Introduction to Micro

Economics
CHAPTER-1:Introduction to
Macroeconomics and
National Income Accounting

1.1. The Origin and Roots of

Macroeconomics

Macroeconomics is a branch of economics that

studies how an overall economy—the markets,
businesses, consumers, and governments—behave.
Macroeconomics examines economy-wide
phenomena such as inflation, price levels, rate of
economic growth, national income, gross domestic
product (GDP), and changes in unemployment.

While the term "macroeconomics" is not all that

old (going back to the 1940s), many of
macroeconomics's core concepts have been the
study focus for much longer. Topics like
unemployment, prices, growth, and trade have
concerned economists since the beginning of the
discipline in the 1700s. Elements of earlier work
from Adam Smith and John Stuart Mill addressed
issues that would now be recognized as the domain
of macroeconomics.

In its modern form, macroeconomics is often

defined as starting with John Maynard Keynes and
his book The General Theory of Employment,
Interest, and Money in 1936. Keynes explained the
fallout from the Great Depression when goods
remained unsold, and workers were unemployed.

Throughout the 20th century, Keynesian

economics, as Keynes' theories became known,
diverged into several other schools of thought.

Before the popularization of Keynes' theories,

economists did not generally differentiate between
micro- and macroeconomics. The same
microeconomic laws of supply and demand that
operate in individual goods markets were
understood to interact between individual markets
to bring the economy into a general equilibrium, as
described by Leon Walras.

The link between goods markets and large-scale

financial variables such as price levels and interest
rates was explained through the unique role that
money plays in the economy as a medium of
exchange by economists such as Knut Wicksell,
Irving Fisher, and Ludwig von Mises.

1.1.1.Need and Relevance of Macroeconomics

 It helps to understand the functioning of a

complicated modern economic system. It
describes how the economy as a whole
functions and how the level of national income
and employment is determined on the basis of
aggregate demand and aggregate supply.
 It helps to achieve the goal of economic growth,
higher level of GDP and higher level of
employment. It analyses the forces which
 determine economic growth of a country and
explains how to reach the highest state of
economic growth and sustain it.
 It helps to bring stability in price level and
analyses fluctuations in business activities. It
suggests policy measures to control Inflation
and deflation.
 It explains factors which determine balance of
payment. At the same time, it identifies causes
of deficit in balance of payment and suggests
remedial measures.
 It helps to solve economic problems like
poverty, unemployment, business cycles, etc.,
whose solution is possible at macro level only,
i.e., at the level of whole economy.
 With detailed knowledge of functioning of an
economy at macro level, it has been possible to
formulate correct economic policies and also
coordinate international economic policies.
 Last but not the least, is that macroeconomic
theory has saved us from the dangers of
application of microeconomic theory to the
problems of the economy as a whole.

1.1.2.Scope of the Macroeconomic

Macroeconomics is an essential field of study for

economists. The scope of macroeconomics is
immense. Government, financial bodies, and
researchers analyze a nation’s general national
issues and economic well-being. It mainly covers
the major fundamentals of macroeconomic
theories and policies.
The Macroeconomic theories involve economic
growth and development, national income, money,
international trade, employment, and general price
level. In contrast, macroeconomic policies cover
fiscal and monetary policies. The study of problems
like unemployment in India, the general price
level, or the disequilibrium in the balance of
payment (BOP) is a part of the macroeconomic
study.

The scope of macroeconomics covers numerous

subject matters. Some of these are as follows:

1. Macroeconomic Theories

It is understandable that the Government is the

regulating body of a nation. It considers the
various critical aspects that directly impact the
lives of the citizens. There are six theories under
the scope of macroeconomics:

 Theory of Economic Growth and

Development

The growth of an economy also comes under the

study of macroeconomics. The resources and
capabilities of an economy are evaluated based on
the scope of macroeconomics. It influences the
increase in national income and output at the
environmental level. They have a direct impact on
the economic development of an economy.

 Theory of Money

Macroeconomics assesses the impact of the

reserve bank on the economy, the inflow and
outflow of capital, and its effects on job rates. The
frequent change in the value of money caused due
to inflation and deflation has adverse effects on a
nation’s economy. They can be cured by taking
monetary and fiscal policies and direct economic
control measures.

 Theory of National Income

It includes different topics related to measuring

national income, including revenue, spending, and
budgeting. The macroeconomic study is vital for
assessing the economy’s overall performance in
terms of national income. At the onset of the Great
Depression of the 1930s, it was essential to
investigate the triggers of general overproduction
and unemployment.

This led to the creation of data on national income.

It helps forecast the level of economic activity and
income distribution among various citizens.

 Theory of International Trade

It is an area of study focusing on exporting and

importing products or services. In brief, it points
out the effect on the economy through cross-
border commerce and customs duty.

 Theory of Employment

This scope of macroeconomics assists in

determining the level of unemployment. It also
determines the causes that lead to such conditions
of unemployment. Hence, this affects the
production, supply, consumer demand,
consumption, and expenditure behaviour.

 Theory of General Price Level

This refers to the study of commodity prices and

how specific price rates fluctuate due to inflation
or deflation.

2. Macroeconomic Policies

The RBI and the Government of India function

jointly to imply the macroeconomic policies for the
nation’s improvement and development. It is
classified into the following two sections:

 Fiscal policy

It is one of the effective tools of macroeconomics

that helps ensure a country’s economic stability. It
refers to how the expenditure meets the deficit
income, which explains itself as a form of budget
decision under the scope of macroeconomics.

 Monetary policies

The Reserve Bank is establishing monetary policy

in coordination with the Government. These
policies are the measures taken to maintain
economic stability and growth by regulating the
different interest rates.

3. Macroeconomics Constraints

The scope of macroeconomics comprises a wide

range of areas. However, certain constraints are
affecting the scope of macroeconomics. An
economist needs to analyze the following problems
while studying macroeconomics:

 Business activities also result in societal costs

like deforestation and land degradation. The
government carries out clear laws and
legislation to regulate such social expenses.
These regulations serve as a barrier for
business organizations.
 The economic conditions of a nation have a
critical impact on the activities of every firm,
either directly or indirectly. Different economic
patterns or variables affecting the industries
include the GDP, job rates and conditions,
revenue, banking, and pricing policies.
 Many organizations trade in international
markets. They are sensitive to the fluctuations
in the economy of other countries, exchange
rates, prices, and other varied factors. Hence,
such changes may influence the economic
conditions of the country. This might also end
up affecting business organizations.

1.1.3.Macroeconomic Concerns and Issues

Macroeconomic seeks to analyze those problems

that affect eh economy as a whole; such problems
cannot be adequately studied with reference to an
individual product, firm or industry. For example,
the effect of introduction of new technology (say
computers) is not limited to a single product or
industry also, it will affect the structure of
economic activity in the economy as a whole; it will
affect the rate of economic growth; it will affect
the level of employment (or unemployment); it will
affect the general price level; it will affect the
country’s balance of payments, etc. All those
problems and issues that affect the economy as a
whole are studied in macroeconomics. We present
a brief view of the major macroeconomic issues as
follows:

i. Economic Growth

Although traditionally macroeconomics has

focused on output gap and has sought to explain
the factors that cause divergence between
potential GDP and actual GDP (i.e. GDP gap), in
more recent times, macroeconomics has also
sought to identify the forces that help an economy
raise the level of potential output. Increase in the
level of potential output constitutes economies
growth, and forms an important issue in
macroeconomics.

ii. Business Cycles

Macroeconomic activity, in the long history of

nations, has never followed a smooth trend;
economic activity faces uptrends and downtrends,
almost in a cyclical regularity. These cyclical
uptrends and downtrends are known as business
cycles. The various phases of a business cycle are
identified as:

 Boom
 Recession
 Depression
 Slump
The various phases have been illustrated in. AB
lime shows the normal trend line. A movement
from A to C takes the economy away from its
normal trend. This constitutes boom. When
recession sets in, economy moves down-hill (from
C to D); if the downtrend is not arrested, economy
may get caught in slump (or what is also called
depression). E to F represents the recovery phase.

This cyclical behavior of economic activity has

always attracted the attention of practitioners of
macroeconomics. As a matter of fact, it was the
great depression of 1930s that gave birth to
modern macroeconomics, in a form that came to
be known the Keynesian Revolution.

Figure 1:1 Business Cycles1

iii. Inflation
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Inflation can be defined as a sustained rise in the
general price level. It has been the experience the
world over that a rise in GDP has generally been
accompanied by an increase in the general price
level. Normally, a moderate inflation has been
consider a necessary condition of economic
growth. But frequently rising general price level
went out of control and reached astonishing limits.
The phenomenon of inflation (and its converse
deflation) is conventionally analyzed in
macroeconomics.

iv. Unemployment

Another experience common to most of the

economies in the world, developed and developing
alike, has been that the rate of creation of new job
opportunities has lagged behind the demand for
jobs. As a result, apart of the labour force remains
unemployed. This non-utilization of available
resources in the economy represents a deadweight
loss. Macroeconomics ahs been trying to seek a
lasting solution to this perennial problem.

v. Government Budget Deficits

Government has been traditionally spending more

than what they could earn by way of taxes and sale
of economic goods and services produced by them.
The resultant deficit (variously known as budget
deficit or fiscal deficit) could be financed by
mobilization of capital by way of loans. An excess
of government expenditure over revenue enabled
it to create more jobs and thereby help the
economy generate more income. But this way of
financing government expenditure has many other
implications, many of these may prove adverse: (i)
budget deficit may prove inflationary, especially if
the economy fails to generate more output; (ii) a
large part of domestic savings may be cornered by
the government; adequate savings may not be
available for private investment; and (iii) this may
put pressures on market rates of interest.
Macroeconomics has been paying more attention
to these issues in recent years.

vi. Interest Rates

In the globalizing world of today, interest rates

have come to occupy centre stage. Globalization
implies cut-throat competition. Successful
globalization requires that all the actors work to
their best efficiency; none of them would like to be
competed out because they have to pay high rates
of interest. Therefore, how to keep interest rates
low is the issue that has attracted the attention of
economists.

vii. Balance of Payments

Again, in the globalizing, increasingly free market

economies, goods, services and capital are flowing
across national borders as never before. The cross-
border transactions in goods, services and capital
given rise to payments and receipts in foreign
exchange. Exchange rates, wherever they are left
to be determined by market forces, exert their own
influence on international economic reactions.
Therefore, a proper analysis of balance of
payments has been a core issue in
macroeconomics.

1.1.4.The Role of Government in Macro

Economy

The public sector in every economy plays a major

role, as a producer and employer. Governments
work locally, nationally and internationally. Here
are the roles they play in the economy:

1. As a producer, it provides, at all levels of

government:
 Merit goods (educational institutions, health
services etc.)
 Public goods (streetlights, parks etc.)
 Welfare services (unemployment benefits,
pensions, child benefits etc.)
 Public services (police stations, fire stations,
waste management etc.)
 Infrastructure (roads, telecommunications,
electricity etc.).
2. As an employer, it provides at all levels of
government, employment to a large population,
who work to provide the above mentioned
goods and services. It also creates employment
by contracting projects, such as building roads,
to private firms.
3. Support agriculture and other prime industries
that need public support.
4. Help vulnerable groups of people in society
through redistributing income and welfare
schemes.
5. Manage the macroeconomy in terms of prices,
employment, growth, income redistribution etc.
6. Governments also manage its trade in goods
and services with other countries by
negotiating international trade deals.

1.1.5.The Components of Macro Economy

Macroeconomics is a field of economics that

studies broader economic trends, such as inflation,
economic growth rates, price levels, gross
domestic product (GDP), national income,
and changes in levels of unemployment.

 Inflation

Inflation is a progressive increase in the average

cost of goods and services in the economy over
time.

 Economic Growth Rate

The economic growth rate is the percent change in

the cost of the output of goods and services in a
country across a specific period of time, relative to
a previous period.

 Price Level

A price level is the variation of existing prices for

economically produced goods and services. In
broader terms, the level of prices refers to the
costs of a good, service, or security.

 Gross Domestic Product (GDP)

The gross domestic product (GDP) is a quantitative

measure of the market value of all finished goods
and services produced over a given time period.
  National Income

National income is the aggregate amount of money

generated within a nation.

 Unemployment Level

The level or rate of unemployment is the

unemployed share of the labor force in a given
country, calculated and stated as a percentage.

1.1.6.The Methodology to Macroeconomics

Microeconomic study historically has been

performed according to general equilibrium
theory, developed by Léon Walras in Elements of
Pure Economics (1874) and partial equilibrium
theory, introduced by Alfred Marshall in Principles
of Economics (1890). The Marshallian and
Walrasian methods fall under the larger umbrella
of neoclassical microeconomics. Neoclassical
economics focuses on how consumers and
producers make rational choices to maximize their
economic well-being, subject to the constraints of
how much income and resources they have
available. Neoclassical economists make
simplifying assumptions about markets—such as
perfect knowledge, infinite numbers of buyers and
sellers, homogeneous goods, or static variable
relationships—in order to construct mathematical
models of economic behavior.

These methods attempt to represent human

behavior in functional mathematical language,
which allows economists to develop
mathematically testable models of individual
markets. Neoclassicals believe in constructing
measurable hypotheses about economic events,
then using empirical evidence to see which
hypotheses work best. In this way, they follow in
the “logical positivism” or “logical empiricism”
branch of philosophy. Microeconomics applies a
range of research methods, depending on the
question being studied and the behaviors involved.

1. Basic Concepts of Microeconomics

The study of microeconomics involves several key

concepts, including (but not limited to):

 Incentives and behaviors: How people, as

individuals or in firms, react to the
situations with which they are confronted.
 Utility theory: Consumers will choose to
purchase and consume a combination of
goods that will maximize their happiness or
“utility,” subject to the constraint of how
much income they have available to spend.
 Production theory: This is the study of
production—or the process of converting
inputs into outputs. Producers seek to
choose the combination of inputs and
methods of combining them that will
minimize cost in order to maximize their
profits.
 Price theory: Utility and production theory
interact to produce the theory of supply and
demand, which determine prices in a
competitive market. In a perfectly
competitive market, it concludes that the
price demanded by consumers is the same
 supplied by producers. That results in
economic equilibrium.

1.2. Circular flow of Income

The circular flow means the unending flow of

production of goods and services, income, and
expenditure in an economy. It shows the
redistribution of income in a circular manner
between the production unit and households.

These are land, labour, capital, and

entrepreneurship.

 The payment for the contribution made by

fixed natural resources (called land) is
known as rent.
 The payment for the contribution made by a
human worker is known as wage.
 The payment for the contribution made by
capital is known as interest.
 The payment for the contribution made by
entrepreneurship is known as profit.

1.2.1.Methods of Calculating National Income

There are three known methods by which national

income is determined. These are:

 Value added method

 Expenditure method
 Income method

Let us look into the details of each of these

methods:
  Value Added Method

The value added method is also known as the

product method or output method. Its primary
objective is to calculate national income by taking
the value added to a product during the various
stages of production into account.

Therefore, the formula for calculating the national

income by the value added method can be
expressed as:

National income (NI) = (NDPfc) + Net factor

income from abroad

 Expenditure Method

The expenditure method of national income

calculation is based on the expenditures taking
place in the economy. The expenditures that
happen in an economy can be done by individuals,
households, business enterprises, and the
government.

Therefore, the formula for calculating the national

income by the expenditure method can be
expressed as:

National income (NI) = C + G + I + (X – M)

Or

National income (NI) = C + G + I + NX

 Income Method
The third method to calculate national income is
the income method. It is based on the income
generated by the individuals by providing services
to the other people in the country either
individually or by using the assets at disposal. The
income method takes the income generated from
land, capital in the form of rent, interest, wages
and profit into consideration.

The national income by income method is

calculated by adding up the wages, interest earned
on capital, profits earned, rent obtained from land,
and income generated by the self-employed people
in an economy. It is known as net domestic product
at factor cost or NDPfc. The addition of the net
factor income from abroad to the net domestic
product at factor cost gives the national income. It
can be expressed in a formula as:

NNPfc = (NDPfc) + Net factor income from

abroad

1.3. Price indices

A price index (PI) is a measure of how prices

change over a period of time, or in other words, it
is a way to measure inflation. There are multiple
methods on how to calculate inflation (or
deflation). In this guide we will take a look at a
couple of methods on how to do so. Inflation is one
of the core metrics monitored by the FED in order
to set interest rates.

The price index formula is:

1.3.1.Types of Price Indices

Inflation is determined by forming inflation indices

and these indices essentially are a reflection of the
price level at a certain point in time. The index
does not contain all prices, but rather a specific
basket of products and services. The specific
basket used in the index represents the products
that are significant to a sector or group. As a
result, multiple price indices exist for the costs
encountered by various groups. The main ones are
as follows: Consumer Price Index (CPI), Producer
Price Index (PPI) and Gross Domestic Product
(GDP) Deflator. The percent change in a price
index, such as the CPI or the GDP deflator, is used
to calculate the inflation rate.

 Consumer Price Index (CPI)

The consumer price index (commonly known as

the CPI) is the most commonly used indicator of
the total price level in the United States, and it is
meant to represent how the cost of all transactions
made by a typical urban household has altered
over a set period of time. It is determined by
polling market prices for a specific market basket
which is designed to depict the expenditure of an
average family of four residing in a standard
American city.

Consumer Price Index (CPI) is a calculation of

the cost of an average family's market basket.
Unfortunately, the CPI as an inflation metric has
some flaws, including substitution bias, which
causes it to exaggerate the actual inflation rate.
The substitution bias is a flaw found in the CPI
that causes it to exaggerate inflation since it does
not factor in when customers opt to substitute one
product for another when the price of the product
they regularly buy falls.

The consumer price index (CPI) also quantifies the

change in salary required by a consumer over time
to maintain the same quality of living with a new
range of prices as was had under the previous
range of prices

 Producer Price Index (PPI)

The producer price index (PPI) calculates the

cost of a standard basket of goods and services
bought by manufacturers. Because product
producers are typically quick to increase prices
when they detect a shift in public demand for their
products, the PPI frequently reacts to rising or
falling inflation trends faster than the CPI. As a
result, the PPI is frequently seen as a helpful early
detection of changes in the rate of inflation.

The PPI differs from the CPI in that it analyzes

expenses from the standpoint of the companies
that manufacture the items, while the CPI analyzes
expenses from the standpoint of consumers.

 Gross Domestic Product (GDP) Deflator

The GDP price deflator, aka the GDP deflator or

the implicit price deflator, tracks price changes for
all products and services manufactured in a
particular economy. Its use allows economists to
compare the amounts of actual economic activity
from one year to the next. Because it is not
dependent on a predefined basket of commodities,
the GDP price deflator is a more comprehensive
inflation measure than the CPI index.

1.3.2.Accounting for an open economy

A healthy economy thrives on good trade relations.

Today, a lot of countries have an open economy
where there are no trade restrictions. An open
economy refers to an economy where people and
businesses can freely trade in goods and services
with other countries. There are several benefits of
an open economy. With increased trade, people
have a wide variety of goods and services to
choose from.

They can choose to invest their money abroad.

International trading is not restricted to just goods
and services alone. An open economy presents
innumerable opportunities for global investments
and technological advancements as well. With
increased trade and economic growth, what
improves is the Gross Domestic Product (GDP) of
the economy.

Let’s now understand how GDP works. In an open

economy, the GDP is the market value of all
finished goods and services produced in a country
within a specific period of time. There are several
approaches to calculating the GDP. The most
common approach is the expenditure approach
that divides the GDP into household consumption
(C), investment (I), government purchases (G), and
net exports (NX). Hence, you can express GDP as
follows:

GDP or Y = C + I + G + NX

This expression of GDP is called the national

income identity for an open economy.

 Consumption

Consumption refers to the household consumption

of goods and services produced domestically. It
includes expenditure on durable goods (home
appliances, jewellery, books), non-durable goods
(food, fuel, medicines), and services (medical care
or education).

 Investment

The investment component in the national income

identity refers to capital expenditure or investment
on new capital for producing consumer goods. It
does not include the exchange of existing assets and
purchase of shares and bonds. Investment involves
capital that can be used in the future.

The purchase of a new house by a family can be

considered as an investment (for calculating GDP).
However, you cannot consider investment in
financial products with the intent of savings
as an investment (in terms of calculating GDP).
Another example would be that of a factory or
company that invests in new equipment or software.
  Government Purchases

The government purchases component refers to the

total expenditure by the federal, state, or local
governments on final goods and services. For
instance, public sector salaries and purchase of
military equipment and medicines would be
categorized as government purchases. Government
purchases do not include transfer payments
(subsidies, social insurance, medical insurance),
pensions, or unemployment benefits as there is
nothing earned in return.

 Net Exports

Net Exports refers to the difference between the

total imports and exports that is the difference
between the value of goods and services exported to
other countries and value of goods and services
imported from other countries.

Imports have to be deducted from the identity

because imports, in most forms, are usually included
in the consumption, investment, and government
purchases components. Hence, the imports must be
subtracted to correctly calculate the value of
domestic goods and services.

1.4. Balance of payments: current and

capital accounts

The Balance of payments (BOP) is the accounting

record of all economic transactions between
residents of the country and the rest of the world
in a particular time period. These transactions are
made by individuals, firms, and the Government.

Usually, government records all the transactions

that arise between a country and the outside
world. This record is titled Balance of Payments.
Balance of Payments can also be known as the
Balance of International Payments. It is a
statement of all transactions between entities in
one country and the outside world over a specified
time period, such as a quarter or a year. It lists all
interactions between residents of one country and
residents of other countries that involve
businesses, organizations, or governments.
Balance of Payments includes all the economic
transactions, which involve the transfer of holding
or title of goods, and services. Economic
transactions include the activity that has a
monetary effect, and also involves a transfer of the
title or ownership of money, assets, goods, and
services. These transactions can be made between
individuals, firms, and the country’s government
within a country and individuals, firms, and
governments outside the country.

1.4.1. Current Account

A current account is a record of the flow of imports

and exports to and from a country's economy.
Exports are goods and services a domestic country
sends to a foreign country for payment. Imports
are goods and services a domestic country
purchases from a foreign country. When a
country's exports outweigh its imports, it has a
trade surplus and a positive current account. When
a country's imports outweigh its exports, it has a
trade deficit and a negative current account. A
nation pays for its imports with the income from its
exports.

A country's current account involves the flow of

cash and non-capital items between countries. It
measures short-term transactions called "actual"
transactions because they have actual effects on a
country's income, outputs and employment levels.
Here are some principal elements of a current
account:

 Visible trade: Visible trade is the exchange,

exporting and importing, of tangible goods
like crops, machinery, oil and clothes.
 Invisible trade: Invisible trade is the
exchange of intangible services, like
tourism, transportation, engineering, design,
consulting, accounting, architectural
services and legal services.
 Unilateral transfers: Unilateral transfers
are one-way payments of money from one
country to another, such as foreign aid,
donations, gifts and workers' remittances
from abroad to their homeland.
 Investment income: Investment income or
income receipts is income a country earns
from ownership of assets in foreign
countries, such as land, dividends, bonds,
interest payments or foreign shares.

Current accounts are part of a country's BOP,

which measures the international flow of money
and products. Due to globalization, many countries
have expanded their trade and investments with
foreign countries. In order to monitor the financial
performance of their trades and investments,
countries study their BOPs, a record of their
economic transactions. The BOP expresses a
country's economic situation; whether it has a
trade surplus or deficit, and helps a country
estimate its long-term growth prospects.

1.4.2.Capital Account

A capital account is a measurement of financial

flows, or the flow of a country's assets and
liabilities in and out of its economy. This is the
inflow and outflow of capital, and is the opposite of
the current account flow of goods and services. It
tracks the changes in the claims of one country on
the assets of another. When one country imports
goods and services from another, it is investing
financial assets into that foreign country. If it
exports goods and services, foreign countries are
investing in it. Here are some principal elements of
a capital account:

 Foreign investments: Foreign direct

investments are payments made by foreign
entities to domestic businesses. Foreign
portfolio investments are payments made in
financial assets like stocks, bonds and
mutual funds.
 Foreign loans: Foreign loans are credit
from foreign governments or international
institutions that a domestic country
promises to repay later.
  Banking balances and other forms of
capital: Banking balances are foreign assets
and liabilities in the banking sector.

1.5. Concepts and Measurement of

National Income: GDP, GNP, NNP, NNP
(FC)

National income means the value of goods and

services produced by a country during a financial
year. Thus, it is the net result of all economic
activities of any country during a period of one
year and is valued in terms of money. National
income is an uncertain term and is often used
interchangeably with the national dividend,
national output, and national expenditure.

1.5.1.Concept of National Income

National Income of any country means the

complete value of the goods and services produced
by any country during its financial year. It is thus
the consequence of all economic activities that are
running in any country during the period of one
year. It is valued in terms of money. In short one
can say that the national income of any country is
the total amount of income that is accrued by it
through various economic activities in one year. It
is also helpful in determining the progress of the
country. It includes wages, interest, rent, profit,
received by factors of production like labour,
capital, land and entrepreneurship of a nation.

1.5.2.Concept
There are various concepts of National Income
including GDP, GNP, NNP, NI, PI, DI, and PCI
which explain the facts of economic activities.

 GDP at market price: Is money value of all

goods and services produced within the
domestic domain with the available resources
during a year.

GDP = (P*Q)

Where,

GDP = gross domestic product

P = Price of goods and services

Q= Quantity of goods and services

GDP is made up of 4 Components

 consumption
 investment
 government expenditure
 net foreign exports of a country

GDP = C+I+G+(X-M)

Where,

C=Consumption

I=Investment

G=Government expenditure

(X-M) =Export minus import

 Gross National Product (GNP): Is market
value of final goods and services produced in a
year by the residents of the country within the
domestic territory as well as abroad. GNP is the
value of goods and services that the country's
citizens produce regardless of their location.

GNP=GDP+NFIA or,

GNP=C+I+G+(X-M) +NFIA

Where,

C=Consumption

I=Investment

G=Government expenditure

(X-M) =Export minus import

NFIA= Net factor income from abroad.

 Net National Product (NNP) at MP: Is

market value of net output of final goods and
services produced by an economy during a year
and net factor income from abroad.

NNP=GNP-Depreciation
or, NNP=C+I+G+(X-M) +NFIA- IT-
Depreciation

Where,

C=Consumption

I=Investment
G=Government expenditure

(X-M) =Export minus import

NFIA= Net factor income from abroad.

IT= Indirect Taxes

 National Income (NI): Is also known as

National Income at factor cost which means
total income earned by resources for their
contribution of land, labour, capital and
organisational ability. Hence, the sum of
the income received by factors of production in
the form of rent, wages, interest and profit is
called National Income. Symbolically or as per
the formula :

NI=NNP +Subsidies-Interest Taxes

or,

GNP-Depreciation +Subsidies-Indirect Taxes

or,

NI=C+G+I+(X-M) +NFIA-Depreciation-
Indirect Taxes +Subsidies

 Personal Income (PI): Is the total money

income received by individuals and households
of a country from all possible sources before
direct taxes. Therefore, personal income can be
expressed as follows:

PI=NI-Corporate Income Taxes-Undistributed

Corporate Profits- Social Security
Contribution +Transfer Payments.
 Disposable Income (DI): It is the income left
with the individuals after the payment of direct
taxes from personal income. It is the actual
income left for disposal or that can be spent for
consumption by individuals. Thus, it can be
expressed as:

DI=PI-Direct Taxes

 Per Capita Income (PCI): It is calculated by

dividing the national income of the country by
the total population of a country.

Thus, PCI=Total National Income/Total

National Population

1.5.3.Personal Income, Private Income and

Personal Disposable Income

Personal Income: The term "personal income" is

used to describe a person's total earnings for a
certain time period, regardless of the specific
sources of those earnings (which may include, but
are not limited to, wages, dividends, bonuses,
pensions, and social benefits). The rent one
receives from one's properties, the dividends one
receives on their investments, and the owner's
share of the earnings from one's enterprises are all
supplementary ways in which a person might bring
in money. The term "gross income" refers to the
amount of money produced before various
expenses and taxes are deducted.

Consumer spending, the fundamental driver of

economic development, is highly sensitive to the
amount of individual income. Trends show a
decline when the economy is weak and an increase
when it's booming. Moreover, a rise in the per
capita income of the people residing in a country
or area is another indicator of economic progress.

Private Income: “Private income is the total of

factor incomes and transfer incomes received from
all sources by private sector (private enterprise
and households) within and outside the country.”

It also includes net factor income from abroad.

