Economics

BUSINESS ECONOMICS -III
REFERENCE MATERIAL
2023-24
(For Private Circulation Only)

MODULE I
Class: SYBCom Semester-III Subject: B. Economics-III
Unit-I- CHAPTER 1
Macroeconomics: Meaning, Scope and Importance
Table of Contents:
Definition of Macroeconomics 1
Tools of Macroeconomics 2
Differences between Microeconomics and Macroeconomics 2
Major Issues and Concerns of Macroeconomics 3
Employment and Unemployment 3
Determination of National Income (or GNP) 3
General Price Level and Inflation 4
Business Cycles 4
Stagflation 4
Economic Growth 5
Balance of Payments and Exchange Rate 5
Importance of Macroeconomics 6
Definition of Macroeconomics
Macroeconomics (Greek makro = ‘big’) describes and explains economic processes that concern
aggregates. An aggregate is a multitude of economic subjects that share some common features.
By contrast, microeconomics treats economic processes that concern individuals.
Example: The decision of a firm to purchase a new office chair from company X is not a
macroeconomic problem. The reaction of Indian households to an increased rate of income tax is
a macroeconomic problem.
We can determine an economy's macroeconomic health by examining a number of goals: growth
in the standard of living, low unemployment, and low inflation. Macroeconomic policies are also
studied like how the nation's central bank conducts monetary policy, which involves policies that
affect bank lending, interest rates, and financial capital markets.
Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 1

Tools of Macroeconomics
Fiscal Policy: relates to the management of government revenue, expenditure and debt to achieve
favorable effects and avoid unfavorable effects on income, output and employment.
Monetary Policy: relates to the management of money supply and credit to step up business
activities, promote economic growth, stabilize the price level, achievement of full employment
and equilibrium in balance of payments.
Income Policy: through this policy direct control is exercised over prices and wages.
Differences between Microeconomics and Macroeconomics

Microeconomics deals with the analysis of small individual units of an economy such as individual
consumers, individual firms, individual industries and markets and explains how prices of products
and factors are determined. On the basis of these prices, microeconomics explains how resources
are allocated among various products and how income distribution among factors is determined.
On the other hand, Macroeconomics is concerned with the analysis of the behaviour of the
economic system in totality. Thus, Macroeconomics studies how the large aggregates such as total
employment, national product or national income of an economy and the general price level are
determined. Macroeconomics is therefore a study of aggregates. Besides, macroeconomics
explains how the productive capacity and national income of the country increase over time in the
long run.
Professor Gardner Ackley makes the distinction between macroeconomics and microeconomics
more clearly when he says, "macroeconomics concerns itself with such variables as the aggregate
volume of the output of an economy, with the extent to which its resources are employed, with the
size of the national income and with the “general price level”. Microeconomics, on the other hand,
deals with the division of total output among industries, products and firms and the allocation of
resources among competing uses. It considers the problem of income distribution. Its interest is in
relative prices of particular goods and services."
It is evident from above that the subject matter of macroeconomics is to explain what determines
the level of total economic activity (that is, the size of the national income and employment) and
fluctuations (i.e., ups and downs) in it in the short run. It also explains what causes the general
price level to rise and determines the rate of inflation in the economy. Besides, modern
macroeconomics analyses those factors which determine the increase in productive capacity and
national income in the long run. The problem of increasing productive capacity and national

income over time in the long run is called the problem of economic growth. Thus, what determines
the rate of growth of an economy is also the concern of macroeconomics.
Major Issues and Concerns of Macroeconomics

1. Employment and Unemployment
2. Determination of National Income (or GNP)
3. General Price Level and Inflation
4. Business Cycle
5. Stagflation
6. Economic Growth
7. Balance of Payments and Exchange Rate
Keynes in his book “Theory of Employment, Interest and Money” explained how levels of income
and employment were determined in a free market economy. During the Second World War
period, he extended his macro-theory to explain inflation. However, after Keynes, economists have
further developed and extended macroeconomics. We briefly explain below the main issues of
macroeconomics.
1. Employment and Unemployment

The first major issue in macroeconomics is to explain what determines the level of employment
and national income in an economy and therefore what causes involuntary unemployment. Why is
the level of national income and employment very low in times of depression as in the 1930s in
various capitalist countries of the world. This will explain the cause of huge unemployment that
emerged in these countries. As mentioned above, classical economists’ denied that there could be
involuntary unemployment of labour and other resources for a long term. They thought that with
changes in wages and prices, unemployment would be automatically removed and full
employment established. But this did not appear to be so at the time of depression in the thirties
and after. Keynes explained that the level of employment and national income is determined by
aggregate demand and aggregate supply. With the aggregate supply curve remaining unchanged
in the short run, it is the deficiency of aggregate demand that causes underemployment equilibrium
with the appearance of involuntary unemployment. According to him, it is the changes in private
investment that causes fluctuations in aggregate demand and is therefore, responsible for the
problems of cyclical unemployment. We will explain Keynes's theory of employment and income
and its various aspects in detail in the subsequent chapters.
2. Determination of National Income (or GNP)

National income is the value of all final goods and services produced in a country in a year. Level
of national income or what is called Gross National Product (GNP) shows the performance of the
economy in a year and determines the overall living standards of the people of a country. The
higher the per capita national income, the greater the amounts of goods and services available for

consumption per individual on an average. Given the technology used for production, the
magnitude of employment goes hand-in-hand with the change in size of national income. The
fluctuations in economic activity primarily manifest themselves in changes in national income and
employment. When all resources in an economy are being employed for production, the size of
national income generated is called potential GNP or full-employment level of income. In a free
market economy, the changes in aggregate demand cause divergence of national income from the
level of potential GNP in the short run. It is important to note that in a developing country such as
India it is not a mere level of aggregate demand that determines national income. In it the supply-
side factors such as availability of physical capital, human capital (skills and education of people),
material resources, the technology used for production in agriculture and industries play a more
important role in the determination of nationalIncome.
3. General Price Level and Inflation

Another macroeconomic issue is to explain the problem of inflation. Inflation has been a major
problem faced by both the developed and developing countries. Classical economists thought that
it was the quantity of money in the economy that determined the general price level in the economy
and, according to them, the rate of inflation depended on the growth of money supply in the
economy. Keynes criticized the Quantity Theory of Money and showed that expansion in money
supply did not always lead to inflation or rise in price level. Keynes who before the Second World
War explained that involuntary unemployment and depression were due to the deficiency of
aggregate demand, during the war period when prices rose very high he explained in a booklet
'How to Pay for War' that just as unemployment and depression were caused by the deficiency of
aggregate demand, inflation was due to the excessive aggregate demand. Thus, Keynes put forward
what is now called demand-pull theory of inflation. After Keynes, theory of inflation has been
further developed and many theories of inflation depending upon various causes have been put
forward. Cost-push and structuralism theories of inflation have been put forward.
4. Business Cycles
Throughout history market economies have experienced what are called business cycles. Business
cycles refer to fluctuations in output and employment with alternating periods of boom and
recession. In boom periods both output and employment are at high levels, whereas in recession
periods both output and employment fall and as a consequence there is unemployment in the
economy. When these recessions are extremely severe, they are called depressions. What are the
causes of these business cycles or ups and downs in market economies is an important
macroeconomic issue which has been highly controversial. The objective of macroeconomic
policy is to achieve economic stability with equilibrium at full employment level of output and
income.
5. Stagflation
How to control business cycles and achieve economic stability has been a very difficult problem
for the economies to solve. But during the decade of 1970s and in subsequent decades market
economies have experienced a still more intricate problem which has been described as stagflation.

While in business cycles, recession or depression is accompanied by high unemployment and

falling prices, in the seventies recession or stagnation was accompanied by not only high
unemployment but also rapid inflation. Since in that period, high unemployment and recession (or
stagnation) co-existed with high inflation, this problem was given the name stagflation.
This stagflation could not be explained with the Keynesian theory which focuses on the demand
side. Therefore, a new economic thought which is called Supply-side Economics emerged which
explained stagflation by laying stress on the supply-side of economic activity. Stagflation is an
important issue of modern macroeconomics.
6. Economic Growth
Another important issue in macroeconomics is to explain what determines economic growth in a
country. Economic growth means sustained increase in national income (GNP) or per capita
income over a sufficiently long period of time. Given the availability of natural resources,
economic growth of a country depends on the growth of physical capital, human capital and
progress in technology. The growth of all these factors requires saving and investment. The growth
rate can therefore be stepped up by raising the rates of saving and investment. However, the
expansion in these factors determines the increase in productive capacity.
Theory of economic growth is an important branch of macroeconomics. The problem of growth is
a long-run problem and Keynes did not deal with it. Keynes focused on the importance of the
short-run problem of fluctuations in the level of economic activity (involuntary cyclical
unemployment, depression). It was Harrod and Domar who extended the Keynesian analysis to
the long-run problem of growth with stability. They laid stress on the dual role of investment -one
of income-generating, which Keynes considered, and the second of capacity-creating which
Keynes ignored because of his preoccupation with the short run. In view of the fact that an
investment adds to the productive capacity, then if growth with stability is to be achieved, income
or demand must be increasing at a rate large enough to ensure the full utilisation of the increasing
capacity. Thus, macroeconomic models of Harrod and Domar have explained the rate of growth
of income that must take place if the steady growth of the economy is to be achieved. These days
growth economics has been further developed and extended a good deal and new theories of
growth have been put forward by Solow, Meade, Kaldor and Joan Robinson.
It is important to note that in the context of developing countries, economic growth has been
distinguished from economic development. Economic development is a more inclusive concept
than economic growth. Economic development is generally understood to mean that apart from
increase in national income or per capita income poverty, unemployment and inequality must also
be declining.
7. Balance of Payments and Exchange Rate

Balance of payments is the record of economic transactions of the residents of a country with the
rest of the world during a period. The aim to prepare such a record is to present an account of all
receipts on account of goods exported, services rendered and capital received by the residents of a

country and the payments made for goods imported, services received and capital transferred to
other countries by residents of a country. There may be a deficit or surplus in balance of payments.
Both create problems for an economy. An important effect is that the transactions in balance of
payment are influenced by the exchange rate. The exchange rate is the rate at which a country's
currency is exchanged for foreign currencies. The instability in the exchange rate has been a major
problem in recent years which has given rise to serious balance of payments problems. For
instance, during the 12 years period (1991-2002), the Indian rupee depreciated to a large extent in
terms of the US dollar giving rise to serious problems.
Importance of Macroeconomics
The study of macroeconomics is important in its own sake, as it tells us how the economy as a
whole works. We cannot obtain and derive the laws governing macroeconomic variables such as
national income, total employment, general price level by studying the microeconomic decisions
of individual consumers, firms and industries. This is because what is true and valid in case of an
individual firm or industry may not be valid for the economy as a whole. Boulding has pointed out
several macroeconomic paradoxes which reveal that results obtained from the study of the
behaviour of individual firms or industries may lead us to misleading conclusions about the
working of the macroeconomy. Boulding compared it to the case of a forest and its trees.
According to him, it will be misleading to apply the rules governing the individual trees to
generalise about the behaviour of the forest. Two examples of macroeconomics paradoxes will
make it clear why the study of macroeconomic analysis separate from microeconomics is
important. Take the case of wages. A neoclassical economist A.C. Pigou suggested an all-round
cut in wage rates to promote employment and thereby to solve the problem of unemployment that
prevailed in times of Great Depression. We know from the marginal productivity theory of
distribution of microeconomics that in the case of an individual firm or industry, it is quite valid
that at a lower wage rate, an individual firm or industry will employ more labour. But this does
not apply to the whole economy. This is because wages are not only cost for a firm or industry,
they represent incomes of the workers who constitute a majority in a society. Fall in wages means
decline in their incomes which would lead to a fall in aggregate demand for goods and services.
This fall in aggregate demand will cause national output and employment to decline. Thus, from
the viewpoint of the economy as a whole cut in wages will increase unemployment of labour rather
than reducing it. The second important example of a macroeconomic paradox relates to saving.
When an individual saves more he is able to invest more and the higher investment yields more
income for him in the future. But this result does not necessarily apply to the case when a society
saves more, Suppose the economy is in the grip of recession and a society as a whole decides to
save more. This may not only fail to increase national income but ultimately even saving may not
rise as well. This is called the paradox of thrift. This happens because more saving than before
leads to the decrease in aggregate demand for goods and services. The fall in aggregate demand
will cause the level of national income to decline and at the lower level of national income, less
saving will be done. Thus, the initial increase in saving will not only lead to lower national income
and output bhut eventually even saving of the society may not rise.

The above two examples of macroeconomic paradoxes clearly reveal that a separate macroeco-
nomic analysis is important to understand the working of the economy as a whole.
Important Nature of Macroeconomic Issues:

Goals of Macroeconomics:
1. To Achieve Higher Level of Gross Domestic Product
2. To Achieve Higher Level of Employment; Stability of Prices
3. Formulation of Economic Policies; and Achievement of Economic Development.
Macroeconomics is concerned with the study of issues and problems which are of vital importance
for determining well-being of the people, Macro economic problems such as unemployment,
inflation, instability of foreign exchange rate cause a lot of human suffering. Unemployment
creates a lot of misery for the unemployed workers and gives rise to many social evils.
Unemployment involves waste of economic resources and loss of potential output. Inflation erodes
real incomes or purchasing power of the people. It redistributes national income in favour of the
rich and thus creates more income inequalities. Inflation sends more people under the poverty line
and thus accentuates the problem of poverty. Similarly, depreciation of domestic currency
encourages flight of capital from an economy and increases the prices of imports and thereby adds
to the inflationary pressures in the economy. Macroeconomics explains the causes of such
important problems and helps in formulating economic policies to tackle them.
Importance of Macroeconomics for Accelerating Economic Growth
Macroeconomics explains the factors which determine economic growth and brings out what
causes slowdown in productivity growth. Every community wants to grow economically because
economic growth helps to raise the standards of living of the people. Moreover, higher rates of
economic growth helps in solving the problems of poverty and unemployment in developing
countries like India. Macroeconomic models of Harrod-Domar and Solow reveal that increase in
the rate of saving and investment (or capital formation) and improvement in technology are the
important factors determining economic growth. Macroeconomic theories also reveal that lack of
growth in aggregate effective demand may serve as constraint to the growth process of an
economy. Thus, macroeconomics provides us knowledge as to how to achieve self-sustained
economic growth.
Understanding Business Cycles
Business cycles have been the biggest ailment of market economies. Though there is no unanimity
in macroeconomic theory about the proper explanation of business cycles, significant advances
have been made in bringing out the causes which lead to them. Fluctuations in aggregate demand
due to volatile nature of investment demand, as explained by Keynes, together with the interaction
of multiplier and accelerator provides an adequate explanation of business cycles. It is because of

this understanding about business cycles that has helped to adopt proper fiscal and monetary
policies to check business cycles and also due to these policies that severity of business cycles in
recent years has greatly reduced.
Formulating Government's Macroeconomic Policies
Understanding how the economy works which is obtained from macroeconomics has a practical
value in formulation of government's fiscal and monetary policies. With the knowledge of the
causes of recession and inflation brought out by macroeconomics, governments formulate proper
fiscal and monetary policies to tackle them. During recession, expansionary fiscal and monetary
policies are adopted to lift the economy out of recession. On the other hand, inflation has been
checked quite successfully by tight monetary policy and contractionary fiscal policy. Besides, the
understanding about the factors which determine economic growth, fiscal and monetary policies
have been so designed as to raise saving and investment and also to promote technological
improvement of the production process. Further, with the knowledge furnished by
macroeconomics about fluctuations in market economies, the central bank often intervenes to
achieve foreign exchange rate stability.
Individual Decision-Making
The understanding about the working of the economy as a whole helps the individuals to make
better decisions. For example, knowledge about macroeconomics helps them to assess the impact
of government's economic policies. If on the basis of certain Government's economic policy they
predict that inflation rate will increase, they may decide to act in the present in a way to ward off
the adverse effect of inflation. The knowledge of macroeconomics tells them that inflation will
erode their real income, will lower the real rate of interest, will make the exports dearer than before.
Keeping in view these impacts of inflation arising out of government’s policy they will make
decisions so as to save themselves from the undesirable consequences of inflation.
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Unit-I- Chapter-II
National Income
Table of Contents:
Introduction 2
Meaning 2
Definitions of National Income 2
Different Concepts of National Income 4
1) Gross National Product (GNP) 4
2) Gross National Product at Market Price (GNP (MP)) 4
3) Gross National Product at Factor Cost: (GNP (FC)) 4
4) Gross Domestic Product at Market Price (GDP (MP)) 4
5) Gross Domestic Product at Factor Cost (GDP (FC) ) 5
6) Net Domestic Product at Market Price (NDP (MP)) 5
7) Net Domestic Product at Factor Cost (NDP (FC)) 5
8) Net National Product at Market Price (NNP (MP)) 5
9) Net National Product at Factor Cost (NNP (FC)) 5
10) National Income at Factor Cost (NI (FC)) 5
11) Personal Income (PI) 6
12) Personal Disposable Income 6
Methods of Measuring National Income 6
1) Output Method 6
2) Income Method 7
3) Expenditure Method 8
Difficulties in the measurement of National Income 10

Introduction
The concept of national income occupies an important place in economic theory. National income
is one of the important subject matters of Macro Economics. National income is an uncertain term,
which is used interchangeably with national dividend, national output and national expenditure.
National income is the flow of goods and services, which become available to a nation during the
year. To be more precise, national income is the
aggregate money value of all final goods and services produced in a country during one year. As
an indicator of economic health and as an instrument of economic analysis, national income
computation is of great importance to the economists.
The total economic performance of a nation is evaluated with the help of national income data.
The basic purpose of national income accounting is to measure the aggregate output and income,
and provide a basis for the government to formulate their policy programmes, to maximize the
national welfare of the people. In India, since 1955, the responsibility for the calculation of national
income rests with the Central Statistical Organization (C.S.O.).
Meaning
In common, national income means the total value of goods and services produced annually in a
country. In other words, the total amount of income accruing to a country from economic activities,
in a year's time is known as national income. It includes payments made to all resources in the
form of rent, wages, interest and profits.
Thus, national income is the aggregate monetary -value of all final goods and services produced-
in the economy in a year.
Definitions of National Income

Dr. Marshall's Definition
Marshall's definition represents a total value of production - it is from production end.
According to Marshall, "The labour and capital of a country acting on its natural resources produce
annually a certain net aggregate of commodities, material and immaterial including services of all
kinds.... This is the true net annual income or revenue of the country or national dividend."
Prof. Pigou's Definition
Pigou's definition of national income represents a receipts total production end.
According to Pigou, the national dividend is that part of the objective income of the community,
including of course income derived from abroad, which can be measured in money.

Fisher's Definition
Fisher's approach is consumption end. "The national dividend or income consists solely of services
as received by ultimate consumers, whether from their material or from their human
environments".
Thus, according to Fisher, the national income of a country is determined not by its annual
production, but by its annual consumption. Fisher's definition provides an adequate concept of
economic welfare, which is dependent on consumption and consumption represents our standard
of living.
National Income Committee's Definition (1948)
"A national estimate measures the volume of commodities and services turned out during a given
period counted without duplication."
Features of National Income

1) National income is a macroeconomic concept : Macroeconomics deals with aggregate or
the economy as a whole. National income data present the picture of the performance of the
country's economy as a whole in the course of a given period of time.
2) National income is a flow concept: National income is the flow of goods and services
produced in the country during a year. It includes only those goods or services which are actually
produced.
3) National income is the money valuation of goods : National income is always expressed
in monetary terms. It represents only those goods and services which are exchanged for money.
4) National income includes the value of only final goods and services : In order to
avoid double counting, while estimating national income, we include only the value of final goods
and services, and not the value of intermediate goods or raw material. For example, while
estimating the production of sugar, there is no need to take the value of sugarcane, as it is already
included in the price of sugar.
5) National income is the net aggregate value: National income includes net value of
goods and services produced and does not include depreciation cost i.e. wear and tear of capital
goods, due to their use in the process of production.
6) Net income from abroad is included in national income: While estimating national
income, net income received from international trade that is the net export value (X-M) as well as
net receipts (R-P).
7) Financial Year: It is always expressed with reference to time period, that is, generally
a financial year, which in India is from 1st April to 31st March of every year.

Different Concepts of National Income

National income is an important concept of Macro Economics. There are a number of
concepts pertaining to national income.
1) Gross National Product (GNP)

Gross national product is the total measure of the flow of goods and services, at market value
resulting from current production, during a year in a country, including net income from abroad.
GNP =C+I+G+(X-M)+(R-P)
2) Gross National Product at Market Price (GNP (MP))

It means the gross value of final goods and services produced annually in a country, which is
estimated according to the price prevailing in the market. Market price including cost of production
+ indirect taxes.
GNP (MP) = C + I + G + (X-M) + (R-P)
C = Private Consumption Expenditure
I = Domestic Private Investment
G = Government's Consumption & Investment Expenditure.
(X-M) = Net Export Value. (Value of exports Value of imports)
(R-P) = Receipts from Property abroad - Payments to abroad.
MP = Production at Market Price.
3) Gross National Product at Factor Cost: (GNP (FC))

Gross national product at factor cost is the sum of the money value of the income, produced by
and accruing to the various factors of production in one year in a country.
In order to arrive at GNP at factor cost, we deduct indirect taxes from GNP at market prices and
add subsidies to GNP at Market. Prices.
GNP(FC) = GNP(MP) - Indirect Taxes + Subsidies
4) Gross Domestic Product at Market Price (GDP (MP))

Gross domestic product at market price is the gross market value of all final goods and services
produced within the domestic territory of a country, during a period of one year.
• The term gross implies that it includes depreciation.
• GDP at market price includes the amount of indirect taxes paid and excludes the
amount of subsidy received, that is, net indirect taxes are included. GDP(MP) = GNP - Net Income
from abroad.
GDP(MP) = C + I + G + (X-M)

5) Gross Domestic Product at Factor Cost (GDP (FC) )

Gross domestic product at factor cost is the gross money value of all final goods and services
produced within the domestic territory of a country, during a period of one year.
GDP at factor cost includes the amount of subsidy, but excludes the amount of indirect taxes paid.
GDP (FC) = GDP (MP) - Indirect Taxes + Subsidies
GDP(FC)=C+I+G+(X-M)-IT+S
6) Net Domestic Product at Market Price (NDP (MP))

Net domestic product at market price is the net market value of all final goods and services
produced, within the territorial boundaries of a country, during a period of one year.
NDP (MP) = GDP (MP) - Depreciation
7) Net Domestic Product at Factor Cost (NDP (FC))

Net domestic product at factor cost is the net money value of all final goods and services produced,
within the territorial boundaries of a country, during a period of one year.
NDP (FC) is also known as domestic income or domestic factor income.
NDP (FC) = GDP (MP) - Net Indirect Taxes - Depreciation
8) Net National Product at Market Price (NNP (MP))

Net national product at market price is the net market value of all final goods and services
produced, by the residents of a country, during a period of one year. If we deduct depreciation
from GNP at market prices we get NNP at market prices.
NNP (MP) = GNP (MP) - Depreciation
9) Net National Product at Factor Cost (NNP (FC))

Net national product at factor cost is the net money, value of all final goods and services produced
by the residents of a country, during a period of year.
It includes income earned by factors of production.
NNP (FC) = NNP (MP) - Indirect Taxes + Subsidies
10) National Income at Factor Cost (NI (FC))

National income at factor cost means the sum of all incomes, earned by resource suppliers for their
contribution of land, labour, capital and entrepreneurial ability, which go into the year's net
production.
NI (FC) = NNP (MP) - Indirect Taxes + Subsidies.

