6203-Economic EnvBuss [MBA-S2-CC4-4.5] Cover Jan25.

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ECONOMIC ENVIRONMENT OF BUSINESS

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 ECONOMIC ENVIRONMENT OF BUSINESS

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Committee held on 08/05/2023 and approved in Academic Council meeting
held on 26/05/2023 Vide item no. 1014 and subsequently Executive Council
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 Contents

PAGE

Lesson 1: Introduction to Macroeconomics 1–26

Lesson 2: National Accounts and Problems of GDP Measurements 27–52
Lesson 3: Economic Growth 53–77
Lesson 4: The IS-LM Model 78–98
Lesson 5: AD/AS Framework 99–116
Lesson 6: Phillips Curve, Monetary Policy, and Fiscal Policy 117–155
Lesson 7: Theories of Trade and Balance of Payment 156–203
Lesson 8: Exchange Rates and the Mundell-Fleming Model 204–242
Glossary243–248

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TOC.indd 2 01-Feb-25 7:34:47 PM
 L E S S O N

1
Introduction to
Macroeconomics
Dr. Minesh Kumar Srivastava
Assistant Professor
School of Business Studies
Vivekananda Institute of Professional Studies
Technical Campus, New Delhi
Email-Id: [email protected]

STRUCTURE
1.1 Learning Objectives
1.2 Introduction
1.3 Macroeconomic Variables: Meaning and Relationships
1.4 Fiscal Policy, Budget Deficits, and Budget Surplus
1.5 Business Cycle
1.6 National Income Accounts
1.7 Measuring Price Changes: Real vs Nominal GDP
1.8 Summary
1.9 Answers to In-Text Questions
1.10 Self-Assessment Questions
1.11 Reference
1.12 Suggested Readings

1.1 Learning Objectives

After studying this chapter, you will be able to:
‹ Understand the subject matter of macroeconomics.
‹ Trace the behaviour of Indian economy over the past several decades.

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 ECONOMIC ENVIRONMENT OF BUSINESS

Notes ‹ Define and measure the important macroeconomic variables.

‹ Examine the national income accounts of the economy.

1.2 Introduction
The term macroeconomics was first coined in the year 1933 by the Nor-
wegian economist Ragnar Frisch. It emerged as a major branch of eco-
nomics during the Great Depression of the 1930s. The severe economic
situation during the Great Depression lent importance to the subject matter
of macroeconomics. It is the study of the behaviour of the economy as a
whole. John Maynard Keynes in his famous book, ‘The General Theory
of Employment, Interest, and Money’, developed a framework to system-
atically analyse the behaviour of aggregate economic variables such as
employment and output. His theories were extended and elaborated by
his followers during the two decades following World War II. Keynesian
economists faced major challenge in the late 1960s, when the world saw
an increased interest in monetarism. Monetarism is a body of theory de-
veloped during 1940s by Milton Friedman and others. In 1970s, a new
school of thought named the new classical economics came into picture.
And, during 1980s, Keynesian economics was challenged by a group of
economists called the supply-side economists. The real business cycle
theory and the new Keynesian economics were two other major schools
of thought that emerged in the 1980s and 1990s.
Alfred Marshall has defined economics as the “study of mankind in the
ordinary business of life; it examines that part of individual and social
action which is most closely connected with the attainment and with the
use of the material requisites of well-being.” This study material exam-
ines the branch of economics called macroeconomics, where we study the
ordinary business of life in the aggregate. Here, we analyse the behaviour
of the economy as a whole. The key variables under macroeconomics are
total output in the economy, the aggregate price level, employment and
unemployment, interest rates, wage rates, and foreign exchange rates. We
will determine the levels of these variables and assess how the variables
change over time. The subject matter of macroeconomics includes the
rate of growth of output, the inflation rate, changing unemployment in

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 Introduction to Macroeconomics

periods of expansion and recession, and appreciation or depreciation in Notes

foreign exchange rates.
Macroeconomics is a subject that is policy-oriented. It questions, to what
extent can government policies affect output and employment? To what
extent the rise in the price level is the result of unplanned government
policies? What governmental measures should be taken to achieve the
lowest possible rates of unemployment or inflation? Do the policies of
the government favour our foreign exchange rates? You will be able to
analyse the effects of various policy decisions made by the government
after reading this chapter.

1.3 Macroeconomic Variables: Meaning and Relationships

According to estimates, India once accounted for one-fourth of the global
GDP. But, when it gained independence in 1947 it was left with mass
unemployment, poverty, starvation, and very few large industries. Even
after a few decades of independence, the country was importing wheat
and other essential commodities from outside. In this section, we see
the trends of key macroeconomic variables such as output, employment,
price level, etc. in the context of Indian economy.

1.3.1 Output
Since its Independence, India has come a long from being nowhere to
be one of the biggest economies in the world. In 1947, India’s GDP
was approximately Rs. 2.8 lakh crore which has increased many folds to
$3.17 trillion, making it the sixth-largest economy. Figure 1.1 shows the
growth rate of output of India from the period 1960–2020. The output
measure in the figure is real Gross Domestic Product (GDP). Gross do-
mestic product is the value of current production of goods and services.
Real means that the value of the GDP has been adjusted for price change.
The data measure growth in the quantity of goods and services produced.
The data in the figure show considerable variation in GDP growth over
the past six decades. During the 1960s and 70s, there were instances of
negative growth in the GDP.

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Notes

Figure 1.1: GDP Growth Trends (1960-2020)

(Source: World Bank (https://www.macrotrends.net/countries/IND/india/gdp-growth-rate))

1.3.2 Aggregate Supply

Aggregate supply refers to the quantity of goods and services produced
by an economy. Aggregate supply is a function of the price level. Just as
in goods markets, higher prices bring about a greater amount of supply
in the short run. Figure 1.2 illustrates a Short-Run Aggregate Supply
(SRAS) curve and a Long-run Aggregate Supply (LRAS) curve. The real
level of output of goods and services (real GDP) is on the horizontal axis
and the overall level of prices in the economy is on the vertical axis.

Full Employment

Figure 1.2: Short-run and Long-run Aggregate Supply Curve

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 Introduction to Macroeconomics

From the figure, first we will understand why the LRAS curve is a vertical Notes
line and why the SRAS curve slopes upward. Then we will discuss the
factors that cause the curves to shift over time. LRAS is not affected by
the price level. LRAS is the potential (full-employment) real output of
the economy. The potential output of an economy will primarily depend
on three factors. Potential output is positively related to:
1. The size of the labour force in the economy.
2. The size of the economy’s capital stock (productive resources).
3. The technology that the economy possesses.
The amount of labour that is readily available at any given time can
change as unemployment changes. The number of people employed and
the number of hours they work will change as people decide to enter
or leave the workforce, change jobs, businesses grow or fail. When the
economy is operating at full employment, the level of real GDP on the
LRAS curve represents the level of production. Remember that there is
still some unemployment even when there is full employment. There will
always be some unemployment as people look for the best jobs out there,
employers look for the best candidates, and as the economy changes and
leaves workers from industries with declining employment without the
skills needed to work in industries that are expanding.
Along the LRAS curve, there is a natural rate of unemployment that is
correlated with the magnitude of real GDP. That level of output is referred
to as full-employment GDP. As we will see, the economy can operate
at less than full employment GDP during a recession when cyclical un-
employment is high, and (temporarily) at above full-employment GDP
during periods of rapid economic growth. The LRAS curve may shift over
time as the full-employment quantity of labour changes, as the amount
of available capital in the economy changes, or as technology improves
the productivity of capital, labour, or both.
Firms will react to changes in the prices of goods and services in the
short term. The key to understanding movements in the SRAS curve is
to understand that we are allowing the prices of final goods and services
to vary while holding the wage rate and the price of other productive
resources constant in the short-run. When goods and services prices rise
(fall), businesses have an incentive to expand (reduce) production, and

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Notes real GDP will increase (decrease) above (below) the full-employment level
shown by the LRAS curve. We depict real GDP as an upward-sloping
function of price level along the SRAS curve to reflect this. Again, in
the short run, we are holding the money wage rate, other resource prices,
and potential GDP (LRAS) constant.
Next, we identify the factors that will shift the SRAS curve. We start
with the elements that also affect the LRAS curve. The SRAS and LRAS
curves will both shift when the full-employment quantity of labour changes,
the amount of available capital in the economy changes or as technology
improves the productivity capital, labour, or both. There are some factors
that will shift SRAS but not affect LRAS. While constructing the SRAS
curve, we held the money wage rate and other resource prices constant.
The SRAS curve will shift to the left, showing a decline in short-run
aggregate supply, if wage rates or prices of other productive inputs rise.
Businesses will reduce their output as the level of output that maximises
profits decline when they notice a rise in resource prices. The change
in money wage rates is influenced by two significant factors. One is
increased unemployment, which lowers the money wage rate because
there is already an excess of labour available at the current rate. On
the other hand, there will be upward pressure on the money wage rate
if the economy is momentarily operating above full employment levels.
Expectations of inflation are the second factor that may have an impact
on the money wage rate. Money wages will rise in response to an antic-
ipated rise in inflation, while money wages will decline in response to
an anticipated decline in inflation.

1.3.3 Aggregate Demand

The aggregate demand curve shows the relation between the price level
and the real quantity of final goods and services (real GDP) demanded.
The components of aggregate demand are: Consumption (C), Investment
(I), Government spending (G), Net exports (X-M), which is exports mi-
nus imports.
Aggregate Demand = C + I + G + (X – M)
The aggregate demand curve is downward sloping because at higher price
levels, consumption, business investment, and exports will decrease. There
are two effects here to consider. First, people’s real wealth declines as the

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 Introduction to Macroeconomics

price level rises. Since they have less accumulated wealth in real terms, Notes
individuals will spend less. This is referred to as the ‘wealth effect’.
Second, interest rates will increase as the price level rises. An increase
in interest rates decreases business investment (I) as well as consumption
(C) as consumers delay or forego purchases of consumer durables such
as cars, appliances and home repairs. This is a ‘substitution effect’, as
consumers substitute consumption later for consumption now because
the cost of consuming goods now instead of later (the interest rate) has
increased. This is referred to as ‘intertemporal substitution’, substitution
between time periods. So changes in the price level cause changes in
(the quantity of) aggregate demand.
Among various factors that can affect aggregate demand there are three
primary factors:
‹ Expectations about future incomes, inflation, and profits
‹ Fiscal and monetary policy
‹ World economy
A rise in anticipated inflation will increase aggregate demand as con-
sumers accelerate purchases to avoid price hikes in the future. An ex-
pectation of higher incomes in the future also will cause consumers to
increase purchases in anticipation of these higher incomes. An increase
in expected profits will lead businesses to increase their investment in
plants and equipment.
Fiscal policy refers to government policy with regard to spending, taxes,
and transfer payments. An increase in spending increases the government
component (G) of aggregate demand. Consumers’ spending power (or
disposable income) will rise as a result of lower taxes or higher transfer
payments (such as social security benefits or unemployment benefits), which
will increase aggregate demand through an increase in consumption (C).
Monetary policy refers to the central bank’s decisions to increase or
decrease the money supply. An increase in the money supply tends to
decrease interest rates and increase consumption and investment spend-
ing, increasing aggregate demand. We will look at both monetary and
fiscal policy effects more closely in subsequent chapters. The state of
the world economy will influence a country’s aggregate demand through
the net exports (X) component. Increased foreign incomes will result in

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Notes greater foreign demand for the nation’s exports, which will raise X. If the
country’s exchange rate increases (foreign currency buys fewer domestic
currency units), its goods are relatively more expensive to foreigners, and
exports will decrease. Additionally, since imports will be relatively less
expensive, there will be greater demand for them. Net exports (exports
minus imports) will tend to decline as a result of both effects, which
will also reduce aggregate demand. The opposite is true when a country’s
exchange rate declines (currency depreciation), as exports rise, imports
fall, net exports rise, and aggregate demand rises.
We show long-run equilibrium at the point where the aggregate demand
curve and the LRAS curve converge in Figure 1.3. Changes in the price
level of final goods and services can move the economy to long-run
macroeconomic equilibrium.

Figure 1.3: Long-Run Equilibrium Real GDP

1.3.4 Unemployment
The unemployment rate, the labour force participation rate (LFPR), and
the employment-to-population ratio are the three key labour market indi-
cators. If a person is not working but is available to work, has actively
looked for employment within the past four weeks, has been laid off and
is awaiting recall, or will begin a new job within the next 30 days, they
are considered to be unemployed. The unemployment rate is the percent-
age of people in the labour force who are unemployed. All individuals
who are either employed or actively looking for work are considered to
be part of the labour force.

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 Introduction to Macroeconomics

Number of Unemployed Person Notes

Unemployment Rate = Labour Force × 100

During expansions, the unemployment rate falls, and during recessions,

it rises. The labour-force participation rate is the percentage of the
working-age population who are either employed or actively seeking
employment.
Labour Force
Labour Force Participation Rate = Working Age Population × 100
Changes in the number of discouraged workers—those who are available
for work but neither employed nor actively seeking employment—can
cause short-term fluctuations in the labour-force participation rate. When
the economy is growing, the labour force participation rate tends to rise;
during recessions, it tends to fall. Once the expansion takes hold and
they feel their chances of finding work are better, discouraged workers
who stopped looking for work during the recession are motivated to do
so again. The employment-to-population ratio is the percentage of the
working-age population who are employed.
Number of Employed Person
Employment to Population Ratio = × 100
Working Age Population
When unemployment is low (during expansions), the employment-to-pop-
ulation ratio tends to increase, and when unemployment is high (during
recessions), it tends to decline. The employment indicators we’ve covered
so far reflect the number of people who have jobs, but to know how
much total labour is being performed, we also need to take into account
the average amount of time that employees are working. To trace the
effects of part-time work and overtime, we calculate aggregate hours,
the total number of hours worked in a year by all employed people. Ag-
gregate hours have shown a long-term upward trend, but they have not
grown as fast as the labour force because the average workweek (weekly
hours worked per person) has been declining over time. Both aggregate
hours and the workweek tend to rise during expansions and fall during
recessions. Aggregate hours worked is an important measure because it
enables us to assess the productivity of labour, the amount of output
produced per hour worked. A labour will receive a higher wage rate for
being more productive. Money wage rates are adjusted for shifts in the
general level of prices to produce real wage rates. The value of an hour’s

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 ECONOMIC ENVIRONMENT OF BUSINESS

Notes labour is expressed in terms of goods and services using real wage rates.
Real wage rates are calculated using total labour compensation, which
includes wages, salaries, and benefits provided by the employer, and they
typically fluctuate with labour productivity.
Types of Unemployment
1. Frictional unemployment is a result of the economy’s ongoing changes,
which delay the timely placement of qualified candidates with open
positions. Employees spend time and effort seeking work and employers
spend time and effort seeking workers. Unemployment resulting
from this job search activity referred to as frictional unemployment
is a persistent problem as businesses grow or shrink and employees
relocate, lose their jobs, or leave to pursue other opportunities.
2. Cyclic Variations in the overall level of economic output are the root
cause of cyclical unemployment. Cyclical unemployment occurs
when the economy is not operating at full capacity. When there is
no cyclical unemployment in the economy, there is full employment.
But keep in mind that even when the economy is at full employment,
there is still structural and frictional unemployment. In other words,
even when the economy is at “full employment,” there will still be
some unemployment.
The natural rate of unemployment is the total of the frictional and struc-
tural unemployment rates. The level of output the economy can generate
(theoretically) when unemployment is at the natural rate is known as po-
tential GDP. Cyclical unemployment rises when real GDP declines below
potential GDP. Cyclical unemployment declines as real GDP increases to
and above potential GDP.

1.3.5 Inflation
A persistent increase in general price level is known as inflation. A
price index that gauges the overall (or general) price level in relation
to a base year is used to determine the rate of inflation. The percentage
rate of change in the price index over a specified period is then used to
calculate the inflation rate.
An ongoing rise in prices over time is referred to as inflation. A curren-
cy’s purchasing power is reduced by inflation. Inflation can ultimately
destroy a nation’s monetary system if it continues to grow unchecked,

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 Introduction to Macroeconomics

forcing people and businesses to use foreign currency or return to bar- Notes
tering physical goods.
The economy is not experiencing inflation if there is a single jump in the
price level but no subsequent increases. Increases in the relative prices of
some goods or in the cost of a single good alone do not constitute inflation.
The cost of almost all goods and services will rise if there is inflation.
We can calculate the annual inflation rate by using a numerical measure
of the price level, such as the consumer price index or the GDP deflator:
Current Year Price Level – Last Year Price Level
Annual Inflation Rate = × 100
Last Year Price Level
The two types of inflation are demand-pull and cost-push. Demand-pull
inflation results from an increase in aggregate demand. While, cost-push
inflation results from a decrease in aggregate supply.
Demand-Pull Inflation
Increased government spending, an increase in the money supply, or any
other factor that raises aggregate demand can all lead to demand-pull
inflation. Figure 1.4 illustrates the impact of rising aggregate demand
on the price level.

Figure 1.4: Demand-pull Inflation

In Figure 1.4, the economy begins at equilibrium with output at GDP1
and the price level at P1. The aggregate demand and short-run aggregate
supply curves are AD1 and SRAS1. Real GDP is equal to potential GDP,
which is represented by the long-run aggregate supply curve LRAS. Now
imagine that the central bank expands the money supply, which increases

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Notes aggregate demand to AD2. With no initial change in aggregate supply,

output increases to GDP2 and the price level increases to P2. Real GDP
exceeds potential GDP (at full employment) as prices rise. Real GDP
growth is unsustainable when it exceeds the level of full employment.
When unemployment falls below its natural rate, real wages are under
pressure to increase. Rising real wages result in a decrease in short-run
aggregate supply (the curve shifts left from SRAS1) until real GDP returns
back to full-employment GDP. Demand-pull inflation would continue
until the central bank slowed the expansion of the money supply and
gave the economy the chance to achieve full employment equilibrium at
a real GDP level equal to potential GDP.
Cost-Push Inflation
Inflation can also result from an initial decrease in aggregate supply
caused by an increase in the real price of an important factor of pro-
duction, such as wages or energy. The impact of a decline in aggregate
supply on output and price level is shown in Figure 1.5.

Figure 1.5: Cost-push Inflation

With no initial change in aggregate demand, the reduction from SRAS1 to
SRAS2, raises the price level to P2, and decreases output to GDP2, while
SRAS1 remains unchanged. The impact on output is the main distinction
between the cost-push and demand-pull effects. While cost-push inflation
results from a reduction in aggregate supply, it initially causes a decline
in GDP, demand-pull effects increase GDP above full employment.
The primary indicators used to measure the inflation rates in India is
Consumer Price Index (CPI) and Wholesale Price Index (WPI).

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 Introduction to Macroeconomics

Consumer Price Index (CPI) Notes

The retail prices of a fixed “basket” of thousands of goods and services
that households buy are measured by the Consumer Price Index (CPI).
The CPI is an explicit price index in that it tracks changes in the weight-
ed average of the prices of the market basket’s goods and services over
time. Because it tracks the costs of goods and services that consumers
directly buy, the CPI is the price index that matters most to them. Many
government pensions, including Social Security benefits, and some wage
rates are indexed to the CPI, meaning that they have provisions for au-
tomatic increases geared to increases in the CPI.
The formula for the index is:
Cost of Basket at Current Prices
CPI = × 100
Cost of Basket at Base Period Prices
As measured by the CPI, the inflation rate is given by the following
formula:
Current CPI – Last Year CPI
Inflation Rate = × 100
Last Year CPI

Calculating the Inflation Rate Based on CPI

Ex: The CPI for all items was 202.9 in June 2021 and 194.5 in June
2020. The CPI for all items less energy was 203.6 in June 2021 and
198.5 in June 2020. Calculate and interpret the inflation rate based
on these two measures.
Answer:
CPI – CPI2020 202.9 – 194.5
(i) Inflation Rate = 2021
× 100 = × 100
CPI2020 194.5
(All items)
= 4.3%
CPI – CPI2020 203.6 – 198.5
(ii) Inflation Rate = 2021
= × 100
CPI2020 198.5
(All items
ex-energy) = 2.6%
As measured by the CPI, the inflation rate for goods excluding en-
ergy was less than the inflation rate for all items over this 12-month
period. This means energy prices must have been increasing faster
than the overall price level.

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 ECONOMIC ENVIRONMENT OF BUSINESS

Notes Wholesale Price Index (WPI)

The Wholesale Price Index (WPI), which calculates the wholesale costs
of about 697 items, is another widely used price index. Since many raw
materials and semi-finished goods are sold at the wholesale level, changes
in the WPI predict future changes in retail prices, such as those tracked
by the CPI.

1.4 Fiscal Policy, Budget Deficits, and Budget Surplus

The use of taxation and spending by the federal government to achieve
macroeconomic objectives is referred to as fiscal policy. Fiscal policies
are used to stabilize the economy. When the government receives the
same amount in overall revenue (tax + non-tax revenue) as it spends
during a fiscal year, the budget is said to be balanced. A budget deficit
occurs when government spending exceeds overall revenue, and a budget
surplus occurs when the opposite is true.
Taxes are raised by the government during inflationary periods and
decreased by the government during recessionary periods to deal with
changes in the business cycles.
The largest component of GDP is total investment. Investment is defined
as outlays for inventory and fixed productive assets. National savings,
foreign borrowing, and government savings are the three main sources
of funding for investments. The first two elements come from private
financing sources. Government savings, the third source, are equal to the
difference between government tax receipts and expenditures. Government
budget deficits (borrowing rather than saving) result in a decrease in the
sources of total investment, whereas budget surpluses (savings) increase
those sources. Investment has a direct impact on real GDP growth. Less
capital is created as investment falls, which lowers the real GDP growth
rate. On the other hand, as investment increases, more capital is produced,
increasing the growth rate of real GDP.
The government’s decisions regarding taxes and spending have a big
impact on the markets for investment capital. Taxes on capital gains
have an impact on the amount saved and invested, which changes real
GDP growth. The incentive to savings falls as taxes imposed on capital

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 Introduction to Macroeconomics

income rises (after-tax returns on savings fall). Therefore, as taxes on Notes

capital income rise, private savings likely will fall.
The availability of government savings is impacted by fiscal policy as
well. Budget deficits necessitate government borrowing, just as budget
surpluses signify government saving (negative saving or dissaving). This
adverse effect of a budget deficit on private investment in capital is re-
ferred to as the crowding-out effect. The decrease in the growth rate of
capital will reduce potential GDP.

IN-TEXT QUESTIONS
1. The different phases of the business cycle are:
(a) Peak and trough
(b) Inflation and deflation
(c) Expansion and contraction
(d) Employment and unemployment
2. The unemployment rate is defined as the number of unemployed
as a percentage of the __________.
(a) Labour force
(b) Number of employed
(c) Working-age population
(d) Civilian non-institutional population
3. Which of the following indicators moves inversely with the
business cycle?
(a) Aggregate hours
(b) Unemployment rate
(c) Labour force participation rate
(d) Employment-to-population ratio
4. Which of the following would be counted as frictional
unemployment?
(a) Due to the negative growth of GOP, person X was laid off
(b) Person X was fired from his job after he got into an
argument with his foreman, and has not sought a new job

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 ECONOMIC ENVIRONMENT OF BUSINESS

Notes (c) Although there were jobs available, person X was unable
to find an employer with an opening
(d) When the plant was modernized, person X lost her job
because she did not have the skill needed to operate the
new equipment

1.5 Business Cycle

The business cycle is characterized by fluctuations in economic activity.
The two main factors used to identify the current stage of the cycle are
real GDP and the rate of unemployment. There are two stages of the
business cycle: expansion (where real GDP is rising) and contraction or
recession (real GDP is decreasing). The business cycle’s peak and trough
are the transitional points between the phases. In Figure 1.6, the phases
and turning points are depicted.

Figure 1.6: Business Cycle

Short-term, or cyclical, changes in output and employment typically result
from changes in both actual and potential output. The level of output that
the economy could produce at high rates of resource utilisation is known
as potential output. Such abrupt changes in output result from variations
in labour and capital utilisation rates. In the long run, potential output

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 Introduction to Macroeconomics

growth—which denotes growth in the quantity of factors of production Notes

(labour and capital) that are available as well as technological advance-
ments—becomes a significant factor in determining output growth.

1.6 National Income Accounts

In subsequent chapters, we will examine macroeconomic models. These
models, which are condensed versions of the economy, make an effort to
capture key elements affecting aggregate variables like output, employment,
and price level. This chapter begins by defining the real-world counter-
parts of the variables in our models as a prelude to comprehending such
relationships. Because we build our models using these relationships, it
also takes into account the accounting relationships that exist between
these variables. We start by describing the key variables measured in
the national income accounts. Nobel Prize-winning economists Simon
Kuznets and Richard Stone played pioneering roles in the development of
national income accounting. In India, economists such as V.K.R.V. Rao,
R.C. Dutt, Dada Bhai Nauroji, etc. played an important role in the study
of national income accounting. In India, national income accounts data
are published by National Statistical Office (NSO), Ministry of Statistics
and Programme Implementation, Government of India.
Like the accounts of a business, national income accounts have two sides:
a product side and an income side. Production and sales are tracked on
the product side. The distribution of sales proceeds is measured on the
income side. Gross Domestic Product (GDP) and Gross National Prod-
uct (GNP) are two frequently reported indicators of total production on
the product side (GNP). They differ in their treatment of international
transactions. GNP includes earnings of Indian businesses overseas and
Indian residents working overseas; GDP does not. Conversely, GDP
includes earnings in India of foreign residents or foreign-owned firms;
GNP excludes those items. For example, profits earned in India by a
foreign-owned firm would be included in GDP but not in GNP. For a
country like India, the difference between GNP and GDP is huge as large
number of residents working overseas.

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Notes Gross Domestic Product

Gross Domestic Product (GDP) is defined as a measure of all currently
produced final goods and services evaluated at market prices. Before
moving further we need to clarify some aspects of above definition.
‹ Currently Produced: The value of only currently produced goods
and services is included in the GDP. It is a flow measure of output
that only includes the goods and services produced during the given
time period, such as a quarter or an entire year. Market transactions
such as exchanges of previously produced machinery, scooters or
buildings do not enter into GDP. Other market exchanges, such as
those involving stocks and bonds, do not directly involve the current
production of goods and services and are therefore excluded from
the calculation of GDP.
‹ Only Final Goods and Services: Only the final goods and services
produced by an economy are included in its GDP. Intermediate
goods that are used to produce other goods rather than being sold
for final consumption are not counted separately in GDP. The
problem of double counting will arise if they are counted separately.
For example, we would not count the value of metal sheets used
in the manufacturing of a car separately and then again when the
car is sold.
‹ Evaluated at Market Prices: Market prices for goods and services
are a common yardstick for estimating GDP. This makes it possible to
measure things like apples, oranges, machines, clothes, etc. However,
the calculation of GDP does not include goods and services that are
not traded on markets. For instance, the services of housewives or
the produce of kitchen gardens, as well as unreported or unlawful
transactions like prostitution, gambling, and the sale of illegal drugs.
GDP is sensitive to changes in the average price level because it
measures the value of output in terms of market prices. At different
average market prices, the same physical output will correspond
to a different GDP level. In order to account for this, real GDP,
in addition to GDP calculated in terms of current market prices,
is also calculated. GDP can be broken down into four components
that are, GDP = Consumption (C) + Investment (I) + Government
Purchases (G) + Net Exports (X – M)

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 Introduction to Macroeconomics

Or Notes
Y = C + I + G + (X – M) ……….……… (i)
The consumption component of GDP consists of the household sector’s
purchases of currently produced goods and services. Consumption can be
broken down into consumer durable goods (e.g., automobiles, televisions),
non-durable consumption goods (e.g., foods, beverages, clothing), and
consumer services (e.g., medical services, haircuts).
Three sub-components make up the investment portion of the GDP. The
largest of these is business fixed investment. Business fixed investment
consists of purchases of newly produced capital goods like plant and
equipment. The second sub-component of investment is residential con-
struction investment, the building of single- and multifamily housing units.
The final subcomponent of investment is inventory investment, which is
the change in business inventories which may be positive or negative.
Government purchases of goods and services is the next part of GDP. This
is the share of the current output bought by the government sector, which
includes the central government as well as state and local governments.
It should be noted that not all government spending is included in GDP
because not all spending reflects a demand for goods and services that are
currently being produced. Government transfer payments to individuals
(e.g., Social Security payments) and government interest payments are
examples of expenditures that are not included in GDP.
Net Exports is the final component of GDP. Net exports are the sum of
all gross exports less all imports. Gross exports are the goods and ser-
vices that are currently produced and sold to customers abroad. They are
included in GDP. Imports are purchases made by domestic consumers of
goods and services made elsewhere and are not appropriate to include in
GDP. However, the GDP totals for consumption, investment, and govern-
ment spending do include imported goods and services. To calculate the
total value of goods and services produced domestically, we must first
subtract the value of imports. The (net) direct impact of transactions in
the foreign sector on GDP continues to be net exports.
National Income
Let’s move on to the national accounts’ income side. The total GNP
rather than GDP serves as the starting point when calculating national

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Notes income. As previously stated, GNP includes income earned by Indian

residents and businesses from abroad but does not include earnings of
foreign residents and businesses from India’s domestic production. In
order to calculate GNP from GDP, we first add the foreign earnings of
Indian residents and businesses, followed by the foreign earnings of In-
dian residents and businesses.
The total factor earnings from the current production of goods and ser-
vices make up the national income. Earnings from production factors like
labour, capital, and land are referred to as factor earnings. Although GNP
and national income are sometimes used interchangeably, there are some
minor adjustments needed to convert between the two. Depreciation is the
factor that is excluded from national income. The portion of the capital
stock used up must be subtracted from final sales before national income
is computed. Depreciation represents a cost of production, not factor
income. Making this subtraction gives us Net National Product (NNP).
GNP – Depreciation = NNP …………. (ii)
Personal and Disposable Personal Income
The basis for some accounting definitions or identities used to build mac-
roeconomic models is the interrelationships between GDP, national income,
personal income, and personal disposable income. Income earned from
the current production of goods and services is measured as national in-
come. However, it is convenient to have a measure of income received
by persons regardless of source. For instance, income has an impact on
a household’s consumption expenditures. Therefore, the relevant income
concept is all income received by persons.
Personal income is the income received by persons from all sources.
When we subtract personal tax payments from personal income, we get
disposable (after-tax) personal income. To go from national income to
personal income, we subtract elements of national income that are not
received by persons and add income of persons from sources other than
current production of goods and services. The portion of corporate profits
in the national income accounts that are not distributed as dividends to
individuals is the first of the main items subtracted from national income
to calculate personal income. These portions include corporate profits tax
payments and undistributed profits (retained earnings). The contributions

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 Introduction to Macroeconomics

made by both employees and employers to Social Security are another Notes
item deducted from national income when calculating personal income.
Payments to individuals that are not in exchange for the current production
of goods and services are items that are added to the national income to
obtain personal income. Transfer payments come first on the list. Most of
these are transfers from the government, like Social Security payments,
pensions, and payments to retired government workers. Interest payments
made by the government to people is also been added. Bonds previously
issued by the central, state, and local governments receive interest pay-
ments from the government. These adjustments will give personal income.
Personal taxes are then subtracted to obtain personal disposable income.
YD = Y – T ………… (iii)
Where, YD is personal disposable income, Y is personal income and T
is the personal taxes. Personal saving is the part of personal disposable
income that is not spent. And all disposable income goes for consumption
expenditures or personal savings.
YD = C + S ……….. (iv)
Or, we can write it as
Y= C + S + T  …………. (v)
If we ignore external sector for the simplification of our understanding
we will have
Y = C + I + G (from eq i)
Therefore, we will have
C + I + G ≡ Y ≡ C + S + T …………… (vi)
This identity states that expenditures on GDP (C + I + G) by definition
equal dispositions of national income (C + S + T).

1.7 Measuring Price Changes: Real vs Nominal GDP

Nominal GDP, which measures currently produced goods and services
valued at current market prices, has been the subject of our discussion
up to this point. When the overall price level and the volume of produc-
tion change, GDP calculated at current market prices will also change.
For many purposes, we want a measure of GDP that varies only with

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 ECONOMIC ENVIRONMENT OF BUSINESS

Notes the quantity of goods produced. Such a measure would be most closely
related to employment. The GDP measure that changes only when quan-
tities, not prices, change is termed real GDP. Real GDP is calculated by
measuring output in terms of constant prices starting from a base year.
Real GDP changes only when production changes; nominal GDP changes
whenever the quantity of goods produced changes or when the market
price of those goods changes. Therefore, the two measures’ movements
sharply diverge when prices change dramatically.
Implicit GDP deflator gives the ratio of nominal GDP to real GDP
(nominal GDP ÷ real GDP), where the ratio is multiplied by 100. The
ratio of nominal GDP to real GDP is a measure of the value of current
production in current prices (e.g., in 2022) relative to the value of the
same goods and services in prices for the base year (2011). The ratio of
nominal GDP to real GDP is simply the ratio of the current price level
of goods and services relative to the price level in the base year because
the same goods and services are present at both the top and bottom. It
is a measurement of the total (or overall) level of prices, also known as
the price index.
By comparing implicit GDP deflator values across years, we can track
changes in the overall level of prices. The ratio of nominal to real GDP
is termed a deflator because we can divide nominal GDP by this ratio to
correct for the effect of inflation on GDP—to deflate GDP. This follows
because:
Nominal GDP
GDP Deflator = Real GDP × 100

Nominal GDP
Real GDP = GDP Defiator × 100

The GDP deflator is an implicit price index since we first construct a

quantity measure, real GDP, and then compare the movement in GDP
in current and constant rupees to measure the price changes. We do not
explicitly measure the average movement in prices. Two explicit price
indices are the Consumer Price Index (CPI) and the Wholesale Price
Index (WPI).

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 Introduction to Macroeconomics

Chain-Weighted Real GDP Notes

When real GDP is calculated using prices from a base year, two
issues occur. One issue is that every time the base year is altered,
we change the weights assigned to various sectors.
Second, changes in relative prices and consequent substitutions among
the product categories contained in GDP. For instance, since 2005,
the relative price of personal computers has decreased, and con-
sumers’ spending patterns have shifted toward computer purchases.
Computers will be overstated as a GDP component if the higher 2005
prices are used to weigh the computer component when calculating
real GDP. Government agencies use the chain-weighted measure of
real GDP to address these issues. Here, the chain-weighted measure
uses the average of the prices in the current year and the year prior
as weights as opposed to using prices from a base year. In order to
calculate real GDP in 2020, prices from 2019 and 2021 are weighted.
In practise, the base advances annually to solve the issue brought on
by relative price-induced substitutions.

What Does not Come under GDP?

The most comprehensive measure of a country’s economic affair is
the GDP. Researchers and decision-makers frequently use GDP to
track both short- and long-term growth trends in any economy. It
does, however, have some expectations.
Non-market Productive Activities: Non-market production, such
as homemaker services, are not included in GDP because goods and
services are valued at market prices.
Illegal Economic Activities: The GDP excludes both legal activities
that are not reported to avoid paying taxes as well as illegal economic
activities like gambling and the drug trade.
GDP Does Not Reflect Welfare: GDP does not reflect welfare or even
material well-being; it measures the production of goods and services.
Leisure is not given any weight. Additionally, some production-related
welfare costs are not subtracted. For instance, we count the production

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 ECONOMIC ENVIRONMENT OF BUSINESS

Notes of electricity in GDP but do not deduct the economic loss from the
pollution if it results in acid rain, water pollution and dying forests.
In fact, if the government spends money to try to clean up the pol-
lution, we count that too. GDP is a useful indicator of economic
activity in general, not of welfare.
GDP and Happiness: If it is not a welfare measure, one would not
expect GDP to measure happiness. According to studies, Ghanaians
are happier than Americans are with their lives, and Nigerians are
just as happy as French people. In a society, relative income might be
more significant than absolute income. The government of Bhutan has
placed more emphasis on Gross National Happiness (GNH), not GDP.

1.8 Summary
Our country has emerged as the fastest growing major economy in the
world and is expected to be one of the top three economic powers in the
world in the coming years. In this chapter, we have discussed about the
past performance and current trends in the key macroeconomic variables
of the Indian economy. India is anticipated to have the third-largest econ-
omy in the world by the year 2031. The economy’s long-term growth
outlook is favourable due to its young population, low dependency ratio,
high savings rate, and international investments.
India is now completely self-sufficient in terms of food grains. From
receiving food aid due to famine and other issues to becoming a new
exporter, India has come a long way. Crop-yield-per-unit-area of all crops
has grown since 1950 because of special emphasis on the sector and
advancements in irrigation, technology, subsidies, and agricultural credit.
India was largely isolated from international markets until 1991. There
were quantitative restrictions, export taxes, and import tariffs that applied
to international trade. The FDI was also restricted by upper-limit equity
participation, apart from government approval.
Due to increased production of fast-moving consumer goods, increased
Foreign Direct Investment (FDI), and ease of doing business, the man-
ufacturing and industry sector has experienced growth in recent years.
Following the country’s independence, domestic sector has faced with

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 Introduction to Macroeconomics

increasing foreign competition including the threat of cheaper Chinese Notes

imports. The country has since handled the change by flattening costs,
revamping management and new technology. The “Atmanirbhar Bharat
Abhiyan” campaign in India has also revitalised MSMEs that had fallen
behind because of foreign competitors.
The services sector has the largest share of India’s GDP, accounting for
53 percent in 2021-22. Nearly 25% of the workforce is employed in the
services sector. The percentage of the labour force that is unemployed
is known as the unemployment rate. Due to the Covid-19 lockdown,
unemployment spiked in recent years and has continued to be extremely
high even after more than two years of economic recovery.

1.9 Answers to In-Text Questions

1. (c) The phases of the business cycle are called expansion and
contraction (or recession)
2. (a) The unemployment rate is the number of unemployed as a
percentage of the labour force
3. (b) The unemployment rate increases when GDP decreases, and
decreases when GDP increases. The other three indicators move
in the same direction as the business cycle
4. Although there were jobs available, person X was unable to find
an employer with an opening

1.10 Self-Assessment Questions

1. What is inflation rate? Explain how inflation rate is calculated.
2. Define unemployment. And also explain the different types of
unemployment.
3. Define the term gross domestic product. Explain which transactions
in the economy are included in GDP.
4. What are the factors that determine the cyclical behaviour of output
and employment?
5. Explain some of the major limitations of the GDP concept.

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 ECONOMIC ENVIRONMENT OF BUSINESS

Notes 6. Define the terms personal income and personal disposable income.
Explain how do these income measures differ from national income?
7. Explain the differences among the GDP deflator, the CPI, and the PPI.
8. Define potential output. Explain why is potential output difficult to
measure?

1.11 Reference
‹ Kuznets, Simon. (1941). National Income and its Composition,
1919–38. New York: National Bureau of Economic Research.

1.12 Suggested Readings

‹ Barro, R. J. (1997). Macroeconomics. MIT Press.
‹ Froyen, R. T. (2013). Macroeconomics: Theories and Policies.
Global Edition. Pearson.

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 L E S S O N

2
National Accounts
and Problems of GDP
Measurements
Dr. Sunil Kumar
Assistant Professor
Department of Finance and Business Economics
South Campus
University of Delhi
Email-Id: [email protected]

STRUCTURE
2.1 Learning Objectives
2.2 Introduction
2.3 Need of National Income Accounts
2.4 Approach to Measure Economic Activities
2.5 Measuring GDP (Gross Domestic Product)
2.6 Practical Exercise
2.7 Other Important Concepts
2.8 Problems Associated with GDP Calculation in India
2.9 Green GDP
2.10 Summary
2.11 Answers to In-Text Questions
2.12 Self-Assessment Questions
2.13 References
2.14 Suggested Readings

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 ECONOMIC ENVIRONMENT OF BUSINESS

Notes 2.1 Learning Objectives

After studying this material, you will be able to:
‹ Understand the logical structure of an economy.
‹ Understand how to measure economic activities of an economy.
‹ Appreciate the contribution of different sectors in the economic
growth of an economy.
‹ Perceive the problems involved in measuring economic activities
and limitation of national income accounting.
‹ Differentiate between real and nominal economic indicators of an
economy.
‹ Converse about other important economic indicators which are not
covered under national income accounting.

2.2 Introduction
Precise measurement is an important component of a scientific study. To
have a fair idea of how the economy works, we should have an accurate
measure of macro-economic variables. Good measures help policy makers
to develop policies, which are best for an economy; National Income
Accounting is one such measure. In 1930s, Simon Kuznets a Nobel Prize
winner calculated the size of the US national income for the first time.
The focus of this chapter is on national income accounts, which is wide-
ly used by the researchers, economists and policy makers to judge the
robustness of an economy. The national income accounts is a conceptual
framework, which measures economic activities. It uses the double-entry
bookkeeping principle of business accounting.

2.3 Need of National Income Accounts

National income accounts help to evaluate the performance of an econo-
my, which further helps in economic planning. The major determinants of
economic welfare are distribution of national income, per capita income
and economic growth; all these factors are evaluated through national
income accounts.

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 National Accounts and Problems of GDP Measurements

National income data combined with financial and monetary data helps to Notes
make policies on inflation. National income accounting helps us to know
the sector specific share in the national income, which further provides
the information about the structural changes taking place in the econo-
my. Through National Income Accounting, we can forecast the impact of
various economic policies on production and employment of an economy.

2.4 Approach to Measure Economic Activities

Almost every country maintains a national income account because it
provides a comprehensive measure of an economy’s output, revenues
and expenses. The national income account is based on the amount of
economic activities that occur over a given period, these economic ac-
tivities can be measured by:
1. The final product of an economy, excluding the intermediate produce
[Product or Value Added Approach]
2. The income earned by the factor of production [Income Approach]
3. The total amount of spending done in an economy [Expenditure
Approach]
Every approach shows different perspectives for a given economy. If there
is no misreporting and incomplete data, then all the three approaches will
give the same measures of an economy in a given year.

Figure 2.1: Circular Flow of Two Sectors [Household and Firms]

The arrows in the upper half of the above figure show the flow of goods
and services provided by the firms to the households and the expenditure

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 ECONOMIC ENVIRONMENT OF BUSINESS

Notes done by the households on the purchase of these goods and services. The
arrows in the lower half of the figure show the flow of factor services
rendered by the households to the firms and the payment of these factor
services by the firms to the households.
We can analyse from the figure that the same amount of money repre-
senting the aggregate value of goods and services, is moving in a circular
way. Therefore, to estimate the aggregate value of goods and services
during a year, we can measure it through arrows A, B, or C.
Arrow A (from Households to Firms) shows the aggregate spending; it
represents the Expenditure Method.
Arrow B (from Firms to Households) shows the aggregate value of goods
and services; it represents the Product or Value-Added Method.
Arrow C (from Firms to Households) shows the total factor income; it
represents the Income Method.
The monetary units of all the three methods are same for a specific year.
Illustration 2.1: Showing equivalence between the three approaches.
Suppose there are only two firms in an economy, Apple Co. that pro-
duces apples and sell them in an open market. The other firm, Juice Co.
purchases some portion of the total apple produce from the open market,
process it to make apple juice and then sell them to the public.

