Elements of Macroeconomics (English Version) 2-munotes

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1MODULE -1
1
INTRODUCTION
Unit Structure :
1.0 Objectives
1.1 Introduction
1.2 Distinction between Microeconomics and Macroeconomics
1.3 Meaning of Circular Flow of Income
1.4 Circular Flow of Income
1.5 Circular Flow of Income and Expenditure in a two –sector
Economy Model
1.6 Circular Flow of Money in a two sector Economy with Savings
and Investment
1.7 Circular Flow of Income in a three sector Economy
1.8 Circular Flow of Money with the Foreign Sector or Circular Flow
of Money in Four sector Open Eco nomy
1.9 Importance of Circular Flow of Income
1.10 Gross National Product (GNP)
1.11 Gross Domestic Product (GDP)
1.12 Personal Income
1.13 Disposable Income
1.14 Methods of Measurement of National Income
1.15 Net Output or Value Added Method
1.16 Factor -Income Method
1.17 Expenditure Method
1.18 Measurement of National Income in India
1.19 Summary
1.20 Questions
1.0 OBJECTIVES
To understand the meaning, subject matter, uses and limitations of
Microeconomics and Macroeconomics
To study the meaning of Circular flow of income
To study the circular flow of income and expenditure in a two sector
model economymunotes.in

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2To study circular flow of money with saving and investment in a two
sector economy
To understand circular flow of income in three sector economy
Tounderstand circular flow of income in a four sector economy
To understand the importance of circular flow of income
To study the concepts of GNP, GDP, NNP and NDP
To understand the meaning of personal income and disposable income
To study different methods of measurement of national income
1.1 INTRODUCTION
Macroeconomics study examine the economy as a whole i.e. it is a
study of aggregates. To study the income and expenditure of the country
macroeconomics provides several tools. Therefore study of these tools
used to explain national income and expenditure and how to measure it
becomes inevitable.
1.2DISTINCTION BETWEEN MICROECONOMICS
AND MACROECONOMICS
1.2.1 Meaning : -
Macroeconomics is concerned with the nature, relationships and
behaviour of such ag gregate quantities and averages as national income,
total consumption, savings and investment, total employment, general
price level, aggregate expenditure and aggregate supply of goods and
services. As macroeconomics deals with aggregate quantities of the
economy as a whole, it is also called as aggregative economics.
1.2.2 Subject matter : -
Theories of National Income, consumption, saving and investment,
theory of employment, theories of economic growth, business cycles and
stabilization policies, theori es of money supply and demand and theory of
foreign trade broadly constitute the subject matter of macroeconomics.
Macroeconomic theories seek to answer questions such as how is the level
of National Income of a country determined? What determines the leve ls
of overall economic activities in a country? What determines the level of
total employment? How is the general level of price determined? etc.
1.2.3 Uses : -
The main justification for macroeconomics lies in the need for
generalising the behaviour of a nd relationships between economic
aggregates. To study the system as a whole and to explain the behaviour of
aggregate quantities and the relationship between them is extremely
difficult. Macroeconomic approach has made it possible. It ignores the
details pertaining to the individual economic agents and quantities and
compresses the unmanageable economic facts to a manageable size andmunotes.in

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3makes them capable of interpretation. Macroeconomic theories are used in
formulating public policies. They provide clarity t o the macroeconomic
concepts and quantities and bring out the relationship between macro
variables of the economy in the form of models or equations.
1.2.4 Limitations : -
Study of macroeconomics is limited to only aggregates. It cannot
be applied to expla in the behaviour of individual components of the
economic system and the individual quantities. Secondly, it ignores the
structural changes in constituent elements of the aggregate. Hence
conclusions drawn from the analysis of aggregates may involve error of
judgement and may be misleading.
1.3MEANING OF CIRCULAR FLOW OF INCOME
The circular flow of money refers to the process whereby money
payments and receipts of an economy flow in a circular manner
continuously over a period of time. The various compon ents of money
payments and receipts are saving, investment, taxation, loans, government
purchases, exports, imports, etc. These are shown i n diagram in the form
of current and cross -current in such a manner that the total money
payments equals the total mo ney receipts in the economy.
1.4CIRCULAR FLOW OF INCOME
The modern economy is a monetary economy, where money is
used in the process of exchange. The modern economy performs
economic activities such as production, exchange, consumption and
investment. In order to carry out these economic activities people are
involved in buying and selling of goods and services. The transactions
take place between different sectors of the economy. The process of
production and exchange generates two kinds of flows.
1.Product or real flow, that is the flow of goods and services, and
2.Money flow.
Product and money flow in opposite direction in a circular way.
The product flow consists of a) factor flow, that is flow of factor services
and b) goods flow that is flow of g oods and services. In a monetized
economy the flow of factor services generates money flows in the form of
factor payments which take the form of money flows. The factor payments
and expenditure on consumer goods and services take the form of
expenditure f low. Expenditure flow is in the form of money flow. Both
income and expenditure flow in a circular manner in opposite direction.
The entire economic system can therefore be viewed as circular flows of
income and expenditure. The magnitude of these flows de termines the size
of national income. We can explain how these flows are generated and
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4The economists, however use simplified models to explain the
circular flow of income and expenditure dividing the economy into four
sectors namely, I) Household sector, II) Business or Firms sector , III)
Government sector, and IV) Foreign sector. These sectors are combined to
make the following three models for the purpose of showing the circular
flow of income.
I)Two-sector model in cluding the household and business sectors;
II)Three -sector model including the household, business and
government sectors; and
III)Four-sector model including the household, business, government and
the foreign sectors.
1.5CIRCULAR FLOW OF INCOME AND
EXPENDITURE IN A TWO –SECTOR ECONOMY
MODEL
We begin with a simple hypothetical economy where there are
only two –sectors, the household and business firms which represent a
closed economy and there is no government and no foreign trade. The
household s ector owns all the factors of production that is land, labour,
capital and enterprise. This sector receives income in the form of rent,
wages, interest and profit, by selling the services of these factors to the
business sector. The business sector consist s of producers who produce
goods and sell them to the household sector. The household sector consists
of consumers who buy goods produced by the business sector.
Thus in the first instance, money flows in the form of such income
payments as rent, wages, i nterest and profits from the business sector to
the household sector when the former buys the services of the factors of
production to produce goods. Money so received is, in turn, spent by the
household sector to buy goods produced by the business sector. In this
way money flows in a circular manner form the business sector to the
household sector and from the household sector to the business sector in
the economy.
The circular flow in a two sector economy is depicted in Fig. 1.1
where the flow of money a s income payments from the business sector to
the household sector is shown in the form of an arrow in the upper portion
of the diagram. On the other hand, the flow of money as consumption
expenditure on the purchase of goods and services by the household sector
is shown to go the business sector by an arrow in the lower portion of the
diagram. As long as income payments by the business sector for factor
services are returned by the household sector to purchase goods, the
circular flow of income payments an d consumption expenditure tends to
continue indefinitely. Production equals sales or supply equals demand,
and the economy will continue to operate at this level in a circular flow of
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5Factors of Production -Land, Labour, Capital & Enterprise
Flow of goods and services
Fig. 1.1
The above analysis of circular flow of income and expenditure in a
two–sector closed economy is based on following assumptions.
1.The economy consist of two sectors name ly household and business
or firms;
2.Household sector spends their entire income received in the form of
rent, wages, interest and profits from the business sector on buying of
goods and services produced by the firms. They do not hold or save
any part of t heir income.
3.The business firms keep their production exactly equally to their sales
or as much as demanded by the households. There are no changes in
their inventories.
4.The business sector does not keep any undistributed money as reserve.
The money it rec eives by selling goods and services to the household
sector is fully spent in making payments as rent, wages, interest and
profits to the household sector.
5.There are no government operations.
6.There is no inflow or outflow of income or no foreign trade.
Itis these assumptions that keep the flow of money to move in a
circular manner in the economy. But these assumptions are unrealistic and
do not fit in the actual working of the economy.Factor income = Wages, Rent, Interest andProfitsPayments for goods and servicesHouseholdSector
Factor Owners
andConsumerso fFirms SectorFactor Users
and Producer ofgoods andFactor Market
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61.6CIRCULAR FLOW OF MONEY IN A TWO SECTOR
ECONOMY WITH SAVINGS AND INVESTMENT
In the analysis of circular flow of income in a two sector economy,
we have assumed that, all money income received by the households is
spending on consumer goods and services. But in reality, the households
do not spend their entire money in come on goods and services. They save
a part of their income for various purposes. Let us now explain if
households save a part of their income, how their savings will affect
money flow in the economy.
When households save, their expenditure on goods an d services
will decline to that extent and as a result money flow to business firms will
contract. With reduced money income firms will hire fewer workers or
reduce payments to the factors of production. This will lead to the fall in
total income of the ho useholds. Thus, savings reduce the flow of money
expenditure to business firms and cause a fall in economy’s total income.
Economist, therefore call savings a leakage from the money expenditure
flow.
But savings by households will not reduce aggregate ex penditure
and income, if their savings are brought back into the flow of expenditure.
In free market economies financial market consists of commercial banks,
stock market and non -bank financial institutions etc. plays an important
role of mobilization of s avings, where households deposit their savings.
On the other hand, business firms borrow money from the financial market
for the purpose of investment. Thus, through the financial market savings
and investment are again brought into the expenditure stream and as a
result total flow of spending does not decrease. Circular flow of money
with savings and investment is explained with the help of following
assumptions.
1.All the households need to deposit their savings with the financial
institutions \market.
2.There are no inter -households borrowings.
In the following figure, in the middle of the circle a box represents
financial market. Money flow of savings is shown from households
towards the financial market. Then the flow of investment expenditure is
shown a s borrowing by business firms from the financial market.
The circular flow of money with savings and investment is shown
in the following fig. 1.2.munotes.in

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7Factors of production -Land, Labour, Capital & Entrepreneurship
Flow of goods & services
Fig.1.2
The necessary condition for the constant flow of income is savings
must be equal to investment. As mentioned above, saving a part of
income is not spent on consumer goods and services. In other words,
saving is withdrawal of some mone y from the income flow. On the other
hand, investment means some money is spent on buying new capital goods
to expand production capacity. In other words, investment is injection of
some money in circular flow of income. But savings and investments in an
economy need not necessarily be equal.
If planned savings is more than planned investment expenditure,
income, output and employment will fall and therefore, flow of money
will decline. On the contrary, if planned investment expenditure is more
than planne d savings, income, output and employment will rise and
therefore, flow of money will increase. Thus, the economy will be in
equilibrium if planned savings is equal to planned investment expenditure.
It is clear from the above analysis that, the flow of m oney will
continue at a constant level only when the condition of equality between
planned savings and planned investment is satisfied.
1.7CIRCULAR FLOW OF INCOME IN A THREE
SECTOR ECONOMY
The two sector economy model consists of households and
business firms. But in a three sector economy additional sector is
government sector. Government affects the economy in many ways. Here
we will concentrate on its taxing, spending and borrowing roles. In theFactor Incomes -Rent, Wages, Interest & Profit
Consumer E xpenditureSavings Investment
Payments for goods & servicesHouseholds Business Firms
Consumer Expenditure
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8modern economy government plays variety of role. Governm ent performs
different functions. For this it requires huge amount of income.
Government receives income in the form of taxes from households and
business firms. Taxes are paid by the households and business firms which
not only reduces their disposable in come but also their expenditure and
savings.
Governments’ spending includes expenditure on goods and
services, pension payments, unemployment allowance etc. Money spent
by Government is an injection of income into the economy which further
received by th e households and business firms.
Another important method of financing Government expenditure is
borrowing from financial market. This is represented by money flow from
the financial market to the Government is labelled as Government
borrowing.
In a th ree sector economy we have the following three economic
agents.
1.Households and business firms
2.Financial sector
3.Government
The circular flow of income in a three sector economy is shown in
the following fig. 1.3.
Wages, Salaries & Payments P urchase of goods & services
Taxes
Taxes
Fig. 1.3Factors of Production
FlFactor Income (W+R+I+P)
Flow of good
Flow of goods & servicesS I
Payments for goods & servicesBusiness Firm HouseholdsGovernmentTaxes
Government
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9The above figure clearly shows that, income received by the
Government in the form of taxes from households and business firms is
used for spending in the form of wages, salaries, allowances, pension,
subsidies and purchases of goods and services from them. Money spent by
the Government is received by the households and business firms.
Thus, the leakages (withdrawal) in the form of savings and taxes
arise in the circular flow of income. The savings and taxes are further get
injected back into the circular flow of income in the form of investment
and Government spending. When these leakages (withdrawal) are equal to
injections in the form of investment and Government spending the flow of
money in the economy operates smoothly.
The inclusion of the Government sector significantly affects the
overall economic situation. Total expenditure flow in the economy is the
sum of consumption expenditure (C), investment expenditure (I), and
Government expenditure (G).
Thus, it is symboli cally expressed as,
Total expenditure (E) = C + I + G
Total income (Y) received is allocated to consumption (C), savings
(S) and taxes (T).
Thus, symbolically expressed as,
Y=C+S+T
Since expenditure (E) made must be equal to the income received
(Y) from equation above we have
C+I+G=C+S+T
Since C occurs on both sides of the equation and will therefore be
cancelled out, we have
I+G=S+T
By rearranging we obtain
G–T=S –I
This equation is very significant because it shows what would be
the consequences if Government budget is not balanced. If Government
expenditure (G) is greater than the tax (T), the Government will have a
budget deficit. To finance the budget deficit, the Government wi ll borrow
from the financial market. For this purpose, then private investment by
business firms must be less than the savings of the households. Thus
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101.8CIRCULAR FLOW OF MONEY WITH THE
FORE IGN SECTOR OR CIRCULAR FLOW OF MONEY
IN FOUR SECTOR OPEN ECONOMY
So far the circular flow of money has been shown in the case of a
closed economy. But the actual economy is an open one where foreign
trade plays an important role. Exports are an injection or inflows into the
circular flow of money. They create incomes for the domestic firms. When
foreigners buy goods and services produced by domestic firms, they are
exports in the circular flow of money. On the other hand, imports are
leakages from the cir cular flow of money. They are expenditure incurred
by the household sector to purchase goods and services from foreign
countries. These exports and imports in the circular flow are shown in
fig. 1.4.
Take the inflows and outflows of the hous ehold, business and
government sectors in relation to the foreign sector. The household sector
buys goods imported from abroad and makes payments for them which is
a leakage from the circular flow of money. The householders may receive
transfer payments fr om the foreign sector for the services rendered by
them in foreign countries.
On the other hand, the business sector exports goods to foreign
countries and its receipts are an injection in the circular flow of money.
Similarly, there are many services ren dered by the business firms to
foreign countries such as shipping, insurance, banking etc. for which they
receive payments from abroad. They also receive royalties, interest,
dividends, profits, etc. for investment made in foreign countries. On the
other h and, the business sector makes payments to the foreign sector for
imports of capital goods, machinery, raw materials, consumer goods and
services from abroad. These are the leakages from circular flow of money.munotes.in

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11X–M (Exports -Imports)
X–M
Fig.1.4
Like the business sector, modern governments also export and
import of goods and services, and lend to and borrow from foreign
countries. For all exports of goods, the government receives payments
from abroad. Simil arly, the government receives payments from foreigners
when they visit the country as tourists and for receiving education, etc. and
also when the government provides shipping, insurance and banking
services to foreigners through the state -owned agencies. It also receives
royalties, interests, dividends, etc. for investments made abroad. These are
injections into the circular flow of money. On the other hand, the leakages
are payments made to foreigners for the purchase of goods and services.
Figure 1.4 sh ows the circular flow of money in four sector open
economy with saving at the right hand and taxes and imports at the left
hand shown as leakages from the circular flow on the upper side of the
figure, and investment, and government purchase (spending) on the right
hand side and exports as injections into the circular flow, on the lower
level left hand side of the figure. Further, imports, exports and transfer
payments have been shown to arise from the three domestic sectors -the
household, the business and the government. These outflows and inflows
pass through the foreign sector which is also called the ‘Balance of
Payments Sector.’
Thus Figure 1.4 shows the circular flow of money where there are
inflows and outflows of money, receipts and payments among the business
sector, the household sector, the government sector, and the foreign sector
in current s and cross -currents.F C
A Taxation Govt. Spending O Savings
C N
T S
O U
R M
I P
N Taxation Govt. Spending T Investments
C I
O O
M N
EHousehold Sector
Business SectorWorld
EconomyFinancial
SectorGovernment
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121.9IMPORTANCE OF CIRCULAR FLOW OF INCOME
1.To understand the functioning of the economy -Money being the life
blood of a modern ec onomy, its circular flow gives a clear picture of
the economy. We can know from its study whether the economy is
working smoothly of there is any disturbance in its smooth
functioning. The circular flow of money is important for studying the
functioning of the economy and for helping the government in
formulating polity measures.
2.To understand the link between producers and consumers –The
circular flow of money establishes a link between producers and
consumers. It is through money that producers buy the s ervices of
factors of production from the household sector and in turn household
sector purchases goods and sector from the producers.
3.To find out the leakages in circular flow of income –Leakages or
injections in the circular flow of money disturb the sm ooth function of
the economy. For example, saving is a leakage out of the expenditure
stream. If saving increases, this contracts the circular flow of money.
This tends to reduce employment, income and prices thereby leading a
deflationary process in the e conomy. On the other hand, consumption
expenditure and investment are injections in the circular flow of
money which help to increase employment, income, output and prices
and thus lead to inflationary tendencies.
4.Highlights the importance of monetary and fiscal policies –The study
of the circular flow of money also highlights the importance of
monetary policy in bringing about the equality between savings and
investment through the capital market. Similarly, it also points out the
importance of fiscal pol icy in bringing about the equality between
saving plus taxes and investment plus government expenditure.
To conclude, the circular flow of money possesses much
theoretical and practical significance in an economy.
1.10GROSS NATIONAL PRODUCT (GNP):
GNP i s the total market value of all final goods and services
produced in a year plus net income from abroad. This is the basic social
accounting measure of the total output or aggregate supply of goods and
services. GNP includes four type of final goods and se rvices. First,
consumer ’s goods and services to satisfy, the immediate needs and wants
of the people .Second, gross private domestic investment. Third, goods
and services produced by government and four, net income from abroad
i.e. net export of goods and services GNP is the total amount of current
production of final goods and services
There are two things which have to be noted in regard to gross national
product Firstly, it measures the market value of annual output or it is amunotes.in

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13monetary measure .This enab les the process of adding up the different
types of goods and services produced in a year. However, for accuracy, the
figure for GNP is adjusted for price changes Secondly, for calculating
gross national product accurately, all goods and services produced in
any given year must be counted only once. GNP includes only the market
value of final goods and ignores transactions involving intermediate
goods. Final goods are those goods, which are being purchased for
final use and not for further processing. The i nclusion of intermediate
goods will involve double counting. This will give us an inflated figure
ofthe national product.
In national income accounting, GNP is calculated both at market
prices and factor cost. In order to calculate GNP at market prices, t he
outputs of all final goods and services are valued at market price and the
values thus obtained are added. The market price of a good includes
indirect taxes such as the sales tax and excise tax. Thus it is greater than
the price received by the seller. Sometimes, the government may grant
subsidy on a product. In this case, the market price would be less than the
price received by the seller GNP at factor cost eliminates the influences of
indirect taxes and subsidies. It provides an estimate of the total value of
the final goods and services produced during a year at cost of production.
GNP at factor cost is obtained by subtracting net indirect taxes from
GNP at market prices. GNP at Factor cost = GNP at market price -Net
indirect taxes = GNP at market p rices -(Total indirect taxes -Subsidies)
National income is usually calculated by 3 methods
(a)The product method.
(b)The income method
(c)The expenditure method
In the product method, GNP is the value added by the various industries
and activities of the ec onomy in a particular year. In the income method,
we add up the income earned by the owners of factors of products in a
particular year. This gives the gross national income (GNI). In the
expenditure method; we add up the final expenditure of all residents in a
country. All the three different ways of looking at one and the same thing.
1.11GROSS DOMESTIC PRODUCT (GDP):
GDP refers to the value of final goods and services produced within
the country in a, particular year. GDP is different from GNP. Ap a r to f
GNP may be produced outside the country For example the money
earned by the lndian ’sw o r k i n gi nU S Ai sap a r to fI n d i a ' s GNP But it is not a
part of GDP since they are earned abroad. Therefore the boundaries of
GNP are determined by the citizens of ac o u n try whereas the boundaries of
GDP are determined by the geographical limits of acountry. It is also clear
that the difference between GDP and GNP is due to the "net revenue from
abroad." If the citizens of a country are earning more from abroad than
foreigners are earning in that country, GNP exceeds GDP If the foreignersmunotes.in

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14in the country are earning more than its citizens are earning abroad, GNP
is less than GDP
1.11.1 Net National Product : -
This is a very important concept of national income. In the
produ ction of gross national product, during a year, some capital is used up
or consumed i.e. equipment, machinery etc. the capital goods wear out or
undergo depreciation. Capital goods fall in value due to its use in production
process. By deducting the charge sf o r depreciation from the gross
national product, we get the net national product. It means the market
value of all the final goods and services after providing for depreciation.
It is called national income at market prices. In other words, net national
product is the total value of final goods and services produced in the
country during a year after deducting the depreciation, plus net income from
abroad.
1.11.2 Net Domestic Products: -
NDP is obtained by subtracting the depreciation from the GDP. NDP
differs from MNP due to the net income from abroad. If the net income
from abroad is positive, NDP will be less than NNP If the net income
from abroad is negative, NDP will be greater than NNP NDP is also
calculated either at market price or at factor cost.
National Income at Factor Cost: -means sum total of all income
earned by resource suppliers for their contribution of land, labour, capital
and entrepreneurial ability which go into the years net production.
National income at factor cost shows how much i tcosts society In terms of
economic resources to produce the net output. We use the term national
income for the national income at factor prices.
National Income at factor cost = Net national product ( National Income
at market prices) -(indirect taxes +Subsidies)
1.12PERSONAL INCOME
Personal income is the sum of the income actually received by
individuals or households during a given year. Personal incomes earned
are different from national income. Some incomes which are earned such as
social security contributions corporate income taxes and undistributed
corporate profits are not actually received by households .In the same
manner, some incomes which are received like transfer payments are not
currently earned ex Old age pension, unemployment compensa tion, relief
payments interest payments etc. To get personal income from national we
must subtract from National income the three types of incomes which are
earned but not received and add incomes that are not currently earned,
Personal income = N.I .-Social Security -contributions -corporate
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151.13DISPOSABLE INCOME
The personal income which remains after payment of taxes to the
government in the form of income tax, personal property tax etc., is
called disposable income. Disposable income = Personal Income -
Personal Taxes. An individual can decide to consume or save the
disposable income as he wishes.
Check Your Progress :
1.Generally three methods are use to calculate national Income -
Expla in.
2.Distinction Between : NNP and NDP
1.14METHODS OF MEASUREMENT OF NATIONAL
INCOME
For measuring national income, the economy through which
people participate in economic activities, earn their livelihood, produce
goods and services and shar e the national products is viewed from three
different angles :
1.The national economy is considered as an aggregate of producing units
combining different sectors such as agriculture, mining,
manufacturing, trade and commerce, etc.
2.The whole nation al economy is viewed as a combination of individuals
and households owing different kinds of factors of production which
they use themselves or sell factor services to make their livelihood.
3.The national economy may also be viewed as a collection of
consuming, saving and investing units (individuals, households and
government).
National income may be measured by three different corresponding
methods :
A)Net product method
B)Factor -income method
C) Expenditure method
1.15NET OUTPUT OR VALUE ADDED MET HOD :
It is also called the Value Added Method. It consists of three
stages: i) estimating the gross value of domestic output in the various
branches of production; ii) determining the cost of material and servicesmunotes.in

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16used and also the depreciation of physic al assets; iii) deducting these costs
and depreciation from gross value to obtain the net value of domestic
output.
Measuring gross value : For measuring the gross value of domestic
product, output is classified under various categories and it is computed in
two alternative ways : i) by multiplying the output of each category of
sector by their respective market price and adding them together, or ii) by
collective data about the gross sales and changes in inventories from the
account of the manufacturing e nterprises and computing the value of GDP
on the basis thereof. If there are gaps in data, some estimates are made
thereof and gaps are filled.
Estimating cost of production : is, however a relatively more complicated
and difficult task because of non -availability of adequate and requisite
data. Countries adopting net -product method find some ways and means to
calculate the deductible cost. The costs are estimated either in absolute
terms or as an overall ratio of input to the total output. The general
practice in estimating depreciation is to follow the usual business practice
of depreciation accounting.
Following a suitable method, deductible costs including
depreciation are estimated for each sector. The cost estimates are then
deducted from the sectora l gross output to obtain the net sectoral products.
The net sectoral products are then added together. The total thus obtained
is taken to be the measure of net national products or national income by
net product method.
1.16FACTOR -INCOME METHOD :
This method is also known as income method and factor -income
method. Under this method, the national income is calculated by adding
up all he ―incomes accruing to the basic factors of production used i n
producing the national product. The total factor -incomes are grouped
under three categories :
Labour income : included in the national income have three components :
a) wages and salari es paid to the residents of the country including bonus
and commission and social security payments; b) supplementary labour
incomes including employer‘s contribution to soc ialsecurity and
employers welfare funds and direct pension payments to retired
employees; c) supplementary labour incomes in kind, e.g. free health and
education, food and clothing, and accommodation, etc. Compensations in
kind in the form of domestic servants and other free -of-cost services
provided to the employees are included in lab our income. War bonuses,
pensions, service grants, are not included in labour income as they are
regarded as transfer payments. Certain other categories of income, e.g.,
incomes from incidental jobs, gratuities, tips etc., are ignored for lack of
data.munotes.in

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17Capital income : According to Studens ki, capital income include
the following capital earnings
Dividends excluding inter -corporate dividends;
Undistributed before -tax profits of corporations;
Interest on bonds, mortgages, and savings deposits (excluding
interests on war bonds, and on consumer -credit)
Interest earned by insurance companies and credited to the
insurance policy reserves;
Net interest paid out by commercial banks;
Net rents from land, building, etc., including imputed net rents on
owner -occup ied dwellings;
Royalties;
Profits of government enterprises.
iii) Mixed income : include earnings from
Farming enterprises;
Sole proprietorship (not included under profit or capital income)
c) Other professions, e.g., legal and medical practices, consult ancy
services, trading and transporting etc. This category also includes the
incomes of those who earn their living through various sources as wages,
rent on own property, interest on own capital, etc.
All these three kinds of incomes added together give the measure
of national income by factor income method.
1.17EXPENDITURE METHOD
Also known as final product method, measures national income at
the final expenditure stages. In estimating the total national expenditure,
any of the tw o following methods a re follows ;
First, all the money expenditures at market price are computed and
added up together, and Second, the value of all the products finally
disposed of are computed and added up, to arrive at the total national
expenditure.
The items of expenditu re which are taken into account under the
first method are
Private consumption expenditure;
Direct tax payments;munotes.in

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18Payments to the non -profit making institutions and charitable
organizations like schools, hospitals, orphanages, etc. ,Private savings.
Under the second method, the following items are considered
Private consumer goods and services;
Private investment goods;
Public goods and services;
Net investment abroad.
The second method is more extensively used because the data
required in this method can be collected with greater ease and accuracy.
Treatment of Net Income from a broad :
Nowadays, most economies are open in the sense that they carry
out foreign trade in goods and services and financial transactions with the
rest of the world. In the process , some nations get net income through
foreign trade while some lose their income to foreigners. The net earnings
or loss in foreign trade affects the national income. In measuring the
national income, therefore, the net result of external transactions are
adjusted to the total. Net incomes from abroad are added to, and net losses
to the foreigners are deducted from the total national income arrived at
through any of the above three methods.
Briefly speaking, all exports of merchandise and of services like
shipping, insurance, banking, tourism and gifts are added to the national
income. And all the imports of the corresponding items are deducted from
the value of national output to arrive at the approximate measure of
nation al income. To this is added the net income from foreign investment.
These adjustments for international transactions are based on the
international balance of payments of the nations.
1.18MEASUREMENT OF NATIONAL INCOME IN
INDIA:
In India, a systematic m easurement of national income was first
attempted in 1949. Earlier, many attempts were made by some individuals
and institutions. The earliest estimate of India‘s national income was made
by Dadabhai Naoroji in 1867 -68. Since then many attempts were made,
mostly by economists and the government authorities to estimate India‘s
national income These estimates differ in coverage, concepts and
methodology and are not comparable. Besides, earlier estimates were
mostly for one year, only some estimates covered a period of 3 to 4 years.
It was therefore not possible to construct a consistent series of national
income and assess the performance of the economy over a period of time.
In 1949, a National Income Committee (NIC) was appointed with
P.C. Mahalnobis as its Chairman, and Dr. D.R. Gadgil and V.K.R.V. Rao
as members. The NIC not only highlighted the limitations of the statistical
system of that time but also suggested ways and means to improve data
collection systems. On the recommendation of the Committee, th emunotes.in

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19Directorate of National Sample Survey was set up to collect additional
data required for estimating nation al income. Besides, the NIC esti mated
the country ’s national income for the period from 1948 -49 to 1950 -52. In
its estimates, the NIC also provided the methodology for estimating
national income, which was followed till 1967.
In 1967, the task of estimating national income was given to the
Central statistical Organization (CSO). Till 1967, the CSO had followed
the methodology laid down by the NIC. Th ereafter, the CSO adopted a
relatively improved methodology and procedure which had become
possible due to increased availability of data. The improvements pertain
mainly to the industrial classification of the activities. The CSO publishes
its estimates i n its publication, Estimates of National Income.
Methodology : -Currently, output and income methods are used by the
CSO to estimate the national income of the country. The output method is
used for agriculture and manufacturing sectors, i.e., the commodi ty
producing sectors. For these sectors, the value added method is adopted.
Income method is used for the service sectors including trade, commerce,
transport and government services. In its conventional series of national
income statistics from 1950 -51to 1966 -67, the CSO had categorized the
income in 13 sectors. But, in the revised series, it had adopted the
following 15 break ups of the national economy for estimating the national
income;
Forestry and logging;
Fishing;
Mining and quarrying;
Large -scale m anufacturing;
Small -scale manufacturing;
Construction;
Electricity, gas and water supply;
Transport and communication;
Real estate and dwellings;
Public administration and Defenc e;
Other services;
External transactions.
National Income is estimated at both constant and current prices.
Check Your Progress :
1. Write notes on the following :
Net output method
Factor income method
c) Expenditure methodmunotes.in

