Economics-Paper-XII-History-of-Economic-Thoughts-I-English-Version-munotes

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1 Module I
1
AN ORIGIN OF CLASSICAL ECONOMICS
Unit Structure:
1.1. Objective
1.2. Introduction
1.3. Mercantilism
1.4. Physiocracy
1.5. Adam Smith
1.5.1 Liberalism
1.5.2 Division of Labor
1.5.3 Theory of Value
1.6 Summary
1.7 Questions
1.8 References
1.1 OBJECTIVES
After going to this modu le you will be able:
 To understand the origin of Classical Economics
 To understand the school of Mercantilism and Physiocracy
 To understand the thoughts of Adam Smith
1.2 INTRODUCTION
The subject, the History of Economic Thought, m ay be defined as a
critical account of the development of economic ideas, searching into their
origins, interrelations, and, in some cases, their results. The history of
economic thought concerns thinkers and theories in the field of political
economy and economics from the anci ent world right up to the present
day. Economics was not considered a separate discipline until the
nineteenth century. For example, Aristotle, the ancient Greek philosopher,
in his works on politics and ethics have thought of ‘art o f wealth
acquisition’. He also considered the question whether property is best left
in private or public hands. In medieval times, scholars like Thomas
Aquinas argued that it was a moral obligation of businesses to sell goods munotes.in

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2 at a just price. Economic tho ught evolved through fe udalism in the Middle
Ages to mercantilist theory during the Renaissance (when people were
concerned to orient trade policy to further the national interest). The
modern political economy of Adam Smith appeared during the industrial
revolution, when techno logical advancement, global exploration, and
material opulence that had previously been unimaginable was becoming a
reality. All these and further developments are subject matter of history of
economic thought changes in economic tho ught have always accomp anied
changes in the economy, just as changes in economic thought can propel
change in economic policy. Economic thought has at times focused on the
aspects of human nature such as greed and selfishness that generally work
against th e good of all; at other times, economic behavior has been seen as
self-regulating and working toward a common purpose. As contemporary
economic thought deals with the issues of globalization and the emergence
of a global economy, economists have turned to the multitude of other
disciplines which, like economics, developed independently. Building on
their discoveries, and united with them in pursuit of the common goal of
benefiting human society, economic thought may be on the road to
achieving a new level o f understanding. There are several ways to present
the history of economic thought. (i) to analyze the changing nature of
economic theory in conjunction with the social and economic
development of society (ii) to emphasize economic thinking as part of the
main currents of philos ophical and political ideas (iii) to emphasize the
internal dynamics of the science where new insights and results emerge as
a consequence of economists’ awareness of the shortcomings of the
present state of the subject.
Economic his tory is different from history of economic thought. Economic
history is the study of the economic aspects of societies in the past; the
history of the economic use of resources land, labor and capital; or the
examination of the past performance of economie s. It is concerned with
how people lived most of their lives, how many were born and died, how
they earned and spent, worked and played. Such variants, however, reveal
little more than the definition which once said simply that it was the sort
of history w hich required a knowled ge of economics; though they are an
advance on that which defined an economic historian as one who wrote as
little history as possible for as much money as possible.
Economic history asks economic questions be they about the demand a nd
supply of goods and services, about costs of production, levels of income,
the distribution of wealth, the volume and direction of investment, or the
structure of overseas trade it inevitably deals with large numbers, with
aggregates. A study of economi c history is important because the
historical economic phenomena to be examined in any given period have
no existence independent of the social, political, cultural, religious and
physical environment in which they occurred.
Classical School
The Classical School, which is regard ed as the first school of economic
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3 Smith, and those British economists that followed, such as Robert Malthus
and David Ricardo. The main idea of the Classical schoo l was that
markets work best when they are left alone, and that there is nothing but
the smallest role for government. The approach is firmly one of laissez -
faire and a strong belief in the efficiency of free markets to generate
economic development. Marke ts should be left to wo rk because the price
mechanism acts as a powerful 'invisible hand' to allocate resources to
where they are best employed. In terms of explaining value, the focus of
classical thinking was that it was determined mainly by scarcity and costs
of production. I n terms of the macro -economy, the Classical economists
assumed that the economy would always return to full -employment level
of real output through an automatically self -adjustment mechanism. It is
widely recognized that the Classica l period lasted until 1 870.
Classical economics refers to work done by a group of economists in the
eighteenth and nineteenth centuries. They developed theories about the
way markets and market economies work. The study was primarily
concerned with the dyn amics of economic growt h. It stressed economic
freedom and promoted ideas such as laissez -faire and free competition.
Economic thought until the late 1800’s. Adam Smith’s Wealth of Nations,
published in 1776 can be used as the formal beginning of Classical
Economics but it actua lly it evolved over a period of time and was
influenced by Mercantilist doctrines, Physiocracy, the enlightenment,
classical liberalism and the early stages of the industrial revolution.
Classical economics as the predominant school of mainstream economics
ends with the ‘Marginalist Revolution’ and the rise of Neoclassical
Economics in the late 1800’s. In the 1870’s William Stanley Jevons’ and
Carl Menger’s concept of marginal utility and Leon Walras’ general
equilibrium theory provid ed the foundations. Hen ry Sidgwick, F.Y.
Edgeworth, Vilfredo Pareto and Alfred Marshall provided the tools for
neoclassical economics. Neoclassical economics is an extension of
Classical economics but, the focus of the questions changed as well as the
tools of analysis. In spite of the dominance of Neoclassical thought,
Classical Economics has persisted and influences modern economics,
particularly the ‘New Classical Economics.’ The belief in the efficacy of a
‘free market’ is central to both classical and neoclassical ideology.
Famous economists of this school of thought included Adam Smith, David
Ricardo, Thomas Malthus and John Stuart Mill. While Adam Smith would
be regarded as the originator and leader of the school, David Ricardo
should be credited with establishing the form and methods of the school.
The debates between Thomas Malthus and David Ricardo about policy
issues such as the ‘Corn Laws’ and the ‘Poor Laws’ contributed to the
focus and form of the school. Smith was concerned about the nature of
economic growth. Malthu s, Ricardo and other classical economists were
concerned about the question of ‘distribution.’ One important debate
among classical economists was whether there was or wasn’t a ‘surplus’
or ‘glut.’ Jean Baptiste Say and Malthus were the two major protagoni sts
in the question about the existence of a surplus and its effects on a market
economy.
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4 1.3 MERCANTILISM
1.3.1 Introduction :
Mercantilism is economic nationalism for the purpose of building a
wealthy and powerful state. Adam Smit h coined the term “mercantile
system” to describe the system of political economy that sought to enrich
the country by restraining imports and encouraging exports. This system
dominated Western European economic thought and policies from the
sixteenth to t he late eighteenth centuries. The goal of these policies was,
supposedly, to achieve a “favorable” balance of trade that would bring
gold and silver into the country and also to maintain domestic
employment. In contrast to the agricultural system of the ph ysiocrats or
the laissez -faire of the nineteenth and early twentieth centuries, the
mercantile system served the interests of merchants and producers such as
the British East India Company, whose activities were protected or
encouraged by the state. The mo st important economic rationa le for
mercantilism in the sixteenth century was the consolidation of the regional
power centers of the feudal era by large, competitive nation -states. Other
contributing factors were the establishment of colonies outside Europ e; the
growth of European com merce and industry relative to agriculture; the
increase in the volume and breadth of trade; and the increase in the use of
metallic monetary systems, particularly gold and silver, relative to barter
transactions. During the me rcantilist period, military c onflict between
nation -states was both more frequent and more extensive than at any other
time in history. The armies and navies of the main protagonists were no
longer temporary forces raised to address a specific threat or ob jective, but
were full -time p rofessional forces. Each government’s primary economic
objective was to command a sufficient quantity of hard currency to
support a military that would deter attacks by other countries and aid its
own territorial expansion. Mos t of the mercantilist policie s were the
outgrowth of the relationship between the governments of the nation -states
and their mercantile classes. In exchange for paying levies and taxes to
support the armies of the nation -states,the mercantile classes induc ed
governments to enact polic ies that would protect their business interests
against foreign competition.
1.3.2 Meaning :
Alexander Gray observes that mercantilism is a misleading and deceitful
word. Different writers have defined mercantilism differently. According
to Lekachman “mercantilism was a battle against hampering medieval
thought and practice”. It was revolt against medievalism resolve to
reconstruct economic life to a more rational scheme. To Edmund
Whittaker mercantilism was the economic counterp art of political
nationalism”. Heima n described it as the ideological justification of
Commercial Capitalism.
Thus mercantilist writers were essentially practical businessmen,
merchants and administrators in various European countries like England,
France, Italy, Germany, Scotland, and Spain etc. They left behind munotes.in

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5 numerous works regarding contemporary national economic problems.
They do not form a school of economists. So the ideas and policies which
dominated the economic scene of England 'and a part of Eur ope between
the close of the 16th ce ntury and the middle of the 18th century can rightly
be called as mercantilism. Mercantilist writers put emphasis on foreign
trade as a means of accumulating treasure and building a strong nation.
1.3.3 Important Economi c Theories of Mercantilism :
Whereas the eco nomic literature of scholasticism was written by medieval
churchmen, the economic theory of mercantilism was the work of secular
people, mostly merchant businessmen, who were privately engaged in
selling and buyin g goods. The literature they produced focus ed on
questions of economic policy and was usually related to a particular
interest the merchant and writer (in one person) was trying to promote. For
this reason, there was often considerable skepticism regarding the
analytical merits of particular argume nts and the validity of their
conclusions. Few authors could claim to be sufficiently detached from
their private issues and offer objective economic analysis. However,
throughout the mercantilism, both the quanti ty (there were over 2000
economic works pub lished in 16th and 17th century) and quality of
economic literature grew. The mercantilist literature from 1650 to 1750
was of distinctly higher quality, these writers created or touched on nearly
all analytical c oncept on which Adam Smith based his Wealth of Nations,
which was published in 1776.
The age of mercantilism has been characterized as one in which every
person was his own economist. Since the various writers between 1500
and 1750 held very diverse views, it is difficult to generalize about the
resulting literature. Furthermore, each writer tended to concentrate on one
topic, and no single writer was able to synthesize these contributions
impressively enough to influence the subsequent development of
econo mic theory.
Secondly, mercantilism can best be understood as an intellectual reaction
to the problems of the times. In this period of the decline of feudalism and
the rise of the nation -states, the mercantilists tried to determine the best
policies for pro moting the power and wealth of the nation, the policies that
would best consolidate and increase the power and prosperity of the
developing economies. What is especially important here is the
mercantilist assumption that the total wealth of the world was f ixed and
constant. These writers applied th e assumption to trade between nations,
concluding that any increase in the wealth and economic power of one
nation occurred at the expense of other nations (the rest of the world).
Thus, the mercantilists emphasiz ed international trade as a mean of
increas ing the wealth and power of a nation. Using some modern game -
theoretic language, we may say, that they perceived economic activity and
international trade in particular as a zero -sum game that is a game, where
it is impossible for both players to win. So a ccording to mercantilists, it is
impossible to increase a global wealth of the world in effect of
international trade. It is a very sad assumption, and modern economists do munotes.in

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6 not share it. The goal of economic activ ity, according to most
mercantilists, was p roduction, not consumption, as classical economists
would later have it. They advocated increasing the nation’s wealth by
simultaneously encouraging production, increasing exports and holding
down domestic consump tion. Thus, in practice, the wealth of nati on rested
on the poverty of the many members of society.
Third general point about mercantilism is their insistence on the notion of
balance of trade. Balance of trade figures, also called net exports, are the
sum of the money gained by a given economy sel ling exports, minus the
cost of buying imports. A positive balance of trade is known as a trade
surplus and consists of exporting more than one imports. A negative
balance of trade is known as a trade deficit and consists of importing more
than one export. As we know today, neither positive nor negative balance
of trade is necessarily dangerous in modern economies, although large
trade surpluses or trade deficits may sometimes be a sign of other
economic problems. According to mercantilists a country should increase
exports and discourage imports by means of tariffs, quotas, subsidies,
taxes and the like in order to achieve a so -called favorable or positive
balance of trade. Production should be stimulated by govern ment
interference in the domestic economy a nd by the regulations of foreign
trade. Protective duties should be placed on manufactured goods from
abroad; and the state should encourage the import of cheap raw materials
to be used in manufacturing goods for export.
1.3.4 Criticisms of Mercantilism :
The foll owing criticisms were levelled against mercantilism by the
opponents:
1. The mercantilists exaggerated the importance of Commerce to the
extent of depressing agriculture and other branches of human industry .
2. Undue importance was attached to gold and sil ver.
3. They were under erroneous belief that a favorable balance of trade
alone would bring prosperity to the country.
4. Their idea about value, utility capital and interest were vague and
imperfect.
5. They are narrow minded nationalists and not cosmopo litans. They could
not conceive the ideas of mutually advantageous trade. However, we
cannot dismiss their ideas as useless or impractical. The idea of
nationalism, self -sufficiency and economic strength we re the outcome
of their policies. The mercantilist policy proved successful in France,
England, Holland and Germany who were competing for colonial
supremacy.

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7 1.4 PHYSIOCRACY
1.4.1 Introduction :
The Physiocrats were a group of economists who believed tha t the wealth
of nations was derived solely from agricult ure. Their theories originated in
France and were most popular during the second half of the 18th century.
Physiocracy was perhaps the first well developed theory of economics.
They called themselves économistes (economists) but are generally
referred to a s Physiocrats in order to distinguish them from the many
schools of economic thought that followed them. Physiocrat is derived
from the Greek for “Government of Nature”. The principles of
Physiocracy were first put forward by Richard Cantillon, an Irish ba nker
living in France, in his 1756 publication Essai sur la nature du commerce
en géneral (Essay on the Nature of Commerce in General). The ideas were
later developed by thinkers such as François Ques nay and Jean Claude
Marie Vincent de Gournay into a more systematic body of thought held by
a united group of thinkers. The Physiocrats saw the true wealth of a nation
as determined by the surplus of agricultural production over and above
that needed to su pport agriculture (by feeding farm laborers and so forth ).
Other forms of economic activity, such as manufacturing, were viewed as
taking this surplus agricultural production and transforming it into new
products, by using the surplus agricultural producti on to feed the workers
who produced the extra goods. Whi le these manufacturers and other non -
agricultural workers may be useful, they were seen as 'sterile' in that their
income derives ultimately not from their own work, but from the surplus
production of the agricultural sector. The Physiocrats strongly oppos ed
mercantilism, which emphasized trade of goods between countries, as they
pictured the peasant society as the economic foundation of a nation's
wealth. The Physiocrats enjoyed some support from the French monarchy
and frequently met at Versailles. Adam S mith, who visited France as a
tutor and mentor to the Earl of Buccleigh's son's Grand Tour, was heavily
influenced by the ideas of the Physiocrats, and Karl Marx cites them as a
reference in Das Kapit al; they popularized the modern version of the labor
theory of value.
Physiocracy is a school of thought founded by François Quesnay (1694 -
1774), a court physician to King Louis the 15th. At one point in time
Physiocracy constituted a sort of religious mov ement that attracted a
number of outstanding and extreme ly fervent believers, and exerted no
small influence on real politics. The history of the Physiocratic movement
is thought to have begun in 1757, when Quesnay met Mirabeau the elder
(1715 -89), and com e to an end in 1776, with the fall of Turgot (1727 -81).
The actual members of the Physiocratic school referred to themselves not
as Physiocrats but as économistes. The term “physiocracy” apparently
came into general use after having first appeared in 1767, with the
appearance of a collection of Quesnay’s works published by Pierre du
Pont under the title Physiocratie, ou Constitution Naturelle du
Gouvernement le Plus Avantageux au Genre Humain. The term is of
course a combination of “physio” (nature) and “cr acy” (rule), thus munotes.in

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8 meaning the “rule of nature.” This exp resses the school’s fundamental
idea that there is a natural order, as opposed to artificial systems, and that
the mission of scholarship and politics being to understand this natural
order and bring it into existence, thereby bringing about this rule of n ature.
1.4.2 The Basic Principles of Physiocracy:
The following are the fundamental principles and policies of physiocracy.
1. Agriculture is the only productive occupation.
2. Industry and trade are sterile occupations.
3. Agriculture alone produces net product .
4. There is a natural order which makes life happy and meaningful.
5. There is harmony among all classes of people.
6. The individual should get maximum liberty.
7. State action should be limi ted to the minimum.
8. Trade is a necessary evil, and there sh ould be free trade.
9. Value depends on utility. Wealth has value. Value and price are the
same things.
10. The wage level is at the subsistence level.
11. There is interdependence in the econom ic system.
12. Real wealth lies in tangible and consumable goo ds.
13. Private initiative must be encouraged.
14. Distribution of products is very essential.
15. Money is a medium of exchange.
16. All that is bought is sold and all that is sold is bought.
17. Rent is a perfectly legitimate income of the landlords.
18. There should be a single and direct tax on land, as it is the only
productive source.
19. Private property is essential.
20. There is the possibility of overpopulation on land.
1.4.3 Criticisms of Physiocracy
The important criticism levelled against physiocracy are as follows:
1. Their theory was drowned in normative statement. This is quite true of
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9 2. The physiocrats failed to consider the laboring Class as a productive
class. Moreover, their contention that manufacturing class is sterile is
also subject to severe criticism.
3. The physiocrats do not have a clear -cut concept of value. They have
confused value with utility. They held the view that value depend on
utility.
4. Their conception of landlord as partly productive class is more ba sed
upon political motive.
5. Physiocrats placed too much emphasis on agriculture and have
neglected the non -agricultural sector.
6. Hanex says that physiocratic doctrines are full of nega tive attitudes.
1.5 ADAM SMITH
Adam Smith was born in Kirkcaldy, Fi fe, Scotland. The exact date of his
birth is unknown; however, he was baptized on June 5, 1723. Smith was
the Scottish philosopher who became famous for his book, ‘The Wealth of
Nations’ wr itten in 1776, which had a profound influence on modern
economics a nd concepts of individual freedom.
In 1751, Smith was appointed professor of logic at Glasgow University,
transferring in 1752 to the chair of moral philosophy. His lectures covered
the fie ld of ethics, rhetoric, jurisprudence and political economy, or
‘police and revenue.’ In 1759 he published his Theory of Moral
Sentiments, embodying some of his Glasgow lectures. This work was
about those standards of ethical conduct that hold society toge ther, with
emphasis on the general harmony of human motives and act ivities under a
beneficent Providence.
Smith moved to London in 1776, where he published An Inquiry into the
Nature and Causes of the Wealth of Nations, which examined in detail the
consequ ences of economic freedom. It covered such concepts as the role
of self-interest, the division of labor, the function of markets, and the
international implications of a laissez -faire economy. ‘Wealth of Nations’
established economics as an autonomous subj ect and launched the
economic doctrine of free enterprise. Smith la id the intellectual framework
that explained the free market and still holds true today. He is most often
recognized for the expression ‘the invisible hand,’ which he used to
demonstrate ho w self -interest guides the most efficient use of resources in
a nat ion’s economy, with public welfare coming as a by -product. To
underscore his laissez -faire convictions, Smith argued that state and
personal efforts, to promote social good are ineffectual compared to
unbridled market forces.
In 1778, he was appointed to a post of commissioner of customs in
Edinburgh, Scotland. He died there on July 17, 1790, after an illness. At
the end it was discovered that Smith had devoted a considerable part of his
income to numerous secret acts of charity. His Important works are: ‘T he munotes.in

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10 Theory of Moral Sentiments’ (1759). ‘An Inquiry into the Nature and
Causes of the Wealth of Nations’ (1776).
1.5.1. Liberalism
Meaning
Classical liberalism is a political and economic id eology that advocates the
protection of civil liberties and laissez -faire econo mic freedom by limiting
the power of the central government. Devel oped in the early 19th century,
the term is often used in contrast to the philosophy of modern social
liberalism. Emphasizing individual economic freedom and the protection
of civil liberti es under the rule of law, classical liberalism developed in the
late 18th and early 19th centuries as a response to the social, economic,
and political changes brought on by the Industrial Revolution and
urbanization in Europe and the Unit ed States. Based on a belief that social
progress was best achieved through adherence to natural law and
indivi dualism, classical liberals drew on the economic ideas of Adam
Smith in his classic 1776 book “The Wealth of Nations.”
Classical liberals also agreed with Thomas Hobbes’ beli ef that
governments were created by the people for the purpose of m inimizing
conflict between individuals and that financial incentive was the best way
to motivate workers. They feared a welfare state as a danger to a free
market economy. In essence, class ical liberalism favors economic
freedom, limited government, and pr otection of basic human rights, such
as those in the U.S. Constitution’s Bill of Rights . These core tenets of
classical li beralism can be seen in the areas of economics, government,
politic s, and sociology.
Economics
On an equal footing with social and political freedom, classical liberals
advocate a level of economic freedom that leaves individuals free to
invent and produc e new products and processes, create and maintain
wealth, and trade freely with others. To the classical liberal, the essential
goal of government is to facilitate an economy in which any person is
allowed the greatest possible chance to achieve his or her life goals.
Indeed, classical liberals view economic freedom as th e best, if not the
only way to ensure a thriving and prosperous society.
Critics argue that classical liberalism’s brand of economics is inherently
evil, overemphasizing monetary profit th rough unchecked capitalism and
simple greed. However, one of the ke y beliefs of classical liberalism is
that the goals, activities, and behaviours of a healthy economy are
ethically praiseworthy. Classical liberals believe that a healthy economy is
one tha t allows a maximum degree of free exchange of goods and services
between individuals. In such exchanges, they argue, both parties end up
better off —clearly a virtuous rather than evil outcome. The last economic
tenant of classical liberalism is that indivi duals should be allowed to
decide how to dispose of the profits rea lized by their own effort free from
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11 Government
Based on the ideas of Adam Smith, classical liberals believe that
individuals should be free to pursue a nd protect their own economic self -
interest free from undue interfe rence by the central government. To
accomplish that, classical liberals advocated a minimal government,
limited to only six functions:
 Protect individual rights and to provide services that cannot be provided
in a free market.
 Defend the nation against for eign invasion.
 Enact laws to protect citizens from harms committed against them by
other citizens, including protection of private property and enforcement
of contracts.
 Create and maintain public institutions, such as government agencies.
 Provide a stable currency and a standard of weights and measures.
 Build and maintain public roads, canals, harbours, railways,
communications systems, and postal services.
Classical liberalism holds that r ather than granting the fundamental rights
of the people, governmen ts are formed by the people for the express
purpose of protecting those rights.
Sociology
Classical liberalism embraces a society in which the course of events is
determined by the decision s of individuals rather than by the actions of an
autonomous, arist ocratically -controlled government structure.
Key to the classical liberal’s approach to sociology is the principle of
spontaneous orderthe theory that stable social order evolves and is
maintained not by human design or government power, but by random
events and processes seemingly beyond the control or understanding of
humans. Adam Smith, in The Wealth of Nations, referred to this concept
as the power of the “invisible hand .
For ex ample, classical liberalism argues that the long -term trends of
market -based economies are the result of the “invisible hand” of
spontaneous order due to the volume and complexity of the in formation
required to accurately predict and respond to market fluc tuations.Classical
liberals view spontaneous order as the result of allowing entrepreneurs,
rather than governments, to recognize and provide for the needs of the
society.
1.5.2 Division of Labor
The main focus of Adam Smith’s The Wealth of Nations lies in the
concept of economic growth. Growth, according to Smith, is rooted in the
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12 specialization of the labor force, essentially the breaking down of large
jobs into many tiny components. Under t his regime each worker becomes
an expert in one isolated area of production, thus increasing his efficiency.
The fact that laborer’s do not have to switch tasks during the day further
saves time and money. Of course, this is exactly what allowed Victorian
factories to grow throughout the nineteenth century. Assembly line
technology made it necessary for a worker to focus his or her attention on
one small part of the production process. Surpr isingly, Smith recognized
the potential problems of this developmen t. He pointed out that forcing
individuals to perform mundane and repetitious tasks would lead to an
ignorant, dissatisfied work force. For this reason, he advanced the
revolutionary belief that governments had an obligation to provide
education to workers . This sprung from the hope that education could
combat the deleterious effects of factory life. Division of labor also
implies assigning each worker to the job that suits him best. Product ive
labor, to Smith, fulfils two important requirements. First, it must ‘lead to
the production of tangible objects.’ Second, labor must ‘create a surplus’
which can be reinvested into production.
Division of labor is the outcome of a tendency common to al l men, the
tendency to barter; and this tendency itself is spontane ously developed
under the influence of personal interest, which acts simul taneously for the
benefit of each and all. Smith in his Wealth of Nations (Book 1, Chapter
1) ‘Of the Division of Labor’ gives the example of a pin factory to explain
the concept of division of labor. We will first see Smith’s own words and
then will interpret it in our own way. ‘The effects of the division of labor,
in the general business of society, will be more ea sily understood by
considering in what manner it operates in some p articular manufactures. It
is commonly supposed to be carried furthest in some very trifling ones;
not perhaps that it really is carried further in them than in others of more
importance: b ut in those trifling manufactures which are destined to
supply the small wants of but a small number of people, the whole number
of workmen must necessarily be small; and those employed in every
different branch of the work can often be collected into the same
workhouse, and placed at once under the view of the spectator. In those
great manufactures, on the contrary, which are destined to supply the great
wants of the great body of the people, every different branch of the work
employs so great a number of workmen that it is impossible to collect
them all into the same wor khouse. We can seldom see more, at one time,
than those employed in one single branch. Though in such manufactures,
therefore, the work may really be divided into a much greater number of
parts than in those of a more trifling nature, the division is not n ear so
obvious, and has accordingly been much less observed.
To take an example, therefore, from a very trifling manufacture; but one in
which the division of labor has been very often take n notice of, the trade
of the pin -maker; a workman not educated to this business (which the
division of labor has rendered a distinct trade), nor acquainted with the use
of the machinery employed in it (to the invention of which the same
division of labor has probably given occasion), could scarce, perhaps, with
his utmos t industry, make one pin in a day, and certainly could not make munotes.in

