Macro Economics concepts and applications (English Version)-munotes

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UNIT ONE –NATIONAL INCOME AND ITS DIMENSIONS
UNIT -1
NATIONAL INCOME AND PRICE LEVEL
Unit Structure :
1.0 Objectives
1.1 Meaning of National Income
1.2 National Income concepts : GNP, GDP & NDP
1.3 Real and nominal income
1.4 Measurement of National Income
1.5 Measures of inflation
1.6 Price indices
1.7 GDP deflator
1.8 Nominal and real interest rates
1.9 PPP theory
1.10 Summary
1.11 Questions
1.0 OBJECTIVES
To understand and study the meaning of National Income
To study different National Income concepts
To understand the Real and Nominal income concepts
To study the measurement of Nat ional income
To understand the concept and measures of inflation
To study the concept of price indices
To understand and study the meaning of GDP deflator
To study the concepts of Nominal and Real interest rates
To study the Purchasing Power Parity theory
1.1 NATIONAL INCOME
National income is the money value of all economic activities
of a nation conducted in each year. An economic activity refers to
production of goods and services which can be valued at market
prices. It includes agricultural production, industrial production and
production of services. Goods and services which do not have an
exchange value or market value are non -economic in nature. Formunotes.in

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instance, services of a house wife or a house hus band, services of
members of family to other members or their own selves, hobbies
etc. The national income of a country can be defined as the total
market value of all final goods and services produced in the
economy in each year.
National income measure s market value of annual output. It
is therefore a monetary measure of the value of goods and
services. To measure the real national income or the measure the
changes in physical output of goods and services, the figure for
national income is adjusted fo r price changes. Further, for the
accurate calculation of national income, all goods and services
produced in a year must be counted only once. Generally, goods
are produced in different stages before they reach the markets in
their final form. Hence, c omponents of goods are exchanged many
times. Thus, to avoid multiple counting, national income includes
only the market value of all final goods. This is how national
income is defined in terms of product flow.
National income can also be defined in ter ms of money flow.
Economic activities generate money flow in the form of payments
i.e., wage, interest, rents and profits. National income can thus be
obtained by adding the factor incomes land adjusting it for indirect
taxes and subsidies. National inc ome obtained in this manner is
known as National Income at Factor Cost.
National income can be viewed from different angles. It
represents total receipts land it also represents total expenditure.
When goods and services are valued at their market price s, three
identities are created, namely: the value of receipts equal to the
value of payments equal to the value of goods and services
produced and sold. These three identities can be put as:
National Income = National Expenditure = National Product.
To understand the concept, let us assume a two -sector
model of an economy consisting of households and firms. Firms
produce goods and services. To produce, firms require factor
services namely: land, labor, capital and enterprise. Factors of
production a re paid their prices in the form of rents, wages,
interests and profits for their contribution to the production of goods
and services. The money value of net production must equal the
total money value of factor prices i.e. rents, wages, interests and
profits. These incomes become the source of expenditure. Thus,
income flows from the firms to the households in exchange for
productive services. The income goes back to the firms in the form
of expenditure made by households on goods and services. This
process is also referred to as the Circular Flow of Economic
Activities. There are thus three measures of national income of a
country, namely:munotes.in

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1.The total value of all final goods and services produced.
2.The total of all incomes received by the factor owner si nay e a r ,
and
3.The total of consumption expenditure, net investment
expenditure and government expenditure on goods and
services.
These three measures denote the three fundamental functions
of an economic system or a national economy, namely: production,
distribution and expenditure. The fourth fundamental function is
that of consumption and is subsumed in expenditure.
1.2 NATIONAL INCOME CONCEPTS
1.2.1 GROSS NATIONAL PRODUCT (GNP)
The GNP is the most widely used measure of national
income. It is the basic accounting measure of the total output of
goods and services. GNP is defined as the total market value of all
final goods an d services produced in a year. It measures the
market value of a yearly output and therefore it is a monetary
measure of national income. In the definition above, the term ‘final’
is used to avoid the possibility of double counting and to ensure
that onl y the value of final goods and services is considered in
measuring GNP. This is because the value of intermediate goods
is included within the value of final goods and services. The term
‘gross’ refers to the fact that depreciation or capital consumption of
goods has not been subtracted from the value of output. While
measuring the GNP, only the final value of goods and services is
considered, i.e., the value is added in each stage of the production
process. For instance, there are many stages in the p roduction of
bread. The farmer produces wheat. The miller converts wheat into
flour. The baker bakes the bread and finally the bread is sold by
the retailer to the consumer. The value addition process in the
production of bread is shown in Fig. 1.1.munotes.in

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As shown in Fig.1.1, value is added to the product at every
stage of production as cost is incurred at every stage of value
addition. The final value of the bread is the total of the value added
at each stage. Su ppose in the second stage, if we add up Rs.7
instead of Rs.2 and in the third sage Rs.12 instead of Rs.5 and so
on then it will be a case of multiple counting. This will give a wrong
and inflated picture of the actual value of the product produced in
each period.
The rate of growth of GNP is the most important indicator of
the nation’s economy. It shows the rate at which the national
income of a country is increasing or decreasing. It is the broadest
statistical aggregate of an economy’s output and grow th. The
estimate of national income in terms of GNP provides the policy
makers and business community a useful tool to analyze the
economic performance of the country.
In an open economy, the value of GNP at market prices may be
symbolically stated as fo llows:
GNP (MP)=C + I + G + X n+R n,w h e r e :
GNP (MP) = Gross National Product at market prices.
C = Consumption goods.
I = Investment goods.
G = Government services.
Xn = Net exports i.e. exports minus imports.
Rn = Net receipts i.e. receipts minus payments.
GNP is the basic accounting measure of national output and
represents final products valued at current market prices.munotes.in

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1.2.2 GROSS DOMESTIC PRODUCT AT MARKET PRICES
(GDP MP)
The Gross Domestic Product refers to the value at market
prices of goods and services produced inside the country in each
year. It can be stated as follows:
GDP MP=C+I+G+( X –M)
Where, C = Consumption goods.
I = Capital goods or Gross investme nts.
G = Government Services.
X = Exports, and
M = Imports.
Here, (X –M) refers to net exports or X nwhich can be
positive or negative. If exports are greater than imports, net
exports will be positive and vice versa. Net positive exports will
lead to rise in GDP and net negative exports will lead to fall in GDP.
1.2.3 NET DOMESTIC PRODUCT (NDP)
While calculating the GDP, no provision is made for
depreciation or capital expenditure. Net Domestic Product is
arrived at by subtracting depreciation f rom the GDP. Depreciation
is accounted for because factories, buildings etc., get depreciated
over their life time during their use in the production process.
These goods need replacement once their life is over. Hence, a
part of the replacement cost of the capital is set aside in the form of
depreciation allowance. Symbolically, Net Domestic Product can
be stated as follows:
NDP = GDP –D
Where, D= Depreciation.
1.3 NOMINAL INCOME (NATIONAL INCOME AT
MARKET PRICES) AND REAL INCOME (NATIONAL
INCOME AT CONSTANT PRICES.
When goods and services produced in each year are
multiplied with their current market prices, we get national income
at current prices. However, prices do not remain constant. The
value of national income at current prices changes according to the
chang es in prices. When we measure, national income at current
prices, what we get is the nominal national income. Thus, during a
period of price rise, the nominal national income would rise even
when the physical quantity of output produced remains constant.
To find out the real rise in national income, the physical quantity of
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prices. This process is called deflating the national income figures
for the change in prices that have taken place duri ng a period.
Thus, through adjustment or deflation, the national income is
calculated at constant prices. The national income at current prices
is deflated by price index numbers to obtain national income at
constant prices. To find out the real nationa l income, the following
formula is used:
National Income at =National Income at Current Prices×100
Constant Prices Price Index Number
For instance, the estimates of India’s national income (NNP)
for various years at current and constant prices are give ni nT a b l e
1.1. The table shows that the increase in Net National Income at
current prices is much greater than the increase in Net National
Income at constant prices. The nominal values of NNP are much
greater than that of the real values because the pr ices have
increased during the period 2015 -16 to 2019 -20.
Table 1.1 Estimating National Income at Constant Prices
from
National Income at Current Prices.
Year NI at Current
Prices
Rupees TrillionWholesale
Price Index No.
(Base 2011 -12)NI at Constant
Prices
(Base 2011 -12)
Rupees Trillion
1 2 3 4=( 2 / 3x1 0 0 )
2015 -16
2016 -17
2017 -18
2018 -19
2019 -20121.62
135.95 (2ndRE)
151.28 (1stRE)
168.37 (PE)
181.10 (1stAE)122.06
126.19
131.19
136.55
139.8599.63
107.73
115.31
123.30
129.49
RERevised Estimates,PEProvisional Estimates &AEAdvanced
Estimates. Source: Collated from IES 2019 -20.
1.4 MEASUREMENT OF NATIONAL INCOME
In national income estimates, all goods and services
produced and exchanged for money during a year are considered.
National output can be estimated at three different levels, namely:munotes.in

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production, distribution and expenditure. Thus, there are three
method s of measuring national income. These are as follows:
1.The Census of Products Method or Output Method.
2.The Census of Income Method, and
3.The Expenditure Method.
The estimates of national income indicate the performance
of the economy and therefore it is an important accessory in the
economist’s toolkit. For economic analysis and forecasting,
accurate and reliable estimates of Gross National Product assume
importance.
1.4.1 The Census of Products Method, Output Method or the
Inventory Method.
Acco rding to this method, the economy is classified into
three sectors, namely: the industrial sector, the service sector and
the external sector. Industrial sector includes all productive
activities. It constitutes the flow of goods in different sub -sectors
like agriculture, mining, transport and public utilities. In the service
sector, the value of services which directly serve the consumers is
taken into consideration. All salary payments are included. Since,
pension is a transfer payment, it is exclude d. In the external sector,
the value of exports and imports (net exports) and receipts from
abroad and payments to other countries (net receipts) are taken
into consideration.
This method of estimating national income helps to find out
the origin of the n ational income. Hence, it is called national
income by industrial origin. This method can be used in a country
where the census of production in each year is undertaken. Since,
census data of production of all industries are not available; this
method i su s e da l o n gw i t ho t h e rm e t h o d st oa r r i v ea tn a t i o n a l
income. For instance, the national Income Committee of India
adopted Census of Production method along with Income method
to estimate national income. This method shows the relative
importance of the different sectors of the economy by revealing
their respective contributions to the national income.
In order to avoid multiple counting, there are two alternative
approaches used in the measurement of national income, namely:
(1) the final goods method a nd, (2) the value -added method.
1.The Final Goods Method of Estimating National Income.
According to this method, the final values of goods and
services are considered without taking into consideration the value
of intermediate goods because the value of intermediate goods is
already included in the value of final goods. For instance, the price
of motor car includes the prices of its various components. Tomunotes.in

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avoid multiple counting, only the final value of the goods and
services are considered to arrive a ta correct estimate of national
income.
2. The Value -Added Method of Estimating National Income.
According to the Value -Added Method, the national income
estimate is obtained by a summation of the value added at each
stage of production until the final product is produced. The value -
added method is shown in Table 1.2. You will notice from Table
1.5that the value of the final product is added in the production
process. To avoid multiple counting, on should consider either the
value of the final output or the sum of values added. National
income estimates by Value Added Method is a tedious exercise
and hence the more convenient Final Goods Method is adopted.
Table 1.2 -Value Added Method of Estimati ng National Income
Precautions to be taken while estimating National Income by
Census of Product or Output Method.
The following precautions are required to be taken to arrive at a
correct result of the national income estimate being made with the
Census of Product Method:
1.To avoid multiple counting, only the value of final product must
be added. The value of raw mater ials and intermediate goods
must be excluded.
2.Farm output set aside for subsistence should be estimated and
measured at the prevailing market prices.
3.Indirect taxes should be deducted and subsides should be
added to find out the correct market value of the products.
4.Export income should be added and import expenditure must be
deducted.
5.Valuation of quantities must be done with reference to base
year prices.
After computing the value of GNP, the value of net exports
(Xn=X–M) and the value of net factor incomes from abroad (R n=
R–P) or net receipts are added to the GNP. Indirect taxes and
depreciation allowance is deducted from the GNP. Symbolically,
theNational Income estimate made with the Census of Product
Method can be stated as follows:munotes.in

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Y = (P–D) + (S –T) + [(X –M) + (R –P)]
Where, Y = National Income.
P = Domestic Output of all productive sectors.
D = Depreciation Allowance.
S = Subsidies.
T = Indirect Taxes.
X = Exports.
M = Imports.
R = Receipts from abroad, and
P = Payments made abroad.
The Census of Product Method is used in USA where it is
also known by ‘Total Product Method’ or ‘Goods Flow Method’.
However, in underdeveloped countries like India, there are practical
difficulties enco untered in using this method because of the
presence of a substantially large non -monetized sector.
1.4.2 Census of Income Method or Factor Income Method
The income method approaches national income from the
distribution point of view. Accordingly, the na tional income is
measured after it has been distributed and appears as income
earned by individuals or factor owners. The national income is
obtained by adding up the incomes of all individuals of the country
in the form of rent, wages, interests, profits , undistributed profits of
joint stock companies and incomes of self -employed people. This
method is therefore called National Income by Distributive Shares.
Transfer payments like subsidies, gifts, etc are deducted from the
total factor incomes. Nation al income is therefore equal to factor
incomes less transfer payments. This method is also known as
Factor Income or Factor Cost Method. To this, net exports and net
receipts are added to obtain the National Income. Symbolically,
this method can be expr essed as follows:
Y = Σ(r + w + i + π)+[ ( X –M) + (R –P)]
Where, w = Wages.
r = Rent.
i = Interest, and
π= Profits.
Precautions to be taken in the estimation of National Income
by Income Method.
To obtain the correct estimates of national in come by income
method, the following precautions should be taken:
1.Income from the sales receipts of second hand goods must be
excluded but the brokerage on such transactions must be
accounted for in the national income.munotes.in

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2.Transfer payments such as unemployment allowance, pensions,
charity, gifts, earning from gambling, windfall gains from lotteries
etc are to be excluded.
3.Financial investments are to be excluded as they do not add to
the real national income. All capit al gains/losses related to
wealth should be ignored.
4.Direct tax revenue to the government should be deducted from
the total income as it is a transfer income from the people to the
government. In the same manner, government subsidies
should be deducte d from the profits of the subsidized industries.
5.All unpaid services should be ignored. For instance, services of
the housewife, service to self etc for which payments are not
made should be excluded.
6.Undistributed profits of companies, income from government
property and profits of public enterprises should be added.
7.Rent because self -occupied accommodation should be imputed
and included in the national income.
8.Value of production for self -consumption should be accounted
for in the national income.
In India, the National Income Committee used the Income
Method for summing up the net income from the services sector.
Due to the lack of personal accounting practices, it is difficult to
know the personal income of individuals and hence the inco me
method is not used entirely for the national income estimates. The
Central Statistical Organization (CSO) uses a combination of the
Census of Product Method and the Census of Income Method for
estimating the national income.
1.4.3 The Expenditure Meth od of Estimating National Income
This method is also known as the Consumption and
Investment Method of measuring national income. National income
from the expenditure point of view is the sum of consumption
expenditure and investment expenditure. Accordi ng to this method,
national income is computed in the following manner:
a) Estimate private and public consumption expenditure.
b) Add the value of investment in fixed capital and stocks.
c) Add the value of net exports i.e. (X –M) and the value of net
receipts (R –P) or net foreign income from abroad.
Symbolically, the national income so estimated can be expressed
as follows:munotes.in

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Y = Σ(C + I + G) + [(X –M) + (R –P)]
Where, C = Consumption Expenditure.
I = Investment Expendi ture, and
G = Government Expenditure.
Precautions to be taken in the estimation of National Income
by Expenditure Method.
The following precautions are required to be taken in the
estimation of national income by expenditure method:
1.Expenditure on se cond hand goods should be excluded
because they are a part of the stock of goods produced in the
past.
2.Expenditure on financial assets such as equity shares, bonds
etc should be excluded because they do not add to the real
national income.
3.Expendit ure on intermediate goods should be excluded.
4.Government expenditure on pensions, scholarships,
unemployment allowance etc should be ignored as these
constitute transfer payments.
5.Expenditure on final goods and services should be included.
1.4.4 Reconciliation of the three methods of estimating
National Income.
The output method, the income method and the expenditure
method are the three different methods of estimating national
income. They give us three different measures of national income,
namely: Gross National Product by output method, Gross National
Income by the Income Method and Gross National Expenditure by
the expenditure method. Since national income is equal to national
product which is equal to national expenditure, any of these thre e
methods will obtain an identical value of national income. Since
change in output is equal to change in income which is equal to
change in expenditure i.e. ∆O= ∆Y=∆E. Symbolically, the three
measures can be expressed as GNP = GNI = GNE.
Choice of M ethods
The three methods of estimating national income give the
same measure of national income provided he required data or
information for each method is sufficiently available. However, all
the methods are not suitable for all the countries and for all
purposes. This gives rise to the problem of choice of methods. A
given method is chosen based on two main considerations, namely:
(1) the purpose of national income analysis and (2) availability ofmunotes.in

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the required data. If the aim is to estimate the net o utput, the
value -added method could be right choice. If the objective is to
estimate the factor income distributed, then the income method
would be appropriate. Similarly, if the aim is to find out the
expenditure pattern of the national income, the expe nditure method
should be used. The availability of adequate and appropriate data
is an important consideration in selecting a method of national
income. The most common method, however, is the value -added
method because it is easy to classify economic ac tivities and output
and the required data is also easily available. Nevertheless, no
single method can accurately measure national income because
want of exhaustive data. Hence, the general practice is to use two
or more methods to measure national income.
Check your progress:
1. Explain the concept of National Income.
2. Distinguish between GNP and GDP.
3. Distinguish between Nominal Income and real Income.
4. State the methods of measuring National income.
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1.5 MEANING AND MEASURE OF INFLATION
A sustained rise in the general price level over time is known
as inflation. Conversely, a sustained fall in the general pr ice level
would be known as deflation. Inflation is measured in terms of a
price index. For instance, in India, we have the wholesale price
index (WPI) and the consumer price index (CPI). The Price Index
is based on a basket of goods and services. With in a given basket,
the prices of some goods and services may rise or fall. However,
when there is a net increase the price of the basket, it is called
inflation.
Table 1.3
Inflation Rate based on Wholesale Price Index (WPI)
in India for the period 2015 -16 to 2019 -20.
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Inflation is a rate of change in the price level. The rate of
change is measured with reference to the base year so that a long -
term perspective is obtained with regard to price rise. For all
practical purposes, inflation rate is measured on yearly basis .
However, in recent years, the inflation rate is also measured on
monthly and weekly basis. The rate of inflation can be measured
as: P=(P1P0)P0100. For example, the price index based
on the Wholesale Prices in India for the year 2015 -16 was 122.06
and in 2016 -17, it was 126.19. The rate of inflation for the year
2016 -17 was 3.38 per cent. Inf lation rate measured based on
wholesale price index (WPI) for the period 2015 -16 to 2019 -20 in
India is given in Table 1.3.
1.6 PRICE INDICES
There are two aspects to the changes in prices. They are:
(1) Changes in relative prices which influence the re source
allocation of micro -economic units, and (2) Changes in the general
price level which influences the purchasing power of money. There
are several price indices which are used to explain the second
aspect of changes in prices. We will try and understa nd the
construction of two types of price indices, namely; the Consumer
Price Index (CPI) and the Wholesale Price Index (WPI).
A.The Consumer Price Index
The Consumer Price Index compares the total money that is
required to purchase a given basket of consumption goods and
services overtime in percentage terms. The basket represents the
actual consumption pattern of a typical family from a specific group
forwhich the CPI is being constructed. As tastes and preferences
vary across families and relative prices vary geographically, a
separate CPI is constructed for each of a few well -defined
population groups. Some such groupings are urban industrial
workers, a gricultural laborers, urban non -manual employees etc.
To construct the index for a given year with reference to a base
year, the following information is required:
1.Consumption basket in the base year,
2.Prices of the items in the basket in the base year, and
3.Relative prices for each item in the given year.
We can obtain the weights of each item in the consumption
basket from (1) and (2) above. The items in the consumption
basket are grouped together int o a small number of groups such
as, food, fuel and light, housing, clothing etc. There are further sub -
groupings amongst the major groups. For instance, in food item, we
can have cereals, pulses, oils, fats etc. It is not necessary to
include all items in the calculation. If prices of a group of items
show similar movements, only one of them needs to be included inmunotes.in

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the index calculation. For example, in the vegetables and fruits
group, we can select two items each of vegetables and fruits for
monitoring pri ce movements. Prices of other items in the category
are presumed to move in the same direction as the selected items
move. The weights of the non -selected items are then appropriately
distributed over the selected items.
The data on consumption basket is obtained from family
budget surveys which are carried out from time to time. These
surveys give estimates of commodity composition of consumption
expenditures of a typical family in a specified population group.
Data on prices are obtained from retail outl ets by a large staff of
field investigators. The base year is changed every few years so
that changes in taste, changes in the composition of the
consumption basket etc. are considered.
The Consumer Price Indices for various population groups
are calculat ed and published by the Bureau of Labor. In Table 2.1
below, a hypothetical example of CPI construction is given. Let us
assume that a typical urban working class family has only five items
in its consumption basket. The items, quantities purchased in 1998 -
99 per month, 1998 -99 prices and 2008 -09 prices are given in
table 1.4.
Table 1.4: Construction of CPI
Item Quantit
y
1998 -99Prices
1998 -99Prices
2008 -09Price Relative
2008 -09 =
Price2008 -
09100 Price
1998 -99
Rice 20 kg Rs. 10/kg Rs. 15/kg 150
Wheat 10 kg Rs. 8/kg Rs. 12/kg 150
Milk 60 litres Rs. 10/ltr Rs. 15/ltr 150
Cotton
Cloth05 mtrs Rs.
100/mtrRs.
200/mtr200
House
RentTwo
BHKRs.1500
p.m.Rs.3,000
p.m.200
1.Total expenditure in 1998 -99.
=p i0qi0= Rs. 2,880
2.Weights.
Let us consider the weight of House Rent in the total
expenditure in 1998 -99. It was Rs. 1,500 p.m. The share of House
Rent in total expenditure was:munotes.in

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WHouse Rent =p0
Hrq0
Hr
pi0qi0=1,500
2,880=0 . 5 3
The weights of other items are as follows:
Rice =0 . 0 7
Wheat =0 . 0 2
Milk =0 . 2 1
Cotton Cloth =0 . 1 7
The sum of the weights will be equal to one or unity.
3.Price Relatives
Price Relative of Rice
pricet
price0100 =15
10100 = 150
The price relative of other items can be similarly obtained
and is also given in the table.
4.Laspeyre’s CPI
It =w1pit
pi0100 =5,320
2,880100 = 184.72
B.The Wholesale Price Index
The construction method of the Whole Price Index is like that
of the Consumer Price Index. The difference between the two
indices is given below:
1) The items included in WPI are different from that of the CPI.
The WPI includes items like industrial raw mate rials, semi -finished
goods, minerals, fertilizers, machinery, equipment etc. in addition to
items from the food, fuel, light and power groups. The WPI can be
considered as an index of prices paid by producers for their inputs.
2) Wholesale prices are used. F or instance, in the case of
minerals ex -mine prices are used, for manufactured products, ex -
factory prices, for agricultural commodities the first wholesaler’s
prices are used.
3) Weights are based on value of transaction in the various
items in the base yea r. For manufactured products, it is the value of
production, for agricultural products, the value of marketable
surplus is considered.munotes.in

