Department of Distance and Continuing Education
University of Delhi
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B.A.(Hons.) Economics - DSC-4
B.A. (Programme) - DSC-3 (Minor)
Semester-II
Course Credit-4
INTRODUCTORY MACROECONOMICS
(Department of Economics)
As per the UGCF - 2022 and National Education Policy 2020
Introductory Macroeconomics
Editorial Board
Prof. J. Khuntia, Devender
Content Writers
Devender
Academic Coordinator
Deekshant Awasthi
© Department of Distance and Continuing Education
ISBN : 978-81-19169-62-7
1st edition: 2023
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economics@col.du.ac.in
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Introductory Macroeconomics
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© Department of Distance & Continuing Education, Campus of Open Learning,
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Introductory Macroeconomics
INTRODUCTORY MACROECONOMICS
Study Material : Lesson 1-14
TABLE OF CONTENTS
Name of Lesson
Page No
LESSON 1
Introduction to Macroeconomics
1-11
LESSON 2
Introduction to National Income Accounting
12-36
LESSON 3
National Product/National Income
37-75
LESSON 4
Balance of Payments
76-80
LESSON 5
Money
81-90
LESSON 6
Measures of Money Supply
91-96
LESSON 7
Money and Price
97-103
LESSON 8
Credit Creation
104-110
LESSON 9
Demand for Money and its Determinants
111-125
LESSON 10
Tool of Monetary Policy
126-129
LESSON 11
Classical Macroeconomics: Equilibrium Output and Employment
130-148
LESSON 12
Keynesian Macroeconomics: Equilibrium Determination a
Multiplier
149-164
LESSON 13
IS-LM Determination
165-178
LESSON 14
Fiscal and Monetary Multiplies
179-188
© Department of Distance & Continuing Education, Campus of Open Learning,
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Introductory Macroeconomics
LESSON-1
INTRODUCTION TO MACROECONOMICS
STRUCTURE
1.1
1.2
1.3
1.4
Introduction
1.1.1 What is Economics?
1.1.2 Scope of Economics: Micro and Macro Economics
1.1.3 Major Macroeconomic Issues
Concepts
1.2.1 Stocks and Flows
1.2.2 Equilibrium and Disequilibrium
1.2.3 Partial and General Equilibrium Analysis
Methods of Macroeconomic Analysis
1.3.1 Static Analysis
1.3.2 Dynamic Analysis
1.3.3 Comparative Statics Analysis
Self-Assessment Questions
1.1 INTRODUCTION
1.1.1 What is Economics?
The science of economics was born with the publication of Adam Smith’s “An Inquiry into
the Nature & Causes of Wealth of Nations” in the year 1776. Before Adam Smith, there were
other writers who expressed significant economic ideas. But economics as a separate branch
of knowledge started with Adam Smith’s book. The word ‘ECONOMICS has been derived
from two Greek word oikos (meaning a house) and nemein (meaning to manage). Hence
economics meant managing a household in an economical manner.
Economics is concerned with the allocative decisions of individual, households,
business and other economic agents operating in the society and how the society itself (as a
whole) allocates its resources. Alternatively, it is the study of how a society chooses to use its
limited resources to produce, exchange and consume goods and services.
Economics has been variously defined. For example, Prof. Alfred Marshall defined it
as “a study of mankind in the ordinary business of life; it examines that part of individual and
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B.A.(Hons.) Economics / B.A.(Programme)
social action which is more closely connected with the attainment and use of material
requisites of well-being”. It is thus “on one side the study of wealth, and on the other and
more important side, the study of man”.
1.1.2 Scope of Economics: Micro and Macro Economics
Modern economics has two major branches—Microeconomics and Macroeconomics.
Before 1930’s most economists concentrated their attention almost exclusively on
microeconomics. Macroeconomics was the junior partner. But after 1936, the year John
Maynard Keynes published “The General theory of Employment, Interest & Money”, a new
interest in macroeconomics arose. Some chose to call it the “Keynesian Revolution” (Late
1930’s – mid 1960’s). Under the influence of Keynes, a whole new branch of economic
theory has been developed called macroeconomics.
In fact, both the branches study economic phenomenon, investigate economic issues
and provide a logical solution to economic problems at two different levels.
Microeconomics analysis is the behaviour of individual decision-making units, such
as consumers, resource owners’ firms. It studies economic problems such as what, how and
for whom to produce at individual level. The unit of study is the part rather than the whole.
Fig. 1.1 Scope of Microeconomics
However, microeconomics fails to explain the functioning of an economy as a whole. It
cannot explain unemployment, poverty, illiteracy and other problems prevailing at the
country level.
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Introductory Macroeconomics
The word Macroeconomics was coined by Ragnar Frisch in 1933. It deals with the
functioning of the economy as a whole. It is concerned with the behaviour and performance
of the aggregates or the “wholes”—such as aggregate output, general price level, size of
national income, level of total employment, aggregate savings, aggregate investment,
economic growth etc. Macroeconomics studies not only the nature and behaviour of the
above variables but also the inter-relationships that exist between the above variables. It is
also known as Theory of Income and Employment since its major subject matter deals with
the determination of income and employment. The scope of macroeconomics in the words of
Dornbusch & Fischer: “Macroeconomics is concerned will the behaviour of the economy as a
whole - with booms and recessions, the economy’s total output of goods and services and the
growth of output, the rates of inflation and employment, the balance of payments, and
exchange rates.”
To conclude we can say: Macroeconomics focus on big picture view of the economy. It
attempts to deal with the big issues of economic life at aggregate level, such as:
a) Why growth rate is less than expected growth rate?
b) Why are jobs plentiful in some years and not in others?
c) Why the prices go up rapidly at some times?
d) Why high rate of inflation persists so long?
e) Why India’s BOP always in deficit?
f) Why fiscal and monetary policies of India failed to achieve their goals?
The scope of macroeconomics includes the following topics as shown in Fig. 1.2.
Fig. 1.2 Scope of Macroeconomics
Macroeconomics has emerged as the most challenging branch of economics. It has both
theoretical and policy orientations.
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B.A.(Hons.) Economics / B.A.(Programme)
1.
Macroeconomics theories use macroeconomic models to explain the behaviour of
macroeconomic variable and specify the nature of the relationship between them.
2.
Study of the inter-relationships between aggregate economic variables assists the
economic policy makers (the Government) to devise appropriate economic policies.
3.
Macroeconomics analyses the working and effects of government policies (especially
monetary and fiscal policy) on the economy.
4.
It explores the consequences of government policies intended to reduce
unemployment, smooth output fluctuations and maintain stable prices.
5.
Macroeconomics provides a framework for controlling and guiding the economy to
achieve desired goals of growth and stability.
6.
Macroeconomic policies formulated and implemented by the Government are directed
towards improving the long-run competitiveness of the economy. The combinations
of wages, prices and exchange rates and productivity are “in-line” so that firms can
market their products profitably to the rest of the world.
7.
The study of macroeconomics is used to solve many problems of an economy like
monetary problems, economic fluctuations, general unemployment, inflation,
disequilibrium in the balance of payments position, etc.
8.
We use this tool to understand why the economy deviates from a path of smooth
growth over time.
9.
Macroeconomic policies bring balance in the economic relations with the rest of the
world.
In conclusion, we may say that in a sense, Microeconomic theory has a foundation in
macroeconomics and Macroeconomic theory has a foundation in microeconomics.
Microeconomic point of view is—optimum allocation of its resources and macroeconomics
point of view is full utilization of its resources.
1.1.3 Major Macroeconomic Issues
Macro Economics deals with whole units of the economy like Aggregate demand, Aggregate
supply, total saving, total investment, national Income, Theory of employment, Balance of
Payment, foreign exchange rate, inflation, Long run Economic growth, overall living
standard, fiscal imbalances & Interest rates are the major issues of macro-Economics.
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Introductory Macroeconomics
Some Major issues of Macro Economics
1.
