notes on macro economics for B.COM (H) II

BBA- 304

Macro Economics

Unit I

1.      What do you mean by macroeconomics?How will you distinguish it from microeconomics?

Ans.Macroeconomics (Greek makro = ‘big’) describes and explains economicprocesses that concern aggregates. It is a branch of economics dealing with the performance, structure, behavior, and decision making of the entire economy. Macro Economics is the study of aggregates or averages covering the entire economy, such as total employment, national income, national output, total investment, total consumption, total savings, aggregate supply, aggregate demand and general price level, wage level and cost structure. Otherwise, it is aggregative economics which examines the interrelations among the various aggregates, their determination and causes of fluctuations in them.

Prof. Ackley defines Macro Economics as “Macro Economics deals with economic affairs ‘in the large, it concerns the overall dimensions of economic life. It looks at the total size and shape and functioning of the elephant of economic experience, rather than working of articulation or dimensions of the individual parts. It studies the character of the forest, independently of the tress which compose it.”

Example: The decision of a firm to purchase a new office chair from company X is not a macroeconomic problem. The reaction of Austrian households to an increased rate of capital taxation is a macroeconomic problem.

Difference between microeconomics and macroeconomics

By itself macroeconomics is only half of economics. For more than half a centuryeconomics has been divided into two branches, macroeconomics and microeconomics.

1.      The difference between microeconomics and macroeconomics can be made on the following counts. The word micro has been derived from the Greek word mikros which means small. Microeconomics is the study of economic actions of individuals and small groups of individuals. It includes particular households, particular firms, particular industries, particular commodities and individual prices.Macroeconomics is also derived from the Greek word makros which means large. It “deals with aggregates of these quantities, not with individual incomes but with the national income, not with individual prices but with the price levels, not with individual output but with the national output.”

2.      The objective of microeconomics on demand side is to maximize utility whereas on the supply side is to minimize profits at minimum cost. On the other hand, the main objectives of macroeconomics are full employment, price stability, economic growth and favourable balance of payments.

3.      The basis of microeconomics is the price mechanism which operates with the help of demand and supply forces. These forces help to determine the equilibrium price in the market. On the other hand, the basis of macroeconomics is national income, output and employment which are determined by aggregate demand and aggregate supply.

4.      Microeconomics is based on different assumptions concerned with rational behaviour of individuals. Moreover the phrase ceteris paribus is used to explain the economic laws. On the other hand, macroeconomics bases its assumptions on such variables as the aggregate volume of output of an economy, with the extent to which its resources are employed, with the size of the national income and with the general price level.

5.      Microeconomics is based on partial equilibrium analysis which helps to explain the equilibrium conditions of an individual, a firm, an industry and a factor. On the other hand, macroeconomics is based on general equilibrium analysis which is an extensive study of a number of economic variables, their interrelations and interdependences for understanding the working of the economic system as a whole.

6.      In microeconomics, the study of equilibrium conditions are analyzed at a particular period. But it does not explain the time element. Therefore, microeconomics is considered as a static analysis. On the other hand, macroeconomics is based on time-lags, rates of change, and past and expected values of the variables.

2.      Discuss the scope of macroeconomics?

Ans.Macroeconomics is the study of aggregates or averages covering the entire economy, such as total employment, national income, national output, total investment, total consumption, total savings, aggregate supply, aggregate demand, and general price level, wage level, and cost structure.

Macroeconomics is also known as the theory of income and employment, or simply income analysis. It is concerned with the problems of unemployment, economic fluctuations, inflation or deflation, international trade and economic growth. It is the study of the causes of unemployment, and the various determinants of employment.

Scope of Macro Economics

Macro Economics is of much theoretical and practical importance. Let us see what are the importance and the scope where macro economics are being used.

1. To Understand the working of the Economy

The study of macro economics variables is requisite for considerate the operation of the financial system. Our main economic complexities are associated with the performance of total income, irredundant and the normal price scale in the fiscal. These variables are geometrically measurable in this manner facilitating the probabilities of analysing the effects on the functioning of the economy.

2. In Economic Policies

Macro Economics is extremely useful from the view point of the fiscal policy. Modern Governments, particularly, the underdeveloped economies are confronted with innumerable national problems. They are the problems of over population, inflation, balance of payments, general under production etc. The main conscientiousness of these governments rests in the regulation and control of over population, general prices, general volume of commerce, general productivity etc.

1. In General Unemployment

Redundancy is caused by deficiency of effectual demand. In order eradicate it, effective demand should be raised by increasing total investment, total productivity, total income and consumption. Thus, macro economics has special significance in studying the causes, effects and antidotes of general redundancy.

2. In National Income

The study of macro economics is very significant for evaluating the overall performance of the economy in terms of national income. This led to the construction of the data on national income. National income data help in anticipating the level of fiscal activity and to comprehend the distribution of income among different groups of people in the economy.

3. In Economic Growth

The economics of growth is also a study in macro economics. It is on the basis of macro economics that the resources and capabilities of an economy are evaluated. Plans for the overall increase in national income, productivity, employment are framed and executed so as to raise the level of fiscal development of the economy as a whole.

4. In Monetary Problems

It is in terms of macro economics that monetary problems can be analysed and understood properly. Frequent changes in the value of money, inflation or deflation, affect the economy adversely. They can be counteracted by adopting monetary, fiscal and direct control measures for the economy as a whole.

5. In Business Cycle

Moreover, macro economics as an approach to fiscal problems started after the great Depression, thus its significance falls in analysing the grounds of fiscal variations and in providing remedies.

3. For Understanding the Behaviour of Individual Units

For understanding the performance of individual units, the study of macro economics is imperative. Demand for individual products depends upon aggregate demand in the economy. Unless the causes of deficiency in aggregate demand are analysed it is not feasible to understand fully the grounds for a fall in the demand of individual products. The reasons for increase in costs of a specific firm or industry cannot be analysed without knowing the average cost conditions of the whole economy. Thus, the study of individual units is not possible without macro economics.

3.      Explain the importance of the study of macroeconomics?

Ans.Importance of Macroeconomics:

1. 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.

2. 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.

3. It helps to bring stability in price level and analyses fluctuations in business activities. It suggests policy measures to control Inflation and deflation.

4. 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.

5. 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.

6. 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.

7. 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.

4.      What are the limitations of macroeconomic analysis?

Ans.There are, however, certain limitations of macroeconomic analysis. Mostly, these stem from attempts to yield macroeconomic generalizations from individual experiences.

(1) Fallacy of Composition:

In Macroeconomic analysis the “fallacy of composition” is involved, i.e., aggregate economic behaviour is the sum total of individual activities. But what is true of individuals is not necessarily true of the economy as a whole.

For instance, savings are a private virtue but a public vice. If total savings in the economy increase, they may initiate a depression unless they are invested. Again, if an individual depositor withdraws his money from the bank there is no ganger. But if all depositors do this simultaneously, there will be a run on the banks and the banking system will be adversely affected.

(2) To Regard the Aggregates as Homogeneous:

The main defect in macro analysis is that it regards the aggregates as homogeneous without caring about their internal composition and structure. The average wage in a country is the sum total of wages in all occupations, i.e., wages of clerks, typists, teachers, nurses, etc.

But the volume of aggregate employment depends on the relative structure of wages rather than on the average wage. If, for instance, wages of nurses increase but of typists fall, the average may remain unchanged. But if the employment of nurses falls a little and of typists rises much, aggregate employment would increase.

(3) Aggregate Variables may not be Important Necessarily:

The aggregate variables which form the economic system may not be of much significance. For instance, the national income of a country is the total of all individual incomes. A rise in national income does not mean that individual incomes have risen.

The increase in national income might be the result of the increase in the incomes of a few rich people in the country. Thus a rise in the national income of this type has little significance from the point of view of the community.

(4) Indiscriminate Use of Macroeconomics Misleading:

An indiscriminate and uncritical use of macroeconomics in analysing the problems of the real world can often be misleading. For instance, if the policy measures needed to achieve and maintain full employment in the economy are applied to structural unemployment in individual firms and industries, they become irrelevant. Similarly, measures aimed at controlling general prices cannot be applied with much advantage for controlling prices of individual products.

(5) Statistical and Conceptual Difficulties:

The measurement of macroeconomic concepts involves a number of statistical and conceptual difficulties. These problems relate to the aggregation of microeconomic variables. If individual units are almost similar, aggregation does not present much difficulty. But if microeconomic variables relate to dissimilar individual units, their aggregation into one macroeconomic variable may be wrong and dangerous.

5.      How microeconomics and macroeconomics are interdependent to each other?

Ans.Dependence of Microeconomic Theory on Macroeconomics:

Take for instance, when aggregate demand rises during a period of prosperity, the demand for individual products also rises. If this increase in demand is due to a reduction in the rate of interest, the demand for ‘different types of capital goods will go up. This will lead to an increase in the demand for the particular types of labour needed for the capital goods industry. If the supply of such labour is less elastic, its wage rate will rise.

The rise in wage rate is made possible by increase in profits as a consequence of increased demand for capital goods. Thus, a macroeconomic change brings about changes in the values of microeconomic variables in the demands for particular goods, in the wage rates of particular industries, in the profits of particular firms and industries, and in the employment position of different groups of workers.

Similarly, the overall size of income, output, employment, costs, etc. in the economy affects the composition of individual incomes, outputs, employment, and costs of individual firms and industries. To take another instance, when total output falls in a period of depression, the output of capital goods falls more than that of consumer goods. Profits, wages employment decline more rapidly in capital goods industries than in the consumer goods industries.

Dependence of Macroeconomics on Microeconomic Theory:

On the other hand, macroeconomic theory is also dependent on microeconomic analysis. The total is made up of the parts. National income is the sum of the incomes of individuals, households, firms and industries. Total savings, total investment and total consumption are the result of the saving, investment and consumption decisions of individual industries, firms, households and persons.

The general price level is the average of all prices of individual goods and services. Similarly, the output of the economy is the sum of the output of all the individual producing units. Thus, “the aggregates and averages that are studied in macroeconomics are nothing but aggregates and averages of the individual quantities which are studied in microeconomics.”

Let us take a few concrete examples of this macro dependence on microeconomics. If the economy concentrates all its resources in producing only agricultural commodities, the total output of the economy will decline because the other sectors of the economy will be neglected.

The total level of output, income and employment in the economy also depends upon income distribution. If there is unequal distribution of income so that income is concentrated in the hands of a few rich, it will tend to reduce the demand for consumer goods.

Profits, investment and output will decline, unemployment will spread and ultimately the economy will be faced with depression. Thus, both macro and micro approaches to economic problems are interrelated and interdependent.

Unit II

6.      Explain and illustrate national income accounting and indicate its usefulness as a tool of economic policy?

Ans.Put simply, national income accounting (also called as social accounting) is the measurement of value of all economic activities of a nation. National Income Accounts are the aggregate data used to measure the wellbeing of an economy.N.I.A. is the process where countries measure these flows.

Cooper has defined as “Social Accounting is concerned with the statistical classification of the activities of human beings and human institutions in ways which help us to understand the operation of the economy as a whole. The field of study summed up by the words ‘social accounting’ embraces, however, not only the classification of economic activity, but also the application of the information thus assembled to the investigation of the operation of the economic system.”

Basic functions of national income accounting are mainly two:

(i) To identify specific economic achievements of a country and

(ii) To provide an objective basis of evaluation and review of policies under implementation.

The data so arrived at enables us to understand, analyse and interpret the working of an economy. That is why the subject of macroeconomics should begin with a study of national income accounting.

Components of Social Accounting

The principal forms of economic activity are production, consumption, capital accumulation, government transactions and transactions from the other parts of the globe. These are the components of social accounting.

1. Production Account

The production account relates to the business sector of the economy. It includes all forms of productive activity, i.e. manufacturing, trading etc. it covers public and private companies.

2.      Consumption Account

The consumption account refers to the income and expenditure account of the household or personal sector. The household sector includes all consumers and non-profit making institutions such as clubs and associations.

