Page 1
1
Module 1
Unit-1
MACROECONOMIC ACCOUNTING -I
Unit Structure:
1.1 Objectives
1.2 Meaning and introduction to Macroeconomics and
Macroeconomics accounting.
1.3 Principal of accounting
1.4 Concept of stock and flow
1.5 Concept of equilibrium and disequilib rium
1.6 Question
1.7 References
1.1 OBJECTIVES
a.To explore the knowledge of Macroeconomics and its one of the
branches that is accounting
b.To understand the distinguish between concept of stock and flow
c.To know different types of equilibrium
d.To find var iation in the concept of static and dynamic model
1.2 INTRODUCTION OF MACROECONOMIC
ACCOUNTING
Meaning: Macroeconomics
Macroeconomics derive from Greek word Makros which means study of
large unit. It is a branch of economics concerned with the performan ce,
structure, behaviour, and decision -making of an economy as a n aggregate .
Forexample , using rates ofinterest , taxes and government expenditure to
regulate an economy's progress and stability.
Macroeconomics considers to explain how and why the econom y
grows and fluctuate over time. The general increasing track of the
economy is due to sluggish moving forces that is population increase ,
requirement of more factories, machines and better technology. Long run
upward path is in oscillation form which is n ot smooth. Leading to series
oftrade cycle recurring in nature, with the phase in the path like recovery,
prosperity, peak, recession, depression, trough and so on.munotes.in
Page 2
2
Macroeconomic accounting contains wholes and accounting
characteristics ,which is with Macroeconomic extents and how they relate
to each other by definition. Macroeconomic accounting does not enlighten
how each magnitude changes as a result of a change in other magnitudes.
Important function of national income accounting is to keep record
of productive activity and income generating transactions in the economy.
Macro accounting is the compilation of economic data for a nation. Also
known as national accounting, the data form the basis for tracking and
forecasting the nation's economic perfo rmance and development and is
used to form government policy.
1.3PRINCIPLES OF THE ACCOUNTS
1.The accounts should be related for economic study .
2.Current data considered while estimating the data of production,
income, expenditure of things andamenities .
3.Output is valued at market price
4.Consistent with an individualistic view of welfare, consumer
expenditure is counted as final demand, rather than as an input to the
labour force.
1.4 STOCKS AND FLOW
Stock and flow are important concept influencing the accounting
estimation of and business economic analysis.
Stocks and flows National accounting include data of the variables
that describe the working of an economy.
1.4.1 Stock:
Stock is estimated at particular stated time and signifies a quantity
prevailing at that point in time. Stock is well-defined as a variable that is
restrained at a specific point oftime. Stock does not have a time
dimension involved with it. Stock is stationary in nature. Stock stimuluses
the flow, as such greater volume of cap ital will lead to greater undertaking
of services. Bank deposits, capital, wealth, population.
1.4.2 Flow:
Aflow ofvariable can be measured over an interval of time ,which
are defined for a particular time period. Transactions are always
represented by flows over a period of time. The concept of Flow variable
iswell-defined as a variable which is measurable over a period of time.
Examples of flow variables are: the cost of production in a nation
throughout aspecified year, the value of final consumptio n done by
households in a country during a given month, the value of income earned
by workers in a province during a given week, etc. Flow concept has amunotes.in
Page 3
3
time measurement attached with it. The Flow concept is dynamic in
nature. Flow effects the stock, as i n increased flow of money supply in an
economy results in increase in the size of money. Capital formation,
income, interest on capital, depreciation.
1.4.3 Stock and Flow accounting:
TheStock is the rateof an asset at a poise date whereas flow refers
asthe total charge ofdealings of sale, purchase, revenue and expenditure
during an accounting period. The number of businesses of a stock in that
accounting dated can be measured by dividing the flow value of an
economic activity by the average stock valu e during an accounting period.
Profit or income is consider as flow concept whereas capital can be
measured as both stock and flow.
Figure No. 1.1 Traditional Example of Stock and Flow
Infigure 1.1 the bathtub shown ,is the classical example used to
illustrate stocks and flows. The quantity of water in the tub referred as
stock: Which is given at a point in time. The amount of water coming out
of the faucet is a flow: it is the quantity of water being added to the tub per
unit of time. U.S investmen t was $2.5 trillion is flow concept and capital
stock was $26 trillion is stock concept. The stock of water in the tub
signifies the accumulation of the flow out of the faucet, and the flow of
water represent the variation in the stock.
Examples of relate d stocks and flows:
Aindividual’s wealth is a stock; income and expenditure are flows
The number of jobless people is a stock; the number of people losing
their jobs is a flow.
Thevolume of capital in the economy is referred as stock; the amount
of inves tment is a flow.
The government debt or borrowings is a stock; the government budget
deficit is a flow.munotes.in
Page 4
4
Table 1.1 Stock and Flow Variables
Stock Variable Flow Variable
Stock of Capital (K) Gross National Product (GNP)
Supply of money (M) Consu mer Expenditure(C)
Business Inventories (BI) Savings(S) and Investment(I)
Accumulated Savings Export(X) and Import(M)
Labour Force Change in Inventories
Total Employment Government revenue(R) and Government
Expenditure(G)
This table consist of varia bles of stock and flow under
macroeconomics accounting.
1.4.4 Comparison of Stock and Flow
Stock and flow both are elastic in nature and the difference
between them should be considered understand the development of the
economic variables.
Generally, maximum economic variables that are studied are
categorised either as stock or flow variable.
Both the stock and flow are reliant on each other. The concept of
stock and flow is very crucial in Economics, as it helps to understand the
development of econom ic variables.
1.Stock and flow have dissimilar unit so its problematic to add, subtract
and compare. One can apply ratio, multiplication and subtraction for
estimation.
2.The ratio of a stock over a flow has units of (units)/(units/time) =
time.
3.Public Debt -GDP Ratio yields the interpretation of the debt to GDP
ratio as "number of years to pay off all debt, assuming all GDP
devoted to debt repayment" as an example .
The ratio of a flow to a stock has units 1/time.
Example: Velocity of Money = GDP ÷ Money Supply it has units of
(dollars / year) / dollars = 1/year.
4.Stocks can only be changed via flows.
5.Mathematically a stock can be seen as an integration of flows over
time –with outflows subtracting from the stock. e.g., the number of
populations at a cert ain moment, or the quantity of water in a reservoir.munotes.in
Page 5
5
6.Flows classically are measured over a certain intermission of time –
e.g., the number of births over a day or month.
1.5 EQUILIBRIUM AND DISEQUILIBRIUM
1.5.1 Equilibrium -In economic sense, equilibriu m refers to a position in
which contrary economic forces, e.g., demand and supply, are in balance
and there is no natural tendency to depart from this position. Machlup
defines equilibrium as a “constellation of interrelated variables so adjusted
to one an other that no inheritance tendency to change prevail in the model
which they constitute.” At macro level economy is said to be in
equilibrium when aggregate demand is equal to aggregate supply and total
investment equal total saving.
1.5.2 Disequilibrium –This is the state in which the opposite forces (e.g.,
demand and supply) are in imbalance. The factors causing disequilibrium
arise out of the working process of economy. The working of a market
economy is governed by such a large number of interrelated and
interacting forces that a continuous balance between market forces –
demand and supply can not be expected. Infact imbalance between
economic forces are routine matter in a market economy. The reason is
that economic activities are undertaken by millio ns of decision makers –
consumers, producers, workers etc and their decision need not always
coincide. The result could be disequilibrium.
1.5.3 Equilibrium and disequilibrium in Macroeconomics
It can be explained with the help of aggregate demand and
aggregate supply variable of macroeconomics. Economy will be in
equilibrium when AD = AS; which is leading to effective demand. At
effective demand position the economy is at full employment that means
the resources are optimally utilised.
Figure No. 1. 2
munotes.in
Page 6
6
AD = C+I+G+(X -M)
AS = N+L+k+T
In the above figure employment/income is on X –Axis and
Proceeds on Y –axis. At point E in the figure –2 Economy is at
equilibrium level of employment. Any fluctuation from point E will lead
to disequilibrium.
Example: 1.ADP > ASP when aggregate demand price is greater than
aggregate supply price. There is scope of increasing employment because
resources are idle unused so employment can be increased.
2. ADP < ASP when aggregate demand price is less than aggregate supply
price it needs to reduce the employment to run the economy smoothly.
3. ADP =ASP thus the optimum level is when the aggregate demand price
is equal to aggregate supply price.
1.5.4 Types of Equilibrium:
A.Partial Equilibrium
Thestate of eco nomic equilibrium which is consider only portionofthe market at equilibrium level.
1.Micro economics uses partial equilibrium analysis based on theassumption, other things remaining constant (Ceteris Paribus Condition) .
Example: TheCommodity price is certain andcontinuous for the consumers.Consumers' taste and preferences, habits, incomes are also considered to beconstant.Prices of prolific resources of a commodity and that of other relatedgoods (substitute or complementary) are known as well as c onstant.Industry is easily availed with factors of production at a known andconstant price compliant with the methods of production in use.Prices of the products that the factor of production helps in producingand the price an dq u a n t i t yo f related factors are known and constant.There is perfect mobility of factors of production between occupationand places.
2.The micro analysis partialequilibrium analyses policy action of creatingequilibrium for specific factor onl y.
3.Partial equilibrium studies the equilibrium of a consumer, a firm, anindustry or a market.munotes.in
Page 7
7
B.General Equilibrium
It is on the basis of bottom -up approach. It explains equilibrium ofdemand, supply and price at aggregate level. It is b asically broder concept.Ageneral equilibrium beneficial as a basicguide as to how real economiesfunction.
1.Macroeconomics uses general equilibrium.
2.It is not based on any` assumption.
3.It deals with the equilibrium position of the economy as a who le.
4.It deals with all the variables of the economic system simultaneously.
5.It is sophisticated.
6.There is interdependence between variables.
7.General Equilibrium is a bird's eye -view.
1.6 QUESTIONS
1.Explain the following:
a.Stock variable
b.Flow variab le
c.Equilibrium
d.Disequilibrium
e.Macroeconomics
2.Is there any difference between stock and Flow variable, Justify?
1.7 REFERENCES
AHUJA, D. (2009). Macroeconomics theory and policy. New Delhi -110
055: S.Chand and Company LTD.
Dwivedi, D. N. (2008). Macroe conomics Theory and Policy. New Delhi
110063: Tata McGraw -Hills.
Mankiew, N. G. (2005). Macroeconomics. New York, NY 10010: Worth
Publishers.
munotes.in
Page 8
8
Unit-2
MACROECONOMIC ACCOUNTING -II
Unit Structure:
2.1 Objectives
2.2 Introduction to Circular flow of income
2.3 Real Income and Money Income
2.4 Significance of Circular flow of Income
2.5 Illustration Circular Income in different Sector Economy
2.6 Circular flow of income -Two sectors Model
2.7 Circular Income Flow with Saving and Investment
2.8 Circular Income Flow in a Three Sector Economy with
Government
2.9 Money Income Flows in the Four Sector Open Economy: Adding
Foreign Sector:
2.10 Conclusion
2.11 Key Terms
2.12 Questions
2.13 References
2.1 OBJECTIVE
1.Tounderstand the concept of Circular flow of income
2.To know two sector/close economy
3.To understand the functioning of three sector model
4.To know four sector/open economy
5.To understand the concept of real flow and money flow
6.To know the concept of leakages and injection
7.To understand the national income identities.
2.2 INTRODUCTION
During primitive period barter system was most popular for
exchange of goods and services. But this system was not successful due to
various difficulty faced by people for exchanging goods. T hen the need of
some invention felt and since then money is accepted as common measure
of exchange. The modern economy is a monetary economy. In the modern
economy, money is used in the process of exchange. Money acts as a
medium of exchange. Money play v arious role in economy. In this chaptermunotes.in
Page 9
9
we introduce the economy. An economy can be defined as an integral
system of production, exchange and consumption.
Thecircular flow model describes, how money moves through
society. Money flows from producers (Firm ) toworkers (Household) as
wages and flows back to producers as payment for products. This
movement is recurring continuously between firm and household. Thus,
this model is described as the circular flow of income model.
2.3 REAL INCOME AND MONEY INCOME –
1.Real Flow -The term real flow means the flow of factor services such
as land, labour, capital and entrepreneur; from household to firms.
Similarly, the flow of goods and services from firms to household.
Real flow is also called as pro duct flow or output flow. Real flow
generate income for the nation thus it can correlated as real income of
nation.
2.Real Income measures the volume of output. An increase in real output
means that AD has risen faster than the rate of inflation and therefo re
the economy is experiencing positive growth. Real income is adjusted
for inflation and measured at constant price. While estimating
economic growth Real income/GDP is taken in to consideration.
3.Money Flow -The Money flow refers to the flow of factor pay ments
such as –Rent ,wages, interest and Profit; from firm to household for
factor services.
It involves two basic principles:
a.In an exchange process, the seller (producer) receives the same amount
which the buyer (or consumer) spends.
b.Goods and servic esflow in one direction and the money payments to
acquire them flow in the return direction giving rise to a circular flow.
The money flow is in opposite direction to real flow.
4.Nominal income measures income at current prices with no adjustment
for the effects of inflation e.g. if my nominal income is £40,000 in
2012 and rises by 5% in the next year, then my nominal income will
rise to £42,000
When we want to measure growth in the economy we h ave to
adjust for the effects of inflation and consider data in real terms.
2.4SIGNIFICANCE OF CIRCULAR FLOW OF INCOME
The concept of the circular flow shows functioning of the
economy. We can know whether the economy is working effectively ormunotes.in
Page 10
10
whether there is any disturbance in its smooth functioning. As such, the
circular flow is of immense significance for studying the functioning of
the economy and for helping the government in formul ating policy
measures.
1.Study of identifying the Problems of Disequilibrium:
It is with the help of circular flow that the problems of
disequilibrium and the restoration of equilibrium can be studied. If any
discrepancy in circular flow is their then policy framed accordingly to
overcome from that disequilibrium.
2.Effects of Leaka ges and Inflows:
Circular flow of income is relevant in balancing in economic
activity. The role of leakages enables us to study their effects on the
national economy. For example, imports are a leakage out of the circular
flow of income because they are p ayments made to a foreign country. To
stop this leakage, government should adopt appropriate measures so as to
increase exports and decrease imports, and will be effective in having
equilibrium in balance of payment.
3.Linkage between Producers and Consumer s:
The circular flow establishes a link between producers and
consumers. It is through income that producers buy the services of the
factors of production with which the latter, in turn, purchase goods from
the producers.
4.Framework for Network of Markets :
As it is mention above point, the linking of producers and
consumers through the circular flow of income and expenditure has
created a network of markets for different goods and services where
problems relating to their sale and purchase are automaticall y solved.
5.Inflationary and Deflationary Tendencies:
Leakages or injections in the circular flow disturb the smooth
functioning of the economy. For example, saving is a leakage out of the
expenditure stream. If saving increases, this depresses the circular flow of
income. This tends to reduce employment, income and prices, thereby
leading to a deflationary process in the economy. On the other hand,
consumption tends to increase employment, in come, output and prices that
lead to inflationary tendencies.
6.Basis of the Multiplier:
Again, if leakages exceed injections in the circular flow, the total
income becomes less than the total output. This leads to a collective
decline in employment, in come, output, and prices over time. On the other
hand, if injections into the circular flow excel leakages, the income is
increased in the economy. This leads to a cumulative rise in employment,
income, output, and prices over a period of time. In fact, th e basis of themunotes.in
Page 11
11
Keynesian multiplier is the collective movements in the circular flow of
income.
7.Importance of Monetary Policy:
Circular flow is relevant for monetary policy making. With the
help of circular flow monetary policy bring equality of savin g and
investment in economy. The equality between saving and investment
comes about through the credit or capital market.
The credit market itself is controlled by the government through
monetary policy. When saving exceeds investment or investment exceed s
saving, money and credit policies help to stimulate investment spending.
This is how a fall or rise in prices is also controlled.
8.Significant to Fiscal Policy:
The circular fl ow of income and expenditure play crucial role for
maintaining stability through fiscal policy. For national income to be in
equilibrium desired saving plus taxes (S+T) must equal desired investment
plus government spending (I + G). S+ T represents leakage s from the
spending stream which must be balance by injections of I + G into the
income stream. If S + T exceed I + G, government should adopt such
fiscal measures as reduction in taxes and spending more itself. And
inverse occur say; If I + G exceed S+T, the government should adjust its
revenue and expenditure by encouraging saving and tax revenue.
9.Importance of Trade Policies:
Circular flow of income is significant not only to balancing close
economy but also relevant for open economy as well. Impor ts are leakages
in the circular flow of money because they are payments made to a foreign
country. Which leads to deficit in balance of payment. To stop it, the
government adopts such measures as to increase exports and decrease
imports. Thus the circular flow indicates the need for adopting export
promotion and import control policies.
10.Basis of Flow of Funds Accounts:
The circular flow helps in calculating national income on the basis
of the flow of funds accounts. It is relevant in finding the GDP, G NP of
economy. The flow of funds accounts are concerned with all transactions
in the economy that are accomplished by money transfers.
They show the financial transactions among different sectors of the
economy, and the link between saving and investment, and lending and
borrowing by them.
To conclude, the circular flow of income possesses much
theoretical and practical significance in an economy.munotes.in
Page 12
12
2.5ILLUSTRATION CIRCULAR INCOME IN
DIFFERENT SECTOR ECONOMY
In carrying out economic activity, people are engage in making
transactions –they buy and sell goods and services.
Economic transactions include two kinds of flows:
1. Product or real flow that is the flow of goods and services, and
2. Money flow produc t and money flow in opposite direction in a circular
fashion.
The product flow consists of
(a) Factor flow, i.e , Flow of factor services, and
(b) Goods flow, i.e, flow of goods and services.
In a monetised economy, the flow of factor services rewarded as
money flow in the form of factor payments. Which is called as income
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 form is in opposite
direction. The entire economic system can therefore observe as Circular
flows of income and expenditure. The extent of these flows, actually,
determine t he size of national Income. To present the flows of income and
expenditure the economy is classified in to four sectors:
1.Household sector
2.Business Sector or the firms
3.Government sector
4.Foreign Sector
These four sectors are combined to make the models fo r the
purpose of showing the circular flow of income.
A.Two -sector model including the household and business sectors
B.Two -sector model including the household and business sectors with
saving as leakages and Investment as Injection close economy
C.Three -sector model including the household, business and
government sectors
D.Three -sector model including the household, business and
government sectors, with tax as leakage and government expenditure
as injections close economymunotes.in
Page 13
13
E.Four -sector including the hou sehold, business and government
foreign sectors.
F.Four -sector including the household, business and government
foreign sectors. With import as leakage and export as injection, open
economy
2.6 CIRCULAR FLOW OF INCOME -TWO SECTOR
MODEL
The circular flow of income is explained by considering a simple
model. The two -sector model includes only household and firm. It
represents private close economy without government and foreign sector.
This model is based on following assumptions.
1.There a re two sectors(a) household and (b) firms
2.Households are owners of factors of production
3.Production takes place only in firms
4.There is no savings
5.There is no governmental intervention
6.There is no international trade
2.6.1 PARTICIPATION:
The primary participants in the circular flow of goods and services
are firm and households. Households are made up of individuals who both
spend money and are the recipients of money. Firms do the same —they
spend money and also receive money from households. Real flo ws of
resources, goods and services have been shown in Fig.2.1.In the upper half
of this figure represents factor market, the resources such as land, capital
and entrepreneurial ability flow from households to business firms as
indicated by the arrow mark.
There arethree different phases incircular flow of national
income, viz. production, income and expenditure. They represent three
related aspects, namely, production (i.e., generation of income),
distribution (ofincome) and disposition (of income, i.e., expenditure).
In opposite direction to this, money flows from business firms to
the households as factor payments such as wages, rent, interest and profits.munotes.in
Page 14
14
Figure No.2.1
Circular Flow of Income in a Simple Two Sector Economy
In the lower part i.e. commodity market of the figure –, money
flows from households to firms as consumption expenditure made by the
households on the goods and services produced by the firms, while the
flow of go ods and services is in opposite direction from business firms to
households.
