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2 Macroeconomics

E
individual as well as the economy level.
(iii) For Whom to Produce? The question of for whom to produce is related to

PL
the distribution of income and determination of wages, rent, interest, profits
or the various factor shares and this problem has also to be tackled for the

AM
individual units as well as the economy as a whole.

Institutional Aspect

EX
In addition to the above two aspects, economics also studies the various institutions
involved in the economic process like the government, banks, financial institutions and
other infrastructural and institutional aspects.
In addition, there are a number of aspects like international trade, economic
welfare, economic growth, economic development etc. which are also a part of economics.

1.1.1 Definitions of Economics

‘Economics’ has its origin in the ancient Greek word “oikonomikos” or “oikonomia”.
which means the task of managing a household. The definition of economics has
evolved over time.
The entire focus of economics is on the problem of scarcity. In fact, the most
accepted definition of economics was given by Lord Lionel Robbins “Economics is the
science which studies human behaviour as a relationship between ends and scarce
means which have alternative uses.”1 All economic activity concentrates on how to
allocate the scarce resources of a country among alternative uses to optimise benefits
to individuals as well as to the economy and society as a whole.
For Adam Smith, enhancing the wealth of a country was the main objective of
a nation. He defines economics as “a political economy, considered as a branch of the
science of a statesman or legislator, proposes two distinct objects: first, to provide a
plentiful revenue or subsistence for the people, or more properly to enable them to
provide such a revenue or subsistence for themselves; and secondly, to supply the
state or commonwealth with a revenue sufficient for the public services. It proposes
to enrich both the people and the sovereign”2.
Alfred Marshall introduced the importance of human welfare in economics and
defined economics as “Economics is on the one side a study of wealth; and on the other,

1. Robbins, Lionel (1932). An Essay on the Nature and Significance of Economic Science, p. 15.
London, Macmillan.
2. Smith, Adam (1776). An Inquiry into the Nature and Causes of the Wealth of Nations, and
Book IV.
Product-Mix

2 Macroeconomics

(i) What to Produce? This problem in economics concerns itself mainly with
what are the goods and services to be produced—not only at the level of
individual firms and industries—but also, at the level of an economy. This
issue is mainly related to deciding the production pattern and Product-Mix. Search the Topic
(ii) How to Produce? The question of ‘how to produce?’ deals with the technique
or technology of production, basically emphasising on the choice between
labour and capital-intensive technology.
Further, the question of technology of production has to be tackled at the
individual as well as the economy level.
(iii) For Whom to Produce? The question of for whom to produce is related to
the distribution of income and determination of wages, rent, interest, profits

E
or the various factor shares and this problem has also to be tackled for the
individual units as well as the economy as a whole.

PL
Institutional Aspect
In addition to the above two aspects, economics also studies the various institutions

AM
involved in the economic process like the government, banks, financial institutions and
other infrastructural and institutional aspects.
In addition, there are a number of aspects like international trade, economic
welfare, economic growth, economic development etc. which are also a part of economics.

EX
1.1.1 Definitions of Economics
‘Economics’ has its origin in the ancient Greek word “oikonomikos” or “oikonomia”.
which means the task of managing a household. The definition of economics has
evolved over time.
The entire focus of economics is on the problem of scarcity. In fact, the most
accepted definition of economics was given by Lord Lionel Robbins “Economics is the
science which studies human behaviour as a relationship between ends and scarce
means which have alternative uses.”1 All economic activity concentrates on how to
allocate the scarce resources of a country among alternative uses to optimise benefits
to individuals as well as to the economy and society as a whole.
For Adam Smith, enhancing the wealth of a country was the main objective of
a nation. He defines economics as “a political economy, considered as a branch of the
science of a statesman or legislator, proposes two distinct objects: first, to provide a
plentiful revenue or subsistence for the people, or more properly to enable them to
provide such a revenue or subsistence for themselves; and secondly, to supply the
state or commonwealth with a revenue sufficient for the public services. It proposes
to enrich both the people and the sovereign”2.
Alfred Marshall introduced the importance of human welfare in economics and
defined economics as “Economics is on the one side a study of wealth; and on the other,

1.2 MEANING AND NATURE OF MACROECONOMICS

As stated earlier, since the subject matter of economics is very vast, and since economic

Bookmark the Page problems have to be tackled at different levels, it was for the sake of convenience
and for the sake of providing a systematic analysis to solve the economic problems at
different levels that the subject matter of economics was divided into two approaches.
1. Microeconomic approach
2. Macroeconomic approach
An economic system may be looked at as a whole or in parts as many decision-
making units such as consumers, households, firms, etc. When we analyse the problems
of an economy as a whole, it is a macroeconomic study. Macroeconomics is thus

E
a study of aggregates in an economy while the analysis of the behaviour of any
particular decision-making unit, like a firm, an industry, a consumer, is covered by

PL
the microeconomic study.
The microeconomic theory explains issues related to the allocation of resources
and distribution of production, whereas, the macroeconomic theory explains issues
concerning the level of total production, employment, income, the general level of

AM
prices and so on.

1.2.1 Background of Macroeconomics

The term macroeconomics was first used by Ragnar Frisch in 1933. Macroeconomic

EX
theory, as a formal theory, gained significance specially after the great depression of
1929–33. Prior to this period there was a strong belief in the working of the Purely
Capitalist Economy. It was felt that the Free Market Mechanism would ensure the
smooth functioning of the system. Therefore, what was more relevant during this time
were the microeconomic issues like resource allocation, determination of equilibrium of
firms and industries, individual welfare etc. For the first time in 1929–33, aggregate
problems like mass unemployment, falling investment, falling output, falling prices,
low national income began to emerge on a large scale.
There was an almost total collapse of the capitalist system the world over, and the
belief in the smooth functioning of the capitalist system came into doubt. It was at this
time that John Maynard Keynes presented his General Theory of Employment, Interest
and Money (1936) which discussed the causes and solutions to the Great Depression
and macroeconomics as a branch of economics gained popularity.

Definitions of Macroeconomics
Macroeconomics has been defined as the study of the aggregate economy. The salient
features of this approach would become clearer by considering certain definitions.
According to Boulding, Macroeconomics deals with ‘great aggregates’ or ‘averages’
of a system rather than particular items in it. It attempts to define these aggregates
in a useful manner and examines how these are related and determined.
Culbertson considers Macroeconomics to be a subject that deals with the theory
of income, employment, prices and money.
4 Macroeconomics

1.2 MEANING AND NATURE OF MACROECONOMICS

E
making units such as consumers, households, firms, etc. When we analyse the problems
of an economy as a whole, it is a macroeconomic study. Macroeconomics is thus

PL
a study of aggregates in an economy while the analysis of the behaviour of any
particular decision-making unit, like a firm, an industry, a consumer, is covered by
the microeconomic study.
The microeconomic theory explains issues related to the allocation of resources

AM
and distribution of production, whereas, the macroeconomic theory explains issues
concerning the level of total production, employment, income, the general level of

Highlight the Text prices and so on.

EX
1.2.1 Background of Macroeconomics
The term macroeconomics was first used by Ragnar Frisch in 1933. Macroeconomic
theory, as a formal theory, gained significance specially after the great depression of
1929–33. Prior to this period there was a strong belief in the working of the Purely
Capitalist Economy. It was felt that the Free Market Mechanism would ensure the
smooth functioning of the system. Therefore, what was more relevant during this time
were the microeconomic issues like resource allocation, determination of equilibrium of
firms and industries, individual welfare etc. For the first time in 1929–33, aggregate
problems like mass unemployment, falling investment, falling output, falling prices,
low national income began to emerge on a large scale.
There was an almost total collapse of the capitalist system the world over, and the
belief in the smooth functioning of the capitalist system came into doubt. It was at this
time that John Maynard Keynes presented his General Theory of Employment, Interest
and Money (1936) which discussed the causes and solutions to the Great Depression
and macroeconomics as a branch of economics gained popularity.

1.2 MEANING AND NATURE OF MACROECONOMICS

E
making units such as consumers, households, firms, etc. When we analyse the problems
of an economy as a whole, it is a macroeconomic study. Macroeconomics is thus

AM
and distribution of production, whereas, the macroeconomic theory explains issues
concerning the level of total production, employment, income, the general level of
prices and so on.
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Text of Macroeconomics
EX
The term macroeconomics was first used by Ragnar Frisch in 1933. Macroeconomic
theory, as a formal theory, gained significance specially after the great depression of
1929–33. Prior to this period there was a strong belief in the working of the Purely
Capitalist Economy. It was felt that the Free Market Mechanism would ensure the
smooth functioning of the system. Therefore, what was more relevant during this time
were the microeconomic issues like resource allocation, determination of equilibrium of
firms and industries, individual welfare etc. For the first time in 1929–33, aggregate
problems like mass unemployment, falling investment, falling output, falling prices,
low national income began to emerge on a large scale.
There was an almost total collapse of the capitalist system the world over, and the
belief in the smooth functioning of the capitalist system came into doubt. It was at this
time that John Maynard Keynes presented his General Theory of Employment, Interest
and Money (1936) which discussed the causes and solutions to the Great Depression
and macroeconomics as a branch of economics gained popularity.

4 Macroeconomics

1.2 MEANING AND NATURE OF MACROECONOMICS

As stated earlier, since the subject matter of economics is very vast, and since economic
problems have to be tackled at different levels, it was for the sake of convenience
and for the sake of providing a systematic analysis to solve the economic problems at
different levels that the subject matter of economics was divided into two approaches.
1. Microeconomic approach
2. Macroeconomic approach
An economic system may be looked at as a whole or in parts as many decision-
making units such as consumers, households, firms, etc. When we analyse the problems
of an economy as a whole, it is a macroeconomic study. Macroeconomics is thus
a study of aggregates in an economy while the analysis of the behaviour of any
particular decision-making unit, like a firm, an industry, a consumer, is covered by
the microeconomic study.
The microeconomic theory explains issues related to the allocation of resources
E

and distribution of production, whereas, the macroeconomic theory explains issues

concerning the level of total production, employment, income, the general level of
PL

prices and so on.

1.2.1 Background of Macroeconomics

were the microeconomic issues like resource allocation, determination of equilibrium of

firms and industries, individual welfare etc. For the first time in 1929–33, aggregate

Jot down yourhere

problems like mass unemployment, falling investment, falling output, falling prices,
low national income began to emerge on a large scale.
There was an almost total collapse of the capitalist system the world over, and the
notes here
belief in the smooth functioning of the capitalist system came into doubt. It was at this
time that John Maynard Keynes presented his General Theory of Employment, Interest
and Money (1936) which discussed the causes and solutions to the Great Depression
and macroeconomics as a branch of economics gained popularity.

Sunayini Parchure
MACROECONOMICS

SUNAYINI PARCHURE
Vice-Principal and Head
Department of Economics
Symbiosis College of Arts and Commerce, Pune

Delhi-110092
2021
MACROECONOMICS
Sunayini Parchure

© 2021 by PHI Learning Private Limited, Delhi.

All rights reserved. No part of this book may be reproduced in any form, by mimeograph or any
other means, without permission in writing from the publisher.

ISBN-978-93-90544-03-5 (Print Book)

ISBN-978-93-90544-04-2 (e-Book)

The export rights of this book are vested solely with the publisher.

Published by Asoke K. Ghosh, PHI Learning Private Limited, Rimjhim House, 111, Patparganj
Industrial Estate, Delhi-110092 and Printed by Syndicate Binders, A-20, Hosiery Complex, Noida,
Phase-II Extension, Noida-201305 (N.C.R. Delhi).
Contents

Preface................................................................................................................................... xi
Acknowledgements.............................................................................................................. xiii

Chapter 1: Macroeconomics.................................................................................... 1–17

1.1 Introduction to Macroeconomics.................................................................................. 1
1.1.1 Definitions of Economics.................................................................................. 2
1.2 Meaning and Nature of Macroeconomics................................................................... 4
1.2.1 Background of Macroeconomics....................................................................... 4
1.3 Subject Matter and Scope of Macroeconomics.......................................................... 5
1.3.1 Explanation of Some Aggregates Studied under Macroeconomics.............. 6
1.4 Significance of Macroeconomic Study......................................................................... 8
1.5 Limitations of Macroeconomics................................................................................. 10
1.6 Macroeconomic Paradox (Fallacy of Composition).................................................. 10
1.7 Need for Integrating Macro and Microeconomics................................................... 12
1.8 Distinction between Micro and Macroeconomics ................................................... 12
Points to Remember............................................................................................................. 14
Annexure ............................................................................................................................. 14
Questions.............................................................................................................................. 17

Chapter 2: National Income................................................................................. 18–54

2.1 Meaning of National Income..................................................................................... 18
2.2 Definitions and Features of National Income ........................................................ 19
2.2.1 Definitions of National Income...................................................................... 19
2.2.2 Features of National Income......................................................................... 19
2.3 National Income and Related Concepts................................................................... 20
2.3.1 Gross Domestic Product (GDP)..................................................................... 20
2.3.2 Gross National Product (GNP)...................................................................... 21
2.3.3 GNP at Market Prices (GNPMP) and GNP at Factor Cost (GNPFC)......... 22
2.3.4 Personal Income.............................................................................................. 23
2.3.5 Personal Disposable Income........................................................................... 24
2.3.6 Private Income................................................................................................ 24
2.3.7 Nominal and Real Income............................................................................. 25
iii
iv Contents

2.4 Final and Intermediate Goods.................................................................................. 27

2.5 Methods of Estimating or Measuring National Income......................................... 28
2.5.1 Product/Output Method ................................................................................ 28
2.5.2 Income Method Approach............................................................................... 30
2.5.3 Expenditure Method or Approach................................................................. 31
2.6 Difficulties and Problems in Estimation of National Income................................ 34
2.6.1 Conceptual Difficulties.................................................................................... 34
2.6.2 Practical Difficulties....................................................................................... 35
2.7 Circular Flow of Income Mechanism........................................................................ 38
2.8 Withdrawals or Leakages and Injections or Additions.......................................... 44
Points to Remember............................................................................................................. 45
Annexure............................................................................................................................... 46
Questions.............................................................................................................................. 52

Chapter 3: Money: Definitions and Functions................................................ 55–64

3.1 Introduction................................................................................................................. 55
3.2 Functions of Money.................................................................................................... 56
3.2.1 Primary Functions.......................................................................................... 56
3.2.2 Secondary or Derivative Functions............................................................... 57
3.2.3 Contingent and Dynamic Functions of Money ........................................... 58
3.2.4 Static and Dynamic Functions of Money..................................................... 59
3.2.5 Other Functions of Money............................................................................. 59
3.2.6 Uses of Money................................................................................................. 59
3.2.7 Dangers of Money .......................................................................................... 60
3.2.8 Characteristics of Good Money...................................................................... 60
3.3 Definitions of Money.................................................................................................. 60
3.3.1 Traditional Approach...................................................................................... 61
3.3.2 Empirical Approach........................................................................................ 61
Points to Remember............................................................................................................. 62
Questions.............................................................................................................................. 64

Chapter 4: Demand for Money............................................................................ 65–77

4.1 Introduction................................................................................................................. 65
4.2 Meaning of Demand for Money................................................................................ 65
4.3 Motives to Demand Money........................................................................................ 65
4.3.1 Classical Approach (Transactions and Precautionary Motives)................. 66
4.3.2 Keynes Approach (Transactions, Precautionary and Speculative Motives)...... 66
4.3.3 Liquidity Preference Theory.......................................................................... 72
4.4 Post-Keynesian Developments in Demand for Money............................................ 75
4.4.1 ‘Asset Approach’ to Demand for Money (Milton Friedman)...................... 75
4.4.2 William Baumol and James Tobin Approach to Demand for Money....... 75
4.4.3 Portfolio Approach to Demand for Money (James Tobin).......................... 76
Points to Remember............................................................................................................. 76
Questions.............................................................................................................................. 77
Contents v

Chapter 5: Supply of Money................................................................................. 78–90

5.1 Money Supply.............................................................................................................. 78
5.2 Meaning and Definition of Money Supply............................................................... 78
5.3 Evolution of Money..................................................................................................... 79
5.4 Components of Money Supply................................................................................... 79
5.4.1 Present Currency System in India............................................................... 80
5.5 Near Money................................................................................................................. 82
5.5.1 Money and Near Money................................................................................. 82
5.5.2 Definition and Meaning of Near Money....................................................... 82
5.5.3 Importance of the Concept of Near Money.................................................. 84
5.6 RBI’s Measures of Money Supply............................................................................. 84
5.6.1 Money Supply Measures: 1977...................................................................... 84
5.6.2 Modified Revised Measures of Money Supply (New Monetary and
Liquidity Measures): 1998............................................................................. 85
5.6.3 Liquidity Measures......................................................................................... 86
Points to Remember............................................................................................................. 89
Questions.............................................................................................................................. 90

Chapter 6: Central Bank: Credit Control Measures.................................... 91–108

6.1 Introduction................................................................................................................. 91
6.2 Functions of The Central Bank................................................................................ 91
6.3 Objectives of Credit Control Policy (Monetary Policy)........................................... 93
6.4 Methods and Instruments of Credit Control (Monetary Policy)........................... 93
6.4.1 Quantitative Instruments............................................................................... 94
6.4.2 Qualitative or Selective Credit Control Instruments................................ 103
Points to Remember........................................................................................................... 107
Questions............................................................................................................................ 108

Chapter 7: Commercial Banks: Multiple Credit Creation....................... 109–119

7.1 Introduction............................................................................................................... 109
7.2 Meaning and Functions of Commercial Banks..................................................... 109
7.3 Multiple Credit Creation.......................................................................................... 111
7.3.1 Basic Clarifications Regarding Multiple Credit Creation......................... 111
7.3.2 Balance Sheet of a Commercial Bank........................................................ 112
7.3.3 Assumptions................................................................................................... 113
7.3.4 Explanation of the Process of Multiple Credit Creation.......................... 113
7.3.5 Numerical Example...................................................................................... 114
7.3.6 Limitations and Criticism of the Multiple Credit Creation Process....... 116
7.4 Multiple Credit Destruction/Contraction................................................................ 117
Points to Remember........................................................................................................... 117
Questions............................................................................................................................ 118
vi Contents

Chapter 8: Quantity Theory of Money.......................................................... 120–147

8.1 Introduction............................................................................................................... 120
8.2 General Price Level and Value of Money.............................................................. 120
8.2.1 General Price Level...................................................................................... 120
8.2.2 Value of Money............................................................................................. 121
8.2.3 Background of the Quantity Theory........................................................... 122
8.3 Versions of the Quantity Theory of Money........................................................... 122
8.4 Classical or Cash Transactions Version................................................................. 123
8.5 Cambridge or Cash Balance Version of the Quantity Theory of Money........... 130
8.5.1 Statement of the Theory.............................................................................. 130
8.5.2 Brief Introduction to the Cash Balance Version....................................... 130
8.5.3 Points of Similarity between Fisher’s Transaction Approach and
the Cambridge Cash Balance Approach..................................................... 131
8.5.4 Explanation of the Cambridge/Cash Balance Version.............................. 131
8.6 Modern Version of the Quantity Theory................................................................ 138
8.6.1 Keynes Version of QTM............................................................................... 138
8.6.2 Friedman’s Quantity Theory of Money (1956)........................................... 140
8.6.3 Tobin’s Portfolio Balance Theory................................................................. 141
Points to Remember........................................................................................................... 145
Questions............................................................................................................................ 147

Chapter 9: Inflation and Deflation................................................................. 148–162

9.1 Introduction............................................................................................................... 148
9.2 Nature Characteristics of Inflation......................................................................... 148
9.2.1 Categories of Inflation.................................................................................. 148
9.3 Causes and Theories of Inflation............................................................................ 149
9.3.1 Demand-Pull Theory of Inflation (DPI)...................................................... 150
9.3.2 Cost-Push Inflation Theory (CPI) .............................................................. 151
9.3.3 Structural Theory of Inflation..................................................................... 153
9.4 Effects of Inflation.................................................................................................... 153
9.5 Control of Inflation................................................................................................... 155
9.6 Concept of Inflationary GAP (Keynes)................................................................... 156
9.7 Deflation: Causes and Consequences..................................................................... 157
9.8 Control of Deflation.................................................................................................. 158
9.9 Concept of Deflationary Gap................................................................................... 158
Points to Remember........................................................................................................... 159
Questions............................................................................................................................ 162

Chapter 10: Phillips Curve................................................................................ 163–175

10.1 Introduction............................................................................................................... 163
10.2 Statement of Phillips Curve.................................................................................... 163
10.3 Short Run Phillips Curve (SRPC) ......................................................................... 163
10.3.1 Original Phillips Curve (OPC)................................................................... 164
10.3.2 Modified Phillips Curve (MPC)................................................................. 165
Contents vii

10.3.3 Short Run Phillips Curve depicting the Trade-off between

Inflation and Unemployment.................................................................... 166
10.4 Long Run Phillips Curve......................................................................................... 167
10.4.1 Why does the Phillips Curve become Vertical in the Long Run?........ 168
10.4.2 Derivation of LRPC.................................................................................... 168
10.5 Policy Dilemma and Policy Implications............................................................... 169
10.6 New Policy Options.................................................................................................. 169
10.7 Stagflation................................................................................................................. 170
10.7.1 Explanation of the Causes of Stagflation................................................ 171
10.7.2 Concluding Comments................................................................................ 173
Points to Remember........................................................................................................... 174
Questions............................................................................................................................ 175

Chapter 11: Trade Cycles.................................................................................. 176–190

11.1 Introduction.............................................................................................................. 176
11.2 Meaning, Definition and Features of a Trade Cycle........................................... 176
11.2.1 Features/Characteristics of Trade Cycles................................................ 177
11.3 Phases of a Trade Cycle......................................................................................... 177
11.3.1 Types of Trade Cycles................................................................................ 180
11.4 Anti-cyclical Policies (Keynes)................................................................................ 181
11.4.1 Working of Anti-cyclical Policies: Monetary and Fiscal......................... 182
11.5 Some Theories of Trade Cycles.............................................................................. 185
11.5.1 Hawtrey’s Monetary Theory of Trade Cycles.......................................... 186
11.5.2 Schumpeter’s Theory of Innovations........................................................ 187
11.5.3 Keynes’ Theory of Trade Cycles............................................................... 188
Points to Remember........................................................................................................... 189
Questions............................................................................................................................ 190

Chapter 12: Classical Theory of Output, Income, Employment

Determination............................................................................... 191–204
12.1 Introduction.............................................................................................................. 191
12.2 Classical Macroeconomics....................................................................................... 191
12.2.1 Introduction to Classical Macroeconomics.............................................. 191
12.3 Basis of Assumption of Full Employment............................................................ 192
12.3.1 Say’s Law of Markets................................................................................. 193
12.3.2 Interest Rate Flexibility Mechanism....................................................... 197
12.3.3 Wage Flexibility Mechanism..................................................................... 199
12.4 Classical Theory of Output and Employment Determination............................ 200
12.4.1 Determination of the Level of Output..................................................... 201
12.4.2 Determination of the Level of the Employment..................................... 201
12.5 Summary of the Classical Model........................................................................... 203
Points to Remember........................................................................................................... 203
Questions............................................................................................................................ 204
viii Contents

Chapter 13: Keynes Theory of Output, Employment and

Income Determination................................................................ 205–223
13.1 Introduction.............................................................................................................. 205
13.2 Keynesian Theory: A Critique of the Classical Theory....................................... 205
13.3 Keynesian Theory of Output, Employment and Income Determination........... 206
13.3.1 Basic Assumptions of the Theory............................................................. 207
13.3.2 Outline of the Theory................................................................................ 207
13.3.3 Concept of Effective Demand (ASF and ADF)........................................ 207
13.3.4 Determination of Equilibrium Level of Output/Employment
(At Less Than Full Employment)............................................................ 211
13.3.5 Significance of Effective Demand............................................................. 213
13.3.6 Keynesian Remedy to Unemployment (Government Intervention)...... 214
13.3.7 Basic Points of Criticism of the Keynesian Theory............................... 217
13.4 Relevance of Keynes in Present Context.............................................................. 218
Points to Remember........................................................................................................... 218
Questions............................................................................................................................ 222

Chapter 14: Consumption Function............................................................... 224–235

14.1 Introduction.............................................................................................................. 224
14.2 Meaning of Consumption Function........................................................................ 224
14.3 Nature and Shape of the Consumption Function................................................ 225
14.3.1 Consumption Schedule............................................................................... 226
14.3.2 Consumption Function............................................................................... 227
14.4 Derivation of the Saving Function from the Consumption Function................ 227
14.4.1 Saving Function.......................................................................................... 228
14.5 Two Important Aspects of the Consumption Function (MPC and APC).......... 229
14.5.1 Marginal Propensity to Consume (MPC)................................................. 229
14.5.2 Marginal Propensity to Save.................................................................... 230
14.5.3 Average Propensity to Consume (APC)................................................... 230
14.6 Importance of MPC and Consumption Function.................................................. 231
14.7 Factors Affecting the Consumption Function....................................................... 231
14.7.1 Subjective Factors...................................................................................... 232
14.7.2 Objective Factors........................................................................................ 232
Points to Remember........................................................................................................... 233
Questions............................................................................................................................ 234

Chapter 15: Investment Function................................................................... 236–248

15.1 Introduction.............................................................................................................. 236
15.2 Meaning of Investment Function........................................................................... 236
15.3 Meaning of Investment in the Keynesian Analysis............................................. 236
15.4 Factors on which Investment Depends (Investment Function).......................... 237
15.5 Marginal Efficiency of Capital (MEC)................................................................... 238
15.5.1 Clarifications and Characteristics of the MEC....................................... 238
15.6 Determination of Rate of Interest in the Keynesian System............................. 239
Contents ix

15.7 Determination of Equilibrium Level of Investment in

the Keynesian Theory............................................................................................. 240
15.8 Factors Affecting MEC........................................................................................... 242
15.8.1 Short Run Factors.................................................................................... 243
15.8.2 Long Run Factors..................................................................................... 243
15.8.3 Shifts in MEC........................................................................................... 244
Points to Remember........................................................................................................... 246
Questions............................................................................................................................ 248

Chapter 16: Investment Multiplier and Principle of Accelerator......... 249–263

16.1 Introduction............................................................................................................. 249
16.2 Meaning and Definition Investment Multiplier.................................................. 249
16.3 Working of the Multiplier..................................................................................... 250
16.4 Assumptions of the Multiplier Analysis.............................................................. 251
16.5 Technical Derivation of the Investment Multiplier............................................ 251
16.6 Leakages from the Multiplier Process................................................................. 254
16.7 Shortcomings of the Multiplier Theory................................................................ 254
16.8 Importance of Multiplier........................................................................................ 255
16.9 Accelerator Principle.............................................................................................. 255
16.9.1 Meaning .................................................................................................... 255
16.10 Accelerator Coefficient........................................................................................... 256
16.11 Limitations of the Accelerator Principle.............................................................. 257
16.12 Relevance and Importance of the Acceleration Principle.................................. 258
16.13 Interaction of Multiplier and Accelerator to Explain Business
Cyclical Fluctuations.............................................................................................. 258
Points to Remember........................................................................................................... 262
Questions............................................................................................................................ 263

Chapter 17: Post Keynesian Developments: Monetarism........................ 264–272

17.1 Introduction............................................................................................................. 264
17.2 Meaning and Origin of Monetarism..................................................................... 264
17.2.1 Essence of Monetarism............................................................................. 264
17.2.2 Origin of Monetarism............................................................................... 265
17.3 Friedman’s Restatement of the Quantity Theory of Money (1956).................. 265
17.3.1 Clarifications............................................................................................. 265
17.3.2 Equation..................................................................................................... 265
17.3.3 Conclusion.................................................................................................. 266
17.4 Main Tenets of Monetarism.................................................................................. 267
17.5 Main Points of difference between Monetarists and Keynes............................ 268
17.5.1 Grounds on which Monetarists Advocated for Monetary Policy......... 268
17.5.2 Grounds on which Keynes Advocated for Fiscal Policy....................... 268
17.6 Comparison of Monetarists and Mainstream Economists................................. 269
17.7 Critical Review of the Main Tenets of Monetarism........................................... 271
Points to Remember........................................................................................................... 271
Question.............................................................................................................................. 272
x Contents

Chapter 18: Post Keynesian Developments: Supply Side Economics..........273–281

18.1 Introduction............................................................................................................. 273
18.2 Main Elements of Supply Side Economics.......................................................... 273
18.2.1 Retreat from Keynes’ Supply................................................................... 274
18.2.2 Greater Emphasis on Aggregate Supply................................................ 274
18.2.3 Reduction in Tax Rates............................................................................ 275
18.3 Laffer Curve Analysis............................................................................................ 276
18.4 Supply Side Response to Stagflation.................................................................... 278
18.5 Experience with Supply Side Economics............................................................. 279
Points to Remember........................................................................................................... 279
Questions............................................................................................................................ 281

Chapter 19: Public Finance.............................................................................. 282–289

19.1 Introduction............................................................................................................. 282
19.2 Meaning and Definitions....................................................................................... 282
19.2.1 Definitions of Public Finance.................................................................. 283
19.2.2 Characteristics of Public Finance........................................................... 283
19.3 Subject Matter and Scope of Public Finance...................................................... 283
19.3.1 Areas of the Study of Public Finance.................................................... 284
19.3.2 Branches of Public Finance..................................................................... 285
19.3.3 Positive and Normative Aspects of Public Finance ............................. 285
19.4 Social (Collective) and Merit Goods..................................................................... 285
19.5 Public Finance and Private Finance.................................................................... 286
19.5.1 Differences between Public and Private Finance.................................. 287
19.6 Significance and Importance of Public Finance.................................................. 288
Points to Remember........................................................................................................... 288
Questions............................................................................................................................ 289

Chapter 20: Budget: Meaning and Types..................................................... 290–302

20.1 Introduction............................................................................................................. 290
20.2 Meaning of the Budget.......................................................................................... 290
20.2.1 Features of a Budget................................................................................ 291
20.2.2 Budget Figures.......................................................................................... 291
20.2.3 Other Concepts Related to the Budget.................................................. 291
20.2.4 Basic Format of a Budget........................................................................ 291
20.3 Major Types of Deficits in the Budget................................................................. 293
20.3.1 Deficit Financing....................................................................................... 295
20.4 Approaches to Budget............................................................................................ 295
20.4.1 Balanced and Unbalanced Budget Approach......................................... 295
20.4.2 Automatic or Built-in Stabilisers and Discretionary Stabilisers......... 298
20.5 Objectives of the Budgetary (Fiscal) Policy......................................................... 300
Points to Remember........................................................................................................... 300
Questions............................................................................................................................ 301
Bibliography......................................................................................................... 303–304
Index...................................................................................................................... 305–309
Preface

This book titled Macroeconomics is a humble attempt to introduce students to the

various dimensions of macroeconomics. Beginning with an introduction to the concept
and approach of Macroeconomics, it moves on to deal with various aspects and issues
related to the subject in detail.
This book is an outcome of several years of lecture sessions and the teaching-
learning experience of the author at the undergraduate and postgraduate levels and
from the earlier works of the author on the theme of Macroeconomics. It has evolved
from actual classroom teaching and therefore adopts a conversational and lucid style
of communication which, it is hoped, would appeal to the students and the academic
fraternity. It attempts to deliver many macroeconomic concepts in a simple, yet
retaining its academic rigour.
This book is specially designed to facilitate the students to understand the various
macroeconomic variables, their structure, composition, behaviour and its applications
and relevance to real-world issues and in economic policy formulation.
This book is primarily directed to the second-year students of economics at
the undergraduate level. This book covers the syllabi of almost two semesters of a
macroeconomic course at the Bachelor of Arts (Economics) and Bachelor of Commerce
and also for those pursuing the BBA degree.
It covers an array of topics ranging from national income and related aggregates,
the demand and supply of money, the role of central banks, theories of output, income
and employment determination with special focus on Keynes theory, post Keynesian
developments like monetarism, supply-side economics. It also covers issues like
inflation, deflation, Phillips curve, trade cycles, public finance, budget, budgetary
deficits and so on. It has chosen to restrict itself to a closed economy and hence, does
not deal with issues of an open economy which requires a totally different treatment.
Every chapter deals with the issues at hand in an exhaustive manner beginning
with the concept and theory and integrates it with real data wherever relevant.
Statistics and data in the Indian context have also been provided wherever necessary
to expose students to real-world data and trends in the macro variables and therefore
bridge the gap between theory and reality. The chapter on Keynes theory of output,
income, and employment determination has a special section on the relevance of Keynes
to contemporary times based on a case study of the Global Financial Meltdown of
2008–2009.

xi
xii Preface

A summary of the chapter and key takeaways is also provided at the end of
every chapter in the section on ‘Points to Remember’ for students to grasp the essence
of the chapter. Also, a set of thought-provoking questions is provided at the end of
every chapter to help students test their understanding of the subject, and serve as
a guideline and framework for systematically understanding the flow and learning
outcomes of the chapter. Exercises and objective type of questions are provided for
some chapters for better clarification of concepts.
An exhaustive list of references is provided at the end of the book which includes
reference books, Government, RBI and other reports and also a list of websites for
ready reference.
It is hoped, that this book on Macroeconomics is well received by the students
since the style and approach to the book is meant to be student-friendly and facilitate
the understanding of macroeconomic concepts, theories and its relevance to the contem-
porary economic issues.
Any feedback on improving the content and delivery style of the book is most
welcome from both the economics teaching fraternity and the students, which will
surely enhance the quality of this book in its further editions.
A sincere appreciation for your interest in reading this book and best wishes to
the students on their educational journey!

Sunayini Parchure
Acknowledgements

Appreciating and acknowledging the contributions of those who have inspired and
encouraged me in this venture is going to be a difficult task because this book has been
the result of almost three decades of an enjoyable teaching and learning experience in
economics. Undoubtedly, therefore, my students are the first recipients of my sincere
thanks for the curiosity and the motivation they provided me to gather my thoughts
and class discussions into a formal book in macroeconomics.
I am grateful to Dr. S.B. Mujumdar, Founder & President, Symbiosis; Chancellor,
Symbiosis International University and Dr. Vidya Yeravdekar, Principal Director,
Symbiosis; Pro-Chancellor, Symbiosis International University who have always believed
that the ‘Student’ comes first, and this book is my humble contribution for the students.
I will forever remain thankful for their inspiration and support throughout.
This book on Macroeconomics is an outcome of my teaching career at Symbiosis
College of Arts and Commerce, Pune. Therefore, needless to say, here, I have found
an assortment of ideas, encouragement, beliefs, constructive critical inputs and finally
appreciation which kept me going in this endeavour and also in my earlier books
on this theme. I have received my ‘Big Push’ from various friends and colleagues at
Symbiosis, Dr. Hrishikesh Soman (Principal, Symbiosis College of Arts and Commerce),
Dr. Jyoti Chandiramani, Director, Symbiosis School of Economics and my colleagues at
the Departments of Economics and Banking Dr. Marcelle Samuel, Dr. Sheena Mathews,
Dr. Neelofar Raina, Mrs. Nalini Sapkal and Dr. Jini Jacob, my other colleagues and
friends Dr. Hilda David, Dr. Tessy Thadathil, Dr. Shirish Limaye and Mr. Anil Adagale.
All of them have always believed in me more than I do in myself. To all of them, my
sincere appreciation and thanks. Consciously or subconsciously they have been my
driving force.
A special thanks is due to Dr. Vasudha Garde, my co-author of the earlier books
which formed the basis of this book.
Angela Thomas, our very dear, dependable and academically oriented postgraduate
student in economics, has borne the brunt of painstakingly reading the manuscript time
and again typing, editing and putting it in the ‘Acceptable’ form as you see it today. A
special thanks to her for creating the first cut of the cover design from our scattered
ideas and imaginations, thank you, Angela, for your creativity and commitment! A
sincere word of appreciation to Mr. Shrinivas Jere and Mrs. Savita Jere for adding
their professional touches to the cover.
xiii
xiv Acknowledgements

There are some individuals who have been a silent but strong support in this
venture and deserve a special mention and thanks, our Librarian, Mrs. Vaishali Vaidya
for her very crucial support in technicalities of publications, Mrs. Eera Khedkar, Mrs.
Snehal Kulkarni, Mrs. Mrunmayee Kulkarni, Mr. Nitin Bhise and Mr. Nazir Sheikh
from our office for handling all unforeseen contingencies.
I would also sincerely like to extend my thanks to Mrs. Shivani Garg, Senior
Editor, PHI Learning Private Limited, Mr. Malaya Ranjan Parida and the whole team
of PHI Learning for providing me with this excellent opportunity to write a textbook
for their esteemed publishing house. Once again, a special thanks to Mrs. Shivani
Garg for mentoring me throughout the process of publication of this book with extreme
patience and positive inputs at every stage. A sincere appreciation to her and her team
for providing the finishing stroke to the cover of the book. The credit and thanks for
the detailing of the book to ensure minimum errors and also present it in its current
form goes to Mr. Ajai Kumar Lal Das and his team.
Finally, coming closer home, ‘My Family’ has been the ‘Invisible Hand’ who
restored equilibrium at every stage of the journey of this book, to them my heartfelt
thanks! A special gratitude to Professor Kamalakar Parchure, an eminent economist,
my father-in-law for his continuous guidance, his book, A Mini Textbook in Economics
written way back in 1976, was in fact, my first inspiration to write a book in Economics.
My sincere gratitude is also due to my mother-in-law, Mrs. Shyama Parchure, who
has been a strong source of support not only in this academic venture, but in many
of my activities both at the professional as well as personal levels.

Sunayini Parchure
CHAPTER

1
Macroeconomics

1.1 INTRODUCTION TO MACROECONOMICS

In order to understand the micro and macro approaches to economics, it is necessary
to begin with the subject matter of economics.
The subject matter of economics can be studied under three significant aspects:
1. The behavioural aspect
2. The technical aspect
3. The institutional aspect

Behavioural Aspect
Economics is a study of the economic behaviour of individual units and the economy
as a whole.
At the level of individual households, economics studies how individuals earn
their income, their expenditures, savings, investments, the household budget and all
related economic decisions.
Economics also deals in detail about the economic behaviour of firms and industries
which would involve the decisions related to production, consumption, costing, pricing
of products, market structures, equilibrium and so on. At the level of the economy,
economics is concerned with the economic behaviour of the economy as a whole. It
analyses major macro aggregates like national income, expenditure, aggregate demand,
supply, savings, investments, employment, and related variables.
The point to be noted is that economics is a study of economic behaviour at both
the individual level as well at the level of an economy.

Technical Aspect
The Technical aspect mainly deals with the three basic problems of economics:
1. What to produce?
2. How to produce?
3. For whom to produce?
1
2 Macroeconomics

(i) What to Produce? This problem in economics concerns itself mainly with
what are the goods and services to be produced—not only at the level of
individual firms and industries—but also, at the level of an economy. This
issue is mainly related to deciding the production pattern and Product-Mix.
(ii) How to Produce? The question of ‘how to produce?’ deals with the technique
or technology of production, basically emphasising on the choice between
labour and capital-intensive technology.
Further, the question of technology of production has to be tackled at the
individual as well as the economy level.
(iii) For Whom to Produce? The question of for whom to produce is related to
the distribution of income and determination of wages, rent, interest, profits
or the various factor shares and this problem has also to be tackled for the
individual units as well as the economy as a whole.

Institutional Aspect
In addition to the above two aspects, economics also studies the various institutions
involved in the economic process like the government, banks, financial institutions and
other infrastructural and institutional aspects.
In addition, there are a number of aspects like international trade, economic
welfare, economic growth, economic development etc. which are also a part of economics.

1.1.1 Definitions of Economics

and more important side, a part of the study of man.”3 implying thereby, that wealth
is a means to attaining human welfare, and not an end in itself.
With the Great Depression of 1929–1933, determination of output, employment
and income, the causes of fluctuations in economic activity and the policy responses
attracted the attention of economists. On the forefront of this school of economic
thinking was J.M. Keynes. According to Keynes, economics studies how the levels of
income and employment in an economy are determined.
With this, economics expanded its boundaries to include the problems of economic
growth, development, trade cycles and policies to stabilise economies, the role of fiscal,
monetary and other economic policies and so on. Economics was then defined as a social
science which concerns itself with the optimum use of limited resources for achieving
growth with stability.
As mentioned earlier, the resources of a country are scarce with unlimited wants.
Thus, economics is primarily concerned with decision making at all levels of the
economy and utilising the resources to optimise the benefit to individuals and also for
the economy and society. At the heart of the development process also lies the very
crucial objective of economic and social justice, which is recognised as a major policy
goal of the economic policies. A study of economics thus encompasses a wide array of
issues ranging from consumer and market behaviour, pricing, the problem of technology,
income and expenditure analysis, employment, economic welfare, economic and social
justice, fluctuations in economic activity and policy instruments to stabilise economies.
All these problems and issues have to be addressed at various levels, i.e. at
individual levels, e.g. households, firms, industries, sectors and also at the level of the
economy and hence the need for microeconomics and macroeconomics. Microeconomics
concentrates on economic issues at the individual unit level, and macroeconomics is
concerned with economic issues at the level of the economy.

Why Micro and Macroeconomics?

From the above analysis, there are two issues to be noted:
1. The subject matter of economics is very vast.
2. Almost all the economic issues have to be studied at different levels, i.e. at
the level of individual units and at the economic level.
It was therefore for the sake of:
• Convenience
• A systematic analysis
• Better policy analysis
that economics was divided into two approaches:
1. Microeconomic approach
2. Macroeconomic approach
wherein microeconomics would study individual units and macroeconomics studies the
economy as a whole.

3. Marshall, Alfred (1890 [1920]), Principles of Political Economy, Vol. 1, pp. 1–2 (8th ed.),
London, Macmillan.
4 Macroeconomics

1.2 MEANING AND NATURE OF MACROECONOMICS

1.2.1 Background of Macroeconomics

The term macroeconomics was first used by Ragnar Frisch in 1933. Macroeconomic
theory, as a formal theory, gained significance specially after the great depression of
1929–33. Prior to this period there was a strong belief in the working of the Purely
Capitalist Economy. It was felt that the Free Market Mechanism would ensure the
smooth functioning of the system. Therefore, what was more relevant during this time
were the microeconomic issues like resource allocation, determination of equilibrium of
firms and industries, individual welfare etc. For the first time in 1929–33, aggregate
problems like mass unemployment, falling investment, falling output, falling prices,
low national income began to emerge on a large scale.
There was an almost total collapse of the capitalist system the world over, and the
belief in the smooth functioning of the capitalist system came into doubt. It was at this
time that John Maynard Keynes presented his General Theory of Employment, Interest
and Money (1936) which discussed the causes and solutions to the Great Depression
and macroeconomics as a branch of economics gained popularity.

The main aspects of macroeconomics are:

1. It is a study of aggregates like national income, aggregate demand, aggregate
supply, aggregate expenditures, aggregate savings, aggregate investments,
general price level, etc.
2. It deals with the determination of these aggregates.
3. It also analyses the inter-relationships between these aggregates.
4. The final objective of any macroeconomic analysis is to formulate policies and
measures to stabilise the economy.

1.3 SUBJECT MATTER AND SCOPE OF MACROECONOMICS

Macroeconomics deals with the aggregates and averages of the economy. The
macroeconomic aggregates or variables include national income, total employment,
aggregate production, total consumption, savings and investments, aggregate demand
and aggregate supply, general level of prices, etc. The macroeconomic theory explains
how these aggregates and averages of the economy are determined, and what causes
fluctuations in them. It analyses the main determinants of economic growth and
development and the different stages and processes of economic growth.
Any macroeconomic analysis of the ‘aggregates’ basically involves the following
aspects:
1. A study of the level and composition of the aggregates
2. Trends in the growth rate of the aggregates
3. Causes of inadequate rates of growth
4. Policy measures and suggestions
The subject matter of Macroeconomics thus includes:
1. A study of aggregates in the economy
2. An analysis of the various macroeconomic policies
3. A study of major macroeconomic theories
A summary of the macroeconomic aggregates, macroeconomic policies, and major
macroeconomic theories are listed in Table 1.1.

TABLE 1.1 Subject Matter and Scope of Macroeconomics

Macroeconomic Macroeconomic Major Macroeconomic

Aggregates/Variables Policies/Instruments Theories
• National Income • Monetary Policy • Theory of Output, Employment
and Income determination
• National Output • Fiscal Policy • Theories of Growth
• Aggregate Expenditures • Trade Policy • Theories of Development
• Aggregate Employment • Industrial Policy • Theories of Business Cycles
• Aggregate Demand • Agricultural Policy • Theories of International Trade

(Contd.)
6 Macroeconomics

Macroeconomic Macroeconomic Major Macroeconomic

Aggregates/Variables Policies/Instruments Theories
• Aggregate Supply • Labour Policy • Monetary Theory
• Aggregate Saving • Price Policy • Theory of Public Finance
• Aggregate Investments • Income Policy • Theories of Inflation and Deflation
• Growth Rates • Growth policy • Macro-Theory of Distribution
• General Price Level • Employment Policy • Theory of Banking Finance
• Money and Banking System
• Government
• Rates of Interest
• Public Finance
• Foreign Sector
• Exchange Rates

Note: Macroeconomics deals with a detailed analysis of the above aggregates, policies and
instruments in an economy.

1.3.1 Explanation of Some Aggregates Studied under Macroeconomics

National Income
The focus of any macroeconomic study is the national income/GNP or GDP, and
most of macroeconomic analysis and policies are centred around this crucial variable.
Macroeconomics studies the determination of national income, its composition, trend,
rate of growth and also involves the formulation of macroeconomic policies to increase
national income. The national income and rate of growth in national income is a
reflection of a country’s level of growth and development.

Determination of National Output, Employment and Income

Macroeconomics deals with the determination of national output, employment and
income, and also studies the causes of slow growth rates, fluctuations in the levels of
output and employment, etc. This is referred to as the theory of output employment
and income determination.

Level of Aggregate Demand and Aggregate Supply

1. Macroeconomics studies the total production of goods and services in an
economy, its level and composition. The total production is also referred to
as the aggregate supply.
2. Aggregate demand is an extremely crucial variable, is an economy, and
the level of aggregate demand along with aggregate supply, determines the
equilibrium level of output/employment and income. Shortages in aggregate
Macroeconomics 7

demand can cause recession and unemployment, and excess aggregate demand
can cause inflationary tendencies.
3. Any fluctuation in aggregate demand causes fluctuations in the economy and
is one of the major reasons for business cyclical fluctuations in the economy.
Regulating and stabilising aggregate demand is a major macroeconomic policy
objective.

Aggregate Savings and Aggregate Investment

Macroeconomics analyses the level of aggregate savings and aggregate investments in an
economy. The level of savings and investments is extremely crucial for determining the
level of capital formation and hence, the level of output in an economy. Macroeconomics
studies the level, the fluctuations, the causes of under or over investment and its impact
on the economy. The volume and behaviour of savings and investments are significant
in determining the growth path of an economy.

Economic Growth and Development

1. A major focus of the study of macroeconomics is achieving a high rate of
growth for the economy measured in terms of increases in the Gross Domestic
Product (GDP).
2. The theories of economic growth and development are a major area of
macroeconomics.

General Price Level (GPL)

1. Macroeconomics is concerned with the study of the general price level, i.e. the
average level of prices of all goods and services in an economy.
2. Movements in the GPL indicate the inflationary and deflationary trends in
an economy.
3. Macroeconomics also seeks to understand how the GPL is regulated and the
policies related to this.

Interest Rates
Macroeconomics studies the determination of interest rates, fluctuations in interest
rates, its impact on the economy and also its regulation and control.

Money and Banking System

The macroeconomic analysis deals with:
1. Demand for money
2. Supply of money
3. Entire banking and financial system
4. Monetary and credit policies

Government
Macroeconomics studies a number of aspects related to the government, which include:
8 Macroeconomics

1. Revenue and Expenditures

2. Budget
3. Fiscal policy
4. Financial administration
5. Government borrowing and debt
6. Public sector

International Trade and Policies

Macroeconomics deals with a complete analysis of the foreign or external sector and
all aspects related to it, namely:
1. International trade/transactions
2. Balance of Payments
3. Exchange Rates
4. Domestic and Foreign Investment
5. External stability

Business Cycles/Trade Cycles

1. Macroeconomics is not only concerned with the growth of the economy but
also with fluctuations in the level of economic activity.
2. It involves an in-depth study of the causes of the cycles and its solutions.
The scope and subject matter of macroeconomics, therefore deals with all the
aggregates in detail and also its inter-relationships.
Macroeconomics is thus a study of the functioning of the entire economy and is
a very comprehensive approach to economics.
The major issues addressed in macroeconomics include:
1. Level and fluctuations in national income.
2. Issues relating to fluctuations in the average level of prices, i.e. inflation and
deflation.
3. Issues relating to fluctuations in the general level of money wages.
4. Issues relating to the optimum allocation of resources between the production
of consumer goods and capital goods.
5. Issues relating to the rate of growth in an economy.
6. Issues related to international trade.
7. Issues related to levels of employment in an economy.
8. Issues concerning stabilisation of the economy mainly through the fiscal and
monetary policy and other macroeconomic policy.

1.4 SIGNIFICANCE OF MACROECONOMIC STUDY

Macroeconomics deals with the dynamic functioning of an economy and is significant
on the following grounds.
Macroeconomics 9

Analysis of Macroeconomic Variables

Macroeconomics is a study of major macroeconomic variables and aggregates in an
economy. It helps to understand crucial variables like national income, aggregate
demand, savings, investments, interest rates and so on. It also deals with an analysis
of these variables and their inter-relationships.

Functioning of an Economy
Macroeconomics helps in understanding the complex working of an economy. It analyses
inter-relationships between production, consumption, distribution, government and rest
of the world. It shows how an economy reproduces itself and moves along the path of
economic growth and development. It shows how an economy attains equilibrium, the
causes of disequilibrium, and the measures to stabilise an economy.

Economic Growth and Development

One of the major goals of an economy is to attain economic growth and development.
Macroeconomics addresses these issues and analyses how an economy can achieve
economic growth and development. It deals with the factors affecting growth, the
various models and theories of growth and development, the constraints to growth,
and economic policies to overcome the same.

Business Cycles
Macroeconomics seeks to explain the causes of fluctuation in economic activity. It
provides an in-depth analysis of the theories and characteristics of the causes of
trade and business cycles and also addresses the policies that can help to stabilise an
economy.

Macroeconomic Policies
There are some crucial macroeconomic policies of a government like monetary, fiscal,
industrial, trade, price, agricultural policy and so on. Macroeconomics provides deep
insights into how these policies are formulated, what are the objectives of such policies,
and how these policies can be implemented.

Useful for Monetary Analysis

Macroeconomics explains the details of the entire monetary and financial sector. It
deals with the functioning of banks, financial institutions, it also deals with problems
of inflation, deflation, and how the central bank tries to regulate the price level. It
also analyses relationships between money supply, interest rates, investments, prices,
and other variables.

Explains Interrelationships between Micro and Macro Analysis

Any macroeconomic analysis requires details on microeconomic aspects of an economy
and working of individual units for a macroeconomic analysis.
10 Macroeconomics

1.5 LIMITATIONS OF MACROECONOMICS

Though macroeconomics is a study of aggregates of an economy, many a time, such
generalisations may ignore certain differences at the individual levels. At times a
simple macro aggregation may not be able to do justice to all issues. The main
limitations of a macroeconomic approach are:

The problem of Aggregation

Many times it is not possible to have a simple aggregation of micro-units due to
the heterogeneity of these units. Hence there is a need for a different treatment for
individual units and for the economy as a whole.

Ignoring Individual Differences

Macroeconomics may not be able to capture the individual differences of micro-units.
It is necessary to understand the specific characteristics of individual units in the
aggregation process for a systematic macro analysis.

Macroeconomics may Ignore Individual Behaviour

Changes in macro variables may not always reflect the behaviour of individual units.
For example, if the general level of prices is increasing, it does not necessarily imply
that the prices of all individual goods are rising. For this purpose, it is necessary to
have a detailed study of individual units.

Macroeconomic Policy Formulation Requires Inputs from all Micro-units

For a meaningful macroeconomic policy formulation, it is necessary to have detailed
information on the composition, behaviour and trends of micro variables. For example,
if any anti-inflationary policy has to be designed at the macro level, it is necessary to
have information on the behaviour of individual prices.

Paradoxes in Macroeconomics
Many times, generalisations from micro-units to macro solutions are not possible and
may lead to entirely paradoxical situations. This paradox states that ‘What is good
for an individual may not be good for the economy as a whole’. For example, saving
is a private virtue but a public vice. It is thus necessary to have both the micro and
macro approaches to economics.
The two approaches micro and macro are thus strongly integrated.

1.6 MACROECONOMIC PARADOX (FALLACY OF COMPOSITION)

The macroeconomic paradox arises from the basic definition of macroeconomics as being
a study of aggregates. It has been observed that a number of times an aggregation
of microanalysis or solutions need not necessarily give a perfect macro solution. In fact,
many times, such a simple aggregation leads to an utterly paradoxical situation
giving rise to the macroeconomic paradox or the ‘Fallacy of Composition’. This paradox
can be stated in two ways:
Macroeconomics 11

1. What is good for an individual need not necessarily be good for the economy
as a whole.
2. What applies to a particular unit need not necessarily apply to the economy
as a whole.
The macroeconomic paradox can be explained with the help of some examples.

Paradox of Savings
At individual level savings is good and is in fact, advocated. However, if the entire
economy only saves, it would mean there would be no investments, no production and
the economy would stagnate. This proves the point that savings is a private virtue but
a public vice. Hence, what is good for an individual need not be good for the economy
as a whole.

Technology Case
For individual units seeking to maximise profits, what is generally advocated is a
capital-intensive technology. However, in a labour surplus economy, such technology
if applied to the entire economy, would in fact generate a problem for the economy in
the form of huge unemployment of labour.

Money Wage-cut Paradox

An essential macroeconomic paradox is a wage-cut paradox. The Classical economists
had advocated a money wage cut at the micro or industry level to solve the problem
of unemployment, wherein an industry by reducing its wages in a labour surplus
economy would be able to increase employment. However, if such a policy is followed
at the macro level, it would create a paradoxical situation. If wages fall at the macro
level, purchasing power declines, this causes a decline in aggregate demand and thus
a decline in output and employment. Thus, wage cut at the macro level leads to a fall
in the employment level creating a macroeconomic paradox.

Bank Withdrawals
If on a particular day a number of withdrawals take place from a bank it would create
a problem at the macro level.
As a result of the above paradoxical situations, it is quite clear that generalisations
from micro to macro cannot always be made. Therefore, there is a need to have a
separate analysis, separate techniques and separate instruments to solve the problems
at the micro and macro levels. Therefore, the need for the two approaches.
The justification for a separate macro approach to the study of several economic
problems lies in the fact that the micro approach is not only inadequate but may lead
to altogether paradoxical conclusions at the macro level.
In economics, what is true of a part is not necessarily true of the whole. This
is the paradox of macroeconomics or fallacy of composition. So also, what is true of
the whole economy may not be true for a particular individual. During a period of
recession, for example, an individual’s savings may be good for him, but if everybody
starts saving the recession will become worse.
12 Macroeconomics

Thus, there are two different levels of analysis to explain the laws concerning
economic behaviour.
1. The level of macroeconomics explains the working of the economy as a whole
or its aggregates. Macroeconomics is concerned with providing a general
outline of the structure of the economy and the relationships between the
major aggregates which constitute the economy.
2. Microeconomics is concerned, on the other hand, with specific economic units
and includes variables such as the output of a specific product, the number
of workers employed by a particular firm or industry, the revenue income of
particular employed firm/household, an expenditure of a firm/household.
However, the generalisations which are valid at one of these levels of analysis
may or may not be valid at the other. It, therefore, becomes necessary to have two
approaches to economics, i.e., micro and macro.

1.7 NEED FOR INTEGRATING MACRO AND MICROECONOMICS

Though economics was divided into two approaches: the micro and macro approach,
these branches are not watertight and in fact, complement each other. To have a
meaningful macroeconomic analysis, it is necessary to have detailed information and
analysis of the micro or individual units. For example, if an economy is facing inflation,
to be able to formulate any macroeconomic policy to address this issue, details of
individual prices of goods and services is required.
Further, an analysis of microeconomic issues, even though they are considered at
an individual level, finally adds up to providing an aggregate analysis.
Therefore, an integration of these two approaches is essential for understanding
and analysing economic problems and for the formulation of economic policies.

1.8 DISTINCTION BETWEEN MICRO AND MACROECONOMICS

The main points of distinction is given in Table 1.2.

TABLE 1.2 Distinction between Micro and Macroeconomics

Microeconomics Macroeconomics
1. Study of the economic behaviour of individual Study of the average and aggregate level
decision-making units such as consumers, of economic activity and of the economy
resource owners, and business firms. as a whole.
2. Microeconomic variables include the price Macroeconomic variables include the
of a particular commodity, a product of a total level of output, the level of national
particular firm, employment of a particular income, the total level of employment,
firm, an income of a household, demand for savings, investments, the general level
a particular product, the supply of particular prices and so on.
a product, etc.
Macroeconomics 13

Microeconomics Macroeconomics
3. Scope of microeconomics covers the theory of Scope of macroeconomics covers the
product, pricing, factor pricing (distribution), determination of national output and
the theory of production and welfare employment, public finance, interna-
economics. It explains the functioning of a tional trade, monetary and fiscal policies,
market economy and explains the allocation the macro theory of distribution etc. It
of resources and distribution of income. explains how economic growth and deve-
lopment takes place in an economy and
also deals with fluctuations in an economy

APPENDIX
Some Major Macroeconomic Policies and Instruments
Policy Instruments
Monetary Policy A. Quantitative Methods
1. Bank Rate
2. Open Market Operations
3. Variable Reserve Ratios
4. REPO and Reverse repo rates
5. Statutory liquidity ratio
B. Qualitative Methods
1. Minimum Margin Requirements
2. Moral Suasion
3. Credit Rationing
Fiscal Policy 1. Taxes
2. Public Expenditure
3. Public Debt
4. Deficit Financing
Income and Price Policies 1. Regulation of Wages and Income Price Controls
(price ceilings, minimum prices, dual prices etc.)
2. Rationing of Goods.
Exchange Rate Policies 1. Devaluation
2. Depreciation
3. Export Promotion
4. Import Substitution
5. Direct Exchange Controls
6. Import Quotas
7. Foreign Exchange Regulations
Foreign Trade Policies 1. Free Trade Policy
2. Policy of Protection
3. Tariffs, Quotas, Subsidies
4. Exchange Controls
5. Commodity Arrangements
6. International Cartels
14 Macroeconomics

Points to Remember
• The basic economic problem is that of the scarcity of resources and unlimited
use of these resources.
• The fundamental problems facing any economy include allocation of resources,
distribution of income and economic growth.
• The study of economics is divided into two parts—microeconomics and
macroeconomics.
• Microeconomics deals with the behaviour of small parts of the economy—for
example, the behaviour of the household and the behaviour of the firm.
• Microeconomic variables include factors like income of a household, savings of
a household, sales of a firm’s product, employment at the level of a firm.
• Macroeconomics deals with the behaviour of the economy as a whole.
• Major macroeconomic theories include Theory of Income and Employment,
Theory of Inflation, Deflation, Business Cycles, Economic Growth, and the
Macroeconomic Theory of Distribution.
• Macroeconomic variables include factors like the National Income, national
savings, employment at the national level. GNP, GDP, Aggregate Supply/
Aggregate Demand, Aggregate Savings/Aggregate Investment, the General Price
Level, Money Supply, Employment, Rates of Interest, Exchange Rates, etc.
• An integrated study of economics at micro as well as macro level help understand
the nuances of the subject.

ANNEXURE
1. Static and Dynamic Economics
• In the context of discussing macro and micro issues, it is necessary to
understand two crucial concepts, i.e. static and dynamic economics.
• Static economics deals with a point of equilibrium and analyses all
variables at a particular point of time. For example, it shows the equilibrium
level of prices determined by the equality between demand and supply at
a point of time and explains the equilibrium condition at this point. All
economic variables are considered to be at a static level and hence, such
an analysis is also referred to as a static economic analysis.
• Dynamic economics on the other hand shows the process by which the
equilibrium is attained. It shows how the various variables change and
adjust to reach the level of equilibrium and also deals with situation of
disequilibrium.
• For example, if the demand for a good is greater than the supply the
prices will start rising. As a result, demand with decrease and supply will
increase and the new equilibrium will be restored. This process of change is
Macroeconomics 15

analysed in dynamic economics which deals with changes in the variables

overtime.
• Static economics considers many crucial variables to be constant whereas
dynamic analysis is more realistic since it explains and analyses the
changes in the variables.
• Both the static and dynamic analysis are complementary to each other and
equally significant in the economic analysis.
2. Key Macroeconomic Indicators

ANNEXURE TABLE 1.1 Growth Rate of GVA at Basic Price at Constant (2011–12) Prices (in %)

2016–17 2017–18 2018–19

Industry 2012–13 2013–14 2014–15 2015–16*
(2nd RE) (1st RE) (PE)
I. Agriculture 1.5 5.6 – 0.2 0.6 6.3 5.0 2.9
II. Industry 3.3 3.8 7.0 9.6 7.7 5.9 6.9
Mining & quarrying 0.6 0.2 9.7 10.1 9.5 5.1 1.3
Manufacturing 5.5 5.0 7.9 13.1 7.9 5.9 6.9
Electricity, gas & 2.7 4.2 7.2 4.7 10.0 8.6 7.0
water supply
Construction 0.3 2.7 4.3 3.6 6.1 5.6 8.7
III. Services 8.3 7.7 9.8 9.4 8.4 8.1 7.5
Trade, hotels,
transport,
communication & 9.8 6.5 9.4 10.2 7.7 7.8 6.9
services related to
broadcasting
Financial services,
real estate & 9.7 11.2 11.0 10.7 8.7 6.2 7.4
professional services
Public administration,
defense and other 4.3 3.8 8.3 6.1 9.2 11.9 8.6
services
GVA at basic price 5.4 6.1 7.2 8.0 7.9 6.9 6.6

*: Third Revised Estimates, RE: Revised Estimates, PE: Provisional Estimates

Source: National Statistical Office.
Related website link: http://www.mospi.gov.in/sites/default/files/press_release/Press%20Note%20
PE%202018-19-31.5.2019-Final.pdf
16 Macroeconomics

ANNEXURE TABLE 1.2 Sectoral Share in GVA at Basic Price at Current Prices (2011–12 Series) (in %)

2015– 2016–17 2017–18 2018–19

Industry 2011–12 2012–13 2013–14 2014–15
16* (2nd RE) (1st RE) (PE)
I. Agriculture 18.5 18.2 18.6 18.2 17.7 17.9 17.2 16.1
II. Industry 32.5 31.8 30.8 30.0 30.0 29.4 29.3 29.6
Mining & 3.2 3.1 2.9 2.7 2.3 2.3 2.3 2.4
quarrying
Manufacturing 17.4 17.1 16.5 16.3 17.1 16.8 16.4 16.4
Electricity, gas 2.3 2.3 2.5 2.5 2.7 2.5 2.7 2.8
& water supply
Construction 9.6 9.2 8.9 8.5 7.9 7.8 7.8 8.0
III. Services 49.0 50.0 50.6 51.8 52.3 52.7 53.5 54.3
GVA at basic 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
price

*: Third Revised Estimates, RE: Revised Estimates, PE: Provisional Estimates

Source: National Statistical Office.
Related website link: http://www.mospi.gov.in/sites/default/files/press_release/Press%20Note%20
PE%202018-19-31.5.2019-Final.pdf

ANNEXURE TABLE 1.3 Ratio of Savings and Investment to GDP (in %)

Item 2011–12 2012–13 2013–14 2014–15 2015–16* 2016–17# 2017–18@

1 Gross Domestic saving 34.6 33.9 32.1 32.2 31.1 30.3 30.5
2 Public sector 1.5 1.4 1.0 1.0 1.2 1.7 1.7
2.1 Public non-financial 1.4 1.2 1.1 1.0 1.1 1.1 1.4
corporation
2.2 Public financial 1.9 1.8 1.5 1.4 1.3 1.3 1.3
corporations
2.3 General Government –1.8 –1.6 –1.5 –1.4 –1.2 –0.8 –1.0
3 Household Sector 23.6 22.5 20.3 19.6 18.0 17.1 17.2
3.1 Gross financial 10.7 10.7 10.6 10.1 10.9 9.4 10.9
savings
3.2 Financial liabilities 3.3 3.3 3.2 3.0 2.8 3.1 4.3
3.3 Savings in physical 15.9 14.7 12.6 12.1 9.6 10.5 10.3
assets
3.4 Savings in the form 0.4 0.4 0.3 0.4 0.3 0.3 0.2
of valuables
4 Private Corporate 9.5 10.0 10.7 11.7 11.9 11.5 11.6
Sector
Macroeconomics 17

Item 2011–12 2012–13 2013–14 2014–15 2015–16* 2016–17# 2017–18@

4.1 Private non-financial 8.3 8.7 9.6 10.3 11.1 10.7 10.8
corporation
4.2 Private financial 1.2 1.3 1.2 1.4 0.8 0.9 0.9
corporation
5 Private Sector (3+4) 33.1 32.5 31.1 31.2 29.9 28.6 28.8
6 Net capital inflow 4.3 4.8 1.7 1.3 1.0 0.6 1.8
from ROW
7 Gross Capital Forma- 39.0 38.7 33.8 33.5 32.1 30.9 32.3
tion (Investment)
8 Saving-Investment Gap 4.3 4.8 1.7 1.3 1.0 0.6 1.8
9 GDP at Current Prices 100 100 100 100.0 100.0 100.0 100.0

*: Third Revised Estimates; #: Second Revised Estimates; @: First Revised Estimates

Note: Gross financial savings & liabilities of household sector includes gross financial savings
& liabilities of quasi corporate sector.
Source: National Statistical Office.
Related website link:
http://www.mospi.nic.in/sites/default/files/press_release/FRE%20of%20National%20
Income%2C%20Consumption%20Expenditure%2C%20Sa ving%20and%20Capital%20
Formation%20For%202017–18_0.pdf

QUESTIONS

I. Short Questions
1. “Macroeconomics is a study of aggregates.” Explain.
2. Why was it necessary to classify economics into micro and macro economic
approaches?
3. “Micro and Macro economics are interrelated and interdependent.” Explain.
II. Long Questions
1. Explain the distinguishing features of macroeconomics and microeconomics.
Elaborate in detail the scope and subject matter of macroeconomics.
2. Discuss the scope of macroeconomics on three counts:
(a) Macroeconomic aggregates and variables
(b) Macroeconomic policies
(c) Macroeconomic variables.
CHAPTER

2
National Income

2.1 MEANING OF NATIONAL INCOME

National Income is the most significant macroeconomic variable in an economy. It is
the monetary measure of the volume of production of an economy and is an indicator
of a country’s performance and status.
Very simply, the National Income refers to the value of the final goods and
services produced during a year in an economy.
Popularly, National Income is considered to be the GDP or Gross Domestic
Product of the country and is an indicator of the country’s growth and performance.
The National Income is a measure of the current level of economic development of
an economy and the trends in the National Income of a country reflects its economic
progress. It should be noted at the outset that National Income can be interpreted in
three ways:
1. National Product: In this approach National Income is measured as the
money value of all goods and services (i.e. total product) in an economy during
a given period of time.
2. National Income or Dividend: Under this approach, National Income
is defined as a ‘sum total of all incomes’ in cash or kind, which factors of
production earn in the process of producing goods and services.
3. National Expenditure: This approach views National Income as an
aggregate of the total expenditures in an economy (consumption expenditures,
capital expenditures, and other forms of expenditures)
The above approaches to viewing National Income gives rise to the three main
methods of calculating National Income, i.e., the product method, the income method,
and the expenditure method. All these approaches to calculating National Income give
the same figures, therefore:
National Product = National Income = National Expenditures
This chapter focuses on the meaning and definitions of National Income, its
importance, the related concepts of National Income, the methods of estimating National
18
National Income 19

Income, and difficulties faced therein. This chapter also deals with the circular flow of
income mechanism which is central to all economic activity.

2.2 DEFINITIONS AND FEATURES OF NATIONAL INCOME

2.2.1 Definitions of National Income

Alfred Marshall: “The labour and capital of a country acting on its national resources
produce a certain net aggregate of commodities, material and immaterial including
service of all kinds. This is the true net annual income or revenue of the country or
national dividend1”.
A.C. Pigou: “National Income is that part of objective income of the community
including of course income derived from abroad which can be measured in money2”.
Simon Kuznets: “National Income is the measure of value of the net output
of commodities and services produced by the private and public enterprises of the
economy3”.

2.2.2 Features of National Income

From the above definitions and an understanding of the National Income, some aspects
of National Income are given below.
1. It is the most significant macro ‘aggregate’ or ‘variable’.
2. National Income is the monetary value of a country’s total output, i.e., goods
and services.
3. It is calculated on an annual basis.
4. It is a flow concept.
5. Output produced within the domestic economy as well as income accruing
from abroad enters National Income calculations.
6. It includes the value of only final goods produced in an economy.
7. Double counting of National Income is avoided by using the value-added
concept.
8. Value of only marketed goods are included in National Income.
9. There is a distinction between Net and Gross National Income concepts.
10. Only first-hand transactions during the current year are included in National
Income, i.e., it is value of only currently produced goods and services.
11. National Income can be approached or measured in three ways: a sum total
of national product (in value terms), a sum total of national dividends or
income, and a sum total of national expenditures.

1. Marshall, Alfred, Principles of Economics, New York, Ny, Cosimo Books, 2009.
2. Pigou, A.C., et al. The Economics of Welfare, Houndmills, Basingstoke, Hampshire; New York,
Palgrave Macmillan, 2013.
3. United States. Bureau of Economic Analysis, United States. Bureau of Foreign and Domestic
Commerce. Survey of Current Business, U.S. Department of Commerce, Bureau of Economic
Analysis, 1941, 27 Oct. 2014.
20 Macroeconomics

Summing up, National Income can be defined as the value of currently produced
final goods and services in an economy during a given period, i.e., a year.

2.3 NATIONAL INCOME AND RELATED CONCEPTS

There are a number of important concepts in relation to the discussion of the National
Income. Each concept has its own meaning and is significant in National income
accounting and analysis.
Some of the concepts crucial to an understanding and analysis of National Income
are given below:
• GDP
• GNP
• GDP/GNP at Market Price
• GDP/GNP at Factor Cost
• NNP
• NDP
• Personal Income
• Personal Disposable Income
• Nominal Income
• Real Income
• GDP/GNP Deflator.

2.3.1 Gross Domestic Product (GDP)

The Gross Domestic Product is the most significant measure of a country’s total
output of goods and services. It is the most crucial measure of an economy’s growth,
performance and economic position.

Definition
GDP has been defined as the value of all final goods and services produced within a
country during a given period (The period is generally a year, and the output is valued
at market prices)

Clarifications
1. Only the value of final goods is considered in the GDP or National Income
calculations.
2. Final goods/services are those goods which are ready for final consumption.
They are different from intermediate goods which are in the process of
production and are used in producing the final goods.
3. In order to calculate the value of final goods, the concept of value-added is
used.
4. The value-added method states that at every stage of production, only the
value added to the product should be included in National Income calculations.
A sum of all such ‘value added’ in the total economy will give the GDP.
National Income 21

For example, if a bike is being sold at ` 50,000 and the value of its spare
parts and other intermediate goods, i.e., inputs is ` 20,000, the value added
at the final stage of production is ` 30,000 and not ` 50,000.
(Details of the concept of value Added are given in section 2.5.1 of this chapter.)
5. GDP refers to only currently produced output, i.e., in the current year which
are also referred to as first-hand transactions.
6. It excludes second-hand transactions, i.e., resale of earlier goods, real estate,
etc.
7. GDP also refers to the value of total goods and services produced within a
nation, i.e., in the domestic country. Therefore, it is also a territorial concept.
8. The word ‘gross’ implies that no provision for depreciation in the calculation
of GDP is made. The concept of Net National Product (GNP) was computed
to account for depreciation or replacement allowances.