3.      Government Account

The government account relates to the outflows and inflows of the government sector. In the government sector are included all public authorities centre, states and local authorities in a nation.

4.      Capital Account

The capital account shows that saving equals domestic and foreign investment. Savings is invested in fixed capital and inventories within the country and or in international assets.

Main Uses of National Income Accounting:

 (i) It indicates performance of the economy signifying economy’s strength and failures.

(ii) It helps to find out structural changes in the economy For instance, in India, proportional share of primary (agricultural) sector in national income is declining whereas those of secondary (industrial) sector and tertiary (services) sector are rising.

(iii) It reflects how national income is shared among various factors of production. In this context, it is especially helpful to trade unions in making rational analysis of remuneration that the labour is getting.

(iv) It helps in making comparison among nations in respect of national income and per capita income which lead us to make suitable changes in plans and approaches to achieve rapid economic development.

(v) National income statistical data reflect the specific contribution of individual sectors and their growth over time.

(vi) It is helpful to UNO which formulates welfare plans for different countries, especially for underdeveloped and developing countries.

(vii) It has several uses for economic policy and research.

Simply put, national income data, in a way, is manifestation of material results of human activity in an economy. National income accounting demands an understanding of the structure of the macro economy which is exposed through a Circular Flow of Income and Product.

7.      What is meant by circular flow of income? Explain its significance in an economy?

Ans.The Circular Flow of Income is a simple model of economy showing flows of goods &services and factors of production between firms and households. In the absence of government and international trade, this simple model shows that households provide the factors of production for firms who produce grads and services, in return the factors of production receivefactor payments i.e.  Land receives  rent, Labour receives  wages, Capital receives interest,Organization earns profits (losses). These factor incomes - wages, rent, interest and profits are spent on the output of firms.

In reality the households do not spend all their current income. The 'savings' by them        represents a leakage from the circular flow. Firms also have, besides, consumer spending, investment spending. This is injected to the circular flow of income, as it does not originate from consumer's current income.

Additional leakage and injections are also thee in the circular flow in real world. i.e. Government's spending are  injected and taxation will  leak from it. Similarly Export flows will be injected and import flows leaked.) But for class XII students simple circular flow of Income is sufficient. Once children understand how and what transactions result in injections to the flow and what results in leakage, the examples can be given as they very well understand what Export means and what Import results in, where Govt. spends and how and why people pay taxation which is revenue for Government.

Flow can be of two types:

(i) Flow of goods & Services.

(ii) Flow of money.

How these flows are measured and also the volume and magnitude of flow indicates the amount of economic activity.

Importance of the Circular Flow

The concept of circular flow gives a clear cut picture of the economy. We know whether the economy is working efficiently or whether there is any disturbance in its smooth functioning.

1. Study of Problems

It is with the help of circular flow that the problems of disequilibrium and the restoration of equilibrium can be studied.

2. Effects of Leakages and Inflows

The role of leakages enables us to study their effects on the national economy. For instance, imports are a leakage out of the circular flow of income for the reason that they are payments made to a foreign country. To stop this leakage, government should adopt appropriate measures so as to increase exports and decrease imports.

3. Link between Producers and Consumers

The circular flow establishes a link between producers and consumers. It is through income that producers buy the services of the factors of production with which the latter, in turn, purchase goods from the producers.

4. Creates a Network of Markets

As a corollary to the above point, the linking of producers and consumer through the circular flow of income and expenditure has created a network of markets for different goods and services where problems relating to their sale and purchase are automatically solved.

5. Inflationary and Deflationary Tendencies

Leakages or injections in the circular flow disturb the smooth functioning of the economy. For instance, saving is a leakage out of the expenditure stream. If saving increases, this depresses the circular flow of income. This tends to reduce employment, income, prices thereby leading to a deflationary process in the economy.Conversely, consumption tends to increase employment, income, productivity and prices that lead to inflationary tendencies.

6. Basis of the Multiplier

Again, if leakages exceed injections in the circular flow, the total income becomes less than the total output. This leads to a cumulative decline in employment, income, productivity and prices over time.Conversely, if injections into the circular flow exceed leakages the income is increased in the economy. This leads to a cumulative rise in employment, income, output and prices over a period of time. In fact, the basis of the Keynesian multiplier is the cumulative movements in the circular flow of income.

7. Importance of Monetary Policy

The study of circular flow also highlights the importance of monetary policy to bring about the equality of saving and investment in the economy. The credit market itself is controlled by the government through monetary policy. When saving exceeds investment or investment exceeds savings, money and credit policies help in stimulate or retard investment spending. This is how a fall or rise in prices is also controlled.

8. Importance of Fiscal Policy

The circular flow of income and expenditure points toward the importance of fiscal policy. For national income to be in equilibrium desired saving plus taxes (S + T) must equal desired investment plus government spending (I + G). S + T represents leakages from the spending stream which must be offset by injections of I + G exceed S + T, the government should adjust its revenue and expenditure by encouraging saving and tax revenue. Thus the circular flow of income and expenditure tells us about the importance of compensatory fiscal policy.

9. Importance of Trade Polices

Likewise, imports are leakages in the circular flow of money for the reason that they are payments made to a foreign country. To stop it, the government adopts such measures as to increase exports and decrease imports. Thus the circular flow points toward the importance of adopting export promotion and import control policies.

10. Basis of Flow of Funds Accounts

The circular flow helps in calculating national income on the basis of flow of funds accounts. The flow of funds accounts are concerned with all transactions in the economy that are accomplished by money transfers. They show the financial transactions among different sectors of the economy, and the link between saving and investment and lending and borrowing by them. To conclude the circular flow of income processes much theoretical and practical significance in an economy.

8.      Explain the process of circular flow of income in a two-sector, three-sector and four-sector economy?

Ans.Circular Income Flow in a Two Sector Economy:

Real flows of resources, goods and services have been shown in Figure below. In the upper loop of this figure, the resources such as land, capital and entrepreneurial ability flow from households to business firms as indicated by the arrow mark.

In opposite direction to this, money flows from business firms to the households as factor payments such as wages, rent, interest and profits.

In the lower part of the figure, money flows from households to firms as consumption expenditure made by the households on the goods and services produced by the firms, while the flow of goods and services is in opposite direction from business firms to households.

Thus there is, in fact, a circular flow of money or income. This circular flow of money will continue indefinitely week by week and year by year. This is how the economy functions.

In order to make our analysis simple and to explain the central issues involved, we take many assumptions. In the first place, we assume that neither the households save from their incomes, nor the firms save from their profits. We further assume that the government does not play any part in the national economy.

In other words, the government does not receive any money from the people by way of taxes, nor does the government spend any money on the goods and services produced by the firms or on the resources and services supplied by the households. Thirdly, we assume that the economy neither imports goods and services, nor exports anything. In other words, in our above analysis we have not taken into account the role of foreign trade. In fact we have explained above the flow of money that occurs in the functioning of a closed economy with no savings and no role of government.

Circular Income Flow in a Three Sector Economy with Government:

In our above analysis of money flow, we have ignored the existence of government for the sake of making our circular flow model simple. This is quite unrealistic because government absorbs a good part of the incomes earned by households. Government affects the economy in a number of ways.

Here we will concentrate on its taxing, spending and borrowing roles. Government purchases goods and services just as households and firms do. Government expenditure takes many forms including spending on capital goods and infrastructure (highways, power, communication), on defence goods, and on education and public health and so on. It will be seen that government purchases of goods and services from firms and households are shown as flow of money spending on goods and services.

Government expenditure may be financed through taxes, out of assets or by borrowing. The money flow from households and business firms to the government is labelled as tax payments in Fig. This money flow includes all the tax payments made by households less transfer payments received from the Government. Transfer payments are treated as negative tax payments.

Another method of financing Government expenditure is borrowing from the financial market. This can be represented by the money flow from the financial market to the Government and is labelled as Government borrowing (To avoid confusion we have not drawn this money flow from financial market to the Government). Government borrowing increases the demand for credit which causes rate of interest to rise.

The government borrowing through its effect on the rate of interest affects the behaviour of firms and households. Business firms consider the interest rate as cost of borrowing and the rise in the interest rate as a result of borrowing by the Government lowers private investment. However, households who view the rate of interest as return on savings feel encouraged to save more.

It follows from above that the inclusion of the Government sector significantly affects the overall economic situation. Total expenditure flow in the economy is now the sum of consumption expendi­ture (denoted by C), investment expenditure (I) and Government expenditure (denoted by G). Thus

Total expenditure (E) = C + I + G …..(i)

Total income (K) received is allocated to consumption (C), savings (S) and taxes (T). Thus

Y = C + S + T … (ii)

Since expenditure) made must be equal to the income received (Y), from equations (i) and (ii) above we have

C + I + G = C + S + T … (iii)

Since C occurs on both sides of the equation (iii) and will therefore be cancelled out, we have

I + G = S + T …(iv)

By rearranging we obtain

G – T = S – I … (v)

Equation (v) is very significant as it depicts what would be the consequences if government budget is not balanced, that is, if Government expenditure (G) is greater than the tax revenue (7), that is, G >T, the government will have a deficit budget. To finance the deficit budget, the Government will borrow from the financial market.

Circular Flow of Income in four sector Economy

A modern monetary economy comprises a network of four sector economy these are:

1.     Household sector

2.     Firms or Producing sector

3.     Government sector

4.     Rest of the world sector.

Each of the above sectors receives some payments from the other in lieu of goods and services which makes a regular flow of goods and physical services. Money facilitates such an exchange smoothly. A residual of each market comes in capital market as saving which inturn is invested in firms and government sector. Technically speaking, so long as lending is equal to the borrowing i.e. leakage is equal to injections, the circular flow will continue indefinitely. However this job is done by financial institutions in the economy.

Take the inflows and outflows of the household, business and government sectors in relation to the foreign sector. The household sector buys goods imported from overseas and makes payment for them which is leakage from the circular flow. The households may receive transfer payments from the foreign sector for the services rendered by them in foreign countries.

Conversely, the business sector exports goods to foreign countries and its receipts are an injection in the circular flow. Likewise, there are many services rendered by business firms to foreign countries such as shipping, insurance, banking etc. for which they receive payments from overseas. These are the leakages from the circular flow.

Like the business sector modern governments also export and import goods and services and lend to and borrow from foreign countries. For all the exports of goods, the government receives payments from abroad.

Similarly, the government receives payments from foreigners when they visit the country as tourists and for receiving education etc. and also when the government provides shipping, insurance and banking services to foreigners through the state owned agencies. It also receives royalties, interest, dividends etc. for investments made abroad. These are injections into the circular flow.

Conversely, the leakages are payments made for the purchase of goods and services to foreigners. In the in the below diagram, the circular flow of the four sector open economy with saving, taxes and imports shown as leakages from the circular flow on the right hand side of the diagram and investment, government purchases and exports as injections into the circular flow on the left side of the figure.

Further, imports, exports and transfer payments have been shown to arise from the three domestic sectors – the household, the business and the government. These outflows and inflows pass through the foreign sector which is also called the “balance of payments sector”.

If exports exceed imports, the economy has a surplus in the balance of payments. And if imports exceed exports, it has a deficit in the balance payments. But in the long run, exports of an economy must balance its imports. This is achieved by the foreign trade policies adopted by the economy.

The whole analysis can be shown in simple equations:

                        Y         =          C + I + G        ……Equation (1)

Where Y represents the production of goods and services, C for consumption expenditure, I for investment level in the economy and G for Government expenditure respectively.

Now we introduce taxation in the model to equate the government expenditure.

Therefore Y = C + S + T                                 ……….Equation (2)

Where S is saving T is taxation.

By equating (1) and (2), we get, C + I + G = C + S + T

Therefore, I + G          =          S + T

With the introduction of foreign sector, we divide investment into domestic investment (Id) and foreign investment (If) and get Id + If + G = S + T

But If = X – M, where X is exports and M is imports.