11) Personal Income (PI)

Personal income is the sum of all incomes, actually received by all individuals or households from
all the sources during a given year. It may be earned or unearned.
12) Personal Disposable Income

Personal disposable income is that part of personal income which is left behind after payment of
personal direct taxes like income tax, personal property taxes, etc.
Methods of Measuring National Income

There are three methods of measuring national income:
1) The output method/Product method
2) The income method
3) The expenditure method
1) Output Method
This method of measuring national income is also known as product method or inventory method.
This method approaches national income from the output side. According to this method, the
economy is divided into different. sectors, such as agriculture, mining, manufacturing, small
enterprises, commerce, transport; communication and other services. The output or product
method is followed either by valuing all the final goods and services, produced during a year, at
their market price or by adding up all the values at each higher stage of production, until these
products are turned into final products.
While using this method utmost care must be taken to avoid multiple or double counting. To avoid
double counting this method suggests two alternative approaches for the measurement of GNP:
i) The Final Goods Approach / The Final Product Approach:
Final goods are those goods which are ready for final consumption. According to this approach,
the value of all final goods and services produced in the primary, secondary and tertiary sector are
included and the value of all intermediate transactions are ignored. Intermediate goods are
involved in the process of producing final goods, that is, the final flow of output purchased by
consumers. Hence, the value of final output includes the value of intermediate products.
For example, the price of bread includes, the cost of wheat, making of flour, etc., wheat and flour
are both intermediate goods. Their values are paid up during the process of production. In the value
of the final product, bread, the values of intermediate goods are already included.
Thus, a separate accounting of the values of intermediate goods, along with the accounting of the
value of the final product, would mean double counting. To avoid this, the value of only the final
product must be computed.

ii) The Value Added Approach / The value Added Method:

In order to avoid double counting, the value added approach is used. According to this approach,
the value added at each stage of the production process is included. The difference between the
value of final outputs and inputs, at each stage of production is called the value added. Thus, GNP
is obtained as the sum total of the values added by all the different stages of the production process,
till the final output is reached in the hands of consumers, to meet the final demand.
Precautions:
While estimating national income by output method, the following precautions should be taken:
1) To avoid double counting, only the value of final goods and services must be taken into
account.
2) Goods used for self-consumption by farmers should be estimated by a guess work that is
imputed value of goods produced for self-consumption, is included in national income.
3) Indirect taxes included in the market prices are to be deducted and subsidies given by the
government to certain products should be added for accurate estimation of national income.
4) While evaluating output, changes in the price level between different years must be taken
into account.
5) Value of exports should be added. and value of imports should be deducted.
6) Depreciation of capital-assets should be deducted.
7) Sales and purchase of secondhand goods should be ignored as it is not a part of current
production. The output method is widely used in the underdeveloped countries. However, it is less
reliable because of the margin of error. In India, this method is applied to agriculture, mining and
manufacturers, including handicrafts. But it is not applied for the transport, commerce and
communication sectors in India.
2) Income Method
This method of measuring national income is also known as the factor cost method. This method
approaches national income from the distribution side.
According to this method, the income payments received by all citizens of a country, in a particular
year, are added up, that is, incomes that accrue to all factors of production by way of rents, wages,
interest and profits are all added together, but income received in the form of transfer payments
are ignored. The data pertaining to income are obtained from different sources, for instance, from
income tax returns, reports, books of accounts, as well as estimates for small income.
The GNP can be treated as the sum of factor incomes, earned as a result of undertaking economic
activity, on the part of resource owners and reflected in the production of the total output of goods.
and services during any given time period.

Thus, GNP, according to income method, is calculated as follows:

NI = Rent + Wages + Interest + Profit + Mixed Income + Net income from abroad.
Precautions:
While estimating national income by income method, the following precautions should be
taken.
1) Transfer incomes or transfer payments like scholarships, gifts, donations, charity, old
age, pensions, unemployment allowance etc., should be ignored.
2) All unpaid services like the services of a housewife, teacher teaching her/his child,
should be ignored.
3) Any income from the sale of second hand goods like cars, houses etc., should be
ignored.
4) Sales of shares and bonds should be ignored as they do not add anything to the real
national income.
5) Revenue received by the government through direct taxes should be ignored, as it is
only a transfer of income.
6) Undistributed profits of companies, income from government property and profits
from public enterprise, such as water supply, should be included.
7) Imputed value of production kept for self-consumption and imputed rent of owner
occupied houses should be included.
In India, the national income committee of the Central Statistical Organization, uses the income
method for adding up the income arising from trade, transport, professional and liberal arts, public
administration and domestic services.
3) Expenditure Method
This method of measuring national income is also known as the Outlay Method.
According to this method, the total expenditure incurred by the society, in a particular year, is
added together. Income can be spent either on consumer goods or on capital goods. Thus, we can
get national income by summing up all consumption expenditure and investment expenditure made
by all individuals, firms as well as the government of a country during a year.
Thus, gross national product is found by adding up
NI = C + I + G (X-M) + (R-P)
1) Private Final Consumption Expenditure Private Final Consumption Expenditure (C)
by households on non-durable goods, such as food, which are used immediately, expenditure on
durable goods such as car, computer, television set, washing machine etc., which are generally

used for a longer period of time, and expenditure on services like transport services, medical
services, etc.
2) Gross domestic private investment expenditure (I)
It refers to expenditure made by private businesses on replacement, renewals and new
investment (I).
3) Government final consumption and investment expenditure (G)
i) Government's final consumption expenditure refers to the expenditure incurred
by government on various administrative services like, law and order, defence, education etc.
ii) Government's investment expenditure refers to the expenditure incurred by
government, on creating infrastructural facilities like construction of roads, railways, bridges,
dams, canals, which are used by the business sector for production of goods and services in any
economy (G).
4) Net Foreign Investment/Net Exports = (X-M): It refers to the difference between
exports and imports of a country during a period of one year.
5) Net Receipts (R-P):
The difference between expenditure incurred by foreigners in the country (R) and
expenditures incurred abroad by residents (P) : (R-P).
Precautions:
While estimating national income by Expenditure Method, the following precautions should be
taken.
1) Expenditure on all intermediate goods and services should be ignored, in order to avoid
double counting.
2) Expenditure on the purchase of second hand goods should be ignored, as it is not incurred
on currently produced goods.
3) Expenditure on transfer payments like scholarships, old age pensions, unemployment
allowance etc., should be ignored.
4) Expenditure on purchase of financial assets such as shares, bonds, debentures etc., should
not be included, as such transactions do not add to the flow of goods and services.
5) Indirect taxes should be deducted.
6) Expenditure on final goods and services should be included.
7) Subsidies should be included.
Out of these methods, the Output Method and Income Method are extensively used. In advanced
countries like the U.S.A. and U.K. the Income Method is popular. Expenditure Method is rarely

used by any country because of practical difficulties. In India, the Central Statistical Organization
(CSO) adopts a combination of output method and income method to estimate national income of
India.
Difficulties in the measurement of National Income

The calculation of the national income of a country is a task full of difficulties and complexities.
The following difficulties generally arise while estimating national income.
i) Theoretical difficulties
ii) Practical difficulties.
i) Theoretical difficulties :
This is also known as conceptual difficulties.
1) Transfer payments:
Individuals get pension, unemployment allowance, but whether these should be included in
national income is a difficult problem. On one hand, these earnings are a part of individual income
and, on the other, they are government expenditure. Therefore, these transfer payments are ignored
from national income.
2) Income of foreign firms:
According to the IMF view-point, income of a foreign firm should be included in the national
income of the country, where the firm actually undertakes production work. However, profits
earned by foreign firms are credited to the parent concern.
3) Unpaid services:
National income is always measured in money, but there are a number of goods and services which
are difficult to be assessed in terms of money. For example, painting as a hobby. by an individual,
the bringing up of children by the mother, these services are not included in national income as
remuneration is not given to them.
Also, services of housewives and the services provided out of love, affection; mercy, sympathy
and charity are not included in national income, as they are not paid for. By excluding all such
services from it, the national income will work out to be less than what it actually is.
4) Incomes from illegal activities:
Income earned through illegal activities such as gambling, black marketing, theft, smuggling etc.,
is not included in national income. Such goods and services do have value and meet the needs of
the consumers. Thus, to that extent national income is underestimated.

5) Treatment of the government sector: Government provides a number of public services

like defence, public administration, law and order etc. Measuring the market value of such
government services is difficult; as the real value of these services is not known, therefore it has
become a convention to treat all such services as final consumption. Hence, it is included in
national income.
6) Production for self-consumption:
Goods produced for self-consumption such as food grains, vegetables and other farm products do
not enter the market. But the value of such goods should be estimated at the rate of market price
that have been marketed and should be included in national income.
7) Changing price levels:

The difficulty of price changes arises in the national income estimate, when the price level in the
country rises, the national income also shows an increase even though the production might have
fallen and when price level falls., National Income may show a decrease even though production
may have increased.
ii) Practical difficulties / statistical:
In practice, a number of difficulties arise in the collection of required statistics in estimating
national income, some of these are.
1) Problem of double counting:
The greatest difficulty in calculating the national income is double counting. It arises from the
failure to distinguish properly, between a final and an intermediate product. It so happens, the
national income would work out to be many times the actual. For example, flour used by a bakery
is an intermediate product and that by a household the final product.
2) Existence of non-monetized sector:
There is a large non-monetized sector, in-the developing economy like India. Agriculture, still
being in the nature of subsistence farming in the developing countries, a major part of the output
is consumed at the farm itself and a part of production is partly exchanged for other goods and
services. Such production and consumption cannot be calculated in national income.
3) Lack of occupational specialization:
There is the lack of occupational specialization, which makes the calculation of national income
by product method difficult. For instance, besides the crop, farmers in a developing country are
engaged in supplementary occupations like dairy farming, poultry farming, cloth making etc. But
income from such productive activities may not be revealed and thus is not included in the national
income estimates.

4) Inadequate and unreliable data:

Adequate and correct production and cost data are not available in a developing country, such data
relate to crops, fisheries, animal husbandry, forestry, the activities of petty shopkeepers,
construction workers, small enterprises etc. That is why, national income of a country will not
show at its actual.
For estimating national income by income method, data on unearned incomes and on persons
employed in the service sector are not available. Data on consumption and investment expenditures
of the rural and urban population are also not available for the estimation of national income.
Moreover, there is no machinery for the collection of data in such countries.
5) Capital gains or losses:

Capital gains or losses, which accrue to the property owners by increases or decreases in the market
value of their capital assets or changes in demand, are not included in the gross national product,
because these changes do not result from current economic activities.
6) Depreciation:
The calculation of depreciation on capital consumption is one more difficulty. Depreciation refers
to wear and tear of capital assets, due to their use in the process of production. Depreciation of
capital assets will depend on the technical life of the asset, the intensity of its use, nature of the
asset, regular and careful maintenance etc. There are no uniform, common or accepted standard
rates of depreciation applicable to the various capital assets. In case of depreciation, one has to
make many reasonable assumptions, which involve an element of subjectivity. So, it is difficult to
make correct deductions for depreciation.
7) Valuation of inventories:
Raw materials, intermediate goods, semi-finished and finished products in the stock of the
producers are known as inventory. All inventory changes, whether negative or positive, are
included in the gross national product. Any mistake in measuring the value of inventory, will
distort the value of the final production of the producer. Therefore, valuation of inventories
requires careful assessment.
8) Illiteracy and Ignorance:
Majority of the small producers in developing countries are illiterate and ignorant; and are not in
a position to keep any account of their productive activities. So, they cannot give information about
the quantity or value of their output. Hence, the estimates of production and earned income are
simply guesses.
******************

Circular flow of Income
Table of Contents
Introduction 1
The Four Macroeconomic Sectors 2
1 The Household Sector 2
2 The Firms Sector 2
3 The Government Sector 2
4 The Foreign Sector 2
The Three Markets 2
1 The Goods Market 2
2 The Factor Market 3
3 The Financial Market 3
The Circular Flow of Income in a Two-Sector Model 3
The Circular Flow of Income in a Two- Sector Model with Saving and Investment 4
The Circular Flow of Income in a Three – Sector Model 5
The Circular Flow of Income in a Four Sector Model 7
Leakages and Injections in the Circular Flow of Income 8
Leakages 8
Injections 9
Summary 10
Introduction
Macroeconomics is the branch of Economics that studies the economic behaviour of all the agents
in the economy; i.e. it is the study of the economy as a whole. In other words, macroeconomics is
the study of aggregate outcomes of the decisions taken by the different agents in an economy.
To begin the study of basic macroeconomics let us introduce the concept of the circular flow of
Income. The circular flow of income forms the basis for all the macroeconomic models of the
economy and it is imperative to understand the circular flow model for understanding essential
concepts like national income, aggregate demand and aggregate supply.
The circular flow of income describes the movement of goods or services and income among the
different sectors of the economy. It illustrates the interdependence of the sectors and the markets
to facilitate both real and monetary flow.
The real flow refers to the flow of factor services and flow of goods and services. The flow of
factor services from the households to the firms and the flow of goods and services from firms to
the household is the real flow. The flow of factor services generates money flows in the form of
factor payments which the firms pay the household and similarly the household need to pay the

firms for the flow of goods and services. The movement to the money/cash payment from one
sector to the other sector corresponding to the real flow is referred to as the monetary flow. Thus,
the income of one sector becomes the expenditure of the other and the supply of goods and services
by one sector becomes the demand of the other sector. The real flow and monetary flow move in
a circular manner in an opposite direction. A continuous flow of production, income and
expenditure is known as the circular flow of income.
The Four Macroeconomic Sectors

1 The Household Sector
This sector includes all the individuals in the economy. The primary function of this sector is to
provide the factors of production. The factors of production include land, labour, capital and
enterprise. The household sectors are the consumers who consume the goods and services
produced by the firms and in return make payments for the same.
2 The Firms Sector

This sector includes all the business entities, corporations and partnerships. The primary function
of this sector is to produce goods and services for sale in the market and make factor payments to
the household sector.
3 The Government Sector

This sector includes the center, state, and local governments. The prime function of this sector is
to regulate the functioning of the economy. The government sector incurs both revenue as well as
expenditure. The government earns revenue from tax and non-tax sources and incurs expenditure
for providing essential public services to the people.
4 The Foreign Sector

This sector includes transactions with the rest of the world. Foreign trade implies net exports
(exports minus imports). Exports include goods and services produced domestically and sold to
the rest of the world and imports include goods and services produced abroad and sold
domestically.
The Three Markets

1 The Goods Market
In this market the goods and services are exchanged among the four macroeconomic sectors. The
consumers are the household, government and the foreign sector while the producers are the firms.

2 The Factor Market

The factors of production are traded through this market. For the production of final goods and
services, the firms obtain the factor services and make payments in the form of rent, wages and
profits for the services to the household sector.
3 The Financial Market

This market consists of financial institutions such as banks and non-bank intermediaries who
engage in borrowing (savings from households) and lending of money.
The Circular Flow of Income in a Two-Sector Model

In this model, the economy is assumed to be a closed economy and consists of only two sectors,
i.e., the household and the firms. A closed economy is an economy that does not participate in
international trade. In this model, the household sector is the only buyer of the goods and services
produced by the firms and it is also the only supplier of the factors of production. The household
sector spends the entire income on the purchase of goods and services produced by the firms
implying that there is no saving or investment in the economy. The firms are the only producer of
the good and services. The firms generate income by selling the goods and services to the
household sector and the latter earns income by selling the factors of production to the former.
Thus, the income of the producers is equal to the income of the households is equal to the
consumption expenditure of the household. The demand of the economy is equal to the supply.
In this model, Y = C where, Y is Income and C is Consumption.
The circular flow of income in a two sector model is explained with the help of the following
diagram, called Model 1.

The Circular Flow of Income in a Two- Sector Model with Saving and
Investment
In the above model, we assumed that the household sector spends its entire income and that there
is no saving in the economy however, in practice, the household sector does not spend all its
income; it saves a part of it. The saving by the household sector would imply monetary withdrawal
(equal to saving) from the circular flow of income. This would affect the sale of the firms since
the entire income of the household would not reach the firm implying that the production of goods
and services would be more than the sale. Consequently, the firms would decrease their production
which would lead to a fall in the income of the household and so on.
There is one way of equating the sales of the firms with the income generated; if the saving of the
household is credited to the firms for investment then the income gap could be filled. If the total
investment (I) of the firms is equal to the total saving (S) of the household sector then the
equilibrium level of the economy would be maintained at the original level. This is explained with
the help of the following diagram, called Model 1a.
The equilibrium condition for a two-sector model with saving and investment is as follows:

Y = C + S or Y = C + I or C + S = C + I
Or, S = I
Where, Y = Income, C = Consumption, S = Saving and I = Investment
The Circular Flow of Income in a Three – Sector Model

The three sector model of circular flow of income highlights the role played by the government
sector. This is a more realistic model which includes the economic activities of the government
however; we continue to assume the economy to be a closed one. There are no transactions with
the rest of the world. The government levies taxes on the households and the firms and it also gives
subsidies to the firms and transfer payments to the household sector. Thus, there is income flow
from the household and firms to the government via taxes in one direction and there is income

outflow from the government to the household and firms in the other direction. If the government
revenue falls short of its expenditure, it is also known to borrow through financial markets. This
sector adds three key elements to the circular flow model, i.e., taxes, government purchases and
government borrowings. This is explained with the help of the following diagram:
In this model, the equilibrium condition is as follows:

Y=C+I+G
Where, Y = Income; C = Consumption; I = Investment and G = Government Expenditure In a
closed economy, aggregate demand is measured by adding consumption, investment and
government expenditure. Thus, aggregate demand is defined as the total demand for final goods
and services in an economy at a given time and price level and aggregate supply is defined as the
total supply of goods and services that the firms are willing to sell in an economy at a given price
level.

The Circular Flow of Income in a Four Sector Model

This is the complete model of the circular flow of income that incorporates all the four
macroeconomic sectors. Along with the above three sectors it considers the effect of foreign trade
on the circular flow. With the inclusion of this sector the economy now becomes an ‘open
economy’. Foreign trade includes two transactions, i.e., exports and imports. Goods and services
are exported from one country to the other countries and imports come to a country from different
countries in the goods market. There is inflow of income to the firms and government in the form
of payments for the exports and there is outflow of income when the firms and governments make
payments abroad for the imports. The import payments and export receipts transactions are done
in the financial market. This is explained with the help of the following diagram, called Model 3.

In this model, the equilibrium condition is as follows:

Y = C + I + G + NX
NX = Net Exports = Exports (X) – Imports (M)

Where, Y = Income;
C = Consumption;
I = Investment;
G = Government Expenditure;
X = Exports and
M = Imports.
Leakages and Injections in the Circular Flow of Income

The flow of income in the circular flow model does not always remain constant. The volume of
income flow decreases due to the leakages of income in the circular flow and similarly, it increases
with the injections of income into the circular flow.
Leakages
A leakage is referred to as an outflow of income from the circular flow model. Leakages are that
part of the income which the household withdraws from the circular flow and is not used to
purchase goods and services. This part of the income does not go to the goods market. There are
three main leakages and these are:
Saving
It is that part of the income that is not used by the household to purchase goods and services or
pay taxes. It is kept with financial institutions like banks that can be lend further by the banks to
the firms for investment or capital expansion purposes.
Taxes
Tax revenue is the income paid by the household and firms to the government. It flows to the
government rather than the goods market.
Imports
Import payments are made to the foreign sector for the good and services bought from them. This
is an outflow of income from the economy.
Thus, we see that leakages reduce the volume of income from the circular flow of income.

Leakages = S + T + M
Where, S = Saving; T = Taxes; and M = Imports
Injections
An injection is an inflow of income to the circular flow. The volume of income increases due to
an injection of income in the circular flow. There are three main injections and these are:
• Investment: It is the total expenditure by the firms on capital expansion. It flows to the goods
market.
• Government Expenditure: It is the total expenditure of the government on goods and services,
subsidies to the firms and transfer payments to the household sector. Transfer payments are
government payments like social security schemes, pensions, retirement benefits, and temporary
aid to needy families etc.
• Exports: Export receipts are the payment made by the foreign sector for the purchase of domestic
goods. It is an inflow of income from the foreign sector to the financial market.
Injections = I + G + X
Where, I = Investment; G = Government Expenditure; and X = Exports
Balance of leakages and Injections in an open economy is; S + T + M = I + G + X
Or, (S –I) = (G – T) + (X – M)
The leakages and injections can be shown with the help of the following diagram called, Model 4.

Summary
• The circular flow of income describes the movement of goods or services and income among the
different sectors of the economy. It illustrates the interdependence of the sectors and the markets
to facilitate both real and monetary flow.
• The real flow refers to the flow of factor services and flow of goods and services. The movement
to the money/cash payment from one sector to the other sector corresponding to the real flow is
referred to as the monetary flow.
• There are four sectors and three markets in the circular flow of income model. The four sectors
are the household sector, the firm sector, the government sector and the foreign sector. The three
markets are the goods market, the factor market and the financial market respectively.
• The circular flow of income can be analysed with the help of three different models, i.e., circular
flow income in a two sector model, in a three sector model and a four sector model.
• A two-sector model is the simplest model of the circular flow of income. It is assumed to be a
closed economy. There are only two sectors – the household sector and the firm sector. The flow
of income and expenditure is between these two sectors only.
• In a three-sector model, apart from the above two sectors there is another sector called the
government sector. The economy is still a closed economy meaning that there is no transaction
with the rest of the world.
• A four-sector model is the complete model of the circular flow of income. It considers the effect
of the foreign sector which includes transactions with the rest of the world. The economy is now
an open economy.
• The volume of income in the circular flow increases with the injections in the economy and
decreases with the leakages in the economy.
• Injections are inflows of income to the circular flow and leakages are outflows of income from
the circular flow.
• The Injections are mainly investment, government expenditure and exports and leakages are
mainly saving, taxes and imports.
****************

Unit-I- Chapter-IV: Trade Cycles
Table of Contents:
I. Meaning of Trade Cycle 1
II. Definitions of a Trade Cycle 2
III. Features of Trade Cycle ( Business Cycles) 2
1. Business Cycle occurs periodically 2
2. Business Cycle is all embracing 2
3. Business Cycle is wave-like 2
4. The process of Business Cycle is cumulative and self-reinforcing 3
5. The cycles will be similar but not identical 3
IV. Explanation of the Trade Cycle 3
V. The phases of a Trade Cycle 5
1.Boom 5
2. Recession 5
3. Depression 6
4. Revival or Recovery 7
VI. Consequence of a Trade Cycle 7
A trade cycle is basically a cyclical form of fluctuation in the economy. However, all the
fluctuations are not cyclical in nature. For example, seasonal fluctuations, random fluctuations,
secular trends do not produce a trade cycle. It is only the cyclical fluctuations in the economic
activities that will produce a trade cycle in an economy.
I. Meaning of Trade Cycle

The cyclical movements in an economy around its long term growth trend give rise to a
phenomenon which is termed as a trade cycle or a business cycle. Thus, a trade cycle, or a business
cycle, will be characterized by upward and downward swings alternatively in the economy in terms
of aggregate income, output, employment, productivity, prices, sales, profit margins and so on.
The fluctuations are commonly measured in terms of real national income.
The upward swing is also identified as a situation of inflation while a downward swing as a
recession. Such swings are always wave-like but of irregular nature. That is, contraction and
expansion of economic activities will emerge alternatively and will form peaks and troughs,
though at a varying pace.

Such swings in the economy are often compared with the movement of a pendulum. As we know,
a movement of a pendulum in one direction automatically generates a movement of equal
momentum in the opposite direction. In a similar fashion, in case of an economy, an upward swing
will produce after a stage a downward swing and vice versa, periodically.
However, the magnitude of such swings will vary as the time passes by. It may increase, decrease
or may have equal magnitude overtime.
II. Definitions of a Trade Cycle

1. According to Haberler, business cycles in general sense may be defined as an alternation
of periods of prosperity and depression of good and bad trade.
2. Estey defined trade cycles as cyclical fluctuations and are characterized by alternative
waves of expansion and contraction. They do not have a fixed rhythm, but they are cycles
in that the phases of contraction and expansion recur frequently and in fairly similar
patterns.
3. According to Keynes, a trade cycle is composed of periods of good trade characterized by
rising prices and low employment percentage, altering with periods of bad trade
characterized by falling prices and high unemployment percentage.
III. Features of Trade Cycle ( Business Cycles)

1. Business Cycle occurs periodically
This means prosperity and depression will be occurring alternatively. But there need not be
uniformity in the extent and magnitude. It may not be perfect rhythmically.
2. Business Cycle is all embracing

The business cycle implies that the prosperity or depressionary effect of the phase will be affecting
all industries in the entire economy and also the economics of other countries. It is international in
character. The Great Depression of 1929 is an example of this.
3. Business Cycle is wave-like

It will have a set pattern of movements which is analogous to waves. Rising prices, production,
employment and prosperity will become the features of upward movement. Falling prices and
employment will become the features of the downward movement.