2.3.2 Gross National Product (GNP)

From understanding the concept of GDP one can now move on to a broader concept,
i.e., the GNP.

Definition
Gross National product (GNP) is the value of final goods and services produced by
domestically owned Factors of Production within a given period.

Clarifications
The difference between GNP and GDP can be explained as given below:
1. In any economy, some output produced in the domestic country is made
by factors of production owned by a foreign nation, so also some domestic
nationals contribute to production in foreign countries.
2. In an open economy, i.e., where international trade and transactions are
allowed, some citizens earn income from abroad by working abroad. This
results in an income inflow into the country.
3. Foreign nationals working in the domestic country earn their income in the
domestic country which is remitted to a foreign country resulting in an income
outflow from the domestic economy.
4. This gives rise to the concept of Net Foreign Income (NFI).
5. The items of Foreign Income outflows and inflows include:
(a) Remittances
(b) Interest payment/receipts on borrowed capital
(c) Dividend on Foreign/Domestic equity capital
(d) Royalties
(e) Insurance receipts and payments, etc.
The income inflows result in international receipts and international payments
result in income outflows. The difference between income outflow and inflow is the Net
Foreign Income (NFI). (Remittances are a very prominent component of the National
22 Macroeconomics

Income flows). In order to arrive at the GNP from the GDP concept, the Net Foreign
Income has to be taken into account.
Therefore, GNP = GDP + NFI
where, NFI is the Net Foreign Income.

2.3.3 GNP at Market Prices (GNPMP) and GNP at Factor Cost (GNPFC)
From an understanding of the GDP and GNP concepts, one can move further to two
related concepts.
1. GNP at Market Prices
2. GNP at Factor Prices
Note: This explanation also applies to GDP at Market Prices (GDPMP) and GDP at
Factor Cost (GDPFC).
1. GNP at Market Prices: GNP at market prices is the total output produced during
a year valued at its market prices.
This would give the current market value of the GNP of an economy.
It can be stated as:
GNPMP = Gross value of Final goods / services + Net Foreign Income (NFI)

2. GNP at Factor Cost (GNPFC): GNP at factor cost is the total value of income
produced by and accruing to the factors of production. It is an aggregation of incomes
that the factors receive in the process of production for the services they render.
It is defined as: The sum of money value of income produced by and accruing to
various factors of production in a given year, in a country.
It is calculated as:
GNPFC = GNPMP – Indirect Taxes + Subsidies.
Note:
1. GNP at market prices includes the indirect taxes that are levied by the
government. These indirect taxes are not received by the factors as income
and therefore, have to be deducted in the first step to arrive at GNPFC.
2. Further, sometimes the cost of producing a commodity to producer may be
higher than price of commodity in the market, in such cases, the government
may provide a subsidy to the producer to cover the gap between price and cost
of production of the commodity. This is done in order to protect the producer.
This subsidy has to be added to the GNPMP to arrive at the GNPFC.
3. Therefore, to arrive at GNPFC from GNPMP the following numerical example
can be considered:
Suppose,
• GNPMP = ` 100 (this is also the sales revenue)
If a 10% indirect tax is introduced,
GNPFC = 100 – 10 = ` 90
(` 10 is the tax at 10% on ` 100)
National Income 23

• If a subsidy of ` 5 is given to the producers by the government, this amount

has to be added to the GNPMP to arrive at GNPFC.
GNPFC = GNPMP – Indirect Taxes + Subsidies
or GNPFC = 100 – 10 + 5
GNPFC = 95

Significance of GNPFC
GNPFC shows the total income which is received by the various factors of production
in the form of wages, rent, interest, profit and so on. It is useful to analyse income
distribution and changes therein.
Moving from ‘Gross’ Concepts to’ Net ‘Concepts
1. The Gross Domestic and Gross National Product concepts show the total value
of goods and services produced in an economy, it however does not account
for the depreciation or wear and tear of machinery which takes place in the
process of production.
2. In the process of production, some machinery and equipment wear out, some
become obsolete. All this is known as depreciation or capital consumption
allowance. It is necessary to make provision and account for the replacement
of this machinery or capital in future.
3. In order to account for depreciation in National Income calculations the Net
National Income concepts are introduced.
• The Net National Product: NNP = GNP – Depreciation
• The Net Domestic Product: NDP = GDP – Depreciation
• NNP at Market Prices: NNPMP = GNPMP – Depreciation.
• NNP at Factor Cost: NNPFC = NNPMP – Indirect Taxes + Subsidies.
The NNPFC is the National Income of a Country
All these “Net” concepts mainly account for depreciation or the wear and tear of
machinery and capital in the process of production and gives an idea of the magnitude
of expenditure required to replace the same.

From National Income to Personal Income

From National Income one can proceed to explain the concept of personal income and
personal disposable income.

2.3.4 Personal Income

There is a basic difference between National Income and personal income. Personal
income refers to the total income received by the individuals. To arrive at the personal
income some items have to be deducted and some added to the National Income.
Personal Income (PI) = National Income (NNPFC) – Corporate Income Tax – Undistributed
Corporate Profit – Social Security Contributions + Transfer
Payments + Interest on Public Debt.
24 Macroeconomics

Items accounting for difference between National Income and Personal Income:
1. Undistributed Income: Some component of income is called undistributed
income. It includes corporate taxes, undistributed corporate profits, retained
earnings, etc. This is a part of National Income but not personal Income.
2. Social Security Contributions: Individuals/employees make certain social
security contributions like provident funds, PPF contribution, contribution
to gratuity, or some welfare schemes. This component is not received by the
individuals as income and therefore is a part of National Income but not
personal income.
3. Transfer Payments: Transfer payments refer to unilateral transfer of funds
by the government to individuals like pensions, gifts, unemployment doles
and other such welfare payments. These are included in personal income but
not in National Income because although it is a monetary transfer of funds
in the nature of incomes, it does not generate any corresponding production
of goods/services. Hence it is not a ‘productive’ activity.

TABLE 2.1 Differences between National Income and Personal Income

National Income Personal Income

⇒ Total income received by the factors of ⇒ Total income actually received by the
production in a year (NNPFC). individuals during a year.
⇒ Includes corporate taxes. ⇒ Excludes corporate taxes.
⇒ Excludes transfer payment. ⇒ Includes transfer payments.
⇒ Excludes social security benefits like PF, etc.
⇒ Excludes interest on national public ⇒ Includes interest on national debt, i.e. on
debt. public savings in government borrowing
schemes.

2.3.5 Personal Disposable Income

The whole of the income received by the individuals is not available for spending.
Some part of the income has to be paid to the government in the form of direct taxes.
Therefore, to arrive at the concept of ‘disposable income’, direct taxes have to be
deducted from personal income.
Personal Disposable Income = PI – Personal Direct Taxes – Government Receipts
(fines, fees, etc.)
Personal Direct Taxes mainly are in the nature of income taxes, wealth tax, gift
tax and so on.

2.3.6 Private Income

Private income is the total income received by private individuals from all sources and
retained income of corporations.
National Income 25

Private Income = National Income (NNPFC) + Transfer Payments + Interest

on Public Debt – Social Security Contributions – Profits and
Surpluses of Public Undertakings.

2.3.7 Nominal and Real Income

GNP is defined as value of current final goods and services produced in an economy
during a given period (i.e., a year).
There are two components of GNP/GDP calculation, i.e.
1. Total Output (Q)
2. Price (P)
To arrive at the GNP figures, very simply the current output is multiplied by the
current price of all the respective output or GNP = P1Q1 + P2Q2 + P3Q3 +… + PnQn.
The GNP values can increase if
1. The output produced in an economy increases.
2. If the market price increases.
3. If both increase.
It may sometimes happen that the prices rise very rapidly or if there is inflation
in an economy it would lead to the value of the National Income rising very rapidly.
This means that the value of National Income will be inflated.
In order to understand the real increase in the value of nominal income two
concepts have been developed.
1. Nominal Income.
2. Real Income.
Nominal Income is the value of the total final output in the current year valued
at the prices of the current year.
Real Income is the value of the total final output in the current year valued at
constant or base year prices.
Thus,
• GNP/GDP valued at current prices or market prices is Nominal GNP/GDP
• GNP/GDP valued at constant/base year prices is Real GNP/GDP.
Introducing the Concept of a Base Year/Constant Year
In order to understand the concept of a base year it is necessary to first understand
and recall the concept of a current year in National Income terminology.
• Current Year: The current year is the ongoing current year for which
National Income calculations are being made, e.g., if the National Income for
the year 2018–19 has to be calculated, 2018–19 is the current year and the
prices prevailing in this year is the current prices.
• Base Year or Constant Year: If the objective is to estimate and identify the
real increase in value of output or National Income of a country, the impact
of price movements has to be accounted for. Any excessive increases in price
level inflates the value of National Income and may be misleading.
26 Macroeconomics

Therefore, what is done is a base year or constant year is chosen for comparison
purposes and the current year’s output is valued at the base year’s prices. This would
give the real National Income figures and show a more realistic picture of the growth
trends in National Income.
It can be further explained as:
1. A base year is chosen for comparison purposes. It could be an immediately
preceding year, or a year prior to a decade, or any year for comparison.
In general practice, a base year for convenience purposes is chosen to be
the beginning of a decade, e.g., 1970–71, 1980–81, 1990–91 & so on.
2. The base year can be any year and generally is a normal year, i.e., with no
abnormal events like a flood, drought, war, crisis pandemic so that it is a
proper base for comparisons and the constant year. For example the year
2020–21 would generally not be considered as a base year in national income
accounts because of the COVID-19 Pandemic since almost all macroeconomic
variables have witnessed major disturbances.
If, for example, 2001 is the base year and 2009 is the current year, the
Nominal and Real income can be calculated as given below:
• Nominal GNP = Value of output of current year (2009) × Prices of output
in current year (2009)
• Real GNP = Value of output of current year (2009) × Prices of output in
the base year or constant year (2000)
3. Using the Real GNP figures gives a better estimate of growth in real value
of output because it deflates the impact of price movements over the years.

Uses of Real GNP Estimate

1. Better indicator of increases/decreases in real value of National Income.
2. Considers the impact of price movements in National Income.
3. Accounts for inflationary increases in National Income values by considering
base year prices.
4. Deflates the value of Nominal Income to show the real Income.
In order to arrive at the real income figures what can be used is the GNP/GDP
deflator. (For details on GNP/GDP deflator see Appendix 2 of this chapter).
TABLE 2.2 Summary of National Income and Related Concepts
GDP Value of final goods and services produced within a
country during a given period. (The period is generally
a year and output in valued at market prices.)
GNP GNP = GDP + NFI, where NFI is Net Foreign Income
GDPMP / GNPMP GDP/GNP at market prices is the final output valued
at market or current prices.
GDP / GNPFC (a) GDPFC = GDPMP – Indirect Taxes + Subsidies
(GDP/GNP at Factor cost) (b) GNPFC = GNPMP – Indirect Taxes + Subsides
National Income 27

NDP (Net Domestic Product) NDP = GDP – Depreciation

NNP (Net National Product): NNP = GNP – Depreciation
NDPFC NDPFC = GDPFC – Depreciation
(Net Domestic Product at Factor
cost)
NNPFC NNPFC = GNPFC – Depreciation
(This is also the National Income of a country)
GDP/GNP at Current Prices Value of GDP / GNP at current market Prices.
GDP/GNP at Constant Prices Value of GDP/GNP at base year prices or constant year
prices. Base year/constant year is the reference year for
comparison, e.g. 1980–81, 2000–01, etc.)
Nominal GDP/GNP GDP/GNP valued at current year or market prices.
Real GDP/GNP Current years GDP/GNP valued at base year/constant
year prices.
PCI: National Income
Per Capita Income PCI =
Population

Personal Income (PY) PI = NNPFC – Corporate Income Tax – Undistributed

Corporate Profit – Social Security Contributions +
Transfer Payments + Interest on Public Debt.
PDY PDY = PI – Personal Direct Taxes – Income (PDY)
Personal Disposable Income Government Receipts (Fees, etc.)

2.4 FINAL AND INTERMEDIATE GOODS

Before proceeding with the methods of estimating the National Income, it is necessary
to understand the distinction between Final and Intermediate goods.

(a) Final Goods and Intermediate Goods

Final Goods: National Income calculations consider only the value of final goods and
services, i.e., goods which are ready for final consumption.
Intermediate Goods: In order to arrive at an accurate estimate of National Income,
all intermediate goods, i.e., goods which are still in the process of production of final
goods are not included in calculations of National Income. This is because the value of
intermediate goods is already included in the value of final goods. Therefore, to avoid
double counting, only the value of final goods is included in National Income.
Some examples of intermediate goods are raw materials, semi-finished products,
spare parts, components, ancillary, a final good in process and so on. These intermediate
goods may be final goods for some industries. For example, tyres for a tyre producing
company is a final product, and at the same time it can be an intermediate good for
28 Macroeconomics

an industry producing motor bikes. This distinction is extremely crucial for national
analysis and estimation.

2.5 METHODS OF ESTIMATING OR MEASURING NATIONAL INCOME

Estimation of National Income is one of the most complex exercises in every economy.
There are mainly 3 methods or approaches to estimate National Income.

2.5.1 Product/Output Method

This includes:
(i) The ‘Final Goods’ approach/method
(ii) The ‘Value Added’ approach/method
(i) ‘Final Goods’ Approach
• Under this approach, the National Income is calculated as the total or aggregate
value of all goods and services produced during a year in a country.
• In order to do so, all output is valued at the current market prices and summed
up to arrive at the National Income.
• Output from all sectors of the economy, i.e. primary sector which includes
agriculture, fishery, mining, etc. Output from manufacturing sector and service
sector is valued at market prices.
• Since service sector does not produce tangible physical output, the income
approach is more applicable in the sector.
Under the Final Goods approach therefore, the National Income is estimated as:
NY = P1 Q1 + P2 Q2 + P3 Q3 +…+ PnQn
where,
NY = National Income
Q1 – Qn = Total output in an economy
P1 – Pn = Current market prices in the economy of the respective outputs Q1 to Qn.
n
Therefore, NY = ∑ PiQi
i =1

Under this approach, it should be noted that only ‘final goods’ should be considered
while measuring the National Income. However, a better approach which makes a
distinction between Final and Intermediate goods is the Value-added Approach.
(ii) Value-added Approach: As GDP and GNP have been defined as the value of
final goods and services produced during a year, to arrive at the value of final goods the
value-added approach has been developed. Under the value-added method, the National
Income is estimated by aggregating only the ‘value added’ at each stage of production.
This method has been developed in order to:
• Distinguish between final and intermediate goods
• To avoid double counting and therefore overestimation of National Income.
National Income 29

Value added can be arrived at in the following manner:

Value added or VA = Difference between Value of Material Output and Inputs
at each Stage of Production
OR
Value added or VA = Value of Material Output – Value of Inputs at each Stage
of Production
The concept of value added can be illustrated with the help of a numerical example
given in Table 2.3. Consider a multi-process commodity, i.e., bread from the stage of
wheat growing farmer to the bakery.

TABLE 2.3 Value-added Method (Multi-process Product-Bread)

Stages of Production Sale of Value of Increase in Value at
Commodity (`) Every Stage (`)
(1) (2) (3)
(1) Wheat Growing Farmer 5 5
(2) Flour Mill 10 5 (10 – 5)
(3) Baker Who makes Bread 20 10 (20 – 10)
(4) Retailer (Bakery) 24 4 (24 – 20)
Total 59 24

Explanation
1. As can be seen, if the value of the output is calculated directly, it is ` 59
2. Using the value-added approach where only the value added at every stage is
aggregated, the value of the output is ` 24, which shows that double counting
has been avoided. ` 24, i.e., the value of output is arrived at by subtracting
value of inputs at every stage of production.
3. The Value-Added approach gives an accurate estimate of the total value of
final goods.

Value-added Approach to Show Calculation of GDP

Applying the concept of value added it can be demonstrated how GDP can be calculated
avoiding double counting, this is shown in Table 2.4.

TABLE 2.4 GDP by Value-added Method (` Cr.)

Sector Total Output Value Intermediate Value Added
(`) Purchases (2) – (3)
(1) (2) (3) (4)
Agriculture 40 15 25
Manufacturing 80 40 40
Service Sector & Others 60 30 30
Total 180 85 95*

* ` 95 is GDP by Value-added Method.

30 Macroeconomics

Explanation
1. As can be seen, considering the 3 sectors in an economy, i.e. agriculture,
manufacturing and others, these sectors use intermediate goods from each
other for production of their goods.
2. If GDP is calculated as total value of goods and services produced by each
sector directly it amounts to ` 180 crores.
3. If the value-added approach is used for every sector, the value of intermediate
goods is subtracted from total value of the goods produced in that sector.
4. If only value added by sectors is aggregated, it is ` 95 crores (column 4) which
gives GDP by the value-added method.
It can be clearly seen that, not using the value-added approach can cause double
counting and would overestimate the National Income figures.
Significance of Value-added Method
• Avoids double counting.
• Considers only final goods and their values.
• Excludes value of intermediate goods to avoid double counting.
• More accurate estimate of National Income.
• Accounts for inter-industry and inter-sectoral flows of goods and excludes value
of such goods from calculation of value of final goods.
• Evaluates the contribution of each sector in the value of GDP/GNP.
• Very useful method for the manufacturing and industrial sector.
Difficulties in Calculation of Value Added
• Difficulty in using the value-added approach in service sector the health,
education, banking, telecom, etc.
• Requires clear and substantial data and record of value of all inputs and
intermediate goods at each stage of production.

2.5.2 Income Method Approach

The income method measures National Income as an ‘Aggregate of total money incomes
paid to the factors of production annually in a country’.
This method is also known as the Factor cost method.
GNP / National Income (by Income Method) = Wages + Salaries + Rent + Interest
+ Dividends + Undistributed Corporate Profits + Retained Earnings + Mixed Incomes +
Direct Taxes + Indirect Taxes + Depreciation + Net Foreign Income – Transfer Payments.
Explanation of Components of Income
1. Wages and Salaries: These include all forms of wages and salaries paid
to the individuals for their contributions to production of goods and services.
All forms of income, i.e. wages, salaries, payment for overtime, perks in kind
like medical facility, transport allowance, subsidised housing is included in
this component of the Income. This category is also known as ‘Income for
labour services.’
2. Rent: Rent refers to rent on land, house, factory rents and rent on other
real estate assets, or fixed assets.
National Income 31

3. Interest: Refers to interest from deposits, bonds, loans, other interest paid by
banks on various forms of investment, all interest on private capital and so on.
4. Dividends: Dividends are earned by the shareholders as a part of their
capital income and included in GNP.
5. Undistributed Corporate Profits or Retained Earnings: Some part of
the profit is not distributed to any factor of production and are retained by
the company. These are included in the GNP.
6. Depreciation or Capital Consumption Allowance: The depreciation or
capital consumption allowance which is maintained by the corporates and
other business organisations are not received by any factor of production. It
is however included in the GNP. Every corporation or production unit keeps
aside this amount for the wear and tear of machinery and fixed assets.
7. Direct Taxes: Direct taxes which are levied on individuals, businesses,
corporates are also included in GNP calculations under the income method.
8. Indirect Taxes: Indirect taxes like excise, GST, sales tax, entertainment
tax, etc. are earned by the government. The revenue from these taxes go to
the government and not to any factor of production. However, to arrive at the
GNP these are added in the total income.
9. Mixed Incomes: These refer to:
(a) Income of self-employed persons.
(b) Profits of self-employed businesses/organisations.
(c) Income of partnerships.
(d) Income of other professionals like those of lawyers, doctors, consultants,
traders, transport companies and so on.
(e) Rent on owned property and interest on owned capital—these have to be
imputed at comparative market rates to give a more accurate estimate
of National Income.
10. Net Income from Abroad: This refers to the Net Foreign Income (NFI).

2.5.3 Expenditure Method or Approach

The Expenditure Approach measures the National Income as ‘The sum total of expenditures
incurred on goods and services during a given year.’
The expenditure method looks at National Income as the flow of total goods and
services which is purchased by the members of the society. This method assumes that
National Income is equal to National Expenditure.
Under this method, the aggregate expenditures of the various sections of society/
economy including the Government and rest of the world is summed up to arrive at GNP
by the Expenditures method. This method is also known as the total outlay method.
GNP by Expenditure method = C + I + G + (X – M)
where,
C = Consumption Expenditure
I = Investment Expenditure
G = Government Expenditure
X = Exports
M = Imports
(X – M) = Net Earnings from Exports and Imports.
32 Macroeconomics

Components of Total Expenditure and its Explanation

1. Private Consumption Expenditure (C)
2. Gross domestic private Investment Expenditure (I)
3. Government Expenditure (G)
4. The difference between value of Exports and Imports, i.e., (X – M)
1. Private Consumption Expenditure (C): Consumption Expenditure includes:
(i) Expenditure on consumer goods like bread, milk, clothing, grocery, etc.
(ii) Expenditure on durable goods also known as consumer durables like TV,
Fridge, car, cycle, bike, etc.
(iii) Expenditure on services like medical services, entertainment, communi-
cations, transport, lawyers’ fees and so on.
Together, these constitute the consumption expenditure, which is aggregated for
all individuals in the economy.
2. Gross Domestic Investment Expenditure (I): Gross domestic investment is
also referred to as Capital Investment Expenditure. Investment Expenditure also
includes the value of the inventory i.e. the inventory of unsold goods, semi-finished
goods, raw material. All this has to be included in the GNP.
Investment can be of two types:
(a) Real Investment, i.e., investment in capital, machinery, equipment and
fixed assets.
(b) Financial Investment, i.e., in financial assets like shares, bonds, debentures,
securities, etc.
The Value of Real Investment is a part of National Income calculations, because
they add to the value of output in an economy. The value of financial shares and stocks
are not included in GNP calculations because they do not contribute to production.
Investment expenditure has two subcomponents:
(a) New Private Investment: This includes investment and expenditures
on machinery, buildings, equipment, capital, fixed assets, plants, house
construction and so on.
(b) Replacement Investment: In the process of production the capital assets,
fixed assets depreciate or there is a wear and tear of such assets. To take
care of this, an amount of investment in the nature of replacement investment
has to be made.
There is also a difference between Gross and Net Investment:
(a) Gross Investment is the total investment incurred in the production process.
(b) Net Investment is gross investment minus deprecation.
(This distinction accounts for the difference between GNP and NNP)
3. Government Expenditure on Goods and Services and Government
Investment (G): This includes:
(a) Expenditure incurred by government on goods and services.
(b) Government expenditure on administration.
National Income 33

(c) Expenditure on Government/Public Enterprises.

(d) Government Investment or capital expenditure.
It excludes expenditure on transfer payments because it is not incurred on current
goods and services.
4. Net Expenditure on Exports/Imports
The difference between expenditure on Exports (X) and Imports (M) is considered
for arriving at the National Income.
Sometimes exports are greater than imports or imports are greater than exports,
whatever the situation may be either positive or negative, it is added to the National
Income, i.e., (X – M).

Application of the above methods in National Income Calculations

In practice, a combination of the above methods is used to arrive at the National
Income figures depending on what type of data is easily available and which method
is convenient in which activity/sector.
All the three approaches would give the same results if all details are calculated
in an accurate manner.
The output and income method are used more extensively as compared to the
expenditure method, because data on expenditures is not very well recorded. The
following Table 2.5 gives the application of the above methods in various areas.

Note:
(i) For arriving at the NNP calculations, depreciation has to be deducted from
the above figures (i.e., NNP = GNP – Depreciation).
(ii) To arrive at NNP at Factor cost the formula given is:
NNPFC = NNP (market price) – Indirect Taxes + Subsidies

TABLE 2.5 Methods of Estimating GNP and its Practical Application

Method/Approach Details of the Method Application in Various

Sectors/Activities

I. Output method n 1. Primary sector

• Final goods
approach
NY = ∑ PiQi = P1Q1 + P2Q2 • Agriculture
• Forestry
i =1
• Value added + P3Q3 + … + PnQn • Fishery
approach • Mining
GNP by value added method = 2. Manufacturing/Industrial
Aggregation of difference between sector
value of material output and • organised
inputs at every stage of production • unorganised
or aggregation of value added at 3. Construction
every stage.
34 Macroeconomics

II. Income Method GNP by Income method = Wages 1. Service sector

+ Salaries + Rent + Interest • Banking and
+ Dividends + Undistributed • Financial services
corporate profits + Retained • Insurance
earnings + Mixed incomes + • Communications
Depreciation + Net foreign income • Transport
– Transfer payments 2. Defence services
3. Public administrations
and other
4. Other professionals, e.g.
medicine, law.
5. Trade tourism, Hotel
6. Aviation
7. Real estate, business
services.
III. Expenditure GNP (by Expenditure method) = 1. Education
Method C + I + G + (X – M) 2. Health and Sanitation
3. Defence

2.6 DIFFICULTIES AND PROBLEMS IN ESTIMATION OF NATIONAL INCOME

The task of estimating the National Income of a country is saddled with a number of
difficulties both conceptual as well as practical. Furthermore, the problem of measuring
National Income becomes all the more difficult in developing countries wherein there
is a huge unorganised sector and also a number of statistical hurdles.
The difficulties in computing the National Income can be analysed under three
categories:
1. Conceptual Difficulties
2. Practical Difficulties
3. Problems Specific to Developing Countries

2.6.1 Conceptual Difficulties

(a) Exclusion of Non-Remunerative Activities: In National Income calcula-
tions only those goods and services which are assigned a market value are
included or only those activities which receive a remuneration are included.
Therefore, hobbies like painting, gardening, services of housewives, services
of a mother bringing up a child, services of a wife or husband cooking at
home, social services, etc. are not considered to be a part of National Income;
though these services would get a reward or payment if commercialised. To
this extent, the value of National Income gets underestimated.
(b) Exclusion of Non-Marketed Products: National Income does not include
commodities kept for self-consumption like food grains retained by the farmer.
To this extent, a major component of output does not feature in National
Income calculations.
(c) Treatment of Regulated Prices: In case of prices which are regulated or
administered by the government like minimum support prices, price ceilings,
National Income 35

a system of dual prices, these may not reflect the true price and hence may
lead to inaccuracies in estimation of national income.

2.6.2 Practical Difficulties

(a) The Problem of Double Counting: One of the major problems in
measurement of National Income is double counting. Extreme caution has
to be taken to distinguish between Final and Intermediate goods and ensure
that no duplications of value of intermediate goods takes place. In practice,
this requires statistical data at every stage of production, a clear record of
the value of intermediate goods, which is really not an easy job. There is thus
a danger of double counting and overestimating National Income in spite of
the Value-Added Approach.
(b) The Problem of Transfer Payments: Transfer payments are in the
nature of pensions, unemployment allowance, interest on public loans, old
age insurance schemes which get included in personal income but not in
National Income. These are a part of the expenditures of the government but
not included in National Income because it is only a redistribution of income.
It does not represent any payment made for productive services.
(c) Illegal Activities: Illegal activities like gambling, smuggling, black
marketing, illicit liquor production, etc. do have a value but are not included
in National Income due to the nature of the activity. In many economies
such activities referred to as a ‘parallel economy’ is of huge magnitude and
if they would have been legal, it would have made significant increments to
National Income figures.
(d) Treatment of Capital Gains/Losses: National Income does not include
gains/losses accruing due to changes in value of property, assets, shares and
so on, which happen due to market situations and fluctuations in prices.
These fluctuations in value are also speculative and caution has to be taken
to see that such gains and losses do not enter National Income calculations.
(e) Difficulty Regarding Imputations of Inventory Value: All inventory
stock changes are included in National Income valued at the current market
prices. However, the value of inventories is recorded at their historical or
original costs and not replacement costs. Therefore, by directly using the
current prices and showing an increase or decrease in inventory value would
not be an accurate estimate of the same. Though, there are methods of
imputation of current values of inventories it is a very complicated process.
To this extent, National Income estimates may not be accurate.
(f) Problem of Accurate Estimation of ‘Depreciation’: To arrive at ‘Net’
National Income figures, depreciation is deducted from the gross figures.
However, in spite of various methods of evaluating the depreciations of capital
and other fixed assets, in practice it is very difficult to use a kind of uniform
method which accounts for the life of the machinery, returns, current prices,
historical costs, and so on. This causes inaccuracy in estimating Net National
Income figures.
36 Macroeconomics

(g) Problem of Accurate Calculation of Nominal/Real National Income

Figures: The impact of price changes may not be accurately captured in
using price indices to distinguish between real and nominal incomes. Some
times the price index measures may not be accurate, sometimes there are
differences of opinion about which price index to use, i.e. consumer or wholesale
or any other price index.
(h) Problem of Estimation of Long duration Profits/social Projects/
defence Projects: Valuations of projects of infrastructure or of public
services becomes difficult given the long gestation period or the nature of
activity like defence. Long duration projects have to be valued at every stage
of completion annually, which is a cumbersome process.
(i) The Social/Environmental Costs of projects are not accounted for in national
income calculations.
3. Problems Specific to Developing Countries
In developing countries, National Income estimates pose further difficulties given the
nature of economic activity and also gives the problems related to statistical records.
(a) Problems Related to Non-monetised Sector: In many developing
countries there is a large non-monetised sector i.e. where the entire output
is not offered for sale. Especially in ‘Subsistence Agriculture’ a proportion of
the output is held back for family consumption. To this extent, value of such
output does not enter National Income calculations, because this output is
not ‘marketed’. The National Income figures show underestimated values to
the extent of the output of the non-monetised sector. It is also difficult to
impute the value of such output because of lack of data regarding the same.
(b) Problem of Estimation of Income of Small Producers, Household
Enterprises, Self-employed Persons: Such economic activities may not
be recorded properly causing problems for National Income estimation.
(c) Problem of Illegal Income: As mentioned earlier, valuation of illegal
income does not enter National Income Calculations.
(d) Mixed Incomes and Lack of Specialisation: Calculation of National
Income poses a major problem when individuals are engaged in a number of
supplementary activities, e.g. farmer could be engaged in poultry, dairy, or
working as a casual labour and so on. Exact data on all sources of income
needs to be maintained for accurate calculations of National Income.
(e) Problems Related to Non-availability of Data as well as Accurate Data:
There is a general lack of professionalism in maintenance of data as well as
in the machinery for data collection. This problem becomes all the more severe
in the primary sector like agriculture, mining, forestry, fishing and also in the
unorganised sector. Data collection takes considerable long periods and also
data reporting techniques face problems of time lag, e.g., it takes almost 4
years to finalise National Income accounts of 1 year. This weakens the data
base of National Income estimates.
Due to the above reasons National Income estimates can at the most be approxi-
mations and not completely accurate estimates specially so in developing countries.
National Income 37

The difficulties in estimating National Income are summarised in Table 2.6 given
below:
TABLE 2.6 Difficulties in Estimation of National Income

Conceptual Practical Difficulties Difficulties Specific to

Developing Countries
• Non-remunerative • Double counting • Non-monetised sector
activities • Transfer payments • Small household, self-
• Non-marketed • Illegal activities employed, small producers
product • Mixed income.
• Capital gains/losses
• Regulated prices • Inadequate and
• Imputation of inventory
values inaccurate data

• Valuation of depreciation
• Real/Nominal income
• Long duration projects.

Significance and Importance of National Income Estimates/Accounts

The significance of ‘National Income’ estimates can be summarised as given below:
Significance of National Income
• Most important macroeconomic indicator
• Monetary measure of an economy’s value of production
• Indicator of a country’s economic position, performance and future trends
• Analysis of the structure and composition of an economy
• Indicator of structural changes in an economy
• Indicator of distribution of income in an economy
• Analysis of income and expenditures in an economy
• Indicator of growth and development of an economy
• Basis for international comparisons
• Provides an understanding of the Economy

Exclusions in National Income

• Includes only current and first-hand transactions and excludes second hand
transactions or resale of goods, real estate, etc.
• Non-remunerative activities or goods and service rendered free of charge are not
included in National Income calculations (e.g. services of a housewife, hobbies
like cooking, gardening, singing, for which no payment is made).
• Only goods and services which arise from the production process in the current
year are included. Non-economic activities for which there is no corresponding
addition to the national product is not included, e.g. payments under social
38 Macroeconomics

security, pension, interest on public loans, gifts. These activities are referred to
as non-productive activities in National Income accounts.
• Any capital gains or real estate price fluctuations or gains and losses from
speculations in share markets are not included in National Income. These
activities do not add to the total output is the economy in the current year, i.e.,
there is no corresponding goods or services produced.
• All income earned from illegal activities like black market, smuggling are excluded
from national income calculations.

2.7 CIRCULAR FLOW OF INCOME MECHANISM

The circular flow of income mechanism deals with the flow of economic activity in
an economy. It shows the basic flows of production, consumption, income generation,
income distribution and shows how an economy reproduces itself.
The circular flow mechanism is at the heart of any economic activity and every
aspect of economic activity like production, consumption, saving, investment, market,
Government, transactions with the rest of the world, exports, imports are all reflected
in this flow.
It shows the inter-sectoral flows, the causes of disequilibrium, the disturbances
in the flow and in effect captures the entire functioning of an economy. It also shows
how the various macroeconomic policies of the Government can be used to stabilise
the economy and restore equilibrium in the economy.
To explain the circular flow, one can begin with a basic 2 sector economic model
and move on to a 4-sector model introducing and expanding the flows as one moves on.
(I) Basic Two Sector Model (Household and Business Sector) (Closed Economy)
• Consider an economy with only 2 sectors, the business sector and household
sector. Such an economy is also a closed economy, i.e., there is no transactions
with rest of the world.
• For the basic economic activity to take place, i.e., for production process to start
the business sector would demand and employ and Factors of Production: land,
labour, capital, and organisation.
• These factor services are provided by the household sector.
• In the business sector, there is a simultaneous production of goods and services
and also a generation of incomes in the form of wages, rent, interest and profit.
• The business sector therefore, generates money income payments which is
distributed to the owners of factors of production in the household sector.
• This money income is spent by the households on goods and services supplied
by the business sector.
• Goods/services/money income payments therefore circulate in the economy and
the process of production and consumption takes place.
• The circular flow of goods/services, money incomes, and expenditure guarantees
that the economy reproduces itself.
• Flow or transfer of goods to the household sector from business takes place
through the Product Market and flow of factor services from household sector
National Income 39

to business sector takes place through the Factor market. These are known
as market intermediaries. Factor markets are markets where factor services
are bought and sold and product markets or goods markets are where goods
are bought and sold.
• The Gross National Product = Gross National Income and the Total Income =
Total Expenditures and equilibrium is maintained in the economy.
• The circular flow in a two-sector model is demonstrated in Figure 2.1.

FIGURE 2.1 Flow Chart of a 2-Sector Model.

(II) Introducing Saving and Investment in the Circular Flow (Closed Economy)
• In the actual economy, the Incomes are not always equal to Expenditures, there
are some disturbances in the nature of Savings and Investments.
• Savings are considered to be leakages or withdrawals from the income stream
and Investments are injections or additions to the income stream. (see Section
2.8 for details on withdrawals and injections)
• Savings and Investment create a disturbance in the income flows.
• All Income is not consumed a part of it is saved, i.e. Y = C + S and the savings
are invested, i.e., S = I (in equilibrium.)
• Introducing savings and investment creates changes in the circular flow of
income mechanism.
• Expenditure takes on two forms:
(i) Consumption expenditures
(ii) Investment expenditure.
40 Macroeconomics

• The Household sector saves, and Business sector invests to generate output
and this is facilitated through the financial market and maintain the circular
flow of Income.
• The capital or financial market here refers to the market consisting of
banks, financial institutions and other institutions through which savings are
channelized into productive investment.
• Assuming that all savings is done by the household sector, the household
sector saves and through the capital market these savings are converted into
productive investments by the business sector.
It must be noted that savings are a withdrawal or leakage from the income
flow and reduces the income flow. On the other hand, Investment are an injection or
addition to the income flow.
As long as Savings = Investment, equilibrium will be maintained in the circular
flow. If Savings is greater than Investment, it can cause a contractionary effect; and
if savings is less than Investment, it has an expansionary effect.
The equilibrium condition is S = I. The capital market ensures that S = I
The circular flow mechanism introducing saving, Investment and the financial
market is shown in Figure 2.2.

FIGURE 2.2 Closed Economy with Savings and Investments.

(III) Three-Sector Model: Business, Household and Government (Closed Economy)

By introducing the Government sector in the economic activity, a number of new flows
are introduced either in the nature of injections/inflows or withdrawal or leakages.
National Income 41

The new flows which enter the Income mechanism due to the Government sector
are taxes (leakages), e.g. personal income tax, commodity taxes, corporate taxes etc. and
Government purchases and expenditure (injections). Government expenditures would
include expenditures on goods, services, investments, subsidies, transfer payments
and so on.
The above flows can disturb the equilibrium in the economy unless the leakages
in form of taxes, etc. are exactly offset by Government purchases/expenditures.
The circular flow of income mechanism after introducing the government sector
can be explained as given below:
(i) Consider the flows between the Government and the household sector. All
taxes in the form of income tax, commodity tax, cause a leakage or outflow
from the income stream. However, the Government also purchases services
from households makes transfer payments like old age pension, social service
benefits like old age benefit, health, and medical schemes and other welfare
schemes. Such expenditures are injections into the income stream. If the
leakages in form of taxes is matched by the above-mentioned government
expenditures the equilibrium in the income flow is maintained.

FIGURE 2.3 3-Sector Model.

42 Macroeconomics

(ii) Considering house hold business and Government together taxes is a leakage
and reduces the consumption and savings of household which reduces sales
and income of business. Taxes on business reduces investment, production,
and income. However, the government also buys goods and services from
the business sector and also makes transfers to the household sector. If the
withdrawals are equal to injections the circular flow will be maintained. The
circular flow mechanism in a 3-sector model with Household, Business and
Government can be seen in Figure 2.3.
(IV) Four-Sector Model (Introducing The Rest Of The World, i.e., Open
Economy)
The final circular flow of income mechanism can be analysed in the context of a
4-sector economic model. This is also called an ‘Open Economy’ which allows for all
international trade and transactions with Rest of the world.
1. Business
2. Household
3. Government
4. Rest of the world (ROW).

ROW and the New Flows

Once the transactions with the rest of the world are introduced, all international
transactions, receipts, payments, capital inflows & outflows will have to be accounted
for in the circular flow of Income mechanism. The scope of economic activity expands
further and becomes more complicated.
The new items would include:
(a) Exports (International receipts), therefore an injection.
(b) Imports (International payments), therefore a withdrawal.
(c) International receipts for services rendered by domestic country in the nature
of insurance, banking, shipping, interest, transport, royalties, dividends
(Injections).
(d) International payments for services rendered by rendered countries for the
above type of services. (withdrawals/leakages).
The above receipts and payments are done by private business firms as well as
by the government. Therefore, all international receipts mentioned above are injections
or additions to the National Income and all international receipts are withdrawals. A
balance between these will indicate an equilibrium situation. All these receipts and
payments are reflected in the Balance of payments (BOP).
Note: If IR > IP: Surplus in Balance of Payments
If IR < IP: Deficit in balance of Payments
If IR = IP: Equilibrium in Balance of Payments.
where,
IR = International Receipts.
IP = International Payments.
National Income 43

Any disturbance in the flows between the Household, Business, Government,

and Rest of the world can cause disequilibrium in the economy. To correct such
disequilibrium the government uses its various macroeconomic policies like Monetary,
Fiscal, Trade, Industrial, Price policies etc. The final flows with a 4-sector economic
model is shown in Figure 2.4.

FIGURE 2.4 4-Sector Model—Introducing Rest of the World.

Significance of Circular Flow of Income

• Indicator of the dynamic functioning of an economy.
• Shows the entire process of flows between various sectors of an economy, i.e.
producers, consumers, government, and the Rest of the World.
• Shows how the economy reproduces itself and moves on the growth path.
44 Macroeconomics

• The intersectoral flows also indicate that if the flows are smooth the economy
is in equilibrium.
• If there are any disturbance in the flow mechanism, the economy gets into
a disequilibrium, e.g. Savings > Investment, Aggregate Demand > Aggregate
Supply, Exports > Imports, Taxes > Expenditure and so on, would cause
disequilibrium in the economy.
• It also indicates how macroeconomic policies can be used to regulate the flows
like the Monetary Policy, Fiscal Policy, Trade Policy, Price Policy and restore
equilibrium.
• It shows the importance of markets like product market, factor market, capital
market, money market in the process of regulating the flows and maintaining
equilibrium.
• Shows how governments taxes, revenue, expenditures through the fiscal policy
can be used to regulate and stabilise the economy.
The circular flow of income mechanism in fact gives an idea of the entire dynamic
functioning of an economy, the inter-relationships between the sectors, the causes of
disequilibrium and also how the government can use its various policies to stabilise
and regulate an economy.

2.8 WITHDRAWALS OR LEAKAGES AND INJECTIONS OR ADDITIONS

In the discussion of the National Income and Circular Flow of Income mechanism there
are 2 concepts which are frequently used:
1. Withdrawals/leakages.
2. Injections/Inflows.
1. Withdrawals/Leakages: Refers to any flow which causes a leakage from the
income stream like savings, taxes, remittances outflow, international payments for
import of goods and services, insurance charges, transport charges etc. All these
are withdrawals from the income stream and reduces the total income flow, e.g. if
individuals save, they do not consume to that extent hence aggregate demand falls
which may lead to fall in production or income. However, withdrawals and leakages
are offset by injections or inflows.
2. Injections/Inflows: Refers to any flow which causes an addition to the income
flow like investment, government expenditures, purchases by business and government,
remittance inflow, all international receipts from exports and other receipts for goods
and services.
In National Income accounts,
1. If Withdrawals = Injections (Income is in equilibrium).
2. If Withdrawals > Injections, the Income has a tendency to fall or contract.
3. If Withdrawals < Injections, the Income has a tendency to rise or expand.
Any imbalances between withdrawals and Injections can disturb the economy
compelling the government to intervene through its various macroeconomic policies
like monetary, fiscal, trade policies and so on.
National Income 45

Points to Remember
National Income Analysis: Some Key Concepts
Current Value of Output: Value of output in the current ongoing year.
Marketed Output: The output which is offered in the market for sale.
Final Goods: Goods which are ready for final consumption.
Intermediate Goods: Goods which are in the process of production.
Productive Activity: Any activity which produces a corresponding output/
service.
Remunerative Activity: All activities, i.e. production of goods/services which
are paid for or receive a remuneration.
Value Added: VA = Value of material output minus value of inputs
at every stage of production
Domestic Country: The ‘Resident’ country/nation.
Foreign Country: Any ‘Foreign’ country other than the domestic country.
Net Foreign Income: Difference between Income outflows and inflows
between domestic and foreign countries.
Transfer Payments: Unilateral transfer of funds from Government to
individuals, e.g. pensions, unemployment doles, etc.
Depreciation: Provision in the nature of a financial allowance for
wear and tear of machinery and other fixed Assets.
Gross: Value of National Income Figures without accounting
for depreciation.
Net: Gross Value – Depreciation.
Current Year: The ‘Ongoing Current’ Year in National Income
Calculations.
Base Year/Constant Year: The reference or base year to which comparisons are
made from the current year.
• National Income is the value of Final Goods and Services produced in an
economy during a given period of time (Generally a year).
• The National Income is valued at current market prices and is the value of only
currently produced goods and services (i.e., in the current year).
• There are number of related concepts in National Income ranging from GDP/
GNP to Real and Nominal Income.
• An important concept in National Income Analysis is that of ‘Value Added’ the
value-added approach provides the most accurate estimate of National Income
because it is an aggregation of only value added at every stage of production
in all activities in an economy and hence avoids double country.
• There are three main methods to estimate National Income:
(a) Product Method which includes final goods and value-added approach
(b) Income Method
(c) Expenditure Method
46 Macroeconomics

• All these methods should give the same figures if calculated accurately.
• There are a number of difficulties in calculating National Income mainly related
to availability of accurate data and statistics specially so in developing countries.
• An important aspect of the analysis of National Income and the analysis of
economic activities the circular flow of Income mechanism. This mechanism
shows how an economy reproduces itself and the role of Household, Business,
Government and Rest of the world in generating and maintaining the circular
flow.

ANNEXURE
1. Stocks and Flows
Before proceeding with the further analysis of National Income and related concepts,
it is necessary to clarify the distinction between stocks and flows.
A flow variable is one that has a time dimension or flows over time (like a flow
through a stream).
A stock variable is one that measures a quantity at a point of time. e.g. Per
hour/per day/per month/per annum.
Stocks are measured at a point of time whereas flows are measured over a period
of time. In economics, some variables are considered as a ‘flow’ and some ‘stock.’ Income
for example, is a flow whereas wealth is a stock.
National Income is defined as the ‘flow’ of goods and services produced during a year.
The stock and flow concepts are used both in micro and macro analysis.
What exactly is meant by stocks and flows?
In economics, stocks refer to the quantity of a variable at a point of time and flows
refers to the quantity of a variable over a period of time. The variable could be the
quantity of commodity, income, wealth, capital, money supply and so on. It is very
essential to understand the difference between flow and stock variables in order to
avoid errors in estimation of the variables.
Examples of ‘Stock’ Variables
Money supply, wealth, total saving at a point of time, inventory stock, outstanding
loans of a bank, total government debt, foreign exchange reserves.
Examples of ‘Flow’ Variables
National Income, income, exports, wages, imports, social security benefits, expenditure,
etc.

Some important aspects related to stocks and flows

• Flow variable has a time dimension like per annum, per week, monthly, and
so on. Stock is measured at a point of time.
• Some stocks have a flow variable as a counterpart, i.e. ‘wealth’ is a stock but
income is a ‘flow.’ Loans by banks is a flow, but total outstanding loan is a
stock. Money is a stock spending is a flow.
National Income 47

• Changes in flows have an impact on the total stock position.

• The stocks can change due to change in flows. For example, if investment
increases the stock of capital will also change.
For proper calculation and understanding of a number of macro and micro
variables, it is essential to understand the distinction between stocks and flow variables.
2. Per Capita Income
Per Capita Income (PCI) is the average income of individuals during a given year in
an economy.
National Income
PCI =
Population
Growth in GDP/GNP does not reflect the average income of individuals. This is
captured in the concept of PCI and in fact, PCI is the universally accepted indicator
of the average income of individuals in an economy. The growth rates in PCI are also
used to analyse the economic growth of a country and are also used for international
comparisons to classify countries into developing or developed countries.
The National Income and Population figures are considered for the specific year
for which the PCI is being calculated, for example, 2008, 2009 and so on.
Real National Income
The Real PCI =
Population
(For Real National Income refer to Section 2.3.7).
PCI is important because
1. It is the universally accepted measure of a country’s economic growth, along
with growth rates in GDP.
2. It is an indicator of a country’s standard of living and the average income of
individuals in an economy.
3. It is used for international comparisons, i.e., the PCI figures are used to
classify countries into developed and developing or developed and third world
countries.

Limitations
1. PCI is an average figure and therefore, does not really reflect each individual’s
income.
2. Does not reflect the inequalities in income distribution.
3. It can therefore be misleading.
4. Though increases in PCI is an indicator of economic growth, it does not reflect
the level of economic development. Increases in PCI have to be accompanied by
technological and infrastructural development, reduction of poverty, increases
in literacy rate, reduction of inequalities in income distribution and so on to
bring about real growth.
3. A Note on Price Index and GDP/GNP Deflator
• In order to measure inflation in an economy and deflate the value of Nominal
GNP to arrive at the Real GNP the concept of GDP/GNP deflator was developed.
48 Macroeconomics

• The GDP/GNP deflator removes the inflationary element in the Nominal Income
and gives a better picture of the real growth in National Income.
• In order to arrive at the GDP/GNP deflator it is necessary to first understand
the meaning of the Price Index.

Price Index
• The price index measures changes in the general level of prices over a given
period of time.
• The General price level is very simply the average of prices of all goods and
services is an economy at a given point of time. (There are a number of price
indices like Wholesale Price Index, Consumer Price Index and so on.)
Value of Production of Current Year at Current Year ′s Prices
Price Index = × 100
Value of Production of Current Year at Base Year ′s Prices
where,
• Current year refers to the ongoing current year for which calculations are being
made. (For example: 2009)
• Current year Prices: Prices prevailing in the current year. (For example: 2009)
To calculate the Price Index, consider a numerical example as given in Table A.1.
ANNEXURE TABLE A.1

Year GNP (P  Q) Nature of Income

2009 (Current) 15000 Nominal

2000 (Base) 14000 Real

• Base/Constant year: The reference year for comparison (which could be any
preceding year, generally beginning of a decade, e.g. 2000.)
Value of Production of Current Year
at Current Year's Prices
Recall Price Index = × 100
Value of Production of Current Year
at Base Year ′s Prices
Substituting values from above example:
15000
=
Price Index × 100
= 107.14285
14000

GDP/GNP Deflator Using Price Index

The GDP/GNP deflator is calculated as:
Price Index
GNP Deflator =
100
This GNP deflator can be used to deflate the Nominal Income to arrive at the
Real income GNP as given below:
National Income 49

Nominal GNP
Real GNP =
Deflator
or substituting values from earlier numerical example
Price Index 107.14285
GNP Deflator = = = 1.0714285
100 100
Nominal GNP 15000
\ Real GNP = = = 14000
Deflator 1.0714285
One can therefore directly arrive at the Real GNP figures from the Nominal
Figures using the GNP/GDP deflator.
Note:
GDP/GNP deflator can alternatively be calculated as:
GNP at Current Prices
GNP Deflator =
GNP at Constant Prices

ANNEXURE TABLE A.2 Gross National Income and Net National Income Trends in India
Gross National Income and Net National Income in India
(Current and Constant Prices 2004–2005 and 2011–2012 Series) (2000–2001 to 2017–2018)}

Gross National Net National Income Per Capita Net

Year
Income (` in Crore) (` in Crore) National Income (in `)
Current Constant Current Constant Current Constant
Prices Prices Prices Prices Prices Prices
2004–2005 Series
2000–2001 2154680 2535911 1947788 2291795 19115 22491
2001–2002 2335777 2661819 2106928 2401875 20259 23095
2002–2003 2519637 2766298 273456 2492931 21529 23607
2003–2004 2820795 2983497 2548640 2692470 23775 25116
2004–2005 3219835 3219835 2899944 2899944 26629 26629
2005–2006 3667253 3518348 3303532 3167455 29869 28639
2006–2007 4261472 3841974 3842743 3456274 34249 30805
2007–2008 4966578 4233768 4481882 3806140 39384 33446
2008–2009 5597140 4390966 5031943 3922062 43604 33987
2009–2010 6439827 4763090 5780028 4241183 49402 36249
2010–2011 7702308 5227739 6942089 4657438 58534 39270
2011–2012 8932892 5586683 8052996 4958849 66997 41255

(Contd.)
50 Macroeconomics

Gross National Net National Income Per Capita Net

Year
Income (` in Crore) (` in Crore) National Income (in `)
Current Constant Current Constant Current Constant
Prices Prices Prices Prices Prices Prices
2011–2012 Series
2011–2012 8659505 8659505 7742330 7742330 63462 63462
2012–2013 9827250 9104662 8766345 8094001 70983 65538
2013–2014 11093638 9679027 9897663 8578417 79118 68572
2014–2015 12297698 10412280 10953761 9231556 86454 72862
2015–2016 13522256 11246305 12076882 9982112 94130 77803
2016–2017 (PE) 14994109 12034713 13408211 10686776 103219 82269
2017–2018 (FAE) 16438895 12835004 14710563 11404413 111782 86660

Abbr.:
PE: Provisional Estimates
FAE: First Advance Estimates
Note: Estimates for the years 2011–2012 to 2015–2016, as released through the Press Note
dated 31.01.2017 on first Revised Estimates of National Income, Consumption Expenditure,
Saving and Capital Formation have been updated due to incorporation of new series of IIP and
WPI with base year 2011–2012, released in May 2017.
Source: Ministry of Finance, Govt. of India. (16944), (ON667), The Fertiliser Association of
India. (ON1668) & (ON1888).

ANNEXURE TABLE A.3 Annual GDP Growth Rate Trends (1990–2018)4

World’s Annual India’s Annual

Year
Growth Rate (%) Growth Rate (%)
1990 2.916 5.533
1991 1.428 1.057
1992 1.768 5.482
1993 1.529 4.751
1994 3.000 6.659
1995 3.022 7.574
1996 3.389 7.550
1997 3.674 4.050
1998 2.556 6.184
1999 3.248 8.846

4. World Bank National Accounts Data, and OECD National Accounts data files “GDP Growth
(Annual %) | Data.” Worldbank.Org, 2020, accessed at data.worldbank.org/indicator/NY.GDP.
MKTP.KD.ZG?locations=IN.
National Income 51

World’s Annual India’s Annual

Year
Growth Rate (%) Growth Rate (%)
2000 4.385 3.841
2001 1.960 4.824
2002 2.182 3.804
2003 2.964 7.860
2004 4.407 7.923
2005 3.915 7.923
2006 4.380 8.061
2007 4.324 7.661
2008 1.853 3.087
2009 –1.674 7.862
2010 4.301 8.498
2011 3.140 5.241
2012 2.517 5.456
2013 2.663 6.386
2014 2.847 7.410
2015 2.879 7.996
2016 2.592 8.256
2017 3.262 7.044
2018 3.098 6.120
2019 2.475 5.024
52 Macroeconomics

QUESTIONS

I. Short Answers
1. What accounts for the differences between GDP and GNP?
2. ‘Depreciation is excluded in the Net National Income concepts.’ What is the
need for this?
3. ‘Including intermediate goods in the calculation of national income will cause
double counting.’ Explain also in this context the concept of final goods.
4. ‘The difference between GNPMP and GNPFC is related to indirect taxes
and subsidies.’ Explain.
5. What is the significance of withdrawals and leakages in national income
accounts?
6. ‘There is no difference between nominal and real income.’ Is it true? Justify
your answer.
7. ‘GDP and GNP deflator are used to derive real Income from nominal income.’
Explain.
8. Transfer payments are not a part of national income. Do you agree?
9. What accounts for the differences between personal and national income?
10. National income is a flow concept, and wealth is a stock concept. Explain
in this context the meaning of stocks and flows.
11. Explain the basic 2 sector circular flow income mechanism.
12. If withdrawals are greater than injections, it can cause disequilibrium in
the circular flow of income mechanism. Explain.

II. Long Answers

1. National Income is a reflection of a country’s economic position. In this
context, explain clearly the aggregates in national income and their
significance.
2. What accounts for the difference between GNP and GDP? Explain in detail
the significance of GNP in national income accounting.
3. ‘To arrive at the personal income some items have to be added and some
deucted from national income.’ Elaborate.
4. ‘The Net national income figures account for wear and tear of machinery
and capital.’ Elaborate and explain the Net national income aggregates and
their significance in national income accounts.
5. ‘Real income shows the real growth of output in an economy.’ In this context
explain:
(a) The difference between nominal and real income.
(b) The difference between current and constant or base year prices.
6. Explain the meaning and significance of the GNP and GDP deflator in
national income accounts with numerical illustrations.
National Income 53

7. Elaborate on the various methods of estimating national income and show

how Q = Y = E. What are the difficulties involved in estimation and
computation of national income?
8. ‘The value-added method of estimating national income gives a more accurate
estimate of the national income.’ Explain.
9. ‘Circular Flow of Income mechanism shows the functioning of an economy.’
Explain in this context, the intersectoral flows in a 4-sector model.
10. Calculate the GDP by final goods approach and the value added approach
for the following data:

GDP by Value-Added Method (` Crores)

Sector Total Output Intermediate Value Added
Value Purchases (` Cr)
(` Cr) (` Cr)
(1) (2) (3) (4)
Agriculture 100 30
Manufacturing 200 60
Service Sector & Others 300 40
Total GDP GDP (Final GDP (Value
goods approach) added approach)

11. Explain meaning of nominal income, real income and GDP deflator. Using
the table below answer the following questions:
Year Nominal GDP GDP Deflator Population
Year 1 8000 1.50 18
Year 2 10,000 1.80 20

(a) What is the real GDP in Year 1?

(b) What is the real GDP in Year 2?
(c) What is the real GDP per capita in Year 1?
(d) What is the real GDP per capita in Year 2?
12. Point out and explain the mistakes in the following definition of GNP by
income method:
GNP/National Income (by Income method) = Wages + Salaries + Rent +
interest + dividends – Undistributed corporate profits + Retained earnings +
Mixed incomes – Direct taxes + Indirect taxes + Depreciation + Net Foreign
income + Transfer payments.
13. Calculate the price index for the following years using the formula given
for calculating price index.
54 Macroeconomics

Year Gross National Product (` in Crore) Price Index

Current Prices Constant Prices
2011–2012 8659505 8659505
2012–2013 9827250 9104662
2013–2014 11093638 9679027
2014–2015 12297698 10412280
2015–2016 13522256 11246305

14. Calculate the annual rate of inflation for the following years from the data
given below:
(Base year = 2000–2001)
Period WPI Annual Rate of
Inflation (%)
2000–2001 100
2001–2002 185
2002–2003 200
2003–2004 230
2004–2005 260
CHAPTER

3
Money
Definitions and Functions

3.1 INTRODUCTION
Prior to the existence and use of money, there existed what is familiarly known as
the Barter System where the exchange mechanism was commodities for commodities
denoted as C ⇒ C. The barter system was found to be very inconvenient as it restricted
exchange trade and commerce.

Difficulties of The Barter System

1. No Common Medium of Exchange to facilitate exchange transactions.
2. No Common Measure of Value: Since there was no standard unit
measurement of value, every time exchange had to take place, the value of
commodities had to be determined in terms of other commodities making
exchange highly time consuming and inconvenient.
3. Problem of Double Coincidence of Wants: Every time exchange took
place, there was a need to find parties who were willing to enter into specific
exchange transactions. For example, if a person ‘A’ wants to exchange rice for
wheat, he had to identify an individual who would be willing and wanting to
exchange wheat for rice and so on.
4. Indivisibility of Commodities: Since commodities are generally indivisible,
it was difficult to arrive at the precise value of commodities. Whenever some
commodities would be divided to arrive at the accurate ‘exchange value’ its ‘use
value’ would be completely destroyed. (For example, half a table for 1 chair.)
5. Difficulty in Storing Value: Because of the high perishability of
commodities like food grains, milk, fruits, etc., it was difficult to store value
for long durations.
6. Bulkiness of Commodities and Difficulty in its Transportation: It was
not only difficult to store commodities but also because of the bulky nature of
commodities, it was difficult to transport them, thus restricting trade.
7. Problem of Maintaining Accounts: In the absence of a common form
of money and a common measure of value, it was difficult to maintain the
55
56 Macroeconomics

accounts. Today, we can express the receipts and expenses in one common
form, i.e., money and that is the reason why we can maintain proper accounts.
8. Difficulties regarding Payments in Future: In a monetised economy,
payments are made over a future period like payment of rent, wages, interest
on borrowed capital, etc. This was hardly possible in a barter economy.
Because of the above difficulties of the barter system, exchange was restricted
mainly to local areas, trade did not expand, specialisation in production was not evident
and in short, this kind of system seemed to be suitable only to a very backward and
primitive society. Therefore, these problems gave rise to the search for an alternative
system which would solve the difficulties of a barter system. This led to the evolution
of money creating a ‘monetised system,’ where the exchange mechanism now became
“Commodities for Money and Money for Commodities”, denoted as: C ⇒ M ⇒ C.

3.2 FUNCTIONS OF MONEY

The best way to define money is:
“Money is what money does.”1 (Prof. Walker, 1878)
The point to be emphasised here is that money is not defined by its physical
characteristics but is, in fact, defined by the functions that it performs. It should also be
noted that the present form of money, i.e. the paper currency, is a highly advanced form
of money and over the years a number of commodities have performed the functions
of money; for example, food grains, shells, precious stones, etc. Therefore, money is a
unique commodity which performs certain crucial functions, and any commodity which
can perform these crucial functions will get the status of money. In order to define
money, one has to consider the functions of money. Based on the functions of money
different approaches to defining money have evolved.

Functions of Money

Primary Functions Secondary Functions Contingent and

(a) Measure of Value (a) Store of Value Dynamic Functions
(b) Standard Measure of Value (b) Standard of Deferred
Payments
(c) Unit of Account
Note: The medium of exchange and store of value functions are the 2 most crucial
functions of money and form the basis for further monetary analysis.

3.2.1 Primary Functions

The primary functions of money include money as a medium of exchange and measure
of value. There are called primary because these are performed by money alone.
1. Walker, F.A., Money, New York: Henry Holt and Co., 1878.
Money: Definitions and Functions 57

1. Medium of Exchange (MOE): The most basic and crucial function of money is
the function of a common medium of exchange.
Money facilitates the process of exchange and is used in any exchange transaction
i.e. in buying and selling of goods and services. To be used as a common medium of
exchange, money should be generally acceptable as means of payment.
In order to be generally acceptable as a means of payment, money should possess
the following characteristics:
1. It should have a legal backing (of a sovereign authority like the central
government and the central bank).
2. It should enjoy the faith of the public.
3. It should possess 100% liquidity. By liquidity here is meant that there should
be no delay, no cost and no inconvenience in using money as a medium of
exchange.
The medium of exchange function is a basic and defining function of money. It is
both a necessary and sufficient condition to define money.
Money being a medium of exchange, it overcomes the problems of the barter
system to a large extent, i.e., the problem of a common medium, measure, double
coincidence of wants, etc.
2. Money as a Standard Measure of Value: Money provides a standard unit of
measurement in terms of which the value of all goods and services can be expressed—
thus simplifying the process of exchange. It overcomes the difficulty of lack of a common
measure of value. Important variables like prices, incomes, costs, etc., can also be
predetermined due to the availability of a common measure of value, in terms of money.

3.2.2 Secondary or Derivative Functions

The derivative functions include money as a store of value, a standard of ‘deferred
payments’ and a ‘unit of account’. These are called ‘derivative functions’ because they
are derived from the primary functions of money.
1. Store of Value (SOV): With the introduction of money, the problem of perishability
of goods and thereby, storing of value is solved to a large extent. The need for storing
value arises due to the fact that there is a gap between people receiving their income
and spending it and money provides this facility through its store of value function.
However, the intrinsic value of money, i.e., its purchasing power would depend on the
General Price Level. Over the years, various forms of storing money have evolved and
it has also become possible to earn return on stored wealth. Money is only one form
of storing value, the others include the wide range of financial assets and other forms
of investments like deposits, shares, debentures, bonds etc.
Wealth can be stored in 3 ways:
1. Monetary assets, like, currency notes, demand deposits,
2. Real assets, like, land, houses, furniture, gold,
3. Financial assets, like, deposits, shares, securities, bonds, etc.
Many of the other forms of storing wealth like the financial assets, in fact,
generate returns and are better stores of value as compared to money. However, in
58 Macroeconomics

spite of this, individuals like to hold money as a store because it is perfect medium of
exchange and possesses 100% liquidity.
The store of value function is of extreme significance in the analysis of demand
for money and further monetary analysis.
2. Standard of Deferred Payments: With the use of money, it is possible to
postpone payments which arises due to the store of value function. This function has
created the entire system of lending and borrowing which is the credit system. With
the use of money, it is possible to postpone or defer payments to a future date.
Examples of deferred payments are interest on capital, dividends on preference
shares, long-term property deals, etc. This function has come to be of great importance
in modern times because of the increasing significance of such deferred payments in
modern economics.
For money to act as a standard of deferred payments, it is necessary for the value
of money to be stable over a period. By acting as a standard measure of payment over
time, money makes borrowing and lending less risky. It thus helps in encouraging all
kinds of economic activity which depends on borrowed money or credit. As a result of
the ‘Standard of deferred payments’ function, it has been possible to have the complex
system of credit and financial institutions in the economy.
3. Unit of Account: Since money is a common measure of value in terms of which
values of all goods and services are expressed, it is possible to use money as ‘a unit
of accounting’. Construction of balance sheets, income expenditure accounts, budgets of
government, balance of payments statements etc. and also other accounting financial
statements have become possible due to the use of money. When values are expressed
in prices (i.e. in money terms) it is also possible to have an idea of the wealth of a
person or community.

3.2.3 Contingent and Dynamic Functions of Money

Contingent/Incidental Functions
1. Distribution of National Income: People earn their incomes (rent, wages,
interest and profit) in the form of money. Money has also made it possible to
express values of various factors of production, i.e., land, labour, capital and
entrepreneur in terms of wage, rent, interest and profit shares which has led
to the development of macro theory of income distribution.
2. Allocation of Scarce Resources: Since all prices are expressed in money
terms, money helps the process of allocation of scarce resources as this depends
on the prices (price mechanism).
3. Equalisation of Marginal Utilities and Marginal Productivities: When
prices of goods and of factors of production (labour, capital, etc.) are expressed
in money-terms, it is easier for consumers to compare marginal utilities of
goods with their prices and easier for producers to compare factor prices with
their marginal productivities. Thus, money helps consumers and producers to
achieve their equilibrium positions regarding purchases of goods and factors.
Money: Definitions and Functions 59

4. Basis of Credit: Money is the basis of the credit system which has assisted
in the development of the whole range of banking and financial institutions
in the economy. Money also forms the ‘cash bases’ for commercial banks to
create credit.
5. Facilitates Income and Expenditure transactions of the Government:
Money facilitates the entire government’s budgetary process, the process of
tax collection, Government expenditures, investments etc. The entire financial
activity of the Government is made easy through the use of money.
6. Money Acts as a Means of Transferring Value: Money is used as a
medium through which property could be transferred or liquidated with ease.

3.2.4 Static and Dynamic Functions of Money

Functions of money can be classified as static and dynamic functions.
1. Static Functions: These include money as a medium of exchange, measure
of value, a standard of deferred payments, store of value and transfer of value.
2. Dynamic Functions: These include the functions of money by which money
influences the working of the economy.
This includes the impact of money on interest, prices, production,
investment, output and so on. Regulation of money supply is an important
function of central banks. The dynamic functions of money have become
important in modern times.

3.2.5 Other Functions of Money

1. Estimation of Macro Variables: With the use of money, it has become
possible to estimate and express a number of macro variables in value terms,
e.g. GNP, money supply, total savings, investments, etc. It is also possible to
calculate important ‘rates of growth’ like growth of GNP, per capita income,
inflation, interest, etc.
2. Expansion of Business/Trade: Use of money has also led to the expansion
of business, industry, trade, commerce on a large scale. This has facilitated
exchange, specialisation in production, etc.
Money therefore has in fact, supported the entire process of economic
development and expansion of economies world over.

3.2.6 Uses of Money

1. Money Removes the Inconvenience of Barter and Facilitates Exchange:
With the use of money and a monetised system the difficulties of barter were
overcome leading to a more efficient process of exchange and also a highly
evolved system of transactions, trade, commerce and economic activity.
2. Money Performs Certain Crucial Functions: Money is the lifeline of an
economy and performs a number of crucial functions. Money acts as medium
of exchange, it is measure and a store of value, it is a standard for deferred
payments, and it facilitates transactions without which modern trade and
60 Macroeconomics

industry could not have evolved to the present level. Money has played a
very significant role in creating a highly evolved banking, financial and credit
system, which is integral to the process of economic development.
3. Money has Led to the Development of the Credit System: The entire
system of savings, investments ,borrowing, lendings is the outcome of the
use of money.
In addition to these aspects money also supports and facilitates the entire
mechanism of production, consumption, distribution and the working of an
economy.

3.2.7 Dangers of Money

Though money is extremely crucial in an economy it could also create disequilibrium
in an economy and destabilise the economy.
1. Economic Instability: Economic instability caused by money could arise in the
following situations:
• Excess of Savings over Investment—When savings in an economy are more
than investment, the national income, output and employment decreases and
the economy goes into a recessionary phase
• Investment Exceeds Saving Beyond the Level of Full Employment—If the process
of money creation and investment continues beyond the point of full employment
it can cause inflationary tendencies in an economy
• Excess Money Supply in the Economy—Any excess money in the economy causes
inflation due to mainly, too much money chasing too few goods
2. Economic Inequalities: An unequal distribution of money and wealth creates
inequalities in the economy.
There are a number of conditions under which money cannot perform its functions
smoothly. This happens during highly inflationary conditions, i.e. hyperinflation which
causes a complete breakdown of the monetary system. Under such circumstances old
money must be demonetised and some new money must be created to take its place.
However, these are relatively rare phenomenon’s. The point to be noted in all this is
that money if uncontrolled or misused has the potential of destabilising an economy
and therefore management and regulation of money supply is an important objective
of all Central Banks.

3.2.8 Characteristics of Good Money

1. Relative stability in value of money,
2. Relative stability in general price level,
3. A good store of value,
4. Should enjoy public faith.

3.3 DEFINITIONS OF MONEY

Having discussed the functions of money, one can now define money in a systematic
manner as given below:
Money: Definitions and Functions 61

3.3.1 Traditional Approach

The traditional approach emphasises on the functions of money or on what money does.

A. Narrow Definitions
The traditional definition under the narrow view concentrates on the Medium of
exchange function (MOE). Some narrow definitions are provided below:
Newlyn defines money as anything is money which generally functions as a
medium of exchange.
Robertson has defined money as anything which is widely acceptable in payment
for goods or in exchange of other kinds of business transactions.
Therefore, money is something which is generally acceptable as means of payment.
The two characteristics which are emphasised in these definitions are the medium
of exchange (MOE) and general acceptability.

B. Broad Definition
G. Crowther looks at money as anything that is generally acceptable as a means
of exchange and which at the same time acts as a measure and as a store of value.
According to the broad approach, money is something which gives an individual
a claim over purchasing power.

3.3.2 Empirical Approach

This approach is based on practical experience and observations as to what are actually
being used as money. As a result, items or assets included in money in this approach
constantly changes.

A. Narrow Definition
According to Yeager, only currency, coins and demand deposits are money. The
empirical approach to money constantly changes to include more and more assets
which are used as money as society progresses.
62 Macroeconomics

B. Broad Definitions
There has been a lot of discussion regarding what should or should not be included
in money. Some approaches are summarised below:
• The Radcliffe Committee on monetary reforms states that assets other than
currency and demand deposits also result in increasing expenditures by the
individuals and therefore such items should be included in Money. Based on
this thinking one has to include fixed deposits, bonds, deposits of NBFI’s, units
of UTI, LIC policies, mutual funds, etc.
• Another school of thought formulated by Gurley and Shaw emphasised on the
degree of moneyness or liquidity of an asset to be included in the definition
of money. Various financial assets get included in the definition of money
depending on the degree of liquidity.
• Milton Friedman defines money as a temporary abode of purchasing power
and includes not only the financial assets but all forms of wealth and property
in the approach to defining money.
Based on the above views, the central banks of various countries have given
various measures of money supply, classified into narrow and broad measures. In
almost every country today the accepted narrow definition of money is:
Money = Currency + Coins + Demand Deposits
Over the years in any monetary discussion, a concept which is gaining importance
is the concept of near money. This concept or form of money has evolved over the years
with the growth of the Banks and Financial Institutions. As an economy progresses,
the proportion of Near Money to the Total Money Supply goes on increasing, hence the
significance of this concept (For details on Near Money refer to Section 5.5 of Chapter 5).