₌Id + (X – M) + G = S + T
=Id + (X – M) = S + (T – G)

The equation shows the equilibrium condition in the circular flow of income and expenditure.

9.      Define national income. Bring out the difficulties involved in national income estimation in under-developed countries like India?

Ans. National Income is the money value of final flow of output of goods & services produced within an economy over a period of time, usually one year and net factor income earned from abroad.

National Income (NI) = NNP at Factor Cost

General Difficulties

(1)   Problems of Definition:

What should we include in the National Income?Ideally we should include all goods and services produced in the course of the year, but there are some services which are not calculated in terms of money, e.g., services of housewives.

(2) Lack of Adequate Data:

The lack of adequate statistical data makes the task of estimation of national income more acute and difficult.

(3) Non-availability of Reliable Information:

The reason of illiteracy, most producers has no idea of the quantity and value of their output and do not follow the practice of keeping regular accounts.

(4) Choice of Method:

The selection of method while calculating National Income is also an important task. The wrong method leads to poor results.

(5) Lack of Differentiation in Economic Functioning:

In all the countries the occupational specialization is still incomplete so that there is a lack of differentiation in economic functioning. An individual may receive income partly from farm ownership and partly from manual work in industry in the slack season.

(6) Double Counting:

Double counting is also an important problem while calculating national income. If the value of all goods and services totaled, the total will overtake the national output, because some goods are currently consumed being used in the making of others. The best way to avoid this error is to calculate only the value of those goods and services that enter into final consumption.

In under-developed countries like India, we face some special difficulties in estimating national income.

 (i) The first difficulty arises because of the prevalence of non-monetized transactions in under-developed countries like India, so that a considerable part of output does not come into the market at all. Agriculture still being in the nature of subsistence farming in these countries, a major part of output is consumed at the farm itself. The national income statistician, therefore, has to face the problem of finding a suitable measure for this part of output.

(ii) Because of illiteracy, most producers have no idea of the quantity and value of their output. They do not follow the practice of keeping regular accounts. This makes the task of getting reliable information from a large number of petty producers all the more difficult.

(iii) Because of under-development, occupational specialization is still incomplete so that there is a lack of differentiation in economic functioning. An individual may receive income partly from farm ownership, partly from manual work in industry in the slack season, etc.

(iv) It is not easy to calculate the value of inventories, i.e., raw materials, semi-finished and finished goods in the custody of the producers. Obviously, any miscalculation on this score will vitiate the estimates of the output of productive enterprises.

(v) The calculation of depreciation on capital consumption presents another formidable difficulty. There are no accepted standard rates of deprecia­tion applicable to the various categories of machines. Unless from the gross national income correct deductions are made for depreciation, the estimate of net national income is bound to go wrong.

(vi) The application of the expenditure method too is full of difficulties. It is difficult to estimate all personal as well as investment expenditure.

10.  Show by chart the relation between different concepts/ components of National Income/ Concepts of National Product.

Ans. Relation between Different concepts of National Income

Gross domestic product at market price

= Market value of all final goods and services produced within the domestic territory. +Net factor Income from Abroad (NFIA)

= Gross domestic national product at market price

-Depreciation or consumption of fixed capital

= Net national product at market price

- Net factor Income from Abroad (NFIA)

= Net Domestic Product at Market Price

-Indirect Taxes

+Subsidies

= Net Domestic Product at Factor Cost or Domestic Income

+depreciation

=Gross Domestic Product at Factor Cost

+ Net factor Income from Abroad (NFIA)

=Gross National Product at Factor Cost

-Depreciation

=Net National Product at Factor Cost

-Property and entrepreneurial income of the government

-Saving of Non-departmental enterprise

- Net factor Income from Abroad (NFIA)

=Factor income from Net Domestic Product accruing to Private Sector

+interest rate on National debt

+Net current transfer payments from the government

+Net current transfer payments from Abroad

+ Net factor Income from Abroad (NFIA)

=Private Income-Corporate Scetor

-Saving of Corporation ( Less Net retained earnings of foreign companies)

=Personal Income

-Direct Taxes

-Miscellaneous receipts of government administratin departments i.e. fees, fines etc.

=Disposable Income

=Consumption +Saving

11.  Discuss the various methods of calculating national income?

Ans.The three alternative methods used for measuring national income are as follows: 1. Value Added Method 2. Income Method 3.Expenditure Method.

Since factor incomes arise from the production of goods and services, and since incomes are spent on goods and services produced, three alternative methods of measuring national income are possible.

1. Value Added Method:

This is also called output method or production method. In this method the value added by each enterprise in the production goods and services is measured. Value added by an enterprise is obtained by deducting expenditure incurred on intermediate goods such as raw materials, unfinished goods (purchased from other firms from the value of output produced by an enterprise.

Value of output produced by an enterprise is equal to physical output (Q) produced multiplied by the market price (P), that is, P.Q. From the value added by each enterprise we subtract consumption of fixed capital (i.e., depreciation) to obtain net value added at market prices (NVA_MP).

However, for estimating national income (that is, Net National Product at factor cost (NNP_FC) we require to estimate net value added at factor cost (NVA_FC) by each enterprise in the economy. NVA_FC can be found out by deducting net indirect taxes (i. e. indirect taxes less subsidies provided by the Government).

Under this method, the economy is divided into different industrial sectors such as agriculture, fishing, mining, construction, manufacturing, trade and commerce, transport, communication and other services. Then, the net value added at factor cost (NVA_FC) by each productive enterprise as well as by each industry or sector is estimated.

It follows from above that in order to arrive at the net value added at factor cost by an enterprise we have to subtract the following from the value of output of an enterprise:

1. Intermediate consumption which is the value of goods such as raw materials, fuels purchased from other firms

2. Consumption of fixed capital (i.e., depreciation)

3. Net indirect taxes.

Summing up the net values added at factor cost (NVA_FC) by all productive enterprises of an industry or sector gives us the net value added at factor cost of each industry or sector. We then add up net values added at factor cost by all industries or sectors to get net domestic product at factor cost (NDP_FC). Lastly, to the net domestic product we add the net factor income from abroad to get net national product at factor cost (NNP_FC) which is also called national income. Thus,

NI or NNP_FC = NDP_FC + Net factor income from abroad

This method of calculating national income can be used where there exists a census of production for the year. In many countries, the data of production of only important industries are known. Hence this method is employed along with other methods to arrive at the national income. The one great advantage of this method is that it reveals the relative importance of the different sectors of the economy by showing their respective contributions to the national income.

Precautions:

The following precautions should be taken while measuring national income of a country through value added method:

1. Imputed rent values of self-occupied houses should be included in the value of output. Though these payments are not made to others, their values can be easily estimated from prevailing values in the market.

2. Sale and purchase of second-hand goods should not be included in measuring value of output of a year because their values were counted in the year of output of the year of their production. Of course, commission or brokerage earned in their sale and purchase has to be included because this is a new service rendered in the current year.

3. Value of production for self-consumption are be counted while measuring national income. In this method, the production for self-consumption should be valued at the prevailing market prices.

4. Value of services of housewives are not included because it is not easy to find out correctly the value of their services.

5. Value of intermediate goods must not be counted while measuring value added because this will amount to double counting.

2. Income Method:

This method approaches national income from distribution side. Thus, under this method, national income is obtained by summing up of the incomes of all individuals of a country. Individuals earn incomes by contributing their own services and the services of their property such as land and capital to the national production.

Therefore, national income is calculated by adding up the rent of land, wages and salaries of employees, interest on capital, profits of entrepreneurs (including undistributed corporate profits) and incomes of self-employed people. This method of estimating national income has the great advantage of indicating the distribution of national income among different income groups such as landlords, owners of capital, workers, entrepreneurs.

Measurement of national income through income method involves the following main steps:

1. Like the value added method, the first step in income method is also to identify the productive enterprises and then classify them into various industrial sectors such as agriculture, fishing, forestry, manufacturing, transport, trade and commerce, banking, etc.

2. The second step is to classify the factor payments. The factor payments are classified into the following groups:

i. Compensation of employees which includes wages and salaries, both in cash and kind, as well as employers’ contribution to social security schemes.

ii. Rent and also royalty, if any.

iii. Interest.

iv. Profits:

Profits are divided into three sub-groups:

(a) Dividends

(b) Undistributed profits

(c) Corporate income tax

iv. Mixed income of the self-employed:

In India as in other developing countries there is fifth category of factor income which is termed as mixed income of self-employed. In India a good number of people are engaged in household industries, in family farms and other unorganised enterprises. Because of self-employment nature of the business it is difficult to separate wages for the work done by the self-employed from the surplus or profits made by them. Therefore, the incomes earned by them are mix of wages, rent, interest and profit and are, therefore, called mixed income of the self-employed.

3. The third step is to measure factor payments. Income paid out by each enterprise can be estimated by gathering information about the number of units of each factor employed and the income paid out to each unit of every factor. Price paid out to each factor multiplied by the number of units of each factor employed would give us the factor’s income.

4. The adding up of factor payments by all enterprises belonging to an industrial sector would give us the incomes paid out to various factors by a particular industrial sector.

5. By summing up the incomes paid out by all industrial sectors we will obtain domestic factor income which is also called net domestic product at factor cost (NDP_FC).

6. Finally, by adding net factor income earned from abroad to domestic factor income or NDP_FC we get net national product at factor cost (NNP_FC) which is also called national income.

 

Precautions:

While estimating national income through income method the following precau­tions should be taken:

1. Transfer payments are not included in estimating national income through this method.

2. Imputed rent of self-occupied houses are included in national income as these houses provide services to those who occupy them and its value can be easily estimated from the market value data.

3. Illegal money such as hawala money, money earned through smuggling etc. are not included as they cannot be easily estimated.

4. Windfall gains such as prizes won, lotteries are also not included.

5. Corporate profit tax (that is, tax on income of the companies) should not be separately included as it has already been included as a part of profits.

6. Death duties, gift tax, wealth tax, tax on lotteries, etc., are paid from past savings or wealth and not from current income. Therefore, they should not be treated as a part of national income of a year.

7. The receipts from the sale of second-hand goods should not be treated as a part of national income. This is because the sale of second-hand goods does not create new flows goods and services in the current year.

8. Income equal to the value of production used for self-consumption should be estimated and included in the measure of national income.

3. Expenditure Method:

Expenditure method arrives at national income by adding up all expenditures made on goods and services during a year. Income can be spent either on consumer goods or capital goods. Again, expenditure can be made by private individuals and households or by government and business enterprises.

Further, people of foreign countries spend on the goods and services which a country exports to them. Similarly, people of a country spend on imports of goods and services from other countries. We add up the following types of expenditure by households, government and by productive enterprises to obtain national income.

1. Expenditure on consumer goods and services by individuals and households. This is called final private consumption expenditure, and is denoted by C.

2. Government’s expenditure on goods and services to satisfy collective wants. This is called government’s final consumption expenditure, and is denoted by G.

3. The expenditure by productive enterprises on capital goods and inventories or stocks. This is called gross domestic-capital formation, or gross domestic investment and is denoted by I or GDCF.

Gross domestic capital formation is divided into two parts:

(i) Gross fixed capital formation

(ii) Addition to the stocks or inventories of goods

4. The expenditure made by foreigners on goods and services of a country exported to other countries which arc called exports and are denoted by X We deduct from exports (X) the expenditure by people, enterprises and government of a country on imports (M) of goods and services from other countries. That is, we have to estimate net exports (that is, exports -imports) or (X—M) which is also denoted by NX.

Thus, we add up the above four types of expenditure to get final expenditure on gross domestic product at market prices (GDP_MP). Thus,

GDP_MP = Private final consumption expenditure + Government’s final consumption expenditure + Gross domestic capital formation + Exports — Imports or

GDP_MP = C+G + I+ (X — M)

= C + G + I + NX

On deducting consumption of fixed capital (i.e., depreciation) from gross domestic product at market prices (GDP_MP) we get net domestic product at market prices (NDP_MP).

