MACRO ECONOMICS -II

MA II SEMESTER
UNIT-1:KEYNESIAN OPEN ECONOMYMODEL

 The economy which is making transactions with rest of

the world sector is called- open economy.
 Derivation of Balance of Payment Curve(BOP)

 Balance of Payment (BOP):

Balance of Payment (BOP) is a systematic record of all

the economic transactions, visible as well as invisible in
a particular time period between one country and rest of
the world. In another world, BOP is a statement that
summarize an economy’s transactions with the rest of the
world for a specific period of time.
 It shows the relationship between one country’s total
receipts from all others and total payments to them.
 BOP adopts double entry book keeping system and has
two sides – named debits and credits.
 Therefore, BOP is a statement of payments and receipts
on international transactions.
 According to Benham, “ Balance of Payment of a
country is record of the monetary transactions over a
period with the rest of the world.”
 The balance of payment has classified all the transactions into
following two accounts:
1)Current Account:
The current account is country’s trade balance plus net
income and direct payment. In another words, it measures a
country’s import and export of goods, services as well as its
trade in capital . Hence, the current account includes
transactions in goods, services, investment, income and
current transfer. The current account of BOP includes
following items:
(a)Commodity trade (b) Foreign trade (c) Banking
(d) Transportation (e) insurance (f) Investment Income (f)
Government purchase etc.
2) Capital Account:
The capital account is a part of country’s balance of
payment. The capital account is BOP of a country consists of its
transaction in financial instruments in the form of short-term
and long-term lending and borrowing, private and official
investment.
Hence, it includes all types of short-term and long- term
international movement of capital and represent a change in
country’s foreign assets and liabilities.
Now, for the equilibrium, the amount of import should be equal
to the amount of export.
Therefore, Export (+) = Import(- )
Capital Inflow = Capital Outflow
 For the whole macroeconomic equilibrium in an open
economy the are three markets:
(1) The goods market represented by negatively sloped IS
curve.
(2) The money market represented by positively sloped
LM curve.
(3) The foreign exchange market represented by positively
sloped BOP curve.
These markets must be in equilibrium
simultaneously.
 The Balance of Payment (BOP) curve can be derived as
follows:
The BOP curve is the locus of various combination of market
rate of interest(r) and real income (y) which yields the foreign
market equilibrium. It can be derived in figure as: Fig:
Derivation of BOP curve
BOP curve

r1
Interest rate(r)

ro
A
D

O yo y1
 In the above figure, real income is shown in x-axis and
interest rate is shown in y-axis. Let initially the BOP is in
equilibrium at the point ‘A’. Now assume that real income is
increased. Once when real income is increased than import
also increased and as a result there is trade deficit in the
economy. When there is trade deficit, BOP is also deficit. Let
this new level of income is y1.
 Now the BOP will be in equilibrium if market interest(r) will
increase.
 It is because when there is increase in market interest rate,
there is capital inflow in the economy due to higher return in
money, as a result, now BOP will be in equilibrium in higher
in higher interest rate(r1) and represented by point ‘B’.
Therefore, the new equilibrium point ‘B’ with higher level
of interest rate and higher level of income in the economy.
Now joining the different points ‘A’ and ‘B’ we will get
positively sloped BOP curve BOP curve.
Any point above the BOP (i.e. point C) , there is trade
surplus and capital inflow and any point below BOP curve
(i.e. point D) there is trade deficit and capital outflow.
Hence, the BOP curve is the locus of the combination of
market interest rate and real income that represent the
foreign exchange market equilibrium.
However, the slope of BOP curve is based on the elasticity
of BOP. How great the mobility of capital it directly
determines the slope of BOP curve. If higher the mobility ,
flatter the curve. Therefore, in case of perfect capital
mobility the BOP curve is horizontal and parallel to x-axis.
This approach was initially developed by the economist
Robert Mundell and Marcus Fleming in 1960 to analyze the
role of monetary and fiscal policy in ‘BOP’.
 Exchange Rate System:
An exchange rate regime is the way an authority
manages its currency in relation to other currencies and
the foreign exchange markets. In another words, it is the
rate in which one unit of currency of one country can be
exchanged with the number of unit of currency of other
country. Basically, there are two types of foreign
exchang rate and they are:
(1) Fixed exchange regime/pegged exchange
(2)Floating exchange regime/fluctuating exchange.
 A fixed exchanged rate is a currency system in which authority try to
maintain their currency value constant against a specific currency or good.
Similarly, a floating exchange rate is a type of exchange rate regime where
in a currency’s value is allowed to freely fluctuate according to the foreign
exchange market.
The demand for foreign currency is done for
i) payment of international loan
ii) investment loan
iii) purchase of foreign goods
iv) speculative motive

The supply of foreign currency may from following sources:

i) exports ii) when foreigners buy domestic goods
iii) remittance iv) speculative motives.
Effect of Monetary Policy in Open Economy at Fixed
Exchange:-
Imperfect Capital Mobility and Fixed Exchange rate: lets
assume that, there is imperfect mobility of capital and fixed
exchange rate. Now what happened when there is increase in
money supply in such model can be explained as below:

BoPo
r LMo

A LM1
Rate of interest

Eo
E1

ISo

O yo y1 y
income
 In the above figure, the whole economy (i.e.all the markets:
goods market, money market and foreign exchange markets
are in equilibrium) is in equilibrium. An expansionary
monetary policy will shift the LM curve from LMo to LM1.
which makes the equilibrium go from point Eo to E1. this
point E1 is not an equilibrium point for general
macroequilibrium of the economy. Since, we are below the
BOP curve, we know that economy has a deficit balance of
payment.
Here the exchange rate is fixed and as we move from Eo to
E1, there is fall in interest rate from higher to lower level,
increase in income from yo to y1 and the balance of payment
will be deficit.
 Hence, under the imperfect mobility of capital of capital
with fixed exchange rate, if we adopt expantionary monetary
policy, it will increase income, stimulating imports and
lowers the interest rate and when there is lower interest rate,
it will cause capital outflow from the economy.
When there is capital outflow, then it will decrease the
money supply and ultimately the LM curve shift towards
original ‘A’ /Eo. Hence, the monetary policy has no effect, no
matter how great or small capital mobility is. Money supply
has only the effect on the change in consumption not in real
phenomenon.
 Assumptions:-
1) Initially all the markets (i.e. goods market, money market
and foreign exchange market) are in equilibrium.
2) There is fixed exchange rate system in the economy.
3) There is expantionary monetary policy.
4) Economy can increase the level of output.
5) Capital account is assumed to be constant.
6) Price level is constant.
Effects of Fiscal Policy under Fixed Exchange Rate:-
There are two cases in case of fiscal policy and they are:
1) BOP curve is less elastic than LM curve.
2) Fixed exchange rate regime.
3) Expantionary fiscal policy
4) Economy can increase the level of output.
5) Price level is constant.
On the basis of above assumptions it can be shown in
following figure:-
 BOP
 . LM1
C
LMo
A B
IS1

