Macro Economics

MACRO ECONOMICS
(FOR PRIVATE CIRCULATION ONLY)

2016
PROGRAMME COORDINATOR
Prof. Prashant Ubarhande
COURSE DESIGN AND REVIEW COMMITTEE

Prof. Dalip Mehra Prof. Sudhir Gijre
Prof. Arun Vartak Dr. Swati Oza
Prof. Avinash Nene Dr. N.M. Vechlekar
Dr. Ravi Chitnis Prof. Sudeep Limaye
COURSE WRITERS
Mr. Dalip Mehra Mr. Debajyoti Ghosh Roy
Mr. Santanu Ray-Chaudhary Ms. Ishita Ghosh
Mr. Avinash Tripathi
EDITOR
Ms. Kumkum Tripathi
Published by Symbiosis Centre for Distance Learning (SCDL), Pune

July, 2012 (Revision 01, 2014)
Copyright © 2016 Symbiosis Open Education Society

All rights reserved. No part of this book may be reproduced, transmitted or utilised in any form or by any
means, electronic or mechanical, including photocopying, recording or by any information storage or retrieval
system without written permission from the publisher.
Acknowledgement
Every attempt has been made to trace the copyright holders of materials reproduced in this book. Should any
infringement have occurred, SCDL apologises for the same and will be pleased to make necessary corrections
in future editions of this book.
PREFACE
India’s economy has grown very rapidly in recent years. Since 1991, it has been among the top 10 of
the world’s countries in terms of economic growth.
This course on Macroeconomics is indispensable for distance learners in order to obtain an
understanding of the working of the economy in aggregate terms and factors affecting economic
growth. In any country, main economic problems are related to the behaviour of total income, output,
employment and the general price level in the economy.
The study of macroeconomics is also very important for the evaluation of overall performance of
the economy in terms of national income. National income data helps in forecasting the levels of
economic activity and to understand the distribution of income among different groups of people in
the economy.
This course will guide distance learners to identify, measure, analyse and monitor general
unemployment, total investment, total output, total income and total consumption as well as effective
demand of the economy.
Since change is the only constant, hence distance learners must keep themselves updated regularly
for changes occurring in the economy.
Mr. Dalip Mehra

Mr. Debajyoti Ghosh Roy
Mr. Santanu Ray-Chaudhary
Ms. Ishita Ghosh
Mr. Avinash Tripathi
iii
ABOUT THE AUTHOR
Mr. Dalip Mehra is Ex-Deputy General Manager, Bank of Maharashtra. He has academic
qualifications of M.Sc. LL.B CAIIB, DBM. He has written over 37 books on various subjects such
as Banking, Risk Management, Finance, Economics, Law and Management. Two of his books have
been recognized and awarded by Ministry of Finance and Ministry of Agriculture.
Mr. Debajyoti Ghosh Roy is a seasoned education professional, with cross-cultural exposure in
teaching, training, facilitation & consultancy in banking industry (Bank of India) and management
institutes for over 19 years. He is Certified Associate of “The Chartered Institute of Bankers”, U.K. and
Certified Associate of IIBF, Mumbai. His qualifications include Diploma in International Banking,
Diploma in Bank Management, M.Sc. and B.Sc.
Mr. Santanu Ray-Chaudhary is Assistant Professor in Economics in the Symbiosis School of

Economics. He started his teaching career in July 1995. His qualifications are SLET, M.Phil and
Masters in Economics. He has published many papers in National and International conferences and
seminars.
Ms. Ishita Ghosh is an analytical scholar of Economics and her academic background includes
research in International, Industrial and Development Economics. She is PG in Economics from
University of Pune and holds Diploma in Foreign Trade with First Class. She is presently Assistant
Professor at Symbiosis School of Economics. She has 8 years of academic and 4 years of corporate
experience.
Mr. Avinash Tripathi has content edited this SLM. He has varied experience and academic
qualifications. He possesses UGC-NET, M.B.A., EPM-IIT(B), M.A.(English) , PGD in Banking &
Finance, PGD in Financial advising and PGD in Higher education. He has more than 12 years of
experience in industry and academics. His areas of research interest are Corporate Finance, e-Financial
services, Market Microstructure, Strategic Management and Corporate Governance.
iv
CONTENTS
Unit No. TITLE Page No.

1 Introduction to Macroeconomics and Measuring Income and Output 1-26
1.1 Introduction
1.2 Micro and Macroeconomics
1.3 Circular Flow of Economic Activities
1.4 National Income and Output
1.5 Methods of Measurement of National Income
1.6 Measurement of National Income in India
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
Annexure
2 Aggregate Demand and Supply 27-44
2.1 Introduction
2.2 Definition
2.3 Expenditures
2.4 The Curve
2.4.1 The Slope
2.4.2 Determinants
2.4.3 Business Cycles
2.5 Aggregate Supply
2.6 Time Periods
2.7 Examples of the Curve
2.7.1 Determinants
2.8 Self-Correction
Summary
Keywords
Suggested Reading
3 Aggregate Markets and Shocks 45-58
3.1 Introduction
3.2 Instability
3.3 Fluctuations
3.3.1 Reasons for Fluctuation
3.4 Self-Correction
3.5 Basic Shifts
3.6 Complex Shifts
3.7 SRAS Curve
3.8 Synthesis of Business Cycles
Summary
Keywords
Suggested Reading
v
4 Unemployment and Business Cycles 59-74
4.1 Introduction
4.2 Theories of Unemployment
4.3 Business Cycles
4.3.1 Business or Trade Cycle: Definition
4.4 Phases of Business Cycle
4.4.1 Important Features of the Phases of Business Cycle
4.5 Ways and Means to control Business Cycles/ Fluctuations and
Unemployment
4.6 Economic Policies to achieve Economic Stability
Summary
Keyords
Suggested Reading
5 Keynesian Economics 75-90
5.1 Introduction to Keynesian Economics
5.2 Classical Foundation to Macroeconomics
5.3 Keynesian Counter-argument and Assumptions
5.3.1 Keynesian counter-arguments
5.3.2 Keynesian assumptions
5.4 Four Macroeconomic Sectors
5.5 The Basic Keynesian Model
Summary
Keywords
Suggested Reading
6 Money Markets 91-112
6.1 Introduction
6.2 History of Money
6.2.1 Barter
6.2.2 Commodity money
6.2.3 Fiat money
6.2.4 Electronic Money
6.3 Money Basics
6.4 Basic Functions and Characteristics of Money
6.5 Monetary Aggregates and Commodity Money
6.6 Monetary Policy
Summary
Keywords
Suggested Reading
vi
7 Central Banking, Federal Reserve Policy and Monetary Policy 113-138
7.1 Introduction
7.2 Evolution of Central Banking
7.3 Roles and Functions of Central Banks
7.4 The Federal Reserve System of the United States
7.4.1 Role and Functions
7.5 Role and Functions of Reserve Bank of India
7.6 Monetary Policy
7.6.1 Monetary Policy Instruments
Summary
Keywords
Suggested Reading
8 Inflation: Measurement, Cost, Sources and Kinds and the Phillips 139-150
Curve and Inflation
8.1 Introduction
8.2 Basic Phillips Curve
8.2.1 Basic Phillips Curve – Economic Trade-offs
8.3 Different Types of Inflation
8.3.1 Different Causes of Inflation
8.4 Costs of Inflation
8.5 Measurement of Inflation
Summary
Keywords
Self Assessment Questions
Suggested Reading
9 Fiscal Policy, Deficits and Public Debt and Deficit Financing in an 151-158
Open Economy
9.1 Introduction
9.2 Fiscal Policy and Aggregate Demand
9.3 Fiscal Policy in an Open Economy
9.4 Deficits in an Open Economy
9.5 Deficit Financing
Summary
Keywords
Suggested Reading
vii
10 Economic Growth, Aggregate Growth and Monetarism and Rational 159-172
Expectation
10.1 Introduction
10.2 Aggregate Supply Curve
10.3 Money Supply and Economic Growth
10.4 Monetary Theories
10.5 The Quantity Theory of Money
10.6 Monetary Policy
Summary
Keywords
Suggested Reading
11 Economic Crises and Policies for Growth and Stability 173-184
11.1 Introduction
11.2 Background
11.3 Global Economic Crisis
11.4 Major Causes of the Crises
11.5 Subprime Lending
11.6 Policies for Growth and Stability
Summary
Keywords
Suggested Reading
viii
Introduction to Macroeconomics and Measuring Income
and Output UNIT
Structure: 1
1.1 Introduction
1.2 Micro and Macroeconomics
1.3 Circular Flow of Economic Activities
1.4 National Income and Output
1.5 Methods of Measurement of National Income
1.6 Measurement of National Income in India
Summary
Keywords
Suggested Reading
Annexure
Introduction to Macroeconomics and Measuring Income and Output 1

Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
●● Differentiate between micro and macroeconomics
---------------------- ●● Discuss the circular flow of economic activities
---------------------- ●● Appraise the concepts of national income and output
---------------------- ●● Deliberate on the methods of measurement of national income
●● Assess the measurement of national income in India
----------------------
---------------------- 1.1 INTRODUCTION

---------------------- Microeconomics studies economic behaviour of individual economic
entities and individual economic variables. The economic entities may be
---------------------- individuals or small group of individuals. It is the study of individual economic
units such as individual firms and households, individual prices, wages, income,
----------------------
individual industries and individual commodities.
---------------------- Macroeconomics is concerned with the nature, relationships and
---------------------- behaviour of such aggregate quantities and averages as national income, total
consumption, savings and investment, total employment, general price level,
---------------------- aggregate expenditure (demand) and aggregate supply of goods and services.
As macroeconomics deals with aggregate quantities of the economy as a whole,
---------------------- it is also called as aggregative economics.
----------------------
1.2 MICRO AND MACROECONOMICS
----------------------
Microeconomics seeks to explain how an individual consumer distributes
---------------------- his disposable income among various goods and services. How he attains the
level of maximum satisfaction and how he reaches the point of equilibrium.
----------------------
Microeconomics is also concerned with how individual firms decide ‘what to
---------------------- produce’, ‘how to produce’ and ‘at what cost to produce’ to minimise the cost
of production. To be specific, theory of consumer‘s behaviour, theory of firms
---------------------- or theory of production, theory of product pricing, theory of factor pricing ( or
distribution theory) and the theory of economic welfare constitute the body of
----------------------
microeconomics.
---------------------- Theories of national income, consumption, saving and investment, theory
---------------------- of employment, theories of economic growth, business cycles and stabilisation
policies, theories of money supply and demand and theory of foreign trade
---------------------- broadly constitute the subject matter of macroeconomics. Macroeconomic
theories seek to answer questions such as how the level of National Income of a
---------------------- country is determined, what determines the levels of overall economic activities
---------------------- in a country, what determines the level of total employment, how the general
level of price is determined and so on.
----------------------
2 Macroeconomics
Microeconomic theory explains the behaviour of various individual Notes
elements and brings out their interrelationship and interdependence.
Microeconomic theories contribute a great deal in formulating the economic ----------------------
policies and can also be applied to examine the appropriateness of economic
policies. One of the most important uses of microeconomic theories is to ----------------------
provide basis for formulating propositions that maximise social welfare. It also ----------------------
suggests ways and means to correct malallocation of resources and to eliminate
inefficiency. ----------------------
The main justification for macroeconomics lies in the need for generalising ----------------------
the behaviour of and relationships between economic aggregates. To study the
system as a whole and to explain the behaviour of aggregate quantities and the ----------------------
relationships between them is extremely difficult. Macroeconomic approach
----------------------
has made it possible. It ignores the details pertaining to the individual economic
agents and quantities, compresses the unmanageable economic facts to a ----------------------
manageable size and makes them capable of interpretation. Macroeconomic
theories are used in formulating public policies. They provide clarity to the ----------------------
macroeconomic concepts and quantities and bring out the relationship between
----------------------
macro variables of the economy in the form of models or equations.
Microeconomic theories assume a given level of National Income, ----------------------
employment, saving and investment. In reality, these factors are subject to
----------------------
change with the change in their determinants. Secondly, microeconomic
theories assume the existence of a free enterprise economy, i.e. absence of ----------------------
any government intervention. However, government controls and regulations
of economic activities are the rules of the day. Thirdly, another limitation of ----------------------
microeconomics is that it is concerned with the behaviour of individual elements
----------------------
of the economic organism and not with the organism as a whole. Microeconomic
theories, therefore, cannot be applied to study the complex economic system ----------------------
treated as one unit.
----------------------
Study of macroeconomics is limited to only aggregates. It cannot be
applied to explain the behaviour of individual components of the economic ----------------------
system and the individual quantities. Secondly, it ignores the structural changes
in constituent elements of the aggregate. Hence, conclusions drawn from the ----------------------
analysis of aggregates may involve error of judgement and may be misleading.
----------------------
Check your Progress 1 ----------------------
State True or False. ----------------------
1. Microeconomic theories seek to answer questions such as how the ----------------------

level of National Income of a country is determined.
----------------------
2. Macroeconomic theories assume the existence of a free enterprise
economy. ----------------------
3. Macroeconomic theories assume a given level of National Income, ----------------------
employment, savings and investment.
----------------------

Notes
Activity 1
----------------------
---------------------- Go to http://www.newagepublishers.com/samplechapter/001753.pdf on
National Income and jot down important components of national income
----------------------
---------------------- 1.3 CIRCULAR FLOW OF ECONOMIC ACTIVITIES

----------------------
An economy can be defined as an integrated system of production,
---------------------- exchange and consumption. In carrying out these economic activities, people
are involved in making transactions- they buy and sell goods and services.
---------------------- Economic transactions generate two kinds of flows:
---------------------- i. Real flow, i.e. the flow of goods and services
ii. Money flow
----------------------
Real and Money flows go in opposite direction in a circular fashion. The
---------------------- goods flow consists of (a) factor flow, i.e. flow of factor services and (b) product
---------------------- flow, i.e. flow of goods and services. In a monetised economy, the flow of factor
services generates money flows in the form of factor payments, which take the
---------------------- form of income flows. The factor payments and expenditure on consumer goods
and services take the form of expenditure flows. The magnitude of income
---------------------- and expenditure flows determines the size of national income. To present the
---------------------- flows of income and expenditure, the economy is divided into four sectors,
i.e. household sector, business sector, the firms, government sector and foreign
---------------------- sector. These are combined to make the following three models for showing the
circular flows.
----------------------
i. Two sector model including the household and business sectors.
---------------------- ii. Three sector model including the household, business and government
---------------------- sectors.
iii. Four sector model including the household, business, government and the
----------------------
foreign sectors.
---------------------- Circular flows of income and expenditure in a two-sector model
---------------------- The two-sector model consists of only household and firm sectors
representing a private closed economy in which there is no government and no
---------------------- foreign trade. It is therefore unrealistic but provides a starting point to analyse
---------------------- the circular flows. The households are assumed to possess certain specific
features: the households are the owners of all factors of production; their total
---------------------- income consists of wages, rent, interest and profits; they are the consumer of all
the consumer goods and services; they save a part of their income and supply
---------------------- finance to the firms. The business firms are assumed to have the following
---------------------- features and functions: they own no resources of their own; they hire and use
the factors of production from the households; they produce and sell goods and
---------------------- services to the households; they do not save, i.e. there is no corporate saving.
4 Macroeconomics
Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Fig. 1.1 Circular Flows in a Two-sector Model ----------------------

There are two sectors, i.e. households and firms. They divide the diagram ----------------------
in two parts. The upper half represents the factor market and the lower half
represents the commodity market. Both the markets generate two kinds of ----------------------
flows- real and money flows. In the factor market, factors of production flow
----------------------
from households to firms. This makes the real flow shown by a continuous
arrow. There is another real flow of factor incomes (wages, interest, rent and ----------------------
profits), which flows from firms to households.
----------------------
In the commodity market (lower half), the goods and services produced
by the firms flow from the firms to the households. The payment made by the ----------------------
households for the goods and services creates money flow. By combining the
goods and money flows, we get a circular flow. In reality, there are leakages ----------------------
from and additions to the circular flows of income and expenditure. They are
----------------------
also called as withdrawals and injections. A withdrawal is the amount that is set
aside by the households and firms and is not spent on the domestically produced ----------------------
goods and services over a period of time. On the other hand, an injection is
the amount that is spent by households and firms in addition to their incomes ----------------------
generated within the regular economy.
----------------------
The two-sector model with savings: Households do save a part of their
income for investment. The financial sector is constituted of a large variety ----------------------
of institutions involved in collecting household savings and passing them on ----------------------
to the business sector. The financial sector includes only banks and financial
intermediaries like insurance companies, industrial finance corporations, which ----------------------
accept deposits from the households and invest them in the business sector in
the form of loans and advances. It is explained in the following figure. ----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Fig. 1.2 Circular Flows in a Two-sector Model with the Financial Sector
----------------------
With the inclusion of the financial sector, the household’s income (Y) is
---------------------- divided into two parts: consumption expenditure (C) and savings (S). As shown
in the following figure, C and S take different routes to reach the business
---------------------- sector. The consumption expenditure (C) flows directly to the firms whereas
---------------------- savings (S) are routed through the financial sector as the banks and FIs use the
deposits to buy shares and debentures of the firms, which is investment (I). In
---------------------- the final analysis, the entire money income generated by the firms flows back to
the firms, which flows back again to the households as factor payments.
----------------------
Y=C+S=C+I
----------------------
Circular flows of income and expenditure with government: A three-
---------------------- sector model
It depicts a more realistic economy. It includes the government, which
----------------------
plays an important role in the economy. The economic role of the government
---------------------- has increased tremendously during the post War II period. Here we will include
only three fiscal variables to the circular flows, viz. direct taxes, government
---------------------- spending on goods and services and transfer payments. These variables have
different kinds of effects on the income and expenditure flows. As seen in the
----------------------
figure below, a part of the household income is claimed by the government in the
---------------------- form of direct taxes. Similarly, a part of the firm‘s income is taxed away in the
form of corporate income tax. The firms pass on to the government the indirect
---------------------- taxes also, which are collected from the households. The government spends a
part of its tax revenue on wages, salaries and transfer payments to the households
----------------------
and a part of it on purchases from the firms and payments of subsidies. Thus, the
6 Macroeconomics
money that flows from households and firms to the government in the form of Notes
taxes flows back to these sectors in the form of government expenditure.
----------------------
Y=C+I+G
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Fig. 1.3 Circular Flows of Income in a Three-sector Model
----------------------
Circular flows in a four-sector model: Model with the foreign sector
----------------------
The four-sector model is formed by adding foreign sector to the three-
sector model. It consists of two kinds of international transactions: foreign ----------------------
trade, i.e. exports and imports of goods and services and inflow and outflow
of capital. For simplicity, we make following assumptions: the external sector ----------------------
consists only of exports and imports of goods and services; the export and import ----------------------
of goods and non-labour services are made only by the firms; the households
export only labour. The circular flow is explained in the following figure: ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Fig. 1.4 Circular Flows of Income in a Four-sector Model
----------------------
The lower part is the circular flows of money in respect of foreign trade.
Exports (X) make goods and services flow out of the country and make money ----------------------

Notes (foreign exchange) flow into the country in the form of receipts from export.
This is in fact, flow of foreign incomes into the economy. Exports (X) represent
---------------------- injections into the economy. Similarly, imports (M) make inflow of goods and
services and flow of money (foreign exchange) out of the country. This is flow
---------------------- of expenditure out of the economy. Imports (M) represent withdrawals from the
---------------------- circular flows.
So far as the effect of foreign trade on the magnitude of the overall circular
----------------------
flows is concerned, it depends on the trade balance, i.e. X-M. If X > M, it means
---------------------- inflow of foreign income is greater than the outflow of income or there is a net
gain from foreign trade. The net gain increases the magnitude of circular flows
---------------------- of income and expenditure. If X < M it decreases the magnitude of circular
flows.
----------------------
Y = C + I + G + (X – M)
----------------------
---------------------- Check your Progress 2
---------------------- State True or False.
---------------------- 1. An economy can be defined as an integrated system of production,

exchange and consumption.
----------------------
2. Real and Money flows go in same direction in a circular fashion.
---------------------- 3. In the commodity market (lower half), the goods and services
produced by the firms flow from the households to the firms.
----------------------
----------------------
Activity 2
----------------------
---------------------- Check the link http://220.227.161.86/16788National_Income_india.pdf,

read the text and answer MCQ of the exercise.
----------------------
---------------------- 1.4 NATIONAL INCOME AND OUTPUT

---------------------- National Income is money value of all the final goods and services
---------------------- produced by a country during a period of one year. National Income consists of
collection of different types of goods and services of different types.
---------------------- Since the goods are measured in different physical units, it is not possible
---------------------- to add them. Thus, we cannot state ‘National Income is so many millions of
meters of textiles’. Therefore, the only way out is to reduce them to common
---------------------- measure. This common measure is money.
---------------------- Output in economics is the “quantity of goods or services produced in a

given time period, by a firm, industry or country,” whether consumed or used
---------------------- for further production. The concept of national output is absolutely essential in
the field of macroeconomics. It is national output, not large amounts of money,
---------------------- that makes a country rich.
8 Macroeconomics
The result of an economic process that has used inputs to produce a Notes
product or service that is available for sale or use somewhere else. Net output,
sometimes called netput, is a quantity. In the context of production, net output ----------------------
is positive, if the quantity is output by the production process and negative, if it
is an input to the production process. ----------------------
Gross National Product (GNP) ----------------------

GNP is the total market value of all final goods and services produced in ----------------------
a year plus net income from abroad. This is the basic social accounting measure
of the total output or aggregate supply of goods and services. GNP includes four ----------------------
types of final goods and services.
----------------------
1. Consumer goods and services to satisfy the immediate needs and wants of
the people. ----------------------
2. Gross private domestic investment. ----------------------
3. Goods and services produced by government. ----------------------
4. Net income from abroad, i.e. net export of goods and services.
----------------------
GNP is the total amount of current production of final goods and services.
----------------------
Two things should be noted regarding gross national product. Firstly,
it measures the market value of annual output or it is a monetary measure. ----------------------
This enables the process of adding up the different types of goods and services
produced in a year. However, for accuracy, the figure for GNP is adjusted for ----------------------
price changes. Secondly, for calculating gross national product accurately, all
----------------------
goods and services produced in any given year must be counted only once. GNP
includes only the market value of final goods and ignores transactions involving ----------------------
intermediate goods. Final goods are those goods, which are being purchased for
final use and not for further processing. The inclusion of intermediate goods ----------------------
will involve double counting. This will give us an inflated figure of the national
----------------------
product.
In national income accounting, GNP is calculated at both market prices ----------------------
and factor cost. In order to calculate GNP at market prices, the outputs of all ----------------------
final goods and services are valued at market price and the values thus obtained
are added. The market price of a good includes indirect taxes such as the sales ----------------------
tax and excise tax. Thus, it is greater than the price received by the seller.
Sometimes, the government may grant subsidy on a product. In this case, the ----------------------
market price would be less than the price received by the seller. GNP at factor ----------------------
cost eliminates the influences of indirect taxes and subsidies. It provides an
estimate of the total value of the final goods and services produced during a ----------------------
year at cost of production.
----------------------
GNP at factor cost is obtained by subtracting net indirect taxes from GNP
at market prices. GNP at Factor cost = GNP at market price - Net indirect taxes ----------------------
= GNP at market prices - (Total indirect taxes - Subsidies).
----------------------
----------------------

Notes National income is usually calculated by 3 methods:
1. The product method
----------------------
2. The income method
----------------------
3. The expenditure method
---------------------- In the product method, GNP is the value added by the various industries
---------------------- and activities of the economy in a particular year. In the income method, we add
up the income earned by the owners of factors of products in a particular year.
---------------------- This gives the gross national income (GNI). In the expenditure method,we add
up the final expenditure of all residents in a country. .
----------------------
GNP is now mostly known as Gross National Income (GNI) and is defined
---------------------- as GDP plus primary income of residents from the rest of the world minus
primary income of non-residents from the economy. a GDP according to the
---------------------- concept of residency of income earners instead of residency of production units.
---------------------- Gross Domestic Product (GDP)
---------------------- GDP refers to the value of final goods and services produced within the
country in a particular year. GDP is different from GNP. A part of GNP may be
---------------------- produced outside the country. For example, the money earned by the Indians
working in USA is a part of India’s GNP but it is not a part of GDP since it is
----------------------
earned abroad. Therefore, the boundaries of GNP are determined by the citizens
---------------------- of a country whereas the boundaries of GDP are determined by the geographical
limits of a country. It is also clear that the difference between GDP and GNP is
---------------------- due to the “net revenue from abroad.”
---------------------- GDP can be estimated at current prices and at constant prices. If the
domestic product is estimated on the basis of the prevailing prices, it is called
---------------------- gross domestic product at current prices. If GDP is measured based on some
fixed price, i.e. price prevailing at a point of time or in some base year, it is
----------------------
known as GDP at constant price or real gross domestic product.
---------------------- The contribution of each producing unit to the current flow of goods and
services is known as the net value added. GDP at the factor cost is estimated
----------------------
as the sum of the net value added by the different producing units and the
---------------------- consumption of fixed capital.
---------------------- Conceptually, the value of GDP, whether estimated at market price or

at factor cost, must be identical. This is because the final value of goods and
---------------------- services must be equal to the cost involved in their production.
---------------------- Limitations of GDP

●● Does not measure nation’s economic well-being.
----------------------
●● Includes only market activity.
---------------------- ●● International GDP comparisons are misleading when the two countries
---------------------- differ greatly in the fraction of economic activity that each conducted in
organised markets.
----------------------
10 Macroeconomics
●● Places no value on leisure. Notes
●● Ecological costs (not deducted from GDP).
----------------------
Net National Product
This is a very important concept of national income. In the production of ----------------------
gross national product, during a year, some capital is used up or consumed, i.e. ----------------------
equipment, machinery etc. The capital goods wear out or undergo depreciation.
Capital goods fall in value due to use in production process. By deducting the ----------------------
charges for depreciation (also called capital consumption allowance) from the
gross national product, we get the net national product. It means the market ----------------------
value of all the final goods and services after providing for depreciation. It is ----------------------
called national income at market prices. In other words, net national product is
the total value of final goods and services produced in the country during a year ----------------------
after deducting the depreciation, plus net income from abroad.
----------------------
NNP = GNP - Depreciation
----------------------
NNP at factor cost is the volume of commodities and services turned out
during an accounting year, counted without duplication. It can also be defined ----------------------
as the net value added at factor cost in an economy during an accounting year.
----------------------
NNP at factor cost or national income is defined as the sum of domestic
factor incomes and net factor income from abroad. If NNP figure is available at ----------------------
market prices, we will subtract indirect taxes and add subsidies to the figures to
get NNP at factor cost or national income of the economy. ----------------------
NNP at factor cost = NI = FID + NFIA ----------------------
where, FID is the factor income earned in the domestic territory of a ----------------------
country; and NFIA is the net factor income from abroad.
National Income at Factor Cost means sum total of all income earned ----------------------
by resource suppliers for their contribution of land, labour, capital and ----------------------
entrepreneurial ability, which go into the year’s net production. National
income at factor cost shows how much it costs the society in terms of economic ----------------------
resources to produce the net output. We use the term national income for the
national income at factor prices. ----------------------
National Income at factor cost = Net national product (National Income ----------------------
at market prices) - (indirect taxes +subsidies)
----------------------
Net Domestic Products
----------------------
NDP is obtained by subtracting the depreciation from the GDP. NDP
differs from NNP due to the net income from abroad. If the net income from ----------------------
abroad is positive, NDP will be less than NNP. If the net income from abroad is
negative, NDP will be greater than NNP. NDP is also calculated either at market ----------------------
price or at factor cost.
----------------------
NDP = GDP - Depreciation
----------------------
----------------------

Notes Personal Income
Personal income is the sum of the income actually received by individuals
----------------------
or households during a given year. Personal incomes earned are different
---------------------- from national income. Some incomes, which are earned, e.g. social security
contributions, corporate income taxes and undistributed corporate profits, are
---------------------- not actually received by households, in the same manner in which some incomes
that are received, e.g. transfer payments, are not currently earned, e.g. old age
----------------------
pension, unemployment compensation, relief payments, interest payments etc.
---------------------- To get personal income from national income, we must subtract from national
income the three types of incomes that are earned but not received and add
---------------------- incomes that are not currently earned.
---------------------- Personal income = N.I. - social security contributions - corporate income
taxes -undistributed corporate profit + transfer payments
----------------------
Personal income may further be defined as the current income of persons
---------------------- or households from all services. Personal income is not a measure of production.
---------------------- Disposable Income

Personal income, which remains after payment of taxes to the government
---------------------- in the form of income tax, personal property tax etc., is called disposable income.
---------------------- Disposable income = Personal Income - Personal Taxes.
An individual can decide to consume or save the disposable income as he
---------------------- wishes.
---------------------- The disposable income may be spent fully or individuals may save. What
remains after saving is called the personal outlay. Disposable income is equal
----------------------
to consumption and savings.
---------------------- Disposable Income = Consumption in the economy + Savings in the economy
---------------------- Disposable Outlay = Disposable Income – Savings
---------------------- Real Income

Since National Income does not reveal the real state of the economy, the
---------------------- concept of real income is used. To find out the real income of the economy, a
---------------------- base year is selected and the price level of that year is assumed to be 100.
Real Income = (Money Income/ Price Index) x 100
----------------------
Distribution of National Income
----------------------
1. Employees’ Compensation: wages, salaries and fringe benefits.
---------------------- 2. Proprietors’ Income: income of non-corporate business.
---------------------- 3. Rental Income: income that landlords receive from renting, including
“imputed” rent less expenses on the house, such as depreciation.
----------------------
4. Corporate Profits: income of corporations after payments to their workers
---------------------- and creditors.
----------------------
12 Macroeconomics
5. Net interest: interests paid by domestic businesses plus interest earned Notes
from foreigners.
----------------------
1.5 METHODS OF MEASUREMENT OF NATIONAL INCOME ----------------------
For measuring national income, the economy through which people ----------------------
participate in economic activities, earn their livelihood, produce goods and
services and share the national products is viewed from three different angles: ----------------------
1. The national economy is considered an aggregate of producing units ----------------------
combining different sectors such as agriculture, mining, manufacturing,
trade and commerce etc. ----------------------
2. The whole national economy is viewed as a combination of individuals ----------------------
and households owning different kinds of factors of production, which
they use themselves or sell factor services to make their livelihood. ----------------------
3. The national economy may also be viewed as a collection of consuming, ----------------------
saving and investing units (individuals, households and government).
----------------------
National income may be measured by three different corresponding methods:
A) Net product method ----------------------
B) Factor-income method ----------------------
C) Expenditure method
----------------------
Net output or value added method
----------------------
It is also called the value added method. It consists of three stages:
i) Estimating the gross value of domestic output in the various branches of ----------------------
production.
----------------------
ii) Determining the cost of material and services used and also the depreciation
of physical assets. ----------------------
iii) Deducting these costs and depreciation from gross value to obtain the net ----------------------
value of domestic output.
----------------------
Measuring gross value: For measuring the gross value of domestic product,
output is classified under various categories and it is computed in two ways: ----------------------
i) By multiplying the output of each category of sector by their respective ----------------------
market price and adding them together.
----------------------
ii) By collective data about the gross sales and changes in inventories from
the account of the manufacturing enterprises and computing the value of ----------------------
GDP on the basis thereof. If there are gaps in data, some estimates are
made thereof and gaps are filled. ----------------------
Estimating cost of production is, however a relatively more complicated ----------------------
and difficult task because of non-availability of adequate and requisite data.
----------------------
----------------------

Notes Countries adopting net-product method find some ways and means to calculate
the deductible cost. The costs are estimated either in absolute terms or as an
---------------------- overall ratio of input to the total output. The general practice in estimating
depreciation is to follow the usual business practice of depreciation accounting.
---------------------- Following a suitable method, deductible costs including depreciation are
---------------------- estimated for each sector. The cost estimates are then deducted from the sectoral
gross output to obtain the net sectoral products. The net sectoral products are
---------------------- then added and the total thus obtained is taken to be the measure of net national
products or national income by net product method.
----------------------
Factor - Income Method
----------------------
This method is also known as income method and factor-income method.
---------------------- Under this method, the national income is calculated by adding up all the
incomes accruing to the basic factors of production used in producing the
---------------------- national product. The total factor-incomes are grouped under three categories:
---------------------- 1. Labour incomes included in the national income have three components:
---------------------- i) Wages and salaries paid to the residents of the country including
bonus and commission and social security payments.
---------------------- ii) Supplementary labour incomes including employer‘s contribution
---------------------- to social security and employer‘s welfare funds and direct pension
payments to retired employees.
---------------------- iii) Supplementary labour incomes in kind, e.g. free health and
---------------------- education, food and clothing, accommodation etc.
Compensations in kind in the form of domestic servants and other free-
----------------------
of-cost services provided to the employees are included in labour income. War
---------------------- bonuses, pensions, service grants are not included in labour income as they are
regarded as transfer payments. Certain other categories of income, e.g. incomes
---------------------- from incidental jobs, gratuities, tips etc. are ignored for lack of data.
---------------------- 2. Capital incomes: According to Studenski, capital incomes include the
following capital earnings:
----------------------
a) Dividends excluding inter-corporate dividends.
---------------------- b) Undistributed before-tax profits of corporations.
---------------------- c) Interest on bonds, mortgages and savings deposits (excluding
interests on war bonds and on consumer-credit).
----------------------
d) Interest earned by insurance companies and credited to the insurance
---------------------- policy reserves.
---------------------- e) Net interest paid out by commercial banks.
f) Net rents from land, building etc., including imputed net rents on
----------------------
owner- occupied dwellings.
---------------------- g) Royalties.
---------------------- h) Profits of government enterprises.
14 Macroeconomics
3. Mixed income includes earnings from Notes
a) Farming enterprises.
----------------------
b) Sole proprietorship (not included under profit or capital income).
----------------------
c) Other professions, e.g. legal and medical practices, consultancy
services, trading and transporting etc. This category also includes ----------------------
the incomes of those who earn their living through various sources
as wages, rent on own property, interest on own capital etc. ----------------------
All these three kinds of incomes added together give the measure of ----------------------
national income by factor income method.
----------------------
Expenditure Method
Also known as final product method, the expenditure method measures ----------------------
national income at the final expenditure stages. In estimating the total national ----------------------
expenditure, any of the two following methods are followed. First, all the money
expenditures at market price are computed and added up; second, the values of ----------------------
all the products finally disposed of are computed and added up. The items of
expenditure, which are taken into account under the first method, are: ----------------------
a) Private consumption expenditure. ----------------------

b) Direct tax payments. ----------------------
c) Payments to the non-profit making institutions and charitable organisations ----------------------
such as schools, hospitals, orphanages etc.
d) Private savings. ----------------------
Under the second method, the following items are considered: ----------------------
a) Private consumer goods and services. ----------------------
b) Private investment goods.
----------------------
c) Public goods and services.
----------------------
d) Net investment abroad.
The second method is more extensively used because the data required in ----------------------
this method can be collected with greater ease and accuracy. ----------------------
Prof. Samuelson calls this as “Flow of Product Approach”. In India, it
is also known as outlay method. GNP, therefore, is the sum of expenditure ----------------------
incurred on goods and services during one year in country, which can be stated ----------------------
as:
----------------------
GNP = Consumption (C) + Investment (I) + Government (G) + Exports (X) –
Imports (M) ----------------------
Treatment of net income from abroad
----------------------
Nowadays, most economies are open in the sense that they carry out
foreign trade in goods and services and financial transactions with the rest of ----------------------
the world. In the process, some nations get net income through foreign trade ----------------------

Notes while some lose their income to foreigners. The net earnings or loss in foreign
trade affects the national income. In measuring the national income, therefore,
---------------------- the net result of external transactions is adjusted to the total. Net incomes from
abroad are added to and net losses to the foreigners are deducted from the total
---------------------- national income arrived at through any of the above three methods.
---------------------- Briefly speaking, all exports of merchandise and of services such as
shipping, insurance, banking, tourism and gifts are added to the national income.
----------------------
Further, all the imports of the corresponding items are deducted from the value
---------------------- of national output to arrive at the approximate measure of national income. To
this is added the net income from foreign investment. These adjustments for
---------------------- international transactions are based on the international balance of payments of
the nations.
----------------------
Important points to be considered in estimating National Income
----------------------
Simon Kutnetzs suggests that National Income is not limited to the
---------------------- territorial boundaries of a country. We must include income of all the residents
of a country even if they are abroad.
----------------------
Income earned through illegal activities is not included in National
---------------------- Income. Services rendered free of charge are not included in GNP. By leaving
out these services, NI will work out to be less.
----------------------
Transfer payments are not included in NI, as they do not contribute to
---------------------- national product.
---------------------- Capital gains or losses are not included in GNP, as they are not the result
of current economic activities.
----------------------
In the calculation of NI, leisure foregone in the process of production is
---------------------- not included.
A difficulty in estimating the National Income of developing countries
----------------------
is the prevalence of non-monetised sector. In developing countries, due to
---------------------- illiteracy, most producers do not keep regular accounts. Another difficulty in
the measurement of NI in developing countries is lack of adequate statistical
---------------------- tools.
----------------------
1.6 MEASUREMENT OF NATIONAL INCOME IN INDIA
----------------------
In India, a systematic measurement of national income was first attempted
---------------------- in 1949. Earlier, many attempts were made by some individuals and institutions.
The earliest estimate of India‘s national income was made by Dadabhai Naoroji
----------------------
in 1867-68. Since then many attempts were made, mostly by economists and the
---------------------- government authorities, to estimate India‘s national income. These estimates
differ in coverage, concepts and methodology and are not comparable. Besides,
---------------------- earlier estimates were mostly for one year, only some estimates covered a period
of 3 to 4 years. It was therefore not possible to construct a consistent series of
----------------------
national income and assess the performance of the economy over a period of
---------------------- time.
16 Macroeconomics
In 1949, a National Income Committee (NIC) was appointed with P.C. Notes
Mahalnobis as its Chairman and Dr. D.R. Gadgil and V.K.R.V. Rao as members.
The NIC not only highlighted the limitations of the statistical system of that time ----------------------
but also suggested ways and means to improve data collection systems. On the
recommendation of the Committee, the Directorate of National Sample Survey ----------------------
was set up to collect additional data required for estimating national income. ----------------------
Besides, the NIC estimated the country‘s national income for the period from
1948-49 to 1950-52. In its estimates, the NIC also provided the methodology ----------------------
for estimating national income, which was followed till 1967. In 1967, the task
of estimating national income was given to the Central statistical Organisation ----------------------
(CSO). Till 1967, the CSO followed the methodology laid down by the NIC. ----------------------
Thereafter, the CSO adopted a relatively improved methodology and
----------------------
procedure, which had become possible due to increased availability of data. The
improvements pertain mainly to the industrial classification of the activities. The ----------------------
CSO publishes its estimates in its publication ‘Estimates of National Income’.
----------------------
Methodology: Currently, output and income methods are used by the CSO
to estimate the national income of the country. The output method is used for ----------------------
agriculture and manufacturing sectors, i.e. the commodity producing sectors.
For these sectors, the value-added method is adopted. Income method is used ----------------------
for the service sectors including trade, commerce, transport and government
----------------------
services. In its conventional series of national income statistics from 1950-51 to
1966-67, the CSO had categorised the income in 13 sectors. But in the revised ----------------------
series, it had adopted the following 15 break-ups of the national economy for
estimating the national income: ----------------------
i) Agriculture. ----------------------
ii) Forestry and logging. ----------------------
iii) Fishing.
----------------------
iv) Mining and quarrying.
----------------------
v) Large-scale manufacturing.
vi) Small-scale manufacturing. ----------------------
vii) Construction. ----------------------
viii) Electricity, gas and water supply. ----------------------
ix) Transport and communication.
----------------------
x) Real estate and dwellings.
----------------------
xi) Public administration and Defense.
xii) Other services. ----------------------
xiii) External transactions. ----------------------
National Income is estimated at both constant and current prices. ----------------------
----------------------

Notes Trends in India’s national income growth and structure
Trends in NNP: The real national income of India has increased at an annual
----------------------
average rate of 4.4% during the 60 years of economic planning. If we consider
---------------------- the last 20 years, we find that the rate of increase in NI has been around 6% per
annum.
----------------------
During the 10th five-year plan, the target was set up at 8% growth rate and
---------------------- achievement rate was 7.6%. This encouraged the planners to set up a target of
8.5% per annum growth rate for the 11th five-year plan.
----------------------
Trends in per capita income: India’s per capita net national product, during
---------------------- the last 60 years of planning has increased at a rate of 2.3% per annum. It is to
be noted that during the last 20 years, the rate of increase in per capita national
---------------------- income is 4.5%, which, compared to the first 30 years of economic planned
period of 1.25% per annum, is significant.
----------------------
Importance of national income analysis
----------------------
National income analysis provides an index of economic activity and an
---------------------- instrument of economic planning. National income accounting indicates the
growth of the economy in terms of income and output.
----------------------
National Income statistics helps the policymakers to frame policies to
---------------------- achieve full employment and rapid economic growth.
---------------------- A compete knowledge about the trends in national income is essential in
economic planning. Research scholars also make use of national income data
---------------------- pertaining to input, output, savings, consumption, investment and employment.
National Income statistics helps in solving and removing inequalities in income
----------------------
distribution.
---------------------- Estimates of annual national income of India 2010-11
---------------------- The Central Statistics Office (CSO), Ministry of Statistics and Program
Implementation, has released the revised estimates of national income for the
---------------------- financial year 2010-11 and the quarterly estimates of Gross Domestic Product
(GDP) for the fourth quarter (January-March) of 2010-11, both at constant
----------------------
(2004-05) and current prices.
---------------------- The CSO has also released the corresponding annual and quarterly
---------------------- estimates of expenditure components of the GDP in current and constant (2004-
05) prices, namely the private final consumption expenditure, government final
---------------------- consumption expenditure, gross fixed capital formation, change in stocks,
valuables and net exports.
----------------------
The salient features of estimates of Annual National Income of India
---------------------- 2010-11 are given in the Annexure -1 as additional information for you.
----------------------
----------------------
----------------------
18 Macroeconomics
Notes
Activity 3
----------------------
Go to http://pib.nic.in/newsite/erelease.aspx?relid=72400 on “Revised ----------------------
Estimates of Annual National Income, 2010-11 and write down the various
heads under which variation from original has been made. ----------------------
----------------------
Summary ----------------------
●● icroeconomics studies economic behaviour of individual economic
M ----------------------
entities and individual economic variables.
●● acroeconomics deals with aggregate quantities of the economy as a
M ----------------------
whole, it is also called as aggregative economics. ----------------------
●● There are three models, which explain the circular flows.
----------------------
●● Two-sector model includes the household and business sectors.
●● hree-sector model includes the household, business and government
T ----------------------
sectors.
----------------------
●● our-sector model includes the household, business, government and the
F
foreign sectors. ----------------------
●● NP is the total market value of all final goods and services produced
G ----------------------
in a year plus the net income from abroad. GNP at factor cost = GNP at
market prices - Net indirect taxes - Subsidy. ----------------------
●● et National Product is the total value of final goods and services
N ----------------------
produced in the country during a year after deducting the depreciation,
plus net income from abroad. ----------------------
●● ational Income at Factor Cost means the sum total of all incomes earned
N ----------------------
by the resource suppliers for their contribution of land, labour, capital and
entrepreneurial ability, which go into the year’s net production. ----------------------
●● ational income at factor prices = [Net National Product (National
N ----------------------
Income at market prices) - Indirect taxes + Subsidies]
●● ersonal Income is the sum of all income actually received by individuals
P ----------------------
or households during a given year. ----------------------
●● ersonal Income = National Income - Social Securities’ Contributions
P
- Corporate income taxes - Undistributed corporate profit + Transfer ----------------------
payment
----------------------
●● ational income may be measured by three different corresponding
N
methods: Net product method, Factor-income method and Expenditure ----------------------
method.
----------------------
●● easurement of National Income in India: The earliest estimate of
M
India‘s national income was made by Dadabhai Naoroji in 1867-68. In ----------------------
----------------------