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201.19 SUMMARY
1.As macroeconomics deals with aggregate quantities of the economy as
a whole, it is also called as aggregative economics. Theories of
National Income, consumption, saving and investment, theory of
employment, theories of economic growth, business cycles and
stabilization policies, theories of money supply and demand and theory
of foreign trade broadly constitute the subject matter of
macroeconomics. Macroeconomic theories are used in formulating
public policies. They provide clarity to the macroeconomic concepts
and quantities and bring out the relationship between macro variables
of the e conomy in the form of models or equations.
2.The circular flow of money refers to the process whereby money
payments and receipts of an economy flow in a circular manner
continuously over a period of time.
3.Product and money flow in opposite direction in a circular way. The
product flow consists of a) factor flow, that is flow of factor services
and b) goods flow that is flow of goods and services. In a monetized
economy the flow of factor services generates money flows in the
form of factor payments which t ake the form of money flows. The
factor payments and expenditure on consumer goods and services take
the form of expenditure flow. Expenditure flow is in the form of
money flow. Both income and expenditure flow in a circular manner in
opposite direction.
4.In a two sector model of circular flow, the household and business
firms which represent a closed economy and there is no government
and no foreign trade. The household sector owns all the factors of
production that is land, labour, capital and enterprise. This sector
receives income in the form of rent, wages, interest and profit, by
selling the services of these factors to the business sector. The business
sector consists of producers who produce goods and sell them to the
household sector. The household sector consists of consumers who
buy goods produced by the business sector.
5.In a three sector economy additional sector is government sector.
Government affects the economy in many ways. Government receives
income in the form of taxes from households and business firms.
Taxes are paid by the households and business firms which not only
reduces their disposable income but also their expenditure and savings.
Governments’ spending includes expenditure on goods and services,
pension payments, unemployment all owance etc. Money spent by
Government is an injection of income into the economy which further
received by the households and business firms. Another important
method of financing Government expenditure is borrowing from
financial market. This is represent ed by money flow from the financial
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216.Four sector open economy the circular flow of income shows where
there are inflows and outflows of money, receipts and payments
among the business sector, the household sector, the government
sector, and the foreign sector in current s and cross -currents.
7.GNP is the total market value of all final goods and services produced
in a year plus net income from abroad. This is the basic social
accounting measure of the total output or aggregate supply of goods
and services.
8.GDP refers to the value of final goods and services produced within the
country in a, particular year. GDP is different from GNP.
9.Net national product is the total value of final goods and servi ces
produced in the country during a year after deducting the depreciation,
plus net income from abroad.
10.NDP is obtained by subtracting the depreciation from the GDP.
11.Personal income is the sum of the income actually received by
individuals or households during a given year. Personal income = N.I -
Social Security -contributions -corporate income taxes -undistributed
corporate profit + Transfer Payments
12.The personal income which remains after payment of taxes to the
government in the form of income tax ,p e r s o n a lp r o p e r t yt a x etc., is
called disposable income. Disposable income = Personal Income -
Personal Taxes.
13. National income may be measured by three different corresponding
methods :
A)Net product method
B)Factor -income method
C) Expenditure met hod
1.20 QUESTIONS
1.Explain the scope and importance of macroeconomics.
2.Explain the circular flow of national income in a two sector economy.
3.Discuss the three sector model of circular flow of national income.
4.Briefly explain circular flow of national in come in an open economy.
5.Explain various national income accounting concepts.
6.Differentiate between personal income and disposable income.
7.Describe various methods of measurement of national income.
munotes.in

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222
TRADE CYCLES
Unit Structure :
2.0 Objectives
2.1 Introduction
2.2 Features of Business / Trade Cycles
2.3 Phases pf Business Cycles
2.4 Introduction o fthe Classical Theory of Income and Employment
2.5 Say's Law of Market
2.6 Summary
2.7 Quest ions
2.0 OBJECTIVES
To study various features of Trade cycle
To understand different phases of trade cycles
To understand the meaning of different phases of trade cycles
To study classical theory of macroeconomics
2.1 INTRODUCTION
Business cycles / t rade cycles are inevitable in an economy. To
study their different phases and features therefore helps the economy to
take remedial measures to maintain economic stability.
National income and employment are macroeconomic concepts
which helps to achieve economic growth and development of the country
at a faster rate. The views of classical economists are useful to understand
these concepts.
2.2FEATURES OF BUSINESS / TRADE CYCLES
Though different business cycles differ in duration and intensity
they ha ve some common features which can explain below.
1. A business cycle is a wave like movement in macro economic activity
like income, output and employment which shows upward and
downward trend in the economy.
2.Business cycles are recurrent and have been occurring periodically.
They do not show some regularity.munotes.in

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233.They have some distinct phases such as prosperity, recession,
depression and recovery.
4.The duration of business cycles may vary from minimum of two years
to a maximum of ten to twelve years.
5.Business cycles are synchronic. That is they do not cause changes in
any single industry or sector but are of all embracing character. For
example, depression or contraction occurs simultaneously in all
industries or sectors of the economy. Recession p asses from one
industry to another and chain reaction continues till the whole
economy is in the grip of recession. Similar process is at work in the
expansion phase or prosperity.
6.There are different types of business cycles. Some are minor and others
are major. Minor cycles operate for a period of three to four years and
major business cycles operate for a period of four to eight years.
Though business cycles differ in timing, they have a common pattern
of sequential phases.
7.Expansion and contracti on phases of business cycle are cumulative in
effect.
8.It has been observed that fluctuations occur not only in level of
production but also simultaneously in other variables such as
employment, investment, consumption, rate of interest and price level.
9.Another important feature of business cycles is that downswing is
more sudden than the changes in upswing.
10. An important feature of business cycles is profits fluctuate more than
any other type of income. The occurrence of business cycles causes a
lot of uncertainty for business and makes it difficult to forecast the
economic conditions.
11. Lastly, business cycles are international in character. That is once
started in one country they spread to other countries through trade
relations between.
2.3PHASES OF BUSINESS CYCLES
Business cycles have shown distinct phases, the study of which is
useful to understand their fundamental causes. Generally, a business cycle
has four phases.
1.Prosperity (Expansion, Boom, or Upswing)
2.Recession (upper turning p oint)
3.Depression (Contraction or Downswing) and
4.Revival or Recovery (lower turning point)
The four phases of business cycle are shown in the following
figure. It starts from trough or lower turning point when the level of
economic activity is at the lowes t level. Then it passes through recovery
and prosperity phase, but due to the causes explained below the expansionmunotes.in

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24cannot continue indefinitely, and after reaching peak, recession and
depression or downswing starts. The downswing continues till the lowest
turning point and reaches to trough. It is important to note that no phase
has any definite time period or time interval. Similarly any two business
cycles are not the same.
The prosperity starts at trough and ends at peak. The recession
starts at peak an d ends at trough. One complete period of such movement
is called as a trade cycle.
Fig. 2.1
Four phase of trade cycles are briefly explained as follows.
1.Prosperity –Prosperity is ‘a stage in which the money income,
consumption, production and level of employment are high or rising and
there are no idle resources or unemployed workers.’
This stage is characterized by increased production, high capital
investment, expansion of bank credit, high prices, high profit, a hi gh rate
of interest, full employment income, effective demand, inflation MEC,
profits, standard of living, full employment of resources, and overall
business optimism etc.
The prosperity comes to an end when forces become weak and
therefore, bottlenecks s tart to appear at the peak of prosperity. Due to high
profit, inflation and over optimism make the entrepreneurs to invest more
and more. But because of shortage of raw material and scarcity of factors
of production prices of goods and services rises. As a result there is fall in
demand and profit, business calculations go wrong. Thus their over
optimism is replaced by over pessimism. Thus prosperity digs its own
grave.
2. Recession -When the phase of prosperity ends, recession starts.
Recession is an uppe r turning point. This is a phase of contraction or
slowing down of economic activities. Recession is generally of a short
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25After boom, demand falls, production becomes excess and
investment results in over investment. Finally, it leads to reces sion.
During this phase profit, investment and share prices falls
significantly, Because of lack of investment the demand for bank credit,
rate of interest, income employment, and demand for goods and services
falls.
If recession continues for a long period of time then finally, it
reaches to the phase of depression.
3.Depression –It is a period in which business or economic activity in a
country is far below the normal. Depression is ‘a stage in which the
money income, consumption, production and level of employment falls,
idle resources and unemployment increases.’
It is characterized by a sharp reduction of production, mass
unemployment, low employment, falling prices, falling profits, low wages,
and contraction of credit, fall in aggregate inc ome, effective demand,
MEC, a high rate of business failure and atmosphere of all round
pessimism etc. The depression may be of a short duration or may continue
for a long period of time.
After a period of time, moderate increase in the demand for goods
and services helps to increase in investment, production, employment,
income and effective demand. Finally, it leads to recovery.
4. Recovery –Depression phase is generally followed by recovery.
Various exogenous and endogenous factors are responsible for reviving
the economy. When the economy enters the phase of recovery, economic
activity once again gathers momentum in terms of income, output,
employment, investment and effective demand. But the growth rate lies
below the steady growth path.
Thus, a recovery phase starts which is called the lower turning
point. It is characterized by improvement in demand for capital stock, rise
in demand for consumption good, rise in prices and profits, improvement
in the expectations of the entrepreneurs, slowing r ising MEC, slowly
increasing investment, rise in employment, output and income, rise in
bank credit, stock market becomes more sensitive and revival slowly
emerges etc.
The phase of recovery once started, it slowly takes the economy on
the path of expans ion and prosperity. With this the cycle repeats itself.munotes.in

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26Check your Progress :
1. What is a business cycle? What are its different features?
2. What is a business cycle? Explain the different phases of a trade cycle.
2.4INTRODUCTION OF T HE CLASSICAL THEORY OF
INCOME AND EMPLOYMENT :
The study of classical theory of income and employment is
essential because some of the aspects of classical theory are more relevant
to the conditions prevailing in the developing countries. Classical theory
highlights those factors, which govern income and employment in these
countries. In fact Keynesian macro economic model is not able to explain
the conditions of unemployment and underemployment in less developed
countries. Hence it cannot explain the dete rmination of income and
employment in such countries.
Hence it is necessary to study the classical theory
The classical theory of employment is a supply -oriented theory. It
is the product of an accumulation and refinement of ideas developed by
the 18lh and 19'" century economists. The classical economists were
basically concerned with the long run problem of growth of the economy's
production capacity and efficient allocation of the given resources at full
employment. The classical economists focused the ir attention more on the
supply side and demand side was neglected while discussing the growth
process. According to Adam Smith, Ricardo, Say, Mill and followers of
classical thought, except Malthus believed that there is no problem on the
demand side as t he aggregate demand would always take care of itself.
Hence the main problem is that of supply rather than demand.
According to the classical economists if prices and wage rates were
flexible, there would be a built in tendency for the economy to operate at
full employment. As a result they ignored the problems of unemployment.
The classical economists focused on the following problems: -
1The different types of goods and services that would be produced in
the economy
2.The allocation of productive reso urces among the competing firms and
industries. The classical economists tried to find out the conditionsmunotes.in

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27leading to the most efficient use and optimum allocation of the given
resources.
3The relative price structure of different goods and factors
4The distribution of real income among the productive factors. The
main postulates of the classical theory of employment are the
following.
1.Long term analysis
2Full employment
3.Say's law of markets
4interest Rate and Flexibility
5.Wage rate and Flexibil ity
2.4.1 The Assumption of Full Employment: -
The classical economists believed in the prevalence of a stable
equilibrium at full employment as the normal characteristic in the long
run. Any deviation from this is abnormal under perfect competition in a
free capitalist economy, forces operate in the economic system which tend
to maintain full employment without inflation. As a result, the level of
output is always at full employment with the optimum use of resources in
the long run. Full employment is a co ndition where there is absence of
involuntary unemployment to restore full employment again.
The classical theory believed m full employment as a normal
condition. This was on certain basic assumptions. –
1.Say‘s law of market -.Supply creates its own d emand according lo
Say's law. Hence there can never be any deficiency of demand.
2.Any unemployment that in the process of a competitive system is
automatically eliminated by the free market price system
2.5SAY'S LAW OF MARKET
The belief of classical t heory regarding the existence of full
employment in the economy is based on Say's Law put forward by a
French economist J B. Say. According to J. B. Say's law. "Supply creates
its own demand". This implies that any increase in production made
possible by t he increase in the productive capacity or the stock of fixed
capital will be sold in the market. There will be no problem of lack of
demand. This appears to be a simple proposition. But it has a number of
implications.
Say's law contends that the producti on of output in itself generates
purchasing power, equal to the value of that output, supply creates its own
demand. Production increases not only the supply of goods but by virtue
of the requisite cost payment to the factor of production, also creates the
demand to purchase these goods. Any production process has two effects:munotes.in

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281.As factors are employed in production process, income is generated in
the economy on account of the payment of remuneration to the factors of
production.
2.It results in the prod uction of a certain level of output, which is supplied
in the market. According to Say's law additional output creates additional
incomes which creates an equal amount of extra expenditure.
A new production process, by paying out income to its employed
factors generates demand at the same time, as it adds to supply. Thus any
increase in production is followed by a matching increase in demand.
In the original form Say's law was applicable to a barter economy.
In a barter economy, people produce goods eithe r to consume or to
exchange them for other products. In the process the aggregate demand for
goods equals the aggregate supply of goods. Hence there is no possibility
of over production. Introduction of money also does not change the basic
law. Money is us ed only as a medium of exchange. The classical theorists
believed that money is neutral and does not influence the real process of
production and distribution. There is a circular flow of money from the
firm to house holds and from households to firms. The firm purchases
inputs for production. They pay in the form of wages, rent, interest and
profits. This becomes the income of households. The households spend
their income on goods and services produced by firms. In this circular
flow there is no saving and hoarding. All income received is spent. In case
the household saves a part of the income, the circular flow can still be
maintained if savings are equal to investment.
If there is a divergence between saving and investment, the
equality is maintained thr ough the flexibility of money interest. Interest is
a reward for saving. Higher the interest, more are the savings and vice -
versa. At the same time, lower the interest rate, higher the demand for
investment and vice -versa. If I > S rate of interest will ri se. Savings will
also increase and investment will fall till the two become equal.
2.5.1 Assumptions of the Law
The following assumption forms the backbone of Say =s law.
1.Optimum Allocation of Resources: -The resources are optimally
allocated in differ ent channels of production on the basis of equality of
marginal products and proportionality.
2.Perfect Equilibrium: -Demand and supply equilibrium leads to the
fixing of commodity price and factor prices.
3.Perfect Competition: -The commodity and the fa ctor markets have
perfect competition as the market conditions.
4.There is a free enterprise or free market economy.
5.Laissez -faire policy of the government: -There is no government
intervention in the economic field. Laissez -fair policy leads tomunotes.in

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29automa tic adjustment and smooth working of the market mechanism in
the capitalist system.
6.Elastic Market: -The market is very wide and spread out without
limits. Therefore as the output product increases, markets also expand.
7. Market Automatism: -Af r e em a r ket economy stimulates capital
formation. In an expanding economy, new workers and firms will be
automatically absorbed into the production channels. There is no
displacement of workers or firm.
8.Circular Flow: -There is no break in the circular flow of income and
expenditure Income is automatically spent through consumption
expenditure, and investment expenditure.
9.Saving Investment Equality: -All the savings are automatically
invested. Therefore, savings is always equal to investment. Savings
investme nt equality is the basic condition of equality. Interest
flexibility ensures this.
10.Long term : -The economy's equilibrium process is considered from
the long term point of view.
Thus according to Say's law, when savings will be offset by an
equivalent investment and since hoarding is zero, aggregate demand will
always be equal to aggregate supply. Hence there will be no general over
production in the long run. Therefore, equilibrium can be maintained
automatically at full employment level. Since over -saving is not possible;
Say s Law implied that underemployment equilibrium is not possible.
Interest rate flexibility and wage flexibility are the 2 factors which
ensures this equilibrium between be discussed.
1.Interest Rate Flexibility : -According to Say's law, all incomes are
spent i.e. income = expenditure. However, there may be "leakages" in the
circular flow of income & expenditure. Whatever is saved is invested in
production activities. Savings and investments tor saving. If savings
exceed investm ent, the rate of interest will fall. Hence investment will rise
and level of savings will fall till they are in equilibrium. Therefore, in
classical theory of employment, the rate of interest is a strategic variable,
which brings about equality between sav ings and investment Interest rate
maintains the equilibrium between savings and investment.
2.Wage Rate Flexibility and Employment : -According to the classical
economist, money wage cut policy can solve the problem Involuntary
employment is due to a rig id wage structure. If the wages can be lowered,
involuntary unemployment will disappear. A self -adjusting system of
wage will push the economy towards full employment stage.munotes.in

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30
Figure 2.2
2.5.2 Implications of Say’s Law: -
1.Automatic Adjustment of Full Employment -A free enterprise
economy automatically reaches a stage of full employment level. There
are no obstacles to full employment General employment and over
production are impossible.
2.Self-adjusting Mechanism: -Increase in supply will ensure an increase
in demand in the process of the functioning of a free capitalist economy
There is no need for government intervention.
3. Resource adjustment and utilisation of resources take place
automatically in an expanding capitalist economy. When new work ers and
firms start operating, they also help to produce additional output and
income. The entire economy becomes richer with the increased National
Income. The unused and new resources are also productively employed in
such a way as to benefit the whole s ociety.
4.Money plays a passive role. It is only a medium of exchange to
facilitate transactions. Behind the flow of money, there is a real flow of
goods and services, which is important. As a result, changes in the supply
of money has no effect on the e conomy‘s process of equilibrium at full
employment level.
5.A free enterprise economy under Laissez -faire policy has built in
flexibility. Market mechanism helps in optimum adjustments in the
economy.
6.Rate of interest is an equilibrating factor in c lassical theory. Flexible
interest rates lead to equilibrium between savings and investment.
2.5.3 Criticism: -
J.M. Keynes vehemently criticized the classical theory. The
assumptions on which the classical theory is based can be criticized The
Great Depr ession of 1930's has revealed the weaknesses of the classicalmunotes.in

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31theory. The classical theory could not suggest a solution to the problem of
a depressed economy facing large scale unemployment.
1.Unrealistic Assumptions at Full Employment: -According to Key nes.
The basic assumption of full employment itself is unrealistic. An
economy can be in a state of equilibrium. In under employment
situation also full employment equilibrium is just one possible
equilibrium condition according to Keynes.
2.Too much emp hasis on Long Run: -Keynes gave importance to the
short run According to him. In the long run, we are all dead.
3.Keynes refuted Say's Law of Markets: -According to Keynes, the
classical economists failed to examine the level of aggregate demand.
Supply may not create demand. Over production is a possibility and
reality according to Keynes. Supply can exceed demand. Hence
automatic self adjusting mechanism will not work.
4.Interest is not an equilibrating factor: -Keynes attacked the classical
theory in regard to savings and investment. Flexible interest rates will
not lead to equilibrium savings and investment. Changes in income
bring about the equilibrium between savings and investment according
to Keynes.
5.Role of money is neglected: -The classical economists considered
money as a veil. It s role is neutral. Keynes recognized the importance
of precautionary measures and speculative demand for money He also
recognized the effect of money on output, incomes, employment.
6.Keynes attacked the Laissez faire policy of classical economists. In the
conditions -of the modern world, state intervention is necessary to
solve the problem of unemployment. Government spending, taxation
and borrowing are important instruments to increase employment and
income in a n economy.
7.Wage cut policy is not practical. Due to the strong trade unionism it is
not possible to cut wage rates as suggested by the classical economists
as a remedy to employ more workers. A wage cut may in fact lead to
reduced purchasing power wit h workers which will lead to reduced
effective demand for products. This will adversely affect the levels of
employment. Hence a general wage cut will lead to reduced volume of
employment. The workers will revolt if the money wages are cut. This
is due to money illusion.
8.The classical system will work only if there is perfect competition. In
such a case there should not be trade unionism, wage legislation etc.
But in. reality, all these factors exist. Hence classical theory will not
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32Check Your Progress :
1.Examine the statement : The classical theory was a supply oriented
theory.
2.What are the main postulates of classical theory of employment?
3.State the assumptions of Say s Law of Markets.
2.6 SUMMARY
1.Thoug h different business cycles differ in duration and intensity they
have some common features.
2.A business cycle has four phases.
Prosperity (Expansion, Boom, or Upswing)
Recession (upper turning point)
Depression (Contraction or Downswing) and
Revival or Re covery (lower turning point)
3.Prosperity is a stage in which the money income, consumption,
production and level of employment are high or rising and there are no
idle resources or unemployed workers.
4.When the phase of prosperity ends, recession starts. Rec ession is an
upper turning point. This is a phase of contraction or slowing down of
economic activities. Recession is generally of a short duration.
5.Depression is a stage in which the money income, consumption,
production and level of employment falls, idl e resources and
unemployment increases.
6.When the economy enters the phase of recovery, economic activity
once again gathers momentum in terms of income, output,
employment, investment and effective demand.
7.The belief of classical theory regarding the exist ence of full
employment in the economy is based on Say's Law put forward by a
French economist J B. Say. According to J. B. Say's law. "Supplymunotes.in

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33creates its own demand". This implies that any increase in production
made possible by the increase in the produc tive capacity or the stock
of fixed capital will be sold in the market. There will be no problem of
lack of demand.
2.7 QUESTIONS
1.What are the features of trade cycle?
2.What is a business cycle? Explain the different phases of a trade cycle.
3.Explain clas sical macroeconomics with special reference to Say’s Law
of Markets.
4.State and explain the Say’s Law of markets.

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34Module 2
3
BASIC CONCEPTS OF KEYNESIAN
ECONOMICS
Unit Structure :
3.0 Objectives
3.1 Introduction
3.2 Introduction of t he Keynesian Theory of Income and Employment
3.3 The Principle of Effective Demand
3.4 Consumption Function
3.5 Keynesian Multiplier Theory
3.6 Introduction o fthe Investment Function
3.7 Summary
3.8 Questions
3.0 OBJECTIVES
To study Keynesian theory of income and employment
To understand the concept of effective demand
To understand the meaning of consumption function
To study Keynesian multiplier theory
To study the concept of investment function
To understand the concept of marginal efficiency of capital
3.1 INTRODUCTION
With reference to the last modules classical economists views on
national income and employment, in this module modern economist, J. M.
Keynes views on national income and employment has been explained.
3.2INTRODUCTION OF THE KEYNESIAN
THEORY OF INCOME AND EMPLOYMENT :
J.M. Keynes in his book "The General Theory of Employmen t,
Interest and Money, popularly known as the General Theory, published
in 1936 rejected the classical theory of full employment equilibrium. He
brought out the real determinants of income and employment in a modern
economy. His theory is called General theory since he studied all the
cases of employment i.e. full employment, less than full employment, and
more than full employment. According to Keynes, the economy canmunotes.in

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35be in equilibrium at any level of employment. Full employment is just one
possible situat ion in an economy. Underemployment situations are more
common. Another reason why Keynes theory is called the General
Theory is that it explains inflation as well as unemployment.
Inflation is due to excess demand, whereas unemployment is due to lack
of de mand. Thus Keyne s theory is demand oriented. It stresses effective
demand as a crucial factor in determining the levels of income and
employment. Yet another reason for Keynes theory being called a genera
Theory is that it integrates theories of money and value. Keynes in
contrast to the classical economists gave importance to the short run
equilibrium. Keynes assumed that the amount of capital, '
population, techno logy etc, do not change in the short run. Therefore, in
the short run, the income and the out put depend on the volume of
employment. The levels of employment in turn depend on the effective
demand, which depends on aggregate spending. Hence it is necessary to
know ‘what is effective demand ?’.
3.3THE PRINCIPLE OF EFFECTIVE DEMAND
The principle o f effective demand occupies a strategic position in
Keynes theory of employment. Effective demand manifests itself in the
total spending of the commodity on consumption and investment
goods. Total employment depends upon effective demand Therefore
unemploy ment results from lack of effective demand. Higher the level of
effective demand, the more the level of employment in the economy.
Effective demand depends upon 2 factors -Aggregate
demand function, and aggregate supply function.
3.3.1 Aggregate Demand Price and Function: -
The aggregate demand price for the output of any given
amount of employment is the total sum of money or proceeds which is
expected from the sale of the output produced .when that amount of labor is
employed. In other words, the aggreg ate demand price is the amount of
money, which the entrepreneurs expect to receive from the sale of output
produced at a particular level of employment. The aggregate demand
curve or function is a schedule of the proceeds expected from the sale of
the outp ut at different levels of employment. The aggregate demand
curve slopes upwards from left to right. It means that as the level of
employment and income increase aggregate demand price also increases
With increase in income, people tend to spend a small amount of income
on consumption goods, Hence with increase in output and employment,
aggregate demand price increases at a diminishing rate The slope of the
curve diminishes will increase in employment. The figure below depicts
an aggregate demand function.munotes.in

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36
Figure 3.1
3.3.2 Aggregate Supply Price :
The main aim of an entrepreneur in a capitalist society is to earn
profits. The producer will employ workers in such a way as to maximise
profits. Employment of labour means that some costs have to be
incurred. Ac e r t a i nm i n i m u ma m o u n to fp r o c e e d sw i l lb e necessary to induce
employers to provide any given amount of employment. The supply price
for any given quantity of commodity refers to that price at which the
seller is willing or is induced to supply that amou nt in the market. If the
seller does not get the minimum receipts, he will reduce output and
employment. The aggregate supply curve or function is a schedule of the
minimum amount of proceeds required to induce entrepreneurs to provide
varying amount of em ployment. It shows the cost of producing a certain
level of output or the minimum receipts which must be obtained if that
level of output is to be maintained. The aggregate supply function slopes
upwards. The shape of aggregate supply function depends enti rely on
technical conditions of production. It is decided by the manner in which cost
rises in response to expansion of employment. The figure below shows the
aggregate supply function.
Figure 3.2
3.3.3 Equilibrium Level of Employment: -
The intersectio no ft h ea g g r e g a t ed e m a n df u n c t i o nw i t h aggregate
supply function determines the level of income and employment. The
aggregate supply schedule represents costs involved at each possible level
of employment. The aggregate demand schedule represents the
expectation of maximum receipts of the entrepreneur at each possiblemunotes.in

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37level of employment. As long as receipts exceed costs, the level of
employment will go on increasing. The process will continue till receipts
become equal to cost. At the point of equilibrium ,t h ea m o u n to fs a l e s
proceeds which the entrepreneurs expect to receive is equal to what
they must receive in order to just appropriate their total costs.
Figure 3.3
The point E, where the aggregate demand curve intersects the
aggregate supply curve is called the point of effective demand. The
equilibrium level of employment is ONF. This is not necessarily full
employment. If the level of employment is more or less than ON, the
profits will be less than maximum. ONF level of employment is the full
employment level in the diagram since at this level of employment the
aggregate supply curve AS is vertical in shape. Hence ON level of
employment is less than full employment. This happens because
investment demand is insufficient to fill the gap between inc ome and
consumption.
Figure 3.4
For reaching full employment, employment level has to be
increased. For this either the aggregate supply curve should be lowered or
aggregate demand should be increased. Increasing the aggregate supply
curve will necessit ate increase in the productivity. This is a long run
problem. Keynesian theory is concerned with short run analysis. Hence
raising the aggregate demand is possible. This shifts the equilibrium point
to £1. This is the full employment equilibrium. Any expan sion of demand
beyond E1 will lead to inflation.munotes.in

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383.4CONSUMPTION FUNCTION
In Keynes theory of income and employment, we have already
seen that the volume of employment in a society depends on the level of
effective demand which in turn is determined by th e aggregate demand
function. The aggregate demand is made up of 2 components i.e.
consumption expenditure and investment expenditure. Consumption
expenditure is a major component of aggregate demand in a neconomy.
The consumption expenditure depends on the size of income and
propensity to consume, which is called consumption function. The
marginal efficiency of capital and the rate of interest determine
investment. The Investment multiplier expresses the relationship between
the increases in investment and increases in consumption. We will be
studying the consumption function and the investment Multiplier in this
unit.
In macro economic theory, Keynes singled out income as the main
determinant -Of consumption. The relationship is expressed in the form of
afunction. The consumption function is the assumed direct relationship
between the national income level and the planned or desired consumption
expenditure. Keynes called it the propensity to consume. Algebraically the
basic relationship between consumption spending and national income is
shown as C = f(Y)
'C' stands for consumption function, 'Y' stands for national income,
'f. stands for functional relationship.
The simplest form of relationship between income and
consumption can be expressed as follows .
C=c Y
This means that the consumption (C) is a constant proportion (c) of
income (Y)
According to Keynes, at various income levels, a schedule of the
propensity to consume is a statement showing the functional relationship
between the level of consumpti on at each level of income.
TABLE: 3.1 CONSUMPTION FUNCTION
INCOME YCONSUMPTION (C) (In crores ofrupees)
200
300 220
400 300
500 380
600 540
700 620munotes.in

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39The schedule relating to the various amounts of consumption at
different levels of income is c alled the consumption function, it is clear
from the above table that consumption is an increasing function of income
since both the variables Y and C move in the same direction. Consumption
function can be represented diagramatically as below.
3.5KEYNES IAN MULTIPLIER THEORY
The multiplier theory explains the effect of changes in the
investment upon the consumption expenditure and the resulting generation
of income. The theory of multiplier is an integral part of the General
theory of employment since it establishes a precise relationship between
aggregate employment and income and the rate of investment, given the
marginal propensity to consume According to the multiplier theory, when
there is an increment of aggregate investment, income will increase by an
amount, which is K times the increase of investment. It explains the
cumulative effects of changes in investment on income through their
effects on consumption expenditures. It helps us to understand the
dynamic process of income generation.
3.5.1 The Concept of Multiplier:
R.F Kahn developed the concept of multiplier in 1931. This was
used to explain the effect of an increase in investment on employment.
Keynes used the idea to explain the effect of an increase in investment on
income Keynes multiplie r is known as the investment income multiplier.
Multiplier expresses a relationship between an initial increment in
investment and the resulting increase in aggregate income. Multiplier is
the numerical coefficient which indicates the increase in income w hich
will result in response to an increase in investment It is expressed as the
ratio of the realised change in aggregate income to the given change in
investment. i.e the reciprocal of the MPS
3.5.2 The Working of the Multiplier Process :
Sequence analy sis helps us to understand the working of the
multiplier. For ex., during a given period, if the investment goes up by
Rs.10 crores income goes up by Rs. 10 crores. Suppose MPC is 0.5 or
50%, Rs.5 crores will be spent for consumption by the people who rece ive
this income. The amount spent on consumption means a further amount of
income received within the economy. Those people who received Rs. 5
crores now will spend 50% of that income in consumption i.e.Rs.2.5
crores in the second round. In the third round , Rs.1.25 crores will be
generated and so on. The interval between consumption responses is the
multiplier period". As we move from one multiplier period to another, the
addition to the income gradually diminishes. The process will continue till
the total increment in income becomes so large that it results in additional
savings which is equal to the increase in investment. This process can be
explained with the help of a formula.munotes.in

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40
ΔY = increase in income, ΔI, initial increase in investment, c = MPC
Since the absolute value of C is less than 1, the sum of the infinite
geometrical progression is
= 10 x 2 = Rs. 20 crores
Given the MPC to be 0 .5 an initial investm ent of Rs 10 crores will
lead to Rs. 20 increase in the income. In the above example, Keynes
ignores time lags. Modern economists on the other hand feel that it takes
time for the impact of the initial investment to make itself felt throughout
the entire e conomy.
The multiplier effects of investment on income can be
diagrammatically shown
Figure 3.5
The C curve is the consumption curve and it is drawn on the
assumption that MPC is consta nt at all levels of income i.e. 0.5. The level
of effective demand is determined by consumption and investment outlays
i.e. consumption and investment. This is super imposed on the C curve.
The 45 degree line OY shows that Income = Consumption + Savings. The
original equilibrium is at E where the consumption + Investment curve
intersects the 45 degree line. The equilibrium level of income is O. As
new investment is injected, the line shifts to C + I + Δ I.munotes.in