Points to Remember
• Prior to the introduction of money, there existed the Barter System in which the
exchange mechanism was ‘commodities for commodities’ or C  C.
• This system was found to be highly inconvenient due to the absence of a common
medium of exchange, a common measure of value; there was difficulty in not only
storing value but also transporting and exchanging goods. Due to these problems
and a number of other related problems like the problem of double coincidence
of wants, indivisibility of commodities, etc., there was a need to develop an
alternative system; which would solve these problems. This system restricted
trade, commerce, exchange and development.
• This led to the evolution of money and the monetised system in which the
exchange mechanism took the form of commodities for money and money for
commodities’, i.e. C ⇒ M ⇒ C.
• The introduction of money reduced the difficulties of the Barter System and led
to rapid growth of trade, production, exchange and economic activity.
• There are a number of crucial functions that money performs and the best way
to define money is ‘money is what money does.’
Money: Definitions and Functions 63

• Primary among its functions is the function of a ‘medium of exchange.’ Money has
in fact been defined as anything ‘which is a medium of exchange’ or facilitates the
exchange process. To be a medium of exchange it has to be ‘generally acceptable
as a means of payment’, it must possess the characteristics of a legal status or
backing of a supreme authority. (i.e. Central Bank) public faith and liquidity.
Money in the form of cash is in its most liquid form, i.e., readily acceptable as a
means of payment. Anything which cannot perform this basic and defining function
of money will at the most come close to money but not get the status of money.
• The other functions of money include a common measure of value, a unit of
account, a standard of deferred payments and the store of value functions. Value
can be stored in the form of not only money, but also in the form of a variety of
financial assets on which it is possible to earn interest income. However, money
is the most liquid form of holding wealth and hence there is a preference for
holding money in the form of cash balances.
• In addition to the above-mentioned functions, money also performs certain
dynamic and other functions which further facilitates the exchange process and
development of the economy.
• There are 2 basic approaches to the definition of money based on the function
of money:
(i) Traditional approach which emphasises on the functions of money or on
‘what money does.’ In this approach there are again 2 viewpoints the narrow
approach which defines money as anything generally acceptable as a means
of payment or something which is used to facilitate exchange transactions.
This approach concentrates on the medium of exchange function of money.
The broad definition includes both the medium of exchange and store of
value function as being important to defining money. Money is considered
to be a good store of value which provides an individual a claim over goods
and services for the period during which it is held.
(ii) Empirical approach is a practical approach to defining money and
includes all those assets which are seen to perform the basic function of
money. In its definition under this approach, coins, currency and demand
deposits would be included in the narrow most definition of money whereas
a range of financial assets, i.e. time deposits, and other forms of investments
would be included in the broad definition.
• All these assets differ in their degree of liquidity. The narrow most definition of money
in most countries is M = Coins + Currency + Demand Deposits or Current Deposits.
• It is also crucial to understand the break-up of the total money supply in an
economy into money and near money for purposes of effective monetary policy
formulation and also monetary regulation.
64 Macroeconomics

QUESTIONS

I. Short Questions
1. What is meant by a monetised system and what are its advantages over
the barter system?
2. ‘Medium of exchange in the basic and defining function of money.’ Explain.
3. ‘The empirical definition of money defines money on the basis of what is
actually used in society as money.’ Explain.

II. Long Questions

1. Discuss the functions of money as classified into primary and secondary
functions.
2. What accounts for the differences in the traditional and empirical approaches
to defining money? Explain by giving various definitions of money under the
two approaches.
3. ‘Money is what money does.’ In this context explain the functions of money.
CHAPTER

4
Demand for Money

4.1 INTRODUCTION
There are two important aspects related to money—the demand for money, and supply
of money.
Regarding the demand for money, it should be noted that money is a unique
commodity because it is a medium of exchange and hence, the demand for money
requires a special treatment.
Money is not generally demanded for its own sake or for direct consumption; it is
only a means to various ends. Therefore, the demand for money is not a direct demand
but an indirect or derived demand. The usefulness of money arises from the fact that
it is acceptable as a means of payments in any exchange transaction.

4.2 MEANING OF DEMAND FOR MONEY

‘Demand for money is demand to hold money in the form of cash.’ This implies that
as long as money is held in the form of cash, it is a demand for money. When money
is spent on goods and services or financial assets, it no longer remains a demand for
money but becomes a demand for the goods, services or financial assets.
Therefore, demand for money is demand for ‘cash balances’. As long as individuals
hold money, they hold a purchasing power or a claim over goods and services. ‘Money’
or ‘cash balance’ is also the most liquid form in which individuals can hold wealth
which accounts for the fact as to why individuals prefer to hold money in cash in spite
of the fact that it earns no interest or return. ‘Cash balances’ would also include the
demand deposits which are cashable on demand and on which cheques can be used.

4.3 MOTIVES TO DEMAND MONEY

This part of the analysis deals with the reasons as to why people demand money.
There are basically three motives to demand money which arise mainly from the two
important functions of money, i.e. Medium of Exchange (MOE) and Store of value
(SOV). This is given in Box 4.1.
65
66 Macroeconomics

BOX 4.1 Motives to Demand Money

4.3.1 Classical Approach (Transactions and Precautionary Motives)

• The Classical Economists emphasised on money as a ‘Medium of Exchange’
(MOE) and hence, stated that money is demanded mainly for transactions
purposes (i.e. Transactions Motive).
• Individuals hold ‘Cash Balances’ or ‘Money’ because it facilitates their exchange
transactions.
• As long as individuals hold money in its most liquid form, i.e. ‘cash’, they hold
purchasing power or a claim over goods and services.
• The classical economists also stated that the ‘transactions’ motive is dependent
dominantly on the level of income and since the number of transactions depends
on the level of income, i.e., there is a positive relationship between transactions
demand for money and income.
• The classical economists emphasised on the ‘Transactions’ motive and did not
recognise the speculative motive which arises from the ‘Store of Value’ function
of money.
Note: The Classical economists recognised the store of value function only in its very
passive sense where individuals can store value in the form of money to spend it at a
later date on goods and services which in effect is for future transactions.

4.3.2 Keynes Approach (Transactions, Precautionary and Speculative Motives)

A more comprehensive analysis of the motives to demand money was given by Keynes
who recognised both the medium of exchange and store of value function of money.
Demand for Money 67

Based on the above two functions Keynes recognised the following motives to
demand money:
1. Transactions motive (Mdt)
2. Precautionary motive (Mdp)
3. Speculative motive (Mds).
The transactions motive for money is based on the medium of exchange function
and the store of value function gives rise to the precautionary and more importantly
the speculative motive.
Keynes recognised the true meaning of the store of value function in the sense
that value can be stored in the form of money to speculate in the financial market
which gave rise to the ‘Speculative Motive’ to demand money.
Keynes found that the transactions and precautionary demand for money are
dominantly affected by the level of income whereas the speculative demand depends
on the rate of interest.
Therefore, total demand for money is:

∑Md = Mdt + Mdp + Mds

1. Transactions Motive to Demand Money (Mdt)

• The transactions demand for money is demand to hold money in the form of
cash balances in order to meet the expected expenditures or transactions.
• The transactions motive to demand money arises due to the fact that money is
a medium of exchange which facilitates the process of exchange transactions.
• Money is required in the process of transactions because it is a medium of
exchange and generally acceptable as means of payment.
• As long as individuals hold money in the form of cash, they hold purchasing
power which gives them a claim over goods and services.
• This motive to demand money was emphasised by the Classical economists who
considered money to be mainly a medium of exchange.
• The need to hold transactions cash balances arises due to the fact that there
is a gap between receipt of income and expenditures, so that individuals would
require to hold cash balances during this period to meet various expenditures.
• The Mdt is further classified into two sub-motives:
(a) Income motive: When individual households demand money to meet the
expected expenditures, it is called the income motive. These expenditures
would include expenditures on grocery, house rent, electricity, telephone
bills, transport charges, entertainment, payment of interest etc. These
expenses are not only expected but are also generally of a recurring nature.
(b) Business motive: When business units’ demand money to hold in the form
transactions balances, it is called business motive.
• The expected expenditures of business units are also referred to as the working
capital or recurring expenses. These includes wages, salaries, purchase of raw
materials and other inputs; interest on capital, rent, depreciation charges,
insurance premium, marketing, advertisement transportation charges etc.
68 Macroeconomics

Factors Affecting Transactions Demand for Money: The transactions demand

for money varies between individuals and also between business units. The factors on
which the transactions demand for money depend include:
1. Level of Income (Y): The higher the level of income, the greater is the
volume as well value of transactions, therefore greater will be the transaction
demand for money. This positive relationship between Mdt and income applies
both to the individuals as well as to the business units and is shown as given
below in Figure 4.1.

FIGURE 4.1 Relationship between Mdt and Level of Income.

2. Certainty of Receiving Income: Greater the certainty of receiving income,

less is the demand for transactions cash balances. This is because individuals
would be required to hold cash balances for a definite period. In absence
of such a certainty a larger cash balance would be required to meet the
expenditures.
3. Frequency of Receiving Income: Greater the frequency of receiving
income less is the transactions demand for cash balances. For example, a
worker earning daily wages would require to hold cash balances only to meet
his expenses over a day as compared to a person earning a monthly salary.
4. General Level of Prices: At higher level of prices, the value of transactions
is higher and therefore the transactions demand for money is higher.
5. Expected Level of Prices: If the prices are expected to rise in future there
is a general tendency to purchase and hoard those goods and services whose
prices will rise leading to a higher transactions cash balance in the current
period.
6. Level of Development of the Banking Habits and Financial Institutions:
A greater level of development of banking habits, i.e., the use of financial
instruments like cheques, credit cards, etc. would reduce the need to maintain
Demand for Money 69

huge cash balances, thus reducing the transactions demand for money.
Similarly, greater level of development of financial institutions.
7. Rate of Interest: The rate of interest generally does not affect the
transactions cash balance at normal or low rates of interest say, e.g. 5%. It is
only when the rate of interest rises to very high levels say 7% that individuals
will be tempted to withdraw from their transaction cash balance and invest in
deposits to take advantage of the rates of interest. This is because transactions
balances are maintained for expected expenditures which generally are not
likely to be postponed. This is shown in Figure 4.2 given below.

FIGURE 4.2 Relationship between Mdt and Interest Rates.

As can be seen in Figure 4.2, when i increases to say 7%, individuals will reduce
Mdt and invest in deposits.
Among all the above factors affecting Mdt, the level of income is considered to
be the most dominant factor.
\ Mdt = f(Y) (i)

2. Precautionary Demand for Money (Mdp)

This motive is also based on the medium of exchange function but recognises the fact
that money can be stored for a considerably long period of time without losing value.
The precautionary demand for money is demand to hold money in the form of cash
balances to meet unexpected expenditures or sudden contingencies.
Both individual and business units require such precautionary balances. When
individuals demand to hold precautionary cash balances to meet sudden expenditures
or contingencies it is known as the Income Motive. Business units have to hold
precautionary balances to meet unexpected events in business like for example, sudden
changes in demand, changes in government’s policies, sudden changes in the cost of
raw material, sudden competition. All these events disturb the revenue and expenditure
pattern of business units for which a precautionary balance is required. This is known
as the business motive.
70 Macroeconomics

Factors Affecting Mdp: As in the case of transactions demand, the Mdp also varies
between individuals and business units. There are a number of factors (similar to Mdt)
which affect Mdp.
1. Level of Income: As the level of income increases both the Mdp as well as the
capacity to maintain such balances will go on increasing, leading to positive
relationship between precautionary demand for money and the level of income,
given below in Figure 4.3.

FIGURE 4.3 Relationship between Mdp and Level of Income.

2. Certainty of receiving income: Greater the certainty of receiving income less

will be the Mdp.
3. Frequency of receiving income: Greater the frequency of receiving income less
is the precautionary demand for money.
4. Level of development of banking and financial habits: If the banking
and financial habits are well developed, individuals will hold a smaller
precautionary cash balance.
5. Rate of interest: The rate of interest is more active in the case of precautionary
demand for money. Even if the rate increases to a slightly higher level say
for example 5.5%, individuals will be induced to withdraw their precautionary
cash balance and invest in the deposits. Therefore, the rate of interest affects the
precautionary demand for money at lower rates as compared to the transactions
demand for money. This is shown in Figure 4.4.
The level of income is the most dominant factor affecting Mdp.
\ Mdp = f(Y) (ii)
Note: Though the demand for money has been defined as a cash balance, it would
automatically apply to the saving or the demand deposits because of their high degree
of liquidity.
Demand for Money 71

FIGURE 4.4 Relationship between Mdp and rate of interest.

3. Speculative Demand for Money (Mds)

The third motive to demand money is the speculative motive which is based on the
SOV function of money. This motive was presented by Keynes. Speculative demand
for money is the demand to hold money in the form of cash balances to speculate in
the financial market.
Whenever any part of this cash balance is actually invested, it becomes a demand
for the financial asset, for example shares, deposits, debentures, or any other form of
investment and no longer remains a speculative demand for money. As individuals
actually start investing in any financial asset, the speculative demand for money
actually declines.
In order to explain this motive, Keynes used the liquidity preference theory of
interest rate determination.
Basic Clarifications
1. Keynes stated that every individual has a preference to hold money in its
most liquid form, that is cash. This gives rise to term liquidity preference.
2. If an individual has to be induced to hold his money in deposits, debentures or
shares, there has to be an interest or a return on these forms of investments.
3. When individuals take advantage of changes in the rates of return, it is called
speculation.
4. The basic objective of speculation is to make a capital gain or avoid a capital loss.
5. The demand for money based on this motive is called the speculative motive
to demand money.
6. Keynes used the liquidity preference theory in order to explain the speculative
motive.
Keynes through the liquidity preference theory and speculative demand analysis
has shown that:
(a) Mds is interest elastic.
(b) The rate of interest is the most dominant factor affecting Mds.
72 Macroeconomics

4.3.3 Liquidity Preference Theory

The liquidity preference theory is a theory of interest rate determination.
According to this theory, the rate of interest is determined by two factors, demand
for money and supply of money. The equilibrium rate of interest is determined at a
point where demand for money (Md) is equal to the supply of money (MS) as shown
below in Figure 4.5.

FIGURE 4.5 Liquidity Preference Theory.

Explanation
1. Rate of interest is determined at the level where MS = Mds, i.e. where money
supply is equal to speculative demand for money.
2. Mds is also the Liquidity Preference Curve (LPC).
3. The Mds is a downward sloping function which indicates the inverse
relationship between speculative demand and the rate of interest (i).
4. When MS increases from MS1 to MS2 interest rates fall from i1 to i2 and when
MS contracts from MS1 to MS3 interest rate increases from i1 to i3. Therefore,
it can be seen that
1 
Mds = f  
i
5. The region where the Mds becomes parallel to the ‘X’ axis is the ‘Liquidity
Trap’ region. In this region changes in money supply fail to bring about
changes in the rate of interest.
Explanation of Speculative Demand for Money: Keynes presented a special
theory to explain the inverse relationship between speculative demand for money and
Demand for Money 73

the rate of interest. The theory is presented under certain given assumptions and
restrictions which needs to be understood before proceeding with the analysis.
Proposition No. 1
Keynes considered two alternative forms of investment:
(a) Bank deposits which earn an interest called the market rate of interest which
is subject to fluctuations.
(b) Government bonds which earn a fixed rate of return, this is a special type of
a bond called consols.
Proposition No. 2
The second proposition of his theory is very crucial to the entire analysis.
‘The rate of interest (i) and the price of bonds (Pb) are inversely related.’ (only if
there are only two alternative forms of investment.)
The above implies that when the rate of interest increases, the Pb falls and
when rate of interest falls Pb increases. This happens since only two alternative forms
of investment are considered. When the rate of interest on deposits increases, the
demand for deposits will increase; as a result, the demand for the alternative form of
investment, i.e. bonds will decrease, due to which the price of bonds will decrease thus
establishing the inverse relationship between i and Pb.
Proposition No. 3
In every economy, there is a concept of a normal rate of interest (in), for example, say 5%.
If the market rate of interest (im) fluctuates above and below the normal rate, it has a
tendency to return to the normal rate as indicated in the diagram given below in Figure 4.6.

FIGURE 4.6 Normal and Market Rates of Interest.

Proposition No. 4
Keynes further stated that in any decision related to speculation, it is not the prevailing
rates which are important but the expectations about the future rates that are of
extreme significance.
This proposition plays a very crucial role in the speculative decisions of individuals.
Every speculator has an idea about the normal rate of interest and therefore, also
an idea of the normal price of bonds. The movements in the rates and the expected
74 Macroeconomics

changes in the rates guide the speculative decisions. Using the above propositions, one
can proceed to understand the inverse relationship between Mds and interest. The
following diagram (Figure 4.7) shows how the speculative demand for money and the
rate of interest are inversely related.

FIGURE 4.7 Speculative Demand for Money (Inverse Relationship between Mds and i).

Explanation
1. As seen in Figure 4.7, when the rate of interest is i1, it is greater than in
(i.e. the normal rate), people will therefore expect the rate of interest to fall
in future (proposition no. 3). When the rate of interest is expected to fall the
price of bonds will be expected to rise in future (proposition no. 2) Therefore
individuals would hold less speculative cash balances, buy more bonds in the
present to sell the bonds in future to make a capital gain when the prices of
bonds rise. Therefore, at high rates of interest like i1, the speculative demand
for money is less at Mds.
(b) If the rate of interest is i2 it is less than the normal rate in people will
therefore expect the rate of interest to rise in future. When the rate of interest
is expected to rise in future, people will expect the price of bonds to fall in
future. Therefore, individuals would hold more speculative cash balances,
sell off bonds in the present to avoid capital loss in the future. Hence at low
rates of interest the speculative cash balances, sell off bonds in the present to
avoid capital loss in the future. Hence at low rates of interest, the speculative
demand for money is high.
(c) When the rate of interest falls to a very low level, e.g., to iL as during the
great depression, the situation is very abnormal This corresponds with the
region of the liquidity trap. When the rate is iL the rate of interest cannot
be expected to fall further. People will therefore expect the rate to rise in
future or they would expect the price of bonds to fall in future. In such a
situation, individuals prefer to hold the entire amount of money in the form of
speculative cash balances. The speculative demand for money corresponding to
the liquidity trap region thus becomes perfectly elastic. The safest speculative
Demand for Money 75

investment decision in such a situation is to wait and watch the financial

market behaviour.
Concluding Observations: Keynes thus established an inverse relationship between
speculative demand for money and the rate of interest and stated that the rate of
interest is the most dominant factor affecting speculative demand of money. Keynes
theory which is presented within certain restrictive propositions however, can be
expanded to explain the general behaviour of speculation in the financial market.
The conclusion that one can derive from Keynes analysis for the general speculative
behaviour is that there are three guiding principles—Liquidity, Return and Risk, which
people consider while making investment decisions. In any financial and speculative
decision what is most crucial is the future expectations about the market behaviour,
individuals who are able to predict the market situation with greater ease, certainty
and accuracy would make capital gains.
The total demand for money is thus:
∑Md = Mdt + Mdp + Mds
where, Mdt = f (Y), Mdp = f (Y), Mds = f (1/i)

4.4 POST-KEYNESIAN DEVELOPMENTS IN DEMAND FOR MONEY

In the later period, i.e., mainly 1950’s, many economists attempted to develop on
Keynes approach to demand for money, prominent among them were William Baumol,
James Tobin and Milton Friedman.

4.4.1 ‘Asset Approach’ to Demand for Money (Milton Friedman)

Friedman has analysed in detail the reasons as to why people demand money and
comes to the conclusion that money is only one kind of an asset in which individuals
hold their wealth, the other forms include bonds, equity shares, real assets and even
investment in education. Therefore, the demand for money should be studied a part
of holding alternative assets leading to the ‘Asset Demand’ for money. For details on
Friedman’s approach to demand for money, see Chapter 8, Section 8.6, Part 2.

4.4.2 William Baumol and James Tobin Approach to Demand for Money
Baumol and Tobin developed on the transactions motive to demand for money and
concluded that the transactions demand for money is also sensitive to the rates of
interest.1 In the Classical and Keynes approach, it was dominantly affected by the
level of income. Baumol and Tobin consider transactions demand for money also to be
inversely related to the rate of interest where individuals would try to economize on
money cash balances and invest money in deposits and other assets to take advantage
of the rise in the rates of interest. This logic would also apply to the precautionary cash
balances. Therefore, they went ahead to show that both transactions and precautionary
demand for money are influenced by rates of interest (inverse relationship).

1. William J. Baumol, “The Transactions Demand for Cash: An Inventory Theoretic Approach,”
Quarterly Journal of Economics, 66 (1952): 545–556; and James Tobin, “The Interest Elasticity
of the Transactions Demand for Cash,” Review of Economics and Statistics, 38 (1956): 241–247.
76 Macroeconomics

4.4.3 Portfolio Approach to Demand for Money (James Tobin)

A significant landmark in the analysis of demand for money was the ‘portfolio approach’
demand given by James Tobin. Tobin developed upon Keynes speculative motive to
show that when individuals make investment decisions, they do not compare only one
or two assets but a whole range of assets and their relative returns. This led to the
portfolio approach or the asset preference approach.
The essence of this approach is that there are various forms of assets in which
wealth can be held i.e. stocks, shares, bonds, real estate etc. and money is only one
such form of asset. When individuals decide to arrive at an ‘Optimum combination’
on optimum portfolio of such assets, they consider basically the three principles of
investment -risk, return and liquidity. Tobin emphasised that money is held as a
part of this portfolio because of its high liquidity, least risk and general acceptability.
Individuals hold a diversified portfolio consisting of a combination of assets which
balance risk, yield or return and safely. Money is significant part of this portfolio
because it imparts ‘Liquidity’ to the asset portfolio and there is a generally a greater
demand for such ‘Liquid cash funds’ when the market is uncertain and wobbly. Tobin’s
approach was, therefore, a broader and more realistic approach to the speculative
demand for money.
For a detailed analysis of Tobin’s Theory, see Chapter 8, Section 8.6.3.

Points to Remember
• Money being a unique commodity, its demand has to be understood in a special
sense. Since money is generally not demanded for its own sake but for the
functions it preforms the demand for money is a Derived demand.
• Demand for Money is ‘demand to hold money in the form of cash balances
Whenever any part of this cash balance is spent on goods, services or is used
for investments in financial assets or even in real assets—it no longer remains a
demand for money but becomes a demand for commodity/asset on which it is spent.
• There has been a lot of discussion as to why people demand money or what
are the ‘Motives to demand money.’ There are two dominant approaches to this
analysis—the Classical approach and Keynes approach.
• The Classical Economists believed that money is basically a Medium of Exchange
and hence is used for meeting various transactions and therefore considered
mainly the Transactions Motive to demand money.
• Keynes recognised both the Medium of Exchange and the Store of Value function
of money and based on this gave a more complete analysis of the demand for
money. He discussed 3 motives to demand money:
(i) The Transaction Motive (Mdt)
(ii) The Precautionary Motive (Mdp)
(iii) The Speculative Motive (Mds)
• When people demand money to meet expected expenditures,it gives rise to
the transaction Motive, and when people demand money to meet unexpected
expenditures, it gives rise to the precautionary motive. Both the Mdt and Mdp are
positive functions of the level of income. Therefore, Mdp = f(Y) and Mdp = f(Y). The
rate of interest (i) was not found to affect Mdt and Mdp in a significant manner.
Demand for Money 77

• Keynes has given detailed explanation of the speculative demand for money
(Mds). The Mds is found to be inversely related to the rate of interest
1 
Mds =  
i
• The Liquidity Preference Theory (LPT) has been used to further explain the Mds.
Individuals have a preference to hold money in its most Liquid form, i.e. cash, and
if they have to be induced to hold money in any other form, they need an incentive
in terms of rates of return. When individuals demand to hold money in the form
of cash balance to speculate about these rates of return on various financial
assets—it is called the speculative demand for money Speculation is undertaken
in order to avoid a capital loss or make a capital gain in the financial market.
• Keynes shows that when the rate of interest increases the Mds falls and vice
versa. Future exceptions about the behaviour of the rate of interest and price of
bonds play a crucial role in the speculative demand for money analysis. The total
demand for money is thus given as ∑Md = Mdt + Mdp + Mds.
• In the Classical and Keynesian approach therefore the Mdt and Mdp are positive
functions of the level of income, and the Mds is inversely related to the rate of
interest.

QUESTIONS

I. Short Questions
1. ‘Demand for Money is demand to hold money in the form of cash balances.’
Explain.
2. What are the distinguishing characteristics of transactions and precautionary
demand for money?
3. In Keynes analysis of demand for money what is meant by speculative
demand for money?
4. ‘The liquidity trap is a region, where the monetary policy becomes ineffective.’
Explain.
5. ‘The rate of interest has a significant role to play in Keynes speculative
demand for money analysis.’ Explain.

II. Long Questions

1. What is meant by demand for money in economic analysis? Explain in detail
the motives to demand money bringing out their distinctive characteristics.
2. ‘Transaction demand for money is demanded for expected expenditures and
precautionary demand for unexpected expenditures.’ Explain.
3. ‘The rate of interest and speculative demand for money are inversely related.’
Explain.
4. ‘The liquidity trap region shows a level where demand for money becomes
perfectly elastic.’ Explain.
CHAPTER

5
Supply of Money

5.1 MONEY SUPPLY

Having understood the concept of demand for money, one can move on to the concept of
money supply which is a very crucial variable in any economy. The level and changes
in money supply affect a number of other variables like rates of interest, general price
level, the internal value of the currency, external value of the currency, the level of
investment, output, growth and the level of stability in an economy.
Money supply refers to the volume of money in circulation or held by public at
any given point of time.

5.2 MEANING AND DEFINITION OF MONEY SUPPLY

Clarifications about Money Supply
1. Money supply refers to the total amount or stock of money in circulation at
any given point of time.
2. It should be noted that money supply is a stock concept, it is measured at a
given point of time.
3. Changes in Money Supply are a flow variable.
4. Money supply refers to the money in circulation with the public which includes
households, firms, industries, the state and municipal governments, banks,
financial institutions, foreign banks, etc.
5. The present form of money is highly evolved; a number of commodities have
been used as money over the years.
6. The supply of money therefore refers to the money with the public or in circulation.
7. It refers to the volume of money held by people in the country, i.e. individuals,
households and others (Money held in government treasury and lying with
the commercial banks is excluded).
The money supply in a country has two main components:
1. Currency Component: This includes coins and currency notes in circulation
issued by the central government and central bank. The other part of currency
component is cash in hand with banks (which is not in circulation).
78
Supply of Money 79

2. Deposit Component: Refers to the deposit of the general public with the
banks which can be used for circulation or spending.
The deposit money consists of demand deposits of banks and other deposits with
the RBI.

5.3 EVOLUTION OF MONEY

Over the year’s various items have been used as money. The prevailing form of money
depends on the stage of economic development.
Stage I: Primitive/Early Stages: Commodity Money: In the primitive or early stages
of development commodity money like shells, food grains were used as money. However,
this system or form of money was found to be very inconvenient.
Stage II: Moderately Developing Economy: Metallic Money: In a moderately
developing economy, ‘Metallic Money’ was used i.e. precious metals like gold and
silver coins. These were useful not only by themselves but are also valuable due to its
scarcity. In later stages, ‘inferior metals’ like nickel also circulated as money and the
idea that money need not have an intrinsic value by itself so long as they are accepted
as a means of payment evolved. Coins, made out of inferior metals are called ‘token
coins’ against the earlier gold and silver coins which are known as “full-bodied coins”.
This system could, however not sustain itself due to the depletion of gold and silver
resources and due to a number of malpractices associated with the use of metallic coins.
Stage III: Commercially Developed Economy: Representative Paper Currency & Coins:
In a commercially developed economy, as exists today, the form of money in existence
is Representative Paper Currency Standard and Token Coins. This currency standard
is backed by gold (to some extent), foreign exchange securities. Over the years this
backing also is on the decline.
Stage IV: Industrially Advanced Economies: Bank/Credit Money: When economies
develop further, along with the paper currency and coins, a significant proportion of money
supply is in the form of bank or credit money which is created by the financial system.

BOX 5.1 Evolution of Forms of Money

Stages of Development Type of Money
STAGE I: Primitive/Early Stage Commodity Money
STAGE II: Moderately/Semi-developed Metallic Money (Precious Metals)
STAGE III: Commercially Developed Representative Currency/Token coins
STAGE IV: Industrially Developed Bank Money/Credit Money + Representa-
tive Currency/Token Coins

5.4 COMPONENTS OF MONEY SUPPLY

Money has been defined primarily as a medium of exchange which also performs the
functions of measure of value, store of value and unit of account.
80 Macroeconomics

Money supply basically includes Coins, Paper currency and Demand Deposits of
commercial and co-operative banks which are cheque-able and hence, are closest to
being a medium of exchange.

5.4.1 Present Currency System in India

The present currency system in India has two components:
1. Coins
2. Paper Currency
3. Demand Deposit
The issue of currency is managed by the RBI (Central Bank of the Country) and
the monetary system of the country is based on ‘Inconvertible Paper Currency.’

1. Coins
Coins can be of two types:
(a) Coins which are ‘full bodied’ coins where the intrinsic value is equal to the
face value. (This was the case under the metallic standard when gold and
silver circulated as coins.)
(b) Token coins represent the ‘face value’ of the coin and the face value is higher
than the metallic value of the coin. These coins represent a certain value and
hence are called ‘Token Coins.’ The Finance Ministry of the Government of
India manages the issue of coins and rupee one notes in India.

2. Paper Currency System

One form of paper currency is the convertible paper currency which can be converted
into coins or precious metals. The other form of paper currency is the Representative
Paper Currency Standard where the currency is backed either by the proportional
system or minimum reserve system in the form of gold coins, gold bullion, rupee coins,
rupee securities, foreign securities, etc. The present system in India is known as the
‘Minimum reserve system of note issue.’
Under this system, a minimum of gold and foreign securities to the extent of
` 200 crores (of which gold value is ` 115 cr.) is maintained against the issue of
currency, the balance is maintained in rupee securities.
The issue of currency in India is managed by the Issue Department of RBI. (` 2
and above currency notes are issued by the RBI in India.)

3. Demand Deposits
These are also known as current deposits and are subject to the facility of the use of
cheques. These refer to the deposits of the general public with commercial banks. Such
deposits are regarded as money because a person can pay for purchases with cheques
directly drawn upon deposits (which get credited and deposited). The demand deposits
being payable on demand easily perform the medium of exchange function.
Bank money is quantitatively more important than currency because most
transactions are made by cheques. Cheques are convenient for mailing, for paying
Supply of Money 81

exact sums of money due, for providing a receipt in the form of the cancelled cheque-
voucher, for protecting against loss when stolen or misplaced. Due to these advantages,
there is widespread use of bank-money.
Notes and coins make up the cash or currency part of the total money supply.
This is also called legal tender money because no one can refuse payment according
to the law. Money in the form of bank-deposit liabilities is not legal tender because no
one can force anybody to accept payment by the transfer of deposits held in a bank.
Thus, in developed economies,
Total money = Currency + Coins + Bank Deposits
(i.e., Liabilities of Central Govt. + Liabilities of Central Bank + Liabilities of Commercial
Banks)
Note: All deposits of the commercial banks do not circulate as money. (Refer to the
chapter on commercial banks).
The composition of money supply changes as per the level of development of the
economy. In an advanced, monetised economy, money mostly consists of bank- money;
hence a change in bank or credit money supply affects the total money situation, which
in turn affects directly or indirectly, the macroeconomic situation.
However, as mentioned in the evolution of money, the economies which are not
well-developed economically show a preference for coins and paper currency. In urban
and industrialised areas, however, bank money is used to a large extent, especially in
commerce and large-scale industries. Even then, bank money forms a comparatively
smaller proportion of the total money-supply in the backward economies as compared
to advanced economies. As can be seen in Figure 5.1 the Cash to GDP ratio in
India is very high, and the High Denomination notes (HDN) are on the lower side.

Source: Economic Survey, Government of India Ministry of Finance Department of Economic

Affairs Economic Division January 2017.
Note: CIC = Currency in circulation
HDN = High denomination notes (INR 500 and INR 1000)
FIGURE 5.1 Currency in Circulation, High Denomination Notes and Real GDP Growth.
82 Macroeconomics

Figure 5.2 shows that the volume of consumer transactions carried out in cash in 2015
in India was very high at 98 per cent of total value and accounted for 68 per cent of
the value of transactions thus indicating a highly cash-dependent economy. This also
provides a background to the Demonetisation of 2016 in India.

Source: Economic Survey, Government of India Ministry of Finance Department of Economic

Affairs Economic Division January, 2015.

FIGURE 5.2 Consumer Transactions Carried Out in Cash (%, 2015).

5.5 NEAR MONEY

5.5.1 Money and Near Money

Over the years, in any monetary discussion, a concept which is gaining importance is
the concept of near money. This concept or form of money has evolved over the years
with the growth of the banks and financial institutions. As can be seen from the above
analysis as an economy progresses, the proportion of near money to the total money
supply goes on increasing, hence the need to study this concept.

5.5.2 Definition and Meaning of Near Money

Before proceeding with the definition of near money, the point to be noted is that Near
Money is only one form of holding one’s wealth, i.e. in the form of ‘financial assets.’
The other forms are Monetary assets and Real assets.
Supply of Money 83

In order to further clarify the concept of near money, it is necessary to recall the
basic and defining function of money, i.e., a Medium of Exchange (MOE). Anything which
cannot satisfy this defining function of money will at the most come close to money
and is called near money or quasi money. This is how the idea of near money evolved.

Definition of Near Money

‘‘Near money are those assets which are good stores of value but are not
perfect mediums of exchange.’’1 Therefore, the distinguishing characteristics of
Near Money as compared to Money can be listed as follows:
1. Near money are not perfect mediums of exchange.
2. Not generally acceptable as a means of payment.
3. Not 100% liquid.
4. These assets do not enjoy the legal backing of the type that money has
(i.e. the backing of the Central Bank and Government).
Near money assets are therefore very close to money because they are highly
liquid, can become acceptable as a means of payment by quickly being converted into
money, and are good stores of value. However, what prevents them from enjoying the
status of money is the inability of near money to be a perfect medium of exchange.
Examples of near money: Near Money includes a whole range of assets like bank
deposits, demand deposits, savings and fixed deposits, shares, debentures, units of UTI,
LIC Policies, Post-Office Savings deposits, NSC, etc.
Note: All the above-mentioned items are financial assets in which value can be stored.
It should not be confused with financial instruments which only facilitate receipts and
payments, e.g. cheques.
All the above Near Money assets differ in their degree of liquidity or moneyness.
The more liquid an asset is, closer it will be to money. As the economy develops
and banking habits develop, some of these assets come very close to money and in
fact become a means of payment and a medium of exchange, e.g. demand or current
deposits. As a result, these deposits have been included in the narrow most definition
of money supply:
M1 = Currency + Coins + Demand Deposits

1. Lipsey, Richard G., and C.D. Harbury. First Principles of Economics, Oxford University Press,
2004.
84 Macroeconomics

5.5.3 Importance of the Concept of Near Money

The proportion of Near Money is increasing in almost all economies. The importance
of this concept can be noted as given below:
1. Breakup of Money Supply: It is necessary to understand the break-up of
money supply into monetary and financial assets or near money to understand
the composition of Money Supply in an economy.
2. Effective Formulation of Monetary Policy: It is crucial to know the
volume of near money and the rate at which it is growing for the effective
formulation and implementation of the monetary policy. Near money is created
by the banks and financial system. Once the volume and trends in the growth
of this ‘Near Money’ component of money supply is known, it is easier to
regulate and control this part of money supply.
3. Reflects the Level of Development of Banking & Financial Institutions:
The growth of Near Money assets indicates the level of development of the
banking and financial institutions in an economy.
4. Necessary for a Complete Monetary Analysis: It is important to
understand the break-up of the Total Money Supply into Money and Near
Money for any complete monetary analysis.

5.6 RBI‘S MEASURES OF MONEY SUPPLY

There has been a lot of debate and discussion on what should or should not be included
in money supply. The most important criteria used for this purpose is the degree of
liquidity of assets.
• This gives rise to what is termed as the narrow and broad approaches to
money supply.
• Before proceeding with the Reserve Bank of India’s (RBI) definition of money
supply, it should be noted that the most acceptable definition of money supply
in almost all countries today is:
MS = Coins + Currency + Demand or Current Deposits
• Using the concept and degree of liquidity, the RBI has come up with various
measures of money supply. Initially, till 1967–68, the RBI used to publish a
single measure of money supply M, which was a sum of currency and demand
deposits held by the public.
• However, after this period, the RBI published a ‘broader’ measure of money
supply [Aggregate Monetary Resources (AMR)] which is ‘M’ plus time deposits
held by the public.
• From 1977, the RBI has provided liquidity measures or concepts of money
supply in India which are known as Money Stock Measures or Measures of
Monetary Aggregates given below:

5.6.1 Money Supply Measures: 1977

M1 = Coins + Currency + Demand Deposits + Other Deposits.
Supply of Money 85

(where other deposits include deposits of the government, commercial banks, foreign
government deposits with RBI.)
M2 = M1 + Savings Deposits with Post-office Savings Banks.
M3 = M1 + Time Deposits of public with all commercial and co-operative banks.
Note: M3 is also called ‘Aggregate Monetary Reserves’ (AMR) of a country and is the
Broad Money.
M4 = M3 + Total deposits with post offices and other saving organisations.
Note:
1. The logic of the above measures is to include not only the cash with the public
but all forms of deposits and assets which can be converted into a medium
of exchange or means of payment.
2. The total money supply in the country is that amount of money which is with
the public and for all practical purposes can become a means of payment.

5.6.2 Modified/Revised Measures of Money Supply (New Monetary and

Liquidity Measures): 1998
The RBI appointed a Working Group on Money supply to modify the earlier measures
of money supply which had been used for almost more than two decades.
In 1998, the Committee recommended and published the modified measures and
created two measures of money supply:
1. Monetary Measures
2. Liquidity Measures
In the modified measures of money supply:
1. Saving bank deposits (included previously in M2) and also all deposits with
Post-office (earlier included in M4) have now been dropped.
2. Therefore, now there are only 3 working Monetary Measures M1, M2, M3.
Modified/Revised Monetary Measures
M1 = Currency + Coins + Demand Deposits + Other Deposits of RBI.
(This is also known as Narrow Money.)
M2 = M1 + Time Liabilities Portion of Savings Deposits with Banks + Certificate
of Deposits Issued by Banks + Term Deposits Maturity within a year
(Excluding FCNR’s Deposits)
Note: Post-office deposits are now excluded, Certificate of Deposits which are issued
by banks and short-term deposits of one year are now included, both these can be
converted into money if the need arises.
M3 = M2 + Term Deposits with Banks of Maturity of over one year + Call and
Term Borrowings of the Banking System.
M3 is also referred to as broad money.
86 Macroeconomics

The 4 major changes in M2 and M3 are:

1. P.O. savings deposits and all other deposits of the post-office have been
excluded.
2. Saving deposits/Term deposits held by the public have also been divided into
short term maturity up to 1 year and long-term maturity above one year.
3. Borrowings of the banking system (call and short term have been included
for the first time).
4. M4 is excluded.
The narrow and broad money definitions is based on the Radcliffe committee
recommendations.

5.6.3 Liquidity Measures

In addition to the monetary aggregates, i.e., M1, M2, and M3, the RBI introduced the
liquidity measures in order to measure the overall liquidity position of the economy.
The monetary measures, i.e., M1 to M3 concentrate only on the commercial banking
system. As a result, the money with other Financial Institutions get excluded.
Therefore, to understand the total liquidity position the RBI publishes three
liquidity measures given as:
L1 = New M3 + All Deposits of P.O. Savings Banks excluding National Saving
Certificate (NSC).
L2 = L1 + Term Deposits with Term Lending Institutions and Refinancing
Institution + Term Borrowing by Financial Institutions (FIs) + Certificate
of Deposits (CD) issued by FIs.
L3 = L2 + Public Deposits of NBFC (Non-Banking Finance Companies)
The Liquidity aggregates L1 to L3 consider term deposits with and borrowings
also of FIs & NBFC; whereas M1 to M3 considers only Bank deposits and borrowings.
An idea of estimates of M1 to M4 in the Indian economy can be seen from the
following Table 5.1.

TABLES 5.1 Money Stock Measures (as on March 31st 1990–1991 and 2018–2019)

1990–91 2018–19 (Nov.’19)

(` crore) (` crore)
(1) Money Supply with Public (M1) 92,892 3,710,285
(2) Post-office Saving Deposits 4,210 1,406.0
(3) M2 (M1 + Sr. No. 2) 97,100 37,151.7
(4) Time Deposits with Banks 1,72,936 11,720,589
(5) M3 (M1 + Sr. No. 4) 2,65,30 1,55,677.8
(6) Total Post-office Deposits 14,680 3,672.9
(7) M4 (M3 + Sr. No. 6) 2,65,828 1,54,30,874
Supply of Money 87

Notes:
1. M1 and M3 are significant.
2. Calculations of post office savings are not very up to date.
3. M4 is not very relevant.

TABLE 5.2 Summary of RBI’s Measures of Money Supply

[Monetary Liquidity and Aggregates in India]

Monetary Aggregates Revised/ Modified Monetary Liquidity Aggregates (1998)

(1977) Aggregates (1998)
M1 = Currency + Demand M1 = Currency + Demand L1 = New M3 + All Deposits
Deposits + Other Deposits Deposits + Other Deposits with P.O. Savings Banks.
(No Change) (Excluding NSC)
M2 = M1 + Saving Deposits M2 = M1 + Time Liability L2 = L1 + Term Deposits with
with P.O. Savings Banks portion of Savings Deposits Term Lending Institutions
with Banks + CDs issued + Term Borrowing of FIs +
by Banks + Term Deposits CDs issued by FIs.
Maturing within one year
M3 = M1 + Time Deposits of M3 = M2 + Term Deposits over L3 = L2 + Public Deposits of
public with all Commercial one-year Maturity + Call/term NBFCs
and Co-operative banks. Borrowings of Banks.
Or
AMR-Aggregate Monetary
Resources
M4 = M3 + Total Deposits M4 = Abolished in Modified
with Post-offices and other and Revised Measures.
Saving Organisations.

Source: Reserve Bank of India (2019), Handbook of Statistics on Indian Economy.

Appendix A Note on Reserve Money and Money Multiplier

In monetary analysis, a concept of extreme significance is the concept of Reserve Money.
Reserve Money (RM) is the cash held by the public and banks.
It includes:
(a) Currency in circulation with public.
(b) Other deposits with RBI.
(c) Cash reserves of banks (CR), which has 2 components:
(i) Cash reserves in currency notes kept by the banks with themselves.
(ii) Bankers deposits with RBI which they maintain with RBI as cash reserve.
\ RM = C + OD + CR
where,
RM = Reserve Money
C = Currency in Circulation with Public.
CR = Cash Reserve of Banks.
88 Macroeconomics

Significance of RM (Reserve Money) and the Concept of Money Multiplier: The

reserve money (RM) and money supply (M) have a very strong interrelationship. ‘M’
and ‘RM’ are directly related, and changes in ‘M’ in a country are dominantly due to
changes in RM. Changes in RM cause changes in the money supply.
The money multiplier shows the nature of the effect on money supply (M1 or M3)
as a result of a change in Reserve Money, i.e., RM.
The theory of money supply states that M is an increasing function of RM
expressed as:
M = mRM
or m = M / RM
where,
M = Money Supply.
m = Money Multiplier.
RM = Reserve Money.
\ Money multiplier is money supply divided by reserve money. This concept can be
applied to both narrow money (M1) or Broad money (M3) and expressed as:

M1
m= (Narrow Money)
RM

M3
and m= (Broad Money)
RM
The concept will become clearer with the help of an example given in Table 5.2.

TABLE 5.2 Calculation of money multiplier figures (as on September 15th 2020)

Year Money Multiplier Narrow Money Broad Money

M1 M3 RM M1/Rm M3/RM
(` crore) (` crore) (` crore)
1980–81 208.91 509.66 19452 1.2 3.0
2013–14 19573.29 89822.12 2059762 1.2 5.6

Source: Reserve Bank of India (2019), Handbook of Statistics on Indian Economy.

Explanation
In the table, if we consider the year 2013–14; for narrow money, the money multiplier
is 1.2, and for Broad money, it is 5.6. What this means is that every increase in RM by
1 it will result in an increase in M1 by 1.2 times and the same will cause an increase
in M3 by 5.6 times.
Therefore, the money multiplier shows the magnitude of increase in M due to
change in RM and also it is quite clear that money supply is an increasing function
of RM.
Supply of Money 89

Points to Remember
• Money supply refers to the total stock of money in circulation at any given point
of time. It should be noted that money supply is a stock concept and measured
at any given point of time. Changes in money supply are a flow variable.
• Money Supply refers to the money in circulation with the public which includes
the state and municipal governments, banks, financial institutions, foreign banks,
etc.
• The present form of money is highly evolved from which has developed over the
years from commodity money to metallic money (precious metals like gold, silver)
to paper currency and coins and finally to credit money or bank money which
exists in a commercially and industrially developed economy. With the growth
of the banking and financial system the credit money/near money has gained
more significance.
• A concept which is gaining importance is the concept of Near Money. Near money
are those assets which are very good stores of value but not perfect mediums
of exchange and hence they are defined as Near or Quasi money. These assets
include financial assets like deposits, shares, bonds, debentures units, National
Savings Certificates etc. in which value can be stored but which have to be
converted into ‘Money’ to acceptable as means of payment.
• There has been a lot of controversy and debate as to what should or should not
be included in the money supply—the most important criteria used has been the
‘degree of liquidity’ of an asset. Depending on the degree of liquidity some assets
come close to money and some do not. This is what gives rise to the Narrow and
Broad definition of money supply.
• The generally acceptable definition of money supply in almost all countries today
is: M = Coins + Currency + Demand or Current Deposits.
• Using the concept and degree of Liquidity and based on the Radcliffe committee
recommendation the RBI devised 4 measures of Money supply, i.e., M1, M2, M3,
and M4 in 1977. Certain modifications in the definitions have been made in later
years. Currently M4, the definition has been abolished, and M3 serves as the
aggregate monetary measure.
• The logic of definitions is to include the highly liquid assets in the narrow
definition of money (M1) and the less liquid assets in the broad definition, i.e. M3.
As a result, demand deposits and other deposits of RBI get included in M1 and M4
includes lesser liquid assets like term and time deposits of the banking system.
• The purpose of these measures is to include not the cash with the public but all
forms of deposits and holdings which can be converted into a medium of exchange
or means of payment.
• In addition to the above definitions/measures of money supply, the RBI has also
introduced the concept of Liquid Resources in India, L1 to L3 which given an idea
of the ‘liquid resources’ of the economy at any given point of time.
90 Macroeconomics

QUESTIONS

I. Short Questions
1. Explain the concept and meaning of ‘Liquidity’ and its significance in the
analysis of Money Supply.
2. There is no difference between money and near money. Do you agree? Justify
your answer.
3. ‘Money has evolved over the years in its form.’ Explain.
4. Account for the differences between monetary and liquidity measures given
by the RBI.

II. Long Questions

1. What is the basis of the various measures of money supply as given by the
RBI? Elaborate in detail the monetary and liquidity measures given by the
RBI.
2. Briefly outline the evolution of money and explain the main components of
money supply in a modern economy.
3. Explain the concept and meaning of ‘liquidity’. Explain the significance
of this concept in arriving at the Narrow and Broad definitions of money
supply.
4. Money supply in an economy is a crucial variable. In this context, explain
the various components of money supply.
5. Point out and also explain the mistakes in the following definition of M2
given in the modified measures given by RBI.
M2 = M1 + Time Liabilities portion of Savings Deposits with Banks –
Certificate of Deposits issued by Banks – Term Deposits Maturity within a
Year (Excluding FCNR’s Deposits).
6. Near Money are those assets which are perfect stores of value but not perfect
mediums of exchange. Elaborate with examples of Near Money.
CHAPTER

6
Central Bank
Credit Control Measures

6.1 INTRODUCTION
The Central Bank of a country occupies an important position in the monetary and
banking structure of the country. The Central Bank is an institution entrusted with
the responsibility of managing the expansion and contraction of the volume of money
in the economy. The Central Bank may be defined as the apex banking and monetary
institution whose main function is to control, regulate and stabilise the banking and the
monetary system of the country in the national interest. It is the supreme monetary
authority in the country and performs unique functions.

6.2 FUNCTIONS OF THE CENTRAL BANK

Although the functions of the Central Bank differ from country to country, there are
certain basic functions performed by the Central Banks in all countries.
The main functions of the Central Bank are given below:
1. Central Bank has a monopoly of note issue: It came to be accepted, over
a period of time, that the Central Bank was the most appropriate institution
to undertake the issue of paper currency due to the following reasons:
(a) Apex Monetary Authority
(b) Unique Legal Status
(c) Enjoys Public Faith and Confidence.
Because of this the right to issue notes has been granted to the Central Bank
in all the countries. In India also the right to issue notes is with the RBI.
This right is regulated by law. Every note issued by the Central Bank must
be backed by an asset of equal value, like foreign currencies, government
securities, other securities, metallic reserves, etc.
91
92 Macroeconomics

2. The Central bank acts as the Banker, Agent, and Adviser to Government:
As a banker to the government, the Central Bank maintains the accounts of
the various government departments and institutions. It accepts deposits from
the government and provides short-term loans (ways and means advances) to
the government when required.
As an agent to the government, the Central Bank accepts loans and
manages public debt, receives taxes and other payments from the public on
behalf of the government.
As a financial adviser, the Central Bank provides guidance to the
government on economic issues like devaluation of currency, commercial
policy, foreign exchange policy, budgetary policy, etc.
3. The Central Bank acts as a Banker’s Bank
(a) The Central Bank is the Custodian of the Cash Reserves of
Commercial Bank: The commercial banks keep a part of their deposit
liabilities with the Central Bank so as to use it during times of emergency.
In every country, the commercial banks are, by law, required to maintain
a part of their liabilities with the Central Bank.
(b) The Central Bank is a Lender of the Last Resort: When the
commercial banks are in need of liquid cash, the Central Bank provides
financial accommodation, if and when all other sources are exhausted.
(c) The Central Bank is the Bank of Central Clearance, Settlement,
and Transfers: The Central Bank acts as a clearing-house for the
commercial banks, this is possible because it holds the reserves cash of
the commercial banks. Since all commercial banks have accounts with
the Central Bank it is possible for the Central Bank to settle claims
and counter-claims of the commercial banks with minimum use of cash.
4. Central Bank is the Custodian of the Nation’s Gold and Foreign
Exchange Reserves: The central bank maintains the foreign exchange
reserves of a country and is entrusted with the responsibility of regulating
demand and supply of foreign exchange and stabilising exchange rates in the
economy.
5. Central Bank Publishes Economic Statistics and other Useful
Information: These publications provide valuable information on the basis
of which the Government can formulate and implement its economic policies.
6. Central Bank acts as the Controller of Credit: This is the most
important function performed by the Central Bank. If the Central Bank is
able to control the creation of credit within limits, it is a conducive to the
economy. But if the credit is not effectively controlled and kept within limits,
it can have dangerous consequences for the country. The credit control and
monetary policy is one of the most important policy tools of the Central Bank.
As a controller of credit, the Central Bank automatically has control over
the internal price-level as well as the fluctuations in the foreign exchange
rates. The Central Bank is in a position to control credit as it acts as the
bank of issue and the custodian of the cash-reserves of the commercial banks.
Central Bank: Credit Control Measures 93

The Central Bank uses different qualitative and quantitative measures

to control the credit in the economy. (These are discussed in detail in the
following sections).
7. Promotional /Developmental Functions: Besides the above-mentioned
functions, the Central Bank promotes and supports economic growth in most
countries, specially developing ones. These are referred to as the promotional
functions of the Central bank which includes financing the developmental
process, special assistance to the priority sectors, i.e. agriculture, small scale
industries, rural-based industries, export-oriented industries, maintaining
regional balance, developing infrastructure, etc.

6.3 OBJECTIVES OF CREDIT CONTROL POLICY (MONETARY POLICY)

The main objectives of the credit control policy of the central bank are as follows:
1. Stability in the Internal Price-Level: The Central Bank tries to bring
about stability in the internal price-level through the control of credit. It
basically tries to ensure that the economy does not face excessive inflation
and deflation
2. Control of Business Cycles: The objective of the credit-control policies of
the Central Bank should be to reduce the problems caused by the cyclical
business fluctuations. By changing the volume of credit, the Central Bank
can control the business cycles to some extent.
3. Stability in Exchange Rates: The instability in foreign exchange rates
can be harmful to the foreign trade of the country. The central bank tries
to regulate the exchange rates through regulating credit and money in the
economy.
4. Stability of Money Market: To achieve this objective, the Central Bank
attempts to reduce the seasonal variations in the demand for funds. It is
responsible for the management of liquidity in the economy.
5. Promotion of Economic Growth: The main goal of credit control policy
in backward and developing countries is to promote economic growth in a
balanced manner. In such countries, the central banks have to ensure that
adequate funds are available for development.

6.4 METHODS AND INSTRUMENTS OF CREDIT CONTROL (MONETARY POLICY)

In an economy the volume of credit and money supply has significant implications for
economic stability. The Central Bank performs the important function of the controller
of credit. There are two very important macroeconomic policies in an economy:
1. Monetary and Credit Policy
2. Fiscal Policy
The monetary policy refers to the policy of the Central Bank related to the
regulation and control of money supply with certain well-defined objectives. The Central
94 Macroeconomics

bank’s monetary policy is a very comprehensive and broad-based policy, and an integral
component of the monetary policy is the credit control policy.
The credit-control policy is one of the most important functions of a Central Bank
through which it regulates the volume, the cost, and the direction of credit. Broadly
speaking, there are two ways in which the Central bank can control the credit of any
economy: Quantitative (General) Credit Control Measures, and Qualitative (Selective)
Credit Control Measures. The quantitative measures seek to regulate the volume and
cost of credit in the economy. The qualitative (selective) measures, on the other hand,
aim at channelising credit to specific sectors. These measures, for example, direct the
funds to priority sectors and discourage the flow of credit into less important sectors.
The summary of these instruments is provided in Box 6.1.

BOX 6.1 Instruments of Credit Control

6.4.1 Quantitative Instruments

The quantitative instruments of credit control aim at influencing the supply of credit,
mainly through regulating the cost or volume or both of credit. The quantitative
measures affect the entire economy and do not discriminate between sectors or uses.
The main quantitative instruments of credit control are given below:
1. Bank Rate
2. REPOS and Reverse Repos
Central Bank: Credit Control Measures 95

3. Open Market Operations.

4. Variable Cash Reserve Ratio
5. Statutory Liquidity Ratios.

1. Bank Rate Policy

The Bank Rate Policy is one of the earliest methods of credit control. The Central Bank
is able to make use of this measure of credit control, because it acts as a lender of last
resort to the commercial banks, financial institutions, discount houses, etc.

Definition
Bank Rate in the narrow sense of the word, is the official minimum rate at which
Central Bank (as a Bank of Rediscount) rediscounts first-class bills of exchange brought
to it by the discount houses or commercial banks.
In a broader sense, Bank Rate is ‘changing of other terms and conditions under
which the market can have temporary access to the Central Bank either in the form
of rediscounts or through secured advances.’
In short, the Bank Rate is the rate of interest at which the Central Bank lends
to the commercial banks.
Working of Bank Rate Policy: Since the Bank Rate is the rate of interest charged
by the Central Bank on its loans issued to the commercial banks, it is looked at as a
cost to the commercial banks. The commercial banks are able to lend on the basis of
their cash reserves with themselves and the Central Bank. During inflationary periods
the Central Bank increases its lending rate, i.e. (bank rate). The commercial banks
would find it rather costly to borrow, they will raise own lending rates (market rate)
and thus, credit expansion will be inhibited. This is called a contractionary money/
credit policy or a ‘Dear Money Policy’ wherein money is made more expensive or credit
is made more expensive.
On the other hand, when there is a general deflationary situation, the Central
Bank lowers its bank rate. The cost of borrowing by commercial banks will reduce,
the market rate (i.e. the rate at which the commercial banks lend to the public) will
reduce and this would encourage credit expansion. This is called an expansionary
money/credit policy or a ‘Cheap Money Policy’ wherein money is made cheap or easily
available at low rates of interest.
In general, one can see that Dear Money Policy leads to a contraction of credit
and business activity and is suitable to fight inflation, and Cheap Money Policy is
appropriate to fight depression.
Assumptions of Bank Rate Policy
1. Dependence of commercial banks on the Central Bank: For the Bank
Rate Policy to be effective, it is necessary that the commercial banks are short
of funds and that it is necessary for them to approach the central bank very
often; so that the central bank can act as a ‘lender of the last resort.’
2. Money market is well-organised, and interest-rates are closely linked:
For the Bank Rate Policy to be effective in controlling credit, it is necessary
that the changes in the bank rate be followed by immediate changes in short
96 Macroeconomics

and long-term interest-rates in the market, i.e. charged by the commercial

banks.
3. Existence of bills of exchange: Commercial banks need to have treasury
bills, first-class bills, gilt-edged securities to enable them to borrow from the
Central Bank.
4. Existence of a strong Central Bank: It is necessary to have a strong
Central Bank to effectively use the bank rate instrument.
5. Borrowings must depend on interest rates: The borrowings of businessmen
must be dependent on the market rates; higher the bank rate and market
rate of interest lower must be the borrowings and lower the Bank Rate and
the market rate of interest higher must be the borrowings.
Critical Evaluation (Limitations) of Bank Rate Policy
1. Conditions not suitable for the success of Bank Rate Policy: There may
not be a close or definite relationship between the bank rate and other rates
of interest; specially in developing countries. So also, in such economies, the
money markets and capital markets are not fully developed, which further
restricts the success of the bank rate policy.
2. Business activity does not necessarily depend upon the interest rates
of banks: Although, one of the assumptions of the bank rate policy, is that
business activity depends on the rate of interest prevailing in the market,
in practice this does not hold good. The business activity is influenced more
by business prospects than by the rate of interest. Since there is no direct
relationship between interest rates and investments, the bank rate policy
cannot be very effective in controlling the volume of credit, level of business
activity and prices in the economy.
3. Interest-push inflation: A number of times when the interest rate increases,
investors continue to borrow at high-interest rates and transfer this to the
price of the commodity since interest is considered as a cost component of
production. This, in fact, aggravates the inflation and leads to ‘’Interest-Push
Inflation’.
4. Bank rate policy is not effective in controlling deflation: Bank Rate
Policy is more effective in controlling inflation than offsetting deflation. An
increase in the bank rate leads to higher market rates of interest resulting
in the higher cost of borrowings from banks and consequently, contraction in
the volume of credit; which is required during periods of inflation. But during
periods of deflation, if the rate of interest is lowered the volume of credit may
not expand, because the lower rates of interest will not induce businessmen
to borrow and invest during a period of falling prices and profits.
5. Conflict between the internal and external effects of the Bank Rate
Policy: If the bank rate is pushed up to control domestic inflation, the
resulting increase in the other (market) interest rates may attract short term
funds from abroad into the country, thus, restricting the success of the Bank
Rate Policy to curtail inflation.
Central Bank: Credit Control Measures 97

6. Reduced dependence of commercial banks on the Central Bank: In

recent times, the commercial banks have come to keep a lot of liquid resources
of their own and thus have come to depend less and less on the Central Bank.
7. Bank rate policy is ineffective in controlling balance of payments
disequilibrium: The Bank Rate Policy is an effective measure of correcting
the balance on payments disequilibrium only on the assumption that there are
no restrictions on foreign exchange and on the international flow of capital.
However, the governments in most countries have many artificial restrictions
on foreign exchange and on the international movement of capital, thus,
reducing the influence of bank rate policy in recent times.
Role of Bank Rate Policy: With all its limitations, the Bank Rate Policy has been
playing an important role in economies.
Bank rate changes may not actually contract credit, but it helps to communicate
the intentions of the Central Bank to the commercial banks, the business community
and the economy. Bank Rate Policy can be effectively used together with other measures
of credit control.

Repo Rate and Reverse Repo Rate

In recent years, the RBI has introduced the instrument of REPOS or ‘Repurchase
agreements’ in the market to control the credit and liquidity. Repos is an agreement
to sell a security and buy it back at a later date at predetermined prices. It is another
way of secured borrowing. Reverse Repo is the agreement to buy security to sell back at
a later date. This, in fact, has become the most-effective instrument to control liquidity.

Definition
The Repo rate is the rate at which the central bank of a country (Reserve Bank of
India in case of India) lends money to commercial banks in the event of any shortfall
of funds. Repo rate is used by monetary authorities to control inflation in the economy.
“Repo” is basically an instrument for borrowing funds by selling securities with
an agreement to repurchase the securities on a mutually agreed future date at an
agreed price which includes interest for the funds borrowed.
“Reverse Repo” is an instrument for lending funds by purchasing securities with
an agreement to resell the securities on a mutually agreed future date at an agreed
price which includes interest for the funds lent.
Working of Repo: In an inflationary situation, central bank increases the repo rate
and as a result, the commercial banks reduce their borrowings from the central bank
and this in turn reduces the money supply in an economy and curtails inflation.
In a deflationary situation, the central bank decreases the Repo rate, thus
encouraging money and credit flow into the economy to curtail the deflationary and
recessionary tendencies.
The repos and reverse repos are instruments to manage short term liquidity in
the market and is a part of the Liquidity Adjustment Facility (LAF) of the RBI.
98 Macroeconomics

Open Market Operations (OMO)

This method of credit control developed after the First World War. Open Market
Operations in the narrow sense, means the purchase and sale of Government securities
by the Central Bank in the open market.
Working of Open Market Operations: The Open Market Operations are based on
the following principle: ‘The purchase or sale of securities by the Central Bank result in
an increase or decrease in the cash reserves of the Commercial Banks, thus resulting
in an increase or decrease in their ability to create credit.’
This policy of open market operations, brings about an immediate change in the
total volume of credit created by the commercial banks and influences the level of
business activity, employment and internal price-level.
Process: During periods of inflation, the Central Bank needs to control the expansion
of (contract) credit; it will, therefore, sell securities in the open market, both to
commercial banks as well as, private individuals. These buyers have to make payments
to the Central Bank for the purchase of these securities. This reduces the cash reserves
of the commercial banks and limits their ability to create credit, thus leading to credit
contraction.
During periods of deflation, the Central bank needs to liberalise the creation of
credit (expand credit) it will buy securities in the open market, make payments for
these securities. This increases the cash reserves of the commercial banks, and the
commercial banks are in a position to create more credit with the result that the
volume of bank credit in the economy will expand.
The open market operations also affect the interest rates in the market by
changing the quantity of money in circulation. An increase in the supply of money
(through the purchase of securities in the open market) will reduce the interest rates.
On the other hand, a reduction in the money supply (through the sale of securities
in the open market), will result in an increase in the rate of interest. Interest rate
changes result in changes in costs, production as well as the internal price-level
Assumptions of Open Market Operations
1. Existence of a well-developed securities market: This condition is
necessary for the success of open market operation. Without a market for
securities, the Central Bank cannot use this policy measure.
2. Fixed cash-reserve ratio by the commercial banks: This is necessary so
that the Central Bank is able to bring about a decrease or increase in cash
reserves of commercial banks through the open market operations and this,
in turn, will regulate the credit created by them.
3. Nonexistence of other factors: For the success of open market operations
as a method of credit control, it is assumed that other factors like hoarding of
money by the public, outflow/inflow of capital due to changes in the balance of
payments, and also changes in the velocity of circulation of money do not exist.
4. Adequate stock of securities with the Central Bank: For this policy to
have an impact on the volume of credit in the economy the Central Bank
needs to have a sufficient stock of securities to be sold in the open market.
Central Bank: Credit Control Measures 99

5. No other direct line between commercial banks and the Central Bank
exists: There should be a strong link between commercial banks and the
central banks. This would allow for centralised buying and selling of securities.
Critical Evaluation (Limitations) of Open Market Operations
1. Nonexistence of a well-developed market for securities: For open market
operations to be successful in controlling credit it is necessary that the country
has a well-organised and developed money and capital market however in
developing countries this is not seen. As a result, it limits the success of the
open market operation.
2. Definite ‘Cash-Reserve Ratio’ not maintained by commercial banks:
Open Market Operations of the Central Bank aim at changing the cash
reserves of the commercial banks, to influence the volume of credit created
by them. This means that the commercial banks must have a definite or fixed
cash-reserve ratio. This may not be the case. Most commercial banks hold
excessive reserves with the Central Bank. Thus, if the Central Bank sells
securities in the open market the commercial banks would buy and pay for
them with excess reserves; as a result, the ability of the commercial banks to
expand credit will not be reduced as desired by the Central Bank.
3. Operation of other factors: The success of the open market operations
cannot be guaranteed if outside factors are operating in the economy. For
example, suppose by purchasing securities, the Central Bank increases the
cash with the public, money may flow out of the country on account of
unfavourable balance of payments or the public may hoard a part of this
money, or the velocity of circulation itself may fall. If on the other hand, by
selling securities, the Central Bank wants to control credit. In that case, this
may not be possible because of the favourable balance of payment, there is
an inflow of money, people dishoard and the velocity of circulation increases.
4. Adequate stock of securities may not exist with the commercial banks:
If the quantity of securities with the commercial banks is limited, then it is
not possible for the open market operations to be successful.
5. Direct access between commercial banks and the Central Banks: Since
commercial banks very often have direct links with the Central Bank for
financial accommodation, the changes in the cash reserves of the commercial
banks due to open market operations will not affect the expansion and
contraction of credit.
(Direct access of Commercial banks with the Central Bank may be for
borrowings for priority sectors, exports, procurement of food, or rediscounting
of bills by the banks with the Central Banks; etc.)

Policy of Open Market Operations is more Successful in Controlling Credit

than in Encouraging Expansion of Credit: As in the case of Bank Rate Policy,
this method too is more effective during periods of inflation (when it is necessary to
curb credit creation), than, during periods of deflation (when it is necessary to expand
credit).
100 Macroeconomics

When the Central Bank sells securities in the market and thereby reduces the
cash-reserves of the commercial banks; the banks have to restrict credit creation but
when the Central Bank buys securities in the market and thereby increases the cash
reserves of the commercial banks the banks with excess reserves may not be able to
expand credit unless the borrowers are willing to borrow from them. Since the business
prospects are poor during periods of depression businessmen, do not borrow, in spite
of the low rates of interest.
Role of Open Market Operations: The open market operations as a measure
of controlling credit has been widely used in different economies in spite of all its
limitations.
The scope of this policy has increased recently because of the increased availability
of government and other securities in the money market. Open market operations are
an important instrument of credit control.
Comparison of Open Market Operations and Bank Rate Policy: It was the
limited effectiveness of the bank rate policy which emphasised the need for an additional
(alternative) measure of credit control. Thus, the open market operations came into
being. These two methods are complementary to each other. Each used separately may
not provide the necessary results. But both the methods when used together can give
the desired result by the Central Bank to a large extent.
However, it may be noted that the policy of open market operations may be more
effective than the policy of bank rate. As mentioned above, the Bank Rate Policy is
an indirect method or way of controlling credit, whereas, the open market operations
are a more direct and therefore, effective way of controlling credit.
Bank rate policy affects only directly the short-term rates of interest whereas,
the open market operations have a direct impact on the long-term rates of interest
through their effect on prices of long-term securities.
However, it must be understood that the two policy measures will be more
effective when used together.

Variable Cash Reserve Ratio

Since the Bank Rate Policy and Open Market Operations prove ineffective during
abnormal situations especially when commercial banks keep excessive reserves with
themselves, on the basis of which they create too much credit, a more direct method
is introduced. This method controls the excess reserves of the commercial banks and
thus the credit created by them. This method is called the Variable Cash Reserve Ratio.
It aims at controlling the credit in the economy by variations in the cash reserves of
the commercial banks.

Definition
The Reserve Requirement condition requires the commercial banks to hold cash equal
to a certain minimum fraction of its total deposit liabilities.
‘Variable Reserve Ratio’ is alternatively called ‘Reserve Ratio’, ‘Minimum Reserve
Requirement’ or ‘Legal Reserve Requirements.’
Central Bank: Credit Control Measures 101

Working of the Variable Cash Reserve Ratio: When the Central Bank changes
the reserve ratio it directly affects the cash reserves of the commercial banks and thus,
also their ability to create credit in the economy.
When the economy faces an inflationary situation, the Central Bank needs to
contract credit. It will raise the cash reserve ratio, which the commercial banks are
required to maintain with the Central Bank. This will reduce the reserves which the
commercial banks hold with themselves and force the banks to curtail the creation
of credit in the economy. This is how the Central Banks, by raising the cash reserve
ratio, controls the inflationary expansion of credit in the economy.
When, on the other hand, the economy faces a deflationary situation, the Central
Bank needs to expand credit. It will reduce the cash reserve ratio which the commercial
banks are required to maintain with the Central bank. This will, in turn, increase the
reserves which the commercial banks hold with themselves and enable the bank to
expand credit in the economy. Thus, by reducing the cash reserve ratio, the Central
Bank is able to tide over a deflationary situation in the country.
By changing the cash-ratio, the Central Bank can change the size of the credit
multiple in the economy.
Note: The credit multiplier is the reciprocal of the cash-reserve ratio, i.e.,
1 1
=
Credit Multiplier =
Cash Reserve Ratio CRR
If the cash reserve ratio is raised by the Central Bank (during period of inflation),
the size of the credit multiplier is lowered, resulting in reduction in the ability of the
commercial banks to create credit and vice versa.
Assumptions and Limitations of CRR: The CRR works on the basis of certain
assumptions which may not hold in reality. As a result, the success of the CRR policy
may be limited. These assumptions/limitations are discussed below:
1. The CRR mechanism is based on the assumption that commercial banks do not
have large cash reserves with them. However, in practice, most commercial banks
hold excess cash reserves; as a result, when the Central Bank raises the cash
reserve ratio, the commercial banks still have sufficient reserves after satisfying
the statutory minimum requirements. Thus, they can continue to create credit
and render the method of variable reserve requirement as ineffective.
2. It is based on the assumption that commercial banks do not have large foreign
funds with themselves. However, this may not be so. Thus, even if the Central
Bank reduces the Reserves with the commercial banks by raising the Variable
Cash Reserve Ratio; the commercial banks will continue to create credit based
on the foreign funds they possess.
3. The assumption is that there is sufficient demand for cash credit from banks.
If the Central Bank, for example, reduces the cash reserve ratio but if the
customers do not come forward to borrow from the banks on account of poor
business conditions in the economy, this method will prove ineffective.
4. This method increases the uncertainty of the commercial banks and restricts
the banks freedom to lend their resources to their customers.
102 Macroeconomics

5. The Central Bank does not pay interest to commercial banks for their cash
reserves thereby imposing the financial burden of the banks.
6. Since this is a direct and very effective measure of credit control, the Central
Bank has to use it with care.
Role of ‘Variable Reserve Ratio’ Policy: In spite of its limitations, the Variable
Cash Reserve Ratio is a method used often to reduce the large excess reserves with
the commercial banks. It is particularly useful in developing countries, where the Bank
Rate Policy and Open Market Operations are not helpful due to their limitations. The
variable reserve ratio is a direct method and has legal backing.
However, since ‘Variable Reserve Ratio’ itself has its own limitations, it must be
used with discretion.

Statutory Liquidity Ratio (SLR)

1. In addition to CRR all commercial banks (under the Banking Regulation Act
1949) have to maintain liquid assets in the form of cash, gold and approved
securities equal to not less than 25% of their total demand and time liabilities).
2. This was raised to 35% and 38.5% gradually.
3. In 1991, with the reform introduced in the banking system, RBI planned to
reduce it again close to 25%.
(Details of the movements in some important rates of credit and monetary policy
in India is provided in Table 6.1.)
Note: The RBI has been using all the instruments simultaneously to control credit,
or to meet other objectives of growth, stability, etc.
Comaprison of ‘Variable Reserve Ratio’ and ‘Open Market Operations’: We
have already seen that Open Market Operations are superior to Bank Rate Policy. Now,
we shall see, the Variable Cash Reserve Ratio is superior to Open Market Operations.
1. The variable Cash Reserve Ratio is more direct and powerful, and thus, it produces
immediate results in the economy as against the Open Market Operations.
2. The Variable Cash Reserve Ratio does not require a well-developed and
organised market for securities for its successful implementation. As a result,
it can successfully be used in under-developed countries, unlike the Open
Market Operations, which require well-developed and organised money market
for their success.
3. The method of Variable Cash Reserve Ratio applies uniformly to all
Commercial Banks; however, Open Market Operations are applicable only
to those commercial banks which deal in the securities and therefore, have
a restricted affect. However, it should be noted that the two methods should
be used to complement each other.

