Money Matters

THE ECONOMIC TIME-LINE Chicago Univ = USA

The era of Neo-Liberalism

CPS

1980 1989 1991 2008 2020

Money Does Not Matters SSAP Fall of GFC Pandemic

Friedman Berlin
Cambridge Univ = UK Wall
India &
The era of Keynesian Economics LPG
SPS

1936 1944 1973

IMF,
J.M. Keynes 1st Int. Oil
Money Matters WB &
Gen Th. Crisis
GATT
Cambridge Univ = UK

The eras of Classical and Neo-Classical Economics

Liberalism
1914 to 1918 1939 to 1945
1776 1917 1929 to 1939

Adam WW1 Russian Great

Smith Rev. Depression WW2
W.O.N.
Keynesian Critique of the Classical / Neo-Classical Economics

1. Laissez Faireism has to be ended

(Dig-A-Hole-Fill-A-Hole Policy)

2. Says Law of the Market (Supply creates its own Demand)

(Demand is the starting point of a country’s economic policies)

3. Economy working at Full Employment is flawed

(Economies work under the full employment mark)

4. Wage-Cut Policy is counter to what is actually needed

(Wage cuts will reduce purchasing power and so consumption)

5. ‘Money Matters’ vs ‘Money Does Not Matter’

(Fiscal Policy can deliver more effectively than Monetary Policy)
The notion of Full Employment and the Wage-Cut Policy
Population Line

Wage
Rate

ASL

TSL
D1 S1 T1
W1 Invol. Unemp. Vol. Unemp. Unemployables P1
Employed

Employed E Voluntary Unemployables

P
W Unemp.
T

DL
Employed Unemployed

L H DL, SL, Pop.

Size
 Keynesian Economics

Psychological Law of Consumption

1. An increase in income leads to an increase in consumption

2. The increase in income exceeds the increase in consumption

1. An increase in income leads to an increase in consumption C = f+(Y)
Slope Issue ??
The consumption curve is positively sloped

Con
C3

C2

C1

Income
2. The increase in income exceeds the increase in consumption 𝚫 𝑪< 𝚫 𝒀
Slopedness Issue ??

Con
Con
C3

C C*
45o C2
U*

45o 90o
U C1
Y Income R*
C

OY = YC
Y Y* Income
Hence, Income = Consumption Income > Con Income < Con
This leads to This leads to
+ve Savings –ve Savings
 Vertical Intercept Issue ??

Con

Y = C line

C1

OA1 is AUTONOMOUS
Consumption
C0
A1

(Current) Income
 Y = C line
Con

U3

( 𝒀 )
𝒂 + 𝒃
𝑪=
Positive Savings

C3
C2 = U2
Income
C1
Income = Consumption,
hence Saving = 0
Dis-Savings
A
Consumption
U1
Consumption

Income

45o
Y1 Y2 Y3 Income
 ?

APC3 < 1 Y = C line

Con

𝑪 𝟑 𝒀 3<𝑼 𝟑 𝒀 𝟑
APC2 = 1

𝑪 𝟐 𝒀 2= 𝑼 𝟐 𝒀 𝟐
𝑪 APC1 > 1
( 𝒀
𝐀𝐏𝐂 =
𝒀 𝑪 𝟏 𝒀 𝟏>𝑼 𝟏 𝒀 𝟏 U3
= 𝒂 +𝒃
𝑪
C2 = U2 C3

C1

A
U1

45o
Y1 Y2 Y3 Income
 Savings Curve and APS
Y = C line
Con &
Savings U3
𝑺
𝐀𝐏𝐒=
𝒀
C

U2 C3
C1
A S

S3
U1

Dis-Savings 450
O
Y1 Y2 Y3 Income
APS2 = 0 APS3 > 0
S1 APC3 < 1
APC2 = 1
A* APS1 < 0
APC1 > 1
𝟏 . 𝒀 =𝑪+𝑺
𝒀 𝑪 +𝑺
𝟐. =
𝒀 𝒀
3

4a

4b
Con

Y = C line
U2

( 𝒀 )
U1 = 𝒂 +𝒃
𝑪
C2
𝚫𝑪
C1 𝚫𝒀 T2

∆𝑪
𝑴𝑷𝑪=
A ∆𝒀

45o 𝚫𝒀
Y1 Y2 Income
 U3C3 = New Savings
Con
Construction: Draw A*C* || AC and passing through U2Y = C line