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The main groups of items are:
1) Primary Articles.
a) Food – Rice, wheat etc.
b) Non-food – raw cotton, jute etc.
c) Minerals – Iron ore, manganese ore etc.
A total of 80 primary articles are covered.
2) Manufactured Articles – 270 items.
3) Fuel, Power, Light and Lubricants – 10 items
1.7THE NATIONAL INCOME DEFLATOR
When we divide nominal national income by real national
income, we obtain the national income deflator. The real national
income can be calculated by dividing nominal national income by
the national income deflator. The national income deflator for
variou sy e a r sg i v e ni sg i v e ni nT a b l e1 . 5 .
Table 1.5 -Calculati ng the National Income Deflator
YearNI at CurrentPrices
Rupees TrillionNI at Constant
Prices
(2011 -12)
Rupees TrillionThe NI Deflator
1 2 3 4=( 2 / 3 )
2015 -16
2016 -17
2017 -18
2018 -19
2019 -20121.62
135.95(2ndRE)
151.28(1stRE)
168.37PE
181.10(1stAE)99.63
107.72
115.31
123.29
129.491.2206
1.2619
1.3119
1.3655
1.3985
You may notice from Table 1.5 that when we divide the
nominal national income by the real income, we can obtain national
income deflator. However, to find out the real national income one
needs the price index of the relevant years. Once, we have the
current year price index number, we can find out the national
income of the current year by dividing the nominal national income
of the current year by the current year price index and multiply the
quotient by hundred. Alternatively, the national income defl ator can
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price index. Since the base year price index is always hundred, the
national income deflator can be simply found by moving the
decimal points by two digits to the left. For insta nce, the wholesale
price index in the year 2015 -16 divided by 100 would give the
national income deflator as 1.2206. You may notice that we have
simply shifted the decimal point by two digits to the left. Now when
we divide the nominal national income or the national income at
current prices by the national income deflator, we can obtain the
real national income. For example, Rs.121.62 Trillion divided by
1.2206 will give us Rs.99.63 Trillion which is the real national
income for the year 2015 -16.
1.8NOMINAL AND REAL INTEREST RATES
The nominal interest rate is the prevailing market rate of
interest. Market interest rates are determined in the money market
by the forces of market demand for money and the supply of
money. The commercial banking system is the largest component
of the money market. The interest rate offered by the commercial
banks on deposits for various term periods is the market or nominal
rate of interest. For instance, commercial banks in India offer
interest rates in the range of 7 to 7.5 percent per annum on
deposits of one year maturity period. The real interest rate is the
difference between the nominal interest rate and the rate of
inflation. If the rate of inflation is six percent per annum, then the
real interest would be calculated as follows:
Nominal in terest rate –Rate of Inflation = Real interest rate
The consumer price inflation rate in India in the year 2016 is
about four percent. The commercial banks offer an interest rate of
7.5 per cent for a fixed deposit of one year maturity. Assuming,
Rs.10 00/-deposited for a period of one year, the real interest rate
on a fixed deposit made in a commercial bank would be 7.5 –4=
3.5. The depositor would earn only Rs.35/ -at the end of the year.
However, if the inflation rate is greater than the nominal interest
rate, depositors would earn negative interest income i.e. they would
be losing on their deposits.
The relationship between the real interest value (r) ,t h e
nominal interest rate value (R) ,a n dt h ei n f l a t i o nr a t ev a l u e( i ) is
given by (1 + r) = (1 + R)/(1 + i). In our example, the real interest
rate would be 1.075/1.04 = 1.037
When the inflation rate (i)is low, the rea l interest rate is
approximately given by the nominal interest rate minus the inflation
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Check your progress:
1. Explain the meaning of inflation.
2. What do you understand by Consumer price index?
3. What do you understand by Whol esale price index?
4. Explain the term National income deflator.
5. Distinguish between Nominal interest rate and Real Interest rate.
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
____________________________________________ _________
1.9PURCHASING POWER PARITY THEORY
The purchasing power parity theory of exchange rate
determination was put forward by Professor Gustav Cassel of
Sweden in the year 1920. There are two versions of the PPP
theory known as the absolute and the relative versions. According
to the absolute v ersion, the exchange rate between two currencies
should be equal to the ratio of the price indexes in the two
countries. The formula for the absolute versions of the theory is as
follows:
RAB = PA/PB
Here, R ABis the exchange rate between two countries Aa n d
B and ‘P’ refers to the price index. The absolute version is not used
because it ignores transportation costs and other factors which
hinder trade, non -traded goods, capital flows and real purchasing
power.
The relative version which is widely use d by Economists can
be illustrated as follows. Let us assume that India and the United
States are on inconvertible paper standard and the domestic
purchasing power of $1 in the US is equal to Rs.45 in India. The
exchange rate would therefore be $1 = Rs.4 5. Assuming the price
levels in both the countries to be constant, if the exchange rate
moves to $1 = Rs.40, it would mean that less rupees are required
to buy the same bundle of goods in India as compared to $1 in the
US. It means that the US dollar is overvalued and the Indian
Rupee is undervalued. Appreciation of the rupee will discourage
exports and encourage imports in India. As a result, the demand
for USD will increase and that of INR will fall till the PPP exchange
rate is restored at $1 = Rs.45 . Conversely, if the exchange rate
moves to $1 = Rs.50, the INR is overvalued and the USD is
undervalued. This will encourage exports and discourage imports
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According to the PPP theory, the exchange rat eb e t w e e n
two countries is determined at a point of equality between the
respective purchasing powers of the two currencies. The PPP
exchange rate is a moving par which changes with the changes in
the price level. To calculate the equilibrium exchange ra te under
the relative version of the theory, the following formula is used:
PA1∕PA0
R = R0×—————
PB1∕PB0
Where 0 = base period,
1 = period one,
A&B = Countries A and B.
P = Price Index.
R0 = Exchange rate in the base period.
Assuming the price index of Country ‘A’ (India) to be 100 in
the base period and 300 in period one and that of United States to
be 100 and 200 in the two periods respectively and the Original
exchange rate to be Rs.40, the new PPP exchange rate would be
as follows:
300∕100 300 100 3
R=40 × ————— =—— ×—— =—=1 . 5=R s . 6 0
200∕100 100 200 2
Thus Rs.60/ -or $1 = INR 60 will be the new PPP exchange rate.
However, the PPP exchange rate will be modified by the cost of
transporting goods including duties, insurance, banking and other
charges. These costs are the limits within which the exchange rate
can fluctuate given the demand supply situation. These limits are
the ‘upper limit’ or the commodity export poin ta n dt h e‘ l o w e rl i m i t ’
or the commodity import point.
Critical Assessment of the PPP Exchange Rate Theory. The
PPP theory is criticized on the following grounds:
1.Price Indices of Two Countries are not comparable. The
base year of indices in two countr ies may be different. The
consumption basket may also be different. The PPP rate may not
therefore give an accurate exchange rate based on the relative
purchasing powers of any two currencies.
2.Base Year is Indeterminate. The theory assumes that the
balance of payments is in equilibrium in the base year. It is difficult
to find the base year in which the balance of payment was in
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3.Capital Mobility Influences the Price Level .T h e t h e o r y
assumes that there is no capital mobility. The general price level
does not affect items such as insurance, shipping, banking
transactions etc. However, these items influence the exchange
rate.
4.Changes in the Exchange Rate affects the General Price
Level . When the exchange rate depreciates, the domestic price
level is influenced by the rise in import prices. Demand for exports
increases, thereby raising the price of export goods. Conversely,
when the exchange rate appreciates, exports are affected and
imports become cheaper, thus bringing about a fall in the price
level.
5.Laissez Faire does not exist. The theory is based on the
policy of laissez -faire. However, laissez faire does not exist.
International trade is greatly influenced by restrictive and protective
trade policies. Non -market forces therefore influence the exchange
rate.
6.Elasticity of Reciprocal Demand influences Exchange
Rates. According to Keynes, the theory neglects the influence of
elasticity of reciprocal demand. The exchange rate is not only
determined by relative prices but also by the elasticity of reciprocal
demand between trading countries.
7.Changes in the Demand for Imports and Exports influence
Exchange Rate. The exchange rate is not determined by
purchasing power parity al one. The demand for imports and
exports also influence exchange rate. If the demand for imports
rise, purchasing power parity remaining constant, the exchange
rate will rise and vice versa.
Conclusion
In spite of the limitations, the PPP exchange rat et h e o r yi s
widely used in development economics to ascertain the real level of
development of an economy. The theory is therefore useful and
PPP exchange rate is therefore a useful macroeconomic tool.
Haberler in support of the theory says that, “While the price levels
of different countries diverge, their price systems are nevertheless
interrelated and interdependent, although the relation need not be
that of equality. Moreover, supporters of the theory are quite right
in contending that the exchanges can always be established at any
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1.10SUMMARY
1.The national income of a country can be defined as the total
market value of all final goods and services produc ed in the
economy in each year.
National income can be viewed from different angles. It
represents total receipts land it also represents total expenditure.
When goods and services are valued at their market prices, three
identities are created, namely : the value of receipts equal to the
value of payments equal to the value of goods and services
produced and sold. These three identities can be put as:
National Income = National Expenditure = National Product
2.The GNP is the most widely used measur e of national income. It
is the basic accounting measure of the total output of goods and
services. GNP is defined as the total market value of all final goods
and services produced in a year. It measures the market value of a
yearly output and therefor e it is a monetary measure of national
income.
3.When goods and services produced in each year are multiplied
with their current market prices, we get national income at current
prices. However, prices do not remain constant. The value of
national in come at current prices changes according to the changes
in prices. When we measure, national income at current prices,
what we get is the nominal national income.
4. National output can be estimated at three different levels,
namely: production, distrib ution and expenditure. Thus, there are
three methods of measuring national income. These are as follows:
a.The Census of P roducts Method or Output Method
b.The Census of Income Method, and
c.The Expenditure Method.
5.A sustained rise in the general price level ov er time is known as
inflation. Inflation is measured in terms of a price index. For
instance, in India, we have the wholesale price index (WPI) and the
consumer price index (CPI). The Price Index is based on a basket
of goods and services. Within a given basket, the prices of some
goods and services may rise or fall. However, when there is a net
increase the price of the basket, it is called inflation.
6.When we divide nominal national income by real national
income, we obtain the national income deflator. The real national
income can be calculated by dividing nominal national income by
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7.The nominal interest rate is the prev ailing market rate of
interest. Market interest rates are determined in the money market
by the forces of market demand for money and the supply of
money. The real interest rate is the difference between the nominal
interest rate and the rate of inflation . If the rate of inflation is six
percent per annum, then the real interest would be calculated as
follows:
Nominal interest rate –Rate of Inflation = Real interest rate
8.The purchasing power parity theory of exchange rate
determination was put forwar d by Professor Gustav Cassel of
Sweden in the year 1920. There are two versions of the PPP
theory known as the absolute and the relative versions. According
to the absolute version, the exchange rate between two currencies
should be equal to the ratio of the price indexes in the two
countries.
1.11QUESTIONS
1.Explain the following concepts:
a)GNP.
b)The National Income Deflator.
c)GDP and NDP.
2.Explain the difference between real and nominal income.
3.Write short notes on the following methods of measuring
national income:
a)Census of Income Method.
b)Expenditure Method.
c)Census of Product Method.
4.Explain the ‘Census of Product Method’ of measuring national
income and state the precautions to be taken in estimating
national income by this method.
5.What is inflation and how inflation is measured?
6.Explain the construction of Laspeyre’s Price Index giving an
example.
7.Explain the construction of wholesale price index.
8.Explain the concept of GDP deflator.
9.Explain the difference between nominal and real i nterest rates.
10.Explain the concept of purchasing power parity income.
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UNIT ONE -NATIONAL INCOME AND ITS DIMENSIONS
UNIT -1A
HUMAN DEVELOPMENT INDEX
Unit Structure :
1A.0 Objectives
1A.1 Concept of HDI
1A.2 Components of HDI
1A.3 Measurement of HDI
1A.4 Summary
1A.5 Questions
1A.0 OBJECTIVES
To understand and study the concept of Human Development
To study various components of Human Development Index
To study the measurement of Human Development Index
1A.1 CONCEPT OF HUMAN DEVELOPMENT INDEX
The UNDP Human Development Report 1997 describes
human development as “the process of widening people’s choices
and the level of well -being they achieve are at the core of the notion
of human development. Such theories are neither finite nor static.
But regardless of the level of development, the three essential
choices for people are to lead a long and healthy life, to acquire
knowledge and to have access to the resources needed for a
decent standard of living. Human development does not end there,
however. Other choices highly valued by many people, range from
political, economic and social freedom to opportunities for being
creative and productive and enjoying self -respect and guaranteed
human rights”. The HDR 1997 further stated that, “Income clearly
is only one option that people would like to hav et h o u g ha n
important one. But it is not the sum -total of their lives. Income is
only a means with human development the end”.
What we understand from the description of human
development found in HDR 1997 is that human development is a
continuous proce ss. The process becomes developmental only if it
increases choices and improves human well -being. Amongst other
choices, the three most important choices are that of long andmunotes.in

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healthy life which is determined by life expectancy at birth, to
acquire knowle dge which is determined by education and a decent
standard of living which is determined by GDP per capita. These
three choices are also the components of human development
index. While these three choices are basic to human development,
the choices go b eyond these three to include the ever expanding
social, political and economic freedoms that make human life worth
living. Thus, guaranteed human rights become an important aspect
of human development.
According to Paul Streeton, human development is
necessary due to the following reasons:
1.Economic growth is only a means to the end of achieving
human development.
2.Investments in education, health and training will increase
longevity and productivity of the labor force and thereby improve
human development.
3.Female education and development widens choices for
women’s development. Reduced infant mortality rate reduces
fertility rate and reduces the size of the family. It further
improves female health and helps to reduce the rate of growth
of population.
4.Encroachment upon the natural environment is the result of
growing size of impoverished populations. Problems of
desertification, deforestation, and soil erosion, erosion of natural
beauty, unpleasant habitats and surroundings will reduce with
human development.
5.Poverty reduction will encourage people to satisfy higher order
needs like esteem needs and the need for se lf-actualization.
Thus, human development can contribute to a better civil
society, a credible democracy and social stability and political
stability.
1A.2 THE HUMAN DEVELOPMENT INDEX (New
method for 2011 data onwards)
1.Life Expectancy Index (LEI)
2.Education Index (EI)
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2.3Mean Years of Schooling Index (MYSI)
2.4Expected Years of Schooling Index (EYSI)
3.Income Index (II)
Finally, the HDI is the geometric mean of the previous three
normalized indices:
LE : Life expectancy at birth
MYS: Mean years of schooling (Years that a 25 -year-old
person or older has spent in Schools)
EYS: Expected years of schooling (Years that a 5 -year-old child
will spend with his education in his whole life)
GNIpc : Gross national income at purchasing power parity per
capita.
1A.2.1 Calculating the Human Development Index
The Human Development Index (HDI) is a summary
measure of human development. It measures the average
achievements in a country in three basic dimensions of human
development: a long and healthy life, access to knowledge and a
decent standard of living. The HDI is the geometric mean of
normalized indices measuring achievements in each dimension.
There are two steps to calculating the HDI.
Step 1. Creating the dimension indices
Minimum and maximum values (goalposts) are set to
transform the indicators expressed in different units into indices
between 0 and 1. These goalposts act as the ‘natural zeroes’ and
‘aspirational goals’, respectively, from which component indicators
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The justification for placing the natural zero for life
expectancy at 20 years is based o n historical evidence that no
country in the 20th century had a life expectancy of less than 20
years (Oeppenand Vaupel 2002; Maddison 2010; Riley 2005).
Societies can subsist without formal education, justifying the
education minimum of 0 years. The maxi mum for mean years of
schooling, 15, is the projected maximum of this indicator for 2025.
The maximum for expected years of schooling, 18, is equivalent to
achieving a master’s degree in most countries.
The low minimum value for gross national income (GNI )p e r
capita, $100, is justified by the considerable amount of unmeasured
subsistence and nonmarket production in economies close to the
minimum, which is not captured in the official data. The maximum is
set at $75,000 per capita. Kahneman and Deaton (201 0) have
shown that there is a virtually no gain in human development and
well-being from annual income beyond $75,000. Assuming annual
growth rate of 5 percent, only three countries are projected to
exceed the $75,000 ceiling in the next five years.
Havin g defined the minimum and maximum values, the
dimension indices are calculated as:
(1)
For the education dimension, equation 1 is first applied to
each of the two indicators, and then the arithmetic mean of the t wo
resulting indices is taken. Because each dimension index is a proxy
for capabilities in the corresponding dimension, the transformation
function from income to capabilities is likely to be concave (Anand
and Sen 2000) —that is, each additional dollar of income has a
smaller effect on expanding capabilities. Thus, for income, the
natural logarithm of the actual, minimum and maximum values is
used.Dimension Indicator Minimum Maximum
Health Life Expectancy 20 85
Expected Years of
Schooling0 18
Education Mean Years of Schooling 0 15
Standard of
LivingGNI PC(PPP 2011 $) 100 75000
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Step 2. Aggregating the dimensional indices to produce the
Human Development Index
The HDI is the geometric mean of the three dimension indices:
HDI = ( IHEALTH .IEDUCATION .IINCOME )1/3
(2)
Example: Costa Rica
Life expectancy at birth (years) 79.93
Mean years of schooling (years) 8.37
Expected years of schooling (years) 13.5
GNI per capita (PPP $) 13,011.7
Note: Values are rounded.
Health index =
Mean years of schooling index =
Expected years of schooling index =
Education index =
Income index =
=
Human Development Index =
The HDR 2015 has grouped countries in four categories:
1.Very hig h human development - 0.800 -1.00
2.High human dev elopment. - 0.700 -0.799
3.Medium human development. - 0.550 -0.699
4.Low human development. - <0 . 5 5 0
The HDI trends for some selected countries are given in Table 2.1
below.
Table 2.1 –Human Development Index Trends.
VERY HIGH HUMANDEVELOPMENT1990 2000 2010 20141N o r w a y0.849 0.917 0.940 0.944
2 Australia 0.865 0.898 0.927 0.933
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4 Denmark 0.799 0.862 0.908 0.923
5 Netherlands 0.829 0.877 0.909 0.922
6 Germany 0.801 0.855 0.906 0.916
6I r e l a n d 0.770 0.861 0.908 0.916
8U n i t e d S t a t e s 0.859 0.883 0.909 0.915
9C a n a d a 0.849 0.867 0.903 0.913
9N e w Z e a l a n d 0.820 0.874 0.905 0.913
11 Singapore 0.718 0.819 0.897 0.912
12 Hong Kong China (SAR) 0.781 0.825 0.898 0.910
HIGH HUMAN DEVELOPMENT
50Belarus - 0.683 0.786 0.798
50 Russian Federation 0.729 0.717 0.783 0.798
63Mauritius 0.619 0.674 0.756 0.777
67 Cuba 0.675 0.685 0.778 0.769
69Iran 0.567 0.665 0.743 0.766
73 Sri Lanka 0.620 0.679 0.738 0.757
MEDIUM HUMAN DEVELOPMENT
106Botswana 0.584 0.561 0.681 0.698
110Indonesia 0.531 0.606 0.665 0.684
116 South Africa 0.621 0.632 0.643 0.666
121 Iraq 0.572 0.606 0.645 0.654130 India0.428 0.496 0.586 0.609
132 Bhutan - - 0.573 0.605
142 Bangladesh 0.386 0.468 0.546 0.570
LOW HUMAN DEVELOPMENT
145Kenya 0.473 0.447 0.529 0.548147 Pakistan0.399 0.444 0.522 0.538
188Niger 0.214 0.257 0.326 0.348
The HDI for some selected countries along with their components is
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Table 2.2: HDI (2014) for Selected Countries .
Source: Compiled from UNDP HDR 2015.HDI
RankCountry HDI
ValueLEB
(Years)MYS
(Years)EYS
(Years)GNIpc
(Constant
2011
PPP$)
Very High Human Development
1 Norway 0.944 81.6 12.6 17.5 64,992
6 Germany 0.916 80.9 13.1 16.5 43,919
8 United
States0.915 79.1 12.9 16.5 52,947
14 United
Kingdom0.907 80.7 13.1 16.2 39,267
20 Japan 0.891 83.5 11.5 15.3 36,927
22 France 0.888 82.2 11.1 16.0 38,056
39 Saudi
Arabia0.837 74.3 8.7 16.3 52,821
High Human Development
50 Russian
Federation0.798 70.1 12.0 14.7 22,352
63 Mauritius 0.777 74.4 8.5 15.6 17,470
69 Iran 0.766 75.4 8.2 15.1 15,440
73 Sri Lanka 0.757 74.9 10.8 13.7 9,779
90 China 0.727 75.8 7.5 13.1 12,547
Medium Human Development
106 Botswana 0.698 64.5 8.9 12.5 16,646
130 India 0.609 68.0 5.4 11.7 5,497
142 Bangladesh 0.570 71.6 5.1 10.0 3,191
Low Human Development
145 Kenya 0.548 61.6 6.3 11.0 2,762
147 Pakistan 0.538 66.2 4.7 7.8 4,866
188 Niger 0.348 61.4 1.5 5.4 908munotes.in

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Check your progress:
1. What do you understand by the term Human development
Index?
2. State the Life Expectancy Index as a method to measure HDI.
3. State the Education Index method to measure HDI.
4. State the Income Index method of measurement of HDI.
_____________________________________________________
_____________________________________________________
_____________________________________________________
_________________________________________ ____________
_____________________________________________________
1A.2.2 CRITICISMS OF THE HDI
The Human Development Index has been criticized for
failing to include any ecological considerations, focusing exclusively
on national performanc e and ranking (although many national
Human Development Reports, looking at sub -national performance,
have been published by UNDP and others —so this last claim is
untrue), not paying much attention to development from a global
perspective and based on grou nds of measurement error of the
underlying statistics and formula changes by the UNDP which can
lead to severe misclassifications of countries in the categories of
being a 'low', 'medium', 'high' or 'very high' human development
country.
Economists Hend rik Wolff, Howard Chong and Maximilian
Auffhammer discuss the HDI from the perspective of data error in
the underlying health, education and income statistics used to
construct the HDI. They identify three sources of data error which
are due to (i) data u pdating, (ii) formula revisions and (iii) thresholds
to classify a country’s development status and find that 11%, 21%
and 34% of all countries can be interpreted as currently
misclassified in the development bins due to the three sources of
data error, re spectively. The authors suggest that the United
Nations should discontinue the practice of classifying countries into
development bins because the cut -off values seem arbitrary, can
provide incentives for strategic behavior in reporting official
statistics , and have the potential to misguide politicians, investors,
charity donators and the public at large which use the HDI.
In 2010 the UNDP reacted to the criticism and updated the
thresholds to classify nations as low, medium and high human
development co untries. In a comment to The Economist in early
January 2011, the Human Development Report Office responded to
a January 6, 2011 article in The Economist which discusses the
Wolff et al. paper. The Human Development Report Office states
that they undertook a systematic revision of the methods used for
the calculation of the HDI and that the new methodology directly
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for continuous updating of the human development categories
whenever formul a or data revisions take place. Some common
criticisms of the HDI are as follows:
1.It is a redundant measure that adds little to the value of the
individual measures composing it.
2.It is a means to provide legitimacy to arbitrary weightings of a
few aspect s of social development.
3.It is a number producing a relative ranking which is useless for
inter-temporal comparisons, and difficult to compare a country's
progress or regression since the HDI for a country in each year
depends on the levels of, say, life e xpectancy or GDP per capita
of other countries in that year. However, each year, UN member
states are listed and ranked according to the computed HDI. If
high, the rank in the list can be easily used as a means of
national aggrandizement; alternatively, if low, it can be used to
highlight national insufficiencies.
Ratan Lal Basu criticizes the HDI concept from a completely
different angle. According to him the Amartya Sen -Mahbub ulHaq
concept of HDI considers that provision of material amenities alone
would bring about Human Development, but Basu opines that
Human Development in the true sense should embrace both
material and moral development. According to him human
development based on HDI alone, is similar to dairy farm
economics to improve dairy farm o utput. To quote: ‘so human
development effort should not end up in amelioration of material
deprivations alone: it must undertake to bring about spiritual and
moral development to assist the biped to become truly human.’ For
example, a high suicide rate wo uld bring the index down.
Af e wa u t h o r sh a v ep r o p osed alternative indices to address
some of the index's shortcomings. However, of those proposed
alternatives to the HDI, few have produced alternatives covering so
many countries, and that no development index (other than,
perhaps, Gross Domestic Product per capita) has been used so
extensively —or effectively, in discussions and developmental
planning as the HDI.
1A.3 SUMMARY
1.The UNDP Human Development Report 1997 describes human
development as “the process of widening people’s choices and the
level o fw e l l -being they achieve are at the core of the notion of
human development.
2. Human Development Index is based on the following three new
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a. Life Expectancy Index
b. Education Index
c. Income Index
3.The Human Development Index has been cr iticized for failing to
include any ecological considerations, focusing exclusively on
national performance and ranking, not paying much attention to
development from a global perspective and based on grounds of
measurement error of the underlying statist ics and formula changes
by the UNDP which can lead to severe misclassifications of
countries in the categories of being a 'low', 'medium', 'high' or 'very
high' human development country.
1A.4 QUESTIONS
1.Explain the concept of Human Development?
2.Explain the construction of the HDI with a suitable example.
3.Explain the criticisms of HDI.
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UNIT TWO -DETERMINATION OF NATIONAL INCOME
UNIT -2
THEORY OF AGGREGATE DEMAND
Unit Structure :
2.0 Objectives
2.1 The Principle ofE f f e c t i v eD e m a n d
2.2 Factors Determining Effective Demand
2.3 Equilibrium Level ofE m p l o y m e n t
2.4 The Concept ofU n d e rE m p l o y m e n tE q u i l i b r i u m
2.5 Concept o fI n f l a t i o n a r yG a p
2.6 Summary
2.7 Questions
2.0 OBJECTIVES
To understand the prin ciple of effective demand
To study the Aggregate Demand and Aggregate Supply
concepts
To study the determination of level of employment
To study the concept of Under employment equilibrium
To study the concept of inflationary gap
2.1 THE PRINCIPLE OF EFFECTIVE DEMAND
According to John Maynard Keynes, the level of employment
and output in an economy is determined by the level of income and
the level of income is determined by the level of effective demand.
Effective demand refers to the total expenditure made by the
people in a country on goods and services produced in each
period. The expenditure stream determines the income stream i.e.
Aggregate Expenditure = Aggregate Income. The level of
expenditure or Aggregate Demand and th e level of income are
directly related to each other. Higher the level of expenditure,
higher will be the level of national income and vice -versa.
Aggregate expenditure in an economy is the sum of
aggregate consumption and investment expenditure. Effect ive
demand, therefore, represents the aggregate demand for
aggregate output produced at any equilibrium level of income.
Aggregate demand shows the monetary value of national output ormunotes.in

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real national income. The national output consists of consumption
andinvestment goods. Effective demand is, therefore, determined
by aggregate consumption and investment demand. In modern
welfare -oriented economies, government demand is also a major
component of aggregate demand and hence it becomes the third
component o f effective demand. The component of effective
demand can therefore be stated as follows:
Effective Demand =C+I+G
Where;
C= Consumption expenditure of the households.
I = Investment expenditure by private firms.
G= Government expe nditure on consumption and
investment goods.
2.2 FACTORS DETERMINING EFFECTIVE DEMAND
According to Keynes, effective demand is determined by the
interaction of aggregate demand and supply functions.
A.Aggregate Demand Function (ADF)
The ADF is a schedule of maximum sales revenue expected
to be received by the class of entrepreneurs from the sale of output
produced at various levels of employment. It is also known as the
demand price. There is a direct relationship between the aggreg ate
demand price and the level of income or employment. Higher the
level of real income or employment, higher will be the aggregate
demand price and vice -versa. The aggregate demand function is
shown in t he form of a schedule in Table 2 .1 below with the help of
a hypothetical data.
Table 2 .1
The Aggregate Demand Schedule
Level of Real Income (Y)
(in Million Workers)Aggregate Demand Price
(in billion rupees)
1 350
2 500
3 650
4 800
5 950
The ag gregate demand schedule relates real income
measured in terms of employment with the flow of expenditure in
the economy. The data in Table 2 .1 can be graphically plotted tomunotes.in

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obtain the aggregate demand curve as shown in Fig. 2.1 below.
Fig. 2 .1 below show s the aggregate demand curve. It is a positive
sloping curve showing direct relationship between the level of
employment or real income and the aggregate demand price.
Symbolically,
ADP = f( N )
Where; ADP = Aggregate Demand Price
N= Level of employment, and
f= Functional relationship
Fig. 2 .1: The Aggregate Demand Curve.
B.Aggregate Supply Function (ASF)
The aggregate supply function schedule shows the minimum
expected sales revenue of the class of entrepreneurs from output
produced at various levels of employment. The aggregate supply
price is the minimum supply price or reserve price which the
entrepren eurs must receive from the output produced. It is the cost
of production that the entrepreneurs must obtain from the sale of
output to continue to remain in business. According to Keynes, the
supply price of national output can be measured in terms of la bor
cost. Accordingly, a hypothetical aggregate supply function
schedule is tabulated in Table 2 .2 below.munotes.in

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Table: 2 .2
The Aggregate Supply Schedule
Level of
Employment(N)
(in Million workers)Aggregate Supply Price
(ASP)
(in Billion rupees)
1 200
2 400
3 600
4 800
5 1000
The data tabulated in Table 2 .2 above assumes that money
wages paid to a worker is Rs.200, 000 per annum. The schedule
therefore shows the minimum expected revenue from the sale of
output produced at different levels of employment. Thus, to employ
one million workers, the entreprene urs must receive Rs.200 Billion
i.e., Rs.200, 000 X 1000,000 workers. The aggregate supply price
is directly related to the level of employment. Higher the level of
employment, higher will be the aggregate supply price and vice -
versa.
The data given in Table 2 .2is graphically plotted in Fig. 2 .2
to obtain the aggregate supply curve.
Fig.2 .2: The Aggregate Supply Curve .
In Fig. 2 .2 above, the X -axis shows the level of employment
and Y -axis shows the aggregate supply price. The aggregate
supply price curve (ASP) is positively sloping towards the rightmunotes.in