4. The process of Business Cycle is cumulative and self-reinforcing

The upward and downward movements are cumulative in their process. When the upward
movement starts, it creates further movement in the same direction by feeding on itself. This
momentum will persist till the forces accumulate to alter the direction and create the downward
movement.When downward movement starts, it persists in the same direction leading to the worst
depression and stagnation till it is retrieved to gain an upward movement.
5. The cycles will be similar but not identical

Different cycles and waves in the business cycles will be similar in general features, but they are
not identical in all respects.
IV. Explanation of the Trade Cycle

A trade cycle, an outcome of cyclical movement of economic activities, passes through different
phases from conditions of slump to conditions of boom. Modern economist Schumpeter identified
four stages of a business cycle. They are — Expansion, Recession, Depression and Recovery. They
can, thus, be considered as four phases of a trade cycle. The Figure shows all the four phases of a
trade cycle.

i. To begin with, let us assume that the level of economic activity in a country is represented by
the point A. This is a situation of equilib-rium at under employment level, as defined by the
Keynes.
ii. Attributing to the initiatives taken by entrepreneurs, growth will take place from this level and
the economy will swing upward so as to reach at point B, which is a peak. The movement from
point A to point B can be defined as a situation of boom in the economy.
iii. At point B, the economy will face considerable inflationary pressure marked by over
employment of resources, excessive capacity utiliza-tion, rising cost and falling profits. In the
modern days, it may even invite government intervention in the form of anti-inflationary policies.
All these will slow down the economic activities and growth will taper off. The economy will
move from point B to point C in the process of contraction. This will have a cooling effect on the
economy.
iv. Still, the level of economic activities at point C will be higher as compared to the same on point
A. It implies that, despite contraction, level of income, production and employment will still be
higher than that of point A.
v. The deceleration of growth will however continue and the level of economic activities will fall
below the long term income level at point C. Thus, the economy will be pushed into a state of
recession which will bottom out at point D. The point D is also termed as a trough. One can see
that at this level, the volume of economic activities is lesser than the level as point A.
vi. This will be a cause of concern as the economy will be in deep trouble suffering from recession.
If no government intervention takes place, the recession will be a prolonged one. However, Keynes
has sug-gested that the government should intervene through expansionary policies which will
pave the way for revival of the economy and the economic activities will start rising again.
vii. As such, income, production and employment levels will improve. This process of revival will
continue up to point E which is a long term income level. One can see that the income at this level
will become more than the same at point C.
viii. This will mark the completion of one cyclical movement in the eco-nomic activities.
ix. The expansionary policies will however continue to push the economy upward and it will enter
into another phase of boom marking the beginning of a new trade cycle. This will lead the

economic activities towards point F, which is another peak representing a higher level of economic
activities as compared to point B.
x. In other words, long term growth will originate from the cyclic movement of the economic
activities in the economy.
V. The phases of a Trade Cycle

1.Boom
The Boom is a phase of the trade cycle which is marked by a feel good factor in the economy. The
economy will continue to witness an increase in economic activities which will be reflected
continu-ously rising real income, production, employment and prices. This will facilitate a fuller
utilization of resources and will take the economy to a highest possible level of prosperity which
can be termed as a peak. The stage will also register a high inflation rate, which will become a
matter of concern at some stage.
Features of Expansion:
a. A continuous increase in real income and output.
b. Fuller utilization of resources and full employment.
c. Factor productivity to peak out.
d. Product and factor prices will be on the rise. Thus, wages, interest rates and various kinds of
rents in the economy will increase as time passes by.
e. Profit margin will grow.
f. Consumption and investment expenditures in the economy will rise and more credit
creation will be attempted by the financial institutions.
g. At this stage, the process will be halted as the economy will peak out. At this, the economy
will witness a high inflationary pressure causing a concern among the policy makers and
operators of the economy.
This phase can also be termed as a phase of prosperity or growth or expansion.
2. Recession
This phase is marked by a deceleration in economic activities. The economy has peaked out and
inflation is on the rise, the profit margins will be increasingly under pressure, factor prices will be
rising more than their respective productivities and new investments will be less productive. To
counter strong inflation-ary tendencies, today’s governments may introduce anti-inflationary
policies. As a result of all these, a phase of slowing down of economic activities will begin.

Features of Recession:
a. Real income and output will fall.
b. Employment and factor productivity will decline resulting into a downward trend in wages and
other factor payments.
c. Borrowings and credit creation will show a sluggish perfor-mance.
d. Profit margins will be lowered.
e. Prices will start subsiding.
f. Aggregate expenditure, on consumption as well as on invest-ment, in the economy will fall. As
a result, output level will settle around the long term equilibrium level from the peak achieved
earlier under the phase of boom.
3. Depression
The process of contraction will, however, not stop at the long term equilibrium income level and
the economy will continue to decelerate. It will result into a further fall, rather sharper, in output,
income and employment. Factor payments and general prices will also decline sharply. The market
will witness a significant fall in demand and excess supply scenario will be witnessed everywhere.
Ultimately, the economy will reach to its bottom which can be termed as a trough.
Features of Depression:
a. Output, income and employment will continue to travel down-ward and will bottom out.
b. Mounting unemployment in the economy.
c. Factor prices and factor productivities will reach their respective lowest levels.
d. Demand of both consumer and capital goods will fall and producers’ profit margins will dip.
Excess supply situations will rule the market.
e. No investment, new or replacement will be taken up by the producers. No significant credit off
takes. Financial institu-tions will be flushed with surplus funds.
f. All round pessimism in the economy.
Such a situation was witnessed during the Great Depression of the thirties and classical Economics
failed to provide a solution to it. It was a failure of market mechanism. The market correction had
dragged the economies deeper into the recession rather than bringing them out of it. It is in this
background that Keynes advocated government intervention to facilitate a recovery from recession
through stepping up effective demand.

4. Revival or Recovery
When the government intervenes in the market by way of enhancing expenditure or reducing taxes,
the process of economic revival will start. It will lead effective demand to increase, production and
employment to rise and factor demand to grow. To summarise, there will be an all-round gradual
recovery from the falling tendencies. Consumers will start returning to the market for purchasing
goods as their income will start rising. Market prices and demand will also begin to pick-up.
Employment opportunities will also grow.
Features of Recovery
a. Output, income and employment to grow.
b. Unemployment to fall.
c. Product demand and, in turn, the factor demand to pick-up.
d. Prices of both products and factors to rise.
e. Investment will also grow.
VI. Consequence of a Trade Cycle

The trade cycle brings an economic instability making the economic environment uncertain and
less conducive to long term growth. Frequent occurrence of trade cycles makes long term planning
difficult. Producers, for example, may suffer from large inventories when recessionary forces
become dominant. Choice of plant size and technology may also become difficult as demand
fluctuates in a very wide range.
The phases of contraction and recession cause a lot of downfall and hardship to the people. They
become unemployed and their buying power falls. Thus, consumption and, in turn, standard of
living declines. Producers also suffer considerably as demand for their products declines along
with a fall in prices and, hence, their sales and profit margins too fall. Even the government loses
a considerable amount of revenue due to economic instability.
At the same time, the boom period witnesses excessive inflationary pressure and, hence,
households face hardship despite rising income. Many items become so expensive that people with
average income just can’t afford to buy them. Producers also suffer from over utilization of plant
and machinery which results in an increase in wear and tear cost, in addition to lowering the life
of equipment.
Considering the wide ranging adverse consequences of economic instability occurring from trade
cycle, socialist school of thought has advocated for an economic system which is free from cyclic
movement so as to avoid the environment of instability and uncertainty. They have therefore
argued for a planned economic developed process in place of a market driven one.
***************

MODULE II
Unit-II: Chapter-I
Theory of Effective Demand: Aggregate Demand and Aggregate Supply
Table of Contents:
The Principle of Effective Demand....................................................................................... 1
Factors Determining Effective Demand ............................................................................... 2
Aggregate Demand Function (ADF)................................................................................. 2
Aggregate Supply Function (ASF) ................................................................................... 3
Equilibrium Level of Employment ................................................................................... 4
The Concept of Under Employment Equilibrium .................................................................. 6
Limitations of the Keynesian Theory of Employment ............................................................ 8
The Principle of Effective Demand

According to John Maynard Keynes, the level of employment and output in an economy is
determined by the level of income and the level of income is determined by the level of effective
demand. Effective demand refers to the total expenditure made by the people in a country on
goods and services produced in each period. The expenditure stream determines the income stream
i.e. Aggregate Expenditure = Aggregate Income. The level of expenditure or Aggregate Demand
and the level of income are directly related to each other. Higher the level of expenditure, higher
will be the level of national income and vice-versa. Aggregate expenditure in an economy is the
sum of aggregate consumption and investment expenditure. Effective demand, therefore,
represents the aggregate demand for aggregate output produced at any equilibrium level of income.
Aggregate demand shows the monetary value of national output or real national income. The
national output consists of consumption and investment goods. Effective demand is, therefore,
determined by aggregate consumption and investment demand. In modern welfare-oriented
economies, government demand is also a major component of aggregate demand and hence it
becomes the third component of effective demand. The component of effective demand can
therefore be stated as follows:
Effective Demand = C + I + G
Where; C = Consumption expenditure of the households.
I = Investment expenditure by private firms.
G = Government expenditure on consumption and investment goods.

Factors Determining Effective Demand

According to Keynes, effective demand is determined by the interaction of aggregate demand and
supply functions.
Aggregate Demand Function (ADF)

The ADF is a schedule of maximum sales revenue expected to be received by the class of
entrepreneurs from the sale of output produced at various levels of employment. It is also known
as the demand price. There is a direct relationship between the aggregate demand price and the
level of income or employment. Higher the level of real income or employment, higher will be
the aggregate demand price and vice-versa. The aggregate demand function is shown in the form
of a schedule in Table below with the help of a hypothetical data.
The aggregate demand schedule relates real income measured in terms of employment with the
flow of expenditure in the economy. The data in Table can be graphically plotted to obtain the
aggregate demand curve as shown in Figure below. Figure below shows the aggregate demand
curve. It is a positive sloping curve showing a direct relationship between the level of employment
or real income and the aggregate demand price.
Symbolically,
ADP = f (N)
Where: ADP= Aggregate demand price
N= Level of employment
f= functional relationship

Aggregate Supply Function (ASF)

The aggregate supply function schedule shows the minimum expected sales revenue of the class
of entrepreneurs from output produced at various levels of employment. The aggregate supply
price is the minimum supply price or reserve price which the entrepreneurs must receive from the
output produced. It is the cost of production that the entrepreneurs must obtain from the sale of
output to continue to remain in business. According to Keynes, the supply price of national output
can be measured in terms of labor cost. Accordingly, a hypothetical aggregate supply function
schedule is tabulated in Table below.

The data tabulated in the table above assumes that money wages paid to a worker is Rs.200, 000
per annum. The schedule therefore shows the minimum expected revenue from the sale of output
produced at different levels of employment. Thus, to employ one million workers, the
entrepreneurs must receive Rs.200 Billion i.e., Rs.200, 000 X 1000,000 workers. The aggregate
supply price is directly related to the level of employment. Higher the level of employment, higher
will be the aggregate supply price and vice-versa.
The data given in the table is graphically plotted in the Figure to obtain the aggregate supply
curve.
In the Figure above, the X-axis shows the level of employment and Y-axis shows the aggregate
supply price. The aggregate supply price curve (ASP) is positively sloping towards the right
indicating a direct relationship between the level of employment and the supply price. The ASP
curve becomes perfectly inelastic or vertical at the full employment level. In our example, the full
employment level is achieved when five million workers are employed. The ASP curve becomes
vertical at point ‘F’ as shown in Figure.
Equilibrium Level of Employment

The equilibrium level of employment and real national income is determined at the point of
equality between the aggregate demand price and the supply price. Employment and real output
continues to rise if demand price is greater than the supply price and stops at the point of equality.
You will notice from Table below that when four million workers are employed the AD price and
the AS price are equal i.e., Rs.800 Billion. This point of equality is the point of Effective demand.
If employment is increased beyond the point of effective demand, the aggregate demand price will
fall below the supply price and the class of entrepreneurs will make losses.

The equilibrium level of employment and real national income or the point of effective demand
can be diagrammatically shown as in Figure below.
In Figure above, the two curves ADP and ASP intersect each other at point ‘E’. Point ‘E’ is the
point of effective demand. Corresponding to point ‘E’, point ‘R’ on the Y-axis indicates
equilibrium receipts and point ‘N’ on the X-axis indicates equilibrium level of employment and
real national income. However, point ‘E’ is only under employment or less than full employment
equilibrium as full employment level is indicated by point ‘F’ on the aggregate supply curve.
Per Keynes, the economy achieves equilibrium at less than full employment level because the gap
between income and consumption is not fully filled up by investment. Both investment and
savings are made by two different classes. While savings are made by the household sector,
investments are made by the class of entrepreneurs. Hence, investment cannot be equal to saving.
If aggregate investment is less than aggregate savings, the economy will operate at less than full
employment level.

Increase in the level of Effective Demand and Employment

As per Keynes, the aggregate supply function is constant in the short run because the productive
capacity of the economy cannot be increased in the short period. However, the level of effective
demand and employment can be increased by increasing the aggregate demand function. This is
shown in Figure below.
In Figure above, the aggregate demand price curve ADP1 intersects the aggregate supply price
curve ASP at point E1 and ON1 level of employment is determined. When the aggregate demand
is increased the ADP, curve shifts upwards and intersects the ASP curve at point E2 and a higher
level of employment i.e. E2 is determined. It may be concluded that the level of employment in
an economy can be increased if aggregate demand is increased. Aggregate demand can be
increased if either investment demand or consumption demand increases.
The Concept of Under Employment Equilibrium

The equilibrium level of employment is determined by the point of equality between the
aggregate demand price and the supply price. Employment continues to rise if demand price
is greater than the supply price and stops at the point of equality. With reference to the table
below, when four million workers are employed, the AD price and the AS price are equal i.e.,
Rs.800 billion. This point of equality is the point of Effective demand. If employment is
increased beyond the point of effective demand, the aggregate demand price will fall below
the supply price and the class of entrepreneurs will make losses.

The equilibrium level of employment or the point of effective demand can be diagrammatically
shown as in Figure below.
In Figure above, the two curves ADP and ASP intersect each other at point ‘E’. Point ‘E’ is
the point of effective demand. Corresponding to point ‘E’, point ‘R’ on the Y-axis indicates
equilibrium receipts and point ‘N’ on the X-axis indicates equilibrium level of employment.
However, point ‘E’ is only under employment or less than full employment equilibrium as full
employment level is indicated by point ‘F’ on the aggregate supply curve. Per Keynes, the
economy achieves equilibrium at less than full employment level because the gap between

income and consumption is not fully filled up by investment. The reasons for the gap in savings
and investment are as follows:
1. The people who save and the people who invest are not the same. The households save and
the entrepreneurs invest.
2. The factors which determine saving are different from the factors which determine
investment. For instance, people save to provide for education, marriage and contingencies
such as disease, unemployment and death. People may also save to acquire durable goods such
as houses, gold and to provide for old age. The level of investment depends upon marginal
efficiency of capital and the rate of interest in the short run and in the long run, it depends upon
population and technological progress.
In view of the reasons mentioned above, we may conclude that investment cannot be equal to
savings at full employment level. If the profit expectations of the entrepreneurs fall, the level
of investment will fall and hence the equilibrium level of national income and employment
will also fall.
Limitations of the Keynesian Theory of Employment

The Keynesian theory of employment and real national income is criticized on the following
grounds:
1. Relevant to Free Market Economy
The Keynesian theory is applicable only in free market capitalist economies which operate
based on market mechanisms. It is not relevant to other economic systems such as socialism
where all economic decisions are taken by the government. It is also not relevant to a mixed
economy where the role of the government is substantially large.
2. Keynesian Theory is Relevant to Depression
Keynes wrote his General Theory in 1936. Both Europe and America were caught in the great
economic depression during the first half of the 20th century. Keynes prescribed increased
Government expenditure to increase the level of effective demand under conditions of
recession. However, the theory cannot be applied under the conditions of jobless growth when
the economy grows along with fall in employment and stagflation when prices rise but
employment and output falls.
3. Keynesian Theory is not relevant to open Economies
Keynes did not consider the impact of international trade and investment on national
economies. Keynes assumed a closed economy while writing his theory.

4. Keynesian Theory is not Relevant to UDCs

Keynes had dealt with the problem of the down-turn in business cycles and the resultant rise
in unemployment. However, under developed countries face the problem of regular and
disguised unemployment.
5. Keynesian Theory Ignores the Long Run Problems
Keynes sought a solution to the short run macroeconomic problems and went on to say that
in the long run we are all dead. He thus ignored the long run problems of changes in the
economic conditions.
**************

Consumption Function
Table of Contents
Introduction 1
Meaning of Consumption Function 1
Properties or Technical Attributes of the Consumption Function 3
(I) The Average Propensity to Consume 3
(II) The Marginal Propensity to Consume 3
Significance of MPC 4
Keynes' Psychological law of consumption 5
Assumptions 5
Propositions of the Law 6
Implications of Keynes’s Law (Importance of the Consumption Function) 8
Introduction
One of the important tools of Keynesian Economics is the consumption function. This chapter
deals with the consumption function, its technical attributes, its importance and its subjective and
objective determinants along with Keynes's Psychological Law of consumption.
Meaning of Consumption Function

The consumption function or propensity to consume refers to . income consumption relationship.
It is a "functional relationship between two aggregates, i.e., total consumption and gross national
income.” Symbolically, the relationship is represented as C = f(Y), where C is consumption, Y is
income, and f is the functional relationship. Thus, the consumption function indicates a functional
relationship between C and Y, where C is dependent and Y is the independent variable, i.e., C is
determined by Y. This relationship is based on the ceteris paribus (other things being equal)
assumption, as such only income consumption relationship is considered and all possible
influences on consumption are held constant.

In fact, propensity to consume or consumption function is a schedule of the various amounts of

consumption expenditure corresponding to different levels of income. A hypothetical consumption
schedule is given in Table I.
Table I shows that consumption is an increasing function of income because consumption
expenditure increases with increase in income. Here it is shown that when income is zero during
the depression, people spend out of their past savings on consumption because they must eat in
order to live. When income is generated in the economy to the extent of Rs. 60 crores, it is not
sufficient to meet the consumption expenditure of the community so that the consumption
expenditure of Rs.70 crores is still above the income amounting to Rs 60 crores. (Rs. 10 crores
are dis-saved). When both consumption expenditure and income equal Rs 120 crores, it is the
basic consumption level.
After this, income is shown to increase by 60 crores and consumption by 50 crores. This implies
a stable consumption function during the short-run as assumed by Keynes. The above Figure
illustrates the consumption function diagrammatically. In the diagram, income is measured
horizontally and consumption is measured vertically. 45° is the unity-line where at all levels
income and consumption are equal. The C curve is a linear consumption function based on the
assumption that consumption changes by the same amount (Rs 50 crores). Its upward slope to the

right indicates that consumption is an increasing function of income. B is the break-even point
where C= Y or OY1 = OC1. When income rises to 0Y1 consumption also increases to OC2, but the
increase in consumption is less than the increase in income, C1 C2 < Y1 Y2. The portion of income
not consumed is saved as shown by the vertical distance between the 45° line and C curve, i.e.,
SS’. Thus, the consumption function measures not only the amount spent on consumption but also
the amount saved. This is because the propensity to save is merely the propensity not to consume.
The 45° line may therefore be regarded . as a zero-saving line, and the shape and position of the C
curve indicate the division of income between consumption and saving.
Properties or Technical Attributes of the Consumption Function

The consumption function has two technical attributes or properties:
(I) the average propensity to consume
(II)the marginal propensity to consume.
(I) The Average Propensity to Consume

The average propensity to consume may be defined as the ratio of consumption expenditure to any
particular level of income. It is found by dividing consumption expenditure by income, or
APC=C/Y. It is expressed as the percentage or proportion of income consumed. The APC at
various Income levels is shown in column 3 of Table II. The APC declines as the income increases
because the proportion of income spent on consumption decreases. But reverse is the case with
APS (average propensity to save) which increases with increase in income (see column 4). Thus,
the APC also tells us about the APS, APS=1− APC.
(II) The Marginal Propensity to Consume

The marginal propensity to consume may be defined as the ratio of the change in consumption to
the change in income or as the rate of change in the average propensity to consume as income
changes. It can be found by dividing change in consumption by a change in income, or MPC=
∆C/∆Y. The MPC is constant at all levels of income as shown in column 5 of Table II. It is 0.83
or 83 per cent because the ratio of exchange in consumption to change in income is ∆C /∆Y=50/60.
The marginal propensity to save can be derived from the MPC by the formula 1 − MPC. It is
0.17 in our example (see column 6).

Table II: Consumption Function (Rs. Crores)
(1) (2) (3) (4) (5) (6)
Income Consumption APC=C/Y APS=S/Y(1- MPC=∆C MPS=

(Y) (C) APC) /∆Y ∆S/∆Y (1-
MPC)
120 120 120/120=1 0 - -
180 170 170/180= 0.94 0.06 (170- 0.17

120)/(180-
120)=50/60=
0.83
240 220 0.916 0.084 0.83 0.17
300 270 0.9 0.1 0.83 0.17
360 320 0.88 0.12 0.83 0.17
Significance of MPC
The MPC is the rate of change in the APC. When income increases, the MPC falls but more than
the APC. Contrariwise, when income falls, the MPC rises and the APC also rises but at a slower
rate than the former. Such changes are only possible during cyclical fluctuations whereas in the
short-run there is change in the MPC and MPC<APC. Keynes is concerned primarily with the
MPC, for his analysis pertains to the short-run while the APC is useful in the long-run analysis.
The post Keynesian economists have come to the conclusion that, over the long-run APC and
MPC are equal and approximate 0.9.
In the Keynesian analysis the MPC is given more prominence. Its value is assumed to be positive
and less than unity which means that when income increases the whole of it is not spent on
consumption. On the contrary, when income: falls, consumption expenditure does not decline in
the same proportion and never becomes zero. The Keynesian hypothesis that the marginal
propensity to consume is positive but less than unity 0<∆C / ∆Y <1 ) is of great analytical and
practical significance. Besides telling us that the consumption is an increasing function of income
and it increases by less than the increment of income, this hypothesis helps in explaining:
a. the theoretical possibility of general overproduction or under employment equilibrium.

b. the relative stability of a highly developed industrial economy- it is implied that the gap
between income and consumption at all high levels of income is too wide to be easily filled
by investment with the possible. consequence that the economy may fluctuate around an
underemployment equilibrium. Thus, the economic significance of the MPC lies in filling the
gap between income and consumption through planned investment to maintain the desired
level of income. Further, its importance lies in the multiplier theory. The higher the MPC, the
higher the multiplier and vice versa. The MPC is low in the case of the rich people and high
in the case of the poor. This accounts for high MPC in underdeveloped countries and low in
advanced countries.
Keynes' Psychological law of consumption
Keynes propounded the fundamental psychology of consumption which forms the basis of
the consumption function. He wrote, "The fundamental psychological law upon which we are
entitled to depend with great confidence both a prior from our knowledge of human nature
and from the detailed facts of experience, is that men are disposed as a rule and on "the
average to increase their consumption as their income increases but not by as much as the
increase in their income." The law implies that there is a tendency on the part of the people
to spend on consumption less than the full increment of income.
Assumptions
Keynes’ law is based on the following assumptions:
1. It assumes a constant psychological and institutional complex
This law assumes that the psychological and institutional complexes influencing consumption
expenditure remain constant. Such complexes are income distribution, tastes, habits, social
customs, price move-ments, population growth, etc. In the short run, they do not change and
consumption depends on income alone. The constancy of these complexes is the fundamental
cause of the stable consumption function.
2. It assumes the existence of normal conditions

The law holds good under normal condi-tions. If, however, the economy is faced with
abnormal and extraordinary circumstances like war, revolution or hyperinflation, the law will
not operate. People may spend the whole of increased income on consumption.
3. It assumes the existence of a Laissez-faire capitalist economy

The law operates in a rich capitalist economy where there is no government intervention.
People should be free to spend increased income. In the case of regulation of private enterprise
and consumption expenditures by the state, the law breaks down. Thus, the law is inoperative
in socialist or state controlled and regulated economies.
Professor Kurihara opines that “Keynes’s law based on these assumptions may be regarded as
a rough approximation to the actual macro-behaviour of free consumers in the normal short
period”.
Propositions of the Law

This law has three related propositions:
1) When income increases, consumption expenditure also increases but by a smaller amount.
The reason is that as income increases, our wants are satisfied side by side, so that the need to
spend more on consumer goods diminishes. It does not mean that the consumption
expenditure falls with the increase in income. In fact, the consumption expenditure increases
with increase in income but less than proportionately.
2) The increased income will be divided in some proportion between consumption
expenditure and saving. This follows from the above proportion because when the whole of
increased income is not spent on consumption, the remaining is saved. In this way,
consumption and saving move together.
3) Increase in income always leads to an increase in both consumption and saving. This means
that increased income is unlikely to lead either to fall in consumption or saving than before.
This is based on the above propositions because as income increases consumption also
increases but by a smaller amount than before which leads to an increase in saving. Thus, with
increased income both consumption and saving increase.
The three propositions of the law can be explained with the help of the following table.
Income (Y) Consumption (C) Savings ( S= Y-C)
0 20 -20
60 70 -10
120 120 0
180 170 10
240 220 20

300 270 30
360 320 40
Proposition (1): Income increases by Rs.60 crores and the increase in consumption is by Rs
50 crores. The consumption expenditure is, however, increasing with increase in income, i.e.
Rs.170, 220, 270 and 320 crores against Rs.180, 240, 300 and 360 crores respectively.
Proposition 2) : The increased income of Rs.60 crores in each case is divided in some
proportion between consumption and saving (i.e. Rs.50 crores and Rs.10 crores).
Proposition (3): As income increases from Rs.120 to 180, 240, 300 and 360 consumption
also increases from Rs.120. to 170, 220, 270, 320 crores, along with an increase in saving
from Rs 0 to 10, 20, 30 and 40 crores respectively. With increase in income neither
consumption nor saving have fallen.
Diagrammatically, the three propositions are explained in the figure below. Here, income is
measured horizontally and consumption and saving are measured on the vertical axis. С is the
consumption function curve and the 45° line represents income.
Proposition (1): When income increases from OY0 to OY1 consumption also increases from
ВY0 to С1 Y1 but the increase in consumption is less than the increase in income.
Proposition (2): When income increases to ОY1 and OY2, it is divided in some proportion
between consumption C1Y1 and C2Y2 and saving A1C1 and A2C2 respectively.