Table 2.1: Representing the Transitions of Each Firm

Apple Co. Juice Co.
Amount Amount
Transaction (Rs.) Transaction (Rs.)
Wages Paid to Employees 30,000 Wages Paid to Employees 20,000
Total Revenue Received (70,000) Apple Purchase from Ap- 50,000
ple Co.
1. Apple sold to the public 20,000 Revenue Received by sell- 80,000
ing juice in public
2. Apple sold to Juice Co. 50,000
1. Product Approach: It measures the value added of final goods and
services, it does not include the value of intermediate goods and
services (Reason: to avoid double counting). Hence,

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 National Accounts and Problems of GDP Measurements

Value added of final goods = V

 alue added of total output- Notes
Value added of intermediate
(Inputs used in production,
purchased from other firms)
For Apple Co.:
Value added of Apple = Rs. 70,000
For Juice Co.:
Value added of Juice = Rs. 80,000* – Rs. 50,000
= Rs. 30,000
Total Value added of final goods = V
 alue added of apple + Value
added of juice
= Rs. (70,000 + 30,000)
= Rs. 100,000
(*Note: Rs. 80,000 includes Rs. 50,000)
2. Income Approach: It measures the economic activity by adding all
the factor payments.
For Apple Co.:
Entrepreneur Net profit = Revenue – Cost (Wage)
= Rs. 70,000 – Rs. 30,000
= Rs. 40,000
Wage of the Employees = Rs. 30,000
For Juice Co.:
Entrepreneur Net profit = R
 evenue – Cost (Wage +
Amount of Input)
= Rs. 80,000 – Rs. 20,000 – Rs. 50,000
= Rs. 10,000
Wage of the Employees = Rs. 20,000
Income of all the Factors = Entrepreneur Profits + Wages
= Rs. (40,000 + 10,000) + Rs. (30,000
+ 20,000)
= Rs. (50,000 + 50,000)
= Rs. 100,000
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Notes 3. Expenditure Approach: This approach measures the value of economic

activities by adding all the spending done on final goods and services.
For Apple Co.:
Expenditure done on Apples by the households = Rs. 20,000
For Juice Co.:
Expenditure done on Juice by the households = Rs. 80,000
Total Expenditure done by the Economy = Expenditure on
Apple + Expen-
diture on Juice
= Rs. 20,000 + Rs.
80,000
= Rs. 100,000
It is not coincidence that the results of all the three approaches are same.
We should not have any doubt that the market value of the final goods
or services must be equal to the money spent on their purchase i.e., in
case of Juice Co the market value of juice Rs. 80,000 must be equal to
the willingness to pay for it. This indicates that Product and Expenditure
Approach will give the same results.
We can observe that, what the seller is receiving must be equal to what
is spent by the buyer. Seller receipts reflect the income of an economy;
it includes all the factor payments. The total expenditure in an economy
is equal to this income generated, thus, income and expenditure approach
gives the same results.
Therefore, we have:
Total production = Total Expenditure (i)
Total Income = Total Expenditure (ii)
from (i) and (ii)
Total production = Total Income = Total Expenditure (iii)
Equation (iii) is the fundamental identity of the national income accounting.

2.5 Measuring GDP (Gross Domestic Product)

GDP is the broadest measure of the aggregate economic activities. It can
be calculated using all the three approaches and all of them will give
the same value.
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 National Accounts and Problems of GDP Measurements

‹ Product or Value Added Approach: Under the product approach, Notes

GDP is defined as “Total market value of all the final goods and
services produced within a specified period by factors of production
located within the geographical boundary of a country”. In this
definition, we need to understand the concept of market value, final
goods and services, value added and specified period.
‹ Market Value: Market value of the goods and services are calculated
by multiplying the quantity of goods and services by their respective
market price (price at which they are sold in the market). For example:
suppose economy produced 20 smart phones and 1000 pencils, if we
add these two quantities this does not make any sense, as the market
price of a smart phone is quite higher than the pencils. Therefore,
we multiply their quantities with their respective market price,
suppose the smart phone is sold at Rs. 10,000 each and pencil at
Rs. 10 each. Market value = Rs. (20 × 10,000) + Rs. (10 × 1,000) =
Rs. 2,10,000.
‹ Final Goods and Services: Goods and services produced for final
consumption are known as final goods and services. Intermediate
goods and services are those, which are used in the process of
making final goods and services. As discussed earlier, to avoid
double counting in the calculation of the GDP, we do not consider
intermediate production.
‹ Value Added: It is the difference between the value of the goods
or services when it leaves the stage of production and the value
when they entered into that stage of production. In calculating GDP,
we can either use the value added at each stage of production or
the value added of the final good or service [it is shown in the
following table with an arrow]
Table 2.2: Value Added in the Production of Barrels of Petrol (in $)
Stage of Production Value of Sales Value Added
Oil Drilling 5 5
Refining 5.6 0.6
Shipping 6.6 1.0
Retail Sale 7 0.4
Total Value Added 7

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Notes ‹ Specified Period: The period for which GDP is calculated is one
year. This one year usually the financial year, in case of India it
starts from 1st April of the year to 31st March of next year. GDP
figures are released yearly and quarterly.
To calculate the GDP, the economy is segregated into three major
sectors:
(i) Primary Sector (includes agriculture, fishing and other allied
activities)
(ii) Secondary Sector (includes manufacturing industries)
(iii) Tertiary Sector (includes services)
GDP is calculated by adding the gross value added from these there
sector;

Where
GVAMP =
Value addded at every stage of production or value added of final goods and service
‹ Expenditure Approach: It calculates the GDP of an economy by
summing the expenditure on final goods and services produced
within the territories of the country in the specified period. In an
open economy, there are four major groups: households, firms,
government and the rest of the world. Expenditure done by these
groups summed to calculate GDP. These expenditures are:
1. Personal Consumption Expenditures or Consumption (C):
The major portions of GDP constitute of consumption done by
the households (Consumers) on the goods and services. The
three main categories where the consumer spends its income
are:
(i) Durables: Goods, which can be used for a longer period
of time. Examples: car, smart phones, laptops, etc. [Note:
House is not included under this head].
(ii) Non-Durables: Good, which have a shorter life span.
Examples: food, clothes etc.

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(iii) Services: These are non-physical that are opposite to goods, Notes
which we can touch and handle. Payment for services
is the intangible part of an economy. Example: Doctor
fee, lawyer fee etc.
2. Gross Domestic Investment or Investment (I): In economics,
fixed investment means purchase of new capital, such as
house, plant, equipment etc., and inventory investment means
a change in the firm’s inventory holdings.1
The fixed investment can be segregated as:
(a) Business Fixed Investment or Non-Residential Investment:
Expenditure done by the firms on business structures, like,
warehouse, factories, office buildings and on equipment,
like, machinery, vehicles, computer, furniture. We also
include computer software in this category.
(b) Residential Investment: These are spending on the
construction of new houses and apartments.2
(c) Change in the Inventories: It refers to the change in the
amount of inventory during the specified period.3
3. Government Expenditure on Goods and Services (G): The
expenditure done by central, state or local government on the
purchase of final goods and services is known as government
expenditure. Example-goods: school buildings, roads, defence
equipment etc.; services: salaries of teachers, member of
parliament, person working in defence etc.
Not all the government purchases are part of G. Government
often provides social security, medical facilities, pension etc.,
all such payments are known as transfer payments. These

1. Economic investment is different from financial investment, which purchase of

bonds, stocks or mutual funds.
2. New houses and apartments are treated as capital goods, because they provide
services, like shelter, for a long period.
3. To run the business smoothly firms produce more, some of the produce they are
not able to sale within the same year. Value the unsold stock is known as the
change in inventories.

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Notes payments are one way and nothing is purchased in exchange

with them, in the current period.
4. Net Exports (NE): It is the gap between exports and imports
of a country in a specified period. If domestically produced
goods or services are sold in the foreign markets, then it is
known as exports. If foreign produced goods or services are
purchased by the domestic country, then it is known as imports.
So, NE = X – M, Where, X = Exports and M = Imports.
GDPMP = C + I + G + NX
‹ Income Approach: This approach looks into the GDP as to who
receives the income. The key component, which is calculated using
this method, is National Income. In National Income calculation we
include 8 types of Income, these are:
(a) Compensation to Employees: It includes the income of the
employees, such as, wages, salaries, benefits given to employees
(private pension funds, social insurance). The share of this
component is the largest.
(b) Proprietors’ Income: Proprietor means the owner of a business
that does not have a separate identity from its owner, better
known as unincorporated business. The profit of such kind
of business comes under this head.
(c) Rental Income: An income earned by a person by renting its
land or structures. Royalty given to the authors and artists
also comes under this category.
(d) Corporate Profits: Income of the corporates, which is calculated
after subtracting wages, interest, rents and other costs from
the corporate revenue. It’s the second major component of
the national income of a country.
(e) Net Interest: It is a difference between the interest received
by the individual from businesses and foreign sources and
interest paid by them.
(f) Tax on Production and Imports: These are the taxes, which
are paid by the businesses on the production and imports,
such as sales tax, excise tax, custom duties. We also minus

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 National Accounts and Problems of GDP Measurements

the subsidies given by the government to these businesses. Notes

Therefore, Net Indirect Taxes = Taxes – Subsidies, it is an
income of the government.
Factor Cost and Market Price
Factor cost is the total cost incurred on using factor inputs in
the production of goods and services.
Market price is the price at which goods and services are sold
in the market.
Market price = Factor Cost + Taxes – Subsidies = Factor Cost
+ (Net Indirect Taxes)
Example: Suppose there is only one business firm in the
economy, it is producing wheat. This business firm produced
4 quintals of wheat in the specified year and sold this in the
market for Rs. 1000 per quintal. This firm spent Rs. 5000 on
labour and paid taxes Rs. 4000, it also received a subsidy of
Rs. 3000. Then,
GVAMP = GVAFC + Tax – Subsidy
GVAMP = Rs. 2,000 + Rs. 5,000 – Rs. 3,000 = Rs. 4,000
(g) Net Business Transfer Payment: These are payments done by
business to others (individuals or government or foreigner) not
for wages or taxes or payment against any services. In fact,
such payment is for charity, for insurance, legal settlements
etc.
(h) Surplus of Government owned Enterprises: The current surplus
of the enterprises, which are owned by the government, such
as water, electricity, sewer etc.
If we add all these 8 components, we get National Income. GDP
and National Income are quite different; however, we can find
one from another. To calculate GDP out of National Income,
we need to address three more components, these are:
(i) Data Measurement Errors: These are the statistical
discrepancies, caused during data collection. If the
data is accurately collected, then the data measurement

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Notes will be 0. The discrepancy occurs due to the fact that

data is compiled from different sources to measure
the production and income separately. If we add this
statistical discrepancy in the National Income, we get
the Net National Product.
(ii) Depreciation or Consumption Fixed Capital: The decline in
the value of goods due to use, wear and tear, obsolescence,
during the specified period of calculating the value of
economic activities. To convert the gross value into
net value, we subtract the depreciation from the gross
value. Example: GDP – Depreciation = NDP, GNP –
Depreciation = NNP.
(iii) Net Factor Income from Abroad (NFIA): Defined as
“difference between the aggregate amount of earnings
of the country’s citizens and companies situated abroad
and aggregate amount of earnings of foreign citizens
and overseas companies earn in the domestic country”.
GDP and GNP
GNP (Gross National Product) is quite different from
GDP. GDP is the market value of all the final goods
and services produced in a specified period within
the boundary of a country. GDP focuses on the final
production within the territories of a country, whether
a citizen does the production or a non-citizen it does
not matter. GNP is the market value of all the final
goods and services produced in a specified period by the
country’s citizen. GNP focuses on the final production
done by the citizen of that country, it does not matter
whether the production took place within or outside the
boundary of the country.
Distinguishing GDP and GNP is quite tricky. Consider an
Apple Inc plant in Gujarat, India; this is an American
based company producing smart phones. Most of the
workers in the plant are Indians. All the output produced
by this plant is a part of India’s GDP, however, only a

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 National Accounts and Problems of GDP Measurements

part of it is included in India’s GNP. The wages paid Notes

to the Indian workers are the part of the Indian GNP,
while the profits of the plant are not. Any profit from
the plant comes under the US GNP because the owner
of the company is American. The profits however will
not be the part of US GDP, reason being production
took place outside the US territories.
We can find the GNP from GDP and vice versa, using
the following formulas:

In the above Apple Inc. plant case,

IN-TEXT QUESTIONS
1. Which one is not an approach to calculate the economic activities
of an economy?
(a) Income Approach
(b) Expenditure Approach
(c) Value-Added Approach
(d) Double-Book Keeping Approach
2. What is the other name for Value-Added Approach?
(a) Value Sum Approach
(b) Product Approach
(c) Price Added Approach
(d) Price Sum Approach

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Notes 3. Value added Approach and Expenditure approach directly

calculates: Royalty, the royalty comes under which head:
(a) Compensation to Employees
(b) Proprietor’s Income
(c) Rental Income
(d) Corporate Profit
4. “In personal consumption expenditure we do not consider, goods
with shorter life span”, this statement is:
(a) True
(b) False
(c) Can’t say
5. In the value added approach we include the value of:
(i) Final Goods
(ii) Final Services
(iii) Intermediate Goods
(iv) Intermediate Services
(a) Both (i) and (ii)
(b) Only (ii)
(c) Both (i) and (iii)
(d) Both (ii) and (iv)

2.6 Practical Exercise

(a) Value Added Method
Table 2.3(a): Calculating GDPMP and NDPMP
Using Product Method
Items (Rs. 000’)
Sales 600
Change in stock –20
Depreciation 40
Purchase of intermediate products 300
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 National Accounts and Problems of GDP Measurements

Notes

Now,
Table 2.3(b): Calculating GDPFC, NDPFC
Items (Rs. 000’)
Tax 100
Subsidy 20

Now,
Table 2.3(c): Calculating GNPMP, NNPMP, GNPFC, and NNPFC

Items (Rs. 000’)

NFIA 100

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 ECONOMIC ENVIRONMENT OF BUSINESS

Notes (b) Expenditure Method

Table 2.4(a): Calculating GDPMP Using Expenditure Method
Items (Rs. 000’)
Personal Consumption expenditure 1800
Gross Domestic Investment 500
Government Expenditure 800
Export 100
Import 160

Now,
Table 2.4(b): Calculating GDPFC, GNPFC, and NNPFC
Items (Rs. 000’)
Net Indirect tax 140
NFIA 100
Depreciation 200

(c) Income Method

Table 2.5(a): Calculating NNPFC Using Income Method
Items (Rs. 000’)
Compensation to employees 1600
Mixed income of self-employed (proprietor’s Income) 1800
Rent and Royalty 700
Profit 1200

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 National Accounts and Problems of GDP Measurements

Items (Rs. 000’) Notes

Interest 900
Net indirect tax 500
Social security contribution by employer 300

Now,
Table 2.5(b): Calculating GNPFC, GDPFC, GDPMP
Items (Rs. 000’)
Depreciation 500
NFIA 1500
Net Indirect Tax 200

2.7 Other Important Concepts

(a) Private and Government Sector Income: Sometimes it is important
to know the income received by private and government sector.
The income received by the private sector is known as private
disposable income. It is deducted by subtracting the taxes paid to
the government (by household and firms) from the sum of income
incurred through private sector activities and the payment received
by a private sector from the government.
Private Disposable Income = Y + NFIA + TR + INT – T

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Notes Where,
Y = Gross domestic product (GDP)
NFIA = Net factor Income from abroad
TR = Transfer payments from the government
INT = Interest payments on the government’s debt
T = Taxes paid to the government
Net government income is the part of the GDP which does not
belong to the private sector. It is calculated by subtracting the sum
of transfer payments from government to private sector and interest
payment on government debt from, government revenue from taxes.
Net Government Income = T – TR – INT
If we are adding private disposable income and net government
income, we get Y + NFIA = Gross National Product.
(b) Savings: Savings are an integral part of an Income; if we subtract
consumption from the income, we get savings. Savings are segregated
into private savings and government savings.
Private Savings = Private Disposable Income – Consumption
= (Y + NFIA + TR + INT – T) – C
Government Savings = Net Government Income - Government
Expenditure
= (T – TR – INT) – G
Total Saving of an Economy:
National Savings   = Private Savings + Government Savings
= (Y + NFIA + TR + INT – T) – C + (T – TR – INT) – G
= Y + NFIA – C – G
Further, using the expenditure method: Y = C + I + C + NX
National Savings = (C + I + G + NX) + NFIA – C – G
= I + NX + NFIA
If we rearrange this,
National Savings = I + (NX + NFIA)
= I + CA

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 National Accounts and Problems of GDP Measurements

Where, Current Account Balance (CA) = NX + NFIA Notes

If we subtract government savings from both sides, we get,
National Savings – Government Savings = I + CA – Government
Savings
Private Saving = I + CA + (–Government Savings)
Where, Negative government savings mean the government is running
under a deficit.
(c) Real vs. Nominal GDP: When the economic variables are calculated
at the current prices, they are known as nominal variables. The
GDP, which we have discussed, is calculated at the current price.
It is good to calculate the GDP at the current price; however, we
face difficulties if we use it for comparison. Thus, it is advisable
to first convert the GDP at current price into GDP at Real Price
(Base Price) and then compare.
Suppose, there is an economy producing only two goods, phones
and computer, we are comparing the GDP of this economy for two
years, year 1 and year 2.
Table 2.6: Detail of an Economy
Quantity Price/Unit (P)
Year Item (Q) (Rs.)
Phone 2000 100
1
Computer 1000 200
Phone 2200 110
2
Computer 1500 250

GDP at Current Price

Table 2.7: Calculating Nominal GDP

Year Item Q P GVA = QXP Total (Rs.)
Phone 2,000 100 2,00,000
1 4,00,000
Computer 1,000 200 2,00,00
Phone 2,200 110 2,42,000
2 6,17,000
Computer 1,500 250 3,75,000
Increase 2,17,000
Growth 54.2%

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Notes By seeing the above result, we can easily predict that the economy
has grown by about 54.25% from year 1 to year 2, but we fail to tell
whether this growth is due to the increase in the price or quantity.
We can address this problem by choosing a base year (constant
price) for both the year and then calculate the Real GDP. Let the
base year be year 1;
Table 2.8: Calculating Real GDP
GVA = Total
Year Item Q P QXP (Rs.)
1 (Base Phone 2,000 100 2,00,000
4,00,000
year) Computer 1,000 200 2,00,00
Phone 2,200 100 (Base Year Price) 2,20,000
2 5,20,000
Computer 1,500 200 (Base Year Price) 3,00,000
Increase 1,20,000
Growth 30%
Real GDP growth is only 30%, which reflects that the growth in
GDP is only due to the increase in the quantity, keeping the price
effect constant. We can convert the Nominal GDP into Real GDP
and vice versa.
Suppose for Computer:
Gross Value Added (real) = GVA (nominal)/GDP deflator
= GVA (nominal) (current price/base price)
= 3,75,000/(250/200)
= 3,75,000/1.25
= Rs. 300,000
Therefore, by using the GDP deflator we can convert the nominal
GDP into real GDP and vice versa. We have done this exercise for a
single good; however, in an economy we are consuming many goods
or a basket of goods. We consider the current price and the base price
of this basket of goods to calculate the GDP deflator.
GDP deflator data is published quarterly. CPI (consumer price Index)
which is published monthly is also used as the GDP deflator. The GDP
deflator is often useful in knowing the inflation rate in an economy.

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 National Accounts and Problems of GDP Measurements

IN-TEXT QUESTIONS Notes

6. GDP when calculated at current price is called as:

(a) Green GDP
(b) Real GDP
(c) Nominal GDP
(d) None
7. Real GDP can be converted into nominal GDP by using:
(a) Current price
(b) Nominal price
(c) GDP Deflator
(d) CPI
8. Real GDP equals to Nominal GDP, if:
(a) Current Price > Base Price
(b) Current Price < Base Price
(c) Current Price = Base Price
(d) None
9. National Savings are equal to:
(i) I + CA
(ii) I + NX + NFIA
(iii) Y + NFIA – C – G
(a) Only (i)
(b) Both (i) and (iii)
(c) Both (ii) and (iii)
(d) All of these
10. Private Disposable Income is equal to:
(a) Y – NFIA + TR + INT – T
(b) Y + NFIA – TR + INT – T
(c) Y + NFIA + TR – INT – T
(d) Y + NFIA + TR + INT – T

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Notes
2.8 Problems Associated with GDP Calculation in India
United Nations developed SNA (System of National Account), it contains
all the recommendation, which are agreed internationally to measure
the economic activities of an economy. India also follows this standard
measure of calculating GDP. In India, NAS (National Accounts Statistics)
is compiled by CSO (Central Statistical Office) under the Ministry of
Statistics and Programme Implementation. The various problems, which
are, faced while measuring India’s GDP, are:
(a) Informal Market: India has a huge informal market. The data,
which is used for the calculation of GDP, is gathered only from the
formal market. Informal market is completely ignored. Therefore,
GDP calculated only considering formal sector is underestimated.
(b) Non-market Goods and Services: These are those goods and services,
which are not sold under the formal market system. Example:
(i) Service rendered by homemaking and child care.
(ii) Underground economy: All the illegal activities and illegal goods
sold, such as drugs, prostitution, gambling.
(iii) Benefits of clean air and water.
(iv) Value of services provided by government, such as defence,
public education, buildings and maintenance of roads and bridges.
(c) Difficult to Identify the Good: Sometimes it is difficult to identify
a good as final or intermediate.
(d) Inadequate and unreliable data.
(e) Production for self-consumption.
(f) Lack of proper occupational classification.
(g) GDP does not account externalities.
IN-TEXT QUESTIONS
11. Who compiles national accounts for India?
(a) UPSC
(b) NAS
(c) MSME
(d) CSO

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IN-TEXT QUESTIONS Notes

12. GDP does not include:

(i) Value of non-traded goods
(ii) Value of goods and services from formal market
(iii) Value of goods and services from informal market
(iv) Externalities
(a) Only (iv)
(b) (i), (iii) and (iv)
(c) Both (i) and (iv)
(d) Only (ii)

2.9 Green GDP

The usual measure of GDP is only the indicator of economic growth; it
fails to tell anything about the sustainability and wealth of an economy.
These limitations are well taken care of with the concept called Green GDP.
Green GDP is an indicator of economic growth, simultaneously considering
the environmental factors. It attributes the triple planetary crisis that is
loss due to climate change, the loss of our nature and biodiversity and
loss due to pollution. Green GDP is measured by subtracting the net nat-
ural capital consumption from the GDP. The natural capital consumption
includes resource depletion, environmental degradation and incentives to
protect environment.
Some criticise the way Green GDP is calculated, they point out that it
is difficult to quantify those goods and services, which are not traded
such as ecosystem. The proponents of Green GDP argue that it may be
difficult to quantify or put value to non-traded goods and service, still
it is a preferable alternative to GDP.

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Notes IN-TEXT QUESTIONS

13. __________ is measured by subtracting the net natural capital
consumption from the GDP.
(a) Real GDP
(b) Nominal GDP
(c) Green GDP
(d) None
14. Triple planetary crisis is referred to:
(a) Loss due to climate change
(b) Loss of our nature and biodiversity
(c) Loss due to pollution
(d) All of the above

2.10 Summary
The broadest measure of economic activities of an economy is GDP.
GDP of any economy is estimated using three approaches i.e. product,
expenditure and income approach. All the three approaches give the same
value of the GDP. In product approach, we sum the value added of all
the final goods and services produced within the domestic territory of an
economy during the specified year. In expenditure approach, we add all
the spending done by the different sectors of an economy in the speci-
fied period. Income approach sums up all the earnings of the different
factors of production in the specified period. There are certain problems
associated with measuring of GDP.
The other important concepts, which help the policy makers, are private
and government sector income, national saving, real and nominal GDP.
Green GDP is another important concept, which incorporates the net
natural capital consumption for measuring GDP.

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Notes
2.11 Answers to In-Text Questions
1. (d) Double-Book keeping approach
2. (b) Product Approach
3. (b) Proprietor’s Income
4. (b) False
5. (a) Both (i) and (ii)
6. (c) Nominal GDP
7. (c) GDP Deflator
8. (c) Current Price = Base Price
9. (d) All of these
10. (d) Y + NFIA + TR + INT – T
11. (d) CSO
12. (c) Both (i) and (iv)
13. (c) Green GDP
14. (d) All of the above

2.12 Self-Assessment Questions

1. “Three approaches of measuring economic activities in an economy
gives the same result”. Justify.
2. What are the components of total spending in an economy? Why
do we take net exports instead of exports?
3. To know the economic growth of an economy, which one is more
appropriate Real GDP or Nominal GDP? Why?
4. Why are services like house making and childcare, income from
gambling and other illegal activities not included in the GDP?

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Notes
2.13 References
‹ United Nation. (1953). A System of National Accounts and Supporting
Tables. New York: UN, Department of External Affairs, Statistical
Office.
‹ United Nations. (2003). National Accounts: A Practical Introduction.
New York: United Nations.
‹ United Nations. (2023). National Accounts Statistics: Analysis of
Main Aggregates, 2021. Department of Economic and Social Affairs,
Statistics Division. New York: United Nations.

2.14 Suggested Readings

‹ Abel, B. A., Bernanke, S. B., & Croushore, D. Macroeconomics
(Latest ed.). Pearson Education, Inc.
‹ Case, E. K., Fair, C. R., & Oster, M. S. Principles of Macroeconomics.
(Latest ed.) Pearson Education, Inc.
‹ Parker, D., & Nellis, G. J. Principles of Macroeconomics. (Latest
ed.) Pearson Education Limited.

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 L E S S O N

3
Economic Growth
Dr. Minesh Kumar Srivastava
Assistant Professor
School of Business Studies
Vivekananda Institute of Professional Studies
Technical Campus, New Delhi
Email-Id: [email protected]

STRUCTURE
3.1 Learning Objectives
3.2 Economic Growth
3.3 Growth around the World
3.4 A Model of Production
3.5 Solow Growth Model
3.6 Total Factor Productivity
3.7 Balanced Growth Path
3.8 Steady State Growth Path
3.9 Transition Dynamics
3.10 Lessons for Developed and Developing Countries
3.11 Summary
3.12 Answers to In-Text Questions
3.13 Self-Assessment Questions
3.14 References
3.15 Suggested Readings

3.1 Learning Objectives

After studying this chapter, you will be able to:
‹ Understand the meaning and importance of economic growth and trend of economic
growth around the globe.

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Notes ‹ Explain the role of savings, investments, capital and labour in

determining the steady-state growth path for an economy.
‹ Describe the process of balanced growth and role of government
policies in achieving sustainable growth.

3.2 Economic Growth

Economic growth is generally measured as a rise in annual per capita
real GDP over a long period of time. This indicates three things firstly,
economic growth means increase in per capita GDP not the aggregate
GDP. Per capita real GDP can be calculated as:
Real GDP
Per Capita Real GDP = Population
Secondly, economic growth is about increase in real income not the nom-
inal income. This means it considers the changes in price level.
Nominal GDP
Real GDP = Deflation × 100
And thirdly, economic growth is about long-run rise in income. A short-
run rise or temporary fluctuation in per capita income due to any reason
cannot be considered as economic growth until and unless it sustains for
a longer duration. Economic growth is also represented by an outward
shift in the Production Possibility Curve (PPC) and rightward shift in
the long-run aggregate supply curve. The reason for this shift could be
technical progress and increase in availability of resources.

3.3 Growth around the World

Economic growth involves a process of transformation and every economy
goes through a series of phases of growth. The phases can be different
for modern and industrialized economy from a poor and under-developed
economy. According to Colin Clark, each phase of growth is dominated
by different sectors (i.e., primary, secondary and tertiary) of an econo-
my. Similarly, W. W. Rostow’s growth model begins from a traditional
society and reaches to maturity stage. In between it passes through to
‘transitional’ and ‘take-off’ phases. As the economy proceeds to maturity
stage, the share of primary sector (agriculture) goes on decreasing and
the share of secondary and tertiary sectors in the GDP increases.

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Economists like David Romer and David Weil have used inter-country growth Notes
regressions in order to explore different growth paths across economies.
This gave rise to a whole new range of theoretical and empirical explora-
tions of the determinants of growth. It was an extensive exercise that uses
sophisticated statistical tools and covers much more countries of the world.
Comparative growth rates show an uneven growth path for group of coun-
tries. The reason for such uneven growth during the period of 1900-50 is
partly due to two major wars and the great depression. However, post-war
period has shown a phenomenal recovery of Germany, Japan and Italy
have puzzled the economists all around the world. New theories were
developed such as the Solow Model to explain such remarkable growth. It
was argued that ‘late starters’ can achieve a high rate of growth because
they can adopt advanced technologies invented by the early starters.
The period of 1950-60 saw a big push for planning and import-substitu-
tion, but it faded away by the 1970s, especially during ‘1973 oil crisis’.
It was the period of high unemployment and stagnant growth around the
world. By 1980s, a sign of convergence started to appear among group
of economies. Economists in the Western world favoured a set of pol-
icies famously known as the “Washington Consensus”. It was a liberal
economic policy which promoted the idea of privatization, openness, flow
of investment, tax reforms etc.

Table 3.1: Rules of Good Behaviour for Promoting Economic Growth

“Augmented” Washington Consensus:
Original Washington Consensus (the previous 10 items, plus)
1. Fiscal discipline 11. Corporate governance
2. Reorientation of public expenditures 12. Anti-corruption
3. Tax reform 13. Flexible labor markets
4. Interest rate liberalization 14. Adherence to WTO disciplines
5. Unified and competitive exchange rates 15. Adherence to international financial codes
and standards
6. Trade liberalization 16. “Prudent” capital-account opening
7. Openness to DFI 17. Non-intermediate exchange rate regimes
8. Privatization 18. Independent central banks/inflation
targeting
9. Deregulation 19. Social safety nets
10. Secure property rights 20. Targeted poverty reduction

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Notes During 1980 to 2000 the real per-capita income grew at an impressive
rate of around 2.3 percent per annum in the developing economies. That
means the incomes doubled at every 30 years. Countries in the East and
Southeast Asia such as China, South Korea, Thailand, Malaysia, etc.
showed a tremendous growth rate of 4.4 per cent per annum during this
period. This also resulted in substantial improvements in social indicators
in these countries such as literacy, infant mortality, life expectation, etc.
It is worth noting that two major economies of Asia i.e., China and In-
dia achieved almost a double digit growth rate after 1990s, despite the
‘Asian financial crisis’ of 1997-98. It is also said that the coming decade
is of India which is showing its potential of becoming a global power.
On the other hand, the growth rate of economies in Latin America and
Sub-Saharan Africa collapsed during this period. Hence the unevenness
of growth path still continues both geographically and temporally.

3.4 A Model of Production

Economists believe that a ‘production function’ can explain why some
economies grow more rapidly than others. A production function is a
mathematical equation showing a relationship between inputs (labour,
capital, etc.) and outputs (automobiles, furniture, clothes, etc.). Growth
in the output means growth in income or GDP. Hence, it is important to
study the role of inputs in the production function.
1. Role of Labour: Economists have attributed the role of population,
especially working population in the economic growth of an economy.
Government all around the world are putting efforts to improve the
quality of labours by spending on health and education. It is believed
that the more time a worker spends on his formal education and
skill development the more productive he becomes. It helps them to
earn more and spend more, hence raising his income and standard
of living.
2. Role of Capital: Same argument applies to the role of capital in the
growth of an economy. The quality of capital stock measured in
terms of efficiency and effectiveness decides the pace of growth.
Technological improvement also called as ‘production of knowledge’

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brings a significant change in the way things being carried out. It Notes
not only increases the returns to scale but also contributes in the
growth of an economy.
3. Role of the Entrepreneur: Unlike classical and Keynesian economics,
modern growth theories gave more importance to the role played by
entrepreneurs in the economic growth. Modern growth economist,
Joseph A. Schumpeter stressed on the role of the entrepreneurs, or
businessmen. Their performance and risk taking abilities determines
the speed of economic growth. For example, in western countries
such as the USA, Canada and major European countries that adopted
liberal economic policies have seen a significant pace of growth
because of their entrepreneurs. These entrepreneurs bring investments
and innovation in their businesses which increases their outputs and
incomes.

3.4.1 Growth Paradigms

The base of modem growth theory was laid in the late 1950s. Tinbergen
in 1959 attempted to explain the significant growth in output in Western
European countries, and the United States. He developed a model using
Cobb-Douglas production function along with capital and labor supply
functions. Followed by Robert Solow (1956) and their neo-classical growth
models that stressed on a type of production functions that operates in
perfect competition and gives diminishing marginal returns to each input.
This was followed by endogenous growth models in which technological
progress was endogenously determined. So, let’s have a look at different
growth theories based on their production in briefly.
1. Neo-classical Growth Model: The growth path is depicted by two
equations:
A production function equation that is Linear Homogenous Production
Function and expresses the current flow of output as a function of
the current stock of capital and labour.
Y = A Kα L1-α
Another equation that shows how investments (savings) and depreciations
affect capital accumulation.
K = sY – δK

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Notes 2. AK Model: It was the first wave of endogenous growth theory. This
theory does not differentiate explicitly between capital accumulation
and technological advancements. They just merged together the
physical and human capital. The AK model is the neo-classical
model without diminishing returns to scale. The production function
used here is linear homogenous in the stock of capital.
Y = AK
This model presents a ‘one size fits all’ view of growth.
3. Product Variety Model of Romer (1990): The second wave of
endogenous growth models that consists of ‘innovation based growth
model’. Innovation results in increasing productivity by creating
new but not necessarily improved varieties of products. This model
gives importance to technology spillovers (Horizontal Innovation).
4. Schumpeterian Model: Innovation based theory focusses on quality
improvement. Hence, involves the force of ‘creative destruction’.
Yit = A1-α Kα
Where, A represents ‘efficiency parameter’ attached to the most
recent technology used in the industry i at time t.
Each intermediate product is manufactured and sold by the most
recent innovator. Hence, faster growth rate implies a higher rate
of firm’s turnover (Vertical Innovation).
5. Kremer’s O-Ring Theory: This model explains why advanced
economies manufacture more complicated products, have large
firms and much higher worker productivity than poor countries. It
predicts that under-development is a coordination failure because
despite their potential benefits, required investments do not occur
and the country becomes trapped in a low level of equilibrium.

3.5 Solow Growth Model

Robert Solow was an American economist who won the prestigious Nobel
Prize in 1987 for his work on the theory of economic growth famously
known as the ‘Solow Model’. It is an exogenous growth model which

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focuses on long-run economic growth. Solow observed that during the Notes
Second World War, Germany and Japan suffered heavy economic loss-
es. Yet, following the war both the countries grew quickly. In fact, they
grew much faster than the US and Britain. Even in the past few decades,
the GDP growth in China has been very high reaching to almost double
digits. In contrast, advanced economies like the US, Canada or Britain
growing around 2% per year.
Earlier, it was thought that to achieve high growth rate is to have good
institutions like, property rights, honest government, political stability, a
dependable judiciary and competitive and open markets. The advanced
economies have it all, plus they have got more human and physical
capital. But they are growing slower than India, China or Bangladesh.
The Solow model of economic growth answered this question. It gives a
clear picture of the dynamics of growth. It also helps us to understand the
difference between two types of growth that is (a) Catching up growth
and (b) Cutting edge growth. Where catching up growth is much faster
than the cutting edge growth.
The simple Solow growth model explains the process of economic growth
using few key variables and some basic mathematics. But before that we
must keep in mind some basic assumptions of this model.

3.5.1 Assumption
The model focuses on long-run economic growth.
1. There exists full employment in the economy. That is all capital
and labour are fully utilized in production process.
2. There is a constant return to scale i.e., output will increase at a
same proportion as an increase in capital and labour.
3. Capital accumulation can be decomposed into capital deepening and
capital widening.
4. Capital widening refers to the capital accumulation required to keep
k (capital per labour) constant as L grows. Capital deepening is the
capital accumulation that permits k to grow.
5. The labour force L (population) grows at a constant rate n.

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Notes 6. Increase in savings and investments in the short run, increases the
national income and output. In contrast, higher savings and investment
have no effect on the rate of growth in the long run.
Based on above assumption, let’s understand the Solow model in detail.

3.5.2 The Solow Model

An important part of this model is its linear homogeneous production
function.
Y = A Kα L1-α
Also known as the Cobb-Douglas Production function, where Y is the
output/GDP, K is the Physical capital like factories and machineries, L is
the labour or human capital. Last but certainly not the least is A (ideas).
“A” represents all of our knowledge about how to produce goods by
using capital and labour. Everything from how to ship huge quantities
of goods from one place to another with ease to how to keep diseases
from spreading to how to do millions of calculations in a fraction of
a second. A is ideas, and better ideas mean that we can produce more
output from the same inputs.
The coefficient α is the capital share (the share of income that capital
receives). Therefore, output per labour is given through the following
equation: y = Akα Where, y = Y/L (output per labour and k = K/L (cap-
ital per labour)

So, the production function represents human capital, physical capital

and ideas being used together to produce output.
‹ Physical Capital and Diminishing Returns: In order to determine
the impact of change in capital on output firstly, we will hold labour
and ideas constant and focus on K. Here, the output is a function
of the quantity of capital Y = F(K). That means increasing K will
increase output. For example, a farmer can grow more crops with
the help of a tractor than with just a shovel.

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Notes

Figure 3.1: Output per Worker and Capital per Worker

Figure 3.1 depicts a positive relationship between capital and output,
as capital increases the output also goes up. But another property
of this kind of production function is that while more capital gives
more output, it should do so at a diminishing rate. Extending our
example, when the farmer allocates his tractors, the first tractor
will be allocated to the most productive work and the subsequent
tractors will be allocated to less and less productive works.
We can represent both these properties in a production function
using Y − K . That means 1 unit of capital will give 1 unit of
output, 4 units of capital will give 2 units of output and so on. The
marginal productivity of capital measures how much additional output
is produced with each additional unit of capital. The production
function above showing diminishing marginal productivity of capital
indicating that the marginal product of first unit of capital is very
high but it goes on decreasing as the capital increases.
After the Second World War, Germany and Japan weren’t left with
much resources, so that the marginal productivity of the first units
of capital was very high. This can be understood as the first road
between two metropolitans, or the first tractor on a farm or the first
new steel factory gives a lot of additional output. Solow model says
that capitals are very productive when it is less. So, capital can
boost growth but because of diminishing returns, the same additions
to the capital stock may get you less and less output.
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Notes ‹ Depreciation: Physical capital goes through Capital rusts or

Depreciation. Roads got potholes, tools wear out, and trucks break
down and need to be repaired. In this model, it was assumed that
depreciation increases at a constant rate as the capital stock increases.
‹ Savings and Investments: Capital accumulation depends on savings
and investments. What we produce is either consumed or saved.
What we save becomes investment. Suppose we invest a constant
fraction of our income (Investment = 0.3 * Y). This can be shown
as an investment curve in our graph (Figure 3.2). It will mimic
the shape of the output line, since investment is just a constant
fraction of output.
Capital accumulation is represented by an equation:
K’= K(1 – δ) + I
Where, K is the Present capital stock, K’ is the future capital stock, δ is
the rate of capital depreciation and I is the level of capital investment.

= sy – δ k

Above equation shows that the change in k over time is equal to

the investment (saving) per worker minus depreciation per worker.
Any positive change in k will increase output per worker. Growth
will stop at a point where dk/dt = 0.

Figure 3.2: Impact of Depreciation on Capital per Worker

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Figure 3.3 below shows the steady state growth path for an economy. At Notes
this point the economy grows at a constant rate. Solow model implies that
economies converge to steady state output per worker (keeping technology
constant). It also implies that, if economies have same steady states, poor
economies grow faster and ‘converge’. We call this classical convergence
or ‘convergence to steady state’ in Solow model.

Figure 3.3: Steady State Capital per Worker and Output per Worker
What Happens if Savings Increased?
Now let’s see the impact of increase in savings on the steady state growth
path. The Solow model argued that the saving rate s increases the eco-
nomic growth rate in the short run, but it has no effect on the rate of
growth in the long run. Please note that a higher saving rate does raise
the steady-state k* (capital/labour ratio). Hence the steady-state output
per worker also increases (Figure 3.4). To achieve long-term growth,
investment should increase at such a rate that so that the steady-state
k* (capital labour ratio) is maintained. Figure 3.4 depicts that raising
saving increases k* and y* to k1* and y1* respectively, but no permanent
‘growth effect’.

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Notes

Figure 3.4: Impact of Increase in Savings on Steady State

What if Labour Force Grows?
According to Solow model, rise in population reduces the steady state
output per worker. In Figure 3.5, as the population rises at a constant
rate n, the capital-widening term (nk) rises. Consequently, the steady-
state capital/labour ratio k* falls, resulting a fall in the steady-state
output per worker. This rise in population also results in the increase
in real interest rate and decrease in the real wage rate. In Figure 3.5
we can see that rise in population shifts the capital depreciation δK
line upwards to (δ + n)K and reduces the steady state k* and y*.

Figure 3.5: Impact of Increase in Population on Steady State

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3.5.3 Golden Path Notes

The ‘golden path’ is the ‘optimal’ saving rate (s) that maximises per
capita consumption. Figure 3.6 depicts the golden path with k** is the
steady state capital per worker.

Figure 3.6: Golden Path

Bangladesh’s Economy: A Lesson for India

Bangladesh ranked 24th out of 53 countries in Bloomberg’s COVID-19
resilience ranking for its economic performance during the pandemic.
A brief history of the economic journey of the country is given below.
From ‘basket case’ to ‘Asian Tiger’
Henry Kissinger once labelled Bangladesh a ‘basket case’ due to
its higher rate of poverty and hunger. Today, the nation has steadi-
ly risen to reach new heights and now being projected as a future
‘Asian tiger’.
In 2019, the country was the world’s seventh fastest growing nation,
with a GDP growth that almost touched the double digit. Even during
the Covid lockdowns in FY’20, the country managed a 5.24% growth
rate in the GDP. And, in FY’21, the country surpassed India in average
per capita income that stood at $2,227, higher than India’s $1,947.
Prudent Economic Governance
With macro-economic stability as its cornerstone, Bangladesh’s econ-
omy has increased by more than 270 times since its independence.

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Notes The country has become the world’s second-largest textile exporter
after China due to its traditional labour-intensive light manufacturing
industry. Bangladesh has managed to achieve macro-economic stability
because of its Cottage, Micro, Small, and Medium sized Enterprises
(CMSMEs). They create 10 million direct employment and contribute
25% to Bangladesh’s GDP.
Lesson for India
India can take lessons on macro-economic stability and fiscal policies
from Bangladesh’s success story. India’s micro and small industries
are suffering from inadequate capital. The export-oriented industries
are also massively suffering. Prudent and supportive policies like
Bangladesh can be a solution for Indian textiles, garments, leather
and gem cutting industries.

IN-TEXT QUESTIONS
1. People in Least Developed Countries are poor because:
(a) Of slow population growth
(b) Of exploitation by multinational companies
(c) Of dependence on foreign aid
(d) Of a variety of development traps
2. The Solow growth model is an example of __________ growth
theory. (Exogenous/Endogenous)
3. Economic growth is measured as a rise in per capita real national
income in short run. (True/False)
4. According to Solow model, an increase in saving rate increases
the economic growth in the __________. (Short run/Long run)

3.6 Total Factor Productivity

Productivity measures the ratio of inputs used i.e., (labour and capital) to
produce outputs. One can measure the productivity of individual inputs
such as labour or capital productivity. Another option is to measure the
combined productivity of inputs also called total factor productivity (TFP).
TFP is measured as the ratio of the total output by weighted average of
the inputs. It is calculated to find out the growth in real output in excess

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of the growth in inputs. TFP also measures the efficiency of a firm. TFP Notes
helps businesses to wisely design their manufacturing policies, introduce
advanced technologies and invest in training and development of human
resources. TFP is known by different names such as;
‹ Catch-all Term: The production function in the Solow Model (Y
= A Kα L1-α) consists of an exogenous component ‘A’ that captures
technological growth and improvement in productivity that is not
related to any other factors of production.
‹ Economists later named it as ‘Solow Residual’.
‹ Solow’s Surprise: The Solow model concluded that investment in
capital cannot sustain long-run growth in GDP per worker. It needs
technological advancement (growth in A) to avoid diminishing
returns to capital. In Figure 3.7, we can see that a rise in ‘A’ shifts
the output per worker upwards.