In this method, we then subtract net indirect taxes (that is, indirect taxes – subsidies) to arrive at net domestic product at factor cost (NDP_FC),

Lastly, we add ‘net factor income from abroad’ to obtain net national product at factor cost (NNP_FC), which is called national income. Thus,

NNP_FC = GDP_MP – Consumption of Fixed capital – Net Indirect taxes + Net Factor Income from Abroad.

 

Precautions:

While estimating Gross Domestic Product through expenditure method or measur­ing final expenditure on Gross National Product, the following precautions should be taken:

1. Second-hand goods:The expenditure made on second-hand goods should not be included because this does not contribute to the current year production of goods and services.

2. Purchase of shares and bonds:Expenditure on purchase of old shares and bonds from other people and from business enterprises should not be included while estimating Gross Domestic Product through expenditure method. This is because bonds and shares are mere financial claims and do not represent expenditure on currently produced goods and services.

3. Expenditure on transfer payments by government such as unemployment benefits, old-age pension should also not be included because no goods or productive services are produced in exchange by the recipients of these payments.

4. Expenditure on intermediate goods such as fertilisers and seeds by the farmers and wool, cotton and yarn by manufacturers of garments should also be excluded. This is because we have to avoid double counting. Therefore, for estimating Gross Domestic Product we have to include only expenditure on final goods and services.

Unit III

12.  Explain the Say’s Law of Markets?

Ans. Say’s law of markets is the core of the classical theory of employment. An early 19th century French Economist, J.B. Say, enunciated the proposition that “supply creates its own demand.” Therefore, there cannot be general overproduction and the problem of unemployment in the economy.

On the other hand, if there is general overproduction in the economy, then some labourers may be asked to leave their jobs. There may be the problem of unemployment in the economy for some time. In the long-run, the economy will automatically tend toward full employment.

In Say’s words, “It is production which creates markets for goods. A product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. Nothing is more favourable to the demand of one product, than the supply of another.” This definition explains the following important facts about the law.

Production Creates Market (Demand) for Goods:

When producers obtain the various inputs to be used in the production process, they generate the necessary income. For example, producers give wages to labourers for producing goods. The labourers will purchase the goods from the market for their own use. This, in turn, causes the demand for goods produced. In this way, supply creates its own demand.

Barter System as its Basis:

In its original form, the law is applicable to a barter economy where goods are ultimately sold for goods. Therefore, whatever is produced is ultimately consumed in the economy. In other words, people produce goods for their own use to sustain their consumption levels.

Say’s law, in a very broad way, is, as Prof. Hansen has said, “a description of a free-exchange economy. So conceived, it illuminates the truth that the main source of demand is the flow of factor income generated from the process of production itself. Thus, the existence of money does not alter the basic law.

General Overproduction Impossible:

If the production process is continued under normal conditions, then there will be no difficulty for the producers to sell their products in the market. According to Say, work being unpleasant, no person will work to make a product unless he wants to exchange it for some other product which he desires. Therefore, the very act of supplying goods implies a demand for them.

In such a situation, there cannot be general overproduction because supply of goods will not exceed demand as a whole. But a particular good may be over produced because the producer incorrectly estimates the quantity of the product which others want. But this is a temporary phenomenon, for the excess production of a particular product can be corrected in time by reducing its production.

J.S. Mill supported Say’s views regarding the impossibility of general overproduction and general unemployment. According to him, Say’s law of markets does not consider the possibility of general overproduction and also rejects the possibility of decrease in the demand of goods produced in the economy. By employing more factors of production, there is an increase in the level of employment and therefore profits are maximised.

Saving-Investment Equality:

Income accruing to the factor owners in the form of rent, wages and interest is not spent on consumption but some proportion out of it is saved which is automatically invested for further production. Therefore, investment in production is a saving which helps to create demand for goods in the market. Further, saving-investment equality is maintained to avoid general overproduction.

Rate of Interest as a Determinant Factor:

Say’s law of markets regards the rate of interest as a determinant factor in maintaining the equality between saving and investment. If there is any divergence between the two, the equality is maintained through the mechanism of the rate of interest.

If at any given time investment exceeds saving, the rate of interest will rise. To maintain the equality, saving will increase and investment will decline. This is due to the fact that saving is regarded as an increasing function of the interest rate, and investment as a decreasing function of the rate of interest. On the contrary, when saving is more than investment, the rate of interest falls, investment increases and saving declines till the two are equal at the new interest rate.

Labour Market:

Prof. Pigou formulated Say’s law in terms of labour market. By giving minimum wages to labourers, according to Pigou, more labourers can be employed. In this way, there will be more demand for labour. As pointed out by Pigou, “with perfectly free competition…there will always be at work a strong tendency for wage rates to be so related to demand that everybody is employed.”

Unemployment results from rigidity in the wage structure and interferences in the working of the free market economy. Direct interference comes in the form of minimum wage laws passed by the state.

The trade unions may be demanding higher wages, more facilities and reduction in working hours. In short, it is only under free competition that the tendency of the economic system is to provide automatically full employment in the labour market.

Propositions and Implications of the Law:

Say’s propositions and its implications present the true picture of the market law.

These are given below:

1. Full Employment in the Economy:

The law is based on the proposition that there is full employment in the economy. Increase in production means more employment to the factors of production. Production continues to increase until the level of full employment is reached. Under such a situation, the level of production will be maximum.

2. Proper Utilization of Resources:

If there is full employment in the economy, idle resources will be properly utilized which will further help to produce more and also generate more income.

3. Perfect Competition:

Say’s law of market is based on the proposition of perfect competition in labour and product markets.

Other conditions of perfect competition are given below:

(a) Size of the Market:

According to Say’s law, the size of the market is large enough to create demand for goods. Moreover, the size of the market is also influenced by the forces of demand and supply of various inputs.

(b) Automatic Adjustment Mechanism:

The law is based on this proposition that there is automatic and self-adjusting mechanism in different markets. Disequilibrium in any market is a temporary situation. For example, in capital market, the equality between saving and investment is maintained by the rate of interest while in the labour market the adjustment between demand and supply of labour is maintained by the wage rate.

(c) Role of Money as Neutral:

The law is based on the proposition of a barter system where goods are exchanged for goods. But it is also assumed that the role of money is neutral. Money does not affect the production process.

4. Laissez-faire Policy:

The law assumes a closed capitalist economy which follows the policy of laissez-faire. The policy of laissez-faire is essential for an automatic and self-adjusting process of full employment equilibrium.

5. Saving as a Social Virtue:

All factor income is spent in buying goods which they help to produce. Whatever is saved is automatically invested for further production. In other words, saving is a social virtue.

Criticisms of Say’s Law:

J.M. Keynes in his General Theory made a frontal attack on the classical postulates and Say’s law of markets.

He criticised Say’s law of markets on the following grounds:

1. Supply does not create its Demand:

Say’s law assumes that production creates market (demand) for goods. Therefore, supply creates its own demand. But this proposition is not applicable to modern economies where demand does not increase as much as production increases. It is also not possible to consume only those goods which are produced within the economy.

2. Self-adjustment not Possible:

According to Say’s law, full-employment is maintained by an automatic and self-adjustment mechanism in the long run. But Keynes had no patience to wait for the long period for he believed that “In the long-run we are all dead.” It is not the automatic adjustment process which removes unemployment. But unemployment can be removed by increase in the rate of investment.

3. Money is not Neutral:

Say’s law of markets is based on a barter system and ignores the role of money in the system. Say believes that money does not affect the economic activities of the markets. On the other hand, Keynes has given due importance to money. He regards money as a medium of exchange. Money is held for income and business motives. Individuals hold money for unforeseen contingencies while businessmen keep cash in reserve for future activities.

4. Over Production is Possible:

Say’s law is based on the proposition that supply creates its own demand and there cannot be general over-production. But Keynes does not agree with this proposition. According to him, all income accruing to factors of production is not spent but some fraction out of it is saved which is not automatically invested. Therefore, saving and investment are always not equal and it becomes the problem of overproduction and unemployment.

5. Underemployment Situation:

Keynes regards full employment as a special case because there is underemployment in capitalist economies. This is because the capitalist economies do not function according to Say’s law and supply always exceeds its demand. For example, millions of workers are prepared to work at the current wage rate, and even below it, but they do not find work.

6. State Intervention:

Say’s law is based on the existence of laissez-faire policy. But Keynes has highlighted the need for state intervention in the case of general overproduction and mass unemployment. Laissez-faire, in-fact, led to the Great Depression.

Had the capitalist system been automatic and self-adjusting. This would not have occurred. Keynes, therefore, advocated state intervention for adjusting supply and demand within the economy through fiscal and monetary measures.

7. Equality through Income:

Keynes does not agree with the classical view that the equality between saving and investment is brought about through the mechanism of interest rate. But in reality, it is changes in income rather than the rate of interest which bring the two to equality.

8. Wage-cut no Solution:

Pigoufavoured the policy of wage-cut to solve the problem of unemployment. But Keynes opposed such a policy both from the theoretical and practical points of view. Theoretically, a wage-cut policy increases unemployment instead of removing it. Practically, workers are not prepared to accept a cut in money wage. Keynes, therefore, favoured a flexible monetary policy to a flexible wage policy to raise the level of employment in the economy.

9. Demand creates its own supply:

Say’s law of market is based on the proposition that “supply creates its own demand”. Therefore, there cannot be general overproduction and mass unemployment. Keynes has criticized this proposition and propounded the opposite view that demand creates its own supply. Unemployment results from the deficiency of effective demand because people do not spend the whole of their income on consumption.

13.  Explain the Keynes theory of income and employment?

Ans. Keynes's theory of the determination of equilibrium income and employment focuses on the relationship between aggregate demand (AD) and aggregate supply (AS). According to him equilibrium employment (income) is determined by the level of aggregate demand (AD) in the economy, given the level of aggregate supply (AS). Thus, the equilibrium level of employment is the level at which aggregate supply is consistent with the current level of aggregate demand. The theory believes that "demand creates its own supply" rather than the Classical claim of "supply creates its own demand".

In the following sections we discuss Keynes' concepts of aggregate demand function, aggregate supply function and finally, the point of effective demand.

Aggregate Demand Function

Aggregate demand or what is called aggregate demand price is the amount of total receipts which all the firms expect to receivefrom the sale of output produced by a given number of workers employed. Aggregate demand increases with increase in the number of workers employed. The aggregate demand function curve is a rising curve as shown in Fig. 1.

Figure.1: Aggregate Demand Function

It can be seen that total expected receipts is D₁L₁ at OL₁ level of employment. Total expected receipts increase to D₂L₂ with increase in the level of employment to OL₂. OL_f is the full employment level. Initially the aggregate demand function (ADF) rises sharply as increase in the number of employment leads to increase in society's expenditure, thereby, increasing producer's expected sales receipts. There is no much increase in employment, income, expenditure and therefore producer's expected sales receipts as the economy reaches near full-employment. The ADF curve becomes perfectly elastic (horizontal) as the economy reaches near full-employment.

Aggregate Demand In Keynes’ theory of income determination is society’s planned expenditure. In a laissez-faire economy it consists of consumption expenditure (C)and investment expenditure (I).

Thus AD = Planned Expenditure = C + I

where,

 C =Ø f (Y_d)andY_d is level of disposable income (Income minus Taxes)

 I is exogenous in the short run.Ø

The short-run aggregate demand function can be written as

Aggregate Supply Function

Aggregate supply is determined by physical and technical conditions of production. However, these conditions remain constant in the short run. As such, given the technical conditions, output in the short run can be increases only by increasing employment of labour.

Aggregate supply or what is called aggregate supply price is the amount of total receipts which all the firms must expect to receivefrom the sale of output produced by a given number of workers employed. In other words, aggregate supply price is the total cost of production incurred by producers by employing a certain given number of workers. Obviously, aggregate supply price increases with increase in the number of workers employed. The aggregate supply function curve is a rising curve and at full employment (OL_f) it becomes perfectly inelastic (vertical) as shown in Fig. 2.