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indicating a direct relationship between the level of employment
and the supply price. The ASP curve becomes perfectly inelastic or
vertical at the full employment level. In our example, the full
employment level is achieved when five million workers are
employed. The ASP curve becomes vertical at point ‘F’ as shown
inFig.2 .2
2.3EQUILIBRIUM LEVEL OF EMPLOYMENT
The equilibrium level of employment and real national
income is determined at the point of equality between the
aggregate demand price and the supply price. Employment and
real output continues to rise if demand price is greater than the
supply price and stops at the point of equalit y. You will notice from
Table 2 .3 below that when four million workers are employed the
AD price and the AS price are equal i.e., Rs.800 Billion. This point
of equality is the point of Effect ive demand. If employment is
increased beyond the point of effective demand, the aggregate
demand price will fall below the supply price and the class of
entrepreneurs will make losses.
Table 2 .3
Equilibrium Level of Employment and National Income
The Po int of Effective Demand
Employmen
t
(million
workers)AD
Price
(Billio
n
Rest)AS
Price
(Billio
n
Rest)Compariso
nChange in
Employment/Rea
l
National Income
1 350 200 ADP > ASP Increase
2 500 400 ADP > ASP Increase
3 650 600 ADP > ASP Increase
4 800 800 ADP = ASP Equilibrium
5 950 1000 ADP < ASP Decrease
The equilibrium level of employment and real national
income or the point of effective demand can be diagrammatically
shown as in Fig.2 .3 below.munotes.in

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Fig. 2 .3: Equilibrium Level of Employment and Real National
Income.
In Fig. 2 .3 above, the two curves ADP and ASP intersect
each other at point ‘E’. Point ‘E’ is the point of effective demand.
Corresponding to point ‘E’, point ‘R’ on the Y -axis indicates
equilibrium receipts and point ‘N’ on the X -axis indicates equilibrium
level of employment and real national income. However, point ‘E’ is
only an under empl oyment or less than full employment equilibrium
as full employment level is indicated by point ‘F’ on the aggregate
supply curve.
Per Keynes, the economy achieves equilibrium at less than
full employment level because the gap between income and
consump tion is not fully filled up by investment. Both investment
and savings are made by two different classes. While savings are
made by the household sector, investments are made by the class
of entrepreneurs. Hence, investment cannot be equal to saving. I f
aggregate investment is less than aggregate savings, economy will
operate at less than full employment level.
Increase in the Level of Effective Demand and Employm ent
Per Keynes, the aggregate supply function is constant in the
short run because the pr oductive capacity of the economy cannot
be increased in the short period. However, the level of effective
demand and employment can be increased by increasing the
aggregate demand f unction. This is shown in Fig.2 .4 below.munotes.in

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Fig. 2 .4: Increase in the level of Employment& Real National
Income .
In Fig. 2 .4 above, the aggregate demand price curve ADP 1
intersects the aggregate supply price curve ASP at point E 1and
ON 1level of employment is determined. When the agg regate
demand is increased the ADP, curve shifts upwards and intersects
the ASP curve at point E 2and a higher level of employment i.e. E 2
is determined.
It may be concluded that the level of employment in an
economy can be increased if aggregate demand is increased.
Aggregate demand can be increased if either investment demand
or consumption demand increases.
2.3.1 Limitations of the K eynesian Theory of Employment
The Keynesian theory of employment and real national
income is criticized on the following grounds:
1.Relevant to Free Market Economy. The Keynesian theory is
applicable only in free market capitalist economies which operate
based on market mechanism. It is not relevant to other economic
systems such as socialism where all economic decisions are taken
by the government. It is also not r elevant to a mixed economy
where the role of the government is substantially large.
2.Keynesian Theory is Relevant to Depression. Keynes wrote
his General Theory in 1936. Both Europe and America were
caught in the great economic depression during the firs th a l fo ft h e
20thcentury. Keynes prescribed increased Government
expenditure to increase the level of effective demand under
conditions of recession. However, the theory cannot be applied
under the conditions of jobless growth when economy grows along
with fall in employment and stagflation when prices rise but
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3.Keynesian Theory is not relevant to open Economies.
Keynes did not consider the impact of international trade and
investment on national economies. Keynes assumed a closed
economy while writing his theory.
4.Keynesian Theory is not Relevant to UDCs. Keynes had
dealt with the problem of the down -turn in business cycles and the
resultant rise in unemployment. However, under developed
countries face the problem of reg ular and disguised unemployment.
5.Keynesian Theory Ignores the Long Run Problems.
Keynes sought solution to the short run macro -economic problems
and went on to say that in the long run we are all dead. He thus
ignored the long run problems of changes i n the economic
conditions.
2.4 THE CONCEPT OF UNDER EMPLOYMENT
EQUILIBRIUM
The equilibrium level of employment is determined by the
point of equality between the aggregate demand price and the
supply price. Employment continues to rise if demand pr ice is
greater than the supply price and stops at the point of equalit y. You
will notice from Table 2 .4 below that when four million workers are
employed, the AD price and the AS price are equal i.e., Rs.800
billion. This point of equality is the point o fE f f e c t i v ed e m a n d . I f
employment is increased beyond the point of effective demand, the
aggregate demand price will fall below the supply price and the
class of entrepreneurs will make losses.
Table 2 .4
Equilibrium Level of Employment/Real National Income
The Point of Effective Demand
Employment
(million
workers)AD
Price
(Billion
Rest)AS
Price
(Billion
Rest)Comparison Change in
Employment/Real
National Income
1 350 200 ADP > ASP Increase
2 500 400 ADP > ASP Increase
3 650 600 ADP > ASP Increase
4 800 800 ADP = ASP Equilibrium
5 950 1000 ADP < ASP Decreasemunotes.in

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The equilibrium level of employment or the point of effective
demand can be di agrammatically shown as in Fig.2 .5 below.
Fig. 2 .5: Equilibrium Level of Employment.
In Fig. 2 .5 above, the two curves ADP and ASP intersect
each other at point ‘E’. Point ‘E’ is the point of effective demand.
Corresponding to point ‘E’, point ‘R’ on the Y -axis indicates
equilibrium receipts and point ‘N’ on the X -axis indicates equilibrium
level of employment. However, point ‘E’ is only an under
employment or less than full employment equilibrium as full
employment level is indicated by point ‘F’ on the aggregate supply
curve. Per Keynes, the economy achieves equilibrium at less than
full emplo yment level because the gap between income and
consumption is not fully filled up by investment. The reasons for the
gap in savings and investment are as follows:
1.The people who save and the people who invest are not same.
The households save and the ent repreneurs invest.
2.The factors which determine saving are different from the
factors which determine investment. For instance, people save to
provide fo r education, marriage and contingencies such as disease,
unemployment and death. People may also save to acquire
durable goods such as houses, gold and to provide for old age.
The level of investment depends upon marginal efficiency of capital
and the ra te of interest in the short run and in the long run, it
depends upon population and technological progress.
In view of the reasons mentioned above, we may conclude that
investment cannot be equal to savings at full employment level. Ifmunotes.in

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the profit expec tations of the entrepreneurs fall, the level of
investment will fall and hence the equilibrium level of national
income and employment will also fall.
Check your progress
1. State the Principle of Effective demand.
2. Distinguish between ADF and ASF.
3. Explain the concept of under employment equilibrium.
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________ ________
_____________________________________________________
2.5 CONCEPT OF INFLATIONARY GAP
Inflation or price rise is the result of a persistent excess
aggregate demand over aggregate supply in the economy. The
rise in aggregate deman d beyond the capability of the economy
during a given time to offer a matching aggregate supply would
result in price rise. The capability of the economy is the productive
capacity with the availability of the given productive resources. If
the rise in a ggregate demand is because a large budget deficit
financed by borrowing from the Central Bank, there will be an
increase in money supply and prices would rise. Thus, along with
rise in aggregate demand, a rise in money supply would also cause
the generati on of inflationary forces. Because excess aggregate
demand, inflationary gap will be created which if not vacated or
neutralized, prices will begin to rise. The fiscal policy instruments
to control inflation are: (a) reduction in government expenditure a nd
(b) increase in taxes. Reduction in government expenditure by way
of reduction in the budget deficit and or by increasing the taxes, the
level of aggregate demand can be brought down. The process of
decrease in government expenditure and its impact on the level of
aggregate demand is shown in Fig.1.6. The figure shows that the
aggregate demand curve C + I + G 1intersect the 45oline or the line
of unity (C = Y) at point ‘E 1’a n dd e t e r m i n e se q u i l i b r i u mn a t i o n a l
income and output at point Y 1which is the potential productive
capacity of the economy during the given time. Beyond this point if
the aggregate demand rises because increase in government
expenditure, financed by a budget deficit, the aggregate demand
curve will intersect the line of unity at point E 2.T h e n e w a g g r e g a t e
demand curve C + I + G 2will determine Y 2level of income which is
greater than the productive capacity of the economy determined at
point Y 1..Thus, excess aggregate demand over aggregate supply
by the amount E 1As h own in the figure generates an inflationary
pressure causing the prices to rise. Such a price rise or inflation is
also known as Demand -pull Inflation.munotes.in

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The inflationary gap can be vacated or neutralized by a
decrease in the level of aggregate demand. The level of aggregate
demand can be reduced by a contractionary fiscal policy using the
fiscal policy instruments of reduced government expenditure and
increase in taxes. With equilibrium at point E 2and money income
being OY2, if the government reduces expenditure by E 2which is
equal to the inflationary gap E 1A, the aggregate demand curve C +
I+G 2will shift downward and once again the original equilibrium
level of aggregate demand C + I + G 1and Y 1level of national
income corresponding to the produc tive capacity of the economy
will be established. You will notice that the fall in the nominal
national income Y 2Y1is much greater than the fall in government
expenditure E 2B. This is because the operation of reverse income
or the investment multiplier.
Fig. 2 .6–Inflationary Gap
Alternatively, the government can also bring about an
increase in the direct taxes and reduce the disposable income of
the community to b ring down the level of aggregate demand and
prices to their desired level. If the government has a balanced
budget and the economy experiences inflationary tendencies, it
would mean that there are supply bottlenecks creating a shortfall in
supply relative to demand. In such a situation, an anti -inflationary
or tight fiscal policy by way of reduction in government expenditure
will create a budget surplus. The government can vacate the
budget surplus either by reducing or by impounding publ ic debt.
Howeve r, if the bduge t surplus is vacated by reducing public debt,
the money supply will increase and thus dampen the anti -munotes.in

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inflationary impact of a tight fiscal policy. The best way to realize
the full impact of a tight fiscal policy in the event of la budget
surplus is to keep the surplus idle so that money supply does not
increase and dampen the deflationary impact of an anti -inflationary
fiscal policy.
2.6 SUMMARY
1.According to John Maynard Keynes, the level of employment
and output in an economy is dete rmined by the level of income
and the level of income is determined by the level of effective
demand. Effective demand refers to the total expenditure made
by the people in a country on goods and services produced in
each period. The expenditure stream d etermines the income
stream i.e. Aggregate Expenditure = Aggregate Income.
2.The ADF is a schedule of maximum sales revenue expected to
be received by the class of entrepreneurs from the sale of
output produced at various levels of employment. It is als o
known as the demand price. There is a direct relationship
between the aggregate demand price and the level of income or
employment.
3.The aggregate supply function schedule shows the minimum
expected sales revenue of the class of entrepreneurs from
output produced at various levels of employment. The
aggregate supply price is the minimum supply price or reserve
price which the entrepreneurs must receive from the output
produced. It is the cost of production that the entrepreneurs
must obtain from the sale of output to continue to remain in
business.
4.The equilibrium level of employment and real national income is
determined at the point of equality between the aggregate
demand price and the supply price. Employment and real
output continues to ris e if demand price is greater than the
supply price and s tops at the point of equality. This point of
equality is the point of Effective demand. If employment is
increased beyond the point of effective demand, the aggregate
demand price will fall below the supply price and the class of
entrepreneurs will make losses.
5.According to Keynes, the economy achieves equilibrium at less
than full employment level because the gap between income
and consumption is not fully filled up by investment.
6.Due to exce ss aggregate demand, inflationary gap will be
created which if not vacated or neutralized, prices will begin to
rise. The inflationary gap can be vacated or neutralized by a
decrease in the level of aggregate demand. The level of
aggregate demand can be r educed by a contractionary fiscalmunotes.in

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policy using the fiscal policy instruments of reduced government
expenditure and increase in taxes.
2.7 QUESTIONS
1.Explain the concept of effective demand.
2.Explain how real national income is determined under the
Keynesian theory.
3.Explain the aggregate demand function.
4.Explain the aggregate supply function.
5.Explain how the actual level of real national income is less than
full employment level of income.
6.Explain the concept of inflationary gap.
7.Explain how the level of real national income can be increased
according to the Keynesian theory of income.

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UNIT TWO -DETERMINATION OF NATIONAL INCOME
UNIT -2A
PHILLIPS CURVE ANALYSIS
Unit Structure :
2A.0 Objectives
2A.1 Introduction to Philips Curve
2A.2 Keynesian Ex planation of the Phillips Curve
2A.3 Collapse o f the Phillips Curve Hypothesis
2A.4 Natural Unemployment Rate Hypothesis and the theory of
Adaptive Expectations
2A.5 Long Run Phillips Curve and the theory of Adaptive
Expectations
2A.6 Rational Expectations and the Long Run Phillips Curve
2A.7 Relationship between the Short Run and the Long Run
Philips Curve
2A.8 Summary
2A.9 Questions
2A.0 OBJECTIVES
To understand the concept of Phillip’s Curve
To study Keynesian explanation of the Phillip’s curve
To understand the collapse of the Phillip’s curve hypothesis
Tostudy the Natur al Unemployment Rate Hypothesis and the
theory of Adaptive Expectations
To understand the Long Run Phillips Curve and the theory of
Adaptive Expectations
To study the Rational Expectations and the Long Run Phillips
Curve
To understand the Relationship betw een the Short Run and the
Long Run Philips Curve
2A.1 INTRODUCTION TO PHILLIP’S CURVE
Economic growth without inflation and unemployment is the
objective behind macro -economic policies of modern times.
However, in the short term, there seems to be a trade -off between
inflation and unemployment and hence macro -economic policymunotes.in

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makers need to balance between inflation, economic growth and
unemployment. A low inflation rate is seen to accompany lower
economic growth rate and higher unemployment whereas a high
inflation rate is seen to accompany higher economic growth rate
and lower unemploymen t. Here, in this chapter, we look at the
Phillips curve which was the first explanation of its kind to show the
negative relationship between unemployment and inflation rate.
We also look at the long run picture and see whether the negative
relationship sustains in the long run.
In 1958, AW Phillips, a professor at the London School of
Economics published a study of wage behavior in the United
Kingdom for the years 1861 and 1957. Phillips found an inverse
relationship between the rate of unemployment a nd the rate of
inflation or the rate of increase in money wages. The higher the
rate of unemployment, the lower the rate of wage inflation i.e. there
is a trade -off between wage inflation and unemployment. The
Phillips curve shows that the rate of wage i nflation decreases with
the increase in unemployment rate. Such a Phillips curve is
depicted in Fig. 2 A.1.
You may notice that when the rate of inflation is ten per cent,
the unemployment rate is three per cent and when the rate of
inflation is five per cent, the rate of unemployment increases to
eight per cent. Empirical or objective data collected from other
developed countries also proved the existence of Phillips Curve.
Economists believed that there existed a stable Philips Curve
depicting a trade -off between unemployment and inflation. This
trade -off presented a dilemma to policy makers. The dilemma was
a choice between two evils, namely: unemployment and inflation.
In a dilemma, you chose a lesser evil and inflation is a lesser evil
for policy makers. A little more inflation can always be traded off for
a little more employment. However, further empirical data obtained
in the 70s and early 80s proved the non -existence of Phillips Curve.
During this period, both Britain and the USA experienced
simultaneous existence of high inflation and high unemployment.
While prices rose rapidly, the economy contracted along with more
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Figure 2 A.1–Phillilps Curve
2A.2 KEYNESIAN EXPLANATION OF PHILLIPS
CURVE
The explanation of Phillips curve by the Keynesian
economists is shown in Fig. 2 A.2. Keynesian economists assume
the upward sloping aggregate supply curve. The AS curve slopes
upwardly due to two reasons. Fi rstly, as output is increased in the
economy, the law of diminishing marginal returns begins to operate
and the marginal physical product of labor (MPP L)b e g i n st o
decline. Since the money wages are fixed, a fall in the MPP Lleads
to a rise in the marginal cost of production because MC = W/ MPP L.
Secondly, the marginal cost goes up due a rise in the wage rate as
employment and output are increased. Following rise in aggregate
demand, demand for labor increases and hence the wage rate also
increases. As m ore and more labor is employed, the wage rate
continues to rise and the marginal cost of firms increases. You
may notice that in Panel (a) of Fig.2 A.2 that with the initial
aggregate demand curve AD 0and the given aggregate supply
curve AS 0, the price lev el P 0and output level Y 0are determined.
When the aggregate demand increases, the AD 0curve shifts to the
right and the new aggregate demand curve AD 1intersects the
aggregate supply curve at point ‘b’. Accordingly, a higher price
level P 1is determined along with a rise in GNP to Y 1level. With
the increase in the real GNP, the rate of unemployment falls to U 2.
Thus, the rise in the price level or the inflation rate from P 0to P 1,
the unemployment rate falls thereby depicting an inverse
relationship b etween the price level and the unemployment rate.
Now when the aggregate demand further increases, the AD curve
shifts to the right to become AD 2.T h e n e w a g g r e g a t e d e m a n d
curve AD 2intersects the aggregate supply curve at point ‘c’ .munotes.in

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Accordingly, the price level P 2and output level Y 2is determined.
The level of unemployment now falls to U 3.I n P a n e l ( b ) o f F i g u r e
2A.2, points a, b and c are plotted and these points corresponds to
the three -equilibrium points a, b and c in Panel ( a) of the figure.
Thus, a higher rate of increase in aggregate demand and a higher
rate of rise in price level are related with the lower rate of
unemployment and vice versa. The Keynesian economists were
thus able to explain the downward sloping Philips curve showing
inverse relation between rates of inflation and unemployment.
Figure 2 A.2-Keynesian explanation of Phillips Curve
2A.3 COLLAPSE OF THE PHILLIPS CURVE
HYPOTHESIS (1971 -91)
The Phillips Curve hypothesis was accepted as a cure to
increase the level of employment and income in the sixties. It
became a macroeconomic tool to explain the trade -off between
inflation rate and unemployment rate. It suggested that policy
makers coul d choose different combinations of unemployment
inflation rates. Policy makers may choose low unemployment and
high inflation if it is politically and economically expedient. However,
the stable relationship between higher inflation and lower
unemployment as seen in the sixties could not be replicated in the
seventies and thereafter, particularly in the United States and Great
Britain. It was seen that both inflation rate and unemployment rate
had increased on numerous occasions and the tradeoff had thus
disappeared. Further, there cannot be a long run trade -off between
inflation and unemployment because in the long run the aggregate
supply curve becomes vertical and any further expansion after the
point of full employment is reached will only add to the price level
without adding anything to income, employment and output. Thus,
there is no permanent unemployment -inflatio nt r a d e -off. Data
obtained in the seventies and thereafter indicated a shift in the
Phillips curve i.e. in various years, at a given rat eo fi n f l a t i o n ,t h e
Phillips curve either shifted to the left or to the right, indicating
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has increased or decreased. The stable relationship between
inflation rate and unemployment rate t hus was proved to be non -
existent.
Causes of Shift in Phillips Curve
The shifts in the Phillips curve according to Keynesians is
due to adverse supply shocks experienced in the seventies in the
form of unprecedented oil price hikes. Adverse supply shocks gave
rise to the phenomenon of Stagflation and the breakdown of the
Phillips curve hypothesis. The impact of adverse supply shocks on
national product and the price level is depicted in Fig. 2.3. The
original aggregate demand and supply curves AD 0and AS 0are in
equilibrium at point E 0. Accordingly, the price level P 0andn a t i o n a l
output Y 0is determined. The oil price hike initiated by the Oil and
Petroleum Exporting Countries (OPEC) an oil cartel of oil producing
Middle East countries contributed to the rise in cost of production of
many goods and services in which oil is used as an input. Increase
in the cost of production caused the aggregate supply curve to shift
to the left in the upward direction, thereby causing the price level to
rise along with a decrease in national output. Notice that the new
aggregate suppl y curve AS 1now intersects the aggregate demand
curve AD 0at point E 1and accordingly the new price level P 1is
determined. However, at a higher price level P 1,t h en a t i o n a lo u t p u t
has fallen to Y 1leading to rise in unemployment. Such a situation
is exp lained in terms of stagflation where in both unemployment
and price level increases. This new phenomenon experienced,
particularly by the United States in the seventies and thereafter has
caused the shift in the Phillips curve. Stagflation, thus, consign ed
the Phillips curve hypothesis to the pages of economic history.
Figure 2 A.3–Adverse Supply Shock, Stagflation
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Check your progress
1. What is the basic idea of Phillips curve?
2. How Keynes represented Phillips curve?
3. Write a note on the collapse of Phillips curve.
4. Give the causes of shift in Phillips curve.
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
____________________________________________ _________
2A.4 NATURAL UNEMPLOYMENT RATE
HYPOTHESIS AND THE THEORY OF ADAPTIVE
EXPECTATIONS
Milton Friedman put forward the concept of ‘natural rate of
unemployment’ to prove that the Phillips curve phenomenon does
not operate in the long run and that the long run Phillips curve is
vertically sloping, thereby having no relationship between inflation
rate and unemployment rate. However, he accepted the fact that
there is a short run negative relationship between inflation rate and
unemployment rate. Milton Friedman says that the economy is
stable in the long run at the natural rate of unemployment and any
intervention in the form of expansionary fiscal and monetary
policies would only result in higher prices without higher output.
When current GDP is at its potential level, unemployment is
not zero or there is no full employment. The unemployment rate
that exists because frictional and structural reasons when the
econ omy is operating at full employment level is called the natural
rate of unemployment or more appropriately NAIRU (Non -
accelerating Inflation Rate of Unemployment). The natural rate of
unemployment is the rate at which in the labor market, the current
numb er of unemployed is equal to the number of jobs available.
Natural unemployment exists due to frictional and structural
reasons. For example, fresh additions to the labor force may spend
time to search suitable jobs. Individuals pursuing higher educatio n
may be in the labor force but may not participate in the workforce
due to educational commitments. While the sunset industries may
be on the decline and thereby reducing the workforce from its rolls,
the sunrise industries would be expanding and adding to its
workforce. However, unemployed labor force needs to be trained
for suitable jobs before they are recruited. Unemployment arising
out of frictional and structural causes is termed as natural
unemployment and the number of such unemployed persons
constitutes the natural rate of unemployment. In other words,
Milton Friedman argues that if information were not to fail, there will
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The natural rate of unemployment is estimated in the range of four
to six per cent in the developed countries.
The term ‘NAIRU’ is a more appropriate term to describe the
natural rate of unemployment because the term ‘natural rate of
unemployment’ connotes that unemployment cannot fall below the
natural rate. Th e Phillips curve hypothesis shows that
unemployment rate can fall below the NAIRU in the short term.
Thus, when actual GDP is greater than potential GDP (Y > Y*),
unemployment will be less than NAIRU (U < U*) and vice versa.
When the unemployment rate is below the NAIRU, demand forces
put pressure on wages to rise faster than productivity. When the
unemployment rate is above the NAIRU, demand forces put
pressure on wages to rise more slowly than productivity or even to
fall. When unemployment is at the NAIRU, demand forces exert no
pressure on wages relative to productivity.
To prove the non -existence of Phillips curve in the long run,
Milton Friedman put forward the theory of adaptive expectations.
People form their expectations based on previous and present rate
of inflation and adapt their expectations only when the actual
inflation rate is different from their expected rate. The trade -off
between inflation and unemployment is therefore only in the short
run. Milton Friedman’s theory of adaptive e xpectations and the
derivation of the vertically sloping long run Phillips curve is depicted
in Fig.2 A.4.
It is assumed that the economy is operating at point A 0on
the short run Phillips curve (SPC 1)a n dt h en a t u r a lr a t eo f
unemployment is six per cent. The actual inflation rate is four per
cent. The nominal wages are set based on four per cent inflation
rate and it is expected that the inflation rate will continue to be the
same in future. When the government adopts expansionary
monetary and fiscal po licies, the inflation rate goes up to six per
cent. Since the nominal wages are set based on four per cent
inflation rate, the firms make additional profits equal to two per cent
and hence they make fresh investments, thereby increasing the
level of emplo yment and output. Because of fresh investments, the
unemployment rate falls below the natural rate of unemployment
and the economy moves to point A 1where the corresponding
inflation rate is six per cent and the unemployment rate is three per
cent. Thus, Milton Friedman and other monetarists argue that there
exists a short run trade -off between inflation rate and
unemployment rate.munotes.in

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Figure 2 A.4–Shift in the SR Phillips curve & the LR Phillips
Curve.
2A.5 LONG RUN PHILLIPS CURVE AND THE THEORY
OF ADAPTIVE EXPECTATIONS
The economy after having reached point A 1does not stay
put at that point because after a time lag, th e workers are informed
that the current inflation rate is six per cent and that their real
wages have fallen by two per cent. Organized workers will
therefore demand compensation for the inflation which is over and
above the expected rate to restore their real incomes. When wage
compensation takes place, the profits levels are also restored to the
original levels and the economy returns to its original equilibrium
position at point B 0.H o w e v e r , p o i n t B 0is on the new short run
Phillips curve SPC 2.C o r r e sponding to point B 0, the actual inflation
rate is six per cent and the unemployment rate is back at its natural
level i.e. six per cent. Now the expected inflation rate would be six
per cent and workers will continue to expect the same rate of
inflation in future. The shift in the Phillips curve will continue if
expansionary monetary and fiscal policies are adopted by the
Government and the economy will move along the points B 1,C 0
etc. When points such as A 0,B0,C0are joined, the long run Phillips
curve is obtained. Note that the LPC is vertically sloping and the
vertical slope indicates that it is neutral between inflation rate and
the unemployment rate. Milton Friedman thus proves that there is
no long run trade -off between inflation rate and une mployment rate.
The theory of adaptive expectations indicate that workers adapt to
the new rates of inflation and their expected inflation rate gets
adapted in due course i.e. after a time lag and the economy returns
to its original status with a higher r ate of inflation.munotes.in

