Macroeconomics Dde PDF

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LESSON – 1
NATURE OF MACRO ECONOMICS – COMPARATIVE STATICS AND

DYNAMICS
1. INTRODUCTION
This chapter deals with the nature of Macro economic, its scope and
Importance. Also in this chapter we could be able to know the meaning of some
concepts like-Macro static, Macro dynamic and comparative static and their
usefulness.
2. OBJECTIVES
 To acquire knowledge about the scope and importance of macro
economics
 To under stand the concepts-Macro static, Dynamic and Comparative
Static
3. CONTENT
3.1 Introduction
3.2 Nature of Macro Economics
3.3 Scope of Macro Economics
3.4 Importance of Macro Economics
3.5 Various concepts
3.5.1 Micro static and Macro static
3.5.2 Comparative static
3.5.3 Macro dynamic
3.5.4 The Usefulness of Macro dynamics as a tool of analysis
3.1 INTRODUCTION
Modern Economic analysis has been divided into microeconomics and
macroeconomics. The terms were coined by Prof. Ranger Frisch of Oslo University
in 1933. Since then it has become very popular and was adopted by other
economists. Now microeconomics are a part and parcel of economic terminology.
Micro, in Greek, means ‘small’ and macro means ‘larger’. Micro Economics is a
study of particular individual, household firm or industry of individual prices,
wages or income. In this we study about the various parts of the economy.
The term macro economics applies to the “study of the relationship between
ANNAMALAI UNIVERSITY
broad economic aggregates” says R.G.D Allen. According, to Culbertson, “Macro
economic theory is a theory of income, employment, prices and money”. Prof.
Boulding says, “Macro economics deals not with individual income but with
national income, not with individual inprices but with national income general price
level, not with individual output but with national output”.
“Macro economics deals with economic affairs in large”. In other words it
studies the character of the forest independently of trees. Hanson says, “Macro
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economics considers the relation between aggregates such as volume of

employment, savings, investment and national income. To Meyers “Macro
economics is a study of the nature, relationship and behavior of aggregates and
average of economic quantity”. Doctor of Heilbroner defines it as, study of large-
scale economic problems, employment and unemployment, prosperity and
recession, growth and defines.
3.2 NATURE OF MACRO ECONOMICS
Macro economics is the of aggregates or averages covering, the entire economy,
such as total employment, national income, total investment, total consumption,
total savings, aggregates supply, aggregate demand and general price level wage
level and cost structure. In other words, it is aggregative economics, which
examines the interrelations among the various aggregates, their determination and
causes of fluctuation in them. But aggregation in macroeconomics is different from
that in macroeconomics. In microeconomics the interrelationships of individual
household, individual firms and individual industries, to each other deal with
aggregation. The concept of ‘industry’ for example aggregates numerous firms or
even products Consumer demand for shoes is an aggregate of the demands of many
households and supply of shoes is an aggregate of the production of many firms.
The demand and supply of labour in a locality are clearly aggregate concepts
“However, the aggregates of microeconomic theory”, according to Professor Bilas, do
not deal with the behaviour of the billions of dollars of consumer expenditures,
business investments and microeconomics”. Thus the scope of microeconomics to
aggregate relates to the economy as whole, together with sub-aggregate with which
(a) across product and industry lines (such as the total production of consumer
goods or total production of capital goods), and which (b) add up to an aggregate of
the whole economy (as total production of consumer goods and of capital and goods
add up to total production of the economy; or as total wage income and property
and income add up to national income). Thus microeconomics uses aggregates
relating to individual household savings, firms and industries, while
macroeconomics uses aggregates, which relate them to the “economy wide total”.
3.3 SCOPE OF MACRO ECONOMICS
Prof Lipsey would prefer to call macroeconomics as a search for short-cut. He
lists out major economic problems coming under macro economics. Thus macro
economics is a study of
1. Problem relating to the allocation of resources between the production of
consumer goods & capital goods.
2. Problems relating to fluctuations in price level
3. Problems relating to fluctuations in price level of wages
4. Problems relating to rate of growth.
5. Problems in relation to international trade & employment.
6. Problems relating to monetary & fiscal polices.
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3.4 IMPORTANCE OF MACRO ECONOMICS

Macro economics has assumed immense importance as an integral part of
modern economics due to the following advantages.
1. Modern economic system is complex and complicated. Therefore, to get a
proper and accurate knowledge of working of economic system, one should
study macroeconomics to understand the behaviour pattern of aggregates
such as level of savings, investment, national output and national income.
2. Macro economic approach is of a great help in the formulation of economic
policies. All governments are interested in promoting economic growth
stability and they take effective steps to control fluctuations. Government
deals not with individual savings but with groups of individuals, thereby
establishing the importance of macro economics.
3. Modern economics stress on economic growth and stability. Economic
fluctuations are the characteristic feature of capitalistic society. The theory
of economics fluctuations can be understood & severity of the fluctuations
can be controlled only with help of macro economics.
4. Macro economics is essential for understanding macro economics. No
macro economics law could be farmed without studying aggregates. For
e.g. the theory of firm could not have been formulated with reference to the
behaviour of a single firm. The theory was possible only after examining
and analysing the behaviour pattern of several firms.
5. Macro economic approach is of utmost importance to analyse and
understand the effects of inflation and deflation. Keynes considers that
inflation are harmful to the society and macro economics help to take
effective steps to control them.
6. Modern governments are interested in promoting and maintaining full
employment. The determinants of full employment namely saving, income
and consumption are all important concepts of macro economics.
7. Macro economics has brought forward the importance of study of National
Income was relegated to the background. It is the study of national income,
which gives an idea about the standard of living of different countries of the
world.
8. The study of Macro economics have revealed not only the glaring
inequalities of wealth within an economy but has shown the differences in
the standard of living. Thus various countries adopt important steps to
promote economic welfare.
3.5 VARIOUS CONCEPTS
Macro Static Comparative Static and Dynamic Analysis
Economic theory is classified into Macro and Micro Economic Theories.
Economics phenomena could be studied through the technique of static,
comparative Macro Economics and Dynamic Macro Economics.
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3.5.1 Static Micro Economics

A greater of economic theory has been formulated with the help of static
analysis. Though static and dynamic techniques of analyses have been used by
classical economics, it was Ragnar Frisch, who made a clear distinction between
the terms in 1928. August comte first introduced these words in social services. It
was john Stuart Mill who first made of the concepts in Economics. However, the
use of these remained clouded and ambiguous till 1928. When Ragnar Frisch made
a scientific distinction between them. This was followed by a lot of controversy
between Hicks, Tinbergen, Samuelson, Harod and Baumol over their nature.
However, in the recent years dynamic technique has been increasingly applied to
the various fields of economic theory, we say that dynamic is that which changes,
static is that which does not change In static analysis time is not variable while
dynamic analysis is a system in which time is a variable. A static system may be
stationary i.e. when it holds itself over time. In the study of dynamic economics, we
study a large number of static positions of an economy. Thus, dynamic analysis is
running commentary on static economics.
Static Macro Economics
Given the consumption at a constant level, private investment and Government
spending is also at a constant level, Static Micro Economics can be understood
from the following equations.
Y=C+I+G
C = a + bY
I=I
G=G
Therefore Y = a + bY + I + G. Static equilibrium income can be represented by
Ye, therefore the equilibrium level of income in a static economy is
Ye = a + bY + I + G.
From this the equilibrium level of income can be determined in another way
also
Y
e 
1

1 b
aIG  AS
AD
C+I+G
Assuming numerical values for a’

= Rs. 25 Crs. I – 25 Crs. G= 25 and E
b=.75.
ANNAMALAI
e  1
UNIVERSITY
25  25  25
1  .75
1
e  75  300Crs. 0
45
.25
O Y X
1 INCOME
Ye  (75)  300Crs.
.25
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The level of equilibrium income can be expressed through aggregate demand

and supply curves.
Static macro analysis can be explained with the help of IS and LM curve also.
The IS curve shows the interest rate that will equate savings and investment at
different levels of national income. The LM curve shows the interest rate at different
levels of national income. Both interest rate and national income will be in
equilibrium when S=I. The over all equilibrium exists where IS and LM interest.
Y
RATE OF INTEREST
LM
Y
IS
O Y INCOME X
3.5.2 Comparative Static Macro Economics
Comparative static macro analysis explains the two static equilibrium
positions. It compares the 2 equilibrium situations, explains the change between
the two situations which is brought about by change in the variables determining
the equilibrium. Comparative static analysis explains the equilibrium position
before and after changes in determinants. But it does not reveal the behaviour
determinants, as it moves from one static equilibrium position to another.
Comparative static macro economics can be analysed with the help of aggregate
demand supply curves and also with IS and LM curve.
Y AS
C+I+G
+ G'
C+I
B
+G
C+I
ANNAMALAI
A UNIVERSITY
O Y Y1 INCOME X
In the first figure equilibrium occurs where aggregate demand curve (C + I +G)
interests the 450 line at A. The equilibrium level of income is OY. Due to a change
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in government spending aggregate DD curve shifts upwards to C+I+G’ giving OY 1,

as the equilibrium level of income and B as the equilibrium point.
Y
LM
RATE OF INTEREST
r1
r IS1
IS
O Y Y1
INCOME X
According to the second figure the initial equilibrium is determined by the
intersection of IS and LM showing the equilibrium level of income at OY and rate of
interest as OY. Due to an increase in government spending IS curve shifts upwards
to IS1. So the income increase from Oy and Oy2 and interest rate from Or to Or1.
Here it is assumed that the money supply and the LM curve remain fixed. Thus in
the comparative static approach the process of adjustment from one equilibrium to
another has been ignored.
3.5.3 Dynamic Macro Economics
Y AS
C+I+G
+ G1
H C+I
D F
B G
E
C
+G
C+I
0
45
X
ANNAMALAI UNIVERSITY O Y Y1 INCOME
Dynamic macro economic analysis explains the path of change in the equilibrium
level of income. It is an analysis of moving equilibrium positions. It can be explained
with the help of aggregate demand and supply curves, Initial equilibrium is at A where
aggregate demand and supply curves intersect and determine equilibrium level of
income Oy. When Govt. expenditure is changed aggregate demand curve shifts up-
wards changing the level of income from Oy to Oy1 and the equilibrium position from A
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to G. AB shows the change in government expenditure. Due to this the income

increases from B to C. This increase in the economy increases investment to increase.
So the investment in the economy increases by CD. This process continues till the final
equilibrium point is reached at G.
Dynamic macro analysis can also be shown with the help of IS and LM curves.
Y
LM
Y2
Y3
RATE OF INTREST
Y1
IS0
IS
INCOME Y1 Y3 Y2 X
In the above figure dynamic adjustment are shown and these adjustment
savings results in a new and stable equilibrium. The initial equilibrium level of
income is Y1 and rate of interest is r1. Due to an increases income in investment IS
curve up to IS which increases income from Y2 to Y3 with no change in rate of
interest. This results in product market equilibrium and a dis-equilibrium in the
money market.
When income is Y2 and interest rate r1 demand for money is greater than supply
and hence the interest rate increase to r2. As the interest rate rises investment
falls, and income also falls. This process continues until the new equilibrium is
attached at Y3 and r2. In the process of adjustment both income and interest rate
rise and fall in a cyclical pattern. Equilibrium is stable because the system is
moving towards equilibrium and reaches it if adequate time is given for adjustment.
3.5.4 The Usefulness of Macro Dynamic as a Tool Analysis
Economic dynamic according to Baumol is the study of the economic
phenomena in relation to proceeding and succeeding events. Viewed from this angle
the equilibrium analysis is of macro statics and comparative statics ignores the
passage of time required for the system to move from one equilibrium to another,
i.e. the process of adjustments are not studied. Therefore comparative statics does
not tell us when the new equilibrium will be reached. The following diagram
illustrates a comparative static approach suppose an increase in government
spending makes the Is curve shift from Is1 to IS2, comparative statics would project
an increase in income from Y1 to Y2 and an increase in the interest rate from I1 to I2
assuming the money supply the LM curve remains the same. But this model takes
for granted the possibility of definite equilibrium and does not tell
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LM1
Intrest rate ( Percent )

Le
IS2
L1
IS1
O Y1 Ye Income ( $ Billion )
Figure 7
when the new equilibrium will be reached. Generally the policy planner is
interested in predicting the impact of his policy within a specified period of time. A
macro dynamic model explicitly considers the time pattern of adjustment to
equilibrium.
A macro dynamic analysis is therefore superior to other two types as a tool of
analysis. It considers the possibility of equilibrium and disequilibrium. If the values
of the target values is in disequilibrium, approach the equilibrium values of
comparative statics as the line lengthens, then the new equilibrium is said to be
stable. In some cases, however the target values never reach the comparative
statics equilibrium, even if a very long time period is allowed for adjustment. Then
the new equilibrium is said to be unstable. The stability or instability of equilibrium
depends upon (1) the dynamic adjustment process specified for the model and (2)
the nature of the original functional relationships of the model.
IS, LM model may be used to depict such equilibrium as well as disequilibrium
models. The following diagram illustrates stability inequilibrium.
Dynamic Adjustment in LS-LM Model with a money lag
LM
CASE I
L2
ANNAMALAI UNIVERSITY Le
L1 IS2
IS1
O Y1 Ye Y2
Figure 8 Income ( $ Billion )
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Here a change is government spending shifts the Is curve from Is1, to Is2. The
initial impact is an increase in income from Y1 to Y2 with on change in interest rate,
(suppose the banking system is slow to the initial increase is demand) This results in
product market equilibrium, with a disequilibrium in the money market, ‘when
income is Y2 and interest I1, the demand for money will exceed supply and eventually
the banking system will have to raise the interest rate to I2, which will clear the
money market when income is Y2. Now the product market must adjust to restore
equilibrium in savings and investment. As the interest rate raises investment falls
and the level of income must fall until savings is reduced and equilibrium is restored.
In this diagram the process, continues until eventually the new equilibrium is
reached at y, and I2. In this process of adjustment it is the money market lag that
causes ‘ups’ and ‘downs’ in income and interest rates. Fortunately, the structure of
the economy was such (the LM curve is flate) indicating greater responsiveness to
interest rates for demand for money) that it is related in a final equilibrium. This is
stable equilibrium, and the economic system will eventually reach an equilibrium, so
long as sufficient time is given for adjustment.
The following diagrams illustrates a dynamic adjustment in the IS LM model in
the money market lag, where there no equilibrium is reached finally.
The following diagrams illustrates a dynamic adjustment in the IS.. LM model
in the money market lag, where there no equilibrium is reached finally. In this case
a charge in fiscal policy, government spending shifts the IS curve IS2. The
immediate effect is to raise y at the given level of interest, rate L 2, but the new
demand for money raises the interest rate to a very high level which brings about a
fall in investment and income. This fall in income brings y to the left of Y1. Where as
LM
CASE 2
Le
L1
IS2
IS1
O Y1 Ye
Figure 9 Income ( $ Billion )
Dynamic Adjustment in the ISLM Model With a money Market Lag

in the previous case it was to the right of Y1. This fall in income lower the
interest rate to a very low level, much process is similar in both the cases, but the
size in rates and automatively being higher and higher making it impossible to
reach a new equilibrium. This is a case of unstable equilibrium. Comparative
statics would have made YE a stable equilibrium always. But if we follow the
process of change, only the 1st one is a stable equilibrium, while the 2nd one is not.
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Macro dynamics as a tool of analysis is for superior since it enables one to study
equilibrium and non-equilibrium models. Dynamic analysis is useful in
understanding cyclical theory too, for equilibrium in the process of adjustment in
the I diagram, both, income and rate of interest rise and fall in a cyclical pattern.
The cycle's economy successively smaller in magnitude as more time passes. If we
follow this time path Y1 we come across damped cycle.
However, adjustments in the product and money markets in the following
diagram produces explosive cycles in income and interest rate, which increase in
magnitude with the passage of time. This time path of income may be depicted as
follows. (Fig. 11)
Y
- Damped Cycle
O X
Figure 10
The reason is in the case the LM curve is steeper, than the IS curve. In general
the money market lag will result in explosive cycles and dynamic instability. The
demand for money is less responsive to the interest rates and the investment
demand is more responsive
Y
to the interest rate.
O X
Figure 11
Such an analysis is an eye-opener in policy making. For e.g. if we want to study

the impact of an increase in the public spending a shift of the first curve to the
right. The economist using the comparative static analysis would project an
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increase in national income, employment and rate of interest. If the banking system
is slow in adjusting the investment rates to the changes in the economic conditions,
the economics can predict a cyclical pattern of income and employment. Whether
the cycles will be damped or explosive will depend upon the sensitivity of the
demand for money and investment to changes in the rate of interest and income.
Thus the projection of the dynamic behaviour of the economy will depend upon.
1. The dynamic adjustment process whether there are lags and where these
lags appear in the cycle.
2. The functional relationships in the static model, whether the LM curve is
steeper than the IS curves. In short a comparative static approach is not
useful it relation to disequilibrium are not immediate and dynamic study
alone helps to understand such changes.
3. Dynamic approach through IS - LM model is very useful to understand the
economic policy. The simple Keynesian model y = c + I may be modified to
include the acceleration theory too. I.e.
y cI
c  a  by
I  
(B is the acceleration coefficient)
y  a  by  
a  Solving for income,
  
b b
This model is a non equilibrium model. If we apply equilibrium concept at this
model, we arrive at a nonsensical conclusion that in equilibrium net investment
would be zero and change in income would be zero. If this model is applicable the
best time to initiate expansionary public policy is not when GNP declines. The
following figure shows the time path of GNP for an economy entering recession.
Y
A
O B X
Figure 12
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Keynesian theory would advise introduction of fiscal policy at B where GNP

decline. But a dynamic approach is interested in the process of changes and now a
given situation has grown out of the previous situation. GNP declines at B and the
rate of increase of income has already started at A. the accelerator model advises
the policy makers to begin their programme of expansion at A where the rate of
income is still increasing, this produces a decline in investment, which will trigger
the down turn in GNP through the multiplier.
We sum up the discussion among macro statics, macro dynamics and
comparative static. Economics static is the study of relation between economic
variables as a point of time, whereas economic dynamics explains the relationship
of economic variables through time. In a static economics there is movement but no
change in economic phenomena while in a dynamic economics the fundamental
forces themselves change. The former studies movement around the point of
equilibrium but the latter traces the path from one point of equilibrium to the
other, both backward of forward. On the other hand, comparative statics studies
and compares two static equilibrium positions. If savings at a point of time are S’ at
another moment of time S’, this is once over change which is comparative statics.
But if a giving rise - in savings leads to increase in investment output, income and
to a further rise in savings, this sequence of interdependence events of continuous
changes is dynamic in nature.
No doubt economic dynamics is the antithesis of economic statics, yet the
study of dynamic economics is a necessary adjust to the hypothetical static
analysis to enable economists to formulate generalisation. The raison d’etre of all
statical investigations is the explanation of dynamic change. On the other hand,
dynamics economics is made up of static situations. If economic dynamics is the
running picture of the working of the economy, economic statics relates to be ‘still
the stationary position of the economy. Thus, both economic dynamics and
economic statistics are essential for the study and solution of economic problem.
4. REVISION POINTS
Macro Economics; It is the aggregates or averages covering the entire economy.
Micro Economics: It is a study of particular individual, house hold firm or
industry of individual prices, wages and income
Macro dynamic: It is that which changes and status in that which does not
change.
Comparative static analysis: It explains the two static equilibrium.
5. QUESTIONS
Section-A
1. Bring out the importance of macro economics
2. Explain the nature and scope of macro economics
Section B
1. Distinguish between static and dynamic methods of analysis and explain
their relative importance.
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2. Comment on the usefulness of macro-dynamics as a tool of analysis.

3. Distinguish between macro static and macro dynamics.
4. Explain how you would construct a macro dynamic model.
6. SUMMARY
Thus, Macro economics is the study of aggregates. Economic static is the study
of relation between economic variables at a point of time and economic dynamics
explains the relationship of economic variables through time.
7. SUGGESTED READING
1. Paul A.Samuelson & William Nordhaus, Economics, Tata Mcgraw –Hill
Publishing co.LTd,Madras.
2. Edward Shapiro, Marcro Economic Analysis, Harcourt Brace, Jovanovich,
1978.
3. Jhingan. M.L,Macro Economic Theory,Vrinda Pulbications(p) Ltd.New Delhi
4. Cauvery. R , V .K Sudha n ayek, M girija ,R.Meenakshi, Macro Economics ,
S.chand & company, New Delhi.
8. KEY WORDS
Marco static
Marco Dynamic
Comparative static

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LESSON – 2
THEORY OF CONSUMPTION AND CONSUMPTION FUNCTION

1: INTRODUCTION
This chapter deals with the meaning of consumption function, Keynes three
psychological functions, consumption function schedule, Relationship between APC
And MPC, the factors determining the consumption function, various theories of
consumption function such as Absolute Income Hypothesis, Permanent Income
Hypothesis and Relative Income Hypothesis.
2. OBJECTIVES
 To acquire knowledge about the Keynes’s prepositions.
 To understand the meaning of consumption function and the relationship
between APC and MPC.
 To obtain knowledge about the attributes of consumption function
 To find out the factors affecting the consumption function.
 To analyse the various theories of consumption function.
 To bring out the importance of comsumption function.
3. CONTENT
3.1 Introduction.
3.2 Various concepts consumption function, Average propensity to consume
and marginal propensity to consume.
3.3 Keynes’s prepositions
3.4 Consumption function and its schedule
3.5 Relationship between APC and HPC
3.6 Factors affecting consumption function
3.6.1 Objective factors.
a. Distribution of income
b. Fiscal policy
c. Financial policies of corporations
d. Change in expectations.
e. Windfall gains or losses
f. Liquid assets
g. Rate of interest
h. Deussenberry hypothesis
i. Selling effort
j. Relative prices
k. Volume of Wealth
l. Demographic Factors
m. Terms of consumer credit
n. Permanent income
o. Consumer durables
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3.6.2 Subjective factors

a. Reserve against unforeseen circumstances
b. Providing for anticipated furture
c. For an larger real consumption at a future date
d. To enjoy gradually increasing expenditure
e. Sense of independence
f. For speculative projects
g. To bequeath a fortune
h. Miserliness
3.7 Importance of consumption function.
3.7.1 Vital importance of investment
3.7.2 Declining in MPC
3.7.3 Repudiation of Say’s Law
3.7.4 Over saving gap
3.7.5 Turning points of Trade Cycle
3.7.6 Underemployment equilibrium
3.7.7 Income generation
3.7.8 State intervention
3.7.9 Secular stagnation
3.8 Measures to raise propensity to consume.
3.8.1 Redistribution
3.8.2 Wage policy
3.8.3 Social security
3.8.4 Easy credit facilities
3.8.5 Urbanisation
3.8.6 Interpersonal comparison
3.9 Various theories of consumption
3.9.1 Pigou’s effect
3.9.2 Keynes consumption function
3.9.3 The Relative income Hypothesis
3.9.4 The Permanent income Hypothesis
3.9.5 The Life cycle Hypothesis
3.1 INTRODUCTION
“Consumption function is the name for the general income consumption
relationships” (Brooman). Lord Keynes gave great importance to the systematic
connection between the changing size of income on the hand and consumption on
the other. His psychological law of consumption is of basic importance in the
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analysis of income output and employment Keynes states. “The psychology of the
community is such that when aggregate real income is increased, aggregate
consumption is increased but not by so much as income”.
Consumption function gives a precise relationship between aggregate
consumption and aggregate income i.e., c = f ( y ) where c is a dependant variable,
while y is a independent variable. The APC is a relationship between total
consumption and total income in a given time period. On the other hand the MPC
is the incremental change in consumption to as a result of given increment in
income. In other words APC is the rate of consumption to income while the MPC is
the ratio of change in consumption the change in income thus.
C
AP C 

C
C 

3.3 PROPOSITIONS
This law consists of 3 propositions (1) when aggregate income increases,
consumption also increases but by a some what smaller amount. This is because as a
persons income increases more and lesser amounts are spent out of the subsequent
increase in income (2) when income increases extra income is divided between
spending and savings (3) with the increase in income both spending and saving go up.
All these reveal that consumption is a function of income
C=f(y)
i.e. consumption function simply shows what expenditure that the consumers
make on goods and services at each possible level of income.
Assumptions
Kenye’s law of consumption is based on 3 consumptions. Firstly it is assumed
that habits of the people regarding spending do not change. In other words the
propensity to consume remains the same. Secondly the conditions remain normal
i.e. there is no hyper inflation or war or any other abnormal condition. The third
consumption is that of the existence of a capitalistlaissez - faire economy. The law
may not hold good in an economy where the state interferes with consumption.
Therefore Keynes law of consumption is a rough approximation to the actual
behaviour of free consumers.
3.4 CONSUMPTION FUNCTION SCHEDULE
The consumption function schedule shows numerically the consumption
expenditure at various levels of income. From this, it is easy to calculate the
average propensity to consume (APC) and marginal propensity to consume (MPC).
The relationship between income and consumption is measured by the average and
marginal propensities to consume. The APC is a relationship between total
consumption and total income in a given time period. On the other hand the MPC
is the incremental change in consumption to as a result of given increment in
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income. In other words APC is the rate of consumption to income while the MPC is
the ratio of change in consumption the change in income thus.
C
AP C 

C
C 

Where C is the incremental change in consumption and Y incremental change in
income. The normal relation between income and consumption is that when income
rises consumption also rises but to an extent smaller than the rise in income.
In other words, the ratio of an increase in consumption to an increase in income is
always less than one. To put it differently the MPC will be always less than unity.
With the increase in income, APC as well as MPC declines but the decline in MPC
is more than that of APC, MPC is higher in poor countries than in rich countries. This
is because in rich countries most of the essential wants of the people have already
been satisfied and therefore a major portion of the additional income is saved. In
contract in poor countries people have many unsatisfied wants and as such a major
portion of the addition income is spent for satisfying these wants.
3.5 RELATION BETWEEN APC AND MPC
The relation between APC and MPC is shown in the following diagram.
Y Y=
C
+
S
C K
N M
O
M
S
U L
M P
PT C
IO
N
(E)
Y Y1 Y2
O INCOME (Y)
Figure 1
In the above diagram, curve O represents the consumption function. The APC
at any point on this curve is shown by the slope of the straight line from this point
to the origin. It would be seen that the slope of OA is street than that of OB which
means that the APC is higher when income is OY than when income is OY.
The MPC at any point on the curve OQ is shown by the slope of the tangent at the
point on the curve. The slope of the tangent is greater when income is smaller. In other
words, LM is steeper than KP. It would also be seen from the diagram that when
income increase from OY to OY2 the decline in MPC is greater than that in APC.
18
The relationship between APC and MPC is quite important because it

determines the shape of the consumption function curve. In the case of a linear
consumption function curve MPC is positive but less than one and very often
constant. The APC may be constant, declining or rising These three possibilities
give us different shape of consumption function
Y
CONSUMPTION (C)
45
O
INCOME ( Y) X
Figure 2
The first possibility is where every increase in income will be fully spent on
consumption in which case consumption function line will be like 450 line. Here is
a possibility where APC and MPC are not only constant but also equal to one But in
reality consumption function does not take this shape because the psychology of
the people is such that when the income increases they tend to spend only a
portion of it. Therefore the other possible shapes of the consumption function
curves are as follows.
In figure 3, MPC is constant
Y but APC is falling. This is the most common type
of consumption function and the APC is always greater than MPC. In the figure,
the consumption function starts a little above the origin on the Y-axis.
Y
APC - Falling C
MPC - Constant
CONSUMPTION (C)
Income
O
INCOME ( Y) X
Figure 3
In figure 4, both MPC & APC are constant and both are equal. Therefore
consumption is always a function of income alone.
19
In figure 5, though interesting from the point of view of theoretical possibility,

the consumption function is not a common one. Table X.
Figure 4 Figure 5
APC C C
MPC } APC - Falling
Constant MPC - Constant
CONSUMPTION ( C)
CONSUMPTION (C)
O
O
INCOME ( Y) X INCOME ( Y)
Figure 4 & 5
Figures APC MPC

Table X 3 falling but greater constant than MPC
4 constant and equals constant MPC
5 rising but less than APC constant.
All the above figures show a linear consumption function but there can be a
curve of linear consumption function also. In this case the APC and MPC are both
changing at every point.
Y
CONSUMPTION ( C )
O INCOME ( Y )
Fig ure 6
CONSUMPTION ( C )
C1 C2
CON
O 20
INCOME ( Y )
Fig ure 6
CONSUMPTION ( C )
C1 C2
O
INCOME ( Y )
This particular type of consumption function tells us that even if the income is
all the consumers will spend a minimum of OCL on consumption. They continue to
do so till the income rises to OYL. After that with every increase in income the
consumption expenditure increases as indicated by c2c2 portion of the curve, but the
curve c2c2 is less steeper than the 45 line which means that the portion of income
consumed falls progressively as income increases. Thus the relationship between
MPC and APC are responsible for the particular shape of consumption function
curve. In short, 3 factors may be noted in the relationship between APC & MPC.
1. As income increases both APC and MPC decline but the decline in MPC is
greater than the decline in APC.
2. MPC is higher in poorer countries than in richer countries.
3. MPC is always less than one.
This is an important point which helps a lot in explaining the turning points in
trade cycles.
Attributes of Consumption Function (or) Properties
The following are the properties of consumption function.
1. The relationship between consumption and income as a rule is presented
in terms of real income and real consumption. In other words, the
amounts measured along with two axes are at constant prices. Further the
income considered is disposable income.
2. The relationship between C and Y is expressed in the form of equations. The
equation of the consumption function C = F(Y) is really speaking C = a + by.
Here curve stands for consumption expenditure, y for income’ ‘a’ and ‘b’ are
constants ‘a’ indicates consumption even then income is zero. ‘b’ signifies
MPC which is almost constant . ‘a’ of the equation is the amount measured
on the consumption (y axis) at the point where the consumption function c=f
(y) curve cuts the axis b is the slope of the consumption function.
If the consumption function starts from the origin there is on O. In this
case equation is c = by where b is constant and is equal to the linear
consumption function. These are made clear in the following diagrams.
If consumption were of the type shown in figure 9, an increase in income would
mean a rise in consumption at a diminishing rate because the slope of the
curve is not constant. In other words C/Y goes on declining as income rises.
21
Here we may use the equation c = a + by. But the value of b will keep
changing with the change in income.
y y= c
c c = b (y)
CONSUMPTION (C)
s c
0
100 % y
c/v = 0
y y= c
(a)
G
IN
AV
c c = b (y)
CONSUMPTION (C)
S s c
IS
D
0
100 % y
c/v =
0
45
0 0
y1 DISPO SABLE INCO ME (Y) (a)
G
IN
AV
S
IS
D
y 0
s = b (y)
45
0
y1 DISPO SABLE INCO ME (Y)
s
SAVING (S)
c
y y s = b (y)
s
0 s
SAVING (S)
DIS SAVING
c
y
s
0
DIS SAVING x
0 y DISPO SABLE INCO ME (Y)
y y= c
x
0 y DISPO SABLE INCO ME (Y)
CONSUMPTION (C)
d
y
x y= c
y
CONSUMPTION (C)
d
y
ANNAMALAI UNIVERSITY 45
0
y
x
INCO ME (Y)
0
45
y INCO ME (Y)
22
y,c
CONSUMPTION ( C )
C2
C0 C1
0
45
O x
INCOME ( Y )
Figure 10
In figure 10, an usual form of consumption function Co, C1,C2 is shown .

This curve is not easy to put into equation form. If income is equal to or less
than Co, consumption is of fixed amount. In this form of consumption
function the equation takes the form of
c  a  by y  a
3. The c ratio is regarded as a significant attribute of the consumption
function. The APC may vary as the income level changes. Figure 8 shows
the point A which is the breakeven point. The break even point is the
income level where net saving is zero. Geometrically it is the point where
consumption function curve c= f(y) intersects the 450 line (y = c) below this
point there is dissaving i.e., consumption is greater than income. Above
this point A there is positive net saving. At point A the APC is 100% ; to
the left point A, APC will be more than 100%, to the right of break even
point the APC will be less than 100% . If the consumption function
originates from the origin then there is no need that c/y should vary as
income level changes. It may remain constant .
4. The concept of MPC forms another important attribute of consumption
function. Normally the MPC is the ratio of a change in consumption to a
change in income (C/Y). In figure 8 and 9 the MPC is measured by the
slope of the consumption function. Figure 9 shows the case where the
MPC as well as APC falls as the income level rises.
5. Keynes assumed that normally the consumption function is stable.
Therefore most of the changes in consumption are induced by changes in
income.
6. The MPC is positive but its value is less than unity. This means that the
slope of the consumption function will normally be less than one. Keynes
basic assumption is that as income increases, consumption will also
increase but not by so much as the increase in income.
23
7. The saving and consumption schedules are mirror twins in the sense that
saving and consumption = disposable income. In other words the saving is
the counter part to the consumption function. A decision to consume ¾ of
the income is also a decision to save ¼ of the income.
3.6 FACTORS AFFECTING CONSUMPTION FUNCTION
The factors that affecting consumption function are of two types, (a) Objectives
factors; (b) Subjective factors.
3.6.1 Objective Factors
a. Distribution of Income
This is an important factor determining the propensities to consume. Normally
the average and marginal propensities to consume of the poor people are higher
than those of the rich. This is because the poor have a lot of unsatisfied wants and
are likely to spend every additional unit of money that they obtained in satisfying
their wants. In contrast, the rich have a high standard of living and relatively less
urgent wants remain to be satisfied. Additional income in their case is more likely
to be saved. Hence the more equal the consume.
b. Fiscal Policy
The Fiscal policy of the government is related to taxation. Expenditure and
public debt affects the propensity to consume. A reduction in taxation will leave
more post-tax incomes with people which would tend to increase their expenditure
on consumption. In contrast, an increase in taxation will decrease consumption. A
highly progressive tax system decreases inequalities in the distribution of income
which increases the propensity to consume.
c. Financial policies of Corporations
If corporations and companies retain more reserves and distribute lesser profits
in the form of dividends, the disposable incomes of the share holders will be
smaller. In contrast if more Profits are distributed more will be spent on
consumption.
d. Change in Expectations
If the consumers expect a shortage or rise in prices of certain goods they may
rush to purchase such goods in excess of their current needs. This would raise the
consumption function. On the other hand, if the people expect a decline in prices
they would tend to postpone purchases of such goods which would lower the
consumption function.
The consumption of a person is also influenced by expectation as to what his
income will be in the future. If he expects an increase in income in future he will
tend to consume more.
e. Windfall Gains or Losses
Sudden and unexpected gains and losses in income affect consumption
function. It is believed that the beneficiaries of windfall gains increase their
consumption above the normal level.
24
f. Liquid Assets
Changes in liquid assets of people affect their consumption with an increase in
their liquid assets, the people have a tendency to increase their consumption.
g. Rate of Interest
It is not possible to say with certainly as to which way a change in the rate of
interest will affect the consumption function. One possibility is that a higher
regard for savings may stimulate savings and thereby decrease consumption.
Keynes , however, considered the effect of variations in the rate of interest on
savings as highly complex and uncertain.
h. Duesenberry Hypothesis
Prof Duesenberry had made two important observations on the factors affecting
consumption function, Which are called Duesenberry hypothesis. In his view,
consumption expenditure of an individual is determined not only by his current
income but also by his standard of living in the past. If income falls, the
expenditure on consumption also falls but not to the same extent because people
find it difficult to adjust their expenditure to the changed income.
Secondly, he has suggested that an individuals consumption depends not only
on the amount of his income but also on the size of income of others. His reaction
to a change in income will differ according to others . The consumption standards
of low income groups are considerably influenced by the consumption standards of
high income groups.
i. Selling Effort
Given the level of income an increase in selling effort may increase the total
volume of consumers expenditure. But this factor has not been given much
attention in the theory of aggregate demand.
j. Relative Prices
There is a tendency among economists to ignore the effect of changes in relative
prices on the aggregate demand. But infact changes in relative prices can affect
aggregate consumer demand.
k. Volume of Wealth
The larger the wealth possessed by a person, the lower would be its marginal
utility to him and as such the weaker would be the desire to add to future wealth
by reducing current consumption.
l. Demographic Factors
Even at a given level of income the consumption expenditure may differ from
family to family. Such differences consumption can be explained by demographic
factors which include size of the family, place of residence , occupation. Other
things remaining unchanged the large sized families would spend more. Families
with children of college age would spend more than those with children of primary
school age further the urban families have a tendency to spend more than the rural
families.
25
m. Terms of Consumer Credit

The terms of consumer credit exert an important influence on consumer
purchases of durables. In recent years there has been considerable increase in the
volume of purchases of consumer durables financed by consumer credit. It is
generally recognised that the interest rate paid on installment credit is not of so
much importance.
n. Permanent Income
A family’s expenditure on consumption is determined not by its current income
but by its permanent income.
o. Consumer Durables
The short run instability of consumption expenditure in relation to income is
considerably concentrated in the area of consumer durables. The logic of the
consumption function suggests that it is the current services rendered by durable
goods which are desired in an amount related to current income. The purchases of
durables are considerably influenced by the size of the existing stock of durable
goods possessed by the consumers.
3.6.2 SUBJECTIVE FACTORS
Keynes mentions the following important motives of a subjective nature which
lead people to refrain from spending
(a) To build up reserve against unforeseen circumstances.
(b) To provide for an anticipated future relation between income and the
needs of the individual different from that which exists in the present.
(c) A larger real consumption at a later date is preferred to a smaller
immediate consumption.
(d) To enjoy a gradually increasing expenditure.
(e) To enjoy a sense of independence and the power to do things.
(f) To carry out speculative projects.
(g) To bequeath a fortune.
(h) To satisfy a pure miserliness.
The above motives are called by Keynes as the motives of precaution, foresight,
calculation, improvement, independence, enterprises, pride and avarice and the
corresponding motives to consumption are called enjoyment, short sightedness,
generosity , miscalculation, ostentation, and extravagance.
In addition, Keynes gave the motives of enterprise, liquidity improvement and
financial precedence whereby firms and corporations save, thus reducing
consumption expenditure. But these psychological characteristic of human nature
do not undergo much change in a short period. Therefore Dillard concluded that
although the propensity to consumer is stable in the short period it is not
absolutely rigid. Subjective factors can bring shifts in consumption function
effectively.
26
Shifts in Consumption Function

Figure 11 (a) shows an increase and decrease in consumption function caused
by an increase and decrease in income Figure 11 (b) shows an increase and
decrease in consumption function due to changes in the propensity to consume
with the given level. The upward and the downward shifts of consumption function
curve C,C1 and C2 in diagram (b) are due to objective factors.
3.7 IMPLICATIONS AND IMPORTANCE
The real importance of Keynes psychological law of consumption is revealed by
an analysis of the implications of the law. The important implications are as
follows.
Y
Y
(B)
(a)
C1
YC
YC C
Y
Y
C2
COMSUMPTION
Yo
COMSUMPTION
Yo
O X O 90 180 110 X
90 180 110
INCOME INCOME
Figure 11 A Figure 11 B
3.7.1 Vital Importance of Investment

One of the most important implications of Keynesian psychological law of
consumption is that it establishes the vital and crucial role of investment when the
community spends less than the increment in income. Increased output and
employment will not be possible to maintain, unless investment is sufficient to fill
the gap between income and consumption. The existence of such a gap implies
that sales fall short of costs necessary to provide current output; with the
consumption function becoming stable, the fluctuations in income, output and
employment are to be sought in the instability of investment. Thus, Keynes’
consumption function and its stable nature, especially in the short run, clearly
bring out the strategic importance of investment in any kind of income analysis.
3.7.2 Decline in MPC ANNAMALAI UNIVERSITY
The expected rate of profitability or the marginal efficiency of capital may
decline with the propensity to consumer remaining unchanged or failing to raise, as
much as the rise in income. Declining tendency of the marginal efficiency of capital
could be avoided, if consumption could be increased with an increase in income. If
the demand for investment was to be guided entirely by the rate of interest, as some
seem to suppose, then the stable consumption function will present no problem .
But there is no reason of evidence that shows that investment opportunities are
27
unlimited even at the lowest possible rate of interest. Therefore, the implication of
stable consumption function is that it tends to lower the MPC and investment in
the short run.
3.7.3 Repudiation of Say’s Law
Keynes’ Law explains general over production and general unemployment . The
marginal propensity to consumer of less than unity explains that all that is
produced (income) is not automatically spent. In other words, entrepreneurs fall to
receive, by means of sales, an amount that must be had to justify the current
output. The supply fails to create its own demand and exceeds the demand simply
to create a glut of goods and services thereby leading to general over production
and general unemployment.
Thus the assumption of MPC being less than one helps us to invalidate Say’s
Law of Markets. It is contended that in the long period the demand is likely to be
sufficient to buy all that the economy is capable of supplying. This long-term
adjustment is brought about by the market forces of demand and supply. Further,
Say’s Law is based on the assumptions of perfect competition, but in consumption
function more realistic assumptions of monopoly etc. are introduced as also t6he
time lags involved. Hence, consumption goes to show that there is nothing
automatic about the adjustment process as the income created is separated from
spending both in time and in space.
3.7.4 Oversaving Gap
If consumption function does not rise with a rise in income, then a permanent
over saving gap may come to exist. Oversaving gap refers to the difference between
the amount people wish to save (out of full employment income) and the volume of
private investment, For example, if the people want to save Rs. 60 crores out of a
full employment income of Rs. 300 crores and businessmen find it profitable to
invest Rs. 40 crores (according to the existing investment opportunities) then there
will be an oversaving gap of Rs. 20 crores annually. The propensity to consume,
being less than one creates a knotty problem of offsetting a large amount of saving
to maintain full employment. In the absence of suitable investment opportunities
on account of stable consumption function, it may not be easy to wipe off this
oversaving gap. A real solution lies in raising the consumption function.
3.7.5. Turning Points of Trade Cycle
MPC being less than one also helps us to explain the turning points of the
business cycle. It enables us to know how upswings and downswings in business are
caused. The traditional theory which was based on Say’s Law of markets also
explained fluctuation in business. But the explanation was based on the presence of
bottlenecks or the ‘shortages’ of the factors of production like raw materials power,
equipment, transport, etc. At the same time, the high rate of interest wage price and
cost rigidities, inflexible credit system were cited as causes. But all these causes did
not explain clearly t6he turning points in the business cycle. The upper turning point
of the business cycle (i.e. from depression to prosperity) are now explained by the limits
set by the MPC being less than one i.e. people fail to spend on consumption the full
28
increment or income. Further, the lower turning point or an upturn from depression
to recovery and prosperity is explained in terms of the failure of the people to curtail
their consumption to the full extent of the decrement in income.
3.7.6 Underemployment Equilibrium
Keynes stable consumption function gives rise to another important implication
called under employment equilibrium. We have already known that the point of
effective demanding the point where the economy is in equilibrium though not
necessarily a full employment equilibrium. The reason is that the MPC being less
than one, consumers fail to spend on consumption as much as the increase in
income. Hence what we have in the economy is the underemployment equilibrium.
3.7.7 Income Generation
MPC of less than unity also accounts for the unique and the slow nature of
income propagation. Whenever purchasing power is injected into the income
stream, it will lead to smaller successive increments of income. This is on account
of the stable consumption function and the MPC being less than one. Since the
income receivers will spend less than the full increment of income, the magnitude
or the value of the multiplier will be extremely limited and the process of income
generation would be dampened.
3.7.8 State Intervention Importance – Consumption Function
This invalidates the thesis that 1. Importance of investment
there is automatic adjustment in the 2. Decline in MPC,
economy under “laissez faire” 3. Repudition of Say’s Law
When consumption lags behind 4. Oversaving Gap.
income and causes Equilibrium. 5. Trade Cycles.
Depression. State has to intervene to 6. Underemployment Equilibrium
encourage consumption and control to in
7. Income Generation
case of inflation
8. State intervention.
9. Secular Stagnation.
Thus, State intervention becomes unimportant implication of consumption
function.
3.7.9 Secular Stagnation
According to R.G. Lipsey “conditions of chronic excess of desired savings over
desired private investment have been called conditions of secular stagnation”. It is
an advanced mature stage of development of an economy where the employment
savings cannot be affected by additional investments. It is because MPC is less
than unity employment savings cannot be affected by additional investments. It is
because MPC is less than unity and savings cannot be invested because enough
demands are not there due to lagging consumption effects. As such, it helps us to
explain and understand the phenomenon of secular stagnation.
These implication fully establish the importance of the psychological Law of
Keynesian consumption function. As a matter of fact, the vital importance of this
29
law can hardly be overemphasized in macroeconomic analysis. This law helped to

overthrow the Say’s Law of Markets and established the crucial role of investment
to increase employment. However, the greatest contribution of this law lies in
explaining the upper and lower turning points of business cycle. Before Keynes’
Law on consumption function no convincing explanation of the turning points of
business cycle could be given. By developing the psychological law of consumption
and assuming MPC to be less than one, Keynes was able to put his finger on one of
the major determinants of effective demand and was able to show the possibility of
‘general overproduction’ and ‘general unemployment’. It is on account of this that
A.H. Hansen has regarded consumption function as “an epoch making contribution
to the tools of economic analysis’. He regarded it even more important than
Marshall’s discovery of the demand function. Keynes’ invention of the consumption
function can indeed be regarded as one of the major landmarks Of modern
economics. Harris regards it as one of the corner stones of the Keynesian
structure, a concept which has stood up well under scrutiny. With the passage of
time, the consumption function has come to occupy a more important place than
was admitted by critics in 1936. This principle leads us to the conclusion that
employment can only increase with an increase in investment.
3.8 VARIOUS MEASURES BY WHICH PROPENSITY TO CONSUME CAN BE RAISED
Consumption function is no doubt stable in the short period on account of
certain psychological and objective factors but is not rigid and in the long run it is
possible to raise consumption function to promote full employment. Lifting the
consumption function schedule upward in the Keynes. The importance to increase
the consumption function in the long run is due to the following reasons:-
3.8.1 Redistribution of Income
Keynes believed that the MPC of poor people is higher than that of the rich
people. Therefore he suggested that aggregate demand might be raised by a
suitable policy of income redistribution in favour of the poor. Increasing the
productivity of lower income groups through better working conditions and public
health programme, increasing the cuts and subsidies and transferring purchasing
power from the rich to the poor classes, were the means to bring out redistribution.
The last point refers to a high rate of progressive taxation to be spent later for
welfare scheme. One thing must be remembered while income is being
redistributed it should not adversely affect capital formation and private investment
in the country.
3.8.2 Wage Policy
It is in the form of stable wages or higher wages it is possible to increase the
amount of consumption expenditure. But increasing the money wages without
increasing productivity of labour may cause money illusion which will deprive the
workers of any increase in real income.
3.8.3 Social Security
A well prepared system of social security with schemes for unemployment
compensation, old age pensions, health insurance, maternity benefits, sickness
30
benefits can also be an instrument to increase the consumption function. In times

of depression a well organised system of allowances for the unemployed will help to
increase consumption expenditure, so also in times of boom people can be made to
pay more towards social security. In normal times also the very fact that their
future is cared for will make people to spend more programme workmen would
naturally save for future. If there is no social security we find that the social
security system is a part and parcel of a high consumption economy.
3.8.4 Easy Credit Facilities
For the purchase of durable consumption goods like radios, motor cycles, cars
etc. If credit becomes easier, greater use will be made out of this. In advanced
countries like U.S.A., the great portion of consumption expenditure takes place on
easy credit installment basis. This also helps in framing suitable policies to increase
consumption function in times of depression, and times of depression the down
payments can be made smaller, installments payments can be lowered and spread
over a longer period. More people will buy goods during inflation and down
payments can be made bigger and installment payments can be raised over a fewer
months. These big payments will prevent people from buying goods. Thus it acts
as a good contra cyclical policy by lowering and raising consumption function.
3.8.5 Urbanisation
If helps people to learn new phase of life. Usually urban families spend more
than rural families. Farmers are usually high savers. Servicemen are good
spenders, however, this is not a easier which can be, manipulated easily to affect
consumption function in the short period. But when it does take place it is sure to
raise consumption function.
3.8.6 Sales Efforts
A well planned scheme of advertisement and publicity can help in stepping up
the consumption function by making consumers aware of new goods. However this
also takes a long time.
3.8.7 Inter Personal Comparison
Inter personal comparison of standard of living of the people living of the people
living in different countries create new wants, where by it increase consumption
expenditure on new produces. People living in backward countries try to follow the
consumption standard of the people living in highly developed countries and they
try to increase their expenditure on new consumer goods. It is nothing but
demonstration effect, poor people following the expenditure pattern of the rich
neighbour. Yet this is not a suitable policy to achieve changes in consumption
function.
3.9 VARIOUS THEORIES OF CONSUMPTION FUNCTION
3.9.1 Pigou Effect (or) Real Balance effects
The noted Cambridge economist A.C Pigou clearly pointed out the relationship
between consumption, cash balances and price level. This was advanced in
defending the classical position relating to the effect of general wage cuts in
reducing the volume of unemployment. The real balance effect measure the
31
influence of a change in an individual wealth holder’s real balance on the aggregate

demand. Pigou argued that a general fall in the price level would increase the real
value of the cash balances of individuals, raise the level of aggregate demand by
shifting the consumption function upwards. By stating this pigou defended the
classical argument namely, that full employment equilibrium was possible through
wage price flexibility. So long as commodity prices, wage rate and interest rate are
perfect by flexible, the system is capable of moving to full employment level.
Today the pigou effect has been criticised on various grounds. Firstly, the
Pigouvian argument cannot apply in the simple form to all fixed rupee assets. Even
through the real value of these assets held by creditors increases as the price level
falls, but this also increases the real burden of debt obligation for the debtors.
Consequently the increase in the creditor’s APC may be offset by the decrease in
debtors APC, leaving the aggregate APC unchanged.
Secondly, the Pigou effect assume that wealth holder taste for wealth does not
increase with the increase in wealth stock i.e. their propensity to accumulate
wealth constant.
Thirdly, a fall in the level may create expectations of a further fall in the price
level. In that case consumers will postpone purchase. Consequently the
consumption function will not shift upward. It might shift downward contrary in
the Pigouvian statement.
Fourthly, the Pigou effect does not say anything about the dynamics of a slow
adjustment to gradual deflation causing undesirable redistribution of income and
wealth. The pigou effect may be regarded as an argument favoring a long run
downward trend in prices which would adversely affect the employment position of
the consumers.
Fifthly, the real balance effect is in consistent with the neo-classical dichotomy
between the real and monetary sectors of the economy.
Lastly, the Pigou effect ignores the adverse effects of deflation upon the non-
cash of the total wealth portfolio of individual wealth holders. It is for these reasons
that economists do not consider Pigou effect as meriting any serious attention.
3.9.2 Conclusion (or) Importance of Consumption Function, (Keynes)
Keynes formulation of the consumption function is considered to be an epoch
making contribution to the tools of economic analysis. This is obvious from the
implications of Keynes Phychological law as mentioned below:-
1. The law of consumption brings about the crucial importance of investment.
The law tells that with every increase in income the gap between income
and consumption widers. If the increasing income is to be maintained more
and more investment must be forth coming.
2. The law tells that there can occur a general over production and
unemployment, since the MPC is less unity. With an increase in income,
consumption would lag behind income which would result in over
production and unemployment.
32
3. With the help of this law Keynes repudiated Say’s Law of market. Since the
MPC is less than unity all that is produced is not automatically demanded.
The supply fails to create its own demand and as such there is a glut
products in the market.
4. Since the entire income earned is not automatically spent there is no
automatic and self adjusting mechanism to ensure a circular flow of
income and expenditure. Therefore the state will have to interfere to ensure
that aggregate effective demand does not fall short of aggregate supply.
5. Since the increase in consumption does not keep pace with the increase in
income there arises the danger of an over saving gap.
6. As result of the propensity to consume to remain unchanged the MPC may
find to decline also. The decline in MPC may affect the decision to invest.
7. Keynes psychological law of consumption also explains the slow nature of
income propagation. Since the MPC is less than unity injection of
increasing purchasing power into the income stream leads to smaller and
smaller successive increments to income.
8. Equilibrium would be attained at full employment, only if investment is
equal to the gap between aggregate income and aggregate consumption
expenditure. But Keynes believed that the investment would not be
adequate to fill the gap between income and consumption. So there will be
equilibrium even if there is under employment.
9. With the increase in income since consumption cannot be increased the
economy may reach a stage where it may not be able to provide outlets for
its growing savings. This stage is known as Secular Stagnation. Such a
situation can be avoided if the consumption function were not stable.
Lastly, Keynes psychological law of consumption is very helpful in explaining
the turning points of the trade cycle when the business cycle reaches the highest
point in prosperity income has increased but MPC being less than unity
consumption does not increase corresponding and the result is the downward start
of the cycle. Similarly, when the business cycle reaches the lowest point, income
has declined very low but people do not reduce their consumption to the full spent
of the decline in income the upward phase of the cycle starts.
Theories of Consumption Function
The idea that consumption is primarily a function of disposable income lies at
the heart of Keynesian economics. Keynes postulated that aggregate consumption
would increase with disposable income, but the increment to consumption would not
be as great as the increment to income. In technical terms Keynes suggested that the
marginal propensity to consume (MPC) would be less than I or algebraically.
C
 

A consumption function such as Keynes had in mind is shown in the following
figure.
33
COMSUMPTION
0
45
O INCOME X
Figure 12
Keynes consumption function is vital in his theory or employment if there
should be sufficient investment to effect the additional saving as income and output
increase. That is the gap between consumption and 450 radias as income increases.
Therefore as the economy becomes wealthier it would have a very difficult time
generating adequate aggregate demand for the maintenance of full employment,
investment and government spending would have to increase indefinitely relative to
consumption.
Keynes model of income determination is theoretical in design. The behavioural
relationships, such as the consumption function are hypothetical and are not based
on actual empirical relationships. Although Keynes policy prescriptions followed on
his analysis his model was meant for actual policy planning and forecasting. It
lacked complete behavioural specification and the actual values of the various
parameters like MPC were not estimated. Further more the stability of the
relationship had not been established.
Following II. W.W economics of the new Keynesian school began to divise
models for planning government expenditure and the first relationship they studied
was consumption function empirically Kuznets tried to study consumption behavior
empirically in 1946 based upon time series data pertaining to 1869-1938 this
consumption function over a long period tended to be proportional to real national
income. Further more value of APC remained nearly stable, varying between 0.85
and 0.89.
34
49
COMSUMPTION
0
0
O X
TANGENT O = 085 NATIONAL INCOME
TANGENT 450 = 1
Figure 13
Algebraically the relationships shown here is C = by where b is both APC MPC

and it is constant. It does not decline with income.
Consumption between Kuznets and Keynes
Kuznets study supported Keynes hypothesis consumption is a stable function
of income and that the MPC is less than one. The idea that the APC and perhaps
the MPC decline with income did not receive empirical support.
A group of economists decided to estimate the consumption function using
quarterly time series data collected over relatively short period 1929-1941 with a
view to forecast post war consumer demand. The consumption function, they
explain, was the type shown here
Y
C OMSU MPTION
B ns of 1954 $
0
26 .5
ANNAMALAI UNIVERSITY O D ISPOSIBLE IN C OME X

