered money. How much money supply H will increase due to increase in H it
depends on Money multiplier or M which in turn depends on High Powered Money
'H
(4) Monetary Control : High Powered Money is main instrument of monetary
control. We know, High Powered Money is that amount which is available with
commercial banks as R and currency (C) with public.

189
So far C is concerned, it is supplied by RBI and the Government of India but its
quantity changes only in the long period. Therefore, C has not more role in
formation of monetary policy.
Now 'R' which commercial banks have to maintain. If supply of R is more than
demand then banks have surplus reserve which they use to purchase securities or
giving credits. Change in R has important influence on economic activities.
Monetary authority can influence the quantity and flow of credit by changing the
value of'R\ In short: M = Hm
which shows that Monetary Authority can control supply of money by changing the
money multiplier on High Powered Money.

190
 DEMAND FOR MONEY

Demand for money arises with two reasons : First: It works as medium of exchange.
Second : It is store of value.
Therefore, individual and businessmen try to keep money partially in cash and
partial in assets.
Four Approaches are there for demand of money :
1. The Classical Approach
2. Neo-Classical Approach
3. Keynes Approach
4. Post Keynesian Approach
I. THE CLASSICAL APPROACH
Money has two important functions :
(a) Medium of Exchange, (b) Measure of value
Prof. Mill, Prof. Fisher etc. economists have stressed more on medium of exchange
functions of money and said money is not demanded for its own sake, but for day to
day purchase. Money is medium of exchange, therefore, demand for money in any
country depends on the amount of goods and services, which is being exchanged.
The country with more exchange of goods, the more will be demand for money. The
demand for money depends on how much amount of goods and services are
available in the market for exchange. In this sense, demand for money in certain
period will be equal to the price of total goods and services sold and purchased in the
market.
In Fisher's Exchange Equation : Where
M is the Total quantity of money V is its velocity of circulation P is the price level
T Quantity of exchanged goods and services.
In this equation PT also expresses the demand for money which depends on the
value of transactions in the economy. MV expresses the supply of money which is
given and equal to the demand of money in the equilibrium. Now the equation is :

191
Total demand for Money = Price of exchanged goods P x Quantity of Goods &
Services (T)
The demand for money as medium of exchange is called Transaction demand for
money.'
This transaction demand for money is determined by full employment income level.
It is so because economists believe in 'Say's Law of Market' which states that:
'Supply creates its own demand, believing that there is full employment level in the
economy'. In this way, according to Fisher :
The demand for money is the fixed proportion of level of transaction level which has
fixed relation with National Income. Then, the demand for money at any time is
related with the business going on in the economy."
The two important factors of classical approach is :
1. In the classical equation PT is related with full employment according to which it
is said that demand for money which is shown by PT is related with full employment
situation.
2. If supply of money increases, the demand for money also increases in the same
proportion because M and P are proportionately related.
II. NEO-CLASSICAL APPROACH
This Approach which is also known as Cambridge Approach is presented by Prof.
Marshall. According to this approach the demand for money can be expressed
through the following equation :
In the above equation :
(i) Per unit of K expresses as per unit accounts expresses demand for money.
It means that K is that portion of money income which people want to keep with
them as cash.
(ii) Per time unit (for e.g. lyr.) is the flow of income and
(iii) Md is the stock of money at a point of time. There is no measurement of Md but
it is for K. For e.g. Suppose Md is ? 6,000 cr. and monetary income is ? 60,000
crVyear then K will be 1/4 every year i.e. people will keep l/4th of their annual
income in the form of money. It is shown in Fig. 1.

192
In figure (1) Md is shown as functional line of Y. This line passes through the origin.
It Md
makes an angle with X-axis i.e. = K.
The demand for money is affected by various factors which are :
(i) The base of demand for money is Total National Income. It has been already
mentioned that the cash demand by any time in the society is equal to one portion of
Total Real Income.
(ii) Time has important place in determination of demand for money. By keeping in
mind cash money in the form of currency is kept in the society with stable business,
if time duration is more the demand for money will be more and if it is less the
demand for money will be less.
If people want cash equal to 4 months of annual real income then : K will be 1/3
if they want cash equal to 2 months of annual real income K will be 1/6.
(iii) The velocity of circulation of Money i.e. V and demand for money K has
opposite relation. If at anytime K is 1/3 it means that in order to purchase whole real
Income we will have to spend cash 3 times. Therefore, it is clear that- Therefore, the
demand for money by society is K of Y. And this K changes according to time and
in reality this K shows the demand for money.
In Cambridge Theory, store of value function has been stressed. These economists
said that people want to keep money with them for various reasons. So, they said
that the demand for money is for cash balances on which various factors influence is
seen. For e. g. :
(i) Exchange of goods and services.
(ii) To make future strong against uncertainities.
(iii) Income and assets of people.
(iv) Opportunity cost of keeping cash other than assets. Main features of Neo-
classical Approach :
(1) According to this theory main determinant of demand for money is income but
according to classical theory the determinant of demand for money is the price of
transaction goods.

193
(2) Neo-Classical model keeps in view the transaction of both present and future but
in classical model it is limited to only present transactions.

III. KEYNES APPROACH: LIQUIDITY PREFERS

Keynes has propounded his theory of demand for money in his famous book 'The
General Theory of Employment, Interest and Money.'
According to Keynes : Demand for money means demand for keeping money in
cash form. Keynes used word 'Liquidity Preference' for demand for money.
Now, what is liquidity ? Liquidity means keeping the wealth in cash form or any
such other form which can be converted into cash immediately. The most liquid
form of wealth is cash or currency. Therefore, Liquidity Preference means 'Demand
for money or cash'.
When it is said that there is more liquidity preference then it means that the demand
for cash by people and businessmen is more and contrary to this less liquidity
preference means less demand for cash.
CAUSES OF LIQUTDITY PREFERENCE
According to Keynes money is most liquid of all assets. It means that it is
universally accepted and it is easily accepted as medium of exchange for other
goods. If we instead of keeping in cash with us, deposit in bank, then we can earn
some interest also. To decide it how much amount we should keep, we will have to
consider the difference between the benefit of Uquidity and loss of interest. The
demand for balance money is called Uquidity preference. People keep cash for
following motives :
(1) Transaction Motive (2) Precautionary Motive (3) Speculative Motive.
(1) Transaction Motive : The main motive of keeping cash is for daily transaction.
One can not wait for money for daily needs. Therefore, people prefer to keep cash to
meet their daily requirements.
(2) The Precautionary Motive: People demand money during emergency and
unforeseen contingencies.
The demand for cash for both the above purposes depend on the level of income.
MT = KT

194
shows that:
MT = Transaction demand for Money T = Total transaction K = Positive part of
transaction Example : A person has a firm and other employee. Suppose employee
gets salary on 1st date of every month Rs 2,000. He spends his whole income on
goods and services produced by the firm. In the beginning of month his cash balance
is Rs 2,000 and in the last cash balance is Rs 0. On the other hand in the beginning
firm's cash balance is zero and in the last it is Rs 1,000. Average money with the
employee is :
and Firm's average money is also Rs 1,000. It is clear that
transaction demand for money is Rs 2,000 (From employee Rs 1,000 and from firm
Rs 1,000). Total transaction of economy is Rs 4,000, because firm sells goods and
services to employees and employees sell services of Rs 2,000. Therefore,
transaction of money demand is the function of total transaction at a unit of time. In
the above example it is 50%.
(3) Speculative Motive : Speculation means take advantage of market's
uncertainities. A person keeps a part of his property in liquid form to earn more
interest and profit in future. Speculative motive demand for money arises from
uncertainities of future interest rates.
In this way total demand for money is transaction motive, precautionary motive and
speculative motive demand. According to Keynes:
'First two motives are stable, only speculative motive demand is affected by changes
of interest rate, therefore it is interest relative.'
US = fir)
In this way, total demand for money is the function of income and rate of interest.
Total demand curve for money, can be drawn by lateral summation of precautionary
motive demand curve and speculative demand curve. It is clear in the following
diagram (Fig. 2).
Figure 2 (A) represents income level and speculative and precautionary motive
demand for money OM at different interest levels. It is clear from the figure that
demand for money remains stable whether rate of interest increases or decreases.

195
Figure 2 (B) shows the speculative demand for money at various interest rates. In the
figure slope of L2 curve is left to right which indicates that the demand for money is
less at higher interest rate and one at lower interest rates.
Figure 2 (C) indicates total demand for money curve L which is lateral summation of
Lx and L2 curves Le. L = Lj + L2. For e.g. at r6 demand for money is ON which is
summation of transaction, precautionary demand OM and speculative demand MN
i.e., ON =OM + MN
At interest rate r2, total demand curve for money, is perfectly elastic and shows
'liquidity trap'.
'Liquidity trap' presents a difficult challenges to monetary authorities. In the
situation of 'liquidity trap' there is no effect on interest rate even if supply of money
increases in the economy or it becomes difficult to influence investment and income
level through the supply of money. It is clear from above analysis that:
(i) Total demand for money is done for transaction, precautionary and speculative
motive.
(ii) The demand for money for transaction and precautionary motive is done in the
ratio of national income level.
(iii) For speculators demand for money depends on the rate of interest.
TV. POST KEYNESIAN APPROACH OF DEMAND FOR MONEY
As we have studied that Keynes by presenting the demand for money for speculative
motive differed from Classical & Neo-classical economists which stressed more on
transaction demand for money. But Keynes' speculative demand for money's main
demerit is its assumption that people keep their whole property either in money form
or in Bond form because in real life people keep their financial property in the form
of money and Bond. On this basis Tobin, Baumol, Friedman presented the 'Portfolio
Approach of Money.'
POST KEYNESIAN INTEGRATION OF THEORY OF MONEY
Now we study modern demand for money.
(i) According to modern economists it is not justified to artificially divide demand
for money under the headings of:
(i) Transaction Motive

196
(ii) Precautionary Motive
(iii) Speculative Motive
(a) The above three types of demand for money are not only affected by rate of
interest only but income level also affects them.
(b) People do not keep their cash under different heads. Therefore, there is not clear-
cut demarcation among them.
Due to above reasons, Post Keynesian approach stopped studying money under L t
and L2. Therefore, now the relation between total income and interest rates and its
relation with total demand for money is not divided in small pieces.
(ii) According to Keynes the demand for money for speculative motive is inelastic
towards rate of interest but according to Tobin and Baumol Modern theory of
demand for money shows that money kept for speculative purpose is also affected
by rate of interest. It can be expressed as :
L or Md = fiy, r)
Where, L or Md= Demand for money y = Income r = Rate of interest In Post
Keynesian Approach an important difference is influence of wealth on the demand
for money. After Keynes, Stock of Wealth (W) is also included in demand for
money. Therefore, according to this approach the components affecting demand for
money Md are income (y), Rate of interest (r) and wealth (w). Then the above
equation will be
Where, w - Demand for money for wealth.
FACTORS INFLUENCING DEMAND FOR MONEY
After analysing the various approaches we can say that following factors affect
demand for Money :
(1) Rate of Interest: Generally, it is said that there is opposite relationship between
rate of interest and demand for money. Higher the rate of interest, lower is the
demand for money. People will like to lend more in order to get more interest rather
keeping the cash with them.
(2) Availability of Credit: Demand for money depends on availability of cash. If
credit is available in ample amount at lower rate of interest then demand for money

197
will be less. Contrary to this, if credit is not available in proper amount and time then
demand for money will be more.
(3) National Wealth : Richer the people of a society, higher will be the demand for
money.
(4) System of Payment: If in the process of production and distribution cash
payment is done, then demand for money will be more. Contrary to this if payment
is not done in cash, the demand for money will be less.
(5) Expected Income : If there is expectation of getting more money in the future
then demand for money will be less. Contrary to this, if there is expectation of less
income in future, then more cash will be demanded so that in the future when their
income will be less they can fulfill their wants.
(6) Expectation of Price Change : Demand for money is also affected by the
possibilities of changes in price. For e.g. if there is possibility of increase in price,
then people will purchase more in present. Then expenditure will increase in present
and people will prefer less to keep money in cash. Therefore, demand for money will
decrease.
(7) Conditions of Economic Development : Generally, stronger the economic
condition of any country, greater will be the exchange. Therefore, demand for
money will increase.
(8) Other Factors : Other components affecting demand for money are :
1. Conditions of transport and communication.
2. Mobility of Credit.
3. Liquidity Preference of public
4. Instability of credit market.
In short, many factors affect demand for money but most of the factors are stable
and their effects can be ignored. Therefore, demand for money is generally stable.

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 QUANTITY THEORY AND CAMBRIDGE THEORY

CONCEPT OF VALUE OF MONEY

VALUE OF MONEY
Rate of Interest
Foreign Exchange
Purchasing Power
Meaning of Value of Money : Economists use value of money in three ways:
(i) Value of money means rate of interest.
(ii) Value of money means its exchange rate.
(iii) Value of money means its purchasing power.
We have to express value of money. Just as the prices of goods and services are
expressed in money, similarly, value of money is that amount of goods and services
which are gained in exchange of a unit of money.
In this way, value of money means the purchasing power of money i.e. The amount
of goods and services purchased from a definite unit of money is called value of
money.' It is also called 'Consumption Value.'
Definitions of Value of Money
1. "The value of money is what it will buy." —Crowther
2. "By value of money we mean the amount of things is general which will be given
in exchange for a unit of money." —Robertson-Money
3. "Value of money indicates its purchasing power of money therefore, the study of
purchasing power of money is equal to price level." —Fisher
QUANTITY THEORY OF MONEY: THE TRANSACTION APPROACH
(FISHER)
Although David Hume, Adam Smith, Ricardo, J. S. Mill etc. economists have
expressed their views on Quantity Theory of Money but Prof. Irving Fisher has
made it popular. At present Milton Friedman who has been awarded Nobel Prize in
1976 for his special contribution in this field, has given new form to this theory.
Prof. Irving Fisher in his book 'The Purchasing Power of Money' (1911) has
propounded the Transaction Approach of Quantity Theory of Money.