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41The new equilibrium point is at E1 and the new equilibrium
income is OY, Taking the original example, an initial outlay of Rs. 10
leads to an increase in income to Rs. 20, where K = 2. Hence theincrease
in income (Δ Y) is a multiplier of the increase ininvestment (Δ l).
4.1.3 Assumptions of the Multiplier Theory :
The following are the assumptions of the multiplier theory :
1.Constant Marginal Propensity to Consume.
2.Monetary and fisc al policies remain stable so that they do not affect
the propensity to consume.
3.The multiplier period is absent.
4.Excess capacity exists in the economic system. The assumption is that
the economy operates at less than full employment.
5.Closed e conomy is another assumption. The effect of international
economic transactions are ruled out.
6.There should be a net increase in investment.
7.Consumer goods are available in sufficient quantities.
4.1.4 Leakages of the Multiplier :
There are ser ious limitations in applying the concept of multiplier
in practice. Certain forces, which operate in an economy, reduce the
strength of the process of income propagation. -Leakages reduce the
income generated. They are
1. Increase in the MPS: The higher the marginal propensity to save, the
greater the leakages of additional income out of the income. In a
dynamic economy, the MPC or MPS is not constant. With increases in
income MPS rises. As a result, the multiplier value may fall.
2.Debt Cancellation: Paying back of debts taken by people reduces the
value of the multiplier since consumption is reduced.
3.Hoarding Idle Cash Balances: If people prefer to hold liquid cash than
spend it on consumption goods, it will lead to a leakage from the
income stream and reduce the value of the multiplier.
4.Imports: the income spent on imports will not lead to income
generation within the domestic country, and hence leads to a
restriction of the value of the multiplier.
5.Purchase of Old Shares and Securities: If t he newly generated income
is used to buy old stocks, shares and securities, consumption will be
less and as a result, the value of the multipliers will be low.
6.Inflation: Rise in the prices adversely affects the real consumption of
people. Hence consump tion will not increase during inflation. This
also affects the value of the multiplier.munotes.in

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423.5.3Criticism :
1.It is a static phenomenon: it does not explain the dynamic change. It
explains the process of income propagation from one point of
equilibrium to another under static assumptions. The actual sequence
of events is not explained.
2.It is a timeless phenomenon: Keynes assumed an instantaneous
relationship between income, consumption, and investment. However,
there are time lags between consumption and income. Hence according
to modern economists, multiplier effect takes time to make an impact.
3.No Empirical Evidence: There is no empirical evidence to prove the
operation of multiplier effect. It does not tell us anything about the real
world.
4.It gi ves too much importance to Consumption: The emphasis is
exclusively on consumption.
5. The theory has neglected the derived demand phenomenon of
investment in capital goods sectors. It fails to establish a relationship
between the demand for capital goods and consumption goods.
6.Some economists like Prof. Hazhtt hold that the multiplier concept is
only a myth .There cannot be a precise mechanical relationship
between investment and income
Check Your Progress :
1.Examine the working of the multiplier pr ocess.
2.Explain the factors which reduces the strength of the process of
income generation.
3.6INTRODUCTION OF THE INVESTMENT
FUNCTION
In modern macroeconomic analysis, the term investment refers to
real investment.
A firm invests when it uses steel or other material to build plant or
when new machines are purchased. This is real investment. When a person
buys shares or deposits money in the money in the bank, it tends to be
financial investment.
Investment leads to the production of new capital goods -plant and
equipment. Capital formation takes place if the newly produced capital
goods leads to a net addition to the given stocks of capital assets over and
above their replacement requirement (depreciation).munotes.in

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43Investment may be eithe r gross investment or net investment.
Gross investment is defined as a flow of expenditure or new fixed capita l
assets or an addition to inventories over a given period of time. Since we
are not considering inventories, gross investment means the investmen t
expenditure on fixed capital. A part of the new capital will be needed
simply to replace the depreciated capital stock This must be deducted to
find out the net addition to the existing capital stock Therefore, Net
investment = Gross investment Depreciat ion of Fixed Capital investment
can also be classified into autonomous investment and induced
investment. Autonomous investment does not change with the changes in
income i.e. it is independent of income. It takes place in construction of
roads, building e tc.
Autonomous investment depends on population growth and
technical progress than on the level of income. Most of the investment
activity of the government is autonomous in nature Induced investment
changes with changes in income,
3.6.1 Determinants o f Investment :
Investment function refers to inducement to invest or investment
demand. According to the classical economists, investment demand is a
decreasing function of the rate of interest.
FORMULA
I = f (i) where I = Investment
(i) = rate of inter est
According to Keynes, the volume of investment depends upon two factors,
1) The marginal efficiency of capital and 2) The rate of interest. The
marginal efficiency of capital is called the expected rate of profit.
Prospective investors
Prospective inv estors will compare the marginal efficiency of
capital with the rate of interest Inducement to investment depends on these
two factors. If investment is to be profitable, the expected rate of profit
must not be less than the current rate of interest in the market. New
investment will take place if the expected rate of profit is greater than the
rate of interest. The rate of interest does not change in the short run. Hence
inducement to invest basically depends on the marginal efficiency of
capital.
3.6.2 Marginal Efficiency of Capital:
To examine the profitability of ventures, Keynes introduced the
concept of marginal efficiency of capital. Marginal efficiency of a given
capital asset is the highest rate of return over the cost expected from an
additional o r marginal unit of that capital asset According to Kurihara,
marginal efficiency of capital is the ratio between the prospective yields of
additional capital assets and their supply price, expressed as e = Q / Pmunotes.in

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44Where e = marginal efficiency of capital
Q= the expected yield of return
P = The supply price of this asset.
Hence the marginal efficiency of capital depends upon two
factors -1) The prospective yield from the capital asset, 2) the supply
price of this asset. "Prospective yield" mea ns the amount of annual income
an investor expects to obtain from selling the output of his investment or
capital assets after deducting the running expenses In other words, the
prospective yield of a capital asset is the aggregate net return expected
from it during its life time The total expected life of a capital asset can be
divided into a series of periods i.e. years. The annual returns or annuities
can be represented by Q1, Q2, Q3, Q4. The series of annuities or returns is
called prospective yield of investment. An investor has to consider the
supply price of an asset. The supply price of a particular type of asset is
the cost of producing a totally new -asset of that kind Combining the two
concepts. Keynes defines marginal efficiency of capital as "bei ng equal to
that rate of discount which would make the present value of the series of
annuities given by the return expected from the capital asset during its life
just equal to its supply price In other words, the marginal efficiency of a
capital asset is therate at which the prospective yield expected from one
additional unit of the asset must be discounted if it is just equal to the cost
i.e. the supply price of the asset The following equation signifies the
concept of MEC.
FORMULA
12 3
23....1 11 1nnRR R RCrrr r    
C = Supply price of capital assets
R1,R2,R3…………………… R nare the annual prospective yields from
the capital asset, 'r' is the rate of discount or the marginal efficiency of
capital, 'r' is the internal rate of return on R that asset. The term
111Rr
represents the current value of the annuity or yield receivable at the end of
the first year, discounted at the rate 'r'. If the rate of discount is assumed to
be 10%, each rupee which we expect to get after a year is worth 90.91
paise now i.e. 90.91 paise currently invested at 10% will become one
rupee within a year. In the same way, (1 + e)2represents the current value
of annuity or return expected at the end of the second year discounted af
the rate of r.
An example can be taken to explain how the marginal efficiency of
capital is calculated .If we suppose that the supply price cost of a machine
is Rs, 1600 and its economic life is two years, the prospective yield on this
machine in each year is Rs. 1440 and its disposal value is also Rs.1440.
The marginal efficiency of capital can also be obtained.munotes.in

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45

2
2
22
2
21440 144016001 1
1600 1 1440 1 1440
1600 1 2 1440 1440 14401600 3200 1600 1440 1440 14401600 1760 1280 0r r
rr
rr r
rr rr
 
 
 By using the formula for the root of anabatic equation
ax2+b x+c=0
242b b acxa

21760 1760 4 1600 12802 16001.6 0.5rr or r  

Since 'r' cannot be nega tive r = 0.5 or r = 50%
If this is the rate of return, investment in the machine will be
profitable, if the cost of borrowing funds (rate of interest) is less than
50% i.e. given the cost of capital asset at Rs. 1600, MEC was calculated at
50%. Suppose th e ratio of interest is 18%. investment will be profitable.
MEC Schedule (curve)
MEC falls as investment increases due to fall in the prospective
yield and increase in the supply price of the capital assets. The marginal
efficiencies of all types of capit al assets which may be made during a
given period of time represents the schedule of MEC or the investment
demand schedule.
Table 3.2
MEC Schedule
Investment Rs. MEC %
20000 15
50000 12
75000 10
It is clear from the above table that as investment incr eases
MEC goes on falling. The downward slope of the curve shows the inverse
relationship between investment and MEC i.e. an increase in investment
will lead, to a fall in MEC.munotes.in

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46
VOLUME OF INVESTMENT
Figure 3.6
The more elastic the MEC curve, the greate rt h ei n v e s t m e n tg i v e na
fall in the interest rate. Usually the MEC curve tends to be inelastic. MEC
curve shifts if the profit expectations change or the technology improves.
Keynes believed that investment responds to changes in expectation and
shifts in MEC rather than the rate of interest.
MEC and t he Rate of Interest:
MEC is expressed as a ratio and compared to the rate of interest.
There is a comparison between the expected rate of profit and the rate of
interest. In effect it is a comparison between thesupply price of an asset
and its demand price. Keynes makes a distinction between the demand
price and the supply price of a capital asset. The demand price of an
asset is defined as the sum of the expected future yields discounted at
the current rate ofinterest. We have already seen that supply price = the
sum of prospective yields discounted by the MEC.
In symbolic terms, demand price of an asset can be put as follows.
23
23.....1 11 1nnQQ Q QDPiiii    
DP = demand price, Q1, Q2, Q3,... Qn = the prospec tive yield or
annuities, i = current rate of interest.
For Example, the market value of an asset., which promises to yield
Rs. 1600 at the end of one year and Rs. 1210 at the end of 2 years will be
estimated at higher than Rs 2000, when the interest rateis less than 10%.
If the market rate of interest is 5% the present value of capital asset will
be
21100 1210Demand Price 1047.62 10971.05 1 0.052144.62  


This is the demand price of a capital asset.
The effect of the relative positions of demand and supply on the
behaviour of invest or in taking decisions will be as followsmunotes.in

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471)When MEC = interest rate, SP = DP -neutral
2)If MEC > DP > SP -favourable
3)When MEC < DP < SP –unfavourable
The two strategic variables in investment decisions are the MEC
and the rate of interest. MEC of an a sset falls as I in that asset increases.
The reasons are,
1. The prospective yield of that asset will fall as more units are produced.
More production will lead to the units competing with each other to
meet the demand for the product.
2T h es u p p l yp r i c e of the asset will rise as more of the assets are
produced. Investment will be in equilibrium when MEC becomes equal to
the given current rate of interest. This is given by the following diagram
Figure 3.7
At i 1rate of interest investment is OM 1. At thi s level of investment,
MEC = i 1.I ft h er a t eo fi n t e r e s tf a l l st oi 2,i n v e s t m e n tw i l lr i s et o OM 2.
However change in profit expectation can shift the MEC curve also.
Figure 3.8
This is shown by the above diagram. Due to rise in profit
expectation, M EC curve shifts to MEC 1.A sar e s u l ti n v e s t m e n ta l s o increases
to i 2. MEC is the prime factor in determining investment, since rate of
interest is rather rigid during the short period.munotes.in

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48Factors Affecting MEC :
A number of short run and long run factors a ffect the marginal
efficiency of capital.
Short run Factors:
1.Expectation about demand, price and cost of Production: It there
is an expectation of demand to increase and hence prices to rise,
a high MEC leads to increased investment and vice versa
2.Busines s Optimism and Pessimism: If the atmosphere is one of
optimism , entrepreneurs will estimate MEC to be high.
3.Changes in Income: Unexpected windfall gains suddenly
increases income levels. This will induce an increase in MEC.
4.An increase in the propensity t oc o n s u m ew i l lr a i s et h eM E C and
vice-versa: Increased demand for consumption goods will induce the
demand for capital goods
Long Run Factors :
1.Population Growth: Increase in population leads to increase in demand.
MEC will increase as a result.
2.Technolog ical Advancement: Improvement and growth of new
technology leads to new products, new markets etc .This will have a
favourable impact on the MEC.
3.Development of Infrastructure :D e v e l o p i n gt h ei n f r a s t r u c t u r e
also has a positive -impact on the MEC in the l ong run.
Check Your Progress :
1.State which two factors determine the investment demand.
2.Examine the factors which affect MEC.
3.7 SUMMARY
1.J.M. Keynes in his book "The General Theory of Employment, Interest
and Money, popularly known as th e General Theory, published in
1936 rejected the classical theory of full employment equilibrium.munotes.in

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492.The principle of effective demand occupies a strategic position in
Keynes theory of employment. Effective demand manifests itself in
the total spending of th e commodity on consumption and investment
goods. Effective demand depends upon 2 factors -Aggregate demand
function, and aggregate supply function.
3.The consumption function is the assumed direct relationship between
the national income level and the plan ned or desired consumption
expenditure. Keynes called it the propensity to consume. Algebraically
the basic relationship between consumption spending and national
income is shown as C = f(Y)
4.According to the multiplier theory, when there is an increment o f
aggregate investment, income will increase by an amount, which is K
times the increase of investment. It explains the cumulative effects of
changes in investment on income through their effects on consumption
expenditures. It helps us to understand the d ynamic process of income
generation.
5.Investment function refers to inducement to invest or investment
demand. According to the classical economists, investment demand is
a decreasing function of the rate of interest.
FORMULAI = f (i) where I = Investment (i) = rate of interest
6.According to Keynes, the volume of investment depends upon two
factors, 1) The marginal efficiency of capital and 2) The rate of
interest. The marginal efficiency of capital is called the expected rate
of profit.
7.According to Kurih ara, marginal efficiency of capital is the ratio
between the prospective yields of additional capital assets and their
supply price, expressed as e = Q / P
Where e = marginal efficiency of capital
Q = the expected yield of return
P = The supply price of th is asset.
3.8 QUESTIONS
1.Differentiate between aggregate demand function and aggregate
supply function.
2.Explain the concept of effective demand.
3.Explain the meaning of consumption function.
4.Discuss the concept of Keynesian multiplier.
5.Critically examine the working of Keynesian multiplier.
6.Explain in detail the concept of marginal efficiency of capital.
munotes.in

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504
INVESTMENT MULTIPLIER EFFECT ON
INCOME AND OUTPUT
Unit Structure :
4.0 Objectives
4.1 Introduction
4.2 Theory of Multiplier
4.3 The Princip le of Acceleration
4.4 Super Multiplier
4.5 Relevance of Keynesian Theory Tools to The Developing
Countries
4.6 Summary
4.7 Questions
4.0 OBJECTIVES
To study the theory of investment multiplier
To study the principle of acceleration
To understand the c oncept of super multiplier
To understand the relevance of Keynesian theory tools to the
developing countries
4.1 INTRODUCTION
In this section we will learn the Keynesian explanation of the terms
investment multiplier. In what way investment multiplie raffect the
income and output is therefore necessary to study. In subsequent topic,
relevance of Keynesian tools to the developing countries economies is
explained.
4.2THEORY OF MULTIPLIER
The theory of multiplier was first developed by Prof. R.F. Kahn in
1931. It explains the effects of initial increase in investment on aggregate
employment. Kahn’s multiplier was thus known as ‘employment
multiplier.’
J.M. Keynes used the concept of multiplier to analyze the effects
of change in investment on income v ia changes in consumption
expenditure. Thus this multiplier came to be known as the investmentmunotes.in

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51multiplier. It may be defined as “the ratio of the change in income to the
change in investment.” It is symbolically expressed as, K = ΔY/ ΔI.
Where K = Stand s for Multiplier, ΔY = change in income and ΔI= change
in investment.
In an economy, when there is a small increase in investment, there
would be multiplier increase in national income. For example, if the
investment is increased by Rs. 4 cro. and if as a result, the national income
increases by Rs. 20 cro. the value of ‘K’ (multiplier) will be 5. In other
words, investment multiplier points out that, national income will rise
much more than the initial increase in investment. A part of this additional
income is spent on consumption goods. Since, one man’s expenditure is
another man’s income. The consumption expenditure of the people at the
first round would become income of the people at the second round and so
on.
Graphical Presentation -
The multipli er is depends upon the marginal propensity to
consume (MPC). If the MPC is higher, the size of multiplier would be
higher and vice versa. The concept of multiplier can be explained with the
help of following diagram.
Fig. 4 .1
In the above diagram, OX axis represents income and OY axis
represents investment, consumption expenditure and savings. 450line is
known as consumption line. C+I is the initial investment curve which
interse cts ON line at E 1point .When the investment is C+I the national
income is OY 1. When there is an increase in investment from C+I to C+I 1
the national income would rise from OY 1to OY 2.
Working of the Multiplier -
The working of ‘K’ is explained as unde r. The following table
shows how there would be a multiplication in income according to incomemunotes.in

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52propagation assuming that MPC is half or 50% of the income with the
initial investment of Rs. 200 crores.
Table 4.1
Rounds Initial investment ΔY ΔC ΔS
1st200 cro. 200 100 100
2nd100 50 50
3rd50 25 25
4th25 12.50 12.50
5th12.50 6.25 6.25
6th6.25 …. ….
Finally 200 400 200 200
The above table shows that the initial investment of Rs. 200 crores
is the income of the people . Out of 200 crores 50% i.e. Rs. 100 crores is
spent on consumption and remaining amount of Rs. 100 crores is saved.
The consumption expenditure of the people at the first round would
become income of the people at the second round. Again out of Rs. 100
crores Rs. 50 crores is spent on consumption and remaining Rs. 50 crores
is saved. The consumption expenditure of the people at the second round
would become income of the people at the third round. Again 50% of the
income is spent on consumption and remain ing 50% is saved. This process
will go on and on till the initial income of Rs. 200 crores would not
become zero.
Calculation of the Multiplier -
The value of ‘K’ or multiplier is equal to reciprocal of 1 -MPC. It
is symbolically expressed as, K =
or K =
If MPC is 4/5 then,
K=
K=
, K = 5. The value of ‘K’ will be 5.
The following table would indicate the different values of ‘K’ at
different MPC figures.munotes.in

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53Table 4.2
MPC MPS Value of ‘K’
0 1 1
1/2 1/2 2
2/3 1/3 3
3/4 1/4 4
4/5 1/5 5
1/3 2/3 1
3/5 2/5 2
8/9 1/9 9
9/10 1/10 10
99/100 1/100 100
1 0 Infinity
So from this schedule it is clear that larger the MPC the greater
would be the value of ‘K’ and vice versa.
Reverse working of the Multiplier -
So far, we have described the working of the multiplier in the
forward direction. But the multiplier may work in the reverse or backward
direction also. It means that a decrease in investment causes a multiple
decrease in aggregate income. For example, if inv estment decreases by Rs.
10 cr. , it will reduce the income by an equal amount. If MPC is half,
consumption ex penditure will fall by Rs. 5 cr . Thus reduction in
investment lead s to the reverse operation of the multiplier which causes a
decrease in aggregate income. This is shown in the following figure with
the help of saving and investment curves.
Fig.4 .2
In the above diagram horizontal straight line is autonomous
investment curve. SS curve is the saving curve. The I curve is the original
investment curve which intersects SS saving curve at E point. At this point
the equilibrium level of income is OY. When the investment decreases themunotes.in

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54original investment curve I shift downwar ds to the I 1.The new investment
curve I 1intersects the SS saving curve at E 1point. At this equilibrium
point the level of income decreases from OY to OY 1.The fall in income
(ΔY) is a multiple of decline in investment (ΔI).
Thus in a community with lower MPC, the initial decline in
investment will have greater adverse effect on the level of income and
employment. However, MPC is less than one but greater th an zero. This
implies that people neither spend the full amount of extra income nor
reduce consumption by the full decrement of income. Hence income and
employment cannot continue to decline till to zero. This otherwise, reverse
working of the multiplier w ould imply a complete collapse of the
economy.
Assumptions -
The concept of multiplier is based on the following assumption.
1.The value of multiplier depends upon increase in investment.
2.It is assumed that the increase in investment has not furthe r indirect
effects on investment.
3.The calculation of multiplier depends on the assumption of a closed
economy.
4.The MPC is constant.
5.There exists unemployment in the economy.
6.There is absence of multiplier period.
7.Keynes has assumed that, change in investment is of autonomous and
not induced type.
8.It is assumed that the consumer goods are regularly made available.
Leakages in Multiplier Process –
The size or value of multiplier is reduced by the leakages in
income stream on account o f the following factors.
1. Savings -In actual life the people does not spend the entire increase in
income on consumer goods. On the contrary they save a part of it. The
saved portion of increased income does not get converted in
investment. This limits the value of ‘K’. Thus higher the propensity to
save of the people lower shall be the value of ‘K’.
2.Repayment of old debts –The income recipients may repay their old
debts to lenders instead of spending their income on consumer goods.
The value of ‘K ’ is reduced if lenders who receive this money from the
borrowers do not spend it.
3.Accumulation of idle cash deposits -A part of increased income may
be saved in the form of idle bank deposit instead of spending their
income on consumer goods. The val ue of ‘K’ is reduced if the bankers
who receive this money do not spend on consumer goods.munotes.in

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554. Purchase of old assets –The income recipients may buy old assets such
as shares and securities from the people who may not increase their
consumption. This will reduce value of ‘K’.
5. Excess of import –The import of foreign goods may be increase this
will not help the domestic employment. This is because money is spent
on foreign goods resulting in a net outflow of funds to foreign
countries. This would reduce value of ‘K’.
6. Inflation –The rise in prices would reduce additional money
expenditure even to buy same amount of goods and services. Hence
actual consumption may not increase. This will reduce value of ‘K’.
7. High taxes –High rate of taxes may lead t o decline in consumption
expenditure and the value of ‘K’.
Limitations -
1. Availability of consumer goods –The theory assumes that multiplier
depends upon the availability of consumer goods. The shortage of
consumer goods will not increase the consumpti on expenditure.
Ultimately it will reduce the magnitude of multiplier.
2. Full employment level –The multiplier works in the economy where
the level of income is low and unemployment is high. Once the
economy reaches the level of full employment the multi plier fails to
work. At this level any increase in investment will not increase
aggregate output and employment. This will limit the value of ‘K’.
3. Multiplier period –According to Keynes, when income of the people
increases they spend a part of it on co nsumption and remaining amount
is saved. But in reality there is time gap between the receipt of
increased income and the expenditure on consumption. This time gap
is called as multiplier period. The value of multiplier depends upon the
multiplier period o f the time gap. Longer the time gap, the smaller will
be the value of ‘K’ and the smaller the time gap, the larger will be the
value of ‘K’.
4. Availability of resources –The concept of multiplier depends on the
availability of resources for the productio n of consumer goods. But the
shortage of resources will adversely affect the working of the
multiplier and thus it will reduce the value of multiplier.
4.3THE PRINCIPLE OF ACCELERATION
The principle of acceleration was propounded first by a French
Econ omist Albert Aftalion in 1909. The principle is generally associated
with the name of an American Economist J.M. Clark in 1917.
Multiplier and accelerator are parallel concepts. Multiplier shows
the effect of change in investment on income (K = ΔY/ΔI). The
accelerator shows the effect of change in consumption on investment.munotes.in

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56The machine making industry depends on consumption goods
industry. It states that a given increase in the demand for consumer goods
in an economy generally leads to an accelerated increase in the demand for
investment goods. The principal of accelerator may be defined as, “the
ratio of change in investment to change in consumption.” We can illustrate
this with the help of a simple example.
An expend iture of Rs. 10 cr . on consumpti on goods
industry le ads to an increase of Rs. 20 cr . in investment goods industry. So
we can say that the value of accelerator is 2. The value of acceleration
depends upon the nature of investment goods. The principle of accelerator
is symbolically express ed as,IaC.
Where a = stands for acceleration co -efficient
ΔI = change in investment expenditure
ΔC = change in consumption expenditure
As stated above 20/10= 2 is the value of accelerator.
The operation of the principle of accelerator may be illustrated by
the following example.
Let us suppose that, in order to produce 1000 consumer goods 100
machines are required. We further suppose that, the working life of a
machine is 10 years and after 10 years the machine has to be replaced.
This means that every year 10 machines have to be replaced. While the
demand for consumer goods remained stable the annual demand for
machines would be 10. This might be called as replacement demand. Now
let us suppose that the demand for consumer goods rises by 10%, naturally
more machines will be required to meet the increa sed demand for
consumption goods. We shall now need 10% or 10 more machines to
increase the production of consumer goods. The annual demand for
machines will thus rise from 10 to 20 (10 machines for replacement
demand and 10 machines for meeting the increa sed demand for consumer
goods). The demand for machines shall be 20 which represent an increase
of 100%. The point to be noted here is that a comparatively small rise of
10% in the demand for consumer goods causes a rise of 100% in the
demand for machines.
Accelerator states that, the changes in the demand for investment
goods are larger than the changes in the demand for consumer goods
industries.
The principle of accelerator can be explained with the help of
following diagram.munotes.in

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57
Fig.4.3
In the above diagram, SS is the saving line slopes upward from
left to right. II and I 1I1are investment curves. OX axis represents savings,
investment and consumption. In this diagram II investment curve
intersects SS saving curve at point ‘E’. At this equilib rium point OM is the
equilibrium level of income and savings and investment both are equal to
each other (OA). However AB increase in investment is exogenous
investment. An increase in investment from OA to OB pushes the income
level from OM to OM 1.An inc rease in investment from II to I 1I1, the new
investment curve I 1I1intersects SS saving line at point E 1.At this
equilibrium point, the equilibrium level of income is OM 2and OC is the
saving and investment. An increase in investment from OB to OC is
induced investment. As a result, income level rises from OM 1to OM 2.
MM 1portion of increase in income is due to multiplier effect and M 1M2
increase in income is due to accelerator effect. This increase in income is
because of induced investment.
In short, t he principle of accelerator shows the change in
investment to the change in consumption.
Working of the Accelerator –
The working of the accelerator is explained by a hypothetical
example based on the following assumptions.
1. Current demand for consum ption goods is 1000 units.
2. To maintain a constant flow of 1000 consumer goods, 100 machines
(capital goods) are required.
3. The capital output ratio remains constant and is equal to 1: 10. The
acceleration co -efficient is 1.munotes.in

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584. The average life of a ma chine is 10 years. After 10 years machines have
to be replaced means 10 machines are needed a very year.
5. Any increase in demand for consumer goods will require additional
machines besides replacement demand.
Table 4.3 Working of the Accelerator
Period Consumption
goods unitsCapital
requiredReplacement
investmentInduced
investmentTotal
investment
0 1000 100 10 0 10
1 1000 100 10 0 10
2 1100 110 10 10 20
3 1200 120 10 10 20
4 1300 130 10 10 20
5 1500 150 10 20 30
6 1700 170 10 20 30
7 1900 190 10 20 30
8 2000 200 10 10 20
9 1900 190 10 -10 0
The above table shows total output of consumption goods, net
capital investment and total investment. When consumption demand rises
by 10% in period 2, total investment rises to 20 that is 100% incre ase in
investment. In period 3 and 4 the demand for consumption goods rises by
10% but total investment remains at 20. It shows that the total output of
consumption goods rises at the same rate. In period 5, 6 and 7the absolute
increase in output of consum ption goods is higher than the earlier periods.
The total investment rises further to 30 units of capital. In period 8, the
demand for consumption goods rises by 10% only. As a result, the total
investment falls to 20 units because the absolute increase in output is
lower. If the demand for final goods falls by 10% in period 9, the net
investment is negative. Hence, the total investment becomes zero.
It is clear from the above table that, net investment depends on the
changes in total output of consumpt ion goods, given the acceleration co -
efficient. Further net investment is positive so long as the demand for
consumption goods rises. However, when it falls, net investment is
negative. It is important to note that in general a small change in the
demand f or consumption goods leads to substantial change in induced
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59Limitations –
Generally, the principle of accelerator works in a way as explained
above. However, in reality it is difficult to find o ut the working of the
acceleration. The operation of the principle of acceleration has certain
limitations.
1. The life of machine used for producing consumer goods is an important
factor in the analysis of principle of acceleration. But in practice it is
very difficult to decide accurate life of the machine.
2. If the capacity of machines is in excess of actual requirements, the
increase in demand for consumers’ goods would not necessarily lead to
increase in investment. The increased demand can be met by using the
excess capacity.
3. If the demand for consumers’ goods is purely temporary in nature, then
there would be no rise in investment. In such a case, a producer would
overwork the existing machinery and thus avoid additional investment.
4. In certain cases, the investors do not wait for changes in the rate of
consumption and therefore, investment is made sufficiently in advance
assuming that the demand would increase in future. Generally, this
happens in case of the public sector undertakings.
5. The p rinciple is based on the assumption that the ratio between
consumption and investment remains constant. But in reality, it hardly
happens.
6. If the economy operates at level of full employment or near that level,
the principle of acceleration would have l ittle scope.
In spite of all these limitations, the principle of acceleration is
considered as a useful tool of economic analysis.
4.4SUPER MULTIPLIER
Combined Effects of Multiplier and Accelerator –
The principles of multiplier and accelerator are useful for
understanding the dynamic process of income generation. The principle of
multiplier explains the effect of change in initial investment on final
increase in income. On the other hand, the principle of accelerator
explains the effect of change i n consumption on the level of investment
and further on income and employment. This clearly shows that, the
principle of multiplier explains only one aspect of income generation. But
the principle of accelerator revels two important aspects namely -income
and employment. Hence, in order to measure the total effect of initial
investment on national income it is necessary to combine the effects of
multiplier and accelerator.
The combined working shows that on the one hand the
autonomous investment raises i ncome through consumption expenditure
as a result of multiplier effect. This induced consumption expendituremunotes.in