TAN GEN T O = 0.75
( Bns of 1854 $ )
Figure 14
MPC with a value of 0.75 is smaller than the one established by Kuznets.
Economists using the short period consumption function under estimated the level
post war demand consumption function goods and MPC turned out to be higher
than .75. Thus post war inflation was not anticipated by the economists who relled
35
upon short period consumption function with MPC .75. This gave rise to the
controversy whether one should use long or short run data to estimate a forecasting
modles. There was controversy between the validity of short run consumption
function which Keynesian would have versus the long run consumption function
which empirical studies of Kuznets and others established. The absolute income
hypothesis; Keynes’s consumption income relationship is non-proportional. Arthur
smithies contended that the short period consumption relationship is basically low
proportional. But the function has shifted up over time as shown below
Y
0
45
COMSUMPTION ( CONSTANT $ )
C ( t = 1950)
C ( t = 1940)
C ( t = 1930)
O DISPOSIBLE INCOME X
( CONSTANT $ )
Figure 15
The Cs are short period consumption function, estimated at different periods of

time. The line CL is a long period consumption function such as Kuznets found. It
is obtained from points on different, short period consumption function. Thus
Smithis argue that the forecasting of post war consumption demand failed to
regonise that the short period consumption function was likely to shift upwards
after war. He attributed the shift to increase in the standard of living as median
family income increased. This consumption function is as follows.
C = a + by + ct
Where it is the year in which the variables are observed. If C is the positive
there as ‘t’ increases, consumption will increase even in the absence of increase in
disposable income. The exact relationship Smithis found is
C = 76.58 + 0.76Y+ 1.15 (t-1922)
This is a per capita relationship. It implies that in 1922, autonomous per capita
consumption (in 1929 prices) was 76.58 and increased by 1.15 every year there
after. The MPC of disposable income is 0.76.
3.9.3 The Relative Income Hypothesis
James Duesenbury, one of Smithies’ students formulated a more complete and
prior explanation for the observed discrepancy between large and short period
36
consumption behaviour. Further more he performed cross section budget studies of

income and consumption. The consumption function derived from the cross-section
data is similar to the short period time series relationship as Keynes visualised. But
unlike Smithies Duesenberry suggested that the most basic consumption
relationship was large and proportional. That is, since saving is undertaken
primarily for the purpose future consumption there is no reason to expect saving to
increase as a percentage of income rises. This equivalent to saying that time
reference is independent of the level of income.
Duesenberry explanation of cross-section behaviour is based on his idea that
consumption patterns are principally social is lower-income families attempting to
keep up with the Joneses spend a higher proportion of their income than higher-
income families. Duesenberry labeled, this phenomenon as the demonstration
effect. As individuals come into contract with superior goods, the impulse to
increase their own consumption will become more intense. This hypothesis has also
been used to explain why the average propensity to save is relatively low in
developing countries.
For the economy as a whole, families with below average income will have a higher
APC than higher income families. This explains why the APC declines with income in
budget studies. As average family income increases with economic growth, on an average
all families enjoy an increased standard of living. This explains the proportionality of the
long period consumption function.
Duesenberry had to explain the non-proportional derivation than short period
data. He said just as consumption is influenced by demonstration effect over a
period of time it is also influenced by past living standards is stronger in the short
run than in the long run, families try to maintain their old living standards and the
APC rises. On the other hand, when disposable income rises, families are still tied
to their old living standards and consequently the APC falls.
Duesenberry labels this tendency for families to maintain living standards in
periods of temporary declines in income the Ratchet effect.
The reason why ei falls than income in the depression. Duesenberry argued, is
that consumers adjust their consumption not only to current income but to
previous income, particularly previous peak income. During the decline consumers
are trying to protect their consumption standards acquired during the previous
boom. As income falls, they reduce consumption as little as possible (this reducing
sharply) when during the subsequent recovery period, income rises towards its
previous peak level, consumption moves up slowly, too, with much of the increase
in income moves into high ground does consumption respond more vigourously to
current income. There is in short, a “ratchet effect” consumers find it easier to
increase consumption than to reduce it.
Consider fig 16 (a) If income should grow steadily over time, as shown by solid
line Y, consumption would grow in the same proportion as shown by solid line Y.
But
37
Y
Y1
( A) Y
1 C
C
REAL COMSUMPTION
DISPOSAL INCOME
and
O TIME X
Figure 16 ( a )
income growth is not steady, it is bunched in spurts and dips, as shown by

broken line Y, Consumption responds to these spurts and dips in income the
ratchet can be already seen in the curve’ line of the figure where consumption
almost in stair step fashion. If we view the history relationship between
consumption and increase proportional. But in a single cycle there is non-
proportionality between C and Y. The behaviour of C’ and Y’ in a single cycle is
shown in figure 16 (b)
Y
REAL COMSUMPTION
DISPOSAL INCOME
1
Y
PREVIOUS PEAK
and
ANNAMALAI UNIVERSITY O
Figure 16 ( b )
Ratchet is, in fact a mechanical arrangement which ensure motion is one

TIME X
direction only (generally upward or forward). In the theory of consumption, there is

ratchet effect, i.e. one direction movement in that consumers find it easier to
increase consumption than to reduce it.
There can be “ratchets” in investment and general price level. It is easier for
general price-level. This is the ratchet over the long run there may be a gradual but
pronounced upward trend in the general price-level-to rise than decline effect. In
38
likely manner, there is the ratchet effect in the matter of investment. Smithies has
made use of ratchet to explain the cycle and the trend (growth). Like consumption,
investment(induced) is positively related to present and peak previous income. The
economy may be subjected to mildly explosive the pattern of GNP decline in
consumption and investment were not operative. Recessions and depressions would
have been far more grim. If ratchets are weak each depression though would be
lower than the previous one in case, the ratchet effect in consumption (and
investment) is strong, it can keep each depression through a higher level of GNP
than the previous one. The ratchet effect keeps income from falling as fast in the
downturn as it otherwise would turn towards off a calamitous downturn. We may
find that cycles are not explosive, but definitely damped. This may be due to the
inclusion that ratchet which would lower the marginal propensity to consume and
invest-these expenditures in past depend on peak previous income. As the
depression level of income persists, the ratchet effect will get smaller and yet
smaller with the memory of the peak previous income becoming dimmer. In such a
case, we may have explosive cycles.
Duesenberry formulated a short period consumption function as –
Ct  yt 
 a  b
 yo 

yt  
Where the subscript t refers to the time period at which the variable is
measured and Y0 refers to previous peak income.
For the period 1929 –1940 Duesenberry found the relationship between real
consumption and real disposable income to be.
Ct  yt 
 1.1.196  0.25
 yo 

yt  
It may be argued in support of Duesenberry’s hypothesis that it is ingenious in

many ways and marks a significant advance over previous consumption function. It
should be clear by now how it scores over Keynes’ analysis. 1. Keynes relates
current consumption to current income and ignores the effect of highest income in
the past consumption standards 2. Keynes is concerned with absolute income; he
does not take notice of the various income group and their position is relation to
one another. 3. For Keynes all consumption is “inner” directed or consumer’s
preferences are independent; he bypasses the fact that preferences are
interdependent and there is such a thing as imitation of other’s consumption
standards (shall we cell it demonstration effect?) 4. Finally, Keynes limits his
analysis for all practical purposes, to short period or cyclical consumption and does
not explain cyclical consumption and does not explain secular upward drift of
consumption. Keynes does not explain cyclical fluctuations in C/Y. Duesenberry’s
theory tells that as income rises, C/Y remains constant and as income fails, C/Y
increases. When income rises, consumers tend to move on CS curve and it shows
the same C/Y at each of its points since it starts from the origin; As the result of
recession-fall in income (peak income achieved) – consumption moves along short-
39
run consumption function curves are supposed to originate from a point on Y-axis,
C/Y decreases as we move to the right and increases as we move backward. And
this is due to the assumption made in Duesenberry’s theory that consumption
functions are irreversible over time.
Brooman maintains that the “relative income” hypothesis is instructive in
drawing attention to the significance of the distribution of income in the
determination of consumption function.
The “relative income” theory has certain weaknesses to which attention need be
drawn. First Duesenberry’s hypothesis implies that consumption and income
always change in the same direction. But it is possible that a slight decrease in
income goes side by side with an increase in consumption. Secondly, the theory
states that the increase in consumption are proportional to increase in income of
any size. But it is quite reasonable to suggest that unexpectedly large increases in
income lead, at least in the initial stages to less than proportional increases in
consumption. Thirdly, it can be argued that the consumer’s behaviour peak income
would have smaller effect on current consumption the greater the time interval from
the last peak i.e. the more we move away from the last peak in the matter of time.
Duesenberr’s hypothesis explains the secular upward drift of the consumption
function. But the “relative income” theory is not the only explanation of it. The
introduction of new produces (new products may be purchased at the expense of
saving) also serves to explains the upward drift of CF. Tobin sits in judgement on
the theory and holds that the statistical testing of the “relative income” hypothesis
has not shown it to explain the facts better than the theory that consumption is
governed by absolute income.
3.9.4 The Permanent Income Hypothesis
Milton Friedman in this theory of consumption function provided an
explanation for the inconsistency in the short and long run empirical studies. Like
Duesenberry, Friedman argues that the consumption function is essentially
proportional. But he contended that households adopt their consumption behavior
not only according to current income but to the general level of their resources
over extended periods of time. The idea is based on a division of both consumption
and income into permanent and transitory components. Consumption depends
upon permanent income. Permanent income is the product of two factors. (1) the
wealth of a consumer unit, estimated as the discounted present value of a stream of
future expected receipts and (2) the rate at which these expended are discounted.
Permanent consumption is assumed to be multiple (K) of permanent income.
Ct=KYP=0.9 YP
YP= 0.33 YT – 0.22 YT –1 + 0.15 YT = - +……
Where YP is permanent income, Yt - I is income measured I periods before ‘t’ K
is the marginal and average propensity to consume out of permanent income.
Thus YP represents a weighted average of past and present values of Y with the
weights declining in a geometric progression with coefficient 2/3.
40
Friedman’s hypothesis may be said to rest on there fundamental principles (1)

An individual consumer’s measured income and measured in consumption and
period may be divided into two components a transitory component and a
permanent component symbolically,
Y=YP + VT
C=CP + CT
Where Y denotes income, YP represent “permanent income” and VT is the
“transitory” components. The meaning apply to ( c ) (c1)
(9) permanent consumption is a multiple (k) of “permanent income”
symbolically
CP = KYP
K = f(r, w, m)
Where (K) is a function of the interest rate (r), the ratio of non human wealth to
total wealth (non human plus human wealth(w) and a catch all variable reflecting
the consumer’s propensity to consume (u) the main determinants of the propensity
to consume are such factors age & tastes. Thus, (K) is independent of permanent
income.
(3) The consumer unit is assumed to determine its standard of living on the
basis of expected returns from it reserves over its life time.
Transitory consumption is assumed to be in correlated with transitory
measured consumption which is CP + CT depends on only permanent income and
not on measured y. It should be noted that Prof. Friedman’s hypothesis is an
integral part of this logical structure of his restatement of theory of money because
Friedman approaches the analysis in terms of broad concept, of wealth.
“Total wealth includes all resumes of income” on consumable services. Income
is defined as expected yield on wealth or “permanent income” Since observed
consumption depends solely on permanent income and the permanent income
fluctuates much less than observed income, it follows that the demand for money is
highly stable. According to Professor Robert of Clover, a free translation of the
Friedman schwarts thesis as follows.
The normal stock of money (MP) and the permanent income level (YP) are
related by the equation of the form.
MP= KYP … (1)
  p   ... (2)
  p  t (or)
     ... (3)
Where (K) is a constant representing the reciprocal of the permanent income
velocity of money any (a) is a constant (a>1) representing the permanent income
elasticity of demand for money. To convert (MP) and YP with the measured stock of
money (Measured) and income (Y) the following equations are introduced.
41
Where (MT) denotes the transitory component of (M), and (YT) is transitory
income.
These two identities together with the equation (1) gives us the following
relationship
     t a  t ... (4)
Friedman’s hypothesis rules out of the influence of transistor ‘y’ on transitory
consumption. According to permanent income hypothesis, for instance and
increase in personal income takes, that is expected to be temporary will have less
impact on consumption spending than a permanent increase.
Friedman’s hypothesis has also be used to explain cross-section behaviour. He
consents that families with an above average income with on the average have a
positive, transitory component to their income. Families with a lower than average
income will, on the average, have a negative transitory component.
Furthermore, the higher the level of income, the greater is the transitory
component of invoke, on the average for the income group. This accounts fur the
MPC to be lower than for the long run consumption function.
In the long run it is the permanent income alone which determines the
consumption standards. The following diagram illustrates Friedman hypothesis in
cross section figure.
The permanent income hypothesis can be explained diagrammatically as in the
following figure. It relates to cross section of population. The permanent
consumption function OC pass through the origin of the axes. It states that the
APC = MPC which is constant. Consequently there is proportionality relationship
between permanent income and permanent consumption. Line BB = a + by is the
Y
LONG TERM
CONSUMPTION C
FUNCTION Y=
REAL COMSUMPTION
y
=B
C
y
+B
O
N S R B=
L
X
F
G N SHORT TERM
B CONSUMPTION
FUNCTION
ANNAMALAI UNIVERSITY O
40
E M A T D X
REAL DISPOSAL INCOME
Figure 17
short run or measured consumption function. It shows non proportionately

relationship and in the short tune APC and MPC it decreases as income increase
and vice versa. OA is the average and measured income for the whole community.
The average permanent income of these families is still OA which equals their
42
average measured income. Corresponding to this OA permanent income these

families have AK = (= OL) permanent consumption against their measured average
mean OA.
However, these families whose measured income is less than the average, for
instance families will OE measured include more than average proportion of
families negative transitory income component. Their permanent income is however
OM because only against this permanent income can these families sustain a
consumption of OG ( = MH) amount permanently. OG is measured consumption
against OE measured income.
It is quite in order to compare the major implication of the relative and
permanent income hypothesis. Both theories agree that the aggregate long-run
MPC is the same as the APC which itself is constant in the long-run. But they
arrive at different.. Conculsions about the cross section evidence. Duesenberry
suggests that the rich save proportionately more of their (permanent) income within
a given socio – economic unit, but Friedman states that it is not so.
The permanent income hypothesis (or any other recent version of consumption
function has not yet been fully established. That is why macro economic theory still
bank upon the simple hypothesis that consumption is a function of current
disposable income. But the permanent income hypothesis like any other Post-
Keynesian theory of consumption function points to the stark fact that the theory of
consumption as at present is still very much is a state of disagreement.
Friedman’s assumption that “permanent” and “transitory” income are
uncorrelated is particularly subject to criticism. So, is the assumption that
“transitory” consumption is uncorrelated with “transitory” income. Friedman argues
is some context that in practise, a three year time dimension gives a good
approximation of permanent income a rise of income that persists for three year is
taken to be permanent. But this view is not acceptable. The issue of time dimension
cannot be decided a priori i.e. on the basis of reasoning. This is an empirical
question. The data themselves should dictate the suitable number of years though
Prof. Evants maintains that the weight of them evidence support Friedman’s theory,
the general view that the theory has not received full empirical support. A good deal
of critical literature has developed in regard to Frideman’s hypothesis, but it is
highly technical.
The significance of Frideman’s theory lies in the fact that it is a pointer to the
possible ways in which consumer decisions may be affected by expectation as well
as by current income. This theory has, no doubt reshaped and given a new
direction to much of the research on consumption function. It can safely be
asserted that it is unusual to discuss consumption function today without involving
Friedman’s terms of reference. From the purely intellectual for academic point of
view Frideman’s contribution is a signal one. His analysis is basically an effort to
define the income concept and shape it into wealth concept. H.G. Johnson says,
“The idea of permanent income is essentially a concept of wealth, because one can
43
always regard wealth as a source of permanent income. And similarly, if one

defines income as permanent income one is in fact defining wealth rather than
income”. Consumption cannot be cut apart from wealth or permanent income.
3.9.5 The Life Cycle Hypothesis
Ando and Modigliani have formulated a consumption function which is known
as the Life Cycle Hypothesis. According to this theory, consumption is a function of
lifetime excepted income of the consumer. The consumption of the individual
consumer depends on the resources available to him, the rate of return on capital,
the spending plan and the age at which the plan is made. The present value of his
income (or resources) includes income from assets or property and from current
and expected labour income.
Before discussing the life cycle hypothesis, its assumptions should be noted: (1)
There is no change in the price level during the consumer, (2) The rate of interest
remains stable (3) the consumer does not inherit any assets and his assets are
result of his own savings.
The aim of the consumer is to maximise his utility over his lifetime which will, in
turn, depend on the total resources available to him during his life time. Given the
life-span of an individual, his consumption is proportional to these resources. But
the proportion of resources that the consumer plans to spend will depend on whether
the spending plan is formulated during the early or later years of his life. As a rule,
individual’s average income is relatively low at the beginning of his life and also at the
end of his life. This is because of the late years his labour income is low. It is,
however in the middle of his life that his income, both from assets and labour, is
high. As a result, the consumption level of the individual throughout his life is
somewhat constant or slightly increasing, shows as the CCI curve in Figure 18 Y0YY1
curve shows the individual consumer’s income steam during his lifetime T.
CY
Y1
C
T1 TIME T2 T Y
Figure 18
44
During the early period of his life represented by T1 in the figure, he borrows
CY0B amount of money to keep his consumption level CB which is almost constant.
In the middle years of his life represented by T1T2 he saves BSY amount to reply his
debt and for the future. In the last years of his life represented by T2T1 he dissaves
SC1Y1 amount.
On the basis of life cycle hypothesis. Ando and Modigliani made a number of
studies in order to formulated the short-run and long-run consumption function. A
cross section study revealed that more persons in the low-income groups were at
low income levels because they were at the end period of their lives. Thus their APC
was high. On the other hand, more than average persons belonging to the high-
income groups were at high income levels because they were in the middle years of
their lives. Thus their APC was relatively low. On the whole, the APC was falling as
income rose thereby showing MPC < APC.
The observed data for the U.S revealed the APC to be constant as 0.7 over the long
run.
The Ando-Modigliani short-run consumption function is shown by the Cs curve in
figure 19. The long-run consumption function is C1 showing a constant APC as income
grows along the trend. It is a straight line passing through the origin. The APC is
constant over time because the share of labour income in total income and the ratio of
assets to total incomes are constant as the economy grows along the trend.
Y
C1
C2
CONSUMPTION
O INCOME X
Its Criticism
Figure 19
The life cycle hypothesis is not free from certain limitations.

First, the contention of Ando and Modigliani that a consumer plans his
consumption over his life time is unrealistic because a consumer concentrates on
the present rather than on the future which is uncertain.
45
Second, the life cycle hypothesis pre-supposes that consumption is directly

related to the assets of an individual. As asses increase his consumption increases
and vice versa. This also unwarranted because an individual may reduce his
consumption to have larger assets.
Third, consumption depends upon one’s attitude towards life. Given the same
income and assets, one person may consume more than the other.
Despite these, the life cycle hypothesis is superior to the other hypothesis
discussed above because it includes not only assets as a variable in the
consumption function but also explains why MPC< APC in the short run and the
APC is constant in the long-run.
4. REVISION POINTS
Consumption function: It shows the relationship between income and
consumption
APC: C/Y
MPC: C/Y
Keynes psychological law of consumption
(a) When income increases, consumption also increases but by a smaller
amount
(b) When income increases, consumption and savings increases.
(c) When income increases, the increased income is shared between
consumption and savings
5. QUESTIONS
Section A
1. Bring out the relationship between the APC and MPC.
2. Bring out the importance of consumption function.
3. Explain the Life cycle hypothesis
Section B
1. What is meant by consumption function? Explain the various factors
underlying the propensity to consume.
2. Is the permanent income hypothesis an adequate explanation of income -
consumption relation?
3. Evaluate Duesenberry’s contribution to the theory of consumption function?
4. Distinguish between the permanent and relative income hypothesis. Of these,
which is a more satisfactory explanation of income consumption relation?
6. SUMMARY
To sum up, consumption function gives the relationship between the income
and consumption and various theories of consumption, which gives their views
about the relationship of consumption function with various other factors like
Disposable Income,Permanent Income, and the lifetime income of the consumer
and the superiority of one theory over the others.
46
1. Paul A.Samuelson & William Nordhaus, Economics, Tata Mcgraw –
Hill Publishing co.LTd,Madras
2. Edward Shapiro, Marcro Economic Analysis, Harcourt Brace,
Jovanovich, 1978.
S.chand & company, New Delhi
5. Milton Friedman ,A theory of the Consumption function, Oxford and IBH
Publishing co New Delhi.
8. KEY WORDS
Consumption function
Average Propensity to consume
Marginal propensity to consume.

47
LESSON – 3
THEORY OF INVESTMENT INVESTEMNT FUNCTION

1. INTRODUCTION
This chapter has dealt with the various types of investment such as Autonomous
and induced and also the meaning of Marginal Efficiency of capital and the Marginal
Efficiency of investment. This chapter also discusses the factors that determine the
Efficiency of capital and its relationship with the cost condition also.
2. OBJECTIVES
 To know the various types of investment
 To acquire knowledge about the Keynesian theory of investment
3. CONTENT
3.1 Introduction
3.2 Types of investment – Autonomous, Induced, Private, Public, Gross and Net
3.3 Saving and investment Equality.
3.3.1 Accounting Equality.
3.3.2 Functional Equality
3.4 Meaning of investment Function and Various concepts
3.5 Factors of influencing investment function
3.5.1.Endogenous Factors
a. Level of Income.
b. Level of demand
c. Existing stock of capital
d. Price of Factors of Production
e. Level of stock Exchange activity
f. Part Profits
3.5.2 Exogenous Factors.
a. Technological change
b. Population growth
c. Natural Resources
d. Investment rate
e. Government Polices
f. Political stability
g. War (Vs) Peace condition
h. Labour movement
3.5.3 Cultural and Institutional factors
a. Attitude
b. consumer psychology
48
c. Socio-legal institution
d. Religious institution
e. Education on the population
f. Attitude towards thrift
3.6 Keynesian theory of investment
3.1 INTRODUCTION
Investment is Keynesian theory means the net addition to the stock of capital
goods like machinery, equipments, etc. It also includes inventories Investment in
this sense does not mean the total stock of capital goods in existence but the net
addition in a certain period.
3.2 TYPES
There are various type of investment - induced investment, autonomous
investment, private investment, public investment, foreign investments. Induced
investment is a function of income. It is undertaken to produce a larger output of
existing commodities. As income in an economy increases people demand more
goods and necessity to meet the increased demand is known as induced
investment.
Autonomous investment results from independent forces. It is not affected by
variation in output and income. The private investment is mainly made by the
private sector, and depends on MEC and rate of interest. On the other hand public
investment is made by the public sector and it is not guided by the profit motive
and is done in the interest of the entire economy. Foreign investment is the money
invested by the people living in other countries.
Importance
Investment affects the working of the economy. According to Keynes the level of
national income and expenditure depends upon effective demand. Effective demand
in turn depends on investment and consumption. It is investment which causes
changes in the level of income and employment. Employment cannot increase
unless investment increases. This is the importance for investment. In keynesian
analysis aggregate investment - aggregate savings.
3.3 SAVINGS AND INVESTMENT EQUALITY
Prior to keynes’ classical Economics also propagated that savings are equal to
investment. But their analysis was different from keynesian analysis. Classical
economists were of the opinion that equality between savings and investment is
brought by interest rate fluctuations. But to keynes it is brought through changes
in the level of national income. This savings and investment equality is an
important notion in macro economic equilibrium. Infact it is an indispensable
condition of equilibrium.
The classical visualised the equality between savings and investment at the
point of full employment. But Keynes pointed out the possibility that savings and
investment could normally be equal to each other at even less than full employment
level.
49
Savings and investment equality can be explained in two ways (1) Accounting
or logical identity (2) functional equality Logical identity between savings and
investment is brought out in the following manner.
a. Accounting Equality
At any point of time an economic output is equal to consumption goods © and
investment goods (1)
O =C + I. We also know that income is also equal to consumption and savings
Y=C + S, N.I. = National output at any point of time i.e. O=Ym or C + I= C + S
therefore S=I .
But this logical identity has some defects. It does not explain the causal factors that
determine the level of S.I.Y and C. Further it can be seen how S and I equality is brought
out a change in equilibrium. In short, accounting equality is only a static approach.
Y S
I
SAVINGS AND INVESTMENTS
O M S Q1 Q Q2
INCOME
Figure 1
b. Functional Equality
Functional equality between savings and investment make full reference to the
level of income and to the concept of equilibrium. It explains the actual process by
which S and I equality is brought out. It can be explained with the help of a
diagram. (Fig 1).
Point P refers to the equilibrium level where S = I. QQ is the equilibrium level
of income. When income is OQ1 investment is Q1P1 savings is K1Q1. Therefore
investment is greater than savings. So the income level increases due to the
multiplier effect till it reaches OQ level where S = I. Suppose if the income level is
OQY the savings is P2Q2 and investment is K2Q2i.e. investment is less than savings.
Therefore income begins to decline till it comes to OQ level. According to Keynes the
economy is in disequilibrium when either S is excess of I or I is excess of S. It
should be remembered that the functional equality of S and I provides as the
dynamic approach to the problem. Hence it is superior to the accounting approach.
Keynes explained that the mere act of investment does not immediately lead to
increase in savings. Along with the increase in investment a number of events
follows. When investment increases initially business activity increases. Due to
this, more people are employed in the capital goods industries. Their income goes
50
up and consumption too. As a result employment increases in consumption goods

industries and at each level the increase result in higher savings.
Y C
Y=
C+I
I I
O INCOME X
Figure 2
Savings and investment equality is an important aspect of macro economic

equilibrium. The C and I line intersecting the 450 line is the same as saving line
intersecting the investment line.
3.4 INVESTMENT FUNCTION
The level of output, income and employment in an economy depends on
effective demand. Effective demand in turn depends on consumption and
investment. As consumption depends mainly on MPC which is more or less stable
greater importance is given only to Investment function. Fluctuation in effective
demand occur mainly due to fluctuations in investment. Thus investment plays an
important role in determining the level of income, output and employment.
Investment means real investment i.e. Investment in the building of new
machines, new factories, buildings, roads and other form of productive activities in
the economy. It does not include the purchase of existing stocks, shares and
securities. Real investment will lead to an increase in the demand for human
resources leading to an increase in employment as already stated.
Investment may be private of public, induced or autonomous, exante and
expost, replacement and it may be gross and net also.
Gross investment refers to the total real investment. But part of the new capital
is actually a replacement of the capital depreciated. Hence this amount should be
deducted from the gross investment. The remaining amount denotes the net
investment is the part is gross investment which represents the net additions to the
total existing capital in the economy.
Replacement investment refers to the investment the is necessary for replacing
the depreciated machinery. When the MPC increases the capital equipment will be
over worked so as to produce goods to meet the increased demand and as such as
the capital will wear out quickly. So some amount of money should be invested to
replace the wear out machinery with new ones. So replacement investment is the
function of current rate of consumption.
51
Investment which depends directly upon income is known as induced

investment. Enterpreneurs take up investment. Programmers when the economy is
busy with business activity. They will be encouraged when sales of goods are going
up and profits increase. Given the MPC an increase in income will lead to an
expansion in aggregate demand and it will lead to an increase in investment. This is
called induced investment which increases or decreases with an increase or
decrease in the level of income. Therefore induced investment is income elastic.
Autonomous Investment
Autonomous investment is independent of income. It will take place as a result
of changes in factors like public policy, innovation change in the population etc.
Normally investment will be private as they are taken up by the private people
with profit motive. Government investment in public utilities like construction of
roads, railways post and telegraphs etc will be of the nature of public investment.
Welfare motive stands behind public investment.
The induced investment which income elastic and the autonomous investment
which income inelastic are depicted
Y ( A )
INVESTMENT
R2
R1
O Y Y1 Y2 X
INCOME
Figure 3
Figure 3 shows A shows induced investment at various levels of income. At OY2

level of income induced investment is R2Y2 when Income is OY2 the induced
investment is R1Y1. When income falls to OY investment falls to zero. Thus larger
the income greater is the investment.
Y (B )
I - INVESTMENT
ANNAMALAI UNIVERSITY R
O Y Y1 x
INCOME
Fig ure 4 a
52
Figure (3b) illustrate autonomous investment which is constant at different

levels of income. At any given time the aggregate investment will be total of induced
and autonomous investment.
Private investment depends on MEC. But the classical economists regarded it
as dependent on rate of interest. That is why they relied on the interest to control
fluctuations. But Keynes believed that investment depended on MEC than on rate
of interest. MEC is the villain of peace against which investment rates changes
often.
3.5 FACTORS INFLUENCING INVESTMENT ARE SUMMARISED AS FOLLOWS:
3.5.1 Endogenous or informal factors:
a. The level of income or rate of change of income
b. The level and the trend or rate of consumer demand.
c. The existing stock of capital, especially fixed capital.
d. The price of factors of production.
e. The level of stock exchange activity.
f. Past profits.
3.5.2 Exogenous or external factors:
a. Technological change
b. Population growth.
c. Natural resources.
d. Investment rate.
e. Government policies - fiscal and monetary.
f. Political stability.
g. War versus peace conditions.
h. Labour movement.
3.5.3 Cultural and institutional factors:
a. Attitudes towards risk, profits success, capital accumulation and power.
b. Consumer psychology.
c. Socio-legal institutions.
d. Religious institutions.
e. Education on the population.
f. Attitudes towards thrift.
3.6 THEORY OF INVESTMENT
According to Keynes, investment can be broadly classified into two types
namely gross investment and net investments. Gross investment refers to the stock
of capital that is available during a period of time. Net investment should be
understood to mean only an addition to the stock of capital. In other words net
investment i.e. equal to gross investment minus depreciation charges.
53
All else being equal, an addition to the stock of capital increases the productive
capacity of the economy. This must be the result when a large physical stock of
capital is available for use with an existing labour force, natural resources and
technology which are assumed as constant factors. But in actual practice we do not
find the presence of these constant elements. In fact productive capacity increase
with increasing labour force and technological improvement.
A business man will invest an amount of capital in the exception that it will be
profitable for him. The decision to invest depends upon the inter relationship
among three elements namely (1) the expected income flow from the capital good in
question (2) the purchase price of the machinery and (3) the rate of interest.
Of course, there is an element of uncertainly which prevails in all these Factors
because (1) the expected income flow from the capital goods depends upon the
durability of capital good (2) the purchase price of the machine differs from one
period to another period because the present value is different from future value of
dollars (3) there is a possibility that the rate of interest will fluctuate due to
disequilibrium between the demand for and supply of money.
To trace through the basic relationship among the three elements involved in
the investment decision. Let us for the moment ignore the matter of uncertainty.
Suppose the management estimates that a particular machine has a life period of
five years. Now the Gross income is equal to the estimated marginal physical
productivity (MPP) multiplied by the price per unit. However in producing the
output and selling the additional output, extra raw materials power, advertising
and labour will probably be required. When we substract these types of costs from
the gross income, we will get net income figures for the five years make up a series
of figures that may be designated as R1, R2, R3, R4 And R5.
Suppose the sum of R1, R2, R3, R4 And R5 exceeds the cost of the machinery,
can this excess be treated as profit? It can not be treated as profit because (1)
income will trickle over a period of time (2) we have not made any allowance for
replacement requirement (3) the present value of the dollar is different from future
value of dollar. As a general rule, investment is profitable only when the rate of
return expected from the capital good exceeds the current rate of interest. Here
comes the importance of marginal efficiency of capital.
MEC: It is clear that investment expenditure cannot be separated from
profitability. The entrepreneur under-takes investment expenditure in the hope that
will be profitable. He therefore views an item of capital asset as a stream of
expected income. Keynes calls it as series of prospective returns. But this alone is
not enough to decide whether investment is profitable. The cost of capital good has
also be taken into account, Keynes called the cost of capital good as the supply
price of the asset. It can safely be asserted that the excess of prospective returns
over the supply price of capital yields a prospective profit. It is this relationship
between the prospective yield and the supply price of capital asset which has been
called as MEC by Keynes. Keynes defines the term MEC as being equal to that rate
54
of discount which would make the present value of the series of return excepted
from the capital asset during its life just equal to its supply price,
In terms of equation
R1 R2 Rn
C  ... 
1  1 1  i 2 1  i 1
Where I MEC C- purchase price of the machine, R1, R2.. Rn expected income
flow from machine. By comparing the MEC with the rate of interest ‘r’ one can say
whether the contemplated investment promises to be profitable or unprofitable.
Investment is profitable so long as MEC exceeds the rate of interest. Investment is
unprofitable when the rate of interest exceeds the MEC, when r=MEC, it is wise for
the entrepreneur to stop incuring additional expenditure.
Stock of Capital and Rate of Investment
Keynes in this theory of investment explains clearly the basis relationship
between the flow called investment and stock called capital. The process of capital
accumulation due to fall in the rate of interest may be shown as follows.
Figure 4(B) explains the level of investment as determined by the rate of
interest 6% and the capital stock would be 400. The actual capital stock is equal to
the profit maximising capital stock, because MEC = r. Now suppose the rate of
interest falls to 3% due to an action of the monitory authorities. The actual capital
T
MEI
1
MEC
MEI 4
6
MEI 3
5
MEI 2
4
MEI 1
Replacement
MEC Investment
O 400 430 450 480 Y 40 50 60 70

30 20 10
PERIOD 3 10
ANNAMALAI UNIVERSITY PERIOD 2

PERIOD 1
20
30
Figure 4 ( B )
stock is 400 now but the rate of interest being 3% MEC would be 3% only for the
capital stock of 480. That is 480 is the profit maximising stock of capital. The profit
maximising stock of capital is higher than the actual capital stock by 80. Thus net
investment would take place so long as profit maximising stock exceeds the capital
55
stock which is determined by the values of ‘r’ and MEC. This is the essence of
keynesian theory of investment.
But will this investment be instantaneous or take some time to be effective? In
short there are other considerations which decide the rate of investment (e.g.) when
extra capital stock 80 is added the capital goods industry supplying this capital is
facing the Marginal Efficiency of Investment (MEI) represented by MEIa. When the
rate of interest falls to 3% capital goods industry is at the equilibrium position at
the point J. Hence for the first period, it can supply an extra 30 capital stock
besides 40 for replacement. This 30 is added to original 400 makes the actual
capital stock 430 which is short of profit maximizing stock of capital 480 for a
given ‘r’ 3%. So they order for 50. Therefore the capital goods industry faces a
downward shift of MEI curve whose starting point is 5% MEIb curve shows this now
for 3% interest, equilibrium is at L and capital goods industry supplies 30 capital
stock for the second period. So 20 stocks are added to existing 430 making it 450
Still the actual capital stock falls short of profit maximizing stock 480. So they
order about 30 extra capital stock. This will shift down the MEI curve to MEIc in
the capital goods industry and for the third period, it supplies only 10 capital stock.
This process goes on till the actual capital stock equals to the profit maximising
stock at 3% interest rate. Thus in Keynesisan theory of investment, that for a given
decrease in rate of interest, net investment will grow up. We may now say with the
title modification that the investment does go up for a given fall in interest rate but
the net addition to the stock of capital comes only in stages depending upon the
capacity of capital goods industry.
Thus there is possibility of profit maximising stock being more than the actual
stock that brings about net investment. This depend upon the MEC schedule and
the market rate of interest.
The following chart presents the various factors we have introduced so for in
keynesian theory of investment.
56
If there is a change in any of these factors, it is sufficient to produce a

difference between actual capital and profit maximising capital stock. The lower
point of chart gives the factors that determine the rate of net investment and the
time needed to raise the actual capital stock to the profit maximising level. For a
short run analysis, it is the change in the MEC schedule shifting upward or a fall in
the rate of interest that brings about net investment. Keynesian theory of
investment considers these aspects
4. REVISION POINTS
Autonomous investment: It is not affected by variation in output and income
Induced investment: It is a function of induced income
Accounting Equality: At any point of time, an economic output is equal to
consumption goods and investment goods.
Functional equality: It makes full reference to the level of income and to the
concept of equilibrium
Real investment: It is the investment in the building of new factories buildings
and roads
Gross investment: It refers to the total real investment
Replacement investment: It refers to the investment that is necessary for
replacing the depreciated machinery
5. QUESTIONS
Section A
i) Explain the factors determining the investment.
Section B
i) Explain the factors determining MEC
6. SUMMARY
Autonomous investment is government investment, which is incurred with
social motive while induced investment is made with profit motive. Marginal
57
efficiency of capital is thus a rate of return from the capital asset and Keynesian
theory of investment explains the basic relationship between the investment and
the capital
7. SUGGESTED READINGS
1. G Ackley,Macro Economic Theory, Macmillan Press LTd, Madras.
2. Jhingan M L Macro Economic Theory,Vrinda Publications (p) LTd. New
Delhi.
3. Edward Shapiro,Macro Economic Analysis, Horcourt Brace ,Jovanovich.
4. Michael R.Edgmand, Macro Economics, Prentice –Hall of India (P) LTd. New
Delhi.
8. KEY WORDS
Autonomous I, Induced I, Gross I, Net I, Replacement I, MEC, MEI, Accounting
Equality, Functional Equality

58
LESSON – 4
AGGREGATE DEMAND AND AGGREGATE SUPPLY FUNCTION AND

THE LEVEL OF INCOME
1. INTRODUCTION
This chapter deals with the aggregate demand function and aggregate supply
function and how it determines the level of employment
2. OBJECTIVES
 To understand the concept of Aggregate demand function and Aggregate
supply function and their interaction
3. CONTENT
3.1 Introduction
3.2 Various concepts-Aggregate demand and Aggregate supply function
3.3 Approaches to aggregate demand function
3.3.1 Quantitative Theory of Money.
3.3.2 Aggregate expenditure
3.1 INTRODUCTION
In the structure of modern theory of income and employment, the concept of
effective demand has got a fundamental significance. The introduction of this concept is
a great landmark in the modern economic thinking and it is through this concept that
classical theoretical structure was completely shattered. Much before keynes, strenuous
efforts were made by T.R. Malthus to convince the classical writers like Ricardo that the
possibility of aggregate supply would causes a state of over-production. But the idea of
the deficiency of demand could not be fully grasped the idea and developed a systematic
income and employment theory on the basis of this aggregative concept.
Just as the micro-economic analysis is greatly dependent upon the demand for
and the supply of individual goods and services, the aggregative analysis related to
the level of income, spending and employment has its most strategic determinant in
the concept of capacity. Assuming that the short run productive capacity of the
economy remains fixed there can be two logical consequences.
(a) The level of real income or output will depend upon the degree to which this
productive capacity is being used.
(b) The level of real income or output will be the function of the level of
employment, since all the factor inputs other than labour remain fixed in the
short period.
At various levels of income and employment, there can be different level of demand
but all these levels of demand can not be regarded as effective. Only that level of
demand is effective which is fully met with the corresponding supply so that there is no
tendency on the part of entrepreneurs to either expand or contract production. The
level of aggregate demand that brings aggregate supply into equilibrium is called as
effective demand which in turn manifests itself in the aggregate spending of the
59
community. The level of effective demand thus depends upon two analytical tools-the
aggregate supply function and the aggregate demand function.
1. The Aggregate Supply Function
The aggregate supply function points to the fact that the existing productive
capacity of the economy is utilized to a greater or lesser degree according to the
expectations of the entrepreneurs. It is conceptually similar to the supply function
of individual commodities. Just as the supply function of individual commodity
represents a series of supply prices for varying amounts of the commodity offered
for sale, so does the aggregate supply function which relates a series of aggregate
supply prices to the varying levels of output and employment.
In the General Theory Keynes related the schedule of aggregate supply prices to
the varying levels of employment. The basic reason why he did so was that the
stastical like technique for the accurate measurement of the aggregates like the
GNP were not so developed at that time and Keynes considered employment to be
the best single measure of aggregate economic activity. The aggregate supply price,
according to keynes at a given level of employment is the expectation of proceeds
which will just make it wort while of the enterpreneur to give that employment. The
keynesian aggregate supply function is based on the assumption that labour is the
only resource and the only cost which must be covered by the sale proceeds is the
labour cost. This can be expressed through the hypothetical table in page 103.
The schedule A represents varying levels of aggregate supply prices at different
levels of employment when the money wage rate remains unchanged. If the level of
employment is, say 50 lakhs the aggregate supply price is Rs.1000, crores. It means
the enterpreneurs must expect to receive the minimum proceeds of Rs.1,000 crores to
sustain this level of employment. This minimum amount indicates the cost which the
employers must recover by the sale of the commodities and services turned on by this
number of workers. Schedule B relates different levels of aggregate supply prices to the
varying levels of employment when the money wages do not remain constant but have
a tendency to be pushed up through the pressure of demand for labour. In this case,
when employment is provided to say. 50 lakhs workers, the total labour cost which
must be recovered by the employer through the sale of output is RS. 1400 crores.
EXPECTED PROCEEDS
O Figure 1
60
Figure 1 shows that Z is the aggregate supply function when money wage rate
is unchanged. This aggregate supply function is linear. But if the wage rate also
increases along with an expansion of employment, the aggregate supply function is
Z1 which traverses a non-linear path. In both the cases, the aggregate supply prices
are related positively to the level of employment. But when the economy approaches
the full employment limit indicated by Nf, the aggregate supply function becomes
perfectly inelastic.
TABLE 1
The aggregate Supply Function
Schedule A Schedule B
Employment (N) Money wages Aggregate supply Aggregate
Money wages (W)
(in Lakhs of (W) (per Hour in price (Z) (in supply price (Z1)
(per Hour in Rs.)
workers) Rs.) Crores of Rs.) (in Crores of Rs.)
10 1.00 200 1.00 200
20 1.00 400 1.10 440
30 1.00 600 1.20 720
40 1.00 800 1.30 1040
50 1.00 1000 1.40 1400
60 1.00 1200 1.50 1800
70 1.00 1400 1.60 2240
The entrepreneurs are expected to maintain continuously particular level of
output, if they are in a position to receive a return flow of expenditure equivalent to
the costs incurred by them. This conception of aggregate supply function will be
represented by a 450 line starting from the point of origin (as shown in fig 2). The
horizandal axis measures the money value of community’s current output of
commodities and services at the constant prices and the vertical axis, the total cost
including labour costs and normal profits for the entrepreneur’s incurred by them
in producing that level of output. Since the total cost is equal to the minimum
proceeds which the entrepreneurs must expect to receive, the aggregate supply
function must conform to a 450 line.
X
EXPECTED PROCEEDS
600
500
400
ANNAMALAI UNIVERSITY 300
200
100
45 0
O 100 200 300 400 500 600 700
VALUE OF OUTPUT
IN CRORES OF RS:
Figure 2
61
Fig. 2. Shows that the value of output and the aggregate supply prices change
exactly in the same proportion before full employment and the aggregate supply
function starts from Output and traverses a45 angle from the horizontal axis. As
the employment level of output is achieved no further increase in the real output
can be possible and alike the Keynesian aggregate supply function, it becomes a
vertical straight line. Although there cannot be a short run propertionate
relationship between the employment and output, yet each possible short run level
output can be correlated with some specific level of employment and we can say
that the level of output and the level of employment are, at best, more or less
directly related.
In the above case we have taken the aggregate supply function at constant
prices. If the allowance is made for changes in the general level of prices, the
aggregate supply function will not move along a 450 path. As a consequence of a
rise in general price level, the flow of excepted proceeds which must be a available
to the enterpreneurs exceed proportionately more than an increase in output.
Nearer an economy approaches the full employment or the capacity output, the
more intense will be an increase in the general price level and hence more steep will
be an increase in the aggregate supply function Z1 as shown in fig. 3. When the full
employment or the capacity output is approached output will become insensitive to
the changes in the expected receipts to the employers and the curve will become
perfectly inelastic.
Z
EXPECTED PROCEEDS
45 0
VALU E OF OU TPU T
IN C R OR ES OF R s .
ANNAMALAI UNIVERSITY Figure 3
In fig. 3.Z represents the aggregate supply function at the constant prices and
Z1 is aggregate supply function at the current prices or at a rising general level of
prices. The shape and position of the aggregate supply function can be derived from
certain inter-relations among output (Q), employment (N), marginal physical
product of labour (MPL), prices (P) and wage rates (W), The aggregate supply
function, based on these variables, can be derived in the following way:
62
Figure 4 part (i) shows the short run production function Q Given the stock of
capital and the technique of production, the varying levels of output are determined
O O
P1
P2
O M PL O
M PL M PL1
F igure 4
by the different amounts of labour input. Part (ii) of this fig. Indicates that marginal
product of labour (MPC) is the inverse function of the labour input. With the
expansion of employment, MPL decreases and vice-versa so that MPL is a curve
having a negative slope. The employment levels N1and N2correspond respectively
with MPL1 and MPL2. Part (iii) of the fig. Shows different levels of product price (P)
at the varying levels of MPL. Their interrelation depends upon the wage rate. The
condition for the profit maximisation of a firm is w/p =MPL or W =p *X MPL. Given
the wage function W, higher levels of MRL will be associated with the lower levels of
prices and vice-versa. Thus, if the marginal physical product of labour is MPL 1 the
price level is P1 and at MPL. The price level corresponding to it is P2 From parts (i).
(ii) and (iii) of the figure 4 we arrive at the conclusian that the output Q1
corresponds with the product price P1 and Q2 is associated with the price level P2
part (iv) of the figure shows that there is a positive relationship between P and Q
and the aggregate supply function Z slopes upwards for left to right. The shaped
and slope of Z is dependent upon the shapes and slopes of the production function,
MPL function and the wage function.
If the production function and the MPL remain unchanged there is, however,
an increase in money wage rates, the aggregate supply function will shift to the left
from its original position. An increase in the money wage rate assuming MPL to be
constant, will cause an increase in the price level. Now the higher price and wage
levels will e associated with the already given levels of output. This will bring about
a decrease in the aggregate in the supply function from Z to Z1 as depicted in
figure 5.
63
P
P
P4 P4
P3
P3
P2
P2
P1
P1
MPL 1 MPL 2
In part (i) of fig 5. We have been given the wage function W and the
corresponding aggregate supply Z in part (ii) it indicates that Q1 and Q2 levels of
output correspond with P1 and P2 levels of prices respectively. If there is an increase
in money wages the function shifts to W 1 given the profit maximisation condition W
= P X MPL, the marginal physical products of labour MPL1 and MPL2 would
respectively be associated with the higher levels of prices P 3 and P4 respectively.
Now the output levels Q1 and Q2 correspond with the price levels P3 and P4
respectively. So the relatively higher price levels are associated with the same levels
of output and hence the aggregate supply function shifts to the left form Z to Z 1.
The implication from the above analysis may be derived that corresponding to each
level or original price P1 and P2 the lower level of output will exist. But this type of
conclusion is a bit hasty, the impact of changes in money wage rates upon the level
of output (Q), employment (N) and prices P can be determined appropriatory only
when these changes are studied in relation with the changes in the level of
aggregate demand. The most crucial determinant of level of effective demand or the
level of spending employment, income and price level, during a short period, is the
aggregate demand function, since the short run aggregate supply function is
relatively fixed by the fixed productive capacity of the economy.
3.3 APPROCHES TO THE AGGREGATE DEMAND FUNCTION
3.3.1 Quantity Theory of Money
The major analytical tool employed by Keynes in the determination of income
and employment is the aggregate demand function. There are basically two
approaches to the problem of aggregate demand, one is the quantity theory of
money or MV approach; and the second is the aggregate expenditure (C + I)
approach. The former treats demand as a global quantity and not as an
independently determined components. It suppose that if one commodity is not
wanted, the other will be and thus under a flexible system of wages and prices all
64
the goods produced in the economy will have a tendency to find the market
automatically. If the aggregate demand is conceived from this point of view, any
possibility of the deficiency in the aggregate demand stands completely ruled out
and the analysis conforms fully to Say’s Law of Markets.
3.3.2 Aggregate Expenditure
The alternative approach to aggregate demand function is the expenditure
approach. The aggregate demand function, from this view point, means the varying
amounts of income that all the enterpreneurs in the community, taken together, expect
to receive by the sale of output produced by varying numbers of workers. The
enterpreneurial expectation of income can also be understood as the amounts which
the major spending units in the economy are expected to spend at different possible
levels of demand, it is simply the possible levels of real income or output. The aggregate
demand schedule does not resent any particular or actual level of demand, level of
demand for different categories of goods, provided certain conditions are satisfied. The
aggregate demand schedule is, thus, an ex-ante concept.
The aggregate demand can be expressed as
D = D1 + D2
Here D is the level of aggregate demand, D1 is the demand for consumer goods
and services and D2 the demand for the investment goods. Keynes laid down the
hypothesis that consumption is a function of real income and that the short run real
income, given the stock of capital and state of technology, varies with the volume of
employment. Thus D1=f(N), D2 on the other hand is largely autonomously determined,
since it is essentially a function of exogenous factors like population and technology.
Harrod however, has explained in his article published in the Economic Journal, June
1951 that there can be the possibility of relating D, with the level of income and
employment. He pointed out the probability of new techniques being exploited more
fully at higher income levels. In this sense even the autonomous investment can be
conceived as related to the level of real income. However, assuming investment
spending to be autonomous, aggregate demand function can be written as:
D = D1 (N) + D2
It may also expressed as;
D=C+I
Since the consumption spending is functionally related to the level of income
the consumption function may be stated as
C = C0 + bY
Where C is the consumption spending, C0 is the consumption expenditure
which is autonomous of income, b is a positive constant, average marginal or
propensity to consume which is less than unity. Assuming that C = Rs.100 and b =
6, the ex-ante consumption spending can be determined at different levels of
income. If the autonomous investment spending is equal to Rs. 20, the aggregate
demand is the sum of autonomous consumption, induced consumption (bY) and
the autonomous investment.
65
D=C+I
C = C0 + bY
The aggregate demand function, given the varying levels of income, the numerical
value of the C0, b and autonomous I, can be determined in the following way.
TABLE 2
The Aggregate Demand Function
Y Co BY C = Co +By I D=C+I=Co+bY+I S=Y – C
(6 X Y)
1 2 3 4 5 6 7
0 100 - 100 20 120 -100
100 100 60 100 20 180 - 60
200 100 120 220 20 240 - 20
300 100 180 280 20 300 20
400 100 240 340 20 360 60
500 100 300 400 20 420 100
The table. 2, (Page 112) shows the varying levels of expected spending by the
community at different levels of real income or output. The interrelationship of Y
and Dindicates the aggregate demand schedule. The equilibrium level or income in
the community will be determined when investment and saving become equal
(S=I=20) and, according to fig. 6,
C1
600
C+I=D
500
C
400
300
200
100
0
45
0
Y
100 200 300 400 500 600
S1
S
100
80
60 F2
40
E1 E E2 I
20
0
100
G
200 300
F
400
G2
500 600
Y
-20 E
-40
-60
-80
Fi gure -6
-100
66
by the intersection between aggregate demand function C+1 and the 45 line
since the point of their intersection denotes that the total expenditure is equal to
the total income or output. At this point of equilibrium, the level of ex-ante I are
equal. These details have been shown through fig 6.
Fig 6. Part (i) is related to the various levels of aggregate spending that the
community is expected to undertake at the varying levels of income. The
equilibrium income is achieved at point Economy where income and aggregate
spending (C+1) are equalised. EF indicates the extent to which the consumption
spending falls short of income or aggregate expenditure thus EF is the saving.
Which has been field up by autonomous investment Fig. 6 part (ii) also shows that
ex-antes S and I are equal at point E corresponding to the income level of Rs. 300
(EF = S =1). At a lower income level of Rs. 200, the saving F1G1 falls short of the gap
between income and expenditure gap E1F1) therefore the system has an upward
tendency. When the level of income is Rs. 400 the saving gap G2 F2 is which is
greater than the gap (E2F2) between aggregate income and the respective levels of
ex-ante S are G1F1 i.e. dissaving and G2 F2 and the respective levels of ex-ante I are
E1G1 and E2G2 At the income of level of Rs. 200, therefore ex-ante I is greater than
ex-ante S and at the income of Rs. 400 the volume of exante S exceeds that of
exante I. For these reasons, the system at he income level of Rs. 200 has a
tendency to move towards the equilibrium level of Rs. 300 and form the income
level of Rs. 400, it tends to contact to Rs.300.
In the two-sector model discussed above, the aggregates demand function is
constituted by the ex-ante consumption and ex-ante I spending. For a three-sector
economic model consisting of households, business and the government sectors the
equilibrium level of income would be determined where aggregate income or output
is equal to the aggregate demand or spending to the community.
Y=E=C+I+G
In other words, the amount of saving and taxes should be equal to the
investment expenditure plus the government expenditure (G)
S = T =I + G
If the economic model is further extended to include even the rest of the world-
sector, the aggregate demand function in equilibrium can be expressed as
Y = E= C + I ( X - M)
Put in a different way, the equilibrium condition for the four-sector economic
model can be stated as
I+G+X=S+T +M
Aggregate Demand, Aggregate Supply and the Levels of Income. Prices Output and
Employment
So far in this analysis, we have assumed a stable price level. If this assumption
is done away with the price level undergoes change and there will be shifts in the
aggregate demand function because the level of money income and money
expenditure will go up and down along with the changes in prices.
67
E3
= DA
3
C 3 +I 3
E2
= DA
2
C 2 +I 2
A I
E1 I =D
C I +I
= DA
E C +I
450
Y
F i g u re - 7
Corresponding to the price level P0 P1 P2 and P3 and the aggregate demand

function has upward shifts from D1or C + I to Dp2 or C1 + I1 or C2 + I2 or C3 + I3 etc.
Along with the shifts in the aggregate demand function, the equilibrium levels of
income and expenditure also undergo changes. During the periods of expansion in
on economy, as the entrepreneurial expectations undergo upwards revision, the
aggregate demand function continue to shift. Similarly during upwards, depression,
when the prices are likely to decline, the expectations about consumption and
investment spending becomes pessimistic and, therefore, the aggregate demand
function continue to have downwards shift and the equilibrium level of income and
spending is also lowered along with thereby, further deepening the economic crisis.
A rises in price level causes changes in aggregate demand, level of money income,
expenditure and value of output. But it does not necessarily mean that the real
output will also increase. As increase in aggregate income of money terms, may
either be on account of a rise in price level or a rise in output, or a combination of
an increase in prices and output. Even when the increase in money income is
reflected in a combination of an increase in P and Q (output) much depends upon
the existing level of employment level, the shifts in aggregate demand to a very large
extent, are associated with an increase in P real output and a smaller extent upon
the rise in P. but near full employment the major part of upward shift in aggregate
demand may be caused by a rise in price. At the full employment level, the upwards
shifts might entirely be on account of the increase in price level.
It is implied in the above discussion that an increase, in money income, given
some shift in aggregate demand, is divided partly between an increase in real –
income and partly an increase in the price level and a greater rise in real output or
income is associated with a smaller rise in price level and vico-versa. Given such a
relation the money income function (Y) shown in fig. 9, is a rectangular hyporbola
with the help of a series of them the changes in the real output can be determined.
Fig. 8 shows varying levels of money income Y0 Y1 Y2 and Y3 corresponding to
D0 D1 D2 and D3 aggregate demand functions and the corresponding points of
effective demand are E0 E1 E2 and E3 respectively. Given the levels of income Y0 Y1
Y2 and Y3 the income curves Y0 Y1 Y2 and Y3 have been drawn in fig 9. The
equilibrium output and equilibrium price levels are determined at any equilibrium
level of money income by the intersection of these rectangular hyperbolic money
68
income curves and the aggregate supply function Z. At the equilibrium point R on
Y, the price and output levels are P0 and Q0 respectively. When the level of money
income shifts to Y1, at the equilibrium point R1, the price level remains P0 and the
output increases to Q, in proportion to a rise in money income. Between R1 and R2
and R3 equilibrium points, the extent of increase in output decreases but the rate of
rise in price increase. When he aggregate supply function becomes perfectly
inelastic, no further rise in output can be possible and there is an
equiproportionate rise between money incomes and price level.
E3
3 =
DA3
C 3+I
E2
2 =
DA2
C 2+I
AI
E1 I = D
C I+I
DA
E C+I =
450
Y
Figure - 8
P2
P1
Y3
P0
Y2
Y1
Y
Figure - 9
The various possible levels of output can be determined through the

intersection of a series of money income curves and the aggregate supply function
the import of charges in aggregate demand upon employment can be assessed only
through their effect on the level of output. The volume of employment, in the short
period is related to the level of output through the short run production function
which explains the association of various employment levels with the different levels
of output.
Fig. 10 (i) indicates varying equilibrium levels of output and prices determined
through the intersection of money income curves and the aggregate supply function
Z. The equilibrium output levels Q0 Q1 Q2 and Q3 correspond with the equilibrium
69
price level P0 P1 P2 and P3respectively. In fig. 10.10 (ii) the production function Q
has been given. It relates various output levels of employment. Thus corresponding
to Q0 Q1 Q2 and Q3 levels of equilibrium output the respective employment levels
are N0 N1 N2 and N3.
The equilibrium level or employment so determined is not necessarily a full
employment level. As a mater of fact all the equilibrium employment levels shown
in fig 10.10 are the under full employment levels. It is only when the aggregate
demand function shifts to an exceptionally higher level such that the equilibrium
money income corresponds to the fullest utilization of the productive capacity and
YM functions shift so high as to intersect the aggregate supply function on its
inelastic part that the equilibrium at full employment can become possible. But it
is highly importable that the consumption and investment expenditure will rise by
so large a measure as to determine the point of effective demand which corresponds
to the full employment level. The interest – inelastic investment and saving function
and the liquidity trap pose very great difficulties in the achievement of full
employment in a mature capitalistic economy. The tendency towards the
accumulation of saving at higher levels of income, when added to the forces
mentioned above, reduces further the already remote chances of full employment.
P 3
P 2
P 1
P 0
N 3
N 2
N 1
N 0
Q 0 Q 1 Q 2 Q 3
Figure - 10
4. REVISION POINTS
Aggregate Demand: It is the amount of money which the entrepreneur expect
to get by selling the output produced by the number of men employed.
Aggregate Supply: It is the proceeds necessary from the output at a particular
level of employment.
70
Effective Demand: The point at which the aggregate demand function intersects
the aggregate supply function.
5. QUESTIONS
Section – A
1. Derive aggregate demand curves and agregare supply curves.
Section – B
1. Derive aggregate demand and aggregate supply curves for the economy.
Show diagrammatically that the equilibrium real output is determined by
the intersection of these two curves.
2. Explain what is aggregate demand function and discuss its role in the
determination of level of employment.
3. “The logical starting point of keynesian theory of employment is the
principle of effective demand” Discuss.
4. “Classical economists do not have a theory of aggregate demand separate
from their theory of aggregate supply. To them aggregate demand is
identical with aggregate supply” Comment
6. SUMMARY
1978.
3. Jhingan. M.L,Macro Economic Theory,Vrinda Pulbications(p) Ltd.New
Delhi.
4. Cauvery.R , V .K Sudha n ayek, M girija ,R.Meenakshi, Macro Economics ,
8. KEY WORDS
Aggregate Demand Function, Aggregate Supply Function, Effective Demand