Coordination of the Three Policies

As seen above, the three methods of quantitative credit controls are effective when
used in proper co-ordination with each other. If, for example, the Central Bank needs
to contract credit, it should also raise its Bank Rate and supplement it by changes in
the reserve ratio.
Central Bank: Credit Control Measures 103

Conclusion
The quantitative credit controls are more effective during periods of inflation when
there is a need to contract credit. These methods of controlling credit are most effective
when used in proper co-ordination with each other. Table 6.1 gives an idea of the
movements in some rates in recent times.
TABLE 6.1 Movements in Some Important Rates in India
Bank Repo Reverse Repo
S.No. Date CRR (%) SLR (%)
Rate (%) Rate (%) Rate (%)
1. April 5, 2018 6.25 6.00 5.75 4.00 19.50
2. June 6, 2018 6.50 6.25 6.00 4.00 19.50
3. August 1, 2018 6.75 6.50 6.25 4.00 19.50
4. October 5, 2018 6.75 6.50 6.25 4.00 19.50
5. December 5, 2018 6.75 6.50 6.25 4.00 19.50
6. January 5, 2019 6.75 6.50 6.25 4.00 19.25
7. February 7, 2019 6.50 6.25 6.00 4.00 19.25
8. April 4, 2019 6.25 6.00 5.75 4.00 19.25
9. April 13, 2019 6.25 6.00 5.75 4.00 19.00
10. June 6, 2019 6.00 5.75 5.50 4.00 19.00

Source: Economic Survey, 2018–19, Vol. 2, p. 65.

6.4.2 Qualitative or Selective Credit Control Instruments

Introduction
The quantitative methods of credit control aim at controlling and regulating the volume
of credit in the economy. The qualitative methods of credit control, on the other hand,
try to divert the flow of credit into specific uses or channels in the economy. These
quantitative measures are discriminatory in nature and hence are called selective
instruments. They encourage the flow of credit into the desired sectors.

Objectives of Selective Credit Control

1. To redirect credit from undesirable or less needy uses to more desirable and
urgent uses.
2. To control a particular sector of the economy without affecting the whole economy.
3. To control excess consumer purchases of durable goods on a hire-purchase
basis, especially during the inflationary condition.
4. To check the unfavourable balance of payments of a country. This may be done
through cheap credit for exports and raising the discount rate on import bills.
5. Selective credit controls aim at correcting the investment structure (by
encouraging the flow of credit into desirable sectors) and thereby bring about
economic growth and stability.
104 Macroeconomics

Instruments of Selective Credit Control

1. Minimum Margin Requirement: The ‘margin’ is the difference between,
‘loan value’ and the ‘market value’ of securities offered by borrowers against
secured loans.
By fixing a margin requirement on secured loans, the Central Bank does
not allow the commercial banks to lend to their customers the full amount or
value of securities offered by them; the commercial banks are allowed to lend
only a part of the market value of securities offered by customers. Thus, for
example, if the Central Bank fixes a margin requirement of 40%, then the
commercial banks can lend up to 60% of the market value of securities.
By changing the margin requirement for various securities, the Central
Bank can control the flow of credit into various uses. If the Central Bank
wants to reduce the flow credit into a particular sector and use, it may raise
the margin requirement for that use. If on the other hand, the Central Bank
wants to increase credit, say to priority sectors/uses, the Bank will reduce the
margin requirement for such uses, and thereby, attain the desired result.
This method is effective to channelise the flow of credit from less productive
uses to more productive uses.
2. Regulation of Consumer Credit: This method aims at regulating the
volume of credit to consumers for the purchase of durable consumer goods
like washing machines, vehicles, refrigerators, etc. According to this system, a
percentage of the price of the durable goods has to be paid as down payment
by the purchaser the rest of the price of the good is financed by bank credit
which the consumer repays in instalments over a specified period of time.
The aim of this method is to restrict the consumption, and therefore, the
demand of such goods which are short in supply.
This method can be used by:
(a) Changing the minimum down payment.
(b) Changing the maturity period of consumer credit and
(c) Changing the cost of consumer credit.
(d) Providing easy instalment schemes.
This method has proved useful in many developed countries, especially during
periods of inflation. However, its use has been limited in underdeveloped
countries where the banking system has yet to develop.
3. Control through Directives by the Central Bank: Very often the commer-
cial banks are forced to act as per the directives of the Central Bank. These
directives may be in the form of written orders, appeals or warnings by the
Central Bank and addressed to the commercial banks. These directives aim at:
(a) Controlling the lending policies of commercial banks.
(b) Diverting credit from less urgent uses to more urgent uses or from the
less productive uses to more productive uses.
(c) Prohibiting lending for certain purposes altogether.
(d) Fixing maximum limits of credit for certain purposes.
Commercial banks generally follow the directives issued by the Central Bank,
and this supplements the traditional quantitative measures of credit control.
Central Bank: Credit Control Measures 105

The effectiveness of this policy measures depends upon:

(a) The statutory powers conferred upon the Central Bank.
(b) Prestige enjoyed by the Central Bank.
(c) The nature of the banking system in the country.
4. Rationing of Credit: The term ‘Rationing of Credit’ means that the Central
Bank fixes a limit upon its re-discounting facilities for any particular bank, or
the Central Bank fixes the quota for every bank for financial accommodation
from the Central Bank. If the demand for credit from the banks is in excess
of its supply, the Central Bank will ration its credit to distribute the available
resources among different banks as per the credit plan.
Though this method is used by Central banks, however, since the Central
Bank is looked at as a lender of the last resort, it is morally bound to be of
help to the commercial banks and thus cannot ration credit to the banks. So
also, too much this method proves effective only when the demand for credit
exceeds the supply and not vice-versa.
5. Moral Suasion: As per this method of credit control, the Central Bank,
advises, requests and persuades the commercial banks to co-operate with it
in the implementation of credit policies. The Central Bank only uses its moral
influence on the commercial bank; this is a very informal method of Direct
Action where the commercial banks are penalised for not abiding by the
directives of the Central Bank. The success of moral suasion as the method
of credit control depends upon the moral influence, prestige and leadership
of the Central Bank in the money market.
This method, however, has its own limitations, and that is it lacks legal
sanction. However, it can be used to supplement the other methods of credit
control.
6. Direct Action: This method can be used as both quantitative as well as
a qualitative method of credit control by the Central Bank. This method
however, is used together with other measures of credit control.
The Central Bank takes direct action against those commercial banks whose
credit policies are not according to those specified by the Central Bank. Direct
action also implies that the Central Bank issues either general instructions to
all commercial banks or special instructions to those commercial banks which
do not act according to instructions of the Central Bank.
However, this method is used as a last resort when the other methods of
credit control fail to give the desired result. Direct action by the Central Bank
may take the following forms:
(a) The Central Bank may refuse to grant discounting facilities to the
commercial banks.
(b) The Central Bank may refuse to sanction further financial accommodation
to a bank whose existing borrowings are over its capital reserves.
(c) The Central Bank may start charging penal rate of interest on money
borrowed by a bank beyond the prescribed limit.
Even though this method is used by the Central Bank to implement its credit
policies, direct action as an instrument of credit control suffers certain limitations:
106 Macroeconomics

(a) Direct action involves action against commercial banks, which is not liked
by the commercial banks. The commercial banks, in turn, are unable to
offer full co-operation to the Central Bank in the implementation of its
credit policies.
(b) Since there are no definite and clearly defined criteria for distinguishing
between essential and non-essential, and productive and non-productive
uses of credit, the commercial banks are unable to follow the instructions
of the Central Bank.
(c) Initially, the commercial banks may be able to regulate the use of credit,
however, they can’t control the ultimate use to which the credit is put
because the loans taken by borrowers may not be used for the purpose
they are taken.
(d) The Central Bank acts as a lender of the last resort, so it is morally bound
to offer rediscounting facilities to any commercial bank which approaches it.
Thus, the method of direct-action conflicts with the function of the Central
Bank as the lender of the last resort.
7. Publicity: Central Bank uses this instrument, not only to influence the
credit policies of the commercial banks, but also to educate the public and
influence their opinion, this is an effective measure to ensure the effectiveness
of the monetary policy of the Central Bank.
Publicity includes regularly publishing the weekly statements of the banks’
assets and liabilities, monthly reviews of credit and business conditions and
comprehensive annual reports on their operations and activities money market,
and banking conditions, finance, trade, industry, agriculture, and so on.
This published material helps the commercial banks and the public to
anticipate future changes in the policies of the Central Bank and to understand
the monetary and economic situation of the country.

Limitations of Selective Credit Control

1. The selective measures of credit control are applicable only to commercial
banks, there are other non-banking financial institutions which create a large
volume of credit in the economy, and their policies may be contradictory to the
policies of the Central Bank. Thus, the desired results of selective measures
may not be achieved by the Central Bank.
2. As mentioned earlier, since it is difficult to distinguish between essential and
nonessential and productive and unproductive uses of capital, the Central
Bank may not be able to achieve its aim of directing credit away from
unproductive uses and into productive uses.
3. Also, the commercial banks may not be able to control the ultimate use to
which the credit is put.
4. The commercial banks may manipulate accounts and give loans to customers
for prohibitive uses. The purpose of qualitative controls is then defeated.
5. Investments in modern selective measures of credit control may not, therefore,
be able to effectively control the credit in the economy.
Central Bank: Credit Control Measures 107

6. Selective controls are effective only if the business community depends on the
banking system for credit, or else these controls are of no use as measures
of credit control.
7. The relationship between credit and prices is not direct and simple. Credit
is only one factor influencing the prices. Thus, by controlling the volume of
bank credit, it is not possible to control the price-level.

Points to Remember
• The Central Bank of a country is the Supreme Monetary Authority and, in this
capacity, performs certain unique functions like note issue, governments bankers,
banker’s bank, lender of the last resort, management of the country’s foreign
exchange, and regulation of money supply and credit control, responsibility of a
country’s developments process among other functions.
• The formulation and implementation of the Monetary Policy and credit control
is an important function of the Central Bank of a country. Through the Credit
Control Policy, the Central Bank regulates the volume, cost and direction of credit.
• The main objectives of the credit policy include facilitating the growth process
in an economy, stabilising internal prices, stabilising the fluctuations in the
economy, maintaining external stability, etc.
• The methods/instruments of credit control can be classified into 2 types Quantitative
and Qualitative or Selective instruments. The Quantitative instruments affect
the entire economy in a uniform manner; whereas Qualitative instruments are
selective in nature and regulate the direction and flow of credit in the economy in
a selective manner. It takes into account the priority of needs of various sectors
of the economy.
• The Quantitative instruments include Bank rate, Open market operation and
Variable reserve ration.
1. Bank rate is the rate at which the Central Bank rediscounts bills of exchange
presented by the commercial banks or it is in effect the rate at which it
lends to the commercial banks. In an inflationary situation, the Bank rate is
increased, and in deflationary situation, it is reduced to control and expand
credit, respectively. The commercial banks change the lending rates in line
with the Bank rate and hence can regulate the volume and cost of credit in
line with the Central Bank’s policy.
2. The open market operations refer to purchase and sale of Government
securities and other eligible papers, i.e. other securities by the central bank
on behalf of the government. It is necessary to note that commercial banks
hold some part of their investment in government securities, which are liquid
as well as safe investments, and it is also a part of their SLR requirements.
When the objective is to control the volume of credit in the economy the
Central Bank will sell securities, as a result, excess cash from the banking
system will be absorbed, which would lead to reduced credit creation. The
opposite mechanism will work in a deflationary period.
108 Macroeconomics

3. Every commercial bank has to maintain some part of their time and demand
liabilities in the form of cash reserves. This ratio can be varied depending on
whether the objective is to encourage or discourage credit and credit creation.
In an inflationary situation, the cash reserve ratio would be increased, thus
reducing the cash available with commercial banks which can be advanced
as loans. The instrument of the variable reserve ratios would work oppositely
in a deflationary situation, when the objective is to encourage credit creation
and flow in the economy.
• These instruments, in reality, work within some limitations and constraints. For
the smooth functioning and effectiveness of these instruments what is needed
is a strong Central Bank, a well-developed bills and securities market, a well-
integrated commercial banking system with strong links with the Central Bank,
and also dependence of the commercial banks on the Central Bank for financial
assistance, (as a lender of the last resort).
• The Qualitative instruments like minimum margin requirements, moral suasion,
Central Bank’s directives, regulation of consumer credit etc., work in a discretionary
manner to regulate the credit flow into selective sectors (e.g. encouraging credit
into priority sectors like agriculture, export-oriented industries etc.)
• The Credit and Monetary Policy is a critical macroeconomic policy of the
Government the other being the Fiscal Policy. The various instruments of the
credit policy are generally used in co-ordination with each other for best results.

QUESTIONS

I. Short Questions
1. Central Bank is the apex bank of a country. Explain its unique functions.
2. ‘The Cash Reserve Requirement (CRR) is an important tool of credit control.’
Explain.
3. The Monetary and Credit Control Policy is a very crucial policy of the
government. What are its objectives?
4. What are the distinguishing features of the quantitative and qualitative
instruments of credit control?

II. Long Questions

1. Critically examine the quantitative instruments of credit control. Which
according to you is the most effective instrument and why?
2. Selective or qualitative instruments are used to channelise credit flow to
specific sectors. Discuss the qualitative instruments in this context.
3. What are ‘Reserve Requirements’? How do variable reserve ratios help to
control credit?
4. State whether the following statements true or false with justifications:
(i) ‘During a period of inflation, Central Bank will sell securities.’
(ii) ‘Repo and Bank rates have exactly the same mechanism for operating’.
CHAPTER

7
Commercial Banks
Multiple Credit Creation

7.1 INTRODUCTION
As seen earlier, the total money supply (in its narrow sense) is made up of coins,
currency and demand deposits, i.e.,
M = Coins + Currency + Demand Deposits
The coins and currency are issued by the central government and the Central
Bank, whereas the third component, i.e., the Demand Deposits or Credit Money is
created by the commercial banks. Before proceeding with the creation of ‘Credit Money’
by commercial banks (which is a very important function of the commercial bank), it
is necessary to understand two aspects:
1. Definition and meaning of commercial banks
2. Functions of commercial banks.

7.2 MEANING AND FUNCTIONS OF COMMERCIAL BANKS

Meaning of Commercial Banks
Very simply, commercial banks are those organisations which perform two major
functions:
1. Accepting deposits
2. Advancing loans
These, in fact, are the traditional defining functions of a commercial bank. These
institutions are basically engaged in transferring fund from the surplus sectors, i.e.,
savers to the deficit sectors, i.e., investors. Hence, these institutions are defined as
financial intermediaries. The process of transferring fund is called the process of
financial intermediation.
109
110 Macroeconomics

The financial intermediation process can be indicated as given below in Box 7.1.

BOX 7.1 Process of Financial Intermediation

Transfer of Funds


Household  Financial Intermediaries Business

Sector [Banks and Financial Sector
Institutions]
  
Surplus Sector Process of Financial Intermediation Deficit Sector
  
[Savers] [Creation of Financial Assets [Investors]
and Instruments]

In the process of financial intermediation as shown above, there is a creation of

financial assets and instruments and a part of this process is referred to as multiple
credit creation.
Note: The banking sector belongs to the service sector, and commercial banks work
on the principle of profitability where profits of a bank are broadly defined as the
interest rate differential between interest on loans and interest on deposits. However,
it should also be noted that nationalised commercial banks are development-oriented
and not profit-oriented.

Functions of Commercial Banks

Banking Credit Utility and Foreign Promotional and

functions control agency exchange developmental
functions dealings functions
The above functions can be briefly explained as given below:

Banking Functions
1. Accepting Deposits: Commercial banks accept a variety of deposits from
the public which include current, saving, fixed or time deposits, recurring
deposits etc. A major portion of the deposits of the commercial banks are
in the nature of current or demand deposits which in fact enables them to
create credit.
2. Advancing Loans: A part of the deposits received by banks are kept back
in the form of cash reserves, and the rest is given as loans to customers in
Commercial Banks: Multiple Credit Creation 111

the form of loans and advances. These loans and advances may take the form
of ordinary loans, overdraft facilities, loans at call, short, medium, and long
terms, discounting of bills, etc.
Commercial banks also invest a part of its funds in government securities
and in industrial securities in the recent years.
3. Credit Creation: In the process of accepting deposits and advancing loans
the commercial bands create credit. This is discussed at length in the multiple
credit creation process. (See section 7.3)
4. Utility and Agency Functions: These functions include transfer of funds
from one place to another, collecting customers’ funds, remittances of funds,
purchase and sale of securities for customers, payments of premiums, locker
facility, etc.
5. Foreign Exchange Dealings: Commercial banks also deal in sale and
purchase of foreign currency which is undertaken by the foreign exchange
department of the banks. The RBI however regulates the exchange rate.
6. Other Functions: These include issuing traveller’s cheques, collection of
data underwriting of company debentures, accepting bills of exchange on
behalf of its customers, financial advice, etc.
7. Promotional/Developmental Functions: In countries like India where
many banks are nationalised and work in the social and national interest;
they perform some promotional functions like:
(a) Financing the developmental process
(b) Special industrial and agricultural finance
(c) Financing the neglected and priority sector
(d) Special export finance
(e) Creating a regional balance through the developmental process

7.3 MULTIPLE CREDIT CREATION

Having understood the main functions and meaning of commercial banks one can
proceed to understand the multiple credit creation by commercial banks.
The commercial banks are unique institutions which create credit money which
is part of the total money supply. Very simply, in the process of accepting deposits
and advancing loans commercial banks create credit money which is termed as the
multiple credit creation process. (multiple, because the credit created is multiple times
the deposits.)

7.3.1 Basic Clarifications regarding Multiple Credit Creation

1. In the traditional theory, commercial banks are considered to be the only
unique institutions which can create credit.
2. This is because a major part of the deposits of the commercial banks are in
the form of demand and saving deposits.
3. It is possible to operate these accounts through cheques leading to crediting
and debiting of accounts and in the process of crediting and debiting of
accounts, credit money is created which is the credit creation process.
112 Macroeconomics

4. Commercial banks have two categories of deposits: Primary deposits and

secondary or derivative deposits.
(a) Primary Deposits: Any new cash deposits which enters the commercial
banking system is called a Primary Deposit. Such deposits are made by
individuals, organisations, institutions, business units etc. These deposits
are created when a customer opens a deposit account in his name. These
deposits are used to make bank loans and advances. A part of these
deposits is to be kept in the form of cash with banks; this is called the Cash
Reserve Ratio (CRR). Primary deposits form the basis of credit creation.
(b) Secondary/Derivative Deposits: When the commercial banks advance
loans against the primary deposits it creates ‘Secondary Deposits’. These
deposits are created by the banks by opening a deposit account in the name
of the borrower. This process of advancing loans on the basis of primary
deposits leads to the multiple credit creation process. The derivative
deposits created by the commercial banks in the process of advancing loans,
discounting bills, buying securities, etc. lead to creation of credit money.
Suppose, a bank grants a loan of ` 10,000 to its customer against a
security, the bank does not give this amount in cash to the borrower, but
instead opens a deposit account in the name of the borrower and credits
this amount to it. The borrower may withdraw a part or the whole amount
of this loan. Thus, by giving a loan, the bank has created a new deposit
in its books. Thus, ‘every loan creates a deposit’. This is the derivative
deposit (because it has been directly derived from the loan transaction of
the bank). The creation of a derivative deposit results in a net increase
in the total supply of money in the economy.
When the loan is repaid by the borrower, the derivative deposit created
by the banks is wiped away. This results in a net decrease in the total
stock of money in the economy.
Thus, the granting of loans by the commercial banks leads to creation
of money, while the repayment of the loans leads to destruction of money.

7.3.2 Balance Sheet of a Commercial Bank

In order to understand the working of the credit creation process it is necessary to
understand the main items on the Balance Sheet of a commercial bank. This is shown
in Table 7.1.

TABLE 7.1 Main items on the Balance Sheet of a Commercial Bank

Liabilities Assets
(i) Capital and Reserves (i) Cash in Vaults and Deposits with Central
Banks.
(ii) Deposits (ii) Balance with other Banks
(a) Current (or Demand) (iii) Money at Call and Short Notice
(b) Savings (iv) Bills Discounted including Treasury Bills
(c) Fixed (Time) (v) Stock Exchange Investment, i.e., Securities
Commercial Banks: Multiple Credit Creation 113

Liabilities Assets
(iii) Borrowing from other Banks (vi) Loans and Advances to Customers
and the Central Bank.
(iv) Other Liabilities (vii) Other (fixed) Assets like Building,
Furniture, etc.
Note: Every bank decides its own investment policy and there are 3 main criteria which govern
the short-term and long-term operations of commercial banks, i.e., liquidity, profitability and
safety of assets.

7.3.3 Assumptions
The credit creation process can be best understood within a set of simplifying and
restrictive assumptions.
1. For the process to take place, there should exist a well-developed commercial
banking system; in the absence of which, the process may not work out
completely.
2. Commercial banks aim at maximizing their income. The banks get income from
loans, discounting operations and investments in securities. Thus, maximizing
income would mean creating maximum amount of derivative deposits.
3. For the process to be understood simply, it is assumed that only one new
primary deposit enters the banking system to be able to see how much credit
is created by one new Primary Deposit.
4. Every commercial bank has to maintain a part of their deposits in the form
of a cash reserve. This Cash Reserve Ratio (CRR) is a minimum reserve
requirement prescribed by the Central Bank.
5. For simplicity sake, it is also assumed the all deposits are demand deposits. It
is also assumed that there are no cash withdrawals from the banking system
during the creation process.
6. There is no significant time-lag between people receiving a cheque and
depositing it back into the banking system.
7. The Cash Reserve Ratio (CRR) is kept constant during the process for simplicity
sake.
8. There is no other restriction by Central Bank in the form of statutory liquidity
ratio, control on loans, etc.
9. It is also assumed that trade and commerce conditions are favourable;
otherwise credit will not be demanded or created.

7.3.4 Explanation of the Process of Multiple Credit Creation

To begin with when a Bank (I) receives a primary deposit, it maintains the minimum
cash reserve and the remaining amount is given as a loan. When bank (I) grants a
loan to a customer, the loan money is credited to his deposit account and not paid in
cash to the borrower. Suppose the borrower (X) pays to his creditor (Y) in connection
with some business transaction, a cheque drawn upon his account with the bank
(I); and the creditor, in turn, deposits a cheque in another bank (II) in his account.
114 Macroeconomics

Bank (II) thus receives a derivative deposit in the form of a cheque drawn upon bank
(I). After maintaining its cash reserves, bank (II) may create another derivative deposit
by giving loan to another borrower (A), who may make the payment out of his account
to another creditor (B) who has a deposit account with bank (III). Bank (III), will now
receive the primary deposit in the form of a cheque drawn on bank (II). This process
continues till the whole of the initial primary deposit is exhausted. The total credit
created by the commercial banks in this process is multiple times the value of the
primary deposit.

7.3.5 Numerical Example

Suppose the minimum Cash Reserve ratio (CRR) is 10% for all commercial banks; and
that a deposit of ` 4,000 is deposited in Bank I.
The Balance Sheet of Bank I is presented in Table 7.2.

TABLE 7.2 Balance Sheet of Bank I

Liabilities Assets

Primary Deposits + ` 4,000 CRR ` 400

Loan ` 3,600
Total + ` 4,000 Total ` 4,000

Since the cash ratio is 10%, the bank has to keep ` 400 as cash reserve requirement
and creates a derivative deposit worth ` 3,600 amount since this is the amount
available to the bank for giving loans and advances after maintaining the CRR.
Bank I can advance a loan of ` 3600. Suppose this loan is given to individual A
who deposits cheque in Bank II. The Balance Sheet of Bank II is presented in Table 7.3.

TABLE 7.3 Balance Sheet of Bank II

Liabilities Assets

Derivative Deposits + ` 3,600 CRR ` 360

Loan + ` 3240

Total + ` 3,600 Total + ` 3,600

Now ` 3,240 is advanced as a loan to individual ‘B’ who deposits the cheque in
Bank III. The Balance Sheet position of Bank III is presented in Table 7.4.

TABLE 7.4 Balance Sheet of Bank III

Liabilities Assets
Derivative Deposits + ` 3, 240 CRR ` 324
Loan + ` 2,916
Total + ` 3,240 Total + ` 3,240
Commercial Banks: Multiple Credit Creation 115

As can be seen from the above example, the commercial banks are able to create
secondary or derivative deposits multiplier times the primary deposit.
Note:
1. The above process would work within a given set of assumptions.
2. The credit creation process will come to an end when the entire primary
deposit is exhausted.
3. This process would have continued indefinitely if CRR = 0 (zero). However as
can be seen the liabilities increase at a diminishing rate (4000; 3,600; 3240; …).
The total credit in the banking system in our example is
` 4,000 + 3,600 + 3,240 + ....
Since it is difficult to make such calculations one can directly use the credit
multiplier given below:
1
Credit Multiplier =
CRR

where, CRR is the Cash Reserve Ratio.

The credit multiplier can be used to calculate:
 1 
1. Total Credit in the Banking System =  × PD 
 CRR 

 1 
2. Credit Created by the Banking System =  × PD  − PD
 CRR 
Using the above formula one can calculate for the above numerical example both
the total credit and credit created in banking system as follows:
(Recall PD = ` 4,000 and CRR = 10%)
 1 
1. Total Credit in the Banking System =  × PD 
 CRR 
1/10
= × 4,000
100
100
= × 4,000
10

= ` 40,000

 1 
2. The credit created by the banking system =  CRR × PD  − PD
 
= 40,000 – 4,000
= ` 36,000
Note: As can be seen the total credit is 10 times the original primary deposit of ` 4,000.
116 Macroeconomics

7.3.6 Limitations and Criticism of the Multiple Credit Creation Process

As can be seen from the above example, commercial banks are able to generate credit
worth ` 36,000 from a primary deposit of ` 4,000. The value of the credit multiplier is
9. This magnitude of multiple credit creation however may not work in reality or the
process may not be so smooth. If the assumptions are relaxed the process of multiple
credit creation may be restricted. The basic criticisms against this process are:
1. Cash Withdrawals: The credit creation process depends upon the restrictive
assumption that there are no cash withdrawals from the banking system. This
is very unrealistic, and if cash withdrawals are allowed the credit creation
will become less and less at every stage.
2. Changes in CRR: If CRR is allowed to change:
(a) It would complicate calculations.
(b) An increase in CRR would reduce the amount of credit created.
3. Introducing Multiple Primary Deposits: If a number of primary deposits
are allowed, it will complicate calculations.
4. Level of Development of Banking Habits: The credit creation also
depends on the amount of primary deposit; therefore, two related aspects
must be noted:
(a) There should be enough savings in the form of currency deposits for the
process to work.
(b) People should be familiar with banking habits.
5. Statutory Liquidity Ratio: By law, commercial banks are required to hold
a part of their assets in the form of near-liquid assets, like government bonds
and securities, treasury bills and other securities which can be easily encashed
(second line of defence). This reduces the amount of cash available for lending
and curtails the commercial bank’s power to create credit.
6. Central Bank’s Monetary Policy: The central bank can influence the
amount of money in circulation and thus the volume of credit created by
commercial banks. Also, through quantitative credit measures of control, the
Central Bank can control the contraction of credit by the banks.
7. Collateral Securities: Every loan made by commercial banks has to be
backed by a security such as, stocks, shares, bills and bonds, etc. The larger the
supply of such collateral securities, the larger is the ability of the commercial
banks to create credit.
8. Trade and Business Conditions: During boom periods, there is greater
demand for credit from banks, with the hope of making large profits. The banks
are thus able to create more credit during periods of prosperity. However,
during periods of depression, there is no incentive for businessmen to borrow
from banks and this reduces the bank’s ability to credit.
In reality, however, due to these limitations the credit creation process may not
be as smooth and perfect as shown in theory, however, the fact remains that one of
the most important functions of commercial banks is credit creation.
Commercial Banks: Multiple Credit Creation 117

7.4 MULTIPLE CREDIT DESTRUCTION/CONTRACTION

Commercial banks as they create credit can also destroy credit when the loans are
repaid by the borrower to the banks or contract credit created by banks is wiped out in
the process. This process is called the multiple credit contraction or destruction process.
The credit multiplier mentioned above works in both the forward and backward
directions. When the banking system receives cash in the form of primary deposits,
multiple expansion of credit takes place. However, when the banking system loses
some cash, it leads to multiple credit contraction (credit multiplier moves backwards).
Thus, for multiple credit contraction, the primary deposits of a bank reduce
because a customer withdraws an amount of cash worth ` 4,000 from the Bank I. When
Bank I loses primary deposits worth ` 4,000, its reserves will also fall by that amount
and to maintain a cash- ratio, the balance sheet of bank I is presented in Table 7.5.

TABLE 7.5 Balance Sheet of Bank I

Liabilities Assets

Primary Deposits – ` 4,000 Cash – ` 4,000

Reserves ` 400
Loan ` 3,600
Total ` 4,000 Total ` 4,000

Bank I will therefore call back loans (or sell securities) worth ` 3,600 this reduces
reserves by ` 400 because deposits have reduced by ` 40,000. This will affect the
deposits and the reserves of banks II, then Bank II, Bank III.
This multiple credit contraction process will continue till the effect of the initial
withdrawal is exhausted.
Total Credit Contraction = (Cash Withdrawn) × (Reciprocal of Cash Ratio)
= ` – 4,000 × 1/10
= ` – 4,000 × 10
Total Credit Contraction = – ` 40,000.

Points to Remember
• Commercial banks are defined as organisations/institutions engaged in the process
of transferring funds from the surplus sectors (Savers) in the deficit sectors
(Investors) in an economy; their characteristic feature still remains acceptance
of deposits and advancing of loans.
• Commercial banks are therefore known as Financial Intermediaries engaged in
the process of financial intermediation.
• The commercial banks perform a variety of functions which can broadly be
classified into banking functions, utility and agency functions foreign exchange
dealings, promotional and developmental functions.
118 Macroeconomics

• One of the very important functions of commercial banks is the multiple credit
creation function.
• The commercial banks create the credit or bank money component of the Money
Supply. (The Money Supply is made up of mainly coins, currency and credit
money.)
• The commercial banks are considered to be unique institutions which create credit
because of a major part of their deposits being in the form of Demand Deposits
(DD). These DD’s are chequeable and there is a direct crediting and debiting
which takes place.
• In the process of crediting and debiting such accounts, Credit money is created
and this process is the process of Multiple Credit Creation.
• Commercial banks have 2 types of deposits: (a) Primary deposit, i.e., a new cash
deposit and (b) Derivative deposit, i.e., when commercial banks advance loans
on the basis of a primary deposit, it creates a derivative deposit which is the
process of credit creation.
• The commercial banks can create credit money, multiple times the initial deposit,
therefore the term Multiple Credit Creation.
• The Primary Deposit (or new cash deposit) is the basis of credit creation and
after keeping aside a cash reserve ratio stipulated by the central bank, the rest
of the deposit is advanced as a loan. This process continues and finally comes to
a halt when the entire initial primary deposit is exhausted.
• To simplify calculations the credit multiplier is used which is given as
 1 
Credit Multiplier = 
 CRR 
where, CRR = Cash Reserve Ratio.
• It is necessary to note that the entire Multiple Credit Creation process takes place
within a given set of restrictive assumptions. In reality, there would be certain
limitations and constraints to this process. Nevertheless, the fact remains that
Credit Creation is an important function of commercial banks.
• Similar to the process of Credit Creation, the commercial banks also can destroy
credit which is referred to as the Multiple Credit Contraction process. The process
involves withdrawal of an initial PD and a multiple contraction of credit.

QUESTIONS
I. Short Questions
1. ‘Commercial banks have come a long way from only accepting deposits and
advancing loans.’ Explain.
2. Elaborate on the following concepts and its significance:
(i) Credit multiplier
(ii) Primary deposit
(iii) Secondary deposit
(iv) Credit contraction
Commercial Banks: Multiple Credit Creation 119

II. Long Questions

1. Critically examine the process of multiple credit creation by commercial
banks. Elaborate with a numerical example.
2. ‘Primary deposits form the basis of multiple credit creation process.’
Elaborate.
3. ‘Commercial banks create credit multiple times the primary deposit.’ Explain.
4. If the RBI buys government securities from the commercial banks worth
` 7 crores and commercial banks have to maintain a CRR of 3.5%, show
the total credit created by commercial banks using the credit multiplier.
CHAPTER

8
Quantity Theory of Money

8.1 INTRODUCTION
Money is a crucial variable in the economy. Any change in the quantity of money
supply would create disturbances in a number of macro variables in the economy like
the rate of interest, investment, output, prices, incomes, etc.
The quantity theory of money deals basically with changes in money
supply and its effect on the general price level.
When the quantity of money supply in an economy changes, it brings about a
rise or fall in the general price level. The quantity theory of money thus analyses the
effects and consequences of changes in money supply on the general price level in an
economy. In its simplest form, the quantity theory of money states that changes in
money supply bring about a direct and proportionate change in the price level.
When money supply, for example, doubles, the price level also doubles and vice versa.
The same conclusion can be stated in terms of the relation between money supply
and the value of money. When money supply increases the price level also increases,
as a result, the purchasing power of money or value of money falls. There is thus, an
inverse relationship between money supply and the value of money.
Since the quantity theory of money deals with the relationship between money
supply, general price level, and the value of money, it is necessary to understand
these concepts.

8.2 GENERAL PRICE LEVEL AND VALUE OF MONEY

8.2.1 General Price Level

Very simply, the general price level is an average of prices of all goods and services in
an economy during the current period.
120
Quantity Theory of Money 121

The general price level reflects the purchasing power of money and the value of
money. Movements and changes in the general price level indicate the rate at which
the price level is changing and therefore shows whether an economy is facing inflation
or deflation.
The calculation of the general price level, however, is a very complicated exercise
which involves the construction of price indices. There are a variety of price indices
like the wholesale price index (WPI), retail price index, consumer price index (CPI),
etc. To arrive at a price index, a basket of commodities is considered and weights are
assigned to the commodities and a weighted average price level is arrived at. There
are a number of difficulties in the construction of price index such as:
1. Which commodities to consider in the basket?
2. Which prices to use (wholesale, retail, etc.)?
3. What weights to assign to different commodities?
For the purposes of the quantity theory, the general price level can be considered
to be a simple average of the prices of all goods and services during the current period.

8.2.2 Value of Money

Money is primarily a medium of exchange and a measure of value. Therefore, by itself,
it does not have any value. This means that since money does not have any intrinsic
value, money is valuable because it can buy goods and services. Therefore, the value
of money is determined by its purchasing power.
In the modern monetised economy, money is useful as a measure of value and
medium of exchange. In the barter system, the form of exchange was commodity for
commodity. With the introduction of money, the form of exchange has now become
commodity for money and money for commodity.
When the quantity of money in circulation increases and the level of output of
goods and services remains constant, more money is required to buy the same quantity
of output. Thus, when the quantity of money supply increases, its value decreases
because of the increase in its supply.
To sum up, other things remaining constant, the expansion in supply of money
brings about a reduction in its purchasing power or the value of money. When the General
Price Level increases, it means purchasing power of money falls, which is a fall in the
value of money. General price level and the value of money are thus inversely related.
The value of money, i.e., the purchasing power of money shows the quantity of
goods and services that can be purchased by one unit of money, for example, one rupee.
When the price-level rises, money can purchase fewer commodities so, value of money
falls; or when price level falls, the same money can purchase more of the commodities
so the value of money increases. The value of money is therefore inversely related to
the price level which can be indicated as:
1
Vm =
P
where,
Vm = Value of money
P = General price level
122 Macroeconomics

Consider an example to show what exactly is meant by the value of money.

If, for instance, in the year 1950, one Rupee could buy two kilos of wheat; and
if presently, one rupee buys only one-fourth of a kilo of wheat; it means that the
purchasing power of one Rupee, in comparison to 1950s, has fallen to one-fourth of
its original value, i.e. worth 25 paise. In other words, one rupee can presently buy
only one-fourth of what it could buy in 1950 (wheat in this example). This fall in the
value of purchasing power of money has taken place because of a rise in the price of
wheat from 50 paise per kilo in 1950 to ` 4 per kilo presently.
Therefore, the value of money or purchasing power of money rises when there is
a fall in the prices of goods and services; and falls when there is a rise in the price
of goods and services, i.e. the price level.

8.2.3 Background of the Quantity Theory

The origin of the quantity theory can be traced to the Mercantilist thought of the
15th century. It was elaborated by David Hume in 1752 in his ‘Essay of Money’. Later
versions of the theory can be traced in the writings of Ricardo, J.S. Mill, Taussig,
Cassel. However, a formal exposition of the theory was done by Irving Fisher in his
famous book The Purchasing Power of Money published in 1911.

8.3 VERSIONS OF THE QUANTITY THEORY OF MONEY

There are three distinct versions of the quantity theory, which was developed and
modified from the crude or original version of the theory.

Original Crude Version

The classical version has been developed on the basis of the crude quantity theory,
which can be traced to the mercantilist thought of the 15th century. The old school of
economists believed that changes in the general price level may occur due to changes
in the quantity of money. A broad outline of the quantity theory was developed in
the 18th century by David Hume (1752) and Ricardo (1830). The crude version of
Quantity Theory of Money 123

the quantity theory has been explained in the writings of Mercantilists (a school of
economic thought), Malynes, Thomas Mun, etc. These writers believed that changes
in the price-level are equiproportional to changes in supply of money. This conclusion
has been presented in a more refined form in the classical, i.e. the cash transaction
version of the quantity theory.

8.4 CLASSICAL OR CASH TRANSACTIONS VERSION

The Classical Version was developed by Irving Fisher in his famous book The
Purchasing Power of Money in 1911.

Statement of the Theory

Fisher found that The price-level varies directly and proportionately with the quantity
of money in circulation, i.e. when the quantity of money doubles the price level also
doubles and vice versa.1
The money supply and general price-level in an economy are thus directly and
proportionately related.

Equation of Exchange
To explain his theory, Fisher used a mathematical formula called the ‘Equation of
Exchange’ given below:
MV = PT
where,
M = Total Amount of Money in Circulation (i.e. is the stock of money at a given
point time).
V = Velocity of Circulation of Cash
P = General Price Level (It is the weighted average of prices of all goods produced
in an economy during a given period of time)
T = Total Amount of Transaction of Sale and Purchase of Output during any
given period of time or in simple terms it is the level of output.
This equation has been extended to include deposit money and its velocity of
circulation, which can be written as:
MV + M1V1 = PT
where M1 = Amount of Deposit Money
V1 = Velocity of Deposit Money
Since the bank deposit money has a constant relationship with cash money, M1
and V1 can be included in the equation and analysis.
However, for the purposes of further analysis, the MV = PT equation is retained
in its original form. It simply means that as the quantity of money increases, other
things remaining equal price level rises in the same proportion.

1. Irving Fisher (1911), The Purchasing Power of Money, New York, Macmillan.
124 Macroeconomics

Brief Explanation of the Concepts of ‘M’, ‘V’, ‘P’ and ‘T’.

1. ‘M’: The money supply refers to the money in circulation, which is determined
by exogenous external agencies, i.e. the Central Government, Central Bank, and
Commercial Banks. These agencies can increase and decrease the money supply in
an economy.
2. ‘V’: V refers to the velocity of circulation of money, i.e., the rate at which the
society spends its money, or the speed with which money travels or circulates in an
economy. To understand this concept, consider an example, suppose there are four
individuals in an economy A, B, C, and D. To begin with, if individual A buys ` 1 worth
of commodity from B who in turn buys `1 worth of commodity from C and C from
D. In this process ` 1 has changed hands 4 times or performed value of transaction
worth ` 4. The velocity of circulation of ` 1 in this example is then 4. In the same
manner, if the money supply in an economy is ` 100 cr. and value of transactions is
` 500 cr. then V = 5.
Factors on which Velocity of Circulation of Money depends
1. Frequency of receipts and payments: Greater the frequency of receiving
income and making payments, greater is the velocity of money.
2. Certainty of receiving Income: Greater the certainty of receiving income,
greater is the velocity of circulation of money.
3. Availability of credit: Greater the availability of credit for making payments,
greater will be velocity of circulation of money in an economy.
4. Speed of payment facilities: If the remittance is done quickly, velocity tends
to be greater.
5. Customs, habits, attitudes of the society: It also affects how fast money is
spent in an economy.
All these factors affecting velocity of circulation do not fluctuate in the
short run and therefore ‘V’ is assumed to be constant in the analysis by Fisher,
i.e. considered to be relatively stable in the short run.
3. ‘T’: T is the total volume of transactions or output in an economy during a given
period.
The level of ‘T’ depends on:
(a) The Stock of Capital in an Economy
(b) Technology of Production
(c) The Level of Employment
In Fisher’s Theory, the level of transactions is considered to be constant because,
in the short run, the stock of capital and the technology of production are relatively
stable.
Further, since the Classical economists believed in the assumption of full
employment, the total output is also at the level of full employment.
4. ‘P’: P is the general price level or the average price of all goods and services
produced in an economy during a given period.
Quantity Theory of Money 125

Assumptions of Fisher’s Theory: In order to arrive at the direct and proportionate

relationship between money supply and the general price level, Fisher makes certain
crucial and restrictive assumptions stated as follows:
1. Assumption of full employment: The Classical Economists believed in the
tendency of a capitalist economy to attain full employment mainly because of
the working of the Says law which states “Supply creates its own demand’’.
2. ‘P’ is a passive element: ‘P’, i.e. the price level is a passive element in
the analysis. Prices are determined by the level of the money supply in an
economy, it does not determine the other variables in the economy, i.e., M.V
and T.
3. Constancy of ‘T’: ‘T’ has been assumed to be constant because
(a) Full-employment output has already been reached.
(b) The capital stock and technology are considered to be stable in the short
run.
(c) ‘T’; is not affected by changes in P, V, and M.
4. Constancy of ‘V’: ‘V’, i.e., velocity of circulation of money is also assumed
to be constant and not determined by the other variable in the equation.
‘V’ depends on a number of independent factors (mentioned earlier in this
chapter) which are also considered to be stable in the given short period.
5. Money is only a medium of exchange: The Classical economists considered
money to be only a medium of exchange, and hence, money is only demanded
for the purposes of fulfilling transactions.
6. Importance of money supply: ‘M’, i.e., the money supply determines ‘P’ in
the economy and is itself determined by exogenous factors, i.e. the Central
Bank, Central Government, and Commercial banks.
Explanation of Fisher’s Theory: Based on the above assumptions, one can explain
the Fisher’s Theory as follows:
If in the equation MV = PT, V and T are kept constant (by assumption) then
there has to be a direct and proportionate relationship between M and P to maintain
the equilibrium in the equation of exchange, i.e.,
MV = PT
\ ∆M = ∆P
If MS doubles, price-level will double; and if MS becomes half, price-level will
also become half and so on.
However, Fisher did provide a detailed explanation of his conclusion as follows:
1. According to Fisher, the General Price Level (GPL) is determined by the
demand and supply of money.
2. Fisher has already explained the concept of money supply but not the demand
for money.
3. Fisher proceeds to explain the demand for money and further assumes the
demand for money to be constant.
126 Macroeconomics

The demand for money can be derived from the original equation MV = PT in
the following manner:
MV = PT (i)

or PT (ii)
M=
V
or, ‘M’ in Eq. (ii) is the demand for money, and the demand for money function can
be written as:
PT
Md =
V
In the above equation, the demand for money at any time is:
The Price Level × The Level of Transactions
Md =
Velocity of Circulation of Money
Consider a numerical example.
If P  T = 400
V = 4
PT
Md =
V
400
Md =
4
Md = 100
This means that if people hold ` 100 in the form of cash, they will be able to
satisfy transactions worth ` 400. Therefore, ` 100 is society’s demand for money.
The conclusion that emerges is that Higher the velocity of money lower would be the
demand for money.
Fisher, however, did not enter into any further explanation of demand for money
and assumed it to be constant in the further analysis.
Explanation of the Process of change in Fisher’s Analysis: Fisher provided a
simple explanation of the direct and proportionate relationship between MS and GPL
as given below:
To begin with, if the money supply is, for example, ` 100 crores, at this level, there is
equilibrium in the economy. If the Central Bank decides to increase the money supply
to say ` 200 crores (i.e. double the MS). There will be excess money supply in the
economy disturbing the original equilibrium.
This excess money supply can be used to:
1. Increase the production of goods and services
2. Speculate in the financial market
3. Increase the demand for goods and services
Quantity Theory of Money 127

Alternatives 1 and 2 are not possible in Fisher’s theory because ‘T’ or the level of
goods and services is already at full employment and thus cannot increase, and money
is only a medium of exchange.
All the excess money supply therefore, there will have to be spent on existing
goods and services. The supply of goods being constant and the demand increasing
one gets into a situation of ‘‘too much money chasing too few goods’’. As a result, the
prices will have to increase, and this will go on till the entire excess money supply is
absorbed, and the price level will increase in exactly the same proportion as increases
in the money supply.
This can be shown with the help of a numerical example.
Situation I
Initial equilibrium:
M = 250 crores
T = 800
V = 4
P = ?
Substituting the values in the equation,
PT
M= (i)
V
P(800)
250 =
4
or 250 × 4 = P(800)
250 × 4
or =P
800
P = 5/4 = 1.25
P = 1.25 or 125%
Situation II
MS increases to ` 500 cr. (doubling of MS)
V = 4
T = 800
\ Substituting new value, in above equation
PT
M=
V
P(800)
or 500 =
4
500 × 4
or =P
800
 P = 2.5 = 250%
This will happen only if V and T remain constant in the equation.
128 Macroeconomics

Fisher’s theory can be explained using a diagram as given below in Figure 8.1.

FIGURE 8.1 Diagrammatic Illustration of Fisher’s Theory.

Explanation
1. The GPL is determined at a point where MS = Md.
2. The demand for money function is given as Md = PT/V and is assumed to be
constant. The GPL is determined by changes in MS.
3. When MS is at MS1 given the Md, prices are determined at OP1. When MS
increases to MS2 price-level to increases OP2 and when MS falls to MS3 prices
fall to OP3 establishing a direct and proportionate relationship between money
supply and the price level.

The essence of Fisher’s quantity theory is that for given and independent values of
Transactions (T) and velocity (V); the equilibrium Value of price level varies directly
and proportionately with the Quantity of Money Supply and vice-versa.

Criticisms and Limitations of Fisher’s Quantity Theory of money

Fisher’s version of the quantity theory came in for heavy criticism mainly because of
the unrealistic assumptions; the main criticisms can be classified under three aspects:
1. Criticism of Fisher’s Assumptions: Fisher’s theory is criticised because
its underlying assumptions are unrealistic.
(a) Fisher’s assumption of full employment is very unrealistic. The implication
of this assumption, i.e., a constant T, also came in for heavy criticism.
If the assumption of full employment is dropped, it will not result in a
direct and proportionate relationship between M and P.
(b) If the assumption of full employment is dropped, increases in MS will
bring about increases in T; so that MS and P would not be proportionately
related.
Quantity Theory of Money 129

(c) Fisher assumed V to be constant and that V does not have a bearing on
P and M. In reality, any change in MS and P will automatically change
V, e.g. if prices are expected to increase people will spend more in the
present so that of circulation of money will increase.
(d) According to Fisher, price is assumed to be a passive factor that means
‘P’ does not change anything. This again is not so, because price changes
can have an effect on T as well as on V. Such changes would disturb
Fisher’s conclusion.
(e) T, V, P, and M are all interrelated macroeconomic variables and cannot
be studied independently of each other. So, to assume that only one or
two variables are related is not proper.
(f) Fisher considers the money supply to be exogenously determined. However;
both changes in P and T can bring about changes in the money supply.
Relaxing any or the above assumptions would make the conclusion of
Fisher’s quantity theory of money weak.
2. Criticism of Fisher’s Concepts Explanation
(a) Fisher’s ‘Equation of Exchange’ is just an equilibrium condition, it by
itself does not prove anything.
(b) The concept of output ‘T’ also is more ambiguous because the level of
output includes both final and intermediate goods. T in Fisher’s analysis
also includes both first and second-hand transactions.
(c) The level of prices, therefore, also is not very accurate.
(d) If the store of value function of money and speculative demand for money
is introduced, a part of the excess money supply will be diverted to
speculation and prices will not increase in proportion to money supply.
(e) By ignoring the speculative motive, Fisher’s also keeps aside the influence
of the rate of interest.
(f) According to Mrs. Joan Robinson, the quantity theory equation just tells
us how it works rather than why it works so. The process of change
between two equilibrium situations also is not very explicit.
(g) Fisher’s theory gives more emphasis on the supply of money and neglects
the demand for money in the determination of the price level and value
of money. The Cambridge economists have tried to overcome this defect
by attempting to reconcile Quantity Theory with the General Theory of
value by giving due emphasis to both supply and demand for money.
(h) The theory emphasises on general price level changes and neglects the
behaviour of relative prices of individual commodities.
(i) Fisher’s equation is static. It applies to a world where all other things
remain constant. But in the real world, all things move together and have
complex interconnections. Thus, the theory does not apply to the dynamic
behaviour of the real world.
3. Criticism on the basis of Empirical Evidence: The direct and
proportionate relationship between money supply and prices is not supported
by historical evidence. The experience of America in the year 1923 during
construction boom activity, for example, shows that in spite of a rise in
130 Macroeconomics

supply of money, the price level did not rise much due to quick increase in
T, which also shows that T is not independent of M and P. It follows that V
will automatically be influenced. The assumption of full employment makes
the theory all the more unrealistic.

Conclusion
Fisher’s conclusion of a proportionate relationship has not been supported either by historical
evidence or current evidence—the direct relationship between M&P is however found.
Fisher’s Theory is given credit because for the first time, the relationship between
money supply and the general price level-two very important variables was established.
Fisher’s theory, in fact, forms the basis and direction for the operation of the Monetary
policy. His theory has opened a controversy among professional economists.
Basic merits of Fisher’s Theory:
1. Clarity
2. Originality
3. Lucid and Logical
Fisher’s version has been modified by the Cambridge and Modern economists.

8.5 CAMBRIDGE OR CASH BALANCE VERSION OF THE QUANTITY THEORY

OF MONEY
The Cambridge approach to the Quantity Theory of Money is associated with the name
of Alfred Marshall, A.C. Pigou, Robertson and Keynes. These economists arrived at the
same conclusion as Fisher’s. However, they used more modified and refined concepts.

8.5.1 Statement of the Theory

According to the Cambridge economists, the value of money and money supply are
inversely and proportionately related. When money supply increases the price increases,
and hence the value of money falls and vice-versa. (As already stated, the value of
money is the reciprocal of the price level). This conclusion is then similar to Fisher’s,
which states that money supply and the price level is directly related.
Four dominant Cambridge economists have presented their versions of the theory
which will be discussed in detail, later in this chapter.

8.5.2 Brief Introduction to the Cash Balance Version

Before proceeding to analyse the Cambridge Cash Balance Approach in detail, it is
necessary to be familiar with certain introductory aspects of the approach which can
very briefly be stated as follows:
1. The value of money is determined by the demand and supply of money.
2. The Cambridge economists kept demand for money to be constant and studied
the relationship between money supply change and value of money.
3. They recognised the fact that the changes in demand for money can bring
about changes in value of money through changes in the price-level.
Quantity Theory of Money 131

4. Money is still considered to be mainly a medium of exchange but the store of

value function has been introduced, without however going into the speculative
motive to demand money.

8.5.3 Points of Similarity between Fisher’s Transaction Approach and

the Cambridge Cash Balance Approach
1. Both approaches believed in the Full Employment assumption.
2. The level of transaction and output is assumed to be constant in both versions.
3. The state of technology and the stock of capital is stable in the short run, in
both the approaches.
4. In both the analysis, money is basically a medium of exchange.
5. Money supply in both approaches is determined exogenously by the Central
Government, Central Bank, and Commercial Banks.
6. Both versions establish the positive relationship between money supply and
the price-level (or an inverse relationship between money supply and the
value of money).

8.5.4 Explanation of the Cambridge/Cash Balance Version

The following analysis deals with the versions of the dominant Cambridge economists,
i.e. Marshall and Pigou; the approaches of the other two important Cambridge
economists, i.e. Robertson and Keynes, is stated in Appendix 1 of the Chapter.
The Cambridge economists used equations similar to Fisher’s ‘Equation of
Exchange’ to explain their approach to the Quantity Theory of Money.
Marshall: M = kY Robertson: M = kPT
kR
Pigou: p = Keynes: n = Pk
M

Alfred Marshall’s Version

In order to establish a direct and proportionate relationship between Money supply
and prices, Marshall used the following equation:
M = kY ... (i)
Y = P  O
So, Equation (i) can also be written as:
M = kPO …(ii)
where,
M = Quantity of Money in Circulation
K = The Fraction of Annual Output over which people wish to have a command in
Money/Cash form (to be explained later)
Y = Money Value of Output Y has 2 variables ‘P’ and ‘O’, where,
P = Price level
O = Real level of annual output
132 Macroeconomics

From the above equation, some basic points of difference between Cambridge and
Fisher’s approach become evident.
1. Fisher’s analysis used ‘T’, i.e., level of transactions which included both final
and intermediate goods, whereas the Cambridge economists used ‘O’, i.e., the
level of output. It is a more accurate concept as it refers to only final goods
and only the new output produced during a year.
2. The Cambridge economists recognise the store of value function along with the
medium of exchange function, which gives rise to their ‘cash balance’ version.
3. The Cambridge economists have used ‘k’ instead of ‘V’ (though as will be seen
later ‘k’ and ‘V’ are nothing but reciprocals of each other.)
4. Finally, the Cambridge economists consider the importance of the demand for
money in determining the price level.
Meaning of Demand for Money (k): Demand for money is defined as the Proportion
of national income which the society desires to hold in the form of cash balances. The
demand for money has been denoted by the term ‘k’ in the Cambridge analysis.
The society’s demand for money is the sum of demands for money by individuals
and institutions. Individuals demand to hold money in the form of cash balances to be
able to meet the transactions or to give them a certain amount of purchasing power.
This demand for money is a fraction of the total value of the output.
To make the concept clearer, if for example, during any period of time the value
of national output is ` 500, then accordingly, the individuals in the society decide to
hold some fraction of this total value in the form of cash balance holdings to give
them command over the level of output. If k = 1/5 then the demand for money or cash
balance holding will be 1/5th of 500 = 100, which means the demand for money by
the society is ` 100 which gives them command over 1/5 of the total value of output
at a given point of time. This is the amount which individuals would like to demand
or hold in the form of cash balances.
Money stock
k=
National income
In the Cambridge version, therefore, the demand for cash balances or money
arises because money gives purchasing power to individuals.
The demand for money along with the supply of money is considered to be
important for the purpose of determining the price level in the Cambridge versions.
However, even in the Cambridge approach demand for money is assumed to be constant.
‘k’ and ‘V’ are nothing but Reciprocals of each other: ‘k’ (the demand for money
or cash balances) is nothing but the reciprocal of ‘V’ (i.e. velocity of circulation money),
and vice versa. Therefore,
1
k=
V
This can be explained with the help of a numerical example:
If at any point of time the national income is ` 1000 and stock of money is ` 500,
then the proportion of national income held in cash balances is
Quantity Theory of Money 133

Money stock
k=
National income
500 1
or k= =
1000 2
On the other hand, since ` 500 worth of money supply circulates and performs
transaction worth ` 1000, the velocity of circulation of money is
1000
V= =2
500
which is the reciprocal of ‘k’ that is 1/2. ‘k’ shows the tendency of the society to hold
money, and ‘V’, its reciprocal, shows the opposite, i.e., the tendency of money to circulate.
Factors on which ‘k’ depends: ‘k’ is determined by almost the same factors
which influenced ‘V’. These factors include the frequency of receipts and payments,
the availability of credit, the customs, habits of banking and credit, the speed of
transportation of money. It is quite obvious that greater the frequency and regularity
of payments and receipts, the more developed the banking and credit facilities; the
greater the speed of transportation of money smaller will be the value of ‘k.’ Since these
factors are relatively stable in the short run ‘k’ or demand for money is also relatively
stable in the short run.
Assumptions of the Cash Balance/Cambridge Version: The Cambridge Theory
is also based on a set of restrictive assumptions which are stated as follows
1. The Cambridge economists for similar reasons as Fisher assume that the
economy has a tendency to full employment.
2. It follows from the above assumptions that the state of technology and capital
stock are given in the short run.
3. ‘O’, i.e., the level of goods and service is taken to be constant because of
assumptions (1) and (2).
4. Money is still basically a medium of exchange, but the store of value function
is introduced.
5. ‘k’ or demand for money, though important in the analysis, is assumed to be
constant for the same reasons as V was held to be constant.
6. The level of money supply determines the price level.
7. The level of money supply itself is determined by the central government,
central bank, and commercial banks.
8. The level of price is a passive factor and does not affect any other variable.
9. ‘O’ and ‘k’ also do not determine the level of ‘P’.
Explanation of Marshall’s Cash Balance Version of the Quantity Theory of
Money: Using Marshall’s equation (as explained earlier), one can understand the
simplest presentation of the Cambridge quantity theory of money.
M = kY ... (i)
or M = kPO ... (ii)
134 Macroeconomics

where,
M = Level of Money Supply (stock of money supply),
k = Demand for Money
P = Price Level
O = Level of Output Produced during a year
Now, since ‘k’ and ‘O’ are assumed to be constant, any increase in the level of
money supply would lead to a proportionate increase in the price and a fall in the
value of money.
This can be shown clearly using the equation
M = kPO

or M = kPO

Since k and O are constants in the short run, there exists a direct relationship between
M and P. Any change in the level of money supply will be directly reflected in changes
in the price level. (This explanation is the same as Fisher.)
When the level of money supply increases, ‘k’ and ‘O’ remaining constant, people
find that they are holding excess cash balances. They try to get rid of this excess by
spending more on constant output flow. This results in pushing up the prices, which
can be illustrated with the help of a diagram (Figure 8.2).

FIGURE 8.2 Diagrammatic Illustration of Marshall’s Theory.

As seen in Figure 8.2, to begin with, equilibrium is established at point e1 where

demand for money Md = kPO is equal to MS1; the price-level is established at OP1.
When money supply increases, i.e., doubles to the level MS2, there is excess cash which
people try to get rid by demanding more goods and services; output being constant the
price-level is pushed to OP2 where new equilibrium is established at point e2. With
doubling of money supply price-level also doubles or value of money becomes half.

Pigou’s Version of the Quantity Theory

Pigou established an inverse and proportionate relationship between money supply
and value of money using the following equation.
Quantity Theory of Money 135

kR
p= ... (i)
M
where,
P = Value of Money (or the reciprocal of price-level)
R = Total Resources (expressed in terms of wheat)
k = Fraction of Resources kept in Cash
M = Amount of Legal Tender or Money Supply
This equation can be converted into the familiar equation expressing relation
between money supply and price level.
1
Since p=
P

where,
p = Value of Money
P = Price Level
Substituting (1/P) for p in Eq. (i),
1 kR
We get, = ... (i)
P M
or M = PkR ... (ii)
Keeping k and R constant a direct and proportionate relation emerges between
M and P.
Pigou’s original conclusion of an inverse relationship between money supply and
value of money can be shown below in Figure 8.3.

FIGURE 8.3 Diagrammatic Illustration of Pigou’s Theory.

In the diagram, demand for money function is given as P = (kR/M), which is

drawn as a rectangular hyperbola indicating a constant demand for money. To begin
with, money supply is at level MS1 and equilibrium at point OP1’. When money supply
increases to MS2, a new equilibrium is determined at point e2, and the value of money
136 Macroeconomics

falls to level OP2. When money supply doubles the value of money becomes half shown
at OP2 (A doubling of the price level reduces the value of money or purchasing power
of money to half.)
The Cambridge conclusion is similar to the classical version. However, it is
considered to be a superior version because of the new elements and modified concepts
used by them.

Criticisms of the Cambridge version

The Cambridge version has been criticised basically on the same grounds as the
transactions or classical version. The main points of criticism of the Cambridge version
can be listed as follows.
1. The assumption of full employment and hence a constant level of output has
come in for strong criticism.
2. The assumption of ‘K’ or demand for money being constant also is not very
realistic.
3. Money is not only a medium of exchange.
4. Price is not only a passive factor because in the absence of full employment
increases in prices would mean higher profits and higher production, which
is not considered.
5. The Cambridge economists also did not study the effect of changes in ‘M’ on
the rate of interest (since the speculative motive for the demand for money
was not considered).
6. The Cash Balance equations like Fisher’s equation of exchange states an
identity.
7. The process of change from one equilibrium to another has not been clearly
defined.
8. Though ‘demand for money’ has been introduced, it is assumed to be constant
so that the real influence of demand for money on price level (value of money)
has not been considered.
9. The Cambridge conclusion, like the Classical version is not supported by
empirical evidence.

Superiority of the Cambridge Version

The Cambridge version is considered to be superior to Fisher’s version not in its
conclusion but in certain new and modified concepts used by the Cambridge economists.
1. Concept of Demand for Money: To begin with, the Cambridge economists
have introduced a new concept, i.e. ‘Demand for money’ (explained earlier).
2. More Balanced Version: The Cambridge version is more balanced since
it considers both demand and supply of money as important in determining
value of money and the price level.
3. Impact of Demand for Money on Price Level: The Cambridge economists
state that the money supply remaining constant, changes in demand for
money can bring about changes in the value of money and the price level.
When demand for money increases, it means people want to hold more cash
Quantity Theory of Money 137

balance as a result of which demand for goods and services will fall, leading
to a fall in the price level. Though it is not a very clear explanation, it no
doubt, recognises the fact that change in demand for money can bring about
changes in the value of money. However, in the Cambridge analysis demand
for money is considered to be constant.
4. More Refined Concept of Output: The concept of output (O) used in the
Cambridge approach is considered to be superior to ‘T’ because
(a) It is more specific; it refers to new goods and services produced during
a year.
(b) It makes a distinction between final and intermediary goods.
(c) It is more accurate and refined.

Conclusion
The Quantity Theory, i.e. Fishers and Cambridge version show that changes in prices
are primarily governed by changes in money supply. The theory seeks to prove that
changes in prices are directly proportional to changes in money supply.
It is an incomplete theory because it fails to integrate the monetary and real
sector.
It, however, paved the way for the Modern Quantity Theory.

Other Elaborations of the Cambridge Version

D.H. Robertson: Robertson arrives at the conclusion of a direct and proportionate
relationship between money supply and level using the following equation:
M = kPT
where,
M = Quantity of Money
P = Price Level
T = Quantity of Goods and Services Purchased during a year
K = Part of ‘T’ over which people which people wish to have a Command in the
form of Cash
The conclusion which emerges is that if k and T are kept constant, there is a
direct and proportionate relation between money supply and price level in an economy.
J.M. Keynes: Keynes presented his version of the Quantity Theory initially in 1923
under the Cambridge School. Later, he has presented a “Restatement of the Quantity
Theory” in 1928.
His original equation is stated as:
n = Pk
where,
n = Cash in circulation
P = Price level
k = Amount of consumption units the public keeps in cash
138 Macroeconomics

This equation was then extended to include bank deposits

n = P (k + rk’)
where,
r = Ratio of Cash Reserves to Deposit Liabilities a bank has to maintain
k = Amount of consumption goods over which people wish to have a command in
the form of deposit money.
The same Cambridge conclusion holds if ‘k’ and ‘r’ are considered to be constants.

8.6 MODERN VERSION OF THE QUANTITY THEORY

The modern version of the quantity theory was presented by Keynes, Milton Friedman
and James Tobin. They analysed the relationship between money supply and the
general price level and presented their views under the modern version of the quantity
theory.

8.6.1 Keynes Version of QTM

Keynes had earlier presented his views in the Cambridge version and also gave a
restatement of his theory in the modern version in 1928, which is a much more
realistic approach.
• For the first time, all these variables were studied in an integrated manner.
• Keynes recognises the importance of a very crucial variable, i.e. the rate of
interest in the quantity theory.
• Keynes recognised that money is both a store of value and a medium of
exchange. He, therefore, introduces speculation.

Statement of the Theory

When Keynes analysed in detail the relationship between MS and GPL, he came to
the following conclusion.
As long as there is the unemployment of resources, any change in MS through
changes in aggregate demand, rate of interest, will bring about changes in the level of
output, prices, and income. Once the economy reaches the level of full employment, any
increase in money supply will cause a proportionate increase in the GPL.
This is summarised as follows:
1. Situation of Unemployment: Increase in MS  Rate of interest declines
 Investment and Aggregate demand increases  Output/Employment/
Income increases
2. Post-Full Employment: Increases in MS  Rate of interest declines 
Aggregate demand increases  Output cannot increase beyond the level of
full employment  Therefore GPL increases.
Note: From the above, it is quite clear that Keynes considered inflation to be a post-full-
employment phenomenon. However, he did recognise that prices could begin increasing
before full employment due to bottlenecks and limitations to production.
Quantity Theory of Money 139

The relationship between money, output and prices in Keynes theory is presented
in Figure 8.4.

FIGURE 8.4 Relationship between Money, Output and Prices in Keynes Theory.

Explanation
‘Panel A’ in Figure 8.4 indicates that till the level of full employment is reached the
output goes on expanding with increases in MS in a proportionate manner. Beyond
the level of full employment indicated by Qf in the diagram, the output can no longer
increase. Therefore, any increase in money supply fails to bring about increases in
output. As a result, the output curve becomes a vertical line.
Panel B of the diagram shows that till point PF is reached, as MS increases the
prices do not change because economy has scope to expand output. However once the
economy reaches the level of full employment at OQF as shown in Panel A of the
diagram, any increases in money supply will lead to increases in the price levels as
indicated by the upward sloping Price Curve in Panel B of the diagram.

Reasons for increasing GPL even before the level of full employment
1. Trade Union Pressures: It pushes up the wages and therefore prices.
2. Diminishing Return to Scale: The operation of this law may not allow
the output to increase at the desired rate, and therefore the demand pressure
on supply will push up prices.
3. Shortage of Raw Materials and other Inputs: It will push up prices due
to increasing costs of production.
4. Technical and Financial Constraints: It slows down the rate of growth
in output and prices. As a result, prices will begin to increase.
5. Mismatch between Supply and Demand: If supply cannot match the
increase in demand, prices will have a tendency to increase.

Concluding Observations
Keynes’ major contribution was the integration of the monetary theory with the real
theory (which deals with the production of goods and services.) Keynes’ theory is a
more realistic approach to the relationship between money supply and prices.
140 Macroeconomics

8.6.2 Friedman’s Quantity Theory of Money (1956)

Milton Friedman presented his version of the Quantity theory in A Restatement in 1956.
Friedman was the founder of the school of economic thought known as Monetarism.
This school believed that that ‘Money’ is a very crucial variable in an economy and also
that changes in money supply can bring about changes in the economy. On this basis,
they stated that Monetary Policy is an effective instrument to stabilise the economy.
Friedman’s Quantity Theory of Money forms the foundation of monetarism. This
theory can be presented in three parts.
1. Clarifications
(a) The quantity theory of money is a theory of demand for money and not
of output and price-determination.
(b) Friedman analysed in detail the reasons as to why people demand money
and came to the conclusion that money is only one kind of an asset, the
others being investment in bonds, equity shares, real assets, education,
etc.
(c) Therefore, the demand for money should be studied as a part of the
demand for different assets, which constitute wealth, or as a part of
holding alternative assets. He, therefore, applied the theory of ‘Asset
Demand’ to money.
(d) Money is both a medium of exchange as well as a store of value.
2. Equation
Based on the above considerations, Friedman arrives at demand for money
function. He recognised that individuals want to hold a certain amount of real
money balance (i.e. quantity of money in real terms).
He then expresses his demand for cash balance/real balances or demand
for money function as:
Md Ê Dp ˆ
= f Á YP , rb , re , , w, u, rm ˜ ... (i)
p Ë p ¯

where,
Md = Demand for Money
Md/p = Demand for Real Balances
Yp = Permanent Income Concept (i.e., very simply the expected average
long run income)
rb = Interest Rates on Bonds
re = Interest Rate on Equities
∆p/p = Rate of change in Prices
W = Ratio of Non-human to Human Wealth
U = Variable that affects Tastes and Preferences
rm = Expected Return on Money
Friedman finds the demand for money to be dominantly influenced by the
permanent income written as:
Quantity Theory of Money 141

Md
= f(Yp )
p
Note: An important conclusion to note about the Permanent Income (Yp) is
that it is subject to lesser fluctuations and therefore demand for money also
will be relatively stable.
3. Conclusions
After having stated the equation, Friedman tested the equation for the
economy of the U.S. and arrived at certain conclusions. (These have important
implications for understanding Monetarism.)
(i) The demand for money is a highly stable function of income.
(ii) Factors that affect supply of money do not affect demand for money.
(iii) Velocity of money is regarded as constant over time. The monetarists
in fact stated that velocity of money changes but in a statistically
predictable manner so that it will not disturb the economy. Velocity of
money is nothing but the reciprocal of Md and if Md is stable V also is
considered to be stable.
(iv) Based on the above, it was found that changes in money supply would
bring about changes in output and prices because the demand for money
and velocity are considered to be relatively stable.
(v) The rate of interest, unlike as in the Keynesian analysis, does not affect
demand for money as dominantly Friedman believed that changes in the
interest rates will have little impact on the demand for money.
(vi) Friedman also believed very strongly that the Liquidity Trap, as shown
by Keynes really does not exist and that demand for money does not
become perfectly elastic as shown by Keynes in his region.

8.6.3 Tobin’s Portfolio Balance Theory

(Tobin’s Portfolio Selection Model: The Risk Aversion Theory of Liquidity
Preference)
In the post-Keynesian literature, the major economists who presented their views
and modifications on the Quantity Theory of money and demand for money, were
Milton Friedman, Baumol and James Tobin.
James Tobin in his article Liquidity Preference as Behaviour towards Risk (1958)
presented his Portfolio Selection Model to explain the Risk aversion theory of liquidity
Preference.2
Tobin, through his theory, which is considered to be superior to Keynes analysis
of speculative demand, shows
(a) That individuals hold both money and bonds in their wealth portfolio and not
only money or only bonds.
(b) He has developed a theory which does not depend upon the elasticity of
expectation of future interest rates (the concept of normal rates in Keynes

2. Tobin, J. “Liquidity Preference as Behavior Towards Risk.” The Review of Economic Studies,
Vol. 25, No. 2, 1958, pp. 65–86.
142 Macroeconomics

theory), but shows that the investor considers the uncertainty in the movement
of interest rates and makes a rational choice of adjusting his money and bond
holding in his wealth portfolio, depending on changes in the rate of interest.
The theory can be explained in three parts.
1. Foundations and Assumptions of the Theory
• The individual asset holder has a portfolio of money and bonds.
• Money has the characteristic that there is no interest, no risk and no return
on money. However, it is a very safe holding, and individuals generally
have a preference to hold liquid money.
• Bonds yield an interest income but are subject to uncertainty. Holding
bonds creates the possibility of capital gains or capital losses, this also
means that there is both a risk and return in holding bonds.
• The return from bonds is necessary to induce the investor to invest in bonds
or it is a compensation for the risk borne by the investor.
• Risk means the uncertainty associated with any investment.
2. Clarifications: Tobin states that there are 3 types of investors:
(i) Risk lovers: This category of investors is not scared to take risks and
invest all their wealth in bonds.
(ii) Plungers: These investors either invest all their wealth in bonds or hold
all their wealth in the form of money.
(iii) Risk Averters/Diversifiers: This class of investors are risk-averse and are
prepared to take risks only if they are duly compensated by high returns.
The majority of investors are risk averters or diversifiers and hold some
portion of their wealth in bonds and some in money by weighing the
risks and returns associated with the above forms of investment.
Tobin proceeds to explain his Portfolio Selection Model using the Indifference
curve analysis. It is, therefore, necessary to understand a few aspects related
to Indifference curves.
• Indifference curves were developed by the economist Vilfredo Pareto
(1923–1948). The indifference curves were developed in the context
of consumer demand theory and show the points of equally desirable
combinations of goods services, giving the same level of satisfaction. (for
example, the satisfaction derived from the consumption of 2 units of bread
and 3 units of fruits, or 3 units of bread and 2 units of fruit.)
• Indifference curves are utility functions which give the same level of
satisfaction along an indifference curve. Different indifference curves give
different levels of satisfaction.
• In Tobin’s theory, indifference curves are used where the horizontal axis
measures ‘risk’ and the vertical axis measures ‘returns.’ Along any indifference
curve the investor gets the same level of satisfaction from a combination of
risk and return and therefore is indifferent to the combination.
• The budget line or budget constraint shows the resource constraint of the
individual, i.e. either his total income available to spend on goods or in
case of Tobin’s model it shows the total amount of money to be invested
in bonds.
Quantity Theory of Money 143

3. Explanation of the portfolio selection between Risk and Return of Diversifier

As mentioned earlier, Tobin uses Indifference curves to find out the preference
of the Risk averter.
The indifference curves used in Tobin’s model has a positive slope indicating
that the risk averter demands proportionally higher returns in order to
undertake more risks. This can be demonstrated in Figure 8.5.