Figure 3.7: Impact of Change in Total Factor Productivity on Output

TFP is the reason why Japan has achieved higher growth rate in the post-
war period. Similarly, the slowdown of growth rate of the USA from 1973
to 1990s can be attributed to poor TFP. It can be said that the rate of
economic growth depends on the growth rate of inputs and the increase
in TFP. Changes in Solow Residual/TFP comes out of several factors:

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Notes ‹ New ways of constructing buildings

‹ Newly invented machineries
‹ New source of power/energy
‹ Changes in work organizations
‹ Efficiency of government regulations
‹ Degree of monopoly in the economy
‹ Literacy and skills of workforce

3.7 Balanced Growth Path

Raganar Nurkse pioneered the balanced growth theory which states that
in order to bring an economy out of the vicious circle of poverty the
government needs to make huge investments in a number of industries
simultaneously. This will not only increase the market size and productivity
of the firms but also act as an incentive for the private sector to invest.
Various economists have contributed in the development of balanced
growth theory which can be explained with the views of:
‹ Ragnar Nurkse
‹ Rosenstein Rodan
‹ W. A. Lewis

3.7.1 Views of Ragnar Nurkse

Prof. Nurkse was the main propounded of the theory balanced growth.
According to him, vicious circle of poverty is the major obstacle in the
growth path of a poor economy. He explained that the vicious circle of
poverty operates both on the supply and demand side.
(a) Supply Side: In Figure 3.8, we can see how vicious circle of poverty
affects the supply side of capital formation. The per capita income
of the people is very low in any underdeveloped economy due to
which the level of saving is also low. Since savings is the main
source of investment, low savings results in low investment and
hence low capital formation. This causes low productivity and in
turn low productivity means low income of people. By this way a
vicious circle operates in supply side.

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Notes

Figure 3.8: Vicious Circle of Poverty: Supply Side

(b) Demand Side: The Vicious circle of poverty also operates in the
demand side affecting capital formation in under-developed countries.
Low income of people in poor economies results in low buying
power. Lower demand means lower income for industries to invest
lower their capital formation. This leads to low productivity and
hence lower income for people.

Figure 3.9: Vicious Circle of Poverty: Demand Side

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Notes A balance between demand and supply side is required to maintain to

break the vicious circle of poverty. This can be done only when there is
high rate of capital formation in the underdeveloped economies. Nurkse
suggested various ways through which the vicious circle of poverty can
be broken. These are:
How to Break Vicious Circle of Poverty?
(i) Complementary Demand: Investment in one industry or one sector
is not sufficient to break the vicious circle of poverty. It needs
simultaneous investment in several industries. This will enlarge the
market size and create demand for various products simultaneously.
This will raise the income level of people associated with these
industries and they will act as mutual customers for each other’s
product. Hence demand and supply both will go up breaking the
vicious circle of poverty.
(ii) Government Intervention: According to Nurkse, the private sector
in any under-developed economy is not self sufficient to bring such
a huge level of investment. So, the government must participate in
economic activities and inject Huge funds in the market through
investments. This will act as a motivating factor for private sector
and will bring positive change in the market.
(iii) External Economies: The strategy of simultaneous investment in
various industries also leads to external economies by setting up of
new industries and expansion of the existing ones. This will increase
the supply of products in the market causing a fall in price. Lower
prices means higher demand and stimuli for industries to invest
more resulting higher capital formation.

3.7.2 Views of Rosenstein Rodan

Rosenstein Rodan is another economist who propounded this theory in
the year 1943 but without using the term ‘balanced growth’. He argued
that the Social Marginal Product (SMP) of an investment is different
from its Private Marginal Product (PMP). If different firms operate their
businesses according to their SMP, the economy will grow much faster
than if it operated according to their PMP. Since the SMP is greater than
PMP for any firm because of the complementarity of different industries
this results in profitable investment for the society.

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He took the example of a shoe factory. He stated that if a large shoe fac- Notes
tory is set up in a suitable location where 20,000 unemployed people get
work. Now if the labours spend their entire incomes on shoes, it would
enlarge the shoe market. On the other hand, if series of different firms
are set up, people will spend their income on different commodities. He
called this ‘planned industrialization’.

3.7.3 Views of W.A. Lewis

W.A. Lewis has favoured the theory of balanced growth on the basis of
the following two arguments:
Firstly, in the absence of balanced growth, prices in one sector may be
higher than the other sector resulting unfavourable terms of trade in the
domestic market. This will cause heavy losses for the industries and
hinder the investment activity. Since balanced growth ensures equality
in comparative prices in all the sectors this will create favourable terms
of trade and all the sectors will grow simultaneously.
Secondly, he argued that when an economy grows, then several bottle-
necks starts to appear in different sectors. For example, increase in per
capita income of people due to economic growth results in increase in
the demand of high income-elastic goods. A lower production of such
goods in this case will increase its prices. Balanced growth ensures
that the production of such goods increases with increase in income
of people.
According to Lewis, “All sectors of the economy should be developed
simultaneously so that balance is maintained between industries and
agriculture, production for domestic consumption and production for
exports”.
ACTIVITY
With the help of World Bank/International Monetary Fund annual
data and international rankings try to comprehend the recent eco-
nomic growth trends among major countries around the globe. You
will find that some poor countries have shown a dramatic rise in
their GDP growth rate on the other hand majority of countries have
experienced a decline or stagnant growth.

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Notes 3.8 Steady State Growth Path

The term steady state growth is similar to the long-run equilibrium in static
theory of economics. Steady state is a condition when all the variables,
output, labour, capital, investments, savings, technological advancement,
either grow at constant exponential rate, or are constant.
Different economists have interpreted steady state differently. Starting
with Harrod, an economy is growing at a steady state when Gw = Gn
(Where, Gw: Warranted rate of growth and Gn: Natural rate of growth).
He called it ‘Razor’s Edge Growth Path. Similar theory propounded
by Domar who called this growth as ‘Knife Edge Growth Path’. Joan
Robinson named steady state growth as ‘Golden Age’ of accumulation.
According to him, steady state is a ‘mythical state of growth not likely
to obtain in any actual economy.’
According to Meade, when the growth rate of total income and per capita
income are constant along with constant population growth and no change
in technology, an economy achieves steady state growth. On the other
hand, Robert Solow in his model determines steady state with the help
of expanding labour force and technological advancements.
Hence, it can be said that at a steady state birth rate is equal to the
death rate meaning constant population. The output growth, per capita
consumption and rate of depreciation all are constant indicating constant
growth of real per capita income.

3.9 Transition Dynamics

The Solow model stressed that long-run steady state growth does not
depend on the saving rate and is determined entirely by exogenous el-
ements. The model also predicts that a poor economy grows faster and
tends to converge with rich countries if it satisfies some conditions. This
can be explained with the help of a diagram below.

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 Economic Growth

Notes

kpoor krich k*

Figure 3.10: Dynamics of the Solow model

We can see that the growth rate of capital per labour (k) is given by the
vertical distance between the saving curve (s · f (k)/k), and the effective
horizontal depreciation line (n + δ). The growth rate of an economy is
positive when k < k∗, and k moves toward k∗ (k∗ indicating steady state
level of k). Similarly, the growth rate of an economy is negative when
k > k ∗.
It can be noted here that, the growth rate of k is approaching toward k∗
from an initially low level of capital per labour. Hence, proving that a poor
country can grow faster and converge to a rich country in the long run.

3.10 Lessons for Developed and Developing Countries

History has told us that no economy can achieve a rapid growth rate
without sound economic policies, property rights, market-oriented ap-
proach, money and fiscal governance. Various economic models have
been developed to explain the movement of an economy from lower
level of economic growth to higher one. Government policies, investment,
entrepreneurship, foreign trade along with other factors are singled out
as critical. For example, ‘two-track’ reform policy of China, setting up
of ‘export processing zones’ in Mauritius and South Korea’s system of
‘financial restraint’.
Taiwan and South Korea adopted export subsidization scheme to reduce
their unfavourable balance of trade. Similarly, Singapore gave generous

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Notes tax rebates to attract foreign investments. Botswana raises the level of
government spending per GDP to bring macroeconomic stability. Chile
provided significant financial, technological, organizational, and marketing
assistance to its infant agro-industries.
As economic policies change, an economy would move from positive
to negative growth rates and back again. According to a study by the
World Bank (2001), sound economic policy can accelerate the growth
rate and cut the poverty rates in half in developing economies. Similar
study by the International Monetary Fund (2000), suggests that “where
sound macroeconomic policies have been sustained, they have raised
growth and reduced poverty”.
In most countries, growth depends upon favourable balance of trade. This
has helped Germany and Japan to recover fast from second world war
devastations. This has also helped China, South Korea and more recently
Bangladesh to achieve high growth rate.
Resource reallocation could also be a source of growth. Economists be-
lieve that high growth rate can also be achieved by shifting resources
from low-productivity sectors to high-productivity ones. For example,
shifting labour from low productive agricultural sector to high productive
manufacturing and service sectors.
New knowledge through innovations and R&D opens up new possibili-
ties for growth. Physical and human capital accumulation cannot sustain
growth in the long run in the absence of technological advancement.
Technological progress is nothing but the ‘production of knowledge’
through education, R&D and innovation.
So, government should adopt policies that encourage innovations and
promote investment on R&D. Along with that ‘easy money’ policies and
tax incentives also work in favour of developing economies to achieve
rapid growth.
IN-TEXT QUESTIONS
5. A balanced growth strategy relies on coordinated increases in
investment in several industries at once in order to create inter-
locking markets for outputs. (True/False)
6. Creative Destruction is an essential aspect of __________ Model.
(Schumpeterian/Neo-classical/AK)

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7. Match the following: Notes

(i) Razor’s Edge Growth Path (a) Robinson

(ii) Golden Path (b) Harrod
(iii) Knife Edge Growth Path (c) Domar
(a) (i)-(a), (ii)-(b), (iii)-(c)
(b) (i)-(b), (ii)-(c), (iii)-(a)
(c) (i)-(c), (ii)-(b), (iii)-(a)
(d) (i)-(b), (ii)-(a), (iii)-(c)

3.11 Summary
Economic growth is the ability of a country to produce more. This in-
creases its real GDP. But it should be kept in mind that such increase
in production in short run is not considered as growth. Economists all
around the world have developed models that depict the stages of growth
through which an economy passes. Some models give importance to sav-
ings and investments in the growth process, some believe on technological
advancement and some put weight on favourable balance of trade.
The exogenous growth model suggested by Robert Solow argued that
an economy moves in a steady-state growth path as a result of constant
change in the growth rate of population (n) and technological advancement
(A). Steady state is a situation when the output, capital, labour, savings,
investments, technology - all grow at a constant rate. This model also
predicts that economies with same population growth rate, savings rate
and depreciation rate will converge in the long run and along this con-
vergence path, a poor economy grows faster than rich country.
Another source of growth as suggested by Schumpeter is innovation
that leads to creative destruction. According to him, entrepreneurs play
a significant role in bringing innovation in the production process that
raises the productivity of labours and level of production. Prof. Nurkse
has favoured simultaneous investment in large number of industries in
order to break the vicious circle of poverty and bring balanced growth
in the economy. His model is also supported by other economists such
as Rodan and Lewis.

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Notes Solow surprise or Total Factor Productivity is the increase in total output
due to change in intangible factors such as technological advancement,
level of education, research and development, etc. It is measured as the
ratio of total output to the weighted average of total inputs. Various factors
can affect the total factor productivity such as technological innovations,
new source of power/energy, better health and education, etc.
Hence, in order to achieve a high rate of economic growth, it is im-
portant for an economy to focus on all these variables along with sound
economic policies.

3.12 Answers to In-Text Questions

1. (d) Of a variety of development traps
2. Exogenous
3. False. It is measured in long-run
4. Short-run
5. True
6. Schumpeterian model
7. (d) (i)-(b), (ii)-(a), (iii)-(c)

3.13 Self-Assessment Questions

1. What is economic growth? What are the major determinants of it?
2. Discuss the importance of savings and investments in economic
growth.
3. Explain the Solow model of economic growth and also write its
shortcomings.
4. What do you understand by the term Vicious Circle of Poverty?
How it can be turned into virtuous circle of prosperity?
5. Why innovation is important for economic growth?
6. Briefly discuss the views of different economists on Steady state
growth path. Why it is important for an economy to maintain this
growth path?

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 Economic Growth

7. Write a short note on: (a) Capital Deepening (b) Capital Widening. Notes
8. Explain how endogenous growth models are different from exogenous
growth models.

3.14 References
‹ Friedman, B. M. (2006). Moral consequences of economic growth:
the John R. Commons lecture, 2006. The American Economist, 50(2),
3-8.
‹ International Monetary Fund. (2000). Policies for Faster Growth
and Poverty Reduction in Sub-Saharan Africa and the Role of the
IMF. Issues Brief. Washington, DC.
‹ Mankiw, N. G., Romer, D., Weil, D. N. (1992). Contribution to
the empirics of economic growth. Quarterly Journal of Economics
107, 407-437.
‹ Murphy, K. M., Shleifer, A., Vishny, R.W. (1989). Industrialization
and the big push. Journal of Political Economy 97 (5), 1003-1026.
‹ Romer, P. (1986). Increasing returns and long-run growth. Journal
of Political Economy 94, 1002-1037.
‹ Rosenstein-Rodan, P. (1943). Problems of industrialization of Eastern
and Southeastern Europe. Economic Journal 53 (210-211), 202-211.
‹ The Wire. (2021, July 18). Bangladesh’s Economy: What Did It Do
Differently To Ride Out the Pandemic? Retrieved from the wire.
in: https://thewire.in/south-asia/bangladesh-economy-pandemic-gdp
‹ World Bank. (2002). World Development Indicators. World Bank,
Washington, DC.

3.15 Suggested Readings

‹ Aghion, P., & Durlauf, S. (Eds.). (2005). Handbook of economic
growth. Elsevier.
‹ Barro, R. J., & Sala-i-Martin, X. (2004). Economic Growth (2nd
ed.). Cambridge: The MIT Press.

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 L E S S O N

4
The IS-LM Model
Dr. Arjun Singh Solanki
Professor
Meerut Institute of Technology, Meerut
Email-Id: [email protected]

STRUCTURE
4.1 Learning Objectives
4.2 Introduction
4.3 Keynesian Framework
4.4 The Interaction of Goods and Money Market Explained by 6 IS-LM Curves
4.5 The Short-run Equilibrium in the IS-LM Model
4.6 Effect of Fiscal Policy on the IS Curve and Changes the Short-run
4.7 Effect of Monetary Policy on LM Curve and the Short-run Equilibrium
4.8 The Interaction between Monetary and Fiscal Policy
4.9 Summary
4.10 Answers to In-Text Questions
4.11 Self-Assessment Questions
4.12 References
4.13 Suggested Readings

4.1 Learning Objectives

‹ To develop a deep understanding of the basic macroeconomic concepts for analyzing
the crucial economic policies.
‹ To understand the problem of Inflation, unemployment and low income in the economy.
‹ To understand the theoretical rationale behind policies framed at the country as well
as corporate level.
‹ To provide the learners sound knowledge of International trade and the existing
complexities.

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4.2 Introduction Notes

It has always been important for students to study and understand the
complexities of maintaining an economy in a stable equilibrium position.
In this lesson the students will understand the Keynesian theory on which
the explanation of the advanced models like IS-LM depends. Here we
discuss the concept of short-run equilibrium in the money market and
goods and services market. We also discuss about the monetary and fiscal
policy effect on the short-run equilibrium level of income.

4.3 Keynesian Framework

Keynes in his The General Theory of Employment, Interest, and Mon-
ey, presented a unique way to analyze the economy. He emphasised the
importance of Aggregate Demand (AD) to bring back the economy to
normalcy from the shocks of slump. Thus he suggested that an increase
in aggregate demand helps to raise income as well as employment in
the economy.
The Keynesian Cross
The General Theory of Employment mainly consists of two important
ideas. First, the total expenditure in an economy and second, its effect on
output, employment and inflation. This theory believes that the spending
plans of government, business and household largely determine the total
income of an economy. And the Keynesian cross simply depicts how
the level of income in the economy is established. It is considered one
of the important components for understanding the IS-LM model.
Let’s understand here the major assumption of Keynesian model which
says that prices are constant in short run and market demand is met by
the firms without increase in the level of prices. The aggregate supply
curve is perfectly elastic at the given price level. This assumption indi-
cates that since prices are somewhat static, shifts in any expenditure such
as investment, consumption or government expenditures cause change
in output. Hence, if government spending exceeds, for example, and all
other spending plans do not change, then output will increase.
Now let’s learn about Aggregate demand. It is defined by planned total
expenditure (PE) on goods and services by firms, households and the

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Notes government. It simply means the sum total of goods demanded in an

economy.
Here, we can explain the aggregate demand or planned expenditure as
the sum of:
AD = PE = C + I + G + NX …….. (1)
Here, C means the consumption expenditure on goods and services by
households, I indicate the planned investment on new capital goods such
as plant, machinery, houses, etc. G stands for the government expenditure
on goods and services, NX (X – M) stands for net exports. It shows the
difference between the amount of goods exported (X) and the amount
of goods imported (M). It gives the net expenditure on domestic goods
by the foreigners.
Aggregate Expenditure (AE) is defined as the total planned spending on
domestic goods and services. It simply determines what is to be produced
in the economy.
It is given by:
AE = Y ... (2)
Now in order to understand the model of IS-LM we need to know the
major components of aggregate demand or planned expenditure. Here we
discuss each component one by one.
Consumption Function
The consumption refers to the expenditure done by a consumer in pur-
chasing, using and eating of consumable goods. Generally, the demand
for consumable goods is not stagnant but increases with multiple reasons
especially if income and families expand. And with increasing income,
the level of consumption also increases. Thus, the consumption function
depicts that the consumption is an increasing function of income.
Here, we explain equation for understanding Consumption Function:
C = Ca + cY …. (3)
Ca = The independent consumption which does not rely on the income
level and is constant.
C = The marginal propensity to consume; it reflects the consumption
increase by per unit increase in income.

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Consumption and Saving Notes

Savings (S) are portion of income which is left after spending on con-
sumption in a closed economy (without government and foreign trade).
We can explain it as follows:
Y = C + I and C + S …. (4)
So,
S = Y – C …. (5)
The equation clearly shows that the remaining amount after spending on
consumption is called savings. The savings in an economy are also an
increasing function of income.
Investment
The term investment refers to the goods bought for consumption in future.
Investment can be divided into two investments - fixed investment and
inventory investment. The fixed investment means purchasing of new
houses, plants and equipment whereas Inventory investments refer to the
difference between production and sales in a given year.
In the closed economy at the equilibrium level of income, savings are
equal to investment. It is clear from the equation (4).
If we put the equation together we get:
C + I = C + S …. (6)
We get:
S = I …. (7)
So, here we can say that the remaining income after spending on con-
sumption is saved and it is automatically getting invested.
Government
We know that Government (G) can directly participate and influence the
level of economic activity through its different policy instruments.
Here we discuss the two important policy instruments of government:
‹ Government expenditure on goods and services for example, building
roads, dams and providing free jab to public during times of Corona.
‹ Increase and decrease in taxes and transfer payments also affect
the real income of the households.

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 ECONOMIC ENVIRONMENT OF BUSINESS

Notes The government basically increases or decreases its spending as per the
requirement of economy in times of recession or inflation and affects the
aggregate demand in the economy.
Net Exports
As we know, today we are the integral part of globalization where most
economies have opened their doors for exchange of various essential
products and facilities. They not only import and export goods and ser-
vices but also borrow and lend in world financial markets. As we know
trade is extremely important for many countries and international trade
is crucial for analyzing the development in economy as it paves the way
for formulating economic policies.
Net exports are the difference between the amount of goods exported
(X) and the amount of goods imported (M), and reflect the state-trade
surplus and trade deficit. The positive net export number shows trade
surplus whereas negative number posits trade deficit.
NX = Y – (C + I + G)
The above equation shows that the domestic expenditure does not need
to be equal to the output of goods and services in an open economy. If
output exceeds domestic expenditure, the surplus amount of output will
be exported and net exports become positive. If output falls short of do-
mestic expenditure, we import the deficit amount of output from abroad
and our net exports become negative.
Therefore, the Government makes its domestic policies in such a way
that it provides a conducive environment for the exports and imports
and the exchange rate, which ultimately affects the aggregate Demand
in the economy.
The Economy in Equilibrium
The economy is said to be in a state of equilibrium when whatever
output is produced in the economy will be sold out and there will be
no surplus or deficit of inventories exist. At this point of equilibrium,
all the stakeholders in the economy are in balance, which suggests that
at this point of equilibrium planned expenditure is equal to the actual
expenditure in the economy.
The equilibrium condition in the economy can be expressed as follows:
Actual Expenditure = Planned Expenditure = Y
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Any divergence of the economy from the equilibrium point will not be Notes
a stable position and adjustments and readjustments will take place until
the equilibrium will not be achieved by the economy.
Inventories play a crucial role in the establishment of equilibrium in the
economy, for instance, if the economy is below the point of equilibrium,
at this point planned inventories are greater than the actual inventories and
this forced the firms to increase the production and it leads to increase
in income until the point of equilibrium is achieved. On the other hand,
if the economy is above the point of equilibrium, at this point actual
expenditure is greater than the planned expenditure, this forced the firms
to cut down production and it leads to a decrease in the level of income
until the equilibrium is achieved.
The below mentioned Keynesian cross explains how the level of income
(Y) is determined for a given level of planned expenditures in an economy.

Figure 4.1: The Keynesian Cross

Figure 4.1 illustrates the Keynesian cross where e is the equilibrium
point where income or the actual expenditure is equal to the planned
expenditure in the economy, so any point below or above leads to the
disequilibrium in the economy. If the economy is below point e then
there is more planned expenditure than the actual which leads to de-
crease in firms unplanned inventories and this motivates them to produce
more which leads to increase in income and again the economy attains
equilibrium at e, Similarly if the economy is above the point e, here the
actual expenditure is more than the planned expenditure which leads to
the accumulation of unplanned inventories of firm, so they are induced

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Notes to cut down the production and income decreases and again the economy
reaches the equilibrium point e.

4.4 The Interaction of Goods and Money Market Explained

by 6 IS-LM Curves
The Goods Market and the IS Curve
After studying the Keynesian cross it is the time to study the economy
as a whole, here for simplicity we divide the whole economy into goods
market and the money market. The goods market is explained by the IS
curve, IS curve shows the combination of interest rate and the level of
income at which the goods market is in equilibrium. It shows the points
where the actual expenditure is equal to the planned expenditures in the
goods market.
The derivation of IS curve can be explained by the below mentioned figure.

Figure 4.2(a): Derivation of IS Curve from Keynesian Cross

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With the help of the Keynesian cross, the IS curve is derived in Figure Notes
4.2(a). As per Keynesian cross, the point of equilibrium explains the
equality between actual expenditure and planned expenditure. Here in
the figure initially the economy is in balance at e1 with Y1 level of in-
come. Any increase or decrease in interest rate will affect the planned
investment in the economy and accordingly the planned expenditure curve
will shift. As we can see in the figure increase in interest rate from r1
to r2 will shift the planned expenditure curve downward and accordingly
the new equilibrium will be established at e2 with a lower income level.
This decrease in income is equal to the multiplier times the decrease in
planned investment expenditure. If we extend the equilibrium points in
part-b of the figure to show the combination of interest rate and the level
of income we will get the IS curve.
The IS curve summarises the equilibrium points in the goods market at
which the interest rate and the level of income are equal.
The IS Curve and its Relationship with the Interest Rate and Investment
In an economy, planned investment is negatively related to the interest
rate. It can be expressed as follows:
I = I(r)
The above mentioned investment demand function shows a negative rela-
tionship between investment demand and the interest rate. Higher interest
rates increase the cost of borrowing to businessmen so at higher interest
rates they decrease their planned investment and keep their money invested
in bonds and fixed deposits. On the other hand decrease in interest rate
will increase the planned investment in the economy; a lower interest
rate induces individuals to liquidate their fixed investments and make a
more planned investment in the economy.
This negative relationship between the interest rate and the planned in-
vestment is one of the reasons for the negative slope of IS curve.
Effects of Fiscal Policy Changes on IS Curve
In any economy the objective of government is to achieve higher employ-
ment and income level with stability in price level. The government can

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Notes achieve these objectives by raising or controlling the aggregate demand

in the economy. We have studied the components of aggregate demand
from Keynesian cross.
When an economy faces recession or inflation in economic activities, it
is the responsibility of government to use its fiscal policy tools to bring
back the economy at the point of equilibrium. Since the fiscal policy is
more effective in raising or controlling aggregate demand in the goods
market, so we draw an IS curve for a given fiscal policy and will discuss
the effect of its tools on this curve.
We see the effect of following fiscal policy changes on IS curve:
‹ First we increase or decrease the government expenditure (G) and
keep the tax rates (T) fixed.
‹ We increase or decrease the Tax rates and keep the government
expenditure fixed.
Keeping the other factors constant if the government increases its expen-
diture, this will raise the aggregate demand by increasing consumption
and investment demand in the economy. Due to increase in government
expenditure the IS curve shifts upward and the economy will reach to a
new equilibrium point at e2 with higher level of income Y2, as illustrated
in Figure 4.2(b).
On the other hand, if the government increases the tax rates while
keeping the other factors fixed, it leads to a decrease in the disposable
income of individuals, so accordingly the consumption and investment
demand in the economy decrease, and the aggregated demand in the
economy is reduced from the previous level. This increase in tax rate
shifts the IS curve downward with a lower level of income than the
previous level.

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Notes

Figure 4.2(b): Effect of Fiscal Expansion on IS Curve

Figure 4.2(b) illustrates the effect of increase in government expenditure
on the level of income in the economy.
In starting the economy is in equilibrium at Y1 level of income, increase
in government expenditure leads to shift in planned expenditure curve
upwards and income increase from Y1 to Y2 level, correspondingly in
panel- b the IS curve shifts rightward.
The Money Market and the LM Curve
In the money market, the demand for real money balance and the sup-
ply of real money balance determine the interest rate. Since the supply
of money is exogenously determined by the central bank of a country,
so we assume it is constant. Therefore it is the demand for real money
balance which plays a crucial role in determining the rate of interest in
the money market.

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Notes So to understand the derivation of the LM curve we should first under-

stand the demand for money explained by the liquidity preference theory
given by Keynes.
The Theory of Demand for Money
The demand for money is also called the liquidity preference theory. The
demand for money is a demand for real money balances, people hold
money for what money is able to buy. The higher is the price level peo-
ple need more nominal money balance to complete the same transaction.
As per liquidity preference theory, people demand money for three reasons.
First, people demand money for complete day-to-day transactions and it
depends on their level of income. An increase and decrease in income
will affect the transaction demand.
Second is the demand for precautionary motives. People hold money to
deal with any kind of emergency situation. It depends on the level of
income. Higher income leads to an increase in money demand for pre-
cautionary purposes.
The third and most important factor determining a demand for money is
the speculative motive. People hold money to earn a return on investment.
An increase in interest rate will reduce this return and a decrease in in-
terest rate will increase the return on investment. Therefore the demand
for precautionary motive is negatively related to the rate of interest.
The demand for real money balances is explained by below mentioned
equation as follows:
(M/P)d = L(r)
Here the left side of the equation shows the supply for real money bal-
ances (M/P)d and the right side of the equation shows the quantity of
money demanded depends on the interest rate. Here we should know that
the interest rate is the cost of holding money, so individuals hold more
money at the lower interest rates and hold less money when interest
rates are higher. This is the reason the demand curve for money is of
negative slope.
Equilibrium in the Money Market
In the money market, the demand for money and the supply of mon-
ey jointly determine the equilibrium interest rates. In Figure 4.3 the

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equilibrium is illustrated with the help of the downward slope of the Notes
money demand curve and the vertical money supply curve. Here in the
short run when the price level is given and the money supply is constant,
it is the demand for money which determines the equilibrium interest rate.
Any increase or decrease in money demand will change the equilibrium
in the money market.
In the money market if there is any disequilibrium due to an increase or
decrease in money demand or money supply it will change the interest
rate and the level of income. Given the supply of money increases in
money demand will increase the interest rate and the level of income
increases, and a decrease in money demand will reduce the interest rate
in the money market and the level of income decreases. The upward slope
of the LM curve shows the direct relationship between the interest rate
and the level of income in the money market as explained by Figure 4.3.
Income, Money Demand, and the LM Curve
After studying the demand for money, it is time to derive the LM curve.
The demand for money theory explains that the interest rate in the money
market is determined by the demand for money and the supply of money
at the given price level.
This relationship between demand for money balance, interest rate and
the level of income can be explained by the following equation:
(M/P)d = L(r, Y)
From the above equation, we can see that the demand for money balances
depends on the level of income and the interest rate in the money market.
Given the price level, the money demand, interest rate, and level of income
are directly related. It can be explained by the below mentioned figure.

Figure 4.3: Derivation of LM Curve

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Notes Figure 4.3 illustrates the equilibrium in the money market. In panel-b
of the figure demand for money balance curve and the supply of money
curve intersect and the equilibrium interest rate r1 is determined. So if
there is any increase in income from Y1 to Y2 demand for real money
balance shifts rightward and the new equilibrium is established with a
higher interest rate and a higher level of income. If we extend the equi-
librium points as shown in panel-b of the figure we will get an upward
sloping LM curve. The LM curve shows the combination of interest rate
and the level of income at which money market will be in equilibrium.
Monetary Policy Change and the LM Curve
The LM curve illustrates the equilibrium combination of interest rate and
the level of income in the money market. If the central bank increase
or decrease money supply the LM curves shits upward or downward
accordingly.
We can see how the LM curve shifts due to contractionary monetary
policy adopted by central bank. Let the central bank decrease the money
supply, it leads to decrease in supply of real money balances from M1/P
to M2/P. keeping the level of income constant, this decrease in supply
of real money balances raises the rate of interest, which maintains the
equilibrium in the money market. So the decrease in money supply shifts
the LM curve upward as shown in below mentioned Figure 4.4. In case
of increase in money supply will shift the LM curve downward.

Figure 4.4: Effect of Money Supply on LM Curve

Here in Figure 4.4 the effect of contractionary monetary policy is shown
on the LM curve. In panel-a with the given level of income decrease in

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money supply leads to a new equilibrium in money market with a higher Notes
interest rate r2. Correspondingly in panel-b the LM curve shift upward.

4.5 The Short-run Equilibrium in the IS-LM Model

As per the above discussion of the goods market and money market and the
deriving the equilibrium in both the markets separately, now we establish
the simultaneous equilibrium of both the markets in the economy. The
IS curve shows the equilibrium points in the goods market and the LM
curve shows the equilibrium points in the money market. The equilibrium
will be established at the point where the IS and LM curve intersects
and the equilibrium interest rate and the level of income is determined.
The IS and LM curve equations can be written as follows:
Y = C (Y – T) + I (r) + G……………IS
M/P = L (r, Y)………………………LM
The LM curve illustrates the equilibrium combination of interest rate and
the level of income in the money market and IS curve represents the
equilibrium in the goods market at which the interest rate and the level
of income are in equilibrium.

Figure 4.5: Simultaneous Equilibrium of Goods (IS)

and Money Market (LM)
Figure 4.5 explains the joint equilibrium of goods and money market
with equilibrium interest rate and the level of income is determined by
the intersection of LS and LM curves.

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Notes 4.6 Effect of Fiscal Policy on the IS Curve and Changes

the Short-run
After establishing the simultaneous equilibrium in the goods and money
market, now we study the effect of fiscal policy changes on the goods
market represented by the IS curve.
We had studied from the Keynesian cross that the changes in fiscal policy
affect the planned expenditure and accordingly IS curve shifts. Here we
try to see how the shift in IS curve influences the level of income and
interest rate at the given level of prices in the short run.
Effect of Government Expenditure
Now we see the effect of government spending on the equilibrium level
of income in the economy. Let the government increase its expenditure,
this increase will increase the planned expenditure in the economy so the
production level in the economy increases and accordingly the level of
income will rise to a higher level. This increase in the level of income
will push the demand for real money balances and so the interest rate
increase. This increase in interest rate offsets the expected increase in
investment and the level of income will increase less than the increase
in the Keynesian cross.
Effect of Changes in Taxes
Now we see the effect of changes in tax rates on the IS-LM model. If the
government increases the tax rates on income, it will reduce the disposable
income of individuals and households, and accordingly, the production
level was cut down by the firms. This increase in tax rate affects both
the level of income and the interest rate, so the fall in income is less
than the fall in the Keynesian cross.

4.7 Effect of Monetary Policy on LM Curve and the

Short-run Equilibrium
We have studied earlier in the liquidity preference theory that the rate
of interest is determined by the demand for real money balances and the
supply of money.
The money market equilibrium is represented by the LM curve, it summarises
the interest rate with the given level of income at the given price level.
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So let us consider that the central bank increases the money supply in Notes
the economy, which leads to a shifting in the LM curve downward at a
lower interest rate. People have more money than they want to hold on
to the prevailing interest rate, so they started depositing it into banks or
interest-bearing assets. The interest rate keeps on falling until the people
are willing to keep all the extra money supplied by the central bank, this
brings the money market to equilibrium. The decrease in interest rate
also affects the goods market by stimulating the planned expenditure,
production, and level of income.

4.8 The Interaction between Monetary and Fiscal Policy

Now it is the time to understand the complexity of an economy where
all things work interdependently. Whenever government applies one of
the policy instruments, its efficacy depends on the support extended by
other institutions in the economy.
We try to understand what will happen if government increases the tax
rate. The effectiveness of this instrument as per IS-LM theory depends
upon the support provided by the central bank.
Here, we assume three policy responses of central bank:
First, the central keeps the money supply unchanged,
Second, the central bank reduces the money supply to maintain the same
level of income,
Third, the central bank increases the money supply to maintain the same
level of income.
It is important to understand that the increase in tax rates reduces the
disposable income of individuals in the economy, so it leads to decrease
in aggregate demand, if other factors like money supply are not increased
correspondingly. On the other hand, if the money supply is increased then
the decrease in disposable income due to increase in tax rate is com-
pensated and there is no decrease in aggregate demand in the economy.
So it is important to note that the effectiveness of fiscal policy depends
on the response of central bank towards the money supply. Generally,
while analyzing a change in one policy, we assume the other policy ef-
fects as neutral.

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Notes IN-TEXT QUESTIONS

1. The IS curve represents equilibrium in which of the following
markets?
(a) Money market
(b) Goods market
(c) Foreign exchange market
(d) Labor market
2. The LM curve shows equilibrium in the:
(a) Goods market
(b) Money market
(c) Foreign exchange market
(d) Labor market
3. If the central bank increases the money supply, the LM curve
will:
(a) Shift leftward
(b) Shift rightward
(c) Become steeper
(d) Remain unchanged
4. An increase in government spending will:
(a) Shift the IS curve rightward
(b) Shift the IS curve leftward
(c) Shift the LM curve rightward
(d) Shift the LM curve leftward
5. A decrease in the interest rate leads to:
(a) An increase in investment and output
(b) A decrease in investment and output
(c) No change in investment
(d) A decrease in money demand

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6. In the IS-LM model, an expansionary fiscal policy will generally Notes

lead to:
(a) A higher interest rate and higher output
(b) A lower interest rate and higher output
(c) A lower interest rate and lower output
(d) No change in output
7. If the demand for money is highly sensitive to interest rates, the
LM curve will be:
(a) Steep (b) Flat
(c) Vertical (d) Upward sloping but steeper
8. The intersection of the IS and LM curves determines:
(a) The equilibrium level of output and interest rate
(b) Only the equilibrium level of output
(c) Only the equilibrium interest rate
(d) The equilibrium level of consumption
9. A rightward shift in the LM curve, holding the IS curve constant,
will:
(a) Increase output and decrease interest rates
(b) Decrease output and increase interest rates
(c) Increase both output and interest rates
(d) Decrease both output and interest rates

4.9 Summary
‹ The equilibrium in the economy as per Keynesian cross will take
place at the point where the aggregate demand or planned expenditure
equals the actual output or actual expenditures.
‹ The IS and LM curve shows the goods market and the money
market respectively. They jointly determine the equilibrium in the
economy, the intersection of both curves determines the equilibrium
interest rate and the level of income in the economy.

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Notes ‹ The changes in the money supply affect the LM curve, any increase
in money supply will shift the LM curve downward, and a decrease
in money supply will shift the LM curve upward.
‹ The IS curve represents the equilibrium in the goods market and
any change in the fiscal policy will shift the IS curve. Any increase
in government expenditure will shift the IS curve upward and a
decrease in government expenditure will shift it downward.

4.10 Answers to In-Text Questions

1. (b) Goods market
2. (b) Money market
3. (b) Shift rightward
4. (a) Shift the IS curve rightward
5. (a) An increase in investment and output
6. (a) A higher interest rate and higher output
7. (b) Flat
8. (a) The equilibrium level of output and interest rate
9. (a) Increase output and decrease interest rates

4.11 Self-Assessment Questions

1. Use the Keynesian cross to explain why fiscal policy has a multiplied
effect on national income.
2. Use the theory of liquidity preference to explain why an increase in
the money supply lowers the interest rate. What does this explanation
assume about the price level?
3. What is liquidity trap? Discuss the measures taken by government
to counter this trap and the economy will reach normalcy.
4. Use the Keynesian cross to predict the impact on equilibrium GDP
of:
(a) An increase in government purchases
(b) An increase in taxes

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(c) Equal-sized increases in both government Notes

(d) Purchases and taxes
5. In the Keynesian cross, assume that the consumption function is
given by:
C = 200 + 0.75 (Y – T)
Planned investment is 100; government purchases and taxes are both
100.
(a) Graph planned expenditure as a function of income.
(b) What is the equilibrium level of income?
(c) If government purchases increase to 125, what is the new
equilibrium income?
(d) What level of government purchases is needed to achieve an
income of 1,600?
6. Consider the impact of an increase in thriftiness in the Keynesian
cross. Suppose the consumption function is:
C = Ca + c(Y – T)
Where Ca is a parameter called autonomous consumption and c is
the marginal propensity to consume.
(a) What happens to equilibrium income when the society becomes
more thrifty, as represented by a decline in Ca?
(b) What happens to equilibrium saving?
(c) Why do you suppose this result is called the paradox of thrift?
(d) Does this paradox arise in the classical model? Why or why
not?

4.12 References
‹ N. Gregory Mankiw. (2005). Macroeconomics, Worth Publisher, 41,
Madison Avenue, New York.
‹ McConnel, C. R. & H. C. Gupta. (1984). Introduction to Macro
Economics, Tata McGraw Hill Publishing Company Ltd., New Delhi.
‹ Ahuja H. L. (2008). Macroeconomics Theory & Policy, S. Chand
& Company Ltd., Ram Nagar, New Delhi.

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 ECONOMIC ENVIRONMENT OF BUSINESS

Notes ‹ Dwivedi D. N. (2007). Macroeconomics Theory & Policy, Tata

McGraw Hill Publication Company Ltd., Delhi.

4.13 Suggested Readings

‹ Mankiw, N. G. (2012). Principles of Macroeconomics (6th ed.).
Cengage India.
‹ Moorthy, V. (2017). Applied Macroeconomics: Employment, Growth
and Inflation. I K International Publishing House Pvt. Ltd.
‹ Moss, D. A. (2015). A Concise Guide to Macroeconomics: What
Managers, Executives, and Students Need to Know (2nd ed.). Harvard
Business School Press.
‹ Roy, S. (2017). Macroeconomic Policy Environment: An Analytical
Guide for Managers (2nd ed.). McGraw Hill Education.

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 L E S S O N

5
AD/AS Framework
Dr. Arjun Singh Solanki
Professor
Meerut Institute of Technology, Meerut
Email-Id: [email protected]

STRUCTURE
5.1 Learning Objectives
5.2 Introduction
5.3 Supply Side Economics
5.4 Difference between the Short Run and Long Run
5.5 The Model of Aggregate Supply and Aggregate Demand
5.6 Policy Effectiveness and AD&AS
5.7 Fiscal Policy
5.8 Monetary Policy
5.9 Trade and Exchange Rate Policy
5.10 Summary
5.11 Answers to In-Text Questions
5.12 Self-Assessment Questions
5.13 References
5.14 Suggested Readings

5.1 Learning Objectives

‹ To understand the theoretical rationale behind formulating policies at the national
as well as corporate level.
‹ To understand the fluctuations in macroeconomic indicators by using more logical
assumptions.
‹ To understand the concept of Supply Side Economics in solving the complex economic
problems of the country.
‹ To understand the role and significance of fiscal and monetary policies in controlling
aggregate demand in the economy.
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Notes
5.2 Introduction
After studying the short-run analysis of aggregate demand of the econo-
my in lesson 4, now we will try to study the long-run effects of policy
changes on the level of income in the economy. Here we also explain
an alternative approach to solving economic problems of an economy.
It deals with the aggregate supply in the economy and recently become
very popular among policy makers.

5.3 Supply Side Economics

As we know that the decade of 1930 is known for great depression in
history. The Keynesian theory also came into light during this world-
wide economic crisis. The whole world witnessed the negative sides of
this economic downfall. The large number of labour force fell short of
employment and a huge loss of production was registered in the face of
unemployment. The entire economy was trampled and massive decline
in income was seen for many years.
After the Second World War, it has also been noticed that inflation was
the major issue addressed by the policymakers instead of unemployment.
Then, Keynesian theorists came up with their ideas and explained it in
terms of excess aggregate demand and called it inflation which is caused
by an increase in demand side factors. Keynesian followers also posit that
to make the economy stabilized in short run, it is essential to manage
the aggregate demand.
They also suggested that the economy should use fiscal and monetary
policies in order to raise the aggregate demand and boost the economy
towards growth by minimizing the imprints of depression or recession
and unemployment.
They believed that such measures would help the economy grow and
reduce the unemployment.
Apart from this, they also suggested the ways to avoid the state of in-
flation from an economy by adopting contractionary fiscal and monetary
policy policies hence reducing the aggregate demand.
Supply-side economics means that the economy will grow by controlling
the supply of goods and services. It simply believes that taxes should
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be reduced in order to generate employment, to speed up businesses and Notes

encourage entrepreneurial activities.
Supply-side economics is considered as one of the applications of micro-
economic theory in the analysis of problems concerning economic aggre-
gates – so-called “macroeconomics.” There are few renowned economists
like Adam Smith, J. B. Say, Milton Friedman and Gary Becker who gave
its conceptual explanations in their works.
The few Key Takeaway from Supply Side Economics are:
1. It emphasises on an increase in the supply of goods for economic
growth.
2. It suggests to encourage production by reducing the tax as well as
regulation and lower the interest rate.
3. It is considered as an alternative to Keynesian aggregate demand-side
policy.
4. It also does not accept the view that decreasing the level or rate of
increase in nominal aggregate demand necessarily results in a drop
in employment and output. It stresses that limiting the growth in
nominal demand accelerates the growth in employment, output, and
real income.
Benefits of Supply-Side Economics
1. It bolsters and inspires for national economic growth and prosperity.
2. It motivates and creates multiple job opportunities in the economy.
3. It aims to incentivize firms, businesses and companies with tax cuts.
4. It focuses upon to cut taxes as an excellent method to stimulate the
economy. The reason behind tax deduction is to augment the amount
of spending money an individual or firms can use in purchasing
goods and services.
5. It encourages using government projects or incentives to strengthen
the economy.
Here are some examples to understand the Supply Side-Economics
1. Purposefully encouraging free trade agreements to ensure business
endeavours and investments.
2. Allowing relaxation in tax rates.

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Notes 3. Allowing relaxation in selling government land for private businesses.

4. Allowing Private Set-ups to involve, participate and contribute their
expertise in government newly organized projects and programmes
to increase labour force as well as growth in economy.
We have learned that the concept of supply-side economics is to be found
in its applications to the public economic policy issues of contemporary
society. It is, therefore, to a great extent, an integral part of macroeco-
nomic policies in the interest of better functioning of the private market
system, significant growth in the stock of capital, sound progress in the
productivity of labour, and sharp increase in aggregate output.

5.4 Difference between the Short Run and Long Run

In microeconomic theory the short run is the time period, when a firm
is not able to increase the production by increasing its fixed factors and
can increase its production only by increasing the variable factors. On the
other hand, in the long run, production can be increased by increasing
all factors in any proportion.
Here in macroeconomics the short-run and long-run difference depend
on the variation in prices.
As per classical theory in long run, the economy is working at the full
employment level and the prices are flexible. But the change in price level
does not affect the level of employment, output, and level of income in
the economy. So the aggregate supply curve, in the long run, is assumed
perfectly inelastic at the given level of income.
On the other hand, the Keynesian theory has explained the theory of em-
ployment in the short run where prices are assumed constant and the firms
are willing to supply an infinite amount of output at the existing price level.
It is due to unemployed resources in the economy, so the cost of firms does
not increase and they will not increase the prices. So the aggregate supply
curve in the short run is assumed perfectly elastic at the given price level.