Business Cycles – Business cycles are the wave like fluctuations. According to
Schumpeter Business cycles have four stages: - Boom, Recession, Depression &
Recovery, which occur time to time and controlling these stages of business cycle is
another important task of the macro economics.
2.
Long run Economic growth- Economic growth is a continuous process in which
National income & per capita income increases. Each and Every country want to
achieve high growth rate of the economy for raising the level of standard of living of
their country people and it is the major issue of macro economics because macro
economics knowledge helps in the achievement of this goal.
3.
Overall living standard – Economic Development depends upon social welfare of
the country people. If country people are able to buy their required or living things,
then their standard of living can rise and it will help in the achievement of higher
growth rate of the economy.
4.
Inflation – When Price rises continuously or persistently that will be called inflation.
Inflation is the main problem which occurs from time to time. It is also the main issue
of macro economics. To control inflation Govt. can use both policies (Monetary
Policy and Fiscal Policy).
5.
Unemployment – This is the main and most important issue of macro economics
because Macro Economics introduced by Keynes at that time when US economy &
U.K. were suffering from the problem of depression. During depression period of
1930’s unemployment rate was rise from 17 to 20%. The solution of this problem was
the interference of the government in economic activities.
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6.
Fiscal Imbalances – Fiscal Imbalance is a situation which occurs when Govt.
Revenue is less than Govt. Expenditure. Govt. make budget which may be in surplus
or in deficit. But generally, it remains deficit and creates the problem of fiscal
imbalance. To solve it Govt. makes fiscal policy in which Govt. can raise their source
of revenue and cut their expenditure & external borrowings.
1.2 CONCEPTS
1.2.1 Stocks and Flows
Macroeconomics uses certain economic aggregates called macro-economic variables, to
assess the performance and to analyse the behaviour of an economy. Macroeconomic
variables that figure in macroeconomic studies are generally grouped under this category
stock variables and flow variables. The twin concepts of stocks and flows are not difficult to
understand but they can cause great difficulty if misunderstood or misused. To begin with,
both are variables, quantities that may increase or decrease over time and are often related
though measured in different units.
A stock is a quantity measured at a given point in time i.e. as on date, whereas a flow is a
quantity measured per unit of time i.e. per hour, per week etc.
For example, the amount of water in a tub is a stock because it is a quantity measured at a
given moment in time and the amount of water coming out of tap is a flow as it is a quantity
measured per unit of time. GDP is probably the most important flow variable in economics
which tells us about the rupees flowing in an economy's circular flow per unit of time.
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Introductory Macroeconomics
Some examples:
Stock Variables
Flow Variables
Person’s Wealth
Person’s income and expenditure
Balance sheet of a firm
Profit and loss account
Supply of money
Spending of money
Fixed deposit in a bank
Interest earned on the deposit
Inventories
Change in inventories
Accumulated savings
Savings
Total stock of capital
Investments
Foreign exchange reserve
Balance of payment
Total employment
Addition to employment
Government tax revenues
Government expenditures
Exports and imports
Wages and salaries
Hint: Any component with which change is associated becomes a Flow concept.
•
Some flow variables have direct counterpart stock variables, e.g., ‘investment’ is a
flow variable having counterpart of stock of capital.
•
But some variables are only flows and have no direct stock counterpart e.g., imports
and exports, wages and salaries, etc. These flow variables indirectly affect the size of
other stocks.
•
A stock can change only as a result of flow. For those flow variables which have a
stock variable, a change in the magnitude of the stock variable between two specified
points in time will depend on the magnitude of the flow variables themselves may be
determined in part by changes in the stock.
The best example of this is the relationship between the stock of capital and
the flow of investment (both of these two depend on each other). The stock of capital
can increase only as a result of an excess of the flow of investment or of new capital
goods produced. However, the flow of investment itself depends on other things on
the size of the capital stock
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•
With respect to this relationship between the flow of investment and the stock of
capital, we may define the short-run period and the long-run period.
Short-run period - as one in which changes in the stock of capital are too
small to influence the flow of investment (stock may be assumed to be
constant in that period). Long-run period - is one in which such changes are
large enough to influence the flow of investment.
So, we can conclude:
Although flows may be influenced by changes in stocks, they will not be so influenced by
changes in stocks in the short run. Stocks can exert an influence on flow only in the long run.
In this sense, elementary macroeconomics theory is primarily short-run, it is essentially a
study of relationships among flows in which size of each flow in any time period is
determined slowly by the size of the other flows.
1.2.2 Equilibrium and Disequilibrium
Equilibrium: refer to a position in which forces working in opposite directions are in balance
and there is no in-built tendency to deviate from this position. In other words, it is expressed
as a state of no change over time.
This is not to say that economics equilibrium is a motion-less state in which no action takes
place whether it is a state of action of repetitive nature.
Disequilibrium: is the state in which the opposite forces produce imbalance or simply it can
be stated as the absence of a state of balance. The factor causing disequilibrium arise of the
working process of the economy. The economic activities are undertaken by million of
decision makers, consumers, producers, workers and others and their decision need not
always coincide and the result is the disequilibrium.
1.2.3 Partial and General Equilibrium Analysis
Partial and general equilibrium analysis are two other concepts which are often used in
macroeconomic analysis.
Partial equilibrium: The analysis of a part of an economy isolated and insulated through
assumptions from the influence of the changes in the rest of the economy. In simple words,
when a part of economic system or an economic phenomenon is analysed in isolation of the
economic system, it is called partial equilibrium analysis.
•
It is based on ceteris peribus, i.e., all other related variables are constant.
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Introductory Macroeconomics
•
It is widely used in microeconomics analysis, but in macroeconomics partial
equilibrium analysis is applicable when macroeconomic analysis is confined either to
the product sector or to the monetary sector.
General equilibrium: General equilibrium analysis is carried out when the objective is to
analyse the economic system as a whole. It takes into account the inter-relationships and
inter-dependence between the various elements of an economy.
•
General equilibrium analysis takes a comprehensive and realistic view of the
economic system and focuses on the simultaneous determination of equilibrium of all
the markets.
•
Macroeconomic analysis is largely of general equilibrium nature as it helps in
formulation of macroeconomics policies and identifies and explain the causes and
effects of economic disturbances.
1.3 METHODS OF MACROECONOMIC ANALYSIS
Three methods/approaches are employed in construction and analysis of economic model in
macroeconomics.
1.3.1 Static Analysis
When an economic phenomenon is studied under static conditions. It is called static analysis.
In this method, it is assumed that macroeconomic variables like the size of the economy,
national income, national consumption, savings, investments, employment, etc. all pertain to
same period of time and remain unchanged over the reference period because static ignore the
passage of time. It cannot explain the process of change in a model so the entire economic
process in a static economy reproduced itself year after year at the same level of output and
employment. Such an economy is said to be in a state of static equilibrium. In this method,
our analysis is limited to a single position of equilibrium only.
Importance: This kind of approach to the study of an economic phenomenon is essentially a
theoretical approach. The primary objective of constructing a static model is to make
generalizations or theoretical prepositions regarding the relationship between the related
variables under static conditions.
Static analysis can identify the equilibrium positions and describe in general terms how
the system will move to this position. It can indicate the position of the model for a but
cannot explain the actual process step-by-step or period-by-period, that the system follows
over time to reach that equilibrium position and also cannot reveal exactly what the position
will be in any other period.
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1.3.2 Dynamic Analysis
When a macroeconomic phenomenon is analyzed under dynamic conditions, it is called
dynamic analysis. Dynamic analysis is able to trace the changes in the value of
macroeconomic variables as they moved through successive disequilibrium position towards
the single equilibrium position over time. It takes into account the time lag involved in the
process of adjustment. It studies the nature and the magnitude of change.
Importance: For a realistic study of economic movements and for policy recommendations,
we require information regarding the whole path of progress, i.e., ‘how’ an economy moves
from one position of equilibrium to the other. It unfolds the changes which occur during the
course of movement of the economy from one position to another. Moreover, a dynamic
economy raises certain issues which cannot be handled through static or comparative - static
approaches.