Private Sector consists of private enterprises and
households [factor owners). Thus, private income
consists of not only factor incomes earned within
the domestic territory and abroad but also all
current transfers from government and rest of the
world. In tills way it is the sum of earned incomes
and transfer incomes received by private sector.

Thus, the concept of private income is broader

than that of personal income because private
income consists of personal income + profit tax +
undistributed profit. Again, it should be kept in
mind that conventionally ‘net factor income from
abroad’ is allocated to private sector and not to
government sector. Three main forms of transfer
income used in numerical are:

 Interest on national debt

 Current transfers from government
administrative departments
 Net current transfers from rest of the world.

Mind, interest on national debt which is paid by

the government on loans taken from public is
treated as transfer income became government
loans are traditionally treated for consumption and
not for production purposes. For the same reason,
interest paid by consumers is also treated as
transfer income and not included in national
income.

Personal Disposable Income: After paying all

required taxes, this is the sum of money or
revenue left over. This means people will have
more disposable income and will be able to put
away more money for the future. Therefore, it is
used to accurately evaluate an economy's
performance. Economists use economic indicators
and statistical measures based on discretionary
income.

Personal disposable income is the share of

disposable income that goes towards long−term
savings and retirement plans.

 Discretionary income: This is what's left over

after paying fixed costs including housing, food,
transportation, and healthcare.
 Marginal propensity to save: Marginal
propensity to save, that’s the percentage of
extra money made from each sale that was
kept.
 Marginal propensity to consume: This is the
fraction of new funds that go straight to
improving operations.

1.5.4.Approaches to calculate GDP

There are three methods of measuring GDP or

Gross Domestic Product:
 1. Income Approach

The GDP income approach formula starts with the

income earned from the production of goods and
services. Under the income approach method, we
calculate the income earned by all the factors of
production in an economy.

Factors of production are the inputs that go into

producing the final product or service. Thus, the
factors of production for a business are – Land,
Labour, Capital and Management within the
domestic boundaries of a country.

Here’s the income method of GDP calculation:

GDP=Total National Income +Sales

Taxes+Depreciation +Net Foreign Factor
Income

Where,

 Total National Income: The total of all

wages, rents, interest, and profits
 Sales taxes: Government taxes imposed on
purchases of goods and services
 Depreciation: Amount attributed to an
asset based on its useful life
 Net Foreign Factor Income: The
difference between the total income that
citizens and companies generate outside
their country of origin and the total income
generated by foreign citizens and companies
within that country
Now if we add taxes and deduct subsidies, then it
becomes Gross Domestic Product formula at
Market cost.

GDP (Market Cost) = GDP (Factor Cost)+

(Indirect Taxes – Subsidies)

2. Expenditure Approach

The second approach, known as the expenditure

approach, is the converse of Income approach as
rather than Income, it begins with money spent on
goods & services. This measures the total
expenditure incurred by all entities on goods and
services within the domestic boundaries of a
country. So let’s learn how to calculate GDP using
the expenditure approach.

Mathematically, GDP (as per expenditure method)

= C + I + G + (EX-IM)

Where,

 C: Consumption Expenditure, i.e. when

consumers spend money to buy various
goods and services. For example – food, gas
bill, car etc.
 I: Investment Expenditure, i.e. when
businesses spend money as they invest in
their business activities. For example,
buying land, machinery etc.
 G: Government Expenditure, i.e. when the
government spends money on various
development activities and
 (EX-IM): Exports minus Imports, i.e. Net
Exports. i.e. We include the exports to other
 countries in the calculation of GDP and
subtract the imports from other countries to
our country.

The calculation of GDP from the above methods

gives us the nominal GDP of the country. Mostly
GDP is calculated using both these approaches and
calculations are done in such a way that the values
from both approaches should come almost
equivalent.

3. Output (Production) Approach

The GDP Output Method measures the monetary

or market value of all the goods and services
produced within the borders of the country.

In order to avoid a distorted measure of GDP due

to price level changes, GDP at constant prices or
Real GDP is computed. Using the Output
Approach, GDP is calculated by this formula:

GDP (as per output method) = Real GDP (GDP

at constant prices) – Taxes + Subsidies.

1.6. Nominal and Real GDP, Green GDP

GDP or Gross Domestic Product is the total money

value of all the goods and services manufactured
within the geographical boundaries of a country
during a period of one year. Gross in GDP means
that depreciation is included in the monetary value
of the goods and services. Domestic signifies that
goods and services included in GDP are produced
within the domestic boundaries of the country.
However, product means that only final goods and
services will be included.

1. Nominal GDP or GDP at Current Price

Nominal GDP is the Gross Domestic Product of a

country of a given year, estimated on the basis of
the price of the goods and services of the same
year. The formula for determining the Nominal
GDP of a country is,

2. Real GDP or GDP at Constant Price

Real GDP is the Gross Domestic Product of a

country of a given year, estimated on the basis of
the price of the goods and services of a base year.
The formula for determining the Real GDP of a
country is,

The Real GDP of a country can be more, equal, and

less than its Nominal GDP.

Real GDP > Nominal GDP: When the price level

of goods and services in the base year is more than
the price level of goods and services in the current
year.

Real GDP = Nominal GDP: When the price level

of goods and services in the base year is the same
as the price level of goods and services in the
current year.
Real GDP < Nominal GDP: When the price level
of goods and services in the base year is less than
the price level of goods and services in the current
year.

3. Green GDP

The Green Gross Domestic Product, or Green GDP

for short, is an indicator of economic growth with
environmental factors taken into consideration
along with the standard GDP of a country. Green
GDP factors biodiversity losses and costs
attributed to climate change. Physical indicators
like “carbon dioxide per year or “waste per capita”
may be aggregated to indices like the “Sustainable
Development Index”

 Rationale behind Green GDP

The standard GDP measurement has limitations on

account of being indicators of economic growth
and desirable standards of living. The standard
GDP measures only the total economic output and
does not have any means to identify wealthy and
assets that arise because of the economic output.

The normal GDP also does not have any way of

knowing whether the level of income created in a
country will be sustainable or not. To overcome
this limitation the green GDP is sought after.

National Capital is poorly described in GDP as they

are not considered relevant. With relations to their
costs, policymakers and economic planners do not
give sufficient importance to benefits that
protective environmental projects might give in the
future. The positive benefits that may arise out of
any forest or agricultural land are not taken into
account due to the operational difficulties around
measuring and assessing such assets. Also, the
impact that depletion of natural resources needed
to run the economy is accounted for in standard
GDP measurements.

A need for a comprehensive macroeconomic

indicator is in tandem with the need for
sustainable development. GDP is falsely believed
to be an indicator of social well-being and thus it’s
used heavily in the analysis of political and
economic policy. The Green GDP will be a suitable
alternative in this regard.

 Green GDP Calculated

Green GDP is calculated by subtracting net natural

capital consumption from the standard GDP. This
includes resource depletion, environmental
degradation and protective environmental
initiatives. These calculations can alternatively be
applied to the net domestic product (NDP), which
subtracts the depreciation of capital from GDP. In
every case, it is required to convert any resource
extraction activity into a monetary value since they
are expressed in this manner through national
accounts.

1.6.1.Difference between Nominal GDP and

Real GDP

Basis Nominal GDP Real GDP

Meaning Nominal GDP is Real GDP is the
 the monetary value monetary value of
of all goods and all goods and
services produced services produced
within the within the
domestic domestic
boundaries of a boundaries of a
country based on country based on
the price of the the price of the
goods and services goods and services
of the same year. of the base year.
What is Nominal GDP is Real GDP is the
it? the Gross inflation-adjusted
Domestic Product GDP of a country.
without any effect
of inflation.
Expressed The Nominal GDP The Real GDP of a
of a country is country is
expressed in terms expressed in terms
of current year of base year prices
prices of goods and or constant prices
services. of goods and
services.
Complexit It is easy to It is quite difficult
y calculate Nominal to calculate Real
GDP. GDP.
Value of The value of The value of Real
GDP Nominal GDP is GDP is much lower
much higher than than the value of
the value of Real Nominal GDP
GDP because it because it takes
takes current the market price of
market changes the base year into
into consideration. consideration.
Compariso One can compare One can compare
n with the the Nominal GDP the Real GDP of
previous of different different financial
GDPs quarters of a years of a country.
country.
Economic One cannot easily One can easily
Growth analyze the analyze the
economic growth economic growth
of a country with of a country using
its Nominal GDP. its Real GDP, as it
is a good indicator
of economic
growth.

1.7. Income, expenditure and the circular

flow

It is a model which explains the flow of income and

expenditure in the circular flow that illustrates the
different sectors in an economy and reveals the
different sources of their incomes and the different
expenditures which they have to bear.

This model is used in calculating national income,

by totalling the income of all the different sectors
in the economy. It is named a circular flow model
because money moves in a circular motion in an
economy i:e one sector spends money on another
sector and receives money from the same sector in
a different form. To understand the biggest and
real-world model which is called four sector model;
the explanation starts with smaller and easier
models. Classification of the circular flow of
income and expenditure different models are:
1. Circular Flow Of Income In Two Sector
Economy

The circular flow of income in two sector economy

is said as a closed and simple economy. Because
the flow of money is taking place between only two
sectors; the household sector and the business
sector. There is no intervention of government in
this form of economy and there are no interactions
with the outside economy i:e foreign sector.

The circular flow of income in two sector economy

is a closed economy, it has no foreign sector.

Figure 1:2 Circular Flow Of Income And

Expenditure In Two Sector Model2

 Household Sector

2
https://www.thekeepitsimple.com/wp-content/uploads/
2021/02/Circular-Flow-Of-Income-And-Expenditure-In-
Two-Sector-Model-640x420.png
 Household’s different sources of income in the
circular flow of income in two sector economy:

o They are the only buyer of goods and

services produced by the firms
o They supply the factors of production, i:e
land, labour, capital and organization.
o Their entire income is spent on goods and
services bought from the business sector.
o Therefore, they do not make any savings and
investments.
o They generate income from the factors of
production they provided in form of rent,
wages, interest and capital.

 Business Sector

Business sectors in the two-sector economy:

o The business sector is the producer in an

economy, which provides goods and services
to households. For this, they receive money
from the household sector.
o For producing goods and services the
household sector provides the factors of
production, land, labour, capital and
entrepreneur.
o Pays the household sector in form of rent,
wages, interest, the capital.

i. Equilibrium in The Two-Sector Economy

Equilibrium in the circular flow of income in two

sectors when they attain the situation where all
two sectors are equal:
 Income (Y) = Consumption (C) = output(O)

ii. Circular Flow Of Income In Two Sector

Economy- Assumptions

The circular flow of income and expenditure in

two-sector economies is not a real economic
model. Assumptions in the circular flow of income
in a two-sector economy are:

 There are only two sectors in this model;

o Household
o Business

 No government involvement in economic

activities.

 Since there is no foreign sector in this model

so there are no import or export activities.

Figure 1:3 Circular Flow Of Income And

Expenditure In Three Sector Model

Because of these reasons, circular flow of income

in a two-sector economy is a closed economy.
 2. Circular Flow Of Income And Expenditure
In Three-Sector Economy

The circular flow of income and expenditure in a

three-sector economy includes three sectors-
household sectors, business and government
sector. The circular flow of income in three sector
economy is not a closed economy but they have no
international trade relations. Circular flow model
in three sectors economy explains:

i. Household Sector

Households in the circular flow of income and

expenditure in three sector economy:

 People from the household sector provide a

factor of production which are; land, labour,
capital and organization.
 For they earn their income in form of rent,
wages, interest, the capital.
 The government sector also purchases
services from the household sector.
 Household spends their income by
purchasing goods and services from the
business sector.
 Pay direct and indirect taxes to a
government which creates leakages.
 Their entire income is spent on goods and
services and taxes.
 Therefore, there is no existence of a
financial market in the economy i:e there is
no savings and investments in the economy.
ii. Business Sector
 Firm’s different sources of income and expenditure
in the circular flow of income and expenditure in
three sector economy:

 The business sector is the producer in an

economy, which provides goods and services
to households. For this, they receive money
from the household sector.
 For producing goods and services the
household sector provides the factors of
production, land, labour, capital and
entrepreneur.
 Pays the household sector in form of rent,
wages, interest, the capital.
 They sell their goods to household and the
government and receives payments in
return.
 They pay taxes to the government.
 The government sector provides subsidies
and other benefits to the firms.

iii. Government Sector

Government sector income and expenditure in the

circular flow of income and expenditure in three
sector economy:

 The household sector pays direct tax which

is also called income tax.
 In return, they provide be various benefits to
the household sector like subsidies, welfare
etc.
 Firms have to pay taxes for production and
profit.
  And, in return firms receives the transfer
payments, like- subsidies.
 Also, they buy goods and services from
firms/ business sectors.

3. Circular Flow Of Income In Four Sector

Model

The circular flow model in the four-sector economy

is a real model which explains the flow of income
and expenditure in the real world. We will study
four different sectors in this model; household,
firms, government, and foreign. Also, there is the
introduction of leakages and injections in this
sector.

Figure 1:4 Circular Flow Of Income In Four Sector

Model
 Each sector has a dual function in the circular flow
of income and expenditure, as each sector has to
make payments to some sectors and receive
payments from some sectors. Circular Flow Of
Income In Four Sector Economy

i. Household Sector
 They are the buyers of goods and services
produced by the firms.
 They supply the factors of production, i:e
land, labour, capital and organization and
receive payments for their supply.
 The household sector pays direct and
indirect taxes to the government and firms
respectively.
 They also purchases the services from the
household and in return, they make transfer
payments to the household sector.
 Household Sector exports one of the factors
of production i:e, manpower to the foreign
sector.
 And there is an existence of imports.

ii. Business Sector

 The business sector is the producer in an
economy, which provides goods and services
to households. For this, they receive money
from the household sector.
 For producing goods and services the
household sector provides the factors of
production, land, labour, capital and
entrepreneur.
 Pays the household sector in form of rent,
wages, interest, the capital.
  They pay taxes to the government and also it
is one of the factors of leakage from the
circular flow.
 The government will purchase goods and
provide subsidies and other benefits to
firms.
 The business sector borrows funds from the
financial market.
 Firms import raw materials from the foreign
sector (rest of the world) and business
sectors make payment for that.
 Also, firms export their final goods and
services to the foreign sector and receive
payment for that.

iii. Government Sector

 The household sector pays the income tax
and indirect tax imposed on goods and
services
 In return, they provide different benefits or
transfer payments to them.
 Firms pay taxes to the government, for
production and profits.
 They provide subsidies and purchase goods
and services from firms.
 The capital market lends money to the
government sector in case of a financial
deficit
 Also, the government uses the financial
market for making their savings and
investment.

iv. Foreign Sector

  The business sector makes payments to the
foreign sector in return for the goods and
services imported.
 They make payments for the imports which
they received from the foreign sector.
 Household Sector exports one of the factors
of production i:e, manpower to the foreign
sector and the foreign sector makes the
payment for the same.
 Plus, there are net transfer payments that
are made by the foreign sector to
households.

v. Capital Market
 Capital Market receives income from
different sectors as they deposit their
savings.
 The capital market lends money to the firms
or government sector for increasing their
resources.

1.8. Concept of Social Accounting

Business is a socio-economic activity and it draws

its inputs from the society, hence its objective
should be the welfare of the society. It should owe
a responsibility towards solving many of the social
problems. In the present age of growing
technological, economic, cultural and social
awareness, the accounting has not only to fulfill its
stewardship function for the owners of the
enterprise, but also accomplish its social function.

Changing environments and social parameters

have compelled business enterprises to account
and report information with regard to discharge of
their social responsibilities. The boundaries of the
principles, practices and skills of conventional
accounting have been extended to such areas for
social disclosure and attestation with regard to the
measures of social programmes.

The concept of ‘Social Accounting’ has gained

importance as a result of high level
industrialization which has brought prosperity as
well as many problems to the society. It has
necessitated the corporate sector, with huge
amounts of funds at their disposal, to invest
substantial amounts in social activities so as to
nullify the adverse effects of industrialization. “In
modern times, accounting efforts have been
extended to the assessment of the state of society
and of the social programmes not for the
satisfaction of any individual or group but for the
application of evaluative procedures in the
allocation of resources towards better social well-
being as a whole.”

Social accounting is concerned with the study and

analysis of accounting practice of those activities
of an organisation. The concept of socialistic
pattern of society, civil rights movements,
environmental protection and ecological
conservation groups, increasing awareness of
society towards corporate social contribution, etc.
Have contributed towards the growing importance
of Social accounting.

Social Accounting, also known as Social

Responsibility Accounting, Socio-Economic
Accounting, Social Reporting and Social Audit,
aims to measure and inform the general public
about the social welfare activities undertaken by
the enterprise and their effects on the society.

1.8.1.Features of Social Accounting

 Social accounting is an expression of a

company’s social responsibilities.
 Social accounting is related to the use of
social resources.
 Social accounting emphasize on relationship
between firm and society.
 Social accounting determines desirability of
the firm in society.
 Social accounting is application of
accounting on social sciences.
 Social accounting emphasizes on social
costs as well as social benefits.

1.8.2.Need/Benefits of Social Accounting

The important benefits of social accounting are as

follows:

 A firm fulfills its social obligations and

informs its members, the government and
the general public to enables everybody to
form correct opinion.
 It counters the adverse publicity or criticism
leveled by hostile media and voluntary social
organisations.
 It assists management in formulating
appropriate policies and programmes.
 Through social accounting the firm proves
that it is not socially unethical in view of
 moral cultures and environmental
degradation.
 It acts as an evidence of social commitment.
 It improves employee motivation.
 Social accounting is necessary from the view
point of public interest groups, social
organisations investors and government.
 It improves the image of the firm.
 Through social accounting, the management
gets feedback on its policies aimed at the
welfare of the society.
 It helps in marketing through greater
customer support.
 It improves the confidence of shareholders
of the firm.

1.8.3.Limitations of GDP as a Measure of

Social Welfare

Limitations of using GDP as an indicator are as

follows:

 Non-monetary exchanges

GDP measures the goods and services produced in

an economy during a particular period of time.
However, it does not take into account those
transactions that do not come under monetary
terms. In less developed countries there are non-
monetary exchanges, particularly in rural areas.
Hence, these transactions remain outside the
domain of GDP. The household sector and
volunteer sectors get ignored in GDP.

 Inflation
GDP does not take into account the level of prices
in a country. Because of inflation, the cost of living
increases leading to a decrease in the standard of
living. The loss of welfare due to this decrease is
not taken into consideration by GDP as an index of
welfare.

 Externalities

Increase in the national income is associated with

increased levels of pollution, accidents, disasters,
shortage and depletion of natural resources, etc.
These factors affect human health and lead to
ecological degradation. GDP fails to consider the
costs or valuations of such factors.

 Income pattern

GDP disregards the income distribution pattern.

The increase in aggregate national income may be
a result of the increase in income of a few
individuals. Thus, this may lead to false
interpretation of social welfare.

 Welfare

GDP ignores the welfare component as the goods

and services produced may or may not add to the
welfare to a society. For example, the production
of goods, like guns, narcotic drugs, high-end
luxurious goods increase the monetary value of
production, but they do not add to the welfare of
the majority of population.

1.9. Difficulties in Measuring National

Income in Developing Economies
National income figures denote the economic
progress of an economy. They also enable to
analyze and understand the significance of each
sector in an economy. They also reveal the trends
in the concentration of economic power and
inequalities between the rich all the poor. There
three methods for calculating national income.
These are production method, income method and
expenditure method. There are many involved in
measuring national income. They are mentioned as
below:

1. Non-monetized sector: Goods and services

which are sold and bought in non-monetized
sector are not included in national income.
Non-monetized sector is prevalent in several
under developed countries. Major portion of
transaction of goods and services take place in
this sector. Such transactions are not
recognized and registered by the state
authorities. Mere calculation of the value of
goods and services in monetized sector is
useless in measuring national income figures.

2. Exclusion of free services: Free services like

wife’s services to the family, maintenance of
libraries, parks and reading rooms etc by the
government are not included in the calculation
of national income. This leads to several
peculiar problems:

 National Income figures does not include

some important services meant for the
public welfare.
  The nature of services of several persons in
several fields can’t be decided easily. If a
teacher gives coaching to his children, it is
considered a free service. If the same
teacher works in a high school, his services
are considered remunerative or economic in
nature. As a teacher in a school, his services
are included in national income figures.

3. Statistical data: Another problem of national

income estimates refers to the availability of
accurate statistical data and information.
Especially in underdeveloped counties,
statistician who supervise the calculation of
National income figures face several problems
in securing correct and accurate information
about the output, savings, investment,
consumption, income and expenditure of
individuals in different spheres.

4. Double counting: Double counting is another

problem faced in measuring national income
figures. Great care should be taken for avoiding
double counting of a commodity. A particular
commodity should be counted only once at a
particular state.

5. Transfer earnings: income received by

individuals productive work like pensions,
unemployment relief funds etc. come under the
category of transfer earnings. Such transfer
earnings are excluded from national income.

6. Income of foreign companies: Another

problem relates to the inclusion of income of
 foreign companies in measuring national
income. According to the opinion of
International Monetary Fund Experts, Foreign
Companies’ income has to be included in the
national income of those countries where
production is organized. But the profits
obtained by the branches of foreign companies
should be included in the national income of
foreign countries.

7. Unproductive activities: The governments of

modern states have been spending large
amounts on some free services like parks,
libraries, recreation, cultural activities, old-age
pensions, orphan houses, child care centers,
Maternity homes etc. Is it a right step to
include such services in National Income? This
is a problem which we have to consider. Since
these services yield no income, some
considered that they have to be excluded in
national income. But many experts are of the
view that all Government expenditure should be
included in measuring national income.

8. Difficulties of Comparison: Difficulties arise

while comparing national income figures of one
Country with that of another. This is so because
the mature of methods adopted for calculating
the national income differ from country to
country.

9. Problems due to changes in Market prices:

Gross national income figures increase due to
an increase in the market prices of goods and
services. But the real national product remains
 the same. Sometimes it falls due to inflationary
effects. So this problem arising due to the
fluctuations in market prices has to be solved
while calculating national income. For this
national income estimates are to be made on
the basis of constant prices during a year.

1.10. GDP and Black Economy

The black economy is a segment of a country's

economic activity that is derived from sources that
fall outside of the country's rules and regulations
regarding commerce. The activities can be either
legal or illegal depending on what goods and/or
services are involved. The black economy is related
to the concept of the black market. In the same
way that an economy is made up of many related
markets considered as an integrated whole, the
black economy is made up of the collection of
various black markets in an economy.

The black economy works within a jurisdiction

such as a state, but without following the laid
down protocols for doing business in that
jurisdiction. As a result, it is known by many
names, like shadow economy, grey economy,
hidden economy, and informal economy, among
others.

An essential component here is that black markets

are a hub of activities where people escape tax
payments on their jobs. An easy way to save taxes
is to have cash dealings that are difficult to track
compared to banks that offer banking statements
for clarification. A wide web of activities prospers
and thrives within a shadow economy based on the
parties’ needs.

A simple example can be when a business employs

child labor or forces the workers to work in
conditions that do not adhere to the labor laws of
the land. The CSR experts dedicate a good deal of
their time to ensuring legal adherence to the
working conditions of the parent and outsourced
firm.

Another method to avoid regulations on quality is

through the sale and purchase of products in black
markets that are either banned in a country or are
available at higher rates. That attracts people to
transact in black markets to save money. The rise
of e-commerce has flourished black markets, and
innumerable cases are hard to track for law
enforcement. The trade-in in the shadow
economies is typically considered illegal, though
there are instances where the transactions’
legality is grey. The study above found that
amongst the 158 countries, from 1991 to 2015, the
shadow economy consisted of around 31.9% of
the GDP. Zimbabwe had a substantial share, with
the shadow economy being 60.6% of its GDP.
Bolivia was close on its heels with 62.3%. The
lowest occurrence was seen in Austria with 8.9%
and Switzerland with 7.2%.

1.10.1. Causes

The International Monetary Fund (IMF) conducted

a study that detailed the black economy meaning
and defined the black economy as the shadow
economy that contains all the economic activities
hidden from the officials for monetary, regulatory,
and institutional reasons. It further mentioned the
reasons behind the black economy getting
established. The study classified the causes into
three categories – financial, regulatory, and
institutional.

 The financial reasons revolve around tax

avoidance and escaping contributions made
towards social security.
 The regulatory reasons hover around
avoiding rules and regulations.
 The institutional reasons stem from
corruption in the legal and political domain
and a less stringent rule of law.

1.10.2. Impact

 This type of economy draws income away

from the real economy. If there is easy
access to the shadow economy to buy goods
without taxes, this becomes a vastly cheaper
alternative. It attracts many to make
purchases in this manner, rather than in
legitimate shops.
 It encourages people to involve in extortion,
tax evasion, smuggling, and human
trafficking. Involvement in such an economy
usually consists of the oppression of one
group of people. For instance, the sale of
weapons in the black market may lead to a
rise in terrorism.
 It can sometimes make solving crimes
harder. Moreover, in politically unstable
 economies, a shadow economy can increase
the burden on governance. Finally, it grants
easier access to anti-social elements and
criminals, threatening citizens’ safety.
 Some of these countries face embargo,
which often lead to adversity. Moreover, in
countries battling economic instability and
corruption, the cost of essential goods and
services in legal institutions is usually high,
depriving the oppressed and impoverished
of affording them. In such cases, a black
market helps the underprivileged access the
essentials lower.

1.11. Concept of Base Year and GDP Index

A base year is the first of a series of years in an

economic or financial index. In this context, it is
typically set to an arbitrary level of 100. New, up-
to-date base years are periodically introduced to
keep data current in a particular index. Base years
are also used to measure the growth of a company.

A base year refers to the base point in time of a

time series. The most frequent use of a base year
in economic data is in compiling price indices such
as the GDP deflator to convert a current value such
as GDP at market prices into GDP at constant
prices. The constant price series are always
published with reference to some base year such
as 2010 in order that real growth in the volume of
goods and services produced since that year can
be measured. The relevant index is constructed to
measure how much prices have changed since the
base year where the mean of the index point
figures of a base year is taken as 100. Therefore,
constant price estimates of GDP use the inflation
adjusted price of goods and services relative to a
base, to weight the volume components of output.

The base year chosen reflects a snapshot of the

structure of the economy and the value of output
in the different sectors – extraction, agriculture,
manufacturing and services – and sub-categories
within these sectors – as estimated by the output
method of calculating GDP at one point in time.

The base year chosen must be a representative

year and must not experience any abnormal
incidents such as droughts, floods, earthquakes, a
major economic downturn etc. It also must be a
year which is reasonably proximate to the year for
which the national accounts statistics are being
calculated. Countries all over the world follow
different ways of fixing the base year. In India, for
example, the first estimates of GDP were made in
1956 taking 1948-49 as the base year. With the
gradual improvement in availability of data, the
methodology was revised. Earlier, the Central
Statistical Office depended on the population
figures in the National Census to estimate the
workforce in the economy. Therefore, the base
year always coincided with the census figures like
1970-71, 1980-81 etc. Subsequently the CSO
decided that the National Sample Survey (NSS)
figures on the workforce size were more accurate
and hence, the base year would change every five
years when the NSS conducted such survey. This
system was started from 1999 when the base year
was revised from 1980-81 to 1993-94. In the case
of many countries, however, the failure to update a
base year which involves in-depth surveys of the
structure of an economy, is due to lack of
resources in terms of the statistical capacity of
national statistics offices. This problem is
compounded by the fact many emerging markets
and lower income countries are economies where
the structure of economic activity is changing most
rapidly.
CHAPTER-2:Money and Banking

2.1. Functions of Money

Money is any object or item which is generally

accepted as a mode for payment of goods &
services and repayment of loans or debts, such as
taxes, etc., in a particular nation or country.
Money was invented to facilitate trade as the
barter system was not able to express the value
and prices of goods & services. The term money
covers all things like currency notes, coins,
cheques, etc., to carry out all economic
transactions and settle claims. As a currency,
money circulates from country to country and
person to person to facilitate trade. Different
stages of money are Commodity Money, Metallic
Money, Paper Money, Credit Money and Plastic
Money.

Functions of money can be broadly categorized

into two parts:

1. Primary functions of money

Primary functions can be further divided into two

subcategories.

 Money as an Exchange Medium

One of the primary functions of money is as a

medium of exchange as it can be used for any or
all transactions wherein goods or services are
purchased or sold. Therefore, one can buy or sell
products in exchange for money.
  A measure of Value

Money can be treated as the parameter of

measuring the value of a product or service. To put
it simply, the value of every product or service can
be expressed in monetary form. The money also
follows a standard and is accepted worldwide even
though the currency does differ from one country
to another. Subsequently, these primary and
secondary functions of money are some important
uses of money in any economic market.