Proposition (3):Increases in income to OY1 and OY2 lead to increased consumption C2Y2>
C1Y1 and increased saving А2С2>А1С1 than before. It is clear from the widening area below
the С curve and the saving gap between the 45° line and С curve.
Implications of Keynes’s Law (Importance of the Consumption Function)

Keynes’s psychological law has important implications which in fact point towards the
impor-tance of the consumption function because the latter is based on the former.
The following are its implications:
1. Invalidates Say’s Law
Say’s Law states that supply creates its own demand. Therefore, there cannot be general
overproduction or general unemployment. Keynes’s psychological law invalidates Say’s Law
because as income increases, consumption also increases but by a smaller amount.
In other words, all that is produced (income) is not taken off the market (spent), as income
increases. Thus, supply fails to create its own demand. Rather it exceeds demand and leads to
general overproduction and glut of commodities in the market. As a result, producers stop
production and there is mass unemployment.
2. Need for state intervention
As a corollary to the above, the psychological law highlights the need for state intervention.
Say’s Law is based on the existence of laissez-faire policy and its refutation implies that the
economic system is not self-adjusting. So, when consumption does not increase by the full
increment of income and consequently there is general overproduction and mass
unemployment, the necessity of state intervention arises in the economy to avert general
overproduction and unemployment through public policy.
3. Crucial importance of investment
Keynes’s psychological law stresses the vital point that people fail to spend on consumption
the full increment of income. This tendency creates a gap between income and consumption
which can only be filled by either increased investment or consumption. If either of them fails
to rise, output and employment will inevitably fall.
Since the consumption function is stable in the short-run, the gap between income and
consumption can only be filled by an increase in investment. Thus, the psychological law
emphasizes the crucial role of investment in Keynes’s theory. It is the inadequacy of

investment which results in unemployment and logically, the remedy to over-come

unemployment is increase in investment.
4. Existence of underemployment equilibrium

Keynes’s notion of underemployment equilib-rium is also based on the psychological law of
consumption. The point of effective demand which determines the equilibrium level of
employment is not of full employment but of underemployment because consumers do not
spend the full increment of their income on consumption and there remains a deficiency in
aggregate demand. The full employment equilibrium level can, however, be reached if the
state increases investment to match the gap between income and consumption.
5. Declining tendency of the Marginal Efficiency of Capital

The psychological law also points towards the tendency of declining marginal efficiency of
capital in a laissez-faire economy. When income increases and consumption does not increase
to the same extent, there is a fall in demand for consumer goods.
This results in a glut of commodities in the market. The producers will reduce production
which will, in turn, bring a decline in the demand for capital goods and hence in the expected
rate of profit and business expectations. It implies a decline in the marginal efficiency of
capital.
It is not possible to arrest this process of declining tendency of marginal efficiency of capital
unless the propensity to consume rises. But such a possibility can exist only in the long run
when the psychological law of consumption does not hold good.
6. Danger of permanent over-saving or under-investment gap

Keynes’s psychological law points out that there is always a danger of an over-saving or
under-investment gap appearing in the capitalist economy because as people become rich the
gap between income and consumption widens.
This long-run tendency of increase in saving and fall in investment is characterized as secular
stagnation. When people are rich, their propensity to consume is low and they save more. This
implies low demand which leads to decline in investment. Thus, the tendency is for secular
stagnation in the economy.

7. Unique nature of income propagation

The fact that the entire increased income is not spent on consumption explains the multiplier
theory. The multiplier theory or the process of income propagation tells that when an initial
injection of investment is made in the economy, it leads to smaller successive increments of
income.
This is due to the fact that people do not spend their full increment of income on consumption.
In fact, the value of multiplier is derived from the marginal propensity to consume, i.e.,
Multiplier = 1/(1-МРС). The higher the MPC, the higher the value of the multiplier, and vice
versa.
8. Explanation of the turning points of the Business Cycles

This law explains the points of a business cycle. Before the economy reaches the full
employment level, the downturn starts because people fail to spend the full increment of their
income on consumption. This leads to fall in demand, overproduction, unemployment and
decline in the marginal efficiency of capital.
****************

Investment function and Marginal Efficiency of capital
Table of Contents:
I. Introduction .................................................................................................................. 1
II. Investment: Meaning .................................................................................................... 1
III. Gross Investment vs Net Investment ............................................................................. 2
IV. Induced Investment vs Autonomous Investment .......................................................... 2
V. Factors affecting the Investment function..................................................................... 4
VI. Marginal Efficiency of Capital...................................................................................... 4
VII. Factors affecting Marginal Efficiency of Capital (MEC) ............................................... 6
VIII. MEC Schedule and MEC Curve .................................................................................. 7
IX. Criticism of the Marginal Efficiency of Capital............................................................. 9
I. Introduction
This unit is concerned with familiarizing you with some basic concepts of investment. Thus,
through this unit, you will be able to derive the meaning of investment and distinguish between
autonomous and induced investment. Autonomous investment is independent of the change in
income. That is why it is known as autonomous investment. Induced investment depends upon
change in the level of income. When there is change in income, there is a change in induced
investment. Most of the private investment is of induced type. Marginal efficiency of capital
(MEC) describes the rate of discount which would make the present value of expected income
from fixed capital assets equal to the present supply price of the asset. Apart from this, the concept
of marginal efficiency of investment (MEI) has been discussed and the distinctions between MEC
and MEI have been made. The relation between MEC, rate of interest and volume of investment
has been explained at the last section of the unit.
II. Investment: Meaning

In Economics, investment typically refers to real investment which adds to the existing stock of
capital in the economy. Such investment leads to increase in the levels of income and production
by increasing the production and purchase of capital goods. Thus, in Economics, investment
includes new plant and equipment, construction of public works like dams, roads, buildings etc.
In the words of Joan Robinson, “By investment is meant as an addition to capital, such as occurs
when a new house is built or a new factory is built. Investment means making an addition to the
stock of goods in existence.” The term capital here refers to the real assets like factories, plants,

equipment, and other inventories of finished and semi-finished goods. Capital also means any
previously produced input that can be used in the process to produce other goods. The amount of
capital available in the economy is nothing but the aggregate stock of capital in that economy.
Thus, capital is a stock concept. From the above discussion it follows that investment is the
production or acquisition of real capital assets during any period of time.
Say, for example, the capital assets of a company as on 31st March, 2011 is Rs.10,000 crores and
it invests an amount of Rs.500 crores in the financial year of 2011-12. Thus, at the end of the
financial year 2011-12 (i.e., on 31st March, 2012), the aggregate (i.e., gross) capital stock of the
company will stand at Rs.10,500 crores. Symbolically, let I be the investment and K be the
capital in year t (here, t is the current year, i.e., 2011-12), then It = Kt - Kt-1. Please note that t-
1 denotes the previous year (i.e., 2010-11 ending on March, 31, 2011).
III. Gross Investment vs Net Investment

The inter-relationship between capital and investment is shown by net investment. In the above
example, an investment of Rs.500 crore during the year 2011-12, refers to gross investment. Thus,
gross investment is the total amount of investment made on new capital assets in a particular year.
It should be noted that some capital stock wears out every year and is used up as depreciation and
obsolescence. To derive the net investment in a particular year, the amount of expenditure made
as depreciation and obsolescence is deducted from the gross investment made in that particular
year. When gross investment equals the cost of depreciation and obsolescence, net investment
becomes zero, and there is no addition to the existing stock of capital in the economy. When gross
investment is less than depreciation and obsolescence, there is disinvestment in the economy and
the capital stock decreases. In this sense, for an increase in the real capital stock in the economy,
gross investment must exceed the cost of depreciation and obsolescence. This also implies that
there is some net investment in the economy.
IV. Induced Investment vs Autonomous Investment

Investment may be categorized as induced or autonomous. Autonomous investment is independent
of the level of income, output, and profit and sales of a business firm. Prof Alvin Hanson and
some other economists are of the opinion that this type of investment is associated generally with
the factors like the development of new resources, growth of population and labor force and
technological innovations or inventions like the introduction of new products into the market.
The investment expenditure which is related in some way with the current income, output and
sales is termed as induced investment. If there is a change in income and output, it will result in

change in induced investment. Since the incentive for such an investment is the direct consequence
of the change in current income, output or demand.
The autonomous investment is generally undertaken by the public authorities like Union, State or
local governments. On the other hand, most of the induced investment is undertaken by private
authorities. This is because people are driven by profit motives. Autonomous investment is
generally not induced by profit, but induced investment is induced by profit.
From the above discussion, it seems like that there is no relation between induced and autonomous
investment. They are totally different concepts. But autonomous investment and induced
investment are related. It can be explained with the help of an example. Suppose there is an
increase in autonomous investment of 20 crores undertaken by the government. Assuming the
multiplier coefficient is 2, it will automatically lead to an increase in income of 40 crores. This
increase in income or output of 40 crores encourages the private investors to undertake induced
investment. It implies that autonomous investment has its effect upon induced investment. The
distinction between autonomous and induced investment has been shown with the help of
following Figure In the figure, a1 and a2 represent autonomous investment while I1 and I2
represent induced investment.

V. Factors affecting the Investment function

Induced investment (or, private investment) is basically driven by the profit motive. As private
entrepreneurs are driven by the profit motive, their inducement to invest in capital goods is driven
by two basic objectives, either to replace the depreciated machineries or to expand the existing
plant capacity. Private investment depends upon marginal efficiency of capital and the rate of
interest.
The marginal efficiency of capital (MEC), in turn, depends upon future expectations which may
be very fluctuating. As such, private investment becomes very much undependable. The marginal
efficiency of capital along with the rate of interest determines the amount of new investment. In
the Keynesian equation Y = C + I, given the propensity to consume, consumption being stable in
the short-run, the volume of investment determines the volume of employment. Investment, thus,
is an essential requirement for attaining full employment in a capitalist economy. In fact, not only
net investment, but also an increasing rate of net investment is necessary to maintain full
employment for a longer period of time.
VI. Marginal Efficiency of Capital

Keynes defined marginal efficiency of capital as the highest rate of return over cost expected from
an additional unit of a capital asset during its lifetime. Thus, marginal efficiency of a particular
type of capital asset is the highest rate of return over cost expected from an additional or marginal
unit of that type of asset. In general, however it may be regarded as the highest rate of return over
cost expected from producing an additional unit of the most profitable of all categories of the
capital assets. Thus, the prospective yield (y)is the aggregate net return from an asset during its
life-time, while supply price (Sp) is the cost of producing that asset. We can express MEC
mathematically as:
where i= marginal efficiency of capital, R= perspective yields of capital asset per unit of time and
Sp = supply price of the asset.

For example, if the annual yield of a capital asset isRs.22,000 and the supply price of the capital
asset is Rs.20,000,and the asset lasts for 1 year then
An increase in the supply price (Sp) of the capital assets given the expected annual yield will reduce
the marginal efficiency of capital (i). Similarly, a decrease in the supply price of the capital asset
given the annual expected yield will raise the marginal efficiency of capital. Thus, i is directly
related to the rise in R and inversely to the supply price of the capital assets (Sp). In a more
generalized sense, Keynes has defined marginal efficiency of capital as “the rate of discount which
would make the present value of the series of annuities given by the returns expected from the
capital asset during its life just equal the supply price”.
Symbolically, it can be expressed as:
where, Sp is the supply price or the cost of the capital asset, R1, R2……….and Rn are the
prospective yields or the series of annuities given by the returns expected from the capital asset in
the years 1,2…..up to n and i is marginal efficiency of capital.
The marginal efficiency of capital of a particular type of capital asset is the highest rate of return
over cost expected from an additional, or marginal unit of that type of capital asset.

VII. Factors affecting Marginal Efficiency of Capital (MEC)

The various factors that bring about shifts in MEC are short run or endogenous factors and long
rim or exogenous factors.
The short run factors are:
1. Expected demand
If the demand for the product is expected to be high in future, the MEC will be high and the
investment will increase. On the other hand if the demand for the product is expected to decline in
future the MEC will be low and investment will fall.
2. Costs and prices
If the costs are expected to decline and if the prices are expected to increase, the expectation of the
producer will go up. On the other hand if the costs are expected to go up and prices are to decline
the MEC will receive a set back and the investment will be less.
3. Propensity to consume
If the propensity to consume is more than the volume of investment will be more and vice versa.
4. Changes in income
An increase in the level of income will stimulate investment while a decrease in the level of income
will discourage investment.
5. Current state of expectation
Businessmen while making expectations take into account the current state of affairs regarding
costs, prices, returns etc. If they are high the MEC is bound to be high for new projects of
investment.
6. Level of confidence
During periods of optimism the businessmen over estimate and boost the MEC of capital assets.
During periods of pessimism they underestimate and reduce the MEC of capital assets.
The long run factors which influence the MEC

1. Population growth
A rapidly growing population means a rapid increase in the demand for all types of goods and
hence investment rises and conversely, a decline in population will decrease the demand
investment.

2. Development of new areas

When a new area is developed heavy investments in all fields such as agriculture, industries,
electricity, housing etc., are to be undertaken.
3. Technological factors
New invention or new discovery may necessitate the installation of new machineries in the
industrial enterprise and encourage investment.
4. Productive capacity of the Industry
If the existing capacity is fully utilised then any further increase in demand will be met with by
making fresh investment on new capital equipment.
5. Level of current investment
If the existing level of investment is already high there will be little scope for further investment
and vice versa.
VIII. MEC Schedule and MEC Curve

Volume of Investment ( in crores) Marginal Efficiency of Capital
( Percent per annum)
10 10
20 9
30 8
40 7
50 6
60 5
The MEC schedule can be prepared by listing the various values of the marginal efficiency of
capital that are associated with different volumes of investment. Such a schedule is illustrated in
the table above.
The table indicates that, under the given circumstances and conditions, if the volume of investment
is Rs. 10 crores, the marginal efficiency of capital will be 10 per cent a year. When the volume of
investment increases, the marginal efficiency of capital declines. Thus, if the investment is Rs. 60
crores, the marginal efficiency of capital is only 5 per cent as against the initial 10 per cent.

Under the given conditions, the marginal efficiency of capital goes on decreasing as the volume of
investment increases. The reasons for this declining tendency of the MEC are said to lie in the
effects of the increase in the volume of investment. First, as the volume of investment increases,
the expected annual returns or the prospective yields of the capital assets decrease.
This is because as more and more capital assets are produced, they will have to be used with the
given amount of other factors of production which may be inelastic in their supply, and hence their
expected net marginal productivity tends to fall.
Even if we assume the factors of production to be relatively elastic in supply, along with the capital,
then, too the expected marginal productivity (i.e., the money value of marginal product which is
obtained by multiplying the marginal physical product with the price) of the capital asset will
diminish, when the marginal unit of a particular commodity cannot be sold without reducing its
price.
Thus, with a given supply price, when the prospective yield of a capital asset decreases, the
marginal efficiency of capital will obviously diminish, as it is the difference between the
prospective yield and the supply price.
Second, it is also possible that as the volume of investment increases, the supply price of capital
may rise. When more and more capital goods are produced, the capital goods industries may face
the law of diminishing returns so that the marginal cost of producing these assets may start rising.
Moreover, with an increase in investment in capital goods, the demand for factors of production
in the capital goods industries and, in view of scarcity of such factors, their prices may rise; this
will also add to the cost of production.
Thus, the supply price of the replacement cost of the capital assets will rise as the volume of
investment increases. Hence, with given prospective yields, when the supply price increases, the
MEC is bound to diminish. It follows that if prospective yields start rising as the volume of
investment increases, the MEC will diminish at a faster rate.

MEC CURVE
IX. Criticism of the Marginal Efficiency of Capital

Keynes used the term marginal efficiency of capital in a vague manner. Secondly, Keynes failed
to recognize that interest rates are also governed by expectations like the marginal efficiency of
capital. He considered marginal efficiency of capital in the field of dynamic economics and rate of
interest in the field of static economics.
The rate of discount or yield i.e., r is conventionally called the Marginal Efficiency of Investment
(MEI). Keynes originally called it the ‘Marginal Efficiency of Capital’. Brooman says that it is
preferable to use a term which refers explicitly to investment (i.e., MEI). The MEI (or MEC) ought
to be distinguished from the ‘Marginal product of capital’ which refers to the increase in current
output resulting from the addition of one more unit of capital.
It is clear that the marginal product of capital is a physical quantity similar to the marginal product
of any other factor. The MEI is a percentage rate, and not the physical quantity. Again the marginal
product of capital does not involve expectations about the yield from the unit of capital during the
remainder of its life. But the MEI is very much concerned with such expectations about the yield.
Strictly speaking, however, there is a difference between the MEC and the MEI. The MEC is
derived as the relationship between i (rate of interest) and the optimum level of capital stock. The
MEI is derived as the relationship between i (rate of interest) and the optimum change in capital
stock. It can be said by way of corollary that the MEC and the MEI are interrelated.
The MEI really indicates the decision to invest whereby there is change in the capital stock. This
relationship between investment as the change in capital stock and the actual capital stock presents

a difficulty in determining the MEI. If investment is changed in capital stock, it can be assumed
that the capital stock is fixed once investment is underway.
Keynes recognized this difficulty and sought to overcome it by stating that he was interested in
short period changes in investment. In the short period change in investment would be insignificant
relative to the entire capital stock; therefore, the impact of investment on capital stock could be
ignored.
***************

Investment Multiplier
Table of Contents:
Introduction 2
Assumptions of the Theory of the Multiplier 3
1. Advanced Economy 3
2. The Marginal Propensity to Consume is Constant 3
3. Stable Fiscal and Monetary Policies 3
4. Closed Economy 4
5. Static Economy 4
6. Absence of Time Lag 4
7. Excess Capacity in Consumer Goods Industry 4
Working of the Investment Multiplier 4
Leakages in the Multiplier Process 7
1. Increase in the MPC 7
2. Hoarding of Cash Balances 8
3. Purchase of Secondary Shares and Securities 8
4. Repayment of Debt 8
5. Net Positive Imports 8
6. Inflation 8
Criticism on Theory of multiplier 8
1. The Impact of Investment on National Income is not Instantaneous 8
2. The Keynesian Multiplier is a Static Concept 9
3. The Keynesian Multiplier has no Empirical Basis 9
4. Over-emphasizes consumption 9
5. Neglects Derived Demand from Investment in Capital Goods 9
6. Operates only under the condition of under employment 9
Importance of the Multiplier 9
Paradox of Thrift 10

Introduction
The effect of changes in investment upon national income and consumption expenditure and the
resultant generation of income in the short run are explained by the concept of Multiplier or
Investment Multiplier. The concept of investment multiplier helps us understand as to by how
many times income would increase with a given change in investment given the marginal
propensity to consume. The multiplier refers to the effects of changes in investment expenditure
on aggregate income through induced consumption expenditures. The multiplier therefore
expresses a relationship between an initial change in investment and the consequent increase in
national income. The multiplier is a numerical coefficient which indicates increase in income as
a result of increase in investment. For example, if change in investment is Rs.100 Billion and the
national income rises by Rs.500 Billion, then the investment multiplier is 5 i.e., change in national
income divided by change in investment or Rs.500/Rs.100 Billion. The investment multiplier is
therefore the ratio of change in national income to the given change in investment. Symbolically,
K = Y/I
Symbolically,
K = Y/I
Where; K = refers to investment multiplier.
Y = refers to change in national income,
and I = refers to a given change in investment.
According to Samuelson, investment multiplier is the number by which the change in investment
must be multiplied in order to present us with the resulting change in income. If you find the
investment multiplier ‘K’, the change in national income as a result of change in investment can
easily be measured. Thus Y = K.I. The marginal propensity to consume determines the size of
the multiplier and the resultant national income. When a change in investment occurs, the national
income increases by the same amount and with the increase in national income, consumption
expenditure also increases. However, an increase in consumption expenditure is less than the
increase in national income. Increased consumption expenditure becomes additional income to
productive factors engaged in the production of consumer goods, resulting in a further increase in
income. The process continues till the initial investment is exhausted through a series of changes
in income and expenditure. Since the marginal propensity to consume is less than one, the process
of income generation must be exhausted when change in investment becomes equal to change in
savings. Keynes believed that with the change in real income, consumption expenditure will also
change but not in the same proportion. The change in consumption expenditure as a result of
change in income will always be less than one i.e., proportionate change in consumption

expenditure will always be less than proportionate change in income. The value of the investment
multiplier is therefore determined by the marginal propensity to consume. Greater the value of the
marginal propensity to consume, greater will be the value of the investment multiplier and vice
versa. The multiplier formula can therefore be stated as follows:
k = 1/(1-mpc)
Where; ‘k’ = is the multiplier coefficient
And mpc = marginal propensity to consume.
Since
1-mpc = mps,
the multiplier formulate can be restated as follows:
k = 1/mps
Where ‘mps’ = marginal propensity to save.
Thus the multiplier coefficient is measured as the reciprocal of the marginal propensity to save.
Assumptions of the Theory of the Multiplier

The theory of multiplier holds good only under the following assumptions:
1. Advanced Economy
The multiplier can work only in an industrially advanced economy because it requires a large stock
of capital and open unemployment. Only when there is substantial unemployment productive
resources will the multiplier work and create more income. In the event of full employment, fresh
investment will only compete for the existing resources and raise their prices.
2. The Marginal Propensity to Consume is Constant

The mpc is assumed to remain constant during the process of income generation. However, in
reality the mpc is known to fall at higher levels of income and in that case the size of the multiplier
will get reduced and the resultant national income will be less than expected.
3. Stable Fiscal and Monetary Policies

Both monetary and fiscal policies influence consumption demand. For instance a contractionary
monetary policy will reduce money supply, raise interest rate and thereby reduce investment,
employment, output and income in the country. Similarly, a contractionary fiscal policy with
higher tax rates will reduce the disposable income of the people and affect consumption demand.

4. Closed Economy
Keynes assumed a closed economy so that the impact of new investment is not dissipated into the
open world economy. For instance, if people who receive income as a result of fresh investment
spend the money to buy imported goods then such an investment will help the national income of
the exporting country to increase and the multiplier will not work along expected lines in the home
country.
5. Static Economy
In order to prove the working of the multiplier, Keynes assumed a static economy which means
the level of technology, capital formation, labor supply, stock of raw materials etc are all assumed
to be constant.
6. Absence of Time Lag

There is no time lag involved in the receipt of income and its expenditure. The process of income
generation is assumed to be instant in each round of investment.
7. Excess Capacity in Consumer Goods Industry

When national income rises as a result of new investment and the working of the multiplier, the
demand for consumer goods will increase. There should be excess capacity in the consumer goods
industry so that the supply of consumer goods is adequate to keep their prices constant. A rise in
the prices of consumer goods will eat into the value of the multiplier.
Working of the Investment Multiplier

The working of the investment multiplier can be explained as follows. Let us assume that the size
of the initial investment is Rs.100 Crore. This investment will generate an income of Rs.100 Crore
for the capital goods industry. If we further assume that the marginal propensity to consume is
fifty percent in the first round of income generation, then Rs.50 Crore will be spent by the income
recipients of the first round on consumption goods and fifty per cent will be saved. Now in the
second round of income generation, Rs.50 Crores will be received by the consumer goods industry
and they in turn will spend Rs.25 Crores on consumption and save Rs.25 Crores because the value
of mpc is 0.5 or fifty per cent. This sequence of income and expenditure is based on the principle
that one man’s expenditure is another man’s income. This process will continue till the initial
investment of Rs.100 Crores gets exhausted through a series of expenditures, income and savings.
Each round of expenditure takes about three months to materialize. The time interval between
consumption responses is the multiplier period or propagation period. The income propagation
process can be explained with the following equation:

ᇫY = 100 X 1/1-0.5 = 100 X 1/0.5 = 100 X 2 = Rs.200 Crores.
Thus, if the value of mpc is 0.5 or fifty per cent, an initial investment of Rs.100 crores will generate
a total income of Rs.200 Crores. The table below shows a hypothetical example of income
generation.
The Rs.100 Crores of initial investment generate over a period of time a total income of Rs.200
Crores. When the total new income level is Rs.200 Crores, Savings of Rs.100 Crores equals

investment of Rs.100 Crores and the income generation process comes to an end. Keynes has
assumed that the multiplier process does not take time to work itself out i.e., an increase in
investment generates income by the multiple amount immediately. Keynes has therefore ignored
time lags in the multiplier process. Modern economists have taken into account time lags in the
multiplier process and consider the multiplier process over time. In order to keep the total income
to the level of the multiplier, repeated increments of investment are required because a single
injection of investment will raise the multiplier value but as soon as the multiplier effect has
worked itself out, total income will fall back to its original level. A steady injection of new
investment is therefore required to raise the total income to the multiplier level and maintain it
there. Thus in order to maintain the new income level of income of Rs.200 Crores and income of
the previous period, a steady investment of Rs.100 Crores in each round must be made. This is
called the Steady Injection or Continuous Injection Model which is depicted in the table below.
The multiplier model with a steady investment of Rs.100 Crores and with 50% marginal propensity
to consume is shown in the aforesaid table. You will notice that continuous investment of Rs.100
Crores in each round of consumption helps the national income to rise to the level of the multiplier
along with the income of the previous period and stay there. The effect of investment multiplier
is diagrammatically shown in the figure below. In this figure, the ‘C’ curve denotes consumption
function with a constant MPC of 50%. While we superimpose the investment curve on the
consumption curve, we get the C+I curve which also reflects the level of effective demand. The
C+I curve intersects the line of unity (Y = C+S) at point E1 and equilibrium level of national

income OY1 is determined. When investment is increased by Rs.100 Crores the C+I curve shifts
upwards and the new curve is C+I+ᇫI. The vertical distance between the two curves is the
monetary value of new investment. This new curve intersects the line of unity at point E2 and
accordingly national income OY2 is determined. The rise in income Y1 Y2 is 100 per cent more
than the initial investment of Rs.100 Crores. This is because the value of the multiplier is Two.
Leakages in the Multiplier Process

The value of the multiplier will be reduced by the leakages in the income stream. These leakages
are as follows:
1. Increase in the MPC

Keynes assumed a constant MPC and therefore a constant MPS to prove his concept of Investment
Multiplier. However, in reality when income rises the MPC falls and MPS rises. This will reduce
the size of the multiplier and therefore the ultimate rise in national income.