1.3.3 Comparative Statics Analysis
As it is clear by its name itself, it is a comparative study of economic conditions at two
equilibrium positions at two different points of time. In other words, it refers to the technique
of analysis which economists employ for comparing positions of economic variables and
their relationship under equilibrium conditions at different points of time.
The economic forces that determine the equilibrium position for a model may be expected to
change over time so as to displace the original equilibrium and lead to the establishment of a
new equilibrium. So, one can compare the two equilibrium positions and explain the change
between the two in terms of the changes in forces. The analysis of this kind of change from
one equilibrium to another may be handled by the method of comparative statics.
Importance: It assumes great significance where the object is to predict the future course of
an economy on the basis of the past experience. Through method of comparative statics, we
can show the direction and magnitude of the change in equilibrium price and quantity that
follows from changes in the underlying forces that causes the shifts in the supply and demand
curve.
CONCLUSION: Comparative statics bridges the gap between equilibrium positions in one
instantaneous jump. But it reveals nothing about how we got from one position of
equilibrium to the other. In reality, we are more interested in the path followed between
positions of equilibrium than in the positions themselves and only dynamic analysis can
handle this task.
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Introductory Macroeconomics
Hence, in short we can conclude that change from one equilibrium position to the next
can be analyzed by method of comparative statics, but actual path followed between
equilibrium positions can be explained only by macro dynamic analysis.
Summary
•
The origin of economics can be traced to Adam Smith's book “An Inquiry into the
Nature & Causes of Wealth of Nations” published in the year 1776.
•
Microeconomics deals with behaviour of individual decision-making units such as
consumers, resource owners, etc. Macroeconomics deals with aggregates such as
national income, aggregate consumption, etc.
•
A stock is a quantity measured at a given point in time.
•
A flow is a quantity measured per unit of time.
•
Equilibrium refers to a position in which forces working in opposite direction are in
balance.
•
Disequilibrium is a state in which opposite forces produce imbalance.
•
When a part of an economy is studied in isolation is called partial equilibrium
analysis.
•
A comprehensive study of an economic system is referred as General Equilibrium
Analysis.
•
Static. Dynamic and Comparative-Static
Macroeconomic Analysis.
Analysis
are
three
methods
of
1.4 SELF-ASSESSMENT QUESTIONS
1.
What is macroeconomics? Distinguish it from microeconomics.
2.
Explain the difference between stock and flow.
3.
What methods are employed by economists for analytical purposes in macroeconomic
theory?
4.
Write a short note on: Major issues of Macro Economics
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B.A.(Hons.) Economics / B.A.(Programme)
LESSON-2
INTRODUCTION TO NATIONAL INCOME ACCOUNTING
STRUCTURE
2.1
2.2
2.3
2.4
2.5
2.6
Introduction
Gross Domestic Product (GDP)
2.2.1 Rules for Computing GDP
2.2.2 Real GDP versus Nominal GDP
2.2.3 The GDP Deflator
2.2.4 Consumer Price Index
Other Measures of Income
2.3.1 Gross National Product (GNP)
2.3.2 Net National Product (NNP)
2.3.3 National Income (NI)
2.3.4 Personal Income (PI)
2.3.5 Personal Disposable Income (DI)
2.3.6 Private Saving
2.3.7 Public Saving
2.3.8 National Saving
2.3.9 Distinguish between National Income, National Capital & National Wealth
2.3.10 Interest Rate
The Components of Expenditure (GDP)
2.4.1 Consumption (C)
2.4.2 Investment (I)
2.4.3 Government Purchases (G)
2.4.4 Net Exports (NX)
Income Expenditure and The Circular Flow
2.5.1 The Circular Flow in 2-Sector Model
2.5.2 Computation or GDP from the Circular Flow
2.5.3 The Circular Flow in a Three-Sector Model
Self-Assessment Questions
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Introductory Macroeconomics
2.1 INTRODUCTION
Economists want to figure out what's going on in the world around them. To do this, they rely
on both theory and observation. Casual observation is one source of information about what's
happening in the economy. They build theories in attempt to make sense of what they see
happening. Then they turn to use statistics to study the economy. Study of national income
and related concepts like Gross Domestic Product (GDP), Gross National Product (GNP), Net
National Product (NNP), Net Domestic Product (NDP), etc. enables the government to judge
whether the economy is contracting or expanding, whether it needs a boost or should be
controlled or rained in a bit, or whether severe inflationary or deflationary pressure are round
the corner.
The data from National income accounts serve like beacons to help economic policy makers
in achieving their objectives, Paul. A. Samuelson and William D. Nordhaus have succinctly
remarked, “Without measures of national economic aggregates like GDP, Policy Makers
would be adrift in a sea of unorganized data”. The three statistics that economists and the
policy makers use most often to qualify the performance of the economy are:
1.
Gross Domestic Product (GDP)—It tells us the nation's total income and total
expenditure on its outputs of goods and services.
2.
Consumer Price Index (CPI)—It measures the level of prices.
3.
Unemployment Rate—It tells us the fraction of workers who are unemployed.
2.2 GROSS DOMESTIC PRODUCT (GDP)
GDP is often considered the best measure of how well the economy to performing. The value
of income or product originating in a country in a particular year is one of the most important
means of evaluating how the economy has preformed in that year. This statistic is computed
every three months by the Bureau of Economic Analysis from a large number of Primary data
sources. The goal of GDP is lo summarize in a single number the rupee value of economic
activity in a given period of time.
GDP is the sum total of market value of all the final goods and services produced on the
geographical or domestic territory of on economy in a given period of time.
GDP
=
Market value of good services produced by the residents in the country.
Plus (+) =
Income earned in the country by foreigners.
Minus (-) =
Income received by residents of the country from abroad.
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B.A.(Hons.) Economics / B.A.(Programme)
This is a geographical territorial concept of Product. What we are concerned is the increased
production, no matter who produces it i.e., whether production is being done by the residents
of a nation or by foreign nationals. Thus, GDP does not make any provision for net factor
income from abroad; it only includes what has been produced on the domestic territory of the
country. Thus, in the context of development GDP is considered as a more appropriate
measure.
There are two ways to view GDP:
(a) It is the sum total of everyone's income in an economy.
(b) It is the total expenditure on the economy's output of goods and services.
How, GDP measures both the economy's income and expenditure on its output. The
reason is that these two quantities are actually the same; for the economy as a whole, income
must equal expenditure. The fact follows from, because expenditure by one person becomes
the income of the other. In other words, every transaction has both a buyer and a seller. For
example, John buys bread of Rs. 10 from Johnny, which is an income of Johnny &
expenditure by John.
2.2.1 Rules for Computing GDP
1.
To compute the total value of different goods & services we make use of the market
prices of these final goods and services. The market price reflects how much the
consumers are willing to pay for the goods and services.
2.
Used goods GDP measures the value of currently produced goods and services.
Thus, the sale of used goods is not included as part of GDP. Used goods were produced
in an earlier period and their value was counted in that period.
3.
Regarding the Inventories - Production for inventory increases the GDP, but the sale
out of inventory does not affect GDP. It will be treated like the sale of used goods. This
treatment of inventories ensures that GDP reflects the economy's current production of
goods and services.
4.
Intermediate goods and value added - GDP includes only the value of final goods. The
reason is that the value of intermediate goods is already included as part of the market
price of the final goods in which they are used. Adding Value of intermediate goods will
lead to double counting.
One way to compute the value of all final goods and services is to sum the value added
at each stage of production.
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Introductory Macroeconomics
The value added of a firm = value of the firms output-(Minus) value of the intermediate
goods that the firm purchases.
For the economy as a whole, the sum of all value added must equal the value of all final
goods and services. Hence, GDP is also the total value added of all firms in the
economy.
5.