2. Secondary Functions of Money

The secondary function can be further segregated

into three parts as mentioned below:

 Store of Value

Being crucial functions of money, it can be stored

or conserved. One can store it for future purposes,
and it is economical as well as convenient to store
money.

 Standard of Deferred Payments

Money can be used conveniently for deferred

payments which need to be paid by individuals. It
has become the standard for payments made
presently or in the future. For instance, if someone
borrows a certain amount from another individual,
they need to repay the amount with interest. With
money in purview, it is convenient to pay the
interest or make deferred payments.
This has led to the popularity of lending and
borrowing transactions and has contributed a big
part to the formation of financial institutions.

 Transfer of Value

The utility of money stretches to the transfer of

value as it can be used to purchase goods not only
within the country but beyond the domestic line.
One can sell or purchase goods in the domestic or
international market with money as a standard
tool.

Therefore, the availability of money in the market

has contributed to stability and liquidity in the
market and helps form essential functions of
money markets.

2.2. Quantity Theory of Money

The quantity theory of money in economics states

that the quantity of money will determine the value
of money. The general level of prices of products
and services in an economy is directly related to
the volume of money that is circulating in the
economy. If the quantity of money changes in an
economy, the price level will also show a change in
that same proportion. So, to stop inflation,
economies need to check the supply of money. This
theory assumes that the output of goods and
velocity remain constant.

Though the quantity theory of money formula has

many limitations and has also been criticized, it
also has certain merits. The quantity theory of
money depends on the simple fact that if people
have more money, they will want to spend more,
and that means more people will bid for the same
goods/services, which will cause the price to shoot
up. Though empirically, the relationship between
value and supply of money is not the directly
proportionate one, we can see that excessive
supply of money increased inflation in the past.

This theory was first formulated by Nicolaus

Copernicus in 1517, and it evolved later with the
help of various other economists.

2.2.1.Equation

The Fisher equation can easily describe the

quantity theory of money. The value of money can
be described by the supply and demand of money,
as we determine the supply and demand of
commodities. The quantity theory of money
formula can be described by:

MV = PT

Where,

 M = Total amount of money in the economy.

 V = Velocity of money circulation, i.e., how
many times money gets exchanged for
goods/services.
 P = general price level in the economy.
 T = Total index of physical volume of
transactions.
 PT can be defined as total expenditure in a
given time.
2.2.2.Assumptions

Let us look at the quantity theory of money

assumptions:

 It assumes that the speed in which the

money is circulating in the economy, which
is the velocity of money, to remain constant
and it depends on the type of population,
trading facilities, interest rates, investment
opportunities.
 It also assumes that the volume of the
products and services are constant in the
economy.
 In this theory, the prices do not play an
active role.
 The theory also considers all transactions
taking place are using money. Thus, money
is the only medium of exchange and no one
accumulated or hoards money.

2.2.3.Benefits

Some of the advantages of quantity theory of

money in economics are as follows:

 It brings out the relationship between

money supply and price level in the
economy.
 The equation is very simple and easy to
understand.
 This equation has been supported
by empirical evidence.

2.2.4.Limitations
  Its simplicity is one of its limitations. People
know that it is obvious that if the money
supply increases, the price will decrease. It
does not state the cause and effect of the
increasing supply.
 This equation assumes that the velocity and
output of goods will remain constant and
will not be affected by other factors, but an
actual change in any of these factors is
changeable.
 It does not explain the trade cycle. If a
decrease in money causes depression, then
if we increase the amount of money, reversal
or quantity theory of
money inflation should happen, but this is
not the case most times in actuality.
 It is not useful in short-term time frames. It
is only useful for a long period.
 Some of this theory’s elements are
inconsistent. For example, P includes the
price of all goods or services in the
economy, but we know that the price
movement of some goods is quite rigid
compared to other goods. So, it is hard to
say which price we refer to in the equation.

2.3. Fundamental Equations and the

Equation of Exchange

The equation of exchange is a mathematical

equation for the quantity theory of money in
economies, which identifies the relationship among
the factors of:
  Money Supply
 Velocity of Money
 Price Level
 Expenditure Level

The equation of exchange was derived by

economist John Stuart Mill. The equation states
that the total amount of money that changes hands
in an economy will always be equal to the total
monetary value of goods and services that changes
hands in an economy.

In other words, the amount of nominal spending

will always be equal to the amount of nominal
income.

Equation of exchange is also used to make an

argument that inflation rates will be proportionate
to the change in the money supply and that the
demand for money can be broken down into:

 The total demand for money for use in

transactions; and
 The total demand for money for holding
in liquidity

The equation is as follows:

Where:

 Ms = Money supply, or the average currency

units in circulation within a time period
  V = Velocity of money, or the average
number of times that a currency unit
changes hands within a time period
 P = Average price level of goods and
services during a time period
 T = Index of the real value of all aggregate
transactions within a time period

“Ms x V” is interpreted as the total amount of

money that is spent within an economy within a
time period

“P x T” is interpreted as the total amount of money

that is spent within an economy within a time
period.

Therefore, as mentioned earlier, the equation

states that the total amount of money that is spent
within an economy over a specific period is always
equal to the total amount of money that is spent on
goods and services during the same period.

The equation can be restated in the following form:

Where:

 Ms = Money supply, or the average currency

units in circulation within a time period
 V = Velocity of money, or the average
number of times that a currency unit
changes hands within a time period
 P = Average price level of goods and
services during a time period
  Q = Index of all real expenditures within a
time period

“P x Q” is interpreted as the nominal GDP over a

time period.

The restated equation states that the total amount

of money spent within an economy over a specific
period is always equal to the total amount of
money earned within the same period; or, nominal
expenditures are always equal to nominal income.

It represents the common expression of the

quantity theory of money, which is used to explain
changes in the money supply and its relationship
to the overall level of prices of goods and services.

2.4. Keynesian Theory of Money and

Prices

During the Great Depression of the 1930s, existing

economic theory was unable either to explain the
causes of the severe worldwide economic collapse
or to provide an adequate public policy solution to
jump-start production and employment.

British economist John Maynard Keynes

spearheaded a revolution in economic thinking
that overturned the then-prevailing idea that free
markets would automatically provide full
employment—that is, that everyone who wanted a
job would have one as long as workers were
flexible in their wage demands. The main plank of
Keynes’s theory, which has come to bear his name,
is the assertion that aggregate demand—measured
as the sum of spending by households, businesses,
and the government—is the most important driving
force in an economy. Keynes further asserted that
free markets have no self-balancing mechanisms
that lead to full employment. Keynesian
economists justify government intervention
through public policies that aim to achieve full
employment and price stability.

He then presented a reformulated quantity theory

of money which brought about a transition from a
monetary theory of prices to a monetary theory of
output. In doing this, Keynes made an attempt to
integrate monetary theory with value theory and
also linked the theory of interest into monetary
theory. But “it is through the theory of output that
value theory and monetary theory is brought into
just a position with each other.”

Keynes does not agree with the older quantity

theorists that there is a direct and proportional
relationship between quantity of money and prices.
According to him, the effect of a change in the
quantity of money on prices is indirect and non-
proportional.

Keynes complains “that economics has been

divided into two compartments with no doors or
windows between the theory of value and the
theory of money and prices.” This dichotomy
between the relative price level (as determined by
demand and supply of goods) and the absolute
price level (as determined by demand and supply
of money) arises from the failure of the classical
monetary economists to integrate value theory
with monetary theory. Consequently, changes in
the money supply affect only the absolute price
level but exercise no influence on the relative price
level.

Further, Keynes criticises the classical theory of

static equilibrium in which money is regarded as
neutral and does not influence the economy’s real
equilibrium relating to relative prices. According
to him, the problems of the real world are related
to the theory of shifting equilibrium whereas
money enters as a “link between the present and
future”.

2.4.1.Assumptions

 All factors of production are in perfectly

elastic supply so long as there is any
unemployment.
 All unemployed factors are homogeneous,
perfectly divisible and interchangeable.
 There are constant returns to scale so that
prices do not rise or fall as output increases.
 Effective demand and quantity of money
change in the same proportion so long as
there are any unemployed resources.

Given these assumptions, the Keynesian chain of

causation between changes in the quantity of
money and in prices is an indirect one through the
rate of interest. So when the quantity of money is
increased, its first impact is on the rate of interest
which tends to fall. Given the marginal efficiency
of capita, a fall in the rate of interest will increase
the volume of investment.
The increased investment will raise effective
demand through the multiplier effect thereby
increasing income, output and employment. Since
the supply curve of factors of production is
perfectly elastic in a situation of unemployment,
wage and non-wage factors are available at
constant rate of remuneration. There being
constant returns to scale, prices do not rise with
the increase in output so long as there is any
unemployment.

Thus so long as there is unemployment, output will

change in the same proportion as the quantity of
money, and there will be no change in prices; and
when there is full employment, prices will change
in the same proportion as the quantity of money.
Therefore, the reformulated quantity theory of
money stresses the point that with increase in the
quantity of money prices rise only when the level
of full employment is reached, and not before this.

According to him, the following possible

complications would qualify the statement that so
long as there is unemployment, employment will
change in the same proportion as the quantity of
money, and when there is full employment, prices
will change in the same proportion as the quantity
of money.”

 “Effective demand will not change in exact

proportion to the quantity of money.
 Since resources are homogenous, there will
be diminishing, and not constant returns as
employment gradually increases.
  Since resources are not interchangeable,
some commodities will reach a condition of
inelastic supply while there are still
unemployed resources available for the
production of other commodities.
 The wage-unit will tend to rise, before full
employment has been reached.
 The remunerations of factors entering into
marginal cost will not all change in the same
proportion.”

Taking into account these complications, it is clear

that the reformulated quantity theory of money
does not hold. An increase in effective demand will
not change in exact proportion to the quantity of
money, but it will partly spend itself in increasing
output and partly in increasing the price level. So
long as there are unemployed resources, the
general price level will not rise much as output
increases. But a sudden large increase in
aggregate demand will encounter bottlenecks
when resources are still unemployed.

It may be that the supply of some factors becomes

inelastic or others may be in short supply and are
not interchangeable. This may lead to increase in
marginal cost and price. Price would accordingly
rise above average unit cost and profits would
increase rapidly which, in turn, tend to raise
money wages owing to trade union pressures.
Diminishing returns may also set in. As full
employment is reached, the elasticity of supply of
output falls to zero and prices rise in proportion to
the increase in the quantity of money.
According to Keynes, an increase in the quantity of
money increases aggregate money demand on
investment as a result of the fall in the rate of
interest. This increases output and employment in
the beginning but not the price level. In the figure,
the increase in the aggregate money demand from
D1 to D2 raises output from OQ1 to OQ2 but the
price level remains constant at OP. As aggregate
money demand increases further from D 2 to
D3 output increases from OQ2 to OQ3 and the price
level also rises to OP3.

This is because costs rise as bottlenecks develop

through the immobility of resources. Diminishing
returns set in and less efficient labour and capital
are employed. Output increases at a slower rate
than a given increase in aggregate money demand,
and this leads to higher prices. As full employment
is approached, bottlenecks increase. Further-more,
rising prices lead to increased demand, especially
for stocks. Thus prices rise at an increasing rate.

But when the economy reaches the full

employment level of output, any further increase in
aggregate money demand brings about a
proportionate increase in the price level but output
remains unchanged at that level. This is shown in
the figure when the demand curve D 5 shifts
upward to D6 and the price level increases from
OP5 to OP6 while the level of output remains
constant at OQF.

2.4.2.Criticisms of Keynes Theory of Money

and Prices
Keynes’ views on money and prices have been
criticised by the monetarists on the following
grounds.

1. Direct Relation

Keynes mistakenly took prices as fixed so that the

effect of money appears in his analysis in terms of
quantity of goods traded rather than their average
prices. That is why Keynes adopted an indirect
mechanism through bond prices, interest rates and
investment of the effects of monetary changes on
economic activity. But the actual effects of
monetary changes are direct rather than indirect.

2. Stable Demand for Money

Keynes assumed that monetary changes were

largely absorbed by changes in the demand for
money. But Friedman has shown on the basis of his
empirical studies that the demand for money is
highly stable.

3. Nature of Money

Keynes failed to understand the true nature of

money. He believed that money could be
exchanged for bonds only. In fact, money can be
exchanged for many different types of assets like
bonds, securities, physical assets, human wealth,
etc.

4. Effect of Money

Since Keynes wrote for a depression period, this

led him to conclude that money had little effect on
income. According to Friedman, it was the
contraction of money that precipitated the
depression. It was, therefore, wrong on the part of
Keynes to argue that money had little effect on
income. Money does affect national income.

2.5. Determination of Money Supply and

Demand

Money supply is a very important financial

indicator and affects the economy in many ways.
Therefore, the government and the central bank
closely watch the money circulation in an
economy. Thus, it should be optimum, neither high
nor less. An increase in the supply implies that
people are spending more, which increases the
demand for products and services in the economy.
As a result, high demand contributes to a rise in
prices. Therefore, the high circulation of money
will lead to higher inflation rates.

In such situations, the central banks will introduce

a contractionary monetary policy to reduce
consumer spending. It is usually done by
increasing interest rates on consumer loans.
Hence, customers will stop borrowing and have to
cut down on spending. Thus, it reduces money
circulation.

However, prolonged periods of reduced supply are

also equally harmful. If customers give up
spending altogether, the economy will become
stagnant, leading to mass unemployment.
Therefore, the government will introduce an
expansionary monetary policy, where the interest
rates on borrowing will be decreased. As a result,
people will borrow more and spend more. Central
banks also inject additional money into the
economy.

2.5.1.Measurement

Since the supply of money is an important

economic parameter, governments constantly
monitor and regulate it. Therefore, they measure
the amount of money frequently to keep it in
check. Standard measures of money supply include
M1, M2, M3, and M4.

The measurement of the supply begins with the

M0 or monetary base. It denotes the amount of
currency in circulation, i.e., currency bills, coins,
and bank reserves.

 M1 money supply: Also called the ‘narrow

money,’ it includes M0 and other highly
liquid deposits in the bank.
 M2 money supply: It is perhaps the most
commonly accepted measure because it
consists of M1 in addition to marketable
securities and less liquid deposits.
 M3 money supply: Known as ‘broad
money,’ it constitutes M2 and money market
funds like mutual funds, repurchase
agreements, commercial papers, etc.
 M4 money supply: It comprises M3 and all
other least liquid assets, usually
outside commercial banks.
Thus, the above types of money supply
measurements and their formulas can be
summarized as follows:

 M0 = Currency notes + coins + bank

reserves
 M1 = M0 + demand deposits
 M2 = M1 + marketable securities + other
less liquid bank deposits
 M3 = M2 + money market funds
 M4 = M3 + least liquid assets

These measures of money supply usually vary

depending on the country. For example, the
Federal Reserve usually focuses on M1 and M2
types to monitor the U.S. money supply, whereas
the Bank of England measures M4 types too.

2.5.2.Determinants of Money Supply

There are many aspects to the circulation of money

in a country. One such aspect is the determinants,
which help influence and accurately quantify an
economy’s supply situation.

 High-powered money – Cash and its

equivalents available with the public
and bank deposits are included in high-
powered money. Since they are highly
liquid, they directly affect the supply of
money in an economy.
 Level of commercial bank reserves – The
central bank mandates commercial banks to
hold a fixed percentage of deposits as
reserves in case of any emergency. Banks
 lend the excess reserve amount to
consumers, increasing money circulation.
 Reserve ratio – It is the ratio of cash
reserve to deposits, as instructed by the
central bank. If the central bank increases
the ratio, banks will have to hold more
money in reserves, reducing banks’ lending
capabilities.
 Liquid cash held by the public – If the
people have more liquid cash at home, they
will only spend a small portion required.
However, if the same cash is deposited in
the bank, the supply in the economy will be
high.

2.6. Credit Creation

Credit creation refers to expanding the availability

of money through the advancement of loans and
credit by banks and financial institutions. These
institutions use their demand deposits to provide
loans to their customers, giving borrowers higher
purchasing power and competitive interest rates.

Demand deposits are an important constituent of

money supply and the expansion of demand
deposits means the expansion of money supply.
The entire structure of banking is based on credit.
Credit basically means getting the purchasing
power now and promising to pay at some time in
the future. Bank credit means bank loans and
advances.

A bank keeps a certain part of its deposits as a

minimum reserve to meet the demands of its
depositors and lends out the remaining to earn
income. The loan is credited to the account of the
borrower. Every bank loan creates an equivalent
deposit in the bank. Therefore, credit creation
means expansion of bank deposits.

The two most important aspects of credit creation

are:

 Liquidity – The bank must pay cash to its

depositors when they exercise their right to
demand cash against their deposits.
 Profitability – Banks are profit-driven
enterprises. Therefore, a bank must grant
loans in a manner which earns higher
interest than what it pays on its deposits.

The bank’s credit creation process is based on the

assumption that during any time interval, only a
fraction of its customers genuinely need cash.
Also, the bank assumes that all its customers
would not turn up demanding cash against their
deposits at one point in time.

2.6.1.Basic Concepts of Credit Creation

1. Bank as a business institution – Bank is

a business institution which tries to maximize
profits through loans and advances from the
deposits.
2. Bank Deposits – Bank deposits form the basis
for credit creation and are of two types:

 Primary Deposits – A bank accepts cash

from the customer and opens a deposit in
his name. This is a primary deposit. This
 does not mean credit creation. These
deposits simply convert currency money into
deposit money. However, these deposits
form the basis for the creation of credit.
 Secondary or Derivative Deposits – A
bank grants loans and advances and instead
of giving cash to the borrower, opens a
deposit account in his name. This is the
secondary or derivative deposit. Every loan
crates a deposit. The creation of a derivative
deposit means the creation of credit.

3. Cash Reserve Ratio (CRR) – Banks know that

all depositors will not withdraw all deposits at
the same time. Therefore, they keep a fraction
of the total deposits for meeting the cash
demand of the depositors and lend the
remaining excess deposits. CRR is
the percentage of total deposits which the
banks must hold in cash reserves for meeting
the depositors’ demand for cash.
4. Excess Reserves – The reserves over and
above the cash reserves are the excess
reserves. These reserves are used for loans and
credit creation.
5. Credit Multiplier – Given a certain amount of
cash, a bank can create multiple times credit.
In the process of multiple credit creation, the
total amount of derivative deposits that a bank
creates is a multiple of the initial cash reserves.

2.6.2.Formula for determining the Credit

creation
The following formula can be used to determine
the total credit creation.

Total Credit Creation = Initial deposits x 1/r

Or

Total credit creation = Original deposit ✕

Credit multiplier coefficient

Where,

Credit multiplier coefficient = 1/r

r = Cash reserve requirement also known as cash

reserve ratio (CRR)

2.6.3.Advantages

The advantages of credit creation for an economy

are similar to money being available to people as a
medium of exchange. Thus, these include,

 Enable efficient monetary policy

 Stabilize the economy along with a
mandatory reserve system
 Mitigates inflation
 Makes credit available to poorer sections of
society, leading to inclusive growth.
 Wider access to consumer goods and
investment opportunities.

2.6.4.Limitations of Credit Creation

The following are some of the limitations that are

experienced by the commercial banks during the
credit creation process.
1. Cash amount present in the bank: The
higher the amount of deposits made by the
public, the higher credit creation from the
commercial banks can be seen. However,
there is a certain limit on the amount of cash
that can be held by the banks at a time. This
limit is determined by the central bank, as
the central bank may contract or expand this
limit by selling or purchasing the securities.
2. Cash reserve ratio or CRR: It refers to the
amount of money in the form of reserve that
needs to be kept with the central banks by
the commercial banks. This amount is used
for meeting the cash requirements of the
users. Any fall in the CRR will lead to more
credit creation.
3. Excess reserve: This takes place when a
country faces recession, at that time the
banks find it conducive in maintaining
reserves in place of lending that leads to
less credit creation.
4. Currency drainage: It refers to the
situation when the public is not depositing
money in the banks. This results in reduced
credit creation in the economy.
5. Borrower availability: Credit creation will
flourish if there are borrowers. The credit
creation will not be done if there are no
borrowers of the money in an economy.
6. Prevalent business conditions: If an
economy is witnessing a depression, then
the businesses will not be seeking credit
that leads to contraction of credit creation.
Whereas, if a nation is prospering, then the
 businesses will seek new funds in the form
of credit from the banks that would lead to
credit creation.

2.6.5.Distribution of Asset and Credit

Creation

2.7. Tools of Monetary Policy

The central bank’s policy reforms majorly deal

with economic recession and expansion. The
prominent tools used for this purpose involves:

 Open Market Operations: In open market

operations (OMO), the Federal Reserve Bank
buys bonds from investors or sells additional
bonds to investors to change the number of
outstanding government securities and money
available to the economy as a whole.
 The objective of OMOs is to adjust the level of
reserve balances to manipulate the short-term
interest rates and that affect other interest
rates.
 Reserve Requirement: Changes in the central
bank’s prescribed limit of reserves that the
commercial banks need to maintain from their
customer deposits is an essential tool. In the
situation of economic expansion, the reserve
requirement is increased to decrease the
money supply in the system. On the other hand,
it is decreased as part of the expansionary
policy.
 Discount Rate: Central bank changes an
interest for short-term lending to the
commercial banks, which is referred to as a
 discount rate. The loan helps in meeting
reserve requirements and short-term cash flow.
If the bank increases the discount rate, it
eventually permeates to other rates, including
those on commercial loans. As a result,
increasing commercial loan rates will
discourage people from borrowing, thereby
bringing down the money supply under
inflation.

2.8. Commercial Bank

2.8.1.Concept

A commercial bank is a kind of financial institution

that carries all the operations related to deposit
and withdrawal of money for the general public,
providing loans for investment, and other such
activities. These banks are profit-making
institutions and do business only to make a profit.

The two primary characteristics of a commercial

bank are lending and borrowing. The bank
receives the deposits and gives money to various
projects to earn interest (profit). The rate of
interest that a bank offers to the depositors is
known as the borrowing rate, while the rate at
which a bank lends money is known as the lending
rate.

2.8.2.History

The name bank derives from the Italian word

banco "desk/bench", used during the Italian
Renaissance era by Florentine bankers, who used
to carry out their transactions on a desk covered
by a green tablecloth.[1] However, traces of
banking activity can be found even in ancient
times.

In the United States, the term commercial bank

was often used to distinguish it from an investment
bank due to differences in bank regulation. After
the Great Depression, through the Glass–Steagall
Act, the U.S. Congress required that commercial
banks only engage in banking activities, whereas
investment banks were limited to capital market
activities. This separation was mostly repealed in
1999 by the Gramm–Leach–Bliley Act.

2.8.3.Functions

The functions of commercial banks are classified

into two main divisions:

1. Primary functions
 Accepts deposit: The bank takes deposits
in the form of saving, current, and fixed
deposits. The surplus balances collected
from the firm and individuals are lent to the
temporary requirements of the commercial
transactions.
 Provides loan and advances: Another
critical function of this bank is to offer loans
and advances to the entrepreneurs and
business people, and collect interest. For
every bank, it is the primary source of
making profits. In this process, a bank
retains a small number of deposits as a
reserve and offers (lends) the remaining
 amount to the borrowers in demand loans,
overdraft, cash credit, short-run loans, and
more such banks.
 Credit cash: When a customer is provided
with credit or loan, they are not provided
with liquid cash. First, a bank account is
opened for the customer and then the
money is transferred to the account. This
process allows the bank to create money.

2. Secondary functions

 Discounting bills of exchange: It is a

written agreement acknowledging the
amount of money to be paid against the
goods purchased at a given point of time in
the future. The amount can also be cleared
before the quoted time through a
discounting method of a commercial bank.
 Overdraft facility: It is an advance given to
a customer by keeping the current account
to overdraw up to the given limit.
 Purchasing and selling of the
securities: The bank offers you with the
facility of selling and buying the securities.
 Locker facilities: A bank provides locker
facilities to the customers to keep their
valuables or documents safely. The banks
charge a minimum of an annual fee for this
service.
 Paying and gathering the credit : It uses
different instruments like a promissory note,
cheques, and bill of exchange.
2.9. Central Banking

A central bank, reserve bank, or monetary

authority is an institution that manages the
currency and monetary policy of a country or
monetary union, and oversees their commercial
banking system. In contrast to a commercial bank,
a central bank possesses a monopoly on increasing
the monetary base. Most central banks also have
supervisory and regulatory powers to ensure the
stability of member institutions, to prevent bank
runs, and to discourage reckless or fraudulent
behavior by member banks.

Central banks in most developed nations are

institutionally independent from political
interference. Still, limited control by the executive
and legislative bodies exists.

Issues like central bank independence, central

bank policies and rhetoric in central bank
governors discourse or the premises of
macroeconomic policies (monetary and fiscal
policy) of the state are a focus of contention and
criticism by some policymakers, researchers and
specialized business, economics and finance
media.

2.9.1.History

In 1668, Sweden founded the first ever central

bank, called Sveriges Riksbank. Its foundation
stems from the failure of Swedens first bank,
Stockholms Banco in 1656. Shortly after its
inception, Stockholms Banco became the first bank
to formally introduced banknotes to Europe in
1661.

The banknote was initially very popular as it

replaced coins which were heavy and difficult to
handle. However, in the subsequent years,
Stockholms Banco issued more banknotes than it
could cover its deposits. As a result, consumers
became wary of the increasing number of notes in
circulation and therefore went to claim their
original coins.

What happened in the 1660s was what we call a

‘run on the bank’. It didn’t have enough coins to
meet its obligations and therefore went bankrupt.
As a result, consumers were left with banknotes
that were worth nothing. This subsequently led to
the nobility of Sweden taking over the bank and
the creation of the Sveriges Riksbank.

The Sveriges Riksbank took charge of monetary

policy, taking official control of coinage and the
supply of money. It also banned the use of all
banknotes due to the severe crisis caused by its
initial adaptation. However, two centuries later in
1874, it was to re-introduce banknotes into the
market.

2.9.2.Objective

Central banks oversee the banking system in their

country. They play an important role in managing
a state’s currency, money supply, and interest
rates. There are five primary objectives of central
banks.
  A central bank pursues a low and stable rate
of inflation.
 It aims for a high, stable real growth and
high employment rate in the economy.
 It promotes a stable financial market and
financial institutions.
 A central bank’s objective to maintain
interest rates.
 The bank also tries to maintain stable
exchange rates.

2.9.3.Function

The functions of a central bank can be discussed

as follows:

 Currency regulator or bank of

issue: Central banks possess the exclusive
right to manufacture notes in an economy. All
the central banks across the world are involved
in issuing notes to the economy. This is one of
the most important functions of the central
bank in an economy and due to this the central
bank is also known as the bank of issue. Earlier
all the banks were allowed to publish their own
notes which resulted in a disorganised
economy. To avoid this situation the
government around the world authorised the
central banks to function as the issuer of
currency, which resulted in uniformity in
circulation and balanced supply of money in the
economy.
 Bank to the government: One of the
important functions of the central bank is to act
as the bank to the government. The central
 bank accepts deposits and issues funds to the
government. It is also involved in making and
receiving payments for the government. Central
banks also offer short term loans to the
government in order to recover from bad
phases in the economy. In addition to being the
bank to the government, it acts as an advisor
and agent of the government by providing
advice to the government in areas of economic
policy, capital market, money market and loans
from the government. In addition to that, the
central bank is instrumental in formulation of
monetary and fiscal policies that help in
regulation of money in the market and
controlling inflation.
 Custodian of Cash reserves: It is a practice of
the commercial banks of a country to keep a
part of their cash balances in the form of
deposits with the central bank. The commercial
banks can draw that balance when the
requirement for cash is high and pay back the
same when there is less requirement of cash. It
is for this reason that the central bank is
regarded as the banker’s bank. Central bank
also plays an important role in the credit
creation policy of commercial banks.
 Custodian of International currency: An
important function of the central bank is to
maintain a minimum balance of foreign
currency. The purpose of maintaining such a
balance is to manage sudden or emergency
requirements of foreign reserves and also to
overcome any adverse deficits of balance of
payments.
 Lender of last resort: The central bank acts
as a lender of last resort by providing money to
its member banks in times of cash crunch. It
performs this function by providing loans
against securities, treasury bills and also by
rediscounting bills. This is regarded as one of
the most crucial functions of the central bank
wherein it helps in protecting the financial
structure of the economy from collapsing.
 Clearing house for transfer and
settlement: Central bank acts as a clearing
house of the commercial banks and helps in
settling of mutual indebtedness of the
commercial banks. In a clearing house, the
representatives of different banks meet and
settle the interbank payments.
 Controller of credit: Central banks also
function as the controller of credit in the
economy. It happens that commercial banks
create a lot of credit in the economy that
increases the inflation. The central bank
controls the way credit creation by commercial
banks is done by engaging in open market
operations or bringing about a change in the
CRR to control the process of credit creation by
commercial banks.
 Protecting depositor’s interests: Central
bank also needs to keep an eye on the
functioning of the commercial banks in order to
protect the interests of depositors.