5.5 The Model of Aggregate Supply and Aggregate Demand

The aggregate demand and aggregate supply model explain the determina-
tion of the equilibrium level of income and the price level in the economy.

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The interaction of aggregate demand and aggregate supply curves deter- Notes
mines the equilibrium in the economy with a given level of income and
prices. Here we see how the change in price level affects the equilibrium
level of income and the level of prices in the economy.
In this model first we drive the aggregate demand curve by using the
IS-LM model and then we study the factors affecting aggregate demand
curve.
Aggregate Supply
Aggregate supply refers to the total quantity of production firms will
produce and sell—in other words it is the real GDP. In another word, it
is the total supply of output that businesses can sell in the economy—at
a particular price and period.
Here, we understand that the rise and fall in aggregate demand causes
change in aggregate supply. For example, the rise in demand results in
expansion of supply whereas the fall in demand causes decrease in sup-
ply. This concept is further divided into short-run supply and long-run
supply. In the short run, supply is driven by price whereas in the long
run, firms increase production.
Now, we learn the formula for estimating the aggregate supply which is
as follows:
AS = C + S
Here, AS means the Aggregate Supply, C means the Consumption Ex-
penditure, and S means Savings.
Aggregate Supply Curve
The aggregate supply curve shows the number of goods or services pro-
duced in relation to price changes. Moreover, the aggregate supply, in
the short run is found horizontal which means it is perfectly elastic. And
aggregate supply curve in the long run, is found vertical which means
it is perfectly inelastic.
This horizontal curve is based on the assumption that since there are
unemployed resources in the economy so firms can produce as much as
they want at the existing cost and there is no price increase in the short
run, this horizontal shape indicates that the firms are willing to supply
whatever amount of goods are demanded at the existing price level.

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Notes On the other hand, the vertical supply curve in the long run shows that
there is no change in the supply of goods whatever the price level. The
vertical supply curve is based on the assumption that in the economy
there is always full employment of labour and that’s why the output is
at its corresponding level and there is no scope for further increase in
production with the existing technology.
Short Run Long Run

Figure 5.1: The Short-Run and Long-Run Supply Curves

Here, in Figure 5.1 we can see the shape of aggregate supply curve in
short run in panel-a, and in the long run in panel-b. In panel-a supply
curve is perfectly elastic at the given price level in the short run. It is
clear from the horizontal slope of supply curve that the firm is willing
to supply as much as required by the economy at the given price level.
On the other hand in panel- b the aggregate supply curve is perfectly
inelastic in the long run at the given level of income. It shows that there
is no effect on the change in the price level on the level of income in
the economy in the long run.
From the above discussion, it is clear that two extremes of supply curves
were assumed one is vertical in the long run and horizontal in the short
run. Considering both the extreme time horizons, we assume an interme-
diate supply curve of an upward slope, showing a positive relationship
between the price level and the level of income in the economy.
Factors Affecting Short-Run Aggregate Supply Curve
1. Changes in wage rate
2. Prices of inputs

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3. Change in labour Notes

4. Corporate taxes and subsidies
Factors Affecting Long-Run Aggregate Supply Curve
1. Changes in technology
2. Change in stock of capital
3. Increase in labour force
Aggregate Demand
Aggregate demand refers to the amount of total spending on domestic
goods and services and measures the total level of demand in an econo-
my. It counts demand for each product produced in the economy. It also
includes the foreign demands for the domestic products but does not
include the domestic market for foreign products.
Here we have the following key takeaways of Aggregate Demand
‹ Aggregate demand estimates the total consumer demand for goods
and services produced.
‹ The variation in aggregate demand causes changes in economy’s
macroeconomic indicators.
‹ The increase in aggregate demand shows rise and growth in
economy. With the growing economy, the industry expands and
opportunities of employment are generated. On the other hand,
the decrease in aggregate demand weakens the economy, shrinks
the industry and rate of production and cuts the level of labour
employed in production.
‹ Aggregate demand consists of foreign demand for domestic
products. The economists consider aggregate demand as a
benchmark for determining the country’s position in international
trade and export.
‹ It helps to understand why government increases its spending
during financial crisis. Since government spending bolsters demand
and increased demand boosts up production, consequently level
of employment also increases over the long term.

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Notes Aggregate Demand Curve

The aggregate demand curve depicts the relationship between the price
level and the level of income at which the goods and services market
and the money market are simultaneously in equilibrium.
Aggregate demand in the economy is the sum of the consumption demand
(C), investment demand (I), government spending (G), and net exports
(NX). It can be explained as follows:
AD = C + I + G + NX …….(1)
The position of the aggregate demand curve depends upon the above
factors any increase in these factors will shift the aggregate demand
curve upwards and a decrease will shift downwards. The confidence of
consumers and investors also affects the position of the aggregate demand
curve in the economy.
The supply of real money balances (M/P) also affects aggregate demand
in the economy, any increase in the supply of real money balances will
shift the aggregate demand curve upward, and a decrease will shift it
downward.
Derivation of Aggregate Demand Curve
The aggregate demand curve describes a relationship between the price
level and the level of national income.
To understand the determinants of aggregate demand more fully, we now
use the IS-LM model with variable price level. To derive the aggregate
demand curve, first, we use the IS-LM model to show why national income
falls as the price level rises—that is, why the aggregate demand curve
is downward sloping. Second, we examine what causes the aggregate
demand curve to shift.
From the below mentioned figures we can see the shift in Aggregate
demand curves by expansionary fiscal and expansionary monetary policy.
The aggregate demand curve shows the set of equilibrium points in goods
and money market simultaneously and shows how the change in price
level changes the level of income in the economy.

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Notes

Figure 5.2: Derivation of the Aggregate Demand Curve by IS-LM Curves

Here in Fig-5.2 we have presented the derivation of Aggregate demand
curve with the help of IS and LM curves.
In panel-a, as we can see what happened to the IS-LM curves when price
level changes. For instance if price rises from P1 to P2, it leads to de-
crease in money supply. This Decrease in money supply leads to increase
in the interest rates from r1 to r2 and the LM curve shifts to the left or
upward. This upward shift in LM curve will leads to a new equilibrium
with higher interest rate and lower level of income from Y1 to Y2.
Corresponding to panel-a we can see in panel-b where the AD curve is
of downward slope and the economy moves along with the AD curve
due to change in price level. So AD curve shows what happened to the
income level if price level varies.
Reasons of Downward Slope of Aggregate Demand Curve
Real Balance Effect: Real balances are the purchasing power of money
balances held by the public in an economy. An increase in price level off-
sets the purchasing power of real money balances held by the public. This
reduction in purchasing power feels them poorer, and they decrease their
spending on consumption and the aggregate demand in the economy falls.
On the other hand, if the price level in the economy decreases, it leads to
an increase in the purchasing power of real money balances held by the
public, now they feel richer due to the increase in purchasing power, and
the demand for consumption increases, and this increase in consumption
spending by the public leads to increase in aggregate demand.

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Notes The effect of change in price level on the real balances due to which
consumption in the economy gets affected and accordingly the aggregate
demand curve becomes downward slope.
The Rate of Interest Effect: It is the effect of change in the price level
on the interest rate due to which investment demand in the economy
gets affected and accordingly the aggregate demand in the economy gets
affected.
Let the price level in the economy rise, due to the rise in price level
people need more money to complete their transactions. This increase
in demand for money at the given money supply leads to an increase
in interest rates in the economy. As we know the negative relationship
between investment and the interest rate, this increase in interest rate
leads to a decrease in investment demand, and accordingly the aggregate
demand in the economy contracts.
On the other hand, if the price level decreases, this leads to more money
available for the existing transactions. So at the existing supply of money
people reduce their demand for money and the interest rates come down,
this reduction in interest rates leads to increase in investment demand
and accordingly the aggregate demand in the economy extends.
Foreign Trade Effect: A change in price level affects the demand for
exports and imports of goods in the economy called the foreign trade
effect. A rise in the level of prices makes the imported goods cheaper
than the domestically produced goods and goods exported become dearer,
so this leads to an increase in imports and a decrease in exports which
makes the net export negative and leads to a contraction in aggregate
demand in the economy. On the other hand decrease in the price level
leads to an increase in exports and a decrease in imports and accordingly
the aggregate demand leads to an extension.
Exchange Rate Effect: An increase in price level affects the exchange
rate in terms of appreciation and depreciation. Appreciation affects the
net exports adversely, and depreciation affects the net exports positively.
Here we are seeing the effect of an increase in price level on the capi-
tal outflow and capital inflow in the country which affects the balance
of payment. Any increase in the price level leads to an increase in the

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interest rate and the exchange appreciates, inducing the foreign capital Notes
to come in order to earn a higher rate of return on investment. Contrary
if the price level decreases it leads to a decrease in the interest rate and
the exchange rate depreciates, and the capital moves out of the country
to earn more return somewhere else, this leads to an adverse balance
of payment, and contracts the aggregate demand assuming net exports
constant.
Factors Affecting Aggregate Demand
The aggregate demand curve summarizes the results from the IS-LM model,
events that shift the IS curve or the LM curve (for a given price level)
cause the aggregate demand curve to shift. For example, an increase in
the money supply raises income in the IS-LM model for any given price
level; it thus shifts the aggregate demand curve to the right, Similarly,
an increase in government purchases or a decrease in taxes raises income
in the IS-LM model for a given price level; it also shifts the aggregate
demand curve to the right. Conversely, a decrease in the money supply, a
decrease in government purchases, or an increase in taxes lowers income
in the IS-LM model and shifts the aggregate demand curve to the left.
Anything that changes income in the IS-LM model other than a change
in the price level causes a shift in the aggregate demand curve. The
factors shifting aggregate demand include not only monetary and fiscal
policy but also shocks to the goods market (the IS curve) and shocks to
the money market (the LM curve).
The aggregate demand and aggregate supply are also affected by the
supply and demand shocks in the economy. Shocks are the disturbances
that change the position of the aggregate demand and aggregate supply
curves in the economy. These shocks are exogenous variable that affects
the economic activities in the economy. For example, if the government
announces anything for the people of the country which is going to increase
their income, it leads to an increase in their consumption spending, and
the aggregate demand curve shifts rightward. On the other hand, if any
policy change affects the cost of production in the economy, it accord-
ingly affects the aggregate supply curve in the economy. An increase in
the cost of production or disturbance in production shifts the aggregate
supply curve leftward.

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Notes

Figure 5.3(a): Effect of Expansionary Monetary Policy

From Figure 5.3(a) we see with the given price level if there is an in-
crease in money supply the LM curve shifts rightward or downward and
so the AD curve shifts rightward at a higher level of income with the
same price level.

Figure 5.3(b): Effect of Expansionary Fiscal Policy

From Figure 5.3(b) we can see due to expansionary fiscal policy the IS
curve shifts towards right or upward and the new equilibrium will be at
higher level of income with higher interest rate at the given price level,
corresponding to this new equilibrium point AD curve also shifts towards
right with the same price level new equilibrium will be at higher level
of income from Y to Y1.

5.6 Policy Effectiveness and AD&AS

The objective of any government is to achieve full employment, stability
in the price level, and faster economic growth, so the government has to

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design its macroeconomic policies in such a manner that the above-stated Notes
objectives will be achieved. Here it is important to understand that the
economy will not work at the full employment level as stated by the
classical school, and it is also not possible to increase output or em-
ployment without an increase in the price level as explained by Keynes
in his theory.
The economy does not always work at equilibrium; there are often eco-
nomic fluctuations that occur in output, employment, and price level. At
times the economy finds itself in the grip of recession when levels of
national output, income, and employment are far below their potential
level. On the other side, the economy faces the problem of hyperinflation,
where prices are increasing at a rapid rate, both economic conditions have
their negative effects on the economy, and they should be contained by
the appropriate macroeconomic policies.
So it is critical to see the efficacy of policies in achieving the objectives.
So here we present some polices which are used by the government to
achieve the objectives of any economy.

5.7 Fiscal Policy

Fiscal policy is the use of government spending and taxation to influence
the aggregate demand in the economy. In actual practice government
interventions in the form of fiscal policy are required to achieve the
potential output, income, and employment objectives.
In a developing economy like India government uses this policy to affect
the aggregate demand in the economy in times of Inflation and recession.
As per the requirements government increases and decreases its spending
and affects the aggregate demand.
Government purchases and government transfer payments act like increases
in autonomous spending in their effects on equilibrium level of income.
The policy effectiveness depends upon so many other factors as well.
Government also raises and lowers taxes and affects the disposable in-
come of households and the aggregate demand.
Government as per requirement makes surplus and deficit budget and
influences the aggregate demand in the economy. It uses expansionary

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Notes and contractionary policy as the objective is to curtail or expand the

aggregate demand accordingly.
Stabilizing the economy at a higher level of employment and national
output is not the only objective of a macroeconomic policy. Ensuring
price stability is its other goal. Both inflation and deflation have bad
effects on the economy. It is therefore desirable to achieve price stability.
Fiscal policy is an important instrument to stabilise the economy, which
is to overcome recession and control inflation in the economy. The fiscal
policy generally aims at managing aggregate demand for goods and ser-
vices in the economy. At the time of recession, the government increases
its expenditure or cuts down taxes, or adopts a combination of both. To
counter recession government adopts an expansionary fiscal policy, which
raises government expenditure and cuts down taxes as well. The adoption
of such kind of fiscal policy will lead to a government budget deficit.
On the other hand, to control inflation government reduces its expendi-
ture or increases taxes to adopt a combination of both; it will lead to a
government budget surplus.

5.8 Monetary Policy

Monetary policy is an important instrument of macroeconomic policy by
which macroeconomic objectives can be achieved. In India, the Reserve
Bank of India works on behalf of the government and acts as per the
objectives decided by the government. Like fiscal policy, monetary policy
is also used to achieve a full employment level of output, maintain price
stability, and faster economic growth in an economy.
The monetary policy is a policy formulated by the central bank, i.e.,
RBI (Reserve Bank of India) and relates to the monetary matters of the
country. The policy involves measures taken to regulate the supply of
money, availability, and cost of credit in the economy.
Monetary policy affects the demand and supply of economy, first by
affecting the interest rates and then by affecting the aggregate demand.
In order to squeeze or expand the aggregate demand central bank uses
expansionary and contractionary monetary policy.
Monetary policy is used to maintain the equilibrium between the money
demand and money supply in the economy. In the case of disequilibrium
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between money demand and money supply, it results in inflationary or Notes

deflationary tendencies in the economy. More specifically, in times of
recession monetary policy used its tools in such a manner that an ade-
quate amount of credit should be available to the household and business
sector. On the other hand, in times of inflation monetary policy is used
to contract the money supply or increase the interest rate by which the
excess credit will be squeezed out from the economy. It uses different
instruments like open market operations and interest rate to curtail and
increase money demand and money supply and accordingly the aggregate
demand is managed in the economy.
It is important to note that the monetary policy has certain limitations
in increasing the supply of money to achieve the expansion in economic
activity. Keynes himself has stated that in times of depression, monetary
policy will be ineffective in the recovery of the economy and therefore
he laid stress on the adoption of fiscal policy to overcome depression.

5.9 Trade and Exchange Rate Policy

In an open economy, international transactions play a crucial role in aug-
menting the level of income in the economy. The degree of openness of
an economy depends upon the amount of international transactions like
capital flows, transfer payments, imports and exports reported in a year
in the balance of payment. The more open is the economy more is the
complexities of managing it.
Trade policies, broadly defined, are policies designed to influence directly
the amount of goods and services exported or imported. Most often, trade
policies take the form of protecting domestic industries from foreign
competition—either by placing a tax on foreign imports (a tariff) or re-
stricting the amount of goods and services that can be imported (a quota).
In large or small open economies policies affect the trade and the exchange
rates through the interest rate. In both large and small open economies,
policies that raise savings or lower investment lead to trade surpluses,
increase trade surplus affects the aggregate demand.
Similarly, policies that lower savings or raise investment lead to trade
deficits. In economies, a protectionist or liberalized trade policies cause
the exchange rate to appreciate and affects the level of aggregate demand
in the economy.
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Notes IN-TEXT QUESTIONS

1. The demand for money is most dependent upon:
(a) The level of prices
(b) The interest rate
(c) The availability of banking outlets
(d) The availability of credit card
2. Which of the following is NOT a reason why the aggregate
demand curves slope downward?
(a) The exchange rate effect
(b) The wealth effect
(c) The classical monetary neutrality effect
(d) The interest rate effect
3. Stagflation occurs when the economy experiences:
(a) Rising prices and rising outputs
(b) Rising prices and falling outputs
(c) Falling prices and rising outputs
(d) Falling prices and falling outputs
4. Which event shifts the short-run aggregate supply curve to the
right?
(a) A decrease in money supply
(b) A decrease in oil prices
(c) An increase in government spending on military equipment
(d) None of the above

5.10 Summary
1. Supply-side economics gives a new perspective to policymakers to
deal with the problem of high inflation and unemployment. Using
fiscal policy tools like a reduction in the tax rate of firms leads to
improvement in productivity and efficiency and affects the aggregate
supply in the economy.

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2. The model of AD-AS with variable price levels gives the complete Notes
picture of the economy. It integrates both the goods and money
market at the given price level with the given level of income. It
explains the effect of changes in price level on consumption demand,
investment demand, and net exports in the economy.
3. Fiscal policy is an effective tool of government to manage the aggregate
demand in the economy in times of recession and hyperinflation.
By using fiscal policy tools like government expenditure, tax rates,
and public borrowing, the government raises the aggregate demand
in the goods market in times of recession. It is more effective in
raising the aggregate demand in the economy.
4. Monetary policy is managed and controlled by the central bank. It
balances the aggregate demand in the economy by managing the
equilibrium in money demand and money supply in the money
market. By affecting the interest rate and availability of credit in
the economy central bank influences the aggregate demand in the
economy in times of inflation and recession. Monetary policy is
more effective in controlling money inflation in the economy.

5.11 Answers to In-Text Questions

1. (b) The interest rates
2. (c) The classical monetary neutrality effect
3. (b) Rising prices and falling output
4. (b) A decrease in oil prices

5.12 Self-Assessment Questions

1. Explain the relevance of IS-LM model in developing the model of
AD-AS.
2. Explain the roles of monetary and fiscal policy in causing and ending
hyperinflations.
3. What is the impact of an increase in taxes on the interest rate,
income, consumption, and investment?

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Notes
5.13 References
‹ Gupta S. G. (2001). Macroeconomics Theory & Applications, Tata
McGraw Hill Publication Company Ltd., Delhi.
‹ Ahuja H. L. (2008). Macroeconomics Theory & Policy, S. Chand
& Company Ltd., Ram Nagar, New Delhi.
‹ Dwivedi D. N. (2007). Macroeconomics Theory & Policy, Tata
McGraw Hill Publication Company Ltd., Delhi.
‹ N. Gregory Mankiw. (2005). Macroeconomics, Worth Publisher, 41,
Madison Avenue, New York.
‹ McConnel, C. R. & H. C. Gupta. (1984). Introduction to Macro
Economics, Tata McGraw Hill Publishing Company Ltd., New Delhi.

5.14 Suggested Readings

‹ Blanchard, O. (2017). Macroeconomics (6th ed.). Pearson Education.
‹ Dornbusch, R., S. Fischer & Startz, R. (2017). Macroeconomics
(11th ed.). McGraw Hill Education.
‹ D’Souza E. (2012). Macroeconomics (2nd ed.). Pearson Education.
‹ Farnham, P. G. (2014). Economics for Managers (3rd ed.). Pearson
Education.
‹ Jones, C. (2017). Macroeconomics. W. W. Norton & Company.

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 L E S S O N

6
Phillips Curve, Monetary
Policy, and Fiscal Policy
Dr. Dezy Kumari
Assistant Professor
FMS
University of Delhi
Email-Id: [email protected]

STRUCTURE
6.1 Learning Objectives
6.2 Introduction
6.3 Phillips Curve
6.4 Expectation Augmented Phillips Curve
6.5 Fiscal Policy
6.6 Monetary Policy
6.7 Neutrality of Money
6.8 Crowding Out
6.9 Liquidity Trap
6.10 Role of the Central Bank
6.11 Answers to In-Text Questions
6.12 Self-Assessment Questions
6.13 References
6.14 Suggested Readings

6.1 Learning Objectives

‹ Concept of Phillips Curve.
‹ Fiscal Policy and Monetary Policy.
‹ Neutrality of Money.

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Notes ‹ Crowding Out.

‹ Role of central bank in India.

6.2 Introduction
This unit will contain Concept of Phillips Curve, Fiscal policy, Monetary
policy and role of central bank in India. The reader will understand the
implications of Phillips curve in the situation of stagflation, the major role
of monetary and fiscal policy, role of central bank in India and efficacy
of credit control. Money plays an important role in the functioning of
economy. Money is an instrument of satisfying human wants. If it does
not possess this quality, it would have no value.

6.3 Phillips Curve

Keynes and Robinson foresaw a possibility of attaining simultaneously the
dual objective of full employment and price stability without the help of
either price control or wage control. This means that during recession or
depression when the economy is having a good deal of excess capacity
and large scale-employment of labour and idle capital stock, the aggregate
supply curve is perfectly elastic. When full employment level of output
is reached, aggregate supply curve becomes perfectly inelastic. With this
shape of aggregate supply curve becomes perfectly inelastic. With this
shape of aggregate supply curve assumed in the simple Keynesian model,
increase in aggregate demand before the level of full employment, causes
increase in the level of real national output and employment with price
level remaining unchanged. That is, no cost has to be incurred in the form
of rise in the price level (i.e. inflation rate) for raising the level of output
and reducing unemployment. However, the experience of many countries
with countries with strong producer pressure group shows that a fall in the
level of unemployment increases pressure on prices and when the price level
is stable, unemployment crosses the level which is considered ‘Socially
tolerable’ by countries committed, in principle, to achieve full employment.
Phillips curve has been substantiated by research into the relationship
between money wage-rates and the level of unemployment in the UK,
between 1861 and 1957 carried out by Prof. A.W. Phillips. The research
made by Prof. Phillips appears to support the hypothesis that the rate

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of change of money wage-rate can be explained by the level of unem- Notes

ployment and the rate of change of employment. The relation between
the rate of change of money-wage rates and unemployment is likely to
be curvilinear and not linear. Phillips has used this curve to determine
that for the UK a rate of 5.5 percent unemployment is needed if wages
are to be held steady and a rate of 2.5 percent employment is needed if
prices are to be held steady. This means that wages would rise by the
same percentage as increase in productivity which is estimated to be 2
percent per year. In other words, wages will rise when employment is low
and wages will fall but slowly because of the downward rigidity of wage
rates, when unemployment is high. This inverse relationship between the
nature of change of money wages and the rate of employment has come
to be known as Phillips Curve.

It appears that Phillips main argument was demand–pull in nature. The

level of unemployment reflects the excess demand because excess of its
demand in the labour market causes wage inflation and also determines
an upward rise in wages. Similarly, during periods of high unemployment
the excess supply of labour causes wages to move downwards.

6.3.1 Lipsey’s Analysis of Phillips Curve

The statistical relationship established by Phillips in the wage inflation
and employment has been further analysed by Prof. Lipsey. In this con-

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Notes nection, he has pointed out two behavioural relationships: (i) a positive
relation between the rate of change in the money wages-rates and the
magnitude of excess demand for labour; and (ii) an inverse non-linear
relation between excess demand for labour and unemployment. These two
relationships are found in single micro labour market.
Lipsey assumes that wages inflation is the increasing function of the
proportionate excess demand for labour. He further maintains that the
relation between excess demand for labour and the rate of employment is
negative and non-linear which implies that the greater the excess demand,
the lower will be the level of unemployment and the lower the excess
demand is zero, the labour market will be in equilibrium, but this the
excess demand for labour by only the excess of number of vacancies over
the number of unemployed persons. Thus, excess demand for labour can
be zero only when the unemployment rate is positive. The unemployment
compatible with zero excess demand is called frictional unemployment,
which arises because of the lack of instantaneous matching of vacancies
with unemployed workers.
The non-linear relationship means that while the unemployment rate
will fall below frictional level because of the positive excess demand
for labour, it can never fall below zero, however high level of excess
demand may be.
Policy Implications of Phillips Curve
Phillips curve analysis aroused considerable interest among the policy
makers particularly because of the implications of its relationship with
price inflation. Changes in the price level were first related to the chang-
es in the money wage rate and that is why Phillips curve expressed the
inverse relationship between the rate of price inflation and the rate of
unemployment. The policy makers, therefore interpreted Phillips curve as
a relation between price inflation and unemployment. Thus, Phillips Curve
enables the policy makers to choose a given rate of inflation. It means
that inflation can be reduced only at the cost of higher unemployment
or it can be increased only at the cost of lower employment.

ACTIVITY
What is Phillips Curve? What are its policy implications?

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Notes
6.4 Expectation Augmented Phillips Curve
Another important explanation of occurrence of a higher rate of infla-
tion simultaneously with a higher rate of unemployment was provided
by Friedman. He challenged the concept of a stable downward sloping
Phillips curve. According to him, though there is a trade-off between
rate of inflation and unemployment in the short run, that is, there exists
a short-run downward sloping Phillips Curve, but it is not stable and it
often shifts both leftward or rightward. He argued that there is no long-run
stable trade-off between rates of unemployment and inflation. According
to Friedman’s natural rate hypothesis though there is trade-off between
inflation and unemployment in the short run, the economy is stable in
the long run at the natural rate of unemployment and therefore the long
run Phillips curve is a vertical straight line. He argues that misguided
Keynesian expansionary fiscal and monetary policies based on the wrong
assumption that a stable Phillips Curve exists only result in increasing
inflation.
Short-Run Phillips Curve and Adaptive Expectations
Another important thing to understand from Friedman’s explanation of
shift in the long-run Phillips curve is that expectations about the future
rate of inflation play an important role in it. Friedman put forward a
theory of adaptive expectations according to which people form their
expectations on the basis of previous period rate of inflation, and change
or adapt their expectations only when the actual inflation turns out to
be different from their expected rate. According to Friedman’s theory of
adaptive expectations, there may be a trade-off between rates of inflation
and unemployment in the short run, but there is no such trade-off in the
long run.
The view of Friedman and his followers is illustrated in figure below. To
begin with, SPC1 is the short-run Phillips Curve and the economy is at
point A0, on its corresponding to the natural rate of unemployment equal
to 5 percent of labour force. The location of this point A0 on the short-
run Phillips curve depends on the level of aggregate demand. Further,
we assume that the economy has been experiencing a rate of inflation
equal to 5%. The other assumption we make is that the economy has

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Notes been experiencing a rate of inflation equal to 5% rate of inflation will

continue in the future.

Now suppose for some reason the government adopts expansionary fis-
cal and monetary policies to raise aggregate demand. The consequent
increase in aggregate demand will cause the rate of inflation to rise,
say to 7 percent. Given the level of money wage rate which was fixed
on the basis of inflation would continue to occur, the higher price level
than expected would raise the profits of the firms which will induce the
firms to increase their output and employ more labour. As a result of
the increase in aggregate demand resulting in a higher rate of inflation
and more output and employment, the economy will move to point A1
on the short-run Phillips curve SPC1 in figure, where unemployment has
decreased to 3.5 percent while inflation rate has risen to 7%. It may be
noted from the figure that in moving from point AO to A1, on SPC1 the
economy accepts a higher rate of inflation as the cost of achieving a
lower rate of unemployment.
Long-Run Phillips Curve and Adaptive Expectations
This brings us to the concept of long-run Phillips Curve, which Friedman
and other natural rate theorists have put forward. According to them, the
economy will not remain in a stable equilibrium position at A1. This is
because the workers will realise that due to the higher rate of inflation
than the expected one, their real wages and incomes have fallen. The
workers will therefore demand higher nominal wages to restore their real
income. But as nominal wages rise to compensate for the higher rate of
inflation than expected, profits of business firms will fall to their earlier

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levels. Their reduction in their profit implies that the original motivation Notes
that prompted them to expand output and increase employment resulting
in lower unemployment rate will no longer be there. Consequently, they
will reduce employment till the unemployment rate rises to the natural
level of 5%. That is, with the increase in nominal wages in the economy
will move from A1 to B0, at a higher inflation rate of 7%. It may be
noted that the higher level of aggregate demand which generated inflation
rate of 7% and caused the economy to shift from A0 to A1 still persists.
Further, at point B0, and with the actual rate of inflation equal to 7
percent, the workers will now expects this 7 percent inflation rate to
continue in future. As a result, the short-run Phillips curve SPC shifts
upward from SPC1 to SPC2. It therefore follows, according to Friedman
and other natural rate theorists, the movement along a Phillips Curve
SPC is only a temporary or short-run phenomenon. In the long when
nominal wages are fully adjusted to the changes in the inflation rate and
consequently unemployment rate comes back to its natural level, a new
short-run Phillips Curve is formed at the higher expected rate of inflation.
However, the above process of reduction in unemployment rate and then
its returning to the natural level may continue further. The government
may misjudge the situation and think that 7 percent of inflation is not
too high and adopt expansionary fiscal and monetary policies to increase
aggregate demand and thereby to expand the level of employment. With
the new increase in aggregate demand, the price level will rise further
with nominal wages lagging behind in the short run. As a result, profits
of business firms will rise further with nominal wages lagging behind
in the short run. As a result, profits of business firms will increase and
they will expand output and employment causing the reduction in rate of
unemployment and rise in the inflation rate. With this, the economy will
move from B0 to B1 along their short-run Phillips Curve SPC2. After some
time, the workers will recognise the fall in their real wages and press
for higher normal wages to compensate for the higher normal wages to
compensate for the higher rate of inflation than expected. When higher
normal wages are granted, the business profits will cause the level of
employment to fall and unemployment rate of return to the natural rate
of 5%. That is in the above figure the economy moves from point B1
to C0. The new short-run Phillips Curve will now shift to SPC3 passing

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Notes through point C0. The process may be repeated again with the result that
while in the short run, the unemployment rate falls below the natural
rate and in the long run it returns to its natural rate. But throughout this
process the inflation rate continuously goes on rising. On Joining Points
such as A0, B0, C0 Corresponding to the given natural rate of unemploy-
ment we get a vertical long-run Phillips Curve LPC in figure. Thus, in
the adaptive expectations theory of the natural rate hypothesis while the
short-run Phillips Curve is downward sloping indicating the trade-off
between inflation and unemployment rate in the short run, the long-run
Phillips curve is a vertical straight line showing that no trade-off exists
between inflation and unemployment in the long run.
It is important to remember that adaptive expectations theory has also
been applied to explain the reverse process of disinflation, that is, fall in
the rate of inflation as well as inflation itself. Suppose in above figure
the economy is originally at point C0 with 9% rate of inflation. Now, if
a decline in aggregate demand occurs, say as a result of contraction of
money supply by the central bank of a country. This will reduce inflation
rate below the 9 percent expected rate. As a result, profits of business
firms will decline because the prices will be falling more rapidly than
wages. The decline in profits will cause the firms to reduce employment
and consequently unemployment will rise. Eventually, firms and workers
will adjust their expectations and the unemployment rate will return to the
natural rate. The process will be repeated and the economy in the long
run will slide down along the vertical long-run Phillips curve showing
falling rate of inflation at the given natural rate of unemployment.

6.4.1 Criticism of Phillips Curve

(i) The explanation provided by Prof. Phillips has not been accepted
by all the economists. According to some economists changes in
the price level are at least as important in determining changes in
the wage-rates and on unemployment, which have been ignored by
Prof. Phillips.
(ii) The ‘money illusion’ among workers as suggested by Keynes is
largely absent in today’s bargaining because wage earners would
make every effort to retain their share of national income if this
has been eroded by rise in prices.

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 Phillips Curve, Monetary Policy, and Fiscal Policy

(iii) Prof. H.G. Johnson has raised doubts about the applicability of Notes
the Phillips curve to the formulation of economic policy. In this
connection he says, “On the one hand the curve represents only a
statistical description of the mechanics of adjustment in the labour
resting on the simple model of economic dynamics with little general
and well tested monetary and the and value theory behind it. On
the other hand, it describes the behaviour of the labour market in
a combination of periods of economic fluctuation and varying rates
of inflation, conditions which presumably influence the behaviour
of the labour market itself, so that it may reasonably be doubted
whether the curve would continue to hold its shape if an attempt
were made by economic policy to pin the economy down to a point
on it”.
(iv) According to Milton Friedman relationship between the volume of
employment and the rate of change in money prices is fallacious
because it implies a relationship between real and nominal magnitudes.
(v) The Phillips curve has virtually no practical value because it is
unstable and not permanent. Relationship between inflation rate and
unemployment rate as observed by Prof. Phillips curve is neither
stable through time within a country nor across the countries.
(vi) The powerful role played by trade unions in the determination of
wage rates in the labour market and thus in influencing the wages
has also been ignored.
(vii) Wages and Prices are influenced by each other. Wage first influence
prices through the increase in the cost of production and then prices
influence wages through their effect on cost of living. The Phillips
curve only considers the effects of wages on the price and ignores
the effect of prices on wages.
(viii) The Phillips Curve analysis is based on the assumption that inflation
is an internal phenomenon of a country but in fact inflation now
is an international phenomenon.
(ix) The Phillips Curve analysis fails to provide an explanation of the
existence of stagflation, that is, existence of high rate of inflation
with high rate of unemployment, found in all the highly industrialised
countries of the world.

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Notes
6.5 Fiscal Policy
In the economic sphere, the deliberate use of fiscal policy to attain and
maintain a high level of employment and a stable price level, began
during the thirties, largely as a result of the apparent ineffectiveness of
monetary policy as an instrument of stopping the severe unemployment
caused by the great depression and the ‘new economics’ of Keynes
with its emphasis on aggregate demand and the growing importance of
government expenditures and taxes to influence the level of output and
employment, and to change the system of income distribution. From its
modest beginnings fiscal policy has now become a major instrument to
achieve economic stability.
For a discussion of fiscal policy we shall treat the aggregate demand
comprising personal consumption, domestic investment and government
expenditures for final product and an aggregate flow of income which is
allocated not only to consumption expenditures and private savings but
also, in part, to taxes. The government incurs certain expenditures on the
purchase of goods and services and thus adds to the private spending. In
any period, by increasing this expenditure, the government can raise the
level of aggregate demand and by decreasing it, can bring down the level
of aggregate demand and by decreasing it, can bring down the level of
aggregate demand. In the former case, it can divert less amount and in
the latter case it can divert a greater amount from the stream of private
expenditures through its net tax collections. The effect of government
spending and taxation upon aggregate demand depends upon how much
it adds by its expenditures to the spending stream and how much it
withdraws through its tax collections.
Rules for Fiscal Policy
The following may be described as the rules for fiscal policy:
1. During a period of falling employment or growing unemployment the
government should obviously be interested in raising the level of
aggregate demand to the level of full employment, either by: (a) an
increase in government expenditure on the purchase of goods and
services, or by (b) an increase in government transfer payments,
or by (c) a balanced budget expansion.

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 Phillips Curve, Monetary Policy, and Fiscal Policy

2. If inflation caused by excess demand is the problem, the government Notes

for slashing the excess demand should reduce the level of aggregate
demand by (a) an increase in taxes, or by (b) a reduction in
government expenditure on goods and services, or by (c) a reduction
in transfer payments or by (d) a combination of these.
3. If the level of employment and output reached is quite high, the
government must try to attain the rate of economic growth necessary
to realise the objectives of continued full employment and price
stability.

6.5.1 Mechanics of Fiscal Policy

How does the government select the most effective alternative? The me-
chanics of fiscal policy can be explained with the help of three models.
Assuming that there are two sectors in the economy, viz. households and
businesses, we shall examine in the first model the effects of tax receipts
(T) and government purchases (G) and assume government transfer payments
to be zero. In the second model, government transfer payments are added.
Both these models assume that tax receipts are independent of the level of
income, i.e. autonomous. In the third model, the breakdown of government
expenditures into purchase of goods and services and transfer payments
is retained, but tax receipts are recognised as being partly dependent on
the level of income and partly upon the level of government expenditures.
These models simply assume certain amounts of government spending and
taxation, and indicate their expansionary and contractionary effects. This
will just explain the pure mechanics of the relationship between government
spending, taxation and the level of income.
First Fiscal Model
In a three-sector economy—households, business houses and govern-
ment—the fundamental equation of income and output would be:
C + S + T =Y= C + I + G
Where, Y is the net national income or product and S and I are net
private saving and net private domestic investment respectively. Thus,
in terms of saving and investment respectively. Thus in terms of saving
and investment the identity can be expressed as:
S + (T – G) = I

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Notes Where, (T – G) represents public savings. The equilibrium between sav-

ing and investment will be found at the level of income and output at
which planned savings plus taxes are equal to planned investment plus
government purchases:
S + T = I + G
Any increase in G will raise the equilibrium level of income. The new
equilibrium level of income must be that at which the amount of income
stream diverted from consumption into planned saving and tax payment
is just equal to the amount added to the income stream in the form of
investment and government expenditure.
Second Fiscal Model
In this model, we shall examine the essential difference in the effects
upon income of changes in government transfer payments. Net tax receipts
are equal to gross tax receipts minus government transfer payments and
interest on debt, or Tg – R. Expressing this as T = Tg – R underscores
the fact that R is really negative taxes, in effect an amount of gross tax
receipts which is returned to individuals through government transfer and
interest payments. Substituting Tg – R for T, the fundamental identity
for net national product now becomes:
C + S + Tg – R = Y = C + I + G
The effect upon Y of an equal increase in R or in G will be less in the
case of the change in R than in the case of G, as long as the MPC or c
is less than 1. That is:

Where, ∆G equals ∆R.

The reason for this difference is that all of any increase in G is an addi-
tion to aggregate demand whereas only part of any increase in R becomes
an addition to aggregate demand. ∆G affects aggregate demand directly,
but ∆R affects it indirectly through the disposable income. Assuming
that there is no change in tax receipts, ∆R directly increases disposable
income by the full amount of ∆R. The consumption function indicates,
however, that not all of any increase in disposable income will be devoted

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 Phillips Curve, Monetary Policy, and Fiscal Policy

to consumer spending; some portion of it will be devoted to personal Notes

saving. In other words, at the first step, some portion of government
transfer payments will fail to appear as demand for goods and services,
but at the first step all government purchases appear as demand for goods
and services. Thus in the case of government purchases the full increase
in government spending is subject to the ordinary multiplier, but in the
case of government transfers only a part which is not diverted to saving
is subject to ordinary multiplier. These amounts may be designated as
∆G and c∆R.
Third Fiscal Model
In the previous model we have analysed the effect of a change in any
one element on Y for a given value of c, assuming other elements remain
constant. In practice, a change in anyone element is bound to effect upon
the level of income. The response of consumption spending to a change
in income is already included in the previous model. In the third model
we would include the response of investment spending, the response of
government spending, at least the response of transfer expenditure, but
to avoid complications, we will continue to treat these as completely
autonomous. To bring this model closer to reality we can make one
modification, that is, to allow for the fact that any change in income
will affect tax receipts—since a major part of the receipts come from
personal and corporate taxes. Now, assuming that tax receipts vary with
changes in income, we may roughly treat tax receipts as a linear function
of income. Hence the tax function will be:
Tg = Ta + ty
This function is of the same type as consumption function and the invest-
ment function, t stands for the MPT or the marginal propensity to tax. It
indicates the marginal rate of tax ∆Tg/∆Y or the fraction of any change
in income that will be diverted from income receivers to government
with a given tax structure and tax rates. It is comparable to the single
rate in a proportional income tax.

6.5.2 Flexibility of the Fiscal Policy

The changes in the level of economic activity in the economy occur so
quickly and with such suddenness that fiscal tools not being flexible
cannot be geared immediately to meet the situation. That’s why it has

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Notes been suggested that a built-in flexibility should be introduced in the fis-
cal system. Built-in flexibility implies that change in tax collections and
government spending occur automatically (i.e. without any decision or
action), promptly and in the right direction (meaning that decreases in
aggregate demand require additional government expenditure and reduced
tax receipts and increases in aggregate demand require the opposite Steps)
to stabilize the aggregate demand.
Under the built-in flexibility system the tax rates would be so fixed that
in the upward swing of the trade cycle, every increase in the national
income, yields from taxes would automatically go up at a rate faster than
the increase in the national income without any change in the rate of
tax, while the government expenditure on relief, unemployment benefits
etc. would fall down automatically. Owing to the operation of these two
forces the budget will automatically show a surplus and thus the upswing
will be automatically put under check. The process will be reversed in
the downswing phase of the cycle.
This system is good in a number of ways: first, it works without changes
in the tax rates and so it does not require any elaborate and cucumber
some legislative procedure. Second, it does not need any forecasting before
initiating the action and hence the chances of mistakes are minimized.
Third, the climate is free from uncertainties and is favourable to private
investment. Lastly, it is the best method of coordinating short-run and
long-run fiscal policies.
Effects of Discretionary Change Initiated by the Government
In the foregoing analysis it has been stated that built-in flexibility pro-
vides appropriately timed helpful fiscal response to cyclical fluctuations,
while flexibility formula provides a greater scope for the fiscal policy to
be effective. The formula device implies discretionary action. We now
examine as to how far the fiscal measures, even with discretionary action,
can, in practice be successful in stabilizing the situation. The government
can take three measures: first change the structure of taxation, second
change the level of government purchases of goods and services and
transfer payments and third change the level of taxation.
(i) Changes in the Structure of Taxation: If the government wishes
to influence the level of consumption and investment in the private
sector without changing the level of its revenue and expenditure,

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 Phillips Curve, Monetary Policy, and Fiscal Policy

it can achieve its objective to some extent by introducing certain Notes

changes in the tax structure. For example, the government may
provide largest relief in the Income-tax at lower income levels
and the loss in revenue may be made up by making the tax more
progressive at higher income levels; it may reduce the burden of
indirect taxes and shift it to direct taxes. In times of inflation the
government may find it very difficult to implement the opposite
of these measures. But a relief in Income tax or excise duty might
encourage personal savings and measures which might encourage
the retention rather than the distribution of profits might encourage
corporate savings. For encouraging private investment, the government
may allow liberal depreciation deductions at the time of assessment
of tax liability. But such changes have their limitations, for example,
higher rates of income or Corporation tax might adversely affect
effort and initiative; the government may also face enormous
difficulty in the choice of the tax policies which are best designed
for stabilization purposes. Besides the government may also face
difficulty in reconciling these policies with the objective of economic
justice because many people might object to these policies on the
basis that they give rise to unfair distribution of the tax burden
among different income classes for different types of income.
(ii) Changes in the Level of Government Purchases: During inflation
the government can reduce the inflationary pressure by reducing
government purchases. In practice, the government’s freedom of
action in this direction is rather limited. A major portion of the total
government purchases is for meeting the requirements of National
defence which is dictated by needs of maintaining security rather
than those of stabilization and hence drastic changes in its volume
cannot be made. In advanced countries, the percentage of defence
expenditure in the total budget is still higher and there is no room
for any cutback. In developing countries the items of expenditure
are such that expenditure cannot be reduced. Moreover, most of the
expenditure is incurred on meeting the requirements of social and
economic development.
During recession an increase in government spending will have a
multiplier effect, there is no reduction in private expenditure to the

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Notes same extent. The more its spending is concentrated on the poorer
sections of the community, where the propensity to consume is
higher, the greater will be the multiplier. Direct expenditure by the
government on goods and services has direct as well as induced
effects. Since the major part of expanded purchases has to be
for public works such as roads, dams, hospitals, schools, public
buildings etc.; the government has a direct control over it and it
can exercise a decision influence over it. Such investment spending
may be increased or decreased as the situation demands. Thus unlike
reduction in taxation where there is no certainty that the increase
in disposable income will actually be a spent public investment
achieves actual spending.
(iii) Changes in the Level of Taxation: Because of their limitations,
public spending programmes are not likely to be sufficiently flexible
to combat successfully the cyclical fluctuations. The government
however has another device at its disposal viz., the budgetary
policy. Through this policy, the government can influence private
consumption by changing the amount of personal disposable income
of the people by changing the level of taxation in its annual budgets.
Budgetary policy is essentially a means for adjusting the relationship
between taxation and government expenditure. Taxation implies and
appropriation by the government of a part of private incomes. The
amount so appropriated is retained in the circular flow of income only
when it is spent by the government. If government taxation is less
than its expenditure, the aggregate demand will increase and income
will expand. If taxation is more than the government expenditure the
aggregate demand will decline and income will contract. To put it in
another way, if aggregate demand is less than necessary to maintain
full employment, the government through budget deficits stimulates
spending out of borrowing which, if continued from year to year,
will have a multiplier effect and increase the size of the national
income. Conversely, during inflation, the government by increasing
taxation and keeping its expenditure constant, or by reducing its
expenditure and keeping taxation constant or by some combination
of both can accumulate a budget surplus and thus increase public
savings to balance the deficiency in private savings. The main merit
of adjusting aggregate demand on the revenue side is that it enables

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 Phillips Curve, Monetary Policy, and Fiscal Policy

the national product to be divided between private and public usage Notes
according to their relative priorities. There are certain tasks which
the government can do better than the private enterprise: defence,
justice, health, roads etc. and government must decide as to what
proportion of the National Product should be spent on them. How
much is to be spent by the government would be given priority and
will not change according to the variations in the level of private
spending for maintaining aggregate demand at full employment
level. Similarly, policy of taxation can be also used for or adjusting
private demand in such a way sufficient resources are released for
the requirements of the public sector. If there is full employment it
and private demand is so high as not to leave sufficient resources for
the public sector, taxation must be increased. If, on the other hand,
whatever resources left after government has met its expenditure
are inadequate for meeting the private demand, then taxation must
be reduced to allow more purchasing power to the people. In this
way, full employment can be achieved without complete control
of resources. Once the essential claims of the public sector on the
economy have been met, the rest of the national product can be
distributed according to the private enterprise system.