U2C2 = R3C3 = Original Savings

U3
Thus, U3C3 - R3C3 = Change in Savings C*
∆S

U2 R3
C

C3
A* C2 ∆C
T3 MPS = U3R3
∆Y ¿
Y2Y3
A

45o
Y2 Y3 Income
𝟏.𝒀 =𝑪+𝑺

𝟐 . ∆ 𝒀 =∆ 𝑪 +∆ 𝑺

5a

5b
 Extension of Savings notion Y = C line
Con & U3
Savings

U2
S

S3
C
U1 C3
C2

C1
U0
S1
A
LDCs Developed Economies
Developing Economies
450

Y0 Y1 Y2 Y3 Income

A*
 Factors Affecting the Consumption Function
Objective Factors Subjective Factors
These are those factors that These are those factors that affect
affect the entire economy in the individual consumers and firms in the
same manner economy differently
Consumers’ Motives = the desire to
1. General price level
1. Build reserves for contingencies
2. Fiscal Policy
2. Provide for future anticipated needs
3. Rates of Interest 3. Enjoy an enlarged future income
4. Stock of Wealth 4. Improve standard of living
5. Monetary Policy 5. Attain economic independence
6. Income Distribution 6. Bequeath a fortune
7. Windfall Gains and Losses Business Motives = the desire to
8. Changes in Expectations 1. Build and expand one’s business width
2. Provide liquidity for future needs
3. Enjoy an enlarged revenues
4. Safeguard against all types of depreciation
Refer: HL Ahuja: Ch 6 Consumption Function (Determinants of propensity to consume)
ML Jhingan: Ch 8 The Consumption Function (Determinants of the consumption function
Investment Multiplier
Investment Multiplier =
Assume MPC = 0.8 & ∆I = 1000

∆I ∆Y = ∆C + ∆S

1000 1000 800 200

800 640 160

640 512 128

5000

= ∆ = 5000
Dynamic Investment Multiplier Assumptions
1. MPC = b
Period Investment Income Consumption
2. Investment made = ∆I
1 ∆I Y1 b(∆I)
2 b(∆I) b{b(∆I)} = b2(∆I)
3 b2(∆I) b{b2(∆I)} = b3(∆I)
4 b3(∆I) b{b3(∆I)} = b4(∆I)
5 b4(∆I) b{b4(∆I)} = b5(∆I)
6 :
: b(n – 1)(∆I)
(n - 1) b(n – 1)(∆I) b{b(n – 1)(∆I)} = bn(∆I)
n

Yn = ∆I + Y1+ b(∆I) + b2(∆I) + b3(∆I) + b4(∆I) + ….. + b(n – 1)(∆I)

(Yn -Y1) = ∆I + b(∆I) + b2(∆I) + b3(∆I) + b4(∆I) + ….. + b(n – 1)(∆I)
(Yn -Y1) = (∆I){1 + b + b2 + b3 + b4 + ….. + b(n – 1)}
(∆Y) = (∆I) Hence, k =
 Investment Multiplier (graphically)

Con Y = C line

C*
E2
C

A* E1

Y1 Y2 Income
 Reverse Investment Multiplier (graphically)

Con Y = C line

C
E1

C*
A
E2

A*

Y2 Y1 Income
Leakages in the Multiplier This implies a fall in MPC = rise in MPS
1. Savings that are Hoarded
(Paradox of Savings : Savings is a private virtue but a Public Vice)
∆ = 5000 ∆ = 2500

2. Patronizing the Second-Hand commodity market and the stock market

New Employment generation is adversely impacted

3. Inflationary pressures that cause ‘Forced Savings’

Now, Rs 100 spent on Ga, Gb and not Gc; hence, Gc sector adversely affected

4. Contractionary Fiscal Policy

High Direct Taxes reduces ability to buy
High Indirect Taxes reduces both willingness and ability to buy
Lesser Subsidies reduces both willingness and ability to buy

5. Adverse Balance of Payments and depreciating domestic currency

Rising Import Expenditure and greater outflow of Forex Reserves
 Investment Multiplier
1. Y = C + I + G But C = a + bYd and Yd = ( Y – T )
2. C = a + b(Y – T)
3. Y = a + b(Y – T) + I + G 4. Y = a + bY – bT + I + G

5. Y – bY = a – bT + I + G 6. Y(1 – b) = a – bT + I + G
7.

8. 9.

10.

11. 12.

13. 14. =
23
 Balanced Budget Multiplier or Government Multiplier
1. Y = C + I + G But C = a + bYd and Yd = ( Y – T )
2. C = a + b(Y – T)
3. Y = a + b(Y – T) + I + G 4. Y = a + bY – bT + I + G

5. Y – bY = a – bT + I + G 6. Y(1 – b) = a – bT + I + G
7.

8. 9.

10.

11. 12.

13. 14. =
24
 Foreign Trade Multiplier
1. Y = C + I + G + [(X – M) + (R – P)]
2. C = a + bYd and Yd = ( Y – T ); hence, C = a + b(Y – T)
Also let [(X – M) + (R – P)] = Z

3. Y = a + b(Y – T) + I + G + Z 4. Y = a + bY – bT + I + G + Z

5. Y – bY = a – bT + I + G + Z 6. Y(1 – b) = a – bT + I + G + Z

7.

8. 9.

10.

11. 12.

13. 14. =
Combined Multiplier

= Tandem working of: kI, kG and kZ

SPS Model : kI + kG + kZ

CPS Model : kI + kG + kZ

Foreign Trade Dependent economies : kI + kG + kZ