Figure.2: Aggregate Supply Function

It can be seen that aggregate supply price or the cost of production is S₁L₁ at OL₁ level of employment. It increase to S₂L₂ with increase in the level of employment to OL₂. Initially, the aggregate supply function (ASF) rises slowly as labour is abundant thereby leading to slow increase in the cost of production. Larour cost rises sharply as the economy reaches near full-employment. The ASF therefore rises sharply and at full employment (OL_f) it becomes perfectly inelastic (vertical).

Determination of Equilibrium Level of Employment

According to Keynes equilibrium level of employment (income) in the short run is determined by the level of effective demand. The higher the level of effective demand, the greater would be the level of income and employment and vice versa. This is shown in Fig. 3.

Fig.3 shows the ADF and ASF together. As discussed above the ADF shows the amount of total receipts which all the firms expect to receive from the sale of output produced by a given number of workers employed and the ASF shows the amount of total receipts which all the firms must expect to receive from the sale of output produced by a given number of workers employed. Entrepreneurs expand output as long as there are opportunities to make profits.

Figure.3: Determination of Equilibrium Employment

It can be seen that up to OL level of employment, aggregate demand price is greater than aggregate supply price (ADF > ASF). Producers expect greater returns than the cost of production. As such, producers expand output up to OL level of employment. Thus at any level of employment up to OL, there would be expansionary tendency in the economy and therefore rise in the level of employment.

Beyond OL level of employment, aggregate demand price is less than aggregate supply price (ADF < ASF). Producers expect less returns than the cost of production. As such, producers prefer to cut down output. Thus at any level of employment beyond OL, there would be contractionary tendency in the economy and therefore fall in the level of employment.

At OL level of employment aggregate demand price equals aggregate supply price (ADF = ASF). Now there is no tendency towards economic expansion or contraction. Thus OL is the equilibrium level of employment. Point 'E' is called the point of effective demand. It represents that level of aggregate demand price that is equal to aggregate supply price and thus reaches short run equilibrium position.

It can be seen that equilibrium point 'E' is established at less-than-full employment equilibrium and there is LL_f amount of involuntary unemployment in the economy. It is important to note that according to Keynes this unemployment is due to deficiency of aggregate demand. At full employment level there exist a gap between the full-employment level of aggregate supply price and the corresponding level of aggregate demand price.

14.  What do you mean by consumption function? Explain the factors influencing consumption function?

Ans.Meaning of consumption function

The consumption function or propensity to consume refers to income consumptionrelationship. It is a "functional relationship between two aggregates, i.e., totalconsumption and gross national income.” Symbolically, the relationship is represented as C =  f(Y), 'where C is consumption, Y is income, and  f  is the functional relationship.

Thus the consumption function indicates a  functional relationship between C and Y, where C is dependent and Y is the independent variable, i.e., C is determined by Y.' This relationship is based on the ceteris paribus (other things being equal) assumption, as suchonly income consumption relationship is considered and all possible influences on consumption are held constant.

In fact, propensity to consume or consumption function is a schedule of the various amounts of consumption expenditure corresponding to different levels of income. Table shows that consumption is an increasing function income because consumption, expenditure increases with increase in income. Here it is shown that when income is zero during the depression, people spend out of their past savings on consumption because they must eat in order to live. When income is generated in the economy to the extent of Rs. 60 crores, it is not sufficient to meet the consumption expenditure of the community so that the consumption expenditure of Rs. 70 crores is still above the income amounting to Rs 60 crores. (Rs. 10 croresare dis-saved). When both consumption expenditure and income equal Rs 120 crores, it is the basic consumption level. 

              CONSUMPTION SCHEDULE                                                      (Rs. Crores)

Income (Y)	Consumption C = f (Y)
0	20
60	70
120	120
180	170
240	220
300	270
360	320

After this, income is shown to increase by 60 crores and consumption by 50 crores. This implies a stable consumption function during the short-run as assumed by Keynes. The above Figure illustrates the consumption function diagrammatically. In the diagram, income is measured horizontally and consumption is measured vertically. 45° is the unity-line where at all levels income and consumption are equal. The C curve is a linear consumption function based on the assumption that consumption changes by the same amount (Rs 50 crores). Its upward slope to the right indicates that consumption is an increasing function of income. B is the  break-even point where C= Y or OY1 = OC1.

When income rises to 0 YI consumption also increases to OC2, but the increase in consumption' is less than the increase in income,  C1  C2 < Y1  Y2. The portion of income not consumed is saved as shown by the vertical, distance between 45° line and C curve, i.e., SS’. "Thus the consumption function measures not only the amount spent on consumption but also the amount saved. This is becauset't1e propensity to save is merely the propensity not to consume. The 45° line may therefore be regarded .as a zero-saving line, and the shape and position of the C curve indicate the division of income between consumption and saving”.

Determinants of the consumption function

Keynes mention two principal factors which influence the consumption' function and determine its slope and position. They are -.(i) the subjective factors, and (ii) the objective factors.

The subjective factors are endogenous or internal to the economic system. They include psychological characteristics of human nature, social practices and institutions and social arrangements. They are unlikely to undergo .a material change over a short period of time. except in abnormal or revolutionary circumstances. They, therefore, determine the slope and position of the C curve which is fairly stable in the short-run.

The objective factors are exogenous or external to the economic system. They may, therefore, undergo rapid changes and may cause marked shifts in the consumption function (i,e., the C curve). 

Subjective Factors in the Consumption Function.

Individual Motives- First, there are, eight motives "which lead individuals to refrain from spending out of their incomes." They.-are 

(i)  desire to build reserves for unforeseen contingencies;

(ii) desire to provide for anticipated future needs, i.e., old age, sickness, etc., 

(iii) desire to enjoy an enlarged future income by way of interest and appreciation; 

(iv) desire to enjoy a gradually increasing expenditure in order to improve the standard of living;

(v) desire to enjoy a sense of independence and power to do things;

(vi) desire to secure a "masse de manoeuvre" to carry out speculative or business projects; 

(vii) desire to bequeath a fortune; 

(viii) desire to satisfy a pure merely instinct.

Business Motives- The subjective factors are also influenced by the behavior of business corporations and governments. Keynes lists four motives for accumulation on their part:

(i) Enterprise, the desire to do big things and to expand; 

(ii) Liquidity, the desire to meet emergencies and difficulties successfully;

(iii) Income raises, the desire to secure large income and to show successful management; 

(iv) Financial prudence, the desire to provide adequate financial resources against depreciation and obsolescence, and to discharge debt.

These factors remain constant during the short-run and keep the consumption function stable.

Objective Factors in the consumption function.

(1) Change in the Wage Level- If the wage  rate rises, the consumption function shiftsupward. The workers having a high propensity  to consume spend more out of their increased income and this tends to shift the C curve upward. If, however, the rise in thewage rate is accompanied by a more than proportionate rise in the price level, the real wage rate will fall and it will tend to shift the C curve downward, A cut in the wage rate will also reduce the consumption function of the community due to a fall in income, employment and output. This will shift the curve downward.

(2) Windfall Gains or Losses- Unexpected changes in the stock market leading to gains or losses tend to shift the consumption function upward or downward. For instance, the phenomenal/windfall gains due to the stock market boom in the American economy after,1925 led to a rise in the consumption spending of the stock-holders by roughly in proportion to the increased income and as a result the consumption function shifted upward. Similarly, unexpected losses in the stock market lead to the downward shifting of the C curve. 

(3) Changes in the Fiscal Policy- Changes in fiscal policy in the form of taxation and public expenditure affect the consumption function. Heavy commodity taxation adversely affect the consumption function' by reducing the disposable income of the people. This, is what actually happened during the Second World War when the consumption function shifted downward due to heavy indirect taxation, rationing and price controls, On the other hand, the policy of progressive taxation along with that of public expenditure on welfare programmes tends to shift the consumption function upward  by altering the distribution of income.

(4) Change in Expectations- Change in future expectations also affect the, propensity toconsume. If a war is expected in the near future, people start hoarding durable and semi-durable, commodities in anticipation of future scarcity and rising prices. As a result,people buy much in,excess of their current needs and the consumption function shifts upward. On the contrary, if it is expected: that prices are likely to -fall in the future, people would buy only those things which are very essential. It will lead to a fall in consumption demand and' to a downward shift of the consumption function.

(5) Change in the Rate of Interest- Substantial changes in the market rate of interest mayinfluence the consumption function indirectly. There are several ways in which the rate of interest may affect the consumption function. A rise in rate of interest will lead to a fall inthe price of bonds, thereby tending to discourage the propensity to consume of the bondholders. It may also have the effect of substituting one type of assets for another. People may be encouraged to save rather than invest in bonds. In case they are buying durable consumer goods like refrigerators, scooters, etc. on hire-purchase system they will tend to postpone their purchases when the rate interest rises. They will have to pay more in installments and thus their consumption function will shift downward.

Besides, these five factors; Keynes also listed changes in accounting practice with respect to depreciation. However, we add some of the other objective factors listed by Keynes's followers." 

(6) Financial Policies of Corporations

(7) Holding of Liquid Assets.

(8) The Distribution of Income

(9) Attitude toward Saving.

15.  Discuss the technical attributes of consumption function?

Ans.The consumption function has two technical attributes or properties:

(i)                 The average propensity to consume, and

(ii)               The marginal propensity to consume.

(1) The Average propensity to Consume:

“The average propensity to consume may be defined as the ratio of consumption expenditure to any particular level of income.” It is found by dividing consumption expenditure by income, or APC = C/Y. It is expressed as the percentage or proportion of income consumed.

The APC at various income levels is shown below. The APC declines as income increases because the proportion of income spent on consumption decreases. But reverse is the case with APS (average propensity to save) which increases with increase in income (see column 4). Thus the APC also tells us about the average propensity to save, APS=1—APC.

Diagrammatically, the average propensity to consume is any one point on the C curve. In Figure 2 Panel (A), point R measures the APC of the C curve which is OC₁/OY₁. The flattening of the C curve to the right shows declining APC.

 

(2) The Marginal Propensity to Consume:

“The marginal propensity to consume may be defined as the ratio of the change in consumption to the change in income or as the rate of change in the average propensity to consume as income changes.” It can be found by dividing change in consumption by a change in income, or MPC = ∆C/∆K. The MPC is constant at all levels of income as shown below. It is 0.83 or 83 per cent because the ratio of change in consumption to change in income is ∆C/ ∆Y = 50/60. The marginal propensity to save can be derived from the MPC by the formula 1 -MPC. It is 0.17 in our example (see column 6).

Diagrammatically, the marginal propensity to consume is measured by the gradient or slope of the C curve. This is shown in Panel (B) by NQ/RQ where NQ is change in consumption (∆C) and RQ is change in income (∆Y) or C₁C₂ /Y₁Y₂.

 

Significance of MPC:

The MPC is the rate of change in the APC. When income increases, the MPC falls but more than the APC. Contrariwise, when income falls, the MPC rises and the APC also rises but at a slower rate than the former. Such changes are only possible during cyclical fluctuations whereas in the short-run there is change in the MPC and MPC < APC.

Keynes is concerned primarily with the MPC, for his analysis pertains to the short-run while the APC is useful in the long-run analysis. The post-Keynesian economists have come to the conclusion that over the long-run APC and MPC are equal and approximate 0.9. In the Keynesian analysis the MPC is given more prominence. Its value is assumed to be positive and less than unity which means that when income increases the whole of it is not spent on consumption.

On the contrary, when income falls, consumption expenditure does not decline in the same proportion and never becomes zero. The Keynesian hypothesis that the marginal propensity to consume is positive but less than unity (O < ∆C/∆Y < 1) is of great analytical and practical significance.