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13 twenty. But in the way in which this business is now carried on, not only
the whole work is a peculiar trade, but it is divid ed into a number of
branches, of which the greater part are likewis e peculiar trades. One man
draws out the wire, another straights it, a third cuts it, a fourth points it, a
fifth grinds it at the top for receiving, the head; to make the head requires
two or three distinct operations; to put it on is a peculiar business, to
whiten the pins is another; it is even a trade by itself to put them into the
paper; and the important business of making a pin is, in this manner,
divided into about eighteen distinct operations, which, in some
manufactories, are all performed by dist inct hands, though in others the
same man will sometimes perform two or three of them. I have seen a
small manufactory of this kind where ten men only were employed, and
where some of them consequently performed two or three distinct
operations. But though they were very poor, and therefore but indifferently
accommodated with the necessary machinery, they could, when they
exerted themselves, make among them about twelve pounds of pins in a
day. There are in a pound upwards of four thousand pins of a middlin g
size. Those ten persons, therefore, could make among them upwards of
forty -eight thousand pins in a day. Each person, therefore, making a tenth
part of forty -eight thousand pins, might be considered as making four
thousand eight hundred pins in a day. Bu t if they had all wrought
separately and independently, and without any of them having been
educated to this peculiar business, they certainly could not each of them
have made twenty, perha ps not one pin in a day; that is, certainly, not the
two hundred an d fortieth, perhaps not the four thousand eight hundredth
part of what they are at present capable of performing, in consequence of a
proper division and combination of their different oper ations.’ Let us now
interpret this.
Adam Smith, explains the optimu m organization of a pin factory.
Traditional pin makers could produce only a few dozen pins a day.
However, when organized in a factory with each worker performing a
limited operation, they could produce tens of thousands a day. This was
the reason why Smi th favored division of labor. He suggests that there are
three causes of increase in the quantity of work:
1. Increase in dexterity in every particular workman : The division of
labor reduce s every man’s business to some one simple operation, and by
making this operation the sole employment of his life, necessarily
increases very much the dexterity of the workman.
2. Saving the time which is commonly lost in passing from one species
of work t o another: He suggests that it is impossible to pass very quickly
from one kind of work to another that is carried on in a different place, and
with quite different tools. A country weaver, who cultivates a small farm,
must lose a good deal of time in pass ing from his loom to his field, and
from the field to his loom. Whe n the two trades can be carried on in the
same workhouse, the loss of time is no doubt much less.
3. Invention of a great number of machines which facilitate and
abridge labor, and enable o ne man to do the work of many: According munotes.in

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14 to Smith, a greater part o f the machines made use of in manufactures in
which labor is most subdivided, were originally the inventions of common
workmen, who, being each of them employed in some very simple
operatio n, naturally turned their thoughts towards finding out easier and
readier methods of performing it.
1.5.3. Theory of Value
A main concern for Smith involved tracing the roots of value. He
identified two different kinds of value, ‘use value’ and ‘exchange v alue.’
The concept of exchange value interested Smith considerably. The
diamond -water paradox, in particular, proved puzzling to him: Why is it
that diamonds, which have very little practical use, command a higher
price than water which is indispensable to life? By discovering the true
source of value Smith hoped to find a benchmark for measuring economic
growth. Eventually Smith settled on labor as the source of value: The
number of hour’slabor that a good can be exchanged for constitutes its
inherent wort h. (Note, this is not the same as saying that a good is worth
the n umber of hours spent in its production.) The value of a good can also
be referred to as the ‘natural price.’ The natural price need not function as
the actual cost of a good in the marketpl ace. Competition, however, was
expected to push the market price to wards the natural price.
Smith believed that the word value has two different meanings, and
sometimes expresses the utility of some particular object, and sometimes
the power of purchasing other goods which the possession of that object
conveys. The one ma y be called ‘value in use’; the other, ‘value in
exchange.’ The things which have the greatest value in use have
frequently little or no value in exchange; and on the contrary, those which
have the greatest value in exchange have frequently little or no va lue in
use. Nothing is more useful than water: but it will purchase scarce
anything; scarce anything can be had in exchange for it. A diamond, on
the contrary, has scarce any value in use; but a very great quantity of other
goods may frequently be had in e xchange for it.
According to Smith, value in exchange is the power of a commodity to
purchase other goods its price. This is an objective measure expressed in
the market. His concept of val ue in use is ambiguous; it resulted in a good
part of his difficult ies in explaining relative prices. On the one hand, it has
ethical connotations and is therefore a return to scholasticism. Smith’s
own puritanical standards are particularly noticeable in his statement that
diamonds have hardly any value in use. On the ot her hand, value in use is
the want -satisfying power of a commodity, the utility received by holding
or consuming a good. Several kinds of utility are received when a
commodity is consumed: its total utility, its average utility, and its
marginal utility. S mith’s focus was on total utility -the relationship
between marginal utility and value was not understood by economists until
one hundred years after Smith wrote and this obscured his under standing
of how demand plays its role in price determination. It is clear that the
total utility of water is greater than that of diamonds; this is what Smith
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15 compared to the use value of d iamonds. However, because a commodity’s
marginal utility often decr eases as more of it is consumed, it is quite
possible that another unit of water would give less marginal utility than
another unit of diamonds. The price we are willing to pay for a commod ity
-the value we place on acquiring another unit - depends not on its total
utility but on its marginal utility. Because Smith did not recognize this
(nor did other economists until the 1870s), he could neither find a satisfac -
tory solution to the diamond -water paradox nor see the relationship
between use value and excha nge value.
Smith’s ‘labor theory of value’ stipulates that the value of a good or
service is dependent upon the labor used in its production. It suggests that
goods which take the same amou nt of time to produce should cost the
same. This theory was an impo rtant concept in the philosophical ideals of
Karl Marx. Opponents of the labor theory of value purport that it is not
labor that determines the price of a good or service; rather, it is sim ply a
function of supply and demand for a given good or service tha t determines
its price. According to the theory, if the cost of purchasing something is
greater than the amount that the purchaser values the time it would take to
produce the good, then he will make it himself rather than buy it.
1.6 SUMMARY
 Economic history is different from history of economic thought.
Economic history is the study of the economic aspects of societies in
the past; the history of the economic use of resources land, labor and
capital; or the examination of the past performance of economies.
 The Classical School, which is regarded as the first school of
economic thought, is associated with the 18th Century Scottish
economist Adam Smith, and those British economists that foll owed,
such as Robert Malthus and David Ricardo.
 Adam Smith coined the t erm “mercantile system” to describe the
system of political economy that sought to enrich the country by
restraining imports and encouraging exports.
 The Physiocrats were a group of eco nomists who believed that the
wealth of nations was derived solely from agriculture. Their theories
originated in France and were most popular during the second half of
the 18th century.
 Classical liberalism is a political and economic ideology that
advoca tes the protection of civil liberties and laissez -faire economic
freedom by limiting the power of the central government.
 The main focus of Adam Smit h’s The Wealth of Nations lies in the
concept of economic growth. Growth, according to Smith, is rooted in
the increasing division of labor.
 A main concern for Smith involved tracing th e roots of value. He
identified two different kinds of value, ‘use valu e’ and ‘exchange
value.’ The concept of exchange value interested Smith considerably. munotes.in

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16
1.7 QUESTIONS
Q1. Explain the Classical Economic Thoughts in detail.
Q2. What do you mean by Mercantil ism? Explain its importance.
Q3. What is Physiocracy? Explain its Principles.
Q4. Define the concept of Liberalism and explain its relevance to
Economics, Government and Sociology.
Q5. Explain the Division of Labor in detail.
1.8 REFERENCES
 Harry Landreth and David C. Colander, History of Economic Thought,
4th Edition, Houghton Mifflin Company , Boston, Toronto.
 An Outline of the History of Economic Thought (2nd Edition),
(2003) Ernesto Screpanti and Stefano Zamagni .
 Blaug, Mark (1985) , Economic Theory in Retrospect , 4th Edition,
Cambridge: Cambridge University P ress.



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17 2
RICARDIAN, MARXISM AND SOCIALISM
SCHOOL
Unit Structure:
2.1. Objective
2.2. Introduction
2.3. David Ricardo
2.3.1. Theory of Rent
2.3.2. Theory of Wage
2.3.3. Theory of Value
2.4. Karl Marx
2.4.1. Theory Surplus Value
2.4.2. The Materialistic Interpretation of History
2.5. Scientific Socialism
2.6 S ummary
2.7 Questions
2.8 References
2.1 OBJECTIVE
After going to this module you will be able:
 To understand the thoughts of David Ricardo
 To understand the school of Marxism
 To understan d the school of Scientific Socialism
2.2 INTRODUCTION
Economics as a science is, on the one hand, a body of knowledge and on
the other hand, an engine of analysis. As a result of knowledge, it contains
generalizations about the work ing of economic system. Prof. Ricardo
added little to the economic knowledge gathered by Smith. As an
analytical engine, economics provides an apparatus through which actual
economic problems are analysed. Ricardo’s greatest contribution to
economics is th e provision of engine o f analysis. By using the technique
of deductive or abstract reasoning, he constructed a rigorous model in munotes.in

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18 which some selected economic variables were systematically placed to
form a logic. Such a theoretical model helps to understand how a system
works and how the change in variables affects the working of the system.
Marx was inspired by classical political economists such as Adam Smith
and David Ricardo , while his own branch of economic s, Marxian
economics, is not favoured among modern mainstream thought.
Nevertheless, Marx's ideas have had a huge impact on societies, most
prominently in communist projects such as those in the USSR, China, and
Cuba. Among modern th inkers, Marx is still v ery influential in the fields
of sociology, political economy, and strands of heterodox econ omics.
2.3. DAVID RICARDO
David Ricardo was born on 19 April 1772 in London. He was the third son
of a Dutch Jew who had made a fortune on the London Stock Exchange.
When he was 14, Ricardo joined his father’s business and showed a good
grasp of economic affairs. In 1793 he married a Quaker called Priscilla
Anne Wilkins on; Ricardo then conver ted to Christianity, becoming a
Unitarian. This caused a breach with his father and meant that Ricardo had
to establish his own business. He continued as a member of the stock
exchange, where his ability won him the support of an emi nent banking
house. He did so well that in a few years he acquired a fortune. This
enabled him to pursue his interests in literature and science, particularly in
mathematics, chemistry, and geology.
In 1799 he read Adam Smith’s Wealth of Nations and for th e next ten
years he stu died economics. His first pamphlet was published in 1810:
entitled The High Price of Bullion, a Proof of the Depreciation of Bank
Notes, it was an extension of the letters that Ricardo had published in the
Morning Chronicle in 1809. In it, he argued in fav our of a metallic
currency, giving a fresh stimulus to the controversy about the policy of the
Bank of England. The French Wars (1792 -1815) caused Pitt’s government
to suspend cash payments by the Bank of England in 1797. Consequentl y,
there had been an in crease in the amount of their paper currency and the
volume of lending. This created a climate of inflation. Ricardo said that
inflation affected foreign exchange rates and the flow of gold. The Bullion
Committee was appointed by the House of Commons in 18 19: it
confirmed Ricardo’s views and recommended the repeal of the Bank
Restriction Act. In 1814, at the age of 42, Ricardo retired from business
and took up residence at Gatcombe Park in Gloucestershire, where he had
extensive landh oldings.
In 1819 he bec ame MP for Portarlington. He did not speak often but his
free-trade views were received with respect, although they opposed the
economic thinking of the day. Parliament was made up of landowners who
wished to maintain the Corn Laws t o protect their profits . Ricardo made
friends with a number of eminent men, among whom were the philosopher
and economist James Mill, the Utilitarian philosopher Jeremy Bentham
and Thomas Malthus, best known for his pamphlet, Principles of munotes.in

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19 Population publi shed in 1798. Ricardo a ccepted Malthus’ ideas on
population growth.
In 1815 another controversy arose over the Corn Laws, when the
government passed new legislation that was intended to raise the duties on
imported wheat. In 1815 Ricardo responded to the C orn Laws by
publishing his Essay on the Influence of a Low Price of Corn on the
Profits of Stock, in which he argued that raising the duties on imported
grain had the effect of increasing the price of corn and hence increasing
the incomes of landowners and the aristocracy at the expense of the
working classes and the rising industrial class. He said that the abolition of
the Corn Laws would help to distribute the national income towards the
more productive groups in society.
2.3.1. Theory of Rent
David Rica rdo, an English classic al economist, first developed a theory in
1817 to explain the origin and nature of economic rent. Ricardo used the
economic and rent to analyse a particular question. In the Napoleonic wars
(1805 -1815) there were large rise in corn a nd land prices. Did the rise in
land prices force up the price of corn, or did the high price of corn increase
the demand for land and so push up land prices. Ricardo defined rent
as, “that portion of the produce of the earth which is paid to the landlord
for the use of the original and indestructible powers of the soil.” In his
theory, rent is nothing but the producer’s surplus or differential gain, and it
is found in land only.
Assumptions
1. Rent of land arises due to the differences in the fertility or situation of
the differ ent plots of land. It arises owing to the original and
indestructible powers of the soil.
2. Ricardo assumes the operation of the law of diminishing marginal
returns in the case of cultivation of land.
3. Ricardo looks at the supply of land from the standp oint of the society as
a whole.
4. In the Ricardian theory it is assumed that land, being a gift of nature,
has no supply price and no cost of production.
According to Ricardo rent arises for two main reasons: 1. Scarcity of land
as a factor and, 2. Differe nces in the fertility of the soil.
1. Scarcity of land
Ricardo assumed that land had only one use to grow corn. This meant that
its supply was fixed, as shown in given figure below. Hence the price of
land was totally determined by t he demand for land. In other words, all the
price of a factor of production in perfectly inelastic supply is economic
rent it has no transfer earnings. munotes.in

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History of Economic Thoughts - I
20

Fig. 2.3.1. Earning of a Factor in Fixed Supply
2. Differences in the fertility of the soil
Ricardo as sumes that the differen t grades of lands are cultivated gradually
in descending order the first -grade land being cultivated at first, then the
second grade, after that the third grade and so on. With the increase in
population and with the consequent incre ase in the demand for a gricultural
produce, inferior grades of lands are cultivated, creating a surplus or rent
for the superior grades.

Fig. 2.3.2. Differential Rent
Here, AD, DG and GJ are three separate plots of land of the same size, but
of differenc e in fertility. The tot al produce of AD is ABCD, that of DG is
DEFG and that of GJ is GHIJ. The first and second plots of land generate
a surplus show by the shaded area, which represents the rent of the first
two plots of land. Since the third plot GJ has no surplus, it is marg inal land
or no -rent land. Grade 4 (below -marginal) land will not be cultivated,
because rent is negative.
2.3.2. Theory of Wage
This theory was propounded by David Ricardo (1772 -1823). According to
this theory, “The labourers are pa id to enable them to su bsist and
perpetuate the race without increase or diminution”. This payment is also
called as ‘subsistence wages’. The basic assumption of this theory is that if
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21 increase and, as a re sult wages will come down to the subsistence level.
On the contrary, if workers are paid less than subsis tence wages, the
number of workers will decrease as a result of starvation death;
malnutrition, disease etc. and many would not marry. Then, wage rate s
would again go up to subsistence level. Since wage rate tends to be at,
subsistence level at all cases, that is why this theory is also known as ‘Iron
Law of Wages’. The subsistence wages refers to minimum wages. This
theory can be discussed with the hel p of diagram.

Fig. 2.3.3.
In given Figure demand and supply of labor has been measured on OX -
axis and wage rate on OY -axis. OW is the subsistence level of wages. At
OW wage rate supply of labor is perfectly elastic. Since, supply o f labor is
perfectly el astic, wage rate neither can fall below OW nor can increase
above the level of OW. Although demand increases from DD to D 1D1 yet
the wage rate remains the same at OW. Though this theory is criticized by
many economists on various gro und still it is one of the successful theory
of wage.
2.3.3. Theory of Value
Modern discussion of the validity of the economic system of David
Ricardo has centered about the theory of value. The labor theory of value
states that the relative price of two g oods is determined by t he ratio of the
quantities of labor required in their production. His labor theory of value
has the following assumptions: 1. Both sectors have the same wage rate
and the same profit rate; 2. The capital employed in production is mad e up
of wages only; 3. The period of production has the same length for both
goods.
In the theory ‘On Value and Riches,’ Ricardo makes effort to illustrate
that exchange value is not the same as ‘value in use’. In this way one can
factor two often contradi ctory results. the capi tal employed in production
must be made up of wages only for his value theory to hold, is answered
by this: that production may be made up of capital and machinery, but it
doesn’t change the principle (which he attributes to Adam Smi th) that he
tries to la y out in this chapter. Machinery may add to one measure of value
beyond almost all measure without adding one penny to the other measure
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History of Economic Thoughts - I
22 somewhat contradictory assumptions which if co nfounded lead to equally
contradictory results.
The key point that Ricardo seems to make is: Accumulation of capital
adds riches without decreasing the value of things to be traded, which may
bring the various economic factors to a win-win. Ricardo first attempts to
show that new riches are not adding as much value as one would think
because they are always decreasing somewhat from the exchangeable
value of what was produced. The decreasing value in exchange as value -
in-use increases he extrapolates to inf er that the sum world total of value
in exchange is a fixed constant. Therefore, in the growth of the global
economy, the first -world countries, he states, will begin to lose value per
trade, even to the purely theoretical extent of taking from the capital base.
2.4 KARL MARX
Karl Heinrich Marx (1818 -1883) was born on May 5, 1818 in the city of
Trier, Germany. His father was a lawyer who came from a long line of
Rabbis, but had changed his faith to Protestantism in order to keep his j ob.
Karl Marx went to the University of Bonn to study law when he was 17
years old. Here he became engaged to Jenny von Westphalen, whose
father, Baron von Westphalen, influenced Marx to read Romantic
literature and Saint -Simonian politics. Only a year lat er, Marx was moved
by his father to the University of Berlin where he studied Hegelianism,
influenced by Ludwig Feurbach and other Hegelians. He admired G.W.F.
Hegel’s dialectics and belief in historical inevitability, but Marx
questioned the idealism and abstract thought of ph ilosophy and maintained
his belief that reality lies in the material base of economics. In distinct
contrast to G.W.F. Hegel’s concentration on the state in his philosophy of
law, Marx saw civil society as the sphere to be studied in order to
understand th e historical development of humankind. In 1841 Marx earned
his doctorate at Jena with his work on the materialism and atheism of
Greek atomists.
2.4.1. Theory Surplus Value
The Marxian concept of surplus value , professed to explain th e instability
of the c apitalist system. In Marxian economics , surplus value is the
difference between the amount raised through a sale of a product and the
amount it cost to the owner of that product to manufacture it: i.e. the
amount raised through sale of the product minus the cost of the materials,
plant and labour power . The concept originated in Ricardian socialism ,
with the term "surplus value" itself being coined by William Thompson in
1824; however, it was not consistently distinguished from the related
concepts of surplus labour and surplus product . The concept was
subsequently developed and popularized by Karl Marx . Marx's
formulation is the standard sense and the pri mary basis for further
developments, though how much of Marx's concept is original and distinct
from the Ricardian concept is disputed. Marx's term is the German word
"Mehrwert", which simply means value a dded (sales revenue less the cost
of materials used up), and is cognate to English "more worth". munotes.in

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23 It is a major concept in Karl Marx 's critique of political economy.
Conventionally, value -added is equal to the sum of gross wage income and
gross profit income. However, Marx uses the term Mehrwert to describe
the yield, profit or return on production cap ital invested, i.e. th e amount of
the increase in the value of capital. Hence, Marx's use of Mehrwert has
always been translated as "surplus value", distinguishing it from "value -
added". According to Marx's theory, surplus value is equal to the new
value c reated by workers in e xcess of their own labour -cost, which is
appropriated by the capitalist as profit when products are sold. Marx
thought that the gigantic increase in wealth and population from the 19th
century onwards was mainly due to the competitive striving to
obtain maximum surplus -value from the employment of labour, resulting
in an equally gigantic increase of productivity and capital resources. To
the extent that incre asingly the economic surplus is convertible into money
and expressed in money, the amassment of wealth is possible on a larger
and larger scale. The concept is closely connected to producer surplus .
Marx used the terms surplus and exploitation in a pejorative sense. He
strongly believed that the income distribution at the time was unfair and
that the institutions that led to this unfairness deserved to be called
exploitative . Most modern economists see such judgments as going
beyond the role of economists as economists. They try to separate
normative judgments from positive analysis. But even in terms of
normative judgments, they question the value of th e exploitation concept .
They see human nature as generally exploitative and see the market as
based on the concept of mutual exploitation. Abba Lerner summarized this
view nicely: in capitalism man exploits man; in socialism it is the other
way around.
2.4.2. The Materialistic Interpretation of History
Introduction
Marx’s general ideas about society are known as his theory of historical
materialism. Materialism is the basis of his sociological thought because
for Marx material conditions or economic factors affect the structure and
development of society. His theory is that material conditions essentially
comprise technological means of production and human society is formed
by the forces and relations of production.
Marx’s theory of historical materialism i s historical. It is hi storical
because Marx has traced the evolution of human societies from one stage
to another. It is called Materialistic because Marx has interpreted the
evolution of societies in terms of their material or economic bases.
Materialism simply means that it i s matter or material reality, which is the
basis for any change.
According to Friedrich Engels, the theory of historical materialism was
discovered by Karl Marx, but Marx thought it was Engels who has
conceived the materialist formula tion of history indepe ndently. We shall
say that both of them used this theory, to quote Marx, as the “guiding
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History of Economic Thoughts - I
24 Materialism means the materialist structure of society. It is how the super
structure of society is based on economic infrastructure. Marx’ s theory of
historical materialism is the materialistic interpretation of the history of
societies. All the societies have experienced similar pattern of history and
every history is built upon its materialist foundations.
Marx has tr ied to suggest that al l society passes through unilinear
evolution, every society progresses stage by stage and every society has
marched ahead. He has suggested about the history of society, i.e.
Primitive Communism → Slavery → Feudalism→ Capitalism
→Soci alism →Communism
Histo rians recorded history in the manner it is found. But Marx had a
vision for future, how is history taking man through time. Each stage sows
the seeds of its own destruction. One will go and other will come. Such
precision and successi on will continue till the ultimate i.e. communism is
reached.
Marx’s theory sought to explain all social phenomena in terms of their
place and function in the complex systems of society and nature. This was
without recourse to what may be considered as met aphysical explanations
clearly outlined in those early writings of Hegal and his followers. This
eventually became a mature sociological conception of the making and
development of human societies.
Assumptions
Historical materialism is based upon a philoso phy of human history. But it
is not strictly speaking, a philosophy of history. It is best understood as
sociological theory of human progress. As a theory it provides a scientific
and systematic research programme for empirical investigations. At the
same time, it also claims to contain within it a revolutionary programme of
intervention into society. It is this unique combination of scientific and
revolutionary characters which is the hall mark of Marx’s original
formulation.
The Theory
The clearest expos ition of the theory of historical materialism is contained
in Marx’s ‘preface’ to A Contribution to the Critique of Political Economy
(1859). Here he says that the actual basis of society is its economic
structure. For Marx, economic structure of society i s made of its relation s
of production. The legal and political super structure of society is based on
relations of production. Marx says that relations of production reflect the
stage of society’s forces of production.
Marx’s theory of Historical Materiali sm states that all obj ects, whether
living or inanimate are subject to continuous change. The rate of this
change is determined by the laws of dialectics. Marx says that new
developments of productive forces of society came in conflict with
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25 Whe n people become conscious of the state of conflict, they wish to bring
an end to it. This period of history is called by Marx the Period of Social
Revolution. The revolution brings about resolution of conflict. It means
that new force s of production take r oots and give rise to new relations of
production.
Thus, we can see that for Marx it is the growth of new productive forces
which outlines the course of human history. The productive forces are the
powers society uses to produce mater ial conditions of life . So for Marx,
human history is an account of development and consequences of new
forces of material production. This is the reason why his view of history is
given the name of Historical Materialism.
The terms mentioned in Marx’s theory of Historical Mate rialism:
1. Social relations, over and above individuals: -Marx says that as a
general principle, the production of material requirements of life, which is
a very basic necessity of all societies; compel individuals to enter into
definite social relations that are independent of their will. This is the basic
idea of Marx’s theory of society. He stresses that there are social relations
which impinge upon individuals irrespective of their preferences. He
further elaborates that an unders tanding of the histori cal process depends
on our awareness of these objective social relations.
2. Infrastructure and Super -structure: - According to Marx, every
society has its infrastructure and superstructure. Social relations are
defined in terms of ma terial conditions whic h he called infrastructure. The
economic base of a society forms its infrastructure. Any changes in
material conditions also imply corresponding changes in social relations.
Forces and relations of production came in the category of i nfrastructure.
Within the superstructure figure the legal, educational and political
institutions as well as values, cultural ways of thinking, religion,
ideologies and philosophies.
3. Forces and relations of production: -The forces of production appear
to be the capacity of a society to produce. This capacity to produce is
essentially a function of scientific and technical knowledge, technological
equipment and the organisation of labour force. The relations of
production arise out of the production proce ss but essentially ove rlap with
the relations in ownership of means of production.
4. Social change in terms of social classes: -Marx elaborates the
significance of the infrastructure of society by tracing the formation of the
principal social classes. He develops the idea of s ocial change resulting
from internal conflicts in a theory of class struggles. For Marx, social
change displays a regular pattern. Marx constructs in broad terms, a
historical sequence of the main types of society, proceeding from the
simple, undifferentia ted society of “primitive communism” to the complex
class society of modern capitalism.
He provides an explanation of the great historical transformation which
demolished old forms of society and created new ones in terms of munotes.in

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26 infrastru ctural changes which h e regards as general and constant in their
operation. Each period of contradiction between the forces and relations of
production is seen by Marx as a period of revolution.
2.5 SCIENTIFIC SOCIALISM
The ceaseless clash of contradiction s which formed the fo undation of
economic life in the middle of the nineteenth century was bound to find
theoretical expression, especially from members of those classes
victimized by those contradictory forces and which had an interest in
changing the dir ection of society. In the works of Karl Marx and of
Frederick Engels the interests of the working class found their best
expression. In their life activities they symbolize the best of German
philosophy, French politics, and British economics, synthesizing all three
elements t o bring forth “Scientific Socialism.”
Scientific Socialism has three principal divisions, namely, philosophy,
economics, and politics. In philosophy, Marx took the theory of dialectics
which he found in Hegel, and, casting out its idea lism, placed it on it s feet
as a theory of dialectical materialism which, when applied to human
society, became a theory of historical materialism. In the field of
economics Marx based himself upon the theory of value as labour which
had already been sugge sted by the Classical School of British economists
before him, and thereby worked out a theory of surplus value and the laws
of accumulation of capital, analysing adequately for the first time both the
structure and evolutionary functioning of the capitali st system. In politic s,
both Marx and Engels grasped the principles of the class struggle which
already had been stated by working class elements, and developed them
into a thesis leading to a new system of society, Socialism or Communism,
through the inst itution of a Dictator ship of the Proletariat.
As Marx put it: “And now as to myself, no credit is due to me for
discovering the existence of classes in modern society nor yet the struggle
between them. Long before me bourgeois historians had described the
historical developmen t of this class struggle and bourgeois economists the
economic anatomy of the classes. What I did that was new was to prove:
(1) that the existence of classes is only bound up with particular, historic
phases in the development of prod uction; (2) that the class struggle
necessarily leads to the dictatorship of the Proletariat; (3) that this
dictatorship itself only constitutes the transition to the abolition of all
classes and to a classless society.
To sum up, Scientific Socialism was both a method as well as a content
and body of scientific conclusions, later becoming both a theory and a
practice. Just as it is impossible to separate program from strategy, and
both from tactics, so it is impossible to divide the philosophical from the
political and economi c, or the method from the data. All are bound up
together by the monist materialism of life. We turn first to the philosophy.
From the days of ancient society, two principal camps have existed in
philosophy, the camp of the materialist and that of the idea list. To the munotes.in

