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Economics
REFERENCE MATERIAL
2023-24
Unit-I- CHAPTER 1
Table of Contents:
Definition of Macroeconomics 1
Tools of Macroeconomics 2
Business Cycles 4
Stagflation 4
Economic Growth 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.
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.
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.
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.
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.
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.
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.
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.
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.
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."
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.
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.
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.
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 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
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:
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
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.
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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.
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.
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.
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.
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.
***************
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 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
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.
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.
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 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.
**************
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.
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.
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:
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 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.
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”.
The three propositions of the law can be explained with the help of the following table.
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.
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.
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).
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.
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.
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
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.
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.
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.
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.
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.
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.
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.
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.
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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."
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.
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.
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.
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.
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)
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”.
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
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.
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.
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.
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.
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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.
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.
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.
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.
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).
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.
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.
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.
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.
(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.
The factors responsible for change in the autonomous spending and therefore, shift in IS
curve are:
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.
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.
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.
(i) The LM curve consists of equilibrium combinations of income and interest rate for the
money market.
(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.
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.
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.
**************
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”.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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
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.
****************
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.
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.
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.
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.
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.
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
(C) Drawbacks
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.
**************
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.
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.
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.
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%.
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.
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.
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.
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.
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.
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.
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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