199
Definitions & Explanations: Quantity theory of money states that there is direct
and proportionate relationship between quantity of money and general price level.
Some definitions of this theory are :
(i) According to Fisher: "Other things remaining the same, according to quantity
theory of money when quantity of money in circulation increases the price level
increases in direct proportion and value of money decreases."
(ii) According to Prof. Taussig: 'Other things remaining the same when the
quantity of money doubles, prices will be doubled and value of money will be
halved. Other things remaining the same by halving the quantity of money, price
will be halved and the value of money will be doubled.
It is clear from the above definition :
(a) There is direct proportional relationship between quantity of money and general
price level.
(b) There is opposite and equal proportionate relationship between quantity of
money and value of money.
It is clear from the following table :
(1) When Quantity of money doubles then general price-level also doubles but value
of money is halved.
(2) Contrary to this, when quantity of money reduces from 10 to 5 i.e. halved then
general price-level also reduces to half and value of money doubles.
EQUATION OF THE QUANTITY THEORY OF MONEY
Fisher's equation is also called 'Equation of Exchange'. It is essential to understand
the concept of demand and supply of money to explain the theory of Prof. Fisher.
(1) Supply of Money : The various components of Fisher's equation are :
M = Mone&in circulation
V = Velocity of money in circulation M' = Bank Credit
V = Velocity of circulation of bank credit
It is clear from the above equation that multiplication of quantity of money (M + M')
and its velocity of circulation (V + V). (MV + M'V) expresses the total supply of
money during a certain period of time.

200
(2) Demand for Money : Money is demanded because through it goods and services
are purchased. Therefore, at particular time, demand for money depends on the
amount of exchange in the society.
Total demand for money is derived by multiplying total quantity of goods and
services (T) available in economy with general price-level (P).
Demand for Money = PT
Revised Equation : Fisher in his revised equation included bank money alongwith
money in circulation. According to Revised Equation : Demand for Money = Supply
of Money
M = Currency in circulation
V = Velocity of circulation of currency M' = Bank money or Credit money
V = Velocity of Circulation of Bank Money T = Total quantity of goods and services
P = Price level
= Value of Money It is clear from the above equation :
(1) The multiplication of Quantity of money (M + M') and its velocity of circulation
(MV + M'V) presents the total supply of money in a definite period of time and
(2) The multiplication of Quantity of goods and services (T) and Price Level (P), PT
expresses the demand for money during a definite period of time.
(3) According to Fisher during a definite time period M'V'V and T are constant. In
such a situation direct relationship between price-level and quantity of money is
established i.e. with increase in (M + M') P increases and value of
money \ — \ decreases.
Statement of Fisher's Equation with example :
2nd situation If M = 1,200 and M } = 2,000 then general price-level will increase
proportionately and value of money will decrease proportionately.
In this way general price-level P doubled but the value of one unit of money = 0.5
halved.
It is clear that there is direct proportionate relationship between quantity of money
and price-level.
Diagrammatic Representation : Fisher's theory can be explained through the
diagram.

201
In Figure A:
(i) On OX-axis quantity of money is shown and price level is shown on OY-axis.
When quantity of money is OM and price level is OP.
(ii) When quantity of money increases to OMj from OM i.e. doubled then general
price level also increases from OP to OPj viz doubles. In this way when quantity of
Mx M2
Quantity of Money Fig.l
money increases 4 times i.e. OM2 then price level also increase 4 times to OP 2.
(iii) In the figure ON line which is made up by joining R, S, T points, expresses the
proportionate relation between the price level and quantity of money.
In Figure B :
(i) Quantity of money is shown on OX line and value of money - is expressed on OY
line. p
(ii) Other things remaining the same there is inverse relationship between quantity of
money and value of money. When quantity of money increases from OM to OM t i.
e. it doubles and then value of money halves from 1/P to 1/2P. Similarly, if quantity
of money increases 4 times i. e. the value of money reduces
(iii) In the figure a curve is formed by joining A, B, C points, it expresses the
inverse proportionate relationship between quantity of money of the value of money.
Conclusion:
The conclusions of quantity theory of money are :
(i) The value of money is determined by quantity of money.
(ii) There is inverse relationship between quantity of money and value of money.
(iii) There is direct relationship between quantity of money and price of goods.
(iv) The relation between quantity of money and price of goods has proportionate
relation. If quantity of money doubles then value of money halves and if quantity of
money halves then the value of money doubles.
(v) Price-level changes in the same proportion to change in quantity of money.
(vi) Total Quantity of Money (MV + M'V) is equal to the price of all goods and
services i.e. PT.

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ASSUMPTION OF QUANTITY THEORY OF MONEY
Quantity theory of money is based on following assumptions :
(i) Fisher has assumed the proportion Money in circulation (M) and Bank Money
(M1) stable.
(ii) In Fisher's equation the velocity of circulation of money in circulation (V) and
velocity of circulation (V') of bank credit is also stable.
(iii) Fisher assumed price-level P as passive and it does not affect M, M', V, V and T
but is affected by them.
(iv) Fisher assumed that economy is condition of full employment and T is also
constant.
(v) Fisher assumed in his theory that 'other things remaining the same' is an
assumption which has no importance in present because the world is dynamic not
stable.
(vi) Fisher's theory is based on long-run assumption. According to this theory in the
long run assumption, quantity of money and price-level is aptly coordinated.

CRITICISMS OF FISHER'S QUANTITY THEORY OF MONEY

Various economists criticized Fisher's Quantity Theory of Money in various ways,
which are following :
(1) Unrealistic Assumptions : In this theory many factors are assumed constant
which influence money. These unrealistic assumptions has made this theory
unpractical. For e.g.
(a) The quantity of trade is changing in short period.
(b) Price (P) is not passive factor.
(c) Velocity of circulation of real money and bank money is not constant.
(d) There is no definite proportion between Bank Money and Legal tender money.
(e) General condition of full employment is unrealistic.
(2) Long Term Theory: The assumption of this theory may prove true in the long
run but knowledge of change in value of money during long period is not very
useful. Short run problems in the economy are more important and its analysis are
more useful.

203
(3) No need to Separate Theory: This theory treats separately the theory of value of
money and general theory of price. Due to this reason it separates the monetary and
real sectors. The price of money is also determined like other goods by relative
powers of demand and supply. Therefore, there is no need for a separate theory for
determination of value of money.
(4) Undue Importance to Supply Side : This theory has given stress only on supply
side which is not fair because value of money is not influenced only by money in
circulation but also by its demand. Therefore, it is one-sided theory.
(5) How Price is affected by the Change in Quantity of Money: Fisher was of the
opinion that inflation starts with the increase in quantity of money and the speed of
inflation depends on creation of money, viz. . In this way AM , is 5% then general
price-level will also increase by 5% per year. But this theory is defective because it
does not clear that process by which total money income increases with the increase
in quantity of money and as a result in the situation stagnant production, prices rise.
In short, this theory does not clear that how quantity of money influences price.
(6) It ignores the effect of Rate of Interest: This theory ignores the effect of rate of
interest on price. Lord Keynes, Prof. Hawtrey, Prof. Hayek, say that this concept is
wrong that there is direct and proportionate relation. In reality change in quantity of
money affects rate of interest and change in rate of interest brings change in price-
level. The relation between quantity of money and price level is indirect not direct,
i.e. :
Change in Quantity of Money -» Change in Rate of Interest -> Change in Investment
Change in Income/ Employment -> Change in Cost of Production -> Change in
Price
Therefore, this theory correctly neglects rate of interest.
(7) It does not correctly measure the purchasing power of money: This theory
calculates only cash transactions but under modern trade many transactions are done
on bank credit and barter system which are not included in T. Therefore, this theory
measures only cash transaction standard.

204
(8) It does not take into account time-lag : The effect of change in quantity of
money price-level is not immediately visible, but it is visible after sometime. Many
things occur in between these which destroyed the effect of that change.
(9) Non-Monetary factors also affect: Price-level does not depend only on quantity
of money but it depends on monetary and non-monetary reasons which can destroy
the effect of money.
(10) It Ignores Store Money : Keynes of the opinion that people do not spend all
money on goods and services but also keep some money for unforeseen
contingencies. This saved money does not affect general price-level. Therefore, it is
necessary to subtract it from quantity of money.
(11) It fails to explain Trade Cycle: It fails to explain those changes in price-level
which arise due to trade cycle. According to this theory if prices fall then it can be
increase by increasing the quantity of money but experience says that during 1929
Great-Depression with the increase in quantity of money prices goes on falling.

UTILITY OF QUANTITY THEORY OF MONEY

(1) A justified monetary policy should be adopted through which supply of money
and credit can be aptly controlled. It is necessary for price stabilization.
(2) Undue hoarding of goods should be checked, so that supply of goods should not
lag behind supply of money.
(3) Import and Export of the country should be taken care of so that goods with less
supply will be imported and goods with more supply will be exported.
(4) One suitable Industrial Policy should be adopted so that production of country
will increase rapidly and there should be no price rise due to lack of goods.

VELOCITY OF MONEY According to Brigress and Jordan :

"During a definite period of time one coin is used for as many times for purchasing
is called velocity of money."
For e.g. If a Rs 10 note goes to a person 5 time as a medium of exchange then its
daily velocity of circulation will be 5. It is included in total quantity of money.

205
In order to get velocity of circulation, Gross National Product is divided by money
in circulation :

Money in Circulation
Factors Determining Velocity of Money:
(1) Quantity of Money: If quantity of money is less in circulation then its velocity
will be high because that money will be used many times and vice-versa.
(2) Modes of Purchase: If the system of purchasing goods is loan then the need for
immediate payment is not there and velocity of money will be decreased.
(3) Saving Habits of People : If people save more then velocity will be less, if habit
of saving is less then velocity will be more.
(4) Mode of Payment of Debt: If deferred payment system is one or two times and
payment is done in huge amount then velocity of money will be less, if payment is
done in small quantities then velocity of money will be more.
(5) Liquidity Preference of Public : If traders and general public keep more cash
for daily transactions the velocity of money will be less and if they keep less then
velocity of money will be high.
(6) Methods of Wage Payments : If wages are paid after long duration then people
will keep more cash with them for daily transactions, then velocity of money will be
less. If wages are paid early or frequently then velocity of money will be more.
(7) Condition of Transport & Communication : If transport and communication
system is developed then, trade will prosper, sale-purchase will increase then
velocity of money will increase.
(8) Condition of Economic Development: Sound the economic condition of the
country, higher will be the exchanges and higher will be velocity of circulation.
(9) Density of Population : More the population, more will be velocity of money
because money will be transferred to more hands. Lower the population lower will
be velocity of money.
(10) Mobility of Credit Instruments : If credit papers like cheques are frequently
transferred among people, the velocity of credit will be more.

206
 THE CAMBRIDGE QUANTITY THEORY OF MONEY
Or
QUANTITY THEORY OF MONEY: CASH BALANCE APPROACH
Cash Balance Approach was presented by economists of Cambridge University
like—Marshall, Pigou, Keynes, Robertson. It is called Cambridge equation.
Economists of Cambridge University have vehemently criticized Fisher's quantity
theory of money. They stated that Fisher has not given importance to the money
deposited in bank by the people. According to economists of Cambridge University
that value of money is not determined by quantity of money but only that quantity of
money which people keep as cash. Therefore, it is called Cash Balance Approach.
This theory gives more stress on demand for money than supply of money.
Main Elements of Theory a
The basic facts of this theory are :
(1) Supply of Money : Supply of money is the addition of coins currency notes and
demand deposits of banks.
Supply of Money = Currency Notes + Coins + Demand Deposits
According to Cambridge Equation, the relation of supply of money is with point of
time but according to Fisher the supply of money is related to period of time.
Velocity of money is affected by period of time and but velocity of circulation is not
affected in point of time.
(2) Demand for Money: In Cambridge approach demand for money is for keeping
money in cash as store of value but according to Fisher demand for money is as
medium of exchange. In this way in Cambridge approach money is not only medium
of exchange but also store of value. Therefore people maintain store of value in the
form of cash balance, which they use, as medium of exchange according to their
convenience.
In this way in an economy Demand for money is that amount of people's real income
which they prefer to keep in cash.
(3) Implication of Increase or Decrease in Demand: According to this theory if
the supply of money is stable then :
(i) When cash is demanded then it means that goods and services are not demanded.

207
(ii) If demand for money increases then it means that economy checks money by
keeping money in cash and spends less on services. In this way increase in demand
for money means that expenditure on goods and services decreases and their prices
fall and value of money increases.
(iii) Contrary to this, when demand for money decreases then it means that
expenditure on goods and services has increased and their prices will rise and value
of money falls.
(iv) In this way, increase in demand for money means less expenditure less price of
goods increase in value of money.
(v) Decrease in demand for money means more expenditure more price of goods
less value of money. Therefore, demand for money and value of money have direct
relation.
DIFFERENT CASH BALANCE EQUATIONS
Various economists have propounded cash balance equations related to determining
value of money in the following way:
(1) Marshall's Equation : According to Marshall in any country people keep a
portion of total annual income and property as cash. But Marshall's
After Pigou's reformation generally Cash balance equation is used as because in use
credit money is used in real money.
According to Pigou K, R, C and h is assumed stable then there will be proportionate
change in value of money due to change in supply of money. It is clear from the
following Fig. 2.
(1) In the figure demand for and supply of money is shown on OX axis and value of
money is shown on OY axis. DD is the demand curve.
(2) It is known from the figure that when supply of money increases from OM1 to
OM2 then value of money decreases to OP 2 from
OPr The decrease in value of money is equal to increase in supply of money.
(3) In this way if supply of money increases to OM 3 from OM2 then value of money
decrease to OP3 from OP2. The value of money decreased in the same proportion to
the increase in the supply of money. Therefore DD demand curve is a rectangular
hyperbola.