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27 materialist, nature is primary, spirit secondary; thinking is a process of the
brain and thought, basically, is but a reflection of the action of matter
which exists outside and independent of man. The universality of all
things consists in th eir materiality; that is, outside of the philosophic
category of “matter” there is nothing.
The opposite to this is the position of the idealist, whose Right Wing
consists of religionists of all sorts and whose Left is made up of the p ure
metaphysicians. S tripping aside theosophical aspects, both religion and
metaphysical idealism agree, contrary to the materialists, that things are
but a collection of images, matter is only the realization of an idea. It is the
idea, the spirit, that i s primary and real, a nd nature is but a reflection of the
spirit.
From the earliest times the battle has raged fiercely. In ancient Greek
society, the materialists were represented by Democritus and Heraclitus.
The idealist position was represented princip ally by Plato and Soc rates.
According to Democritus and the early Atomists, nothing could be
destroyed, nor could anything arise from nothing. All change was but a
combination and separation of atoms. No change occurred of itself, but
only through cause an d necessity. Both tel eology and religion had to be
explained by efficient causes. Nothing existed save atoms and empty
space. All else was but opinion.
The philosophy of these Greek materialists who lived in a stagnant slave
society could not but take on a static character. Th e fact that matter could
not be destroyed meant for them that all becoming and perishing was
denied (Parmenides), or that all motion was denied, change being
considered as phenomenal only (the Eleatics), or finally, where change did
occur, it was believed the changing world would return to its old position
(Heraclitus).
With Epicurus and the development of the Roman State, materialism took
on a sensationalist guise. The sensationalist school accorded well with the
Hedonists, who affirme d that desire is the moving principle of all human
action, and that the true aim of life is not happiness but sensual pleasure
alone; physical pleasure is better than mental, just as physical pain is
worse.
There was no consciousness without sensation. How ever, this sort of
sensationalism could be a bridge to idealism also; since sensations are the
basis of knowledge and depend on the individual, it is easy to reach the
conclusion that man is the measure of all change, and thus, that
contradictory assertion s are equally true. I n this way, the material reality is
forgotten in the stress on the sensations to which it gives rise.
The opposing idealism of Socrates and Plato took the form of insisting that
name and thing are identical and that whatever propositio n is most general
is the most nearly correct. Like the materialists, all these idealists also
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28 In the middle ages, the fight between materialism and idealism assumed
the nature of a conflict between nominalists and realists, and also, within
the Cath olic Church, of a struggle against various heresies. The
theologians of the day argued the question regarding the creation of the
world whether God created the world from nothing, or whether the matter
had existed for God to create it into a world. They al so argued about the
relation of God to the worldwhether God existed in every particle of
matter and thus was pantheistic, etc. The question of how many angels can
stand on the point of a pin was important precisely from the point of vi ew
of materialism or idealism.
The eighteenth century development of the factory system and of science
led to the creation of a new school of mechanical materialists who were
non-historical and non -dialectical, and who regarded human nature
abstractly. The se materialists theor ized on how to interpret the world; they
made no efforts to change it. They belonged to the upper aristocratic
classes rather than to the rebellious lower orders.
Nineteenth -century reaction returned to idealism. As it idealized the pa st
and bemoaned the c hanges that the revolutions had brought from the age
of the romantic, it elaborated the dialectic method of which the best
exponent was the German, Hegel.
With Hegel, “in the beginning was the word.” Analysing the working of
his own mi nd, Hegel found that thesis constantly gave way to antithesis
and both were resolved in a synthesis. No sooner did we have one than we
had the other, and the whole, only to start all over again. The same process
occurred in nature, which apparently was but the realization of t he idea
unfolded in history. The start was logic, the thesis; nature was the
reflection of this logic, or the antithesis; the synthesis lay in the
philosophy of Hegel, the acme of world’s thought. Thus Hegel, whose
dialectic method of incessant contradicti on might have led to a
revolutionary attitude, ends his theory with the conservatism of a closed
system. To Hegel, all that was real was reasonable, that is, necessary; thus,
could the status quo eternally be justified.
At the same tim e Hegel also could sa y, all that was reasonable was real.
Therefore, if the masses found it reasonable to protest against a given
system, the reasonableness would compel them to realize their aim. In this
way, in spite of the fact that Hegel himself create d a closed system, hi s
really implied method was eternal and perpetual flux. For the reactionary
idealistic dialectic of Hegel, Marx substituted his own materialistic
dialectic.
Dialectic materialism is at least materialism, and materialism to the
Marxist is thetexture of all science. Testing the positions of materialism
and science through an examination of the basic questions of philosophy,
he finds them identical. This is the reason why the Marxist boasts that he
is scientific.
The first philosophical qu estion is one of onto logy-the nature of being.
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29 our ideas? This question is put by the Scientific Socialists in another way;
did nature exist prior to man? Science of course answer s, yes. The whole
theory of evolution is evidence of the opinion of the scientist that nature,
the earth, existed before man and before the ideas of man came into being.
Man is but a part of nature, a product of natural forces, of the material
elements.
The second basic philos ophical question is one of epistemology the nature
of ratiocination, of the cognitive process. What is the relation of thinking
to flesh? The Scientific Socialist puts the question in another way: Does
man think with the help of his br ain? Here, too, of co urse, science
answers, yes. Thinking is a process of the material brain, just as the light
from the electric lamp is the result of a material process.
The third basic philosophic question has to do with whether causation, the
relation of cause and effect, really exists in nature, or whether the laws of
science which have to do with the analysis of cause and effect are merely
ideas of man. To this question is related another. Is there a necessity in
nature? Must things happen? Can we pre dict them? Again, in answer to
these questions, science supports materialism and affirms that the laws of
science are really the expressions of actual relations in nature.
Furthermore, the objectivity of scientific law applies not only to causality
but to the laws of space and time. Space and time are not mere ideas of
man, but are a real part of the dimensional materiality of the universe.
Of course, our ideas about things are approximate. We are always learning
more and more about the qualities and functi ons of this or that f orm of
matter. All science, dealing as it does with a becoming, deals with
constant change. To the scientist there is no line to be drawn between
matter and its functions. In proportion as we know more about the
functions of a particul ar object it loses it s mysterious character of being a
“thing -in-itself” and becomes increasingly a “thing for -us.”In that sense,
all of the laws of science are relative. Nevertheless, these relative laws are
absolute within the definite framework of relat ionships that may be under
consideration. What is true today may be false tomorrow, but only when
the frame of conditions has changed.
The idea of relativity early was expressed by the Scientific Socialists and
became a part of the basic understanding of t he dialectical proces s of
nature. To the dialectician, all unity is the combination of contradictions,
the result of diverse strains. Society, rocks, cabbages, ether waves,
chemical solutions, buildings, and the macrocosm itself, all these, large
and small , are the resultant o f opposing forces. Each unity is composed of
opposites and will break up into opposites. To view things in constant
movement, to see them as the result of constant movement, to mark the
movements as contrary and conflicting, this is th e dialectic method. T he
dialectician tries to see the relation of each part to every other part, and of
each part to the whole, as their mutual relations evolve from moment to
moment. munotes.in

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30 The Scientific Socialist adopted the dialectic manner of approaching
things in nature, not be cause of his wilfulness, but solely because this
method of approach accurately reflects the actual contradictory processes
of nature where everything is eternally posed, opposed, and composed.
However, it is not enough to say that the only thing changeless is change.
The materialist must also add that the materiality of the universe is
absolute. Here, then, is the dogma of the Scientific Socialists, their
“absolute truth” so to speak. While the Marxist materialists are constantly
on the alert for changes, t rying to find out within what patterns a
proposition is correct and where it becomes error, they are at the same
time persistently resisting the spiritualists and bewildered idealists of all
kinds who insist that the idea of change and relativity includes the concept
of the materiality of the universe itself and that we must bow to the
possibility that the universe might be made up of “accidental varia,” God,
luck, chance, spirits, etc., which have nothing to do with materiality. This
dogma of the materiali sts, incidentally, forms the axiom of all scientific
work.
When applied to history, the dialectical method of approach becomes
historical materialism attempting to obviate the two chief defects in early
historical theories, namely, the ir idealism and their neglect of the activities
of masses. “Historical materialism first made it possible to study with
scientific accuracy the social conditions of the life of the masses and the
changes in these conditions.”
The materialistic conception o f history starts with the proposition that the
mode of production, which itself is based upon the given level of
technique prevailing at the time, is the prime mover of all social forces. In
trying to understand the laws of motion of a given society, its e volution
and its dire ction, the Marxist begins first of all with a study of the
technique of that society, the level of its productive forces. These
productive forces include not merely the means of production, the
instruments and subject of labour, but th e labourer as well. T he whole is to
be analysed concretely. Such a concretization does not overlook national,
racial, or psychological traits or other secondary features of society. On
the contrary, an adequate study must also trace the interconnection
between these factors an d their mutual development from the primary
sources.
Starting from this foundation, the Marxist examines those economic
relations between persons which have been rendered necessary by the
technical plane of production. Upon these econo mic relations which
constitute the given mode of production, there is erected the whole texture
of political and social relations. Politics, family life, customs, ideology,
thus flow fundamentally from the relations of the production and
distribution of we alth.
In other terms, one must never lose sight of the reciprocal action of
economics to politics and social life. A careful study of this interaction led
Marx to the conclusion that the laws of motion involved in the capitalist munotes.in

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31 mode of production would le ad to the throttling of the forces of production
by the social relations inherent in capitalism.
2.6 SUMMARY
 Economics as a science generalize about the working of economic
system.
 As an analytical engine, economics provides an apparatus through
which act ual economic problems are analyzed. Ricardo’s greatest
contribution to economics is the provision of engine of analysis.
 Marx questioned the idealism and abstract thought of philosophy and
maintained his belief that reality lies in the material base of eco nomics.
 Scientific Social ism has three principal divisions, namely, philosophy,
economics, and politics.
2.7 QUESTIONS
Q1. Explain the following theories given by David Ricardo -
a) Theory of Rent
b) Theory of Wage
c) Theory of Value
Q2. Elaborate the Theory of Surplus Value by Karl Marx.
Q3. Make a note on The Materialistic Interpretation of History.
Q4. What is Scientific Socialism? Elaborate.
2.8 REFERENCES
 Harry Landreth and David C. Colander, History of Economic Thought,
4th Edition, Houghton Mifflin Comp any, Boston, Toronto.
 Paul Thoma s, Marxism and Scientific Socialism, From Engels to
Althusser, Routledge, Taylor & Francis Group, London and New
York.



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32 Module II
3
NEO -CLASSICAL ECONOMICS - I
Unit Structure :
3.0 Objectives
3.1 Introduction
3.2 Life Sketch of Alfred Marshall
3.3 Marshallian Theory of Value and Time Element:
3.4 Marshall’s concept of Representative Firm
3.5 Marshall’s concept of Consumer’s Surplus
3.6 Internal and External Economies of Scale
3.7 Marshall’s Concept of Quasi Rent
3.8 Questions
3.9 References
3.0 OBJECTIVES
1. Understand Alfred Marshall’s life, ideas and various theories in
economics.
3.1 INTRODUCTION
Neo-classical approach was adopted by Alfred Marshall and his followers
to diverge from earlier economic theories and to formulate them in
accordance with the changing situations. They paid more attention to the
fact relating to the concrete economic realities. This approach was a
reconciliation between deductive and inductive methods of study. The
Neo-classical approach believed that “Inductive and Deductive reasoning
are necessary for the science of economics just as the right and left feet are
necessary for walking”.
Joseph Schumpe ter, who believed that an entrepreneur could earn
economic profits by introducing successful innovations. He believes that a
large firm needs short -run legal protection which would provide enough
short -run market power to create an incentive to invest in R &D. Without
any protection, Schumpeter feels that large firms would not be as likely to
invest in innovative activities and there would be no technological change. munotes.in

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33 Whereas, the approach of Pigou was categorised as welfare approach,
which contains a qualita tive presentation. It aims at maximizing the
welfare of the people. The welfare approach lays importance of utility,
demand and consumption whereas classical approach stressed on cost,
supply and production.
3.2 LIFE SKETCH OF ALFRED MARSHALL
Marshall was born at Clapham, London on July 26, 1842. In 1861, he
joined the Saint John’s College (Cambridge University) from where he
graduated with high honours in Mathematics. He taught Mathematics at
Cambridge University for a period of 7 years. He began a seriou s study of
Economics in 1867. While a student at Cambridge he came into contact
with eminent philosophers like Professor Sidgwick, T.H. Green and
Mourice under whose able guidance he studied the works of Kant and
Hegel which considerable shaped his ideas. He regarded Kant as his guide
– “the only man I ever worshipped.” In order to study the original works
of Kant he went to Germany in 1868 and 1870.
Marshall was the first Principal of the University College, Bristol from
1877 to 1881. He spent a year in It aly for the improvement of his health.
Following the death of A. Toynbee he served the Balliol College, Oxford
as a fellow from 1883 to 1885 which post he resigned in 1908 at the age of
66 years. Even after his retirement he continued his association with the
University as a research specialist until his death which occurred on July
13, 1924.
He also served on the Royal Commission on Labour (1891 -94) and
appeared before several committees. Among his chief works are The
Economics of Industry (1878), Principl es of Economics (1890), Industry
and Trade (1919) and Money, Credit and Commerce (1923).
Economic Ideas of Marshall
In 1875, Marshall visited the USA for 4 months. At Harvard and Yale he
had long talk with academic economists, but his main purpose was to
study the problem of protection. On his return home, he delivered one
lecture on November 17, 1875 at the Moral Science Club, Cambridge on
the development of American industry and the other at Bristol in 1878 on
the Economic condition of America. The Americ an trip influenced and
coloured all his future work.
Principles of Economics
Marshall’s Principles of Economics book was published by London based
publisher Macmillan and Co in 1890. The eight edition was published in
1920 which has been reprinted 11 times . It’s divided into 6 books; Book -I
deals with the preliminary survey; Book -II examines some fundamental
notions; Book -III discuses wants and their satisfaction; Book -IV describes
and analyses the agents of production; Book -V deals with the general
relatio ns of demand, supply and value; and Book -VI presents a discussion
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History of Economic Thoughts - I
34 Marshall’s Definition of Economics:
“Political Economy or Economics is a study of mankind in the ordinary
business of life; it examines the part of in dividual and social action which
is most closely connected with the attainment and with the use of the
material requisites of well -being. Thus,it is on the one side a study of
wealth; and on the other, and more important side, a part of the study of
man.”
It’s clear from his definition that he laid emphasis on two things – study of
man and study of wealth. Whereas earlier economists had stressed upon
wealth -getting and wealth -spending activities only. Marshall stated that
although money or general purchasin g power or command over material
wealth “is the centre round which the economic science clusters” yet that
was not the main aim of human activity. It was simply a convenient means
of measuring human motives. For him, economics was concerned with
individual s as members of a social organism. The aim of economic
science, then is to contribute to the solution of existing social problems.
It’s concerned with well -being of human also. Although the study of
economics is confined to those forces which can be measur ed in terms of
money, yet besides selfishness, other factors like habits, love of family,
work for pleasure, etc., also influence economic actions.
3.3 MARSHALLIAN THEORY OF VALUE AND TIME
ELEMENT:
For a very long time, there were different arguments regar ding what
determines the value of a product. The classical economists had an opinion
that the cost of production and thereby the supply of the product
determines its value. But the economists of the early marginalist school
said that demand based on margin al utility determines the value of a
commodity. But Marshall was an opinion that both supply and demand
determine the value of any product.
Marshall did not try to demolish the economics of Smith, Ricardo and
Mill, but he tried to supplement it. He sought a synthesis of the utility
theory of the Austrian economists and the cost of production theory of
classical economists.
Marshall associated supply and demand with two blades of a pair of
scissors. It is useless to ask which does cutting. In his own words, “We
might as reasonably dispute, whether it is the upper or under a blade of a
pair of scissors that cuts a piece of paper, as whether the value is governed
by utility or cost of production. It is true that when one blade is held still,
and the cutting is effected by moving the other, we may say with careless
brevity that cutting is done by the second; but the statement is not strictly
accurate, and is to be excused only so long as it claims to be merely a
popular and not a strictly scientific account of wh at happens”.
Marshallian theory of value, owing to its emphasis both on supply and
demand as forces governing value, is known as the Dual theory of value. It munotes.in

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35 is important to note that the theory emphasises the role of margin. Value is
determined by the for ces of supply and demand at the margin. It is
marginal utility and marginal cost of production that govern value.
Types of value (on the basis of time)
i. Market value
ii. Short period value
iii. Long period value
iv. Secular value
The market price of a co mmodity may be defined as the price ruling at a
particular period. In the case of market price, the supply is fixed and price
depends mainly on demand.

Figure No. 3.1
MS is the supply curve that is vertical because in the short period supply
can’t change with a change in the price of the product. DD is the market
demand curve that is downward sloping. P is the equilibrium price level. If
the demand increase s to D’D’, the price level will also increase to P’ as
the supply is fixed. If the demand decreases to D”D”, the price will also
fall to P”. However, the equilibrium level of output OM never changes in
the short run.
In the case of a short period, we think of supply as the amount which can
be produced at a given price, with a varying amount of labour and raw
material. It can be defined as “that period during which the variable inputs
can be increased or decreased but the fixed plant can’t be changed”. So in
the case of short period price, both demand and supply determine the
price. munotes.in

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36

Figure No. 3. 2
DD is the demand curve and MPS is the market period supply curv e and
SRS is the short -run supply curve. When there is an increase in demand,
DD will shift to D’D’ and the short -run price will be OP" at which new
demand curve D’D’ intersects the SRS. The quantity supplied has also
increased from OM to OM'. Therefore, i n the short run, if demand
increases, a more amount of the quantity is sold and the price is also not as
high as in the market period.
In the case of a long period, supply means “what can be produced by the
plant which itself can be remuneratively produced and supplied within the
given time”. In the long run, the cost of production is the most important
determinant of price. So, when there is an increase in the demand for the
product in the long -run more factories can be built, more machinery can
be employe d, more workers can be trained and more raw material can be
utilised.

Figure No. 3. 3
LRS is the long -run supply curve, which is relatively more elastic than the
short -run supply curve. MPS is the market supply curve and SRS is the
short -run supply curve. DD is the market demand curve and OP is the
price. If the demand increases to D’D’, the market price will increase to
OP’. Short period price will be OP” at which SRS intersects the D’D’
curve. But in the long -run, the price will be OP"' at which LRS inte rsects munotes.in

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37 the D’D’ curve. Marshall defined long -run normal price as one which in
the long -run would exactly balance supply and demand and which would
be equal to long -run total cost of production. Marshall has also made the
point market price will tend to flu ctuate around normal price.
The secular period is very long. According to Marshall, it is a period of
more than ten years in which changes in demand fully adjust themselves to
supply. Since it is not possible to estimate the changes in demand due to
change s in techniques of production, population, raw materials, etc. over a
very long period, Marshall did not analyse pricing under the secular
period.
Marshall has also conceived of gradual and secular changes in the normal
value. The secular changes in the no rmal values are caused by the changes
in the economic data like population, tastes and preferences of people,
capital, organisation and so on.
Marshall’s introduction of the time element in economic analysis was one
of his many significant contributions to economic thinking. In conceiving
of market broadly into the short and long period, his object was to “trace a
continuous thread running through and connecting the applications of the
general theory of equilibrium of demand and supply of different periods of
time.”
3.4 MARSHALL’S CONCEPT OF REPRESENTATIVE
FIRM
According to Marshall, a representative firm as one which has had a fairly
long life and fair success, which is managed with normal ability and which
has normal access to the economies, external and i nternal, which belong to
that aggregate volume of production the conditions of marketing them and
the economic environment generally. His representative firm is in a sense
an average firm. It is neither old nor new, neither very efficient nor
inefficient. It is neither earning supernormal profits nor incurring losses. It
is neither developing fast nor decaying.
Marshall says, “the firms rise and fall but the representative firm remains
always of the same size as does the representative tree of the virgin
forest”.
Marshall has explained representative firm with an example of trees in a
jungle. There are several types of trees, some are very old and are on the
verge of dying. Some are very new and upcoming, some trees are there
that do not allow the small tree s to grow. Only a few will survive. They
will gradually grow up. But we can find one such tree that is neither
growing nor decaying. It is neither old nor new, that type of tree can be
taken as the representative tree.
Features
1. Representative firm will be an average firm. It has a fair amount of
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History of Economic Thoughts - I
38 2. It is neither declining nor increasing.
3. Its management is neither very efficient nor inefficient.
4. It is neither old nor new.
5. It is neither earning super normal profits nor incurring losses.
6. There can be more than one such firm.
Criticisms
1. If the law of increasing returns operates in a firm then the firm will
be enjoying profits. On the other hand, if the firm is subject to the
operation of decreasing returns, it will be incurring loss es.
2. Robbins has said that even the clearest statement given by Marshall
for his so -called representative firm does not make it clear whether it
is a representative plant or a technical production unit or a
representative business unit.
3. Representative firm is also criticised as an illusory and unnecessary
one.
4. Robertson has pointed out that in practice it is not so easy to locate a
representative firm. A firm that may be representative now may not
be in future.
5. It is assumed that representative firm is neith er increasing nor
decaying. In practice, we cannot find firms that will be happy in that
position.
6. Kaldor regards the representative firm as a state of mind rather than
a concrete analysis.
Despite the above criticisms, some economists have tried to discov er a
representative firm. Chapman and Taussig have tried to locate a
representative firm in 1914 in England. Prof. J.K. Mehta had also tried to
prove that the concept is not altogether incorrect.
3.5 MARSHALL’S CONCEPT OF CONSUMER’S
SURPLUS
Another signifi cant contribution of Marshall in the economic literature
was the concept of consumer's surplus. According to Marshall, “The
excess of price which he would be willing to pay rather than go without
the thing, over that which he does pay, is the economic meas ure of this
surplus satisfaction. And it may be called as consumer’s surplus”.
Consumers are generally prepared to pay a higher price for a commodity
rather than go without it. But actually, they pay less for it. As a result, the
consumer enjoys a surplus satisfaction and it is known as consumer’s
surplus. The concept of consumer’s surplus has become the basis of
welfare economics.
Consumer’s Surplus = The price a consumer is ready to pay – The
price he actually pays
In the words of Eric Roll, “The whole fi eld of welfare economics of which
Marshall’s disciple and successor, Prof. Pigou, is the founder, really rests munotes.in

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39 on considerations of which the consumers surplus doctrine is the
intellectual ancestor”.
The concept of consumer surplus is derived from the law of diminishing
marginal utility. As per the law, as we purchase more of a commodity, its
marginal utility reduces. Since the price is fixed, for all units of the goods
we purchase, we get extra utility. This extra utility is consumer surplus.
Example
The c onsumer is in equilibrium when the marginal utility is equal to the
price. That means, he purchases those many numbers of units of a good at
which its marginal utility is equal to the price. Now, the price is fixed for
all units. Hence, he gets a surplus f or all units except the one at the
margin. This extra utility is consumer surplus.
Table No. 3.1
No. of Units Marginal Utility Price (Rs.) Consumer’s Surplus
1 20 12 8
2 18 12 6
3 16 12 4
4 14 12 2
5 12 12 0
Total 80 60 20
As we can see from the ab ove table, a first unit gives the 20 utility which
gradually falls as there is an increase in the unit consumption. However,
the price of the product has remained the same as Rs. 12. A rational
consumer will consume 5 units as the marginal utility is equal to its price.
Here the total utility is 80 units and the price he paid is Rs. 60, therefore
he will have a 20 as consumer's surplus.

Figure No. 3. 4 munotes.in

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40 In the above figure, the X -axis measures the amount of commodity, while
the Y -axis measures the price an d marginal utility. Further, MU represents
the marginal utility curve, which is sloping downwards. This indicates that
as the consumer consumes more units its marginal utility falls. However,
the price of the commodity is fixed as OP. The total utility he derived here
is ODRQ and total price paid is OPRQ. Therefore, consumer enjoys DPR
as a consumer's surplus.
Criticism:
1. The objective measurement of utility and therefore consumer’s surplus
is not possible.

2. For necessary goods, the marginal utilities of th e first few units are
infinitely large. Hence the consumer’s surplus is infinite for such
goods.

3. The availability of substitutes also affects the consumer’s surplus.

4. Deriving the utility -scale for prestigious goods like diamonds is very
difficult.

5. We ca nnot measure the consumer’s surplus in terms of money. This is
because the marginal utility of money changes as a consumer makes
purchases and his stock of money diminishes.
3.6 INTERNAL AND EXTERNAL ECONOMIES OF
SCALE
The Economies of scale are an importa nt concept for any business in any
industry and represent the cost -savings and competitive advantages larger
businesses have over smaller ones.
In microeconomics, economies of scale are the cost advantages that
enterprises obtain due to their scale of oper ation, and are typically
measured by the amount of output produced. A decrease in cost per unit of
output enables an increase in scale. At the basis of economies of scale,
there may be technical, statistical, organizational or related factors to the
degree of market control.
There are two types of economies of scale; internal and external.

1. Internal Economic of Scale:

Internal economies are borne from within the company. The vital sources
of economies of scale are discussed below:

 Purchasing: A large firm can buy raw materials in bulk through long -
term contracts can save a lot of its money.

 Managerial: A big firm can recruit specialized managers. By utilising
their skills they can cut down the per -unit cost of production. munotes.in

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41  Financial: For a large firm it is relatively easy to raise a fund. They
can obtain funding at a lower interest when borrowing from banks.
They are also having access to a greater range of financial
instruments.

 Marketing: A large firm can spread the cost of advertising over a
greater ran ge of output in media markets.

 Technological: A large firm can afford machinery with the latest
technology. That can be used to take advantage of returns to scale in
the production function.

2. External Economies of Scale:
The external economies of scale, o n the other hand, are achieved because
of external factors, or factors that affect not a firm but an entire industry.
That means no one company controls costs on its own. These occur when
there is a highly -skilled labour pool, subsidies and/or tax reductio ns, and
partnerships and joint ventures —anything that can cut down on costs to
many companies in a specific industry.
External economies of scale are generally described as affecting the whole
industry. So, when the industry grows, the average costs of bus iness drop.
External economies of scale can happen because of positive and negative
externalities. Positive externalities include a trained or specialized
workforce, relationships between suppliers, and/or more innovation.
Negative ones happen at the indus try levels and are often called external
diseconomies.
There are several contributing factors behind external economies of scale.
When competing companies set up shop in one area, specialized workers
will seek employment. An example of this would be the IT industry in
Silicon Valley, which has attracted a special set of skilled workers.
Secondly, certain industries may become so important, they can develop
bargaining power with politicians and local governments. This, in turn,
can lead to more favourable tr eatment in the form of subsidies or other
concessions. The fertilizer industry has a long history of subsidies in India,
which were historically given to continue a steady flow of domestic
supply of chemical fertilizers.
3.7 MARSHALL’S CONCEPT OF QUASI REN T
Marshall introduced another term quasi -rent. Quasi meaning as if.
Distinguishing between rent and interest in relation to tie element he
remarked in the preface to the first edition of his book –“That which is
rightly regarded as interest on free or floa ting capital or on new investment
of capital, is more properly treated as a soft rent – a quasi -rent on old
investment of capital.” Quasi -rent is a temporary differential gain or profit
yielded by the agents of production other than land. It occurs to fixe d
capital – capital which is invested in machinery or factory, may yield for a
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42 According to Ricardo, the term rent is applied to income from land and
other free gifts of nature, whereas quas i-rent is the income derived from
man-made appliances and machines. The supply of these man -made
producer goods cannot be increased in a short period even though the
demand for them may increase. Marshall, therefore, coined the term quasi -
rent for the earn ings of such capital goods in a short period.
In addition, Marshall gave an exposition of the Quantity Theory of
Money -Value as part of the General Theory of Value, drew a distinction
between the real rate of interest and the money rate of interest; and
enunciated the Purchasing Power Parity theory, appended to his evidence
given before the Gold and Silver Commission 1888. Moreover, he
introduced the chain method of index numbers, proposed paper currency
based on gold and silver symmetallism and suggested a n official tabular
standard for optional use in the case of long contracts.
Durable factors like machines, ships, houses and even human skills are
similar to the land whose supply is fixed in the short run. When the
demand for them increases suddenly, thei r supply cannot be increased in
the short run, therefore they earn a surplus which is not rent but is similar
to rent.
Example
Due to the increase in urban population the demand for houses increases.
But the supply cannot be increased because of the scarci ty of land and
building materials. This abnormal increase in their earnings is quasi -rent.
It is not rent proper or pure rent because the supply of houses can be
increased in the long -run.
3.8 QUESTIONS
A. Short -Answers
1. Explain Marshall’s theory of Representa tive Firm.
2. Write a note on Internal and External Economies of Scale.
3. Highlight the concept of Quasi Rent.