6.5.3 Limitations of the Fiscal Policy

The limitations of fiscal policies are as follows:
(i) The success of fiscal policy largely depends on fairly accurate
forecasting of the course of trade cycles, which is an extremely
difficult task.
(ii) Even if we are able to know the future course of trade cycles, it
is very difficult to know the impact of various combinations of
the various instruments of fiscal policy on the different variables.
Furthermore, there are administrative delays in taking decisions,
especially when legislative approval is needed for changing the
rates and the structure of Taxation or for undertaking any Public
Work project. Again, there is lot of uncertainty due to the time
lag between the implementation of official measures and their full
impact on the level of income, output and employment.

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Notes (iii) Increase in public investment may cause a decline in private

investment because of a rise in the prices of factors due to the
keen, competition from the government. The fiscal policy may not
be effective in combating serious depression and hyper-inflation,
because of the psychology of private investors.
(iv) A vigorous fiscal policy to combat depression may cause a vast
increase in public debt which may make the debt management
extremely difficult.
(v) Fiscal policy for achieving full employment may be made ineffective
by rising wages which may also adversely affect the employment
emanating from the spending of those who receive funds from the
government. Again, if the monopolists, instead of increasing their
output, increase the price of their products, no additional secondary
employment will be created in the monopoly industries and thus
the achievement of full employment would become impossible.
(vi) Fiscal measures may be effective only in curing unemployment
resulting from a deficiency of demand and not from any other
causes. Public spending may not succeed in curing unemployment
caused by structural changes, Wage rise and Monopoly restrictions.
(vii) A fiscal policy for curing unemployment may create balance of
payment difficulties, because the additional income may be spent on
the purchase of imported goods. Increase in imports and decrease
in exports may also partly neutralize the effect of increased public
spending.
(viii) Increase in government spending on public works projects during
deflation and a decrease in the same may clash with other social
and economic objectives.

6.5.4 Fiscal Policy and Economic Development

Fiscal policy can help countries in accelerating the pace of economic
development by affecting the reallocation of resources between different
sectors and industries and regions in accordance with the objectives of the
economic plan, by changing the distribution of income on a more equita-
ble basis, by increasing the rate of capital formation and by controlling
inflation. Fiscal policy can affect the distribution of resources between

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 Phillips Curve, Monetary Policy, and Fiscal Policy

different sectors and industries through the instruments of government Notes

spending and taxation. Government spending in a particular sector of
the economy tends to divert resources from other sectors to that sector.
Taxation of a sector or industry produces the opposite effect. It is the
pattern of government revenues and expenditures which acts as a Lever
for mobilizing resources among different industries and occupations and
helps the reallocation of resources according to the goal in view.
The taxation policy through various exemptions, concessions and discrim-
inating rates can influence the pattern and level of private investment
and distribution of property and wealth and subsidies, grants etc.; can
induce investment in the sectors and industries which the government
wants to develop. Through this very tool, the government can make the
distribution of income more rational and equitable. For example, gov-
ernment spending on health and education may enhance the occupational
and geographical mobility of the workers; land and property taxes may
change the distribution of ownership inland and property; an element of
progression in the tax structure can ensure a more rational distribution
or government spending on items which benefit the poorer and backward
sections of the community can reduce the gap between the rich and the
poor. However, from the point of view of economic development the rate
of capital formation and effects of inflation are more important. In fact
it is the rate of capital formation that determines the rate of economic
development of a country. Capital formation can take place either through
investment spending in the private sector—financed other by saving or
by creation of credit or by foreign Investments; or through investment
spending in the public sector—financed by taxation revenues, borrowing
or deficit spending. Since the level of savings in developing countries
is very low, the scope of private investment is very much limited; the
flow of capital on a larger scale from other countries also doesn’t have a
bright chance; and so the only major source of capital formation is that
of public investment through taxation and borrowing.
Taxation: Taxation is the only effective financial instrument for reducing
private consumption and investment and transferring resources to the
government for economic development. In the early stages of economic
development a country needs to use investment on building up the eco-
nomic and social overheads viz., transportation and Communications,

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Notes electrification, irrigation works, education and Health Services etc. Such
projects don’t yield any direct return and are not at all attractive to pri-
vate enterprise; and have therefore to be undertaken by the state. It is
also not advisable to undertake them with borrowed funds and these are
to be financed through taxation. True that taxation didn’t play a very
critical role crucial role in the development of the existing developed
countries of the world. But the situation in those countries was entirely
different. Firstly, in those countries most of the development took place
through private initiative. Secondly, they had the resources for developing
the scientific and Technical know-how. Thirdly, the inequalities in the
distribution of income were not so large. Fourthly, the per capita income
was not as low as in the underdeveloped countries. And so going to the
conditions prevailing in these countries, state participation is considered
as essential for their economic development. Not only that since estab-
lishment of a classless society has been fixed as the goal, the extension
of the public sector is very important.
The taxation potential of developed countries is quite low because of
the low level of income the structure of the economy political setup and
inequalities in the distribution of incomes but taxation if used gradually
and wisely can prove very effective in removing all these deficiencies
and in raising the taxes on potential of this countries unequal distribu-
tion of income is not only socially undesirable but economically very
harmful for the growth of the economy the expenditure by the rich on
luxury goods which are imported from abroad is not only and productive
and wasteful but also depletes the foreign exchange resources which can
be profitably utilised for the import of equipment technical no techni-
cal 9 how and raw materials required for the economic development
of the country hence taxation of higher incomes will not only lead to
the raising of resources for economic development but also help in the
profitable use of foreign exchange and in reducing the inequality in the
distribution of incomes reduction of inequalities will not motive motivate
the poor classes to sacrifice some of their essential needs and thus con-
tribute to the cause of national development it must however be noted
that reduction of inequalities does not imply the reduction of functional
inequalities those arising from intelligence hard work skill education etc
but the reduction of inequalities which arise from inheritance functional
inequalities are necessary for the economic growth of a country and must

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 Phillips Curve, Monetary Policy, and Fiscal Policy

be preserved to the extent necessary for the development of the country Notes
taxation of personal incomes is an important source of revenue in many
developed countries but in underdeveloped countries it can only be used
for strengthening equity because most of the people life on the verge
of subsistence and can’t be taxed a large part of income does not come
through commercial channels and is directly consumed by the producers
majority of the people are illiterate and cannot maintain proper accounts
for assessment purposes agriculture being the predominant occupation of
vast number of people cannot be brought within the fall of the tax integrity
efficiency and administrative competence are far below the mark so far
as the effect on incentives is concerned there would be no adverse effect
on incentives of a high rate of personal income taxation if consumption
of luxury goods is very high if there is voting or flight of capital or if
capital is invested in speculative Enterprises otherwise the savings would
be discouraged investment and the rate of capital formation will decline
so in the light of the foregoing analysis it can be concluded that the
taxes and masonry can be gear in the interest of economic development
of a country it has the necessary potential provided that the physical
authorities act causes Li and with foresight gorging the effect of each
major and making necessary changes in the tax structure and implement-
ing with promptness scale and efficiency but the greatest difficulty with
many underdeveloped countries is that the prevailing conditions do not
allow the use of the tax policy for mobilizing resources for economic
development because of the existence of a large non-monetary sector the
difficulty of bringing the rural population in the Income-Tax net lack of
integrity and efficiency in the administrative staff lack of consonance
and responsibility among the taxpayer etc.

6.6 Monetary Policy

Paul Einzig defines monetary policy, “as including all monetary decisions
and measures irrespective of whether their aims are monetary or non-mon-
etary, and all non-monetary decisions and measures that aim at affecting
the monetary system.” Monetary Policy in its narrow sense, refers to the
credit control of a central bank; in its broad sense, it means all those
monetary and not monetary measures which influence the cost and supply
of money. Monetary policy as an instrument of economic stabilization,

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Notes has been used by various countries to manage their economies, especially
since the nationalisation of Central banks. Such a policy involves influ-
encing the level and composition of aggregate demand by manipulating
rates of interest and the volume of credit. The traditional instrument of
monetary policy is bank rate, supplemented by open market operations
and selective credit control, where necessary. Since the end of the last
World War, certain other methods of credit control have been developed
and attempts have been made to make monetary policy more effective
and more selective in its impact on the economy.
In fact, monetary policy has a positive role to play in bringing about
non-monetary reforms as an instrument to implement the economic policy
of the state. Such a role has been only recognised by the governments
of various countries after the World War-II. This is due to:
(i) The persistence of world-wide inflationary trends.
(ii) The inability of the governments to check such trends and to bring
about stabilisation through non-monetary measures.
(iii) The belief that the extent to which fiscal measures can be effectively
used is limited by international and domestic political consideration
and for successful fight against inflation available instruments of
monetary technique must be put in active operations.
It may be pointed out that before the Great Depression of the 1930s,
monetary policy was considered to be the most effective instrument of
economic stabilisation but during the depression it lost its prestige and
fiscal policy occupied its place. It was only after the outbreak of the World
War-II, owing to worldwide inflation that the monetary policy regained
its lost prestige. These days, the governments have been making uses of
both monetary and fiscal policies in economic management.
Understanding Monetary Policy
Money Supply � Currency Board
� Liquidity Management
Inflation � Fluctuations
� Instruments of Credit Control
� Buying and Selling or Government bonds

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 Phillips Curve, Monetary Policy, and Fiscal Policy

Macro Economic Goals � Rate of Interest Notes

� Employment level
� Foreign Exchange Rate

6.6.1 Objectives of Monetary Policy

� Ensuring price stability
‹ To Promote economic growth
‹ Stability of exchange rate
‹ Credit control
‹ Creation and expansion and monitoring of financial institution
‹ Control of Inflation

6.6.2 Role of Monetary Policy in Developing Economy

The chief objective of the monetary policy in developing economies should
be, obviously, to raise the rate of capital formation and economic growth.
This can be done by adopting a policy of cheap money and to stimulate
investment by lowering the rate of interest, directing investment into de-
sired channels through selective credit control and by undertaking public
investment on a large scale. In view of scarcity and shyness of capital,
some economists have suggested a policy of high rates of interest for
such economies. In their opinion, high rate of interest would channelise
the scarce capital only to the most productive and uses would eliminate
wasteful uses of resources. It would stimulate savings and check infla-
tion. It is true that a policy of high interest rates may be successful in
doing all this but it may not be desirable to desirable to generally restrict
investment just for keeping inflation under check.
In fact, a mild dose of inflation helps in raising the level of investment.
But, if the inflationary pressure continues mounting up, then the mone-
tary authority would be required to use both direct and indirect methods
of credit control. Of these measures, the open market operations cannot
be of much help because in such economies the bill market is generally
small and undeveloped. The central bank does not have a complete control
over the commercial banks and therefore they maintain an elastic cash
deposit ratio. The commercial banks are also not encouraged to invest

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 ECONOMIC ENVIRONMENT OF BUSINESS

Notes in government securities because of their low rate of interest, and they
prefer to keep their reserves in liquid form. Commercial banks generally
also do not borrow from the central bank.
Similarly, the bank rate policy can also not be effective because of:
(i) Lack of bills of discount
(ii) The small and undeveloped bill market
(iii) A large non-monetised sector
(iv) The existence of indigenous bankers, beyond the control of central
bank
(v) Habit of the commercial banks to maintain large cash reserve
(vi) A large unorganised money market
The monetary policy can create a favourable climate both for saving and
investment in such economies. The shape of investment would, howev-
er, depend on the policy of credit institutions and the forms of credit
institutions and the forms of credit control that are adopted. In most de-
veloping countries, the commercial banks provide only short-term credit
which is chiefly used for carrying inventories, purchasing land and real
estate and for financing the production of export crops. The government
will have to make guarantees or provide rediscount facilities, if the
commercial banks are to be induced to advance medium and long-term
loans. Selective credit controls can also influence pattern of investment
and production. The commercial banks can differentiate between differ-
ent sectors and industries in matters of cost and amount of credit, the
duration, the amount of collateral, etc. If the central bank has adequate
control on the commercial banks, selective control could be exercised to
indirectly influence the behaviour of banks by having different rediscount
rates for different types of loans or by making exception in regard to
reserve requirements on a selective basis.

6.6.3 Monetary Policy in India

There is no formal structure of coordination between fiscal policymakers
and monetary policymakers. However, in the six-member Monetary Pol-
icy Committee, three members are nominated by the government, which
does facilitate coordination between the government and RBI. Hence,
both policies are supplementary in nature. On the other side, the MPC

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 Phillips Curve, Monetary Policy, and Fiscal Policy

framework can hamper independence of RBI in the true sense, where the Notes
RBI functions as an agent of the government. There is a correlation between
central-bank independence and macroeconomic equilibrium. Moreover, in-
dependent central banks strongly promote stability and sustainability in the
macroeconomic framework (Mankiw, 2006). There is a specific inflation
target of 4% (plus or minus 2%); no such specific target exists for output,
growth or unemployment (Sivramkrishna, 2016). As per Article 112 of the
Constitution of India, the fiscal policy is an annual financial statement of
the government’s receipts and expenditures prepared by the Ministry of
Finance after consulting with other ministries and the Niti Aayog. More-
over, the fiscal policymakers ensure that they take care of concerns of
essential stakeholders from the agriculture sector, industry and services
sector before finalizing the budget. The policymakers aim to meet expec-
tations and requirements of the stakeholders on the basis of the economic
situation. Based on Article 266 of the Constitution of India, all revenues
are received, loans raised and receipts from recoveries of loans granted
by the government from the consolidated fund of India. All expenditures
of the Government are incurred from the consolidated fund of India. Ar-
ticle 267 of the Constitution authorizes the Contingency Fund to be used
by the Government to meet urgent unforeseen expenditures. The money
in provident funds, small savings, or special funds are part of the public
account. In India, under the aegis of the Finance Ministry, the department
of economic affairs prepares the fiscal policy. The Reserve Bank of India
is responsible for the monetary policy (Surbhi, 2015). In short, the fiscal
policy is concerned with public revenue and public expenditure while the
monetary policy is concerned with a change in the money supply and change
in the rate of interest. There is the possibility of political influence in fis-
cal policy due to the nature of the task and election pressures (Mankiw,
2014). Moreover, the politician’s primary goal is to develop confidence in
their policies in voters’ minds so that they are re-elected. A fiscal stimulus
package before an election helps to increase aggregate demand, leading
to higher economic growth and lower unemployment (Blanchard, 2006).
During a recessionary period, the fundamental problem is inadequate
effective aggregate demand. The first line of monetary policy against
economic downturns is increasing the money supply; the central bank
reduces interest rates. This decrease in the rate of interest will decrease
the cost of borrowing to finance investment projects, such as new fac-

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 ECONOMIC ENVIRONMENT OF BUSINESS

Notes tories and new housing. It will lead to increase in investments, finally
increase aggregate demand and facilitates increase in production and
employment. Fiscal policy can mitigate this recessionary pressure. The
government may reduce tax rates; it increases disposable income, which
increases overall consumption, finally increases the aggregate demand
(Mankiw, 2014). Both the fiscal and monetary policies increase aggregate
output through multiplier effects based on value of marginal propensity
to consume. It further induces consumption, which accordingly increases
aggregate demand.

6.7 Neutrality of Money

Certain economists like Wicksteed, Koopmans, Hayek, Robertson, etc.,
advocate that the objective of monetary policy should be to keep the money
neutral, i.e., to ensure that the quantity of money in circulation does not
affect the prices. These economists believe that business fluctuations occur
because of the changes in the quantity of money in circulation and if the
disturbances caused by monetary change could be controlled or eliminated,
then instead of vigorous fluctuations, only smooth adjustments to changes
in technology, consumer’s preferences. Or act of God will take place in
the economy. A neutral money policy thus, implies two things: first, the
monetary authority will have to be given authority to counter balance
changes in the velocity of circulation of money caused by hoarding and
dishoarding of people. Second, unless basic changes in the structure of
the economy, viz., population, technology etc are compensated by changes
in the quantity or velocity of circulation of money, there would be such
disturbances as would be quite contrary to the neutral money theory. It
should also be noted that changes in prices may even occur when money
remains neutral, owing to the changes in the volume of transactions and
improved productivity of the factors of production.
This theory has, therefore, been criticised on a number of points:
(i) It is based on wrong premises, i.e. it carries with it all the assumptions
on which the quantity theory of money is based.
(ii) It is not easy to implement this policy because it is not possible to
keep the supply of money constant in actual practice without which
money cannot act in a neutral fashion.

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 Phillips Curve, Monetary Policy, and Fiscal Policy

(iii) Even after keeping the money supply constant at a particular level, Notes
it is not sure that the price level would be stable because other
factors like technological improvements may cause changes in the
level of output, which would certainly lead to a decline in the price
level owing to a decline the production cost.
(iv) The policy appears to be self-contradictory because on the one hand,
the protagonists of this policy advocate that the state should not
interfere in the economic affairs, on the other hand for maintaining
a constant supply of money they expect monetary authority to make
frequent adjustments with the fundamental changes in the economy.

6.8 Crowding Out

The crowding out effect refers to a phenomenon where increased govern-
ment deficits can lead to a rise in interest rates. This, in turn, can cause
activity in the private sector to diminish. The crowding out effect is an
economic situation that happens when both the government and the private
sector are competing for access to the same funds or other resources.
When the economy isn’t able to meet the demand of both groups, the
government tends to be able to claim resources first. This causes private
industry to be unable to obtain all the money or raw materials that it
wishes to make use of. Oftentimes, interest rates increase significantly
when the government consumes more from the private sector. This rise
in rates, in turn, can cause a slowdown in economic activity. This is
primarily a situation that occurs when governments and private industry
compete for access to the same funds. Crowding out can happen in theory
at any point. However, in practice, it tends to be a problem when the
government puts much more strain on an economy’s lending or industrial
capacity than usual. Examples of this can occur during:
‹ Wartime
‹ Inflationary periods
‹ When the government runs large budget deficits
How ‘Crowding Out’ Works
Like with other goods, money itself is an economic market which reacts
to the forces of supply and demand. Crowding out happens when both

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 ECONOMIC ENVIRONMENT OF BUSINESS

Notes private individuals and companies and the government demand additional
funding, and the supply of loans is not sufficient to meet that demand.
When there is an inadequate supply of capital, this forces interest rates
to increase to create a new market equilibrium.
Traditionally, fixed income investors are more eager to lend to the gov-
ernment than private enterprises because the government has the power of
taxation to pay its bills. This makes government credit a safer risk than
lending in the private sector. In other words, when both the government
and a private company want to take out a loan, the government generally
is able to obtain financing first.
When the government consumes more of the economy’s private lending
capacity, however, it leaves fewer loans available to everyone else in
the marketplace. Private companies that would have borrowed funds to
expand their factories, build new stores, or hire more employees instead
may have to forgo those plans because the cost of capital becomes too
high and these proposed projects no longer meet a company’s hurdle rate.
Types of Crowding Out
The classical economics textbook example of the crowding out phenom-
enon is in interest rates and the demand for money. However, there can
be other types of crowding out as well. Here are a few primary cases.
(i) Financial Crowding Out: Financial crowding out is the most common
form. This is where the government’s demand for additional borrowed
funds causes interest rates to go up, and thus stifles private sector
investment.
(ii) Resource Crowding Out: Resource crowding out can happen when
the government buys up a large portion of the supply of a given
good, and thus makes it difficult for the private sector to meet its
production schedules. This often happens during wartime when the
government prioritizes the construction of armaments and other
military equipment. This could cause a deficit of goods such as
iron ore, steel, copper, and so on in the broader economy.
(iii) Infrastructure Crowding Out: A tension can occur in market-
based economies where both the government and the private sector
provide certain infrastructure services. Suppose that the government
invests more in building transportation-related assets such as ports,

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 Phillips Curve, Monetary Policy, and Fiscal Policy

railroads, postal services and the like. This can discourage private Notes
companies from providing these services since it can be challenging
to compete against a government-run provider which has less of a
profit motive when managing its operations.

6.9 Liquidity Trap

Liquidity trap’s idea was discovered originally by J.M. Keynes and Hicks
(1937), as it was said to occur during the great recession of the 1930’s
for the first time. Since the 1970’s central banks in the developed world
was interested in fighting inflation rather to stimulate the economy by
increasing money supply, as they follow Milton Friedman (1969, pp.
1-50) rule. In the 1990’s and 2000’s the main central bank’s objective
was to ensure the credible monetary policy with inflation target (Svens-
son, 2010) clearly stated. As economic agents used the same forecasting
models as the central banks that time, they were able to predict monetary
policy more accurate. This in turn led to decrease in economic aggregates
volatility such as: output, inflation etc., which Bernanke (2004) called
this period ‘The Great Moderation’. Woodford (2003, p. 268) shows the
path of learning dynamics by economic agents, when the Taylor rule is
satisfied much more in recent decade than in previous periods. In the
late 1990’s B. Bernanke, L. Svensson, M. Woodford and P. Krugman
(Krugman, 2010) researched the Japan’s lost decade. Th outcome clearly
shows that Japan’s economy has been caught into the liquidity trap since
mid-1990. Krugman (1998) argued that if liquidity trap has occurred in
Japan, it can occur elsewhere anytime now.
Crisis 2008- and the quantitative easing policy in the United States,
which was targeted not only to restore liquidity on the financial markets
but also to lower right-tail of yield-curve, might cause elements of the
liquidity trap. The aim of this paper so, is to find if some aspects of
liquidity trap are visible in the United States. The literature review shows
two approaches to assessing liquidity trap. The standard Keynesian view
augmented by rational expectation and the monetary, which focus on
monetary aggregates cointegration. If evolutions of monetary aggregates
become irrelevant to prices and output, economy may be caught into
liquidity trap. The paper is organized as follows: the two sections pro-
vide literature survey on Keynesian and monetary approach to liquidity

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 ECONOMIC ENVIRONMENT OF BUSINESS

Notes trap. The third one assesses some cointegration evidence and the fourth
concludes.
Liquidity Trap: Keynesian Approach
Liquidity trap was originally discovered by J.M. Keynes (1936) and
Hicks (1937). This phenomenon is due to nominal interest rate positive
only. When it is not possible to make lower nominal interest rate than
zero, further monetary stimulation of aggregate demand is ineffective.
Additionally, LL curve is sloped upward since an increase of income
and further it goes into perfect inelastic (Hicks, 1937). The model has
got into standard macroeconomic textbook and was not developed much
until famous Krugman’s paper (1998). According to Krugman (1998),
the lack of economists’ interest in this field was due to the lack of faith
that liquidity trap will ever happen. Krugman (1998) sheds new light on
liquidity trap, which was proposed by standard IS-LM model. Krugman’s
model combines interest rate, consumption, money supply and expectations:

…………..(1)

Where, i - interest rate, D - discount factor, P* - future price level, P -

current price level, y*/y - the relation between future output (expected)
and current output, ρ - relative risk aversion. The relation (1) can be
viewed as a model, which assumes sticky or flexible futures prices.
The risk aversion coefficient comes from agent’s utility function, as
they are to decide whether they won’t to buy bonds at interest rate i or
spend money on consumption (which drives output). Therefore if future
prices remains fixed (P*), any raise in current prices (P) will produce
future deflation, as higher P means lower i and i cannot be negative. If
nominal interest rate was negative, agents would hold money instead
of bonds. When interest rate is close to zero bonds and money become
perfect substitutes and further increase in money supply will not change
neither output nor price level. The Krugman’s (1998) model incorporated
financial intermediation in the above. The evidence for financial inter-
mediation to liquidity trap is also visible in the evolution of monetary
aggregates. In Japan for example monetary base in years 1994-97 rose
by 25.6 per cent, while bank credit rose only by .9 per cent (Krugman
1998, Table 7). Similar data provided Friedman and Schwartz (1963,

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 Phillips Curve, Monetary Policy, and Fiscal Policy

Table A-1). Between 1930 and 1933 in the United States currency held Notes
by public rose by ca. 46 per cent, while commercial bank total deposits
fall by ca. 41 per cent. As it was associated with banking crisis that had
begun in the early 1930. Krugman’s (1998) provides a way to escape the
liquidity trap. This is a credible overshoot of inflation target by central
bank. In other words central bank should set agent’s expectations of the
future price level to rise.
In the Keynesian approach liquidity trap condition can be seen through
market friction in the financial intermediation sector. Bernanke and Gertler
(1995) introduce the term ‘external finance premium’. The premium comes
from the ‘lemons problem’ directly. Financial intermediation assesses the
borrowers’ creditworthiness, which cost is incorporated to the ‘external
finance premium’. The level of an average ‘premium’ is varying over the
business cycle. Usually during the economic downturn ‘premium’ raises,
which in turn makes the interest rate that entrepreneurs and consumers
faces higher; even though central bank’s short-term interest rate is very
low. The raise in cost of ‘lemons’ in some circumstances can sharply de-
crease the transaction volume, as suggested by Akerlof (1970). Kacperczyk
and Schnabl (2010) shows that financial market in the United States was
blocked by the problem of ‘lemons’. Liquidity trap in that sense should
occur, when financial sector is reluctant to lend money to private sector
in spite of high banks reserves. This condition is somehow similar to the
mentioned above problem of natural interest rate, as the ‘premium’ raises
the nominal interest rate. Martens and Raven (2011) evidence shows, that
credit channel in the United States depressed the expectations and hence
caused the liquidity trap recession recently.

6.10 Role of the Central Bank

The variation in circumstances surrounding the origins of central banks
means that their roles and functions have not all evolved in the same
way. Some started life as special purpose government banks constructed
to bring some order to the issuance of banknotes. Some were established
to act as funding conduits for the government. Some were large commer-
cial banks, whose dominance was subsequently boosted by the granting
of monopoly rights to issue banknotes. The majority were, however,
created in the 20th century specifically as central banks – public policy

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Notes agencies for central banking functions. The bundle of functions that con-
stitutes a central bank is not fully defined beyond the basic point that a
central bank is the agency that conducts monetary policy and provides
the means of settlement. Nor can the definition always be inferred from
the functions allocated to central banks established in the 20th century,
since the bundle of functions often differed substantially from country to
country. This chapter explores the global diversity of functions assigned
and objectives specified, noting implications for the array of governance
practices observed. Some common themes are worth noting at the outset.
First, in the past few decades, a more focused concept of the role and
responsibilities of the central bank seems to have emerged. Objectives
have become better identified and used more actively as a means to shape
the performance of the central bank. However, objectives for some func-
tions – including the important financial stability function – remain to
be spelled out clearly, limiting the completeness of governance arrange-
ments. Second, difficult trade-offs often must be made between multiple
objectives in relation to specific functions and between objectives for
different functions. Those trade-offs complicate the related governance
structures as well as the performance of the tasks. But just as a clear
picture of the archetypical central bank seemed to be emerging, events
moved the image out of focus. The current financial crisis has brought
various unsettled issues to the fore (including incomplete objectives and
trade-offs) and has thus renewed some uncertainties about the future
shape of central bank functions and objectives.

6.10.1 Functions of the Central Bank

Functions of RBI (The India’s Central Bank) Reserve Bank of India being
an apex court of the centre enjoys enormous power and functions under
banking system in India. It has monopoly over the issue of bank-notes
and monetary system of the country. These power and functions as to
issue of bank notes and currency system are governed by the Reserve
Bank of India Act, 1934. Besides it the Banking Regulation Act, 1949
also empowers certain power and Function of the Reserve Bank. Main
Functions of RBI Main functions are those functions which every cen-
tral bank of each nation performs all over the world. Basically, these
functions are in line with the objectives with which the bank is set up.

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 Phillips Curve, Monetary Policy, and Fiscal Policy

It includes fundamental functions of the Central Bank. They comprise Notes

the following tasks:
1. Issue of Currency Notes: The RBI has the sole right or authority
or monopoly of issuing currency notes except one rupee note and
coins of smaller denomination. These currency notes are legal tender
issued by the RBI. Currently it is in denominations of Rs. 2, 5,
10, 20, 50, 100, 500, and 1,000. The RBI has powers not only to
issue and withdraw but even to exchange these currency notes for
other denominations. It issues these notes against the security of
gold bullion, foreign securities, rupee coins, exchange bills and
promissory notes and government of India bonds.
2. Banker to Other Banks: The RBI being an apex monitory institution
has obligatory powers to guide, help and direct other commercial
banks in the country. The RBI can control the volumes of banks
reserves and allow other banks to create credit in that proportion.
Every commercial bank has to maintain a part of their reserves with
its parent’s viz. the RBI. Similarly, in need or in urgency these
banks approach the RBI for fund. Thus, it is called as the lender
of the last resort.
3. Banker to the Government: The RBI being the apex monitory body
has to work as an agent of the central and state governments. It
performs various banking function such as to accept deposits, taxes
and make payments on behalf of the government. It works as a
representative of the government even at the international level.
It maintains government accounts, provides financial advice to the
government. It manages government public debts and maintains
foreign exchange reserves on behalf of the government. It provides
overdraft facility to the government when it faces financial crunch.
4. Exchange Rate Management: It is an essential function of the RBI.
In order to maintain stability in the external value of rupee, it has
to prepare domestic policies in that direction. Also, it needs to
prepare and implement the foreign exchange rate policy which will
help in attaining the exchange rate stability. In order to maintain
the exchange rate stability, it has to bring demand and supply of
the foreign currency (US Dollar) close to each other.

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Notes 5. Credit Control Function: Commercial bank in the country creates

credit according to the demand in the economy. But if this credit
creation is unchecked or unregulated then it leads the economy into
inflationary cycles. On the other credit creation is below the required
limit then it harms the growth of the economy. As a central bank
of the nation the RBI has to look for growth with price stability.
Thus, it regulates the credit creation capacity of commercial banks
by using various credit control tools.
6. Supervisory Function: The RBI has been endowed with vast powers
for supervising the banking system in the country. It has powers
to issue license for setting up new banks, to open new branches,
to decide minimum reserves, to inspect functioning of commercial
banks in India and abroad, and to guide and direct the commercial
banks in India. It can have periodical inspections an audit of the
commercial banks in India.

6.10.2 Credit Control

The Reserve Bank of India has a credit policy that aims at pursuing higher
growth with price stability. Higher economic growth means to produce
more quantity of goods and services in different sectors of an economy;
Price stability however does not mean no change in the general price
level but to control the inflation. The credit policy aims at increasing
finance for the agriculture and industrial activities. When credit policy
is implemented, the role of other commercial banks is very important.
Commercial bank’s flow of credit to different sectors of the economy
depends on the actual cost of credit and arability of funds in the economy.
Method of Credit Control:
‹ The lowering or raising of their discount and interest rates with a
view to lowering or raising money rates generally and encouraging
the expansion or contraction of credit.
‹ The buying or selling of securities or bills of exchange in the open
market with a view to putting additional funds into the market or
withdrawing funds there from and thus expanding or contracting
credit.
‹ The rationing of credit as an alternative or an addition to raising
discount and interest rates.

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 Phillips Curve, Monetary Policy, and Fiscal Policy

‹ The lowering or raising of the minimum cash reserve requirements Notes

to be maintained by the commercial banks as an additional means
of enabling the central bank to expand or contract their capacity
to create credit.
‹ The imposition of minimum secondary reserve requirements to be
maintained by the commercial banks in the form of government
securities and other specified assets, in order to restrict their capacity
to extend credit for general business purpose.
‹ The regulations of terms and conditions under which credit repayable
in instalments may be granted for purchasing or carrying consumers’
durable goods, as a mean of exercising some direct control over
the volume of outstanding consumer credit.
IN-TEXT QUESTIONS
1. What does the Phillips Curve illustrate?
(a) Relationship between inflation and unemployment
(b) Relationship between interest rates and inflation
(c) Relationship between GDP and fiscal deficit
(d) Relationship between money supply and exchange rates
2. In the long run, according to the Phillips Curve, the trade-off
between inflation and unemployment:
(a) Becomes steeper
(b) Remains the same
(c) Disappears
(d) Becomes more favorable
3. Which economic theory challenges the short-run Phillips Curve
by arguing that inflation expectations adjust over time?
(a) Keynesian Theory
(b) Rational Expectations Theory
(c) Classical Theory
(d) Quantity Theory of Money

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Notes 4. Which of the following is an example of expansionary fiscal

policy?
(a) Increasing income tax rates
(b) Reducing government spending
(c) Increasing government infrastructure spending
(d) Selling government bonds to the public
5. Which of the following is NOT a tool of fiscal policy?
(a) Government spending
(b) Taxation
(c) Open market operations
(d) Public debt management
6. Which institution primarily controls monetary policy in India?
(a) Ministry of Finance
(b) Securities and Exchange Board of India (SEBI)
(c) Reserve Bank of India (RBI)
(d) NITI Aayog
7. What happens when the central bank increases the repo rate?
(a) Money supply increases
(b) Interest rates decrease
(c) Borrowing becomes more expensive
(d) Inflation rises
8. A contractionary monetary policy is used to:
(a) Reduce inflation
(b) Increase economic growth
(c) Decrease interest rates
(d) Increase government debt
9. What is a liquidity trap, and how does it impact the effectiveness
of monetary policy in an economy?
(a) It occurs when interest rates are high and savings increase
(b) It occurs when interest rates are very low, and individuals
prefer holding cash rather than investing or consuming

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 Phillips Curve, Monetary Policy, and Fiscal Policy

(c) It leads to an increase in inflation, making monetary policy Notes

more effective
(d) It prevents governments from borrowing money from central
banks
10. What does the term “crowding out” refer to in the context of
fiscal policy?
(a) The reduction in private sector investment due to higher
government borrowing
(b) The increase in private investment when government
spending rises
(c) The government spending on infrastructure that enhances
private sector investment
(d) The decrease in public sector investments due to lower
government taxes

6.11 Answers to In-Text Questions

1. (a) Relationship between inflation and unemployment
2. (c) Disappears
3. (b) Rational Expectations Theory
4. (c) Increasing government infrastructure spending
5. (c) Open market operations
6. (c) Reserve Bank of India (RBI)
7. (c) Borrowing becomes more expensive
8. (a) Reduce inflation
9. (b) It occurs when interest rates are very low, and individuals prefer
holding cash rather than investing or consuming
10. (a) The reduction in private sector investment due to higher
government borrowing

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Notes
6.12 Self-Assessment Questions
1. Examine the factors which cause shifts in the short run in Phillips
Curve.
2. How does Phillips Curve explain the trade-off between unemployment
and inflation? Discuss its policy implication.
3. What do you mean by neutrality of money? How did the classical
economist establish it?
4. Explain the concept of neutrality of money.
5. What are the Principal Objectives of Monetary Policy? Is there any
conflict between these objectives?
6. Discuss the main objectives of monetary Policy.
7. Explain how fiscal policy measures can be effectively used by
underdeveloped countries for their economic development.
8. Distinguish between monetary and fiscal policy, and discuss their
relative advantages as means of controlling inflation.
9. What are the roles and functions of Central Bank?

6.13 References
‹ RBI. (2013). Fiscal-Monetary Co-ordination: Theory and International
Experiences, Accessed July 07, 2020. https://m.rbi.org.in/Scripts/
PublicationsView.aspx?id=14938
‹ Surbhi S. (2015). “Difference Between Fiscal Policy and Monetary
Policy.” Accessed December 11, 2017. https://keydifferences.com/
difference-between-fiscal-policy-and-monetary-policy.html
‹ Cecchetti, S. G. (1986). ‘’Testing short-run neutrality’’, Journal of
Monetary Economics 17, May, 409-23.
‹ Brock, W. A. (1974). “Money and growth: the case of long run
perfect foresight”, International Economic Review 15, October,
750-77.

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 Phillips Curve, Monetary Policy, and Fiscal Policy

Notes
6.14 Suggested Readings
‹ As per APA style (APA Manual 6th Edition to be referred).
‹ Kurozumi, T. (2008). “Optimal Sustainable Monetary Policy.” Journal
of Monetary Economics 55:1277-1289.
‹ Laidler, D. E. W. (1985). “The Demand for Money: Theories,
Evidence, and Problems”, 3rd ed., New York: Harper and Row.
‹ Linde, J. (2005). “Estimating New-Keynesian Phillips Curves: A Full
Information Maximum Likelihood Approach.” Journal of Monetary
Economics 52(6):1135-1149.

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 L E S S O N

7
Theories of Trade and
Balance of Payment
Dr. Meghna Aggarwal
Assistant Professor
Deen Dayal Upadhyaya College
University of Delhi
Email-Id: [email protected]

STRUCTURE
7.1 Learning Objectives
7.2 Introduction
7.3 Theories of International Trade
7.4 Balance of Payment
7.5 Summary
7.6 Answers to In-Text Questions
7.7 Self-Assessment Questions
7.8 References

7.1 Learning Objectives

After reading the lesson, the learners are expected to understand:
‹ Mercantilism.
‹ New Trade Theory.
‹ Theory of Absolute Advantage/Absolute Differences in Cost.
‹ Theory of Comparative Advantage/Comparative Differences in Cost.
‹ Modern Theory of International Trade/Heckscher Ohlin (H.O.) Theory.
‹ Superiority of H.O. Theory over the Classical Theory/Difference between H.O. Theory
and the Classical Theory.
‹ The Leontief Paradox.
‹ Product Life Cycle Theory.
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 Theories of Trade and Balance of Payment

‹ Theory of National Competitive Advantage. Notes

‹ Meaning of Balance of Payments (BOP).
‹ Balance of Trade.
‹ Balance of Trade and Balance of Payments.
‹ Components of Balance of Payments.
‹ Difference between Current Account and Capital Account.
‹ Autonomous and Accommodating Items of Balance of Payments
(BOP).
‹ Equilibrium and Disequilibrium in the Balance of Payment.
‹ Measures to Control Disequilibrium in Balance of Payment.

7.2 Introduction
The countries today are globally linked with each other through trade in
goods and services and the movement of factors of production. This helps
the countries to make optimum use of their resources through specializa-
tion, in turn, making the industries and workers more productive. These
outcomes further help in lowering the cost of production of a number of
products which translates into higher living standards. Without interna-
tional trade, most nations would be unable to provide the basic amenities
to their citizens at current levels. In short, not only nations, companies
and citizens benefit from international trade, modern life would be nearly
impossible without it.
There are multiple motives for international expansion, some strategic
in nature, some reactive. These include the ability to increase sales and
profits, serve customers better, access lower cost or superior production
factors, optimize sourcing activities, develop economies of scale, con-
front competitors more effectively, develop rewarding relationships with
foreign partners, and gain access to new ideas for creating or improving
products and services.

7.3 Theories of International Trade

The goods and services that are traded between nations vary greatly.
Rarely do countries adopt the export and import trade patterns of other

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 ECONOMIC ENVIRONMENT OF BUSINESS

Notes countries; instead, they develop their own product portfolios and pat-
terns of trade. Furthermore, the susceptibility of different countries to
the changes in exogenous factors varies significantly. This chapter aims
to discuss various theories of international trade in order to provide a
conceptual understanding of the fundamental principles of international
trade and the shifts in trade patterns. Trade is essential for the very
survival of nations with scarce resources, like Singapore or Hong Kong
(currently a province of China), or nations with unbalanced resources,
like those in the Caribbean and West Asia. However, engaging in trade
requires a logical foundation for nations with diversified resources, like
India, the US, China, and the UK. A nation’s trade patterns are a dynamic
phenomenon rather than a static occurrence. Furthermore, a country’s
trade partners and product profile do alter over time. The undisputed
leader in diamond polishing and trade, the Belgian city of Antwerp,
had previously seen a shift in the diamond industry to India and other
Asian nations. A few fundamental questions must also be addressed by
managers of international businesses such as why do countries trade with
one another? Is trading a zero-sum game or a profitable endeavour for
both parties? Why do trade patterns differ so greatly between nations?
Can government policies influence trade? Theories of international trade
provide the reason for most of these queries.
Trade theories offer an insight into the potential product portfolio and trade
patterns. They also make it easier to comprehend the fundamental factors
that have influenced a nation’s development as a source of supplies or a
market for particular goods. These fundamental economic theories also
have varying degrees of influence on the guiding principles of national
regulatory frameworks and those of international organizations.

7.3.1 Mercantilism
According to the mercantilism theory, a country’s wealth is determined
by the quantity of its accumulated wealth. Between the sixteenth and
the nineteenth centuries, European colonial powers encouraged interna-
tional trade to enhance their holdings of goods, which was then invested
to create a potent army and infrastructure. The colonial powers mainly
carried out international trade for the benefit of their native countries,
which viewed their colonies as resources to be exploited. The first ship
of the East India Company arrived at the port of Surat in 1608 to carry

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out trade with India and take advantage of its rich resources of spices, Notes
cotton, finest muslin cloth, etc. Other European nations-such as Germa-
ny, France, Portugal, Spain, Italy and the East Asian nation of Japan
also actively set up colonies to exploit the natural and human resources.
Governmental interventions that actively promoted colonial expansion and
the maintenance of trade surpluses were used to implement mercantilism.
Imports were restricted by national governments through tariffs and import
quotas and encouraged exports by subsidizing production. The colonies
provided relatively cheap sources for basic necessities like unprocessed
cotton, grains, spices, herbs and medicinal plants, tea, coffee, and fruits,
which were used both as consumer goods and as industrial raw materi-
als. Thus, the mercantilism policy significantly aided and benefited the
colonial powers’ ability to amass wealth.
During this period, gold and silver were the most important sources of
wealth. A country could earn gold and silver by exporting goods whereas
importing goods would result in an outflow of gold and silver. The main
principle of mercantilism was to maintain a trade surplus by maximizing
exports and minimizing or restraining imports. By doing so, a country
would accumulate gold and silver and consequently will increase its
national prosperity.
In accordance with this principle, the mercantilist doctrine recommended
intervention of the government to achieve a trade surplus. The mercantilist
saw no benefit in a large volume of trade. Rather, they recommended
policies to maximize exports and minimize imports. To achieve this,
imports were restricted by non-tariff barriers like tariffs and quota and
exports were subsidized.
In 1752, a classical economist David Hume drew attention to the basic
discrepancy in the mercantilist doctrine. According to him, if England
had a balance of trade surplus with France, it would result in an in-
creased inflow of gold and silver. Consequently, there’ll be an increased
domestic money supply resulting in inflation in England. France would
have the opposite effect due to the outflow of gold and silver. There’ll
be a contraction of money supply in France thereby causing the prices
to fall. This change in relative prices between France and England would
encourage the French to buy fewer English goods that have become
relatively expensive and the English to buy more French goods that

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Notes have become relatively cheaper. This would cause the balance of trade
position of England to decline and that of France to improve until the
English surplus was eliminated. Hence, in the long run no country could
continue to have a surplus on the balance of trade according to Hume
unlike what the mercantilists had anticipated.
Criticism
1. It considered trade as a zero-sum game (a situation in which gain or
loss by one country is exactly balanced by loss or gain by another
country). It was left to Adam Smith and David Ricardo to prove
that trade is a positive-sum game (a win-win situation where no
one wins at someone else’s expense).
2. The importing firms, especially those that import raw materials
and parts used in the manufacture of finished goods, suffer due to
mercantilism.
3. It harms the consumers because restricting imports limits the choice
of goods the consumers can buy.
4. Import restrictions result in product shortages that may lead to higher
prices i.e. inflation. When taken to an extreme, mercantilism may
invite beggar-thy-neighbour policies (an international trade policy
that benefits the country that enacted it, while harming its neighbours
or trade partners.
IN-TEXT QUESTIONS
1. The main principle of Mercantilism was to __________.
2. The theory of Mercantilism was contradicted by __________.
3. The theory considered trade as a __________ game.