2. Hoarding of Cash Balances

People tend to hold a part of their income in the form of idle cash balances. These balances will
constitute a leakage in the income generation process. Further, the size of idle cash balances would
be large during a recession and small during the prosperity phase of the business cycle. Thus, in
a dynamic economy on account of hoarding and spending of cash balances the size of the multiplier
will change.
3. Purchase of Secondary Shares and Securities

If people decide to invest their new found additional income in the stock market, their consumption
expenditure will reduce and neither will investment expenditure rise as buying secondary shares
and securities constitute speculation. Fall in consumption expenditure will reduce the MPC and
thus the size of the multiplier.
4. Repayment of Debt
If people who receive the newly generated income to repay their debts, their consumption
expenditure will fall thereby reducing the size of the marginal propensity to consume and hence
the multiplier will fall and the expected rise in national income will not materialize.
5. Net Positive Imports

Although Keynes assumed a closed economy to explain his concept of investment multiplier, in
reality economies are open. Hence, if net imports are positive, income from the domestic stream
will flow into international channels and thereby reduce the size of the multiplier.
6. Inflation
When the investment multiplier is in operation, incomes rise and along with rise in incomes, prices
may also rise. On account of price rise, the real consumption of the people may remain constant
or even fall thus affecting the multiplier. If these leakages are not taken care of, they will reduce
the size of the multiplier and the expected rise in national income will not materialize. If the
leakages do not occur, the national income will continue to increase through the multiplier process
until full employment of resources is achieved.
Criticism on Theory of multiplier
1. The Impact of Investment on National Income is not Instantaneous

Keynes assumed an instant relationship between investment, income and consumption. In
reality, there is a time lag between the receipt of income and consumption and between
consumption expenditure and income.

2. The Keynesian Multiplier is a Static Concept

The Keynesian concept of investment multiplier is a static concept. In reality, the world is dynamic
and dynamic factors would affect the progression of the multiplier thereby either reducing its
impact or accelerating its impact on the national income.
3. The Keynesian Multiplier has no Empirical Basis

There is no real life evidence to the working of the investment multiplier. No statistical data has
been acquired to prove the Keynesian hypothesis.
4. Over-emphasizes consumption
According to Prof. Gordon, Keynes has over emphasized consumption to the neglect of
expenditure per se. Keynes thus neglected the impact on total private investment and government
expenditure.
5. Neglects Derived Demand from Investment in Capital Goods

The concept of investment multiplier considers the impact of induced consumption on income.
However, it neglects the impact of induced consumption on induced investment. It fails to see that
the demand for capital goods is a derived demand whereas the demand for consumption goods is
direct demand.
6. Operates only under the condition of under employment

The Keynesian concept of investment multiplier will not work under the conditions of full
employment. Unemployed productive resources must be available for the working of the
investment multiplier.
Importance of the Multiplier

The introduction of multiplier analysis in income theory is one of Keynes’ path-breaking
contributions, in as much as it has not only enriched economic analysis but also profoundly
affected economic policies. “It is true that Lord Keynes did not discover the multiplier, that honour
belongs to Mr. R.F. Kahn. But he gave it the role it plays today, by transforming it from an
instrument for the analysis of ‘road-building’ into one for the analysis of ‘income building’. From
his own and subsequent work, we now have a theory, or at least its sound beginning, of income
generation and propagation, which has magnificent sweep and simplicity. It set a fresh wind
blowing through the structure of economic thought”.
Despite the structures, multiplier has been of great importance both to economic theory and policy.
Firstly, it established the immense importance of investment as the major dynamic element in the

economy. Not only did it indicate the direct creation of employment, it also revealed that income
was generated throughout the system like a stone causing ripples in a lake.
On the side of practical economic policy, it is of the utmost importance because the case for public
investment has all the more been strengthened by the introduction of this concept; it tells us that a
small increment in investment leads to a large increase in investment and employment. A
knowledge of multiplier is of vital importance during the course of business-cycle studies and for
its accurate forecasting and control. Further, it is a useful analytical tool for following suitable
employment policies. Thus, we find that the theory of multiplier has brought almost a virtual
revolution in the thinking of economists and policy-makers alike. With the use of this concept, the
approach has radically changed from ‘no intervention’ to the growth of the public sector in
practically all the countries of the world
Paradox of Thrift
Paradox of thrift refers to contrasting implications of savings to households and to the economy as
a whole. Saving is treated as a virtue by households as they provide a protective umbrella against
bad spells but the same is treated as a vice by the economy as it retards the process of income
generation.
In this connection, Keynes pointed out the ‘paradox of thrift’ and showed that as people become
thriftier, they end up saving less or the same as before. If all the people of an economy increase
the proportion of income which is saved (i.e., MPS), the value of savings in the economy will not
increase, rather it will decline or remain unchanged. Let us understand this statement with the help
of the figure.

In the figure, the initial saving curve is SS and the investment curve is II. The economy attains
equilibrium (Saving = Investment) at E and equilibrium level of income is OY. Now, suppose
society decides to become thrifty by reducing consumption expenditure and increasing saving by,
say, AE. As a result, the saving curve shifts upward to S1S1 intersecting Investment curve II at E1.
Unplanned inventories will increase and firms will cut down production and employment and
move to new equilibrium E1. The figure shows that in the end, planned saving has fallen from AY
to E1Y1. Notice at new point of equilibrium E1, investment level and also realised savings remain
the same (E1Y1) but level of income has fallen from OY to OY1. The decline in equilibrium level
of income shows the paradox of thrift as the reverse process of multiplier has worked on reducing
consumption expenditure. In fact Increased saving is virtually a withdrawal from circular flow of
income.
******************

Relevance of Keynesian theory tools to the developing countries
Table of Contents:
Introduction .................................................................................................................... 1
Keynesian assumptions and developing countries ........................................................... 1
1. Short-period Analysis .............................................................................................. 1
2. Cyclical Unemployment .......................................................................................... 2
3. Closed Economy ..................................................................................................... 2
4. Excess Supply of Labour and Complementary Factors ............................................ 2
Tools of Keynesian Economics and Developing Countries .............................................. 2
1. Effective Demand ................................................................................................... 2
2. Propensity to Consume............................................................................................ 3
3. Propensity to Save................................................................................................... 3
4. Marginal Efficiency of Capital ................................................................................ 3
5. Rate of Interest ........................................................................................................ 3
6.The Multiplier .......................................................................................................... 4
7. Policy Measures ...................................................................................................... 4
Shortcomings of Keynesian Theory ................................................................................. 5
Introduction
The Keynesian theory is strictly applicable to advanced capitalist countries. It is fundamentally
a capitalistic theory. The Keynesian theory may provide basic tools to formulate economic
growth theory for developing countries. Hence Keynesian theory has little relevance in solving
the problems of economic development of the developing countries. As A. K. Das Gupta wrote,
"the Keynesian economics was developed in a setting entirely different from that of
underdeveloped countries, the nature of problems of two types of countries is quite different,
and, therefore, the Keynesian techniques of analysis and policy recommendations are not very
helpful in the context of and underdeveloped countries". As Schumpeter wrote, "Practical
Keynesianism is a seedling which cannot be transplanted into foreign soil, it dies there and
becomes poisonous before it dies. But left in English soil, this seedling is a healthy thing and
promises both fruit and shade. All this applies to every bit of advice that Keynes ever offered."
Keynesian assumptions and developing countries

Keynesian Economics is based on the following assumptions:
1. Short-period Analysis
The Keynesian analysis is a short-period analysis in which all the economic factors are static.
Factors such as the skill and quantity of labour, the quantity and quality of equipment, the
production technique, the degree of competition, the taste and habits of the consumers, the

activities of organisation as well as social structure. But in the long period analysis all these
economic factors change over time. Keynesian economics is static in nature. It deals with short-
run phenomena only. It pays little attention to the long-run problems of a dynamic economy.
2. Cyclical Unemployment
The Keynesian theory deals with the problem of cyclical unemployment which is faced by the
developed countries. Cyclical unemployment occurs during depression and is caused by the
deficiency in effective demand. Therefore, it can be removed by increasing the level of
effective demand. Developing countries, the nature of unemployment is chronic and not
cyclical. Developing countries also face disguised unemployment. It is not due to lack of
effective demand but it is due to the deficiency in capital resources. Keynesian Economics did
not provide any solution to chronic or disguised unemployment which is existing in developing
countries.
3. Closed Economy
Keynes assumed a closed economy model for the sake of simplicity. But developing countries
are open economies in which foreign trade plays a dominant role in developing them. Such
economies depend on the imports of capital goods and crude oil and export agricultural goods
and industrial raw materials.
4. Excess Supply of Labour and Complementary Factors

The Keynesian theory assumes an excess supply of labour and other complementary factors.
But in developing countries capital, labour, skills, etc are all lacking.
Tools of Keynesian Economics and Developing Countries

The basic tools of Keynesian theory are discussed so as to test their relevance to developing
countries.
1. Effective Demand
According to Keynes, in the advanced capitalist countries unemployment is caused by the
deficiency of effective demand. To overcome it, Keynes encouraged spending (consumption
and non-consumption expenditure) and condemned savings. This results in creating
employment in the economy. On the other hand, in a developing country, there is disguised
unemployment. In such countries, unemployment is not caused by the deficiency of effective
demand but by the deficiency of resources. To overcome it, the developing countries need curbs
on spending and increase in savings for capital formation and for wide-scale investment. This
will stimulate economic development in the developing countries.

2. Propensity to Consume
One of the important tools of Keynesian economics is the propensity to consume. Keynesian
economics shows the relationship between income and consumption. When income increases,
consumption also increases but less than the increase in income. When there is increase in the
income and consumption, it leads to an increase in effective demand resulting in high level of
production and employment. On the other hand, in the developing countries these relationship
between income and consumption do not hold. In developing countries, when income
increases, people spend more on consumption goods. But due to lack of capital and other
resources, production of consumer goods does not increase. As a result, prices of commodities
rise instead of level of employment.
3. Propensity to Save
Another important tool of Keynesian economics is the propensity to save. Propensity to save
shows the relationship between income and savings. When income is high, and consumption
is lower than income then saving increases. According to Keynes, excess savings leads to
decline in aggregate demand and hence Keynes encouraged spending (consumption) and
condemned savings. But in the developing countries, savings are the remedy of all their
economic problems. Increase in savings leads to an increase in the capital formation. This
increase in capital formation further leads to economic development. Thus, developing
countries can progress by curbing spending (consumption) and increasing savings for capital
formation and wide-scale investment to break the vicious circle of poverty.
4. Marginal Efficiency of Capital

Keynes has considered the marginal efficiency of capital as the major determinant of
investment. There is an inverse relationship between investment and marginal efficiency of
capital (MEC). When investment increases, MEC falls and vice-versa. However, this inverse
relationship between investment and MEC is not applicable to developing countries. In
developing countries, there is low level of investment and MEC is also low. This paradox is
due to the deficiency of capital and other resources, high cost lead to low demand and
underdeveloped markets. All this results in MEC (profit expectations) at a low level.
5. Rate of Interest
Keynes has considered the rate of interest as the secondary determinant of investment. The rate
of interest is determined by the supply of money and the liquidity preference. There are three
motives for liquidity preference- the transaction motive, the precautionary motive and the
speculative motive. Out of the three motives, the transaction and precautionary motives are
income elastic because they do not affect the rate of interest. The speculative motive is interest
elastic as it affects the rate of interest. In developing countries, the liquidity preference for

transaction and precautionary motives are high and while for the speculative motive is low.
The liquidity preference tor speculative motive is low because there is no desire to earn from
the rise or fall in prices of bonds and securities as the bonds and securities market is not well
developed. As a result, liquidity preference fails to affect the rate of interest. The rate of interest
is also determined by the supply of money. According to Keynes, an increase in the supply of
money leads to the fall in the interest rate and increases the level of investment, income and
employment. But this is not the case in the developing countries. In developing countries, an
increase in the supply of money leads to the rise in the price level rather than fall in the interest
rate.
6.The Multiplier
The Keynesian theory of multiplier is based on the following assumptions:
1. Involuntary unemployment
2. Constant marginal propensity to consume (MPC)
3. Excess capacity in the consumer goods industries
4. Stable monetary and fiscal policies
5. Closed economy model
6. No dynamic changes in the economy
All these conditions prevail in the developed capitalist countries as the multiplier works over
there. But in a developing country, these conditions are not likely to be found. Dr. V.K.R.V.
Rao has pointed out the Keynesian multiplier theory is not applicable to developing countries.
Keynes multiplier depends on the size of MPC. The higher the MPC, the greater is the
multiplier and vice versa. In the developing countries, the MPC is fairly high and hence the
size of the multiplier should be very high but this is not so.
7. Policy Measures
Keynesian policy prescription is hardly applicable to developing countries. Keynesian policy
of public investment can be applied in developing countries to achieve a higher standard of
living and to increase employment opportunities. But in the absence of public investment
Dasgupta recommended a policy of deficit financing. According to Dr. V.K.R.V Rao, in
underdeveloped countries "the old-fashioned prescription of work harder and save more still
seems to hold as the medicine for economic progress than the Keynesian hypothesis that
consumption and investment should be increased simultaneously".
The Keynesian theory may be inapplicable to the problems of developing countries, but
Keynesian tools of analysis can help in understanding the major problems of any economy,
whether developed or developing.

Shortcomings of Keynesian Theory

Though Keynesian economics has revolutionised modern economic thinking, it has the
following inherent weaknesses:
1. Keynesian theory is purely macro-economic analysis. It has completely neglected
micro-economic issues.
2. Keynesian theory is fundamentally a capitalistic theory. It basically examines the
determinants of employment in a free enterprise economy. Though Keynes suggests
Government intervention and controlled capitalism, his theory fails to deal with the
socialist economic system.
3. Keynesian economics is static in nature. It does not consider time lags in the behaviour
of economic variables. Indeed, the post-Keynesian economic analysis is truly dynamic
in nature as it gives due regard to the time element.
4. Keynesian theory assumes perfect competition in the model which is, however, not a
very realistic phenomenon.
5. Keynes' theory deals with short-run phenomena only. It pays little attention to the long-
run problems of a dynamic economy.
6. Keynes assumed a closed economy model for the sake of simplicity. But, in doing so,
the impact of international trade on a country's growth of employment and income
remained unexposed.
7. Keynesian theory is not applicable to the underdeveloped countries. Keynes deals with
the problem of cyclical unemployment. Underdeveloped countries face the problem of
chronic unemployment and disguised unemployment. Keynes encouraged spending
and condemned savings. But poor countries need curbs on spending and increase in
savings for capital formation and wide-scale investment to break the vicious circle of
poverty.
*****************

MODULE III
Demand for Money
Keynes’ Liquidity Preference Theory

Table of Contents:
Demand for money 1
Transactions Motive 2
Precautionary Motive 2
Speculative Motive 3
The Total Demand for Money 4
Determination of rate of interest 5
Impact of changes in Money demand and supply on the rate of interest 6

Change in Demand for Money 6
Change in Supply of Money 7
The Liquidity Trap 8
Critical evaluation 8
Keynes defines the rate of interest as the reward for parting with liquidity for a specified period
of time. According to him, the rate of interest is determined by the demand for and supply of
money.
Demand for money

Liquidity preference means the desire of the public to hold cash. The Keynesian Liquidity
Preference Approach to demand for money is based on two important functions:
(a) Medium of Exchange;
(b) Store of Value
People’s desire to hold money in the form of cash or their preference for liquidity, according
to Keynes, is due to fear of uncertainty regarding the future. According to Keynes, there are
three motives behind the desire of the public to hold liquid cash:
(1) the transaction motive
(2) the precautionary motive
(3) the speculative motive

(1) Transactions Motive

The transactions motive relates to the demand for money or the need of cash for the current
transactions of individual and business exchanges. Individuals hold cash in order to bridge the
gap between the receipt of income and its expenditure. This is called the income motive. The
Transactions motive is further subdivided into income motive and business motive. The former
refers to the households; whereas the latter refers to the business people. For both the groups,
there is a time lag between receipts and expenditure for which they require to hold cash for
transactions. The amount of money kept by them depends on their income. Higher the income,
larger will be the amount held under these motives. Other factor includes: Time interval –
Longer the income time interval, more is the cash balance and vice-versa; The price level-
generally, during inflation, transactions demand for money rises due to rising price level;
Volume of employment- When volume of employment and output rises, the transaction
demand for output rises
(2) Precautionary Motive

It is necessary to be cautious about the future which is uncertain. An additional amount of
money over and above for the known requirements is held for contingencies requiring sudden
expenditure and for unforeseen opportunities of advantageous purchase. Individuals hold
money to meet unexpected increases in expenditure due to illness, accidents and any other
unforeseen emergencies. Money may also be required to make up a fall in income due to
temporary unemployment. Business people also hold cash as they too face such uncertainty
depending upon the market conditions which can’t be predicted. Demand for money for
precautionary motive has a direct relationship with the level of income. Rich people will have
a larger amount for this motive against the poor who may hardly have any balance for this
purpose. A firm’s precautionary motive depends upon their turnover. Smaller firms will have
a lesser demand for such motives. Firms demand for such purpose is also influenced by
unstable political conditions, as firms tend to become more cautious, holding a larger amount
of cash.

Both the transaction and precautionary motives are based on the role of money as medium of
payment and both are influenced by the level of income. Thus we have the following function:
Lt = f (y)
Where Lt = Demand for Money for transactions and precautionary motives;
Y= Income
The demand for money for these motives is not influenced by the rate of interest except perhaps
at a very high rate. It is not unlikely that people may decide to reduce their cash balances in
order to earn some additional income offered by an attractive interest rate. In general, the
demand for money for transactions and precautionary motives is interest inelastic (as shown in
the figure below)
From the figure above, the vertical line ML1 indicates that the transaction and precautionary
demand for money is unaffected by changes in the rate of interest i.e. demand for money (L1)
is interest inelastic
L1 = f(Y)
(3) Speculative Motive

The demand for money for speculative motive is related to the store value function of money.
It is also called “Asset Demand for Money”. People have the alternative of holding either cash
money or financial assets like government bonds or equities. Speculative demand for money is
also related to uncertainty, which is concerned with uncertain capital value of financial assets.
People desire to gain by purchasing the financial assets at a low price and selling them when
their price rises. Those who expect the prices of bonds and equities to fall and others who do
not expect the prices to increase any further unload the bonds and securities held by them.
The speculative demand for money is interest elastic. At a higher rate of interest, less money
is held for this motive and vice-versa. Holding cash when the rate of interest is high has a
greater opportunity cost. There is a inverse relationship between interest rate and security
prices. Demand for money held under the speculative motive is referred to as the demand for
idle cash balances. Demand for speculative motive (L2) depends on the rate of interest (r).

L2 = f ( r )
Where L2 = Demand for speculative motive; r = rate of interest; L2= Rate of interest.
L2 and r are inversely related.
Demand for Money/ Liquidity Preference for speculative motive can be explained with the help
of the diagram below.
In the figure, Lp is the demand for money for speculative purpose and at interest r, OM quantity
is demanded. At a lower interest rate, that is r’ and r”. OM1 and OM2 quantity is demanded.
From point T, demand for LP becomes perfectly elastic which is called “Liquidity Trap”.
The Total Demand for Money

The aggregate demand for money arises out of three motives: Transaction; Precautionary and
Speculative. The demand for the first two motives is income determined and interest inelastic.
The speculative demand for money is interest elastic. The total demand is expressed as:
Md = L1 (y) + L2 (r)
Where L1 (y)= demand for transaction and precautionary motives, both being an increasing
function of level of income ;
L2 (r) = speculative demand for money, as a declining function of rate of interest.
In Keynesian terms the total demand for money can be expressed as :
Md = L (yr)
Where the transactions and precautionary demand for money is considered as active balance
and is the function of income. It is positively related to the level of income. The speculative
demand is a demand for idle balance and is inversely related to the rate of interest.
Consider the following total demand for money diagrammatically:

Figure (I) shows OM, the transactions and precautionary demand for money at y level of
income and different rate of interest. Figure (II) shows the speculative demand for money at
various rates of interest. Figure (III) shows the total demand curve for money. It represents
liquidity preference of the community at different rates of interest
Determination of rate of interest
According to Keynes, interest is the price paid for parting with liquidity. It is determined by
the supply of and demand for money. The following figure explains the determination of rate
of interest by demand for and supply of money. Md curve slopes downward and from point T
becomes horizontal. Up to point T, there is an inverse relationship between demand for money
and rate of interest. From point T onwards, Md curve is horizontal implying that demand for
money is perfectly elastic.
According to Keynes, at a very low rate of interest, people prefer to hold cash rather than
purchase bonds and securities. Lending at a very low rate of interest is not worth the risk
involved besides the opportunity cost of holding money is very low. People would not purchase
bonds or securities since at a low rate of interest their prices are high and it is expected they
may fall at any time since the low rate of interest may not remain at that level for long. Besides
there is hardly any scope of earning speculative profit since prices of bonds or securities are
unlikely to increase further. Therefore, the straight horizontal line from point T is termed as
‘liquidity trap’. From point T onwards demand for money is perfectly elastic.
Money supply at a given time is taken as constant. The quantity of supply is determined by the
monetary authorities. Any change in the quantity of money supply is subject to the decision of

monetary authorities and need not necessarily in response to a change in rate of interest. At a
given time, Money supply is constant which is shown by a vertical line.
The Figure above explains the determination of rate of interest by intersection of demand for
money (i.e. liquidity preference) and supply of money (Ms) at point E where the interest OR is
determined.
Impact of changes in Money demand and supply on the rate of interest
Change in Demand for Money

Demand for money for transaction motive, that is for M1, may increase whenever income (Y)
increases. Such an increase in demand for money has to be met either by reducing the
speculative cash balance or by selling bonds/ securities. If such sales are large in quantity,
prices of bonds/ securities will decline which will result in an increase in the rate of interest. A
change in demand for money for speculative purposes may also take place, if prices of bonds/
securities rise and people expect it to increase further. This would encourage speculators
further, demand for more money as they expect the prices to rise further. Meanwhile
speculators would like to purchase bonds/ securities and sell them at a higher price later. An
increase in demand for money either for M1 or M2 or at times for both would shift the Md curve
upward to the right leading to an increase in the rate of interest. An increase in the rate of
interest due to an increase in demand for money (liquidity preference) is explained in the figure
below:

A number of factors – economic and non-economic – may result in a shift in liquidity

preference curve. Shift may be upwards or downward. Given the money supply, the rate of
interest will change depending on the direction of shift of Md curve. The figure above explains
the change in rate of interest due to change in demand for money (Md). The initial rate of
interest is OR determined by the Ms (money supply) and Md (liquidity preference) curves. An
increase in demand for money, shifts the Md curve upward thus having a new demand curve
(Md1). The new point of intersection between Money Supply and Demand for Money (liquidity
preference) curves is E1, with an increased rate of interest at R1.
As explained above the rate of interest is determined by demand for and supply of money. The
rate of interest changes, that is, increases or decreases whenever there is a change in demand
for money (increase or decrease) with a given supply.
Change in Supply of Money

The money supply is determined by monetary authorities. If more money is put in circulation
by them, with the given demand for money, the rate of interest will decline. The figure below
explains the change in rate of interest due to exchange in money supply.