Thus, we see that money flows from business firms to households
as factor payments and then it flows from households to firms. Thus, there
is, in fact, a circular flow of money o r income. This circular flow of
money will continue indefinitely week by week and year by year. This is
how the economy functions. It may, however, be pointed out that this flow
of money income will not always remain the same in volume.
In other words, th e flow of money income will not always continue
at a constant level. In year of depression, the circular flow of money
income will contract, i.e., will become lesser in volume, and in years of
prosperity it will expand, i.e., will become greater in volume.
This is so because the flow of money is a measure of national
income and will, therefore, change with changes in the national income. In
year of depres sion, when national income is low, the volume of the flow
of money will be small and in years of prosp erity when the level of
national income is quite high, the flow of money will be large.munotes.in
Page 15
15
2.6.2Important Identities:
Y Ξ FP
FP Ξ w + r + I + p
W+r+i+p Ξ V Ξ M
V Ξ Y Ξ M
Where Y = household income, FP = factor payment, w = wages, r
= rent, i = interest, p = profits, V = value of output, and M = money flow
(at constant prices) Ξ = identities equal to sign.
In the final analysis, household income = factor payment = the
mone y value of output.
That is Y Ξ FP Ξ V
The identity of circular flow of income is significant while
estimating national income of economy.
2.7 CIRCULAR INCOME FLOW WITH SAVING AND
INVESTMENT
It is assumed that income which is earned by household entire is
spend for purchase of goods and services produced by firm. But let
assume that which is reality as well that household save part of their
earned income in the form of saving. We will now explain if households
save a part of their income, how their savin gs will affect money flows in
the economy.
When households save, their expenditure on goods and services
will reduce to that extent and as a result money flow to the busi ness firms
will decrease. With reduced money receipts, firms will appointlessworkers
or reduce the factor payments they make to the suppliers of factors such as
workers.
Because of which it led to the fall in total incomes of the
households. Thus, savings reduce the flow of money ex penditure to the
business firms and will cause a fall in economy’s aggregate income. Thus,
savings is considered as leakage from the money expenditure flow.
But savings by household can be restore by free market economies.
There exists a set of institutions such as banks, insurance companies,
financial houses, stock markets where households deposit their savings.
All these institutions together are called financial institutions or financial
market. We as sume that all the savin gs of households come in the
financial market. We further assume that there are no inter -households’
borrowings.munotes.in
Page 16
16
Then business ente rprise can borrow from these financial
institution for further investment in capital goods such as machines,
factories, tools and instruments, trucks. Firms spend on investment in
order to expand their productive capacity in future.
Hence through investment expenditure by borrowing the savings of
the households deposited in fin ancial market, are again cumulated into the
expenditure stream and as a result total flow of spending does not
decrease.
Circular money flow with saving and investment is illustrated in
Fig. 2.2 where in the middle part a box representing financial marke ti s
drawn. Money flow of savings is shown from the households towards the
financial market. Then flow of investment expenditure is shown as
borrowing by business firms from the financial market.
Figure No.2.2
Circular Money Flow with Saving and Investme nt
2.7.1 Condition for the Constancy of Circular Income Flow:
Saving a part of income means it is not spent on consumer goods
and services. In other words, saving is withdrawal of some money from
the income flow. On the other hand, investment means some money is
spent on buying new capital goods to expand production capacity have in
other words, investment is injection of some money in circular flow of
income. For circular flow of money to be continuation wit hout any
disturbance it is necessary to have planned savings equal to planned
investment if the constant money income flow in an economy is to be
obtained.
Now, what will happen if planned investment expenditure falls
short of the planned savings? As a re sult of fall in planned investment
expenditure, income, output and employment will fall and therefore the
flow of money will contract.munotes.in
Page 17
17
If the equality between planned savings and planned investment is
disturbed by increase in savings, then the immediate e ffect will be that the
stocks of goods unsold will increase, in the shops. Due to the deficiency of
demand for goods and the collection of stocks, retailers will place small
orders with the wholesalers. Consequently, lesser quantity of goods will be
produc ed and therefore fewer capital goods like ma chinery will be indeed
with the result that fixed investment will tend to fall.
Thus, the ultimate effect of either the fall in planned investment or
the increase in planned savings is the same, namely, the fal l in income,
output, employment and prices with the result that the flow of money will
contract.
On the other hand, if the equality between planned savings and
planned investment is disturbed by the increase in investment demand, the
result will be increa se in income, output and employment. Consequently,
the flow of money income will expand.
It is thus clear from the above analysis that the flow of money
income will continue at a constant level only when the condition of
equality between planned saving an d investment is satisfied.
According to J.M. Keynes, since in a free -market capitalist
economy, investment is made by business enterprises and savings are
mostly done by households and for different reasons, there is no guarantee
that planned investment will be equal to planned savings and thus
fluctuations in income, output and employment are unavoidable.
As a result, circular flow of income does not continue at a steady
level in a free -enterprise capital ist economy unless certain corrective and
preventive steps are taken by the government to maintain stability in the
economy.
2.7.2Saving -Investment Identity in National Income Accounts in a
Two Sector Economy:
As we assume that people who save are household and investment
is by business firms. In national income accounts savings are identical or
always equal to investment in a simple two sector economy having no
roles of Government and foreign trade.
In national income accounts we are concerned with actual saving
and actual investment. It is these actual or realised saving and invest ment
that are identical in national income accounts. We can prove their identity
in the following way.
In a simple economy which has neither government, nor foreign
trade, the value of output produced which we denote by Y is equal to the
value of output sold. Sin ce the value of output sold in a simple two sectormunotes.in
Page 18
18
economy is equal to the sum of consumption expenditure and investment
expenditure, we have
Y Ξ C+ I (i)
where Y = Value of aggregate output, C = Consumption expenditure and I
= Investment expenditure Ξ = identities equal to.
A pertinent question which arises here is what happens to the
unsold output. The unsold output leads to the increase in the inventori es of
goods and in national income accounting increase in inven tories of goods
is treated as a part of actual investment. This may be considered as the
firms selling the goods to themselves to add to their inventories. Thus,
gross national product (GNP) p roduced is used either for consumption or
for investment.
Now, look at the gross national product or income in the simple
economy from the viewpoint of its allocation between consumption and
saving. Since national income (which is equal to GNP) can be either
consumed or saved.
Y Ξ C+ S (ii)
From the identities (i) and (ii) we get
C+ I Ξ Y Ξ C+ S (iii)
The left hand side of the identity (iii), namely C + I = Y shows the
components of aggregate demand (that is, aggregate expenditure on goods
and services produced) and the right -hand side of the identity (iii) namely
Y = C + S shows the allocation of natio nal income to either consumption
or saving. Thus, the identity (iii) shows that the value of output produced
or sold is equal to the total income received. It is income received that is
spent on goods and services produced.
Now subtracting the consumption (C) from both sides of the
identity (iii) we have
I Ξ Y Ξ S
or I = S
In our two -sector simple economy with neither government, nor
foreign trade, investment is identically equal to saving.
Thus, there is triple identity:
OUTPT = INCOME = EXPENDITUREmunotes.in
Page 19
19
2.8 CIRCULAR INCOME FLOW IN A THREE SECTOR
ECONOMY WITH GOVERNMENT
In two sector there is absence of government sector because of
which it can be only hypothetical. This is quite unrealistic because
government absorbs a good part of the incomes earned by households.
Government affects the economy in a number of ways.
To study three sector economy important to know taxing, spending
and borrowing roles of government. Government purchases goods and
services just as households and firms do. Government expendi ture takes
many forms including spending on capital goods and infrastructure
(highways, power, communication), on defence goods, and on education
and public health and so on. These add to the money flows which are
shown in Fig. 2.3 where a box representing Government has been drawn.
It will be seen that government purchases of goods and services from
firms and households are shown as flow of money spending on goods and
services.
Figure 2.3
Circular Income Flow Market with Government
Government expenditure may be financed through public revenue
and public debt that is through -taxes, out of assets or by borrowing. The
money flow from households and business firms to the government is
labelled as tax payments in Fig. 2.3. This money flow includes all the tax
payments made by households less transfer payments received from the
Government. T ransfer payments are treated as negative tax payments.munotes.in
Page 20
20
Other way of financing Government expenditure is borrowing
from the financial market. This can be represented by the money flow
from the financial market to the Government and is labelled as
Governmen t borrowing. Government borrowing increases the demand for
credit which causes rate of interest to rise.
The government borrowing through its effect on the rate of interest
affects the behaviour of firms and households. Business firms consider the
interes t rate as cost of borrowing and the rise in the interest rate as a result
of borrowing by the Government lowers private investment. However,
households who view the rate of interest as return on savings feel
encouraged to save more.
It is clear from above analysis that follows from above that
intervention of Government sector affects overall economic situation.
Total expenditure flow in the economy is now the sum of consumption
expendi ture (denoted by C), investment expenditure (I) and Government
expendit ure (denoted by G). Thus
Total expenditure (E) = C + I + G …..(i)
Total income (Y) received is allocated to consumption (C), savings (S)
and taxes (T). Thus
Y=C+S+T…( i i )
Since expenditure) made must be equal to the income received (Y),
from equati ons (i) and (ii) above we have
C+I+G=C+S+T…( i i i )
Since C occurs on both sides of the equation (iii) and will therefore
be cancelled out, we have
I + G = S + T …(iv)
By rearranging we obtain
G–T=S –I … (v)
If government budget is not balanced, that is, if Government
expenditure (G) is greater than the tax revenue that is, G >T, the
government will have a deficit budget. To finance the deficit budget, the
Government will borrow from the financial market.
Forthis purpose, then private investment by business firms must
be less than the savings of the households. Thus, Government borrowing
reduces private investment in the economy. In other words, Government
borrowing crowds out private investment. Government f ollow balance
budget revenue is equal to expenditure (R = E), with the help of its
constituent. Thus, completing the circular flowmunotes.in
Page 21
21
2.9MONEY INCOME FLOWS IN THE FOUR SECTOR
OPEN ECONOMY: ADDING FOREIGN SECTOR
Circular flow of mone y is open economy where international
trading take place. Export and import of goods and services real flow of
circular flow and receipt and payment of the same in money flow in the
circle .We now turn to explain the money flows that are generated in an
open economy, that is, economy which have trade relations with foreign
countries. Thus, the inclusion of the foreign sector will reveal to us the
interaction of the domestic economy with forei gn countries. Foreigners
interact with the domestic firms and households through exports and
imports of goods and services as well as through borrowing and lending
operations through financial market.
Figure 2.4 illustrates additional money flows that oc cur in the open
economy when exports and imports also exist in the economy. In our
analysis, we assume it is only the business firms of the domestic economy
that interact with foreign countries and therefore export and import goods
and services.
Figure 2. 4
Circular Flow of Income in an Open Economy with Government and
Foreign Sector
A flow of money spending on imports have been shown to be
occurring from the domestic business firms to the foreign countries (i.e.,
rest of the world). On the contrary, flow of money expenditure on exportsmunotes.in
Page 22
22
of a domestic economy has been shown to be taking place from foreign
countries to the business firms of the domestic economy.
Three different possibility can take place in open economy.
1.Balance of trade when E = M. If exports are equal to the imports, then
there exists a balance of trade.
2.when E > M; If value of exports exceeds the value of imports, trade
surplus occurs.
3.When E < M;if value of imports exceeds value of exports of a country,
trade deficit occurs.
Generally, exports and imports are not equal to each other On the
other hand in the open econ omy there is interaction between countries not
only through exports and imports of goods and services but also through
borrowing and lending funds or what is also called financial market. These
days financial markets around the world have become well integ rated.
When there is a trade surplus in the economy, that is, when exports
(X) exceed imports (M), net capital inflow will take place. Which resultsin
domestic savers acquisition for foreign financial assets.
Just opposite to it will take place, in case of import surplus, that is,
when imports are greater than exports, trade deficit will occur. Therefore,
in case of trade deficit, domestic consumer households and business firms
will borrow from abroad to finance their excess of imports over exports.
As a result, foreigners will acquire domestic financial assets.
From the circular flows that occur in the open economy the
national income must be measured by aggregate expenditure that includes
net exports, that is, X -M where X represents exports and M repres ents
imports. Imports must be subtracted from the total expenditure on foreign
produced goods and services to get the value of net exports. Thus, in the
open economy
National Income = C + I + G + NX
where NX represents net exports, X -M.
Since national income can be either consumed, saved or paid as
taxes to the Government we have
C+I+G+N X=C+S+T
Since C is common on both sides of the above equation, we have
I + G + NX = S + T (vi)
The above equation (vi) show s that sum of private investment (I),
Government expenditure and net exports (X -M) is equal to the sum of
savings and tax revenue.munotes.in
Page 23
23
2.10CONCLUSION:
Although this version of the circular flow is simple, it teaches us
four key insights that remain true. Thus, we conclude that in circular flow
of income all the sectors are interrelated with each other in the following
way
1.Spending = production. The total value of all spending by households
becomes an inflow into the firm sector and thus ends up on the
revenue side of a firm’s balance sheet. The revenues received by firms
provide us with a measure of the total value of production in an
economy.
2.Production = payments to inputs. Flows in and out of the firm sector
must balance. The revenues received by firms are ultimately paid out
to households.
3.Payments to inputs = income. Firms are legal entities, not people. We
may talk in common speech of a firm “making money,” but any
income generated by a firm must ultimately end up in the hands of real
people —that is, in the household sector of an economy. The total
value of the goods produced by firms becomes an outflow of dollars
from the firm sector. These dollars end up in the hands of households
in the form of income. (This ownership is achieved through many
forms, ranging from firms that are owned and operated by individuals
to giant corporations whose ownership is determined by stock
holdings. Not all ho useholds’ own firms in this way, but in
macroeconomics it is sufficient to think about the average household
that does own stock in firms.)
4.Income = spending. We complete the circle by looking at the
household sector. The dollars that flow into the househo ld sector are
the income of that sector. They must equal the dollars that flow out of
the household sector —its spending.
The circular flow of income highlights a critical fact of national
income accounting:
GDP = income = spending = production.
Leakage s include Saving (S), Taxes (T), Imports (M)
Injection Includes Investment (I), Government Expenditure (G),and
Export(X) Symbolically
S+T+M = I+G+X
Thus, from above we can conclude that economy will be in
equilibrium when leakages are equal to injectionsmunotes.in
Page 24
24
2.11KEY TERMS
1.Circular Flow of Income: The circular flow of income orcircular
flow is a model of the economy in which the major exchanges are
represented as flows of money, goods and services, etc. between
economic agents. The flows of money and goods exchanged in a
closed circuit correspond in value, but run in the opposite direction.
2.Factor Market: Factor markets aremarkets in which households
supply factors of production —labor, capital, and natural resources —
demanded by firms. Our model is called a circular flow model because
households use the income, they receive from their supply of factors of
production to buy goods and services from firms.
3.Real Flow: Real flow or physical flow refers to the flow of factor
services from househo lds to firms and the corresponding flow of goods
and services from firms to households.
4.Money Flow: money flows refer to the payments for the services
(wages, for example) or consumption payments.
5.Leakages: Leakage is usually used in relation to a particul ar depiction
of the flow of income within a system, referred to as the circular flow
of income and expenditure, in the Keynesian model of economics.
Within this depiction, leakages are the non -consumption uses
ofincome, including saving, taxes, and import s.
6.Injection: Injection means introduction of income into the flow. When
households and firms borrow savings, they constitute injections.
Injections increase the flow of income .Injections can take the forms of
investment, government spending and exports.
7.Closed economy: A closed economy is an economy that does not
interact with the economy of any other economy. A closed economy is
one without international trade i.e neither export nor import takes
place.
8.Open Economy: A open economy is an economy in which
international trade take place. In the open economy export and import
as well as international payment and receipts are taken in to
consideration.
2.12 QUESTIONS
1.What are the two main flow in an economy? How do they arise? what
do they Signify?
2.Describe an economy as circular flow of income and expenditure.
What determine the magnitude of the circular flow?
3.Illustrate graphically the circular flows of income and expenditure in a
four-sector model. Explain also the effect of adverse and favourable
balance of trade on the size of the circular flow.munotes.in
Page 25
25
4.If investment by business firms falls short of savings, how will it affect
the circular flow of income?
5.What is meant by saving and investment? How do they affect circular
flow of income in a free market economy?
2.13REFERENCES
AHUJA, D. (2009). Macroeconomics theory and policy. New Delhi -
110 055: S.Chand and Company LTD.
Blanchard. ((2000)). Macroeconomics ( (2nd Edition) ed.). ((. Edition),
Ed.) Prentice Hall: Olivier.
Dwivedi, D. N. (2008). Macroec onomics Theory and Policy. New
Delhi 110063: Tata McGraw -Hills.
Mankiew, N. G. (2005). Macroeconomics. New York, NY 10010:
Worth Publishers.
munotes.in
Page 26
26
MODU LE-2
Unit-3
DETERMINATION OF NATIONAL
INCOME AND PRICE LEVEL
Unit Structure :
3.1 Objective
3.2 Introduction
3.3 Features of national Income
3.4 Concepts of National Income
3.5 Determination of National Income
3.6 Determination of National Income in Two Sector Economy With
Fixed Price Level
3.7 Determination of National Income –Saving Investment Approach
3.8 Determination of National with Government
3.9 Determination of National in an Open Economy
3.10 Questions
3.11 References
3.1 OBJECTIVES
1.To understand the concepts of National Income
2.To understand how national income can be determine in two sector
economy
3.To determine national income in three sector economy
4.To understand income determination in open economy
5.To estimate nation income given t he values of saving and investment
3.2INTRODUCTION
Determination of national Income and price level:
Macroeconomics deals with study off aggregates. The macro
variables are aggregate demand, Aggregate Supply, National Income,
national output, National expenditure, Inflation, unemployment,
international trade, balance of payment, fiscal and monetary policy etc.
As from above it is clear that national income is macro Variable
and it determines total income of nation. National income can be can be
defined as total money value of final goods and services produced in amunotes.in
Page 27
27
country over a period of one year including income from abroad without
duplication.
In India since 1955, Central Statistical organization took the
responsibility of calculation of national in come in closed economy
basically when we consider two sector model the three factors are
expressed as:
National Expenditure = National Product = National income or Dividend.
a.National Expenditure is total spending on the goods and services
produced during a given year.
b.National product is total goods and services produced during one year
and measured in money terms.
c.National income or dividend is total income earned by factors of
production during given period of one year.
Definition:
1.According to A.C. Pig ou,“National income is that part of objective
income of the community, including of course income derived from
abroad which can be measured in money.”
2.According to Fisher, “The National dividend or income consists solely
of services as received by ultimat e consumers, whether from their
material or from the human environments. Thus, a piano, or an
overcoat made for me this year is not a part of this year’s income, but
an addition to the capital. Only the services rendered to me during this
year by these thi ngs are income.”
3.According to Marshall, “The labour and capital of a country, acting on
its natural resources, produce annually a certain net aggregate of
commodities, material and immaterial, including services of all kinds
and net income due on account o f foreign investments must be added
in. This is the true net annual income or revenue of the country, or the
national dividend.”
4.As per national income committee the national income is defined as,
"the value of commodities and services produced in an econ omy
during a given period, counted without duplication."
3.3FEATURES OF NATIONAL INCOME
1.National income is macro economic concept:
As macroeconomic variables deals with aggregates i.e economy as a
whole and not individual thus total income of nation wi ll be macro
concept.munotes.in
Page 28
28
2.National income is flow concept:
Income of one become expense of other and it flow continuously in
circular flow form thus it is consider as flow concept.
3.National income is the money value of goods:
National income always expresse d in terms of money value while
calculating and it consider only those goods and services which can be
exchange in money.
4.Avoid double counting:
National income include value of only final goods and services in
terms of money for the year, so that the er ror or problem of double
counting can be avoided.
5.Annually Estimated:
National income is estimated every financial year. Example for India it
will be estimated from 1stApril to 31stMarch.