7.3.2 The New Trade Theory

The New Trade theory, as propounded by Prof. Paul Krugman, is a collec-
tion of economic models in international trade which focuses on the role
of increasing returns to scale and network effects which were developed
in the late 1970s and early 1980s. The new trade theorists relaxed the
assumption of constant returns to scale and suggested that using protec-
tionist measures to build up a huge industrial base in certain industries
will then allow those sectors to dominate the world market. What was new

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in new trade theory was the use of mathematical economics to model the Notes
increasing returns to scale and especially the use of the network effect
to argue that the formation of important industries was partly dependent
in a way which industrial planning and judicious tariffs might control.
The model also showed how past dependent industrial concentrations
can sometimes lead to monopolistic competition or even situations of
oligopoly. Thus, it explains why countries can export and import designer
clothes. This means that capital-intensive countries often dominate the
most profitable industries. Being the first to develop these industries,
these countries gain the first mover advantage.
The New Trade Theory suggests that the government has an important
role in promoting new industries and supporting the growth of key in-
dustries in a developing economy to be able to achieve economies of
scale. However, government intervention might be controversial, as stated
by many economists, as it may encourage inefficiency in the long run if
it has poor information about the new industries it is likely to support.
Thus, the New Trade Theory recognizes that economies of scale are a
key factor in influencing the development of trade. It also suggests that
free trade and laissez-faire government intervention may be much less
desirable for developing economies who find themselves unable to com-
pete with established multi-nationals.
IN-TEXT QUESTIONS
4. The focus of the New Trade Theory is on _________ and
_________.
5. The increasing rate of return was modelled through _________
in this theory.

7.3.3 Theory of Absolute Advantage

In 1776, Adam Smith questioned the mercantilists’ assumptions by stat-
ing that the real wealth of a country consists of the goods and services
available to its citizens rather than its holdings of gold. He emphasized
on the virtue of free trade that are the results of division and special-
ization of labour at the national and international level. However, at
the international level, the division of labour requires the existence of

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Notes absolute differences in cost. Absolute difference in cost arises when one
country produces a commodity at a lower cost than the other country
and the other country produces some other commodity at a lower cost
in comparison to the first country. Thus, according to this theory, every
country should specialize in the production of that commodity which it
can produce more cheaply than others (i.e. enjoys absolute advantage)
and exchange it for those commodities which cost less in other countries
(i.e. in which it has absolute disadvantage).
To illustrate, let there be two countries A and B producing a commodity
each, X and Y respectively, at an absolute lower cost of production than
the other. The absolute difference in cost is illustrated in Table 7.1.
Table 7.1: Absolute Difference in Cost
Commodity X Commodity Y
Country (in units) (in units)
A 10 5
B 5 10
The table shows that country A can produce 10 units of commodity X
(10X) or 5 units of commodity Y (5Y) with one unit of labour and country
B can produce 5 units of commodity X (5X) or 10 units of commodity
Y (10Y) with one unit of labour. Thus, country A has an absolute advan-
tage in the production of commodity X (10X > 5X) and country B has
an absolute advantage in the production of commodity Y (10Y > 5Y).
Both the countries will benefit from trade if country A specializes in the
production of commodity X and country B specializes in the production
of commodity Y as shown in Table 7.2.
Table 7.2: Gains from Trade
Production before Production after Gains from
Trade (1) Trade (2) Trade (2 – 1)
Commodity X Y X Y X Y
Country
A 10 5 20 — +10 –5
B 5 10 — 20 –5 +10
Total produc- 15 15 20 20 +5 +5
tion
By applying one unit of labour on the production of each commodity, both
the countries can produce only 15 units each of the two commodities. If
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country A were to specialize in the production of commodity X, its total Notes

production will be 20 units of X by using both units of labour. Similarly,
if country B were to specialize in the production of commodity Y alone,
its total production will be 20 units of commodity Y by using both units
of labour. The combined gain from trade to both the countries will be 5
units each of commodities X and Y respectively.

Figure 7.1
The PPC of country A is YAXA and that of country B is YBXB. PPC of
country A shows that it can produce either OXA of commodity X or OYA
of commodity Y. Similarly, the PPC of country B shows that it can pro-
duce either OXB of commodity X or OYB of commodity Y. The diagram
also reveals that country A has an absolute advantage in production of
commodity X (OXA > OXB) whereas country B has an absolute advantage
in the production of commodity Y (OYB > OYA).
Criticism
Adam Smith’s analysis of the basis of international trade is unrealistic.
This is because a number of developing and underdeveloped countries
have trade relations with other countries even though they do not possess
absolute advantage in the production of any commodity.
IN-TEXT QUESTIONS
6. The theory was propounded by __________.
7. When one country produces a commodity at a lower cost than
the other country and the other country produces some other
commodity at a lower cost in comparison to the first country,
it gives rise to __________.

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Notes 7.3.4 Theory of Comparative Advantage

According to David Ricardo, the trade relation between two countries is
determined by the comparative differences in costs and not by the absolute
differences. The costs differ in countries because of geographical division
of labour and specialization in production causing a country to produce
one commodity at a lower cost than the other. In this way, each country
specializes in the production of that commodity in which its comparative
cost of production is the least. Thus, when a country enters into trade
with some other country, it will export those commodities in which its
comparative cost of production is less and will import those commod-
ities in which its comparative cost of production is high. According to
Ricardo, this is the basis of international trade.
Statement of the Theory
“Each country will specialize in the production of those commodities
in which it has the greatest comparative advantage or the least com-
parative disadvantage”.

7.3.4.1 Assumptions of the Theory

The theory of comparative advantage is based on the following assumptions:
1. There are only two countries, say India and Bangladesh producing
the same two commodities, say rice and wheat.
2. Both countries have similar tastes and preferences.
3. Labour is the only factor of production and all its units are homogeneous.
4. There is no change in supply of labour.
5. Labour cost (the number of units of labour employed to produce
each commodity) determines the prices of the two commodities.
6. Commodities are produced under the law of constant costs.
7. Technological knowledge remains the same.
8. There is barter system of trade.
9. There is full employment of factors of production in both the countries.
10. Factors of production are perfectly mobile within countries but
perfectly immobile between countries.
11. Trade is free between two countries.

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12. There are no transportation costs. Notes

13. The international market is perfect; therefore, the exchange ratio is
the same for the two commodities.

7.3.4.2 Explanation of the Theory

Given these assumptions, Ricardo shows that trade is possible between two
countries when one country has an absolute advantage in the production
of both commodities, but a comparative advantage in the production of
one commodity than in the other. This is illustrated with an example of
trade between India and Bangladesh as shown in Table 7.3.
Table 7.3: Man-years of Labour Required for Producing One Unit
Country Rice Wheat
Bangladesh 120 100
India 80 90
The table shows that the production of a unit of rice in Bangladesh needs
120 men for a year while a unit of wheat requires 100 men for a year.
On the other hand, the production of a unit of rice in India requires
80 men for a year and 90 men for a year for the production of wheat.
Thus, Bangladesh uses more labour than India in producing both rice
and wheat. In other words, Indian labour is more efficient in producing
both the commodities. Thus, India possesses an absolute advantage in
the production of both rice and wheat. But India would benefit more by
producing rice and exporting it to Bangladesh because it possesses greater
comparative advantage in it. This is because the cost of production of rice
(80/120 men) is less than the cost of producing wheat (90/100 men). On
the other hand, Bangladesh should specialize in the production of wheat
in which it has least comparative disadvantage. This is because the cost
of producing wheat in Bangladesh is less (100/90 men) as compared
with rice (120/80 men). Thus, trade is beneficial for both the countries.
The comparative advantage theory can also be illustrated with the help
of production possibility curve.
IN is the production possibility curve of India and BG that of Bangladesh.
India enjoys an absolute advantage in the production of both rice and
wheat over Bangladesh. It produces ON of rice and OI of wheat as against
OG of rice and OB of wheat produced by Bangladesh.

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Notes

Figure 7.2: Comparative Difference in Cost with the Help of PPC

The slope of BR (parallel to IN) shows that India has a greater compar-
ative advantage in the production of rice because if it gives up resources
required to produce OB of wheat, it can produce OR of rice which is
greater than OG of rice produced by Bangladesh. On the other hand,
Bangladesh has the least comparative disadvantage in the production of
OB amount of wheat. Thus, India will export OR of rice to Bangladesh
in exchange for OB of wheat from it.

7.3.4.3 Gains from Trade

Ricardo does not discuss the actual ratio at which rice and cloth would
exchange and how much the two countries gain from trade. The domes-
tic trade ratios before trade in the two countries for rice and wheat are
shown in Table 7.4.
Table 7.4: Domestic Exchange Ratios
Bangladesh India
Rice 120 : 100 Wheat (6/5) Rice 80 : 90 Wheat (8/9)
1 : 1.2 1 : 0.89
Wheat 100 : 120 Rice (5/6) Wheat 90 : 80 Rice (9/8)
1 : 0.83 1 : 1.13
The cost of production of one unit of rice in Bangladesh is 120 men and
that of producing one unit of wheat is 100 men. It shows that the cost of
producing rice is more as against wheat because one unit of rice can be

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exchanged for 1.2 units of wheat. On the other hand, the cost of producing Notes
one unit of rice in India is 80 men and that of producing one unit of wheat
is 90 men. Thus, the cost of producing wheat is more than that of rice
because one unit of rice can be exchanged for 0.89 units of wheat.
Let’s assume trade begins between the two countries. Bangladesh will
gain if it imports one unit of rice from India in exchange for less than
1.2 units of wheat. India will also gain if it imports one unit of wheat
from Bangladesh in exchange for more than 0.89 units of rice.
Table 7.4 also shows that the domestic exchange ratio in Bangladesh is
one unit of wheat = 0.83 units of rice and in India one unit of rice =
0.89 units of wheat. Assuming the exchange ratio between two countries
to be 1 unit of wheat = 1 unit of rice, Bangladesh would gain 0.17 (1 –
0.83) units of rice by exporting one unit of wheat to India. Similarly, the
gain to India by exporting one unit of rice to Bangladesh will be 0.11
(1 – 0.89) units of wheat. Thus, trade is beneficial for both countries.
The gains from trade and their distribution are shown in Figure 7.3 where
the line P1R2 depicts the domestic exchange ratio 1 unit of wheat = 0.83
units of rice of Bangladesh and the line P2R1 that of India at the domestic
exchange ratio 1 unit of rice = 0.89 units of wheat.

Figure 7.3: Gains from Trade

The line P1R1 shows the exchange rate of trade of 1 unit of wheat = 1
unit of rice between the two countries. At this exchange rate Bangladesh
gains R2R1 (0.17 units) of rice while India gains P 2P1 (0.11 units) of wheat.

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Notes Summing up, both India and Bangladesh specialize in the production of
one commodity based on the comparative costs and accordingly reallo-
cate their factors of production. Each country exports that commodity
in which it has comparative advantage and imports that commodity in
which it has comparative disadvantage. Both gain through trade and can
increase the consumption of the two commodities.

7.3.4.4 Criticism
The principle of comparative advantage has been the very basis of in-
ternational trade for centuries but it is not free from few defects. In
particular, Bertil Ohlin and Frank D. Graham have criticized this theory
several times. Some of the important criticisms are:
1. Unrealistic Assumption of Labour Cost: It is assumed that this
theory considers only labour cost and ignores non-labour costs in
calculating the cost of production. This is highly unrealistic because
the basis of national and international transactions is money cost and
not labours cost. Further, the assumption of homogeneous labour is
also unrealistic because labour is heterogeneous of different kinds,
skilled and unskilled or specialized and general.
2. No Similar Tastes: The assumption of the two countries having
similar tastes and preferences is unrealistic because preferences
differ with different income standards in a country. Economic growth
and development of trade relations also bring about a change in the
tastes and preferences of people.
3. Assumption of Constant Costs: The theory assumes that commodities
are produced under the law of constant costs which is unrealistic.
Factually, there are either increasing or diminishing costs. The
comparative advantage is increased if the costs are reduced due
to large scale production whereas the comparative advantage is
reduced if an increased output is the result of an increased cost of
production.
4. Transport Costs Ignored: Ricardo ignores transport costs in determining
comparative advantage in trade. This is again an unrealistic assumption
as transport costs play an important role in determining the pattern
of world trade. For instance, the gain from international trade can
be reduced or nullified due to high transportation cost.

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5. Immobile Factors of Production Internationally: Another unrealistic Notes

assumption of this theory is that factors are perfectly mobile nationally
and perfectly immobile internationally. However, within a country,
factors are not freely mobile from one industry to another or from
one region to another. The greater the degree of specialization in
an industry, the less is the factor mobility from one industry to
another. Thus, factor mobility influences costs and hence the pattern
of international trade.
6. Unrealistic Two-Country, Two Commodity Model: Ricardo’s doctrine
of comparative advantage is based on trade between two countries
trading two commodities. However, in reality, international trade
takes place between many countries trading in many commodities.
7. Unrealistic Assumption of Free Trade: Another drawback of this
theory is that it assumes free trade among countries. This is not
realistic. World trade is not free. The countries impose restrictions
in the form of tariff and non-tariff barriers on the movement of
goods to and from other countries.
8. Neglects the Role of Technology: Technological innovations in
international trade are ignored by this theory which is unrealistic.
Much is gained from innovations, research and development. For
instance, technological changes help in increasing the supply of
goods both nationally and internationally.
9. One-Sided Theory: Since the theory considers only the supply side
of international trade and ignores the demand side, it is considered
to be a one-sided theory.
10. An Incomplete Theory: The theory is considered incomplete as
it simply explains how two countries gain from trade but fails to
explain how the gains from trade are distributed between the two
countries.
Despite these weaknesses, the theory of comparative advantage is considered
to be the basis of international trade. In the words of Prof. Samuelson,
“Yet for all its oversimplifications, the theory of comparative advantage
has in it a most important glimpse of truth. Political economy has found
few more principles. A nation that neglects comparative advantage may
have to pay a heavy price in terms of living standards and potential
rates of growth.”
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Notes IN-TEXT QUESTIONS

8. The theory of Comparative Advantage was given by __________.
9. The difference in costs is due to __________ and __________.
10. The theory considers only the __________ side of international
trade.

7.3.5 Modern Theory of International Trade

In his famous book ‘Inter-regional and International Trade (1933)’, Bertil
Ohlin criticized the classical theory of international trade and formulat-
ed the General Equilibrium or Factor Endowment or Factor Theory of
international trade. The Heckscher Ohlin theory of international trade is
therefore the difference in prices of commodities based on relative factor
endowments and factor prices as some commodities can be bought more
cheaply from the other regions than in the same region where production
is possible only at high prices.

7.3.5.1 Assumptions of the Theory

The following assumptions hold good for the H.O. theory:
1. It is a two X two X two model i.e. two countries, say A and B,
two commodities, say X and Y, and two factors of production, say
labour and capital.
2. Both commodity and factor markets are perfectly competitive markets.
3. Resources are fully employed.
4. Technology is given and constant.
5. There are quantitative differences in factor endowments in different
countries, but qualitatively they are homogeneous.
6. Production functions of the two commodities have different factor
intensities (i.e. capital intensive and labour intensive) that are non-
reversible.
7. Factors are perfectly mobile within the country and perfectly immobile
between countries.
8. There are no transportation costs.
9. There is free trade between countries.

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10. Each commodity in each country is produced under the law of Notes
constant cost.
11. Tastes and preferences of consumers and their demand patterns are
identical in both the countries.
12. Neither country specializes in the production of one commodity. In
other words, there is incomplete specialization.
13. Production functions are different for different commodities, but are
the same for each commodity in both countries. It means that the
production function of commodity X is different from commodity
Y but the technique of production of commodity X and commodity
Y respectively in both the countries is the same.

7.3.5.2 Explanation to the Theory

Given these assumptions, Heckscher and Ohlin contend that the imme-
diate cause of international trade is the difference in relative commodity
prices caused by differences in relative demand and supply of factors
(factor prices) as a result of differences in factor endowments between
two countries. Fundamentally, the relative scarcity of factors (shortage of
supply in relation to demand) is essential for trade between two countries.
Commodities which use large quantities of scarce factors are imported
because their prices are high while commodities which use abundant
factors are exported because their prices are low.
H.O. theory is explained in terms of two definitions:
1. Factor Abundance (or scarcity) in Terms of Price Criterion: In this
criterion, richness in factor endowments is explained by Heckscher
Ohlin in terms of factor prices. Given the two countries A and B
producing two commodities X and Y by employing labour and
capital as factors of production, country A is abundant in capital
if (PC/PL)A ˂ (PC/PL)B where PC and PL refer to prices of capital
and labour respectively and the subscripts A and B denote the two
countries. In other words, country A is abundant in capital if capital
is relatively cheap in it whereas country B is abundant in labour if
labour is relatively cheap in it. Thus, country A will produce and
export the capital intensive good and import labour intensive good
and country B will produce and export labour intensive good and

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Notes import capital intensive good. In other words, the capital abundant
country will export the relatively cheap capital-intensive commodity
and the labour abundant country will export the relatively cheap
labour-intensive commodity.
2. Factor Abundance in Physical Terms: Another way to explain the
H.O. theory is in physical terms of factor abundance. According
to this criterion, a country is relatively capital abundant if it is
endowed with a higher proportion of capital and labour than the
other country. If country A is relatively capital abundant and country
B is relatively labour abundant, then measured in physical amounts
CA/LA > CB/LB, where CA and LA are the total amounts of capital
and labour respectively in country A and CB and LB are the total
amounts of capital and labour respectively in country B.
Both the countries specialize and gain from trade for two reasons: first,
their factor price rates are equal and second, tastes and preferences for
the two commodities are similar in both countries.
But the above analysis of physical terms does not show that the capital
abundant country will export the capital intensive commodity and the
labour abundant country will export the labour intensive commodity.

7.3.5.3 Criticism
H.O. Theory has been criticized on the following grounds:
1. Two-by-two-by-two Model: Ohlin has been criticized for presenting
two-by-two-by-two model based on oversimplified assumptions. But,
he has demonstrated in the mathematical appendix to his book that
the model can be extended to many countries, many commodities
and many factors.
2. Non-homogeneous Factors: The theory assumes that the factors
of production in the two countries are homogeneous and factor
endowment ratios can be calculated by measuring them. In reality,
however, no two factors are homogeneous qualitatively between as
well as within the country.
3. Non-homogeneous Production Techniques: The H.O. model assumes
homogeneous production techniques for each commodity in the two
countries. But, the technique of production is different in the two
countries for the same commodity.
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4. Distinct Tastes and Demand Patterns: The assumption of similar Notes

tastes and demand patterns of consumption in both countries is
unrealistic. Innovations, diversifications and accessibility of products
bring about a change in the tastes and demand patterns of consumers.
5. No Constant Returns: It is unrealistic to assume constant returns
to scale as the advantages of economies of scale are obtained by a
country having rich factor endowments through lesser production
and exports. Thus, there are increasing returns to scale rather than
constant returns.
6. Transport Cost Ignored: The theory ignores transport costs in trade
between two countries. But, in reality, when transport costs, loading
and unloading charges and other port charges that affect the price of
produced commodities in the two countries are included, they lead
to price differentials for the same commodity in the two countries.
7. Unrealistic Assumption of Full Employment and Perfect Competition:
The theory assumes full employment and perfect competition to
exist in both the countries which is not true. Factually, due to the
existence of differentiated products, perfect competition does not
exist and each country strives to achieve full employment.
8. Leontief Paradox has made the Theory Questionable: Leontief’s
empirical study of Ohlin’s theorem, known as Leontief Paradox,
has led to paradoxical results that the United States exports labour-
intensive goods and imports capital-intensive goods, even though
it is a capital-rich country.
9. Partial Equilibrium Analysis: Prof. Haberler regards Ohlin’s theory
as, by and large, a partial equilibrium analysis. He criticized him for
his failure to develop a comprehensive general equilibrium concept.
10. Vague and Conditional Theory: As pointed out by Haberler,
“With many factors of production, some of which are qualitatively
incommensurable as between different countries, and with dissimilar
production functions in different countries, no sweeping a priori
generalization concerning the composition of trade are possible”.
Despite these criticisms, Ohlin’s theory is definitely an improvement
over the classical theory of trade as it attempts to address the basis of
international trade in the general equilibrium setting.

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Notes 7.3.5.4 Superiority of H-O Theory over Classical Theory

Heckscher-Ohlin Theory Classical Theory
The merit of H.O. theory lies in ex- According to Samuelson, the Ri-
plaining the causes of differences in cardian theory could not explain the
comparative advantage satisfactorily. causes of differences in comparative
advantage.
H.O. theory is scientific and focuses The classical theory demonstrates
on the basis of international trade. the gains from trade between the
It thus relates to the positive theory. two countries. Thus, it is related
to the welfare theory.
According to Haberler, the H.O. The classical theory regards different
theory is a location theory which countries as space-less markets.
highlights the importance of the
space factor in international trade.
The H.O. theorem is explicitly based The classical theory is based on
on the assumption of production differences in the production of the
functions of the two countries. trading countries.

The H.O. model leads to complete The trade between two countries may
specialization in the production of or may not lead to specialization in
one commodity by one country and the classical theory.
that of the other commodity by the
second country when they enter into
trade with each other.
In the H.O. theory, trade will not In the classical theory, differences
cease in future even if the labour in comparative costs between two
becomes equally efficient in the two countries are due to differences in
countries because the basis of trade efficiency of labour. Over time, if
is differences in factor endowments labour in both countries becomes
and factor prices. equally efficient in both countries,
there’ll be no trade between them.

7.3.5.5 The Leontief Paradox

The first comprehensive attempt to verify the Heckscher-Ohlin model was
made by Wassily Leontief in 1953. The Heckscher-Ohlin theory states that
relatively capital-abundant country will export relatively capital-intensive

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goods and it will import relatively labour-intensive goods i.e. the goods Notes
in whose production relatively large amounts of relatively scarce factor
labour are required. Leontief in his study reached the paradoxical conclu-
sion that the United States which possesses a relatively large amount of
capital and a relatively small amount of labour in relation to the rest of
the world, exported labour-intensive goods and imported capital-intensive
goods. This result has come to be known as Leontief Paradox.
To test the Heckscher-Ohlin prediction, Leontief used the 1947 input-output
table of the US economy. He aggregated 200 groups of industries into
50 sectors of which 38 traded their products directly on the international
market. He took two factors, labour and capital and estimated their re-
quirements for production of one million dollars worth of United States
export and import competing commodities.
His results showed that in the US import-competing industries were rela-
tively more capital-intensive than the export industries. Given the proposi-
tion that the US is relatively capital abundant, it exports labour-intensive
goods. This is just contrary to the Heckscher-Ohlin theorem. Thus, it is
called the Leontief Paradox.

7.3.5.5.1 Criticism
Leontief has been criticized by a majority of economists on methodological
and statistical grounds. Some points of criticism are as follows:
1. 1947, an Unconventional Year: Swerling did not consider 1947 as a
conventional year for testing the Heckscher-Ohlin theorem because
by that year the disorganization of production had not been corrected.
Moreover, the United States was the only major industrial economy
that was saved from the destruction of the war. Thus, Leontief study
was basically a description of US trade in 1947.
2. Low Capital-Labour Ratio Industries: Swerling criticized Leontief
for including certain industries with low capital-labour ratios like
fisheries, agriculture and services like transport, wholesale trade
etc. that biased his results. In response to this criticism, Leontief
reworked his study by taking a much wider range of studies but
the results obtained were similar to the original study.
3. Consumption Patterns: The impact of consumption patterns on the
US exports and imports is not considered by Leontief Paradox. The

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Notes consumption pattern may be biased either towards labour-intensive

or capital-intensive commodities with an increase in the per capita
income. Brown’s study showed that the US consumption patterns
had bias towards labour-intensive commodities rather than capital-
intensive commodities. This contradicts the Leontief Paradox.
4. Capital Durability: Buchanan criticized Leontief for using “investment-
requirements coefficients” as capital coefficients in his study.
Therefore, he failed to take into account the difference in the
durability of capital in various industries.
5. Tariffs Not Considered: Travis argued that the pattern of trade was
often distorted by tariffs and thus reflected relative factor endowments
of a country. In his study, Leontief ignored the impact of US and
foreign tariffs which would have otherwise affected his results.
6. Natural Resources Overlooked: Buchanan criticized Leontief for
neglecting the role of natural resources which were very important
in determining trade patterns.
7. Human Capital Ignored: Leontief, in his study, only considered
physical capital and ignored the value of human capital. Kenen
found in his study that Leontief Paradox was reversed when human
capital was added to Leontief’s physical capital.
8. Unbalanced Trade: When the trade is unbalanced, Leontief Paradox
fails as per Lerner. He found no evidence of exports being labour-
intensive when he examined US trade in 1947. He only concluded
that US had a trade surplus.
9. Factor Intensity Reversals: Leontief’s results led to the presence
of factor intensity reversals whereby a capital abundant country
will export its labour-intensive goods. Leontief has been criticized
for taking only one country (the US) in his study. If he had taken
a second capital-abundant country, the results would have been
different.
Despite the criticisms leveled against his study, Leontief retested his
results by using the average composition of US exports and imports in
1951. He increased the group of industries into 192 sectors. However,
the results again confirmed the Leontief Paradox though the capital in-
tensity over US exports reduced considerably. So, the Leontief Paradox
continues to persist in the US.
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IN-TEXT QUESTIONS Notes

11. The General Equilibrium was formulated by __________ and

__________.
12. The H-O Theory was verified empirically by __________ and
the results attained are popularly known as __________.
13. The theory is explained on the basis of __________ and
__________ criterion.

7.3.6 Imitation Gap Theory

Michael V. Posner in an article in 1961 analyzed the effect of technol-
ogy on trade. The merit of the theory is that it paves the way for the
development of the product cycle theory. The comparative cost theory
developed by Ricardo and the factor endowment theory as given by
Heckscher-Ohlin are based on the assumption of constant technology
in all trading countries. The imitation gap or technological gap theory
relaxes this assumption. It assumes that the same technology is not al-
ways available in all countries and there is a delay in the transmission
or diffusion of technology from one country to another.
The theory simply states that technological innovation and the introduc-
tion of a new product leads to the imitation gap and the demand gap
in the other country. The extent to which trade will take place between
the two countries depends on the net effect of the imitation gap and the
demand gap.
Consider countries X and Y. Suppose that a new product appears in coun-
try X due to the successful efforts of research and research team. The
innovating firm and nation get a monopoly through patents and copyrights
which turn other nations into importers of this product as long as the
monopoly status remains.
The theory implicitly assumes that this new product will not be produced
immediately by firms in country Y. Incorporating a time dimension. The
imitation lag is defined as the length of the time (e.g., 24 months) that
elapses between the product introduction in country X and the appearance
of the version produced by firms in country Y. The imitation lag includes
a learning period during which the firms in country Y must acquire tech-
nology and know-how in order to produce the product.
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Notes In addition, it takes time to purchase inputs, install equipment, process the
inputs, bring the finished product to market and so on. In this theory, a
second adjustment is the demand lag, which is the length of time between
the products appearance in country X and its acceptance by consumers
in country Y as a good substitute for the products they are currently
consuming. This lag may arise from loyalty to the existing brand, inertia
and delays in information flows. This demand lag can also be expressed
in a number of months, say 6 months.
A key point in this theory is the comparison of the length of the imitation
lag with the length of the demand lag. For instance, if the imitation lag
is 20 months, the net lag is 14 months., that is 20 months less 6 months
(demand lag). During this 14-month period, country X will export the
product to country Y.
The central point in imitation gap analysis is that once the foreign firms
acquire this technology, they may become more competitive than the in-
novator because of certain favourable factors (e.g., cheap labour). When
it happens, the innovating country may turn into an importer of the very
product it has introduced.
Firms in the developed countries, however, strive to stay ahead through
frequent innovations which make the earlier products obsolete. Posner’s
imitation gap analysis is portrayed in Figure 7.4.

Figure 7.4: Imitation Gap

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Posner’s theory is explained in Figure 7.4 where time is plotted on the Notes
horizontal axis and the trade balance of the innovating country A against
the imitating country B is taken on the vertical axis. Up to point t1, there
is no trade between the two countries, in say good X. At t1, A innovates
the new product. The demand lag in B will determine the amount of
exports of A and thus the slope of t1B. The imitation lag will determine
how long country B will import the commodity from A and the extent
of A’s exports. If there is no imitation of the commodity in B, country
A will continue to export it till exports reach the maximum level B at
time t3. The period from t1 to t3 is the demand lag. If producers in B start
producing the new product by time t3, the exports of A will decline and
may even stop at time t4 as shown by the downward arrow from B to t4.
In this situation, the imitation lag t3t4 is shorter than the demand lag. If
the imitation lag is longer and producers in B are unable to adopt the
innovation of the new commodity till time t5, country A will continue to
export it to its maximum level B1. As B starts producing this commodity,
the imitation lag becomes shorter and exports from A continue to decline
until they fully stop at time t6 when the commodity is fully imitated in
country B. If producers in B introduce an innovation in the commodity
so that it is better than A’s commodity, B will penetrate A’s market. In
this case, A will start importing it from B, as shown by the downward
arrow from t6 to A.

7.3.7 Product Life Cycle Theory

In a 1966 article, Raymond Vernon sought to explain international trade
based on the evolutionary process that occurs in the development and
diffusion of products to markets around the world. In his International
Product Life Cycle (IPLC) Theory, Vernon points out that each product
and its manufacturing technologies go through a continuum or cycle of
evolution that consists of introduction, growth, maturity and decline. The
location of production will shift to serve markets according to the stage
of cycle a product is therein.
Introduction: Historically, a new product originated in an advanced
economy, such as the US or Germany, in the Introductory stage. This is
because such countries have abundant capital and research and development
facilities that prove advantageous to produce new products or to produce

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Notes old products in new ways. Advanced economies also have abundant,
affluent (high income) consumers who are willing to try new products,
which are often expensive. During the introduction stage, production of
the new product takes place in the inventing country so that the producer
can obtain rapid market feedback and save upon the transportation cost,
since most sales are domestic. Any export sales are mainly to advanced
countries having high income consumers and who are willing to spend
on novelties. Since production process is not standardized in this stage,
it remains labour-intensive.
Growth: Over time, the market grows and enters the growth phase. The
sales growth attracts competitors to the market, particularly in other
developed countries, who establish a manufacturing unit in their own
country and develop unique product variations for the consumers of their
country. However, the cost of production may still be high because of
start-up problems.
Growth in sales provides an incentive to companies to develop labour-sav-
ing technology but this incentive is partly offset because competitors
produce differentiated products to suit the needs of their country. Thus,
the production process still remains labour-intensive though less than the
introductory stage. In other words, the capital intensity is relatively more
than the introductory stage. The original producing country will increase
its exports, especially to developing countries, but will lose certain key
export markets in which local production is initiated.
Maturity: As the product enters the maturity stage, the production pro-
cess gets more standardized and price becomes an important competitive
strategy. The demand in developing countries increases on account of
reduced per-unit cost of production due to capital-intensive production.
The innovating country no longer commands a production advantage.
Since the innovator may earn only a narrow profit margin, the innovating
country shifts its production base to developing countries where they can
employ less skilled labour efficiently at a lower cost for capital-inten-
sive production. Foreign production thus, displaces the exports from the
innovating country.
Decline: Once the production process is standardized, mass production
becomes the dominant activity and can be accomplished using cheaper

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 Theories of Trade and Balance of Payment

inputs and low-cost labour. Production shifts to low-income countries Notes

where competitors enjoy low-cost advantages and can economically serve
export markets worldwide. The innovator country eventually becomes a
net importer.

Figure 7.5: PLC Model of International Trade – Innovating Country

Figure 7.6: PLC Model of International Trade – Imitating Country

(Source: Shenkar and Luo for both)

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Notes 7.3.7.1 Criticism

‹ The PLC theory holds that the location of production facilities that
serve world markets shifts as products move through their life cycle.
Many industrial products like steel, coal etc. or basic foodstuff like
salt, sugar etc. fall outside the purview of life-cycle.
‹ The movement of the product from one stage to another is not
certain.
‹ The present stage in which the product is cannot be known with
certainty.
‹ Certain products have extremely short life cycle because of rapid
innovation. Shifting production of such products from one country
to another doesn’t reduce their cost. Hence, there’s no benefit of
shifting.
‹ The new products are introduced simultaneously in all parts of the
world due to shortened life- cycle, integration of the world economy
and globalization. Thus, no leads and lags exist between markets.
‹ Luxury products for which cost is of little concern to the consumers
aren’t covered by the PLC theory.
‹ The production location of products requiring technical expertise to
move into their next generation of models usually does not shift.
This seems to explain the US dominance of medical equipment
production and German dominance in rotary printing presses.
‹ It’s difficult to predict in advance the life of the product.
‹ The companies today develop products for worldwide market
segments and so introduce the new products at home and abroad
simultaneously. In so doing, they choose an initial production
location (that may or may not be in the innovating country) that
will minimize costs for serving markets worldwide.
The theory was empirically satisfactory during 1950s to 1970s but the
recommendations of the theory are either unclear or not fit in today’s
world. In context of shifting to low-cost countries, i.e. the comparative
advantage, one of the economists comments, “In essence, it is the Ri-
cardian story once again.”

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 Theories of Trade and Balance of Payment

IN-TEXT QUESTIONS Notes

14. The cycle of evolution consists of ___________, _________,

____________, and ___________ stages.
15. As per the PLC theory, the innovator country eventually becomes
a net____________.

7.3.8 Theory of National Competitive Advantage

Schumpeter emphasized many decades ago, “Competition is profoundly
dynamic in character. The nature of economic competition is not equilib-
rium but a perpetual state of change. Improvement and innovation in an
industry are never-ending processes. Today’s advantages are soon super-
seded or nullified”. Michael Porter, in his book, “Competitive Advantage
of Nations (1990)” explained why a nation provides an environment in
which firms improve and innovate and continue to do so faster and in
the proper directions compared to their international rivals and why some
nations’ firms achieve technological superiority, produce more differen-
tiated or higher quality products or products which are more attuned to
customer needs than others.
Why does a nation achieve international success in a particular industry?
The answer lies in four broad attributes of a nation that shape the envi-
ronment in which local firms compete that promote or impede the creation
of competitive advantage. These determinants are: (1) Factor Conditions;
(2) Demand Conditions; (3) Related and Supporting Industries; and (4)
Firm’s Strategy, Structure and Rivalry. The Porter’s model also points
out two additional determinants that influence the four main determinants.
These are governmental policy and the role of chance events.
1. Factor Conditions: The factors most important to competitive
advantage in industries in advanced economies are not inherited
but are created within a nation. To understand the role of factors in
competitive advantage, it is necessary to distinguish between types
of factors. The first demarcation is between advanced and basic
factors. Advanced factors of production are skilled labour, knowledge,
capital and infrastructure. Basic factors such as unskilled labour and
raw material can be obtained by any company and do not generate
competitive advantage. The second distinction is between specialized

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Notes and generalized factors. Specialized factors involve narrowly skilled

personnel, infrastructure with specific properties, knowledge bases
in particular fields and other factors with relevance to a limited
range or even to just a single industry; for e.g. a port specialized
in handling bulk chemicals or a pool of venture capital seeking to
fund software companies etc.
2. Demand Conditions: The second broad determinant of national
competitive advantage is demand conditions. The main factor is home
demand conditions which have influence in nearly every industry.
The composition of home demand shapes how firms perceive,
interpret and respond to buyer needs. Nations gain competitive
advantage in industries where the home demand gives local firms
a clearer or earlier picture of buyer needs than foreign rivals. It
is not merely the size of the market that is important but it is the
intensity and sophistication of the demand that is significant for
competitive advantage. If consumers are sophisticated, they will
make demands for sophisticated products and that in turn will help
the production of sophisticated products. Gradually, the country will
achieve competitive advantage in such production. As significant as
early home market penetration so is early or abrupt saturation. Early
saturation forces companies to continue innovating and upgrading as
well as finding international markets for their products. In consumer
electronic products, saturation in the Japanese home market is rapid
and product life cycles are extremely short. This is because buyers
have homogeneous tastes combined with sophistication and status
consciousness. This combination gives them competitive advantage
in comparison with foreign rivals.
3. Related and Supporting Industries: The third broad determinant is
related and supporting industries. The presence of internationally
competitive supplier industries in a nation creates advantages in
subsequent industries. It gives efficient, early, rapid and sometimes
preferential access to the most cost-effective inputs. The benefit of
home-based suppliers may be found in the process of innovation
and upgrading. Firms gain quick access to information, to new
ideas and insights and to supplier innovations. The presence in
a nation of competitive industries, that are related, often leads to
new competitive industries. Related industries are those in which
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firms can co-ordinate or share activities in the value chain when Notes
competing. An example is pharmaceutical firms who use the same
university when testing new drugs.
4. Firm Strategy, Structure and Rivalry: The fourth and last broad
determinant is firm strategy, structure and rivalry. Many aspects of a
nation, too numerous to generalize, influence the ways in which firms
are organized and managed. Some of the most important aspects are
attitudes towards authority norms of interpersonal interaction, attitudes
of workers towards management and vice-versa, social norms of
individualistic or group behavior and professional standards. These in
turn grow out of the educational system, social and religious history,
family structures and many other unique national conditions. Sharp
differences exist within and among nations in the goals that the
firms seek to achieve as well as the motivations of the employees
and managers. Domestic rivalry creates particularly visible pressure
on each other to improve vigorous local competition. It not only
sharpens advantages at home but pressures domestic firms to sell
abroad in order to grow.
These four main determinants are influenced by the governmental policy
through various regulatory and de-regulatory measures. Policies imple-
mented without consideration of how they influence the entire system of
determinants are as likely to undermine national advantage as enhance
them.
Government affects factor conditions in many ways. Among the most
important roles of government is creating and upgrading factors. The
government procurement can be a positive force for upgrading national
competitive advantage if they provide early demand for advanced new
sophisticated products or services from local firms. The government must
support the related and supporting industries in the same way as the
industries that have the advantage. Government has an important role in
the nurturing and reinforcing clusters.
Government’s policy has numerous ways of influencing how firms are
created, organized, how they manage their goals and how they compete.
Sustaining and enhancing competitive advantage requires that nation’s
firms take a global approach to strategy. Government policy should seek
to avoid currency restrictions, restrictions on foreign investments and

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Notes restrictions on the inflow and outflow of skilled personnel that impede
internationalization.
Few roles of the government are more important to the upgrading of an
economy than ensuring vigorous domestic rivalry and this requires strong
antitrust policies because a dominant domestic competitor rarely results
in international competitive advantage.
The last determinant that influences the four main determinants is chance
events. Chance events are developments outside the control of firms (and
usually the nation’s government) such as pure inventions, breakthroughs
in basic technologies, wars, external political developments and major
shifts in foreign demand. They create discontinuities that can unfreeze
or reshape industry structure and provide opportunity for one nation’s
firms to supplant another’s. Chance has played an important role in
shifting competitive advantage in many industries. A shift that changed
competitive advantage was the oil shock in the 1970s. The oil shock ul-
timately helped upgrade Japanese industry. Because Japan was especially
vulnerable to energy costs and therefore, took aggressive steps towards
energy conservation.
In a nutshell, the Porter’s Diamond must be seen as a system wherein the
effect of one determinant often depends on the state of other determinants.

7.3.8.1 Criticism
The Theory of Competitive Advantage suffers from the following criti-
cisms/limitations:
1. Porter feels that sizeable domestic demand must be present for
attaining competitive advantage but there are industries that have
flourished only because of demand from foreign consumers. For
example, Nestle; a major share of its earnings comes from foreign
sales.
2. Where domestic suppliers of inputs are not available, the backward
linkage will be meaningless as the determinant related and supporting
industries don’t exist in that nation.
3. Availability of national resources, according to Porter, is not the
only condition for attaining competitive advantage. There must
be other factors also. But, a study has shown that some Canadian

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 Theories of Trade and Balance of Payment

industries emerged on the global map only on the basis of such Notes
natural resource availability.
Nevertheless, these limitations do not undermine the significance of
Porter’s national competitive advantage theory, especially in advanced
industries located in advanced countries.
IN-TEXT QUESTIONS
16. All determinants of the theory are influenced by ___________
and __________.
17. The four broad attributes of a nation that shape the environment
are __________, __________, __________, and __________.

7.4 Balance of Payment

In the words of Kindleberger, “The balance of payments of a country is
a systematic record of all economic transactions between the residents
of the reporting country and the residents of foreign countries during a
given period of time.”In other words, it is a statement of account recording
all international receipts and payments of a country with the rest of the
world. Thus, the balance of payments of a country serves as an important
index that reflects the true economic position of a country.
The economic transactions of a country with the rest of the world can
be broadly classified as:
1. Visible Items which include the export and import of all types of
physical goods (made of matter/material) which are recorded at the
ports (i.e. can be seen crossing the borders).
2. Invisible Items which include the export and import of all types of
services, like those rendered by shipping, banking and insurance
companies, payment ports of interest etc., which are not recorded
at the (i.e. cannot be seen crossing the borders)
3. Capital Transfers that involve the transfer of assets. Such transfers
are concerned with capital receipts and payments of a country with
the other countries.
Thus, “the balance of payments shows the country’s trading position,
changes in its net position as foreign lender or borrower, and changes
in its official reserve holding.”
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Notes 7.4.1 Balance of Trade

The balance of trade (positive or negative) is the difference between the
value of exports and imports of goods i.e. visible items only. Thus,
Balance of Trade = Export of visible items – Import of visible items
During a given period of time, the balance of trade is said to be balanced
if the difference between the value of exports and the value of imports
of visible items is zero. In other words, the country is said to have a
balance of trade if the value of exports is exactly equal to the value
of imports. But, it is not necessary that the country will always have a
balanced balance of trade. If the value of exports exceeds the value of
imports during a given time period, the country is said to have an export
surplus or a favourable balance of trade. On the other hand, if the value
of imports exceeds the value of exports, the country is said to have an
import surplus (export deficit) or unfavourable (adverse) balance of trade.

7.4.2 Balance of Trade and Balance of Payments

The terms balance of trade and balance of payments, though related to
each other, do not have the same meaning. Table 7.5, summarizes the
difference between the balance of trade (BOT) and the balance of pay-
ments (BOP).