FIGURE 8.5 Portfolio selection between Risk/Return of Diversifier.

Explanation
• The horizontal axis shows ‘risk’ and the vertical axis shows the ‘returns.’
• ‘OR’ is the Risk Averters budget line which shows a combination of risk and
return and also the combination of money and bond holding.
• I1 and I2 are two indifference curves, and along an indifference curve, the
investor gets the same level of satisfaction by different combinations of risks and
returns. A higher indifference curve gives a higher overall level of satisfaction.
• The equilibrium will be attained at point ‘T’ where the budget line OR is
tangent to I1.
• The lower segment of the function shows the total wealth held by the investor,
which consists of both money and bonds.
• ‘OC’ shows the risk undertaken proportional to the share of the total portfolio
in bonds.
• The total wealth held by the individual is ‘OW’ and point ‘E’ corresponding to
point T determines the proportion or portfolio mix of money and bonds.
• OW is divided into two forms of holding wealth, i.e. ‘OP’ in Bonds and ‘PW’
in money form.
• The risk averter does not hold his wealth either entirely in money or fully
in bonds, in fact, he diversifies his holding between the two forms of holding
wealth. The ‘risk averter’ has an inherent preference for money and needs
higher interest rates to induce him to take risk.
• Two conclusions can be drawn here:
(a) Higher the interest rates, higher is the incentive to hold bonds.
(b) Lower the interest rates, lower is the incentive to hold bonds.
144 Macroeconomics

Equilibrium of Risk Averter with Changes in Rates of Interest: The following

analysis shows how the risk averter reaches equilibrium with changes in rates of
interest. This is given in Figure 8.6.

FIGURE 8.6 Equilibrium of Risk Averter with changes in Rates of Interest.

Explanation
• The Y-axis shows the expected returns and X-axis shows the risks associated
with bonds
• I1 and I2 are indifference curves showing various combinations of bond and
money holdings which gives the same level of utility to the investor.
• OL1 and OL2 show the possibilities of exchanging bonds for money in the
market. In simple terms, it denotes the market price of the bonds since the rate
of interest is reciprocal of the price of bonds. It also denotes the rate of interest.
• The rate of interest gives the slope of L1 and L2, as interest rates change the slope
of the L curve changes. When interest rate increases, L increases from L1 to L2.
• At point e1 the return is low denoted by R1, and therefore bond holding is low,
and money holdings are high, at point e2 the return is higher at R2 and bond
holdings are higher and correspondingly money holdings are low.
• At higher rates of interest return on bonds, the bond holding increases and
holdings in the form of money reduces and vice versa.
It can thus be seen that, as rates of interest increase, bond holdings increase and
money holding declines.

Speculative Demand for Money

From the above analysis, one can draw the speculative demand for money curve, which
shows the inverse relationship between speculative demand for money and rates of
interest shown in Figure 8.7.
LS is the speculative demand for money generated from Tobin’s analysis which
shows an inverse relationship between the interest rate and demand for money.
Quantity Theory of Money 145

FIGURE 8.7 Speculative Demand for mMoney.

Superiority of Tobin’s Version over Keynes Version
• Tobin’s Risk Aversion theory of Portfolio Selection is more realistic because it
shows that individuals hold a diversified portfolio of bonds and money and not
‘only bonds’ or ‘only money.’
• Tobin also shows that demand for money is strongly dependent on the rate of
interest movements and are inversely related to rates of interest Tobin also
does not discuss the concept of a liquidity trap or perfect elasticity of money,
which is more realistic perfect elasticity of demand, i.e. the concept of the
liquidity trap.
• Tobin’s theory also demonstrates how the investor behaves when there is
uncertainty about future rates of interest and how he adjusts his bond and money
proportion in his investment portfolio to minimise risks and maximise returns.
It does not depend upon inelasticity of expectations of future interest rates.

Points to Remember
• The Quantity Theory of Money (QTM) basically deals with the relationship
between Money Supply (MS) and the General Price Level (GPL). There are 3
dominant versions of the Quantity theory—The Classical version; The Cambridge
Version and the Modern Version.
• The quantity theory is a significant area of economic analysis because it deals
with a very crucial variable in an economy, i.e. Money supply and its effect on
the General price Level.
• There are 2 concepts involved in the quantity theory which need clarification:
(i) The General Price Level (GPL) to understand the QTM, is considered to
be a ‘simple average of the prices of all goods and services produced in an
economy’ during a given period. (The GPL, however, is reflected in the ‘Price
Indices’ like wholesale, retail, consumer price index etc.). Movements in the
GPL would indicate whether the economy is facing inflation, deflation or
stability in prices.
(ii) The second related concept is the value of money (Vm) which reflects the
purchasing power of money. Quite obviously the purchasing power of money
would be dependent on the GPL (i.e. an inverse manner).
146 Macroeconomics

1
Therefore, Vm =
GPL
• Both the classical version (Fisher) and the Cambridge versions (Pigou, Marshall,
Robertson and Keynes) established a direct and proportionate relationship between
MS and GPL or an inverse and proportionate relationship between MS and Vm.
• Fisher used the famous MV = PT Equation of Exchange to explain his conclusion,
where he considers ‘T’ the level of output or transactions and ‘V’, i.e. velocity of
circulation of money to be relatively stable in the short run thus establishing his
conclusion. The level of ‘T’ is considered to be stable due to classical assumption
of full employment’s and ‘V’ is stable because the institutional factors on which
‘V’ depends are relatively stable in the short run. The essence of Fisher’s quantity
theory is that, for given and independent values of Transactions (T) and Velocity
(V); the equilibrium Value of price level varies directly and proportionately with
the Quantity of Money Supply and vice-versa.
• The Cambridge Version arrived at the same conclusion following almost the same
logic and assumptions as Fisher,
(i) Marshall: M = kY; (ii) Pigou: p = kR/M
• The Cambridge version is however considered to be superior to the classical
approach, not in its conclusion but because of the modified and refined concepts
that they have used. The Cambridge economists not only used a more refined
concept of the level of output by including only first-hand goods and final goods
but they have given a better analytical treatment to the concept of demand for
money (k).
• The Cambridge economists introduced the store of value function of money along
with the medium of exchange. They developed the idea of ‘cash balances’ and
based on this developed the concept of Demand for Money (k). Individuals make
deliberate decision to demand money to hold in the form of cash balances money
given them a claim over goods and services.
• This demand for money ‘k’ is a fraction of the total value of the output in an
economy and would depend on the speed with which money travels in an economy,
i.e. ‘V’ (Velocity of circulation of money). ‘K’ and ‘V’ therefore are reciprocals of
each other or
1
k=
V
Greater the velocity of money less will be the amount of cash balances or demand
for money and vice versa.
• Keynes in his restatement of the quantity theory (under the modern version)
modified his earlier analysis and gave a better version of the QTM. His
conclusion is that as long as there is unemployment in an economy, changes in
money supply will bring about a change in the level of output; beyond full
employment, any change (increases) in money supply would be reflected in
increases in the GPL.
• He also provided a more integrated theory since he states that changes in money
supply affect, e.g. if MS   i   I   O 
Quantity Theory of Money 147

In fact, he was the first one to introduce the rate of interest as a crucial link
in the Quantity theory.
• He showed that the monetary and real sectors are interlinked and that one
cannot isolate these sectors.
• Further development in the QTM was made by Milton Friedman (1956) who
stated that the QTM is basically a theory of demand for money and gives an
elaborate demand for money function in which he shows that money is only one
form of holding one’s wealth, the others being deposits, shares, bonds, investment
in education etc. Therefore, he used an Asset demand approach to the demand
for money and links it to the return on all other forms of investments.
• In the modern version of the Quantity theory of money James Tobin presented
his Portfolio Selection Model to explain the Risk aversion theory of liquidity
Preference and showed that as rates of interest increase, bond holdings increase
and money holding declines.

QUESTIONS

I. Short Questions
1. The General Price Level and Value of Money are inversely related.’ Explain.
2. Explain the essence of the Quantity Theory of Money.
3. Explain the variables and their significance in Fisher’s equation MV=PT.
4. ‘K’ and ‘V’ are reciprocals of each other explain.
5. Explain the relationship between value of money and general price level.
6. Friedmans Quantity theory of Money is a theory of demand for money and
not of output and price-determination. Explain.

II. Long Questions

1. Critically examine Fishers (or cash transactions) approach of the quantity
theory of money. How realistic is it?
2. Show how the cash balance version (of Cambridge economists) is superior
to the cash transactions approach.
3. Elaborate the approaches of the Modern version of the Quantity Theory of
Money and how do they differ from the classical approach.
4. The Quantity Theory of Money deals with a very crucial relationship between
Money Supply and General Price Level. Discuss.
5. In Tobins Portfolio Balance Theory, as rates of interest increase, bond
holdings increase and money holding declines. Explain.
6. Keynes modern version of the Quantity theory is an integration of the
monetary theory with the real theory. Explain.
CHAPTER

9
Inflation and Deflation

9.1 INTRODUCTION
Inflation is a persistent and considerable rise in the general level of prices. It is also a
situation in which the value of money keeps falling. It is situation when there is too
much currency in the economy. There is no single satisfactory definition of inflation,
however, it is considered to be persistent rise in the general level of prices as indicated
by a suitable price index.

9.2 NATURE CHARACTERISTICS OF INFLATION

Based on the above definition of inflation one can list out the main characteristics of
inflation as follows:
1. A temporary rise in the general price level cannot be termed as inflation; it
has to be continuous and persistent.
2. It implies a decline or fall in the value of money.
3. Inflation generally occurs during the recovery or boom period of a trade cycle.
4. Inflation is a monetary phenomenon.

9.2.1 Categories of Inflation

Inflation can be characterised into various categories depending on the rate at which
prices rise.
1. Creeping Inflation: Creeping inflation occurs when the prices rise at a very
slow rate, i.e. about 2–3 percent. Such inflation is, in fact, necessary for an
economy, since it provides an incentive for producers to continue production.
2. Walking Inflation: Under this type of inflation, the prices rise at about
4–5 percent and if not controlled can move onto the stage of running inflation
3. Running Inflation: It is a situation where the prices increase at a very
rapid rate, i.e., about 10 percent per annum. Such a level of inflation can
have extreme adverse effects and should be controlled.
148
Inflation and Deflation 149

4. Galloping or Hyperinflation: This is the most dangerous type of inflation

wherein prices rise every minute. Keynes refers to this type of inflation as
true inflation. Hyperinflation occurs after full employment is reached.
Inflation can also be classified on basis of how the Government responds to the
problem. On this basis inflation is classified as:
1. Open Inflation: It is a situation where the government takes no steps to
control the rise in the price-level. The market mechanism works without the
restrictions of the government. Allocation of resources, distribution of income
and economic development take place freely without the interventions of the
government.
2. Repressed or Suppressed Inflation: It is a situation where the government
actively intervenes to control the rise in the level of prices. This may be done
through various policies of the government like the monetary, fiscal, price,
income and wages policies, and other measures.
Some amount of inflationary tendency is, in fact, essential to boost the economy.
However, any excess inflation would have adverse consequences for the economy.

9.3 CAUSES AND THEORIES OF INFLATION

There are a number of views as to why inflation occurs. The classical economists
attributed inflation to increases in money supply, which causes an excess demand for
goods and services leading to increase in prices. Keynes viewed inflation to be a post
full employment phenomenon, where any increases in money supply beyond the level
of full employment would increase the aggregate demand and pull up the level of
prices causing inflation. The monetarists also believed that inflation is basically due
to excess money supply.
From all the above views, it can be concluded that it is basically aggregate demand
in excess of aggregate supply of goods and services that creates inflation.

Causes and Theories of Inflation

Causes operating on the Causes operating on the
DEMAND SIDE SUPPLY SIDE
• Excessive increases in money supply. • Increase in price of raw materials
• Reduction in taxes • Increase in price of other inputs
• Increase in demand for exports • Power shortages
• Speculative tendencies • Government’s policies
• Excessive production of investment • Increase in rate of interest
goods
• Increase in income and wages • Increase in the level of wages
• Increase in population
 
Demand-Pull Cost-Push
Theory of Inflation (DPI) Theory of Inflation (CPI)
150 Macroeconomics

The main causes of inflation can, therefore, be classified into:

1. Causes on the Demand side
2. Causes on the Supply side
Causes which operate on the demand side cause demand-pull inflation and those
which operate on the supply side cause cost-push inflation. It is however only for a
theoretical understanding that these two causes are studied under separate theories.
In reality however, both these set of factors operate together to create inflation in the
economy. In addition to the above dominant theories there are also structural causes
which lead to inflation.
According to the structural theory, inflation is a result of maladjustment in the
economic system which occurs mainly in less developed countries. These economies are
characterised by excess labour and scarcity of capital which results in low output, high
prices and unemployment of labour. Various bottlenecks and limitations to production
like infrastructure, technical and financial constraints also limit production, causing
structural inflation.

9.3.1 Demand-Pull Theory of Inflation (DPI)

Statement of the theory
According to this theory, inflation arises when aggregate demand is in excess of supply
of goods and services. This excess demand pulls up the prices causing DPI.

Details of the theory

1. When aggregate demand increases without corresponding increases in
aggregate supply, it creates an excess aggregate demand situation.
2. This excess aggregate demand pulls up the prices causing demand-pull inflation.
3. The demand-pull inflation theory can be best explained in a situation of full
employment where increases in aggregate demand beyond the level of full
employment fail to bring about increases in aggregate supply.
Therefore, demand-pull inflation generally occurs in a post-full employment
situation wherein aggregate supply cannot match the increases in aggregate demand,
as a result the excess demand pulls up the level of prices, this is indicated below in
Figure 9.1.
Explanation
To begin with, OS is the supply curve and AD1 is the demand curve. The equilibrium
level of output is determined at point OQf and equilibrium prices are determined at
OP1 corresponding to point e1. This is the full employment level of output. If due to
some reason the demand increases to AD2 and AD3 the prices will rise from OP1 to OP2
to Op3 because output cannot increase beyond the full employment level indicated at
OQf. Such a rise in prices from OP1 to OP2 to OP3 is termed as demand-pull inflation.
Note: DPI can also occur before the level of full employment but was not considered
to be very severe in earlier times. It should thus be noted that any situation of AD in
excess of AS causes the above kind of inflation.
Inflation and Deflation 151

FIGURE 9.1 Demand-Pull Inflation.

Causes of Increase in Demand

Since excess aggregate demand has been identified as the dominant cause of DPI, it
is necessary to briefly list out the reasons for a rise in AD.
1. Excessive Increases in Money Supply: When there is an excessive
increase in money supply because of excessive credit creation or increases
in government expenditure or deficit financing it causes excess increases in
aggregate demand which pulls up the prices. This happens because there is
no corresponding increase in output or aggregate supply.
2. Reduction in Taxes: When taxes like income tax are reduced, the disposable
income would increase leading to increases in demand for goods and services
which if not matched by increases in supply would lead to inflation.
3. Increase in Demand for Exports: An increase in demand for exports
would create a rise in the level of prices if not matched by increases in supply.
4. Production of Investment Goods Instead of Consumption Goods: This
creates an imbalance between demand and supply; as a result, prices will rise.
5. Liquidation of Post-saving: Liquidation would imply increases in disposable
income and has the potential of generating increases in the level of prices.
Other factors like easy schemes of consumption and other strategies to encourage
consumption also would create excess AD causing DPI.

9.3.2 Cost-Push Inflation Theory (CPI)

The cost-push theory of inflation focuses on the factors operating on the supply side
that create inflation. Inflation according to this theory occurs mainly because there is
a rise in the costs of production which pushes up the level of prices leading to what
has been termed as cost-push inflation.
152 Macroeconomics

1. The total cost of production is made up of a number of cost components i.e.

wages, interest, rent, depreciation, other input costs, taxes, cost of advertising
and others given as:
TC = (Wages + Interest + Depreciation + Rent + Input Costs + Taxes + Others)
When any of these cost components increase, it would result in an increase
in the total cost of production, which would automatically result in pushing
up the level of prices, generating cost-push inflation.
2. The supply side factors creating cost-push inflation include:
(i) Increase in price of raw materials
(ii) Increase in price of other inputs
(iii) Power shortages
(iv) Government’s policies
(v) Taxes (excise duties and other taxes)
(vi) Increase in the rates of interest
(vii) Increase in the level of wages.
Among the above causes, increase in wages (in excess of increase in labour
productivity) is considered to be a major factor, leading to inflation. Therefore, the
cost-push theory is also referred to as the wage-push theory of inflation.
This is because wages form a major proportion of the total cost of production, i.e.
the wage bill is a dominant cost incurred by the producers. When wages increase in
excess of productivity of labour, it pushes up the prices of commodities creating wage-
push and cost-push inflation. This also explains the phenomenon of the wage-price
spiral where the economy gets into a vicious circle of inflation where prices rise and so
there is a demand for higher wages which further aggravates inflationary tendencies
in the economy and so on. However, an increase in any cost component can cause cost-
push inflation. The cost-push inflation is graphically depicted in Figure 9.2.

FIGURE 9.2 Cost-push Inflation.

Inflation and Deflation 153

Explanation
1. In the above diagram, SAS is the supply curve and AD is the demand curve.
The equilibrium output is determined at point OQf, which corresponds to the
full employment level of output.
2. Initially, the full employment level of output OQf is produced at price OP.
However, as wages and other cost components go on increasing, it becomes
more and more costly to produce the same level of output OQf.
3. The supply curve SAS shifts to S1AS on account of rise in cost of production.
The demand curve shifts leftward to AD1. The price level increases to OP1
which indicates a higher cost of producing the same level of output OQf.
4. The increase in prices from OP to OP1 is cost-push inflation.

Causes of Increase in Supply

The causes on the supply side causing cost-push inflation can be summarised as given
below:
1. Increase in the prices of raw materials and other inputs, which pushes up
the cost of production and thereby prices.
2. Shortages of crucial inputs like power, or technology would lead to an increase
in their costs causing a rise in prices.
3. Increase in wages.
4. Increase in the rate of interest which gets transferred to price causing an
interest-push inflation.
5. Government’s policies.
The above two theories though they have been stated separately, operate together
in an economy. The dominance of a set of factors however, depends on the nature of
the economy and other conditions.

9.3.3 Structural Theory of Inflation

Structural theory states that inflation is a result of maladjustment in the economic
system. To some extent, this occurs in under-developed countries. In such economies,
there is an imbalance in factors of production. Many such economies have too much
labour and too little of capital and land. This results in low output, high prices, and
unemployed labour. Problems like those of transport, power, and fertiliser exist and
this causes a limitation on increases in output which eventually leads to higher prices.
Thus, inflation in under-developed countries is, essentially, structural in nature
and is accompanied by unemployment (unlike in developed economies). These structural
factors include over-population, monopoly and bottlenecks.

9.4 EFFECTS OF INFLATION

A mild degree of inflation is beneficial for an economy since it implies rising profit
and favourable business conditions. Such inflation generates output, income and
employment in an economy. However, when inflation becomes excessive it becomes a
matter of concern and has to be controlled.
154 Macroeconomics

The effects and consequences of inflation can be discussed as given below:

Effects on Production
1. It increases the overall cost of production, which further aggravates inflation.
2. It leads to a misallocation of resources and concentration of production of
goods where the prices and profits are high.
3. It generates a possibility of imbalance in the production pattern of the economy
due to neglect of essential commodities whose prices do not keep pace with
other commodities.
4. It results in speculation, hoarding, and black marketing in commodities which
further aggravates the problem of inflation by creating an artificial scarcity
of goods.
It should however be noted that inflation is not always harmful to productive
activities in the economy, it is only when it is excessive that the above problems arise.

Effects on Consumption
1. It causes a rise in the prices of goods and services and therefore a decline in
the standard of living.
2. It causes a reduction in the real income as the purchasing power of money
declines.
3. It causes a reduction in the level of savings.

Effects on Distribution
1. A long period of inflationary pressure results in the redistribution of income
and wealth in favour of the richer classes of society.
2. It adversely affects the fixed income group of consumers, i.e. salaried persons,
pensioners, interest-earners, insurance policy holders etc.
3. It aggravates inequalities between the various classes.

Effects on Employment
A reasonably mild level of inflation is conducive to increases in output and thereby
employment.

Effects on Savings
Savings however may be discouraged because a rise in the price-level means a fall
in the money-value of savings. However, in spite of inflation, savings in the form of
shares (whose value generally appreciates during inflation) may increase.

Effects on Balance of Payments

During inflation, due to a rise in the internal price-level, the exports of a country
become expensive. This may cause a decline in the demand for exports adversely
affecting the balance of payment position of a country.
Inflation and Deflation 155

Non-economic Consequences of Inflation

Inflation affects the socio-political situation of the economy. Inflation is socially unjust;
it results in inequitable distribution of income in favour of the rich, and thus, it results
in class-conflict. It also affects the political stability and business morals and ethics.
The quality of the product deteriorates with the businessmen’s hope of earning a
quick profit. Inflation, among its other effects discourages production by tempting the
businessmen to adhere to speculation with the hope of making quick profits.

9.5 CONTROL OF INFLATION

Inflation is a very complicated phenomenon. Thus, measures have to be taken on many
fronts-monetary and non-monetary to control it.
These measures mainly include:
1. Monetary policy measures
2. Fiscal policy measures

Monetary Policy Measures

One of the major instruments used to correct inflation is the monetary policy. The
Central Bank, through its Quantitative and Qualitative instruments of monetary
policy, regulates the money supply and credit in the economy and this controls inflation.
The monetary policy basically operates through controlling the cost and availability of
credit. During a period of inflation, the Central Bank can raise the cost of borrowing
and thus reduce the credit creating capacity of the commercial banks. The major
monetary measures to control inflation include:
1. Increasing the Bank Rate
2. Government Sale of Securities in the Open Market
3. Increasing the Cash Reserve Ratio
4. Selective Credit Control Instruments like minimum margin requirement,
rationing of Credit, etc.

Fiscal Policy Measures

The fiscal policy refers to the policy relating to government revenue and expenditures.
The major instruments of the fiscal policy include:
1. Government Revenue
2. Government Expenditures
3. Public Debt
4. Deficit Financing
These instruments are used by the Government to stabilise the economy.
During an inflationary period, the government uses its major fiscal policy
instruments in the following manner:
1. Increasing Personal Income Tax to Reduce Disposable Income
2. Increasing other Taxes on Expenditure
156 Macroeconomics

3. Reducing Public Expenditure

4. Reducing Deficit Financing.
The other measures include price controls, wages and incomes policies, rationing
of goods, etc. These measures are generally used together to control inflation in an
economy.

9.6 CONCEPT OF INFLATIONARY GAP (KEYNES)

Keynes considered inflation to be a post-full employment phenomenon, i.e. any excess
demand beyond the level of full employment not matched by increases in output
generates inflation. According to him, as long as there is unemployment in the economy,
increases in money supply would increase the level of output; it is only after the level of
full employment has been reached that increases in money supply will generate excess
demand and thus generate increases in the price level of full employment because of
increasing cost of production, increasing wages, increasing cost of raw material and
other bottlenecks to production.
Keynes introduced the concept of ‘Inflationary Gap’ in order to measure the extent
of inflation, so that proper policy measures to control inflation could be adopted.
This concept can be explained using the basic model of Keynes theory is shown
in Figure 9.3.

FIGURE 9.3 Inflationary Gap.

Explanation
1. Y = E is the equilibrium line and AD is aggregate demand.
2. In the above diagram, the equilibrium output in determined at e1 corresponding
to OQ1 where AD1 cuts the equilibrium line. The Aggregate demand in a
private capitalist economy is made up of consumption demand (C) and private
investment demand (I).
\ AD = C + I. This level of output is less than the full employment level.
Inflation and Deflation 157

3. In order to bring about full employment, Keynes advocated government

intervention so that aggregate demand shifts to AD2 = C + I + G and output
is determined at OQf (G is the Government Expenditure).
4. If due to some reason the aggregate demand increases further to AD3, since
output cannot increase to OQ3, the increase in aggregate demand from AD2 to
AD3 will generate an excess demand ‘g’ thereby creating an inflationary gap.
5. The amount ‘g’ is the excess aggregate demand which causes inflation which
is the cause of inflationary gap.

Reasons for Excess Aggregate Demand

Excess aggregate demand causing the inflationary gap could arise due to the following
reasons:
1. Increase in Public Expenditure
2. Increase in Non-development type of Expenditure (Maintenance, Welfare
projects, etc.)
3. Sudden Wartime Expenses
4. Sudden Increases in Consumption Expenditure
This concept of inflationary gap is very useful in:
1. Understanding the exact amount of excess demand measured by ‘g’.
2. By being able to measure this gap, it becomes useful for the operation and
implementation of both the fiscal policy and monetary policy. For example,
it is possible for the government to estimate the amount by which the public
expenditure or the money supply or deficit money would have to be reduced
to control inflation.

9.7 DEFLATION: CAUSES AND CONSEQUENCES

Deflation is a persistent fall in the General Price-Level and is a situation where the
value of money goes on increasing.
It is defined as a situation where the aggregate demand for goods and services
goes on falling, supply cannot contract and, therefore, prices begin to fall.
Deflation occurs during recession or depression. Any excessive depression is more
harmful to the economy as compared to excessive inflation.

Consequences and Effects of Deflation

1. Effects on Producers and Traders: During deflation as prices fall, profits
decline and the incentive to produce declines. The economy faces recession
and during deflation there is a lot of unsold stock of goods.
2. Effects on Investors: A deflationary situation is adverse because there are
very fewer opportunities to invest. The business activity and stock market
activity are at low levels and there is general business pessimism creating
an adverse effect on investment.
158 Macroeconomics

3. Effects on consumers: Deflation benefits the consumers because when

value of money falls during deflation, the purchasing power of money increases.
However, this is only a temporary benefit because in the long run a decline
in prices would cause output and incomes to fall which would adversely affect
the consumers.

9.8 CONTROL OF DEFLATION

Deflation can be controlled through:
1. Monetary Policy Measures
2. Fiscal Policy Measures
3. Other Measures Include Promotion of Exports, Price-support Measures,
Regulation of Production, etc.
All these instruments work in the opposite manner compared to inflation to
control a situation of deflation.

9.9 CONCEPT OF DEFLATIONARY GAP

Keynes had used the concept of the inflationary gap to show how excess aggregate
demand can create inflation. The concept of deflationary gap explains what happens
when aggregate demand declines. The total expenditure falls short of the total output
and as a result of this, prices start falling thus creating a deflationary gap.
The deflationary gap is graphically depicted below in Figure 9.4.

FIGURE 9.4 Deflationary Gap.

Explanation
1. Aggregate demand is given at AD1 and equilibrium level of output is
determined at OQ1. When AD1 falls to AD2, the output cannot contract from
OQ1 to OQ2 which is the new equilibrium level of output.
2. Therefore, prices will begin to fall creating a ‘deflationary gap’ to the extent
of this decline in aggregate demand denoted by ‘dg’ in the diagram.
Inflation and Deflation 159

The deflationary gap arises mainly due to shortages in aggregate demand caused
by:
1. A fall in government investment and expenditures
2. A decline in money income due to decline in government expenditures and
investment.
This concept is useful in measuring the extent of deflation in an economy and in
formulating monetary and fiscal policies and other relevant policies to control deflation.
Table 9.1 shows the rates of inflation in the Indian economy between 2012–13 to
2018–19 measured by the WPI and CPI index.

TABLE 9.1 Rates of Inflation in India in per cent (based on WPI and CPI)

Years 2012–13 2013–14 2014–15 2015–16 2016–17 2017–18 2018–19

WPI 6.9 5.2 1.2 –3.7 1.7 3.0 4.3*
CPI-C 9.9 9.4 5.9 4.9 4.5 3.6 3.4
CPI-IW 10.4 9.7 6.3 5.6 4.1 3.1 5.4
CPI-AL 10.0 11.6 6.6 4.4 4.2 2.2 2.1
CPI-RL 10.2 11.5 6.9 4.6 4.2 2.3 2.2

Notes: CPI–C—inflation for 2012–13 and 2013–14 is based on old series 2010 = 100;
*— Provisional; C—Combined; IW—Industrial Workers;
AL—Agricultural Labourers; RL—Rural Labourers.
Source: Economic Survey of India, Vol. II (2018–19), p. 89, Government of India.

Points to Remember
• Inflation has been defined as a persistent rise in the General Level of Prices and a
state in which the value of money declines. Inflation is a monetary phenomenon,
which generally is associated with the recovery or boom period of a trade cycle.
• There are number of views as to why inflation occurs—The Classical economists
and Friedman attributed inflation to excess increases in Money Supply. Keynes
considered inflation to be a post full-employment phenomenon. (Though he
did recognise that prices can rise before full employment due to bottlenecks to
production and trade union pressures.)
• There are two dominant causes of inflation:
(i) Causes operating on the demand side leading to the Demand-Pull Theory
of Inflation (DPI).
(ii) Causes operating on the supply side leading to the ‘Cost-push Theory of
Inflation (CPI).
• The general conclusion which emerges is that it is aggregate demand in excess
of aggregate supply of goods and services that creates inflation.
• According to the Demand-Pull Theory, it is aggregate demand (in excess of
Supply) which pulls up the general price-level causing inflation. Such increases
160 Macroeconomics

in demand are caused by a number of factors prominent among them are increase
in money supply, reduction in taxes, increase in foreign demand, liquidation of
past savings etc.
• The Cost-Push Theory of Inflation attributes the rise in general level of prices to
increases in various costs of production, which pushes up the prices. A prominent
cause is the excessive rise in wages and therefore this theory is also referred
to as the Wages-Push Theory of Inflation. The other factors responsible for the
cost-push inflation include increase in price of raw material, increase in price of
other inputs, increase in capital cost, shortages in raw material etc.
• The demand-pull, cost-push and other factors like institutional, financial and
structural constraints in production, all operate together to generate inflation in
an economy.
• A mild degree of inflation is, in fact, considered to be favourable to the growth
process but any excessive inflation must be avoided at all costs because of its
adverse effects on allocation of resources, distribution of income, on the standard
of living etc.
• A situation opposite of inflation, i.e., where the GPL shows a continuous decline is
termed as Deflation. It is defined as a situation where the aggregate demand for
goods and services goes on falling, with supply unable to contract, prices start falling.
Any excessive deflation is worse than inflation- in such a situation investment,
output, employment suffers with the economy facing recessionary trends.
• The traditional Monetary, Fiscal and other Policies like the Prices, Income; Wage
policies are used to control both inflation and deflation.
• In the analysis related to inflation, Keynes introduced the concept of ‘Inflationary
Gap’–which is a measure of the extent to which aggregated demand exceeds
supply thus causing inflation. This concept is useful to measure the extent of
excess aggregate demand and design policies for control of inflation. Similar to
this concept, is the concept of deflationary gap, which measures shortfalls in
aggregate demand causing deflation.

ADDITIONAL TABLES
Annual Inflation Rate Based on Wholesale Price Index (All Commodities) in India
{(Base Year: 2004–05 to 2011–2012) (2009–2010 to 2018–2019)}

Year All Primary Of which: Fuel Manufactured Non-food

Commodities Articles Food and Products Manufactured
Articles Power Products
Base Year:
2004–2005
2009–2010 3.8 12.7 15.3 –2.1 2.2 0.2
2010–2011 9.6 17.7 15.6 12.3 5.7 6.1
2011–2012 8.9 9.8 7.3 14.0 7.3 7.3
2012–2013 7.4 9.8 9.9 10.3 5.4 4.9
Inflation and Deflation 161

Year All Primary Of which: Fuel Manufactured Non-food

Commodities Articles Food and Products Manufactured
Articles Power Products
Base Year:
2011–2012
= 100
2013–2014 5.2 9.8 12.3 7.1 3.0 2.7
2014–2015 1.3 2.2 5.6 –6.1 2.6 2.7
2015–2016 –3.7 –0.4 2.6 –19.7 –1.8 –1.8
2016–2017 1.7 3.4 4.0 –0.3 1.3 -0.1
2017–2018 2.9 1.4 2.1 8.2 2.7 3.0
2018–2019 4.3 2.7 0.3 11.5 3.7 4.2

Source: RBI, Ministry of Finance.

Year CPI (IW) Of which CPI (AL) CPI (RL)

CPI–IW Food (1986–87 = 100) (1986–87 = 100
2006–07 6.7 9.2 7.8 7.5
2007–08 6.2 8.4 7.5 7.2
2008–09 9.1 12.3 10.2 10.2
2009–10 12.4 15.2 13.9 13.8
2010–11 10.4 9.9 10 10
2011–12 8.4 6.3 8.2 8.3
2012–13 10.4 11.9 10 10.2
2013–14 9.7 12.3 11.6 11.5
2014–15 6.3 6.5 6.6 6.9

2015–16 5.6 6.1 4.4 4.6

2016–17 4.1 4.4 4.2 4.2
2017–18 3.1 1.5 2.2 2.3
2018–19 5.4 0.6 2.1 2.2

Abbr.: CPI: Consumer Price Index.

AL: Agricultural Labourer.
RL: Rural Labourer.
IW: Industrial Worker.
Source: Reserve Bank of India, (ON858) and (ON1532), Ministry of Finance, Government of
India (16944).
162 Macroeconomics

QUESTIONS

I. Short Questions
1. Inflation is defined as a persistent rise in the General Price Level. Explain.
2. ‘It is only excess increases in price level which adversely affects an economy.’
Explain the effects of inflation.
3. What are the distinguishing characteristics of Demand pull and cost push
inflation?
4. ‘Inflation affects the different classes in society differently.’ Explain.

II. Long Questions

1. ‘Both demand pull and cost push factors cause inflation’. Explain
2. Explain in detail the factors causing demand–pull inflation. In this context,
also explain the demand–pull inflation in detail.
3. Explain in detail the factors causing cost-push inflation. In this context,
explain the cost-push inflation in detail.
4. Inflationary gap was developed by Keynes to measure the extent of inflation.
Explain how excess aggregate demand can cause inflation.
CHAPTER

10
Phillips Curve

10.1 INTRODUCTION
The earlier theories of inflation dealt mainly with the causes of inflation focussing on
demand-pull and cost-push factors. We can now turn to an empirical theory of inflation
presented by A.W. Phillips based on data from the economy of the UK for the period
1862 to 1957.
Phillips studied the relationship between a number of macroeconomic variables
like prices, wages, unemployment, etc. and attempted to establish a relation between
these variables.

10.2 STATEMENT OF PHILLIPS CURVE

After making a detailed study of the data on the movements in money wages (i.e., wage
rate increase) and unemployment for the period 1862–1957 in the UK, Phillips came to
the conclusion that there is an inverse relationship between prices and unemployment;
which implies an inverse relationship between inflation and unemployment. This
relationship is popularly known as the Phillips Curve.

10.3 SHORT RUN PHILLIPS CURVE (SRPC)

• On analysing the data, Phillips found that in the short run, there exists an
inverse relationship between inflation and unemployment (This, however, was
not found in the long run.).
• Phillips proceeds to explain the short run relationship in two stages:
1. The Original Phillips curve
2. The Modified Phillips curve

163
164 Macroeconomics

10.3.1 Original Phillips Curve (OPC)

In the original Phillips curve, Phillips begins by establishing an inverse relationship
between wage increase and unemployment. This relationship is developed as follows:
1. A study of data on wage increase and unemployment reveals that inflation is
mainly caused by cost-push factors of which wage increase is the dominant
factor causing inflation.
2. However, every increase in wages will not be inflationary and it is only when
wages increase in excess of labour productivity that inflation is generated.
For example, if in an industry wages increase by 10% and labour productivity
increases by 5%, inflation to the extent of 5% will be generated.
3. Having stated the above Phillips found that there is an inverse relationship in
the short run between wage increase and unemployment. This was presented
in the original Phillips curve in the short run.
The Original Phillips Curve is presented in Figure 10.1.

FIGURE 10.1 Original Phillips Curve in the Short Run.

Phillips Curve 165

Explanation
1. The vertical axis shows the changes in the money wage rate indicated as
∆w/w. The horizontal axis shows the percentage of unemployment of labour
force indicated as UE.
2. The Phillips curve being downward sloping indicates that increases in money
wage rate and unemployment are inversely related. For example if money
wage rate is 10%, it will be consistent with an unemployment rate of 6%, at
8% money wage rate unemployment increases to 7%.
3. There is then clearly a trade-off between money wage rate increases and rate
of unemployment.
Note: The inverse relationship between wage increase and unemployment can be
explained in a very simple manner. If wages increase at the macro-level, the purchasing
power increases. As a result, aggregate demand and production will increase implying
increases in the level of employment or a reduction in unemployment. This establishes
the Phillips curve conclusion in a very simple manner.

10.3.2 Modified Phillips Curve (MPC)

1. The Modified Phillips curve is based on the Original Phillips curve.
2. The MPC establishes an inverse relationship between inflation and
unemployment, since wage increases leads to inflation.
3. However, as stated earlier in the original Phillips curve analysis, not every
increase in wages will be inflationary in nature. It is only the increase in
wages in excess of productivity which would cause inflation. Taking the
original example, if money wages increase by 10% and labour productivity in
the industry increases by 5%, prices will rise by 5% (inflationary).
4. Assuming that this excess increase in wages is considered to be constant
throughout, then the modified Phillips curve will lie below the original Phillips
curve to the extent of this difference. This is shown in Figure 10.2.

FIGURE 10.2 Modified Phillips Curve.

166 Macroeconomics

Explanation
1. In the above diagram, the MPC lies below the OPC at a difference of 5%,
which is assumed to be constant.
2. The OPC shows the inverse relationship between wage increases and
unemployment. The MPC shows the inverse relationship between inflation
and unemployment.

10.3.3 Short Run Phillips Curve depicting the Trade-off between

Inflation and Unemployment
1. The short run Phillips Curve (SRPC) is the modified Phillips curve, which
establishes an inverse relationship between inflation and unemployment.
2. This has very strong implications for policy formulation such that there is
a serious trade-off between two major economic problems, i.e. inflation and
unemployment.
3. If an economy can reduce inflation, unemployment levels will increase and
vice versa. Both problems cannot be solved simultaneously. This is the famous
trade off which arose from the Phillips Curve analysis.
4. The Short Run Phillips Curve depicting the trade-off between inflation and
unemployment is shown in Figure 10.3.

FIGURE 10.3 Short Run Phillips Curve (Trade-off between Inflation and Unemployment).

Explanation
1. As can be seen in Figure 10.3, in the short run when the economy is able
to reduce inflation from OI1 to OI2 it has to bear the burden of increasing
unemployment from UE1 to UE2 and so on.
2. This is the policy dilemma which the policy makers face.

Derivation of SRPC
1. The SRPC establishes an inverse relationship between Inflation and
Unemployment.
2. Though Phillips conclusion seems to be a new concept its basis can be found
in the familiar Keynesian model as shown in Figure 10.4.
Phillips Curve 167

FIGURE 10.4 Derivation of the Phillips Curve (Short run).

Explanation: In the diagram, when aggregate demand increases from AD1 to AD2 to
AD4 for example, price increases from P1 to P2 to P4, and employment increases from
ON1 to ON2 to ON4, which, in other words, means as price increases unemployment
falls which is nothing but the inverse relationship between inflation and unemployment
given in the Phillips curve, i.e. greater inflation is associated with lower unemployment.
As mentioned earlier, it can be seen in the above diagram that as price increases
from P1 to P4, employment increases from ON1 to ON4 or unemployment falls establishing
the inverse relationship between inflation and unemployment which is the Phillips curve.

10.4 LONG RUN PHILLIPS CURVE

In the long run, there is no inverse relationship between inflation and unemployment and
the trade-off between these two variables ceases to exist. Inflation and unemployment,
in the long run, behave in an independent manner and the Long run Phillips curve
becomes a vertical line as shown in Figure 10.5.

FIGURE 10.5 Long run Phillips Curve.

168 Macroeconomics

Figure 10.5 indicates that in the long run, the trade-off between inflation and
unemployment ceases to exist, i.e. inflation becomes independent of unemployment.
The level of unemployment will settle at the natural rate of unemployment given
as Un in the figure.

10.4.1 Why does the Phillips Curve become Vertical in the Long Run?
An explanation given by Friedman was in terms of ‘the natural rate of unemployment.’
In the long run, the Phillips curve becomes a straight line at the natural rate of
unemployment indicated by Un in Figure 10.5. At this point, inflation becomes
independent of unemployment. The natural unemployment rate has been defined as
the equilibrium rate towards which the economy moves in the long run, i.e. it is that
rate of unemployment, which is consistent with the definition of full employment,
which is generally about 2–3%. Such unemployment arises on account of frictional
unemployment, market imperfections, unemployment due to sickness of industries, etc.
It is not affected by the rate of inflation in the economy. No matter what the rate of
inflation is the natural rate of unemployment will remain at a particular level.
Therefore, in the long run, the two major problems in the economy, i.e., inflation
and unemployment become independent of each other and, therefore, will also have
to be dealt with independently.

10.4.2 Derivation of LRPC

The long run Phillips Curve can be derived in the same manner as the short run
Phillips curve from basic Keynesian model as shown in Figure 10.6.

FIGURE 10.6 Long Run Phillips Curve (LRPC).

Explanation
1. As can be seen in Panel ‘A’ of the diagram, beyond the level of full employment,
i.e., OQ/NF increases in AD from AD1 to AD2 to AD3 cause increases only in
prices from OP1 to OP3 without affecting the level of employment/unemployment.
Phillips Curve 169

This implies that in the long run there is no inverse relationship between
inflation and unemployment.
2. Panel B of the diagram shows the LRPC which a straight line indicating that
in the long run, unemployment remains at the ‘natural’ level indicated by Un
in the diagram and inflation becomes independent of unemployment.

10.5 POLICY DILEMMA AND POLICY IMPLICATIONS

• The most important conclusion which emerges from the Phillips curve is the
problem of trade-off between two major problems, i.e. inflation and unemployment.
• This gives rise to the policy dilemma, which arises in an economy where policy
makers have to choose between controlling inflation or unemployment.
• This policy dilemma exists in the short run where the economy has to minimise
the trade-off between inflation and unemployment. The problem then is how to
control the two major economic problems and to decide how much of inflation
an economy can tolerate with how much of unemployment. In this case, the
policy makers have to choose between the two evils and minimise the two
problems as far as possible.
• The Phillips curve draws attention to the fact that if an economy reduces
inflation, it is only at the cost of unemployment and vice versa. This is the
policy dilemma which arises from the Phillips curve analysis and which the
economy and policy makers have to resolve. In the long run however, the
two problems inflation and unemployment become independent of each other
when the economy reaches the ‘natural’ level of unemployment and inflation
continues to exist. In the long run therefore, independent policies are required
to control inflation and unemployment.

10.6 NEW POLICY OPTIONS

The traditional fiscal and monetary policies were found to be inadequate to control the
twin problem of inflation and unemployment.
A number of alternative policies were thus suggested.
1. Policies to reduce Market Imperfection
2. Income Policies
3. Price Polices and Direct Price Controls
4. Tax-based Income Policies (TIP)
1. Policies to Reduce Market Imperfections: Market imperfections are an
important cause of inflation and unemployment and therefore the policies
should be directed to reducing such market imperfections. These policies and
programs would include measures like having better manpower planning,
matching of jobs to job-seekers, vocational training programs, more employment
exchanges, better market information about employment opportunities, etc.
This would improve the unemployment situation. Inflation on the other hand,
could be controlled by having restrictions on profits, anti-monopoly laws; which
makes the market more competitive.
170 Macroeconomics

2. Income Policies: In the face of ineffectiveness of fiscal and monetary policies

to be able to control inflation and unemployment, economists have suggested
the incomes policy which could be more successful in this connection. Income
policies focus on fixing incomes according to changes in productivity of labour
and to regulate changes in the level of wages accordingly. In brief, if money
wages rise at the same rate as increases in labour productivity, inflationary
rise in prices will not take place. The idea crucial to income policies is that
if rate of increase in wage rate is controlled, inflationary tendencies in the
economy also will be controlled. Such income policies can be adopted on a
voluntary basis by linking wage rate rise to productivity increases or by
compulsion, i.e. putting a ceiling on the wages and incomes in the economy, a
freeze on the Dearness Allowance etc. However, in reality it becomes difficult
to link the wage increases to productivity due to trade union pressures, etc.
3. Price Policies and Direct Price Controls: In addition to the income
policies, other direct price control measures, can also be used. These include
price ceilings, price control policies, dual pricing, etc. especially for essential
commodities like electricity, food grains, cement, sugar, etc. The other
related instruments in this direction would also include regulation of cost of
production, providing input subsidy which would automatically control costs
of production and thereby prices and so on.
4. Tax-based Incomes Policies (TIP): A third alternative suggested is the
tax-based income policies. According to those who propose the TIP (H.C.
Wallichand, S. Weintraub and A.M. Okun), they argue that incomes and price
policies would in fact distort resource allocation and may not be conducive to
solving the inflation and unemployment problem. They advocate using taxes
and not direct wage and price controls to control the increase in wage rates
and prices. The crux of this argument is that those industries where wage
and prices are increasing rapidly should be penalised by levying higher taxes
on them and those industries which are not inflationary should be given tax
exemption or concessions. However, working out a practical, workable policy
of this kind has a number of difficulties.
All the above policies could be used to solve the problem of inflation and
unemployment.

10.7 STAGFLATION
Having traced the background and basic theories related to inflation one can now
analyse in brief the concept and problem of stagflation.
The Phillips curve had observed an inverse relationship between inflation and
unemployment. Keynes had categorically stated inflation would generally occur beyond
the level of full employment and if it occurs before employment, it is not of a very
severe nature.
In the mid-1970s and even a little earlier a range of behaviour between these
two variables in inflation and unemployment was found.
It was found that though Phillips curve was valid for the period 1963–69 but it
was observed that in the period 1969–70, 1973–74, 1975–76 and 1970–80, inflation
Phillips Curve 171

and unemployment began to move in the same direction. This phenomenon, which
emerged in 1970s, is known as stagflation, which involves a coexistence of inflation
and unemployment.
Therefore, stagflation implies a coexistence of inflation unemployment or inflation
and stagflation. The problem of stagflation cannot be explained by the classical theory
nor the Keynesian theory of inflation. Keynes considered inflation to occur after the
level of full employment whereas stagflation is the simultaneous existence of inflation
and unemployment. However, the problem of stagflation continues to occur, in a
number of countries specially developing countries.

10.7.1 Explanation of the Causes of Stagflation

There is no generally accepted theory of stagflation, what exists in the literature are
different and varied views on the causes of stagflation.
1. Supply-Side Theory of Stagflation
Supply-side economists were a school of thought, which originated in the late 1970s
and early 1980s in the US.
According to this set of economists, the phenomenon of stagflation and other
related problems in an economy are caused by the improper management or behaviour
of Aggregate Supply (AS) in the economy.
Stagflation according to them, was a result of a leftward shift in the aggregate
supply curve (i.e. a contraction in supply) as compared to increases in Aggregate Demand
(AD). These economists attributed the large upward shifts of Aggregate Supply to:
1. Increasing levels of income taxes which has a tendency to decrease work effort
and therefore aggregate supply.
2. Increasing rate of interest which reduced the level of investment and therefore
output or supply.
This simply means a contraction in the Total Output or the failure of output to
keep pace with the increases in AD. This can be seen in Figure 10.8.

FIGURE 10.8 Supply-side Cause of Stagflation.

172 Macroeconomics

Explanation
1. As shown in Figure 10.8 with the Aggregate Demand AD1 and Aggregate
Supply at AS1, output is determined at OQ1 and prices at OP1.
2. When AD1 expands to AD2, according to the supply-side economists, AS1 shifts
leftwards to AS2. The new level of output is determined at OQ2 corresponding
to e2, implying a contraction in the level of output. At the same time, prices
increase from OP1 to OP2.
3. It can be seen that price has increased from OP1 to OP2 (inflation) and at the
same time, the level of output has fallen from OQ1 to OQ2 which is nothing
but a decline in the levels of employment or unemployment.
This rise in price level and simultaneous fall in employment is nothing but
stagflation. However, this theory does not seem very convincing because stagflation is
generally associated with a decline in the rate at which output increases and not a
significant contraction in Aggregate Supply as shown in the above analysis.
Aggregate supply according to these economists, contracts due to the following
two reasons:
1. An increase in tax rates curves a disincentive to work
2. Increase in interest rates causes a reduction in investment and output
2. Political Theory of Stagflation
(a) Increasing Government Expenditure: The second set of causes put
forth to explain stagflation is the increasing government expenditures
especially of the non-productive types. The economists who believe in the
political theory of stagflation observed that not only are the Government’s
expenditures increasing but also the composition of Government spending
over the years has changed towards more unproductive expenditure in the
sense that they do not increase material production over time. For example,
education subsidies, aid to foreign countries, welfare expenditure, price support
programs, and so on.
(b) Deficit Financing: Such unproductive excess government expenditures
by the government cause inflation and do not contribute to increasing
unemployment. This results in deficit financing, i.e. creation of new money
supply. Such increasing government expenditures of the unproductive type,
increases in demand which pushes up the level of prices generating inflation.
These forces together lead to stagflation where prices keep rising without
corresponding increases in output and employment.
The political theory of stagflation thus shows stagflation to be a cause of the
mismanagement of government’s fiscal policy.
3. Causes given by James Meade
(a) Impact of Pressure Groups: According to Meade, the major cause for
inflation in many economies was due to the working of pressure groups like
trade unions, union of government employees, teachers’ unions, union of bank
employees, farmers unions, etc. Most of these groups demand higher wages
Phillips Curve 173

and incomes which leads to an increase in the purchasing power and aggregate
demand causing both causing both demand pull and cost push inflation.
Meade argues that the workers union in the recent times are becoming
more and more inward looking in the sense that rather than protecting
employment, unions prefer to demand higher wages. Such increases in wage
levels causes inflation because it is generally not matched by increases in
labour productivity.
The above two put together account for an increasing inflation rate and
increasing unemployment rate.
(b) Technological Development: The second strand of Meade’s argument
is that during the development process, economies rely more and more on
capital intensive technologies which obviously displace some amount of labour
leading to increasing unemployment in the economy and without corresponding
increases in output it causes inflation.
4. Other Causes
(a) Oil Price Hike: Another reason stated for stagflation in late 1970s and
1980s was due to the oil price hike by OPEC (Oil and Petroleum Exporting
Countries). This leads to tremendous inflation in many developing countries
since oil and petroleum are crucial commodities and inputs in any economy.
(b) Slow rate of Industrial and Economic Growth: Failure of industrial
and economic growth to provide employment opportunities to match growth
in labour force also aggravated the problem of employment.
(c) Bottlenecks in Production: Limitations and bottlenecks in production also
contributed to price hikes and did not guarantee adequate rates of increases
in output and employment. This includes scarcity of raw material technology,
capital, etc.
(d) Industrial Sickness: Many industries had become sick; as a result, on
one hand, unemployment was increasing and on the other hand slow rate of
growth output lead to increase in prices.

10.7.2 Concluding Comments

There is as yet no satisfactory explanation of the theory of stagflation. The only thing
definite about this problem is that it continues to persist rather stubbornly for about
more than three decades (1970 onwards). The policies to control stagflation would
require a balance between the traditional and new policies which include:
1. Fiscal Policy
2. Monetary Policy
3. Wages and Income Policies
4. Price Policy
5. Labour and Employment Policies
6. Policies to bring about Structural changes in the Economy
174 Macroeconomics

Points to Remember
• The Phillips Curve states that there is an an inverse relationship between inflation
and unemployment; Keynes had defined inflation as a monetary phenomenon,
which occurs dominantly in the Post full employment situation.
• A.W. Phillips found that in the short run there is an inverse relationship between
Inflation and unemployment. This is popularly known as the Phillips curve.
• In the long run, the inverse relationship between inflation and unemployment
ceases to exist. The long run Philips curve is a vertical line which means
independent of each other.
• The Philips curve is significant because it shows the trade-off between inflation
and unemployment, i.e. in the short run, policy makers face the policy dilemma
of balance the objectives of inflation and unemployment.
• There are a number of new policy options to solve the problem of Inflation and
unemployment.
• However, since 1970’s, a phenomenon which has characterised a number of countries
is the phenomenon of stagflation, i.e. a coexistence of inflation and unemployment.
• Unfortunately, there is no generally accepted theory of stagflation; what exists,
are different views on the causes of inflation like:
(a) Supply side causes of stagflation according to which it is the improper
management or behaviour of Aggregate Supply (AS) in the economy,
which causes stagflation. They attributed contractions in ‘AS’ as being
responsible for falling output, employment and rising prices i.e. stagflation.
However, this theory was not very convincing because what is observed
during stagflation is not very convincing because what is observed during
stagflation is not falling output but slow growth in output.
(b) The second set of causes-held increases in expenditures by the Government
especially of the non-productive type to be responsible for rise in level of
prices-without corresponding increases in output and employment. This
generated stagflation.
(c) Stagflation was also a result of the working of ‘pressure groups’ which
demand higher wages pushing up the price level and also a greater use
capital intensive technique of production which displaces labour causing
unemployment. The combined result of these forces is to create stagflation
pressures in the economy.
• The other causes of stagflation include the oil price in the 1970s, bottlenecks
to production, failure of industry to absorb labour, industrial sickness, etc. as a
result what emerged was unemployment and inflation.
• To control of stagflation would require a use of traditional and new policy options
like monetary policy, fiscal policy, wages and income policy, price policies, etc.
Phillips Curve 175

QUESTIONS

I. Short Questions
1. Explain the implication of trade-off between inflation and unemployment
in the short run.
2. State and explain policy dilemma of the Phillips curve.
3. Why does the trade-off between inflation and unemployment cease to exist
in the long term?
4. ‘Stagflation implies a coexistence between inflation and unemployment.’
Explain.

II. Long Questions

1. ‘The Phillips curve analysis gained attention due to the short-run trade off
between inflation and unemployment.’ In this context, explain the SRPC
and policy delimma in the short-run.
2. In the long run there is no inverse relationship between inflation and
unemployment. Explain.
3. Phillips curve brought out an inverse relationship between inflation and
unemployment. What are the new policy options to control inflation and
unemployment?
4. How is stagflation different from inflation? What are the main causes and
the policies to control stagflation?
5. Justify whether the following statement in the context of the Phillips curve
is true or false:
‘In the short-run, the government can control the problem of inflation only
at the cost of unemployment’.
CHAPTER

11
Trade Cycles

11.1 INTRODUCTION
Generally, an economy does not move in a steady and stable manner for long periods.
It is subject to fluctuations in business and economic activity. Such fluctuations are
termed as trade cycles or business cycles.
A business or trade cycle is a prominent characteristic of capitalist economies;
however, it occurs in varying degrees in almost all types of economies. Trade or
business cycles are upward and downward movements in business and level of economic
activity and follows a cyclical pattern. Trade cycles are wave like fluctuations in the
level of output, employment, income, prices and have been defined in various ways.

11.2 MEANING, DEFINITION AND FEATURES OF A TRADE CYCLE

W.C. Mitchell defines a business cycle as a series of fluctuations in the economic
activity.
Keynes points out “A trade cycle is composed of period of good trade characterised
by rising prices and low unemployment percentages, altering with period of bad trade
characterised by falling prices and high unemployment percentages”.1 Keynes thus,
emphasises two indicators namely, price and unemployment for measuring the upswing
and downswing of the business cycles.
Professor Haberler defines trade cycles as “The business cycle in the general
sense may be defined as an alteration of periods of prosperity and depression of good
and bad trade.2”
Thus, trade cycles are an alternate expansion and contraction in overall business
activity, as shown by fluctuations in aggregate economic activity, such as, the gross
product, the index of industrial production, employment and income.

1. Keynes, J.M., The General Theory of Employment, Interest and Money, London, Macmillan, 1936.
2. Harberler, Gottfried, Prosperity and Depression: A Theoretical Analysis of Cyclical Movements,
London, Routledge.
176
Trade Cycles 177

11.2.1 Features/Characteristics of Trade Cycles

• Trade cycles refer to cyclical fluctuations in economic activity.
• For a trade cycle to occur all phases of a trade cycle must be completed, i.e.
recovery, prosperity recession and depression.
• Trade cycles are wave like movements.
• Trade cycles are repetitive in nature.
• A temporary spurt in economic activity cannot be labelled as a trade cycle.
• There is no uniform duration of a trade cycle it could range from short to very
long cycles.
• Trade cycles are generally characterised by alternate phases of expansion and
contraction.
• There is no uniform cause for a trade cycle. The causes of trade cycles could
differ between different times, different economies or even in the same economy
at different periods.
• Trade cycles are more pronounced and violent in capitalist economies where
there are no government policies to stabilise the economies.
• With policies like the monetary and fiscal policies trade cycles can be controlled
to some extent.

11.3 PHASES OF A TRADE CYCLE

Generally, a business cycle is characterised by four phases:
1. Depression
2. Recovery
3. Prosperity
4. Recession
The various stages of a trade cycle can be seen in Figure 11.1.

FIGURE 11.1 Phases of Trade Cycles.

178 Macroeconomics

A typical trade cycle takes the following shape (see Figure 11.2).

FIGURE 11.2 Trade Cycles.

As can be seen there are four well defined phases of a trade cycle:
1. Recovery or Revival—Movement from depression to prosperity
2. Prosperity—Expansion or upswing
3. Recession—Movement from prosperity to depression
4. Depression—Contraction or downswing

1. Recovery (Revival)
Recovery or revival implies an increase in business activity after the lowest point of
the depression has been reached (see Figure 11.1). During this phase, there is a slight
improvement in economic activity. In some sectors of the economy the aggregate demand
picks up. The atmosphere in the business world moves slowly towards optimism and
this leads to further increase in business activity. As industrial production picks up,
the volume of employment also increases, prices and therefore profits of businessmen
are on the rise, so also are the employed persons. Rising profits encourage businessmen
to borrow from banks for business purposes leading to expansion in credit and further
investment.
The recovery phase continues until the level of business activity shows an upward
trend. The more severe the depression, the more rapid is the recovery, however nothing
definite can be said about the duration of the recovery.
Once the recovery has started, it gathers momentum. This is the beginning of
the expansion phase of the trade cycle. This can be divided into prosperity (or full-
employment) and actual boom (or overfull employment) and then end of boom.

2. Prosperity
(i) Prosperity: It is characterised by increased production, high capital
investment in basic industries, expansion of bank credit, high prices, high
Trade Cycles 179

profits, a high rate of capital formation of new business enterprises and full-
employment.
(ii) Actual Boom: During this stage, there is a rapid expansion of business,
this results in high prices of stock and commodities, high profits and overfull
employment of resources. This stage also gives rise to the problem of inflation.
Thus, the prosperity stage leads to the emergence of the actual boom. When
investment continues beyond the stage of full-employment, it results in a sharp
inflationary rise of prices. This results in more investments by businessmen
with the hope of making more profits. As a result, there is a pressure on the
factors of production, which are already fully employed, and this causes a sharp
rise in their prices. Profits touch newer heights, businessmen increase their
investments and prices of factors increase, generating inflationary pressures.
Prices reach the sky. There is an atmosphere of over optimism.
(iii) End of Boom: Boom conditions however, generate their own checks. Quality
of factors of production deteriorates, less efficient workers have to be paid high
wages, the rate of interest rise, costs start rising and rise above the prices,
and thus profits begin to fall and ultimately disappear. Businessmen become
overcautious and the boom phase comes to an end.

3. Recession
As the boom phase of a business cycle ends, the downward course begins. Business
activity drops, with that the demand for factors of production drops, lenders ask for
repayment, stocks accumulate, people desire to hold liquid cash and this aggravates the
depression. Like recovery is self-re-enforcing, so also the forces of depression are self-
accumulating. Thus, recession has a cumulative effect. This crisis ultimately results in
a slump or depression or a state of stagnation. In absence of any government regulation
or control the economy can move into depression.

4. Depression (Contraction)
This is a period during which all business activity is much below normal. Level of
production is low. There is mass unemployment (low employment). Those employed
get very low wage, prices and profits fall, the purchasing power of money is high, but
that of a person is low, there is credit contraction, business failures are on the rise
and the general atmosphere in the economy is pessimistic. Productive activity is at
a very low level. The whole business in the economy stagnates at a very low level of
equilibrium. This position of low prices, costs and profits may carry on for years or
for a short period. This has been illustrated in Figure 11.1.
If depression is not controlled the economy goes into the trough, i.e. the rock
bottom. This is the worst phase of a trade cycle. This leads to the completion of one
cycle.
The trough is the lowest point of business activity. Coming after a period of
depression and before the period of recovery, the trough is usually of a short interval,
lasting only for a month or two.
180 Macroeconomics

Phases of a Trade Cycle and their Characteristics

Recovery/Revival Prosperity/Peak Boom Recession Depression
Expansion/Upswing (Contraction/
Downswing)
Initial slow increase Rapid expansion in Accumulation of Very low level of
in aggregate demand aggregate demand unsold stocks of goods output
Increase in Increased production/ Overproduction Very low aggregate
Investment incomes demand
Increase in demand High capital Overinvestment Almost negligible
for capital goods investment growth
Slow rise in price, Expansion of bank Excess supply Low level of
profits credit production
Slow rise in high profits Falling aggregate Huge level of
production demand unemployment
Slow rise in employ- High rate of business Investment demand Credit contraction
ment/income expansion falls
Slow increase in Resources close of full Banks demand repay- Business pessimism
bank credit employment ment of loans
Beginning of Business optimism Liquid cash holding Economy close to
business optimism stagnation
High profit expectations Prices fall Low level of prices
Inflation Deflation Deflation
Over optimism Profits fall Business liquidation
Dangers of over Unemployment Workers get laid off
expansion sets in and increases
overfull employment
of resources
Depression if not
controlled goes into
trough where the
economy reaches
rock bottom levels.

11.3.1 Types of Trade Cycles

Trade cycles can be of varying duration, the main types are classified as follows:
1. Short Kitchin Cycle: Named after Joseph Kitchin, such cycles are minor
cycles of a duration of about 40 months. Kitchin made a distinction between
minor and major cycles and stated that one major cycle could be made up of
2-3 minor cycles of 40 months duration each.
Trade Cycles 181

2. Long Juglar Cycle: The duration of Juglar’s cycle is on an average for

about nine and a half years. These cycles were explained by Clement Juglar,
a French economist.
3. Kondratieff Cycle: These are very long cycles of more than 50 years
duration given by N.D. Kondratieff. A Kondratieff Cycle is made up of six
Juglar cycles.
4. Kuznets Cycle: Propounded by Simon Kuznets, it refers to strong cycles of
16–22 years which overshadows the minor cycles of 7 to 11 years.
5. Building Cycles: A very interesting type of a cycle associated with names
of two American economists Warren and Pearson who found building cycles
which lasted for about 18 years and was linked to the construction of building
activity.

11.4 ANTI-CYCLICAL POLICIES (KEYNES)

During the business cycles, the economy is characterised by fluctuations in the level
of economic activity. Any fluctuation, whether it is an expansion or contraction of
business activity destabilises the economy and must be controlled.
According to Keynes, it is fluctuations in the aggregate demand that leads to
fluctuations in the levels of economic activity. When the aggregate demand which is
made up of consumption and investment demand is slack or low, it fails to support
income/output at high levels and thus results in unemployment. When the level of
Aggregate Demand in the economy is high it is able to sustain the economy at full-
employment levels. Therefore, it is deficient aggregate demand which becomes the
major cause of deflationary tendencies, unemployment and deflation in the economy.
When ‘aggregate demand’ is high or tending towards an ‘excess demand’ situation, it
means output fails to cope up with increasing demand. This leads to too much money
chasing too few goods and hence, builds up inflationary tendencies in the economy or
takes the economy towards the ‘peak’ level of business activity.
According to Keynes, inflation occurs due to ‘excess demand’ and inversely deflation
arises when there is a ‘deficient demand’3. In the Keynesian analysis inflation arises
only after the full employment level when output can no longer increase but demand
for goods and services goes on increasing.
It is a situation of excess or deficient demand which brings about fluctuations in
the level of income, output, employment, and prices in the economy generating business
cyclical fluctuations. Therefore, the level of ‘Aggregate Demand’ determines the level of
business activity in an economy. As long as excess or deficient demand can be avoided
the economy would remain relatively stable.
In order to control such fluctuations, Keynes advocated government intervention
in a capitalist economy through the two main instruments of the government, i.e. the
fiscal policy and the monetary policy. These polices, through regulating the aggregate
demand, can stabilise the business cyclical fluctuations.
The main elements of the above arguments can be briefly summarised as follows:

3. Ibid.
182 Macroeconomics

Thus, proper ‘Demand Management’ in the economy becomes the key factor in
controlling the fluctuations in the economy.

11.4.1 Working of Anti-cyclical Policies: Monetary and Fiscal

The two main policies available to the government to control depressionary and
inflationary tendencies or cyclical fluctuations in the economy are as follows:

Monetary Policy
The Monetary policy refers to control of money supply and liquidity by the Central
Bank to attain certain objectives in the economy. The objective would be to achieve
price stability, economy growth, full employment, external stability, etc.
(The other details about objectives, instruments, working and operation of the
monetary and credit policy have been discussed at length in Chapter 6.)
In this chapter, therefore, we are basically going to deal with the manner in
which the monetary policy instruments can be used to control the anti-inflationary
and depressionary tendencies in the economy.
To briefly recall,
Monetary policy means regulation and control of money supply. During Inflation,
the money supply has to be reduced and a tight or a Dear Money Policy is followed.
During depressionary situations, money supply and credit is expanded or a Cheap
Money Policy is followed.
Trade Cycles 183

The monetary policy works through the quantitative and qualitative (selective)
instruments.

Instruments of Monetary Policy

1. Quantitative Instruments 2. Selective Credit Control Instruments

(i) Bank Rate (i) Minimum margin requirements
(ii) Open Market Operations (ii) Moral Suasion
(iii) Variable Reserve Ratios (iii) Others

1. Quantitative Instruments
(i) The bank rate: The bank rate is the rate at which Central Bank discounts
bills of exchange for commercial bank. In India, bank rate is more popularly
known as the rate at which the Central Bank lends to the commercial banks.
In a situation of excess money supply in the economy leading to inflationary
tendencies- characteristic of a phase of economic prosperity- the bank rate
is increased; commercial banks find it costlier to borrow from the Central
Bank; lending and credit flow is reduced due to the increase in the Bank
Rate, which leads to general credit contraction (investors borrow less since
borrowing becomes costlier). The net effect of an increase in Bank Rate is
to bring about credit contraction control money supply, control inflation and
hence stabilise the economy.
During a depressionary phase, characterised by deflationary tendencies in
the economy, the Bank Rate is reduced as a result of which, funds are easily
available, there is liberalisation of credit and general expansion. All these
helps to bring the economy out of depression and generate recovery. Due
to the easy and cheap availability of credit, investors are induced to invest
thereby increasing the output and employment levels in the economy.
(For details of the working and limitations of the bank rate, see Chapter 6.)
The bank rate, in spite of its limitations, is a most commonly used
instrument to control the cyclical fluctuations in the economy.
(ii) Open market operations: These refer to buying and selling of government
securities by the Central Bank. During inflation, the Central Bank sells
government securities to commercial banks, mopping up excess credit
securities with the bank whereby the lending capacity of commercial bank
increases and credit expansion takes place. This monetary instrument is used
in many countries to raise public debt for the government.
The open market operations thereby, can be used to control cyclical
fluctuations in the economy.
(iii) Variable reserve ratio: This instrument has a very direct impact on credit
creation since it directly determines the liquidity and cash position of the
commercial banks. During inflation, the cash reserve ratio is increased
whereby credit creation capacity of commercial banks is reduced. In a situation
184 Macroeconomics

of depression, the cash reserve ratio is reduced, increasing the credit creation
capacity of commercial banks thus generating expansion of credit in the
economy.
The quantitative credit control instruments work in the above manner to
control the cyclical fluctuations in an economy.
2. Selective Credit Control Instruments: Selective credit control instruments are
used to direct and channelize the credit into certain section of the economy. It is a
discretionary policy, which is used to direct credit into sectors, which are crucial for
development for example, the priority sectors. It can also be used to restrict the flow
of credit into certain sectors, depending on the government policy decisions to curb
credit flow into particular sectors (e.g. to curb monopolistic tendencies).
Concluding remarks: The monetary policy, as already stated, is frequently used to
curb cyclical fluctuations in the economy. However, through it is possible to control
booms or inflationary tendencies through monetary policy to some extent, it cannot
guarantee removal of depressionary tendencies in the economy very effectively. Getting
an economy out of depression is a more difficult task involving a more direct method
to influence the aggregate demand, i.e. the consumption and investment level in
an economy. Fiscal policy provides greater potential to set an economy on to path
of recovery. However, both monetary and fiscal policies have to be used together to
control cyclical fluctuations. Further, the timing, and the magnitude of the monetary
instruments have to be perfect if the monetary policy is to be effective.

Fiscal Policy for Control of Business Cycles

The importance of ‘fiscal policy’ as an instrument to control cyclical fluctuations and
stabilise the economy got a stimulus after the Keynesian revolution, i.e. mainly after
the great depression when Keynes propounded his famous ‘General Theory.’ However,
the origin of fiscal policy dates far back.
Definition of Fiscal Policy: Fiscal policy refers to the policy of the government
related to government revenues and expenditures. It has been defined as the
“Government taxation and expenditure policy to regulate the level and composition
of output”.
Since fluctuations in the level of business activity arise out of fluctuations in
the ‘aggregate demand’ in the economy, the fiscal policy aims at controlling such
fluctuations through a proper management of the ‘aggregate demand’ in the economy.
The instruments of the fiscal policy can be broadly classified as under:
1. Government Revenue
2. Government Expenditure
3. Deficit Financing
4. Public Debt
The basic principles of the working of fiscal policy in controlling cyclical fluctuations
can be seen as follows:
1. In an inflationary phase or during economic prosperity, when the government
feels that the level of aggregate demand is too high, it can reduce it by
Trade Cycles 185

reducing public expenditures, increasing taxes on income and reducing deficit

financing thereby reducing aggregate demand and controlling inflationary
tendencies in the economy. The government also could incur pubic debt to
mop up excess money supply from the economy during such times.
2. During a deflationary phase, characterised by low levels of aggregate demand,
deflation and unemployment the government increase public expenditure
increases deficit financing and reduces taxes. All this generates increases
in aggregate demand and thereby increases the level of output, income and
employment in the economy.
Further, along with fiscal policy measures, the monetary policy also plays an
equally important role in stabilising the economy. In addition, price, income and
international policies can also be used to stabilise the economy.
These are discussed briefly as follows:
(a) Income policy for full employment: Policies regarding the incomes of people
affect the level of economic activity and therefore, the level of employment in
the economy. If, for example, the government does not control the incomes (i.e.
salaries, wages, dividend, incomes, etc.), there would be inflationary pressures
in the economy. Thus, a proper income policy is necessary to achieve and
maintain a high level of employment. This policy can be useful to bring a
coordination between economic growth and price-stability.
(b) Price-policy for full employment: A suitable price is important for achieving
a high level of employment. Price instability (inflationary or deflationary
situation) goes against the steady economic growth. Thus, a price policy must
aim at protecting an economy from business fluctuations.
Further, stability in prices of goods and services may result in expansion of
markets and increased demand for factors of production and thus an increase
in employment. Thus, in conclusion, we can say that, price controls and price
support policy is useful to maintain economic activity at a high level, and this
means increase in employment.
(c) International measures for full employment: International cooperation and
transactions help every country to increase its economic activity and thus the
level of employment. Loans from international organisations, like the I.M.F.,
World Bank, etc., help to maintain economic stability in advanced countries
and promote economic development in under-developed countries. All this,
result in increase in the volume of employment
The domestic fiscal, trade and monetary policy, if co-ordinated well with
these international measures, would, no doubt increase economic activity and
thus the level of employment.