71
LESSON – 5
THEORY OF MULTIPLIER AND ACCELERATOR

1. INTRODUCTION
This chapter deals with the investment multiplier, its forward operation and
backward operation, Assumption and leakages of multiplier, Importance of
multiplier, Dynamic multiplier, Employment multiplier, Balanced Budget Multiplier
and Foreign Trade Multiplier.
2. OBJECTIVES
 To acquire knowledge about Keynes’s investment Multiplier and its
working
 To find out the leakages in the Multiplier process and the importance of
multiplier and criticism
 To understand the working of accelerator and super multiplier
3. CONTENT
3.1 Introduction
3.2 Meaning of investment Multiplier
3.3 Working of the Multiplier
a. Forward Operation
b. Backward operation
3.4 Leakages in the multiplier process
a. saving
b. strong liquidity preference
c. purchase of old stocks and securities
d. Debt cancellation
e. Net Imports
f. Price Inflection
g. Undistributed profits
h. Taxation
i. Excess stocks of consumption goods
j. Public investment programs
3.5 Criticisms
a. Tautological
b. Timeless static equilibrium Analysis
c. Myth
d. Growing the effect of consumption on investment
e. Exclusive emphasis on consumption
f. Emphasis between consumption and income non-linear
72
3.6 Importance
a. Investment
b. Trade cycle
c. Saving investment Equality
d. Formulation of economic policies
3.7 Types of Multiplier
a. The Dynamic Multiplier
b. The Employment Multiplier
c. Balanced Budget Multiplier
d. Foreign Trade Multiplier
3.8 Principles of Accelerator
a. Operation of the Principle
b. Assumption
c. Criticism
3.9 Principles of Super Multiplier
a. Operation of the Principle
b. Assumption
c. Criticism
3.1 INTRODUCTION
The concept of multiplier was first developed by R.F. Kahn. Kahn’s multiplier
was the Employment Multiplier. Keynes took the idea from Kahn and formulated
the investment Multiplier.
3.2 THE INVESTMENT MULTIPLIER
Keynes considers his theory of multiplier as an integral part of his theory of
employment. The multiplier, according to Keynes, “establishers a precise
relationship given the propensity to consume, between aggregate employment and
incomes and the rate of investment. It tells us that, when there is an increment of
investment, income will increase by an amount which is k times the increment of
investment” i.e.  Y = KI. In the words of Hansen, Keynes, investment multiplier
is the coefficient relating to an increment of investment to an increment of income,
i.e. K = Y/I, where y is income, I is investment,  is change (increment or
decrement and K is the multiplier.
In the multiplier theory the important element is the multiplier coefficient, K
which refers to the power by which any initial investment expenditure is multiplier
is determined by the marginal propensity to consume. The higher the marginal
propensity to consume, the higher is the value of the multiplier and vice versa. The
relationship between the multiplier and the marginal propensity to consume is as
follows.
73
  C  
  C   C  C 
C  I
   C   

 
C
 

   C
 
K  
C 
Since C is the marginal propensity to consume, the multiplier K is, by definition
equal to I-I/C. The multiplier can also be derived from the marginal propensity to
save (MPS) and it is the reciprocal of MPS, K = I/MPC.
TABLE – 1
Derivation of the Multiplier
C/ (MPC) S/Y(MPS) K(multiplier Coefficient)
0 1 1
½ ½ 2
1/3 1/3 3
¾ ¼ 4
4/5 1/5 9
8/9 1/9 9
9/10 1/10 10
1 0 (Infinity)
The table show that the size of the multiplier varies directory with the MPC and
inversely with the MPC. Since the MPC is always greater than zero and less than
one (i.e. O<MPC<I), the multiplier always between one and infinity (i.e.,= I < K ). If
the multiplier is one, it means that the whole increment of income is saved and
nothing is spent because the MPC is zero. On the other hand, an infinite multiplier
implies that MPC is equal to one and the entire increment of income is spent on
consumption. It will soon lead to full employment in the economy and then create a
limitless inflationary spiral. But there are rare phenomena. Therefore, the multiplier
coefficient varies between one and infinity.
3.3 WORKING OF THE MULTIPLIER
The multiplier works both forward and backward. First we study its forward
working.
We first take the “sequence analysis” which shows a “motion picture” or the
process of income propagation. An increase in investment leads to increased
production which creates income and generates consumption expenditure. This
process countries in dwindling series till no further increase in income and
expenditure is possible. This is a lagless instantaneous process in a static
framework, as explained by keynes.
74
a. Forward Operation
Suppose that in an economy MPC is ½ and investment is raised by Rs. 100
crores. This will immediately spent on consumption goods which will lead to
increase in production and income by the same amount and so on. The process is
set out in table 11. It reveals that an increment of Rs. 100 crores of investment in
the primary round leads to the same in increase in income. Of this Rs. 50 crores
are saved and Rs. 50 crores are spent on consumption which go to increase in
income by the same amount in the second round. This dwindling process of income
generation continues in the second rounds till the total income generated from Rs.
100 crores of the multiplier formula Y = K  I 200 = 2 X 100, where K=2
(MPC=1/2) and I=Rs.100 crores. This process of income propagation as a result
of increase in investment is shown diagrammatically in Figure, 1.
TABLE – 2
Sequence Multiplier
Rs. Crores
Round I (Increment in Y (increment in C=CY  S(Y= C)

investment) income ) C = 0.5 (increment in
saving)
0
1 100 100 50 50
2 50 25 25
3 25 2.50 12.50
4 12.5 6.25 6.25
5 6.25 3.12 3.12
0 0 0
Finally 100 200 100 100
FIGURE - 1 0
45 C + I + I
E"
MPC = 0.5
C+I
CONSUMPTION & INVESTMENT
E' C
I
Y
O Y' Y"
INCOME
75
The C curve has a slope of 0.5 to show the MPC equal one-half. C + I is the
investment curve which intersects the 45 line at Economy’ so that the old
equilibrium level of income is OY’. Now there is an increase in investment of I as
shown by the distance between C + I and C + I +  I curves. This curve intersects
the 45 line at E’’ to give OY’ as the new income. Thus the rise in income Y’ Y’’ as
shown by Y is twice the distance between C + I and C + I+ I, since the MPC is
one – half.
MPC = 0.5
S
I+I
I
I
Y' Y"
Figure - 2
The same results can be obtained. If MPS is taken so that when income
increases, savings also increase to equal the new investment at a new equilibrium
level of income. This is shown in figure 2. S is the saving function with a slope of
0.5 to show MPS of one-half. I is the old investment curve which cuts S at
Economy’ so that OY’ is the old equilibrium level of income. The increase in
investment I is superimposed on the I curve in the shape of a new investment
curve I + I which is intersected by the S curve at Economy’’ to give OY’’ as the new
equilibrium level of income. The rise in income Y’ Y’’ is exactly double the increase
in investment  I, as the MPS is one-half.
b. Backward Operation
The above analysis pertains to the forward operation of the multiplier. If,
however, investment decreases, instead of increasing, the multiplier operates
backward. A reduction in investment will lead to contraction decline in income and
consumption till the contraction in aggregate income is the multiple of the initial
decrease in investment. Suppose investment decreases by Rs. 100 crores, with an
MPC= declining till aggregate income is decreased by Rs. 100 crores. In terms of
multiplier formula’ –  Y =K(-  I,) we get –200 = 2(-100).
76
The magnitude of contraction due to the backward operation of the multiplier

depends on the value of the multiplier and the greater the cumulative decline in
income and vice versa; on the contrary, the higher the MPS, the lower is the value
of the multiplier and the smaller the cumulative decline in income and vice versa.
Thus, a community with a high propensity to consume (or low propensity to save)
Will be hurt more by the reverse operation of the multiplier than one with a low
propensity to consumer (or high propensity to save).
Diagrammatically, the reverse operation can be explained in terms of Figure 1
and 2 taking Figure 1, when investment decreases, the investment function C + I +
I shifts downward to C + I. As a result, the equilibrium level also shifts from E’’ to
E’ and income declines from OY’’ to OY’’. The MPC being 0.5, the fall in income Y’’Y’
is exactly double the decline in investment as shown by the distance between C + I
+ I and C + I. Similarly, in Figure 2. When investment falls, the investment
function I + I shifts downward as I curve and income decreases from OY’ to OY’’.
The MPS being 0.5 the decreases in income Y’’ Y’ is double the decline in
investment as measured by the distance between I +  I and I curves.
Assumption of Multiplier
Keynes’ theory of the multiplier works under certain assumptions which limit
the operation of the multiplier. They are as follows:
1. There is change in autonomous investment and that induced investment is
absent.
2. The marginal propensity to consume is constant.
3. Consumption is a function of current income.
4. There are no time lags in the multiplier process An increase(decrease) in
investment instantaneously lead. To a multiple increase (decrease) in
income.
5. The new level of investment is maintained steadily for the completion of the
multiplier process.
6. There is net increase in investment.
7. Consumer goods are available in response to effective demand for them
with the increase in income due to an increase in investment.
8. There is surplus capacity in consumer good industries to meet the
increased demand for consumer goods in response to a rise in income
following increased investment.
9. Other resources of production are also easily available within the economy.
10. There is an industrialised economy in which the multiplier process
operates.
11. There is a closed economy unaffected by foreign influences.
12. There are no changes in prices.
13. The accelerator effect of consumption on investment is ignored.
14. There is less than full employment level in the economy.
77
3.4 LEAKAGES OF MULTIPLIER

Leakages are the potential diversion from the income stream which tend to
weaken the multiplier effect of new investment. Given the marginal propensity to
consume, the increase in income in each round declines due to leakages in the
income stream and ultimately the process of income propagation. “peters out”. (see
Table II).
The Following are the Important Leakages
a. Saving is the most important leakage of the multiplier process. Thus the
higher the marginal propensity to save, the smaller the size of the
multiplier and the greater the amount of leakage out of the income stream,
and vice vesa, for instance. If MPS = 1/6, the multiplier is 6 according to
the formula K= 1/MPS; and the MPS of 1,3 gives a multiplier of 3.
b. Strong Liquidity Preference if people prefer to hoard the increased income
in the form of idle cash balances to satisfy a strong liquidity preference for
the transaction, precautionary and speculative motives, that will act as a
leakage out of the income stream. As income increases people will hoard
money in inactive bank deposits and the multiplier process is checked.
c. Purchase of old stocks and securities. If a part of the increased income is
used in buying old stocks and securities instead of consumer goods, the
consumption expenditure will fall and its cumulative effect on income will
be less than before. In other words, the size of the multiplier will fall with a
fall in consumption expenditure when people buy old stocks and arrested.
d. Debt cancelation. If a part of increased income is used to repay debts to
bank, instead of spending it for further consumption that part of the
income peters out of the income stream. In case, this part of the increased
income is repaid to other creditors who save or hoard it, the multiplier
process will be arrested.
e. Net Imports: If increased income is spent on the purchase of imported
goods it acts as a leakage out of the domestic income stream. Such
expenditure fails to effect the consumption of domestic goods. This
argument can be extended to net imports when there is an excess imports
over exports there by causing a net outflow of funds to other countries.
f. Price Inflation: When increased investment leads to price inflation, the
multiplier effect of increased income may be disipated on higher prices. A
rise in the prices of consumption goods implies increased income is
absorbed by higher prices and the real consumption and income fall. Thus
price inflation is an consumption on higher prices rather than in increasing
output and employment.
g. Undistributed Profits: If profits accuring to joint stock companies are not
distributed to the shareholders is the form of dividend but are kept in the
reverse fund, it is a leakage from the income stream. Undistributed profits
with the companies tend to reduce the income and hence further
78
expenditure on consumption goods thereby weakening the multiplier

process.
h. Taxation. Taxation policy is also an important factor in weakening the
multiplier process. Progressive taxes have the effect of lowering the
disposable income of the taxpayers and reducing their consumption
expenditure. Similarly commodity taxation tends to raise the prices of
goods and a part of increased income may be dissipated on stream and
lowers the size of the multiplier.
i. Excess Stocks of consumption Goods. If the increased demand for
consumption goods is met from the existing excess stocks of consumption
goods there will be no further increase in output, employment and income
and the multiplier process will come to a halt till the old stocks are
exhausted.
j. Public investment programmes. If the increase in income as result of
increase in investment is affected by public expenditures, it may fail to
induce private enterprise to spent that income for further investment due
to the following reasons.
(a) Public investment programmes may raise the demand for labour and
materials leading to a rise in the costs of construction so as to make the
understanding of some private projects unprofitable.
(b) Government borrowing may, if not, accompanied by a sufficiently liberal
credit policy on the part of the monetary authority, increase the rate of
interest and thus discourage private investment.
(c) Government operations may also injure private investors, confidence by
arousing animousity or fears of nationalisation.
3.5 CRITICISM OF MULTIPLIER
The multiplier theory has been severely criticised by the Post-Keynesian
economists on the following grounds.
a. Tauto Logical
Prof. Haberker has critisied keyens’ multiplier as tautological. It is a truism.
Which defines the multiplier as necessarily true as.
1

C
1

As pointed by professor hansen, such a Co-efficient is a mere arithmetic
multiplier (i.e. a truism) and not a true behaviour multiplier based on a behaviour
pattern which establishes a verifiable relation between consumption and income. A
mere arithmetic multiplier is tautological
1
C
1

79
b. Timeless static equilibrium analysis

Keynes’ logical theory of the multiplier is an instantaneous process without
time la. It is a timeless static equilibrium analysis in which the total effect of a
change in investment of income is instantaneous so that consumption goods are
produced simultaneously and consumption expenditure is also incurred
instantaneously. But this is not borne out by facts because time lag is always
involved between the receipt of income and its expenditure on consumption goods
and also in producing consumption goods. Thus “the timeless multiplier analysis
disregards the transition and deals only with the new equilibrium income level”
and is therefore unrealistic.
c. Myth
According to Hazlitt, the keynesian multiplier “is a strange concept about
which some keynesians make more fuss than about anything else in the keynesian
system. It is a myth for there can never be precise, predeterminable or mechanical
relationship between investment and income”. Thus he regards it as “a worthless
theoretical toy”.
d. Growing effect of Consumption of Investment
One of the weakness of the multiplier theory is that it studies the effects of
investment on income through changes in consumption expenditure. But it ignores
the effect of consumption on investment which is known as the acceleration
principle. Hicks Samuelson and others have shown that is the interaction of the
multiplier and the accelerator which helps in controlling business fluctuations.
e. Exclusive emphasis on consumption
Gorden points out that the greatest weakness of the multiplier concept is its
exclusive emphasis on consumption. He favours the use of the term ‘marginal
propensity to spend’ in place of marginal propensity to consume to make this
concept more realistic. He also objects to the constancy of the marginal propensity
to spend (or consume) because in a dynamic economy, it is not likely to remain
constant. If it is assumed to be constant, it is not possible “to predict with much
accuracy the multiplying effect over the cycle of a given increase in private
investment or public spending”.
f.
Keynes, multiplier theory established a linear relation between consumption
and income with the hypothesis that the MPC is less than one and greater than
zero. Empiricial studies of the behaviours of consumption in relation to income
show that the relationship between the two is complicated and non-linear. As
pointed out by Gardner Ackley, “the relationship does not run simply from current
income to current consumption, but rather involves some complex average of past
and expected income and consumption. There are other factors than income to
consider”.
Other economists have not been lagging behind in their criticism of the
multiplier concept. Prof. Hart considers it “a useless fifth wheel”. To Stigler, it is the
80
fuzziest part of the keynes’s theory. While Hault calls it a “rubbish apparatus”
which should be expunged from text books.
But despite its scathing criticism, the multiplier principle has considerable
practical applicability to economic problems are below.
3.6 IMPORTANCE OF MULTIPLIER
The concept of multiplier is one of the important contributions of keynes’, the
income and employment theory. As apply observed by Richard Goodwin, “Lord keynes
did not discover the multiplier; that honour goes to Mr. R.F.Kahn. but he gave it the
role it plays today by transforming it from an instrument for the analysis of road
building into one for the analysis of income building…. It set a fresh wind blowing
through the structure of economic thought”. Its importance lies in the following:
a. Investment: The multiplier theory highlights the importance of investment
in income and employment theory. Since the consumption function is
stable during the short-run fluctuations in income and employment are
due to fluctuations in the rate of investment. A fall in investment leads to a
cumulative decline in income and employment by the importance of
investment and explains the process of income propagation.
b. Trade Cycle: As a corollary to the above, when there are fluctuations in the
rate of income and employment due to variations in the rate of investment,
the multiplier process throws a spotlight on the different phases of the
trade cycle. When there is a fall in investment, income and employment
decline in a cumulative manner leading to recession and ultimately to
depression. On the contrary, an increase in investment leads to revival and
is this process continues to a boom. Thus the multiplier is regarded as an
indispensabel tool in trade cycles.
c. Saving Investment Equality. It also helps in bringing the equality between
saving and investment. If there is a divergence between saving and
investment, an increase in investment leads to rise in income via the
multiplier process by more than the increase in initial investment. As a result
of the increase in income, saving also increases and equals investment.
d. Formulation of economic policies. The multiplier is an important tool in the
hands of modern states in formulating economic policies. Thus this
principle presupposes state intervention in economic affairs.
i. To achieve full employment. The state decides upon the amount of
investment to be injected into the economy to remove unemployment
and achieve full employment. As initial increase in investment leads to
the rise in income and employment by the multiplier time the increase
in investment. If a single does of investment is insufficient to bring full
employment, the state can inject regular doses of investment for this
purpose till the full employment level is reached.
ii. To control trade cycles. The state can control booms and depressions in
a trade cycle on the basis of the multiplier effect on income and
81
employment. When the economy is experiencing inflationary pressures

the state can control them by a reduction in investment which leads for
a cumulative decline in income and employment via the multiplier
process. On the other hand, in a deflationary situation and increase in
investment can help increase the level of income and employment
through the multiplier process.
iii. Deficit financing. The multiplier principle highlights the importance of
deficit budgeting. In a state of depression cheap money policy of
lowering the rate of interest is not helpful because the marginal
efficiency of capital is so low that a low rate of interest fails to encourage
private investment. In such a situation, increased public expenditure
through public investment programmes by creating a budget deficit
helps in increasing income and employment by multiplier time the
increase in investment.
iv. Public investment. The above discussion reveals the importance of the
multiplier in public investment policy. Public investment refer to the
state expenditure on public works and other works meant to increase
public welfare. It is autonomous and is free from profit motive. It
therefore, applies with greater force in overcoming inflationary and
deflationary pressures in the economy and in achieving and maintaining
full employment.
3.7 TYPES OF MULTIPLIES
3.7.1 The Dynamic of Period Multiplier
The dynamic multiplier relates to the time lags is the process of income
generation. The series of adjustment in income and consumption may take months
or even years for the multiplier process to complete, depending upon the
assumption made about the period involved. This is explained in Table INCREASE
where if each round is of one month it takes seventeen rounds for an initial
investment of Rs. 100 crores to generation as income of Rs. 200 crores, given the
value of MPC to be 0.5, then the multiplier process will take 17 months to complete.
TABLE – 3
Dynamic or period multiplier
(Rs. Crores)
Period I (increment in C = CY = 0.5 Y (increment in
in Investment) (increment in consumption) income)
Months
0
0 0 0
t + 1 100 0 100
t + 2 100 50 100 + 50
t + 3 100 25 100 + 25
… … … …
t + n 100 100 200
82
The Table shows that if the MPC remains constant at 0.5 throughout, an initial
increase of Rs. 100 crores of investment will first raise income by Rs. 100 crores in
the first month out of this of Rs. 50 crores will be spent on consumption. This will
raise income in the second month to of Rs. 50 crores and out of this, of Rs. 25
crores and so on till in the seventeenth month the income increases by of Rs. 0.001
crore. This can also be explained algebraically as:
 Yn =  I +  IC + IC 2+ IC3 +…+ IC N-1 (C is MPC)
= 100 + 100 (0.5) 2 + 100 (0.5) 3 + … 100 (0.5) n-1
= Rs. 200 crores.

This process of dynamic income propagation assumes that there is a
consumption lag and no investment lag so that consumption is a function of the
proceeding period i.e. ct = f (Yt-1) and investment is a function of time (t) and of
constant autonomous investment I, i.e., It = f(I). In Fig. 3, c % I is the aggregate
demand function and the 45 line is the aggregate supply function. if we begin in
period to where with an equilibrium level of OY. Income, investment is increased by
I, then in period t income rises by the amount of the increased investment (from
t0 to t). The increased investment is shown by the new aggregate demand function
C + I + I. But in period to consumption lags behind and is still equal to the
original income E0. But at Y0 level total demand rises from Y0 to Y0. There is not an
excess of demand over supply equal to t. In period t + I consumption rises due to
the rise in demand to Y0t new investment it increases income still higher to OY1.
But at this level, total demand Y1 E1is which exceeds total supply by AE1. This will
further tend to raise income to OY2 and to a rise in demand Y2 E2 leading to an
excess of total demand over total supply by BE2. This process of income generation
will continue till the aggregate supply function C + I + I equals the aggregate
supply function 45 line at E0 in the nth period and new equilibrium level of income
is determined at OYn. The curved steps to en is the path of income propagation
showing the dynamic process of multiplier. “This suggests that in an advanced
economy where all shorts of uncertainties and rigidities exist, consumption
expenditure may lag considerably behind the receipt of income, production behind
sales and divided payment, behind corporate profits all tending to lengthen each
round and so to slow the speed of income propagation”.
3.7.2 The Employment Multiplier
The concept of employment multiplier was introduced by R.F. Kahn in 1931 as
a ratio between the total increase in employment and primary employment. i.e.
K1=N/N1 Where K1 stands for the employment multiplier N1 for the increase in
primary employment. Thus the “employment multiplier is a coefficient relating to an
increment or primary and secondary combined. To illustrate it, suppose 2,00,000
additional men are employed in public works so that the (secondary) employment
increased by 4,00,000. The total employment is increased by 6,00,000 = 2,00,000
primary + 4,00,000 secondary). The employment multiplier would be 6,00,000/
6,00,000/2,00,000 = 3.
83
0
45
C + I + I
CONSUMPTION & INVESTMENT

E2
E1 Eo
B
to C+I
A
t
Eo
I
Yo Y1 Y2 Y
INCOME
Figure - 3
Algebraically the keynesian multiplier Y= KI is analogous to kahn’s
multiplier N=K  N1. But keynes points out that there is no reason in general to
suppose that K = K1 because income in terms of wage units may rise more than
employment, if in the process, non wage earner’s income should rise
proportionately more than wage earners income. Moreover, with decreasing return,
total product would rise proportionately less than employment. In short, income in
terms of wage units would rise-most, employment next and output the least. Still
according to Hansen in the short-run, all three would trend to rise s fall together as
envisaged by the keynesian income and employment theory. He concludes that
thus for practical purpose we do no great violence to the facts if we assume that the
employment multiplier K1 equals the investment multiplier K.
If, however, output increases towards the full employment output, per unit of
labour will fall due to decreasing returns. In such a situation, K1 is larger than K
when the multiplier is working to increase output and employment. But is K1
smaller than K if the multiplier is working in the opposite direction.
Dillard points out the employment multiplier is useful for showing the relation
between primary and secondary employment from public works. (But keynes’
conception is superior to kahn’s for in the works godwin, “he gave it the role it plays
today by transforming it from an instrument for the analysis of income building”.)
3.7.3 Balanced Budget Multiplier
The balanced budget multiplier is used to shown an expansionist fiscal policy.
In this the increase in taxes (T) and in government expenditures (G ) are of and
equal amount (T =G ) Still there is increase in income. “the basis for the
expansionary effect of this kind of balanced budget is this a tax merely tends to
reduce the level of disposable income. Therefore, when only a portion of an
economy’s disposable income is used for consumption purpose, the economy’s
consumption expenditure will not fall by the full amount of the tax. On the other
84
hand, government expenditure increases by the full amount of the tax”. Thus the
government expenditure rises more than the fall in consumption expenditure due to
the tax and there is not increase in national income.
AS
CONSUMPTION & GOVT. EXPENDITURE

C+G
C1
A
G
O INCOME Yo Y1
Figure - 4
This balanced budget multiplier or theorem is based on the combined operation

of the tax multiplier and the government expenditure multiplier. In the balanced
budget multiplier, the tax multiplier is smaller than the government expenditure
multiplier. The government expenditure multiplier is
1
  G
1 c
 1
or 
G 1  c
Which indicates that the change in income (Y) will equal the multiplier (I/I-c)
times the change in autonomous government expenditure. The tax multiplier is
 C

1 c
 C
or 
 1  C
Which shows that the change in income (Y) will equal to multiplier (1/1-c) times
the product of the marginal propensity to consume © and the change in taxes (T).
A simultaneous change in public expenditure and taxes may be expressed as a
combination of equations (1) and (2)
  1 1 1 c
    1
 G 1  c 1  c 1  c
Since G =T income will change by an amount equal to change in
government expenditure and taxes.
85
To understand it, it is explained numerically. Suppose the value of c = 2/3 and

the increase in government expenditure G = Rs. 10 crores, since G =T, therefore
the increase in taxes (Iumpsum) T = T Rs. 10 cores.
We first calculate the government expenditure multiplier
 1 1
  3
G 1  c 1  2 /3
 c  2 /3
The tax multiplier is   2
 1  c   2 /3
To arrive at the increase in income as a result of the combined operation of the
government expenditure multiplier and the tax multiplier, we write the balanced
budget multiplier equation as
1 c
  G  
1 c 1 c
and fit in the above values of c, G and T so that
  3G  2T
= 3 X 1 – 2 X 10
= 10
Thus the increase in income (Y) exactly equals the increase in government
expenditure (G) and the lumpsum tax (T). This balanced budget multiplier or
unit multiplier is explained with the help of Figure 4.C is the consumption function
before the imposition of the tax with income at OY0 level. Tax of AG amount is
imposed. As a result, the consumption function shifts downward to CI. Now
government expenditure of GE amount is injected into the economy which is equal
to the tax yield AG. The new government expenditure line CI + G which determines
oY income at point E.
The increase in income Y0 X equals the tax yield AG and the increase in
government expenditure GE. This proves that income has risen by 1 (one) times the
amount of increase in government expenditure which is a balanced budget expansion.
The above analysis to the imposition of a lumpsum tax. If a proportional income
tax is levied, the MPC national income is reduced and the value of the multiplier is
less than under the lumpsum tax. The multiplier formula in this case is
 1

G 1  c1  t 
Here the term c (I-t) is the MPC of taxable national income. Thus the fraction of
taxable national income spent on consumption will equal (1-t). in this case, an
increase in government expenditure raises the disposable income only by (1 – t)
time the increase in income because a proportion of the levied (t) goes to the
government exchequer. Consequently the MPC of national income is reduced and
the value of the multiplier is low.
86
AG
E
C+G
CONSUMPTION & GOVT. EXPENDITURE

C
C1
A
O INCOME Y1 Y2
Figure - 5
However it can be shown diagrammatically that if the government expenditure

is increased by the full amount of the tax revenue, the balanced budget theorem
holds. This is illustrated in Figure 5, where C is the consumption function before
the imposition of the income tax. An income tax equal to Y1Y2/OT2, is levied. As a
result, the old consumption function pivots to the lower position of C1. The tax
revenue going to the exchequer is AG. Now into the economy. This is GA = AE. The
new government expenditure line C 2+ G determines OT2 national income at point
E. the increase in income Y1Y2 equals the tax revenue AG and the increase in
government expenditure EE. Thus the increase in income exactly equals the
increase in balanced budget theorem under proportional income tax. The analysis
also shown that even after the imposition of income tax, there is no reduction in the
MPC of individuals. It remains unchanged A Y1 = AY2.
But this is highly unrealistic because the tax rate increases and lowers the level
of disposable income and the government is not able to match expenditure equal to
the tax yield.
Its Assumption
The concept of balanced budget multiplier is based on some unrealistic
assumptions. First, it takes into account only government expenditure on goods
and services and excludes transfer payments. Infact a transfer payments’ multiplier
offsets the negative tax multiplier. Second it assumes a uniform MPC for those who
pay taxes s those who sell their goods and services to the government. Third, it does
not take into consideration the impact of government expenditure and takes on
investment so far as taxes are concerned, they affect either investment or
consumption depending upon the type of tax-payers, whether the tax is levied on
the business community or the fixed income groups. Fourth, there is less than full
employment.
Its Criticisms
The use of the balanced as an expansionary device has been found inefficient
and inadequate. This policy requires large government expenditures which may
87
lead to a considerable diversion in the allocation of resources from the private to

the public sector, thereby affecting the former adversely. Further, it requires large,
self defeating and unnecessary increases in taxes which may have a damping
influence on investment.
However, the weakness of the balanced budget dogma of the classcicals led
economists to propound the balanced budget theorem. The classicists, principle of
balancing the budget untially is contradictory to the policy of economic ability. For
it means that during inflation the government should either increase government
expenditure or reduce taxes to balances the budget which would intensify rather
than pacify inflation. Since during depression the government revenues decline, the
deficit can be eliminated by either increasing taxes or reducing government
expenditure. Such a policy would bring the economy to the bottom of the
depression. Thus a policy of balanced budgeting would have harmful effect on the
economy. In this sense, the balanced budget theorem is superior to the classical
doctrine of balanced budgeting.
Some economists, however, favour the Swedish budget Policy of the 1930s
which aims at balancing the budget over the business cycle. Such a policy requires
that during inflationary periods the budget should have an excess of tax receipts
over expenditure and the same may be utilised for reliving the public debt so that
the budget remains a balanced one. On the other hand, during deflationary periods,
the budget should have a deficit. Expenditure should be more than the tax receipts
and I should be balanced by incuring public debt. Such a policy presupposes a
strong government capable of making changes in its expenditure, tax rate and
public debt policy. Moreover, it excepts of the state to have a machinery capable of
forecasting the cyclical fluctuations accurately. But it is too much to expect of a
modern state whose decisions are politically motivated and due to the balancing of
the budget at the appropriate time becomes an impossibility. Economists therefore
favour compensatory fiscal policy.
3.7.4 Foreign Trade Multiplier
The foreign trade multiplier, also known as the export multiplier, operates like
the investment multiplier or keynes. As exports increase, there is an increase in the
income of all persons associated with the export industries. These, in turn create
demand for goods. But this is dependent upon their marginal propensity to import.
The smaller these two marginal propensities, the larger will be the value of the
multiplier and vice versa. The foreign trade multiplier process can be explained
likes this. Suppose the exporters will sell their products to foreign countries and
receive more incomes. In order to meet the foreign demand, they will enage more
factors of production to produce more. This will raise the income of the owner of
factors of production. This process will continue and the national income increases
by the value of the multiplier. The value of the multiplier depends on the value of
the marginal propensity to save and the marginal propensity to import, there being
an inverse relation between the two propensities and the export multiplier.
The foreign trade multiplier can be derived algebraically as follows:
88
The national income identity in an open economy.

Y=C+1+X–M
Where Y is the national income. C is the national consumption . I is total
investment, X is exports and M is imports.
The above relationship can be solved as
Y–C=I+X–M
Or S=I+X–M
S+M=I+X ( S= Y –C)
Thus at equilibrium levels of income the sum of the savings and exports (S+M)
must equals the sum of investment and exports (I + X)
In an open economy the investment (I) consumption is divided into domestic
investment (Ia) and foreign investment
(i)
I=S
Ia + If = S (i)
Foreign investment (Ia) is the different between export and imports of goods
and services.
If = X – N (ii)
Substituting (ii) into (i), we have
Ia + X – M = S
or Ia + X = S + M
Which is the equilibrium condition of national income in an open economy.
The foreign trade multiplier coefficient (K) is equal to.


  S  
 S  

 
1 S     
or   t  
Kt    

ort 
S   
 t 
1
S 
 dividin gby

 
1
Hen cet 
S   
Dividing both sides by Y, we get

89
(S+M)Y (S+M)Y
E1
Id+X1
E E
Id+X Id+X1
S M X Id
S M X Id
S(Y) S(Y )
Id Id
S
O Y O Y
NAT IONAL INCOME Y1
NATIONAL INCOME
Figure - 6 Figure - 7
The equilibrium level in the economy is shown in Figure 6 where S (Y) is the
saving function and (S + M) Y is the savings plus import function. id represents
domestic investment and Id + X the export plus domestic investment. The (S + M)
and Id + X function determine the equilibrium level of national income Y where
savings equal domestic investment and exports equal imports.
If there is a shift in Id + X function due to an increase in exports, the national

income will increase from Y to Y1, as shown in Figure 7. This increase in income is
due to the multiplier effects i.e. Y = Kf X. The exports will exceed imports by sd,
the amount by which savings will exceed domestic investment. The new equilibrium
level of income will be Y1. It is a case of positive foreign investment.
(S+M)Y
E1
Id+X1
E
Id+X1
S M X Id
S(Y)
Id
S
O Y Y1
NATIONAL INCOME
ANNAMALAI UNIVERSITY Figure - 8
If there is fall in exports, the export function will shift downward to Id + X as

shown in Figure 8. In this case imports would exceed exports and domestic
investment would exceed savings by d. The level of national income is reduced from
OY to OY1. This is the reverse operation of the foreign trade multiplier.
In the above analysis, the foreign trade multiplier has been studied in the case
one of only country. But, in reality, countries are inter related with each other
through trade. A country’s exports or imports affects the national income of the
90
other country, which in turn, affects the foreign trade and national income of the
first country. The is known as the foreign repercussion or the backwash effect. The
smaller the country in relation to the other trading partner, the negligible is the
foreign repercussion. But the foreign repercussion will be high in the case of a large
country will have significant foreign repercussions or backwash effects. The foreign
repercussions can be explained as under, assuming two countries. A and B.
In the accompanying Figure 9, when domestic investment (Id) increases in country.
A, it increases its exports to country B. thus country A’s national increases ( + Y).
C ount ry A
Id C ount ry B
X+
+Y
Y+
+M
M+
+X
X+
+Y
Y+
+M
M+
F ig u r e - 9
It induces country A to import more from country B; increasing demand for

country B’s exports (X+). Consequently, national income in country B increases
(Y +). Now this country imports more (M +) from country. A’s exports increases, its
national income increases further. This is the foreign repercussion or the backwash
effect for country A. These stages of foreign repercussion are explained in the
adjacent diagrams. 10, 11 and 12.
PANEL I ( S+ M ) Y O
COUNTRY A
PANEL II
Id 1+X COUNTRY B
E1 (S+M)Y
E1
Id+X Id + X
E
ANNAMALAI UNIVERSITY Id 1 Id1 + X

S, M, X, Id
S, M, X, Id
Id
Id
O Y Y1
NATIONAL INCOME O Y Y1
Figure - 10 Figure - 11
91
PANEL III
COUNTRY A
(S+ M)Y
E1
Id+X1
E
Id1+ X
S, M, X, Id
Id
O Y1 Y2
NATIONAL INCOME
Figure - 12
In stage I, domestic investment in country A increases from Id 1 to d1 in panel I

of figure. This leads to an upward shift in the Id1 + X. As a result, the new
equilibrium point is at E1, which shows an increase in national income from Y to
Y1. As national income increases the demand for imports from country B also
increases. This means increase in the exports of country B. this shown in panel II
of Figure. When the Id + X schedule of country B shifts upward as Id + X1.
consequently, the national income in country B shifts upward as B increases from
Y1 to Y’ at the higher equilibrium level E’. As country B’s income increases. This in
turn, leads to the back wash effect in the form of increase in the demand for
exports of country A. this is shown in panel III of Figure where the Id1 + X schedule
(of panel I) further shifts upward to Id1 + X1 and consequently the national income
increases further from Y1 to Y2.
This shows how the foreign repercussions in one country affect its own national
income and that of the other country which, in turn, again affects its own national
income through the backwash effect with greater force.
Criticism of the Foreign Trade Multiplier
The two model’s of the foreign trade multiplier presented above are based upon
comparative static analysis and on certain assumptions which make the analysis
unrealistic.
First, the analysis is based on the assumption that export and investment (both
domestic and foreign) are independent of change in the level of national income.
But, in reality, this is not so. A rise in exports does not always lead to increase in
national income. On the country, certain imports, of say capital goods, have the
effect of increasing the national income.
Second, the foreign trade multiplier is assumed to be an instantaneous process
whereby it supplies the final results. Thus it involves no lags and is unrealistic.
Third, the analysis is based on the assumption of a fully employed economy.
But there is less than full employment in every economy. Thus the foreign trade
multiplier does not find clear expression in an economy with less than full
employment.
92
Fourth, the whole analysis is applicable to a two-country model. If there are

more than two countries, it becomes complicated to analysis and interpret the
foreign repercussions of this theory.
Despite these shortcomings, the foreign trade multiplier is powerful tool of
economic analysis which help in formulations
3.8 THE PRINCIPLE OF ACCELERATION
The principle of acceleration is based on the fact that the demand for capital
goods is derived from the demand for consumer goods which the former help to
produce. The acceleration principle explains the process by which an increase (or
decrease) in the demand for consumption goods leads to an increase (or decrease)
in investment on capital goods. According to Kurchara, “The accelerator coefficient
is the ratio between induced investment and an initial change in consumption
expenditure”.
Symbolically, B = I/C or I = BC where B is the accelerator coefficient. I
is net change in investment ard C is the net change in consumption expenditure.
If the increase in consumption expenditure of Rs. 10 crores leads to an increase in
investment of 30 crores, the accelerator coefficient is 3.
This version of the acceleration principle has been more broadly interpreted by
Hicks as the ratio of induced investment to changes in output it calls forth. Thus
the accelerator v is equal to I/Y or the capital –output ratio. It depends on the
relevant change in output (Y) and the change in investment (I). It shows that
the demand for capital goods is not derived from consumer goods alore but from
any direct of national output.
In an economy, the required stock of capital depends on the change in the
demand for output. Any change in output will lead to a change in the capital stock.
This change equals v times to change in output. Thus I = v Y where v is the
accelerator. If a machine has a value of Rs. 4 lahks and produces output worth Rs.
1 lakh, then the value of v is. An entrepreneur who wishes to increase his output by
Rs. 1 lakh every year must invest Rs. 4 lakh on the machine. This equally applies to
an economy where if the value of the accelerator is greater than one, more capital is
required per unit of output so that the increase in net investment is greater than
the increase in output that causes it. Gross investment in the economy will equal
replacement investment plus net investment. Assuming replacement investment
(i.e. replacement demand for machines due to obsolescence and depreciation) to be
constant, gross investment will vary with the levels of investment corresponding to
each level of output.
The acceleration principle can be expressed in the form of the following
equations given by Brooman.
Igt = (Yt - Yt - 1) + R
= v Yt + R
93
where Igt is gross investment in period t, v is the accelerator Yt is the national

output in period t, Yt - 1 is the national output in the previous period (t – 1 ) and R
is the replacement investment.
The equation tells that gross investment during period t depends on the change
in output (Y) from period t – 1 to period t multiplied by the accelerator (v) plus
replacement investment R.
In order to arrive at net investment (in), R must be deducted both sides of the
equation so that net investment in period t is
Int = v(Yt-Yt-1)
= v Yt
This equation is nothing but I = v = Y, since Y =Yt-1. As a matter of fact, there
is little difference between I = v = Y as defined by Hicks and I = B  C, as
defined by Samuelson and others. The accelerator V and B are the same. Hicks
takes the increase in final output (Y) while Samuelson takes the increase in the
demand for consumer goods (C). In Hicks’ model net investment equals Int = v (Yt
- Yt -1) while in Samuelson’s model Int = ( B Ct – C 1). It has become customary to
explain the acceleration principle in terms of final output (Y).
TABLE – 3
Operation of the acceleration principle
Period in Years Total output Required Replacement Net invest- Gross
(Y) Capital investment ment Investment
(R) (In) (Ig)
(1) (2) (3) (4) (5) (6)
T 100 400 40 0 40
t+1 100 400 40 0 40
t+2 105 420 40 20 60
t+3 150 460 40 40 80
t+4 130 520 40 60 100
t+5 140 560 40 60 80
t+6 145 580 40 20 60
t+7 140 560 40 -20 20
t+8 130 520 40 -40 0
t+9
125 600 40 20 20
If Yt > Yt -1, net investment is positive during period t. on the other hand, if Yt
< Yt -1, net investment is negative during period in t.
3.8.1 Operation of the Acceleration Principle
The working of the acceleration principle is explained with the help of an
hypothetical example given in Table 1.
The table traces changes in total output, capital stock net investment and gross
investment over ten time periods. Assuming the value of the acceleration v =4, the
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required capital stock in each period is 4 times the corresponding output of that
period, as shown in column (3) The replacement investment is assumed to be equal
to 10 percent of the capital stock in period. Net investment in column (5) equals v
times the change in output between one period and the preceeding period t + 3 = v
(Yt - 3 Yt +2) or 40 = 4 (115 – 105). It means that given the acceleration of 4, the
increase of 10 in the demand for final output leads to an increase of 40 in the
demand for capital goods (machines). Accordingly the total demand for capital
goods (machines) rises to 80 made up of 40 for replacement and 40 of net
investment. Thus the table recalls that net investment depends on the change in
total output, given the value of the accelerator. So long as the demand for final
goods (output) rise net investment is positive. But when it falls investment in
negative. In the table I total output (column 2) increases at an increasing rate from
period t + 1 to t + 4 and so does not investment (column 4). Then it increases at a
diminishing rate from period t + 5 to t + 6 and net investment declines from period t
+ 7 to t+ 9, total output falls and net investment becomes negative.
PUT
OU T
O t + 1 t + 2 t + 3 t + 4 t + 5 t + 6 t + 7 t + 8 t + 9
GR OS S IN V E S T ME N T
NE T
O t + 1 t + 2 t + 3 t + 4 t + 5 t + 6 t + 7 t + 8 t + 9
T IM E
F i g u re - 1 3
The acceleration principle is illustrated diagrammatically y in figure 13 where

in the upper position. Total output curve Y increases at an increasing rate up to
period t + 6. After this it starts diminishing. The curve In. in the lower part of due
figure, shows that the rising output leads to increasing at an increasing at an
increasing rate. But when output increasing at an increasing rate between t + 4 and
t + 6 periods, net investment declines. When output starts declining in period t + 7
net investment becomes negative. The curve Ig represents gross investment is not
negative and once it become zero in period t + 8 the curve is again starts rising.
This is because despite net investment being negative, the replacement investment
is taking place at a uniform rate.
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3.8.2 Assumptions
The acceleration principle is based upon the following assumption.
1. The acceleration principle assumes a constant capital output ratio.
2. It assumes that resources are easily available.
3. The acceleration principle assumes that there is no excess or idle capacity
in plants.
4. It is assumed that the increased demand is permanent.
5. The acceleration principle also assumes that there is elastic supply of
credit and capital.
6. It further assumes that an increase in output immediately leads to a rise in
net investment.
3.8.3 Criticisms
The acceleration principle has been criticised by economists for its rigid
assumptions which tend to limit its smooth working. The following are its limitations:
1. The acceleration principle is based on a constant capital – output ratio. But
this ratio does not remain constant in the modern dynamic world.
Inventions and improvements in techniques of production are constantly
taking place which lead to increase in output per unit of capital. Or
existing capital equipment may be worked more intensively. Moreover
changes in the expectations of businessmen with regard to prices, wages,
interest may affect future demand and vary the capital – output ratio. Thus
the capital – output ratio does not remain constant but changes in the
different phases of the trade cycle.
2. The acceleration principle assumes the availability of resources. Resources
should be elastic so that they are employed in the capital goods industries
to capable then to expand. This is possible when there is unemployment in
the economy. But once the economy reaches the full employment level, the
capital goods industries fall to expand due to the non availability of
sufficient resources. This limits the working of the acceleration principle.
3. The acceleration theory assumes that there is no unused (or idle) capacity
in plants. If some machines are not working to their full capacity and are
lying idle, then an increase in the demand for consumer goods will not lead
to the increased for capital goods. In such a situation the acceleration
principle will non work.
4. As a corollary, the assumption of the existence of full capacity implies that
increased demand for output immediately leads to induced investment. The
acceleration principle, therefore, fails to explain the timing of investment.
At best it explains the volume of investment. As a matter of fact, there may
be a time lag before new investment can be generated. For instance, if the
time lag is four years, but effect of new investment will not be felt in one
year but in four years.
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5. Further, the timing of the acquisition of capital goods depends on their

availability and cost of financing them.
6. It is assumed that no increased demand for consumer goods had been
foreseen and provided for in previous capital invest. If by anticipating
future demand capital equipment has already been installed, it would not
lead to induced investment the acceleration effect will be zero.
7. This theory further assumes that the increased demand is permanent. In
case the demand for consumer goods is expected to be temporary the
produces will refrain from investing in new capital goods. Instead they may
meet the increased demand by working the existing capital equipment
more intensely. So the acceleration will not materialise.
8. The acceleration principle assumes an elastic supply of credit so that when is
induced investment as a result of induced consumption. Cheap credit is easily
available for investment in capital goods industries. If cheap credit is not
available in sufficient quantities, the rate of interest will be high and investment
in capital goods will be very low. Thus the acceleration will not work fully.
This assumption further implies that firms resort to external sources of finance
for investment purposes. But empirical evidence has shown that firms prefer
internal sources of finance to external sources. The acceleration principle is weak in
that it neglects profits as a source of internal finance. As a matter of fact, the level
of profits is a major determinant of investment.
1. The acceleration principle neglects the role of expectations in decision-
making on the part to enterpreneurs The investment decisions are not
influnced by demand alone. They are also affected by future anticipations
like stock market changes, political developments, international events,
economic climate, et. As pointed by J.W.Angell’ “Regardless of the state of
the present demand enterpreneurs will not increase present capacity
unless their anticipations for the future warrant the step”
2. The acceleration principle is weak in that it neglects the role of technological
factors in investment. Technological changes may be either capital –saving or
labour –saving. They may, therefore, reduce or increase the volume of
investment.. further, as pointed out by professor Knox, Capital equipment may
be bulky and the employment of additional plant is justified only when output
has risen considerably. This factors is all the more important because usually
what is added is a complex of machines and not a machine.
Despite these limitation, the principle of acceleration makes the purposes of
income propagation clear and more realistic then the multiplier theory. The
multiplier shows the effects of a change in investment on income via the
consumption while the acceleration shows the effect of consumption or output on
investment and income. Thus the acceleration explains voiatile fluctuations in
income and employment as a result of fluctuations in capital goods industries. But
it can explain upper turning points better than lower turning points.
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According to professor Knox, “The acceleration principle is …. Not precise and

is unsatisfactory as an explanation of the timing of investment. It suffers as an
explanation of the timing of investment. It suffers from a further weakness; it is not
of much use for explaining the lower turning point. …. The acceleration principle by
itself is inadequate as theory of investment. But prof Shapiro opines that – “the
acceleration principle, however, indequate by itself, clearly emerges as one of a
number of major factors that are needed in combination with the multiplier to
explain the fluctuations observed in the world of investment spending”.
3.9 THE SUPER MULTIPLIER OR THE MULTIPLIER ACCELERATION INTERACTION
In order to measure that total effect of initial investment on income, Hicks has
combined the multiplier and the accelerator mathematically and given it the name
of the super multiplier and the accelerator is also called the leverage effect which
may lead the economy to very high or low level of income propagation.
The super-multiplier is worked out by combining both induced consumption
(cY or  C’  Y or MCP) and induced investment ( v Y or  I |  Y or MPI). Hicks
divides the investment component into autonomous investment I = I a + v Y. where
Ia is autonomous investment and vY is induced investment.
Since Y=C+I
Therefore Y = C = Y + Ia + v  Y
Y - C  Y – v  Y = Ia
Y (I – C – v) = Y Ia
Where Ks is the super-multiplier, c is the marginal propensity to consume, v is
the marginal propensity to invest and s is the marginal propensity to save (s =1 = c).
 1 1
 
a 1  c  v s  v
1 1
s  
1 c  v 1 v
The super –multiplier tells us that if there is an initial increase in autonomous
investment, income will increase by K times the autonomous investment. So the
super –multiplier in general form will be
1
 a
1 c  v
 sa
3.9.1 Operation of the principle
Let us explain the combined operation of the multiplier and the accelerator in
terms of the above equation. Suppose c = 0.5, v = 0.4 and autonomous investment
increase by Rs.100 crores. The increase in aggregate income will be
1
  100
1  0.5  0.4
1
  100  10  100  1000
0.1
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It shows that a rise in autonomous investment by Rs.100 cores has raised

income to Rs. 1, 000 crores. The simple multiplier would have raised income to only
Rs. 200 crores, given the value of K the multiplier as 2 (since MPC = 0.5). But the
multiplier combined with the accelerator (ks = 10) has raised income to Rs. 1,000
crores which is higher than generated by the simple multiplier. Table II explains
how the process of income propagation via the multiplier and the accelerator with
the value of super –multiplier Ks = 10 leads to a rise in income to RS. 1,000 crores
with an initial investment of Rs. 100 crores.
In period t + 1 constant investment of 1,00 is injected into the economy but there is
no immediate induced consumption or investment. In period t + 2 induced consumption
of 50 takes place out of the income 100 of period t + 1, since the marginal propensity to
consume is 0.5, while there is an induced investment of 40 out of 100 income (v being
0.4). The increase in income in different periods can be calculated is Yt + 2 =
cYt+1+vYt+1=0.5X100+0.4X100=90. Similarly, the increase in income in period t +
3 can be calculated as Yt + 3 = c Yt + 2 = 0.5 X 90 + 0.4 X 90=45+36 =81. The total
increase in income (column 6) is arrived at by adding the increase in income (column 5)
of the current period to the total increase in income (column 6) in period t + 2 of 190 is
arrived at by adding the increase in income (column 6) of
TABLE – 4
Multiplier – accelerator interaction (Rs. Crores)
Induced Induced
Initial Increase in Total Increase
Period Investment Investment
Investment Income in Income
(C=0.5) (v=0,4)
(1) (2) (3) (4) (5) (6)
T+0 0 0 0 0 0
T+1 100 - - 100 100
T+2 100 50 40 90 190
T+3 100 45 36 81 271
t+4 100 40.5 32.4 72.9 343.9
t+5 100 36.45 29.16 65.61 409.51
… … … … …
t+n ANNAMALAI UNIVERSITY

100 0 0 0 1000
this period to the total increase in income (100 of column 6) of the previous period
t + 1. Similarly, the total increase in income in period t + 3 of 271 = increase in income
of 81 in this period plus 190 of column 6 of period t + 2 . This cumulative process of
income propagation continues till in period t + n induced consumption induced
investment and increase in income dwindle to zero. If we add up the increase in
consumption, investment and income from period t + 1 to t + n, the total income
99
increases to Rs. 1,000 crores, total consumption to Rs. 500 crores and total investment
to Rs. 400 crores, given the initial investment of Rs. 100 crores.
Y1 Y1
INCOME
PATH OF INCOME
O Y
TIME
Figure - 14
The dynamic path of income is shown in the adjoining Figure 14. Income is
measured vertically and time horizontally. The curve OYt shows the time-path of
income with a super multiplier of 10. The curve rises with time and reaches the
new equilibrium level of income Y1 and flattens out. It indicates that income
increases at a decreasing rate.
3.9.2 Use of multiplier – accelerator interaction in business – cycles
However, with different values of MPC and the accelerator the multiplier-
accelerator may show different results in terms of cyclical coefficient is 2. Given the
same assumptions and the initial investment of Rs. 100 crores, let us study how
changes in income take place. Table III explains this process of income propagation.
Table reveals that in period t + 1 there is an increase of RS. 100 crores by the
amount of initial investment. This increase in income leads to a rise in consumption of
Rs. 50 crores (column 3) in period t + 2 because the value of MPC is 0.5. this rise in
consumption induces investment to Rs. 100 crores = 50 X 2(column 4 ) the accelerator
coefficient being 2. And income increases Rs. 250 crores (column 2 + column 3 + column
4). The increased income, in turn, leads to an increase in consumption of Rs. 250 crores
as the MPC is 0.5 But consumption in period t is a function of income of the previous
period. Therefore, the actual increase in consumption in period t + 3 and t +3 i.e., 125
.50 = 75. If we multiply this increase in consumption 75 by the value of the accelerator
2, we get induced investment of 150 = 75 + 2 (column 4) in period 1 + 3. Thus the total of
columns 2 + 3 + 4 gives increase in income of Rs. 375 crores in period t + 3. This
increased income leads to induced consumption of 187.50 (column 3) in period t + 4 and
t + 3 (187.50 minus 125) is 62.50 which multiplied by the value of the accelerator 2 gives
the figure of 125 of induced investment (column 4) and the total of columns 23 and give
the increase in income of RS. 412.50 crores (column 5) in period t + 4, and so on. The
increase in income is the highest in period 1 + 4 which shows the peak of the bottom or
through when income is minus Rs. 11.70 crores in period t + 8. From period t + 9, it
again starts rising which shows the revival phase of the cycle. This behaviour of income
as a result of the combined operation of the multiplier and the falls and again rises at
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constant amplitudes. The actual behaviour of the cycle, however, depends on the values
of the multiplier and the accelerator as shown by somuelson in his model.
TABLE – 5
Multiplier – accelerator interaction (Rs. Crores)
Time Initial Induced Induced Increase in Income
Investment Consumption Investment (Column 2+3+4)
(=0.5) (v = 2)
(1) (2) (3) (4) (5)
0 0 0 0 0
t+1 100 - - 100
t+2 100 50 100 250
t+3 100 125 150 375
t+4 100 187.50 125 412.50
t+5 100 206.25 37.50 343.75
t+6 100 171.88 68.74 203.14
t+7 100 101.57 140.62 60.95
t+8 100 30.48 142.18 11.70
t+9 100 -5.48 72.66 21.42
t + 10 100 10.75 32.20 143.95
3.9.3 Criticisms
Professor kurihara points out that a less than unity marginal propensity to consume
provides an answer to the question. Why does the cumulative process come to a stop
before a complete collapse or before full employment? According to hansen, this is due to
the fact that a large part of the increase in income in each period is not spent on
consumption in each successive period. This eventually leads to a decline in the volume
of induced investment and when such a decline exceeds the increase in induced
consumption, a decline in income sets in. Thus, writes professor Hanseni “It is the
marginal propensity to save which calls a halt to the expansion process even when the
expansion is intensified by the process of acceleration top of the multiplier process”.
4. REVISION POINTS
Investment multiplier: It establishes a precise relationship,given the propensity to
consume, between aggregate Employment and incomes and the rate of investment
Dynamic Multiplier: It relates to the time lags in the process of income generation
Employment multiplier: It is a co efficient relating to as increment or primary
and secondary combined
Balanced Budget Multiplier: It is based on the combined operation of the Tax
Multiplier and Government expenditure multiplier
Foreign trade Multiplier: This depends on the marginal propensity to import
Acceleration: It explains the Process by which an increase in the demand for
consumption goods leads to an increase in the demand for capital goods.
Super Multiplier: It is a combination of induced consumption and I
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5. QUESTIONS
Section A
1. Bring out the importance of multiplier
2. Explain the leakages of multiplier
3. Explain the operation of Acceleration
4. What is Super Multiplier?
Section B
1. Explain the term multiplier. show its forward and backward working. How
is Keynes’ investment multiplier related to MPC?
2. Explain the multiplier principle and indicate the conditions under which
income increases according to this principle.
3. Explain the concept and working of acceleration principle.
4. What is super multiplier? Explain the interaction between multiplier and
acceleration.
6. SUMMARY
Thus the Multiplier concept helps us to find out the relationship between the
aggregate employment income and the rate of investment. But the acceleration
principle explains the change in the demand consumption goods, which will bring
about a change in investment of capital goods. But when there is interaction, the
results will result in higher level of income
1. Explain the multiplier principle and indicate the conditions under which
income increases according to this principle.
2. Explain the concept and working of acceleration principle.
3. What is super multiplier? Explain the interaction between multiplier and
acceleration.
2. Edward Shapiro, Marcro Economic Analysis, Harcourt Brace, Jovanovich, 1978.
4. Cauvery. R, V .K Sudha n ayek, M girija ,R.Meenakshi, Macro Economics ,
8. KEY WORDS
Multiplier, Dynamic Multiplier, Employment Multiplier, Balanced Budget
Multiplier, Foreign Trade Multiplier, Acceleration, Super-Multiplier.