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60further leads to an increase in induced investment. This generates more
income as a result of accelerator effect. Again multiplier works because of
increase in investment and similarly, expands the increase in income and
employment. This leads to a flow of induced investment.
This effect of combined operation of the multiplier and
acceleration is called the ‘Leverage Effects’ or the super multiplie r. This
leverage effects brings about the accelerated change in income and
employment.
The process of income propagation by way of the multiplier and
accelerator principles can be explained with the help of following
example. Let us suppose that, the MPC is half or 50%. The ac celeration
co-efficient is 2 i.e.capital -output ratio is 2:1 and the initi al investment
expenditure is 100 crores.
The Following table shows that the initi al investment expenditure
of Rs.100 cr . generates an equal amou nt of incre ase in income i.e. Rs. 10
cro. The induced consumption expenditure in the first period from this
increased income will be Rs. 50 crores because MPC is half and the
induced investment is Rs. 100 crores. The acceleration co -efficient is 2
and income increase s to Rs. 250 crores (100 + 50 +100 = 250).
Table 4.4 Combined Effects of Multiplier and Accelerator
(In Crores)
Multiplier
periodInitial
InvestmentInduced
consumptionInduced
investmentTotal
increase in
National
Income
0 100 0 0 100
1 100 50 100 250
2 100 125 150 (2 X75 ) 375
3 100 187.50 125 (2 X 62.50) 412.50
4 100 206.25 37.50 (2 X 187) 343.75
Further, in the second period, the induced consumption
expenditure form this increased income is Rs. 125 cr. ,as the MPC is 50%
of the income. But, consumption in period 2 is a function of income of the
previous period. Therefore, the actual increase in consumption in period 3
is the difference between the period 2 and 1 i.e. 125 -50 = 75. H ence the
induced investment is Rs. 150 crores because the value of co -efficien ti s2
and income increases to Rs. 375 crores (100 + 125 + 150 = 375).
In this wa y, total inco me reaches the peak level of Rs. 412.50
crores in the third period. However, income starts falling from fourthmunotes.in

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61period as the induced investment declines. The effect of induced
investment comes to an end after a certain period.
The consumption expenditure falls further and thus the
acceleration effect becomes negative. However, income will once again
start rising due to autonomous investment.
The above table revels that induced investment will be high in the
initial stages when consumption i s quite high. But when additional
consumption expenditure is not high enough in the later stages the induced
investment will gradually fall.
The following diagram shows combined operation of the multiplier
and accelerator.
In the above diagram the hor izontal lines II and I 1I1are
autonomous investment of the multiplier. Further, the saving curve SS
intersects II investment curve at E point. At this point the equilibrium
level of income is OY at which S = I. When investment increases to I 1I1,it
interse cts SS curve at E1 point. At this new equilibrium point the level of
income increases from OY to OY1. Therefore, increase in income YY 1is
the multiplier effect.
Fig. 4 .4
On the other hand, in case of acceleration principle, the induced
investment is shown by the rising curve I 3I3.It shows that when
autonomous investment I 1I1is undertaken the rising curve I 3I3intersects
SS curve at E 2point. The horizontal line I 4I4shows indu ced investment.
At this equilibrium point E 2the level of income is OY2 which indicates
that induced investment brings about further increase in income from OY1
to OY2. Thus, Y1 Y2 is the acceleration effect and YY2 is the super -
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624.5 RE LEVANCE OF KEYNESIAN THEORY TOOLS TO
THE DEVELOPING COUNTRIES
J.M.Keynes by his publication of ‘The General theory’ (1936) has
had a great influence on economic policies of both developed and
developing countries. The Keynesian theory of income and empl oyment
was presented in 1936 in the context of the Great World Trade Depression
of 1929 -33. The Keynesian prescription have been adopted by some
advanced economies which succeeded in achieving high employment and
reasonable price stability. Economics in developing countries like India.
They argued that Keynesian prescriptions cannot be applied in developing
countries due to differences in economic structures of such countries from
those of industrially advanced countries. However, some modern
economists be lieve that some of the Keynesian concepts and prescriptions
are still applicable to the present developing countries.
I: The Traditional View: This view explains the views about the
irrelevance of Keynesian economics
1.Demand Deficiency: According to Keyne s, deficiency of demand or
purchasing power is the root cause of unemployment in advanced
countries. But in underdeveloped countries unemployment occurs
mainly due to shortage of capital and general scarcity of
entrepreneurship arising from lack of suffici ent employment
opportunities. In developing countries, the unemployment arises due to
the structural constraints/limitations -inadequate capital stock
compared to the size of labour force.
The Keynesian policy of increasing aggregate demand by increasing
government expenditure (financed by printing money) is quite relevant
for solving the problem of cyclical unemployment of capitalist
countries. But this policy cannot solve the problem of disguised
unemployment of developing countries caused by rapid growth of
population, especially in rural areas, shortage of physical capital and
inadequate availability of mass consumption goods. In simple terms,
since unemployment is not due to lack of demand, the solution to the
problem does not lie in creating additional demand or purchasing
power.
2.Stability v /s Growth: J. M. Keynes was concerned with the short -run
macroeconomic problems of the advanced capitalist countries. But
Keynes ignored the issue of economic growth which is a long -term
phenomenon. This is the major drawback of Keynesian economics.
Therefore, the Keynesian theories and policies cannot be applied to
study the problems of slow rate of economic growth of developing
countries as also to promote faster economic growth by adopting
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63Keynes did not address the problem of economic growth which is so
important for developing countries.
3.Irrelevance of Keynes’s Policy Prescriptions: According to some
economists the main Keynesian prescription or remedy i.e., increasing
government e xpenditure (through creating new money) is likely to
cause inflation in developing countries (LDCs or UDCs), rather than
increasing employment, output and real income. Whereas the Classical
prescription, i.e., increasing the rate of savings and capital for mation is
more effective for increasing employment and output in such
countries. This may be supported by a steady increase in the supply of
essential consumer goods, mainly food grains. Thus, the Classical
Supply Side policies are more relevant in UDCs ra ther than the
Keynesian Demand Side policies or measures.
4.Working of Multiplier: Keynesian multiplier principle does not work
in the developing countries for diminishing unemployment and for
raising income due to the existing structure of the economy.
Underdeveloped/ developing countries like India are still agrarian
economies. It is characterised by low productivity and low supply
elasticity. Under such situation, an increase in public investment
expenditure in agriculture is likely to have a different t ype of
multiplier effect. It will lead to an increase in the prices of agricultural
goods rather than an increase in the supply of such goods. A shortage
of industrial raw material (from agriculture) also leads to cost -push
inflation. In LDCs, there is not much excess capacity in consumer
goods industries. Similarly, it is not possible to increase the supply of
basic inputs in response to an increase in demand and the main
problem of labour -surplus countries like India is the prevalence of
disguised unemplo yment in rural areas. Thus Keynesian multiplier
principle fails to increase employment and output in such countries.
II. Modern Views: Relevance of Keynesian Economics: Modern
economists have found relevance of Keynesian economics, mainly in
developing co untries. Following points will explain this relevance.
1.Full Employment: The faith that in a free competitive economy
envisaged by the English Classical School full employment would be
automatically reached and the economy would stabilise there has been
completely shattered as a consequence of the General Theory of
Keynes. Thus the General Theory has dealt a death -blow to the laissez -
faire doctrine. Keynes has convincingly demonstrated that the
government will have to intervene and follow a positive and ste adfast
policy to raise the level of employment and thus avoid fluctuations in
the economy. Therefore, both in developed and developing countries, a
positive and interventionist policy is being followed by the
governments to realise the objective of full em ployment (or to raise the
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642.Demand Deficiency or Deficiency of Demand: In developing
countries also capital is bound to remain unutilised in spite of the fact
that the return on it is positive. According to Ragna r Nurkse ,i n
developing countries the inducement to invest is low due to limited
size of the domestic market for industrial goods. Wide spread poverty
and low per capita income is responsible for the low market for mass
consumption goods. Stagnation and demand def iciency is due to many
reasons such as slow growth in agricultural production, fall in
consumption demand of the rural people due to negative growth of
agricultural sector, slow down in the rate of investment in public as
well as public sector, fall in exp orts etc. Industrial growth has slowed
down due to supply -side constraints like low rate of savings,
inadequate stock of capital, infrastructural deficiency and shortage of
raw material. It shows that the setback is from both the demand side
and the supply side. So, the Keynesian concept of deficiency of
demand has some relevance to developing countries like India.
The Keynesian concept of demand deficiency is partly relevant in
India.
3.Business Investment Behaviour: According to Keynes, the two
important determinants of investment are the Marginal Efficiency of
Capital and the Rate of Interest. Expectations play an important role in
influencing investment behaviour of the firm.
Keynes explained investment behaviour in terms of ‘Animal Spirits’.
Animal Sp irits refers to entrepreneurs’ optimism and willingness to
undertake risky investment projects. Thus, investment is the most
volatile component of GDP. Keynes linked the high variability of
investment to the animal spirits of entrepreneurs’, i.e., their fi ckle
(indecisive, inconsistent) and volatile expectations of the future
profitability of investment. Keynes argued that major investment
projects are usually undertaken not on the basis of careful calculation
of profits they are expected to make, but on th e strength of ‘hunches’
of entrepreneurs that, beneath the uncertainties that would make a
rational and cautious person delay a decision, there is an opportunity to
be grasped by whoever has the courage to try.
The periodic decline in private investment in India can be explained in
terms of ‘Animal Spirits’. Private investment in India fell from time to
time due to political instability and economic uncertainty, which
reduced confidence of investors. Investment in both financial assets
(new shares) and ph ysical assets (real capital) fell due to uncertainty
regarding implementation and continuation of various economic
reform programmes.
4.Investment Choice by Household: Keynes’s theory of demand for
money postulates that at a high rates of interest people ho ld less cash
and buy more bonds. At low rates of interest, they just do the opposite.
People’s liquidity preference depends on the existing rates of interest
as also on uncertainties regarding changes in the rate of interest in themunotes.in

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65future. This is what is experienced in India sometimes. Sometimes,
investment in shares by households has declined and investment in
bank deposits has increased steadily. People in developing countries
like India keep a large sum of money in liquid form (in the form of
cash balan ce and bank deposits, withdrawable by cheques) and make a
small investment in financial assets like equity shares.
5.Household Consumption Behaviour: The Keynesian consumption
function hypothesis is quite relevant in developing countries like India
both at the micro level and at the macro level. An individual’s
consumption expenditure depends only on his disposable income, as
has been postulated by Keynes’s absolute income hypothesis. The rate
of interest does not affect short -run consumption spending in suc h
countries much. Aggregate consumption also depends on the pattern of
income distribution and the stock of wealth of the community as
suggested by Keynes.
6.The Working of the Multiplier: In the developing economies like
India, the Keynesian multiplier pri nciple now works for a number of
reasons. At present in India there is considerable idle capacity in
various industries. In addition, due to the partial success of Green
Revolution, the production of food grains has increased steadily over
the years. Under such situation an act of Investment is likely to
generate a multiplier effect from the supply side such as shortage of
power, coal, infrastructural deficiency and imperfections in the
economy. For such constraints the true size of the multiplier is less
than what is warranted by a high Marginal Propensity to Consume
(MPC).
7.Fiscal policy and Deficit Financing: Keynes in his later writings laid
emphasis on fiscal policy (taxation and public expenditure/expenditure
policy) to attain the goal of full employme nt. Keynes recommended
that manipulating rates of various taxes and with appropriate pattern of
public expenditure, the goal of full employment or higher level of
employment can be realised more effectively than by monetary policy
alone. What is more impor tant is that Keynes completely knocked out
the foundation and accepted practice of the concept of balanced
budget. In case of the existence of substantial unemployment in the
country, instead of raising tax rates (which might discourage private
investment) , Keynes recommended the policy of deficit financing. It is
as a result of the Keynesian theory that deficit financing or budgeting
has become a fairly common practice, especially in developing
countries where there are vast potential resources lying unuti lised and
enormous poverty but not adequate saving and investment to make use
of the resources because of the low level of income of the people.
8.Income Analysis: Another impact of Keynesian theory has been that
the entire approach of looking at economic phenomenon and the
system has undergone radical change. Now it has become common
practice to think in terms of income analysis -level of incomemunotes.in

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66(aggregate and per capita), rate of saving and investment and so on.
Almost every country compiles and publishes such annual income
analysis which gives true picture of the functioning of the national
economy.
9.Economic Role of the Government: Keynes suggested the adoption
of Stabilisation Policy by the government to fight depression and
unemployment and also to ma intain price stability. Although Keynes
completely ignored the problem of long -term growth, there is need for
government intervention in the form of adoption of appropriate
monetary and fiscal policies to give a genuine boost to private
investment and enab le the economy to achieve self -sustaining growth,
in the long run along with reasonable price stability. The government
of a developing country should also make sufficient investment to
provide an integrated infrastructure without which faster economic
growth is not possible. Adequate infrastructure will enable the private
sector to overcome supply -side constraints on economic growth. The
government should also invest in social infrastructure such as
education and public health, as has been suggested by Ama rtya Sen.
A related point may be noted in this context. In advanced countries,
the government spending obstructs private investment by diverting
loanable funds and raising the rate of investment. This is known as the
‘Crowding -Out Effect’.
But in devel oping countries, government expenditure on
infrastructural investment stimulates private investment by removing
supply constraints. This is known as the Crowding -In Effect. Public
investment not only generates demand for goods and services
produced in the private sector but stimulates growth of the economy
by improving infrastructural facilities, the absence of which is a major
obstacle to economic growth in developing countries like India.
While in advanced countries government spending and private
inves tment are competitive in nature, in developing countries, they are
complementary.
Conclusion: J.M.Keynes has left deep impact on economic thinking in
almost all developing countries.
4.6SUMMARY
1.The theory of multiplier was first developed by Prof. R.F. Kahn in
1931. It explains the effects of initial increase in investment on
aggregate employment. Kahn’s multiplier was thus known as
‘employment multiplier.’ J.M. Keynes used the concept of multiplier
to analyze the effects of change in investment on incom e via changes
in consumption expenditure. Thus this multiplier came to be known as
the investment multiplier. It may be defined as “the ratio of the changemunotes.in

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67in income to the change in investment.” It is symbolically expressed
as, K = ΔY/ ΔI.
Where K = Sta nds for Multiplier, ΔY = change in income and ΔI=
change in investment.
2.The principle of acceleration was propounded first by a French
Economist Albert Aftalion in 1909. The principle is generally
associated with the name of an American Economist J.M. Cla rk in
1917. Multiplier and accelerator are parallel concepts. Multiplier
shows the effect of change in investment on income (K = ΔY/ΔI). The
accelerator shows the effect of change in consumption on investment.
3.This effect of combined operation of the mult iplier and acceleration is
called the ‘Leverage Effects’ or the super multiplier. This leverage
effects brings about the accelerated change in income and
employment.
4.J.M.Keynes by his publication of ‘The General theory’ (1936) has had
a great influence on economic policies of both developed and
developing countries. The Keynesian theory of income and
employment was presented in 1936 in the context of the Great World
Trade Depression of 1929 -33. The Keynesian prescription have been
adopted by some advanced economies which succeeded in achieving
high employment and reasonable price stability in economics in
developing countries like India. Some modern economists believe that
some of the Keynesian concepts and prescriptions are still applicable
to the present developing countries.
4.7QUESTIONS
1.Discuss in detail the theory of investment multiplier.
2.Explain the working of investment multiplier.
3.Briefly explain the leakages and importance of investment multiplier.
4.Explain in detail the principle of acceleration.
5.Discuss the relevance of Keynesian theories to developing countries
economy.
munotes.in

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68Module 3
5
POST KEYNESIAN DEVELOPMENTS IN
MACRO ECONOMICS
Unit Structure :
5.0 Objectives
5.1 Introduction
5.2 Integrated Approach (The IS & LM Model)
5.3 The Goods Market a nd the IS Curve
5.4 The Money Market a nd the LM Curve
5.5 Equilibrium i nthe Goods and Money Markets
5.6 Fiscal and Monetary Policies a nd the IS -LM Model
5.7 Introduction of Phillips Curve
5.8 Keynesian Explanation of Phillips Curve
5.9 Collapse o fthe Phillips Curve Hypothesis (1971 -91)
5.10 Natural Unemployment Rate Hypothesis a nd t he Theory of
Adaptive Expectations
5.11 Long Run Phillips Curve a nd the Theory of Adaptive Expectations
5.12 Rational Expectations a nd the Long Run Phillips Cur ve
5.13 Relationship between Short and Long Run Phillips Curve
5.14 Summary
5.15 Questions
5.0 OBJECTIVES
To study integration of commodity and money markets
To understand the meaning of the goods market and the IS curve
To understand the meaning of th e money market
To study equilibrium in the goods and money market
To study the impact of fiscal policy and the monetary policy on the
goods and money market
To understand the meaning of Phillips curve
To understand Keynesian explanation of Phillips curve
To study short run and long run Phillips curvemunotes.in

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695.1 INTRODUCTION
In the first two modules we have seen the Classical economists and
Modern economist Keynesian theories applicable to macroeconomic
study. In this module we are going learn about the Post Keynesian
developments of macroeconomics.
5.2INTEGRATED APPROACH (THE IS & LM
MODEL)
The goods and the money markets are interlinked by two economic
variables, namely: interest rate and national income. In this model,
interest rate is introduced in th e goods market through investment demand.
The goods market therefore has two variables –interest rate (i) and
national income (GDP). The goods market equation is known as the IS
curve. The IS curve represents equality between saving (S) and investment
(I) and all points on the IS curve show goods market equilibrium at
different levels of interest and national income. The money market
equilibrium is determined by the demand for and supply of money at
various levels of interest and national income. The dema nd for money is a
function of income and interest rate. The supply of money is determined
by the Central Bank (the RBI in India or the Federal Reserve in the USA).
The money market equation is known as the LM curve. The LM curve
represents equilibrium b etween demand and supply of money at various
levels of interest rates and national income. Various points on the LM
curve shows equality between demand for money (L) and supply of
money (M).
The IS -LM model shows how the equilibrium levels of income an d
interest rates are simultaneously determined by the simultaneous
equilibrium in the two interdependent goods and money markets. Hicks,
Hansen and Johnson put forward the IS -LM model on the basis of
Keynesian framework of national income determination in which
investment, national income, rate of interest, demand for and supply of
money are interrelated and inter –dependent. These variables are
represented by two curves, namely; the IS and the LM curves.
5.3THE GOODS MARKET AND THE ISCURVE
The goods mar ket is in equilibrium when aggregate demand is
equal to national income. In a closed two sector economy, the aggregate
demand is determined by consumption demand and Investment demand
(AD = C + I). Changes in the interest rate affect aggregate demand
throu gh changes in investment demand. With the fall in interest rates, the
profitability of investment rises because the cost of investment falls.
Increase in investment demand leads to increase in aggregate demand and
rise in the equilibrium level of national income. The IS curve shows the
different combinations of national income and interest rates at which themunotes.in

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70goods market is in equilibrium. The derivation of the I S curve is depicted
in Figure 5 .1 below.
In panel (A) of Fig. 5 .1 you will notice that the rel ationship
between planned investment and rate of interest is depicted. It will be
obvious from the figure that planned investment is inversely related to the
rate of interest. When the interest rate falls, planned investment rises,
leading to an upward shi ft in the aggregate demand function. The shift in
the aggregate demand function is depicted in panel (B) of the figure,
where in, you will see that an upward shift caused in the aggregate
demand function leads to a higher level of national income in the go ods
market. Thus in the goods market, the level of national income is inter -
connected with the interest rate through planned investment. The IS curve
is the locus of various combinations of interest rates and the levels of
national income at which the good s market is in equilibrium.
In panel (C) of Fig. 5 .1, the IS curve is depicted. It shows that the
changes in the level of national income are a function of changes in the
level of aggregate demand, planned investment and rate of interest. At the
given ra te of interest r 0, the level of national income Y 0is plotted. When
the interest rate falls to r 1, planned investment increases to I 1and the
aggregate demand function shifts from AD 0to AD 1and the goods market
assumes equilibrium at Y 1level of national income. We therefore plot Y 1
level of national income corresponding to r 1level of interest rate.
Similarly when the interest rate further falls to r 2, planned investment
increases to I 2and the aggregate demand curve shifts upward to AD 2.
Now the goods m arket assumes equilibrium at Y 2level of national income.
In panel (C), the equilibrium national income Y 2is shown against the rate
of interest r 2. By repeating this process for all possible interest rates, we
can trace a series of combinations of interes t rates and income levels
corresponding to goods market equilibrium. By joining points such as E 0,
E1,E2etc. in panel (C) of the diagram, we obtain the IS curve. You will
notice that the IS curve so obtained is downward sloping indicating that
when the r ate of interest falls, the equilibrium national income rises.munotes.in

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71National Income
National IncomeRateofInterest
AggregateDemand(B)
(C)
OO
YY
XX450
Y0 Y1 Y2
Y0 Y1 Y2AD0AD1AD2
E0
E0E1
E1E2
E2II
Planned InvestmentRateofInterest(A)
OY
XII
r0
r0r1
r1r2
r2I0I1I2r
r
II
Fig. 5 .1: Derivation of the IS Curve
THE SLOPE OF ISCURVE
The IS curve has a negative slope indicating an inverse relationship
between the rate of interest an d the level of aggregate demand. A higher
interest rate will lower the level of planned investment and hence lower
the level of aggregate demand and the equilibrium level of national
income. Similarly, a lower interest rate will raise the level of planned
investment and hence higher will be the level of aggregate demand and the
equilibrium level of national income.
The steepness of the IS curve is determined by the elasticity of
investment demand curve and the size of the investment multiplier. The
elastic ity of investment demand shows the degree of responsiveness of
investment expenditure to the changes in the rate of interest. If the
investment demand is relatively elastic, a given fall in the rate of interest
will result in a more than proportionate chan ge in investment demand
bringing about a larger shift in the aggregate demand curve and larger
level of national income, thus making the IS curve flatter. Conversely, if
the investment demand is relatively inelastic, the IS curve will be
relatively steep. The steepness of the IS curve is also determined by the
size of the investment multiplier. The value of the multiplier is determined
by the size of the marginal propensity to consume. Greater the mpc,
greater will be the size of the investment multiplier a nd greater will be the
level of national income as a result of increase in investment. Thus making
the IS curve flatter. Conversely, if the mpc is lower, the IS curve will have
a steeper slope.munotes.in

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72SHIFTS IN THE ISCURVE
Changes in autonomous expenditure caus es a shift in the IS curve.
Autonomous expenditure is independent of the level of income and the
rate of interest. Autonomous expenditure may increase on account of
increase in government expenditure, increase in autonomous consumption
expenditure or incre ase in autonomous investment demand. Autonomous
investment demand may rise due to increase in firm’s optimism about
future profits. Autonomous consumption demand may rise due to
households’ estimate of future incomes. Government expenditure has an
autonomo us component given the wide -scale use of deficit financing. An
increase in autonomous expenditure at a given interest rate would shift the
aggregate demand curve upwards leading to an increase in the equilibrium
level of national income. With interest rate remaining constant, an upward
shift in the aggregate demand curve will cause the IS curve to shift
towards the right indicating increase in national income at the given
interest rate.
In figure 5 .2 below, the shift in the IS curve is depicted by introduc ing the
third component of the aggregate demand namely government expenditure
and it is denoted by ‘G’.
National Income
National IncomeRateofInterestAggregateDemand(A)
(B)
OO
YY
XX450
Y0 Y1
Y0 Y1C+I ( r)=A D00 0C+I ( r)+G=A D00 1
E0
E0E1
E1
E2
Fig. 5 .2: Shift in the IS Curve on account of
Increase in Autonomous Expenditure
You will notice from the figure 5 .2that when the rate of interest is
r0, the planned investment is I 0and the Aggregate Demand Curve is ADmunotes.in

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73which intersects the 45 line at point E 0and Y 0level of national income is
determined. It is also depicted in panel (B) of the diagram by point E 0.L et
us now introduce the government component in the composition of the
aggregate demand and assume that the entire component is autonomous in
nature. Government expenditure ‘G’ will shift the aggregate demand curve
to AD 1which intersects the 45 line at po int E 1and a higher level of
national income Y 1is determined. Correspondingly, we obtain point E 1on
panel (B) of the diagram as the new equilibrium point and accordingly Y 1
level of national income is plotted. The change in the level of national
income f rom Y 0to Y 1is not on account of any change in the interest rate
and hence the IS curve shifts to the right. The new equilibrium point E 1is
horizontally contiguous and to the right of point E 0indicating a shift in the
IS curve.
The movement along the I S curve indicates shifts in equilibrium
income caused by shifts in the aggregate demand curve as a result of
changes in interest rates. A shift in the aggregate demand curve caused by
any other factor other than interest rate must be represented by a shift in
the IS curve.
5.4THE MONEY MARKET AND THE LMCURVE
The LM curve shows the different combinations of interest rates
and incomes corresponding to equilibrium in the money market.
According to Keynes, liquidity preference is the sum of transaction and
speculative demand for money. The transaction demand for money is
directly related to the level of income and the speculative demand for
money is inversely related to the rate of interest. The total money demand
function can be stated as: M d= L(Yr), where ‘Md’ stands for demand for
money, ‘Y’ for real income and ‘r’ for rate of interest. The LM curve can
be obtained by drawing a series of money demand curves at various levels
of income intersecting the supply curve of money as determined by the
monetary au thorities. The LM curve so obtained shows various interest
rates given the demand for and supply of money at different levels of
income. The derivation of the LM curve is depicted in Fig. 5 .3 below. munotes.in

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74National Income(B)
OY
X Y0Y1E0 E0E1E1LM
Quantity of MoneyRateofInterest(A)
OY
XM( Y )d0 0Md (Y )1
1r1
r0r1
r0
Ms
Fig. 5 .3: Derivation of the LM Curve
In Fig. 5 .3 above, panel (A) shows various money market
equilibrium points at different levels of income and panel (B) depicts the
derivation of the LM curve showing the different combinations of interest
rates and income corresponding to money market equilibrium. In panel
(A), the M scurve indicates the supply of money as fixed by the monetary
authorities. For the given income level Y 0, the money demand curve Md0
is drawn which intersects the supply curve at point E 0. Point E 0indicates
the initial money market equilibrium. It shows that when the money
demand is Md0, the interest rate is r 0.
In panel (B) of the figure, the corresponding point E 0is shown. At
point E 0, the money market is in equilibrium with the com bination of
income level Y 0and interest rate r 0. At the higher income level Y 1, the
demand for money will be higher at each interest rate. The new money
demand curve Md1at interest rate r 1, intersects the supply curve at point
E1. Point E 1is the new mon ey market equilibrium. At a higher income
level, the quantity of money demanded rises but higher interest rates
reduces the quantity of money demanded to the original level. In panel
(B), point E 1is plotted showing the new money market equilibrium with
interest rate r 1and income level Y 1. By considering all possible income
levels and by plotting the money demand curves at each income level and
by plotting the corresponding equilibrium points in panel (B), the LM
curve is derived.
THE SLOPE OF THE LMCURV E
The LM curve is upward sloping. At higher income levels, it
requires higher interest rates to maintain the money market equilibrium
with constant money supply. If the quantity demanded of money is
proportionately greater than the change in the income lev el, the interest
rate will be higher and steeper will be the slope of the LM curve. Further,
if the quantity demanded of money is less responsive to the rise in interest
rates, greater will be the rise in interest rate to maintain the money market
equilibr ium and steeper will be the LM curve. Conversely, the more themunotes.in

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75quantity of money demanded responds to interest rates and the less it
responds to income, the flatter will be the LM curve.
SHIFTS IN THE LMCURVE
Given the money demand function, an increase in money supply
will lead to fall in interest rate at the given level of income. With fixed
income level the rate of interest must fall with a rise in money supply in
order to maintain the money market equilibrium. The fall in interest rate
will shift the LM curve to the right indicating a rise in the money demand
function. This is de picted in Fig. 5 .4 below.
Fig. 5 .4: Shift in the LM Curve on account of Increase in Money
Supply
You wil l notice in panel (A) of fig. 5 .4 that with the initial mone y
supply Ms
0at Y 0level of income, the money market is in equilibrium at
the interest rate r 0. When the money supply increases to Ms
1at r 0interest
rate, there is excess money supply at the given income level Y 0. In order to
maintain the money market equ ilibrium, the interest rate must fall to r 1if
the people are induced to demand more money at the income level Y 0and
the new money supply Ms
1. The new interest income combination (r 1,Y0)
will be on LM 1as shown in panel (B). Similarly, with the increase in
money supply from Ms
0to Ms
1and with the given interest rate r 0, the
income must increase to Y 1so that more money is demanded
corresponding to the new money supply Ms
1. You will notice in panel (A)
that with the increase in money supply at the given i nterest rate r 0, the
income increases and raises the money demand curve to Md1(Y1) and the
money market is in equilibrium at point ‘E 2’w i t hr 0as the interest rate and
Y1as the income level. The new interest -income combination (r 0,Y 1)i s
plotted on the LM 1curve in panel (B). Thus increase in money supply will
shift the LM curve to the right and if the money supply is reduced, it will
raise the interest rate at the given level of income and cause the LM curve
to shift to the left.munotes.in

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765.5EQUILIBRIUM IN THE GOODS AND MONEY
MARKETS
The equilibrium rate of interest and the level of income is
determined at the intersection point of the IS and LM curve. The goods
market is in equilibrium at all points on the IS curve and the money
market is in equilibrium at al l points on the LM curve. Hence, only at the
point of intersection between these two curves, both the money market and
the goods market will be simultaneously assuming equilibrium. Such an
equilibrium condition is depicted in Fig. 5 .5 below.
National IncomeRateofInterestYB
C
ISDA
ELM
X Or0r1
r2
Y1 Y2 Y0
Fig. 5 .5: Simultaneous Equilibrium in the Goods and Money Market
The simultaneous equilibrium in both the markets is determined at
point E, whereby r 0is the interest rate determined and Y 0is the level of
national income. At interest r ate r 1and income level Y 1, the goods market
will be in equilibrium at point ‘A’ on the IS curve. But at the interest rate
r1, the money market will be in equilibrium only at income level Y 2at
point ‘B’ on the LM curve. At interest rate r 1, the income lev el Y 1is too
low for money market equilibrium and hence the money demand is not
enough to match the given quantity of money supply. With excess supply
of money, interest rate will fall until it reaches r 0level. At r 0interest rate,
aggregate demand and na tional income would have risen sufficiently to
increase money demand so that equilibrium in the two markets is obtained.
Alternatively, at r 2interest level, the income level Y 2required for goods
market equilibrium at point ‘C’ is greater than the income level Y 1
required for equilibrium in the money market at point ‘D’. With income
too high for money market equilibrium, there is excess demand for money
pushing the interest rates up until they reach r 0with Y 0income level
where both markets are in equilib rium.munotes.in