11.5 SOME THEORIES OF TRADE CYCLES

Prior to the Great Depression (1929–33), the lassiez-faire economies (purely capitalist
economies) had not witnessed any major fluctuations in economic activity to cause
serious concern about trade cycles.
186 Macroeconomics

It was after 1933, and especially after the publication of Keynes ‘General Theory’
in 1936, that business cyclical fluctuations were looked at with new interest. However,
there have been a number of economists who have worked on understanding the causes
of such fluctuations and propounded a number of theories.
The causes of trade cycle vary between time periods, between situations and
between economies. Some of the main theories of trade cycles is given as follows:
1. Hawtrey’s Monetary Theory of Trade Cycle
2. Schumpeter’s Theory of Innovations
3. Keynes Theory of Trade Cycle

11.5.1 Hawtrey’s Monetary Theory of Trade Cycles

Prof. R.G. Hawtrey (1928) stated that trade cycles are a purely monetary phenomenon.
It is the expansion and contraction in bank credit which alters the flow of money in
an economy and causes cyclical fluctuations. When credit is increased or reduced by
the banking system through changes in interest rates its cause fluctuations in credit
and money flows in the economy and thereby cyclical fluctuations.
Such cycles caused by the changes in money flows can be summarised as follows:

Expansion Phase of Trade Cycles

Rate of interest reduces: demand for borrowings by business and merchants increase
 investment by producers increase  employment of factors of production increase
 money income increase  demand for goods/services increase  production orders
increase  cumulative increases in demand/production/output, employment, prices and
profits increase  business optimism

Contraction Phase of Trade Cycle

There is a limit to the expansion of bank credit and a point is reached when banks
refuse to lend further due to the following causes:
1. Reduction in Cash Balances
2. Rising Domestic Price of Commodities (due to export of gold to other countries
and imports > exports)
The process of contraction or recession sets in and can be explained as summarised
below:
Bank credit contracts  rates of interest increase  repayment of loans 
businessman start selling stocks to repay bank loan  prices start falling  production
orders are cancelled  fall in demand for factors of production  unemployment
increases  incomes fall  prices fall  signs of depression  liquidation of firms
 cumulative process causes depressionary tendencies
Once the process of depression sets in, it takes the economy long to come out of
it. The economy recovers when traders pay back loans slowly by selling stocks, banks
credit position slowly strengthens and banks start to encourage lending. However due
to business pessimism, borrowings are low and have to be propelled up with a Cheap
Money policy and the economy can recover slowly.
Trade Cycles 187

Criticisms of the Theory

This theory was supported by Milton Friedman and other Monetarists. It was mainly
criticised by economists like Harberler, Hamburg on the following grounds:
1. Over emphasis on monetary and credit factors
2. Availability of credit and money cannot support expansion indefinitely
3. Excess importance to businessman and traders
4. Businessman can continue some business/production with owned funds
5. The changes in rates of interest have to be permanent to affect producers
6. Role of business expectations, price changes and costs ignored in process of
production
7. No mention of duration of cycles
8. Lopsided because excess importance to monetary factors
9. Ignored factors like innovation, capital stock, multiplier and accelerator
interaction in explaining cycles

11.5.2 Schumpeter’s Theory of Innovations

Joseph Schumpeter’s theory of trade cycles originating from ‘innovations’ is an
extremely significant theory of trade cycles.
Schumpeter shows that trade cycles are an outcome of economic development and
innovations in a capitalist society.
The essence of his theory can be explained as follows:
1. Trade cycles are an outcome of innovations.
2. The theory is explained in two stages:
(i) Stage 1 which deals with the initial impact of an innovation.
(ii) Stage 2 shows the reaction to the original impact of innovations.
3. To begin with, the economy is in equilibrium and all factors are fully employed.
4. The economy reproduces itself and there is a smooth ‘circular flow’ in the
economy.
5. When an ‘innovation’ is introduced by a producer, it will bring about changes
in the economy.
6. An innovation can be of following types:
(i) Introduction of a new product
(ii) Introduction of a new method of production
(iii) Opening of a new market
(iv) Conquest of a new source of raw material or semi-manufactured good
(v) Carrying out a new organisation of an industry
6. Innovations to be implemented requires bank credit.
7. Bank credit/funds lead to innovators increasing production, money incomes
rise, production increases, factors of production are attracted to the innovations
industry. Production expands. This is the prosperity phase.
8. However, slowly supply exceeds demand and the reverse chain of reaction
sets in. Prices fall, credit falls, producers are not willing to increase output
and recession sets in.
188 Macroeconomics

The whole process of expansion and contraction is repeated and spreads to all
producers who follow the innovator in ‘swarm like clusters.’
Schumpeter states that cyclical fluctuations are almost a permanent feature of
capitalism since innovations are an integral part of the system. He also believes in
the long Kondratieff wave of trade cycles.

Criticism
Though Schumpeter’s theory of ‘innovations’ to explain trade cycle is unique, it has
been criticised on the following grounds:
1. Ignores other economic, financial, and natural causes.
2. Too much emphasis on innovations.
3. In current times, innovations are continuous.
4. In modem times, an innovator is a ‘Company.’
5. Too much emphasis given to volume and behaviour of bank credit in trade
cycles.
6. No mention of shares, debentures, owned funds to support expansion process.

11.5.3 Keynes’ Theory of Trade Cycles

Keynes’ states that trade cycles arise mainly due to fluctuations in aggregate demand.
His views on causes of trade cycles can be summarised as follows:
1. Shortages in aggregate demand are the main causes of recession and
depression.
2. Aggregate Demand = Consumption Demand (C) + Investment Demand (I).
3. Since ‘C’ is stable in the short run, the Investment Demand is crucial to
sustain the economy.
4. A fall in investment can cause recession and depression and this is caused
by a decline in mec or expected rate of profit in business.
5. Fluctuations in investment are caused by fluctuations in mec.
Based on this premise the expansion and contraction phase can be explained as
follows:

Expansion Phase (Prosperity)

The expected rate of profit or mec is high  creates business optimism  investment
increases  output/employment/income increases  an increase in investment causes
multiplier times increase in income (multiplier effect). This process continues till the
economy reaches boom. As boom continues  mec starts declining due to falling yield
on capital goods and increasing costs of capital goods.

Contraction phase (Recession)

Mec starts declining  investment falls  income/employment falls (due to multiplier
effect)  cumulative decline in employment income and output
Trade Cycles 189

Recovery/Revival
All stocks are exhausted  slowly mec increases  fresh investment take place 
economy starts reviving or recovering

Criticism
Keynes’ theory was a very unique theory and also explains behaviour of income/output
and employment. It was mainly criticised by economists on the following grounds:
1. Over emphasis on role of mec and role of expectations
2. Importance to psychology of business over emphasised
3. No detailed account of all phases

Points to Remember
• Business cycle is an important feature of a capitalistic economy. A business cycle
is the course of economic activity or business activity.
• Keynes stresses two indicators namely, prices and unemployment, for measuring
the upswing and downswing of the business cycle.
• A business cycle is characterised by different phases. These phases are depression,
recovery, prosperity, boom, and recession.
• Depression is a period of a business cycle characterised by low level of production,
unemployment, low wages, low prices, low level of business activity and general
atmosphere of pessimism.
• Recovery implies increase in business activity. After the period of depression
industrial production picks up and the volume of employment, wages, prices and
therefore, the profits of businessmen increase; business expands and there is a
general atmosphere of optimism in the economy.
• Boom period is divided into prosperity, actual boom and the end of the boom.
Here, prosperity is characterised by increased production, high capital investment
in basic industries, high prices, high profit, a high rate of formation of new
business enterprise and full employment. Actual boom is seen when there is a
rapid expansion of business, high prices of stocks and commodities, high profit
and over-full employment. This stage gives rise to the problem of inflation. Boom
conditions, however, generate their own checks. Quality of factors of production
deteriorates, wages rise, costs rise and profit begin to fall and ultimately disappear.
Businessmen become overcautious and the boom phase comes to an end.
• Recession is a phase of the business cycle wherein the business activity drops,
the demand for factors of production declines stocks accumulate and there is low
level of business activity. This is self-reinforcing and it finally results in a slump
or depression. The business cycle is thus complete.
• Expansion phase of business cycles is associated with the problem of inflation. It
means a period of rising prices of goods and factors of production.
• The contraction phase of a business cycle is characterised by unemployment.
190 Macroeconomics

• Cyclical unemployment is a characteristic feature of the contraction phase

of business cycles. It means that since level of production is low during the
contraction phase, the demand for factors of production, including labour is low,
and this is the cause of cyclical unemployment in an economy.
• Cyclical unemployment can be reduced through the fiscal policy measures, as
explained by Keynes.
• Full employment may exist with frictional, seasonal, structural and technological
unemployment.
• Keynes explains full-employment as, “that particular situation in the economy
in which an expansion of effective demand fails to bring about an expansion of
outcome and employment.”
• Extreme situations of boom and depression need to be curbed or controlled through
anti-cyclical monetary, and fiscal policies. Further, international measures to curb
the extremes of business cycle become relevant in the new global era.
• There are a number of theories to explain trade or business cycles. Prominent
among them are Hawtrey’s Theory, Schumpeter’s Theory and Keynes’ Theory.

QUESTIONS

I. Short Questions
1. Elaborate:
(a) Cyclical fluctuations are an inherent feature of economic activity.
(b) For a trade cycle to be complete all phases of the trade cycle must occur.
(c) ‘Every recession must lead to a depression’.
(d) Trade cycles basically are an outcome of fluctuations in aggregate
demand.

II. Long Questions

1. ‘Trade cycles refer to fluctuations in economic activity.’ Elaborate and also
discuss the distinguishing characteristics of the various phases of a trade
cycle.
2. Elaborate on the characteristics of the various phases of a trade cycle. What
are the factors that can cause a recession?
3. What policy approaches does a government adopt to control trade cycles?
4. Explain whether the following statement with justification: ‘Fiscal policy
measures are more effective during recession.’
CHAPTER

12
Classical Theory of Output, Income,
Employment Determination

12.1 INTRODUCTION
The determination of output, income and employment in an economy is a matter of
crucial importance and has occupied the attention of a number of economists.
There are two major versions of the theory:
1. Classical Theory
2. Keynes Theory

12.2 CLASSICAL MACROECONOMICS

12.2.1 Introduction to Classical Macroeconomics

Classical economics is a term used by Karl Marx for the English Economists who
propounded their theories broadly in the period 1750 to 1850. This class of economists
include Adam Smith, David Ricardo, Malthus, J.B. Say, J.S. Mill and others. Keynes
used the term classical economics to include also the neo-classical economists who were
dominant during the period 1870 to 1930. They included Alfred Marshall, W.S. Jevons,
L. Walras, V. Pareto, I. Fisher, F. Taussig, A. C. Pigou, D.H. Robertson and others.
Classical economics is the traditional school of economic thought which is respected
as the trendsetter in economic analysis.

Features of a Capitalist Economy

The classical economists presented their theory of output, employment and income
determination within the framework of a purely capitalist, i.e. a laissez-faire economy.
The characteristics of such an economy are highlighted herein after:

191
192 Macroeconomics

1. Purely Capitalist Economy: The classical economists presented their

analysis within the framework of a purely capitalist economy (i.e. a free
market economy or a laissez-faire economy).
2. Ownership of Means of Production by Private Individuals: The means
of production in a capitalist system is owned by private individuals (right to
private property).
3. Profit Maximisation: The major objective of production in a capitalist
economy is profit-maximisation. Dominance of self-interest ensures progress
of the economy.
4. Minimum Role of the Government: In such a system the role of the
Government was restricted to the minimum, i.e., law, order, and defence.
5. Importance of the Free Market Mechanism: The free market mechanism
is very crucial in a capitalist system. This free market mechanism is also
known as the working of the invisible hand.
The market is significant because
(a) It indicates the market preferences and guides the decisions regarding
‘what to produce’, ‘how much to produce’, and ‘for whom to produce’.
(b) If anything goes wrong in the economy, the free market mechanism will
adjust and automatically stabilise the economy.
6. Money is basically a Medium of Exchange: The classical economists
considered money to be basically a medium of exchange. Thus, money is used
mainly to buy goods and services or to facilitate transactions.
The Classical economists believed in the functioning of a capitalist system and
the working of a free market mechanism. As a result of this, the classical economists
believed that such a system would have a tendency towards full employment.
Therefore, a crucial foundation of the Classical Theory is the assumption of full
employment. The Classical Theory, whether it was the output determination theory
or their monetary theory, were all presented within the framework of the assumption
of full employment tendency in a capitalist system. They believed that a capitalist
economy left to itself without government intervention could automatically achieve full
employment. On the other hand, Keynes’ Theory is almost fully devoted to the problem
of unemployment and the means to overcome it.

12.3 BASIS OF ASSUMPTION OF FULL EMPLOYMENT

The Classical economists have discussed at length the reasons as to why a capitalist
economy will have a tendency to reach full employment. This is summarised as
follows:
Classical Theory of Output, Income, Employment Determination 193

Basis of the Assumption of Full Employment in the Capitalist System

Say’s law of markets Interest-rate flexibility Wage-price flexibility

Guarantees Aggregate Guarantees Aggregate Guarantees Supply of

Demand = Aggregate Savings = Aggregate Labour = Demand for
Supply (AS = AD) Investments (S = I) Labour (SL = DL)

Guarantees equilibrium Guarantees equilibrium Guarantees equilibrium

in the product market in the capital market in the labour market

All above mechanisms generate tendency of full employment

As a result of the working of the above three mechanisms, the Classical economists
believed in the tendency of full employment.

12.3.1 Say’s Law of Markets

A basic foundation of the classical economics is the Say’s Law of Markets propounded
by Jean Baptise Say, a French Classical economist in 1803. This law is an important
basis of the Classical assumption of full employment.

Statement of the Law

In its most general and simplest form the law states that ‘Supply creates its own
demand.’
That is, Aggregate Supply (AS) = Aggregate Demand (AD)
This law implies that in a capitalist economy there would be neither overproduction
nor underproduction in the market. Since whatever is produced is automatically
demanded, the market would be cleared. This leads to a tendency of full employment
in a capitalist system.

Assumptions and Conditions under which the Say’s Law would Operate
Say’s law which states that Supply creates its own demand implies that in the very
act of supplying goods and services an equivalent demand is created in the economy.
This guarantees that production of goods and services would continue till all resources
in the economy are utilised till the fullest and optimum level.
194 Macroeconomics

Conditions under which the Law Operates:

1. The law operates only in a purely capitalist economy.
2. The role of the Government is restricted to the minimum.
3. The law would operate only if money is basically a medium of exchange. So
that money can be used only to buy goods and services and that there is no
speculation.
4. There is no significant time-lag between people receiving their income and
spending it.
5. For simplicity sake, it is assumed that there is no foreign sector.
6. A closed economy model with only two sectors, the Household and Business
Sector is considered.

Explanation of the Say’s Law of Markets

One can now proceed to explain the Say’s Law of markets with the help of the circular
flow of income mechanism.
Assuming that there are two dominant sectors in the economy:
1. Household Sector
2. Business Sector
The Says Law can be explained using the two sector Circular flow of income
mechanism as given below in Chart 12.1.

Chart 12.1 Circular Flow of Income Mechanism

Notes: DO = Change in Output

DY = Change in Income
DE = Change in Expenditure

(a) As can be seen from the above flow chart, in the process of production of
goods, a simultaneous income or purchasing power is generated so that a
simultaneous demand for the goods is created.
Classical Theory of Output, Income, Employment Determination 195

(b) To produce the goods and services, the Business Sector requires factors of
production which is provided by the household sector as shown in Flow 1.
(c) Once the factors of production are made available to the business sector,
production of goods and services takes place in this sector and there is an
outflow of goods and services, i.e., a supply of goods and services to the
household sector as indicated by Flow 2.
(d) There is simultaneously a flow of income to the factors of production in the
form of money payments of rent, wages, interest and profits shown as Flow 3.
(e) This means that in the very act of supplying the goods and services an
equivalent income or purchasing power to demand the same is created so that
whatever is supplied is automatically demanded and the possibility of over
or underproduction does not exist. This is what Say emphasised in his law:
“Supply creates its own Demand”.
(f) The final stage of the above mechanism is shown as Flow 4, where the
household sector uses its income to buy goods and services from the business
sector indicated as payment for goods and services in the flowchart.
(g) As can be seen therefore, if goods worth ` 1000 is produced, it generates income
worth ` 1000 and money being only a medium of exchange it automatically
gets spent on the goods.

\ DO = DY = DE

which implies that aggregate supply creates its own demand.

Thus, the above flow chart gives a simple explanation as to how the law operates,
an a important simplistic assumption in the analysis being that money is a medium of
exchange; so that when people receive money incomes they would spend all it on the
purchase of goods and services, thus allowing the circular flow of income to continue.

Summing up the Content of the Law

According to the Say’s law, whatever is supplied is automatically demanded, so that
the possibility of general overproduction and underproduction is ruled out. When
there is no fear of goods not being sold, producers guided by the profit-maximisation
motive will go on expanding production till full employment level. As a result, all of
the resources will be fully employed.
In short, any change in output results in an equal change in income and an
equivalent change in expenditure which can be denoted as:

DO = DY = DE
where, O = Output
Y = Income
E = Expenditure
Therefore, the circular flow of income and expenditure is maintained in the
economy, removing the possibility of general overproduction and underproduction, thus
assuring full employment in the long-run.
196 Macroeconomics

Implications of the Law

The important implications of the Say’s law crucial for the Classical analysis can be
stated as follows:
1. In the process of supply of goods and services, a simultaneous demand is
generated, i.e. an income/purchasing power equal to value of goods and
services is created.
2. This implies that in a capitalist economy, there emerges a situation where
aggregate supply is exactly equal to aggregate demand, i.e. AS = AD, so that
possibilities of over or under production are ruled out.
3. As a result of AD = AS, the market in a capitalist economy will always be
cleared.
4. The most important implication is that Say’s law of market ensures, in a
capitalist economy, a tendency towards full employment because in absence
of a fear of glut in the market the producers have a tendency to continue
production till the level of full employment.

Limitations of the Say’s Law

The Say’s law operates under very restrictive conditions and, therefore, came in for
criticism. The flaws in the assumptions of Say’s Law can be briefly summarised as
follows:
1. No Significant Time-lag: The Say’s law assumes that there is no significant
time-lag between individuals receiving their income and spending it. In reality
however, there are significant time gaps. As a result, the demand may not
support the aggregate supply.
2. Money is only a Medium of Exchange: The Say’s Law works on the
assumption that money is only a medium of exchange and therefore, the
entire of the income generated is spent on goods and services. However, if the
speculative motive to demand money is allowed, then the whole of the income
may not be spent on goods and services creating a gap between aggregate
demand and aggregate supply.
3. No Leakages from Expenditure Stream: The law assumes that there
are no leakages from the expenditure’s stream in the form of hoarding and
speculation, otherwise it would disturb the working of the Law.
4. The Law works only in a Capitalist System.
5. No Savings: If savings is introduced into the model, it might disturb the
equality between AS and AD. However, the classical economists have shown
through the interest-rate mechanism that savings will automatically be
invested and hence will not create problem.
6. Minimum Role of the Government: If the Government is given an active
role, one would have to consider taxes and government expenditures.
7. No Foreign Sector: If the foreign sector is considered, it would create
problems for the Say’s Law. One would have to include exports, imports and
other international transactions.
Classical Theory of Output, Income, Employment Determination 197

In spite of its limitations, the Say’s law was accepted by the classical economists
(and also the neoclassical economists to some extent). This Law is the most important
basis for the assumption of full employment in the Classical Theory.

12.3.2 Interest Rate Flexibility Mechanism

The second important mechanism which guarantees full employment according to
the classical economists is the flexible rate of interest mechanism which works to
maintain equality between savings and investment. This mechanism guarantees that
at any point of time in a capitalist system, there is a tendency for aggregate savings
(S) to equal aggregate investment (I); and when this is ensured there is tendency for
full employment.

Explanation of the Mechanism

1. According to the Classical economists, the rate of interest ‘i’ is simply the
price of Capital.
2. Therefore, like any other price, it is determined by demand for capital (Dk)
and supply of capital (Sk).
3. Capital in this analysis refers to financial capital or loanable funds.
4. The equilibrium rate of interest would be determined at the level, where,
Dk = Sk.
5. The demand for capital is nothing but the aggregate investments in an economy.
6. The supply of capital represents the aggregate savings in the economy.
7. Both savings and investments are interest-elastic in the Classical theory, i.e.
they are functions of interest-rate.
8. The supply of capital or savings is a direct function of the rate of interest
written as S = f(i).
(This is because the higher the rates of interest on savings, greater is the
incentive to save.)
9. The demand for capital or investment is inversely related to the rate of interest
written as
1
I = f 
i

10. The equilibrium rate of interest will be thus determined at a point, where,
S = I or where Supply of capital = Demand for capital.

Explanation of the Interest Rate Flexibility Mechanism

1. According to the Classical economists, the rate of interest is determined at
the point where aggregate savings equals aggregate investment (S = I).
2. Any disequilibrium between S and I is corrected through changes in the rate
of interest. In a capitalist system with no Government intervention, interest
rates are flexible. This mechanism is shown below in Figure 12.1.
198 Macroeconomics

FIGURE 12.1 Interest Rate Flexibility Mechanism.

Explanation
1. As can be seen in Figure 12.1, the equilibrium level of interest rates is
determined at ie where S = I.
2. In case of a disequilibrium situation when the rate of interest is i1, saving is
greater than investment or supply of capital is greater than the demand for capital.
As a result, the rate of interest will start falling and the demand for capital or
investment will increase, supply of capital or saving will contract and investments
will increase till the equality between savings and investments is restored.
3. In case of a disequilibrium situation like at i2, the saving or supply of capital
is less than investments or demand for capital. The rate of interest will start
rising, savings will increase, investments will contract till once again the
equality between S and I is restored.
Therefore, according to the Classical economists, it is flexibility in the interest
rates which guarantees equilibrium between savings and investments.

Implication of the Interest Rate Flexibility

1. This mechanism guarantees a tendency towards Aggregate Saving = Aggregate
Investment.
2. Because of the working of the above mechanism any saving in a capitalist
system is automatically invested.
3. Therefore, according to the Classical economists there are no idle savings.
4. The interest rate flexibility mechanism guarantees that savings will be equal
to investment. As a result, all the income saved gets invested, so that no
leakage is created in the circular flow of income and expenditure and whatever
is supplied is demanded thus guaranteeing a tendency in the economy towards
full employment.
The Say’s Law of market works to guarantee AS = AD, interest flexibility
works to guarantee S = I (aggregate). Therefore, in the absence of the fear of over
or underproduction and in the absence of the fear of savings generating shortages in
demand, production will continue in the capitalist economy till full employment level.
Classical Theory of Output, Income, Employment Determination 199

12.3.3 Wage Flexibility Mechanism

The third mechanism which forms the basis of the assumption of full employment in
the classical system is the wage-price flexibility mechanism.
This mechanism guarantees that the demand for labour is equal to supply labour
and this equilibrium in the labour market ensures the tendency towards full employment.
The mechanism can be explained in detail as follows:
1. Wages are the price of labour.
2. The price of labour in free market would be determined according to the
demand for labour (DL) and supply of supply of labour (SL).
3. The equilibrium level of wages would settle at a point where DL = SL.
4. The demand and supply of labour of labour are both functions of wages.
1
DL = f   ... (i)
w
(Demand for labour is inversely related to the level of wages.)
and
SL = f (W) ... (ii)
(Supply of labour is a direct function of wages.)
Note: The wages in the above equations refer to money wages. However, the classical
economists had stated that both demand and supply of labour are functions of real
wages which is the purchasing power of money.
The real wages are written as:
Real wages = w/p
The above DL and SL functions can now be rewritten as:
DL = f(1/ w/p)
SL = f(w/p)
The determination of wages in the free market and the Wage–Flexibility
mechanism is shown in Figure 12.2.
Explanation
1. The equilibrium level of wages in a capitalist system is determined in the
labour Market according to demand and supply of labour.
2. As can be seen in Figure 12.2, the equilibrium level of wages is determined
at a point where DL = SL.
3. Any disequilibrium in the labour market will be automatically corrected
through the wage flexibility mechanism.
4. If the wages are at ow1 there is a temporary disequilibrium. At this point
SL > DL, there is excess supply of labour and as a result wages will start
declining. This process will continue till the whole of the excess labour is
absorbed and equilibrium is restored. In a situation where SL < DL, the
opposite mechanism will work.
5. Flexible wages, therefore, guarantees equilibrium in the labour market.
200 Macroeconomics

FIGURE 12.2 Determination of Wages in the Free Market (Wage-Price Flexibility Mechanism).

Implication of Wage Flexibility Mechanism

1. Wage flexibility guarantees DL = SL and therefore equilibrium in labour
market.
2. Since the Say’s Law guarantees AS = AD, there is equilibrium in the product
market and as a result of this, in absence of the fear of overproduction,
employment of labour will also continue till the point of full employment.
3. This is how the classical economists believed that wage flexibility will
guarantee equilibrium at the full employment level.
4. Since a wage-cut was found to solve the problem of unemployment, the
classical economists in fact extended this argument to advocate a money
wage-cut policy to solve the problem of unemployment in the economy.
Such a policy was however, criticised on the following grounds mainly by Keynes:
1. It would create a paradox at the macro level
2. Minimum wages act would not allow such wage-cuts
3. Trade union pressures.
Therefore, summing up, full employment in a capitalist system is guaranteed due
to working of the following mechanisms:
1. The Say’s Law of Market
2. Interest–Rate Flexibility
3. Wage–Price Flexibility

12.4 CLASSICAL THEORY OF OUTPUT AND EMPLOYMENT DETERMINATION

Having explained the basis for full employment in a capitalist economy, the classical
economists presented a model of employment and output determination.
Classical Theory of Output, Income, Employment Determination 201

The Classical economists stated that:

1. The level of employment is simultaneously determined along with the level
of output.
2. Both the equilibrium level of output and employment are determined by the
aggregate production function and the demand and supply of labour.
3. The level of output is determined by the aggregate production function.
4. The level of employment is determined in the labour market by demand and
supply of labour.

12.4.1 Determination of the Level of Output

1. The Aggregate Production Function (APF) refers to the production function
of the entire economy. It shows the maximum level of output which can be
produced in an economy, given the technology and resources. The classical
economists used the following APF to proceed with the analysis.
Q = f (N, C, T) ... (i)
where,
Q = Level of Output
N = Level of Employment
C = Stock of Capital
T = Level of Technology
2. They assumed that the stock of capital and the technology would remain more
or less constant. Therefore, the equation can now be rewritten as
Q = f(N, C, T) ...(ii)
3. As can be seen in the Eq. (ii), since C and T do not change, the level of output
becomes a direct function of the level of employment.
Q = f(N)
4. As the level of employment increases, the level of output increases and since
employment has a tendency towards full employment, the output level in a
classical system would also be determined at the level of full employment.

12.4.2 Determination of the Level of the Employment

1. The equilibrium level of employment is determined at a point, where DL = SL.
2. Both demand for and supply of labour are functions of the wage-rate.
3. The demand for labour is an inverse function and supply of labour is a direct
function of the wage-rate.
4. The wage rate considered was not the money wage rate, but the real wage
rate which can be given as:
Real wage = w/p
where, w = the money wage rate
p = the price level
202 Macroeconomics

5. The demand and supply of labour can be restated as function of the real
wage rate written as:
SL = f (w/p) (direct)
DL = f (1/w/p) (inverse)
The level of employment is determined in the labour market through demand and
supply of labour, and the level of output in equilibrium is determined in the product
market simultaneously by the aggregate production function. This is shown in Figure 12.3.

FIGURE 12.3 Determination of the Level of Employment/Output in the Classical Theory.

Observations
1. The level of employment in the classical analysis gets determined in the
labour market according to the demand and supply of labour, indicated in
Panel ‘A’ of Figure 12.3.
2. The equilibrium level of employment is thus determined at ONf in Panel B of
Figure 12.3 which is the full employment level in the classical system.
3. If there is any disequilibrium in the labour market, wage flexibility will restore
equilibrium at full employment level.
4. Panel ‘B’ of the diagram shows the Aggregate Production Function given as
Q = f(N, C, T) and the determination of output in the economy. Since the output
is directly determined according to the level of employment, the equilibrium
output will settle at OQf corresponding to ONf in Panel ‘A’ of the diagram.
Classical Theory of Output, Income, Employment Determination 203

5. Therefore since employment has a tendency towards full employment, in the

Classical theory, the output level would also be determined at the level of
full employment in the Classical analysis.
6. Any adjustment in the labour market will be reflected in changes in the level
of output.
7. Therefore, in the Classical Theory both the level of employment and output
will have a tendency to be determined at full employment level. This belief is
based on the working of the three mechanisms. The Say’s Law of markets, the
Interest rate flexibility mechanism and the Wage-Price flexibility mechanism.
Since the classical economists believed in the Full Employment assumption, they
were more concerned with the problems of optimum allocation of resources, the relative
price-structure, the distribution of rewards of factors of production, etc.

12.5 SUMMARY OF THE CLASSICAL MODEL

Level of output is a function of employment of labour, stock of capital and level of

technology.

Stock of capital and state of technology is considered to be stable /constant in the

short-run.

Therefore, level of output is directly dependent on the level of employment.

Since the level of employment has a tendency to be determined at the full

employment level (by assumption), the level of output also is determined at full
employment.

Points to Remember
• The Classical economists included a class of economists who propounded their
theories broadly between the period 1750 to 1850. This class of economists include
Adam Smith, David Ricardo, Malthus, J.B. Say, J.S. Mill and others.
• This group of economists presented their Theory of Output, Employment
determination within the framework of a purely capitalist economy, i.e. a free
market economy.
• The Classical economists believed in the smooth functioning of a capitalist system
and in the working of the free market mechanism. As a result, they believed in
the tendency of full employment in a Capitalist system.
• The crucial assumption of full employment has its basis in the working of three
mechanisms:
204 Macroeconomics

1. The Say’s Law of market which stated that ‘Aggregate Supply creates its
own demand’ guarantees employment determination at the full employment
level due to absence of the fear of over or under-production.
2. The interest rate flexibility mechanism guarantees equality between
aggregate saving and aggregate investment and therefore equilibrium in
the capital market.
3. The wage flexibility mechanism guarantees equality between demand for
labour and supply of labour and therefore equilibrium in the labour market.
• In the Classical model, output (Q) is basically a function of the level of employment
(N) that is Q = f(N), and since ‘N’, or the level employment, Q will also be
determined at the level of full employment.
• The Classical economists strongly believed that any disequilibrium in the economy
would get automatically corrected by the forces of the ‘Free Market Mechanism’
thus leading to the ‘Full Employment’ tendency.
• Since the Classical economists already assumed ‘full employment’ in an economy,
they concerned themselves with other issues like resource allocation, welfare,
the relative price structure, the determination of rewards to various factors of
production, etc.
• The Classical belief in ‘Full Employment’ and in the smooth functioning of a
capitalist system came in for heavy criticism by Keynes in the later years,
especially after the Great Depression of 1929–33 when almost all capitalist
economies faced a near total collapse.

QUESTIONS

I. Short Questions
1. ‘Supply creates its own demand.’ Explain in this context the Say’s law of markets.
2. ‘Interest rate flexibility mechanism guarantees that savings would be equal
to the investment.’ Explain.
3. ‘The wage flexibility mechanism ensures full employment equilibrium in the
labour market.’ Explain.
4. Explain clearly the role and significance of:
(a) Say’s Law of market in the Classical Theory
(b) Interest-rate mechanism in the Classical Theory
(c) Wage-price flexibility mechanism in the Classical Theory.

II. Long Questions

1. What is basis of the assumption of full employment in the classical theory?
Explain the determination of equilibrium level of output and employment
in the Classical Model.
2. ‘Equilibrium level of output and employment is always determined at full
employment in the Classical analysis.’ Discuss.
CHAPTER

13
Keynes’ Theory of Output, Employment
and Income Determination

13.1 INTRODUCTION
John Maynard Keynes (1883–1946) presented his theory of output and employment
determination in his famous work The General Theory of Employment, Interest and
Money in 1936.
The Keynesian theory is basically a critique of the classical belief in the automatic
adjustments in a capitalist economy leading to full employment. The General Theory,
as the theory is popularly known, was published immediately in the post-Great
Depression period of 1929–33. The Great Depression had clearly proven that a pure
capitalist system by itself could not sustain itself and was self-defeating. Keynes’
theory is an outcome of the depression and was basically a critique of the classical
analysis. It provided an alternative approach to the problem of employment and output
determination in an economy, and was more realistic because it did not accept the
classical belief in full employment. Keynes believed that full employment is not the
general case but a rare occurrence and that deliberate government intervention is
required to achieve full employment in an economy. Keynes’ General Theory created a
revolution in economic thinking and paved the way for what is referred to as ‘Modern
economics’
Keynes at no point advocated socialism, but recommended government intervention
in a capitalist economy specially to solve the problem of unemployment in such an
economy. Based on Keynes’ analysis, governments have intervened in the economies
to avert the repetition of the depression.

13.2 KEYNESIAN THEORY: A CRITIQUE OF THE CLASSICAL THEORY

Keynes was critical of the classical approach on the following grounds:
1. Assumption of Full Employment: The most important and fundamental
assumption of full employment as stated by the capitalist economists, was not
205
206 Macroeconomics

accepted by Keynes. He considered full employment to be a rare phenomenon

and showed that equilibrium below the full employment level was a more
normal occurrence. The Classical approach by assuming full employment
became highly unrealistic and irrelevant to the real-world situation, which is
characterised by largescale unemployment.
2. Say’s Law of Markets: The Say’s Law of markets came in for criticism by
Keynes. He showed that the law which states that ‘Supply creates its own
demand,’ could not be blindly accepted and that full employment based on
this law also did not occur. In fact, according to Keynes it is ‘shortages of
aggregate demand’ in the economy which is the main cause for unemployment.
3. Importance of Equilibrium in the Short Run: Keynes’ Theory is a short
run theory. He was critical of the Classical analysis which was a long-run
equilibrium theory to quote him ‘In the long-run we all are dead.’ He believed
that it is more relevant to analyse the short run.
4. Saving-Investment Analysis: Keynes was also critical of the Classical
belief that saving will always be equal to investment through rate of
interest changes. On the contrary, Keynes maintained that it is the level of
income which brings about the equality between saving and investment and
equilibrium in the economy.
5. Wage-Price Flexibility and the Wage Paradox: Keynes was critical of
the wage flexibility mechanism and also did not believe that a ‘Money wage
cut’ could solve the problem of unemployment. Firstly, because it is not
possible to continuously lower wages under conditions of growing awareness of
labour, trade union pressure and government intervention. Secondly, a ‘wage-
cut’ policy can at the most solve the problem of unemployment for particular
firms and industries but not for the economy as a whole; in fact, it would lead
to further unemployment if followed at a macro level through fall in income
and aggregate demand in the economy( The money-wage cut paradox).
6. Failure of Classical Analysis to explain Crucial Real-World Problems:
The classical model fails to explain problems like unemployment, fall in level
of aggregate demand, excess supply, gluts in the market, fluctuations in
business and also was unable to suggest policies to overcome these problems.
In a nutshell, the Classical Theory, though it was logical and clear-lacked the
realistic approach.

13.3 KEYNESIAN THEORY OF OUTPUT, EMPLOYMENT AND INCOME

DETERMINATION
Keynes’ Theory addresses itself to the three major issues given below:
1. Determination of the Equilibrium Level of Output, Employment, and Income
in an Economy
2. Causes of Unemployment
3. Solutions to the Problem of Unemployment
Keynes’ Theory of Output, Employment and Income Determination 207

In order to understand Keynes’ theory, it is necessary to start with the assumptions

of the theory.

13.3.1 Basic Assumptions of the Theory

1. Keynes’ Theory is a short-run equilibrium analysis presented within the
framework of a capitalist economy.
2. The technology and stock of capital are assumed to be constant in the short-run
and therefore, the level of output is determined by the level of employment.
3. There is perfect competition in the labour and product markets.
4. Keynes assumed increasing costs in the industries which implies that to
produce more and more output the marginal cost of production would go on
increasing.
5. The analysis pertains to a closed economy, i.e., the Foreign Sector was kept
out of the basic analysis.
6. The Government is introduced only as a solution to stabilise the economy in
Keynes’ Theory.

13.3.2 Outline of the Theory

The essence of Keynes’ Theory can be summarised as given below:
1. The level of output and employment in an economy gets determined
simultaneously.
2. The level of output and employment is determined by the level of Effective
Demand.
3. This level of Effective Demand itself is determined or dependent on two
factors:
(a) Aggregate Supply Function (ASF)
(b) Aggregate Demand Function (ADF)
4. The level of Effective demand is determined at point where ASF = ADF
5. The level of ‘Effective demand’ therefore becomes the crucial factor in Keynes
theory in determining level of employment and output.
Therefore, if the level of ‘Effective Demand’ is high, the level of employment also
will be high and if the level of Effective Demand is not high enough, it would generate
shortages in aggregate demand and therefore the possibilities of unemployment. Keynes
found that in a purely Capitalist system the level of effective demand was not high
enough to support full employment and therefore advocated Government intervention
to solve the problem of unemployment.

13.3.3 Concept of Effective Demand (ASF and ADF)

Since the level of ‘Effective Demand’ is dependent on ASF and ADF, one can proceed
to explain these concepts in detail.
208 Macroeconomics

Aggregate Supply Function (ASF)

The ASF is an aggregate of individual Supply functions in an economy. To understand
the ASF, it is necessary to understand the concept of Individual Supply Functions.
This is explained as given below:
1. Every producer or entrepreneur while producing any given level of output has
to incur some costs of production in the form of cost of raw materials, labour,
machines, depreciation charges, fixed assets etc. which constitutes the total
cost of production.
2. The Total Cost of Production (TC) is made up of Fixed Costs (FC) and Variable
Costs. (VC).
TC = FC + VC
For example, if a producer produces 10 units, he may incur ` 100 as cost, if
output increases to 15 units, his cost may rise to ` 150 and so on.
3. The cost of production gives the minimum expected level of receipts below which
a producer would not like to produce and supply a particular level of output.
In the above example if the producer wants to sell 10 units of output then
his minimum expected receipt would be ` 100.
4. Every individual producer expects to receive a price which at least covers his
cost of production. No rational producer would like to accept a price below
his cost of production.
5. The individual Supply Function expresses a relationship between various
levels of output and the minimum expected receipts from the sale of these
different levels of output.
6. If such ‘Individual Supply Functions’ are aggregated for all producers/
entrepreneurs in an economy, it will give the ‘Aggregate Supply Function.’
7. The ASF is a schedule of minimum amount of receipts required to produce
varying quantities of output hence employment.
8. The ASF shows the relation between varying levels of output/employment and
the total costs of producing these levels of output.
9. In Keynes’ analysis as the level of output and employment goes on increasing,
the total costs also increase till the level of full employment is reached. Beyond
this level, the costs go on increasing (which can be attributed to the law
of diminishing returns, increasing competition among producers, increasing
input costs, etc.) but output remains constant because economy has attained
full employment.
Therefore, the Aggregate Supply Function can be defined as, ‘A schedule which
shows the minimum expected receipts for different levels of output and employment.’
The ASF indicates the Supply Price of various levels of output or it represents the
Total Cost aspect of production.

Aggregate Supply Schedule

The Aggregate Supply Function can be drawn on the basis of the Aggregate Supply
Schedule. This Schedule shows the relationship between different levels of output,
employment and the minimum expected receipts (Table 13.1).
Keynes’ Theory of Output, Employment and Income Determination 209

TABLE 13.1 Aggregate Supply Schedule

Levels of Output and Employment (Units) Minimum Sales Expected Receipts (`)
10 400
20 600
30 800
40 1000
50 1200
50 1400

Note: One point of clarification must be made here that in Keynes’ analysis, employment is
used to measure output since employment and output are determined simultaneously. Further,
Keynes believed in the labour theory of value where all value can be converted into labour value.
Therefore, he expressed all costs in terms of wage costs.

Explanation
1. As can be seen, initially as output increases the total cost or minimum
expected receipts also increase till the level of full employment is reached at
level 50 for example, in the Table given above.
2. Once this level is reached, output/employment will remain constant but costs
would go on increasing.

Aggregate Supply Function: The shape, nature, and behaviour of the Aggregate
Supply Function is shown in Figure 13.1.

FIGURE 13.1 Aggregate Supply Function.

Explanation
1. Initially, as the levels of Output/Employment increases, the minimum expected
receipts (Total Costs) also go on increasing till the level of full employment is
reached at OQf (i.e. at level 50).
2. Beyond the level of full employment, the level of employment and output
remains constant at Qf whereas total cost goes on increasing.
3. Therefore, the ASF takes the above shape.
This is a linear function one can also draw a non linear function.
210 Macroeconomics

Aggregate Demand Function (ADF)

The second important factor determining the level of ‘Effective Demand’ is the ADF,
explained as given below:
(a) The ADF is an aggregation of individual demand functions.
(b) An individual demand function shows the maximum that consumers are
willing to pay for different levels of output and employment.
(c) In simple words, it is the demand price for various levels of output.
(d) When such individual demand functions are aggregated, it gives the total
demand of all individuals in an economy for different levels of output.
Therefore, the ADF can be defined as ‘The maximum expected sales proceeds
from different levels of output.’ It is the maximum that consumers are willing to pay
for different levels of output or it represents the Demand Price or Total Revenue
(expected) from the sale of various levels of output.
A point to be noted is that ‘how much individuals can pay’ would depend on the
level of income. The level of income in an economy is itself dependent on the level of
output and employment. Hence, the ADF is a positive function of the level of output
and employment, as level of output increases, the aggregate demand price also tends
to increase.

Aggregate Demand Schedule

The aggregate demand schedule states the relation between various levels of
employment and the maximum sales proceeds from the sale of those levels of output.
This is shown in Table 13.2.

TABLE 13.2 Aggregate Demand Schedule

Levels of Employment / Output (Units) Maximum Expected Sales Proceeds (`)

10 550
20 700
30 850
40 1000
50 1150
50 1300

Observation: As output and employment go on increasing, the expected sales

proceeds or the demand price increases. After the level of full employment is reached,
the demand price goes on increasing but output and employment remains constant at
level 50 in the example.

Aggregate Demand Function

On the basis of the ‘Aggregate Demand Schedule’ one can draw the Aggregate Demand
Function (ADF) as given in Figure 13.2.
Keynes’ Theory of Output, Employment and Income Determination 211

FIGURE 13.2 Aggregate Demand Function.

Explanation
1. The ADF is a positive function of the level of employment and output.
2. The ADF begins from above the origin ‘a’ indicating that even at zero level of
income there is some positive consumption, (i.e. meet the basic minimum needs).

13.3.4 Determination of Equilibrium Level of Output/Employment

(At Less Than Full Employment)
The Equilibrium level of output and employment in Keynes’ Theory is determined at
the level of Effective Demand, i.e. at the point, where,
ASF = ADF
As stated earlier, this is also a point where Supply Price = Demand Price. The ASF
or Supply Price represents the Costs of Production (including competitive profit). The
ADF represents the Revenue from sale of output. Thus, in familiar terms, equilibrium
will be established at a point where Costs = Revenue. As long as Revenue is greater
than Costs, employment/output will go on increasing. The equilibrium level of output
and employment will be determined at the point where Revenue = Cost. Beyond this,
when costs exceed revenue employment and output will have a tendency to decrease,
since no rational producer will produce at a level of output whose cost exceeds revenue.
To sum up,

1. When ASF = ADF Equilibrium level of Output/Employment.

or C = R
2. When ASF > ADF Output and Employment has a tendency to decrease.
or C > R
3. When ASF < ADF Output and Employment has a tendency to increase.
or C < R

In sum therefore, the point where ASF (costs of production) is equal to ADF (the
revenue from sale of output) is the point of ‘Effective Demand’, which determines the
equilibrium level of employment and output in Keynes theory. And this equilibrium
in Keynes analysis can occur before the level of full employment.
212 Macroeconomics

TABLE 13.3 A Comparison of ASF/ADF

Levels of Minimum Maximum Comparison of Behaviour of

employment/ expected receipts expected sales levels of ASF employment/
output (ASF) (`) proceeds (ADF) and ADF output
(`)
10 400 550 ASF < ADF Output/
Employment will
20 600 700 ASF < ADF
increase
30 800 850 ASF < ADF
40 1000 1000 ASF = ADF Equilibrium
level of output
and employment
at less than full
employment
50 1200 1150 ASF > ADF Output/
Employment will
50 1400 1300 ASF > ADF
decrease

Observations
As can be seen in Table 13.2, equilibrium level of employment is determined at the
level of 40 where ASF = ADF which is the level of effective demand. This is below the
full employment level, i.e. at 40 indicating that in Keynes theory equilibrium occurs
at less than the full employment level. According to Keynes, it is ‘deficient demand’
or ‘shortages in aggregate demand’ which leads to unemployment in an economy.
This analysis is illustrated diagrammatically in Figure 13.3.

FIGURE 13.3 Determination of Equilibrium at less than Full Employment.

Keynes’ Theory of Output, Employment and Income Determination 213

Explanation
1. In Figure 13.3, the level of equilibrium employment/output is determined at
the point Qe which corresponds to point ‘e’ where ADF = ASF which is the
level of effective demand.
2. This equilibrium occurs at employment level Qe which is below the full
employment level indicated by QF in the diagram.
According to Keynes, it is shortfall in the aggregate demand, which is the
main cause of unemployment in a capitalist economy.
3. Before point ‘e’ is reached, ADF > ASF, so employment /output will go on
increasing. Beyond point e, ASF > ADF and hence employment will begin
to decrease. Thus, ‘e’ becomes the point of effective demand determining the
equilibrium level of output and employment.
4. The equilibrium level of price is determined at point Pe corresponding to point
‘e’ in the diagram.
5. According to Keynes, an increase in the level of effective demand can increase
the level of employment and output to the full employment level, i.e., QF.
6. Changes in the ASF or ADF could bring about the desired change in the level
of effective demand. In the Keynesian analysis, it is the ‘aggregate demand
function’, which becomes important to bring about changes in the level of
employment and output.

Importance of Aggregate Demand Function

In Keynes analysis, ASF is considered to be a relatively stable function in the short-run
and hence, it is the ADF which becomes crucial in determining the level of employment.
The aggregate supply function is considered to be a relatively stable function
and received little importance in the further analysis because of the following factors:
1. The Keynesian analysis is a short run analysis.
2. In the short-run the stock of capital and technology are considered to be stable.
The General Theory is therefore a theory of ‘aggregate demand’. It is the changes
in aggregate demand which becomes the effective element in determining the level of
effective demand and hence employment and output in an economy.

13.3.5 Significance of Effective Demand

Effective demand is the most important element in Keynes Theory. The level of effective
demand in the economy would determine the level of employment. The level of effective
demand is basically the aggregate demand and is made up of two components, Consumption
demand and Investment demand. Any shortfall in these could cause unemployment.
To elaborate, the effective demand is the aggregate demand in the economy which
is made up of the consumption demand or consumption expenditure and investment
demand or investment expenditure. This can be denoted as:
AD = C + I
Keynes showed that as income goes on increasing in an economy, consumption
demand increases but at a slower rate and hence, a consumption gap is created. This
consumption gap can be overcome only if the investment demand is able to increase
214 Macroeconomics

at an adequately high rate. However, according to Keynes, investment left to the

private individuals fails to generate the required demand to sustain full employment
equilibrium. Government intervention thus becomes essential to ensure full employment.
The level of effective demand will increase if C increases or I increases. However,
according to Keynes, in a private capitalist economy left to itself, consumption and
investment expenditures are not high enough to generate full employment. What
Keynes advocated was to introduce government expenditures to overcome the shortages
in aggregate demand to achieve the level of full employment in an economy. Government
intervention could take the form of fiscal policy measures like Government expenditures,
taxes, subsidies, deficit financing. Government expenditures would increase the level of
Effective Demand and enable an economy to attain full employment equilibrium. By
introducing government expenditure, the aggregate demand would become
AD = C + I + G
where the term ‘G’ is government expenditure.
In this manner, a capitalist economy would solve the problem of unemployment
in times of recession and depression in the economy. This is shown in Figure 13.4.

FIGURE 13.4 Effect of Government Expenditures on Equilibrium Level of Employment.

13.3.6 Keynesian Remedy to Unemployment (Government Intervention)

When the government intervenes in an economy and undertakes expenditures, it
generates demand in the economy, thereby increasing the level of aggregate demand.
Figure 13.4 shows how an economy can reach the level of full employment due to
government intervention.
Explanation
1. Keynes advocated government expenditures to sustain full employment in
a capitalist economy. As can be seen in Figure 13.4, in the absence of the
government the level of aggregate demand is shown by AD = C + I. Equilibrium
Keynes’ Theory of Output, Employment and Income Determination 215

is established at point e, where AD = ASF, and the level of output employment

is determined at point Qe which less than full employment level Qf.
2. By introducing government expenditure ‘G’, the level of aggregate demand now
shifts up to AD1 = C + I + G. Equilibrium is now established at point e1 where
AD1 = ASF and the level of employment is now determined at Qf level which
is full employment level. (The aggregate demand gradually increases due to
government expenditures to enable equilibrium at full employment level.)
3. The shortfall in the aggregate demand, i.e. effective demand is made good by
government expenditures as a result it is possible to attain full employment.
4. Keynes strongly advocated government intervention through fiscal policy
measures to solve the problem of unemployment and stabilise the economy.
These measures would include government public works program like building
roads, dams, reduction in taxes, subsidies and government investments,
expenditure on infrastructure, public debt and deficit financing.

Consumption and Investment Function

The Aggregate Demand consists of:
(i) Consumption Demand
(ii) Investment Demand
Consumption Function: The consumption demand, which is analysed under the
Consumption Function is an important component in the aggregate demand. The
Consumption Function studies the relation between the income and consumption
expenditure, i.e., the behaviour of consumption when income changes. Keynes has
shown in his analysis that as income increases consumption increases but at a lower
rate than the increases in income so that, a consumption gap between income and
consumption is created. The consumption demand is also considered to be relatively
stable in the short-run because of the relatively stable nature of the factors affecting
the consumption demand.
(The consumption function is discussed in detail in Chapter 14)
Investment Function: Since consumption does not increase at the same rate as
income, and since it is considered to be relatively stable in the short run, what becomes
the most important factor to step up the level of effective demand in the Keynesian
analysis is the Investment demand. According to Keynes, Investment Expenditure
must increase at a rate high enough to sustain a high level of investment demand as
well as to overcome the continuously increasing gap in aggregate demand caused by
deficiencies in consumption expenditures, if an economy has to attain full employment.
However, the investment demand is itself, dependent on a number of factors mainly:
(a) The marginal efficiency of capital or the expected rate of profit.
(b) The rate of interest.
However, it is necessary to mention here that, of the above two factors, the rate of
interest is considered to be relatively stable in the short-run and it is the fluctuations
in the marginal efficiency of capital which finally determines the level of investment.
The marginal efficiency of capital, as will be seen later, is nothing but the expected
rate of profit from business. The marginal efficiency of capital, i.e., expected rate of
216 Macroeconomics

profit, according to Keynes, in a private capitalist economy is not high enough to

sustain full employment in the economy. This was the reason why Keynes advocated
Government intervention to bring about full employment in a capitalist economy.
(The investment function is discussed in detail in Chapter 15.)

Conclusion
To conclude, in the Keynesian theory, since consumption expenditure has its limitations
and is relatively stable in the short-run, the major burden of sustaining Effective
or Aggregate demand at full employment levels falls on the Investment demand
or Expenditures. Private investment, by itself, cannot generate aggregate demand
high enough to sustain full employment equilibrium and hence Keynes advocated
Government intervention to attain full employment in a capitalist economy, mainly
through fiscal policy measures.
The basic model of the Keynesian Theory of Output and Employment can be
illustrated as shown in Chart 13.1 given below:
Chart 13.1 Basic Model of Employment and Output Determination in the Keynesian System
Keynes’ Theory of Output, Employment and Income Determination 217

13.3.7 Basic Points of Criticism of the Keynesian Theory

Though the Keynesian theory was without doubt a major breakthrough from the
traditional Classical beliefs and made a revolutionary beginning for modern economic
thinking, it is not free from some basic limitations. Keynes’ work drew a variety
of reactions. First, there was a school of thought who said that Keynes was saying
nothing new; he was only using a different terminology, e.g., the ASF, ADF, liquidity
preference, multiplier etc. This view was taken by G.H. Haberler, Lionel Robbins,
F., Hayek, A.C. Pigou to mention a few. There were others who were critical of Keynes’
ideas. This group included the famous monetarists and supply side economists, like
Milton Friedman, Brunner, Meltzer, Arthur B, Laffer etc. There was however a group
of very influential economists such as Alvin Hansen, R.F. Kahn, Paul Samuelson,
Lawrence Klein, John Hicks, Franco Modigliani, Abba Lerner and others who felt that
Keynes’ work was revolutionary in as much as it focussed attention on the rigidities
of important prices like the wage rates and the interest rates in modern capitalist
economies. These rigidities were more or less assumed away by the Classical economists
with the result that their models were simply incapable of explaining the predominant
problem that arose in 1930’s. It is largely due to the work of these scholars that we
have today a full-fledged Keynesian model.
However, for our purposes we will not go into detailed criticism here, but briefly
list out the main points of criticism of the Keynesian analysis:
(i) The assumption of perfect competition may not hold.
(ii) It has not considered dynamic changes in long run and restricts itself to the
short run analysis.
(iii) The technology and the capital stock is assumed to be constant in the short
run which restricts the dimensions of the analysis.
(iv) It is a depression analysis, i.e. it concerns itself with how an economy can
come out of depression of 1930’s. Deficit-financing an important instrument
advocated by Keynes for removing depression cannot be applied successfully
to many economies now given the inflationary nature of this instrument.
(v) The Keynesian analysis was concerned with cyclical unemployment which occurs
during depression and recession and not the chronic type of unemployment
which characterizes underdeveloped countries and so his policy measures may
not directly impact the unemployment problem in such economics. It also
gives no solution to problems like disguised unemployment, a major problem
in such economics.
(vi) It ignored the influence of international trade and its impact on demand,
employment, and income in an economy.
(vii) Being an aggregative macroeconomic analysis, micro problems are not
considered.
(viii) The multiplier analysis, a very important concept of the Keynesian theory is
too mechanical.
(ix) Finally, Keynes was concerned with the problems of a capitalist economy and
suggested government intervention as remedy, it thus becomes irrelevant to
socialism and its problems.
218 Macroeconomics

13.4 RELEVANCE OF KEYNES IN PRESENT CONTEXT

Though a number of schools of economic thought developed in the latter years, the
tendency and temptation to return to Keynesian economics is witnessed time and again.
Keynes’ views, analysis, and deep understanding of the Great Depression of
1930’s, and the causes and solutions to depression and recessions which he had
advocated, gains relevance every time a recession or depression surfaces.
The major cause of any recession or depression Keynes had found to be in
Shortages of aggregate demand which results from excess savings over investment,
underconsumption and building up of inventory stocks. As level of profitability declines
or expected rates of profit (mec) in business fall, business pessimism sets in, and
the downswing in economic activity is set into motion, resulting in recession and
cumulating into depression if not controlled. Very briefly this is the essence of the
recessionary phase.
His solution of an aggressive use of the fiscal policy to combat recession and
depression is the mainstay of government policies even today to bring an economy
out of recession.
The recent recessionary/depressionary conditions which emerged due to an
aftermath of the ‘Global Financial Meltdown’ (2008) has been tackled not so much by
monetary measures but predominantly by fiscal measures.
The Fiscal Stimulus measures in various countries agreed upon in the G20
Summit Meet, and also the policy prescriptions of reforming the International Financial
system to create International stability are mainly policy prescriptions given by Keynes
to stabilise an economy.
The reason for a continuous return to Keynesian arguments, both at the theory
and policy levels, lies in the fact that in spite of rapid institutional, behavioural, and
economic changes, since 1936 i.e. almost 70 years after Keynes, the world has witnessed
many economies still in recession with mass unemployment. The primary reason for
this still remains to be ‘shortages of aggregate or ‘effective demand’ and the primary
solution to recession still remains to be not so much monetary but fiscal policies as
stated and advocated by Keynes.

Points to Remember
• Keynes General Theory (1936) addresses itself to 3 main issues:
(a) The determination of the Equilibrium level of output employment and
income.
(b) The causes of unemployment
(c) The solutions to the problems of unemployment.
• The equilibrium level of output/employment in Keynes model gets determined at
the level of ‘Effective Demand’ which itself is dependent on two crucial factors:
(a) Aggregate Supply Function (ASF)
(b) Aggregate Demand Function (ADF).
• ASF being relatively stable in the short run and Keynes Theory is a short run
analysis, the burden of generating full employment in a capitalist economy falls
on the ADF.
Keynes’ Theory of Output, Employment and Income Determination 219

• The ADF which is the ‘Aggregate Demand’ AD is made up of the Consumption

demand (C) and Investment demand (I). On analysing these two aspects in detail
Keynes arrives at the following conclusions:
(a) That the ‘C’ or consumption demand does not keep pace with increases
in Income (Y) and hence generates possibilities of shortages in C or a
‘Consumption gap.’
(b) That private Investment demand denoted as I is not high enough in a
capitalist economy to support full employment.
(c) Therefore, it is ‘Shortages in AD’ which is the prime cause of unemployment
in capitalist economy, contrary to the classical belief that “Supply would
always create its own demand’ and thus guarantee full employment tendency
is a capitalist system.
• To support and sustain the economy at full employment, Keynes thus advocated
Government intervention through mainly fiscal policy measures like Government
expenditures, taxes and subsidies. This would push up the ‘AD’ taking the economy
closer to full employment.
• It should be noted that Keynes was concerned with unemployment of the type that
characterises depression and hence was dealing with mainly the problems and
causes of cyclical unemployment which characterises capitalist economies. His
theory therefore is best understood in this context. His theory is popularly known
as a ‘Theory of Depression’ or a ‘Theory of Shortages in Aggregate Demand’.
• Keynes causes of and solutions to recession and depressionary condition are of
relevance even in the contemporary times.

APPENDIX I
Relevance of Keynes in Contemporary Times
(A Case Study of the Global Financial Meltdown 2008–2009)
You have to know that I believe myself to be writing a book on economic theory which
will largely revolutionize not, I suppose, at once but in the course of the next 10 years—
the way the world thinks about economic problems.
—J.M. Keynes in a letter to GB Shaw, 19351

The recurring recessionary conditions which recur almost across the whole world
compels one to recall the Great Depression of 1929–33, its causes, consequences and
solutions. The Global Financial Meltdown of 2008–2009, and its aftermath created a
“crisis of confidence” in the financial sector and spread to the real sector, the impact of
which is seen in the declining trend in crucial macroeconomic variables. Uncertainties
and risks, dominate economics throughout. In such an atmosphere, economists and
policy makers tried to find a theoretical basis or policy prescription which would
stabilise the situation. A name which emerges in such situations is that of John
Maynard Keynes.

1. As quoted in R.F. Harrod, The Life of J.M. Keynes (1951).

220 Macroeconomics

Keynes’ views, analyses and a deep understanding of the great depression of

1930’s and his strong beliefs in the working of government policies, especially the
fiscal policy, his views on the limitations of the working of the monetary policy during
recession, are re-emerging in modern times as solutions to combat the risks and
uncertainties associated with economic recessions across the world.

Keynes on Economic Recessions

In the context of business cycles, a period of economic expansion and prosperity is
generally followed by a period of recession or financial crisis and, in some cases, a
prolonged depression. As regards a recessionary phase Keynes believed, and it has
been proved, that the major cause of any recession is shortages in aggregate demand
resulting from an excess of savings over investment, declining sales of goods and
services and a build-up of inventories. All this leads to falling levels and rates of
profitability, which Keynes termed as the marginal efficiency of capital (mec). As levels
of profitability decline or expected rates of profits in business fall, business pessimism
sets in, and the downswing in economic activity sets into motion. Very briefly this
is the essence of a recessionary phase. Shortages of aggregate demand in recession
imply that sales of firms suffer. They face high liquidity crunch and this causes them
to default on loan repayments. Banks have excess liquidity because opportunities to
invest funds are limited. Banks cannot keep idle funds and therefore they desperately
begin looking for new lending and investment opportunities. This has the potential to
trigger into a financial crisis.

Genesis of the Global Financial Meltdown 2008–2009

The financial meltdown of 2008–2009 in the USA has a similar story to tell. After
a phase of prosperity between 1997–2001, the US Economy witnessed the first signs
of a recession in the year 2002. The GDP growth rates within a period of one year
declined from 5% in 2001 to 0.3 percent in 2002. The sequence of events that followed
the recession of 2002 were:
(i) Profitability in business showed a decline
(ii) Banks were not willing to lend to unprofitable enterprises
(iii) Corporates began to default because of liquidity crunch
(iv) Banks too were not willing to extend funds in such uncertain times.
In such a situation, banks were desperate for sound investment opportunities and
this is when the booming real estate sector in the US captured the attention of the
banks which were high on liquidity. Herein, began the story of the subprime crisis.
Banks and financial institutions started lending funds to the subprime borrowers
for house loans (given the fact that the prime-borrowers’ list was already exhausted
or there were no takers). This coupled with the securitization of loans, i.e., passing
on existing loans to other financial institutions at discounted interest rates, further
aggravated the problem by spreading the subprime risks across the financial system.
Huge defaults, a weak loan recovery system, corrections in the housing prices which
had been artificially pushed up due to huge speculations in this market, falling value
of home mortgages—all of these developed into a financial crisis with its origin in the
Keynes’ Theory of Output, Employment and Income Determination 221

already existing recession in the US. The collapse of the Lehman Brothers and Bear
Stearns, the weakening of Morgan Stanley and Goldman Sachs and the failure of
9 commercial banks in September 2008 was the final straw, and the US was declared as
facing one of the worst crises since the 1930s depression. Thus, the economic recession
aggravated into an economic, business and financial crisis culminating into what
today is popularly known as the Global Financial Meltdown or the ‘Great Economic
Recession’. Keynes in his general theory had very rightly cautioned the world way
back in 1930s, when he had said that “Speculation is harmless as bubbles riding on a
steady stream of enterprise. But the position is serious if enterprise becomes a bubble
on the whirlpool of speculation.”2 Interestingly, this is precisely what happened in
the subprime crisis and the financial crisis where speculation in the housing sector
in fact seemed to lead the growth of the US economy. This is evident from the fact
that the GDP of the US picked up from the rate of 2.4% in 2003 to 4.5% in 2005 and
then 3.2% in 2006–2007. It declined to an abysmal 2.2% in 2008 (after correction of
housing prices).

Keynesian Policy Prescriptions for Recession and Financial Speculative Crisis—the

Fiscal Stimulus Package
The Keynesian view states that what works in recession is not so much the monetary
measures but the fiscal policy measures which are in the nature of tax cuts and
increasing government expenditures. This boosts aggregate demand (and through
the multiplier process) also the output, incomes and employment in the economy.
Keynes also advocated deficit financing and Government borrowing for public works
programme—all this would naturally pump money into the economy, thereby pushing
up the demand in the economy. These were precisely the recommendations of the G20
summit meet and the IMF with regard to the solutions to crisis of 2008–2009. The IMF
estimated that that the drop in demand caused by the crisis would require a substantial
fiscal stimulus of at least 2% of the world GDP, which amounts to almost $1.5 to 1.8
trillion, if the world growth has to be sustained. If the growth is higher in forthcoming
years, this package will have to increase further. This has to be coupled with targeted
tax cuts. The public expenditure programmes have to be both short and long term in
nature as advocated by Paul Krugman to sustain employment and economic growth
over the next couple of years. The US then announced a $ 700 billion package to be
topped up with $800 billion more, if the need arises. But this package was basically
in the nature of a bailout package and not really a spending plan of the Keynesian
type. China in November declared a 4 trillion Yuan package and India, in spite of
its commitment to the FRBM declared a ` 31,000 crores package directed mainly to
infrastructure. Many other countries followed the similar trend.

Ineffectiveness of the Monetary Policy Measures during Recession

Following the crisis, the US Federal Reserve and the central banks of a number
of countries began cutting the interest rates to inject liquidity into the market and
encourage borrowings by corporate and business in the hope of initiating the recovery.

2. J.M. Keynes, The General Theory of Employment, Interest and Money, 1936, London, Macmillan.
222 Macroeconomics

However, the fact remains that in a period of recession or depression. monetary

measures have a limited use because of:
1. Low expected rate of profit
2. A slack effective and aggregate demand
3. Low business morale
4. A reluctance on the part of the banks to lend at such times.
Indeed, this was visualised by Keynes and is akin to the concept of liquidity
trap enunciated by him. An emphasis on fiscal policy measures seems to be a strong
policy alternative to boost an economy in recession—its impact is more direct whether
through government expenditure programmes or through tax cuts.

The Return to Keynes

The reason for a continuous return to the Keynesian arguments, both at the theory
and policy levels, lies in the fact that in spite of the rapid institutional, behavioural,
and economic changes that the world has witnessed since 1936 (almost a period of 70
years after Keynes), the fact remains that many economies witness recurring recessions
with mass unemployment. The primary reason for this is the shortages of effective
demand originating in different ways and for different causes and the policy measures
still tilt in favour of fiscal policy initiatives with monetary measures taking a backseat
during recession.
Keynesian economics even in its original 1930’s form has a lot to contribute to the
current global economic recessionary conditions and policy makers continue to return
to Keynes policy prescriptions even after almost seven decades.

QUESTIONS

I. Short Questions
1. Explain the concept and significance of effective demand in Keynes’ Theory.
2. Aggregate supply function represents the ‘producers’ point of view in Keynes
Theory of output, income and employment determination. Explain.
3. Discuss the meaning and significance of the aggregate demand function in
Keynes’ theory of output income and employment determination.
4. Explain Keynes critique of the Classical Theory.
5. How do shortages in aggregate demand explain unemployment in Keynes’
analysis?
6. What are the significant contributions of Keynes’ Theory relevant to the
contemporary times?

II. Long Questions

1. ‘The equilibrium level of output and employment in Keynes’ Theory is
determined at the level, where, ADF = ABF.’ Explain. What accounts for
unemployment in this theory?
Keynes’ Theory of Output, Employment and Income Determination 223

2. Keynes Theory is a theory of shortages in aggregate demand. Explain.

3. ‘The level of output and employment is determined at the level of effective
demand.’ Explain. Show how and why the effective demand in Keynes theory
falls short of full employment equilibrium.
4. Show how equilibrium occurs before full employment in Keynes’ Theory.
How can government intervention bring about full employment?
5. ‘Shortages in aggregate demand explains unemployment and recessionary
trends in an economy in Keynes’ Theory.’ Is this explanation valid in
contemporary times? Elaborate.
6. ‘Keynes’ analysis of the causes and solution to recession are valid to a large
extent even today.’ Do you agree? Explain.
7. ‘Fiscal Policy is more effective than Monetary Policy to bring an economy
out of recession.’ Explain Keynes’ views on this. Does it corroborate with
real world situations?
CHAPTER

14
Consumption Function

14.1 INTRODUCTION
The level of output and employment in Keynes Theory is determined at the level
of effective demand. Effective demand itself is determined by the aggregate supply
function and aggregate demand function. Since the aggregate supply is considered to
be relatively stable in the short run, aggregate demand assumes great significance in
Keynes’ theory.
The aggregate demand is made up of:
1. Consumption demand
2. Investment demand (expenditures).
It is a shortfall in the aggregate demand which leads to unemployment in the
economy. Keynes discussed these two very important concepts under Consumption
Function and Investment Function.

14.2 MEANING OF CONSUMPTION FUNCTION

The consumption function studies the relationship between consumption expenditures
with respect to changes in income.
It shows how consumption expenditures change when the level of income changes.
It is one of the most important innovations of Keynes’ analysis and is of crucial
importance in explaining the problem of unemployment in his theory.
The consumption function is defined as the relationship between the size of
national income (Y) and size of consumption spending. The aggregate consumption in
an economy is an aggregation of individual consumption functions.
Keynes analysed the above relationship and came to the following conclusions:
1. Consumption (C) and Income (Y) are positively related. Therefore, C = f(Y),
where, C is the level of consumption and Y is the level of income.
2. As the level of income increases, consumption increases, but less than in
proportion to increases in income.
224
Consumption Function 225

3. This gives rise to a ‘consumption gap’ in the aggregate demand causing problems
of shortages in aggregate demand and the possibility of unemployment. This
behaviour of the consumption function is explained by what Keynes termed
as the Fundamental Psychological Law of Consumption.
Note: Keynes stated the law as The fundamental psychological law upon which we
are entitled to depend with great confidence, both from our prior knowledge of human
nature and from the detailed facts of experience, is that men are disposed, as a rule
and on the average to increase their consumption as income increases but not by much
as increase in income.1
The law states that as the level of income increases, consumption increases in
less than in proportion to the increases in income because the whole of the income is
not consumed; a part of it is saved, i.e.
Y = C + S
where, Y = Income
C = Consumption
S = Savings
As a result, with every increase in income, individuals have an inbuilt tendency or
psychology to save more and more which generates a continuous gap between income
and consumption known as the consumption gap. As a result of this consumption
gap, there are shortfalls in aggregate demand and the possibility of unemployment in
Keynes’ theory.
The following implications for Keynes’ theory emerge from the above law:
1. The income of individuals is distributed under two heads, i.e. Consumption
and Saving.
2. It follows that the whole of the income is not consumed.
3. As income goes on increasing, consumption does not keep pace with increases
in income, generating a consumption gap.
4. As income level reaches higher and higher levels, the consumption gap goes
on increasing which leads to shortfalls in aggregate demand and hence, the
possibility of unemployment, unless investment can increase at a very high
rate to cover this gap.
5. As a result of the consumption gap, the burden of generating output and
employment falls on the investment demand making it very crucial to Keynes
analysis.

14.3 NATURE AND SHAPE OF THE CONSUMPTION FUNCTION

As already stated, the consumption function studies the relationship between the level
of income and consumption levels given as:
C = f(Y)

1. Keynes, John M. (1936). The General Theory of Employment, Interest and Money. New York:
Harcourt Brace Jovanovich.
226 Macroeconomics

Keynes postulated that the level of consumption increases as national income

increases, but the increase in consumption is less than the increases in income. The
consumption function can be stated in the form of a simple equation:
C = a + bY
where, C = Level of Consumption Expenditure,
Y = National Income,
a = Autonomous Consumption which has to be incurred even at Income Level
Zero,
b = Proportion of Income which is consumed.
Note: ‘a’ gives the intercept of the consumption function and ‘b’ is the slope of the
function.

14.3.1 Consumption Schedule

The consumption schedule shows the relationship between various levels of income
and various levels of consumption expenditures as given Table 14.1.