With the initial supply of money OQ intersecting demand curve (liquidity preference) at E, the
rate of interest is R. Subsequently, if money supply increases to OQ1, the new Money Supply
line is MS1 intersecting Md curve at E1, the changed rate of interest is R1. In case of Money
supply is reduced and the new money supply line is shifted to the left of Ms line, the rate of
interest will be OR.
The Liquidity Trap

The inverse relationship between the rate of interest and speculative demand for money
transforms into a different form of relationship at a very low rate of interest. Keynes suggested
that at a very low rate of interest, the speculative demand for money becomes perfectly elastic.
Keynes considered a 2% rate of interest as the lowest rate, below which the market rate of
interest would not decline. At such a low rate of interest people prefer cash and not securities.
At this point, when the expectation about the future fall in the security prices is high and
widespread, everyone prefers to hold cash to gain from future market situation.
From the figure (above), the L2 is downward sloping upto point T indicating the inverse
relationship between speculative demand for money and market rate of interest.
At point T, L2 becomes horizontal, which is “Liquidity trap”, which shows perfectly elastic
demand for money for speculative motive.
People prefer to hold cash instead of bonds due to the fear of an imminent decline in their
prices. At such a low rate of interest, people do not prefer to hold any other asset or debt as the
risk is far greater than the interest offered.
This situation has a lot of significance for the Monetary Policy. Any attempt by monetary
authorities at this point to increase money supply would not affect the rate of interest since it
has already dropped to its lowest level.
Critical evaluation
1. Real factors are ignored: Keynes ignored real factors like saving and investment in
this theory of interest. Such factors are important in determining supply and demand
for capital (money) and in turn determining the rate of interest. Factors like marginal
propensity to consume and marginal propensity to save play an important role

determining supply and demand for capital (money) and in turn determining the rate of
interest.
2. No liquidity without savings: Interest, according to Keynes, is a price for parting with
liquidity. It is a payment neither for sacrifice involved in savings nor for waiting
between the period of lending and receiving money back. However to have liquidity
one has to save money.
3. Confined to short-run : He answered this criticism saying that “we all are dead in the
long-run”
4. Doesn’t explain the existence of different of different rates of interest: In the
market, in reality, there exists more than one rate of interest. They all are determined
by the demand for and supply of money. In Keynesian theory we get no explanation for
this phenomenon.
5. Indeterminate theory: In Keynesian theory, interest is determined by the demand for
liquidity and supply of money available for speculation purposes. At the same time,
demand for liquidity preference itself depends on interest, so also the supply of money
kept for the purpose. Besides, the level of income determines the quantity of money
kept for transactions and precautionary motives, leaving the remaining money if at all,
for speculative motive. Rate of interest, as in the classical theory, is determined by
demand for supply of money. At the same time the level of demand depends on the rate
of interest.
****************

Money Supply
Table of Contents:
Concept of Money 1
Concept of Money Supply 1
Constituents of Money Supply 2
Current measures of money supply in India 4
Velocity of Circulation of Money 5
Factors determining Velocity of Circulation of Money 5
Concept of Money
Money is defined in Economics as ‘anything that is generally accepted in payment for goods and
services as a medium of exchange.’ Money consists of currency and checkable demand deposits.
Money is the most liquid asset. The liquidity of assets refers to the ease with which an asset can
be converted into a medium of exchange. Assets are classified as either financial assets or real
assets and are ranked according to their liquidity. Currency, checkable deposits, savings deposits
are examples of liquid financial assets. Stocks and bonds are relatively less liquid financial assets.
Precious metals like silver, gold, platinum etc., are liquid real assets. Artwork, machinery and real
estate are the examples of less liquid real assets. The liquidity of an asset is determined by the
following factors:
1. Existence of a well-established market in which the asset can be quickly sold.
2. Size of transaction costs (brokers fees, time costs)
3. Stability of the asset’s price.
Concept of Money Supply

Money supply refers to the amount of money which is in circulation in an economy at any given
time. It is the total stock of money held by the people consisting of individuals, firms, State and
its constituent bodies except the State treasury, Central Bank and Commercial Banks. The cash
balances held by the Federal and federating governments with the Central Bank and in treasuries
are not considered as part of money supply because they are created through the administrative
and non-commercial operations of the government. Further, money supply refers to the disposable
stock of money. Therefore, money supply is stock of money in circulation. Money supply can be
looked at from two points of views, namely, money supply as a stock and money supply as a flow.
Thus, at a given point of time, the total stock of money and the total supply of money is different.
Money supply viewed at a point of point is the stock of money held by the people on a given day
whereas money supply viewed overtime is viewed as a flow. Units of money are spent and re-

spent several times during a given period. The average number of times a unit of money circulates
amongst the people in a given year is known as velocity of circulation of money. The flow of
money is measured by multiplying the stock of money with the coefficient of velocity of
circulation of money.
Constituents of Money Supply

There are two approaches to the constituents of money supply. They are the traditional and the
modern approaches.
1. Traditional Approach
According to the traditional approach, the money supply consists of currency money consisting of
coins and notes and bank money consisting of checkable demand deposits with commercial banks.
The currency money is considered high powered money because of the legal backing of the State.
The Central Bank of a country issues currency notes and coins because it has the monopoly of note
and coin issues. The supply of money in a country depends upon the system of note issue adopted
by the country. For instance, India adopted the Minimum Reserve System in 1957. Under this
system, the Reserve Bank of India has to maintain a minimum reserve of Rs.200 Crores consisting
of gold and foreign securities. Out of this, the value of gold should not be less than Rs.115 Crores.
With this reserve, the Reserve Bank of India has the power to issue unlimited amount of currency
in the country.
Checkable demand deposits of commercial banks are used in the settlement of debt. Payments
made through checks change the volume of demand deposits by creating derivative deposits. The
creation of demand deposits is determined by the credit creation activities of the commercial banks.
Bank money is considered as secondary money whereas cash money is known as high powered
money. Thus according to the traditional approach, the total supply of money is the sum of high-
powered money and secondary money or currency and bank money. The ratio of bank money to
currency money depends upon the extent of monetization, banking habits and banking
development in a country. In advanced countries, ratio of bank money to currency money is high
whereas in poor countries the ratio of currency money to bank money is high.
2. The Modern Approach

According to the modern approach, money supply includes currency money and near money.
Money supply therefore consists of coins, currency notes, demand deposits of commercial banks,
time deposits of commercial banks, financial assets, treasury bills and commercial bills of
exchange, bonds and equities.
Determinants of Money Supply

Currency in circulation and demand deposits are the main constituents of money supply. While
the demand deposits are created by the commercial banks, currency is issued by the Central Bank
and the Government. The supply of money is determined by the following factors:
1. Size of the Monetary Base/Reserve Money or High-Powered Money
Money supply depends upon the size of the monetary base. The monetary base refers to the group
of assets which empowers the monetary authorities to issue currency money. Money supply
changes with changes in the monetary base. The monetary base of an economy consists of
monetary gold stock, reserve assets such as government securities, bonds and bullion, foreign
exchange reserve with the central bank and the amount of central bank’s credit outstanding. In the
present times, gold stock is not considered as part of the monetary base.
2. Community’s Choice
The relative amount of cash and demand deposits held by the people also influences the supply of
money. If the people prefer to make check payments much more than cash payments, the total
money supply maintained by a given monetary base would be larger and vice versa. Since money
deposited in commercial banks generates derivative deposits and expand the supply of bank money
through the credit multiplier, people’s preference of bank money to cash would increase the supply
of money. However, the choice of the community is determined by factors such as banking habits,
per capita income, availability of banking facilities and the level of economic development. If
these factors are developed, the money supply would be larger and vice versa.
3. Extent of Monetization
Monetization refers to the use of money as a medium of exchange. The choice of the community
for money as a liquid asset depends upon the extent of monetization of the economy. If
monetization is high, demand for money would be high and vice versa.
4. Cash Reserve Ratio
The Cash Reserve Ratio refers to the ratio of a bank’s cash holdings to its total deposit liabilities.
It determines the coefficient of the credit multiplier. The CRR is determined by the Central Bank
of a country. The credit multiplier (m) is determined as the reciprocal of the CRR (r). Therefore
m = 1/r. Excess funds with the commercial banks multiplied by the credit multiplier will give us
the extent of credit creation by the commercial banks. Lower the CRR, greater will be the value
of the credit multiplier and therefore greater will be the supply of bank money and vice versa.
5. Monetary Policy of the Central Bank. Monetary policy is defined as the policy of the Central
Bank with regard to the cost and availability of credit in the economy. The monetary policy of the
Central Bank of any country will be according to the macro-economic conditions. Thus under
inflationary conditions, the Central Bank may follow contractionary monetary policy and thereby
reduce the supply of bank money by pursuing both qualitative and quantitative measures of

controlling money supply. Similarly under recessionary conditions the Central Bank may follow
expansionary monetary policy and thereby raise the supply of money in the economy.
6. Fiscal Policy of the Government
Fiscal policy is defined as a policy concerning the income and expenditure of the government.
While the government raises revenue through various sources like different types of taxes,
borrowing and through deficit financing, it spends the money raised for various developmental
and non-developmental purposes. When the government raises revenue by imposing fresh taxes
or by raising the existing level of taxes, it helps to reduce money supply. Similarly, market
borrowing by the government reduces money supply and raises the market interest rates. This is
known as the crowding out effect of government borrowing. When the government spends the
money so raised, money supply increases. However, when the government runs a deficit budget,
it adds to the existing stock of money supply and thus raises the supply of money in the economy.
The opposite will be the impact of a surplus budget, but surplus budgets are a rarity in modern
times.
7. Velocity of Circulation of Money
Velocity of circulation of money refers to the average number of times a unit of money as a
medium of exchange changes hands during a given year. Money supply is measured as total
money in circulation multiplied by the velocity of circulation (M×V). Thus, higher the velocity of
circulation of money, higher will be the money supply and vice versa.
Current measures of money supply in India

According to the Reserve Bank of India since its inception in 1935, money supply in the narrow
sense of the term was the sum of currency with the people and demand deposits with the
commercial banking system. Narrow money was denoted by the RBI by M1. In 1964-65, the
concept of broad money or aggregate monetary resources was introduced. Broad money was
considered equal to M1 + Time deposits with commercial banks. In March 1970 the RBI accepted
the report of the Second Working Group on Money Supply. This report was published in the year
1977 and it gave a broad definition of money supply. Accordingly, four measures of money supply
were brought into effect.
These four measures are as follows:
1. M1 = Currency with the public + Demand deposits with the commercial Banks + Other
deposits with the RBI.
2. M2 = M1 + Post Office Savings Bank Deposits.
3. M3 = M1 + Time deposits with the commercial banks.
4. M4 = M3 + Total Post Office Deposits (excluding NSCs).

The Reserve Bank of India gives importance to narrow money (M1) and broad money (M3).
Narrow money excludes time deposits because they are not liquid and are income earning assets
while broad money includes time deposits because some liquidity is involved in it as these assets
earns interest income in future. Since time deposits have become convertible in recent times, they
have become more liquid than what they were before. The M2 and M4 measures of money supply
include post office savings and other deposits with the post offices.
The third working group on money supply recommended the following measures of monetary
aggregates through their report submitted in 1998:
1. M0 = Currency in circulation + Bankers’ deposits with the RBI + Other deposits with the
RBI. (M0 is compiled on a weekly basis).
2. M1 = Currency with the public + Demand deposits with the banking System + Other deposits
with the RBI = Currency with the public + Current deposits with the banking system + Demand
liabilities Portion of Savings Deposits with the banking system + other Deposits with the RBI.
3. M2 = M1 + Time liabilities portion of saving deposits with the banking System + Certificates
of deposits issued by the banks + Term Deposits [excluding FCNR (B) deposits] with a contractual
maturity of up to and including one year with the banking system = Currency with the public +
current deposits with the banking System + Savings deposits with the banking system +
Certificates Of Deposits issued by the banks + Term deposits [excluding FCNR (B) deposits] with
a contractual maturity up to and Including one year with the banking system + other deposits with
the RBI.
4. M3 = M2 + Term deposits [excluding FCNR (B) deposits] with a Contractual maturity of
over one year with the banking system + Call borrowings from Non-depository financial
corporations by the Banking system.
(M1, M2 & M3 are compiled every fortnight).
Velocity of Circulation of Money

The velocity of circulation of money determines the flow of money supply in an economy in a
given period of time, normally such a period is one year. The average number of times a unit of
money changes hands is known as the velocity of circulation of money. The supply of money in
a given period is obtained by multiplying the money in circulation with the coefficient of velocity
of circulation i.e., M ×V where M refers to the total amount of money in circulation and V refer to
the velocity of circulation of money in the given period.
Factors determining Velocity of Circulation of Money

The velocity of circulation of money is determined by the following factors:
1. Time unit of income receipts

The more frequently people receive income, the shorter will be the average time period of holding
money and greater will be the velocity of circulation of money. Thus if in a given society large
number of people receive income on daily basis, the velocity of circulation of money would be
higher than the one in which people receive income on weekly, fortnightly or monthly basis.
2. Method and habits of payment
The velocity of circulation of money would be high if large number of people prefers to make
payment on installment basis. As a result, the same unit of money will change hands more often
than when payments are made in full.
3. Regularity of income receipts
If in a society people receive income on a regular basis, they will spend their current income
without bothering about the future and hence the velocity of circulation of money would be high.
However, if future income receipts are uncertain, people will not spend more money in the present
and hence the velocity will be less.
4. Saving habits of the people
If the marginal propensity to save is high in a society, then the people will be spending less in the
present and hence the velocity will be less. Similarly, if the marginal propensity to consume is
high the people will spend more and the velocity of circulation of money will be high.
5. Income distribution
Income distribution may be more equal or more unequal in a society. If inequalities of income are
high in a society with the top 20 % taking away a major portion of the national income, velocity
of circulation of money would be low because the richer sections of the society will be holding
more idle cash balances. However, if income distribution is more equal or less unequal, the bottom
40% of the people will receive more incomes and spend more thereby increasing the velocity of
circulation of money.
6. Development of banking and financial system
If the banking and financial institutions in a country are well developed, mobilization of savings
can be effectively carried out and more credit made available to the needy. This not only prevents
hoarding of cash balances but also increases the velocity of circulation of both currency and bank
money.
7. Business Cycle
During the prosperity phase of the business cycle, investment, output, income, employment and
prices rise. Thus, the velocity of circulation of money would be high during the prosperity phase.
However, during the downturn of the business cycle, investment, output, income, employment and
prices begin to decline thereby reducing the velocity of circulation of money.

8. Liquidity preference of the people

If the liquidity preference of the people is high i.e., if they wish to hold a greater part of their
income in the form of idle cash balances, the velocity of circulation of money would be low and
vice versa.
9. Speedy clearance of checks and transfer of funds
A more advanced banking system would help speedy clearance of checks and transfer of funds
from one account to another account, thereby increasing the velocity of circulation of money.
****************

IS-LM Model
Table of Contents:
I. Goods Market Equilibrium ...................................................................................... 1
A. The IS Curve........................................................................................................ 1
B. Derivation of the IS Curve ...................................................................................... 2
C. Properties of IS Curve: Summary ........................................................................... 4
D. Shifts in IS Curve ................................................................................................... 4
E. Factors Responsible for Change in Autonomous Spending...................................... 5
II. Money Market Equilibrium ...................................................................................... 5
A. The LM Curve ..................................................................................................... 5
B. Derivation of the LM Curve ................................................................................. 5
III. The equilibrium in the goods and money markets ................................................. 7
The modern theory of income determination was largely developed by Keynes. It begins with
emphasis on aggregate demand. The important components of aggregate demand are
consumption, investment, and government expenditures on goods and services. The
government expenditure is taken as policy determined. Consumption is treated as a function of
income. Investment is determined by the rate of interest and the marginal efficiency of capital.
The rate of interest is determined in the money market by the demand for and the supply of
money. The rate of interest influences the investment which in turn determines the level of
income. Thus, it is observed that there is an interdependence between real and monetary factors
in the determination of income.
The IS-LM model describes how aggregate markets for real goods and financial markets
interact to balance the rate of interest and total output in the macroeconomy. The model shows
how the goods and money markets interact to determine simultaneously the equilibrium levels
of income (or output) and interest rate that lead to equilibrium in both goods and money markets
at the same time. Hicks and Hansen have shown the integration of the real and money markets
with the IS and LM curves.
I. Goods Market Equilibrium

A. The IS Curve
The goods market is in equilibrium when the output or income is equal to aggregate demand
in the economy. At this point, saving is equal to investment. Investment depends on the rate of
interest and it is inversely related to interest rate. Saving depends on the level of income and it
is directly related to income. IS curve reflects the combination of the interest rate and national
income for which investment equals saving, I=S. The goods market equilibrium is shown by

the IS curve. The IS curve shows the different combinations of interest rates and the levels of
income at which the goods market is in equilibrium.
B. Derivation of the IS Curve
In the goods market, we have:
(i) the saving function,
(ii) the investment function, and
(iii) an equilibrium condition.
These are expressed as:
S = f(Y) … (1)
I = f(r) … (2)
and S = I … (3)
To develop the IS curve we have to find combinations of interest rate, r, and the level of income,
Y, that equate investment with saving. At a given ‘r’, one can determine the volume of
investment expenditure.
Once we determine investment expenditure, we are able to find out the equality between
investment and saving. Consequently, equilibrium national income is determined in the goods
market. In fact, there are a series of combinations of r and Y that ensure equality between
saving and investment. Once these combinations are plotted on the r – Y plane, we get a curve
which Hicks-Hansen called the IS curve.
The IS curve shows alternative combinations of national income (Y) and the rate of interest (r)
which equilibrate the commodity market.
The derivation of the IS curve can be made in terms of a four-part diagram (Figure below). In
part (a), we have drawn an investment function that shows the inverse relationship between
investment and the rate of interest. Part (c) plots the saving function that represents direct
relationship between income and saving. Part (b) is simply a 45° identity line, and part (d) plots
the IS curve.

Suppose, the rate of interest is r0. At this rate of interest, investment must be I0 and, thus, the
volume of saving must be S0 necessary for equilibrium. This volume of saving implies an
equilibrium income of Y0necessary for equilibrium. This establishes one point on part (d), say
point M. If the rate of interest rises to r1, investment declines to I1. This results in a decline in
national income to Y1. With this level of income the volume of saving becomes S1 (< S0). This
establishes another point on part (d), say point N.
The procedure may be repeated for each level of income (interest) to obtain corresponding
values of interest rate (income value) that ensures equality between saving and investment. By
joining all these equilibrium points, we get an IS curve drawn in part (d).
Thus, the IS curve shows various combinations of income and interest rate that brings
commodity market in equilibrium. The IS curve is negatively sloped. Its slope depends on the
nature of saving and investment functions. The IS curve may shift if there is a change in
autonomous consumption, private investment and government expenditure and taxes.
Autonomous increase in consumption demand, private investment expenditure and government

spending cause IS schedule to shift to the rightward direction while an autonomous increase in
taxes causes a leftward shift of the IS schedule. However, an equal increase in both taxes and
government spending leads to a rightward shift of the IS curve.

C. Properties of IS Curve: Summary
(i) The IS curve is the equilibrium combinations of income and interest rate such that the
product market or goods market is in equilibrium.
(ii) The IS curve slopes downward to the right because an increase in interest rate causes
investment expenditure to decline, therefore, reduces aggregate demand and, hence,
equilibrium national income.
(iii) Its slope depends on the saving and investment functions. The IS curve will be relatively
steep (flat) if investment is less (more) sensitive to interest rate changes.
(iv) This IS curve will shift by an autonomous change in investment spending or government
spending.
D. Shifts in IS Curve
The purpose of IS curve is to explain the effect of changes in interest rate alone on the aggregate
demand and the equilibrium income level. Changes in other factors that would shift the
aggregate demand will shift the IS curve. Thus, an increase in autonomous
spending, for instance an increase in government expenditure, will shift the IS curve to the
right, while a decrease in autonomous spending shifts the IS curve to the left. This is shown in
the figure below.
The initial IS curve is ISo If there is an increase in autonomous spending IS curve shifts right
to IS1. This means that for each level of interest there is a higher real income consistent with
equilibrium in the goods market. Conversely, if there is a fall in autonomous
spending IS curve shifts left to IS2.

E. Factors Responsible for Change in Autonomous Spending
The factors responsible for change in the autonomous spending and therefore, shift in IS
curve are:
1. Change in Government Spending: An increase in government spending given other

factors, will shift the IS curve to the right, while a decrease in government spending shift the
IS curve to the left.
2. Change in Taxes: An increase in taxes will shift the IS curve to the left, while a decrease
in taxes shift the IS curve to the right.
3. Autonomous Change in Investment: An increase in autonomous investment will shift the

IS curve to the right, while a decrease in autonomous investment will shift the IS curve to the
left.
II. Money Market Equilibrium

A. The LM Curve
Equilibrium in the money market occurs at that point where money demand equals money
supply. In the Keynesian system, money demand for transaction purposes depends on the level
of income and money demand for speculative purposes depends on the rate of interest.
B. Derivation of the LM Curve
The money demand function, denoted by Md, can be expressed as:
Md = f(Y, r) … (1)
Supply of money (M) is institutionally given. Given M , corresponding to each level of income
there is a rate of interest which produces equilibrium in the money market. Money market
equilibrium occurs when
M = Md … (2)
A four-part diagram may be used to derive the LM curve. In the figure below, part (a) shows a
proportional relationship between money income and transaction demand for money (Mt=
kPY). Part (c) represents speculative demand for money [MS = f(r)]. The schedule in (b) is an
identity line that mechanically divides money supply into transaction and speculative elements.
Part (d) represents the LM curve.

Suppose, the rate of interest, r0, is known. Given r0, the volume of speculative demand for
money is MS0. Given the total money supply (M), money not used for speculative purposes
must be held for meeting transaction demand for money. Thus, the transaction demand for
money must be M10. To ensure this transaction demand for money there must be a level of
income Y0. Thus, we see in part (d), for interest rate r0 the only possible money market
equilibrium value for income is Y0.
If the rate of interest declines to r1, the equilibrium level of income will be Y1. The procedure
can be repeated such that equilibrium combinations of r and Y emerge to ensure equality in the
money market. By joining all these combinations (such as, M and N), we get the LM curve
drawn in part (d). Note that, at a floor interest rate, rmin, money demand becomes infinitely
elastic. This makes speculative demand for money (shown in part c) to become horizontal at
the minimum rate of interest. Because of this liquidity trap, the LM curve also becomes
perfectly elastic. Anyway, the LM curve slopes upward from left to right.
C. Properties of the LM Curve: Summary
(i) The LM curve consists of equilibrium combinations of income and interest rate for the
money market.
(ii) The LM curve slopes upward to the right.

(iii) The slope of the LM curve depends on the interest elasticity of money demand. The LM
curve will be (flat) steep if the interest-elasticity of money demand is relatively (low) high.
(iv) The LM curve shifts due to changes in money supply and money demand.
D. Shift in the LM Curve
The LM curve is constructed for a given supply of money. An increase in the money supply
will shift the LM curve right to LM1, while a decrease in the money supply will shift the LM
curve left to LM2. This is shown in Fig below.
III. The equilibrium in the goods and money markets

The simultaneous determination of equilibrium in the goods and money markets is shown in
the figure below.