2.9.4.Relevance, Performance
 CHAPTER-3:The Closed
Economy in the Short Run: 01

3.1. Classical and Keynesian Systems

Classical Economics: Classical economic theory

is the belief that a self-regulating economy is the
most efficient and effective because as needs arise
people will adjust to serving each other’s
requirements. According to classical economic
theory there is no government intervention and the
people of the economy will allocate scare
resources in the most efficient manner to meet the
needs of individuals and businesses.

Prices in a classical economy are decided based on

the raw materials used to produce, wages,
electricity, and other expenses that have gone in to
deriving an output finished product. In classical
economics, government spending is minimum,
whereas spending on goods and services by the
general public and business investments is
considered as the most important to stimulate
economic activity.

Keynesian Economics: Keynesian economics

harbors the thought that government intervention
is essential for an economy to succeed. Keynesian
economics believes that economic activity is
influenced heavily by decisions made by both the
private and the public sector. Keynesian economics
places government spending to be the most
important in stimulating economic activity, so
much so that even if there is no public spending on
goods and services or business investments, the
theory states that government spending should be
able to spur economic growth.

3.1.1.Difference between Classical Economics

and Keynesian Economics

In classical economic theory, a long term

perspective is taken where inflation,
unemployment, regulation, tax and other possible
effects are considered when creating economic
policies. Keynesian economics, on the other hand,
takes a short term perspective in bringing instant
results during times of economic hardship. One of
the reasons as to why government spending is so
important in Keynesian economics is that, it is
treated as a quick fix to a situation that cannot be
immediately corrected by consumer spending or
investment by businesses.

Classical economics and Keynesian economics take

very different approaches to varying economic
scenarios. Taking an example, if a country is going
through an economic recession, classical
economics states that wages would fall, consumer
spending would decrease, and business investment
would reduce. However, in Keynesian economics,
government intervention should kick in and
stimulate the economy by increasing purchases,
creating demand for goods and improving prices.

 Classical economics and Keynesian

economics are both schools of thought that
are different in approaches to defining
 economics. Classical economics was founded
by famous economist Adam Smith, and
Keynesian economics was founded by
economist John Maynard Keynes.
 Classical economic theory is the belief that a
self-regulating economy is the most efficient
and effective because as needs arise people
will adjust to serving each other’s
requirements.
 Keynesian economics harbors the thought
that government intervention is essential for
an economy to succeed.

3.2. Simple Classical System of Output

and Employment

To build up a classical macroeconomic model, here

we will consider a particular framework within
which the classical system can be studied. This
framework is composed of an aggregate
production function, the labour market, the money
market, and the goods market.

1. Employment-Output Determination:
Labour Market

Let us first consider the labour market where we

deal with production function in which capital
stock is fixed and labour is the variable input.

The aggregate production function is: Y = f (K , L)

where K denotes a constant capital stock and L

denotes quantities of variable input, labour.
In the classical model, equilibrium level of output
is determined by the employment of labour. The
level of output and, hence, the level of employment
is established in the labour market by the demand
for and supply of labour.

Assuming a profit-maximising economy, labour will

be demanded up to the point where the revenue
earned from selling the total product produced by
the marginal unit of labour is equal to the MC of
labour. MC of labour is equal to the money wage
divided by the marginal product of labour, MPL,
i.e., MC = W/MPL

The condition for profit maximisation is

where W is the money wage, P is the absolute

price level, and W/P is the real wage.

We know that the MP curve for labour indicates

the firm’s demand for labour. More labour is
demanded at a lower wage. Thus, demand for
labour depends inversely on real wage. The
aggregate demand curve for labour is the
horizontal summation of all individual firm’s
demand curve for labour. Aggregate labour
demand function, shown in equation, is also
inversely related to the real wage rate. That is,
DL=f (W-p)
Like labour demand, aggregate labour supply
function also depends on the real wage rate, but in
a direct manner. Thus, SL=g (W/P)

These relationships, together with the equilibrium

condition for the labour market DL = SL

determine output, employment and real wage in

the classical system.

Equilibrium real wage rate and the equilibrium

level of employment are determined at that point
where the negative sloping labour demand curve
cuts the positive sloping labour supply curve. Once
we know the equilibrium level of employment from
the aggregate production function we can derive
the equilibrium level of output.

In the lower panel, aggregate production function

has been shown. The intersection between DL and
SL curves at point E in the upper part of the figure
determines the equilibrium level of employment
(LF) at the equilibrium real wage rate (W/P) F. The
equilibrium of the classical labour market is one
where everyone willing to work at the real wage
(W/P)F is able to find work. Incidentally, this is the
full employment position, denoted by LE = LF. The
corresponding equilibrium level of output (at the
equilibrium level of employment) is Y F. This
equilibrium output level is also called full
employment output level.

In the classical system, full employment is

achieved automatically due to wage-price flex-
ibility. For instance, at a real wage (W/P) 1 there
exists a situation of unemployment. Now, this
excess supply of labour (AB) will reduce the real
wage rate until labour supply is equal to the labour
demand. Ultimately, real wage rate will decline to
(W/P)F where aggregate labour demand is exactly
matched by aggregate labour supply.

It may be added here that the volume of output

and employment in the classical system are
determined by only supply side of the market for
output. Since the classical model is a supply-
determined one, it says that equiproportionate
increases (or decreases) in both money wage and
the price level will not change labour supply.

2. Price Level Determination: Money Market

In this section, we analyse the classical theory of

aggregate price level determination. To do this,
money market is introduced.

Classicists answered this question in terms of the

quantity theory of money which determines
aggregate demand, which, in turn, determines the
price level. In the classical model, it is assumed
that people hold money solely to facilitate
transactions. Obviously, such transactions depend
on the volume of money income.

So we can say that the total demand for money in

an economy is a function of money national income
or output. The supply of money and the demand for
money jointly establish equilibrium in the money
market. The demand for money equation that will
be presented here is the Marshallian cash balance
version of the quantity theory of money. It is; Md =
kPY
where Md stands for demand for money, Y the
output level, P the price level and k is the fraction
of Y that people want to hold to facilitate
transaction. Equation states that people hold cash
balance since there is a gap between money
receipts and expenditures.

The supply of money is fixed as it is supplied by the

central bank. Thus, Ms= M

For equilibrium in the money market, = kPY

Equation shows a proportional relationship

between money stock and the price level. The
quantity theory of money says that the quantity of
money determines the price level. It is to be
remembered here that Y is also fixed due to the
existence of full employment in the economy.

represents money market equilibrium where we

plot total money stock M on the horizontal axis and
the levels of PY on the vertical axis. The vector
(OL), the slope of which is (1/k), shows the levels
of PY that can be supported by different quantities
of money supply. As money supply increases from
M1 to M2, the price level rises proportionately from
P1to P2.

Thus, we see a link between money supply and the

price level: an excess money supply means
increasing demand for commodities that pulls up
the general price level. But money supply does not
have any impact on Y which is determined in the
real sector and Y is fixed due to full employment.
The only way for equilibrium output to change in
this classical model can be attributed to a shift in
labour demand or labour supply curve.

One essential feature that follows from the

classical money market is that money is neutral.
This means that changes in money stock affect
only absolute prices and money wages
proportionately. Real variables such as, output,
level of employment and real wage rate remain
undisturbed following a change in money supply.

3. Interest Rate Determination: Goods Market

In the classical model the components of

aggregate demand consumption and investment
determine equilibrium interest rate. Interest rate
that guarantees that changes in the particular
components of demands do not affect the
aggregate level of commodity demand. It may be
noted here that the interest rate is a ‘real’ variable
in the goods market. The goods market is
concerned with the way the fixed output or income
is split between saving and consumption. Here we
determine equilibrium rate of interest.

Saving implies a choice between present and

future consumption. People save in the current
period to have larger income or consumption at a
future date. Of course, such saving then depends
on the rate of interest in the classical system, and
not on income as was said by J. M. Keynes.

Classicists assumed that saving (S) is an increasing

function of the rate of interest (r), that is, S = f (r)
Investment may be defined as the amount of an
economy’s product that is not consumed.
Investment refers to the creation of additional
stock of capital. An investment is something that is
used to create value in future. An economy
considers a number of capital projects in each time
period. It undertakes those investment projects
that yield a rate of return greater than the market
rate of interest. Thus, investment, in the classical
system, depends on the market rate of interest.

 Classical Dichotomy

One important conclusion from the classical model

is the classical dichotomy. Quantity of money does
not influence the real variables of the system-
output, employment, and the interest rate.
Quantity of money only influences the price level.
This means that the goods market is segmented
completely from the remainder of the system. Real
sectors cannot influence the monetary sector and,
hence, monetary variables. Monetary sector is not
concerned with relative prices and real variables.

 Policy Implications

The policy implication of this classical model is

that monetary policy alone can influence economic
activity. What is required for stable price level is
the stable money supply since quantity of money
determines the price level. Fiscal policy is an
impotent instrument to influence aggregate
demand.
3.3. Keynesian Model of Income
Determination

Keynes is considered to be the greatest economist

of the 20th century. He wrote several books.
However, his 'The General Theory of Employment,
Interest and Money' (1936) won him everlasting
fame in economics. The book revolutionized
macroeconomic thought. Keynesian economics is
called the Keynesian revolution.

The central problem in macroeconomics is the

determination of income and employment of a
nation as a whole. That is why modern economists
also call macroeconomics as the theory of income
determination. Keynes brings out all the important
aspects of income and employment determination
and Keynesian economics itself can be called
macroeconomics. He attacked the classical
economics and effectively rejected the Say's Law,
the very foundation of the classical theory. He
believed that in the short run, the level of income
of an economy depends on the level of
employment. The higher the level of employment,
higher will be the level of income.

A perusal of the basic ideas of Keynes can be

clearly understood from the brief summary in the
flow chart. Total income depends on total
employment which depends on effective demand
which in turn depends on consumption
expenditure and investment expenditure.
Consumption depends on income and propensity to
consume. Investment depends upon the marginal
efficiency of capital and the rate of interest.

1. The Principle of Effective Demand

The principle of effective demand occupies a key

position in the Keynesian theory of employment.
Effective demand is the ability and willingness to
spend by individuals, firms and government. The
level of output produced and hence the level of
employment depends on the level of total spending
in the economy.

Keynes used 'aggregate demand and aggregate

supply approach' to explain his simple theory of
income determination. The term 'aggregate' is
used to describe any quantity that is a grand total
for the whole economy.

Aggregate demand is the total demand for all

commodities (goods and services) in the economy.
Aggregate supply is the total of commodities
supplied in the economy. These two factors are
called by Keynes as aggregate demand function
(ADF) and the aggregate supply function (ASF).

Keynes made it clear that the level of employment

depends on aggregate demand and aggregate
supply. The equilibrium level of income or output
depends on the relationship between the
aggregate demand curve and aggregate supply
curve. As Keynes was interested in the immediate
problems of the short run, he ignored the
aggregate supply function and focused on
aggregate demand. And he attributed
unemployment to deficiency in aggregate demand.
It is important to note that all demand is not
effective. According to Keynes, effective demand is
that point where the ADF and ASF are equal. ASF
represents cost and ADF represents receipts. Cost
must not exceed receipt. When the entrepreneurs
find that their receipts are less than their costs,
they will stop offering employment to new workers.
So long as their receipts are higher than the costs,
they will increase employment as they can
increase their profits by offering more and more
employment.

As already mentioned, the point of intersection

between the two curves shows the maximum
possible employment. According to Keynes, the
level of employment depends on total demand and
unemployment results as a consequence of a fall in
total demand. If unemployment is to be averted,
the remedy lies in increasing the effective demand.

2. Aggregate Demand

The total expenditure of an economy can be

divided in to four categories of spending. They are
consumption expenditure (C), investment
expenditure (I), government expenditure (G) and
net expenditure on trade or net exports that is,
exports minus imports, (X-M). The aggregate
demand is the sum total of all such spending.
Hence the aggregate demand function is
represented as

AD = C+ I + G + (X-M)

This function shows that the aggregate demand is

equal to the sum of expenditure respectively on
consumption (C), Investment (I), Government
spending (G) and net exports (X-M). Thus
aaggregate demand is the total value of all planned
expenditure of all buyers in the economy. It is the
total demand for goods and services in the
economy (Y) in a specific time period. Moreover,
the aggregate demand is known as the amount of
commodities people want to buy.

In the economy, as one man's expenditure is

another man's income, the total expenditure of the
economy must be equivalent to the total income.
That is Total income(Y) = Total expenditure (AD).
Since Y = AD, equation ( 1) can be written as

Y = AD = C+ I + G + (X-M)

Keynes gives all attention to the ADF. This aspect

was neglected by economists for over 100 years.
Assuming that ASF is constant, the main basis of
Keynesian theory is that employment depends on
aggregate demand which itself depends on two
factors:

 Propensity to consume (Consumption function)

 Inducement to invest (Investment function).

3.4. Aggregate Supply and Demand

Aggregate supply and demand refers to the

concept of supply and demand but applied at a
macroeconomic scale. Aggregate supply and
aggregate demand are both plotted against the
aggregate price level in a nation and the aggregate
quantity of goods and services exchanged at a
specified price.
 1. Aggregate Supply

The aggregate supply curve measures the

relationship between the price levels of goods
supplied to the economy and the quantity of the
goods supplied. In the short run, the supply curve
is fairly elastic, whereas, in the long run, it is fairly
inelastic (steep). This has to do with the factors of
production that a firm is able to change during
these two different time intervals.

In the short run, a firm’s supply is constrained by

the changes that can be made to short run
production factors such as the amount of labor
deployed, raw material inputs, or overtime hours.
However, in the long run, firms are able to open
new plants, expand plants or adopt new
technologies, indicating that maximum supply is
less constrained.

The reason why the supply curve is more inelastic

(steeper) in the long run is because firms will be
able to adapt to changes in price levels better. For
instance, suppose that a firm can only increase
production by 5% by changing short-run
production factors and that the price level
increases by 15%. Assuming unit-elasticity for
simplicity, the firm cannot supply the equilibrium
supply quantity in the short run. Thus, its short-run
aggregate supply curve will flatten as the firm
cannot keep supplying goods at the same rate as
prices increase.

However, in the long run, the firm is able to

manipulate long-run production factors and
provide the equilibrium quantity by producing 15%
more. Thus, the curve is more inelastic as the firm
becomes more responsive to price changes. In this
case, short and long-run production are usually
correlated with output quantity; such that a firm is
able to better keep up with changes in output
when long-run factors of production need to be
changed to meet the equilibrium quantity. The
graph below illustrates this concept:

Figure 3:5 Aggregate Supply3

2. Aggregate Demand
3
https://cdn.corporatefinanceinstitute.com/assets/aggre
gate-supply-e1530124972286.jpg
Since consumer demand does not face the same
constraints faced by suppliers, there is no relative
change in the elasticity of demand itself. Rather,
the steepness of the demand curve depends on
the price elasticity of demand for the good. Thus,
the aggregate demand curve follows a consistent
downward slope, whose elasticity is subject to
change due to factors such as:

 Changing consumer preferences

 New literature about certain products
 Changes in the rate of inflation
 Changes in interest rates
 Changes in the level of household wealth
 Foreign currency risk

3.5. Fiscal and Monetary Multipliers

The fiscal multiplier measures the impact of a

fiscal stimulus on the Gross Domestic Product
(GDP) of an economy. Fiscal stimulus is the
increase in government spending to stimulate the
economy. The fiscal multiplier should not be
confused with the monetary multiplier, which is
the impact of change in money supply on the
output of an economy.

The monetary multiplier is driven by the central

bank, which controls the money supply via the
interest rates. The fiscal multiplier is driven by
government spending on tangible things like
building infrastructure or social programs.

3.5.1.Formulas
There are two types of fiscal multipliers – the
expenditure multiplier and the revenue multiplier:

Expenditure Multiplier: It measures the change

in output for every extra dollar spent by the
government. The formula for the expenditure
multiplier is given below:

Where:

 Delta Y = Change in Output

 Delta G = Change in Government Spending

Revenue Multiplier: It measures the change in

output for every dollar increase in revenues
collected by the government. The formula for the
revenue multiplier is given below:

Where:

 Delta Y = Change in Output

 Delta T = Change in Taxes or Government

Revenue

3.5.2.Measuring the Fiscal Multiplier

The fiscal multiplier is extremely difficult to
estimate. It is because the economy is complex,
with multiple forces affecting its output. In such a
situation, it becomes too hard to pinpoint the
change in output that is directly attributable
to fiscal policy. There are two main approaches to
estimating the fiscal multiplier. First is the
econometric or statistical approach, and the
second in the simulation or model-based approach.

 Econometric Estimation: The econometric

estimation of the fiscal multiplier is performed
using a statistical model called a Structural
Vector Autoregressive model or an SVAR
model. The model is a multivariate time series
model that measures the relationship between
multiple variables through time. The SVAR
approach requires a lot of data, which is not
always available. Hence, even though the
method is based on data, the results may not be
stable.
 Model-Based Estimation: The model-based
estimation approach creates a model of the
economy and then uses simulation to estimate
the required variable. The models that are often
used to model the economy are known as
Dynamic Stochastic General Equilibrium
(DSGE) models. They model different sectors of
the economy and the interaction among them.
The simulations from the models are
aggregated to measure the required variable, in
our case, the fiscal multiplier. Such an
approach does not require a lot of data, but it
suffers from model risk.
 Bucket Approach: The bucket approach is a
very simple method that estimates the fiscal
multiplier depending on how an economy ranks
on various factors. It is more of a back of the
envelope calculation, which can provide
a ballpark figure for the multiplier based on the
experience of other economies with similar
features.

3.5.3.Factors Affecting the Multiplier

Many factors affect the size of the multiplier.

Generally speaking, the higher the control of the
government on the economy, the higher the fiscal
multiplier. The factors are of two types:

1. Structural: Structural factors are the

permanent features of the economy. Different
economies respond differently to fiscal
stimulus. The following are some important
structural factors that affect the size of the
fiscal multiplier:

 Debt Level: High levels of debt can reduce

the impact of the fiscal multiplier. It is
because any fiscal stimulus is used to
service debt before being used for more
productive activities. Hence, the output
increases by a smaller amount, which means
the fiscal multiplier is reduced.
 Trade Openness: The size of the fiscal
multiplier is inversely proportional to the
trade openness. If there are high restrictions
on trade, then the fiscal stimulus can be
more effective because the output does not
 depend on the global economy. Higher
dependence on an external economy means
the domestic economy cannot productively
absorb the fiscal stimulus if the global
economy remains weak.
 Exchange Rate Regime: A more flexible
interest rate regime leads to a smaller
multiplier. It happens because any growth
push created by the fiscal stimulus can be
offset by a reduction in the value of the
currency, which implies a reduction in the
purchasing power.

2. Conjunctural: Conjunctural factors are

transient features of the economy that can
affect the size of the multiplier. Two main
conjunctural factors are:

 Business Cycle: The fiscal multiplier tends

to be larger during a downturn compared to
an expansion. In an expansion, there is little
capacity to absorb government spending,
and any fiscal stimulus crowds out private
consumption. Hence, the multiplier remains
low.
 Monetary Policy: An accommodative
monetary policy can greatly increase the
fiscal multiplier, which means when interest
rates are low, the impact of the fiscal
stimulus is higher. A lower cost of capital
acts as a catalyst to growth in the output,
and even small amounts of fiscal stimulus
can grow the output. It is a matter of recent
importance, as governments around the
world are increasing spending in tandem
 with interest rates being reduced to the
Zero Lower Bound (ZLB).

3.6. Relevance and Limitation of

Keynesian Economics to Developing
Economy

Keynesian theory was mainly concerned with

cyclical unemployment which arose in
industrialised capitalist countries especially in
times of depression. During the period of Greet
Depression (1929-33), the developed capitalist
countries faced a drastic fall in GNP resulting in
severe unemployment.

J.M. Keynes explained that it was fall in aggregate

effective demand for goods and services that was
responsible for depression and huge
unemployment that arose during the period of
depression. Keynes put forward a theory of income
and employment which explained the
determination of income and employment through
aggregate demand and aggregate supply.

Much of the above arguments for irrelevance of

Keynesian economics and instead the applicability
of classical economics were advanced in the early
fifties when the developing countries were
industrially backward and there was a paramount
need for underscoring the importance of capital
accumulation through raising the rate of saving.

That the inadequate growth in aggregate demand

could serve as a constraint on the process of
industrial growth was totally neglected. Thus, the
fashion among economists in the fifties and sixties
was to lay stress on the importance of supply-side
factors with which classical economics was
concerned to the total neglect of the demand-side
of the problem of economic growth.

However, in the beginning of the current

millennium, the situation in the developing
countries has vastly changed as a result of 50
years of economic development and structural
transformation that has taken place in their
economies. With this change in the economic
conditions of the developing countries, a number
of modern economists think that several crucial
elements of Keynesian economics have become
relevant to the present-day developing countries.
The following elements of Keynesian economics
have become relevant to the present-day
developing countries:

1. Problem of Deficiency of Effective Demand

Development experience of the last half a century

has revealed that even in the developing countries
the role of adequate growth in effective demand
for achievement of sustained economic growth on
which Keynes laid a great emphasis cannot be
ignored. The narrow size of the market in the
developing countries is primarily due to the mass
poverty prevailing in these countries. This mass
poverty has been caused by lack of adequate
economic growth, the existence of huge
unemployment and underemployment and a highly
skewed distribution of income.
Poverty of the people means that they have small
purchasing power so that the level of effective
demand is low which adversely affect inducement
to invest in consumer goods industries. As a result,
sustained rapid growth of consumer goods
industries is not possible. As a matter of fact, in
certain periods of industrial development in these
economies lack of effective demand has caused
slowdown and deceleration of industrial growth
and smaller utilisation of established capital stock.

Various explanations for it have been offered but

the widely accepted view has been that of decline
in effective demand caused by decrease in public
investment during this period. Besides, slowdown
in industrial growth has also been attributed to the
fall in growth of agricultural production resulting
in lower incomes and demand of the rural people
for the industrial products.

Apart from the above explanation of the actual

slackening of demand for industrial products in
certain specific periods of industrial growth, even
theoretically, the emergence of slackening of
effective demand causing under-utilisation of the
existing capital stock in the industrial sector of the
developing countries has been brought out.

2. Investment Behaviour in Developing

Countries

Keynesian economics is also relevant to the

developing countries with regard to its analysis of
investment behaviour as distinct from the classical
analysis. Classical economists did not distinguish
between decision to save and decision to invest.
According to them, decisions regarding saving and
investment were coterminous. Keynes
distinguished between decision to invest and save
and argued that it was investment that determined
saving and not the other way around. According to
him, when investment goes up, income will
increase through the operation of multiplier and at
a higher level of income more will be saved.

An important contribution made by Keynes to the

theory of investment refers to the role of business
expectations in determining investment. According
to him, the rate of investment is determined by
rate of interest on the one hand and marginal
efficiency of capital on the other. Marginal
efficiency of capital refers to the expected rate of
return on investment. The marginal efficiency of
capital depends on the state of business
expectations regarding future prospective yields
from the investment currently made.

When businessmen become pessimistic about

future prospective yields, the marginal efficiency
of capital declines which adversely affects
investment. This investment behaviour as
visualised by Keynes is as much relevant to the
investment in the modern sector of the developing
countries as to the industrialised developed
economies.

It may be noted that in the current context of

slowdown in private investment which is an impor-
tant factor causing slowdown in industrial growth,
we can explain the decline in private investment in
new shares and physical capital assets in terms of
‘animal spirits’, a term used by Keynes to refer to
the waves of pessimistic and optimistic
expectations of investors.

According to them, due to political uncertainty as

well as due the uncertainty about the ability of the
Government to pursue certain crucial economic
reforms, there is lack of investors’ confidence
which has prevented them from investing in new
shares and physical capital assets. The above
analysis clearly brings out the relevance of Keynes’
investment analysis to the developing countries.

3. Portfolio Choice by Investors

Another important element of Keynesian analysis

which is relevant to the developing countries is
related to portfolio choice. Since classical
economists were concerned with the economy
where there existed a commodity money and credit
played no role in it, they were not concerned with
portfolio choice. In the modern exchange economy
even in developing countries like India credit plays
a crucial role and portfolio choice by the investors,
at least among three types of assets, namely,
bonds and shares, physical capital assets and
money balances (for example, in the form of bank
deposits) must be made.

In the developing countries the situation may arise

when due to high capital costs and low prospective
yields expected from them the investors may not
be induced to invest in physical assets and new
bonds or shares of companies and instead opt for
keeping their savings in the form of money
balances (for example, in time deposits of banks).

The portfolio choice has also caused stagnation of

investment in the years 1996-2002, which, as seen
above, cannot be explained in terms of classical
economics. In fact, the followers of classical
economists think that relative shortage of physical
capital in the developing countries, rate of return
on investment must be high, which as seen above,
is contrary to what has been actually observed.
This clearly brings out the correctness of Keynes’s
fundamental insight into the determination of
investment and portfolio choice.

4. Keynes’ Consumption Function

An important contribution of Keynes was his

consumption function. Classical economists
thought that rate of interest were the dominant
influence on decision to consume and save.
However, Keynes argued that consumption is a
function of current level of absolute income (C = a
+ bY) where C is the amount of consumption and Y
is the current level of absolute income. Using
consumption expenditure data of the Indian
economy researchers have found that in
accordance with Keynes’ consumption function,
disposable income is the dominant determinant of
private consumption expenditure in the Indian
economy and further that rate of interest does not
play any significant role in determining
consumption.
Besides current income, income distribution and
the amount of wealth which were considered by
Keynes as objective factors determining
consumption have also been found to be important
factors determining consumption expenditure. It is
interesting to note that no empirical evidence in
favour of post-Keynesian theories of consumption,
namely, Modigliani’s Life Cycle theory of
consumption and Friedman’s Permanent Income
hypothesis of consumption have been found
applicable to India. Thus, Keynes’s principle of
consumption function is very relevant to the
developing countries like India and accordingly it
has been extensively used in various econometric
models of the Indian economy.

5. Role of Government Intervention

A fundamental departure from classical economics

made by Keynes related to the intervention by the
Government for regulating the economy if full
employment is to be re-established. Keynes
showed that if left free the market mechanism
would not work to restore automatically full
employment if the economy finds itself in the grip
of depression caused by deficiency of effective
demand arisen due to the fall in marginal
efficiency of capital. The same applies to the
problem of sustained economic growth in the
developing countries. If left completely free to the
market mechanism there is no guarantee that
sustained economic growth will be achieved in the
developing countries. In the developing countries,
the Government has to intervene by way of
adoption of suitable fiscal and monetary policies to
stimulate not only private investment to achieve
rapid growth but also to ensure growth with price
stability.

Besides, for achieving sustained economic growth

it requires that Government should step up public
investment in building up economic infrastructure
such as power, telecom, irrigation, ports, roads
and highways to tackle supply-side bottlenecks to
economic growth but also to invest in social capital
such as education, public health.

Public investment not only generates demand for

the private sector but also improves infrastructural
facilities such as power, transport, communication,
which help private sector investment and
stimulates overall growth of the economy. All this
is contrary to classical economics which believes in
Laissez Faire policies. From the foregoing analysis
we conclude that certain crucial elements of
Keynesian analysis have become relevant to the
present-day developing countries.

CHAPTER-4:The Closed
Economy in the Short Run: 02

4.1. Classical Macroeconomics: Money,

Prices and Interest
4.2. Keynesian system: Money, Interest
and Income
4.3. IS-LM Model
The IS-LM model appears as a graph that shows
the intersection of goods and the money market.
The IS stands for Investment and Savings. The LM
stands for Liquidity and Money. On the vertical
axis of the graph, ‘r’ represents the interest rate
on government bonds. The IS-LM model attempts
to explain a way to keep the economy in balance
through equilibrium of money supply versus
interest rates. The IS-LM is also sometimes called
the Hicks-Hansen model.