ISo

O yo y2 y1

Suppose all the markets are initially in equilibrium at point

‘A’. Let government expenditure has been increased of tax
rate has been decreased IS curve shifted towards right
direction from ISo to IS1 and now new shifted IS curve
intersects LM curve at point
 ‘B’ which is now new point of equilibrium but at such point
all the markets are not clear. That is at point ‘B’ goods
market and money markets are clear but foreign exchange
market is uncleared. Hence, point ‘B’ is quasi-equilibrium
point.
Since, foreign exchange market is not clear at point ‘B’, real
income has increased above its original level of yo. At this
point, the domestic interest rate given by intersection of the
LMo and IS1 is below that rate necessary for equilibrium on
the foreign exchange market hence there is deficit in BOP.
Since there is lower domestic interest rate, as a result there
will be outflow of foreign currency and hence the supply of
money in the economy will go down in the long run shown
by LMo shifted to LM1.
 Hence, the long-run equilibrium level of income is ½ and is
lower than the short-run situation y1 but higher than original
income yo, provided that higher domestic interest rate induce
a larger capital inflow to offset the increase import.
Therefore, expantionary fiscal policy with fixed exchange
rate and imperfect mobility of capital and BOP curve is less
elastic than LM curve will increase the level of real income.
Since income increases employment also increases but
employment is not seen here.
2) when BOP curve is more elastic than LM:
On the basis of above assumption, it can be shown in
following figure:- LMo
r
LM1
BOP
B

A C

IS1

ISo

yo y1 y2
 The case shown in above figure is having more elastic BOP
curve than LM curve. Suppose, all the markets are in
equilibrium at point A. here the fiscal expansion shifts the is
function from ISo to IS1. the new IS curve (i.e.IS1) intersects
with LMo function at point ‘B’ and at such point there is
higher interest rate in domestic economy and hence there is
surplus BOP. So in the short run income rises to y1. butin the
long run with higher domestic interest rate, there is increase
in capital inflow and hence there is increase in money supply
and LM curve, therefore, shifts from LMo to LM1 and leads
to higher equilibrium level of income y2.
 Therefore, we can see that, given the Keynesian aggregate
supply assumption and a fixed exchange rate, fiscal policy is
effective and it becomes more effective the more responsive
capital flows are to interest rat differentials.
UNIT-II: RECENT DEVELOPMENT IN
MACROECONOMICS
 Price and output determination under IS-LM Model
 Both the classical and Keynesian economics suffer from
their own shortcomings.
 Classical economics as supply side economic neglects
the demand side while Keynesian economics as demand
side economics neglects the supply side.
 Classical economics assumes that the level of income is
given and doesn’t have effect on interest rate i.e. interest
rate is determined by investment & saving.
 Keynesian economics doesn’t consider interest rate is a
determinant of income & advocate that is only determined by
the equality of AD & AS.
 In Keynesian economics interest rate is assumed to be given
somewhere and saving – investment equality determine the
level of income (y) and interest is not determining factor.
 Both of the systems are not wrong but also both are not
complete. Hence modern economists have combined both of
them and then developed IS-LM model, synthesizing them.
Therefore, interest (i) and income (y) are determination of ‘i.’
and ‘y’ is called IS curve.
(1) IS-CURVE:
1)It shows the various combination of national income(y)
and rate of interest (i) that gives the real market
equilibrium of goods market equilibrium.
2) Therefore IS curve is the locus of various combination
between interest and income representing goods market
equilibrium.
3) Equilibrium in the sense that total injection in the
economy is just sufficient to meet the total leakage from
the economy.
4) According to Keynes, for any level of output to be in
equilibrium level, it should be equal to aggregate
demand. i.e. y = AD.
5) AD in simple economy consists of three components
including consumption expenditure, investment
expenditure and government expenditure.
Derivation of IS curve:
The IS curve can be derived using either equilibrium
condition. However we follow the following relations to
derive the IS curve.
y = C + I + G ----(1) (goods market eqilibrium)
C = f( yd, i)---(2) (consumpn is function of yd & i.)
I = f(y, i) -----(3) (investment is function of y & i.)
G = Go--------(4) ( Government expenditure is assumed
to be autonomous)
 In liear form,
C = Co + C1yd + C2i : Co ≥0, 0<C1, C2<0.
(Note: Mathematically Co (autonomous consumption) can be
+ve, -ve or zero.
C1 & C2 are MPC and C2 is interest rate induced consumption
expenditure and which is negatively related to interest rate (i)
Therefore, C = Co + C1yd – C2i ------------(5)
Similarly,
I = bo + b1y + b2i
bo autonomous and positive investment
b1> (b1 is income induced investment)
B2<0( b2 is interest rate induced investment and there is
negative relation between investment & interest rate, hence it
is –ve)
 Therefore, I = bo + b1y – b2i ---------(6)
yd = y – T ----------------(7) (T = lump-sum tax)=> Net
T = f(y) -------------(8)
Or, T = to + t1y -------------(9)
where, to 0, 0<t1<1
Where,
y = Net national income
C= Consumer purchase
I = Investment purchase
G = Government purchase
T = Net tax ( taxes less Transfer payment)
yd = disposable income
i. = interest rate.
 Substituting these value in equation (1) it becomes:
y = Co + C1yd – C2i + bo + b1y – b2i + Go
Or,y = Co + C1(y – T) – C2i + bo + b1y – b2i + Go
Or,y = Co + C1(y – to – t1y) – C2i + bo +b1y – b2i + Go
Or,y = Co + C1y – C1to – C1t1y – C2i + bo + b1y –b2i+Go
Or, y – C1y + C1b1y – b1y = Co + bo + Go – C1to- C2i- b2i
Or, y(1- C1 + C1t1 – b1) = Co + bo + Go – C1to – i(C2+b2)

1
Or,y = [Co + bo + Go – C1to – i(C2+b2)] ------------(10)
1 – C1 + C1t1 – b1
1
In equation (10) is multiplier and other
1 – C1 + C1t1 – b1
part is multiplicant.
 This equation shows a special case where income depends on
the parameters but also on i. So it is more than simple
Keynesian income determination. Hence it is called the
extended Keynesian fiscal model.
Now, Finding the value of i( i.e. interest rate)

y = Co + C1y – C1t1y + bo + b1y + Go – i( C2 + b2)

or,i(C2 + b2) = - y + C1ty + b1y + Co + bo + Go – C1to or,i(C2
+b2) = [ - y( 1 – C1 + C1t – b1) + (Co + bo + Go- C1to)]
i= 1
[ - y( 1 – C1 + C1t – b1) + (Co + bo + Go- C1to)] -----(11)
(C2 +b2)
 Equation (11) tells, i depends upon y and eqn(10) tells, y
depends on i. In fact they are not independent rather
interdependent- they should be determined simultaneously.
 Therefore, equation (11) is the extended version of classical
theory of interest which incorporates both classical theory of
interest and Keynesian theory of interest.
 In classical theory there is no any clear reference for fiscal
policy. So let to, t1 and Go = 0.
 Moreover in classical system saving and investment depends
not on y but on i. So we can put b, and C1 equal to zero i.e. C1
= 0, b1 = 0. Then eqn (11) become,
 i= ---------------(12)

-Y (1) + Co + bo
C2 + b2
 Where, Co, bo, C2, b2 are constant. So i depends on ‘y’.
It is simple version of classical theory of interest.
Similarly,
In Keynesian system there is no clear reference for
the interest induced consumption as Keynes said that
consumption does not affected by interest rate. .•. i.e C2 = 0. If
we assume only autonomous investment b1 and b2 will be
zero.
So equation (10) becomes.
y = Co + bo + Go – C1to -----(13)
1 – C1(1 – t1)