Notes 1949, A National Income Committee (NIC) was appointed. In 1967, the
task of estimating national income was given to the Central statistical
---------------------- Organisation (CSO).
----------------------
Keywords
----------------------
●● Factor costs: Compensation paid to the production factors capital
---------------------- (machinery and buildings) and labor, by profits and wages, without taxes
(net minus subsidies).
----------------------
●● Primary income: Defined as income earned by direct participation in the
---------------------- production process.
---------------------- ●● Labor and property income: Formerly ‘factor income’.
---------------------- Self-Assessment Questions

----------------------
1. Discuss in detail the difference between Microeconomics and
---------------------- Macroeconomics.
2. Explain the Circular Flow of various economic activities.
----------------------
3. Define the concepts: a) GNP b) NNP c) GDP d) Disposable income.
----------------------
4. Describe the various methods of measuring national income.
---------------------- 5. Distinguish between net-product method and factor-income method.
---------------------- 6. How is foreign income treated in national income estimates?
---------------------- 7. What is value-added? Explain the value-added method of estimating
national income.
----------------------
---------------------- Answers to Check your Progress

State True or False.
----------------------
1. False
----------------------
2. False
---------------------- 3. False
----------------------

----------------------
1. True
----------------------
2. False
---------------------- 3. False
----------------------
20 Macroeconomics
Notes
Suggested Reading
----------------------
1. http://demonstrations.wolfram.com/KeynesianCrossDiagram/
2. http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=Keynesi ----------------------
an+cross
----------------------
3. http://www.econ.ucla.edu/workingpapers/wp383.pdf
----------------------
4. http://www.khanacademy.org/finance-economics/macroeconomics/v/
keynesian-cross-and-the-multiplier ----------------------
5. http://njsanders.people.wm.edu/101/Ch10_11_Handout.pdf ----------------------
6. www.jurgilas.net/fpdb/Econ%20219%20Spr05/03-02-2005.pdf
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes Annexure-I
----------------------
(a) Estimates at constant (2004-05) prices
----------------------
Gross Domestic Product
----------------------
GDP at factor cost at constant (2004-05) prices in the year 2010-11 is
---------------------- estimated at Rs. 48,77,842 crore showing a growth rate of 8.5 % over the
Estimates of GDP for the year 2009-10 of Rs. 44, 93,743 crore. The downward
---------------------- revision in the GDP growth rate is mainly on account of lower performance
in ‘mining and quarrying’, ‘manufacturing’ and ‘trade, hotels, transport and
----------------------
communication’ and ‘financing, insurance, real estate & business services’ than
---------------------- anticipated.
Due to this upward revision in the production, ‘agriculture, forestry and
----------------------
fishing’ sector in 2010-11 has shown a growth rate of 6.6 %, as against the
---------------------- growth rate of 5.4 % in the Advance estimates.
In the case of ‘mining and quarrying’, the Index of Industrial Production
----------------------
of Mining (IIP-Mining) registered a growth rate of 5.9 % during 2010-11, as
---------------------- against the growth rate of 8.0 % during April-November, 2010, which was used
in the Advance Estimates. Due to this decrease in the IIP-Mining, the growth
---------------------- rate in GDP is now estimated at 5.8 %, as against the advance estimate growth
rate of 6.2 %.
----------------------
Similarly, the IIP of manufacturing registered a growth rate of 8.1 %
---------------------- during 2010- 11, as against the growth rate of 10 % during April-November,
---------------------- 2010. Due to this decrease in the IIP, the growth rate in GDP of ‘manufacturing’
sector is now estimated at 8.3 %, as against the Advance estimate growth rate
---------------------- of 8.8 %.
---------------------- The sector ‘community, social and personal services’ has shown a rise
in growth rate to 7.0 % in the revised estimates, mainly due to rise in total
---------------------- expenditure of Central Government than anticipated (during April-December,
2010, the total expenditure of Central Government showed an increase of 11.2
---------------------- % over the corresponding period of previous year which was extrapolated in the
---------------------- advance estimates, whereas the RE, 2010-11 showed a rise of 19.4 % during
2010-11).
---------------------- Growth rates in various sectors are as follows: ‘agriculture, forestry and
---------------------- fishing’ (6.6 %), ‘mining and quarrying’ (5.8 %), ‘manufacturing’ (8.3 %),
‘electricity, gas and water supply’ (5.7 %) ‘construction’ (8.1 %), ‘trade, hotels,
---------------------- transport and communication’ (10.3 %), ‘financing, insurance, real estate
and business services’ (9.9 %) and ‘community, social and personal services’
---------------------- (7.0 %).
---------------------- Gross National Income
---------------------- The Gross National Income (GNI) at factor cost at 2004-05 prices is now
estimated at Rs. 48,34,759 crore, during 2010-11. In terms of growth rates, the
----------------------
22 Macroeconomics
gross national income is estimated to have risen by 8.3 % during 2010-11, in Notes
comparison to the growth rate of 7.9 % in 2009-10.
----------------------
Per Capita Net National Income
The per capita net national income in real terms (at 2004-05 prices) during ----------------------
2010-11 is estimated to have attained a level of Rs. 35,917. The growth rate in
----------------------
per capita income is estimated at 6.5 % during 2010-11 as against 6.1 % during
2009-10. ----------------------
(b) Estimates at current prices
----------------------
Gross Domestic Product
----------------------
GDP at factor cost at current prices in the year 2010-11 is estimated at
Rs. 73,06,990 crore, showing a growth rate of 19.1 % over the year 2009-10 of ----------------------
Rs. 61,33,230 crore.
----------------------
Gross National Income
----------------------
The GNI at factor cost at current prices is now estimated at Rs. 72,41,026
crore during 2010-11, as compared to Rs. 60,95,230 crore during 2009-10, ----------------------
showing a rise of 18.8 %.
----------------------
Per Capita Net National Income
The per capita income at current prices during 2010-11 is estimated ----------------------
to have attained a level of Rs. 54,835 as compared to the year 2009-10 of ----------------------
Rs. 46,492, showing a rise of 17.9 %.
II Annual Estimates of Expenditures on GDP, 2010-11 ----------------------
Along with the Estimates of GDP by economic activity, the CSO is also ----------------------
releasing the estimates of expenditures of the GDP at current and constant
(2004-05) prices. These estimates have been compiled using the data on ----------------------
indicators available from the same sources as those used for compiling GDP ----------------------
estimates by economic activity, detailed data available on merchandise trade in
respect of imports and exports, balance of payments and monthly accounts of ----------------------
central government. As various components of expenditure on gross domestic
product, namely, consumption expenditure and capital formation, are normally ----------------------
measured at market prices, the discussion in the following paragraphs is in ----------------------
terms of market prices only.
----------------------
Private Final Consumption Expenditure
Private Final Consumption Expenditure (PFCE) at current prices is ----------------------
estimated at Rs. 45,02,974 crore in 2010-11 as against Rs. 37,82,013 crore in
----------------------
2009-10. At constant (2004-05) prices, the PFCE is estimated at Rs. 30,91,328
crore in 2010- 11 as against Rs. 28,46,410 crore in 2009-10. In terms of GDP ----------------------
at market prices, the rates of PFCE at current and constant (2004-05) prices
during 2010-11 are estimated at 57.2 % and 58.3 %, respectively, as against the ----------------------
corresponding rates of 57.7 % and 58.5 %, respectively in 2009-10.
----------------------
----------------------

Notes Government Final Consumption Expenditure
---------------------- Government Final Consumption Expenditure (GFCE) at current prices
is estimated at Rs. 9,06,665 crore in 2010-11 as against Rs. 7,85,443 crore in
---------------------- 2009-10. At constant (2004-05) prices, the GFCE is estimated at Rs. 5,91,761
crore in 2010-11 as against Rs. 5,64,835 crore in 2009-10. In terms of GDP
----------------------
at market prices, the rates of GFCE at current and constant (2004-05) prices
---------------------- during 2010-11 are estimated at 11.5 % and 11.2 %, respectively, as against the
corresponding rates of 12.0 % and 11.6 %, respectively in 2009-10.
----------------------
Gross Fixed Capital Formation
---------------------- Gross Fixed Capital Formation (GFCF) at current prices is estimated
---------------------- at Rs. 23,22,097 crore in 2010-11 as against Rs. 20,16,186 crore in 2009-10.
At constant (2004-05) prices, the GFCF is estimated at Rs. 16,93,284 crore in
---------------------- 2010-11 as against Rs. 15,59,126 crore in 2009-10.
---------------------- In terms of GDP at market prices, the rates of GFCF at current and
constant (2004- 05) prices during 2010-11 are estimated at 29.5 % and 32.0
---------------------- %, respectively, as against the corresponding rates of 30.8 % and 32.0 %,
respectively in 2009-10. The rates of Change in Stocks and Valuables at current
---------------------- prices during 2010-11 are estimated at 3.3 % and 2.0 %, respectively.
---------------------- The discrepancies at current and constant (2004-05) prices during 2010-
11 are estimated at (-) 0.2 % and (-) 1.5 %, respectively of the GDP at market
----------------------
prices, as against the corresponding rate of (-) 0.3 % each in 2009-10.
---------------------- Estimates of gross/net national income and per capita income, along with
GDP at factor cost by kind of economic activity and the Expenditures on GDP
----------------------
for the years 2008-09, 2009-10 and 2010-11 at constant (2004-05) and current
---------------------- prices are given in Statements 1 to 6.
Estimates of National Income and Expenditures on GDP, 2010-11
----------------------
(At 2004- 05 prices)
---------------------- Item 2008-09 2009-10 2010-11
---------------------- A. Estimates at Aggregate Level
1. National Product (INR Crore)
---------------------- 1.1 Gross National Income (GNI) at 4137125 4464854 4834759
factor cost
---------------------- (7.9) (8.3)
1.2 Net National Income (NNI) at 3669890 3946540 4259782
----------------------
factor cost
---------------------- (7.5) (7.9)
2. Domestic Product (INR Crore)
---------------------- 2.1 Gross domestic product (GDP) at 4162509 4493743 4877842
factor cost
----------------------
(8.0) (8.5)
---------------------- 2.2 Gross domestic product (GDP) at 3695274 3975429 4302865
market prices
---------------------- (9.1) (8.8)
24 Macroeconomics
Item 2008-09 2009-10 2010-11 Notes
2.3 Net domestic product (NDP) at 3695274 3975429 4302865
factor cost ----------------------
(7.6) (8.2)
----------------------
B. Estimates at Per Capita Level
Population (million) 1154 1170 1186 ----------------------
Per capita NNI at factor cost (INR) 31801 33731 35917
(6.1) (6.5) ----------------------
Per capita GDP at factor cost (INR) 36070 38408 41129
----------------------
Note: The figures in parenthesis show the percentage change over previous year
Estimates of National Income for the year 2010-11 (At current prices) ----------------------
Item 2008-09 2009-10 2010-11 ----------------------
A. Estimates at Aggregate Level
1. National Product (INR Crore) ----------------------
1.1 Gross National Income (GNI) at 5249163 6095230 7241026
----------------------
factor cost
(16.1) (18.8) ----------------------
1.2 Net National Income (NNI) at 4685873 5439557 6503394
factor cost ----------------------
(16.1) (19.6)
2. Domestic Product (INR Crore) ----------------------
2.1 Gross domestic product (GDP) at 5282086 6133230 7306990 ----------------------
factor cost
(16.1) (19.1) ----------------------
2.2 Gross domestic product (GDP) at 5582623 6550271 7875627
market prices ----------------------
(17.3) (20.2)
----------------------
2.3 Net domestic product (NDP) at 4718796 5477557 6569358
factor cost ----------------------
(16.1) (19.9)
2 . 4 Gross National Disposable 5752909 6759384 8050341 ----------------------
Income
----------------------
B. Estimates at Per Capita Level
Population (million) 1154 1170 1186 ----------------------
Per capita NNI at factor cost (INR) 40605 46492 54835
(14.5) (17.9) ----------------------
Per capita GDP at factor cost (INR) 45772 52421 61610
----------------------
Note: The figures in parenthesis show the percentage change over previous year
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
26 Macroeconomics
Aggregate Demand and Supply
UNIT
2
Structure:
2.1 Introduction
2.2 Definition
2.3 Expenditures
2.4 The Curve
2.4.1 The Slope
2.4.2 Determinants
2.4.3 Business Cycles
2.5 Aggregate Supply
2.6 Time Periods
2.7 Examples of the Curve
2.7.1 Determinants
2.8 Self-Correction
Summary
Keywords
Suggested Reading
Aggregate Demand and Supply 27

Notes
Objectives
----------------------
----------------------
●● Explain the meaning of aggregate demand and supply
---------------------- ●● Discuss how aggregate demand translates into aggregate expenditures
---------------------- ●● Analyse how demand and supply affect business cycles
----------------------
---------------------- 2.1 INTRODUCTION

---------------------- This Unit discusses the concept of aggregate demand, that is, the demand
side of the aggregate market. The aggregate market is the central model that
----------------------
explains and analyses the mechanism of the macro economy. Aggregate demand
---------------------- is the decisive half of this model (while the other is aggregate supply). Taking the
cue from market demand, this Unit examines the nature of aggregate demand,
---------------------- including the relation between the price level and aggregate expenditures,
the reason the aggregate demand curve is negatively sloped and the assorted
----------------------
aggregate demand determinants that cause the aggregate demand curve to shift.
---------------------- Aggregate supply emulates market supply more than aggregate demand
encapsulates market demand. This is because aggregate supply can be divided
----------------------
into two different relations or component: the short and long runs. This Unit
---------------------- tells us about the relation between the price level and real production and the
determinants that cause a change in aggregate supply with respect to long and
---------------------- short runs. Lastly, this Unit tells us the self-correction mechanism that depends
on the changes in the aggregate supply and how this is accountable for business
----------------------
cycle stabilisation.
----------------------
2.2 DEFINITION
----------------------
Aggregate demand is the aggregate or total expenditure on final goods and
----------------------
services produced in the domestic economy, at a range of price levels, during a
---------------------- given time period (usually a fiscal year).
●● Expenditures are made by all persons or members of society.
----------------------
●● Expenditures are made throughout a fiscal year.
----------------------
●● xpenditures are made on the production of goods and services that
E
---------------------- people use to satisfy their wants and needs.
Aggregate demand is only one side of the aggregate market, that is, the
----------------------
expenditure side. The other side is aggregate supply or the production side of
---------------------- the macro economy.
●● xpenditures come from the households, businesses, the government and
E
----------------------
foreign sectors.
----------------------
28 Macroeconomics
●● roduction is made possible from resources, such as labour, capital, land
P Notes
and entrepreneurship.
The aggregate market is a model used to analyse the economy’s total ----------------------
production and the price level. This analysis, also known as the AD-AS model, ----------------------
allows us to understand macroeconomic events, such as recessions, inflation
and unemployment. In turn, the aggregate market can be used to evaluate the ----------------------
effects of government policies.
----------------------
Aggregate demand and the aggregate market are all about the flow of
production through the product markets of the circular flow. ----------------------
The circular flow is the continuous flow of production, income and ----------------------
resources between households and businesses.
----------------------
●● usinesses acquire the services of productive factors through the factor
B
markets. ----------------------
●● ouseholds acquire the resulting production from businesses through the
H
----------------------
product markets.
●● he aggregate market combines all of the individual markets for individual
T ----------------------
goods and services into an overall, comprehensive, complete, aggregate
----------------------
product market.
●● This is the demand side of the aggregate market. ----------------------
----------------------
2.3 EXPENDITURES
----------------------
Aggregate demand translates into all the expenditures made by all
members of society, that is, aggregate expenditures. ----------------------
Aggregate expenditures are the total expenditures on gross domestic ----------------------
product (GDP) undertaken in a given time period. Society is grouped into four
sectors: households, business, government and foreign. ----------------------
Expenditures by each of these sectors are: ----------------------
●● Household consumption
----------------------
●● Business investment
●● Government purchases ----------------------
●● Foreign net export (export minus import) ----------------------
1. Consumption expenditures: The household sector is responsible for ----------------------
the consumption component in aggregate expenditures. Consumption
is the expenditure by the household sector on final goods and services ----------------------
undertaken in a given time period.
----------------------
There are three specific categories of consumption:
●● Non-durable goods: Goods lasting less than a year. ----------------------
●● Durable goods: Goods lasting more than a year. ----------------------

●● Services: Intangible activities. ----------------------

Notes Each consumption category plays a different role in the macro economy.
2. Investment expenditures: The firms or the business sector is responsible
----------------------
for investment expenditures. Investment is the expenditures made by
---------------------- firms on final goods and services, mainly capital goods like factories and
equipment, undertaken in a given time period.
----------------------
There are three specific categories of investment:
---------------------- ●● Fixed structures: Buildings, factories, housing.
---------------------- ●● Equipment: Machinery and tools.
●● Inventories: Raw materials and unsold goods.
----------------------
Investment is the most unstable component out of the four categories of
---------------------- expenditures.
---------------------- 3. Government Purchases: The government sector, like the household
and business sectors, also buys a portion of the final goods and services
---------------------- produced by the economy. These are government purchases.
---------------------- Government purchases made at three levels: centre, state and local. We
will focus on the sum total of all Government expenditures in an economy
---------------------- or nation.
---------------------- Government spending is considered only for newly produced goods in a
fiscal year. We exclude government spending on transfer payments.
----------------------
4. Net exports: The foreign sector, that is, individuals, households, firms
---------------------- and business houses and governments that are not a part of our economy
or nation, also purchases from domestic production. These are termed net
---------------------- exports.
---------------------- Net exports are exports minus imports.
---------------------- ●● Exports are purchases of domestic production by the foreign sector.
●● I mports are the purchases of foreign production by the domestic
----------------------
sector.
---------------------- ●● Net exports give us an overall picture of how our economy interacts
with the foreign sector.
----------------------
●● alculating net exports by subtracting imports gives us aggregate
C
---------------------- expenditures on domestic production only.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
30 Macroeconomics
Notes
Check your Progress 1
----------------------
Fill in the blanks.
----------------------
1. Aggregate demand is the aggregate or total expenditure on final
goods and services produced in the domestic economy, during one ----------------------
__________ (period).
----------------------
2. Aggregate expenditures are the total expenditures on _____________
undertaken in a given time period. ----------------------
3. Government spending excludes government spending on __________. ----------------------
4. Net exports represent the net expenditures of the foreign sector ----------------------
on domestically produced _________ and ___________for final
consumption. ----------------------
----------------------
Activity 1 ----------------------
To ascertain the aggregate expenditure in retail marketing, identify minimum ----------------------

two heads of expenditure pertaining to households, business, government
----------------------
and foreign
----------------------
2.4 THE CURVE ----------------------
The aggregate demand curve represents the demand side of the aggregate ----------------------
market.
----------------------
Characteristics of the curve
----------------------
●● he price level is on the vertical axis and real production is on the
T
horizontal axis. ----------------------
●● he aggregate demand curve has a negative slope. Price and real aggregate
T
----------------------
expenditure are inversely related, that is, at lower prices, real aggregate
expenditures are higher. ----------------------
●● ll else remaining constant in a given period of time, the determinants of
A
----------------------
aggregate demand are constant.
●● The aggregate demand curve gives us information for a given time period. ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes 2.4.1 The Slope
The aggregate demand curve has a negative slope.
----------------------
This negative slope means households, business, government and foreign
---------------------- sectors are inclined to increase their aggregate spending on real production if
the price level decreases and decrease spending if the price level rises.
----------------------
There are three reasons for this. They are:
----------------------
1. Real-balance effect: The amount of production we purchase depends
---------------------- on how much money we have and the price of the good/commodity or
service we want to buy. A higher price level means money can buy less
---------------------- real production and vice-versa.
---------------------- The real-balance effect takes place when a change in the price level
alters the value of aggregate expenditures on real production because the
---------------------- purchasing power of money has changed.
---------------------- “Real” means the real purchasing power of money and “balance” means
the amount of money we have with us to make purchases.
----------------------
2. Interest rate effect: Changes in the interest rate can modify consumption
---------------------- and investment spending. Changes in the investment and consumption
spending that take place because there are changes in the price level
----------------------
caused by changes in the interest rate is the interest rate effect.
---------------------- Investment and consumption expenditures may be made with borrowed
funds. The interest rate affects the cost of borrowing these funds.
----------------------
The price level and interest rates interact in the following way:
----------------------
●● higher price level induces a higher interest rate, which raises the
A
---------------------- cost of borrowing and discourages investment and consumption;
while the vice- versa holds good as well.
----------------------
3. Net export effect: An increase in the price level increases imports and
---------------------- decreases exports. This results in a decrease in net exports. If the price
level increases in one country, the production cost in other countries
---------------------- becomes relatively cheaper. An increase in the Indian price level, for
---------------------- example, discourages foreign buyers from buying Indian goods and
encourages Indian buyers to buy relatively cheaper foreign goods.
---------------------- The net export effect means that a change in the price level changes the
---------------------- relative prices of exports and imports, thereby changing the value of net exports
to a negative figure because imports are more than exports in this case. This
---------------------- means that India will pay foreigners more than they will receive payments from
foreigners while trading in such circumstances.
----------------------
2.4.2 Determinants
----------------------
Instability
---------------------- Expenditures by the household, business, government and foreign sector
change with time. This causes volatility in the economy.
----------------------
32 Macroeconomics
Economic instability can be found in complex economies in the form of Notes
business cycles. These can be traced to shifts of the aggregate demand curve.
The determinants of the aggregate demand curve are those conditions that ----------------------
disrupt equilibrium and lead to macroeconomic instability.
----------------------
The determinants of aggregate demand are reasons or situations, other
than the price level, that affect aggregate demand. ----------------------
Shifts: Increase ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
The determinants of aggregate demand cause the aggregate demand curve
to shift. An increase in aggregate demand shifts the aggregate demand curve to ----------------------
the right.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Shifts: Decrease
----------------------
A decrease in aggregate demand shifts the aggregate demand curve to the
left. ----------------------
2.4.3 Business Cycles ----------------------

The determinants − consumption, investment, government purchase ----------------------
and net export − cause the aggregate demand curve to shift and lead to
macroeconomic instability. This instability is best viewed in terms of business ----------------------
cycles. The effects of business-cycle instability are:
----------------------
●● Recession: This means higher unemployment rates and related problems.
----------------------
●● Expansion: This means that the possibility of higher inflation rates and
related problems are more rampant. ----------------------

Notes Aggregate demand is the key foundation of economic volatility.
Policies
----------------------
The Central government can exert a great deal of control over the aggregate
---------------------- demand curve through government policies. This control of aggregate demand
is called demand management policies.
----------------------
Government use of purchases and taxes to affect aggregate demand is
---------------------- termed fiscal policy. Government can influence aggregate demand directly
through government purchases. It can also indirectly alter the aggregate demand
----------------------
through taxes that affect household consumption and business investment.
---------------------- Government also changes the interest rate through monetary policy with the
goal of affecting consumption and investment.
----------------------

---------------------- Fill in the blanks.
---------------------- 1. _____________ and ___________ are the effects of business-cycle
instability.
----------------------
2. Government use of purchases and taxes to affect aggregate demand is
---------------------- termed as ________________ policy.
----------------------
Activity 2
----------------------
---------------------- Prepare a demand schedule for a consumer good based on its ruling price
in the market.
----------------------
----------------------
2.5 AGGREGATE SUPPLY
----------------------
In this section, we will examine the other side of the aggregate market –
---------------------- the aggregate supply – to see how gross domestic product is created or formed.
---------------------- We already know that society has scarce resources with alternate uses.
The opportunity cost of these alternative uses must be combined to produce all
---------------------- these goods and services that society demand.
---------------------- Aggregate supply is the sum or aggregate production of all final goods
and services produced in the domestic economy, given a range of price levels,
---------------------- during a given time period (usually one year or a fiscal year).
---------------------- The objective of the aggregate supply is to combine scarce resources to
produce the economy’s gross domestic product.
----------------------
There are four resource categories of aggregate supply:
---------------------- ●● Labour: People who offer their knowledge and skills by working in a
firm or business facility.
----------------------
34 Macroeconomics
●● Capital: Factory shed, tools and equipment. Notes
●● Land and raw material
----------------------
●● Entrepreneurs: Those who assume the risk of running a business.
The goods and services produced are supplied to meet the demands of our ----------------------
households, firms, the government and the foreign sector. ----------------------
Gross production is the supply side of the aggregate market. It is counted
as the supply of actual production or real GDP. ----------------------
Price Level ----------------------

Aggregate supply is the relationship between real production, measured ----------------------
as real GDP, and the price level, measured as the GDP price deflator. This is
analogous to the relationship that we have seen earlier for aggregate demand. We ----------------------
need to combine both these relationships to build the concept of the aggregate
----------------------
market.
We can now ask the following questions: ----------------------
●● Does the price level affect the supply of real production? If yes, how? ----------------------
●● I n microeconomics, the law of supply says that a higher price means that
----------------------
suppliers/producers are willing to supply more or that there would be an
increase in the quantity supplied. Is this true for aggregate supply too? ----------------------
●● Would the long and short runs influence the price levels that affect real
----------------------
production?
----------------------
2.6 TIME PERIODS
----------------------
In economics, broadly, there can be two types of times periods: short run
and long run. ----------------------
●● ong run: The period in which all prices are flexible. Long-run price
L ----------------------
flexibility means all markets are in equilibrium.
----------------------
●● hort run: The period in which some prices are flexible while some are
S
inflexible or rigid. ----------------------
o Short-run price rigidity leads to disequilibrium in the resources ----------------------
markets, although the product and financial markets are in
equilibrium. ----------------------
o In the short run, disequilibrium in resources markets (especially ----------------------
labour) means that jobs remain unfilled or some workers are
unemployed in spite of equilibrium prevailing in the product ----------------------
markets.
----------------------
Long run
----------------------
In the long run, all prices are flexible. This enables all markets to clear.
Prices move upwards to remove market shortages and move downwards to ----------------------
do away with market surpluses. This results the clearing of markets and they
achieve equilibrium. ----------------------

Notes Equilibrium in the labour market is particularly important because:
●● In the long run, the labour market is characterised by both flexible prices
----------------------
and full employment.
---------------------- ●● he economy operates at the periphery of the production possibilities
T
curve.
----------------------
The time taken for prices to adjust, in order to correct market disequilibrium
---------------------- and transition to the long run, is vital to the study of macroeconomics and
government policies.
----------------------
Short run
----------------------
In the short run, some prices are flexible while some are inflexible or
---------------------- rigid. Rigid prices are most important to resources and labour markets.
Rigid prices prevent markets from removing surpluses and achieving
----------------------
equilibrium. In the labour market, surpluses mean unemployment and not
---------------------- reaching full employment. Short-run aggregate supply involves the interaction
of many determinants, other than just price rigidity alone.
----------------------
---------------------- Activity 3
----------------------
Write two major parameters, which will have an effect on the supply of
---------------------- a product in the long run.
----------------------
2.7 EXAMPLES OF THE CURVE
----------------------
Long Run
----------------------
The Long-Run Aggregate Supply (LRAS) curve embodies the relationship
---------------------- between the price level and the aggregate supply of real production in the long
run.
----------------------
The GDP deflator (the price level) is measured on the vertical axis (Y-axis).
---------------------- Real GDP or the measure of real production is measured on the horizontal axis
(X-axis).
----------------------
●● The LRAS is a straight, vertical line parallel to the Y-axis.
----------------------
●● The price level does not affect the aggregate supply of real production.
---------------------- ●● he supply is equivalent to real production, given that all resources in the
T
economy are fully employed and optimally utilised.
----------------------
●● lexible prices ensure that full-employment production is maintained in
F
---------------------- the long run.
---------------------- Short Run
The Short-Run Aggregate Supply (SRAS) curve embodies the relationship
----------------------
between the price level and the aggregate supply of real production in the short
---------------------- run.
The GDP deflator (the price level) is measured on the vertical axis (Y-axis).
36 Macroeconomics
Real GDP or the measure of real production is measured on the horizontal axis Notes
(X-axis).
----------------------
●● The SRAS is a positively sloped line, that is, it is upward moving.
●● he positive slope means that higher price levels match up to greater
T ----------------------
levels of real production.
----------------------
●● With rigid prices, the price level does affect the aggregate supply of real
production in the short run. ----------------------
Market Supply ----------------------
Though the market supply curve and the short-run aggregate supply curve
look similar, there are important differences. They are as follows: ----------------------
●● The price and quantity for the short-run aggregate supply curve are the ----------------------
price level and real production and not the price and quantity of a specific
----------------------
good.
●● he positive slope of the short-run aggregate supply curve is based on rigid
T ----------------------
wages, augmented by specific (frictional and structural) unemployment
types and misinformation about real wages. ----------------------
●● he slope of the market supply curve is based on increasing opportunity

T ----------------------
costs.
----------------------
●● he short-run aggregate supply curve is not just the aggregation of all
T
market supply curves in the economy. ----------------------
2.7.1 Determinants ----------------------
Stability
----------------------
The shifts in the aggregate supply curves are usually small in size and
easily predictable. ----------------------
●● he supply side of the aggregate market is usually dependable in terms of
T ----------------------
stability.
----------------------
●● ost of the economy’s volatility results from instability on the demand
M
side of the aggregate market. ----------------------
●● hifts of the aggregate supply curve are due to determinants at ceteris
S
paribus status. ----------------------
●● he supply determinants are the variables other than the price level that
T ----------------------
affect aggregate supply.
----------------------
Both, short-run aggregate supply and long-run aggregate supply curves
can increase or decrease. ----------------------
In both, long run and short runs: ----------------------
●● n increase shifts the aggregate supply curve to right. It means that
A
----------------------
producers are willing and able to offer more real production for sale at
any and all price levels. ----------------------
●● A decrease shifts the aggregate supply curve to left. It means that producers
----------------------

Notes are willing and able to offer less real production for sale at any and all
price levels.
---------------------- Long-Run Supply
---------------------- The most important characteristic of the LRAS curve is that it is vertical at
the full employment level of production. Whatever affects the full-employment
---------------------- level of real production will cause the long-run aggregate supply curve to shift.
---------------------- The determinants of the long-run aggregate supply curve are the same
that cause the production possibilities frontier to shift.
----------------------
They quality and quantity determinants are as follows:
----------------------
Quantity of Resources
---------------------- A change in the quantity of labour, capital, land or entrepreneurs will
---------------------- change full- employment real production and shift the long-run aggregate
supply curve.
---------------------- ●● Changes in resource quantities tend to be stable and expected.
---------------------- ●● Labour can change for three reasons:
---------------------- o Natural increase of population.

o Migration and relocation of population.
----------------------
o The labour force participation rate.
----------------------
●● apital quantities change with the depreciation and further investment of
C
---------------------- capital.
●● roductivity of land changes with exploration and discovery of natural
P
----------------------
resources.
---------------------- ●● Entrepreneurship increases when more people assume the risk of
production. This may not be measurable but individuals are attracted to
---------------------- profits and this may increase the number of individuals who would like
---------------------- to take risks and run businesses to cater to increasing demands in the
economy.
---------------------- Quality of Resources
---------------------- Resource quality tends to change slowly and gradually. We rarely witness
a sea change in these long-run aggregate supply determinants.
----------------------
There are ways to improve resource quality:
----------------------
●● echnology: Production techniques usually improve with research
T
---------------------- and development in due time. This positive change directly affects the
aggregate supply such that it increases. Technology primarily affects
---------------------- capital, land and labour in the sense that the proportions in which these
resources will be used in production, will eventually determine the type
----------------------
of technology used in an economy.
----------------------
----------------------
38 Macroeconomics
●● ducation: Increasing information, knowledge, awareness and
E Notes
transference of technical and personnel skills. Increasing know-how
and skills help in increasing aggregate supply. Education is especially ----------------------
important for skilled labour.
----------------------
Resource quality generally increases with time. However, in certain
circumstances, it can regress as well, for example, supply-side policy changes. ----------------------
Short-Run Supply ----------------------
The short-run aggregate supply (SRAS) curve is related to the price level
----------------------
while this relation depends on production cost.
●● An increase in production cost decreases aggregate supply and shifts the ----------------------
SRAS leftward/downward.
----------------------
●● A decrease in production cost increases aggregate supply and shifts the
SRAS rightward/upward. ----------------------
Determinants to production cost changes: ----------------------
●● ages: Wages shift the SRAS from adjustments in workers’ perceptions
W
----------------------
of the current price level and expectations about future prices.
●● Material cost: Key economy-wide resources, such as oil, can cause the ----------------------
SRAS to shift through big changes in price.
----------------------
2.8 SELF-CORRECTION ----------------------
The aggregate market has self-correcting mechanisms that ensures that ----------------------
the long- run full-employment equilibrium will be achieved by itself without
government policies. However, ----------------------
●● Long run means full employment and flexible prices. ----------------------

●● Short run means price rigidity without full employment. ----------------------
●● This dichotomy gives rise to a dilemma.
----------------------
The automatic and self-correcting solution to this problem is disequilibrium
in the labour market exerts pressure on wages to correct the imbalance, even ----------------------
with wage rigidity. This automatically moves the economy from the short run to
the long run and full-employment equilibrium. However, the important question ----------------------
here is that how long does the self-correcting mechanism take? ----------------------
Policies
----------------------
Government can use supply-side management policies to shift the
aggregate supply curves. Supply-side policies have been less popular among ----------------------
politicians because they tend to be slower than demand-side management
policies. Politicians tend to prefer faster demand-side policies when looking to ----------------------
replace the slower paced automatic mechanism. ----------------------
----------------------
----------------------

Notes Supply-side management policies include:
●● Business deregulation to reduce production cost.
----------------------
●● Tax policies that stimulate capital investment.
---------------------- ●● Technology and education that increase capital and labour quality.
----------------------
----------------------
Fill in the blanks.
----------------------
1. __________ and __________ are the ways to improve resource
---------------------- quality.
---------------------- 2. Production cost changes mainly due to _________ and ___________
factors.
----------------------
---------------------- Activity 4
----------------------
Using the Internet as your resource, study the factors that affect the supply
---------------------- of labour force in a given market.
----------------------
---------------------- Summary
---------------------- ●● ggregate demand represents expenditures made by all members of all
A
sectors of our economy.
----------------------
●● ggregate demand is one side of the aggregate market (the AD-AS model)
A
---------------------- that is used to analyse national economic problems, such as recessions,
unemployment and inflation that might plague our economy.
----------------------
●● Aggregate demand and the aggregate market are related to the circular
---------------------- flow model of the economy.
●● he four expenditures that make up aggregate demand are consumption,
T
----------------------
investment, government purchases, and net export expenditures.
---------------------- ●● Consumption expenditures are made by households on services, durable
goods and non-durable goods.
----------------------
●● I nvestment expenditures are made by firms or business establishments on
---------------------- inventories, equipment and other fixed assets.
---------------------- ●● nly government purchases of final goods and services are eligible as
O
expenses for aggregate demand.
---------------------- ●● Net exports mean exports minus imports. Net exports represent the net
---------------------- expenditures of the foreign sector on domestically produced goods and
services for final consumption.
---------------------- ●● he AD curve shows the negative relationship between the price level
T
---------------------- and real GDP.
40 Macroeconomics
●● he AD curve slopes negatively because of the real-balance effect, the
T Notes
interest rate effect and the net export effect.
●● he real-balance effect means that a higher (or lower) price level reduces
T ----------------------
(or increases) the purchasing power of money, resulting in less (or more) ----------------------
real production purchased.
●● he interest rate effect means that a higher (or lower) price level leads
T ----------------------
to higher (or lower) interest rates and thus a higher (or lower) cost of ----------------------
borrowing, which decreases (or increases) consumption and investment
expenditures on real production. ----------------------
●● he net export effect means that a higher (or lower) price level decreases
T ----------------------
(or increases) exports and increases (or decreases) imports thus decreasing
(or increasing) net export expenditures on real production. ----------------------
●● he cause of economic instability stems from the four sectors in the
T
----------------------
economy.
●● The nature of aggregate demand determinants that are initially assumed ----------------------
as constant are not measured explicitly on the AD graph.
----------------------
●● n increase (or decrease) in aggregate demand is characterised as a shift
A
to the right (or left) and this increase (or decrease) represents an increase ----------------------
(or decrease) in aggregate expenditures over a range of price levels.
----------------------
●● hifts in the aggregate demand curve is a source of macroeconomic
S
(business cycle) instability. ----------------------
●● he two basic types of macroeconomic problems associated with business
T ----------------------
cycles are recessions (with unemployment) and booming expansions
(with inflation). ----------------------
●● ggregate demand instability can be controlled through demand
A ----------------------
management policies, including fiscal and monetary policies.
●● ggregate supply is half the aspect of the aggregate market (the AD/AS
A ----------------------
model) that can be used to analyse macroeconomic problems, such as ----------------------
recessions, unemployment and inflation.
●● ggregate supply is the measure of real output of goods and services
A ----------------------
produced from factors of production in the domestic economy. ----------------------
●● The general price level in the economy affects the supply of aggregate
real production. ----------------------
●● he long-run and the short-run aggregate supply are different with respect
T ----------------------
to price flexibility and full employment.
----------------------
●● I n the long run, all prices are flexible. The economy is in full employment
and the product, financial and resource markets are all in equilibrium ----------------------
respectively.
----------------------
●● I n the long run, the aggregate supply adjusts to more (or less) demand
for aggregate production to maintain full employment at a range of price ----------------------
levels.
----------------------

Notes ●● he vertical long-run aggregate supply curve graphically illustrates that
T
the price level has no affect on the full employment level of aggregate
---------------------- supply in the long run.
---------------------- ●● he positively sloped short-run aggregate supply curve graphically
T
illustrates that the price level does affect aggregate supply in the long run.
---------------------- ●● I t is possible to change short-run production (above or below full
---------------------- employment) if the price level changes.
●● here are similarities and differences between aggregate supply and
T
---------------------- market supply.
---------------------- ●● ggregate supply determinants shift the LRAS and SRAS curves, with
A
an increase in aggregate supply moving rightward and a decrease moving
---------------------- leftward.
---------------------- ●● he aggregate supply and aggregate demand curves shift due to specific
T
determinants and this helps us analyse the macro economy.
----------------------
---------------------- Keywords
---------------------- ●● ggregate demand: The aggregate or total expenditure on final goods
A
and services produced in the domestic economy, at a range of price levels,
---------------------- during a given time period (usually a fiscal year).
---------------------- ●● ggregate expenditures: The total expenditures on gross domestic
A
product (GDP) undertaken in a given time period.
----------------------
●● Durable goods: Goods lasting more than a year.
---------------------- ●● eal-balance effect: A change in the price level alters the value of
R
aggregate expenditures on real production because the purchasing power
----------------------
of money has changed.
---------------------- ●● ggregate supply: The sum or aggregate production of all final goods
A
and services produced in the domestic economy, given a range of price
---------------------- levels, during a given time period (usually one year or a fiscal year).
----------------------
----------------------
1. What are the major resources in an economic activity and what are its
----------------------
characteristics?
---------------------- 2. What is the general consumption pattern of an individual?
---------------------- 3. Critically examine the provisions in the latest annual budget regarding
imports and exports.
----------------------
4. Write in detail the constituents of aggregate expenditure.
----------------------
5. What are the important factors responsible for the negative slope of an
---------------------- aggregate demand curve?
----------------------
42 Macroeconomics
6. Why is equilibrium in the labour market important and what are the causes Notes
for it?
----------------------
7. Explain how level of employment depends on production activity.
----------------------
----------------------
----------------------
Fill in the blanks.
----------------------
1. Aggregate demand is the aggregate or total expenditure on final goods
and services produced in the domestic economy, during one fiscal year ----------------------
(period).
----------------------
2. Aggregate expenditures are the total expenditures on gross domestic
product undertaken in a given time period. ----------------------
3. Government spending excludes government spending on transfer ----------------------
payments.
4. Net exports represent the net expenditures of the foreign sector on ----------------------
domestically produced goods and services for final consumption. ----------------------
----------------------
----------------------
Fill in the blanks.
1. Recession and expansion are the effects of business-cycle instability. ----------------------
2. Government use of purchases and taxes to affect aggregate demand is ----------------------
termed as fiscal policy.
----------------------
----------------------
Fill in the blanks. ----------------------
1. Technology and education are the ways to improve resource quality. ----------------------
2. Production cost changes mainly due to wages and material factors. ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
Suggested Reading
----------------------
---------------------- 2. http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=Keynesi
an+cross
----------------------
----------------------
---------------------- keynesian-cross-and-the-multiplier
---------------------- 5. http://njsanders.people.wm.edu/101/Ch10_11_Handout.pdf
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
44 Macroeconomics
Aggregate Markets and Shocks
UNIT
3
Structure:
3.1 Introduction
3.2 Instability
3.3 Fluctuations
3.4 Self-Correction
3.5 Basic Shifts
3.6 Complex Shifts
3.7 SRAS Curve
3.8 Synthesis of Business Cycles
Summary
Keywords
Suggested Reading
Aggregate Markets and Shocks 45

Notes
Objectives
----------------------
----------------------
●● Discuss the importance of aggregate demand, supply, the price level,
---------------------- real production, unemployment and inflation
---------------------- ●● nalyse how short-term equilibrium is reached in the period of
A
instability
---------------------- ●● ompare the propensity of the market to adjust to long- run
C
---------------------- equilibrium from short-run equilibrium
----------------------
3.1 INTRODUCTION
----------------------
In this Unit, you will learn about the workings of the aggregate market,
----------------------
which is a combination of the aggregate demand curve and the two (long and
---------------------- short run) aggregate supply curves. The main focus is on how the aggregate market
achieves equilibrium in the long and short runs. A vital conclusion is that the
---------------------- short-run equilibrium does not necessarily correspond to the full-employment
production achieved by the long-run equilibrium. This gap creates recessionary
----------------------
and inflation gaps, which correspond to the macroeconomic problems of
---------------------- unemployment and inflation.
We are making the following assumptions on the workings of the
----------------------
aggregate market:
---------------------- ●● he aggregate market aids in analysing the macro economy and its
T
adjustments towards equilibrium.
----------------------
●● ggregate market adjustments are important to the discrepancy between
A
---------------------- short-run equilibrium and long-run equilibrium.
---------------------- ●● he aggregate market curves (AD, LRAS and SRAS) are constructed
T
assuming other determinants at ceteris paribus (other things remaining
---------------------- constant).
---------------------- ●● Ceteris paribus determinants are the source of business cycle fluctuations.
●● That is, they are deviations from the long run full employment growth
---------------------- trend of the economy.
---------------------- ●● hifts of the AD, LRAS and SRAS curves are induced by different
S
determinants.
----------------------
●● eal-world situations − a rise in physical wealth, altering monetary policies,
R
---------------------- technological advancements, wage rate changes – all create volatility in
the macro economy.
----------------------
●● he self-correcting mechanism works through wage rate changes and the
T
---------------------- labour market to re-establish the long-run equilibrium.
●● I ncreases in aggregate demand in the long-run affect only the price level
----------------------
and not the real production which remains at full employment.
46 Macroeconomics
●● I ncreases in aggregate demand in the short run affect both the price level Notes
and the level of real production, which may be below or above the full
employment level. ----------------------
●● he self-correcting mechanism shifts the aggregate market from short-
T ----------------------
run equilibrium to long-run equilibrium.
●● he analysis of the shifts of the AD and SRAS curves are more intricate
T ----------------------
when we include self-correcting shifts of the SRAS. ----------------------
●● he two adjustment stages that are set off by shifts of the AD curve
T
are: one, the shift of the AD curve and two, the self-correcting shift of the ----------------------
SRAS curve. ----------------------
●● he two adjustment stages that are set off by shifts of the SRAS curve
T
are: one, the shift of the SRAS curve and two, the self-correcting shift of the ----------------------
SRAS curve that makes the aggregate market come back to its original
----------------------
position.
●● he aggregate market can be used to show a simple business cycle that
T ----------------------
is caused by consumption expenditures on durable goods and assets.
----------------------
We will first consider the basics of the aggregate market, including the
importance of aggregate demand, aggregate supply, the price level, real ----------------------
production, unemployment and inflation. We will then assess the concept of
----------------------
equilibrium and see how it relates to the aggregate market in both the short run
and the long run. ----------------------
Then, we will examine the short and long-run equilibrium by combining
----------------------
the aggregate demand, short-run aggregate supply and long-run aggregate
supply curves. ----------------------
Next, we shall look into self-correction as an aggregate market ----------------------
equilibrium mechanism, especially how automatic shifts of the short-run
aggregate supply curve can eliminate recessionary and inflationary gaps. ----------------------
Lastly, we will learn about the use of the aggregate market to analyse ----------------------
business cycle stabilisation policies, highlighting on the time period for
adjustment. ----------------------
Now let us analyse each of the following component and see how the ----------------------
aggregate market achieves equilibrium in the long and short runs.
----------------------
i. Instability
ii. Fluctuations ----------------------
iii. Self-Correction
----------------------
iv. Basic Shifts
v. Complex Shifts ----------------------
vi. SRAS Curve ----------------------
vii. Synthesis of Business Cycles
----------------------
----------------------

Notes 3.2 INSTABILITY
---------------------- The aggregate market is a useful analysis for the study of the macro economy
and its adjustments. The aggregate market has a tendency towards equilibrium.
----------------------
Short-run equilibrium involves the following:
---------------------- ●● Intersection of AD and SRAS curves.
---------------------- ●● Expenditures on real output match production.
---------------------- ●● The labour market is prone to be out of equilibrium.