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2A.6 RATIONAL EXPECTATIONS AND THE LONG
RUN PHILLIPS CURVE
According to Milton Friedman’s theory of adaptive
expectations, nominal wages lag changes in the price level or the
inflation rate. The adjustment lag in nominal wages to the price
level causes business profits to go up. When profits go up,
business units expand their scale output and thus the level of
unemployment in the economy falls below the natural rate.
The advocates of rational expectation theory believe that
there is no adjustment lag involved between nominal wages and
changing price level. They argue that there is a quick adjustment
between nominal wages and expected changes in the price level
and hence there is no trade -off between inflation and
unemployment. The r ate of inflation resulting from increase in
aggregate demand is well anticipated by workers and firms and
gets factored in wage agreements. Such adjustments made in
quick succession sometimes and sometimes in advance lead to
further price increases. Thus , there is a rise in the price level
without any rise in the real output or fall in unemployment below the
natural rate. According to the Rational Expectations theorists,
given the availability of resources and technology, the aggregate
supply curve is ve rtically sloping at the potential GDP level or at the
natural unemployment rate level. The long run Phillips curve
therefore corresponds to the long run aggregate supply curve at the
natural rate of unemployment. The long run Phillips curve is
therefore a vertical straight line or vertically sloping at the natural
rate of unemployment. The derivation of the long run aggregate
supply curve is shown in Fig. 2 A.5and the long run Phillips curve is
depicted in Fig. 2 A.6.
According to the Rational Expectatio ns theorists, the workers
and firms are rational beings and have a good understanding of the
operation of the economy. Both workers and firms can therefore
fairly and correctly anticipate the consequences of the economic
policies of the Government. Seco ndly, all product and factor
markets are very competitive and hence factor and product prices
are highly flexible to bring about quick and rapid adjustments.
Figure 2A .5shows the argument made by Rational Expectations
theorists about the relation between inflation and unemployment.
The original equilibrium is at point ‘a’ where the initial short run
aggregate demand curve AD 0and the short run aggregate supply
curve AS 0intersect each other and the equilibrium, full
employment, national output OY 0and pr ice level P 0is determined,
given the natural rate of unemployment.
Now when the government adopts expansionary monetary
and fiscal policies, the economic units or the factor owners willmunotes.in

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correctly anticipate the inflationary impact of these policies and
make upward adjustment in factor and product prices thereby
holding real national output and real wages at their original level.
The shift in the short run aggregate demand and supply curves will
therefore be vertically upward as shown in the figure. The
economy now operates at the new equilibrium point ‘b’ which is
corresponding to the original equilibrium point ‘a’. However, the
equilibrium is achieved at a higher price level P 1. At every occasion
when the Government adopts expansionary policies when t he
economy is operating at the full employment level of income and
output, the aggregate demand and supply curves behave in the
same manner and the equilibrium point changes from point ‘b’ to
point ‘c’ and so on and so forth. By joining these points, the Long
Run Aggregate Supply curve is obtained. Note that the long run AS
curve is vertically sloping indicating thereby that once the full
employment equilibrium income and output is determined at the
natural rate of unemployment, any expansionary policy wi ll only
result in price rise, real national output remaining constant.
As the long -run aggregate supply curve is vertically sloping
at the natural unemployment rate, the long run Phillips curve is also
vertically sloping.
Fig.2 A.5–Derivation of the Long Run AS Curve.munotes.in

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Fig.2 A.6–Long Run Phillips Curve.
Check your progress
1.Explain the concept of natural rate of unemployment.
2.Explain the relationship between Phillips curve and the Theory
of Adaptive expectations.
3.Explain the relationship between Phillips curve and the Theory
of Rational expectations.
_____________________________________________________
_____________________ ________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
2A.7 RELATIONSHIP BETWEEN SHORT AND LONG
RUN PHIL LIPS CURVE
The position of the short run Phillips curve passing through a
long run Phillips curve is determined by the anticipated or expected
inflation rate. The short run Phillips curve can be compared to the
short run aggregate supply curve because bo th the curves are
drawn with a given expected price level. The short run Phillips
curve drawn with an expected inflation rate shifts its position as the
inflation rate changes (See figure 2. 7). If the expected inflation rate
is six per cent, the short ru n Phillips curve (SPC 1) also passes
through the corresponding point ‘A 0’ on the long run Phillips curve
with natural unemployment rate of six per cent. The movement
along a short run Phillips curve is determined by changes in
aggregate demand. When there is an unexpected increase in
aggregate demand, the actual inflation rate is found to be more
than the expected inflation rate and the real national output
increases causing the unemployment rate to fall below the natural
rate. The new short run equilibri um is determined at point ‘A 1’munotes.in

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which is to the left of the original equilibrium point. Conversely, if
there is an unexpected decrease in aggregate demand, the actual
inflation rate will fall below the expected rate and the
unemployment rate will increase and real national output will fall. In
this case, the movement will be downwards and to the right. The
shift in the short run Phillips curve is caused due to the divergence
between actual and expected inflation rates and this divergence is
caused by une xpected changes in monetary and fiscal policies of
the government. If the actual inflation rate is greater than the
expected inflation rate, the short run Phillips curve will shift upward
and vice -versa. The distance by which the short run Phillips curve
shifts to a new position is equal to the change in the expected rate
of inflation.
Fig.2 A.7–Short Run and Long Run Phillips Curve
2A.8 SUMMARY
1.A.W.Phillips, a professor at the London School of Economics
published a study of wage behavior in the United Kingdom for the
years 1861 and 1957. Phillips found an inverse relationship
between the rate of unemployment and the rate of inflation or the
rate of increase in money wages. The higher the rate of
unemployment, the lower the rate of wage inflation i.e. there is a
trade -off between wage inflation and unemployment. The Phillips
curve shows that the rate of wage inflation decreases with the
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2.The Keynesian economists were thus able to explain the
downward sloping Philips curve showing inverse relation between
rates of inflation and unemployment.
3.Data obtained in the seventies and thereafter indicated a shift in
the P hillips curve i.e. in various years, at a given rate of inflation,
the Phillips curve either shifted to the left or to the right, indicating
thereby that at times, given the inflation rate, unemployment rate
has increased or decreased. The stable relation ship between
inflation rate and unemployment rate thus was proved to be non -
existent.
4.The shifts in the Phillips curve according to Keynesians is due to
adverse supply shocks experienced in the seventies in the form of
unprecedented oil price hikes. Ad verse supply shocks gave rise to
the phenomenon of Stagflation and the breakdown of the Phillips
curve hypothesis.
5.Milton Friedman put forward the concept of ‘natural rate of
unemployment’ to prove that the Phillips curve phenomenon does
not operate in the long run and that the long run Phillips curve is
vertically sloping, thereby having no relationship between inflation
rate and unemployment rate. However, he accepted the fact that
there is a short run negative relationship between inflation rate and
unemployment rate. Milton Friedman says that the economy is
stable in the long run at the natural rate of unemployment and any
intervention in the form of expansionary fiscal and monetary
policies would only result in higher prices without higher output.
6.The term ‘NAIRU’ is a more appropriate term to describe the
natural rate of unemployment because the term ‘natural rate of
unemployment’ connotes that unemployment cannot fall below the
natural rate. The Phillips curve hypothesis shows that
unemploym ent rate can fall below the NAIRU in the short term.
7.Milton Fri edman proved that there is no long run trade -off
between inflation rate and unemployment rate. The theory of
adaptive expectations indicate that workers adapt to the new rates
of inflation and their expected inflation rate gets adapted in due
course i.e. after a time lag and the economy returns to its original
status with a higher rate of inflation.
8.The advocates of rational expectation theory believe that there is
no adjustment lag inv olved between nominal wages and changing
price level. They argue that there is a quick adjustment between
nominal wages and expected changes in the price level and hence
there is no trade -off between inflation and unemployment.munotes.in

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59
9.The position of the sho rt run Phillips curve passing through a
long run Phillips curve is determined by the anticipated or expected
inflation rate.
2A.10 QUESTIONS
1.Explain the trade -off between inflation and unemployment with
the help of Phillips curve analysis.
2.Explain the derivation of the Phillips curve with the Keynesian
AD-AS model.
3.Write a note on the collapse of the Phillips Curve Hypothesis.
4.Explain the natural rate of unemployment hypothesis and the
theory of adaptive expectations.
5.Explain the long run Ph illips curve and the theory of adaptive
expectations.
6.Explain the theory of Rational Expectations and the long run
Phillips curve.
7.Explain the relationship between the short and the long run
Phillips curve.

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60UNIT -Three
Unit -3
“THE IS -LM MODEL ”
Unit Structure:
3.0 Objectives:
3.1 Introduction
3.2 TheIS-LM M odel
3.3 Money Market Equilibrium
3.4 Summary
3.5 Questions
3.0 OBJECTIVES
To enable the learners to grasp fully the theoretical rationale
behind policies at the country as well as corporate level.
To receive a firm grounding on the basic macroeconomic
concepts that strengthen analysis of crucial economic policies.
3.1INTRODUCTION
The IS -LM model, which stands for "investment -savings" (IS)
and "liquidity preference -money supply" (LM) is a
Keynesian macroeconomic model that shows how the market for
economic goods (IS) interacts with the loanable funds market (LM)
ormoney market. It is represented as a graph in which the IS and
LM curves inte rsect to show the short -run equilibrium between
interest rates and output.
The IS -LM (Investment Savings -Liquidity preference Money
supply) model focuses on the equilibrium of the
market forgoods and services, and the money market. It basically
shows the relationship between real output and interest rates.
John R. Hicks, based on J. M. Keynes’ “General Theory”, in
which he analyses four markets, developed it: goods, labour, credit
and money. This model, firstly named IS-LL, appeared in his article
“Mr. K eynes and the Classics: a Suggested Interpretation”,
published in 1937 in the journal Econometrica.munotes.in

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61In order to understand how this model works, we’ll first see
how the IS curve, which represents the equilibrium in the goods
market, is defined. Then, the LM curve, which represents the
equilibrium in the money market. Finally, we’ll analyz eh o wt h e
equilibrium is reached.
The IS -LM model describes how aggregate markets for real
goods and financial markets interact to balance the rate of
interest and total output in the macroeconomy.
IS-LM stands for "investment savings -liquidity preference -
money supply."
The model was devised as a formal graphic representation of a
principle of Keynesian economic theory.
On the IS -LM graph, "IS" represents one curve while " LM"
represents another curve.
IS-LM can be used to describe how changes in market
preferences alter the equilibrium levels of gross domestic
product (GDP) and market interest rates.
The IS -LM model lacks the precision and realism to be a useful
prescriptio n tool for economic policy.
The three critical exogenous, i.e. external, variables in the
IS-LM model are liquidity , investment, and consumption. According
to the theory, liquidity is dete rmined by the size and velocity of
themoney supply .T h el e v e l so f investment and consumption are
determined by the marg inal decisions of individual actors.
The IS -LM graph examines the relationship between output,
orgross domestic product (GDP), and interest rates. The entire
economy is boiled down to just two markets, output and money;
and their respective supply and demand characteristics push the
economy towards an equilibrium point.
The IS -LM graph consists of two curves, IS and LM. Gross
domestic product (GDP), or (Y), is placed on the horizontal axis,
increasing to the right. The interest rate, or (i or R), makes up the
vertical axis.
The IS curve depicts the s et of all levels of interest rates and
output (GDP) at which total investment (I) equals total saving (S).
At lower interest rates, investment is higher, which translates into
more total output (GDP), so the IS curve slopes downward and to
the right.
The LM curve depicts the set of all levels of income (GDP)
and interest rates at which money supply equals money (liquidity)
demand. The LM curve slopes upward because higher levels ofmunotes.in

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62incom e (GDP) induce increased demand to hold money balances
for transactions, which requires a higher interest rate to keep
money supply and liquidity demand in equilibrium.
The intersection of the IS and LM curves shows the
equilibrium point of interest rates and output when money markets
and the real economy are in balance. Multiple scenarios or points in
time may be represented by adding additional IS and LM curves.
3.2 THE IS -LM MODEL
The IS -LM model provides another way of looking at the
determination of the level of short -run real gross domestic product
(real GDP) in the economy. Like the aggregate expenditure model,
it takes the price level as fixed. But whereas that model takes the
interest rate as exogenous —specifically, a change in the interest
rate results in a change in autonomous spending —the IS -LM model
treats the interest rate as an endogenous variable.
The basis of the IS -LM model is an analysis of the money
market and an analysis of the goods market, which together
determine the equilibrium le vels of interest rates and output in the
economy, given prices. The model finds combinations of interest
rates and output (GDP) such that the money market is in
equilibrium. This creates the LM curve. The model also finds
combinations of interest rates and output such that the goods
market is in equilibrium. This creates the IS curve. The equilibrium
is the interest rate and output combination that is on both the IS
and the LM curves.
IS Curve
The IS curve relates the level of real GDP and the real
interes t rate. It incorporates both the dependence of spending on
the real interest rate and the fact that, in the short run, real GDP
equals spending. The IS curve is shown in Figure 3.1 "A Change in
Income". We label the horizontal axis “real GDP” since, in the short
run, real GDP is determined by aggregate spending. The IS curve
is downward sloping: as the real interest rate increases, the level of
spending decreases.
The IS curve ( Ifor investment and Sfor savings)
summariz es all the combinations of income and interest rates that
ensure equilibrium on the B&S → market inverse relationship
between Yand the interest rate.
In Figure: 3.1 Initial equilibrium: 1 and 1' → fall in r →
interest -sensitive compon ents of total expenditure (C and I)
increase → shift of E upwards → new equilibrium: 2 and 2'.munotes.in

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63Linking the points 1' and 2' in the bottom graph gives the IS
curve = set of equilibria on the B&S market associated with different
income and interest rate leve ls.The slope of the IS curve reflects
the responsiveness of C and I to changes in r.Any increase
(decrease) in an exogenous component of the expenditure, as well
as G and X, causes the IS curve to shift to the right (left).
Figure: 3 .1
In fact, the de pendence of spending on real interest rates
comes partly from investment. As the real interest rate increases,
spending by firms on new capital and spending by households on
new housing decreases. Consumption also depends on the real
interest rate: spendin g by households on durable goods decreases
as the real interest rate increases.
The connection between spending and real GDP comes
from the aggregate expenditure model. Given a particular level of
the interest rate, the aggregate expenditure model determi nes the
level of real GDP. Now suppose the interest rate increases. This
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64rate. In the aggregate expenditure framework, this is a reduction in
autonomous spending. The equilibrium level of out put decreases.
Thus the IS curve slopes downwards: higher interest rates are
associated with lower real GDP.
LM Curve
The LM curve represents the combinations of the interest
rate and income such that money supply and money demand are
equal. The demand fo r money comes from households, firms, and
governments that use money as a means of exchange and a store
of value. The law of demand holds: as the interest rate increases,
the quantity of money demanded decreases because the interest
rate represents an oppo rtunity cost of holding money. When
interest rates are higher, in other words, money is less effective as
a store of value. Money demand increases when output rises
because money also serves as a medium of exchange. When
output is larger, people have more income and so want to hold
more money for their transactions.
The LM curve ( Lfor liquidity and Mfor currency)
summarizes all the combinations of income and interest rates that
ensure equilibrium on the currency market → direct relation
between Yand the interest rate.
Figure: 3 .2
In Figure: 3 .2Starting equilibrium: 1 and 1' → increase of Y →
moving Mdupwards → beingMsfixed, new equilibrium: 2 and 2'.By
connecting points 1' and 2' in the graph on the right, we obtain the
LM curve = all combinations of income and equilibrium interest
rates on the money market.
The slope of the LM curve reflects the sensitivity of Mdto
changes in Y.
Any increase (decrease) in the money supply causes the LM
curve to move down (up).munotes.in

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65Check your progress
1. Explain the meaning and derivation of IS curve.
2. Explain the meaning and derivation of LM curve.
___________________________________________________ __
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
3.3 MONEY MARKET EQUILIBRIUM
The supply of money is chosen by the monetary authority
and is independent of the interest rate. Thus, it is drawn as a
vertical line. The equilibrium in the m oney market is shown
inFigure 3 .3 "Money Market Equilibrium". When the money supply
is chosen by the monet ary authority, the interest rate is the price
that brings the market into equilibrium. Sometimes, in some
countries, central bank target the money supply. Alternatively,
central banks may choose to target the interest rate. Figure 3 .3
"Money Market Equilib rium" applies in either case: if the monetary
authority targets the interest rate, then the money market tells us
what the level of the money supply must be.
To trace out the LM curve, we look at what happens to the
interest rate when the level of output in the economy changes and
the supply of money is held fixed.
Figure: 3 .3
InFigure 3.4 "AChange in Income" shows the money
market equilibrium at two different levels of real GDP. At the higher
level of income, money demand is shifted to the right; t he interest
rate increases to ensure that money demand equals money supply.munotes.in

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66Thus, the LM curve is upward sloping: higher real GDP is
associated with higher interest rates. At each point along the LM
curve, money supply equals money demand.
We have not yet been specific about whether we are talking
about nominal interest rates or real interest rates. In fact, it is the
nominal interest rate that represents the opportunity cost of holding
money. When we draw the LM curve, however, we put the real
interest ra te on the axis, as shown in Figure 3 .4 "The LM Curve".
The simplest way to think about this is to suppose that we are
considering an economy where the inflation rate is zero. In this
case, by the Fisher equation, the nominal and real interest rates are
thesame. In a more complete analysis, we can incorporate inflation
by noting that changes in the inflation rate will shift the LM curve.
Changes in the money supply also shift the LM curve.
Figure 3 .4A Change in Income
Equilibrium
Combining the discussi on of the LM and the IS curves will
generate equilibrium levels of interest rates and output. Note that
both relationships are combinations of interest rates and output.
Solving these two equations jointly determines the equilibrium. This
is shown graphica lly in Figure 3 .5, The crossing of these two
curves is the combination of the interest rate and real GDP,
denoted (r*,Y*), such that both the money market and the goods
market are in equilibrium.munotes.in

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Figure 3 .5 :Equilibrium in the IS -LM Model.
Comparative S tatics
Comparative statics results for this model illustrate how
changes in exogenous factors influence the equilibrium levels of
interest rates and output. For this model, there are two key
exogenous factors: the level of autonomous spending (excluding
any spending affected by interest rates) and the real money supply.
We can study how changes in these factors influence the
equilibrium levels of output and interest rates both graphically and
algebraically.
Variations in the level of autonomous spending wi ll lead to a
shift in the IS curve, as shown in Figure 3 .6"A Shift in the IS
Curve". If autonomous spending increases, then the IS curve shifts
out. The output level of the economy will increase. Interest rates
rise as we move along the LM curve, ensuring money market
equilibrium. One source of variations in autonomous spending is
fiscal policy. Autonomous spending includes government spending
(G). Thus an increase in G leads to an increase in output and
interest rates as shown in Figure 3.6 "A Shift in th eI SC u r v e " .
Figure 3 .6A Shift in the IS Curvemunotes.in

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68Variations in the real money supply shift th e LM curve, as
shown in Figure 3 .7 "A Shift in the LM Curve". If the money supply
decreases, then the LM curve shifts in. This leads to a higher real
interest rate and lower output as the LM curve shifts along the fixed
IS curve.
Figure 3 .7AS h i f ti nt h eL MC u r v e
Fiscal andMonetary Policies andIS-LMCurve Model
Effect ofFiscal Policy:
Let us first explain how IS -LM model shows the effect of
expansionar y fiscal policy of increase in Government expenditure
on level of national incom e. This is illustrated in Fig. 3.8 . Increase in
Government expenditure which is of autonomous nature raises
aggregate demand for goods and services and thereby causes an
outwar d shift in IS curve, as is shown in Fig. 3.8 where increase in
Government expenditure leads to the shift in IS curve from IS 1to
IS2.
Note that the horizontal distance between the two IS curves
is equal to the increase in government expenditure times the
government expenditure multiplier, that is, ΔG x 1/1-MPC which
shows the increase in national income equal to the horizontal
distance EK that occurs in Keynes’ multiplier model. However, in
IS-LM model actual increase in national income is not equal to EK
caused by the working of Keynesian multiplier.munotes.in

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Fig 3.8 Expansionary Fiscal Policy
This is because with the rightward shift in IS curve rate of
interest also rises which causes reduction in private investment .I t
will be seen from Fig. 3.8 that, with the LM curve remaining
unchanged, the new IS 2curve intersects LM curve at point B. Thus,
in IS -LM model with the increase in Government expenditure (ΔG),
the equilibrium moves from point E to B and with this the rate of
interest rises from r 1to r 2and income level from Y 1to Y 2.
Income equal to CK has been wiped out because of rise in
interest causing a decline in private investment. Th us, CK
represents crowding -out effect of increase in government
expenditure Thus, IS -LM model shows that expansionary fiscal
policy of increase in Government expenditure raises both the level
of income and rate of interest.
It is worth noting that in the IS-LM model increase in national
income by Y 1Y2in Fig. 3.8 is less than EK which would occur in
Keynes’ model. This is because Keynes in his simple multiplier
model assumes that investment is fixed and autonomous, whereas
IS-LM model takes into account t he fall in private investment due to
the rise in interest rate that takes place with the increase in
Government expenditure. That is, increase in Government
expenditure crowds out some private investment.
Likewise, it can be illustrated that the reduction in
Government expenditure will cause a leftward shift in the IS curve,
and given the LM curve unchanged, will lead to the fall in both rate
of interest and level of income. It should be noted that Government
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70Expansionary Fiscal Policy: Reduction inTaxes:
An alternative measure of expansionary fiscal policy that
may be adopted is the reduction in taxes which through increase in
disposable income of the people raises consumption demand of the
peop le. As a result, cut in taxes causes a shift in the IS curve to th e
right as is shown in Fig. 3.9 from IS 1to IS 2.
It may however be noted that in the Keynesian multiplier
model, the horizontal shift in the IS curve is determined by the
value of tax multi plier times the reduction in taxes (ΔT), that is, ΔT x
MPC/1 -MPC and causes level of income to increase by EH.
However, in the IS -LM model, with the shift of the IS curve
from IS 1to IS 2following the reduction in taxes, the economy moves
from equilibrium point E to D and, as is evident from Fig. 3 .8,r a t eo f
interest rises from r 1to r 2and level of income increases from Y 1to
Y2. Income equal to LH has been wiped out because of crowding -
out effect on private investment because of rise in interest rate.
Fig 3.9 Expansionary Fiscal Policy :E f f e c to fC u ti n
Taxes
On the other hand, if the Government intervenes in the
economy to reduce inflationary pressures, it will raise the rates of
personal taxes to reduce disposable income of the people. Rise in
personal taxes will lead to the decrease in aggregate demand.
Decrease in aggregate demand will help in controlling inflation. This
case can also be shown by IS -LM curve model.
Role ofMonetary Policy toEnsure Economic Stability:
Explained through IS-IMCurv eModel:
Through making appropriate changes in monetary policy the
Government can influence the level of economic activity. Monetary
policy may also be expansionary or contractionary depending on
the prevailing economic situation. IS-LM model can be used t o
show the effect of expansionary and tight monetary policies .Amunotes.in

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71change in money supply causes a shift in the LM curve; expansion
in money supply shifts it to the right and decrease in money supply
shifts it to the left.
Suppose the economy is in grip of recession, the
Government (through its Central Bank) adopts the expansionary
monetary policy to lift the economy out of recession. Thus, it takes
measures to increase the money supply in the economy. The
increase in money supply, state of liquidity prefere nce or demand
for money remaining unchanged, will lead to the fall in rate of
interest.
At a lower interest there will be more investment by
businessmen. More investment will cause aggregate demand and
income to rise. This implies that with expansion in m oney supply
LM curve will shift to the right as is shown in Fig. 3 .10.As a result,
the economy will move from equilibrium point E to D, with this the
rate of interest will fall from r1 to r2, and national income will
increase from Y 1to Y 2.T h u s ,I S -LM mo del shows that expansion in
money supply lowers interest rate and raises income.
We have also indicated what is called monetary transmission
mechanism, that is, how IS -LM curve model shows the expansion
in money supply leads to the increase in aggregate d emand for
goods and services. We have thus seen that increase in money
supply lowers the rate of interest, which then stimulates more
investment demand. Increase in investment demand through
multiplier process leads to a greater increase in aggregate deman d
and national income.
Fig 3.10 Effect o fExpansion i nM o n e yS u p p l y on Interest Rate
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72If the economy suffers from inflation, the Government will
like to check it. Then its Central Bank should adopt tight or
contractionary monetary policy. To control inflation the Central
Bank of a country can reduce money supply through open market
operations by selling bonds or government securities in the open
market and in return gets currency funds from those who buy the
bonds. In this way liquidity in the banking system can be reduced.
To reduce money supply for fighting inflation the Central
Bank can also raise cash reserve ratio of the banks. The higher
cash rese rve ratio implies that the banks have to keep more cash
reserve with the Central Bank. As a result, the cash reserves with
the banks fall which force them to contract credit. With this money
supply in the economy declines.
3.11 Contractionary monetary policy to Fight Inflation
Thus, IS -LM model can be used to show that reduction in
money supply will cause a leftward shift in LM curve and will lead to
the rise in interest rate and fall in the level of income. The rise in
interest rate, which will cause reduction in investment demand and
consumption demand and help in controlling infla tion. This is shown
in Fig.3.11 .
3.4 SUMMARY
1.The IS -LM model, which stands f or "investment -savings" (IS)
and "liquidity preference -money supply" (LM) is a
Keynesian macroeconomic model that shows how the market
for economic goods (IS) interacts with the loanable funds
market (LM) or money market. It basically shows the
relationshi pb e t w e e n real output and interest rates.munotes.in