The goods market is in equilibrium at all points on the IS curve and the money market is in
equilibrium at all points on the LM curve. At the point E, both the goods and money markets
are in equilibrium. The goods and money markets interact to determine the equilibrium rate of
interest i0 and the equilibrium level of income Y0 at which both these markets are cleared.
The IS - LM model, which is explained above, is very helpful for studying the effects of
monetary and fiscal policies on income and the interest rate. An expansionary monetary policy
will shift the LM curve to the right, while an expansionary fiscal policy will shift the IS curve
to, the right. The IS-LM model is very helpful to analyse the effectiveness of both monetary
and fiscal policies in the economy.
**************

MODULE IV
Inflation
I. Introduction 2
II. Concepts of inflation 2
1. Single digit and double-digit inflation 2
2. Headline and core inflation 2
3. Food inflation 3
4. Retail inflation 3
III. Causes of inflation 3
(a) Demand-Pull inflation 3
(b) Cost-Push Inflation 5
IV. Effects of Inflation 6
1. Effects on Distribution of Income and Wealth 6
2. Effects on Production 7
3. Effects on Income and Employment 8
4. Effects on Business and Trade 8
5. Effects on the Government Finance 8
6. Effects on Growth 8
V. Measures to control Inflation 8
(a) Quantitative credit controls 8
(b) Qualitative measures 10
(c) Fiscal Measures 10

I. Introduction
Inflation refers to the rise in the prices of most goods and services of daily or common use,
such as food, clothing, housing, recreation, transport, consumer staples, etc. Inflation measures
the average price change in a basket of commodities and services over time.
When the general price level rises, each unit of currency buys fewer goods and services;
consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss
of real value in the medium of exchange and unit of account within the economy.
According to G. Crowther (British economist) “inflation is a state in which the value of money
is falling i.e prices rising”.
II. Concepts of inflation
1. Single digit and double-digit inflation

It is now common to express the inflation in digital form. Single digit inflation (0.01-9.99%
per year) has become almost a normal feature in the recent decades. People and authorities
become concerned when double-digit (10% and above per year) inflation occurs. In the
traditional sense it is running inflation and therefore viewed seriously. Samuelson terms the
single digit inflation as moderate inflation.
2. Headline and core inflation
Headline Inflation: Headline or Top-line inflation is a measure of total inflation within the
economy. Headline inflation is measured on the basis of wholesale price index (WPI). It is the
current rate of inflation, at which prices are rising now. It is affected by the sudden changes in
prices of food and energy products. However, it may not present an accurate picture of the
current state of economy as it does not take into account of prices of services provided by
service sector. For the typical household, the total or headline rate of inflation is what matters.
It measures the rate at which the cost of living is rising It is headline inflation relative to income
growth that determines whether a household's standard of living is rising or falling.
Core inflation: It is a measure of inflation which excludes transitory or temporary price

volatility as in the case of commodities like food items and energy products. Core inflation (CI)
is equal to Headline Inflation (HL) minus food and fuel price (FF), i.e.
CI = HL- FF
Food and energy prices are sometimes extremely volatile from month to month due to
temporary supply disruptions related to weather or political crises. In those instances, the

headline rate of inflation, which includes the volatile food and energy price components, tends
to be less representative of the underlying rate of inflation.
3. Food inflation
Food inflation is calculated based on prices of food articles in the primary articles group and
manufactured food products in the manufactured product group. From the primary articles
group the important items included are (i) rice, (ii) wheat, (iii) pulses, (iv) vegetables, (v)
potatoes, (vi) onions, (vii) fruits, (vii) milk, (ix) eggs, meat, fish. Under manufactured food
products the main items included are tea, sugar, gur and oil cakes.
4. Retail inflation
Retail price inflation is measured on the basis of consumer price index. It measures price
changes from the perspective of the retail buyer. It is the real index for the common people.
Retail inflation reflects the actual inflation borne by an individual consumer, since it is designed
to measure changes over time in the level of retail prices of selected goods and services on
which consumers of a defined group spend their income. Accordingly, we have consumer price
index for urban, rural and also for labourers of different sectors. The new indices are being
constructed for state, union territories and for All India level.
III. Causes of inflation
We are, by now, familiar with the meaning, concepts, measurement and other related aspects
of inflation. In this section we will discuss the causes of inflation. They can broadly be
classified as demand pull and cost push factors.
(a) Demand-Pull inflation
1. Increase in Money Supply: When the monetary authorities increase the money supply in
excess of the supply of goods and services it results in additional demand and consequent
increase in price level. As Milton Friedman put it "Inflation is always and everywhere a
monetary phenomenon".
2. Deficit Finance: An increase in money supply also takes place when the government resorts
to deficit financing to incur the public expenditure. Deficit financing undertaken for
unproductive investment or expenditure becomes purely inflationary. Even when it is used on
productive activities, prices would still increase during the gestation period.

3. Credit Creation: Commercial banks increase the quantity of money in circulation when
they advance loans through credit creation. Credit creation is similar to that of deficit financing
in its effects.
4. Exports: Exports reduce the goods available in the domestic market. Export earnings
enhance the purchasing power of the exporters and others linked with export. An increase in
exports would aggravate the situation by reducing the supply of goods and at the same time
pushing up the demand because of additional income.
5. Repayment of Public Debt: Public debt is a common feature of modern governments. When
such debts are repaid, people will have more income at their disposal. Additional disposable
income tends to raise the demand for goods and services.
6. Black Money: Social and economic evils like corruption, tax evasion, smuggling and other
illegal activities give rise to unaccounted (for tax payment) or black money. People with black
money indulge in extravaganza, affecting demand and thus the price level.
7. Increase in Population: The size of the population is one of the important determinants of
demand. In many developing countries the population is large in size and still increasing. India
provides an example where demand outstrips supply due to the large and increasing population.
Price
AS
AS
P4 D
P3 C
P2 B
AD4
P1 A
AD3
AD2
AD1
0 Y1 Y2 Y3 Y4 Output
The diagram explains an increase in price level due to demand pull. AS is the supply curve.
𝑂𝑃# , is the price determined by the interaction of demand curve -(𝐴𝐷# ,) and supply curve (AS).
Demand curve shifts from 𝐴𝐷# , to 𝐴𝐷& … . 𝐴𝐷) . Accordingly, the price level increases from 𝑃#
to 𝑃& ....𝑃) Supply responds to an increase in demand up to 𝑌) . Shift in demand from 𝐴𝐷# to

𝐴𝐷) results in increase in price as well as supply. However additional supply is not enough
specially after 𝑌+ , Or point C to prevent the prices from rising.
(b) Cost-Push Inflation
Inflation need not necessarily be due to an increase in demand. Prices may increase even when
demand does not increase. It is also possible that prices may increase even when an economy
experiences a decline in demand. Here the main cause is an increase in cost.
Increase in the prices of inputs including labour, increase in profit margin by the business firms
and monopsony in factor market may push up prices as they are in position to influence the
supply price Supply shocks such as decline in food grain supply due to monsoon failure, oil
crisis experienced in 1970s and thereafter due to crude oil cartel (OPEC), shortages due to
natural calamities may affect the cost of supply. Under the above circumstances, same quantity
of goods and services or even the reduced quantity is supplied at a higher price due to increase
in cost. Supply curves shifts to the left, with a new equilibrium with higher price.
The important cost push factors are:

1. Increase in Wages: When prices increase due to increase in wages it is called wage push
inflation. Wages are influenced by many factors besides the demand and supply forces. Trade
unions play an important role in deciding the wage rate. Strong and powerful trade unions
succeed in securing higher wages for their members. Higher wages granted in the organised
sector influence the wage rate in the unorganised sector too, resulting in an increase in cost
everywhere. Every increase in wages however need not be cost increasing. Higher wages
granted on the strength of increased productivity or of higher profits earned by the industries
do not affect the cost. The burden of higher wages is usually shifted forward on the consumers
in the form of higher prices unless the demand is highly elastic.
2. Increase in Material Cost: Prices of materials used in producing goods constitute a
significant part of the cost. Prices of the materials may increase either due to an increase in
demand for these materials or independently owing to national and international developments.
Increase in crude oil price till recently is an example in this context. When the prices of basic
inputs like energy, cement, steel, etc. increase, the effect is felt throughout the economy. An
increase in the prices of materials especially the basic inputs alters the cost structure of all
goods and services. Higher cost of production leads to upward revision of final prices. Our
experience of the last two decades tells us that the prices of almost all materials have gone up
either due to market forces or administrative decisions. Increase in material cost thus has
become one of the important factors responsible for continuous upward movement of price
level.
3. Increase in Profit Margin: Firms operating under oligopoly or enjoying monopoly power
(petroleum firms in public sector) may have 'administered prices with higher profit margin.
Such administered prices though imposed by few firms, have their impact on other firms too.
While firms enjoying some monopoly power will find easy to increase prices, others will be

compelled to raise their prices due to higher material cost as a result of initial spurt in
administered prices. The desire to have higher profit margins by all those who have the power
to do so becomes the cause for inflationary trend.
4. Other Factors: Cost of production may increase when input prices go up due to scarcity
natural or artificial. Natural calamities like draught or floods adversely affect the supplies of
raw materials thus making them dearer. Firms operating with excess capacity either because of
monopolistic competitive market or any other reasons, produce at a higher cost.
Price
AS3
AS2
P3 AS1
P2
P1
AD
Output
Y3 Y2 Y1
In the above diagram, initial price 𝑂𝑃# , is determined by the interaction of demand (AD) and
supply (𝐴𝑆# ) at point A, the output level 𝑌# , which we may assume as full employment output.
Supply curve shifts up to the left because of the increase in cost. The new supply curve 𝐴𝑆& ,
intersects the demand curve at point B, establishing a new but higher price- 𝑃& . As the supply
curve shifts further, price increases and output decreases. The increase in price is mainly due
to cost-push factors.
IV. Effects of Inflation

1. Effects on Distribution of Income and Wealth
The impact of inflation is felt unevenly by the different groups of individuals within the
national economy—some groups of people gain by making big fortune and some others lose.

We may now explain in detail the effects of inflation on different groups of people:
(a) Creditors and debtors
During inflation creditors lose because they receive in effect less in goods and services than if
they had received the repayments during a period of low prices. Debtors, on other hand, as a
group gain during inflation, since they repay their debts in currency that has lost its value (i.e.,
the same currency unit will now buy less goods and services).
(b) Producers and workers
Producers gain because they get higher prices and thus more profits from the sale of their
products. As the rise in prices is usually higher than the increase in costs, producers can earn
more during inflation. But, workers lose as they find a fall in their real wages as their money
wages do not usually rise proportionately with the increase in prices. They, as a class, however,
gain because they get more employment during inflation.
(c) Fixed income-earners
Fixed income-earners like the salaried people, rent-earners, landlords, pensioners, etc., suffer
greatly because inflation reduces the value of their earnings.
(d) Investors
The investors in equity shares gain as they get dividends at higher rates because of larger
corporate profits and as they find the value of their shareholdings appreciated. But the
bondholders lose as they get a fixed interest the real value of which has already fallen.
(e) Traders, speculators, businesspeople and black-marketers
They gain because they make more profits from the persistent rise in prices.
(f) Farmers
Farmers also gain because the rise in the prices of agricultural products is usually higher than
the increase in the prices of other goods.
Thus, inflation brings a shift in the pattern of distribution of income and wealth in the country,
usually making the rich richer and the poor poorer. Thus, during inflation there is more and
more inequality in the distribution of income.
2. Effects on Production
The rising prices stimulate the production of all goods—both of consumption and of capital
goods. As producers get more and more profit, they try to produce more and more by utilising
all the available resources at their disposal.
But, after the stage of full employment the production cannot increase as all the resources are
fully employed. Moreover, the producers and the farmers would increase their stock in the
expectation of a further rise in prices. As a result hoarding and cornering of commodities will
increase.

But such favourable effects of inflation upon production are not always found. Sometimes,
production may come to a standstill position despite rising prices, as was found in recent years
in developing countries like India, Thailand and Bangladesh. This situation is described as
stagflation.
3. Effects on Income and Employment

Inflation tends to increase the aggregate money income (i.e., national income) of the
community as a whole on account of larger spending and greater production. Similarly, the
volume of employment increases under the impact of increased production. But the real income
of the people fails to increase proportionately due to a fall in the purchasing power of money.
4. Effects on Business and Trade

The aggregate volume of internal trade tends to increase during inflation due to higher incomes,
greater production and larger spending. But the export trade is likely to suffer on account of a
rise in the prices of domestic goods. However, the business firms expand their businesses to
make larger profits.
During most inflation since costs do not rise as fast as prices profits soar. But wages do not
increase proportionate with prices, causing hardships to workers and making more and more
inequality. As the old saying goes, during inflation prices move in escalator and wages in stairs.
5. Effects on the Government Finance

During inflation, the government revenue increases as it gets more revenue from income tax,
sales tax, excise duties, etc. Similarly, public expenditure increases as the government is
required to spend more and more for administrative and other purposes. But the rising prices
reduce the real burden of public debt because a fix sum has to be paid in instalment per period.
6. Effects on Growth
A mild inflation promotes economic growth, but a runaway inflation obstructs economic
growth as it raises cost of development projects. Although a mild dose of inflation is inevitable
and desirable in a developing economy, a high rate of inflation tends to lower the growth rate
by slowing down the rate of capital formation and creating uncertainty.
V. Measures to control Inflation

In India, the legal framework of RBI’s control over the credit structure has been provided Under
Reserve Bank of India Act, 1934 and the Banking Regulation Act, 1949. are used to maintain
proper quantity of credit of money supply in market.
(a) Quantitative credit controls

1. Bank Rate Policy
Bank rate is the rate at which the Central bank lends money to the commercial banks for their
liquidity requirements. Bank rate is also called discount rate. In other words, bank rate is the
rate at which the central bank rediscounts eligible papers (like approved securities, bills of

exchange, commercial papers etc) held by commercial banks. Bank rate is important because
it is the pace setter to other market rates of interest. Bank rates have been changed several times
by RBI to control inflation and recession.
2. Open market operations
It refers to buying and selling of government securities in open market in order to expand or
contract the amount of money in the banking system. This technique is superior to bank rate
policy. Purchases inject money into the banking system while sale of securities do the opposite.
During last two decades the RBI has been undertaking switch operations. These involve the
purchase of one loan against the sale of another or, vice-versa. This policy aims at preventing
unrestricted increase in liquidity.
3. Cash Reserve Ratio (CRR)
The Cash Reserve Ratio (CRR) is an effective instrument of credit control. Under the RBl Act
of, l934 every commercial bank has to keep certain minimum cash reserves with RBI. The RBI
is empowered to vary the CRR between 3% and 15%. A high CRR reduces the cash for lending
and a low CRR increases the cash for lending. The CRR has been brought down from 15% in
1991 to 7.5% in May 2001. It further reduced to 5.5% in December 2001. It stood at 5% on
January 2009. In January 2010, RBI increased the CRR from 5% to 5.75%. It further increased
in April 2010 to 6% as inflationary pressures had started building up in the economy.
4. Statutory Liquidity Ratio (SLR)

Under SLR, the government has imposed an obligation on the banks to; maintain a certain ratio
to its total deposits with RBI in the form of liquid assets like cash, gold and other securities.
The RBI has power to fix SLR in the range of 25% and 40% between 1990 and 1992 SLR was
as high as 38.5%. Narasimham Committee did not favour maintenance of high SLR. The SLR
was lowered down to 25% from 10th October 1997. It was further reduced to 24% on
November 2008.
5. Credit Control Function
Commercial bank in the country creates credit according to the demand in the economy. But if
this credit creation is unchecked or unregulated then it leads the economy into inflationary
cycles. On the other credit creation is below the required limit then it harms the growth of the
economy. As a central bank of the nation the RBI has to look for growth with price stability.
Thus, it regulates the credit creation capacity of commercial banks by using various credit
control tools.
6. Repo and Reverse Repo Rates
In determining interest rate trends, the repo and reverse repo rates are becoming important.
Repo means Sale and Repurchase Agreement. Repo is a swap deal involving the immediate
Sale of Securities and simultaneous purchase of those securities at a future date, at a
predetermined price. Repo rate helps commercial banks to acquire funds from RBI by selling
securities and also agreeing to repurchase at a later date.

Reverse repo rate is the rate that banks get from RBI for parking their short-term excess funds
with RBI. Repo and reverse repo operations are used by RBI in its Liquidity Adjustment
Facility. RBI contracts credit by increasing the repo and reverse repo rates and by decreasing
them it expands credit. Repo rate was 6.75% in March 2011 and Reverse repo rate was 5.75%
for the same period. On May 2011 RBI announced Monetary Policy for 2011-12. To reduce
inflation, it hiked repo rate to 7.25% and Reverse repo to 6.25% w.e.f 03/05/2013
(b) Qualitative measures

1. Ceiling on Credit
The Ceiling on level of credit restricts the lending capacity of a bank to grant advances against
certain controlled securities.
2. Margin Requirements
A loan is sanctioned against Collateral Security. Margin means that proportion of the value of
security against which loan is not given. Margin against a particular security is reduced or
increased in order to encourage or to discourage the flow of credit to a particular sector. It
varies from 20% to 80%. For agricultural commodities it is as high as 75%. Higher the margin
lesser will be the loan sanctioned.
3. Discriminatory Interest Rate (DIR)
Through DIR, RBI makes credit flow to certain priority or weaker sectors by charging
concessional rates of interest. RBI issues supplementary instructions regarding granting of
additional credit against sensitive commodities, issue of guarantees, making advances etc.
4. Directives
The RBI issues directives to banks regarding advances. Directives are regarding the purpose
for which loans may or may not be given.
5. Direct Action
It is too severe and is therefore rarely followed. It may involve refusal by RBI to rediscount
bills or cancellation of license, if the bank has failed to comply with the directives of RBI.
6. Moral Suasion
Under Moral Suasion, RBI issues periodical letters to bank to exercise control over credit in
general or advances against particular commodities. Periodic discussions are held with
authorities of commercial banks in this respect.
(c) Fiscal Measures

Fiscal measures to control inflation include taxation, government expenditure and public
borrowings. The choice of fiscal measures for controlling inflation depends on the causes of
excess demand as follows-
i. Government expenditure: When excess demand is caused by the government
expenditure in excess of real output, the most effective measure is to cut down on the

public expenditure. A cut in the public expenditure reduces not only the government’s
demand for goods and services but also private consumption expenditure. Therefore,
the excess demand decreases more than a given cut in the public expenditure.
ii. Taxation: When excess demand is caused by private expenditure such as the
expenditure by the households and firms, taxation of income is a more appropriate
measure to control inflation. Taxation of income reduces the disposable income. As
consumer demand is a function of disposable income, consumer demand decreases due
to taxation. Thus, a well-designed taxation policy reduces aggregate demand and
thereby brings the inflation under control.
iii. Public borrowing: Borrowings by the government to fund budget deficits uses idle
money lying with banks and financial institutions for productive functions by investing
it. When the Government borrows money from the market, it reduces the purchasing
power of the public.
****************

Nature of Inflation in a Developing Economy
Table of Contents:
A. Introduction ............................................................................................................. 1
B. Causes of Inflation................................................................................................... 1
(i) Factors causing Demand – Pull inflation .............................................................. 1
(ii) Factors causing Cost Push inflation ....................................................................... 2
(A) Tools for inflation targeting .............................................................................. 3
(B) Benefits ............................................................................................................ 4
(C) Drawbacks........................................................................................................ 4
(D) Effectiveness of the tools of inflation targeting ................................................. 4
A. Introduction
Developing countries are mostly agrarian countries with a large population compared to the
resources, low per capita income and are less industrialised. These countries suffer from
unemployment and social backwardness. Developing countries put in efforts for developments
however they are confronted with many problems inflation being one of them.
In developing countries both demand pull and cost push factors are responsible for inflation
though at times one of them may exert more influence than the other. It is a by-product of the
development process.
B. Causes of Inflation
(i) Factors causing Demand – Pull inflation
1. Increase in Income – As the economy develops, per capita income increases leading to an
additional demand which causes increase in propensity to consume thus leading to inflation.
2. Huge expenditure- The Government incurs huge investment to promote growth, which
injects more money in the economy, causing more demand.
3.Gestation period- Development projects have long gestation periods (time gap between
investment and output) which results in more money in circulation than available goods and
services
4. Increasing population- More population leads to more demand for demand for goods and
services, specially for essential items.
5.Unproductive expenditure- Resources are wasted with huge amounts spent on public
administration. Most of the poor countries spend unwarranted expenditure on Royal

administration with VIP culture based on their feudal background which result in wasteful
expenditure with no corresponding increase in useful goods and services.
6. Foreign Aid- Developing countries depend on foreign aid, especially for implementing
many of their projects. When foreign aid flows in, domestic money supply increases as the
foreign exchange requires has to be converted into the domestic currency.
(ii) Factors causing Cost Push inflation

1.Backward agricultural sector: agricultural is undergoing a transformation yet it has
symptoms of backwardness hence it does not respond sufficiently to a change in demand.
2.Supply shocks: Most of the developing countries depend on imports from advanced
countries for their capital goods, raw materials and other intermediate goods. For example: the
petroleum price crisis of 1970s. An increase in input prices make supply costlier.
3.Structural rigidities: In UDC, like market rigidities, there are policy restrictions in most of
the sectors which require structural reforms. In the absence of such changes cost of investment
increases.
4.Change in exchange rate: To promote exports and earn more foreign exchange, developing
countries encourage depreciation of their currencies or devalue them, making imports costlier.
5.Increase in in wages: As the price level increases, labourers through trade unions demand
higher wages, which lead to higher wages, which lead to higher prices. It is termed wage –
price spiral inflation. Increase in wags leads to increase in prices which leads to a demand for
more wages resulting in wage push inflation.
6.Infrastructure Bottleneck: Poor infrastructural facilities such as road, transport, energy,

irrigation, communication etc. reduce production and supply. Cost of production rises due to
high cost for these services.
7.Inefficient public sectors: In developing countries, governments play an active role in

promoting development through public sector undertaking. Unfortunately many of them
perform poorly and incur heavy losses. Example: Air India in India. More money is spent to
support such enterprises leading to higher cost and additional money supply.
In developing countries the development process itself leads to interaction of demand pull and
cost push factors. Structural rigidities including rigid government policies aggravate the
situation. Due to above factors, developing countries experience double digit inflation.
(ii) Monetary policy and inflation targeting
A central bank seeks to readjust its monetary policy by doing inflation targeting. This is done
by raising or lowering interest rates based on above-target or below-target inflation,

respectively. The conventional wisdom is that raising interest rates usually cools the economy
to rein in inflation; lowering interest rates usually accelerates the economy, thereby boosting
inflation. The first three countries to implement full-fledged inflation targeting were New
Zealand, Canada and the United Kingdom in the early 1990s, although Germany had adopted
many elements of inflation targeting earlier. Inflation targeting is a monetary policy strategy
used by Central Banks for maintaining price level at a certain level or within a range. It
indicates the primacy of price stability as the key objective of monetary policy.
Inflation targeting involves the following elements:
1. Public announcement of medium-term numerical targets for inflation.

2. Institutional commitment to price stability as the primary goal of policy.
3. And information of valuables used.
4. Increased transparency of monetary policy strategy.
5. Increased accountability of central-bank object to attain its inflation objective.
For the success of inflation targeting the following conditions need to be fulfilled:
1. Central banks independence to conduct the monetary policy. The central bank of the
country must enjoy sufficient autonomy in order to take objective decisions.
2. Fiscal policy of the government should not dominate monetary policy.
The argument for price stability stems from the fact that rising prices create uncertainties in
decision making, adversely affecting savings and encouraging speculative investments.
Inflation targeting brings in more predictability and transparency in deciding monetary policy.
Various advanced economies including United States, Canada and Australia have been using
inflation targeting as a strategy in their monetary policy framework. India adopted inflation
targeting based on Urjit Patel Committee Report. Under this RBI would aim to contain
consumer price inflation within 4 percent with a band of (+/-) 2 percent.
(A) Tools for inflation targeting
1. Liquidity Adjustment Facility- With this RBI controls the money supply in the
economy. These interest rates and inflation rates tend to move in opposite directions.
2. Open Market Operations- RBI buys or sells short-term securities in the open market,
thus impacting money available with the public.
3. Variable Reserve Requirement- Cash Reserve Ratio (CLR) and the Statutory
Liquidity Ratio (SLR) are increased or decreased in accordance with inflation or
deflation respectively.
4. Bank rate- It is the rate at which RBI lends money to commercial banks without any
security. When bank rate is increased interest rate also increases leading to inflation.
5. Moral Suasion- If there is a need RBI can urge the banks to exercise credit control at
times to maintain the balance of funds in the market.

(B) Benefits
1. Inflation targeting allows monetary policy to “focus on domestic considerations and to

respond to shocks to the domestic economy”, which is not possible under a fixed-
exchange-rate system.
2. Transparency is another key benefit of inflation targeting. Central banks in developed
countries that have successfully implemented inflation targeting tend to “maintain
regular channels of communication with the public”.
3. An explicit numerical inflation target increases a central bank’s accountability, and thus
it is less likely that the central bank falls prey to the time-inconsistency trap. This
accountability is especially significant because even countries with weak institutions
can build public support for an independent central bank.
(C) Drawbacks
1. There is a propensity of inflation targeting to neglect output shocks by focusing solely

on the price level.
2. Leading economists argue that inflation targeting would maintain or enhance the
transparency associated with a system based on stated targets, while restoring the
balance missing from a monetary policy based solely on the goal of price stability, thus
neglecting other factors of an economy as well.
(D) Effectiveness of the tools of inflation targeting
1. Inflation contained- For the last year, inflation remained in the desired bracket of 4%,
giving good real returns to the people.
2. Impact on growth- Though inflation was within limits, but the growth could not be
spurred because of the mandate of RBI to stay within the target.
3. Better prediction and stability- With each monetary policy review, RBI provides a
‘neutral’, ‘accommodative’, or ‘calibrated tightening’ stance giving an indication to
businesses and banks about the trends in future interest rates.
Inflation targeting thus had success in controlling inflation through monetary policy. However,
growth suffered due to this, thus it’s advisable to not look at just one indicator, rather at multiple
indicators and making financial stability as the underlying theme.
**************

Short run trade-off between inflation and unemployment
Table of Content:
Introduction 1
Derivation of Phillips Curve from AS Curve 2
Causes of Shift in Phillips Curve 3
Long Run Phillips Curve 4
Relationship between Short and Long Run Phillips Curve 5
Introduction
Economic growth without inflation and unemployment is the objective behind macro-economic
policies of modern times. However, in the short term, there is a trade-off between inflation and
unemployment and hence macro-economic policy makers need to balance between inflation,
economic growth and unemployment. A low inflation rate is seen to accompany lower economic
growth rate and higher unemployment whereas a high inflation rate is seen to accompany higher
economic growth rate and lower unemployment.
In 1958, AW Phillips, a professor at the London School of Economics published a study of wage
behavior in the United Kingdom for the years 1861 and 1957. Phillips found an inverse
relationship between the rate of unemployment and the rate of inflation or the rate of increase in
money wages. The higher the rate of unemployment, the lower the rate of wage inflation i.e. there
is a trade-off between wage inflation and unemployment. The Phillips curve shows that the rate
of wage inflation decreases with the increase in unemployment rate.
Such a Phillips curve is depicted in the figure below. When the rate of inflation is ten per cent, the
unemployment rate is three per cent and when the rate of inflation is five per cent, the rate of
unemployment increases to eight per cent. Empirical or objective data collected from other
developed countries also proved the existence of Phillips Curve. Economists believed that there
existed a stable Phillips Curve depicting a trade-off between unemployment and inflation. This
trade-off presented a dilemma to policy makers. The dilemma was a choice between two evils,
namely: unemployment and inflation. In a dilemma, you chose a lesser evil and inflation is a lesser
evil for policy makers. A little more inflation can always be traded off for a little more
employment. However, further empirical data obtained in the 70s and early 80s proved the non-
existence of Phillips Curve. During this period, both Britain and the USA experienced
simultaneous existence of high inflation and high unemployment. While prices rose rapidly, the
economy contracted along with more and more unemployment.