In order to gain a full understanding of how the

four components work together, it is important to
first understand what each component means on
its own.

 Investment

In macroeconomics, an investment is defined as a

quantity of goods purchased in a period of time
that are not consumed or used in that time.
Investment increases as interest rates decrease.

 Savings

Savings, sometimes known as deferred

consumption, is income that is not spent. As
interest rates fall, savings also fall, as most
households take advantage of lower interest rates
to make purchases.

 Liquidity

Liquidity refers to the demand for and amount of

real money, in all of its forms, in an economy.
Those who part with liquidity, in the form of saving
or investing, are rewarded through interest
payments or dividends.

 Money

Money is a any verifiable record or item that can

be used as a means of paying for goods and
services.

4.3.1.Characteristics of the IS-LM Graph

The IS-LM graph consists of two curves: IS and

LM. GDP is placed on the horizontal axis,
increasing to the right. The interest rate makes up
the vertical axis.

 The IS Curve

The IS curve depicts the set of all levels of interest

rates and output (GDP) at which total investment
(I) equals total saving (S). At lower interest rates,
investment is higher, which translates into more
total output (GDP), so the IS curve slopes
downward and to the right.

 The LM Curve

The LM curve depicts the set of all levels of income

(GDP) and interest rates at which money supply
equals money (liquidity) demand. The LM curve
slopes upward because higher levels of income
(GDP) induce increased demand to hold money
balances for transactions, which requires a higher
interest rate to keep money supply and liquidity
demand in equilibrium.
  The Intersection of the IS and LM
Curves

The intersection of the IS and LM curves shows

the equilibrium point of interest rates and output
when money markets and the real economy are in
balance. Multiple scenarios or points in time may
be represented by adding additional IS and LM
curves.

In some versions of the graph, curves display

limited convexity or concavity. Shifts in the
position and shape of the IS and LM curves,
representing changing preferences for liquidity,
investment, and consumption, alter the equilibrium
levels of income and interest rates.

4.3.2.IS-LM Model Assumptions

 All businesses make similar products, which

are utilized for consumption and residential
investment.
 There is no influence of aggregate
supply on the equilibrium level of income,
defined by aggregate demand.
 The only assets in the financial-market are
money and bonds.

4.3.3.IS-LM Graph

Two intersecting lines graphically represent the

model. The horizontal axis Y represents national-
income, often known as a real gross domestic
product . Similarly, ‘i’ denotes the real interest
rate on the vertical axis ‘X.’
 Figure 4:6 IS-LM Graph4

IS refers to the investment and savings

equilibrium. Implying total expenditure equals
total output. Where total expenditure can include
consumer spending, planned private investment,
government purchases, and net-exports. Total
output implies real-income or GDP Each point
reflects equilibrium in savings and investment.
Consequently, every interest rate level creates a
particular amount of anticipated fixed investment
and consumption.

The IS LM curve illustrates real income levels and

interest rate combinations (when the money
market is in equilibrium). An upward sloping curve
depicts the relationship between finance and the
economy. Each point on the curve represents a
specific equilibrium position in the money market
based on a certain income level.
4
https://policonomics.com/wp-content/uploads/2016/02/
IS-LM.jpg
The IS LM curve swings to the right as the
liquidity preference function changes in response
to an increase in GDP. IS LM curve adjustments
are studied to anticipate a rise in interest rates.
Therefore, the slope of the LM function is positive.

Since this model is non-dynamic, the nominal and

real-interest-rate have a fixed connection. In
addition to the predicted inflation rate, which is
exogenous in the near run, both numbers are
identical. Similarly, money demand relies on
the nominal interest rate. This junction signifies
a short-term balance in the real and financial
industries. Hence, this circumstance produces a
unique combination of the interest rate and real
GDP (where both the money and product markets
are in equilibrium).

4.3.4.Limitation

The IS-LM model serves as the conceptual

foundation for the vast majority of governmental
and commercial macro-econometric models.
However, every model has certain limitations.
Consequently, those of IS-LM Model are listed
below:

 Earlier models did not consider inflation.

The model did not anticipate conditions in
which prices would exhibit long-term
upward or downward movements.
 The IS-LM model is predominantly static. It
disregards the crucial time lag when
analyzing the implications of economic
policy changes. As a result, the use of the
 “Phillips-curve,” is done to address the
model’s flaws.

4.4. Policy effects

A closed economy is self-sufficient, which means

that no imports enter the country and no exports
leave the country. The aim of a closed economy is
to provide all necessities through domestic
production.

Countries with closed economies can grow, but not

as high as under an open economy. To grow the
domestic economy, it relies on household
consumption, business investment, and
government spending. All production inputs come
from within the country. Likewise, investment in
the economy only relies on national savings
without foreign capital inflows.

Maintaining a closed economy is difficult in

modern society. For example, not all countries
have raw materials for production. Many countries
are poor in natural resources and are forced to
import them from abroad.

Take crude oil, for example. That is not only for

energy input but also for various other products,
from fertilizers to plastic materials that we use
every day. And, not all countries have oil reserves.

A closed economy makes the production of goods

highly limited, both in terms of quantity and
variety. People are forced to consume what is
available, curbing their freedom to consume
various goods and services.

A closed economy contradicts the modern

economic theory. International trade is the
pathway to a prosperous economy. Export is one of
the engines of economic growth. When exports
increase, domestic production grows. As a result,
businesses create more jobs and income in the
economy.

To get the benefits of international trade, they

should produce goods and services with a
comparative advantage. They should allocate labor
and resources to the production of goods, which
have lower opportunity costs. For comparatively
uncompetitive goods, they can import them from
abroad, which tends to be cheaper.

4.5. Theories of Business Cycle

A number of theories have been developed by

different economists from time to time to
understand the concept of business cycles. In the
first half of twentieth century, various new and
important concepts related to business cycles
come into existence.

However, in nineteenth century, many of the

classical economists, such as Adam Smith, Miller,
and Ricardo, have conducted a study on business
cycles. They linked economic activities with the
Say’s law, which states that supply creates its own
demand. They believed that stability of an economy
depends on market forces. After that, many other
economists, such as Keynes and Hick, had
provided a framework to understand business
cycles.

4.5.1.Hawtrey (Pure Monetary Theory)

The traditional business cycle theorists take into

consideration the monetary and credit system of
an economy to analyze business cycles. Therefore,
theories developed by these traditional theorists
are called monetary theory of business cycle. The
monetary theory states that the business cycle is a
result of changes in monetary and credit market
conditions. Hawtrey, the main supporter of this
theory, advocated that business cycles are the
continuous phases of inflation and deflation.
According to him, changes in an economy take
place due to changes in the flow of money.

For example, when there is increase in money

supply, there would be increase in prices, profits,
and total output. This results in the growth of an
economy. On the other hand, a fall in money
supply would result in decrease in prices, profit,
and total output, which would lead to decline of an
economy. Apart from this, Hawtrey also advocated
that the main factor that influences the flow of
money is credit mechanism. In economy, the
banking system plays an important role in
increasing money flow by providing credit.

An economy shows growth when the volume of

bank credit increases. This increase in the growth
continues till the volume of bank credit increases.
Banks offer credit facilities to individuals or
organizations due to the fact that banks find it
profitable to provide credit on easy terms.

The easy availability of funds from banks helps

organizations to perform various business
activities. This leads to increase in various
investment opportunities, which further results in
deepening and widening of capital. Apart from
this, credit provided by banks on easy terms helps
organizations to expand their production.

When an organization increases its production, the

supply of its products also increases to a certain
limit. After that, the rate of increase in demand of
products in market is higher than the rate of
increase in supply. Consequently, the prices of
products increases. Therefore, credit expansion
helps in expansion of economy. On the contrary,
the economic condition is reversed when the bank
starts withdrawing credit from market or stop
lending money.

This is because of the reason that the cash

reserves of bank are washed-out due to the
following reasons:

 Increase in loans and advance provided by

banks
 Reduction in inflow of deposits
 Withdrawal of deposits for better investment
opportunities

When banks stop providing credit, it reduces

investment by businessmen. This leads to the
decrease in the demand for consumer and capital
goods, prices, and consumption. This marks the
symptoms of recession.

Some of the points on which the pure monetary

theory is criticized are as follows:

 Regards business cycle as monetary

phenomenon that is not true. Apart from
monetary factors, several non-monetary
factors, such as new investment demands,
cost structure, and expectations of
businessmen, can also produce changes in
economic activities.
 Describes only expansion and recession
phases and fails to explain the intermediary
phases of business cycles.
 Assumes that businessmen are more
sensitive to the interest rates that is not true
rather they are more concerned about the
future opportunities.

4.5.2.Keynes

Keynes theory was developed in 1930s, which was

the period when whole world was going through
great depression. This theory is the reply of
Keynes to classical economists. According to
classical economists, if there is high
unemployment condition in an economy, then
economic forces, such as demand and supply,
would act in a manner to bring back full
employment condition.

In his theory of business cycles, Keynes advocated

that the total demand helps in the determination of
various economic factors, such as income,
employment, and output. The total demand refers
to the demand of consumer and capital goods.

In such a case, total investment and expenditure

on products and services is more, the level of
production would increase. When the level of
production increases, it results in the increase of
employment opportunities and income level.
However, if the total demand is low, the level of
production would also be less.

Consequently, the income, output and investment

would also be low. Therefore, changes in income
and output level are produced by changes in total
demand. The total demand is further affected by
changes in the demand of investment, which
depends on the rate of interest and expected rate
of profit.

Keynes referred expected rate of profit as the

marginal efficiency of capital. Expected rate of
profit is the difference between the expected
revenue generated by the capital employed and
the cost incurred to employ that capital.

In case, the expected rate of profit is greater than

the current rate of interest, then the investors
would invest more. On the other hand, the
marginal efficiency of capital is determined by
expected return from capital goods and cost
involved in the replacement of capital goods.

Marginal efficiency of a capital increases due to

new inventions or innovations in economic factors,
such as product, production technique, investment
option, assuming that prices would rise in future.
On the other hand, it decreases due to various
reasons, such as decrease in prices, increase in
costs, and inefficiency of the production process.

According to Keynes theory, in the expansion

phase of business cycle, investors are positive
about economic conditions, thus, they
overestimate the rate of return from an
investment. The rate of return increases until the
full employment condition is not achieved.

When the economy is on the path of achieving full

employment, this phase is termed as boom phase.
In the boom phase, investors are not able to
diagnose the fall in marginal efficiency of capital
and even do not consider the rate of interest. As a
result, the profit from investments starts Calling
due to the increase in the cost of investment and
production of goods and services. This situation
results in the contraction or recession in economy.

This is because the rate of decrease in the

marginal efficiency of capital is more than that of
current rate of interest. In addition, in this
situation, investment opportunities shrink. Banks
are not also able to provide credit because of the
lack of funds.

Current rate of interest is higher that encourages

people to save rather than invest. As a result, the
demand for consumer and capital goods decreases.
Further, the income and employment level
decreases and economy reaches to the phase of
depression.
Keynes has proposed three types of propensities to
understand business cycles. These are propensity
to save, propensity to consume, and propensity of
marginal efficiency of capital. He has also
developed a concept of multiplier that represents
changes in income level produced by the changes
in investment.

Keynes also advocated that the expansion of

business cycle occurs due to increase in marginal
efficiency of capital. This encourages investors
(including individuals and organizations) to invest.
Organizations replace their capital goods and start
production.

As a result, the income of individuals increases,

which further increases the rate of consumption.
This increases the profit of organizations, which
finally lead to an increase in the total income and
investment level of an economy. This marks the
recovery phase of an economy.

Some points of criticism of Keynes theory are as

follows:

 Fails to explain the recurrence of business

cycles.
 Ignores the accelerator’s role to describe
business cycles. However, a business cycle
can be explained property with the help of
multiplier acceleration interaction.
 Offers only a systematic framework for
business cycles, not the whole concept.

4.5.3.Samuelson
The economists of post-Keynesian period
emphasized the need of both multiplier and
accelerator concepts to explain business cycles.
Samuelson’s model of multiplier accelerator
interaction was the first model that represents
interaction between these two concepts.

In his model, Samuelson has described the way the

multiplier and accelerator interact with each other
for generating income and increasing consumption
and demand of investment. He also describes how
these two factors are responsible for creating
economic fluctuations.

Samuelson used two concepts, namely,

autonomous and derived investment, to explain his
model. Autonomous investment refers to the
investment due to exogenous factors, such as new
product, production technique, and market.

On the other hand, derived investment refers to

the increase in the investment of capital goods
produced due to increase in the demand of
consumer goods. When autonomous investment
occurs in an economy, the income level also
increases. This brought the role of multiplier into
account. The income level helps in determining the
marginal propensity to consume. If the income
level increases, then the demand for consumer
goods also increases.

The supply of consumer goods should satisfy the

demand for consumer goods. This is possible when
the production technique is capable to produce a
large quantity of products and services. This
encourages organizations to invest more to
develop advanced production techniques and
increase production for meeting consumer
demand.

Therefore, the consumption affects the demand of

investment. This is referred as derived investment.
This marks the starting of the acceleration
process, which results in further increase in
income level. An increase in the income level
would increase the demand of consumer goods. In
this manner, the multiplier and accelerator
interact with each other and make the income
grow at a much higher rate than expected.

Autonomous investment leads to multiplier effect

that result in derived investment. This is called
acceleration of investment. Derived investment
would make the accelerator to come into action.
This is termed as multiplier-acceleration
interaction.

Samuelson made certain assumptions for the

explanation of business cycles. Some of the
assumptions are that the production capacity is
limited and consumption takes place after a gap of
one year. Another assumption made by him is that
there would be a gap of one year between the
increase in consumption and increase in the
demand of investment. In addition, he assumed
that there would be no government activity and
foreign trade in the economy.

According to the assumption given by Samuelson

that there would be no government activity and
foreign trade, the equilibrium would be achieved
when

Yt = Ct + It

Where, Yt = National income

Ct = Total consumption expenditure

It = Investment expenditure

t = Time period

Some of the drawbacks of Samuelson’s model

are as follows:

 Represents a simpler model that is not able

to explain business cycles completely
 Ignores other factors that influence business
cycles, such as expectations of businessmen
and taste and preferences of customers
 Assumes that the capital/output ratio
remains constant, which is not true.

4.5.4.Hicks Model

Hicks has associated business cycles to the growth

theory of Harrod-Domar. According to him,
business cycles take place simultaneously with
economic growth; therefore, business cycles
should be explained in association with the growth
theory.

In his theory, he has used the following

concepts to explain business cycles:
  Saving-investment relation and multiplier
concepts given by Keynes
 Acceleration concept given by Clark
 Multiplier-acceleration interaction concepts
given by Samuelson
 Growth model of Harrod-Domar
 Hicks has also framed certain assumptions
for describing business cycle concept.

The important assumptions of Hicks’s theory

are as follows:

 Assumes an equilibrium rate of growth in a

model economy where realized growth rate (Gr)
and natural growth rate (Gn) are equal. As a
result, the increase in autonomous investment
is constant and is equal to the increase in
voluntary savings. The equilibrium growth rate
can be obtained with the help of rate of
autonomous investment and voluntary savings.
 Assumes the consumption function given by
Samuelson, which is Ct = α Yt-1. As discussed
earlier, according to Samuelson theory
consumption takes place after a lag of one year.
The time lag in consumption occurs due to the
gap between income and expenditure and gap
between Gross National Product (GNP) and
non-wage income.
The gap between income and expenditure
produces when income is ahead of expenditure.
The gap between GNP and non-wage income
produces when fluctuations in GNP occur more
frequently than the fluctuations in non-wage
income.
 The saving function becomes the function of
past year’s income. With the time lag between
income and investment-saving, the multiplier
process has a diminishing impact on business
cycles.
 Assumes that autonomous investment is a
function of output at present. In addition,
autonomous investment is used for replacing
capital goods. However, induced investment is
regarded as the function of changes in output.
The change in output produces induced
investment, which marks the beginning of the
acceleration process. The acceleration process
interrelates with the multiplier effect on income
and consumption.
 Makes use of the words ceiling and bottom for
explaining the upward and downward flow of
business cycles. The ceiling on upward flow is a
result of scarcity of resources required. On the
other hand, the bottom on downward flow does
not have a direct limit on contraction. However,
an indirect limit is the effect of accelerator on
depression.

Hicks explains business cycles by assuming that

the economy has reached to Po point of
equilibrium path and autonomous investment is
the result of innovation. The autonomous
investment results in the increase of output.

Consequently, the economy moves upward from

the equilibrium path. After a certain point of time,
the autonomous investment brings the multiplier
process at work, which further increases output
and employment. The increased output makes the
induced investment to work that further results in
accelerator process to work.

The multiplier-accelerator interaction results in

the growth of the economy. Consequently, the
economy enters in the phase of expansion. The
economy moves on the expansion path of P0P1. At
point P1, the economy is in full employment
condition. Now, the economy cannot grow further,
it can only move on the FF line.

However, it cannot remain at FF line because

autonomous investment becomes constant;
therefore, now at FF, only the normal autonomous
investment would be produced. This infers that the
expansion of the economy is governed by induced
investment only. When the economy reaches to
point P1, the increase in induced investment
becomes stable and the growth of economy starts
declining. This is because of the reason that the
output produced at FF line is not sufficient for
induced investment.

As a result the induced investment stops. The

decline of the economy can be postponed, if the
time lag between output and investment is of three
to four years. However, the decline in output
cannot be ceased. When the decline in output
occurs at point P then the decline in output would
continue till the economy reaches back to EE line.

After arriving at EE line, it would continue to fall

further. The rate of decline in economy is very
slow because disinvestment depends on the rate of
depreciation. The decrease in output leads to the
decline in the rate of depreciation. The effect of
reverse accelerator on the depression is not as
frequent as in the case of expansion. During the
path Q1Q2, the induced investment is nil while
autonomous investment is less than normal. In
addition, the indefinite decline of economy is
represented by Q1q. However, Q1q is a very rare
case that does not occur normally.

When the economy reaches to trough, it moves

along the LL line, which is associated with AA line
that represents autonomous investment.
Therefore, output starts increasing again with the
increase in autonomous investment. Increase in
output makes the accelerator to work again. This
phase is termed as recovery phase. Along with
accelerator, multiplier also comes into action and
their interaction makes economy run on the
growth path and reaches to equilibrium EE line
again.

There are certain limitations of Hicks’s

theory, which are as follows:

 Fails to explain the reasons for linear

consumption function and constant multiplier.
When the economy is going through different
phases of business cycles, the income is
redistributed that affects the marginal
propensity to consume, which further affects
the multiplier process.
 Suspects the constancy of multiplier in
changing economic conditions. Without
practical evidence, the accelerator and
multiplier cannot be assumed to be constant.
 Takes into consideration the abstract theory,
which cannot be applied in the real world.

4.6. Analysis of Business Cycle: Phases

of business Cycle

The business cycle model shows how a nation’s

real GDP fluctuates over time, going through
phases as aggregate output increases and
decreases. Over the long-run, the business cycle
shows a steady increase in potential output in a
growing economy.

A recession is actually a specific sort of vicious

cycle, with cascading declines in output,
employment, income, and sales that feed back into
a further drop in output, spreading rapidly from
industry to industry and region to region. This
domino effect is key to the diffusion of
recessionary weakness across the economy,
driving the comovement among these coincident
economic indicators and the persistence of the
recession.

4.6.1.Business Cycle Phases with Graph

A country keeps track of the trade cycle to ensure

that the economy is on the path of growth,
unemployment steeps down, and the inflation
rate remains under control. To understand the
economic fluctuations and pattern, let us have a
look at the following graph:

An economy is expected to have constant growth,

represented by the growth trend line. In reality,
though, the economy is unstable. National output
goes up and down periodically. It expands to touch
the peak and contracts down to the trough. Thus, a
trade cycle consists of the following four phases:

 Expansion: When a nation’s GDP shows an

upward move or recovers with time, this period
of growth is remarked as economic expansion.
During this phase, the various economic
indicators like consumer spending, income,
demand, supply, employment, output, and
business returns shoot up.
 Peak: During the expansion phase, the GDP
spikes to its highest level; this is considered the
economy’s peak. At this point, economic
factors like income, consumer spending, and
employment level remain constant.
 Contraction: Next comes the phase of
economic slowdown; it occurs when the
stagnant peak GDP starts tumbling down
towards the trough. With this, the nation’s
production, employment level, demand, supply,
income level, and other economic parameters
plummet.
 Trough: This is the stage at which the GDP and
other economic indicators are at their lowest.
During this phase, the economy gets stuck at a
negative growth rate. Additionally, the demand
for goods and services reduces.

4.6.2.Limitations

Predicting the business cycle phase is crucial for

policymakers and governments so that they can
deal with deflation and inflation accordingly. The
cycle also warns investors, owners, consumers,
and strategists. However, the following are the
disadvantages associated with the business cycle:

 Limited Information: Since the economic

cycle analysis is based on research, it becomes
difficult for economists to access complete and
accurate data. Moreover, the process of
correlating and interpreting acquired
information is equally challenging.
 Two Contrasting Models: The Keynesian
theories consider money supply to be the
important factor behind fluctuations. But the
Real Business Cycle theory opposes this
concept and proposes that market imperfection
is the important factor behind fluctuations.
 Human Glitch: Economic researchers are
humans; they are the ones who study trade
cycle trends and present economic indicators
that cause the trend. Thus, this analysis is
prone to human errors.
 CHAPTER-5:Open Economy
Models

5.1.1.Short-run Open Economy models

An open economy is a type of economy where not

only domestic factors but also entities in other
countries engage in trade of products (goods and
services). Trade can take the form of managerial
exchange, technology transfers, and all kinds of
goods and services. Certain exceptions exist that
cannot be exchanged; the railway services of a
country, for example, cannot be traded with
another country to avail the service.

It contrasts with a closed economy in which

international trade and finance cannot take place.
The act of selling goods or services to a foreign
country is called exporting. The act of buying
goods or services from a foreign country is called
importing. Exporting and importing are collectively
called international trade.

A small open economy, abbreviated to SOE, is an

economy that participates in international trade,
but is small enough compared to its trading
partners that its policies do not alter world prices,
interest rates, or incomes. Thus, the countries with
small open economies are price takers. This is
unlike a large open economy, the actions of which
do affect world prices and income.

The theory of a small open economy is used in the

study of macroeconomics to model a price-taking
economy, allowing exogenous assumptions of the
conditions in the rest of the world.

5.1.2.Mundell-Fleming Model

The Mundell–Fleming model, also known as the IS-

LM-BoP model (or IS-LM-BP model), is an
economic model first set forth (independently) by
Robert Mundell and Marcus Fleming. The model is
an extension of the IS–LM model. Whereas the
traditional IS-LM model deals with economy under
autarky (or a closed economy), the Mundell–
Fleming model describes a small open economy.

The Mundell–Fleming model portrays the short-run

relationship between an economy's nominal
exchange rate, interest rate, and output (in
contrast to the closed-economy IS-LM model,
which focuses only on the relationship between the
interest rate and output). The Mundell–Fleming
model has been used to argue that an economy
cannot simultaneously maintain a fixed exchange
rate, free capital movement, and an independent
monetary policy. An economy can only maintain
two of the three at the same time. This principle is
frequently called the "impossible trinity," "unholy
trinity," "irreconcilable trinity," "inconsistent
trinity," "policy trilemma," or the "Mundell–
Fleming trilemma."

5.1.3.Assumptions

Basic assumptions of the model are as follows:

  Spot and forward exchange rates are
identical, and the existing exchange rates
are expected to persist indefinitely.
 Fixed money wage rate, unemployed
resources and constant returns to scale are
assumed. Thus domestic price level is kept
constant, and the supply of domestic output
is elastic.
 Taxes and saving increase with income.
 The balance of trade depends only on
income and the exchange rate.
 Capital mobility is less than perfect and all
securities are perfect substitutes. Only risk
neutral investors are in the system. The
demand for money therefore depends only
on income and the interest rate, and
investment depends on the interest rate.
 The country under consideration is so small
that the country cannot affect foreign
incomes or the world level of interest rates.

5.1.4.Equations

This model uses the following variables:

 Y is real GDP
 C is real consumption
 I is real physical investment, including
intended inventory investment
 G is real government
spending (an exogenous variable)
 M is the exogenous nominal money supply
 P is the exogenous price level
  i is the nominal interest rate
 L is liquidity preference (real money
demand)
 T is real taxes levied
 NX is real net exports

5.2. Exchange rate determination

The exchange rate is the price of a currency

in comparison to another currency. It is either
fixed by the central bank or determined by the
market demand of demand and supply. When the
central bank fixes the exchange rate, it is known as
the fixed exchange rate. On the other hand, when
the rate is fixed by demand and supply, it is known
as a floating exchange rate.

5.2.1.Characteristics of Exchange Rate

An exchange rate is an indispensable tool in

facilitating international trade.

 It also shows the comparative value of the

currency. By making it easier to make
transactions with international partners,
exchange rates help countries to trade without
any barriers. Therefore, in terms of functions,
exchange rates are invaluable.
 By checking the exchange rates, economists
also determine the economic well-being of a
country. If too much of fluctuations in the
currency exchange rate occurs, the authorities
must intervene to make the rates fixed. This
helps the economy stay stable and any chance
of an economic downturn could be thwarted.
 When a country imports goods in bulk, the
demand usually pushes up the exchange rate
for that country. This makes the imported
goods more expensive to consumers in that
country. When the goods become increasingly
expensive, demand drops, and the country’s
money becomes cheaper in comparison to other
countries’ money. Therefore, the country’s
commodities become cheaper to buyers abroad,
demand goes up, and export from the country
increases.
 World trade now depends on a hybrid system of
the exchange rate which can be called managed
floating exchange system. In such as system,
governments intervene to stabilize their
countries’ exchange rates by stimulating
exports, limiting imports, or devaluing the
currencies.

Although a very important concept for

international trade, the establishment of exchange
rates is not a very old phenomenon. It was
established after the second world war in the 20th
century.

5.2.2.Determination for Exchange Rate

There are numerous methods of calculating the

exchange rate of currencies. Some popular
methods are -

 Floating Exchange Rate

An exchange rate that is not fixed is called a

flexible exchange rate. The flexible exchange rate
fluctuates from one value to another. The market
determines whether the exchange rate moves or
not. The term "floating currency" is used to
indicate any currency subject to a floating regime.

For example, the US dollar is an example of a

floating exchange currency.

Floating rates are notable and are very popular

among economists. The believers in a free market
are of the mindset that markets should determine
the currency value. The USD values usually decline
when crude oil prices rise, for example. So, the
crude oil prices and USD currency value are
inversely related. Therefore, the USD value
fluctuates freely because oil prices fluctuate daily.

Economists are of the point of view that markets

generally correct themselves frequently. Most
major economies are generally dependent on
floating exchanges because of little government
intervention. These countries are popularly known
as 'First World Countries'.

 Flexible Exchange Rate

The flexible exchange rate is called pegged

exchange rate system because of government
intervention. The value of a currency is maintained
either to certain currencies’ values–either
collectively or individually–or to the reserves of
gold and foreign currencies available in the given
country.

 Fixed Exchange Rate

China is probably the most famous example of
fixed exchange regimes. A fixed-rate regime also
used to exist under the former Soviet Union. It
must be noted that the flexible exchange rate is
not solely determined by market forces. If the
foreign exchange market fluctuates widely, the
central banks will have to sell or buy currency
reserves.

 Speculation

Money is an asset for every nation. Therefore,

citizens of one country may hold reserves of
foreign exchange from another country as an
asset. Therefore, Indians will be more interested in
the value of the USD if they think that the value of
their own currency will fluctuate in the near
future. When people hold foreign exchange to get
a benefit from the changing values, the currency
values are affected by it.

 Interest rates

The difference in interest rates of different

countries also plays a major role in the
determination of the value of exchange rates. In
order to get more returns, banks, MNCs, and
affluent investors invest money around the globe.
This also affects the exchange rates to a large
extent for a country.

5.3. Purchasing Power Parity

Purchasing power parity (PPP) is a measurement

of the price of specific goods in different countries
and is used to compare the absolute purchasing
power of the countries' currencies. PPP is
effectively the ratio of the price of a basket of
goods at one location divided by the price of the
basket of goods at a different location. The PPP
inflation and exchange rate may differ from the
market exchange rate because of tariffs, and other
transaction costs.

The purchasing power parity indicator can be used

to compare economies regarding their gross
domestic product (GDP), labour productivity and
actual individual consumption, and in some cases
to analyse price convergence and to compare the
cost of living between places.