●● Long-run equilibrium is characterised by:
----------------------
●● Intersection of AD and LRAS curves.
---------------------- ●● Expenditures on real output match production.
---------------------- ●● The labour market tends to be in equilibrium.
Real-world changes can be analysed by examining how the aggregate
----------------------
markets adjust towards equilibrium.
---------------------- To inspect aggregate market adjustments we need to make use of the
ceteris paribus concept.
----------------------
●● he aggregate market curves, that is, AD, LRAS and SRAS, are put up or
T
---------------------- created assuming other things remain unchanged.
---------------------- ●● he determinants of each curve, initially assumed constant, do not really
T
stay unchanged while they cause changes in the aggregate market.
----------------------
●● The purpose of this aggregate market analysis is to help us to understand why
---------------------- the macro economy tends to be volatile and prone to face business cycles.
---------------------- 3.3 FLUCTUATIONS

---------------------- In this section, we will learn what business cycle fluctuations are made
---------------------- of and what they imply.
The following observations can be made for fluctuation characteristics in
---------------------- business cycles:
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
---------------------- ●● The real GDP path the economy would take with long-run equilibrium
at full employment. This is represented by the straight, green upward-
----------------------
sloping line.
48 Macroeconomics
●● he actual real GDP path is the uneven red line. This line has a tendency
T Notes
to be less smooth.
●● he business cycle is the movement above and below the long-run trend
T ----------------------
(the green, straight, upward-sloping line). ----------------------
●● hen the actual real GDP is below the long-run equilibrium line, there
W
is unemployment in the economy. ----------------------
●● hen the actual real GDP is above the long-run equilibrium line, we face
W ----------------------
inflation in the economy.
----------------------
●● eteris paribus factors are what generate variation (fluctuations and
C
hence, instability) from the long-run trend. ----------------------
●● Aggregate demand determinants are the main cause of this fluctuation.
----------------------
----------------------
There are four specific real-world circumstances that lead to the
analysis of economic volatility. They are: ----------------------
●● I ncreasing demand for physical wealth and tangible assets (especially ----------------------
consumer durable goods and capital investment) affects aggregate demand.
●● hanges in monetary policies that alter interest rates may affect aggregate
C ----------------------
expenditures on durable goods and capital.
----------------------
●● Improvements in technology may positively modify the long-run and
short- run aggregate supply. ----------------------
●● ny change in wage rates and costs of production will affect the short-run
A ----------------------
aggregate supply.
----------------------
Multiple Choice Multiple Response. ----------------------
1. Short-run equilibrium involves the following: ----------------------
i. Intersection of AD and SRAS curves
----------------------
ii. Volume of total production and distribution
----------------------
iii. Expenditures on real output match production
iv. The labour market is prone to be out of equilibrium ----------------------
Multiple Choice Single Response. ----------------------
1. When the actual real GDP is below the long-run equilibrium line, ----------------------
there is:
i. Full employment ----------------------
ii. Underemployment ----------------------

iii. Unemployment in the economy ----------------------
----------------------

Notes
Activity 1
----------------------
---------------------- Identify the four specific real-world circumstances that led to the analysis
of economic volatility after studying the sub-prime crisis of 2008
----------------------
---------------------- 3.4 SELF-CORRECTION

----------------------
The aggregate market has a propensity to adjust from short-run
---------------------- equilibrium to long-run equilibrium.
●● The aggregate market self-correction mechanism depends squarely on
----------------------
wages, which is the key production cost determinant.
---------------------- ●● hort-run labour market disparities encourage wage rate alterations that
S
tend to shift the aggregate market to long-run equilibrium.
----------------------
A recessionary gap means that unemployment has caused wages and
---------------------- production costs to move downwards along with an increase in the short-run
aggregate supply.
----------------------
An inflationary gap means that the labour market imbalances have increased
---------------------- wage rates and production costs, thereby decreasing the short-run aggregate
supply.
----------------------
Long-run equilibrium will be restored in either case. However, as we
---------------------- know by now, that will be a matter of time.
----------------------
3.5 BASIC SHIFTS
----------------------
AD Shifts
----------------------
There are two ways in which the aggregate demand curve can shift. They
---------------------- are:
---------------------- ●● n increase in aggregate demand brings about a rightward shift of the AD

A
curve.
---------------------- ●● decrease in aggregate demand brings about a leftward shift of the AD
A
curve.
----------------------
The AD curve shifts in two cases of the aggregate market: long run and
---------------------- short run. This means that we can have four cases in terms of the shifting of
an AD curve:
----------------------
●● A rightward shift or increase in the long-run aggregate market.
----------------------
●● A leftward shift or decrease in the long-run aggregate market.
---------------------- ●● A rightward shift or increase in the short-run aggregate market.
---------------------- ●● A leftward shift or decrease in the short-run aggregate market.
----------------------
50 Macroeconomics
AD Increase: Long Run Notes
The long-run equilibrium is given by the intersection of the negatively
----------------------
sloped AD curve and the vertical LRAS.
●● n increase in AD results in a new long-run equilibrium towards the right
A ----------------------
of the original equilibrium point.
----------------------
●● t the new equilibrium, real production does not change, it stays at Qf.
A
The price level increases from Po to P1. ----------------------
●● e cannot capture lot of “short-run” changes or effects that occurs as we go
W ----------------------
from one long-run equilibrium to another.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
The long-run equilibrium is given by the intersection of the negatively sloped
AD curve and the vertical LRAS. ----------------------
●● decrease in AD results in a new long-run equilibrium towards the left of

A ----------------------
the original equilibrium point.
----------------------
●● At the new equilibrium, real production does not change but stays at Qf.
The price level decreases from Po to P2. ----------------------
●● gain, we cannot capture lot of “short-run” changes or effects that occurs
A ----------------------
as we go from one long-run equilibrium to another.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
AD Increase: Short Run ----------------------

The short-run equilibrium is given by the intersection of the negatively ----------------------
sloped AD curve and the positively sloped SRAS.
----------------------
●● n increase in AD results in a new short-run equilibrium, rightwards from
A
the original equilibrium point. ----------------------

Notes ●● t the new equilibrium point, real production and the price levels, both
A
rise.
---------------------- ●● Real production can increase above full employment in the short run.
---------------------- ●● his shift gives us a transitional point from one long-run equilibrium to
T
another.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
---------------------- AD Decrease: Short Run

---------------------- The short-run equilibrium is given by the intersection of the negatively
sloped AD curve and the positively sloped SRAS.
----------------------
●● decrease in AD results in a new short-run equilibrium, leftwards from
A
---------------------- the original equilibrium point.
---------------------- ●● At the new equilibrium point, real production and the price level, both fall.
●● Real production can decrease below full employment in the short run.
----------------------
●● his shift gives us a transitional point from one long-run equilibrium to
T
---------------------- another.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
52 Macroeconomics
Notes
----------------------
Fill in the blanks.
----------------------
1. A recessionary gap means that unemployment has caused
___________and _____________ costs to move downwards along ----------------------
with an increase in the short-run aggregate supply.
----------------------
2. An inflationary gap means that the _____________ market
imbalances have increased wage rates and production costs, thereby ----------------------
decreasing the short-run aggregate supply.
----------------------
----------------------
----------------------
3.6 COMPLEX SHIFTS
----------------------
AD
----------------------
The AD-curve-induced aggregate market adjustment from one equilibrium
to another is more complex when we include the self-correction mechanism ----------------------
from the short run to the long run.
----------------------
There can be two alternatives in such a situation:
●● Increase in aggregate demand. ----------------------
●● Decrease in aggregate demand. ----------------------
The complex adjustment is a two-step process.
----------------------
1. The AD curve shifts, which leads to a short-run equilibrium and moves the
aggregate market away from the long-run equilibrium. ----------------------
2. Wages adjust to achieve equilibrium in the labour market. This eventually ----------------------
changes production costs, shifts the SRAS and restores long-run
equilibrium. ----------------------
AD Increase ----------------------
The following is the case of an increase in the AD curve. Let’s start at ----------------------
long-run equilibrium. All three curves, AD, LRAS and SRAS, intersect at the
same long- run equilibrium values, Po and Qf. ----------------------
●● With a rightward shift of the AD curve, the aggregate market achieves short- ----------------------
run equilibrium at a higher price level and more real production.
----------------------
●● he labour market imbalance causes wages and production cost to rise.
T
The SRAS shifts leftward. It stops shifting when it intersects the new ----------------------
AD and the original LRAS curves for a new long-run equilibrium. The
price level is even higher and real production returns to full employment. ----------------------
----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
---------------------- AD Decrease
---------------------- In case of a decrease in the AD curve, let us consider the long-run
equilibrium: AD, LRAS and SRAS intersect at the same long-run equilibrium
---------------------- values, Po and Qf.
---------------------- ●● decrease or leftward shift of the AD curve means that the aggregate
A
market attains the short-run equilibrium at a lower price level and lower
---------------------- real production level.
---------------------- ●● he labour market disequilibrium causes wage rates and production costs
T
to fall. The SRAS increases or shifts rightward. It will stop shifting when
---------------------- it intersects the new AD and the original LRAS curves for a new long-run
equilibrium. The price level ends up being even lower than before and real
----------------------
production returns back to full employment.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
3.7 SRAS CURVE
----------------------
---------------------- The shifting of the SRAS curve that moves the aggregate market further
away from the long-run equilibrium is also the trigger for the self-correcting
---------------------- mechanism that moves it back towards equilibrium, again.
---------------------- ●● he original shift of the SRAS curve is caused by any of the determinants
T
at ceteris paribus.
---------------------- ●● he self-correcting shift of the SRAS curve is caused by wage rate changes
T
---------------------- that are triggered by disequilibrium in the labour market.
54 Macroeconomics
Once again, we have two outcomes: Notes
●● Short-run aggregate supply curve moves rightwards or increases.
----------------------
●● Short-run aggregate supply moves leftwards or decreases.
SRAS Increase ----------------------
The following is the case of an increase in the SRAS curve. Let’s start at ----------------------
long-run equilibrium, Po and Qf.
----------------------
●● ith a rightward shift of the SRAS curve, the aggregate market achieves
W
short-run equilibrium at a lower price level and more real production. ----------------------
●● The labour market disequilibrium causes wages and production costs to ----------------------
rise. The SRAS shifts leftward, returning to its original position. The price
level and real production return to full-employment levels. ----------------------
From one long run position to another, nothing has changed. However, ----------------------
before the long-run adjustment, we have more production at lower prices.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
SRAS Decrease
----------------------
The following is the case of a decrease in the SRAS curve. Again, we
begin by looking at the long-run equilibrium, Po and Qf. ----------------------
●● ith a leftward shift or a decrease of the SRAS curve, the aggregate market
W ----------------------
achieves short-run equilibrium at a higher price level and with lesser real
production, as compared to the original equilibrium point. ----------------------
●● he labour market disequilibrium results in wage rates and production
T ----------------------
costs to fall. The SRAS shifts rightward or increases, thereby, returning to
its original position. The price level and real production or output returns ----------------------
to full-employment levels.
----------------------
From one long-run position to another, nothing has changed. However,
before the long-run adjustment, we have less production at higher prices. ----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
3.8 SYNTHESIS OF BUSINESS CYCLES
----------------------
To demonstrate a business cycle, let us first look at the long-run full-
---------------------- employment equilibrium.
---------------------- 1. With an expansion in the economy, aggregate demand/output has increased
and hence consumers have accumulated durable goods and assets.
----------------------
2. This gradually decreases consumption spending and aggregate demand
---------------------- over a period of time resulting in a decrease of the AD curve which now
shifts leftwards. The economy is in recession.
----------------------
3. Before the SRAS curve automatically shifts to restore full employment,
---------------------- consumers start spending again on durable goods and assets so that the AD
curve shifts rightward. The economy is recovering at this point.
----------------------
4. The AD curve does not stop at full employment. With expansion,
---------------------- the economy is possibly inflated. However, the accumulation of durable
goods and assets results in a decrease in aggregate demand again and hence,
---------------------- another recession.
---------------------- The above process continues with time.
---------------------- Note: You can begin with any of the possible equilibrium situations for the above
analysis; you will realise that the analysis yields a cyclical pattern and the process
---------------------- continues in a fixed sequence, no matter where you decide to start examining
it from.
----------------------
---------------------- Summary
---------------------- ●● ggregate market is a combination of the aggregate demand curve and the
A
two (long and short run) aggregate supply curves.
----------------------
●● hort-run equilibrium does not necessarily correspond to the full-employment
S
---------------------- production achieved by the long-run equilibrium. This gap creates
recessionary and inflation gaps, which correspond to the macroeconomic
---------------------- problems of unemployment and inflation.
----------------------
56 Macroeconomics
●● eal-world changes can be analysed by examining how the aggregate
R Notes
markets adjust towards gaps.
●● I ncreasing demand for physical wealth and tangible assets (especially ----------------------
consumer durable goods and capital investment) affects aggregate demand. ----------------------
●● recessionary gap means that unemployment has caused wages and
A
production costs to move downwards along with an increase in the short- ----------------------
run aggregate supply. ----------------------
●● An inflationary gap means that the labour market imbalances have
increased wage rates and production costs, thereby decreasing the short- ----------------------
●● The labour market disequilibrium results in wage rates and production
costs to fall. ----------------------
●● ith an expansion in the economy, aggregate demand/output has increased
W ----------------------
and hence, consumers have accumulated durable goods and assets.
----------------------
●● his gradually decreases consumption spending and aggregate demand
T
over a period of time resulting in a decrease of the AD curve, which now ----------------------
shifts leftwards. The economy is in recession.
----------------------
Keywords ----------------------
●● ecessionary gap: It means unemployment has caused wages and
R ----------------------
production costs to move downwards along with an increase in the short-
●● I nflationary gap: It means that the labour market imbalances have ----------------------
increased wage rates and production costs, thereby decreasing the short-
----------------------
----------------------
1. What is the basic assumption while constructing the aggregate market
curves AD, LRAS and SRAS? ----------------------
2. Write down the important causes that affect the aggregate market demand ----------------------
and explain how equilibrium in the short run is reached.
----------------------
3. Write the various measures introduced by RBI in the current monetary
policy and alteration in interest rates. ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes Answers to Check your Progress
---------------------- Multiple Choice Multiple Response.

1. Short-run equilibrium involves the following:
----------------------
i. Intersection of AD and SRAS curves
----------------------
iii. Expenditures on real output match production
---------------------- iv. The labour market is prone to be out of equilibrium
---------------------- Multiple Choice Single Response.
---------------------- 1. When the actual real GDP is below the long-run equilibrium line, there is:
iii. Unemployment in the economy
----------------------
----------------------
---------------------- 1. A recessionary gap means that unemployment has caused wages and
production costs to move downwards along with an increase in the short-
---------------------- run aggregate supply.
---------------------- 2. An inflationary gap means that the labour market imbalances have
increased wage rates and production costs, thereby decreasing the short-
---------------------- run aggregate supply.
----------------------
Suggested Reading
----------------------
----------------------
2. http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=Keynesi
---------------------- an+cross
---------------------- 3. http://www.econ.ucla.edu/workingpapers/wp383.pdf
---------------------- 4. http://www.khanacademy.org/finance-economics/macroeconomics/v/
keynesian-cross-and-the-multiplier
----------------------
5. http://njsanders.people.wm.edu/101/Ch10_11_Handout.pdf
---------------------- 6. www.jurgilas.net/fpdb/Econ%20219%20Spr05/03-02-2005.pdf
----------------------
----------------------
----------------------
----------------------
----------------------
58 Macroeconomics
Unemployment and Business Cycles
UNIT
4
Structure:
4.1 Introduction
4.2 Theories of Unemployment
4.3 Business Cycles
4.4 Phases of Business Cycle
4.4.1 Important Features of the Phases of Business Cycle
4.5 Ways and Means to control Business Cycles/Fluctuations and
Unemployment
4.6 Economic Policies to achieve Economic Stability
Summary
Keywords
Suggested Reading
Unemployment and Business Cycles 59

Notes
Objectives
----------------------
----------------------
●● Describe unemployment
---------------------- ●● Analyse the different theories of unemployment
---------------------- ●● Discuss business cycles
---------------------- ●● Analyse the impact of business cycles
●● ppraise the ways and means to control business cycles/fluctuations
A
---------------------- and unemployment
----------------------
4.1 INTRODUCTION
----------------------
Unemployment (or joblessness) occurs when people are without
----------------------
work and actively seeking work. The unemployment rate is a measure of the
---------------------- prevalence of unemployment and it is calculated as a percentage by dividing
the number of unemployed individuals by all individuals currently in the
---------------------- labour force. During periods of recession, an economy usually experiences a
relatively high unemployment rate.
----------------------
In a 2011, Business Week reported, “More than 200 million people globally
---------------------- are out of work, a record high, as almost two-thirds of advanced economies
and half of developing countries are experiencing a slowdown in employment
----------------------
growth.”
----------------------
4.2 THEORIES OF UNEMPLOYMENT
----------------------
Economics of employment and income and monetary economics are
----------------------
the major fields of macroeconomics, which have utmost practical relevance.
---------------------- Planning and policy making is not possible without the understanding of these
two fields.
----------------------
Economists distinguish between various overlapping theories of
---------------------- unemployment including:
1. Cyclical or Keynesian unemployment
----------------------
2. Frictional unemployment
----------------------
3. Structural unemployment
---------------------- 4. Classical unemployment
---------------------- Cyclical or Keynesian unemployment, also known as deficient-
demand unemployment, occurs when there is not enough aggregate demand in
----------------------
the economy to provide jobs for everyone who wants to work. Demand for
---------------------- most goods and services falls, less production is needed and consequently
fewer workers are needed, wages are sticky and do not fall to meet the
----------------------
60 Macroeconomics
equilibrium level, and mass unemployment results. The Keynesian Theory Notes
of Employment and Output Determination was presented in the famous
work of Lord J.M. Keynes’ The General Theory of Employment, Interest ----------------------
and Money in 1936. The Keynesian Theory is basically a criticism against the
classical analysis and classical belief in the automatic adjustments in a capitalist ----------------------
economy leading to full employment. The Keynesian Theory is an outcome of the ----------------------
depression and was basically a critique of the classical analysis. It provided an
alternative approach to the problem of employment and output determination in ----------------------
an economy, and was more realistic because it did not accept the classical belief
in full employment. Keynes believed that full employment is not the general case ----------------------
but a rare occurrence and that deliberate government intervention is required to ----------------------
achieve full employment in an economy. Keynesian economics emphasises the
cyclical nature of unemployment and recommends interventions it claims will ----------------------
reduce unemployment during recessions. This Theory focuses on recurrent shocks
that suddenly reduce aggregate demand for goods and services and thus reduce ----------------------
demand for workers. Keynesian models recommend government interventions ----------------------
designed to increase demand for workers; these can include financial stimuli,
publicly funded job creation and expansionist monetary policies. ----------------------
Frictional unemployment is the time period between jobs when a ----------------------
worker is searching for, or transitioning from one job to another. It is sometimes
called search unemployment and can be voluntary based on the circumstances ----------------------
of the unemployed individual.
----------------------
Frictional unemployment exists because both jobs and workers are
heterogeneous, and a mismatch can result between the characteristics of supply ----------------------
and demand. Such a mismatch can be related to skills, payment, work time,
----------------------
location, attitude, taste and a multitude of other factors. New entrants (such as
graduating students) and re-entrants (such as former homemakers) can also suffer ----------------------
a spell of frictional unemployment. Workers as well as employers accept a certain
level of imperfection, risk or compromise, but usually not right away; they will ----------------------
invest some time and effort to find a better match. This is in fact beneficial
----------------------
to the economy since it results in better allocation of resources. However, if the
search takes too long and mismatches are too frequent, the economy suffers, since ----------------------
some work will not get done. Therefore, governments will seek ways to reduce
unnecessary frictional unemployment. Frictional unemployment is related to and ----------------------
compatible with the concept of full employment because both suggest reasons
----------------------
why full employment is never reached. Frictional unemployment is always
present in an economy, so the level of involuntary unemployment is properly ----------------------
the unemployment rate minus the rate of frictional unemployment, which means
that increases or decreases in unemployment are normally under-represented in ----------------------
the simple statistics. Frictional unemployment coincides with an equal number
----------------------
of vacancies. Numerically, it is therefore maximal when the labour market is
in equilibrium. When, for instance, demand far exceeds supply, the frictionally ----------------------
unemployed will be few as they will get many job offers.
----------------------
Structural unemployment is a form of unemployment resulting from a
mismatch between demand in the labour market and the skills and locations of ----------------------

Notes the workers seeking employment. Even though the number of vacancies may
be equal to, or greater than the number of the unemployed, the unemployed
---------------------- workers may lack the skills needed for the jobs, or they may not live in the part
of the country or world where the jobs are available. Structural unemployment
---------------------- is a result of the dynamics of the labour market, such as agricultural workers
---------------------- being displaced by mechanised agriculture, unskilled labourers displaced by
both mechanisation and automation or industries with declining employment.
---------------------- Many of these displaced workers are “left behind” due to costs of training and
moving (e.g., the cost of selling one’s house in a depressed local economy),
---------------------- inefficiencies in the labour markets, such as discrimination or monopoly power,
---------------------- or because they are not suitable for work in growing sectors, such as health care
or high technology.
----------------------
Classical or real-wage unemployment occurs when real wages for a job
---------------------- are set above the market-clearing level, causing the number of job seekers to
exceed the number of vacancies.
----------------------
Many economists have argued that unemployment increases the more
---------------------- the government intervenes into the economy to try to improve the conditions of
those without jobs. Minimum wage laws, for example, raise the cost of labourers
---------------------- with few skills to above the market equilibrium, resulting in people who wish
to work at the going rate but cannot as wage enforced is greater than their value
----------------------
as workers becoming unemployed. Laws restricting layoffs made businesses
---------------------- less likely to hire in the first place, as hiring becomes more risky, leaving many
young people unemployed and unable to find work.
----------------------
---------------------- 1. ____________ occurs when real wages for a job are set above the
market-clearing level, causing the number of job seekers to exceed
---------------------- the number of vacancies.
---------------------- 2. _____________ is a form of unemployment resulting from a mismatch
between demand in the labour market and the skills and locations of
---------------------- the workers seeking employment.
---------------------- 3. _____________ is the time period between jobs when a worker is
searching for, or transitioning from one job to another.
----------------------
4. ___________ is also known as deficient-demand unemployment.
----------------------
----------------------
----------------------
----------------------
----------------------
62 Macroeconomics
Notes
Activity 1
----------------------
A poor man of low means strives hard to make ends meet. He lives in a ----------------------
very shoddy locality; owes a lot of money to creditors and cannot send his
children to school. He is basically living below the poverty line. He wants ----------------------
to come out of his pathetic condition by looking out for more and better
----------------------
jobs (he is willing to put in more number of hours as well). He wants his
income to grow and improve his living conditions on the whole. Where ----------------------
does this example fit in the macroeconomic study?
----------------------
----------------------
4.3 BUSINESS CYCLES
----------------------
Business fluctuations are booms and slumps in the economic activities
essentially from the economic environment of a country. They influence business ----------------------
decisions tremendously and set the trend of the future business. The period of
prosperity opens up new and larger opportunities for investment, employment and ----------------------
production, and thereby promotes business. ----------------------
On the contrary, the period of depression reduces business opportunities.
A profit- maximising entrepreneur must therefore analyse the economic ----------------------
environment of the period relevant for his important business decisions, ----------------------
particularly those pertaining to forward planning.
----------------------
The term “trade cycle” in economics refers to the wave-like fluctuations in ----------------------
the aggregate economic activity, particularly in employment, output and income.
----------------------
In other words, trade cycles are ups and downs in economic activity. A trade
cycle is defined in various ways by different economists. Wesley C. Mitchell, ----------------------
for instance, defined trade cycle as “a fluctuation in aggregate economic
activity”. According to Gottfried Haberler, “The business cycle in the general ----------------------
sense may be defined as an alternation of periods of prosperity and depression,
----------------------
of good and bad trade.”
The following features of a trade cycle are worth noting: ----------------------
1. A trade cycle is a wave-like movement. ----------------------
2. Cyclical fluctuations are recurrent in nature. ----------------------
3. Expansion and contraction in a trade cycle are cumulative in effect.
----------------------
4. Trade cycles are all-pervading in their impact.
----------------------
5. A trade cycle is characterised by the presence of crisis, i.e., the peak and the
trough are not symmetrical, that is to say, the downward movement is more ----------------------
sudden and violent than the change from downward to upward.
----------------------
6. Though cycles differ in timing and amplitude, they have a common pattern
of phases which are sequential in nature. ----------------------

Notes Keynes, points out that “a trade cycle is composed of periods of good
trade characterised by rising prices and low unemployment, altering with periods
---------------------- of bad trade characterised by falling prices and high unemployment.” Keynes,
thus, stresses two indices, namely, prices and unemployment, for measuring the
---------------------- upswing and downswing of the business cycles.
----------------------
4.4 PHASES OF BUSINESS CYCLE
----------------------
The ups and downs in the economy are reflected by the fluctuations in
---------------------- aggregate economic magnitudes, such as production, investment, employment,
---------------------- prices, wages, bank credits, etc. The upward and downward movements in these
magnitudes show different phases of a business cycle. Basically there are only
---------------------- two phases in a cycle, viz., prosperity and depression. However, considering
the intermediate stages between prosperity and depression, the various phases
---------------------- of trade cycle may be enumerated as follows:
---------------------- 1. Expansion
---------------------- 2. Peak
3. Recession
----------------------
4. Trough
----------------------
5. Recovery and expansion
---------------------- The five phases of a business cycle have been presented in Figure 4.1.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
---------------------- Fig. 4.1 Phases of Business Cycle
---------------------- The steady growth line shows the growth of the economy when there are
no economic fluctuations. The various phases of business cycles are shown by
---------------------- the line of cycle, which moves up and down the steady growth line. The line of
cycle moving above the steady growth line marks the beginning of the period of
---------------------- “expansion” or “prosperity” in the economy.
---------------------- The phase of expansion is characterised by increase in output,
employment, investment, aggregate demand, sales, profits, bank credits,
----------------------
64 Macroeconomics
wholesale and retail prices, per capita output and a rise in standard of living. The Notes
growth rate eventually slows down and reaches the peak. The phase of peak is
generally characterised by slacking in the expansion rate, the highest level of ----------------------
prosperity and downward slide in the economic activities from the peak.
----------------------
The phase of recession begins when the downward slide in the growth rate
becomes rapid and steady. Output, employment, prices, etc. register a rapid decline, ----------------------
though the realised growth rate may still remain above the steady growth line.
----------------------
So long as growth rate exceeds or equals the expected steady growth rate, the
economy enjoys the period of prosperity − high and low. When the growth rate ----------------------
goes below the steady growth rate, it makes the beginning of depression in the
economy. ----------------------
In a stagnated economy, depression begins when growth rate is less ----------------------
than zero, i.e., the total output, employment, prices, bank advances, etc, decline
during the subsequent periods. The span of depression spreads over the period ----------------------
growth rate stays below the secular growth rate or zero growth rate in a stagnated
----------------------
economy.
Trough is the phase during which the downtrend in the economy slows ----------------------
down and eventually stops, and the economic activities once again register an
----------------------
upward movement. Trough is the period of most severe strain on the economy.
When the economy registers a continuous and rapid upward trend in output, ----------------------
employment, etc., it enters the phase of recovery though the growth rate may still
remain below the steady growth rate. When it exceeds this rate, the economy ----------------------
once again enters the phase of expansion and prosperity. If economic fluctuations
----------------------
are not controlled by the government, the business cycles continue to recur as
stated above. ----------------------
4.4.1 Important Features of the Phases of Business Cycle ----------------------
Let us now describe in some detail the important features of the various
phases of business cycle and also the causes of the turning points. ----------------------
1. Prosperity (expansion and peak): The prosperity phase is characterised ----------------------

by rise in the national output, rise in consumer and capital expenditure
and rise in the level of employment. Inventories of both, the input and the ----------------------
output increase. Debtors find it more and more convenient to pay off ----------------------
their debts. Bank advances grow rapidly even though bank rate increases.
There is general expansion of credit. Idle funds find their way to productive ----------------------
investment since stock prices increase due to increase in profitability
and dividend. Purchasing power continues to flow in and out of all kinds ----------------------
of economic activities. So long as the conditions permit, the expansion ----------------------
continues, following the multiplier process.
----------------------
In the later stages of prosperity, however, inputs start falling short of their
demand. Additional workers are hard to find. Hence, additional workers ----------------------
can be obtained by bidding a wage rate higher than the prevailing rates.
Labour market becomes seller’s market. A similar situation appears also in ----------------------
other input markets. Consequently, input prices increase rapidly leading
----------------------

Notes to increase in cost of production. As a result, prices increase and overtake
the increase in output and employment. Cost of living increases at a rate
---------------------- relatively higher than the increase in household income. Hence, consumers,
particularly the wage earners and fixed income class, review their
---------------------- consumption. Consumer’s resistance gets momentum. Actual demand
---------------------- stagnates or even decreases. The first and most pronounced impact falls
on the demand for new houses, flats and apartments. Following this,
---------------------- demand for cement, iron and steel, construction labour tends to halt.
This trend subsequently appears in other durable goods industries like
---------------------- automobiles, refrigerators, furniture, etc. This marks reaching the peak.
---------------------- 2. Turning point and recession: Once the economy reaches the peak, the
increase in demand is halted. It even starts decreasing in some sectors, for
----------------------
the reason stated above. Producers, on the other hand, unaware of this fact,
---------------------- continue to maintain their existing levels of production and investment.
As a result, a discrepancy between output supply and demand arises. The
----------------------
growth of discrepancy, between supply and demand, is so slow that it goes
---------------------- unnoticed for some time. However, producers suddenly realise that their
inventories are piling up. This situation might appear in a few industries at
---------------------- the first instance, but later it spreads to other industries as well. Initially, it
might be considered as a problem arising out of minor maladjustment.
----------------------
However, the persistence of the problem makes the producers believe
---------------------- that they have indulged in “over-investment”. Consequently, future
investment plans are given up; orders placed for new equipment, raw
---------------------- materials and other inputs are cancelled. Replacement of worn-out capital
is postponed. Demand for labour ceases to increase; rather, temporary
----------------------
and casual workers are removed in a bid to bring demand and supply in
---------------------- balance. The cancellation of orders for the inputs by the producers of
consumer goods creates a chain reaction in the input market. Producers
---------------------- of capital goods and raw materials cancel their orders for their input. This
is the turning point and the beginning of recession.
----------------------
Since demand for inputs has decreased, input prices, e.g., wages, interest, etc.
---------------------- show a gradual decline leading to a simultaneous decrease in the incomes
of wage and interest earners. This ultimately causes demand recession.
----------------------
On the other hand, producers lower down the price in order to get rid of
---------------------- their inventories and to meet their obligations. Consumers in their turn
expect a further decrease in price, and hence, postpone their purchases.
---------------------- As a result, the discrepancy between demand and supply continues to
grow. When this process gathers speed, it takes the form of irreversible
----------------------
recession. Investments start declining. The decline in investment leads
---------------------- to decline in income and consumption. The process of reverse (negative)
multiplier gets underway (the process is exactly the reverse of expansion).
---------------------- When investments are curtailed, production and employment decline
resulting in further decline in demand for both consumer and capital
----------------------
goods. Borrowings for investment decreases; bank credit shrinks; share
---------------------- prices decrease; unemployment increases along with a fall in wage rates.
66 Macroeconomics
At this stage, the process of recession is complete and the economy enters Notes
the phase of depression.
----------------------
3. Depression and trough: During the phase of depression, economic
activities slide down their normal level. The growth rate becomes negative. ----------------------
The level of national income and expenditure declines rapidly. Prices of
consumer and capital goods decline steadily. Workers lose their jobs. ----------------------
Debtors find it difficult to pay off their debts. Demand for bank credit
----------------------
reaches its low ebb and banks experience mounting of their cash balances.
Investment in stock becomes less profitable and least attractive. At the ----------------------
depth of depression, all economic activities touch the bottom and the phase
of trough is reached. Even the expenditure on maintenance is deferred in ----------------------
view of excess production capacity. Weaker firms are eliminated from the
----------------------
industries. At this point, the process of depression is complete.
How is the process reversed? The factors (variables) reverse the downswing ----------------------
varying from cycle to cycle, just like the factors responsible for the business
----------------------
cycle vary from cycle to cycle. Generally, the process begins in the labour
market because of widespread unemployment; workers offer to work at wages ----------------------
less than the prevailing rates. The producers anticipating better future try
to maintain their capital stock and offer jobs to some workers here and ----------------------
there. They do so because they feel encouraged by the halt in decrease in
----------------------
price in the trough phase. Consumers on their part, expecting no further
decline in price, begin to spend on their postponed consumption and ----------------------
hence demand picks up, though gradually. Bankers having accumulated
excess liquidity (idle cash reserve) try to salvage their financial position ----------------------
by the private investors. Consequently, security prices move up and
----------------------
interest rates move downward. On the other hand, stock prices begin to rise
for the simple reason that decline of stock prices ends and an optimism is ----------------------
underway in the stock market.
----------------------
Besides, there is a self-correcting process within the price mechanism.
When prices fall during recession, the prices of raw materials and that of ----------------------
other inputs fall faster than the prices of finished products. Therefore, some
profitability always remains there, which tends to increase after the trough. ----------------------
Hence, the optimism generated in the stock market gets strengthened in the
----------------------
commodity market. Producers start replacing the worn-out capital and making
up the depleted capital stock, though cautiously and slowly. Consequently, ----------------------
investment picks up and employment gradually increases.
----------------------
Following this recovery in production and income, demand for both
consumer and capital goods, start increasing. Since banks have accumulated ----------------------
excess cash reserves, bank credit becomes easily available and at a lower
rate. Speculative increase in prices gives an indication of the continued rise ----------------------
in price level. For all these reasons, the economic activities get accelerated. ----------------------
Due to the increase in income and consumption, the process of multiplier
gives further impetus to the economic activities, and the phase of recovery ----------------------
gets underway. The phase of depression ends over time, depending on the
speed of recovery. ----------------------

Notes 4. Recovery or revival: As the recovery gathers momentum, some firms
plan additional investment, some undertake renovation programmes,
---------------------- some undertake both. These activities generate construction activities in
both consumer and capital goods sectors. Individuals who had postponed
---------------------- their plans to construct houses undertake it now, lest cost of construction
---------------------- mounts up. As a result, more and more employment is generated in the
construction sector. As employment increases, despite the wage rates
---------------------- moving upward, the total wage income increases at a rate higher than
the employment rate. Wage income rises and so does the consumption
---------------------- expenditure. Businesspeople realise a quick turn over and an increase in
---------------------- profitability. Hence, they speed up the production machinery.
Over a period, as the factors of production become fully employed, wages
----------------------
and other input prices move upward rapidly. Investors, therefore, become
---------------------- discriminatory between alternative investments. Like prices, wages
and other factors like price increase, a number of related developments
---------------------- begin to take place. Businesspeople start increasing their inventories,
consumers start buying more and more of durable goods and variety items.
----------------------
With this process catching up, the economy enters the phase of expansion
---------------------- and prosperity. The cycle is thus complete.