Housing service and other Imputations - Although most goods and service are valued at
their market prices when computing GDP, some are not sold in the marketplace (e.g.,
sell owned house, Government service etc.), and therefore do not have market prices. To
include the value of these goods and services in the figure of GDP, we estimate their
imputed value.
2.2.2 Real GDP versus Nominal GDP
GDP is useful for comparing economic activity, from year to year. GDP measured at current
year prices (i.e., Nominal GDP) does not measure accurately the economy's Performance. It
will produce a misleading picture of economy's performance because if the prices doubled
without change in quantities, GDP also double which reflects economy's ability to satisfy
demands has doubled whereas, in actual the quantity of every good produced remain the
same. Therefore, to measure the actual economic performance, value of good and services
should be measured using a constant of Prices, called real GDP. Hence real GDP is a better
measure of economic well-being, which is not influenced by changes in Prices. It shows what
would have happened to expenditure on output if quantities had changed but prices had not.
Nominal GDP = Value of goods and services measured at current prices.
Red GDP
= Value of goods and services measured using a constant set of Prices of
the base year.
Example of Real vs. Nominal GDP
Year
Price of Wheat
Quantity of
wheat
Price of Bread
Quantity of
Bread
2013
10
100
20
50
2014
20
150
30
100
2015
30
200
40
150
Calculating Nominal GDP
2013
(10 x 100) + (20 x 50)
=
2000
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2014
(20 x 150) + (30 x 100)
=
6000
2015
(30 x 200) + (40 x 150)
=
12000
Calculation Real GDP (Base Yr. 2013)
2013
(10 x 100) + (20x50)
=
2000
2014
(10 x 150) + (20 x 100)
=
3500
2015
(10 x 200) + (20 x 150)
=
5000
Calculating the GDP Deflator
2013
(2000 x 2000) x 100 =
100
2014
(6000 / 3500) x 100
=
171
2015
(12000 / 5000) x 100 =
240
2.2.3 The GDP Deflator
It is also called the implicit price deflator of GDP. It reflects what's happening to the overall
level of Prices in the economy.
GDP is defined as the ratio of nominal GDP to real GDP:
GDP Deflator =
Nominal GDP
Real GDP
It is used to deflate (that is, take inflation out of) nominal GDP to yield real GDP.
We can also write the equation as:
Nominal GDP =
Real GDP × GDP deflator
OR
Real GDP
=
Nominal GDP
GDP Deflator
Where,
Nominal GDP - measures the current rupee value of the output of the economy.
Real GDP
- measures output value at constant prices.
GDP deflator
- measures the price of output relative to its price in the base year.
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Introductory Macroeconomics
Note: The Bureau of Economic Analysis has decided to update periodically the prices used to
compute real GDP. About every five years, a new base year was chosen. The prices were
then held fixed and used to measure year-to-year changes in the production of goods and
services until the base year was updated once again.
2.2.4 Consumer Price Index
CPI is the Direct Price index and most suitable (appropriate) to consumers because it
measures the Prices of those goods and services which are directly consumed or purchased by
the consumers. Many govt. pensions like social security benefits, and some wage rates are
indexed to the CPI.
(i)
CPI is constructed by using following information –
(i)
consumption basket in the base year
(ii)
Prices of items in the basket in the base year
(iii)
Prices of items in the given year
CPI measures retail prices on which consume purchase
CPI increases due to increase in inflation & vice-versa goods & services from the market.
CPI =
TotalCost of thegoodsin thecurrent year
x100
Totalcos t of thegoodsin the base year
Price index is the measuring level of Aggregate Price, relative to a chosen base year.
WPI the Laspeyres Index is used
 P q or  x w
P q x w
l
o
i
i
o
o
o
o
Producer Price index is a measure of the cost of a basket of goods & services bought by
firms.
CPI is a measure of the cost of a basket of goods & services bought by households.
Indexation is the automatic correction by law or contract of a dollar / rupee amount for the
effect of inflation, that amount is said to be indexed for inflation. Index is a main feature of
many laws for example when price increases, social security benefits are also adjusted every
year to compensate it. Same as when Price rises dearness allowance also adjusted every year
to compensate it.
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The inflation rate is a rate which is calculated on the basis of the current year’s Price (Pt) &
last year’s Price (Pt-1). In other words, it is the rate of change in prices & the price level is the
accumulation of past inflation.
=
( Pt − Pt −1 ) x100
Pt −1
2.3 OTHER MEASURES OF INCOME
The national income accounts include other measures of income that differ slightly in
definition from GDP. They all are also important to study as they also are often referred by
economists.
2.3.1 Gross National Product (GNP)
It is the most comprehensive machine of the nation’s productive activities. It measures the
total income earned by nationals (residents of a nation).
GNP is the sum total of market value of all the final goods and services produced by the
residents of a country in a given period of time.
GNP
= market value of goods and services produced by the resident in the country.
+ (plus)
= Income earned abroad by nationals.
- (Minus) = Incomes earned locally by the foreigners.
In other words, to obtain Gross national product (GNP), we add receipts of factors income
(wages, profit and rent) from the rest of the world and subtract payments of factor income to
the rest of the world.
GNP = GNP + Factor payments from Abroad – factor Payments to Abroad.
2.3.2 Net National Product (NNP)
It is another concept of National income. The concept of NNP is closely related to the
concept of GNP. The concept of GNP includes the output of both final consumer and capital
goods. However, a part of capital goods is used up or consumed in the process of production
of these goods. That is called depreciation or capital consumption (the amount of the
economy's stock of plants, equipment and residential structure that wears out during the
year). So, GNP is gross of depreciation and NNP is net of depreciation.
NNP = GNP - Depreciation
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Introductory Macroeconomics
2.3.3 National Income (NI)
The next adjustment in the national income accounts is for indirect business taxes such as
sales taxes. As firms never receive these taxes, it is not a part of their income. Once, we
subtract indirect business taxes from NNP, we obtain a measure called national income.
National Income (NI) = NNP - Indirect Business Taxes
2.3.4 Personal Income (PI)
It is the sum total of all kinds of incomes received by the individuals (including transfer
earnings) from all source’s income within and outside the country during an accounting year.
It includes wages and salaries, fees & commissions, bonus fringe benefits. dividends, interest
earnings and also includes transfer incomes like pension, allowances, old age security
benefits etc.
Personal Income = National Income + Dividend + Government Transfers to Individuals +
Personal Interest Income-Corporate Profits-Social Insurance
Contributions-Net Interest
2.3.5 Personal Disposable Income (DI)
It is the amount households and non-corporate businesses have available to spend after
satisfying their tax obligations to the government.
It is the amount households and non-corporate businesses have available to spend after
satisfying their lax obligations to the government.
Personal Disposable Income = Personal Income – Personal Tax and non-tax Payments
2.3.6 Private Saving –private saving is the income of the households which left for saving
purpose after paying the direct taxes to the govt. and expenditure on consumption.
Private Saving – Private disposable Income minus Consumption expenditure.
SPvt.
= Private disposable income – Consumption
= (Y-T+TR+INT+NFP) – C
Private saving is very useful because it helps in capital formation or investment in the
economy. Private saving provides financial resources to the govt. to overcome the problem of
deficit budget and it reduces the burden of foreign borrowings.
As we know that under expenditure method
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Y = C+I+G + NX
National Saving = (C+I+G+NX) + NFP – C – G
S = I + (NX + NFP)
The sum of Net exports (NX) & Net factor Payment (NFP) may be called current Account
balance (CA).
Now we can rewrite saving in this form.
S = I + CA
Private Saving = 1 + (-Sgovt.) + CA
Where, -Sgovt. Govt. budget deficit
Uses of private saving
Private saving can be used in the economy be following ways1)
For Investment – Business firms & producing units can take loans or borrow money
from financial institutions for smooth functioning of the business enterprises.
2)
Govt. budget deficit (-Sgovt.) – when govt. Revenue is less than govt. expenditure
then Govt. make deficit budget & to compensate it govt. need money, so Private
saving can help in solving the problem of budget deficit.