208
Characteristics of Pigou's Equation:
(i) Prof. Pigou has considered money not only medium of exchange but also store of
value.
(ii) The demand for money does not depend on size of trade but also storing
preference.
(iii) During depression value of cash money increases.
(iv) During boom with the rise in price of goods the demand for cash increases and
value of money decreases.
(3) Robertson's Equation : Robertson's equation is the most important equation.
Generally, Robertson equation is explained as Cambridge Equation. Robertson has
given following equation for measurement of price :
M = PKT
Where, M = Quantity of Money P = General Price Level
T = Transaction of goods and services during a definite period K = Quantity of
money which is kept for transaction by the public M = PKT
1M
then P=-MorP=-

Therefore, if K and T remain same the quantity of money changes then there will be
proportionate change in Price level P. In this way, Robertson fully believe in the
'Law of Proportion of quantity theory of money.'
(4) Keynes' Equation: Keynes has given his cash-balance equation in his book 'A
Tract on Monetary Returns' which is related to only consumer goods. According to
him people keep money for purchasing consumer goods only. His equation is like
this :
n = P(K+ rK)
In this equation:
n = Legal tender money which is in circulation P = Unit of consumption goods
K = The quantity of these consumption goods which people keep
as cash r = Cash with banks K' = Amount of goods and services for which people
keep cash in
banks

209
In such a situation the value of one unit of money is :
P=
(K+rK')
Conclusion : The conclusion of above equations are :
(1) P also changes according to the change in ratio of n when KjK and r remain
constant.
(2) Demand for money does not depend on goods and services but also on the cash
with public.
(3) If people and banks keep more cash then value of K is less and that of K' is more.
CRITICISMS OF CAMBRIDGE EQUATIONS
(1) Static Theory: It is not sufficient theory to explain dynamic tendency of prices of
economy. It is unable to explain complex economic problems.
(2) Speculation Motives: It does not deal with the demand for money for speculative
motive which has important role in determining the total demand for money.
(3) Unreal Assumptions : Like Fisher's equation this equation also assumes K and
T as constant which is not justified.
(4) Types of Savings: According to Prof. Keynes Cambridge Equation has not paid
attention on savings ratios of people.
(5) Rate of Interest: Cambridge Approach failed to recognise the role of rate of
interest. It seems that there is direct relation between changes in supply of money
and prices which is not right.
(6) Incomplete Theory: It is an incomplete theory. It gives importance to one factor
i.e. present income (R) to affect cash balance (K), but cash balance depends on other
factors like—Price-level, monetary habits, business structure. These factors are
ignored in this theory.
(7) Lack of Integration of Theory of Value and Theory of Money : According to
Don Patinkin :
'There is lack of coordination in price theory or relative prices and theory of money
or general price level' in cash-balance approach.

210
(8) Fails to explain Trade Cycles : This theory does not explain why
(boom/depression) Trade cycle occurs ? In other words, this theory explains long
term changes but not short term changes.
(9) Unitary Elasticity of Demand for Money: According to this theory the value of
money changes in the same ratio to change in demand for money viz. according to
this theory elasticity of demand for money is equal to unity but in real life due to
continuous changes occuring in economy elasticity of demand is not equal to unity.
In spite of above criticisms it can be concluded that this theory presents scientific
and elaborated explanation of determination of price level.
COMPARISON OF FISHER'S AND CAMBRIDGE EQUATION
COMPAR1SON
Transaction Approach Cash Balance Approach Keynes' Real Cash
of Fisher of Pigou Balance Equation
n
p_ MV+M'V T P_ KR M P= K + rK'

SIMILARITIES BETWEEN FISHER'S & tlDGE EQUATIONS

CAMB1

All the above three equations have following similarities :

(i) In all three equations P i.e. i indicates price-level.
(ii) There is similarity between MV + M'V, M & n. In Fisher's equation MV + M'V
= Cambridge Equation, M = Keynes' Equation n, all three express supply of money.
(hi) T, KR and K + rK are different forms of same fact. Fisher's T indicates
transaction but KR of Cambridge equation and K + rK indicates that quantity of cash
which people keep in cash or in banks for future transactions.
DISTINCTION BETWEEN FISHER'S AND CAMBRIDGE EQUATIONS
There are some fundamental differences between the two concepts of quantity
theory of money. It is shown in the following chart:
COMPARISON BETWEEN FISHER'S AND CAMBRIDGE EQUATION
Base
Demand for Money
Importance in value determination of money

211
Flow & Stock Velocity of Circulation
Money & Credit
Time limit Price level
Interval Period
Rate of Interest Nature
Fisher's
Demand for money means that quantity of tranasction which is exchanged through
cash i.e., Money is considered medium of exchange in it In determination of value of
money, more importance on supply of money. Money is flow Here velocity of
circulation of money and bank credit has been dealt separately. Money and Credit
are treated differently.
It is related with period of time.
Price-level means general price-level.
It indicates long-term chan-nges.
It has not given importance to rate of interest.
This theory is mechanical.
Cambridge
In it demand for money is meant to keep cash or store of money.
It has given more stress on demand for money. Money is stock. It is not dealt here.
Here bank credit is considered as a part of money. It is related with point of time.
Price-level indicates price level of consumption goods. This equation states the
causes of short-term and regular changes.
It has given importance to rate of interest.
This theory is psychological.
SUPERIORITY OF CAMBRIDGE APPROACH OR IMPORTANCE OF
CAMBRIDGE QUANTITY THEORY
Expressing the superiority of Cambridge Approach Crowther:
"In this analysis we approached towards reality. In the form of clarification of Trade
cycles such analysis is more reliable than the analysis of velocity of circulation."
Cash balance approach is superior to Fisher's Quantity Theory on the following
grounds:

212
(1) Explanation to Trade Cycles : Cash balance approach of quanity theory's
explanation can not be understood as 'old wine in new bottle'. Cash Balance
Approach is better than velocity concept which is limited to determinants of
velocity. If people demand more money i.e. (increase in K) then they have to spend
less on goods and services because total supply of money is constant at a particular
time. Decreased demand of goods and services will decrease the price. Contrary to
this, when people wish to keep less cash then their demand for goods and services
will increase. In this way cash balance approach explains deflation and trade cycle.
SBPD Publications Economics
(2) Significance of Human Aspirations: Cash Balance approach accounts
individual expressions, objectives and decisions as basis of economic activities,
which has not given place in Fisher's theory.
(3) Integration with General Theory of Demand and Supply: Since Cambridge
equation is presented in the context of demand and supply, therefore this co-
ordinates monetary theory with demand and supply theory of money.
(4) Clear Explanation : Cambridge theory explains cause and effect relations in
effective way. Change in desire to keep money in cash form changes price level.
Since money and credit quantity remain the same but Fisher's theory is mechanical.
(5) Realistic : In Cambridge equation more stress is given on the fundamental truth
that it is stored and K (Liquidity preference) is more stressed and velocity of
circulation is more appropriate.
(6) Liquidity Preference : Cash balance approach gave birth to liqudity preference
theory is the base of modern income, employment theory.
(7) Influence on Psychological Factors : In Cambridge equation preference is
given to factors influencing in demand for money rather than psychological factors
but Fisher has given importance on technological and institutional components
influencing demand for money.
(8) More Useful: Cambridge equation is more useful as it gives stress on short term
changes whereas Fisher stresses only on long term changes.

213
(9) Relation of National Income with the Value of Money: One reason of
superiority of Cambridge equation is that it relates the value of money with National
Income.
(10) Basis for Keynesian Employment Theory : Cambridge equation proved more
useful when Liquidity Preference Theory propounded by Keynes developed the
theory of income, employment and special monetary theories of controlling the
economy.
(11) Simplicity : Cambridge theory is simple because it is easy to know that how
much money is kept as liquid or in banks.
Prof. Robertson has accepted the superiority of cash balance approach because it
enables us to understand the psychological factor determining the value of money.

214
 LIQUIDITY PREFERENCE AND RATE OF INTEREST

Famous economist of 20th Century Lord Keynes propounded a monetary theory of

determination of interest in his book 'The General Theory of Employment, Interest &
Money', in 1936 is called 'Liquidity Preference Theory'. Interest is a monetary
phenomenon because interest is determined by demand and supply. Supply of
money depends on money in circulation and bank deposits. Demand for money is for
keeping money in liquid form or for liquidity. Definition of Interest
According to Keynes, "Interest is the reward for parting with liquidity for a specific
period."
It makes clear that people keep their wealth in the form of money, bonds,
debentures, Government securities. Among these money can be used immediately
according to will but bonds and debentures will have to be changed in money first
then used. Therefore, there is inconvenience in using money kept in the form of
bonds and debentures. When a person is ready to face the inconvenience and
uncertainty only when he gets some reward. Therefore, according to Keynes, "Rate
of Interest is that reward which encourages people to keep their saved money in
other form."
DETERMINATION OF INTEREST
According to this theory determination of interest is done through demand and
supply of money. According to Prof. Kurihara, "Rate of interest is determined by
demand and supply of money."
Rate of interest will be determined where Supply of money (SM) = Demand for
money (DM)
Demand for Money: According to Keynes money is demanded because it is the
most liquid asset. Every person wants to keep his asset in liquid form, therefore,
everyone demands money. In order to give money as loan we have to sacrifice
liquidity. The reward for parting with liquidity is called interest. More the money,
more will be the reward which people should be given for sacrificing the liquidity.

215
CAUSES FOR LIQUIDITY PREFERENCE
Why people want to keep their income in liquid ? Reasons are following :
(1) Transaction Motive : Every person keeps a portion of his income for daily
transactions, it is called transaction motive.
Keynes has said, "Cash is required to pass the time in between receiving of income
and spending." The need for money generally depends on level of income.
(2) Precaution Motive: Every man keeps cash to meet unprecedent needs, liabilities
and unforseen contingencies like sickness, accidents, it is called precaution motive.
The demand for money for such motive is not influenced by the rate of interest.
(3) Speculation Motive : Many people like speculators keep money in cash to get
advantage of change in interest rates. It is called speculative motives. Speculative
motive is a motive of earning profit by knowing better the market what the future
will bring forth'. —Keynes
Money as saving, any people can save money in the form of land, precious metal,
bonds etc. Except money all assets can be classified as Bonds. Therefore, according
to Keynes:
"Assets are of two types : Money and Bonds."
How can both best used we will have to take care. If we deposit cash in Savings
bank account then we will get interest and if we purchase bond we will get monetary
return. Future change in prices of bonds and interest rate is not forecasted. Therefore
demand of money is called 'Speculative demands'.
(i) Relationship between Bond Price and Interest Rates: The price of bonds and
rate of interest have reciprocal relations. For e.g.—If Bond is price Rs 1,000 and it
earns 10% fixed return which means that income on Bond is Rs 100. Suppose the
interest rate of saving bank account reduces to 8% from 10% then the question arises
how much amount
should be kept in bank to earn Rs 100 after one year (Equal to return of Bond)
Suppose X is the amount 10
then X. = 100

216
X = Rs 1250 It means that if we keep Rs 1250 in saving Bank account then we will
get equal return ? 100 which is earned after investing Rs 1000 in Bonds. It is clear
that people will prefer to purchase Bonds. Due to competition among purchasers to
purchase Bonds, its prices rise to 1,250. In this way due to decrease in interest rates
Bond's
(Maximum)
Liquidity Position prices rise. There is reciprocal relation between the prices of
Bonds and interest rates.
(ii) Relationship between Speculative Demand for Money and Rate of Interest:
There is reciprocal relationship between speculative demand and interest rate i.e.,
higher the interest rate lower will be the demand for money for speculative motive.
Therefore, the demand for money curve for speculative demand is sloping towards
right. It is shown in Fig. 1.
Where r is maximum : When rate of interest is very high then all will hope to
reduce it in future and in this way they expect the capital gains by purchasing Bonds.
Therefore, people will start changing there wealth in Bonds. In this way, the demand
for money will be less for speculative motive. When interest rate reduces in the
market, most people expect that there will be rise in future which will lead to loss in
capital, therefore, they will try to convert Bonds into money then speculative
demand for money will increase. In this way, there is reciprocal relation between
demand for money and interest rate for speculative motive.
Speculative Demand for Money:
Where, r is interest rate in the market and r maximum and r minimum are the
maximum and minimum limits. Both are positive determinants. It is proved from the
equation that as the rate of interest falls from r maximum to r minimum, 's price
increase 0 to a>. r Maximum = if rate of interest in the market is very low then every
person expects it to rise, this will cause capital loss then no one will like to keep
Bonds. Everyone in the economy will like to keep his wealth in money form and if
extra money is invested in the economy then its use will lead to increase in demand
for Bond. Again r minimum = decrease in rate of interest below the level surplus
money will be used to satisfy the caring for money. This situation is called 'Liquidity

217
Trap'. Demand function of money for spectulation is here mfinite elastic. In Fig. (1)
the speculative demand for money is shown on horizontal axis and rate of interest on
vertical axis.
Keynes has expressed the demand for money arising for transaction and
precautionary motive by M t, M^. Since This demand for money depends on income,
therefore, it can be expressed as :
In other words, M1 is the function of income which expresses income Y. When
income changes then M x also changes.
Keynes has expressed the speculative demand for money by M 2. Since this demand
depends on rate of interest. Therefore, Keynes has expressed it as function of Rate of
interest.
In other words, when rate of interest changes then M t also changes. Here r means
rate of interest. In this way L : depends on levels of income, and L2 depends on rate
of interest Le., demand of cash for speculative motive changes with the change in
rate of interest. There is inverse relation between demand of money for speculative
motive and the rate of interest i.e., as rate of interest increases, the demand for
money for speculative motive decreases. Keynes has stressed more on the demand
for money for speculative motive in the determination of rate of interest.
Total Demand for Money : Total supply of money in the country is expressed as M
then :
M = Mj + M2
Generally, Mi; the money kept for transaction and precaution motive is called Active
Money because this money is actively used for sale and purchase of this money.
Contrary to this M2 i.e., money for speculative motive is called Idle or Passive
Money.
Now it is clear that according to Keynes first two motives are permanent therefore,
the demand for money for these motives do not affect rate of interest directly but the
third motive that is speculative motive mainly depends on psychological condition
of creditor, therefore, it is difficult to assess that. Thus, speculative demand for
money is the main reason of change in the rate of interest. Total demand for money
is shown by Fig. (2).