TABLE 14.1 Consumption Schedule

Levels of Income (`) Consumption Expenditures (`)

(Y) (C)
100 140
200 220
300 300
400 380
500 460

Observations
1. ‘C’ is positively related to changes in ‘Y’.
2. Initially C > Y indicating some negative savings, i.e., dis-saving (this is the
autonomous consumption, i.e. ‘a’ in the equation C = a + bY).
3. At one point, Y = C. Therefore savings = zero.
4. Beyond that as income (Y) goes on increasing, consumption increases but less
than the increases in Y, which means savings are positive. The total income
therefore gets divided into consumption and savings (i.e. C + S), so that
savings function is automatically derived from the consumption function as
Y = C + S
\ S = Y – C
where, S = Savings
Y = Income
C = Consumption Expenditure
The above implies that whatever is not consumed is saved and therefore the
linkages between consumption and savings.
Consumption Function 227

14.3.2 Consumption Function

The consumption function can be drawn on the basis of the consumption schedule as
given in Figure 14.1.

FIGURE 14.1 Consumption Function.

Explanation
1. The 45° line C = Y in the figure indicates a condition where at every level,
income is equal to consumption. This is the equilibrium line denoted as C = Y.
2. The consumption function begins from above the origin at point, ‘a’ which
implies that even at income zero, some minimum consumption is necessary.
(This is the autonomous consumption).
3. The consumption function C = a + bY states that at any point of time the
consumption expenditures is made up of some autonomous expenditure ‘a’
plus some proportion of the income, i.e. bY.
Note: b is always less than 1 because if b = 1 then it would mean the
whole of income is consumed; which is not so, as already established by the
‘Fundamental Law of Consumption.’
4. Point ‘e’ corresponds to a level where C = Y. Before the point ‘e’ is reached,
C > Y, indicating negative savings; at ‘e’ point. C = Y. Therefore, savings are
zero. Beyond point e, Y > C which implies positive savings. This is how the
savings function is directly derived from the consumption function.

14.4 DERIVATION OF THE SAVING FUNCTION FROM THE CONSUMPTION

FUNCTION
As stated, Y = C + S. Therefore, savings is income minus consumption given as
S = Y – C
Given the consumption expenditures at various levels of income, savings can
easily be calculated as the difference between income and consumption; thus, the savings
function can directly be derived from the consumption function. Considering the earlier
228 Macroeconomics

numerical example of the consumption function, one can calculate the level of savings
and draw the savings schedule as given in Table 14.2.

TABLE 14.2 Savings Schedule

Level of income (`) (Y) Consumption expenditures (`) (C) Savings (`) (S = Y – C)

100 140 – 40
200 220 – 20
300 300 0
400 380 + 20
500 460 + 40

14.4.1 Saving Function

Based on the above schedule one can derive the savings function given in Figure 14.2.

FIGURE 14.2 Savings Function.

Explanation
1. At every level of income, savings is the difference between income and
consumption, hence at all level of income Y = C – S.
2. The savings function in Figure 14.2 begins from the negative axis at ‘–a’
corresponding to ‘a’ on the positive axis. ‘–a’ is the negative savings or dis-
savings.
3. At a point where Y = C, S = 0, the savings function will cut the income axis
at ‘r’ corresponding to point ’e’ where S = 0.
4. Beyond this level, since income is greater than consumption, the difference
between Y and C becomes the level of savings and as can be seen there is a
positive relationship between Y and S.
Notes:
1. Both the savings and consumption functions are aggregate functions and
therefore, the possibility of savings exceeding consumption at the aggregate
level would not hold.
Consumption Function 229

2. As income increases, savings go on increasing and hence as progress takes

place there are greater and greater possibilities of shortfalls in aggregate
demand.

14.5 TWO IMPORTANT ASPECTS OF THE CONSUMPTION FUNCTION

(MPC AND APC)
In the discussion of consumption function, there are two attributes of the function the
marginal propensity to consume, i.e. mpc, and the average propensity to consume, i.e.
apc. which are used for the measurement of the propensity or tendency to consume
in an economy as income changes.

14.5.1 Marginal Propensity to Consume (MPC)

The marginal propensity to consume has been defined as the rate at which consumption
changes with changes in income or it is the additional consumption, which takes place
due to additions in income.
DC
mpc =
DY
where, ∆C = Change in Consumption
∆Y = Change in Income
What the mpc shows is that if income increases by ` 10 and consumption increases
by ` 6 then mpc can be calculated as:
6
mpc =
10
= 0.6

In this case, mpc is 0.6, i.e., out of every ` 1 earned as income, 0.6 or 60 paise
is spent or becomes consumption expenditure. The concept of the marginal propensity
to consume assumes great significance to explain a number of issues in the Keynesian
analysis.
A basic feature about the mpc should be noted is that the mpc is always less
than one, i.e. mpc < 1.
In the equation C = a + bY, b is the mpc which is less than one, indicating that
as income increases, consumption increases at a lower rate than the increase in income
generating a continuous consumption gap. The mpc, therefore, measures the tendency/
propensity individuals to consume as income changes.
Keynes analysed the available date on income and changes consumption and came
to the following major conclusions which have important implications for his theory
1. mpc is higher for less developed countries and ranges between 0.8 to 0.9.
2. It is lower for more developed countries and ranges between 0.6 to 0.7.
3. He also found mpc to be relatively stable.
230 Macroeconomics

14.5.2 Marginal Propensity to Save

Marginal propensity to save can directly be derived from the mpc and is denoted as
mps. Whatever is not consumed is saved.
Y = C + S
S = Y – C

\ mpc + mps = 1

Considering the earlier numerical example,

mps = 1 – 0.6 = 0.4

14.5.3 Average Propensity to Consume (APC)

The average propensity to consume measures by how much, on an average the
consumption expenditure changes with changes in the level of income, or it is the
average consumption expenditure of a society for different levels of income.
It indicates the average tendency or propensity of individuals to consume out of
given levels of income. Like the mpc, the apc also is low in more developed economies
and high in less developed economies. The average propensity to save, is the residual
after consumption. The aps is defined as:

aps = 1 – apc

Provided below is simple numerical example to understand how mpc, mps, apc,
and aps are calculated and the relation between them. This is shown in Table 14.3.

TABLE 14.3 MPC and APC

Level of Consumption Change Changes in mpc apc

Income Expenditures in Income Consumption DC/DY C/Y
(Y) (C) DY DC
100 140 — — — 1.4
200 220 100 80 0.8 1.1
300 300 100 80 0.8 1
400 380 100 80 0.8 0.95
500 460 100 80 0.8 0.92

Note: Since a part of the income is saved and a part is consumed, generally, mpc
is not equal to one. At any given point of time, whatever is not consumed is saved.
Therefore, the savings function can directly be derived from the consumption function
and the mps can be derived from mpc.
Consumption Function 231

Observations
1. mpc = DC/DY; and is directly calculated from the given figures.
2. apc = C/Y; and is also calculated from the given figures.
3. mpc is ‘b’ in the consumption function C = a + bY.
4. ‘b’ or mpc, therefore, shows by how much consumption expenditures changes
when income changes.
5. ‘b’ or mpc is considered to be constant in the short run.
6. ‘b’ or mpc gives the slope of the consumption function.
7. Greater the mpc or ‘b’, steeper will be the consumption function. Lower the
mpc or ‘b’, flatter will be the consumption function.

14.6 IMPORTANCE OF MPC AND CONSUMPTION FUNCTION

The mpc becomes a highly significant and important tool in the Keynesian analysis.
It is especially useful to understand shortfalls in aggregate demand and resulting
unemployment, and to understand the multiplier analysis. Its importance can be
highlighted as given below.
1. Explains Shortfalls in Aggregate Demand: It explains shortfalls in
aggregate demand arising out of shortfalls in the consumption level. Therefore,
it is crucial to explain unemployment in Keynes theory.
2. Distribution of Income Consumption and Savings: It explains how
additional income gets distributed between consumption (C) and savings (S).
3. The Consumption Gap: mpc being less than one (MPC < 1) clearly shows
that it is inevitable to avoid the consumption gaps and shortfalls in aggregate
demand necessary to support full employment.
4. Failure of Say’s Law of Markets: mpc being less than one also indicates
that the Say’s law of markets, which states that AS = AD does not hold. As
a result, full employment cannot be automatically assumed.
5. Importance of Investment Function: Since the mpc is stable in the short
run, there is inherent limitation on increasing consumption expenditures or
demand and therefore, in order to increase aggregate demand, it becomes
necessary to concentrate on the second component of aggregate demand,
i.e., investment demand.
6. Useful in Explaining the Multiplier Theory and Business Cycles: The
mpc and consumption function are also extremely useful in explaining the
multiplier and ups and downs in the level of business activity as shall be
explained in Chapter 16.

14.7 FACTORS AFFECTING THE CONSUMPTION FUNCTION

The consumption function in Keynes Theory depends on basically two sets of factors:
Subjective Factors and Objective Factors: These factors are assumed to be
relatively stable in the short run and hence, in the Keynesian analysis the consumption
function is also considered to be relatively stable in the short run. Generally,
consumption expenditures do not fluctuate rapidly.
232 Macroeconomics

14.7.1 Subjective Factors

These factors are dependent on the human nature and behaviour. These include
psychology of the individuals, the social structure practices, and institutions. Basically,
these are ‘human behavioural factors’ which have an influence on individual’s
consumption decision.
According to Keynes, individuals’ nature compels them not to spend the whole of
their incomes and hence, they save a part of their incomes, thereby influencing the
consumption levels. There are basically eight motives, which induce people to save and
hence affect the consumption levels:
1. Motive of Precaution: As a precaution against future unforeseen
contingencies, individuals build reserves in the form of savings, thus lowering
present consumption levels.
2. Motive of Foresight: This motive relates to providing for future needs like
retirement, old age, future education, etc.
3. Motive of Calculation: It involves a well thought out savings plan for the
future to get capital gains and interest income in future.
4. Motive of Independence: This refers to attaining financial independence
in future is in order to enjoy consumption and other benefits in future.
5. Motive of Enterprise: It refers to undertaking a business venture in future
for which individuals save in the present.
In addition to the above listed factors, there are other subjective factors like making
improvements for future, improvements in standard of living in future and so on.

14.7.2 Objective Factors

These include factors external to the individuals’ behaviour, which have a strong
bearing on their consumption expenditures. These are:
1. Changes in Fiscal Policy: Changes in taxes strongly affect the consumption
levels. The increase in tax rates for example, income tax would reduce the
disposable income and hence consumption levels and vice-versa. Other taxes
like taxes on expenditures and savings also would affect consumption.
2. Expectations about Future Prices: Due to an expected rise in price of
commodities in future, individuals would have a tendency to buy more in
present increasing the consumption expenditures in present.
3. Distribution of Income: If the distribution of income in a society is more
equal, the propensity to consume will be higher compared to a society where
the distribution is unequal.
4. Possibilities of Saving: In the savings and investment opportunities like
deposits, shares, securities, bonds, etc. are easily available in an economy
the individuals would have a tendency to save more, thereby reducing their
consumption levels.
5. Rate of Interest: Favorable rates of interest will affect savings positively but
according to Keynes, that effect is likely to be weak. The major determinant
of consumption and savings is the level of income.
Consumption Function 233

6. Expectation about Future Incomes: An expected rise in the income in

future would increase the level of consumption in present.
7. Windfall Gains and Losses: Any windfall gain or loss would affect the
consumption levels by creating sudden increases in the purchasing capacity
of individuals.
All these above mentioned subjective and objective factors affecting the consumption
function, however are not subject to frequent changes and hence, are considered to be
relatively stable in the short run. As a result, the consumption function is relatively
stable in the short-run and the burden of supporting and generating full employment
falls on investment demand. Therefore, as income increases, the consumption gap also
goes on widening. Keynes thus emphasized on investment demand to generate full
employment.

Points to Remember
• The Consumption Function (CF) deals with the relationship between levels of
national income (Y) and the levels of consumption expenditures (C).
• The aggregate consumption in an economy is an aggregation of individual
consumption functions.
• C and Y are found to be positively related and denoted as C = f (Y).
• On analysing the CF, Keynes arrives at the following conclusions which are
extremely crucial to his theory:
1. As ‘Y’ increases ‘C’ increases but less than in proportion to increase in ‘Y’
thus generating a ‘consumption gap.’
2. This behaviour is explained by the ‘Fundamental Psychological Law of
Consumption’ which states that, every individual has a tendency to save
some amount out of the given level of income or Y = C + S.
3. It is this ‘consumption gap’ which generates ‘shortages in aggregate demand’
and the problem of unemployment.
• The level of consumption depends on a set of subjective and objective factors
which are considerably stable in the short run which accounts for the stability
of the CF in the short run.
• These are two very important aspects of the consumption function:
1. Marginal propensity to consume (mpc)
2. Average propensity to consume (apc)
• The mpc refers to the rate at which consumption changes with changes in income
and is denoted as mpc = DC/DY.
The apc measures the average consumption out of given levels of income and
is denoted as apc = C/Y.
• The mpc is generally less than 1.
• Similar to the concepts of mpc, apc there are mps and aps which are marginal
propensity to save and average propensity to save.
• A point to be noted about mpc and apc is that both there are higher for less
developed countries and lower for more developed countries. As a result, as the
economy advances there are possibilities of greater ‘consumption gaps.’
234 Macroeconomics

• Since Y = C + S, whatever is not consumed is saved. Hence, the savings function

can be directly derived from the consumption function S = Y – C.
• Some very crucial implications arrive from the discussion of the CF and mpc:
1. The ‘consumption gap’ helps in explaining the shortfalls in AD causing
unemployment, to a large extent.
2. The mpc < 1 shows how it is inevitable to avoid consumption gaps and
shortfalls in aggregate demand, and also that the Say’s Law of markets
(AS = AD) does not always work and whatever is supplied may not be
demanded.
3. As a result of the above two implications the conclusion which arises is that
in Keynes analysis, the CF is not only relatively stable in the short run but
consumption cannot increase at a rate to sustain AD at the full employment
level and hence the burden of generating and supporting full employment
falls on the investment demand.

QUESTIONS

I. Short Questions
1. ‘As income increases, consumption increases but at a slower rate.’ Explain
2. Show how the saving function can be derived from the Consumption
Function.
3. Explain the essence of the Fundamental Psychological Law of Consumption
and its significance in Keynes’ Theory.
4. Why does the Consumption Function begin from above the origin?
5. Explain the significance of the mpc in Keynes theory.

II. Long Questions

1. ‘The Consumption Function analyses the relationship between increases
in income and consumption.’ Explain the Consumption Function and its
behaviour.
2. Explain the ‘Psychological Law of Consumption’. What is the significance of
this Law in Keynes Theory?
3. Show how the Consumption Function is extremely crucial to explain
unemployment in Keynes theory.
4. Show how the saving function can be derived from the Consumption Function.
Illustrate with the help of a diagram. Also explain the interrelationship
between mpc and mps.
5. ‘As income goes on increasing, Consumption increases but at a lower rate
than increases in income, creating a Consumption Gap.’ Explain the reason
for this in Keynes Theory.
Consumption Function 235

6. What are the short and long run factors affecting the consumption function?
7. Calculate the mpc and apc from the following data:

MPC and APC

Level of Consumption Change Changes in mpc apc

income expenditures in income consumption
(Y) (C) DY DC
200 250 — — — —
400 340 200 90 — —
600 430 200 90 — —
800 520 200 90 — —
1000 610 200 90 — —
CHAPTER

15
Investment Function

15.1 INTRODUCTION
Investment demand is the most crucial factor in the Keynesian theory of output and
employment determination since consumption expenditures do not increase at the same
rate as increases in income creating a consumption gap. As a result, the burden of
generating full employment in Keynes analysis falls on investment demand.
In the Keynesian analysis, therefore, it is increases in investment demand which
can be relied upon to overcome any deficiency in aggregate demand and thus support
the level of effective demand at full employment levels.

15.2 MEANING OF INVESTMENT FUNCTION

The investment function addresses the following issues:
1. Factors on which investment depends in an economy.
2. How is the equilibrium level of investment determined in an economy?
3. Reasons for private investment not being able to generate aggregate demand
to support full employment equilibrium.
4. Policy measures to increase investment in a capitalist economy.

15.3 MEANING OF INVESTMENT IN THE KEYNESIAN ANALYSIS

Before proceeding with the discussion of the investment function, it is necessary to
clarify as to what ‘investment’ in the Keynesian analysis.
To begin with, one should distinguish between consumption expenditure
(demand) and investment expenditure (demand). Consumption expenditure refers to
expenditure on consumption goods and services whereas investment expenditure refers
to expenditure on goods requires for the further production of goods. The consumption
demand is generally guided by prices whereas investment demand depends on a
number of factors which are discussed in latter part of this chapter.
236
Investment Function 237

Investment can also be classified into financial investment or real investment.

Financial Investment Real Investment

Financial investment Real investment
refers to refers to
investments in investment in
financial assets capital goods,
like shares, machinery
securities, deposits, and other types
Debentures, etc. of capital inventories.

In the analysis of the investment function, Keynes considers real investment which
involves a decision or demand to purchase machinery, plant equipment, etc. Investment
thus refers to addition to the stock of capital goods.
Further, investment can be either induced investment or autonomous investment.
1. Induced Investment: Induced investment is profit or income motivated.
This kind of investment is a function of the level of income, i.e.
I = f (Y)
2. Autonomous Investment: On the other hand, autonomous investment is
independent of changes in income and is an independent decision of business
units. Keynes considered autonomous investment in his analysis.

15.4 FACTORS ON WHICH INVESTMENT DEPENDS (INVESTMENT FUNCTION)

The decision to invest in a new capital asset (i.e. real investment) depends upon a
number of factors which have been analysed in the investment function by Keynes.
These include:
1. The cost of the machinery and the life time of the machinery
2. The expected rate of profit or returns from the machinery during its life time
3. The market rate of interest (on the amount borrowed)
These factors have been summarised in the ‘investment function’ by Keynes into
two main factors:
1. Marginal efficiency of capital denoted as mec
2. Market rate of interest, i.e. ‘i’
The investment function thus states that investment is a function of, or is
dependent on the marginal efficiency of capital and the rate of interest. This can be
denoted as:
I = f (mec, i)
where, I = Volume of Investment
mec = Marginal Efficiency of Capital also referred to as ‘e’
i = Market Rate of Interest
238 Macroeconomics

Note: In the classical analysis, the volume of investment was simply an inverse
function of the rate of interest.
In the Keynesian analysis, to arrive at the equilibrium level of investment, what
is compared is the mec and the rate of interest.

15.5 MARGINAL EFFICIENCY OF CAPITAL (MEC)

In very simple terms, the marginal efficiency of capital means the expected rate of profit
from a given level of investment. It has been defined as the profitability of a capital asset.
(Its technical and specific meaning shall be discussed in the Appendix to this chapter.)
The marginal efficiency of capital however should not be confused with the
marginal productivity of capital, which is the increase in total physical product by
employment an additional unit of capital or the contributions to total physical product
by an additional or marginal unit of capital. According to Keynes, marginal efficiency
of capital, now denoted as mec, is the expected rate of profit or rate of return
over cost from a given level of investment. The marginal productivity of capital is
measured in physical terms, whereas mec is an expected rate of profit.

15.5.1 Clarifications and Characteristics of the MEC

1. It is considered that it is possible to predict the returns or expected profits
from given level of investments.
2. As the level of investment goes on increasing, the expected profit or mec goes
on decreasing.
3. The mec is inversely related to the volume of investments and hence, the
marginal efficiency of capital is downward sloping function.
This is due to two reasons:
(a) As investment increases the law of diminishing returns sets in because
all factors cannot be varied in the exact proportion required. (The Law
of Variable Proportions).
(b) Increasing investment by all producers leads to competition among them
pushing up the cost production and thus reducing the marginal efficiency
of capital or expected rate of profit.

MEC Schedule
The mec schedule shows the marginal efficiency of capital for various levels of
investment. The mec schedule is presented in Table 15.1.
TABLE 15.1 MEC Schedule
Investment levels (in lakhs of `) MEC (in percentage %)
10 9
20 8
30 7
40 6
50 5
Investment Function 239

The MEC schedule indicates the downward sloping of the mec curve. The MEC
function is shown in Figure 15.1.

FIGURE 15.1 MEC Function.

Explanation
1. As shown in Figure 15.1, when the volume of investment increases from I1
to I2 to I3, the mec declines from mec1 to mec2 to mec3. The mec is, therefore,
a negatively sloping function of Investment.
2. The mec function given above is for individual business units, however to
arrive at the aggregate mec a horizontal summation of the mec schedule of
all producers in an economy is made. The basic nature of the aggregate mec
function will remain the same as the individual mec.

15.6 DETERMINATION OF RATE OF INTEREST IN THE KEYNESIAN SYSTEM

The second factor affecting the equilibrium level of investment is the rate of interest.
To briefly recall the main elements of Keynes Liquidity Preference Theory of interest
rate determination.
1. The rate of interest refers to the market rate of interest.
2. This market rate of interest is determined in the money market according to
the demand for money and supply of money.
3. Demand for money arises from three basic motives.
(a) Transaction Motive
(b) Precautionary Motive
(c) Speculative Motive
In the ‘Liquidity Preference Theory’, the demand for money is the speculative
demand for money, which is an inverse function of the rate of interest.
4. The supply of money is determined by the Central Government, the Central
Bank and the Commercial Banks. The Central Government and Central Banks
regulate the money supply.
240 Macroeconomics

5. The equilibrium rate of interest is determined at the point where demand for
money is equal to supply of money or Mds = Ms.
(Mds is the speculative motive to demand money and Ms is the money supply).
This is shown in Figure 15.2.

FIGURE 15.2 Liquidity Preference Theory—Rate of Interest Determination.

Observations
1. Without going into details of the theory it can be seen that as MS increases
from MS1 to MS2 interest rate declines from i1 to i2 and when MS decreases
to M3, rate of interest increases to i3.
2. One aspect about the rate of interest which should be noted is that in the
short run the rate of interest is relatively stable.

15.7 DETERMINATION OF EQUILIBRIUM LEVEL OF INVESTMENT IN THE

KEYNESIAN THEORY
1. Having analysed the two important factors determining the volume of
investment, the determination of equilibrium level of investment can be
explained as follows:
I = f (mec, i)
2. Equilibrium level of investment is determined at the point where, mec = I, i.e.,
Ie : mec = I
where Ie is the equilibrium level of investment.
3. The mec or expected rate of profit is inversely related to the volume of
investment.
4. It should be noted that a comparison of mec and i is in effect, a comparison of
returns in a business (i.e. mec or expected rate profit) and costs of a business
(i.e. i, the rate of interest.)
5. Therefore, the equilibrium condition which states that
Ie = mec
also implies a situation where
Returns (R) = Costs (C)
Investment Function 241

6. The above implies that equilibrium level of investment would be determined at

a point where returns from investment = Cost of investment or where mec = i.
The following three major conclusions about the equilibrium level of investment
can be noted:
(a) When mec = i ..... Investment is at the equilibrium level.
or R = C
(b) When mec > i ..... Investment has a tendency to increase.
or R > C
(c) When mec < i ..... Investment will have a tendency to decline.
or R < C
With the above clarifications one can proceed to show the determination of
equilibrium level of investment which is given in Figure 15.3.

FIGURE 15.3 Determination of Equilibrium Level of Investment.

Explanation
1. Panel ‘A’ of Figure 15.3 deals with the determination of the rate of interest
‘i’ in the money market using the Liquidity Preference Theory.
2. Panel ‘B’ deals with the ‘real sector’ where actual investment decisions are
made and shows the investment function I = f (mec, i)
3. To begin with, it should be noted that the rate of interest is determined in the
monetary sector (Panel A) and to arrive at the equilibrium level of investment
the following condition must be satisfied. Ie: mec = i
4. Initially, if money supply is MS1 given the demand for money, the rate of
interest gets determined at i1 in Panel ‘A’ of the diagram corresponding to
this rate of interest in Panel ‘B’ of the diagram the level of investment gets
determined at OI1 where mec1 = i1.
5. If for some reasons, say a change in the monetary policy, the money supply
increases, MS2, the rate of interest will decline to i2. At this level since
i2 < mec1, (or costs are less than returns) investment starts increasing mec
will begin to fall. This process will continue till the new equilibrium level of
investment settles at OI2 where mec2 = i2.
242 Macroeconomics

6. If money supply contracts to MS3, the rate of interest will increase to i3,
(Panel A). At this level compared to the original situation i3 > mec1 (or costs
are more than returns). Investment will start contracting as a result of
which mec will start increasing (the inverse relationship between mec and
I). Investment will continue to decline till it reaches OI3 where mec3 = i3 and
equilibrium is again established.
This is the manner in which equilibrium level of investment is determined in the
Keynesian theory at the level where mec = i.
However, according to Keynes, the rate of interest is relatively stable in the
short run, and therefore, what is more important in finally determining the level of
investment is the mec, and it is the fluctuations in the mec which lead to changes in
the level of investment.
The marginal efficiency of capital, i.e. mec thus becomes the most important
variable affecting the level of investment demand and hence aggregate demand
(i.e. effective demand), and therefore, the level of employment in the economy.
The above analysis shows that for an investor making a decision whether to
expand investment or not, he compares the returns to the cost and optimises his
investment level at a point where mec = i. For the aggregate economy, such an analysis
would indicate the optimum level of investment in the economy.
Note: The same equilibrium analysis is explained using the demand price and supply
price concepts in the Appendix to this chapter.

15.8 FACTORS AFFECTING MEC

Since the rate of interest is considered to be relatively stable in the short run, it is
fluctuations in mec, which are important in determining the level of investment in an
economy. MEC is dependent on two sets of factors:
1. Short Run Factors
2. Long Run Factors
Factors Affecting mec

Short Run Factors Long Run Factors

(i) Expectations about Level of Prices (i) Technological Improvements

(ii) Changes in income (ii) Development of Infrastructural Facilities
(iii) Changes in Demand. Consumers’ (iii) Structural and Institutional changes in
Tastes and Fashions the Economy
(iv) Expected changes in the Costs of
Production
(v) Advertisements
(vi) Political Stability
Investment Function 243

The Short Run and Long Run Factors affecting mec can be explained as follows:

15.8.1 Short Run Factors

1. Expectations about Level of Prices: A higher expected level of prices in
future would shift up the marginal efficiency of capital.
2. Changes in Income: Any rise in the level of income may increase demand
for commodities leading to increases in the mec.
3. Changes in Demand, Consumers’ Tastes and Fashions: Favourable
changes would increase demand for such types of goods thereby increasing
the expected rate of profit in such business.
4. Expected Changes in the Costs of Production: As a result of increases
in the cost of production due to competition, increase in price of raw material,
other inputs or any such factors would lead to decline in expected rate of
profits, i.e. mec.
5. Business Pessimism and Optimism: Any kind of expectations about the
future trend in costs, price, profit, and business situation, creates uncertainties
in the future giving rise to general optimism or pessimism about the business
conditions.
6. Advertisements: The responses to ‘advertising policies’ followed by firm,
also affects the demand for their products, shifting the mec.
7. Political Stability: In the present context where most of the economies
have government interventions, the policies of the government have a strong
impact on mec. However, this aspect was kept out of the Keynesian analysis
since Keynes was interested in the nature of investment in a purely capitalist
economy and government intervention was advocated as solution to stabilising
economies.

15.8.2 Long Run Factors

There are certain dynamic changes which take place in the long run which can affect
the mec; however, since the Keynesian analysis is a short run equilibrium analysis,
these factors do not become very relevant in bringing about shifts in the mec. They are:
1. Technological Improvements: Any technological development, innovations,
improvement in methods of production, a discovery of a new market, etc.,
would lead to increases in the expected rate of profit, such technological
improvements are favourable to mec.
2. Development of Infrastructural Facilities: Infrastructural facilities like
transport, communication, financial institutions, creation of social overheads
would create a favourable impact on the mec.
3. Structural and Institutional changes in the Economy: Other factors
like changes in the level of population, improvement of skills, etc. would also
affect the expected rate of profit in the long run.
In the Keynesian analysis it is expectations about the behavior of mec in future,
which is of extreme significance in any investment decisions in an economy. These
include short run expectations relating to changes in prices, interest rates, demand
244 Macroeconomics

for commodities, money supply, etc., the long run factors that impact mec include
technological changes, innovations, sudden outbreak of war and so on. Business
optimism or pessimism has a strong influence on the expected rates of profits and
thereby mec.
Summing up, the above factors cause fluctuations and hence shifts in the mec
leading to changes in the level of investment in an economy.

15.8.3 Shifts in MEC

The above short and long run factors would affect and create fluctuations in mec so
that even without changes in the rate of interest, the investment volume would change
leading to shifts in the mec schedule or investment schedule as shown in Figure 15.4.

FIGURE 15.4 Shifts in MEC.

Explanation
1. As can be seen in Figure 15.4, even without changes in the rate of interest
the equilibrium volume of investment increases from I1 to I2 and decreases
from I1 to I3, due to shifts in the mec schedule.
2. If mec shifts to say mec2, it means the expected rate of profits from business is
expected to rise and investment will increase to OI2. In the other case, if mec
schedule falls to mec3 the equilibrium volume of investment also falls to OI3.

Tendency Towards Declining Rate of Profit and hence mec in a Capitalist Economy
The marginal efficiency of capital in the Keynesian theory thus comes out to be the
key variable, which determines the level of investment. However, there is, according to
Keynes, an inherent tendency in a capitalist economy for the expected rate of profit and
hence mec to decline. As the economy progresses, there is a tendency for the marginal
propensity to consume to decline and capital accumulation, saving and investment to
increase. This creates over saving, over investment and under consumption of goods
since high consumption demand is not forthcoming, there is stock of unsold commodities,
investment tends to become surplus and the rate of profit tends to decline, as a result
Investment Function 245

of which expected rate of profits, i.e. mec also tends to decline. This tends to cumulate
the depression due to absence of any institution like the government to correct such
fluctuations and imbalances in an economy. Once a capitalist economy moves from the
boom period in business activity into the recession phase, profits continue to decrease
plunging the economy into depression.

Conclusion
Investment demand is the key variable in Keynes’ theory which can bring about
increases in aggregate demand. Investment itself is a function of mec and rate of
interest. The rate of interest is a relatively stable factor in the short run, mec thus
becomes responsible for fluctuations in the level of investment. A high mec (or the
expected rate of profit) in the economy would generate increases in the level of
investment and vice-versa.
However, according to Keynes, mec, in a capitalist economy, has tendency to
decline and hence private investment left to itself cannot generate investment high
enough to support aggregate demand at full employment levels. Keynes therefore
advocated Government intervention in the form of government or public expenditures
to support aggregate demand in a capitalist economy at full employment economy. He
strongly advocated fiscal policy measures to stabilise the economy.

APPENDIX

Determination of Equilibrium Investment: Using Supply Price Demand Price Analysis

Keynes had provided an alternative approach to explain the determination of equilibrium
level of investment using the Supply Price (SP) and Demand Price (DP) analysis.
He showed that equilibrium level of investment in an economy will be determined
at the point where the supply price is equal to the demand price of an investment.
The meaning of demand and supply price can be explained briefly as follows:
• Any investment gives a series of returns over the lifetime of machinery.
• Using mec, one can derive the supply price.
• Using the rate of interest, one can derive the demand price.

Supply Price
MEC, is that rate of discount which equates the discounted expected rate of profit to
the supply price of the machinery.’ Or mec is that rate of discount which when used to
discount the expected revenues from an investment project equates the present value
of these revenues to the cost of the investment project.
Consider a machinery which has a life of say ‘n’ years. There is a cost of the
machinery, which Keynes called the supply price of machinery. Any producer would get
into a business only if the returns from the machinery in future, at least covers the
cost of the machinery. The returns from the machinery occurs over its lifetime given
as Q1, Q2, Q3…Qn. These returns arise in the future but the cost of the machinery is
borne in the present and therefore obviously what the investor would be interested in,
is the present value of the future returns.
246 Macroeconomics

MEC is that rate of discount, which makes the supply price of an asset exactly
equal to the discounted present value of returns from machinery. The MEC has been
denoted as ‘e’ and the general formula for supply price is given as:
Q1 Q2 Q3 Qn
SP = + 2
+ 3
+…+
(1 + e) (1 + e) (1 + e) (1 + e)n
where,
Q1 … Qn = Returns from the Machinery over its Life Time ‘n’, i.e. Q1 is Return in year
1; Q2 is Return in year 2 and so on.
SP = Cost of the Machinery or the Supply Price
e = mec

Demand Price
For investment decisions, there are two variables which an investor has to consider:
1. mec
2. Rate of Interest
The investor for comparison purposes will compare supply price to demand price-
which is the series of returns from an investment discounted at the rate of interest.
The general formula to arrive at the demand price is:
Q1 Q2 Q3 Qn
DP = + 2
+ 3
+…+
(1 + i) (1 + i) (1 + i) (1 + i)n
where, DP = Demand Price of an Asset
Q1 … Qn = Series of Returns/Annuities during the Life Time of the Machinery
‘i’ = Rate of Interest
The equilibrium level of investment is then determined at the point, where
SP = DP which is nothing but the point where mec = i.
The following rules regarding investment decisions would hold:
1. When SP = DP or mec = i equilibrium level of investment is determined
2. If SP > DP or mec < i producers will reduce investment.
3. If SP < DP or mec > i producers will increase investment.
Equilibrium will be attained at the point where SP = DP.
The above analyhsis is an alternative approach to explain determination of
equilibrium level of investment. In fact, it is also a comparison of mec and rate of
interest using discounted flow approach.

Points to Remember
• The investment function is of great significance in Keynes’ theory because the
burden of generating full employment in the economy finally rests on the ‘level
of investment demand’. This is due to the fact that consumption demand is
found to be relatively stable and cannot be expected to generate rapid increases
in aggregate demand.
Investment Function 247

• The ‘investment function’ very briefly deals with

1. Factors on which the level of investment in an economy demands.
2. Reasons for private investment not being able to generate aggregate demand
to support full employment equilibrium.
3. Policy measures to increase investment in a capitalist system.
• ‘Investment’ in Keynes investment analysis refers to real investment (i.e. in
machinery capital goods, plants, equipments, etc.) and also is of the ‘autonomous’
type, i.e. not dependent on changes in income.
• There are three factors on which the investment decision (to say purchase a
machinery) depends:
1. The cost of the machinery and lifetime of the machinery.
2. The expected rate of profit or returns from the machinery during its lifetime
3. The market rate of interest (on the amount borrowed)
These factors have been condensed into two:
(i) The marginal efficiency of capital (mec)
(ii) The market rate of interest (i)
• The level of investment thus becomes a function of mec and I denoted as I =
f(mec, i), and the equilibrium level of investment is determined at the level where
mec = i. MEC, very simply, is the expected rate of profit from a given level of
investment or the rate of return over cost. In the technical sense, mec is defined
as that rate of discount which when used to discount the expected revenues from
an investment project equates the present value of these revenues to the cost of
the investment project. It is the profitability of an asset. MEC is inversely related
to the level of investment. The rate of interest is determined by forces of money
supply and demand for money (The Liquidity Preference Theory).
• A comparison between mec and ‘i’ is in fact a comparison between the Returns
from investment (mec) and costs of a given level of investment (i) The condition
related to the equilibrium level of investment can thus be stated as:
When mec > i
Investment has a tendency to expand.
Returns > Costs
When mec < i
Investment has a tendency to contract.
Returns < Costs
When mec = I
Equilibrium level of investment
Returns = costs
• An alternative approach to the investment analysis has been provided by Keynes
by using the concepts of Demand Price (DP) and Supply Price (SP). Equilibrium
level of investment is determined at the level where SP = DP (which in effect
implies the same equilibrium condition mec = i)
• Proceeding further with the investment analysis, Keynes found that of the two
factors affecting ‘I’, the rate of interest is relatively stable in the short run and
therefore, it is mec which is important in determining the level of investment.
The mec or expected rate of profits from a given level of investment itself is
dependent on a set of short run factors which include expectations about changes
in level of prices, income demand, etc. The long run factors refer to technological
248 Macroeconomics

improvements, development of infrastructure factors, structural changes in the

economy, etc.
• Keynes identified expectations to be the dominant factor affecting and causing
shifts in mec.
• However, he found that in a capitalist economy there is an inherent tendency for
profits to decline as the economy progresses, due to excess capital accumulation,
excess investment and under consumption or shortages in aggregate demand. As
a result, a private capitalist economy left to itself cannot generate investment
high enough to support aggregate demand at full employment levels.
• Keynes, therefore, advocated government intervention in the form of government or
public expenditures (fiscal policy) to support aggregate demand at full employment.

QUESTIONS

I. Short Questions
1. Explain the significance of marginal efficiency of capital (mec) in Keynes’
Investment Function.
2. I = f (i, mec). Explain.
3. Explain why the mec is downward sloping in Keynes theory.
4. What leads to changes and shifts in the mec?

II. Long Questions

1. ‘The equilibrium level of investment in Keynes theory is determined according
to rate of interest and mec.’ Discuss.
2. Explain the relevance of liquidity preference theory in Keynes Investment function.
3. ‘The burden of generating full employment in Keynes theory falls on investment
function.’ Elaborate.
4. ‘Mec or expected rate of profit is a crucial factor in causing recession and
recovery.’ Do you agree and how relevant is this in contemporary times?
CHAPTER

16
Investment Multiplier and
Principle of Accelerator

16.1 INTRODUCTION
A very important concept developed by Keynes was the Investment Multiplier. The
multiplier theory studies the effect of changes in aggregate investment on aggregate
income through changes in consumption. When investment changes it causes changes
in income through changes in consumption, this change in income is multiplier times
the change in initial investment, thus giving rise to the term multiplier.
Consider an example, if investment in the economy increases by ` 1 crore, and
income increases by ` 5 crores, then the value of the multiplier is 5. The value of the
multiplier, however, depends on the marginal propensity to consume or the value of
the mpc and other factors.

16.2 MEANING AND DEFINITION INVESTMENT MULTIPLIER

The investment multiplier is defined as follows: It expresses a relationship between an
initial change in investment and the resulting changes in the aggregate income.1
The multiplier measures the changes in income due to changes in investment
and is denoted as:
M = DY / DI
where, M = Multiplier
∆Y = Changes in Income
∆I = Changes in Investment

1. John Maynard Keynes. The General Theory of Employment, Interest, and Money. Amherst,
New York, Prometheus, 1997.

249
250 Macroeconomics

To elaborate further, the multiplier studies the impact of a change in investment on

income, which occurs through changes in consumption or it can be denoted as:
∆I  ∆C  ∆Y
Technically, it is defined as a numerical co-efficient which indicates the increase in
income in response to an increase in investment.

16.3 WORKING OF THE MULTIPLIER

Keynes, through the multiplier analysis, has shown how changes in investment can
bring about greater changes in income; thus, leading to generation of higher and higher
level of income in an economy. In fact, the working of the multiplier can explain the
cumulative increases and decreases in level of income, i.e. fluctuations in the capitalist
economy. The multiplier along with the accelerator explains the business cyclical
fluctuations in a capitalist economy.
When the level of investment increases (or decreases), it initially causes an
equivalent change in the level of income. This income is spent on goods and services
and constitutes consumption expenditures. These expenditures get converted into
income for those who receive it in payment for their goods and services (one man’s
expenditure is another man’s income). This is how the income generation process begins
and continues till the whole of the initial amount of new investment is exhausted.
The above process can be better understood with the help of a numerical example
given below:
• If there is a new investment equal to the amount ` 10,000. This leads to
employment of various factors of production who receive a payment for their
services.
• In the first stage the initial investment of ` 10,000 is distributed as direct
income, which is paid to the factors of production employed in the new
investment activity (assuming that whatever is invested takes the form of
money income payments). If the marginal propensity to consume, i.e. the
mpc is 0.5 or 50%; it means that, out of every income level generated, 50% is
consumed and 50% would be saved.
• In the second stage, if the mpc is 0.5 or 50%, the individuals who receive
` 10,000 as income will spend 50% of ` 10,000, i.e. ` 5,000. The national income
generated up to now, would then be
Y = 10,000 + 5,000
Assuming that the mpc remains constant at 0.5 during the entire process. The
income generation in the other stages can be shown as follows.
• In the third stage, those individuals who receive income equal to ` 5,000 will
again spend 50 % of ` 5,000, i.e. ` 2,500 and so on.
• This process will continue till the whole of the income is exhausted, which will
ultimately work itself out because mpc is always less than 1. If mpc were equal
to 1 then it would be an infinite process, which is not the case. The reason for
mpc < 1 as already explained in the consumption function is because a part of
the income of a person is saved.
Investment Multiplier and Principle of Accelerator 251

• Therefore, the total income generated in the economy through this process in
our example will be:
Y = 10,000 + 5000 + 2,500 + ......
In order to calculate the total income generated in the multiplier process the
investment multiplier is used.
The above process is based on some very critical assumptions, and it should also
be understood that through theoretically the income generation is shown so simply
and systematically, in reality there are a number of limitations and leakages, which
may not allow the multiplier to work out fully.

16.4 ASSUMPTIONS OF THE MULTIPLIER ANALYSIS

The multiplier process works within a set of crucial assumptions:
1. The marginal propensity to consume or the mpc is assumed to be constant
during the working of the multiplier. This is mainly to simplify calculations.
2. It is also assumed that mpc < 1.
3. It is assumed again for a better understanding of the process that there is
no significant time lag between people receiving and spending their income. In
case of a time-gap, the multiplier process will take a long time to work out.
4. The fiscal and monetary policies are assumed not to change during the working
of the multiplier-process. A change in the money supply or the taxation and
expenditure policy of the government would create disturbance in both the
levels of investment, income and other important macroeconomic variables.
5. A closed economy has been assumed to keep out the influences of international
trade (i.e. expenditures on foreign goods, investment abroad, etc.).
6. It is assumed further that there is no limit to production and supply of
consumption goods so that goods are easily available for consumption, and
the income generation process continues.
7. It assumes a static economy, with no technological change.
8. To understand the working of the multiplier process, only a one-time new
investment (in our example ` 10,000) is assumed. So that complications in
calculations are not introduced because every new change in the investment
process will generate a new stream of income because of the multiplier effect.
9. A very crucial assumption is that when the consumers demand more goods these
goods are easily available which means industries are assumed to have excess
capacity. In absence of such excess capacity, the income generation process would
come to a standstill. (This problem is considered in the accelerator analysis.)

16.5 TECHNICAL DERIVATION OF THE INVESTMENT MULTIPLIER

The investment multiplier can be derived from the income equation in the Keynesian
theory as shown below:
Y = C + I ...(i)
252 Macroeconomics

where, Y = Income
C = Consumption
I = Investment
The consumption function is stated as:
C = a + bY ...(ii)
where, ‘a’ = Autonomous Consumption
bY = Proportion of Income Consumed so ‘b’ is the mpc
Y = Income
Equation (i) can be rewritten substituting a + bY for the variable C as:
Y = a + bY + I ...(iii)
Further simplifying the equation
Y – bY = a + I
or Y (1 – b) = a + I
Since ‘a’ is autonomous consumption, it can be kept aside from the equation which
now becomes
Y (1 – b) = I
or
 1 
Y=   ×I
1 − b 
where ‘b’ is the mpc, so substituting mpc for ‘b’ the equation becomes

 1 
Y=  
1 − mpc 

Therefore, the investment multiplier M, the multiplier is written as:

 1 
M=  
 1 − mpc 

1 – mpc the denomination of the above equation is, nothing but the mps. So, the
investment multiplier ‘M’ can also be written as:
1
M=
mps
Note: The total income generated due to a change in investment as a result of the
working of the multiplier will be
 1 
Y=  ×I
1 − mpc 
Investment Multiplier and Principle of Accelerator 253

1 – mpc the denominator in the equation is, the mps. So, the multiplier is also written as:
1
M=
mps
Therefore, the total income generated in the multiplier process can be calculated
directly by using the multiplier. The income will increase by multiplier times the level
of new investment. This can be explained with the help of following numerical example:

Income Generation through the Multiplier Process

Consider a new investment of ` 10,000 and mpc is 0.5.
Now, the total income generated through the multiplier can be calculated as given
below using the investment multiplier:
 1 
M=  
1 − mpc 
The total income generated (Y) through the multiplier process will be
 1 
Y=  ×I
1 − mpc 
Substituting the above values,
 1 
Y=   × 10,000
 0.5 

10 
=   × 10,000
5
= 2  10,000
Y = 20,000
Total income generated is ` 20,000 which is twice the amount of investment that
means the value of the multiplier in this example is 2. Higher the mpc, greater will
be the income generated through the multiplier. The multiplier effect of changes in
investment on the levels of income is illustrated in Figure 16.1.

FIGURE 16.1 The Multiplier Effect.

254 Macroeconomics

Explanation
1. In Figure 16.1, the equilibrium level of income is determined at OY1 where
the aggregate demand cuts the equilibrium line Y = C + I at point e1.
2. If new autonomous investment is introduced to the extent of I, the consumption
function shifts to C + I, and the new equilibrium is established at point e2
where income is determined at the level OY2.
3. As can be clearly seen the change in income is greater than change in
investment is ∆Y > ∆I indicating that income increases by a greater amount
than the change in investment because of the multiplier effect.

16.6 LEAKAGES FROM THE MULTIPLIER PROCESS

In reality, the multiplier effect does not work so perfectly as shown theoretically; it
does of course have an income generation effect but it is neither as perfect nor as
smooth or occurring within a short span, as shown. There are certain leakages from
the income generation stream so that the full multiplier effect may not work itself out
fully. These are listed as follows:
1. Fall in mpc: Since the ultimate value of the multiplier depends on the
propensity to consume, any fall in the mpc would reduce the value of multiplier.
2. Hoarding: If people indulge in hoarding, i.e. holding money in the form
of cash with them the consumption demand will fall and value of multiplier
will also be less.
3. Changes in Monetary and Fiscal Policy: If the monetary or fiscal policies
change, it would affect the value of multiplier through changes in mpc, mps
and investment.
4. Liquidation of earlier Debts: If a part of the income is used to pay off
earlier debts a lesser amount is used for consumption thus reducing the total
income generated in the multiplier process.
5. Significant Time Lags: In reality, there is a significant time lag between
people receiving and spending their income which will delay the multiplier
process.

16.7 SHORTCOMINGS OF THE MULTIPLIER THEORY

The basic criticisms against the multiplier theory are as follows:
1. The multiplier analysis is the based on some highly restrictive assumptions
and works only if certain specific condition hold; which may not be possible
in reality.
2. There is a significant time lag between income and expenditure, which if
taken into consideration, would not allow the multiplier to work out within
a short period.
3. The multiplier process assumes that any increase in consumption expenditure/
demand is automatically met, since there is excess capacity in the consumer
industries. In fact, it is difficult to increase production so easily because of the
Investment Multiplier and Principle of Accelerator 255

various bottlenecks in production, leading to limitations in income generation.

The multiplier theory cannot explain the process of income generation if excess
capacity in industries does not exist and the supply cannot increase to meet
the new consumption demand.
4. Too much emphasis is given to consumption in the whole analysis.
5. It is a very mathematical and algebraic exercise.
6. Empirically the multiplier works but not as perfectly as shown in theory.
In spite of its shortcomings, the investment multiplier analysis is an extremely
important aspect of Keynesian economics, its significance will become clearer once the
accelerator principle is explained.

16.8 IMPORTANCE OF MULTIPLIER

1. Important for analysis of the effect of a change in autonomous investment on
income, it gives an idea as to the benefits of increasing the level of investment
for increasing the level of income in an economy.
2. It shows how increases in investment can generate multiplier times an
increase in income.
3. It explains fluctuations in the level of income and provides an explanation of
the trade cycles.
4. It shows how government expenditures and investments can generate income
and help an economy to come out of recessions and depression.

16.9 ACCELERATOR PRINCIPLE

16.9.1 Meaning
The multiplier theory studies the effect of an initial change in investment on aggregate
income through consumption expenditures or changes in consumption. The accelerator
principle is a very important post-Keynesian concept developed by J.M. Clark (1917),
Harrod (1939)2, 3, and used for the theory of business cycles by Hanson, Samuelson,
Hicks and others. The multiplier analysis was in a sense incomplete since it did not
consider the effect of changes in consumption on investment. As a result of an initial
increase in investment, there is a generation of income, which leads to an increased
demand for consumption goods however this increase in consumption will in turn,
increase demand for investment. The accelerator deals with the effect of an
increase in consumption demand on the level of investment, i.e. demand for
capital goods.
The demand for capital goods is a derived demand, whenever demand for consump-
tion goods increases, there is a need to produce these goods to meet the new demand,

2. J. Maurice Clark, 1917. “Business Acceleration and the Law of Demand: A Technical Factor
in Economic Cycles,” Journal of Political Economy, University of Chicago Press, Vol. 25.
3. Harrod, R., 1936. The Trade Cycle: An Essay. Oxford: The Clarendon Press.
256 Macroeconomics

which generates a demand for capital goods used in the production of consumer goods.
This aspect has been analysed under the accelerator principle which is an extension
of the multiplier analysis.
The accelerator thus studies how investment responds to changes in demand for
consumer goods. The change in investment is much greater than change in demand for
consumer goods and hence the term ‘accelerator.’ When there is a change in demand
for consumption goods and services, it requires a change in the level of investment,
i.e., it generates a demand for capital goods. If a firm cannot meet this new demand
for output/consumption from existing excess capacity, it will invest in new machinery
in addition to replacing its old worn out machinery. The accelerator principle shows
that this change in investment is greater than the change in the level of output. This
implies that ‘net investment will rise by a proportionally larger amount to accommodate
the demand for larger output’.

16.10 ACCELERATOR COEFFICIENT

The accelerator coefficient shows the amount by which investment changes in response
to changes in consumption.
It can be denoted as:
DI
A=
DC
or A studies ∆C  ∆I

where, A = Accelerator Coefficient

∆I = Change in Investment
∆C = Change in Consumption
For example, if consumption increases by 10 crores and as a result of this if
investment increases by 20 crores, the value of ‘A’ can be calculated as:
DI
A=
DC
20
A=
10
A = 2
The value of the accelerator coefficient, i.e. the accelerator measures the change in
investment caused by changes in consumption demand. It shows that when consumption
changes, it induces further changes in the level of investment, if industries lack excess
capacity.

Factors on which the Magnitude or Strength of the Accelerator would Depend

How much investment would increase to meet the increased demand for consumption
goods would depend on:
Investment Multiplier and Principle of Accelerator 257

1. The Capital–Output Ratio: The capital output ratio, i.e. C:O refers to
how many units of capital are required to produce one unit of output. The
higher the capital output ratio, the greater will be the capital required to
produce one unit of the output and hence higher would be the accelerator
coefficient. For example, if the capital output ratio for a particular industry
is 4:1, it means it requires 4 units of capital to produce one unit of output
in this particular firm. In this manner, the C:O ratio determines the amount
of investment required to meet the increased demand. Higher the C:O ratio,
higher will be the amount of investment required to meet the new demand
of goods and vice-versa.
2. The Replacement Investment: Investment involves two important types
of investments: (a) new investment, i.e. investment in new machinery and
(b) replacement investment, i.e. investment required for wear and tear of
machinery, depreciation or to replace old machinery.

With an increase in demand for output, the investment will have to increase at
a much more rapid rate, to take care of the above two requirements. Therefore,
Total Investment = New Investment + Replacement Investment
I = NI + RI
A simple example will make it clear:
• If ∆C is ` 10,000.
• If the C:O ratio is 2:1, ` 20,000 will be required as new investment.
• In addition to the new investment, suppose a replacement investment of ` 2000
has to be made. Then the total investment will be:
New I + Replacement
20,000 + 2,000 = 22,000
Therefore, the conclusion is that higher and higher levels of investment is required
to meet increases in consumption demand. Therefore, the term ‘Accelerator.’

16.11 LIMITATIONS OF THE ACCELERATOR PRINCIPLE

1. In the working of the accelerator what is assumed is a constant capital: output
ratio, this however is a very restrictive assumption is only made to simplify
calculations.
2. There is supposed to be no excess capacity in the industries which witnesses an
increase in demand otherwise the new demand can be met without increases
in investment. The acceleration principle would not be relevant here. What
is assumed in the accelerator principal in the accelerator principal is that
the consumer goods industry where the demand has increased is already
producing to its fullest capacity so that when demand for its goods increases
it has to make new investments.
258 Macroeconomics

3. The changes in demand for consumer goods must be permanent otherwise

producers will not make new investments.
4. It is assumed as if the related resources required in production along with
capital goods; for example, labour, raw material and other technical know-
how, etc. are easily available and that there are no limitations to increase
production. This as we know is not quite true because there are a number of
limitations and bottlenecks of production.
5. The foreign sector has not been introduced in the analysis.
6. Money supply is elastic so no restrictions on investment because of limited
money supply is created. There is no shortage of funds hampering further
investment.

16.12 RELEVANCE AND IMPORTANCE OF THE ACCELERATION PRINCIPLE

1. The accelerator principle analyses the effect of consumption on investment,
thereby indicating the magnitude of induced investment. An initial change
in the level of investment can thus start off a chain of reactions in consump-
tion, investment; generating ‘increases’ in the level of income. It thus explains
the income generation process arising out of changes in investment and
consumption.
2. It explains the violent fluctuations in the level of business activity in the
capitalist economy. In fact, the multiplier and accelerator work together to
generate ups and downs in business activity. The interaction between the
multiplier and accelerator leads to trade cyclical fluctuations in an economy.
3. The accelerator principle can show the causes for economic instability. Due to
the working of the accelerator changes in output and income cause further
increases in investment.

16.13 INTERACTION OF MULTIPLIER AND ACCELERATOR TO EXPLAIN

BUSINESS CYCLICAL FLUCTUATIONS
The accelerator principle is a very important post-Keynesian development to explain
trade cyclical fluctuations in a capitalist economy. The multiplier and accelerator have
been used to explain the fluctuations in business activity trade cycles. The accelerator
principle along with the autonomous investment multiplier is used to explain how once
income increases it goes on increasing because of both multiplier and accelerator effect.
The multiplier and accelerator also work in the opposite direction to aggravate any
fall in the level of income. Due to the operation of both these principles the cyclical
fluctuations get more pronounced. Thus, the acceleration principle and the multiplier
interact to produce a cumulative recession or recovery, boom or bust. The tendency for
such violent fluctuations is more evident in a capitalist economy with no government
to control such fluctuations.
The mechanism of the interaction between multiplier and the accelerator can be
stated as follows:
Investment Multiplier and Principle of Accelerator 259

1. When there is an initial increase in investment (i.e. an autonomous increase in

investment), it gives rise to income generation through changes in consumption
outlays due to the multiplier effect.
2. The increase in demand for consumption goods induces a new investment to
produce the consumption goods (through the acceleration principle).
3. This new induced investment sets off a stream of income generation due to
the interaction between the multiplier and accelerator process.
In this manner, the multiplier and accelerator principle operate together to
generate higher and higher increases in the income or in the opposite case, decreases
in the income level, leading to business cyclical fluctuations.
The process of interaction between the multiplier and accelerator generating
fluctuations in income or trade cyclical fluctuations can be briefly explained as
follows:
Stage I The multiplier effect ∆I  ∆C  ∆Y1
Stage II The accelerator effect ∆C  ∆I  ∆Y2
Stage III The multiplier effect ∆I  ∆C  ∆Y3
Stage IV The accelerator effect ∆C  ∆I  ∆Y4
Interaction between ‘M’ and ‘A’ bring about cumulative increases in ‘Y’ leading
to fluctuations in income.
Note: The interaction of ‘M’ and ‘A’ also work together to bring about cumulative
decreases in income, which arise out of initial decreases in investment.
This model gives an idea about how the multiplier and accelerator interact to
produce business cyclical fluctuations.
Explanation: As can be seen in Stage 1, there is an initial change in investment
(autonomous) which leads to increase in income through changes in consumption
expenditures due to the working of the multiplier effect.
In Stage II, the changes in consumption sets off an increase in demand for new
investment through the accelerator effect, which generates a further increase in income.
This cycle continues in Stages III and IV and so on to generate further increases
in income.
Any rise or fall in the level of income is aggravated through the working of these
two principles, which explain the tendency of violent fluctuations in capitalist economy.
The cumulative increases and decreases in the level of income are due to the interaction
between the Multiplier and Accelerator is illustrated in Table 16.1.

Numerical Illustration: Table 16.1 illustrates the income generation process

due to Interaction between Multiplier (M) and Accelerator (A) for given numerical
values:
mpc = 0.66,
Accelerator (A) = 1.25
Autonomous Investment (Io) = ` 10 Crore
260 Macroeconomics

TABLE 16.1 Income Generation Process due to Interaction between Multiplier and Accelerator (` Cr)

Period Autonomous Change in Consumption Change in Investment Income

Investment (Io) (∆C) (∆I) (Y)
0 10 0 0 10
1 10 6.67 8.33 25
2 10 16.5 12.28 38.78
3 10 25.59 11.37 46.97
4 10 31.00 6.75 47.75
5 10 31.51 0.64 42.16
6 10 27.82 –3.69 34.13
7 10 22.53 –5.29 27.23
8 10 17.97 –4.55 23.41
9 10 15.45 –3.14 22.30
10 10 14.72 –0.91 23.80
11 10 15.71 1.23 26.94
12 10 17.78 2.59 30.37
13 10 20.05 2.83 32.88
14 10 21.70 2.06 33.76
15 10 22.28 0.72 33.01

Observations
1. As can be seen from Table 16.1, the income, initially goes on increasing at
rapid rates due to the interaction between ‘M’ and ‘A’, after which it declines
and again moves upward indicating a cyclical behaviour or fluctuations in
the economy.
2. As can be seen in Table 16.1, in period zero, the autonomous investment (Io)
is ` 10 crore and income (Y) is also ` 10 crore.
3. Numerical Example: Consider the values in the example given for Table 16.1.
C = 0.66
(Accelerator) A = 1.25
Autonomous investment (Io) = ` 10 crore
The following formulae are given for calculating change in consumption (∆C),
change in investment (∆I) and income (Y):
Change in Consumption (∆C)
Change in consumption (∆C) = (mpc) (Yt – 1)
where, Yt = current year
Yt – 1 = the income in the preceding year
Investment Multiplier and Principle of Accelerator 261

Change in Investment (∆I)

Change in investment ∆I = (A)(∆C)
where, ∆C = Ct – (Ct – 1)
Ct = consumption in current year
Ct – 1 = consumption in preceding year
Income (Y)
Y = ∆C + Io + ∆I
As can be seen in Table 16.1,
In Period 1
∆C = (0.66)(10) = 6.67
∆I = (6.67)(1.25) = 8.33
Y = 6.67 + 10 + 8.33 = 25
In Period 2
∆C = (0.66)(25) = 16.5
∆I = (16.5 – 6.67)(1.25) = 12.28
Y = 16.5 + 10 + 12.28 = 38.78
In Period 3
∆C = (0.66)(38.78) = 25.59
∆I = (25.59 – 16.5)(1.25) = 11.37
Y = 25.59 + 10 + 11.37 = 46.97
4. The income generation process continues in this manner. The changes in
income follow a cyclical pattern, i.e. increase and then decrease followed by
increase and so on
5. As can be seen from Table 16.1, income initially goes on increasing due to
the interaction between multiplier and accelerator. This happens till period 4
is reached and corresponds with the upward movement of the business cycle,
i.e. recovery and prosperity. The income level reaches its peak in period 4 at
` 47.5 crores.
6. The downturn begins from period 5 wherein income begins to decline till
period 9 and income declines to ` 22.30 crores. This corresponds to the
recession and depression phase of the trade cycle.
7. The cycle again begins an upward movement from period 10 onwards and this
process continues till period 14 when income reaches level ` 33.76 crores and
beyond this from period 15 onwards the income levels and economy show a
downturn.
These income changes are greater than what it would have been if only the ‘M’ was
working, the interaction between multiplier and accelerator thus leads to cumulative
increases and decreases in levels of income and thus is used to explain business cyclical
fluctuations.
262 Macroeconomics

Note:
1. The multiplier and accelerator theory is a behavioural theory of business
cycles, i.e. the cycle takes place because of the way in which consumption and
investment respond to income and changes in income respectively.
2. For different values of mpc and A, the cycle behaves differently and the cycles
could be periodic, dampened or explosive.
• If (mpc)(A) = 1, it leads to periodic cycles.
• If (mpc)(A) < 1, it leads to dampened cycles.
• If (mpc)(A) > 1, it leads to explosive cycles.

Points to Remember
• The multiplier theory, as stated, studies the effects of an initial change in
investment on aggregate income through consumption expenditure or changes in
consumption. This theory was incomplete because it did not deal with the impact
of changes in consumption on further investment (When consumption demand
increases, in absence of excess capacity in industries to meet this new demand
it would generate further investment).
• The accelerator therefore deals with the effect of an increase in consumption
demand on the level of investment, i.e. demand for capital goods. This principle
was developed by Harrod, Clark.
• The accelerator therefore shows how investment responds to changes in
DI
consumption demand and the accelerator coefficient is denoted as A = .
DC
• The value or strength of the accelerator would depend on:
1. Capital: Output Ratio (i.e. the number of units of capital required to
produce one unit of an output): Greater the C: O ratio greater will be the
capital required to produce one unit of output and hence greater will be
value of ‘A’.
2. Replacement Investment: Along with the new investment some replacement
or maintenance investment is required so that the rate of increases in
investment to meet the new consumption demand must be maintained at
higher rates (accelerator).
• The ‘Accelerator Principle or ‘Induced Investment Multiplier’ explains the
cumulative income generation process arising out of changes in consumption
and thereby investment. Together with the multiplier it is useful in explaining
‘Business Cyclical’ fluctuation in income. The interaction between multiplier and
accelerator generates cumulative increases and decreases in the level of income
and thus explains the ups and down in business activity.
• There are certain limitations to the working of this principle, i.e. the changes
in consumption should be of a permanent nature to induce new investment.
Further the other resources required in production should be available otherwise
new investment would be restricted and further industries should not be having
‘excess capacity’ otherwise the new consumption demand can be met without
increases in investment.
Investment Multiplier and Principle of Accelerator 263

QUESTIONS

I. Short Questions
1. Show how income increases by multiplier times the changes in investment.
2. Explain the significance of Investment multiplier during times of recession.
3. ‘Multiplier works within a given set of assumptions.’ Explain.
4. ‘Accelerator explains what multiplier fails to explain.’ Elaborate.

II. Long Questions

1. Critically examine the process of income generation through the investment
multiplier.
2. What is the essence and significance of Investment Multiplier in Keynes
theory?
3. What is the essence and implications of the accelerator principle?
4. ‘Interaction between M and A causes cumulative increases and decreases in
income and causes business cyclical fluctuations.’ Explain.
5. Calculate the total income generated due to the multiplier process if the
change in investment is ` 38000 and mpc is 0.6.
6. What will be the total investment required to meet a new consumption
demand of ` 35000 if the capital : output ratio is 3 and replacement
investment is ` 13000.
CHAPTER

17
Post Keynesian Developments
Monetarism

17.1 INTRODUCTION
There are two dominant schools of thought in macroeconomics- Keynesian and
Monetarism. Till about the mid-1950s, Keynes’ ideas dominated. However, in about
1956, a new school of thought, founded by Milton Friedman (of the Chicago School)
emerged, known as monetarism.
The two schools are sharply divided in their views on:
1. Role of money
2. Causes and nature of instability in the economy
3. Policy instruments to stabilise the economy

17.2 MEANING AND ORIGIN OF MONETARISM

Monetarism was founded by Milton Friedman in 1956. Other prominent monetarists
include Allan Meltzer, Karl Brunner, Beryl Sprinkle, Jerry Jordan, and others.
Monetarism as a school of thought evolved basically as a challenge against Keynes’
theory and its policy prescriptions. These economists considered money to be the single
most crucial variable in the economy, and thus believed that the monetary policy and
not the fiscal policy is a more effective instrument in stabilizing the economy.

17.2.1 Essence of Monetarism

The most important aspects to be noted about monetarism are:
1. Money is the most important variable in an economy which determines the
level of output and prices. In fact, according to them, only money matters in
an economy.
2. The monetary policy is a more effective instrument to stabilize the economy
(since money is the crucial variable in the economy).
264
Post Keynesian Developments: Monetarism 265

17.2.2 Origin of Monetarism

Monetarism has its origin in the Quantity Theory of Money. The basic conclusion
of both the Classical and Cambridge versions of the quantity theory was that if ‘V’
(velocity of circulation of money) and ‘T’ (level of transactions of money) are kept
constant, then changes in money supply would bring about a direct and proportionate
change in the General Price Level. Recall the Classical and Cambridge equations given
as:
MV = PT (Classical or Fisher’s version)
M = kY (Cambridge or Marshall’s version).
Going a step further, if the assumption of full employment (crucial to the
traditional Quantity Theory) is dropped then, changes in the money supply will cause
changes in prices as well as output.
It is at this point that the Monetarists picked up the idea of money being
important in an economy and developed a new school of thought called Monetarism.
The monetarists analysed three important aspects:
1. Money and its impact on output and prices
2. The link between money supply, rate of interest, and change in output.
3. The role of monetary policy.

17.3 FRIEDMAN’S RESTATEMENT OF THE QUANTITY THEORY OF MONEY (1956)

Quantity Theory of Money is the basis of Monetarism. The theory can be presented
in three parts:
(a) Clarifications
(b) Equation
(c) Conclusions

17.3.1 Clarifications
1. The Quantity Theory of Money is a theory of demand for money and not
of output and price determination.
2. Friedman analysed in detail the reasons as to why people demand money, and
came to the conclusion that money is only one kid of an asset, others being
investment bonds, equity shares, real assets, education, etc.
3. Therefore, the demand for money should be studied as a part of the demand
for different assets which constitute wealth, or as a part of holding alternative
assets. He, therefore, applied the theory of ‘Asset Demand’ to money.
4. Money is both a medium of exchange as well as a store of value.

17.3.2 Equation
Based on the above considerations, Friedman arrives at a demand for money function.
He recognized that individuals want to hold a certain amount of real money balance,
i.e. quantity of money in real cash balances. He then expresses the demand for cash
balances/real balances or demand money function as:
266 Macroeconomics

Md  Dp 
= f  YP , rb , re , , w, u, rm  …(i)
P  p 
where,
Md = Demand for Money
Md/p = Demand for Real Balances
Yp = Permanent Income Concept (the expected average long-run income)
rb = Interest Rates on Bonds
re = Interest Rate on Equities
Δp/p = Rate of change in Prices
w = Ratio of Non-human to Human Wealth
u = Variable that affects Tastes and Preferences
rm = Expected Return on Money
He found that the demand for money to be dominantly influenced by permanent
income. This can be written as:
Md
= f(YP ) …(ii)
P
Note: An important conclusion to note is about permanent income (Yp) is that it is
subject to lesser fluctuations, and therefore, the demand for money is relatively stable.

17.3.3 Conclusion
After having stated the equation, Friedman tested it for the US economy and arrived
at certain conclusions, which have important implications to understand monetarism.
1. The demand for money is a highly stable function of income.
2. Factors that affect money supply do not affect demand for money.
3. Velocity of money is regarded as constant over time. The monetarists in fact
stated that velocity of money changes but in a statistically predictable manner
so that it will not disturb the economy. Velocity of money is nothing but the
reciprocal of Md; and if Md is stable, V is also considered to be stable.
4. Based on the above, it was found that changes in the money supply would
bring about changes in the output and prices because demand for money and
velocity are considered to be relatively stable.
5. The rate of interest, unlike as in the Keynesian analysis, does not affect
demand for money as Friedman believed that changes in the interest rate
will have little impact on the demand for money.
6. Friedman also believed very strongly that the Liquidity Trap as shown by
Keynes, does not really exist, and the demand for money does not become
perfectly elastic as shown by Keynes.
With the above conclusions in view, one can proceed to explain the main elements
of monetarism.
Post Keynesian Developments: Monetarism 267

17.4 MAIN TENETS OF MONETARISM

The salient features of monetarism can be stated as:
1. Belief in the Working of a Free Enterprise: The monetarists, like
Keynes, believed in the working of a free capitalist economy.
2. Minimum Role of the Government: In view of the above belief, they
advocated minimum interference by the government and restricted the role
of the government to law, order, and defence.
3. Tendency of Full Employment in a Capitalist Economy: Unlike Keynes,
they believed in the assumption of a long-run tendency of full employment in
the capitalist economy.
4. Money Supply is a Major Determinant of National Income, Prices
and Output: The amount of money supply determines the income, output,
and employment in an economy. Changes in money supply affects both prices
and output in the short-run, but only the level of prices in the long-run. This
is because of the assumption of full employment in the long-run. Therefore,
money supply is the most important variable in an economy.
5. Only Money Matters: The monetarists believed, as mentioned earlier, that
it is money that determines the GNP and movements in the level of Income.
According to them, ‘only money matters’, this belief was based on the stability
of income and the stability of demand for money. When money supply changes,
it would affect income and output in a predictable manner. If velocity of money
and demand for money are not stable, the effect of changes in money supply
cannot be predicted. These are also the grounds on which the Monetarists
strongly advocated monetary policy to stabilise an economy.
6. Belief in the Flexibility of Wages and Prices: According to the
monetarists, wages and prices are considered to be flexible so that the rigidity
in wages do not become a cause of unemployment as in the Keynesian system.
7. Inflation: The monetarists were concerned with the problem of inflation and
according to them, excessive increases in money supply was a major cause of
inflation. As a result, they talked about ‘monetary targeting’, i.e. controlling the
rate of growth of money supply to prevent inflationary tendencies in the economy.
8. Constancy of the Velocity of Money: Monetarists emphasized on the
constancy of the velocity of money, and stated that ‘V’ changes, but in a
statistically predictable manner so that the effect of changes in money supply
can be predicted.
9. Prominent Role of Monetary Policy: Unlike the Keynesian system
where fiscal policy was considered to be the most effective instrument, the
monetarists have relied on monetary policy as the more effective instrument
to stabilize the economy and control inflation.
According to them, as mentioned earlier, the economy should follow monetary
targeting whereby money supply should be allowed to grow at a predetermined and
controlled rate. When money supply grows in a stable manner the economy too would
be able to attain a stable rate of growth and stability in prices. This is the main policy
conclusion of the monetarists.
268 Macroeconomics

17.5 MAIN POINTS OF DIFFERENCE BETWEEN MONETARISTS AND KEYNES

1. The monetarists considered inflation to be the major problem in a capitalist
economy, whereas Keynes was concerned with unemployment, which arises
due to shortages in aggregate demand in a capitalist system.
2. According to the Monetarists, it is changes in money supply (excess increases)
which creates inflation whereas, according to Keynes, it is mismanagement of
aggregate demand which causes unemployment in an economy.
3. According to monetarists, only money matters and money supply determines
the level of output and prices in an economy. They also state that demand for
money is stable in an economy, and since velocity (V) is stable, it is possible
to predict the effect of changes in money supply on output and prices. If,
for example, demand for money and ‘V’ would have also changed with every
change in MS, one would not have been able to predict the effect of changes
in MS on output and prices.
According to Keynes, it is not only money, but also government expenditures
(G) and taxes (T) which affect the level of output and prices through changes
in aggregate demand.
4. The monetarists and Keynesian economists also differed regarding the pressing
problem, cause, and its solution in a capitalist economy.
5. The major point of difference between these two approaches is regarding the
effectiveness of policy instruments to stabilise the economy. According to the
Monetarists, it is monetary policy which is more effective, and according to the
Keynesian approach it is fiscal policy, which is more effective in stabilising
the economy.

17.5.1 Grounds on which Monetarists Advocated for Monetary Policy

1. Since demand for money is considered to be stable, changes in money supply
through the monetary policy will affect output and prices.
2. Velocity of money ‘V’ being stable- changes in money supply will affect output
and prices.
3. There is no liquidity trap as shown by Keynes so that monetary policy does
not become ineffective in this region as visualised by Keynes. In fact, it is
changes in money supply and rate of interest affected through the monetary
policy that brings about changes in output and prices.