Dr. R. Kaveri
Head of the Dept. of Economics
Sri Saradha college, Salem – 4.
102
LESSON – 6
DETERMINATION OF NATIONAL INCOME AND OUTPUT

1. INTRODUCTION
This chapter deals with the various concepts of national income, methods of
measuring national income, difficulties in measuring national incomeand factors
determining national income.
2. OBJECTIVES
 To acquire knowledge about the concepts of national Income and its
importance.
 To know the various method of measuring national Income, Factor
determining it and the difficulties involved in measuring it.
 To find out the relationship between National Income and Economic
welfare.
3. CONTENT
3.1 Introduction
3.2 Definition
3.3 Concepts
3.3.1 Gross National Product
3.3.2 Net National Product
3.3.3 National Income at Factor Cost
3.3.4 Personal Income.
3.3.5 Disposable Personal Income.
3.4 Methods of calculating National Income.
3.4.1 Product Method
3.4.2 Income Method
3.4.3 Expenditure Method
3.5 Difficulties in calculating National Income.
3.6 Uses of National Income Statistics
3.7 Factors determining National Income.
3.8 National Income and Economic Welfare.
3.1 INTRODUCTION
The concepts of national income and national product are most significant in
macro economic analysis. Both these macro concepts are frequently used to measure
the economic performance of an economy. While national product refers to a flow of
goods and services over any given period of time national income represents the flow of
total factor earnings in the economy during any given time period.
The concept of national income occupies an important place in the sphere of
production and distribution in economic theory. It is an important statistics for a
nation as personal income is for an individual. It gives information about the
103
nation's productive capacity and economic strength. National income study will
also reveal the extent of unemployment.
3.2 DEFINITION
But the concept if national income is being subjected to diverse interpretations.
In the words of Marshall, who was one of the earliest writers to popularise the
concept. "The labour and capital of a country acting on its natural resources
produce annually a certain net aggregate of commodities material and immaterial
including services of all kinds".
The limiting word 'net' is used to provide for the using - up of raw and half-
finished commodities and for the wearing-out and depreciation of plant which is
involved in production; all such wastes must of course be deducted from the gross
produce before the true or net income can be found. And net income on account of
foreign investment must be added in. Theoretically Marshall's definition is perfectly
correct. It brings out the full meaning of national 'income' the necessary deductions
to be made and the necessity to avoid double-counting. Above all it runs in terms
of goods produced. However it does not give a clear idea about the methods of
calculating the national dividend.
Pigou defined national income as follows: "The national dividend is that part of
the objective income of the community including of course income derived from
abroad which can be measured in money".
The chief merit of this definition is that it imparts preciseness in the sense that
it includes those goods and services that are actually sold for money. However, the
real difficulty about Pigou's definition is that it makes an artificial and deliberate
separation between the things that are exchanged for, money and that are not
exchanged for money.
But an altogether different concept of national income has been given by Irving
Fisher who has adopted consumption as the criterion of national income
accounting to him. "The National dividend or income consists solely of services as
received by ultimate consumers, whether from their material or from their human
environments. Thus a Piano or an overcoat made for me this year is not a part of
this year's income, but an addition to capital. Only the services rendered to me
during this year by these things are income".
Though Fisher's approach is better, scientific and reasonable in practical life it
will be very difficult to calculate the money value of the consumption of goods and
services. Further many of the durable goods provide service for many years and it
is difficult to estimate the value of services year after year.
In recent years Richard Stone has defined national income as follows: "The
National income or product provides a measure of the total value at factor cost of
goods and services produced in a period which are available either for consumption
or for additions to wealth. This total is valued in terms of the money and it is
equivalent to the income going to the factors of production" - labour, management
enterprise and property.
104
Simou Kuznets, an authority on national income Accounting defines national

income as "the net output of commodities and services flowing during the year from
the country's productive system into the hands of ultimate consumers or into net
additions to the country's stock of capital goods".
National Income Committee of India in 1951 defined this concept in a simple
manner. "A National income estimate measures the volume of commodities and
services turned out during a given period counted without duplication".
United Nations Department of Economic Affairs gives an elaborate definition of
National Income "Gross national product at market prices is the market value of the
produce before deduction of provisions for the consumption of fixed capital
attributable to the factors of production supplied by the normal residents of the
given country. It is identically equal to the sum of consumption capital and gross
domestic capital formation private and public and the surplus of the nation on
current account. Thus surplus us identically equal to the net exports of goods and
services plus the net factor income received from abroad".
J.R.Hicks defined national income as a collection of goods and services reduced
to a common basis by being measured in terms of money.
All the above definitions make it clear that national income is the money measure of
1. The net value of all products and services,
2. An economy during a year
3. Economy counted without duplication
4. An economy after allowing for depreciation
5. Both in the public and private sector of products and services
6. In consumption and capital goods sector
7. The net gains from international transactions.
3.3 CONCEPTS OF NATIONAL INCOME
A study of the concepts of national income follows from that of the definition.
Most countries have been compiling national income estimates for many years and
they have incorporated into them the following concepts, which are in general use.
3.3.1 Gross National product (GNP)
This is the basic measure of a nation's output stated in terms of money
representing the total value of a nation's annual output. It is evaluated in terms of
market prices. It includes all the economic productions in the economy from apples
and auto mobiles to zinc and zippers.
GNP is defined as the money value of the national production for any given
period. Here we take into account the money value of the final goods and services
produced in the economy to avoid double counting. Intermediate products are
excluded from the GNP.
Secondly we take into account the money value of only currently produced goods
and services as GNP is a measure of the economy's productivity during the year.
105
Thirdly the word gross has significance in the term GNP; we do not deduct the
depreciation or replacement of the fixed assets. It is well known that in the process
of production there is wear and tear of fixed assets. This depreciation is loss to the
economy and it will not be deducted from the GNP producted in the economy.
GNP is the most frequently used national income concept. It is a better index than
any other concept. It is also a simpler concept as it takes no account of depreciation
and replacement problems. Computation of GNP for several years of comparing them
will tell us whether there has been a long run growth or decline in the economy.
3.3.2 Net National Product (N.N.P)
N.N.P. refers to the net production of goods and services in a country during
the year. It is G. N. P. minus depreciation during the year. NNP=GNP depreciation
NNP is also called national income at market prices. NNP is a better and a highly
useful concept in the study of growth economics as it takes into consideration of
net increase in the total production of the country. But this concept has the
complex problem of fixing appropriate rates of depreciation for plants, equipments
buildings etc., in the economy.
3.3.3 National Income at Factor cost
National Income at factor cost is a slightly different concept from GNP & NNP. It is
the total of all incomes earned by the owner of factors of production for their
contribution of factors of production. Therefore in calculating N.I. at factor cost such
payments which are not made for any productive service is not included. Thus a man
may include the value of gifts he receives, transfers payments from business firms and
the government to calculate his income but he has not rendered any service to get from
them. Therefore they do not enter the calculation of national income at factor cost.
National Income is therefore the aggregation of factor earnings. It does not
include capital consumption allowance government business and individual
transfer payments and indirect taxes. All these do not reach the factors of
production. Similarly if the government pays any subsidy in support of any
industry whose cost of production is high as in the case of Handloom industry in
India these subsidies have to be added.
N.I. at factor cost = N. N .P. - indirect taxes + subsidies.
3.3.4 Personal Income (P. I.)
This is the actual income received by the individuals and households in the
country from all sources. It denotes aggregate money payments received by the people
by way of wage interest profits, and rents. It is the spendable income at current prices
available to individuals. This aggregate amount will be different from the national
income at factor cost. National income at factor cost is what is earned and personal
income is what is received. This undistributed corporate profits may not be available
for individuals. Corporate income taxes and payment towards social security measures
will not be available for individuals. Hence these amounts have to be deducted from
what is earned. Conversely there are certain incomes which are not currently earned
but paid to individuals. Payments as old age pensions or widow pensions, payments for
unemployment or any other welfare measures accrue of individuals. These are called
106
transfer payments by Government. These incomes have to be added. Thus P.I. is

arrived at, Personal income = N.I.-Corporate taxes undistributed corporate profits-
social security contributions + transfer payments.
3.3.5 Disposable Personal Income (DPI)
The whole of the personal income is not available for consumption as personal
direct taxes have to be paid. What is left after payment of personal direct taxes is
called Disposable personal income-DPI=PI-Personal taxes, property taxes and
insurance payment. This is the amount available for individuals and house holds
for consumption. It is not that the entire DPI is spent on consumption. A part of it
may be saved. Thus DPI = consumption + saving. This concept is useful in finding
money burden of personal direct taxation. What remains after saving is called the
personal outlay, which represents the community's demand for goods.
Having discussed the meaning and significance of GNP, NNP + other related
concepts, it is easy to estimate the value of one aggregate magnitude from that of
the other if we remember that it is chain relationship between different income
concepts. This relationship can be explained as below
Gross national product measured at market price
Rs. 500 Cr.
Minus Capital consumption allowance 20
Equals Net national product 480
Minus Indirect business taxes 30
Business transfer payments 2
Current surpluses of government enterprises 2
Plus Subsidies given by government 6
Equals National income at Factor cost 452
Minus Corporate profits 30
Employer's contribution for social Insurance 5
Employer's contribution 5
Plus Government transfer payments 15
Business transfer payments 5
Interest paid by government 5
Interest paid consumer dividends 2
Dividends 10
Equals Personal income 449
Minus Personal taxes 49
Equals
Minus
Disposable personal income
Personal saving
400
50
Equals Personal outlay 350
The relationship between

N.I.+ N. P. in an economy can be grasped properly by a simple eg. Of a
hypothetical economy. We assume that over our hypothetical economy is a market
economy with no government. Therefore, there are no Government outlays, no
107
taxes, no subsidies, no social insurance contributions. We also assume that the

simple economy is a closed economy having no relationship with the outside world.
In such an economy the relationship between GNP and N.I. at factor cost are the
flows throughout the economy will be as follows:
Output of Purchase of
Intermediate Goods Intermediate Goods
Production & Sales

Total Business
Purchase of
Output of Input Services
Consumer Wages Intrest
Gross National
Goods Rent
Product
Profits
Output of Capital Goods Capital Stock
Depreciation
Investment National
Outlays Income
Personal
Savings
Disposable
Income
Consumer
Outlays
FIG. 1
Relationship between G. N. P and national incomes at factor cost

Here we assume that the entire production takes place in the business sector,
output of intermediary goods is shown at the top in the form of a small box. The
total product originates in the business sector. After allowing for a capital
depreciation it goes into national income flow in the form of wages, interest, rent
and profits. All these are flows from the business sector to the factory owners as
shown on the right hand side. Out of national income which happens to be
disposable income, people divided it between C & S. This is shown in the bottom
right hand side of the figure. It is a return flow to the business sector in the form of
demand for consumption goods and capital goods. The circular flow of income is
complete as shown in the diagram.
108
A real world economy of course is some what different from a simple economy
pictured here. In our simple economy which is a closed economy with no
government N.I., N.N.P., Disposable income all are the same. But in reality
government sector and international relations are very important. Of course there
the analysis will have to be changed, Though the fundamental principles are the
same. That is why social accountings are more complicated than single national
income accounts.
3.4 METHODS OF CALCULATING NATIONAL INCOME
The estimates of GNP and N.I provide economists with a powerful tool for
analysing an economy's performance. Therefore, it is essential to construct
accurate and reliable GNP estimates. Thus methods are used for the calculation of
N. I. the product method, the income method and the expenditure method.
3.4.1 Product Method
This is also called the output method, the inventory method or the census
method. This method consists of finding out the market value of all goods and
services produced during a given year.
According to this method the economy is classified into different sectors,
namely agriculture industry, direct services and for big transactions. In each sector
we make an inventory of goods produced and find out the end product making an
addition to the value of goods. The value added method can be followed in order to
avoid double accounting. The value added of a firm if its output less whatever it
purchases from other firms such as raw materials, and other inputs.
In the direct sector, the value of services of such professions like doctors,
dramatists, soldiers, politicians etc., are taken by equating to the services.
In the international transaction sector, we take into account the value of goods
exported and imported, payment, from abroad payments to other countries. When
all the sector incomes are added we get national income at market prices.
This method has a merit because it helps us to have a comparative idea of the
importance of various activities in economy like agriculture, manufacturing, trade
etc. However in advanced countries like U.S.A., their method may be successful as
it is very easy to get data from government records. But in U.D.C. this method may
give rise to various problems like imputation of money values to non-monetised
sector.
3.4.2 Income Method
This method refers to the gross national income obtained by adding together
wages and salaries, interests, profits and rents of persons and institution and
including government incomes are earned either from property or through work. To
arrive at the totality of income of nation, the following procedure will be adopted:
1. net rents include the rental value of owner occupied houses.
2. wages, salaries and all such earnings of person employed, pensions are
excluded.
3. earnings by way of interest.
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4. income of joint stock companies.

5. income from overseas investment.
This method gives us national income at factor cost.
3.4.3 Expenditure Method
The American economist Samuelson calls it as "Flow of product approach". In
India it is known as outlay method. Here we take into account the expenditure on
finished products.
1. Expenditure by consumers on goods and services.
2. Expenditure by producers on investment of goods.
3. Expenditure by government on consumption as well as capital goods.
To this we should add money received from abroad through trade and other
payments. The figure thus arrived at will give us GNP. The merit of this method is
that it believes in the identity between national expenditure, income and total product.
Whichever method we use the result should be more or less same. In other we
might have added depreciation cost and thus arrive at GNP. In the other we might have
to include only incomes and thus arrive at national income at factor cost. All these
have to be borne in mind while comparing the data which we get from the adoption of
the method. All the 3 method can be used to cross-check reliability of our estimates,
but no country has perfected national income accounting to such an extent.
3.5 DIFFICULTIES IN CALCULATING NATIONAL INCOME
The measurement of national income is beset with difficulties. In U. D. C. s.
these difficulties are more prominent, making the computation of national dividend
an extremely difficult task and figures may not be much dependable.
A. Conceptional difficulties
1. There has been difference of opinion regarding the term 'nation' in the
concept of national income. It has to define exactly, whether it is
geographical entity of the country or the nationals including those residing
abroad Since N.I., constitutes a quantitative measure of economic activity
rather than verbal description, the problem of including services has
become a controversial one.
Since everything has to be equated to the money value, services produced
in economy for love of humanity affection, and philanthrophy could not be
taken into consideration in calculating national income.
2. Besides, in a backward economy like India, there is an overlapping of
occupation in rural sector which makes it difficult to know the income by
origin. A worker in a peak season works in a farm, drives a country cart
during off season and even takes up unskilled work in the neighbouring
town. Similarly, the village money lender combines his profession with the
cultivating of his farm.
3. Further, in the rural sector of backward economics, the cultivators,
artisans and cottage industry workers do not have a fair idea of the
110
expenses of their occupation. Hence the net value of their products cannot
be estimated precisely.
4. Whether there is a big chunk of non- monetized sector and barter dealings
are prevalent, the problem of inputting the value to the cottage dealt
outside the monetized sector creates a problem leading to much of guess
work and approximation.
Due to ignorance and illiteracy of the people in rural sector of backward
economics, the data may not be available and even if it is available, it will be
unreliable. The figures furnished by the village officials and block officials are far
from reliable as they are not trained for the purpose, nor do they keep correct and
current data.
In the agricultural activities there is a good deal of guess work in data relating
to cropwise production and in figures relating to animals and forest products.
In the factory establishments, data relating to output, cost etc., are available
only in big units. The small units do not maintain these figures correctly. The
hundreds and millions of small industrial units do not supply figures, nor do they
have correct figures. The banking sector will be another formidable problem in the
unorganised sector. The village money lenders and indigenous bankers maintain
absolute secret of their and they do not furnish correct information.
Above all in a big country like India with wide disparities and regional differences,
the gaps cannot be got over by using a uniform formula. The data of one region cannot
be applied to another region with minor modifications. Every region would be a
separate entity requiring specialised approach suited only to that region.
Though abundant data are available for government activities, the diversity and
copiousness of exceptions make it almost irreducible to economic categories.
The error of double counting is another obstacle to be avoided in the
calculation of national income.
Finally, the machinery for collecting statistical data may not be efficient. The
investigators may be ill-equipped and quite unsuitable to the task. Lack of qualified
statistical investigators, preparation of adhoc figures, making sample surveys etc.
3.6 USES OF N.I. STATISTICS
a) National income statistics are valuable instruments of economic
analysis and a guide to economic policies to be pursued. It is more
useful in the context of planning and of the city. It helps in
formulating realistic plans.
b) National income statistics given an idea India structure of the
economy. It helps to make inter-leinporal comparisons and to study
the rate of growth of the economy. The growth in N.I. is an index of
the growth of the productive capacity of an economy.
c) National income estimates help us to study intersectoral growth. Such
intersectional comparisons are useful in a developing economy. The
111
share of agriculture, industry transport and communications and

other services can be studied with the help of national income series to
find out structural defect and weaknesses in the economy.
d) A national income estimate enables us to study class distribution.
Percapital income or percapita consumption are general indicators of
economic welfare. But they are unable to reveal distribution of income
in society. For this purpose, national income on distribution of income
by size are prepared.
e) N.I. estimates enable us to make international comparisons and the
standard living of the people.
f) N.I. figures show the capacity of each country to bear some common
burden of international institutions like the U.N.O.
In short, National income figures help governments in planning. Policy making.
Preparation of budgets and forecasting the level of economic activity.
3.7 FACTORS DETERMINNING NATIONAL INCOME
1. Quality and Quantity of Factors of Production
The quality and quantity of land the climate, the rainfall etc., determine the
quantity and quality of agricultural production. This determine the size of N.I. the
quantity of labour has double influence since labour is both a factor of production as
well as the consumer of what is produced. The quality of labour depends upon
intelligence, training which inturn decides the volume of industrial productivity. This
will have decisive influence on output. Likewise, the quantity and quality of
entrepreneurial ability is also a main element in the determination of N.I. of the city.
2. State of Technical Know -how
The extent of technical know how and technology in production determine the
capital formation in the country.
A country with abundant resources will be dormant without any determination
if, the resources are not scientifically exploited. Natural resources combined with
advanced technology will go a long way in increasing the size of national income.
3. Political Stability
The key to increase the N.I. rests with important factors like capital formation,
national resources, technical know-how political stability and above all national
character of the people.
In backward cities all three factors will be deplorably lacking and the size of the
N.I. will be small.
3.8 NATIONAL INCOME AND ECONOMIC WELFARE
National income is considered as an indication of economic welfare of a city.
Marshall considers that national income is a suitable measure of economic progress
of a city rather than the national wealth.
J. R. Hicks considers that "when national income has been converted to real
Terms, it is the best single measure of the nation's well being or economic progress".
112
A city with a higher percapita income is supposed to enjoy greater economic

welfare than a country with a lower percapita income.
To Pigou, Economic welfare is "that part of social welfare that can be brought
directly or indirectly in relation with the measuring rod of money". The need for drawing
distinction between economic and non-economic welfare arises because at a given point
of time, in a country, economic welfare could have increased without, however, welfare
as such not increasing. Economic welfare is a part of social welfare the other part being
non-economic welfare which cannot be brought under the measuring rod of money. Any
cause which increases economic welfare may not necessarily increase the total welfare.
The reason is obvious. The cause which increase economic welfare may also be the
cause which diminishes non-economic welfare to an equal extent. So that the Total
welfare may remain unchanged or even go down. For instance the phenomenal increase
in cigarette production may add to he GNP of the country. But the cost of treating lung
cancer victims due to smoking is the disproduct in the process of development. Hence,
economic welfare cannot be the index of total welfare.
4. REVISION POINTS
National product - it refers to a flow of goods and services over any given
period of time
Net national product - GNP – depreciation
National income at factor cost - national income - indirect taxes + subsidies
Personal income - National income – corporate taxes – un distributed corporate
profits – social security contributions + transfer payments
Disposable personal income - consumption + saving
Product method - market value of all goods and services produced during a
given year.
Income method - wages and salaries + interest + rent + direct axes + indirect
axes + mixed income + depreciation + income from abroad expenditure method :
expenditure on consumption goods + expenditure on investment goods +
government expenditure + net income from abroad.
5. QUESTIONS
Section –A
1. Explain any one method of measuring the National income.
2. Bring out the Importance of National Income
Section-B
1. What do you understand by national income? Is national income a true
indicator of a country's prosperity?
2. Discuss the limitations inherent in the aggregates of national income and
product.
3. Define the various concepts to national income. Which of these concepts is
the best measure of the performance of the economy and why?
113
4. Explain and differentiate between(1) GNP (2) NNP (3) National Income ) (4)
Personal Income (5) Disposable Income.
6. SUMMARY
Thus National Income refers to the flow of goods and services over any given
period of time. Though there may arrive many difficulties in the calculation of
national income, it can be used as a guide to economic policies and as a measure of
economic progress.
1978.
4. R. Cauvery.R , V.K Sudha nayek, M girija, R.Meenakshi, Macro Economics
, S.chand & company, New Delhi.
8. KEY WORDS
Gross National Product, Net National Product, Gross National Product, Net
National Product at Factor cost, Personal Income, Disposable Income, Percapita
Income

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LESSON – 7
GOVERNMENT EXPENDITURE AND THE LEVEL OF INCOME

1. INTRODUCTION
This chapter deals with the fiscal model that studies the possible influence of
government expenditure, and taxation separately and both taken together and also
the transfer expenditure
2. OBJECTIVES
 To gain knowledge over the fiscal models of government expenditure.
 To know the concept Transfer Multiplier
3. CONTENT
3.1 Introduction
3.2 Three Fiscal Models of government Expenditure
3.3 Transfer Multiplier
3.1 INTRODUCTION
All factors affecting national income determination are of great relevance in
policy making. A two sector model of Y = C + I considers consumption expenditure
and investment expenditure both by individuals and household sectors.
Manipulation of these two as anti cyclical policy is very difficult if not impossible.
The twentieth century saw, the emergence of government demand or government
expenditure as another component of income determination i.e., Y = C + I x G has
brought about immense possibilities in the realm of policy making because
government expenditure can be manipulated to suit the needs of times.
Government can expand aggregate demand by increasing its purchases of goods
and services (government expenditure) or by decreasing the amount it diverts from
the stream of private spending thought its net tax collections. Similarly the
government can control aggregate demand by reducing its purchase of goods and
service or by increasing the amount of its net tax collections, government policy
with respect to spending and taxing in known as its fiscal policy. Fiscal policy can
therefore be wielded to control a depression or an inflation.
In the years since great depression fiscal policy has been accepted as an
important instrument to the attainment of certain economic force of which full
employment ranks at the top. Thus if the economy is at less than full employment
level, the appropriate fiscal policy should be expansionary. If the economy is at full
employment with a strong upward pressure on prices, fiscal policy should be
contractionary. Thus there are two sets of basic fiscal policy alternatives and if the
need is for an expansion of income the fiscal policy alternatives and are to increase
government spending, decrease taxes or both. On the other hand if inflationary
pressures need collraction of income the fiscal policy alternatives are to decrease
government spending, increase taxes or both.
Shapiro constructs three fiscal models to explain the influence of government
expenditure on national income. In the first model he adds only tax receipts are
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assumed, T and government purchases G to the two sector model =  = C + I

government transfer payments are assumed to be zero. In the second model
government transfer payments are added in third model tall receipts are assumed
to be dependent on the level of income. These models help in understanding how
fiscal policy serves, as a useful tool to bring destabilisation of income.
3.2 THREE FISCAL MODELS OF GOVERNMENT EXPENDITURE
First fiscal model including net taxes and government purchases
The first fiscal model studies the possible influence of government expenditure
G, taxation T., separately and they both taken together. When government
demands goods and services for a price, national income equilibrium is shown by
Y=C+I+G
In this case any change in the value of G becomes equal to the influence of
ordinary multiplier for eg.
Y=C+I+G
Y = a + I in the absence of G.
I-b
Now it would be
Y = a + I + G. if there is
I-b
any change in G, then G. will bring about an increasing income Y.
Assuming C and I to be constant the change in Y is.
1
    a  I  G  1 G
1 b 1 b
1
  G
1 b
 1
 or
G 1  b
Government expenditure will produce the same effect on national income as the
value of ordinary multiplier.
The figure shows the government expenditure multiplier in operation. Let us
say the government holds taxes constant. But it increases its expenditure by a
budgetary deficit. The increase in government expenditure is equal to G. The
aggregate demand curve shifts from C + 1 + G to C + 1 + G + G in panel B.
The same shift is indicated by the upward shift of 1 + G curve to 1+ G + G in
panel C. The economy as a result reaches a new equilibrium level of increase from
Y2 to Y3. The increase in income Y3-Y2 is greater than the change in government
expenditure of<G. This is because of government expenditure multiplier in action.
The government expenditure means higher incomes, higher consumption and
higher demand. This means greater production and an increase in employment
from N1 to N2 in panel A.
116
Y (A ) Z Y (B )
EXPECTED TOTAL REVENUE
DEMAND
Y3
Y2
AGGREGATE
O N1 N2 X O
Y1 Y2 Y3 NATIONAL
INCOME
EMPLOYMENT
Y
(C)
INFLOWS AND OUTFLOWS

T
+
S
I+G+G
I+G
O
Y1 Y2 Y3
Fig. 2
NATIONAL INCOME
Thus if MPC is 0.75 and multiplier (K) = 4. G of Rs.10 crs will increase income
by Rs.40crs. Therefore it full employment income is short of just Rs. 40 crs The
government can restore full employment equilibrium by spending Rs. 10crs. For
purchase of goods and services. This was what Keynes has recommended in times
of depression as a part of compensatory fiscal policy.
The first fiscal model studies the impact of taxation too. The only difference is
the introduction of T in national income equation influences income Y only through
consumption C because Yd disposable income is equal to
Yd = Y - T
C = a + by
Y=C+I
  a  b    
1
 a  b  1
1 b
If taxes are increased by Rs. 10crs. Indicated by T then Y/T
will be equal to -b/1-b. The tax multiplier is equal to 3. Hence a taxation of Rs.
10crs. Will lead to a fall in the income of Rs.30 crs. So if there is need for fiscal
policy to raise income to the tune of Rs. 40 crs. Taxes may have to be reduced to
the extend of Rs. 13.1/3 crs. And if there is inflation taxes have to be increased by
Rs. 13.1/3 crs.
There is a striking difference between taxation and expenditure as fiscal tools
for stabilisation. Government expenditure of Rs. 10 crores brings an income of Rs.
40 crs. because government expenditure multiplier is 4 in the given example. But a
tax reduction of by Rs. 10 crs. brings about an increase of only Rs.30 crs. because
117
the tax multiplier is 3. Only government expenditure reaches the economy in the
first round. But when government reduces taxes by Rs. 10 crs. disposable income
goes up by Rs. 10 crs. out of which a portion is saved and a portion is spent
depending on MPC. If MPC is .75 people will save Rs. 2.5 crs. And spend Rs. 7.5
crs and it is this Rs.7.5 crs Which reaches the people as income and that is why
Rs. 7.5 crs. through ordinary multiplier would produce Rs 30crs or taxation of Rs,
10crs. Through tax multiplier 3 produces 30. In either way government expenditure
proves to be more expansionary or contractionary compared to an equal amount of
taxation. The government should carefully decide about whether it requires an
expenditure of Rs. 10 crs. if its aim is to increase income by Rs. 40 crs. which is
good. One cannot therefore say for certain because it depends on the nature of the
economy and the fiscal system.
The fiscal model used by Shapiro has become a useful tool to analyse the
impact of a balanced budget on national income. The classicals had held that the
balanced budget i.e. government expenditure financed by equal amount of taxation
is neutral in effect and they had concluded that under conditions of full
employment the best policy is to follow a balanced budget. But the extension of
multiplier theory to fiscal models have exploded the myth that balanced budget is
neutral. In simple terms the working of the balanced budget multiplier may be
shown as follows:
Government expenditure multiplier
 1

G 1  b
A budget is balanced when G = T. Therefore when we have a balanced
budget it means the following impact will be on the economy viz.
 

G 

1

 b  1  b  1
1 b 1 b 1 b
That is, the value of budget multiplier is unity. Once we accept that it is unity,
balanced budget can never be neutral because an expenditure of Rs. 10 crs.
financed by taxation of Rs. 10crs. will bring about an increase in income of Rs. 10
crs.
G = Rs. 10crs. X = Rs. 40 crs.
expansion of income
T = Rs. 10crs. X 3 =
Rs. 30 crs. of contraction of income.
Net effect = Rs. 10 crs. expansion.
This unit multiplier theorem has dramatic implication for fiscal policy. If the
economy is under employment with Rs. 40 crs. a balanced budget of Rs. 10 crs. will
raise income in four stages or it may require a balanced budget of Rs. 40 crs. at one
118
stroke. Secondly, if the economy is at full employment and balanced budget were
adopted as recommended by the classicals, there would still be expansion of
income which would escalate inflationary potential. In short a balanced budget in
an economy with full employment will prove to be inflationary. This is of great
importance for stabilisation policies. An economy with full employment may
require a surplus budget to avoid inflation and not a balanced budget as the
classicals suggested.
Second Fiscal Model Including Gross Taxes, Government Purchases And Transfer Payments
The first model emphasised the effects on income of changes in the net tax
receipts of government. T, and government purchase of goods and services G. In
the second model let us introduce simple modification which brings out the
essential difference between the effects on income of changes in government
purchase and of changes in government transfer payments.
Net tax receipt T, are equal to gross tax minus government transfer payments
and interest on debt of Tg - R. expressing this as T = Tg - R underscores the fact
that R is really negative taxes, in effect an amount of gross tax receipts that is
returned to individuals through government transfer and interest payments
substibility Tg-R for T, the net national product now becomes.
C + S + Tg - R = Y = C + I + G
C + S + Tg - R = Y = C + I + G
Disposable personal income Yd = Y - Tg+R
The consumption function therefore is
C = a + b(Y-Tg+R)
Equilibrium level of income is
1
 a  bg  bR    G
1 b
Y = a + b (Y - Tg + R)+ I + G
The only difference between the equations without and with transfer payment
is that T is substituted by Tg-R. G effects aggregate spending while, it through its
effect on disposable income and that too that part of disposable income devoted to
consumption while the whole of G forms a part of the aggregate spending but
only b R is added to consumption expenditure out of R. Government spending
multiplier is given by the formula.
 ANNAMALAI UNIVERSITY

1
G 1  b
While the government transfer multiplier
1
  bR
1 b
 b

R 1  b
119
The transfer multiplier is the same as tax multiplier except it is not negative.
Let us compare the multiplier effect of G and R. Let us assume that
G = 5 R=5 b = .75
1 1  20
  G  5  20  4
1 b .25 G 5
1 1
  bR  .75  5  15
1 b .25
 15
  3.
R 5
If the tax financed increase in government expenditure is an increase in R
rather than in G, the result will be
bk  bg
    15  15  0
1  b 1 b
Here we note that the expansionary effect of R is offset by the contractionary
effect of Tg.
Third fiscal Model- Including Gross tax Receipts as a Function of Income
Government Purchase Tax and Transfer Multiplier
The government may by way of creating deficit budgets (1) reduce tax receipts
(2) increase its purchases (3) increase its transfer payments (4) a combination of
these methods.
Expenditure on purchases will have a higher multiplier effect than tax
reduction or transfer payment. Increasing or decreasing transfer payments and tax
receipts by the same amount will not affect the level of income.
So far we have studied the effect of a change in any one of the variables, may
be C, I, G ,T or R on the level of income assuming all other factors to remain
constant. In reality it is likely that a change in one will affect the others also. A
change in income will affect tax receipts as Income Corporate taxes, Sales tax,
Excise etc. increase with an increase in income. Therefore tax receipts can be
treated as a linear function of income.
Tg = Ta + tY
Ta = denotes autonomous tax receipts which independent of income, t marginal
propensity to tax. If R denotes transfer payments at all levels of income the net tax
function T = Ta + Ty - R. Tg = Ta + Ty. Substituting for Tg we have the equilibrium
equation.
C + S + Ta + ty - R = Y = C +1 + G
Disposable personal income becomes
d    a  ty   R
d    a  t  R
120
C  a  b  a  ty  R 
  a  b  ba  bt  bR  1  G
consumption function equals
1
 a  ba  bR  1  G
1  b1  t 
In the previous model discussed when T was assumed to be independent of
income, the multiplier was 1/1-b when it is assumed to be dependent on income,
the multiplier is 1 / (1-b) (1-t) which will be less than 1/1-b for eg., if b-, 75, I = 20
G - 10
1
  10  1.25
1  .751  .20
1
 10  40
1  .75
while
The marginal propensity to tax disposable income and consumption. At each
period the disposable income is reduced by 1/5th
The following table will illustrate the multiplier process when the marginal
propensity to tax (t) is taken into account.
t = 2 & b = .75
Period Y G Tg Yd C
0 0 0 0 0
T+1 10.0 10.0 2.0 80. 0
T+2 16.0 10.0 3.2 12.8 6
T+3 19.6 10.0 3.9 16.7 9.6
T+4 21.8 10.0 4.4 17.4 11.8
T+5 23.0 10.0 4.6 18.4 13.0
T+n 25.0 10.0 5.0 20.0 15.0
Tg = T Y
d    tor  g
C  bd
 25

G 10
2.5
If we assume the marginal propensity to tax as zero, then Tg = 0 and

therefore Y = Yd G will have the same effect as 1.
1 1 1
K    4.
1  MP C 1  .75 .25
The increase in income would have been 40.
121
It will be unrealistic to assume any fiscal policy comprising government

expenditure alone and no taxation. Therefore the success of fiscal policy can be
analysed only by taking into account the complained effect of the tax multiplier and
the government spending multiplier.
3.3 TRANSFER MULTIPLIER
Transfer expenditure denotes the government expenditure towards payment of
pensio, flood relief, unemployment relief etc. Its effect is to increase the disposable
income (Yd) on which consumption depends.
Yd = NNP - Taxes + Transfer payment (TR) Transfer payment increases the
consumption expenditure through which national income increases due to the
multiplier effect Transfer multiplier is the ratio of the change in transfer
expenditure and the change in the equilibrium level of income caused by the same.
As transfer expenditure affects income through MPC which is less than 1 the value
of the transfer multiplier will be less than the value of the income multiplier. The
formula for Transfer multiplier is
 b
  t
R 1  b
In the pre industrial society poverty was due to famine or due to uneven
income distribution. The modern capitalistic laissez faire economies suffer from
poverty in the midst of plenty. There exists production gaps between full
employment equilibrium output and the actual output brought about by the
savings investment equality. Here comes the role of fiscal policy to restore the
macro economic equilibrium. A fall in private spending should be offset by an
increase in government expenditure. We should avoid both inflationary and
deflationary gaps so that full employment savings and investment just match
without demand pull inflation. If C + I + G is too high, we have an inflationary gap
and we rise taxes to shift the C + 1 + G schedule downward. Taxation reduces the
disposable income and consumption and through the negative tax multiplier effect
will reduce the income. The deflationary gap arises due to deficiency of investment
schedule at full employment compared with full employment saving. This gap
should be bridged by increasing government spending which has the same
multiplier effect as increased investment. Therefore we can conclude that the
government is called upon to do something about price rise or wide spread
unemployment, it resorts to fiscal policy which comprises tax and government
expenditure policies in order to change the equilibrium level of income. Permanent
tax reductions are almost as powerful a weapon, against mass unemployment as
are increases in government expenditure eg: Kennedy Johnson tax cut in U.S in
1994. An increase in government taxes and investment unchanged has
expansionary effect on national income. The C + I + G curve shifts up-ward to a
higher equilibrium intersection with the 450 line. Similarly an increase in taxes with
I & G unchanged lowers the equilibrium level of national income. The consumption
schedule is shifted downwards.
122
4. REVISION POINTS
First-Fiscal Model- It includes Net taxes and government Purchases.
Second Fiscal Model–It includes gross taxes, government purchase and transfer
payments.
Third Fiscal Model- It includes from tax Receipts as a function of Income,
government purchase tax and transfer multiplier.
Transfer Multiplier: It includes the government expenditure towards payment of
pension, flood relief unemployment relief etc.
5. QUESTIONS
Section A
1. Explain any one Model of government Expenditure.
2. Explain Transfer Multiplier.
Section B
1. Explain the different types in which the government can influence the level
of income through its first operations?
2. Elucidate the statement that taxes affect the income level a manner which
is exactly the opposite of transfer expenditure.
3. Explain the statement that the thesis of balanced budget multiplier can
only by expansionary and not neutral?
4. Analyse the implications of government purchase, tax and transfer
multipliers in the process of income generation?
6. SUMMARY
The theory of income determination discussed so far is a powerful tool to
understand the influence consumption investment, government expenditure and
taxation on the level of national income economic activity. It helps us to understand
the ups and downs of the business cycle and how governmental fiscal policy can be
used to fight economic fluctuations, and restore macro economic equilibrium
1978.
4. Cauvery R. , V .K Sudha n ayek, M girija ,R.Meenakshi, Macro Economics ,
8. KEY WORD
Transfer Multiplier

123
LESSON – 8
INTERNATIONAL TRADE AND THE LEVEL OF INCOME

1. INTRODUCTION
This lesson deals with the balance of international payment which includes
Balance of trade and balance of payment and also the interdependence between
imports and exports And also the derivation of IS and LM model including imports
and exports.
2. OBJECTIVES
 To establish equilibrium in a open and closed economy.
 To derive the IS-_LM model including imports and exports
3. CONTENT
3.1 Introduction
3.2 Balance of Payment
3.3 Balance of Trade
3.4 Equilibrium
3.4.1 In a closed economy
3.4.2 In an open economy
3.5 Interdependence between imports and exports
3.6 Derivation of the IS function
3.7 Shift in the IS-LM function
3.8 Measures to convert Dis-Equilibrium
3.8.1 Automatic Measures
3.8.2 Deliberate Measures
3.8.3 Monetary Measures
3.1 INTRODUCTION
An open economy is that economy which trades and carries on financial
transactions with the outside world. The basis element introduced by open
economy (international trade) is that certain countries can use goods which they
themselves do not produce - they can get these goods from other countries
(imports); and they can sell goods which they themselves do not want -they can give
goods to other countries (exports). One approach stresses the need for domestic
progress regardless of its effects on the balance of payments, while the other
approach stresses the need for balance of payments equilibrium whether that
external balance is or is not conductive to internal growth. The constraints facing
individuals in an open economy can be and are, thus quite different from those they
face in a closed one. In the international trade were a kind of barter (that is, goods
were exchanged for goods) there would perhaps be no problem; but international
trade and international capital transactions involve currency flows amongst
countries, and situations do arise when imports may be more than exports and
124
exports may be more than imports. Hence, we examine the balance of payments
and the effect of domestic variables on the balance of payments. This also leads us
to an examination of the conditions for internal and external equilibrium or
balance. In other words, the study involves an understanding of the conditions
necessary for balanced or equilibrium growth without internal inflation and
external imbalance.
3.2 BALANCE OF INTERNATIONAL PAYMENT
Balance of Payment
Balance of payment accounts is nothing but a country's transactions with
other economics. There are two accounts in the balance of payments:
a) The current account: It records (1) trade in goods and services and (2)
transfer payment, services include freight, royalty payment, and interest payments.
Transfer payments consist of remittances gifts and grants. We talk of current
account surplus if exports are greater than imports, plus net transfers to
foreigners.
b) The capital account: It records (1) purchases and sales of assets such as
stocks, bonds, land etc. we talk of capital account surplus if net capital inflow (i.e.
receipts from the sale of stocks, bonds, land, bank deposits and other assets) are
greater than payments for our own purchases of foreign assets.
The overall balance of payments is the sum of the current and capital accounts.
If both current account and capital account are in deficit. If one account is in
surplus, and the other is in deficit to the same extent then we can say that the
balance of payments is zero. I.e. neither in surplus nor in deficit. Sometimes
current account will be consistently in surplus while capital account is in deficit.
The balance of payments is a statement that records all economic transactions
visible and invisible, within a given period (usually a year) between the residents of
one country and the rest of the world (the residents of other countries). The balance
of payments forms part of the national income or social accounts of a country
because the rest of the world sector is an important sector in social accounting. It
shows what is sent to foreign countries by one nation and what I received from
them in return. In the words of Peterson "A nation's international economic balance
involves all the international economic transactions that residents of one nation
enter into with the residents of all other nations of the world during some specific
period of time". Balance of payments show to the government authorities the
international economic position of the country and enables them to arrive at fiscal
and monetary policies on foreign trade and foreign exchange and international
payments.
Balance of payments accounting of a particular country is done on the basis of
double entry system of recording accounts (credit and debits) with the rest of the
world. A model of the accounting system is shown below.
Country's balance of Payments - Account
125
Credit (Receipts) Debit (payments)

Item Rs.(Crores) Items Rs.(Crores)
1. Mechandise Trade (goods 200 8. Merchandise Trade (goods 300
exported) imported)
2. Service exported 100 9. Service imported 200
3. Income from foreign 200 10. Foreign investments at home 200
Investments
4. Unilateral receipts 100 11. Unilateral payments 100
Sub Total 600 Sub Total 800
Capital Transactions
5. Long term 12. Long – term
borrowing 200 Lendings 80
6. Short-term 13. Short-term
borrowings 100 Lendings 60
7. Sale of gold /assets 100 14. Purchase of gold / assets 60
subtotal 400 Subtotal 200
GRAND TOTAL 1000 GRAND TOTAL 1000
In this table, items 1 and 8 show the country's visible exports; and imports; items
2 and 9 refer to items of invisible trade; items 3 and 10 pertain to investment incomes
items 4 and 11 show unilateral transfers like gifts and donations (private and official).
Items 5 and 6; 12 and 13 show capital movements. Items 7 and 14 show gold outflow
and gold inflow. Items 1 to 7 show receipts ® and items 8 to 14 show payments (p). The
total value of the both credit and debit side is the same (Rs. 1000/crores). Moreover, all
the items 1 to 4 and 8 to 11 are in current account and represent flow dimension
(during the current year). Items 5 to 7 and 12 to 14 represent capital account and
show changes in stock magnitudes during the period.
A country with equilibrium balance of payments is said to be in external
balances. When a country's total receipts (from the rest of the world), then balance
of payments is said to be favourable. When a country's total receipts are lesser than
the total payments then balance of payments is said to be unfavourable or adverse.
If balance of payments is positive, a country is called a surplus country. If
balance of payments is negative it is called a deficit country.
3.3 BALANCE OF TRADE
"Balance of payments" is to be distinguished from " Balance of Trade". Balance
of trade to the difference between the value of exports and imports of commodities
or goods or of visible items only. It is thus a part of the balance of payments and
balance of payments covers many more items apart from visible items such as
services like shipping, banking, insurance, interest, gifts, royalties, subsides,
pensions to military and civil personnel etc. These are called invisible items.
balance of payments is thus a comprehensive term.
Balance of trade has nothing to do with the prosperity or the poverty of a
country favourable balance of trade is not an index of economic prosperity and in
the same way unfavourable balance of trade has nothing to do with the economic
backwardness of a country. India before independence had favourable balance of
trade, but was very poor and backward. Britain at that time which had
126
unfavourable balance of trade was rich and strong. But however balance of
payments is a better guide to judge the economic position of a country. Favourable
balance of payments is desirable and indicates economic prosperity.
3.4 EQUILIBRIUM
There may be temporary disequilibrium in the balance of payments but
persistent deficit is not good. As a rule exports must pay for imports. It is not
necessary that balance of payments with each and every country must be equal but
overall balance should be equal and favourable in the long run the next question to
be analysed is the way in which central banks through their official transaction
finance balance of payments surplus and deficits. Here we have to distinguish
between fixed and floating exchange rate systems.
In a fixed exchange rate system central banks have to finance any surplus of
deficit that arises in the balance of payments at the official exchanges rate. This the
central banks do by buying and selling foreign currencies. In order to ensure that
the exchange rate stays fixed it is very much essential to take an inventory Foreign
exchange that can be sold in exchange for domestic currency. As long as a
country's central bank has the necessary reserves, it can keep the exchange rate
constant. However when there are continuous deficits in technology balance of
payments, the central bank may run out of foreign exchange and may not be able
to continue its intervention.
In the flexible exchange rate system the exchange rate are freely determined in the
foreign exchange markets. But however at present the central banks intervene to buy
and sell foreign currencies with a view to influence exchange rates. The stability of the
rate of exchange depends upon the equilibrium in the balance of payments.
3.4.1 Equilibrium in a closed economy
The equilibrium condition in a closed economy is expressed as
Y = C + I + G whose
Y = National income
C = Consumption
I = Private investment
G = Government expenditure
3.4.1 Equilibrium in an open economy
In an open economy foreign trade must also be included. In an open economy
excess of imports over exports leads to payments to other countries. The multiplier
operates in the reverse direction and hence it reduces the national income. Excess
of exports over exports over imports leads to receipts from other countries and thus
increases the national income because of the operation of multiplier in the forward
direction. It can write the equation.
Y = C+I+G+GE-M
E = Exports
M = Imports
127
If exports are greater than imports (E-M) will be positive other wise it will be
negative. If exports are greater than imports national income is enhanced, and vice
versa whenever national income increases IS capacity to import Consumer goods,
machinery & technical know-how from other countries also increases. This
relationship between the level of national income and demand for imports is called
import function. The import -function curve is shown in
Y
M
+
O
M
=
M
G A
X X1
INCOMES & EXPORTS
F S
( Rs. in Crs.)
B X
MO
Y
O Y Y1
INCOME
FIG 1
Fig 1.
Import function is shown by ht curve M=M0 + MY. It slopes upwards. It starts
from 'R' & not from origin O. The distance OR denotes autonomous imports
independent of the level of income. From 'R' the curve of import function shows a
clear relationship with income. M = f(Y). The curve indicates that whenever national
income increases imports also increase. The positives slope of curve shows the
marginal propensity to import. Imports increase as national income increases.
M/Y
M - change in imports
Y - change in real income of the country.


is assumed to be: In figure the horizontal curve FX indicates that exports are
'OF' for all level of income. In the case of 'GX' curve there is an increase in exports
from 'OF' to OG, whatever may be the level of income oy 0 r oyl, exports remain
constant at OG which means the country exports goods for which there is no local
demand.ANNAMALAI UNIVERSITY
The equilibrium conditions is C + I if government expenditure and taxes are
not included Y = C if we assume that the entire income is spent on consumption.
The above equation can be written as Y + M = C + E
Here
Y =C
Therefore C + M = C +E&M = E
128
Hence at equilibrium levels of income exports are equal to imports. The level of
income is determined by combining the schedules of exports and imports. In the
figure the import function and curve M= MO+ ny is meeting the exports schedule
(X) at point 'S' and produces 'OY' level of income. When exports shift from 'X' Xi
income increases from 'Y' to Y1. The change in income YY1, is really change in
exports multiplied by in reciprocal of the marginal propensity to import.
We can express it algebraically as E =M at equilibrium levels of income. This
means that in equilibrium E M. If we divided Y BY E and M respectively
(since both exports cause a change in income ) we have
   1
 Or 
   

Thus Y/E is the reciprocal of the marginal propensity to import. Y/E Is
the value of foreign trade multiplier in this context and it is the reciprocal of the
marginal propensity to import. Any increase in exports in and open economy [without
savings and investment] will raise the equilibrium level of income to the point where
the increase in exports is matched by equal increase in imports. Because of increased
exports money from other countries flows to our country. Due to multiplier effect it
further raises our national income. Income expands, to such an extent that it induces
imports to the same value of exports and brings about an equality between exports and
imports at the new level of income. In the absence of savings the increased spending
injected in to the economy as a result of increased exports can be spent on
consumption or on imports., income continues to expand because of increases in
consumption and imports being leakages reduce aggregate demand and income. The
growth of income comes to a stop when the cumulative increase in imports offsets or
cancels out the increase in autonomous exports. It is not true to imagine that an
increase in exports alone will cause a shift in income. The shift in the import function
will also affect national income. This is evident from the following diagram.
Y
M
+
Y
Y
O
M
M
M
+
+
=
O
O
2
M
M
M
=
=
M
M
INCOMES & EXPORTS
S0 S
( Rs. in Crs.)
S1
ANNAMALAI UNIVERSITY X
O
Y0 Y Y1
(INCOME Rs in crs)
FIG 2
Figure 2
129
In exports schedule remains the same (line 'X') but here imports are assumed
to be reduced for each and every level of income. The import curve instead of being
M=M0+mY it is now M1 = M0+my. This means that for all levels of income now the
propensity to import is less. Such a downward shift in import function may take
place because of a change in tastes of due to a shift in the distribution of income or
because of any other factor. For both income levels 'OY' and 'OY' the level of import
remains the same i.e. SI, Y1 which is equal to 'SY'. If the import function shifts
upward the opposite effect will be produced i.e. income falls as shown by the dotted
line M2 = M0 X my and level of income. When the propensity to import increases it
indicates a higher proportion of spending on imported articles which means a flow
of income from our country to other countries. The initial decline in income is
further reduced when multiplier operates in the backward directions. Thus income
falls iY' to 'Y0'
Now let us introduce saving and investment into our 'analysis of foreign trade
multiplier. The equilibrium condition of national income is S = 1. But investment
consists of two part; domestic investment and foreign investment i.e.
I = Ia X It.
Where Ia = domestic investment; and it - foreign investment i.e. IaXIt = S.

Foreign investment is nothing but the difference between exports of goods and
services and imports of goods and servicees. So If = E -M. This we can substitute in
the original equation (Id X If = Savings) and write as,
Ia X E-M = S. i.e. IaXE=SXM
This is the basis equilibrium condition of national income in an open economy.

That is in an open economy equilibrium level of income is achieved when domestic
investment (id) plus exports (E) are of the same value as savings (S) and imports
(M). The two injections (Investment and exports) are equal to the leakages (savings
and imports).
Now let us assume that domestic investment is constant at all levels of income,
but a change in exports. The change in exports must be equal to the changes in
savings puls the change in imports. i.e.
  Sx
If we divide Y by the above factors,
S
Here is nothing but marginal propensity to save and

130
 
  S   

 = Kt (i.e. foreign trade multiplier).