218
Total demand for money can be obtained by lateral summation of demand for money
for transaction, precaution and speculative motive.
(i) In Fig (A) curve AB shows the demand curve of money for transaction and
speculative motive which is parallel to OY-axis. It shows that there is no effect of
change in rate of interest on it.
(ii) In Fig. (B) CL is the demand curve for speculative motive and this demand curve
slopes from left to right and from point L onward it is parallel to OX-axis. It shows
that with the increase in rate of interest demand for money decrease and with
decrease in rate of interest demand for money increases. The LD portion of CD
demand curve is parallel to OX-axis i.e., when rate of interest reduces to less than
2% money is kept with speculative motive.
(iii) In fig. (C) the total demand for money is shown. It is the lateral summation of
transaction motive demand curve and speculative motive demand curve. This
demand curve is also downward sloping upto L point and after that horizontal to
OX-axis. This curve is called Liquidity
Preference Curve.
Supply of Money : Money includes metal coins and bank credits. More the money
supply, lower will be the rate of interest. Lower the supply of money, higher will be
the rate of interest. In any economy the total supply of money is controlled by the
Government. Therefore, the supply of money remains constant during a certain
period. It is shown in the following figure (3). In the figure quantity of money is
shown on OX-axis and the rate of interest is shown on the OY-axis. Since supply of
money is fixed during short period therefore supply curve of money MM is shown
vertical.
DETERMINATION OF RATE OF INTEREST
According to Keynes the Rate of interest depends on the demand for money
(Liquidity Preference) and the supply of money. Rate of interest and liquidity
preference of money has inverse relationship, but supply of money remains constant.
Therefore, the rate of interest at which liquidity preference of money
Demand/Supply of Money

219
is equal to the supply of money, that rate of interest is determined or fixed. The
determination of rate of interest is shown in the Figure (4).
Diagrammatic Representation : Keynes' interest rate determination is explained
with the help of Figure (4).
(i) In the figure (4) LP is the Liquidity Preference Curve which shows the demand
for money. This curve shows the inverse relationship between the rate of interest and
liquidity preference.
(ii) SM is the supply curve of money shows the fixed supply of money.
(iii) Demand for money LP and supply of money SM intersect each other at point E
where both the demand for and supply of money are OM and equilibrium rate of
interest is OR.
(iv) At the interest rate R1( Ya M„ M M. IS there is disequilibrium because at this
rate of interest liquidity preference is less than the supply of money i.e., OM1 < OM.
Due to this disequilibrium people will purchase more Bonds, due to which prices of
Bonds will rise and rate of interest will decline, again equilibrium will be established
where kquidity preference and the supply of money is equal.
(v) If rate of interest is determined R 2 then again there
Money
is disequilibrium in money market because at this rate of interest liquidity prefer-
ence and prices of Bonds decrease and rate of interest increases. Again equilibrium
is reached at point E where liquidity preference is equal to supply of money.
Equilibrium rate of interest changes due to two reasons :
(1) Change in Demand for Money : If supply of money is constant and
demand for money increases i.e., liquidity preference increases then rat? of
interest also increases.
In the figure (5) SM is the supply of money curve and M lf M2 and M are demand for
money curve. Suppose, initial demand curve is M, then equilibrium is point 'E'
where liquidity preference curve M cuts supply curve MS and OR is the rate of
interest. If liquidity preference curve shifts to M then the new equilibrium will be E1
and rate of interest shifts to OR r Contrary to this when liquidity preference curve is
M2 then equilibrium point will be E 2 where the rate of interest will be OR 2.

220
If liquidity preference is constant then Y Si S S2
-LP
(2) Change in Supply of Money
due to change in supply of money, rate of interest will also change with the increase
in supply of money rate of interest will decline and with the decrease in supply of
money rate of interest will increase. Therefore, there is inverse relation between the
supply of money and the rate of interest.
In the Fig. (6) LP is the Liquidity Preference Curve and MjSj, MS and M 2S2 curves
are supply of money curves. Suppose, initial supply of money is MS where LP and
MS curve cut each other at E. At this equilibrium rate of interest will be OR. If
supply of money reduces to OMl then equilibrium will be at E x point where LP and
MJSJ curves intersect each other. At this point of equilibrium rate of interest
increases to ORr Contrary to this if supply of money increases to OM 2 then rate of
interest reduces to OR 2.
In short, according to Liquidity Preference Theory, Rate of interest will be
determined at that point where demand for money i.e. liquidity preference and
supply of money are equal to each other.
KEYNES LIQUIDITY PREFERENCE THEORY AT A GLANCE
1. Interest is the reward for parting with liquidity.
2. Money in cash is demanded for three purposes : (a) Transaction Motive (b)
Precautionary Motive (c) Speculative Motive
3. Money demanded for transaction and precautionary motives have no effects on
the rate of interest. On the contrary, money demanded for speculative motive affects
rate of interest completely.
4. Like General pricing theory, Rate of interest is also determined by the equilibrium
of demand for money and supply of money.
5. Demand for money means liquidity preference of people and supply of money
means the total quantity of money. Since supply of money is fixed during short
period therefore rate of interest is affected by demand for money.

221
6. Rate of interest and liquidity preference have inverse relation. With the increase in
rate of interest demand for money decreases and with the decrease in rate of interest
demand for money increases.
7. Equilibrium of rate of interest changes due to two reasons :
(a) Change in Demand for Money (b) Change in Supply of Money.
Some Implications of Keynesian Liquidity Preference Theory of Interest:
(i) Inverse Relation between Price of Bond and Rate of Interest:
Main aspect of Liquidity Preference Theory is that there is inverse relationship
between prices of Bonds and the rate of interest i.e., when rate of interest falls then
prices of Bonds increase and the prices of Bonds fall when rate of interest increases.
For analysis we will take the example of Government Bond. The face value of Bond
is written on it and percentage rate of interest is also paid on that. Therefore, there is
definite annual income from any Bond. Suppose, the printed value of any Bond is ?
100 and the Government gives 6% interest on it Le., 6% definite income accrues
through it. Now, if rate of interest falls to 3%, then market price will be 200 because
only 3% rate of ineterest on ? 200 Bond will give ? 6 as annual interest. It is clear
that due to fall in rate of interest market price of Bond has increased. On the
contrary, if rate of interest rises to 12% then the market price of the Bond will fall to
? 50. 12% rate of interest on bond of? 50 will give ? 6 as annual interest. Now we
can say that there is inverse relation between price of the Bond and accrued rate of
interest.
Decrease in Liquidity Preference means that it will increase the prices of Bond and
rate of interest will fall and on the contrary, Bond's prices will fall and rate of
interest will rise.
(ii) Rate of Interest and Supply of Money : According to Keynes by reducing the
rate of interest and increasing the supply of money employment can be increased. It
is based on this assumption that increase supply of money will increase the supply of
money for speculative money (M 2), which will cause fall in rate of interest and
encourage investment and income. There are many limitations of such policy for e.g.
:

222
(a) If increase in liquidity preference is greater than increase in supply of money
then due to increase in money supply rate of interest will not decrease.
(b) If decrease in Marginal productivity of capital is greater then the decrease in rate
of interest then it will not increase employment rate. Therefore, during depression
period when liquidity preference is greater and marginal productivity of capital is
lower then such policy is not more effective.
(iii) Liquidity Trap : The situation of Liquidity trap states that rate of interest
cannot fall below the determined level of rate of interest whatever increase in supply
of money is done by monetary authority. The Liquidity Preference Theory of
Keynes states that the rate of interest is determined by liquidity preference (demand
for money) and the rate of interest. If quantity of money increases rate of interest
falls and a situation comes when increase in quantity of money does not lead further
fall in rate of interest. It is lowest rate of fall of interest rate. This situation is called
'Liquidity Trap' in Keynesian analysis. In such a situation economy is in a Liquidity
trap where whatever amount of money has been increased it vanishes as passive
money balances with people and monetary authorities are unable to take out the
economy from such trap. Since rate of interest remains the same therefore
investment and employment and income level of the economy remains unaffected.
The theory of Liquidity Trap says that the level where liquidity trap starts even
during depression through increasing the quantity of money and decreasing the rate
of interest investment and Aggregate demand cannot be increased.
Diagrammatical Presentation : It is shown in Fig (7) where LP is the Liquidity
Preference curve which shows that:
(i) As rate of interest decreases from 8% to 2%, the LP curve becomes more elastic
and becomes parallel to OX axis which indicates that here the demand for money is
infinity. The meaning of elastic demand for money is that due to inverse relationship
between lower rate of interest and demand for money when the quantity of money in
the economy increases then it goes on, accumulating with people and is not used in
any economic activity.
(ii) Although with the increase

223
in quantity of money rate of interest falls, for e.g. In the figure when quantity of
money is OM to OMj and OM2 the rate of interest falls from AM to BM t to CM2.
But after that a situation comes when rate of interest stops falling and remains
unaffected even with the increase in money supply.
(iii) In the fig (7) when quantity of money is OM2 or ? 1,000 then rate of interest is
at its lowest 2% or CM2 and when quantity of money increases to ? 1,200 or DM 3
then the rate of interest remains same at 2%.
(iv) Since DM3 = CM2 it means rate of interest remains the same. It is the situation
of Liquidity Trap which shows the tendency of LP curve to be parallel and at this
rate people will keep money in cash form and not lent then the situation of 'Credit
Dead lock' will come. This is called by Keynes 'Liquidity Trap'.
Y (v) Liquidity trap is defined that it shows
the combinations of those points on LP curve were % change of rate of interest (A
i/i) the % change in demand for money (AM/M) become infinite.
Now we see why Liquidity Preference Curve becomes perfectly elastic after point P?
In fig (8) at 2% rate of interest LP curve becomes perfectly elastic which means any
further increase in quantity of money will be kept in cash by people. They will not
invest that in Bonds why so ? The reason is that:
(i) People do not hope that rate of interest will fall below 2% then how the prices of
Bonds will increase. Therefore, there is no scope of earning profits through investing
in Bonds, people will not invest.
(ii) Along with it 2% rate of interest is so low that there is all possibility of increase
in it. Whenever such will happen the prices of Bonds will decrease. The persons who
will purchase Bonds now will incur loses in future. Therefore, people will prefer to
keep cash with themselves.
It can be concluded now, that rate of interest cannot be lowered after a certain point,
whatever need be for social benefit. Due to this especiality of liquidity preference
rate of interest cannot be zero.
Prof. Hicks does not agree with Keynes view. According to him the reason for rate
of interest not becoming zero is not the uncertainity or lower rate of interest but it
the fact that money is a liquid asset. It is liquid and medium of exchange so it is kept

224
in cash form to purchase goods and services where Bonds and securities take time to
be converted in cash which creates inconvenience. So, according to Prof. Hicks rate
of interest can never be zero. Money due to its liquidity is supposed to be the best.
Therefore, if interest is not paid people will not invest their liquid money in Bonds
and securities. Along with it the demand supply for goods and services are different
from demand/supply of money. When the supply of goods is greater than its demand
then prices may fall to zero but in case of money, if increase in supply of money can
never reduce rate of interest to zero because money is liquid. Therefore, demand for
money never ends. So rate of interest is always positive never be zero. Therefore
Prof. Hicks view is better than that of Prof. Keynes. The important points related to
Liquidity Trap are following:
1. In Liquidity trap situation rate of interest is fixed at the minimum level.
2. In Liquidity trap situation whatever increase may be done in quantity of money,
rate of interest remains the same.
3. In such a situation demand for money or liquidity preference is mfinite, the reason
is that due to lowest level of rate of interest people keep extra money in the cash
form.
4. In such a situation rate of interest and prices of Bonds are slack in the market.
5. Since there is inverse relationship between rate of interest and the prices of Bond,
therefore in the situation of Liquidy trap, when the rate of interest is the lowest the
price of Bond is the highest.
6. Monetary policy is unable to overcome such a situation therefore the level of
investment, income and employment are affected and economy is in the situation of
imperfect employment.
7. Keynes has said the Liquidity trap situation is the situation of economic stability
because all activities become slack and economic development is hampered.
8. In Liquidity trap situation when monetary policy has zero effect, fiscal policy
reaches at its maximum.
9. Liquidity trap is only ultimate analysis of Keynesian theory. It can emerge only in
the situation of serious depression.