B. Long -Answers
1. Discuss the Marshall’s thoughts of Value.
2. Explain the Marshall’s concept of Consumer’s Surplus.
3.9 REFERENCES
 Kirti, S. (2021, Decembe r 15), Top 14 Contributions of Alfred
Marshall to Economics , Economics Discussion, https://bit.ly/3muuqeQ
 Lokanathan V. (2018), A History of Economic Thought, 10th Edition,
S. Chand Publishing, New Delhi munotes.in

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43  Raghavan V. P. ( 2009), History of Economic Thought , Kunal Books,
New Delhi
 Roll Eric (1973), A History of Economic Thought , Faber and Faber
Ltd, 3 Queen Square, London
 Shrivastava S. K. (1996), History of Economic Thought , S Chand &
Company Ltd, New Delhi
 Ayesha J (2021, December 12), Schumpeter’s Theory of Economic
Development | Economics, Economics Discussion,
https://bit.ly/3mB9YsL


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44 4
NEO -CLASSICAL ECONOMICS - II

Unit Structure:
4.0 Objectives
4.1 Marshall’s concept of Quasi Rent
4.2 Joseph Schumpeter
4.3 Schumpeter Theory of Economic Development and Innovation
4.4 Arthur Pigou(1877 -1959)
4.5 Pigou’s Welfare Economics
4.6 Concept of Pigouvian tax
4.7 Questions
4.8 References
4.0 OBJECTIVES
1. Discuss Schumpeter’s life and innovation and economic development
theory.
2. Learn Pigou’s life, views on economics of welfare and concept of
Pigovian Tax.
4.1 JOSEPH SCHUMPETER
Another Neo -classical economist who contributed a significant literature
in the economic science is Joseph Schumpeter. He was a political
economist and was born on February 8, 1883, in Moravia, the Czech
Republic. Schumpeter was one of the most influential and renowned 20th-
century economists and promoted the phrase “creative destruction” an
economic conceptwhich was coined by Werner Sombart.
Schumpeter's work centred on business cycles and development theories,
where he argued that entrepreneurs disrupt eq uilibriums and are the
predominant driver of economic growth, which progresses cyclically
across a series of time scales.Furthermore, he described innovation as an
essential element for economic reform. He also concluded that economic
development is centre d around innovation, entrepreneurial activity, and
market forces.

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45 Life Sketch
Joseph Alois Schumpeter entered was born in the Austrian province of
Moravia (now in Czech Republic) in the Catholic German -speaking
family.
His father owned a factory, but he di ed when Joseph was just four years
old. In 1893, Joseph and his mother moved to Vienna. After attending
school at the Theresianum, Schumpeter began his career studying law at
the University of Vienna under the Austrian capital theorist Eugen von
Böhm -Bawer k, taking his PhD in Law in 1906.
After practising law for a short period in Cairo, he decided to specialise in
economics. He had the privilege of studying under Professors Weiser,
Philippovich and Bohm -Bawer; and those who participated in seminars
includ ed Ludwig Von Mises, Felix Somary, Otto Bauer and Rudolf
Hilferding. In 1909, after some study trips, he became a professor of
economics and government at the University of Czernowitz in modern -day
Ukraine. In 1911, he joined the University of Graz, where he remained
until World War I.
In 1918, Schumpeter was a member of the Socialization Commission
established by the Council of the People's Deputies in Germany. In March
1919, he was invited to take office as Minister of Finance in the Republic
of German -Austria, where he proposed a capital levy as a way to tackle
the war debt and opposed the socialisation of the Alpine Mountain plant.
From 1925 to 1932, Schumpeter held a chair at the University of Bonn,
Germany. He lectured at Harvard in 1927 –1928 and 1930 and from 1932
to 1950.
Schumpeter received an honorary D.Litt. from the Columbia University in
1914. He was famous far and wide for his scholarly achievements. He was
President of the Econometric Society from 1937 to 1941, and of the
American Economic Asso ciation in 1949. His best -known works are The
Theory of Economic Development (1992, English translation 1934),
Business Cycles 2 Volumes (1939), Capitalism, Socialism and Democracy
(1942), Ten Great Economists (1951), Essays (1951), Imperialism and
Social Classes (1951), History of Economic Analysis (edited by his wife,
1954) and Economic Doctrine and Methods (1957).
4.2 SCHUMPETER THEORY OF ECONOMIC
DEVELOPMENT AND INNOVATION
Schumpeter’s theory of development is also known as the innovation
theory of deve lopment. This theory assigns a paramount role to the
entrepreneur and innovations in the process of economic development.
According to Schumpeter, the process of production is marked by a
combination of material and immaterial productive forces. The materi al
productive forces arise from the traditional factors of production, viz., land
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46 conditioned by the ‘technical facts’ and ‘facts of social organization’. The
Schumpeterian production fun ction can be written as
Q = ƒ [k, r, I, u, ν)
Where Q stands for the output, k for capital, r for natural resources, and l
for the employed labour force. The symbol u represents the society’s fund
of technical knowledge and ν represents the facts of social organization,
i.e., the socio -cultural environment of the economy.
The above function shows that the rate of growth of the output depends
upon the rate of growth of productive factors, the rate of growth of
technology and the rate of growth of the investm ent-friendly socio -cultural
environment. Schumpeter held that the alterations in the supply of
productive factors can only bring about gradual, continuous and slow
evolution of the economic system. On the other hand, the impact of
technological and social change calls for spontaneous, discontinuous
change in the channels of output flow.
Schumpeter regarded land to be constant. The growth component will,
therefore, include only the effects of changes in population and of increase
in the producer goods. But S chumpeter further maintains that there does
not exist any a priori relationship between the changes in population and
the changes in the flow of goods and services. In other words, Schumpeter
considers the population growth to be exogenously determined. Th e
increase in producer goods results from a positive rate of net savings. The
major part of savings and accumulations are attributed by Schumpeter to
profits. According to him, profits can arise if innovations are introduced.
Hence ultimately it is the cha nge in the technical knowledge (i.e., variable
u) that is responsible for any change in the stock of producer goods, i.e.,
the rate of capital accumulation directly depends on the rate of technical
change. In other words, according to Schumpeter, the growt h of output is
geared by the rate of innovations.
No doubt, Schumpeter holds that the trend of economic growth shall be
fixed by the exogenous variable of population growth, yet according to
him, the process of economic development is synonymous with
disco ntinuous technical change, i.e., innovations. The agent which brings
about innovations is called by Schumpeter as an entrepreneur. Thus, the
entrepreneur becomes the pivot of Schumpeter’s model.
According to Schumpeter, entrepreneurs play a key role in eco nomic
development. The credit for innovations and the outburst of economic
activity goes entirely to the entrepreneur. According to him, innovation
may be of five types:
1. Introduction of a new good
2. Introduction of a new method of production
3. The opening of a new market
4. The discovery of a new source of supply of raw materials or semi -
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47 In a world characterised by a high degree of risk and uncertainty, only a
few people who have the exceptional ability and daring will be able to
undertake innovations and launch enterprises and exploit opportunities for
profit. But these entrepreneurs are not only lured by profit but are also
motivated with a desire to found a dynasty in the business world or a
desire for conquests in the competitive world or have the joy of creating.
Thus, in the Schumpeterian analysis, the role of the entrepreneur is a
determining factor of the rate of economic growth. In his absence, the
growth rate is bound to be slow.
The sup ply of entrepreneurs depends not only on the rate of profits (which
is obvious) but also on the favourable social climate. They will appear and
continue only in a society that honours them, where prestige is attached to
them and the social rewards or recog nition they are able to earn. Any
tendency to squeeze profits, increase taxes, intensify welfare programmes,
strengthen the trade union movement or measures of redistribution of
income will deteriorate the climate for investment and so for economic
develop ment. Schumpeter’s starting point in the “circular flow” is a
stationary equilibrium in which there is no investment, population growth
is at a standstill position and there is full employment. But there are
numerous opportunities in business which the ent repreneurs are quick to
exploit and innovations are undertaken. As the economy is in equilibrium,
saving is equal to investment. So, when the innovators make an
investment, he does it bank loan. The banks provide loans to the
innovators through credit crea tion. Thus, according to Schumpeter credit
creating plays an important role in economic development.
The success of the original innovators attracts many others who follow
them. The economic activity becomes brisker and brisker and the boom
gathers moment um with the result that prices and money incomes rise.
There is then the secondary economic wave ‘imitative investment’
superimposed upon the earlier one, i.e., ‘innovational investment’. But
soon follows the process of creative destruction. The boom gives way to
slump or recession. Completion of innovations brings in a large supply of
goods that cannot be marketed at a profitable price. There are forced
bankruptcies since the banks call back loans.
The repayment of bank loans accentuates deflationary force s. Business
risks scare away prospective entrepreneurs. In this unfavourable climate,
the innovational activity comes to a halt. After this painful process of
adjustment in which weak enterprises are liquidated, the businessmen find
conditions again ripe f or a further spurt of entrepreneurial activity. The
economic activity is resumed at a higher equilibrium. This is how the
circle of the development process is completed. There is a new wave of
innovations and the development cycle repeats itself.
Critical Evaluation
Schumpeter has been a great ‘theorist’ whose writings contain brilliant
thoughts and a deep insight into the working of an economy. However, his
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48 conditions in which the act of inventio n and innovation is carried on not
by individual entrepreneurs but by large corporations as a routine affair. It
is not possible to identify entrepreneurs who introduced many actual
innovations.
Critics also pointed out that what Schumpeter gives is the t heory of
business cycles and not an analysis of economic development. Even
Schumpeter’s analysis of business cycles can be accepted only with some
modifications to suit modern economic conditions. According to
Schumpeter, a crisis in capitalism is brought about by maladjustment
caused by waves of innovations. But big businesses in modern times can
absorb these waves and produce steadier and larger expansion of the total
output.
The assumption that innovations are financed by borrowing from credit
creation b y the banks is also not very realistic. It is a well -known fact that
most bank loans are short -term loans whereas the implementation of
innovations requires long -term finances.
4.3 ARTHUR PIGOU (1877 -1959)
Arthur C. Pigou was a British economist and is bes t known for his work in
welfare economics. In his book The Economics of Welfare (1920) Pigou
further developed Alfred Marshall’s concept of externalities. According to
him, externalities are the costs imposed or benefits conferred on others
that are not ta ken into account by the person taking the action. He also
claimed that the existence of externalities is sufficient justification for
government intervention.
If someone is creating a negative externality, such as pollution, for
instance, he is engaging in too much of the activity that generated the
externality. Pigou advocated a tax on such activities to discourage them.
Someone creating a positive externality —say, by educating himself and
making himself more interesting or useful to other people —might not
invest enough in education because he would not perceive the value to
himself as being as great as the value to society. Pigou advocated
subsidies for activities that created such positive externalities. These are
now called Pigovian taxes and subsidies, respectively.
Life sketch of Pigou
Arthur Cecil Pigou was born on 18 November 1877at Ryde on the Isle of
Wight, the son of Clarence George Scott Pigou, an army officer and was
educated at Harrow and King’s College, Cambridge. He started off with
reading hi story but later went on to study economics under Alfred
Marshall as part of the Moral Science Tripos, rapidly becoming a prized
scholar. Through Marshall’s efforts, Pigou began lecturing himself in
economics in 1901, became a member of King’s in 1902 and w on the
popular Adam Smith Prize in 1903.
Pigou was considered one of the best students of Alfred Marshall. When
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49 named as Marshall’s substitute. Pigou was responsible for disseminating
many of Marshall’s ideas and thereby presented the leading hypothetical
basis for what came to be known as the Cambridge school of economics.
4.5 PIGOU’S WELFARE ECONOMICS
Pigou provided the first organized hypothetical basis of welfare economics
and unified the normative problems with the progressive ones. He
delivered a foundation for state interference at places here reserved and
social net product deviated but his policy proposals were all value -based
as his study was more normative than theoretical. Though it was the first
clear analysis of welfare economics, was criticized on many grounds.
Welfare is reflected in a person’s mental condition or awareness which are
made up of his satisfaction or utilities. The basis of welfare, therefore, is
essentially the level to which an individual’s basic needs are met.
Social welfare is deliberated as the core of the welfare of all the people in
a society. Subsequently, overall wel fare is a very broad, complex and
unfeasible idea. Pigou set the limits of the assortment of his study to
economic welfare. According to him, economic welfare is by no means a
directory of aggregate welfare as several other components, like the
excellence of work, one’s surroundings, human relations, prestige,
accommodation, and public safety are far away from economic welfare.
Pigou, therefore, described economic welfare as “that part of social
(general) welfare that can be brought directly or indirectly i nto relation
with the measuring rod of money.” Thus, economic welfare, in the
Pigovian sagacity, comprises the aspiration of utility resulting from the
usage of negotiable goods and services.
Pigovian Welfare Conditions
In Pigou's opinion the economic welf are and national revenue as basically
synchronized. Based on this, he sets two situations for maximization of
welfare. The first incident states that welfare will increase when there is
national income rises.
Second, for welfare maximization, the sharing of the national income is
similarly essential. If national income rests steady, flowing of income
from the rich to the deprived would ensure welfare. According to Pigou,
such allocations mean a minor amount to the prosperous than to the
deprived, as a cons equence the financial situation of the former is
improved. This welfare circumstance is based on the double Pigovian
postulates of ‘equal capacity for satisfaction and retreating marginal utility
of income.’
He argued that different people obtain the same pleasure out of the same
real income and that “people now rich are different in kind from the
people now poor having in their original nature greater capability for
enjoyment.” With income subject to moving back to marginal utility, and
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50 satisfying the more passionate wants of the latter at the expense of the less
intense wants of the former. Thus, it is equal economic opportunity that
maximizes welfare.
Dual Criterion
To find up -gradation in social welfare, Pigou implements a dual criterion:
a. A rise in the national revenue ‘brought about either by increasing some
goods without diminishing others or by relocating factors to activities
in which their social value is higher,’ is regarded as development in
welfare without dropping the share of the poor.

b. Any restructuring of the economy which adds to the share of the poor
without sinking the national income is also considered a development
in social welfare.
Assumptions
1. Each person tries to maximize his satisfaction and happiness from
his expenses on different goods and services.
2. Satisfactions are comparable interpersonally.
3. The law of diminishing marginal utility of income applies. It means
that the marginal utility of income decreases as income rises. As a
consequence, the growth in the utility of a surplus volume of income
to a deprived man is superior to the cost of utility to an opulent man
from a similar extent of revenue.
4. There is an equivalent capability for satisfaction. It foll ows that
different people gain the same satisfaction out of the same real
income. Given this theory, it is possible to satisfy the Pigovian
circumstances of maximum social welfare based on his double
measure.
4.6 CONCEPT OF PIGOVIAN TAX
The notion of externalities is established by A.C. Pigou. He argued that
the government should intervene to correct them by taxing undertakings
that harm the entire economy and financing activities that help society as a
whole.
A Pigovian tax is a tax assessed against p rivate individuals or businesses
for engaging in activities that create adverse effects for society. Adverse
effects are those costs that are not included as a part of the product's
market price. These include environmental pollution, strains on public
healthcare from the sale of tobacco products, and any other side effects
that have an external, negative impact.
A.C. Pigou argued that businessmen seek their own private interests, so
when the social interest of the society diverges from the private interes t of
these businesses the industrialists have no incentive to curb this cost. For
example, if a businessman builds a factory in the middle of a crowded city
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51 the neighbours. These a re not services but disservices that remain
uncharged. Let's take another example of businesses that sell alcohol, the
sale of alcohol necessitates higher costs in policemen and prisons. Because
of the crime associated with alcohol. In other words, the net social impact
of the alcohol business is relatively large to the net private impact of the
same business. So A.C. Pigou gave a solution to solve this problem, a
Pigovian tax. This is one of the major reasons why many countries tax
alcohol businesses. It is placed on any good which creates negative
externalities and the aim of tax is to make the price of the good equal to
the social marginal cost and create a more socially efficient allocation of
resources.
The main dispute against the Pigovian tax is that the objective
measurement of externalities is challenging. The distortive effects of an
imperfectly set tax, especially added with the administrative costs of
implementation, outweigh any potential benefit. But with the costs of
pollution and climate chan ge so extensive, the wrong increase in the cost
of pollution is almost certainly better than none at all.
4.7 QUESTIONS
A. Short -Answers
1. Explain different types of Innovations in Schumpeter’s theory
2. Write a note on Pigovian Tax

B. Long -Answers
1. Critically evalu ate the Schumpeter’s theory of Innovation and
Economic Development.
2. Explain in details the Pigou’s Welfare Economics
4.8 REFERENCES
 Kirti, S. (2021, December 15), Top 14 Contributions of Alfred
Marshall to Economics , Economics Discussion, https://bit.ly/3muuqeQ
 Lokanathan V. (2018), A History of Economic Thought, 10th Edition,
S. Chand Publishing, New Delhi
 Raghavan V. P. (2009), History of Economic Thought , Kunal Books,
New Delhi
 Roll Eric (1973), A Histo ry of Economic Thought , Faber and Faber
Ltd, 3 Queen Square, London
 Shrivastava S. K. (1996), History of Economic Thought , S Chand &
Company Ltd, New Delhi
 Ayesha J (2021, December 12), Schumpeter’s Theory of Economic
Development | Economics, Economics Dis cussion,
https://bit.ly/3mB9YsL

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52 Module III
5
KEYNESIAN IDEAS – I
Unit Structure:
5.0 Objectives
5.1 Introduction
5.2 Keynesian Theory of Employment
5.3 Money -Wage rigidity Model
5.4 Multiplier and Accelerator and their interaction
5.5 Questions
5.0 OBJECTVES
 To study the Keynesian theo ry of employment.
 To analyse the money -wage rigidity model.
 To understand the concepts of multiplier and accelerator and their
interaction.
5.1 INTRODUCTION
Keynes is perhaps the greatest economist of the twentieth century and will
remain one of the great est in the history of economics. Keynes introduced
a new paradigm in the analysis of economics. Keynes was basically a
classical economist. Keynes' contribution to the classical tradition is his
famous Treatise on Money. Keynes is primarily a monetary econ omist. He
analysed the monetary problems in macro perspective. Keynes found that
the classical prescription of monetary policy could not eliminate
unemployment and the great depression of the thirties. Then he examined
very closely the problems associated with unemployment and depression.
This is treated in his General Theory of Employment, Interest and Money,
which was published in 1936. Keynesian economics, therefore, is
sometimes called the economics of depression. Anyway, Keynes pointed
out the ineffica cy of monetary policy and prescribed the use of fiscal
policy for curing unemployment and depression. Keynes has written a
number of books including Indian Currency and Finance (1913), A Tract
on Monetary Reform (1923) and how to pay for the War (1940). Ho wever,
the General Theory is his magnum opus.

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53 5.2 KEYNESIAN THEORY OF EMPLOYMENT
In his General Theory, Keynes attacks the classical theory of employment
and systematically develops his own theory of employment, output and
income. According to Keynes, to tal income of an economy is a function of
total employment. The volume of employment depends on effective
demand. The effective demand depends on aggregate demand price and
aggregate supply price. The equilibrium point between aggregate demand
(AD) functio n and aggregate supply (AS) function determines effective
demand. The Keynesian model, aggregate supply function is assumed as
given, and the whole analysis centres round the factors that determine and
influence aggregate demand function. Effective demand depends on
consumption demand and investment demand. Consumption depends on
the level of income and the propensity to consume. The propensity to
consume does not increase in the same proportion as the increase in
income. Keynes observes that in the short p eriod, consumption function is
more or less stable. Therefore, for increasing employment in the short
period, the main emphasis is placed on investment. Investment bridges the
gap between income and consumption. If the volume of investment is
insufficient, the aggregate demand price will fall short of aggregate supply
price, and employment and income would be reduced. Thus, variation in
employment and income mainly depends on the variation in investment.
Investment depends on two factors:
a. Marginal efficienc y of capital, and
b. Rate of interest.
Marginal efficiency of capital depends on the supply price of capital and
the prospective yield from capital. The supply price of capital depends on
the physical and technical conditions of production, which, in the shor t
run, cannot be significantly altered. Therefore, in the short run,
prospective yield becomes a more dominant factor in investment decision.
When profit expectations are high and the entrepreneurs are guided by
"animal spirits", the rate of investment gen erally becomes higher. On the
other hand, when profit expectations are low, investment goes down.
The rate of interest (another determinant of investment) depends on the
quantity of money and the liquidity preference. If the supply of money is
given, the r ate of interest will be determined by the liquidity preference,
Liquidity preference depends on three human motives
1. Transaction motive,
2. Precautionary motive, and
3. Speculative motive.
The first two motives for holding money are generally interest -inelastic,
while the third one may be said to be interest -elastic. However, if liquidity
preference is given, the rate of interest is determined by the monetary
policy of the banking system. Investment can be stepped up either by
raising the marginal efficiency of c apital or by lowering the rate of
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54 Ordinarily, an increase in investment leads to increase in income and
employment. But employment will not increase, if the propensity to
consume of the people is reduced at the same time. In fact, con sumption
function is the "heart of Keynesian analysis" of employment and income.
A rise in income and employment without a corresponding increase in
investment, is sustained by increased consumption at least up to a point.
The importance of investment and consumption, for employment, income
and output, in the Keynesian theory, can be best understood with reference
to the operation of the multiplier effect. The multiplier refers to the
numerical coefficient indicating the increase in income that results from a
given increase in investment. The multiplier "establishes a precise
relationship, given the propensity to consume, between aggregate
employment and income and the rate of investment." A rise in investment
leads to a rise in income, out of which there ar ises a higher demand for
consumption goods which again leads to a further increase in income and
employment.
When the process becomes cumulative, a given rise in investment causes a
multiple increase in income, via the propensity to consume. The size of th e
multiplier depends on the marginal propensity to consume. If the marginal
propensity to consume is high, the multiplier will be large and vice versa.
Therefore, for increasing income and employment, both marginal
propensity to consume as well as investme nt have to be increased. But
since marginal propensity to consume is likely to fall with an increase in
income, what is necessary is to step up the rate of investment in the
economy. Investment demand along with consumption demand will
determine the effect ive demand which, in turn, will determine the level of
income and employment of an economy. This, in a sense, is the Keynesian
theory of employment, income and output. Keynesian theory of
employment is summarised in the chart .