----------------------
---------------------- 1. As employment increases, despite the wage rates moving upward, the
---------------------- total wage income decreases at a rate higher than the employment
rate.
---------------------- 2. During the phase of recovery, economic activities slide down their
---------------------- normal level.
3. The depression phase is characterised by rise in the national output,
----------------------
rise in consumer and capital expenditure, and rise in the level of
---------------------- employment.
----------------------
Activity 2
----------------------
---------------------- If you were to start a business of your own, in which stage of the cycle will
you start thinking of a new concept and conceptualise the idea? In which
---------------------- stage will you actually implement the concept, as in start the business? Will
it all be in one stage or in different stages?
----------------------
----------------------
----------------------
----------------------
68 Macroeconomics
4.5 WAYS AND MEANS TO CONTROL BUSINESS Notes
CYCLES/FLUCTUATIONS AND UNEMPLOYMENT
----------------------
Business cycles, i.e., fluctuations in the economic activities, cause not only
harm to business but also misery to human beings by creating unemployment ----------------------
and poverty. Economists and the government have, of late, felt concerned ----------------------
with the business cycles and suggested various ways and means to control the
economic fluctuations. ----------------------
The experience of the Great Depression and Keynesian revolution in ----------------------
the mid- 1930s assigned a big role to the government in economic growth,
employment and prevention of business fluctuations. Therefore, the government ----------------------
interventions in the economy all over the world increased in a big way. The
----------------------
free enterprise economies not only entered in the production of commodities
and services but also adopted a number of fiscal and monetary measures to ----------------------
control and regulate the economy and prevent violent economic fluctuations.
The governments in many developing countries like India assumed the role of ----------------------
a key player in economic growth, employment and stabilisation.
----------------------
The problems similar to those faced in the different phases of the trade cycle
are being faced by the world in modern times. The major stabilisation problem ----------------------
in the developing countries is the problem of controlling prices and preventing
----------------------
growth rate from sliding further down. For developed countries, maintaining the
growth rate to fight against recession world over are the major stabilisation ----------------------
problems.
----------------------
Following are the major macroeconomic stabilisation policies undertaken
by various governments to maintain the growth rate. ----------------------
1. Full employment: Full employment is the commonly accepted goal of ----------------------
macroeconomic policy in a developed country. The classical economists
assumed that full employment is automatically attained by a free and ----------------------
competitive market economy in the long run.
----------------------
Keynes, however, pointed out that full employment in practice is a rare
phenomenon. Actually, an economy attains equilibrium at underemployment ----------------------
level. Accepting Keynesian argument, countries have set full employment
as an important goal in their macroeconomic policies. ----------------------
In the technical language of macroeconomic analysis, full employment is ----------------------

viewed as an equilibrium situation in which the sum of the demands in all
----------------------
labour markets tends to be equal to the sum of the supplies. However, of
course, in many of these markets, there is the likelihood of an excess of ----------------------
demand over supply or of supply over demand. Keynes also provides an
alternative definition of full employment as “a situation in which aggregate ----------------------
employment is inelastic in response to an increase in the effective demand
----------------------
for its output”. He, therefore, suggested that an economic policy aiming
at achieving full employment should be designed to uplift the effective ----------------------
demand appropriately.
----------------------

Notes 2. Economic stabilisation: Stabilisation broadly means preventing the extremes
of ups and downs or booms and depression in the economy without preventing
---------------------- factors of economic growth to operate. It also implies preventing over
and underemployment. Stabilisation does not mean rigidities; it should
---------------------- permit a reasonable degree of flexibility for “self-adjusting forces of the
---------------------- economy”.
The major objective of stabilisation policies are:
----------------------
i. Preventing excessive economic fluctuations.
----------------------
ii. Utilising efficiently labour and other productive resources as far as
---------------------- possible.
---------------------- iii. Encouraging free competitive enterprise with minimum interference

in the functioning of the market economy.
----------------------
4.6 ECONOMIC POLICIES TO ACHIEVE ECONOMIC
----------------------
STABILITY
----------------------
The two most important and widely used economic policies to achieve
---------------------- economic stability are fiscal policy and monetary policy.
---------------------- 1. Fiscal policy: Fiscal policy refers to the variations in taxation and public
expenditure programmes by the government to achieve pre-determined
---------------------- objectives. Taxation is a measure of transferring funds from the private
purses to the public coffers; it amounts to the withdrawal of funds from
----------------------
private use. Public expenditure, on the other hand, increases the flow of
---------------------- funds into the private economy. Thus, taxation reduces private disposable
income and thereby the private expenditure, and public expenditure
---------------------- increases private incomes and thereby the private expenditure. Since tax
revenue and public expenditure form the two sides of the government
----------------------
budget, the taxation and public expenditure policies are also jointly called
---------------------- “budgetary policy”.
Fiscal or budgetary policy is regarded as a powerful instrument of
----------------------
economic stabilisation. The importance of fiscal policy as an instrument
---------------------- of economic stabilisation rests on the fact that government activities in
modern economies are greatly increased and government tax revenue and
---------------------- expenditure account for a considerable proportion of GNP, ranging from
10−25%. Therefore, the government may affect the private economic
----------------------
activities to the same extent through variations in taxation and public
---------------------- expenditure. Besides, fiscal policy is considered to be more effective than
monetary policy because the former directly affects the private decisions
---------------------- while the latter does so indirectly. If fiscal policy of the government is so
formulated that it can be used during the period of expansion, it is known
----------------------
as “counter-cyclical fiscal policy”. An economic or financial policy is
---------------------- called countercyclical if it works against the cyclical tendencies in the
economy.That is, countercyclical policies are the ones that cool down the
----------------------
70 Macroeconomics
economy when it is in an upswing and stimulate the economy when it is in Notes
a downturn.
----------------------
2. Monetary policy: Monetary policy refers to the programme of the
central bank’s variations in the total supply of money and cost of money ----------------------
to achieve certain predetermined objectives. One of the primary objectives
of monetary policy is to achieve economic stability. The traditional ----------------------
instruments through which the central banks carry out the monetary
----------------------
policies are the quantitative credit control measures, such as open market
operations, changes in the bank rate (or discount rate) and changes in the ----------------------
statutory reserve ratios. Briefly speaking, open market operation by the
central bank is the sale and purchase of government bonds, treasure bills, ----------------------
securities, etc. to and from the public. Bank rate is the rate at which
----------------------
the central bank discounts the commercial banks’ bills of exchange or
first-class bill. The statutory reserve ratio is the proportion of commercial ----------------------
banks’ time and demand deposits, which they are required to deposit with
the central bank or keep the cash in vaults. All these instruments when ----------------------
operated by the central bank reduce (or enhance) directly and indirectly
----------------------
the credit creation capacity of the commercial banks and thereby reduce
(or increase) the flow of funds from the banks to the public. ----------------------
In addition to these instruments, central banks also use various selective
----------------------
credit control measures and moral persuasion. The selective credit
controls are intended to control the credit flows to particular sectors without ----------------------
affecting the total credit and also to change the composition of credit from
undesirable to desirable pattern. Moral suasion is a persuasive method to ----------------------
convince the commercial banks to behave in accordance with the demand
----------------------
of the time and in the interest of the nation.
The fiscal and monetary policies may be alternatively used to control the ----------------------
business cycles in the economy, though the monetary policy is considered to be
----------------------
more effective to control inflation than to control depression. It is, however,
always desirable to adopt a proper mix of fiscal and monetary policies to check ----------------------
the business cycles.
----------------------

1. ___________ refers to the variations in taxation and public ----------------------
expenditure programmes by the government to achieve pre-determined
objectives. ----------------------
2. ___________ broadly means preventing the extremes of ups and ----------------------
downs or booms and depression in the economy without preventing
factors of economic growth to operate. ----------------------
3. Full employment is the commonly accepted goal of macroeconomic ----------------------
policy in a __________ country.
----------------------

Notes Summary
---------------------- ●● nemployment (or joblessness) occurs when people are without work
U
and actively seeking work. The unemployment rate is a measure of the
----------------------
prevalence of unemployment and it is calculated as a percentage by dividing
---------------------- the number of unemployed individuals by all individuals currently in the
labour force.
----------------------
●● Business or trade cycles or cyclical fluctuations are recurrent in nature.
---------------------- ●● he two main phases in a cycle are prosperity and depression, but they
T
are characterised by different stages, namely, expansion, peak, recession,
----------------------
trough, recovery and expansion. An economy swings between them and the
---------------------- stage it is in, marks the chain reactions in various economic activities, in
terms of affecting the level of output, the level of employment, investment,
---------------------- aggregate demand and supply and the general living standards.
---------------------- ●● he prosperity phase is characterised by rise in output, consumer and
T
capital expenditure and thus a rise in the level of employment. There is
---------------------- general “happiness” in the economy. Banks are willing to advance credits
and investors are willing to take them. People are willing to spend. There
---------------------- is general expansion of economic activities of all kinds that lead to steady
---------------------- growth rate. The economy enjoys the period of prosperity. The growth rate
eventually slows down and finally reaches its peak, i.e., the highest level
---------------------- of prosperity. From then on, begins the downward slide of the economic
activities.
----------------------
●● he recessionary trend starts in the labour market, wherein inputs start
T
---------------------- falling short of their demand. Labour gets difficult to come by. Labour
market becomes seller’s market, thus leading to rise in input prices and so
---------------------- in commodity prices. This adversely affects the cost of living, especially
---------------------- of the fixed income earners, and they in turn respond to such adverse
conditions by finally bringing down their own demand for goods and
---------------------- services. It starts with a handful, then increases to a little more and finally
spreads throughout the economy infectiously. This marks reaching the
---------------------- peak.
---------------------- ●● he trend goes on to affect the investors. They are not ready to come forward
T
with their investment plans. Producers of capital goods and raw materials
---------------------- stop their input orders.
---------------------- ●● his is the turning point and the beginning of recession. Apparently,
T
incomes fall and this causes demand recession for consumption as well as
---------------------- investment. Negative multiplier sets in. Private and bank business decline.
---------------------- It is a very unfortunate situation for the economy, which is featured by
unemployment on one hand and falling wage rate on the other. At this
---------------------- stage, the process of recession is complete and then the economy enters
the phase of depression, which is marked by negative growth rate.
----------------------
●● he level of national income and expenditure, the demand for bank credit
T
---------------------- for consumer and capital goods, all show an aggregate and consistent
72 Macroeconomics
decline. There is generally excess production capacity in the economy, Notes
which is lying idle to get utilised, but there is lack of willingness and
investment in the economy to employ the idle resources. There is no place ----------------------
for weaker firms. At this point, the process of depression is complete.
----------------------
●● As the process gets reversed, the economy enters the phase of recovery.
●● The economic activities slowly start picking up. Beginning with positive ----------------------
spurts in the labour market (with more and more workers coming forward ----------------------
to offer their productive services at less than prevailing wage rates),
producers and investors pull up their sleeves and production picks up. ----------------------
The process of multiplier further takes the consumption and investment
demand to higher grounds. This shows the end of depression and speedy ----------------------
path to recovery. ----------------------
Keywords ----------------------
●● iscal policy: Stabilisation objective of the government brought about

F ----------------------
by variations in taxation and public expenditure. ----------------------
●● Inflation: Sustained and appreciable rise in prices.
----------------------
●● rade cycle: The cyclical fluctuations in business showing alternate swings
T
of depression and prosperity. ----------------------
●● rough: The phase during which the downtrend in the economy slows
T
----------------------
down and eventually stops and the economic activities once again register
an upward movement. ----------------------
----------------------
----------------------
1. Explain with an illustration the various phases of a business cycle.
2. Define fiscal policy and monetary policy. ----------------------
3. What are the consequences of unemployment? ----------------------

4. Explain macroeconomic policies with special emphasis on: ----------------------
i. Full employment ----------------------
ii. Economic stabilisation
----------------------
Answers to Check your Progress ----------------------
1. Classical or real-wage unemployment occurs when real wages for a job are
set above the market-clearing level, causing the number of job seekers to ----------------------
exceed the number of vacancies. ----------------------
----------------------

Notes 2. Structural unemployment is a form of unemployment resulting from a
mismatch between demand in the labour market and the skills and locations
---------------------- of the workers seeking employment.
---------------------- 3. Frictional unemployment is the time period between jobs when a worker
is searching for, or transitioning from one job to another.
----------------------
4. Cyclical or Keynesian unemployment is also known as deficient-demand
---------------------- unemployment.
----------------------
----------------------
---------------------- 1. False
---------------------- 2. False
---------------------- 3. False
----------------------
----------------------
Fill in the blanks.
----------------------
1. Fiscal policy refers to the variations in taxation and public expenditure
---------------------- programmes by the government to achieve pre-determined objectives.
2. Stabilisation broadly means preventing the extremes of ups and downs
----------------------
or booms and depression in the economy without preventing factors of
---------------------- economic growth to operate.
3. Full employment is the commonly accepted goal of macroeconomic policy
----------------------
in a developed country.
----------------------
---------------------- Suggested Reading
---------------------- 1. http://www.bis.org/publ/qtrpdf/r_qt1206e.pdf
2. http://www.oecd.org/tax/publicfinanceandfiscalpolicy/45276589.pdf
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
74 Macroeconomics
Keynesian Economics
UNIT
5
Structure:
5.1 Introduction to Keynesian Economics

5.2 Classical Foundation to Macroeconomics
5.3 Keynesian Counter-Argument and Assumptions
5.3.1 Keynesian Counter-Arguments
5.3.2 Keynesian Assumptions
5.4 Four Macroeconomic Sectors
5.5 The Basic Keynesian Model
Summary
Keywords
Suggested Reading
Keynesian Economics 75
Notes
Objectives
----------------------
----------------------
●● Define Keynesian Economics
---------------------- ●● Explain how macro economy is a separate national concern driven
---------------------- by a set of economic principles
●● Discuss the three important assumptions of classical economics
----------------------
---------------------- 5.1 INTRODUCTION TO KEYNESIAN ECONOMICS

----------------------
Macroeconomics was established as a typical economic thought by J. M.
---------------------- Keynes. It was inspired by the idea that aggregate demand is the principal source
of business-cycle instability and the chief reason for economic downturns.
---------------------- Keynesian economics supports discretionary fiscal policy, as the primary way of
evening out business cycles. Keynes wrote The General Theory of Employment,
----------------------
Interest and Money, which was published in 1936. This introduced the modern
---------------------- study of macroeconomics as we know it. The publication aided macroeconomic
theory and policies for the next forty years or so. Although the school of
---------------------- thought was unsuccessful in explaining many macroeconomic phenomena by
the 1980s, Keynesian doctrines remain the central foundation of contemporary
----------------------
macroeconomic concepts, particularly the aggregate market (AS-AD) analysis.
---------------------- Focuses of the Keynesian thought are:
---------------------- ●● Offers a justification and resolution for persistent unemployment (especially
the Great Depression)
----------------------
●● he theoretical construct of the Keynesian views is based on the fact that
T
---------------------- the macro economy is a separate national concern that is being driven
by a set of principles, which are very different from the ones guiding the
---------------------- microeconomic aspects of an economy. Macro economy is not just an
aggregate of microeconomic markets.
----------------------
●● eynesian economics points out that aggregate markets do not inevitably
K
---------------------- accomplish equilibrium. This means that full employment is not an assured
outcome in every aggregate market.
----------------------
●● eynes also suggests that in order to achieve full employment, government
K
---------------------- intervention is a must. He particularly emphasises on intervention through
Fiscal Policy.
----------------------
----------------------
----------------------
----------------------
----------------------
76 Macroeconomics
5.2 CLASSICAL FOUNDATION TO MACROECONOMICS Notes
One of the merits of Keynesian Economics is that it created the foundation ----------------------
for the “Classical way” of analysing macroeconomics.
----------------------
Classical Economics is based on three important assumptions:
●● lexible prices: Classicals firmly believed that prices are flexible.
F ----------------------
Therefore, all markets can efficiently achieve equilibrium. The ----------------------
achievement of equilibrium eliminates scarcities and excesses.
When this idea is applied to goods and services, money and labour ----------------------
markets, it implies that full employment is achieved at all costs and
unemployment is ruled out of the economy. ----------------------
●● ay’s law: The next tenet is that the aggregate production of goods
S ----------------------
and services offers enough revenue to exactly buy-out all production or
output. Propagated as “supply creates its own demand”, Say’s law directs ----------------------
us to the possible conclusion that business cycle volatility is always ----------------------
initiated by a mismatch between aggregate demand and aggregate supply.
However, the mismatch itself is usually rare, according to J.B. Say. ----------------------
●● aving-investment equality: The third belief is actually an extension
S ----------------------
of the previous point to ensure that Say’s law remains valid across all
instances. Since any reduction in consumption is due to saving, then that ----------------------
saving should be matched by an equivalent amount of investment. The
saving-investment equality is made reliable by ensuring that the concept ----------------------
of flexible prices, that is, the flexible movement of interests in the financial ----------------------
markets, remain valid at all times.
----------------------
5.3 KEYNESIAN COUNTER-ARGUMENTS AND
----------------------
ASSUMPTIONS
----------------------
The Classical economists believed that prices and wages are flexible. That
means prices are not rigid and will not change depending upon the economic ----------------------
conditions and prevailing market conditions. But Keynesians had a counter
argument to this, which is as follows: ----------------------
5.3.1 Keynesian Counter-Arguments ----------------------

Keynesian counter argument is inspired by the idea that aggregate demand ----------------------
is the principal source of business-cycle instability and the chief reason for
economic downturns. Keynesian economics firmly believes that prices and wages ----------------------
are inflexible especially when the economy is in the downward direction due to the
----------------------
following.
●● gainst flexible prices: Keynes contended that prices (and wages) are
A ----------------------
inflexible as opposed to the Classical view. Prices are rigid, especially
----------------------
in the downward direction. This is because sellers are reluctant to accept
lower prices. Inflexible or rigid or “sticky” prices hinder markets ----------------------
from eliminating scarcities and excesses. Explicitly, inflexible wages let an
excess of unemployment to continue. ----------------------
Notes ●● gainst Say’s law: Earnings generated by production finally end up being
A
household income; however, this does not happen instantaneously. This
---------------------- suggests that households can only spend the incomes that they actually
have. If they have a smaller amount of incomes, then they spend less;
---------------------- hence, lesser production is sold. Therefore, lesser production takes place
---------------------- and hence less revenue is generated.
●● gainst saving-investment equality: Finally, according to Keynes, the
A
---------------------- equivalence between saving and investment is arguable. Sticky prices
---------------------- might also hinder equilibrium in financial markets while the achievement
of equilibrium might actually require negative interest rates. Specifically,
---------------------- a disequilibrium, in which saving is greater than investment, implies that
aggregate demand would be less than aggregate production. This could
---------------------- lead to prolonged depression in the economy.
---------------------- Combining the above three counterarguments that Keynes provided
against the Classical School, it is a fairly reasonable indication as to why there
---------------------- was high unemployment rates during the Great Depression. Aggregate demand
---------------------- was less than the potential production possibility. According to Keynes, this
was probably due to lack of investment expenditures. Owners of resources did
---------------------- not have the amount of income and thus had to cut down on their expenditures.
Unemployment increased in the bargain and the surplus of resources continued
---------------------- because resource prices did not come down to re-establish equilibrium.
---------------------- 5.3.2 Keynesian Assumptions
---------------------- To reassess and replace the contentious (according to Keynes) assumptions
of the Classical economists, Keynesian economics provides three comparable
---------------------- and parallel assumptions:
---------------------- ●● igid prices: Contrasting the belief of flexible prices, Keynesian
R
economics accepts that prices are sticky in the downward direction. Sticky
---------------------- prices are an outcome of sellers’ preferences (sellers prefer higher prices
to lower prices and are reluctant to accept lower prices), long-term
----------------------
contracts (firms often have long-term contracts stipulating the prices paid
---------------------- for resources), employer preferences (employers often find it easier to lay
off a few workers, when they reduce production cost, than to reduce the
---------------------- wages of every worker) and menu costs (firms are reluctant to change
prices due to the cost of implementing the change, such as printing new
----------------------
price lists).
---------------------- ●● ffective demand: Converse to Say’s law, Keynesian economics is based
E
on the idea of effective demand. Effective demand is the principle that
----------------------
consumption expenditures on the disposable income are actually available
---------------------- to the household sector rather than income that would be available at
full employment. This effective demand proposition is embodied in a
---------------------- key Keynesian principle, termed the consumption function, which is the
relation between household consumption expenditures and household
----------------------
income. The consumption function indicates that people use only a
---------------------- fraction of any extra income for consumption.
78 Macroeconomics
●● aving and investment determinants: Classical economics depends
S Notes
on the notion that saving and investment are both chiefly dependent on
the interest rate. A higher interest rate increases saving and decreases ----------------------
investment. A lower interest rate works in the opposite way. Keynesian
economics, on the other hand, suggests that other reasons have bigger ----------------------
impact on saving and investment – household saving is based on household ----------------------
income and the wish to save money for future expenses/consumption.
Business investment is based on the expected profitability of the goods ----------------------
produced with the capital.
----------------------
5.4 FOUR MACROECONOMIC SECTORS ----------------------
The underpinning of the Keynesian model is built on expenditures for ----------------------
aggregate production by the four macroeconomic sectors- household, business,
government and foreign- what are termed aggregate expenditures. The four ----------------------
sectors and their expenditures are:
----------------------
●● ousehold and consumption expenditures: The household sector
H
includes all and sundry in the economy and their consumptions/buying ----------------------
of production used for current satisfaction are termed consumption ----------------------
expenditures.
●● usiness and investment expenditures: The business sector includes
B ----------------------
firms and other entities that produce output and their expenditures on capital
----------------------
goods are termed investment expenditures.
●● Government and Government purchases: The government sector ----------------------
includes federal, state and local governments and their purchases of the
----------------------
production used to provide government services are termed government
purchases. ----------------------
●● Foreign and net exports: The foreign sector includes all households,
----------------------
businesses and governments beyond the political boundaries of the domestic
economy and their expenditure contribution is termed net exports, which ----------------------
is the difference between exports and imports.
----------------------
1. The underpinning of the Keynesian model is built on expenditures ----------------------
for aggregate production by the household, business, government and
foreign sectors, which are _______________ sectors. ----------------------
2. Say’s Law that the aggregate production of goods and services offers ----------------------
enough revenue to exactly buy-out all production or output can
briefly be stated as ___________________. ----------------------
----------------------
----------------------
Notes 5.5 THE BASIC KEYNESIAN MODEL
---------------------- Fixed Prices
---------------------- It is always assumed that prices are fixed. In this case, changes in nominal
income will be same as changes in real income. This means that when we
---------------------- assume the price is fixed, there is no need to distinguish real variable changes
from nominal variable changes. In the very short run, prices are fixed and
---------------------- sellers adjust output to meet the demand for goods and services. Hence, in the
---------------------- short run, it is demand for output at a given price that determines how much
each firm produces and sells. Therefore, the fixed price level assumption has a
---------------------- vital implication: if the quantity of output that each firm sells is determined
by demand, then it is this aggregate demand that determines the level of real
---------------------- gross domestic product (RGDP) or the aggregate quantities of goods and services
---------------------- sold in an economy. Thus, in Keynesian economics, we first study fluctuations in
aggregate demand so as to understand changes in real gross domestic product
---------------------- (RGDP).
---------------------- The figure to the right is a graphical illustration of the basic Keynesian
model, popularly referred to as the “Keynesian cross”. The “cross” refers to the
---------------------- point of intersection between the two lines: the red AE line and the black Y=AE
line.
----------------------
Keynesian Cross
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Let us analyse the graph. The y-axis measures expenditures, specifically
---------------------- aggregate expenditures. The x-axis measures production, specifically aggregate
---------------------- production or gross domestic product. Hence, the graph demonstrates activity in
the macroeconomic product markets or the aggregate product market.
----------------------
Now consider the two lines.
---------------------- ●● =AE: The black Y=AE line, at the 45-degree mark, denotes all points
Y
in the exhibit, in which aggregate expenditures are equal to aggregate
----------------------
production, that is, the demand for gross domestic product (GDP) is equal
---------------------- to the supply of GDP. It is termed as a 45-degree line, because it exactly
bisects the 90-degree angle of the two axes and thus the angle formed
----------------------
80 Macroeconomics
with either axis is exactly 45 degrees. The implication of this is that the Notes
slope of the 45-degree line is not only positive but equal to 1. Hence, one
can say that if the economy is functioning on this 45-degree line, then ----------------------
aggregate product market is in equilibrium.
----------------------
●● E: The red AE line is the aggregate expenditure line. It shows the relation
A
between aggregate expenditure and aggregate production. Aggregate ----------------------
expenditures refers to the combined expenditures of four macroeconomic
sectors – consumption expenditures by the household sector, investment ----------------------
expenditures by the business sector, government purchases by the government ----------------------
sector and net exports by the foreign sector. The slope, which refers
to fundamental concept of effective demand in Keynesian economics, is ----------------------
positive but less than one.
----------------------
The intersection of the 45-degree line and AE line, at the $12 trillion
mark in the graph is the equilibrium point. At this point, aggregate expenditure ----------------------
on production equals aggregate production. This means that all four sectors
can purchase all the output that they want and also that all output produced is ----------------------
purchased by one of the four sectors. Hence, there is neither a surplus nor a ----------------------
shortage of aggregate production.
It is important to note that if the economy is not producing the equilibrium ----------------------
point of $12 trillion, then it will automatically move to that level. This movement ----------------------
would be a result of business inventories (namely “private inventories”).
----------------------
For example, if aggregate production is at $18 trillion, then aggregate
expenditures will fall short of aggregate production (the AE line being below ----------------------
the 45-degree line). In this case, all output produced will not be sold and business
inventories will increase, following which the business sector will reduce ----------------------
production, which will move the economy toward the $12 trillion equilibrium.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Alternatively, for example, if aggregate production is at $6 trillion, ----------------------
then aggregate expenditures will exceed aggregate production (the AE line
being above the 45- degree line). Then the four sectors cannot purchase any ----------------------
more output than that generated by current production, which they do from
accumulated inventories, hence, reducing business inventories and motivating ----------------------
Notes the business sector to increase production, thus moving the economy toward the
$12 trillion equilibrium mark.
----------------------
Hence, we can see that the Keynesian model, like most economic models,
---------------------- has a static equilibrium. If the economy is not at equilibrium, it is assumed it will
move towards equilibrium and once there, it remains at equilibrium.
----------------------
The Case of Full Employment
---------------------- Keynesian economics’ principal proposition is that the economy may not
be at full employment. This is also revealed in the cross model by one simple
----------------------
observation. In this graph, although equilibrium is at $12 trillion, it does
---------------------- not show how this level of aggregate production relates to full employment.
Keynesian economics states that the full employment of resources MIGHT
---------------------- generate $12 trillion of output. Or it MIGHT NOT.
---------------------- If $12 trillion is NOT full employment, there are two possibilities:
---------------------- Less Than Full Employment: If the amount of aggregate production

generated by full employment is greater than $12 trillion, then we have a
---------------------- recessionary gap. In our example, let us assume that the full employment level of
aggregate production is $15 trillion. Since production is less than full-employment
---------------------- production, the result is unemployment. This recessionary gap is what was
---------------------- responsible for the Great Depression in the US and has a tendency to occur in
the modern economy every 3 to 5 years in varying degrees.
---------------------- Greater Than Full Employment: If the amount of aggregate production
---------------------- generated by full employment is less than $12 trillion, then we have an
inflationary gap. In this example, let us assume that the full employment level
---------------------- of aggregate production is $9 trillion. Because production exceeds the full-
employment production, the result is inflation.
----------------------
Hence, we see that the economy ACHIEVES equilibrium at $12
---------------------- trillion and REMAINS at this point. However, $12 trillion is NOT necessarily
full employment. As a result, unemployment or inflation, as seen in the
----------------------
examples above, might persist until something shifts the AE line.
---------------------- Aggregate Expenditures Determinants
---------------------- Like all curves that capture economic relations, the AE line in the graph
below is subject to factors that cause a shift in the line. These factors are
---------------------- many and varied, but they all work through the four aggregate expenditures-
---------------------- consumption expenditures, investment expenditures, government purchases
and net exports.
---------------------- Hence, anything OTHER than the abovementioned aggregate production
---------------------- or gross domestic product affecting aggregate expenditures will cause the AE
line to shift.
----------------------
----------------------
----------------------
82 Macroeconomics
Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Some of these factors are as follows: ----------------------
Interest Rates: Interest rates affect the price of borrowing funds to finance
investment in capital goods and consumption of durable goods. These higher ----------------------
interest rates decrease aggregate expenditures, resulting in a downward shift ----------------------
of the AE line, while lower interest rates increase aggregate expenditures, thus
causing an upward shift of the AE line. ----------------------
Confidence Level: The confidence or expectations of the household and ----------------------
business sectors will affect how much they spend. If they are confident and
optimistic about the future of the economy, then they are more likely to increase ----------------------
consumption and investment, which increases aggregate expenditures and cause
----------------------
a rightward shift of the AE line. If they are not confident and pessimistic about
the economy, then they are less likely to decrease consumption and investment, ----------------------
which will consequently decrease aggregate expenditures and cause a leftward
shift of the AE line. ----------------------
Government Policies on Deficit: The federal deficit is the difference ----------------------
between government expenditures and incomes, predominantly from taxes.
A deficit is then the result of the government spending more than it earns. ----------------------
Although rare, if spending is less than taxes, then the government has budgetary
----------------------
surplus. One of Keynes’ most important contributions has been the study of
impact of government policies on the budgetary deficit or surplus. An increase in ----------------------
government spending or a decrease in taxes causes an increase in the deficit and
aggregate expenditures and thus, a rightward shift of the AE line. A decrease ----------------------
Notes in government spending or increase in taxes, which causes a budgetary surplus,
also decreases aggregate expenditures and results in a leftward shift of the AE
---------------------- line.
---------------------- These three determinants of aggregate expenditures are of utmost
important to Keynesian economics because they indicate the source and solution
---------------------- to business- cycle instability. According to Keynesian economics, interests and
expectations that stimulate changes in consumption and investment are the
----------------------
prime sources of business-cycle instability, particularly in causing recessionary
---------------------- gaps and higher rates of unemployment. Government fiscal policies that influence
the budget are then the key solution to business-cycle instability and to achieve
---------------------- full employment.
---------------------- The Multiplier
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
---------------------- Shifts in the AE line, as demonstrated above, trigger the multiplier process.
This process reflects the change in aggregate production or gross domestic
---------------------- product that is the result of a change in one of the aggregate expenditures.
---------------------- The graph on the right demonstrates the multiplier process. As seen
previously, the original equilibrium is at $12 trillion of aggregate production.
---------------------- Now suppose that reduction in interest rates brings about a $1 trillion increase
---------------------- in investment expenditure on capital goods.
●● o demonstrate the shift of the aggregate expenditures line, we see a new
T
----------------------
aggregate expenditures line in the graph below; it is $1 trillion higher than
---------------------- the original line.
●● he new equilibrium is at the intersection of the 45-degree line and the
T
---------------------- new aggregate expenditure line (AE`), which is $16 trillion of aggregate
---------------------- production. The difference between the original equilibrium and the
new equilibrium is $4 trillion (16-12). This amount is four times the initial
---------------------- change in investment ($1 trillion), which is the multiplier process.
----------------------
----------------------
----------------------
84 Macroeconomics
Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
This change in aggregate production can be divided into two parts- ----------------------
autonomous and induced. ----------------------
●● utonomous is when the initial change in investment causes a vertical
A
----------------------
shift of the aggregate expenditure line that changes the equilibrium point.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Induced: The above mentioned autonomous change in expenditure then induces ----------------------
further changes in aggregate production and expenditure, particularly in
consumption expenditure. The household sector is stimulated by this additional ----------------------
income generated from the increase in production and they increase consumption.
This is the movement along the aggregate expenditures line from point B to point C ----------------------
in the graph below. This movement along the aggregate expenditure line reinstates ----------------------
balance between aggregate expenditures and aggregate production.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Notes The movement along the aggregate expenditures line not only restores
equilibrium it also generates the multiplier process. The reason is that each change
---------------------- in aggregate production on the supply side of the economy induces a change in
consumption and aggregate expenditures on the demand side. The process of
---------------------- closing one gap between production and expenditures ends up creating another
---------------------- gap.
Let us see an example for this. Let us assume that an initial investment
----------------------
creates a $1 trillion imbalance between production and expenditures. This gap
---------------------- is closed with $1 trillion of production. However, this production induces $750
billion of consumption, which creates a new $750 billion gap. Closing this gap
---------------------- with $750 billion of production induces another $563 billion in consumption,
which creates another new gap.
----------------------
As seen from the above example, the gaps grow smaller until they
---------------------- shrink to virtually nothing. The multiplier process ends when these gaps
become infinitesimally small.
----------------------
Fiscal Policy
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
As a result of the discussion above, the final element of Keynesian
---------------------- economics is to use fiscal policy to trigger the multiplier process and close any
---------------------- recessionary or inflationary gaps that are created from changes in interests,
expectations or other aggregate expenditures.
---------------------- Fiscal policy is the use of the government spending and taxing to stabilise
---------------------- business cycles. Its purpose is to neutralise the problems of unemployment and
inflation created by fluctuations in a business cycle.
----------------------
The graph on the right shows the desired situation for the economy. The
---------------------- equilibrium achieved by the intersection of the AE line and the 45-degree line
at Yf is also the point of full-employment of aggregate production. However,
---------------------- if the AE line shifts, then full-employment equilibrium is disturbed. Keynesian
economics advises the use of fiscal policy to counteract this disturbance.
----------------------
----------------------
----------------------
----------------------
86 Macroeconomics
Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Which fiscal policy to use - expansionary or contractionary - depends on ----------------------
the type of gap and the nature of the business-cycle instability. The goal of fiscal
policy is to shift the AE line such that it deals with any shifts caused by other ----------------------
expenditures. For example, a decline in investment causes a leftward shift of
----------------------
the AE line, with a possibility of creating a business-cycle contraction and then
expansionary fiscal policy is required to create a corrective upward shift. ----------------------
Alternatively, an increase in consumption, which causes an upward shift of the
AE line, which is likely to create inflation, must be corrected by the leftward ----------------------
shift resulting from contractionary fiscal policy.
----------------------
Fiscal Policy
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
●● xpansionary Fiscal Policy corrects the problems resulting from
E ----------------------
unemployment caused by a business-cycle contraction. It includes
increased government purchases, decreased taxes and/or increased ----------------------
transfer payments.
----------------------
●● ontractionary Fiscal Policy corrects problems caused by inflation from
C
a business-cycle expansion. It includes decreased government purchases, ----------------------
increased taxes and/or decreased transfer payments.
----------------------
----------------------
----------------------
Notes Fiscal Policy
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Multiple Choice Single Response.
----------------------
1. The choice of expansionary or contractionary fiscal policy depends
---------------------- on the type of gap and the nature of the:
---------------------- i. National economy
---------------------- ii. International economy
---------------------- iii. Business-cycle instability

---------------------- 2. The three determinants of aggregate expenditures which are of
utmost important to Keynesian economics are:
----------------------
i. Interest rates, confidence level and government policy
----------------------
ii. Demand, supply and market position
---------------------- iii. Full employment, underemployment, over employment
----------------------
---------------------- Activity 1
----------------------
Identify five companies that have implemented the Keynesian model.
----------------------
---------------------- Summary
---------------------- ●● eynesian economics supports discretionary fiscal policy as the primary
K
way of evening out business cycles. Keynes wrote The General Theory
----------------------
of Employment, Interest and Money, which was published in 1936.
---------------------- ●● eynesian economics points out that aggregate markets do not inevitably
K
accomplish equilibrium. This means that full employment is not an assured
----------------------
outcome in every aggregate market.
88 Macroeconomics
●● lassical Economics is based on three important assumptions: Flexible
C Notes
Prices, Say’s Law and .Saving-Investment Equality.
●● eynesian economics provides three comparable and parallel assumptions:
K ----------------------
Rigid Prices, Effective Demand and Saving and Investment Determinants. ----------------------
Keywords ----------------------
●● aving-investment equality: Equilibrium between the amount of

S ----------------------
saving that leads to investment. ----------------------
●● rice rigidity: The proposition that some prices adjust slowly in response
P
to market shortages or surpluses. This condition is most important for ----------------------
macroeconomic activity in the short run and short-run aggregate market ----------------------
analysis. In particular, rigid (also termed inflexible or sticky) prices are a
key reason underlying the positive slope of the short-run aggregate supply ----------------------
curve. Prices tend to be the most rigid in resource markets, especially
labor markets and the least rigid in financial markets, with product markets ----------------------
falling somewhere in between. ----------------------
●● oreign and net exports: All households, businesses and governments
F
beyond the political boundaries of the domestic economy. ----------------------
----------------------
----------------------
1. What is the principal proposition put forth by Keynesian economics?
----------------------
2. What is the chief determinant of Saving and Investment?
----------------------
3. Explain the term deficit financing. How it is generally met?
----------------------
----------------------
----------------------
Fill in the blanks.
----------------------
1. The underpinning of the Keynesian model is built on expenditures
for aggregate production by the household, business, government and ----------------------
foreign sectors, which are macroeconomic sectors.
----------------------
2. Say’s Law that the aggregate production of goods and services offers enough
revenue to exactly buy-out all production or output can briefly be stated as ----------------------
supply creates its own demand.
----------------------
----------------------
----------------------
----------------------
----------------------
Notes Check your Progress 2
----------------------
1. The choice of expansionary or contractionary fiscal policy depends on
---------------------- the type of gap and the nature of the:
---------------------- iii. Business-cycle instability
---------------------- 2. The three determinants of aggregate expenditures which are of utmost

important to Keynesian economics are:
---------------------- i. Interest rates, confidence level and government policy
----------------------
Suggested Reading
----------------------
----------------------
2. http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=Keynesi
---------------------- an+cross
---------------------- 3. http://www.econ.ucla.edu/workingpapers/wp383.pdf
---------------------- 4. http://www.khanacademy.org/finance-economics/macroeconomics/v/
keynesian-cross-and-the-multiplier
----------------------
5. http://njsanders.people.wm.edu/101/Ch10_11_Handout.pdf
---------------------- 6. www.jurgilas.net/fpdb/Econ%20219%20Spr05/03-02-2005.pdf
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
90 Macroeconomics
Money Markets
UNIT
6
Structure:
6.1 Introduction
6.2 History of Money
6.2.1 Barter
6.2.2 Commodity Money
6.2.3 Fiat Money
6.2.4 Electronic Money
6.3 Money Basics
6.4 Basic Functions and Characteristics of Money
6.5 Monetary Aggregates and Commodity Money
6.6 Monetary Policy
Summary
Keywords
Suggested Reading
Money Markets 91
Notes
Objectives
----------------------
----------------------
●● Explain how money is a vital constituent of the macro economy
---------------------- ●● Enlist the basic functions of money
---------------------- ●● Discuss monetary aggregates
----------------------
6.1 INTRODUCTION
----------------------
In this unit, we examine money as the vital constituent of the macro economy.
---------------------- The fundamental understanding with money is that too much money causes
inflation and too little money causes unemployment.
----------------------
The history of money is also important here in order to understand the
---------------------- evolution of “modern” money, as we know and use it. The various topics covered
---------------------- include monetary aggregates and their role in the macro economy and the linkages
between money and monetary policies.
----------------------
6.2 HISTORY OF MONEY
----------------------
Invention of money as a medium of exchange has travelled through ages
----------------------
and taken the form of modern paper-based money form. Realising the constraints
---------------------- in barter exchange, probably money in some form was introduced. Herein we
will review the history of money in brief.
----------------------
6.2.1 Barter
---------------------- Transactions in societies and civilisations have been recorded since ancient
---------------------- history.
Making transactions or trading satisfied wants and needs. This gave rise to
----------------------
barter.
---------------------- Bartering took into account specialisation of resources and individuals
gained access to a wider variety of goods and commodities than they could
----------------------
produce on their own by mobilising limited resources.
---------------------- The problem with barter was that there was a requirement for “double
coincidence of wants”. Not only that, not all goods that were exchanged
----------------------
were divisible according to the value required to be traded. For example, an
---------------------- individual needs a goat and another, a trunk. Two things needed to be fulfilled
in this case for a transaction to take place:
----------------------
1. The individual owning a goat should want a trunk and the other way round.
---------------------- 2. The size or quality of the goat should be valued equal to the perceived value
---------------------- of the trunk. If the perceived value translated to “half a goat was good
for a trunk” or vice-versa, then, understandably, there would be a serious
---------------------- problem in completing the transaction.
92 Macroeconomics
Thus, to fix the above problem, societies started using commodities as money. Notes
6.2.2 Commodity Money
----------------------
Commodity money is any commodity, article or item whose “worth
serves as the value of money”. Precious metals, stones, gems, jewelry, antiques, ----------------------
articles of value etc. – all are examples of commodity money.
----------------------
Most commodity money was eventually in the form of various metal
coins. The reason was that metal coins were durable, divisible, transportable ----------------------
and difficult to counterfeit.
----------------------
However, metals were heavy to carry around and could be transformed into
other household articles by melting and forging coins. Not only that, the value ----------------------
in use of metals also affected the value of exchange of these metals. These ----------------------
problems distorted prices in the kingdoms/economies and destroyed the smooth
workings of money circulation and transactions in the economy. ----------------------
In most countries, commodity money has been replaced with fiat money. ----------------------
Fiat money is a good, the value of which is less than the value it represents as
money. ----------------------
Most nations gradually transitioned into Fiat money. ----------------------
6.2.3 Fiat Money
----------------------
Fiat money is currency, which is declared by the government to be legal
tender. This means that it is not backed by a physical commodity and solely ----------------------
has value because the government accepts it for payments of taxes and debts.
----------------------
Almost all of the world’s currency is fiat money.
Use of fiat money in monetary system is definitely practical because fiat ----------------------
money serves the three important functions of money: a medium of exchange, ----------------------
a unit of account and a store of value. These are all satisfied as long a nation
acknowledges that the fiat money is a legitimate form of currency. ----------------------
Over time, a lot of political debate has generated about the issue of ----------------------
commodity- backed money versus fiat money. However, in reality, the distinction
between the two is not quite as great as people perceive it to be. ----------------------
1. The doubt against fiat money is the requirement of intrinsic value. Opponents ----------------------
of fiat money often claim that a system using fiat money is essentially
weak because fiat money does not have a non-money value. While this is ----------------------
a compelling argument, then how is it that a monetary system backed by
gold is notably different? Given that only a small fraction of the world’s ----------------------
gold supply is used for non-ornamental assets – the argument that gold has ----------------------
value mostly because people believe it has value, much like fiat money –
should also be valid. ----------------------
2. Challengers of the fiat money system maintain that the capacity for ----------------------
a government to print money without having to back it up with a definite
commodity is potentially risky for the economy. This is also a convincing ----------------------
argument to some degree; however, this aspect is not completely prohibited
----------------------
Money Markets 93
Notes by a commodity-backed money system, since it is possible for the government
to reap more of the commodity in order to produce more money or to revalue
---------------------- the legal tender by changing its trade-in value.
---------------------- 6.2.4 Electronic Money
Electronic money is generally defined as an electronic store of pecuniary
----------------------
value on a mechanical device supported with technology that may be widely used
---------------------- for making payments to undertakings other than the issuer without necessarily
involving bank accounts in the transactions, but acting as a prepaid bearer
---------------------- instrument.
---------------------- Electronic money is merely an electronic representation of money and
not “fiat money” itself.
----------------------
Electronic money has two of the four characteristics of money: it is easy
---------------------- to transport and completely divisible. However, it may be easily counterfeitable
and non-durable.
----------------------
---------------------- 1. Near monies is an economic term describing non-cash assets that are
highly liquid in the nature of:
----------------------
i. Commodities in stock
---------------------- ii. Finished goods
---------------------- iii. Savings of different types
---------------------- 2. Fiat money serves the three important functions of money:
i. Buying, selling, storing
----------------------
ii. A medium of exchange, a unit of account and a store of value
----------------------
iii. Negotiate, transfer and remit
----------------------
---------------------- Activity 1
----------------------
Write down five major characteristics of paper-based money as exhibited in
---------------------- your usage of money.
----------------------
6.3 MONEY BASICS
----------------------
---------------------- Money can be just about anything that can be used for exchange.
●● he ‘any’ part: Anything can function as money. What money is, is less
T
---------------------- important than what money does.
---------------------- ●● The ‘thing’ part: Money is an asset ─ something of value. In the modern
94 Macroeconomics
world, we use paper currency, coins or cheques to make transactions. We Notes
also have debit and credit cards. However, not all can be categorised as
money, though all of them help in making transactions. ----------------------
Hence, money is anything or something that can be readily traded for ----------------------
valuable assets.
Definition: ----------------------
●● oney is any object or record that is generally accepted as payment for

M ----------------------
goods and services and repayment of debts.
----------------------
The Medium
----------------------
The belief of “general acceptance” makes money the medium of exchange
for transactions. There are two types of value when considering the concept of ----------------------
money:
----------------------
●● I ntrinsic value (Value in Use): An article or thing satisfies wants and
needs. ----------------------
●● alue in exchange: An article or thing does not satisfy wants and needs
V
----------------------
directly but can be traded for something that does.
Money may or may not have intrinsic value; however, to function as a ----------------------
medium of exchange, it must have “value in exchange”.
----------------------
It is often said that money is an economic lubricant. Too much money
gives rise to inflationary expansion and too little brings about recession driven ----------------------
unemployment. Amongst other things, the secret of a stable macro-economy is
----------------------
to maintain an appropriate balance between too much and too little money.
----------------------
6.4 BASIC FUNCTIONSAND CHARACTERISTICS OFMONEY
----------------------
Money has four vital functions:
----------------------
1. Medium of exchange: Money makes it easier to buy, sell, produce and
consume goods and services. ----------------------
2. Measure of value: Prices are stated in terms of the monetary unit. ----------------------
3. Store of value: Value can be stored over time with money. ----------------------
4. Standard of deferred payment: Future payments are also in terms of the
monetary unit. ----------------------
Explanation: ----------------------
1. Medium of Exchange ----------------------
The primary function of money is as the medium of exchange.
----------------------
An economy without money:
----------------------
●● Barter exchange happens when you trade one good for another.
●● A barter economy is one that uses nothing but barter trades, no money. ----------------------
----------------------
Money Markets 95
Notes ●● Barter requires double coincidence of wants: I must want what you have
and you must want what I have.
---------------------- ●● With no money, resources are used for trading and not for production.
---------------------- The bottom line:
---------------------- Using money as a medium of exchange eases the exchange process,

makes it more efficient and frees resources for production.
----------------------
2. Measure of Value
---------------------- Money functions as the measuring unit for prices; it is the unit of
account or measure of value. Market prices are expressed in terms of the medium
----------------------
of exchange.
---------------------- Reason:
---------------------- ●● ellers are willing to trade for and buyers are willing to give up the medium
S
of exchange: Money.
----------------------
Therefore:
---------------------- ●● Money is used for exchanges.
---------------------- ●● sing money as the unit for prices gives a measure for value, i.e. how much
U
value we place on a good.
----------------------
●● he measure of value helps macroeconomists calculate gross domestic
T
---------------------- product.
Store of Value
----------------------
Another function of money is store of value. It means that we retain the
---------------------- value, the satisfaction of wants and needs, provided by a good over a period.
---------------------- Ways to store of value:
---------------------- ●● Buy a product and store it for a week.