3.4 CONCEPTS OF NATIONAL INCOME
1)Gross Domestic ProductMPGDP :
Gross Domestic product is the total money value of all final goods
and services produced within the domestic territory of a country in a given
year. This is measured at market price.
Hence, GDP = C + I + G + (X -M)
where,
C= Consumption expenditure
I = Investment expenditure
G = Government expenditure
(X-M) = Export -Import (Net Export)
2)Gross National ProductMPGNP :
Gross National Product refers to the total market value of all final
goods and services produced during a given year including income from
abroad.MPGNP =C+I+G+( X -M)+( R -P)
3)Net Domestic product at market priceMPNDP :MPNDPis obtained by deductin g the value of depreciation from the
GDP.
Hence,MPNDP=G D P -Depreciationmunotes.in
Page 29
29
4)Net National product at market priceMPNNP :
Net domestic product at market price is the net market value of all
final goods an d services produced, by the residents of a country, during a
period of one year.MPNNP=MPGNP-Depreciation
Depreciation means wear and tear of machinery in the process of
production.
5)Gross Domestic pr oduct at factor costFCGDP:FCGDP=MPGDP-Indirect Taxes + Subsides
FCGDP =C+I+G+( X -M)-IT + S
GDP at factor cost refers to sum of factors income (rent, wa ges,
interest and profits) generated within the domestic territory of a country in
ay e a r
6)Gross National Product of Factor Cost (FCGNP):
Gross National product at factor cost is the sum of money value of
the income, produced b y and accruing to the various factors of production
in one year in a country. In order to getFCGNPwe deduct indirect taxes
from GNP at market prices and add subsidies to GNP at market prices.
FCGNP=MPGNP-Indirect Taxes + Subsidies
7)Net Domestic Product at Factor CostFCNDP:
Itis the net money value of all final goods and services produced,
within the territorial boundaries of a country, during a period of on ey e a r .
FCNDPis also known as domestic income or domestic factor
income.
FCNDP=MPGDP -NetIndirect Tax -Depreciation orFCNDP=
MPNDP -Indirect Tax + Subsidies.
8)Net National Product of Factor Cost(FCNNP):
Net National product at factor cost is the net money value of all
final goods and services produced by the residents of a country, during a
period of year. I t include income earned by factors of a production .
FCNNP=MPNNP-Indirect Tax+Subsidiesmunotes.in
Page 30
30
9)National Income at current price and constant price :
National Income at current price is net national product calculated on
the basis of current market price. It is also called as Nominal National
Income.
National Income at constant price refers to the Net National product
calculated on the basis of constant prices of a certain base year. It is
also called as Real National Income.
10)Personal Income (PI) : =Personal Income is the sum of all incomes,
actually received by all individuals or households from all the sources
during a given year. It may be earned or unearned.
11)National Income at factor costFCNI :
National Income at factor cost means the sum of all incomes,
earned by resource suppliers for their contribution of land, labour, capital
and entrepreneurial ability, which go into the year net production.
FCNI=MPNNP-Indirect Taxes + Subsidies
12)Personal Disposable Income (PDI) :
PDI is that part of personal income which is left behind after
payment of personal direct tax like income Tax, personal property tax.
13)Person al Savings (PI):
Personal savings refer to the difference between disposable
personal income and personal consumption expenditure.
14)Per Capita Income (PCI) :
Per Capita Income is obtained by dividing National Income by the
population.National IncomePer Capita IncomePopulation
Per Capita Income highlight the average income of the people in the
country.
15)Real Vs Nominal GNP :
Nominal GNP is the total money -value of all the goods and services
measured at the current years prices i.e. nominal GNP for th ey e a r
2018 will be measured at the market prices ruling in the year 2018.
Real GNP is the total money value of all goods and services measured
at the prices of some base year.
Thus we can say in other wordsGNP measured at current price is
termed as no minal GNP.On the other hand GNP measured at constant
prices ruling in some base year is termed as real GNP.munotes.in
Page 31
31
Nominal GNP does not account for inflation but real GNP is inflation
adjusted. It gives actual market value of products and services
produced in an economy.
Nominal GNP :GNP ptqtwhere, P = Price, q = quantity and t= year (current year)
RealGNP pbqtb = base yearNominal GNPReal GNPGNP Deflator Nominal GNPReal GNP=GNP DeflatorGNP Deflator is one of measure of inflation.
16)PPP Income :
Purchasing power parity is a method of measuring the relative
purchasing power of different countries currencies over the same types of
goods and services.
Purchasing power parity is the exchange rate whereby a unit of a ny
given currency should be able to buy the same quantity of goods in all
countries. Economists generally prefer the use of PPP method for
comparing income across countries.
3.5 DETERMINATION OF NATIONAL INCOME
In the short run, the level of national i ncome is determined by
aggregate demand and aggregate supply. Keynesian model of income
determination assumed that price level in the economy remain unchanged.
3.6 DETERMINATION OF NATIONAL INCOME IN
TWO SECTOR ECONOMY WITH FIXED PRICE
LEVEL
In a two s ector economy aggregate demand has two components
i.e. consumption demand and investment Demand.
AD = C + I
where AD = Aggregate Demand , C = Consumption demand and I =
Investment demand.munotes.in
Page 32
32
Consumption Demand -Consumption Demand depends upon
propensity t o consume. Given the propensity to consume, consumption
demand is function of income.
Short Run consumption function is C = a + by
where, a is the intercept autonomous consumpt ion,bis slope of function
i.e. MPC marginal propensity to consume.
Figure 3.1
National Income = Consumption + Saving
Y=C+S
Consumption curve upward sloping indicating direct Relation with
income.
If the gap between income and consumption widens showing that
saving is increasing.
Investment Demand :
Important component of Aggregate demand is investment demand
indetermining equilibrium lev el of national Income.
Investment demand depends upon two factors :
a)marginal efficiency of capital
b)rate of interest
Figure 3.2
Autonomous Investment
In adjoing figure autonomous investment is those which does not
depend on income. Investm ent is indirectly related to income.munotes.in
Page 33
33
Aggregate Supply -Aggregate Supply means total money value of goods
and services produced in an economy in a year.
Constituents of Aggregate Supply
1)The supply or output of final goods and services
2)The outpu t of capital goods
Keynes derived short run production function
Y=N ,L ,K ,T
In short run except labour all other factors remain same (constant)
and only labour is variable factor.
450line as Aggregate supply curve (with fixed prices) :
In the simple keynesion model of determination of national income
price level is assumed to be given and constant.
Figure 3.3
Aggregate supply curve in Keyne’s model of income determination
with fixed price level
at every point of 450line from the origin, the vertical distance equals
horizontal distance which measures real national income or GDP (i.e.
aggregate supply of output at constant prices). This 450line is also
called income line along which Y = C + S.
450linein adjoin figure shows two things (i ) It shows varying level of
aggregate production or the supply of goods that will be offered for
sale at given price level. The greater the AD, the greater will be AS at
given price level. (ii) It represents national income.
Equilibrium level of National Income :
The C + I curve in the given fig. is representing Aggregate demand
curve and 450OZ line represents aggregate supply of output. Both AD
curve and AS curve intersects each other at point E in given figure which
leads to OY 1level of income. Any flu ctuation towards above this
equilibrium point or below this equilibrium point brings deficiency in the
economy.munotes.in
Page 34
34
Figure 3.4
Determination of National Income: Basic Kevinson Model
If AS > AD leads to increase in inventories of goods with the firms
beyond the desired levels. Thus firm will respond by cutting down
production to keep their inventories at the desired level. Which will lead to
fall in national income until the OY 1level is reached where (C + I)
Aggregate demand is equal to the value of Aggre gate supply.
Hence, OY 1is the equilibrium level of National Income.
Principle of Effective demand :
The particular aggregate demand which is equal to aggregate
supply and therefore determines the equilibrium national income is called
effective deman d.
Keynesian model, we can express the principal of effective
demand in symbolic terms as under :
y=A D*
AD*=C+I
y=A D*=C+I
where,
Y = National Income, AD*= Effective demand
C = Consumption Demand I = Investment
Thus it is clear tha t national income and employment in the short
run are determined by effective demand.
Classical Economist believ ethat effective demand (AD = AS) is
enough to ensure full employment. But Keynesian explained in his model
that effective demand equilibrium is achieved before full employment
equilibrium and due to involuntary unemployment there is gap between
effective demand equilibrium and full employment equilibrium.munotes.in
Page 35
35
Numerical illustration of equilibrium level of income.
Problem 1 : Suppose in an econo my, autonomous investment (I) is Rs.
600 crores and the consumption function is given :
C = 200 + 0.8y
given the above find out the equilibrium level of income.
Solution : The equilibrium level of income is
y=C+I
C = 200 + 0.8y
I = 600
Putting the value of (C) and (I) in the equation we have
y = 200 + 0.8y + 600
y = 800 + 0.8y
y(1-0.8)= 800
0.2y = 800
y = 800/0.24000yProblem 2 : Suppose the consumption function of an economy is C =
0.8y. Planned Investment by entrepreneurs for a year is Rs. 500 crore find
out what will be equilibrium level of income.
Y = C + I (C = 0.8y, I = 500 crore)
Substituting
y = 0.8y + 500
y-0.8y = 500
y(1-0.8) = 500
y = 500/0.2
2500y crores3.7 DETERMI NATION OF NATIONAL INCOME –
SAVING -INVESTMENT APPROACH
In (fig. 3.4)equilibrium level of National Income is OY, saving
and investment are equal to GE.
Saving represent withdrawal of some money from the income
stream and investment represent injecti on of money into the income
stream.
If intended investment is greater than intended saving, it means
that more money has been put into income stream than has been taken out
of it as a result flow of National Income Expand. And just opposite to itmunotes.in
Page 36
36
occur w hen investment is less than intended saving. National income will
decrease. Thus at equilibrium level of national income will be determined
at the level of which the intended investment is equal to intended saving.
Figure 3.5
Determination of National I ncome Saving Investment approach
Thedetermination of nation income by investment and saving is
illustrated in (fig. 3.5).In X -axis National income, SS is saving curve
intended saving at different level of income. II curve shows investment
demand, int ended investment, saving curve and investment curve intersect
at point (E) i.e. investment and saving are in equilibrium at OY level of
income in fig. 5.
Determination of National Income has been explained above by two
method :
Figure No. 3 .6
i)Aggr egate Expenditure or Demand = Aggregate supply of output and
ii)Intended Investment = Intended savings.munotes.in
Page 37
37
Infig.3.6Aggregate Demand curve C + I intersects Aggregate
Supply Curve OZ at point Q and thereby determines national income
equal to OY. In the lower part of this diagram we have drawn intended
savings curve SS and intended investment curve II. It is worth to note that
saving curve SS has been derived from consumption function curve C and
measure the gap between income and consumption at various level of
income. Further investment curve II drawn in the lower part of figure
represents the difference between consumption function curve C and
Aggregate demand curve C + I. This difference is the amount of intended
investment in this fig. 3.6.We thus s ee that both saving and investment
curve drawn in the lower part are embedded in the upper part showing
aggregate demand and aggregate supply. This is because of this, that
intended saving and intended investment curve also determine the same
level of Nati onal Income OY which is determined through the equality of
Aggregate demand (C + I) and Aggregate supply.
Numerical problem on saving -Investment approach :
Suppose the level of autonomous investment in an economy is 200
crores. The saving function is given as
S=-80 + 0.25y
Find equilibrium level of income
Solution -According to saving investment approach the level of income is
in equilibrium at which S = I
S=-80 + 0.25y
I = Rs. 200 crores
Substituting the value of S & I in equation
S=I
-80 + 0.25y = 200
0.25y = 200 + 80
y = 280/0.25
1120y crores3.8 DETERMINATION OF NATIONAL WITH
GOVERNMENT
Government plays vital role in economic functioning. Government
expenditure treated as autonomous expenditure and we denote
Government expenditure by G. Three sector economy whenever take into
account theincome generating effects of Government expenditure, we get
the following equation for equilibrium level of National Income :
Y=C+I+G
Y = National Income
C+I+G= Aggregate demand including government expenditure, Gmunotes.in
Page 38
38
To illustrate the determination of national income with three sector
model i.e. C + I + G as effective demand. The equilibrium national income
OY is determined at the level at which the aggregate expend iture curve (C
+ I + G) intersects 450line, that is Aggregate Demand is equal to
aggregate supply of output. Any discrepancy from this level will be
ultimately restored at OY level of National Income.
Figure No. 3 .7
In the presence of government exp enditure, national income is
determined at the level at which the saving gap is equal to the sum of
private investment and Government expenditure (I + G)
In equilibrium Y = C + I + G
Y-C=I+G
Y-C = Saving (S)
Therefore, in equilibrium S = I =G
3.9 DETERMINATION OF NATIONAL IN AN OPEN
ECONOMY : THE FOUR SECTOR MODEL
An open Economy is one which has not only trade relations with
other countries but has financial capital flows between it and other
economi esof the world.
Foreign trade and National Income in an open Economy :
In the four sector model of determination of national income, we
add the foreign trade sector to three sec tors, namely Household, firms,
Government. Volum eof export and import of country affects the level of
national income of a country.
Keynesian model of income determination export and import are
autonomous that is independent of income. Increase or decrease in export
and import affect aggregate expenditure.munotes.in
Page 39
39
When we include net export (X m) in our analysis we get the
following equa tionfor equilibrium level of income.
Y=C+I+G+( X -M)
C=a+b( Y -T) = a + by -bT
Y=a+b y -bT + I + G + X n
Y( 1 -b) = a -bT + I + G + X n
Y= 11na bT I G Xb
Thus , the equilibrium level of income is t he sum of all fixed
autonomous expenditure (i.e.ab T IGX n)times the value of
multiplier1/ 1b.
In the four sector model, national income is determined at the level
at which saving gap between consumption and inco me is equal to the sum
of investment Government expenditure and net exports. (i.e.nIGZ)
Graphical Illustration :
Figure No. 3.8
Determination of National Income with foreign
Trade Four Sector Model:
In Fig. 3.8 we have depic ted the determination of national income
when there are positive net export (i.e., when exports exceed imports0XM.T o obtain the aggregate expenditure curve incorporation the
positive net exportnXwe add t henIGXto the consumption
function curve to C to get the higher aggregate expenditure curvenCIGXwhich intersects the 450line at point R and determines a
level of Income OY .If the net exportsnXwere negative, i.e. import
greater than export ,0XM, the aggregate demand curve incorporating
net exports would lie at a lower level than C + I + G curve and determine a
lower level of income.munotes.in
Page 40
40
3.10 QUESTIONS
1)Explain different concepts of National Income.
2)What are the features of National Income?
3)How to determine National Income in two sector model?
4)Illustrate determination of National Income in Open Economy.
3.11 REFERENCES
Ahuja, D. (1986). Macroeconomi cs Theory and Policy. New Delhi: S.
CHAND & COMPANY LTD.
Dwivedi, D. N. (2008). Macroeconomics Theory and Policy. New
Delhi 110063: Tata McGraw -Hills.
Mankiew, N. G. (2005). Macroeconomics. New York, NY 10010:
Worth Publishers.
munotes.in
Page 41
41
Module -2
Unit -4
IS-LM Analysis
Unit Structure :
4.1 Objective
4.2 Introduction
4.3 Goods Market Equilibrium IS curve
4.4 Money Market Equilibrium LM Curve
4.5 Intersection of IS and LM Curve
4.6 Algebra of IS –LM Model
4.7 Policy Analysis w ith IS –LM (Effect of monetary and Fiscal
Policy at IS -LM)
4.8 Questions
4.9 References
4.1 Objectives
1. To understand the concept of IS –LM Market
2.To Know the Goods Market and Money Market
3.To Derive the level of equilibrium of saving and investment
4.To learn the factor responsible to get money market equilibrium
5.To Understand the concept of crowding out and liquidity trap
4.2 INTRODUCTION
TheGoods Market and Money Market and link between them:
Macroeconomics deals with aggreg ates. Keynesian in his book,
General theory of employment, interest and money Published in 1936.
Where very beautifully explained the importance of effective demand for
any economy to overcome from the problem of depression. Keynesian
recommends that most of the macro variable are directly or indirectly
related with each other. Example –Change in rateofinterest will bring
about change in variable like consumption and investment and national
income as well. Just one year after in 1937 Hicks developed a m odel
called IS –LM model. To explain goods market and money market attain
equilibrium simultaneously at the similar level of income and interest rate.
Thus the extended Keynesian model is known as IS -LM model. IS -LM
model has become relevant instrument of macroeconomics and impact of
thefiscal policy and monetary policy are consider using this IS –LM
model.munotes.in
Page 42
42
In IS –LM model
I = Investment
S = Saving
L = Liquidity preference
M = Money Supply
Hicks has obtain two curves Namely IS and LM. Where IS St ands for
product/ goods market and LM represents money market. According to
Neo Keynesian economist Hics, Hansen and Lerner there are four
variables Viz., saving, investment, liquidity prefence and quantity of
money that are consolidated with income. IS–LM Model relates how
aggregate market of real and financial interact to balance interest rate
and output/income.
4.3 GOODS MARKET EQUILIBRIUM: IS CURVE
Goods market achieve equilibrium when S = I ,Saving is equal to
Investment.
Saving is positively rel ated with income, higher the income more
the saving and vice versa.
S=f (Y)
Where as investment is influenced by rate of interest prevailing in
the market, Investment is inversely related with rate of interest.
I=f ( r )
Derivation of How saving can be equal to investment,
Y=C+S ( i )
Income is what we consume and what we do not consume we keep
it in the form of saving. If any two variable value is given we can obtain
third example,
C=Y –S,
S=Y-C
Variable in two sector model of close economy with only
household and firm with saving and investment,
Y=C+I ( i i )
Thus
From equation (i) and (ii) we get
C+S=C +I (iii)munotes.in
Page 43
43
Substracting C from both the side we will get,
S = I (iv)
Saving investment identity, in short run saving must be equal to
Investment.
4.3.1Derivation of IS Curve:
IS Curve is graphical representation of product/goods market
equilibrium. It derive due to endogeneous factor like income, output,
consumption and interest rate. When rate of interest falls, investor
encourage to invest, due to low cost of project to him. Investment w illrise
which will increase aggregate demand and thus eventually national
income will rise.Thus IS curve is associated with different equilibrium
levels of national income with various rate of interest.
IS curve is locus of combination of rate of intere st and the level of
national income that result in goods market equilibrium.
Figure –4.1
In the given figure in Panel A, investment is on X -Axis rate of
interest is represented on Y –axis, when rate of interest is r 0planned
investment is I 0and inPanel –B , we have 450line shows that each and
every point on it gives us the equality between the aggregate demand and
the level of national income AD = Y aggregate demand is C + I 0andmunotes.in
Page 44
44
equilibrium E 0the national income of the economy is Y 0.therefore, at
Panel –C the level of national income Y 0isplotted against rate of interest.
Further if rate of interest is fall to r 1due to which business man
find project less costly and they prefer to invest more ( ∆I) at I 1level which
induce to shift Aggregate demand curve shift upward. i.e at C + I 1
resulting in increase in national income at higher equilibrium level Y 1at
panel B. the effect of which we can find at panel -C rightside (∆Y)
increase in national inc ome at Y 1.
If rate of interest decrease further at r 2leading to further increase in
investment I 2which results in to increase aggregate demand C+ I 2in panel
B and higher level of equilibrium income E 2generating more increase in
national income Y 2.
By joining points A, B and C in Panel –C we derive downward
sloping IS Curve evaluating that when interest rate falls national income
increases.
4.3.2Slope of IS Curve:
IS curve isdownward sloping as rate of interest decrease national
income increa ses.
The s teepness of IS curve depends on:
1.Thelevel elasticity of investment demand curve and
2.Theoptimum size of multiplier
1.Thelevel of elasticity of investment demand curve –if elasticity of
investment demand is highly elastic to the change in ra te of interest
then due to fall in rate of interest causes drastic increase in
investment because of which aggregate demand curve will also
expand drastically and shift upward. Then the IS curve will be
Flatter.
When elasticity of investment is less elasti c or not very sensitive to
change in rate of interest then IS curve will be Steeper.