In classical system, saving and investment determine ‘i’ , so

they forget the influence of change in y on s.
 In Keynesian system, saving and investment determine the
level of income (y). It can not affect i, so he forget the effect
of i and y.
 In fact, saving and investment determines either not i nor y,
rather any combination of y and i which is consistent that
brings equality between saving and investment which is
known as IS curve.
 If we plot eqn (10) in graph, we get
i
A

y
O B
 If we put y = 0 in eqn (10), we get the vertical intercept and
if we put i = 0, we get horizontal intercept where i is on
vertical and y is on horizontal axis.
 .· . Let i = 0, in eqn (10)

y= Point B
bo + Co + Go – C1to
Let y = 01-inC1
eqn (11)– b1
+ C1t1

i= Point A
bo + Co + Go – C1to
C2 + b2
 The slope of IS curve is
bo + Co + Go – C1to
i = C2 + b2
Slope =
y bo + Co + Go – C1to
1- C1 + C1t1 – b1

= bo + Co + Go – C1to 1 – C1 + C1t1 – b1
C2 + b2 bo + Co + Go – C1to
= 1 – C1 + C1t1 – b1
C2 + b2

= 1 – C1(1 + t1) – b1
C2 + b2
 IS curve is downward sloping which indicates at high
level of i, income will be low and vice versa.
Alternatively, at high level of income, interest will be
low because when income increases interest must be
declined to hold the equilibrium between S and I. hence,
the IS curve shows classical theory of interest
determination and Keynesian theory of income
determination.
(2) LM CURVE
 The LM curve represents various combination of national
income(y) and rate of interest(i) that produces money market
equilibrium, given the total stock of money supply and price
level.
 Equilibrium in the sense that total supply of money just meets
the total demand for money for various purposes.
 The classical system assume that people demand money only
for transaction motive. But Keynes said that people demand
money for three purposes. They are:
(i) transaction (ii) precautionary Income elastic
(iii) Speculative Interest elastic
Therefore, money demand is choice variable and depends on
income level and rate of interest.
 .· . Md= mpy + f (i) -----------(1) f´ < 0, f´´ > 0
 Money supply is a policy variable determined by the
monetary authority and is assumed to be constant for a
time being
.· . Ms = M ------------(ii)
In linear form,
Md = Mo + M1py + m2i
or,Md = Mo + m1py – m2i -------------(iii) [because there
is negative relation between i and speculative motive]
For equilibrium, money demand must be equal to money
supply.
or, Md = Ms
or, Mo + m1py – m2i = M
or, m1py = M – mo + m2i

M – Mo + m2i
.· . y = m1P
.· .y = M – Mo + m2i--------------(5)
m1P m1P

If we plot in graph, an upward sloping straight line can be

obtained which is LM curve. Whether the horizontal
intercept is positive or negative ( the vertical intercept is
negative or positive) depends on the relative magnitudes of
mo and M.
 Where,
Md = demand for money
Ms = Supply of money
Mo = autonomous money demand
y = income
P = Price Level
i = interest rate
M = Supply of Money
 i
Horizontal intercet (i= 0)
.· . y = M – Mo shows as
m1P

a: where M< mo ( -ve intercept) c

b: where M > mo (+ve intercept)
a b
y
Vertical intercept (y = 0)
d
i= M – Mo shown as
m2

c: where M< mo (+ve intercept)

d: where M> mo ( - ve intercept)
 Joining the points where M>mo i.e. point ‘b’ and ‘d’ and
where, M<mo i.e. point ‘a’ and ‘c’, we get LM curve.
 If m2 were zero ( the demand for money independent of the
interest rate), the LM curve would be vertical and y would be
independent of the interest rate, but would be depended on M,
mo, m, and P.

LM
i i

LM

y y
When m2 = 0 When m2 =oo
 However, if we assume as Keynes, money demand is a non-
linear function with d²f
> 0 (f” >0)
di²
 So equation (4) can be written as,

M – Mo 1
 Y= m1P f (i) ---------------(6)
m1P
 Equation (6) gives the LM curve:
i LM
M – Mo 1 f(i)
m1P m1P
io

1 f(i)
m1P

yo
y
0 M – Mo
m1P
 Equation (6) consists two components: first part is demand for
money independent of rate of interest (transaction demand for
money) shown by horizontal and vertical line. The next
component is negative. That can be found by subtracting
transaction demand for money from total stock of money.
 The subtracted part of LM curve given m1 and P reflects
investment demand for money.
 In this way, we characterized the IS curve as showing all of
the possible combination of interest rate and income at which
saving would equal investment.
 Similarly, we characterized the LM curve as showing all of the
possible combinations of i and y at which supply of money
and demand for money are equal.
 IS curve is the locus of various combinations of interest rate
and income level representing equilibrium in the goods market,
the LM curve is showing all possible positions of equilibrium
in the money (bond) market.
 However for the simultaneous determination of equilibrium in
both sectors we have to combine both IS and LM curves.
GENERAL EQUILIBRIUM
 General equilibrium is a state where IS-LM curve are at
equilibrium or where the goods market and money
market are in equilibrium simultaneously.
 We have the equation of IS

 Y= [ Co + bo + Go – C1to – i(b2+C2)]
1
1 – c1(1 – t1) – b1
Subtracting the value of i from LM model

Y=
1 Mo – M M1py
Co + bo + Go – C1to – i(b2+C2) +
1 – c1(1 – t1) – b1 m2 m2
Or,y
Co + bo + Go – C1to – i(b2+C2) Mo – M M1py
(1 – c1(1 – t1) – b1) = + m2
m2
 Mo – M M1py
 Or,y (1 – c1(1 – t1) – b1) = Co + bo + Go – C1to – i(b2+C2)
m2 + m2

b2(Mo – M) b2m1Py
 Or,y (1 – c1(1 – t1) – b1) = Co + bo + Go – C1to –
m2
–
m2
–C2(Mo – M) – C2m1Py2
m2 m2

 Or,
y(1 – c1(1 – t1) – b1) + y b2m1P + C2m1P = Co + bo + Go – C1to
m2 m2
–(Mo – M) (b2 + C2)
m2

b2m1P C2m1P
or, y 1 – c1 + t1 – b1 + + m2 = Co + bo + Go – C1to
m2
–(Mo – M) (b2 + C2)
m2
1
Co + bo + Go – C1to
Or,y = C2m1P
=
1 – c1 + t1 – b1 + b2m1P
+ m2 –(Mo – M)
m2 m2 (b2 + C2)
 Hence, income depends on the parameters of consumption,
investment, tax, money demand, money supply, price level and
government expenses.
 According to above equation,

1) When government expenditure , income , so Keynesian

Fiscal policy is applicable.
2) As money supply , income also , monetary policy is
viable too.
3) As increase in Co(Autonomous Consumption) and invstment
(autonomous) causes to increase income level.
4) Increase in tax reduce money income.

5) Increase in price level reduces the income.