Table 7.5: Difference between the Balance of Trade

and Balance of Payments
Balance of Trade (BOT) Balance of Payments (BOP)
1. Balance of Trade is defined as the Balance of payment is defined
difference between the exports and as ‘a systematic record of all
imports of goods (visible items.) economic transactions between
the residents of the reporting
country and the residents of for-
eign countries during a given
period of time.’
2. BOT = Net Earnings on Exports – BOP = Current Account Balance
Net payments made for imports. + Capital Account Balance +
Errors and Omissions (–Balanc-
ing item)

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 Theories of Trade and Balance of Payment

Balance of Trade (BOT) Balance of Payments (BOP) Notes

3. BOT is favourable if exports exceed BOP will be favourable if the
the imports of goods and unfavour- country is able to pay off all
able if imports exceed the exports past loans in her capital account
of goods. from the surplus in the current
account. However, BOP is said
to be unfavourable if the country
borrows from the foreigners to
offset its current deficit.
4. The main factors that affect BOT are: The main factors that affect BOP
(i) Cost of production are:
(ii) Availability of raw materials (i) All factors affecting BOT
(iii) Exchange rate  conomic policy of the gov-
(ii) E
ernment
(iv) Domestic price of goods
(iii) Conditions of foreign lenders.
5. In the accounting sense, BOT may In the accounting sense, BOP
be favourable, unfavourable or in always balances i.e. receipts are
equilibrium. always equal to payments.
6. It is not an indicator of the economic It gives a true picture of the econ-
performance of a country. omy’s economic performance.
7. BOT is a narrow concept BOP is a more comprehensive
term.
8. BOT is a part of the current account BOP comprises of three accounts
of the BOP of which BOT is only one part
of the current account.

7.4.3 Components of Balance of Payment

Broadly, the balance of payment (BOP) account includes: (i) current ac-
count (ii) capital account and (iii) official settlements account as shown
in Table 7.6.

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Notes Table 7.6: Components of Balance of Payments (BOP) Account

Credits (+) (Receipts) Debits (–) (Payments)
I. Current Account
1. Export of goods 5. Import of goods
2. Export of services 6. Import of services
3. Income received (Interest, 7. Income paid (Interest, profit and
profit and dividends dividends paid)
received) 8. Unilateral payments (Transfer payments
4. Unilateral receipts made)
( Tr a n s f e r p a y m e n t s
received)
II. Capital Account
9. Foreign investment 12. Investment abroad
10. Short term borrowings 13. Short-term lending
11. Medium and long term 14. Medium and long-term lending
borrowing
III. Official Settlement Account
15. Increase in foreign official 16. Increase in official reserve of gold
holdings and foreign currencies.
IV. Errors and Omissions

7.4.3.1 Current Account

The current account of the balance of payments includes all transactions
relating to trade (imports and exports) in goods, services, income and current
transfer and thus constitutes an important segment of balance of payments.
Components of Current Account
In the current account, the merchandise exports and imports are the most
important items. For the purpose of compilation of balance of payments,
exports are valued on the basis of ‘free on board’ (f.o.b.) whereas im-
ports are valued on the basis of ‘cost, insurance and freight’ (c.i.f.). The
difference between the exports and imports of a country is its balance of
visible trade or merchandise trade or simply balance of trade. If visible
exports exceed the visible imports, the balance of trade is favourable
whereas it is unfavourable if the visible imports exceed the visible exports.

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 Theories of Trade and Balance of Payment

It is, however, the invisible items of the current account, namely ser- Notes
vices, income and transfer payments, that reflect the true position of the
balance of payments account. While service transactions include costs
of travel, transportation, insurance, communications, royalties, financial
and computer services, and other business services that are becoming
increasingly important, income and transfers include receipts and pay-
ments of interests and dividends on investments and gifts, donations,
grants etc, respectively.
The net value of these visible and invisible trade balances is the balance
of the current account that may be favourable or unfavourable.
Current Account Deficit/Surplus
A nation’s current account balance may be either a deficit or a surplus,
depending on whether its total receipts from other countries are less than
or greater than its total payments to other countries. A current account
deficit occurs when a country sends more money abroad than it receives
from abroad. If the nation receives more money from abroad than it sends,
it has a current account surplus.
7.4.3.2 Capital Account
The capital account of the balance of payments shows an international
flow of loans and investments between residents of a country and the rest
of the world. In other words, the capital account represents a change in
the asset and liability status of the residents of a country or its govern-
ment. In short, capital account transactions record long term as well as
short term capital receipts and payments.
Components of Capital Account
The main components of capital account as classified by the Reserve
Bank of India are as follows:
1. Loans/Borrowings
(i) Commercial Borrowings: Commercial borrowings include
borrowings by the government and the private sector from
the world money market at the market rate of interest without
considerations of any concession.
(ii) External Assistance: External assistance includes borrowings
by the country from the foreign countries under concessional

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Notes rate of interest. Thus, borrowings as external assistance

involve a lower rate of interest as compared to the interest
rate prevailing in the open market.
2. Foreign Investment
(i) Foreign Direct Investment (FDI): Foreign Direct Investment
refers to the purchase of assets in the world market by acquiring
control over them. For example, purchase of a firm or setting
up a plant by RELIANCE INDUSTRIES in the rest of the
world.
(ii) Portfolio Investment: When the residents (industry/firm) of
a country purchase shares in the foreign companies or bonds
issued by foreign government over which they have no control
is referred to as portfolio investment. For example, the Reliance
Industries buys shares in foreign companies.
3. Banking Capital
Banking capital refers to the capital transactions in the form of
foreign exchange transactions and investment in foreign currency
and securities by the foreign branches of Indian commercial banks.
It also includes deposits made by non-residents and changes in gold
and foreign exchange reserves with the RBI.
4. Other Capital
All movements of capital not included above are recorded under
this head.
Thus, capital account in the balance of payments shows international
lending and borrowing of long-term as well as short-term capital.

7.4.3.3 Official Settlement Account

The official settlement account is in fact a part of the capital account.
The official settlement account measures the change in nation’s liquid
and non-liquid liabilities to foreign official holders and the change in a
nation’s official reserve assets during the year.
The official reserve assets of a country include its gold stock, holdings
of its convertible foreign currencies and SDR’s and its net position in
the IMF.

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7.4.3.4 Errors and Omissions Notes

Imperfect compilation procedures and different data sources may lead to
imbalances in the balance of payment account. This imbalance is termed
as ‘net error and omissions’ and is explicitly identified in the BOP state-
ment. In simple terms, net errors and omissions is the difference between
the current balance and the capital balance.

7.4.4 Difference between Current and Capital Account

The following differences between the current account and the capital
account of the balance of payments account have been enumerated below:
Current Account Capital Account
1. Payment for currently produced goods Payment of debts and claims
and services is recorded in the current is recorded in the capital
account. Interest earned or paid on account.
claims, gifts and donations are also
included.
2. The level of national income is directly The capital account influ-
affected by the current account of the ences the volume of assets
balance of payment. In other words, held by the country. It, how-
receipts and payments in the current ever, does not affect the
account cause a respective increase level of national income
and decrease in the flow of income directly.
in the economy.

7.4.5 Autonomous and Accommodating Items of Balance of Payments

(BOP)
In the words of Sodersten and Reeds, “transactions are said to be au-
tonomous if their value is determined independently of the balance of
payments.” Thus, all those items of BOP accounts are termed as auton-
omous items or ‘above the line’ items that are:
(a) Related to such transactions that are undertaken for profit motive,
(b) Independent of BOP considerations-positive/negative or favorable/
unfavorable, and
(c) Not meant to establish BOP identity.
Since all transactions in the current account and capital account are auton-
omous items, their balance determines the deficit or surplus of balance of
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Notes payments. If the autonomous payments exceed the autonomous receipts,

the balance of payment is said to be in deficit and vice-versa.
Accommodating items, also known as compensatory items are short-term
capital flows, such as drawings from SDR, borrowings from IMF or cen-
tral banks of other countries etc., which have to be made to correct the
disequilibrium in the autonomous items of balance of payment. According
to Sodersten and Reed, “Accommodating items are determined by the net
consequences of the autonomous items.” Thus accommodating items often
referred to as ‘below the line of items’, are meant to bring about equality
between the payment and receipts of foreign exchange by compensating
the surplus or deficit in the autonomous items. In the accounting sense,
therefore, the balance of payments always balances i.e. it is always in
equilibrium theoretically. Table 7.7 summarizes the relationship between
the autonomous and accommodating items.

Table 7.7: Relationship between Autonomous and Accommodating Items

Trade balance a Autonomous items
Transfer payment balance b
Current account balance c = (a + b)
Long-term capital balance d
Basic balance e = (c + d) Accommodating
Short-term private non-liquid capital balance f items
Allocation of SDR’s g
Errors and omissions h
Net liquid Balance i = (e + f + g + h)
Short-term private liquid capital balance J
Official Settlements Balance k = (i + j)
Sodersten and Reed thus point out that “essentially the distinction between
autonomous and accommodating items lies in the motives underlying a
transaction, which are almost impossible to determine”.

7.4.6 Equilibrium and Disequilibrium in the Balance of Payment

Factually, when we speak about the equilibrium and disequilibrium in
the balance of payment, we refer to only the basic balance i.e. we only

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 Theories of Trade and Balance of Payment

consider the autonomous items and exclude the accommodating items. If Notes
there is neither a deficit nor a surplus in the overall balance of payment,
when accommodating items are excluded, the balance of payment of a
country is said to be in equilibrium. On the contrary, the balance of pay-
ment is said to be in disequilibrium if there is either a deficit or surplus.
Disequilibrium in the balance of payments is undesirable and harmful
for the country concerned. However, a deficit balance of payment creates
more difficulties for the economy than the surplus balance of payment
as the burden of bringing about adjustments in it falls more heavily on
the countries having a deficit.

7.4.7 Measures to Control Disequilibrium in Balance of Payment

The disequilibrium in the balance of payments can be corrected (con-
trolled) by adopting the measures as discussed below.

7.4.7.1 Automatic Measures

The equilibrium in the balance of payments of an economy can be re-
stored automatically after some time period. For example, under the gold
standard, the disequilibrium in the balance of payments of the concerned
country was automatically corrected through the outflow and inflow of
gold. Similarly, under the paper standard, the disequilibrium in the bal-
ance of payment is automatically corrected through the fluctuations in the
exchange rate. For e.g., in a situation of an adverse balance of payment,
the demand for foreign exchange becomes more than its supply. As a
result, the exchange value of the currency goes down. Consequently, the
exports are encouraged and the imports are discouraged. The opposite
happens in a favorable balance of payments situation.
However, the automatic measures were not very effective in the short
run as well as in dealing with a serious disequilibrium in the balance of
payments. Thus, deliberate measures had to be undertaken by the con-
cerned country in order to bring about an improvement in its balance of
payments.

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Notes 7.4.7.2 Deliberate Measures

In order to improve the disequilibrium in the balance of payment situa-
tion, the concerned country has to resort to certain deliberate measures
that can be classified as follows:
1. Trade Measures: The trade policy measures refer to the measures
adopted by the economy to promote exports and reduce imports in
order to improve the balance of payments.
(a) Export Promotion: Exports can be pushed up by the government
by:
(i) Reducing or completely abolishing the export duties. The
goods become cheaper in foreign countries thereby
encouraging exports.
(ii) Giving subsidies and cash assistance to the exporters. This
helps in cutting down their production costs on one
hand and improving their competitive position in the
international market on the other.
(iii) Providing incentives to the exporters in the form of tax
exemption on exportable goods.
(b) Import Control: The deficit in the balance of payment can be
kept in check by reducing imports. The imports can be cut
down by:
(i) Imposing new import duties or tariffs and increasing the
existing import duties. The price of the imported goods
rises. They become more expensive in the domestic
economy and as a consequence the demand for imported
goods will decline. This helps in reversing the deficit
in the balance of payment.
(ii) Adopting the import quota system. The volume of
imports are restricted by quotas by applying quantitative
restrictions i.e. the imports of the country cannot exceed
the quota fixed by the government. If, however, the
importers import more than the fixed quota, they have
to pay a penal rate of import duty.
(iii) Prohibiting the imports of certain commodities, which are
considered non-essential from the national perspective.
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2. Monetary Measures: The disequilibrium in the balance of payments Notes

is dealt with by the government by adopting the following monetary
measures that are used individually or jointly.
(i) Money Contraction: Currency contraction leads to an automatic
fall in the prices of goods and services. As a result, imports
are discouraged and exports are encouraged. Consequently, the
disequilibrium in the balance of payments is reduced. However,
certain economists do not favour currency contraction as a
method to improve balance of payments. This is because a
fall in prices of goods and services may cause the producers
to incur heavy financial losses due to which they may be
compelled to close down their business. Thus, utmost care must
be taken while using this method to remove the disequilibrium
in the balance of payment.
(ii) Devaluation: When the value of domestic currency in terms of
foreign currency is deliberately reduced by the government in
order to improve its balance of payments, it is referred to as
devaluation. It means that the exports are encouraged because
foreigners pay less for the devalued currency and imports
are discouraged because the residents of the country whose
currency has been devalued pay more for foreign currencies.
Let’s explain this with an example. Suppose, a commodity is
worth $5 in the U.S.A. If the exchange rate is $1 = Rs. 60,
the price of the commodity in terms of Indian currency (Rs.)
is Rs. 300 (5 × 60 = 300). Now, if the Indian government
devalues its currency such that the exchange rate increase from
$1 = Rs. 60 to $1 = Rs. 70, the price of the same commodity
in terms of Indian currency will be Rs. 350 (5 × 70 = 350).
Thus while the domestic price of imported goods increases;
the exports get an additional Rs. 10 (Rs. 70 instead of Rs.
60) in domestic currency for every dollar earned by them.
Therefore, they can afford to reduce the price of their exports
in order to increase their sales.
(iii) Exchange Controls: Exchange controls is yet another method
to bring about equilibrium in the balance of payments. Under

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Notes this method, the exporters are required to surrender their

foreign exchange earnings to the central bank in exchange
for domestic currency. The foreign exchange so surrendered
to the central bank is then rationed out among licensed
importers. Thus, imports are kept within limit. Similarly, all
importers buy foreign exchange from the central bank to make
payments for imports. In such a case, the central bank may
provide foreign exchange for the imports of only essential
goods. Thus, the volume of imports is restricted by utilizing
the exchange control system.
3. Miscellaneous Measures: Apart from the monetary and trade measures
as discussed above, the following other measures are undertaken to
improve the balance of payments.
‹ Foreign Loans: Deficit in the balance of payments can be
corrected by government borrowings from foreign banks, foreign
governments or international financial institutions like the IMF,
the World Bank etc. Since the repayment of these loans is spread
over a long period, this helps the government to remove the
deficit in the balance of payments by utilizing the time spread
in improving the foreign exchange position.
‹ Foreign Investment: The government tries to attract foreigners
to make investment in the country by offering them various
incentives and concession, for example raising the domestic rate
of interest and/or offering tax concessions to foreign investors
etc. Consequently, there is more capital inflow in the economy
from abroad that helps the government to reduce the deficit in
the balance of payments.
‹ Tourism Development: In order to earn foreign exchange,
the government attracts foreign tourists to visit the country in
increasing numbers by offering them various facilities like good
hotels, transport facility, concessional travel etc. This helps in
increasing the foreign exchange earnings of the country which
is utilized by the government to reduce the balance of payments
deficit.
‹ Foreign Remittances: The government encourages foreign
remittance by giving various incentives to people working abroad.

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 Theories of Trade and Balance of Payment

This helps in more inflow of foreign exchange which in turn Notes

helps in reducing the deficit in the balance of payment.
‹ Import Substitution: Production of substitutes of imported
goods is encouraged by the government by providing various
incentives and concessions to the domestic industries. This helps
the government in saving foreign exchange by replacing imported
goods with their substitutes.
IN-TEXT QUESTIONS
18. BOP is a __________ recording all international receipts and
payments of a country with the rest of the world.
19. The difference between the exports and imports of visible items
is known as __________.
20. When the value of domestic currency in terms of foreign currency
is deliberately reduced by the government, it is referred to
as__________.

7.5 Summary
This chapter discusses various theories of international trade so as to de-
velop a conceptual understanding of the fundamental principles underlying
international trade. Early trade was based on the theory of mercantilism
that measured the wealth of a nation by the size of its accumulated trea-
sures of gold and silver. In order to accumulate such financial wealth,
the theory suggested a nation should encourage exports and discourage
imports. Since one country’s gain was dependent upon another’s loss, trade
was considered to be a zero-sum game. However, the later theories of
specialization promulgated that trade enhances the overall global wealth
by way of enhancing world production. The theory of absolute advantage
emphasizes that a country should produce and export those goods that
it can produce more efficiently than others. The theory of comparative
advantage advocates that even if a country does not have an absolute
advantage in the production of any goods, it should produce those goods
that it can produce more efficiently than others.
As per the Heckscher-Ohlin factor endowment theory, a nation will
export the commodity whose production requires an intensive use of

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Notes the nation’s relatively abundant and cheap factors and will import the
commodity whose production requires the intensive use of the nation’
scarce and expensive factors. However, the Leontief paradox does not
support the factor endowment theory and finds that the US exports more
labor-intensive commodities and imports more capital-intensive products.
Posner’s Imitation gap theory simply states that technological innovation
and the introduction of a new product leads to the imitation gap and the
demand gap in the other country. The extent to which trade will take
place between the two countries depends on the net effect of the imitation
gap and the demand gap. The new trade theory brings in the concept of
economies of scale leading to increase in returns, enabling countries to
specialize the production of such goods. The shifting patterns of mar-
kets as well as manufacturing bases are aptly explained by the theory
of international product life cycle. The theory of competitive advantage
emphasizes upon environmental factors, such as factor conditions, demand
conditions, related and supporting industries, firm strategy, structure, and
rivalry as determinants of national competitiveness. The trade theories
also provide guiding principles for the regulatory framework and trade
promotion strategies to a varying extent to national governments and
international organizations.
A country’s balance of payment is the summary of all economic transactions
of a country that have taken place between the country’s residents and the
residents of other countries during the specified period. The constraints
in the growth of India’s exports, as summarized in the chapter, include
India’s adoption of the import substitution rather than export promotion
strategy, overprotection to Indian industry from external competition, high
import tariffs and other barriers, inadequate infrastructure, and complexity
of trade procedures.

7.6 Answers to In-Text Questions

1. Trade Surplus
2. David Hume
3. Zero sum game
4. Increasing returns to scale; network effects
5. Mathematical economics

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 Theories of Trade and Balance of Payment

Notes
6. Adam Smith
7. Absolute difference in costs
8. David Ricardo
9. Geographical division of labour; specialization in production
10. Supply
11. Eli Heckscher; Bertil Ohlin
12. Wassily Leontief; Leontief Paradox
13. Price; physical
14. Introduction; growth; maturity; decline
15. Importer
16. Government policy; chance events
17. Factor conditions; demand conditions; related and supporting
industries; firm’s strategy, structure, and rivalry
18. Statement of account
19. Balance of trade
20. Devaluation

7.7 Self-Assessment Questions

1. Analyze the product life cycle theory of international trade in detail.
What criticisms are levelled against it?
2. What are the main differences between the factor proportions and
product life cycle theories of international trade?
3. Explain Porter’s theory of national competitive advantage as a theory
of international trade.
4. How is the factor proportion theory superior to the classical theory
of international trade?
5. Critically examine the Leontief Paradox.
6. What are the assumptions and criticisms of Ricardo’s theory of
international trade?

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Notes 7. Explain the absolute and comparative advantage theory of international

trade.
8. What are the main sources of national competitive advantage? What
are the sources of competitive advantage that explain the success
of a product that you think is very successful in your country?
9. Critically examine the Heckscher-Ohlin theory of international trade.
10. What is the balance of payment account? What are its different
components?
11. (a) The balance of payment account is a cash flow statement that
records the flow of foreign exchange from all international
transactions over a period of time.’ Discuss.
(b) List the constituents of the current account and capital and

financial account of the balance of payment accounts.
12. Discuss the various components of Balance of Payment Account.
13. “Balance of Payments always balances.” Elucidate. How do you
explain disequilibrium in balance of payments?
14. What are the causes of an adverse balance of payments? Give
suggestions to remove an unfavourable balance of payments.
15. Distinguish between:
‹ Balance of Current Account and Balance of Capital Account
‹ Autonomous and Accommodating Transactions
‹ Deficit and Disequilibrium in Balance of Payments.

7.8 References
‹ A. J. Brown, Prof. Leontief and the Pattern of World Trade. Yorkshire
Bulletin of Economic and Social Research, November, 1957.
‹ B. C. Swerling. Capital Shortage and Labour Surplus in the United
States, RES Vol. 36, August, 1954.
‹ B. J. Coher. Balance of Payments Policy, 1969.
‹ Charles P. Kindleberger. International Economics, 1978, p. 17.
‹ M. L. Jhingan. Macroeconomic Theory, 11th edition.

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 Theories of Trade and Balance of Payment

‹ N. S. Buchanan. Lines on the Leontief Paradox, Economic Internazionale, Notes

November, 1955.
‹ P. O. Kenen. Nature, Capital and Trade, JPE, October, 1956.
‹ Raymond Vernon. International Investment and International Trade
in the Product Cycle, Quarterly Journal of Economics 80 (May
1966), pp. 190-207.
‹ W. P. Travis, The Theory of Trade and Protection, 1964.
‹ W. W. Leontief, Factor Proportions and the Structure of American
Trade; Further Theoretical and Empirical Analysis, RES, November,
1956.

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 L E S S O N

8
Exchange Rates and the
Mundell-Fleming Model
Dr. Minesh Kumar Srivastava
Assistant Professor
School of Business Studies
Vivekananda Institute of Professional Studies
Technical Campus, New Delhi
Email-Id: [email protected]

STRUCTURE
8.1 Learning Objectives
8.2 Introduction
8.3 Exchange Rates and the Foreign Exchange Market
8.4 Capital Account Convertibility
8.5 The Mundell-Fleming Model
8.6 Summary
8.7 Answers to In-Text Questions
8.8 Self-Assessment Questions
8.9 References
8.10 Suggested Readings

8.1 Learning Objectives

After reading this chapter, you will be able to:
‹ Understand the meaning of exchange rates and how it is determined.
‹ Differentiate between various types of exchange rate regimes.
‹ Understand the concept of capital account convertibility.
‹ Determine the equilibrium level in money market and goods market with the help
of Mundell-Fleming model.

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8.2 Introduction Notes

Over the past three decades, financial markets in India and other coun-
tries have become much more interconnected. Greater capital flows and a
stronger correlation between asset returns across nations are two effects of
financial market integration. The Indian economy has opened up signifi-
cantly, proving that the globalisation you read about is indeed a reality.
Other chapters emphasise the connections between the Indian economy
and the economies of other countries through examples and perspectives.
These relationships take centre stage because in this chapter we explicitly
discuss the macroeconomics of open economies. This chapter examines
how exchange rates are set, the current global monetary system, as well
as how our domestic economy and global economy interact. We start by
describing the various exchange rate systems used to determine exchange
rates in currency markets. Then the current global monetary system’s
actual exchange rate arrangements are examined. After that a comparison
of pegged and flexible exchange rate systems is made. Finally, the risks
posed by some rising trade imbalances are assessed.
The main topic of discussion of this chapter is exchange rates. The
price of one currency in relation to the other is known as the exchange
rate between two currencies. On 1st March 2023, the price of an American
dollar was Rs. 81.72 ($1 = 81.72 rupees), and the price of a euro was
Rs. 86.90. When Indian residents want to buy foreign goods or assets,
as well as when foreign residents want to buy Indian goods and assets,
exchanges between the Indian rupee and other currencies take place. In
this chapter we will examine how exchange rates are set between India
and other nations.

8.3 Exchange Rates and the Foreign Exchange Market

Demand for foreign exchange is the term used to describe the demand for
foreign currencies by domestic residents. The market where different national
currencies are exchanged is known as the foreign exchange market. For
instance, this market is where Indian citizens sell their rupees in order to
buy foreign exchange (foreign currencies). To understand how the balance
of payments accounts and transactions in the foreign exchange market
are related, we must first acknowledge that all foreign purchases made

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Notes by Indian residents as well as all foreign transfer payments (also known
as foreign exchange debits, which is a general term for an aggregate of
foreign currencies in the balance of payments accounts) also represent
demands for foreign currencies, or demands for foreign exchange.
The European exporter will demand payment in Euro even though the
Indian resident purchasing the European car does so in rupees. Therefore,
on the foreign exchange market, rupees must be converted into Euro. Take
another example, in order to purchase a share of stock on the London Stock
Exchange, an Indian rupee must first be converted into British pounds
by the broker. The overall foreign spending by Indian citizens indicates
a demand for foreign currency. When viewed from the perspective of the
rupee, we can say that the total foreign expenditure of Indian residents
represents an equal supply of rupees in the foreign exchange market. On
the other hand, all of the foreign income earned by residents of India
reflect equal earnings of foreign exchange. For instance, Indian exporters
will demand payment in rupees, and foreign buyers must exchange their
money for rupees in order to purchase our goods. The total credits in the
balance of payments accounts then equal the supply of foreign currency,
or the demand for rupees, which is the same thing.

8.3.1 Demand and Supply in the Foreign Exchange Market

The foreign exchange market is where exchange rates between different
national currencies are decided. To understand this process, we make the
following assumptions. At first, we do not include central bank official
reserve transactions. We assume that central banks do not intervene in
the foreign exchange market. This assumption will be relaxed later in
this section. For the sake of simplicity, we also assume that there are
only two nations: “Europe” and “India,” with euro and rupee as their
official currency.
In this straightforward scenario, the exchange rate is the relative price of
the two currencies, which we express as the price of the euro in terms of
rupees. For example, if the price of the euro is 100 rupees, then 1 euro
trades for 100 rupees; at 125 rupees, the exchange rate (price of the euro)
is higher, and 1 euro equals 125 rupees, (0.80 euro = 100 rupees). It’s
crucial to keep in mind that when the exchange rate is expressed in this
way, a higher exchange rate denotes an increase in the price of foreign

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 Exchange Rates and the Mundell-Fleming Model

currency (or foreign exchange). When the exchange rate rises, we refer Notes
it as an appreciation of foreign currency or the depreciation of rupee.
Alternatively, a drop in the exchange rate indicates a decrease in the
price of foreign exchange (the price of the euro). The rupee has appre-
ciated while the euro has depreciated. Figure 8.1 displays the foreign
exchange supply and demand schedules plotted against the exchange rate
(π). Foreign expenditures such as Imports, purchases of foreign assets, and
transfers made by Indian citizens abroad are all considered demands for
foreign currency. Figure 8.1 depicts a downward sloping demand curve
(Dfe), indicating a fall in the demand for foreign exchange as the price of
foreign exchange (price of euros) rises. The reason is that rising foreign
exchange rates will make foreign goods more expensive in rupees. As a
result, imports will decrease and the demand for foreign exchange will
decrease.

Figure 8.1: Demand and Supply in the Foreign Exchange Market

Keep in mind that we are holding all prices except the exchange rate,
constant. Let’s say you’re thinking about spending 200 euros on a handbag
made in France. The handbag will cost Rs. 20,000 if the exchange rate, or
the price of the euro in terms of rupees, is 100 (200 euros = Rs. 20,000
at a 100 euro to rupee exchange rate). The price of the handbag will
increase to Rs. 25,000 if the exchange rate increases to 125 (200 euros
= Rs. 25,000 at 0.08 euro to the rupee). The cost of imported goods in
rupees increases as the exchange rate rises. Now take into account the
demand for foreign exchange for transfers to foreign countries and the

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Notes purchase of foreign assets. We do not find a clear correlation between the
volume of international transfers and the exchange rate. It is unclear how
the change in the exchange rate will affect international aid initiatives,
or gifts to foreign nationals. When buying foreign assets, an increase
in the exchange rate will increase the price of foreign stocks or bonds
in rupees, just like it does when buying imported goods. However, a
proportional increase in the interest or dividend payment on the foreign
bond or stock, again expressed in rupees, will also follow a rise in the
exchange rate. For instance, at an exchange rate of 100 (1 euro = 100
rupees), a French bond that costs 800 euros and pays 80 euros in interest
a year would cost 80,000 rupees and pay 8000 rupees in interest a year.
The bond will cost Rs.1,00,000 and have an annual interest payment
of Rs. 10,000 at a conversion rate of 125 (0.80 euro = 100 rupees). In
either scenario, the bond generates an annual return of 10%. As a result,
we would not necessarily anticipate that a change in the exchange rate
would have any impact on the demand for foreign assets. Only the fact
that imports decrease as the exchange rate increases contribute to the
downward slope of the demand for foreign exchange.
Figure 8.1 depicts the supply schedule for foreign exchange with a posi-
tive slope indicating the supply of foreign exchange rises as the exchange
rate rises. As the exchange rate (price of euros) rises, exports from India
to Europe become more affordable. Once more, we are maintaining the
fixed rates of all other prices, including the rupee value of Indian exports.
For instance, Europeans would pay 5 euros per bushel for Indian wheat
that sells for 500 rupees per bushel at an exchange rate of 100 but only
4 euros at an exchange rate of 125. As the exchange rate rises, there
should be an increase in the demand for Indian exports. Observe, how-
ever, that at the higher exchange rate, a given rupee volume of exports
earns less foreign currency (fewer euros). For instance, if the exchange
rate increased by 10% and the volume of exports in rupees increased as
a result, foreign exchange earnings would remain unchanged. India would
sell 10% more but make 10% less in euros on average. The foreign de-
mand for our exports must be more than unit elastic, which means that
a 1 percent increase in the exchange rate (which results in a 1 percent
decline in the price of the export good to Europeans) must result in an
increase in demand of more than 1 percent, in order for the supply of

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 Exchange Rates and the Mundell-Fleming Model

foreign exchange to increase as the exchange rate rises. If this requirement Notes
is satisfied, the volume of our exports in rupees will increase more than
proportionately to the increase in the exchange rate, and the earnings
of euros (the supply of foreign exchange) will rise as the exchange rate
increases. In Figure 8.1, we have made this assumption.

8.3.2 Exchange Rate Determination: Flexible Exchange Rates

We have not yet included central bank intervention (official reserve
transactions). Only autonomous transactions in the balance of payments
accounts are included in the supply and demand schedules in Figure 8.1.
Let’s keep making this assumption and examine how, in the absence of
intervention, the exchange rate is set. In this situation, we would antic-
ipate a change in the exchange rate to clear the market and balance the
supply and demand of foreign currency. This equilibrium exchange rate
is shown as π0 in Figure 8.1. A flexible exchange rate system, or floating
rate system as it is sometimes referred to, is one that determines exchange
rates without the involvement of a central bank.

Figure 8.2: Effect of Increase in the Demand for Imports

A set of international laws governing the determination of exchange rates
is known as an exchange rate system or regime. The central banks have
an especially easy set of rules to follow in a totally flexible or floating
rate system because they have no control over the level of the exchange
rate. The market determines the exchange rate. We investigate the impact

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Notes of a shock that increases the demand for foreign exchange in order to
better comprehend the operation of a flexible exchange rate system. Let’s
say that Indian consumers become more interested in imported goods.
Assume, for instance, that rising gas prices lead to a switch from SUVs to
small, foreign cars that are more fuel-efficient. The result of this increase
in import demand would be a shift to the right in the foreign exchange
market’s demand schedule, such as from Dfe0 to Dfe1, as shown in Figure
8.2. India has a higher demand for imports at a given exchange rate,
which causes a higher demand for foreign currency. There is currently an
excess demand for foreign currency at the initial equilibrium exchange
rate π0, (shown as XDfe in Figure 8.2). The exchange rate must increase
to the new equilibrium value of π1. Because the price of imported goods
in rupees increases along with the exchange rate, the increase in the ex-
change rate will result in a decrease in the amount of imports that are
demanded. Additionally, since Indian exports are now less expensive to
foreign buyers due to the increase in the exchange rate, the demand for
exports will grow. The supply and demand for foreign exchange are once
again equal at the new equilibrium with the higher exchange rate (π1).
The rise in import demand causes the rupee to lose value.
India’s exchange rate system hasn’t always been completely flexible.
Central banks, including the RBI, have intervened in the foreign exchange
market to affect the values of their currencies to varying degrees during
this time. The characteristics of the current global monetary system are
covered later. Before we get started, it is helpful to look at how the for-
eign exchange market functions under the system of fixed, or pegged,
exchange rates, which is the complete opposite of a completely flexible
rate system.

8.3.3 Exchange Rate Determination: Fixed Exchange Rates

An international monetary system is a set of regulations governing the
setting of exchange rates and deciding which assets will serve as official
reserve assets. The Bretton Woods system, established after World War II,
is an example of a fixed exchange rate system. Near the end of the war,
negotiations took place to create the international monetary agreements
that made up this system (at Bretton Woods, New Hampshire). To run the
Bretton Woods system, the IMF was established. The United States was

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 Exchange Rates and the Mundell-Fleming Model

required to set a parity, or par value, for its currency in terms of gold in Notes
accordance with IMF regulations. Due to the dollar’s link to gold, other
countries would set their currency parities in terms of dollars, which also
fixed the value of these other currencies in terms of gold.
The United States consented to uphold the fixed exchange rate (originally
$35 per ounce) between the dollar and gold. After a period of post-war
adjustment, other nations agreed to maintain convertibility with the dollar
and other currencies but not with gold. The other nations agreed to keep
their currency values versus the dollar within a 1% range on either side of
parity. Given that the US held roughly two-thirds of the world’s official
gold reserves at the time, the US’s differential obligation to other IMF
members regarding convertibility into gold seemed reasonable.

8.3.4 Pegging the Exchange Rate

We look at how a nation can “peg,” or fix, the level of its exchange rate
in order to understand how a system of fixed exchange rates operates.
In order to accomplish this, we go back to our two-country example and
assume that India wants to fix its exchange rate in relation to the euro,
which we are using to represent the currencies of the rest of the world.
We ignore the 1% margin that was just mentioned and assume that the
RBI wants to set the rupee’s exact par value, such as at a conversion
rate of 100 rupees to 1 euro. Figure 8.3 shows how the foreign exchange
market functions under this fixed exchange rate system.
Assuming a flexible rate system, we assume that the official fixed ex-
change rate of 100 is below the equilibrium rate of 125 (0.80 euro =
100 rupees) shown in Figure 8.3. In such a case, the rupee would be
considered to be overvalued and the euro to be undervalued at the fixed
exchange rate. According to this terminology, if the exchange rate were
set by the market, it would have to increase for the market to be cleared
if the price of the euro was compared to the rupee. What stops this from
occurring? Just to refresh your memory, the demand and supply schedules
we created for the foreign exchange market only measure autonomous
transactions; they do not account for accommodating transactions carried
out by central banks to finance payments imbalances.

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Notes

Figure 8.3: Foreign Exchange Market with a Fixed Exchange Rate

To fix the exchange rate at a value that is not in equilibrium, like the
100 rupees in Figure 8.3, such central bank intervention is necessary.
India must be prepared to buy and sell rupees at that exchange rate in
order to maintain the rate at 100. The exchange rate cannot drop below
that level because no one would sell elsewhere for less if the RBI agreed
to buy 1 euro for 100 rupees. In a similar manner, the exchange rate is
unable to increase above 100 due to the central bank’s willingness to sell
euros at that level. With the exchange rate below the equilibrium rate in
the scenario shown in Figure 8.3, there is an excess demand for foreign
exchange (euros), denoted in the figure as XDfe. The RBI can supply
foreign exchange, i.e., exchange euros for rupees on the foreign exchange
market, to prevent the exchange rate from rising. As an alternative, the
European Central Bank might step in. To meet the excess demand for
euros and keep the price of the euro at the set exchange rate, this bank
would supply euros (sell euros and buy rupees).

8.3.5 Current Exchange Rate System

In 1971, the Bretton Woods system broke down. For major industrialised
nations, the current global exchange rate determination system is best

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 Exchange Rates and the Mundell-Fleming Model

described as a managed float (or in the case of the countries in the euro Notes
area, for a group of countries). Although some allow for varying degrees
of exchange rate flexibility, developing countries frequently have fixed
exchange rate systems. A managed or “dirty” float combines elements of a
fixed rate system and a flexible exchange rate system (the managed part).
The exchange rate is permitted to fluctuate for a nation with a managed
float in response to market forces. The central bank can, however, step
in to stop any unfavourable or disruptive changes in the exchange rate.
We will now examine the issue of how central banks have decided to
intervene in the foreign exchange markets and how an undesirable or dis-
ruptive movement in the exchange rate has been defined in practise. There
is also discussion of the causes of the Bretton Woods system’s failure.
Exchange Rate Arrangements
The exchange rate policies of the nations that are IMF members are
compiled in Table 8.1. As was just mentioned, there is no single system
for determining exchange rates. Some nations set their exchange rates
within a narrow range of 1% or less, either to a single currency or to a
basket of currencies. This is the 42-nation group that the table’s “fixed
peg arrangements” label refers to. Pegged arrangements within bands are
another group that adheres to a fixed exchange rate policy, albeit with
a larger band. Between fixed and flexible rates, the currency category
known as “crawling pegs” modifies the value of its currency in relation
to a central rate in response to a number of economic indicators (such as
domestic versus foreign inflation rates). The group labelled “participate
in an exchange rate mechanism” comprises the European nations that
have adopted a common currency, the euro, but float as a group relative
to other currencies. More information about this exchange rate setup is
provided later in the chapter. The 77 countries listed next in the table
all have managed floats but have floating rate systems. The last group,
dubbed “other,” uses a different system for determining exchange rates.
Among the nations with floating exchange rates are the United States,
Canada, the United Kingdom, and Japan.

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Notes
Table 8.1: Exchange Rate Arrangement of IMF Member Countries
Exchange Rate Arrangements No. of Countries
Fixed peg arrangements 42
Pegged arrangements within bands 14
Crawling pegs 5
Participate in an exchange rate mechanism 17
Managed floating and float independently 77
Other 34
(Source: IMF, International Financial Statistics)
How much managing? How much floating?
To prevent disruptive changes in their exchange rates, central banks
intervene in the foreign exchange markets in a managed float. Their ex-
change rates float otherwise. The degree to which industrialised nations
intervened in the foreign exchange market varied significantly during the
post-1973 era. The American central bank frequently intervened in the
foreign exchange market in the 1970s. For instance, the U.S. govern-
ment organised a significant support programme for the dollar’s price in
November 1978. The Reagan administration declared in 1981 that central
bank intervention would only take place when it was absolutely neces-
sary to stop chaos in the foreign exchange market brought on by crisis
situations. U.S. intervention in the foreign exchange market significantly
decreased after this change in how one should define a disruptive move-
ment in the exchange rate. The current exchange rate system prevents
the price of the dollar from floating freely even in the absence of U.S.
central bank intervention because other central banks buy or sell dollars
to affect the value of their currencies relative to the dollar. For instance,
European central banks sold dollars from their reserve holdings in 1981
and 1984 to halt the rise in the price of the dollar, which would have
resulted in a decline in the value of their respective currencies (a rise in
their exchange rate relative to the dollar). Then, with the signing of the
Plaza Accord in September 1985, coordinated intervention by the central
banks of the major industrialised nations to devalue the dollar began
(raising the U.S. exchange rate). For reasons that will be discussed later,
these central banks reversed course in 1987 and once more intervened
jointly to support the dollar. The main currency market interventions in

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recent years have involved Asian central banks buying dollars. To keep Notes
the value of its currency pegged, the Bank of China amassed enormous
reserves. To prevent (or at least limit) the appreciation of the Japanese
yen, the Bank of Japan has also purchased a significant amount of dol-
lars. To increase their stock of reserves, other Asian central banks have
spent hundreds of billions of dollars on purchases.
Advantages of Alternative Exchange Rate Regimes
Each nation, or group of nations, selects an exchange rate regime within
the current framework for determining exchange rates. The selection of the
degree of exchange rate flexibility is a crucial component of this choice.
A nation makes a decision along a spectrum that, at one end, calls for
total exchange rate flexibility and, at the other, a rigid peg. Other con-
siderations when choosing an exchange rate regime include the quantity
and kind of reserve assets to hold, as well as the currency to use as the
basis for any currency pegs. However, the exchange rate regime’s choice
of degree of flexibility is crucial. Economists and central bankers have
long disagreed about the relative advantages of pegged (fixed) versus
flexible exchange rates. We examine the main justifications offered for
and against each system in this section.
Advantages of Exchange Rate Flexibility
We start with the justifications put forth for exchange rate flexibility. One
benefit of more exchange rate flexibility is that it would free policymak-
ers from worrying about balance of payments deficits, allowing them to
focus on domestic objectives. Potential conflicts between internal balance
(domestic goals) and external balance would be eliminated (balance of
payments equilibrium). Secondly, exchange rates that are flexible would
protect the domestic economy from shocks to the global economy.
Policy Independence and Exchange Rate Flexibility
According to our earlier analysis, a country’s central bank would lose
official reserve assets if it intervened in the foreign exchange market to
finance a balance of payments deficit. The central bank would eventual-
ly run out of reserves as a result of ongoing deficits. The central bank
would need to implement measures to close the balance of payments
deficit before reserves ran out. Here is where there may be a conflict
between domestic objectives and the balance of payments. We look at

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Notes the relationship between the major balance of payments items and the
level of domestic economic activity to better understand the nature of
the conflict.
The Trade Balance and the Level of Economic Activity
Figure 8.4 shows the domestic national income on the horizontal axis,
along with imports (Z) and exports (X) on the vertical axis. The import
schedule is drawn sloping upward because the demand for imports de-
pends positively on income. Because income has a positive impact on
consumption, this relationship follows. Consumption of both domestic and
imported goods rises as income rises. Additionally, as domestic national
income rises, the need for imported inputs will grow (e.g., imported crude
oil). The export schedule, however, is horizontal. The foreign demand for
imports includes the demand for Indian exports. Foreign income deter-
mines the demand for imports from abroad. India views foreign income
and consequently the need for exports as exogenous factors.
The relative price levels in the two countries as well as the level of
the exchange rate are additional factors that affect both Indian demand
for imports as well as foreign demand for Indian exports. These factors
determine the relative costs of the goods produced by the two countries
for the citizens. For the time being, we will assume that both price levels
and the exchange rate are constant. Exports and imports will be equal
if income is at YTB = 0, as shown in Figure 8.4. (where TB, the trade
balance, equals zero). With this level of income, import demand equals
exogenous export level. However, there is no reason to believe that the
equilibrium level of income will be YTB = 0. The overall economy’s ag-
gregate demand and supply, not just that of the international sector, will
determine equilibrium income.
Assume, for instance, that the equilibrium income in Figure 8.4 is at Y0,
above YTB = 0. At Y0, there is a trade deficit because imports are higher
than exports. In earlier chapters, we have seen how, at least according to
the Keynesian perspective, aggregate demand management can influence
equilibrium income. These policies could then be used to raise equilibrium
income to the point where exports and imports are equal, or YTB = 0.
This would be a position of external balance for the economy, which in
a fixed exchange rate system means balance of payments equilibrium, if
the other current account items and the financial account were in balance

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(official reserve transactions deficit equals zero). In Figure 8.4, the deci- Notes
sion-maker could, for instance, use a stringent fiscal strategy like a tax
hike to lower income from Y0 to YTB = 0.