●● Buy a gift certificate and redeem it after a week.
----------------------
●● uy another good, keep it for a week, sell it and then use this money to buy
B
---------------------- a product.
●● Keep the money one week or then buy the good.
----------------------
A potential problem:
----------------------
If the price of the good rises, money becomes a less effective means of
---------------------- storing value.
---------------------- Price inflation is the nemesis for the store of value function of money.
4. Standard of Deferred Payment
----------------------
Money is used as a standard of deferred payment, buying now and paying
---------------------- later.
---------------------- ●● car loan: Borrow money to buy a car today; then pay off the loan with
A
deferred payments into the future.
----------------------
96 Macroeconomics
●● oney as a standard of deferred payment is a direct consequence of the
M Notes
unit of account and store of value functions of money.
●● oney is the standard for current prices and future payments based on
M ----------------------
those prices. ----------------------
●● For money to function as a deferred payment, it must retain value.
----------------------
●● The key to storing value in money is price inflation.
●● eferred payments need to anticipate future money values based on future
D ----------------------
inflation.
----------------------
●● The inflation adjustment is accomplished through interest rates.
----------------------
Characteristics of Money
Four characteristics let money do what it does. They are as follows: ----------------------
1. Durable: It helps to retain value from one exchange to the next and store ----------------------
value for future exchanges.
----------------------
2. Divisible: It lets us accurately match an amount of money to the precise
value of a good. ----------------------
3. Transportable: It lets us conduct exchanges far and wide, to go where we ----------------------
need to go for an exchange.
----------------------
4. Non-counterfeitable: It keeps the value of money from being diluted.
----------------------
----------------------
1. The belief of ______________ makes money the medium of exchange
for transactions. ----------------------
2. The value of money from being diluted is protected by ____________ ----------------------

characteristic feature of the money.
----------------------
----------------------
Activity 2
----------------------
Identify three important checkable deposit accounts that you used in your
----------------------
monetary transactions
----------------------
6.5 MONETARY AGGREGATES AND COMMODITY ----------------------

MONEY ----------------------
Monetary aggregates are watched closely by economists and investors, as ----------------------
they give a clear picture of the true size of the “working” money supply. Frequent
reporting of the M1 and M2 measures (data is published weekly) allows investors ----------------------
to measure the rate of change in the monetary aggregates and overall monetary
velocity. ----------------------
Money Markets 97
Notes If the monetary aggregates are growing too quickly, it could trigger
inflationary fears (more money chasing after the same amount of goods and
---------------------- services leads to rising prices) and cause central-banking groups to raise interest
rates or otherwise halt money-supply growth.
----------------------
While the monetary aggregates were once key in determining overall
---------------------- central-banking policy, the past few decades have shown a lower correlation
between changes in the money supply and key metrics like inflation, GDP and
----------------------
unemployment.
---------------------- M1: It is the aggregation of currency and coins held by the public and checkable
deposits (any demand deposit account against which checks or drafts of
----------------------
any kind may be written). Checkable deposit accounts include checking, savings
---------------------- and money market accounts. They also include any kind of negotiable draft,
such as a Negotiable Order of Withdrawal (NOW) or Super Now account. These
---------------------- are the generally accepted items in payment and are regularly used for day-to-day
market transactions. [Source: http://www.investopedia.com/terms/c/checkable-
----------------------
deposits. asp#axzz29HSHzDly]
---------------------- M2: It is a broader measure of money that includes M1 plus near money.
---------------------- Near Monies
---------------------- Near monies are savings, but there are several different types of savings.
This is an economic term describing non-cash assets that are highly liquid, such
---------------------- as bank deposits, certificates of deposit (CDs), overnight repurchase agreements,
treasury bills etc. Central banks, economists and statisticians may utilise near
---------------------- money when determining the current money supply. Near money refers to assets
---------------------- that can be quickly converted into cash. This is also called quasi-money. [Source:
http://www. investopedia.com/terms/n/near-money.asp#ixzz29HU59H00]
---------------------- M3 = M2 plus other near monies. Other near monies added to M3 are less liquid
---------------------- than the M2 near monies. M3 other near monies are essentially investments.
L: It stands for liquid assets. The economy’s total financial assets can be converted
----------------------
to M1.
---------------------- L = M3 + liquid assets (such as commercial paper, treasury bills, saving bonds,
bankers’ acceptances etc.) [Source: www.nowandfutures.com/download/m123.
----------------------
txt]
---------------------- Note: Refer to the Reserve Bank of India website to learn about the
---------------------- Indian Monetary Aggregates: http://www.rbi.org.in/scripts/Publications View.
aspx?id =9455 http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/32272.
---------------------- pdf
---------------------- 6.6 MONETARY POLICY

----------------------
The importance of the role of money in the economy is undeniable. Money
---------------------- is vital to the production, consumption and exchange in a complex economy.
However, too much money can cause inflation and too little money can cause a
----------------------
98 Macroeconomics
recession. One way to strike a balance between these two extremes is to control Notes
money. This is known as Monetary Policy.
----------------------
The Central Bank (and indirectly the government) is given the regulatory
duty of controlling the money in the economy. ----------------------
Money Markets
----------------------
In this section, we will delve into the link between money markets, bond
markets and interest rates. We will first examine the demand for money. ----------------------
The demand curve for money is derived like any other demand curve, ----------------------
by establishing the relationship between the “price” of money (which is really
the interest rate) and the quantity demanded, holding all other factors constant. ----------------------
Next, we connect the demand for money to the concept of money supply to ----------------------
ascertain the equilibrium rate of interest. This way, we can demonstrate how
fluctuations in interest rates affect the macro economy. ----------------------
The Demand for Money ----------------------
In determining how much money to hold, individuals make a choice as to
how to hold their wealth, i.e. how much wealth shall be held as money and how ----------------------
much as other assets. For a given quantity of wealth, this choice will depend ----------------------
on the opportunity cost of holding money vis-à-vis other assets. The demand for
money is the relationship between the quantity of money people want to hold ----------------------
and the factors that determine that quantity.
----------------------
To make things easier, we will say that there are only two ways of holding
wealth: as money in banks or as assets in a bond market. We will also consider the ----------------------
demand for money as a curve that signifies the consequences of choices between
----------------------
a greater liquidity of money deposits in banks versus the higher interest rates
that can be earned at a later date by holding a bond. The difference between the ----------------------
interest rates paid on money deposits and the interest return available from
bonds is the cost of holding money. ----------------------
Motives for Holding Money ----------------------
One major purpose people hold their wealth/salary as money is because they ----------------------
need to make transactions in the markets by purchasing goods and services.
That is, buying groceries or paying the rent etc. or it may be kept on hand for ----------------------
unforeseen circumstances. The transactions demand for money is the money
people hold to pay for goods and services they plan or hope to buy. When ----------------------
individuals carry money in their wallets to pay for a bus ride or buy a movie ----------------------
ticket or maintain a bank account balance so they can buy groceries in a given
period and so and so forth; then, this money that they are holding is a part of the ----------------------
transactions demand for money.
----------------------
The money people hold for possible emergencies in the future denotes
their precautionary demand for money. Money held for precautionary reasons ----------------------
may include bank account balances kept for potential home repairs or health-
care needs. People do not know exactly when the need for such expenses will ----------------------
----------------------
Money Markets 99
Notes arise. However, they can prepare for such contingencies by holding money so
that they will have it available when the requirement arises.
----------------------
People also hold money for speculative reasons. Bond prices change
---------------------- continuously. Consequently, holders of bonds not only earn interest but may
also gain or lose the worth of their assets. Bondholders gain when bond prices
---------------------- increase and lose when bond prices fall. This is the reason “expectations” are
a key determinant in the demand for bonds. Holding bonds is one alternative
----------------------
to holding money, so these same anticipations or expectations can affect the
---------------------- demand for money.
It is observed that bondholders who anticipate a fall in bond prices will try
----------------------
to sell their bonds before the price actually falls. This is in the hope that they
---------------------- will avoid loss in asset value. Selling a bond means liquidating it to money. The
money held by individuals in response to concern that bond prices and the
---------------------- prices of other financial assets might change was referred to as speculative
demand for money by Keynes.
----------------------
It is difficult to distinguish between money held for transactions and money
---------------------- held for precaution. However, we need to differentiate between money held
for the different motives so that we can understand how the quantity of money
----------------------
demanded will be affected by an important determinant of the demand for money:
---------------------- the interest rate.
---------------------- Interest Rates and the Demand for Money

The quantity of money people hold for transactions and fulfillment of
---------------------- precautionary and speculative demand is expected to vary with the interest income
---------------------- that they can earn from assets such as bonds. When interest rates rise relative to
the rates that can be earned on money deposits, people hold less money. When
---------------------- interest rates fall, people hold more money. The basis of these conclusions about
the money people hold and interest rates depends on the people’s intentions for
---------------------- holding money.
---------------------- The quantity of money that individuals and households would like to
hold will depend on their current income levels and the prevailing interest rates
---------------------- in the given time. Different average quantities of money held can fulfill their
---------------------- transactions and precautionary demands for money.
Example:
----------------------
To see why, suppose a household earns and spends $3,000 per month. It
---------------------- spends an equal amount of money each day. For a month with 30 days, that is
$100 per day. One way the household could manage this spending would be
----------------------
to leave the money in a checking account, which we will assume pays zero
---------------------- interest. The household would thus have $3,000 in the checking account
when the month begins, $2,900 at the end of the first day, $1,500 halfway
---------------------- through the month and zero at the end of the last day of the month. Averaging the
daily balances, we find that the quantity of money the household demands equals
----------------------
$1,500. This approach to money management, which we will call the “cash
----------------------
100 Macroeconomics
approach,” has the virtue of simplicity, but the household will earn no interest on Notes
its funds.
----------------------
Consider an alternative money management approach that permits the same
pattern of spending. At the beginning of the month, the household deposits $1,000 ----------------------
in its checking account and the other $2,000 in a bond fund. Assume the bond fund
pays 1% interest per month or an annual interest rate of 12.7%. After 10 days, the ----------------------
money in the checking account is exhausted and the household withdraws another
----------------------
$1,000 from the bond fund for the next 10 days. On the 20th day, the final
$1,000 from the bond fund goes into the checking account. With this strategy, ----------------------
the household has an average daily balance of $500, which is the quantity of
money it demands. Let us call this money management strategy the “bond fund ----------------------
approach.”
----------------------
Remember that both approaches allow the household to spend $3,000
per month, $100 per day. The cash approach requires a quantity of money ----------------------
demanded of $1,500, while the bond fund approach lowers this quantity to
----------------------
$500.
The bond fund approach generates some interest income. The household ----------------------
has $1,000 in the fund for 10 days (1/3 of a month) and $1,000 for 20 days (2/3 of
----------------------
a month). With an interest rate of 1% per month, the household earns $10 in interest
each month ([$1,000 × 0.01 × 1/3] + [$1,000 × 0.01 × 2/3]). The disadvantage ----------------------
of the bond fund, of course, is that it requires more attention—$1,000 must be
transferred from the fund twice each month. There may also be fees associated ----------------------
with the transfers.
----------------------
Of course, the bond fund strategy we have examined here is just one
of many. The household could begin each month with $1,500 in the checking ----------------------
account and $1,500 in the bond fund, transferring $1,500 to the checking ----------------------
account midway through the month. This strategy requires one less transfer,
but it also generates less interest — $7.50 (= $1,500 × 0.01 × 1/2). With this ----------------------
strategy, the household demands a quantity of money of $750. The household
could also maintain a much smaller average quantity of money in its checking ----------------------
account and keep more in its bond fund. For simplicity, we can think of any ----------------------
strategy that involves transferring money in and out of a bond fund or another
interest-earning asset as a bond fund strategy. ----------------------
[Source: Principles of Macroeconomics, v. 1.0 by Libby Rittenberg and Timothy ----------------------
Tregarthen]
Which option should the household choose? That will depend on each ----------------------
household. Although the above example does not help in making a ----------------------
definite choice the household, we can make some broad observations about its
implications. ----------------------
Firstly, households want to invest in bonds if interest rates are higher and ----------------------
vice- versa. They would rather hold money if interest rates are lower and
not so attractive. This means that as interest rates go up, money demand goes ----------------------
down.
----------------------
Money Markets 101

Notes Secondly, if the transaction cost of swapping between holding money to
investing in bonds is lowered due to technology (such as e-transfers, ATMs etc.),
---------------------- then the demand for holding hard cash or money will be reduced.
---------------------- Different forms of money deposit accounts offer some amount of interest
on the principal sum. In assessing between whether to hold assets as some form
---------------------- of money or in other forms such as bonds, households will look at the gap
between what deposit accounts pay and what they could earn in a bond market.
----------------------
A higher interest rate in the bond would increase this difference; a lower interest
---------------------- rate will decrease it. This means that a rise in the “spread” between rates on
money deposits and the interest rate in the bond market decreases the quantity
---------------------- of money demanded; a decrease in the spread raises the quantity of money
demanded.
----------------------
As far as possible, firms would also like to plan their income and
---------------------- expenditures for a given period. However, even for a small firm, usually the
amount of money holding versus interest earning investment would be a large
----------------------
sum of money when compared to any household. The interest differentials between
---------------------- money holding and investing are also significantly larger when compared to
that for individuals and households. For very large enterprises, interest rate
---------------------- differentials among various forms of holding their financial assets translate into
millions of units of currency earnings per day.
----------------------
Speculative Money Demand and Interest Rates
----------------------
Based on various factors and information available about financial
---------------------- markets, investors predict if the prices of bonds and other assets will decrease.
In such a case, their speculative demand for money goes up. The speculative
---------------------- demand for money is dependent on expectations about future changes in asset
---------------------- prices.
A key factor that affects this kind of money demand is the value of the
---------------------- prevailing interest rates. If interest rates are low, bond prices are high. There is
---------------------- a strong possibility that if bond prices are high, investors will be concerned that
the prices would fall later. This indicates that high bond prices (and low interest
---------------------- rates) would raise the quantity of money held for speculative purposes. On
the other hand, if bond prices are already relatively low, it is likely that fewer
---------------------- investors will expect them to fall still further. They will hold smaller speculative
---------------------- balances. Hence, the quantity of money demanded for speculative reasons will
be negatively related to the interest rate.
---------------------- The Demand Curve for Money
---------------------- We know that the transactions, precautionary and speculative demands for
money vary negatively with the interest rate. Putting those three ideas of money
----------------------
demand together, one can draw a demand curve for money to depict how the
---------------------- interest rate affects the total quantity of money people hold (see below: The
Demand Curve for Money). “The demand curve for money shows the quantity
---------------------- of money demanded at each interest rate, all other things unchanged”.
----------------------
102 Macroeconomics
The Demand Curve for Money Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Relatively higher interest rates mean that quantity of money demanded is ----------------------
reduced. The converse is also true.
The demand curve for money demonstrates the quantity of money ----------------------
demanded at each value of interest rate. Its downward slope expresses the negative ----------------------
relationship between the quantity of money demanded and the interest rate. Also,
the relationship between interest rates and the quantity of money demanded is ----------------------
motivated by the law of demand. If we think of the substitute to holding money
as holding bonds, then the gap between the interest rate in the bond market and ----------------------
the interest paid on money deposits will be the cost of holding money. Like in all ----------------------
goods and services markets, an increase in price reduces the quantity demanded.
Other Determinants of the Demand for Money ----------------------
The demand curve for money shows the quantity of money people will ----------------------
hold at each interest rate, all other determinants of money demand unchanged. A
----------------------
change in those “other determinants” will shift the demand for money. Among
the most important variables that can shift the demand for money are the ----------------------
level of income and real GDP, the price level, expectations, transfer costs and
preferences. ----------------------
Real GDP ----------------------
A household with an income of Rs. 1,00,000 per month is likely to demand
----------------------
a larger quantity of money than a household with an income of Rs.1,000 per
month. This suggests that money is a normal good, i.e. as income increases, ----------------------
people demand more money at each interest rate and vice-versa.
----------------------
An increase in real GDP implies that increase in incomes throughout the
economy has been observed. The demand for money in the economy in such an ----------------------
instance is therefore likely to be greater when real GDP increases.
----------------------
----------------------
----------------------
Money Markets 103

Notes The Price Level
At higher price levels, more money is required to buy a given quantity of
----------------------
goods and services. All other things unchanged, the higher the price level, the
---------------------- greater the demand for money.
Expectations
----------------------
The speculative demand for money is based on expectations about bond
---------------------- prices. All other things unchanged, if people expect bond prices to fall, they will
increase their demand for money. If they expect bond prices to rise, they will
----------------------
reduce their demand for money.
---------------------- The expectations that bond prices are about to change actually causes bond
---------------------- prices to change. If people expect bond prices to fall, then they are likely to sell
their bonds in return for money. This behaviour will shift the supply curve for
---------------------- bonds to the right, thus lowering their price. The importance of expectations in
dynamic markets can lead to a “self-fulfilling prophecy”.
----------------------
Expectations about price levels in the future can also affect the demand
---------------------- for money. The expectations of higher price levels mean that people expect the
money they are holding to fall in value. Given that expectation, they are likely to
---------------------- hold less of it while expecting an upward surge in prices.
---------------------- Transfer Costs
---------------------- In general, the demand for money will increase as it becomes more costly to
transfer between money and non-money accounts. The demand for money will
---------------------- fall if transfer costs decline. In recent years, transfer costs have fallen with the
advent of technology, leading to a decrease in money demand.
----------------------
Preferences
----------------------
Individual preferences and tastes also affect the demand for money.
---------------------- Some individuals think that it is important to hold large sums of money at hand
while some others may not. Individual preferences towards risk also affect
---------------------- money demand. We know that bonds pay higher interest rates than money
deposits. However, holding bonds means that there is always a risk of bond
----------------------
prices falling. There is also a likelihood that the issuer of a bond will fail to pay
---------------------- the amount specified on the bond to bondholders or may even end up paying
nothing at all. Compared to that, a money deposit in a bank savings’ account
---------------------- would earn a lower interest, but it would be a safer return. Individuals’ approach
and outlook towards the trade-off between risk and returns have an effect on the
----------------------
extent to which they hold their wealth as money.
---------------------- The following figure shows an increase in the demand for money. Such an
---------------------- increase could result from a higher real GDP, a higher price level, a change in
expectations, an increase in transfer costs or a change in preferences.
----------------------
----------------------
----------------------
104 Macroeconomics
An Increase in Money Demand Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
An increase in real GDP, the price level or transfer costs, for example,
will raise the quantity of money demanded at any interest rate r, increasing the ----------------------
demand for money from D to D . The quantity of money demanded at interest ----------------------
rate r rises from M to M′. Contrary events would reduce the quantity of money
demanded at every interest rate, shifting the demand curve to the left. ----------------------
The Supply of Money ----------------------
The supply curve of money shows the relationship between the quantity
----------------------
of money supplied and the market interest rate, all other determinants of supply
unchanged. We know that the Central Bank uses open-market operations to ----------------------
determine the total quantity of reserves in the banking system. We may thus
safely assume that banks increase the money supply in fixed proportion to their ----------------------
reserves. Since the quantity of reserves is determined by the Central Bank’s
----------------------
monetary policies, we draw the supply curve of money as a vertical line (see
below). When we draw the supply curve of money as a vertical line, we assume ----------------------
that the money supply does not depend on the interest rate. Changing the quantity
of reserves and hence the money supply is an example of monetary policy. We ----------------------
assume that the quantity of money supplied in the economy is determined as
----------------------
a fixed multiple of the quantity of bank reserves, which is determined by the
Central Bank. The supply curve of money is a vertical line at that quantity. ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Money Markets 105

Notes The Supply Curve of Money
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Equilibrium in the Market for Money
----------------------
The money market is the interface amongst institutions through which
---------------------- money is supplied to individuals, firms and other institutions that demand
money. Money market equilibrium occurs at the interest rate at which the
---------------------- quantity of money demanded is equal to the quantity of money supplied.
The following figure combines demand and supply curves for money to
----------------------
demonstrate equilibrium in the market for money. With a stock of money M, the
---------------------- equilibrium interest rate is r.
---------------------- Money Market Equilibrium
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
The market for money is in equilibrium if the quantity of money demanded is
---------------------- equal to the quantity of money supplied. Here, equilibrium occurs at interest rate
r.
----------------------
----------------------
106 Macroeconomics
Effects of Change in the Money Market Notes
A shift in money demand or supply will lead to a change in the equilibrium
----------------------
interest rate. Let us look at the effects of such changes on the economy.
Changes in Money Demand ----------------------
Suppose that the money market is initially in equilibrium at r with supply curve ----------------------
S and a demand curve D as shown in Panel (a) below. If there is a decrease in
money demand, all other things remaining constant, then a decrease in money ----------------------
demand could be the effect of a decrease in the cost of transferring between money
----------------------
and non-money deposits or from a change in expectations or from a change in
preferences or a combination of such like. Panel (a) shows that the money demand ----------------------
curve shifts to the left to D and so the interest rate falls to r . We know that when
the interest rate falls, individuals want to hold less money and hold more bonds, ----------------------
instead. Panel (b) below shows that the demand for bonds increases; higher price
----------------------
of bonds means lower interest rates. The lower interest rates, in turn, restore
equilibrium in the money market. ----------------------
Lower interest rates increase the quantity of investment and motivate an ----------------------
increase in net exports. Lower interest rates also lead to a lower exchange rate.
In turn, the aggregate demand curve shifts to the right, as shown in Panel (c) ----------------------
below from AD1 to AD2. Given the short-run aggregate supply curve SRAS, the
economy moves to a higher real GDP and a higher price level. ----------------------
A Decrease in the Demand for Money ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
A decrease in the demand for money due to a change in transactions ----------------------

costs, preferences or expectations, as shown in Panel (a), will be accompanied
----------------------
by an increase in the demand for bonds as shown in Panel (b) and a fall in the
interest rate. The fall in the interest rate will cause a rightward shift in the ----------------------
aggregate demand curve from AD1 to AD2, as shown in Panel (c). As a result, real
GDP and the price level rise. ----------------------
An increase in money demand due to shifts in expectations or preferences ----------------------
or transactions costs that make individuals want to hold more money at level
interest rate will have the opposite effect. The money demand curve will shift ----------------------
to the right and the demand for bonds will shift to the left. The resultant higher ----------------------
interest rate will lead to a lower quantity of investment. Also, higher interest
rates will lead to a higher exchange rate and depress net exports. Thus, the ----------------------
Money Markets 107

Notes aggregate demand curve will shift to the left. All other things unchanged, real
GDP and the price level will fall.
----------------------
Changes in the Money Supply
---------------------- Let us take a situation where the money market is in equilibrium and the
Central Bank adjusts the money supply. All other things unchanged, this change
----------------------
in the money supply should have an effect on the aggregate demand, equilibrium
---------------------- interest rate, real GDP and the price level. For example, the Central Bank conducts
open market operations in which it buys bonds. This is expansionary monetary
---------------------- policy. The outcome of such a measure by the Central Bank is demonstrated in
Panel (a) below. The Central Bank’s buying of bonds shifts the demand curve
----------------------
for bonds to the right, raising bond prices to Pb because when the Central Bank
2
---------------------- buys bonds, the supply of money increases. Panel (b) shows an economy with a
money supply of M, which is in equilibrium at an interest rate of r1.
----------------------
Let us now suppose the bond purchases by the Central Bank, as shown in
---------------------- Panel (a), end up as an increase in the money supply to M′, i.e. the policy change
shifts the supply curve for money to the right to S2. At the original interest
---------------------- rate r1, people do not wish to hold the newly supplied money; they would prefer
to hold non-money assets.
----------------------
To re-establish equilibrium in the money market, the interest rate must
---------------------- fall to increase the quantity of money demanded. In the economy shown, the
---------------------- interest rate must fall to r2 to increase the quantity of money demanded to M′.
The decrease in interest rates required to restore equilibrium to the market
---------------------- for money after an increase in the money supply is attained in the bond market.
---------------------- The rise in bond prices lowers interest rates, which will increase the quantity of
money people demand. Lower interest rates will encourage investment and
---------------------- net exports, via changes in the foreign exchange market and cause the aggregate
demand curve to shift to the right, as shown in Panel (c), from AD1 to AD2. Given
---------------------- the short-run aggregate supply curve SRAS, the economy moves to a higher
---------------------- real GDP and a higher price level.
An Increase in the Money Supply
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
The Central Bank increases the money supply by buying bonds, increasing the
---------------------- demand for bonds in Panel (a) from D1 to D2 and the price of bonds to Pb2 . This
---------------------- corresponds to increase in the money supply to M′ in Panel (b). The interest rate
108 Macroeconomics
must fall to r2 to achieve equilibrium. The lower interest rate leads to an increase Notes
in investment and net exports, which shifts the aggregate demand curve from AD1
to AD2 in Panel (c). Real GDP and the price level rise. ----------------------
Open-market operations in which the Central Bank sells bonds, i.e. a ----------------------
contractionary monetary policy, will have the opposite effect. When the Central
Bank sells bonds, the supply curve of bonds shifts to the right and the price of ----------------------
bonds falls. The bond sales result in a decrease in the money supply, thereby
----------------------
shifting money supply curve to the left and raising the equilibrium interest rate.
Higher interest rates lead to a shift in the aggregate demand curve to the left. ----------------------
Changes in the demand for money and the supply of money both work
----------------------
hand-in- hand to achieve equilibriums in the money market as well as in the bond
market. The interest rate determined by money market equilibrium is consistent ----------------------
with the interest rate achieved in the bond market.
----------------------
Summary ----------------------
●● arter allowed transaction and trade in societies. It also allowed
B ----------------------
specialisation in production such that nations could access a wider
variety of goods than they could produce on their own. ----------------------
●● ommodity money is any commodity, article or item whose “worth serves
C ----------------------
as the value of money”.
●● etals are a natural for use as commodity money because their most
M ----------------------
important characteristic is durability. ----------------------
●● iat money is currency, which is declared by the government to be legal
F
tender and has little or no value in use compared to value in exchange. ----------------------
●● lectronic money is merely an electronic representation of money and
E ----------------------
not “fiat money” itself. It is easy to transport and completely divisible,
maybe highly counterfeitable and non-durable. ----------------------
●● oney is anything that is generally accepted in exchange for goods and
M ----------------------
services or payment of debts.
----------------------
●● oney may or may not have intrinsic value but it should have value of
M
exchange. ----------------------
●● oney is the medium through which all market transactions are made in
M
----------------------
the economy
●● There are two types of value: value in use and value in exchange. ----------------------
●● Money is an economic lubricant. ----------------------
●● oo much money gives rise to inflationary expansion and too little brings
T
about recession driven unemployment. ----------------------
●● The four functions of money: ----------------------

n Medium of exchange ----------------------
n Measure of value
----------------------
Money Markets 109

Notes n Store of value
n Standard of deferred payment
----------------------
●● The four characteristics of money:
----------------------
n Durable: It holds on to the value from one exchange to the next and is
---------------------- a store value for future transaction.
n Divisible: It can precisely match an amount of money to the exact
----------------------
value of a good to the last denominator.
---------------------- n Transportable: It enables transactions across economies,
internationally and can be exchanged in terms of other money
----------------------
values.
---------------------- n Non-counterfeitable: It keeps the value of money from being diluted.
---------------------- ●● 1 is the sum of currency and coins held by the non-bank public and
M
checkable deposits. Debit and credit cards are not part of M1.
----------------------
●● M2 is a broader measure of money that includes M1 plus near money.
---------------------- ●● Near monies are savings; there are several different types of savings.
---------------------- ●● 3 is equal to M2 plus other near monies, which comprise of larger
M
denominations of certificates of deposit and longer-term repurchase
---------------------- agreements.
---------------------- ●● iquid assets (L) are the economy’s total financial assets that can be converted
L
to M1.
----------------------
●● oney is vital to the production, consumption and exchange in a complex
M
---------------------- economy.
●● oo much money can cause inflation and too little money can cause
T
----------------------
a recession.
---------------------- ●● The Central Bank regulates money in the economy.
---------------------- ●● eople hold money in order to buy goods and services (transactions
P
demand), to have it available for emergency (precautionary demand) and
---------------------- in order to avoid possible drops in the value of other assets such as bonds
(speculative demand).
----------------------
●● he higher the interest rate, the lower the quantities of money demanded
T
---------------------- for transactions, for precautionary and speculative purposes. The lower
the interest rate, the higher the quantities of money demanded for these
---------------------- purposes.
---------------------- ●● he demand for money will change as a result of a change in real GDP, the
T
price level, transfer costs, expectations or preferences.
----------------------
●● e assume that the supply of money is determined by the Central Bank. The
W
---------------------- supply curve for money is thus a vertical line. Money market equilibrium
occurs at the interest rate at which the quantity of money demanded equals
---------------------- the quantity of money supplied.
----------------------
110 Macroeconomics
●● ll other things unchanged, a shift in money demand or supply will lead
A Notes
to a change in the equilibrium interest rate and therefore to changes in the
level of real GDP and the price level. ----------------------
----------------------
Keywords
----------------------
●● arter: Requirement for “double coincidence of wants”. For example,
B
an individual needs a goat and another, a trunk. Two things needed to be ----------------------
fulfilled in this case for a transaction to take place.
----------------------
●● iat money: Fiat money is currency, which is declared by the government
F
to be legal. ----------------------
●● lectronic money: It is generally defined as an electronic store of pecuniary
E ----------------------
value on a mechanical device supported with technology that may be widely
used for making payments to undertakings other than the issuer without ----------------------
necessarily involving bank accounts in the transactions, but acting as
a prepaid bearer instrument. ----------------------
●● oney basics: Money can be just about anything that can be used for
M ----------------------
exchange.
----------------------
●● onetary aggregates and commodity money: It is the aggregation
M
of currency and coins held by the public and checkable deposits (any ----------------------
demand deposit account against which checks or drafts of any kind may be
written). ----------------------
●● heckable deposit accounts: These include checking, savings and
C ----------------------
money market accounts. They also include any kind of negotiable draft,
such as a Negotiable Order of Withdrawal (NOW) or Super Now account. ----------------------
●● oney market equilibrium: Money market equilibrium occurs at
M ----------------------
the interest rate at which the quantity of money demanded is equal to the
quantity of money supplied. ----------------------
----------------------
----------------------
1. Explain the terms barter exchange, commodity money and fiat money.
----------------------
2. Write down four important functions of money.
----------------------
3. What do you understand by near monies? What are its different forms?
----------------------
----------------------
----------------------
----------------------
1. Near monies is an economic term describing non-cash assets that are highly
liquid in the nature of: ----------------------
iii. Savings of different types
----------------------
Money Markets 111

Notes 2. Fiat money serves the three important functions of money:
ii. A medium of exchange, a unit of account and a store of value
----------------------
----------------------
---------------------- 1. The belief of general acceptance makes money the medium of exchange
for transactions.
----------------------
2. The value of money from being diluted is protected by non-counterfeitable
---------------------- characteristic feature of the money.
----------------------
Suggested Reading
----------------------
1. Rittenberg, Libby and Tregarthen, Timothy. Principles of Macroeconomics,
---------------------- v. 1.0
---------------------- 2. http://faculty.babson.edu/ricciardi/MMS/MishkLiquidPref.pdf
---------------------- 3. http://wps.aw.com/wps/media/objects/2095/2146070/Ch04App03.pdf
4. http://www.wellesley.edu/Economics/weerapana/econ202/econ202pdf/
----------------------
lecture%20202-15.pdf
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
112 Macroeconomics
Central Banking, Federal Reserve Policy and Monetary
Policy UNIT
Structure: 7
7.1 Introduction
7.2 Evolution of Central Banking
7.3 Roles and Functions of Central Banks
7.4 The Federal Reserve System of the United States
7.5 Role and Functions of Reserve Bank of India
7.6 Monetary Policy
Summary
Keywords
Suggested Reading
Central Banking, Federal Reserve Policy and Monetary Policy 113

Notes
Objectives
----------------------
----------------------
●● Describe the evolution of central banking
---------------------- ●● Appraise the roles and functions of central banks
---------------------- ●● Discuss the role and functions of the Federal Reserve of the US
---------------------- ●● Analyse the role and functions of the Reserve Bank of India
----------------------
7.1 INTRODUCTION
----------------------
All over the world, the central banks are known to execute a large range of
---------------------- specialised functions, which by and large, include conducting banking operations
for governments, supervising and regulating banking institutions, managing the
---------------------- payments and settlement system and above all, formulating monetary policy for the
economy. The key driving force for establishing central banks and strengthening
----------------------
their activities across the globe was to act as bankers to government in normal
---------------------- times and to finance wars was the most important function during times of war.
Once the spectre of war receded, the role of central banks came to be increasingly
---------------------- focussed in mobilisation of resources for planned development and at the same
time in tackling high inflation. Over a period of time, the role and functions of
----------------------
central banks have evolved in response to the then prevailing economic scenarios
---------------------- and the policies and requirements of the respective governments.
---------------------- 7.2 EVOLUTION OF CENTRAL BANKING

----------------------
The early central banks were founded in the 17th century with the
---------------------- establishment of the Swedish Riksbank in 1668 and the Bank of England in
1694. Until 1800, the Riksbank and the Bank of England were the only central
---------------------- banks. Significant expansion in the number of central banks occurred in the
latter part of the 19th century. The Banque de France was set up in 1800 to
----------------------
restore confidence in the French banking system after the financial upheavals
---------------------- of the revolutionary period. The Banco de Portugal was established as public
limited company in 1846 as a note issuing commercial bank. Its main job was
---------------------- maintaining convertibility of its notes. The German Central Bank was set up in
1875 against the backdrop of the need to restore and maintain a stable currency.
----------------------
The Bank of Italy was founded in 1893 as part of the reorganisation of the Italian
---------------------- banking and monetary system that had reached the state of near collapse at the
beginning of the 1890s. The wave of bank failures and the need for a lender of
---------------------- last resort led to the establishment of the US Federal Reserve System (US Fed)
in 1914 for the provision of a nation-wise payment and depository system. The
----------------------
Reserve Bank of India (RBI) was established on April 1, 1935 under the Reserve
---------------------- Bank of India Act, 1934.
----------------------
114 Macroeconomics
The spreading out became especially pronounced in the second half of Notes
the 20th century finally leading to a situation wherein nearly every sovereign
nation had established its own central bank. As financial systems developed, ----------------------
central banks had to reorient their policies and strengthen their roles in order
to cope with the new challenges. During the Great Depression of the 1930s, ----------------------
the mandate given to most central banks included monetary stability, promotion ----------------------
of full employment and maximisation of growth. The role of central banks
thus enhanced in succession after every catastrophe. In case of developing ----------------------
nations, the central banks broadened their activities to cover ensuring economic
recovery and growth. As economies grew, complexities and size of the financial ----------------------
systems also broadened both in terms of superstructure and complexity of the ----------------------
financial instruments; as a result the volume and complexity of transactions
also grew. This necessitated appropriate payment and settlement systems and ----------------------
greater supervision and regulation. Consequently, the roles and functions of
the central banks underwent transformation to keep pace with the emerging ----------------------
challenges. Today, world over, the central banks have assumed a wide range of ----------------------
role and functions that include development of financial markets, institutions,
instruments, systems, financial regulation and supervision, administration of ----------------------
payment and settlement systems, management of government debt, etc.
----------------------
7.3 ROLES AND FUNCTIONS OF CENTRAL BANKS ----------------------
The role and functions of central banks vary from nation to nation depending ----------------------
upon the stage of development of the country. The developed countries have a
well-diversified and strong financial setup. They are advanced in the sense of both ----------------------
financial widening and financial deepening, as such the monetary transmission is ----------------------
swift. In addition to the above, it is well known that in developed countries use of
cheques/drafts and electronic means of transactions is prevalent to a great extent, ----------------------
whereas in developing countries there is a predominance of use of currency in
transactions, as a result the problem of currency management is comparatively ----------------------
negligible in comparison to that in developing economies. In addition to the ----------------------
above, in developing countries there is problem of existence of informal markets
which operate parallel to the controlled markets. As a result of this the monetary ----------------------
transmission process is weakened and the effect of central bank policies is not
fully achieved. The functions of the central banks have evolved in harmony with ----------------------
the specific needs of the countries concerned. Some of the important functions ----------------------
of a central bank are as under:
1. Banker to the government: One of the conventional functions of central ----------------------
banks has been to finance the respective governments. The reason for ----------------------
this stems from the need for supporting the government particularly in
situations of mismatches between government revenues and expenses. ----------------------
It is well known that many countries face problems of financing their
budget deficits, and have felt the need to have the support to effectively ----------------------
manage their finances. For this they have all the while depended on their ----------------------
central banks. Governments maintain their accounts with the central banks
and meet their funds requirements by placing bills with the central bank. In ----------------------

Notes turn, the central bank issues notes against these bills and credits an amount
equivalent to the nominal value of bills to the account of the government.
---------------------- This is generally termed as the central bank’s credit to government and
the money thus created is termed as monetisation of the public debt.
---------------------- The higher the borrowing requirement, the higher would be the credit
---------------------- extended by the central bank to the government. The credit extended to
the government leads to additional creation of money which is often
---------------------- found to bring in inflationary pressure in the economy. It is, therefore,
necessary that monetary and fiscal policy need to be coordinated well so
---------------------- that too much money is not created that would tend to prejudice central
---------------------- bank’s basic objective of price stability.
One more justification for the central banks to assume the job of managing
----------------------
public debt is because of the harmonising nature of monetary and fiscal
---------------------- policies. As a part of the market borrowing programme, central banks issue
government securities. These securities not only serve as a backup for note
---------------------- issue but also are used for the conduct of monetary policy through open
market operations. Open market operations involve the purchase and sale
----------------------
of government securities. The purchase of securities by the central bank
---------------------- increases the liquidity in the system while their sale results in the pulling
out/ shrinking of liquidity from the system. The central banks use this
---------------------- instrument suitably depending on the liquidity situation in the system.
Another reason for the central banks managing public debt emanates
----------------------
from the view that the central banks by managing public debt would be
---------------------- in a better position to influence the interest rates in the economy.
In the wake of the increasing dependence of governments on central banks for
----------------------
financing their debt obligations, the issue of separation of debt management
---------------------- from monetary management has been advocated. In view of the above, the
trend in a number of countries has been of separation of debt management
---------------------- function from the monetary management function by setting up separate
debt offices to implement specialised debt management strategies. As a
----------------------
result, in these countries the central banks are increasingly focussing on
---------------------- targeting inflation or price stability and are moving away from performing
the function of manager of public debt.
----------------------
2. Banker to banks: Banks are required to maintain reserves with the
---------------------- central bank, thus necessitating maintenance of accounts with it. Further
they need to maintain accounts with the central bank for the settlement
---------------------- of inter-bank obligations. During crisis the central bank acts as a lender of
the last resort. As a result, the central bank assumes the responsibility of
----------------------
maintaining financial stability.
---------------------- 3. Lender of last resort: In banking, a crisis is a situation when one or
---------------------- more banks are unable to meet their payment obligations to their clients
or other creditors. Such a situation often leads to what is known as, a run
---------------------- on the bank/ banks. Under such a crisis, the central bank provides the
required liquidity to the banks to meet their payment obligations. It may
----------------------
116 Macroeconomics
also bail out illiquid or insolvent banks so as to avert a systemic crisis. By Notes
providing liquidity to solvent but illiquid banks at the time of crisis, the
central banks help in averting a systemic crisis and thus ensure stability of ----------------------
the banking sector.
----------------------
In many countries central banks were set up just to handle banking crises
prevailing at the relevant times and to act a lender of the last resort. ----------------------
The Federal Reserve in the United States is one such central bank which
----------------------
was established in 1913 primarily to take care of frequent banking crisis.
In such a situation it had a very limited mandate of playing the role of a ----------------------
lender of last resort.
----------------------
4. Monetary policy functions: The core of central banking operations is
its monetary policy functions. Monetary policy function has been evolving ----------------------
over the years but has gained a high level of sophistication of late.
During the formative years, the central banks were entrusted with the ----------------------
function of note issuance. In those days, central banks based their note
----------------------
issue function against gold backing. This ensured certain discipline as it
prevented unplanned and ad hoc expansion in currency. As central banks ----------------------
started financing public debt, government paper came to be accepted as
backing for currency issue. Central banks adopted this paper as backing ----------------------
for extension of credit to government. Government accounts maintained
----------------------
with the central bank consist of both its deposits and liabilities. The
deposit balances in the government accounts increase whenever credit is ----------------------
extended to government. The difference between the government deposit
balances and its liabilities results in net central bank credit to government. ----------------------
With the development in international trade and the growth of foreign
----------------------
exchange markets, foreign exchange reserves emerged as another backing
for note issue. The net foreign exchange position provides backing for ----------------------
the quantum of currency expansion. In other words, the resultant currency
expansion could be traced to the external operations of the country. As a ----------------------
result the volatility in external operations could lead to undue expansion or
----------------------
contraction of domestic currency expansion. Hence, the need to maintain
a stable exchange rate assumes importance in monetary management. In ----------------------
short, the twin factors that contribute to monetary expansion are the net
central bank credit to government and the net foreign exchange reserves ----------------------
position. The third factor contributing to monetary expansion has been the
----------------------
credit extended by the central government to the commercial sector.
Central banks have equipped themselves with appropriate instruments ----------------------
for carrying out their monetary policy function. One such measure is the
----------------------
stipulation that the commercial and other banks maintain a certain proportion
of their demand and time liabilities with the central bank. These reserves could ----------------------
be varied by central banks depending upon emerging economic scenario.
This policy instrument is termed as variable reserve ratio. These reserves ----------------------
or balances maintained by banks with the central bank together with
----------------------
cash in hand with them constitute base money or high powered money.
An increase in the base money could bring about an expansion in money ----------------------