2.The size of multiplier
Slope of steepness of IS curve is also based on value of Multiplier.
Marginal propensity to Consume (MPC) determines the value of
multiplier.
Examp le: If MPC is high then with the fall in rate of interest,
investment increases due to greater effect of increased MPC will
shift aggregate demand multiplier time and IS curve will be more
flatter. Smaller value of multiplier will be brings about small
increase in equilibrium income due to which IS curve will be more
steeper.
2.3.2Shift in IS Curve:
Position of IS curve is dependent on level of autonomous
expenditure. Autonomous expenditure is those expenses which does notmunotes.in
Page 45
45
dependent on income. So most of govern ment expenditure on programmes
and policies for welfare purpose does not depend on income and interest
rate.
Example: Increase in population require more investment for school,
building, roads, and various other facilities does not depend on income. So
such autonomous increase in investment expenditure shift IS curve
Upward and Vice versa.
The goods market and IS curve
Figure No. 4.2
a.Higher autonomous spending shift the IS curve to the right. As we cav
see in figure –2, IS curve shifted to right i.e IS1
b.Decrease in autonomous spending will shift the IS curve towards left
from original position.
c.The horizontal shift equals the multiplier times the increase in
autonomous spending.
4.4 MONEY MARKET EQUILIBRIUM
4.4.1Derivation of LM Curve :
The LM curv e exhibit the relationship between the interest rate and
national income. The LM –Schedule can be derived from money market
equilibrium condition.
Ms=Md
The neo –keynesian economist (Hicks, Lerner and Hansen) have
derived the LM curve from Keynes liqu idity preference theory. Wheremunotes.in
Page 46
46
MdKeynes considered it as Liquidity preference -demand for money.
And Ms
According to Keynesian theory demand for money based on
different motive which is transaction motive, precaution motive and
speculative motive o f which transaction and precaution motive is
dependent on income and speculative motive is influenced by rate of
interest. The demand for money based on level of income as people need
to fulfil their basic transactionary need of basic requirement. It also
depend on rate of interest as it is cost of holding money.
Hence demand for money can be expressed as:
Md= L(Y,r)
Md= demand for money
Y = Income
r = rate of interest
demand for money is function of income and rate of inte rest. Hansen
states that from Keynesian formulation we get a family of liquidity
preference at different income levels supply of money is fixed by
monetary authority.
Figure No. 4.3
Equilibrium in the money market at various level of income
In above f igure 4.3 we can see that major components to derive
LM curve are Demand for money, supply of money rate of interest and
level of national income. As per the Keynesian theory of liquidity
preference the rate of interest is determined at the level where Dem and for
money is equal to supply of money.
Demand for money is derived from there different motives.
a)Transaction motive
b)Precaution motive
c)Speculation motivemunotes.in
Page 47
47
Transaction motive is denoted by Ltthat is liquidity preference for
transaction motive. Precaution motive denoted by L Pand speculative
motive is denoted by L Sthus conclusion of it is thatdtp sML L L………………………………. (i)
of which1tpLL Lwhich affected by income. So,we can say that it is
income .
1Lf y…………………………………….. (ii)
elastic.
Lsisconsidered as2Lfor Keynesian formulation.2Lf r……………………………………… (iii)
So,we can say that total demand for money i.e.12LL L……………………………………… (iv)
Let assume L is denoted by letterdM12dML LSothus it means Demand for money increases with the increases
in income. The quantity of real money balances demand ed is negatively
related to the interest rate but positively related to income. Thus by using
the theory of Keynesian liquidity preference curve, we can analyse what
happen to the equilibrium interest rate when the level of income changes.
Explanation of Diagram for derivation of LM curve.
In figure 4.3 onx axis quantity of money and on y axis rate of
interest panel (A) at panel (B) x axis we represent National Income and on
y rate of interest. As in figure B when income increases from0yto1yand
finally to2yon panel (B). This increase in income shift money demand is
curve to the right with the supply of real money balances unchanged the
interest rate must rise from0rto1rand then to2rto equilibrate the money
market.
Therefore according to the theory of liquidity preference, higher
income leads to higher interest rate.
When we join point A, point B and point C of panel (B) we derive
upward sloping LM curvemunotes.in
Page 48
48
The LM curve plots the relationship between the level of income
and interest rate. The higher the level of income, the higher the demand
for real money balances and the higher the equi librium interest rate for this
reason, the LM cure slopes upwards as shown in fig. 4.3.
4.4.2 Slope of LM Curve :
There are two factors on which the slope of the LM curve depends.
1)The liquidity preference of demand for money to the change in
income .
Example : In panel (B) as income increases from0yto1ythe demand
curve of money shifts from0Mto1Mthat is with an increase in income
demand for mone y would increases for being held for transactions motivedMto1Lf y. This will affect money market equilibrium .Thus rate
of interest need to increases at new intersecting point on panel (A) at
equilibrium E1to restore the money market at higher interest rate1r.
2)Elasticity or responsiveness of demand for money (
i.e. liquidity preference for speculative motive) to the change in rate of
interest.
The slope of LM curve is depen d upon the income elasticity and
the interest elasticity of the demand for money. The larger the income
elasticity and the lower the interest elasticity of the demand for money, the
steeper the LM cure will be.
Suppose the demand for money is relativel y insensitive to the
interest rate, the LM cure is nearly vertical. If demand for money is highly
sensitive to the interest rate, LM curve is close to horizontal.
Lower elasticity of demand for money for speculation motive with
respect to changes in th e rate of interest the steeper will be the LM curve
and if the elasticity of demand for money to the changes in the rate of
interest is high the LM curve will be flatter.
4.4.3 Shifts in the LM Curve :
Demand for money is based on different motives. It increases with
increase in income. The LM curve, the equilibrium points in the market
for money, shift for two reason.
1)Change in money demand
2)Change in money supply
If money supply increases as we know with the help of Keynesian
liquidity prefer ence theory and determination of rate of interest. As money
supply increases keeping Demand for money unchanged then rate of
interest falls at each level of income. Thus, LM curve shift towardsmunotes.in
Page 49
49
rightside and if money supply decreases then rate of interest falls and with
the given level of income the LM curve shift left.
4.5THE INTERSECTION OF IS AND LM CURVES :
SIMULTANEOUS EQUILIBRIUM OF GOODS MARKET
AND MONEY MARKET :
The IS curve represents goods market and LM curve represent
money market. The IS cu rve reflect negative (inverse) relationship
between rate of interest and national income. IS curve slopes downwards.
On the other hand LM curve reflect positive relationship between rate of
interest and national income. Th usLM curve is upward sloping curv e. The
intersection interest of the IS and LM curve is called equilibrium point,
that determine the rate of interest and level of income.
In fig. 4.4IS curves is a downward sloping curve and LM curve is
an upward sloping curve.
Figure 4.4
Interest Ra te & Income Determin ination
The intersection of IS and LM curve is at point E which determines
the rate of interest or OR in fig. 4.4and National income OY.
At this point income and the rate of interest stand in such relation
to each other that
i)Investment and savings are at equilibrium.
ii)Demand for money is in equilibrium with the supply of money. This is
how the goods market and the money market are integrated by the neo -
Keynesian economist in explaining interest rate and level of income
determination in IS -LM model.munotes.in
Page 50
50
4.6 ALGEBRA OF IS -LM MODEL
4.6.1 Derivation of IS Function : Algebra Method
The IS function can be derived by using both the equilibrium
conditions of the product market. The two equilibrium conditions are (i)
AD = AS a nd (ii) I = S. We will show here the derivation of the IS curve
by using both the conditions of product market equilibrium.AD Y C Y I i………………………. (i)C y a by………………………………… (ii)I=I-h i………………… ………………… (iii)
C = Consumption, a = autonomous consumption
b = Marginal propensity to consume, y = Income
I = autonomous investment, i = interest rate and/hI P.Y a by I hi…………………….. (iv)
11Y a I hib
Assume that consumption function is given as10 0.5Cy y……………………… (v)
Investment function is given as
Investment function is given as200 2000Ii i…………………….. (vi)
The product market equilibrium condition equ ation (iv) can be
exposed in terms of (v) and (vi) as10 0.5 200 2000yy i…………… (vii)
110 200 20001 0.5
2 210 2000ii
420 4000yi
4.6.2 Derivation of IS curve by equilibrium condition I = S
The IS schedule ca n also be derived on the basis of the other
equilibrium condition of the product market; that is I = SSy y cy………………………….. (viii)munotes.in
Page 51
51
substituting the value of consumption function, we get10 0.5Sy y……………………………. (ix)
Given the investment and saving functions the equilibrium
condition of the product market (I = S) can be expressed as
200-2000i = -10 + 0.5y …………………. (x)
210 = 2000i + 0.5y
By multiplying both sides of equation (X) by 2, we get
420 = 4000i + y ………………………….. (xi)420 4000yi………………………….. (x)
4.6.3 Derivation of LM schedule : Algebraic method :
Money market is in equilibrium when
dMM s
where,
,dt s pt
spMM MMk Y k oML i
In the Keynesian system, thespMdemand function produces a curvilinear
schedule with a part made of straight horizontal line that is, the part
showing liquidity trap,
spML I i……………………………… (xi)
whereLand I are constan t, and I is interest rate.
rate
Given thetMandspMfunction, the aggregate money demand
function can be expressed asdM= k Y + L - I i……………………. (xii)
The money supplyMsassume to remain constant in the entire
analysis of the money market equilibrium . If the price level also (P) is also
assured to remain constant, then the nominal money supplyMsequals
to real money supply denoted as/Ms p. The money market equilibrium
condition given in E quation (xii) can be now be expressed asmunotes.in
Page 52
52sdMMMs kY L Ii………………………… (xiii)
equation . (xiii) gives the money market equilibrium at different le vel of
income and the rate of interest. From this equation is derived the LM
schedule. By manipulating E quation . (xiii), we get LM function as
1YM s L I ik……………………… (xiv)
4.7THE POLICY ANALYSIS WITH IS AND LM
4.7.1 Monetary Policy :
When central government increase the money supply, this increase
money supply will shift curve to the right. The effect such change on the
interest rate and income is shown in figure.
Figure No. 4. 5
Increase in money supply Increase in g overnment spending
As the left hand panel, indicates the theory predicts. that when the
money supply increases the interest rate falls and GDP rises.
4.7.2 Effect of monetary and fiscal policies :
In the left panel, an increase in the money supply shifts the LM
curve, to the right; this raise GDP and lower interest rate. In the Right
hand panel an increase in government spending shift the IS curve the right;
this raises GDP and raises the interest rate. There is fundamental
difference between expansi onary monetary policy lowers rate of interest
and expansionary fiscal policy raises interest rates.
4.7.3 The Liquidity trap :
A situation in which the public is prepared at a given interest rate;
to hold whatever amount of money is supplied. The LM cur ve become
horizontal to x -axis. At lowest rate of interest the entire cash is trapped by
people. In the liquidity trap, monetary policy is powerless to affect the
interest rate.munotes.in
Page 53
53
Thus from given figures on x -axis quantity demand on y-axis Rate
of Interest at lowest rate of interest say at 2% people hold money with
them self leading to liquidity trap.
Figure No.4.6
4.7.4 Fiscal policy and crowding out :
As we known from our analysis of study towards IS curve. It is
goods market model. It get influen ce due to government policy changes
the impact of it leads to shift in IS curve either right to original IS curve or
lefthand side of original IS curve . Thus we can say that any government
(fiscal) policy programme related to taxation or expenditure affec tI S
curve accordingly.
The equation of IScurveY G A bi
Increasing in Government spending :
Fiscal expansion increases equilibrium level of income and interest
rate which raises Aggregate Demand. In creased Aggregate demand raises
output and shifting IS curve towards right hand side from the original IS
curve can be illustrates in diagram. InFigure 4.7wehave illustra tedthe
effect of a shift in the Is schedule. At each level of interest rate
equilibrium income must increase mu ltiplier time. Initially economy is
Equilibrium at E and government expenditure increase will shift IS curve
at E11if rate of interest remains same. At E11the goods market is in
equilibrium in that planned spending equals output. But the money market
will not be at equilibrium. Due to increase in income demand for money
increases. Thus excess demand for real balances, the interest rate rises.
Firms planned investment spending declines at higher interest rates and
aggregate demand falls.munotes.in
Page 54
54
Figure No.4.7
Income / Output
Increased Government sp ending increases aggregate demand shifting
the IS curve to the risk
Hence full adjustment take place by expansionary effect of higher
government spending and the dampening effect of the higher interest rate
reduces private spending. Figure 4.7shows that only at point E1both the
goods market and money market will be at equilibrium. Thus point E1is
new equilibrium point where quantity of real balances demanded equal to
given real money stock.
4.7.5 Crowding Out :
In fig. 4.7we see that increased government spending raises both
income and interest rate to achieve equilibrium. But comparison can be
done between E and E11the equilibrium in the goods market at unchanged
interest rate point E11is at equilibri um when we neglect impact of interest
rate on the economy. In comparing E11with E in (fig. 4.7) it is clear that
adjustment of interest rate and its effect on aggregate demand dampen the
expansionary effect of increased government spending, income, instea d of
increasing level y11, rises only to y1.
The factor responsible beyond income increase only to y1rather y11
is that the increase in interest rate from I 0to I 1reduces the level of
investment spending. Thus increase in government expenditure crowd out
investment spending.
Crowding out occurs when expansionary fiscal policy causes
interest rate to rise, thereby reducing private spending, particularly
investment.
Determination of level of crowd out i.e. level of adjustment of equilibrium
level du e to dampen of output expansion induced by increased government
spending and higher rate of interest.munotes.in
Page 55
55
1)If income increases more and interest rate increases less
flatter the LM schedule
2)Income increases less and interest rate increases less. The fl atter the IS
curve.
3)Income and interest rate increase more the larger the multiplies, and
thus the horizontal shift of the IS schedule.
In each situation the extent of crowding out is greater the more the
interest rate increases when government spe nding rises.
4.8 QUESTIONS
1.How to Derive IS Curve?
2.What factors are responsible for downward slope of IS curve?
3.Explain derivation of LM curve.
4.Explain Shift of LM Curve.
5.Explain the concept of Liquidity Trap.
6.How Fiscal Policy inf luences IS Curve?
7.Explain the concept of crowding out.
4.9 REFERENCES
AHUJA, D. (2009). Macroeconomics theory and policy. New Delhi -
110 055: S.Chand and Company LTD.
Blanchard. ((2000)). Macroeconomics ( (2nd Edition) ed.). ((. Edition),
Ed.) Pren tice Hall: Olivier.
Dwivedi, D. N. (2008). Macroeconomics Theory and Policy. New
Delhi 110063: Tata McGraw -Hills.
Mankiew, N. G. (2005). Macroeconomics. New York, NY 10010:
Worth Publishers.
munotes.in
Page 56
56
Unit -5
AS AND AD MODEL AND
INFLATION AND UNEMPLOYMENT
Unit Structure :
5.1 Objective
5.2 Introduction
5.3 Aggregate Demand
5.4 Derivation of AD Curve
5.5 Aggregate Supply
5.6 Long Run Aggregate Supply Curve
5.7 Macroeconomic Equilibrium
5.8 Inflation and Unemployment
5.9 Inflation and rate of unemployment
5.10 Phillps Curve
5.11 Trade off b etween unemployment and wage price rise
5.12 Long Run Phillips Curve
5.13 Long Run Phillips Curve and Rational Expectation
5.14 Questions
5.15 References
5.1 Objectives
1.To understand the concept of Aggregate demand and aggregate supply
2.To know factors affecting Aggregate demand
3.To Understand the factors responsible for long run aggregate supply
curve
4.To understand the level of equilibrium of aggregate demand and
aggregate supply
5.To know trade off of unemployment and inflation
6.To understand short run Phillips Curve
7.To understand difference between short run and long run Phillips
Curve
8.To Know the concept of long run and rational expectation conceptmunotes.in
Page 57
57
5.2 INTRODUCTION :
The model of Aggregate Supply and Aggregate Demand : -
In classical macroeconomic theory the amount of output depends on
the economy’s ability to suppy goods and services, which in turn depends
on the supplies of capital and labour and on the available prod uction
technology. Flexible prices are a crucial assumptions of classical theory.
This theory implies that price adjust to ensure the quantity of output
demanded equals the quantity supplied. The economy work on different
way when prices are sticky. Moneta ry and Fiscal Policy can influence the
output over time period when prices are sticky price stickiness provides a
rational for why these policies may be effective in stabilizing economy in
short run.
5.2.1. The AD -AS model are used to explain variability in output, price
level and level of inflation in the Economy.
Aggregate Demand curve depicts the total output of goods and
services which holds firms, households Government are willing to buy at
various price levels.
5.2.2. Aggregate Demand curve show s those combination of price level
and aggregate output at which goods market and money market are in
equilibrium.
Aggregate supply curve shows the quantity of aggregate output of
goods and services that firms of the econom y produce and supply at each
given price level.
5.2.3. Determination of output and price level through Aggregate
Demand and Supp ly.
In the given figure 5.1. On x -axis Aggregate Output is represents
on y-axis price level. The intersection of AD and AS at equilibrium point.
E determine equilibrium price level P oand equilibrium output Y ochanges
in any of these will affect price level and output.munotes.in
Page 58
58
FigureNo.5.1
5.2.4.Change in Aggregate Demand and its impact on price level
and output.
If Government expenditure increases AD curve shift to the Right
keeping As curve unchanged in fig. 5.2 as we can see due to increase in
government expenditure. AD curve shift upwar d towards Right hand side.
Leading to increase in output from Y oto Y 1and increase in price level
from P oto P 1.
FigureNo.5.2
munotes.in
Page 59
59
5.2.5.Impact of decrease in Aggregate Supply on price level and
output
If price of input such as wages of labour, prices of raw materials
fuels etc. rise ; leading to leftward shift in as curve in given figure 3 due to
increase in input cost as curve shift leftward fro nt the original as curve due
to which we can see that pric e level rises from P oto P 1and output decline
from Y oto Y 1.
FigureNo.5.3
5.3. AGGREGATE DEMAND (AD) :
Aggregate Demand is the relationship between the quantity of
output demanded and the aggregate price level.
5.3.1.Aggregate Demand Curve : The AD slopes downward the
higher the price level the lower the level of real balances and therefore the
lower the quantity of goods and services demands Y.
In the given fig. 5.4O nx -axis represents aggregate output and on
y-axis price level. Here we can illustrate why AD curve is downward
sloping. Factors responsible for downward slopeof AD curve -munotes.in
Page 60
60
FigureNo.5.4
Aggregate of output
Aggregate Demand Curve with varying price level.
(i) Real Balance effect :
The changes in price level affect the real value (purchasing power
of money balance) and monetary assets with fixed nominal values held by
the people with the rise in the general price level the real value of these
monetary asse ts will fall making pe ople feel poorer than before. Due to
which consumption will decline and demand will reduce. And just inverse
to that if the price level falls the real value of their monetary assets
increases inducing them to buy more. This is called real balance effect of
the change in the price level.
(ii) Rate of Interest :
At a higher price level, the people will require more money for
conducting a given amount of transaction. Due to which Demand for
money shoot up for making transactions. Keeping money supply constant
if demand for money increases as we have seen in IS -LM m odel. In case
of LM model it leads to increase in rate of interest. As a result of which,
with higher rate of interest investment in capital formation will reduce. On
the contrary, Given the money supply, constant if price level falls, it leads
to decrease in demand for money. Because they require less money for
transaction. Due to effect of which the rate of interest falls. To conclude,
the investment demand and the general price level are inversely related.
(iii) Foreign Trade Effect :
It can also consider as Balance of payment effect if a general price
level in India falls, exports will become cheaper leading to their increase.
Thus fall in price level in India will lead to more exports and lessermunotes.in
Page 61
61
imports causing expansion in aggregate demand for Indian goods. On the
contrary rise in price level in India causes decline in exports and increase
in its import.
Thus during inflation rise price level leading to decline in net
exports.
Hence, to sum up, the quantity of Aggrega te demand for
consumption, investment and net export increases with a fall in price level
and decline with a rise in price level.