3)
The Current Account balance – Current A/c balance is the summation of Net
Exports & net Factor payment. To finance current account balance Private saving is
useful.
2.3.7 Public Saving
Public Saving is that part of govt. income or tax revenue which left after paying for its
expenditure.
Public saving or govt. saving = Govt. saving is calculated by deducting govt. Purchases from
govt. Income.
Sgovt. = Net govt. income – govt. purchase (T-TR-INT) – G
2.3.8 National Saving
National Saving is the sum of Private saving & Public Savings
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Introductory Macroeconomics
National Saving = SPV+ + SGovt.
S= SPVT + Sgovt.
= (y+NFP – T + TR + INT – C) + (T-TR – INT – G)
= Y + NFP – C – G
Here
Y + NFP is Total income of the economy which is equivalent to GNP (Gross National
Product)
C – Consumption expenditure
G – Govt. Purchases
NFP – Net Factor Payment
2.3.9 Distinguish between National Income, National Capital & National Wealth
National Income is a flow concept, but National Capital and National Wealth is a stock
concept.
National Income is estimated every year but National Capital and Wealth Can’t be estimated
every year because it includes Stock of capital goods and land, and net foreign Assets (Which
is the difference between foreign Assets minus foreign Liabilities).
S = I + CA
If the investment is greater than National Saving S then the current account balance will be
negative.
2.3.10 Interest Rate
Interest is the reward of capital which the owner of capital gets by separating the money from
himself and give it to others for business purpose.
Nominal Interest rate
=
i
Real Interest rate
=
r
Expected inflation
=
e
Nominal Interest rate is the summation of real interest rate & expected inflation.
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I = r + e
And Real interest rate = I – e
Fisher’s effect shows the adjustment Process of the nominal Interest rate to the inflation rate.
If inflation is higher nominal interest rate will be higher & vice-versa. Fisher effect has
maintained a long-period perspective & this effect need not hold in the short run because in
short term inflation may be unanticipated.
Nominal interest rate is that rate which pays by the bank & real interest rate increase
purchasing power the quantity theory of money & the fisher’s equation both tells us how
growth of money affects the nominal interest rate.
According to the quantity theory of money, an increase in the rate of growth of money of 1%
causes a 1% increase in the rate of inflation and in turn it increases nominal interest rate by
1%. The one-for one relationship between the inflation rate and nominal interest rate is called
the fisher effect.
2.4 THE COMPONENTS OF EXPENDITURE (GDP)
Economists and policy makers care not only about the economy's total output of goods and
services but also about the allocation of this output among alternative uses.
The national income accounts divide GDP into four broad categories of spending, according
to the identity of the purchaser:
•
Consumption (C)
•
Investment (I)
•
Government Purchases (G)
•
Net Exports (NX)
Mathematically, their relation could represent as
Y = C + I + G + NX
Where, Y stands for GDP
GDP is the sum of consumption, investment, government purchases and net exports. Each
rupee of GDP falls into one of these categories. This equation is the national income
account’s identity.
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Introductory Macroeconomics
NATIONAL INCOME EQUATION
In a closed economy:
In a Two Sector economy, Y = C + I
In a Three Sector economy, Y = C + I + G
In an open economy:
In a Four Sector economy, Y = C + I + G + NX
Let us now discuss each of the components of GDP in a detailed manner.
2.4.1 Consumption (C)
Consumption is expenditure on final goods and services with a view to derive satisfaction. It
is the most important function used in macroeconomic theory because all forms of
consumption together make up two-thirds of GDP.
Consumption depends on number of factors e.g., income wealth, lifestyle, sex etc. but
assumption is aggregate amount of real consumer spending is determined exclusively by the
real disposable income of consumers. The relationship between consumption and income is
described by consumption function. Thus,
The consumption function is the assumed direct relationship between the disposable income
level and the planned or desired consumption expenditures.
Algebraically, the basic relationship between country's consumption spending and disposable
income is shown as:
C = F(Yd)
……………………consumption function
in which,
C Stands for the consumption spending, and
Y Stands for the disposable income.
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Fig. 2.1: The Consumption function
The consumption curve has a positive slope showing that when the income increases
consumption also increases.
Consumption consists of the goods and services brought by households. It is divided into
three subcategories:
(1) Durable goods: Goods that last a long time, such as T.V. and cars etc.
(2) Non- durable goods: Goods that last only a short time, such as food and clothing.
(3) Service: In includes the work done or services rendered for consumers by
individuals, and firms such as consultation, doctor visits, hair cuts etc.
2.4.2 Investment (I)
Investment consists of goods bought for future use. In other words, it is expenditure on goods
not for current consumption. Sometimes confusion arises because what looks like investment
for an individual may not be investment for the economy as a whole. For an economy
investment is something which adds or creates new capital. In other words, investment means
additions to the physical stock of capital. Economy's investment does not include purchases
that merely reallocate existing assets among different individuals.
Let’s consider an example. Suppose we observe two events:
➢ Mack buys for himself a 100-year-old factory.
➢ Jones builds for himself a brand-new factory.
What is total investment here? Two factories, one factory or zero?
A macro economist seeing two transactions counts only the Jones' factory as investment.
Mack's transaction has not created new housing for the economy: it has merely reallocated
existing housing. Mack's purchase is investment for Mack, but it is disinvestment for the
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Introductory Macroeconomics
person selling the factory. By contrast, Jones has added new factory to the economy, his new
factory is counted as investment.
Investment is divided into three subcategories:
(1) Business fixed investment: It is the purchase of new plant and equipment by firms.
(2) Residential fixed investment: It is the purchase of new housing by households and
landlords.
(3) Inventory Investment: It is the increase in firms' inventories of goods. The
investment is inventory can be positive or negative depending on the fact whether
investments rise or are depleted.
Investment (I) depends on the rate of interest (r) Investment function is
I = f(r)
Investment is the cost of borrowing and so when interest rate increases, cost of borrowing
(funds) increases. Thus, investment curve has a negative slope.
2.4.3 Government Purchases (G)
By Government Purchases we refer to the Government spending on goods and services as
purchase of goods and services by federal, state and local governments. This category
includes such items as military equipment, highways, and the services that government
workers provide. In addition, the Government makes transfer payments, payments that are
made to people without their providing a current service in exchange. Typical transfer
payments are social security benefits and unemployment benefits. Transfer payments are not
counted as part of GDP, because transfer payment reallocates existing income and are not
made in exchange for some of the economy's output of goods and services; they are not part
of current production.
Govt. purchases = Government Expenditure – Transfer payments
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2.4.4 Net Exports (NX)
The final component of GDP is net exports. It takes into account trade with other countries.
Net export is the difference between the value of goods and services exported by Domestic
County to other countries and the value of goods & services that other countries provide to
the domestic economy.
In other words, Net exports represent the net expenditure from abroad on our goods and
services which providers income for domestic produces.
NX
= Value of goods and services exported (EX)
Minus = Value of goods and services imported (IM)
NX = EX-IM
The difference between exports and imports, called net exports, is a component of total
demand for our goods.
The GDP is expressed as the sum of expenditure on domestically produced final goods and
services. The four types of expenditure that are included in GDP and the economic group
who makes those expenditures and some examples of each type of expenditure are
summarized in the following table:
Type of Expenditure
Economic group that Examples
makes the expenditure
Consumption
Individuals, households
Food, clothing, shelter
Investment
Business firms
New plant and machinery
equipment, new houses,
increase
in
inventory.
Government purchases
Central, state and local New defence equipment,
governments.
salaries of government
officials, new government
schools etc.
Net Exports
Foreign Sector
Export of manufactured
items, services provided to
foreigners by domestic
residents.
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Introductory Macroeconomics
In Short,
Expenditure Method – It is useful in the calculation of National Income in secondary sector
or Manufacturing sector in which raw material is converted into finished goods.