Notes and vice versa. The ratio of money supply to the base money or high
powered money is called “multiplier”. This implies that a given increase
---------------------- in base money brings about “multiplier” times increase in money supply.
In order that the policy measures are effective, central banks have put in
---------------------- place appropriate regulatory and supervisory mechanisms to ensure that the
---------------------- banks comply with the policy prescriptions.
In addition to the above, in many countries, the objective of price stability
----------------------
has emerged as a dominant objective of monetary policy. As a part of
---------------------- the monetary policy operations, central banks set forth the warranted rate
of monetary expansion over a period of say a year, keeping in view the
---------------------- broad objectives of monetary policy. The monetary growth also defines the
growth in currency and deposits of banks. While the issuance of currency
----------------------
and its management rests with the central bank, the growth of deposits is
---------------------- a function of growth of real sector and operations of commercial banks.
The monetary policy framework ensures that the deposit growth of
---------------------- commercial banks is broadly in line with the monetary projections of the
central bank. As the credit expansion of commercial banks depend on their
----------------------
deposit growth, credit policy of the central banks is regarded as an add-on
---------------------- to monetary policy.
5. Currency issue and management: Another basic function of a central
----------------------
bank is the monopoly of note issue. Central banks have always attempted
---------------------- to explore ways and means of imparting greater credibility and authenticity
to the currency issued by them. Prior to central banks taking over
---------------------- this function, the mode of currency issue was promissory note issued
by banks. The promissory note was an instrument containing a promise
----------------------
to pay to the bearer, the promised value in terms of precious metals.
---------------------- Precious metals, such as gold and silver as backing for the currency were
adopted to ensure credibility and acceptance to the currency. Later,
---------------------- what is known as the “fractional reserve system” was adopted, according
to which the promissory notes issued were not required to be fully backed
----------------------
by the precious metal and only a fraction of the value of notes issued
---------------------- was enough. The system led to issue of currency beyond reasonable levels
and consequent failures in terms of honouring commitments. As a result
---------------------- it was considered necessary to have an independent authority to ensure
that the currency issued is not excessive beyond the precious metal
----------------------
backing and that it commands credibility and authenticity. Over the years
---------------------- this function was performed by the central banks in most countries. As
stated earlier, currency notes were, initially written as promissory notes
---------------------- and were signed and circulated. Later currency notes were printed. The
currency management function has gained sophistication not only in the
----------------------
methodology of note issue but also in terms of note design and printing
---------------------- and “soiled note destruction” technology.
6. Payment and settlement systems: Payment and settlement systems play
----------------------
a vital role in facilitating financial transactions. As economic development
---------------------- takes place, there is significant growth in the volume and value of
118 Macroeconomics
these financial transactions. With development, new types of financial Notes
instruments surface to facilitate trade and industry. These transactions
need to be settled within a specified time-frame as otherwise delayed ----------------------
payments/settlements may interrupt trade and finance.
----------------------
All over the world central banks took over the payment and settlement system
and put in place well-established processes to ensure smooth conduct ----------------------
of these operations. The structure of the payment and settlement systems
----------------------
vary across the world. Broadly, there are three variants of organisational
structure followed wherein: ----------------------
i. The entire range of operations, i.e., the regulatory and operational
----------------------
aspects of clearing function are managed by central banks.
ii. The regulatory aspects are looked after by the central banks, the ----------------------
clearing operations are managed by private entities.
----------------------
iii. The regulatory aspects are with the central bank while the clearing
operations are shared by the central bank and the participating ----------------------
entities such as commercial banks. ----------------------
Over time, central banks have been progressively focussing more on
macroeconomic and liquidity management and are slowly letting go the ----------------------
clearing functions. The role of central banks, however, is confined to that ----------------------
of regulating the clearing houses or processing centres and performing
the settlement function in order to ensure finality in settlements. ----------------------
The most important factor is that this approach holds good for retail and ----------------------
generally small-value transactions. Large-value payment systems which
are systemically important, such as the Real Time Gross Settlement ----------------------
(RTGS) are typically operated and managed by the central bank on account
of many factors including the central bank being the largest source of ----------------------
liquidity and the impact these transactions could have on monetary policy ----------------------
operations of central banks.
----------------------
7. Maintaining internal value of currency: This function is derived from the
use of money as a medium of exchange which requires that the medium of ----------------------
exchange also serves as store of value. The fluctuations in the value of money
as a unit of account and as a standard of deferred payment also influence its ----------------------
role as a store of value. Large fluctuations in the value of money ─inflation
----------------------
or deflation─ would make money not only a poor measure of value, but also
a poor standard of deferred payment. This is because the value of money ----------------------
is not something intrinsic to it, but an economic and social phenomenon.
This makes monetary management to ensure the stable value of money ----------------------
socially important. Therefore, it is a major policy objective for the central
----------------------
banks to ensure maintenance of a stable price level. Over the years, there is
an increasing realisation that a stable price level has become a prerequisite ----------------------
for raising real growth rates and trade. In view of this, the maintenance of
price stability through the conduct of monetary policy has become a major ----------------------
objective of central banks.
----------------------

Notes Central banks use the technique of leading indicators to arrive at a forecast
of inflationary conditions. Such an advance forecast allows central bank
---------------------- to take a pro-active role in modulating its monetary policies in line with
the emerging scenario. If the causative factors point at fiscal sphere,
---------------------- then monetary policy actions need to be supplemented by fiscal policy
---------------------- measures.
8. Maintenance of external value of currency: The maintenance of the
----------------------
external value of money has received utmost importance of central banks
---------------------- in view of its implications for international trade and finance. The rationale
and practices followed in managing the exchange rate differs from country
---------------------- to country and over time in the same country. The mercantilist doctrine
stressed the importance of having an excess of exports over imports with
----------------------
a view to maintain a positive balance of trade.
---------------------- Through the 1990s, the reform process has transformed many economies
into vibrant and open ones. The free determination of the exchange rate
----------------------
is becoming increasingly complex for the emerging market economies.
---------------------- The matter is further complicated by the possibility of capital flows as
a result of integration of global markets. The structural changes that
---------------------- have been undertaken in a number of these countries make it feasible to
consider exchange rate flexibility or exchange rate targets or target zones.
----------------------
With fully convertible capital and current accounts, central banks cannot
---------------------- continue to have an independent domestic monetary policy. If the central
bank targets the internal value of the currency (inflation rate) by setting the
---------------------- interest rate, it has to let the exchange rate float. However, central banks can
temporarily set both internal and external values of the currency by putting
----------------------
circuit breakers between domestic and international financial markets by
---------------------- imposing limits on foreign purchases of domestic assets and/or through
sterilised intervention. But in the long run, the central bank may need
---------------------- to choose between targeting the domestic value of the currency and its
external value.
----------------------
9. Regulation, facilitation and supervision of financial system: With
---------------------- a view to protect the interest of depositors as also to ensure that the
functioning of the banks and financial institutions is in accordance with
----------------------
the best interests of the economy, central banks all over the world have
---------------------- traditionally been supervising and regulating commercial banks and other
financial institutions. There are valid and strong reasons for central banks to
---------------------- undertake supervisory functions, some of which are as under:
---------------------- i. Central banks collect mammoth amount of data on the financial
sector and the real sector alike and are therefore in a good position
---------------------- to form relatively objective views on market expectations and the
---------------------- need to act when necessary.
ii. Most central banks provide payment and settlement services and are
---------------------- in a position to quickly monitor the liquidity position of the system.
---------------------- iii. Being considered as a lender of last resort, the central bank is
120 Macroeconomics
in a better position to get prior indications about the borrowing Notes
requirements of the financial sector, which would provide clues
about their liquidity requirements. ----------------------
Accordingly central banks have put in place regulatory and supervisory ----------------------
mechanisms with a view to ensuring that financial institutions conform to
the rules of business and that operations are carried out in such a manner ----------------------
that they do not hurt the economic system. Regulation and supervision
----------------------
not only ensures proper monitoring of the financial entities but also helps
central banks in sending signals to the financial system so as to avert ----------------------
possible crisis situations.
----------------------
Central bank’s role as a regulator has evolved gradually over the years.
They have also been introducing improvements in their regulatory and ----------------------
supervisory frameworks by taking cognizance of the evolving risks to
the financial system. Central banks have been taking an active interest in ----------------------
financial sector regulation and supervision with a view to maintaining
----------------------
financial sector stability.
Bank supervisors seek to ensure that banks are financially sound, well ----------------------
managed and do not pose a threat to the interests of the stakeholders.
----------------------
In pursuing these objectives, supervisors base their judgements on three
aspects: (i) how much risk each bank is undertaking, (ii) what resources, ----------------------
tangible (capital, liquidity, etc.) or intangible (quality of management and
control systems) are available to manage that risk and (iii) whether the ----------------------
identified level of resources are sufficient to manage/balance the risk.
----------------------
In the recent years, there has been a perceptible shift from the traditional
CAMELS (Capital, Assets, Management, Earnings, Liquidity and Interest ----------------------
Rate Sensitivity) approach to a risk-based approach suggested by the ----------------------
Basel Capital Accord (1988). The risk-based supervision approach
involves identification of key risks, their level and the areas where these ----------------------
are likely to surface. After identification of these risks, a comprehensive
supervisory framework with appropriate resources is assembled to ----------------------
mitigate these risks. ----------------------
In the recent years some of the nations have floated the idea of a
separate supervisory authority other then the monetary policy function. ----------------------
In the United Kingdom, the supervisory body the Financial Services ----------------------
Authority (FSA) is placed outside the ambit of the central bank. In this
case, there is immense need for coordination in terms of policies, activities ----------------------
and information between the FSA, central bank and the treasury. Any
failure in coordination and cooperation could possibly lead to systemic ----------------------
catastrophe. ----------------------
10. Financial stability: From an operational point of view, financial stability has
been defined as ensuring uninterrupted financial transactions, maintenance ----------------------
of a level of confidence in the financial system amongst all the participants ----------------------
and stakeholders and absence of excessive volatility that unduly and
adversely affects real economic activity. From the above definition, it ----------------------

Notes is clear that an individual bank failure or every large swing in asset
prices does not necessarily mean financial instability.
----------------------
All over the world, the central banks keep a close watch on movements
---------------------- in national and international financial markets so as to provide emergency
liquidity assistance, whenever needed. Moreover, smooth implementation
---------------------- of the monetary policy largely depends upon the functioning of key markets
and financial institutions. In addition to the above, the central bank’s
----------------------
interest in financial stability stems from its role in the operation of oversight
---------------------- of payment and settlement systems.
So far as the central bank is concerned, there are certain well-developed
----------------------
precautionary measures that help in maintaining financial stability of
---------------------- the economy. These include development of a set of standards and
codes, prudential regulation, early warning signals, supervision of banks,
---------------------- compliance with international standards as regard capital adequacy
norms, asset classification procedures, income recognition principles,
----------------------
market valuation of assets and recovery mechanisms to reduce the Non-
---------------------- Performing Assets (NPAs) of banks.
11. Promotional functions: A development function commonly performed
----------------------
by the central banks is the “promotion of growth”. However in a strict
---------------------- sense, in most countries, this function seems to be limited to facilitating
a pro-growth atmosphere or ensuring that there are no bottlenecks to
---------------------- growth in terms of high cost of interest rates. In addition to the above,
in developing countries the central bank must also to ensure that there is
----------------------
adequate credit flow to all productive sectors and also to backward regions.
---------------------- There is often a requirement to support growth in certain sectors that have
priority over the others. In order to ensure a balanced regional growth, the
---------------------- central banks need to monitor the flow of savings from the poorer regions
to the richer and more progressive regions.
----------------------
12. Development of financial markets and institutions: In recent
---------------------- years, monetary authorities are increasingly using market-based tools
---------------------- to implement monetary policy. This has prompted the development of
financial markets. Well-developed domestic financial markets are
---------------------- necessary to withstand disturbances and shocks to the domestic financial
system during crisis period. Financial markets generally comprise the
---------------------- money market, bond market, foreign exchange market and capital
---------------------- market. Monetary policy depends on markets for its transmission, and
therefore, their development is an enabling factor for an effective monetary
---------------------- policy. Central banks in developing countries are required to strive hard for
the efficient functioning of the financial sector. They are often involved
---------------------- in the designing of the financial infrastructure and making appropriate
---------------------- regulation for ensuring market discipline. In order to address the problems
of the financial system, central banks in developing countries have to
---------------------- make specific efforts to replace informal credit by spreading the umbrella
of organised credit. Expansion of commercial banks’ network is also very
---------------------- useful in the mobilisation of savings and ensuring that adequate formal
122 Macroeconomics
credit replaces any extant usurious relationships. The deposit insurance and Notes
credit guarantee schemes have to be introduced to address the issue of
market failure that is often encountered in a developing economy. ----------------------
13. Central bank communication policies: Communications from the ----------------------
central banks play a crucial role in shaping the expectations of the markets.
Central banks have to communicate to the public their perception of ----------------------
outlook, risk assessments and objectives.
----------------------
Central banks communicate their views and policies in the form of monetary
and credit policy announcements and various reports that they publish. ----------------------
----------------------
----------------------
Fill in the blanks.
----------------------
1. The developed countries are advanced in the sense of both
financial __________ and _________ financial , as such the monetary ----------------------
transmission is swift.
----------------------
2. Governments maintain their accounts with the central banks and meet
their funds requirements by placing ___________ with the central ----------------------
bank.
----------------------
3. A crisis situation often leads to what is known as a _____________.
----------------------
Activity 1 ----------------------
----------------------
Trace the changes in the Variable Reserve Policy of RBI as announced in
the successive credit policy announcements of the Reserve Bank of India ----------------------
and prepare a list of the changes in CRR/SLR over the last five years. ----------------------
----------------------
7. 4 THE FEDERAL RESERVE SYSTEM OF THE UNITED
----------------------
STATES
----------------------
The Federal Reserve System is the central bank of the United States. It
was founded in 1913 to provide the nation with a safer, more flexible and a more ----------------------
stable monetary and financial system. The Federal Reserve System is considered
to be an independent central bank because its decisions do not have to be ratified ----------------------
by the president or anyone else in the executive branch of the government. The ----------------------
System is, however, subject to oversight by the US Congress. The Federal Reserve
works within the framework of the overall objectives of economic and financial ----------------------
policy established by the government. Federal Reserve’s duties fall into four
general areas: ----------------------
i) Conducting the nation’s monetary policy by influencing the monetary ----------------------

and credit conditions in the economy in pursuit of maximum employment,
stable prices and moderate long-term interest rates. ----------------------

Notes ii) Supervising and regulating banking institutions to ensure the safety and
soundness of the nation’s banking and financial system and to protect the
---------------------- credit rights of consumers.
---------------------- iii) Maintaining the stability of the financial system and containing systemic
risk that may arise in financial markets.
----------------------
iv) Providing financial services to depository institutions, the US government
---------------------- and foreign official institutions, including playing a major role in operating
the nation’s payments system.
----------------------
The Federal Reserve implements monetary policy through its control
---------------------- over the federal funds rate, i.e., the rate at which depository institutions trade
balances at the Federal Reserve. It exercises this control by influencing the
---------------------- demand for and supply of these balances through the following means:
---------------------- i. Open market operations: The purchase or sale of securities, primarily
US Treasury securities, in the open market to influence the level of balances
---------------------- that depository institutions hold at the Federal Reserve Banks.
---------------------- ii. Reserve requirements: Requirements regarding the percentage of certain
deposits that depository institutions must hold in reserve in the form of cash
---------------------- or in an account at a Federal Reserve Bank.
---------------------- iii. Contractual clearing balances: An amount that a depository institution
agrees to hold at its Federal Reserve Bank in addition to any required
---------------------- reserve balance.
---------------------- iv. Discount window lending: Extensions of credit to depository institutions
made through the primary, secondary or seasonal lending programmes.
----------------------
----------------------
The following are some of the major functions of the Federal Reserve
---------------------- of the United States:
---------------------- 1. Formulation of monetary policy: The Federal Reserve sets the nation’s
monetary policy to promote the objectives of maximum employment,
---------------------- stable prices and moderate long-term interest rates.
---------------------- 2. Implementation of monetary policy: The Federal Reserve exercises

considerable control over the demand for and supply of balances that
---------------------- depository institutions hold at the Reserve Banks. In so doing, it influences
the federal funds’ rate and ultimately, employment, output, and prices.
----------------------
3. International activities: The activities of the Federal Reserve and the
---------------------- international economy influence each other. Therefore, when deciding on
the appropriate monetary policy for achieving the basic economic goals,
----------------------
it considers the record of the US international transactions, movements in
---------------------- foreign exchange rates and other international economic developments.
The Federal Reserve formulates policies that shape, and are shaped
---------------------- by, international developments. It also participates directly in international
affairs. These transactions are undertaken in close and continuous
----------------------
124 Macroeconomics
consultation and cooperation with the US Treasury. The Federal Reserve Notes
also works with the Treasury and other government agencies on various
aspects of international financial policy. It participates in a number of ----------------------
international organisations and forums and is in constant contact with
other central banks on subjects of common concern. ----------------------
4. Supervision and regulation: The Federal Reserve has supervisory and ----------------------
regulatory authority over a wide range of financial institutions and activities.
----------------------
It works with other federal and state supervisory authorities to ensure the
safety and soundness of financial institutions, stability in the financial ----------------------
markets and fair and equitable treatment of consumers in their financial
transactions. The Federal Reserve also has extensive and well-established ----------------------
relationships with the central banks and financial supervisors of other
----------------------
countries, which enables it to coordinate its actions with those of other
countries when managing international financial crises and supervising ----------------------
institutions with a substantial international presence.
----------------------
5. Consumer and community affairs: The Federal Reserve has been
assigned with the duty of implementing many of the federal laws intended ----------------------
to protect consumers in credit and other financial transactions and
to ensure that consumers receive comprehensive information and fair ----------------------
treatment. Among the Federal Reserve’s responsibilities in this area are:
----------------------
i. Writing and interpreting regulations to carry out many of the
major consumer protection laws. ----------------------
ii. Reviewing bank compliance with the regulations. ----------------------
iii. Investigating complaints from the public about state member
banks’ compliance with consumer protection laws. ----------------------
iv. Addressing issues of state and federal jurisdiction. ----------------------
v. Testifying before Congress on consumer protection issues.
----------------------
vi. Conducting community development activities.
In carrying out these responsibilities, the Federal Reserve is advised by ----------------------
its Consumer Advisory Council, representing the interests of consumers,
community groups and creditors nationwide. ----------------------
6. Payment systems: The Federal Reserve also plays an important role in the ----------------------
US payment system. The various Federal Reserve Banks provide banking
----------------------
services to depository institutions and to the federal government.
They maintain accounts of the depository institutions and provide various ----------------------
payment services, including collecting cheques, electronically transferring
funds and distributing and receiving currency and coin. For the federal ----------------------
government, the Reserve Banks act as fiscal agents, paying Treasury
----------------------
cheques, processing electronic payments, and issuing, transferring and
redeeming US government securities. ----------------------
----------------------
----------------------

Notes 7.5 ROLE AND FUNCTIONS OF RESERVE BANK OF INDIA
---------------------- The Reserve Bank of India (RBI) was established under the Reserve Bank
of India Act, 1934. It began operations on April 1, 1935. RBI was established with
---------------------- the objective of ensuring monetary stability and operating the currency and
credit system of the country to its advantage. Its functions comprise monetary
----------------------
management, foreign exchange and reserves management, government
---------------------- debt management, financial regulation and supervision, apart from currency
management and acting as banker to the banks and to the government. In addition,
---------------------- from the beginning, RBI has played an active developmental role, particularly for
the agriculture and rural sectors. Over the years, these functions have evolved in
----------------------
tandem with national and global developments.
---------------------- A core function of the Reserve Bank in the last 75 years has been the
---------------------- formulation and implementation of monetary policy with the objectives of
maintaining price stability and ensuring adequate flow of credit to productive
---------------------- sectors of the economy. To these was added, in more recent times, the goal of
maintaining financial stability. The objective of maintaining financial stability
---------------------- has spanned its role from external account management to oversight of banks
---------------------- and non-banking financial institutions as also of money, government securities
and foreign exchange markets. The Reserve Bank designs and implements the
---------------------- regulatory policy framework for banking and non-banking financial institutions
with the aim of providing people access to the banking system, protecting
---------------------- depositors’ interest and maintaining the overall health of the financial system.
---------------------- Consequent to the 1991 balance of payments and foreign exchange crisis, there
was a paradigm shift in India’s economic and financial policies. The approach
---------------------- under the reform era included a thrust towards liberalisation, privatisation,
---------------------- globalisation and concerted efforts at strengthening the existing and emerging
institutions and market participants. The Reserve Bank adopted international
---------------------- best practices in areas, such as prudential regulation, banking technology,
variety of monetary policy instruments, external sector management and
---------------------- currency management to make the new policy framework effective.
---------------------- The rapid pace of growth achieved by the financial system in the
deregulated regime necessitated a deepening and widening of access to banking
----------------------
services. The new millennium has seen the Reserve Bank play an active role in
---------------------- balancing the relationship between banks and customers, focusing on financial
inclusion, setting up administrative machinery to handle customer grievances,
---------------------- pursuing clean note policy and ensuring development and oversight of secure
and robust payment and settlement systems. The last one-and-a-half decades
----------------------
have also seen growing integration of the national economy and financial system
---------------------- with the globalising world. While rising global integration has its advantages in
terms of expanding the scope and scale of growth of the Indian economy, it also
---------------------- exposes India to global shocks. Hence, maintaining financial stability became
an important mandate for the Reserve Bank. This, in turn, has brought forth the
----------------------
need for effective coordination and consultation with other regulators within the
---------------------- country and abroad.
126 Macroeconomics
The functions of Reserve Bank of India can be categorised as follows: Notes
1. Monetary policy: One of the most important functions of central banks
----------------------
is formulation and execution of monetary policy. In the Indian context, the
basic functions of the Reserve Bank of India as enunciated in the Preamble ----------------------
to the RBI Act, 1934 are “to regulate the issue of bank notes and the
keeping of reserves with a view to securing monetary stability in India ----------------------
and generally to operate the currency and credit system of the country to its
----------------------
advantage”. Thus, the Reserve Bank’s mandate for monetary policy flows
from its monetary stability objective. ----------------------
Essentially, monetary policy deals with the use of various policy instruments
----------------------
for influencing the cost and availability of money in the economy.
As macroeconomic conditions change, a central bank may change the ----------------------
choice of instruments in its monetary policy. The overall goal is to promote
economic growth and ensure price stability. Over time, the objectives of ----------------------
monetary policy in India have evolved to include maintaining price stability,
----------------------
ensuring adequate flow of credit to productive sectors of the economy for
supporting economic growth and achieving financial stability. ----------------------
2. Regulation and supervision of the banking and non-banking
----------------------
financial institutions: The Reserve Bank’s regulatory and supervisory
domain extends not only to the Indian banking system but also to the ----------------------
developmental financial institutions, non-banking financial companies
(NBFCs), primary dealers, credit information companies and select ----------------------
segments of the financial markets. In respect to banks, the Reserve Bank
----------------------
derives its powers from the provisions of the Banking Regulation Act,
1949, while the other entities and markets are regulated and supervised ----------------------
under the provisions of the Reserve Bank of India Act, 1934. The credit
information companies are regulated under the provisions of the Credit ----------------------
Information Companies (Regulation) Act, 2005. As the regulator and the
----------------------
supervisor of the banking system, the Reserve Bank has a critical role to
play in ensuring the system’s safety and soundness on an ongoing basis. ----------------------
The objective of this function is to protect the interest of depositors through
an effective prudential regulatory framework for orderly development and ----------------------
conduct of banking operations, and to maintain overall financial stability
----------------------
through various policy measures.
3. Currency management: Management of currency is one of the core ----------------------
central banking functions of the Reserve Bank for which it derives the ----------------------
necessary statutory powers from Section 22 of the RBI Act, 1934.
Along with the Government of India, the Reserve Bank is responsible ----------------------
for the design, production and overall management of the nation’s currency,
with the goal of ensuring an adequate supply of clean and genuine notes. In ----------------------
consultation with the Government, the Reserve Bank routinely addresses ----------------------
security issues and targets ways to enhance security features to reduce the
risk of counterfeiting or forgery of currency notes. ----------------------
----------------------

Notes 4. Banker to banks: Banks are required to maintain a portion of their
demand and time liabilities as cash reserves with the Reserve Bank, thus
---------------------- necessitating a need for maintaining accounts with RBI. Further, banks
are in the business of accepting deposits and giving loans. As banker to
---------------------- banks, RBI focuses on (i) enabling smooth, swift and seamless clearing and
---------------------- settlement of inter-bank obligations, (ii) providing an efficient means of
funds transfer for banks, (iii) enabling banks to maintain their accounts
---------------------- with the Reserve Bank for statutory reserve requirements and maintenance
of transaction balances and (iv) acting as a lender of last resort.
----------------------
5. Debt and cash management for central and state governments: Since
---------------------- its inception, the Reserve Bank has undertaken the traditional central
banking function of managing the Government’s banking transactions. The
----------------------
Reserve Bank of India Act, 1934 requires the Central Government to entrust
---------------------- the Reserve Bank with all its money, remittance, exchange and banking
transactions in India and the management of its public debt. The Government
---------------------- also deposits its cash balances with the Reserve Bank. The Reserve Bank
may also, by agreement, act as the banker to a state government. Currently,
----------------------
the Reserve Bank acts as banker to all the state governments in India, except
---------------------- Jammu & Kashmir and Sikkim. It has limited agreements for the management
of the public debt of these two state governments.
----------------------
As a banker to the Government, the Reserve Bank receives and pays money
---------------------- on behalf of the various Government departments. As it has offices in only
27 locations, the Reserve Bank appoints other banks to act as its agents
---------------------- for undertaking the banking business on behalf of the governments. The
Reserve Bank pays agency bank charges to the banks for undertaking the
----------------------
government business on its behalf. The Reserve Bank has well-defined
---------------------- obligations and provides several services to the governments. The Central
Government and state governments may make rules for the receipt, custody
---------------------- and disbursement of money from the consolidated fund, contingency fund
and public account. These rules are legally binding on the Reserve Bank.
----------------------
The Reserve Bank also undertakes to float loans and manage them on
---------------------- behalf of the governments. It also provides ways and means advances
– a short-term interest bearing advance – to the governments to meet
---------------------- the temporary mismatches in their receipts and payments. Besides, it
arranges for investments of surplus cash balances of the governments
----------------------
as a portfolio manager. The Reserve Bank also acts as adviser to the
---------------------- Government, whenever called upon to do so, on monetary and banking
related matters.
----------------------
6. Management of foreign exchange reserves: The Reserve Bank, as
---------------------- the custodian of the country’s foreign exchange reserves, is vested
with the responsibility of managing their investment. The legal provisions
---------------------- governing management of foreign exchange reserves are laid down in the
Reserve Bank of India Act, 1934.
----------------------
----------------------
128 Macroeconomics
The Reserve Bank’s reserves management function has in recent years Notes
grown both in terms of importance and sophistication for two main reasons.
First, the share of foreign currency assets in the balance sheet of the Reserve ----------------------
Bank has substantially increased. Second, with the increased volatility in
exchange and interest rates in the global market, the task of preserving the ----------------------
value of reserves and obtaining a reasonable return on them has become ----------------------
challenging.
----------------------
The basic parameters of the Reserve Bank’s policies for foreign exchange
reserves management are safety, liquidity and returns. ----------------------
7. Foreign exchange management: The Reserve Bank oversees the
----------------------
foreign exchange market in India. It supervises and regulates it through the
provisions of the Foreign Exchange Management Act, 1999. Like other ----------------------
markets, the foreign exchange market has also evolved over time, and the
Reserve Bank has been modulating its approach towards its function of ----------------------
supervising the market.
----------------------
8. Oversight of the payment and settlement systems: The regulation
and supervision of the payment systems is being increasingly recognised ----------------------
as a core responsibility of central banks. Safe and efficient functioning of
----------------------
these systems is an important pre-requisite for the proper functioning of the
financial system and the efficient transmission of monetary policy. The ----------------------
Reserve Bank, as the regulator of financial systems, has been initiating
reforms in the payment and settlement systems to ensure efficient ----------------------
and faster flow of funds among various constituents of the financial
----------------------
sector. The increasing monetisation in the economy, the country’s large
geographic expanse, people’s preference for paper-based instruments and ----------------------
rapid changes in technology are among the factors that make this task a
formidable one. The Reserve Bank has adopted a three-pronged strategy ----------------------
of consolidation, development and integration to establish a modern and
----------------------
robust payment and settlement system which is also efficient and secure.
The consolidation revolves around expanding the reach of the existing ----------------------
products by introducing clearing process in new locations. The reach ----------------------
is also facilitated by the use of latest technology, such as mechanised
cheque processing and image-based cheque processing systems and ----------------------
interconnection of the clearing houses. The Reserve Bank has also taken
steps towards integrating the payment system with the settlement system ----------------------
for government securities and foreign exchange. To facilitate settlement ----------------------
of Government securities transactions, it created the Negotiated Dealing
System (NDS), a screen-based trading platform. The NDS facilitates the ----------------------
dealing process and provides for electronic reporting of trades, online
information dissemination and settlement in a centralised system. ----------------------
For settlement of trade in foreign exchange, Government securities and other ----------------------
debt instrument, it has set up the Clearing Corporation of India Limited
(CCIL). It plays the role of a central counter party to transactions and ----------------------
guarantees settlement of trade, thus managing the counter- party risk. ----------------------

Notes The Payment and Settlement Systems Act, 2007 provides for regulation
and supervision of payment systems in India and designates the Reserve
---------------------- Bank as the authority for the purpose. As per the Act, only payment systems
authorised by the Reserve Bank can be operated in the country. The Act also
---------------------- provides for the settlement effected under the rules and procedures of the
---------------------- system provider to be treated as final and irrevocable.
The Reserve Bank has put in place an institutional framework and structure
----------------------
for oversight of the payment systems. In 2005, it created a Board for
---------------------- Regulation and Supervision of Payment and Settlement Systems (BPSS) as
a Committee of the Central Board. A new department called the Department
---------------------- of Payment and Settlement Systems (DPSS) was constituted to assist the
BPSS in performing its functions.
----------------------
9. Currency management: Management of currency is one of the core
---------------------- central banking functions of the Reserve Bank for which it derives the
necessary statutory powers from Section 22 of the RBI Act, 1934.
----------------------
Along with the Government of India, the Reserve Bank is responsible
---------------------- for the design, production and overall management of the nation’s currency,
with the goal of ensuring an adequate supply of clean and genuine notes. In
---------------------- consultation with the Government, the Reserve Bank routinely addresses
security issues and targets ways to enhance security features to reduce the
----------------------
risk of counterfeiting or forgery of currency notes.
---------------------- 10. Developmental role: The Reserve Bank is one of the few central banks
that have taken an active and direct role in supporting developmental
----------------------
activities in their country. The Reserve Bank’s developmental role includes
---------------------- ensuring credit to productive sectors of the economy, creating institutions
to build financial infrastructure, and expanding access to affordable
---------------------- financial services. Over the years, its developmental role has extended to
institution building for facilitating the availability of diversified financial
----------------------
services within the country. The Reserve Bank today also plays an active
---------------------- role in encouraging efficient customer service throughout the banking
industry. Through financial inclusion it is ensuring extension of banking
---------------------- service to all. Given the predominantly agrarian character of the Indian
economy, the Reserve Bank’s role has been to ensure timely and adequate
----------------------
credit to the agricultural sector at affordable cost. Section 54 of the RBI
---------------------- Act, 1934 states that the Bank may maintain expert staff to study various
aspects of rural credit and development and in particular, it may tender
---------------------- expert guidance and assistance to the National Bank for Agriculture and
Rural Development (NABARD) and conduct special studies in such
----------------------
areas as it may consider necessary to do so for promoting integrated rural
---------------------- development.
---------------------- The Reserve Bank introduced the Lead Bank Scheme in 1969. Here
designated banks were made key instruments for local development and
---------------------- were entrusted with the responsibility of identifying growth centres,
assessing deposit potential and credit gaps and evolving a coordinated
---------------------- approach for credit deployment in each district in collaboration with other
130 Macroeconomics
banks and other agencies. The Reserve Bank has assigned a Lead District Notes
Manager for each district who acts as a catalytic force for promoting
financial inclusion and smooth working between government and banks. ----------------------
11. Research and statistics: The Reserve Bank has over time established a sound ----------------------
and rich tradition of policy-oriented research and an effective mechanism
for disseminating data and information. Like other major central banks, ----------------------
the Reserve Bank has also developed its own research capabilities in the
----------------------
field of economics, finance and statistics, which contribute to a better
understanding of the functioning of the economy and the ongoing ----------------------
changes in the policy transmission mechanism. The Reserve Bank’s two
research departments – Department of Economic Analysis and Policy and ----------------------
Department of Statistics and Information Management – provide analytical
----------------------
research on various aspects of the Indian economy.
The Reserve Bank releases several periodical publications that contain ----------------------
a comprehensive account of its operations as well as information of the
----------------------
trends and developments pertaining to various areas of the Indian economy.
Besides, there are periodical statements on monetary policy, official press ----------------------
releases, and speeches and interviews given by the top management which
articulate the Reserve Bank’s assessment of the economy and its policies. ----------------------
The Reserve Bank has also set up an enterprise-wide data warehouse ----------------------
through which data is made available in downloadable and reusable formats.
Users now have access to a much larger database on the Indian economy through ----------------------
the Reserve Bank’s website. This site has a user-friendly interface and enables easy
----------------------
retrieval of data through pre-formatted reports. It also has the facility for simple
and advanced queries. ----------------------
Under the aegis of the Development Research Group (DRG) in the Department ----------------------
of Economic Analysis and Policy, the Reserve Bank encourages and promotes
policy-oriented research backed by strong analytical and empirical basis on ----------------------
subjects of current interest. The DRG studies are the outcome of collaborative
efforts between experts from outside the Reserve Bank and the pool of ----------------------
research talent within. The annual Report on Currency and Finance has now ----------------------
been made into a theme-based publication, providing in-depth information
and analysis on a topical subject. It has become a valuable reference point for ----------------------
research and policy formulation.
----------------------
7.6 MONETARY POLICY ----------------------
Monetary policy deals with the use of various policy instruments for ----------------------
influencing the cost and availability of money in the economy. Based on its
assessment of macroeconomic and financial conditions, the Reserve Bank takes ----------------------
the call on the stance of monetary policy and monetary measures. Its monetary
----------------------
policy statements reflect the changing circumstances and priorities of the
Reserve Bank and the thrust of policy measures for the future. Faced with ----------------------
multiple tasks and a complex mandate, the Reserve Bank emphasises clear
and structured communication for effective functioning of the monetary policy. ----------------------

Notes Improving transparency in its decisions and actions is a constant endeavour at
the Reserve Bank.
----------------------
The Reserve Bank announces the monetary policy in April every year
---------------------- for the financial year that ends in the following March. This is followed by three
quarterly reviews in July, October and January. However, depending on the
---------------------- evolving situation, the Reserve Bank may announce monetary measures at any
point of time. The Monetary Policy in April and its Second Quarter Review
----------------------
in October consists of two parts: (i) Part A provides an appraisal of the
---------------------- macroeconomic and monetary developments and sets the stance of the monetary
policy and the monetary measures, (ii) Part B provides a rundown of the action
---------------------- taken and the status of past policy announcements together with fresh policy
measures. It also deals with important topics, such as financial stability, financial
----------------------
markets, interest rates, credit delivery, regulatory norms, financial inclusion
---------------------- and institutional developments. However, the First Quarter Review in July and
the Third Quarter Review in January consist of only Part A.
----------------------
The monetary policy framework in India, as it is today, has evolved over
---------------------- the years. There was a time when the Reserve Bank used broad money (M3)
as the policy target. However, with the weakened relationship between money,
---------------------- output and prices, it replaced M3 as a policy target with a multiple indicators
approach. As the name suggests, the multiple indicators approach looks at a
----------------------
large number of indicators from which policy perspectives are derived. Interest
---------------------- rates or rates of return in different segments of the financial markets along with
data on currency, credit, trade, capital flows, fiscal position, inflation, exchange
---------------------- rate and such other indicators are juxtaposed with the output data to assess the
underlying trends in different sectors. Such an approach provides considerable
----------------------
flexibility to the Reserve Bank to respond more effectively to changes in domestic
---------------------- and international economic environment and financial market conditions.
----------------------
The Reserve Bank traditionally relied on direct instruments of monetary
---------------------- control, such as Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio
---------------------- (SLR). CRR indicates the quantum of cash that banks are required to keep with
the Reserve Bank as a proportion of their net demand and time liabilities. SLR
---------------------- prescribes the amount of money that banks must invest in securities issued by the
Government.
----------------------
In the late 1990s, the Reserve Bank restructured its operating framework
---------------------- for monetary policy to rely more on indirect instruments, such as Open
Market Operations (OMOs). In addition, in the early 2000s, the Reserve Bank
---------------------- instituted Liquidity Adjustment Facility (LAF) to manage day-to-day liquidity in
---------------------- the banking system. These facilities enable injection or absorption of liquidity that
is consistent with the prevailing monetary policy stance. The repo rate (at which
---------------------- liquidity is injected) and reverse repo rate (at which liquidity is absorbed) under
the LAF have emerged as the main instruments for the Reserve Bank’s interest
---------------------- rate signaling in the Indian economy. The armour of instruments with the Reserve
---------------------- Bank to manage liquidity was strengthened in April 2004 with the Market
132 Macroeconomics
Stabilisation Scheme (MSS). The MSS was specifically introduced to manage Notes
excess liquidity arising out of huge capital flows coming to India from abroad.
----------------------
In addition, the Reserve Bank also uses prudential tools to modulate the
flow of credit to certain sectors so as to ensure financial stability. The availability ----------------------
of multiple instruments and their flexible use in the implementation of monetary
policy has enabled the Reserve Bank to successfully influence the liquidity and ----------------------
instruments if circumstances warrant such actions. Often, complex situations
----------------------
require varied combination of direct and indirect instruments to make the policy
transmission effective. ----------------------
The recent legislative amendments to the Reserve Bank of India Act,
----------------------
1934 enable a flexible use of CRR for monetary management without being
constrained by a statutory floor or ceiling on the level of the CRR. The amendments ----------------------
to the Banking Regulation Act, 1949 also provide further flexibility in liquidity
management by enabling the Reserve Bank to lower the SLR to a level below ----------------------
25% of Net Demand and Time Liabilities (NDTL) of banks.
----------------------
An important factor that determines the effectiveness of monetary
policy is its transmission – a process through which changes in the policy ----------------------
achieve the objectives of controlling inflation and achieving growth. In the
----------------------
implementation of monetary policy, a number of transmission channels have
been identified for influencing real sector activity. These are (i) the quantum ----------------------
channel relating to money supply and credit, (ii) the interest rate channel,
(iii) the exchange rate channel and (iv) the asset price channel. ----------------------
How these channels function in an economy depends on its stage of ----------------------
development and its underlying financial structure. In an open economy, for
example, one would expect the exchange rate channel to be important; similarly, ----------------------
in an economy where banks are the major source of finance as against the capital ----------------------
market, credit channel could be a major conduit for monetary transmission.
Of course, these channels are not mutually exclusive, and there could be ----------------------
considerable feedback and interaction among them.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
----------------------
1. Reserve requirements as a part of monetary policy means:
---------------------- i. Maintaining reserve on deposits
---------------------- ii. Maintaining reserve on advances
iii. Maintaining reserve in the form of CRR and SLR
---------------------- 2. Cash reserve is maintained equivalent of:
---------------------- i. Certain percentage of total deposits
ii. Certain percentage of total demand and time deposits iii. Certain
----------------------
percentage of long-term deposits
1. A core function of the Reserve Bank in the last 75 years has
----------------------
been the _____________ and _______________ of monetary
---------------------- policy with the objectives of maintaining price ____________ and
ensuring adequate flow of ___________ to productive sectors of the
---------------------- economy.
---------------------- 2. Reserve Bank’s mandate for monetary policy flows from its
_____________ objective.
---------------------- 3. The regulation and supervision of the payment systems of the
RBI is an important pre-requisite for the proper functioning of the
----------------------
_______________ and the efficient transmission of ____________ .
----------------------
---------------------- Activity 2
----------------------
Study the last four Monetary Policies announced by the Reserve Bank of
---------------------- India and make a note of the various measures announced to check inflation
----------------------
---------------------- Summary
---------------------- ●● ll over the world the central banks are known to execute a large
A
range of specialised functions which by and large include conducting
---------------------- banking monetary policy for the economy. Over a period of time, the role and
---------------------- functions of central banks have evolved in response to the then prevailing
economic scenarios and the policies and requirements of the respective
---------------------- governments.
●● The functions of the central banks have evolved in harmony with the
----------------------
specific needs of the countries concerned. Some of the important functions
---------------------- of a central bank are as under:
 Banker to the government
----------------------
134 Macroeconomics
 Banker to banks Notes
 Lender of the last resort
----------------------
 Monetary policy functions
----------------------
 Currency issue and management
 Payment and settlement systems ----------------------
 Maintaining internal value of currency ----------------------

 Maintenance of the external value of currency ----------------------
 Regulation, facilitation and supervision of financial system
----------------------
 Financial stability
----------------------
 Promotional functions
 Development of financial markets and institutions ----------------------
 Central bank communication policies ----------------------

●● he Federal Reserve System is the central bank of the United States. It
T ----------------------
was founded in 1913 to provide the nation with a safer, more flexible, and
more stable monetary and financial system. ----------------------
●● he Federal Reserve System is considered to be an independent central
T ----------------------
bank because its decisions do not have to be ratified by the president
or anyone else in the executive branch of government. The System is, ----------------------
however, subject to oversight by the US Congress. The Federal Reserve
works within the framework of the overall objectives of economic and ----------------------
financial policy established by the government. ----------------------
●● he Federal Reserve implements monetary policy through its control
T
over the federal funds rate, i.e., the rate at which depository institutions ----------------------
trade balances at the Federal Reserve. ----------------------
●● he Reserve Bank of India has been established under the Reserve Bank of
T
India Act, 1934. It began operations on April 1, 1935. RBI was established ----------------------
with the objective of ensuring monetary stability and operating the currency ----------------------
and credit system of the country to its advantage. Its functions comprise
monetary management, foreign exchange and reserves management, ----------------------
government debt management, financial regulation and supervision,
apart from currency management and acting as banker to the banks and ----------------------
to the Government. ----------------------
●● eserve Bank has played an active developmental role, particularly for
R
the agriculture and rural sectors. Over the years, these functions have ----------------------
evolved in tandem with national and global developments. ----------------------
●● core function of the Reserve Bank in the last 75 years has been the
A
formulation and implementation of monetary policy with the objectives ----------------------
of maintaining price stability and ensuring adequate flow of credit to
----------------------
productive sectors of the economy.
----------------------

Notes ●● he objective of maintaining financial stability has spanned its role
T
from external account management to oversight of banks and non-banking
---------------------- financial institutions as also of money, government securities and foreign
exchange markets.
----------------------
●● onetary policy deals with the use of various policy instruments
M
---------------------- for influencing the cost and availability of money in the economy.
As macroeconomic conditions change, a central bank may change the
---------------------- choice of instruments in its monetary policy. The overall goal is to promote
---------------------- economic growth and ensure price stability. Over time, the objectives of
monetary policy in India have evolved to include maintaining price stability,
---------------------- ensuring adequate flow of credit to productive sectors of the economy for
supporting economic growth and achieving financial stability.
----------------------
●● he Governor of the Reserve Bank announces the Monetary Policy in
T
---------------------- April every year for the financial year that ends in the following March.
This is followed by three quarterly reviews in July, October and January.
---------------------- However, depending on the evolving situation, the Reserve Bank may
---------------------- announce monetary measures at any point of time. An important factor
that determines the effectiveness of monetary policy is its transmission
---------------------- – a process through which changes in the policy achieve the objectives
of controlling inflation and achieving growth. In the implementation of
---------------------- monetary policy, a number of transmission channels have been identified
---------------------- for influencing real sector activity. These are (a) the quantum channel
relating to money supply and credit; (b) the interest rate channel; (c) the
---------------------- exchange rate channel; and (d) the asset price channel.
----------------------
Keywords
----------------------
●● Financial stability: The prevalence of a financial system, which is
---------------------- able to ensure in a lasting way and without major disruptions, an efficient
allocation of savings to investment opportunities.
----------------------
●● Federal Reserve: The central bank of the United States of America.
---------------------- ●● ultiplier: The ratio of money supply to the base money or high powered
M
---------------------- money.
●● tatutory liquidity reserve: The amount of cash, gold or unencumbered
S
---------------------- approved securities that every banking company is required to maintain
in India, which shall not, at the close of business on any day, be less than
----------------------
as prescribed by RBI.
---------------------- ●● ash reserve ratio: The ratio of bank’s cash reserve balances with RBI
C
with reference to the bank’s net demand and time liabilities.
----------------------
●● ank rate: The standard rate at which RBI is prepared to buy or rediscount
B
---------------------- bills of exchange or other commercial papers eligible for purchase. As the
provision regarding rediscounting of bills by RBI remained inoperative
----------------------
for a long time in the past, the rate charged by RBI on its advances to banks
---------------------- has been treated as the bank rate.
136 Macroeconomics
●● pen market operations: Under the open market operations the RBI
O Notes
sells or purchases Government securities and thus reduces or increases
the cash resources of the commercial banks. ----------------------
----------------------
----------------------
1. Briefly trace the evolution of central banking.
----------------------
2. What are the functions of a central bank? Explain any five.
3. Why was the Federal Reserve System of US established? What are its role ----------------------
and functions? ----------------------
4. Discuss the role and functions of Reserve Bank of India.
----------------------
5. Write short notes on:
----------------------
i. Monetary policy functions
ii. Currency management ----------------------
iii. Open market operations ----------------------
iv. Financial stability ----------------------