Thus we can conclude that through figure –4 Aggregate Demand
Curve showing relationship between Aggregate output demanded and the
general price level slopes downward to the right.
5.4.DERIVATION OF AD CURVE :
Aggregate Demand determinants are (C + I + G + (x –M)) shows
equilibrium aggregate expenditure at various levels with lower price level
real purchasing power of the money balance or financial asses with fixed
nominal values held by he people will increase. Due to lower price level
people will consume more at each level of national Income. Hence
consumption function curve will shift upward due to which Aggregate
expenditure (C + I + G +x-M) curve shift above.
Illustration of diagram. Initially at price level P othe Aggregate
Expenditure function curve. (C + I + G + x n) intersect the 45oline at point
Eoaccording to which Y ois the equilibrium quantity of real GNP or
aggregate outpu t demanded. Thus initial price level P othe equilibrium
quantity of aggregate output demanded is Y o. Therefore, in the panel (b) at
the bottom aggregate output Y odirectly against price level P o. munotes.in
Page 62
62
FigureNo.5.5
Derivation of Aggregate Demand Curve
Let take another condition. Suppose the price level falls from P oto
P2due to decrease in price level the purchasing power of people will
increase and leading to upward shift in consu mption function curve (C 2+I
+G+x n). Thus at lower price P 2inpanel (b) equilibrium output (E 2)
aggregate demand at higher level of output Y 2.munotes.in
Page 63
63
Now, if situation get inverse say price rises from P oto P 1. People
feel that they become poor due to fall in their purchasing power. Due to its
negative effect they will consume less and consumption function curve
(C1+I+G+x n) will shift downward. Consumption function curve
intersect 45oline at point E 1inpanel (a). Lower equilibrium level. Thus E 1
determine Y 1Aggregate Demand at price P 1in lower panel (b).
Thus by joining equilibrium position at different price level
i.e.11E,10E,12Ewe will derive Aggregate Demand curve.
Similarly due to rise in price demand for money increases money
supply rema ins same. This is leading to higher interest rate due to which
investment in the market will reduce. And thus Aggregate expenditure
curve shift downward and thus lower aggregate output demanded.
Just inversely to it at lower price demand for money will fa ll
keeping supply of money unchange. Due to which rate of interest falls. So
more investment will take place. And Aggregate expenditure curve shift
upward. Hence their will be increase in Aggregate Output Demanded.
Similarly, change in price level also af fect exports (x) and imports
(M) and therefore cause change in net exports (X n). When price falls
export increases and import falls. On the contrary, due to rise in price
export falls and import increases. And according Aggregate Output
increase and decre ase.
5.4.1.Shift in Aggregate Demand Curve and multiplier effect :
In our above analysis we can see that due to change in price level
Aggregate expenditure upward and downward. We kept Government
taxation (G), Investment I, and money supply (M), Constant as we
consider it as autonomous of changes in price level (and induc ed changes
in the rate of intere st).
Now when these non price factors change, aggregate demand curve
will shift.
1) Suppose, Government expenditure increases by AG, this will raise
expenditure curve upward. Resulting in equilibrium level of aggregate
output will increase at the given price level. This means shift in aggregate
demand curve at the given price.
In the upper panel of fig. 6 the Aggregate expenditure at given
price level P, is C + I + x n+ G which is intersecting at 45oline at point E
yieldi ng equilibrium level of National Income or output equal to Y 1.
Assume that Government expenditure increases G, leads to
upward shift of aggregate expenditure curve say C + I + x n+G+ Gmunotes.in
Page 64
64
which in tersects at higher equilibrium level at P 1to 45oline and yield more
income Y 2at given price level in lower panel. This process of increase in
Aggregate expenditure due to increase in Government expenditure.
Keeping price constant leads to more Aggregate output shifts to Aggregate
demand curve towards right hand side as it is shown in the lower panel of
fig.5.6.
Figure No. 5.6
Shift in Aggregate Demand Curve
5.4.2.Multiplier effect :
Government expansion policy refers to decrease in taxation and
increase in government expenditure. If government expenditure or
investment increases it has multiplier effect. Thus aggregate output
demanded depending on the size of multiplier.munotes.in
Page 65
65
Y=Y 1Y2=A B= G11-MPCYChange in income denoted by AB from Y 1to Y 2in figure 5.6
G = Increase in government expenditure.
MPC =Marginal Propensity to Consume and 1/1 -MPC is the nvalue of
multiplier.
The above equation is derived from figure 5.6 and it represent that
increase in government expendi ture can bring about multiplier time
increase in aggregate output RT in the increase level due to multiplier
effect.
Similarly deduction of tax rate by government can also influence
the Aggregate Output and shift AD curve right hand side.
5.4.3.Shifting of Aggregate Demand is also taking place due to
money supply.
Increase in money supply : Increase in money supply keeping same
price level rate of interest will fall which leads to more investment in
economy. Aggre gate Output demanded will be greater at the given
level of price level. Hence expansion in money supply shift,
aggregate demand curve to the right.
Decrease in money supply : On the contrary to above analysis, if
money supply decreases at given price level . Due to its effect interest
rate increases and investment falls which causes aggregate demand
to fall. Hence AD curve shift leftward from original curve.
Conclusion :
Thus we can concluded from above analysis of a ggregate demand.
Fiscal and Monetary Policy can affect AD curve position. Expansionary
Monetary and Fiscal policy shift AD curve rightward and output increase.
On the contrary to it contractionary monetary and fiscal policy
shift AD curve leftward and output decl ines.
5.5. AGGREGATE SUPPLY :
Aggregate supply is also known as total output, it is the total
supply of goods and services produced within an economy at a given
overall price in a given period.munotes.in
Page 66
66
Example of events that would increase aggregate supply include an
increase in population, increase in physical capital stock and technology
progress.
Aggregate supply can be explained with the help of diagram in
different time period.
5.5.1.Short Run Aggregate Supply Curve (With variable pr ice
level) :
5.5.1.1. Classical Economist are assumed that full employment prevail
in the economy. Thus aggregate supply curve is perfectly inelastic
(vertical parallel to Y –axis).
Figur 5.7 Figur 5.8
Aggregate Supply Cu rve Aggregate Supply Curve
Classical view Keynesian view
Aggregate output Aggregate output
Figure 7 shows Classical approach of Aggregate supply curve with
given price level and employment.
5.5.1.2. Keynesian : -Keynesian Aggregate Supply Curve shows
relationship between price level and the aggregate production (Supply)
during the period of depression and involuntary unemployment when there
is excess capacity in the economy. As sho wn in figure 8 Aggregate Supply
is horizontal straight line perfectly elastic showing that in response to
increase in Aggregate Demand more is produced and supplied at the same
price level OP.
Three Ranges of Short Run Aggregate Supply Curve:
Short Run Ag gregate Supply Curve consist of three ranges
i.e. (a) Horizontal Range
(b) Intermediate (upward sloping range) and
(c) Vertical Range.
Figure No. 5.9munotes.in
Page 67
67
Short run aggregate supply curve with three ranges
(a) Horizontal Range : -(P.a.)
Keynesian and his followers assumes that Aggregate Supply Curve
was horizontal from P to a in fig. 9 is consider as Keynesian Range.
Economy reaches its optimal level at full employment Ypin fig. 9. As we
can see from abo ve diagram that Keynesian range comprises levels of
output that are substantially less than full capacity production Y f.T h eg a p
between Y and Y fimplies that production can be expanded without facing
rise in unit cost of production. This gap shows grip of severe recession or
depression with a lot of idle capacity in the form of unemployed labour,
unutilised machinery and other capital equipment.
(b) Intermediate Range: -(a.b)
In figure 5.9 range between ab is intermediate range where as
curve is upward sloping increase in output from Y to Y fbrings about rise
in price level.
Causes of upward sloping Aggregate Supply Curve. First, the gap
between the resource available for utilisation and full employment.
Example nation production expands in this range some industries
say electronics and computer hardware may experience shortage of skilled
engineers engaged in these industries while some industries. Such as
textile industries may be stil l facing quite large unemployment. Due to
such factors bottlenecks in production arise which will increase the cost of
production where as economy is operating below full employment level.munotes.in
Page 68
68
Secondly, due to more demand for raw material for expanded form of
production will increase the cost of production.
Thirdly, constant wage and diminishing marginal productivity of
labour causes increase in cost of production.
Thus due to all above reasons, unit cost of production increases
even before full employment. T hus product price must rise it firms have to
recover the rising cost.
(c) Vertical Range : (b –c)
Classical Range in figure 9 is vertical i.e. perfectly inelastic.
Classical believe that economy is at full employment level Y f.
The vertical shape of AS curve represent that any further rise in the
price level will fail to cause any increase in aggregate output because
economy is at optimum utilisation of resources.
5.6 LONG RUN AGGREGATE SUPPLY CURVE : (LRAS)
Determinants of LRAS are labour, capital and technology.
Y=F( L ,K ,T )
The Long Run Aggregate Supply Curve is vertical which reflects
economists beliefs that changes in the aggregate demand only temporarily
change the economy’s total output.
From above given determinants labour is most variable factor and
they are ready to supply their labour at equilibrium wage rate at which full
employment will exist. Even at full employment level some workers are in
search of new and better job.
Thus frictional and structural type unemployment type of
unemployment exist even at full employment level of Aggregate Output.
Such type of unemployment is called natural rate of unemployment. So
around 4% to 5% of unemployment exist in economy is consider to be full
employme nt. At quantity of real GDP produced and supplied at natural
rate of unemployment.
The Long Run Aggregate Supply describes the relationship between
the quantity of Real GDP and the price level in the long run where real
GDP equals potential GDP.
Figure No. 5.10 Long Run Aggregate Supplymunotes.in
Page 69
69
As we can see in fig. 5.10 long run Aggregate supply curve is
vertical because potential GDP does not vary with price level.
To show this we can illustrate with help of diagram (fig. 10) where
Aggregate Demand curve shift upward to AD2price level rises to P1but
Aggregate output is much percentage of change in price bring about equal
percentage change in real wage as well thus Aggregate Supply curve in
long run is unchanged i.e. vertical.
5.6.1 Changes in Aggregate supply curve :
It is changes in potential GDP which shifts the Aggregate supply
curve the factors responsible for change in Aggregate supply curve in
Long Run (i) change in the full employment quantity of labour. (ii) change
in the stock of capital (iii) progress in technology.
Figure No. 5.11 Figure No. 5.12
Increase in labour force, Short run Aggregatemunotes.in
Page 70
70
Capital stoc and progress
In technolog y increase
Potential GDP and Shifts
LAS curve
Figur 5.11 Figur 5.12
Thus from above fig. 11 we can analyse that if we have efficient
trained, skilled, educated labour force with aboundant capital availability
and Advance technique of production leads to Righ ward shift in
Aggregate supply (LRAS) and increases real GDP from1Yto2Y.
In short run Fig. 12 only labour is variable factor, capital and
technology remains constant. Nominal wages are sticky in the short run.
When actual price level rises in t he short run, more quantity of real GDP
produced and supplied. Though wage rate is sticky as it is determined on
the basis of long run contract. But due to increase in actual price level the
real wage falls. The lower real wage induces firm to employ more labour.
The increase in employment of labour will lead to the increase in
aggregate output. Due to which the Aggregate supply curve in short run is
upward sloping.
Short Run Production Function :,,YF L K TYAggregate outputLLabour is variableKConstant capital in short runTTechnology also is constant in short run
5.7 MACRO ECONOMIC EQUILIBRIUM :munotes.in
Page 71
71
AS-AD model
The level of equilibrium where both AD -AS intersect is also
know as effective Demand or macro economic variable. According to J.M.
Keynes, the level of income and output in an economy is determined by
the level of employment and the level of employment i s determined by the
level of effective demand. Greater the level of effective demands, greater
would be the level of employment.
Macro Economic equilibrium explained below at both short run
and long run situation.
5.7.1. Short -Run Macroeconomic Equilibrium :
Short Run Macroeconomic Equilibrium take place when
AD = AS.
Figure No. 5.13
Short run Macroeconomic variable
As it is shown in Fig.13 at point E 1. Any deviation from this level
will bring disequilibrium. Suppose price level rises from P 1to
P2.Aggregate demand will be at G < than H quantity supplied at P 2price.
Due to which unintended inventories will fill up and firm will at both
production and the prices. And thus will reach to equilibrium at P 1price
level. On the contrary, when price level is P 1aggregate demand is at J >
than aggregate supply at N. Which in…… firm to increase production and
raise prices. Thuswe can conclude that changed in factors at AD and AS
fluctuate level of equilibrium
5.7.2. Long -Run Macroeconomic Equilibrium :munotes.in
Page 72
72
Long Run equilibrium occurs when real GDP equals potential
GDP. Long run equilibrium of price level and real GDP is reached when
money wage rate adjusts so that the short -run aggregate supply curve
shifts to intersect the long run Aggregate Supply Curve (LRAS) at the
point at which aggregate demand curve intersects the latter.
Figure No. 5.14
Panel (a) : Short run Panel (b) : Long run
equilibrium less than equilibrium at potential GDP
full employment
(or potential GDP)
As we can see in Fig. 5.14 Panel (a) Short run aggregate supply
curve intersects short run aggregate demand curve at point S at Y0is Real
GDP level at price P owhich is less than potential GDPY. The gap
between Y oYis due to recession this situation exists because the
production is less than potential GDP. Cyclical unemployment occur due
to which unemployment rate exceed the natural rate of unemployment.
If money wage rate is flexible at classical economist think t hey are
then in the short run equilibrium at point S at more than natural rate of
unemployment, money wage rate will fall. As a result, short run aggregate
Supply Curve (SAS) will shift rightward. This shifting will be continue
until it intersects the Long Run Aggregate Supply Curve at point E in
panel (b). This new equilibrium price level falls to P1and aggregate
demand increase to potential GDP.
On the contrary if short run equilibrium is at more than potential
level of output. Then is leads to inflation ary gap in the economy.munotes.in
Page 73
73
Thus the optimum level is the position where Aggregate Demand
Curve intersects Long Run Aggregate Supply Curve at potential real GDP
at full employmentY.
5.8 INFLATION AND UNEMPLOYMENT
5.8.1 Introduction :
Inflation : In a broad sense the term, inflation means a considerable and
persistent rise in the general level of prices over a long period of time.
According to pigou, “Inflation exists when money income i s
expanding more than in proportion to increase in earning activity.”
According to Ackley, “Inflation is a persistent and appreciable rise in
the general level or average of prices.”
According to Samuelson, “Inflation denotes a rise in general level of
prices.”
5.8.2 Measure of Inflation :
There are two measure of inflation
i)Percentage change in price index number (PIN).
ii)Change in GNP Deflator
tt - 1
tPIN -PINRate of Inflation = ×100PIN
Nominal GNPGNP deflator =Roal GNP5.8.3 Types of Inflation :
1)Moderate Inflation : Single digit rate of annual inflation is collect
moderate inflation or ‘creeping inflation’.
2)Galloping Inflation :
According to Baumal and Blinder, “Galloping inflation refers to an
inflation that proceeds at an exceptionally high rate.”
According to Samuelson and Nordhaus, “Inflation in the double -
or triple digit range of 20,100 or 200 percent a year is labeled g alloping
inflation.
3)Hyper Inflation : A price rise at more than three digit rate per annum
is called hyper inflation. Inflation that exceeds 50% month. During the
period of hyper inflation paper currency becomes worthless and demand
for money decrease s drastically.
5.8.4 Unemployment :
Unemployment is a situation in which those who are willing to
work at the prevailing wage rate do not find job.munotes.in
Page 74
74
Unemployment -Labour force -number of employees
Labour force of a country consists of person bel onging to the age
group of 15 to 65 years.
Labour force = Number of Employed + Number of unemployed
Labour force - employmentUnemployment rate = ×100Labour force
Number of employedUnemployment rate = ×100Labour force
5.8.5 Concept of unemployment :
i)Usual status of unemployment
ii)Current weekly status unemployment
iii)Daily status unemployment
5.8.6 Kinds of unemployment :
i)Frictional unemployment
ii)Structural unemployment
iii)Natural unemployment
iv)Cyclical unemployment
5.9 INFLATION AND THE RATE OF UNEMPLOYMENT
Theneoclassical economist held the view that inflation does not
affect the level of employment. However in 1958, A.W. Phillips, a British
Economist and a professor at London School of Economics, brought out a
study of the relationship between unemployment an d the change in money
wage rates in the British economy (1862 -1957). Phillips found on inverse
relationship between the rate of changes in the money wage rate and the
rate of unemployment. This inverse relation implies a trade -off. To reduce
unemployment i nflation need to increase i.e. increase in price level.
5.10 THE PHILLIPS CURVE
Phillips revealed in his study that there exists an inverse
relationship between the change in money wage rate and the rate of
unemployment in the form of a curve called Phillips curve.munotes.in
Page 75
75
Figure No. 5.15
The Philips curve is presented in Fig. 5.15 on x axis Rate of
unemployment and on y axis. Rate of inflation is presented. PC curve is
Philips curve. It is downward sloping showing inverse relation between
unemployment and rate of inflation. At high inflati on rate say 10% the
level of unemployment is 3% whereas at low rate of inflation at 5% the
unemployment rate increased to 8%.
This trade off presents a dilemma for the policy makers; should
they choose a higher rate of inflation with lower unemployment or a
higher rate of unemployment with a low inflation rate.
Explanation of Philip Curve :
Keynesian approach for Philips curve Aggregate supply is upward
sloping at intermediate range. It is near to full employment level.
According to Keynes there are two reason for upward slope in
Aggregate supply curve are those are
1)AS output increased by the firms in the economy, diminishing returns
to variable factors, especially to labour, resulting in fall in marginal
physical productLMPPof labour with given constant money wage fall
inLMPPcauses rise in marginal cost (MC) of production.LwMCMPP 2)As employment and output increase, increase in Aggregate demand as
we have seen in fig. 14, demand for labour increases. And thus increases
wage rate leading to upward sloping Aggregate supply curve.
Philips curve while describing the relationship between inflation
and unemployment, consider the relationship between rate of increase in
wage on one hand and unemployment one other hand.munotes.in
Page 76
76
Trade offbetween Unemployment and Wage -Price Rise :
Phillips c urve not only explain the relationship and wage rates and
unemployment rates but also explain the relationship between rice level
and unemployment rate.
Figure No. 5.16
Theoretical Phillips curve inflation and unemployment
Trade off means that a certain rate of inflation can be traded for
same rate of unemployment. In fig. 5.16 the vertical axis on the left
measures the annual rate of inflation and the horizontal axis measures the
rate of unemployment. The ve rtical axis on the Right measured the annual
percentage rise in the wage rate.
Inflation rate equals rate of increase in curves cost annual rate of
increase in labour productivity wage rate will be 2% greater than inflation
rate. e.g. if wages increases by 5 percent and labour productivity increases
by two percent, then the rate of inflation is only 3% (average push
inflation).
Given the Phillips curve in fig. 5.16 the trade off between the
unemployment and the inflation rate can be easily found.
Example : In fig. 16, a 2.5% (6.5% -4%) unemployment can be traded for
a 2 percent (=5% -3%) inflation. This shows that if policy maker tries to
reduce unemployment by 2.5% that from 6.5% to 4%, they have to
increase inflation from 3% to 5%. And on the co ntrary if target is tomunotes.in
Page 77
77
reduce inflation by 3% from 5% then we have to accept increase in
unemployment from 4% to 6.5%.
A similar conclusion can be drawn by unking unemployment rate
to wage -inflation rate given on the vertical axis on the right hand si de.
Phillips curve is short run phenomenon in the long run Phillips
curve keeps shifting. The Phillips curve found relevant only for the period
(1961 -69). In 1970 in its economy their was cut adverse ??? economy was
suffering from high level of unemploy ment as well as high inflation. Due
to which the growth of economy was very low. Such situation with high
unemployment + high inflation and low economic growth is termed as
stagflation.
It is therefore concluded that there exists either no or a weak
relationship between inflation and unemployment in the long run.
5.11 THE LONG RUN PHILLIPS CURVE
Prideman’s theory of Natural Rate of unemployment.