Derivation of Phillips Curve from AS Curve

The explanation of Phillips curve by the Keynesian economists is shown in the figure below.
Keynesian economists assume the upward sloping aggregate supply curve. The AS curve slopes
upward due to two reasons.
Firstly, as output is increased in the economy, the law of diminishing marginal returns begins to
operate and the marginal physical product of labor (MPPL) begins to decline. Since the money
wages are fixed, a fall in the MPPL leads to a rise in the marginal cost of production because MC
= W/ MPPL.
Secondly, the marginal cost goes up due to a rise in the wage rate as employment and output are
increased. Following rise in aggregate demand, demand for labor increases and hence the wage
rate also increases. As more and more labor is employed, the wage rate continues to rise and the
marginal cost of firms increases. In the left Panel of the figure, with the initial aggregate demand
curve AD0 and the given aggregate supply curve AS0, the price level P0 and output level Y0 are
determined. When the aggregate demand increases, the AD0 curve shifts to the right and the new
aggregate demand curve AD1 intersects the aggregate supply curve at point ‘b’. Accordingly, a
higher price level P1 is determined along with a rise in GNP to Y1 level. With the increase in the
real GNP, the rate of unemployment falls to U2. Thus, the rise in the price level or the inflation
rate from P0 to P1, the unemployment rate falls thereby depicting an inverse relationship between
the price level and the unemployment rate. Now when the aggregate demand further increases,

the AD curve shifts to the right to become AD2. The new aggregate demand curve AD2 intersects
the aggregate supply curve at point ‘c’. Accordingly, the price level P2 and output level Y2 is
determined. The level of unemployment now falls to U3. In the right Panel of the figure, points
a, b and c are plotted and these points correspond to the three-equilibrium points a, b and c on the
left side of the Panel of the figure. Thus, a higher rate of increase in aggregate demand and a
higher rate of rise in price level are related with the lower rate of unemployment and vice versa.
The Keynesian economists were thus able to explain the downward sloping Phillips curve showing
inverse relation between rates of inflation and unemployment.
Causes of Shift in Phillips Curve

The shifts in the Phillips curve according to Keynesians is due to adverse supply shocks
experienced in the seventies in the form of unprecedented oil price hikes. Adverse supply shocks
gave rise to the phenomenon of Stagflation and the breakdown of the Phillips curve hypothesis.
The impact of adverse supply shocks on national product and the price level is depicted in the
figure below. The original aggregate demand and supply curves AD0 and AS0 are in equilibrium
at point E0. Accordingly, the price level P0 and national output Y0 is determined.
The oil price hike initiated by the Oil and Petroleum Exporting Countries (OPEC) an oil cartel of
oil producing Middle East countries contributed to the rise in cost of production of many goods
and services in which oil is used as an input. Increase in the cost of production caused the
aggregate supply curve to shift to the left in the upward direction, thereby causing the price level

to rise along with a decrease in national output. The new aggregate supply curve AS1 in the figure
below now intersects the aggregate demand curve AD0 at point E1 and accordingly the new price
level P1 is determined. However, at a higher price level P1, the national output has fallen to Y1
leading to rise in unemployment. Such a situation is explained in terms of stagflation where in
both unemployment and price level increases. This new phenomenon experienced, particularly by
the United States in the seventies and thereafter has caused the shift in the Phillips curve.
Stagflation, thus, consigned the Phillips curve hypothesis to the pages of economic history.
Long Run Phillips Curve

The Long Run Phillips Curve was devised after in the 1970s, the unemployment rate and inflation
rate were both rising (this came to be known as stagnation). Economists Ed Phelps and Milton
Friedman claimed that the Phillips Curve trade-off only existed in the short run, and in the long
run, the Phillips curve becomes vertical. The Long Run Phillips Curve is the vertical line at the
natural rate of unemployment, where the rate of inflation does not affect unemployment.

If the government tries to lower unemployment below the Natural Rate of Unemployment (NRU),
then they will succeed in the short run at the cost of increasing inflation permanently.
The tradeoff between unemployment and inflation works in the short run because of ‘money
illusion,’ where workers are slow to anticipate the inflation in the next year. Say the current
inflation rate is 3% and the natural rate of unemployment is 5%, so in the short run when the
government tries to reduce the unemployment rate to 4%, the inflation rate increases to 5%. Firms
hire more workers during the expansionary policies, however, workers don’t realize that the
inflation rate is 5% and not 3%, and when they demand higher wages firms have to fire extra
workers, so unemployment returns back to 5%.
Relationship between Short and Long Run Phillips Curve

The position of the short run Phillips curve passing through a long run Phillips curve is determined
by the anticipated or expected inflation rate. The short run Phillips curve can be compared to the
short run aggregate supply curve because both the curves are drawn with a given expected price
level. The short run Phillips curve drawn with an expected inflation rate shifts its position as the
inflation rate changes (See figure). If the expected inflation rate is six per cent, the short run
Phillips curve (SPC1) also passes through the corresponding point ‘A0’ on the long run Phillips
curve with a natural unemployment rate of six per cent. The movement along a short run Phillips
curve is determined by changes in aggregate demand. When there is an unexpected increase in

aggregate demand, the actual inflation rate is found to be more than the expected inflation rate and
the real national output increases causing the unemployment rate to fall below the natural rate.
The new short run equilibrium is determined at point ‘A1’ which is to the left of the original
equilibrium point.
Conversely, if there is an unexpected decrease in aggregate demand, the actual inflation rate will
fall below the expected rate and the unemployment rate will increase and real national output will
fall. In this case, the movement will be downwards and to the right. The shift in the short run
Phillips curve is caused due to the divergence between actual and expected inflation rates and this
divergence is caused by unexpected changes in monetary and fiscal policies of the government. If
the actual inflation rate is greater than the expected inflation rate, the short run Phillips curve will
shift upward and vice-versa. The distance by which the short run Phillips curve shifts to a new
position is equal to the change in the expected rate of inflation.
******************

Supply-Side Economics
Table of Contents:
I. Introduction ...........................................................................................................1
II. Main Features of Supply-Side Economics ...............................................................2
1. Tax-induced Change in Aggregate Supply ..........................................................2
2. Increasing Growth Rate ......................................................................................3
III. Policy Prescriptions of Supply-Side Economics ......................................................4
1. The Laffer Curve: Tax Rate Vs. Tax Revenue ........................................................4
2. Reduction in Government Spending .......................................................................5
3. Monetary Policy .....................................................................................................5
4. Increased Depreciation ...........................................................................................5
5. Reduction in Welfare Benefits ................................................................................5
6. Reducing Trade Union Power.................................................................................5
7. Deregulation and Privatisation................................................................................5
8. Free Trade and Capital Movements ........................................................................6
IV. Criticisms of Supply-side Economics ......................................................................6
1. Laffer Curve controversy........................................................................................6
2. Tax cuts do not bring high growth rate ...................................................................6
3. Tax cuts do not measure work effort.......................................................................6
4. Tax cuts do not affect target incomes......................................................................6
5. State intervention necessary ...................................................................................7
6. Supply-side policies fail to bring social justice .......................................................7
V. The Laffer Curve........................................................................................................7
Laffer Curve Chart .....................................................................................................8
Tax Cuts Work Best in the Prohibitive Range .................................................................9
I. Introduction
Supply-side economics is a theory that focuses on influencing the supply of labour and goods,
using tax cuts and benefit cuts as incentives to work and produce goods. It was expounded by
the U.S. economist Arthur Laffer and implemented by President Ronald Reagan in the 1980s.
Supporters point to the economic growth of the 1980s as proof of its efficacy while detractors
point to the massive federal deficits and speculation that accompanied that growth.
Supply-side economics is a relatively new term which came into use in the mid-1970s as a
result of the failure of Keynesian demand-side policies in the US economy which led to
stagflation. The term is new but its basic principles are to be found in the works of the classical
economists.
According to J.B. Say, supply creates its own demand. The very act of supplying goods implies
a demand for them. If there is an imbalance between demand and supply, it is corrected
automatically by changes in prices and wages and the economy always tends toward full
employment.
The main emphasis of the classical economists was on economic growth for which they
advocated non-interference with the market mechanism. It was the “invisible hand” which led
to the maximisation of national wealth.

They believed that entrepreneurs, investors and producers were the prime movers on which the
economy depended. It was the increase in the supplies of capital and labour and increase in
their productivities that determined growth. Free trade and capital movements internationally
were instrumental in a faster growth rate of the economy.
II. Main Features of Supply-Side Economics

Modern supply-side Economics lays emphasis on providing all types of economic incentives
to raise aggregate supply in the economy. Incentives to producers are essential to invest,
produce and employ. Similar incentives are to be given to individuals to work and save more.
The government plays a limited role in liberalising markets, reducing taxes and freeing the
labour market. The main objectives of supply-side policies are to keep inflation at a low level,
achieve and maintain full employment and attain faster economic growth. Supply-side
economists suggest the following policy measures in order to achieve these objectives.
1. Tax-induced Change in Aggregate Supply

Supply-siders regard tax cuts as an effective means of raising the growth rate of the economy.
To assess the likely effects of tax reductions, they distinguish between income and substitution
effects of a cut in the marginal rate of income tax.
The substitution effect of a tax cut induces people to work more and have less leisure, and the
income effect causes people to work less and enjoy more leisure. It is only when the substitution
effect of a tax cut is larger than the income effect that there will be an incentive to work more,
thereby leading to reduction in unemployment.
A reduction in personal tax rates increases the incentive of people to work and save more. High
savings reduce short-term interest rates and lead to increased investment and thus to an increase
in the economy’s capital stock. Reduction in marginal tax rates by improving the work effort
of the people also increases their productive capacity and the level of output and employment
in the economy.
Thus, supply-side tax cuts by raising work, effort, saving and investment, increase the supplies
of labour and capital and shift the aggregate supply curve to the right. The effect of a. supply-
side tax cut is illustrated in Fig. 1 where AS is the aggregate supply curve and AD is the given
demand curve.
Real output or GDP is measured along the horizontal axis and the price level on the vertical
axis. AS and AD curves intersect at point T and determine OP price and OQ real output of the
economy. Suppose there is a tax cut both on persons and firms. This increases work effort and
saving on the part of workers and investment by firms.
As a result, supplies of labour and capital increase which shift the aggregate supply curve AS
to the right as AS1. Now the AS1 curve cuts the AD curve at point C. As a result, the price level
falls to OP1 and the real output increases to QQ1 as a result of a tax cut.

Similarly, reduction in corporate tax rates, by giving incentives to the corporate sector in the
form of increasing tax credit for larger investment and providing higher depreciation
allowance, encourage investment. Higher investment leads to the production of more goods
and services per unit of labour and capital.
Supply-siders also advocate an additional tax relief for firms employing researchers because
R&D help in increasing productivity. They also favour reduced estate taxes for small farmers
which will induce them to spend more on inputs so as to increase production.
Further, tax cuts reduce diversions to “shelter” (protected) industries and minimise or eliminate
the need for accountants, investment consultants and tax-lawyers. Moreover, tax reductions
reduce ‘underground’ (black market) activity where exchange is not recorded in the books and
no taxes are paid.
2. Increasing Growth Rate

According to supply-side economists, tax cuts increase the disposable income of the people
who raise additional demand for goods and services. On the other hand, the faster growth in
productivity leads to the production of additional goods and services to match the additional
demand. This leads to balanced growth in the economy without shortages. When the economy
is moving towards balanced growth, the rate of inflation is low. This, in turn, leads to an
increase in the real disposable income of the people which raises consumption, output and
employment.
Low inflation leads to increase in net exports which strengthen the value of national currency
in relation to foreign currencies. The increase in productivity increases the production of more
goods for export, thereby further strengthening the country’s currency.
Thus supply-side economists advocate reduction -in tax rates in order to increase the incentives
to work, save and invest and to get more tax revenue by the government. Increase in investment
leads to an increase in the economy’s capital stock, to increase in productivity, to larger output,
low inflation, high level of employment and high growth rate of the economy.
These policy prescriptions shift the aggregate supply curve of the economy to the right. This is
illustrated in Fig. 2 where AS is the aggregate supply curve and AD is the given aggregate
demand curve. They intersect at point E which is the initial equilibrium point of the economy
with OP price level and OQ real output.

Suppose the supply-side policies increase the total supply of factors like labour and capital due
to tax policies, incentives, etc. They increase real output and shift the AS curve to the right as
AS1. The new equilibrium is at where the AS1 curve cuts the AD curve. Now real output
increases to OQ1 and the price level falls to OP1 thereby increasing the growth rate of the
economy.
III. Policy Prescriptions of Supply-Side Economics
Following are the policy prescriptions of supply-side economics:
1. The Laffer Curve: Tax Rate Vs. Tax Revenue
The most popular aspect of supply-side economics is the Laffer curve named after its originator
Prof. Arthur Laffer. The Laffer curve depicts the relation between tax rate and tax revenue. It
is based on the assumption that a cut in the marginal rate of tax will increase the incentives to
work, save and invest. This tax cut, in turn, will increase the tax revenue. The Laffer curve
shows two extremes of tax rates: a 0% tax rate and a 100% tax rate.
Both yield no tax revenue. If the tax rate is 0%, no revenue will be raised. If the tax rate is
100%, people will have no incentive to work, save and invest at all because the whole income
will go to the government. Thus the tax revenue will again be zero. As the tax rate increases
from 0% to 100%, tax revenue correspondingly rises from zero to some maximum level and
then starts declining to zero. Thus the optimum tax rate is somewhere between the two
extremes.
Figure 3 shows the Laffer curve where the tax rate (0%) is taken on the horizontal axis and the
tax revenue on the vertical axis. As the tax rate is raised above zero, the tax revenue starts
increasing. The Laffer curve is upward sloping. At the relatively low tax rate, it is upward
sloping. At the relatively low tax rate T1, the tax revenue is R1.
As the tax rate rises to T, the tax revenue continues to increase and the curve reaches the peak,
P where the tax revenue R is the maximum. Thereafter, further rise in the tax rate will reduce
revenue to the government. Thus T is the optimum rate of tax.
According to Laffer, “Except for the optimum rate, there are always two tax rates that yield the
same revenue.” In the figure, the revenue R1 at the high tax rate T2 is the same as the revenue
collected at the low tax rate T1. If the government wishes to maximise tax revenue, it will
choose the optimum tax rate T.

An important feature of the Laffer curve is that it has a normal range and a prohibitive range.
The normal range is to the left of the optimum tax rate T and the prohibitive range is to its right.
In the normal range, increases in the tax rate bring more revenue to the government.
But in the prohibitive range, when the tax rate becomes high, it reduces the incentives to work,
save and invest. Consequently, the fall in output more than offsets the rise in tax rate. When
the tax rate reaches 100%, the revenue falls to zero because no one will bother to work.
Thus high tax rate stifles economic growth and results in high unemployment. Therefore, a
reduction in the tax rate will actually increase revenue by encouraging the incentives to work,
save and invest. People not only produce and earn more but also switch money out of low-
yielding “tax shelters” and untaxed “underground” economy into more productive and socially
desirable investment. The result would be higher employment and economic growth leading to
high tax revenue.
2. Reduction in Government Spending

To achieve full employment, low inflation and high growth rate of the economy, the supply-
side economists emphasise reduction in government expenditure accompanied by tax cuts.
They are against monetization of budget deficit which the Keynesians advocate.
But the reduction in government expenditure should be more than or equal to tax cuts so that
savings increase to finance larger investments. This will increase employment, income and
growth rate of the economy.
3. Monetary Policy
Another plank of supply-side policy is to have restrained monetary expansion in order to keep
the inflation rate low.
4. Increased Depreciation
To encourage more investment, supply-siders suggest increased investment allowance and/or
higher depreciation on buildings, machines vehicles, and other capital goods.
5. Reduction in Welfare Benefits

To reduce unemployment, supply-side economists emphasise reduction in welfare benefits,
especially unemployment allowance. This will encourage workers to accept jobs at lower
wages, thereby reducing unemployment in the economy.
6. Reducing Trade Union Power

Supply-siders also advocate reduction in the power of trade unions through legislation which
will make the labour market more competitive. Trade unions raise wages above the competitive
level which the employers cannot afford. Thus they destroy jobs and increase unemployment.
When the government restricts union power, unemployment and cost-inflation are reduced.
7. Deregulation and Privatisation

Deregulation and privatisation are important supply-side policies. They are used to encourage
more competition within the economy. Removal of public sector monopolies and sale of public
sector enterprises and transfer of public utilities in private hands lead to increase in productive
efficiency, wider consumer choice and lower prices.

8. Free Trade and Capital Movements

Free trade and free capital movements among countries are another policy measure of supply-
siders. The removal of exchange controls and free inflow and outflow of both short- term and
long-term capital lead to the maximisation of output and growth by widening markets and
checking monopolies.
IV. Criticisms of Supply-side Economics

The above prescriptions of supply-side economics have been criticised by economists on the
following grounds:
1. Laffer Curve controversy

The Laffer curve is an interesting but a controversial concept. No one knows with certainty
either the location of the optimum point or the exact shape of this curve. The curve may peak
at 40% or 90% tax rate, or it may peak in-between these rates.
For instance, if we take the curve which peaks at point A in Figure 4, the present tax rate-T
should be cut to T1 to maximise revenue. On the other hand, if another curve peaks at point B,
the tax rate T should be increased to T2. Without the knowledge of either the peak or the shape
of the curve, it is not possible to know the effect of reducing (or increasing) the tax rate or tax
revenue and economic activity. In fact, nobody knows the exact shape of the Laffer curve or
the relationship between tax rate and tax revenue.
2. Tax cuts do not bring high growth rate

Economists do not agree that cutting tax rates will lead to high growth rate and more tax
revenue. They point out that high growth rate generates higher incomes which, in turn, generate
higher tax revenue. Therefore, it is not reduction in tax rates that leads to the high growth rate
of the economy.
3. Tax cuts do not measure work effort

It is not possible to measure work effort specifically as a result of tax cut. No doubt, increased
work effort leads to higher incomes and to increase in tax revenue. But the increased tax
revenue may not be sufficient to compensate the government for the decrease in revenue due
to the lower tax rate. Moreover, it is possible that people may work less when their disposable
income increases with the lower tax rate.
4. Tax cuts do not affect target incomes

Critics argue that some persons have ‘target’ real income. When taxes are reduced, they will
work less and have more leisure to maintain their target income.

5. State intervention necessary

Supply-siders have been criticised for their policy of non-intervention by the state. But there
are many contradictions in the working of the capitalist system which cannot sustain balanced
growth of the economy. When the economy reaches full employment, a number of distortions
and imbalances develop which fail to maintain full employment. Therefore, state intervention
is necessary to remove them.
6. Supply-side policies fail to bring social justice

Supply-side economists emphasise reduction in social spending, subsidies, grants and budget
deficit with reduction in taxes. But such a policy has actually led to huge budget deficits in the
United States. Further, the policy of reducing social spending, subsidies and grants adversely
affects the poor and unemployed and fails to bring social justice.
V. The Laffer Curve

The Laffer Curve states that if tax rates are increased above a certain level, then tax revenues
can actually fall because higher tax rates discourage people from working.
Equally, the Laffer Curve states that cutting taxes could, in theory, lead to higher tax revenues.
It starts from the premise that if tax rates are 0% – then the government gets zero revenue.
Equally, if tax rates are 100% – then the government would also get zero revenue – because
there is no point in working. If tax rates are very high, and then they are cut, it can create an
incentive for business to expand and people to work longer. This boost to economic growth
will lead to higher tax revenues – higher income tax, corporation tax and VAT.
The importance of the theory is that it provides an economic justification for the politically
popular policy of cutting tax rates. However, economists disagree on the level at which
higher tax rates actually cause disincentives to work.

The Laffer curve became important in the 1980s because it appeared to give an economic
justification to cutting income tax rates. The Laffer Curve analysis is attractive – it appears to
give the best of both worlds:
• Lower tax rates which are politically popular.
• Increased tax revenues and lower budget deficits
Economist Arthur Laffer argued that tax cuts have two effects on the federal budget: arithmetic
and economic.
Arithmetic: The arithmetic effect is immediate and on a 1-for-1 basis. Every rupee in tax cuts
translates directly to one less rupee in government revenue. It also decreases the stimulative
effect of government spending by exactly one rupee.
Economic: The economic effect is longer-term and has a multiplier effect. Its impact may be
more or less than the tax cut.
A tax cut puts money into the hands of taxpayers, who then spend it. The increase in demand
creates more business activity. For this, companies hire more workers, who then spend their
additional income.
A tax cut's impact on the economy also depends on four other components:
1. The time period being considered
2. How easy it is to switch to an underground economy
3. The availability of tax loopholes
4. The economy's productivity level
Any of these factors can prevent tax cuts from stimulating economic growth. If all these
circumstances lined up right, the tax cut could generate enough economic growth to generate
a larger tax base. Eventually, it could replace any revenue lost from the tax cut.
Laffer Curve Chart

The Laffer Curve chart shows how, at the bottom of the curve, zero taxes results in no
government income and, thus, no government.
Of course, increasing taxes from zero boosts government revenue right away. In the beginning,
raising taxes still does a good job of increasing total revenue, as shown by the flatness of the
curve. As the government keeps raising taxes, the payoff in additional revenue becomes less,
causing the curve to steepen.
The high tax burden takes money out of consumers' pockets. Demand falls so much that the
long-term decline in the tax base more than offsets the immediate increase in tax revenue.
That's where the curve boomerangs backward. This is the shaded section on the chart, which
Laffer calls the "Prohibitive Range." Beyond this point, additional taxes result in reduced
government revenue.
At the top of the curve, when tax rates are 100%, government revenue is zero. If the government
takes all personal income and business profit, then no one works or produces goods. This results
in the disappearance of the tax base.

Tax cuts work in the "Prohibitive Range" because the economic effect outweighs the arithmetic
effect. It increases consumer spending and demand. It encourages business growth and hiring.
This results in increased government revenues in the long-run.
In fact, tax cuts during a recession or a period of slow growth harm the economy. During
recessions, government-funded unemployment benefits, social welfare programs, and jobs
boost the economy enough to keep it from going into a depression. If revenues are curtailed
even further with tax cuts, demand drops and businesses suffer from too few customers.
*****************

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BUSINESS ECONOMICS -III

(For Private Circulation Only)

Macroeconomics: Meaning, Scope and Importance

Differences between Microeconomics and Macroeconomics 2

Major Issues and Concerns of Macroeconomics 3

Employment and Unemployment 3

Determination of National Income (or GNP) 3

General Price Level and Inflation 4

Balance of Payments and Exchange Rate 5

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 1

Differences between Microeconomics and Macroeconomics

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 2

Major Issues and Concerns of Macroeconomics

1. Employment and Unemployment

2. Determination of National Income (or GNP)

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 3

3. General Price Level and Inflation

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 4

While in business cycles, recession or depression is accompanied by high unemployment and

7. Balance of Payments and Exchange Rate

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 5

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 6

Important Nature of Macroeconomic Issues:

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 7

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 8

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 1

Definitions of National Income

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 2

Features of National Income

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 3

Different Concepts of National Income

1) Gross National Product (GNP)

2) Gross National Product at Market Price (GNP (MP))

3) Gross National Product at Factor Cost: (GNP (FC))

4) Gross Domestic Product at Market Price (GDP (MP))

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 4

5) Gross Domestic Product at Factor Cost (GDP (FC) )

6) Net Domestic Product at Market Price (NDP (MP))

7) Net Domestic Product at Factor Cost (NDP (FC))

8) Net National Product at Market Price (NNP (MP))

9) Net National Product at Factor Cost (NNP (FC))

10) National Income at Factor Cost (NI (FC))

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 5

11) Personal Income (PI)

12) Personal Disposable Income

Methods of Measuring National Income

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 6

ii) The Value Added Approach / The value Added Method:

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 7

Thus, GNP, according to income method, is calculated as follows:

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 8

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 9

Difficulties in the measurement of National Income

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 10

5) Treatment of the government sector: Government provides a number of public services

7) Changing price levels:

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 11

4) Inadequate and unreliable data:

5) Capital gains or losses:

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 12

Circular flow of Income

Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 1