PRICE & OUTPUT DETERMINATION
UNDER AD-AS APPROACH
 In and economy, equilibrium price and output are determined by the
position of AD and AS.
 AGGREGATE SUPPLY (AS) FUNCTION/CURVE
It shows the relationship between price level and level of income or
output. In another word, aggregate supply function shows the effect
of change in income on price level. It is derived with the help of
wage and price equations.
1) The wage setting equation,
w = p ef(u, z) ------------(1)
where,
w = nominal wage
p e = expected general price level
u = unemployment rate z = all other catch all factors.
 This equation states that the nominal wage set by the wage setter depends
e including working condition,
on expected price level (p ) and variables
unemployment benefits collective bargaining capacity etc.
2) The price setting equation,
P = (1 + µ)w --------------(2)
where,
P = nominal price level
µ = mark-up variable/factor
w = wage/cost
This equation states that price set by the firm depends on/equivalent to general
price level which is equals to wage rate plus (cost), which is known as
profit.
Now, Substituting equation (1) in equation (2) we get,

e
P = (1+µ) P f(u, z) ---------------(3)
From equation (3) it is analyzed that the price level is based on expected
price, unemployment rate, other catchall variables and mark-up over cost.
In general, catchall variable are not changed instantly, hence they are
assumed as constant, therefore the price is based on expected general price
and unemployment rate in short-run.
.· . P = (1+µ) P f(u, z)
e
µ , z denotes, they are assumed constant.
3) The rate of unemployment (µ) is defined as the ratio of unemployment and
labour force.
.· . U = v/L ---------------(4)
Where, U = No. of unemployed person
L = Total labour force
 L –N
or, u= L
where, N = No. of employed person
or, u = L – N
L L
– N
or, u = 1 L-----------------(5)

Equation (5) shows that if there is increase in no. of employed person the
unemployment rate will be fall and if there is increase in labour force
keeping ‘N’ constant, the unemployment rate will rise.
1) Suppose, there is single variable production function
2) y = AN -----------------(6)
where, A is efficiency parameter measuring the productivity of N.
If the production function shows the constant return to scale (CRS) then,
A = 1, and y = N -------------(7)
 Now, Substituting equation (7) in equation (5) we get,

u=1- y-----------------(8)
L

Equation (8) states that, there is inverse relationship between national income
and rate of unemployment.
Again, substituting equation (3) we get,

y
P = (1+µ) P ef 1 –
L .z ---------------(9)

Equation (9) is the AS function, showing the relationship between y, P and

P . And µ, eL and z are dependent on institutional factors and are x constant
in short run.
This function shows the positive relationship between between y and P. As y
increases, employment also increases, when employment increase the rate of
unemployment will decrease,
 when there is decrease in unemployment it will rise the bargaining capacity
and which will increase the nominal wage rate as a result there is finally
increase in price level.
[ when y N, when y = N => µ bkz y = 1 – N/L
when u = w ( bkz w = p f(u,z) e & finally increase in price bkz P = (i
+µ) w]
There is proportional and direct (one to one) relation between p and price e
level(P). It is because when there is increase in expected price , it will rise
nominal wage rate and finally there is increase in price level by same
amount of increase.
The equation (9) can be shown in following graph:-
 e AS1 AS
P/P
 . P2 = p e B

P=p e
A

O y = yn yn = national income

=> AS curve is upward sloping

=> AS curve initially passes through point ‘A’ because at that point P = p
and y = yn. e
=> If there is increase in expected price (hence the price line is shifted
upward because there is one to one relation between p & P). e
the level of income is remained constant , then the AS curve shifted upward
and passes through point B where P = P2 and produce y level of income &
output. e
2)THE AGGREGATE DEMAND FUNCTION (AD)
 Aggregate demand shows the relationship between output level or income
level and the level of price. It can be derived from the general equilibrium
approach or using IS-LM approach.
 The IS curve shows the goods market equilibrium ; in the sense that total
output is just sufficient to meet consumption expenditure, government
expenditure and investment expenditure.
 i.e. y = C + I + G (All the variable has real values)
 Price level has no effect on the IS curve.
 LM curve gives the money supply and price level.

 For money market equilibrium Md = Ms. And f(i).

Ms =
P
 LM2
 .
LM1
i1

IS

y2 y1

P1

Po

AD

y2 y1
(Fig: Price & output determination)
 At Po price level the corresponding LM curve is LM1, and when price
increases to i1, then LM curve shifts to LM.
 AD is downward sloping signifying the negative relation between income
& price.
 Equilibrium money market requires the supply of real money equal to the
demand for real money, which gives the LM curve. The LM curve is
defined as the combinations of national income and rate of interest, given
the money supply and price level that gives the money market equilibrium.
However, any change in price level will affect the real money and
consequently will shift the LM curve.
 The intersection of the IS and LM curves defines the point of AD.
 Given the money supply M and price level P the LM curve is LM1. As
price level increases from LM1 to LM2. The LM1 schedule shifts left
rising the interest rate and lowering investment and aggregate demand.
 In the lower part of figure, we have plotted the level of aggregate demand
for output corresponding to each of two prices. The AD curve shows the
level of output demanded at each price.
 The aggregate demand reflects the influence in economy that is because of
monetary factors as well as direct influences (factors affecting IS schedule).
Factors that affecting the level of equilibrium income in the IS – LM curve
model will shift in the aggregate demand curve right.

AS

In the economy the equilibrium price &

P1 output are determined by the intersection of
AS & AD as in the figure.
AD

y1
CLASSICAL APPROACH OF AD & AS
 The classical theory is based on the premises of laissez faire, which
guaranties the perfect competition in the market. Therefore, wage is
determined by the demand for and supply of labour. Therefore, wage rate is
flexible in both direction. In the labour market the demand for labour is
taken to be an inverse function of real wage. i.e.
N=f w ; f < 0 -----------(i) and the supply of labour is
assumed to be an increasing
P function or real wage i.e.

L=f w
and f >0 --------------(ii)
P
The theory used short run production function as an analytical tool, where
the production function shows the law of diminishing returns. i.e. y = f(N) ,
f´ > 0, f´´ < 0 -----------------(iii)
 y
 .
yo Y = f(N)

N
0 No
(w/p) L

(w/p)o E

0 N,L
No
(Fig: Income, employment & wage determination)
 Given the production function, the intersection of demand and supply
schedule of labour (N = L) determines the full employment level and
corresponding real wage and real output of the economy.
 Therefore, classical economists output supply is given at full employment,
which result vertical aggregate supply curve at full employment as shown
by the curve ‘L’.
 The vertical AS curve implies the output supply is determined only by
supply sides and there is no role of demand on determining output. AD only
determine the price level i.e. price level is determined by AD/position of
aggregate demand given ate AS.
 Factors such as change in government expenditure, taxes and the money
supply which shifts the demand curve but would not affect the equilibrium
output but only price.
 This can show with IS – LM model as below:-
 LM2
 . LM1

i1

IS2
io
IS1

y1 y2 ASC => full employment

ASC level of output in
classical system.
P1
P y1 = full employment level
AD2 of output.

AD1

y1 y2
 When the government expenditure increases then the IS curve shifts from
IS1 to IS2 as a result there is upward shift is AD from AD1 to AD1 to
AD2.
 If price level is fixed at ‘P’ then output would increase to the level given by
y2 i.e. y2 > y1 which is not possible because y1 is already at full
employment hence price level increased from P to P to P1.
 The increase in price level causes shift in LM curve leftward from LM1 to
LM2. the shifted LM curve intersects the IS2 at higher point giving a
higher interest rate.
 As interest increases, investment declines which causes to decline in
income to initial level y1.
 Therefore, fiscal policy is not helpful in classical model because increase
in government expenditure brings increase in price level, the interest rate
and reduction in investment.
KEYNESIAN VERSION OF AD-AS APPROACH
 Keynesian believed that, money wage would not adjust sufficiently in the
short run to keep the economy at full employment. Wage is rigid specially
in downward . The reasons for wage rigidity are:-
1) Workers are reacting on the basis of absolute and relative (as well as
relative) wage, so when there is wage differentials between workers with
different skills. Therefore, when there is wage cut they feel, they are
discriminated by the management, hence they resists wage cut even if
unemployment exist and wage is downward rigid.
2) Stickiness in money wage is the institutional one. In the unionized labour
market wages are set by contract. So money wage does not respond
during the contract period even if labour supply increases. Therefore, let
up assume.
(a) Wage is downward rigid
(b) Price is flexible
(c) There is excess supply of labour.
(Note:- In Keynesian model economy is in equilibrium below full
employment so there exist excess supply of labour.)