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732.The IS curve ( Ifor investment and Sfor savings) summarizes
all the combinations of income and interest rates that ensure
equilibrium on the B& S→ market inverse relationship
between Yand the interest rate.
3.The LM curve ( Lfor liquidity and Mfor currency) summarizes
all the combinations of income and interest rates that ensure
equilibrium on the currency market → direct relation
between Yand the interest rate.
4.The crossing of the two curves i.e. IS and LM is the combination
of the interest rate and real GDP, denoted (r*,Y*), such that both
the money market and the good s market are in equilibrium.
5.Expansionary and Contractionary Fiscal and monetary policies
leads to a shift in the IS and LM curve.
3.5 QUESTIONS
1.Discuss the derivation of IS curve.
2.Explain the derivation of LM curve.
3.Explain how equilibri um is achieved in the goods and the money
market.
4.Explain the effect of changes in the fiscal policy on IS curve.
5.Explain the effect of changes in the Monetary policy on Money
market equilibrium.
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74Unit -Three
Unit-3A
“THE IS -LM MODEL ”
Unit Structure :
3A.0Objectives
3A.1Introduction
3A.2Stabiliz ationPolicies
3A.3Understanding Stabilization Policy
3A.4The Roots of Stabilization Policy
3A.5The Future of Stabilization Policy
3A.6Transmission mechanism and the crowding out effect
3A.7Composition of output and policy mix
3A.8How a Policy Mix Works
3A.9Special Considerations
3A.10IS-LM in India
3A.11Macroeconomic Overview of the Indian Economy Since
1980
3A.12 Summary
3A.13Questions
3A.0 OBJECTIVES
To enable the learners to grasp fully the theoretical rationale
behind policies at the country as well as corporate level.
To receive a firm grounding on the basic macroeconomic
concepts that strengthens analysis of crucial economic policies.
3A.1 INTRODUCTION
Growth, stabilit y,and distribution arethethree principal
concerns ofeconomics. Since economics deals with the
material well-being alone, growth isdefined interms ofthegrowth
inreal national income, stability (rather instability) interms ofthe
fluctuations inrealnational income orintherate ofunemployment
(the two arelinked through theOkun’s law) andinthe(general)
price level (inflation/ deflation), and distribution interms ofthe
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75unani mously recommend every country toaim atahigh growth
rate, high stabilit y,and afair, though not equal, distribution.
However, most economists believe that growth and price stability
areincompatible goals intheshort-run(Phillip's curve) and thus
anideal mixofthetwo isadebatable issue.
The famous Kuznet's curve suggests that growth and
desired income distribution donotalways move intandem. This
lesson addresses theissue ofeconomic fluctuations and their
monitoring through theapplication ofstabilization policies. We
analyses time series data oneconomic fluctuations and the
indicators ofstabilizing policies inselected countries toexamine
thedepth and spread ofthese fluctuations and theactual uses
ofthe corresponding policies. We also highlight inherent
limitations ofthese policies toappreciate their less than perfect role
intaming business cycles.
ECONOMIC FLUCTU ATIONS
Economic fluctuations are simply fluctuations in the level
of the nation al income of a country representing growth or
contraction. A market economy is not static. It's dynamic. A rise
in national income means an economy is growing, while a
decline in national income means that an economy is contracting.
The current economic mo del describing economic fluctuations in
am a r k e te c o n o m yi st h e business cycle.
The business cycle is a pattern of economic fluctuations
describing the periods of economic growth, contraction, and the
transitions in between. If you plot these periods on a graph, you'll
see peaks and troughs, ups and downs.
Economic fluctuations are afact oflife (Schumpeter,
1939) Allcountries have suffered from these though thebooms
and busts have notalways synchronized across countries and
neither thelength northe amplitude have been uniform. Table 1
provides data forselected years onthethree most significant
macro -economic variables (viz., growth rate, unemployment rate,
and inflation rate) forselect countries, including India, China,
Malaysia, theG-7countr ies, and theworld.
The average growth rate inthese countries during the
last 34years (1964 -1997) has fluctuated between 2.3percent
inUKand 9.2percent inChina, with standard deviations of2.2
percent and 6.7percent, respectivel y.Fortheworldasawhole,
while the average growth rate during thesaid period stood at
3.7percent, thestandard deviation turned outtobe1.4percent,
giving acoefficient ofvariation of38per cent. These indicate a
fairly high degree ofvolatility both over spaceand time. The data
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76further highlight the presence and depth ofbusiness cycles.
The data also indicate that, among thecountries, themaximum
fluctuations in the growth rate were in China, in the
unemployment rate in the UK, and in the inflation rate in India.
InIndia, thedrought of1979 -80(when the agriculture
output fellby12%) ledtotheworst negative growth rate of6per
cent and themild reforms -induced prosperity ofthesecond half
ofthe 1980s (when industrial output went upby9.6%,and
finance, insurance, real estate, and business services’ output
was upby11.4%) took thegrowth toitspeak rate ofaround 10
percent in1988 -89.
Some striking examples ofextreme fluctuations intheglobe
arecited below:
The Great Depression of1929 -33was fairly widespread
across allcountries. During these four years, theGDP fellby
about 29percent intheUS, 22percent inAustralia, 18per
cent inCzecho slovakia, 16per cent inGerman y,11per
cent inFrance and Hungar y,9percent inSweden, 6per
cent intheUK, and soon.The unemployment rates were
accordingly high and most countries had experienced fairly
high rates ofdeflation.
The hyperinflation (inflation over 1000%/year) plagued
several European countries, including German y,Hungar y,
Austria, and Poland during the 1920s and again Hungary
during August 1945 toJuly 1946. Several Latin American
countries including Argentina, Bolivia, Brazil, Nicaragua,
Peru, andUkraine suffered from thisdisease during the1980s
and 1990s.
The stagflation during 1974 -75and 1979 -82was fairly
widespread throughout theworld. For instance, thegrowth
rate intheworld output fellmonotonously from 5.8percent in
1973 to0.7percent in1975 and from 4.1percent in1978 to
0.4percent in1982. The world inflation rate stood attwo digit
levels inallthese years. Several countries including the
USand the UKhad experienced negative growth rates in
most ofthese years, and the rest had lower than their
respective trend rates inallthese years. Most ofthecountries
hadsuffered atwo-digit inflation rate orahigh one-digit rate.
Japan witnessed fast growing prosperity during the 1950s
and 1960s. The Japanese economy iscurrently suffering from
reces sion forover adecade. China hadexperienced arelatively
high growth rate (two-digit level) during most ofthe 1960s
(barring 1967, when she had the worst recession), and the
1980s and 1990s. The USsuffered theworst recession after the
Great Depressio nduring 1979 -82 but has performedmunotes.in

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77reasonably wellduring most ofthe1990s.
India has had anegative growth rate in1956 -57,1964 -
65,1972 -73,and 1979 -80(maximum at6.0%), and amaximum
growth rate ofabout 10percent in1988 -89.Most oftheSouth
East Asian nations had achieved high growth rates during 1986
through 1996 until they gotcaught upbytherecent financial crisis.
The growth rates inEuropean countries were either negative or
lowduring theperiods ofstagflation (1974 -75,1979 -82)aswell
astheearly 1990s, and better inmost other years.
African countries and Latin American countries have
witnessed even worse cycles. The world recorded thehighest
growth rate of6.2percent in1964 and thelowest of0.4percent
in1982. Ingeneral, the1980s and 1990s have been decades
ofrelatively good performance inmost countries.
Since early 2001, most regions inthe world are
experiencing arecession which is in terms ofafallinthe
growth rate rather than anegative growth rate. This
recessio n,liketheGreat Depression oftheearly 1930s, and
thestagflation ofthemid-70s and early 80s iswell spread
across countries. However, theinflation rate hasbeen quite
modest lately inmost countries.
The unemployment and inflation data (Panels BandC,
Table 1)further demonstrate the recurrence ofbusiness cycles.
AsperArthur Okun’s law, the unemployment figures arejustthe
mirror image ofthegrowth rate. The average inflation rate during
1964 -2000 fluctuated between 3.2percent inGermany and9 . 1
percent inIndia, with astandard deviation of1.8percent and2.8
percent, respectivel y.The said figures fortheworld turned outto
be11.1 per cent and 5.9 per cent, respectivel y.Thus, the
standard deviation ofinflation was fairly high aswell.
The fluctuations inreal GDP have not always
synchronized across countries. Inparticular, while Japan had
achieved arelatively high economic growth during the1950s and
1960s, ithassuffered badly during the1990s. Incontrast, China,
Malaysia, India,and even the UShave done well during the
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78Table 3A.1: Economic Fluctuations (Percentages)
Source: IMF: International Financial Statistics ,various issues.
*For the period 1964 -1997. **For the period 1964 -1997/85 -86-98. ***For
theperiod 1964 -2000.
The fundamental factors behind these fluctuations are
shocks inaggregate demand (AD) and/or aggregate supply (AS) .
These can becaused bychanges inone ormore ofthe
exogenous variables (policy ornon-polic yones) and the
behavioural parameters of the decision -makers, viz.
consumers, input supplier, andfirms. Thenon-policy variables that
affect ADinclude autonomous components ofconsumption,
investment, exports andimports, which, inturn, areguided bythe
confidence and expectations ofconsumers and firms, both
domestic and foreign. The non-policy variables that impinge on
ASinclude weather/monsoon, prices ofinputs, raw-materials and
intermediate goods, stipulations about pollution and environment
regu lations, business expectations about future prices, factor
supplies, technolog y,discovery ofnew natural resources, etc.
The policy variables that have abearing onADinclude
money supply (orthehigh-powered money), government fiscal
operations like government expenditure, taxation, and transfer
payments, andtheforeign exchange rate, tariffs, andquotas. The
classists (supply -siders) believe that direct taxes (personal
income tax, corporate tax, and the rebates onsaving and
investment) affect ASaswellthrough incentives/ disincentives to
supply more labour and save and invest more orless.munotes.in

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79The behavioural parameters affecting AD include
propensities toconsume/save, invest and import, interest
sensitiveness ofinvestment and money demands, price
elasticities ofimport and export, etc. Workers’ leisure -work
preference, firms’ attitude towards risk and profit, industrial
relations and riots, etc. constitute thebehavioural parameters
that affect AS. While the behavioural parameters are fairly
constant intheshort -run, thenon-policy and policy variables do
change even intheshort -run. Thus, the shifts inADand AS
could becaused byavariety offactors even intheshort -run,
and anyone ormore ofthem could have triggered/reinforced a
particular contraction orrecover y.
The stagflation was triggered bytheformation ofacartel
byoilexporters (OPEC) leading torestricted oilsupply and
significant increases inthecrude oilprice. The increase inthe
energy cost ledtoincrease intheproduction cost ofallgoods all
over theworld. The firms were forced tojack uptheir prices and
hence theAScurve shifted upward. This being anadverse supply
shock, while the output fell, prices went up. As a
consequence, theworld forthefirst time experience dthetwin
evils ofunemployment and inflation atthesame time.
The hyperinflation ofEurope inthe1920s was triggered
bywar time damages and reconstruction, causing heavy
debts. When the debt became un-sustainable, those
countries started financing thedeficits through increasing the
high-powered (base) money (and thereby money supply) more
and more, giving rise tohyperinflation. The Latin America’s
hyperinflation was caused byitsattempts togrow through
debts, and when debt became unsustainable, some ofthe
countries gotinto external debt crisis and allofthem resorted to
excessive printing ofcurrency causing hyperinflation. Needless
tosay, allthese hyperinflations were accompanied byequally
high growth inthehigh-powered mone y.
The prosper ityofthe1980s and 1990s could becredited
tothe spread ofglobalization, technical progress, and the
proper handling ofstabilizing policies. The countries which
liberalized trade and international capital flows grew faster than
theothers. The South -EastAsian countries and China provide
enough evidence tothishypothesis.
The collapse of the USSR and the poor experience of
theAfrican countries offer theadded support. The part shifting of
theproduction base from thehigh cost North American, Japan ese,
and European regions tothelowcost Asian and Latin American
regions has helped inbringing down inflation throughout the
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80resulted into astructural shift from thetraditional industries to
theknowledge -based industries andservices. The busting ofthis
boom and thespeculations inforeign exchange, causing the
Asian financial crisis ofthe 1997 -98, are considered tobe
among the main factors responsible forthe current growth
recession. The growi ngterrorism, fluctuating monsoons, and
environmental hazards have also contributed inaggravating
therecession.
3A.2 STABILIZ ATION POLICIES
The built-in(automatic) stabilizers, viz.progressive direct
taxes and social security system, are never enough to
counter business cycles. Fiscal polic y,monetary polic y,and
theforeign exchange rate system provide thenecessary tools in
thehands ofthepolicy -makers totame economic fluctuations .
Governments’ fiscal operations, viz.govern ment expenditure and
taxation, affect ADboth directly and indirectly and ASindirectly.
Government expenditure isacomponent ofADand taxation
reduces private income thereby reducing private consumption and
investment. Part oftheeffect oftheexpansionary fiscal policy is
crowded outthrough reduction inprivate investment and net
exports, as increased government expenditure leads to
increase ininterest rate, and through that theappreciation ofthe
exchange rate (iftheeconomy isonafloating rate system).
Stabilizati on policy is a strategy enacted by a government or
itscentral bank that is aimed at maintaining a healthy level of
economic growth and minimal price changes. Sustaining a
stabilization policy requires monitoring the business cycle and
adjusting fiscal pol icy and monetary policy as needed to control
abrupt changes in demand or supply.
In the language of business news, a stabilization policy is
designed to prevent the economy from excessive "over -heating" or
"slowing down."
Stabilization policy seeks to ke ep an economy on an even keel
by increasing or decreasing interest rates as needed.
Interest rates are raised to discourage borrowing to spend and
lowered to boost borrowing to spend.
Fiscal policy can also be used by increasing or decreasing
government sp ending and taxes to affect aggregate demand.
The intended result is an economy that is cushioned from the
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813A.3 UNDERSTANDING STABILIZATION POLICY
A study by the Brookings Institution notes that the U.S.
economy has been in a recession for about one in every seven
months since the end of World War II. This cycle is seen as
inevitable, but stabilization policy seeks to soften the blow and
prevent widespread unemployment.
A stabilization policy seeks to limit erratic swing si nt h e
economy's total output, as measured by the nation's gross
domestic product (GDP), as well as controlling surges in inflation or
deflation. Stabilization of these factors generally leads to healthy
levels of employment.
The term stabilization poli cy is also used to describe
government action in response to an economic crisis or shock such
as a sovereign debt default or a stock market crash. The responses
may include emergency actions and reform legislation.
3A.4 THE ROOTS OF STABILIZATION POLICY
Pioneering economist John Maynard Keynes argued that an
economy can experience a sharp and sustained period of
stagnation without any kind of natural or automatic rebound or
correction. Previous economists had observed that economies
grow and contract in a cyclical pattern, with occasional downturns
followed by a recovery and return to growth. Keynes disputed their
theories that a process of economy recovery should normally be
expected after a recession. He argued that the fear and uncertainty
that consumer s, investors, and businesses face could induce a
prolonged period of reduced consumer spending, sluggish business
investment, and elevated unemployment which would all reinforce
one another in a vicious circle.
In the U.S., the Federal Reserve is tasked with raising or
lowering interest rates in order to keep demand for goods and
services on an even keel. To stop the cycle, Keynes argued,
requires changes in policy in order to manipulate aggregate
demand. He, and the Keynesian economists who followed him ,a l s o
argued the reverse policy could be used to fight off excessive
inflation during periods of optimism and economic growth. In
Keynesian stabilization policy, demand is stimulated to counter high
levels of unemployment and it is suppressed to counter r ising
inflation. The two main tools in use today to increase or decrease
demand are to lower or raise interest rates for borrowing or to
increase or decrease government spending. These are known
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823A.5 THE FUTURE OF STABILIZATION POLICY
Most modern economies employ stabilization policies, with
much of the work being done by central banking authorities such as
the U.S. Federal Reserve Board. Stabilization policy is widely
credited with the moderate but posi tive rates of GDP growth seen in
theU.S.sincetheearly1980s.Itinvolves using expansionary monetary
and fiscal policy during recessions and contractionary policy during
periods of excessive optimism or rising inflation. This means
lowering interest rates, cu tting taxes, and increasing deficit
spending during economic downturns and raising interest rates,
rising taxes, and reducing government deficit spending during
better times.
Many economists now believe that maintaining a steady
pace of economic growth an d keeping prices steady are essential
for long -term prosperity, particularly as economies become more
complex and advanced. Extreme volatility in any of those variables
can lead to unforeseen consequences to the broad economy.
Stabilizing policies have helped rescue the debt and
foreign exchange crises faced byseveral countries including
Mexico, Argentina, Thailand, andIndonesia during the1980s and
1990s. Currently,these tools are being applied successfully in
many countries, including theUSand India totame thegrowth of
recession and tocome out ofthe terrorist attacks. Data in
Table 3A.2indicate the broad workings ofthese policies in
select countries, viz. India, US, and China forsome selected
years. Acareful analysis ofthese results indicate sthefollowing:
Table 3A.2: Changes in policy indicators (Percentages)
Source: IMF: International FinancialStatistics ,variousissues.
*Fortheperiod 1969 -2000
There is no particular pattern among the grow th rates in
GDP, growth rate in money supply, government expenditure as a
proportion of GDP, and fiscal deficit as a proportion of GDP in the
three countries under analysis. It may be noted that, if the
stabilizing policies are applied to counter business fluctuations,FiscalDeficit(%of GDP)YearMoney Supply Grow
thIndia ChinaGovernmentExpenditure(%of GDP)Indi
aChina USAIndiaChinaUSA19699.80N.A.5.908.60N.A.19.342.52N.A.-0.50197010.80N.A.3.809.00N.A.19.503.15N.A.1.11198012.3024.806.3013.2326.5921.626.542.852.47199018.9013.403.8017.2716.8122.438.120.814.10199712.6019.403.5017.7812.5919.494.870.730.24200010.7021.40-3.8016.9818.0918.195.352.702.59Mean*14.7921.385.9714.2818.1120.865.601.172.55SD*4.119.013.822.884.991.481.790.971.87munotes.in

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83their corresponding magnitudes would grow slower during
prosperity and faster during recession.
Of the five correct ones, three are for the US (all during the
worst year) and one each for India (for money supply during the
worst year) and China (for fiscal deficit during the best year). This
simple analysis thus suggests that the stabilizing policies were
applied consistently only to tame recession in the US. In a majority
of the cases, these policies were pro -cyclical thereby aggravating
the fluctuations rather than countering them.
In contrast, the fiscal policy was anti -cyclical in the US and
China and pro -cyclical in India. Economists differ with regard to the
relative effectiveness of different stabilizing policies. The classists
favour the monetary policy over the fiscal instruments as they
believe that the demand for money and the other behavioural
functions is relatively stable. In contrast, the Keynesians favour the
fiscal policy, particularly to check recession, when the interest rate
hardly responds to fiscal deficit. Both schools believe that for
policies to be effective, they have to be credible. The foreign
exchange rate policy has not been used much in stabilizing the
economy. The other two have been applied with varied succes s.
The improvements in the knowledge base, technology, and
transparency in policies, and recognition of the significance of
macro -economic (fiscal) balance in economic growth, among other
factors, are responsible for the inadequate effectiveness of polici es
in countering the current growth recession. Pump priming is
desirable during recessions and thus easy fiscal -monetary policy
mix is a good policy currently in operation in many countries.
Economic fluctuations have occurred, would continue to
recur, an da r en o te n t i r e l yb a d .T h e r ea r eu p sa n dd o w n si na l l
walks of life and economic performance cannot be an exception.
There is nothing perfect in real life and so policies cannot
guarantee full freedom from fluctuations. Recessions provide
opportunities to introspect, relax, learn the ways to improve
performance, discover new techniques, etc. Was not Keynes
motivated to revolutionize macro -economic theory and policy on
experiencing the Great Depression? Similarly, was not Milton
Friedman encouraged to count er the inadequacy of the Keynesian
theory to account for the stagflation through his hypotheses of price
expectations, natural rate of unemployment, and policy lags? His
ideas got the added support from Robert Lucas and others, through
their advancement of the rational expectations’ hypothesis.
The new Keynesians accepted therational expectations’
theory and rationalized thewage -price rigidity hypothesis ofthe
oldKeynesian school. These, among others, have enriched ourmunotes.in

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84understanding ofthe economy and accordingly economic
fluctuations are now better understood and managed than ever
before. The discoveries ofnew products, new technologies, and
trends towards mergers and globalization, etc. have been
inspired bythebusiness cycles.
Deep or/and long recessions and unsustainable
prosperity are, ofcourse, notgood. The former brings undue
hardship resulting into both economic and
social/psychological loss. The latter tends toraise the standard
ofliving which noone likes toreverse. Fortunatel y,atleastone
ofthethree stabilizing policies analyzed above iseffective under
any condition toatleast partially counter fluctuations. Itis
because ofthis that theworld has notseen any deep recession
since 1929 -33, and wecan safely state that such agreat
depression would never bethere infuture. Countries after
countries have faced slow -down butthey have allbeen short -lived
andrelatively shallow.
The credit forthis goes squarely tothedevelopment in
macro -economics and itsapplication bypolicy -makers across
theglobe. These policies have been applied inthereal world with
varying successes. The lack offullsuccess hasbeen partly dueto
theinherent limitations ofthese policies and partly due totheir
poor applications. Needless tosay, international organizations
like the World Bank and IMF have helped themember nations to
implement effective counter -cyclical policies, though theliterature
provides examples oftheir poor guidance/ force aswell. The
policies dohave side effects, some ofwhich may beundesirable,
butajudicious combination ofthevarious tools canminimize the
bad effects. For example, aproper mixofanexpansionary fiscal
and anexpansionary monetary policy would tend toraise
output without raising interest rate. Also, ifan
expansionary fiscal ormonetary policy were accompanied
with adevaluation oftheforeign exchange rate, wewould have
higher output without endangering the trade balance.
Nevertheless, cycles arebad and unfortunatel y,inspite ofvast
developments inmacro -economic theory and policy and
technological innovations, cycles, though milder over time,
have persisted andareunlikely toever disappear
Check your progress
1. Explain the concept of economic fluctuations.
2. Explain the meaning of stabiliza tion policies.
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
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853A.6 TRANSMISSION MECHANISM AND THE
CROWDING OUT EFFECT
Crowding out refers to a process where an increase in
government spending leads to a fall in private sector spending. This
occurs as a result of the increase in interest rat es associated with
the growth of the public sector. Crowding out has been considered
by many economists from a variety of different economic traditions,
and is the subject of much debate. Thus, the phenomenon,
whereby increased government expenditure may l ead to a
squeezing of private investment expenditure, is referred to as the
crowding -out effect. Gov ernment expenditure crowds out private
sector investment expenditure. Thus, the multi plier effect of
government expenditure (K G) is lessened because of t he negative
effect on private investment following higher interest rates. It is
because of the crowding -out effect aggregate output declines but
interest rate increases.
We can explain the phenomenon of crowding -out effect in
terms of (i) aggregate demand (C + I + G) and aggregate output
approach and (ii) the IS -LM approach. We have learnt that
equilibrium national income is determined at that point where C + I
+ G line cuts the 45° line. This is demonstrated by C + I 1+G 1line
when the rate of interest i s assumed to be r 1.I nF i g .3 A.1,C+I 1+
G1line cuts the 45° line at point E, and the equilibrium national
income, thus, determined is OY 1.
Figure 3A. 1Govt. expenditure crowds out private investment
and reduces aggregate output
Let there be an increase in government expenditure from
G1to G 2. This causes C + I 1+G 1(holding r = r 1) line to shift up to C
+I+G 2(for r = r 1). This causes aggregate in come to rise to
OY 2(full multiplier effect). This higher income (OY 2>O Y 1),
however, causes money demand and interest rate to rise from r 1tomunotes.in

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86r2, leading to a fall in private planned investment expenditure from
I1to I 2.
This causes aggregate demand lin e to shift down to C + I 2+
G2(assuming r = r 2that equilibrium income has declined to OY 3crowding -out phenomenon private sector investment is being
squeezed. Here we see ‘partial’ multiplier effect in operation.
However, there would not have been any crowding -out
phenomenon if interest rate were to decline. Suppose, central bank
increases money supply to finance govern ment expenditures. Its
impact can now be felt in the money market in the form of lower
interest rate. This means that higher money demand by the public
can be met by excess quantity of money. This may cause interest
rate to fall, causing aggregate output to rise. In other words, instead
of crowding -out effect, one may experienc e ‘crowding -in effect’.
Crowding -out phenomenon can be better explained in terms
of IS -LM framework as it combines both goods market and money
market. Aggregate demand -aggregate output approach does not
display the links between the goods market and the m oney market.
In Fig. 3 A.2, we have drawn IS and LM curves. For simplicity, we
have not considered liquidity trap effect on the LM curve. Initially,
our economy is at equilibrium at point E 1. The corresponding
income -interest rate combi nation is r 1–Y1.
Figure 3A.2 Crowding out effect in the IS -LM model
An increase in government spending shifts the IS curve to
IS2, shifting the equilibrium point to E 2. Consequently, income rises
to OY 1from OY, (a full multiplier effect of government spending).
But the economy is out of equilibrium: goods market is in
equilibrium (since planned expenditure equals aggregate output),munotes.in

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87but money market is out of equilibrium. This is because higher
income causes money demand to rise.
This excess demand for money (in the mon ey market) then
pulls up the interest rate, leading to a fall in aggregate demand as it
squeezes out some private investment, tending to reduce the size
of the multiplier effect on income. Final equilibrium (determined by
the IS -LM intersection) now occurs at point E 3and aggregate
output declines to OY 3. Note that the increase in aggregate income
(OY 3–OY 1) is less than the amount indicated by the multiplier (Y 2–
Y1) having the ‘full’ effect. This feedback phenomenon is often
referred to as a “crowding -out effect”. It reduces the size of
government expenditure multiplier.
It may be noted here that the strength or impact of crowding -
out effect depends on the interest sensitivity of investment function
(i.e., the slope of the IS curve) and interest sensiti vity of the money
demand function (i.e., the slope of the LM curve). The greater the
value of the interest -sensitivity of the investment function and lower
the value of the money demand function, greater will be the
crowding -out effect, and vice versa.
3A.7 COMPOSITION OF OUTPUT AND POLICY MIX
The term policy mix refers to the combination of fiscal and
monetary policy that a country uses to manage its economy. A
policy mix is developed and determined by a nation's
policymakers —notably its federal governme nt and central bank.
The policy mix is a pivotal part in boosting a nation's economic
growth and helps keep the country on track to maintaining the
strength of its economy.
A policy mix is the combination of fiscal and monetary policy
that a country uses to manage its economy.
Fiscal and monetary policies make up a nation's economic
policy -the federal government handles the former while the
latter is overseen by a central bank.
Fiscal policy involves spending and tax initiatives while
monetary policy inv olves interest rates and the money supply.
Although governments and central banks have different goals
and time horizons, they may work together to stimulate
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883A.8HOW A POLICY MIX WORKS
A country's economic policy consists of two comp onents -its
fiscal policy and its monetary policy. A fiscal policy consists of any
spending plans and tax initiatives that a nation's government uses
to boost and influence economic conditions such as inflation,
employment, and demand for goods and servic es.Monetary policy,
on the other hand, refers to any actions taken to control a
country's supply of money. Monetary policy is supposed to help the
nation sustain economic growth.
In most democratic countries, elected legislatures -the
federal government -control fiscal policy, while independent central
banks handle monetary policy. In the United States, this is
theFederal Reserve System (Fed), which is made up of a dozen
regional Federal Reserve Banks. Governments and central banks
generally share a br oad set of goals. They include
lowunemployment, stable prices, moderate interest rates, and
healthy growth.
These policymakers may employ different tools to
accomplish these goals and often stress different priorities. For
instance, government budgets af fect long -term interest rates, while
monetary policy affects short -term ones. That's because they each
have different objectives and time horizons to accomplish their
goals. Governments must win popular approval from the general
public and are generally vo ted for in four -year cycles, while central
bankers are technocrats that don't directly answer to voters. This
makes them much more independent.
So how does this all work? Inflation occurs when prices rise
and the purchasing power of a single unit of curre ncydeclines. This
means people can't afford to buy goods and services because their
money doesn't stretch as far as it once did -prices are just too high.
This situation spreads throughout the economy, leading to a drop in
consumer and business spending and higher unemployment, to
name a few effects. A nation's federal government and central bank
may step in to help curb inflation through a policy mix. For instance,
the government may implement tax cuts to encourage consumers
to spend more money while its central bank may reduce interest
rates to inject more liquidity in the financial market. The central
bank may also increase the money supply to boost investment and
also encourage spending.
3A.9 SPECIAL CONSIDERATIONS
There are times when fiscal and mon etary policymakers
actually work together. For example, the government may passmunotes.in