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775.6 FISCALAND MONETARY POLICIES AND THE
IS-LMMODEL
The IS -LM model helps us to explain as to how changes in
monetary policy initiated by the Central Bank of a country and changes in
fiscal policy initiated by the Government of a country influen ces the rate
of interest and the level of national income in a country.
FISCAL POLICY AND IS -LM MODEL
Changes in fiscal policy can be explained in terms of changes in
government expenditure and changes in taxes imposed by the
Government. We will first loo k at the impact of increase in government
expenditure on the rate of interest and the level of national income. This is
shown in Fig. 5 .6 below. Autonomous increase in government expenditure
raises aggregate demand for goods and services produced in an eco nomy
and pushes the IS curve to the right in the upward direction. You will
notice that autonomous increase in government expenditure shifts the IS
curve from IS 1to IS 2. Here, the horizontal distance between the two IS
curves is equal to G1
MPSwhich shows the increase in income that
takes place according to the Keynesian multiplier. You may notice that
with the LM curve remaining constant, the IS 2curve intersects the LM
curve at point F. The IS -LM model therefore explains us that with the
increase in autonomous government expenditure ( G), the equilibrium
shifts from point E to point F and the rate of interest rises from R 1to R 2
and the level of national income increases from Y 1to Y 2. The IS -LM
model therefore explains us that increase in autonomous government
expenditure or expansionary fiscal policy helps to increase both the level
of national income and the rate of interest.
An interesting point that IS -LM model brings to light is the
difference in the increase in national income as gi ven by the Keynesian
multiplier and the one given by this model. The increase in national
income by Y 1Y2is less than what would happen given the Keynesian
multiplier. Keynes assumed that investment is fixed and autonomous and
brought out his concept of in vestment multiplier to explain changes in
national income as a result of changes in investment expenditure.
However, the IS -LM model takes into consideration the fall in private
investment due to the rise in interest rate that takes place with the increase
in government expenditure. The extent of fall in private investment
expenditure as a result of rise in interest rates is termed as Crowding Out
effect. Similarly, a fall in government expenditure will bring about the
leftward shift in the IS curve and wit h the LM curve remaining constant,
the rate of interest will fall along with a fall in the level of national
income. Reduction in government expenditure to control inflation is an
example of Anti -inflationary or Contractionary fiscal policy.munotes.in

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78R1
XYRateofInterest
0R2Level of National IncomeY1 Y2F
DYH
IS1IS2E
DG1
MPS¥LM
Fig. 5 .6: Impact of increase in Government Expenditure on Interest
Rate and National Income
Now, we will see what would be the impact of reduction in taxes
on the rate of interest and the level of national income in the economy.
Reducti on in taxes is an alternative to increase in government expenditure.
Tax reduction increases the disposable income of the people leading to
increase in consumption expenditure and thereby increase in aggregate
demand. When the government reduces taxes, the IS curve shifts to the
right as shown in Fig. 5 .7 below from IS 1to IS 2. Once again, you will
notice that the change in national income as result of reduction in taxes is
only Y 1Y2which is less than what the Keynesian tax multiplier T
MPC
MPSwould make us available. You may notice that the effective increase
in national income as a result of the tax multiplier is equal to EH.
Whereas, the IS -LM model shows that the increase in national income is
much less than what the Keynesian tax multipl ier would generate as the
LM curve remains constant and the new IS curve IS 2intersects the LM
curve at point D. According to the new equilibrium point D, the new rate
of interest is R 2and the rise in national income is Y 1Y2. Similarly, if the
government wants to control inflationary pressures in the economy, it may
initiate a raise in taxes. When the taxes are increased, the disposable
incomes of the people would fall leading to a fall in consumption
expenditure. Fall in consumption expenditure will help in controlling price
rise.munotes.in

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79
Fig. 5 .7: Impact of Reduction in Taxes on Interest Rate and National
Income
MONETARY POLICY AND THE IS-LMMODEL
The monetary policy of the government is determined and
executed by the Central Bank of the country. Changes i n the monetary
policy can bring about changes in the rate of interest and the level of
national income. Like fiscal policy, the monetary policy can be
expansionary or contractionary. In order to increase the availability of
credit and push economic growth rate to a higher level, the Central Bank
may follow an expansionary monetary policy. However, in times of rising
prices, the Central Bank may follow a contractionary or tight monetary
policy to control the rising prices. The IS -LM model can be used to show
the impact of both expansionary and contractionary monetary policies on
the rate of interest and the level of national income. Changes in money
supply will cause a shift in the LM curve. While increase in money supply
will shift the LM curve to the right, the opposite will happen when money
supply is reduced. Assuming that the economy is in a state of recession
i.e., when the growth rate in the national income is regularly falling, the
Central Bank would follow an expansionary monetary policy to draw the
economy out of recession. The Central Bank would follow steps that
would increase money supply in the economy. Increase in money supply,
with demand for money remaining constant would create a downward
pressure on the rate of interest and the rate of intere st would fall. When the
interest rate falls, investment demand will rise leading to an increase in
national income in the economy. Thus, with the increase in money supply,
the LM curve will shift towards the right and intersect the constant IS
curve at poi nt D as shown in Fig. 5 .8 below. You will notice that themunotes.in

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80economy moves from the initial equilibrium point E to D, the rate of
interest falls from R 1to R 2and the level of national income increases from
and the level of national income increases from Y 1toY 2. The IS -LM
model therefore shows that expansion in money supply lowers the rate of
interest and increases national income. Similarly, if the economy is caught
in an inflationary spiral, the Central Bank may follow a tight monetary
policy that is it wo uld reduce money supply and bring about a rise in the
rate of interest and fall in the level of national income. Less income will
reduce the aggregate demand in the economy and reduce the pressure on
rising prices thereby controlling the inflation rate.
Fig. 5 .8: Impact of Expansionary Monetary Policy on Interest Rate
and National Income
5.7INTRODUCTION OF PHILLIPS CURVE
Economic growth without inflation and unemployment is the
objective behind macro -economic policies of modern times. However, in
theshort term, there seems to be a trade -off between inflation and
unemployment and hence macro -economic policy makers need to balance
between inflation, economic growth and unemployment. A low inflation
rate is seen to accompany lower economic growth rate and higher
unemployment whereas a high inflation rate is seen to accompany higher
economic growth rate and lower unemployment. Here, in this chapter, we
look at the Phillips curve which was the first explanation of its kind to
show the negative relationsh ip between unemployment and inflation rate.
We also look at the long run picture and see whether the negative
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81In 1958, AW Phillips, a professor at the London School of
Economics published a study of wage behavior i n the United Kingdom for
the years 1861 and 1957. Phillips found an inverse relationship between
the rate of unemployment and the rate of inflation or the rate of increase in
money wages. The higher the rate of unemployment, the lower the rate of
wage in flation i.e. there is a tradeoff between wage inflation and
unemployment. The Phillips curve shows that the rate of wage inflation
decreases with the increase unemployment rate. Assuming W tas the
wages in the current time period and W t+1in the next tim e period, the rate
of wage inflation, g w, is defined as follows:
Wt+1-Wt
gw= ———— ……..(1)
Wt
By representing the natural rate of unemployment with u*, the Phillips
curve equation can be written as follows:
Gw=-ε(u–u*) ……. .. (2)
where εmeasures the responsiveness of wages to unemployment. This
equation states that wages are falling when the unemployment rate
exceeds the natural rate i.e. when u > u*, and rising when unemployment is
below the natural rate. The difference between unemployment and the
natural rate, u –u*is called the unemployment gap. Let us assume that
the economy is in equilibrium with stable prices and the level of
unemployment is at the natural rate. At this point, if the money supply
increases by t en per cent, the wages and the price level must rise by ten
per cent to enable the economy to be in equilibrium. However, the
Phillips curve shows that for wages to rise by ten per cent, the
unemployment rate will have to fall. A fall in the unemployment rate
below the natural level will lead to increase in wage rates and prices and
the economy will ultimately return to the full employment level of output
and unemployment. This situation can be algebraically stated by rewriting
equation one above as follo ws.
Wt+1=W t[1-ε(u–u*)] ……… (3)
Thus for wages to rise above their previous level, unemployment
must fall below the natural rate. The Phillips curve relates the rate of
increase of wages or wage inflation to unemployment as denoted by
equation two above, th e term ‘Phillips curve’ over a period of time came
to be used to describe a curve relating the rate of inflation to the
unemployment rate. Such a Phillips curve is depicted in Fig. 7.1.
You may notice that when the rate of inflation is ten per cent, the
unemployment rate is three per cent and when the rate of inflation is five
per cent, the rate of unemployment increases to eight per cent. Empirical
or objective data collected from other developed countries also proved the
existence of Phillips Curve. E conomists believed that there existed a
stable Philips Curve depicting a tradeoff between unemployment andmunotes.in

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82inflation. This trade -off presented a dilemma to policy makers. The
dilemma was a choice between two evils, namely: unemployment and
inflation. In a dilemma, you chose a lesser evil and inflation is definitely a
lesser evil for policy makers. A little more inflation can always be traded
off for a little more employment. However, further empirical data
obtained in the 70s and early 80s proved the n on-existence of Phillips
Curve. During this period, both Britain and the USA experienced
simultaneous existence of high inflation and high unemployment. While
prices rose rapidly, the economy contracted along with more and more
unemployment.
Phillips Curve
10-
9-
8-
7-
6-
5- PC
012 3 4 5 6 7 8
Rate of Unemployment (%)
Fig.5.9 –Phillips Curve
5.8 KEYNESIAN EXPLANATION OF PHILLIPS CURVE
The explanation of Phillips curve by the Keynesian economists is
shown in Fig. 5.10 . Keynesian economists assume the upward sloping
aggregate supply curve. The AS curve slopes upwardly due to two
reasons. Firstly, as output is increased in the economy, the law of
diminishing marginal returns begins to operate and the marginal physical
product of labor (MPP L) begins to decline. Since the money wages are
fixed, a fall in the MPP Lleads to a rise in the marginal cost of production
because MC = W/ MPP L.Secondly, the marginal cost goes up due a r ise in
the wage rate as employment and output are increased. Following rise in
aggregate demand, demand for labor increases and hence the wage rate
also increases. As more and more labor is employed, the wage rate
continues to rise and the marginal cost of firms increases. You may not ice
that in Panel (a) of Fig.5.10 that with the initial aggregate demand curve
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83output level Y 0are determined. When the aggregate demand increases, the
AD 0curve shifts to the right and the new aggregate demand curve AD 1
intersects the aggregate supply curve at point ‘b’. Accordingly, a higher
price level P 1is determined along with a rise in GNP to Y 1level. With
the increase in the real GNP, the rate of unemployment falls to U 2. Thus
the rise in the price level or the inflation rate from P 0to P 1, the
unemployment rate falls down thereby depicting an inverse relationship
between the price level and the unemployment rate. Now when the
aggregate demand f urther increases, the AD curve shifts to the right to
become AD 2. The new aggregate demand curve AD 2intersects the
aggregate supply curve at point ‘c’. Accordingly, the price level P 2and
output level Y 2is determined. The level of unemployment now fal ls to
U3. In Panel (b) of Figure 5.10 , points a, b and c are plotted and these
points corresponds to the three equilibrium points a, b and c in Panel (a) of
the figure. Thus a higher rate of increase in aggregate demand and a
higher rate of rise in price level are related with the lower rate of
unemployment and vice versa. The Keynesian economists were thus able
to explain the downward sloping Philips curve showing inverse relation
between rates of inflation and unemployment.
AS0
Phillips
Curve
P2 C P2 C
P1 bA D 2 P1 b
a a
P0 AD 1 P0
AD 0
0Y 0Y1Y2 0U 1U2U3
Real GNP Rate of Unemployment
Fig.5.10 –Keynesian Explanation of Phillips Curve
5.9 COLLAPSE OF THE PHILLIP SC U R V EH Y P O T H E S I S
(1971 -91)
The Phillips Curve hypothesis was accepted as a cure to increase
the level of employment and income in the sixties. It became a
macroeconomic tool to explain the trade -off between inflation rate and
unemployment rate. It sug gested that policy makers could choose
different combinations of unemployment inflation rates. Policy makers
may choose low unemployment and high inflation as long as it is
politically and economically expedient. However, the stable relationship
between h igher inflation and lower unemployment as seen in the sixtiesPriceLevelPC
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84could not be replicated in the seventies and thereafter, particularly in the
United States and Great Britain. It was seen that both inflation rate and
unemployment rate had increased on numerou s occasions and the trade -off
had thus disappeared. Further, there cannot be a long run trade -off
between inflation and unemployment because in the long run the
aggregate supply curve becomes vertical and any further expansion after
the point of full empl oyment is reached will only add to the price level
without adding anything to income, employment and output. Thus there is
no permanent unemployment -inflation trade -off. Data obtained in the
seventies and thereafter indicated a shift in the Phillips cu rve i.e. in
various years, at a given rate of inflation, the Phillips curve either shifted
to the left or to the right, indicating thereby that at times, given the
inflation rate, unemployment rate has increased or decreased. The stable
relationship betwe en inflation rate and unemployment rate thus was
proved to be non -existent.
Causes of Shift in Phillips Curve
The shifts in the Phillips curve according to Keynesians is due to
adverse supply shocks experienced in the seventies in the form of
unprecedent ed oil price hikes. Adverse supply shocks gave rise to the
phenomenon of Stagflation and the breakdown of the Phillips curve
hypothesis. The impact of adverse supply shocks on national product and
the pri ce level is depicted in Fig. 5.11 . The original a ggregate demand and
supply curves AD 0and AS 0are in equilibrium at point E 0. Accordingly,
the price level P 0and national output Y 0is determined. The oil price hike
initiated by the Oil and Petroleum Exporting Countries (OPEC) an oil
cartel of oil prod ucing Middle East countries contributed to the rise in cost
of production of a large number of goods and services in which oil is used
as an input. Increase in the cost of production caused the aggregate supply
curve to shift to the left in the upward dir ection, thereby causing the price
level to rise along with a decrease in national output. Notice that the new
aggregate supply curve AS 1now intersects the aggregate demand curve
AD 0at point E 1and accordingly the new price level P 1is determined.
Howev er, at a higher price level P 1, the national output has fallen to Y 1
leading to rise in unemployment. Such a situation is explained in terms of
stagflation where in both unemployment and price level increases. This
new phenomenon experienced, particularl y by the United States in the
seventies and thereafter has caused the shift in the Phillips curve.
Stagflation, thus, consigned the Phillips curve hypothesis to the pages of
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85AS1
AS0
P1 E1
P0 E0
AD 0
OY 1Y0
Aggregate Output
Fig. 5.11 –Adverse Supply Shock, Stagflation and
Rejection of the Phillips Curve Hypothesis
5.10 NATURAL UNEMPLOYMENT RATE HYPOTHESIS AND
THE THEORY OF ADAPTIVE EXPECTATIONS
Milton Friedman put forward the concept of ‘natural rate of
unemployment’ to prove that the Phillips curve phenomenon does not
operate in the long run and that the long run Phillips curve is vertically
sloping, thereby having no relationship between inflation rate and
unemployment rate. However, he accepted the fact that there exist a short
run negative relationship between inflation rate and unemployment rate.
Milton Friedman says that the economy is stable in the lo ng run at the
natural rate of unemployment and any intervention in the form of
expansionary fiscal and monetary policies would only result in higher
prices without higher output.
When current GDP is at its potential level, unemployment is not
zero or ther e is no full employment. The unemployment rate that exists on
account of frictional and structural reasons when the economy is operating
at full employment level is called the natural rate of unemployment or
more appropriately NAIRU (Non -accelerating Infla tion Rate of
Unemployment). The natural rate of unemployment is the rate at which in
the labor market, the current number of unemployed is equal to the
number of jobs available. Natural unemployment exists due to frictional
and structural reasons. For e xample, fresh additions to the labor force may
spend time to search suitable jobs. Individuals pursuing higher education
may actually be in the labor force but may not participate in the workforce
due to educational commitments. While the sunset industri es may be on
the decline and thereby reducing the workforce from its rolls, the sunrise
industries would be expanding and adding to its workforce. However,
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86unemployed labor force needs to be trained for suitable jobs before they
are recruited. Unemployme nt arising out of frictional and structural
causes is termed as natural unemployment and the number of such
unemployed persons constitutes the natural rate of unemployment. In
other words, Milton Friedman argues that if information were not to fail,
there will be no divergence between full employment and actual
employment. The natural rate of unemployment is estimated in the range
of four to six per cent in the developed countries.
The term ‘NAIRU’ is a more appropriate term to describe the
natural rate o f unemployment because the term ‘natural rate of
unemployment’ connotes that unemployment cannot fall below the natural
rate. The Phillips curve hypothesis shows that unemployment rate can fall
below the NAIRU in the short term. Thus, when actual GDP is g reater
than potential GDP (Y > Y*), unemployment will be less than NAIRU (U
demand forces put pressure on wages to rise faster than productivity.
When the unemployment rate is above the NAIRU, demand forces put
pressure on wages to rise more slowly than productivity or even to fall.
When unemployment is at the NAIRU, demand forces exert no pressure
on wages relative to productivity.
In order to prove the non -existence of Phillips cur ve in the long
run, Milton Friedman put forward the theory of adaptive expectations.
People’s expectations are formed on the basis of previous and present rate
of inflation and adapt their expectations only when the actual inflation rate
is different from their expected rate. The tradeoff between inflation and
unemployment is therefore only in the short run. Milton Friedman’s
theory of adaptive expectations and the derivation of the vertically sloping
long run Phill ips curve is depicted in Fig.5.12 .
Itis assumed that the economy is operating at point A 0on the short
run Phillips curve (SPC 1) and the natural rate of unemployment is six per
cent. The actual inflation rate is four per cent. The nominal wages are set
on the basis of four per cent inflatio n rate and it is expected that the
inflation rate will continue to be the same in future. When the government
adopts expansionary monetary and fiscal policies, the inflation rate goes
up to six per cent. Since the nominal wages are set on the basis of fo ur per
cent inflation rate, the firms make additional profits equal to two per cent
and hence they make fresh investments, thereby increasing the level of
employment and output. As a result of fresh investments, the
unemployment rate falls below the natur al rate of unemployment and the
economy moves to point A 1where the corresponding inflation rate is six
per cent and the unemployment rate is three per cent. Thus, Milton
Friedman and other monetarists argue that there exists a short run trade -off
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87SPC 3 LPC
9- SPC 2
8- ●B1 ●C0
7- SPC 1
6- ● ● B0
A1
5-
4- ● A0
3-
2-
1-
0 36
Unemployment Rate
Fig.5.12 –Shift in the Short Run Phillips Curve &
derivation of the Long Run Phillips Curve
5.11LONG RUN PHILLIPS CURVE AND THE
THEORY OF ADAPTIVE EXPECTATIONS
The economy after having reached poin tA 1does not stay put at
that point because after a time lag, the workers are informed that the
current inflation rate is six per cent and that their real wages have fallen by
two per cent. Organized workers will therefore demand compensation for
the inf lation which is over and above the expected rate in order to restore
their real incomes. When wage compensation actually takes place, the
profits levels are also restored to the original levels and the economy
returns to its original equilibrium position at point B 0. However, point B 0
is on the new short run Phillips curve SPC 2. Corresponding to point B 0,
the actual inflation rate is six per cent and the unemployment rate is back
at its natural level i.e. six per cent. Now the expected inflation rate w ould
be six per cent and workers will continue to expect the same rate of
inflation in future. The shift in the Phillips curve will continue as long as
expansionary monetary and fiscal policies are adopted by the Government
and the economy will move along the points B 1,C0etc. When points such
as A 0,B0,C0are joined, the long run Phillips curve is obtained. Note that
the LPC is vertically sloping and the vertical slope indicates that it is
neutral between inflation rate and the unemployment rate. Mil ton
Friedman thus proves that there is no long run trade -off between inflation
rate and unemployment rate. The theory of adaptive expectations indicate
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88that workers adapt to the new rates of inflation and their expected inflation
rate gets adapted in due course i.e. after a time lag and the economy
returns to its original status with a higher rate of inflation.
5.12RATIONAL EXPECTATIONS AND THE LONG
RUN PHILLIPS CURVE
According to Milton Friedman’s theory of adaptive expectations,
nominal wages lag beh ind changes in the price level or the inflation rate.
The adjustment lag in nominal wages to the price level causes business
profits to go up. When profits go up, business units expand their scale
output and as a result the level of unemployment in the e conomy falls
below the natural rate.
The advocates of rational expectation theory believe that there is
no adjustment lag involved between nominal wages and changing price
level. They argue that there is a quick adjustment between nominal wages
and expec ted changes in the price level and hence there is no trade -off
between inflation and unemployment. The rate of inflation resulting from
increase in aggregate demand is well anticipated by workers and firms and
gets factored in wage agreements. Such adjus tments made in quick
succession sometimes and sometimes in advance lead to further price
increases. Thus, there is a rise in the price level without any rise in the
real output or fall in unemployment below the natural rate. According to
the Rational Exp ectations theorists, given the availability of resources and
technology, the aggregate supply curve is vertically sloping at the
potential GDP level or at the natural unemployment rate level. The long
run Phillips curve therefore corresponds to the long r un aggregate supply
curve at the natural rate of unemployment. The long run Phillips curve is
therefore a vertical straight line or vertically sloping at the natural rate of
unemployment. The derivation of the long run aggregate s upply curve is
shown in Fig. 5.13 and the long run Phillip s curve is depicted in Fig. 5.14.
According to the Rational Expectations theorists, the workers and
firms are rational beings and have a good understanding of the operation
of the economy. Both workers and firms can the refore fairly and
correctly anticipate the consequences of the economic policies of the
Government. Secondly, all product and factor markets are very
competitive and hence factor and product prices are highly flexible to
bring about quick and rapid adjust ments. Figure 7.6 shows the argument
made by Rational Expectations theorists about the relation between
inflation and unemployment. The original equilibrium is at point ‘a’
where the initial short run aggregate demand curve AD 0and the short run
aggregat e supply curve AS 0intersect each other and the equilibrium, full
employment, national output OY 0and price level P 0is determined, given
the natural rate of unemployment.
Now when the government adopts expansionary monetary and
fiscal policies, the econ omic units or the factor owners will correctlymunotes.in

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89anticipate the inflationary impact of these policies and make upward
adjustment in factor and product prices thereby holding real national
output and real wages at their original level. The shift in the short run
aggregate demand and supply curves will therefore be vertically upward as
shown in the figure. The economy now operates at the new equilibrium
point ‘b’ which is corresponding to the original equilibrium point ‘a’.
However, the equilibrium is achiev ed at a higher price level P 1.A t e v e r y
occasion when the Government adopts expansionary policies when the
economy is operating at the full employment level of income and output,
the aggregate demand and supply curves behave in the same manner and
the equ ilibrium point changes from point ‘b’ to point ‘c’ and so on and so
forth. By joining these points, the Long Run Aggregate Supply curve is
obtained. Note that the long run AS curve is vertically sloping indicating
thereby that once the full employment eq uilibrium income and output is
determined at the natural rate of unemployment, any expansionary policy
will only result in price rise, real national output remaining constant.
As the long run aggregate supply curve is vertically sloping at the
natural une mployment rate, the long run Phillips curve is also vertically
sloping.
Y
LAS
AS2
AS1
c AS0
b AD 2
a AD 1
AD 0
0Y 0 X
Real National Output
Fig.5.13 –Inflation and Output (Rational Expectations Theory)PriceLevelmunotes.in

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90Y LPC
0U*X
Unemployment Rate
Fig.5.14 –The Long Run Phillips Curve (Rational Expectations
Theory)
5.13RELATIONSHIP BETWEEN SHORT AND LONG
RUN PHILLIPS C URVE
The position of the short run Phillips curve passing through a long
run Phillips curve is determined by the anticipated or expected inflation
rate. The short run Phillips curve can be compared to the short run
aggregate supply curve because both the curves are drawn with a given
expected price level. The short run Phillips curve drawn with an expected
inflation rate shifts its position as the inflat ion rate changes (See figure
5.15). If the expected inflation rate is six per cent, the short run Phi llips
curve (SPC 1) also passes through the corresponding point ‘A 0’ on the long
run Phillips curve with natural unemployment rate of six per cent. The
movement along a short run Phillips curve is determined by changes in
aggregate demand. When there is a n unexpected increase in aggregate
demand, the actual inflation rate is found to be more than the expected
inflation rate and the real national output increases causing the
unemployment rate to fall below the natural rate. The new short run
equilibrium is determined at point ‘A 1’ which is to the left of the original
equilibrium point. Conversely, if there is an unexpected decrease in
aggregate demand, the actual inflation rate will fall below the expected
rate and the unemployment rate will increase and r eal national output will
fall. In this case, the movement will be downwards and to the right. The
shift in the short run Phillips curve is caused due to the divergence
between actual and expected inflation rates and this divergence is caused
by unexpect ed changes in monetary and fiscal policies of the government.
If the actual inflation rate is greater than the expected inflation rate, the
short run Phillips curve will shift upward and vice -versa. The distance byPriceLevelmunotes.in

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91which the short run Phillips curve shif ts to a new position is equal to the
change in the expected rate of inflation.
LPC
9- SPC 2
8-
7-SPC1
6- ● ● B0
A1
5-
4- ● A0
3-
2-
1-
0 6
Unemployment Rate
Fig.5.15 –Relationship between the Short Run Phillips Curve
and the Long Run Phillips Curve
5.14SUMMARY
1.The IS -LM model shows how the equilibrium levels of income and
interest rates are simultaneously determined by the simultaneous
equilibrium in the two interdependent goods and money markets.
Hicks, Hansen and Johnson put forward the IS -LM model o n the basis
of Keynesian framework of national income determination in which
investment, national income, rate of interest, demand for and supply of
money are interrelated and inter –dependent.
2.The IS curve shows the different combinations of national inco me and
interest rates at which the goods market is in equilibrium.
3.The LM curve shows the different combinations of interest rates and
incomes corresponding to equilibrium in the money market.
4.The equilibrium rate of interest and the level of income is d etermined
at the intersection point of the IS and LM curve. The goods market is
in equilibrium at all points on the IS curve and the money market is in
equilibrium at all points on the LM curve. Hence, only at the point of
intersection between these two cu rves, both the money market and the
goods market will be simultaneously assuming equilibrium. InflationRate
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925.The IS -LM model helps us to explain as to how changes in monetary
policy initiated by the Central Bank of a country and changes in fiscal
policy initiated by the Government of a country influences the rate of
interest and the level of national income in a country.
6.In 1958, AW Phillips, a professor at the London School of Economics
published a study of wage behavior in the United Kingdom for the
years 1861 and 1957 . Phillips found an inverse relationship between
the rate of unemployment and the rate of inflation or the rate of
increase in money wages. The higher the rate of unemployment, the
lower the rate of wage inflation i.e. there is a trade -off between wage
inflation and unemployment. The Phillips curve shows that the rate of
wage inflation decreases with the increase unemployment rate.
7.The position of the short run Phillips curve passing through a long run
Phillips curve is determined by the anticipated o r expected inflation
rate.
5.15QUESTIONS
1.Explain the derivation of IS curve in the goods market.
2.Discuss the derivation of LM curve in the money market.
3.Briefly explain the simultaneous equilibrium in the goods and money
market.
4.Explain the impact of in crease and decrease in government
expenditure on interest rate and national income.
5.Discuss the impact of expansionary monetary policy on interest rate
and national income.
6.Discuss Keynesian explanation of Phillips curve.
7.Explain Rational expectations theo ry.
8.Discuss the relationship between short run and long run Phillips curve.
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936
STAGFLATION AND SUPPLY SIDE
ECONOMICS
Unit Structure :
6.0 Objectives
6.1 Introduction
6.2 Stagflation
6.3 Supply -Side Economics: Basic Propositions and Critical Approach
6.4 Summary
6.5 Questions
6.0 OBJECTIVES
To study the meani ng of stagflation
To study meaning and propositions of supply side economics
6.1 INTRODUCTION
Inthis section we are going to study the meaning of the concept
stagflation and basic propositions and critical approach to supply -side
economics.
6.2STAGF LATION
The Keynesian economics emphasised the importance of adoption
of demand management policies (like monetary and fiscal policies) to
fight either inflation or to solve the problem of unemployment. Keynes
was of the view that true inflation occurs onl y when the country reaches
full employment. This implies that inflation and unemployment cannot
exist simultaneously.
However, the Phillips Curve established an inverse relationship
between inflation and unemployment. It was not possible for a country to
achieve price stability and full employment at the same time. So, the
policy makers came across the dilemma situation. The rate of inflation
could be reduced only by allowing the rate of unemployment to rise and
the rate of unemployment could be reduced on ly by allowing the rate of
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946.2.1 Stagflation
In 1070s most of the advanced capitalist countries of the world
faced the problem of stagflation. It refers to a situation of high inflation
and high unemployment, when the rate of growth o f GDP itself is low.
The Keynesian policy measures failed to solve this new problem. As a
result, a new school of economics emerged. This is known as the supply -
side economics which lays stress on the management of aggregate supply
to fight the disease of stagflation (i.e., inflation in the midst of stagnation).
The term stagflation refers to an economic situation where
stagflation and inflation co -exist. It is characterised with low economic
growth, increasing unemployment and high rate of inflation. It g oes
against the conclusion of Phillips Curve, the inverse relation between
inflation and unemployment. In this we come across a continuous increase
in price level and also increasing rate of unemployment.
Stagflation refers to the coexistence of inflation and unemployment
in a stagnant economy.
The term "stagflation" was first used during a time of economic
stress in the United Kingdom by politician Iain Macleod in the 1960s
while he was speaking in the House of Commons. At the time, he was
speaking about inflation on one side and stagnation on the other, calling it
a "stagnation situation." It was later used again to describe the
recessionary period in the 1970s following the oil crisis, when the U.S.
underwent a recession that saw five quarters of negativ e GDP growth and
inflation doubled in 1973 and hit double digits in 1974 unemployment hit
9% by May 1975.
Causes of Stagflation: Economists are not unanimous about the causes
of stagflation. To some supply shocks or cost push as major factors
responsible f or stagflation where as others argued that demand pull is the
main reason for this unusual economic phenomenon known as stagflation.
Following are the factors responsible for of stagflation. The sharp rise in
oil price
1.Supply Shock (The Oil Price Hike):
Stagflation refers to the coexistence of inflation and unemployment in
a stagnant economy. A high rate of unemployment means a reduced
rate of output. The problem of stagflation occurred in the context of
adverse supply shock caused by a sudden and a sharp rise in the price
of crude oil in October 1973 by the OPEC (Organisation of Petroleum
Exporting Countries) cartel. A sharp rise in oil price by almost 300%
at a time raised the cost of in oil importing countries and resulted in
high prices of several prod ucts. The reason was that oil was used as the
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95
Fig 6.1
In the above diagram Real GDP(Y)/output is shown on the X -axis and
Aggregate Price Level on the Y -axis. The curve AS is the Aggregate
Suppl y Curve and AD is the Aggregate Demand Curve. The economy is in
equilibrium at point E where AD curve and AS curve intersect with each
other. At this equilibrium point E, the output in the economy is OM and
the price level is OP. A supply shock such as a s harp rise in oil price
increases the production costs of making goods and services in the
economy. This results in the shift in the AS curve upwards from AS to
. The new equilibrium point is
This results in an increase in price
from OP to
and fall in output from OM to
In this case the
economy experiences fall in output i.e., increasing unemployment and a
rise in price i.e., inflation. The output falls due to increase in cost of
production and the price l evel rose due to fall in output and rise in cost.
Thus, there was stagflation -fall in output and employment and cost -push
inflation at the same time. A fall in production leads to unemployment and
the country faces the problem of recession i.e., a situatio n of high price
and low demand (due to fall in income).
2.Cost-Push: Cost of production increases due to many factors besides
the above -mentioned causes. Other factors are increase in wages, price
of raw materials and other inputs. Cost also increases due t o
infrastructural bottlenecks.
3.Low Productivity: Labour productivity is not only very low but may
decline due to protection provided to the employees by the trade
unions and labour laws enacted by the government. If trade unions
have strong bargaining po wer–they may be able to bargain for higher
wages, even in periods of lower economic growth. Higher wages are a
significant cause of inflation. Similarly, if an economy experiences
falling productivity –workers becoming more inefficient; costs will
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964.Social Benefits: Social benefits in the form of unemployment benefits,
free supply of goods and services to the poor, food security schemes,
minimum basic income scheme, provide income to the poor with no
obligation to work create the prob lem of inflation. These benefits
create more demand (inflation) and shortage of goods and services
(stagflation).
5.Excessive Regulation: Government policy bringing in excessive
controls on production and distribution and rigid labour laws, results in
lessavailability of goods and at the same time increase in cost.
6.Higher Taxes: Government increases its expenditure with additional
revenue. Cost of production increases due to higher tax which may
affect supply and/or demand.
7.Monetary Shocks: Cheap monet ary policy whereby more money is
pumped into the economy at a lower cost results in inflation.
8.Deficit Finance: Government expenditure more than its revenue leads
to more demand for goods and services resulting in higher prices.
9.Policy Changes: Democrati c governments with an eye on vote bank
may introduce popular policy measures such as basic income policy,
farmers debt waiver, free electricity, increase in procurement prices
and increase in wages and salaries. All these measures increase
demand with less than corresponding increase in production of goods
and services.
10.Rise in structural unemployment: If there is a decline in traditional
industries, we may get more structural unemployment and lower
output. Thus, we can get higher unemployment –even if i nflation is
also increasing.
11.Causes in USA: Fall in supply of agricultural products, depression of
the dollar, removal of wage and price controls are also responsible for
supply shocks in USA leading to stagflation. Huge military
expenditure by USA in the wake of the Vietnam war in the late 1960s,
workers expected the rate of inflation to accelerate in the early 1970s.
So, labour unions demanded and succeeded in getting higher wages
which later on created the problem of inflation due to increase in
purchas ing power. This further resulted in higher cost, fall in output
and aggregate supply curve shifting to left which finally resulted in
stagflation.
6.2.2 Consequences of Stagflation:
Stagflation refers to the coexistence of inflation and unemployment in
astagnant economy Stagflation is a situation of inflation in a stagnant
economy. Thus, it has all the negative aspects associated with inflation
and recession. It is a strange situation which neglects the conclusion of
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97It is a situation whe re economy is stagnant. Output and employment is
stagnant, does not increase, yet prices continue to rise.
The economy is in recession state in terms of production and
employment. It means the economy is in stagnant position. While
unemployment increases, investment does not respond to the
incentives provided by increase in prices. Decline in investment leads
to less production of goods and services.
There is vicious circle of downfall. Less or fall in investment leads to
fall in production which again re sults in less or fall in income. This
leads to fall in the savings and then further decline in investment.
The above explained situation actually should lead to a decline in
price. But on the contrary the price level increase. However, this
inflation doe s not attract more investment and employment.
The economy does not have the advantage of a trade -off between
inflation and unemployment. The relation is direct where people suffer
from twin problems of inflation and unemployment. The production
and suppl y are reduced, bringing down the income and employment
and at the same time pushing the prices up. Any additional money
supply to encourage more production and employment will only result
in increase in prices with hardly any response from supply of goods
and services. Following diagram will explain the effects on output and
price.
Fig 6.2munotes.in