Besides telling us that consumption is an increasing function of income and it increases by less than the increment of income, this hypothesis helps in explaining “(a) the theoretical possibility of general over production or ‘underemployment equilibrium,’ and also (b) the relative stability of a highly developed industrial economy.

For it is implied that the gap between income and consumption at all high levels of income is too wide to be easily filled by investment with the possible consequence that the economy may fluctuate around underemployment equilibrium.”

Thus the economic significance of the MPC lies in filling the gap between income and consumption through planned investment to maintain the desired level of income. Further, its importance lies in the multiplier theory. The higher the MPC, the higher the multiplier and vice versa. The MPC is low in the case of the rich people and high in the case of the poor. This accounts for high MPC in underdeveloped countries and low in advanced countries.

16.  Explain Keynes’s psychological law of consumption and discuss its implications?

Ans. Keynes propounded the fundamental psychological law of consumption which forms the basis of the consumption function. He wrote, “The fundamental psychological law upon which we are entitled to depend with great confidence both a prior from our knowledge of human nature and from the detailed facts of experience, is that men are disposed as a rule and on the average to increase their consumption as their income increases but not by as much as the increase in their income.” The law implies that there is a tendency on the part of the people to spend on consumption less than the full increment of income.

Propositions of the Law:

This law has three related propositions:

(1) When income increases, consumption expenditure also increases but by a smaller amount. The reason is that as income increases, our wants are satisfied side by side, so that the need to spend more on consumer goods diminishes. It does not mean that the consumption expenditure falls with the increase in income. In fact, the consumption expenditure increases with increase in income but less than proportionately.

(2) The increased income will be divided in some proportion between consumption expenditure and saving. This follows from the above proposition because when the whole of increased income is not spent on consumption, the remaining is saved. In this way, consumption and saving move together.

(3) Increase in income always leads to an increase in both consumption and saving. This means that increased income is unlikely to lead either to fall in consumption or saving than before. This is based on the above propositions because as income increases consumption also increases but by a smaller amount than before which leads to an increase in saving. Thus with increased income both consumption and saving increase.

The three propositions of the law can be explained with the help of the following Table III.

Table III                                                                                             (RsCrores)

Income (Y)	Consumption C = f (Y)	Savings (S= Y-C)
0	20	-20
60	70	-10
120	120	0
180	170	10
240	220	20
300	270	30
360	320	40

Proposition (1):

Income increases by Rs 60 crores and the increase in consumption is by Rs 50 crores. The consumption expenditure is, however, increasing with increase in income, i.e., Rs 170, 220, 270 and 320 crores against Rs 180, 240, 300 and 360 crores respectively.

Proposition (2):

The increased income of Rs 60 crores in each case is divided in some proportion between consumption and saving (i.e., Rs 50 crores and Rs 10 crores).

Proposition (3):

As income increases from Rs 120 to 180, 240, 300 and 360 crores, consumption also increases from Rs 120 to 170,220,270,320 crores, along with increase in saving from Rs 0 to 10, 20, 30 and 40 crores respectively. With increase in income neither consumption nor saving has fallen.

Diagrammatically, the three propositions are explained in Figure 3. Here, income is measured horizontally and consumption and saving are measured on the vertical axis. C is the consumption function curve and 45^o line represents income.

Proposition (1):

When income increases from OY₀ to OY₁ consumption also increases from BY₀ to C₁Y₁but the increase in consumption is less than the increase in income, i.e., C₁Y₁ 1

(=OY₁) by A₁C₁.

Proposition (2):

When income increases to OY₁ and OY₁ it is divided in some proportion between consumption C₁Y₁ and C₂Y₂ and saving A₁C₁ and A₂C₂ respectively.

Proposition (3):

Increases in income to OY and OY lead to increased consumption C₂Y₂> C₁Y₁ and increased saving A₂C₂ > A₁C₁ than before. It is clear from the widening area below the C curve and saving gap between 45° line and C curve.

 

It’s Assumptions:

Keynes’s Law is based on the following assumptions:

1. It assumes a Constant Psychological and Institutional Complex:

This law is based on the assumption that the psychological and institutional complexes influencing consumption expenditure remain constant. Such complexes are income distribution, tastes, habits, social customs, price movements, population growth, etc. In the short run, they do not change and consumption depends on income alone. The constancy of these complexes is the fundamental cause of the stable consumption function.

2. It assumes the Existence of Normal Conditions:

The law holds good under normal conditions. If, however, the economy is faced with abnormal and extraordinary circumstances like war, revolution or hyperinflation, the law will not operate. People may spend the whole of increased income on consumption.

3. It assumes the Existence of a Laissez-faire Capitalist Economy:

The law operates in a rich capitalist economy where there is no government intervention. People should be free to spend increased income. In the case of regulation of private enterprise and consumption expenditures by the state, the law breaks down. Thus the law is inoperative in socialist or state controlled and regulated economies.

4. Implications of Keynes’s Law (Or Importance of the Consumption Function):

Keynes’s psychological law has important implications which in fact point towards the importance of the consumption function because the latter is based on the former.

The following are its implications: 

1. Invalidates Say’s Law:

Say’s Law states that supply creates its own demand. Therefore, there cannot be general overproduction or general unemployment. Keynes’s psychological law invalidates Say’s Law because as income increases, consumption also increases but by a smaller amount.

In other words, all that is produced (income) is not taken off the market (spent), as income increases. Thus supply fails to create its own demand. Rather it exceeds demand and leads to general overproduction and glut of commodities in the market. As a result, producers stop production and there is mass unemployment.

2. Need for State Intervention:

As a corollary to the above, the psychological law highlights the need for state intervention. Say’s Law is based on the existence of laissez-faire policy and its refutation implies that the economic system is not self-adjusting.

So when consumption does not increase by the full increment of income and consequently there is general overproduction and mass unemployment, the necessity of state intervention arises in the economy to avert general overproduction and unemployment through public policy.

3. Crucial Importance of Investment:

Keynes’s psychological law stresses the vital point that people fail to spend on consumption the full increment of income. This tendency creates a gap between income and consumption which can only be filled by either increased investment or consumption. If either of them fails to rise, output and employment will inevitably fall.

Since the consumption function is stable in the short-run, the gap between income and consumption can only be filled by an increase in investment. Thus the psychological law emphasises the crucial role of investment in Keynes’s theory. It is the inadequacy of investment which results in unemployment and logically, the remedy to overcome unemployment is increase in investment.

4. Existence of Underemployment Equilibrium:

Keynes’s notion of underemployment equilibrium is also based on the psychological law of consumption. The point of effective demand which determines the equilibrium level of employment is not of full employment but of underemployment because consumers do not spend the full increment of their income on consumption and there remains a deficiency in aggregate demand. Full employment equilibrium level can however, be reached if the state increases investment to match the gap between income and consumption.

5. Declining Tendency of the Marginal Efficiency of Capital:

The psychological law also points towards the tendency of declining marginal efficiency of capital in a laissez-faire economy. When income increases and consumption does not increase to the same extent, there is a fall in demand for consumer goods. This results in glut of commodities in the market.

The producers will reduce production which will, in turn, bring a decline in the demand for capital goods and hence in the expected rate of profit and business expectations. It implies a decline in the marginal efficiency of capital. It is not possible to arrest this process of declining tendency of marginal efficiency of capital unless the propensity to consume rises. But such a possibility can exist only in the long run when the psychological law of consumption does not hold good.

6. Danger of Permanent Over-saving or Under-investment Gap:

Keynes’s psychological law points out that there is always a danger of an over-saving or under-investment gap appearing in the capitalist economy because as people become rich the gap between income and consumption widens.

This long-run tendency of increase in saving and fall in investment is characterised as secular stagnation. When people are rich, their propensity to consume is low and they save more. This implies low demand which leads to decline in investment. Thus the tendency is for secular stagnation in the economy.

7. Unique Nature of Income Propagation:

The fact that the entire increased income is not spent on consumption explains the multiplier theory. The multiplier theory or the process of income propagation tells that when an initial injection of investment is made in the economy, it leads to smaller successive increments of income.

This is due to the fact that people do not spend their full increment of income on consumption. In fact, the value of multiplier is derived from the marginal propensity to consume, i.e., Multiplier = 1—1/MPC. The higher the MPC, the higher the value of the multiplier, and vice versa.

8. Explanation of the Turning Points of the Business Cycles:

This law explains the turning points of a business cycle. Before the economy reaches the full employment level, the downturn starts because people fail to spend the full increment of their income on consumption. This leads to fall in demand, overproduction, unemployment and decline in the marginal efficiency of capital.

17.  Distinguish between autonomous investment and induced investment?

Ans. Investment may be autonomous and induced. Usually, investment decision is governed by output and/or the rate of interest.

i) Autonomous Investment:

If investment does not depend either on income/output or the rate of interest, then such investment is called autonomous investment. Thus, autonomous investment is independent of the level of income, change in rate of interest or rate of profit. This investment is not related to national income, so it is termed as independent investment. It is income inelastic i.e. the volume of autonomous investment is same at all levels.It is not related to national income. Generally, government makes autonomous investment because of the welfare socialistic attitude. The quantum of autonomous investment is affected by the following factors:

a)      Invention or discovery of new goods

b)      Change in the population

c)      Change in the consumer’s demand

(ii) Induced Investment:

Investment that is dependent on the level of income or on the rate of interest is called induced investment. The investment made with a view to earn more profit is known as induced investment. Investment that would respond to a change in national income or in the rate of interest is called induced investment. It has positive relationship with national income. Fig. below shows that, as national income rises from OY₀ to 0Y₁, (induced) investment increases from OI₀ to OI₁. Thus, investment that is income-elastic is called induced investment.

That is,

I = f(Y)

The slope of the investment line II is the marginal propensity to invest (MPl). MPl is the ratio of change in investment to the change in income. Or the ratio of increase in investment (A I) to an increase in income (A Y) is called MPl, i.e.,

MPL = ∆l/∆Y

Keynes believed that interest rate and the expectation of future profitability of investment projects are the two main determinants of investment expenditures in the short run. Investment is inversely related to the level of interest rate, i.e., I = f(r)

However, Keynes emphasised more on the expected yield of investment project. But expectations about the future profitability of investment are based on uncertain knowledge and, hence, such expectations are full of uncertainties leading to instability in investment expenditure.

It is to be pointed out here that Keynes was primarily concerned with autonomous investment and not with induced investment. However, in practice, it is very difficult to draw a line of demarcation between these two types of investment.

18.  Discuss the concept of investment multiplier and its role in the theory of income and employment?

Ans.The concept of multiplier was first of all developed by F.A. Kahn in the early 1930s. But Keynes later further refined it. F.A. Kahn developed the concept of multiplier with reference to the increase in employment, direct as well as indirect, as a result of initial increase in investment and employment.

Keynes, however, propounded the concept of multiplier with reference to the increase in total income, direct as well as indirect, as a result of original increase in investment and income.

Therefore, whereas Kahn’s multiplier is known as ’employment multiplier’, Keynes’ multiplier is known as investment or income multiplier. The essence of multiplier is that total increase in income, output or employment is manifold the original increase in investment.

In practice, it is observed that when investment is increased by a certain amount, then the change in income is not restricted to the extent of the initial investment, but it changes several times the change in investment. In other words, change in income is a multiple of the change in investment. Multiplier explains how many times the income increases as a result of an increase in the investment.

Multiplier (k) is the ratio of increase in national income (∆Y) due to an increase in investment (∆I).

K= ∆Y/∆I 

Multiplier and MPC:

There exists a direct relationship between MPC and the value of multiplier. Higher the MPC, more will be the value of multiplier, arid vice-versa. The concept of multiplier is based on the fact that one person’s expenditure is another person’s income.

When investment is increased, it also increases the income of the people. People spend a part of this increased income on consumption. However, the amount of increased income spent on consumption depends on the value of MPC.

1. In case of higher MPC, people will spend a large proportion of their increased income on consumption. In such case, value of multiplier will be more.