Milton Friedman integrated the logic of the short -run Phillips
curve into the macro economic theory and explained the spiraling. Phillips
curve. In the process he formed (constructed) Long run Phillips curve.
According his studies he believes that in the L ong run there is only one
rate of unemployment whatever is the rate of inflation. This rate of
unemployment is called “Natural rate of unemployment”. It is also termes
as “Non -accelerating inflation rate of unemployment” (NAIRU).
NAIRU is that it exist e ven when labour market is cleared and is
consistent with the potential level of output. Friedman argues that NAIRU
cannot be eliminated permanently by means of expansionary monetary
and fiscal policies of the government. The expansionary policy may only
accelerate the rate of inflation and cause an upward shift in the Phillips
curve showing higher levels of unemployment and inflation rates. It is thus
ultimately the Phillips curve becomes a vertical line.munotes.in
Page 78
78
Figure No. 5.17
Fig. 5.17 Friedman’s Longrun Phillips curve on x axis
unemployment Rate % is meationed. On y axis inflation rate % is
measured123,,SRPC SRPC SRPCare short run Phillips curves at different
level of unemployment and inflation rates. Now suppose that at some
point of time the economy is at point A with unemployment*nUand
inflation r ate ofand that these rates are consistent with the potential
level of output. If policy maker decides to reduce unemployment to do so
they will apply expansionary policy. As economy is at potential level as
we can see in fig. 17 at*nUexpansionary policy will push up the price
level. Due to increase in price real wage of workers go down. As a result
employee increase the ir demand for labour, employment increases and
unemployment decreases. Thus with rising prices and decreasing
unemployment Trade off at point A moves towards point B along the short
run Phillips curve1SRPCthe range area from A -B i.e. unemployment
reduce from*nUtoU. However the decrease in the unemployment rate
below its natural rate could be possible only if real wage declines and
there is a time lag between the money wage catching up with the price
rise. This time lag is due to lack of realization of pinch of incr ease in
inflation rate.
But latter on they started realizing the pinch of higher inflation rate
?????
Thus they begin to incorporate their expectations into their demand
for higher money wages maturing with the expected price rise.
Labour’s will ne gotiate for higher wage rate. Wage bargaining will
take place as a result the real wage begin to increase. The rise in Real
wage causes decline in demand both labour. Due to which the labour
market begin to move towards higher level of equilibrium point at C.munotes.in
Page 79
79
movement from B to C indicate increase in both inflation and
unemployment. Thus this will shift1SRPCto2SRPC. As a result , the rate
of unemployment rises back to its natural level,*nU. The rate of inflation
rises fromto2. Any further step taken towards reduction in
unemployment again same movement will takes place further from C to D
and they ultimately from D to E as is happen earlier. An attempt to reduce
the natural rate of unemployment through expansionary policies results
only into an upward shift in the Phillips curve without reducing the natural
rate of unemployment permanently. When we consider long run view of
the Phillips curve and its upward shift. We will get equilibrium point
shifting upward from A to C and then to E all conforming to the short run
Phillips curve. When we join all these equilibrium points A, C, E we get a
straight vertical line which is called friedman’s Long Run Phillips curve
(LRPC).
5.12LONG RUN PHILLIPS CURVE AND RATIOANL
EXPECTATIONS
Rational Expectation theory which is popularly known as new
classical macro economics. According to Rational expectation theory there
is no lag in adjustment of nominal wages consequently to the rise in price
level. Rational expectation theory rest on two basic elements.
1)According to it, workers and producers being quite rational have a
correct understanding of the economy and therefore correctly anticipate
the effects of the governments economic po licies using all the available
relevant information.
2)Wages and product prices are highly flexible and therefore can quickly
change upward and downward. New information is quickly assimilated in
the demand and supply curve of the market. Thus new equil ibrium prices
adjust to the new economic events and policies. The increase in Aggregate
demand or expenditure as a consequence of easy monetary policy of the
Government will fail to reduce unemployment and only inflatin will be
increasing. According to rat ional expeditions the off long -run aggregate
supply curve is a vertical straight line at potential GDP level such as
LRPC in fig. 17.
5.13 CONCLUSION
The logical conclusion that follows is that attempt should be to
keep the unemployment rate close to its natural rate. but some economist
criticize and recommended that Natural rate of unemployment itself is
fuzzy concept. Even optimum level that potential level of economy itself
is also fuzzy concept it’s better to start or to learn to line with inflation.munotes.in
Page 80
80
5.14QUESTION
1)Explain the concept of Aggregate Demand.
2)How to derive aggregate demand curve.
3)Why Aggregate Demand Curve slope downward?
4)Explain short run supply curve.
5)Illustrate with suitable diagram Long Run Aggregate supply curve.
6)Explain macro economic equilibrium AD -AS model.
7)Explain Short Run Phillips curve.
8)Explain Long Run Phillips curve.
9)Explain Long Run and Ra tional Expectations.
5.15 REFERENCE:
AHUJA, D. (2009). Macroeconomics theory and policy. New Delhi -
110 055: S.Chand and Company LTD.
Blanchard. ((2000)). Macroeconomics ( (2nd Edition) ed.). ((. Edition),
Ed.) Prentice Hall: Olivier.
Dwivedi, D. N. (2008). Macroeconomics Theory and Policy. New
Delhi 110063: Tata McGraw -Hills.
GORDON, R. (1981). MAcroeconomics. Little Brown.
Mankiew, N. G. (2005). Macroeconomics. New York, NY 10010:
Worth Publishers.
TOBIN, J. (1972). Inflation and Un employment. Am.Eco.Rev.62,.
munotes.in
Page 81
81
Module 3
Unit-6
THE OPEN ECONOMY:
DEFINITION SAND CONCEPTS
Unit Structure:
6.0 Objectives
6.1 Introduction
6.2 Trade Balance
6.2.1 Positive Trade Balance
6.2.2 Negative Trade Balance
6.3 Balance of Payment
6.4 Capital Mobility
6.5 Automatic Adjustment
6.6 Summary
6.7 Questions
6.8 References
6.0 OBJECTIVES:
After going to this unit you will able to:
1.Understand the concept of ba lance of payment (BoP).
2.Understand the concept of trade balance.
3.Understand the concepts of capital mobility and automatic adjustment.
6.1 INTRODUCTION:
Macro open economy model mostly includes international trade of
the nation where balance of payment, trade balance, capital mobility,
exchange rate regimes, what is automatic adjustment ?etc. T hese are the
key concepts to understand open macro economy models and policy
framework. So, in this chapter, we discuss abov e important concepts in
detail .
6.2. TRADE BALANCE:
Trade balance is also known as the balance of trade (BoT) which
indicates the distinction between the monetary value of a country’s
imports and exports in a given time period.munotes.in
Page 82
82
Balance of trade (BoT) or trade balance is the visible current
account of balance of payment (BoP).
Formula,
Trade balance calculates by below formula.
Trade Balance = Value of Exports of Goods –Value of Imports of
Goods
In the case of trade balance there are two possibilit ies as below -
1.Positive trade balance/ Trade Surplus
2.Negative trade balance/ Trade Deficit
6.2.1 Positive Trade Balance / Trade surplus:
When the value of trade balance comes positive, it means export
value is greater than import value, it is called as trade surplus.
Trade surplus = value of export > value of import
The positive trade balance or trade surplus has been explained in
detail by below diagram -
Figure No. 6.1
Trade Surplus
Above figure shows the trade surplus. In this figure , on the X axis
imports of goods have been shown and Y axis, exports of goods. OS curve
is a trade surplus curve and OB is a trade balance curve. OS curve is a
right of OB curve which shows positive trade balance on which every
point (a, b & c) shows that exports of goods is greater than imports of
goods.
6.2.2 Negative Trade Balance/ Trade Deficit:
When the value of trade balance comes negative means export
value is less than import value, it is called as trade deficit.munotes.in
Page 83
83
Trade deficit = value of export < v alue of import
The negative trade balance or trade deficit has been shown in detail
by below figure .
Figure No. 6.2
Trade Deficit
Above figure indicates that the trade deficit. In this figure , on the X
axis imports of goods have been shown and Y axis; exports of goods have
been mentioned. OD curve is a trade deficit curve and OB is a trade
balance curve. OD curve is a left of OB curve which shows negative trade
balance on which every point (a, b & c) indicates that import of goods is
greater than export of goods (export of goods is less than import of goods).
6.3BALANCE OF PAYMENT (BOP)
The balance of payment (BOP) of a country is the record of all
economic transactions between the residents of the country and the rest of
the world in a particular period of time (one year). In the balance of
payment, there are two sub -accounts which are current account and capital
account. The balance of payment account structure isas follows. munotes.in
Page 84
84
Figure No. 6.3
Balance of payment (BoP) is a record book of international
transactions which is called as double entry account. The structure of BoP
account is slightly complex, because in this single account, there are
multiple subaccounts which have been explained with the help of above
diagram. In this diagram, there are mainly two accounts, first is current
account and second is capital account . In the case of current account, there
are two subaccounts these are visible account and invisible account.
Visible account refers to only export of goods and import of goods which
also known as balance of trade (BoT) or trade account, invisible account
which refers export and import of services, income (wage, profit, rent and
dividend) and transfers (remittances, donation and gift).munotes.in
Page 85
85
Capital account refers to international investment flow in which
FDI, FII and debt services are explicitly shown. Balance of payment (BoP)
has another important three accounts. These are also known as adjustment
accounts. These are overall balance, error and omission and reserve
account.
The actual balance of payment (BoP) sheet of Government of India
has been given for th e financial year 2018 -19 which has been taken from
economic survey of India, 2019 -20.
Table No. 6.1
Balance of Payment Sheet of India, 2018 -19
Sr.
No.Item 2018 -19
I Current Account
1. Exports 3,37,237
2. Imports 5,17,519
3. Trade Balance (1 -2) -1,80,283
4. Invisibles (net) 1,23,026
A. Services 81,941
B. Income -28,861
C. Transfers 69,946
5. Goods and Services Balance -98,342
6. Current Account Balance (3+4) -57,256
II Capital Account
Capital Account Balance 54,403
i. External Assistance (net) 3,413
ii. External Commercial Borrowings (net) 10,416
iii. Short -term credit 2,021
iv. Banking Capital (net) of which: 7,433
Non-Resident Deposits (net) 10,387
v. Foreign Investment (net) of which: 30,094
FDI (net) 30,712
Portfolio (net) -618
vi. Other Flows (net) 1,026
III Errors & Omission -486
IV Overall balance -3,339
V Reserve Changes
[increase ( -)/ decrease (+)]3,339
(Source: Economic Survey of India, 2020 -21)munotes.in
Page 86
86
Above table provides practical and more appropriate example to
understand what is the exact composition and structure of balance of
payment (BoP).
6.4 CAPITAL MOBILITY
Capital mobility is become inevitable in globalized economy;
because, economic integration is increasing in 21stcentury. Therefore,
financial market and capital market in which bonds and stocks are traded.
In the industrial countries, there are no restrictions on asset holding in
abroad. There are two main versions of capital mobility. One among them
is very popula r in developed countries and second one is popular in
developing countries like India, Shrilanka and most Asian countries etc.
These two versions of capital mobility areas follows -
1)Perfect capital mobility.
2)Imperfect capital mobility.
Perfect capital mo bility is the version adopted by developed
countries where economic integration became necessary. So, there is no
issue of capital mobility. Capital mobility means capital is perfectly
mobile internationally when investors can purchase assets in any countr y
by their interest, this transaction happens at very low cost and unlimited
amount. When capital is perfectly mobile, investors or asset holders are
willing and able to move a large amount of funds across borders in a
search of highest profit on assets. S o, profit or returns on capital is main
driven source behind capital mobility. Perfect capital mobility is suitable
and favourable to most developed countries.
The second version of capital mobility is called imperfect capital
mobility where capital is no t perfectly mobile, but with the permissions of
government of nation, there are some companies, government sectors,
investors which can invest in abroad. This type of system is called
imperfect capital mobility where investors faces restrictions on investm ent
in abroad and vice -versa. This type of system mainly found in the
developing countries like India and most Asian countries.
6.5 AUTOMATIC ADJUSTMENT
Automatic adjustment is the concept related to the balance of
payment (BoP) of the country. How automatic adjustment happens in
balance of payment? The automatic adjustment in balance of payment is a
complex phenomenon and difficult to understand. Automatic adjustment
in the nation’s balance of payment is very important issue for economist
and policy makers. The economists have suggested various methods and
approaches to correct the balance of payment disequilibrium. One among
them is the classical approach of automatic adjustment which is automaticmunotes.in
Page 87
87
adjustment in balance of payment under fixed exchang e rate and automatic
adjustment in balance of payment under flexible exchange rate.
6.6 SUMMARY
This unit is delivered the knowledge about trade balance (positive
trade balance and negative trade balance) the structure of balance of
payments (BOP), capi tal mobility and automatic adjustment which are
very important concepts in the study of open economic models in macro
economics. The actual structure of balance of payment (BOP) of India is
easy to understand with the help of balance of payment sheet which has
been given for 2020 -21 in this unit.
6.7 QUESTIONS
1)Explain the concept of trade balance with the help of diagrams.
2)Explain structure of Balance of Payment (BOP).
3)Explain the concepts of capital mobility and automatic adjustment in
short.
6.8 REFERENCES
1.Carlin, Wendy and David Soskice (2007), Macroeconomics, Oxford
University Press.
2.D’Souza, Errol, Macroeconomics (2012), Dorling Kindersley (India)
Pvt. Ltd.
3.Michl, Thomas (2009), Macroeconomic Theory, PHI Learning.
4.Ahuja H. L. (2016), Mac roeconomics Theory and Policy, S. Chand &
Company Lts.
5.Richard T. Froyen (2015), Macroeconomics, Pearson.
6.Economic survey of India, 2020 -21.
munotes.in
Page 88
88
Unit -7
IS-LM-BP Model
Unit Structure :
7.0 Objectives
7.1 Introduction
7.2 IS Curve (Goods Market Equilibrium)
7.3 LM Curve (Money Market Equilibrium)
7.4 BP Curve
7.5 IS-LM-BP Models
7.5.1 Fixed Exchange Rate: IS -LM-BP Model
7.5.1.1 IS -LM-BP Model in Monetary Policy with Perfect Capital
Mobility.
7.5.1.2 IS -LM-BP Model in Fiscal Policy with Imperfect Capital
Mobility.
7.5.2 Flexible Exchange Rate: IS -LM-BP Model
7.5.2.1 IS -LM-BP Model in Monetary Policy with Imperfect
Capital Mobility.
7.5.2.2 IS -LM-BP Model in Fiscal Policy with Imperfect Capital
Mobility.
7.6 Summary
7.7 Questions
7.8 References
7.0OBJECTIVES
After going to this unit you will able to :
1.Understand the IS curve
2.Understand the LM curve
3.Understand the BP curve
4.Understand IS -LM-BP model under flexible and fixed exchange rates.
7.1INTRODUCTION
The IS -LM-BP model is known as IS -LM-BoP model or Mundell -
Fleming model or open economy IS -LM model. IS -LM model is used in
autarchy. IS -LM model is formulated by Robert Mundell and Marcus
Fleming. Mundell explained this model in his research paper entitle d
‘Capital Mobility and Stabilization Policy under Fixed and Flexible
Exchange Rate’ in 1963 and Fleming depicted in his article ‘Domesticmunotes.in
Page 89
89
Financial Policies under Fixed and under Floating Exchange Rates’ in
1962. This model is more realistic in nature, be cause it assumed imperfect
capital mobility and thus made this IS -LM-BP model more rigorous and
comprehensive model.
For more understanding this IS -LM-BP model and how it works?
We will see first what the IS curve represent, secondly we will see LM
curve phenomena and thirdly we will see BP curve. Finally we will see
how IS -LM-BP model works in both version under fixed exchange rate
and flexible exchange rate.
7.2 IS C URVE (GOODS MARKET EQUILIBRIUM)
IS curve repr esents the relationship between output and interest
rate. Output is the sum of consumption, investment, public spending and
net export.
Mathematically,Y=C( Y –T) + I + G + NX
In the above equation, investment is not constant which is mainly
depends on interest rate. So, in other words, IS curve indicates relationship
between production or output and interest rate which shows equilibrium in
the goods market. IS curve has been explained with the help o f diagram as
below -
Figure No. 7 .1
IS Curve
In the above figure ,on the x -axis output has been mentioned and
on the y -axis interest rate has been given. IS curve shows the relationship
between output and interest rate. IS curve has a negative slope, because
there is inverse relation between output and interest rate.
If, Interest rate decreases, output increases and interest rate
increases, output decrease s.munotes.in
Page 90
90
Interest RateoutputInterest RateoutputThere is good market equilibrium exists at any point of IS curve.
7.3 LM Curve (MONEY MARKET EQUILIBRIUM):
The LM curve represents money market equilibrium. The LM
curve showsthe relationship between liquidity and money. In the
globalized economy or open economy, the interest rate is determined by
the equilibrium of supply and demand for money.M/P = L( i, Y)
Where,
M = Amount of money offered
Y = Real income
i=R e a l interest
L = Demand for money which is function of i and Y
Exchange rate of currency affects LM curve in some way. The
equilibrium of money market indicates or implies that given amount of
money, the interest rate is an increasing function of national out put level
when the national income (Y) or output increases; the demand for money
also increases. But if the money supply is given, therefore the interest rate
should rise until the opposite effects acting on the demand for money are
cancelled, people of th e country will demand more money because of
higher income and will reduce demand for money due to higher interest
rate. This relation between the output and interest rate is positive. That is
why the shape of LM curve is upward sloping as depicted in the b elow
figure .
Figure No. 7.2
LM Curve
In the above figure , LM curve represents money market
equilibrium where interest rate and output of the country are inmunotes.in
Page 91
91
equilibrium. In the figure , output is given on X axis and interest rate is
given on Y axis. The LM curve shows positive relation between output
and interest rate means when output of the country increases, interest rate
also increases due to raise in income and vice -versa.
Intere stoutputInterestoutput7.4 BP CURVE (BALANCE OF PAYMENT CURVE)
The BP curve indicates or shows that at which points the nation’s
balance of payment is in equilibrium. The slope of BP curve is usually
upward sloping. The h igher production in the country, the higher imports
which creates disequilibrium in balance of payment and the balance of
payment adjusts by interest rate which affects international capital flow
which makes balance of payment is balanced. Below figure depicts
balance of payment curve and its relationship.
Figure No. 7 .3
BP Curve
In the above figure , BP curve represents balance of payment curve
which represents the relationship between interest rate and output.
Normally, it has positive relationship between these two economic
variables. The slope of BP curve is mainly depends on the degree of
capital mobility. It means greater the capital mobility, flatter the BP curve.
When we draw horizontal BP curve like as above diagram which
represents perfect capital mobility in which small changes in interest rate,
capital mobility comes in action.
7.5 IS-LM-BP MODEL/ MUNDELL -FLEMING MODEL
The IS -LM-BP model is also known as IS -LM-BoP model or
Mundell -Fleming model. The IS -LM-BP model or Mundell -Fleming
model is an open economy version of the IS -LM model which is closed
economy model.munotes.in
Page 92
92
IS-LM model consists the following two equations which
represents money market equilibrium and goods market equilibrium.
M=L( Y ,r ) -(1)
S(Y) + T = I(r) + G -(2)
Equation (1) shows the money market equilibrium which always
exists on LM curve and equation (2) shows that the goods market
equilibrium which always exists on IS curve. The IS -LM model
determines the nominal interest rate (r) and level of real income w here the
aggregate price level held constant.
In the case of an open economy, the LM schedule will not be
changed. But IS schedule will change. Equation (2) is derived from the
goods market equilibrium condition for a closed economy as below.
C+S+T=Y=C+I+G -(3)
If, we subtracted the above equation by C, we will get below equation.