 
So, Kt =  If we divide each and every component by
S   
S  1
Kt   
  S 

 
Here S/E Y is nothing but marginal propensity to save and M/Y is
nothing but marginal propensity to import. So we can write the above equation as
1
Kt 
S
The foreign trade multiplier therefore the reciprocal of marginal propensity to
save and marginal propensity to import.
Now let us take all the components into account, i.e. all the three injections
and all three leakages. I + G + E = S + T + M. while I, G and E are injections (s)
Savings, T and M are leakages. Then the equilibrium condition in an open economy
becomes, Y = C + I + G + E - M. Let us introduce a small change; Y = C + I +
E-M. Assume that C=a1 Y, I = b Y(induced investment ) M = mY. A1 stands for
MPC mb stands for marginal propensity to invest m stands for marginal propensity
to import, Y stands for a small change in income (C = al Y should be interpreted
as when income (Y) increases by a small amount () i.e Y, then consumption
increases i.e. C by the proportion of at (MPC) out of the increased income ). By
substitution we have Y=al Y + b Y + G+ E – m Y. For simplicity sake let
us assume that G = O. then we get Y = a1 Y + b Y E – m Y we can bring all Ys
to one side. So that Y –a1 Y -bY+  m Y = E. Since  Y is common we take
it out and write Y(1-a1-b-m) =  E. Now take Y to the other side where it will
become a dividing factor

(1  al  b  m) 

 1
(or) which is kf The
 (1  al  b  m)
1
1  al  b  m
above equation gives us the vale of the multiplier in an open economy. But in
the above formula we have excluded marginal propensity to tax. If we include that
then a1 = (a-at). We can substitute this in the above equation and write as
1
kl 
1  a  at  b  m
131
T
+
+
T
S
+
S
I + G + X'
I +G+X
I + G + X S+ T+ M
I +G
S
I
45
O Y Y1 X
INCOME
A diagrammatically illustration of the concept of equilibrium in an open

economy is given in Fig. 3. In the diagram we have considered only autonomous
investment and not induced investment. It however embodies the spirit of the
complete multiplier in an open economy. In an open economy equilibrium level of
income takes place at the point of intersection I+G+X curve with S+T+M+ curve i.e.
at OY -level of income.
For simplicity sake the diagram has been so manipulated that the initial
equilibrium income level exports and imports are in balance. But this need not
necessarily be the case. All that is required for income equilibrium is that I+G+X
exante is equal to S+T+M exante. It is not necessary that I be exactly equal to 'S', 'G'
be exactly equal to 'T' etc. Now if exports increase then the curve I+G+X shifts
upward and now it is I+G+XI. It intersects S+T+M curve at a different place and
produces YI level of income. The increase in exports X has cause multiplier effect
and has raised the income form Y to YI the rise in the income level in turn brings
about an increase in imports savings and taxes. So at the higher income level Y1
once again 1 + G + X = S+T+M.
3.5 INTERDEPENDENCE BETWEEN IMPORTS AND EXPORTS
Imports are usually taken to be a positive (upward slopping) function of
income.
If there is a rise in the price of foreign goods relative to domestic goods then the
demands for domestic goods will rise for all the products and services where
domestic and foreign goods are important substitutes. The relative prices of foreign
and domestic goods in the turn are influenced not only by the selling prices of the
goods in the respective nations but also by the rate of currency exchange.
132
By a similar reasoning exports of a particular country can be thought of as

dependent on the level of income available in the group of nation which are the
domestic nation's trade partners since this country’s exports are imports for foreign
nations.
Now we must understand how imports of one county affects its exports as well
and vice versa.
For some purpose it is reasonable to consider foreign income levels as
autonomous with respect to domestic income levels. For a country with small level
of imports this is correct but not for a country which has large level of imports. This
is so, because if we country 'A' which imports from some other nations, then
country 'A' imports add to the income of the foreign nations with which it traders
which in turn influence on the level of exports thus exerts a secondary influence on
the level of exports for country 'A'. If a nation's level of imports is small relative to
the income levels of its trading partners this secondary influence will be
inconsequential and exports will be independent of imports for the nation. On the
other hand if a nation's level of imports is an important proportion of the income of
its trading partners then an increase in that nation's imports may add sufficiently
to the purchasing power of its trading partners to cause them to increase their
international purchases of the products of country 'A'.
The following diagrams show the effects graphically.
BALANCE OF TRADE
BIG COUNTRY Z
SMALL COUNTRY
( Imports )
Z1 X
E1
( Exports )
rts
po
Z1 Im
X
Real Imports & Exports
Exports
E0
Z0
Z0
Y0 Y
Domestic Real Income
Y1 O Yo
Domestic Real Income
Y1
( Rs. in Crs )
( Rs. in Crs )
Fig - 5
Fig - 4
In the small country diagram, while exports remain constant imports rise in
domestic real income. Here an increase in domestic real income increases the level of
imports from Z0 to Z1. Since exports are constant the balance of payments moves
133
toward deficit levels by the exact amount of the increase in imports Z1-Z0. Form the
figure it is clear that an increase in income converts an initial trade surplus into deficit.
For the big country case however an increase in domestic real income increase imports
along a similar import function from Z0 to Z1, but exports also increase from E0 to E1.
So the balance of payments deficit is equal to (Z1-Z0) – (E1-E0) rather than Z1-Z0,.
This clearly brings out of the fact that the impact on the trade position of a Jomestic
income increase is less adverse for big country case than for the small country case. In
addition to this the income level at which a zero trade balance occurs (the intersection
point of export and import curves) is increased due to the big country effect as
illustrated in figures by a shift to the right of the zero trade balance point from YBS for
the small country case to YBB for the big cose.
The IS And LM Model Including Imports And Exports
The first step in elaboration the earlier IS-LM apparatus to include foreign
transaction is to show the way that imports and exports fit into that apparatus.
Just as the IS curve for the two-sector economy and the three-sector economy,
respectively show all combinations of r and Y at which S – I and S+T=I+G, the IS curve
for the four-sector economy shows the combinations of r and Y at which S+T+M =
L+G+X, the leakages from the income steam are equal to the injections into it the
quantity of goods demanded remains unchanged. However, as for the two and three-
sector economies the IS curve for the four-sector economy will show a different level of
Y at which S+T+M = I+G+X for each different interest rate, assuming, of course, that no
part of the IS curve is perfectly inelastic. For a given IS curve, the level of Y identified
by a particular interest rate is the specific amount of goods that will be demanded by
the four sectors combined at that rate. If the economy is operating at that level of Y, the
amount of goods demanded is equal to the amount supplied, and the goods market
clears. At a lower(higher) interest rate, the quantity of goods demanded is larger
(smaller) and the goods market will correspondingly clear at a higher (lower) level of Y.
S+T+M
S+T+M
M
T+
S+T
S+
45
O Y O I +G+X
D B
Y Y
Y1
45
O Y O I +G+X
D 134 B
Y Y
Y1
I +G I +G+X
IS0 IS1
O Y1 O
I +G+X
D A
Figure - 6
3.6 DERIVATION OF THE IS FUNCTION
Figure 8 shows the derivation of the IS curve for both a three and a four-sector
economy in order to demonstrate the change that occurs with the introduction of
the fourth sector. The IS curve for the three-sector or closed (c) economy is derive
from the I X G curve import A and the SXT curve in part C.to introduce exports the
amount of X is added horizontally to I X G curved in part A to produce IXGXX curve
because the amount of X is assumed to be determined entirely by factors outside
the domestic economy, the interest rate in the domestic economy does not affect
exports. The I+G+X curve is accordingly equidistant from the I X G curve at each
interest rate. To introduce imports, M is added vertically to the S X T curve in part
C. In the model here M= Ma X mY. So that the spread between the slope of S X T
and the slope of S X T X M varies directly with the level of Y. the difference between
the slope of S X T and the slope of S X T X M is equal to m or the marginal
propensity to import. The varies combinations for and v at which the sum of the
leakages, S X T X M equals the sum of the injection, I X G X M, are identified in the
usual way. The points in the y, r space corresponding to these combinations are
connected with a line that is has Iso curve for open (0) economy.
The ISO curve slopes downward to the right as does the ISO curve, but the
slope of the ISO curve is seen to be greater than that of the ISO curve. A decline in
the interest rates investment spending. The resulting increase in income will be
that at which the sum of leakages from the income stream grows by an amount
equal to then to the increase in injection-that is, to the increase in investment
spending. With the leakage into imports now added to the leakage into saving the
indicated increase in the sum of leakages will occur with a smaller increase in
income than would be the case if there were only the leakage into saving.
The relationship between the curves in parts A and C of Figure is such that the
Iso and curves intersect. If the fixed spread between the I X G and the I x G x X
curves in Part A were greater than the maximum spread between S X T and S X T X
Min part C, the ISo curve would lite to the right of the Iso curve throughout. In the
135
opposite case, the ISo curve would lie to the left of the ISo curve throughout.
However, over a sufficient range of income, it is most likely that the curves intersect
at some point as shown in Figure.
Pd =0.9
Pf
Pd =1 LM
Pf
Pd =1.1
Pf
PA = 1
PC
IS 0.9
r2
IS 1
r1
IS 1.1
IS 1
Y1 Y2
Figure - 7
3.7 SHIFTS IN THE IS-LM FUNCTIONS

The IS curve for the open economy will shifts as a result of any change in
autonomous spending, whether that change originates with any of the domestic
sectors or with the foreign sector. To focus on the foreign sector, assume that the
I+G And S+T curves remain constant; Then a rightward or a decrease in M in the
equation. M = Ma+my; a leftward shift in the IS curve will result from either of the
opposite changes. Because X is simply equal to Xa or is completely autonomous,
the subscript a has not been attached to it. The amount by which the IS curve will
shift in the present model is equal to the change in X or in Ma times. (1/1c+m).
Figure 7 shows some of the effects of a shift in the IS curve caused by foreign
trade. IS I and L MI are the original positions of the curves. The intersection
indentifies Y1 and r1. Assume now a rightward shift of the IS curve resulting from
an increase in X, the causes of which might be an increase in incomes in other
countries, a decrease in import duties in other countries, or a change in the
tastesof people in other countries in favour of foreign goods and travel. The shift in
the IS curve could also result from a decrease in ma, the cause of which might be
an increase in import duties in the domestic economy or a change in tastes by
people in the domestic economy away from foreign goods and travel. Suppose one
or more such changes shifts the ISI curve to ISI’. Assuming no change in relative
price levels or other things, and the new equilibrium is given by the intersection of
ISI’ and LMI at which Y= Y2 and r=r2.
We may now examine the effects of a change in relative price levels or the ratio
of the domestic price level. Pd, to foreign price levels, P 1. Assume that Pd/P1 is
initially 1 and that this ratio is one of the factors that initially establisesh: the
position of the IS curve at ISI. At the same time that the shift from ISI to ISI’ occurs,
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assume that all the relative price ratio changes from 1 to 1.1 – in other words, that
domestic goods become relatively more expensive, or foreign goods become
relatively less expensive. Taken by itself, this change in Pd/P1 will ordinarily
increase real imports and reduce real exports and thereby shift the Is curve
leftward from ISI.
However, combining this change with the change that shifts IS from ISI’ to ISI’
and assuming that the strength of the change, in the price level ratio is less than
the strength of the other change, the IS curve on balance will shift rightward to a
position shown by ISI.1. In the same way, if the change in the relative price ratio
were from 1 to 0.9, domestic goods would become relatively less expensive, and
foreign goods relative by more expensive. This change, taken by itself, would shift
the IS curve rightward from ISI. In combination with the shift in the curve ISI’ due
to the other change, the total shift will be to a position to the right of ISI’ say to the
position shown by /8’0.9.
In order to identify the equilibrium Y and r resulting from changes in relative
price levels we must also observe what happens to the absolute price level at the
same time. Changes in the absolute price level, assuming an unchanged nominal
money supply, also cause shifts in the IS and LM curves. The IS curve will shift due
to a change in the relative price levels, but it will also due to a change in absolute
price level.
Because a change in relative price levels as consistent with an increase,
decrease, or no change in the domestic price level, various effects on the Y, r
combination may follow. For example, a decrease in the Pd/P1 ratio from 1.0 to 0.9
will in itself tend to shift the IS curve rightward. If the decrease occurs in part or in
whole via a decline in the domestic price level, there is an increase in the real
money supply. Therefore, the rightward shift in the IS curve due to foreign trade
effects will be reinforced by a absolute price level. Moreover, in this case, the Lm
curve will shift rightward and the IS-Lm intersection must occur at a higher Y than
otherwise. On the other hand, if the decline in the ratio from1.0 to 0.9 is entirely
the result of a smaller absolute increase in the domestic price level than in foreign
price levels, there is a decrease in the real money supply, assuming an unchanged
nominal money supply. The rightward shift in the IS curve due to the foreign trade
effect will be accompanied by a leftward shift due to the pigon and other effects that
before. Whether the IS curve shifts rightward or leftward. The new Y and r may be
higher or lower than the original values, depending on the particular shifts in the IS
and LM curves.
Just as we have so far used the IS LM apparatus to trace the effects on Y and r
of changes in variables like autonomous exports, autonomous imports, and relative
and absolute price levels, we can use it trace the effects on Y and r of changes in
yet other international variables, for example, foreign exchange rates. Although
much more can be seen with the IS-LM apparatus alone, much more can be seen
by supplementing its IS and LM functions with a third function, a balance of
payments or BP function.
137
The Is curve for the open economy will shift as a result of an increase in
exports. An increase in exports raises the demand for domestic goods and thus
shifts the IS curve to the right to IS’ as shown in figure.
1
NX = 0 NX = 0
LM
1
E
INTREST RATE ( % )
E
1
LS
LS
O YB 1
YB
INCOME & OUTPUT
Figure - 8
At the same time the increase in exports implies that at each level of income
the trade balance is improved and that therefore the trade balance equilibrium
schedule shifts out and to the right. Now it requires a higher level of income to
generate the import spending to match the higher level of exports. Thus the trade
balance schedule shifts to NX=O. So starting from a position of balanced trade at
point E we find that increase in exports raises equilibrium income and improves
the balance of trade at point E. but through the increase in exports by itself
improves the trade balance the increase in income leads to increased import
spending which perhaps may offset the direct improvement from the export
increase.
A Shift in the Composition of Demand
The last disturbance which we have to consider is a shift in demand from
imports to domestic goods. This has the same effects as an increase in exports. It
means increased demand for domestic goods and means also an improvement in
the trade balance.
3.8 MEASURES TO CONVERT DISEQUILIBRIUM
The most important problem of international economic policy is that of restring
balance since president balance of payments ‘surplus or deficit’ both are bad for the
country concerned. The surplus disequilibrium may not be so bad for the country
as the deficit disequilibrium is. The reason is that the burden of brining about
adjustment in the balance of payments falls more heavily on the deficit than on the
surplus countries.
There are automatic measures and deliberate measures that can be adopted to
correct disequilibrium in the balance of payments.
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3.8.1. Automatic Measures

The disequilibrium in the balance of payments may automatically disappear
after sometime when certain forces come into operation in the economy. For
example, the disequilibrium in the balance of payments of a country under the gold
standard was automatically corrected through the inflow and outflow of gold. If the
balance of payments was unfavourable, there was an outflow of gold from the
country, causing a contraction in the volume of currency and credit, and ultimately
a fall in the domestic price level. This encouraged exports, discouraged imports. The
equilibrium in the balance of payments was automatically restored after sometime.
The opposite process worked when the balance of payments of the country was
favourable.
Likewise, the equilibrium in the balance of payments of a country on the paper
standard was automatically corrected through fluctuations in its rate of exchange.
For example, if the country’s balance of payments was unfavourable, the demand
for foreign exchange exceeded its supply, and consequently, the exchange value
encouraged exports while it discouraged imports. The equilibrium in the balance of
payments was automatically restored after the lapse of sometime. The opposite
process worked when the balance of payments of the country turned favourable.
The automatic measures discussed above did not produce the desired results
in the short period. Now were they effective in dealing with a serious and
fundamental disequilibrium in the balance of payments. The country concerned
had, therefore, to resort to certain deliberate measures to bring about an
improvement in the balance of payments.
3.8.2 Deliberate Measures
The deliberate measures can be discussed under two sub-heads.
Trade Measures: The following trade measure could be undertaken by the
country concerned to correct disequilibrium in its balance of payments
(a) Encouragement to Exports. To remove the deficit in the balance of
payments, it is essential to maximise the country’s exports. The exports
of a country can be pushed up in two ways.
i. Reduction in export Duties. The government should either
reduce or altogether abolish the export duties so that the
export of goods become cheaper in foreign countries.
ii. Subsides to Export Industries: The government should give
subsides to the export industries within the country to enable
them to cut down their production costs and improve their
competitive position in the international market.
(b) Reduction in Imports. It is essential to cut down imports in order to
eliminate the deficit in the balance of payments of the country. The
imports can be reduced by adopting the following measures:
i. Imposition of New Import duties and the Enhancement of the
existing import duties. This step will go a long way in making
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imported goods more expensive within the country.

Consequently, the demand for the imported goods will
automatically decline in course of time.
ii. Import Quota System. The imports of the country can also be
cut down through the adoption of the import quota system.
This system can be discussed under the following sub-heads.
(c) Licence Quota System. Under this system, the importers have to secure
import licences from the government and these licences are granted by
the government after taking an overall view of the import position of the
country.
(d) Unilateral Quota System, the country imposes two types of restrictions
on its imports.
i. Global Quota System. Under this, the government fixes in
advance the global quota for every imported item. The country
cannot import more than the quota fixed by the government.
But, to the extent of the quota, the importers can import the
commodity concerned from any country.
ii. Alloeated Quota System. Under this system, the government
not only fixes the global of the commodity concerned but also
decides in advance how much of the commodity is to be
imported from individual countries.
(e) Bilateral Quota System. Under this system, the government fixes the
maximum quota of a commodity which is to be imported from abroad.
Up to the extent of this quota, the commodity can be imported at a
concessional import duty. If however, the importers exceed the quota,
they have to pay a penal rate of import duty.
(f) Import Prohibitions. This is an extreme measure which is sometimes
adopted by the government of a country to eliminate the disequilibrium
in the balance of payments. Under this, the government prohibits
altogether the import of certain goods which are considered to be non-
essential from the national point of view. Developing countries trying to
bring about speedly economic development through planning often
resort to this method to check the consumption of imported luxury
goods by the affluent sections of the community.
3.8.3 Monetary Measures
The following monetary measures are taken either singly or in combination by
the government to deal with the disequilibrium in the balance of payments.
1. Currency Devaluation. The government of the country may resort to the
devaluation of its currency to eliminate or to reduce the deficit in the
balance of payments. Devaluation implies a deliberate reduction in the
external value of the currency of the country. Devaluation always
encourages exports by cheapening them in foreign countries. On the
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country, devaluation has the effect of discouraging imports by making

them more expensive within the country. For example, if the currency of a
country is devalued, then its purchasing power in foreign countries
automatically goes down. In other words, the imported goods become more
expensive than before. Hence, devaluation discourages imports into the
country. On the country, the purchasing power of the devalued currency
increases in terms of foreign currencies as a consequence of devaluation.
Consequently, the foreigners start importing more goods from that country.
This gives an incentive to the exports of the country. It was to remove the
deficit in her balance of payments that India resorted to the devaluation of
the rupee in September, 1949. The rupee was devalued for the second time
on 6th June, 1966. The objective again was to eliminate or reduce the
deficit in the country’s balance of payments.
2. Money Contraction. If the government of a country does not look upon
currency devaluation as a proper measure it may resort to currency
contraction to remove the disequilibrium in the balance of payments. The
prices of goods and service automatically go down as a result of currency
contraction. This gives the much – needed incentive to exports. But the
imports are discouraged as a result of the fall in the internal price level.
The increase in exports, and the decline in imports helps the country to
remove the disequilibrium in the balance of payments. But currency
contraction as a method to remove the disequilibrium in the balance of
payments is not looked upon with favour by certain economists. If the price
level in the country is deliberately brought down with the help of currency
contraction, it may pose a serious economic problem for the country. It
may even lead to a slump in the economy. The producer may suffer heavy
losses consequent upon the fall in prices. Ultimately, they may be
compelled to close down their business rather than to suffer heavy
financial losses. Hence, the method of currency contraction should be used
with a good deal of caution to bring about an improvement in the balance
of payments.
3. Exchange Control: Sometimes the government prefers exchange control to
other methods for bringing about an equilibrium in the balance of
payments. Currency devaluation, it is said, adversely affects the self-
respect and reputation of the country. Currency contraction may likewise
result in a slump or depression in the economy. Similarly, if the imports
are cut down by imposing various types of restrictions by the government,
this may lead to retaliation on the part of other countries. They may
likewise impose the same restrictions on the exports of the country
concerned. Keeping in view the limitations of the above methods, the
governments often resort to the system of exchange control to eliminate the
deficit in the balance of payments. Under this system the exporters have to
surrender their earnings of foreign exchange to the government in
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exchange for domestic currency. Likewise the government allocates foreign

exchange to the importers to enable them to make payments for imported
goods. Thus, the government comes to have –full control over foreign
exchange. It utilizes the exchange control system to effect a cut in the
volume of imports. Unnecessary imports are altogether stopped by the
government.
4. Foreign Loans: The government can also secure loans from foreign banks
or foreign governments to reduce the deficit in the balance of payments.
Since the repayment of these loans is spread over a long period, this helpsi
the government to remove the deficit in the balance of payments. During
the currency of the loans, the government takes steps to improve its foreign
exchange position.
5. Encouragement to Foreign Investment: The government induces the
foreigners to make investment in the country by offering then all sorts of
incentives and concessions. This provides the government with extra
foreign exchange which is utilized to reduce the deficit in the balance of
payments. But while inviting the foreign capitalists to invest their capital
within the country, the government sees to it that this does not produce
any adverse repercussions on the economy.
6. Incentives to Foreign Tourists: The government may also encourage the
foreign tourists to visit the country in increasing numbers by offering them
various facilities and concessional travel. This increases the foreign
exchange earnings of the country with the help of which the deficit in the
balance of payments can be reduced.
4. REVISION POINTS
Balance of Payment: It is country’s tramaition with other economics. It includes
two accounts.
Current Account: It includes trade in goods and revises and transfer payments
Capital Account: Purchase and sales of assets
Balance of Trade: It includes visible items
5. QUESTIONS
Section A
1. Explain the balance of payment and balance of trade
2. How does the import of one country affect the exports of its own country
and the other country?
3. Derive the IS function in a three sector economy
Section B
1. Critically examine the efficacy of various measures of correcting the
balance of payments deficit?
2. Define and discuss the concept of foreign trade multiplier. How does it
bring about change in the level of income?
142
3. Discuss the manner in which income, price adjustments and money supply
adjustments interact in leading economy ultimately to full employment and
external balance.
4. Using IS and LM show how equilibrium income is determined in an open
economy.
6. SUMMARY
To sum up, the deficit in the balance of payments is not a desirable
phenomenon for a country. The methods discussed above aim at reducing imports
and stimulating exports. Of these, the first method, trade measures, is obviously
the best and the most effective. It produces immediate results. The government of a
country may use this method in combination with other methods to eliminate or
reduce a chronic deficit in its balance of payments.
1978.
4. Cauvery.R , V .K Sudha n ayek, M Girija ,R.Meenakshi, Macro Economics ,
8. KEY WORDS
Balance of Payment, Balance of Trade

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LESSON – 9
CLASSICAL AND KEYNESIAN MACRO ECONOMICS A COMPARISON

1. INTRODUCTION
This lesson deals with the assumption of classical economics, Pre Keynesian
Reaction against classicism, Keynes attack on classicism, the differences between
Keynes and Classical with the help of diagrammatic illustrations
2. OBJECTIVES
 To acquire knowledge about the assumptions of classical
 To view Keynes idea against classicism
 To find out the difference between Keynes and classical
 To compare classical with Keynesian system with diagrammatic
illustration
3. CONTENT
3.1 Introduction
3.2 Assumption of classical economics
3.2.1 Full employment
3.2.2 Allocation of Resources
3.2.3 Philosophy of Laissez-faire
3.2.4 Importance of the rate of interest
3.2.5 Say’s law
3.2.6 Role of Money
3.2.7 Wage cut
3.2.8 Automatic Adjustment
3.2.9 Long term Equilibrium
3.2.10 Partial Equilibrium
3.2.11 Saving
3.3 Keynes attack on classicism
3.3.1 Unemployment
3.3.2 Waste of Resources
3.3.3 State Intervention
3.3.4 Rate of Interest
3.3.5 Say’s law
3.3.6 Monetary Theory
3.3.7 Wage cut
3.3.8 No automatic Adjustment
3.3.9 Short-term
3.3.10 General Equilibrium
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3.3.11 Saving
3.4 Difference between Keynes and classical
a. Equilibrium
b. Saving
c. Wage policy
d. Theory of Money
e. Full Employment
f. Nature of economy
g. Micro and Macro
h. Theoretical and Practical
i. Saving and Equality
j. Budget
k. Realistic or unrealistic
l. Institutional
m. Automatic Mechanism
n. Various types of employment
3.5 Diagrammatic representation for comparing and contrasting classical with
Keynesian system
3.1 INTRODUCTION
To appreciate the nature and novelty of Keynes’ theory of income and
employment, it is better to know something about the classical background against
which it has been developed. By ‘classical economics’, Keynes means the traditional
or orthodox principles of economics, first presented by David Ricardo and Adam
Smith and then followed, refined and modified by later representatives of classical
school, including J.S.Mill, A.Marshall and A. C.Pigou. The basic principles of
classical economics were generally accepted for a long time. The assumption and
the implications derived from them remained largely the same.
3.2 ASSUMPTION OF CLASSICAL ECONOMICS
3.2.1 Assumption of Full Employment
Classical theory always assumes full employment of labour and other
resources. To them full employment is a normal situation and unemployment is an
abnormal situation. According to classicals, even if there is less than full
employment in the economy. There is always a tendency toward full employment.
By the term ‘full employment’ of the available resources, the classical economists
meant that ‘there is no involuntary employment’. If there is unemployment in the
economy. Classicists feel that it is due to the existence of monopoly in industry and
governmental interference with the free play of the forces of competitions in the
market or it may be due to imperfections of the market owing to the immobility of
the factors of production. If these limitations could some how be eliminated, full
employment, according to classical economists would always exist. Hence, the best
145
way to ensure full employment for the government is to pursue the policy of ‘laissez
faire’ capitalism under which the free competitive market forces are allowed to have
full and free play.
3.2.2 Allocation of Resources
The existence of ‘full employment’ being normal situation in the classical
scheme, it follows that factors of production in the classical scheme, it follows that
factors of production are always full employed and there is no further scope for
additional employment of resources in new industries. The choice, according to
classicals, is not between employment and unemployment but between employment
here and employment there. I.e., increase in production in one direction could be
achieved only at the cost of some decrease in production in another direction in the
economy. In other words, classicals felt that there could not be any significant
malallocation of resources, as the price mechanism, acting as an ‘invisible hand’
would achieve the best and the most efficient allocation of resources. Since the
optimum allocation of given quantity of resources was the main subject matter of
classicals economics it was but natural that they did not discuss the problem of
national output, income or employment. With their assumption of full employment,
there. Obviously, could not be any change in the real national income of the
community. What could possible change, occurring to them, was the composition of
the real national income and not its absolute size. As such, they remained
concerned with the special case of full employment and not with the general factors
that go to determine employment at any time in brie, the well-known theory of
value, distribution and production formed the ‘core’ of classical economics.
3.2.3 Philosophy of Laissez faire
Classicals had great faith in the philosophy of laissez faire capitalism, which
means ‘level alone’ or ‘let alone’ in business matters. laissez faire capitalism would
not tolerate any kind of intervention by the government in business matters; they
rather considered it as a positive hindrance in the free working of the market
economy. Classicals believed in laissez faire capitalisum as it was the traditional
model of study from the very beginning. Classicals had great faith in price
mechanism, profit-motive, free and perfect competition and the self adjusting
nature of the system. They felt that if the system is allowed to work freely without
any encroachments on behalf of the state, it has potentialities to overcome the
maladjustment in the economic system, if there are any.
3.2.4 Importance of the Rate of Interest
Rate of interest occupies a very important place in the classical system. It is
treated as the ‘equilibrating mechanism’ between saving and investment because it
brings equality between the two. In case saving tends to be excessive as compared
to the demand for it. The rate of interest brings into operation the forces which
reduce savings rendering its supply equal to demand, as the higher rate of saving
will bring down the rate of interest thereby affecting the incentive to save and
encouraging investment making them equal to each other. Besides, many other
146
influences also enter the picture and help to maintain the equality between saving
and investment (at full employment).
3.2.5 Say’s Law
Another essential element of classical economics is Say’s Law of Market’s after
J.B. Say, a French economist who first stated the law in a systematic from. Briefly
stated, this law means that ‘supply always created its own demand’. In other words
according to J.B.Say, there cannot be general overproduction of general
unemployment on account of the excess of supply over demand because whatever
is supplied of produced is automatically exchanged for money. In an exchange
economy whatever is produced represents the demand for another product because
whatever is produced is easily sold. Whenever additional production takes place in
the economy, necessary purchasing power is also generated at the some time to
absorb the additional supply; hence, there is no scope of supply exceeding demand
and causing unemployment. This law was the basis of their assumption of full
employment in the economy which rested on the plea that income is spent
automatically at a rate which will always keep the resources fully employed saving,
according to classicals, is just another form of spending; all income, they believed,
is partly spent on consumption and partly on investment. There is, thus, no ground
to fear a break in the flow of income stream in the economy. Hence, there cannot be
any general over-production or unemployment
3.2.6 Role of money
Classicals did not give much importance to money except treating it as a
medium of exchange its role as a store of value was not considered. To them, money
facilitated the transactions of goods but had no effect on income, output and
employment. They considered it is a veil which hides real things – goods and
services. In other words, they assumed that people have only one motive for holding
money, the transaction motive. Classicals completely ignored the precautionary and
speculative motives for holding money.
3.2.7 Wage Cuts
Classicals further believed that involuntary unemployment could be easily
cured by cutting wages down as a result of free and perfect competition which
always exists in the labour market. They argued that so long as labour does not
demand more than what it is ‘worth’ or more than its marginal productivity, there is
no possibility of president unemployment in the economy. Classicals believed that
employment is determined by the wage bargains between the workers and
employers, therefore, wage cuts will reduce unemployment, such a policy if pursued
vigorously can restore full employment as well. Basing their reasoning on the
existence of free and perfect competition in the product and labour market,
classicals argused that the unemployed workers will bid down wages leading to a
fall in prices, which in turn, will encourage demand giving a fillip to sales. As a
result of all this, more will be produced as more is demanded and the employment
would increase because more workers are employed at lower wages to increase
147
production. Wage- cuts thus, occupied a central place in the classical scheme of
reasoning.
3.2.8 Automatic Adjustment
According to classicals there is automatic adjustment in the economy. To force
of demand and the forces of supply are self adjusting at full employment levels.
They believed in the automatic elasticity of the economic system. If there are
certain obstacles in the self adjusting automatic mechanism, the invisible hand
(current price mechanism) takes care of these difficulties. Classicals believed that
flexible price, wage, interest system could set things right to bring about automatic
adjustment.
3.2.9 Long term Equilibrium
However, this automatic adjustment of equilibrium is attained only in the long-
run under classical version. Reductions in prices, wages and interest influence the
forces of demand and supply side only in the long-run.
3.2.10 Partial Equilibrium
Classicials equilibrium is partial equilibrium and not a general equilibrium.
Its laws and generalisation apply to a firm or an industry but not to the economy.
Similarly, saving in case of an individual may be alright but not for the economy as
a whole.
3.2.11 Saving
Classicials gave a jot of importance to individual saving for capital formation.
According to them saving is great private and social virtue. A penny saved is a
penny earned’ they believed. If all individuals save more, the aggregate savings of
the community will go up.
Pre-Keynesian Reaction Against Classicism
It is not correct to say that Keynes was the first economist to attack the
Classical doctrines in his book ‘General Theory’ published in 1936. In fact, since
the days of Ricardo except occasional intervals, Classicials, economics had been
denounced, by one economist or the other. According to R.L. Meek, the rapid
decline of certain basic Ricardian doctrines was clearly in evidence. Malthus
himself criticised Say’s law and made an unsuccessful attempt to convince Ricardo
that demand could be deficient. Mill who tried his best to remedy the situation was
attacked by Longe and Thornton, followed by Jenson’s attack on the prevailing
doctrines. In the united states the institutional economists - vablen, Commons,
Mitchell and their followers were highly critical of Classical theory. The early
socialist economists ascribed the phenomenon of over production to the peculiar
structure of society. Marx also repudiated Classical principles and he was
supported in his criticism of classicism by Ross Luxemburg and Lenin. Further, in
the economic literature of 1900 to 1936 there are many references that were made
to attack prevailing Classical doctrines. Hobson in England Clark in U.S.A and
Aftalian in France criticised Say’s Law, and the Classical theory of automatic self-
adjustment. Spithoff and wicksell also opposed Say’ s Law. Thus, Keynes was not
148
the first to attack Classical economics. There was lot of pre-Keynesian reaction
against classicism.
3.3 KEYNES’ ATTACK ON CLASSICALS
Keneys did not agree with any one the Classical assumption and their policy
implications as enunciate above. He denounced them one by one both o practical
theoretical grounds. Keynes, no doubt, started his career as classical economists
and a devoted pupil of Dr. Marshall. But with the passage of time and specially with
the advent of depression relaisation dawned upon him, and his faith in the classical
system was rudely shaken. According to kenyes, the classical theory is healthy
logical on the basis of its assumptions, but these assumptions are highly
unrealistic. Hence criticism are leveled mostly against the assumptions of classical
school rather than against its content and logic “I shall argue that the postulates of
the classical theory are applicable to a special case only and not to the general
case… moreover, the characteristics of the special case assumed by the classical
theory happen not to be those of the economic society in which we actually live,
with the result that its teaching is misleading and disastrous if we attempt to apply
it to the facts of experience. Classical theory had placed income distribution at the
centre of the economic theory, and, as a result, said keynes, it became inattentive
to the problems of its size. Classical theory assumed that the amount of national
income was already fixed at full employment level. This was not at all an acceptable
proposition. As such, he attacked the basic contents of classical economics one by
one as under.
3.3.1 Unemployment Equilibrium
According to keynes, the tacit assumption of full employment by the classicals
is not wholly warranted by actual facts, as there always exists some unemployment
in the economy based upon the philosophy of lassiez faire capitalist economies and
investment are not only inadequate but also often fluctuate. In such economics less
than full employment is the rule, and full employment equilibrium only an
exception. Thus, keynes felt that underemployment equilibrium (equilibrium at
less full employment) is the normal situation in such economies. Keynes, thus gave
a rude shock to the classicals by challenging their most important assumption
regarding the existence of full employment.
3.3.2 Waste of Resources
Having presumed the full employment of resources, the only problem with the
classicals was how to allocate the given quantity of resources in an optimum
manner between firms and industries; to them, there was no wastage of the
resources as these were assumed to be fully employed. Keynes, however,
denounced this assumption on the plea that there is a colossal waste of resources
in a free enterprise economy on account of the frequent fluctuations in output and
employment in the economy as a whole. Besides. Unemployment results in the
wastage of time, money and energy. According to S. E. Harris. “To keynes the waste
of economic resources through unemployment seemed nonsensical and suicidal. He
149
concentrated more of his energies on the solution of this problem than any other,
and he had considerable success”.
3.3.3 State Intervention
Keynes also denounced the free enterprise economy and its automatic and self
adjusting nature through the ‘invisible hand and price mechanism’. Actually keynes
made a strong plea for state investment in economic matters. As a result of the
depression of the ‘thirties’. Keynes started doubting the basic principle of
‘enlightened self-interest’ on which capitalism was supposed to function. whatever
served the interest of businessmen did not serve the interest of the community.
Keynes was in favour of giving relief to the unemployed people to boost up effective
demand, besides advocating deficit financing and large-scale public expenditure on
public works to increase employment. According to keynes, the policy laissez fair
capitalism might have held away in good old days, but its weakness were
thoroughly exposed in recent times, specially during the depression when it failed
to deliver the goods and services. Keynes, therefore, favoured governmental
intervention and viewed government spending taxing and borrowing as the most
important weapon against unemployment.
3.3.4 Rate of interest
According to keynes, income and not the rate of interest is the equilibrating
mechanism between saving and investment as presumed by the classical
economists. keynes argued that savings are not very sensitive to the rate of interest,
they rather depend upon the level of income. Keynes believed that very few people
saved to earn a higher rate of interest. According to him, lower rates of interest
alone did not encourage investments as they depended upon the marginal efficiency
of capital and other factors. Thus, keynes condemned the unique importance given
to the rate of interest by classicals in bringing about equality between saving and
investment.
3.3.5 Say’s Law
Say’s Law of Markets which was the core of classical Keynes theory, became the
subject-matter of special attack from keynes. Keynes particularly condemned Say’s
Law for its exhoration that ‘supply creates its own demand’ and that there is no
general over-production and unemployment. According to keynes, income is not
automatically spent at a rate which will keep all the factors of production employed.
Unemployment, according to keynes, is on Account of the failure to spend current
income on consumption and investment goods. In a free enterprise economy,
supply does not automatically create enough demand within the economy. Classical
theory based on Say’s Law is no good and is not warranted by facts. The actual
state in a free enterprise economy is a fluctuating level of income, output and
employment which depends upon effective demand, the deficiency of which causes
unemployment and the excess of which causes inflation.
3.3.6 Monetary Theory
Keynes linked the theory of money to general theory. Money, in keynesian
system is the link between the present and the future. Denouncing the classical
150
theory of value and distribution as partial theory, keynes remarked that treatises
with little or no attention paid to money are not likely to be popular unless they
deal with income formation also. Keynes integrated the theory of money and
employment with the theory of income. He took strong exception to the veif attitude
of classicals and denied that money is an illusion. He brought forth the importance
of precautionary and speculative motives for money. Money is no more merely an
accounting device. Suggesting that inflation (increase in money supply) in the
ordinary sense was no longer heinous affair that conservative mood made it out to
be he insisted that a rise in prices could be a pleasant and respectable experience.
In other words, the influence of money on income, output and employment was
duly recognised.
3.3.7 Wage Cuts
Keynes never felt conviced by the Pigouvian formulation of Say’s Law that wage
cut can cure unemployment. Prof. Pigou argued that wages should be cut to
increase employment. According to him, this was possible because under through
going competition in the labour market workers will bid wages down till they are all
employed. Keynes, however, did not agree with his thesis wage reductions,
according to Keynes, were no remedy to reduce unemployment as this will also
reduce the general purchasing power of the workers thereby leading to a decline in
the effective demand. Keynes also felt that under modern conditions it is not at all
easy to resort to wage – cuts on accounts of the strong growth of trade unions
resulting in more collective bargaining. In short, Keynes always laughed at the
classical reasoning that unemployment would disappear if workers were just willing
to accept low wage rates.
3.3.8 No Automatic Adjustment
Keynes criticised the classical contention of automatic adjustment of the
economic system through free market forces of demand, supply and prices.
According to keynes changes in prices or interest rates cannot bring automatic
equilibrium between the forces of demand and supply or between saving and
investment. Infact, deliberate state action would be required to attain the same. If
that were so why and how did we face depression in the economy during the
thirties was his question.
3.3.9 Short – Term
Keynes also criticised the assumption of long – term equilibrium in the
economy. He rather assumed short-run. He said, “we are all dead in the long-run”.
The solution to the problems must be found out in the short-run and not
postponed to long-run thereby creating confusion.
3.3.10 General Equilibrium
Keynes is more concerned with the study, analysis and attainment of general
equilibrium in the economy in the economy rather than partial equilibrium. He
critisied the classical theory as a special partial theory concerning with full
employment only. His own analysis is general in as much it is concerned with all
levels of employment.
151
3.3.11 Saving
Saving may be a great private virtue but according to keynes it is a great social
vice because more saving on the part of individuals don’t necessarily mean more
savings on the part of the economy as a whole. Savings cannot be the basis of
capital formation. More saving depend upon more incomes, more outputs and more
employments.
3.4 DIFFERENCE BETWEEN KEYNES AND CLASSICALS
a. Unlike classicals who were concerned with the long-run equilibrium,
keynes gave greater importance to short-run equilibrium, for according
to keynes, “we are all dead in the long-run”. What really matters is the
short-run and not the long-run.
b. To classicals saving was a great virtue and the important means for
capital formation. To keynes saving was a vice and spending a virtue.
“savers are the villains in Keynesian economic mythology, the desire to
hold liquidity is the great curse on humanity”. He was against savings as
it led to the decline in effective demand.
c. Classicals thought that wage-cuts and a flexible wage policy was the best
way to cure unemployment, but keynes was opposed to wage –cuts as a
means to cure unemployment.
d. Keynes linked the theory of money with the general theory, which
remained separated from each other under the classical scheme.
e. Classicals assumed full employment of resources. Keynes opined that in
the real world there could not be full employment, nut less than full
employment called underemployment equilibrium.
f. Classical theories of Mill, Marshall, Jove’s etc., were static in nature,
while Keynes introduced dynamism by bringing to the force the role of
expectations and institutional factors.
g. Classical economy was cast mainly in microterms; keynes gave a macro
tringe to economic theory.
h. Classical economics was purely theoretical in nature, while according to
Prof. Robinson, Keynes most important contribution was his success in
relating academic economics to the field of public and economies of
government.
i. Classical thought that the equality between saving and investment is
brought about by changes in the level of interest while keynes argued
that this equality is brought about by change in the level of income.
j. Classicals always believed in balanced budgets. Keynes upheld deficit
budgets or surplus for economic development and stability.
k. Classical economics was least empirical and less practical or realistic but
economies of Keynes is not only practical but also highly empirical.
152
l. Keynician economics is more institutional than classical economies.

Institution like trade, money supply, rate of interest etc. are an integral
part of Keynesian economics.
m. Classical economics is based on automatic adjustment as a result of Say’
Law but economics of keynes is based on his psychological law of
consumption.
n. Classical don’t brother about varying levels of employment, income or
output but keynesian economics and is general in nature. The study of
national income occupies a central place in Keynesian economicsNow let
us summarise the classical and Keynesian in Mathematical from lu the
chart given below:
Classical School Keynesian School
1. Y = f(N) Y = f(N)
2. N= f(W/P) N = f(W
3. W/P = M.P.P.L. W = wo
4. S = f(i) S = f(Y)
5. I = f(i) I = f(MEC,i)
6. S=I S>I
7. M=mpY S>I
M=M1+M2
M1=K Y
M2 = f(i)
1. The first equation says, that both for classicals and Keynesian ‘output is a
function of employment’.
(Y=Output or income, N = employment)
2. Level of employment is a function of real wage for the classicals. N =
employment W = money wage P II price level). But for keynes, employment
is of course a function of wage but nor real wage. It is a function of money
wage.
3. Real wage in turn is determined by marginal physical product of labour for
the classicals. For keynes wages are inflexible especially in the downward
direction and so current wage ‘W’ is grid and to denote this ‘rigidity’ we
have put it as wo.
4. Savings is a function of interest rate for classicals. For keynes it is a
function of income. But exceptionally high rates of interest may have some
influence on savings.
5. Investment is a function of interest rate for classicals. But for keyneys it is
a function of M.E.C and only to a minor extent the rate of interest.
6. Saving are always equal to investment for classical. For keynes savings are
either greater than investment or less than investment. In a dynamic world
153
equality between S, and I is possible even in an underemployment

situation, but for classical it coincides with the full employment situation.
7. Prices are directly proportional to money supply, when quantity of money is
doubled prices also double. For keynes money is not a passive factor.
Money also acts as a store of value, where M2 = f(i) speculative holdings
have an impact on all other economic variables.
3.5 DIAGRAMATIC REPRESENTATION FOR COMPARING AND CONTRASTING
CLASSICAL WITH KEYNESIAN SYSTEM
Now let us Compare and Contrast the Classical and Keynesian Systems with the help of
Diagrammatic Illustrations
According to the classicals an increase in government expenditure seldom
causes changes in output and employment.
Government spending – classical view
1 D
Y D
Yo
Rate of Intrest
1
D
1
D
Mo M1 M2
VOLUME OF LOANABLE FUNDS
Figure - 1
Let us assume that the government wants to increase expenditure to the tune
equal to M2 – M0. Accordingly the total demand for loanable funds will shift from D
to D1. With an increase in demand for funds the rate of interest will increase from
‘ r0 ’ to ‘ r1’.
Some additional supply of loanable funds emerges. But at the same time
because of the higher rate of interest cost of borrowing increase leading to a
reduction in private business demand for funds. Lured by the higher rate of interest
consumers will save more and thus the volume of funds sought by the government
for its expenditure is accomodated. As the volume of funds M1 – M0 comes from the
154
saving of the consumers who reduce their spending attracted by high rate of
interest it is to be observed that the resulting additional government spending is
purely at the expends of private spending. The remainder M2 – M1 is financed by
funds released by some private business firms who want to go for investment
expenditure because of the high rate of interest. Thus according to the classicals
the desire of the government for more funds simply reallocates the volume of
current purchasing power from the consumers and business firms towards
government. This is implemented through the manipulation of the rate of interest is
upward direction. Thus total output and total employment even after increased
government expenditure remains unaffected. As money supply is held constant
expenditure changes seldom cause changes in over all prices. While prices of
government purchases may rise consumer prices and investment goods prices fall.
But in Keynesian model an increase in government expenditure increases real
output through multiplier mechanism.
Figure 2
In part A an increase in government expenditure from G0 – G1, shifts the
aggregate expenditure curve forwards from C+1+G1. This will raise the equilibrium
real output from Y0 – Y1 when G is increased, the aggregate demand function part
B shifts to the right from Q to O’ leading to a higher general prices at the new
equilibrium output level Y1. Thus according to keynes an increase in government
spending is expected to increase real output employment and prices:
In the classical model, the major impact of an increase in money supply is
over prices is quantity of money. This fact is substantiated through the following
figure.
Figure 3
If figure 3(A) the original stock of money is represented by M0 and the
corresponding price level P0. In labour market this price P0 combines with a money
wage rate to W0 produce the equilibrium real wage W0/ P0 that clears the labour
market of any excess supply or demand and produce the profit maximising and full
employment level of employment No. When money supply is increased from M 0 to
M1, prices rise from P0 to P1. This lowers the real wage temporarily to W0/ P1. At
this lower real wage, the profit maximising employment level demanded is Nd while
the labour supply is Ns. A shortage of labour to the tune of Nd-NS appears. The
scarcity of labour pushes up the money wage rate to W1. At a money wage rate W1
the real wage was has returned to its former position (W1/ P1=W0/ P0) no labour
shortage exists and the labour market is equilibrium. This in the classical model an
increase in money supply leads to an increase in prices, a proportional increase in
wages, and unchanged real wage, employment, and output levels.
In the Keynesian model however an expansion in money supply leads to lower
rates of interest. This is shown in figure 4.
45 0
Figure - 3
O Yo K
(A) Y1 =X
P
P1 REAL GNP
155
Government Spending - Keynesian View Oo
(B)
Figure - 2 Y
E
=
Y
PRICES
G1
PRICE LEVEL
(A) I+
C+
Monetary Effects : Keynesian Model
I+ Go
C+ Figure - 4
Q1
103 E
=
Y
EXPENDITURE
Q G
100 (A) I+
C + 4%)
ADC=
(Y
G
O Mo M1 +XIo +
C % )
5
( Y=
MONEY STOCK ADC
45 0
O Yo Y1 X
O REAL GNP Yo Y1 X
REAL GNP
EXPENDITURE
Monetary Effects: Classical Model
(B)
Y
Figure - 3 SL
(B) K
Y (A) =
P
REAL WAGE
P1
PRICES
Wo
Oo Q1
103 P1
Q
100
Wo
P10
PRICE LEVEL
ADC
Wo
45
P1
ADC
O Yo Y1 X
Y1 X REAL GNP DL
O REAL GNP Yo
O Ns No Nd X
O Mo M1 X
MONEY STOCK EMPLOYMENT
Monetary Effects : Keynesian Model
(B) AS
Figure - 4 Y
(B) E
Y =
SL Y
PRICES
G
(A) I+
C + 4%)
=
REAL WAGE
(Y
G
Io +
Wo C + 5% )
P1 ( Y=
Wo 103
P1
Wo
EXPENDITURE
P1
100
DL
B
O Ns No Nd X
EMPLOYMENT
A
45 0
O Yo X
Y1
O REAL GNP Yo Y1 X
REAL GNP
When the interest rate falls from 5% to 4% aggregate demand function gets
Because
Y AS
shifted upwards to C +I1+G from C +I0+G. This is due to more investment spending.
(B)
of this shift, equilibrium output raises from Y0 to Y1. This rise in income
correspondingly shifts the aggregate demand function from A to B. prices rise as
PRICES
real output increases from Y0 to Y1. Therefore in the Keynesian model, as

expansion
103
in money supply finds its way into bind markets as additional demand
for
100 securities which lower the rate of interest increases real output, level of
B
employment and rises the price of speculative assets.
A
O REAL GNP Yo Y1 X
156
Not only the important changes in money supply but the consequences of shift
in the spending habits are also different in the classical model when compared with
the Keynesian model.
Shifts in spending habits – Classical Model
Figure - 5 S1
S
INTEREST RATE
Y1
Yo
Mo M1 M2 X
VOLUME OF LOANABLE FUNDS
In the classical model when the propensity to spend increases, consumption

rises as a percent of consumer income and savings fall as a percent as illustrated in
the following figure.
When saving falls the supply of loanable funds decrease. Saving curve shifts
backwards. At r0 interest rate the consumers want to supply savings M1 to M0 less
than before the shift because the amount is now diverted to consumer
expenditures. At r0 rate of interest there is shortage of loanable funds. This creates
competition among the borrowers and the rate of interest shifts to r1. This rise in
the rate of interest restores a portion ( M1-M2) to the funds withdrawn by
consumers. Because of the increased rate, the reminder of the shortage of funds
(M0 – M2) is eliminated by a reduced demand for funds by business firms. At the
new equilibrium M1 the net increase in consumer expenditure just equals the net
decrease in investment spending so that total output remains unchanged. Thus in
the classical model change in spending habits creats higher level of investment
spending, higher interest rate and unchanged levels of real output of employment.
If the Keynesian model, when there is an upward revision of spending habits
there are higher real, output, higher prices and non employment as shown in fig. 6.
When the desire to spend increases, the consumption function shifts C1+I+G.
This raises the level of real output from Y0 to Y1.
In part B the aggregate demand curve shifts from A to B. such a shift causes
the prices to increase from P0 to P1 resulting in higher level of real output, higher
prices and non employment.
The from a comparison of classical and Keynesian School we come to the
conclusion that Keynesian macro economic model has given a new set of policy
prescription to governments and central banks. These conclusions are new and
different from those associated with classical model.
Revolution of Evolution?
157
Keynes vehemently denounced the contents of classicism and put fourth the
General Theory, which deals with all levels of employment and the factors that go to
determine it at a time. It would be no exaggeration to say that keynes, thereby led a
revolution in economic thinking. According to some economists, however, keynes
hardly evolved a new approach or brought about a revolution in thought; to them, it
was just an extension of classical economics. In their opinion “General Theory is
simply classical economics, further developed and embroidered”. They hold that it
was difficult for keynes to get rid of early impressions. His thinking was essentially
based on the study of early impressions. His thinking was essentially based on the
study of early classical economists. It is pointed out that somewhere
Figure -6 in literature
Y
every element of the Keynesian system was at some time discussed.
It is, however, not so easy to agree with the view(A) that Keynesian economics+I
+G
1
does not represent a genuine break. Although it is matter of judgement Cand a
satisfactory answer is not easy to give, it is no the same old wine in new bottles. G
+I+
Co
The Keynesian theory was essentially new as compared to the existing body of
doctrines prevailing in the twenties. Its exposure of the Say’s Law which was based
on unrealistic assumptions combined with the theory of ‘effective demand’ and
EXPENDITURE
practical policy measures definitely represents a revolution in thinking, in relation

to clssicals. His consumption function, theory of multiplier saving and investment
equality, marginal efficiency of capital and liquidity, preference are analytical tools
of immense importance. The classical functional relation between interest and
investment did not fit facts and theory of the determination of the level of income
45 0
was needed to replace the theory of the determination of the rate of interest. His
demonstration that unemployment is possible
O in equilibrium Yoand his analysis
Y1 X of
the factors determining the size and changes of employment
REAL GNP and unemployment are
generally regarded as keynes’ most important theoretical discovery. The revolution
Shifts in Spending habits – Keynesian Model
Figure - 6
Y (B)
Y
+G
(A) +I
PRICES
C1
G
+I+
Co
P1
EXPENDITURE
Po
B
45 0 A
O Yo Y1 X
O REAL GNP Yo Y1 X
REAL GNP
“was solely the determination of the level of effective demand, a theory of the
determination of the level of output as a whole. According to S. E.Harris, “As a
(B)
result
Y of Keynes’ work, the classicists will have to check their assumptions, pay
much more attention to institutional and short-run problems, better integrate the
PRICES
P1
Po
B
158
theory of money, income and output, make theory more useful in the area of public,
be more concerned with general demand, thrift and expectations, and be less
certain on the relation of wage –cutting and employment.
Although keynes’ gratitude to the classical master is profound it will be unfair
to deny him credit that he deserves After all, ‘every contributor to any field to
knowledge stands on the shoulders of his predecessors. Specialists in any field of
knowledge know that no one man ever single handed invented anything. In a sense
there are no revolutionary discovers’. As remarked by Prof. Harris, “Keynesian
economics may seem like and may largely be a new plan; and yet its debts to the
older economics are quite clear”. Keynesian assumption of the existence of free and
perfect competition is truly classical in nature. In an article which appered after his
death in 1946, keynes paying tributes to the classicals and warning the younger
Keynesian enthusiasts wrote, “I find myself moved, not for the first time, to remind
contemporary economists that the classical teaching embodies some permanent
truths of great significance which we are liable today to overlook because we
associate them with other doctrines which we cannot now accept without much
qualification…”.
4. REVISION POINTS
Say’s law of Market - Supply Creates its own Demand
Laissez-faire - Minimum interference of the government
Government spending according to classical - An increase in government
expenditure seldom causes changes in output and employment.
Government spending according to Keynes - An increase in government
Expenditure increases real output through multiplier mechanism
5. QUESTIONS
Section A
1. Bring out the assumption of classical economist
2. Compare and contrast the classical with Keynes
Section B
1. Discuss main difference between classical and Keynesian economics?
2. Give brief description of the contents of classical economics. Examine the
grounds of Keynesian attack.
6. SUMMARY
Despite keynes’ rejection of the neoclassical theory, his system was deeply
rooted in it. Keynes’s assumption of this existence of free and perfect competition
and the law of diminishing returns are truly classical nature. Marshall’s individual
demand was disaggregate image of keynes’ total demand. Again, aggregate supply
was an extension of the optimum output of the firm. In both, the short period
predominated and equilibrium was the central problem of economic analysis. We,
thus, reach the conclusion that as far as the logical content of keynes theory goes,
no revolution has taken place. General Theory, no doubt, marks a milestone, but
not a break or a new beginning in the development of economic theory. Keynes was
159
perfectly conscious his debts to the early writers as well as his own contributors.
Keynes himself makes pertinent remarks in the preface of the ‘General Theory’ .
“those who are strongly wedded to what I call the classical theory will fluctuate. I
except, between a belief that I am quite wrong and a belier that I am saying nothing
new”. His judgements of the typical shapes of the various functions are indeed
revolutionary. No other economist had ever worked out a complete and determinate
model based on the propensity to consume, marginal efficiency of capital and
liquidity preference. Keynes theory though essentially evolutionary in nature yet
contains lot of revoluntionary elements.
1978.
5. J.Harvey and M.Johnson,introduction to Macro Economics Macmillan
Press Ltd Madras.
8. KEY WORDS
Say’s law of market, Laissez-faire, Pigou’s wage cut

160
LESSON – 10
GENERAL EQUILIBRIUM IN THE PRODUCT AND MONEY MARKETS

1. INTRODUCTION
This lesson deals with the product market and money market and also the
general equilibrium position by deriving the IS curve and L M curves
2. OBJECTIVES
 To acquire knowledge about the equilibrium
 To find out the equilibrium in the money market
 To find out the general equilibrium position
3. CONTENT
3.1 Introduction
3.2 Equilibrium is goods market and derivation of IS curve
3.3 Equilibrium in money market and derivation of LM curve
3.4 General equilibrium
3.1 INTRODUCTION
The Modern Theory of Income determination begins with the composition of
aggregate demand. The important components are consumption, investment and
government expenditures on goods and services which are taken as given since they
are policy determined. Consumption is treated as a function of income and
investment as a function of interest rate. The interest rate is determined by the
demand for and the supply of money. While the supply of money is taken as fixed
by monetary authorities, demand is influenced by income and interest rate. The
money market determines the interest rate. The interest rate influences
investment. Investment determines the level of income through the multiplier
which is dependent upon MPC. The demand for money is affected by a change in
income. Thus, the general equilibrium model requires a simultaneous
determination of the variables in the money market and in the product market.
The general equilibrium model consists of two parts: The first draws together
the determinants of equilibrium in the goods market and the second draws together
the determinants of equilibrium in the money market. Goods market equilibrium is
defined by an equality between saving and investment the condition that is
necessary for the equilibrium level of income. At the level of income of which
Savings = I (in a simple 2 sector economy) the leakage from the income stream into
saving is exactly matched by offsetting investment spending or at this income level
aggregate demand for goods just equals the aggregate supply of goods. There is
accordingly, goods market equilibrium at this level of income.
Money market equilibrium is defined by an equality between the supply and
demand for money – the condition which is necessary for the determination of the
equilibrium rate of interest. At the rate of interest at which M (supply of money) =
L, (the demand for money), there is money market equilibrium. The particular level
of income at which S = I depends in part on conditions in the market for money,
S1 I
S
I2
I1
161
and the particular interest rate at which M = L Odepends in part on

Y conditions
Y Yin the 1 2
market for goods.