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FEATURES AND IMPORTANCE OF KEYNESIAN THEORY Keynes theory
of Liquidity Preference is very important theory of economics.
1. Monetary Element: Keynes has tried to modify the classical theory by adding
monetary factors in the theory of interest. Classical economists had not given
importance to money in determining rate of interest because according to them
interest is the price of capital. Keynes said that interest is purely a monetary
phenomenon therefore rate of interest can be controlled by banks.
2. Integration of Monetary Theory with the Theory of Employment and
Production : Before Keynes' Liquidity preference theory in the theory of Income,
Employment, Production money had no place because classical economists had
assumed money as only medium of exchange. Keynes in his theory of liquidity
preference stressed more on the role of money as store of value than medium of
exchange. According to Keynes rate of interest influences investment i.e. change in
rate of interest increases or decreases the quantity of investment which in turn
changes income, production and employment.
3. Relation between Quantity of Money and Price : Keynes through Liquidity
Preference theory tried to prove that the supply or quantity of money neither has
direct relation with price level and nor money is always inflationary According to
Keynes in the situation of less than full employment situation when supply of money
is increased then rate of interest is low which in turn causes increase in investment,
production, income and employment. Through Liquidity Preference Theory, value of
money or price level postulates now theories which discards the classical concept
that every increase in supply of money is inflationary.
4. Scope : It applies in all types of economies.
5. Economic Policy: It helps in adopting proper economic policy to maintain
employment and income in the country. The active way to influence rate of interest
is to increase the quantity of money and cheap money policy should be adopted.
6. Equality between Savings and Investment: Other quality of Liquidity
Preference theory is that it explains how saving and investment are balanced in an
economy which is due to increase or decrease in income and employment and not
due to fall and rise of rate of interest.

226
Criticisms :
1. It has ignored non-monetary factors like producer and sacrifices of economies and
assumed interest as a monetary phenomenon.
2. One sided: This theory is one sided. Keynes has stressed more on demand
side.
3. Liquidity and Illiquidity : It is not easy to differentiate liquid and illiquid money
and it makes interest a complex problem.
4. Interest rate not independent of demand for investment, both are interdependent.
5. It is a short period explanation only but unable to explain various levels of interest
rate in long period.
6. Applicable only in the economy which is based on money, not applicable in barter
system economy.
7. It is a Narrow Approach because it does not gives attention to savings, propensity
to consume and Marginal efficiency of capital which affect rate of interest.
8. It does throws light on the factors which increases the tendency of hoarding.
9. Keynes assumed that 'Interest is the reward for parting with liquidity' but Prof.
Henry and Prof. Jacob Viner is of the view that until money is not stored the
question of sacrifice of liquidity does not arise. Therefore, interest is the reward of
store of money.
10. It is indeterminate theory. According to Keynes rate of interest is determined by
mutual action of demand and supply of money. But if we have no knowledge of
level of income we cannot say about the curve of demand and supply.

227
 CREATION OF CREDIT BY BANKS
Important work of modern banks is credit creation. Famous economists Sayers says
that "Bank is not only money collecting organization but also creator of money."
MEANING OF CREDIT MONEY AND CREATION OF CREDIT
The money created by bank is known as 'bank money' or credit money*. Bank
money or credit money is circulated by commercial banks and it is related with that
money of public deposited with banks. The deposited money can be used as money
through cash. Cheque is representative of deposit money. They circulate like money.
Therefore, 'bank money' or 'credit money' is called 'deposit money.'
Commercial banks create credit on the basis of their deposits. Definitions:
(1) According to Newlyn :
"Credit Creation refers to the power of commercial banks to expand secondary
deposits either through the process of making loans or through investment in
securities.
(2) According to G.N. Halm : The creation of derivative deposit is identical with
what is commonly called the creation of credit.
In short 'credit creation' is that power of banks by which banks expand their
secondary deposits more than primary deposits through loans, advances and
investments.
BASIS OF CREDIT CREATION
The basis of 'credit money' is 'bank deposits' therefore, bank can create credit by
increasing the quantity of deposits. Deposits are of two types :
(1) Cash or Primary Deposits: The money which people deposit in cash form in
banks is known as 'primary deposit' or cash deposit'. Lord Keynes has said it
'Passively created deposit'. It depends on the wish of customers to deposit cash in
bank or not. Base for creation of bank money depends on cash deposits.
(2) Credit Deposits or Secondary Deposits : If a person visits bank to take loan then
bank does not give cash amount but opens an account on his name and gives him
right to withdraw money through cheques. Such deposits are called 'credit deposit' or
'secondary deposit.' Every advance given by bank creates a new deposit. Credit

228
deposit is the result of primary deposit because bank keeps some portion of cash
deposit as reserved and then creates credit.
Credit deposit is 'derivative deposit'.
Example : Suppose a person named A takes loan ? 20,000 from Allahabad Bank.
Bank deposits that money in his account instead of giving the amount in cash which
A withdraws later through cheques according to his needs. The amount which is
deposited in A's account is not cash deposit but 'credit deposit' or 'secondary' or
'derivative deposit.' In this way major portion of loan is deposited with the banker
itself. Therefore, every advance given by bank creates a new deposit. Therefore,
Hartley Withers says :
"Loans Create deposits"
CREATION OF CREDIT BY DERIVATIVE DEPOSITS
According to Halm:
"Creation of derivative deposit is the creation of credit. Therefore, more the bank
gives loans, more will be the credit deposits and more loans are created. In other
words,
'Loans create deposits and deposits create loans.' According to Prof. Keynes:
"Loans are offspring's of deposits and deposits are offspring of loans." In this way
bank creates credit by advancing the loans to its customers which are the lifeline of
today's economy.
PROCESS OF CREDIT CREATION
Bank's credit creation process is clears from the following example :
(1) Suppose any customer deposits Rs 100 in his bank A. In this way Rs 100 is the
primary deposit of Bank A.
(2) Bank knows from its experience that customers will demand only a certain
portion of its deposits, therefore, there is no need of keeping Rs 100 as cash to fulfill
its demand.
(3) If customers withdraw only 20% of his deposits then banks have to keep only ?
20 of Rs 100. Therefore, on this assumption that cash reserve ratio is 20% then Bank
A will keep Rs 20 as cash reserve and lent ? 80, to another customer Ram.

229
(4) Suppose this money is not given as cash but deposited in the Account of Ram. In
this way Bank A creates derivative deposit of Rs 80.
(5) Suppose Ram pays this money for some payment to Shyam through cheque.
(6) Shyam deposits it in Bank B. Therefore, Rs 80 will be the 'Primary deposit' of B.
Now Bank B keeps Rs 16 (20% of 80) as cash reserve with it and give Rs 64 to other
man Mohan.
(7) Rs 64 after payment to Mohan it becomes primary deposit of Bank C. Then Bank
C will also keep Rs 12.8 (20% of 64) and rest Rs 51.20 will give advance. This
process will continue in various banks when total deposits amount Rs 100 will
multiplied 5 times. It is clear from the following table :
It is clear from the above table that on the basis Bank A's Rs 100 'Primary Deposit'
banking system of the country gives loan of Rs 400 and as a result total Rs 500
deposits are created.
Mathematical formula:
TD =
where TD = Total deposits P = Primary deposit R = Cash reserve ratio
100 100
TD= 100x =500
Primary deposit is Rs 100 Total deposit = 100 x 5 = Rs 500
If we subtract Rs 100 primary deposit Rs 500 - Rs 100 = Rs 400 is derivative deposit
Example: If primary deposit is Rs 8,000 and cash reserve ratio is 10%, then what
will be the amount of credit creation Rs Answer:
= Rs 80,000 Here total deposit is Rs 80,000. After deducting the primary deposit Rs
8000
= Rs 80,000 - Rs 8,000 = Rs 72,000 is the credit created or derivative deposit. Here
it should be noted that banks can increase their credit creation by reducing the Cash
Reserve Ratio (CRR). Along with it banks create credit by providing 'overdraft'
facility because overdraft facility is provided to only reputed customers. By
purchasing the securities and paying them through their cheques banks can create
credit.

230
CREDIT MULTIPLIER
Credit multiplier is the ratio of increase in total deposit to increase in primary
deposit. If primary deposit increases by Rs 100 and due to this total deposit increase
by Rs 1,000 then credit multiplier will be 10. Credit multiplier and cash reserve ratio
has opposite which can be expressed through the following equation:
Credit Multiplier =
Cash Reserve Ratio
LIMITATIONS OF CREDIT CREATION
Although banking system can create credit money but it has not unlimited power.
In short, credit creation depends on following factors :
(1) Volume of Money in the Country : Credit is created on the basis of cash.
Therefore, the countries where the quantity of money will be more, they have more
money in banks and they can create more credit.
(2) Cash Reserve Ratio : Every bank keeps a certain percentage of its deposit in
cash reserve form, therefore, whether bank will create more or less credit depends on
cash reserve ratio. If cash reserve ratio is more then less credit will be created and if
cash reserve ratio is less then more credit will be created. This fact is shown in the
following table :
Table II: CRR and Credit Creation
CRR Primary Total Deposit Credit Creation
TD
Deposit =R TD-P
10% 1,000 10 x 1,000 = 10,000 10,000-1,000 = 9,000
5% 1,000 20 x 1,000 = 20,000 20,000-1,000 = 19,000

20% 1,000 5 x 1,000 = 5,000 5,000 - 1,000 = 4,000

It is clear from the above table that
(i) When primary deposit is Rs 1,000 and CRR is 10% then Rs 9,000 credit is
created.
(ii) When CRR increases to 20% then credit creation is only Rs 4,000.
(iii) It is clear that credit creation and CRR has opposite relation.
(3) Size of Primary Deposits : The basis of credit creation by banks is 'cash or
primary deposits'. If amount of primary deposits is more then while keeping CRR

231
constant credit creation will be more. On the contrary, when the amount of primary
deposits is less then credit creation will be less. This is shown in the Table-Ill.
Table III : Relation between Primary and Total Deposit
Primary CRR TD= P R Increase in Total Deposit
Deposits
Rs 10,000 10% =1000x100 Rs 10,000
To

Rs 5,000 10% = 500x10 Rs 5,000

To

Rs 20,000 10% =2,000x10 Rs 20,000

To
It is clear from the above that if CRR is fixed then higher the primary deposit higher
will be the increase in total deposits and as a result higher will be the credit creation.
(4) Demand of Cash Money by the Public : If people by nature uses more cash
than cheques as it is in India, then credit creation capacity of banks will reduce. On
the contrary, if people use cash only for small transactions then banks cash reserve
will not reduce and their capacity to create credit increases.
(5) Bank Deposits with Central Bank : Banks as a rule have to keep certain portion
of their liabilities with central bank as reserve fund. When central bank increases the
amount of reserve fund then bank's cash reduces and their credit creation reduces.
On the contrary when central bank decreases the amount of reserve fund, then credit
creation increases.
(6) Development of Trade and Industry : The credit creation capacity of banks
depends on country's commercial and industrial condition. During depression due to
lack of loan demand bank cannot create more credit. During boom banks can create
more credit.
(7) Nature of Securities or Availability of Good Borrowers : The credit creation
capacity of banks depends on nature of securities also. If borrowers are reliable i.e. if
they provide good securities against loans then banks can create more credit. On the
contrary if the securities are improper, less credit will be created.

232
Crowther said: "Bank does not create credit in air but it transforms other forms of
assets in the form of money."
(8) Credit Policy of Central Bank: Credit creation depends on monetary or credit
policy of the central bank. The reason is :
(a) Central Bank has power to influence quantity of money.
(b) It can directly or indirectly affect expansion and contraction of credit of banks.
(9) Credit Creation Policy of Other Banks: Due to many banks available in the
country every bank has to keep in view the credit creation policy of other banks also.
Reason is that for successful working no bank can be ahead or behind other banks in
credit creation for long time.
(10) Leakages in Circulation: The process of credit creation depends on leakage of
credit. If during the process of credit creation in any stage a person instead of
depositing the money in banks, spends it then that money goes out of banking
system and credit creation recedes.
DO BANKS REALLY CREATE CREDIT ?
First Thought: According to Prof. Hartley Withers, Prof. J. M. Keynes, Prof. Sears,
Prof. Halm's view : Banks create credit according to methods mentioned earlier.
Second Thought: According to Walter Leaf and Prof Cannon, Banks do not create
credit themselves. Credit is created by depositors because deposits by depositors
provide monetary source to bank and bank gives a part of deposit as loan. Due to
this credit is created. If depositors keep their money with them, then Banks will not
create credit.
Right Approach: In reality, the approach of Leaf and Cannon is not clear. Their
views will be accepted only on this point that the deposits by depositors, encourages
banks for credit creation. But they are wrong in thinking that banks create credit on
the basis of those deposits which not withdrawn.
Prof. Crowthers has given two reasons : (i) Theoretical (ii) Practical.
(i) On the theoretical basis if on individual basis bank is unable to create credit they
are able to create credit on collective basis.
(ii) On the practical basis Crowther has said that bank's deposit's size becomes clear
by comparing the deposits in bank and money in circulation.

233
For e.g. In 1904 in Britain total deposit in Commercial Banks was 6,500 million
pound but in circulation it was 1647.6 million pound and cash with banks was 23
million pound. If it is said that bank can advance loans only according to their cash
reserve then only 23 million pound loan could be given. But by creating the credit
6,263 million pound extra credit had created. Therefore, Banks have credit creation
power and the limit of credit creation is determined by the amount of cash available
in banks.
In this way, according to modern economists Walter Leaf and Cannon's view are not
just because banks advance loans more than primary deposits. So it is true that
"Banks create credit."
Hartley Withers said:
"Loans make deposits and initiative of creating, them goes to the bank'.
Lipsey and Stinner:
"Expansion of credit is not automatic. It depends on the decisions of bankers. If
Banks does not uses increase in deposits for investment then deposits will not
expand.
All Banks jointly do credit creation by giving overdraft facility, purchasing
securities and paying through cheques and discounting the bills. Therefore, Banks
can create credit and they create it also.