2. In case of low MPC, people will spend lesser proportion of their increased income on consumption. In such case, value of multiplier will be comparatively less.

Thus, the value of multiplier depends upon the MPC

Algebraic Derivation of Multiplier:

The multiplier can be derived algebraically as follows:

Writing the equation for the equilibrium level of income we have

Y = C + I … (1)

As in the multiplier analysis we are concerned with changes in income induced by changes in investment, rewriting the equation (1) in terms of changes in the variables we have

∆Y = ∆C + ∆I … (2)

In the simple Keynesian model of income determination, change in investment is considered to be autonomous or independent of changes in income while changes in consumption are function of changes in income.

In the consumption function,

C = a + bY

where a is a constant term, b is marginal propensity to consume which is also assumed to remain constant. Therefore, change in consumption can occur only if there is change in income. Thus

This is the same formula of multiplier as obtained earlier. Note that the value of multiplier ∆Y/∆I will remain constant as long as marginal propensity to consume remains the same.

Multiplier is directly related to MPC and inversely related to MPS:

The value of multiplier depends upon the value of marginal propensity to consume. Multiplier (k) and MPC are directly related, i.e., when MPC is more, k is more and vice-versa. On the contrary, higher the MPS, lower will be the value of multiplier and vice-versa.

Minimum and Maximum Value of Multiplier:

Value of K depends upon value of MPC or MPS. We know that MPC cannot be negative, it can be at the most zero (minimum value) and maximum value can be 1.

(i) Minimum value of multiplier is 1 because minimum value of MPC can be zero.MPC = 0 indicates that the economy decides to save the whole of its additional income and nothing is spent as consumption expenditure. So, there will be no further increase in income. As a result, the total increase in income (∆Y) will be equal to the increase in investment (∆I), i.e., ∆Y = ∆I Here, the value of multiplier is equal to 1.

(ii) Maximum value of multiplier may be – (infinity) because maximum value of MPC can be 1indicates that the economy decides to consume the whole of its additional income. Here, not even a bit of the additional income is saved. It will lead to a continuous increase in the consumption expenditure and value of multiplier will be infinity.

Symbolically: K = 1/1-MPC = 1/1-1 = 1/0 = Infinity (∞)

Between these two extremes (1 and infinity), value of multiplier varies depending upon value of MPC.

Diagrammatic Presentation of Multiplier:

The multiplier can also be shown graphically using the AD and AS approach. In Fig below income is taken on the X-axis and aggregate demand on the Y-axis. Suppose, the initial equilibrium is determined at point E where AD curve intersects the AS curve. The equilibrium level of income is OY. Now, suppose that the investment increases by ∆I / so that the new aggregate demand curve (AD₁) intersects the aggregate supply curve (AS) at point ‘F’.

Thus, the new equilibrium level of income is OY₁. The income rises from OY to OY₁, in response to an initial increase in investment (∆I ). It is clear from the figure that the increase in income (YY₁ or ∆Y) is greater than increase in investment (∆I ). The value of multiplier is given byK=∆Y/∆I.

Importance of Investment Multiplier

Firstly, it established the immense importance of investment as the major dynamic element in the economy. Not only did it indicate the direct creation of employment, it also revealed that income was generated throughout the system like a stone causing ripples in a lake.

On the side of practical economic policy it is of the utmost importance because the case for public investment has all the more been strengthened by the introduction of this concept; it tells us that a small increment in investment leads to a large increase in investment and employment. A knowledge of multiplier is of vital importance during the course of business-cycle studies and for its accurate forecasting and control. Further, it is a useful analytical tool for following suitable employment policies. Thus, we find that the theory of multiplier has brought almost a virtual revolution in the thinking of economists and policy-makers alike. With the use of this concept, the approach has radically changed from ‘no intervention’ to the growth of the public sector in practically all the countries of the world.

Unit IV

19.  What do you mean by a business cycle? Explain briefly characteristics of a business cycle?

Ans.While the topic of economic growth is concerned with changes in GDP over very long periods of time, it is an economic fact of life that GDP changes occur over much shorter time-horizons as well.  The periodic ups and downs of economic activity are termed the “business cycle.” Itis the recurrent ups and downs in economic activity observed inmarket economies.

1. Business cycles occur periodically- Though they do not show same regularity, they have some distinct phases such as expansion, peak, contraction or depression and trough. Further the duration of cycles varies a good deal from minimum of two years to a maximum of ten to twelve years.

2. Secondly, business cycles are Synchronic- That is, they do not cause changes in any single industry or sector but are of all embracing character. For example, depression or contraction occurs simultaneously in all industries or sectors of the economy. Re­cession passes from one industry to another and chain reaction continues till the whole economy is in the grip of recession. Similar process is at work in the expansion phase, prosperity spreads through various linkages of input-output relations or demand relations between various industries, and sectors.

3. Thirdly, it has been observed that fluctuations occur not only in level of production but also simultaneously in other variables such as employment, investment, consump­tion, rate of interest and price level.

4. Another important feature of business cycles is that investment and consumption of durable consumer goods such as cars, houses, refrigerators are affected most by the cyclical fluctuations. As stressed by J.M. Keynes, investment is greatly volatile and unstable as it depends on profit expectations of private entrepreneurs. These expec­tations of entrepreneurs change quite often making investment quite unstable. Since consumption of durable consumer goods can be deferred, it also fluctuates greatly during the course of business cycles.

5. An important feature of business cycles is that consumption of non-durable goods and services does not vary much during different phases of business cycles. Past data of business cycles reveal that households maintain a great stability in consumption of non-durable goods.

6. The immediate impact of depression and expansion is on the inventories of goods. When depression sets in, the inventories start accumulating beyond the desired level. This leads to cut in production of goods. On the contrary, when recovery starts, the inventories go below the desired level. This encourages businessmen to place more orders for goods whose production picks up and stimulates investment in capital goods.

7. Another important feature of business cycles is profits fluctuate more than any other type of income. The occurrence of business cycles causes a lot of uncertainty for businessmen and makes it difficult to forecast the economic conditions. During the depression period profits may even become negative and many businesses go bankrupt. In a free market economy profits are justified on the ground that they are necessary payments if the entrepreneurs are to be induced to bear uncertainty.

8. Lastly, business cycles are international in character- That is, once started in one country they spread to other countries through trade relations between them. For ex­ample, if there is a recession in the USA, which is a large importer of goods from other countries, will cause a fall in demand for imports from other countries whose exports would be adversely affected causing recession in them too. Depression of 1930s in USA and Great Britain engulfed the entire capital world.

20.  Explain briefly the different phases of a business cycle?

Ans.A typical business cycle has two phases ex­pansion phase or upswing or peak and con­traction phase or downswing or trough. The upswing or expansion phase exhibits a more rapid growth of GNP than the long run trend growth rate. At some point, GNP reaches its upper turning point and the downswing of the cycle begins. In the contraction phase, GNP declines.

At some time, GNP reaches its lower turning point and expansion begins. Starting from a lower turning point, a cycle experiences the phase of recovery and after some time it reaches the upper turning point the peak. But, continuous prosperity can never occur and the process of downhill starts. In this con­traction phase, a cycle exhibits first a reces­sion and then finally reaches the bottom—the depression.

Thus, a trade cycle has four phases:

(i) depression,

(ii) revival,

(iii) boom, and

(iv) recession.

These phases of a trade cy­cle are illustrated below. In this figure, the secular growth path or trend growth rate of GNP has been labelled as EG. Now we briefly describe the essential characteristics of these phases of an idealised cycle.

1. Depression or Trough:

The depression or trough is the bottom of a cycle where eco­nomic activity remains at a highly low level. Income, employment, output, price level, etc. go down. A depression is generally character­ised by high unemployment of labour and capital and a low level of consumer demand in relation to the economy’s capacity to pro­duce. This deficiency in demand forces firms to cut back production and lay-off workers.

Thus, there develops a substantial amount of unused productive capacity in the economy. Even by lowering down the interest rates, fi­nancial institutions do not find enough bor­rowers. Profits may even become negative. Firms become hesitant in making fresh invest­ments. Thus, an air of pessimism engulfs the entire economy and the economy lands into the phase of depression. However, the seeds of recovery of the economy lie dormant in this phase.

2. Recovery:

Since trough is not a permanent phenomenon, a capitalistic economy experiences expansion and, therefore, the process of recovery starts.

During depression some machines wear out completely and ultimately become useless. For their survival, businessmen replace old and worn-out machinery. Thus, spending spree starts, of course, hesitantly. This gives an optimistic signal to the economy. Industries begin to rise and expectations tend to become more favourable. Pessimism that once prevailed in the economy now makes room for optimism. Investment becomes no longer risky. Additional and fresh investment leads to a rise in production.

Increased production leads to an increase in demand for inputs. Employment of more labour and capital causes GNP to rise. Further, low interest rates charged by banks in the early years of recovery phase act as an incentive to producers to borrow money. Thus, investment rises. Now plants get utilised in a better way. General price level starts rising. The recovery phase, however, gets gradually cumulative and income, employment, profit, price, etc., start increasing.

3. Prosperity:

Once the forces of revival get strengthened the level of economic activity tends to reach the highest point—the peak. A peak is the top .of a cycle. The peak is characterised by an allround optimism in the economy—income, employment, output, and price level tend to rise. Meanwhile, a rise in aggregate demand and cost leads to a rise in both investment and price level. But once the economy reaches the level of full employment, additional investment will not cause GNP to rise.

On the other hand, demand, price level, and cost of production will rise. During prosperity, existing capacity of plants is overutilised. Labour and raw material shortages develop. Scarcity of resources leads to rising cost. Aggregate demand now outstrips aggregate supply. Businessmen now come to learn that they have overstepped the limit. High optimism now gives birth to pessimism. This ultimately slows down the economic expansion and paves the way for contraction.

4. Recession:

Like depression, prosperity or pea, can never be long-lasting. Actually speaking, the bubble of prosperity gradually dies down. A recession begins when the economy reaches a peak of activity and ends when the economy reaches its trough or depression. Between trough and peak, the economy grows or expands. A recession is a significant decline in economic activity spread across the economy lasting more then a few months, normally visible in production, employment, real income and other indications.

During this phase, the demand of firms and households for goods and services start to fall. No new industries are set up. Sometimes, existing industries are wound up. Unsold goods pile up because of low household demand. Profits of business firms dwindle. Output and employment levels are reduced. Eventually, this contracting economy hits the slump again. A recession that is deep and long-lasting is called a depression and, thus, the whole process restarts.

The four-phased trade cycle has the following attributes:

(i) Depression lasts longer than prosperity,

(ii) The process of revival starts gradually,

(iii) Prosperity phase is characterised by extreme activity in the business world,

(iv) The phase of prosperity comes to an end abruptly.

The period of a cycle, i.e., the length of time required for the completion of one complete cycle, is measured from peak to peak (P to P’) and from trough to trough (from D to D’). The shortest of the cycle is called ‘seasonal cycle’.

21.  What is inflation? Explain it economic effects on different people?

Ans. Inflation - general increase in all prices. Inflation is the overall general upward price movement of goods and services in an economy (often caused by a increase in the supply of money), usually as measured by the Consumer Price Index and the Producer Price Index. Over time, as the cost of goods and services increase, the value of a dollar is going to fall because a person won't be able to purchase as much with that dollar as he/she previously could.

Effects of inflation impact different people in different ways

If inflation is fully anticipated and people can adjust their nominal income to account for inflation then there will be no adverse effects, however, if people cannot adjust their nominal income or the inflation is unanticipated those individual will see their standard of living eroded.

a. Debtors typically benefit from inflation because they can pay loans-off in the future with money that is worth less, thereby creditors are harmed by inflation.

b. Inflation typically creates expectations among people of increasing prices, which may contribute to future inflation.

c. Savers generally lose money because of inflation if the rate of return on their savings is not sufficient to cover the inflation rate.