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98Output is shown on the X -axis and the price level on the Y -axis.
The original Aggregate Demand Curve
cuts the original Aggregate
Supply Curve
at the original equilibrium point
The output is
and the price is
The aggregate supply curve shifts to the left i.e.
from
to
The new equilibrium point is
The output falls from
to
and the price rises from
to
Here the economy
experiences both the stagnation (falling output) and inflation (rising
prices). This situation is termed as stagflation.
If we discuss the situation through Phillips Curve, we will have an
upward sloping supply curve where both price level and unemployment
increase together.
To bring out the economy out of stagflation the government may
require to adopt a combination of measures which has simultaneous effect
on inflation and stimulating production of goods and services. A judicious
application of monetary, fiscal and other measures are required to be
implemented.
6.3 SUPPLY -SIDE ECONOMICS: BASIC
PROPOSITIONS AND CRITICAL APPROACH
Supply -side economic s is the school of thought that promotes the use
of fiscal policy to stimulate long -run aggregate supply. Supply -side
economists advocate reducing tax rates in order to encourage people to
work more or more individuals to work and providing investment tax
credits to stimulate capital formation.
Serving as the standard economic model from the Great Depression
onwards, Keynesianism’s star began to fade in the 1970s, as it struggled to
arrest the declining growth and rising inflation -known as stagflation -
that plagued many advanced economies. Sensing an opportunity,
neoliberals stepped in, pushing supply -side principles as the antidote.
Most famously, the new theory became the bedrock of ‘Reaganomics’ or
the "trickle -down" -the economic policy pursued by 40 th U.S. President
Ronald Reagan.
President Reagan and his Republican contemporaries popularized the
controversial idea that greater tax cuts for wealthy investors and
entrepreneurs provide them with incentives to save and invest, and
produce economic benef its that trickle down into the overall economy. He
often quoted the aphorism "a rising tide lifts all boats" to explain his
take on the theory.
Supply -side economics is an economic theory that postulates tax cuts
for the wealthy result in increased savings and investment capacity for
them that trickle down to the overall economy. The intended goal ofmunotes.in

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99supply -side economics is to explain macroeconomic occurrences in an
economy and offer policies for stable economic growth.
The three pillars of supply -side eco nomics are tax policy, regulatory
policy, and monetary policy. The core point of supply -side economics is
that production (i.e., the "supply" of goods and services) is the most
important in determining economic growth as against the Keynesian
economics, or demand -side economics, which believes that the level of
demand or the demand for goods (spending) in the economy is the key
driving factor to economic growth, rather than supply.
The focus of the supply -side economics is on the supply side of
macroeconomi c equilibrium. According to supply -side economics, the
short -term problem of stagflation can be brought under control by shifting
the aggregate supply curve to the right.
Fig 6.3
In the above diagram, the o riginal Aggregate Demand Curve
cuts the original Aggregate Supply Curve
at the original equilibrium
point
The aggregate output is
and the aggregate price level is
The aggregate supply cu rve initially shifts to the left from
due to adverse supply shocks which raises costs and prices. Thus,
aggregate output falls from
to
and the price rises from
due to cost -push pressures. Now the problem can be solved by
shifting the aggregate supply curve
to the right to
by adopting
appropriate supply management policies. As a result, aggregate output
returns to the original level (
and the price level also falls from
The supply -siders also lay stress on long -term growth of the
economy. The main determinants of the growth are the supply of labour,
the rate of saving and rate of investment. These can be incr eased by giving
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1006.3.1 The Main Propositions of Supply -Side Economics:
Following are the important propositions of supply -side economics: -
1.The Effect of Tax Cut on Work Effort: Since beyond some point a
rise i n marginal tax rate reduces people’s willingness to work, a cut in
marginal rate will increase labour supply by increasing the after -tax
wage and giving necessary inducement to people to enjoy less leisure
and work hard (i.e., work for longer than normal h ours). Similarly, a
cut in marginal tax rates on corporate income increases the after -tax
return on labour employed. This will induce firms to employ more
labour. An increase in the supply of and the demand for labour will
lead to an increase in aggregate output.
2.Incentives for savers and Investors: A cut in marginal tax rate will
also encourage people to save more and business firms to invest more.
A cut in tax will raise interest income of households and the net return
on capital employed by business fi rms. In fact, a cut in tax on
investment income, such as profit, induces firm to invest more and
take more risks. As a result, the rate of capital formation will increase.
An increase in the stock of capital will, in its turn, raise labour
productivity and lead to a fall in labour cost. As a result, the rate of
inflation will slow down. In addition, with an increase in the rate of
capital accumulation, there will be an expansion of the economy’s
production capacity. These two factors will conjointly lead to an
increase in aggregate supply. So, the aggregate supply curve will shift
to the right. As a result, the aggregate output will rise, the rate of
unemployment will fall and the price level will come down.
3.Cost-Push Effects of Indirect Taxes: The Keynesi an economists
considered only direct taxes such as income tax on individuals and
corporations. Such taxes reduce aggregate demand by reducing
disposable income of people and thus consumption and investment
components of demand. As a result, inflation can b e brought under
control.
By contrast, the supply -siders take into account indirect taxes such
as sales tax, excise duty and the VAT or goods and Services Tax (GST).
Such taxes are a part of business cost. So, if the government imposes
additional taxes on commodities and raw materials in order to cover its
growing expenditure (as part of its policy of expanding of the public
sector) cost -push pressures will be generated in the economy. Such
indirect taxes, much like rise in the wage rate or oil price hike, act as a
supply shock and are responsible for causing stagflation by shifting the
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101Thus, while direct taxes act as an anti -inflationary measure in
Keynesian economics, indirect taxes create inflation from the supply side
by generating cost -push pressures in the economy.
4.Parallel Economy: High taxes encourage tax evasion and tax
avoidance and finally leads to the emergence of parallel economy. In
many countries this parallel economy is as strong as the official
economy. When tax rates are very high, individuals and business firms
try to evade and avoid tax payment. A cut in taxes is likely to increase
tax compliance and raise tax revenue.
5.Tax Rate and Tax Revenue: The main argument of the supply -side
economics is that ma croeconomic problem can be solved by cutting
taxes. Arthur Laffer, in 1974, explained through the ‘Laffer Curve’ the
relationship between tax rate and tax revenues. As pointed out by
Arthur Laffer, there is the possibility that an increase in the tax rate,
because of the disincentive effect actually lowers tax revenue. Laffer
based his argument on the logic that tax revenue would be zero if tax
rates were either zero or 100 per cent. If, they were zero, obviously no
tax would be collected. If they were 100 per cent, all of a person’s
income would be taken away by the government. So, there would be
no incentive to work and, therefore, no income to tax. As real world
tax rates are higher than zero but lower than 100 per cent, Laffer
concluded that there must b e a tax rate at which tax revenue is
maximised. As tax rates rise, initially revenue would also rise. Then it
would reach a maximum and if the tax rate is raised further, tax
revenue will fall.
It is explained in the following diagram ---
Laffer Curve
Fig 6.4
As the tax rate increases the tax revenue also rises. At some point ‘a’, in
the above diagram, tax revenue is maximum. If the tax rate is raised
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102Tax cuts raise revenue by giving incentives to people to w ork hard and
save more. Similarly, tax cuts give incentives to business firms to invest
more and take more risks. As a result, the aggregate supply curve shifts to
the right and stagflation is brought under control.
Laffer also pointed out that low tax rat es will increase tax revenue
by widening the tax net, i.e., by ensuring that more and more people have
taxable income. Tax revenue is also likely to rise due to widening of the
tax base, due to an increase in the size of the GDP or national income. If
income of a country increases more and more people will pay taxes.
A policy of tax cut raises revenue for two more reasons.
i.It imposes tax compliance and reduces the extent of tax evasion
and avoidance. Many people buy NSCs (National Saving
Certificates) an d put their money in PPF because it is tax free.
ii.If employment increases due to fiscal stimulus, the government’s
transfer expenditure in the form of unemployment compensation or
cash subsidy will fall. So, the net revenue of the government (=
taxes –transfers) will rise.
6.3.2 Criticism of Supply -Side Economics
The main propositions of supply -side economics have been
criticised by several economists.
1.The Ineffectiveness of Tax Cut: A cut in income (wage) tax is
unlikely to raise work effort if, at a h igher level of income, people
show leisure preference. An individual is likely to work less and still
maintain the same standard of living. A cut in tax on interest income
will have the same effect. People may not save more and may even
reduce saving. W.J. Baumol has pointed out that if any individual saves
for a particular purpose or has a certain target level of saving in mind,
a rise in interest rate will lead to a fall in saving. And a cut in interest
tax is equivalent to a rise in interest on saving. St atistical studies
suggest that tax reduction leads to a very small increase in either
labour supply or household saving.
2.Increase in Budget Deficit: A cut in taxes is also likely to increase
budgetary deficits., government’s expenditure remaining constan t.
This is likely to cause inflation due to monetisation of the deficit, i.e.,
creation of new money by the central bank for making loan to the
government. Inflation is bound to occur because the economy will get
overheated. Milton Friedman criticised this supply -side economics as
he said that a tax cut reduces tax revenue but increases deficit.
3.Increasing Inequality: A cut in taxes will benefit only the and
affluent sections of society, which earn income from various sources
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103investment in equity shares and real estate. This will lead to an
increase in the degree of inequality of income and wealth (since
income itself is a source of wealth). In other words, the rich will get
richer, whi le the economic conditions of the poor will remain
unchanged or may even deteriorate.
4.Krugman’s Criticism: Krugman stated that supply -side economists
got a chance to experiment their theory during President Regan’s
administration but unfortunately, they failed.
5.Gaibraith Criticism: John Kenneth Galbraith pointed out that supply -
side economics was merely a cover for the tickle down approach to
economic policy, what an older and less elegant generation called
‘horse -and sparrow theory’. If you feed the ho rse enough oats, some
will pass through the road for the sparrows. As it was humorously put,
‘water -trickles down but money trickles up’.
6.The Possibility of Inflation: Supply -siders have also ignored the
possibility of inflation from marginal tax cuts. A cut in personal tax
will stimulate spending by raising disposable income. Similarly, a cut
in corporate income (profit) tax will raise investment spending. As a
result, aggregate private demand (C + I) will increase and will shift the
aggregate demand curv e to the right. It is explained in the following
diagrams:
Fig 6.5
In diagram (a), the aggregate demand curve shifts to the right
from
to
It causes the demand pull inflation as Keynesian thought.
Due to this shift in the dema nd curve the price level rises from
to
OP 2
in spite of an increase in real GDP (or aggregate output).
However, supply -siders point out that the tax cuts will
stimulate the economy and shift the aggregate supply curve to the righ tmunotes.in

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104from
to
as shown in panel (b). However, since the supply -side
effects of tax cuts are stronger than their demand -side effects, there is very
little rise in the price level but a substantial increase in real GDP from
to
. As a result, the rate of unemployment will fall. So, the economy will
be able to achieve high employment growth even in the absence of
accelerating price inflation. Thus, the problem stagflation can be largely, if
not totally, avoided .
6.3.3 Conclusion: In the short run, the demand -side effect of tax cuts will
be stronger than their supply -side effects. So, tax cuts are not likely to
accelerate inflationary pressures in the economy. Tax cuts will raise
aggregate demand immediately. Bu t their supply -side effects can be felt
only in the long run. Thus, supply -side policies cannot be used for
achieving price stability and full employment in the short run. In other
words, supply -side policies are not substitutes of Keynesian short -run
stabilisation policies. However, supply -side policies can be used to
achieve faster economic growth in the long run.
6.4SUMMARY
1.The term stagflation refers to an economic situation where stagflation
and inflation co -exist. It is characterised with low econ omic growth,
increasing unemployment and high rate of inflation. It goes against the
conclusion of Phillips Curve, the inverse relation between inflation and
unemployment. In this we come across a continuous increase in price
level and also increasing rate of unemployment.
2.Supply -side economics is the school of thought that promotes the use
of fiscal policy to stimulate long -run aggregate supply. Supply -side
economists advocate reducing tax rates in order to encourage people to
work more or more individual s to work and providing investment tax
credits to stimulate capital formation.
6.5QUESTIONS
1.Explain the meaning and causes of stagflation.
2.Discuss the consequences of stagflation with the help of a diagram.
3.Explain the meaning and propositions of supply side economics
4.Critically examine supply side economics.
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105Module 4
7
MONEY, PRICES AND INFLATION
Unit Structure :
7.0 Objectives
7.1 Introduction
7.2 Concept of Money Supply
7.3 Constituents of Money Supply
7.4 Determinants of Money Supp ly
7.5 Velocity of Circulation of Money
7.6 Meaning of Money
7.7 Keynes’ Theory of Demand for Money
7.8 The Liquidity Preference Theory of Interest
7.9 Friedman’s Theory of Demand for Money
7.10 Questions
7.11 Summary
7.0OBJECTIVES
To understand the con cept, constituents and determinants of money
supply
To study the concept of velocity of circulation of money
To study Keynesian theory of demand for money
To study Keynesian Liquidity Preference Theory of rate of Interest
To study Friedman’s theory of dema nd for money
7.1 INTRODUCTION
In this module we will study the concepts and theories rated to money as
one of the important aspect in macroeconomics. What are the constituents
of money supply, what factors determine the supply of money in an
economy, an d the Keynesian and Friedman’s approach to demand for
money are explained in detail.
7.2CONCEPT OF MONEY SUPPLY
Money supply refers to the amount of money which is in
circulation in an economy at any given time. It is the total stock ofmunotes.in

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106money held by t he people consisting of individuals, firms, State and its
constituent bodies except the State treasury, Central Bank and
Commercial Banks . The cash balances held by the Federal and
federating governments with the Central Bank and in treasuries are not
considered as part of money supply because they are created through the
administrative and non -commercial operations of the government. Further
money supply refers to the disposable stock of money. Therefore money
supply is stock of money in circulation. M oney supply can be looked at
from two points of views, namely, money supply as a stock and money
supply as a flow. Thus at a given point of time, the total stock of money
and the total supply of money is different. Money supply viewed at a
point of point is the stock of money held by the people on a given day
whereas money supply viewed overtime is viewed as a flow. Units of
money are spent and re -spent several times during a given period. The
average number of times a unit of money circulates amongst t he
people in a given year is known as Velocity of Circulation of Money.
The flow of money is measured by multiplying the stock of money with
the coefficient of velocity of circulation of money.
7.3CONSTITUENTS OF MONEY SUPPLY
There are two approache s to the constituents of money supply. They are
the traditional and the modern approaches.
1.Traditional Approach: According to the traditional approach, the
money supply consists of currency money consisting of coins and
notes and bank money consisting of checkable demand deposits with
commercial banks. The currency money is considered high powered
money because of the legal backing of the State. The Central Bank of
a country issues currency notes and coins because it has the monopoly
of note and coin issue. The supply of money in a country depends
upon the system of note issue adopted by the country. For instance,
India adopted the Minimum Reserve System in 1957. Under this
system, the Reserve Bank of India has to maintain a minimum reserve
of `.2 00 Crores consisting of gold and foreign securities. Out of this,
the value of gold should not be less than `.115 Crores. With this
reserve, the Reserve Bank of India has the power to issue unlimited
amount of currency in the country.
Checkable demand d eposits of commercial banks are used in the
settlement of debt. Payments made through checks change the volume
of demand deposits by creating derivative deposits. The creation of
demand deposits is determined by the credit creation activities of the
comm ercial banks. Bank money is considered as secondary money
whereas cash money is known as high powered money. Thus
according to the traditional approach, the total supply of money is the
sum of high powered money and secondary money or currency and
bank mon ey. The ratio of bank money to currency money depends
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107development in a country. In advanced countries, ratio of bank money
to currency money is high whereas in poor countries the ratio of
curren cy money to bank money is high.
2.The Modern Approach: According to the modern approach, money
supply includes currency money and near money. Money supply
therefore consists of coins, currency notes, demand deposits of
commercial banks, time deposits of commercial banks, financial
assets, treasury bills and commercial bills of exchange, bonds and
equities.
RESERVE BANK OF INDIA’S APPROACH TO THE
MEASUEMENT OF MONEY SUPPLY:
According to the Reserve Bank of India since its inception in 1935,
money supply in the narrow sense of the term was the sum of currency
with the people and demand deposits with the commercial banking
system. Narrow money was denoted by the RBI by M 1.In 1964 -65, the
concept of broad money or aggregate monetary resources was introduc ed.
Broad money was considered equal to M 1+ Time deposits with
commercial banks. In March, 1970 the RBI accepted the report of the
Second Working Group on Money Supply. This report was published in
the year 1977 and it gave a broad definition of money s upply.
Accordingly, four measures of money supply were brought into effect.
These four measures are as follows:
1. M 1= Currency with the public + Demand deposits with the
commercial Banks + Other deposits with the RBI.
2. M 2=M1+ Post Office S avings Bank Deposits.
3. M 3=M1+Time deposits with the commercial banks.
4. M 4=M3+ Total Post Office Deposits (excluding NSCs).
The Reserve Bank of India gives importance to narrow money
(M1) and broad money (M 3). Narrow money excludes time depos its
because they are not liquid and are income earning assets while broad
money includes time deposits because some liquidity is involved in it as
these assets earns interest income in future. Since time deposits have
become convertible in recent times, t hey have become more liquid than
what they were before. The M 2and M 4measures of money supply include
post office savings and other deposits with the post offices.
The third working group on money supply recommended the
following measures of monetary ag gregates through their report
submitted in 1998:
1.M0=Currency in circulation + Bankers’ deposits with the RBI +
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1082. M 1=Currency with the public + Demand deposits with the banking
Syste m + Other deposits with the RBI = Currency with the
public + Current deposits with the banking system + Demand
liabilities Portion of Savings Deposits with the banking system +
other Deposits with the RBI.
3. M 2= M1+ Time liabilities portion of saving deposits with the
banking System + Certificates of deposits issued by the banks +
Term Deposits [excluding FCNR (B) deposits] with a contractual
maturity of up to and including one year with the banking system
=Currency with the public + current deposits with the banking
System + Savings deposits with the banking system +
CertificatesOf Deposits issued by the banks + Term deposits
[excluding
FCNR (B) deposits] with a contractual maturity up to and including one
year with the banking system + other deposi ts with the RBI.
4. M 3= M2+ Term deposits [excluding FCNR (B) deposits] with a
Contractual maturity of over one year with the banking system
+Call borrowings from Non -depository financial corporations by
the Banking system. (M 1,M2&M 3are compiled e very
fortnight).
In addition to the monetary measures stated above, the following
liquidity aggregates to be compiled on monthly basis were also
recommended by the working group:
1.L1=M 3+ All deposits with the Post Office Savings Banks (excluding
National Savings Certificates).
2.L2=L 1+ Term deposits with Term lending institutions and
refinancing Institutions (FIs) + Term borrowing by FIs + Certificates of
Deposits issued by FIs.
3.L3=L2+ Public deposits of Non -banking Financial Companies.
(L3is compiled on quarterly basis).
7.4DETERMINANTS OF MONEY SUPPLY
Currency in circulation and demand deposits are the main
constituents of money supply. While the demand deposits are created by
the commercial banks, currency is issued by the Centra l Bank and the
Government. The supply of money is determined by the following
factors:
1.Size of the Monetary Base: Money supply depends upon the size of
the monetary base. The monetary base refers to the group of assets
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109Money supply changes with changes in the monetary base. The
monetary base of an economy consists of monetary gold stock, reserve
assets such as government securities, bonds and bullion, foreign
exchange reserve with the central bank and the amount of central
bank’s credit outstanding. In the present times, gold stock is not
considered as part of the monetary base.
2.Community’s Choice: The relative amount of cash and demand
deposits held by the people also influences th e supply of money. If
the people prefer to make check payments much more than cash
payments, the total money supply maintained by a given monetary
base would be larger and vice versa. Since money deposited in
commercial banks generates derivative deposi ts and expand the supply
of bank money through the credit multiplier, people’s preference of
bank money to cash would increase the supply of money. However,
the choice of the community is determined by factors such as banking
habits, per capita income, av ailability of banking facilities and the
level of economic development. If these factors are developed, the
money supply would be larger and vice versa.
3.Extent of Monetization: Monetization refers to the use of money as a
medium of exchange. The choice of the community for money as a
liquid asset depends upon the extent of monetization of the economy.
If monetization is high, demand for money would be high and vice
versa.
4.Cash Reserve Ratio: The Cash Reserve Ratio refers to the ratio of a
bank’s cash holdings to its total deposit liabilities. It determines the
coefficient of the credit multiplier. The CRR is determined by the
Central Bank of a country. The credit multiplier (m) is determined as
the reciprocal of the CRR (r). Therefore m = 1/r. Excess funds with
the commercial banks multiplied by the credit multiplier will give us
the extent of credit creation by the commercial banks. Lower the
CRR, greater will be value of the credit multiplier and therefore
greater will be the supply of ba nk money and vice versa.
5.Monetary Policy of the Central Bank: Monetary policy is defined as
the policy of the Central Bank with regard to the cost and availability
of credit in the economy. The monetary policy of the Central Bank of
any country will be a ccording to the macro -economic conditions.
Thus under inflationary conditions, the Central Bank may follow
restrictive monetary policy and thereby reduce the supply of bank
money by pursuing both qualitative and quantitative measures of
controlling money supply. Similarly under recessionary conditions the
Central Bank may follow expansionary monetary policy and thereby
raise the supply of money in the economy.
6.Fiscal Policy of the Government: Fiscal Policy is defined as a policy
concerning the income an d expenditure of the government. While the
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110of taxes, borrowing and through deficit financing, it spends the money
raised for various developmental and non -developmental purposes.
When the government raises revenue by imposing fresh taxes or by
raising the existing level of taxes, it helps to reduce money supply.
Similarly, market borrowing by the government reduces money supply
and raises the market interest rates. This is known as t he crowding out
effect of government borrowing. When the government spends the
money so raised, money supply increases. However, when the
government runs a deficit budget, it adds to the existing stock of
money supply and thus raises the supply of mo ney in the economy.
The opposite will be the impact of a surplus budget but surplus
budgets are a rarity in modern times.
7.Velocity of Circulation of Money: Velocity of circulation of money
refers to the average number of times a unit of money as a medi um of
exchange changes hands during a given year. Money supply is
measured as total money in circulation multiplied by the velocity of
circulation (M V). Thus higher the velocity of circulation of money,
higher will be the money supply and vice versa.
7.5VELOCITY OF CIRCULATION OF MONEY
The velocity of circulation of money determines the flow of money
supply in an economy in a given period of time, normally such a period is
one year. The average number of times a unit of money changes hands is
known as the velocity of circulation of money. The supply of money in a
given period is obtained by multiplying the money in circulation with the
coefficient of velocity of circulation i.e., M V where M refers to the total
amount of money in circulation and V refer to the velocity of circulation
of money in the given period.
Factors Determining Velocity of Circulation of Money: The velocity of
circulation of money is determined by the following factors:
1.Time Unit of Income Receipts: The more frequently peo ple
receive income, the shorter will be the average time period of
holding money and greater will be the velocity of circulation of
money. Thus if in a given society large number of people receive
income on daily basis, the velocity of circulation of mone y would be
higher than the one in which people receive income on weekly,
fortnightly or monthly basis.
2.Method and Habits of Payment: The velocity of circulation of
money would be high if large number of people pr efers to make
payment on instal ment basis . As a result, the same unit of money
will change hands more often than when payments are made in full.
3.Regularity of Income Receipts: If in a society people receive
income on a regular basis, they will spend their current incomemunotes.in

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111without bothering about future and hence the velocity of circulation
of money would be high. However, if future income receipts are
uncertain, people will not spend more money in the present and
hence the velocity will be less.
4.Saving Habits of the People: If the marginal prop ensity to save is
high in a society, then the people will be spending less in the present
and hence the velocity will be less. Similarly, if the marginal
propensity to consume is high the people will spend more and the
velocity of circulation of money wil l be high.
5.Income Distribution: Income distribution may be more equal or
more unequal in a society. If inequalities of income are high in a
society with the top 20 % taking away a major portion of the national
income, velocity of circulation of money wou ld be low because the
richer sections of the society will be holding more idle cash
balances. However, if income distribution is more equal or less
unequal, the bottom 40% of the people will receive more incomes
and spend more thereby increasing the veloc ity of circulation of
money.
6.Development of Banking and Financial System : If the banking
and financial institutions in a country are well developed,
mobilization of savings can be effectively carried out and more
credit made available to the needy. This not only prevents hoarding
of cash balances but also increases the velocity of circulation of both
currency and bank money.
7.Business Cycle: During the prosperity phase of the business cycle,
investment, output, income, employment and prices rise. Thus the
velocity of circulation of money would be high during the prosperity
phase. However, during the downturn of the business cycle,
investment, output, income, employment and prices begin to decline
thereby reducing the velocity of circulation of money.
8.Liquidity Preference of the People: If the liquidity preference of
the people is high i.e., if they wish to hold a greater part of their
income in the form of idle cash balances, the velocity of circulation
of money would be low and vice versa.
9.Speedy Cl earance of Checks and Transfer of Funds: A more
advanced banking system would help speedy clearance of checks
and transfer of funds from one account to another account, thereby
increasing the velocity of circulation of money.
7.6 MEANING OF MONEY
Money is defined in Economics as ‘anything that is generally
accepted in payment for goods and services as a medium of exchange.’munotes.in

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112Money consists of currency and checkable demand deposits. Money is
different from income and wealth. While income refers to a fl ow of
purchasing power which is used to make payments for the services
obtained from the factors of production, wealth is a stock of accumulated
purchasing power. While income is a flow variable that is measured over
a given period of time, wealth is a st ock variable that is measured at a
given point of time. While income is generally in the form of money and
income in the form of money is known as nominal income, income in the
form of goods and services is known as income in kind or real income.
Real in come is also measured in terms of constant prices. Wealth can be
held in the form of monetary assets. Saving is the primary source of
wealth. Money is the most liquid asset. The liquidity of assets refers to
the ease with which an asset can be converte d into a medium of exchange.
Assets are classified as either financial assets or real assets and are ranked
according to their liquidity. Currency, checkable deposits, savings
deposits are the examples of liquid financial assets. Stocks and bonds are
relatively less liquid financial assets. Precious metals like silver, gold,
platinum etc are liquid real assets. Artwork, machinery and real estate are
the examples of less liquid real assets. The liquidity of an asset is
determined by the following facto rs:
1.Existence of a well established market in which the asset can be
quickly sold.
2.Size of transaction costs (brokers fees, time costs)
3.Stability of the asset’s price.
The price of a rupee is always a rupee. The prices of other assets
measured in terms of money generally fluctuate. However, the value of a
rupee is not fixed as it is measured in terms of purchasing power. For
instance, at current prices a potato vada would cost you Rupees Ten a
piece. In 1974 when I was studying in the fifth s tandard, Rupees Ten
would fetch me 100 pieces of potato vada and with that money I could
have arranged a potato vada party for 100 students. (The value of money:
Vm= 1/P, where ‘P’ stands for price level.
7.6.1FUNCTIONS OF MONEY:
Money is a matter of fu nctions four: medium, measure, standard
and store. Money therefore has four important functions.
1.Medium Of Exchange: Money functions as a medium of exchange
and hence permits a time interval between buying and selling goods
and services. M oney replaces barter where goods or services are
traded directly for other goods or services. Barter does not provide a
time interval between buying and selling goods and services. Money
eliminates the need for a double coincidence of wants. For instance, a
farmer wh o has jowar in his stocks and wants to trade it for wheat
must find a person who has wheat and also wants to trade wheat for
jowar. Money greatly improves the efficiency of transactions by
reducing transactions costs. In a barter economy, transaction cos ts
would include cost of search. The cost of search is eliminated in amunotes.in