Given the fixed money wage, flexible price and excess labour supply,
the actual employment is determined by the labour demand .
Firm will be able to hire any amount of labour at going wage rate.
Labour demand is an inverse function of real wage and is determined by
the price level, given the marginal physical productivity of labour.
The firm are profit maximizer therefore, the firm will hire that level of
labour where the value of marginal physical productivity of labour is
equal to money wage i.e. VMPPL = w.
 So the VMPPL curve is the demand curve for labour. At the fix money
wage ‘W’ ‘N’ is labour demand and therefore the employment is No as
shown in following figure.
W L
Money wage

Wo

0 No
N (Empoloyment)

The supply schedule is shown by curve ‘L’. At the fixed money wage the
labour wage supply is rigid. The supply curve shows the excess supply of
labour, i.e. more than No. therefore, there is no role of labour suppy in
determination of employment of labour as well as the wage.
Hence, the equilibrium condition indicates the VMPPL is also the demand
curve for labour.
 Since there is fixed wage rate, hence labour demand is determined by the
price level. The amount of labour firm will hire as a consequence the
amount they will supply the output depends on the price level. The
relationship between output supplied and price-level is shown in the
following figure:- Fig b
w Fig a
Y2

Y1
w Yo

VMPPL1 VMPPL2 VMPPL3

No N1 N2
No N1 N2 AS
Fig c
P2
B
P1
A
Po

N/y
No N1 NF
 In part (a) of the figure, relationship between price and labour demand of
employment is revealed. At price Po, with fixed wage rate, the demand for
labour is No determined by intersection of wage and VMPL. As price
increases the VMPL shifts upward and employment also increases from No
to N1. Hence, with increase in price, there is increase in labour demand and
increase in employment also.
 The part (b) of the figure shows the relationship between employment and
income. Given the production function y = f(N), at No employment income
is yo. When employment increases from No to N1 then income also
increase from yo to y1.
 The part (c) combines the information from part (a) and (b). It shows the
relationship between price and output or employment. At po price,
employment is No. The ‘No’ employment gives ‘yo’ level of income. The
‘yo’ level of income/output is supplied at po price. The poyo combination
gives ‘A’ point of AS curve as price rise from po to p1, employment
increase from No to N1.
 The higher employment ‘N1’ gives a higher income y1. The y1 income
supplied at price p1. The p1y1 combination of curve AS gives point ‘B’.
Thus a high price level results higher supply. Therefore, AS function is
upward sloping.
 At some level of income or employment (NF) or (yF) full employment
will reach and further increase in price would have no effect in output.
The AS curve become vertical at full employment level.
 Below ‘yF’ the AS curve is not vertical, the shift in AD curve will change
the level of output. Beyond full employment no output effect.
EFFECT OF INCREASE IN MONEY SUPPLY
 Suppose government adopt expansionary fiscal policy or there is
increase in money supply the AD shift rightward and LM also shift
rightward.
 As shift in AD, it will increase in output. Hence fiscal policy is
effective upto full employment level in Keynesian approach.
 After full employment , similarly when there is increase in money
supply, the LM curve shift rightwards reducing interest rate and
increase the AD.
 If price is to remain constant output level also increased. However
increase in income leads to increase in price also increased.
However increase in income leads to increase in price also which
causes leftward shift in LM curve, with higher interest rate and low
investment. The low investment reduce income to lower level. Thus,
an increase in money is to increase in price & output.
 Therefore, in Keynesian model, fiscal policy and monetary policy both
have an effect on income level to some context but either monetary or
fiscal policy can’t achieve their goal alone. So they must be supplementary
each other.
MONETARISM APPROACH TO AD-AS:
MONETARISM SCHOOL:
 Monetarism school was developed after failure of the Keynesian
proposition. During the 1960’s the world economy faced oil crisis as a
result there was failure of demand management policy. At that time the
Keynesian theory of AD is failed. At that time inflation and unemployment
both rises at the same time. After such crisis there was development of
another school of thought called ‘Monetarists’. They focused on private
owned economy rather than government regulated economy.
 At that time, two major proposition were failed. They were:
(i) The Philip Curve (ii) Okun’s Law
Philip Curve:-
It states that there is inverse relationship between rate of unemployment
and inflation.
i.e. P U E
P U E Keynesian growth promotion factor.
 Where,
P = price level i.e. inflation rate
U = unemployment rate
E = Employment rate
However during that period both inflation and unemployment were
increasing. i.e.
. P U E
Philips curve is dead for practical purpose.
P U E
Proposition of Monetarisms:
1) The supply of money is the dominant influences on nominal income.
2) In the short-run, the supply of money does influence real variables. It
means money supply determines income and employment in short run. i.e.
money has output & price effect in short run. (Keynesian view)
3) In the long-run, the influence of money is primarily on the price level and
other nominal magnitudes (monetary variables). It means money has only
price effect in long-run. In the long-run real variables, such as output, and
employment are determined by real factors/ real forces, not by monetary
factors. Real factors are stock of capital, quality of labour force, state of
technology etc.(Classic view)
[ Note: Keynesian economy failed to explain supply side because of his
thoughts emergence at the time of over supply so he thinks supply is self
adjusting phenomena when there is an effective demand and as a result
there was oil crisis in 1960’s – 1970’s by OPEC. They reduced oil supply
and as a result there was increase in price and increase in unemployment.
Therefore, according to Monetarists, in the short run money has price and
output both effect and in the long run money has only price effect.]
4) Private economy / Free economy is inherently stable. Instability in the
economy is primarily the result of government policies.[classical view]
5) Monetarists focused on rule-based growth of money supply for the
stabilization.(Policy has lags effect)
From these assumptions, two policy conclusions are as follow:
1) Stability in the growth of the money supply is crucial for a stable
economy. Monetarists believe that such stability is best achieved by
adopting a rule for the growth rate in the money supply. Milton Friedman
has long proposed a constant money growth rate rule.
2) Fiscal policy, by itself, has little systematic effect on either real or nominal
income. Fiscal policy is not an effective stabilization tool.
 Basic Equations:-
1. Wage setter set wage on the basis of expected price (P e ), rate of
unemployment (u) and all other catchall variables ‘z’ i.e.
w = P fe (u , z) -------------------------(i)
2. The price setting equation,
P = ( 1 + µ) w ---------------------------(ii)

.· . From equation (i) & (ii)

P = P ef (u , z) (1 + µ) --------------------------(iii)

As we know,
Unemployment rate (U) = u / L
or, u = L–N = 1 – N
L L
.· . P = (1 +µ) P fe 1– Y ,z
L
(Detail is in AS function of initial discussion)
 This equation shows the general monetarism equilibrium showing positive
relationship between price and output.
 Monetarists support the Keynesian labour demand function i.e. a producer
will be in equilibrium when,
w
= MPPL Or w = VMPPL
P

It means, Monetarism assumed labour demand depends on real wage i.e.