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89fiscal stimulus by cutting taxes and increasing spending. The
central bank may decide to provide monetary stimulus by cutting
short -term interest rates. Broadly speaking, this was the policy mix
that characterized the response to the 2008 financial crisis in the
United States. The crisis was ushered in by a collapse in the
housing market, rising interest rates, defaulting subprime
borrowers. This had a domino effect that led to a crash in the global
financial market, ultimately resulting in the Great Recession.
Fiscal and monetary policy can also push in different
directions. The central bank might ease monetary policy while fiscal
policymakers pursue austerity measures. This is what happened in
Europe following the financial crisis. Or the government, eager to
win popular support, may decide to cut taxes or boost spending
despite a tight labor market and inflationary pressures. These
actions could force the central bank to raise interest rates.
Check your progress
1. Explain the term Crowding out effect.
2. What do you understand by the use of Policy mix?
_____________________________________________________
_____________________________________________________
___________________ __________________________________
_____________________________________________________
_____________________________________________________
3A.10 IS -LM IN INDIA
India embarked on a major reform to liberalize its economy
in the year 1991. But there had been a gradual and effective policy -
level effort to loosen import and business controls since the 1980s,
which reached its culmination a decade later. India’s growth story
has been rewritten since then and prior to the current pandemic;
India was the fifth largest economy in terms of size and the fastest
trillion -dollar emerging economy in the world.
This holistic framework is premised considerably on New
Keynesian theoretical philosophy, where a simple Keynesian
consumption function is included along with an investment function,
which is motivated by the accelerator principle. However, an
augmented version of the Phillips curve is proposed, which
incorporates backward -looking inflation expectation to corroborate
the Indian experience where inertia plays an instrumental role in
deciding the future dynamic of inflation. A two -stage least squares
technique, a variant of the structural equation model (SEM), is
employed for the analysis in which equations for consumption
expenditure, private capital formation, e xternal sector comprising
import and export, supply side of the economy, inflation dynamic,
tax collection, and money demand function are considered.munotes.in

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90Finally, to assess the model’s efficacy in predicting the effect
of expansionary monetary and fiscal pol icy interventions, a
simulation is carried out for the past 10 years from FY2009 -2010
through 2018 -2019. This is done by reducing the interest rate and
increasing government capital formation as well as government
consumption expenditure, respectively. Empirical findings from the
simulation suggest the effectiveness of both fiscal and monetary
policies.1 Expansionary monetary policy, as envisaged by a 100 -
basis point reduction in the short -term interest rate, leads to around
a 4% increase in GDP.
On t he other hand, increases in two variables, namely
government consumption expenditure and public capital formation,
are considered as fiscal stimuli. Results indicate that a 10% rise in
government consumption expenditure results in a 19.65% increase
in outp ut, whereas a 10% higher public capital formation raises
output by 24.23%. The fiscal stimulus and economic growth are
only sustainable if this can also generate revenue through tax
collection. In both cases, tax collection increases by around 50%.
Given t hat tax collection is already low in India, this increase is not
surprising.
3A.11 MACROECONOMIC OVERVIEW OF THE INDIAN
ECONOMY SINCE 1980
The Indian economy’s growth trajectory has been
experiencing a gradual and consistent evolution since the 1980s.
This dynamic growth can be mainly attributed to change in
economic policies, adopted in different phases during the last four
decades. A brief snapshot of India’s macroeconomic performance
during this 40 -yearp e r i o di sp r e s e n t e di nT a b l e3 A . 3 .I n t e r n a l
factors, coupled with global attributes, led this journey to a distinct
destination where India has been recognized as growing from an
underdeveloped economy to a promising emerging power on the
global economic platform. During the period 1980 -1990, the rat e
of growth accelerated to an unprecedented level of 5.8% and this
figure was surpassed by as few as eight out of 113 countries in the
world. Post liberalization, during the period 1990 -1995, the growth
rate marginally dipped to 4.70% due to structural c hanges, but it
witnessed a further surge in the last five years of the previous
century, i.e., up to 6.84%, followed by a consistent 5.65% growth
during the first five years of the new millennium.
From 2005 to 2010, the Quinquennial growth rate of GDP is
estimated at an all -time high of 6.92%. This was the phase in its
history when the Indian economy recorded annual y -o-yg r o w t h
rates close to 8% consistently for about eight years, from the fiscal
year (FY) 2003 -04 to FY2010 -11, except for FY2008 -09.
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91the Indian economy experienced a downward trend in output
growth in successive years. This decay was further aggravated by
the adverse impact of poor implementation of structural reforms,
like demonetization in 2016 and GST in 2017. However, many
argue in favour of the long -term benefits of such reforms, which can
only be judged in the due course of time.
Table 3A.3 : Macroeconomic Indicators: Quinquennial Averages
from 1980 through 2020
Agranular look at different components of aggregate -level
output is a very revealing and informative exercise in assessing the
dynamic growth of the Indian economy. Though lately India has
been experiencing a consumption -led growth, its initial economic
propulsion was fueled by the private investment rate, which
consistently rose from a meager 8.57% for the period 1980 -1985
to 30.32% in 2010 -2015. At the same time, public investment in
India witnessed a secular downward trend, mainly caused by a
sharp d ecline in infrastructure investment by government at varying
levels, including state and central.
The emergence of a middle class and transition in the
demographic profile led to higher consumption in the last decade
and brought down the otherwise strong resilient factor and strength
of the economy, i.e., private saving. It registered steady growth
from 13.23% in 1980 -1985 to an enviable 33.23% in 2005 -2010,
cushioning its financial system against the global turmoil during the
2008 crisis. After the i ntroduction of GST and demonetization, both
the saving rate and the private investment rate declined, to 29.71%
and 27.76%, respectively, during the period 2015 -2019. Further,
on the fiscal front, India’s policy follows an orthodox stance to
maintain a l ow level of fiscal deficit, which has ranged between its
maximum value of 7.44% during the period 1985 -1990 and its
lowest one of 3.60% from 2015 to 2020.
Global experience suggests that any emerging nation like
India is always susceptible to inflation ary shocks, mainly caused bymunotes.in

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92structural factors. Although India’s experience with high inflation,
averaging around 9.5%, during the first one and half decades after
1980 was painful, it steered its monetary policy devices efficiently to
contain inflation t o a more comfortable level of an average of 6.41%
in the subsequent two decades, i.e., between 1995 and 2015. The
nation’s Apex Bank fixed a target level of a 4% inflation rate for a
painless growth, and there is evidence of success and optimism in
that di rection since inflation was as low as 3.35% for the period
2015 -2020. However, towards the end of FY2019 -2020 and
thereafter, like every other country across the globe, the Indian
economy was severely hit by the Covid -19 crisis. The y -o-yg r o w t h
of GDP in the first quarter of fiscal year 2020 -2021 has declined
by 23.9%. The performance of various sectors reveals that all
sectors except the agricultural sector have shown a declining trend
in Q1 2020 -2021. The growth rates in service components like
construction, trade, transport, and tourism have declined by about
50%. The manufacturing and mining industries have marked 39.3%
and 23.3% declines, respectively. On the expenditure side, the
investment rate during Q1 2020 -2021 has been as low as 22%,
compared to an average of 30% in the past 10 years. Amidst this,
the retail inflation in India has also surged significantly with its rates
touching 7.61% in October 2020 the highest in the last six years.
These signs are worrying as the monetary policy has already taken
an expansionary stance to mitigate the crisis. On the fiscal front,
the crisis has had a significant impact on deficits. According to the
controller of general accounts (CGA) reports for September 2021,
the fiscal deficit for the first two qu arters has already reached 114%
of the annual estimate for FY2020 -2021.
The current study is an attempt to capture the
macroeconomic dynamics in India at an aggregate level. The study
covers annual data from 1980 through 2019. The theoretical
underpinni ngs of our analysis follow the New Keynesian framework
based on the microeconomic foundations of Keynesian economics.
Aggregate demand is modeled under its four components, namely
consumption, private investment, exports, and imports. Under this
framework, government expenditure and government capital
formation are considered exogenous.
Aggregate supply takes the form of a simple neoclassical
production function driven by labour, capital, and exogenous
technical progress. The rate of inflation is taken as af u n c t i o no f
output gap, past inflation expectations, and exchange rate. This
follows New Keynesian Phillips curve representation. The LM curve
specification is determined by income and short -term rate of
interest. Linking monetary policy and fiscal poli cy to the goods
market, long -run interest rates are determined by short -term
interest rates and government investment. Finally, tax is estimated
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93An expansionary fiscal policy in comparison to that of a
monetary one is cr itical to the Indian economy’s structure since
investment growth, induced by lower interest rates, lost its steam in
propelling output due to several frictions and a weaker transmission
mechanism. This necessarily implies the need to focus on prudent
fiscal stances to steer the economy toward a sustainable growth
trajectory in the future.
3A.12 SUMMARY
1.Economic fluctuations are simply fluctuations in the level of the
national income of a country representing growth or contraction.
The current economic model describing economic fluctuations in
am a r k e te c o n o m yi st h e business cycle. The business cycle is a
pattern of economic fluctuations describing the periods of economic
growth, contraction, and the transitions in between.
2.Stabilization policy is a strategy enacted by a government or
itscentral bank that is aimed at maintaining a healthy level of
economic growth and minimal price changes. Sustaining a
stabilization policy requires monitoring the business cycle and
adjusting fiscal policy and monet ary policy as needed to control
abrupt changes in demand or supply.
3.Stabilizing policies have helped rescue thedebt and foreign
exchange crises faced byseveral countries including Mexico,
Argentina, Thailand, and Indonesia during the 1980s and
1990s. Currently,these tools are being applied successfully in
many countries, including theUSand India totame thegrowth of
recession and tocome outoftheterrorist attacks.
4. Crowding outrefers to a process where an increase in
government spending lead s to a fall in private sector spending. This
occurs as a result of the increase in interest rates associated with
the growth of the public sector. Government expenditure crowds
out private sec tor investment expenditure. Thus, the multi plier
effect of go vernment expenditure (K G) is lessened because of the
negative effect on private investment following higher interest rates.
It is because of the crowding -out effect aggregate output declines
but interest rate increases.
5.The term policy mix refers to th ec o m b i n a t i o no f fiscal and
monetary policy that a country uses to manage its economy. A
policy mix is developed and determined by a nation's
policymakers —notably its federal government and central bank.
The policy mix is a pivotal part in boosting a natio n'seconomic
growth and helps keep the country on track to maintaining the
strength of its economy.munotes.in

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943A.13 QUESTIONS
1.Explain the meaning of economic fluctuations.
2.Discuss the role of Stabilization policies in economic
fluctuations.
3.Explain the role of transmission mechanism and crowding out
effect with reference to IS -LM framework.
4.Discuss the IS -LM framework in India.

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95Unit -Four
Unit -4
“INTERNATIONAL ASPECTS OF
MACROECONOMIC POLICY”
Unit Structure:
4.0 Objectives
4.1 Introduction
4.2 The Current Account
4.3 The Capital Account
4.4 The Balancing Act
4.5 Liberalizing the Account
4.6 Factors affecting the Balance ofP a y m e n t s
4.7 Structure of Balance of Payments
4.8 Disequilibrium inthe Balance ofP a y m e n t s
4.9 Main types of Disequilibrium inthe Balance ofP a y m e n t s are
4.10 Causes andMeasures ofDisequilibrium
4.11 Measures to Correct Disequilibrium inthe BOP
4.12 Expenditure Changing Policies and Expenditure Switching
Policies BOP adjustments through Monetary and Fiscal
Policies
4.13 Summary
4.14 Questions
4.0 OBJECTIVES
To enable the learners to grasp fully the theoretical rationale
behind policies at the country as well as corporate level.
To receive a firm grounding on the basic macroeconomic
concepts that strengthen analysis of crucial economic policies.
4.1INTRODUCT ION
Balance of payments
The balance of payments (BOP) is a statement of all
transactions made between entities in onecountry and the rest of
the world over a defined period of time, such as a quarter or a year.munotes.in

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96The balance of payments (BOP), also known as balance of
international payments, summarizes all transactions that a country's
individuals, companies, and government bodies complete with
individuals, companies, and government bodies outside the
country. These transactions consist of impor tsandexports of
goods, services, and capital, as well as transfer payments, such as
foreign aid and remittances.
A country's balance of payments and its net international
investment position together constitute its international accounts.
The balance of payments divides transactions in two
accounts: thecurrent account and the capital account. Sometimes
the capital account is called the financial account, with a separate,
usually very small, capital account listed separately. The current
account includes transactions in goods, services, investment
income, andcurrent transfers. The capital account, broadly
defined, includes transactions in financial instruments and central
bank reserves. Narrowly defined, it includes only transactions in
financial instrum ents. The current account is included in
calculations of national output, while the capital account is not.
The sum of all transactions recorded in the balance of
payments must be zero, as long as the capital account is defined
broadly. The reason is that every credit appearing in the current
account has a corresponding debit in the capital account, and vice -
versa. If a country exports an item (a current account transaction), it
effectively imports foreign capital when that item is paid for (a
capit al account transaction).
If a country cannot fund its imports through exports of
capital, it must do so by running down its reserves. This situation is
often referred to as a balance of payments deficit, using the
narrow definition of the capital account that excludes central bank
reserves. In reality, however, the broadly defined balance of
payments must add up to zero by definition . In practice, statistical
discrepancies arise due to the difficulty of accurately counting every
transaction between an economy and the rest of the world,
including discrepancies caused by foreign currency
translations. Thebalance of payments (BOP) is the method
countries use to monitor all international monet ary transactions at a
specific period. Usually, the BOP is calculated every quarter and
every calendar year.
All trades conducted by both the private and public sectors
are accounted for in the BOP to determine how much money is
going in and out of a coun try. If a country has received money, this
is known as a credit, and if a country has paid or given money, the
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97Theoretically, the BOP should be zero, meaning that assets
(credits) and liabilities (debits) should balance, but in practice, this
is rarely the case. Thus, the BOP can tell the observer if a country
has a deficit or a surplus and from which part of the economy the
discrepancies are stemming.
4.2THE CURRENT ACCOUNT
The current account is used to mark the inflow and outflow of
goods and services into a country. Earnings on investments, both
public and private, are also put into the current account.Within the
current account are credits and debits on the trade of merchandise,
which includ es goods such as raw materials and manufactured
goods that are bought, sold, or given away (possibly in the form of
aid). Services refer to receipts from tourism, transportation (like the
levy that must be paid in Egypt when a ship passes through the
Suez Canal), engineering, business service fees (from lawyers
ormanagementconsulting,forexample),androyaltiesfrompatentsand
copyrights
When combined, goods and services together make up a
country's balance of trade (BOT). The BOT is typically the biggest
bulk of a country's balance of payments as it makes up total imports
and exports. If a country has a balance of trade deficit, it imports
more than it exports, and if it has a balance of trade surplus, it
exports mor e than it imports.
Receipts from income -generating assets such as stocks (in
the form of dividends) are also recorded in the current account. The
last component of the current account is unilateral transfers. These
are credits that are mostly worker's rem ittances, which are salaries
sent back into the home country of a national working abroad, as
well as foreign aid that is directly received.
This is a record of all payments for trade in goods and
services plus income flow it is divided into four parts.
Balance of trade in goods (visibles)
Balance of trade in services (invisibles) e.g. tourism, insurance.
Net income flows. Primary income flows (wages and investment
income)
Net current transfers. Secondary income flows (e.g. government
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984.3THE CAPITAL ACCOUNT
The capital account is where all international capital
transfers are recorded. This refers to the acquisition or disposal of
non-financial assets (for example, a physical asset such as land)
and non -produced assets, which are needed for production but
have not been produced, like a mine used for the extraction of
diamonds.
The capital account is broken down into the monetary flows
branching from debt forgiveness, the transfer of goods, and
financial assets by migrants leaving or entering a country, the
transfer of ownership on fixed assets (assets such as equipment
used in the production process to generate income ), the transfer of
funds received to the sale or acquisition of fixed assets, gift
andinheritance taxes, death levies and, finally, uninsured damage
to fixed assets.
The Financial Account
In the financial account, international monetary flows related
toinvestment in business, real estate, bonds, and stocks are
documented. Also included are government -owned assets, such as
foreign reserves, gold, special drawing rights (SDRs) held with
theInternational Monetary Fund (IMF), private assets held abroad,
and direct foreign investment. Assets owned by foreigners, private
and official, are also recorded in the financial account.
This is a record of all transactions for financial investment. It
includes:
Direct investment. This is net investment from abroad. For
example, if a UK firm built a factory in Japan it would be a debit
item on UK financial account)
Portfolio investment. These are financial flows, such as the
purchase of bonds, gilts or saving in b anks. They include
short -term monetary flows known as “hot money flows” to
take advantage of exchange rate changes, e.g. foreign investor
saving money in a UK bank to take advantage of better interest
rates –will be a credit item on financial account
4.4THE BALANCING ACT
The current account should be balanced against the
combined -capital and financial accounts; however, as mentioned
above, this rarely happens. We should also note that, with
fluctuating exchange rates, the change in the value of money canmunotes.in

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99add to BOP discrepancies.If a country has a fixed asset abroad,
this borrowed amount is marked as a capital account outflow.
However, the sale of that fixed asset would be considered a current
account inflow (earnings from investments). The current account
deficit would thus be funded.
When a country has a current account deficit that is financed
by the capital account, the country is actually foregoing capital
assets for more goods and services. If a country is borrowing
money to fund its cur rent account deficit, this would appear as an
inflow of foreign capital in the BOP.
Check your progress:
1.Define balance of payments.
2.State the transactions included in the current account of balance
of payments.
3.State the transactions included in the capi tal account of balance
of payments.
4.In accounting sense balance of payments always balances:
Explain.
_____________________________________________________
_____________________________________________________
________________________________________________ _____
_____________________________________________________
_____________________________________________________
4.5LIBERALIZING THE ACCOUNTS
The rise of global financial transactions and trade in the late -
20th century spurred BOP and macroeconomic liber alization in
many developing nations. With the advent of the emerging
market economic boom, developing countries were urged to lift
restrictions on capital -and financial -account transactions to take
advantage of these capital inflows.
4.6FACTORS AFFECTING THE BALANCE OF
PAYMENTS
A current account deficit could be caused by factors such as.
1.The rate ofconsumer spending onimports .F o re x a m p l e ,
during an economic boom, there will be increased spending
and this will cause a deficit on the c urrent account.
2.International competitiveness. If a country experiences
higher inflation than its competitors, exports will be less
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1003.Exchange rate. If the exchange rate is overvalued, it makes
exports relatively more exp ensive leading to a deterioration in
the current account.
4.Structure ofeconomy –deindustrialisation can harm the
export sector.
Factors affecting current account deficit
Should we be concerned about a current account deficit?
Figure 4.1 Effects of a current account deficit
Why balance of payment is vital for a country?
A country’s BOP is vital for the following reasons:
BOP of a c ountry reveals its financial and economic status.
BOP statement can be used as an indicator to determine
whether the country’s currency value is appreciating or
depreciating.
BOP statement helps the Government to decide on fiscal and
trade policies.
It pro vides important information to analyze and understand the
economic dealings of a country with other countries.
By studying its BOP statement and its components closely,
one would be able to ident ify trends that may be beneficial or
harmful to the economy of the county and thus, then take
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1014.7STRUCTURE OF BALANCE OF PAYMENTS
Table 4.1 Structure of Balance of Payments
4.7.1Errors and Omission
According to double entry book –keeping concept for every
credit, there exists a matching debit and thus, there must be a
balance in BOP as well. In reality BOP may not balance. Once
various types of international financial flows are recorded, the
statistical discrepancy, referred to as errors and omissions, is also
recorded. The statistical discrepancy occurs due to complications
associated with collecting balance of payments data. You can find
different sources of data which occasionally differ in their
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102the payments are received in April. If statistics are compiled on the
31st March, the numbers will differ. The errors and omissions
amount is equal to the amount required to balance both the sides.
It is useful to keep in mind that whenever past figures for the BOP
are adjusted as time passes by, the figures for ‘net errors and
omissions’ get smaller and smaller as the errors are located and
fixed.
4.7.2Foreign Exchange Reserves
Foreign exchange reserves exhibits the res erves that are
kept in the form of foreign currencies. If the overall balance is
surplus, it is moved to the official reserves account which raises the
foreign exchange reserves. It may be in form of dollar, pound, gold
and Special Drawing Rights (SDRs).
If there exists a deficit, a sum equal to the deficit is taken
from the official reserves account bringing the BOP into
equilibrium. When surplus is moved to the foreign exchange
reserve, it is displayed as minus in that specific year’s balance of
payment account. The minus sign ( -) signifies a rise in forex and
plus sign (+) exhibits the borrowing of foreign exchange from the
forex account in order to meet the deficit.
The BOP measures all flows of money between India and
the rest of the planet. The main aspect is to understand the
difference between the current account and the capital account and
understand the connection between them.
Check your progress:
1. State the factors affecting the current account transactions of
balance of payments.
2. Discuss the importance of balance of payments for a country.
3. Explain the role of Errors and Omission item in BOP.
4. Explain the meaning of foreign exchange reserves.
_____________________________________________________
________________________________________ _____________
_____________________________________________________
_____________________________________________________
_____________________________________________________
4.8DISEQUILIBRIUM IN THE BALANCE OF
PAYMENTS
Disequilibrium is a situation where internal and/or external
forces prevent market equilibrium from being reached or cause the
market to fall out of balance. This can be a short -term byproduct of
a change in variable factors or a result of long -term struct ural
imbalances.munotes.in

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103Disequilibrium is also used to describe a deficit or surplus in
a country’s balance of payments.
A disequilibrium in the balance of payment means its condition
of Surplus o r deficit.
A Surplus in the BOP occurs when Total Receipts exceed s
Total Payments. Thus, BOP= CREDIT>DEBIT.
A Deficit in the BOP occurs when Total Payments exceeds Total
Receipts. Thus, BOP= CREDITDisequilibrium is when external forces cause a disruption in a
market's supply and demand equilibrium. In response, the
market enters a state during which supply and demand are
mismatched.
Disequilibrium is caused due to several reasons, from
government intervention to labor market inefficiencies and
unilateral action by a supplier or distributor.
Disequilibrium is gen erally resolved by the market entering into
a new state of equilibrium.
4.9MAIN TYPES OF DISEQUILIBRIUM IN THE
BALANCE OF PAYMENTS ARE:
i.Cyclical Disequilibrium:
It occurs on account of trade cycles. Depending upon the
different phases of trade cycles like prosperity and depression,
demand and other forces vary, causing changes in the terms of
trade as well as growth of trade and accordingly a surplus or deficit
will result in the balance of payments.
Cyclical disequilibrium inthebalance ofpayments may occur
because:
i. Trade cycles follow different paths and patterns in different
countries. There are no identical timings and periodicity of
occurrence of cycles in different countries.
ii. No identical stabilizationprogrammes and measures are a dopted
by different countries.
iii. Income elasticities of demand for imports in different countries
are not identical.
iv. Price elasticities of demand for imports differ in different
countries.
In short, cyclical fluctuations cause disequilibrium in th e
balance of payments because of cyclical changes in income,munotes.in

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104employment, output and price variables. When prices rise during
prosperity and fall during a depression, a country which has a
highly elastic demand for imports experiences a decline in the value
of imports and if it continues its exports further, it will show a
surplus in the balance of payments.
Since deficit and surplus alternatively take place during the
depression and prosperity phase of a cycle, the balance of
payments equilibrium is automa tically set forth over the complete
cycle.
ii.Structural Disequilibrium:
It emerges on account of structural changes occurring in
some sectors of the economy at home or abroad which may alter
the demand or supply relations of exports or imports or both.
Suppose the foreign demand for India’s jute products declines
because of some substitutes, then the resources employed by India
in the production of jute goods will have to be shifted to some other
commodities of export.
If this is not easily possible, In dia’s exports may decline
whereas with imports remaining the same, disequilibrium in the
balance of payments will arise. Similarly, if the supply condition of
export items is changed, i.e., supply is reduced due to crop failure
in prime commodities or shor tage of raw materials or labour strikes,
etc. in the case of manufactured goods, then also exports may
decline to that extent and structural disequilibrium in the balance of
payments will arise.
Moreover, a shift in demand occurs with the changes in
taste s, fashions, habits, income, economic progress, etc.
Propensity to import may change as a result. Demand for some
imported goods may increase, while that for certain goods may
decline leading to a structural change.
Furthermore, structural changes are als op r o d u c e db y
variations in the rate of international capital movements. A rise in
the inflow of international capital tends to have a direct impact on a
country’s balance of payments.
iii.Short -runDisequilibrium:
A short -run disequilibrium in a country ’s balance of
payments will be a temporary one, ‘lasting for a short period, which
may occur once in a while. When a country borrows or lends
internationally, it will have short -run disequilibrium in its balance of
payments, as these loans are usually for a short period or even if
they are for a long duration, they are repayable later on; hence, the
position will be automatically corrected and poses no serious
problem.munotes.in