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113monetary economy. In a monetary economy, the farmer only needs to
find a person who wants to buy jowar and has the purchasing power to
pay for it. The farmer need not be bothered if the person has wheat
and is willing to trade wheat for jowar. The need for double co -
incidence of wants is eliminated in a monetary economy.
2.Unit of Account: Aunit of account is a standard numerical unit of
measurement of the market value of goods, serv ices and other
transactions. It is also known as a "measure" or "standard" of relative
worth and deferred payment. Money as a unit of account is essential
for entering into commercial agreements that involve debt and future
payments. Money is divisible i nto small units without destroying its
value. Precious metals can be coined from bars and melted down to
bars again. Money is fungible, i.e. , one unit or piece must be
perceived as equivalent to any other commodity or service. Hence
diamonds or works of art are not suitable as money. A specific
weight, or measure, or size must be verifiably countable. For instance,
coins are often made with ridges around the edges so that any removal
of material from the coin leading to fall in its intrinsic value will be
easy to detect . The unit of account is the unit in which values are
stated, recorded and settled. Money is a means of measuring and
recording value. Wheat is measured in kilograms. Distance is
measured in kilometers. Value is measured in units of mone y. In
barter, the value or price of every good and service must be measured
in terms of the value of every other good and service. In a barter
economy with only 100 goods there would be: [(N(N -1))/2] = 4950
prices. However, in a monetary economy with onl y 100 goods, there
would be only 100 prices. At current prices, a kilogram of wheat
would be accounted in the range of Rs.25 to Rs.35 and a kilogram of
rice would be accounted in the range of Rs.30 to Rs.50.
3.Store of Value: Since money, as a medium of e xchange, represents
purchasing power, it can be stored and used in the future. Money is a
store of value but it is not usually a good store of value. During
inflation, money looses its value. The value of money is inversely
related to the price level. Higher the price level, lower will be the
value of money and vice versa. Symbolically, the value of money can
be found out with the following formula:
Vm=1/P
Assuming the price level to be 100, the value of Rs. 100 would be 100.
If the price level goe s up to 200, the value of Rs. 100 would be only
50. Money may therefore not be acceptable as a store of value during
periods of high inflation. Instead, people may prefer to store value in
the form of gold and real estate.
4.Standard of Deferred Paymen ts:Deferred payment means future
payments. Money is used as a standard of deferred payments and
hence debt contracts are signed in monetary terms. Loans and future
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114are accepted as the means of settling future accounts. However, during
periods of very high inflation, money may not be used as a standard of
deferred payments because the future value of present money is
inversely related to the general price level i.e. when the price level
goes up, the value of money falls. Thus during inflationary periods,
money may be used as a medium of exchange but not as a standard of
deferred payments.
7.7KEYNES’ THEORY OF DEMAND FOR MONEY
Keynes put forward his theory of demand for money in his f amous
work “The General Theory of Employment, Interest and Money” (1936).
According to Keynes, people hold cash balances on account of three
reasons or motives. These are the transaction motive, the precautionary
motive and the speculative motive. Accor dingly the demand for money
can be separated into three parts namely transaction demand,
precautionary demand and speculative demand for money. The total
demand for money or cash balances can be divided into two namely;
active and idle cash balances.
Active Cash Balances:
Demand for active cash balances is divided into transaction and
precautionary demand for money. The transaction demand for money
arises due to the fact that money is a medium of exchange. Further
receipts and payments do not take pl ace simultaneously. There is always a
time gap between two successive receipts and payments are an ongoing
affair in the routine course. Hence people need to hold cash balances to
pay for their regular transactions. According to Keynes, transaction
motive for holding money is the need of cash for the current transactions
of personal and business expenditure. Therefore, households and firms
hold money on account of the transaction motive. Their respective
transactions motives can be referred to as incom e and business motives.
The income motive refers to the transaction motive of households.
Families hold cash balances to execute routine transactions. Household
demand for money depends upon the following factors:
1.The Level of Income : Transaction dem and for money by the
households is directly related to the level of income, i.e. higher the
level of income, higher will be the transaction demand for money and
vice versa.
2.The Price Level : Higher the price level, higher will be the
transaction demand f or money and vice versa. When prices rise, more
money will be required to purchase the same quantity of goods and
services and hence the transaction demand for money would rise when
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1153.The Spending Habits : If the people in a society are thrif ty, they
would require less money for transactions purposes. However, if large
number of persons in a society is spendthrift, they would require more
money for transaction purposes.
4.The Time Interval: If the time interval between two successive
income receipts is big, then the people will hold larger cash balances
under transaction motive and vice versa.
Similarly, firms need cash balances to pay for raw materials, transport,
wages and salaries and other payments. Cash balance held by firms to
satisf y these requirements is the money held under business motive . The
quantum of money held under business motive is directly related to the
turnover of firms i.e. larger the turnover, larger will be the amount of
money held under business motive.
Transactio ns demand for money is therefore the sum of money held
under income motive and business motive. It is income determined and
remains stable in the short run because income change takes place only in
the long run. Transactions demand for money is an increa sing function of
income. Symbolically, the transactions demand for money function can be
stated as follows: -
Lt=f ( Y )
Where; L t= Liquidity preference under transactions motive.
Y = Level of national income.
People also hold cash balances to provide for unforeseen
requirements. The amount of cash balances held by people to provide for
unforeseen requirements is referred to as precautionary demand for money
or money held under precautionary motive. Sickness, unemployment,
death, accidents etc are some of the unforeseen events which may take
place in the lives of people. The precautionary demand for money
depends upon uncertainty of future receipts. It is directly related to
income and relatively stable. The precautionar y demand for money is
interest inelastic and changes in response to changes in uncertainty.
Symbolically, the precautionary demand for money can be stated as
follows:
Lp=f( Y )
Where; L p= Liquidity preference under precautionary motive.
The transaction and precautionary demand for money cannot be
easily separated in practice and since both the money demand functions
are income determined and also interest inelastic, they are collectively
known as active balances . Symbolically, the demand for active balances
can be stated as follows:
L1 = Lt+L pmunotes.in

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116Both transaction and precautionary demand for money is income
determined, we can restate the money demand function for active balances
as follows:
L1=f( Y )
The demand for active balances i s grap hically depicted in Fig. 7 .1
below.
You will notice that at income level OY 1,O M 1is the demand for
active cash balances. When income level rises to OY 2, the demand for
active cash balances also rises to OM 2. The demand for active cash
balances is propo rtionate to changes in income.
Y
L1=L t+L p
M2
M1
OY 1 Y2 X
Income
Fig. 7 .1: Demand for Active Cash Balances
Idle Cash Balances (Speculative Demand for Money):
The cash balances held by people for speculative purposes are
known as demand for idle cash balances. The speculative motive for
holding cash balances originates from uncertainty about the future rate o f
interest. Speculative demand for money arises because of the store of
value function of money. The speculator holds cash balances in order to
make speculative gains from investment in securities. According to
Keynes, investors make capital gains by sp eculating in securities or bonds.
The speculative demand for money depends upon the rate of interest. The
demand for speculative cash balances is inversely related to the rate of
interest. When people expect the prices of income yielding assets such as
bonds to fall, the speculative demand for money rises and vice versa.
Symbolically, the speculative demand for money can be stated as follows
L2=f( i )DemandforMoney
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117Where; L 2=Speculative demand for money.
I=Rate of interest.
The opposite relationship between rate of interest and speculative
demand for money is shown in Fig.7 .2 below:
Y
20%
2% Liquidity Trap L 2
OX
Speculative Demand for Money
Fig. 7 .2: Demand for Idle Cash Balances
You will notice that the specul ative demand for money is inversely
related to the rate of interest. When the rate of interest falls, the
speculative demand for money rises and vice versa. Speculative demand
for money is therefore highly interest elastic. However, at a very low
intere st rate, the speculative demand for money becomes perfectly elastic
i.e., the entire income is held in the form of idle cash balances. This is due
to the fact that bond prices and interest rates move in opposite directions.
When the interest rate rises, the bond or security prices fall and vice versa.
The speculative demand for money is also income determining and not
income determined as in the case of transaction and precautionary demand
for money. When the interest rate is expected to rise, people pr efer to hold
cash balances at the current interest rate so that they can take advantage of
a rise in interest rate in the future. When speculative demand for money is
rising, it indicates a greater preference for liquidity.
The Concept of Liquidity Trap:
At a very low rate of interest, the speculative demand for money is
perfectly elastic i.e., the entire income is held by people in the form of
cash balances for speculative purposes. In the situation of liquidity trap,
percentage change in the demand for money in response to a percentage
change in the rate of interest is equal to infinity. Symbolically, the
liquidity trap situation can be stated as follows:
MiRateofInterest
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118M i
You will notice that the L 2curve in Fig.5.2 shows the liquidity
preference under the speculative motive at different rates of interest. At a
very high interest rate of 20%, the speculative demand for money is very
low and vice versa. However, when the interest rate is only 2%, the
speculative demand for mon ey becomes perfectly elastic. At this point,
any increase in money supply or income will be held by the people in the
form of idle cash balances. In the diagram, the liquidity trap situation is
shown by highlighting the horizontal segment of the liquidit y preference
curve. The liquidity trap situation arises because at very low rate of
interest, the opportunity cost of holding cash balances is negligible and
that in future the opportunity cost of holding cash balances is expected to
rise.
Aggregate De mand for Money:
The aggregate or total demand for money is the sum of transaction,
precautionary and speculative demands for money. Symbolically, the
aggregate demand for money can be stated as follows:
L=L 1L2
Where; L=Aggregate demand for money.
The functional relationship between aggregate demand for money
and the determining variables: nominal level of aggregate income and the
rate of interest can be stated as follows:
L=f (Y, i)
The liquidity preference schedule of a community can be obtai ned
by superimposing the L 1curves at each level of income on the L 2curves.
The liquidity preference schedule of a community is shown in Fig.7 .3
below.
In Fig.7 .3, Panel (A) shows the schedule of active balances (the
sum of transaction and precautionary demand for money) held by people
at different levels of income. The demand for active balances is perfectly
inelastic to changes in interest rate in the short run and changes
proportionately to the changes in the level of income. Accordingly, L 1
(Y1) shows the demand for active cash balances at Y 1level of income and
so on and so forth. The L 1curves are vertically sloping because they are
interest -inelastic. In Panel (B), the L 2curves shows demand for idle cash
balances or speculative demand for mone y.You will recall that
speculative demand for money is interest -elastic and inversely related to
the rate of interest. Hence the L 2curve is downward sloping. However, at
a very low rate of interest, it becomes horizontal indicating that the entire
income is held in the form of idle cash balances. In Panel (C), the
liquidity preference curve indicating total demand for money is shown. It
is the result of super -imposition of the L 1curves on the L 2curves.
Accordingly, the curves L(Y 1), L(Y 2) and L(Y 3)are obtained and theymunotes.in

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119represent the liquidity preference schedules of the community at various
levels of interest rates and national income.
Fig.7.3: Total Demand for Money
THE LIQUIDITY PREFERNECE THEORY OF INTEREST
7.8THE LIQUIDITY PREFERNECE THE ORY OF
INTEREST
According to Keynes, the rate of interest is determined by the
demand for and supply of money. Interest is the reward for lending
liquidity or temporarily giving up cash balances held by the people.
Symbolically, the rate of interest can be stated as follows:
Ri=f ( D M,SM)
Where, Ri= Rate of interest.
DM= Demand for money, and
SM= Supply of money.
The demand for money can be expressed in the form of a liquidity
preference schedule. Further, the demand for mone y as stated earlier is
the sum of demand for active and idle cash balances. While the demand
for active cash balances is determined by the transaction and precautionary
motives, the demand for idle cash balances is determined by speculative
motive. There is a direct relationship with the demand for active cash
balances and the level of income. Whereas, the demand for idle cash
balances is inversely related to the rate of interest. The total demand for
money can be symbolically stated as follows:
L=L1L2
Where; L = Aggregate demand for money.
L1= Demand for active cash balances.
L2= Demand for idle cash balances.munotes.in

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120The total demand for money can therefore be symbolically re -
stated as follows:
L=f ( r , y )
Where L = Aggregate demand for mon ey.
r = Rate of interest.
y = Level of national income.
DETERMINATION OF THE RATE OF INTERST:
The equilibrium rate of interest is determined by the intersection
between the demand curve for and supply curve of money. The supply of
money is determined a nd controlled by the monetary authority and the
banking system. At any time, the stock of money is fixed. The supply of
money is a stock rather than a flow. Hence, it is represented by a vertical
straight line. The money held by all the people in the co untry is the total
supply of money held as shown in Figure 7 .4. In this figure, OM is the
supply of money. SM is the vertical supply curve of money and LP is the
demand or liquidity preference curve. They intersect with each other at
point E. EM or OR is the equilibrium rate of interest. It shows that the
demand for money is exactly equal to the supply of money. Any change
in the demand or supply of money will bring about a change in the rate of
interest. If the supply of money alone increases, the e quilibrium rate of
interest would fall and vice versa. This is shown in Figure 5.5. It can be
seen in this figure that the original equilibrium rate of interest is OR. The
original supply of money is OM. When the supply of money alone
increases to OM 1,the equilibrium rate of interest would fall to OR 1and
vice versa. On the supply side, the rate of interest is influenced by the
supply of money. By controlling the supply of money, the monetary
authority can influence the rate of interest and the liqui dity preference.
YS
RE
LP
OM X
Fig. 7 .4–Determination of Interest RateRateofInterest
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121YS 1 S2
E1
R1
R2 E2 LP1
OM 1 M2 X
.
Fig. 7 .5 (A) –Changes in the Rate of Interest
Y
S1
R2 E2
R1 E1 LP2
LP1
OM 1 X
.
Fig. 7 .5 (B) –Changes in the Rate of Interest
CRITICAL ANA LYSIS OF THE LP THEORY OF INTEREST:
The Keynesian theory of interest has been criticized by Hansen,
Robertson, Knight, Hazlitt, Hutt and others. The following are the main
criticisms:
1.The theory lacks in realism and comprehensiveness: Speculative
deman d for money is the most important component which determines
interest rate according to Keynes. The theory assumes that people will
hold more money by selling bonds when the rate of interest falls and
RateofInterest
Demand & Supply of Money
Demand & Supply of MoneyRateofInterest
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122hold less cash but more bonds in the case of the rise in the interest rate.
However, Robertson does not regard bonds as the only alternative to
money. The theory is therefore not realistic and lacks
comprehensiveness.
2.Methodologically Inadequate: A change in the quantity of money
would tend to change the price of the good in the same proportion but
not the price of bonds. There is no functional relationship between the
price level and the rate of interest. Monetary changes do not have
direct or lasting effect on the rate of interest. By assuming a funct ional
relationship between the quantity of money and the rate of interest, the
Keynesian theory is found to be methodologically inadequate.
3.Only Speculative Demand for money is considered to be
rewarding: Keynes believed that money held as a store of wea lth
does not bear any fruit whereas money held for speculative purpose
yields rate of interest as a reward. According to WH Hutt, money is as
productive as all other assets and the demand for money assets is a
demand for productive resources.
4.Saving is E ssential for Liquidity: Keynes believed that the rate of
interest is the reward for parting with liquidity and not for saving.
Saving is essential for making investments. According to Viner,
“Without saving there can be no liquidity to surrender. The ra te of
interest is the return for saving without liquidity”.
5.Liquidity Trap does not exist: In reality the liquidity preference
schedule may be perfectly inelastic at a low rate of interest. It is
wrong to assume that people will expect the rate of inter est to go up in
a depression.
6.Incomplete Theory: Hicks, Hansen, Somers, Lerner and others says
that the rate of interest along with the level of income is determined by
four factors, namely: the investment demand function or MEC, the
saving function or t he consumption function, the liquidity preference
function and the quantity of money function. Keynes did not bring all
these factors in his interest theory and therefore failed to provide an
integrated and determinate theory of interest.
7.9FRIEDMAN’S THEORY OF DEMAND FOR
MONEY
According to Milton Friedman who restated the quantity theory
of money and prices there are four determinants of demand for money
(i) the level of prices (ii) the level of real income and output (iii) the rate
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123Friedman Classifies the holders of money into (a) ultimate wealth holders
(b) business enterprises His theory is relevant to the ultimate wealth
holders
Friedman has given a very broad concept of wealth which
includ es all sources of income or services. According to Friedman, the
demand for money is a demand for capital asset since money like
capital assets provides services and returns. Bonds are monetary
assets in which the people can hold their wealth and enjoy fix ed interest
income. The return on bonds is the sum of the coupon rate of interest and
the anticipated capital gains or losses due to the expected change in the
market rates of the interest People can also hold their wealth in the form
of equity shares and enjoy returns in the form of dividend income and
capital gains or losses Milton Friedman gave his demand function in the
following manner
Md = f (w. h. rm ,rb , re , P., u)
This is the nominalmoney demand function. The demand for
real money balances can be derived by dividing the nominal money demand
by the price level
Md = f (w. h, r m, rb, re, P . ____ , u)
Where. .= demand for real money balances.
w=wealth of the individual
h=t h ep r o p o r t ion of human wealth to the total wealth held by
the individuals
rm =the rate of return on money or interest
rb=the rate of interest on bonds
re=the rate of return on equity shares
p =the price level
u= Institutional factors.
The simpl ified version of Friedrm an's demand function for
money can be written as,
. =f( r ,Y p ,u )
The demand -function of Friedman, though it looks similar to Keynes
equation is different from Keynes in some ways : -
(1)Keynes gave importance to current income whereas F riedman gave
importance to wealth
(2)Friedrm an's theory does not consider unstable elements like the
Keynes speculative demand for money
(3) Friedman did not consider the possibility of a liquidity trap
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124Check Your Progress :
1.What is the Keynesian approach to demand for money?
2.Explain the concept of Liquidity trap.
3.Wha ta r et h eF r i e d m a n ‘ sd e t e r m i n a n tso fd e m a n df o r money?
7.10 SUMMARY
1.Money supply refers to the amount of money which is in circulation in
an economy at any given t ime. It is the total stock of money held by
the people consisting of individuals, firms, State and its constituent
bodies except the State treasury, Central Bank and Commercial Banks.
2.The velocity of circulation of money determines the flow of money
supply in an economy in a given period of time, normally such a
period is one year. The average number of times a unit of money
changes hands is known as the velocity of circulation of money. The
supply of money in a given period is obtained by multiplying the
money in circulation with the coefficient of velocity of circulation i.e.,
MV where M refers to the total amount of money in circulation and
V refer to the velocity of circulation of money in the given period.
3.Money is defined in Economics as ‘any thing that is generally accepted
in payment for goods and services as a medium of exchange.’
4.According to Keynes, people hold cash balances on account of three
reasons or motives. Accordingly the demand for money can be
separated into three parts namely transaction demand, precautionary
demand and speculative demand for money. The total demand for
money or cash balances can be divided into two namely; active and
idle cash balances.
5.According to Keynes, the rate of interest is determined by the demand
for and supply of money. Interest is the reward for lending liquidity or
temporarily giving up cash balances held by the people. Symbolically,
the rate of interest can be stated as follows:
Ri = f (DM, SM)munotes.in

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125According to Milton Friedman who restated t he quantity theory of
money and prices there are four determinants of demand for money (i)
the level of prices (ii) the level of real income and output (iii) the rate
of interest (iv) rate of change in general price level.
7.11 QUESTIONS
1.Explain the mea ning and constituents of money supply.
2.What are the factors affecting velocity of circulation of money?
3.Discuss Keynesian approach to demand for money.
4.Critically analyze Keynesian Liquidity Preference theory of rate of
interest.
5.Explain Friedman’s approac h to demand for money.


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1268
MONEY AND PRICES AND INFLATION
Unit Structure :
8.0 Objectives
8.1 Introduction
8.2 The Classical Approach to Demand for Money
8.3 The Fisher’s Approach to Demand for Money
8.4 The Neo -Classical or Cambridge Appr oach to Demand for Money
8.5 The Keynesian Approach of Demand for Money
8.6 Meaning of Inflation
8.7 Demand Pull, Cost Push and Structural Inflation
8.8 Causes of Inflation
8.9 Effect of Inflation
8.10 Measures to Control Inflation
8.11 Summary
8.12 Quest ions
8.0 OBJECTIVES
To study classical approach to demand for money
To study Fisher’s equation of exchange
To study Cambridge approach to demand for money
To understand the meaning and types of inflation
To study various causes of inflation
To understan d various effects of inflation
To know the measures to control inflation
8.1 INTRODUCTION
As against the Keynesian and Friedman’s approach to demand for money
in previous unit, the views of Classical economists and Cambridge
economists to demand for mo ney is explained in this unit. The meaning,
types, causes, effects and measures to inflation in an economy is explained
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1278.2THE CLASSICAL APPROACH TO DEMAND FOR
MONEY
The classical economists emphasized the medium of
exchange function of money According to the classical economists like J.S.
Mill. David Hume and Irving Fisher, the demand for money arises since
money facilitates the exchange of real goods and services among
individuals. Hence money is demanded for buying and selling goods an d
services or for spending over a period of time The classical economists
believed that the demand for money depends on objective factors like
the volume of exchange transactions of goods and services produced and
supplied during a given period of time, th e amount of money needed to
buy the goods and services and by the velocity of circulation. Since the
volume of goods and services changes from time to time, the demand for
money also changes The classical approach to the demand for money can
be grouped int o the Fisher’ s cash --Transactions Approach and the
Cambridge economists' cash -Balances approach
8.3THE FISHER’S APPRO CH TO DEMAND FOR
MONEY
Irving Fisher's Equation of Exchange is one of the most prominent
explanations which analyse the demand for mo ney. According to Fisher,
the demand for money means the amount of money to be held to
undertake a given volume of transactions over ap e r i o do ft i m e .F i s h e r ' s
equation of exchange is given as MV = PT, where M is the money
supply, V the transaction velocit y, T transactions and 'P‘the price level.
'PT' in the equation represents the demand for money and MV stands for
the supply of money. The demand for money (Md) is equal to . It means
that the demand for money is equal to 'P' multiplied by 'T' over a perio d
of time and divided by V The demand for money depends on the
amount of money which people have to hold in order to carry on a volume
oftransactions over a period of time. According to Fisher 'V and 'T' are
constant during the short period As a result, t he demand for money varies
with changes in 'P'. According to Fisher the supply of money (Ms) is equal
todemand for money (Md) .It means that the demand for money is always
equal to the supply of money. Fisher‘s version of demand for money
stresses the rol eo fm o n e yi ns p e n d i n ga n dn o ts a v i n gT h ed e m a n d
formoney changes in proportion to the changes in the price level. V
also determines the demand for money.
8.4THE NEO -CLASSICAL OR CAMBRIDGE
APPROACH TO DEMAND FOR MONEY :
The Cambridge approach or the ca sh balances approach was given
by Marshall, Pigou, Robertson and Keynes. These economists stressed the
store of value function of money. This approach concentrates on what
individual want to hold for satisfying the transaction motive andmunotes.in

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128precautionary moti ve. According to this approach, the demand for
money refers to the cash balances held by all individuals in an economy.
The following factors influence the decisions of individuals in holding cash.
(i)The prevailing prices of goods and services and the expec ted
changes.
(ii)The existing interest rates and expected changes in future.
(iii)The wealth in the hands of the people.
These factors remain constant according to the Cambridge
economists. The total demand for money or cash balances is a certain
proportio no fn a t i o n a li n c o m e .T h ed e m a n df o rm o n e yc a n be expressed
as,Md = KPY, where MD is the demand for money, K is the constant
proportion of income Y. It is the proportion of national income which
people desire to keep in the form of cash balances and Py is the nominal
national Income. According to the Cambridge economists the demand for
money is the constant proportion (K) of Y. Wherever there is a change
in the price level or in the real national income, the demand for money
also changes in equal proportio nF o re x a m p l ei fM Di sR s .2 0 0 0c r o r e s
and the money income is Rs 6000 crores per year K = 1/3 per year.
This imples that on an average the public likes to hold money
amounting to 1/3 of the annual income.
Check Your Progress :
1. Distinguish between Cash transaction and Cash balance approach
to demand for money.
8.5THE KEYNESIAN APPROACH OF DEMAND FOR
MONEY :
J M Keynes introduces his theory on the demand for money through
his book titled, the "General Theory of Employment. Interest and
Mone y" in 1936. According to Keynes money was demanded due to three
main motives i.e. the transactions motive, the precautionary motive
and the speculative motive. The speculative motive of demand for
money is a special contribution of Keynes.
(i)The transac tion motive :
It refers to the transaction demand for money as a medium of
exchange for carrying on current trade and business transactions. Money is
demanded for transaction purposes since it is received at discrete intervals
of time and expenditure goe s on continuously. Keynes classified the
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129(a)The income motive :
People hold cash to bridge the gap between the receipt of
income and expenditure. The income in the form of salary or wag esis
recovered at a certain time like once in a week or once in a month. But
expenditure goes on throughout all the time. To meet day-to-day
expenditure a part of the income has to be held in the form of liquid
cash. The following factors decide the amoun to f money held by
people:
(i)Level of Income As the level of income increases, the transaction
demand for money of the individual will increase and vice versa.
(ii)Tune Interval: The longer the time interval between the receipt
of income and expenditure, the hi gher the amount of money held by
people for transaction purposes.
(iii) The standard of Living : The higher standard of living, the larger
the amount of money held and vice versa.
(b) The business Motive :
The businessmen and the firms also hold cash bala nce in order
to bridge the interval between the time of incurring business costs or
expenses and the receipt of the sale proceeds. The larger the volume of
turnover or transactions for the business firms, the greater will be the
amount of money held for th is purpose. The amount of money held by
the business firms depends on the size of their income and their turnover.
The aggregate demand for money for satisfying the transaction
motive is the sum total of the individuals demand for cash as well as
the indiv idual firm's demand for cash. This aggregate demand for money
will depend upon total size of national income, the level employment and
the price level.
The transactions demand for money primarily depends on the level of
income. The transaction demand for money which is income -elastic can
be expressed in the following manner.
L = (fy) where Lt with transaction demand for money, T stands for
function of and y stands for the national income. The figure below shows
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130
Figure 8.1
In the above figure, dd is rising indicating that, with the increase in national
income, the demand for money for transaction purposes also rises,
(ii)The Precautionary Motive :
Besides the money kept also for transaction purposes, people hold
additional amount of money to meet unexpected or unforeseen
contingencies, emergencies or unexpected events. Money held for such
precautions is known as precautionary motive. The accessibility of
individuals and firms to the credit market determines the amount of
money held for this purpose. If borrowing is easy or the assets of the
people can be easily connected into cash, the amount of money held for
this motive will be very low and vice versa. Uncertainty regarding
future will make individuals and firms keep aside money for precaution
purposes. The precautionary motive of demand for money depends on
the income level ie. L = f(y), where 'Lp‘stands for precautionary motive,
Taf u n c t i o no fa n d y, the level of income,
(iii)Speculative motive :
People hold money as a stor e of wealth or liquid asset for investment
and lending, with a view to make speculative gains. People speculate
about the future prices of bonds or securities or future interest rates.
People prefer to hold securities where prices are expected to rise in f uture
and vice -versa. People make capital gains from speculative about the
prices of bond or securities or future interest rates. According to
Keynes. the speculations motive is the desire to earn profit by knowing
better than the market what the future wi ll bring forth The individuals
have to choose between holding money or other assets Uncertainly
regarding the behavior of the future interests and price of bonds leads to
speculation. If the rate of interest is high and the prices of bonds are low,
the low er will be liquidity preference. In such a case money will be lent
or bonds will be purchased. There is an inverse relation between the
prices of bonds and interest rate.
If the interest rate is expected to rise, or the prices of bonds to fall,
people sel lt h eb o n d so ra s s e t sa n dh o l dm o r ec a s h .T h e people willmunotes.in