The economic theory is often broken down into two

main concepts:

 Absolute parity

Absolute purchasing power parity (APPP) is the

basic PPP theory, which states that once two
currencies have been exchanged, a basket of goods
should have the same value. Usually, the theory is
based on converting other world currencies into
the US dollar.

If this does not hold true, then APPP suggests that

the currency exchange rate will change over time
until the goods are of equal value – as without any
barriers to trade, there should be an equilibrium in
the price of goods. This is a completely price-level
theory, which only looks at the exact same basket
of goods in each country, with no other factors
included.
However, the theory ignores the existence of
inflation and consumer spending, as well as
transportation costs and tariffs, which can impact
the short-term exchange rate. Without these
inclusions, a currency’s power is poorly
represented.

 Relative parity

Relative purchasing power parity (RPPP) is an

extension of APPP and can be used in tandem with
the first concept. While it maintains that the value
of the same good in different countries should
equal out over time, RPPP suggests that there is a
correlation between price inflation and currency
exchange rates. It looks at the amount of a good or
service that one unit of currency can buy, which
can change over time as inflation rates alter. The
theory suggests that inflation will reduce the real
purchasing power of a currency, so in order to
properly adjust the PPP, inflation must be taken
into account.

5.3.1.PPP formula

The PPP formula calculation will vary depending

on what you are trying to achieve and which PPP
you want to use.

The absolute PPP calculation is calculated by

dividing the cost of a good in one currency, by the
cost of a good in another currency (usually the US
dollar).

Then, to calculate the relative PPP rate, you’d

simply assume that the ratio of price levels was
equal to the exchange rate from one currency to
another, adjusted for the inflation rate. This would
give you the rate of depreciation for one currency
compared to another, and an estimate of the future
exchange rate.

P1
S=
P2

Where

 S= Exchange rate of currency 1 to currency

2
 P1= Cost of good X in currency 1
 P2= Cost of good X in currency 2

5.3.2.Drawbacks of Purchasing Power Parity

Since 1986, The Economist has playfully tracked

the price of McDonald's Corp.’s (MCD) Big Mac
hamburger across many countries. Their study
results in the famed "Big Mac Index". In
"Burgernomics"—a prominent 2003 paper that
explores the Big Mac Index and PPP—authors
Michael R. Pakko and Patricia S. Pollard cited the
following factors to explain why the purchasing
power parity theory is not a good reflection of
reality.

 Transport Costs

Goods that are unavailable locally must be

imported, resulting in transport costs. These costs
include not only fuel but import duties as well.
Imported goods will consequently sell at a
relatively higher price than do identical locally
sourced goods.

 Tax Differences

Government sales taxes such as the value-added

tax (VAT) can spike prices in one country, relative
to another.

 Government Intervention

Tariffs can dramatically augment the price of

imported goods, where the same products in other
countries will be comparatively cheaper.

 Non-Traded Services

The Big Mac's price factors input costs that are not
traded. These factors include such items as
insurance, utility costs, and labor costs. Therefore,
those expenses are unlikely to be at parity
internationally.

 Market Competition

Goods might be deliberately priced higher in a

country. In some cases, higher prices are because
a company may have a competitive advantage over
other sellers. The company may have a monopoly
or be part of a cartel of companies that manipulate
prices, keeping them artificially high.

5.4. Asset Market Approach

Asset market approach is a method of long-term

foreign exchange rate determination that assumes
that whether foreigners are willing to hold claims
in monetary form depends on an extensive set of
investment considerations of drivers.

The market approach means a unique valuation

method that allows one to determine the actual
value of any asset based on other similar asset
types having similar features. For example,
the market approach valuation method can
calculate the actual price of any tangible
or intangible asset like securities and real
estate. For this purpose, one studies the recent
sales transaction that has taken place for a similar
asset to that of the asset under consideration,
like mergers and acquisitions.

One can understand the asset market approach to

business valuation in real estate. Other than
this, privately held companies have no shares to
trade publicly. Most often, investors use it for
valuing companies within a similar activity
group, revenue growth, potential growth, and
market base. The surveyors scan the recent and
past transactions of companies of similar groups
that adjusted assets since no two assets’ values are
the same.

One important aspect of the market data

approach is the usage of prices of assets rather
than the size of assets adjusted for quantities. One
can also use the past selling price of the company’s
share to calculate the exact value of the company
fairly. The total market approach is quite useful in
specific business value determination. It also aids
an analyst in setting an appropriate offer
or asking price for a business to make a business
purchase.

The method is also important to determine the

amount of taxes a firm must pay to the tax
authorities. Moreover, the approach of valuation
facilitates conflict resolution during legal suits.
Finally, in case of the buyout of a business, the
partners can set their share of the sales
revenue sales using this method.

5.4.1.Market Approach Methods

One can use multiple market approach methods in

valuation. However, only two prime market
approach types are used widely. They are the
following –

 Public Company Comparable

Under this method, assessment metrics of

companies that get publicly traded get used to
ascertain the price of a company under
consideration for getting its value. However, most
companies do not trade publicly, so one cannot
know their value. Therefore, most public
companies’ data need experts to perform the
selection, application, and adjustment of data for
comparison with the subject company.

 Precedent Transactions

It is based on the assumption that transaction

value is readily available for all companies. An
analyst can then use these companies to set prices
for a subject company. The process involves
knowing the complex transaction involved during
mergers and acquisitions. Analysts can have the
data for such transactions from public or private
deals. Moreover, only transactions related to
similar and comparable companies can get
considered for this.

5.4.2.Advantages And Disadvantages

Every evaluation has certain advantage and

disadvantage that needs to get considered for
better decision-making. Let’s look at some of its
advantages and disadvantages in the following
table:

Advantages Disadvantages
The evaluation method It becomes difficult to
gets based on simple yet identify similar-sized
straightforward comparable companies or
calculations. transactions.
Appropriate numbers of
One uses public data that
comparable companies or
is real, verifiable, and not
transactions may not be
speculative in this
present to apply the
method.
method.
The method does not
The method remains rigid
take the help of
in its approach.
subjective forecasts.
There gets a question
One can easily find
raised on the quality and
similar companies for
quantity of data for
comparison based on
comparison and
size.
evaluation.
Up-To-Date market Many privately held
pricing represents the companies do not disclose
overall market situation,
performance assumption,
current shareholder their sizes or transactions.
sentiments, and industry
perspective.
Moreover, all subjective
Public listed companies
estimates or forecasts
differ greatly in other
get eliminated using
aspects besides size and
goal-oriented and
transaction concerning
comparable information
private companies.
from the market.

5.5. Dornbusch's Overshooting Model

In economics, overshooting, also known as the

exchange rate overshooting hypothesis, is a way to
think about and explain high levels of volatility in
currency exchange rates using the concept of price
stickiness. Overshooting was introduced to the
world by Rüdiger Dornbusch, a renowned German
economist focusing on international economics,
including monetary policy, macroeconomic
development, growth, and international trade.
Dornbusch first introduced the model, now widely
known as the Dornbusch Overshooting Model, in
the famous paper "Expectations and Exchange
Rate Dynamics," which was published in 1976 in
the Journal of Political Economy.

Before Dornbusch, economists generally believed

that markets should, ideally, arrive at equilibrium
and stay there. Some economists had argued that
volatility was purely the result of speculators and
inefficiencies in the foreign exchange market, such
as asymmetric information or adjustment
obstacles.

Dornbusch rejected this view. Instead, he argued

that volatility was more fundamental to the market
than this, much closer to inherent in the market
than to being simply and exclusively the result of
inefficiencies. More basically, Dornbusch was
arguing that in the short run, equilibrium is
reached in the financial markets, and in the long
run, the price of goods responds to these changes
in the financial markets.

5.5.1.Assumptions

One needs to understand the assumptions used

in overshooting model to understand the concept
better. The following three assumptions are the
foundation stone of Dornbusch’s model:

 It assumes that exchange rates exhibit

flexibility.
 The uncovered interest parity (UIP) gets
applicable. As a result, the difference
between United States interest rates and
the Eurozone interest will be equal to that
of the expected depreciation rate of the US
dollar.
 The demand for money entirely depends on
the production output and the interest
rate.

Goods prices remain fixed in the short run but

keep adjusting slowly in the long run to counter
the monetary shocks. So, increasing the money
supply level gest fully reflected by the increasing
price of goods in the long run. However, one must
note that the increase in price level includes the
exchange rate and foreign currency prices.

One must be aware that Dornbusch’s model

terminology has become common in all modern
international macroeconomics. Thus, one can find
it essential in forecasting macroeconomics and
an economy’s future responses concerning
changes in monetary prices. Moreover,
Dornbusch’s model concept successfully explains a
significant empirical regularity in that the
exchange rates experience more volatility than the
goods price and interest rates.

It is also quite interesting to note that goods prices

gradually adjust to their new level in the long run,
but the exchange rates keep bouncing from one
level to another for a long time. As a result, one
finds extreme volatility in exchange rates and
relatively more minor volatility in other prices.
Nevertheless, unlike other models, Dornbusch’s
model does not help much in exchange rate
prediction as the data does not prove its UIP
assumptions.

5.6. Monetary Approach to Balance of

Payments

The monetary approach to the balance of payments

is an explanation of the overall balance of
payments. It explains changes in balance of
payments in terms of the demand for and supply of
money. According to this approach, “a balance of
payments deficit is always and everywhere a
monetary phenomenon.” Therefore, it can only be
corrected by monetary measures.

5.6.1.Assumptions

This approach is based on the following

assumptions:

 The ‘law of one price’ holds for identical goods

sold in different countries, after allowing for
transport costs.
 There is perfect substitution in consumption in
both the product and capital markets which
ensures one price for each commodity and a
single interest rate across countries.
 The level of output of a country is assumed
exogenously.
 All countries are assumed to be fully employed
where wage price flexibility fixes output at full
employment.
 It is assumed that under fixed exchange rates
the sterilisation of currency flows is not
possible on account of the law of one price
globally.
 The demand for money is a stock demand and is
a stable function of income, prices, wealth and
interest rate.
 The supply of money is a multiple of monetary
base which includes domestic credit and the
country’s foreign exchange reserves.
 The demand for nominal money balances is a
positive function of nominal income.
5.6.2.Theory

Given these assumptions, the monetary approach

can be expressed in the form of the following
relationship between the demand for and supply of
money:

The demand for money (MD) is a stable function of

income (Y), prices (P) and rate of interest (i):

MD=f(Y, P, i)

The money supply (Ms) is a multiple of monetary

base (m) which consists of domestic money (credit)
(D) and country’s foreign exchange reserves (R).
Ignoring m for simplicity which is a constant,

MS = D + R

Since in equilibrium the demand for money equals

the money supply,

or MD = D + R [MS = D + R]

A balance of payments deficit or surplus is

represented by changes in the country’s foreign
exchange reserves. Thus

∆R = ∆MD – ∆D

Where B represents balance of payments which is

equal to the difference between change in the
demand for money (∆MD) and change in domestic
credit (∆D).

A balance of payments deficit means a negative B

which reduces R and the money supply. On the
other hand, a surplus means a positive B which
increases R and the money supply. When B = O, it
means bop equilibrium or no disequilibrium of
BOP.

The automatic adjustment mechanism in the

monetary approaches is explained under both the
fixed and flexible exchange rate systems.

Under the fixed exchange rate system, assume that

MD = MS so that BOP (or B) is zero. Now suppose
the monetary authority increases domestic money
supply, with no change in the demand for money.
As a result, MS > MD and there is a BOP deficit.

People who have larger cash balances increase

their purchases to buy more foreign goods and
securities. This tends to raise their prices and
increase imports of goods and foreign assets. This
leads to increase in expenditure on both current
and capital accounts in BOP, thereby creating a
BOP deficit.

To maintain a fixed exchange rate, the monetary

authority will have to sell foreign exchange
reserves and buy domestic currency. Thus the
outflow of foreign exchange reserves means a fall
in R and in domestic money supply. This process
will continue until MS = MD and there will again be
BOP equilibrium.

On the other hand, if MS < MD at the given

exchange rate, there will be a BOP surplus.
Consequently, people acquire the domestic
currency by selling goods and securities to
foreigners. They will also seek to acquire
additional money balances by restricting their
expenditure relatively to their income.

The monetary authority on its part, will buy excess

foreign currency in exchange for domestic
currency. There will be inflow of foreign exchange
reserves and increase in domestic money supply.
This process will continue until MS = MD and BOP
equilibrium will again be restored. Thus a BOP
deficit or surplus is a temporary phenomenon and
is self-correcting (or automatic) in the long-run.

MS and MD curves intersect at point E where the

country’s balance of payments is in equilibrium
and its foreign exchange reserves are OR. In Panel
(B) of the figure, PDC is the payments
disequilibrium curve which is drawn as the vertical
difference between Ms and MD curves of Panel (A).
As such, point B0 in Panel (B) corresponds to point
E in Panel (A) where there is no disequilibrium of
balance of payments.

If MS < MD there is BOP surplus of SP in Panel (A).

It leads to the inflow of foreign exchange reserves
which rise from OR1 to OR and increase the money
supply so as to bring BOP equilibrium at point E.
On the other hand, if M S > MD, there is deficit in
BOP equal to DF.

There is outflow of foreign exchange reserves

which decline from OR2 to OR and reduce the
money supply so as to reestablish BOP equilibrium
at point E. The same process is illustrated in Panel
(B) of the figure where BOP disequilibrium is self-
correcting or automatic when B1S1 surplus and
B2D1 deficit are equal.

Under a system of flexible (or floating) exchange

rates, when B = O, there is no change in foreign
exchange reserves (R). But when there is a BOP
deficit or surplus, changes in the demand for
money and exchange rate play a major role in the
adjustment process without any inflow or outflow
of foreign exchange reserves.

Suppose the monetary authority increases the

money supply (MS > MD) and there is a BOP deficit.
People having additional cash balances buy more
goods thereby raising prices of domestic and
imported goods. There is depreciation of the
domestic currency and a rise in the exchange rate.

The rise in prices, in turn, increases the demand

for money thereby bringing the equality of MD and
MS without any outflow of foreign exchange
reserves. The opposite will happen when MD > MS,
there is fall in prices and appreciation of the
domestic currency which automatically eliminates
the excess demand for money. The exchange rate
falls until MD = MS and BOP is in equilibrium
without any inflow of foreign exchange reserves.

5.6.3.Criticisms

The monetary approach to the balance of payments

has been criticised on a number of counts:

 Demand for Money not Stable

Critics do not agree with the assumption of stable
demand for money. The demand for money is
stable in the long run but not in the short run
when it shows less stability.

 Full Employment not Possible

Similarly, the assumption of full employment is not

acceptable because there exists involuntary
unemployment in countries.

 One Price Law Invalid

Frankel and Johnson are of the view that the law of

one price holds for identical goods sold is invalid.
This is because when factors of production are
drawn into sectors producing non-trading goods,
the excess demand for non-traded goods will spill
over into reduced supplies of traded goods. This
will lead to higher imports, and disturb the law of
one price for all traded goods.

 Market Imperfections

There are also market imperfections which prevent

the law of one price from working properly in
many markets for traded goods. There may be
price differentials due to the lack of information
about overseas prices and trade regulations faced
by traders.

 Sterilisation not Possible

The assumption that the sterilisation of currency

flows is not possible under fixed exchange rates,
has not been accepted by critics. They argue that
“the sterilisation of currency flows is entirely
possible if the private sector is willing to adjust the
composition of its wealth portfolio with regard to
the relative importance of bonds and money
balances, or if the public sector is prepared to run
a higher budget deficit whenever it has a balance
of payments deficit with which to contend.”

 Link between BOP and Money Supply

not Valid

The monetary approach is based upon direct link

between BOP of a country and its total money
supply. This has been questioned by economists.
The link between the two depends upon the ability
of the monetary authority to neutralise the inflows
and outflows of foreign exchange reserves when
there is BOP deficit and surplus. This requires
some degree of sterilisation of external flows. But
this is not possible due to globalisation of financial
markets.

 Neglects Short Run

The monetary approach is related to the self-

correcting long-run equilibrium in BOP. This is
unrealistic because it fails to describe the short
time through which the economy passes to reach
the new equilibrium. As pointed out by Prof.
Krause, the monetary approach’s “concentration
on the long-run assumes away all of the problems
that make the balance of payments a problem.”

 Neglects Other Factors

This approach neglects all real and structural
factors which lead to disequilibrium in BOP and
concentrates only on domestic credit.

 Neglects Economic Policy

This approach emphasises the role of domestic

credit in bringing BOP equilibrium and neglects
economic policy measures. According to Prof.
Currie, the balance of payments equilibrium can
also be “achieved by expenditure-switching
policies working through real flows and
government budget.”

5.7. International Financial Markets

The International Financial Market is the place

where financial wealth is traded between
individuals (and between countries). It can be seen
as a wide set of rules and institutions where assets
are traded between agents in surplus and agents
in deficit and where institutions lay down the rules.

The financial market comprises the markets strictu

sensu (stock market, bond market, currency
market, derivatives market, commodity market and
money market), the institutions which work in
them with different aims and functions, as well as
direct/indirect policies orientated to making the
market the place (not necessarily a physical place
and not necessarily ruled but regulated) where the
exchange between surplus and deficit units is
carried out as efficiently as possible.
With regard to policies, consideration must be
given to those connected with monetary, fiscal and
more structural policies, as well as those directly
connected with the governance of the market
itself.

Governance in the financial market can be defined

as a set of rules useful in interconnecting the
agents who operate within it and the institutions.
These rules define the market. Governance rules in
a financial market can be defined at both a
microeconomic and macroeconomic level.

5.7.1.Features of International Finance

Following are the key features of international

finance:

 Foreign Exchange Markets: A foreign

exchange market is a decentralized market
where global currencies get traded. The main
participants in this market are the large
international banks. Financial institutions,
multinational corporations, governments, and
other central banks. The foreign exchange
market is open 24 hours a day from 5 p.m. EST
Sunday to 4 p.m. EST Friday.
 International Investment: International
investment is the purchase of assets by
foreigners. This is to get an income from them
or to benefit from capital gains when the asset
sells at a higher price than paid for.
 Balance of Payments: The balance of
payments (BOP) is a statement of all
transactions made between entities in one
 country. Entities in all other countries during a
specified period of time, usually a year. The
BOP includes information on trade in goods and
services, investments, and transfers of money.
 Foreign Direct Investment: This is an
investment made by a company or individual in
one country in business interests located in
another country. Usually, FDI takes the form of
a controlling ownership stake in a foreign
company.
 Multinational Corporations: A multinational
corporation (MNC) is a company that operates
in more than one country. MNCs are typically
large companies that have a global reach and
engage in cross-border activities.
 International Trade: International trade is the
exchange of goods and services between
countries. This type of trade gives rise to a
world economy, in which prices, or supply and
demand, are affected by global events.
 Exchange Rates: An exchange rate is the rate
at which one currency can get exchanged for
another. Exchange rates can be either fixed or
floating. A fixed exchange rate is one that is set
by the central bank of a country and does not
change. A floating exchange rate is one that
allows fluctuation in response to market forces.
 Currency Crises: A currency crisis is a
situation in which the value of a currency
plummeting rapidly. Currency crises can have a
number of causes, such as economic
mismanagement, speculative attacks, or a loss
of confidence in a currency.
 Interest Rates: Interest rates are the amount
of money charged by a lender to a borrower for
the use of money, expressed as a percentage of
the total amount of money lent. Interest rates
are usually determined by the market, but can
also be set by central banks.

5.7.2.Benefits of International Finance

There are many benefits that can be gained from

participating in international finance. These
benefits include:

 Access to new markets: By participating in

international finance, companies and countries
can gain access to new markets.
 Diversification: International finance can help
to diversify a company’s or country’s portfolio
of assets.
 Increased competitiveness: International
finance can help to improve a company’s or
country’s competitiveness.
 Efficiency gains: International finance can
lead to efficiency gains through the pooling of
resources and the sharing of risk.
 Learning opportunities: International finance
can provide learning opportunities for
companies and countries.
 CHAPTER-6:Inflation,
Unemployment and
Expectations

6.1. Inflation

Inflation is an economic indicator that indicates

the rate of rising prices of goods and services in
the economy. Ultimately it shows the decrease in
the buying power of the rupee. It is measured as a
percentage.

This quantitative economic measures the rate of

change in prices of selected goods and services
over a period of time. Inflation indicates how much
the average price has changed for the selected
basket of goods and services. It is expressed as a
percentage. Increase in inflation indicates a
decrease in the purchasing power of the economy.

This percentage indicates the increase or decrease

from the previous period. Inflation can be a cause
of concern as the value of money keeps decreasing
as inflation rises.

1. Calculate Inflation Rate

Inflation is calculated using the Consumer Price

Index (CPI). Inflation can be calculated for any
product by following these steps.

 Determine the rate of the product at an earlier

period.
 Determine the current rate of the product
 Use the inflation rate formula (Initial CPI –
Final CPI/ Initial CPI)*100. Here CPI is the rate
of the product.
 This gives the increase/decrease percentage in
the price of the product. One can use this to
compare the inflation rate over a period of time.

6.1.1.Types of Inflation

The three types of Inflation are Demand-Pull, Cost-

Push and Built-in inflation.

 Demand-pull Inflation: It occurs when the

demand for goods or services is higher when
compared to the production capacity. The
difference between demand and supply
(shortage) result in price appreciation.
 Cost-push Inflation: It occurs when the cost
of production increases. Increase in prices of
the inputs (labour, raw materials, etc.)
increases the price of the product.
 Built-in Inflation: Expectation of future
inflations results in Built-in Inflation. A rise in
prices results in higher wages to afford the
increased cost of living. Therefore, high wages
result in increased cost of production, which in
turn has an impact on product pricing. The
circle hence continues.

6.1.2.Causes of Inflation

 Monetary Policy: It determines the supply of

currency in the market. Excess supply of money
leads to inflation. Hence decreasing the value
of the currency.
 Fiscal Policy: It monitors the borrowing and
spending of the economy. Higher borrowings
(debt), result in increased taxes and additional
currency printing to repay the debt.
 Demand-pull Inflation: Increases in prices
due to the gap between the demand (higher)
and supply (lower).
 Cost-push Inflation: Higher prices of goods
and services due to increased cost of
production.
 Exchange Rates: Exposure to foreign markets
are based on the dollar value. Fluctuations in
the exchange rate have an impact on the rate of
inflation.

6.1.3.Cost of Inflation

A Cost Inflation Index table is used to calculate the

long-term capital gains from a capital asset
transfer or sale. The profit earned through the sale
or transfer of any capital asset, such as land,
property, stocks, shares, trademarks, patents, and
so on, is referred to as capital gain. Long-term
capital assets are typically documented in books at
their cost price. As a result, despite growing asset
prices, these capital assets cannot be revalued.

As a result, when these assets are sold, the profit

or gain obtained from them remains high due to
their high sale price in relation to their acquisition
price. As a result, assessees must pay a greater
income tax on these assets' gains. In the long run,
the application of the Cost Inflation Index for
capital gain adjusts the purchase price of assets
based on their sale price, resulting in smaller
earnings and a lower tax amount.

There are many costs associated with inflation; the

volatility and uncertainty can lead to lower levels
of investment and lower economic growth. For
individuals, inflation can lead to a fall in the value
of their savings and redistribute income in society
from savers to lenders and those with assets. At
extreme levels, inflation can destabilise society and
destroy confidence in the economic system. Impact
of inflation on society is called social cost of
inflation i.e. impact of inflation on economy. Social
cost of inflation may be divided in to two parts:

1. Perfectly anticipated inflation (The cost of

expected inflation): In this case the growth rate of
inflation steady is expected and predictable. In this
situation we can see following effects of inflation:

 Falling Purchasing Power: when inflation

rate is increases automatically purchasing
power decreases.
 Shoe-leather cost: As we know a higher
inflation rate leads to a higher nominal
interest rate, which in turn leads to lower
real money balances. If people are to hold
lower money balances on average, they must
make more frequent trips to the bank to
withdraw money. The inconvenience of
reducing money holding is metaphorically
called the shoe leather cost of inflation,
because walking to the bank more often
causes one’s shoes to wear out more
quickly.
  Menu- cost: Regularly increases inflation
induces firms to change their posted prices
more often. Changing prices is sometimes
costly: for example, it may require printing
and distributing a new catalog. These costs
are called menu costs, because the higher
the rate of inflation, the more often
restaurants have to print new menus.
 Cost of relative price viability: Impact of
fluctuation of inflation makes on different
sources. If inflation increases this impact
will be upon goods, transportation cost,
wages rent, unemployment etc.
 Tax Distorting: When inflation rate
increases then tax burden also increases.
 Inconvenience Financial Planning: A
changing price level complicates personal
financial planning. One important decision
that all households face is how much of their
income to consume today and how much to
save for retirement. A dollar saved today
and invested at a fixed nominal interest rate
will yield a fixed dollar amount in the future.
Yet the real value of that dollar amount—
which will determine the retiree’s living
standard—depends on the future price level.
Deciding how much to save would be much
simpler if people could count on the price
level in 30 years being similar to its level
today.

2. Imperfectly anticipated inflation (The cost

of unexpected inflation): In this case inflation
rate may be higher or lower than the expected
of inflation. Unexpected inflation has an effect
that is more pernicious than any of the costs of
steady, anticipated inflation: it arbitrarily
redistributes wealth among individuals. There
are following effects of unexpected inflation:
 Effect on Decision making: Inflation also
impacts a firm's stock and bond values
because interest rates are directly affected
by inflation expectations. As a result,
understanding inflation is critical to
managing a firm's financial resources and
directly impacts financial decision-making.
 Effect on wealth: Investors can
underestimate the damaging effect inflation
can have on their wealth. Increases in the
cost of living reduce the spending power of
money. Inflation can be good for holders of
assets, if their values rise faster than the
general level of inflation
 Problem of fixed income: Unexpected
inflation also hurts individuals on fixed
income groups. Suppose an employee and
firm often agree on a fixed nominal pension
when the employee retires (or even earlier).
Because the pension is deferred earnings,
the employee is essentially providing the
firm a loan: the employee provides labour
services to the firm while young but does
not get fully paid until old age. Like any
creditor, the employee is hurt when inflation
is higher than anticipated. Like any debtor,
the firm is hurt when inflation is lower than
anticipated.
  Effect on Debtors and Creditors: Most
loan agreements specify a nominal interest
rate, which is based on the rate of inflation
expected at the time of the agreement. If
inflation turns out differently from what was
expected, the ex post real return that the
debtor pays to the creditor differs from what
both parties anticipated. On the one hand, if
inflation turns out to be higher than
expected, the debtor gains and the creditor
loses because the debtor repays the loan
with less valuable dollars. On the other
hand, if inflation turns out to be lower than
expected, the creditor gains and the debtor
loses because the repayment is worth more
than the two parties anticipated.
 Effect on Producers and Customers: On
account of increase in inflation producer will
get profit while customer will suffer from
loss because of customer will have to pay
more money. In reverse case producer will
get loss and customers will get profit

6.2. The Fisher Effect

The Fisher Effect refers to the relationship

between nominal interest rates, real interest rates,
and inflation expectations. The relationship was
first described by American economist Irving
Fisher in 1930.

The relationship is described by the following

equation:

(1+i) = (1+r) * (1+π)

Where:

 i = Nominal Interest Rate

 r = Real Interest Rate
 π = Expected Inflation Rate

The Fisher Effect is an important relationship in

macroeconomics. It describes the causal
relationship between the nominal interest rate and
inflation. It states that an increase in nominal rates
leads to a decrease in inflation. The key
assumption is that the real interest rate remains
constant or changes by a small amount.

6.2.1.Importance of the Fisher Effect

The importance of the Fisher effect is that it is an

essential tool for lenders to use in determining
whether or not they're earning money on a loan. A
lender will not benefit from interest except when
the rate of interest charged is higher than the rate
of inflation in the economy. Furthermore, as per
Fisher's theory, even if a loan is made without
interest, the lending party must at the very least
charge the same amount as the inflation rate is in
order to preserve buying power upon repayment.

The Fisher Effect also explains how the money

supply effects both the inflation rate and the
nominal interest rate. For example, if monetary
policy is changed in such a way that the inflation
rate rises by 5%, the nominal interest rate rises by
the same amount. While changes in the money
supply have no effect on the actual interest rate,
fluctuations within the nominal interest rate are
related to changes in the money supply.
6.2.2.Applications of the Fisher Effect

Since Fisher identified the link between the real

and nominal interest rates, the notion has been
used in a variety of areas. Let's look at the
important applications of the Fisher Effect.