22.  Discuss the causes of inflation.

Ans.Inflation is a sustained rise in the general price level. Inflation can come from both the demand and the supply-side of an economy.

• Inflation can arise from internal and external events
• Some inflationary pressures direct from the domestic economy, for example the decisions of utility businesses providing electricity or gas or water on their tariffs for the year ahead, or the pricing strategies of the food retailers based on the strength of demand and competitive pressure in their markets.
• A rise in the rate of VAT would also be a cause of increased domestic inflation in the short term because it increases a firm's production costs.
• Inflation can also come from external sources, for example a sustained rise in the price of crude oil or other imported commodities, foodstuffs and beverages.
• Fluctuations in the exchange rate can also affect inflation – for example a fall in the value of the pound against other currencies might cause higher import prices for items such as foodstuffs from Western Europe or technology supplies from the United States – which feeds through directly or indirectly into the consumer price index

Demand-pull inflation

• Demand pull inflation occurs when aggregate demand is growing at an unsustainable rate leading to increased pressure on scarce resources and a positive output gap
• When there is excess demand, producers can raise their prices and achieve bigger profit margins
• Demand-pull inflation becomes a threat when an economy has experienced a boom with GDP rising faster than the long-run trend growth of potential GDP
• Demand-pull inflation is likely when there is full employment of resources and SRAS is inelastic

What are the main causes of Demand-Pull Inflation?

1. A depreciation of the exchange rate increases the price of imports and reduces the foreign price of a country's exports. If consumers buy fewer imports, while exports grow, AD in will rise – and there may be a multiplier effect on the level of demand and output
2. Higher demand from a fiscal stimulus e.g. lower direct or indirect taxes or higher government spending. If direct taxes are reduced, consumers have more disposable income causing demand to rise. Higher government spending and increased borrowing creates extra demand in the circular flow
3. Monetary stimulus to the economy: A fall in interest rates may stimulate too much demand – for example in raising demand for loans or in leading to house price inflation. Monetarist economists believe that inflation is caused by “too much money chasing too few goods" and that governments can lose control of inflation if they allow the financial system to expand the money supply too quickly.
4. Fast growth in other countries – providing a boost to UK exports overseas. Export sales provide an extra flow of income and spending into the UK circular flow – so what is happening to the economic cycles of other countries definitely affects the UK.

Cost-push inflation

Cost-push inflation occurs when firms respond to rising costs by increasing prices in order to protect their profit margins.There are many reasons why costs might rise:

1. Component costs: e.g. an increase in the prices of raw materials and other components. This might be because of a rise in commodity prices such as oil, copper and agricultural products used in food processing. A recent example has been a surge in the world price of wheat.
2. Rising labour costs - caused by wage increases, which are greater than improvements in productivity. Wage costs often rise when unemployment is low because skilled workers become scarce and this can drive pay levels higher. Wages might increase when people expect higher inflation so they ask for more pay in order to protect their real incomes. Trade unions may use their bargaining power to bid for and achieve increasing wages, this could be a cause of cost-push inflation
3. Expectations of inflation are important in shaping what actually happens to inflation. When people see prices are rising for everyday items they get concerned about the effects of inflation on their real standard of living. One of the dangers of a pick-up in inflation is what the Bank of England calls “second-round effects" i.e. an initial rise in prices triggers a burst of higher pay claims as workers look to protect their way of life. This is also known as a “wage-price effect"
4. Higher indirect taxes – for example a rise in the duty on alcohol, fuels and cigarettes, or a rise in Value Added Tax. Depending on the price elasticity of demand and supply for their products, suppliers may choose to pass on the burden of the tax onto consumers.
5. A fall in the exchange rate – this can cause cost push inflation because it leads to an increase in the prices of imported products such as essential raw materials, components and finished products
6. Monopoly employers/profit-push inflation – where dominants firms in a market use their market power (at whatever level of demand) to increase prices well above costs. A summary of some of the main inflationary forces in an economy.

23.  Discuss the measures taken by the government to control Inflation?

Ans.Some of the most important measures that must be followed to control inflation are: 1. Fiscal Policy: Reducing Fiscal Deficit 2. Monetary Policy: Tightening Credit 3. Supply Management through Imports 4. Incomes Policy: Freezing Wages.

We discuss below the efficacy of the various policy measures to check demand-pull inflation which is caused by excess aggregate demand.

1. Fiscal Policy: Reducing Fiscal Deficit:

The budget deals with how a Government raises its revenue and spends it. If the total revenue raised by the Government through taxation, fees, surpluses from public undertakings is less than the expenditure it incurs on buying goods and services to meet its requirements of defence, civil admin­istration and various welfare and developmental activities, there emerges a fiscal deficit in its budget.

It may be noted here that the budget of the government has two parts:

(1) Revenue Budget,

(2) Capital Budget.

In the revenue budget on the receipts side revenue raised through taxes, interests, fees, surpluses from public undertakings are given and on the expenditure side consumption expenditure by the government on goods and services required to meet the needs of defence, civil administration, education and health services, subsidies on food, fertilizers and exports, and interest payments on the loans taken by it in the previous years are important items.

In the capital budget, the main items of receipts are market borrowings by the government from the Banks and other financial institutions, foreign aid, small savings (i.e., Provident Fund, National Savings Schemes etc.). The important items of expenditure in the capital budget are defence, loans to public enterprises for developmental purposes, and loans to states and union territories.

The deficit may occur either in the revenue budget or capital budget or both taken together. When there is overall fiscal deficit of the Government, it can be financed by borrowing from the Reserve Bank of India which is the nationalised central bank of the country and has the power to create new money, that is, to issue new notes.

Thus, to finance its fiscal deficit, the Government borrows from Reserve Bank of India against its own securities. This is only a technical way of creating new money because the Government has to pay neither the rate of interest nor the original amount when it borrows from Reserve Bank of India against its own securities.

It is thus clear that budget deficit implies that Government incurs more expenditure on goods and services than its normal receipts from revenue and capital budgets. This excess expenditure by the Government financed by newly created money leads to the rise in incomes of the people. This causes the aggregate demand of the community to rise to a greater extent than the amount of newly created money through the operation of what Keynes called income multiplier.

However, when there is too much resort to monetisation of fiscal deficit, it will create excess of aggregate demand over aggregate supply. There is no wonder that this has contributed a good deal to the general rise in prices in the past and has been an important factor responsible for present inflation in the Indian economy.

To reduce fiscal deficits and keep deficit financing (which is now called monetization of fiscal deficit) within a safe limit, the Government can mobilise more resources through raising:

(a) Taxes, both direct and indirect,

(b) Market borrowings, and

(c) Raising small savings such as receipts from Provident Funds.

National Saving Schemes (NSC and NSS) by offering suitable incentives. The Government borrows from the market through sales of its bonds which are generally purchased by banks insurance companies, mutual funds and corporate firms.

Therefore, to check inflation the Government should try to reduce fiscal deficit. It can reduce fiscal deficit by curtailing its wasteful and inessential expenditure. In India, it is often argued that there is a large scope for pruning down non-plan expenditure on defence, police and General Administration and on subsidies being provided on food, fertilizers and exports.

Thus, both by greater resource mobilisation on the one hand and pruning down of wasteful and inessential Government expenditure on the other, the fiscal deficit and consequently inflation can be checked.

2. Monetary Policy: Tightening Credit:

Monetary policy refers to the adoption of suitable policy regarding interest rate and the avail­ability of credit. Monetary policy is another important measure for reducing aggregate demand to control inflation. As an instrument of demand management, monetary policy can work in two ways.

First, it can affect the cost of credit and second, it can influence the credit availability for private business firms. Let us first consider the cost of credit. The higher the rate of interest, the greater the cost of borrowing from the banks by the business firms. As anti-inflationary measure, the rate of interest has to be kept high to discourage businessmen to borrow more and also to provide incen­tives for saving more.

It is noteworthy that a recent monetary theory emphasizes that it is the changes in the credit availability rather than cost of credit (i.e., rate of interest) that is a more effective instrument of regulating aggregate demand. There are several methods by which credit availability can be reduced.

Firstly, it is through open market operations that the central bank of a country can reduce the availability of credit in the economy. Under open market operations, the Reserve Bank sells Govern­ment securities. Those, especially banks, who buy these securities, will make payment for them in terms of cash reserves. With their reduced cash reserves, their capacity to lend money to the busi­ness firms will be curtailed. This will tend to reduce the supply of credit or loanable funds which in turn would tend to reduce investment demand by the business firms.

The Cash Reserve Ratio (CRR) can also be raised to curb inflation. By law banks have to keep a certain proportion of cash money as reserves against their deposits. This is called cash reserve ratio. To contract credit availability Reserve Bank can raise this ratio. In recent years to squeeze credit for checking inflation, cash reserve ratio in India has been raised from time to time.

Another instrument for affecting credit availability is the Statutory Liquidity Ratio (SLR). According to statutory liquidity ratio, in addition to CRR, banks have to keep a certain minimum proportion of their deposits in the form of specified liquid assets.

And the most important specified liquid asset for this purpose is the Government securities. To mop up extra liquid assets with banks which may lead to undue expansion in credit availability for the business class, the Reserve Bank has often raised statutory liquidity ratio.

Selective Credit Controls:

By far the most important anti-inflationary measure in India is the use of selective credit control. The methods of credit control described above are known as quantitative or general methods as they are meant to control the availability of credit in general. On the other hand, selective credit controls are meant to regulate the flow of credit for particular or specific purposes.

Whereas the general credit controls seek to regulate the total available quantity of credit (through changes in the high powered money) and the cost of credit, the selective credit control seeks to change the distribution or allocation of credit between its various uses. These selective credit controls are also known as Qualitative Credit Controls. The selective credit controls have both the positive and negative aspect.

In its positive aspect, measures are taken to stimulate the greater flow of credit to some particular sectors considered as important:

(1) Changes in the minimum margin for lending by banks against the stocks of specific goods kept or against other types of securities.

(2) The fixation of maximum limit or ceiling on advances to individual borrowers against stock of particular sensitive commodities.

(3) The fixation of minimum discriminatory rates of interest chargeable on credit for particular purposes.

3. Supply Management through Imports:

To correct excess demand relative to aggregate supply, the latter can also be raised by importing goods in short supply. In India, to check the rise in prices of food-grains, edible oils, sugar etc., the Government has often taken steps to increase imports of goods in short supply to enlarge their available supplies.

When inflation is of the type of supply-side inflation, imports are increased to augment the domestic supplies of goods. To increase imports of goods in short supply the Govern­ment reduces customs duties on them so that their imports become cheaper and help in containing inflation. For example in 2008-09 the Indian Government removed customs duties on imports of wheat and rice and reduced them on oilseeds, steel etc. to increase their supplies in India.

5.      Incomes Policy: Freezing Wages:

Another anti-inflationary measure which has often been suggested is the avoidance of wage increases which are unrelated to improvements in productivity. This requires exercising control over wage-income. It is through wage-price spiral that inflation gets momentum.

When cost of living rises due to the initial rise in prices, workers demand higher wages to compensate for the rise in cost of living. When their wage demands are conceded to, it gives rise to cost-push inflation. And this generates inflationary expectations which add fuel to the fire.

To check this vicious circle of wages-chasing prices, an important measure will be to exercise control over wages. However, if wages are raised equal to the increase in the productivity of labour, then it will have no inflationary effect. Therefore, the proposal has been to freeze wages in the short run and wages should be linked with the changes in the level of productivity over a long period of time. According to this, wage increases should be allowed to the extent of rise in labour productivity only. This will check the net growth in aggregate demand relative to aggregate supply of output.

However, freezing wages and linking it with productivity only irrespective of what happens to the cost of living has been strongly opposed by trade unions. It has been validly pointed out why freeze wages only, to ensure social justice the other kinds of income such as rent, interest and profits should also be freeze similarly. Indeed, effective way to control inflation will be to adopt a broad- based incomes policy which should cover not only wages but also profits, interest and rental incomes.