234
 MONETARY POLICY
MEANING OF MONETARY POLICY
Monetary policy means those monetary methods or measures on the basis of which
the government of any country finds the objectives for the formulation of polices for
economic development.
Definitions
(1) According to Johnson : "Monetary Policy is the policy of Central Bank to
control the supply of money, so that general objectives of economic policy can be
fulfilled."
(2) According to Paul Einzing : "All monetary decisions and measures are included
in monetary policy whose objectives are to influence Monetary System."
(3) According to Kent: "Monetary Policy means a system of expansion and
contraction of money for fulfilling a definite objective."
In short : Monetary Policy includes all those measures of Central Bank through
which it controls the quantity of currency and credit in the economy.
OBJECTIVES OF MONETARY POLICY
There is a lot of controversy regarding the objectives of Monetary Policy and
different objectives are given importance in different times. During Gold Standard
period the objective of monetary policy was to attain external stability of currency.
But when non-convertible paper currency come into circulation, since then to attain
internal stability of currency is the objective of monetary policy. But economic
stability is possible only when savings and investment equilibrium is established at
full employment level.
According to Crowther : "The clear objective of monetary policy of any country is
to attain equilibrium of savings and investment at full employment." Therefore, the
objectives of monetary policy are :
(1) Exchange stability (2) Price stability (3) Neutrality of money (4) Full
employment (5) Economic growth.
(1) Exchange Stability : The objective of monetary policy is to maintain stability of
exchange rate. Exchange stability means keeping exchange rate stable or acquiring
external equibibrium. It is expected from monetary authority to maintain stability in

235
exchange rate and adjust the simple changes of exchange rates from internal price
level but should never allow heavy fluctuations in exchange rates.
Agruments in Favour of Exchange Stability : Due to fluctuation in exchange rate
many difficulties arise like :
(i) Encouragement to Speculation: In foreign exchange market tendency to
speculate arises which hampers the credit of the country.
(ii) Distrust of Foreign Capitalists : Due to heavy fluctuations in exchanges rate
foreign capitalists trust is lost and they start taking back their capital.
(hi) Bad Effect on Internal Price Level: Simple fluctuations in a country's
exchange rate badly affects the internal price-level.
(iv) International Co-operation : Stability of exchange rate is essential for
international co-operation. With international co-operation balanced growth is
possible.
On the basis of above discussion it can be said that main objective of monetary
policy is to maintain exchange stability.
After First World War countries left Gold Standard one by one and since then the
importance of stability of foreign exchange rate has ended. Now almost all countries
of the world gives more importance to economic stability than to foreign exchange
rate stability.
(2) Price Stability: After the Great Depression (1929-33) the main objective of
monetary policy has become to establish stability in price level and stability in
business cycles. Economist Callons and Keynes, opined that the objective of
monetary policy should be to maintain the internal price stability. It is worth
mentioning that stable price-level does not mean that average price level should not
fluctuate more as indicated by Wholesale Price Indicators.
Government had adopted the objective of price stability of Monetary Policy in New
Deal Plan of America.
Arguments in Favour of Price Stability : In reality many difficulties arise due to
instability in price. For e.g. :
(1) During falling price trade disrupts and employment and production declines.
(2) Rising prices lead to inequality in income distribution.

236
(3) Instability in internal price are cumulat: e in nature i.e. they go on increasing day
by day and fear of crash in economy arises and may lead to civil war.
Although price stability is important but economist does not support price-stability
policy as an objective of monetary policy. They think creeping inflation is desirable
to remove unemployment and to attain full employment.
(3) Neutrality of Money : The policy of neutrality of money was recommended by
Prof. Wicksteed. Explanation of Neutral Money Policy was done by Prof. Hayek in
his book 'Price and Production'. 'Prof.' Robertson also supported this policy.
Neutral Money Policy is based on free trade. The supporters of this policy say that
due to change in quantity of money, instability arises in economic life of the country.
Therefore, if economic stability has to be maintained in the country then there
should not be any change in quantity of money viz. money should be neutral.
According to this view money has only one function is to facilitate exchange.
In other words, policy of money should be regularized in such a way that it will not
unduly affect employment, production, price and income. By keeping the supply of
money constant, one can expect the neutral role of money.
In reality this view is applicable in static society only where there is no change in
production. But we live in a changing society where it is not feasible to implement
this policy.
(4) Full Employment: Now the objective of full employment is the main aim of
monetary policy. When the objectives of full employment is achieved then other
objectives will be automatically achieved.
According to Crowther : 'The clear objective of monetary policy of a country is to
attain equilibrium of savings and investment at full employment level.
According to Prof. Keynes: "The objective of monetary policy is to reduce
fluctuations of trade-cycles and attempt to establish equilibrium between savings and
investments at full employment level."
According to Keynes the best way to encourage investment is to increase the
quantity of money and by reducing the interest rate cheap money policy should be
followed. In such situations cheap money policy helps in increasing employment by
increasing the investment.

237
Monetary policy helps not only in achieving full employment, but after attaining the
full employment level, it can be used to maintain the economy at this level. Keynes
had made it clear that until factors are not properly used till, then investments should
be more than saving. In this way. the objectives of monetary policy will be to
encourage investment but when full employment reaches equilibrium, savings and
investment must be equal. The reason is that in such a situation increase in
investment will not increase the quality of investment, therefore increase in
investment will cause inflation. Therefore, the aim of monetary policy at the level of
full employment is to maintain the equilibrium between saving and investment.
Dussenbury said that Monetary policy is one of the tools to attain full
employment. According to him main Savings and Quantity of function of monetary
policy is to Investment Money investigate those interest rate levels
(A) g (B) which equates the total investment
Y
A demand with total savings.
In the figure (1) A, SS is the vertical straight line, showing the savings from full
empolyment. I line is showing the quantity of investm-k interest rates.
1
equates investment and saving at full employment income level. In figure B,YE
curve shows the demand
for money at Employment income level. Therefere, ON supply of money is required
to get R0 rate of interest. R„ is the rate of interest which increases investment equal
to full employment saving. It is clear that equality in saving and investment can be
attained through savings rate and interest rate depends on the supply of money.
It is clear from the above discussion that monetary policy should be adjusted in such
a way so that:
(i) By creating credit money or creating surplus bank deposit or by increasing the
velocity of circulation present investments can be increased more than present
saving.
(ii) As the economy reached the full employment level, the aim of monetary policy
should be equality of savings and investment at full employment level.
(5) Economic Growth or Monetary Policy in Underdeveloped Countries : The main
aim of monetary policy in underdeveloped countries should be economic

238
development and price stability. In short, the monetary policy adopted by
underdeveloped countries should be named as 'controlled
expansion' which is called Development with Stability' by Burnsteen Fund Mission
viz. the aim of this policy should be adequate fund management for economic
development and on the other hand price stability should be maintained.
In short, Monetary Policy related to economic development should have :
(i) Efficient Payment Machinery : From the point of view of economic development
the important work of monetary authority is the establishment of an efficient
payment machinery. Because as country develops, the monetary sector of the
economy goes on expanding. In such a situation if monetary system or payment
machinery is not conducted efficiently then increasing specialization and investment
will be lost.
(ii) Adequate Money Supply : In the process of economic development there should
be adequate money supply. Demand for money increases with economic
development, therefore, supply of money should also be increased. There are so
many reasons of increase in demand for money. For eg. Till now money was not
being used, now it started. National Income increases therefore, in ordinary business
also demand for money increases, variety of demands take place. Therefore,
Monetary authority should take care that supply of money with regard to growth
should be enough and flexible.
(hi) Encouragement to Investment: Low interest rate in underdeveloped countries are
important for economic development because cheap money policy encourages new
investments by public enterprise. Alongwith it only private entrepreneur is not able
for rapid development of the country, therefore, Government undertakes public
investment for which also cheap money policy is helpful.
(iv) Expansion of Financial System : Monetary authority should help in continuous
development of all banking and financial system and should help Government Bond,
shares, securities market so that financial system can expand.
(v) Creation of New Financial Institutions : In order to make new savings dynamic
for productive works, new financial institutions should be established. It is the duty
of Central Bank that to expand the commercial banks to rural areas, establish

239
cooperative bank committees to provide financial help to farmers, small industries
and businessmen.
(vi) Solution of Balance Of Payment Problems: In the primary stage of economic
development developmental imports are more in quantity which badly affects
balance of payment. In such a situation Monetary Authority has to implement direct
control on foreign exchange along with impose traditional control on bank-rate, so
that problem of balance of payment can be solved.
So, it can be concluded that in an underdeveloped economy, economic development
is the objective of monetary policy.

TOOLS OR INSTRUMENTS OF MONETARY POLICY

or
CREDIT CONTROL BY CENTRAL BANK
Monetary management of the economy is most important work of Central Bank.
Monetary Management is meant to regulate the supply of money and credit in such a
way so that Demand for money for trade, commerce and economic activities is met
in a satisfactory way.
Credit expansion is done by commercial banks. These institutions are profit earning
institution which used to increase or decrease credit for their profit. Central bank
controls all banks and controlling the credit is also an important work of Central
Bank.
The main objectives of credit control are :
(i) To stablize internal price-level.
(ii) To make successful economic planning.
(iii) To establize foreign exchange rate.
(iv) To control trade cycles.
(v) To arrange finance for wars.
METHODS OF CREDIT CONTROL
In order to fulfill the objectives of credit control, the tools used by Central Bank are
divided in two parts :
(I) Quantitative Credit Control

240
(II) Selective Credit Control
I. QUANTITATIVE CREDIT CONTROL Those tools of credit control which
directly affect the cash balances of banks are called Quantitative Controls. Main
quantitative tools are : (1) Bank Rate Policy
Meaning and Definitions : Bank rate is that on which Central Bank rediscounts 1st
class bills of member banks and gives loans. Whenever commercial banks are no
getting money from other sources and they are in need of money then it rediscounts
it's consumer's bill at central bank or takes loans on the basis of securities. For this
service of rediscounting or advancing loans Central bank charges interest which is
called bank rate or discount rate. Some definitions of bank rate are :
(i) According to R. A. Young: "Bank rate is the publicly announced charge applied
by the Central Bank on discounts of securities or advances to member banks."
(ii) According to Spalding : "Bank rate is the minimum interest rate at which
central bank rediscounts the approved securities or advances loans to other banks."
There is difference between bank-rate and market rates. Market rates are those rates
at which commercial banks of a country and other financial institutions are ready to
give advances. In this way when bank-rate is the rediscount rate of the Central Bank,
market rate is the rate of discounting.
Process of Credit Control: Central Bank, by changing the bank rate controls the
credit in the following way :
(a) Expansion of Credit: If Central Bank feels that there is less expansion of credit
than requirement then it reduces the bank rate to expand credit. Suppose previously
bank rate was 10% then it reduces to 9%. It will impact the commercial banks now
they will get advances at cheaper rates and they will rediscount their bill at low rate
when commercial banks get loan at cheap rates they will advance loans at low
interest and discount their bills at lower rate. It's effect on country will be :
(i) Businessmen will take more loan.
(ii) Credit will expand.
(iii) Business growth
(iv) Increase in production
(v) Increase in price level.

241
(b) Contraction of Credit : When credit expansion is done more than requirement
then it is harmful for the economy. Central Bank uses its bank rate to control the
credit. It increases the bank rate. Suppose, previously bank rate was 9%, then
Central Bank will increase it to 10%. Then commercial banks will have to pay more
interest and they have to pay more for rediscounting.
Its effect will be that commercial banks will give loans to their customers at high
interest rates. It's effect will be :
(i) Businessmen will reduce taking loans.
(ii) The expanded credit by bank will reduce.
(iii) Trade will contract.
(iv) Production will diminish.
(v) Price level will diminish.
The process of credit control through bank rate is shown in the following table:
Table I
Process of Credit Control through Bank Rate
I. Central Bank 1 Reserve Bank ii. Central Bank/Reserve Bank of
of India India
If RBI wants to reduce money If RBI wants to increase supply of
supply money
It increases Bank Rate Reduces Bank rate
Banks create less credit Banks create more credit
People get less money People get more money
Quantity of money reduces Supply of money increases.
Assumptions of Bank Rate Policy : In order to make Bank rate policy successful, it
is essential to follow certain rules :
(i) The economy of country should be flexible.
(ii) Other interest rates prevalent in Money market should be according to change in
bank rate.
(iii) Commercial banks should depend on Central Bank.
(iv) The approach of businessmen should be according to bank rate.
(2) Open Market Operations

242
In credit control open market operations means sale and purchase of securities of
private and public institutions by Central Bank.
Definitions :
(i) According to De-Kock : "Open market operations imply the purchase and sale of
securities by Central Bank in the open market."
(ii) According to R. A. Young: "Open market operations consists of central banks'
purchases or sales of securities in the open market."
Working of the Open Market Operations : Under open market operations Central
Bank expands or contracts credit by selling and purchasing securities in the open
market.
(i) Contraction of Credit : When there is surplus money in the money market and
Central Bank wants to contract it then Central Bank starts selling securities in open
market. People have more faith on Central Bank, therefore they through (a)
withdrawing the cash from their banks, (b) more saving, (c) withdrawing the given
loans by them start purchasing securities sold by Central Bank. In this way cash
returns to Central Bank and money in circulation reduces and bank's cash also
reduces. Due to reduction in bank's cash they are forced to contract credit.
(ii) Expansion of Credit : When money contracts then banks start purchasing
securities and returns money. The poeple start getting money, some part of which is
deposited in banks. With the increase in deposits of banks, they are able to create
more credit.
It is clear from open market operations process Central Bank influences the credit
creation capacity of commercial banks.
Credit Control process through open market operation is shown in the following
table:

243
 Table II
Credit Control through Open Market Operations
Reserve Bank of India 1 Central Bank Reserve Bank of India 1 Central Bank
If RBI wants to reduce money supply If RBI wants to increase supply of
money
Starts selling securities Starts purchasing securities.
Cash reserve of banks falls Cash reserve of banks will
increase.
People will get less money People will have more money.
Quantity of money will decrease Quantity of money will increase.
Basic conditions of success of open market operation :
(i) Demand and supply of securities should be always present.
(ii) Money market should be fully developed.
(hi) Cash reserve of commercial banks should be affected through open market
operations of Central Bank.
(iv) There should not be any change in the loan advancing policy of commercial
banks.
(v) There should be no change in demand for loans.
(vi) The power of selling and purchasing securities of central bank should be
unlimited.
(vii) The prices of securities should not be more fluctuating.
Although open market operations are more important and effective than bank rate
but for a successful, credit control both policies should be complementary to each
other.
(3) Variations in Bank Cash Reserve Ratio, CRR
Third main method of quantitative credit control is variation in Bank Cash Reserve
Ratio. This method was first of all used by Federal Reserve System of America in
1933. Every commercial bank of a country has to deposit a certain percentage of its
deposit in cash reserve in central bank. It is called 'Statutory Minimum Cash
Reserve'. Central Bank can control credit by changing this minimum cash reserve.