1. The developed countries are advanced in the sense of both financial ----------------------
widening and financial deepening, as such the monetary transmission is
swift. ----------------------
2. Governments maintain their accounts with the central banks and meet ----------------------
their funds requirements by placing bills with the central bank.
----------------------
3. A crisis situation often leads to what is known as a run on the bank.
1. Reserve requirements as a part of monetary policy means: ----------------------
iii. Maintaining reserve in the form of CRR and SLR
----------------------
2. Cash reserve is maintained equivalent of:
----------------------
ii. Certain percentage of total demand and time deposits
1. A core function of the Reserve Bank in the last 75 years has been the ----------------------
formulation and implementation of monetary policy with the objectives
of maintaining price stability and ensuring adequate flow of credit to ----------------------
productive sectors of the economy. ----------------------

Notes 2. Reserve Bank’s mandate for monetary policy flows from its monetary
stability objective.
----------------------
3. The regulation and supervision of the payment systems of the RBI is an
---------------------- important pre-requisite for the proper functioning of the financial system
and the efficient transmission of monetary policy.
----------------------

---------------------- 1. Case, Karl E, and Ray C. Fair. 2006. Principles of Economics. Prentice
Hall.
----------------------
2. Goyal, Ashima, ed. 2012. Macroeconomics and Markets in India: Good
---------------------- Luck or Good Policy? London: Routledge.
---------------------- 3. Rangarajan, C., and Bakul H. Dholakia. 2001. Principles of Macroeconomics.
New Delhi: Tata McGraw-Hill.
----------------------
4. Samuelson, Paul A, and William D. Nordhaus. 2006. Economics. New
---------------------- Delhi: Tata McGraw-Hill.
5. Sloman, John. 2004. Economics. New Delhi: Prentice Hall of India.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
138 Macroeconomics
Inflation: Measurement, Cost, Sources and Kinds and
The Phillips Curve and Inflation UNIT
Structure: 8
8.1 Introduction
8.2 Basic Phillips Curve
8.2.1 Basic Phillips Curve – Economic Trade-Offs
8.3 Different Types of Inflation
8.3.1 Different Causes of Inflation
8.4 Costs of Inflation
8.5 Measurement of Inflation
Summary
Keywords
Suggested Reading
Inflation: Measurement, Cost, Sources and Kinds and The Phillips Curve and Inflation 139
Notes
Objectives
----------------------
----------------------
●● Explain how to measure the rate of inflation
---------------------- ●● State various kinds of inflation
---------------------- ●● Describe the relationship between Phillips curve and inflation
----------------------
8.1 INTRODUCTION
----------------------
For a layman, inflation means a persistent general price rise of commodities
---------------------- in an economy over a period, which would imply the fall in purchasing power of
currency. Economists have different opinions regarding the origins of inflation.
---------------------- However, it is true that rise in the supply of money in an economy would cause
---------------------- inflation.
Definitions given by the different economists like Ackley and Johnson
----------------------
have common paraphrase for inflation and they have observed it as “a
---------------------- phenomenon of rising prices”. According to Crowther, inflation is a “state in
which the value of money is falling, i.e. the prices are rising.” In the words of
---------------------- Gardner Ackley, “inflation is a persistent and appreciable rise in the general
level or average of prices.” Johnson argued that inflation could be seen as
----------------------
“substantial rise in prices.”
---------------------- However, Economists like Friedman, Coulborn, Hawtrey, Kemmerer
observed inflation “as a monetary phenomenon.” According to Friedman,
----------------------
“inflation is always and everywhere a monetary phenomenon.” Hawtrey has
---------------------- defined it as the “issue of too much currency.” According to Kemmerer, “inflation
is too much money and deposit currency, that is, too much currency in relation to
---------------------- the physical volume of business being done.” This indicates the quantity theory
of money depending on the money supply, its velocity and volume of trade.
----------------------
Adam Smith and David Hume proposed a quantity theory of inflation for money
---------------------- and a quality theory of inflation for production.
Keynes (General Theory, 1934) defined inflation as a phenomenon under
----------------------
full employment through the passage of demand side of the economy. According
---------------------- to him, inflation is the result of the excess of aggregate demand over the available
aggregate supply and rise in price starts after full employment when aggregate
---------------------- demand exceeds aggregate supply. If there is unemployment, employment would
be modified in the same proportion as the money supply. Keynes approved price
----------------------
rise even before full employment, but he argued that it (semi-inflation, by him) is
---------------------- due to the existence of ‘certain bottlenecks in the expansion of output.’According
to him, the true inflation (after full employment) would be the real threat to the
---------------------- economy. A fundamental concept in such Keynesian analysis is the relationship
between inflation and unemployment, called the Phillips curve by A. Phillips.
----------------------
This model suggested that there would be a trade-off between price stability and
----------------------
140 Macroeconomics
employment. Therefore some level of inflation could be considered desirable in Notes
order to minimise unemployment.
----------------------
Modern economists analyze inflation in a comprehensive and unified
manner. Generally, two types of inflation are distinguished: Demand-pull ----------------------
inflation and Cost-push inflation.
----------------------
In the demand-pull inflation, price rise and increasing employment are
seen to move together, while in the cost-push inflation, price rise and falling ----------------------
employment are supposed to move simultaneously. During late 1950’s, A.W.
Phillips tried to observe the issue and empirically supported the idea that there ----------------------
would be a long- run trade off between inflation and unemployment and their
----------------------
link is negative. This means price stability is coupled with more unemployment,
whereas lesser unemployment would coexist with a higher rate of inflation. ----------------------
During late sixties, the monetarist group of economists held the view that the
trade-off existed only in the short-run, but not in the long run. In the long run, ----------------------
it is argued that anticipated inflation would be equal to actual inflation and both
----------------------
of them will rise simultaneously. The Monetarist School (Friedman, Phelps,
Leijonhufvud etc) tried to combine and integrate demand-pull and cost-push. ----------------------
According to them, inflation is a unified phenomenon on which demands and
cost elements appear as a part of one integrated cycle and in which expectations ----------------------
of future price level movements play a prominent role.
----------------------
8.2 BASIC PHILLIPS CURVE ----------------------
William Phillips wrote a paper in 1958 titled The Relation between ----------------------
Unemployment and the Rate of Change of Nominal Wages in the United
----------------------
Kingdom, 1861-1957, which was published in Economica. The relationship
can be described as an inverse relationship between nominal wage rate and ----------------------
unemployment.
----------------------
The original Phillips Curve: Wage inflation against unemployment
Inflation (%) ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Unemployment ----------------------
----------------------
Notes The essence of the Phillips Curve is that there is a short-term trade-off
between unemployment and inflation. But the original Phillips Curve has come
---------------------- under sustained attack, in particular from monetarist economists and when we
consider the data for unemployment and inflation in Britain over the last fifteen
---------------------- years, we will find that the nature of the trade-off has certainly changed for the
---------------------- economy and others as well.
The curve is also used to describe the relation between inflation
----------------------
rate and unemployment. In the labour market relation, we know money wage
---------------------- rate (w) is related to value of marginal productivity of labour in the price taker
condition, i.e. marginal physical product of labour (MP1 ) multiplied by price
---------------------- level (P).
---------------------- Therefore, w = (P).MPL
Thus, P = w/ MPL , or, log P = log (w) – log (MPL )
----------------------
Differentiating both sides, we obtain (1/P). dP/dt = (1/w) (dw/dt) – (1/
---------------------- MP). (d MPL /dt)
---------------------- The above equation shows that change in price level is equal to the
difference between rate of change of nominal wage and rate of change of labour
---------------------- productivity over time. If we assume that marginal productivity remains constant,
---------------------- then rate of price change is equal to the rate of wage change.
But in the labour market, wage change is dependent on excess supply of
---------------------- labour, that is, (1/w) (dw/dt) = f (Ns - Nd), where f / < 0. Thus, (1/P). dP/dt = f
---------------------- (Ns - Nd) with f / < 0.
The last equation provides the basic Phillips equation where it is seen that
----------------------
there is negative relation between inflation rate and unemployment.
---------------------- 8.2.1 Basic Phillips Curve – Economic trade-offs
---------------------- In 1958, Phillips empirically tested wage inflation of Great Britain
against unemployment. It was observed that the trade-off between unemployment
---------------------- and inflation is negative. Falling unemployment might cause rising inflation
---------------------- and a fall in inflation might only be possible by allowing unemployment to
rise. In general, the possible policy of any democratic government is to reduce
---------------------- unemployment by which aggregate demand could be increased. But implication
is that it may be possible through the trade-off by increasing inflation; thus, the
---------------------- Phillips relation gives a broad channel by which the product market and labour
---------------------- market are related. This means that the possible inflationary effects in both labour
and product markets would occur from an increase in the national output and
---------------------- employment.
---------------------- The labour market scenario: As unemployment falls, demand for skilled labour
would rise. This generates extra pressure in the labour market; thus, wages would
---------------------- rise. As a result, prices may rise.
---------------------- Other factor markets: Cost-push inflation can also come from rising demand
for commodities. When an economy is booming, the demand for commodities
---------------------- would rise.
142 Macroeconomics
Product market: Rising demand and output puts pressure on scarce resources Notes
and can lead to suppliers raising prices to widen profit margins. The risk of rising
prices is greatest when there is a positive output gap. ----------------------
Phillips Curve through Aggregate Demand (AD) and Aggregate Supply: ----------------------
Let us consider the explanation for the trade-off using AD-AS analysis and the
----------------------
concept of the output gap. In the next diagram, we draw the LRAS curve as
vertical. This assumes that the productive capacity of an economy in the long run ----------------------
is independent of the price level.
----------------------
We see an outward shift of the AD curve (for example, caused by a large rise in
consumer spending) which takes the equilibrium level of national output to Y2 ----------------------
beyond potential GDP Yfc. This creates a positive output gap and this is thought
to cause a rise in inflationary pressure, as described above. Excess demand in ----------------------
product markets and factor markets causes a rise in production costs and this
----------------------
leads to an inward shift in short run aggregate supply from SRAS1 to SRAS2.
The fall in supply takes the economy back towards potential output but at a higher ----------------------
price level.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Fig. 8.1 Short-run Phillips Curve and the trade-off between ----------------------
Unemployment and Inflation
Notes
----------------------
----------------------
1. Economists Ackley and Johnson have used common paraphrase for
---------------------- inflation, which is:
---------------------- i. A phenomena of rising costs
ii. A phenonema of rising prices
----------------------
iii. A phenomena of rising unemployment
----------------------
2. Demand-pull inflation is characterised by:
----------------------
i. Price rise and increasing employment together
---------------------- ii. Price falling and increasing employment
---------------------- iii. Price falling and employment falling
---------------------- 3. Cost-push inflation is characterised by:

i. Cost and prices rise simultaneously
----------------------
ii. Cost and employment rise simultaneously
----------------------
iii. Price rise and falling employment simultaneously
----------------------
---------------------- Activity 1
----------------------
Study the financial budget of Government of India for the year 2012
---------------------- and write down how the total budgetary deficit is planned to be met
----------------------
----------------------
8.3 DIFFERENT TYPES OF INFLATION
---------------------- Inflation has been classified in the following manner:

●● Comprehensive inflation: When the prices of all commodities rise
---------------------- throughout the economy.
---------------------- ●● poradic inflation: When prices of only few commodities in few geographical
S
regions (areas) rise.
----------------------
Types of inflation may also be classified on the basis of time incidence:
---------------------- ●● ar-time inflation: Inflation that takes place during the period of a war-
W
---------------------- like situation.
●● ost-war inflation: Inflation that takes place soon after a war is known
P
---------------------- as Post-War Inflation. After the war, government controls are relaxed,
---------------------- resulting in a faster hike in prices than what is experienced during the war.
●● eace-time inflation: When prices rise during a normal period of peace. It
P
---------------------- may be due to high public capital expenditures with long gestation period.
144 Macroeconomics
●● yperinflation: Hyperinflation refers to a situation where the prices rise
H Notes
at an alarming high rate. The prices rise so fast that it becomes very
difficult to measure its magnitude. ----------------------
Types of inflation on the basis of different causes: ----------------------
●● Deficit inflation: Inflation that takes place due to deficit financing.
----------------------
●● redit inflation: Credit inflation takes place due to excessive bank credit
C
or money supply in the economy. ----------------------
●● carcity inflation: Scarcity inflation occurs due to high hoarding. Hoarding
S ----------------------
is an excess accumulation of basic commodities by unscrupulous traders
and black marketers. ----------------------
●● ricing power inflation: It is also called as Administered Price inflation.
P ----------------------
It occurs when industries and business houses increase the price of their
goods and services with an objective to boost their profit margins. ----------------------
●● Tax inflation: It occurs due to rise in indirect taxes; sellers charge high
----------------------
price to the consumers.
●● age inflation: If the rise in wages in not accompanied by a rise in output,
W ----------------------
prices rise.
----------------------
●● Built-in inflation: Vicious cycle of built-in inflation is induced by
adaptive expectations of workers or employees, who try to keep their wages ----------------------
or salaries high in anticipation of inflation.
----------------------
●● iscal inflation: It occurs due to excess government expenditure or spending
F
when there is a budget deficit. ----------------------
●● xport-boom inflation: Considerable increase in exports may cause
E ----------------------
a shortage at home supply of essential commodities and thus prices rise.
●● I mport price-hike inflation: If prices of imported goods increases due ----------------------
to inflation abroad, then the prices of domestic products also rises. This ----------------------
is known as Import Price-Hike Inflation. Sectoral Inflation: It occurs
when there is a rise in the prices of goods and services produced by certain ----------------------
sector of the industries.
----------------------
●● emand-pull inflation : Inflation which arises due to various factors
D
such as rising income, exploding population etc. leads to aggregate ----------------------
demand, exceeds aggregate supply and tends to raise prices of goods and
services. This is known as Demand-Pull or Excess Demand Inflation. ----------------------
●● ost-push inflation: When prices rise due to growing cost of production
C ----------------------
of goods and services, it is known as Cost-Push (Supply-side) Inflation.
For example, if wages of workers are raised, the unit cost of production ----------------------
also increases. As a result, the prices of end products or end-services being ----------------------
produced and supplied are consequently hiked.
8.3.1 Different Causes of Inflation ----------------------
According to economist Robert Gordon, there are three major causes of ----------------------
inflation, viz.
----------------------
Notes ●● Demand-pull inflation: Inflation is caused due to the increase in demand.
●● ost-push: Inflation is caused due to the increase in supply and the decrease
C
---------------------- in production.
---------------------- ●● uilt-in inflation: Inflation is caused due to the conflict between the workers
B
who demand higher wage and the owners who pass on this burden to the
---------------------- consumers to compensate their expenditure.
----------------------
8.4 COSTS OF INFLATION
----------------------
Inflation affects both individuals as well as the whole economy
---------------------- in a large scale. Sometimes inflation is distinguished into expected and
unexpected inflation. If it is predictable to a large extent, then people may take
----------------------
precautions against it. This kind of trait may be observed in many developed
---------------------- economies and if it stands at low level, it is not considered as a cause of concern.
But high, volatile and unpredictable inflation is considered a serious problem
---------------------- and it is a characteristic of most of the developing economies.
---------------------- Inflation leads to reluctance to hold money. Thus, it seriously
impedes the saving behaviour of an economy. As a result, it also influences
---------------------- the investment, as interest rate is related to saving of the economy. It also creates
high variability in the relative prices, leading to microeconomic inefficiencies
----------------------
in the allocation of resources.
---------------------- It also leads to the distortions in the tax liabilities, thus causing alteration
in the distributive aspects of the economic agents, as all segments of the earning
----------------------
members are not affected by the inflation by same degree and thus creates
---------------------- economically inefficient distributive pattern.
---------------------- Inflation creates problems in respect of undertaking economic transactions

with volatile price levels.
---------------------- Costs of unexpected inflation
---------------------- Inflation redistributes wealth arbitrarily among individuals. If inflation is
higher than expected, the borrower is better off and lenders are worse off. The
----------------------
opposite situation happens if inflation is lower than expected.
---------------------- It hurts individuals or fixed income people and the people who are bound by
fixed contracts of returns.
----------------------
---------------------- 8.5 MEASUREMENT OF INFLATION

---------------------- Contesting on the challenges faced, several economists have questioned
the methodology by which inflation is measured. In India, the wholesale price
----------------------
index (WPI) is taken in general while several other economies follow the
---------------------- consumer price index (CPI) as a measure of inflation.
However, the CPI is the most widely used and recognised measure of
----------------------
inflation. It is available relatively frequently and it is typically not subject
---------------------- to revisions. The overall CPI is the representative of the cost of a basket of
146 Macroeconomics
commodities consumed by an average household. In many economies, producer Notes
price index (PPI) is also used. While PPIs record the price change from sellers’
sides, CPIs measure price change from the consumers’ perspective. Sellers and ----------------------
consumers’ prices differ due to government subsidies, indirect taxes and cost of
distribution. This distinction between the PPI and the CPI is not alike with the ----------------------
Indian distinction between the WPI and the CPI. ----------------------
The WPI is the price of a representative basket of wholesale commodities.
----------------------
In India, WPI figure was earlier released weekly, which were assumed to
influence stock and fixed price markets. It is now published on a monthly basis. ----------------------
The WPI focuses on the prices of commodities traded between corporations.
The purpose of the WPI is to monitor price movements that reflect supply and ----------------------
demand in industry, manufacturing and construction. This helps in analyzing
----------------------
both macroeconomic and microeconomic conditions. The WPI is based on the
wholesale price of a few relevant commodities and the commodities chosen ----------------------
for the calculation are based according to the regional importance and time
importance. ----------------------
A consumer price index (CPI) measures the changes in the price level of ----------------------
consumer goods and services purchased by households. The CPI is a statistical
estimate constructed using the prices of a sample of representative items whose ----------------------
prices are collected periodically. Sub-indexes and sub-sub-indexes are computed
----------------------
for different categories and sub-categories of goods and services, being combined
to produce the overall index with weights reflecting their shares in the total of ----------------------
the consumer expenditures covered by the index. It is one of several price indices
calculated by most national statistical agencies. The annual percentage change in ----------------------
a CPI is used as a measure of inflation. A CPI can be used to index (i.e. adjust for
----------------------
the effect of inflation) the real value of wages, salaries, pensions, for regulating
prices and for deflating monetary magnitudes to show changes in real values. ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Notes
----------------------
----------------------
1. The overall CPI is the representative of the cost of a basket of
---------------------- commodities consumed by an average household.
i. Represents cost of a basket of commodities consumed by
----------------------
household.
---------------------- ii. Represents cost of products consumed.
iii. Represents cost of raw material used in the production.
----------------------
2. In many economies, producer price index (PPI) record the price change
---------------------- from whose point of view?
i. Producers side
----------------------
ii. Consumers side
---------------------- iii. Sellers’ sides
---------------------- 3. CPIs measure price change from the perspective of which component
of the economy:
---------------------- i. Manufacturer
---------------------- ii. Seller
iii. Consumer
----------------------
----------------------
Summary
----------------------
●● ontinuous increase in the rate of general price level means the purchasing
C
---------------------- power of the country is declining.
●● here is a trade-off between unemployment and inflation at least in the
T
----------------------
empirical way, but a low inflation rate can also have a downside for any
---------------------- economy. To control inflation, the central bank has to stiffen the monetary
policy, which follows an increase in the interest rate that curtails the
---------------------- investment and employment opportunities and leads to a slump in growth
rate of the economy.
----------------------
●● here is always a scuffle between inflation and growth, particularly in the
T
---------------------- developing economies. In India, CPI (Consumer Price Index) is generally
used for the computation of inflation rate, although other measures are
----------------------
available to observe different economic scenario for the price change.
---------------------- ●● lthough different measures are available to curb inflation, it happens
A
since is an inevitable phenomena in economics.
----------------------
---------------------- Keywords
---------------------- ●● I nflation: A persistent general price rise of commodities in an economy
over a period.
----------------------
148 Macroeconomics
●● rade-off: When choices are made (collectively or by an individual)
T Notes
to accept having less of one thing in order to get more of something else,
the results are called trade-offs. ----------------------
----------------------
----------------------
1. Define inflation with suitable examples.
----------------------
2. Why is there trade-off between unemployment and inflation?
3. Explain Phillips curve. How is it related to inflation? ----------------------
4. Describe the different types of inflation. ----------------------

5. Explain the measures by which inflation can be curbed. ----------------------
6. Give at least three important causes that lead to inflationary trend in economy.
----------------------
7. What are the two important causes for fiscal inflation?
----------------------
----------------------
1. Economists Ackley and Johnson have used common paraphrase for
inflation, which is: ----------------------
i. A phenomena of rising costs ----------------------
2. Demand-pull inflation is characterised by: ----------------------
i. Price rise and increasing employment together
----------------------
3. Cost-push inflation is characterised by:
----------------------
iii. Price rise and falling employment simultaneously
----------------------

1. The overall CPI is the representative of the cost of a basket of commodities
----------------------
consumed by an average household.
i. Represents cost of a basket of commodities consumed by household. ----------------------
2. In many economies, producer price index (PPI) record the price change ----------------------
from whose point of view?
----------------------
iii. Sellers’ sides
3. CPIs measure price change from the perspective of which component of ----------------------
the economy: ----------------------
iii. Consumer
----------------------
Notes
Suggested Reading
----------------------
1. Case, Karl E, and Ray C. Fair. 2006. Principles of Economics. Prentice
---------------------- Hall.
2. Goyal, Ashima, ed. 2012. Macroeconomics and Markets in India: Good
----------------------
Luck or Good Policy? London: Routledge.
---------------------- 3. Rangarajan, C. and Bakul H. Dholakia. 2001. Principles of Macroeconomics.
---------------------- New Delhi: Tata McGraw-Hill.
---------------------- Delhi: Tata McGraw-Hill.
---------------------- 5. Sloman, John. 2004. Economics. New Delhi: Prentice Hall of India.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
150 Macroeconomics
Fiscal Policy, Deficits and Public Debt and Deficit
Financing in an Open Economy UNIT
Structure: 9
9.1 Introduction
9.2 Fiscal Policy and Aggregate Demand
9.3 Fiscal Policy in an Open Economy
9.4 Deficits in an Open Economy
9.5 Deficit Financing
Summary
Keywords
Suggested Reading
Fiscal Policy, Deficits and Public Debt and Deficit Financing in an Open Economy 151
Notes
Objectives
----------------------
----------------------
●● Explain the meaning of fiscal policy
---------------------- ●● Describe deficit financing
---------------------- ●● Analyse how public debt and deficit financing is managed
----------------------
9.1 INTRODUCTION
----------------------
An economy is “open” when it trades with other countries in goods, services
---------------------- and financial assets. There are a number of advantages of an open economy.
One is that the citizen consumers have a much larger variety of commodities to
---------------------- choose from. Additionally, consumers have an opportunity to invest their savings
---------------------- abroad to reap benefits.
In an open economy, a country’s spending in any given year need not
----------------------
equal its output of goods and services. A country can spend more money than it
---------------------- produces by borrowing from abroad, or it can spend less than it produces and
lend the difference to foreigners. There is no closed economy in today’s world.
----------------------
In a closed economy, all output is sold domestically and expenditure
---------------------- is divided into three components: consumption, investment and government
purchases.
----------------------
Y= C + I + G
---------------------- In an open economy, some output is sold domestically and some is
---------------------- exported to be sold abroad. We can divide expenditure on an open economy’s
output Y into four components: consumption of domestic goods and services
---------------------- (Cd), investment in domestic goods and services (Id), government purchases of
domestic goods and services (Gd) and exports of domestic goods and services
---------------------- (X). The division of expenditure into these components is expressed in the
---------------------- identity
Y = Cd + Id + Gd + X
----------------------
The sum of the first three terms, Cd + I d + Gd, is domestic spending
---------------------- on domestic goods and services. The fourth term, X, is foreign spending on
domestic goods and services (the value of exports). Since, the total domestic
---------------------- spending is a sum of spending on domestic as well as foreign goods and services,
---------------------- we can say that, C = Cd + Cf, I = Id + If, G = Gd + G f. We substitute these three
equations with the identity above:
----------------------
Y = (C − Cf) + (I − If) + (G − Gf) + X We can rearrange to obtain
---------------------- Y = C + I + G + X − (Cf + If + Gf )
---------------------- The sum of domestic spending on foreign goods and services (Cf + If
+ Gf) is expenditure on imports (IM). We can thus write the national income
---------------------- accounts identity as:
152 Macroeconomics
Y = C + I + G + X − IM. Notes
Since the value of total imports is a part of domestic spending and it is not
----------------------
a part of domestic output, it is subtracted from the total output. This gives us the
value of Net Exports (NX = X − IM), the identity becomes ----------------------
Y = C + I + G + NX
----------------------
9.2 FISCAL POLICY AND AGGREGATE DEMAND ----------------------
In the conventional form, fiscalpolicy is an instrument of demand management. ----------------------

That is to say, changes in government spending and tax policy as well as in the
----------------------
budget are the principal components of fiscal policy and it is assumed to manage the
volatility of national output, instability in the economy and also the external shock. ----------------------
Two opposing arguments exist relating to fiscal stimulus:
----------------------
●● ccording to the Keynesian thought, fiscal policy can be an effective
A
instrument to stimulate aggregate demand, output and employment of an ----------------------
economy through demand- side manipulation of an economy. Keynesians
believe that government’s role is important to manage the level of aggregate ----------------------
demand of an economy.
----------------------
●● he Monetarists, on the other side, consider that government spending and
T
tax changes can only have transitory effect on both aggregate demand and ----------------------
output and employment. According to them, monetary policy is the
----------------------
fundamental and effective instrument for controlling demand side of the
economy and inflationary pressure. ----------------------
9.3 FISCAL POLICY IN AN OPEN ECONOMY ----------------------
Government can influence macro variables through fiscal policy in the ----------------------
forms of government spending and taxation. The economic impact of any ----------------------
change in the government budget is faced by all citizens directly or indirectly.
Although changes in taxes or spending, considered as revenue neutral, may ----------------------
be construed as fiscal policy and may affect the aggregate level of output by
changing the incentives of economic agent. Thus, the term “fiscal policy” is ----------------------
generally used to describe the effect of overall levels of spending and taxation ----------------------
on the aggregate economy, and more particularly, the gap between them.
Fiscal policy is said to be tight or contractionary when revenue is higher than ----------------------
spending (i.e., the government budget is in surplus) and loose or expansionary when ----------------------
spending is higher than revenue (i.e., the budget is in deficit). Often, the focus is
not on the level of the deficit, but on the change in the deficit. ----------------------
In an open economy, fiscal policy also affects the exchange rate and ----------------------
the trade balance. In case of a fiscal expansion, the rise in interest rates due to
government borrowing attracts foreign capital. ----------------------
Fiscal policy is an important tool for managing the economy because of ----------------------
its ability to affect the total amount of output produced, i.e., gross domestic
product. The first impact of a fiscal expansion is a rise in the demand for goods ----------------------
Notes and services. This greater demand leads to increases in both output and prices.
The degree to which higher demand increases output and prices depends, in
---------------------- turn, on the state of the business cycle. If the economy is in recession, with
unused productive capacity and unemployed workers, then increase in demand
---------------------- will lead mostly to more output without changing the price level. If the economy
---------------------- is at full employment, by contrast, a fiscal expansion will have more effect on
prices and less impact on total output.
----------------------
This ability of fiscal policy to affect output by affecting aggregate demand
---------------------- makes it a potential tool for economic stabilisation. In a recession, the government
can run an expansionary fiscal policy, thus helping to restore output to its normal level
---------------------- and can enhance employment opportunities. Fiscal policy also changes the burden of
future taxes. When the government runs an expansionary fiscal policy, it adds to its
----------------------
stock of debt. As the government will have to pay interest on this debt (or repay
---------------------- it) in future years, expansionary fiscal policy today imposes an additional burden
on future taxpayers. Just as the government can use taxes to transfer income between
---------------------- different classes, it can run surpluses or deficits in order to transfer income between
different generations. Some economists have argued that this effect of fiscal policy
----------------------
on future taxes will lead consumers to change their saving behaviour. Recognising
---------------------- that taxes would be higher in the future, the argument goes: people will simply save
the value of the tax cut they receive now in order to pay those future taxes. The
---------------------- extreme of this argument, known as Ricardian equivalence, holds that tax cuts will
have no effect on national saving because changes in private saving will exactly
----------------------
offset changes in government saving. However, if consumers decide to spend some
---------------------- of the extra disposable income they receive from a tax cut (because they are myopic
about future tax payments, for example), then Ricardian equivalence will not hold;
---------------------- a tax cut will lower national saving and raise aggregate demand. Most economists
do not believe that Ricardian equivalence characterises consumers’ response to tax
----------------------
changes.
----------------------
----------------------

1. In an open economy, a country’s ______________ in any given year
---------------------- need not equal its ___________ of goods and services.
---------------------- 2. Government ___________ and ___________ can only have transitory
effect on both aggregate demand output and employment.
----------------------
3. Government can run an expansionary fiscal policy and help restore
---------------------- _____________ to its normal level and can enhance ____________
opportunities.
----------------------
4. _____________ will have no effect on national savings because
---------------------- changes in private savings will exactly offset changes in government
savings.
----------------------
----------------------
154 Macroeconomics
9.4 DEFICITS IN AN OPEN ECONOMY Notes
In an open economy, a small country’s budget deficits or social security ----------------------
programmes would have negligible effects on the real interest rate. Therefore,
the home country’s decision to substitute a budget deficit for current taxes leads ----------------------
mainly to increased borrowing from abroad, rather than to a higher real interest
----------------------
rate.
That is to say, budget deficits lead to current account deficits. Expected ----------------------
rise in real interest rates may influence world financial markets if the increased ----------------------
national debt induces foreign lenders to demand higher expected returns on this
country’s obligations. In any event, there is a weaker tendency for a country’s ----------------------
budget deficits to crowd out its domestic investment in the short run and its stock
of capital in the long run. However, the current account deficits show up in the ----------------------
long run as a lower stock of national wealth and correspondingly higher claims ----------------------
by foreigners.
If the whole world runs budget deficits or expands the scale of its social ----------------------
insurance programmes, real interest rates rise on international capital markets, ----------------------
and crowding out of investment occurs in each country. Correspondingly, the
world’s stock of capital is lower in the long run. ----------------------
The deficit budget policy is a famous instrument of fiscal policy used to ----------------------
increase the rate of economic growth of the country. That way of financing
was establish after the two World Wars, oil crises and current financial and ----------------------
economic crises. There are three ways to finance the deficit – taxes, borrowing
----------------------
and monetisation (inflation tax). The most popular model of deficit finance
is borrowing, which is usually done by issue of government bonds. When ----------------------
the government is over indebted, it tends through national bank, to buy
government bonds, which increases the money flow and reduces the interest ----------------------
rate pressure. However, it diminishes the real value of money and makes the
----------------------
future unpredictable for the economic sectors.
If the current expenditure of the government exceeds its current tax revenue, ----------------------
there is said to be a deficit in the budget. A budget deficit is the excess of
----------------------
government outlays over receipts taken in from taxes, fees and charges levied by
government authorities. This is normally covered by market borrowing and, in ----------------------
extraordinary situations, by deficit financing (i.e., borrowing from the central
bank against foreign exchange reserves or by selling treasury bills). ----------------------
When government borrows money, it is said to be public debt. The ----------------------
instrument of public debt takes the form of government bonds or securities of
various kinds. Such securities are drawn as a contract between the government ----------------------
and the lenders. By issuing securities, the government raises public loan and
----------------------
incurs liability as per contract. In India, government issues treasury bills, post
office savings certificates, National Saving Certificates as instrument of public ----------------------
borrowings. Government debt may be classified into the following types:
----------------------
1. Productive debt: Public debt is said to be productive when it is raised for
productive purposes and is used to add to the productive capacity of the ----------------------
Notes economy. The borrowed money is generally invested in public utilities.
Productive loans are self-liquidating. Generally, such loans should be
---------------------- repaid within the lifetime of property. Thus, such loans does not cause any
net burden on the community.
----------------------
2. Unproductive debt: Unproductive debts are those, which do not add
---------------------- to the productive capacity of the economy. Unproductive debts are not
necessarily self-liquidating. The interest and the principal amount may
----------------------
have to be paid from other sources of revenue, generally from taxation,
---------------------- and therefore, such debts are a burden on the community.
3. Voluntary debt: Most of the loans obtained by the government are
----------------------
voluntary in nature. The voluntary debt may be obtained in the form of
---------------------- market loans, bonds, etc. The rate of interest is normally higher than that
of compulsory debt, in order to induce the people to provide loans to the
---------------------- government.
---------------------- 4. Compulsory debt: A compulsory debt is a rare phenomenon in modern
public finance unless there are some special circumstances like war or
---------------------- crisis. In India, compulsory deposit scheme is an example of compulsory
debt.
----------------------
5. Internal debt: The government borrows funds from internal and external
---------------------- sources. Internal debt refers to the funds borrowed by the government from
---------------------- various sources within the country, may be from public or private. The
various instruments of internal debt would include market loans, bonds,
---------------------- treasury bills, ways and means advances, etc. Internal debt is repayable
only in domestic currency. It implies a redistribution of income and wealth
---------------------- within the economy and, therefore, it has no direct burden.
---------------------- 6. External debt: External loans are raised from foreign countries or
international institutions. These loans are repayable in foreign
---------------------- currencies. External loans help to take up various developmental
---------------------- programmes in developing and underdeveloped countries. These
loans are usually voluntary.
----------------------
9.5 DEFICIT FINANCING
----------------------
---------------------- Deficit budget means higher government expenditures than its income
from taxes and other revenue sources. Thus, deficit financing is the source of
---------------------- resource generation to overcome deficit budget. Governments use deficit
financing for several purposes. One of the most common is to increase the money
---------------------- supply and the number of bonds it has in the economic system, thus influencing
---------------------- the economic activity of investors.
Governments may have a choice between using debt and raising taxes.
---------------------- Issuing more bonds is usually more politically attractive than raising taxes.
---------------------- Government uses borrowed money for enhancing social and economic
infrastructure in the development planning, which helps to improve productivity
---------------------- of the aggregate economy.
156 Macroeconomics
Again, government expenditure would increase money supply in the Notes
economy, which increases price level in the economy. Government expenditure
and private capital formation may create more jobs opportunities in the economy. ----------------------
Increased employment would increase the demand for commodities, which
again fosters saving and investment. ----------------------
However, the disadvantages of deficit financing are firstly, there is always ----------------------
a time lag between Government investment and the output from the projects and
----------------------
secondly, increase in supply of money creates inflation.
----------------------
----------------------
1. The instrument of public debt takes the form of _______________ or
securities of various kinds. ----------------------
2. Higher government expenditure than its income from taxes and other ----------------------
revenue sources means ______________.
----------------------
----------------------
Activity 1
----------------------
Study the latest Financial Budget of the Union of India and analyse the ----------------------
ways and means in which the budget deficit is planned to be met.
----------------------
Summary ----------------------
●● iscal policy explains issues like the use of government spending, taxation
F ----------------------
and borrowing to manipulate the level and growth of aggregate demand, ----------------------
output and employment, by which the economy can be maneuvered.
Thus, fiscal policy impacts both aggregate demand (AD) and aggregate ----------------------
supply (AS).
----------------------
●● eynesians and Monetarists have clear difference in opinion relating
K
to demand management. ----------------------
●● ebt and deficit financing instruments must be applied with utmost care
D ----------------------
as both have very distinctive qualities, merits and demerits that can affect
the economy with both the ways of prosperity and downfall. ----------------------
----------------------
Keywords
----------------------
●● pen economy: An economy trading with other countries in goods,
O
services and financial assets. ----------------------
●● udget deficit: The excess of government outlays over receipts taken
B ----------------------
in from taxes, fees and charges levied by government authorities.
●● Fiscal policy: An instrument of demand management. ----------------------
Notes ●● Public debt: When government borrows money, it is said to be public
debt.
---------------------- ●● Internal debt: The funds borrowed by the government from various
sources within the country, may be from public or private.
----------------------

---------------------- 1. What is fiscal policy? How does it affect economic expansion?
2. What are the differences between the Keynesian and the Monetarists
---------------------- in respect to fiscal policy and demand management?
---------------------- 3. What is public debt? How can it be effective in an economy?
4. Define deficit financing. Explain its pros and cons.
----------------------
---------------------- Answers to Check your Progress

Fill in the blanks.
---------------------- 1. In an open economy, a country’s spending in any given year need not equal
---------------------- its output of goods and services.
2. Government spending and taxchanges can only have transitory effect on
---------------------- both aggregate demand output and employment.
---------------------- 3. Government can run an expansionary fiscal policy and help restore output
to its normal level and can enhance employment opportunities.
---------------------- 4. Taxcuts will have no effect on national savings because changes in private
---------------------- savings will exactly offset changes in government savings.
----------------------
Fill in the blanks.
----------------------
1. The instrument of public debt takes the form of government bonds or
---------------------- securities of various kinds.
2. Higher government expenditure than its income from taxes and other
----------------------
revenue sources means deficitbudget.
----------------------

---------------------- Hall
---------------------- 2. Goyal, Ashima ed. 2012. Macroeconomics and Markets in India: Good
----------------------
3. Rangarajan, C., and Bakul H. Dholakia. 2001. Principles of Macroeconomics.
---------------------- New Delhi: Tata McGraw-Hill.
---------------------- Delhi: Tata McGraw-Hill
---------------------- 5. Sloman, John. 2004. Economics. New Delhi: Prentice Hall of India,
158 Macroeconomics
Economic Growth, Aggregate Growth and Monetarism
and Rational Expectation UNIT
Structure: 10
10.1 Introduction
10.2 Aggregate Supply Curve
10.3 Money Supply and Economic Growth
10.4 Monetary Theories
10.5 The Quantity Theory of Money
10.6 Monetary Policy
Summary
Keywords
Suggested Reading
Economic Growth, Aggregate Growth and Monetarism and Rational Expectation 159
Notes
Objectives
----------------------
----------------------
●● Explain economic growth
---------------------- ●● Analyse the contributing factors for aggregate growth
---------------------- ●● Discuss how monetarism and rational expectation are arrived at
----------------------
10.1 INTRODUCTION
----------------------
In this Unit, we are going to study the various aspects of economic
---------------------- growth. Economic growth is reflected in the aggregate of monetary supply,
which fuels industrial and economic activities. How monetary policy and other
---------------------- policies of the Government contribute to this growth will be discussed.
----------------------
10.2 AGGREGATE SUPPLY CURVE
----------------------
As per the classical theory, automatic market adjustments to the changes in
---------------------- the supply and demand lead to full employment, which is the “self-equilibrating
---------------------- nature” of the economy. Thus, according to the classical thought aggregate supply
curve is vertical in the long run. The Keynesian theory deals with a depressed
---------------------- economy with underemployment equilibrium. So in the short run, the aggregate
supply curve reflects a positive relationship between the price level and the real
---------------------- output.
---------------------- This short-run positive relationship occurs primarily because production
wages are “sticky” relative to output prices to the changes in demand. Increase in
---------------------- aggregate demand causes upward movement along the aggregate supply curve
---------------------- in which price rises more quickly than wages, so higher profit induces more
output. Fall in aggregate demand causes price fall more quickly than costs, so
---------------------- profits decline and firms in the economy reduce production.
----------------------
10.3 MONEY SUPPLY AND ECONOMIC GROWTH
----------------------
The relationship between money supply and economic growth has been
---------------------- receiving increasing attention than any other subject matter in the field of
economics in recent years. The significance of economic growth is a prime
---------------------- concern as it is considered as one of the basic macroeconomic objectives of
---------------------- nations for both developed and developing economies. Economists differ on the
impact of money supply on economic growth. While some of the economists
---------------------- have the view that variation in the quantity of money is the most central
determinant of economic growth, others are somehow highly pessimistic about
---------------------- the function of money on the growth perspectives.
---------------------- Economies that largely allocate significance in the behaviour of aggregate
money supply hardly ever experience variation in economic activities to a
----------------------
large extent. See Handler (1997).
160 Macroeconomics
Although Kuznets (1955) had the view that monetary market starts Notes
growing as the economy approaches towards the intermediary stage and
develops when the economy would be matured. ----------------------
There is also one view that the low level of money supply as well as ----------------------
stock in particular had been responsible for the elemental failure of many
African economies to attain desirable growth rates. Various scholars have laid ----------------------
much of the blame for the failure of monetary policies to translate into economic
----------------------
growth on the state authorities for poor implementation and mendaciousness of
the policies. ----------------------
10.4 MONETARY THEORIES ----------------------
According to Nobay and Johnson (1977), four major kinds of monetary ----------------------
theories have been in existence. ----------------------
The first one was developed during 1950s and 60s, which fundamentally
----------------------
confers the empirical tests of single equation within the small framework.
These models tried to differentiate monetarist and Keynesian propositions ----------------------
analytically and empirically. Most of the studies did not take into account the
influence of foreign sector and the currency movements. ----------------------
The second distinctive theoretical analysis has been propelled mainly by ----------------------
the role of money in the open economy. The studies are made by Robert Mundell
(1968) and Harry Johnson (1971) and others. The basic presumption is that ----------------------
money stock may be controlled only if exchange rates are flexible. Under the
----------------------
fixed exchange rate, the money stock (base money or currency) adjustment
responds to the commodity price as well as to the interest rate. ----------------------
The third strait of the monetarist theory was developed by Karl Brunner and
----------------------
Allan H. Meltzer (1968, 1972). They broadly assumed three distinct assets − base
money, bonds and real capital. The stock of money is determined in the asset ----------------------
market where the fundamental components are demand for money and demand
for and supply of bank credit. Occasion for intermediation and interest rate ----------------------
differential on assets are taken into consideration in the framework.
----------------------
The fourth theory, the rational expectations monetary theory, was
developed by Robert Lucas (1972, 1975), Robert Barro (1976), Thomas Sargent ----------------------
and Neil Wallace (1975), Finn Kydland and Edward Prescott (1977) among ----------------------
others.
----------------------
10.5 THE QUANTITY THEORY OF MONEY
----------------------
The quantity theory of money has its roots in the works of the early
----------------------
monetary theorists like David Hume and others. It gives a very straightforward
but very powerful clarification of how money supply affects the economic ----------------------
expansion.
----------------------
The demand for money means the holding of money by the people
to make transactions, so the more people hold money, more is the demand for ----------------------
Notes money. In the classical framework it is assumed that people demand money for
two motives − one is transaction motive and another is precautionary motive
---------------------- (broadly we mention transaction demand for money in a collective sense).
Combined they are termed as L1. Thus, the quantity of money in the economy
---------------------- is correlated to the number of money units exchanged in transactions by the
---------------------- people. The basic structural proposition of the theory was elaborated by Irving
Fisher.
----------------------
The theory is elaborated based on two assumptions:
---------------------- i. Full employment exists in the economy.
---------------------- ii. Say’s law of market is valid.
---------------------- The economic principle relating to market clearing was given by French
economist Jean-Baptiste Say (1767−1832) which has been considered as
---------------------- one of the most important classical fundamental laws in economics. He
opined that “supply creates its own demand”, which is known as Say’s law
----------------------
of market. This means that there would not be any overproduction or glut
---------------------- in the economy.
The above two assumptions have deep implications in the sense that
----------------------
money performs only monetary functions and does not have any impact on the
---------------------- real sector. Thus, according to the quantity theory of money, the relationship
between money supply and price level is direct. This means that if money supply
---------------------- is doubled, the price level will also be doubled. Increase in money supply causes
inflation, thus decreasing the marginal purchasing power of money.
----------------------
The relation in simplest form is expressed with the following equation
---------------------- called the quantity equation:
---------------------- M V = PT (1)
---------------------- In the above equation (1), M is the money supply, V is velocity of money,
P is general price level (sometimes termed as general price index) and T is
---------------------- volume of transactions of goods and services in the economy. The right-hand side
represents the money value of total transactions in an economy in a given period
---------------------- of time and the left-hand side is the total amount of money used to make those
---------------------- transactions. The velocity of money or the transaction velocity measures the rate at
which money circulates in the economy. This means that it counts the number
---------------------- of transactions that have been made by a unit currency in any economy in a
particular year for transaction purposes.
----------------------
When studying the role of money in the economy, economists use a
---------------------- different version of the quantity equation. The problem with equation (1) is that it
is difficult to measure the total number of transactions in a year for any economy.
----------------------
Therefore, the number of transactions is replaced by the total real output
---------------------- produced in the economy (Y), as according to Say’s law, the total supply of output
(Y) is demanded through transaction. Thus, equation (1) can be rewritten as
---------------------- follows:
----------------------
162 Macroeconomics
MV=PY (2) Notes
In equation (2), the right-hand side measures the money value of real
----------------------
output produced in an economy in a particular year, which simply means
national income. Thus, the whole equation means that national income is ----------------------
equivalent to the total value of transactions that have taken place in the economy
in that particular year. ----------------------
Thus, we have, P = (V/Y) M, where V/Y is constant. The reason behind it is ----------------------
very simple. As full employment is assumed, output production (Y) is constant.
This is because there is no idle labour available in the economy (all labour units ----------------------
are employed). The same reason is applied for the velocity of money. Thus, we
----------------------
have P = k M, where k is constant, which again follows P (P directly varies as
M). This means that if money supply will rise by some proportion, price level ----------------------
will also rise by same proportion.
----------------------
Cambridge Equation
When we analyse how money affects the economy, it is often useful to ----------------------
express the quantity of money in terms of quantity of goods and services it can ----------------------
buy. This amount, M/P, is called the real money balances. Real money balances
measure the purchasing power of the stock of money. A money demand function is ----------------------
an equation that shows the determinants of the quantity of real money balances
people wish to hold. A simple money demand function is ----------------------
----------------------
where k is a constant that tells us how much money people want to hold for ----------------------
every monetary unit of income. This equation states that the quantity of real ----------------------
money balances demanded is proportional to real income. This money demand
function can be rearranged to view the quantity equation. To see this, add to the ----------------------
demand function the condition that the demand for real money balances equals
the supply M/P. Therefore, ----------------------
----------------------
----------------------
Hence, the quantity equation is
----------------------
The assumption is constant velocity gives us an approximation to reality
and is useful in many situations. Once we assume that the velocity is constant, ----------------------
the quantity equation can determine nominal GDP. The quantity equation says ----------------------
that a change in the quantity of money (M) must cause a proportionate change in
nominal GDP. Since the inflation rate is the percentage change in the price level, ----------------------
this theory of the price level is also a theory of the inflation rate. The growth in
money supply determines the rate of inflation. Thus, the quantity theory of money ----------------------
states that the central bank, which controls the money supply, has ultimate control ----------------------
over the rate of inflation. If the central bank keeps the money supply stable, the
price level will be stable. If the central bank increases the money supply rapidly, ----------------------
the price level will rise rapidly.
----------------------
Notes With the recapitalisation in banking sector through the passage of mergers,
acquisitions and other forms of combinations, increased banking facilities,
---------------------- capital market growth and new technological innovations, the Nigerian
---------------------- financial system remained on the whole moderately undersized because of
lack of financial intermediation and financial deepening which is required
---------------------- for economic expansion.
Arguments by Montiel (1995), Emenuga (1996) and Osikoya (1992)
---------------------- revealed that the possible effect of financial depth (money in circulation) on
---------------------- economic growth can be obvious in three channels: (i) improved efficiency of
financial intermediation, (ii) improved efficiency of capital stock, and (iii)
---------------------- increased national savings rate.
---------------------- Prior to the publication of Kuznets’ (1955) seminal paper, the common
economic contention was that the benefits of growth will eventually trickle down
---------------------- to affect the velocity of monetary aggregate. Most of the modern macroeconomic
theories seem to agree on the issue of systematic association between growth
----------------------
of money supply and economic development.
----------------------
----------------------