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105As such, a disequilibrium arising from international lending
and borrowing activities is perfectly justified. However, a short -run
disequilibrium may also emerge if a country’s imports exceed its
exports in a given year.
This will be a temporary one if it occurs once in a way,
because later on, the country will be in a position to correct it easily
by creating the required credit surplus by exporting more to offset
the deficit. But even this type of disequilibrium in the balance of
payments is not justified, because it may pave the way for a long -
term disequilibrium.
When such disequilibrium (arising from imports exceeding
exports or even vice versa) occurs year after year over a long
period, it becomes chronic and may seriously affect the country’s
economy and its international economic relations. A persistent
deficit will tend to deplete it s foreign exchange reserves and the
country may not be able to raise any more loans from foreigners.
iv.Long -runDisequilibrium:
The long -term disequilibrium thus refers to a deep -rooted,
persistent deficit or surplus in the balance of payments of a cou ntry.
It is secular disequilibrium emerging on account of the
chronologically accumulated short -term disequilibria —deficits or
surpluses.
It endangers the exchange stability of the country
concerned. Especially, a long -term deficit in the balance of
payments of a country tends to deplete its foreign exchange
reserves and the country may also not be able to raise any more
loans from foreigners during such a period of persistent deficits.
In short, true disequilibrium is a long -term phenomenon. It is
caused by persistent deep -rooted dynamic changes which slowly
take place in the economy over a long period of time. It is caused
by changes in dynamic forces/factors such as capital formation,
population growth, territorial expansion, technological
advancemen t,innovations, etc.
A newly developing economy, for instance, in its initial
stages of growth needs huge investment exceeding its savings. In
view of its low capital formation, it has also to import a large amount
of its capital requirements from foreign countries and its imports
thus tend to exceed its exports. These become a chronic
phenomenon. And in the absence of a sufficient inflow of foreign
capital in such countries, a secular deficit balance of payments may
result.munotes.in

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1064.10CAUSES AND MEASURES OFDISEQUILIBRIUM
Overall account of BOP is always in equilibrium. This
balance or equilibrium is only in accounting sense because deficit
or surplus is restored with the help of capital account.
In fact, when we talk of disequilibrium, it refers to cur rent
account of balance of payment. If autonomous receipts are less
than autonomous payments, the balance of payment is in deficit
reflecting disequilibrium in balance of payment.
There are several factors which cause disequilibrium in the
BOP indicating either surplus or deficit.
Such causes fordisequilibrium inBOP arelisted below:
(i)Economic Factors:
(a) Imbalance between exports and imports. (It is the main cause of
disequilibrium in BOR), (b) Large scale development expenditure
which causes lar ge imports, (c) High domestic prices which lead to
imports, (d) Cyclical fluctuations (like recession or depression) in
general business activity, (e) New sources of supply and new
substitutes.
(ii)Political Factors:
Experience shows that political ins tability and disturbances
cause large capital outflows and hinder Inflows of foreign capital.
(iii)Social Factors:
(a) Changes in fashions, tastes and preferences of the people bring
disequilibrium in BOP by influencing imports and exports; (b) High
popul ation growth in poor countries adversely affects their BOP
because it increases the needs of the countries for imports and
decreases their capacity to export.
(iv) Other factors;
Cyclical fluctuations
Short fall in the exports
Economic Development
Rapid increase in population
Structural Changes
Natural Calamites
International Capital Movementsmunotes.in

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1074.11MEASURES TO CORRECT DISEQUILIBRIUM IN
THE BOP
1. Monetary Measures :
a) Monetary Policy : The monetary policy is concerned with money
supply and credit in the economy. The Central Bank may expand or
contract the money supply in the economy through appropriate
measures which will affect the prices.
b) Fiscal Policy : Fiscal policy is government's policy on income
and expenditure. Government incurs development and non -
development expenditure. It gets income through taxation and non -
tax sources. Depending upon the situation government expenditure
may be increased o r decreased.
c) Exchange Rate Depreciation By reducing the value of the
domestic currency :, government can correct the disequilibrium in
the BOP in the economy. Exchange rate depreciation reduces the
value of home currency in relation to foreign currency. As a result,
import becomes costlier and export become cheaper. It also leads
to inflationary trends in the country
d) Devaluation :devaluation is lowering the exchange value of the
official currency. When a country devalues its currency, exports
become s cheaper and imports become expensive which causes a
reduction in the BOP deficit.
e) Deflation: Deflation is the reduction in the quantity of money to
reduce prices and incomes. In the domestic market, when the
currency is deflated, there is a decrease in the income of the
people. This puts curb on consumption and government can
increase exports and earn more foreign exchange.
f) Exchange Control : All exporters are directed by the monetary
authority to surrender their foreign exchange earnings, and the total
available foreign exchange is rationed among the licensed
importers. The license -holder can import any good but amount if
fixed by monetary authority
2. Non -Monetary measures :
a) Export Promotion : To control export promotions the country
may ado pt measures to stimulate exports like: export duties may be
reduced to boost exports ;cash assistance, subsidies can be given
to expo rters to increase exports ;goods meant for exports can be
exempted from all types of taxes.munotes.in

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108b) Import Substitutes :S t e p sm a y be taken to encourage the
production of import substitutes. This will save foreign exchange in
the short run by replacing the use of imports by these import
substitutes.
c) Import Control : Import may be kept in check through the
adoption of a wide vari ety of measures like quotas and tariffs.
Under the quota system, the government fixes the maximum
quantity of goods and services that can be imported during a
particular time period.
1. Quotas –Under the quota system, the government may fix and
permit th e maximum quantity or value of a commodity to be
imported during a given period. By restricting imports through the
quota system, the deficit is reduced and the balance of payments
position is improved.
2. Tariffs –Tariffs are duties (taxes) imposed on i mports. When
tariffs are imposed, the prices of imports would increase to the
extent of tariff. The increased prices will reduced the demand for
imported goods and at the same time induce domestic producers to
produce more of import substitutes .
Check you r progress:
1.What do you understand by the disequilibrium in balance of
payments?
2.State the various types of disequilibrium in BOP.
3.State the different causes of disequilibrium in BOP.
4.What are the effects of disequilibrium in BOP?
5.State the monetary measures to correct disequilibrium in BOP.
6.State the non -monetary measures to correct disequilibrium in
BOP.
_____________________________________________________
_____________________________________________________
__________________ ___________________________________
_____________________________________________________
_____________________________________________________
4.12EXPENDITURE CHANGING POLICIES AND
EXPENDITURE SWITCHING POLICIES BOP
ADJUSTMENTS THROUGH MONETARY AND FISCAL
POLICIES
Expenditure Changing and Expenditure Switching policies
In an open economy setting, policymak ers need to achieve
two goals of macroeconomic stability, viz. internal and external
balances. Internal balance is a state in which the economy is at its
potential level of output, i.e., it maintains the full employment of amunotes.in

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109country’s resources and domesti c price levels are stable. External
balance is attained when a country is running neither excessive
current account deficit nor surplus (i.e., net exports are equal or
close to zero). Attaining internal and external balances requires two
independent policy tools (also see Swan diagram). One is
expenditure changing policy and the other is expenditure switching
policy.
Expenditure changing policy aims to affect income and
employment with the goal of equating domestic exp enditure or
absorption and production and takes the form of fiscal or monetary
policy. Expenditure switching is a macroeconomic policy that
affects the composition of a country’s expenditure on foreign and
domestic goods. More specifically it is a policy t o balance a
country’s current account by altering the composition of
expenditures on foreign and domestic goods (see Balance of
payments account). Not only does it affect current account
balances, but it can influence total demand, and thereby the
equilibr ium output level.
4.12.1Internal and External Balances
The interaction between internal and external balances can
be demonstrated through a simple Keynesian model where
consumption is a function of disposable income; current account is
of the real exch ange rate and disposable income (while foreign
income that affects the domestic country’s exports is assumed to
be constant); and investment and government spending are
exogenous. Internal and external balances are:
Internal balance (II): Y = Yf = C (Yf –T) + I + G + CA (EP*/P, Yf –
T)
External balance (XX): CA = CA (EP*/P, Y –T) = XX
where XX is a sustainable amount of current account deficit or
surplus
When the exchange rate is flexible, fiscal expansion --either
government expenditure increase or t ax cuts --raises output, but
worsens current account balances. Conversely, fiscal contraction
improves current account balances, but lowers output. More
specifically, if a country wants to raise its income level through
fiscal expansion, it would have to ex perience a worsening in trade
balances, because expansionary fiscal policy would lead to a rise in
imports through improved disposable income and therefore
worsens current account balances. Or, if a country with a current
account deficit attempts to regain it, it could achieve that by
implementing contractionary fiscal or monetary policy, so that as to
reduce imports.munotes.in

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110When a country wants to achieve both internal and external
balances simultaneously, it is most effective if the country lets the
value of i ts currency change so that change in the real exchange
rate can affect both the economy’s total demand and the demand
for imports. Such policy to achieve current account balances by
manipulating the demand for domestic and foreign goods through
changes in the value of the currency is called expenditure switching
policy.
When expenditure switching policy is not available --that is,
when an economy is under the fixed exchange rate regime --
expenditure changing policy through fiscal policy becomes the only
available policy tool for attaining internal and external balances. In
the fixed exchange rate system, monetary policy becomes
unavailable because it affects the interest rate and the exchange
rate. However, fiscal policy is insufficient to achieve both i nternal
and external balances in such an environment.
4.12.2Effects of Expenditure Changing Policy
Although it is expected that expenditure changing policy with
fiscal policy changes can affect output in the short run regardless of
whether the exchang er a t ei sf l e x i b l eo rf i x e d ,i t se f f e c t ,o rt h e
“multiplier of fiscal policy,” is smaller in a open economy than that in
a closed economy. That is, when fiscal expansion is implemented,
that would increase money demand and thereby the interest rate,
which results in discouraging private investment –the crowd -out
effect. This outcome arises as long as some degree of price
stickiness is assumed. Hence, some of the effect of fiscal
expansion will be offset by the crowding out of investment, which
makes the ov erall effect on income and also net exports (i.e., EX –
IM = S –I) smaller than what could have been if the interest rate
were assumed to be constant. Also the multiplier is smaller the
more open to international trade the economy is, because more
portion of income “leak out” of the system as the demand for
foreign goods.
Expenditure changing policy with monetary expansion, on
the other hand, involves a reduction in the interest rate in the short
run, which expands income and same way; incomes rises whil e
current account worsens in the short run. However, while monetary
expansion favors private investment, fiscal expansion favors
government spending. Under the fixed exchange rate system, while
monetary policy becomes ineffective, the effect of fiscal poli cy can
be larger than under the flexible exchange rate system. When
expansionary fiscal policy is implemented, the interest rate would
rise because of the crowd -out effect, but at the same time, the
central bank would have to implement accommodative, i.e.,
expansionary, monetary policy to cancel the rise in the interest ratemunotes.in

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111–such an action of cancelling the effect on money supply or
interest rate is called sterilization. Otherwise, the interest rate would
be affected, and that would affect the capital flo ws across the
border (given the unchanged foreign interest rate) and therefore the
exchange rate. Because fiscal expansion must be accompanied
with sterilization, the effect of fiscal expansion on output is larger
than that under the flexible exchange rate system where the
exchange rate is allowed to fluctuate to reflect the change in the
interest rate.
4.12.3Effects of Expenditure Switching Policies
Among possible expenditure -switching policies, devaluation
or revaluation is the most focused policy to affect current account
balances and the equilibrium level of output. Devaluation increases
the domestic price of imports and decreases the foreign price of
exports; therefore, it decreases imports and increases exports.
However, whether devaluation leads to an improvement in current
account balances depends upon the elasticities of demand for
exports and imports. According to the Marshall -Lerner condition ,i f
the sum of the elasticities of demand for exports and imports is
greater than one, depreciation of the domestic currency leads to a
current account improvement (see Marshall -Lerner condition).
When an economy attempts to attain both internal and exter nal
balance, expenditure switching policy alone is insufficient. For
example, if an economy is at the full employment level, i.e., internal
balance is already attained, but if it is running current account
deficits, policy makers in the economy could deval ue its currency
so that net exports rise. However, the improvement of current
account balances would lead the economy to experience over -
heating so that internal balance would disappear.
If an economy is experiencing an inflationary gap, or over -
heating , while maintaining balanced current account, a revaluation
policy may reduce total expenditure back to the full employment
level, but lead to current account deficits. Therefore, a policy mix of
expenditure switching and changing policies is usually neces sary to
achieve both internal and external balances (also see Swan
diagram and Assignment problem,). With the assumption that the
Marshall -Lerner condition holds, for any given level of expenditure,
devaluation leads to improvement of net exports, or curre nt
accounts, and therefore, a rise in output. However, when prices are
assumed to be sticky in the short run, expenditure switching policy
with devaluation involves the crowding -out effect. That is, the
increase in output also raises the demand for money a nd
consequently the interest rate, which discourages private
investment. It is the crowding -out effect that offsets part of the
income increase caused by devaluation.munotes.in

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112Hence, the new equilibrium income level will be a little lower
than what could be achi eved if the interest rate could remain
constant. Although devaluation policy is the most focused
expenditure switching policy, it is not the only one. In general,
expenditure policies take the form of trade (control) policy since
they are aimed at affectin gt h ev o l u m e so fe i t h e ro rb o t he x p o r t s
and imports. Tariff policy can be implemented to discourage the
inflow of imports, and export subsidy can be used to encourage
exports, though these policies tend to be industry specific.
The most well -known tariff policy that has been actually
implemented with macroeconomic ramifications is the infamous
Smoot -Hawley Tariff Act of 1930. The goal of this policy was to
switch demand for foreign goods to that for domestic ones at the
expense of other countries to rescu e domestic industries battered
by the Great Depression. This policy, however, was followed by
other countries that also tried to protect their domestic industries,
eventually leading to rapid contraction of international trade.
4.13SUMMARY
1.BOP Adjustme nt
Automatic adjustment and Policy issues
2.Policy Issues
Expenditure changing policy : -Monetary and fiscal policies
Expenditure switching policy : -Devaluation and revaluation
Exchange controls : -Controlling exchange rates
3.https://image.slidesharec dn.com/adjustmentinbalanceofpayment
spolicymeasures -191125173341/95/bop -adjustment -policy -
measures -4-638.jpg?cb=1576259175 EXPENDITURE CHANGIN G
POLICY: MONETARY & FISCAL POLICIES
Expenditure changing policy for BOP adjustment:
Mone tary Policy: Through changes in money supply and rate of
interest
Fiscal policy: Through changes in government expenditure and
taxes
FISCAL POLICYAND BOP ADJUSTMENT
4.Initial Position of the Economy
•I n t e r n a la n de x t e r n a lb a l a n c e
• Economy has equilib rium income and rate of interest
•I nt h eI S -LM-BP framework, income is ‘Y*’ and interest rate is ‘r*’
• At ‘Y*’ and ‘r*’ economy is in equilibriummunotes.in

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113• Income -interest rate combination in which internal balance and
external balance can be achieved
5.https://image.slidesharecdn.com/adjustmentinbalanceofpayment
spoli cymeasures -191125173341/95/bop -adjustment -policy -
measures -8-638.jpg?cb=1576259175 IS-LM-BP model
6.Disturbance Occurs in BOP
• Due to increase in government expenditure (G)
•Gh a sm u l t i p l i e re f f e c t
• It will shift the IS curve to the right
•I S 1w i l l be the new curve
• Equilibrium shifts from E to H
• Increase in G leads to reduction in fund for private investment -it
pushes the interest rate
• Change in rate of interest and income will disturb the BOP
equilibrium
7.What Type of Disturbance? BOP def icit
• Increase in G leads to increase in income
• It increases the import
• Deficit on current account • It depends on MPI
8.BOP surplus
• Increase in G will hike the rate of interest
• It will attract capital inflow
• Surplus on capital account
•It depends on interest elasticity of capital flows
9.Effect of Government Expenditure
• Two effects in tandem
• Increase in rate of interest and income
• Increase in r leads to capital inflow
• Increase income leads to increase in import
• Current acc ount deficit and capital account surplus
•T h u sf i n a l l yB O Pw i l lb ei ne q u i l i b r i u m
10.Whether final outcome would be equilibrium?
• It depends on strength and weakness of current account deficit
and capital account surplus
• If surplus is unable to correc t deficit, equilibrium cannot be
achieved
11.What happens to BOP when govt. expenditure reduces?
• Income reduces
• Interest rate reduces
• Import reduces -current account surplus
•C a p i t a lo u t f l o w -capital account deficit.munotes.in

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11412.Monetary Policy & Bop Adjustment
• What happens to BOP when there is any change in money
supply?
• What happens to BOP when money supply increased?
• What happens to BOP when money supply decreased?
13.Difference from fiscal policy
• Impact of fiscal policy on BOP is conditional
•D e p e n d s on value of income multiplier, MPI and interest elasticity
of capital flows
• Impact of monetary policy on BOP is certain
• Any change in money supply will disturb BOP equilibrium
14.Two chances : Increase in money supply OR Decrease in
money supplyIncre ase in Money Supply & CurrentAccount
• Income will increase
• Import will increase
• Current account deficit will be resulted
15.Increase in Money Supply & CapitalAccount
• Rate of interest will diminish
•C a p i t a lo u t f l o ww i l lh a p p e n
• Capital account deficit will emerge
16.Increase in Money Supply & BOP equilibrium
• Both current account deficit and capital account deficit
• It surely disturb the BOP equilibrium
17.Decrease in Money Supply & Current Account
• Reduce the income
• Reduce import
• Reduce current account deficit
18.Decrease in Money Supply & Capital Account
• Interest rate increases
•C a p i t a li n f l o ww i l lh a p p e n s
• Capital account deficit will diminish
19.Decrease in Money Supply & BOP Equilibrium
•Both current account surplus and capital account surplus
• It surely disturb the BOP equilibrium
20.Why don’t decrease in money supply for persistent BOP
surplus?
• We need more income
• We need economic growth
• We need economic welfare
•W en e e dt or educe interest rate to boost investment
• We need to give priority to income rather than external sector
balancemunotes.in

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11521.Expenditure Switching Policy: Devaluation & Revaluation
Expenditure switching policy
•D e v a l u a t i o na n dR e v a l u a t i o nf o rB O Pe q u i l i b r i u m
•F o c us on current account balance
• During current account deficit (CAD) devaluation is recommended
• During current account surplus (CAS) revaluation is
recommended
22.Devaluation • Used during CAD
• Deliberate reduction in the value of a country’s currency
• To reduce deficit through increasing export and reducing import •
How?
• When currency value diminish, foreigners can purchase more
• They wish to buy from domestic economy
• It boosts export
23.Success of devaluation depends on …….
•Elasticities of demand for imported and exported commodities
• Elastic demand is required for improvement in BOP
• Market access for the foreign traders
• Need less restricted economy
• Export tax should be removed
• Production capacity of the econom y
•N e e dt ob ea b l et op r o d u c ew h a ti sr e q u i r e db yf o r e i g nc o u n t r i e s
• Domestic price stability
• International co -operation (No currency war is desirable)
24.Why devaluation is expenditure switching policy?
• Devaluation leads in reduction in import and increase in export
• Expenditure of domestic economy on foreign commodities switch
over to domestic commodities
• Expenditure of foreigners switch over to domestic commodities
25.Devaluation for Internal and External Balance
• Insufficient for both
•Devaluation can bring external balance equilibrium
• Devaluation alone cannot bring both equilibrium
• Suppose an economy has internal balance and external
imbalance
• Devaluation was resorted to correct external imbalance
•I n t e r n a lb a l a n c ew i l lb ed isturbed when price structure changes
26.Suppose an economy has internal imbalance and external
balance
• No scope for devaluationRevaluation
• Used during CAS
• Deliberate increase in the value of a country’s currency
• To reduce surplus through increasi ng import and reducing export •
How?munotes.in

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116• When currency value increases, foreigners can purchase only
less
• They wish to sell at domestic economy
• It boosts import
27.Whether devaluation & revaluation are the only parts of
expenditure switching policy?
•Certainly no
•B u tt h e s ea r em a j o rp a r t s
• Tariff policy is an expenditure switching policy
• It helps switch expenditure from one economy to another
• Through change in import and export
28.Need for Policy Mix
• Only one policy cannot ensure BOP equil ibrium
• Use of both expenditure changing and switching policies for BOP
equilibrium
• That is a combination of fiscal policy, monetary policy, devaluation
and revaluation
• Different effects of various policies will work together
•B o t hi n t e r n a la n de xternal balance have to be ensured
29.Exchange Controls
What is exchange control?
• Various forms of controls imposed by a government/central bank
on currency
• Control on purchase/sale of foreign currencies by residents •
Control on purchase/sale of local currency by non -residents • It is
a drastic means of BOP adjustment
30.Common exchange controls
• Banning the use of foreign currency within the country
• Banning locals from possessing foreign currency
•Restricting cur rency exchange to government -approved
exchangers
• Fixed exchange rates
• Restrictions on the amount of currency that may be imported or
exported
31.Objectives of exchange controls
• To reduce import
• To control capital flight
• To ensure economic grow th by permitting governments to follow
independent domestic policies
• To service external debt: Need required foreign exchange
repayment and interest payment
• During 1930s this was the objective in many debtor countriesmunotes.in

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11732.To ensure exchange rate stability
• With partner country’s or regions’ currency
• To over value domestic currency
• To make import cheaper
• To import raw materials and capital goods at less price
• To reduce the foreign debt burden (Austria, Hungary and
Germany did this during 1930s afterWorld War I)
• To under value domestic currency
• To make export cheaper
• To make import dearer
33.Methods o f Exchange Controls
Methods Direct methods of exchange control
•Related with exchange rate and foreign currency Indirect methods
of exchange control
• Tariff, export subsidy, bilateral and multi -lateral arrangements
1)Foreign exchange rate regulation through intervention
• Government intervention in foreign exchange market
• Buy or sell foreign exchange
• To control excess fluctuation
• If there is increasing rate (domestic currency in depreciation),
foreign exchange will be sold
• If there is decreasing rate (domestic currency in appreciation),
foreign exchange w ill be bought
2)Exchange restrictions
• More severe form of exchange control
• Foreign exchange earnings may be directed to surrender
• People may be given no freedom to carry foreign exchange • Not
desirable in the liberalised period
•( F E M Aa n dF E R A )
Why foreign exchange may be held?
•T o u ra n dt r a v e l
• Investment in foreign financial market
• Investment in foreign exchange market
•T r a n s f e rp a y m e n t s
• Import bill settlement
3)Multiple exchange rate policies
• Different exchange rates may be adop ted
• Also called selective devaluation policy
• One rate (lower) to make export cheaper
• One rate (lower) to make import of essential goods cheaper
• Or dual exchange rate
• Lowering the value to increase certain exports
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1184)Exchange clearing agreements
•B i l a t e r a lo rm u l t i -lateral
•F o ri n t e r n a t i o n a lc o -operation in the fields of trade, investment,
migration, tourism, supply of arms etc.
5)Indirect methods of exch ange control
• Tariff • Import duty reduces the import
• Less exchange transactions will be the result
•I m p o r tq u o t a s
• Depress the import
• Less exchange transactions will be the result.
4.14 QUESTIONS
1.Explain the meaning and structure of Balance of Payments.
2.‘Balance of Payment always balances’, examine the statement.
3.What are the factors affecting Balance of Payments?
4.Why Balance of Payments is important to a country?
5.Explain the role of foreign exchange reser ves in Balance of
Payments.
6.Explain the meaning and types of disequilibrium in Balance of
Payments.
7.What are the causes of disequilibrium in Balance of Payments?
8.Discuss the measures to correct disequilibrium in Balance of
Payments.
9.Explain the role of monetary and fiscal policies in correcting
balance of payments diequibrium.
munotes.in

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119Unit-Four -“International aspects of Macroeconomic policy”
Unit -4A
THE MUNDELL -FLEMING MODEL
Unit Structure:
4A.0 Objectives
4A.1 Introduction
4A.2 Meaning ofTheMundell -Fleming Model
4A.3 Assumptions
4A.4 Variables
4A.5 TheOpen Economy isCurve
4A.6 General Equilibrium
4A.7 Main Message ofMundell -Flemming Model
4A.8 Devaluation, Revaluation as Expenditure Switching Policies
4A.9 Expenditure –Switching Policies: Devaluation
4A.10 Income -Absorption Approach toDevaluation
4A.11 Devaluation andTheBalance ofTrade: TheJCurve
4A.12 Understanding A J Curve
4A.13 J-Curve Effect
4A.14 Devaluation and Inflation
4A.15 Summary
4A.16 Questions
4A.0 OBJECTIVES
To enable the learners to grasp fully the theoretical rationale
behind policies at the country as well as corporate level.
To receive a firm grounding on the basic macroeconomic
concepts that strengthen analysis of crucial economic policies.
4A.1 INTRODUCTION
In an open economy with external trade and financial
transactions, how are the key macro variables (GDP, inflation,
balance of payments, exchange rates, interest rates, etc)
determined and interact with each other? Wh at are the effects of
fiscal and monetary policies? The Mundell -Fleming model is the
standard open macroeconomic model that tries to answer these
questions.munotes.in

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120The IS -LM-BP model (also known as IS -LM-BoP or Mundell -
Fleming model) is an extension of the IS-LMmodel , which was
formulated by the economists Robert Mundell andMarcus Fleming ,
who made almost simultaneously an analysis of open economies in
the 60s. Basically we could say that the Mundell -Fleming model is a
version of the IS -LM model for an open econ omy. In addition to the
balance in goods and financial markets, the model incorporates an
analysis of the balance of payments .
Even though both economists researched about the same
topic, at about the same time, both have different analyses.
Mundell’s paper “Capital Mobility and Stabilization Policy under
Fixed and Flexible Exchange Rates”, 1963, analyses the case of
perfect mobility of capital , while Fleming´s model, depicted in his
article “Domestic Financial Policies under Fixed and under Floating
Exchange Rates”, 1962, was more realistic as it assumed imperfect
capital mobility, and thus made this one a more rigorous and
comprehensive model. However, nowadays, his model has lost
cogency, as the actual world situation has more resemblance with
total capital mobility, which corresponds better to Mundell’s view.
In order to understand how this model works, we’ll first see
how the IS curve, which represents the equilibrium in the goods
market, is defined. Secondly, the LM curve, which represents the
equilibrium in the money market. Thirdly, the BP curve, which
represents the equilibrium of the balance of payments. Finally, we’ll
analyse how the equilibrium is reached.
4A.2MEANI NGOFTHE MUNDELL -FLEMING MODEL
The basic Mundell -Fleming model —like the IS-LM model —
is based on the assumption of fixed price level and shows the
interaction between the goods market and the money market.The
model explains the causes of short -run fluctuations in aggregate
income (or, what comes to the same thing, shifts in t he ad curve) in
an open economy.
The Mundell -Fleming model is based on a very restrictive
assumption. It considers a small open economy with perfect capital
mobility.
This means that the economy can borrow or lend freely from
the international capital ma rkets at the prevailing rate of interest
since its domestic rate of interest is determined by the world rate of
interest. So, the rate of interest is not a policy variable in the small
economy being studied.
This means that macroeconomic adjustment occu rs only
through exchange rate changes. In other words, the brunt ofmunotes.in