244
Definition by RA. Young:
"Variation in cash reserve ratio implies in the minimum percentage of the deposits to
be kept as reserve funds by the banks with Central Bank".
Working of Variation in Cash Reserve Ratio, CRR: Through the policy of
variation in Cash Reserve Ratio Central Bank expands or contracts credit.
(i) If quantity of credit increases in the economy then Central Bank increases the
minimum cash reserve.
(ii) On the contrary, if more credit money is required then central bank reduces the
minimum cash reserve.
(4) Statutory Liquidity Ratio, SRR
This method was invented during Second World War. Under it commercial banks
have to keep a certain percentage of their deposits in cash with them.
Working of Liquidity Ratio System: By changing the Statutory Liquidity Ratio
Central Bank can contract and expand credit in the following ways :
(i) When Central Bank wants to contract credit then it increases the Statutory
Liquidity Ratio.
(ii) When Central Bank wants to expand credit then it decreases the Statutory
Liquidity Ratio.
In short, in order to achieve dual goal of full employment level and price stability of
production the expansion and contraction of monetary policy process is given in the
following table :
Table III
Working Process of Monetary Policy
Expansionary Monetary Policy Tight Monetary Policy
Problem : Depression and Unemplo- Problem: Inflation
yment
Measures : Measures :
(1) Central Bank purchase securities (1) Central Bank sells securities through
through open market operations. open market operations.
(2) It decreases Cash Reserve Ratio (2) It increases Cash Reserve Ratio
(CRR)

245
(CRR).
(3) It increases Bank Rate.
(4) It increases Money Supply.
Decreases interest rate
Increases Investment
Aggregate Demand increases
Aggregate production increases
with multiplier effect
and Statutory Liquidity Ratio (SLR)
(3) It decreases Bank Rate.
(4) It increases the stock of goods to
maximum as collateral.
Decreases money supply
Increase investment
Investment expenditure decreases
Aggregate Demand decreases
Price-level decreases

II. QUALITATIVE OR SELECTIVE CREDIT CONTROL

Qualitative credit control is that credit control which regualtes the credit quantity
given by some special banks for some special purposes. It is called Qualitative
Credit Control. It does not affect the quantity of credit. It's aim is to regulate the
various objectives of credit, Qualitative credit controls are :
(1) Change in Margin Requirement on Security Loans: This method is used for those
credit control which are provided for speculative purposes.
Central Bank sets the margin for loans on security of securities given by commercial
banks for speculative motive.
In short, the difference between prices of securities and the loan amount is called
'Margin'. During last years Reserve Bank had instructed to keep margin of 10% on
the securities of Rice or Paddy.
Working:
(1) When bank wants to contract credit for particular goods it contracts credit by
increasing margin requirement.
(ii) When bank wants to expand credit it reduces the margin requirements of loans.
(2) Rationing of the Credit: Central Bank of any country is the lender of the last
resort, therefore, if required it can do rationing of the credit to control credit. Central
Bank does rationing of Credit through the following ways :
(i) Central Bank can reduce the loan amount to various commercial banks.

246
(ii) Central Bank can fix the quota of credit for commercial banks.
(iii) Central Bank can refuse to give loan to any bank.
(iv) Central Bank can set limit of credit for industries and business.
In this way Central Bank can do rationing of credit. As a result, commercial banks
have to advance loans cautiously and credit is contracted.
Although this method is very effective but there are many practical problems in it.
For e.g. It is very difficult to estimate the credit requirements of all commercial
banks.
(3) Regulation of Consumer's Credit: This was used for the first time in America.
Under it credit given for durable consumer goods is controlled. In many countries
consumer goods are sold in 'Hire Purchase System'. Its payment is done in
instalments. Credit is contracted during boom and expanded during depression.
Working:
In order to check money expansion, there should be control on the maximum good
being sold on instalments, Initial instalment amount should be increased, maximum
payment period should be reduced, so that consumers repay the loan quickly. During
contraction of money working will be vice-versa.
(4) Direct Action : When Central Bank sees that any bank is working against its
policy. Direct action means all those regulations and directions which bank can
implement on all banks or any bank so that loans and investments can be controlled.
Direct action may be following :
(i) Banks do not co-operate in actions of Central Bank. Central Bank may refuse to
discount their bills.
(ii) By not providing loans.
(iii) By imposing monetary fine. For the success of this policy :
(i) Central Bank should be powerful.
(ii) It should lead money market.
(iii) It has co-operation with other banks.
(5) Moral Suasion : Since Central Bank is banker's bank and being most effective in
money market it can persuade request or morally suppress them to follow its
policies.

247
It there is situation of inflation in the country then Central Bank requests other banks
not to come for loans, not to advance more loans to public and not to invest in
unncessary business. On the contrary, if there is depression in the country then
Central Bank can request other banks to increase the amounts of loans.
(6) Methods of Publicity : In modern age Central Bank in order to make its policy
successful, tries to tell the public through advertisements that which policy related to
credit is justified with a view of national interest. It is a general way of moral
suasion.
Conclusion : It is clear from the above discussion that there are many methods of
credit control, some of which gives result quickly, some lately. Every method has
some difficulties.
Therefore both quantitative and qualitative methods should be used as
complementary method. In the complex economic system, it is not possible to
control credit by anyone method.
LIMITATIONS OF MONETARY POLICY
(1) Ineffective in Depression : Monetary policy can control economic activities
effectively but cannot encourage them. Therefore, monetary policy is totally
ineffective in treating depression.
(2) Non-Monetary Factors : Prices and economic activities are influenced by non-
monetary factors also. So they cannot be treated with monetary measure.
(3) Indirect Measures : In order to control aggregate demand monetary policy is
indirect measure, its effectiveness is not certain. If these methods are implemented
freely then economic development will be hampered and situation of economic crisis
will appear and if they are implemented in a restricted way then income and demand
level will not be affected.
(4) Frequent Changes in Rate of Interest: Main tool of monetary policy is to
reduce interest rate but it is not possible to change rate of interest frequently because
it badly hits public debt system.
(5) Mutual Contradictory Objectives: According to Redcliff Committee monetory
policy is related with complex economic objectives. These objectives may be
mutually contrary and they can be adjusted only in long period.

248
(6) Different Conditions: For different countries different type of monetary policies
are required.
LIMITATIONS OF MONETARY POLICY IN UNDERDEVELOPED
COUNTRIES
Although Monetary Policy has important role in underdeveloped countries but due
to organisational difficulties it is very difficult to apply successful monetary policy
here. The reasons are :
(i) Large Non-monetary Sector: Underdeveloped countries have a large non-
monetary sector where barter system prevails. Therefore change in quantity of
money and interest have not much influence in the activities of economic changes.
(ii) Absence of Organised Money Market: The money market of underdeveloped
countries are unorganised, small and undeveloped.
(iii) Absence of Bill Market : Due to absence of bill market in underdeveloped
countries credit system does not work properly.
(iv) Delayed Effect of Monetary Policy in Underdeveloped Countries
(v) Less importance of Credit Money : In Underdeveloped Countries money in
circulation is more important than credit money, therefore, if Central Bank controls
bank credit, supply of money is not controlled.

MONETARY POLICY ADOPTED FOR ECONOMIC STABILITY

Or
CHEAP MONEY POLICY
Meaning : Supply of money and rate of interest both affect economy. The money
which is acquired at lower interest rate is called cheap money. When Central Bank
makes available credit at lower rate of interest then it is called cheap money or
expansion of money policy.
ARGUMENTS IN FAVOUR OF CHEAP MONEY POLICY
Keynes, for the first time advocated cheap money policy or lower interest policy to
take out the world economy from the grip of depression. He said if rate of interest is
low then government and investors will get loan at lower rate and thereby

249
investment and employment will increase. Arguments in favour of cheap money
policy are :
(1) Good Effect on Capital Market and Investment : Personal investment depends
on capital's marginal productivity and the rate of interest. Since during depression
marginal productivity of capital falls. Therefore, until rate of interest will not
decreased in the same ratio then private investment will not be sufficient so it is
essential to lower interest rate.
(2) Encouragement to Consumption Expenditure: Cheap money policy
encourages consumption.
(3) Long Term Capital Formation : Manufacturing and public work investments
are very much influenced by rate of interest. Lowering of rate of interest encourages
the expansion of such industries as a result gradually economy comes out from the
grip of depression.
(4) Incentive to Government Investment : Since private investment decreases
during depression, Government has to invest more to compensate the deficiency in
investment. In such a situation, government takes loan from money market to meet
its expenses. If interest rate is low then government loan will be relatively cheaper.
(5) Solution of Unemployment Problem : According to Prof. K. Kurihara, since
wage cut is opposed by trade unions, therefore in order to solve problem of
unemployment, cheap money policy is better option. If there is wage cut then
effective demand will be low then aim of full employment will not be achieved.
Thus we see that during depression and unemployment cheap money policy is
important. In reality during depression the aims of cheap money policy are :
(i) Lowering the interest rate to encourage investment consumption expenditure.
(ii) To make strong cash position of banks.
(iii) To reduce the diminishing velocity of circulation money.
METHODS OF CHEAP MONEY POLICY
(1) Bank Rate Policy : Bank rate is the rate at which central bank gives loan to
commercial banks or the rate at which it rediscounts the bills of member banks. It is
duty of Central Bank to reduce bank rate during depression so that investment will
increase.

250
(2) Open Market Operations : Open market operation means sale and purchase of
government securities in open market by Central Bank. During depression Central
Bank should purchase securities so that cash deposits of banks will increase and
their lending capacities increase. It in turn increases investment and employment.
(3) Changes in Statutory Ratio : Every member bank has to keep a certain portion
of its deposit with Central Bank known as Cash Reserve Ratio (CRR). Higher the
CRR lower will be the lending capacity. During depression and unemployment
Central Bank should diminish CRR so that lending capacities of banks will increase.
Above measures will encourage credit and businessmen will invest more and create
more employment and depression situation will improve.
WORKING OF CHEAP MONEY POLICY
As we know that cheap money policy is used to combat depression. During
depression consumer demand for goods and services and investment demand
decreases, depression situation occurs. In such a situation Central Bank by adopting
cheap money policy makes credit available to people and businessmen and increases
the demand for investment goods. For this purpose Central Bank uses various tools
of credit control like reducing the bank rates, purchasing government securities in
the market, reducing the CRR. With these measures Central Bank reduces the cost
and availability of credit in money market.
The working of cheap money policy is shown in Figure (2). In the figure :
(i) IS curve show creditable assets: This curve slopes left to right because as rate of
interest falls investment and income increases.
(ii) LM shows all the combinations of interest rates and income level where demand
and supply are equal
(iii) IS and LM curves are related to income levels and interest rates. Point at which
IS and LM intersect each other determines the rate of interest.
(iv) In Figure (A) LM and IS cut each other at point E, therefore according to OY
income level OR interest rate will be determined. In such a situation in Fig. (B)
production of good is OM and price is OP.

251
(v) Now suppose due to central bank's cheap money policy money supply in the
economy increases then this LM curve shifts right to LM1 as a result income
increases from OY to OYv
(vi) With the increase in income effective demand will increase and demand curve D
in Fig. (B) will shift upward to D r With the increase in demand for goods services,
production at high price level OP : increases from OM to OMr If cheap money policy
works effectively then full employment will be at F equilibrium point.
In this way through cheap money policy economy can be dragged to full
employment from depression.

LIMITATIONS OF CHEAP MONEY POLICY

Now the question is that to which extent only monetary policy can drag out economy
from the grip of depression. Before 1920 monetary policy's effectiveness could be
doubted but during 1929-33 when it failed to drag economy from depression then it
was openly doubted.
According to Redcliff Committee: "Monetary policy may be effective during
inflation but its capacity is very limited during depression."
According to Prof. Bechh : "Monetary policy is depression ineffective".
Limitations of cheap money policy are :
(i) Cheap money policy is based on the assumption that Central Bank can increase
the cash reserve of commercial banks through cheap money policy by purchasing the
securities from the market, decreasing the interest rates. As a result lending facility
of banks increase. But experience of Great Depression says that when businessmen
are in despair, business stagnates.
They do not take loan even at lower interest rates and try to repay the old loans.
(ii) Consumers have also same situation, facing unemployment and reduce income,
not willing to purchasing anything on loan.
In this way banks make credit available but cannot force businessmen and
consumers to accept. During the decade of 1930 very lower interest rate and cash
reserve of bank could not influence the economies facing depression.