N = f (w/P)
.· . MPPL = w/P And f´<0

P. MPPL = w
VMPPL = w
Labour supply is assumed a positive function of expected real wage rate.
i.e.
L=f w
, f´ > 0
e
P
 Where,
P e is function of a1pt – 1 + a2pt – 2 + ………..+ anpt – n
.· . P e = a1Pt – 1 + a2pt -2 + ………….+ anpt –n
i.e. expected price is formed on the basis of current and all past prices with
geometrically declining weights. Therefore, ‘a’ denotes weight and sum of
all a is equals to 1.
.· . P e = 1Pt -1 + Pt – 2 + …………+ Pt –n

e
Monetarist assumed P remains unchanged during the short run
(expectations are not adopted) but changes in the long run when
expectations are formed properly.
( Formed expectation – long run)
( Not formed expectation – short run)

Employment and output under monetarists approach can be determined as

below:
 Figure (a) determine wage & employment under monetarism school. N*
indicates Keynesian employment level as real wage rate remain constant.
 Figure (b) shows the real output determination given the production
function. This production level clear in the market at price P1 shown in
figure (c). Therefore, (c) is the combination of figure (a) and (b).
 Suppose, P shift upward and as a result there is increase in employment and
increase in output also. This output clear in the market at increased price.
 Suppose, the government increase the money supply from Mo to M1 then
price level also increase and increase in AD also.
 Using these information monetarists concluded that AS function would be
upward sloping during the short run where money supply determines the
income level. In the long run, if real forces are remain unchanged then AS-
function would be vertical straight line indicating that monetary policy is
ineffective in the long-run. If real variables are changed then AS function
does not vertical straight line.
.˙. Policy effects can be explained,
Monetary policy is effective only in the short run.
In the long run, with the adoption of information there is no
effectiveness of policy in employment & output. Hence, in the long
run only the real forces such as technology, stock of natural
resources determine the level of employment and output.
Explanation of figure:-
It is mentioned that change in money supply has significant role in
both Keynesian and Monetarism school in short-run. However, in
long- run change in money supply only change in price level nor
real sector employment and output.(monetarism)
[Note: There is no labour union, private monopoly, government
intervention in classical system. Free market economy is in classical
school.]
 Let us assume that, change in money supply from Mo to M1 leads to rise
in aggregate demand from AD(Mo) to AD(M1) in above figure.
 Similarly rise in output from yo to y1 with rise is price from p1 to p2. It is
true in both Keynesian and monetarism. This is only possible in short run
when labour don’t react.
 However, in long run, when labour realize that fall in purchasing power
and pinch them so labour union reduce labour supply and demand for
higher wage. Reduction labour supply leads to fall in output or supply
ASo to AS1 with higher price P3 and initial output yo. This yo output is
natural rate of output.
 NEW CLASSICAL APPROACH TO AD-AS

 The new classical economics is the output of the failure of Keynesian

demand management policy to solve the 1970’s stagflation.
 Keynesian argued that private enterprise economy nees to be, can be and
should be stabilized by active fiscal policy or by proper government
intervention/AD management.
 In contrary New-classical argued that stabilization of real economic
variable such as output and employment can’t be achieved through demand
management policy because the value of these variables are
irresponsiveness to the systematic change in demand management policy.
It mean to say that the real economic variable are sensitive to change in
other real variables like technology, stock of natural resource, quality of
labour forces etc. Therefore, in the new classical view, systematic
monetary and fiscal policy actions that change AD will not affect output
and employment even in the short-run.
 Post – Keynesian argued that labour suppliers form and expectation of
current price level (or, future inflation rate) on the basis of past behavior of
prices. Price adjustment is slow, and can be assumed to be fixed in the
short-run.
 But New-classical economist argued that labour suppliers will form national
expectation using all relevant information for which their prediction are
almost that economic agents are rational. It means they are using all
available information. Therefore, there will not be any systematic errors.
(rule based errors). Hence, there is no any gap between expected and
calculated aspect/result hence it is known as rational expectation. Therefore,
it is assumed that, all the economic agents will form rational expectation.
 The Keynesian expectation is backward looking and new classical’s
expectation is forward looking. In Keynesian backward looking,
expectation of variable seen on the price level adjust to the past behavior.
According to rational expectations hypothesis economic agents are rational
and they are using all the available relevant information and intelligently
assess the information for
 for the future behavior of a variable such as price level.
 The main difference between Keynesian and new classical case is the use
of variable that determine the position of labour supply and aggregate
supply schedule.
 As in Keynesian, in new-classical model, the labour supply depend on
expected real wage.
w
 i.e. L = f e-------------------------(i)
P

 Consequently, the position of labour supply schedule and the AS function

depends on expected price level. An increase in expected price level will
shift both schedule to the left.
 The expected price level depends on the expected level of the variables
including money supply(Me), government expenditure(Ge), tax(Te),
autonomous investment (Ie) and others.
 Therefore,
Pe = f ( Me, Ge, Te, Ie,……………)---------------------(ii)
And the AS function is
P = g ( Me, Ge, Te, Ie,……….) (1+μ) ( 1 - , z)y
L

or, P = g ( Me, Ge, Te, Ie,…….) (1+ μ) f (1 - , zy ------------(iii)

L

Equation (iii) shows the positive relation between price and output
given other variables.
 Labour demand function in new-classical model is the inverse function of
real wage rate.
 i.e. N = f (w)
 Being a rational firm, the equilibrium condition is w = VMPPL.
 Therefore, the VMPPL curve itself is labour demand curve. There is inverse
relation between real wage and demand of labour because with extra unit of
labour rate VMPPL will declined.
 As explained by equation (iii) there is positive relationship between price
and output. Hence P is price and y is output level determined in above
figure.
 However, expected price does not remain constant as policy changes. The
effect of policy change on the expected price, labour supply and output
shows in following figure:-
 Panel ‘A’ shows the price and output relation and panel ‘B’ shows thee wage
and employment relation. Suppose, AD(Mo), AS(Mo ), N(Po), L(Po ) are
e
the initial aggregate demand, aggregate supply, labour demand and labour
supply. Similarly, yo, Po, No and wo are the initial level of output, price,
employment and wage rate respectively.
 Let us assume, fully anticipated money supply increases from Mo to M1
which causes to shift in AD curve from AD(Mo) to AD(M1). If supply
schedule should not shift outward from AS(Mo) to AS(M1), output would
rise from yo to y1 and price level would increase from po to p1.
 With the rise in price level, the labour demand curve shift to the right from
N(po) to N(p2).
 If labour supply curve did not shift then employment would rise to N1. But
expansionary policy actions are fully anticipated, the level of expected
money stock also increase. This increase in money supply will cause to
increase in price level because with rational
 expectations the labour suppliers will understand the inflationary effect of
the increase in money supply.
 The labour supply schedule and the aggregate supply schedule will shift to
the left to AS(Me1) and L(P1e). Now AS intersects with AD at higher price
level. P2e and previous level of output yo. Hence, decline in output puts
further pressure to increase in price level. The labour demand shift to
N(P1). The new equilibrium is where output and employment are returned
to the original level but the price level and money wage are permanently
higher.
 Therefore, in new-classical any policy measure can’t affect real economic
variable in the short run too. Philips curve is dead even in short run.
NEW-KEYNESIAN MACROECONOMICS:
 New-Keynesian school is developed by N Gregory Mankiw and
David Romer. Old (early) Keynesian show the affect of AD on level
of employment and output of an economy. Less than full
employment Keynesian proposition leads to rise in level of
employment and output. Another remain proposition of this theory
is wage rigidity and backward looking price expectation under
short-run.
 However, N. Gregory Mankiw and David Romer, both of them have
made important contribute to the new Keynesian economics, state
that, the new classical economists argued persuasively
(compellingly) the Keynesian economics was theoretically
inadequate that macroeconomics must be built on a microeconomic
foundation. Not all new Keynesian model, but their main task has
been to improve the microeconomic foundation of the Keynesian
system. Main comparison between early Keynesian and new-
Keynesian as follow:
1) Old Keynesian school is based on perfect competition market. On the other
hand, new Keynesian is based on imperfect competition market.
2) Early Keynesian school is based on nominal wage rigidity. However, new
Keynesian is real price of product rigidity.
3) Old Keynesian school explains nominal variables but new Keynesian
explains real variables.
● The new Keynesian model is the extension of the basic Keynesian model
The model starts from labour market equilibrium and explain that wage is
fixed by contract at the beginning of the period while prices of product may
●
change within the period.
According to new-Keynesian, wage is rigid for three reasons:
a) Menu cost: Menu cost model states that reduction of wages convening,
●
bargaining with the labour. In many case, menu cost will be greater than
benefit from reduction. So wage is downward rigid.
b) Efficiency model: It states a decline in wage increase the absenteeism, and turnover
ratio of labour which increases cost to the producer. In many cases increase in cost due
to decrease in efficiency will be greater than the benefits obtained from reduction in
wage. So producers maintain fixed wages.
c) Inside – outside Cost: It includes the hiring and firing cost, cost of training. If this
cost is greater than benefit from reduction in wage, wage remains rigid downwards.
Both firms and labour set the wage at the level that they expect, will produce
equilibrium in the labour market.
● P be the expected price level, then firms and labour will agree to set the wage at the
level, which is expected to make the real wage equal to
e
●
W
i.e. = where, p* = actual price, P*
W W
Pe
Assume, P*= v ( a constant)