 Monetary Policy

Fisher's economic theory importance results in it

being used by central banks to manage inflation
and keep it within a reasonable range. One of the
central banks' tasks in every country is to
guarantee that there is enough inflation to avert a
deflationary cycle but not that much inflation to
overheat the economy.

To prevent inflation or deflation from spinning out

of control, the central bank may set the nominal
interest rate by altering reserve ratios, conducting
open market operations, or engaging in other
activities.

 Currency Markets

The Fisher Effect is known as the International

Fisher Effect in its application in currency
markets.

This important theory is often used to forecast the

current exchange rate for various nations'
currencies based on variances in nominal interest
rates. The future exchange rate may be calculated
using the nominal interest rate in two separate
nations and the market exchange rate on a given
day.
  Portfolio Returns

To better appreciate the underlying returns

produced by an investment over time, it's
necessary to grasp the differences between
nominal interest and real interest.

You may get excited if you're able to invest your

cash and get a nominal interest rate of 15%.
However, if there is a 20% inflation within the
same time period, you will notice that you have
lost 5% buying power.

Consequently, the Fisher equation's application is

that it is used to calculate the appropriate nominal
interest return on capital required by an
investment in order to assure that the investor
earns a "real" return over time.

6.3. Concept of Unemployment and its

types and Measurement

The unemployment rate is the most commonly

used indicator for understanding conditions in the
labour market. The labour market is the term used
by economists when talking about the supply of
labour (from households) and demand for labour
(by businesses and other organisations). The
unemployment rate can also provide insights into
how the economy is performing more generally,
making it an important factor in thinking about
monetary policy.

6.3.1.Types of unemployment
There are three main types of unemployment –
cyclical, structural and frictional unemployment. In
practice, these cannot be measured directly, and
they can often overlap, but they provide a useful
way of thinking about unemployment.

1. Cyclical Unemployment

Cyclical unemployment occurs with changes in

economic activity over the business cycle. During
an economic downturn, a shortfall of demand for
goods and services results in a lack of jobs being
available for those who want to work. Businesses
experiencing weaker demand might reduce the
amount of people they employ by laying off
existing workers, or hiring fewer new workers. As
a result, people looking for work will also find it
harder to become employed. The opposite situation
occurs when demand strengthens.

An increase in cyclical unemployment might

suggest the economy is operating below its
potential. With more people competing for jobs,
businesses might offer lower wage increases,
which would contribute to lower inflation. Policies
that stimulate aggregate demand, such as
expansionary monetary policy, can help reduce
this type of unemployment (because businesses
experiencing stronger demand are likely to employ
more people).

2. Structural Unemployment

Structural unemployment occurs when there is a

mismatch between the jobs that are available and
the people looking for work. This mismatch could
be because jobseekers don’t have the skills
required to do the available jobs, or because the
available jobs are a long way from the jobseekers.

Workers may become unemployed if they work in

industries that are declining in size or have skills
that could be automated as a result of large-scale
technological advances. It may be difficult for them
to find work in another industry and they may need
to develop new skills or move to a region that has
more opportunities.

Structural unemployment tends to be longer

lasting than other types of unemployment. This is
because it can take a number of years for workers
to develop new skills or move to a different region
to find a job that matches their skills. As a result,
workers who are unemployed because of structural
factors are more likely to face long-term
unemployment (for more than 12 months).

In contrast to cyclical unemployment, structural

unemployment exists even when economic
conditions are good. In theory, this type of
unemployment should not directly influence wages
or inflation and is best addressed through policies
that focus on skills and the supply of labour.

3. Frictional Unemployment

Frictional unemployment occurs when people

move between jobs in the labour market, as well as
when people transition into and out of the labour
force.
Movement of workers is neccessary for a flexible
labour market and helps achieve an efficient
allocation of labour across the economy. However,
people may not find jobs immediately and need to
invest time and effort in searching for the right
job. Businesses also spend time searching for
suitable candidates to fill job vacancies. As a
result, people looking for jobs are not matched
immediately with vacancies and may experience a
period of temporary unemployment.

This type of unemployment is generally shorter

term (less than one month). Frictional
unemployment is likely to occur at all points of the
business cycle and, like structural unemployment,
may not influence wages or inflation.

These three types of unemployment are not

independent of each other. For example, a period
of high cyclical unemployment might lift structural
unemployment. This could occur when people are
unemployed for such a long period that their skills
and productivity deteriorate, and they become
seen as being less employable, reducing the
probability that they will be hired in the future.

4. Other Types of Unemployment

There are some other types of unemployment that

are also important to consider. In particular, the
underemployment rate can be thought of as a
complementary indicator to the unemployment
rate when thinking about conditions in the labour
market.
  Underemployment occurs when people are
employed, but would like and are available to
work more hours. There are two categories of
underemployed people defined by the ABS.
First, part-time workers who would prefer to
work additional hours. Second, people who
usually work full time, but are currently
working part-time hours. Underemployment
rates are generally higher among groups that
have a larger proportion of people working
part time, such as females, younger workers
and older workers.
 Hidden unemployment occurs when people
are not counted as unemployed in the formal
ABS labour market statistics, but would
probably work if they had the chance. For
example, someone might have looked for work
for a long time, given up hope and stopped
looking, but still wish to work. (These people
are sometimes referred to as ‘discouraged
workers’.)
 Seasonal unemployment occurs at different
points over the year because of seasonal
patterns that affect jobs. Some examples
include ski instructors, fruit pickers and
holiday-related jobs. The ABS publishes
seasonally adjusted labour market statistics,
which remove seasonal patterns in the data.

6.3.2.Unemployment rate measured

Unemployment occurs when someone is willing

and able to work but does not have a paid job.
The unemployment rate is the percentage of
people in the labour force who are unemployed.
Consequently, measuring the unemployment rate
requires identifying who is in the labour force. The
labour force includes people who are either
employed or unemployed. Figuring out who is
employed or unemployed involves making practical
judgements, such as how much paid work someone
needs to undertake for them to be considered as
having a job, as well as actually counting how
many people have jobs or not. Three broad
categories:

 Employed – includes people who are in a

paid job for one hour or more in a week.
 Unemployed – includes people who are not
in a paid job, but who are actively looking
for work.
 Not in the labour force – includes people
not in a paid job, and who are not looking
for work.

This can include people who are studying, caring

for children or family members on a voluntary
basis, retired, or who are permanently unable to
work. Once the number of people in each of these
categories has been estimated, the following
labour market indicators can be calculated:

 Labour force – the sum of employed and

unemployed people.
 Unemployment rate – the percentage of
people in the labour force that are
unemployed.
 Participation rate – the percentage of
people in the working-age population that
are in the labour force.
6.4. Inflation and its social costs
6.5. Hyperinflation

In economics, hyperinflation is used to describe

situations where the prices of all goods and
services rise uncontrollably over a defined time
period. In other words, hyperinflation is extremely
rapid inflation.

Generally, inflation is termed hyperinflation when

the rate of inflation grows at more than 50% a
month. American economics professor Phillip
Cagan first studied the economic concept in his
book, “The Monetary Dynamics of Hyperinflation.”

6.5.1.Causes of Hyperinflation

Hyperinflation commonly occurs when there is a

significant rise in money supply that is not
supported by economic growth. The increase in
money supply is often caused by a government
printing and injecting more money into the
domestic economy or to cover budget deficits.
When more money is put into circulation, the real
value of the currency decreases and prices rise.

6.5.2.Effects of Hyperinflation

Hyperinflation quickly devalues the local currency

in foreign exchange markets as the relative value
in comparison to other currencies drops. This
situation, will drive holders of the domestic
currency to minimize their holdings and switch to
more stable foreign currencies.
In an attempt to avoid paying for higher prices
tomorrow due to hyperinflation, individuals
typically begin investing in durable goods such as
equipment, machinery, jewelry, etc. In situations of
prolonged hyperinflation, individuals will begin to
accumulate perishable goods.

However, that practice causes a vicious cycle – as

prices rise, people accumulate more goods, in turn
creating higher demand for goods and further
increasing prices. If hyperinflation continues
unabated, it nearly always causes a major
economic collapse.

Severe hyperinflation can cause the domestic

economy to switch to a barter economy, with
significant repercussions to business confidence. It
can also destroy the financial system as banks
become unwilling to lend money.
 CHAPTER-7:Economic Growth

7.1. Basic concept of Economic growth

and its measurement

Economic growth is the increase in the goods and

services produced by an economy, typically a
nation, over a long period of time.

It is measured as a percentage increase in the real

gross domestic product (GDP) which is the gross
domestic product (GDP) adjusted for inflation. The
market value of all final goods and services
produced in a country or economy is referred to as
GDP.

Economic historians have tried to come up with a

theory of stages that each economy must go
through as it develops. To explain the progression
from one stage to the next, various theories have
been proposed.

The two most frequently mentioned factors are

entrepreneurship and investment. While the
definition of economic growth is simple, measuring
it is extremely difficult. Income measures are just
one way to look at how countries' economies differ
and how their prosperity changes over time.

Price, quality, and currency differences complicate

comparisons over time and across borders, as
explained below. Economic prosperity and long-
term economic growth are relatively recent
achievements for humanity, according to long-term
social history.

7.1.1.Measuring Economic Growth

Economists use a variety of methods to determine

how quickly the economy is growing. Real gross
domestic product, or real GDP, is the most
common way to measure the economy.

GDP is the total value of everything produced in

our economy, including goods and services. The
term "real" denotes that the total has been
adjusted to account for inflationary effects.

Real GDP growth can be measured in at least

three different ways. It's crucial to know which one
is being used and what the differences are
between them. The three most common methods
for calculating real GDP are:

1. Income approach

The income earned from the production of goods

and services is the starting point for the GDP
income approach formula. We calculate the income
earned by all the factors of production in an
economy using the income approach method.

The inputs that go into making the final product or

service are referred to as factors of production.
Within a country's domestic boundaries, the
factors of production for a business are Land,
Labor, Capital, and Management.
Gross Domestic Product (GDP) = total
national income + sales taxes, depreciation +
net foreign factor income.

Where,

 Total National Income (TNI) is the sum of all

wages, rents, interest, and profits in the
country.
 Sales taxes are levied by the government on
purchases of goods and services.
 Depreciation is the amount that is attributed
to an asset-based on how long it will be
used.

Net foreign factor income is the difference

between total income generated by citizens and
companies outside their country of origin and total
income generated by foreign citizens and
companies within that country.

2. Expenditure approach

The second approach, known as the expenditure

approach, is the polar opposite of the income
approach, as it begins with money spent on goods
and services rather than income. This metric
measures the total amount spent on goods and
services by all entities within a country's domestic
borders. Let's take a look at how to calculate GDP
using the expenditure method.

GDP (as measured by expenditure method) =

C + I + G + (EX-IM)

Where,
 C: Consumer Expenditure, which refers to
when people spend money on various goods
and services. For example, food, gas, and a car.
 I: Investment Expenditure, which refers to
when businesses spend money to invest in their
operations. Purchasing land, machinery, and
other items, for example.
 G: Government Expenditure, which refers to
how much money the government spends on
various development projects.
 Exports minus Imports, or Net Exports (EX-IM).
i.e., we calculate GDP by including exports to
other countries and subtracting imports from
other countries into our country.

3. Output approach

The monetary or market value of all goods and

services produced within a country's borders is
calculated using the GDP Output Method.

GDP at constant prices, or Real GDP, is calculated

to avoid a distorted measure of GDP due to price
level changes. GDP is calculated using the Output
Approach using the following formula:

Real GDP (GDP at constant prices) – Taxes +

Subsidies = GDP (as per output method).

7.2. Classification of growth models

 CHAPTER-8:Microeconomic
Foundations of
Macroeconomics

8.1. Consumption

Consumption, in economics, the use of goods and

services by households. Consumption is distinct
from consumption expenditure, which is the
purchase of goods and services for use by
households. Consumption differs from
consumption expenditure primarily because
durable goods, such as automobiles, generate an
expenditure mainly in the period when they are
purchased, but they generate “consumption
services” (for example, an automobile provides
transportation services) until they are replaced or
scrapped.

Neoclassical (mainstream) economists generally

consider consumption to be the final purpose of
economic activity, and thus the level of
consumption per person is viewed as a central
measure of an economy’s productive success.

The study of consumption behaviour plays a

central role in both macroeconomics and
microeconomics. Macroeconomists are interested
in aggregate consumption for two distinct reasons.
First, aggregate consumption determines
aggregate saving, because saving is defined as the
portion of income that is not consumed. Because
aggregate saving feeds through the financial
system to create the national supply of capital, it
follows that aggregate consumption and saving
behaviour has a powerful influence on an
economy’s long-term productive capacity. Second,
since consumption expenditure accounts for most
of national output, understanding the dynamics of
aggregate consumption expenditure is essential to
understanding macroeconomic fluctuations and
the business cycle.

Microeconomists have studied consumption

behaviour for many different reasons, using
consumption data to measure poverty, to examine
households’ preparedness for retirement, or to test
theories of competition in retail industries. A rich
variety of household-level data sources allows
economists to examine household spending
behaviour in minute detail, and microeconomists
have also utilized these data to examine
interactions between consumption and other
microeconomic behaviour such as job seeking or
educational attainment.

8.1.1.Concept of Consumption Function

The term consumption function refers to an

economic formula that represents the functional
relationship between total consumption and gross
national income (GNI). The consumption function
was introduced by British economist John Maynard
Keynes, who argued the function could be used to
track and predict total aggregate consumption
expenditures. It is a valuable tool that can be used
by economists and other leaders to understand the
economic cycle and help them make key decisions
about investments as well as monetary and fiscal
policy.

1. Calculating the Consumption Function

The consumption function is represented as:

C = A + MD

Where:

 C=consumer spending
 A=autonomous consumption
 M=marginal propensity to consume
 D=real disposable income

2. Assumptions and Implications

Much of the Keynesian doctrine centers around the

frequency with which a given population spends or
saves new income. The multiplier, the consumption
function, and the marginal propensity to consume
are each crucial to Keynes’ focus on spending and
aggregate demand.

The consumption function is assumed stable and

static where all expenditures are passively
determined by the level of national income. The
same is not true of savings or government
spending, both of which Keynes referred to as
investments.

For the model to be valid, the consumption

function and independent investment must remain
constant long enough for gross national income to
reach equilibrium. At equilibrium, the expectations
of businesses and consumers match up. One
potential problem is that the consumption function
cannot handle changes in the distribution of
income and wealth. When these change, so too
might autonomous consumption and the marginal
propensity to consume.

8.1.2.Keynesian Consumption Function

The consumption function states that aggregate

real consumption expenditure of an economy is a
function of real national income. This is called the
Keynesian Consumption Function. The classical
economists used to argue that consumption was a
function of the rate of interest such that as the rate
of interest increased the consumption expenditure
decreased and vice versa. Keynes stated that the
rate of interest may have some influence on
consumption but the real income was the
important determinant of consumption.

It should be remembered that in the consumption

function consumption expenditure refers to
intended or ex-ante consumption and not actual
consumption. Similarly, income refers to
anticipated income and not actual income.
Therefore, the consumption function shows what
consumption expenditure would be at different
levels of income. The aggregate consumption in
the economy can be found out from the
consumption expenditure of different individuals
purchasing commodities.
 The Keynesian consumption function expresses the
level of consumer spending depending on three
factors.

 Yd = disposable income (income after

government intervention – e.g. benefits, and
taxes)
 a = autonomous consumption (consumption
when income is zero. e.g. even with no
income, you may borrow to be able to buy
food)
 b = marginal propensity to consume (the %
of extra income that is spent). Also known as
induced consumption.

i. Consumption function formula

C = a + b Yd

This suggests consumption is primarily determined

by the level of disposable income (Yd). Higher Yd
leads to higher consumer spending. This model
suggests that as income rises, consumer spending
will rise. However, spending will increase at a
lower rate than income.

 At low incomes, people will spend a high

proportion of their income. The average
propensity to consume could be one or
greater than one. This means people spend
everything they have. When you have low
income, you don’t have the luxury of being
able to save. You need to spend everything
you have on essentials.
 However, as incomes rise, people can afford
the luxury of saving a higher proportion of
 their income. Therefore, as incomes rise,
spending increases at a lower rate than
disposable income. People with high
incomes have a lower average propensity to
spend.

ii. Implications of consumption function

If you cut income tax for those on low income, they

tend to have a higher marginal propensity to
consume this extra income. Therefore, there is a
large increase in spending. People with high
incomes will tend to have a lower marginal
propensity to consume. If they benefit from a tax
cut, they will save a greater proportion.

 Shift in the consumption function

In this diagram, the consumption function has

shifted to the upwards (to the left. (C1 to C2). This
means consumers are spending a higher % of their
income. This could be due to a rise in property
prices which increases consumer confidence and
lead to higher consumer spending.

 Increased marginal propensity to

consume

In this diagram, the consumption function has

become steeper. This means the value of b (MPC)
has increased. Therefore, people are spending a
higher % of their additional income. This could be
due to rising confidence, lower saving and easier
availability of credit.

iii. Limitations of consumption function

In the real world, people are influenced by other
factors

 Life cycle factors – e.g. students more likely

to borrow and spend during university days.
 Behavioural factors – e.g. people may be
influenced by general optimism.

8.1.3.Kuznet's Consumption Function

Kuznets found that consumption function is of the

following form:

C = bY

In Kuznets’ consumption function there is no

intercept term (that is, autonomous consumption).
This is shown in Fig. 9.8 where it will be seen that
Kuznet’ consumption function curve starts from
the origin and is very near to 45° line depicting
that the propensity to consume (b) is very high.

From his empirical study Kuznets estimated that

average propensity to consume was nearly 0.9.
Besides, by dividing the entire period (1869-1933)
into three overlapping 30 years sub-periods
Kuznets found that the proportion of consumption
to income (that is, average propensity to consume)
was nearly the same and equal to about 0.87 in all
the three sub-periods.

Thus Kuznets concluded that there was no

tendency for the average propensity to consume to
decline as disposable income rises. Thus, rounding
off Kuznets estimated propensity to consume is
equal to 0.9.
Keynes’ consumption function (C = a + bY) and
Kuznets’ consumption function (C = bY) are
different. Whereas in Keynes’ consumption
function A PC falls as income rises, in Kuznets
‘consumption function it remains constant over a
long period. Further, the value of marginal
propensity to consume which is less than one is
much higher in Kuznets’ function as compared to
that of Keynes.

The reconciliation between two types of

consumption functions has been made by some
economists by pointing out that whereas Keynes’
function is short-run consumption function,
‘Kuznets’ function is concerned with long run and
is referred to as long-run consumption function.

In the long run, short run consumption function

curve shifts above and therefore in the long run
consumption function, propensity to consume, is
higher as compared to that in the short run.
Further, Friedman’s permanent Income
Hypothesis and Modigliani’s Life Cycle Hypothesis
have also tried to reconcile the two functions by
referring to the short-run and long-run
consumption behaviour of the people.

8.1.4.Relative Income Theory of Consumption

In 1949, James Duesenberry presented the relative

income hypothesis. According to this hypothesis,
saving (consumption) depends on relative income.
The saving function is expressed as St =f(Yt/ Yp),
where Yt / Yp is the ratio of current income to some
previous peak income. This is called relative
income. Thus current consumption or saving is not
a function-of current income but relative income.

Duensenberry pointed out that during depression

when income falls consumption does not fall much.
People try to protect their living standards either
by reducing their past savings (or accumulated
wealth) or by borrowing.

However as the economy gradually moves initially

into the recovery and then in to the prosperity
phase of the business cycle consumption does not
rise even if income increases. People use a portion
of their income either to restore the old saving rate
or to repay their old debt.

Thus we see that there is a lack of symmetry in

people’s consumption behaviour. People find it
more difficult to reduce their consumption level
than to raise it. This asymmetrical behaviour of
consumers is known as the ratchet effect.

Thus if we observe a consumer’s short-run

behaviour we find a non-proportional relation
between income and consumption. Thus MPC is
less than APC in the short run, as Keynes’s
absolute income hypothesis has postulated. But if
we study a consumer’s behaviour in the long run,
i.e., over the entire business cycle we find a
proportional relation between income and
consumption. This means that in the long run MPC
= APC.

8.2. Investment
An investment can be defined as an asset that is
created with the intention of helping your wealth
to grow with time and secure your future financial
requirements. The wealth created through
investment plans can be used for a variety of
objectives such as meeting shortages in income,
saving up for retirement, or fulfilling certain
specific obligations such as repayment of loans,
funding children’s higher education, purchase of
other assets, etc.

An investment is essentially an asset that is

created with the intention of allowing money to
grow. The wealth created can be used for a variety
of objectives such as meeting shortages in income,
saving up for retirement, or fulfilling certain
specific obligations such as repayment of loans,
payment of tuition fees, or purchase of other
assets.

Understanding the investment definition is crucial

as sometimes, it can be difficult to choose the right
instruments to fulfill your financial goals. Knowing
the investment meaning in your particular
financial situation will allow you to make the right
choices.

Investment may generate income for you in two

ways. One, if you invest in a saleable asset, you
may earn income by way of profit. Second, if
Investment is made in a return generating plan,
then you will earn an income via accumulation of
gains. In this sense, ‘what is investment’ can be
understood by saying that investments are all
about putting your savings into assets or objects
that become worth more than their initial worth or
those that will help produce an income with time.
Financially speaking, an investment definition is an
asset that is obtained with the intention of allowing
it to appreciate in value over time.

8.2.1.Keynesian Theory of Investment

According to the classical theory there are three

determinants of business investment:

 Cost,
 Return
 Expectations.

According to Keynes investment decisions are

taken by comparing the marginal efficiency of
capital (MEC) or the yield with the real rate of
interest (r). So long as the MEC is greater than r,
new investment in plant, equipment and machinery
will take place.

However, as more and more capital is used in the

production process, the MEC will fall due to
diminishing marginal product of capital. As soon as
MEC is equated to r, no new investment will be
made in any income-earning asset. The following
factors affect a firm’s investment decisions:

 Increased optimism among

managers

If managers are more optimist about the future,

they will place more orders for machines. This will
enable them to make more profit by venturing out
in those areas where demand for consumer goods
is picking up.

 An increase in the growth rate of the

economy

Keynes assumed that all investment is autonomous

and is thus independent of national or per capita
income. However, according to the acceleration
theory of investment, investment has an induced
component as well. So anything which increases
the demand for consumer goods is always
beneficial for the capital goods producing industry.

If India’s growth rate (as measured by the annual

rate of increase of per capita income) increases
there will be more demand for consumer goods
such as food and textiles. So industries producing
such goods will be stimulated and the managers of
such industries will place more orders for
purchase of machines.

In other words, there will be more demand for

food-producing and textile-producing machines.
This is because the demand for capital
(investment) goods is a derived (indirect) demand.
In fact, the acceleration principle suggests that a
small increase in the demand for consumer goods
leads to an accelerated increase in the demand for
capital goods.

 An increase in capital stock

An increase in society’s stock of capital — all other

factors remaining the same — will lead to a fall in
the marginal physical product of capital and will
reduce the MEC by lowering the prospective rate
of return on new investment.

 A change in technology

A favourable technological change (not an adverse

technology shock) will shift the MEC schedule to
the right and will increase the volume of
investment even if the rate of interest remains
constant.

 Changes in the rate of interest

Economists differ in their views about the interest

rate sensitivity of investment. Some Keynesian
economists argue that investment depends largely
upon expected return and is not very interest rate
sensitive, so that even large changes in interest
rates have little effect upon investment (the
marginal efficiency of capital curve being very
steep). Thus the Keynesians economists claim that
monetary policy will not be very effective in
influencing the level of investment in the economy.
By contrast the monetarists argue that investment
is very interest rate-sensitive.

So even small changes in interest rates will have

significant impact upon investment (the marginal
efficiency of capital/investment curve being very
shallow). Thus, monetarists claim that monetary
policy will be effective in influencing the level of
investment. Empirical evidence tends to support
the Keynesian view that interest rates have only a
limited effect on investment.
However, the neo-classical economists such as
Dale Jorgenson and his co-workers have
abandoned the classical and the Keynesian
theories of investment on the ground that both are
unrealistic. They have developed an alternative
theory of investment in terms of the profit-
maximising behaviour of a firm under perfect
competition. It is to this theory to which we turn
now.

8.3. Determinants of Business

Business performance is a measure of how well a

business is doing. It can be measured in terms of
financial indicators such as profitability and
revenue growth or other factors such as customer
satisfaction or employee engagement.

Improving business performance is a crucial goal

for business owners and managers, and there are
many different ways to go about it. Some common
approaches include improving business processes,
investing in new technology, or hiring and training
new staff. There are a few key determinants of
business performance:

 Business Model: This refers to how the

business makes money and delivers value to
customers. A well-designed business model
should be able to generate profits and scale
over time.
 Team: A business is only as good as the
people who are running it. A strong team
with the right mix of skills and experience
 can make all the difference between a
successful business and one that struggles.
 Market: The business needs to be operating
in a market that is growing or has growth
potential. Otherwise, generating the
necessary sales and profits will be very
difficult.
 Product: The business needs to have a
product or service that people want or need.
If there is no demand for what the company
is selling, it will be very difficult to generate
sales.
 Timing: Sometimes, businesses can be
ahead of or behind the curve in terms of
timing. Being too early or too late to the
market can make it difficult to find
customers and generate sales.
 Execution: Even the best business ideas
will not succeed if they are not executed
well. Poor execution can lead to missed
opportunities, wasted resources, and a
general decline in business performance.
 Technologies: A good use of technologies
can help a business save time, money, and
resources. It can also give the business a
competitive edge.

Many other factors can affect business

performance, but these are some of the most
important ones. Business owners and managers
should keep these in mind as they strive to
improve their company’s performance.

8.4. Fixed Investment

Fixed income broadly refers to those types of
investment security that pay investors fixed
interest or dividend payments until their maturity
date. At maturity, investors are repaid the
principal amount they had invested. Government
and corporate bonds are the most common types of
fixed-income products.

Unlike equities that may pay out no cash flows to

investors, or variable-income securities, where
payments can change based on some underlying
measure—such as short-term interest rates—the
payments of a fixed-income security are known in
advance and remain fixed throughout.

In addition to purchasing fixed-income securities

directly, there are several fixed-income exchange-
traded funds (ETFs) and mutual funds available to
investors.

8.4.1.Residential Investment and Inventory

Investment

Residential Investment: Residential investment

refers to the expenditure which people make on
constructing or buying new houses or dwelling
apartments for the purpose of living or renting
out to others. Residential investment varies from
3 per cent to 5 per cent of GDP in various
countries.

Two important features of residential investment

are worth noting. First, since the average life of
a housing unit is of 40 to 50 years, the stock of
existing housing units at a point of time is very
large as compared to the new residential
investment in a year (i.e., flow of residential
investment). Second, there is well developed
resale market for housing units so that people
who construct or own them can sell them in this
secondary market.

Residential investment depends on price of

existing housing units. The higher the price of
existing units, the higher will be investment in
constructing and buying new housing units. The
price of housing units is determined by demand
for housing units which slopes downward and
the supply of existing units which is a fixed
quantity and its supply curve is therefore
vertical straight line.

In the long run demand for housing is

determined by rate of population growth and
formation of new households. The higher rate of
population growth will lead to the increase in
demand for housing units. The tendency towards
two-member households has led to greater
demand for housing units.

Income is another important factor determining

demand for houses and therefore greater
residential investment. Since level of income
over time fluctuates a good deal, there is strong
cyclical pattern of investment in residential
construction.

Finally, interest is another important factor that

determines demand for dwelling units. Most
houses, especially in cities, are purchased by
borrowing funds from banks for a long time, say
20 to 25 years. Generally, the houses purchased
are mortgaged with banks or other financial
institutions who provide funds for this purpose.

The individuals who purchase houses on

mortgage borrowing pay monthly installment of
original sum borrowed plus interest. Therefore
demand for housing units is highly sensitive to
changes in rate of interest. Therefore, monetary
policy has a substantial effect on residential
investment.

Inventory Investment: Firms hold inventories of

raw materials, semi-finished goods to be
processed into final goods. The firms also hold
inventories of finished goods to be sold shortly.
The change in the inventories or stocks of these
goods with the firms is called inventory
investment. Now, why do firms hold inventories?
The first motive of holding inventories is
smoothing of the level of production.

The firms experience temporary booms and

busts in sales of their output. Instead of
adjusting their production each time to match
the changes in sales of the product they find
cheaper to produce goods at a steady rate. With
this steady rate of production when sales are
low, the firms will be producing more than they
are selling and therefore in these periods they
will hold the extra goods produced as
inventories.