Equilibrium levels of Income and Interest –Rate
S1 I M
S
L1 L2
I2
I1
Y2
Y1
O Y1 Y2 Y
O L2 M
B
FIgure - 1
Figure – 1
In Figure I, given the S and I curves the equilibrium level of incomes is Y1, at
which the supply of and the demand for goods are equal. If investment depends at
all on the interest rate, the M I curve must have been drawn on the assumption of
some particular
L1 interest
L2 rate. A lower interest rate, would indicate a different
position for the curve say I2, instead of I1. This in turn would indicate a different
equilibrium level of income y2 instead of Y1. Part II of the figure, however does not
tell us what the rate of interest may be- it assumes some rate and proceeds from
there. Part B shows the determination of the equilibrium rate of interest. Given
the
Y2 M and L curves the equilibrium rate is r1, at which rate, the demand for and the
supply
Y1 of money are equal, or L1 = M. But since the demand for money is
composed in part of the transactions demand, which depends on the level of
income, the L1 curve must have been drawn on the basis of some assumed level of
income.
O A higher income B level, wouldL2 M indicate a different position for the curve say
L2 instead of L1. This would indicate a different equilibrium rate of interest at

FIgure - 1
which L2 = M. Part B does not tell us what the level of income – it assumes some
income and proceeds from there.
It appears that we cannot determine the equilibrium level of income without
first knowing the interest rate and that we cannot determine the equilibrium
interest rate without first knowing the income level. Somehow Y and r must be
determined simultaneously. Hicks and Hansen have shown the keynesian synthesis
of the real and money markets with the curves popularly known as the IS and LM
curves. We will discuss the derivation of these curves.
3.2 EQUILIBRIUM IN GOODS MARKET
Derivation of IS Curve
Since the equilibrium in the goods market requires the equality of S and I, all
the factors that produce changes in saving and investment influence the
determination of this equilibrium. We assume here then investment is a function of
the interest rate alone, and what saving is a function of income along. We then
have 3 equations to cover the goods market.
Saving function S = S (Y)
162
Investment function I = I ( r)
Equilibrium condition : S (Y) = I ( r)
Derivation of IS curve
S S
100
100
80
80
60
60
40
40
20 20
0
40 80 120 160 200 Y 20 40 60 80 100
c. Saving B. Saving Investment
s = s (y)
Function Equal s=I
Y
S
5 5
4 0
IS 4
3 3
2.5 2.5
1.5 2
1 1
Y
0 0
40 90 120 160 200 20 40 60 80 100 I
goods
investment
equilibriu
market I = I(y)
function
m
s(y) = I
(y) Figure 2
This system is depicted in the figure. Part A gives the Marginal Efficiency of
Investment demand schedule, showing the investment spending varies inversely
with the interest rate. The straight line in Part B is drawn at a 45 0 angle from the
origin. Whatever the amount of planned investment, measured along the horizontal
axis of part B, equilibrium requires that planned saving measured along the vertical
axis of Part B be the same. Thus, all points along the 450 line in Part B indicate the
equality of saving and investment. Part C brings in the saving function, showing
that saving varies directly with income. The IS curve in Part D is derived from the
other part of the figure. To illustrate, let us assume an interest of 3% in part A,
indicating that investment is Rs. 20 lakhs per time period. In part B, to satisfy the
equality between S and I, saving must also be Rs. 20 lakhs as shown on the vertical
axis. In part C we find the saving will be Rs. 20 lakhs only at an income level of
‘Rs. 120 lakhs. Finally, bringing together Y of Rs.120 lakhs from part C and r of 3%
from part A , we have one combination of Y and r at which S= I, or at which there
163
is equilibrium in the goods market. If we assume the lower interest rate of 2.5%
part A indicates that investment will be Rs. 30 lakhs, which gives us an income
level of Rs. 140 lakhs in part C.
Therefore, Y of Rs. 140 lakhs r of 2.5%, is another combination of ‘Y’ and ‘r’ at
which S = I. Other combinations could be found in the same way by starting with
other assumed interest rates and finding the income level at which saving is eaual
to the I indicated by that interest rate. Connecting these combinations gives us the
IS curve in part D. We find that there is no longer a single level of income at which
S = I but different levels for each different rate of interest. The lower the rate of
interest, the higher is the level of income at which S = I. Viewed in one way, this
follows from the fact that a high “r” means a low ‘I’ and a low ‘I’, through the
multiplier means a low Y. Viewed in another say, this follows from the fact that a
low Y means low S. Since equilibrium requires that S = I, a low S means a low I,
and a low I is the result of high ‘r’.
Although the IS function indicates that equilibrium in the goods market will be
found at a lower level of income for a high ‘r’, it alone does not tell us what
particular combinations, of Y and r will be found in any specific time period. All
combinations on the IS function are equally possible equilibrium combinations of Y
and r in the goods market.
3.3 EQUILIBRIUM IN MONEY MARKET
Derivation of LM Curve
Equilibrium in the money market requires an equality between the supply of
and the demand for money. The keynesian theory of the demand for money makes
the transactions demand for money (Which includes precautionary demand) a
direct function of the income level alone and the speculative demand for money an
inverse function of the interest rate alone. This gives us three equations to cover
the money market.
Transactions demand for money : L1 = ky
Speculative demand for money : L2 = l ( r)
Equilibrium condition : L1 + L2 + L = M
The money supply M, is determined independently by the monetary authority.
Derivation of LM Curve
This system is depicted in Figure-3. Part A shows the speculative demand for
money as function of r. Part B is drawn to show a total money supply of Rs. 100,
all of which must be held and in either transactions balances or speculative
balances. The points along the line indicate all the possible ways in which the
given money supply may be divided between Lt and Ls. Part Curve shows the
amount of money required for transactions purposes at each level of income on the
assumption that K = ½. The LM curve of Part D is derived from the other parts as
follows.
164
L t
L t
1 0 0
1 0 0
8 0
6 0 8 0
M = R s. 1 0 0
6 0
4 0
4 0
2 0
2 0
0
0
4 0 8 0 1 2 0 1 6 0 2 0 0 Y 2 0 4 0 6 0 8 0 1 0 0 L s
c . T r a n s a c ti o n s D e m a n d B . S u p p ly o f M o n e y
L = K Y Ls + Lt = M
Y
S
5 5
4 4
3 3
2 .5 2 .5
2 2
1 1
Y
0 0
4 0 8 0 1 2 0 1 6 0 2 0 0 2 0 4 0 6 0 8 0 1 0 0 L
D . M o n e y M a r k e t E q u ilib r iu m A . S p e c u l a tiv e D e m a n d
M = K Y ( r ) L s = l( r )
F ig u r e 3
Assume in part A interest rate of 3 percent, at this interest rate the public will
want to hold Rs. 40 in speculative balances. In part B, subtracting the Rs. 40 or
speculative balances from a total money supply of Rs. 100 leaves Rs. 60 of
transactions balances, an amount consistent with an income level of Rs. 120 as
shown in part C. Finally, in part And, bringing together Y of Rs. 120 from part C
and r of 3 percent from part A, we have one combination of Y and r at which L = M,
or at which there is equilibrium in the market for money. If we assume the lower
rate of 2.5 percent, part A indicates that speculative balances will be Rs. 60; part B
indicates that transaction balances will be Rs. 40; and part Curve indicates the
income level of Rs. 80 as that consistent with indicates the income level Rs. 80 as
that consistent with transaction balances of Rs. 40. This gives us another
combination of Y and r – Rs. 80 and 2.5 percent – at which L = M. When other
such combination determined in this way are connected, the function in part D
labeled LM results.
Although particular characteristics of the LM function will call for attention
later, in general it is seen that the function slopes upward to the right with a given
stock of money, - market equilibrium is found at combinations of high interest rates
and high income levels or low interest rates and low income levels. Viewed in one
way, this can be seen to follow from the fact that a high level of income calls for
relatively large transactions balances which, with a given money supply, can be
drawn out of speculative balances only by pushing up the interest rate. Viewed in
another way, it can be seen to follow from the fact that a high interest rate is one at
which speculative balances will be low; this releases more of the money supply for
transactions balances that will be held in such balances only at a correspondingly
165
high level of income. Although the LM function indicates in this fashion why
equilibrium in the money market will occur at a high interest rate for a higher level
of income, it alone cannot tell us what particular combination of Y and r will be
found in any given time period. All combinations on the LM function are equally
possible equilibrium combinations in the money market.
3.4 GENERAL EQUILIBRIUM – THE GOODS AND MONEY MARKETS
Equilibrium between S and I is possible at various combination of Y and r,
similarly, equilibrium between L and M is possible at various combination of Y and
r. However, there is only one combination of Y and r at which both S = I and L = M.
This combinations is defined by the intersection of the IS and LM functions.
General Equilibrium in the Goods and Money markets
0 40 80 100 120 160 200 240
Figure - 4
In this illustration, general equilibrium occurs with Y = Rs120 lakhs and r =

Rs.31 lakhs. Every other combination of Y and r is a dis-equilibrium combination.
Suppose that Y was 80 and r was 4 per cent. With this Y, r combinations S = I but
M>L. After meeting the transactions demand that accompanies Y of Rs. 80 lakhs,
the balance of the money supply (which is necessarily held in speculative balances)
is greater than the amount people want to hold at a 4 per cent interest rate. (this
amount would be held only at 4 of 2.5 per cent)
The excess money then flows into the securities market, bids up security
prices, and forces down the interest rate. The fall in the interest rate stimulates
investment spending and moves the S = I equilibrium down the IS curve to a
combination of lower r and higher Y. This movement continues to the intersection
at which IS = LM and at which the rise in Y has so increased transactions demand
and the fall in r has so increased speculative demand that L = M. An opposite dis-
equilibrium in which again S = I but now L>M – for example at Y = Rs.160 lakhs
and R = 2 per cent – would be corrected in a similar manner.
These dis-equilibrium were between L and M; S and I were in equilibrium
throughout. Consider now a dis-equilibrium between S and I such as that at Y =
166
Rs.160 lakhs and r = 4 per cent. Here, L = M but S>I. The excess of S over I
indicates a deficiency of demand, and Y falls. The fall in Y reduces the public’s
needs for transactions balances, and the funds so released spill over into
speculative balances, thus reducing R. The L = M equilibrium moves down the LM
curve to a combination of lower r and lower Y. A falling r increases investment, and
a falling Y decreases saving. Both of these changes help eliminate the excess of S
over I. This movement continues to the intersection at which IS = LM.
The fall in r has been that fall necessary to increase I, and the fall in Y has
been that all necessary to decrease. S by the amounts needed to produce equality
between S and I at the Y, r combination at which IS = LM. An opposite dis-
equilibrium in which L = M but I>S, at Y of Rs. 80 lakhs and r of 2.5 per cent, for
example, would be corrected in a similar way.
4. REVISION POINTS
Product market equilibrium: saving function S = F(Y)
Investment function I = F(r)
Equilibrium condition S (Y) = I ®
Money market equilibrium: Transaction demand for money: LT=F(Y)
Speculative demand for money: LS=F(r)
Equilibrium condition: LT+LS+L=M
5. QUESTIONS
Section – A
1. Derive the IS curve
2. Derive the LM curve
Section – B
1. Explain the general equilibrium with the help of IS – LM curve
6. SUMMARY
Equilibrium is the goods market requires the equality of saving and investment
where I is a function of interest rate alone and S is a function of income alone. At
the same time, equilibrium in money market is attained when the demand for
money is equal to supply of money where transaction demand for money is a direct
function of income alone and the speculative demand for money is an inverse
function of the interest. But the general equilibrium is achieved at the point where
IS and LM curves intersect each other.
1. J.R. Hick, Mr. Keynes and the classic “A suggested interpretation”
econometrics
2. A.H.Hansen, monetary theory and fiscal policy Edward shapried – Macro
Economics’ Analysis
8. KEY WORDS
Product market equilibrium, Money market

167
LESSON – 11 AND 12
SHIFTS IN GENERAL EQUILIBRIUM

1. INTRODUCTION
This chapter discusses ruth the factors which will bring about changes in the
IS and LM curves and a change in these curves simultaneously and also the
changes in the masticutives of these curves
2. OBJECTIVES
To acquire knowledge about the shift in the IS curve and LM curve
3. CONTENT
3.1 Introduction
3.2 Shifts in General Equilibrium
3.2.1 An Increase in Investment
3.2.2 An Increase in Money Supply
3.2.3 A Simultaneous increase in Investment and the Money Supply
3.3 Elasticity of the IS and LM functions
3.4 Monetary and Fiscal policy in IS-LM frame work
3.4.1 The Keynesian Range
3.4.2 The Classical Range
3.4.3 The Intermediate Range
3.1 INTRODUCTION
The general equilibrium combination of R and Y identified by the intersection of
the IS and LM functions will of course, change in response to any shift in the IS
and LM functions function. Shifts in the IS function are caused by shifts in the
investment function or the saving function; shifts in the LM curve are caused by
shifts in the money supply or transactions demand or speculative demand
functions. We thus have a method of analysis by which we can trace the effects of
a change in any of these factors through the system to its final effect on the income
level and interest_rate assuming, of course, that all other factors remain
unchanged.
3.2 SHIFTS IN GENERAL EQUILIBRIUM
3.2.1 An Increase in Investment
Suppose that innovations shift the investment demand schedule to the right.
We find that the IS function is shifted rightward by Rs. 40 at each rate of
interest. With an increase in investment of Rs.20, income must rise Rs.40 to induce
an increase in saving of Rs.20 with an MPS of ½. This is nothing more than the
simple multiplier.
Y = I/MPS, which in the present case gives us Rs.40. Effect on General
Equilibrium of an Increase in Investment.
168
0 40 80 100 120 160 200 240
Figure - 4
= Rs.20/(1/2). The original and the new IS functions are shown in the figure
as IS1 and IS2. They are combined with the original LM functions derived earlier.
The original equilibrium was at Y of 120 and r of 3 per cent; the new
equilibrium is Y of 140 and r of 3.5 per cent. If the interest rate had not risen at
all, income would have risen by Rs.40 or from 120 to Rs.160 as would be expected
with the multiplier of 2. Instead, an increase in investment spending raises the
income level, which in turn raises the interest rate, and this feeds back to make the
increase in income less than the Rs.40. they would have been with no rise in the
interest rate. Thus, the actual rise in investment is Rs. 10, which, with a multiplier
of2, gives us an increase in income of Rs.20. In this fashion. The income-
expansion-any effect of an increase in aggregate demand is dampened by the rise in
the interest rate brought about by an expansion of income. The extent of this
dampening effect depends to some extent on how great the rise in the interest rate
is, and the rise in the interest rate itself depends on the elasticity of LM function.
3.2.2 An Increase in the Money Supply
Next take the case if a Rs.20 increase in the money supply, which shifts the M
curve in the right by Rs.20. With no change in the speculative demand function 0of
part C, the increase in M of Rs.20 will shift the LM function rightward by RTs.40 at
each rate of interest. Equilibrium between Labour and M requires a rise in Y
sufficient to absorb the Rs.20 increase in M in transactions balances, Lt – since
Lt=KY, we have Y =Lt/K and Y=Lt/k. With K gives as ½, Y must be Rs.40 to
produce a new equilibrium between Labour and M at each rate of interest. The
original and the new LM functions, shown as LM, and LM2 in the figure are
combined with the original IS function derived earlier.
The original equilibrium was at Y of Rs.120 and r of 3 per cent; the new
equilibrium that results from the increase in the money supply is at Y of
approximately Rs.140 and r of 2.5 per cent. Although the increase in M of Rs.20
169
will shift’ the LM curve Rs.40 to the right at each rate of interest, it will not raise
the equilibrium level of income by Rs.40 because, with no shift in the IS curve, a
rise in the equilibrium level of income can occur only if there is a fall in r. The new
equilibrium is one in which approximately Rs.10 of the increase in M is absorbed in
speculative balances as r fails to about 2.5 per cent. This is just the fall in r that is
necessary to increase I by Rs.10 and, through the multiplier. Effect on General
Equilibrium of an Increase in Money supply raise Y by Rs.20, which absorbs the
other Rs.10 of the Rs.20 increase of M in transactions balances.
Although the rise in the equilibrium level of income is less than Rs.40 as long
as there is not change other than the purely monetary one of an increase in the
money supply, we still find that there is an increase in the level of real income. In
short, monetary policy appears capable of influencing the economy’s level of output.
LM 1
4
LM 2
1 IS1
0 40 80 100 120 160 200 240 Y
Figure - 2
The effect on the income level of and increase in the money supply depends on
(1) how great the fall in the interest rate is, which in turn depends on the and
increase in the money supply depends on (1) how great the fall in the interest rate
is, which in turn depends on the elasticity of type superlative demand function, and
(2) how much investment spending rises as a result of any given drop in the
interest rate, which in turn depends on the interest-elasticity of the investment
demand function. If the interest rate falls with a rise in the money supply and if
investment spending rises with a fall in the interest rate, some rise in the income
level will result.
3.2.3 A Simultaneous Increase in Investment and the Money Supply
Now suppose that the two changes we have discussed separately occur
simultaneously, so that the shift in the investment demand function moves the IS
curve from IS1, to IS2, and the rise in the money supply moves the LM curve from
LM1, to LM2as shown in the figure.
170
Effect on General Equilibrium of a simultaneous Increase in investment and

the money supply.
The result is a shift in the equilibrium position from Y of Rs.120 and r of 3
percent to Y of Rs.160 and r of 3 percent. A rise in investment spending, with no
change in the money supply, produces a rise in income, but a rise that is
dampened by the rise in the interest rate resulting from the income rise. If the
money supply increases by just the amount necessary to percent the rise in the
interest rate that would otherwise result form the rise in the interest rate that
would otherwise result from the rise in the income, the full income – expansion any
effect of the rise in investment will be realized. The increase in Y from Rs.120 to
Rs.160, with an increase in investment of Rs.20 and a MPC of ½, is just the result
we found in the simple keynesian model.
LM1 LM2
1
IS 1 IS 2
0 40 80 100 120 160 200 240 Y
Figur e - 3
3.3 ELASTICITY OF THE IS AND LM FUNCTIONS

With a fixed money supply, the Lm function slopes upward to the right.
However, at one extreme the function may be expected to become perfectly elastic,
and at the other extreme it may be expected to become perfectly in elastic, with a
range of varying elasticities in between. In general, the higher the interest rate, the
less elastic the corresponding point on the LM function will be. These three ranges
are laid off in the figure, in which the perfectly elastic section is “ the Keynesian
range”, the perfectly inelastic section is “the classical range”, and the section
between is “the intermediate range”
Why this particular shape with perfect elasticity at one extreme and perfect
inelasticity at the other? Recall that at some very low rate of interest the
speculative demand for money may become perfectly elastic, the result of a
consensus by wealth-holders that the interest rate will fall no lower and that
security prices will rise no higher. Wealth-holders accordingly stand ready to
exchange securities for cash at existing security prices, which produces the
171
liquidity trap on the speculative demand function. Here on the LM function, it

produces what is known as the Keynesian range. Recall that, at the other extreme,
at some very’ high rate of interest, the speculative demand for money may become
perfectly inelastic, the result of consensus by wealth holders that the interest rate
will rise no high and that security prices will fall no lower at this or any higher rate,
wealth-holders according prefer to hold only securities and no idle cash. This
perfectly inelastic section of the speculative demand function becomes what is
known as the classical range on the LM function,
Why are the three sections into which the LM function has been divided labeled
in this fashion? Recall that, in our simplified version of classical theory, money is
demanded only for transaction purposes. Thus, classical theory assumes that the
speculative demand for money is zero at each rate of interest. In effect, Part A of
that figure vanishes. If the total money supply given in part B is Rs.100, that
Rs.100 will be held in transactions balances, or M=L1 and L3 = 0. With K given in
Part C as ½, the LM curve of part And becomes a perfectly vertical line at the
income level of Rs.200. If the public holds money only for transactions purposes
and if it holds money balances equal to one-half of a period’s income, money
market equilibrium is found at an income level of Rs.200 at all rates of interest.
Elas ticity of the LM Function
LM1 LM2
JS3
clas s ical
Y5 range
IS3
Y4
Y3
Keynis ian
range
Interm ediate
range
Y2
Y1
IS1
JS1
0 Y1 Y2 Y3 Y4 Y5
Y
Figure - 4
With the exception of the perfectly inelastic section, or the 20-called classical
range, it would not be altogether incorrect to call the remainder of the LM function
the Keynesian range. However, because of Keynes’s emphasis on the
ineffectiveness of monetary policy, the liquidity trap section alone has come of
monetary policy, the liquidity trap section alone has come to be identified as the
Keynesian range, Within this range, monetary policy is completely ineffective;
therefore, this range most closely fits Keyney’s emphasis.
172
Elasticity of the IS function
LM1
X LM2
IS3H
IS3
IS2H
Y
IS1H IS2
Y1
IS1
0 Y1 Y2 Y3 Y4 Y5
Y
Figure - 5
The IS function as derived in the figure slopes downward to the right. Its
elasticity depends on the responsiveness of investment spending to changes in the
rate of interest and on the magnitude of the multiplier. If the investment demand
schedule is perfectly in elastic, indicating that investment spending is completely
insensitive to the interest rate, k the ’S’ curve derived in part D will be perfectly in
elastic, regardless of the magnitude of the multiplier. If, on the other hand, the
investment demand schedule shows some elasticity, as seems to be the case, the IS
curve will be more elastic the lower MPS. The lower the MPS the higher will be the
multiplier and so the greater will be the change in income for any increase in
investment resulting from a fall in the rate of interest. The figure shows three pairs
of IS curves, each made up of one highly inelastic and one elastic IS curve.
3.4 MONETARY AND FISCAL POLICY IN IS – LM FRAMEWORK
Monetary policy is the exercise of the central bank’s control over the money
supply as an instrument for achieving the objectives of general economic policy.
Fiscal policy is the exercise of the government’s control over public spending and
tax collections as instruments for the same purpose. We will confine ourselves here
to the single policy objective of raising the level of real income. The IS-LM frame
work than provides a basis for comparing the effect of the two types of policy on the
income level and the interest rate and for comparing the conditions under which
each type of policy will be effective or ineffective in producing the change in income
that is the policy objective. For this purpose, the discussion is conveniently divided
into three parts, each corresponding to a range of the LM function.
3.4.1 The Keynesian Range
Consider first the Y1,r1 (lesson 11, Fig4) equilibrium in the Keynesian range. An
increase in the money supply shifts the LM curve to the right, from LM1 to LM2, and
means that for each possible level of income M=L only at a lower rate; the rate must fall
by the amount necessary to make the public willing to hold larger idle case balances.
But his is not true in the “liquidity trap”. Here the interest rate is already at what is for
173
the time being an irreducible minimum. As the monetary authority purchases

securities, security-holders are willing to exchange them for cash at the existing prices of
securities. Therefore, expansion of the money supply cannot cause the interest rate to
fall below the rate given by the trap. All that happens is that the public holds more in
speculative balances and less in securities. Further increases in the money supply
would by expected to sift the LM curve still further right, but lower end of the curve will
remain anchored in the same liquidity trap. If the economy is already in the trap, it
fallow that monetary policy is power less to raise the income level, since if cannot reduce
the interest rate any further and there by produce a movement down the IS, curve to a
higher equilibrium income level. The belief that the economy was in the trap during the
early thirties led keynes to his then unorthodox fiscal policy prescriptions. Since
government cannot raise the income level through monetary policy, whatever
government is to do through monetary-fiscal policy it cannot be achieved by producing a
movement down the IS curve through monetary-expansion, a rise in income can be from
IS1 to IS2. Fiscal measures such as increased government spending or reduced taxes
that could shift the IS curve became the order of the day.
It should be noted that, to the extent that monetary policy operates by raising
investment spending through a reduction in the cost of money, the in pass of
monetary policy for an economy caught in the trap means that the elasticity or in
elasticity of the IS function is no longer relevant, In Figure (Lesson- 11) for example
it does not matter whether the IS function is the elastic IS1 or the inelastic IS1”.
The liquidity trap is an extreme case that could occur only during a deep
depression, if even then. A prosperous economy and a liquidity trap do not go hand
in hand. Since the pure Keynesian range is the range of the liquidity trap, one can
now appreciate what Professor Hicks meant by his observation, made shortly after
the appearance of Keynes’s book, that “the General Theory of Employment is the
Economics of Depression”.
3.4.2 The Classical Range
Next let us examine the Y4,r4 equilibrium defined by the intersection of IS3 and
LMI in Figure 4 (Lesson 11) There is some increase in the money supply that will
shift the LM2 curve to LM2. In contrast to the result in the Keynesian range, the
result is now an increase in the income level from Y4 to Y5 and a fall in the interest
rate from r4 to r3. In the classical range, the interest rate is so high that speculative
balances are zero; money is held for transaction purposes only. If the monetary
authority under these circumstances enters the market to purchase securities,
security-holders can be induced to exchange securities of cash only at higher
security prices. As security prices are bid up and the interesting rate pushed down,
investment is stimulated (and, in classical theory, saving is discouraged). Since
nobody chooses to hold idle cash expansion of the money supply will produce a new
equilibrium only by reducing the interest rate by whatever amount is necessary to
increase in the money supply in transactions balances. If in the present case we
assume that Measured=Rs.20 and K=1/2, equilibrium will be restored only when Y
has risen by Rs.40, or in classical quantity theory of money as a theory of aggregate
174
demand. Y rises proportionately with increase in M. If V=2 or K= 1/2 the rise in Y

must be twice the rise in Measured in order to satisfy the equilibrium condition:
MV=Y or M=KY.
In contrast to the Keynesian range, in which monetary policy is completely
ineffective, monetary policy appears to be completely effective in the classical range.
No part of any increase in the money supply disappears into the idle case balances.
The increase in the money supply means increase in the money supply is absorbed
into transactions balances. Still assuming that all income changes are r4real
changes, we find that the increase in the money supply that shifts LK1, to LM2
causes an increase from Y4 to Y5 in output as well as in income.
Again in contrast to the Keynesian range, in which fiscal policy alone can be
effective, fiscal policy in the classical range is completely ineffective. An upward
shift in the IS function from IS3 or IS’3 in Figure can raise only the interest rate
from r4 to r5; the income level stays unchanged at Y4. Given the increase in
demand that lies behind the upward shift in the IS function there will be a rise in
the rate of interest sufficient to choke off enough demand to leave aggregate
demand unchanged. Thus, if the rise in demand resulted from increased
government spending, the rise in the interest rate will choke off an amount of
private spending equal to the rise in government spending. The level of income is
as high as the given money supply can support. In the classical range, an increase
in income is thus impossible without an increase in the money supply, and
monetary policy becomes an all – powerful method of controlling the income level.
How does the elasticity of the IS function affect the equilibrium positions in the
classical range? Let us compare the elastic IS3 function and the inelastic IS’3
function shown in Figure 5. Here we see that with the IS’3 function no increase in
the money supply and no reduction in the interest rate is capable of raising the
income level from T4 to Y5. Monetary policy will raise Y but not be the multiple of
Measured given by 1/K. Although this seems to upset the result suggested by
classical theory, classical – theorists would deny that the IS curve could be so
inelastic. Recall that in both classical and Keynesian theory investment is a
function of the interest rate but in classical theory saving also is a function of the
interest rate. Thus, it can be shown that only if both saving and investment are
quite insensitive to described by IS’3 in Figure 9 (Lesson – 11). As long as one or
the other in elastic, the resulting IS function will also be elastic, and with an elastic
IS function the result of a change in the money supply is Y = M/K.
3.4.3 The Intermediate Range
Finally, let us examine the equilibrium of Y2,r2 as defined by the intersection of
IS2 and LM1 in Figure 4. (Lesson 11) Here again we see that there is some increase
in the money supply that will shift the LM1 function LM2. In the Keynesian range,
this increase in Measured left both Y and r unchanged because the total increase in
money supply was absorbed in speculative balances at the existing interest rate,
which defines the liquidity trap. In the classical range, this increase in M raised
and Y by the amount necessary to absorb the full increase of M in transactions
175
balances. This worked itself out through that reduction in the interest rate that
raised spending by the amount needed to produce the required rise spending by the
amount needed to produce the required rise in income, In the intermediate range,
however, the increase in M is absorbed partially in speculative balances and
partially in transactions balances. The level of income rises but by an amount less
than that which would require the full increase in M for transactions purposes.
To illustrate, let us suppose that Measured is Rs.20 and K is ½. The resultant
shift in the LM function is Rs.40, but in this case the rise in income (Y3-Y2) is only
half that amount. In reducing the interest rate by the amount that produces the
increase in spending needed to raise the income level by Rs.20, Rs.10 (one half of
the increase in the money supply) is absorbed in speculative balances. The
remaining Rs. 10 is just the additional amount of money needed for transaction
purposes with the income level by Rs.20.
Thus, in the intermediate range, monetary policy is found to have a degree of
effectiveness but not the complete effectiveness it has in the classical range. In
general, the close the equilibrium monetary is to the classical range, the more
effective monetary policy becomes, and the closer the intersection is to the
Keynesian range, the less effective it becomes.
Within this range fiscal policy is also effective to some extent. Fiscal measures
that shift the IS function from IS2 to IS’2. For example will raise the level of income
and the rate of interest to the new equilibrium defined by the ubtersection of IS’ 2
and LM1. If the shift in the IS function is the result of a deficit-financed increase in
government spending, the interest rate must rise. We are assuming a fixed money
supply described by LM1. So the increased government spending is being financed
by borrowing from the public. The sale of additional securities by the government
depresses security prices, raises the interest rate, and chokes off some amount of
private spending. The rise in the interest rate, following any given increase in
government spending, will be greater the higher in the intermediate range the
equilibrium happened to be. Conversely, it will be smaller the lower in the
intermediate range the equilibrium happened to be. Although fiscal policy is found
to have a degree of effectiveness anywhere in the Keynesian range and less effective
the close equilibrium is to the intermediate range, in general it will be more effective
the close equilibrium is to the classical range.
Although both monetary and fiscal policies have varying degrees of
effectiveness in the intermediate range, the relative effectiveness of each depends in
large part on the elasticity of the IS function. If the IS function is the inelasticIS”2
in Figure 5 (Lesson112 monetary policy can do very little to raise the level of
income, even in the intermediate range; fiscal policy alone is effective in such a
situation. Furthermore, an expansionary fiscal policy need not be concerned with
adverse monetary effects in this case. A shift in an inelastic Is function will have
little feedback on the amount of spending. Keynes maintained that the investment
demand schedule (as well as the saving schedule) was interest –inelastic. If this is
the case, the IS schedule must also be inelastic, and fiscal policy, which is
176
completely effective in the keynesian range, would be almost as effective in the

intermediate range. If the Is schedules indeed interest – inelastic, then the
Keynesian range becomes, in effect, the complete LM curve, more applicable at the
lower end than at the upper end but with some applicability throughout.
4. REVISION POINTS
Increase in I - A shift in the investment demand schedule to the right
Increase in the money supply - A shift in the LM curve to the right
Keynesian Range - Liquidity trap, Perfectly elastic, Fiscal policy is effective
Intermediate Range - Becoming elastic when it raises upward
Classical Range - Perfectly inelastic, Monetary policy is effective
5. QUESTIONS
Section A
1. Explain the shift in the curve
2. Explain the Keynesian range
Section B
1. Explain the general equilibrium when there is shift in both IS and LM
curves
2. Explain the effect of monetary and fiscal policy on the IS-LM Frame work.
6. SUMMARY
Thus a shift in the IS function is caused by a shift in the investment function
and a shift in the LM is caused by a shift in the money supply and the shift is
caused because of the elasticity of the IS and LM function. From the above
discussion we are able to find out the IS-LM frame work which provides us a basis
for comparing the effect of the Monetary and Fiscal policy
1978.
8. KEY WORDS
Classical Range, Liquidity trap, Keynesian Range, Intermediate Range

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LESSON – 13
THE THEORY OF INFLATION: DEMAND PULL AND COST PUSH

INFLATION – MARK UP INFLATION
1. INTRODUCTION
This lesson deals with the meaning of inflation infaltionary gap, Importance
and criticism, Demand-pull inflation, Cost-punch inflation mixed of both demand
pull and cost punch. The convergent inflationary process, divergent inflationary
process, Sectoral shift and Mark-up Inflation
2. OBJECTIVES
 To gain knowledge about the inflation and inflationary gap
 To acquire knowledge about the Demand pull and cost punch inflation
 To know about the Mark-up infaltion
3. CONTENT
3.1 Introduction
3.2 Meaning of Inflation
3.3 Infaltionary gap-Criticisms and its Importance
3.4 Demand-Pull Inflation
3.5 Cost-Push Inflation
3.6 Mixed demand-pull and cost-punch Inflation
3.7 The convergent and Divergent Inflationary process
3.8 Sectional demand shift Inflation
3.9 Mark-up Inflation and control of Mark-up
3.1 INTRODUCTION
Inflation is a destroying disease born out of lack of monetary control whose
results undetermind the rules of business, creating havoc in market and financial
ruin of even prudent. According keynes, if the money supply increases beyond the
full employment level, output ceases to rise and prices rise in proportion with the
money supply. This is true inflation.
Keyney’s analysis subjected to two main drawbacks. First it lays emphasis on
demand as the cause of inflation, and neglect the cost side of inflation. Second, it
ignores the possibility that a price rise may lead to further increase in aggregate
demand which may, in turn, lead to further rise in prices.
However, the types of inflation during the Second World War, in the immediate
postwar period, till the middle of the 1950s were on the Keynesian model based on
his theory of excess demand. “In the latter 1950s, in the United States,
unemployment was a higher than it had been in the immediate postwar period, and
yet prices still seemed to be rising, at the same, the war time fears of postwar
recession had belatedly been replaced by serious concern about the problem of
inflation. The result was a prolonged debate. On the one side of the debate cost-
push, school of though, which maintained that was no excess demand- on the
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other side was the “demand-pull” school… Later, in the United States, there
developed a third school of though, associated with the name of Charles Schultz,
which advanced the sectoral demand-shift theory of inflation… While the debate
over cost-push versus demand-pull was raging in the United States a new and very
interesting approach to the problem of inflation and anti-inflationary policy was
developed by A.W.Philips.
3.2 MEANING OF INFLATION
Inflation is fundamentally a monetary phenomenon. In the words of Friedman,
Inflation is always and everywhere a monetary phenomenon… and can be produced
only by a more rapid increase in the quantity of money than output. But
economists do not agree that money supply alone is the cause of inflation. As
pointed out by Hicks,” Our present troubles are not of a monetary character”.
Economists, therefore, define inflation in terms of a continuous rise in prices.
Johnson defines “ Inflation as a sustained rise, in prices. Brooman defines it as “ a
continuing increase in the general level”. Shapiro also define inflation in a similar
vein, “ as a persistent and appreciable rise in the general level of price. Dernbeg
and MC-Dougaling are more explicit when they write that “the term usually refers
to a continuing rise in price as measured by an index such as the consumer price
index (CPI) or by the implicit price deflator for gross national product.
However, it is essential to understand that a sustained rise in prices may be of
various magnitudes. Accordingly, different names have been give to inflation
depending upon the rate of rise in prices. A sustained rise in prices of annual
increases of less than 3 percent annum is known as a creeping inflation. It is
walking or trotting inflation when the rate of rise in prices is in the intermediate
range of more than 3 to 6 per cent per annum, when the sustained rise in prices is
about 10 percent per annum it is called running inflation. On the other hand,
galloping or hyper inflation is that when annual increases in prices are 20 per cent
30 per cent more.
Again, inflation may be open or repressed. Inflation is open when “ markets for
goods and factors of production are allowed to function freely, setting prices of
goods and factors without abnormal interference by the authorities. On the
contrary when prices are not rising due to the imposition of physical and monetary
controls by the government whereby the economy does not function normally, it is a
state of repressed or suppressed inflation. “The analysis of repressed inflation has
been particularly relevant in periods such as the late 1940, when by the use of
licensing, price controls and subsides, the economic authorities in some countries
attempted to the interfere with the free interplay of market mechanisms. The
principal motive for this was the belief that if such controls had been removed the
change over from a war time to a peace-time economy would have resulted in an
extensive rise in prices. In reality as soon as these controls were removed, there
was open inflation.
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3.3 THE INFLATIONARY GAP

In his pamphlet, How to pay for the War published in 1940. Keynes explained
the concept of the inflation gap. It differs from his views on inflation given in the
General Theory. In the general Theory, be stated with under employment
equilibrium. But in how to pay for the war, he began with a situation of full
employment in the economy. He defined an inflationary gap as an excess of
planned expenditure over the available output at pre-inflation or base prices.
According to Lipsey. “The inflationary gap is the amount by which aggregate
expenditure would exceed aggregate output at the full employment level of income.
“The classical economists explained inflation as mainly due to increase in the
quantity of money, given the level of full employment. Keynes on the other hand,
ascribed it to the excess of expenditure over income at the full employment level
The larger the aggregate expenditure, the larger the gap and the more rapid the
inflation. Given a constant average propensity to save, rising money incomes a full
employment level would lead to an excess of demand over supply and to a
consequent inflation gap. Thus Keynes used the concept of the inflationary gap to
show the main determinants that cause an inflationary rise of prices.
The inflationary gap is explained with the help of the following example.
Suppose the gross national product at pre-inflation prices is Rs.200 crores. Of
this Rs.80crores is spent by the Government. Thus Rs.120 (Rs. 200-80) crores
worth of output is available to the public for consumption at pre-inflation prices.
But gross national income at current prices at full employment level is Rs. 250
crores. Suppose the government taxes away Rs. 60 crores, leaving Rs. 190 crores
as disposable income. Thus Rs. 190 crores is the amount to be spent on the
available output worth Rs. 120 crores, thereby creating an inflationary gap of Rs.
79 crores.
This inflationary gap model is illustrated as under:
Gross National Income at current prices = Rs.250 Cr.
Taxes = Rs.060 Cr.
Disposable Income = Rs.190 Cr.
GNP at per-inflation prices = Rs.200 Cr.
Government expenditure = Rs.080 Cr.
output available for consumption at pre-inflation prices = Rs.120 Cr.
Inflationary gap (Item 3-6) = Rs.070 Cr.
In reality, the entire disposal income of Rs. 190 Crores is not spent and a part
of it is saved. If say, 20 per cent (Rs. 38 Crores) of it is saved, then Rs. 152 crores
(Rs. 190-Rs.38) crores would be left to create demand for goods worth Rs. 120
crores. Thus the actual inflationary gap would be Rs. 32 (Rs. 152-120) crores
instead of Rs. 70 crores.
Diagrammatically the inflationary gap EE’ is shown in Fig 1 Yf is the full
employment level of income which is arrived at by the equality of aggregate
consumption and Investment expenditure line C + I + G and the 45 0line
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representing total supply of goods at point. E At the full employment level, there is
excess demand because consumer’s firm, and government spend more than the
available output at current prices by EE’ amount. This increased demand or
expenditure shifts the C+I+G curve upward to C+I+G’ position. This intersects the
450 line at E’ so that the total expenditure is E’Y’ while the available output is EYf
Thus EA = EE’ is the inflationary gap.
X E
E1 C+I+G
E C+I+G
EXPENDITURE ( C+I+G)
A
C
0
45
0 Y2 Y1 INCOME
Figure - 1
The inflationary gap can be wiped out by increase in saving so that aggregate
demand is reduced. Another solution is to raise value of available output to much
the disposal income. But output cannot be increased during the short run. Private
investment cannot be reduced while the government expenditure is autonomous.
So both cannot be reduced during the short run. Thus the only alternatives left to
the government are to increase taxation and induce saving.
Its Criticism
The concept of inflationary gap has been criticised by Friedman Koopmans,
Salant and other economists.
The analysis of inflationary gap is based on the assumption that full
employment prices are flexible upward. In other wards, they respond to excess
demand in the market for goods. It also assumes that money wages are strictly
when prices are rising, but the share of profits in GNP increases. So this concept is
related to excess-demand inflation in which there is profit inflation. This has led to
the mixing up of demand and cost inflations.
Bent Hansen also criticises Keyness for confining the inflationary gap to the
goods market only and neglecting the factor market. According to him, an
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inflationary gap is the result of excess demand in the goods market as well as in the
factor market.
The inflationary gap is a static analysis. But the inflationary phenomena are
dynamic. To make them dynamic, keyness himself suggested the introduction
output time lags concerning receipts and expenditures of income. Koopmans has
developed relationships between lags and the rate of price increase per unit of time.
He has shown with help of spending lags and wage-adjustment lags that the speed
of inflation becomes smaller that is the inflationary gap is narrowed.
Holzman has criticised keyness for applying the multiplier technique to a full
employment situation. According to him the multiplier technique is not adequate
in periods of full employment and inflation. It abstracts from changes in the
distribution of income. In a full employment situation, the share of one group in
the national output can only be increased at the expense of another.
Another weakness of the inflationary gap analysis is that it is related to flow
concepts, such as current income expenditure, consumption and saving. In fact
the increase in prices at the full employment level is not confined to prices of
current goods along. But they also affect the prices of the goods already produced.
Further, the disposable income which is the differences between current income
and taxes, may include idle balances from the income of previous periods.
Its Importance
Despite these criticisms the concept of inflationary gap has proved to be of
much importance in explaining rising prices at full employment level and policy
measures in controlling inflation.
It tells that the rise in prices, once the level of full employment is attained, is
due to excess demand generated by increased expenditures. But the output cannot
be increased because all resources are fully employed in the economy. This leads
to inflation. The larger the expenditure, the larger the gap and more rapid the
inflation.
As a policy measure, it suggests reduction in aggregate demand to control
inflation. For this the best course is to have a surplus budget by raising taxes. It
also favours saving incentives to reduce consumption expenditure. The analysis of
the inflationary gap in terms of such aggregates as national income investment
outlays and consumption expenditures clearly reveals what determines public
expenditure, saving campaings, credit control, wage adjustments-in short, all the
conceivable anti-inflationary measures affecting the propensities to consume, to
save and to invest, which together determine to general price level.
3.4 DEMAND – PULL INFLATION
Demand – pull or excess demand inflation is a situation often described as “too
much money chasing to few goods”. According to this theory, an excess of
aggregate demand over aggregate supply will generate inflationary rise in prices. Its
earliest explanation is to be found in the simple quantity theory of money, the
theory states prices rise in proportion to the increase in the money supply. Given
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the full employment level of output, doubling the money supply will double the
price level. So inflation proceeds at the same rate at which the money supply
expands. In this analysis the aggregate supply is assumed to be fixed and there is
always full employment in the economy. Naturally, when the money supply of
goods cannot be increased due to the full employment of resources. This leads to
raise in prices. But it is a continuous and prolonged rise in the money supply that
will lead to true inflation.
Modern quantity theorists led by Friedman hold that “ Inflation is always and
everywhere a monetary phenomenon”. The higher the rate of inflation. Inflation
arises when the nominal money supply, the higher the rate of inflation. Inflation
arises when the nominal money supply increases more that the rise in the real
money demanded. Thus they relate changes in income to changes in the money
supply rather than to the price level. Modern quantity theorists neither assume full
employment as a normal situation nor a stable velocity of money. Still they regard
inflation as the result of excessive increase in the money supply.
The quantity theory version of the demand-pull inflation is illustrated
diagrammatically in Fig. 2 (A) & (B). Suppose the money is supply is increased at a
given price level P as determined by D and S curves in panel (B) of the figure. The
initial full employment situation at this price level is shown by the intersection of IS
and LM curves at E in panel (A) of the Figure where R is the interest rate and Yf
fluctuations is the full employment level of income. Now with the increase in the
quantity of money, the LM curve shifts rightward to LMI and intersects the IS curve
at E1 such that the equilibrium level of income rises to Y1 and the rate of interest is
lowered to R1. As the aggregate supply is assumed fixed, there is no change in the
position of the IS curve.
Consequently, the aggregate demand rise which shifts, the D curve to the right
to D1 and thus excess demand is created equivalent to EE1 (=YFY1) in panel (B) of
the figure. This raises the price level, the aggregate supply being fixed, as shown by
the vertical portion of the supply curve S. The rise in the price level reduces the
real value of the money supply. So that the LM1 curve shifts to the left to LM.
Excess demand will not be eliminated until aggregate demand curve D1 cuts the
aggregate supply curve Savings at E’. This means a higher price level P1 in Panel
(B) and return to the original equilibrium position in E the upper panel of the figure
where IS cuts the LM curves “The result, then, is self-limiting, and the price level
rise in exact proportion to the real value of the money supply to its original value.
The Keynesian theory on demand – pull inflations based on the argument that
if the multiplier is relatively stable, changes in income can be predicated from
changes in investment. So long as there are unemployed resources in the
economy., an increase in investment expenditure will lead to increase in
employment, income and output. Once full employment is reached and bottlenecks
appear, further increase in expenditure Will lead to excess demand and to increase
in prices. As pointed out Weintraub, “In sum, as inflation is a creature of excess
demand, there is no serious price level distortion until full employment is reached”.
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( A) E2 LM1
R2 LM
E1
R1
E
INTREST RATE
(B)
PRICE LEVEL
Ex
E
Ed
D1
D
Y1
O
INCOME
The Keynesian theory of demand-pull inflation is explained diagrammatically in
Figure 3 (A) and (B). Suppose the economy is in equilibrium at E where the IS and
LM curves interest with full employment income level and interest rate R as
shown in panel (A) of the figure. Corresponding to this situation, the price level is P
in lower panel (B). Now the government increases its expenditure . This shifts the
IS curve rightward to IS1 and intersects the LM curve at E1 when the level of
income and the interest rate rises to Y1 and R1 respectively. The increase in
government expenditure implies an increase in aggregate demand which is shown
by the upward shift of the D curve to D1 in the lower panel (B) of the figure. This
create excess demand to the extent of EE1 (=YfY1) at the initial price level P. Excess
demand tends to raise the price level, as aggregate supply of output cannot be
increased after the full employment level.
184
LM
( A)
R E LM1
E1
R1
IS
INTREST RATE
o
Yf y
S
(B)
PRICE LEVEL
P1 E
P E
Ed
D1
D
Y1 Y1
O
ANNAMALAI UNIVERSITY INCOME
Figure - 3
A is the price level rises, the real value of money supply falls. This shifts the
LM curve to the left to LM1 such that it cuts the IS1 curve at E2 where equilibrium
is established at the full employment level of income Yf but at higher interest rate
R2 (in panel A) and a higher price level P1 (in panel B).
Thus the excess demand caused by the rise in government expenditure
eliminates itself by changes in the real value of money.
185
3.5 COST-PUSH INFLATION

Cost-push inflation is caused by wage increases enforced by unions and profit
increases by employers. This type of inflation has not been a news phenomenon
and was found even during the medieval period. But it was revived in the
1950savings as the principal cause of inflation. It also came to be known as the
“New Inflation”, Cost-push inflation is caused by wage-push and profit push to
prices.
The basic cause of cost-push inflation is the rise in money wages more rapidly
than the productivity of labour. In advanced countries, trade unions are very
powerful. They press employers to grant wage increases considerably in excess of
increases in the productivity of labour, thereby raising the cost of production of
commodities Employers, in turn, raise prices of their products, Higher wages enable
workers to buy as much as before inspite of higher price. On the other hand, the
increase in prices induces unions to demand still higher wages. In this way, the
wage-cost spiral continues, thereby leading to cost-push or wage-push inflation.
Cost-push inflation may be further aggravated by upward adjustment of wages
to compensate for rise in the cost of loving index. This is usually done in either of
the ways. First, unions include an “escalator clause” in contracts with employers
whereby money wage rates are adjusted upward each time the cost of living index
increases by some specified number of percentage points. Second, in case where
union contracts do not have as escalator clause, the cost of living index is used at
the basis for negotiating larger wage increases at the time of fresh contract
settlement.
Again a few sectors of the economy may be affected by money wage increases
and prices of their products may be rising. In man cases, their products are used
as inputs for the production of commodities in other sector. As a result, production
costs of other sectors will rise and thereby push up the prices of their products.
Thus wage-push inflation in a few sectors of the economy may soon lead to
inflationary rise in prices in the entire economy.
Further, an increase in the prices of domestically produced or improved raw
materials may lead to cost-push inflation. Since raw materials are used as inputs
by the manufacturers of finished goods, they enter into the cost of production of the
latter. Thus a continuous rise in the prices of raw materials tends to set off a cost-
price wage spiral.
Another cause of cost-push inflation is profit-push inflation. Oligopolist and
monopolist firms raise the prices of their products to offset the rise in labour and
production costs so as to earn higher profits. There being imperfect competition in
the case of such firms, they are able to “administer prices” of there products. “In
an economy in which so called administered prices abound there is atleast the
possibility that these prices may be administered upward faster than cost in a
attempt to earn greater profits. To the extent such a process is side spread profit-
push inflation will result. Profit-push inflation is, therefore, also called
186
administered price theory of inflation or price-push inflation of setter’s inflation or

market-inflation.
But there are certain limitations on the power of firms to raise their profits.
They cannot raise their selling price to increase their profit margins if the demand
for their products is stable. Moreoever, firms are reluctant to increases their profits
every time unions are successful in raising wages. This is because profits of a firm
depend not only on prices but sale sand unit costs as well and the latter depend
impart on prices charges”. So firms cannot rise their profits because their motives
are different from unions. Lastly, profits from only a small fraction of the price of
the produce and a one-for-all increase in profits is not likely to have much impact
on prices. Economists, therefore, do not give much importance to profit-push
inflation as an explanation of cost-push inflation.
Cost-push inflation is illustrated in ‘Figure 4 (A) and (B) first consider panel (B)
of the figure where supply curves. S0 and S1 are shown as increasing function of
the price level up to full employment level of income Yf. Given the demand
conditions as represented by the demand curve D, the supply curve, S0 is shown to
shift to S1 in response to cost-increasing pressures of oligopolies, unions etc., as a
result of rise in money wages. Consequently, the equilibrium position shifts from E
to E1 reflecting rise in the price level from P to P 1 and fall in output employment
and income from Yf to Y1 level.
Now consider the upper panel (A) of the figure. As the price level rises, the LM
curve shifts to the left to LM1 position because with the price level to P1 the real
value of the money supply falls, Similarly the IS curve shifts to the left to IS 1
position because with the increase in the price level the demand for consumer
goods falls due to the Pigon effect. Accordingly, the equilibrium position of the
economy shifts from E to E1 where the interest rate increases from R to R1 and the
output employment and income levels fall from the employment level of Yf to Y1.
The cost-push theory has been criticised on three issues. First cost-push
inflation is associated with unemployment. So the monetary authoring is in a fix
because to control inflation it will have to tolerate unemployment. Second, if the
government is committed to a policy of full employment, it will have to tolerate wage
increases by unions, and hence inflation. Lastly, if the government tries to
increases aggregate demand during periods of unemployment, it may lead to
increase in wages by trade union action instead of raising output and employment.
Demand-Pull Versus Cost push Inflation
There has been a lot of controversy among economists over the issue whether
inflation is the consequence of demand-pull or cost push. According to F.
Machinup, “ the distinction between cost-push and demand-pull inflation is
unworkable, irrelevant or even meaninglessness.
187
LM1
IS 1
( A) LM
E1
R1
E
R
IS
INTREST RATE
O
Y1 Yf
S
(B)
PRICE LEVEL
P1 E1
S1
P E
D
So
ANNAMALAI UNIVERSITY O INCOME

Y1 Yf
Figure - 4
However, the debate between demand-pull and cost push arises mainly from
the differences between the policy recommendations on the two views.
Recommendations demand-pull inflation are related to monetary and fiscal
measures which lead to a higher level of unemployment. On the other hand,
188
recommendations on cost-push aim at controlling inflation without unemployment

through administrative control on price increases and income policy.
Machlup argues that the controversial issue is partly duly to be blamed for
inflation and party what policies should be pursued to avoid a persistent increase
in prices if demand-pull is the cause of inflation than the government is blamed for
over spending and taxing little, and the central bank is blamed for keeping interest
rates too low and for expansion of too much credit. On the other hand, if cost-push
is the cause of inflation then trade unions are blamed for excessive wage increases,
industry is blamed for granting them, big firms for raising administered prices of
materials and goods to earn higher profit and government is blamed for not
persuading or forcing unions and industry from raising their wages and profits.
But trade unions reject the wage-push theory because they would not like to be
balanced for inflation. They also reject the demand-pull view because that would
prevent the use of monetary and fiscal measures to increase employment. Thus
they hold only big firms responsible for inflationary raise in prices through
administered prices. But there is no conclusive proof that the profit margins and
profits rates of firms have been increasing year after year.
Machlup further points out that there is a group of economists who holds that
a cost-push is no cause of inflation, “because, without an increase in purchasing
power and demand, cost increases would lead to unemployment”. On the other
hand there is another group of economists believe that demand-pull is to no cause
of inflation, it takes a cost-push to produce it.
Thus it is difficult to distinguish demand-push from cost-pull inflation in
practice and it is easy to say that inflation has been caused by cost-push when, in
face, demand-push may be the cause. As pointed out by Samuelson and Solow.
The trouble is that we have no normal initial standard from which to measure, no
price level which has always existed to which every one has adjusted. It is also
suggested that identification of demand-pull or cost push inflation can be made
with reference to timing. If prices increase first it is a demand-pull inflation and if
wage increase follow, it is cost-push inflation.
Like Machlup Johnson regards the issue of demand-pull versus cost-push as
“Largely a superious one”. He assigns three reasons for this. First, the proponents
of the two theories fall to investigate the monetary assumption on which the
theories are based. Neither the demand-pull nor the cost-push theory can generate
a sustained inflation unless monetary policy followed by the monetary theory is
taken into consideration under varying circumstances. “The two theories are,
therefore, not independent and self-contained but rather theories concerning the
mechanism of inflation in a monetary environment that permits it”. The second
reason is based on difference between the two theories about their definitions of full
employment. If full employment is defined as a situation when the demand for
goods is just sufficient to prevent prices from rising or falling, then it is a case of
demand-pull inflation which is associated with excess demand for goods and
labour. Full employment here means overfull employment. On the other hand, if
189
full employment is defined as the level of unemployment at which the percentage of

the unemployed just equals the number of persons seeking jobs, then inflation is
caused by forces other that excess demand. Such force cause cost-push inflation.
In the third place, it is extremely difficult to device a test capable of determining
whether a particular inflation is of the demand-pull or cost-push type.
We may conclude with Lipsey; “Debate continues on the balance between
demand and cost as forces causing inflation in the contemporary inflationary
climate. The debate is important because the policy implications of different causes
of inflation are different and different target variables need to be controlled
according to the cause. Until the caused of inflation are fully understood, there will
be debate about policies”.
3.6 MIXED DEMAND-PULL COST PUSH INFLATION
Some economists do not accept this dishotomy that inflation is either demand-
pull or cost-push. They hold that the actual inflationary process contains some
elements of both. Infact, excess demand and cost-push forces operate
simultaneously and interdependently in an inflationary process. Thus inflation is
mixed demand-pull and cost-push level changes reflect upward shifts in both
aggregate demand and supply inflation.
But it does not mean that both demand-pull and cost-push inflations may start
simultaneously. Infact, an inflationary process may being with either excess,
demand or wage-push. The timing in each case may be different. In demand-pull
inflation, price increases may proceed wage increases while it may be other way
other way round in the case of cost push inflation. So price increase may start with
either of the two forces, but the inflationary process cannot be substained in the
absence of the other forces.
Suppose an inflationary process begins with excess demand with no cost push
forces at work. Excess demand will raise prices which will in due to sources pull
up money wages. But the rise in money wages is not the result of cost-push forces.
Such a mixed inflation will lead to sustained rise in prices. This is illustrated in
figure. 5
The initial equilibrium is at Y1 level of full employment income determined by
aggregate demand. Do and aggregate supply. So savings curves, at A,. The price
level is po with increase in aggregate demand from D0 to D1 and D2 given the
vertical portion of the supply curve S S, prices rise form Po to P1 to P5 the
inflationary path being A,B and C . This sustained increase in prices has been also
the result of the increase in money wage prices has been also the result of the
increase in money wage rates due to increase in aggregate demand at the full
employment level. When prices rise, producers and encouraged to increase output
as their profits rise with increased aggregate demand. They, therefore, raise the
demand for labour thereby increasing money wages which further lead to increase
in demand of goods and services. So long as the demand for output continuous to
raise money incomes, inflationary pressure will continue.
190
FIGURE - 5
S
C
P5
G D2
P4
F
P3 B
P2
E
P1 D1
S2
A
P0
D0
S1
S0
Y1 Y2 YF
Consider an inflationary process that may begin from the supply-side due to
increase in money wage rates. This will raise prices every time there is a wage-
push. But the rise prices will not be sustained if there is no increase in demand.
This is illustrated in Figure 5.
Where given the aggregate demand curve D0, a wage-push shifts the supply curve
S0 to S1. The new equilibrium is at E. This raises the price level from P0 to P1 and
lower output and employment to Y2 below the full employment level Y1. A further
wage-push will again shift the supply curve to S2 ad new equilibrium will be at F, given
the demand curve Do, thereby raising the price level further to P3 and also reducing
output and employment to Y1. In the absence in aggregate demand this cost-push
inflationary process will not be a sustained and will sooner or later come to an end.
The cost-push inflationary process will be self sustaining only if every wage-
push is accompanied by a corresponding increase in aggregate demand. Since
every cost-push is accompanied by a fall in output and employment. In this way,
cost-push will lead to a sustained inflationary process because the government will
try to achieve full employment by raising aggregate demand which will, in turn, lead
to further wage-push and so on such a situations again explained with the held of
Figure 5. Suppose there is a wage-push at E which shifts the supply curve from S1
to S2 and equilibrium is established at F with the demand curve D0. The price
level rises to P3 and the level of employment is reduced to Y1. When due to an
expansionary monetary and fiscal policy, aggregate demand increases to D1 the
new equilibrium position is at G where the price level rises to P4 and the level of
employment rises to Y2. A further increases in demand shifts the aggregate
demand curve upward to D2. Such that equilibrium is attained at point C where
the price level rises to P5 and the economics attains the full employment level Y1.
191
Thus a wage-push expansionary monetary and fiscal policies traces out a ratchet
like inflationary path from A to E to F to G and to C.
3.7 THE CONVERGENT INFLATIONARY PROCESS
A convergent inflationary process terminates in a new equilibrium point, while
a divergent inflationary process involves continuous dis-equilibrium. In otherwords,
once inflation starts continuous dis-equilibrium is disturbed. In some cases, a new
equilibrium is reached and in some other cases, the dis-equilibrium continues to
exist for ever. The former is called the convergent inflationary process.
In the case of a convergent inflationary process, the inflationary gap gets closer
and finally disappears in the successive increase of money income. As known, the
inflationary gap is produced by excess investment demand. After some time, in the
case of convergent inflation the excess in investment demand disappears and
saving and investment are equal at a new equilibrium point.
Let us now see how the inflationary process converges on a new equilibrium. As
the price level rises, the demand for money for transactions purposes and thus the
amount of money available for buying assists becomes less. In other words, in times of
inflation, while the transactions demand for money increases the speculative demand
for money decreases. The price of bond falls and so the interest rate rises. This rise in
interest rate chockes, off some of the investment demand and finally investment equals
saving. The convergent inflationary process may also be explained by what is known
as money illusion. Under the influence of money illusion consumers react to increases
in money income as if their incomes has increased. They save the same proportions of
an increase in real income. Thus the real consumption releases the resources for
investment. Assuming that this release of resources is the only source of investment.
We can expect that inflation comes to an end.
Next, we shall see how the divergent inflationary process occurs.
The divergent inflationary process.
In case of a divergent inflationary process, the inflationary gap becomes larger
as the money income increase. In the absence of money illusion or the Pigou effect
and other effects, consumer may be expected to maintain the real consumption
they enjoyed at the full employment income level as inflation carries the money
income over and above the full employment level of income. Once the inflationary
gap has arisen, the inflationary process gets under the way. As consumers
increase their consumption expenditures relative to their money income in order to
preserve the pre-inflation consumption, the inflationary gap remains permanent.
Further, when money income increases as a result of inflation, investment
expenditure also increases at current prices. As a result, the inflationary gap gets
larger and larger. Thus inflation proceeds without limit.
3.8 SECTIONAL OF DEMAND SHIFT INFLATION
Sectoral or structural of demand-shift inflation is associated with the name of
Charles Schultz who in a paper, entitled ‘Recent Inflation in the United States’
pointed out that price increases from 1955-57 were caused by neither demand-pull
192
not cost-push but by sectoral shifts is demand. Schultz advanced his there is with
reference to the American economy but it has how been generalised in the case of
modern industrial economies.
Schultz begins his theory by pointing out that prices and wages are flexible
upward in response to excess demand but they are rigid downward. Even if the
aggregate demand is not excessive excess demand in some sectors of the economy and
deficient-demand in other sectors will still lead to a rise in the general price level. Is
because price do not fall in the deficient-demand sectors there being downward rigidity
of prices. But prices rise in three excess-demand sectors and remain constant in the
other sectors. The net effect is an overall rise in the price level.
Moreover, increase in prices in excess-demand industries (or sectors) can spread
to deficient-demand industries through the prices of materials and the wages of labour.
Excess demand in particular industries will lead to a general rise in the prices of
intermediate materials supplies and components. These rising prices of materials will
spread to demand-deficient industries which use them as inputs. They will, therefore,
raise the prices of their products in order to protect the in profit margins.
Not only this, wage will also be bid up in excess demand industries, and wages
in demand-dificient industries will follow this rising trend. Because if wage in the
latter industries are not raised they will lead to dissatisfaction among workers, the
by leading to inefficiency and fail in productivity. This rising wages rates,
originating in the excess demand industries, spread throughout the economy.
The spread of wage increases from excess-demand industries to other parts of the
economy increases the rise price of semi-manufactured materials and components
other thing rema9ining the same the influence of increasing costs will be larger at the
final stages of production. Thus producers of finished goods will face a general rise in
the level of costs, thereby leadings to rising prices. This may happen even in case of
those industries which do not have excess demand for their products.
Another reason for demand-shift inflation in modern industrial economics in a
increase in the relative importance of overhead cost. This increase is due to two
factors. First, there is an increase in overhead staff at the expense of production
workers. According to Schultz, automation of production methods instrumentation
of control functions, mechanisation of office and accounting procedures, self-
regulating materials handling equipment, etc., lead to the growth of professional
and semi-professional personal in supervising operating maintenance roles,
similarly, the growth of formal research and development (R &D) as a separates
function not only alters the production processes but also the composition of the
labour force required to service them. These developments lead to the decline in
the ration of production workers to technical and supervisory staff in industries.
The second reason for the rise in overhead costs is that the ratio of relatively short-
lived equipment to long-lived plant rises substantially. As a result, depreciation as a
proportion of total cost increases. The ultimate effect of an increasing proportion of
overhead costs in the total cost is to make average costs more sensitive to variations in
193
output. The distinguishing characteristic of the demand-shift inflation is a continued

investment boom in the face of stable aggregate output. All industries expand their
capacity and their employment or overhead personnel, yet only a few enjoy a
concomitant rise in sales. So producers facing shrinking profit margins try to recover a
part of their rising costs in higher prices.
Thus demand-shift inflationary process “arises initially out of excess demand in
particular industries. But it results in a general price rise only because of the
downward rigiditics and cost-oriented nature of price and wages. It is not
characterized by an autonomous upward push of costs not by an aggregate excess
demand. Indeed its basic nature is that it cannot be understood in terms of
aggregate alone. Such inflation is the necessary result of sharp changes in the
composition of demand, give the structure of prices and wages in the economy.
This the theory was evolved by Schultz to examine the nature of the gradful
inflation to which the American economy had been subject during the period 1955-57.
It has been generalised in the case of modern industrial economics. However, Johnson
has criticised it for two reasons. First, empirical evidence has failed to confirm
Schultzs proposition that sectoral price increases are explained by upward shifts of
demand. Second, it fails to investigate the monetary preconditions for inflation, and
impression respecting the definitions of full employment and general excess demand.
3.9 MARK-UP INFLATION
Gardner Ackley has suggested a model of mark-up inflation in corporating both
demand pull and cost push forces. A formal model of pure mark up inflation is
provided by F. D. Hatzman. A model combining mark up and demand element has
also been presented by J. Dueses-senberry Mark-up inflation arises due to the
behaviour of business firms. The business firms have practice of producing goods
and service on the basis of same standard markup, over their cost of direct
materials and direct labour. This mark-up therefore covers both overall costs and
profits, it is easy to see that this model both overall costs and profits, It is easy to
see that this model can generators stable either arising over failing price level
depending upon the markup which business employs. If the price are cost
determined the markup will be raised as soon as the rising costs are feared to erode
the margin of profits. These compensatory increases in price will reduce the real
wages and this will necessitate an increases in money wages. This will further
push up the costs. Consequently the business firms will have to further raise the
prices of final products and the inflationary prices will continue.
The markup pricing tends to create cost push inflation due to two reasons 1)
prices rise direct by and more rapidly than the money wages. 2) When business
firms are making use of markup pricing the management will put up less resistance
to wage increase.
If the mark up pricing model is dreadfully over simplified. For e.g. when public
utility is increasing the business and entrepreneurs may concept with each other to
share this activity. In that case mark up pricing will further aggravate inflation.
194
The mark up hypothesis is important on the ground that it places emphasis not
on the level of prices,. Not on supply and demand but on maintaining a fair
relationship between buying prices and selling prices. However may economists
reject this idea as meaningless.
Control of Mark up Inflation
The tools of monetary and fiscal policy can have some effect on inflation for e.g.
reduction of total demand for goods may reduce the general level of mark ups i.e. as
total demand fails there is reduced employment and trade unions lower the demand
for wage increases. The usual cost push inflation puts the blame of raising prices
on labour i.e. inflation occurs because labour is demanding higher wages but the
mark up analysis qualities this conclusion. By pointing out that it is combination
of the interaction of wage claims and business values that may produce inflation.
The question is now to find out whether the business are keeping a high mark
up or low mark up. For this experience alone is the answer. What one should
remember is that if the attempted or desired mark ups by both labour and business
are high then the mark up inflation becomes dangerous some point out that mark
ups tend to be adjusted with some time lag with changes in demand conditions but
if not properly checked. Pricing habits can contain a built in fragmentary inflation.
Ackley suggests the establishment of a permanent wage and price commission to
control this type of inflation. He argues that there is universal relationship between
inflation and employment and hence monetary and fiscal policies alone are not
sufficient to control inflation.
4. REVISION POINTS
1. Inflation: Increase in quantity of money than output
2. Inflationary gap: It is the amount by which aggregate expenditure is greater
than output
3. Demand-pull: An excess of aggregate demand over supply of commodities
4. Cost-punch: It is caused by Wage increase enforced by unions and profit
increases by employers
5. Convergent Process & Divergent process: It terminates in a new
equilibrium point while a divergent equilibrium process involves
continuous dis-equilibrium.
6. Sectoral shift in demand: price increase may be neither because of
Demand-Pull or Cost-Punch
7. Mark-up Inflation: It is due to the behaviour of business firms
5. QUESTIONS
Section A
1. Explain the Inflationary gap
2. Explain tha convergent and divergent inflationary process
3. Explain tha Mark-up Inflation
195
Section B
1. Give a critical assessment of any one of the theories of inflation and give
reason for selecting this particular theory.
2. What is inflationary gap? Examine the usefulness of this concept in
analysing a process of inflation.
3. Distinguish between demand-pull and cost-push inflation.
4. “The distinction between cost-push and demand pull inflation is
unworkable, irrelevant and even meaningless”. Do you agree with this
view. Give reasons in support of your answer.”
6. SUMMARY
Inflation is fundamentally a monetary phenomenon and the gap arises when
there is an excess of planned expenditure over the available output at Pre-infletion
or base prices. But Cost-punch inflation is caused by wage increase enforced by
unions and profit increase by employers.
A convergent inflationary process terminal in a new equilibrium point while a
divergent infaltionary process involves continuous disequilibrium. The tools of
monetary and fiscal policy also can have its effect on inflation.
1978.
4. Cauvery. R , V .K Sudha n ayek, M girija ,R.Meenakshi, Macro Economics,
8. KEY WORDS
Inflation, Inflationary Gap, Demand pull, Cost punch, Sectoral, Mark-up
Inflation