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55

5.3 MONEY -WAGE RI GIDITY MODEL
According to J.M. Keynes money wage rigidity means downward
inflexibility of money wages causing involuntary unemployment of labour
at a given wage rate supply of labour exceed demand for labour which
causes unemployment according to him money wage will not change
sufficiently e in the short run to keep the economy at full employment. To
understand money wage rigidity causing unemployment we should
examine why la bour market doesn't clear through reduction in wage rates.
5.3.1 Causes of Money -Wage ri gidity Model

1. Money Illusion:
Firm will not cut wages despite an excess supply of labour because
workers will resist any move to cut wages which they accept fall in real
wages due to rise in prices. Workers does not realise the value of money munotes.in

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56 or purchasing power of money. They feel money has stable value so they
strongly oppose fall in wages but they does not resist if real wages are
reduced by increase in prices.
There are t wo reasons of money illusion
Firstly , workers of a firm think that through rise in prices reduce their real
wages it equally affects workers in other industries so their relative wages
as compared to those employed in others remain the same.
Secondly , work ers blame their employees for cut in money wages for cut
in real wages that think w orking of general economic forces in this case
strike has live little effect because Trade union remain silent spectator.
2. Wage fixation through contracts:
In the USA and UK wages are fixed by contract with in form and workers
for a given period in situatio n of surplus or deficit labour supply money
wage remains same.
Under trade unions bi collective bargaining money wage rate is much
more it is fixed for 3 -4-5 yes also.
Trade unions never accept wage cuts even if some union workers remain
unemployed so labo ur market does not clear in the short run and money
wage rigidity leads to involuntary unemployment.
3. Minimum wage Laws:
Due to government law over fixed minimum wages below which
employers are not permitted to pay wages below which employers are not
permit ted to pay wages.
4. Efficiency wages :
Employers are also not interested in reducing wages as high wages make
workers more efficient and productive. These difficulties are are hotels for
firms in reducing wages so money wage rigidity exists in the short run.
Keynes money wage rigidity and flexible price model
Emergence of involuntary unemployment


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57

Figure No. 5.1
In Keynes contractual labour market it is assumed that : -
1. Price are free to vary
2. Money wage is fixed
According to Keynes money wage rigidity d oesn't mean money wage is
completely fixed or sticky. His mean money wage do not fall quickly to
bring demand for and supply of labour to rich full employment money
wages are slow to adjust to ensure full employment because involuntary
unemployment comes i nto existence kings was concerned about
downward money wage rate.
● In the diagram (b) short run AS & AD intersecti on determines Po price
level & Yo real GDP level.
● AS is down with fixed money wage rate Wo level of labour
employment number shows number of j obs when economy is
producing Yo output ( GNP).
● At No workers are demanded and employed it repres ents full
employ ment.
● Suppose due to fall in in in marginal efficiency of capital there is
reduction in investment the multiplier effect causes leftward shift in
AD curve due to fixed money wage rate aggregate supply curve
remains unchanged the new AD curv e is AD 1& AS cur ve intersect at
point K determining new equilibrium lower price P1 & smaller real
GNP Y1 with less than full employment.
● At higher real wage ra te W0/P1 small amount of labour N1 will be
demanded and employed so RT number of workers are jobl ess
according to him with money wage rate remaining fixed at Wo, with
flexible prices the fall in aggregate demand results in involuntary
unemployment. munotes.in

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58 ● Keynes theory is a departure from the classical view of free market
economy which denied the existence o f involuntary un employment.
5.4 MULTIPLIER AND ACCELERATION:
INTERACTION
One has to consider combined effects of the multiplier and the
acceleration to know th e aggregate increase in income due to an initial rise
in autonomous spending. Any rise in autonom ous spending res ults in an
equal increase in income in the first instance, which in turn induces
consumption causing a further rise in income. This, as already pointed out,
is the multiplier effect. In the absence of an excess capacity in consumer
goods in dustries, an inc rease in consumption induces investment and
further increase in income takes place. This, as we know, is the
acceleration effect. Hence total i ncrease in income in response to a rise in
autonomous spending can be understood only in terms of interaction
between the multiplier and acceleration.
Now we shall like to explain the interaction between the multiplier and
acceleration with the help of an example. Let us assume that the marginal
propensity to consume (MPC) is 0.5 and the acceleration coefficient is 2 .
If, under these circumstances, the autonomous investment rises by Rs. 100
crore, the total increase in income in the first multiplier period would be of
the order of Rs. 250 crore. The process of income propagation in the
multiplier perio d 1 has been cle arly shown in Figure .
Figure No. 5. 2
Multiplier and accelerator

Shows the process of rise in income only in the first multiplier period in
response to an increase in autonomous investment equal to Rs. 100 crore.
The total increase in in come will materi alise in an infinitely large number
of multiplier periods through the interaction between the multiplier and
acceleration. In Table “ 5.1”, we h ave considered the impact of a rise in munotes.in

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59 autonomous investment equal to Rs. 100 crore on income in the first four
multiplier periods.
Table No. 5. 1
Combined Impact of Multiplier and Acceleration on Income

Multipl
ier
Period Increase in
Autonomou
s
Investment Induced
Consumpti
on
(Rs. crore) Induced
Investme
nt
(Rs.
crore) Total Increase
in Income
(Rs. cro re)
0 100 - - 100
1 100 50 100 250
2 100 125 150 375
3 100 187.5 125 412.5
4 100 206.5 37.5 343.75

In Table"B.1 the rise in income due to increase in au tonomous investment
has been shown. In the multiplier period 0, the rise in income is just equal
to the amount of initial inc rease in investment i.e., Rs. 100 crore. In the
multiplier period 1, this increase in income will induce consumption, and
since MPC is 0.5 the spending on consumer goods will rise by Rs. 50
crore which in turn, on the basis of a cceleration coef ficient bein g 2,
induces investment equal to Rs. 100 crore.
Hence the total increase in the multiplier period 1 will be equal to Rs. 250
crore . In the multiplier period 2, half (or 0.5) of this increased income will
be spent on consumer go ods and thus ind uced consump tion will amount to
Rs. 125 crore. Since in the previous multiplier period additional capacity
has been created for producing consu mer goods worth Rs. 50 crore, in the
current period i.e.multiplier period 2, firms will like to e xpand their
capacity for pro ducing additional consumer goods worth Rs. 75 crore.
Thus, in the multiplier period 2, induced investment will amount to only
Rs. 1 50 crore (2x Rs. 75 crore) and the total increase in income will be
equal to Rs. 375 crore. The a mount of induced consumption in the
multiplier period 3 will be Rs. 187.5 crore.
Since the consumption in this period has risen by only Rs. 625 crore, the
induced investment in this period will amount to Rs. 125 crore and the rise
in income will be of the order of Rs. 41 2.5 crore. T his, in fact, is the
highest limit, that income will reach in response to a rise in autonomous
investment equal to Rs. 100 crore. I n the subsequent multiplier period the
income level will fall. Consider the multiplier period 4, in which the munotes.in

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60 amount of induc ed consumption is equal to Rs. 206.25 crore. It exceeds
the amount of induced consumption in the multiplier period 3 by only Rs
18.75 crore.
Hence in this period, induced investment will be just Rs. 37.5 crore.
Compared to indu ced investments in the earli er multiplier periods, this is
too little. It is this sharp decline in induced investment which causes a
beginning of the recession ary process. Considering this fact, J.R. Hicks
has enunciated his theory of trade cycle.
Check Yo ur Progress :
1. Who is the auth or of the book ‘General Theory of Employment,
Interest and Money’?
2. On which factor Keynesian Theory of Employment depends?
3. ________ ______ is the determining factor for investment
4. According to J.M. Keynes money wage rigidity mean s
_____________i nflexibility of money wages.
5. With increase in investment, MEC______________.
6. Money wages rigidity causing __________unemployment.
7. The combined effects of the multiplier and the acceleration to know
the _____________due to an initial rise in autonomous spen ding.
8. The ma rginal propensity to consume (MPC) is 0.5 and the acceleration
coefficient is __________.
5.5 QUESTIONS
Q1. Explain Keynesian the ory of employment.
Q2. Explain money wage rigidity
Q3. What are the causes of involuntary un employment?
Q4. Explain mu ltiplier and acceleration interaction.
Q5. Find out the value of multiplier when C=20+.75Y
Q6. Find out the value of income mul tiplier when MPS = .25


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61 6
KEYNESIAN IDEAS - II
Unit Structure:
6.0 Objectives
6.1 Keynesian Theory of Trade Cycle
6.2 Keynesian Theory of Inflation
6.3 Keynes Idea on Role of Fiscal Policy
6.4 Keynesian Economics and Developing Countries
6.5 Summary
6.6 Questions
6.0 OBJECTIVES

 To study th e Keynesian theory of trade cycle.
 To understand the Keynesian theory of inflation.
 To know the Keynes idea on role of fiscal policy.
 To study the relationship between Keynesian economics and
developing countries.
6.1 KEYNESIAN THEORY OF TRADE CYCLE
Acco rding to Keynes, business cycle is caused by variations in the rate of
investment caused by fluctuations in the Marginal Efficiency of Capital.
The term ‘marginal efficiency of capital’ means the expected profits from
new investments. Entrepreneurial activ ity depends upon profit
expectations. In his business cycle theory, Keynes assigns the major role
to expectations.
Business cycles are periodic fluctuations of employment, income and
output. According to Keynes, income and output depend upon the volume
of employment. The volume of employment is determined by three
variables:
1. The marginal efficiency of capital,
2. The rate of interest and,
3. The propensity to consume.
Keynes suggest that the essential character of the Trade Cycle and,
especially, the regularit y of time -sequence and of duration which justifies
us in calling it a cycle, is mainly due to the way in which the marginal
efficiency of capital fluctuates. The Trade Cycle is best regarded, Keynes
think, as being occasioned by a cyclical change in the ma rginal efficiency munotes.in

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62 of capital, though complicated and often aggravated by associated changes
in the other significant short -period variables of the economic system.
The following short notes will be sufficient to indicate the line of
investigation which o ur preceding theory suggests.
By a cyclical movement we mean that as the system progresses in, e.g.,
the upward direction, the forces propelling it upwards at first gather force
and have a cumulative effect on one another but gradually lose their
strength until at a certain point they tend to be replaced by forces
operating in the opposite direction; which in turn gather force for a time
and accentuate one another, until they too, having reached their maximum
development, wane and give place to their opposi te. We do not, however,
merely mean by a cyclical movement that upward and downward
tendencies, once started, do not persist for ever in the same direction but
are ultimately reversed. We mean also that there is some recognisable
degree of regularity in th e time sequence and duration of the upward and
downward movements.
There is, however, another characteristic of what we call the Trade Cycle
which our explanation must cover if it is to be adequate; namely, the
phenomenon of the crisis the fact that the su bstitution of a downward for
an upward tendency often takes place suddenly and violently, whereas
there is, as a rule, no such sharp turning -point when an upward is
substituted for a downward tendency.
Any fluctuation in investment not offset by a correspo nding change in the
propensity to consume will, of course, result in a fluctuation in
employment. Since, therefore, the volume of investment is subject to
highly complex influences, it is highly improbable that all fluctuations
either in investment itself or in the marginal efficiency of capital will be of
a cyclical character. One special case, in particular, namely, that which is
associated with agricultural fluctuations, will be separately considered in a
later section of this chapter. Keynes suggest, ho wever, that there are
certain definite reasons why, in the case of a typical industrial trade cycle
in the nineteenth -century environment, fluctuations in the marginal
efficiency of capital should have had cyclical characteristics. These
reasons are by no means unfamiliar either in themselves or as explanations
of the trade cycle. His only purpose here is to link them up with the
preceding theory.
Keynes can best introduce what he have to say by beginning with the later
stages of the boom and the onset of t he "crisis".
We have seen above that the marginal efficiency of capital depends, not
only on the existing abundance or scarcity of capital -goods and the current
cost of production of capital -goods, but also on current expectations as to
the future yield of capital -goods. In the case of durable assets it is,
therefore, natural and reasonable that expectations of the future should
play a dominant part in determining the scale on which new investment is
deemed advisable. But, as we have seen, the basis for suc h expectations is munotes.in

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63 very precarious. Being based on shifting and unreliable evidence, they are
subject to sudden and violent changes.
Now, we have been accustomed in explaining the "crisis" to lay stress on
the rising tendency of the rate of interest under t he influence of the
increased demand for money both for trade and speculative purposes. At
times this factor may certainly play an aggravating and, occasionally
perhaps, an initiating part. But he suggest that a more typical, and often
the predominant, exp lanation of the crisis is, not primarily a rise in the rate
of interest, but a sudden collapse in the marginal efficiency of capital.
The later stages of the boom are characterised by optimistic expectations
as to the future yield of capital goods sufficie ntly strong to offset their
growing abundance and their rising costs of production and, probably, a
rise in the rate of interest also. It is of the nature of organised investment
markets, under the influence of purchasers largely ignorant of what they
are buying and of speculators who are more concerned with fore casting
the next shift of market sentiment than with a reasonable estimate of the
future yield of capital -assets, that, when disillusion falls upon an over -
optimistic and over -bought market, it sho uld fall with sudden and even
catastrophic force.
Moreover, the dismay and uncertainty as to the future which accompanies
a collapse in the marginal efficiency of capital naturally precipitates a
sharp increase in liquidity -preference -and hence a rise in the rate of
interest. Thus the fact that a collapse in the marginal efficiency of capital
tends to be associated with a rise in the rate of interest may seriously
aggravate the decline in investment. But the essence of the situation is to
be found, neverth eless, in the collapse in the marginal efficiency of
capital, particularly in the case of those types of capital which have been
contributing most to the previous phase of heavy new investment.
Liquidity -preference, except those manifestations of it which are
associated with increasing trade and speculation, does not increase until
after the collapse in the marginal efficiency of capital.
It is this, indeed, which renders the slump so in tractable. Later on, a
decline in the rate of interest will be a great aid to recovery and, probably,
a necessary condition of it. But, for the moment, the collapse in the
marginal efficiency of capital may be so complete that no practicable
reduction in the rate of interest will be enough. If a reduction in the rate of
interest was capable of proving an effective remedy by itself, it might be
possible to achieve a recovery without the elapse of any considerable
interval of time and by means more or less directly under the control of the
monetaryauthority. But, in fact, this is not usually the case; and it is not so
easy to revive the marginal efficiency of capital, determined, as it is, by
the uncontrollable and disobedient psychology of the business world. It is
the return of confidence, to speak in ordinary language, which is so
insusceptible to control in an economy of individualistic capitalism. This
is the aspect of the slump which bankers and business men have been right
in emphasising, and which the economists who have put their faith in a
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64 This brings me to my point. The explanation of the time -element in the
trade cycle, of the fact that an interval of time of a particular order of
magnitude must usually elapse before recovery begins, is to be sought in
the influences which govern the recovery of the marginal efficiency of
capital. There are reasons, given firstly by the length of life of durable
assets in relation to the normal rate of growth in a given epoch, and
secondly by the carrying -costs of surplus stocks, why the dur ation of the
downward movement should have an order of magnitude which is not
fortuitous, which does not fluctuate between, say, one year this time and
ten years next time, but which shows some regularity of habit between, let
us say, three and five years.
Let us recur to what happens at the crisis. So long as the boom was
continuing, much of the new investment showed a not unsatisfactory
current yield. The disillusion comes because doubts suddenly arise
concerning the reliability of the prospective yield, perhaps because the
current yield shows signs of falling off, as the stock of newly produced
durable goods steadily increases. If current costs of production are thought
to be higher than they will be later on, that will be a further reason for a
fall in t he marginal efficiency of capital. Once doubt begins it spreads
rapidly. Thus at the outset of the slump there is probably much capital of
which the marginal efficiency has become negligible or even negative. But
the interval of time, which will have to el apse before the shortage of
capital through use, decay and obsolescence causes a sufficiently obvious
scarcity to increase the marginal efficiency, may be a somewhat stable
function of the average durability of capital in a given epoch. If the
characterist ics of the epoch shift, the standard time -interval will change.
If, for example, we pass from a period of increasing population into one of
declining population, the characteristic phase of the cycle will be
lengthened. But we have in the above a substanti al reason why the
duration of the slump should have a definite relationship to the length of
life of durable assets and to the normal rate of growth in a given epoch.
The second stable time -factor is due to the carrying costs of surplus stocks
which force their absorption within a certain period, neither very short nor
very long. The sudden cessation of new investment after the crisis will
probably lead to an accumulation of surplus stocks of unfinished goods.
The carrying -costs of these stocks will seldom be less than 10 percent per
annum. Thus the fall in their price needs to be sufficient to bring about a
restriction which provides for their absorption within a period of, say,
three to five years at the outside. Now the process of absorbing the stocks
represents negative investment, which is a further deterrent to
employment; and, when it is over, a manifest relief will be experienced.
Moreover, the reduction in working capital, which is necessarily attendant
on the decline in output on the downward phase, represents a further
element of disinvestment, which may be large; and, once the recession has
begun, this exerts a strong cumulative influence in the downward
direction. In the earliest phase of a typical slump there will probably be an
investment in inc reasing stocks which helps to offset disinvestment in
working -capital; in the next phase there may be a short period of munotes.in

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65 disinvestment both in stocks and in working capital; after the lowest point
has been passed there is likely to be a further disinvestmen t in stocks
which partially offsets reinvestment in working -capital; and, finally, after
the recovery is well on its way, both factors will be simultaneously
favourable to investment. It is against this background that the additional
and superimposed effec ts of fluctuations of investment in durable goods
must be examined. When a decline in this type of investment has set a
cyclical fluctuation in motion there will be little encouragement to a
recovery in such investment until the cycle has partly run its co urse.¹
Unfortunately a serious fall in the marginal efficiency of capital also tends
to affect adversely the propensity to consume. For it involves a severe
decline in the market value of Stock Exchange equities. Now, on the class
who take an active intere st in their Stock Exchange investments,
especially if they are employing borrowed funds, this naturally exerts a
very depressing influence. These people are, perhaps, even more
influenced in their readiness to spend by rises and falls in the value of their
investments than by the state of their income. With a "stock -minded"
public, as in the United States to -day, a rising stock -market may be an
almost essential condition of a satisfactory propensity to consume; and this
circumstance, generally overlooked un til lately, obviously serves to
aggravate still further the depressing effect of a decline in themarginal
efficiency of capital. When once the recovery has been started, the manner
in which it feeds on itself and cumulates is obvious. But during the
downwa rd phase, when both fixed capital and stocks of materials are for
the time being redundant and working -capital is being reduced, the
schedule of the marginal efficiency of capital may fall so low that it can
scarcely be corrected, so as to secure a satisfa ctory rate of new investment,
by any practicable reduction in the rate of interest. Thus with markets
organised and influenced as they are at present, the market estimation of
the marginal efficiency of capital may suffer such enormously wide
fluctuations that it cannot be sufficiently offset by corresponding
fluctuations in the rate of interest. Moreover, the corresponding
movements in the stock -market may, as we have seen above, depress the
propensity to consume just when it is most needed. In conditions of laissez
faire the avoidance of wide fluctuations in employment may, therefore,
prove impossible without a far -reaching change in the psychology of
investment markets such as there is no reason to expect. I conclude that
the duty of ordering the current volume of investment cannot safely be left
in private hands.
The preceding analysis may appear to be in conformity with the view of
those who hold that over investment is the characteristic of the boom, that
the avoidance of this over -investment is the on ly possible remedy for the
ensuing slump, and that, whilst for the reasons given above the slump
cannot be prevented by a low rate of interest, nevertheless the boom can
be avoided by a high rate of interest. There indeed, force in the argument
that a high rate of interest is much more effective against a boom than a
low rate of interest against a slump.
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66 According to Keynes analysis, however, it is only in the former sense that
the boom can be said to be characterised by over -investment. The
situation, whi ch he indicating as typical, is not one in which capital is so
abundant that the community as a whole has no reasonable use for any
more, but where investment is being made in conditions which are
unstable and cannot endure, because it is prompted by expec tations which
are destined to disappointment.
It may, of course, be the case -indeed it is likely to be that the illusions of
the boom cause particular types of capital -assets to be produced in such
excessive abundance that some part of the output is, on an y criterion, a
waste of resources; -which sometimes happens, we may add, even when
there is no boom. It leads, that is to say, to misdirected investment. But
over and above this it is an essential characteristic of the boom that
investments which will in fa ct yield, say, 2 percent in conditions of full
employment are made in the expectation of a yield of, say, 6 per cent., and
are valued accordingly. When the disillusion comes, this expectation is
replaced by a contrary "error of pessimism", with the result that the
investments, which would in fact yield 2 percent in conditions of full
employment, are expected to yield less than nothing; and the resulting
collapse of new investment then leads to a state of unemployment in
which the investments, which would ha ve yielded 2 percent in conditions
of full employment, in fact yield less than nothing. We reach a condition
where there is a shortage of houses, but where nevertheless no one can
afford to live in the houses that there are.
Thus the remedy for the boom is not a higher rate of interest but a lower
rate of interest for that may enable the so -called boom to last. The right
remedy for the trade cycle is not to be found in abolishing booms and thus
keeping us permanently in a semi slump; but in abolishing slump s and
thus keeping us permanently in a quasi -boom.
The boom which is destined to end in a slump is caused, therefore, by the
combination of a rate of interest, which in a correct state of expectation
would be too high for full employment, with a misguided state of
expectation which, so long as it lasts, prevents this rate of interest from
being in fact deterrent. boom is a situation in which over -optimism
triumphs over a rate of interest which, in a cooler light, would be seen to
be excessive.
It may be co nvenient at this point to say a word about the important
schools of thought which maintain, from various points of view, that the
chronic tendency of contemporary societies to under -employment is to be
traced to under -consumption; -that is to say, to social practices and to a
distribution of wealth which result in a propensity to consume which is
unduly low. In existing conditions -or, at least, in the conditions which
existed until lately -where the volume of investment is unplanned and
uncontrolled, subject to the vagaries of the marginal efficiency of capital
as determined by the private judgment of individuals ignorant or
speculative, and to a long -term rate of interest which seldom or never falls
below a conventional level, these schools of thought are, as guides to munotes.in

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67 practical policy, undoubtedly in the right. For in such conditions there is
no other means of raising the average level of employment to a more
satisfactory level. If it is impracticable materially to increase investment,
obviously there is no m eans of securing a higher level of employment
except by increasing consumption.
Practically Keynes only differ from these schools of thought in thinking
that they may lay a little too much emphasis on increased consumption at
a time when there is still muc h social advantage to be obtained from
increased investment. Theoretically, however, they are open to the
criticism of neglecting the fact that there are two ways to expand output.
Even if we were decide that it would be better to increase capital more
slowly and to concentrate effort on increasing consumption, we must
decide this with open eyes after well considering the alternative. He
himself impressed by the great social advantages of increasing the stock of
capital until it ceases to be scarce. But thi s is a practical judgment, not a
theoretical imperative.
Moreover, He was readily concede that the wisest course is to advance on
both fronts at once. Whilst aiming at a socially controlled rate of
investment with a view to a progressive decline in the mar ginal efficiency
of capital, he support at the same time all sorts of policies for increasing
the propensity to consume. For it is unlikely that full employment can be
maintained, whatever we may do about investment, with the existing
propensity to consume . There is room, therefore, for both policies to
operate together; -to promote investment and, at the same time, to promote
consumption, not merely to the level which with the existing propensity to
consume would correspond to the increased investment, but to a higher
level still.
If to take round figures for the purpose of illustration the average level of
output of to -day is 15 percent below what it would be with continuous full
employment, and if 10 percent of this output represents net investment and
90 percent of it consumption -if, furthermore, net investment would have to
rise 50 per cent. in order to secure full employment with the existing
propensity to consume, so that with full employment output would rise
from 100 to 115, consumption from 90 to 10 0 and net investment from 10
to 15: -then we might aim, perhaps, at so modifying the propensity to
consume that with full employment consumption would rise from 90 to
103 and net investment from 10 to 12.
Another school of thought finds the solution of the trade cycle, not in
increasing either consumption or investment, but in diminishing the supply
of labour seeking employment; i.e. by redistributing the existing volume
of employment without increasing employment or output.
This seems to me to be a prematur e policy -much more clearly so than the
plan of increasing consumption. A point comes where every individual
weighs the advantages of increased leisure against increased income. But
at present the evidence is, I think, strong that the great majority of
individuals would prefer increased income to increased leisure; and I see munotes.in

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68 no sufficient reason for compelling those who would prefer more income
to enjoy more leisure.
It may appear extraordinary that a school of thought should exist which
finds the solution f or the trade cycle in checking the boom in its early
stages by a higher rate of interest. The only line of argument, along which
any justification for this policy can be discovered, is that put forward by
Mr. D. H. Robert son, who assumes, in effect, that full employment is an
impracticable ideal and that the best that we can hope for is a level of
employment much more stable than at present and averaging, perhaps, a
little higher.
If we rule out major changes of policy affecting either the control of
inves tment or the propensity to consume, and assume, broadly speaking, a
continuance of the existing state of affairs, it is, I think, arguable that a
more advantageous average state of expectation might result from a
banking policy which always nipped in the b ud an incipient boom by a
rate of interest high enough to deter even the most misguided optimists.
The disappointment of expectation, characteristic of the slump, may lead
to so much loss and waste that the average level of useful investment
might be highe r if a deterrent is applied. It is difficult to be sure whether or
not this is correct on its own assumptions; it is a matter for practical
judgment where detailed evidence is wanting.
It may be that it overlooks the social advantage which accrues from th e
increased consumption which attends even on investment which proves to
have been totally misdirected, so that even such investment may be more
beneficial than no investment at all. Nevertheless, the most enlightened
monetary control might find itself in difficulties, faced with a boom of the
1929 type in America, and armed with no other weapons than those
possessed at that time by the Federal Reserve System; and none of the
alternatives within its power might make much difference to the result.
However th is may be, such an outlook seems to me to be dangerously and
unnecessarily defeatist. It recommends, or at least assumes, for permanent
acceptance too much that is defective in our existing economic scheme.
The austere view, which would employ a high rate of interest to check at
once any tendency in the level of employment to rise appreciably above
the average of, say, the previous decade, is, however, more usually
supported by arguments which have no foundation at all apart from
confusion of mind. It flows , in some cases, from the belief that in a boom
investment tends to outrun saving, and that a higher rate of interest will
restore equilibrium by checking investment on the one hand and
stimulating savings on the other. This implies that saving and investm ent
can be unequal, and has, therefore, no meaning until these terms have been
defined in some special sense.
It is sometimes suggested that the increased saving which accompanies
increased investment is undesirable and unjust because it is, as a rule, als o
associated with rising prices. But if this were so, any upward change in the
existing level of output and employment is to be deprecated. For the rise in munotes.in

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69 prices is not essentially due to the increase in investment; it is due to the
fact that in the short period supply price usually increases with increasing
output, on account either of the physical fact of diminishing return or of
the tendency of the cost -unit to rise in terms of money when output
increases. If the conditions were those of constant supply -price, there
would, of course, be no rise of prices; yet, all the same, increased saving
would accompany increased investment. It is the increased output which
produces the increased saving; and the rise of prices is merely a by -
product of the increased o utput, which will occur equally if there is no
increased saving but, instead, an increased propensity to consume. No one
has a legitimate vested interest in being able to buy at prices which are
only low because output is low.
Or, again, the evil is suppos ed to creep in if the increased investment has
been promoted by a fall in the rate of interest engineered by an increase in
the quantity of money. Yet there is no special virtue in the pre -existing
rate of interest, and the new money is not "forced" on any one;-it is created
in order to satisfy the increased liquidity -preference which corresponds to
the lower rate of interest or the increased volume of transactions, and it is
held by those individuals who prefer to hold money rather than to lend it at
the lo wer rate of interest. Or, once more, it is suggested that a boom is
characterised by "capital consumption", which presumably means negative
net investment, i.e. by an excessive propensity to consume. Unless the
phenomena of the trade cycle have been confus ed with those of a flight
from the currency such as occurred during the post -war European currency
collapses, the evidence is wholly to the contrary. Moreover, even if it were
so, a reduction in the rate of interest would be a more plausible remedy
than a rise in the rate of interest for conditions of under -investment. I can
make no sense at all of these schools of thought; except, perhaps, by
supplying a tacit assumption that aggregate output is incapable of change.
But a theory which assumes constant outp ut is obviously not very
serviceable for explaining the trade cycle.
In the earlier studies of the trade cycle, notably by Jevons, an explanation
was found in agricultural fluctuations due to the seasons, rather than in the
phenomena of industry. In the li ght of the above theory this appears as an
extremely plausible approach to the problem. For even to -day fluctuation
in the stocks of agricultural products as between one year and another is
one of the largest individual items amongst the causes of changes in the
rate of current investment; whilst at the time when Jevons wrote -and more
particularly over the period to which most of his statistics applied this
factor must have far outweighed all others.
Jevons's theory, that the trade cycle was primarily due t o the fluctuations
in the bounty of the harvest, can be re -stated as follows. When an
exceptionally large harvest is gathered in, an important addition is usually
made to the quantity carried over into later years. The proceeds of this
addition are added t o the current incomes of the farmers and are treated by
them as income; whereas the increased carry -over involves no drain on the
income -expenditure of other sections of the community but is financed out
of savings. That is to say, the addition to the carr y-over is an addition to munotes.in

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70 current investment. This conclusion is not invalidated even if prices fall
sharply. Similarly when there is a poor harvest, the carry -over is drawn
upon for current consumption, so that a corresponding part of the income -
expenditur e of the consumers creates no current income for the farmers.
That is to say, what is taken from the carry -over involves a corresponding
reduction in current investment. Thus, if investment in other directions is
taken to be constant, the difference in agg regate investment between a
year in which there is a substantial addition to the carry -over and a year in
which there is a substantial subtraction from it may be large; and in a
community where agriculture is the predominant industry it will be
overwhelmin gly large compared with any other usual cause of investment
fluctuations. Thus it is natural that we should find the upward turning -
point to be marked by bountiful harvests and the downward turning -point
by deficient harvests. The further theory, that ther e are physical causes for
a regular cycle of good and bad harvests, is, of course, a different matter
with which we are not concerned here.
More recently, the theory has been advanced that it is bad harvests, not
good harvests, which are good for trade, ei ther because bad harvests make
the population ready to work for a smaller real reward or because the
resulting redistribution of purchasing -power is held to be favourable to
consumption. Needless to say, it is not these theories which I have in mind
in the above description of harvest phenomena as an explanation of the
trade cycle. The agricultural causes of fluctuation are, however, much less
important in the modern world for two reasons. In the first place
agricultural output is a much smaller proportion of total output. And in the
second place the development of a world market for most agricultural
products, drawing upon both hemispheres, leads to an averaging out of the
effects of good and bad seasons, the percentage fluctuation in the amount
of the worl d harvest being far less than the percentage fluctuations in the
harvests of individual countries. But in old days, when a country was
mainly dependent on its own harvest, it is difficult to see any possible
cause of fluctuations in investment, except war, which was in any way
comparable in magnitude with changes in the carry -over of agricultural
products.
Even to -day it is important to pay close attention to the part played by
changes in the stocks of raw materials, both agricultural and mineral, in
the de termination of the rate of current investment. I should attribute the
slow rate of recovery from a slump, after the turning point has been
reached, mainly to the deflationary effect of the reduction of redundant
stocks to a normal level. At first the accum ulation of stocks, which occurs
after the boom has broken, moderates the rate of the collapse; but we have
to pay for this relief later on in the damping -down of the subsequent rate
of recovery. Sometimes, indeed, the reduction of stocks may have to be
virtually completed before any measurable degree of recovery can be
detected. For a rate of investment in other directions, which is sufficient to
produce an upward movement when there is no current disinvestment in
stocks to set off against it, may be quite in adequate so long as such
disinvestment is still proceeding. munotes.in