GDP
=
C + I + G + NX (X-M)
Private Final consumption expenditure
+
Govt. Final consumption expenditure
+
Gross Domestic Capital Formation –
i)
ii)
Gross Domestic fixed Capital formation
Change in Stock (Closing – opening stock)
+
Net Exports (Exports – Imports)
NNPFC or National Income = GDPMP – Dep. – NIT + NFIA
Income Method: This method can be used in Testing sector or service sector in which
banking, insurance, Transportation, communication is included in it.
In this method we will take factors Income in form of Rent, Interest, wages and Profit which
factors of production receive by rendering their services in the production of goods and
services.
Classification of factors income into three main broad categories
1.
Compensation of employees
2.
Operating Surplus
3.
Mixed Income
(i)
Compensation of Employees: It is the reward of labour by rendering their services in
the form of cash or in kind. It includes wages and salaries in cash or in kind and
employer’s contribution in social security schemes like Bonus, PPF etc.
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(ii)
Operating Surplus: It is the summation of income from property including Rent and
Interest and Income from entrepreneurship includes profit. If we add all income like
Rent, Interest and Profit then we can get operating surplus. Profit is also divided into
three categories – Dividend, Undistributed Profit and Corporate Tax.
(iii)
Mixed Income: It is the sum of all factors of income like Income from work, Income
from Property and Income from entrepreneurship. When we can't classify the factors
income into some specific category that type of income is called mixed income of
self- employed person.
NDPFC or Domestic Income
=
Compensation of employees
Surplus + Mixed Income
+
Operating
National Income
=
NDPFC + NFIA (Net factor income from abroad)
NFIA is the difference b/w income received from abroad and income paid to the abroad
Product Method  This method is useful to calculate N.Y in primary sector in which
Agriculture and its allied activities are included in it.
GDP or GVA = Value of output - Intermediate Consumption
NNP FC or National Income = GDP - Dep - NIT + NFIA
Identity of National Income Accounting
Total output = Total Income = Total expenditure
2.5 INCOME EXPENDITURE AND THE CIRCULAR FLOW
As macroeconomics is the study of the economy as a whole. An economy can be defined as
an integrated system of production, exchange and consumption. The three economic activities
are inter-related. Changes in one lead to changes in the other. In carrying out these economic
activities, people are involved in making transactions - they buy and sell goods and services.
The transactions take place between different sectors of the economy due to which income
and expenditure moves in a circular form called circular flow of income and expenditure.
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Introductory Macroeconomics
Real flow: It is the flow of goods is services from the firm to the households and flow of
factor services from the household to the firm.
Money flow: It is the flow of money from the household to the firms in the form of Payment
for goods and services and from the firm to the households, the flow of factor payments.
Note: Both Real flow and money flow go in opposite direction in a circular fashion.
In our economy, both commodities and factors of production are constantly being exchanged
for money. The money flows hand to hand in much the same way as water flows through pipe
or electricity through a circuit. Therefore, the entire economic system can be viewed as
circular flows of income and expenditure. The magnitude of these flows, in fact determines
the size of national income.
The mechanism of Income and Expenditure flows is extremely complex in reality. Therefore,
to present this; the economy is divided into four sectors:
(1) Households
(2) Business firms
(3) Government sector
(4) Foreign sector
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2.5.1 The Circular Flow in 2-Sector Model
A two-sector model is obviously an unrealistic model consisting of household and business
firm which represents a private closed economy but provides a convenient starting point to
analyze the circular flow.
Features of households:
(1) Households are the owners of at factors of production.
(2) They are the consumers.
(3) Their total income consists of wages, rent, interest and profits.
(4) Whole of their income is spent on the consumption expenditure and therefore, savings
=0
Features of Business firms:
(1) They own no resources of their own.
(2) They hire and use the factors of production from households
(3) They produce and sell goods and services to the households.
(4) There are no corporate savings.
Fig. 2.5 The circular flow of Income and Expenditure in a two-sector model
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In the factor market (Upper Hall)
(1)
Firm purchases the factors of Production (Land, labour capital and entrepreneurship)
from the households who own them. This makes real flow shown by a continuous
arrow.
(2)
In return to the services, provided, the households receive income in the form of
wages, rent, interest and profits (factors income) - shown by dolled arrow. In reverse
direction from firms to households.
Therefore, real or factor flow causes another and a reverse money flow. In the product market
(Lower half)
(1)
Firm produces goods and services with use of factors of production (purchased from
households) and sell the same to the households. This is shown by continuous inner
loop of real flow but in opposite direction from firms to households.
(2)
The households spent their earned income and make payments to firms for goods and
services and create money flow but this too, in opposite direction shown by dotted
arrow.
Now, when we continue the goods and money flows in factor and product market and look at
the flows in continuity we find circularity in flows.
The circular flow in a simple economy is thus complete wherein:
(i)
Firm purchases factors of production from households and then use these factors to
produce commodities that are bought by households – circular flow of goods.
(ii)
Money paid for factor services become income for households, which they spent to
purchase goods and services so produced become income of the firms. Money flows
around the circuit, passing from firm to household and back again - circular flow of
income.
2.5.2 Computation or GDP from the Circular Flow
GDP measures the flow of rupees in an economy. Since the circular flow shows ·that the
GDP is both the total expenditure on the goods and services and the total income from the
production of the goods and services, so to compute GDP we can look at either the flow of
rupees from firms to households or the flow of rupees from households to the firms.
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These two alternative ways of computing GDP must be equal because the expenditure of
buyers on products is, by the rules of accounting, income to the sellers of those products. In
other words,
Expenditure by the buyers = Income of the sellers.
2.5.3 The Circular Flow in a Three-Sector Model
A three-sector model depicts a more realistic economy. It reflects more accurately how real
economies function. It includes government, the central authority, which plays an important
role in the economy. In other words, it shows the linkages among the economic factors—
households firms and the government—and how rupees flow among them through the
various markets in the economy.
Features:
(1)
(2)
(3)
(4)
The economy is a closed economy and does not trade with rest of the world. The
economy consists of three sectors:
(a)
Households
(b)
Firms
(c)
The Government
Three fiscal variables are included in the circular flow:
(a)
Direct taxes
(b)
Government expenditure on goods and services
(c)
Transfer payments
The three markets under study are:
(a)
The factor markets
(b)
The product market, and
(c)
The financial market
The Central authority (Government) affects the circular flow both by withdrawing
income from it through taxes and by infecting income into it through their spending.
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Introductory Macroeconomics
Fig. 2.5 Circular flow of Income and Expenditure in a three-sector model (showing only
money flow)
(1)
The household receive factor income by supplying factor services to the firms, they
use the factor income to consume goods and services, to pay taxes to the government
and to save through the financial markets.
(2)
Firms receive revenue from the sale of goods and services and use it to pay for the
factors of productions, and to pay business taxes to the government.
(3)
Both households and firms borrow in financial markets to buy investment goods, such
as houses and factories.
(4)
The government receives revenue from taxes and uses it to pay for government
purchases and transfer payments.
(5)
In case, the tax revenue of the government is greater than government purchases, the
government will have a budget surplus and is termed as public savings. However, if
tax revenue is less than government purchases the government will have a budget
deficit (and negative public savings).
Thus, the circular flow of income and expenditure takes place as long as the leakages =
injection. The circular flow binds the various segments and its different units together and
keeps the system moving without any interference or regulation.
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Summary
•
The GDP is the country's total income or the total expenditure on its output of goods
and services.
•
In the computation of the GDP only the value of the currently produced goods and
services is included where the goods are valued at market prices.
•
The real GDP is a better measure of economic well-being than the nominal GDP.
•
GNP is the total value of final goods and services produced in the economy during a
year plus net income from abroad.
•
NNP is GNP – (Minus) Depreciation
•
Personal income is total income received by individuals in a year.
•
Personal disposable income amounts to personal income minus direct taxes, fines,
fees, etc. paid to the government.
•
All economic transactions in an economy generate two kinds of flows–real flow and
money flow.
•
Real flow and money flow moves in circularity but in opposite direction.