1. As per Keynes theory, demand of money arises:
----------------------
i. To satisfy the consumption needs
----------------------
ii. To meet transactions, precautionary and speculative motive
---------------------- iii. To satisfy luxury needs
---------------------- 2. In Economics, real money balances measure:
---------------------- i. Availability of liquid funds

ii. Availability of short-term and long-term investments
----------------------
iii. Purchasing power of the stock of money
----------------------
---------------------- Activity 1
----------------------
Note down your observations as to how an inflationary economic
---------------------- condition affects the demand for money with the people and state
reasons for that.
----------------------
----------------------
10.6 MONETARY POLICY
----------------------
Monetary policy is the manipulation of the money supply with the
---------------------- objective of affecting macroeconomic outcomes, such as GDP growth, inflation,
unemployment and exchange rates. The monetary policy by the central bank
----------------------
164 Macroeconomics
affects aggregate demand will be examined and comparative policy effectiveness Notes
of monetary and fiscal policy will be described.
----------------------
The Money Market
To understand the role of money in the macro economy, we first need to look at ----------------------
money demand and money supply.
----------------------
Demand for Money
----------------------
According to Keynes, people demand money for three reasons:
i. Transactions motive ----------------------
ii. Precautionary demand ----------------------

iii. Speculative demand ----------------------
The first and second motives jointly are called L and the third is called L . Thus,
----------------------
the total demand for money in Keynesian framework is:
MD= L + L = kPY + L (r) ----------------------
In the above equation, the first part is classical in nature where transaction ----------------------
and precautionary motives dependent on level of income, but speculative
demand for money depends on the rate of interest. This means that when rate of ----------------------
interest is minimum, the speculative demand for money is infinitely elastic, thus ----------------------
causing liquidity trap.
People hold money for speculative purposes for purchasing bond as ----------------------
bonds pay interest. However, in the bond market there is uncertainty about ----------------------
the future interest rate and thus bond price and interest rates are negatively
related through the passage of future expected capital gain or loss. Therefore, ----------------------
if people expect rise in the future rate of interest, they start purchasing more
bonds and therefore speculative demand for money starts falling. However, if ----------------------
it is expected to fall to a minimum, people sell all their bonds and hold all the ----------------------
money for future rise in interest, thus making speculative demand function
infinitely elastic. This is called liquidity trap. In this situation, monetary policy ----------------------
would become ineffective, according to Keynes.
----------------------
Thus, the total demand for money is downward sloping with respect to
interest rates. ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Notes Supply of Money
The money supply is set by the central bank at any level they choose, so
----------------------
money supply is vertical at the quantity chosen by the central bank.
---------------------- By shifting the money supply, the central bank can change equilibrium
interest rates. Suppose the RBI buys bonds on the open market. This increases the
----------------------
money supply, shifting the MS curve to the right, causing interest rates to fall.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
---------------------- Friedman’s Approach

---------------------- Friedman assumes that the demand for nominal money is proportional
to nominal income and independent of the distribution of income between
---------------------- prices and real income. At times, the supply of money (Ms) depends on r, but
more often international capital movements and intermediation are ignored, and
----------------------
Ms is exogenous to the model. Let Ms = Mt so that, in equilibrium,
---------------------- Mt = L(r) Yt
---------------------- Decisions to consume or save and to invest depend on the real rate (p) and
real income (Y/P). Let
----------------------
C and I are real consumption and investment respectively. Friedman
---------------------- assumes:
---------------------- C = f1(Y/P, p)
Random deviations of actual from expected real income affect nominal
----------------------
rates of interest and the price level, but they do not affect expected real income.
---------------------- Friedman’s discussion of the adjustment process is not developed as an
implication of his theory but appears compatible with the interpretation of the
---------------------- Phillips curve.
---------------------- Friedman, like Keynes, offers a theory of the level of income. Real
income fluctuates around its expected value and prices change. So, in this
---------------------- sense, Friedman’s theory is a theory of nominal income.
---------------------- His framework differs from Keynes on two major points. The level of
equilibrium real income does not depend explicitly on the variability of income,
---------------------- and inflation is incorporated. Friedman does not explain why expected real income
is higher some times and in some places than in others. There is no relation
----------------------
between expected real income and the risks or uncertainties that society bears.
166 Macroeconomics
Unlike Keynes, Friedman does not suggest a relation between expected income Notes
and institutional arrangements that cause risks to be reduced or augmented.
----------------------
Money and Aggregate Demand: A Keynesian View
A change in interest rates will in turn affect the spending decisions of ----------------------
consumers and firms. With lower interest rates it is cheaper for firms to
----------------------
invest and for consumers to buy durable goods, and this will shift the aggregate
demand curve to the right, increasing output. Similarly, decreasing the money ----------------------
supply would raise interest rates, decrease investment and consumption and
decrease aggregate demand. ----------------------
Monetary Policy: Keynesian vs. Monetarist Views ----------------------
In the Keynesian model above, interest rates and investment are the ----------------------
transmission mechanism of monetary policy, i.e., the way monetary policy affects
macroeconomic outcomes. However, there are other points of view. ----------------------
The Monetarists believe that monetary policy affects prices, but not real ----------------------
GDP or unemployment. The impact of monetary policy can be expressed using
the equation of exchange: ----------------------
MV = PQ ----------------------
where M= the quantity of money in circulation, V = the velocity of money,
----------------------
P = the price level, and Q = real GDP. Velocity is the number of times a dollar is
used to purchase goods and services in a given year. ----------------------
If we assume that V is stable (it does not change very often), then a
----------------------
change in the money supply, M must change P or Q. So, no matter what happens
to interest rates, total spending changes. If we assume the Q is near full capacity ----------------------
the vertical part of the AS curve changes. This difference in the Keynesian and
Monetarists views also leads to different remedies for fighting inflation and ----------------------
unemployment
----------------------
Fighting Inflation
----------------------
Keynesians would advocate a decrease in the money supply
(contractionary monetary policy), which would increase interest rates, decrease ----------------------
spending, decrease AD, and decrease prices and real output. Monetarists would
argue that if inflation is too high, then interest rates are already high: nominal ----------------------
interest rate = real interest rate + anticipated inflation rate. ----------------------
So, monetarists believe that decreasing the money supply will cause
nominal interest rates to fall (not rise) because the anticipated inflation rate ----------------------
will fall eventually. Monetarists advocate steady, predictable money growth ----------------------
to keep anticipated inflation and nominal interest rates low.
----------------------
Both Keynesians and monetarists advocate a decrease in the money
supply to fight inflation, but they expect it to work for different reasons. ----------------------
Fighting Unemployment
----------------------
Keynesians would advocate an increase in the money supply
(expansionary monetary policy), which would decrease interest rates, increase ----------------------
Notes spending, increase AD, increase prices and output and decrease unemployment.
However, monetarists believe that an increase in the money supply will
----------------------
affect mostly prices, not output. This would raise inflationary expectations and
---------------------- actually increase nominal interest rates. Monetarists do not believe that
expansionary monetary policy is effective, unless the economy is way below
---------------------- full employment (on the horizontal part of the AS curve).
---------------------- In general, monetarists believe in fixed money supply targets or a “rule”
for how much to change the money supply. Keynesians disagree, and believe
---------------------- in more flexibility or “discretion”, with the Federal Reserve adjusting money
supply to respond to economic conditions. This debate is known as “rules vs.
----------------------
discretion”.
---------------------- Rational Expectations
---------------------- Emphasis on rational expectations in macroeconomics began with Lucas
(1972), and he has remained a major contributor. Economists from Marshall
---------------------- to Keynes relied on wage rigidity, at least in part, to explain the severity or
---------------------- persistence of unemployment during business cycles. Neither these authors,
nor others, offered an explanation of the labour supply curve consistent with
---------------------- maximising behaviour. Marshall, like many who followed, refers to the power of
labour unions. Marshall finds some merit in the increased real wages received by
---------------------- those who continue to work during recessions. In Marshall’s view, there are both
---------------------- welfare gains and losses during recessions. Keynes (1939) criticised Marshall’s
work on the grounds that Marshall had not provided a theory of labour supply
---------------------- useful for explaining the supply of output.
---------------------- A major problem posed in the rational expectations literature on

employment (or unemployment) and business cycle is to explain why people
---------------------- choose to vary hours of work instead of varying wages. The same general
problem arises for other factors of production, for example, capital is used more
---------------------- intensively at the peak of the cycle than at the trough; time series on investment
---------------------- spending show relatively large cyclical changes. There is a presumption in
much of the rational expectations literature, however, that once economists can
---------------------- explain how tastes and constraints combine to induce people to choose the
patterns that produce aggregate unemployment, other aspects of the cycle will
---------------------- be easier to explain.
---------------------- This presumption differs from Keynes view that the duration of business
cycles depends mainly on the relation of expectations to the marginal efficiency
---------------------- of capital and the carrying costs of inventories. Rational expectations business
---------------------- cycle theory can be described as an attempt to develop a theory of business
cycle dynamics consistent with maximising behaviour. Although some markets
---------------------- may be missing, all other existing markets would be clear. Information is used
efficiently and expectations are rational. Business cycles arise because people
---------------------- cannot perceive the situation as per Friedman (1968) and Phelps (1968) in the
---------------------- perspective of natural rate hypothesis. This has been explained in the following
points:
----------------------
168 Macroeconomics
The rational expectations hypothesis assumes people know the “true model” Notes
of the economy and that they use this model to form their expectations of the
future. ----------------------
By “true” model, we mean a model that is on average correct in ----------------------
forecasting inflation.
----------------------
As there are costs associated with making a wrong forecast, it is not rational
to overlook information, as long as the costs of acquiring that information do ----------------------
not outweigh the benefits of improving its accuracy.
----------------------
If firms have rational expectations, on average, prices and wages will be
set at levels that ensure equilibrium in the goods and labour markets. In other ----------------------
words, on average, there will be no unemployment.
----------------------
The Lucas supply function is the supply function that embodies the idea
that output (Y) depends on the difference between the actual price level (P) and ----------------------
the expected price level (Pe):
----------------------
Y = f ( P − Pe )
Current rational expectations macro models differ from Friedman’s ----------------------
(1974) framework not only by giving more explicit attention to the way ----------------------
information and disturbances (or shocks) affect market participants but also by
introducing a supply equation or Phillips curve, as a part of the model. ----------------------
Rational expectations theory, combined with the Lucas supply function, ----------------------
proposes a very small role for government policy in the economy. However, the
potential link between Keynes and the rational expectations model lies in the ----------------------
relation of policy rules and procedures for investment, the size of the capital
----------------------
stock of the firm(s), the choice of labour or leisure for individual(s), the size
of the labour force and the expected output. ----------------------
The argument against rational expectations is that it required households
----------------------
and firms to know too much. People must know the true model or at least a good
approximation of it and this is a lot to expect. One of the main implications of ----------------------
the rational expectations monetarism is the policy ineffectiveness proposition.
This proposition states that the real variables are independent of systematic ----------------------
changes in money supply. Another major development of this policy is the time
----------------------
inconsistency proposition of Kydland and Prescott. They showed that the choice
of policy rules affects the structure of the policymaker’s model in the economy. ----------------------
The choice of policy affects expectations, the structure of the model and thus the
optimal policy. ----------------------
These policy implications of the rational expectations model are more ----------------------
closely related to one of the main issues raised by Keynes in General Theory.
In the Keynesian framework, attention is paid to the relation of institutional ----------------------
structure with expectations, to the variability of output and to the distribution of ----------------------
risk between the public and the private sectors.
----------------------
----------------------
Notes
----------------------
Fill in the blanks.
----------------------
1. If people expect rise in the future rate of interest, __________ for
---------------------- money starts falling.
---------------------- 2. Friedman does not suggest a relation between for __________
and _________ that cause risks to be reduced or augmented.
----------------------
----------------------
Activity 2
----------------------
As per Reserve Bank of India monetary policy, if CRR is reduced
---------------------- from 3.5% to 3%, what effects will it have on the availability of cash
---------------------- with banks. State the reasons.
----------------------
Summary
----------------------
●● hile conventional growth theory has no place for aggregate demand,
W
---------------------- Keynesian growth models in which aggregate demand determines growth
---------------------- neglect the role of aggregate supply.
●● he Monetarists consider regulation of supply of money than other
T
---------------------- fiscal instruments, and to them, stock of money is the driving force of
---------------------- economic growth, as fiscal policy cannot be considered as a measure
to stimulate stabilisation policy.
----------------------
---------------------- Keywords
---------------------- ●● ggregate supply: The total supply of goods and services that
A
firms in a national economy plan to sell during a specific time period.
---------------------- ●● emand for money: Holding of money by the people to make transactions,
D
---------------------- so the more people hold money, more is the demand for money.
●● onetary policy: The manipulation of the money supply with the objective
M
---------------------- of affecting macroeconomic outcomes, such as GDP growth, inflation,
---------------------- unemployment and exchange rates.

----------------------
1. What are the fundamental differences between Keynesian and Monetarist
---------------------- approaches?
2. Give economic explanations of the Cambridge equation.
----------------------
----------------------
170 Macroeconomics
3. Explain the rational expectation model and its operation in economic Notes
thought.
----------------------
4. Discuss the quantity theory of money.
5. How far is the rate of inflation determined by the quantity of money? ----------------------
----------------------
----------------------
----------------------
1. As per Keynes theory, demand of money arises: ----------------------
iii. To satisfy luxury needs ----------------------
2. In Economics, real money balance measure: ----------------------
iii. Purchasing power of the stock of money
----------------------
----------------------
1. If people expect rise in the future rate of interest, speculative demand for ----------------------
money starts falling.
----------------------
2. Friedman does not suggest a relation between expected income and
institutional arrangements that cause risks to be reduced or augmented. ----------------------
----------------------
Suggested Reading
----------------------
Hall. ----------------------
2. Goyal, Ashima ed. 2012. Macroeconomics and Markets in India: Good ----------------------
----------------------
3. Rangarajan, C., and Bakul H. Dholakia 2001. Principles of Macroeconomics.
New Delhi: Tata McGraw-Hill. ----------------------
4. Samuelson, Paul A, and William D. Nordhaus. 2006. Economics. New ----------------------
Delhi: Tata McGraw-Hill.
----------------------
5. Sloman, John. 2004. Economics. New Delhi: Prentice Hall of India.
----------------------
----------------------
----------------------
----------------------
----------------------
Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
172 Macroeconomics
Economic Crises and Policies for Growth and Stability
UNIT
11
Structure:
11.1 Introduction
11.2 Background
11.3 Global Economic Crisis
11.4 Major Causes of the Crises
11.5 Subprime Lending
11.6 Policies for Growth and Stability
Summary
Keywords
Suggested Reading
Economic Crises and Policies for Growth and Stability 173

Notes
Objectives
----------------------
----------------------
●● Explain the meaning and significance of economic crises
---------------------- ●● Analyse the causes that lead to economic crises and policies to
---------------------- control such crisis
●● Discuss the policies to be adopted for growth and stability
----------------------
---------------------- 11.1 INTRODUCTION

---------------------- The term “economic crisis” is applied generally to various situations
---------------------- where the values of financial assets unexpectedly fall. During the 19th and early
20th centuries, many financial crises were connected with banking crises and
---------------------- related recessions with the panics in economic activities. Recent financial crises
largely consist of the stock market crashes and associated bursts of financial
---------------------- bubbles and it has now taken a worldwide shape after globalisation. Its outcome
---------------------- is directly observed in the loss of paper wealth to a large extent; they do not
directly result in changes in the real economy unless a recession or depression
---------------------- follows.
----------------------
11.2 BACKGROUND
----------------------
The global economy is now rebounding from the crisis. There is a
---------------------- widespread belief that the worst of the global crisis is over as output and trade is
back to pre-crisis levels in 2010 in most of the emerging and developing world,
---------------------- whereas the OECD (Organisation for Economic Co-operation and Development)
---------------------- countries still suffer from low growth and high fiscal deficits. Unprecedented
expansionary fiscal policies to stimulate demand and large interest rate cuts to
---------------------- inject liquidity in the market, domestic as well as international, to sustain credit
have helped lower uncertainty and systemic risk in financial markets. However,
---------------------- there is no consensus in the path of recovery as global imbalances persist and
---------------------- major regulatory reforms are still debated.
The immediate cause or trigger of the crisis was the bursting of the
---------------------- United States’ housing bubble, which peaked approximately around 2005–
---------------------- 2006. Already rising default rates on subprime and Adjustable-Rate Mortgages
(ARM) began to increase quickly thereafter. As banks began to give out more
---------------------- loans to potential homeowners, housing prices began to rise.
---------------------- Steadily decreasing interest rates backed by the US Federal Reserve from
1982 onward and large inflows of foreign funds created easy credit conditions
---------------------- for a number of years prior to the crisis, fueling a housing construction boom
and encouraging debt-financed consumption. The combination of easy credit
----------------------
and money inflow contributed to the United States’ housing bubble. Loans
---------------------- of various types (mortgage, credit card and auto) were easy to obtain and
consumers assumed an unprecedented debt load.
174 Macroeconomics
As part of the housing and credit boom, the number of financial agreements Notes
called Mortgage - Backed Securities (MBS) and Collateralised Debt Obligations
(CDO), which derived their value from mortgage payments and housing prices, ----------------------
greatly increased. Such financial innovation enabled institutions and investors
around the world to invest in the US housing market. As housing prices declined, ----------------------
major global financial institutions that had borrowed and invested heavily in ----------------------
subprime MBS reported significant losses.
----------------------
Falling prices also resulted in homes worth less than the mortgage loan, providing
a financial incentive to enter foreclosure. The ongoing foreclosure epidemic ----------------------
that began in late 2006 in the US continues to drain wealth from consumers
and erodes the financial strength of banking institutions. Defaults and losses ----------------------
on other loan types also increased significantly, as the crisis expanded from the
----------------------
housing market to other parts of the economy. Total losses are estimated in the
trillions of US dollars globally. ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Fig. 11.1 Share in GDP of US Financial Sector since 1860 ----------------------

[Source: www.wikipedia.com] ----------------------
While the housing and credit bubbles were building, a series of factors ----------------------
caused the financial system to both expand and become increasingly fragile.
Government policy from the 1970s onward has emphasised deregulation ----------------------
to encourage business, which resulted in less oversight of activities and less
disclosure of information about new activities undertaken by banks and ----------------------
other evolving financial institutions. Thus, policymakers did not immediately ----------------------
recognise the increasingly important role played by financial institutions, such
as investment banks and hedge funds, also known as the shadow banking ----------------------
system. Some experts believe these institutions had become as important as
commercial (depository) banks in providing credit to the US economy, but they ----------------------
were not subject to the same regulations. ----------------------
“When written in Chinese, the word ‘crisis’ is composed of two characters.
----------------------
One represents danger and the other represents opportunity.”
− John F. Kennedy. ----------------------

Notes 11.3 GLOBAL ECONOMIC CRISIS
---------------------- The collapse of Lehman Brothers in September 2008 sent a wave of
fear around world financial markets. Banks virtually stopped lending to each
---------------------- other. The risk premium on interbank borrowing rose sharply to 5%, whereas
typically it was close to zero. Although authorities scrambled to inject liquidity
----------------------
into financial markets, the damage was done. The risk premium on corporate
---------------------- bonds shot up even more to over 6%. Large Capital Expenditures (CAPEX)
projects were shelved, the corporate sector virtually stopped borrowing, trade
---------------------- credit was hard to get and, with falling demand, particularly for investment
goods and manufacturing durables like cars, trade volumes collapsed.
----------------------
The result is that this global financial crisis has seen the largest and
---------------------- sharpest drop in global economic activity of the modern era. In 2009, most
---------------------- of the major developed economies found themselves in a deep recession. The
fallout for global trade, both for volumes and for the pattern of trade, has been
---------------------- dramatic.
---------------------- Governments have responded with an easing of monetary and fiscal policy
that in turn have their own effects on activity and financial and trade flows. The
---------------------- downturn in activity is causing unemployment to rise sharply and, with it, a
political response to protect domestic industries through various combinations
---------------------- of domestic subsidies and border protection. There is potential for protectionism
---------------------- to rise further. (McKibbin and Stoeckel, 2009, The Global Financial Crisis:
Causes and Consequences, The Lowy Institute for International Policy,
---------------------- Melbourne, Australia).
---------------------- The 2007–2012 global financial crisis is considered by many economists
to be the worst financial crisis since the Great Depression of the 1930s. It
---------------------- resulted in the threat of total collapse of large financial institutions, the bailout
of banks by national governments and downturn in stock markets around the
----------------------
world. The housing market also suffered, resulting in evictions, foreclosures
---------------------- and prolonged unemployment. The crisis played a significant role in the failure
of key businesses, declines in consumer wealth estimated in trillions of US
---------------------- dollars and a downturn in economic activity leading to the 2008–2012 global
recession and contributing to the European sovereign-debt crisis. The active
----------------------
phase of the crisis, which manifested as a liquidity crisis, can be dated from
---------------------- August 7, 2007 when BNP Paribas terminated withdrawals from three hedge
funds citing “a complete evaporation of liquidity”.
----------------------
The bursting of the US housing bubble, which peaked in 2006, caused
---------------------- the values of securities tied to US real estate pricing to plummet, damaging
financial institutions globally. The financial crisis was triggered by a complex
---------------------- interplay of government policies that encouraged home ownership, provision
of easier access to loans for subprime borrowers, overvaluation of bundled
----------------------
subprime mortgages based on the theory that housing prices would continue to
---------------------- escalate, questionable trading practices—including those based on over-reliance
on Black-Scholes- Merton formula—on behalf of both buyers and sellers and a
----------------------
176 Macroeconomics
lack of adequate capital holdings from banks and insurance companies to back Notes
the financial commitments they were making.
----------------------
Questions regarding bank solvency, decline in credit availability and
damaged investor confidence had an impact on global stock markets, where ----------------------
securities suffered huge losses during 2008 and early 2009. Economies
worldwide slowed during this period, as credit tightened and international trade ----------------------
declined. Governments and central banks responded with unprecedented fiscal
----------------------
stimulus, monetary policy expansion and institutional bailouts. Although there
have been aftershocks, the financial crisis itself ended sometime between late ----------------------
2008 and mid-2009. In the US, the Congress passed the American Recovery and
Reinvestment Act, 2009. In the European Union (EU), the UK responded with ----------------------
austerity measures of cuts in spending and increases in taxes without export
----------------------
growth and it has since slid into a double-dip recession.
If you followed this economic crisis and you do not think that the world ----------------------
is getting flatter, you are not paying attention. We saw the entire global ----------------------
economy at one time acting totally in sync. The real truth is the world is
even flatter than I thought. Our mortgage crisis is killing Deutsche Bank. ----------------------
You still don’t think the world is flat? − Thomas Friedman.
----------------------

1. The collapse of ______________ in September 2008 sent a wave of ----------------------
fear around world financial markets.
----------------------
2. The 2007–2012 global financial crisis is considered by many
economists to be the worst financial crisis since the ____________. ----------------------
3. The financial crisis was triggered by a complex interplay of ----------------------
government policies that encouraged home ownership, provision of
easier access to loans for _____________, overvaluation of bundled ----------------------
subprime mortgages.
----------------------
----------------------
Activity 1
----------------------
Conduct a research on US Financial Crisis and write down five major ----------------------
problems that led to the situation.
----------------------
11.4 MAJOR CAUSES OF THE CRISES ----------------------
The report of the US Financial Crisis Inquiry Commission came into the ----------------------
people domain in January 2011. It concluded that the crisis was avoidable and
----------------------
----------------------

Notes was caused by:
●● idespread failures in financial regulation, including the Federal
W
----------------------
Reserve’s failure to stem the tide of toxic mortgages.
---------------------- ●● ramatic breakdowns in corporate governance, with too many financial
D
firms acting recklessly and taking on too much risk.
----------------------
●● n explosive mix of excessive borrowing and risk by households and
A
---------------------- Wall Street that put the financial system on a collision course with crisis.
---------------------- ●● ey policymakers ill-prepared for the crisis and lacked full understanding
K
of the financial system they oversaw.
---------------------- ●● Systemic breaches in accountability and ethics at all levels.
----------------------
11.5 SUBPRIME LENDING
----------------------
The extreme rivalry in the US mortgage market for more proceeds
---------------------- and shares coupled with imperfect borrower supply market in terms of
creditworthiness had led mortgage lenders to trade with imperfect legal
----------------------
standards and to initiate more and more perilous mortgages. Prior to 2003,
---------------------- the mortgage securitisation market in USA was controlled by Government
Sponsored Enterprises (GSEs). The GSEs were responsible to monitor
---------------------- mortgage originators and it also maintained higher underwriting standards.
However, the market power was shifted from securitises to originators
----------------------
which ultimately diluted the power of GSE and led to decline in mortgage
---------------------- standards and, hence the risky loans proliferated and originated during
2004–2007, which ultimately resulted in huge crash in the subprime market.
----------------------
Growth of the housing bubble
---------------------- During 1991−2006, the average price of a US house had increased by
more than 100% due to huge demand in the housing market as well as lesser
----------------------
legal constraints in the mortgage as mentioned earlier. This resulted in the
---------------------- housing bubble through the refinancing of homes at lesser interest rates and
incurring expenditure by taking out mortgages that had been secured with
---------------------- appreciated price. Thus, the simpler security obligation had allowed the
financial institutions to acquire funds to finance subprime mortgage through the
----------------------
payments from multiple mortgages or other debt obligations. Securities with
---------------------- lower priority had lower credit ratings but theoretically a higher rate of return
on the amount invested was shown.
----------------------
During September 2008, the average housing prices in the USA had started
---------------------- declining and the borrowers (with adjustable-rate mortgages) were unable to
refinance to avoid higher payments linked with rising interest rates and became
---------------------- defaulters. The outcome of the subprime mortgage market ultimately spread
---------------------- over to other markets in the US and to the other parts of the world and it led to
a huge global recession.
---------------------- Increased debt burden or over-leveraging
---------------------- Prior to the crisis, financial institutions used to get higher leverage through the
178 Macroeconomics
complex financial instruments like off-balance sheet securitisation and derivatives. Notes
Actually, the whole process of off-balance sheet securitisation could not be
monitored to obtain zero-level risk. These complex financial instruments and the ----------------------
related daily transactions had made constraints to reveal the actual financial position
of the institutions in the market, particularly the institutions, which got bankrupt and ----------------------
needed government bailouts. The whole panorama had increased the chances of ----------------------
collapse and deteriorated the consequent economic conditions.
----------------------
The following statistics show the outcome. Free cash used by consumers
from home equity extraction doubled from $627 billion in 2001 to $1,428 billion ----------------------
in 2005 as the housing bubble built, a total of nearly $5 trillion dollars over the
period, contributing to economic growth worldwide. US home mortgage debt ----------------------
relative to GDP increased from an average of 46% during the 1990s to 73%
----------------------
during 2008, reaching $10.5 trillion.
USA household debt as a percentage of annual disposable personal income ----------------------
was 127% at the end of 2007 versus 77% in 1990. In 1981, US private debt was
----------------------
123% of GDP; by the third quarter of 2008, it was 290%. From 2004–07, the top
five US investment banks each significantly increased their financial leverage, ----------------------
which increased their vulnerability to a financial shock. Changes in capital
requirements, intended to keep US banks competitive with their European ----------------------
counterparts, allowed lower risk weightings for AAA securities. The shift from
----------------------
first-loss tranches to AAA tranches was seen by regulators as a risk reduction
that compensated the higher leverage. These five institutions reported over $4.1 ----------------------
trillion in debt for fiscal year 2007, about 30% of USA nominal GDP for 2007.
Lehman Brothers was liquidated, Bear Stearns and Merrill Lynch were sold at ----------------------
fire-sale prices and Goldman Sachs and Morgan Stanley became commercial
----------------------
banks, subjecting themselves to more stringent regulation. With the exception
of Lehman, these companies required or received government support. ----------------------
Some of the other important factors are namely deregulation, financial
----------------------
innovation and complexity, boom and collapse of the shadow banking system,
commodities boom etc. ----------------------
11.6 POLICIES FOR GROWTH AND STABILITY ----------------------
----------------------
Economic stability would adequately address the issues to overcome
financial crisis and price volatility. This means it tries to avoid large sway in ----------------------
economic activities, hyperinflation and explosive volatility in exchange rates.
This is because these instabilities are the main causes of uncertainty in economic ----------------------
policymaking and forecasting of policy macro- variables, which ultimately
----------------------
depress investment decision, obstruct output growth and damage general living
standards of an economy. Although a minimal degree of instability is a part of ----------------------
dynamic process of structural change, a high degree of instability is not at all
welcome for the economic prospect. Thus, the challenge for economic planners ----------------------
is to minimise the instability by encouraging the economy’s ability to raise
----------------------
living standards through higher productivity, efficiency and employment.
Economic as well as financial stability are both national and multilateral ----------------------

Notes apprehension from the point of view of aggregate global economic well being,
as in the post-WTO regime it has been observed that economies have become
---------------------- more unified. Thus, if one problem would arise in one market, it would spillover
to other markets within and across borders.
----------------------
Surveillance
----------------------
Every country that joins the IMF accepts the obligation to subject its
---------------------- economic and financial policies to the scrutiny of the international community.
The IMF is mandated to oversee the international monetary system and monitor
---------------------- the economic and financial policies of its 188 member countries. This process,
known as surveillance, takes place at the global level and in individual countries
----------------------
and regions. The IMF tries to highlight all possible risks to domestic and external
---------------------- stability and gives necessary policy advices.
Bilateral surveillance
----------------------
The core of IMF’s bilateral surveillance is regular—usually annual—
---------------------- consultations with each member country. During these consultations, the IMF
---------------------- staff discusses economic and financial developments and policies with national
policymakers and often with representatives of business, labour unions and
---------------------- civil society. Consultations consider the impact of fiscal, monetary, financial
and exchange rate policies on the member’s domestic and external stability and
---------------------- assess risks and vulnerabilities. The IMF offers advice on policies to promote
---------------------- macro-financial stability and external stability, drawing on experience across its
membership.
---------------------- The policy framework for these consultations is set in the 2007 Decision
---------------------- on Bilateral Surveillance and the recently adopted Integrated Surveillance
Decision. These consultations are also informed by membership-wide initiatives,
---------------------- including:
---------------------- Work to systematically assess countries’ vulnerabilities to crises.
The Financial Sector Assessment Program (FSAP), in collaboration
----------------------
with the World Bank. The FSAP assesses countries’ financial sectors and helps
---------------------- formulate policy responses to risks and vulnerabilities.
A Standards and Codes Initiative also in collaboration with the World
----------------------
Bank. The initiative assesses countries’ observance of a dozen internationally
---------------------- recognised standards and codes of good practice to support the design and
implementation of related policies. (www.imf.org)
----------------------
Multilateral surveillance
---------------------- The IMF also closely monitors global and regional trends in economic
---------------------- expansion. The IMF’s periodic reports on the World Economic Outlook, its
regional reports, the Fiscal Monitor and the Global Financial Stability Report,
---------------------- analyse global and regional macroeconomic and financial developments. The
IMF is well positioned to facilitate multilateral discussions on issues of relevance
---------------------- or common concern to groups of members and in the process, advance shared
---------------------- understanding on policies to promote stability. In this context, the Fund has
been working with G-20 to assess the consistency of those countries’ policy
180 Macroeconomics
frameworks with balanced and sustained growth for the global economy. Notes
The Fund has recently reviewed its surveillance mandate in light of
----------------------
the global crisis. It has introduced a number of reforms to improve financial
sector surveillance within member countries and across borders, to improve ----------------------
understanding of inter- linkages between macroeconomic and financial
developments (including through the Spillover Reports) and promote greater ----------------------
debate on these matters. These reforms, along with those being implemented
----------------------
following the 2011 Triennial Surveillance Review, will go a long way to address
the concerns raised in the 2011 Report by the Independent Evaluation Office. ----------------------
Data: In response to the financial crisis, the IMF is working with members, the
----------------------
Financial Stability Board and other organisations, to fill data gaps important for
global stability. ----------------------
Technical assistance: The IMF helps countries strengthen their capacity to
----------------------
design and implement sound economic policies. It provides advice and training
on a range of issues within its mandate, including fiscal, monetary and exchange ----------------------
rate policies, the regulation and supervision of financial systems, statistics
systems and legal frameworks. ----------------------
Lending: Even the best economic policies cannot completely eradicate ----------------------
instability or avert crises. In the event that a member country does experience
financing difficulties, the IMF can provide financial assistance to support policy ----------------------
programmes that will correct underlying macroeconomic problems, limit ----------------------
disruption to the domestic and global economies and help restore confidence,
stability and growth. IMF financing instruments can also support crisis ----------------------
prevention. (www.imf.org)
----------------------
State True or False. ----------------------

1. The core of IMF’s bilateral surveillance is consultations with each ----------------------
member country twice a year.
----------------------
2. The FSAP assesses countries’ financial sectors and helps formulate
policy responses to risks and vulnerabilities. ----------------------
3. The best economic policies can completely eradicate instability or ----------------------
avert crises.
----------------------
Activity 2 ----------------------
----------------------
Based on the above research, give two instances of over-leveraging
adopted by the US bankers, which led to the fall of Lehman Brothers. ----------------------
----------------------
----------------------

Notes Summary
---------------------- ●● conomic expansion always needs a stable framework in monetary
E
and financial aspects; otherwise, it leads to crisis, which again retards
----------------------
economic expansion.
---------------------- ●● I MF and other International bodies express their concern and suggest
different stabilisation policies to maintain trend growth and to prevent
----------------------
economic crisis.
----------------------
Keywords
----------------------
●● Economic Crises : Various situations where the values of financial assets
----------------------
unexpectedly fall.
---------------------- ●● ubprime lending: Giving loans to people who may have difficulty
S
maintaining the repayment schedule.
----------------------
---------------------- 1. How does debt burden lead to economic crisis? Discuss with reference to
---------------------- sub-prime crisis of 2008.
2. How does multilateral surveillance help to control economic crisis?
----------------------
3. Explain the growth of housing bubble and its consequences.
----------------------
----------------------

Fill in the blanks.
----------------------
1. The collapse of Lehman Brothers in September 2008 sent a wave of fear
---------------------- around world financial markets.
---------------------- 2. The 2007–2012 global financial crisis is considered by many economists
to be the worst financial crisis since the Great Depression of the 1930s.
----------------------
3. The financial crisis was triggered by a complex interplay of government
---------------------- policies that encouraged home ownership, provision of easier access
to loans for subprime borrowers, overvaluation of bundled subprime
---------------------- mortgages.
---------------------- State True or False.

1. False
----------------------
2. True
----------------------
3. False
----------------------
182 Macroeconomics
Notes
Suggested Reading
----------------------
2. http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=Keynesi ----------------------
an+cross
----------------------
----------------------
keynesian-cross-and-the-multiplier ----------------------
5. http://njsanders.people.wm.edu/101/Ch10_11_Handout.pdf ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
184 Macroeconomics

Macro Economics

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Macro Economics

Uploaded by

Copyright:

Available Formats

MACRO ECONOMICS

(FOR PRIVATE CIRCULATION ONLY)

COURSE DESIGN AND REVIEW COMMITTEE

Published by Symbiosis Centre for Distance Learning (SCDL), Pune

Copyright © 2016 Symbiosis Open Education Society

Mr. Dalip Mehra

Mr. Santanu Ray-Chaudhary is Assistant Professor in Economics in the Symbiosis School of

Unit No. TITLE Page No.

Introduction to Macroeconomics and Measuring Income and Output 1

---------------------- 1.1 INTRODUCTION

Check your Progress 1 ----------------------

State True or False. ----------------------

1. Microeconomic theories seek to answer questions such as how the ----------------------

Introduction to Macroeconomics and Measuring Income and Output 3

---------------------- 1.3 CIRCULAR FLOW OF ECONOMIC ACTIVITIES

Fig. 1.1 Circular Flows in a Two-sector Model ----------------------

Introduction to Macroeconomics and Measuring Income and Output 5

Introduction to Macroeconomics and Measuring Income and Output 7

---------------------- Check your Progress 2

---------------------- State True or False.

---------------------- 1. An economy can be defined as an integrated system of production,

---------------------- Check the link http://220.227.161.86/16788National_Income_india.pdf,

---------------------- 1.4 NATIONAL INCOME AND OUTPUT

---------------------- Output in economics is the “quantity of goods or services produced in a

Gross National Product (GNP) ----------------------

Introduction to Macroeconomics and Measuring Income and Output 9

---------------------- Conceptually, the value of GDP, whether estimated at market price or

---------------------- Limitations of GDP

Introduction to Macroeconomics and Measuring Income and Output 11

---------------------- Disposable Income

---------------------- Real Income

Introduction to Macroeconomics and Measuring Income and Output 13

a) Private consumption expenditure. ----------------------

Introduction to Macroeconomics and Measuring Income and Output 15

Introduction to Macroeconomics and Measuring Income and Output 17

Introduction to Macroeconomics and Measuring Income and Output 19

---------------------- Self-Assessment Questions

---------------------- Answers to Check your Progress

---------------------- Check your Progress 1

---------------------- Check your Progress 2

Introduction to Macroeconomics and Measuring Income and Output 21

Introduction to Macroeconomics and Measuring Income and Output 23

Introduction to Macroeconomics and Measuring Income and Output 25

Aggregate Demand and Supply 27

---------------------- 2.1 INTRODUCTION

●● Durable goods: Goods lasting more than a year. ----------------------

Aggregate Demand and Supply 29

To ascertain the aggregate expenditure in retail marketing, identify minimum ----------------------

Aggregate Demand and Supply 31

2.4.3 Business Cycles ----------------------

Aggregate Demand and Supply 33

---------------------- Check your Progress 2

Price Level ----------------------

Aggregate Demand and Supply 35

●● he slope of the market supply curve is based on increasing opportunity

Aggregate Demand and Supply 37

---------------------- o Natural increase of population.

●● Long run means full employment and flexible prices. ----------------------

Aggregate Demand and Supply 39

Aggregate Demand and Supply 41

Aggregate Demand and Supply 43

Aggregate Markets and Shocks 45

Aggregate Markets and Shocks 47