S+T=I+G -(4)
If we add the imports (Z) and exports (X) to the equation (3), then
equation (3) is replaced by,
C+S+T=Y=C+I+G+X –Z -(5)
It means, the IS equation becomes,
S+T=I+G+X –Z -(6)
In the above equation, (X -Z) is the net exports which is the foreign
sector’s contribution to aggregate demand. If, we bring imports over to the
left-hand side and indicate the variables on which each element in the
equation depends, the o pen economy IS equation can be written as below -
IS equation in Open Economy:
S(Y) + T + Z(Y, π)=I ( r )+G+X ( Yf,π) -(7)
LM equation in open economy same as closed economy -
M=L ( Y ,r ) -(8)
BP equation in open economy -
X(Yf,π)–Z(Y, π)+F ( r –rf)=0 -(9)
In the equation (9), first two terms indicates net exports (trade
surplus) and third term shows net capital inflow (trade deficit).munotes.in
Page 93
93
Figure No. 7.4
IS-LM-BP Model
The BP schedule is positively sloped as depicted in above figure .
As income rises, demand for import increases whereas export does not. In
this condition to keep balance of payment in equilibrium for that capital
inflow must increase and for the increment in capital inflow interest rates
should be higher, then balance of payment will be in equilibrium. In above
diagram, there is need to understand slope of BP curve which is upward
sloping it means capital mobility in international financial market is
imperfect. Horizontal BP curve shows perfect capital mobility. In the
context of perfect capital mobility, r = rf, means domestic interest rate =
foreign interest rate. If, r ≠rf, it shows imperfect capital mobility in
international financial market.
7.5.1 Fixed Exchange Rate: IS -LM-BP Model
Figure 7.5
munotes.in
Page 94
94
7.5.1.1 Fixed Exchange Rate: IS -LM-BP Model under Perfect Capital
Mobility:
Monetary Policy:
When the perfect capital mobility is in international financial
market, we see monetary policy is completely ineffective when exchange
rates are fixed. How it happens? We need to understand with the help of
IS-LM-BP schedule with intervention policies.
Figure No. 7.6
IS-LM-BP Model in Monetary Policy with fixed Exchange rate and
Perfect Capital Mobility
We will explain above Figure by taking a hypothetical example.
With perfect capital mobility and effect of expansionar y monetary policy,
we will take an example of India. In India, increase in money supply from
M0to M1 as illustrated in above diagram, increasing money supply shifts
to the LM schedule to the right from LM0 to LM1. The India’s interest
rate temporary falls from r0 to r1, this interest rate is below than foreign
interest rate. This situation leads to high capital inflow from India. In the
case of perfect capital mobility, investors will be selling India’s asset,
therefore indirectly India’s currency will be selling. In this case ,Indian
Central Bank (RBI) can not restore equilibrium through sterilized
intervention in the foreign exchange market. The massive capital outflow
will be continued as long as the India’s interest rate remains below the
foreign intere st rate. India’s sterilized intervention policy will be just mean
that exhausting foreign assets holding. It implies that monetary policy
action is completely ineffective in nature. There is need to reduce the
monetary supply in money market. Then ,initial point will be achieved. It
means ,there is no gain from monetary action in the case of perfect capital
mobility under fixed exchange rate system.munotes.in
Page 95
95
Fiscal Policy: -
In the case of perfect capital mobility and fixed exchange rate,
there is quite differen t results found in fiscal policy as compare to the
monetary policy when perfect capital mobility in international financial
market and fixed exchange rate prevails, fiscal policy became effective
which discussed as in the below figure -
Figure No. 7.7
IS-LM-BP Model in Fiscal Policy with Fixed Exchange Rate and
Perfect Capital Mobility
In the above figure , when government spending increased in the
case of perfect capital mobility, it will affect IS curve. IS curve will shift
from IS0 to IS1, the domestic interest rate is reached at r, which is more
than international interest rate. This results more capital inflow in
domestic country. The central bank of country will intervene to maintain
fixed exchange rate, it leads t o increase in money supply. Now LM
schedule will shift from LM0 to LM1 and new equilibrium point E
achieved where r = rfand all market is in equilibrium. So, this fiscal policy
effect is from E0 to E1. It means that national income increased from Y0
to Y1 . It indicates that under the perfect capital mobility and fixed
exchange rate system, expansionary fiscal policy is very effective in
nature.
7.5.1.2 Fixed Exchange Rate: IS -LM-BP Model under Imperfect
Capital Mobility: -
Monetary Policy:
When the imperfect capital mobility with fixed exchange rate
system, what is effect of expansionary monetary policy? Discussed in
below diagram -munotes.in
Page 96
96
Figure No. 7.8
IS-LM-BP Model in Monetary Policy with fixe d Exchange Rate and
Imperfect Capital Mobility
Suppose, money supply increased from M0 to M 1, this leads to
shift in LM schedule from LM0 to LM1. The equilibrium point shifts from
E0 to E1. It leads to fall in interest r ate in domestic country and increase in
income from Y0 to Y1, but new equilibrium point E1 shows that balance
of payment deficit, because this E1 point is below the BP curve. So, it is
indicating deficit in balance of payment.
Fiscal Policy: -
When imperfe ct capital mobility under fixed exchange rate system
how fiscal policy of the nation works? Discussed in detail in the below
figure -
Figure No. 7.9
IS-LM-BP Model in Fiscal Policy with fixed Exchange Rate and
Imperfect Capital Mobility
In the case of expansionary fiscal policy, suppose government
increase spending in the economy, it will shifts IS schedule which shifts
from IS0 to IS1 and equilibrium point E0 to E1. It will lead to increase in
interest rate from r0 to r1 and income Y0 to Y1. The new equilibriummunotes.in
Page 97
97
point E1 i s above the BP curve which indicates that surplus in balance of
payment. So, expansionary fiscal policy will lead to create balance o f
payment (BoP) surplus.
7.5.2 Flexible Exchange Rate: IS -LM-BP Model
7.5.2.1 Flexible Exchange Rate: IS -LM-BP Model unde rP e r f e c t
Capital Mobility: -
Monetary Policy:
The perfect capital mobility with flexible exchange rates prevails
in international market, the effect of expansionary monetary policy is
discussed in below figure -
Figure No. 7.10
IS-LM-BP Model in monetary Policy with Flexible Exchange Rate
and Perfect Capital Mobility
Suppose, an increase in money supply by central authority affects
LM schedule to shift from LM0 to LM1, it leads to fall in domestic
interest rate. This situation leads to massive outflow of capital from
domestic country, because r rate rise, this will shift in IS curve from IS0 to IS1, the domestic interest
rate is brought back. This policy is very effecti ve in nature, because
income is increased from Y0 to Y1. So, in the case of perfect capital
mobility under flexible exchange rate system, the expansionary monetary
policy is very effective in nature.
Fiscal Policy:
When flexible exchange rate with perfect capital mobility prevails
in international financial market, expansionary fiscal policy is completely
ineffective in nature which briefly discussed in the below figure -munotes.in
Page 98
98
Figure No. 7.11
IS-LM-BP model in Fisca l Policy with Flexible Exchange Rate and
Perfect Capital mobility
In the case of expansionary fiscal policy, suppose government
increases spending which leads to shift in IS schedule from IS0 to IS1; it
leads to increase in domestic interest rate above that foreign interest rate.
This result will increase capital inflow in domestic country. Again policy
effect will lead to fall in exchange rate. The fall in exchange rate will
affect IS schedule which shifts from IS1 to IS0 as beginning point which
indicates that the expansionary fiscal policy is completely ineffective in
the case of flexible exchange rate with perfect capital mobility.
7.5.2.2 Flexible Exchange Rate: IS -LM-BP Model under Imperfect
Capital Mobility: -
Monetary Policy:
In completely flexible exchange rate regime, central bank does not
intervene or not able to intervene. The exchange rate of the currency will
adjust automatically by demand and supply forces in international
financial market. Therefore, th ere is need to understand the expansionary
monetary policy effect on IS -LM-BP model which discussed with the help
of below figure -
Figure No. 7.12
IS-LM-BP Model in Monetary Policy with Flexible Exchange Rate
and Imperfect Capital Mobility
munotes.in
Page 99
99
Suppose, money supply increase in the economy, it affects
economy and equilibrium E0 to E1 point. This will lead to fall in interest
rate from r0 to r1, income of the country increases from Y0 to Y1. We
move to the point be low the BP curve which indicates deficit in balance of
payment (BoP). In the case of flexible exchange rate, exchange rate of
currency will be rised. The changes in the exchange rate will shift the BP
schedule from BP0 to BP1 and IS schedule will shift fro m IS0 to IS1. The
final equilibrium point will be E2 where income is Y2 and interest rate
will be r2.
Fiscal Policy: -
Figure No. 7.13
IS-LM-BP model in Fiscal Policy with Flexible Exchange Rate and
Imperfect Capital Mobility
Government applies expansionary fiscal policy which increases
government expenditure. Increase in the government expenditure shifts the
IS schedule from IS0 to IS1. It leads to shift equilibrium point from E0 to
E1. The above diagram indicates that B P curve is more flat than LM
curve. E1 point is the above of BP curve which indicates balance of
payment (BoP) surplus. This will lead to fall in exchange rate and this
policy affect IS schedule again. The new equilibrium will reach at E2
point where incom e level is Y2 which is below than initial income level.
7.6 SUMMARY
The IS -LM-BP model exp lained various effects of policy change
where under the perfect capital mobility and fixed exchange rate, fiscal
policy is more appropriate measure to economic development and here
monetary policy is slightly ineffective in nature. And in another case of
flexible exchange rate, monetary policy found more efficient.munotes.in
Page 100
100
7.7QUESTIONS
1)Give Notes on :
a)IS curve
b)LM curve
c)BP curve
2)Explain the IS -LM-BP curve in the case of fixed exchange rate &
Perfect capital mobility.
3)Explain the IS -LM-BP curve in the case of fixed exchange rate &
Imperfect capital mobility.
7.8REFERENCES:
1.Carlin, Wendy and David Soskice (2007), Macroeconomics, Oxford
University Press.
2.D’Souza, Errol, Macroeconomics (2012), Dorling Kindersley (India)
Pvt. Ltd.
3.Michl, Thomas (2009), Macroeconomic Theory, PHI Learning.
4.Ahuja H. L. (2016), Macroeconomics Theory and Policy, S. Chand &
Company Lts.
5.Richard T. Froyen (2015), Macroeconomics, Pearson.
munotes.in
Page 101
101
MODULE –4
Unit-8
CONSUMPTION AND INVESTMENT
Unit Structure:
8.0 Objectives
8.1 Introduction
8.2 Consumption
8.3 Consumption Smoothing
8.4 Temporary and Permanent Shocks
8.5 Investment
8.6 Keynes Theory of Investment
8.7 Determinants of Investment
8.8 The Optimal Capital Stock
8.9 Irreversibility and Investment
8.10 Summary
8.11 Questions
8.12 References
8.0 OB JECTIVES
After going to this unit you will able to:
Understand the concept of consumption and consumption smoothing.
Understand the concept of investment and irreversibility.
Understand the concepts of seigniorage.
Understand the concepts of money, bond and private wealth.
8.1 INTRODUCTION
In the study of macroeconomics, the investment and the
consumption these are two important key concept to understand how
determine the national income, level of employment and d emand variation
in the economy. Second important thing is the concept of demand for
money. Why people of the country holding cash? What are the motives of
demand for money? These are important concepts we will discuss in this
unit.munotes.in
Page 102
102
8.2 CONSUMPTION
The consumption is the key macroeconomic concept which decides
or affects whole economy like as national income, employment, full
employment level and many more. That is why, there is need to
understand the concept of consumption in the study of macroecono mics.
What is Consumption?
Consumption is the utility driven phenomena where consumption
happened of goods and services, definitely utility is acquired from it. That
is why, we stated above consumption is the utility driven act. The various
macro economi sts define the consumption in the economy. Most important
among them is given by Prof. J. M. Keynes who defined short term
consumption function in his famous psychological consumption theory.
Relationship between Consumption and Income:
When income incr eases, consumption also increases; but it is not
as much as income. This important fact of consumption was focused by
Keynes who first of all evolved the concept of consumption function. Why
it happens, because whatever income increases which is not consum ed all,
some were saved. So, that is the main reason behind it.
Keynesian linear consumption function isas follow:
C=a+b Y
Where,
C = consumption
a = autonomous consumption
b = intercept term/ slope (co efficient of disposable income/ marginal
propensity to consume (MPC)
Y = disposable income.
Above Keynesian consumption function is explained by following figure -
Figure No. 8.1
Keynesian Consumption Function
In above figure consumption function is depicted, where
consumption function curve ‘cc’ deviates from the 450line that is OZ line.munotes.in
Page 103
103
Initially low income consumption curve is above than OZ curve which
suggest consumption is more than income, at the point of Y0, CC’ curve
merge with OZ line where consumption = income, then after with
increasing income consumption is decreasing and the gap between income
and consumption increases, this gap between consumption and income is
called saving gap.
Therefore, the consumptio n function figure implies that, with the
increasing income, consumption increases and it leads to increase the
saving gap, it has a significant implication in macro economics.
Income-Consumption-Saving Gap
The concepts of Average Propensity to Consume (APC) and Marginal
Propensity to Consume (MPC): -
There are two very important concepts in consumption function
and these are average propensity to consume and marginal propensity to
consume. There is need to understand variation between these two
concepts, because some where these are same, but somewhere it varies.
With the help of following table we will be able to understand the linear
consumption function.
Table No. 8.1
Linear Consumption Function
Income
(Rs. in crores)Consumption
(Rs. in crores)Average Propensity
to Consume (C/Y)Marginal Propensity to
Consume ( ∆C/∆Y)
1000 950 0.950 -
1100 1020 0.927 0.7
1200 1090 0.908 0.7
1300 1160 0.892 0.7
1400 1230 0.878 0.7
1500 1300 0.867 0.7
1600 1370 0.856 0.7
The Keynesian consumption function is given in the above table
where MPC ( ∆C/∆Y) remains constant 0.70 and APC (C/Y) is falling with
increase in income. Marginal propensity to consume (MPC) ( ∆C/∆Y)
indicates slope of consumption function which shows the linear
consumption function; because MPC is constant. In the Keynesian
consumpti on function, marginal propensity to consume is less than
average propensity to consume (MPC < APC).munotes.in
Page 104
104
The consumption demand depends on income (Y) and propensity
to consume. But propensity to consume is depends on various factors such
like general price lev el, interest rate, stock of wealth and several
subjective factors. J. M. Keynes is related with short run or short term
consumption function. Therefore, Keynes assumed that price level,
interest rate and stock of wealth etc. are constant in the short run. It means
that Keynesian theory assumed the short run where other factors being
constant.
Thus,
C=f( Y )
Where,
C = consumption
Y = Income
F = function
It means that consumption is the function of income. The specific
Keynesian or linear c onsumption function can be as follows -
C=a+b Y
Keynesian Theory of Consumption:
J. M. Keynes published his book in 1936 entitled “The General
Theory of Employment, Interest and Money” the foundation of modern
macro economics. The concept of consumption or consumption function
plays an important role in the Keynesian theory of income and
employment. J. M. Keynes mentioned various factors which determines
the consumption of society in his book. Keynesian economic thoughts
were mainly based on s hort run. So, he explained short run consumption
function. Keynes laid stress on the current income as a consumption
determinant. That is why; his consumption theory is also known as
absolute income theory of consumption while Keynes studied many
subjectiv e and objective factors including interest rate and wealth which
influences consumption level. He stated that individual and the society
mainly depends on current level of income for consumption.
Keynesian Ps ychological Law of Consumption:
According to t he Keynesian psychological law of consumption,
“As income increases, consumption increases; but not as much as increase
in income.” In other words, in the Keynesian psychological consumption
law, marginal propensity to consume is not zero but less that 1.
1>∆C/∆Y>1munotes.in
Page 105
105
Above equation implies that here is saving gap in consumption
function means whatever not consumed will be saved. There are three
important features of Keynesian consumption theory as follows -
Consumption expenditure depends on absolute income of current
period.
Marginal propensity to consume (MPC) is greater than 0, but less than
1.
There is no proportional relationship between income and
consumption. It means average propensity to consume (APC) falls
with increase in income.
8.3 CONSU MPTION SMOOTHING
In the modern macro economics, consumption smoothing approach
is the standard tool. Consumption smoothing theory is not just a
behavioral theory, but a preference maximization theory where individuals
are forward looking or the cons umption smoothing is the practice of
increasing or optimizing people’s standard of living by making a proper
balance between expenditure on consumption and saving during the
various phases of our lives. It simply implies that the balance between
consumptio n expenditure and income.
Suppose, a person saved more from his income in the current
period, definitely he will enjoy his saving in the future; but if he saved less
and consumed more in the current period, definitely he will suffer in
future.
8.4 TEMP ORARY AND PERMANENT SHOCKS
Consumption shocks refer to the disturbances that change the value
of consumption or variable by random amount. In the consumption theory,
we have treated future income which is well -known economic variable. In
fact,in the con sumption theories in particular Ando Modigliani
demonstrated that in average future income is proportional to the current
income ,we expect smooth consumption in future or in the whole life. But
it is realistic, because the effect of consumption and saving shocks of
income discussed here.
The temporary and permanent shocks of consumption are the most
important determinants of household’s consumption. According to
Friedman’s permanent income hypothesis, household consumption always
responds to permanent inc ome shock more than temporary income shocks.
Effect of Permanent and Temporary Income Shocks of Consum ption
on Saving:
Effects of permanent and temporary income shocks of
consumption have been explained in the below table.munotes.in
Page 106
106
Table No. 8.2
Effects of Shocks
Sr.
No.Types of Income
Shocks of
ConsumptionEffect on Saving Effect on
Consumption
Temporary Current
Negative ShockSaving Consumption 1.
Temporary Current
Positive ShockSaving ConsumptionAnticipated FutureNegative ShockSaving Consumption 2.
Anticipated Future
Negative ShockSaving Consumption
1.Temporar y Income Shocks of Consumption:
There are mainly following two temporary income shocks of
consumption which discussed as below -
Temporary Current Negative Shock of Consumption
Temporary Current Positive Shock of Consumption
Temporary Current Negative Shock of Consumption:
In the temporary current negative shocks of consumption,
individual adjust a temporary current negative shocks which decreases his
income with decreases his income with dissaving and maintaining the
smoothness of consumption.
Figure No.8.2
Temporary Carmet Negative Shock
Above figure indicates the temporary current negative shocks of
consumption w hich results to the decline in current income which is
accompanied by decrease in savings.munotes.in
Page 107
107
Temporary Current Positive Shock of Consumption:
In the temporary current positive shock of consum ption, income
increases of individual, he increases the saving while smoothing
consumption.
The temporary current positive shock of consumption has been
explained with the help of below diagram.
Figure No.8.3
Temporary Current Positive Shock
In the above diagram temporary current positive shock has been
depicted which shows that lifetime income is given at point E rather than
point A. It results ,an increase in current savings to Y 1’–C1’ and an
increase in c urrent consumption to C 1’* with the temporary current
shocks. It means that increases in consumption and saving absorb the
impact of the shock.
2.Permanen t Income Shocks of Consumption:
There are mainly two permanent income shocks of consumption
which are given as follows.
Anticipated Future Negative Shock of Consumption.
Anticipated Future Positive Shock of Consumption.
Anticipated Future Negative Shock of Consumption:
If individual’s future income decreases, an individual increase
today’ s saving, it is known as anticipated future negative shock of
consumption which has been explained with the help of below diagram.munotes.in
Page 108
108
Figure No.8.4
Anticipated Future Negative Shock
Above diagram indicates that anticipated future positive shock of
consumption. In this case, current income i snot change dat Y1, but in
future there is expectation to decline in income to Y2’. And the
consumption path moves from point A to point B with c onsumption
smoothing and current consumption declines to C1’* despite no change in
current income Y1. If current consumption declines, saving must rise
anticipating a decline in future income and individual is transferring to
current income to future incom e by saving. Therefore, saving increases in
response to decline in an anticipated future income.
Anticipated Future Positive Shock of Consumption:
In the anticipated future positive shock, anticipated future income
increases, individual decreases his today’s saving and increases present
consumption as with improved future income there is no need to save as
much as before.
Figure No.8.5
Anticipated F uture Positive Shock
munotes.in
Page 109
109
Above figure indicates anticipated future positive shock of
consumption in which individual borrows the income for consumption in
the present and because of rise in current consumption.