•
The magnitude of real flows and money flows determines the size of National Income
in an economy.
2.6 SELF-ASSESSMENT QUESTIONS
1. What is the GDP? How can GDP measures two things at once?
2. How is the Gross Domestic Product computed? What is the treatment given to
inventories, intermediate goods and housing services in the computation of the GDP?
3. Distinguish between real and nominal GDP? Nominal GDP is a better measure of
economic well-being. Do you agree?
4. Write a short note on the following:
(a) Gross National Product (GNP)
(b) Net National Product (NNP)
(c) Disposable Income (DI)
(d) GDP Deflator
(e) Uses of Private Saving
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Introductory Macroeconomics
(f)Nominal Versus Real interest rate
5. What are the different components of Expenditure? What is the significance of these
components in national income accounts?
6. What are the adjustments required to be made to the national income lo arrive all the
personal income? Discuss.
7. Explain the circular Now of income in a two-sector economy.
8. Explain are the circular flow of income in a three-sector economy.
Self-Check Exercise
Compute all the product and income aggregates shown in the chart and also personal and
disposable incomes from the four sets of data given below which relate to India’s national
incomes for the years 1980-81 to 1983-84. The figures are in crores of rupees.
COMPONENTS
1980-81
1981-82
1982-83
1983-84
1.
Indirect taxes (net of subsidies)
13905
16914
19175
21357
2.
Undistributed profits of the private corporate sector (net of
retained earnings of foreign enterprises)
1188
1034
1039
961
3.
Capital consumption
8103
9797
11473
13448
4.
Corporate profits tax
1377
1970
2184
2493
5.
Net fixed capital formation
17106
19986
23446
27113
6.
Change in stocks
6248
6446
5557
6694
7.
Property and entrepreneurial income accruing to the
government
2135
2409
3352
3231
8.
Net factor income from abroad (ROW)
+ 298
(-) 7
(-) 681
(-) 991
9.
Exports minus imports
(-) 4574
(-) 4560
(-) 4138
(-) 4374
10.
Savings of non-departmental enterprises
116
1046
1560
1476
11.
National debt interest
1490
1873
2675
3696
12.
Private consumption
89775
102404
112730
134609
13.
Government consumption
13033
15276
18016
20788
14.
Statistical discrepancy
(-) 2238
(-) 1665
(-) 1948
(-) 4217
15.
Other current transfers from the government
2835
3370
4009
4640
16.
Labour income from abroad (net)
(-) 29
(-) 18
(-) 62
(-) 63
17.
Labour income from domestic production
43029
49093
56248
64893
18.
Operating surplus from abroad (net)
327
11
(-) 619
(-) 928
19.
Operating surplus from domestic production
17336
21558
25083
27668
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B.A.(Hons.) Economics / B.A.(Programme)
20.
Other current transfers from abroad
2257
2221
2527
2774
21.
Mixed income of self-employed
45080
50022
53157
66695
22.
Direct taxes paid by the households
2500
2881
3129
3367
1980.81
1981.82
1982.83
1983.84
ANSWERS
Name of the Product / Income Aggregate
1.
Gross National Product at Market
127751
147677
16445
193070
2.
Gross Domestic Product at Market Prices
127453
147684
165136
194061
3.
Net National Product at Market prices
119648
137880
152982
179622
4.
Net Domestic Product at Market Prices
119350
137887
153663
180613
5.
Gross National Product at Factor Cost
113846
130763
145280
171713
6.
Gross Domestic Product at Factor Cost
113548
130770
145961
172704
7.
Net National Product at Factor Cost
105743
120966
133807
158265
8.
Net Domestic Product at Factor Cost
105445
120973
134488
159256
9.
Gross National Income at Market Prices
127751
147677
164455
19307
10.
Gross Domestic Income at Market Prices
127453
147684
165136
194061
11.
Net National Income at Market Prices
119648
137880
152982
179622
12.
Net Domestic Income at Market Prices
119350
137887
153663
180613
13.
Gross National Income at Factor Cost
113846
130763
145280
17173
14.
Gross Domestic Income at Factor Cost
113548
130770
145961
172704
15.
Net National Income at Factor Cost
105743
120966
133807
158265
16.
Net Domestic Income at Factor Cost
105445
120973
134488
159256
17.
Personal income
107509
121971
134883
161214
18.
Disposable Personal Income
105009
119090
131754
157847
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Introductory Macroeconomics
LESSON-3
NATIONAL PRODUCT/NATIONAL INCOME
STRUCTURE
3.1
Introduction
3.2
National Product (NP)/National Income (NI)
3.3
Classification of The Product Aggregates According to Basis of Valuation
3.4
From National Product to National Income
3.5
Different Product/ Income Aggregates and Their Inter-Relationship
3.6
Changes in Prices: Nominal and Real National Income
3.7
Measurement of National Income
3.8
Different Methods of Measurement
3.9
The Income Method
3.10
The Expenditure (or Final Products Method)
3.11
National Income and Economic Welfare
3.12
National Income Estimation on India
3.13
Difficulties in Measurement of National Income in India
3.14
National Capital: Concept and Measurement
3.1 INTRODUCTION
NP/NI is a single measure (in monetary terms) of the flow of final goods and services that
accrues to the normal residents of a country as the result of their production efforts during a
year, (whether carried out at home or abroad), without adversely affecting the initial capital
stock of the country.
3.2 NATIONAL PRODUCT (NP)/NATIONAL INCOME (NI)
National Product (NP)/National Income (NI) basically is the measure (in monetary
terms) of the total amount of goods and services produced by the normal residents of a
country during a given period. The diverse types of goods and services which comprise NP
/NI cannot be added together into a single meaningful aggregate except by converting them in
money values by multiplying various quantities with the respective prices. Here money acts
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merely as the unit of account (i, e, as the measuring rod of value) and not as wealth. The
expression of NP NI in monetary terms should not blind us to the quantities of goods and
services that the money values represent. Whenever we talk of the NP /NI of a country we
always refer to the aggregate of goods and services produced during a given period. For
example, when we say that during 1984-85 India's NP /NI was Rs. 1, 97,515 crores, this
simply means that goods and services worth so much accrued to India as the result of the
production efforts of its residents during that year. This aggregate of Rs. 1,97,515 crores
consisted of (a) Rs. 1,45,327 crores worth of consumer goods and services supplied to the
households, (b) Rs. 24,062 crores worth of goods and services used by the govt. for providing
collective services to the people, (e) Rs. 28,974 crores worth of durable use capital goods and
another Rs. 8,016 crores worth of stocks (raw-materials, semi-finished goods, goods in
process, etc.) accumulated by business enterprises, households and the government, and (d)
goods and services worth Rs. (-) 6,447 crores exported to other countries. Net exports were
negative because during the year in question imports exceeded exports by Rs 6,447 crores.
Thus, the basic thing to remember about NP INI concept is that it always refers to the
quantities of goods and services produced during a given period and money is used merely as
the unit of account.
3.1.2 Second, NP /NI
Second, NP /NI is a flow Production is a process which generates goods and services over a
period. Without time period there cannot be any production nobody speaks of output at a
point of time. Being a flow, production can be measured only for different periods of time.
The unit of time for the measurement of NP /NI is generally one year.
3.1.3 Third, Np /Ni
Third, NP /NI measures goods and services which accrue to a country only as the result of
its production efforts and it excludes all goods and services received otherwise. Goods and
services can be received by a country as gifts or as aid from other countries or by the use of
force as reparation, through piracy, etc. These are not included in the NP /NI measure
Marshall aid given to countries during the post-world-war Il period or goods received through
U.N. agencies or from other countries are examples of international gifts or aid. It also does
not include goods and services produced illegally. NP /NI measures only the goods and
services accrued as the result of the production efforts of the normal residents of a country
and not the availability of goods and services as such.
Production refers to the complex of human activities concerned with the creation, with
the aid of scarce human and material resources, of good and services capable of satisfying
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Introductory Macroeconomics
human wants, directly and goods that aid their production, having determinable economic
price or cost. This concept of production is known as the comprehensive production concept.