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71 We have seen, I think, a signal example of this in the earlier phases of
America's "New Deal". When President Roosevelt's substantial loan
expenditure began, stocks of all kinds -and particularl y of agricultural
products -still stood at a very high level. The "New Deal" partly consisted
in a strenuous attempt to reduce these stocks -by curtailment of current
output and in all sorts of ways. The reduction of stocks to a normal level
was a necessary process -a phase which had to be endured. But so long as
it lasted, namely, about two years, it constituted a substantial offset to the
loan expenditure which was being incurred in other directions. Only when
it had been completed was the way prepared for s ubstantial recovery.
Recent American experience has also afforded good examples of the part
played by fluctuations in the stocks of finished and unfinished goods -
"inventories" as it is becoming usual to call them -in causing the minor
oscillations within th e main movement of the Trade Cycle. Manufacturers,
setting industry in motion to provide for a scale of consumption which is
expected to prevail some months later, are apt to make minor
miscalculations, generally in the direction of running a little ahead of the
facts. When they discover their mistake they have to contract for a short
time to a level below that of current consumption so as to allow for the
absorption of the excess inventories; and the difference of pace between
running a little ahead and dr opping back again has proved sufficient in its
effect on the current rate of investment to display itself quite clearly
against the background of the excellently complete statistics now available
in the United States.
6.2 KEYNESIAN THEORY OF INFLATION
Keyn es's theory of inflation is considered as 'only a little more than an
extension and generalisation of classical theory especially of Wicksell's
view". Keynes has, however, made an important departure from the
classical view. While classical economists cons idered an increase in
money supply as the only cause of an increase in aggregate demand and
the only cause of inflation, Keynes too postulated that inflation is caused
by increase in aggregate demand.
According to Keynes, the aggregate demand might increa se because of
increase in real factors, increase in consumer demand due to increase in
MPC, increase in investment demands due to upward shift in marginal
efficiency of investment (MED) and increase in government expenditure.
Such changes may take place ev en when supply of money remains
constant. Increase in aggregate demand, aggregate supply remaining
constant, creates demand -supply gap which he called the 'inflationary
gap". According to Keynes, the inflationary gap is the cause of inflation.
Keynes had e xpressed his view on inflation in his book, How to Pay for
the War (1940), wherein he gave the concept of inflationary gap.
Inflationary gap is defined as the gap between the planned expenditure and
the real output available at full employment.
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72 Following Keynes, the British Chancellor of Exchequer defined the
inflationary gap in his budget speech of 1941 as the amount of the
government's expenditure against which there is no corresponding release
of real resources of manpower or material by some other mem bers of the
community. The 'inflationary gap' is so called because it causes inflation,
without increasing the level of output.
It is important to note here that Keynes linked inflationary gap and the
consequent inflation tofull -employment output. In his opinion, if the
economy is at less -than-full-employment level, a price rise is not inflation.
It implies that the expenditure creating demand in excess of output supply
at less -than full -employment level is not inflationary even if prices
increase. For, su ch increase in price generates additional employment and
output. The additional output supply absorbs the excess demand with a
time lag. According to Keynes, price rise during the time lag is not
inflation.
According to the Keynesian theory of inflation, a price rise due to excess
demand only at full employment level is inflationary, i.e., inflation takes
place only when the economy is at the level of full employment.
The concept of inflationary gap and its impact on the price level is
exemplified by using the 'Keynesian cross' in Fig. 2.A. Suppose that the
economy is in full -employment equilibrium at point E where aggregate
demand (C+I+G) = AD, schedule intersects the aggregate supply (AS)
schedule.
At point E , resources are fully employed. At the full employment level
of output, the aggregate income equals the aggregate expenditure, that is,
OY = EY.
Given the full -employment status of the economy, let us suppose that the
government increases its spending by E, E AD. Consequently, the
aggregate deman d schedule shifts upward to AD=C+I+GAG and
equilibrium point shifts from point E, to point E.








munotes.in

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73


However, since there full employment, additional resources (capital and
labour) would not be forthcoming in respo nse to the additional demand.
There fore, higher factor prices would be offered to draw the factor inputs
from the existing employment. This creates an inflationary pressure in the
economy. This inflationary pressure b arisen due to AG -EE, Therefore,
EE, i s inflationary gap. The inflationar y gap generates only money income
without creating matching real output because the economy is in full
employment equilibrium the rise in money income would create multiplier
effect depending on the MPC. Since the economy is in the state of full
employment and additional goods and services would not be forthcoming,
the multiplies would work only on the money income generating more and
more demand. The prices would, therefore, rise until the entire extra
money income and ex cess demand are absorbed by the ris e in the general
price level. According to Keynes, this price rise is inflation - not the price
rise prior to full employment level.
The Rate of Inflation
According to the Keynesian theory of inflation, the rate of infla tion equals
the percentage of addit ional money income (AY) generated by AG to the
pre-AG money income. Since pre -AG money income equals OY1,
Inflation rate (%) = ∆Y/OY1×100

Figure No. 6.1 Inflation Gap & Inflation
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74 As figure "C" shows, ∆Y=OY2 - OY1=Y1Y2. By subtracting Y1Y2 for
∆Y, we get
Inflation rate (%) = Y1Y2/OY1×100
6.3 KEYNES VIEW ON ROLE OF FISCAL POLICY
As an instrument of macroeconomic policy, fiscal policy has been very
popular with the modern governments to influence the size and
composition of the national product, employment, industrial production,
prices, etc., in the economy. The deliberate use of fiscal policy as a means
to achieve and maintain full employment and pri ce stability in the
economy has been a characteristic feature of the past seven decades after
the publication of John Maynard Keynes' well -known book titled The
General Theory of Employment, Interest and Money in 1936.
The post -Keynesian popularity of fis cal policy has been largely due to the
following three factors:
1. Ineffectiveness of the monetary policy as a means of removing mass
unemployment in the great depression of the 30s;
2. The development of 'new economics' by John Maynard Keynes with its
stress on the role of aggregate effective demand; and
3. The growing importance of government spending and taxation in
relation to thenational income and output. From its modest beginnings
in the 40s, fiscal policy today has become a majormacroeconomic
polic y instrument employed by the governments to achieve
fullemployment, to prevent inflation and to promote rapid economic
growth.
Following Keynes, economists have argued that substantial amount of
spending and fund raising in the form of taxation by governme nt are
capable of changing the size of national product and the tempo of
aggregate economic activity in the system. By determining what goods
and services will be produced, the fiscal operations of the government
affect significantly the direction of emplo yment of the economy's
resources.
Government expenditure and tax revenue are not, however, closely related
to one another. In any given year, government's total expenditure and total
tax receipts may be unequal in which case the budget will be either a
deficit or a surplus budget. When the expenditure and income of the
government are equal, the budget is said be a balanced budget. The use of
budget deficit and surplus in order to affect the level of the aggregate
economic activity or to maintain economic st ability or to promote
economic growth in the economy is the essence of fiscal policy. Both the
Keynesian and the neo -Keynesian economists rely primarily on the fiscal
policy to stabilize the economy. During a major recession, such as the one
which occurred in the 1930s, even the monetarists believed that fiscal munotes.in

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75 policy could be used more effectively to increase the level of aggregate
demand in the economy.
Meaning of Fiscal Policy
In his epoch -making book The General Theory of Employment, Interest
and Money , Keynes used fiscal policy when referring to the influence of
taxation on savings and government investment spending financed through
loans raised from the public. Keynes looked a it as state policy which used
public finance as a balancing factor in the e conomy's development.
Ordinarily, by fiscal policy is meant a policy which affects the important
macroeconomic variables -aggregate output, employment, saving,
investment, etc., through the budgetary manipulation. Fiscal policy refers
to the regulation of t he level of government spending, taxation and public
debt. According to Arthur Smithies, the term fiscal policy refers to 'a
policy under which a government uses its expenditure and revenue
programmes to produce desirable effects and avoid undesirable effe cts on
the national income, production and employment. According to Buehler,
"by fiscal policy s meant the use of public finance or expenditure, taxes,
borrowing and financial administration to further our national economic
objective. According to Fred R G lahe, by fiscal policy is meant the
regulation of the level of government expenditure and taxation to achieve
full employment in the economy. While referring to fiscal policy here we
mean pure fiscal policy. A fiscal policy affects the level of government
spending or taxation while the nominal money supply remains constant.
Fiscal Policy and Economic Activity
Government expenditure, tax income and public debt act as important
levers to influence aggregate outlay, employment and prices in the
economy. A give n change -increase of decrease in aggregate government
expenditure causes a change increase of decrease in the aggregate demand
thereby increasing or decreasing the factor incomes. Government
expenditure incurred on wages and salaries of its employees, inte rest paid
on government debt, social security and old age pension payments, all
tend to increase the disposable personal income of people as a
consequence of which the aggregate demand for consumer goods
increases. Thus an increase in the total expenditure of government tends to
expand the aggregate economic activity in the economy. On the other
hand, taxes levied on the people to finance government expenditure tend
to reduce disposable personal and corporate incomes which could have
been either spent on co nsumption or devoted to capital formation through
saving. Thus taxes tend to reduce the aggregate demand and income in the
economy. These effects of government budget are equally valid for the
central, state and local government budgets although the budget of the
central government is much more powerful in affecting the level of
aggregate economic activity in the economy than are the combined
budgets of all the states and local bodies like the municipal and district
boards.
Government expenditure and revenu e can be combined in several ways in
order to stimulate or depress the aggregate effective demand and economic munotes.in

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76 activity in the economy. A surplus in the budget will exert a deflationary
effect on national income because the inflow of aggregate government i nto
the circular income flow will be less than the tax leakage from the circular
income flow. Conversely, a deficit in the budget expands the net national
product since the leakage from the aggregate income flow due to taxes is
less than the additional inf low into the circular flow in the form of
government expenditure. It follows, therefore, that in slump when there is
need for expanding the aggregate demand deficit budget while in inflation
when the problem is of preventing the aggregate demand from excee ding
the aggregate supply, surplus budget should be prepared. This
generalization should not, however, lead us to conclude that a balanced
budget is neutral in its effects on the national income and economic
activity in the system. Depending upon the parti cular circumstances, a
balanced budget may be no less important than an unbalanced -deficit or
surplus -budget.
For a correct appraisal of the effects of government's fiscal policy on the
level of aggregate economic activity, apart from the magnitude of
gove rnment expenditure and revenue, their composition or structure is also
equally significant. A given amount of revenue can be realized by the
government in several ways -by levying taxes, by increasing the area of
and profits from commercial activities and b y borrowing from the public.
However, even though the revenue raised through these several alternative
methods may be the same, each method of raising revenue will affect the
economy differently. For example, the same amount of revenue may be
raised either through taxing the people or through floating bonds in the
market but the effect of each one of these two methods is of raising the
government revenue will be different. Even in the case of taxes the effects
will be different in the case of different tax levies like the income tax and
excise duty.
Similarly, the government can incur a given expenditure in several ways.
It might, for example, spend upon building hospital or slum clearance or
on the construction of a sugar mill or on unemployment doles. The effect
on the level of aggregate economic activity will be different although the
total expenditure is the same in each case. An expenditure of 5 crore
incurred on constructing a new national highway or on slum clearance will
not affect the aggregate inves tment activity in the private sector adversely;
if anything, it will affect private investment favourably by causing an
increase in the demand for raw materials and equipment needed for road
construction or for housing the slum dwellers. But if the same am ount is
spent for starting a new sugar factory, it might cause an offsetting fall in
the aggregate private investment by depressing the marginal efficiency of
capital in the private sector. Consequently, the beneficial effects of public
expenditure on the level of aggregate economic activity will be partially
lost. Thus a balanced budget is not neutral in its effects on national income
and economic activity unless it is assumed that the composition of
expenditure and income remains unchanged from year to ye ar. Although
the level of aggregate economic activity in the economy can be affected by
varying the size of a balanced budget, the stabilizing effect of the fiscal
policy depends largely on the size of the surplus or deficit in the budget. munotes.in

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77 The extent to wh ich fiscal policy can prove effective as an instrument of
economic stability depends on the extent to which the government can
vary the difference between the income and expenditure rather than upon
the balanced budget and the change in its size.
Objective s of Fiscal Policy
As an instrument of macroeconomic policy, the goals of fiscal policy are
likely to be different in different countries and in the same country in
different situations. For example, while in a developed economy operating
either at the ful l or at near -full employment level the goal of fiscal policy
should be the maintenance of full employment while in a developing
economy the main concern of fiscal policy has to be the promotion of
economic economy growth with stability and reduction in the economic
inequalities.
Broadly speaking, overall fiscal policy involves two types of important
decisions. While one of these two decisions is related to the goal of full
employment, the other is concerned with determining the social priorities.
The second policy decision is concerned with the issue of allocation of
economy's productive resources as between their different rival uses
should more resources be allocated for education, health care, public
housing slum clearance, transport, etc. The government expenditure on
different items in any society will be determined by the prevailing social
values.
Economists generally agree that fiscal policy should be employed to
achieve full employment and economic stability in the economy. Before
the great depression of the 30s, by economic stability was largely
understood the stability of the general price level. The severity of the
depression focussed attention on the need to remove unemployment and to
employ fiscal policy for this purpose. The Employment Act of 194 6 in the
USA stated that it was the responsibility of the federal government to use
all possible means, including fiscal policy, to promote maximum
employment, production and purchasing power in the economy.
After the Second World War, inflation has become a worldwide problem.
Consequently, economic stabilization has come to be widely defined so as
to include the elimination of inflationary pressures in the economy. This
means that the achievement of full employment and price stability should
be simultaneou sly attained through the instrument of fiscal policy. At
times, however, both these goals may be difficult to achieve as these might
be mutually inconsistent. An economy which wants to achieve full
employment must accept moderate price rise unless it resor ts to price
control, rationing and wage freeze policies.
6.4 KEYNESIAN ECONOMICS AND DEVELOPING
COUNTRIES
Some writers are of the view that Keynesian economics does not
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78 advanced cou ntries like the U.K. or the U.S.A. Keynesian economics is
believed to be the economics of Depression; and hence, according to
some, it cannot be applied to the cases of under -developed countries, for
such countries are in the midst of secular inflation. Sc humpeter contends
that "practical Keynesianism is a seedling which cannot be transplanted
into foreign soil; it dies there and becomes poisonous before it dies." In
the same sentiment, Harris writes that "those who seek universal truths
applicable in all p laces and at all times, had not better waste their time on
the General Theory.
Some Indian economists also hold a similar view. A.K. Dasgupta remarks:
"Whatever the generality of the General Theory may be in the sense in
which the term 'general' was used b y Keynes, applicability of the
propositions of the General Theory to conditions of an underdeveloped
economy is at best limited."5 V. K. R. V. Rao observes that the "blind
application of the Keynesian formulae to the problems of economic
development has in flicted considerable injury on the economies of
underdeveloped countries and added to the forces of inflation that are
currently affecting the whole world."
But there are others who hold quite opposite views. Some writers in this
latter group maintain that "the Keynesian theory is a general theory of
income determination; it is valid for a developed as well as
underdeveloped economy." A few among these writers have challenged
the views of the former group of writers who are opposed to the
application of Key nesian economics to backward countries. According to
this latter camp, Keynesian tools and concepts are still applicable to cases
of underdeveloped countries. Let us examine the views of both the groups
of writers side by side with reference to Keynesian c oncepts, tools and
assumptions.
Nature of Unemployment
Keynes is mainly concerned with the problem of involuntary
unemployment in the advanced countries and his whole thesis relates to
the question of how to secure full employment in the case of these
coun tries.? In Keynesian theory unemployment is caused by deficiency in
effective demand. V. K. R. V. Rao maintains that in underdeveloped
countries, there is no involuntary unemployment, but there is disguised
unemployment. Again, unemployment here is caused not by lack of
effective demand but by lack of complementary resources.
The above view, however, is not always correct for underdeveloped
countries. In these countries, unemployment is rampant, both in the
agricultural sector as well as in the industrial s ector. Similarly, under
employment, be it visible or disguised, is partly involuntary in nature, and
arises out of lack of alternative openings. It is also not right to say that in
backward economies, there is always a lack of resources. Underdeveloped
countries are often rich in resources; but the problem is that these
resources are not yet properly utilised. These resources can be utilised
with the help of higher monetary incentives and effective demand. In fact, munotes.in

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79 effective demand in underdeveloped countri es is not adequate. Effective
Demand
It is often contended that in underdeveloped countries, effective demand is
quite sufficient, and the Keynesian analysis which mainly advocates the
raising of effective demand for removing unemployment is not applicabl e
in backward economies.
In underdeveloped countries, due to the low per capita income, effective
demand (ie., purchasing power) is never adequate; on the other hand, it is
very low. The principle of aggregate demand has the same significance in
the explan ation of inflationary conditions in developing countries as in the
case of the inflationary gap analysis in mature economies. The principle
provides a theoretical basis for policies aimed at controlling inflation in
developing countries. But for the concep t of aggregate demand and the
related tool of analysis, the technique of national income accounting,
which forms such an important basis for development planning, would not
have been possible. Even in backward economies, the conditions of rising
effective demand are essential for a favourable investment outlook, at least
in the private sector. Rising aggregate demand is very important for
breaking the vicious circle and for initiating a take -off.
Multiplier
Rao believes that Keynesian multiplier analysis do es not work in
underdeveloped economies. The working of the multiplier requires the
existence of the following conditions:
(1) Involuntary unemployment,
(2) Elastic supply of output,
(3) Excess capacity,
(4) Elastic supply of working capital.
According to Rao, absence of the above conditions in backward
economies stands in the way of operation of the multiplier process.
We have already explained that involuntary unemployment exists in
backward countries. Here, all the above mentioned conditions are very
much present. Excess capacity in industries, particularly in the public
sector, as in India, is a problem. Investment itself has a capacity -creating
effect in the long run.10 Supply of output and working capital in
developing countries is not completely in elastic. Monetary and credit -
creating institutions have been expanding the supply of working capital in
all such countries in recent years. Outputs of the agricultural and
consumption goods sector have also shown an upward movement in recent
decades.
Ther e are enormous possibilities for increasing the output in these sectors
still further. In the long run, forward and backward linkage effects may
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80 setting. In a developing economy (a nd not in the traditional society of
Rostownian type), in the long run, output cannot be inelastic. In the
developing countries, interaction between the multiplier and the
accelerator is likely to come about almost immediately after the initial
injection o f invest ment.11 Multiplier in underdeveloped countries will
increase output, and bottlenecks and skill will not be stumbling blocks, if
investment is taken up in moderate doses, and confined to quick -yielding
type of consumer goods industries. In that cas e, Rao's fear of possible
inflation may be eliminated,
Rao asserts that the existence of disguised unemployment in backward
countries hinders the working of the principle of multiplier. To be
operationally effective, multiplier requires, among other thing s, an elastic
supply of the labour force willing to accept employment at the current
wage level. However, Rao's view is not a correct presentation of the real
situation in backward countries. In such countries, labour is abundant and
cheap. A high magnitud e of unemployment in the industrial sector, not to
speak of the agricultural sector, makes the supply of labour elastic at
current wages, as Prof. Lewis observes. Disguised unemployment of the
primary sector can also be mobilised, as shown by Nurkse, at th e current
industrial wage rate, which is higher than the agricultural wage.
Deficit Financing
Prof. Rao maintains that the economic policy of deficit financing
advocated by Keynes for securing full employment does not apply in
backward countries. He holds this view primarily on the ground that the
supply curve of output is inelastic in an underdeveloped country, and
deficit financing in such a context is bound to be inflationary.
Rao himself accepts that deficit financing need not always be inflationary.
It is rather self -liquidating in character. As we have already noted, the
supply curve of output in developing countries is not really inelastic. If
deficit financing is used for increasing the capacity and for expanding the
output in the quick -yielding type of consumer goods industries, it need not
be inflationary. Deficit financing, on the other hand, creates forced saving
in the economy and thereby can increase the rate of capital formation in
poor countries. Prof. Rao accepts this to be true. Deficit fina ncing should
be properly planned and should be moderate in dose.
Saving and Investment According to Prof. Rao, Keynesian policy of
disregard for thrift is not helpful for economic progress in backward
countries. He holds that the old -fashioned classical pr escription of saving
more and working harder is relevant for poor countries.
It is not right to believe that saving always determines investment. Saving
and investment are independently taken up by different categories of
people. Mere increase in saving ca nnot do anything favourable if it is
hoarded or not productively utilised. It is investment and not saving that
determines growth. The idea that low saving is bad arises implicitly from
the connection that is believed to exist between saving and investment ,
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81 In fact, more correctly, investment determines saving and not vice versa.
Investment has its effects on prices, which in turn influence income
distribution and shares of profit and wage; and given the marginal
propensity to save, the magnitude of saving is determined.
Low saving is sometimes beneficial. Low saving means higher
consumption which means, other things being the same, higher profit,
higher or investible surplus and high er investment. Thus, low savings need
not hinder investment. The main bottleneck in underdeveloped countries is
not low saving, but lack of utilisation of resources and of organisational
ability. However, the bottlenecks can be reduced to a very great exte nt by
increasing the tempo of investment, a large part of which can be financed
by foreign capital. Thus, Keynes's analysis in which saving plays a passive
role is still valid in backward countries.
Importance of Other Measures Keynes lays great emphasis o n the role of
state in eradicating depression. In underdeveloped countries, state action is
indispensable in guiding and in lifting the economy from the rut of low
level stagnation trap. The state can increase investment in social overhead
capital and can create a favourable climate for increasing private
investment. In other words, without increasing state responsibility, no plan
of economic development can be a success.
Keynesian policy of public investment to achieve a higher standard of
living and to pr ovide increasing employment opportunities is applicable to
underdeveloped countries.
Keynes emphasised the positive role of monetary and fiscal policies in
advanced countries. In underdeveloped countries, monetary and fiscal
policies are becoming more and more growth oriented. Keynesian
monetary theory provides a logical framework for the discussion of the
place of money in economic development. His framework helps us to
identify the points at which quantitative monetary expansion may fail to
generate eco nomic development. Keynesian concepts of liquidity, national
income accounting, inflationary gap and deficit financing, etc., are still
being used with much popularity in developing economies.
6.5 SUMMARY
On concluding point of view Keynesian analysis has been used in recent
years by Joan Robinson, Harrod -Domar and others for analysing long -run
dynamic growth problems. Though not in the stagnant traditional society,
Keynesian economics is largely valid in the case of developing societies
with a growing org anised sector. Keynesian theory provides an apparatus
of thought, and its essential contents can be used for analysing a wide
range of problems under varying conditions. Keynesian concepts and tools
may be more or less applicable in our context much the sa me way as
Malthusian, Marxian or Marshallian concepts. What is more important is
not so much the written words of Keynes but the spirit of his analysis.
Keynesian system as a whole may not be fully applicable, but taken with a
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82 solution of economic problems in underdeveloped countries. To use Dr.
K.N. Raj's words, "discarding the Keynesian thesis as altogether
inoperative in underdeveloped countries, is really throwing the baby awa y
with the bath water.
Check Your Progress:
1. According to Keynes, business cycle is caused by variations in the rate
of investment caused by fluctuations in the______________.
2. According to Keynes, the aggregate demand might increase because of
__________.
3. The _______output supply absorbs the excess demand with a time lag.
4. According to Keynes, price rise during the time lag is _____inflation.
5. According to the Keynesian theory of inflation, a price rise due to
excess demand only ______________level is inflatio nary
6. Keynes used fiscal policy when referring to the influence of
________on savings and government investment spending financed
through loans raised from the public.
6.6 QUESTIONS
Q) Explain following questions in detail
1. Explain Keynesian view on tra de cycle.
2. Explain Keynes theory of inflation
3. What is the rate of inflation?
4. Explain inflationary gap.
5. What are the objectives of fiscal policy?
6. Explain Keynes view on role of government in economic activity of
state.
7. Explain Keynesian th eory of development special reference to
developing countries.
6.7 REFERENCES
● B.N.Ghosh Rama Ghosh: Concise History Of Economic Thought:
“Keynesian Economics And Developing Countries, Employment
Theory”.
● R.D. Gupta: Keynesian and Post Keynesian: “Keynes View On Role
Of Fiscal Policy”.
● D.N.Dwivedi: Macroeconomics Theory And Policy: “Keynesian
Theory Of Inflation”. munotes.in

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83 ● N. Gregory Mankiw: Principles of Macroeconomics: “ Money -Wage
rigidity Model”.
● J.M. Keynes: The General Theory of Employment: “Trade C ycle”.
● Mishra & Puri : Business Economics: “Multiplier & Acceleration:
Interaction”.
Suggestion for Readings
● Ryuzo Kuroki : Keynes & Modern Economics;
● E.K.Hunt & Mark Lautzenheiser: History of Economic Thought:
● Errol D’Souza: Macroeconomics:







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84 Module IV
7
POST KEYNESIAN ECONOMICS - I
Unit Structure
7.1 Objectives
7.2 Introduction
7.3 Supply -Side Economics
7.4 Hayek’s Theory of Trade Cycle
7.5 Life Cycle Theory Consumption
7.6 Summary
7.7 Questions
7.8 References
7.1 OBJECTIVES
 To make the r eaders awar e ofthe development of theories breaking
Keynesian tradition.
 To Elaborate evolution of new concepts that emphasized supply side
 To understand the monetary theory of trade cycles
 To study the Life Cycle Theory of consumption
7.2 INTRODUCTION
Post Keynes ian Economics is a segment of economic theories that were
developed either to break the tradition of Keynesian arguments or to
supplement Keynesian arguments and make them applicable in modern
times by providing supportive evidence. This section includes t he topics
like supply -side economics which emphasizes the supply side to provide
solutions to economic problems. New Trade cycle Theory like Hayek’s
Theory of Trade Cycle and the Life cycle Theory of Consumption.
7.3 SUPPLY -SIDE ECONOMICS
7.3.1 Introduc tion
Supply -side economics is a relatively new thought in macroeconomics.
Economists who believe that the supply side factors are more influential to
reduce economic problems are called supply -siders. Their thoughts and
ideas are called supply -side econom ics. The economic theory is divided
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85 and his followers emphasized the importance of demand. according to
them the problems of recession and unemployment can be reduced by
applying expans ionary fiscal and monetary policies to increase aggregate
demand.
But in the 1970s the western world experienced a crisis marked by
simultaneous unemployment and inflation. The Keynesian theory had no
solution to such a situation of simultaneous inflation and unemployment.
A group of economists like Laffer, Irving Kristol, Paul Roberts, John
Rutledge, Norman True supported supply -side solutions to the problem.
7.3.2 The Difference Between Supply -Side Economics and the
Demand Side Economics: Altho ugh both th e supporters of demand -side
economics and supply -side economics aim at economic growth their
policies and methodologies to achieve the desired objectives are different.
The differences can be observed in the following lines.
1 Emphasis on produ cer’s V/S C onsumers: The demand side
economists claim thatthe demand for goods can be generated by assisting
consumers through governments spendings. If the Governments spends on
creating jobs, for example, will help to increase incomes of the people
which they will spend on the consumption of goods. But supply -side
economics concentrates on encouraging businesses. According to them,
production will generate employment and income which will create
demand.
2 Emphasize on Tax Cut Policy: Supply -side economis tsadvocatet ax cut
as a policy to encourage supply. Such policy is useful for businesspersons
to encourage business activity. But demand -side economists believed that
tax cuts should be granted to the consumers to encourage them to spend
more on consumption .
3 Govern ment intervention: The Supply -side economists claim for
minimum government control for production and the economy. But
demand -side economists expect intervention by the Government to
encourage demand and growth through public spending. If Spend ing
generat ed deficits in the short run, but as the economy grows and tax
revenues increase, the deficits will diminish.
4 Offer consumers more options versus more money: Supply -side
economics emphasizes Supply; the objective is to provide consumers with
more produc ts and service options to purchase. It implies supporting the
businesses to devote resources for production and research to make a
variety of products available to the consumers. As against, demand -side
economics focuses on helping consumers ma ximize thei r income by
reducing taxes to spend more on goods and services.
7.3.3 Propositions of supply -side economics
1 Taxation and labour supply – According to supply -side economists, if
the rate of tax is reduced, labor supply increases this is because the after -munotes.in

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86 tax return on labor will increase.An increase in labor supplyleads to a
change in the aggregate supply curve as denoted in the diagram.
Figure 7.1


In the above dia gram, X -axis represe nts output, and Y -axis represents the
price level. AD is the aggregate demand curve. AS is the original
aggregate supply curve. E is the original equilibrium situation where the
aggregate demand curve intersects the aggregate supply cur ve. At poin t E,
theO P price is determined. When the government reduces the income tax
rate, the labour supply increases. as a result, the aggregate supply curve
ships to its right. Movement in the supply curve changes the equilibrium
situation, E1 becomes the new equ ilibrium situation. At this new
equilibrium point,the price falls from OP to OP1. But the output increases
from OY to OY1. An increase in the level of output reduces
unemployment in the economy. The problem of stagflation can be reduced
by reduc ing tax rat es.
2 Incentive to save and invest - According to supply -side economists,
reduction in tax rates helps to increase saving and investment in the
economy.Lower tax rates encourage savings. Lower tax rates for a
business, will increase profit margi n and encou rage furt her investment and
capital formation.
An increase in capital formation and investment also helps to increase
labor productivity. The use of capital in the form of technology improves
labor productivity. It will reduce labor costs. Lower labor cost s, an
increase in investment,and capital formation will increase the aggregate
supply. The curve will shift to its right as denoted in the diagram. Which munotes.in

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87 will reduce the price. This way price can be reduced by increasing
employment.
3 Cost -Push effect of tax- Wedg e- In modern times there has been an
increase in the activities of the government. The government requires
more revenue to finance its activities.The welfare functions of the
government also have increased in modern times. For that rea son, the
government requires revenue. The government gets revenue from taxes.
According to demand -side economists (Keynes) increase in taxation
reduces demand. When demand falls, output declines which reduces
employment. But according to supply -side econom ists increa sed taxat ion
increases the cost of production. As the cost of production increases, it
shifts the supply curve to the backward direction. Thus, the growth of the
public sector requires more funds. It imposes a high taxwhich causes the
aggregate supply curv e to shif t to its left.
4 Factor Supply and Out -Put Growth - According to supply -side
economists the long -term and medium -term growth of output is
determined by the supply of the factors. For example, the supply of Labor
and capital along with technology determine s the growth of output in the
economy. It is denoted with the help of the following diagram.




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88 In the above diagram, Income is denoted on X -axis and the price level is
denoted on the Y -axis.AS is the aggrega te supply c urve,AD is the
aggregate deman d curve.Both the curves intersect each other at point E. It
is the original equilibrium situation. When the supply of labor and other
factors of production including technology increases, the aggregate supply
curve shifts to i ts right. This rightward movem ent of the aggregate supply
curve changes the equilibrium situation. Now AS1 becomes the new
aggregate supply curve. E1 is a new equilibrium situation. At the new
equilibrium situation E1, OY1 one level of income an d P1 pric e is
determined. This income l evel is higher than the earlier level of income or
output. OP1 price is less than the earlier price. This shows that an increase
in supply or factors leads to an increase in output or growth of the
economy. Thus,the medium -term growth rate of the economy i s
determined by supply -side factors.
5 Underground Economy - The supply -side economists advocated that
the rate of taxes should be reduced by the government. If the rate of tax is
very high, it encourages people to operate in the underground economy.
The u nderground economy is also called a parallel economy or a black
economy. when the taxes are very high people evade taxes. Sometimes it
becomes difficult for the government to find out those people who evade
taxes. T his reduces the value of the government. Therefore, the supply -
side economists advocated that the lower taxes would not only increase
the revenue of the government but also discourage the people to evade
taxes and operating in the black economy.
6 Laffer Cu rve- Arthur Laffer has pointed out the relationship between
tax rate and tax revenue. According to him the relationship between tax
rate and tax revenue is inverse. The demand -side economists could not
explain any relationship between the tax an d the reven ue
ofthe government. But according to s upply -side economists when the
government reduces tax, revenue earned by the Government through
taxes, increases. The Laffer curve shows the limit on the increase in tax
rates. The relationship between tax rate and ta x revenue can be explained
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89

In the diagram, the tax rate is measured on X -axis, andtax revenue is
denoted on the Y -axis. L C is the La ffer Curve. The curve starts from zero.
It slopes upwards up to point C. It slopes upwards upward till the tax rate
OT3. W hen tax is OT3 the tax revenue is maximum it is OR3. After the
OT3 tax rate, the tax revenue decreases. Suppose the tax rat e is increa sed
up to OT4, the tax revenue OR2.
But before the OT3 tax rate, the tax revenue can be raised. For example, If
the tax r ate is increased from OT1 to OT2 the tax revenue increases from
OR1 to OR2.
In short, the Laffer Curve suggests that the t ax revenue can be raised with
an increase in tax rate only up to a certain extent. (OT3 in the diagram) but
beyond that, it is not po ssible to increase the tax revenue by increasing the
tax rate. Rather reduction in the tax rate would increase tax revenue.
7.4 HAYEK’ S THEORY OF TRADE CYCLE
7.4.1 Introduction
The theories of trade cycles or business cycles are useful to understand
fluctuations in the macroeconomic variablesin the economy. Economists
suggest different causes of trade cycles. Earlier theories of trade c ycles
emphasized instability of investment in capital asset and investment, while
Changes in relative input and output pri ces, interest rates, and profits were
also emphasized. Factors like Uncertainty about the profitability of future
business ventures an d volatility of the associated expectations received
much attention even before Keynes. But monetary factors got very litt le
attention in Keynesian works. Hayek who represents the Austrian school
emphasized that trade cycles occur due to inequal ity between the market
rate of interest and the natural rate of interest.
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90 7.4.2 Hayek’s Monetary over -investment Theory:
Hayek’s the ory of trade cycles is a monetary theory.It emphasizes the
importance of monetary factors in determining changes in the eco nomic
varia bles. According to him, it is necessary to examine deviations of
prices from their equilibrium position which were caused by the monetary
factor rather than movements in the general price level.
Hayek developed his theory based on the ideas of Wicksell. W icksell
made difference between the natural rate of interest and the market rate of
interest. The natural rate of interest is the rate at which the demand for
loanable funds equals the supply of loanable funds. The market rate of
interestis the one that pr evails in the market at a particular time. The two
rates must be brought into equality for attainingequilibrium.
Hayek’s theory is called ‘monetary’ overinvestment theory because it
explains that overinvestment of resources in the capital goods sector is the
only cause of the business cycle, and the overinvestment occurs when
there is too much expansion of money. Cheaper mon ey encourages the
producers to undertake capital -intensive methods of production as capital
is less costlyand mayprovide a higher rate of profit.
According to him, the economy is in balance, if the proportion of the
resources devotedfor consumer goods and capital goods are in balance.
Producers decide to invest resources in their capacity. According to
Hayek, so long as the na tural rate of interest equals the market rate of
interest, the economy remains in a state of equilibrium and full
employment.
Prosper ity:
when the market rate of interest is less than the natural rate of interest the
prosperity phase begins. As the demand for inves tment funds is more than
the supply of existingsavings, theinvestment demand is satisfied by
increasing the supply of money . As a result, the interest rate falls.
Itencourages producers to demand more loans. Theloans are investedto
produce more c apital goo ds. The capital -intensive methods are used for
producing more capital goods. Consequently cost of production declines
and p rofits increase. As the production process becomes very extensive
with the adoption of capital -intensive methods, prices of capital g oods in
comparison to consumer goods.
If there is full employment in the economy, there will bea transfer of
factors of the production from the consumer goods sector to the capital
goods sector. Consequently, the production of consumer goods fall s, their
prices increase,and consumption decreases. Forced savings increase with
the fall in consumption which is invested to produce capital goods. This
leads to an increase in their production. On the other hand, with an
increase in the prices of consume r goods, t heir producers earn more
profits. They try to produce more as they are encouraged by high profits.
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91 tocompetition between the two sectors, prices of factors and prices in the
economy in crease. This leads to prosperity.
Depression:
According to Hayek, when the prices of factors are rising continuously,
the rise in production costs bringsa fall in the profits of producers. The
producers invest less in capital goods to avoid loss . Conseque ntly, the
natural interest rate falls. As a result, banks put restrictions on loans. With
low profits and restrictions on l oans, producers reduce the production of
capital goods. Labor -intensive techniques are preferred in such situations.
There is less i nvestment in capital goods. The production process is small
and labor -intensive, the demand for money is reduced, which inc reases the
market interest rate which is more than the natural interest rate. There is a
transferof the factors from the p roduction from capital goods to that of
consumer goods. The consumer goods sector can not absorb the factors of
production beyond a c ertain capacity. As a result price of factors falls and
resources become unemployed. Due to a reduction in the prices of go ods
and fa ctors and unemployment in the economy is pushed into depression.
Revival:
Hayek suggests that when the decrease in prices ends duringthe
depression, banks increase the supply of money. This may reduce the
market rate of interest below the natura l interest rate. This provides
support to investment and the process of revival begins.
7.4.3 Implications:
1. Price as Signals -
According to Hayek, Prices are determined by the market forces, but they
provide a signal to the market players that is buyer s and sell ers. It conveys
necessary information to each participant in the market about changes in
valuation made by buyers and the r elative scarcity of resources. The price
signals provide the basis for economic coordination. If price signals are
misrepre sented the re is discoordination.
2. Role of Interest Rates -
Interest rates bring equilibrium in the loanable funds market. It brings
savings and investment into equality. Change in rate of interest due to
change in saving patterns determines investment pa tterns. Lo wer interest
rates encourage investment.
3. Monetary Manipulations -
Monetary manipulations create unfavorable conditions. Credit expansion
reduces the rate of interest. It stimulates demand for loans for production,
but beyond the capacity to p roduce in time. But with low -interest income
earners save less. As a result, monetary management may create
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92 4. Heterogeneous Capital Goods
Capital goods are heterogeneous in nature and are related to each other at
different degrees of substit utability and complementarity. If monetary
manipulation (Artificial Supply of Money) creates over -investment in
higher -order capital goods. The relationship between high order capital
(Machines)goods and low order capital goods (Labour) is distor ted over
time which creates an imbalance.
5. Effect on Capital Goods
During the early phase of the cycle, a low rate of interest favo urs
investment in higher -order capital goods (Machines). As a result, lower -
order capital goods (labours) trigger their pri ces to mov e up sharply.
Increased demands in the credit market push the interest rate higher. It
affects investment in higher -order c apital goods.
6. Opposite Demand for Output and Factors - In a particular period,
consumption spending and investment spen ding move in opposite
directions especially when there is full employment. The shifting of
resources between consumption and investm ent activities and between the
different stages of the production process as a response to changes in
consumer preferences over time brings the economy to adjust for
equilibrium.
7. Imperfect Information About Market - Participants in the market do
not have perfect knowledge about consumer preferences, resource
availabilities, technology, the plans of other market participants, and the
effect of the plan on one another. if market participants were already
having the information that the price system conveys, then distortions of
price signals could not cause cyclical fluctuations or any other kind of
disequilibrium.
7.4.4 Critici sms:
The m onetary over -investment theory of Hayek has been criticized on the
following counts:
1. Narrow Assumption of Full Employment :
The theory assumes that there is full employment and therefore more
capital goods can be produced by reducing consumer go ods. But i n the
realworld, there is no full employment. If the resources are unutilized,
there would be simultaneous expansion in the capital goods sector and
consumer goods sector as result, a need of transferring resources from one
sector to the other ma y not aris e.
2. Unrealistic Assumption of Equilibrium:
The theory assumes that initially savings and investment are in
equilibrium,but the banking system breaks this equilibrium. But this
assumption is unrealistic. The equilibrium situation changes due to
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93 3. Interest Rate, not the only Determinant:
According to Hayek changes in the rate of interest is the ca use of changes
in the economy. But apart from changes in the rate of interest, the factors
like expectations of profit, inn ovation, i nvention, etc. also affect trade
cycles.
4. Excessive Importance to Forced Savings:
Prof. Strigl has criticized this theory as it givesexcessive importance to
forced savings. According to him, when people with fixed incomes reduce
their consumptio n due to h igh prices the high -income groups also reduce
their consumption. In such a situation savings will be voluntary. The
express ion of forced saving is wrong.
5. No decline in Investment with Increase in Consumer Goods:
It has been suggested by Hayek that with an increase in the productionof
consumer goods and profits in the consumer goods sector,investment in
capital goods declin es. But according to Keynes,with the increase in
profits of consumer goodsmarginal productivity of capital increases. As a
result, in vestment in capital goods also increases.
6Various Phases of Trade Cycles not explained:
As the theory explains only a few phases of the trade cycle, therefore it is
regarded as an incomplete explanation.
7.5 LIFE CYCLE HYPOTHESIS
7.5.1 Introdu ction
The life cycle hypothesis is associated with the name of Ando Modigliani
and Richard Brumberg. It substituted the hypothesis d eveloped by Keynes.
Keynes proposed that Savings grow with income growth, but at the
aggregate level, it may reduce aggrega te demand. Ando Modigliani and
Richard Brumberg suggested that individuals plan their consumption and
savings over a long period to a llocate their consumptionover the lifetime.
Their theory was contemporary to Friedman’s work on the permanent
income hypoth esis, they developed a theory of consumer expenditure
based on the life cycle of income and consumption requirements of
households. F riedman’s hypothesis is suited for cross -section data, but
Modigliani and Brumberg tried to derive time -series implications of their
hypothesis.
According to the Life Cycle hypothesis,lifetime consumption is a function
of the lifetime expected income of t he consumer. It asserts that an
individual plans his/her consumption and savings pattern based on their
anticipated lifetim e income. The consumption of the individual consumer
depends on the resources available to him, the rate of return on capital, the
spending plan, and the age at which the plan is made. The present value of
his resources includes income from assets or wealt h or prope rty and
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94 his income and wealth. Life Cycle theory l inks consumption and savings
behavior to demographic factors, especially to the age distribution of the
population. The mar ginal prop ensity to consume out of permanent income,
changes with age. With growing age MPC declines. In an economy, there
are people of many different ages and life expectancies, so the MPC for
the economy is a mixture of corresponding MPCs. As a result, economies
with different age mixtures have different marginal propensities to save
and consume.
7.5.2 Assumptions
The following are assumptions of the Life Cycle Hypothesis
1 There is no change in the price level during the life of the consumer.
2 The ra te of inte rest paid on assets is zero.
3 The net assets of the consumer are the result of his savings.
4 Future consumption is the o utcome of a consumer’s current savings.
5 A Consumer expects to consume his total lifetime earnings plus current
assets.
6 He does n ot plan any donations.
7 There is certainty about consumers’ present and future flow of income.
8 The consumer has a defini te conscious vision of life expectancy.
9 Consumer is aware of the future emergencies, opportunities, and social
pressures which will affect his consumption spending.
10 The consumer is rational.
Based on these assumptions life cycle hypothesis explains th at the
consumer will maximize his utility over the lifetime. His utility
maximization depends upon his lifetime resources.
In symbol ic terms

Where
– Consumption at time t
- Total resources at time t
Life cycle theory conn ects the consumption and saving behaviour of
people with the age distribution of the population. The consumption of the
consumer is p roportionate to the resources available to him. But the
consumption of the individual depends upon whether the consumption
plan is made at an early age or later age. An Individual’s income is
relatively low in the early years of life. In the midd le of life , an
individual’s income is high. He earns from his labour and assets. Again, at
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95 very little from his labours and, he has few assets. As in the middle of life
income of t he individ ual is high, the consumption level throughout the life
remains constant. The life cycle hypothesis explains that in general , the
individuals maintain the same level of consumption because in the later
stage of life they utilize the savings create d in their prime earning years or
they may liquidate their assets. In the early stage of life, if income is not
sufficient to maintai n certain levels of consumption, the individuals may
maintain their consumption level through borrowings. The theory predi cts
that w ealth accumulation takes a hump -shaped pattern as denoted in the
diagram.

In the figure, C C1 is the consumption curve. Y0Y1 is an individual’s
income curve, it shows an individual’s income over the lifetime T. During
the early period of life (OT1) individual’s income is less than his
consumption. The consumptio n curve CC1 is above income curve Y0Y,
he borrows to maintain h is consumption level. Y0CB is dissaving. His
consumption level is CB which is almost constant. The middle years of the
life of an individual are denoted by T1T2. In the middle years, his income
is greater than his consumption. The income curve Y0Y1 is abov e the
consumption curve CC1. His saving level is very high. BYS is the total
savings in middle age. Further, in the later stage of the life denoted by
T2T, again his income drops but consumptio n level remains somewhat the
same. The consumption curve in thi s phase of life is above the income
curve. He utilizes savings in the earlier phase of life to maintain the
constant level of consumption. SC1Y1 is the dissaving.


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96 7.5.3 Implications
1. Saving rate is determined by the growth rate of Income -
According to the Keynesian theory, the aggregate saving rate is
determined by the level of income, but the life cycle hypothesis implies
that the savings rate depends on the growth rate of income.
2. Differ ent Marginal Propensities to Consume -
The life cycle hypothesis implies different marginal propensities to
consume from permanent income, transitory income, and wealth. His
consumption determined by his lifetime expectations of income remains
constant, but his income at different stages of life changes as a result
ofMarginal propensity to consume changes.
3. Average Propensity to consume remains Constant -
As income increases, APC remains constant with growth in income
because the share of Labou r income i n total income and the ratio of wealth
(assets) to total income are constant as the economy grows.
4. Smooth and Uninterrupted Consumption -
The life cycle hypothesis shows that savings change over the lifetime of a
consumer. In an early phase of l ife, a con sumer may not have wealth, but
he will save and collect wealth during his working years. But again, in the
later stage of his life, during retirement, he will use earlier savings. It
implies that the consumer wants smooth and uninterrupted consum ption
over his lifetime. During working years, he saves and later he diss aves.
5. Economies with different age compositions and wealth have
different MPCs and MPS
Consumption and saving propensities will change with wealth
composition and age composition. A high-income family consumes a
smaller proportion of their income than a low-income family. Economies
with different wealth composition different age groups have different
propensities to consume and save.
7.5.4 Criticisms
1. Wrong Assumpti on ofLifet ime Consumption - The hypothesis
assumes that a consumer plans h is consumption over his lifetime. But a
consumer may focus on the present rather than on future consumption as
the future is uncertain.
2. Higher Savings for Next Generations. The li fe cycle h ypothesis
assumes that at the later stage of life, savings decl ine, but people may
accumulate more wealth to pass the heritage to the next generation. Also,
they may consume less due to unwillingness to consume more at old age.
3. Consumption de pends on t he Mindset of Consumers - Consumption
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97 attitude towards life. People with the same income and assets may have
different levels of consumption and savings.
4. Consumer May Behave Irrationa lly – It has been assumed that the
consumer is rational he has complete knowledge about his income and
future income. His consumption decisions are determined by the lifetime
income, he plans his consumption over the lifetime. But this is an
unrealistic a ssumption because consumers cannot be completely rational,
they may not have entire knowledge about their lifetime income, and they
may not have the capacity or willingness to plan their consumption for
their lifetime.
5. Requires Estimation of Many Varia bles- This theory depends on
many variables such as current inc ome, the value of assets, future
expected Labour income, wealth, etc., the assessment of numerous
variables becomes very difficult.
6. Credit Constraints . An individual may have littl e opportun ity for
borrowing in the capital market in the early stage of l ife based on his
expected future income. As a result, consumers may change with changes
in current income than predicted income based on the lifetime income.
7. No Consideration of Wi ndfall Gai ns The hypothesis does not take
into consideration sudden gains and their effects on consumption.
8 Consumption is not smooth - The life cycle theory assumes that the
consumption is smooth and constant throughout the life of an individual,
but it has b een observed in US and UK that consumption increases in the
middle age, and it falls in the later stage of the life.
Despite the limitations,the Life cycle hypothesis has a key position in
modern macroeconomic theory.
7.6 SUMMARY
Post Keynesian Economics is a school of thought that is based on
Keynesian ideas but rej ects the ideas of mainstream economics. Supply -
side economics emphasizes the supply side or production. Economists
who believe that the supply side factors are more influential to red uce
econom ic problems are called supply -siders. both the supporters of
demand -side economics and supply -side economics aim at economic
growth their policies and methodologies to achieve the desired objectives
are different. The proposed reduction in taxes to encoura ge production or
supply. The theory that belongs to post Keynes ian theory is Hayek’s
theory of trade cycles. Earlier theories of trade cycles emphasized
instability of investment in capital asset and investment, while Changes in
relative input an d output p rices, interest rates, and profits were also
emphasized while a nalyzing trade cycles.Ando Modigliani and Richard
Brumberg. It substituted the hypothesis developed by Keynes. Keynes
proposed that Savings grow with income growth, but at the aggrega te
level, it may reduce aggregate demand. Ando Modigliani and Richard
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98 over a long period to allocate their consumption in the best possible way
over the lifetime.
7.7 QUESTIONS
1 What is supply -side economics?Explain the prepositions of supply -side
economi cs.
2 Bring out the difference between demand -side economics and supply -
side economics.
3 Critically evaluate Hayek’s theory of Trade Cycles.
4 Describe Hayek’s Theory of Trade Cycl es. What a re its implications?
4 Explain Life Cycle Hypothesis. What are its implications?
5 Examine Life Cycle Hypothesis.
7.8 REFERENCES
1 Robert J. Gordon, “What Is New -Keynesian Economics?” Journal of
Economic Literature, Vol. 28, No. 3 (Sep. 1990 ), pp. 111 5-1171
2 N. Gregory Mankiw and David Romar, “The New Keynesian
Economics and output inflation trade -off”, Brookings Papers on
Economic Activity, 1:1988
3 R. G. Hawtrey “Monetary Theory and the Trade Cy cle. by F. A. Hayek
“A Review,The Economic Journal, Vol. 43, No. 172 (Dec . 1933), pp.
669-672
4 Franco Modi gliani, “ The Collected papers of Franco Modigliani”, vol.
6,(1992), The MIT PressCambridge, Massachusetts, London,England
5 Victor Zamowitz, “Bu siness CyclesTheory, History, Indicators,and
Forecasting” NBER Studies in Business CyclesVolume 27, (1992)
ISBN (paper): 0-226-97891 -5 The University of Chicago Press,
Chicago, and London
6 Roger W Garrison, “Hayekian Trade Cycle Theory: A Reappraisal”
CatoJournal, Vol.6, No.2 (1986) pp 437 - 453
7 Michael D. Bordo, “Austri an Influence on BusinessCycle Theory”
Cato Jour nal, Vol.6, No.2 (1986) pp - 455- 459
8 Victor a. canto, Douglas h. joines, Arthur b. Laffer “Foundations
ofSupply -Side EconomicsTheory and Evidence”,1983,
AcademicPress,
9 Blanchard, Olivier, and Jeffrey S heen., Macroeconomics; Australasian
Edition. Pe arson Higher Education AU, 2013. munotes.in

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99 10 R. Dornbusch,S. Fischer, Richard Startz, “Macroeconomic s” 13th
Edition, McGraw -Hill Education, 2 Pen n Plaza, New York, 2018
11 Sanjay Chugh, “Modern Macro Economics “MIT Pre ss, 2015
12 BrianSnowdon, Howard R. Vane, “ModernMacroeconomics, Its
Origins, Development and Current State” Edward Elgar Publishing
2005
13 Mankiw , N. Gregory. "Small menu costs and large business cycles: A
macroeconomic model of monopoly." The Quarterly Journal of
Economics 100.2 (1985): 529 -537.
14 Domitrovic, Brian. Emergence of Arthur Laffer. Springer International
Publishing, 2021.
15 M.L.Jhingan, Macro Economic Theory,2010, 12th Edition, Vipul
Publication,
16 Kriesler, Peter. The Oxford Handbook o f Post -Keynesian Economics,
Volume 1: Theory and O rigins. O xford University Press, 2013.
17 Mankiw, N. Gregory. The reincarnation of Keynesian economics. No.
w3885. National Bureau of Economic Research, 1991.