8.5 INVESTMENT
Investment is the important concept in macro economics which
implies the situation of national income, employment and capital
formation in country. It means, investment is the key economic variable in
the development of country.
Definition of Investment:
The investment means to addition in the stock of capital or creation
of new capital such as plant, machine, and transportation vehicle, new
factories and so on which creates employment and income in the
economy. Just holding financial asset i s not real investment like holding
shares, holding bonds etc. This type of investment is merely called
financial investment. It may or may not create income and employment.
Therefore, creation of physical capital in the economy, it is called real
investmen t.
Types of Investment:
There are mainly two types of investment which discussed as
below -
1.Autonomous Investment
2.Induced Investment
1.Autonomous Investment:
After the Keynesian analysis two types of investment
distinguished, these are autonomous investment and induced investment.
The autonomous investment is the investment which does not change with
the change in income level. It means, the autonomous investment is
independent from income.
J. M. Keynes explained that the level of investment is de pends
upon marginal efficiency of capital (MEC) and rate of interest. He states
that change in income level will not affects investment. Therefore, the
concept of autonomous investment of Keynes is mainly based on short
term analysis or short run problems. He said, income effects investment in
the long run.
The autonomous investment explained with the help of below figure .munotes.in
Page 110
110
Figure No.8.6
Autonomous Investment
In the above figure , X axis represents national income and Y axis
represents investment I AIA’ indicated autonomous investment. The
autonomous investment takes place houses, road constructions, public
undertakings and other types of public infrastructure development which
arenecessities, not depends on income. That is why, the autonomous
investment curve is horizontal to X axis. It implies with the increase in
income or change in income; autonomous investment does not change.
2.Induced Investment:
The induced investment is the investment which changes with
changes in the level of income. The high level of income, the higher the
consumption level, consumption will lead to increase in demand and
increase in demand will promote to industry to produce more which will
increase the investment level in economy due to increase in profit
expectations of investors.
The induced investment we can explain with the help of diagram
which discussed in the below diagram -
Figure No.8.7
Induced Investment
In the above figure 8.7 , Y axis represents investment and X axis
represents national income. IdId represents induced investment curve
which is upward sloping. It implies that with increase in income,
investment also incre ases. It means that there is positive relation between
national income and investment.munotes.in
Page 111
111
8.6 KEYNES THEORY OF INVESTMENT
J. M. Keynes explained his investment theory in his famous book
entitled “The General Theory of Employment, Interest and Money” in
1936. In this book ,he states that investment demand is depends on two
factors, these are expected rate of profit (Keynes called it marginal
efficiency of capital –MEC) and rate of interest. The people of the
country have two choices of investment, either in vest in physical capital to
earn profit or lend money to earn certain rate of interest. It implies
investment is mainly depends on rate of interest and marginal efficiency of
capital (MEC). In other words, the greater the rate of profit or MEC as
compared to interest rate, the greater the chance to increase in investment.
For example, marginal efficiency of capital is 25% and cur rent rate
of interest is 10%. So, 25 -10 = 15, which is net MEC. In this situation,
investor will try to more invest, because MEC is greater than rate of
interest.
Therefore, the equilibrium will happen in financial market where,
marginal efficiency of capital equals the rate of interest. According to
Keynes, rate of interest is not important in the short run; because in the
short run there is less chances to variation in the rate of interest. Therefore,
Keynes focused mainly on the rate of profit or mar ginal efficiency of
capital (MEC) in the short run.
According to Keynes interest rate is determines by supply of
money and the liquidity preferences. Greater the money supply, lower the
interest rate and vice versa. There are two important factors of inv estment
discussed as below -
1.Marginal Efficiency of Capital (MEC)
2.Rate of Interest.
1.Margin al Efficiency of Capital (MEC):
The concept of marginal efficiency of capital explained by J. M.
Keynes refers to the rate of expected profit to be make from investm ent in
certain capital assets. The rate of expected profit from an extra unit of
capital asset is known as marginal efficiency of capital.
According to Keynes, marginal efficiency of capital is the rate of
discount which renders the prospective yields fro m a capital asset over its
whole life period equal to the supply price of that asset. So, the marginal
efficiency of capital is obtained by following equation -
Supply Price = Discounted Prospective Yields
2312 3
1 11 1nRR R R nCrrr r munotes.in
Page 112
112
Where,
C = supply price or replacement cost
R1….R3 = annual prospective yields from the capital asset.
r = expected rate of profit or marginal efficiency of capital.
2.Rate of Interest and Investment Demand:
The rate of interest and investment demand curves discussed with
the help of following figure .
Figure No. 8 .8
In the above figure , Y axis represents interest rate and MEC and X
axis represents investment. Above figure indicates the relationship
between investment demand, interest rate and MEC. The MEC curve
represents, when interest rate falls, investment increase due to increase in
MEC and vice versa.
Interest Rate-MEC-investmentinterest Rate-MEC-investment8.7 DETERMINANTS OF INVESTMENT
Determinants of investment mean the factors or economic
variables which affects the level of investment. The determinants of
investment are as follows : -munotes.in
Page 113
113
Marginal Efficiency of Capital
Expected Demand fo r Product
Cost of Capital
Transfer of value
Transfer of value
Technology
Innovation
Availability of Credit
Fiscal Policy
Above seven factors which are very important to determine the
level of investment in the economy.
8.8 THE OPTIMAL CAPITAL STOCK
The concept of the optimal capital stock is concerned with the
principle of profit maximization. Optimal capital stock means the
additional profit from employing one additional unit of capital is the
marginal revenue product of capital (MRPC). The additional cost or
sacrifice of employing an additional unit of capital is the user cost o f
capital. The benefit or profit is maximized by employing unit of capital
(k*), where marginal revenue of product (MRP) equals to the user cost.
The optimal stock of capital where a firm which maximize profit
should employ is illustrated in the below fi gure-
Figure No.8.9
Optimal Capital Stock
Stock of Capital
The above diagram represents marginal product of capital, user
cost of capital on Y axis and on X axis, stock of capital has been shown.munotes.in
Page 114
114
The marginal product of capital (MRK) decreases with the increase in a
stock of capital and the output price is given ( pMPk) or the extra revenue
generated from employing extra unit of capital decreases as the capital
stock increased. This phenomenon is depicted by the downward sloping
curve or the marginal revenue product of capital (MRPC) curve.
The optimal stock of ca pital is depicted by K*. Any firm who is
profit maximize rwill try to operate at K* where profit is maximized or
capital stock is optimum.
8.9 IRREVERSIBILITY AND INVESTMENT
Irreversibility and investment is the modern concept in macro
economics and mor e recent approach to investment. The alternative theory
of investment is the theory of irreversible investment. The concept of
irreversibility refers to the important fact that many firms may not able to
sell the stock of capital. A firm or industry faces complete irreversibility
when resale market is completely absent which means resale price of
capital stock is equals to zero.
8.10SUMMARY
Consumption and investment are the key concepts in macro
economics and consumption is function of income there is positive
relationship between consumption and income, marginal propensity to
consume (MPC) and average propensity to consume (APC) are the two
important concepts in consumption function. In this unit we studied
concepts and theories of consumption as well investment. Like concept of
consumption smoothing, temporary and permanent shocks of
consumption, induced and autonomous investment, Keynesian theory of
consumption as well as investment, investment and irreversibility etc.
Which are important for the stud y of consumption.
8.11QUESTION
1)What is consumption? Explain the relationship between Consumption
and Income.
2)What are temporary and permanent shocks?
3)What is the meaning of investment? Explain types of investment with
the help of figure.
4)Explain Keynesian theory of investment.munotes.in
Page 115
115
8.12REFERENCE
Carlin, Wendy and David Soskice (2007), Macroeconomics, Oxford
University Press.
D’Souza, Errol, Macroeconomics (2012), Dorling Kindersley (India)
Pvt. Ltd.
Michl, Thomas (2009), Macroeconomic Theory, PHI Learning.
Ahuja H. L. (2016), Macroeconomics Theory and Policy, S. Chand &
Company Lts.
Richard T. Froyen (2015), Macroeconomics, Pearson.
munotes.in
Page 116
116
Unit-9
THE DEMAND FOR MONEY
Unit Structure :
9.0 Objectives
9.1 Introduction
9.2 Fisher’s Transaction Approach
9.3 Keynesian Approach of Demand for Money
9.4 Money
9.4.1 Definition of Money
9.4.2 Functions of Money
9.5 Bonds
9.6 Private Wealth
9.7 Financial Assets
9.8 Seigniorage : The Optimal Level of Seigniorage
9.9 Summary
9.10 Questions
9.11 Reference
9.0OBJECTIVES
After going to this unit you will able to :
1)Understand Fisher’s and Keynesian approaches of demand of money
2)Understand functions of money
3)Understand the concept and types of bond
4)Understand the optimal level of Seigniorage
9.1 INTRODUCTION:
Demand for money is highly important in micro economics,
because demand for money is not only determined the interest rate but also
national income and country’ s price level. According to classical
economists, money is only as a medium of exchange. Therefore, they used
merely money as a medium of purchase of goods and selling of goods. It
means, they just want money (demand for money) only for transaction
purpose . But J.M. Keynes focuses on another important function of money
and that is store of value.
According to J. M. Keynes, people hold money as an asset to take
advantage of price variation. So, again Keynes said one another importantmunotes.in
Page 117
117
motive of demand for mo ney which is speculative demand for money.
Here is important to note that what people demand for money which is not
just nominal money holding, but real balances. It means people are
interested in the purchasing power of money holding. If, people of the
country merely concern with nominal income (just holding currency notes
irrespective with price level), the people will definitely suffer money
illusion. In the macro economics, there is always lively debate on demand
for money among the economist, because j ust we said above that money is
not just merely matter of exchange; but it affects economy as a whole.
There are main two approaches of demand for money.
1.Fisher’s Transaction Approach
2.Keynesian Approach
9.2 FISHER’S TRANSACTION APPROACH
The classical ec onomists focus or use money only as a medium of
exchange. It implies that money does not matter in economy. Money uses
as a medium of buying and selling of commodity. So, the relation between
money and commodity is explained by Fisher in below equation.MV=P T
Where,
M = The quantity of money in circulation.
Y = Transaction velocity of circulation
P = Average Price.
T = The total number of transactions
According to Fisher, in any period the value of all goods and
services or assets sold must equal to the number of transactions (T)
multiplied by price level (P). It means, total value of transaction equals to
PT.The value of money flow or money supply (M) is multiplied by
average number of transactions or money circulation in economy (v)
which denotes velocity of money in the economy.
In short, Fisher’s equation MV = PT explains just role of exchange
for money in the economy. Money plays only the role of medium of
exchange.
9.3 KEYNESIAN APPROACH OF DEMAND FOR
MONEY
Prof. J. M. Keynes explained another view of demand for money.
Why people demand for money? He explained various motives of demand
for money which were not discussed in the classical theory. Keynes states
that money is not just merely medium of exchange, it has another
functions also like as store of value which makes money as an importantmunotes.in
Page 118
118
variable in economy which affects national income, general price level. It
means that money matters.
According to Keynes, liquidity preference means the demand for
money to hold or the desire of people of the nation to hold cash. This
desire of people to hold cash (liquidity) arises due to 3 motives which
discusses as below -
1.The Transaction Motive
2.The Prec autionary Motive
3.The Speculative Motive
1.The Transaction Motive of Demand for Money: -
The transaction motive of demand for money is explained by
classical economists also. It is common motive between classical and J. M.
Keynes of demand for money. Under th is motive people hold cash for
their daily needs of goods and services to sell and buy it. In other words,
people keep some cash in their pockets for daily transactions. This is the
motive of transaction.
According to Keynes, this transaction motive is de pends on the
level of income (Y).M1 = L1 (Y)
Where,
M1 = transaction demand for money
L1 = demand function
Y = Income.
2.The Precaution ary Motive of Demand for Money:
Precaution is the part of human life. People make the strategies by
theprecautionary motive also. So, J. M. Keynes emphasize on this
precautionary motive; it means people of the country keeping some cash
in their pockets for unforeseen or unexpected emergencies as a precaution,
it is called precautionary demand for money is also depends on income
like transaction demand for money.
3.The Speculative Motive of Demand for Money:
J. M. Keynes emphasizes more on this motive of demand for
money. Keynes explained the important function of demand for money
which has store of value whi ch creates new motive of demand for money
and that is speculative demand for money where people of the nation are
holding some cash to take the advantage of price change or variation in
prices of assets and bonds. So, this motive of demand for money is cal led
speculative motive.
M2 = L2 (r)
It means, above equation indicates that speculative demand for
money (M2) is depends on rate of interest (r) instead of income.munotes.in
Page 119
119
9.4 MONEY
Money is the medium of exchange as we discussed in the Fisher’s
equation; but here is need to understand the concept of money? What
money does? What are the functions of money? So, these are the
important facts of money, we are going to discuss in this topic.
9.4.1 Definition of Money:
There is no unique definition of money. Variou s economist or
monetarists try to define what is money? Among these various definitions
more acceptable and comprehensive definitions discussed as below.
According to Crowther, “Money can be defined as anything that is
generally acceptable as a means of e xchange and at the same time it acts
as a measure and a store of value.”
According to Prof. D. H. Robertson, “Money means anything
which is widely accepted in payment for goods or in discharge of other
kinds of business obligations.”
Some economists defi ned, money is that what money does.
Therefore, above definitions implies the performance of money
and functions of money. In these all definitions ,which has been explained
above, there are some key value, measure (unit of account) etc. these are
the main functions of money with other functions.
9.4.2 Function s of Money:
There are five important functions of money (currency) as bellow:
Function of Money
Medium of exchange
Measurement of value
Store of value
Standa rd of deferred payments
Transfer of valuemunotes.in
Page 120
120
Medium of Exchange:
Money is very important for buying or selling of goods and
services. With the help of money, people get any goods and services
without disturbances and sell any goods and service.
Measurement of Value:
Value of goods and services measured in the form of money.
Money is generally used to determine and show the price of commodity.
For example, suppose the price of 1 kg. of Tomato is Rs.50. It means 1kg.
Tomato= Rs.50.
Store of Value:
Wealth would be store d in the term of money. It means, money has
a store value. It can be stored for very long time. Before existence of
money, wealth could not store in the same value. Today, it is possible only
because of money.
Standard of Deferred Payments:
Money is also useful for the deferred payments. If a person
borrows today, then he can pay back their loan in the future with the help
of money.
Transfer of Value:
Money is also useful to transfer of value. Today within few
minutes, money transferred from one bank to a nother bank, one asset to
another asset, one person to another person with the help of internet and
financial instruments. Even though, the value of transfer remains constant.
9.5 BONDS:
Bond is the financial instrument or tool in financial market which
is one of the important financial asset for investor, so bonds have its own
value in financial market. There are various types of bonds depends on
various facts like as maturity date.
Definition:
Bond is a legal promise to repay a debt. It is an investmen t tool
where investor getting some amount of interest at fixed rate on fixed date.
So, it implies that bond is the income earning source of investors. Bond
prices vary inversely with interest rate.
9.6 PRIVATE WEALTH
As we discussed above, what is money? What is bond? Apart of
this households and firms in the private sector apparently holds no other
assets and liabilities like as mutual funds, share, equity and common stock.
So, what is net private wealth? Net private wealt h or net private sector
wealth is sum of its assets minus the sum of its liabilities common stockmunotes.in
Page 121
121
representing possession (ownership) in a firm are the assets of households
and corresponding liabilities of the firm that issue them.
Thus, the net private w ealth consists of its net claims on outside
that sector. There is important to note that only the outside financial
wealth that we are concerned with, these are two types of sources of
wealth. One is government liabilities on bond and second is central ban k
liabilities on money. This relation we can explain by follows formula.Wt = Mt + Bt/ It
Where,
Wt = nominal wealth of the private sector
Mt = Stock of money held by the private sector at the time of t.
Bt = stock of bonds held at the time of t.
It=interest rate at the time of t.
So, it implies that interest rate affects bond holding and money
holding in the financial market.
9.7 FINANCIAL ASSETS
The financial assets in financial market are non -physical assets.
The value of assets is depends on contractual claim such like bank deposit,
bonds and stocks. The financial asset is more preferable, because it has
high liquidity as compare to other assets like commodity or real estate.
Financial assets are very easy to sell and buy. There are various ty pes of
financial assets according to the international financial reporting standards
(IFRS). Afinancial asset can be equity, cash or cash equivalent,
contractual rights and many more.
Financial assets are the measure way for investors to earn profit in
financial market.
9.8 SEIGNIORAGE: THE OPTIMAL LEVEL OF
SEIGNIORAGE
There is basic idea behind seigniorage which is the net revenue
producing from money. It simply implies that government generates
revenue through printing of money. In other words, the dif ference between
the exchange values of produced money and the cost of producing money
and maintain it in circulation, it is called as seigniorage in macro
economics.
The concept of seigniorage is so old which studies since gold
standard. In the gold stand ard system, when every citizen hold gold as a
money in the form of gold coins, a duty payable on this service was
known as seigniorage. If the coins in this system were produced in mint,
then the mint operations were following account identity.munotes.in
Page 122
122M=P Q+C +S
Where,
M = the nominal value assigned to the batch of coins (e.g. 100 INR)
P = nominal price paid by mint per gram of precious metal.
Q = the number of grams of precious metal embodied in the batch of
coins.
C = the remaining average cost of operating the mint (called ‘brassage’)
S = the nominal seigniorage.
Here, the S is written as seignioage profit available for spending by
the king. Total seigniorage revenue depends on how many batches of
coins are produced per annum.
In the world of 21stcentury, there is fiat money standard. In this
system the content of the bullions in the money is zero. Therefore,
production cost is almost zero. In this system, the government’s nominal
seigniorage is just the change in the stock of base money per year .S=∆M0
Where,M0 = stock of base money and real seigniorage (RS) is
RS = ∆M0/P
Seignorage has a revenue implication in that rate of monetary
expansion or the expansionary monetary policy is not infinite. So, this is
the equals to the profit maximiz ation for a monopolist who has to take into
account the decrease in the sales as he raises the price.
The Optimal Level of Seigniorage:
The optimal seigniorage is the concept refers to increase in the
growth rate of nominal money supply, increase in the r ate of inflation and
results in a reduction in the demand for real balances or real money
balances.
Seigniorage can be written as follow -00 00MM MSPM P
Where,00MM=the growth rate of base money0MP=tax base
S = Seignioragemunotes.in
Page 123
123
The optimum level of seigniorage is explained with the help of
following diagram of optimum seigniorage and inflation where panel A,
Panel B and Panel C are plotted.
Figure No.9.1
Optimal Seigniorage and Inflation
In the above diagram, S0, S1, S2 and S3 these are various levels of
seigniorage in Panel A and DD curve depicted real money demand
function. Point E shows that the equilibrium or maximum point of
seigniorage in panel A and Panel C. Panel C indicates the phenomenon of
seigniorage where Y axis shows seigniorage and X axis indi cates ∆M/M.
Point E indicates optimal seigniorage.
9.9SUMMARY
This unit delivered the most important concepts which are
investment, consumption, consumption sm oothing, temporary and
permanent shocks of consumption, seigniorage, financial assets and
demand for money etc. These concepts affect the economy. Changes in
these economic variables will make change in the level of employment,
level of income, general pri ce level, level of full employment and many
more.
9.10QUESTION
1)Explain Keynesian approach of demand for money.
2)Give the definition of money and explain the various functions of
money.
3)Explain the capital level of Seigniorage with the help of diagram.munotes.in
Page 124
124
9.11 REFERENCES
Carlin, Wendy and David Soskice (2007), Macroeconomics, Oxford
University Press.
D’Souza, Errol, Macroeconomics (2012), Dorling Kindersley (India)
Pvt. Ltd.
Michl, Thomas (2009), Macroeconomic Theory, PHI Learning.
Ahuja H. L. (2016), Macroeconomics Theory and Policy, S. Chand &
Company Lts.
Richard T. Froyen (2015), Macroeconomics, Pearson.
munotes.in