17.5.2 Grounds on which Keynes Advocated for Fiscal Policy

1. Keynes continued to maintain that the liquidity trap does exist and, in the
region of the Liquidity Trap, the monetary policy becomes totally ineffective
in bringing about changes in the rate of interest, and therefore, output and
prices. Therefore, the only alternative is fiscal policy.
2. According to Keynes, fiscal policy instruments like government expenditure
and taxes have more of a direct impact on aggregate demand as compared to
monetary policy which takes a long time to work out.
Post Keynesian Developments: Monetarism 269

3. Keynes also strongly supported the fiscal policy based on his finding that the
consumption function and the marginal propensity to consume are relatively
stable.
Keynes had found mpc to be relatively stable. The implication of stability of mpc
is that during periods of shortages of AD when the government undertakes expenditure
programs, it would generate employment and income. Since the mpc in stable, the
Government knows with some certainty the magnitude of consumption or aggregate
demand it would be able to generate. For example, if mpc is 0.6 it implies that
60 percent of the income will be consumed, leading to an income generation stream
through the multiplier effect. Such certainty of prediction does not exist for monetary
policy.

17.6 COMPARISON OF MONETARISTS AND MAINSTREAM ECONOMISTS

The differences between monetarists and mainstream economists which was dominated
by Keynesian ideas have been summarised by Samuelson. The difference can be
summarised under two aspects:
1. What is the role of money in determining output in an economy?
2. What is the effect of changes in aggregate demand on output and level of
prices in an economy?
1. Role of Money: Regarding the role of money, the mainstream (Keynesian)
economists and monetarist conclusions can be stated as follows:
(a) Keynesian economists considered money as being only one variable along
with government expenditure and taxes, that determine the level of
output.
(b) According to the monetarist’s, money is the only variable which determines
the level of output, income and prices (at least in the short-run). In the
long-run, however, it determines only prices.
3. Effect of changes in Aggregate Demand on Output and Prices:
Regarding this aspect the following conclusions emerge:
(a) The Keynesian economists believe that changes in aggregate demand
affect both the level of output and prices; since they did not believe in
the assumption of full employment.
(b) The monetarists state that changes in aggregate demand will significantly
affect the prices and not so much level of output in the long-run when
the economy reaches full employment.
The reason for this difference in the results of the analysis of the
Keynesians and the monetarists stems from the basic difference in the
shape of the aggregate supply curves. The aggregate supply curve is
steeper (although not fully vertical in the short-run) in the monetarist
analysis, whereas in the Keynesian theory it is flatter and then becomes
constant after the level of full employment has been reached. The
differences between the two approaches is summarised in Figure 17.1.
270 Macroeconomics

FIGURE 17.1 The Monetarists and Mainstream (Keynesian) Approach.

Monetarist Case
1. As can be seen in Panel A of the above diagram, according to the monetarists,
money supply is a major factor affecting aggregate demand and hence output.
2. Further, as can be seen, because of the almost vertical nature of AS, changes
in money supply in the long run would affect only prices. Money and thus
monetary policy occupies the key position in the monetarist analysis.
3. AS is the aggregate supply curve which is relatively inelastic.
4. AD is affected only by ‘M’ as indicated by the box.
5. The line indicated as potential output shows the near full employment-output
tendency in the economy.
6. If AD changes, i.e. shifts up to AD, it would affect mainly the prices and
not so much the output because of the AD curve being already close to the
potential output level.
7. Hence, in the long-run, money supply affects only prices.
The emphasis in the monetarist case is thus, on money and monetary policy.

Mainstream Case (Keynes)

1. Panel B of Figure 17.1 shows the mainstream case. As can be seen, the AS
curve is flatter, and it is not only money which affects aggregate demand, but
government expenditure (G) and taxes (T) are equally important in bringing
about changes in the level of output and prices.
2. The mainstream economists rely of fiscal policy as a more important instrument
to affect changes in the economy.
3. To summarize, in the diagram, changes in AD through fiscal policy would affect
both output and prices. As can be seen when aggregate demand increases from
AD to AD the prices increase from P to P and the output increases from
OQ to OQ.
Post Keynesian Developments: Monetarism 271

17.7 CRITICAL REVIEW OF THE MAIN TENETS OF MONETARISM

The monetarist’s doctrines have been criticized on the following grounds:
1. The monetarists consider changes in velocity of money to be statistically
predictable, and therefore, consider it to be constant. This explanation is not
very clear.
2. The monetarists do not define money supply by the traditional definition. It
consists of assets that can be used as mediums of exchange, i.e. money supply
consists of currency and chequeable deposits. Friedman includes time deposits
in money supply as well and monetarists in general, indicate that other
assets such as deposits of non-bank financial intermediaries can, and should
be included. Therefore, it is not clear as to which assets, precisely should be
included in money. This also would have implications for formulation and
implementation of the monetary policy.
3. It will be recalled that Keynes, in his theory of demand for money, recognised
three alternative assets in which wealth could be held:
(a) Money
(b) Bonds and equities
(c) Real assets
If we observe the demand for money function used by the monetarists, we
find that the monetarists have simply extended the list of factors on which
demand for money depends; thus the bond rate of interest, equity rate of
dividend, the rate of change of price level, and ratio of human to non-human
wealth are shown separately.
Thus, it is believed that the monetarists demand for money function is
simply a more detailed form of the Keynes’ liquidity preference function.
4. The monetarists have claimed that a change in the supply of money in the
short run partly changes price level and partly the level of real national
income. But the relative proportion in which the two change is not clearly
stated. This becomes a constraint while formulating the monetary policy.

Points to Remember
• There are two very dominant schools of economic thought in macroeconomics—
Keynesians and Monetarists. Monetarism is a school of economic thought founded
by Milton Friedman in 1956.
• Monetarism differed from Keynes ideas regarding the following:
(a) Role of money in an economy
(b) Causes and nature of instability in the economy
(c) Policy instruments to stabilise the economy.
• The Monetarists assigned a prominent role to money in an economy; and therefore,
the monetary policy as an effective instrument to stabilise the economy. According
advocated to them only money matters, and changes in money supply can bring
about increases in output and prices in the short-run only prices in the long-run.
272 Macroeconomics

• The idea that money is an important variable in an economy originated from

the Classical and Cambridge Quantity Theory of Money. The conclusion of these
theories was that given velocity (V) and transactions (T) relatively stable and
given the assumption of full employment changes in the price level. Friedman
developed this idea and showed that if the assumptions of V and T being constant
is dropped, changes in MS would cause changes in both output and prices.
• Friedman, through his quantity theory of money and further analysis, found that
it is mainly changes in MS which bring about changes in output Q and prices
GPL in an economy.
• The main element of monetarism can thus be summarised as follows:
(a) The major problem in a capitalist economy is inflation (and unemployment
as stated by Keynes)
(b) It is MS which determines the level of prices and output in an economy
through the rate of interest.
(c) (MS I  I  (Investment being interest elastic)  Aggregate demand 
Employment, Output  Prices )
• In the long-run, however, with the tendency of full employment, changes in MS
will affect only the level of prices.
• The monetary policy and not fiscal policy is the more effective investment to
stabilise the economy and solve its problems, especially of inflation.
• The monetarists and Keynesian differed mainly regarding the effectiveness of the
monetary policy versus fiscal policy where monetarists favoured the monetary policy.

QUESTION

I. Short Questions
1. What differentiates the monetary approach from Keynes approach?
2. Explain the significance of money supply in Monetarism.
3. Summarize the main elements of Monetarism.
4. In Monetarism ‘Only money matters’. Explain.

II. Long Questions

1. What are the major differences between Keynes and Monetarism? How does
this lead to differences in the effectiveness of the Fiscal and Monetary policy
in the two schools of thought.
2. Explain in detail the main elements of monetarism. What is the role of the
Monetary Policy in Monetarism and how effective can Monetary Policy be
in bringing an economy out of recession?
CHAPTER

18
Post Keynesian Developments
Supply Side Economics

18.1 INTRODUCTION
Supply-side economics represents a recent development in macroeconomic theory. It
evolved mainly in the late seventies when the American and British economies were
undergoing serious recession. This school of thought developed initially in the USA
during President Ronald Reagan’s tenure and later spread to England and other
countries. Supply-side economics was basically originated to overcome the problem
of recession and stagflation, which characterized a number of economies during the
period of 1970–80s. By the 1970s, the problem of stagflation was becoming dominant
and Keynesian economists were a loss to explain the problem.
Supply-side economics developed, mainly as an alternative to the preceding
theories which were too demand oriented, and was basically a challenge to Keynesian
economics which emphasized on ‘aggregate demand’ in an economy.
The main supply-side economists were Arthur Laffer, Jude Winniski, Norman
Tuse, Paul Craig Roberts.
The essence of supply-side economics (SSE) can be summarized as follows:
1. It arose as an alternative to Keynesian views.
2. It emphasises on ‘aggregate supply’, rather than ‘aggregate demand’ to stabilize
the economy.
3. It advocates heavy cuts in tax rates in the economy, since according to them,
high tax rates was the major cause of stagflation in an economy.

18.2 MAIN ELEMENTS OF SUPPLY SIDE ECONOMICS

Main Elements of SSE

Retreat from Greater emphasis on Reduction in tax rates

Keynes’ supply aggregate supply to overcome stagflation
273
274 Macroeconomics

18.2.1 Retreat from Keynes’ Supply

1. The supply-side economists stated that too much government intervention in
the past was responsible for a number of problems in the economy.
2. They stated that Keynes had given too much emphasis to aggregate demand
and the Fiscal Policy, and this could not really solve the problem that the
US economy was facing during the 1970–80s, i.e., recession and stagflation.
3. Therefore, they emphasized on the aggregate supply and attempted to provide
an alternative to Keynes theory.

18.2.2 Greater Emphasis on Aggregate Supply

1. The major problem in the US economy during the 1970s and 1980s was
recession and stagflation; therefore, if the US economy had to be got out of
recession and stagflation what were required were improvements in aggregate
supply through supply-oriented policies.
2. Supply oriented policies include the following measures:
(a) Access to cheap raw materials and other inputs
(b) Subsidies of various types
(c) Improving infrastructural facilities
(d) Concessional price and credit facilities
(e) Making skilled labour, technology available
(f) Import facilities
(g) Tax concessions
(h) Supporting the process of investment and capital formation
Such supply-oriented policies would increase the aggregate supply, i.e. it would
cause a rightward shift in the Aggregate Supply Curve (AS). This would, in turn, lead
to increases in output, employment, and income in an economy. The effects of supply
oriented policies is shown in Figure 18.1.
Explanation
1. As shown in Figure 18.1, the initial equilibrium is determined at point e1
where AD1 = AS1. The output is determined at OQ1.
2. When supply-oriented policies are introduced, the aggregate supply marginally
shifts to the right to AS2, with aggregate demand at AD1 the new equilibrium
is determined at point e2 and output increases from OQ1 to OQ2.
3. However, it should be noted that this increase in output from OQ1 to OQ2 is
a very marginal increase, which indicates that only supply-oriented policies
cannot be very effective during recession (The region of the supply curve which
increases gradually indicates recession).
4. It should also be noted that during the prosperity phase of the economy, i.e.
the rising part of the supply curve, the supply-oriented policies would be more
effective in causing greater increases in supply. However, during the already
prosperous phase, there is no need for the government to support supply and
production.
Post Keynesian Developments: Supply Side Economics 275

FIGURE 18.1 Effects of Supply-oriented Policies.

18.2.3 Reduction in Tax Rates

The supply-side economists felt that stagnation and recession was caused by high tax
rates and high interest rates. Therefore, they advocated tax cuts. High tax rates have
two adverse effects on the level of economic activity:
1. High tax rates are a disincentive to invest.
2. High tax rates are a disincentive to work effort.
Therefore, both capitalists, as well as, workers reduce their levels of activity due
to high tax rates, which leads to a reduction of output and therefore stagnation.
They argued that during the period 1960s and 70s, the government increased
tax rates to increase total revenue. However, they did not take into account the above
disincentives which would adversely affect saving, investment and work effect. They
thus advocated a reduction in tax rates in the interest of economic growth and to
increase the work effort, investment and saving in the economy.

Effects of Tax Cuts

According to the supply-side economists, a tax cut would have two effects:
1. Increase in Aggregate Demand: When taxes are reduced, for example,
personal income taxes, the disposable income of the people would increase
causing an increase in AD.
2. Increase in Aggregate Supply: A reduction in tax rates (like personal
income tax, corporate tax, excise duties) would also, according to them, shift
up the aggregate supply curve through providing greater incentive to work
and invest, and through encouraging capital formation.
The combined effect of an increase in aggregate demand and aggregate supply
276 Macroeconomics

due to cuts in tax rates would lead to increase in the level of output as shown in
Figure 18.2.

FIGURE 18.2 Effects of Reduction in Taxes.

Explanation
1. Initially, with high rates of taxes, the supply and demand curves are given
as AD and AS and the equilibrium is determined at point e, with output at
OQ in Figure 18.2.
2. With the reduction in taxes, both AS and AD increases to AD1 and AS1, so
that the new output is determined at OQ1.
3. It should be noted that most of the increases in output has occurred due
to shifts in aggregate demand rather than aggregate supply, which is more
difficult to increase during a period of recession.
Therefore, contrary to the belief of these economists, it is aggregate demand, which
is more important in bringing about increases in output and employment rather than
aggregate supply, especially during recession.
Therefore, though the supply side economists are advocating supply increases
to do the job of generating economic growth, the responsibility ultimately falls on
aggregate demand.

18.3 LAFFER CURVE ANALYSIS

Since the supply-side economists blamed high rates of taxes for causing stagflation
and recession in the US economy, they advocated strong tax cuts as an incentive to
bring the economy out of its two major problems, i.e. recession and stagflation.
The Laffer Curve was presented by Arthur Laffer, a prominent supply-side
economist. The Laffer Curve is a hypothesis presented to show the behaviour of total
revenue from tax rates as the tax rates increase.
Based on the hypothesis, Arthur Laffer demonstrated that the tax rates in the
US economy were very high, which created strong created strong disincentive effects
(to work and invest). Hence, on the basis of the hypothesis of the Laffer Curve he
advocated strong tax-cut policies.
Post Keynesian Developments: Supply Side Economics 277

Note: To proceed with analysis, it is necessary to clarify that

TR = t  Tax base
where, TR = Total revenue from taxes
t = Rate of taxes
Tax base is the component which is taxed for example income in case of income
tax.
The behaviour, nature, and shape of the Laffer Curve can be noted as follows:
1. According to these economists as the tax rates go on increasing, initially the
Total Revenue (TR) will also go on increasing till the TR reaches a maximum.
This is the level at which the tax rates are at an optimum level.
2. If the taxes go on increasing beyond this level, the disincentive (to work and
to invest) will set in. As a result of this, the TR will actually begin to decline.
3. The Laffer Curve, therefore, takes the shape of an inverted ‘u’ as shown in
Figure 18.3.

FIGURE 18.3 The Laffer Curve: Hypothesis.

Explanation
1. In the above diagram as can be seen when ‘t’ increases, TR increases till
it reaches point ‘M’ which is the optimum level of taxation at 50% in this
example.
2. If the tax rate ‘t’ increases beyond this level (corresponding to point ‘M’, i.e.
at 50%), the TR, in fact, declines due to disincentive effect.
3. An important point to be noted is that a given level of total revenue TR
can be achieved at two rates of taxation, for example, at 20% and 70% in
Figure 18.3. This is due to the adverse effects of extremely high levels of
taxation at 70%.
278 Macroeconomics

4. Laffer and his followers felt that the US economy has crossed the optimum
level of taxation during 1970s causing the problems of stagflation and recession
in the economy.

Policy Proposal
On the basis of Laffer Curve, the supply-side economists thus advocated a drastic
cut in the tax rates in the US, since they believed the tax rates in the US rates had
crossed the optimum level.

Laffer Curve—In reality

It should be noted that the Laffer Curve is only a hypothesis. Arthur Laffer neither
proved it nor established it empirically. The hypothesis has only an intuitive appeal.
In fact, study by Don Fuller Con based on empirical data in the US shows that the tax
rates actually prevalent in the US were far below those that maximize total revenue,
let alone beyond it. This is indicated in Figure 18.4.

FIGURE 18.4 The Laffer Curve- in Reality.

The study revealed that the tax rates in the US economy was somewhere at point
‘C’ in the diagram which is clearly much below the maximum/optimum rate indicated
by the point ‘M’, and therefore, the tax rates in reality were not high enough to create
disincentive effects. The policy proposal of the supply-side economists to have tax cuts
in the US economy then becomes questionable.

18.4 SUPPLY SIDE RESPONSE TO STAGFLATION

The supply side economists had suggested the following measures to control the
problem of stagflation, i.e. unemployment and inflation.
1. A reduction in Taxes: This would increase output and employment through
creating incentives to work and invest.
2. A Restrictive Monetary Policy: Such a restrictive policy through
controlling money supply would be able to control inflation.
Post Keynesian Developments: Supply Side Economics 279

3. Controlling Trade Union Pressure: This would help to reduce Cost Push
inflation which arises due to demand for higher wages.
4. Reducing Excessive Government Expenditure: By controlling excessive
government expenditures, inflation can be controlled.

18.5 EXPERIENCE WITH SUPPLY SIDE ECONOMICS

Around the early eighties supply-side economics gained momentum in the United
States and spread to United Kingdom.
In the US, following the policy proposals of the supply-side economists during
the 1979–81 personal income taxes were slashed by 25%, the Government expenditure
too was proposed to be cut which however did not materialize. However, this policy
generated mixed reactions. The total revenue of the US government reduced with
huge mounting deficits in the mid-1980s. Further, the tax cuts did not, as visualized
by these economists, lead to increase in work effort nor investments. Unfortunately,
the supply-side policies were not successful in controlling inflation which continued to
increase accompanied by high unemployment. How far the increases in productivity
in the US can be attributed to these polices also is not clear. The experiences with
supply side policies therefore did not meet with much success.
In the UK, the supply-side economics met with relatively greater success. These
policies were able to reduce inflation and improve productivity. Britain went in for
heavy privatization. A reason stated for its success is that probably there was too much
rigidity in the economy before Thatcher, and that relaxing the system could have led
to the above benefits.
Supply-side economics seems to have generated mixed results; its performance
has not been very encouraging, whether it would work better in the long run remains
to be seen.
Certain aspects to be noted, from the experience with supply-side economics are:
1. It provided an alternative approach to the problems of an economy, shifting
the emphasis to supply-side policies rather than only demand-oriented policies
(as emphasized by Keynes).
2. It brought forth the point that both supply-oriented as well demand-oriented
policies are required to stabilize an economy, especially so in case of recession.
During recession or stagflation only supply oriented policies take a considerable
time to have a significant impact on the economy and therefore, contrary to the belief
of these economists, supply-side policies have to be supported by demand policies.

Points to Remember
• Supply-side economics represents a comparatively recent development in
macroeconomic thought (1980s) and originated in the US. It emerged mainly as
a challenge to the Keynesian ideas and was an attempt to provide a solution
to the problem of recession and stagflation, which characterised a number of
economics during 1970–80s.
280 Macroeconomics

• The essence of supply-side economics can be summarised as:

1. It was a retreat from Keynes.
2. It emphasizes on aggregate supply policies rather than aggregate demand
policies to stabilize the economy.
3. Its advocated heavy cuts in tax rates since, according to them, high tax rates
were the major cause of stagflation in an economy.
• Through the supply-side economists strongly advocated supply-oriented policies
like easy availability of raw material, finance, technology, infrastructural support,
skilled labour, etc. To boost aggregate supply- it was found the supply oriented
policies by themselves could bring about only very marginal increases in the
output and that what is required is a combination of both demand and supply-
oriented policies, especially to bring the economy out of recession and stagflation.
• The supply-side economists also had advocated strong tax cuts, since according
to them high tax rates produce two disincentive effects, i.e. disincentive to invest
and disincentive to work which caused stagflation.
• They proposed that tax reduction would have two effects:
1. It would increase aggregate demand.
2. It would increase aggregate supply.
• As a result, output would increase. However, it was found that it is increases
in aggregate demand which are more substantial and effective in generating
increases in output-contrary to the supply-side economist view that aggregate
supply policies are more effective.
• In support of their policy for tax reduction and its favourable impact these
economists presented the Laffer Curve named after Arthur Laffer. The Laffer
Curve is a hypothesis, which shows the behaviour of the Total Revenue from tax
rates as tax rates increases. The essence of the Laffer Curve is that as taxes go
on increasing, the Total Revenue initially increases, reaches a maximum, and
then begins to decline due to ‘disincentive effects’ of high taxes.
• Based on this hypothesis and behaviour, they concluded that tax rates in the
1970s in the US had reached very high levels which was responsible for the
recession and stagflation. On these grounds, they advocated strong tax cuts in
the US.
• However, empirical evidence, data and research did not support the above
hypothesis, and in fact, it was found that the tax rates in the US were far below
the optimum level.
• The policy proposals of the supply-side economists, therefore, were not very
effective in stabilizing the economy of the US as with the drastic tax cuts, the
US economy had to face huge deficits in the budget.
Post Keynesian Developments: Supply Side Economics 281

QUESTIONS

I. Short Questions
1. ‘Supply-side economics differs from Keynes’ approach.’ Explain.
2. Show how supply-oriented policies can bring an economy out of recession.
3. Show how reduction in tax rates can cause increases in output and
employment.
4. ‘Laffer Curve analysis is a major contribution of Supply-side economics.’
Elaborate.

II. Long Questions

1. ‘The Supply-side economists emphasized on supply-oriented policies to bring
an economy out of recession.’ In this context, explain the essence of Supply-
side economics.
2. ‘At very high tax rates, the total revenue begins to decline due to the
disincentive effects of high taxes.’ Explain the Laffer Curve in this context.
3. ‘Stagflation is a situation where inflation and unemployment coexist together.’
What where the supply-side policies to solve the problem of stagflation?
4. How relevant are Supply-side economics policies in current recessionary
conditions?
CHAPTER

19
Public Finance

19.1 INTRODUCTION
Prior to 1930s, the economic system which existed was mainly lassiez-faire or a purely
capitalist economy. In such an economy, the government was assigned a minimum role
of maintaining law, order and defence, and the ‘Free Market Mechanism’ was supposed
to ensure the smooth functioning of an economy. However, post 1930s, mainly after
the great depression, the belief in the working of a capitalist system became weak and
governments now play an increasing role in economic affairs. In both socialism, mixed
economy, or even in the case of liberal capitalism, there is an increasing participation
by the governments. Today, the functions of the government extend much beyond its
minimum functions and include areas of defence, security, justice, administration,
regulation, public utility, welfare, public enterprises, infrastructure, education and so
on. In order that governments are able to undertake such functions, it requires funds
and needs to spend extensively. Public expenditures are expanding rapidly due to
expansion of functions of modern governments.
The branch of economics which deals with the finances of the government, i.e.
how the government gets its revenue, how it spends it, how it balances its finances is
known as public finance. Public finance thus studies the ‘Finances’ of the government.

19.2 MEANING AND DEFINITIONS

Public finance deals with the financial operations of a public authority like a federal
government, state government or a local body. It originates from the Greek word
Fiscal which symbolizes ‘public purse’ or Fisc, i.e. public treasury. Hence, the concept
of ‘fiscal policy.’
Public finance also deals with the problems of adjustment of income and
expenditures of the government. It studies the principles underlying the revenues
and expenditures of public authorities.
282
Public Finance 283

19.2.1 Definitions of Public Finance

Bastable: ‘Public finance deals with the expenditure and income of public authorities
of the state and their mutual relation and with financial administration and control.’1
Harold Groves: ‘A field of inquiry that treats the income and outgo of governments
(federal, state and local). In modern times, this includes four major divisions: public
revenue, public expenditure, public debt and certain problems of the fiscal system as
a whole such as fiscal administration and fiscal policy.’2
Hugh Dalton: ‘Public finance deals with the income and expenditure of public
authorities and with the manner in which one is adjusted to the other.’3
Findlay: ‘Public finance is the study of the principles underlying the spending and
of raising funds by public authorities.’4
Plehn: ‘Public finance is the science which deals with the activities of statesman in
obtaining and applying material means necessary for fulfilling the proper functions
of the state.’5

19.2.2 Characteristics of Public Finance

From the above definitions, the characteristics of public finance are given as follows:
1. Public finance deals with:
• Income/expenditures of the government
• Collection of revenue
• Forms of expenditure
• Imbalances in income and expenditure
• Public borrowing and public debt
• Centre-state financial relations
• Administration of financial and fiscal policy.

19.3 SUBJECT MATTER AND SCOPE OF PUBLIC FINANCE

Public finance is the science which deals with the income and expenditure of the
government. It deals mainly with the finances of the government at different levels
such as the centre, state and local levels.
Following are the main questions addressed under the scope of public finance:
1. What are the sources of revenue of the government?
2. What are the various heads of expenditure of the government?

1. Bastable, Charles F. (1903), Public Finance, 3rd ed. Revised and Enlarged. London, Macmillan.
2. Groves, Harold M. (1958), Financing Government, 5th ed., New York, Henry Holt and
Company, p. 1.
3. Dalton Hugh (1957), Principles of Public Finance, London, Routledge and Kegan Paul Ltd.
4. Shirras, G. Findlay, The Science of Public Finance, 1924, London, Macmillan.
5. Plehn, Carl Copping (1902), Introduction to Public Finance, 2nd ed., London, Macmillan.
284 Macroeconomics

3. How does the government balance its revenue and expenditure?

4. What are the sources and methods of government borrowings?
5. What is the impact of the government’s public finance policy on the society/
economy?
6. How does the government decide on optimum levels of taxation and
expenditures?
7. How are the resources divided between the centre and states?
8. What are the objectives of government’s financial activity?

19.3.1 Areas of the Study of Public Finance

There are mainly five areas of the study of public finance:
1. Public Revenue; 2. Public Debt; 3. Public Expenditure; 4. Public Financing;
5. Financial Administration.
1. Public Revenue: This deals with the various sources of the government’s
revenue. It involves a detailed study of the various methods by which the
government raises money, i.e. tax revenues, non-tax revenues, and other
sources. It also involves an analysis of the impact of taxation, the optimum
level of taxation, how taxes can be used as an instrument to reduce inequalities
and so on. The trends in revenue, the various deficits which arise if revenue
falls short of expenditures is also analysed.
2. Public Expenditures: This deals with the classification of government
expenditures, i.e. the various heads on which the government spends, the
causes of increasing expenditures of the government, the allocations of
resources by the government, the optimum level of government expenditures,
the impact of government expenditure programs on society and economy are
also analysed. Public finance also shows how government can use its fiscal
policy to stabilise the economy.
3. Public Debt: This area deals with the various sources of government
borrowings or debt, both internal as well as external. It also deals with public
debt management and its impact.
4. Deficit Financing: When the government cannot meet its expenditures
through its various sources of revenue or borrowings, it can print additional
money or increase money supply. This is known as deficit financing and has
a strong impact on the economy. Deficit financing is of extreme significance
in the study of Public Finance.
5. Financial Administration: This area of public finance deals with
management of public funds, implementation of government’s financial
policies, centre–state financial relations and all matters related to formulation
of the budget and so on.
The scope of public finance is not static but dynamic, in the sense that it is
continuously expands with the changes in the concept of state, functions of state and
the changing problems of economics. The techniques of raising public income, public
expenditure and public borrowing are changing, economic and social responsibilities
of the state are increasing, new problems of defence and public administration, etc.
are growing. These factors are responsible for widening the scope of public finance.
Public Finance 285

19.3.2 Branches of Public Finance

Any public finance policy or government’s financial activity is undertaken with certain
objectives and functions in mind. In this context, there are three major functions of
the government’s financial or budgetary policy also referred to as branches of public
finance:
1. Allocation Branch
2. Distribution Branch
3. Stabilisation Branch.
1. Allocation Branch: This area of public finance policy basically deals with
allocation of resources of the government in the most possible optimum manner.
The government tries to promote competition in production, curb monopolies,
provide public goods, and promote production of goods for development of
economy and also for welfare considerations. Through proper allocation of
resources, the government tries to ensure maximum efficiency in the economy.
2. Distribution Branch: The government through its financial and budgetary
policy also attempts to reduce inequalities in income distribution and tries to
promote equity in the income and wealth distribution. This is done primarily
through the taxes and expenditure programs of the government.
3. Stabilisation Branch: One of the major functions of the government
financial or fiscal policy is to promote macroeconomic stability. The government’s
public finance instruments such as revenue, expenditure and debt are used
to reduce business cyclical fluctuations, increase employment, stabilise the
general price level, promote growth and thereby maintain stability of the
economy.

19.3.3 Positive and Normative Aspects of Public Finance

There are two aspects of the study of public finance.
1. Positive Aspect: The positive aspect of public finance involves a study
of the main sources of public revenue, the types of public expenditure, the
magnitude of public debt and so on. The positive aspect is basically a scientific
study of the various components of public finance.
2. Normative Aspect: The normative aspect is mainly concerned with the
evaluation and judgement about the various fiscal programs of the government.
It studies the consequences and impact of the government’s financial activity
on the society as well as the economy.

19.4 SOCIAL (COLLECTIVE) AND MERIT GOODS

One of the important functions of the modern government is to provide public goods
or satisfy public wants. These categories of goods are those which cannot be provided
satisfactorily by the free market. Such public goods have been classified mainly into
two types:
286 Macroeconomics

1. Social or collective goods or wants

2. Merit goods or wants
1. Social or Collective Goods: In case of collective goods, there is a total market
failure to provide such goods, for example provision of defence, law and order, national
highway, streetlights, public parks, etc. These goods are therefore provided by the
government and are referred to as Social or collective goods. There is a public demand
for such goods but these cannot generally be provided by private enterprise because
there is no possibility of exclusion and such goods do not fit into a regular commercial
activity, and therefore, are generally not provided by the private sector.
The main features of social goods are as follows:
• There is a collective want from the society for social goods.
• The principle of ‘no exclusion’ applies to such goods, i.e. no individual can choose
not to use the services of such goods for example defence, street lights, etc.
• There is no direct link between payment and benefit of such goods.
• There is no ‘one to one’ pricing of such goods for example street lighting,
defence, highways, etc.
• One individual’s use does not prevent other’s use.
Many times, in case of such goods, the investments involved are very huge
(defence, highways, etc.) and also the principle of profit maximisation does not apply
here and hence it is a social good which is provided by the government.
These social/collective goods are financed through government taxes and other
sources of revenue. Left to itself, the free market is unable to cater to such goods.
2. Merit Goods: Merit goods are those which can be provided by the free market
or private enterprise but only at very high costs. In this case there is partial market
failure. Such goods include health, education, food, low cost housing, transport, etc.
Generally, the private sector can provide these goods but the cost of such goods/
services is very high, and therefore, the government intervenes and provides the above
at subsidised or reasonable rates.
In case of both social and merit goods, the government has to decide, which goods
to provide, the amount of such goods to be provided, the cost of such goods/services.
Providing public goods is a major function of government for which it has to plan as
to how to raise revenues to meet the expenditures on such goods.

19.5 PUBLIC FINANCE AND PRIVATE FINANCE

There are a number of similarities and differences between the finances of the
government and that of individuals. Private finance refers to the finances of an
individual and includes all the related details. Public finance, on the other hand,
refers to the finances of the government. The main objective of private finance is
individual welfare and benefit, whereas public finance seeks to promote social welfare
and maximize benefit to the community.
Public Finance 287

19.5.1 Differences between Public and Private Finance

The nature, objective, goals and principles of private and public finance differ and
hence public finance needs a separate treatment and analysis. Findlay Shirras has
identified the following main points of difference between public and private finance6:
1. Adjustment of Income and Expenditure: An individual generally adjusts
his expenditure to income and tries to maintain his expenses within the limits
of his income. The government, on the other hand, prepares an estimate of its
expenditures to be incurred in a financial year which is recorded in the annual
budget of a country. It then plans the sources of income, which includes tax
revenue, non-tax revenue, borrowings and also the extent of deficit financing.
Hence, an individuals expenditure is determined by his income, whereas for
the government the expenditures determine the income.
2. Time Duration and Budgeting: The budget of the public authority is an
annual document; whereas for individuals, there is no such time restriction or
duration during which a statement of accounts of income and expenditure has to
be presented. The government has an obligation to prepare a budget every year.
3. Resource Base: The individual’s expenditures are by and large limited by
their income and extends to some borrowings and debt. Whereas, in the case
of public finance, the entire nation’s resources are the basis for raising revenue
through taxes and other sources. The government also has the additional
source of raising more money through deficit financing, i.e. printing of new
currency if the situation demands it.
4. Coercive Action: Various sources of the revenue of the government like
taxes have a legal basis, and therefore, it is compulsory and obligatory on
the part of individuals to pay the taxes and other fees to the government.
There is thus an element of coercion in public finance which is not applicable
to private finance.
5. Transparency in Public Finance: The budget and finances of the
government are a public document and presented to the public in the budget
session as an annual feature. On the other hand, private finance of the
individuals has an element of secrecy and privacy.
6. Motive of Expenditure: The government’s motives of expenditure and
finance plans differ from the individual’s expenditures. The individual’s
attempt to restrict their expenditures within the limits of their income as
far as possible; whereas the government is more concerned with ensuring
that all public, social and merit goods are provided to the society even if
these expenditures exceed the income. Welfare and other such considerations
dominate public finance whose ultimate aim is the betterment of society. The
government also is not guided only by the goal of balancing its budget but
can have a deficit or a surplus budget depending on the economic situation
and the requirement of the economy. For example, if the economy is facing
recession the government deliberately maintains deficit budget wherein the
government expenditures is more than the revenue and uses its sources of

6. Shirras, G. Findlay (1924), The Science of Public Finance. London, Macmillan, p. 33.
288 Macroeconomics

revenues and expenditures to stabilize the economy. It is the economic policy

objectives which decide the goals of public finance during any time period.
7. Welfare of the Society: For individuals, it is their own private interest or
welfare which dominates their finances; whereas for public finance the welfare
of the society is the ultimate goal.
8. Provision for the Future: A major objective of public finance or the
government finances is to make provisions for the future. To this end, the
government makes huge investment in infrastructure and other projects to
cater to the future generations and also to provide for facilities in the long
term. On the other hand, the finances of an individual are generally restricted
to their family and does not run very deep into the future.
9. Flexibility in Public Finance: There is greater flexibility in the government
sources of revenue and also huge diversity in the sources. The government can
devise various types of tax and non-tax revenue sources to expand its income. It
also has the opportunity and access to borrow from both internal and external
sources. The sources of income for individuals is far more restricted and rigid.
The finances of the government, i.e. public finance has a much broader and
comprehensive goal of maximizing welfare to the society. Public finance, i.e. the tools of
public revenue and public expenditures are also used to bring about economic growth,
full employment, price stability, internal and external economic stability, economic
justice and so on. Public finance and the related budgetary and fiscal policy, in fact,
is a very crucial policy instrument of the government.

19.6 SIGNIFICANCE AND IMPORTANCE OF PUBLIC FINANCE

Public finance as a branch of economic study is an extremely crucial area of economics.
Its significance is evident from the following counts:
1. It provides an in-depth study of the government’s finances (incomes and
expenditures).
2. It analyses how the government allocates its resources for the benefit of the
society.
3. It shows how the government’s financial/fiscal and budgetary policy can be
used to stabilize the economy and also bring about economic justice.
4. It analyses the role of public debt in an economy.
5. It deals with all aspects of financial administration and management.

Points to Remember
• Public finance is related to the financing of the state activities. Public finance
is a subject which discusses financial operations of the fiscal or public treasury.
• Public finance explains the income and expenditure of public authorities like the
governments at various levels: central, state and local. Public finance also deals
with the problem of adjustment of income and expenditure of the government.
Public Finance 289

• The importance/scope of public finance can be understood in the context of:

(a) Functions of the state
(b) Effects of fiscal operations on economic life
(c) Subject-matter of public finance
• There are three main branches of public finance:
(a) The allocation branch
(b) The distribution branch
(c) The stabilisation branch
• The scope of public finance is not static but dynamic. It continuously expands
with the changes in the concept of state, functions of state and the changing
problems of economics.
• One of the important functions of the government is to provide social/collective
goods and merit goods.
• In case of collective goods, there is a total market failure to provide such goods,
for example provision of defense, law and order, national highway, streetlights,
public parks, etc. These goods are therefore provided by the government and are
referred to as Social or collective goods.
• Merit goods are those which can be provided by the free market or private
enterprise but only at very high costs. In this case there is partial market failure.
Such goods include health, education, food, low cost housing, transport, etc.
• There are many differences between Private and public finance. The finances of
the government, i.e. public finance has a much broader and comprehensive goal
of maximizing welfare to the society.

QUESTIONS

I. Short Questions
1. ‘Public finance deals with the finances of the Government.’ Explain.
2. What are the differentiating characterstics of private versus public finance?
3. ‘The scope of public finance expands as the role of the government goes on
increasing.’ Explain.
4. Elaborate on the various branches of Public Finance.

II. Long Questions

1. ‘Public finance is a very crucial branch of the Government.’ In this context
explain the scope and subject matter of Public finance.
2. Distinguish between private finance and public finance. Explain the growing
importance of public finance in modern times.
3. ‘Social goods are goods which the government provides when there is a total
market failure.’ Elaborate with examples.
4. ‘There is no distinction between social and merit goods.’ Do you agree?
Justify your answer.
CHAPTER

20
Budget
Meaning and Types

20.1 INTRODUCTION
Fiscal policy refers to the policy of the government related to government revenues
and expenditures to regulate and stabilize the economy.
The instruments of the fiscal policy include:
1. Government Revenue
2. Government Expenditure
3. Deficit Financing
4. Public Debt.
These instruments of the fiscal policy are used to regulate and stabilize an
economy and attain objectives like economic growth, economic and price stability,
economic justice, etc. The budget is an important aspect of the fiscal policy. In fact,
the fiscal policy is also referred to as the budgetary policy though the fiscal policy is
more comprehensive.

20.2 MEANING OF THE BUDGET

The budget is an annual financial statement recording the revenues and expenditures
and other aspects related to the finances the government.
The budget is the principal instrument of the fiscal policy. Fiscal policy refers to
the policy of the government related to government revenues and expenditures. It has
been defined as the Government taxation and expenditure policy to regulate the level
and composition of output. Fiscal policy, is also referred to as the budgetary policy.
The budget provides a detailed break up of the government’s sources of revenue,
items of expenditure, deficit position, public borrowings and so on. It is an annual
financial document of the government which records the governments various sources
of revenue, expenditures and details related to public debt, deficits and other matters
of finances of the government.
290
Budget: Meaning and Types 291

20.2.1 Features of a Budget

1. Annual financial statement
2. Requires sanction of Parliament
3. High level of secrecy in budget
4. Record of a government’s estimated receipts and proposed expenditure
5. Record of related financial plans of a government.

20.2.2 Budget Figures

A budget generally gives three sets of figures:
1. Actual figures for the preceding year
2. Budget and revised figures for current year
3. Budget estimates for the following year.
For example, the Budget of 2008–09 would contain:
1. Actual figures for the year 2006–07
2. Budget’s revised estimates for 2007–08
3. Budget estimates for 2008–09.

20.2.3 Other Concepts Related to the Budget

1. Surplus Budget: Public revenue > Public expenditure
2. Deficit Budget: Public expenditures > Public revenue
3. Interim Budget: A temporary budget which is declared in critical political
circumstances such as a change in the government.
4. Ordinary Budget: It refers to the regular budget.
5. Supplementary Budget: In case of any sudden public expenditure, such as
expenditure on war, calamities, etc., a supplementary budget is formulated to
take care of the revenues and expenditures.
There is also the concept of a legislative budget and executive budget. Under the
legislative budget, it is prepared and adopted by the legislature and its committees.
An executive budget is prepared by the executive branch of the government and then
passed and adopted by the legislative.

20.2.4 Basic Format of a Budget

The budget has broadly two aspects:
1. The revenue budget or account
2. The capital budget or account.
The basic format of the budget is given in Table 20.1.
292 Macroeconomics

TABLE 20.1 Basic Format of a Budget

Item ` (Crores)
(I) REVENUE ACCOUNT
Receipts --------
Expenditures --------
Surplus/Deficit --------

(II) CAPITAL ACCOUNT

Receipts --------
Expenditures/Disbursements --------
Surplus/Deficit --------
Overall Budgetary Deficit/Surplus

Revenue Budget/Account
The revenue account is further subdivided into:
1. Revenue receipts
2. Revenue expenditures
The revenue account deals with receipts and expenditures of the government
which are recurring in nature.
1. Revenue Receipts: The sources of revenue of the government are classified as:
Tax Revenue and Non-tax Revenue.
(a) Tax revenue includes:
• Taxes on income and expenditures
• Taxes on property and capital transactions
• Taxes on commodities and services
(b) Non-tax revenue includes
• Currency coinage mint
• Interest receipts and dividends
• Other non-tax receipts like fees, fines etc.
2. Revenue Expenditures: It includes expenditure mainly on:
(a) Administration
(b) Maintenance of law and order
(c) Defence, judiciary
(d) Social community services like education, public health, transport
(e) Interest payments
(f) Salaries, pension
(g) Economic services like agriculture, industries, transportation trade.
Budget: Meaning and Types 293

Capital Budget/Account
Capital account generally includes lumpsum, one-time payments or receipts which have
long term repercussions. These are in the nature of acquiring and disposing capital
assets.
The capital account is subdivided into:
1. The Capital Receipts
2. The Capital Expenditures
1. Capital Receipts: It includes:
(a) Net recoveries of loans and advances made to state government
(b) union territories, and public sector undertakings
(c) Net market borrowing and small savings
(d) Other-capital receipts like provident funds, deposits and so on.
2. Capital Expenditures: It includes mainly:
(a) Loan to states and union territories
(b) Projects on social community development
(c) Capital expenditure on defence
(d) Capital expenditure on economic development
(e) Capital expenditure on general services.
Note: In 1987–88 central government of India classified public expenditure into plan
expenditure and non-plan expenditure.
Non-plan Expenditure: Non-plan expenditure is further classified into revenue
and capital expenditure.
• Revenue non-plan expenditure includes mainly interest payment, defence, major
subsidies, pensions other general services like organizations of state, external
affairs, etc.
• Capital non-plan expenditure includes defence, capital expenditure, loans to
public enterprises, loans to foreign governments.
Plan Expenditure: It includes:
• Expenditure on agriculture, rural development, irrigation, energy industry,
social services and so on.
• Central assistance for plans of the states and union territories.

20.3 MAJOR TYPES OF DEFICITS IN THE BUDGET

There are four types of deficits in the budget:
1. Revenue deficit; 2. Budgetary deficit; 3. Fiscal deficit; 4. Primary deficit.
1. Revenue Deficit: Revenue deficit = Revenue expenditure – Revenue receipts
2. Budgetary Deficit: Budgetary deficit = Total expenditures – Total receipts
294 Macroeconomics

3. Fiscal Deficit: Fiscal deficit = Budgetary deficit + Net Market borrowings

Net Market Borrowings = Market Borrowings – Recovery of Loans – Other Receipts
Borrowings of the government include borrowings from:
(a) Public (PPF, NSC, PF)
(b) Institutional borrowings from domestic sources like LIC, GIC, ICICI,
banks, etc.
(c) Foreign institutional borrowings, i.e. from foreign institutions, commercial
banks, foreign companies, etc.
(d) Inter-governmental borrowings.
The fiscal deficit reflects the true picture of a government deficit and shows
the true gap between government’s expenditures and revenue.
4. Primary Deficit: Primary deficit = Fiscal deficit – Interest payments
Table 20.2 shows the deficits of the Government of India in 2019–20.

TABLE 20.2 Budget at Glance Calculation of Fiscal and other Deficits

Item 2019–2020
(Revised estimates)
(in ` Crore)
(1) Revenue Receipts 18,50,101

(2) Capital Receipts of which 8,48,451

(a) Recovery of Loans 16,605
(b) Other Receipts 65,000
(c) Borrowing and other Liabilities 7,66,846
(Net Borrowings)
(3) Total receipts (1 + 2) 26,98,552
(4) Revenue Expenditure 23,49,645
(5) Capital Expenditure 3,48,907
(6) Total Expenditure 26,98,552
(7) Revenue Deficit (1–4) 4,99,544
(8) Budgetary Deficit (3–6) Nil
(9) Fiscal Deficit
[6 – (1 + 2a + 2b)] 7,66,846

Sources: Budget at a Glance, 2020–2021. Government of India Ministry of Finance.

Note: (i) Fiscal deficit in Table 20.2 can also alternatively be calculated using formula given
in above Section 20.3.
Fiscal deficit = Budgetary deficit + Net Market Borrowings
where, Net Market Borrowings = 2 – (2a + 2b)
So, Fiscal Deficit = 8 – (2 – (2a + 2b) or Fiscal deficit = 8 + 2c
Budget: Meaning and Types 295

20.3.1 Deficit Financing

When the government cannot raise enough financial resources through taxations, it
finances its expenditures through borrowings from the market and RBI. This is called
the fiscal deficit.

Methods of Deficit Financing

There are three important techniques through which the government can finance its
deficit:
1. Borrowing from the Central Bank
2. Using accumulated cash balances by the government
3. Issue of new currency.

Objectives of Deficit Financing

1. Deficit financing is used to finance the expenditures of the government, in
excess of its revenue when it has exhausted all its sources of borrowing.
2. It is an instrument to stabilize the economy and get the economy out of
recession and depression.
3. It is necessary to finance the projects of the government required for economic
development.

Effects of Deficit Financing

Deficit financing has the following impacts on the economy:
1. Increase in Money Supply: Deficit financing through creation and
expansion of money supply causes excess money supply and excess credit in
an economy.
2. Increase in Price: Deficit financing through creating excess money supply
can push up the level of prices causing inflationary tendencies in the economy.
3. Effect on Distribution of Income: Deficit financing leads to inequalities
in wealth and income distribution by favouring the business and producer
class and adversely affecting the fixed income groups.
Thus, any excess deficit needs to be avoided and a lot of caution needs to be
exercised while embarking on any program of deficit financing.

20.4 APPROACHES TO BUDGET

20.4.1 Balanced and Unbalanced Budget Approach

There have been two dominant approaches to budgetary policy and its role in the
economy:
1. The Balanced Budget Approach (Classical)
2. The Unbalanced Budget Approach (Functional finance).
296 Macroeconomics

1. Balanced Budget Approach (Classical Approach)

Classical economists advocated a minimum role to the government, because of the belief
in the smooth functioning of the capitalist economy. In this context, they advocated
what is called The Balanced Budget Approach. Their approach was that the role
of the fiscal policy should be kept to the minimum and that fiscal policy or the
budgetary policy should not become an active instrument in the economy. In a sense
they advocated a passive role to the budget.
A ‘balanced budget’ implies that the current government revenue equals current
government expenditures, i.e. R = E. This approach, according to them, could be a sound
system of public finance. The government was not required to use its revenue and
expenditure instruments in the economy, since the capitalist economy was supposed
to correct any imbalance through the working of the ‘Free Market Mechanism’.
Any imbalance in the budget, i.e. when revenue and expenditures are not balanced,
would only cause a number of problems like unnecessary government intervention,
economic uncertainties, burden of taxation, burden of public debt, etc.
Thus, a balanced budget was considered to be the most ideal and rational budget
according to the classical economists.
Grounds on which economists advocated a balanced budget:
(a) Unbalanced budgets may create excess intervention by the government in
economic activity which could lead to excess government expenditures and
thereby inflationary pressures.
(b) Unbalanced budget can increase the burden of public debt.
(c) Unbalanced budget through excess government expenditures can cause
inflation.
(d) When there is imbalance in the budget, the government has to borrow, this
may put a strain on the market funds. Therefore, the gap between governments
revenue and expenditures should be minimized to maintain stability of the
economy.
On this basis the classical economist advocated minimum intervention by the
government in economic affairs and believed in the lassiez-faire policy.
2. Unbalanced Budget Approach or Concept of Functional Finance
With the importance of government intervention, and increasing significance of the
role of the fiscal policy or budgetary policy in the economy, a concept, which has been
developed, is that of functional finance. The term was introduced by A.P. Lerner1, and
gained popularity after the Keynesian revolution. Functional finance means using the
instruments of fiscal policy, i.e. public expenditures and public revenue, to achieve
certain objectives in the economy. That is, each instrument is to be used for some
purpose or a specific function. The principle of judging fiscal measures by the way
they work or function in an economy is called ‘functional finance’.
Functional finance implies an ‘unbalanced budget approach’ where either
government revenue exceeds government expenditure or the government expenditures
exceeds government revenue.

1. Lerner, Abba P. (1948). The Burden of National Debt. Income, Employment and Public Policy,
New York. W.W. Norton, pp. 255–275.
Budget: Meaning and Types 297

The instruments of the fiscal policy, i.e. government expenditure and revenue,
public debt, deficit financing, etc, are to be used to attain specific objectives in the
economy. The functional finance or unbalanced budget approach assigns a positive role
to the government to intervene to correct any imbalances, fluctuations and related
problems in the economy.
The essence of the working of this approach can be summarised as follows:
(a) In an inflationary situation, the government expenditures should be kept to
the minimum and government revenue raised to the maximum, i.e. where
R > E (i.e. revenue greater than expenditure). This would help mopping up
excess money supply in the economy by increasing taxes (income) and other
sources of revenue.
(b) During a deflationary period, the government should deliberately increase its
expenditure in excess of revenue, i.e. E > R to generate income, purchasing
power, and aggregate demand in an economy. These measures would include
a reduction in taxes, tax concessions, etc.
(c) To bring the economy out of depression, this approach advocated ‘deficit
financing’, i.e. issue of new currency, to sustain aggregate demand and to
provide funds to increase production, to be able to attain full employment
levels.
(d) Public debt was advocated to finance government expenditures or to mop
up excess money supply from circulation. In inflationary situations, if the
government raises public debt, it mops up excess money supply and purchasing
power from the economy, hence stabilising the price level.
(e) Unfortunately, however, deficit financing and public debt has been misused
and mismanaged in many economies, defeating its very purpose and in some
cases, aggravating the problem of inflation even further.
Significance of an Unbalanced Budget: The unbalanced budget is advocated on
the grounds that the budget can play a very active role in the economy and bring
about economic stability. The unbalanced budget can be used in the following manner:
• In inflation, government can create a Deficit Budget, where, GE > GR.
• In deflation, the government can create a Surplus Budget, i.e., GR > GE.
• Public debt can be used as an instrument to curtail inflation or government
can raise excess public debt to finance development programs.
The instruments of budget, i.e., government expenditures, revenue, debt, and
deficit financing can be used to attain the objectives of:
(a) Economic Stability
(b) Economic Growth
(c) Price Stability
(d) Economic Justice.
Dangers of Unbalanced Budget: If an ‘unbalanced budget’ approach specially if
a deficit budget is used without caution, it can cause adverse consequences in the
economy namely:
(a) Excess Inflation
(b) Excess Intervention by the Government
298 Macroeconomics

(c) Distortion of Tax Structure

(d) Excess Burden of Expenditures and Subsidies by Government
(e) Crowding Out Effect (Excess Government Investment/Expenditures may
discourage Private Participation).
Therefore, the limits of an unbalanced budget must be understood and the optimum
extent of government intervention must always be kept in mind while practising the
‘unbalanced budget’ approach.

20.4.2 Automatic or Built-in Stabilisers and Discretionary Stabilisers

The revenue and expenditure instruments of the government can also be classified
into two types:
1. Automatic or Built-in Stabilisers
Automatic or built-in stabilisers refer to policy instruments that automatically act
to stabilise fluctuations in income, employment, etc. without specific government
intervention. These kinds of stabilisers are supposed to automatically correct any
imbalance in the economy. There should be maximum reliance on such stabilisers to
reduce the burden on the government.
The automatic stabilisers which once designed, are supposed to correct any
disturbances in the economy. Along with such automatic stabilisers there are
‘discretionary stabilisers’ which need constant review and changes by the government.
Examples of Automatic Stabilisers: The nature and working of automatic
stabiliser will become evident by following examples of such types of stabilisers:
(a) Progressive income taxes. The simplest example of an automatic stabiliser is
the progressive income tax. As the national income increases, the collection
of revenue from income to the government also increases so that the excess
money supply with the economy gets mopped up, reducing the possibility
of inflation which may occur due to excess money supply in the economy.
This is a ‘built in’ stabiliser which works against the direction of change
in the income. In the other case, if income levels are falling, it means that
automatically the tax receipts of the government fall or people pay fewer taxes
so that they have more disposable income to keep the aggregate demand in
the economy going. Such taxes stabilise any upward or downward movements
in the level of income, thus avoiding the adverse effects of an excessive
increase in income inflationary or excessive fall in income, i.e. deflationary
tendencies in the economy. Every time the income level increases or decreases,
the government does not have to immediately change this tax structure, it
has an in-built stabilising element which works automatically to stabilise the
fluctuations and moderate the business cycles.
(b) Unemployment insurance and other welfare transfers. In some countries,
there are unemployment insurance benefits or unemployment doles (e.g.
United States of America, UK and so on). Such benefits sustain the incomes
and aggregate demand in the economy, once the individuals get employment
these benefits are automatically withdrawn, thus stabilising the economy
automatically.
Budget: Meaning and Types 299

The other automatic stabilisers include income support programmes,

unemployment welfare benefits.
Concluding Comments: ‘Built-in’ stabilisers however, by themselves, cannot be relied
upon to correct all imbalances in the economy and guarantee stability. In a developing
country, like ours, other discretionary instruments like public debt, public expenditure
has to be largely resorted to.
Built-in stabilisers can reduce some of the fluctuations but does not wipe out 100
per cent of the disturbances, these would require monetary and fiscal interventions
by the government.
2. Discretionary Stabilisers
Since automatic stabilisers alone cannot stabilise the economy, discretionary stabilisers
become necessary to control fluctuations in the economy.
Discretionary fiscal stabilisers refer to those instruments of the government, which
involve continuous vigilance and discretion. To control any fluctuation or disturbance
in the economy deliberate changes are made in such instruments.
The major weapons of the discretionary fiscal policies are:
(a) Public Works Programs
(b) Public Employment Programs
(c) Variations in Tax Rates
(a) Public works programs: In time of recessionary or depressionary trends in the
economy, the government may take up public works programs like road construction,
irrigation projects, building, construction works, etc. which generates income and
employment and so creates purchasing power thus boosting aggregate demand in the
economy. The public works program is a deliberate and well thought out decision of
the government and is thus discretionary in nature. The magnitude of this expenditure
would depend on the extent of recession.
(b) Public employment programs: These programs have almost a similar effect as
public works programs but with the advantage that such programs may be of shorter
duration, therefore, the effect is felt more strongly. The public works programs are
many times of a very long duration so that its impact in correcting imbalances may
be long drawn out.
(c) Variations in tax rates: It refers to deliberate increase and decrease in tax
rates to cope up with a temporary inflationary or deflationary situation in the economy.
It is quite obvious that during a depressionary or deflationary phase, tax cuts will
be introduced to support and encourage the aggregate demand. During inflationary
conditions, income tax, for example, will be raised to mop up excess money supply in
the economy.
The other discretionary stabilisers include welfare expenditures, concession on
taxes, tax exemptions, public debt and its management. Discretionary stabilisers would
have strong stabilising effects if applied in the right measure and right time.
Concluding Comments: It is quite clear that both automatic and discretionary
stabilisers have to be relied on to stabilise the economy. However, though a distinction is
made between ‘built in’ and ‘discretionary’ stabilisers sometimes the built-in stabilisers
300 Macroeconomics

can also be changed to perform a discretionary function. e.g. increasing the rate of
income tax. These two instruments are thus complementary in nature.

20.5 OBJECTIVES OF THE BUDGETARY (FISCAL) POLICY

Every instrument of the budget, is used in a deliberate manner in an economy to
achieve certain objectives. These objectives include:
• Objective of Full Employment
• Objective of Economic Growth
• Objective of Economic Stability
• Objective of External Stability
• Objective of Economic Justice.
The budget promotes, regulates and stabilises the economy through
• Increasing the Rate of Investment and Capital Formation
• Encouraging Savings (through Tax Measures)
• Discouraging Excess and Unnecessary Consumption
• Channelizing Investment into Productive Sectors
• Correcting Sectoral Imbalances
• Reducing Inequalities in Income/Wealth Distribution
• Providing Social Goods, Increasing Economic and Social Welfare

Points to Remember
• The budget is an annual financial statement recording the revenues and
expenditures and other related financial aspects of the government.
• It is an annual financial document of the government which records the
governments various sources of revenue, expenditures and details related to
public debt, deficits and other matters of finances of the government.
• The budget is an important aspect of the fiscal policy. In fact, the fiscal policy
is also referred to as the budgetary policy though the fiscal policy is more
comprehensive.
• There are two main approaches to the budget. The ‘Balanced Budget’ approach
and the ‘Unbalanced Budget’ approach.
• The Balanced Budget Approach states that the use of the fiscal policy should be
kept to the minimum and that fiscal policy or the budgetary policy should not
become an active instrument in the economy.
• The Unbalanced Budget approach or Functional finance means using the
instruments of fiscal policy, i.e., public expenditures and public revenue, to
achieve certain objectives in the economy.
• The revenue and expenditure instruments of the government can also be classified
into two types: Automatic Stabilisers and Discretionary stabilisers.
• The budget has broadly two aspects: (1) The revenue budget or account; (2) The
capital budget or account.
Budget: Meaning and Types 301

• The revenue account deals with receipts and expenditures of the government
which are recurring in nature. Capital account generally includes lumpsum, one-
time payments or receipts which have long term repercussions. These are in the
nature of acquiring and disposing capital assets.
The capital account is subdivided into: The Capital Receipts and The Capital
Expenditures
• There are four types of deficits in the budget:
1. Revenue deficit; 2. Budgetary deficit; 3. Fiscal deficit; 4. Primary deficit.
1. Revenue Deficit: Revenue deficit = Revenue expenditure – Revenue receipts
2. Budgetary Deficit: Budgetary deficit = Total expenditures – Total receipt
3. Fiscal Deficit: Fiscal deficit = Budgetary deficit + Net market borrowings
4. Primary Deficit: Primary deficit = Fiscal deficit – Interest payments
• Deficit Financing: When the government cannot raise enough financial
resources through taxations, it finances its expenditures through borrowings
from the market and RBI. This is called the fiscal deficit.

QUESTIONS

I. Short Questions
1. ‘A budget is a reflection of the the finances of a government.’ Explain.
2. Explain the distinguishing features of the Balanced and Unbalanced Budget
approach.
3. Explain the meaning of ‘functional finance’. What does it imply?
4. Why are automatic stabilizers not enough for a Government? Explain the
meaning of automatic stabilizers.
5. What are the techniques of deficit financing and its significance?
6. Explain the significance and meaning of:
(a) Revenue deficit
(b) Budgetary deficit
(c) Fiscal deficit.

II. Long Questions

1. A budget is a very important instrument of the Government to stabilize an
economy. What is the significance of the Budgetary Policy?
2. Discuss the structure of a budget and give details of the Revenue and
Capital items.
3. ‘It is very crucial to maintain the deficits in a budget within limits.’ In
this context, explain the meaning and significance of fiscal deficit in an
economy.
302 Macroeconomics

4. Calculate Revenue, Budgetary and Fiscal Deficits from data given in the
table below using the definitions given in the chapter for calculating the
above deficits.
(` Crores)
Item 2018–2019
(1) Revenue Receipts 17,25,738
(2) Capital Receipts of which 7,16,475
(a) Loan Recoveries 12,199
(b) Other Receipts 80,000
(c) Borrowing and other Liabilities 6,24,276
(3) Total Receipts (1 + 2) 24,42,213
(4) Revenue Expenditure 21,41,772
(5) Capital Expenditure 3,00,441
(6) Total Expenditure 24,42,213
(7) Revenue Deficit —
(8) Budgetary Deficit —
(9) Fiscal Deficit —
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Website Resources
https://www.rbi.org.in/
https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG?locations=IN-1W
https://www.rbi.org.in/scripts/AnnualPublications.aspx?head=Handbook%20of%20
Statistics%20on%20Indian%20Economy
https://www.indiabudget.gov.in/keytoBudDoc.php
https://www.indiabudget.gov.in/economicsurvey/
https://economicoutlook.cmie.com/
https://www.indiastat.com/
Index

A Budgetary policy, 290

Business motive, 67
Accelerator coefficient, 256
Accelerator principle, 255 C
Actual boom, 179
Aggregate demand, 213 Cambridge or cash balance version, 130
function, 210 Capital account, 292
schedule, 210 Capital budget/account, 293
Aggregate monetary reserves, 85 Capital expenditures, 293
Aggregate Supply Function (ASF), 208 Capital gains/losses, 35
Alfred Marshall’s Version, 131 Capital non-plan expenditure, 293
Allocation branch, 285 Capital-output ratio, 257
Anti-cyclical policies, 181 Capital receipts, 293
Approaches to budget, 295 Capitalist economy, 191
Arthur Laffer, 276 Cash balances, 65
Asset approach to demand for money, 75 Cash Reserve Ratio (CRR), 113
Asset demand, 265 Central bank, 91
Assumption of full employment, 192 Cheap money policy, 95
Automatic or built-in stabilisers, 298 Chicago school, 264
Autonomous investment, 237 Circular flow of income mechanism, 38
Average propensity to consume, 230 Classical macroeconomics, 191
Classical or cash transactions version, 123
B Closed economy, 38
Collateral securities, 116
Balanced budget approach, 296 Commercial banks, 109
Bank rate policy, 95 Commodity money, 79
Bank/Credit money, 79 Concept of effective demand, 207
Banking functions, 110 Constant year, 25
Barter, 55 Consumption function, 215, 224
Base year, 25 Consumption schedule, 226
Basic format of a budget, 291 Contraction or downswing, 178
Branches of public finance, 285 Convertible paper currency, 80
Broad money, 85 Cost-push inflation theory, 151
Budget, 290 Credit control policy (monetary policy), 93
Budget figures, 291 Credit multiplier, 115
Budgetary deficit, 293 Creeping inflation, 148
305
306 Index

Currency component, 78 Financial assets, 82

Current deposits, 80 Financial intermediaries, 109
Current year, 25 Financial intermediation, 109
Financial investment, 32, 237
D Financial market, 40
Fiscal, 282
Dear money policy, 95 Fiscal deficit, 294
Deficient demand, 212 Fiscal policy, 184, 290
Deficit budget, 291, 297 Fiscal policy measures, 214
Deficit financing, 284, 290, 295 Fiscal stimulus package, 221
Deficits in the budget, 293 Format of a budget, 292
Definitions of public finance, 283 Free market mechanism, 282
Deflation, 157 Friedman’s quantity theory of money, 140
Deflationary gap, 158 Friedman’s restatement of the quantity theory
Demand deposits, 80 of money, 265
Demand for money, 65, 126 Full bodied, 80
Demand oriented, 273 Functional finance, 296
Demand-pull theory of inflation, 150 Fundamental psychological law of consumption,
Deposit component, 79 225
Depreciation or capital consumption allowance,
23, 31 G
Depression (contraction), 179
Derived demand, 65 GDP/GNP deflator, 47
Direct action, 105 General price level, 120
Direct price controls, 170 General theory of employment, interest and
Direct taxes, 31 money in 1936, 205
Directives by the Central Bank, 104 Global financial meltdown 2008–2009, 219
Discretionary stabilisers, 299 GNP at Factor Cost (GNPFC), 22
Disincentive to invest, 275 GNP at market prices, 22
Disincentive to work effort, 275 Government expenditure, 214, 290
Distribution branch, 285 Government intervention, 214
Dividends, 31 Government revenue, 290
Double counting, 35 Gross domestic investment expenditure, 32
Dynamic economics, 14 Gross Domestic Product (GDP), 20
Gross investment, 32
E Gross National Product (GNP), 21

Economic behaviour, 1 H
Economics, 2
Equation of exchange, 123 Hawtrey’s monetary theory of trade cycles, 186
Equilibrium level of investment in the HDN, 81
Keynesian theory, 240 Hyperinflation, 149
Expansion or upswing, 178
Expected expenditures, 67 I

F Illegal activities, 35
Illegal income, 36
Factors affecting MEC, 242 Income generation process due to interaction
Fallacy of composition, 10 between multiplier and accelerator, 260
Final goods, 27 Income inflows, 21
Index 307

Income motive, 67 M
Income outflows, 21
Income policies, 170 Macroeconomic aggregates/variables, 5
Indirect taxes, 31 Macroeconomic paradox, 10
Induced investment, 237 Macroeconomic policies/instruments, 5
Ineffectiveness of the monetary policy measures Macroeconomics, 3, 4
during recession, 221 Mainstream economists, 269
Inflation, 148 Major macroeconomic theories, 5
Inflationary gap, 156 Marginal Efficiency of Capital (MEC), 238
Interaction of multiplier and accelerator, 258 Marginal Propensity to Consume (MPC), 229
Interest-push inflation, 96 Marginal propensity to save, 230
Interest rate flexibility mechanism, 197 Marshall’s cash balance version, 133
Interim budget, 291 Maximum expected sales proceeds, 210
Intermediate goods, 27 Meaning of demand for money (k), 132
International payments, 42 MEC schedule, 238
International receipts, 42 Medium of exchange, 57
Inventory value, 35 Merit goods, 286
Investment, 39 Metallic money, 79
function, 215, 236 Microeconomics, 3
multiplier, 249 Milton Friedman, 264
Investments are injections, 39 Minimum expected receipts, 208
Minimum margin requirement, 104
J Minimum reserve requirement, 100
Minimum reserve system of note issue, 80
Juglar cycle, 181 Modified Phillips curve, 165
Monetary assets, 82
K Monetary measures, 85
Monetary policy, 182
Keynesian theory of output, employment and Money supply, 78
income determination, 206 Money wage-cut paradox, 11
Keynes on economic recessions, 220 Monopoly of note issue, 91
Keynes’ theory of trade cycles, 188 Moral suasion, 105
Keynes version of QTM, 138 Motive of calculation, 232
Kitchin cycle, 180 Motive of enterprise, 232
Kondratieff cycle, 181 Motive of foresight, 232
Kuznets cycle, 181 Motive of independence, 232
Motive of precaution, 232
Multiple credit creation, 111
L
Multiple credit destruction/contraction, 117
Laffer curve, 276
N
Lassiez-faire, 282
Leakages or withdrawals, 39
Legal reserve requirements, 100 National income, 18
Lender of the last resort, 92 Near money, 82
Liquidity, 57 Net domestic product, 23
measures, 86 Net Foreign Income (NFI), 21
preference, 71 Net investment, 32
preference theory, 239 Net national income, 23
trap, 72 Net national product, 23
Long run Phillips curve, 167 NNP at factor cost, 23
308 Index

NNP at market prices, 23 Public finance, 282, 286

NNPFC, 23 Public revenue, 284
No exclusion, 286 Purely capitalist economy, 194, 282
Nominal income, 25
Non-marketed products, 34 Q
Non-plan expenditure, 293
Non-remunerative activities, 34 Qualitative or selective credit control instruments,
Non-tax revenue, 292 103
Quasi money, 83
O
R
Objective factors, 232
Objectives of the budgetary (Fiscal) policy, 300 Radcliffe committee, 62
Open economy, 42 Rationing of credit, 105
Open inflation, 149 Real assets, 82
Open Market Operations (OMO), 98 Real income, 25
Ordinary budget, 291 Real investment, 32, 237
Real money balance, 265
P Recession, 179, 273
Recovery (revival), 178
Paradoxes in macroeconomic, 10 Relevance of Keynes in contemporary times,
Partial market failure, 286 219
Per capita income, 47 Replacement investment, 32, 257
Permanent income, 266 Repo rate, 97
Personal disposable income, 24 Revenue account, 292
Personal income, 23 Revenue budget/account, 292
Phillips curve, 163 Revenue deficit, 293
Pigou’s version of the quantity theory, 134 Revenue expenditures, 292
Plan expenditure, 293 Revenue non-plan expenditure, 293
Plungers, 142 Revenue receipts, 292
Policy dilemma, 169 Reverse repo, 97
Portfolio approach to demand for money, 76 Risk averters/diversifiers, 142
Positive and normative aspects of public Risk lovers, 142
finance, 285 Row, 42
Positive aspect, 285 Running inflation, 148
Post Keynesian developments: monetarism, 264
Post Keynesian developments supply side S
economics, 273
Precautionary demand for money, 69 Saving, 39
Price index, 48 Saving function, 227
Price policies, 170 Say’s law of markets, 193
Primary deficit, 294 Schumpeter’s theory of innovations, 187
Primary deposits, 112 Scope of public finance, 283
Primary functions, 56 Secondary/derivative deposits, 112
Private finance, 286 Shifts in MEC, 244
Private income, 24 Short run phillips curve, 163
Progressive income taxes, 298 Shortages of aggregate demand, 218
Prosperity, 178 Social or collective goods, 286
Public debt, 284, 290 Social security contributions, 24
Public expenditures, 284 Speculative demand for money, 71
Index 309

Stabilisation branch, 285 Trade-off between inflation and unemployment,

Stagflation, 170, 273 166
Static economics, 14 Transactions motive to demand money, 67
Statutory liquidity ratio, 116 Transfer payments, 24
Stocks and flows, 46 Trough, 179
Store of value, 57
Structural theory of inflation, 153 U
Subjective factors, 232
Supplementary budget, 291 Unbalanced budget approach, 296
Supply oriented policies, 274 Undistributed income, 24
Supply price, 208 Unemployment insurance, 298
Supply price demand price, 245 Unexpected expenditures, 69
Supply side response to stagflation, 278
Supply-side theory of stagflation, 171 V
Suppressed inflation, 149
Surplus budget, 291, 297
Value of money, 121
Variable cash reserve ratio, 100
T Velocity of circulation of money, 124

Tax-based Incomes Policies (TIP), 170 W

Tax revenue, 292
Theories of trade cycles, 185
Wage flexibility mechanism, 199
Tobin’s portfolio balance theory, 141
Wage-push theory of inflation, 152
Tobin’s portfolio selection model, 141
Walking inflation, 148
Token coins, 80
Welfare transfers, 298
Total cost, 208
Withdrawals or leakages and injections or
Trade cycles, 176
additions, 44
Macroeconomics Sunayini Parchure
This book titled Macroeconomics is an outcome of the author's teaching-learning experience
spanning several years of teaching economics at the undergraduate and postgraduate levels
and has evolved from the earlier works of the author on the theme of Macroeconomics. It has
evolved from actual classroom teaching and therefore adopts a conversational and lucid style
of communication. The book seeks to capture the interest of the students towards
macroeconomic issues and make it relatable to the actual dynamic functioning of economies.
Primarily intended for the undergraduate students of commerce and economics, it will also be
useful for the students pursuing BBA course. It covers an array of topics ranging from national
income and related aggregates, the demand and supply of money, the role of central banks,
theories of output, income and employment determination with special focus on Keynes
theory, post-Keynesian developments like monetarism, supply-side economics. It also covers
issues like inflation, deflation, Phillips curve, trade cycles, public finance, budget, budgetary
deficits and so on. It has chosen to restrict itself to a closed economy and hence, does not deal
with issues of an open economy which requires a totally different treatment.
KEY FEATURES
1. Evolved from actual classroom teaching
2. Analysis of major concepts, theories and issues in macroeconomics
3. Blends economic concepts, theories and real data wherever relevant
4. Relevant statistics and data in the Indian context
5. An exhaustive list of references including websites is provided for ready reference
6. Key takeaways, thoughtprovoking questions and relevant exercises provided at the end of
every chapter
ABOUT THE AUTHOR
SUNAYINI PARCHURE, PhD in Economics, is Vice-Principal and Head, Department of
Economics, Symbiosis College of Arts and Commerce, Pune. A recognized research guide for
PhD in the faculty of Humanities at the Symbiosis International University, she has published
several research papers in national and international journals and also participated in national
and international seminars, conferences and workshops. Dr. Parchure is actively involved as
Member on various Board of Studies in framing syllabus in Economics for UG and PG
programmes.

ISBN:978-93-90544-04-2

9 789390 544042

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