252
CHEAP MONEY POLICY AND UNDERDEVELOPED COUNTRIES
Many economists are of the opinion that cheap money policy should be adopted for
underdeveloped countries, because if government will not interfere and leave free on
market forces for determining the rate of interest. Then rate of interest will be very
high because in such countries supply of capital is less than the demand of capital.
Therefore Government has to adopt cheap money policy so that investment will
increase at lower rate of interest. Thereby employment and income will also increase
when finance is available at lower rate and investment in capital goods sector then
after a certain 'Gestation Period' stock of capital goods will increase which is must
for development.
In order to adopt cheap money policy is approved by Principle of Sound Debt
Management and it is said that if interest rate is above public debt then cost of
production in public sector will be more which will increase the price all the more.
So it can be said that the cheap money policy will not be suitable for underdeveloped
countries.
(i) Cheap money policy is based on the assumption that economy has a huge unused
stock of capital, but it is not true for underdeveloped countries.
(ii) Lower interest rates discourage the market of Government securities therefore,
Government's cheap money policy will discourage savings.
(iii) Cheap money policy encourages capital intensive techniques but in
underdeveloped countries require labour intensive techniques.
In this way, in order to acquire 'Growth with Stability' cheap money policy cannot be
adopted permanently. It can be used as subsidy for those producers who are
producing with domestic technique. Government should adopt Differential Interest
Rate Policy in which lower interests are charged for productive works and higher
interest rates are charged for speculative and unproductive works.

253
RESERVE BANK OF [NDIA VND MONETARY CONTROL OR
MONETARY POLICY OF INDIA
Reserve Bank of India, the Central Bank of India controls the whole credit of money
of the country. The objective of monetary policy of Reserve Bank of India is
adopting controlled monetary expansion from the beginning.
The policy of Controlled Monetary Expansion means :
(i) To arrange sufficient finance for economic development.
(ii) To Maintain Price Stability: With the starting of Five Year Plans in India it
was essential to change monetary policy according to the needs of planned
development. After 1952 stress is given in Monetary Policy of present economic
policy on dual objectives which are :
(a) To speed up the economic development so that national income and standard of
living will rise.
(b) To control the inflationary pressure which arose after Second World War due to
deficit financing.
Therefore, during the plan period the policy adopted by Reserve Bank of India is
called 'Controlled Expansion Policy' on the one hand and on the other it established
'Price stability'.
Monetary Policy of RBI will be studied under two heads :
(I) Controlled Expansion Monetary Policy before Liberalization.
(II) Monetary Policy after Economic Reforms (1991).
I. CONTROLLED EXPANSION MONETARY POLICY BEFORE
LIBERALIZATION (1951-90)
After independence in order to developed economy RBI had to regulate money
supply and bank-loans in such a way so that the requirements of both private and
public sectors are met. Along with it RBI had to take care that private sectors should
not get more loans to create inflationary pressures. This is the reason that the
monetary policy adopted during this period (1951-72) is known as 'Controlled
Expansion'.
During 1951-90 the steps of monetary policy of RBI are :

254
(1) Changes in Bank Rate : According to RBI Act 1949, Article 49 bank rate is
defined as : "Bank rate is that standard rate at which RBI under this Act is ready to
purchase or rediscount any commercial paper or exchange bill."
But in practice, RBI provides loan or facilities of advances to commercial banks is
known as 'bank rate'. RBI has used time to time bank rate policy for credit expansion
or contraction. Bank rate is lowered for credit expansion and bank rate is expanded
for credit contraction.
In order to control inflation during this period in November 1951 bank rate was
raised from 3 to 3.5 percent which again in 1959 it was raised to 4 percent. In third
Five Year Plan when inflation increased more then bank rate increased to 4.5 percent
in January 1963 and to 5 percent in October 1964 and 6 percent in March 1965. In
July 1981 it increased to 10 percent. After that during 1981-91 bank rate remained
unchanged.
(2) Open Market Operations : In order to control credit RBI uses open market
operations. Open market operations means sale and purchase of securities and first
class bills and promissory notes by RBI control the credit.
Till 1958 open market operations had no place in Reserve Bank of India's monetary
policy. The reasons was that time the market of Government securities was not
properly developed because the interest rate on these securities was very low.
Therefore till 1990 in India open market operations were not used as main tool of
credit control.
After 1987 the interest rate on government securities was raised equal to prevalent
wage rate.
It resulted that RBI is now in position to control the credit through open market
operations due to high rate of interest on government securities.
(3) Variable Cash Reserve Ratio, CRR : According to Reserve Bank of India Act
1934, Article 42 (1) every commercial bank has to keep 5% of its Demand deposits
and 2% of term deposits with RBI as cash reserve. But in 1962 there were two
Amendments done in it.
Firstly : Demand and Term deposits are merged.

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Secondly : RBI has been given power to fix the CRR between minimum 3% to
maximum 15%.
RBI has used this right many time. In June 1973 CRR had been increase from 3% to
5%, in September 1973 7%, in August 1983 8.5% and in October 1987 it 10% and in
April 1990 raised to 10.5% so that loan amount can be controlled by reducing the
cash of commercial banks.
(4) Statutory Liquidity Ratio, SLR : Under Banking Regulation Act Article 24 it is
essential for Scheduled Banks that they should keep in liquid form at least 25% of
total deposits in the form of cash, gold or Government securities. It is called
Statutory Liquidity Ratio which RBI can change according to need.
Under this right RBI had increased SLR from 25% to 32% in 1972 and 35% in 1981
and 36% in 1984 and 38.5% in January 1990. There were two objectives of
increasing SLR:
(i) To decrease the advancing loan capacity of commercial banks to trade and
industry.
(ii) To shift the bank money investment from loans and advances to government
approved securities.
Selective Credit Control
Through general methods of credit control RBI controls the quantum of credit but
through selective credit control it regulates both the direction and quantity of credit.
Banking Regulation Act has given the right to RBI to implement selective credit
control. RBI can give following instructions under selective credit control, (a) The
cases for which advances cannot given.
(b) Margin requirement which are essential as security advance.
(c) The maximum amount which can be lent to any company, firm or person.
(d) The maximum amount which can be guaranteed by any company or firm.
(e) Rate of interest and other conditions on which loans are available. Selective
credit control is being practised by RBI on such goods which are
sensitive or of less supply. Such controls are used to discourage the bank loan for
hoarding goods so that undue price of that commodity may be checked.

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These control are used on the advances given for (i) grains, (ii) pulses, (iii) oilseeds,
(iv) vegetable oils, (v) cotton, (vi) sugar, jaggery and khandsari.
RBI instructed in May 1956 to Scheduled banks that they limit the advances against
paddy and rice and raise their margin requirement by 10%. In 1964-65 RBI
instructed to keep certain margin security against advances given for foodgrains,
oilseeds, vegetable oils etc. After 1965 under Credit Authorization Scheme
commercial banks had to take permission from RBI for granting loans upto 1 crore
or more. Credit Authorization Scheme cancelled in October 1988. Achievements
Before Economic Reforms (1951-90) the main objective of Monetary Policy was
'growth with stability' but except First Five Year Plan, in price indexes bases on
Wholesale Price had increase of 6.2% in Second Five Year Plan, 5.8% in Third Five
Year Plan. The price situation was disturbed at the end of Fourth Five Year Plan
(1972-74). In 1974 Government had undertaken various monetary and fiscal
measures. As a result Wholesale Price Index reduced to 283 in 1976. During 1977-
79 Janata Government regime price -educed and government was successful in
controlling price. On the base year 1970-71 Wholesale Price Index was 185 in 1979
but in Janauary 1980 it rose to 224. In 1984-85 it stood at 338. 1985-90 price level
increase. Inflation rate in 1985-86 was 4.7% which touched 9.4% in 1987-88.
Average inflation rate was 7%.
Therefore, it can be concluded that before Economic Reforms Monetary Policy
failed to establish 'Growth with stability'.
II. MONETARY POLICY IN POST REFORM PERIOD : 1991 ONWARDS
There were fundamental changes in the institutional set up of India in the year 1991-
92, which made it necessary to change the monetary policy of Reserve Bank of India
to achieve various objectives.
After 1991 due to heavy flow of foreign exchange in India the problem of severe
liquidity arose in Indian banking sector. After 1991 especially after 1995 RBI
followed liberal or Easy Monetary Policy. The various steps under Easy Monetary
Policy are :
(1) Reduction in Bank Rate : After Liberalization India's Bank Rate is reduced to a
great extent. In October 1991 Bank Rate was 12%. After this Bank rate was changed

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so many times. In April, June and October 1997 everytime Bank rate reduced by 1%
to indicate the starting of low interest rate. On 1st April 2000, Bank rate was reduced
from 8% to 7% which again increased to 8% in 4 April 2016.
On 23rd March 2001 Bank rate reduced to 7%. From 4th April 2016, New Bank
Rate is 7%.
Important Banking Rates
Bank Rate 7%
Cash Reserve Ratio (CRR) 4%
Statutory Liquidity Ratio (SLR) 21.25%
Repo rate 6.5%
Reverse Repo Rate 6.0%
In is clear now that in order to regulate the cost of bank credit, Bank Rate is used as
a tool to influence the rate of interest on loans taken by commercial banks.
(2) Open Market Operations : After 1991 due to heavy flow of foreign exchange
in India, banking sector had faced the problem severe liquidity and RBI had used
open market operations at a large scale.
Open market operations as a tool to control credit is not successful due to lack of
organised money market in India.
(3) Variable Cash Reserve Ratio (CRR) : After 1990-91 according to Economic
Reforms it has been increased and decreased at many levels fixed at 8% from 22nd
April, 2000. It had increased to 8.25% in 29 July, 2000 and to 8.5% in 12th August
2000. After reducing in many steps it has been done 4% on 4th April 2016.
(4) Change in Statutory Liquidity Ratio (SLR): Narsimham Committee has
recommended to reduce this ratio to 25% so that desirable loan supply can be made
available for making the economy dynamic. So, from 1992-93 it has been reduced in
a systematic way. Today it is 23%.
(5) Repo Rate : Repo rate is that rate at which RBI gets short term loans from
commercial banks. In other words, repo rate is that rate at which commercial banks
deposits their excess liquidity in RBI for short period. From 4 January 2016 Repo
rate is 6.5% and Reverse Repo rate is 6%.

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(6) Selective Credit Control: Under Liberal Monetary Policy selective credit
control is adhered in three forms :
(a) Determine minimum margin requirement for loans on specific securities.
(b) Determination of maximum limit of credit for specific purposes.
(c) To acquire differential interest rate for various advances. Although Credit
Authorization Scheme was ended in October 1988, but in
order to maintain basic financial discipline RBI will monitor those advances which :
(a) Provide ? 5 crore or more as working capital to some parties.
(b) Provide ? 2 crore or more as Term loans.
It is known as credit Monitoring Arrangement.
(7) Moral Suasion : RBI is following the policy of moral suasion also. According to
this RBI requests commercial banks to follow its monetary policy.
(8) Direct Action : Banking Company Act, 1949 gives the power to RBI to check
any particular bank or all banks from special lending. RBI has power to inspect any
bank's account.

Evaluation of Liberal Monetary Policy

Before 1996 strong monetary policy adopted by RBI helped a lot in controlling
inflation. It had not only checked the increasing inflation but also reduced the rate of
inflation to 4% per year. But after 1996 adoption of Liberal or Easy Monetary policy
was not very successful because lower interest rate also failed to give riddance to
economy from depression by encouraging the investment. The reason behind this
was that private investment depends on Marginal Efficiency of capital along with
rate of interest. But in India low profit from investment is due to :
(1) Political instability.
(2) Lack of infrastructure facility.
(3) Lack of effective demand for industrial goods.
(4) Lack of Public investment.
Due to above reasons investment not increased by private investors inspite of lower
interest rates. So it can be said that the lower lending rates of interest are necessary
but not a sufficient condition for boosting private investment.

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 FAILURES OF MONETARY POLICY Or
WHY HAS RBI FABLED IN CONTROLLED CREDIT ?
(a) Excess Cash Reserves with Banks: In reality when deposits of banks are
increasing, high bank rate, more liquidity ratio does not affect the expansion of
bank's credit.
(b) No control on Non-banking Institutions : It is worthnoting that RBI has no
control on Non-banking institutions and indigenous banks and they play an
important role in the business and industries of the country. Therefore monetary
policy remained handicapped.
(3) Financial Indiscipline : Nationalized banks do not follow financial discipline.
On the contrary, these banks done expansion of unnecessary credit in huge amount
which encouraged hoarding and price rise. Harshad Mehta Scam of 1992 is its
burning example.
(4) Limited Working Field : The controlling tools and workfield of RBI is limited
to only scheduled banks. Therefore the reason for inflationary situation are deficit
financing and deficiency of goods prevalent in India, the measures of RBI cannot be
proved effective.
(5) International Monetary Crisis : International monetary crisis also reason for
suppressing the effects of RBI worldwide inflation has also affected Indian
economy. The rate of currencies of strong nation an oil crisis of UAE also affected
badly.
(6) Existence of Capital Market: Many transactions of capital market pressurizes
price-level. For e.g. the loans given by Life Insurance Company affect price level.
(7) Wide Circulation of Black Money : Black Money or Parallel economy is one of
the important component which harms the monetary policy. According to non-
government estimate the quantity of black money is 30% to 40% of Gross National
Product.
(8) Lack of Monetary Targeting : There is deep relation between money supply,
production and price, but sad thing is that RBI and the Government both neglected
this equation. For e.g. whatever increase has taken place in money supply (M3) is
based on government loan demand not on the basis of production growth.

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(9) Slow Growth of Money Market : Monetary Policy or success of monetary
controls depends on well-organised and efficient money market. Since money
market of India is unorganised and inefficient, monetary policy has become
ineffective.
(10) Use of e-Money : Wide use of e-money can take a large place of notes in public
hands. Since currency notes have important place in any bank's Balance Sheet.
Therefore, e-money expansion means the size of balance sheet will shrink and it
reduce the capacity of central bank to conduct open market operations. In such a
situation, wide use of e-money will lead storage of huge surplus reserved money,
that could not be sterlized and that will become a challenge for banking policy.
Conclusion : In keeping view the limitations of monetary authorities of India have
to adopt monetary policy in such a way that control should not be less or more and
there should not be delay in implementing them. Therefore by adjusting the various
measures an effective monetary policy can be made.

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