Figure 8.4: Trade Balance and the Level of Economic Activity

Politicians, however, also have domestic objectives. Achieving internal
balance requires the use of policies for aggregate demand management
in the Keynesian framework in order to pursue goals for unemployment
and inflation. The issue is that there is no evidence to support the notion
that the level of income that results in external balance is also the level
that is best for achieving domestic objectives. Assume, for instance, that
Y0 in Figure 8.4 represents the ideal level in terms of domestic goals.
Internal balance would be upset and an unfavourably high unemployment
rate would result from using a restrictive fiscal policy to reduce income
to YTB = 0. However, if income is kept at Y0, there will be a trade deficit
and no external balance in the economy.
Capital Flows and the Level of Economic Activity
Expected rates of return on assets in each country serve as the main
determinants of capital flows between countries. With a fixed exchange
rate system, asset returns are not affected by anticipated exchange rate
movements (except at times when there is speculation that the official
exchange rate is to change). The different countries’ interest rates will
serve as indicators of the relative rates of return. If we assume that other
countries rates of return are constant, the amount of capital entering a

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Notes given nation will positively depend on the level of that nation’s interest
rate (r); that is,
F = F(r) (8.1)
Where, F is the net inflow of capital (a negative value of F represents
a net outflow or deficit on the financial account). Therefore, how the
interest rate changes in response to changes in economic activity will
determine how those changes affect the balance on the financial account.
Start by taking into account the rises in economic activity brought on by
expansionary monetary policies. By lowering the interest rate, an expan-
sionary monetary policy will increase aggregate demand. The balance on
the financial account will suffer as a result of the lower interest rate. As
foreign assets become comparatively more appealing, foreign investment
in India will decrease while Indian investment abroad will rise. As we
saw in the section before, increases in income for any reason lead to an
increase in imports while maintaining export levels, which worsens the
trade balance. The trade balance and the financial account will worsen
if the increased income is the result of an expansionary monetary policy.
What if, on the other hand, the rise in economic activity was the result of
an expansionary fiscal strategy? With a fixed money supply, the interest
rate will rise as income rises due to an increase in the demand for money.
In this instance, an increase in interest rates coincides with an increase in
income. As a result, the increase in interest rates will encourage a cap-
ital inflow even though the trade balance is getting worse. The relative
strength of these two effects of the fiscal policy-induced expansion—the
favourable effect on the financial account or the unfavourable effect on
the trade balance—determines whether the overall effect on the balance
of payments is favourable or unfavourable.
As a result, we discover that in a fixed exchange rate system, there may
be conflicts between domestic objectives, like a low unemployment rate,
and the objective of external balance, as determined by the balance of
payments equilibrium. With regard to monetary policy, the conflict is
particularly severe because expansive policy actions have negative effects
on both the trade balance and the financial account. The price level serves
as a final link between the balance of payments and economic activity.
Expansive aggregate demand policies, whether monetary or fiscal, will
raise prices unless the economy is still far from reaching full employment.
With a fixed exchange rate, an increase in domestic prices will result in
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higher imports and lower exports for a constant level of foreign prices. Notes
Indian citizens will generally find foreign goods to be less expensive,
while foreign consumers will find Indian exports to be more expensive.
The direct negative impact that an economic expansion has on the trade
balance for both monetary and fiscal policies is reinforced by this price
effect on the balance of trade.
Exchange Rate Flexibility and Insulation from Foreign Shocks
The ability of flexible exchange rates to protect an economy from certain
shocks is cited by proponents. Consider a nation that is initially in a state
of macroeconomic equilibrium with an optimal level of unemployment,
an optimal price level, and equilibrium in the balance of payments to
understand the justification for this assertion. Now imagine that there is a
global recession and that foreign income decreases. Because foreign income
determines the demand for this country’s exports (import demand), it will
decline along with the global recession. This decrease in export demand
will be reflected in the foreign exchange market as a leftward shift in
the foreign exchange supply schedule. The foreign recession will cause
the supply schedule to change from Sfe0 to Sfe1, as shown in Figure 8.5.

Figure 8.5: Insulation of the Domestic Economy

in a Flexible Exchange Rate System
The nation would experience a balance of payments deficit equal to dis-
tance AB in Figure 8.5 under a fixed exchange rate system. Additionally,

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Notes the recession abroad will have contractionary effects on the domestic
economy; aggregate demand will fall, and income will decline because
export demand is a portion of aggregate demand (the foreign demand
for domestic output). A system with flexible exchange rates will see an
increase in the exchange rate as a result of the excess demand for foreign
currency (equal to the balance of payments deficit AB) brought on by the
international recession. With the higher exchange rate π1, point C will
represent the new equilibrium. The deficit in the balance of payments
will be eliminated by the increase in the exchange rate. Take note of yet
another feature of the transition to a new equilibrium. As we proceed to
point C, the rise in the exchange rate boosts export demand while reduc-
ing import demand. The increase in exports brought on by the increase
in the exchange rate will cause the aggregate demand to increase. The
decline in imports brought on by the increase in the exchange rate will
also have an expansionary effect; domestic aggregate demand will rise as
people start purchasing domestic goods instead of imports. In the flexible
exchange rate scenario, we can observe that changing the exchange rate
counteracts the contractionary impact of a foreign recession on the do-
mestic economy. In this way, a system of flexible exchange rates protects
an economy from external shocks.
Arguments for Fixed Exchange Rates
Supporters of fixed exchange rates think that a system like this will
create a more stable environment for the expansion of global trade
and foreign investment. They also contend that more effective policy
coordination between industrialised economies and a fixed exchange
rate system will increase macroeconomic stability. The world economy
experienced a period of freely fluctuating exchange rates following
the collapse of an earlier fixed exchange rate system at the beginning
of the 1930s. Ragnar Nurkse, a Norwegian economist, presented the
following arguments in opposition to flexible exchange rates based
on this experience: Freely fluctuating exchange rates have three sig-
nificant drawbacks. First of all, they add a risk component that tends
to deter international trade. Where a forward exchange market exists,
the risk may be mitigated through “hedging” operations; however,
such insurance, if available at all, comes with a cost.

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Secondly, as a means of adjusting the balance of payments, exchange Notes

fluctuations involve constant switching of labour and other resources
between production for the domestic market and production for export.
Such changes may be expensive and upsetting; they frequently lead
to frictional unemployment, and they are unquestionably wasteful if
the exchange-market conditions that necessitate them are temporary.
Thirdly, it has been demonstrated through experience that fluctuating
exchanges cannot always be counted on to encourage adjustment. A
significant and persistent change in the exchange rate may lead to
expectations of further movement in the same direction, which could
lead to speculative capital transfers that disrupt the equilibrium.

8.4 Capital Account Convertibility

The current account and capital account make up the balance of payments
account, which is a statement of all transactions between a nation and
the outside world. The capital account is made up of the cross-border
movement of capital through investments and loans, whereas the current
account primarily deals with the import and export of goods and services.
The ability of a country’s currency to be converted into any other for-
eign currency (such as the US dollar, British pound, or Euro) and back
again is referred to as capital account convertibility. It is the ability to
exchange domestic financial assets for foreign financial assets at market
exchange rates. Unrestricted capital movement would eventually result
from full capital account convertibility. Due to the unfavourable current
account situation—India had a sizable current account deficit—the Indian
rupee was not granted full capital account convertibility. The government
wanted to make sure that imports of essential goods and commodities
could be made with foreign currency at a lower cost.
India approached the full convertibility of the rupee for capital accounts
with caution in light of the Mexican crisis. The ensuing East Asian
financial crisis supported the partial convertibility of capital accounts.
In the past, partial capital account convertibility was allowed in certain
circumstances. Complete capital account convertibility can encourage
capital inflows into the nation, but if circumstances worsen, there is a

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Notes sizable risk of capital outflows from the home nation. This may result in
greater exchange rate volatility and even a crisis akin to the one that hit
East Asia. This year, as the government and RBI work to permit more
foreign participation in domestic bond markets, the process of capital
account convertibility is likely to advance.
Evolution of Capital Account Convertibility
India’s path to opening its economy was set in motion by the recom-
mendations of the Narasimham Committee in 1991. The nation had
switched to a market-determined exchange rate and full current account
convertibility within five years. Current account and, to some extent,
capital account transactions were further liberalised with the passage of
the Foreign Exchange Management Act, 1999. Foreign Direct Investment
(FDI) is largely unrestricted in India, where it has contributed nearly
50% of all FDI inflows since 1991 over the past five years. The highest
amount ever invested by FPIs was 10.8 billion dollars in the IPOs of
Indian companies in 2021. Progress on this front has been slow over
the three decades since liberalisation started, and the capital account is
currently only partially open.
Importance
The irregular inflows and outflows of domestic and foreign capital can
cause excessive currency appreciation or depreciation and have an adverse
effect on the stability of the money supply and the financial system. Fol-
lowing the 1997 currency crisis in East Asian nations, India was praised
for its caution in opening up its capital account. According to the S.
S. Tarapore committee’s report on fuller capital account convertibility,
which was published in 2006, even nations with sound fiscal positions
have experienced currency crises and sharp declines in exchange rates.
According to the report, excessive exchange rate appreciation makes
exporting industries unprofitable and makes imports much more compet-
itive, worsening the current account deficit. The Indian government has
made numerous efforts to achieve complete convertibility of the capital
account. Increased foreign portfolio investment limits in the Indian debt
markets, for instance.
‹ Launching the Fully Accessible Route (FAR), which allows NRIs
to invest without restrictions in certain government securities.

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‹ Relaxing end-user restrictions to ease the external commercial Notes

borrowing framework.
‹ Permitting inward FDI in the majority of sectors.
‹ Permitting FDI from Indian-incorporated businesses that is a multiple
of their net worth.

Figure 8.6: Effect of an Expansionary Monetary Policy:

Flexible Exchange Rates

IN-TEXT QUESTIONS
1. The increase in the value of foreign commodities is known as
devaluation. (True/False)
2. Select the correct statements about the balance of payments:
(a) Exchange control is a measure intended to improve the
adverse balance of payments
(b) Import substitution is a measure intended to improve the
adverse balance of payments
(c) Currency devaluation is a measure intended to improve the
adverse balance of payments
(d) All of the above
3. Foreign exchange market is a __________ market. (Forward
market, Spot market or Both)

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Notes 4. The foreign exchange is determined by the supply of foreign

currency alone. (True/False)
5. The foreign exchange transactions that are dependent on other
transactions are known as __________. (Autonomous transactions/
Accommodating transactions)

8.5 The Mundell-Fleming Model

All economies are open to some extent, as they are engage in trade and
capital flows with other nations. We examine monetary and fiscal policy
in an open economy model in this section. How are the outcomes of
policy changes different in an open economy versus a closed economy?
Depending on whether exchange rates are fixed or flexible, how do they
differ? In the earlier discussed system of fixed exchange rates, we take
into consideration any conflicts that might occur between internal and
external balance. We provide examples to show why when exchange
rates are flexible, those conflicts do not occur. There are various macro-
economic frameworks for open economies. The Mundell-Fleming model,
referred to as the workhorse model for open economy macroeconomics.
The IS-LM model has an open economy version called the Mundell-Flem-
ing model. The two equations in the closed economy IS-LM model are
as follows:
M = L(Y, r) (8.2)
S(Y) + T = I(r) + G (8.3)
The money market equilibrium is represented by equation (8.2) and the
goods market equilibrium is represented by equation (8.3) (IS sched-
ule). While maintaining a constant level of aggregate prices, the model
simultaneously determines the nominal interest rate (r) and the amount
of real income (Y). What adjustments are necessary to analyse an open
economy? The LM schedule won’t be changed when an open economy
is taken into account. Equation (8.2) states that in order for there to be
an equilibrium, the real money supply—which we assume is under the
control of the domestic policy maker—must equal the real demand for
money. The policy maker has control over the nominal money supply,
but since prices are assumed to be fixed at a certain level, changes in

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the nominal money supply also affect the real money supply. The goods Notes
market equilibrium condition for a closed economy serves as the basis
for the equation (8.3):
C + S + T ≡ Y = C + I + G (8.4)
Which, when C is subtracted from both sides, reduces to
S + T = I + G (8.5)
If we add imports (Z) and exports (X) to the model, equation (8.4) is
replaced by
C + S + T ≡ Y = C + I + G + X – Z (8.6)
And the IS equation becomes
S + T = I + G + X – Z (8.7)
Where, net exports (X-Z) is the contribution of the foreign sector to total
demand. The open economy IS equation can be written as follows if we
move imports to the left-hand side and identify the variables that each
component of the equation depends on.
S(Y) + T + Z(Y, π) = I(r) + G + X(Yf, π) (8.8)
Investment and saving are the same as those in the closed economy
model. Income has a positive impact on imports. The exchange rate (π)
has a negative impact on imports. Therefore, a rise in the exchange rate
will increase the cost of goods from abroad while decreasing imports.
Indian exports are actually imports for other nations, and it is positively
depends on foreign income (Yf) and the exchange rate. The reason for
the relationship is that an increase in the exchange rate reduces the cost
of rupees measured in terms of the foreign currency and lowers the price
of Indian goods for foreign residents.
As depicted in Figure 8.7, it is possible to show that the open economy
IS schedule is downward sloping. Low investment levels will be the
result of high interest rates. To satisfy equation (8.8), income must be
low at these high interest rates in order for imports and saving rates to
be low. Alternatively, at low interest rate levels, which lead to high lev-
els of investment, the equilibrium of the goods market necessitates high
imports and saving; as a result, Y must be high. We hold four variables
constant when constructing the open economy IS schedule in Figure 8.7:

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Notes taxes, government spending, foreign income, and the exchange rate.
These factors cause the schedule to change. The schedule is shifted to the
right by expansionary shocks like an increase in government spending,
a reduction in taxes, a rise in foreign income, or a rise in the exchange
rate. The increased demand for our exports makes an increase in foreign
income expansionary.

Figure 8.7: Open Economy IS-LM Model

The increased demand for our exports makes an increase in foreign
income expansionary. In addition to increasing exports and decreasing
imports for a given level of income, an increase in the exchange rate
causes a shift in demand from imported to domestic goods. For the same
reason, an autonomous decline in import demand is expansionary. The IS
schedule shifts to the left when these variables change in the opposite
direction. In Figure 8.7, our open economy model includes a balance of
payments equilibrium schedule, the BP schedule in addition to the IS and
LM schedules. All interest rate-income combinations that lead to balance
of payments equilibrium at a specific exchange rate are plotted on this
schedule. Equilibrium in the balance of payments signifies that there is

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 Exchange Rates and the Mundell-Fleming Model

no balance in the official reserve transaction. The BP schedule equation Notes

can be expressed as:
X(Yf, π) – Z(Y, π) + F(r – rf) = 0 (8.9)
In equation (8.9), the first two terms together make up the trade bal-
ance (net exports). The net capital inflow, or the surplus or deficit in
the financial account in the balance of payments, is the third item. The
difference between the domestic interest rate and the foreign interest rate
(r − rf) determines positively the net capital inflow. Increased demand for
Indian financial assets (such as bonds) at the expense of foreign assets
results from an increase in the interest rate differential between India and
other countries. As a result, net capital inflow rises. The opposite hap-
pens when the foreign interest rate increases. The assumption is that the
foreign interest rate is exogenous. Figure 8.7 illustrates the BP schedule
is positively sloped. While export demand remains constant as income
rises, import demand does. A higher interest rate will result in an increase
in capital inflow, which is necessary to maintain balance of payments
equilibrium. Now take into account factors that impact the BP schedule.
The schedule will move horizontally to the right as π increases. A higher
level of income will be needed for balance of payments equilibrium for
a given level of interest rate, which fixes the capital flow, at a higher
exchange rate. For this reason, a higher level of income that will stimu-
late import demand is required for balance of payments equilibrium. The
higher exchange rate promotes exports and discourages imports. The BP
schedule will also move to the right in response to an exogenous increase
in export demand (caused by an increase in Yf) or a decrease in import
demand. If exports increase, for instance, at a specific interest rate that
fixes the capital flow once more, a higher level of income and conse-
quently of imports is needed to re-establish the balance of payments. The
BP schedule is moved to the right. The BP schedule would also move
to the right in response to a decline in the foreign interest rate because,
for a given domestic interest rate (r), the decline in the foreign interest
rate results in an increase in capital inflow. Imports and consequently
income must increase for the balance of payments to be in equilibrium.
There is one thing to note about the BP schedule before we look at the
effects of various policy changes. If capital mobility is imperfect, the

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Notes BP schedule will be upward sloping. Domestic and foreign assets (such
as bonds) are substitutes in this situation, but they are not perfect ones.
Investors would move to equalise interest rates across nations if domestic
and foreign assets could perfectly substitute one another, or in a situation
known as perfect capital mobility. Investors would shift to an asset with
a temporarily higher interest rate if it existed until the rate of the other
asset was lowered to make it equal. Perfect capital mobility implies that
r = rf in the context of our model. This equality implies a horizontal BP
schedule. Interest rates do not necessarily need to be equal if the assets
are imperfect substitutes. Foreign assets may not be a perfect substitute
for Indian assets due to factors such as differential risk on international
assets, exchange rate risks, transaction costs, and a lack of knowledge
about the characteristics of foreign assets.

8.5.1 Imperfect Capital Mobility

In this section, we assume that these factors are enough to make domestic
and foreign assets less than perfect substitutes. We start with the scenario
of fixed exchange rates to examine monetary and fiscal policy under the
assumption of imperfect capital mobility.
Policy under Fixed Exchange Rates
Monetary Policy
Think about what would happen if the money supply increased from
M0 to M1. In Figure 8.8, the LM schedule moves to the right, from LM
(M0) to LM (M1) as a result of the increase in the money supply (M1).
With a decrease in interest rates from r0 to r1 and an increase in income
from Y0 to Y1, the equilibrium shifts from E0 to E1. What happened to
the payment balance? First, keep in mind that every point below the BP
schedule represents a deficit in the balance of payments, while every
point above the schedule represents a surplus. A deficit in the balance
of payments results when we move from an equilibrium point on the
BP schedule to points below the schedule, such as by raising income or
lowering the interest rate, or both. As a result, after the increase in the
money supply, we move from point E0 to point E1, and the balance of
payments also moves into deficit.

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Notes

Figure 8.8: Monetary Policy with a Fixed Exchange Rate

The expansionary monetary policy boosts income, encourages imports,
and drives down interest rates, which results in a capital flight (F de-
clines). Potential conflicts between the objectives of domestic policy and
the external balance are raised by the fact that, starting from a point of
equilibrium, an expansionary monetary policy results in a deficit in the
balance of payments. Moving to point E1 and income level Y1 may be
preferable on domestic grounds if the level of income, Y0, at point E0 in
Figure 8.8 is low in comparison to full employment. Due to the limited
foreign exchange reserves, there will be a balance of payments deficit
at point E1, which cannot continue indefinitely.
Fiscal Policy
Figure 8.9 shows the results of increasing government spending from G0
to G1 in the case of fixed exchange rates. Government spending growth
causes the equilibrium point to shift from E 0 to E1, moving the IS schedule
to the right from IS (G0) to IS (G1). The interest rate increases from r0
to r1, and income increases from Y0 to Y1. Figure 8.9 illustrates the new
equilibrium point, where we are above the BP schedule and the balance
of payments is in surplus. The BP schedule in Figure 8.9 is flatter than
the LM schedule, which is how we arrive at this conclusion. s shown
in Figure 8.10, an expansionary fiscal policy action would result in a

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Notes balance of payments deficit if the BP schedule were steeper than the LM
schedule. The BP schedule will become steeper as capital flows become
less sensitive to interest rates. The rise in interest rate needed to maintain
balance of payments equilibrium as we move to a higher income (and
therefore import) level will be greater the smaller the increase in capital
inflow for a given increase in the interest rate (given the fixed value of
rf); this means that the BP schedule will be steeper. The BP schedule
will also become steeper the higher the marginal propensity to import.

Figure 8.9: Fiscal Policy with a Fixed Exchange Rate

A given increase in income will result in a greater increase in imports
if the marginal propensity to import is higher. A larger compensatory
increase in capital inflow and, as a result, a larger increase in interest
rate will be needed for the balance of payments to return to equilibrium.
Income rises as a result of the expansive fiscal policy action shown in
Figures 8.9 and 8.10. A worsening trade balance results from increased
income, which also raises interest rates and improves the financial account.
A steeper BP schedule will have a larger negative impact on imports and
the trade balance and a smaller positive impact on capital flows.

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Notes

Figure 8.10: Fiscal Policy with a Fixed Exchange Rate:

An Alternative Outcome
Therefore, the steeper the BP schedule, the more likely it becomes that
an expansionary fiscal policy action will result in a balance of payments
deficit. Finally, take note that whether an expansionary fiscal policy action
results in a balance of payments surplus or deficit depends on the slope
of the BP schedule in relation to the slope of the LM schedule. Given
the slope of the BP schedule, the likelihood that the LM schedule will
be steeper than the BP schedule—a condition necessary for a surplus to
result from an expansionary fiscal policy action—increases as the LM
schedule gets steeper. This conclusion is reached because other factors
being equal, the steeper the LM schedule, the greater the increase in
interest rate (which results in the favourable capital inflow), and the
lesser increase in income (which produces the unfavourable effect on
the trade balance).
Policy under Flexible Exchange Rates
Monetary Policy
Now let’s consider the scenario in which there is no central bank in-
tervention and the exchange rate is completely flexible. In the foreign
exchange market, the exchange rate is adjusted according to supply and
demand. Consider first the same monetary policy measure that was pre-

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Notes viously examined, namely an increase in the amount of money from M0

to M1. Figure 8.11 shows the results of this expansionary monetary policy
action in the scenario of a flexible exchange rate. Prior to a change in
the exchange rate, the expansion of the money supply has the immediate
effect of advancing the economy from point E0 to point E1. The interest
rate falls from r0 to r1. Income increases from Y0 to Y1, and we move to
a point below the BP schedule where a balance of payments deficit is
beginning to emerge. To clear the foreign exchange market in a flexible
exchange rate system, the exchange rate will increase from π0 to π1).
This adjustment was previously depicted in Figure 8.6. The BP schedule
will move to the right as the exchange rate increases; in Figure 8.11, the
schedule moves from BP (π0) to BP (π1).

Figure 8.11: Monetary Policy with a Flexible Exchange Rate

Due to the fact that exports increase and imports decrease as the exchange
rate rises, IS schedule also moves to the right, from IS (π0) to IS (π1).
With the interest rate at r2 and the income at Y2, the new equilibrium
is depicted at point E2. Following an expansionary monetary policy, the
exchange rate adjustment adjusts the balance of payments and resolves
any potential inconsistency between internal and external balance. It is
important to note that the income increase brought on by the expan-
sionary monetary policy action is higher in the flexible rate case than
it is in the fixed rate case. Income would only increase to Y1 in Figure
8.11 or Figure 8.8 with a fixed exchange rate. A flexible exchange rate

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would allow the increase in the exchange rate to further boost income Notes
by boosting exports and lowering import demand (for a given income
level). Therefore, monetary policy is a more effective stabilisation tool
in a regime of flexible exchange rates than in a regime of fixed rates.
Fiscal Policy
The effects of an increase in government spending from G0 to G1 with
a flexible exchange rate are shown in Figure 8.12. The initial effect—
again, the result prior to the exchange rate adjustment is a change in the
IS schedule from IS (G0, π0) to IS (G1, π0) which causes the economy
to move from E0 to E1. Income increases as the interest rate increas-
es (from r0 to r1) (from Y0 to Y1). With the slopes of the BP and LM
schedules depicted in Figure 8.12 (the BP schedule being flatter than the
LM schedule), this expansionary policy action leads to a small balance
of payments surplus. For the foreign exchange market to clear in this
scenario, the exchange rate must decrease from π0 to π1. In Figure 8.12,
the BP schedule will move to the left as the exchange rate declines, from
BP (π0) to BP (π1). Because the decline in the exchange rate will cause
exports to decline and imports to increase, the IS schedule will also move
left, from IS (G1, π0) to IS (G1, π1).

Figure 8.12: Fiscal Policy with a Flexible Exchange Rate

The expansionary impact of the fiscal policy action will be partially off-
set by the exchange rate adjustment. The new equilibrium point will be
at Y2, which is higher than Y0 but lower than Y1, the level that would

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Notes have been reached if the exchange rate had been fixed. However, unlike
monetary policy, there is no clear correlation between the effectiveness
of fiscal policy and the type of exchange rate regime. A balance of pay-
ments deficit will result from an expansionary fiscal policy for a specific
exchange rate if the BP schedule is steeper than the LM schedule, as
shown in Figure 8.10. The exchange rate must increase in the flexible
exchange rate regime due to an incipient balance of payments deficit in
order to bring the foreign exchange market back into equilibrium. The
shift to the right in the BP and IS schedules will reinforce the initial
expansionary impact of the rise in government spending. In contrast to
the fixed exchange rate case, the expansionary fiscal policy action would
have a greater impact on income in this scenario. Though this alternate
result is theoretically possible, most economists believe the result shown
in Figure 8.12 is more likely. They think adopting an expansionary fis-
cal strategy will result in lower exchange rates (raise the value of the
domestic currency). This assumption is supported by the idea that there
is a significant amount of global capital mobility, which makes the BP
schedule relatively flat and likely to be flatter than the LM schedule (see
Figure 8.12).

8.5.2 Perfect Capital Mobility

We have assumed up to this point that while domestic and foreign assets
can be substituted, they are not a perfect substitute. In this section, we
examine monetary and fiscal policy for the scenario of perfect capital
mobility, where assets are perfect substitutes. Capital can move freely
between nations in this case, asset risk differences between nations are
insignificant, and transaction costs are negligible.
In the Mundell-Fleming model, the assumption of perfect capital mobility
means that the BP equation (8.9) is replaced with the condition
r = rf(8.10)
The BP schedule is horizontal due to the assumption of perfect capital
mobility. A balance of payments equilibrium can only exist when the
domestic interest rate is equal to the exogenously determined foreign
(world) interest rate because massive capital flows result from any

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interest-rate differential. Prior to examining the effects of policy in the Notes

scenario of perfect capital mobility, take into account the assumption that
the domestic interest rate must, in an ideal situation, equilibrate with
the exogenously determined foreign rate. Although we also assumed that
the foreign interest rate was exogenous, imperfect capital mobility could
result in a difference between the domestic interest rate and the foreign
interest rate. Two possibilities exist in that situation.
One is that we are thinking about a small nation whose actions have
no bearing on the global economy. In addition to being assumed to be
exogenous, an expansionary monetary policy that lowers the domestic
interest rate has no impact on the global interest rate or income in other
nations. Another possibility is that the nation is large, like India, but that
we were just ignoring the impact of its actions on other economies and,
consequently, ignoring potential repercussive effects. These were thought
to be of secondary importance. Only the first assumption is reasonable
in the perfect capital mobility. Due to capital mobility and the domestic
country’s small size, which prevents it from having an impact on global
financial market conditions, the domestic interest rate must adjust to reflect
global rates. We would need to model the impact of Indian policies on
the global interest rate in order to consider India as the perfect capital
mobility case. To think that the interest rate in India is entirely unaffected
by the interest rate in the rest of the world is unrealistic.
Policy Effects under Fixed Exchange Rates
Monetary Policy
We will see that perfect capital mobility renders fixed exchange rates
completely ineffective for monetary policy. We need to think more about
the connection between money supply and foreign exchange market inter-
vention in order to fully comprehend this result. Previously, we found that
an expansionary monetary policy produced a balance of payments deficit
when there was a fixed exchange rate. With this context in mind, think
about what an expansionary monetary policy would do in the scenario of
perfect capital mobility. Assume, in keeping with the previous discussion,
that a small nation like New Zealand expands its money supply. Figure
8.13 shows how the increased money supply causes the LM schedule to
move from LM (M0) to LM (M1). For a brief period, the interest rate in
New Zealand moves from r0 to r1. The interest rate in New Zealand is

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Notes currently lower than the foreign (global) interest rate. In the scenario of
perfect capital mobility, there will be a significant capital outflow when
the domestic interest rate is lower than the foreign interest rate. The
sale of New Zealand assets by investors will result in the sale of New
Zealand currency. Through sterilised intervention in the foreign exchange
market, the central bank of New Zealand is unable to return the situation
to equilibrium in this instance. As long as New Zealand’s interest rate
is lower than the foreign rate, the massive capital outflow will continue.

Figure 8.13: Monetary Policy with a Fixed Exchange Rate

Sterilized intervention would simply mean that the central bank of New
Zealand would quickly run out of foreign reserve assets. The central
bank must allow its intervention to reduce the money supply through
the method described at the beginning of this section in order to restore
equilibrium. Until the LM schedule shifts back to the original position,
LM, the money supply will decline (M0). The New Zealand interest rate
will be brought back to parity with the foreign interest rate at this point
(E0). The money supply will stop declining as a result of the capital
outflow. The money supply and income will also have returned to their
initial levels at this point. The monetary policy change will have had no
effect at all.
Fiscal Policy
Regarding fiscal policy, the situation is quite different. The ideal capital
mobility case is shown in Figure 8.14 to show how an increase in gov-

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ernment spending would affect the economy. The shift of the IS schedule Notes
to the right from IS (G0) to IS (G1) is a direct result of the increased
spending (G1). Spending growth causes a huge capital inflow by raising the
domestic interest rate above the foreign interest rate. The domestic central
bank must step in and, in this instance, purchase foreign exchange using
New Zealand dollars. The money supply in New Zealand will increase
as a result of this action. To change the LM schedule to LM (M1) and
bring back parity between domestic and foreign interest rates at point E1,
the New Zealand central bank will need to continue purchasing foreign
currency. The expansionary impact of the rise in government spending
is strengthened by this endogenous increase in the money supply. The
output increases to Y1 rather than Y’1.

Figure 8.14: Fiscal Policy with a Fixed Exchange Rate

This expansionary fiscal policy is extremely effective in a fixed exchange
rate system with perfect capital mobility because there is no increase
in the domestic interest rate and consequently no crowding out of pri-
vate-sector spending.
Policy Effects under Flexible Exchange Rates
The situation is reversed in a flexible exchange rate system. Here, we
discover that monetary policy works effectively while fiscal policy com-
pletely fails.
Monetary Policy
Once again, we take into account a rise in the money supply from M0 to
M1. Figure 8.15 demonstrates how this increased money supply causes

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Notes the LM schedule to change from LM (M0) to LM (M1). Similar to the

fixed exchange rate scenario, the expansion of the money supply causes
the New Zealand interest rate to temporarily drop below the foreign in-
terest rate, which results in a significant outflow of capital. However, in
a flexible exchange rate system, the New Zealand central bank does not
intervene in the foreign exchange market as a result. Instead, the New
Zealand exchange rate increases and the value of the New Zealand dollar
decreases as investors sell New Zealand assets and as a result, sell New
Zealand dollars. This increase in the exchange rate causes a shift to the
right in the IS schedule as well as an increase in New Zealand exports
and a decrease in New Zealand imports. New Zealand dollars continue
to be sold up until the exchange rate sufficiently increases from π0 to π1
and shifting the IS schedule from IS (π0) to IS (π1).

Figure 8.15: Monetary Policy with a Flexible Exchange Rate

The New Zealand interest rate has now (E1) been brought back into par-
ity with the foreign interest rate. Revenue has increased to Y1. Perfect
capital mobility and flexible exchange rates make monetary policy very
effective. Income increases by the full amount of the LM schedule’s
horizontal shift. Notice that the interest rate, which is now fixed at the
foreign exchange rate, is no longer the mechanism by which monetary
policy is implemented. Instead, it is accomplished through net exports
and the exchange rate.

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 Exchange Rates and the Mundell-Fleming Model

Fiscal Policy Notes

Figure 8.16 shows the results of an increase in government spending
under conditions of perfect capital mobility and flexible exchange rates.
Increased government spending causes the IS schedule to shift from IS
(G0, π0) to IS (G1, π0). As a result, the domestic interest rate increases
above the foreign interest rate, moving towards r1 in the figure. With a
flexible exchange rate, this movement results in a significant inflow of
capital, which lowers the exchange rate (the domestic currency to appre-
ciate). As a result, imports increase while exports decline. This shifts the
IS schedule to the left. Only when the IS schedule has completely shifted
back to IS (G0, π0) = IS (G1, π1) and the domestic interest rate is once
again equal to the foreign interest rate is the equilibrium restored. The
pressure on the exchange rate to fall and the capital inflow both stop at
this point. At this point, income has also returned to its starting point.
This makes the fiscal policy completely ineffective.

Figure 8.16: Fiscal Policy with a Flexible Exchange Rate

8.6 Summary
This chapter has dealt with the determination of exchange rates and the
related issue of how the global monetary system is set up. The ideal lev-
el of flexibility in exchange rate determination is a key question in the
field. The majority of the major currencies experienced a managed float

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Notes after the Bretton Woods system broke down. Throughout the period of
floating exchange rates, the US dollar’s value has been quite irregular.
There have been calls for changes to the international monetary system
during times of sharply fluctuating currency values in order to provide
more stability of exchange rates.
In order to achieve greater exchange rate stability, national macroeco-
nomic policies would probably need to be better coordinated. Effective
international policy coordination is hampered by a number of factors, not
the least of which are the divergent political ideologies and industrial
configurations of the major world economies. Freeing nations from the
need to coordinate policies, floating exchange rates come at the expense
of extremely volatile exchange rates. Growing current account imbalances
among the major economies of the world have recently prompted calls
for better policy coordination.
In this chapter, we have also examined within an open economy ver-
sion of the IS-LM model, monetary and fiscal policy for both cases of
imperfect and perfect capital mobility. Between the two cases, there are
clear differences. The following results are particularly striking when
perfect capital mobility is assumed: If the exchange rate is fixed, neither
fiscal nor monetary policy will have any effect. If the exchange rate is
flexible, neither will have any effect. Though there are some quantitative
differences, our findings are more in line with the closed economy IS-
LM model when capital mobility is imperfect.
One study came to the conclusion that the world capital markets were
probably “two-thirds or three-fourths of the way but no further than that”
towards perfect capital mobility based on the situation in the middle of
the 1980s. Over the past 40 years, capital markets have advanced further
in that direction. A preference for the model with imperfect capital mo-
bility but a comparatively flat BP schedule may result from this trend.
However, it is challenging to make a generalisation that applies to all
nations. Government controls on capital movements exist in some coun-
tries, though their prevalence is declining. These controls severely limit
capital mobility. The assumption of perfect capital mobility is preferable
for other nations whose capital markets are closely integrated with those
of a large neighbour, such as Canada and Austria.

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 Exchange Rates and the Mundell-Fleming Model

8.7 Answers to In-Text Questions Notes

1. True
2. (d) All of the above
3. It is both a Forward market and a Spot market
4. False. It is determined by both the supply and demand in the foreign
exchange market
5. Accommodating transactions

8.8 Self-Assessment Questions

1. Define balance of payments accounts. Describe the various items
that are listed in the balance of payments accounts.
2. Describe how a fixed exchange rate system determines a country’s
exchange rate.
3. Describe the Bretton Woods system, which was established at the
end of World War II and remained in place until 1973.
4. Explain how, in a fixed exchange rate system, the trade balance and
the level of economic activity are related.
5. Explain the connections between balance of payments equilibrium
and both expansionary monetary and fiscal policies within a fixed
exchange rate system, taking into account the impact on the trade
balance and the financial account.
6. “The adoption of a flexible exchange rate regime would liberate
monetary and fiscal policy for use in achieving domestic goals of
full employment and price stability.” Comment.
7. What are some of the relative benefits and drawbacks of fixed
exchange rates in comparison to flexible exchange rates?
8. Analyse the effects of the following policy actions for both the fixed
and flexible exchange rate cases in the Mundell-Fleming model
under the assumption of imperfect capital mobility: (a) A decrease
in the amount of money. (b) A reduction in public spending.
9. Explain why, even with perfect capital mobility, fixed exchange rates
render monetary policy completely ineffective.

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Notes 10. What does it mean to sterilise the effects of interventions in the
foreign exchange market? Describe how sterilisation functions when
capital mobility is insufficient.

8.9 References
‹ Mundell, Robert. (1963). Capital Mobility and Stabilization Policy
Under Fixed and Flexible Exchange Rates. Canadian Journal of
Economics and Political Science, pp. 475-485.
‹ Fleming, Marcus. (1962). Domestic Financial Policies Under Fixed
and Under Floating Exchange Rates. International Monetary Fund
Staff Papers, pp. 369-379.

8.10 Suggested Readings

‹ Froyen, R. P. (2011). Macroeconomics-theories and policies (8th
Edition). Pearson.
‹ Dornbusch and Fischer. (2010). Macroeconomics (9th Ed). Tata
McGraw Hill.
‹ Gregory Mankiw. (2010). Macroeconomics (7th Ed). Worth Publishers.

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 Glossary

Aggregate Demand Curve: The negative relationship between the price level and the
aggregate quantity of output demanded that arises from the interaction between the goods
market and the money market.
Aggregate Demand: The sum of the demands for current output by each of the sectors of
the economy: households, businesses, the government, and foreign purchasers of exports.
Aggregate Supply Curve: The relationship between the price level and the aggregate
quantity of output firms produce.
Aggregate Supply Function: The macroeconomic analogy to the individual market sup-
ply function, which shows the output forthcoming at each level of product price. The
aggregate supply function shows the total output firms will supply at each value of the
aggregate price level.
Aggregate-demand Externality: The macroeconomic impact of one firm’s price adjust-
ment on the demand for all other firms’ products.
Automatic Stabilizers: Changes in taxes and government transfer payments that occur
when the level of income changes.
Autonomous Expenditure Multiplier: Gives the change in equilibrium output per unit
change in autonomous expenditures (e.g., government spending).
Autonomous Expenditures: Expenditures that are largely determined by factors other
than current income.
Average Propensity to Consume (APC): The ratio of consumption to income.
Average Propensity to Save (APS): The ratio of savings to income.
Balance of Payments: The balance of payments accounts keep track of all economic
exchanges of goods and assets between the home country and foreign residents.
BP Schedule: The BP schedule displays the combinations of r and Y that, at a specific
exchange rate, will balance supply and demand in the foreign exchange market.
Bretton Woods System: It was a pegged exchange rate system set up at the end of World
War II.
Business Fixed Investment: Expenditure done by the firms on business structures, like,
warehouse, factories, office buildings and on equipment.

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Notes Capital Account Convertibility: This refers to the freedom to carry out
investment transactions free from restrictions, i.e., there are no limits on
the amount of rupees an Indian resident may convert into foreign currency
in order to purchase any foreign asset.
Capital Deepening: The process of increasing the amount of capital per
labour.
Capital Goods: Capital resources such as factories and machinery used
to produce other goods.
Capital Widening: The process of equipping of new workers with capital,
as the population grows.
Compensation to Employees: Income of the employees.
Consumer Price Index (CPI): It is the measure of the retail prices of a
fixed “market basket” of several hundred goods and services purchased
by households.
Consumption Function: The Keynesian relationship between income
and consumption.
Consumption: The household sector’s demand for output for current use.
Consumption expenditures consist of purchases of durable goods (e.g.,
autos and televisions), nondurable goods (e.g., food and newspapers),
and services (e.g., haircuts and taxi rides).
Corporate Profits: Income of the corporates, calculated after subtracting
wages, interest, rents and other costs from the corporate revenue.
Depreciation: The decline in the value of goods due to use, wear and
tear, obsolescence, during the specified period of time.
Durables: Goods, which can be used for a longer period of time.
Exchange Rate System: It is a set of rules for determining exchange
rates between currencies.
Exchange Rate: It is the value of a nation’s currency in relation to other
currencies.
Exogenous Growth Model: Where the long-term growth rates are deter-
mined by variables not explained by the model itself. The neo-classical
models are examples of exogenous growth model.

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 Glossary

Expenditure Approach: This approach measures the value of economic Notes

activities by adding all the spending done on the final production of
goods and services.
Factor Cost: It is the total cost incurred in using factor inputs in the
production of goods and services.
Final Goods and Services: Goods and services produced for final con-
sumption are known as final goods and services.
Financial Account: It keeps track of foreign residents’ purchases of In-
dian assets (capital inflows) and Indian residents’ purchases of foreign
assets (capital outflows).
Fiscal Policy: The government’s choice regarding levels of spending
and taxation.
Flexible Prices: Prices that adjust quickly to equilibrate supply and
demand.
Foreign Exchange: It is a general term to refer to an aggregate of for-
eign currencies.
Government Expenditure: The expenditure done by central, state or
local government on the purchase of final goods and services.
Government Purchases: Goods and services that are the part of current
output that goes to the government sector—the central government as
well as state and local governments.
Gross Domestic Investment: In economics, fixed investment means pur-
chase of new capital, such as house, plant, equipment etc. and inventory
investment means a change in the firm’s inventory holdings.
Gross Domestic Product (GDP): The total income earned domestically,
including the income earned by foreign-owned factors of production; the
total expenditure on domestically produced goods and services.
Gross National Product (GNP): The total income of all residents of a
nation, including the income from factors of production used abroad; the
total expenditure on the nation’s output of goods and services.
Horizontal Innovation: It causes productivity growth through techno-
logical progress reflected in an expansion of the number of varieties of
products that is by creating new but not necessarily improved varieties
of products which means a series of opening up of new industries.

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Notes Income Approach: It measures the economic activity by adding all the
factor payments.
Intermediate Goods and Services: Goods and services used in the pro-
cess of making final goods and services.
Inventory Investment: The change in the quantity of goods that firms
hold in storage, including materials and supplies, work in process, and
finished goods.
Investment: Goods purchased by individuals and firms to add to their
stock of capital.
IS Curve: The negative relationship between the interest rate and the
level of income that arises in the market for goods and services.
IS Schedule: It displays combinations of r and Y that represent equilib-
rium in the goods market.
IS-LM Model: A model of aggregate demand that shows what determines
aggregate income for a given price level by analyzing the interaction
between the goods market and the money market.
Life Cycle Hypothesis: About consumption asserts that the saving and
consumption decisions of households reflect a plan for an optimal con-
sumption pattern over their lifetime, subject to the constraint of their
resources.
Liquidity Preference: A Keynesian term for the demand for money
relative to bonds.
Liquidity Trap: A situation at a very low interest rate where the specu-
lative demand for money schedule becomes nearly horizontal.
LM Schedule: It displays combinations of r and Y that represent money
market equilibrium.
Market Price: Price at which goods and services are sold in the market.
Market Value: Market value of the goods and services are calculated by
multiplying the quantity of goods and services by their respective market
price (price at which they are sold in the market).
Monetary Policy: Central bank’s use of control of the money supply and
interest rates to influence the level of economic activity.

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 Glossary

Money Market: A set of markets for low-risk liquid assets with matur- Notes
ities of less than one year.
Money Multiplier: Gives the increase in the money supply per unit
increase in the monetary base.
Money: Whatever is commonly accepted as payment in exchange for
goods and services (and payment of debts and taxes).
National Income Accounts: The national income accounts is a conceptual
framework, which measures economic activities.
National Income: The sum of the earnings of all factors of production
that come from current production.
Net Exports: It is the gap between exports and imports of a country in
a specified period.
Net Factor Income from Abroad: It is defined as “difference between
the aggregate amount of earnings of the country’s citizens and companies
situated abroad and aggregate amount of earnings of foreign citizens and
overseas companies earn in the domestic country”.
Net Interest: It is a difference between the interest received by the in-
dividual from businesses and foreign sources and interest paid by them.
Non-Durables: Goods which have a shorter life span.
Personal Consumption Expenditures: The major portions of GDP con-
stitute of consumption done by the households (consumers) on the goods
and services.
Personal Income: Measure of income received by persons from all sources.
Potential Output: The level of output that would be reached if productive
resources (labour and capital) were being used at benchmark high levels.
Price Index: Measures the aggregate price level relative to a chosen
base year.
Product Approach: It measures the value added of final goods and ser-
vices, it does not include the value of intermediate goods and services.
Proprietors’ Income: Proprietor means the owner of a business, that does
not have a separate identity from its owner, better known as unincorporat-
ed business. The profit of such business is called as proprietors’ income.

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Notes Rental Income: An income earned by a person by renting its land or

structures.
Residential Investment: These are spending on the construction of new
houses and apartments.
Services: Services are non-physical that are opposite to goods, which
we can touch and handle.
Shock: An exogenous change in an economic relationship, such as the
aggregate demand or aggregate supply curve.
Sterilization: A central bank may use sterilisation as a form of mone-
tary action to reduce the impact of capital inflows and outflows on the
money supply.
Supply Shocks: Exogenous events that shift the aggregate supply curve.
Trade Deficit: The excess of imports over exports.
Unemployment Rate: The number of unemployed persons expressed as
a percentage of the labour force.
Value Added: The difference between the value of the goods or services
when it leaves the stage of production and the value when they entered
into that stage of production.
Vertical Innovation: It causes productivity growth through technolog-
ical progress reflected in quality improvement for an array of existing
kind of products, which means continuous quality enhancement within
an established industry.
Wholesale Price Index (WPI): It measures the wholesale prices of ap-
proximately 697 items.

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School of Open Learning, University of Delhi

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