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121adjustment is borne by exchange rate movements in foreign
exchange markets to maintain the officially determined exchange
rate. The central bank permits the exchange rate to move up or
down in response to changing economic conditions.
4A.3ASSUMPTIONS
Basic assumptions of the model are as follows:
Spot and forward exchange rates are identical, and the existing
exchange rates are expected to persist indefinitely.
Fixed money wage rate, une mployed resources and
constant returns to scale are assumed. Thus domestic price
level is kept constant, and the supply of domestic output is
elastic.
Taxes and saving increase with income.
The balance of trade depends only on income and the
exchange rate.
Capital mobility is less than perfect and all securities are perfect
substitutes. Only risk neutral investors are in the system. The
demand for money therefore depends only on income and the
interest rate, and investment depends on the interest rate.
The country under consideration is so small that the country
cannot affect foreign incomes or the world level of interest rates.
4A.4VARIABLES
This model uses the following variables:
YisrealGDP
Cis real consumption
Iis real physical investment, includ ing intended inventory
investment
Gis real government spending (anexogenous variable)
Mis the exogenous nominal money supply
Pis the exogenous price level
iis the nominal interest rate
Lis liquidity preference (real money demand)
Tis real taxes levied
NXis real net exports
The basic assumption of this model is that the domestic rate
of interest (r) is equal to the world rate of interest (r*) in a small
open economy with perfect capital mobility. No doubt any change
within the domestic economy m ay alter the domestic rate of
interest, but the rate of interest cannot stay out of line with the world
rate of interest for long.munotes.in

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122The difference between the two, if any, is removed quickly
through inflows and outflows of financial capital.
It may be rec alled that “smallness” of a country has no
relation to its size. A small country is one which cannot alter the
world rate of interest through its own borrowing and lending
activities. In contrast, a large economy is one which has market
(bargaining) power so that it can exert influence over the world rate
of interest.For such a country, either international capital mobility is
far from perfect, or the country is so large that it can exert influence
on world capital markets.
The main prediction from the Mun dell-Fleming model is that
the behaviour of an economy depends crucially on the exchange
rate system it adopts, i.e., whether it operates a floating exchange
rate system or a fixed exchange rate system. We start with
adjustment under a floating exchange ra te system, in which case
there is no central bank intervention in the foreign exchange
market.
In such a situation, if the domestic interest rate goes above
the world rate, foreigners will start lending to the home country.
This capital inflow will create excess supply of funds and the
domestic rate of interest r again will fall to r*.
The converse is also true. If, for some reason, the domestic
rate of interest (r) falls below r*, there will be capital outflow from
the home country and the resulting shor tage of funds will push up r
to the level of r*. Thus, in a world of perfect capital mobility, r will
quickly get adjusted to r*.
Check your progress:
1. State the assumptions of Mundell -Fleming Model.
2. Discuss the various variables in Mundell -Fleming Model.
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________ ________________________________
4A.5 THE OPEN ECONOMY ISCURVE
Inthe Mundell -Fleming model, the market forgoods and
services isexpressed bythefollowing equation:
Y=C ( Y –T) + I(r*) + G + NX(e) … (1)
where all the terms have their usual meanings. Here investment
depends on the world rate of interest r* since r = r* and NXmunotes.in

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123depends on the exchange rate e which is the price of a foreign
currency in terms of domestic currency.
In the Mundell -Fleming model, it is assumed that the price
levels at home and abroad remain fixed. So, there is no difference
between real exchange rate and nominal exchange rate. We now
illustrate the equation of the goo ds market equilibrium in Fig. 4A .1.
Fig 4A .1 The New is Curve
In part (a), an increase in the rate from e 0to e 1,l o w e r sn e t
exports from NX(e 0)t oN X ( e 1). As a result, the planned expenditure
line E 1shifts downward to E 0. Consequently, income falls from Y 1to
Y0. In part (c), we show the new IS curve, which is the locus of
points, indicating alternative combinations of e and Y which ensure
equilibrium in the goods market.
Thenew IScurve isderived byfollowing thissequence:
e rises →NX falls →Yf a l l s
TheOpenEconomy LMCurve:
Theequilibrium condition ofthemoney market intheMundell -
Fleming model is:
M = L(r*, Y) … (2)
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124Here the supply of money equals its demand and demand
for money varies inversely with r* and the posi tively with Y. In this
model, M remains exogenously fixed by the central bank.
The n ew LM curve, as shown in Fig. 4A .2(b), is vertical —
since the equation (2) has no relation to the exchange rate. This
equation deter mines only Y, whet her e is high or low. In Fig.
4A.2(a) , we draw the closed economy LM curve as also a horizon -
tal line showing parity between r and r*.
The intersection of the two curves at the point A determines
the equilib rium level of income Y 0, which has no relation to e,
shown on the vertical axis of F ig. 4A .2(b). This is why the new
(open economy) LM curve is vertical. The LM Ncurve of Fig. 4A .2(b)
is derived from r* and the closed ec onomy LM curve, shown in Fig.
4A.2(a).
Fig 4A.2 The New is Curvemunotes.in

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1254A.6 GENERAL EQUILIBRIUM
In the Fig. 4A .3, we show the general equilibrium of goods market
and the money market. The equilib rium income (Y 0) and exchange
rate (e 0) are determined simultaneously at point A where the IS and
LM curves intersect.
Fig 4A. 3 General Equilibrium in MF Model
4A.7MAIN MESSAGE OFMUNDELL -FLEMMING
MODEL
The main message of the Mundell -Fleming model is that the
effect of any economic policy (fiscal, monetary or trade) depends
on the exchange rate system of the country under consideration,
i.e., whether the country is following a fixed or a floatin g exchange
rate system. Table 4A .1 summarises the effects of three different
policies in the Mundell -Fleming model.
Table: 4A.1The Effects ofThree Types ofPolicies inthe
Mundell -Fleming Model
The Mundell -Fleming model shows how to make appropriate
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126macroeconomic objective. The influence of these policies depends
on the exchange rate system. Under floating exchange rate system,
only monetary policy can alter national income.
The effect of expansionary fiscal policy is totally neutralized
by currency appreciation. Under fixed exchange rate system, only
fiscal policy can alter Y. The central bank loses control over money
supply since it has to be adjusted upward or downward for
maintaining the exchange rate at a predetermined level.
4A.8DEVALUATION, REVALUATION AS
EXPENDITURE SWITCHING POLICIES
Devaluation , reduction in the exchange value of a
country’s monetary unit in terms of gold, silver, or
foreign monetary units. Devaluation is employed to eliminate
persistent balance -of-payments deficits. For example, a devaluation
of currency will decrease prices of the home country’s exports that
are purchased in the import country’s currency . While making the
exported goods cheaper for other countries, devaluation also
increases the prices of imports purchased in the home country. If
the demand for both exports and imports is relatively elastic (that is,
the quan tity purchased is highly responsive to changes in price),
the country’s income from exports will rise, and its expenditure for
imports will fall. Thus, its trade will be more in balance and
itsbalance of payments improved. Devaluation will not be effective
if the balance -of-payments disequilibrium is a result of basic
structural flaws in a country’s economy.
In contrast to devaluation, revaluation involves an increase
in the exchange value of a country’s monetary unit in terms of gold,
silver, or foreign monetary units. It may be undertaken when a
country’s currency has been undervalued in comparison with
others, causing persistent balance -of-payme nts surpluses.
A revaluation is a calculated upward adjustment to a country's
official exchange rate relative to a chosen baseline, such as
wage rates, the price of gold, or a foreign currency.
In a fixed exchange rate regime, only a country's government,
such as its central bank, can change the official value of the
currency.
In floating exchange rate systems, currency revaluation can be
triggered by a variety of events, including changes in the
interest rates between various countries or large -scale even ts
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1274A.8.1Understanding a Revaluation
In a fixed exchange rate regime, only a decision by a
country's government, such as its central bank, can alter the official
value of the currency. Developing economies are more likely to
useaf i x e d -rate system in order to limit speculation and provide a
stable system. A floating rate is the opposite of a fixed rate. In a
floating rate environment, revaluation can occur on a regular basis,
as seen by the observable fluctuations in the foreign currency
market and the associated exchange rates.
4A.9EXPENDITURE –SWITCHING POLICIES:
DEVALUATION
A significant method which is quite often used to correct
fundamental disequilibrium in balance of payments is the use of
expenditure -switching policies. Expenditure switching policies work
through changes in relative prices. Prices of imports are increased
by making domestically produced goods relatively cheaper.
Expenditure switching policies may lower the prices of exports
which will encourage exports of a country. In this way by changing
relative prices, expenditure -switching poli cies help in correcting
disequilibrium in balance of payments.
The impo rtant form of expenditure switching policy is the
reduction in foreign exchange rate of the national currency, namely,
devaluation. By devaluation we mean reducing the value or
exchange rate of a national currency with respect to other foreign
currencies. It should be remembered that devaluation is made
when a country is under fixed exchange rate system and
occasionally decides to lower the exchange rate of its currency to
improve its balance of payments.
Under the Bretton Woods System adopted in 1946, fix ed
exchange rate system was adopted, but to correct fundamen tal
disequilibrium in the balance of payments, the countries were
allowed to make devaluation of their currencies with the permission
of IMF. Now, Bretton Woods System has been abandoned and
most of the countries of the world have floated their currencies and
have thus adopted the system of flexible exchange rates as
determined by market forces of demand for and supply of them.
However, even in the present flexible exchange rate system,
the value of a currency or its exchange rate as determined by
demand for and supply of it can fall. Fall in the value of a currency
with respect to foreign currencies as determined by demand and
supply conditions is described as depreciation.
If a country permits its currency to depreciate without taking
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128devaluation. Thus, in our analysis we will discuss the effects of fall
in value of a currency whether it is brought about through
devaluation or depreci ation. In July 1991, when India was under
Bretton -Woods fixed exchange rate system, it devalued its rupee to
the extent of about 20%. (From Rs. 20 per dollar to Rs. 25 per
dollar) to correct disequilibrium in the balance of payments.
Now, the question is how devaluation of a currency works to
improve balance of payments. As a result of reduction in the
exchange rate of a currency with respect to foreign currencies, the
prices of goods to be exported fall, whereas prices of imports go
up. This encourages e xports and discour ages imports. With exports
so stimulated and imports discouraged, the deficit in the balance of
payments will tend to be reduced.
Thus policy of devaluation is also referred to as expenditure
switching policy since as a result of reduct ion of imports, people of
a country switches their expenditure on imports to the domestically
produced goods. It may be noted that as a result of the lowering of
prices of exports, export earnings will increase if the demand for a
country’s exports is pric e elastic (i.e., e r> 1). And also with the rise
in prices of imports the value of imports will fall if a country’s
demand for imports is elastic. If demand of a country for imports is
inelastic, its expenditure on imports will rise instead of falling due to
higher prices of imports.
Devaluation: Marshall Lerner Condition. It is clear from above that
whether devaluation or depreciation will lead to the rise in export
earnings and reduction in import expenditure depends on the price
elasticity of foreign de mand for exports and domestic demand for
imports.
Marshall and Lerner have developed a condition which
states that devaluation will succeed in improving the balance of
payments if sum of price elasticity of exports and price elasticity of
imports is great er than one. Thus, according to Marshall -Lerner
Condition, devaluation improves balance of payments if
ex+em>1
where
exstands for price elasticity of exports
emstands for price elasticity of imports
If in case of a country e x+e m<1 ,t h e devaluation will
adversely affect balance of payments position instead of improving
it. If e x+e m= 1, devaluation will leave the disequilibrium in the
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1294A.10 INCOME -ABSORPTION APPROACH TO
DEVALUATION
Further, for devaluation to be successful in correcting
disequilibrium in the balance of payments a country should have
sufficient exportable surplus. If a country does not have adequate
amount of goods and services to be exported, fall in their prices
due to devaluati on or depreciation will be of no avail.
This can be explained through income -absorption approach
put forward by Sidney S Alexander. According to this approach,
trade balance is the difference between the total output of goods
and services produced in a co untry and its absorption by it.
By absorption of output of goods and services we mean how
much of them is used up for consumption and investment in that
country. That is, absorption means the sum of con sumption and
investment expenditure on domestically produced goods and
services.
Expressing algebraically wehave;
B=Y –A
Where:
B = trade balance or exportable surplus
Y = national income or value of output of goods and services
produced
A = Absorption or sum of consumption and investment expenditure
It follows from above that if expenditure or absorption is less
than national product, it will have positive trade balance or
exportable surplus. To create this exportable surplus, expenditure
on domestically produced consumer and investment goods should
be reduced or national product must be raised sufficiently.
To sum up, it follows from above that for devaluation or
depreciation to be successful in correcting disequilibrium in the
balance of payments, the sum of price elasticities of demand for a
countr y s exports and imports should be high (that is, greater than
one) and secondly it should have sufficient exportable surplus. The
devaluation will also not be successful in the achievement of its aim
if other countries retaliate and make similar devaluatio ni nt h e i r
currencies and thus competitive devaluation of the exchange rate
may start.
After Independence India devalued its currency three times,
first in 1949, the second in June 1966 and third in July 1991 to
correct the disequilibrium in the balance o f payments. The devalua -
tion of June 1966 was not successful for some time to reduce
deficit in the balance of payments.munotes.in

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130This is because the demand for bulk of our traditional
exports was not very elastic and also we could not reduce our
imports despite th eir higher prices. However devaluation of July
1991 proved quite successful as after it our exports grew at a rapid
rate for some years and growth of imports remained within safe
limits.
4A.11 DEVALUATION AND THEBALANCE OF
TRADE: THE JCURVE
What Is a J Curve?
A J Curve is an economic theory which states that, under
certain assumptions, a country's trade deficit will initially worsen
after the depreciation of its currency —mainly because in the near
term higher prices on imports will have a greater impac to nt o t a l
nominal imports than the reduced volume of imports. This results in
a characteristic letter J shape when the nominal trade balance is
charted as a line graph.
The J Curve is an economic theory that says the trade deficit
will initially worsen af ter currency depreciation.
The nominal trade deficit initially grows after a devaluation, as
prices of exports rise before quantities can adjust.
Then, as quantities adjust, there is an increase in imports as
exports remain static, and the trade deficit sh rinks or reverses
into a surplus forming a “J” shape.
The J Curve theory can be applied to other areas besides trade
deficits, including in private equity, the medical field, and
politics.
4A.12UNDERSTANDING A J CURVE
The J Curve operates under the theory that the trading
volumesofimportsandexportsfirstonlyexperience microeconomic ch
anges as prices adjust before quantities. Then, as time progresses,
export volumes begin to dramatically increase, due to their more
attractive prices to foreign buyers. Simultaneously, domestic
consumers purchase less imported products, due to their higher
costs.
These parallel actions ultimately shift the trade balance, to
present an increased surplus (or smaller deficit), compared to those
figures before the devaluatio n. Naturally, the same economic
rationale applies to the opposite scenarios —when a country
experiences a currency appreciation, this would consequently result
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131The lag between the devaluation and the response on the
curve is mainly due to the effect that even after a nation’s currency
experiences a depreciation, the total value of imports will likely
increase. However, the country's exports remain static until the pre -
existing trade contracts play out.
Over the long hau l, large numbers of foreign consumers may
bump up their purchases of products that come into their country
from the nation with the devalued currency. These products now
become cheaper relative to domestically -produced products.
4A.13J-CURVE EFFECT
The J Curve effect a depreciation in the exchange rate can
cause a deterioration of the current account in the short -term
(because demand is inelastic). However, in the long -term, demand
becomes more price elastic and therefore, the current account
begins to im prove.
The J -Curve is related to the Marshall -Lerner condition, which
states:
If (PED x + PED m > 1) then a devaluation will improve the
current account.
The J -Curve is an example of how time lags can affect
economic policy. It also shows the link betwee n microeconomic
principles (elasticity) and macroeconomic outcomes (current
account). The current account on the balance of
payments measures the net value (X -M) of exports and imports of
goods, services and investment incomes.
4A.13 .1Short -term effect ofdepreciation
Figure 4A.4munotes.in

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132In the short -term, a fall in the price of exports will only cause a
smaller percentage rise in quantity demanded.
A rise in the price imports will cause a smaller percentage fall in
demand for imports. Therefore, the value of imports actually rises
(we spend more on imports)
Therefore, if demand is inelastic, following a depreciation, we
actually get a worsening of th e current account
4A.13 .2 Long -term effects
Figure 4A.5
In the long -term, demand for exports and imports will tend to
become more price elastic. (more sensitive to price)
Therefore, a fall in the price of exports will cause a bigger
percentage rise in quantity demand. (And therefore we get a bigger
rise in the value of exports) When demand is elastic, the value of
exports rises –and we get an improvement in the current acc ount
position.
Also, if demand for imports is price elastic, then there will be
a bigger percentage fall in demand for imports. In this case, the
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133
Figure 4A .6
In the future, the trade deficit may continue to improve if global
demand picks up.
4A.13 .3Why is demand more price elastic in the long -term?
Figure 4A.7
In the short -term, firms and consumers may have contracts to
keep buying the good.
It takes time to find alternatives.
The higher price of imports will be an incentive for domestic
firms to increase production, but this takes time
Elasticity andtimemunotes.in

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1344A.13.4Evaluation of the J -Curve effect
Many factors affect the current account apart from the
exchange rate
The current account will depend on consumer spending and the
rate of economic growth.
It also depends on consumer spending in foreign countries
(hence demand for exports)
It depends on Inflation (e.g. depreciation can cause imported
inflation which reduces the competitiveness of exports)
Firms may engage in insurance policies to hedge again st
exchange rate movements.
The Marshall Lerner condition
This states that, for a currency devaluation to lead to an
improvement (e.g. reduction in deficit) in the current account, the
sum of price elasticity of exports and imports (in absolute value)
must be greater than 1.
If (PED x + PED m > 1) then a devaluation will improve the
current account.
If (PED x + PED m > 1) then an ap preciation will worsen the
current account.
This is because the effect on the current account depends
on the total value and not just the quantity of exports.
4A.14.5 Example US depreciation and current account
Figure 4A.8
From early 2002 to 2008, there is a steady depreciation in the US
dollar.munotes.in

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135
Figure 4A.9
From 2002 to 2006, there is a deterioration in the current
accou nt (also caused by strong domestic consumption)
After 2006, there is a sharp improvement in the current account.
Suggesting that the J -Curve may be coming into play –the
current account is finally responding to the depreciation in the
dollar.
However, the sharp improvement in the current account from
2006 was also due to the slowdown in the US economy and a
decline in consumer spending on imports.
4A.14.6 Example UK devaluation 2008 -09
Figure 4A.10
Sharp devaluation in the value of the pound from 2007 to 2009.
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136
Figure 4A.11
During the depreciation of 2007 -09, there is no discernable
improvement in the UK current account –it is volatile, but remains
in deficit.In the longer -term, after the depreciation, we might expect
an improvement in the current account, but actually, it w orsens.This
is not helpful for trying to prove the J -Curve effect. But, it shows
many factors can influence the current account balance of
payments other than the exchange rate. This includes
State of the economy (in a recession demand for import
spending falls)
Consumer demand in other countries (e.g. Eurozone recession
hit demand for UK exports)
Productivity and competitiveness of manufacturing industries –
relative to main competitors.
Lowering of the value of a currency of a country tends to
raise its exports by making its goods cheaper for foreigners. On the
other hand, devaluation or depreciation makes the imports from
abroad expensive in terms of domestic currency (rupees in case of
India) and therefore the imports tend to fall.With exports increasing
and imports declining, it is expected that devalua tion (depreciation)
will reduce a country’s trade deficit. As a matter of fact, in recent
years when a country experienced a severe dis equilibrium in the
balance of trade or balance of payments, it de valuated its currency
to raise exports and reduce imports and thus to restore equilibrium
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137However, it may be noted that the effect of devaluation or
depreciation on balance of trade is ambiguous and quite uncertain
because a good deal depends on the price elasticity of ex ports and
imports of a country. For example, if the price -elasticity of exports in
terms of a foreign currency of a country is less than unity, t he value
of exports in terms of a foreign currency will fall as increase in
physical volume of exports will be more than offset by the
depreciation of the currency. On the other hand, if the demand for
imports is in elastic, they will not decrease despite devaluation.
Many economists are of the view that devalua tion is likely to
worsen the balance of trade for the few quarters (probably three to
six) after the initial devaluation. However, they think after a time lag,
the balance of trade may improve. In fact, a concept called J. Curve
effect has been put forward. According to this, after the initial
depreciation the balance of trade moves according to the shape of
the letter J.
This means that in the first few quarters following
devaluation the balance o f trade becomes worse and after that it
becomes positive and starts improving. This J -curve effect is shown
in Fig.4A.12 where along the X -axis we measure time, that is,
quarters after devaluation and on the Y -axis we measure the
balance of trade. If the value of balance of trade is positive, that is,
if the balance of trade lies above the zero line and the curve rises
the balance of trade improves.
Figure 4A.12 The Effect of Devaluation o nt h eB a l a n c eo f
Trade: The J. Curve
If the balance of trade is negative, it will be below the zero
line and if the curve slopes down, it implies that balance of trade
worsens . It will be seen from Fig.4A.12 that in the first few quarters,
the balance of trade remains negative and also deteriorating and
then starts improving and ultimately in the long run turns positive.
Now, pertinent question arises how the .J -curve comes
about. We will explain this with re ference to devaluationmunotes.in

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138(depreciation) of rupee. It may be recalled here that balance of
trade is equal to the value of exports minus value of imports. Thus;
Balance of Trade = Value of Exports in Rupees –Value of Imports
in Rupees
It may be noted that value of both exports and imports is
equal to the volume of exports or imports multiplied by the rupee
price of exports and imports respectively. The depreciation (devalu -
ation) of the currency affects both the volume and rupee price of
exports and imports . First, depre ciation (devaluation) of currency
increases the volume of exports and reduces the volume of
imports, both of which have a favourable effect on the balance of
trade, that is, they will lower the trade deficit or increase the trade
surplus.
Secondly, as a result of devaluation, rupee -price of exports
is not likely to change much in the short run. The rupee -price of
exports depends on the domestic price level and, in the short run,
the devaluation (depreciation) of rupee will have only a very s mall
effect on the domestic price level.
On the other hand, the rupee -price of imports increases
immediately after devaluation. Imports into India from abroad would
be more costly because as a result of devaluation a hundred rupee
note will buy fewer US dollars and pound sterling’s than before.
Thus, a rise in the rupee -price of imports has a negative effect on
the balance of trade, that is, it will tend to increase the trade deficit
or reduce the trade surplus.
Price effect and quantity ef fect of devaluation. An example
will make clear the negative effect of depreciation or devaluation on
the balance of trade as a result of devaluation or deprecia tion.
Suppose the rupee cost of a particular US machine goes up from
Rs. 50,000 to 60,000 foll owing the devaluation of rupee from Rs. 46
per dollar to Rs. 44 per dollar.
Thus with the rise in price of a US machine, Indians will
spend more on a US machine than before. This is a price effect.
But increase in the price of the US machine will lead to the
decrease in the quantity demanded of US machines by the Indians.
This is the quantity effect. Now, the net effect of devaluation on the
value of imports depends on whether quantity effect is larger than
price effect or vice versa. And this depends on t he price elasticity of
imports.
It therefore follows that net effect of devaluation
(depreciation) on the balance of trade could go either way. The
historical experience shows that initially the negative effectmunotes.in

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139predominates. This is because whereas the ef fect of
devaluation/depreciation on the price of imports is quite fast, it
takes some time for quantity of imports to decline in response to the
rise in rupee -price of imports and the value of exports to increase in
response to the fall in price of exports in terms of foreign currency.
According to the J -Curve Effect, the initial effect of
devaluation/depre ciation on the balance of trade is negative and
when in the long run i mports and exports adjust to the changes in
prices, the net effect on the balance of trade becomes positive. The
more price elastic is the demand for exports and imports, the
greater the improvement in the balance of trade in the long run.
4A.14 DEVALUATION AND INFLATION
The devaluation or depreciation of currency tends to raise
the price level in the country and thus increase the rate of inflation.
This happens because of two reasons. As a result of depreciation/
devaluation, prices of imported goods rise. In case of imports of
consumer goods rise in their prices directly leads to the increase in
the rate of inflation.
In case of imports of capital goods and raw materials, the
rise in their import prices will not only directly raise the price le vel
but as they are used as inputs in the production of other goods, rise
in their imports prices will also push up the cost of production of
these other goods and thus will bring about cost -push inflation.
Second, depreciation makes the exports cheaper a nd
therefore more com petitive in the world markets. This causes the
exports of goods to increase and reduces the supply and
availability of goods in the domestic market which tends to raise the
domestic price level. Besides, due to higher prices of import ed
goods, people of a country tend to substitute domestically produced
goods for the now more expensive imports.
As a result, the aggregate demand or expendi ture on
domestically produced goods and services will increase causing
either expansion in output of goods or rise in their prices or both.
However, if the economy is working close to the capacity output,
the effect will be more on raising prices of goods.
4A.15 SUMMARY
1.Basically the Mundell -Fleming model is a version of the IS -LM
model for an open economy. In addition to the balance
ingoods and financial markets, the model incorporates an analysis
of the balance of payments .munotes.in

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1402.The Mundell -Fleming model is based on a very restrictive
assumption. It considers a small open economy with perfect capital
mobility.
3.The main message of the Mundell -Fleming model is that the
effect of any economic policy (fiscal, monetary or trade) depends
on the exchange rate system of the country under consideration,
i.e., whether the country is following a fixe do raf l o a t i n g exchange
rate system.
4.Devaluation ,reduction in the exchange value of a country’s
monetary unit in terms of gold, silver, or foreign monetary units.
Devaluation is employed to eliminate persistent balance -of-
payments deficits .
5.In contrast to devaluation ,revaluation involves an increase in the
exchange value of a country’s monetary unit in terms of gold, silver,
or foreign monetary units. It may be undertaken when a country’s
currency has been undervalued in comparison with others, causing
persistent balance -of-payme nts surpluses.
6.A J Curve is an economic theory which states that, under certain
assumptions, a country's trade deficit will initially worsen after
thedepreciation of its currency —mainly because in the near term
higher prices on imports will have a gre ater impact on total nominal
imports than the reduced volume of imports. This results in a
characteristic letter J shape when the nominal trade balance is
charted as a line graph.
4A.16 QUESTIONS
1.State and Explain the Mundell -Fleming Model.
2.Explain the General Equilibrium in goods and money market in
Mundell -Fleming Model.
3.Explain the role of devaluation as expenditure switching policies
in BoP adjustment.
4.Explain the J curve effect in Balance of Trade.
munotes.in