DR. R. CAUVERY
P.G. Prof. and H.O.D.
Department of Economics
Sri Saradha College,
Salem.
196
I. G. P.
BOOK POST
ANNAMALI UNIVERSITY
DIRECTORATE OF DISTANCE EDUCATION
STUDENTS RESPONSE SHEET
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Name..................................................... Directorate of Distance Education,
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Address
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Course Name: M. A. Economics II Year Response Sheet. No. 2

Subject: Economics Statistics Lessons Covered:11 to 20
Marks awarded : Signature of the Examiner
———————————————————————————————————————
(Detach this portion and paste it to your Response Sheet, Question Paper can be retained by the student)
M. A. Economics – II – Year
MACRO ECONOMICS
Answer any Five questions
1. Discuss the significance of the shifts in the IS and LM functions and of
their clasticities.
2. Derive IS and LM curves and explain the macro economics equilibrium.
3. Inflation is a system and not a disease by itself. Examine with reference to
india.
4. State, draw and discuss the significance of the Phillips curve.
5. Explain the modern theories of business cycle.
6. Explain the multiplier – accelerator Intersection Theory of Business cycle.
7. Discuss the Hicksian Theory of Business cycle.
8. Explain the economic goals of macro economic policy.
9. Indian monetary policy in India does not go with our economic democracy.
Comment in the light of our experience.
10. Discuss the note of fiscal policy in stabilising income.
197
LESSON – 14
PHILLIPS CURVE AND ITS IMPLICABLE

1. INTRODUCTION
This chapter deals with Phillips curve and its implications and the factors that
determine the relation between unemployment and Wage and Jobin’s view and
Solow’s on this relation as well as the policy implications of the Phillips curve.
2. OBJECTIVES
 To acquire knowledge about the pphillps curve aqnd factors influencing
the relationship between wage and unemployment
 To know the views of Tobins and Solow on Phillip’s curve
 To know the policy implication of the phillip’s curve
 To explain the relationship of Phillip’s curve
3. CONTENT
3.1 Introduction
3.2 Factors determining the wage unemployment relation
3.2.1 Relative bargaining strength of trade unions and bargaining
3.2.2 Generalised excess demand for labour
3.2.3 Imbalances between supply and demand in labour market
3.3 Explanation of Phillip’s curve relationship with diagram
3.4 Criticisms and Modifications
3.5 Tobin’s view on Phillip’s curve
3.6 Solow’s view on Phillip’s curve
3.7 Policy Implication of the Phillip’s curve
3.1 INTRODUCTION
The most widely debated aspect of the theory of inflation during the 1950’s has
been the Phillips Curve. Prof A. W. Phillips analysed the statistical data concerning
the unemployment percentages and the percentages of the changes in money wage
rates in Britain during the Period 1861-1957. One of the objects of this study was
to identify whether the demand pull element had been stronger than the cost-push
or vice versa in the British economy. Another object was to determine the extent to
which restrictive monetary and fiscal policies can be appropriate in the control of
inflation. In demand inflation, the monetary and fiscal restraints seem to be quite
capable of checking the expansion of aggregate demand. But these policies become
somewhat in appropriate in case of supply inflation. The most significant evidence
of the existence of supply inflation is the rising price level associated with the level
of output appreciable below the full employment level of output. A restrictive
monetary-fiscal policy, by restraining the excess demand, may aggravate the
“inflationary situation through its restrictive impact upon the rate of investment
spending and thereby slowing down the rise in labour productivity which could
198
otherwise have off-set the wage push. The monetary and fiscal restraints are likely
to check wage push inflation through creating in money wages over and above the
rise in labour productivity is fully prevented. Thus the society can have price
stability. Only at the cost of permitting the unemployment to exist in such
amounts that may be socially and economically unacceptable. If the maintenance
of price stability necessitates a high Percentage of unemployment over the
sustained periods, the society may prefer the lesser of the two evils and accept a
moderate inflation that accompanies a socially and economically acceptable rate of
unemployment. “The central contribution of Phillips’ approach”. Says Johnson, “is
to substitute an empirical relationship between the rate of inflation and the
percentage of unemployment for the vague literary and judgemental arguments
about how much reduction in employment would be necessary to half inflation that
had previously dominated the debate about economic policy”.
Phillips found that wage rates rose rapidly when employment was low,
decreased when it was high and remained unchanged when about 2 ½% of the
labour force were out of job. The relationship between unemployment and the rate
of change of wage rates, according to Phillips, is both inverse and non-linear. The
inverse character of wage unemployment relation may be due to the following
factors.
3.2 FACTORS DETERMINING THE WAGE UNEMPLOYMENT RELATION
3.2.1 Relative Bargaining Strength of Trade Unions and Management
The relative bargaining strength of the worker’s unions and management seems
to vary considerably with the changes in the unemployment rates and the general
business activity. When the unemployment rates are low and the labour shortages
are being felt, the trade union can quite aggressively press for substantial increases
in money wages During the periods of high employment, on the contrary, the wage
claims are generally not pressed upon the managements.
3.2.2 Generalised Excess Demand for Labour
Another reason for this inverse relationship between rates of money wages and
unemployment is a state of generalised excess demand for labour. It is not
necessary that the wage increase are brought about by the organised union action.
In the United States only a small proportion of total labour force is unionized yet
the money wages increase both in the unionized and non-unionized segments of the
labour force primarily because there is an excess demand for labour.
3.2.3 Imbalances between Supply and Demand in Labour Market
The Phillips type relationship between money wage rate and the unemployment
rates may exist also on account of the imbalances between supply and demand in
particular labour markets. If there are difficulties in the occupational and
geographical mobility of labour, the existence of labour shortages in particular
sectors may push up the wage rates even in a period of substantial unemployment
because the workers from other sectors find it difficult to shift over to such sectors
or occupations where the demand for labour is in excess of labour supply.
199
The Phillips curve depicts the trade-off between unemployment and money
wages. It relates percentage change in money wages on the vertical axis with
percentage of labour force unemployed on the horizontal axis, as shown in Fig1.
(Page 3). The Phillips curve is shown by the PC curve. The curve is convex to the
origin when shows the percentage change in money wages rises with decreases in
the unemployment rate. Suppose that ON rate of unemployment (3%) is associated
with OM growth rate or money wages (2%), Suppose also that the rate of labour
productivity is 2 percent. That is equal to OM. Since the growth rate of money
wages equals the rate of labour productivity, the price level remains constant. The
rate of change in the price level (P/P) is shown as zero in the figure. If now
aggregate demand it increased, this lowers the unemployment rate to OT (2%) and
raises the wage rate to OS (4%) per year. If labour productivity continues to grow at
2 percent per annum, the price level will also rise at the rate of 2 percent per
annum at OS in the figure
FIGURE - 5
S
C
P5
G D2
P4
F
P3 B
P2
E
P1 D1
S2
A
P0
D0
S1
S0
Y1 Y2 YF
Thus a money wage-rate increase which is in excess of labour productivity

leads to inflation. To keep wage increase to the level of labour productivity (OM) in
order to avoid inflation, ON rate of unemployment will have to be tolerated.
The shape of the PC curve, further, suggests that when the unemployment rate
is less than 5 ½ per cent (that is, to the left of point A), the demand for labour is
more than the supply and this tends to increase money wage rates On. The other
hand, when the unemployment rate is more than 5 ½ per cent (to the right of point
A), the supply of labour is more than the demand which tends to lower wage rates,
200
The implication that is the wage rates will be stable at the unemployment rate OA
which is equal of 5 ½ percent per annum.
Samuelson and Solow extended the Phillips analysis to the trade – off between
the level of unemployment to the rate of change in the level of prices. Thus the
Phillips curve suggests that unemployment can always be reduced by having more
inflation and that the inflation rate also can be reduced having more
unemployment.
3.3 EXPLANATIONS OF THE PHILLIPS CURVE RELATIONSHIP
There are two principal explations for the Phillips curve relationship. One
relates to the behaviour of organized labour. Organized labour can cause
autonomous increase in wage rate in excess of increases in productivity. This leads
to rising prices of goods, in a process that is accordingly called wage push inflation.
To the argument that organized labour can push through autonomous increases in
wage rates greater than productivity increases, we now add the following. The
degree to which labour can do this will vary inversely with the unemployment
percentage and the case of labour markets. With lower unemployment and higher
labour markets. Organized labour will become more aggressive and press for larger
wage increases; under the opposite conditions, organized labour will be less
demanding. Furthermore, because times of low unemployment and tight labour
markets are ordinarily times of buoyant demand for goods and abundant profits,
business will usually grant the “excessive’s wage increase demand rather than face
the possibility of a strike and a shutdown of such profitable production. Under the
opposite set of condition-high unemployment and low profits-business would have
much less to lose and would show considerable resistance to even moderate wage
increase demands. With the relative bargaining strength of labour unions and
employers varying in this way, We can expect an inverse relationship between the
percentage wage increases and the unemployment percentage of the kind shown by
the Phillips curve.
W
SL
W4
M N
W3
W2
G H
W1
J
DL
I
O
A L
Figure - 2 Part A
201
A second explanation, which is general and not dependent on the relative

bargaining powers of organised labour and business relates to excess demand for
labour. The explanation is somewhat involved and we will sketch only the
essentials here. For this purpose, an abbreviated two paragraphic system is used
instead of the four-part system needed to snow the complete analysis graphically.
Figure 2 – Part A
The explanation begins with supply and demand curves or labour; as shown in
part A of Figure 2. For the curves as given, the wage rate W3 equates the supply of
and demand for labour. Although this wage rate indicates equilibrium in the
labour market, it does not indicate an absence of unemployment. It is equilibrium
in the sense that the number of unemployed workers is just equal to the number of
vacancies that employers seek to fill. It would be equilibrium with zero
unemployment only if frictional unemployment were always zero. This would
require, for example, that no worker ever changed jobs or, if they did, that not a
days work was lost in the process-a situation obviously not realized in practice.
At any wage rate below this equilibrium-for example W2 the number of
vacancies exceeds the number seeking jobs there is excess demand for labour, in
this case equal to GH In the same way, at any wage rate above the equilibrium
there are fewer vacancies than the number seeking jobs; there is excess supply of
labour. At W1 excess supply is equal to MN. If we look specifically at cases of
excess demand, a key argument in the present explanation is that the rate at which
wage rates varies directly with the extent of the excess demand for labour.
Accordingly, with a wage rate of W1 and an excess demand of II, there will be a
more rapid rise in wage rates than there would be with a wage rate of W 2 and, the
smaller excess demand of GH.
Another key argument is that the average period of time required for
unemployed people to find jobs varies inversely with the extent of excess demand
for labour. In figure 2; the average search time involved for unemployed workers to
find the kind of jobs they are looking for will be shorter when excess demand is IJ
than where it is GH. From this follows the important conclusion that the amount of
unemployment will vary inversely with the amount of excess demand. In other
words, with a given labour supply, whatever rate of unemployment exists at the
equilibrium wage rate will be smaller as we move to successively lower wage rats or
successively larger levels of excess demand However, a greater excess demand for
labour will also rise the rate at which wage rates increase. This brings in the earlier
argument that the speed with which wage rates rise in the facts of excess demand
depends on the magnitude of that excess demand, when we put together this
relationship in which the rate of increase in the wage rate depends directly on the
amount of excess demand and the rate of unemployment depends in versely on the
amount of excess demand, we have the Phillips curve relationship, in which the
rate of wage increase and the unemployment rate are inversely related.
For example, suppose that when there is neither excess supply nor excess
demand-that is, a wage rate of W3 in part A of Figure 2 there is an amount of
202
unemployment that yields the unemployment rate U1 in part B of that figure (page
7). This unemployment rate is accompanied by a zero percentage rate of wage
increase, because there is neither an excess supply of nor an excess demand for
labour at, that wage rate. At any wage rate below W3 we have excess demand. This
means a lower unemployment rate or a leftward movement in terms of the
horizontal axis in part B, and vertical axis in part B. We therefore finding
movement to a point back up the Phillips curve. The greater the excess demand,
the further from the originally selected point at U1 will be. The same reasoning may
be applied to a wage rate above W3. In this case, there is excess supply which
means a higher unemployment rate than U1 and a rate of wage increase lower than
zero or a movement to a point down he Phillips curve from the originally selected
point at U1.
W/W
U1 U
Figure - 2 Part B
The two explanations of the Phillips curve relationship noted here are not
alternatives. The factors involved in the union power explanation and those in the
excess demand explanation may be operating at the same time. The tendency of
the rate of increase in money-wage rates to rise with a falling unemployment,
percentage may therefore be explained in terms of both these causes.
Our concern here has been limited to an explanation of the inverse relationship
between the rate of increase of the money-wage rate and the unemployment rate-
that is, with the fact that the Phillips curve slopes downward to the right Another
matter is the position of the curve Does this curve shift upward or downward from
one time period to another? A part from the fact that a lower unemployment rate
will be accompanied by a higher rate of wage increase, will the rat of wage increase
corresponding to any particular unemployment rate be higher or lower from one
time period to the next? This question of the stability of the Phillips curve is of the
greatest importance. During most of the 1960s, it was widely believed that the
curve. Was quite stable, but in the 1970s, the statistical and theoretical evidence
supported the opposite belief.
Its Users
203
If the Phillips curve analysis is correct, it is useful because it suggests the

extent to which fiscal and monetary policy can be pressed into use to counteract in
inflation without involving high levels of unemployment. The Phillips curve comes
handy to the extent that it tells the policy makers as to what rate inflation has been
historically compatible with given in level of unemployment. Most economists who
accept Phillips trades off are of the opinion that terms of the trade-off in the USA
have worsened i.e. more of employment can be secured at the cost of a high level of
inflation. The policy makers must decide whether the existing. Phillips curve
represents some combination of price stability and unemployment, which is
acceptable. An appropriate fiscal and monetary policy can be used to regulate the
level of aggregate demand which will lead to the desires combination of price
stability and unemployment.
3.4 ITS CRITICISMS AND MODIFICATIONS
Economists have criticised and in certain cases modified the Phillips curve.
They argue that the Phillips curve related to the short run and it does not remain
stable. It shift with changes in expectations of inflation. In the long run there is no
trade off between inflation and employment. These views have been expounded by
Friedman and Phillips in what has come to be known as the “accelerationist”
hypothesis.
According to Friedman, there is a ‘natural rate of unemployment” which is
composed mainly of frictional unemployment. Therefore, it is the rate of
unemployment corresponding to full employment. Friedman’s hypothesis is that it
is unemployment below the natural rate which causes money wages to rise, rather
than the rate of unemployment. On the contrary, it is unemployment in excess of
the natural rate which causes wages to fall. If unemployment is below the natural
rate, the short run Phillips curve will twist upward and the price rise will
accelerate. If unemployment is more than the natural rate, the short-run Phillips
curve will twist downward and the price rise will decelerate.
The theory is illustrated in Figure 3. (Page 9) Suppose unemployment is at
natural rate N equal to 3 per cent. In the short run if labour and firms expect the
inflation rate to rise 4 per cent, them money wages will rise at that rate. As a
result, real wages decline and unemployment will be reduced. Unemployment will
move along the short-run Phillips curve SPC1 from point A to B . In other words,
with a rise in the inflation rate from 2 per cent to 4 per cent, unemployment falls
from 3 percent to 2 percent But as the price level begins to rise, workers begin to
realise that their real wages are declining. So they will demand higher money
wages to real wages to the initial level A (2 per cent inflation. As real wages will
tend to rise toward the initial level unemployment will increase to 3 per cent and
equal the natural level, of unemployment. N. But firms are willing to pay rising
money wages because they expect to pass on these wage increases into prices. So
the rate, of wage increase remains at4 percent inflation rate. The increase in real
wages and the level of employment will shift the Phillips curve SPC 1 upward to
SPC2 so that the natural rate of unemployment upward to SPC2 so that the natural
204
rate of unemployment N(3 %) is associated with a 4 percent rate of wage increases

at point C where the only Phillips curve LPC cuts the SPC2 curve.
SPC1 SPC2 LPC
B C
4
A
2
1 2 3 4
Unemployment ( % )
If the authorities want to reduce this unemployment rate to percent, they can
only be successful during the short run. In this situation, the rate of wage increase
will have to be 8 percent corresponding to 2 per cent unemployment rate and the
rate of inflation will rise to 6 percent (=8%-2%). This will again shift up the short-
run Phillips curve SPC2 to the natural level or unemployment, as represented by
the LPC curve. This upward shifting of short-run Phillips curve from point A to C
and so on along the LPC curve has come to be known as the accelerationist theory.
“ The to us conclude, in this view the long-run Phillips curve is vertical. This
means that there is no trade-off except in the run, that the natural rate of
unemployment is compatible with any rate of inflation, and that a lower rate of
unemployment implies ever-accelerating inflation."
The accelerationst hypothesis is controversial, some economists have argued
that wage rates have not increased at a high rate of unemployment. Second, it is
believed that workers have a money illsion. They are more concerned with the
increase in their money wage rates than real wage rates. Third, some economists
regard the natural rate of unemployment as a mere abstraction because Friedman
has not tried to define it in concrete terms. Finally, Saul Hyman has estimated that
the long-run Phillips curve is not vertical but is negatively slopped according to
Hyman the employment rate can be permanently reduced if we are prepared to
accept an increase in inflation rate.
3.5 TOBIN’S VIEW
James Tobin in his presidential address before the American Economic
Association in 1971 proposed a compromise between the negatively sloping and
vertical Phillips curve Tobin believes that there is a Phillips curve within limits, but
as the economy expands and employment grows, the curve becomes ever more
fragile and vanishes until it becomes vertical it some critically low rate of
unemployment. Thus Tobins Phillips curve is kinked shaped, a part like a normal
Phillips curve and the rest vertical, as shown in Figure 5. In the fig 4 (page 11) UC
205
is the critical rate of unemployment at which the Phillips curve becomes vertical
where there is on trade off between unemployment and inflation. According to
Tobin the vertical portion of the curve is not due to increase in the demand for more
wages but emerges from imperfections of the labour market at the UC level, it is not
possible to provide more employment because the job seekers have wrong skills or
wrong age or sex or are in the wrong place, Regarding the normal portion of the
Phillips curve which is negatively sloping, wages are sticky downward because
labourers resist a decline in their relative wages. For Tobin, there is a wage-change
floor in excess supply situations. In the range of relatively high unemployment to
the right of UC in the figure as aggregate demand and inflation increase and
involuntary unemployment is reduced, wage-floor markets gradually diminish.
When all sectors of the labour market are above the wage floor, the level of critically
low rate of unemployment UC is reached.
SPC1 SPC2 LPC
B C
4
A
2
1 2 3 4
Unemployment ( % )
3.6 SOLOW’S VIEW

Like Tobin, Robert Solow does not believe that the Phillips curve is vertical at
all rates of inflation. According to him, the curve is vertical at positive rates of
inflation and is horizontal at negative rates of inflation, as shown in Figure 5 (page
12). The basis of the Phillips curve LPC of the figure is that wages are sticky
downward even in the face of heavy unemployment or deflation. But at a Particular
level of unemployment when the demand for labour increases, wages rise in the
face of expected inflation. But since the Phillips curve CLPC becomes vertical at
that minimum level of unemployment there is no trade-off between unemployment
and inflation.
Conclusion
206
The vertical Phillips curve has been accepted by the majority of economists.
They agree that at unemployment rate of about 4 percent, the Phillips curve
becomes vertical and trade-off between unemployment rate of about 4 percent, the
Phillips curve bec0omes vertical and trade off between unemployment and inflation
disappears it is impossible to reduce unemployment below this level because of
market imperfect.
INFLATION ( % )
O
P
UNEMPLOYMENT ( % )
LPC
3.7 POLICY IMPLICATIONS OF THE PHILLIPS CURVE
The Phillips curve has important policy implications. It suggests the extent to
which monetary and fiscal policies can be used to control inflation without high
levels of unemployment. In other words, it provides guidelines to the authorities
about the rate of inflation which can be tolerated with a given level of
unemployment. For this purpose, I t is important to know the exact position of the
Phillips curve, it the curve is PC1 an in Figure 6 where the labour productivity and
the wage rate are equal at point E, both full employment and price stability would
be possible. Again a curve to the left of point E suggest full employment and price
stability as consistent policy objectives. It implies that a lower level of inflation can
be traded-off for a low level of unemployment. If, on the other hand the Phillips
curve is PC as in the figure, it suggests that the authorities will have to choose
between price stability and more unemployment. Thus observing the position of
the Phillips curve the authorities can decide about the nature of monetary and
fiscal policies to be adopted, For instance, if the authorities find that the inflation
rate P2 is incompatible with the unemployment rate U1 of Figure 6 they would
adopt such monetary and fiscal as to shift the Phillips curve PC to the left in the
position of PC1 curve. This will give a better trade-of between lower inflation rate
P1 with the same level of unemployment. U1. While explaining the natural rate of
unemployment, Friedman pointed out that the only scope of public policy in
influencing the level of unemployment lies in the short run in keeping with the
position on the Phillips curve. He ruled out the possibility of influencing the long-
207
run rate of unemployment because of the vertical Phillips curve. But economists do
not agree with Freedman. They suggest that is possible to reduce the natural rate
of unemployment through labour market policies, whereby labour market can be
made more efficient. so the natural rate of unemployment can be made more
efficient. So the natural rate of unemployment can be reduced by shifting the long-
run vertical Phillips curve to the left.
PC1
PC
P2
INFLATION ( % )
P1
E
U1 U2
UNEMPLOYMENT ( % )
But the policy implications of the Phillips curve are not so simple at they
appear. The authorities are faced with certain constraints concerning the dicision
with regard to the rate of inflation that may be compatible with a particular rate of
unemployment. Thus the problem of trade off between inflation and unemployment
is one of choice under constraints. This illustrated in Fig 7, (page 14). The
constraints are a given Phillips curve PC and the indifference curve I 1I1, I2I2, I3I3 and
I’I’ representing the choice of authorities between unemployment and inflation. The
208
PC
L4
L3
L2
INFLATION ( % ) E
A
L1
F
C
O D I2
B I1 E I3
UNEMPLOYMENT ( % )
indifference curves are concave to the origin because if the authorities between
unemployment, they must have higher inflation and vice versa. So they represent
negative utility. But the curve I2I2 represent a higher level of public welfare than
the curve I1I1 and the curve I3I3 still higher welfare than I3I3 still higher welfare than
I2I2 curve. This is because any point on the lower curve represents a lower rate of
unemployment and inflation than on a higher curve. The optimum trade-off point
is E where the indifference curve I2I2 is tangent to the Phillips curve PC where the
trade-off is between OA rate of inflation and OB rate of unemployment. If, however,
the public authorities adopt such monetary and fiscal policies whereby they want to
have less inflation and more unemployment the indifference curve becomes I,I’.
This curve I’I’ is tangent to the Phillips curve PC at Fluctuations and the trade-off
becomes OC of inflation and OD of unemployment.
It has been suggested by certain economists that there is a loop or orbit about
the Phillips curve based on observed value of inflation and unemployment. This is
illustrated in Fig 8, (page15) in the early expansion phase of the business cycle the
unemployment-inflation loop involves rising output with reduced Inflation. This is
due to demand-full following an expansionary monetary or fiscal policy. In this
phase of the cycle, the normal relationship between inflation and unemployment
suggested by the Phillips curve is maintained It is shown by the movement of
arrows from below the PC curve when rate of unemployment fall and the rate of
inflation increases. If aggregate demand continues to increase inflationary
pressures gain momentum and the dotted loop crosses the Phillips curve at point.
209
PC
INFLATION ( % ) A B
UNEMPLOYMENT (%)
A tight monetary of fiscal policy will reduce aggregate demand. But the
expectations of increases in prices will bring wage increases and inflation will be
maintained at the previous rate. So unemployment will increase with no reduction
in prices. This is revealed by the upper portion of the loop to the right of the
Phillips curve. However, when excess demand is controlled and output increases
the rate of inflation starts falling from point B along with fall in the rate of
unemployment. Thus we find that the conclusion of the Phillips curve hold in the
early phase of the business cycle due to an expansionary monetary or fiscal policy.
But in the downward phase the trade-off between inflation and unemployment goes
contrary to the Phillips curve.
Johnson doubts about the applicability of the Phillips curve to the formulation
of economic policy on two grounds. On the one hand. The curve represents only a
statistical description of the mechanics of adjustment in the labour market, resting
on a simple model of economic dynamics with little general and well tested
monetary theory behind it. On the other hand, it describes the behaviour of the
labour market in a combination of periods of economic fluctuation and varying rate
of inflation conditions which presumably influenced the behaviour of the labour
market itself, so that it may reasonably be doubted whether the curve would
continue to hold its shape if an attempt were made by economic policy to pin the
economy down to a point on it”.
4. REVISION POINTS
Phillips curve relationship
Organized labour can cause an autonomous increase in wage rate in excess of
increase in productivity
210
It is in general depends on the relative bargaining of powers of the organized

labour and business relates to excess demand for labour
Tobin’s view
When the economy expands and employment grows,the curve becomes even
more fragile and vanishes until it becomes vertical
Solow’s view
The curve is vertical at positive rates of inflation and is horizontal at negative
rates of inflation.
5. QUESTIONS
Section – A
1. Explain the Phillip’s curve
2. Examine Tobin’s view about Phillip’s curve
3. Bring out the implications of the Phillip’s curve
Section – B
1. Discuss the Theory of the Phillips curve and bring out its apparent policy
implications.
2. How does the Phillips curve explain the tradeoff between unemployment
and inflation? Discuss its policy implications.
3. Evaluate the theory of the Phillips curve.
211
6. SUMMARY
Phillip’s curve gives us the inverse and non-linear relationship between wage
and unemployment. Tobin’s curve is kinked shape, a part like a normal Phillip’s
curve and the rest vertical because of the tradeoff between unemployment and
inflation. According to Solow, the curve is vertical at positive rates of inflation and
is horizontal at negative rates of inflation. Phillip'’ curve provides guidelines to the
authorities about the rate of inflation which can be tolerated with a given level of
unemployment.
1. Paul A. Samuelson & William Nordhaus, Economics, Tata McGraw –Hill
Publishing co. Ltd, Madras.
2. Edward Shapiro, Macro Economic Analysis, Harcourt Brace, Jovanovich,
1978.
3. Jhingan. M.L, Macro Economic Theory, Vrinda Pulbications (p) Ltd., New
Delhi
4. Cauvery. R, V .K Sudha Nayek, M girija, R. Meenakshi; Macro Economics;
S. Chand & company, New Delhi.
8. KEY WORDS
Phillips curve, Tobin’s curve, Solow’s curve

212
LESSON – 15
MODERN BUSINESS CYCLE THEORY

1. INTRODUCTION
This chapter discusses about the business cycles, which is caused because of
the interaction of the multiplier and the acceleration which plays a prominent place
in the business cycle literature
2. OBJECTIVES
 To examine the modern business cycle theory
3. CONTENT
3.1 Introduction
3.2 A note on Samuelson’s Theory and Hicks Theory
3.3 Kaldor’s Theory
3.4 Methods of Controlling Business Cycle
3.1 INTRODUCTION
Economic activity is subject to periodical fluctuations. The fluctuations that
occur in a business activity in a cyclical fashion are called business cycles.
According to Shapiro, business cycles are the movements that occur in economic
activity over years. There are four phases of trade cycle viz depression, recovery,
boom and recession.
The older theories of trade cycles are those associated. With the names of
Jevons. Hawtrey, Pigou. Hopson.Hayek Schumpeter and others. As they are in
adequate to explain the full meaning of the business cycles, modern economist have
developed some new theories of business cycle.
3.2 A NOTE ON SAMUELSON’S THEORY AND HICKS THEORY
Samuelson made a study of the multiplier and the accelerator. And he derived
a model in which a series of equations express the way in which the two forces
interact to cause changes in income, consumption and investment over time. The
subscripts it in the equations represent time periods. It is a given time-period t-1 is
the previous period, t + 1 is one period in the future and so on.
Hicks discussed his theory of the trade cycle in his book ‘A Contribution to the
Theory of the Trade Cycle, published in 1950. Although 30 years have passed, the
theory still occupies a prominent place in the business cycle literature. According
to Hicks, cyclical fluctuations are movements of the system above and below the
rising trend or growth lines. In other words, the growth path to the economy is
characterised by cyclical fluctuations. The long-run equilibrium growth path for
the economy is determined by the growth rate of autonomous investment. The ratio
of the equilibrium income to autonomous investment depends upon the size of the
accelerator and the multiplier Hicks waves his theory around interaction of the
multiplier and the theory of the accelerator are the two sides of the theory of
213
fluctuations. Just as the theory of demand and the theory of supply are two sides
of the theory of value”.
In Hicks’s trade cycle theory, multiplier, accelerator and warrnated rate of

growth of income-the rate of growth which maintains itself over time-play a crucial
role. The warranted rate of growth of income is consistent with the saving-
investment equilibrium. The system is said to be growing at the warranted rate of
growth when real investment in the economy is taking place at the same rate at
which real saving is taking place in the economy. The interaction between the
multiplier and the accelerator weaves its path of movements of income around the
warranted rate of growth which is the equilibrium output growth path. Basic to
Hicks trade cycle model are a consumption function, an induced investment
function with a fixed accelerator and an autonomous investment. As in
Samuelson’s trade cycle model, the consumption function, which shows a lagged
income-consumption relationship, is of the following one time period lagged
relationship form.
Ct = byt-1
Hicks assumes that both the induced investment and autonomous investment
co- exist in the economy. Autonomous investment is not affected by changes in the
level of income. I.e., it is that part of the total net investment which is not related to
the growth of the economy. It is exogenously determined. Stating that autonomous
investment is not a function of changes in the aggregate output (income), Hicks
writes; while “there can be little doubt that quite a large proportion of the net
investment which goes on in normal.
3.3 KALDOR’ MODEL OF THE BUSINESS CYCLE

Kaldor discussed his model in his article “A Model of the trade Cycle”. In his
model the consumption function or the savings function depends on income and
the investment function is of the stock adjustment type which is variation of the
accelerator. Kaldor’s originality lies in his use of nonlinear consumption and
investment functions, and this aspect has been pressed into use and further
developed by later theorists.
If marginal propensity to invest (m p l) is smaller than marginal prosperity to
save (m p s) as in Fig 5. (page 49) (a) there will be stable equilibrium. If, however,
mpl is greater than mps as in Figure 5 (b) there will be unstable equilibrium. In
both these cases, there will be no cycles. In both cases the investment (1) and
savings (Savings) curves are linear in relation to income. In case certain regions
where mpl, mps and some regions where mpl mps. The core of Kaldor’s theory is
that in such a case (i.e. when mpl or mps), gross national product might shift back
and forth between multiple equilibrium (many points of equilibrium) and this would
lead cyclical fluctuations.
214
(a)
S (b) I
I S
I &S
I &S
O Y
0 Y
Figure 5
So for as the investment function is concerned it is likely to be income-inelastic
at low levels of income. It is due to the existence of excess capacity. At very high
levels of income also it is likely to be inelastic at low levels of income. And this is
due to high costs of construction and of borrowing. Keeping in view these
possibilities, the investment function need be modified. The modified investment
function is shown in Figure (6). This is nonlinear investment function.
0 Y
Figure 6
The savings function may also be nonlinear. Kaldo states that the marginal
propensity to consume (mpc) for each unit of extra income will be high in case
income is at normal levels (this means that the mps will be low in such a case).
The mps will below which means that the mps will be high at very low and at very
high levels of income. In fact this can be treated as an early version of the
permanent (normal) income hypothesis. In a situation of very low income, people
will do their bit to keep up former standards of living any further decrease in
income will be accompanied almost the full amount of decrease in savings. In a
situation of very high income any further addition to0 income will be coupled with a
very large proportional increase in savings. It is because people do not expect these
high levels of income to continue. Figure7 depicts this type of savings function. If
215
we combine the two types of curves (nonlinear I and S curves we get different points
of equilibrium (multiple equilibria)'’Fig. 8 (page 51) shows that at points A and C
mpI mps (i.e. the slope of I curve is smaller than that of Savings curve). Therefore,
A and Curve represent points of stable equilibrium, in relation to low and high
levels of gross national product (Y) the point B is one of unstable equilibrium the
economy cannot for long stay at B.
0 Y
Figure 7
The curves I and S Curves-used here are short-run curves. These curves will,
however, shift overtime. Investment will increase at a factor pace at a high level of
income. This means that the capital stock continues to grow, But after some time
the increase in capital stock will shift the investment curve downward. This is just
the stock adjustment principal. i.e. I = aY - bk1. Triangle K = I Kaldor states that
the savings curve will shift up at high levels of income over time. But this is the
position taken by the under consumptions. It is not likely to be valid unless it
applies to purchases of consumer durables. The more likely position is that the
people will save a smaller proportion of income (at high levels of income) Thus the
slope of the savings curve is likely to be reduced as people get accustomed to the
high level of income. This does not however, affect the general nature of Kaldor’s
argument. The argument will be valid even if the I curve alone shifts-the S curve
remaining stable.
S
C
I
Z+S
B
A
0 Y
Figure 8
216
Let us suppose that the economy is functioning at point C. In course of time

the I curve will shift downward and the S curve will either flatten out or shift up.
The result is that point B will move closer to point C, and the two points-B and C
will eventually coincide. But in such a case the economy will be in a position of
unstable equilibrium. There are deflationary pressures at work. The economy will
therefore move downward from the unstable equilibrium toward point A. There will
be a new stable position at a much lower level of income. This is shown in Figure 9
(Page 5 (C) so far as Figures 9(A) and 9(B) are concerned they just show that the
economy is moving towards the position shown in figure 9(C). At the low level of
income at which the economy attains stable position i.e. point A in Figure 9 (C)
investment will be smaller than depreciation. The capital stock will thus decrease.
This will tend to raise the investment curves. Since the stocks of durables are
depreciated and there is greater demand for new purchases, the savings curve
either falls or flattens out (at low levels of income). As a result of these shifts point
B will move clause to point A until they coincide as shown in Figure 9 (F). But the
economy cannot stay at the point of coincidence between A and B slopes of the two
curves at this point are equal which means mpl = mps. For equilibrium mpl must
be less than mps. The economy must return to point Curve as shown in Figure 9.
Figures 9 (D) and (E) just show t at the economy is moving towards the position
brought out in Figure 9 (F).
S S
(C)
(A) (B) C S
C I I
I
C
B
B
B
I&S
A A
O O O
Y Y Y
(F)
(D) (E) S
C
C C
I
I&S
B
A
A
A
O O Y O
Y Y
Figures ( ) thus shows fluctuations in income and it diagrams a complete cycle.

It brings out the stable and unstable positions of the economy and higher as well as
over levels of stable income. The process of shifts in income can continue
217
indefinitely. The cycles which come into existence because of this mechanism need
not all be of the same length. It is also not essential that the expansion and
contractions are symmetrical. Everything depends upon the exact slopes and the
rate at which the investment and savings curves shift. There is also the possibility
of no cycle being generated.
Kaldor’s analysis of the cycle is simple enough. At the same time it is an
ingenious or cleverly designed model. The nonlinearities of the investment function
are of critical importance in explaining the cycle. These nonlinearities are due to
excess capacity and credit squeeze. A consumption function with different values
of mpc at rising and falling levels of income is necessary to explain the differences
between short-run and long-run effects of income on consumption and therefore
savings). But there is need to quantity the model to get actual values of the
functions in relation to different. Phases of the cycle. We can say that Kaldor’s
model is a definite advance in cycle theory; it provides the framework for further
development of the business cycle theory. Kaldor’s model however falls behind
‘Hicks’ and Smithies’ models. Hicks combined the interaction of the nonlinear
accelerator and the multiplier with the growth theory of the Harrod-Domer model.
His model is an attempt to combine dynamic equilibrium (long term or trend) with
cyclical fluctuations. Smithies and others have sought to correct the shortcomings
of Hicks’ model. They have employed the concept of “ratchets” to explain both the
cyclical and secular aspects of movements in GNP i.e. both the cycle and the trend.
3.4 METHODS OF CONTROLLING BUSINESS C
Economic stability is a precondition for growth and prosperity. Violent
fluctuations in the business activity hamper the progress of the country affecting the
interests of both the producing and consuming sections. Therefore to counter the
business cycle is the chief responsibility of the government. The government policy
aimed at economic stabilisation is termed as the contracyclical policy. It is , at one
time, resorted to combating the inflation. It is, at another time, resorted to combating
the deflation or depression. A policy designed to fulfil the former objective is
contractionary and conversely, a policy for the latter purpose is expansionary.
The chief policy instruments that the government employs to counter the business
cycle are monetary, fiscal and incomes, These policies are complementary policies, the
success and failure of the one depends upon the success and failure of the other.
Monetary policies are aimed at varying the cost and availability of credit. The
cost of credit is the rate of interest rates policies comes up to the surface.
Nevertheless, doubts are now cast on the effectiveness of it in influencing
investment. It is ineffective at the top of the boom or at the bottom of the
depression. But it must be admitted that it plays a useful role between these two
extremes in stabilising the investment activities.
The availability of credit is largely concerned with selective controls. Thus the
success of the monetary policy depends on the successful enforcement of selective
credit controls. The main weakness of monetary policy is that it is only really
218
effective when the economy is at full employment. In a depression it does little to

revive spending.
Fiscal policy is essentially one of adjusting the relationship between
government taxation and expenditure with a view to levelling off the ups and downs
in the economic activity like monetary, policy, fiscal policy also has drawback in
bringing the economy to normal conditions-conditions neither of boom nor or
depression. It is ineffective in the classical range in the SLM model, where
monetary expansion alone will produce the desired expansionary effect during
unemployment.
Thus all the policy instruments or measures that are available have drawbacks
in one way or another. So the economic stabilisation is an onerous task.
4. REVISION POINTS

Multiplier: Y
I
I
Accelerator:
C
Consumption Function: Ct =  (Yt-1)
Warranted rate of growth: The rate of growth, which maintains itself over time
5. QUESTIONS
a) Critically examine Kaldor’s theory of business cycle
6. SUMMARY
In kaldor’s theory, the consumption function and the savings function depends
on income and the investment function is of the stock adjustment type, which is
the variation of the accelerator. Fiscal and monetary policies are used to control the
business cycle but these policies are complementary policies. So the economic
stabilisation is an onerous task.
1978.
4. Cauvery. R, V .K Sudha nayek, M girija , R. Meenakshi, Macro Economics,
S. chand & company, New Delhi.
8. KEY WORDS
Multiplier, Accelerator, Warranted rate of growth, Consumption function

DR. R. CAUVERY, M.A.. PH. D
P.G. Professor & H.D.of Economics,
Sri Saradha College,
Salem – 636 016.
219
LESSON – 16
PAUL SAMUELSON’S MULTIPLIER – ACCELERATOR INTERACTION

MODEL
1. INTRODUCTION
This chapter deals with the business cycle model which has become
indispensable for all studies of growth, which is caused because of Multiplier and
Accelerator and variation in the model and the limitation
2. OBJECTIVES
 To explain the Paul-Samuelson’s Multiplier – Accelerator Interaction
Model
3. CONTENT
3.1 Introduction
3.2 Interaction of Multiplier and Accelerator
3.3 Variation on the Model
3.4 Limitation
3.5 Relevance of the Model to developing country
3.1 INTRODUCTION
The concepts of multiplier and accelerator have become so indispensable for all
studies of growth and income fluctuations that by themselves, they command a
separate study. The concept of multiplier came to play a great role in economic
analysis after Keyness. The principle of acceleration has a still distant origin. It
can be dated back to 1914 and beyond. A aftalion. T.N. Cavers and others are
credited with its invention. Later J.M. Clark. Pigou, Hicks and others made it a
special tool of economic analysis.
As the concept of multiplier emerged it was noted that the accelerator was its
parallel force. It is contended by economists that both these principles are not only
intertwined but are simultaneously the cause of trade cycles. The interaction
between the multiplier and the accelerator at any particular point of time or
situation may cause different effects. Therefore the study of accelerator-multiplier
interaction became crucial. Hicks, Harod and Paul Samuelson have contributed
very much in this direction. Before we concern ourselves with Samuelson’s theory
it is essential that we discuss briefly what multiplier and accelerator is all about.
Multiplier is best defined as that effect which is the result of a change in
investment on the income and employment level. In other words, when the level of
investment changes, income and employment levels also undergo changes. Thus in
the multiplier process, consumption is dependent on investment. If the scale of
investment rises, consumption also rises, thereby repeating the cycle of further
investment and consumption.
Accelerator is, on the other hand, the effect of a change in consumption on
investment. When the level of consumption changes, it changes the level of
investment. An increase in the propensity to consume causes an increase in
220
investment The accelerator principle explains that the net investment. It during
any given time period t depends upon the value of the accelerator w and the change
in income in the time period
i.e. I t = ( Y t =w (Y t– Y t – l)
Assuming a change in aggregate income Y, net investment lt in any time period

t will differ from investment I t-l of the preceding time period t-l as indicated by the
accelerator principle.
However, a change in investment (increase or decrease) will affect the aggregate
income Y in the succeeding time periods as indicated by the multiplier principle.
But any increase or decrease in income from one period to the next will, in turn
affect the net investment due to the operation of the accelerator which in turn will
affect income due to the action of the multiplier and so on. This process may
continue endlessly due to the interaction of multiplier and accelerator.
3.2 THE INTERACTION
The interaction between the multiplier and accelerator according to Samuelson,
is an endogenous force which generates business cycle in the economy. The
process of multiplier- accelerator interaction and income propagation can be seen
in Table 16’ l
Table 16.1
Multiplier and Accelerator Interaction Effects on Income
The Leverage Effects
Multiplier Initial Induced consumption Inducement Increase in national

period outlay x 1/2 investment Total income
RS. RS. P. RS. P. RS. P.

1 10 0 0 10.00
2 10 05.00 10.00 25.00
3 10 12.50 15.00 37.50
4 10 18.75 12.50 41.25
5 10 20.62 03.74 34.36
6 10 17.18 04.88 22.30
7 10 11.15 12.06 09.09
8 10 4.50 13.03 01.20
9 10 0.50 08.00 02.00
10 10 1.00 01.00 12.00
11ANNAMALAI UNIVERSITY
10 6.00 10.00
Assume ( 1 ) MPC = ½ . Acceleration Coefficient = 2. In the first period there is
26.00
an initial outlay of Rs. 10 crores which does not lead to any induced investment.
So the total increase in national income in the first period is Rs. 10 crores (being
equal to the initial outlay of Rs. 10. crores.
As MPC ½ , the induced consumption in the second period is Rs. 5 crores and
the acceleration coefficient being 2, the induced investment in the secone period is
Rs. 10 crores. The leverage effect (total increase in national income) is Rs. 25
221
crores (see columns 5), likewise, in the third period increase in consumption is Rs.
12.0 and the induced investment is Rs. 15 crores, being the difference between Rs.
12.50 crores and 5 crores. The total income in the fourth period reaches the peak
level of Rs. 1.25 crores as a result of the combined effects of multiplier and
accelerator; through their interaction which is called ‘Super Multiplier’.
The total income starts falling off in the fifth period and reaches the rock
bottom level of 1,2 crores in the eighth period. Then, in the nineth period it starts
rising again and rises to Rs. 26 crores, there by completing a cycle. If the
multiplier-accelerator interaction results in the various columns are calculated., it
will show a quite moderate type of recurring cycle which repeats itself indefinitely.
This indicates that an MPC< unity provides answer to the crucial questions why
does the cumulative process came to an end before a complete collapse or before
full employment? According to Hansen, the rise in income slowed down
progressively on account of the fact that a substantial portion of the rise in income
in each period is not spent on consumption. This leads to a decline in the volume
of induced investment. And when the decline induced investment exceeds the rise
in induced consumption, a decline in income begins, Samuelson attempted to
combine different values of the multiplier and accelerator and noted that different
types of fluctuations are obtained. Figure 16,1 shows the type of the cycle
occurring after plotting the values of income obtained in Table 16.1.
FIGURE 16 - 1
Acceleration - Multiplier Interaction To
Generate a Cycle
50
Income (Rs. Crores)
40 w
30
20
c
10
ANNAMALAI UNIVERSITY 0 2 4 6 8 10
Time periods
12
3.3 VARIATIONS ON THE MODEL

In his article “Interaction Between the Multiplier Analysis and the Principle of
Acceleration”. Samuelson showed that with different values of marginal propensity
to consume on the one hand and the accelerator on the other it is possible to obtain
five different types of cycles or fluctuations. The fives types of fluctuations are as
follows and shown in Figure 16.2.,
222
(A) Income moves upward or downward at a decreasing rate and asympotically

approaches a new equilibrium;
(B) Income fluctuates through a series of cycles of smaller and smaller
amplitude until the cycles virtually disappear.
(C) Income fluctuates through a series of cycles of wider and wider amplitude;
(D) Income moves upward or downward at an increasing ate;
(E) Income fluctuates through a series of cycles of constant amplitude.
Types (A) and (B) resemble each other in stability both end to converge towards
an equilibrium. Types (C) and
FIGURE 16 - 2
DIFFERENT INCOME PATTERNS
Output Output
New equilibrium
New equilibrium
Orginal equilibrium
Orginal equilibrium
A Time B Time
Output Output
Ceiling Output Ceiling Output
Orginal equilibrium
Orginal equilibrium
C Time D
Time
Output
Orginal equilibrium
A Time
(D) resemble each other in their instability-both tend to diverge from

equilibrium by increasing amounts. Type (E) is the in-between situation-movement
is neither toward nor away from the equilibrium. In other words, Types (B) and (C)
223
exhibit cyclical fluctuations. Types (A) and (D) do not. The special case, (E) goes
with (B) and (C) in this classification. Each of these income patterns is illustrated
in Figure 16.2.
The difference between these five income patterns result solely from different
combinations of value for marginal propensity to consume (C) and Acceleration co-
efficient (w) Every possible combinations of c with values ranging from zero to 1.2.
and w with values ranging from zero to 5 may be noted in figure 16.3. These
combinations of c and which fall in the area (b) will produce a series of damped
cycles such as shown in Part B of Figure 16.12. Like wise, these combinations of c
and w in areas A,C and D will produce
FIGURE 16-3
Boundaries of Regions Yielding Different Income
Patterns
A
D
1 2 3 4 5 W
Income movements such as parts A, C and D of Figure 16.2. Combination c

and w that fall along the broken line marked E produce cycles of constant
amplitude at those of Part E of figure 16.2
The essence of the argument is that multiplier-accelerator interaction is
capable of generating various types of cycles and fluctuation mild. damped and
explosive. These cycles or fluctuations are of varying periodicity and amplitude. If
we are able to find out the interacting values of the multiplier and accelerator in
Practice we can ascertain for ourselves the nature of income fluctuations we are
likely to experience in the absence of exogenous restraints. Professor J.R. Hicks
has used this mechanism in building up a theory of the trade cycle that explains
the behaviour of business cycles around a rising trend of income.
Thus, Super-Multiplier (interaction of multiplier and accelerator) assumes
greater importance in as much as it lends to speed up the rate at which the
national income rises through the multiplier effects. The study of the interaction of
the two principles have payed the way for a more accurate analysis of the nature of
the cyclical process. Further an analysis of the interaction shows thus it is possible
to explain turning points in business cycles without resorting to special
224
explanations, These actors are a marginal propensity to consume of less than one
plus the acceleration effect, the former being perhaps more important. The
combination of the multiplier and the accelerator seems capable of producing
cyclical fluctuations. The multiplier alone produces no from cycle from any given
impulse, It only gradually increases to a constant level as determined by the
propensity to consume, But if the principle of Acceleration is introduced, the result
is a series of oscillations about what might be called the multiplier level. The
accelerator first carries total income above this level, but as the rate of increase of
income diminishes, the accelerator induces a down urn which carries total income
below the multiplier level, then up again and so on.
3.4 LIMITATION
The Multiplier-Accelerator may appear to cause increases in national income.
However many a economist believe that at best it only leads to cyclical swings in
income but not growth. Therefore it is also essential to consider other factors such
as savings and government policy to elevate national income, along with the forces
of the Super-Multiplier. Nevertheless it is erranuous to believe that the super
multiplier alone is the cause of trade cycle. There are other factors which are
powerful enough to change (increase or decrease) the periodicity of the cycle.
However, the basic criticisms of multiplier-accelerator interaction model are
related to the weakness of the rigid acceleration principled. Since the naïve
acceleration principle is unacceptable, the multiplier-accelerator interaction which
interacts the acceleration principle is also unacceptable as a perfect explanation of
the occurrence of trade cycle According to Duesemberry. “the basic concept of
multiplier-acceleration is an important one but we cannot really expect to explain
observed cycles by a mechanical application of that concept”.
3.5 RELEVANCE OF THE MULTIPLIER-ACCELERATOR INTERACTION ANALYSIS TO
DEVELOPING COUNTRIES
The developing and under-developed countries have a poor rate of consumption
hence the question of a multiplier does not arise. What about the accelerator? The
too is damped by a lot of factors thereby making this analysis more effective in
developed capitalist economies. Various reasons are given for the ineffectiveness of
the Super-multiplier in a less developed economy.
The primary reason being that consumer goods are still manufactured
traditionally, consumption is also traditional, new goods are looked upon with
distrust. Therefore accelerator fails to operate, as investment becomes limited. In
the event of an existence of a modernized production sector, in such countries the
unit produces to excess capacity again causing a fall in the power of the
accelerator. Thirdly the expenditure in such countries are more autonomous in
nature and are also unproductive like defence spending. Thus social overheads are
not built up resulting in accelerator being damped Banks, monetary institutions
and general consumption is not well organised in such economics as a result of the
multiplier-accelerator concept remains exclusively of the developed capitalist
economy.
225
4. REVISION POINTS
Interaction of multiplier and accelerator
A combination of induced consumption and induced investment
5. QUESTIONS
1. Discuss Samuelson’s theory of trade cycles.
2. Is it correct to say that trade cycle is generated by the interaction of the
multiplier and the acceleration principles?
3. Critically examine Samuelson’s Multiplier-Accelerator interaction Model
6. SUMMARY
Thus the Samuelson model is based on the interaction between Multiplier and
Accelerator
1. J.A Estey: Business Cycles
2. Prof.A.Samuelson: “Interaction between the Multiplier Analysis and
Principles of Acceleration”
8. KEY WORDS
Super Multiplier