On the other hand, when sales are high with a

steady rate of production, they will be producing
less than they sell. In such periods to meet the
market demand for goods, they will take out
goods from inventories to meet the demand.

The second reason for holding inventories is that

it is less costly for a firm to buy inputs such as
raw materials less frequently in large quantities
to produce goods and therefore it is required to
hold inventories of raw materials and other
intermediate products. Buying small quantities
of the materials more frequently to produce
goods is a more costly affair.

The third reason for holding inventories by the

firms is to avoid ‘running out of stock’
possibilities when their sales of goods are high
and therefore it is profitable to sell at that time.
This requires them to hold inventories of goods.

8.4.2.Autonomous and Induced Determinants

of Investment

Autonomous Investment: By autonomous

investment we mean the investment which does
not change with the changes in the income level
and is therefore independent of income.

Keynes thought that the level of investment

depends upon marginal efficiency of capital and
the rate of interest. He thought changes in
income level will not affect investment. This view
of Keynes is based upon his preoccupation with
short-run problem. He was of the opinion that
changes in income level will affect investment
only in the long run.
Therefore, considering it as the short-run
problem he treated investment as independent of
the changes in the income level. In fact the
distinction between autonomous investment and
induced investment has been made by post-
Keynesian economists. Autonomous investment
refers to the investment which does not depend
upon changes in the income level.

This autonomous investment generally takes

place in houses, roads, public undertakings and
in other types of economic infrastructure such as
power, transport and communication. This
autonomous investment depends more on
population growth and technical progress than
on the level of income. Most of the investment
undertaken by Government is of the autonomous
nature.

Induced Investment: Induced investment is that

investment which is affected by the changes in
the level of income. The greater the level of
income, the larger will be the consumption of the
community. In order to produce more consumer
goods, more investment has to be made in
capital goods so that greater output of consumer
goods becomes possible.

Keynes regarded rate of interest as a factor

determining induced investment but the
empirical evidence gathered so far suggests that
induced investment depends more on income
than on the rate of interest. Increase in national
income implies that demand for output of goods
and services increases. To produce greater
output, more capital goods are required to
produce them. To have more capital goods more
investment has to be undertaken. This induced
investment is undertaken both in fixed capital
assets and in inventories.

The essence of induced investment is that

greater income and therefore greater aggregate
demand affects the level of investment in the
economy. The induced investment underlines the
concept of the principle of accelerator, which is
highly useful in explaining the occurrence of
trade cycles.

8.5. Marginal Efficiency of Capital

Marginal efficiency of investment refers to the

expected rates of return on investments when
additional investment is made within certain
parameters and over a given time frame. It is
possible to determine the investment’s
profitability by comparing these rates with the
market interest rate. The rate of return is
calculated as the amount that must be deducted
from the anticipated stream of future returns from
an investment project for their current value to
equal the project’s cost.

According to Keynes, “the marginal efficiency of

capital” is defined as the rate of discount that
would bring the supply price of a capital asset’s
supply exactly into line with the present value of
the series of annuities that would result from the
returns expected from the asset over its expected
lifetime. He adds that the supply price of the asset
should not be confused with its current price but
rather with the price that would merely motivate a
producer to create an additional unit of such
assets, i.e., it is frequently called its replacement
cost.

8.5.1.Factors

The marginal efficiency of capital (MEC) is

influenced by several factors, including:

 Technological progress: New technologies

can increase the productivity of capital,
leading to an increase in MEC.
 Competition: Competition among firms can
lead to a reduction in the rate of return on
investment, reducing MEC.
 Expectations: The expectations of investors
about future market conditions can impact
MEC. If investors expect high profits, MEC
will be high, and investment will increase.
 Interest rates: Higher interest rates
increase the cost of borrowing, lowering
MEC.
 Time preference: The time preference of
investors, i.e., their preference for
current consumption over future
consumption, can impact MEC.
 Risk: The perceived risk of an investment
can influence MEC, as investors will require
a higher rate of return to compensate for
the risk.
 Availability of investment
opportunities: If investment opportunities
 are abundant, MEC will be high, and
investment will increase.

These factors interact and can affect MEC

fluctuations, impacting investment and economic
growth.

8.5.2.Formula

Here,

 Sp: Supply price or the cost of the capital

asset
 R1, R2… Rn: Series of expected annual
returns from the capital asset in the years
1,2…….n
 i: Rate of discount

8.6. Investment Demand Curve

The investment demand curve show the amount of

money spent on investments each year at each
interest rate, assuming that all other investment
conditions remain constant. In other words, the
investment demand curve implies a relationship
between the quantity of investment and the
economy’s interest rate.
 Figure 8:7 Investment Demand Curve5

The curve indicates that when the interest rate

declines, the amount of money invested per year
increases. To understand the connection between
interest rates and investment, remember that
investment is an addition to capital. Capital is
anything made in order to make additional goods
and services.

8.6.1.Determinants of Investment Demand

The factors that affect investment demand are

listed below.

1. Expectations: Future production capacity is

affected by changes in capital stock. As a result,
capital change plans are highly reliant on
expectations. A company is considering future
sales. When expectations change as the
expected return on investment increases, the
investment demand curve shifts to the right.
Similarly, lower profitability expectations shift

5
https://econtips.com/wp-content/uploads/2022/06/Inve
stment-Demand-Curve.jpg
 the investment demand curve to the left. Also,
lower profitability expectations shift the curve
to the left.

2. Level of Economic Activity: To generate

products and services, businesses require
capital. The need for capital increases as the
amount of production rises. This will lead to a
huge investment. As a result, an increase in
GDP will most likely cause the investment
demand curve to move to the right.

3. Stock of capital: The amount

of capital already in use affects the level of
investment in two ways.

 As more investment replaces depleted

capital, more capital will lead to more
investment.
 More capital stock may tend to decrease as
investments are made to adjust the capital
stock to the desired level.

4. Cost of capital goods: When drawing the

investment demand curve, changing a constant
variable affects the curve. The cost of capital
goods is one of these factors. For example, if
the cost of building constructions rises, the
quantity of money available for investment at
any interest rate is expected to decrease. As a
result, the id curve moves to the left.

5. Other factor costs: Companies have a wide

range of choices regarding how products can
be manufactured. For example, a factory uses a
complex capital facility and relatively few
 employees. Or it uses more employees and
relatively less capital. The choice would be to
use capital. It affects the cost of capital goods
and interest rates, but it also affects labor
costs. Capital demand is likely to increase as
labor costs rise.

8.6.2.Concept of Accelerator in Investment

The acceleration principle is an economic concept

that draws a connection between fluctuations in
consumption and capital investment. It states that
when demand for consumer goods increases,
demand for equipment and other investments
necessary to make these goods will grow if there is
not excess capacity in the economic system
already to make these goods. In other words, if a
population's income increases and it, as a result,
begins to consume more, there will typically be a
corresponding but magnified change in
investment.

Under the acceleration principle, the reverse is

also true, meaning a decrease in consumption
spending will tend to be matched by a larger
relative decrease in investment spending as
businesses freeze investment in the face of falling
demand. The acceleration principle, also referred
to as the accelerator principle or the accelerator
effect, thus helps to explain how business cycles
can propagate from the consumer sector into the
business sector.

8.6.3. Acceleration Principle Works

If an increase in consumer demand is rapid and
sustained, then more businesses will undertake
new capital investment. That is because
investments to boost output often require
significant fixed outlays and take time to build.

Economies of scale determine that investments are

generally more efficient and come with greater
cost advantages when they are significant. In other
words, it is often technically or economically
infeasible to expand capacity in small increments
to meet short-term changes in consumer demand,
and makes more sense financially to increase
capacity substantially, rather than just by a little
bit. The acceleration principle does not compute
the rate of capital investment as a product of the
overall level of consumption, but as a product of
the rate of change in the level of consumption.

Because of the often large fixed costs required to

undertake new capital projects, once businesses
begin to expand investment in the face of a
sustained increase in demand, the size of the new
investment spending may have to be significantly
larger than the observed increase in demand. So
an increase in consumer demand can lead to a
proportionally larger increase in investment, once
businesses decide to expand capacity.

Expanding fixed capital investment in the face of a

temporary spike or falling demand could obviously
be a costly mistake. As soon as demand slows,
businesses will tend to reduce or eliminate costly
new investments in expanded capacity—and
usually freeze investment entirely if they expect
demand will fall. This means that even a small
reduction in consumer spending, or just a
slowdown in its growth rate, can induce a
significant cut back in business investment
spending.
 CHAPTER-9:Government and
Macroeconomy: Policy
Options

9.1. Concept of Fiscal and Monetary

Policy

Fiscal Policy refers to the use of government

spending and tax policies to affect macroeconomic
conditions, particularly employment, inflation, and
macroeconomic variables such as aggregate
demand for goods and services. These actions are
primarily intended to stabilize the economy. To
accomplish these macroeconomic objectives, fiscal
and monetary policy actions are usually combined.

Everything relating to the government’s income

and expenditures is covered under Fiscal Policy.
The most significant aspects of the economy are
addressed through fiscal policy measures, which
range from budgeting to taxation. The three
components of fiscal policy in India are as follows.
Public Debt, Government Expenditures, and
Government Revenues. The Ministry of Finance
establishes the fiscal policy with support from NITI
Ayog.

1. Monetary Policy and Fiscal policy

 Fiscal policy is defined as relating to
government taxes and finance. In other
words, fiscal policy is anything that relates
 to government spending and how much it
brings by taxation tools.
 Likewise, the monetary policy relates to the
money of a country. Thus, monetary policy
has to do with a country’s money supply. It
defines the way policies increase and
decrease their supply, and the money is
created.
 In simple words, fiscal policy refers to
government spending and tax, whereas
monetary policy refers to the creation and
supply of money in an economy.

9.1.1.Objectives of Fiscal and Monetary Policy

A government has several fiscal policy

objectives in mind when making decisions. Some
governments may favour an objective over the
other one. Below are the five main objectives of the
fiscal policy:

 Economic growth– As an economy

develops, its citizens become flourishing on
the whole. Also, the economy’s government
should be careful, as a violent fiscal policy
may turn destructive in the long run.
 Full employment– It is the primary
objective of a government to get people into
work. Not only do the higher taxes benefit
the governments, but also the lower
expenditures on social security. Although,
an expansionary policy may invest in
infrastructure to create employment
opportunities in future. Likewise, it may also
minimize taxes to supply more money to
 consumers to stimulate employment
indirectly from purchases.
 Control debt– Operating a budget deficit is
not a harm. It creates more and more debt
over time. If the tax receipts and economic
growth do not increase its line, a nation
witnesses an unsustainable debt. Thus, a
rational fiscal policy tends to control to
avoid drastic action.
 Redistribution– The transfer of wealth
from rich to poor is another government’s
objective. High taxes may result in high tax
receipts, but not always. Although avoidance
and evasion may occur, small incremental
increases may not be impactful in the short
term.
 Control Inflation– When an economy
develops strongly, it may witness inflation
depending on the monetary policy. Although
inflation is a monetary phenomenon, the
government still takes necessary steps to
stem such a situation. Nevertheless,
governments take steps by increasing taxes
to minimize disposable incomes and
consumption.

9.1.2.Tools of Fiscal and Monetary Policy

There are two main fiscal policy instruments,

i.e., taxation and spending.

 Taxation– Governments optimize taxation as a

way of capitalizing expenditures. The higher
taxes are not popular with voters. Still, they
want higher spending on defence, education
 and healthcare. It aims at encouraging
investment, reducing inequality, regulating
consumption, preventing domestic industries
etc. Thus, there is a complex act that maximum
governing bodies don’t follow. Consequently,
spending more than they receive.
 Spending– Government spending plays a vital
role in shaping the overall economy. Thus,
trillions of amounts are spent on wealth
transfers such as social security, Medicaid, and
Medicare. Even in other developed nations,
social transfers and healthcare are high
expenditures.

9.2. Role in Economic Growth for

Developing Economies

Economic growth is the most powerful instrument

for reducing poverty and improving the quality of
life in developing countries. Both cross-country
research and country case studies provide
overwhelming evidence that rapid and sustained
growth is critical to making faster progress
towards the Millennium Development Goals – and
not just the first goal of halving the global
proportion of people living on less than $1 a day.

Growth can generate virtuous circles of prosperity

and opportunity. Strong growth and employment
opportunities improve incentives for parents to
invest in their children’s education by sending
them to school. This may lead to the emergence of
a strong and growing group of entrepreneurs,
which should generate pressure for improved
governance. Strong economic growth therefore
advances human development, which, in turn,
promotes economic growth. But under different
conditions, similar rates of growth can have very
different effects on poverty, the employment
prospects of the poor and broader indicators of
human development. The extent to which growth
reduces poverty depends on the degree to which
the poor participate in the growth process and
share in its proceeds. Thus, both the pace and
pattern of growth matter for reducing poverty.

A successful strategy of poverty reduction must

have at its core measures to promote rapid and
sustained economic growth. The challenge for
policy is to combine growthpromoting policies with
policies that allow the poor to participate fully in
the opportunities unleashed and so contribute to
that growth. This includes policies to make labour
markets work better, remove gender inequalities
and increase financial inclusion. Asian countries
are increasingly tackling this agenda of ‘inclusive
growth’.

India’s most recent development plan has two

main objectives: raising economic growth and
making growth more inclusive, policy mirrored
elsewhere in South Asia and Africa. Future growth
will need to be based on an increasingly globalised
world that offers new opportunities but also new
challenges. New technologies offer not only ‘catch-
up’ potential but also ‘leapfrogging’ possibilities.
New science offers better prospects across both
productive and service sectors. Future growth will
also need to be environmentally sustainable.
Improved management of water and other natural
resources is required, together with movement
towards low carbon technologies by both
developed and developing countries. With the
proper institutions, growth and environmental
sustainability may be seen as complements, not
substitutes. DFID will work for inclusive growth
through a number of programmes and continues to
spend heavily on health and education, which have
a major impact on poor people’s ability to take part
in growth opportunities. More and better research
on the drivers of growth will be needed to improve
policy. But ultimately the biggest determinants of
growth in a country will be its leadership, policies
and institutions.

9.3. Discretionary and Non-Discretionary

Fiscal Policy
9.4. Working of Monetary policy

Central banks use monetary policy to manage

economic fluctuations and achieve price stability,
which means that inflation is low and stable.
Central banks in many advanced economies set
explicit inflation targets. Many developing
countries also are moving to inflation targeting.

Central banks conduct monetary policy by

adjusting the supply of money, usually through
buying or selling securities in the open market.
Open market operations affect short-term interest
rates, which in turn influence longer-term rates
and economic activity. When central banks lower
interest rates, monetary policy is easing. When
they raise interest rates, monetary policy is
tightening.

Through its monetary policy, a central bank can

affect the demand in the economy, but it has no
power to affect the supply. When growth falls, the
central bank may reduce the repo rate. As this
monetary signal works its way through the
economy, the rates for all sorts of loans fall. This
stimulates the demand and helps the economy
return to its potential growth rate. Sometimes the
growth rate is too high, pushing up inflation. The
economy is said to be overheating, which means
that it is growing at a rate faster than its potential,
and this is causing the prices (of inputs, like wages
and commodities) to rise. The central bank may
then raise the repo rate. By trying to reduce
demand within the economy, it tries to bring about
a ‘soft landing’. This means that it tries to slow
down the growth rate to the economy’s potential
rate. If allowed to grow unhindered, the economy
could suffer a ‘hard landing’ (its growth rate may
fall much below its potential).

9.5. Methods of Credit Control:

Qualitative and Quantitative

Monetary policy aims to achieve accelerated

growth with price stability. Implementation
of monetary policy is one of the major roles of
central banks. The central banks world over
achieve these objectives through two types of
credit controls techniques; quantitative or general
credit control method and qualitative or selective
credit control methods. Let us examine the
methods adopted by the Reserve Bank of
India (RBI) as part of monetary policies.

9.5.1.Quantitative or General Credit Control

Methods

The quantitative or general credit control methods

adopted by the RBI directly influence the total
volume of credit in the economy and also the cost
of credit ( rate of interest). The instruments
available with the RBI for this method are:

 Repo Rate
 Reverse Repo Rate
 Bank Rate or Discount Rate (BR)
 Cash Reserve Ratio (CRR)
 Statutory Liquidity Ratio (SLR)
 Open Market Operations (OMO)
 Marginal Standing Facility (MSF)
 Long Term Repo Operation (LTRO)
 Targeted Long Term Repo Operation
(TLTRO)

A change in policy rates gets reflected in the short

term money market rates ( such as call money
rate, certificate of deposits, commercial papers,
treasury bills etc) followed by changes in forex
market and equity market. The yields on medium
and long term government and corporate bonds
also undergo changes. However, the envisaged
changes get reflected only if adequate competition
exists among banks and lending rates off banks
strictly follow the policy rates. Though the changes
in policy rates gets reflected in market over a
period of time, the rate transmission has not been
happening in the way that the RBI wanted.

Making banks to follow various interest rates over

a period for lending, like Prime Lending Rate
(PLR), Bench Mark Prime Lending Rate
(BPLR), Base Rate (BR), Marginal Cost of
funds based Lending Rate (MCLR) were
attempts by RBI to ensure transmission of policy
rate to market. RBI has now proposed to link
interest rate to External Benchmark.

9.5.2.Qualitative or Selective Credit Control

Methods

The qualitative or selective credit control

techniques are employed by the RBI to control the
direction and use of credit rather than the volume
of credit. Through these qualitative measures, the
RBI encourages the use of credit for more
desirable purposes by restricting the use of credit
in undesirable ways. The selective credit control
methods employed by the RBI include:

 Variation in margin requirements

 Regulation of consumer credit
 Direct action
 Moral suasion
 Credit rationing
 Publicity

Both quantitative and qualitative credit controls

have their own merits and demerits. Both are
crucial in the economy for fostering economic
stability and price stability. Effective and efficient
application of these methods controls economic
evils like inflation and deflation. It is proven over a
period of time that co-ordinated use of general and
selective controls yield better result than
independent use of any of them.

9.6. Government Budget Constraint

Generally, the government finances its expenditure

through the revenue received from taxes (both
direct and indirect). When government
expenditure exceeds its revenue received from
taxes, it can finance its expenditure by borrowing
money from the market or by printing new money.

The government has the power to increase taxes to

increase revenue but increase in the rates of taxes
adversely affects the incentives to work more, save
and invest. Increase in taxes also promotes tax
evasion. So, there are limits to increasing revenue
from taxes to finance the increased expenditure of
the government.

When government finds it difficult to raise

adequate resources to finance its increased
expenditure fully through normal taxes, it faces a
constraint which is called Government Budget
Constraint, which results in budget deficit also
called fiscal deficit.

In simple terms, government budget constraint

refers to the limit placed on the government
expenditure to which it can raise resources
through taxation, borrowings from the market and
using printed money.
The general form of government budget constraint
is

G = T + ∆B + ∆M

G = Government expenditure (including subsidies

and interest payments on past debt)

T = Tax revenue

∆B = New borrowing from market (by the sale of

bonds or securities)

∆M = New printed money issued to finance

government expenditure

(∆M is also called High Powered Money or Money

Financing)

The government has to make a choice between the

magnitude of T, ∆B and ∆M to finance its budget
deficit.

Equation of the government budget constraint can

also be written as

G – T = ∆B – ∆M

G – T = Budget Deficit or Fiscal Deficit

Budget Deficit or Fiscal Deficit = New Market

Borrowing by Government + New Printed
Money

The government budget (fiscal) deficit can be

financed either by printing new money by the
government or by selling bonds to the public
(which includes banks, mutual funds, insurance
companies and other financial institutions). The
government borrows from the market by selling
bonds or securities which adds to the government
debt. The government has to pay interest annually
on its debt and also have to pay back the principal
amount borrowed at the maturity of bonds or
securities. Borrowing by the government also leads
to the rise in interest rates which crowds out
(discourages) private investment.

If the government finances its budget deficit by

printing new money, it can lead to inflation.
Therefore, due to budget constraint, the
government has to make choice between
borrowing from the market and using printed
money to finance its budget deficit. Financing by
new printed money is also called Money Financing.

9.7. Budget Deficit

A budget deficit occurs when government

expenses exceed revenue. Many people use it as
an indicator of the financial health of a country. It
is a term more commonly used to refer to
government spending and receipts rather than
businesses or individuals. Budget deficits affect the
national debt, the sum of annual budget deficits,
and the cumulative total a country owes to
creditors.

When a budget deficit is identified, current

expenses exceed the income received through
standard operations. To correct its nation's budget
deficit, often referred to as a fiscal deficit, a
government may cut back on certain expenditures
or increase revenue-generating activities.

A budget deficit can lead to higher levels of

borrowing, higher interest payments, and low
reinvestment, which will result in lower revenue
during the following year. The opposite of a budget
deficit is a budget surplus. When a surplus occurs,
revenue exceeds current expenses, resulting
in excess funds that can be further allocated.
When the inflows equal the outflows, the budget
is considered balanced.

1. Objectives of Deficit Financing

The Main Objectives of Deficit Financing are:

 To finance expenditures related to defence

during war.
 To lift the economy out of depression so that
employment, income, investments rise.
 To instigate the ideal resources and divert
resources from unproductive sectors to
productive sectors with the main objective
of increasing national income, leading to
higher economic growth.
 To improve the country's infrastructure so
that the taxpayer may be certain that the
money they spent in tax is used wisely.

9.7.1.Financing of Budget Deficit and

Government Expenditure

In a Developed Economy, deficit financing played a

significant role during the depression. During the
depression period, the level of expenditure and
demand falls to a very low level and the banks and
the general public are not willing to undertake the
risk of investment. Instead, they prefer to
accumulate idle cash balances.

All the machinery and capital equipment are

available but what lacks is the incentive to produce
due to deficiency in aggregate demand. Suppose
the government instigates additional purchasing
power in the economy (through deficit financing).
In that case, the level of effective demand is likely
to increase to meet this demand, the machinery
and capital equipment lying idle will be pressed
into operation. Accordingly, the level of production
will increase. If this increase can cope with the
increase in aggregate spending level, inflationary
tendencies will not be generated.

1. Advantages of Deficit Financing

The foremost thing to be considered is that the

deficit is not only worse. When the economy goes
into recession, deficit spending through tax cuts or
the purchase of goods and services made by the
government can stop the devaluation and help to
turn the economy back into a position. Hence,
deficit financing helps to stabilize the economy.
Also, the outlook of the business improves as the
economy improves due to the deficit financing, and
this can lead to increased investment, an effect
known as crowding in.

Deficits enable us to purchase infrastructure and

spread the ball across the time, similar to the way
households finance the purchase of a car or house
or the way local governments finance schools with
bond issues. This enables us to purchase
infrastructure that we might not be able to afford if
it has to be financed all at once.

When the government employs deficit financing, it

usually borrows from the RBI. The interest paid to
the RBI comes back to the government in the form
of profit. Through deficit financing, resources are
used much earlier than differently. The
development is accelerated. This enables the
government to acquire resources without much
opposition.

2. Components of Budget Deficit

 Revenues

For national governments, a majority of revenue

comes from income taxes, corporate taxes,
consumption taxes, and social insurance taxes. For
non-governmental organizations and companies,
revenues come from the sale of goods and
services.

 Expenses

For governments, expenses include government

spending on healthcare, infrastructure, defense,
subsidies, pensions, and other items that
contribute to the health of the overall economy.
For non-governmental organizations and
companies, expenses include the amount that is
spent on daily operations and factors of
production, including rent and wages.

3. Measures to Overcome Deficit Financing

Following are the measures are taken to overcome
the deficit financing:

 The amount of deficit financing should be

limited to the needs of the economy.
 Efforts should be made to eliminate the
surplus money hence injected for a new
part. So that saved money is not permitted
to return back again to the mainstream soon
after its withdrawal.
 Control on the price of goods, specifically in
wage-good, and their equitable distribution
through formal or informal rationing will go
a long way in eliminating the inflationary
impact on low-income groups of people and
on the cost structure of the economy.

9.8. Fiscal Deficit and Economic Growth

Fiscal deficits are negative balances that arise

whenever a government spends more money than
it brings in during the fiscal year. This imbalance—
sometimes called the current accounts deficit or
the budget deficit—is common among
contemporary governments all over the world.

9.8.1.Effect of Fiscal Deficit on Economy

There are two broad effects of the fiscal deficit on

the economy as judged by economists. On the one
hand, economists stand by the fact that fiscal
deficits boost a sluggish economy. This is because
when there is a fiscal deficit there is more money
in the market. Hence there are more opportunities
for businesses to expand and generate more
revenue. This leads to more government revenue
and hence less fiscal deficit.

On the other hand, economists also believe that a

long term fiscal deficit means that the country
does not have enough resources to take care of its
growing expenditure. This can mean that the price
of commodities in the country can rise. That is a
high amount of inflation can occur. The production
costs of goods can also rise since imports in the
country also reduce if there is a high amount of
outstanding fiscal deficit in the country.

The continued borrowing by the country to offset

the fiscal deficit but reduced printing of notes can
also lead to increased pressure on the economy.
But the fiscal deficit can also be offset if the
expenditure that is made by the government is on
productive investments that can take care of both
supply and demand. Then the government
expenditure can be offset by a small amount from
the revenue that is generated from this
investment.
 CHAPTER-10: Schools of
Macroeconomic Thoughts

The field of macroeconomics is organized into

many different schools of thought, with differing
views on how the markets and their participants
operate.

10.1. Some Common tenets of Classical

Classical economists held that prices, wages, and

rates are flexible and markets tend to clear unless
prevented from doing so by government policy,
building on Adam Smith's original theories. The
term “classical economists” is not actually a school
of macroeconomic thought but a label applied first
by Karl Marx and later by Keynes to denote
previous economic thinkers with whom they
respectively disagreed.

Classical economic theory was developed shortly

after the birth of western capitalism and the
Industrial Revolution. Classical economists
provided the best early attempts at explaining
capitalism's inner workings. The earliest classical
economists developed theories of value, price,
supply, demand, and distribution. Nearly all
rejected government interference with market
exchanges, preferring a looser market strategy
known as laissez-faire, or "let it be."

Classical thinkers were not completely unified in

their beliefs or understanding of markets although
there were notable common themes in most
classical literature. The majority favored free trade
and competition among workers and businesses.
Classical economists wanted to transition away
from class-based social structures in favor of
meritocracies.

10.2. Keynesian

Keynesian economics was founded mainly based on

the works of John Maynard Keynes and was the
beginning of macroeconomics as a separate area of
study from microeconomics. Keynesians focus on
aggregate demand as the principal factor in issues
like unemployment and the business cycle.

Keynesian economists believe that the business

cycle can be managed by active government
intervention through fiscal policy, where
governments spend more in recessions to
stimulate demand or spend less in expansions to
decrease it. They also believe in monetary policy,
where a central bank stimulates lending with lower
rates or restricts it with higher ones.

Keynesian economists also believe that certain

rigidities in the system, particularly sticky prices,
prevent the proper clearing of supply and demand.

10.3. Monetarist

The Monetarist school is a branch of Keynesian

economics credited mainly to the works of Milton
Friedman. Working within and extending
Keynesian models, Monetarists argue that
monetary policy is generally a more effective and
desirable policy tool to manage aggregate demand
than fiscal policy. However, monetarists also
acknowledge limits to monetary policy that make
fine-tuning the economy ill-advised and instead
tend to prefer adherence to policy rules that
promote stable inflation rates.

10.4. New-Classical Thoughts

The New Classical school, along with the New

Keynesians, is mainly built on integrating
microeconomic foundations into macroeconomics
to resolve the glaring theoretical contradictions
between the two subjects.

The New Classical school emphasizes the

importance of microeconomics and models based
on that behavior. New Classical economists
assume that all agents try to maximize their utility
and have rational expectations, which they
incorporate into macroeconomic models. New
Classical economists believe that unemployment is
largely voluntary and that discretionary fiscal
policy destabilizes, while inflation can be
controlled with monetary policy.

10.5. New-Keynesian Thoughts

The New Keynesian school also attempts to add

microeconomic foundations to traditional
Keynesian economic theories. While New
Keynesians accept that households and firms
operate based on rational expectations, they still
maintain that there are a variety of market
failures, including sticky prices and wages.
Because of this "stickiness," the government can
improve macroeconomic conditions through fiscal
and monetary policy.
 CHAPTER-11: The Closed
Economy in the Short Run

11.1. Classical and Keynesian Systems

11.2. Simple Keynesian model of income-

determination
11.3. IS-LM model
11.4. Fiscal and monetary multipliers