W
.˙. New nominal wage
P* N = P v.
e
 Once the wage is set, firm will produce for market taking the cost of labour as
given, as diminishing MPPL make the firms willing to produce more output when
price increases.
 There is positive relation between price and output. As relation is given by
 y=f( )
W
e
P
 y = f ( P v)
e

 Second Generation of New-classical system / Real Business Cycle or School of

thought (RBC)
 Real business cycle is the second generation of New-classical school of thought.
Therefore, RBC accepts the fundamental ideas of New-classical economics and
based on classical school of thought.
 The theory assumes that,
(i) All the economic agents rational and they form rationalization and they use all the
available information hence there will not be any systematic errors.
(ii) Real economic variables are totally insensitive with any kinds of demand
management policies. It means it is the real variables (i.e. technology and stock of
natural resources) are main determinants of aggregate supply and income.
The theory argues that, the “ variation real opportunities” of the private economy
are the basic reason for the fluctuation in employment and output. Where real
opportunities include stock of the technology, variation in environment condition,
change in real relative price, imports of raw materials, change in the fixed policy that
affect supply.
Similarly, fluctuation in output may occur with the change in the individuals
preference.
Let us take simple utility function,
.˙. Ut = f (Ct , Let ) -------------------(1)
i.e. utility is the function of consumption and leisure time. It means the current utility is
based on current consumption (Ct) and current leisure time ( Let ).
where, Ct = Current Consumption
Let = Current Leisure time
 The consumption is the function of income at the time ‘t’ i.e. at current income.
 .˙. Ct = yt -----------------------------(2)
 The income at the same time is the function of stock of capital and natural resource/
production function :-
 .˙. yt = Zt f ( K , N) t --------------------------(3)
 or, yt = Zt f ( K , N)
 where, Zt = stock including technological, environmental condition, relative
price, tax rates, preferences, business environment, price of important raw material
etc.
 .˙. yt = Ct + St -----------------------(4)
 It means national income is the sum of consumption and saving.

 Let, Kt+1 = (1 – d )Kt + St ----------------------(5)

 Where,
 Kt+1 = stock of capital for next year / time period
 (1 – d) = Depreciation St = Current saving
 .˙. Stock of capital at the time period (Kt+1) or next time period (Kt+1) is the sum of
current saving (St) and available stock of capital at time ‘t’ after deducting
depreciation. ‘St’ depends on fiscal policy.
Therefore, the real business cycle advocate on only one principle and that is the
income & employment are determined by real variables like stock of capital, stock of
natural resources and stock in short run and long run.
If technology and business environment
Y1=z1 f(K,N) is improved then the production function
is shifted from yo to y1.
y2 Yo=zo f(K,N) Yo=zf (K,N) Y1=zf (K,N)
Y2=zf (K,N)
output

y1
Price level
P1

N1 employment
y1 y2 y3
output
When there is shift in production function, supply curve is perfectly
elastic and non-sensitive with nominal price.
UNIT-III: GROWTH MODEL
• Economic Growth:
• The stead process by which the productive capacity of an economy increases so as
to bring increase in the real per capita of the people is called economic growth.
• In another word, the increase in real per capita GDP of the people the country is
called economic growth or economic development.
• It is multidimensional phenomenon because real economic development is
represented by positive impact on social, economic, human political, environmental
etc. indicators.
• Symbolically,
• Qy = Y = f ( K, L, H, T)
• Where,
• K = stock of physical capital
• L = ordinary labour force
• H = Human resource (Health & Education)
• T = State of Technology
• Economic growth theories try to explain major factors that brings increase in the real
GDP or real output or real output of the country.
HARROD GROWTH MODEL
 The main attack of Keynesian Macro economics/theory on the classical economics was on the
classical assumption that an economy always operates in full employment level and any
disturbance is subject to automatic correction by the natural forces of market.
 Therefore, Keynes focused on the short-run analysis by switching off the long-run analysis and
concluding that the price and wage are far from being as flexible as the classical believed.
 To observed the same for an economy Roy.F.Harrod used dynamic approach in formulating the
growth of an economy using acceleration principle and multiplier theory. Harrod theory or
growth provides a dynamic concept to the Keynesian growth theory by combing multiplier and
acceleration principle. This theory was published in the article ‘ An Essay in Dynamic Theory’
in 1939.
 Basic concept of theory:

 Δ y = dy = growth =
dy
 Δ y/y = growth rate = dt.
1 dy
y dt
 Assumptions of the model:-
 The Harrod model of economic growth is based on following assumptions:
(1) Saving is the linear function of incomel. i.e. S = sy ------------------(i)
where, S = Saving, s = mps, y = income
As we know,
S/y = s = APS, ds/dy = s = MPS
.˙. APS = MPS = s.
Hence, in Harrod model average and marginal propensity to save are equal and constant.

(2) Labour force is growing at ‘n’ exogeneous rate.

i.e.
1 dL nt
L dt = n --------------(ii) and its time path is Lt = Lo e
(3) There is fixed coeffiecient production function:-

Y = min , ----------------(iii)
L K
μ V
 Where,
 μ = L/y =minimum amount of labour required to produce one unit of output
 v = K/y = minimum amount of capital required to produce one unit of
 output.
 There equation (iii) states that there is no any technological advancement. Hence, labour and
capital are used in fixed proportion in the production process. Therefore to increase the output
the labour & capital must be increased in the same proportion.
 (4) The economy is closed and is producing a single commodity, which is partly consumed &
partly invested.
 (5) there are two types of capital output ratio: Capital output ratio is the ratio of capital used to
produce one unit of output over a period of time. Harrod basically concerned marginal capital
output ratio. In his model marginal and actual capital output ratio are same.
 Definitioin-1: Actual marginal COR:-
 It is the actual increase in capital which is associated with increase in output. It is denoted by v.
 .˙. AMCOR (v) = Actual ΔK / Actual Δ y
 Definition 2: Desired Marginal COR
 It is the desired increase in capital which is associated with increase in output. It is denoted by
Vr.
.˙. Vr = Desired ΔK / Desired Δy
Derivation of Equilibrium Condition: Dynamic Equilibrium
we have,
K
v= -------------------------(4) [ COR ]
y

or, K = vy
By total differentiation,
dK = v.dy
I = v.dy --------------------(5)
where, dK = change in stock of capital = investment
It is the acceleration principle which states that investment depends on change in output . If
there is increase in level of output, there is increase in investment also, hence there is direct
relationship between increase in investment and level of output.
 Macroeconomic equilibrium condition requires that,
 I=S
 v. dy = sy
1 s
.dy =
y v
s
.˙. dy = -------------------(6)
y v

where, dy
= change in output.
y
which is the fundamental equation in Harrod’s model. It indicates that, to attained the dynamic
equilibrium, output should grow at constant s/v rate. The time path of the output will be
yt = yo.e -----------------(7)
s/v.t
Rough:-