226
LESSON – 17
HICK’S THEORY OF THE TRADE CYCLE

1. INTRODUCTION
This chapter discusses about the trade cycle, which is caused because of rate
of growth of autonomous, the assumption, operation of the model, the criticism
2. OBJECTIVES
 To acquire knowledge about the Hicks theory of Trade cycle
3. CONTENT
3.1 Introduction
3.2 The Model
3.2.1 Assumptions
3.2.2 Operation of the Model
3.2.3 Criticism of the theory
3.1 INTRODUCTION
Hicks discussed his theory of the trade cycle in his book A Contribution to the
Theory of Cycle published in 1950. Although more than three decades have passed,
Hicks’s theory still occupies a prominent place in the literature on business cycle.
According to him, the growth path of an economy is characterised by cyclical
fluctuations. Viewed from the historical perspective, trade cycles appear to be
movements that swing above and below a normal path of growth. In this sense, it
is common place that the real output of the economy in a recession may be larger
that the same economy’s output at the peak of the prosperity a decade or so earlier.
Therefore , when trade cycles are analysed, it is imperative that they be considered
in the backdrop of growth.
3.2 THE MODEL
Hicks define a long-run equilibrium growth-path for the economy that is
determined buy the rate of growth of autonomous investment. The ratio of
equilibrium income to autonomous investment depends upon the magnitude of the
accelerator-multiplier interaction or what is known as the super multiplier. Hicks
also assume that autonomous investment tends to grow at a fairly constant rate
over a period of time. With a fairly stable accelerator and multiplier, it then follows
that there is an equilibrium growth path for income which exhibits the same
constant percentage rate of growth as autonomous investment. The failure of
output to move along this equilibrium growth path over time identifies cycles.
According to Hicks autonomous investment is not affected by changes in the
level of income. It is exogeneously determined. He used autonomous investment to
mean “public investment, investment that occurs in direct response to innovation
and much of the ‘longrange, investment which is only expected to pay for itself over
a long period”. The rest of all investments and an amount that makes up a large
part of net investment in normal circumstances, is so-called induced investment.
227
That is, investment taking place, directly or indirectly, due to past changes in the
level of output. Hicks iecognies that the distinction between autonomous and
induced investment is not sharp in practice. Nevertheless he considers this
distinction a crucial one for developing his theory of trade cycle.
Since induced investment depends upon changes in the aggregate output, such
investment is a function of the rate of growth of output in the economy. The
induced investment is of crucial role in Hick’s theory of trade cycle, because the
operation of accelerator depends on it. According to him the growth of output in
one period causes a “hump” of investment (induced investment) in the subsequent
period which interacts through the multiplier. This Hicksian is accelerator.
3.2.1 Assumptions of the Model
Hicks assume the following factors in formulating the business cycle theory:
The economy is progressive with a regularising rate of autonomous
investment. This is essential to have a steady rising growth path and is
also the basis of this theory.
Savings and investment ratios are such that the economy tends to move
away from the equilibrium path.
There is a maximum ceiling on expansion caused by the scarcity of
resources.
Accelerator is not symmetrical for all periods.
Multiplier and accelerator have fixed values and act with a lapse in time.
3.2.2 Operation of the Model
The theory is founded on the above assumptions. In Hick’s own words. ‘If
anything happens to stimulate the rate of investment by entrepreneurs, there will
be, first of all a period of preparation whose only visible effects are a small increase
in the demand for money…. Then on investment increase tending towards the
optimum growth … The growth path thus deviates from the normal and swings
upwards until a maximum is reached and then recession begins.
Hicks explain the cause of these swings with the help of the accelerator,
multiplier and the warranted rate of growth. The warranted rate of growth of
income is consistent with. The saving-investment equilibrium in Hicks’s theory a
constant value has been given to the accelerator, and multiplier the upswing of the
cycle is caused by the action of both the forces. Multiplier and accelerator when
optimum is reached, although consumption increases and there by multiplier
works, accelerator becomes passive as a result of disinvestment. Therefore the
downswing starts purely by the multiplier effect. The lower points of the swing
while reaches necessitate investment and speeding up of consumption by injecting
more investment. The accelerator and multiplier work together to revive the
economy. This is illustrated in Figure 17.1
228
FIGURE 17 - 1
The Hicksian Cycle
output investment
(los scale) E
c
b
C
F
Q
A
TIME
The line AA in figure 17.1 shows autonomous investment and the line EE the
equilibrium growth path for income that is based on line AA The vertical axis is
measured in logarithmic scale: then only the straight line shown in the figure
indicate a constant percentage rate of growth of the variables in question. The
equilibrium given overtime given by line EE will be a constant multiple of
autonomous investment, the size of the multiple depends upon tie strength of the
multiplier-accelerator interaction, The assumption of constant rate of the growth of
autonomous investment is unrealistic and that Hicks model allows the shifts in the
rate of growth of autonomous investment occasionally.
The line CC represents the growth path of ceiling output produced with full
employment of the economy’s resources. Assumed that line EE lies above CC, the line
FF shows the lower limit growth path by indicating the floor to which real income can
fall during the contraction phase of the cycle. The main theme of the Hicksian theory
to be explained is that why the income level does not follow the equilibrium growth
path described by EE. Given a shift from this path how the upper and lower
boundaries are fived by the lines CC and FF within which cycle fluctuates?
Suppose the economy has been in equilibrium growth along the path EE and is
at point a And an innovation produces a temporary spurt in autonomous
investment. Accumulative movement upward from a is set into motion is the
multiplier accelerator interaction takes place. The actual movement of the economy
output is described by the path ab. The economy’s ceiling output is also growing
with time due to the trend growth in the economy. Therefore for some time the
economy’s output will grow along the ceiling path as is shown along the portion
from b to c. Now the rate of actual output cannot exceed the rate of growth of the
ceiling therefore sooner or later the actual growth must be checked by bumping
against the ceiling. It brings into play a crucial element in the analysis. The
expansion phase comes to an end and eventually contraction takes place.
Once the downward trend starts the accelerator-multiplier mechanism starts
working in the opposite direction. But the process of contraction cannot go as fast
as the process of expansion. This is because of the asymmetrical working c the
229
acceleration effect. On the upswing the limit to the expansion of real investment
was set by the capacity of the system to produce but on the downswing the limit to
negative investment (dis investment) in any period is set by that period’s
depreciation. What the businessmen as a whole can do is at the most do no
replacement of machines that wear out. Therefore, during the slump accelerator
has a limited role, only multiplier works back. The line FF is, in other words, set by
autonomous investment times the multiplier.
According to Hicks autonomous investment typically declines during the slump
(the line AA shifts downward) but remains positive and maintains a steady rate of
growth. This growth of autonomous investment continues to support income but at
a slump level as shown by demand. How long income shall move along the floor
depends in part on the redundancy of capital inherited from the spurt of induced
investment in the earlier periods. Once the inherited capital stock is used up new
investment orders have to be placed for replacement to maintain the existing floor
level flow of output gross investment level to push the income level upwards from
the FF line. This sets the accelerator working again to raise income upwards. The
rise in income does not stop with the EE line because that rate of growth is
consistent with the AA line not the FF line. Having over-shot the line EE, the
income level goes up and until up finally restrained by the ceiling from which it
bounces off to start the downward movement of another cycle.
3.2.3 Criticism of the Theory
Hick’s theory has been appreciated as well as criticised by writers. The major
deficiencies of the theory especially noted are discussed in this section.
1. The main weakness of the theory is that the multiplier and the accelerator
have fixed values during different phases of the cycle. The constant
multiplier is derived from the constant marginal propensity to consume.
Various studies have shown that the marginal propensity to consume is
not constant in relation to cyclical changes in income. Similarly the
assumption of fixed value of the acceleration, a most powerful tool in the
theory, is assailable. It is one thing to say that there exists a relationship
between changes in income and consumption expenditure on the one hand
and the quantity of capital facilities on the other quite another to assert
that this relationship is of fixed nature. The capital output ratio will not
necessarily remain constant over time.
2. Hicks fails to take note of the psychological factors of uncertainty and
expectations. These play an important role in the dynamics of investment.
As Duesmburg has put it. “The basic concept of multiplier accelerator
interaction is an important one but we cannot really expect to obtain
observed cycles by a mechanical explanation of that concept”.
3. Durnbeg also attacked that concept of the ceiling to the expansion set by
resource limitations. In his view, the experience of the 1953 –54 recession
in U.S.A. casts doubt on the assumption. Only resource shortages cannot
cause a very large and sudden crash in investment.
230
4. Professor Harrod has doubted that autonomous investment is likely to be

advancing in a slump. The possibility is more that the depression retards
it. In his study of the American business cycles in the nineteen century.
Readings Fels noted that the revivals were not due to the wearing out of
excess of capacity the upturns did not wait for induced investment falling
to zero. Rather in many cases expansion started in spite of the existence of
excess capacity.
5. Some writers have questioned the validity of the distinction on empirical
level. In the short period much of investment is autonomous which
becomes induced investment from the long-period viewpoint. This seriously
limits the possibility of confronting theory with facts.
It may be noted that each of the economists who has highlighted the deficiencies
of Hicks’s theory, has also praised it. For example. Kaldor has referred to the
“many brilliant and original pieces of analysis found in the theory. Overall,
despite its deficiencies, Hicks’s theory is an “ingenious piece of work”.
4. REVISION POINTS
Autonomous Investment - Not influenced by price or profit
Induced investment - influenced by price or profit
5. QUESTIONS
1. “In Hick’s business cycle theory, the multiplier and accelerator play a
crucial role”. Discuss.
2. Critically examine Hick’s theory of trade cycle.
3. “The growth path of an economy is characterised by cyclical fluctuations”.
Elucidate.
6. SUMMARY
While Samulesons Model is based on the interaction of the Multiplier and
Accelerator, Hicks model is based on the rate of growth of autonomous investment
1978.
8. KEY WORDS
Autonomous I, Ceiling, Full employment

DR. C. MURUGADOSS
Asst. Professor of Economics
Presidency College, Madras.
231
LESSON – 18
ECONOMIC POLICY: MACRO ECONOMIC POLICY

1. INTRODUCTION
This chapter deals with the aims of Macro Economic policy. The conflicting
Macro Economic goals and policies and the tools of Macro Economic policy
2. OBJECTIVES
 To understand about the Macro Economic Policy
3. CONTENT
3.1 Introduction
3.2 Development of Macro Economic Theory
3.3 Aims of Macro Economic Policy
3.3.1 Achieving Full Employment
3.3.2 Achieving Price Stability
3.3.3 Maintaining Balance of payment position
3.3.4 Raising rate of Economic growth
3.3.5 Achieving Economic Justice
3.3.6 Conflecting Macro Economic goals and policies
3.4 Tools of Macro Economic Policy

3.1 INTRODUCTION
Every economy developed as well as developing, aspires to certain goals in
India, as in other countries these include rapid economic growth, high employment
and stable prices To achieve this, appropriate macro economic policy must be
pursued. In this lesson we will examine the essentials of macro economic policy.
Theory of Economic Policy
Policy economics is the realm of normative economics and should be
differentiated from positive economics, Positive economics deals with purely
analytical matters of cause and effect. For example the question of how much the
level of income will be raised by an increase in government purchases without at
the same time inquiring if the change is desirable. Policy economics turns the
question around starting with some pre-determined target level of income and so
on, the society judges to be essential, it asks how much as change in government
expenditure would be required to attain this target. Thus, macro economic policy
refers to the process of manipulating a number of policy instruments in such a way
as to achieve desired changes in the size and composition of national income,
employment level and price stability in the economy. And macro economic policies
are framed within the limitations of the economic policy.
232
3.2 DEVELOPMENT OF MACRO ECONOMIC POLICY

The classical and neo-classical economists relied more on the market
mechanism to correct economic disorders. But in recent years economics have
brought in the short-run aggregate analysis as a better tool to understand and
solve the problem of the whole economy. Advances in economic knowledge and the
ability to apply that knowledge to matters of practical policy making have come
from several complimentary sources. The first was the Keynesian’s theoretical
breakthrough of 1930s, The second and perhaps equality important, was the
increase in fatal knowledge about the behavior of the economy. Before the close of
the first quarter of the twentieth century no systematic records of Gross National
Product GNP and its component were published. Sufficient data regarding labour
force, employment, unemployment did not become available until after second
world war. The third was the development of ‘multisectoral, models of the economy
with the help of computer technology,. These models have improved forecasting
and analysis to a degree unthinkable in the period before. World War II>
Obviously the last forty years or so have witnessed the transition of economics from
a field characterized by deductive speculation into a truly empirical policy science.
3.3 AIMS OF MACRO ECONOMIC POLICY
The aims of macro economic policy vary with the goals and objectives of
governments. In the earlier days the tools of macro economic policy were used to
suit the ends of the rulers. Dictators like Adolf Hitler used it for war finance. But
in modern days macro economic policy aims at broadly speaking, “growth with-
stability”. Generally, the aims of macro-economic policy can be stated as follows.
3.3.1 Achieving Full Employment
Since employment is the general factor determining consumption and
investment and also the well being of the subject’s governments pay more attention
to the aims of achieving full employment. Unemployment is a serious problem all
over the world. There are various types of unemployment, The goal of macro
economic policy is to keep the level of unemployment at the minimum level, Full
employment is said to be reached when unemployment is kept at the minimum.
Keynes and Post-Keynesians have highlighted it he importance of maintaining the
level of full employment in an economy. In fact many a country has accepted full
employment as one of the primary goals of macro economic policy. In a way it has
become an essential responsibility of modern governments to aim at maintaining
the level of full employment in order to avoid distortions in the economy.
Macro economic policy has to be designed in such a way as to deal with two
major types of unemployment, viz, I) unemployment due to inadequate aggregate
demand, and ii) due to structural changes. Both these cases can operate.
Simultaneously and lead to the total volume of unemployment unemployment
arising as a result of deficient demand can be removed by a suitable combination of
monetary and fiscal policies. But it is rather difficult to combat structural
unemployment, Economic policies, fiscal as well as monetary, assigned to achieve
233
and maintain full unemployment operate through a complicated process of change

in the variables and as a result such policy work under certain limitasilons.
3.3.2 Achieving Price Stability
Another major goal of macro economic policy is maintaining the economy at the
level of employment without fluctuations, i.e. maintaining stability of prices. A
policy for prices stability must protect the economy from the dangers of both
inflationary and deflationary pressures. The is achieved by controlling the
aggregate demand through monetary as well as fiscal measures. Moreover
government can seek to control price level through wage-price policies or income
policies. Stability can also be maintained through another kind of price policy
called exhortation i.e., the central authorities make appeals for moderation in fixing
prices and wages. This policy has the support of the proponents of the cost-push
theory of inflations, wage-price stabilization policies face another problem caused
by wage drift it is easy to control the negotiated wage rates than the earnings of
workers. When labour is scarce and the wage rate is controlled. Labour has to be
provided certain incentives in the form of bonus, overtime allowance etc. In such a
situation there is an increase in average earning of labour although wage rates
remain stable This tendency for earnings to follow aggregate demand, although
wage rates do not change is called wage drift such a situation will affect the
working of wage-price stabilization policy. Consequently at present, the control of
inflation has become the main element of macro economic policy.
3.3.3 Maintaining the Balance of Payments
Macro economic policy also aims at avoiding fluctuations in exchange rate. A
huge import surplus or a large export surplus is considered undesirable for the
smooth functioning of an economy. The balance of payments problems are caused
by changes within as well as outside the economy. The central authorities can do
little to control exchanges outside the country. The internal causes are ( I)
domestic inflation and (ii) the changes in consumption patterns taking place in the
course of economic growth. Domestic inflation also affects balance of payments.
When a country’s price level is rising faster than the price levels of competitor
countries . Exports will tend to fall and imports well tends to rise thereby creating
balance of payment problems. The changes in consumption patterns occur as a
result of technological innovations and differing income elasticities of demand for
imports and exports.
The balance of payments problem can be talked with two types of macro
economic policies. The first type of policy called expenditure-dampering policy,
attempts to reduce national income by raising taxes or reducing government
expenditure. The reduction in income will inturn, reduce the expenditure of
households on goods. However, the effect of this policy depends upon the
proportion of income spent on imports. The second type of policy, namely, the
expenditure switching policy attempts tax imports and subsidise exports or devalue
the exchange rate. Such a policy changes the prices of foreign goods relating to the
exchange rate domestic goods.
234
However the policise for maintaining the balance of payments problems have to
be applied with great caution . Both these types of macro economic policies can
produce certain incidental effects. Nevertheless, the expenditure dampening
policies will be preferred during times of overfull employment, whereas the
expenditure-switching policies will be preferred during periods of full employment.
3.3.4 Raising Rates of Economic Growth
At present, achieving rapid economic growth has become the major objective in
all economies, particularly in the developing onces. Faster rate of economic growth
is the surest way to achieve higher standards of living for the people of a country.
Growth is a complex macro economic policy variable. It is rather difficult to identify
the causes, of growth or on growth and therefore difficult to identify the causes of
growth or on growth and therefore difficult to influence these causes. Several
theories have been put forth by economic about the causes of rapid economic
growth. Most of them advocate the policy of raising the rate of new investment as a
stimulant to growth.
Various views have been expressed about the process of growth some others
believe that periods of excess capacity without inflationary pressuers are beneficial
to growth. It is also held that a drastic cut in demand and recession will have a
short term dampening effect on growth.
3.3.5 Achieving economic Justice
Another objective of macro economic policy is achieving distributive justice;
Many believe that growth without distributive justice will lead to a dangerous trend
in the economy. Economic justice is an clusive concept. Generally speaking, it
means that the national income is distributed to all sections of population
inaneqauitable manner. In the process of economic development, unless adequate
measures are taken the fruits of development. Will go to the rich which will lead to
the continuous exploitation of the masses. Gros inequalities in income and wealth
will lead to class hatred between the haves and havenots.
Economic justice cannot be ensured by promoting more economic growth. It
requires deliberate and bold actions poverty has to be eradicated and employment
potential augmented in order to meet the demand for jobs for the increasing
population. Adequate care must be made to avoid concentration of wealth and
income. Therefore, distributive justice could be ensured only through concerted
efforts.
3.3.6 Conflicting Macro Economic Goals and Policies
We have seen certain important macro economic goals to be pursued framing
economic policies and implementing them. But in actual practice, it may so
happen that the different , goals or objectives pursued may be conflecting. It is
possible that in implementing a policy to achieve a particular goal, it may be
incompartible with another goal. Simply speaking, what is done or attempted to be
done by one set of policies may be undone by another set of policies having different
goals there are many occasions in which we meet with .
235
Ordinarily, the sphere where conflicting policies will be met with are :
(a) Conflict between growth and unemployment.
(b) Conflict between prices and unemployment.
(c) Conflict between prices and balance of payments.
(d) Conflict between saving and investment.
(e) Conflict between political ideology and practice.
Thus, the governments will face conflicting goals and policies in different
spheres . when conflict arises in macro-economic goals, the government should
have to clearly specify the priorities and evolve a compromise so that it will create
least distortion in the economy.
3.4 TOOLS OF MACRO ECONOMIC POLICY
Just as economists refer in the broadest categories the above mentioned macro
economic goals, they similarly refer in equally broad categories to monetary policy
and fiscal policy as the two basic types of policy that are employed in working
towards the achievement of specified goals.
Monetary policy aims at reorganising the monetary sector and controlling the
economy by monetary curbs like credit control or credit creation, lowering or raising
interest rates, and so on. Prior to Keynes monetary policy was considered as the
only policy measure to control the economy.
Keynes advocated strong fiscal measures to overcome the great depression. It
was realised during the depression that monetary measures were alone not
sufficient. Fiscal policy was therefore incorporated in the kit of macro economic
policy. Fiscal policy consists of tax measures, relief measures, deficit or surplus
budgeting, etc.,
However, these two policies have to be applied as mutually complementary
policies. Although there is often significant overlapping between monetary policy
and fiscal policy, it is rather impossible to envisage any major monetary or fiscal
measure which does not influence the other. Nevertheless it is necessary to make
meaningful distinction between monetary policy on the one hand and fiscal policy
on the other in order to limit the scope of these policies.
4. REVISION POINTS
Full Employment
By inducing inadequate aggregate demand
Due to structural changes
Price Stability
Maintaining stability of prices
5. QUESTIONS
Section – A
1. How can we maintain the balance of payment position with the help of
monetary policy?
236
Section – B
1. Explain the economic goals of Macro Economic Policy.
2. What are the practical difficulties in implementing Macro Economic Policy?
3. Explain the aims and instruments of Macro Economic Policy.
6. SUMMARY
This monetary policy aims at reorganising the monetary sector and controlling
the economy by monetary curbs like credit controls or credit creation
1978.
8. KEY WORDS
Full Employment, Price stability, Economic growth, Economic Justice, Balance
of Payment

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LESSON – 19
INSTRUMENT OF MACRO ECONOMIC POLICY MONETARY POLICY

1. INTRODUCTION
This chapter deals with the instruments of Macro Economic policy, Monetary
Policy, its objectives, and its instruments and the role of Monetary policy in
inflation and deflation, its role in India, its objectives in India
2. OBJECTIVES
 To impart knowledge about the various objectives of monetary policy
 To understand the working of Monetary policy in a developing economy
 To have knowledge about the various instruments of Monetary policy
 To find out the usefulness of Monetary policy in India
3. CONTENT
3.1 Introduction
3.2 Objectives of Monetary policy
3.3 Instrument of Monetary policy
3.4 Monetary policy and Recession
3.5 Monetary policy and Inflation
3.6 Monetary policy in developing countries
3.7 Monetary policy in India
3.8 Objectives of Monetary Policy in India
3.8.1 Expansion in the supply of money
3.8.2 Restraints on the secondary expansion of credit
3.9 Evaluation of Monetary Policy in India
3.1 INTRODUCTION
Monetary policy is perhaps the oldest macro economic policy. In the Pre-
Kenesian days, monetary policy was the single established instrument of macro
economic policy with price stability as its establishment objective. Two events in
the 1930s drastically changed the role of monetary policy and the sphere of its
objectives. Firstly the Great Depression which produced mass unemployment
caused a major shift in the objective of national economic policy in favour of full-
employment. Secondly, the Keynesian Revolution following the publication of
Keynes’ General Theory in 1936 brought to the fore another economic policy
instrument namely, fiscal policy and a second objective, namely the maintenance of
full employment, now more commonly described economic stability.
The concept of monetary policy eludes precise definition, Paul Elnzig defines
monetary policy as ‘All monetary decisions and measures irrespective of whether
their aims are monetary; or non-monetary system”. Harry Johnson describes
monetary policy as a sel decisions of the Central Bank’s control over the supply and
cost of money as an instrument for achieving the objectives of economic policy.
238
With respect to the objectives before us the overall effectiveness of monetary policy
thus, depends on what contribution it can make to the attainment of full
employment, price stability and rapid economic growth.
3.2 OBJECTIVE OF MONETARY POLICY
The scope and objectives of monetary policy have widened after the Keynesian
Revolution of 1930s. Before the Keynesian breakthrough the sole objective of
monetary policy was to secure price stability. However the publication of Kenes,
book general Theory and the Great Depression of 1929 had radically altered the
nature and scope of monetary policy. The maintenance of full employment or
economic stability became the leading objective of monetary policy in the post-war
years. The problems of economic growth and balance of payments have also come
under the purview of monetary policy.
The various objectives of monetary policy are
(a) To attain full employment.
(b) To maintain price stability
(c) To achieve rapid economic growth, and
(d) To maintain the balance of payments equilibrium Hence there is often
the problem of giving the priority among these objectives. These
objectives are also often conflicting with each other. It may not be
possible to achieve all these objectives simultaneously. Therefore the
central banks are inclined to choose a set of objectives which will
primarily serve the interest of national economic welfare.
3.3 INSTRUMENTS OF MONETARY POLICY
In order to implement the different objectives of the monetary policy it has some
instruments and tools which can be classified into the general or quantitative
instruments and the selective or quantitative instruments. The general instruments
employed by the central bank to carryout its monetary policy are open market
operations, changes in the minimum legal reserves requirements and changes in the
bank or discount rate. The central bank can influence increase or decrease
commercial bank’s cash reserves through its open market operations. The
instruments of open market operations are the most effective instruments which are
available to the central bank to carryout its monetary policy. Being flexible, it enables
the central bank to change the direction of its open market operation according to
circumstances from a policy of increasing the reserves and vice versa. Open market
operations are either defensive or dynamic. Defensive operations are those which are
taken to offset other factors that change the volume of bank’s reserves.
The instrument of variable minimum legal reserve ratio requirements affects
not the total amount of commercial banks cash reserves but the amount of their
excess cash reserves which in turn affects their total ability to lend. Thus, the
central, bank can carryout its expansionary monetary policy by providing the
commercial banks with additional lending or credit-creating power either by
increasing their total cash reserves through the open market. Purchases of
239
securities or, their total cash reserves remaining unchanged by decreasing the
minimum legal reserves ratio requirement. As a result of decreasing the minimum
legal reserves requirement, a part of existing required reserves is reclassified as
excess reserves and consequently becomes available for credit creation by the
banks. In terms of the lending power of commercial banks reserves so released are
in effect similar to an addition to banks, excess reserves produced through open
market operations conducted by the central bank.
Changes in the bank rate do not in themselves affect the cash reserves of the
commercial banks. Such changes affect the cost at which the financial
accommodation in the form of borrowings can be made available to the banks from
the central bank. From the point of view of controlling the lending or credit
creating capacity of the banks, the instrument of bank rate is the least important of
the three general instruments of credit control which are at the disposal of central
bank because banks generally borrow from the central bank not to expand their
earning assets but no meet the shortfall in their cash reserves.
As the central bank indulges in open market sales of government securities to
restrain the lending or deposit creating power of the banks the move
simultaneously exerts an upward pressure on the whole structure of interest rates
because the mass-scale of securities and it has to be on a mass scale if the credit-
creating power of the banks has to be curtailed is possible only at falling prices for
the government securities marketed by the central bank. A fall in the prices of
securities raises the yields on these securities and tends to raise yields on other
securities. To the extent the demand for loans i.e. interest elestic, the rise in the
interest rates cuts back the aggregate demand for bank credit. The same result
follows by increasing the minimum legal reserves ratio requirement for the banks.
As a result of their action, the excess, reserves on which the bank, can rise the
pyramid of credit are reduce. This forces them to raise the entire structure of their
lending rates in order to discourage borrowers from borrowing in excess of their
reduced lending capacity. Generally the central bank reinforces the action of one
instrument by applying others monetary policy instruments also.
Certain vital effects of changes in the central bank’s bank rate are
psychological. Such effects are particularly important when observes feel that the
bank rate is being used by the central bank to signal a shift in the direction of
policy in such cases, the financial markets react in the ally sentiments even in
advance to central bank’s actions when the more is anticipated if the bank rate is
raised interest rates-particularly those on short-term securities generally rise and
credit markets tighten, conversely, a cut in the bank, rate which clearly signals an
easing of central bank’s monetary policy is ordinarily followed by easier conditions
in the money and capital markets.
There are various selective or qualitative credit control instruments which are
empowered by the central bank from time to time unlike the general instruments
which a fect the total volume of credit directly, the selective instruments of
monetary policy affect the types of credit extended by the banks – these
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instruments affect the composition rather than the size of the loan portfolios of the
commercial banks. The immediate object of imposing selective credit controls is to
regulate both the amount and terms on which credit is extended by the banks for
selected purposes.
3.4 MONETARY POLICY AND RECESSION
The monetary policy proved to be quite ineffective during the great depression
of 1930’s Keyness book General Theory confirmed the view that monetary policy will
be an ineffective weapon to promote recovery during a period of depression. Since
the fifties, the monetary policy has been gradually given an important role in
fighting deflation. In recent years the economists opine that monetary policy is
more effective in controlling deflation rather inflation. However there is no change
in the conclusion that monetary policy will be ineffective a period of acute
depression,
We can explain how monetary policy is ineffective a period of severe depression.
The expansionary monetary policy during depression will lead to the flow of more
and more funds into the commercial banks. The lending capacity commercial
banks is increased through the instruments of monetary policy like cash reserve
requirement. Discount rate and open market operations. But the mere availability
of credit at attractive rates does not ensure economic recovery. The entrepreneurs
and consumers must have the necessary motivation to decide upon additional
spending.
During depression the entrepreneurs are not sure of earning profits from new
investments. The marginal efficiency of capital declines during this period. The
enterpreneures will be willing to borrow short term funds to build up inventories.
They will not also like to borrow long-term funds to finance new plants and
machinery. Similarly the consumers are unwilling to borrow from bank and
increase their spending. During depression the consumers are restricted by the
growing unemployment and reduncomes. However the benefit of an expansionary
monetary policy during a severe depression cannot be denied. The merit of
expansionary monetary policy during depression is that it prevents the economic
conditions becoming worse and chaotic.
3.5 MONETARY POLICY AND INFLATION
This monetary policy is often used by the central bank to fight inflation. The
restrictive monetary policy during a period of demandfull inflation facts certain
limitations. During this period prices due to a rapid expansion of aggregate
demand the central bank through its respective monetary policy would try to keep
the money supply constant or reduce it. But still the monetary policy may bot be
effective because the aggregate demand ma to increase. This is due to the fact
that velocity of money in the hands of the public is increasing during this period.
The central bank can employ the general weapons of monetary control and
restrict the expansion of money supply. The restrictive monetary policy in times of
inflation is rendered ineffective under certain conditions sometimes the commercial
banks might finance the expanding business activity through portfolio adjustment
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securities. This is done by commercial banks selling the government securities and
lending the sale proceeds to the borrowers. This practice of the commercial banks
will not increase the total amount of credit and during a period of inflation it
reduced the efficacy of restrictive monetary policy.
Another limition to restrictive monetary policy is due to the existence of
financial intermediaries like insurance companies. The ending operations of these
institutions in times of inflation reduces the effectiveness of restrictive monetary
policy. They practice of business houses accepting public deposits also imposes
another limitation on the working of monetary policy. Since these business houses
are able to secure public deposits at higher interest rates, the effectiveness or
restrictive monetary policy is weaken.
3.6 MONETARY POLICY IN DEVELOPING COUNTRIES
In the case of developing countries the primary objectives is to achieve rapid
economic growth. These countries face many problems like inflationary pressure,
continuos deficits in balance of payments, merge domestic savings and slow rate of
capital formation. The rising prices are checked by price controls. These are not
administered properly and the result is that there is only suppressed inflations. To
tackle the unfavourable balance of payments, import controls, and exchange
controls are introduced in the less developed countries. To earn foreign exchange
export promotion policies are introduced.
These problems create uncertainity regarding the pattern of economic growth.
The unstable price level upsets the economic decision making. The patterns of
investment in these countries is also adversely affected by the uncertain economic
conditions.
The role of monetary policy in the less developed countries must be considered
only in this background. The monetary policy has to be applied in the midst of
these barriers to growth the success of monetary policy in stimulating economic
growth, achieving price stability and promoting cannot formation will depend upon
favourable conditions. The foremost problem in the application of monetary policy
for the developing economics is absence of co-ordination between macro economic
policies. Another problem is the limited and sectoral impact of monetary policies in
these countries. Another problem is the choice of suitable instruments of monetary
policy and the proper time for their application.
The success of monetary policy in promoting economic growth will depend
largely upon the competence and expert knowledge and proper judgement on the
part of monetary authorities. To facilitate the proper use of monetary policy the
developing nations must first improve their currency and credit systems. To
control effectively the supply and use of money, the art of central banking must be
acquired.
More use can also be made of selective credit controls in order to influence the
pattern of investment and production. By differentiating between the cost and
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availability of credit to different sectors, selective credit can influence the allocation
of credit and there by the pattern of development.
The potential effectiveness of monetary policy should not be however over
estimated. As a means of promoting capital formation, monetary policy is of
secondary importance compared to fiscal policy. An easy money policy can increase
the availability of credit. But it will not be utilised unless profit expectations are
reasonably high. Such a policy will promote inflation. The experience of many a
country shows that mere expansion of bank credit does not necessarily promote
investment of inflation ensures. The success of monetary policy as a means to
economic growth in developing economics will depend upon the fundamental
stimulus which should come from enterprise and entrepreneurship.
3.7 MONETARY POLICY IN INDIA
The commencement of the process of planned economic development in 1950-
51 meant that the Indian economy had to achieve certain pre-determined targets in
terms of the rate of growth of national income. In turn, this required stepping up
the savings, effective mobilisation of savings and investing them in an appropriate
manner in the various sectors of the economy. As the structure of financial
institutions which existed them was not adequate from the point of view of
mobilising saving and changing them in the desired manner to the various sectors.
One of the major tasks before the country was to develop this structure. This
required in strengthening the structure through various measures and ii) the
establishment of new institutions either to work in social field or to affords some
measure of protection to the existing units in the structure.
Along with the problem of developing the structure of financial institutions
there was also an equally urgents problem of monetary policy to facilitate
achievement of the targets. As the planning process gathered momentum the
environment in which banking institutions had to work underwent significant
changes. The sector of large and medium scale industry experienced sustained
upsurge. Its demands for credit not only increased in volume but it needed
different types of credit. The needs of the public sector for bank credit also
increased considerably especially when with the adoption of the objectives of
creating a socialistic pattern of society, the public sector entered the field of
industry in a big way.
While the industrial sector of the economy was undergoing a rapid development and
incomes were being generated as a result of the programmes of investment in industry
and infrastructure, agriculture continued to lag behind for a variety of reasons giving rise
to shortages of basic wage goods either directly as in the case of food grains or indirectly
because of shortages of raw materials like raw cotton. Raw jute, oil seeds, etc. based on
agriculture which were required for manufacturing articles of essential consumption or
for exports. The resultant inflationary pressures stepped up further the demand for bank
credit.
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This necessitated an increasingly active monetary policy It was expected from

the monetary authorities that they will ensure an adequate supply of credit to meet
the increasing developmental needs of agriculture, industry and other sectors of the
economy, specially the priority sectors. At the same time it was also realised that a
large expansion in bank credit without matching supplies of real goods would lead
to inflationary pressures in the economy. Inflation, it must be recalled, if not
consistent with planned programmes of development. Therefore, it was further
expected from the monetary authorities that they are to so regulate the monetary
economy that an undue expansion of bank credit to the different sectors of the
economy was not allowed. The policy that was formulated and adopted by the
Reserve Bank of India, came to be known as that of controlled monetary expansion.
3.8 OBJECTIVES OF MONETARY POLICY IN INDIA
In a developing economy like India the keynote of monetary policy is what may
be called ‘controlled monetary expansion, Controlled monetary expansion implies
two things:
a) Expansion in the supply of money, and
b) Restraint on the secondary expansion of credit.
3.8.1 Expansion in the Supply of Money
In a developing economy money supply has to be expanded sufficiently to
match the growth of real national income. Although it is difficult to say what
relation the rate of increase in money supply should bear to the rate of growth in
national income, more generally the rate of increase in money supply has to be
somewhat higher than the projected rate of growth of real national income for two
reasons.
First, as incomes grow the demand for money as one of the components of
savings tends to increase.
Secondly, an increase in money supply is also necessitated by the gradual
reduction of the non-monetarised sector of the economy.
In India the rate of increase in money supply has been far in excess of the rate
of growth in real national income. It has resulted to a large extent in the creation of
consistent inflationary pressures in the economy.
3.8.2 Restraint on the Secondary Expansion of Credit
Government budgetary deficits for financing a part investment outlays
constitute an important aspect. Major aim of monetary policy is to restrain the
secondary expansion of credit. This indeed possesses difficult problems. Since the
general tendency in such a situation is not a marked expansion of credit for the
private sector also, while exercising restraint care is taken that the legitimate
requirements of production and trade are not affected adversely. The Reserve Bank
has also a positive responsibility for channeling credit into desired sectors.
The fulfillment of the above twin goals requires;
a) a correct choice of instruments of monetary policy designed to regulate the
flow of credit and an effective credit planning
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3.9 Evaluation of Monetary Policy in India

The Reserve Bank of India is empowered under the statue to use the usual
instruments of monetary policy such as the bank rate, open market operations,
variable reserve ratios, selective credit controls and so on. The choice of
instruments of the monetary controls that can be used in limited however by the
structural characteristics of the money market.
The monetary policy of the Reserve Bank of India has been marked by flexibility
to suit the changing condition of the economy. The Reserve Bank of India has
employed general as well as selective instruments of credit control to combat
inflationary pressures in the economy The policy of selective credit control which
generally dominated the some has not however been rigidly applied. Nevertheless
in the midst of restriction of monetary policy the Bank often resorted of effective
credit liberalisation. The financing of the priority sectors of a significant scale
would not have been possible without the liberal re-finance facilities provided by
the Bank.
A review of the operation of selective credit control measures implemented by
the Reserve Bank of India shows that these measures to a larger, extent succeeded
in achieving their objective. However these created at the same time certain
limitations. Especially in a setting of over – all monetary expansion making it
possible for the borrower to take resource to non-banking sources for finance. This
underlined the need for maintaining harmony between the monetary and fiscal
policies. Thus the Reserve Bank’s monetary policy, in its long term perspective
continued basically to be attuned to the requirements of planned economic
development with preferential treatment to priority sectors such as small scales
industries co-operatives defence supplies and exports Nevertheless in the short-
term, adjustments in the availability and cost of credit have been made from time to
time to suit the needs on the particular situation.
The monetary policy of the ?Reserve Bank of India has been described as one of
the controlled expansion of credit. The object has been to restrain prices while
answering at the same time the legitimate credit requirements so as to avoid
adverse effect on production, an articulate and flexible monetary policy has been
pursued by the Reserve Bank of India which aimed at reconciling the needs of an
increasing volume of money supply to finance expansion of output while restraining
the use of credit for unproductive and non-essential purposes. In short monetary
policy has been operated within the overall framework of mixed economy wedded to
development planning.
The major failure of the monetary policy lies on the price front. The monetary
authorities in India has been in a position to curb inflationary rises, in prices,
which has often taken violent jumps at intervals. However, in evaluating the
success or failure of Reserve Bank’s monetary policy it should be borne in mind
that the Bank can at the best, provided the fiscal operations of the Government do
not run counter to the goals of monetary policy pursued by the Bank, control only
those forces which create pressure on the price level form the side of money supply.
245
The Reserve Bank has nothing within its power to control the non-monetary
pressure in the economy which tends to push up prices.
In the face of given limitations the monetary policy in India has been operated
with a fair amount of success. The Reserve Bank has played the useful role of a
careful watch dog over the affairs of commercial banking system in the economy,
making the system play a positive role in the planned economic development of the
country.
4. REVISION POINTS
Bank Rate - The rate at which the RBI discounts the bills of commercial banks
Open Market Operation - Purchase and sale of securities
Minimum Reserve Ratio - The ratio of the deposit that is to be kept by the
commercial bank with the RBI
5. QUESTIONS
Section – A
1. How does the Monetary Policy used to fight inflation?
2. How can we use Monetary Policy to remove the recession in a economy
Section – B
1. What is meant by monetary policy? Explain the various instruments of
monetary policy.
2. Describe the main objectives of monetary policy in a developing economy.
3. While in a developed economy the main objective of monetary policy is
economic stabilisation, in a developing economy the objective is resource
mobilisation”… Discuss.
4. Discuss the main objectives of monetary policy in India, Critically evaluate
its effectiveness.
6. SUMMARY
Thus monetary policy is the sole decision of the central bank’s control over the
supply and cost of money as an instrument for achieving the objectives of economic
policy
1978.
8. KEY WORDS
Minimum legal reserve ratio, Open Market Operation, Bank Rate

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LESSON – 20
INSTRUMENT OF MACRO ECONOMIC POLICY FISCAL POLICY

1. INTRODUCTION
This chapter deals with the instrument of Macro Economic Policy -Fiscal Policy,
which is a Combination of taxation, expenditure and borrowing, its objectives,
Contra-cyclical fiscal policy, fiscal policy in inflation, depression and economic
growth, its limitations, its role in developing countries and specially in India
2. OBJECTIVES
 To know the effectiveness of Fiscal policy
 To acquire knowledge about the objectives of Fiscal Policy
3. CONTENT
3.1 Introduction
3.2 Fiscal Policy and Economic Activity
3.3 Objectives of Fiscal Policy
3.3.1 Contra cyclical Fiscal Policy
3.3.2 Fiscal Policy in Inflation
3.3.3 Fiscal Policy in Depression
3.3.4 Fiscal Policy and Economic Growth
3.4 Limitations
3.5 Role of Fiscal Policy in developing countries
3.6 Fiscal Policy in India
3.1 INTRODUCTION
The importance of fiscal policy as an instrument of economic control was first
emphasised by Keynes in his “General Theory of Employment, Interest and Money”.
Earlier writers based discussed the effects of individual fiscal measures. But the
full implications of public finance for the total economic situation were not
understood by economists and authorities at that time. When the government
spent money on relief works, the sums so spent were obtained only by raising
special taxes or rates, because formal balancing of the budget was always regarded
as inevitable Additional public expenditures did practically nothing to bring about
general economic improvement. Keynes analysis showed that the total national
income was an index of economic activity and emphasised the relation of the
activity to total spending.
3.2 FISCAL POLICY AND ECONOMIC ACTIVITY
Public expenditure and tax revenue act as important levers to influences
aggregate outlay, employment and the level of prices in the economy. Government
expenditure and in on one can be combined in several ways in order to stimulate or
depress the aggregate demand and economic activity in the economy. A surplus in
the budget will exert a deflationary fect on national income because the inflow of
aggregate public expenditure into the circular income flow will be less than the tax
247
leakage from the circular income flow Conversely, a deficit in the budget expands
net national product since the leakage from the aggregate income flow due to taxes
is less than the additional inflow into the circular flow in the form of public
expenditure. It follows, therefore, that in slump, when there is need for stimulating
aggregate demand: deficit budget is an essential requirement . In infratation, when
the problem is keep aggregate supply, surplus budget should be prepared. This
generalisation should not, however lead to the conclusion that a balanced budget is
neutral in its effects on the level of national income and economic activity. A
balanced budget may be no less important than an unbalanced deficit or surplus
budget.
In order to have a proper understanding of the effects of government’s fiscal
policy on the level of aggregate economic activity, apart from the magnitude of
public expenditure and revenue, their composition or structure is equally
significant. A given amount of revenue can be realised by the government in
several ways-by levying taxes, by increasing profits from commercial activities. And
by borrowing from the public. Although the revenue raised through various
methods may be the same, each method of raising revenue will affect the economy
differently. For example the same amount of revenue may be raised either through
taxing the people or through floating bonds in the market,. But the effect of each
one of these two methods of rising government income will be different. And even
in the cases of taxes the effect will be different in the case of different tax and excise
duty. Similarly, the government can incur a given expenditure in several ways. It
might’ for example spend upon building a hospital or on slum clearance or on
construction of a sugar mill or on unemployment doles or on nutritious noon meal
to the poor children. The effect on the level of aggregate economic activity will be
different even though the total expenditure is the same in each case.
3.3 OBJECTIVES OF FISCAL POLICY
At present, there is concensus of opinion among economists that fiscal policy
should be employed to achieve full employment and stability in the economy. Prior
to the great depression of the thirties, by economic stability was largely understood
the stability of general price level. The severity of the depression focussed attention
on the need to remove unemployment and the employ fiscal policy for this purpose.
The employment Act output 1946 in the U.S.A. stated that it was the responsibility
of the federal government to use all possible means including fiscal policy to
promote maximum employment, production and purchasing power in the economy.
Since World War II inflation has become a global phenomenon. Consequently,
economic stabilization has come to be widely defined so as to include the
elimination of inflationary pressures in the economy. This means that the
achievement of full employment and price stability should be simultaneously
attempted through the instrument of fiscal policy. At times, now ever both these
goals may be difficult to achieve as these might be mutually inconsistent. In fact
full employment and rigid price stability are mutually inconsistent. It is argued
248
that an economy which wants to achieve full employment must accept moderate
price rise unless it resorts to price controls, rationing and wage freeze.
3.3.1 Contra-cyclical Fiscal Policy
If fiscal policy has to be used as an instrument of economic stability then it has
to be contra-cyclical in behaviour. The government can contribute to rise the levels
of employment, income and economic activity by spending more than its current
income. Conversely, it exert a contrationary effects on employment, income and
economic activity by collecting more from the people in form of taxes than it
spends. To use its policy as an instrument of economic stability, the government
should carefully regulate both the time and size of its spending and tax revenue
operations. A deficit in the budget during inflation will further aggregate inflation
and will, therefore, act as a destabilising factor rather than act as a stabilising force
in the economy. But the same policy is enforced in recession will promote
economic stability by maintaining recovery. Similarly surplus budgeting in
recession by aggravating the fall in the level of aggregate demand will convert a mild
recession into a great depression. But the same policy pursued during boom will
promote stability in the economy.
3.3.2 Fiscal Policy in Inflation
Inflation arises when the aggregate demand for goods and services exceeds the
aggregate supply. Therefore, The obvious fiscal remedy for it is to reduce total
demand. This as we have seen, is possible by the government budgeting for a
surplus. Reduction of public expenditure and increase of tax revenues are the
measures to be adopted. These measures are quite practicable when authorities
have to control the boom phase of the trade cycle. When inflation of the type which
occurs due to excessive public spending in war or for development programmes has
to be dealt with a surplus budget is not feasible proportion. The huge government
expenditure in time of war cannot be reduced . Nor can the government in an
under-developed country scale down its expenditure which it incurs as a part of a
long-term plan for economic development. Large government expenditure is
inevitable in such conditions and is the primary cause of inflation. Inflation as a
long term evil, therefore, cannot be effectively attacked from the expenditure side
and most of the fiscal action taken by the authorities is confined to the revenue side
alone.
Moreover, inflation is caused by one or more of two groups of factors. It is
either due to an increase in demand or a result of changes in cost. The changes in
costs often after from rises in wages. A rise in prices gives rise to demand for
higher wages on the part of organised labour, and if these demands are met, the
rise in wages, causes costs and prices to increase further. This kind of wage-
induced inflation cannot be controlled by reducing demand alone by increasing
taxation. In fact, indirect taxation raises prices and costs of living and leads
demands for higher wages, thus worsening the inflationary situation. Subsidies to
consumption to lower the prices of essential commodities help in some measure to
provide a solution to the problem this case.
249
Furthermore, when increased taxation adversely affects production, the

inflationary pressure is likely to happen in an underdeveloped country. Private
investment in such countries must increase in order to increase the national
income in the long-run. Thus, how far is an increase in taxation an appropriate
anti-inflationary device is often difficult to decide.
Promotion of private saving appears to be the most suitable measure in such a
case. The reduction of private consumption and mopping up of all surplus
purchasing power from the people must be the main immediate object of fiscal
policy. Increasing public borrowings helps considerably. The tax policy is also
shaped largely to this end. Monetary measures and direct commodity controls play
an important part.
3.3.3 Fiscal Policy in Depression
During depression the economy suffers from rising unemployment, falling
income and shrinking economic activity. In slump private investment is very small.
There is massive idle plant capacity as writing, utilization, Resources are the in the
economy but there is no demand for them. The aggregate demand for current
output falls very low. The economy faces the paradox of “actual poverty amidst
potential plenty”. In depression, when the existing aggregate private and
government spending is too low to achieve full employment, the government must
increase public spending by undertaking public works programmers on massive
scale and indirectly by including people to spend more. There amount or
government spending incurred on unemployment doles and payments made to
various schemes like the veterans and the age should be increased. The real merit
of public works programmes is that they raise personal incomes and consumption
by multiplier time of original expenditure with out depressing the marginal
efficiency of investment in the private sector. Aggregate spending can be increased
also by reducing taxes. The effect of tax-cuts would be to increased the amount of
disposable income of individuals and business frame sales tax should be abolished
and excise duties on consumer goods must be reduced.
To relieve the economy of depression, it is not enough to the aggregate
consumption; aggregate investment should also be simultaneously raised. Fiscal
policy can induce changes in aggregate investment demand by making appropriate
changes in the tax structure. Since the marginal efficiency of private investment
should be raised, business and corporate taxes should be reduced. Firms engaged
in capital formation in depression should be allowed tax concessions. Government
debt policy should be so designed that public debt should be reduced in depression
so that disposable income of bond holders may increase causing substantial
increase in aggregate spending in the economy.
3.3.4 Fiscal Policy and Economic Growth
The operation of fiscal policy measures for attaining full employment and stable
price level in the economy was due to ( I) the ineffectiveness of monetary policy as a
means to remove unemployment in the Great. Depression, (ii) the “new economics”
which was developed by Keynes, and (iii) the increasing importance of government
250
spending and taxation in national income and output. As an instrument of growth

with stability fiscal policy should be so employed that while promoting consumption
and investment. It may check inflation. Accelerating the rate of growth requires
the allocation of higher proportion of the fully employed resources to those activities
which increase the productive capacity of the economy. In other words, the fraction
of the fully employment real output devoted in consumption must decrease while
that devoted to investment increases. Fiscal policy through its tax instrument
should encourage investment and discourage consumption so that production may
increase. It is also necessary to increase the rate of capital formation in the
economy by reducing the high income-tax rates on personal incomes.
3.4 LIMITATIONS OF FISCAL POLICY
The effectiveness of fiscal policy depends on the size of the measures adopted
and their timing, exact change effected in the revenue total national income will
depend on the change in the expenditure made by authorities moreover the currect
timing of the change in the expenditure made by authorities to realise that a boom
or slump is coming. The political and administrative delay in taking measures,
particularly when legislative sanction is necessary for changing the rates of altering
expenditure on programs, detract from the efficacy of whatever measures are
adopted. The measures adopted may be slow in taking effect. The effect of changes
in tax rates and the multiplier action of government expenditure often take time
and the results obtained might be after a considerable time laga. Due to the fact
that all significant changes in tax and expenditure require the prior approval of the
parliament and state legislatures the action lag for fiscal policy is long and variable.
The actual legislative process which surround fiscal policy decisions is very
cumbersome and time consuming. Therefore fiscal policy often becomes a wholly
inappropriate instrument of economic stabilization and growth.
Tax flexibility of public revenue itself may work as a restrictive influence on any
fiscal policy adopted by the government when increased government spending is
done for the purpose of expanding total spending in the community. A apart of it
might come back to the government as more revenue, thereby reducing the effect of
higher government expenditure.
3.5 THE ROLE OF FISCAL POLICY IN DEVELOPING COUNTRIES
Public finance in developing countries differs from that as developed countries
both in respect of objectives and its content. In a developing economy, the state
has to play an increasing role in promoting economic development which is its
primary goal. Fiscal policies properly framed and efficiently executed can accelerate
the process of economic development. There are four essential objectives of fiscal
action in a developing economy.
1. Promotion and acceleration of capital formation in both the public and
private sectors.
2. Mobilization of real and financial resources for the public sector without
hampering the expansion of resources for the private expenditure.
251
3. Creating conditions for a reasonable degree of stability in the economy in

keeping with the requirements of economic development.
4. Ensuring social justice by redistribution of national income and wealth.
Truly, there is, to a certain extent, contradiction in these aims and an attempt
to realise one aim may create difficulties in respect of another. For instance a
police that aims at a rapid rise in the rate of capital formation may lead to
instability in the economy by creating inflationary conditions and may widen
inequalities of income. An attempt to reduce inequalities may lower the rate of
saving and capital formation. Therefore, a sound fiscal policy involves a suitable
harmony among all these aims.
3.6 FISCAL POLICY IN INDIA
During the nineteenth century, the financial requirements of the government
were small and land revenues was the main source of revenue in India. The rigidity
of the land tax, however, did not allow the revenue from it to expand with public
expenditure, In the first part of the twentieth century also public expenditure
continued to below. The second World war necessitated large increases in
government expenditure. New sources had, therefore to be tapped. In the early
years of the post-war period, fiscal policy was determined by the fear of a slump
and the need for rehabilitation of industry and encouragement to investment and
capital formation. Tax relief was given by abolishing excess profits tax and of
income tax. Nevertheless the expansion in social and development expenditure
underlined the need for an increased tax effort.
In recent years, public expenditure has increased further owing to the
formulation and implementation of the plan for economic development and the
efforts of the government to the establishment of a welfare state. Since 1951, the
important factor influencing budgetary policy has been economic planning. Since
then, the government has been following a vigorous budgetary policy designed to
achieve such economic goals as rapid economic development, price stability
commensurate with growth, reduction of inequalities of income and wealth,
increase in employment opportunities and so on-A brief reference to these points
may be made here.
Firstly, the effect of fiscal policy on the mobilization resources for economic
development through planning can be considered. Between 1951 and1983 more
than Rs. 175000 crores has been invested in the public sector alone. A sizeable,
proportion of the investment was made for the development of basic and heavy
industries. To mobilize resources for the plans, the government resorted to
taxation, loans and deficit financing. On the one side, it was possible to create and
develop transportation, communications, power and other aspects of infrastructure
needed for economic development. On the other hand, the heavy tax burden
created adverse impact on incentives to invest and produce. Heavy taxation also
led to tax evasion and avoidance and the creation of huge black money with its
consequential adverse effects. Again the budgetary policy led to increasing
concentration of wealth and economic power in the hands of a few and to the
252
creation of monopolies in different sectors. Furthermore the policy of large

investment and of deficit financing created inflationary pressures in the economy.
Secondly, the fiscal policy since 1950-51 gave rise to inflationary pressures in
the country. Large scale investment with emphasis on basic and heavy industries
and financing of development projects through budget deficits gave rise to general
rise in prices.
Thirdly, budgetary policy also led to increasing inequalities of income and dwealth,
Ironically enough the government aimed at reducing inequalities of wealth through the
use of fiscal policy. For example, it was explicity stated that the higher rates of taxes
would fall upon higher income groups so as to reduce the volume of purchasing power
in their hands. Even in regard to indirect taxes, the governments policy was to impose
them most heavily upon the richer sections of the community. In practice, however,
budgetary policy helped to divert income into the hands of the rich. This was due,
partly, because of encouragement to the private sector through licensing and controls
and partly through enabling the richer section to evade taxes. Inflation has.
Lastly, the impact of budgetary policy on the effect on employment and
unemployment may be noted. The large volume of investment made by the
government and the consequent building up of infrastructure in the country have
helped in direct as well as indirect growth in em-ployment in India However the
problem of unemployment continue to evade solution because of the stupendous
increase in population.
4. REVISION POINTS
Contra-cyclical Fiscal Policy
It exerts a Contractionary effects on Employment, income and economic activity
by collecting more from the people in the flow of taxes than it spends
During Inflation - Measures should be taken to reduce the total demand
During Depression - Aggregate demand and aggregate consumption should be
raised simultaneously
5. QUESTIONS
Section – A
1. Bring out the objectives of Fiscal policy.
2. How can we use fiscal policy to combat Inflation?
Section – B
1. What are the objectives of fiscal policy?
2. What are the limitations of obtaining price stability and full employment?
3. Discuss the role of fiscal policy as an instrument of macro economic policy.
4. What is meant by fiscal policy?
5. What should be its objective in a developing country like India?
6. SUMMARY
In short, since Independence , the government have been taking vigorous steps
in promoting economic development. And an active fiscal policy has been pursued
253
in order to achieve the goals. The fiscal policy pursued by the government during
the past 35 years has resulted various consequences both favorable and
unfavorable.
1. Paul A.Samuelson & William Nordhaus, Economics, Tata Mcgraw Hill
Publishing co.LTd,Madras
1978.
8. KEY WORDS
Public Taxation, Public Borrowing and Public Expenditure, Contra-Cyclical
Fiscal Policy

DR. C. MURUGADASS
Asst. Prof. Of Economics
Presidency College
Madras - 5

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1

NATURE OF MACRO ECONOMICS – COMPARATIVE STATICS AND

economics considers the relation between aggregates such as volume of

3.4 IMPORTANCE OF MACRO ECONOMICS

3.5.1 Static Micro Economics

Assuming numerical values for a’

The level of equilibrium income can be expressed through aggregate demand

in government spending aggregate DD curve shifts upwards to C+I+G’ giving OY 1,

to G. AB shows the change in government expenditure. Due to this the income

Intrest rate ( Percent )

Dynamic Adjustment in the ISLM Model With a money Market Lag

Such an analysis is an eye-opener in policy making. For e.g. if we want to study

Keynesian theory would advise introduction of fiscal policy at B where GNP

2. Comment on the usefulness of macro-dynamics as a tool of analysis.

THEORY OF CONSUMPTION AND CONSUMPTION FUNCTION

3.6.2 Subjective factors

The relationship between APC and MPC is quite important because it

In figure 5, though interesting from the point of view of theoretical possibility,

Figures APC MPC

In figure 10, an usual form of consumption function Co, C1,C2 is shown .

m. Terms of Consumer Credit

Shifts in Consumption Function

3.7.1 Vital Importance of Investment

law can hardly be overemphasized in macroeconomic analysis. This law helped to

benefits can also be an instrument to increase the consumption function. In times

influence of a change in an individual wealth holder’s real balance on the aggregate

Algebraically the relationships shown here is C = by where b is both APC MPC

ANNAMALAI UNIVERSITY O D ISPOSIBLE IN C OME X

The Cs are short period consumption function, estimated at different periods of

consumption behaviour. Further more he performed cross section budget studies of

income growth is not steady, it is bunched in spurts and dips, as shown by

Ratchet is, in fact a mechanical arrangement which ensure motion is one

direction only (generally upward or forward). In the theory of consumption, there is

It may be argued in support of Duesenberry’s hypothesis that it is ingenious in

Friedman’s hypothesis may be said to rest on there fundamental principles (1)

short run or measured consumption function. It shows non proportionately

average measured income. Corresponding to this OA permanent income these

always regard wealth as a source of permanent income. And similarly, if one

The life cycle hypothesis is not free from certain limitations.

Second, the life cycle hypothesis pre-supposes that consumption is directly

THEORY OF INVESTMENT INVESTEMNT FUNCTION

up and consumption too. As a result employment increases in consumption goods

Savings and investment equality is an important aspect of macro economic

Investment which depends directly upon income is known as induced

Figure 3 shows A shows induced investment at various levels of income. At OY2

Figure (3b) illustrate autonomous investment which is constant at different

O 400 430 450 480 Y 40 50 60 70

ANNAMALAI UNIVERSITY PERIOD 2

If there is a change in any of these factors, it is sufficient to produce a

AGGREGATE DEMAND AND AGGREGATE SUPPLY FUNCTION AND

ANNAMALAI UNIVERSITY 300

ANNAMALAI UNIVERSITY Figure 3

Corresponding to the price level P0 P1 P2 and P3 and the aggregate demand

The various possible levels of output can be determined through the

THEORY OF MULTIPLIER AND ACCELERATOR

Round I (Increment in Y (increment in C=CY  S(Y= C)

The magnitude of contraction due to the backward operation of the multiplier

3.4 LEAKAGES OF MULTIPLIER

expenditure on consumption goods thereby weakening the multiplier

b. Timeless static equilibrium analysis

employment. When the economy is experiencing inflationary pressures

= Rs. 200 crores.

CONSUMPTION & INVESTMENT