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100 8
POST KEYNESIAN ECONOMICS -II

Unit Structure
8.1 Objectives
8.2 Introduction
8.3 Friedman’s Theory of Demand for Money
8.4 Long Run Philips Curve
8.5 Mankiw’s New Keynesian Model
8.6 Stagflation
8.7 Summary
8.8 Questions
8.9 References
8.1OBJECTIVE S
1. Understandd ifferentiate between Milton Friedman’s demand for Money
and earlier versions of demand for money
2. To evaluate Friedman’s Theory of demand
3. To examine the behaviour of Long Run Philips Curve
4. To study New Keynesian Approach
5. To understand Mankiw’s model of New Keynesian Economics
8.2 INTRODUCTION
Post Keynesian Economics is a body of knowledge that is evergrowing.
Many theories and arguments are based on Keynesian theories. A few
more theories are included in this unit. One of the prominent theories
among these is Friedman’s Demand for money theory. The theory of
demand by Milton Friedman is partly based on Keynesian ideas but it
deviates in some respects from Keynesian Theory. Another argument
based on the Keynesian idea is Ph ilips Curve which expresses the opposite
relationship between inflation and unemployment. The argument that such
a relationship does not hold in the long run is explained in detail.
Mankiw tried to support the Keynesian argument that there prevails
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101 costs. The problem of the existence of inflation and unemployment at the
same time in the economy termed as stagflation also has a prominent
position in Post Keynesian Economics, The problem of s tagflation has
been discussed in this unit.
8.3. MILTON FRIEDMAN’S DEMAND FOR MONEY
8.3.1 Introduction
The Classical quantity theory of money was criticized by the Cambridge
economists, especially by Keynes. He argued that the classical theory
treated mon etary theory and the value theory separately. Keynes
reformulated the quantity theory of Money by connecting monetary theory
and value theory and linked interest rate determination theory to the
monetary theory. Keynes's theory of money got wide acceptance . But a
group of economists at the University of Chicago were working on the
traditional quantity theory of money. At the University of Chicago, the
scholars like Milton Friedman Henry Simons, Lloyd Mints, Frank Knight,
and Jacob Viner developed a relevant version of the quantity theory of
money. They integrated quantity theory money with general price levels.
Milton Friedman published an article in 1956“Quantity Theory of Money -
ARestatement”. The model of the new version of the quantity theory of
money was discussed in the article. With the publication of the article,
Monetarist’s revolution turned out to be significantly stronger. The theory
of demand by Milton Friedman is partly based on Keynesian ideas as he
treats demand for money as a part of the th eory of capital but the theory by
Milton Friedman does not consider the classification of the motives for
holding money as it was considered by Keynes .
8.3.2 Friedman’s Theory
Milton Friedman in his restatement of Quantity Theory Money
treatedmoney as one type of asset. The demand for money is properly
equal to that of the demand for a consumption service. He treats
thenumber of real cash balances (M/P) as a commodity. It is demanded
because it is useful for the person who owns it. Economic agents such as
households, firms , andthe government want to hold a certain portion of
their wealth in the form of money.Thus, money is an asset or capital which
has a positive return. Hence Friedman’sdemand for money theory is a part
of wealth theory. Friedman takesperman ent income as a proxy for wealth.
8.3.3 Money Demand Function
According to Friedman, demand for money is for holding money.H e
asserts that money is one type of asset in which people hold their wealth.
Individuals hold money for transaction purposes. Money serves as
purchasing power, and it is also very convenient for buying goods and
services. His approach to the demand for money does not consider any
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102 According to Milton Friedman w ealth takes five different forms , Money,
Bonds, Equities,Physical Goods, and Human Capital. Each form of wealth
has distinctivequalities and they give returns.
1. Money – It includes currency, demand deposits, and time deposits
which yield interest on deposits. Money also generates a real return in
the form of accessibility, security, etc. to the holder.
2. Bonds - Bonds are securities that give interest income, fixed in nominal
terms. The y ield on bonds is the rate of interest and anticipated capital
gain or loss due to expected changes in the market rate of interest.
3. Equities - are a claim to a time stream of payments that are fixed in real
units. The return from equity is determined by the rate of dividends ,
expected capital gain or loss, and expected changes in the price level.
4. Physical Goods -Physical goods or non -human goods are stocks of
producer and consumer durable s.
5. Human capital – is the income -generating productive capacity of human
beings such as education, skill, or good health .
The first four forms were categorized as non -human wealth while the last
one is human wealth.Non -human wealth can be converted into money
very easily . Human wealth can neither be liquidated easily nor can it be
used as securityto borrowmoney.
The wealth can be expressed in a symbolic term as under -
Where
- Current value of total wealth, y –the total flow of
expected income from five types of wealth, r-rate of interest
8.3.4 Determinants of Demand for Money
Keynesian demand for money is a function of the level of income and th e
rate of interest. But Friedman ’s theoryjustifies that the demand for money
or an asset is determined by the following factors.
1 Total wealth: An individual’s total stock of wealth is one of the
importantdeterminant s of money demand in Friedman’s Theory . The
greater the wealth of an individual,the more money is demanded
transaction s and another purpose.Friedman used discounted value of
permanent income as an index ofwealth. The permanent income is the
aggregate expected yield fromwealth during the person ’s lifetime.
2 The proportion of human to non -human wealth: The proportion of
human to non -human wealth (permanent income) is an important factor in
determining the moneydemand. The ratio of non -human to human wealth
or the ratio of wealth to income is deno ted as w. But Friedman in his
Permanent Income Hypothesissuggest ed that the MPC out of human
wealth is lower . Therefore,even if the ratio of human wealth to non -human
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103 3 The expected rate of return on money and other financial
assets :Unlike other theories that demand money, Friedman takes a broad
definitionof money. He includes time deposits along with the
demanddeposits and currency. So, money has expected a nominal
returnlike other forms of assets. As the permanent income of an individual
is steady,his wealth is stable. Moneyand other financial assets compet e to
get their shareout of this fixed wealth. In other words, the proportion of
money or other financial assets is determined b y the incentivesfor holding
other assets like bonds, equities relative to money . If the return on the
financial assets for example bonds and equities is higher the demand for
money will be lower. But if the returns on other financial assets like bonds
and equity are lower, the demand for money will be greater.
4 Price and expected inflation: Inflation has twoopposite effects on
demand for money. Inflation reduces the purchasing power of money. As
a result , an individual will want to hold highermoney balanc es so that he
will be able to maintain the same purchasing power as earlier. But due to
inflation, there is an increase in the relative return on non -human
assetssuch as real estate, gold, etc. as a result, people will hold less money
and invest in high -yielding non -human assets . Therefore, the demand for
money depends on the
5 Other variables: Variables such as taste and preference,
expectedeconomic instability like global financial crisis, phases of the
business cycle , etc. ,and institutional factors like a method of wage
payment, payments ofbillstoo affect the demand for money.
8.3.5 Friedman’s Equation for Demand for Money:

In the equation
- Demand for real money balances
f- Functional relationship
- Real permanent income
- Ratio of human wealthto nonhuman wealth
- Expected nominal return from money
- Expected nominal return from bonds
- Expected nominal return from equity
- Expected rate of inflation
- Any other variables which seem to have the power to affect the utility
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104 The demand for real money balances, according to Friedman, increases
when permanent income increases and declines when expected returns on
bond s, equities, or assets increase compared to the expected nominal
return on money.
This is indicated with help of the following diagram.
Figure No. 8.1

In fig ure 8.1 Money balances are denoted on X -axis while the Rate of
Interest is shown on Y -axis. MD i s demand for money. The demand for
money has a very little effect due to changes in the rate of interest. As the
rate of interest changes, change in the long run demand for money is
negligible.
Friedman introduces the quantity theory as the theory of the demandfor
money and the demand for money is assumed to depend on assetprices or
relative returns and wealth or income. He demonstrates that a theory of
demand for money becomes a theory of prices and output .
He argues that a change in the stock of money l eads to a change in the
price level or income or both in the same direction. It implies that if there
is less than full employment in the economy, an increase in money supply
will lead to a rise in output a nd employment because of a rise in
expenditure in the short period . Changes in money supply cannot affect
money balances in the long run. At the full employment level, an increase
in money supply will raise prices.
8.3.6 Critical Evaluation
1 Very Broad Definition of Money -Friedman includes currency
andd emand deposits (M1) and time deposits with commercial banks (M2)
in his definition of Money . His broad definition suggests that the
interestelasticity of the demand for money is negligible. For example, i f
the rate of interest on time deposits increases , the demand for time
deposits (M2) will rise. But thedemand for currency and demand deposits
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105 negligible on the demand for money. Further, Friedman's analysis does not
make any dif ference between long-term and short -term interest rates for
the deposits. For demand deposits (M1) , a short -term rate of interest is
preferable, but a long-term rate of interest ismore suitable for time deposits
(M2).
2. Money , not a Luxury Good - Friedman treated money as a
commodity. Most probably money in his theory was treated as a luxurious
commodity as included time deposits in the definition of money. He
included time deposits in the notion of money because he observed that in
the United States, there was a highermoney supply than income. But
suchobservation proved wrong in the situation ofEngland.
3 Excessive Importance to Wealth Variables - In Friedman's demand
formoney function, wealth variables are desirable to income .In this case,
thesimultaneous opera tion of wealth and income variables is not acceptable
to some economists . For example, Johnson explains that the income in
Milton Friedman’s Theory is the return on wealth, also wealth is the
present value of income. The presence of the rate ofinterest and o ne of
these variables in the demand for money functionmake s the other variable
redundant.
4 Much Importance to Demand for Money - Friedman describes the
supply of money tobe unstable as it is determined and changed by the
monetary authorities .But the money supply consists of bank deposits
created bychanges in bank lending. Bank lending is determined by
bankreserves which expand and contract withdeposits and withdrawals
ofcurrency by non -bank financial intermediaries; borrowings
bycommercial banks and inflows andoutflows of money from
abroad;purchase and sale ofsecurities by the Central Bank . But Friedman
just considers the supply of money as an exogenous factor which is
unreasonable.
5. Does not consider Time Factor - Friedman do esnot specify thetime
dimensi on. The time required for the variables to cause difference andthe
time required for the adjustment is not specified.
8.3.7 Summary : Milton Friedman analyzed money as a consumer
good and demand for money as a direct extension of the demand for any
consume r durable goods which has utility. According to him, Individuals
hold money for transaction purposes. Money works as purchasing power,
and it is also very convenient for buying goods and services. His approach
to the demand for money does not take into acco unt other motives for
holding money . In his theory wealth is one of the important determinants
of demand. He categorizes wealth into human and non -human wealth but
takes permanent income as a proxy for wealth . Friedman’s stable demand
for money is a functi on of the permanent income of individual
consumers. The demand for real money balances, according to Friedman,
increases when permanent income increases and declines when expected
returns on bond s, equities, or other assets increase compared to the
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106 money leads to a change in the price level or income or both in the same
direction. It implies that if there is less than full employment in the
economy, an increase in money supply will lead to a rise in output and
employment because of a rise in expenditureonly in the short run. Changes
in money supply cannot affect money balances in the long run.
8.4 PHILIPS CURVE
Classical economists believed in full employment equilibrium. Keynes
refute d the idea and stated that the economy can attain equilibrium at less
than full employment level. A.W. Philips a professor at the London School
of Economics analyzed the data and developed a theory in 1958 about the
relationship between unemployment and inf lation.
He gathered data about unemployment and changes in wage levels in the
UK from 1861 to 1957. By observing the relationship between wage rates
and unemployment rates, he explained the relationship between inflation
and unemployment rate. He observe d that there is a trade -off between
inflation and unemployment. Inflation and unemployment are
inversely/negatively related. If the rate of inflation is high, the rate of
unemployment is low. At a lower rate of unemployment, there is a high
degree of infla tion.
Low unemployment means high demand for workers. At low
unemployment when there is a high demand for workers, wages increase.
An increase in wages increases incomes and inflation. Therefore, at a low
level of unemployment, there is a high inflation r ate. The trade -off
between inflation and unemployment suggests that the government cannot
achieve lower inflation and lower unemployment simultaneously. 1 To
achieve lower inflation it must accept higher unemployment. Or 2 Achieve
lower unemployment it mus t accept the higher inflation rate
The relationship between unemployment and inflation is denoted with the
help of the Philips curve.
Figu re No. 8 .2
Philips Curve
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107 As denoted in the diagram,the Philips curve showsan inverse relationship
betw een unemployment an d inflation. For example, when the rate of
inflation is OK the level of unemployment is OL1. It means, at a lower
inflation rate, the unemployment rate is higher. In other words, to achieve
a lower inflation rate the government must acce pt a higher unemplo yment
rate.
But on the other hand, when the rate of inflation is higher, i.e. Ok1, the
unemployment rate is lower as OL. It implies that if the government
wants to keep the unemployment rate under control, it must accept a
higher level of inflation.
The Philips curve shows a trade -off between inflation and unemployment.
It also suggests that economies cannot have lower inflation with lower
unemployment. The lower inflation rate is achieved at the cost of the high
unemployment rate.
Indirectly the Philips curve suggests that if the economy is operating
below capacity, an increase in aggregate demand (C+I+G) leads to a
reduction in the unemployment rate.
Economists like Paul Samuelson and Robert Solow observed the data for
the US economy for the year 1960 -61 and recommended the theory for
policy measures. But monetary economists criticized the theory of the
Philips curve.
8.4.1 Long Run Philips Curve
According to economists like Milton Friedman and Edmund Phelps,
workers take into consi deration real wages and inflation -adjusted money
wages. Therefore, the government cannot get lower unemployment with
higher inflation at least in the long run.
Figure No. 8.3
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108 According to economists like Edmond Phelps, the long-run Philips curv e
is a vertical straight lineas indicated in the diagram. In the short run , there
is an inverse relationship between the unemployment rate and inflation as
denoted by the downward sloping Philips curve SPC1 . The curve suggests
that the rate of unemployment can be reduced from OL 1 to OL by
accepting a higherinflation rate from OK to OK 1 (or through expansionary
monetary policy) But it can be done onlyin a shortperiod. Overa long
period, people expect a rise in prices equal t o current prices. The
Philipscurve shifts to its right. SPC2 becomes the new Philips curve.
People expect inflation , the inflationrate increases from OK to oK1, but
there is no change/ fall in the unemployment rate. In the longrun, the
Philips curve become s a vertical straight line. In th e diagram, LPC is the
long-run Philipscurve. It indicates that in the long run monetary expansion
or accepting inflation rate, would notwork to reduce the unemployment
level or to increaseemployment . There is no trade -off betweenthe inflation
rate and unem ployme nt rate in the longrun .
8.5 MANKIW’S NEW KEYNESIAN MODEL
8.5.1 Introduction
New Keynesian economics is a branch of modern macroeconomics which
is based on Keynesian thoughts. Keynesian thoughts influenced the world
from 1930 till 1970 but some new cl assic al economists questioned many
beliefs of Keynesian theory. The economists who responded to the
critiques of the new classicalists with the adjustments in Keynesian
ideologies are called new Keynesians.
The New class ical economists developed their mac roeco nomic theory
based on assumption that wages and prices of flexible . According to them
prices clear the market and balance supply and demand by adjusting
quickly. But according tothe New Keynesian economi sts,market -clearing
models cannot explain short -run e conomic fluctuations .They supported the
theories regarding sticky wages and prices. They argue the stickiness of
wages and prices can explain the existence of involuntary unemployment
and the strong influence of mon etary policy on the economy. Some o f the
leading new Keynesian economists are George Mankiw, Robert Gordon,
David Romer, Oliver Blanchard Lawrence Summers, Joseph Stiglitz, and
Bruce Greenwald.
The Keynesian model emphasized involuntary unemployment and th e role
of aggregate demand in deter minin g output and employment. The new
Keynesian Economists have given an additional explanationof involuntary
unemployment. The Main contributors are N. Gregory Mankiw and
David Romer. They tried to combine this microe conomic foundation in
the Keynesian system.
8.5.2 Mankiw’s model - Nominal price stickiness
Classical economists believed in the assumption of flexibility in prices.
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109 Keynesian eco nomists’ prices are sticky. They ar gue t hat the menu costs
are the reason for price stickiness. Gregory Mankiw in his article.” Small
Menu Costs and Large Business Cycles: A Macro -Economic Model of
Monopoly” claimed that adjusting price is costly. Menu cos ts are the costs
of modifying price s. Ac cording to Mankiw, markets do not clear quickly
(Attain equilibrium through adjustments in prices) because adjusting
prices is costly. The theory of price stickiness is based on the following
assumptions.
8.5.3 Assu mptions
1. The market is imperfect and t here isa large number of monopolistic
competitive firms.
2. Firms produce standardized or differentiated products.
3. Majority of the firms are price -makers with control over the prices of
their products.
4. There is a cost involved for price adjustme nts.
5. The firms have linear demand curves.
6. The marginal cost curve is horizontal.
Based on these assumptions, it has been argued that menu costs affect the
price and quantity of the firms. When the firms change the prices, it
involves costs like prin ting a new price list (Menu), although such costs
are less, they affect the price and output of the firms. Mankiw suggests
that it is profitable for firms to react to small changes in demand by
keeping prices constant ove r a short period. In this case, the firms may
respond by changing the output. The hypothesis can be explained with the
help of the following diagram.
Figure No. 8.4
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110 In the above figure, the original demand curve i s D0, D1 indicates a
decrease in demand. MR0 is ori ginal Mar ginal Revenue MR1 indicates a
change in the Marginal Revenue curve due to a decrease in demand. MC1
is a new marginal cost curve. OP0 is the original price. When MR0
intersects MR0, P0 price, and OQ1 quantity. The firm earns AEKP0
profit. As the d emand dec lines, D1 becomes the new demand curve. MR1
is the new Marginal Revenue Curve. It intersects Marginal cost at point F.
At F OP1 becomes the new price and OQ2 is the new quantity. The profit
become s KFCP1. If the menu cost is high, the firms will k eep price OP0
and keep output at OQ1. The profit of the firms will be KGBP0. The firms
will reduce price up to OP2 only if the profit KEDP2 is greater than
KFCP1( KEDP2 > KFCP1 ) The firms will not reduce the price therefore
there will be price rigidity at OP 0.
The h ypothesis also explains the macroeconomic impact of the price
reduction. Reduction in price benefits other firms in the economy.
When the price is reduced by the firm, the average price level sligh tly
declines which will increase the real income of the cons umers . The
increase in real income will increase the demand for the products of all
firms in the market . This macroeconomic impact of price adjustment by a
firm on the demand for the products of a ll firms in the market is called an
aggregate -deman d externa lity by Mankiw.
8.5.4 Criticisms
The hypothesis has been criticized on the following grounds.
1. The approach neglects adjustment in quantity of production. The theory
emphasizes adjustments in t he price. Output adjustments also achieve
the expec ted impac t of bringing the economy into equilibrium.
2. It has been assumed that as the demand changes the marginal cost
changes in the same proportion, but in reality, marginal cost is not
perfectly corr elated to the aggregate demand.
3. It has been poi nted out that the menu costs are small and in modern
times they have become smaller due to the digital revolution.
4. The theory explains the stickiness of prices, but it overlooks the
stickiness of the ra te of prices.
5. Some economists disagree that the small men u cost can explain the
stickiness of the prices. The costs are very small, and it cannot explain
the situations like recession and depression.
8.6 STAGFLATION
Lord Keynes emphasized the import ance of effective demand in his
theory. According to him, th e solution to reduce unemployment is to
increase effective demand. Phillips introduce d the idea of trade -off
unemployment a nd inflation . He further explained that the Government
cannot reduce unem ployment without accepting a certain degree of
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111 inflation. In other words , if there is inflation there is less degree of
unemployment in the economy .
But in recent times, the economies experiencea situation in which price
level continuously increases but unemployment level also increases .
Professor Samuels on has d escribed this situation as stagflation . According
to him, stagflation implicates an inflationary rise in prices and wages at the
same time , people do not get jobs and firms cannot find customers for the
products produced. In other words, stagflation is a sit uation where there
exists unemployment and inflation at the same time . India and other
developing economies in the world are facing the problem of stagflation.
In such economies, prices are contin uously increasing but at the same
time, there is une mploymen t in the economy. Stagflation is an economic
phenomenon that occurs when inflation is high and economic growth is
low there is a high degree of unemployment.
Stagflation = high inflation +high un employment +low economic growth
Stagflation occurs because of many factors . Such factors affect supply
which affects prices as denoted in the diagram.
Figure No. 8. 5

In the diagram, the output is denoted on X -axis and the price level is
denoted on the Y -axis. AD is the aggregate demand curve. AS is the
original aggregate supply curve. E is an equilibrium situation. At the E OY
level output and op price i s determined. Due to some supply -side factors,
the supply decreases . The supply curve moves backward. AS1 becomes
the new supply curve. If the demand remai ns the same (AD) E1 becomes
the new equilibrium. At E1, the price is OP1, and the out -put falls up to
OY1. As output declines employment also declines. Decrease in outp ut
and employment with an increase in price stagflation. Here, i nflation is
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112 Suppose the government / central bank takes measures like change in
monetary polic y or printing of new currency, these are demand -side
factors, it ch anges the aggregate demand curve. The aggregate demand
curve shifts to its right AD1 bec omes the new aggregate demand curve. E2
becomes the new equilibrium situation, in this situation, out -put slightly
increases from OY to OY2 but the price increases from OP to OP2.
The causes and consequences of stagflation are listed below.
8.6.1 Cause a nd Consequences of Stagflation
1. The rise in the oil prices: Stagflation occurs when an economy
exper iences a sudden increase in the prices of fuel oil and other petrol eum
products, resulting in a sharp increase in the cost of production and higher
prices of manufactured products. As a result of a sharp increase in oil
prices, the aggregate supply curve s hifts to its left which increases prices
and reduction in output. T here is an existence of both inflation and
unemployment.
2. Shortageof agricultural pro ducts: Stagflation occurs when an
economy experiences a shortage of agricultural products. A short sup ply
of agricultural product s leads to an increase in the prices of raw material s.
It raises the cost of production which affects the supply . It causes a shift in
the aggregate supply curve to the left (backward) . As a result, inflation ,
and unemployment.
3. Devaluation of rupees: Another factor causingstagflation is the
devaluation of rupees. Devaluation reduces the value of the currency. The
devaluation of r upees raises the prices of imports and increase s the cost of
production of those industries which are using imported goods as inputs.
This shift s the aggregate supply curve to the left or backward because
higher cost result s in the backward shift of suppl y and the product prices
increase.
4. Higher taxes :If the government increases taxes, the cost of
production increases, and on the other hand , produc tion falls . This m ay
affect supply and shift the aggregate supply curve to the left and further
create inf lation in the economy.
5. High -interest rate :Stagflation occurs when there is an increase in
the lendi ng rates of interest. This raises the costs of production of the
firms which affect supply and thus the supply curve shifts to the left which
will further contribute to the rise in the inflation rate.
6. Increase in administered prices : Administered price s are the
prices that are determined by the Government . An increase in
administered prices of steel, coal, cement, fertilizer raises the cost of
production . Higher cost affects supply and shifts the aggregate supply
curve to the left (backward) resulting in a sharp increase in the prices of
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113 7. Slow industrial Growth: Stagflation occurs when t here is slow
industrial growth.Important factors responsible for the slow growth of the
industrial se ctor are:
1. Restriction on imports of raw materials required for th e industries,
2. The decline in public investment,
3. High investment rate and
4. Reduced a vailabilities of credit
All these factorsreduce growth in output. This sow industrial growth and
a high rate of inflation create a situation of stagflation.
8. Expect ations about Prices: If people expect that shortly prices
would increase people decide t o buy products immediately and this creates
aggregate demand which leads to a further increase in pri ces. The worker's
unions demand higher wages as compensation for pr ice rise. Such
inflationary expectations create inflation and stagflation.
9. Monetary P olicies: The central bank monetary policies create credit
in the economy. This leads to an increase i n the money supply resulting in
additional demand and this causes t he aggregate demand curve to shift to
the right and further raise the inflation rate giv ing rise to stagflation.
10. Deficit financing: When the government goes for deficit
financing, (when the government prints new currency) it increase s the
money supply in the economy causing the aggregate demand curve to shift
to the right and further rais e the inflation rate and the economy slows
down giving rise to stagflation.
The r ise in oil price, d evaluation of rupee, slow industrial growth, increase
in administer ed prices, inflationary expectation, etc. are supply -side
factors that shift the aggrega te supply curve to the left causing stagflation.
8.6.2 Policy Measures
To bring the economy out of st agflation the government must adopt
measures such as
1 To r educe the fiscal deficit
2 To c ontrol the growth of the money supply
3 To r emov e restriction s on private investmen t, especially in
theinfrastructure.
4 To r educe corporate and personal income taxes
5 To r educe excise and customs duties etc.
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114 8.7 SUMMARY
Post-Keynesian economics is a broader stream. A range of theories that
were developed to br eak Keynesian tradition is included in this school of
thought. One such theory breaking the tradition al thought is the theory by
Milton Friedman. He integrated quantity theory money with general price
levels. He argues that a change in the stock of money le ads to a change in
the price level or income or both in the same direction. It implies that if
there is less than full employment in the economy, an increase in money
supply will lead to a rise in output and employment because of a rise in
expenditure only in the short run. Changes in money supply cannot affect
money balances in the long run .
Another rema rkable argument by Milton Friedman and Edmond Phelps is
the express ion about the behaviour of the long -run Philips curve. Philips
Argued for an inverse rel ationship between the Inflation rate and
unemployment rate. Which implied that the Government could r educe
unemployment by accepting some degree of inflation. But Milto n
Friedman and Edmund Phelps, in the long workers , take into consideration
real wages an d inflation -adjusted money wages. Therefore, the
government cannot get lower unemployment with higher inflation at least
in the long run.
A school of thought that was d eveloped after Keynesian tradition was
New Keynesians. Mankiw developed an argument that there exists
involuntary unemployment in the economy because firms do not want to
adjust the price t o reach equilibrium. To attain equilibrium by adjusting
prices is c ostly. As firms do not change prices and prices become sticky,
there is involuntary unem ployment in the economy.
Lord Keynes emphasized the importance of effective demand in his
theory. Ac cording to him, the solution to reduce unemployment is to
increase effective demand. But economists observed that in modern times
there is the existence of inflation and unemployment at the same time. The
situation has been termed stagflation. The Keynesia n theory could not
provide a solution to this problem. But it has b een suggested that measures
like reducing the money supply, reducing fiscal poly can hel p to bring the
economy out of stagflation.
8.8 QUESTIONS
1 Explain Friedman’s Demand for money. What are its limitations?
2 Explain the behaviour of Long run Philips c urve.
3 Critically examine Mankiw’es model of nominal price stickiness.
4 What is stag flation? What are the causes and consequences of
stagflation?
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115 8.9 REFERENCES
1. R. G. Hawtrey “Mon etary Theory and the Trade Cycle. by F. A. Hayek
“A Review, The Eco nomic Journal, Vol. 43, No. 172 (Dec. 1933), pp.
669-672.
2. Victor a. canto, Douglas h. joines, Arthur b. Laffer “Foundations of
Supply -Side Economics Theory and Evidence ”, 1983, Academic P ress,
3. Blanchard, Olivier, and Jeffrey Sheen., Macroeconomics; Australasian
Edition. Pearson Higher Education AU, 2013.
4. R. Dornbusch, S. Fischer, Rich ard Startz, “Macroeconomics” 13th
Edition, McGraw -Hill Education, 2 Penn Plaza, New York, 2018
5. Sanjay Chugh, “Modern Macro Economics “MIT Press, 2015
6. Brian Snowdon, Howard R. Vane, “Modern Macroeconomics, Its
Origins, Development and Current State” Edw ard Elgar Publishing
2005
7. Mankiw, N. Gregory. "Small menu costs and large business cycles: A
macroe conomic model of monopoly." The Quarterly Journal of
Economics 100.2 (1985): 529 -537.
8.M.L.Jhingan, Macro Economic Theory,2010, 12th Edition, Vipul
Publi cation,
9. Kriesler, Peter. The Oxford Handbook of Post -Keynesian Economics,
Volume 1: Theory an d Origins. Oxford University Press, 2013.
10. Mankiw, N. Gregory. The reincarnation of Keynesian economics. No.
w3885. National Bureau of Economic Research, 19 91.

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