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131buy the bonds when their prices actually fall In the other hand, if the
people expect the rate of interest to fall, or prices of bonds to rise,
people will buy bonds whose prices are expected to goup. This leads to a
fall in liquidity preference. This shows that speculative demand for money
is interest elastic. –
L=f ( i )w h e r e .L 2i st h ed e m a n df o rm o n e yf o rs p e c u l a t i v ep u r p o s e , (i)
the rate of interest
Liquidity preference (Speculative demand for money)
Figure 8 .2
The above figure shows the inverse relation between the rate of
interest and the speculative demand for money. It slopes downwards from
left to right indicating that when the rate of interest is high, the demand
for money is low and vice versa.
8.6MEANING OF INFLATION
A sustained rise in the general price level over a period of time is
known as inflation. Conversely, a sustained fall in the general price level
would be known as deflation. Inflation is measured in terms of a p rice
index. For instance in India, we have the wholesale price index (WPI) and
the consumer price index (CPI). The Price Index is based on a basket of
goods and services. Within a given basket, the prices of some goods and
services may rise or fall. Ho wever, when there is a net increase the price
of the basket, it is called inflation.
Inflation is a rate of change in the price level. The rate of change
is measured with reference to the base year so that a long term perspective
is obtained with regard to price rise. For all practical purposes, inflation
rate is measured on yearly basis. However, in recent years, the inflation
rate is also measured on monthly and weekly basis. The rate of inflation
can be measured as: P= (P1P0)P0100. For example, the
price index based on the Wholesale Prices in India for the year 2003 -04
was 180.3 and in 2004 -05, it was 189.5. The rate of inflation for the year
2004 -05 was 5.1 per cent. Inflation rate measured on the basis of
wholesale price index ( WPI) for the period 2005 -06 to 2012 -13 in India is
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132TYPES OF INFLATION BASED ON RATES OF INFLATION
On the basis of the rate of price rise, inflation is classified into five
categories. The ya r e creeping or moderate inflation, walking, running,
galloping and hyper inflation . When the rate of price rise is less than
three per cent per annum, it is called creeping inflation. An inflation rate
of about three per cent per annum is considered c reeping. When prices
creep upwards at a moderate rate, inflation serves as an incentive to
investment. As a result, the rate of investment, employment, output and
aggregate demand rises in the economy and the economy moves into the
prosperity phase.
When inflation rate crosses the three per cent mark and remains
within single digits i.e. below the 10 per cent mark, it becomes walking
inflation. Walking inflation leads to a much rapid fall in the purchasing
power of money. However, the negative consequ ences of single digit
inflation are not widely felt and hence it is considered within the tolerable
limits. However, both monetary and fiscal policies are swung into action
to control the rate of inflation and keep it within single digits.
When inflat ion rate is in double digits, it is known as running
inflation. When prices begin to rise by more than 10 per cent per annum
and the rate of inflation accelerates, money begins to flow away from
productive activities into unproductive or speculative activ ities. As a
result, the supply of goods and services fall in the economy and their
prices begin to rise more rapidly. Thus commodity prices rise rapidly for
want of investment and prices of gold, real estate and stocks rise more
rapidly because more and more money is diverted from the productive
sector to the unproductive sector.
When prices rise by about 100 per cent annum, the situation is
known as galloping inflation and when the inflation rate is over 1000 per
cent a year, it is called hyper infla tion. Both galloping and hyper inflation
signals the collapse of the economy. Productive activity is at an all timeTable 8 .1
Inflation Rate based on Wholesale Price Index (WPI)
in India for the period 2005 -06 to 2012 -13.
Year Wholesale
Price IndexInflation Rate (%)
P= (P1P0)P0100
2005-06 104.5 -
2006-07 111.4 111.4 –104.5/104.5 100 = 6.6%
2007-08 116.6 116.6 –111.4/111.4 100 = 4.6%
2008-09 126.0 126.0 –116.6/116.6 × 100 = 8.06
2009-10 130.8 130.8 –126.0/126.0 × 100 = 3.80
2010-11 143.3 143.3 –130.8/130.8 × 100 = 9.55
2011-12 156.1 156.1 –143.3/143.3 × 100 = 8.93
2012-13 164.8 164.8 –156.1/156.1 × 100 = 5.57
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133low, people lose confidence in the currency and the economy looks like
more of a barter economy. During world war one, countries like Aus tria,
Hungary, Germany, Poland and Russia experienced hyper inflation. For
instance between1920 -23, the German price index rose from one to one
billion. In 1994, the inflation rate in Georgia was 15000 per cent per
annum. In 2008, the inflation rate in Zimbabwe was 11.2 million per
cent. In such situations, the paper on which money is printed become
more valuable than the money itself i.e. the intrinsic value of even paper
money becomes greater than the face value. Thus if you sell money by
kilograms you may get more money in return than by exchanging money
in the market for goods and services.
8.7DEMAND PULL, COST PUSH AND STRUCTUAL
INFLATION
Broadly speaking, there are three types of inflation which
constitutes the causes of inflation. Demand sid e factors will cause demand
pull inflation, supply side factors will cause cost push inflation and
structural factors will cause structural inflation. Here in this section, we
will analyze these three major types of inflation.
1.Demand -pull Inflation: Demand pull inflation takes place due to
rise in aggregate demand. Aggregate demand may rise due to combined
effect of higher demand from the various sectors of the economy such as
the firms, households and the government. According to Keynes, inflatio n
arises when there is an inflationary gap in the economy. Inflationary gap
arises when aggregate demand is greater than aggregate supply at full
employment level of output. Keynes explained inflation in terms of
demand pull forces. When the economy is operating at the full
employment level of output, supply cannot increase in response to
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134AS
P4
P3 AD 4
AD 3
P2
P1 AD 2
AD 1
OY 1 Y2Y3
Aggregate Demand & Supply
Fig. 8.3 :D e m and Pull Inflation
Demand pull inflation is depicted in Fig.8.3 . You may note that
aggregate demand and supply curves are measured along the X -axis and
the general price level is measured along the Y -axis. The aggregate
supply curve AS rises upward in th e beginning and becomes vertical when
full employment level of output is achieved at point OY f. This is because
the supply of output cannot be increased once full employment level of
output is achieved. When the aggregate demand curve is AD 1, the
equilib rium is less than full employment level and the price level OP 1is
determined. When aggregate demand increases to AD 2, the price level
rises to OP 2due to excess demand at price level OP 1. Since the economy
is operating at less than full employment level , the real sector of the
economy responds to rise in prices and hence the output increases to OY 2.
When the aggregate demand further rises to AD 3, the price level rises to
OP3followed by increase in output to OY f. When the aggregate demand
further rises to AD 4, the aggregate supply does not respond to remain
constant at OY fand only the price level rises to OP 4.After the full
employment level of output the aggregate supply curve becomes perfectly
inelastic and parallel to the Y -axis.
2.Cost-push Inf lation:
In the absence of rise in aggregate demand, prices may rise due to
increase in cost in terms of higher wages, higher input costs and higher
profits. These are known to be autonomous increases in costs. Inflation
on account of rise in costs is known as Cost push inflation.PriceLevel
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135a)Wage -push Inflation: Powerful trade unions may bargain for higher
wages and also get it even when the cost of living has not changed or
the general price level is constant and there is no change in the
productivity of labor. When employers have no choice but to yield to
the demands of the trade union, they may pass on the higher costs to
the consumers by charging higher prices on the goods and services
produced. Such a situation leads to Cost -push inflation. In case of
Cost-push inflation, the aggregate demand curve shifts to the left
leading to fall in output and rise in the price level. Cost push inflation
is also known as stagflation. Cost -push inflation is depicted in
Fig. 8 .2
b)Profit -push Inflation: Firms operating under imperfect market
conditions such as monopoly, monopolistic and oligopoly markets
may hike their profit margins either autonomously or through
collusion. When prices rise on account of hike in profit margins, it is
called profit -push inflation. Profit push inflation may lead to cost push
inflation if the products are used as inputs by other firms. When prices
of capital goods, intermediate goods and raw materials are increased to
increase the profit margin by firms operating under im perfect
competition and when these goods are used as inputs by other firms,
the cost of production of these firms go up, thereby leading to cost
push inflation.
c)Input Cost Inflation: Supply shocks leading to rise in input costs is
an important cause of input -cost inflation. For instance, the oil price
shocks of 1970s. The sharp rise in world oil prices during 1973 -75
and in 1979 -80 created supply shocks and cost -push inflation. Recent
increases in the prices of crude oil also caused the inflation rate to go
up. For instance, the weekly inflation rate in India was 12.34% during
the second week of September 2008 as a result of sharp increase in the
international prices of crude oil to $150 per barrel. The government of
India took monetary and fiscal me asures to bring down the prices.
Fortunately, the crude oil prices also fell below the $50 per barrel
mark in January 2009 and the weekly inflation rate in India also fell
down to 6.4 per cent from the high of 12.34 per cent in September
2008.
d)In January 2009 and the weekly inflation rate in India also fell down to
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136AS2
AS1
P2 E2
P1 E1
AD
OY 2Y1
Aggregate Output
Fig. 8.4 Cost-push Inflation
AS3
AS2
AS1
P3 E3
P2 E2
P1 E1
AD
O Y3Y2Y1
Aggregate Output
Fig. 8.5 Cost-push Inflation & Direct and Indirect
Effects of Supply Shocks
Cost push inflation as a result of rise in inpu t prices is depicted in
Fig. 8.4 . Oil price s hocks and rise in the price of other inputs have direct
and indirect effects on the price level. When prices actually rise due to
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137rise in input costs, the workers revise their price expectations upward.
With upward price expectations, real wage rate decl ines and hence less
labor is supplied at the given nominal wage rate. With the upward
revision in the expected price level, the aggregate supply curve shifts to
the left. This is known as the indirect effect of an expected up ward price
revision. In Fig. 8.5, you will notice that the AS 1curve shifts to the left to
AS2and the price level rises to P 2on account of oil price shock. This is
known as the direct effect of a rise in the input cost. Now that the price
level has gone up, the workers will revise the expected price level to P 2.
This pushes the AS curve further left to AS 3and further rise in price level
to P 3. The movement from AS 2to AS 3is known as the indirect effect of
oil price shock.
8.8CAUSES OF INFLATION
The causes of inflation are c lassified into two categories. They are
demand side and supply side factors. These factors are discussed in this
section.
Demand side Factors Causing Inflation:
Inflation is caused by a rise in aggregate demand over aggregate
supply. Factors causing i n aggregate demand over aggregate supply are as
follows.
1.Increase in Public Expenditure: Public expenditure has been
increasing by leaps and bounds since the emergence of the Welfare
State in the second half of the 20thcentury. Particularly in mixed
economies with a pre -dominant public sector, the rise in public
expenditure has been phenomenal. The interventionist role of the
State has increased over time and the governments are seen to be
responsible for building social and economic infrastructure.
For instance, Government expenditure has regularly increased in India.
The Government expenditure in India has continuously increased since
the beginning of economic planning. Rising government expenditure
has been an important cause of inflation in India . The government or
public expenditure was 15.3 per cent of GDP in 1960 -61 and since
then it has been on a continuous rise. In 1990 -91, it was 31 per cent of
the GDP. It further rose to 31.2 per cent in 2000 -01. About 48% of
the public expenditure in I ndia is on non -developmental activities.
Expenditure on defense, interest payments and governmental
machinery constitutes non-developmental expenditure. Expanding
governmental machinery, rising defense expenditure, expenditure on
subsidies and growing pub lic borrowing has contributed t o the rise in
non-developmental expenditure. While non -developmental
expenditure increases aggregate demand in the economy, it does not
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1382.Deficit Financing: There is no surplus o r even a balanced budget.
Governments do not spend according to their incomes. Government
budgets are always deficit budgets which means, government
expenditure is always greater than income. Increasing fiscal deficit is
a general feature of the governm ent budgets of developing countries.
In order to finance the budget deficit, governments take recourse to
public borrowing and also borrowing from their Central Banks. In
order to raise resources for repaying public debt, governments may
raise the existi ng tax rates or raise new taxes. Deficit financing leads
to rise in public expenditure and hence rise in aggregate demand,
thereby causing inflation.
For example, the expenditure of the government of India has been
more than its income. The gap betwee n expenditure and income or the
deficit is filled through deficit financing. The deficit is financed by
borrowing funds from the banking system. If the borrowed funds are
used for unproductive purposes, they will give rise to inflation. The
government o f India has used the borrowed funds for non -
developmental purposes in a careless manner. The fiscal deficit during
the year 2002 -03 was Rs.145072 crore and in the year 2007 -08, it was
Rs.150948 crore.
3.Increase in Money Supply: Increase in money supply o ver and
above the quantity of output produced in the economy would result in
price rise. Irving Fisher’s quantity theory of money explains how
increase in money supply without a proportionate increase in output
leads to rise in prices and fall in the valu e of money. Commenting on
the effect of money supply on prices, Dr. C Rangarajan, former
Governor of the Reserve Bank of India states that “Money has an
impact on both output and price. The process of money creation is a
process of credit creation. Mone y comes into existence because credit
is given either to the government or the private sector or the foreign
sector. Since credit facilitates the production process, it has favorable
impact on output. But at the same time the increased money supply
raises the demand with an upward pressure on prices”. Dr.
Rangarajan has therefore accepted the fact in India, price effect of
money supply is greater than output effect.
If increase in money supply was the only reason for rising prices then
the rise in pr ices should be equal to the difference between the increase
in money supply and increase in output. In the Indian context, no such
relationship is found between the increase in money supply and the
inflation rate. For instance, the inflation rate in the year 2004 -05 was
5.1 per cent and the excess of money supply over real GDP was only
4.8 per cent. Going by Irving Fisher’s formula, the inflation rate must
be equal to excess money supply. However, in the Indian context, the
inflation rate was slightly h igher than the excess money supply. In
subsequent years, it is surprising to find that the inflation rate has been
much lower than the excess of money supply over real GDP.
Divergence between excess money supply and the inflatio nr a t ei smunotes.in

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139brought out in T able 8 .2. It clearly means that there are other factors
also which lead to increase in prices.
Table 8 .2
Comparison between Money Supply,
Real GDP and Inflation Rate in India
Source: IES 2007 -08.
4.Corruption and Black Money: Financial corru ption leads to creation
of black money. Corruption by public servants and ministers amounts
to unearned income and leakages in the system. Any leakage in the
flow of production would reduce the total quantity of output and
increase in aggregate demand. Further unreported incomes or black
money would also cause rise in prices. Although unreported incomes
are not entirely unearned incomes, they do contribute to excessive
consumption expenditure and therefore cause rise in prices.
According to Transpare ncy International, India and Centre for Media
Studies; India Corruption Report 2007, the below the poverty line
households (BPL) in India paid a total bribe of Rs.8830 million to
obtain public services in the year 2007. This amount is only the tip of
theiceberg. Out of the 180 countries surveyed by Transparency
International for corruption, India’s rank was 74 with an index of 3.5
in the year 2006. An index of 10 indicates complete freedom from
corruption and an index of zero indicates total corruption. Countries
like Finland, Denmark and New Zealand with a CPI (corruption
perception index) score of 9.4 were found to be least corrupt.
Countries with a CPI score of less than five are considered to have
serious problem. India is therefore one of the most seriously corrupted
countries in the world. Myanmar and Somalia with a CPI score of two
were the most corrupt countries of the world.
Supply Side Factors Causing Inflation:
Supply lags in the economy causes aggregate supply to fall short of
aggregate d emand and cause price rise. These supply side causes are as
follows.
1.Fluctuating Agricultural Growth: The rate of growth of output of
food grains must be equal to the rate of growth of demand for foodYearIncrease in
Money
Supply
M3(%)Change in
GDP (%)
at 1999 -2000
PricesExcess of
Money Supply
Over Real GDP
(%)Inflation
Rate
(WPI based)
2003-04 -
2004-05 12.3 7.5 4.8 5.1
2005-06 17.0 9.4 7.6 4.1
2006-07 21.3 9.6 11.7 5.9
2007-08 22.4 8.7 13.7 4.1
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140grains. Demand for food grains increases due to rise in incomes and
rise in population. In poor countries, the income elasticity of demand
for food grains is high. In poor countries, the agricultural sector is
under -developed and largely dependent on nature. Thus when the
agricultural sector fails to produ ce adequate output, the prices of
agricultural goods rise.
In the Indian context, population growth rate and the rate of growth of
agricultural output has remained the same in the last twenty years.
Indian agriculture is dependent on monsoons. Thus bad and poor
monsoons mean crop failure and rise in food prices leading to rise in
the general price level in the country. In the year 2004 -05, food
production fell by seven per cent. In the subsequent two years, food
production was by 5.2 and 4.2 per cent but once again fell to 0.9 per
cent in the year 2007 -08. The growth in real national income was
much higher than the rise in food production thereby causing the
prices to rise.
2.Hoarding of Essential Goods: When the agricultural sector fails, food
pries b egin to rise more rapidly than non -food prices. The problem of
food price rise is compounded by hoarding of agricultural goods by
traders. Artificial scarcity is created by both whole -sellers and
retailers. As a result, there is much greater increase in prices than
what is justified by real shortages. In the Indian context, both the big
farmers and agricultural traders indulge in hoarding of agricultural
goods during the periods of crop failure. In times of food scarcity,
hoarding of food grains and ot her food products only helps the prices
to rise further.
3.Inadequate Rise in Industrial Production: In the prosperity phase of
the business cycle, there is a sustained rise in investment demand
which causes a sustained rise in demand for industrial goods. If the
capital goods industry fails to respond to the rise in demand, the prices
of industrial goods will rise and when the prices of industrial goods
goes up, the prices of consumer goods also rise. In the Indian
context, during the period 1995 -96 to 2001 -02, the industrial sector
registered slow growth. Inadequate increase in industrial production
has also been an important cause of inflation in India.
8.9EFFECT OF INFLATION
EFFECT OF INFLATION ON PRODUCTION AND ECONOMIC
GROWTH, DISTRIBUTION OF IN COME AND WEALTH AND
CONSUMPTION AND ECONOMIC WELFARE
Inflation is a theft of income of the unprotected segments of the
society. Inflation is therefore a crime against the poor who experience a
fall in their real incomes during a period of sustained price rise. Inflationmunotes.in

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141affects the three most important functions of an economy namely;
production, consumption and distribution in an adverse manner.
(A)Effect of Inflation on Production and Economic Growth:
In economies where labor is largely unorganized, s ingle digit or
creeping inflation will increase profitability and therefore lead to greater
investment, employment, output, income, demand and prices. This is
because the wages of unorganized labor is not indexed to inflation. The
real wages of unorganiz ed labor will always fall overtime during inflation
whether anticipated or not. In the case of unanticipated inflation, the real
wages of organized labor will also fall and may be compensated with a
time lag. The firms will gain during the intervening pe riod between
unanticipated price rise and its compensation to labor. Thus from the
point of view of production and economic growth, single digit inflation
has a positive impact.
(B)Effect of Inflation on Distribution of Income and Wealth:
The impact of inf lation with regard to distribution of income and
wealth is not even on all sections of the society. In case of labor, the
section that is protected from inflation is the organized labor whose wages
and salaries are indexed to inflation. But unorganized l abor is not
protected from inflation and therefore their real incomes decrease on
account of inflation. Similarly debtors who have borrowed money on
fixed interest gain on account of inflation because real interest rate falls
during a period of rising inf lation while creditors lose because at times the
real interest rate may be zero and even negative. Similarly people holding
ownership capital like equity shares, balanced and growth funds make
capital gains because of rising profits of business enterprise s while people
holding creditor capital like bonds, debentures, fixed deposits and income
funds lose due to the fall in real interest rates. Broadly speaking, during
an inflationary period, households lose and firms gain. Hence it is said
that during inf lation the rich become richer and poor become poorer.
(C)Effect of Inflation on Consumption and Economic Welfare:
Inflation is known as a poor man’s tax. It reduces the purchasing
power of money earned by the poor people and hence their economic
welfare. The workers who do not get compensated for the increase in
price rise, experience reduction in real incomes because their nominal
income remains constant over a long period of time. Even those workers
who get compensated for the price rise lose purchasing power during the
intervening period between the rise in prices and the compensation in
price rise. For instance, the Central and State Government employees in
India get compensated for inflation twice in a year and there is always a
lag of six months bef ore such compensations are given. Economic welfare
depends upon consumption of goods and services and during a period of
sustained rise in prices, the people are able to consume less goods and
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1428.10MEASURES TO CONTROL INFLATION
Inflation is the result of excess demand over the supply of goods
and services. Inflation management, however, needs both demand and
supply management as well. Both monetary and fiscal measures can be
adopted to contro l inflation.
Attempt to control inflation in India was made for the first time in
the early sixties after experiencing rapid rise in prices during the second
five year plan. However, measures taken by the government were not
effective to control inflat ion. Prices continued to rise throughout the
planning era except the first five year plan. One of the important tasks
of the government was to maintain price stability under the new economic
policy. Accordingly, the government undertook various measur es to
control inflation in the country. These measures were as follows:
(A)MONETARY POLICY MEASURES:
The Central Bank’s policy with regard to cost and availability of credit
is known as monetary policy. The RBI can raise the rate of interest and
increa se the cost of credit and also reduce the availability of credit.
Quantitative instruments of credit control such as the bank rate, the cash
reserve ratio and the statutory liquidity ratio can be used to reduce
aggregate demand in the economy. Increase i n the bank rate by the RBI
will increase the market interest rate in the country. This will reduce the
demand for credit and further lead to reduction in aggregate demand.
Similarly, if the CRR and SLR are increased, the banks will have less
money at thei r disposal to give loans and advances to the borrowers.
Monetary expansion due to rising foreign exchange reserves was
controlled by sterilization of foreign exchange reserves. Commenting on
the effect of money supply on prices, Dr. C Rangarajan, former G overnor
of the Reserve Bank of India states that “Money has an impact on both
output and price. Since credit facilitates the production process, it has
favorable impact on output. But at the same time the increased money
supply raises the demand with a n upward pressure on prices”. Dr.
Rangarajan has therefore accepted the fact in India that price effect
of money supply is greater than output effect.
1.The Bank Rate: Bank rate is the rate at which Reserve Bank provides
loans to the commercial banks in t he country. It is also called the
discount rate because the Central Bank provides finance to commercial
banks by rediscounting bills of exchange. The bank rate in India was
10 per cent in the 1980s. It was raised to 12 per cent in October 1991.
The b ank rate was not a very effective in controlling money supply in
the pre -reform period. However, in the post reform period, the bank
rate has been made more effective and in keeping with the objective of
low inflation and high economic growth, the bank ra te was reduced to
6 per cent in April 1998 and it continued to be retained at 6 per cent
until July 2010. The bank rate however went up to 9.5 % as on 29thmunotes.in

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143March 2012 on account of inflationary pressures in the Indian
economy. Thereafter, the bank rate was brought down to 8.25% in
view of recessionary trend in the Indian economy. However, due to
sustained inflationary pressures, the bank rate was raised to 10.25% in
July 2013.
2.The Repo and Reverse Repo Rates: The bank rate as a credit control
instrum ent is losing importance. The repo and reverse repo rates are
becoming important in deciding interest rate trends in the Indian
economy. The Repo (sale and repurchase agreement) is a swap deal
involving the immediate sale of securities and simultaneous p urchase
of those securities at a future date at a predetermined price. These
swap deals take place between the RBI and financial institutions. The
repo or the repurchase rate is the rate at which the Central Bank
provides funds to banks. Continuing with its anti -inflationary
monetary policy stance, between March, 2010 and April, 2011, the
RBI has raised the policy rates six times. The repo rate was 5% in
March 2010 and in April, 2011 the repo rate went up to 6.75%. The
repo rate was further raised to 8.5 % on 25thOctober, 2011 on the
occasion of the Second Quarter Review of the Monetary Policy for the
year 2011 -12. The reverse repo rate is the rate at which the Central
Bank takes funds from banks and the reverse repo rate in March 2010
was 3.5% and in A pril, 2011 was 5.75 per cent. In October, 2011, the
reverse repo rate was raised to 7.5 per cent. In June 2013, the repo rate
was 7.25 and the reverse repo rate was 6.25%. Until July 2013, these
rates have been retained by the RBI.
3.Open Market Operatio ns: Open market operations means the
buying and selling of securities by the central bank. The sale of
securities leads to contraction of credit and purchase of securities lead
to credit expansion. The RBI uses switch operations for buying and
selling g overnment securities. Switch operations involve purchase of
one loan against sale of another. The use of switch operations
prevents unrestricted increase in money supply. Recently, in January
2011, when the SLR was reduced from 25% to 24%, the RBI
neutr alized the excess liquidity through OMOs. The SLR was further
reduced to 23% in the year 2012 and continues to remain at 23%. The
RBI conducted Open Market Sales of Government of India Securities
of Rs.12,000 crore on July 18, 2013.The RBI, however, coul d gain Rs.
2,532 crore from the auction, as rest of the bids received had quoted
yield rates higher then acceptable to the RBI.
4.The Cash Reserve Ratio: The CRR is an effective instrument of
credit control. It refers to the cash which the banks have to m aintain
with the Reserve Bank as a certain percentage of their demand and
time liabilities. Changes in the CRR bring about changes in the
loanable resources of the banks, particularly the commercial banks.
In the late 1980s, there was a rapid growth i n money supply and hence
the CRR was raised from 10 per cent to 15 per cent. In the post reform
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144of the Narasimham Committee to below the 10 per cent level.
However, in August 1994, the CRR w as raised to 15 per cent to
control the inflationary trends in the economy. Since then inflationary
pressures were reduced in the economy and accordingly the CRR was
progressively reduced to 4.5 per cent in June 2003. The RBI had to
increase the CRR to f ive per cent in October 2004 and further to 7.5
per cent in October 2007. In August 2008, the CRR was raised to nine
per cent. As part of the anti -recessionary policy in the wake of global
financial crisis of 2008 -09, the CRR was reduced to five per cent in
January, 2009. It was raised to 5.75 per cent in February, 2010 and
further to six per cent in April 2010 as inflationary pressures started
building in the economy on account of the huge fiscal stimulus that
was given by the government in the aftermat h of the financial crisis of
2008 -09 and its negative impact on economic growth in India. In the
first quarter review of the monetary policy for the year 2010 -11,
released in July 2010, the CRR was retained at 6 per cent by the RBI.
Subsequently, the CRR was reduced to 4.75 per cent in March 2012 to
ease liquidity conditions in the money market. In June 2013, the CRR
was 4.0% and it continues to be 4 % in July 2013.
5.The Statutory Liquidity Ratio: The Banking Regulation
(Amendment) Act 1962 provides for maintaining a minimum SLR of
25% by the banks against their net demand and time liabilities. The
SLR is fixed at 25% for co -operative banks, non -scheduled banks and
the regional rural banks. In case of commercial banks, it can be raised
to 40%. The RB I has used this instrument quite often during the 70s
and 80s. In September 1990, the SLR was raised to 38.5 per cent and it
remained at this level up to January 1993. This was done to control
inflationary pressures and make larger resources available to the
government. The Narasimham Committee recommended reduction of
SLR to 25 per cent and accordingly the SLR was reduced to 25% in a
phased manner in October, 1997. In November 2008, the SLR was
further reduced to 24 per cent and in October, 2009, the SL Rw a s
restored to 25 per cent once again. However, in December 2010, the
SLR was once again reduced to 24%. The SLR was further reduced to
23% in the year 2012 and continues to remain at 23%.
(B)FISCAL POLICY:
The fiscal policy of a country refers to the p olicy of the
Government with regard to income and expenditure. Expansionary fiscal
policy is adopted during the periods of economic stability or during the
times of recession. In contrast, a tight fiscal policy is adopted when the
economy is in the grip of inflation. In order to promote growth, the
government may reduce both direct and indirect taxes and increase the
level of aggregate demand. The government may also increase public
expenditure to increase the level of aggregate demand and achieve a
higher economic growth rate. However, in order to control inflation, the
Government may raises taxes, add new taxes and reduce public
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145The Government of India made attempts to remove fiscal
imbalance from 1991 -92 by bringing down fiscal deficit from 6.6 per cent
to 4.7 per cent of GDP. However, in 1993 -94 the fiscal deficit rose to 6.4
per cent. It was 5.9 per cent in 2001 -02. In 2005 -06, the fiscal deficit was
brought down to below the five percent mark. During the decade 1995 -
2005, the government has been able to keep the average inflation rate
below the five per cent level. However, between 2005 -06 and 2012 -13, the
government had failed to control inflation rate and fiscal deficit once again
went up to 6.0 and 6.5 % in the years 2008 -09 and 2009 -10. The fiscal
deficit during the year 2010 -11 was Rs.3, 69,043crores and in the year
2011 -012, it was Rs.4, 12,817crores. The budget for 2010 -11 announced
going back to fiscal consolidation and the projected fiscal d eficit for 2010 -
11, 2011 -12 and 2012 -13 is 5.5%, 4.8% and 4.1 % respectively. The
actual fiscal deficit figures in the years 2010 -11 and 2011 -12 were below
the projected figures. However, fiscal deficit in 2008 -09 and 2009 -10, had
gone up due to fiscal i ntervention made by the Government of India in the
wake of the Global Financial Crisis. Near double digit inflation and a very
high food price inflation in the last three years is the price paid by the
people of India for the fiscal profligacy of the Gove rnment of India.
(C)SUPPLY SIDE MEASURES:
Inflation is the result of mismatch between aggregate demand and
aggregate supply. Both monetary and fiscal policies can act on the
demand and supply side through interest rates, money supply, taxation and
public e xpenditure. However, some measures can directly influence the
supply of goods and services. These measures are explained below.
1.Public Distribution System: The Public Distribution System was
established in the country to provide essential consumer go ods
particularly to the poor people at low prices. The entire country is
covered by this system. However, one cannot say that the system has
been able to control price rise. The agricultural price support policy of
the government has worked against the o bjective of price stability. As
a result of faulty agricultural policy, food production in India had
failed to keep pace with rising demand for food. The recently enacted
Food Security Act by the Government of India promises cheap and
heavily subsidized food for about 65 % of the population. It remains
to be seen whether this measure will bring down food price inflation
in the coming years.
2.Import of Essential Commodities: In order to improve the supply of
essential commodities, the government of Indi a had allowed food
imports. During 1995 -96, imports of edible oils, palmolein, sugar and
pulses were allowed. The Food Corporation of India sold rice and
wheat in the open market to control market prices of these food
grains. Excise duties on a number of industrial products were reduced
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1463.Capacity Utilization and Increase in Aggregate Supply: The
productive capacity of the economy should be fully utilized.
Widespread unemployment can only lead to rising price level because
the unemployed generates demand for goods and services without
contributing to their production. The productive apparatus in the
country consisting of farm lands, industries, services, forestry, fishing,
mining etc must be fully utilized. Un der utilization of the potential
and sometimes the actual productive capacity will lead to shortage of
aggregate supply and hence price rise.
(D)INCOME POLICY:
Income freeze is an important policy measure to counter inflation. Here
income freeze refers to inflationary income. Revision in wage rates on
account of payment of dearness allowance to organized workers and
revision in wage rates to all kind of workers due to rise in the cost of
living is an example of wage push inflation. Factor incomes such as rent,
wages, interest and profit should reflect the marginal productivity of the
given factor. Policy that delinks factor incomes from the price level may
help stabilizing the prices and may be the price level comes back to the
original level in due cours e. However, the policy of freezing only wages
will not be accepted by organized labor. The argument that wage rate
must reflect the marginal productivity of labor is economically sound. But
the same argument must be extended to other factors of producti on.
8.11SUMMARY
1.The classical economists emphasized the medium of exchange
function of money According to the classical economists like J.S. Mill.
David Hume and Irving Fisher, the demand for money arises since money
facilitates the exchange of real goo ds and services among individuals.
Hence money is demanded for buying and selling goods and services or
for spending over a period of time The classical economists believed
that the demand for money depends on objective factors like the
volume of exchange transactions of goods and services produced and
supplied during a given period of time, the amount of money needed to
buy the goods and services and by the velocity of circulation.
2.According to Fisher, the demand for money means the amount of
money to be held to undertake a given volume of transactions over a
period of time. Fisher's equation of exchange is given as MV = PT,
where M is the money supply, V the transaction velocity, T
transactions and 'P‘the price level. 'PT' in the equation represents the
demand for money and MV stands for the supply of money.
3.The Cambridge approach or the cash balances approach was given by
Marshall, Pigou, Robertson and Keynes. These economists stressed the
store of value function of money. This approach concentrates on what
individual want to hold for satisfying the transaction motive andmunotes.in

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147precautionary motive. According to this approach, the demand for
money refers to the cash balances held by all individuals in an
economy. The following factors influence the decisions o f individuals
in holding cash.
4.A sustained rise in the general price level over a period of time is
known as inflation. Conversely, a sustained fall in the general price
level would be known as deflation. Inflation is measured in terms of a
price index.
5.Broadly speaking, there are three types of inflation which constitutes
the causes of inflation. Demand side factors will cause demand pull
inflation, supply side factors will cause cost push inflation and
structural factors will cause structural inflati on.
6.Inflation is the result of excess demand over the supply of goods and
services. Inflation management, however, needs both demand and
supply management as well. Both monetary and fiscal measures can
be adopted to control inflation.
8.12QUESTION S
1.Explain Fisher’s approach to demand for money.
2.Explain Cambridge approach to demand for money.
3.Discuss the meaning and types of inflation.
4.What are the causes of inflation?
5.Differentiate between demand pull and cost push inflation.
6.Discuss various effec ts of inflation.
7.What measures can be adopted to control inflation?
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148QUESTION PAPER PATTERN
Business Economics Semester I II
Maximum Marks: 100 Marks
Time: 3 Hours
Note :
1)Attempt all Questions
2)All Questions carry equal marks
3)Attempt any two questions out of three in each of question 2, 3, 4 & 5
Question
NoParticular Marks
Q-1 Objective Questions
A)Conceptual questions (Any Five out of
Eight )(Two from each module)
B)Multiple Choice Questions ( 10 questions at
least two from e achModule)10 Marks
10 Marks
Q.2(From
Module I)A) Full Length Question
B) Full Length Question
C) Full Length Question20Marks
Q.3(From
Module II)A) Full Length Question
B) Full Length Question
C) Full Length Question20Marks
Q.4(From
Module
III)A) Full Length Question
B) Full Length Question
C) Full Length Question20Marks
Q.5(From
Module
IV)A) Full Length Question
B) Full Length Question
C) Full Length Question20Marks munotes.in