Using time subscription (वार्षिक मूल्य) equation (6) can be written as



1 dyt s
=
yt dt v
 By intergration,

1 Yt .dt s . dt
yt dt =
v
 Log yt = t s+ K
v

 e Log=yte s/v.t
+K
 yt = e .s/v.t
e K
s/v.t
 Let, e = KA , yt = e . A --------------(*)


 Assume t = 0
 .˙. yo = e .s/v.o
A
 yo
.˙.= A

s/v.t
 From equation (*) , yt = yo . e --------------------(7)
 It shows that, the output should grow at s/v constant rate to attain the dynamic macroeconomic
equation. Now, employing the two definition of capital output ratio or Marginal COR of
incremental COR the fundamental equation can be analysed as,
(1) Actual growth rate (G ): A

It is such types of growth rate which gives the increase in output for a given period of time.
Hence it shows the actual increase in output of the economy.
As we know,
fundamental equation in Harrod model is
dy = s v.dy = s. y
y v I = sy [˙.˙ v.dy = I ]
I=S [ s.y ˙.˙
= S ] .˙. G = s
------------------(8)
A
v
This means that, saving (S) should be equal to investment (I) in any period. The relation represent
the re-statement of truism that S = I.
Therefore, actual growth rate shows actual economic activity of an economy. That means it shows
actual income, actual marginal propensity to save and actual capital output ratio.
(2) Warranted Growth Rate (Gw) :-
The concept of warranted rate of growth is primarily related to the behavior of entrepreneurs.
It is the rate of growth at which producers will be connected with what they have done the right
things.
Therefore, it is the path on which macroeconomic system will be in equilibrium. The capital
stock of the economy will be fully utilized and entrepreneurs will be willing to continue to invest
the amount of saving generated at full potential income.
 Gw is therefore, self – sustaining growth. In this case the planned investment is equal to
saving. If we follow the definition II of COP, then the fundamental equation (6) gives
equilibrium growth path of the economy.
 .˙. dy = s .˙. Gw = s
---------------------(9)
y Vr Vr
 This relation states that, if the economy grows at ‘Gw’ rate than macroeconomic system will be
in equilibrium.

 Stead state of equilibrium growth:-

The steady state of equilibrium growth requires that the actual growth rate must be equal to the
warranted growth rate.
.˙. G = Gw
A ----------------------(10)
It implies that, output should actually grow at the warranted rate. If it happens, then the actual
capital stock will confirm to desired capital stock and entrepreneurs would be prepared to carry on
the same rate of growth in future.
From equation (8) we have,
G = A
s
v
.˙. v G = s ------------(11)
A
 Similarly, from equation (9) we have,

s
 Gw =
Vr


 or, Vr Gw = s -------------------------(12)
 Combining (11) and (12) we get,
 VG = s A= Vr.Gw ---------------------(13)
 In above equation, if G =AGw, then V must be equal to Vr. (i.e. ACOR = DCOR). It means the
actual capital output ratio is equal to desired capital output ratio.

 Steady state of equilibrium growth with full employment

If labour force to be fully employed, from the production function
we have, y = 1-------------------(14)
u
y 1
constant
L = u =
 Where, y/L = per capital output and is constant. It means that ‘y’ should grow (output should
grow) at the same rate as labour force grow. But ‘L’ is growing at ‘n’ growth rate. .˙. Gn = n
it is known as the natural rate of growth.
 So steady state of full employment growth requires,
G = AGw = Gn
or, G =A =S n ---------------------(15)
Vr

Therefore, natural growth rate is the maximum potential rate of growth with labour force, state of
technology and natural resources. The natural rate of growth is determined by the labour force
growth in economy and technological improvement and which may be called full employment rate
of growth.
Therefore, equation (15) shows that, if we combine actual growth rate, warranted growth rate and
the natural growth rate then the labour, capital and all the other resources in the economy are fully
utilized and hence then economy is in equilibrium with full employment of labour, capital and all
the other resources.

It these three growth rate are not equal to each other then there are basically two problems arise in
Harrod model as,
(1) Problem of attaining equilibrium and
(2) Problem of maintaining/stability of equilibrium
(1) Problem of attaining equilibrium:-
In the model s, n and v all are determined independently. Hence, there is very less possibility
of attaining equilibrium. Therefore, only a happy accident will generate steady state growth at full
employment in the Harrod model.
Since ‘s’ is determined by firms and households preference about saving. ‘n’ is determined by
biological factor-death rate and birth rate. ‘Vr’ is the reflexing of fixity of technology, by
assumption, hence there is no mechanism is Harrod Model rather than accident which would
ensure the steady state growth at full employment level.

(2) Problem of stability of equilibrium:

Suppose, economy attains G A = Gw = Gn by happy accident. But by some reasons the
situation get disturbance and again have to wait for happy accident.

If G A>
s >
s s s.Vr = s . V
v v v
Vr > V
It means desired ICOR is greater than actual ICOR. Entrepreneurs give higher doses of investment
in the economy. This intern increases the further G . There will be greater hyper
A inflation between
G and Gw. Hence it leads to “chronic”Ainflationary gap.
Similarly, if G <
A Gw
or, s s
< S. Vr < s. v
v v
Vr < v
It means the desired ICOR is lower than actual ICOR. It indicates that there is excess
of capital which leads to realized investment is higher than planned level, entrepreneurs
reduces leading G < Gw. This lead to chronic deflationary gap, businessman would
fail to sell all that they have produced.
Therefore, the model is the highly ustable model. Therefore, Harrod
conclusions are,
There is warranted rate of growth in output, which once achieve will be
maintained.
If any other rate of growth is attained, then adjustment within the system will
move the rate not towards but further away from the Gw.
DOMAR MODEL OF ECONOMIC GROWTH
 Domars growth model is integration between classical and Keynesian
income determination with dynamic analysis on them. His model is also the
combination between Keynesian multiplier and acceleration principle,
therefore there is not any fundamental differences between Harrod model of
growth and Domars model of growth.
 Basic assumption of the model is any change in the rate of investment flow
per year will produce a dual effect in the economy. It will affect the
aggregate demand side (i.e. income generating effect) and also affect on the
production capacity (i.e. capacity generating effect).
 The income generating effect (AD) of investment works through Keynesian
multiplier and on the other hand investment on physical capital (machine,
equipment, furniture) increase the productive capacity of the economy.
 Domar’s main objective is to explore the growth rate of investment required to
achieve the equilibrium between potential and actual growth rate of the output of the
economy i.e. how rapidly investment must grow in order to full capacity is to be
maintained.
 Assumptions of the model:-
 The basic assumption of the models are same as in Harrod’s model, however
following can be added as assumptions of the model.
1) The society is inclined with constant marginal propensity to save. i.e.
St = syt.
2) Capital output ratio for the economy is constant.
3) There is no change or improvement in the technology.
4) The production function is characterized by no substitution possibility between
factor inputs.
5) Capital does not depreciate.
 The Model:-
1) Supply side effect / capacity generating effect:- The productive capacity of the
economy is the function of stock of natural resources,