This concept underlies the view of NP /NI in capitalist countries. This view has been
sanctified by the United Nations and also adopted by India.
National income, according to this concept, includes the following first two categories of
goods and services and excludes those mentioned under the third category.
I. Goods and Services Produced by the Market Economy
All goods and services produced for sale by private and public enterprises (small or big)
including current services of dwellings are included in NP NI and evaluated at their market
prices.
II. Goods and Services Produced by the Non-Market Economy
A. Foods and other goods produced on the farm for farmer's self-consumption are
included in national income and evaluated at their market prices. Rental values of
owner-occupied houses and all payments in kind for current services are evaluated
on the basis of their market prices.
B. Goods and Services supplied free by government and non-profit institutions are
included in NP /NI and evaluated on the basis of their cost
III. Goods and Services Excluded from NP /NI
A. Unpaid services of housewives and other members of the family including selfservices (e g; shaving, dressing, driving own car, etc.), other "do-it-yourself hobbies"
(eg, gardening, carpentering, painting, singing etc.), neighbourly advice and
cooperation and social services of all kinds are excluded from national income
B. Current services of consumer durables, properties of the government and non-profit
making institutions are excluded from NI.
3.1.4 Four, not all goods and services produced during a year are included in
NP/NI measure
It includes only the final goods and services produced during a year and excludes all goods
and services used up in the production of the former. In other words, NP /NI includes only
the goods and services that finally emerge out of the year's production process and excludes
all those used up as materials or ingredients of other goods-i.e., intermediate consumption.
For example, NP /NI measure includes only the value of bread and not also the materials and
services that have gone into the production of the bread. In NP /NI accounting, final goods
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are not to be confused with finished goods. Here the word 'final' only signifies the fact that
the goods in question have not been used up in the production of other goods during the year.
When a good or service is used up in the production of another good, the value of the former
gets incorporated into the latter. The former simply ceases to exist. Therefore, counting the
final good as well as the goods (and services) that have been used up as materials in the
production of the former as the year's production, would be double counting.
For measuring NP /NI the period of accounting is one year. Therefore, the question
whether goods are final or intermediate has to be settled with reference to the accounting
period. Goods used up in production during the year are intermediate goods and goods not
used up in the year's production process are final goods. Whether goods produced during a
year are used as final goods or as materials for the production of other goods during
subsequent years is not relevant. From the standpoint of the current year if cement produced
during the year is not used up in the production of other goods during the same year, it is a
final good even if it is used up as an intermediate good in the construction of a bridge during
any subsequent year. On the other hand, if cement produced has been used up in the
construction of a building during the same year, it is an intermediate good Its value having
been incorporated into the building, it will not be included in NP /NI again. Thus, counting
the final goods as well as the intermediate goods used up in their production would be double
counting. This is the real significance of the distinction between 'final' and 'intermediate
goods in national accounting.
The goods and services worth Rs. 1,97,515 crores referred to as India's NP /NI during
1984-85 were the goods and services made available to the final users -consumers,
government, investors and foreign countries and did not duplicate the values of the goods and
services used up in their production during the year.
3.1.5 Five, NP /NI is the aggregate measure of the goods and services produced during
the current year only and do not include any element or past production
Obviously, old goods (like, old houses, old cars, refrigerators, T. V sets, etc). produced
in some past period cannot be counted in current year's production. Doing so would be
double counting. Secondly, durable-use capital goods, which aid production for a number of
years, are an embodiment of the country's production efforts in the past. As a result of their
use in production their productive efficiency diminishes, i e; they depreciate. This
depreciation of capital goods in production is also known as capital consumption. The part of
capital goods consumed (or used up) in current production represents a claim of past
production over current production. The value of the capital goods used up in current
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Introductory Macroeconomics
production gets incorporated into the value of the mat put produced during current period.
Thus, a part of the newly produced capital goods has to be viewed as a replacement of those
used up in production during the current year. Therefore, to get true or net measure of what a
country has actually produced during a year we must deduct capital consumption from the final product of the year. The final product net of depreciation, known as the net national
product (NNP), is the true measure of the final goods and services accrued to the country as
the net result or its current production efforts, without adversely affecting the country's initial
capital stock.
However, the conceptual issues and the difficulties involved in the measurement of
capital consumption are insurmountable and allowances actually made for this purpose are
generally based on considerations other than economic logic Economists, therefore, prefer to
present NP / NI in gross as well as net terms. Final product without deducting capital
consumption is known as gross national product (GNP) and final product net of capital
consumption is known as net national product (NNP). Thus, we have net and gross versions
of NP /NI -NNP and GNP. Rs. 1,97,515 crores were the NNP and Rs. 2,12,914 crores were
the GNP of India during 1984-85, the difference between the two figures (Rs. 15,399 crores)
being the amount of capital consumption during that year.
3.1.6 Six, National Product is the measure of the result of production by normal
resident of a country
Six, NP /NI is the measure of the results of the production efforts of the normal residents
of a country, whether these production efforts are carried out at home or abroad. In other
words, the concept of NP /NI is the measure of production due to national resources,
irrespective of where this production takes place on the other hand, there is a territorial
concept of production, according to which whatever production takes place within the
territorial boundaries of a country, irrespective of who participated in this production and to
whom the product belongs, is known as the country's domestic product.
What is the relationship between these two concepts of production? Let us first imagine a
country which has no economic relations with other countries in the sense that neither it
permits foreign productive resources to engage in production on its territory nor does it
permit its own resources to participate in the domestic production of other countries. It is
evident that whatever production takes place within the territorial boundaries of such a
country will be entirely the result of its own productive resources. Therefore, the domestic
product (DP) of such a country will also be its national product (NP). However, in today's
world, it is difficult to find such a county Normally, productive resources of most countries
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participate in each other's domestic production, though the degree of this participation varies
widely among different countries. As a result, a part of the DP of such countries belongs to
foreigners as the reward for the factor services rendered by them. On the other hand, such
countries may also have similar counterclaims over several other countries.
Even in such a case, if the factor incomes payable by a country to the Rest of the World
(ROW) exactly equals factor incomes receivable by it from the ROW, its NP will still equal
its DP. However, if the factor incomes receivable from and factor incomes payable to ROW
are different, as is normal, NP must be different from DP. If a country's factor incomes
receivable from the ROW are greater than the factor incomes payable by it to the ROW, its
net factor incomes from ROW will be positive and as a result its NP will exceed its DP by the
same amount On the other hand, if factor incomes payable by a country to the ROW exceed
factor incomes receivable by it from the ROW, the net factor incomes of the country from the
ROW will be negative and as a result its NP will fall short of its DP by this amount. Thus;
GNP = GDP plus net factor income from ROW (Rest of the World)
NNP = NDP plus net factor income from ROW (Rest of the World)
Let us note that while the amount of capital consumption accounts for the difference
between the gross and net concepts of NP as well as DP, the amount of net factor income
from the ROW accounts for the difference between the concepts of National Product and
Domestic Product. Thus;
NNP = GNP minus Depreciation
NDP = GDP minus Depreciation
GNP = GDP plus net factor income from ROW
NNP = NDP plus net factor income from ROW
During 1984-85 India's GDP was Rs. 2,14,385 crores. During the same year Rs. 2,073
crores were payable by India to ROW as factor income (that is Rs. 113 crores as
compensation of employees and Rs. 1,960 crores as property and entrepreneurial income),
while it claimed only Rs. 602 crores as factor income from ROW. In other words, during
1984-85, India's net factor income from ROW was (-) Rs. 1,471 crores. Consequently. India's
GNP (= GDP + net factor income from ROW) was Rs. 2,12,914 crores. (= Rs. 2,14,385 + (-)
1,471 = 2,12,914), while NNP amounted to Rs. 1,97,515 crores (= 1,98,986 + (-) 1,471 =
1,97,515).
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Introductory Macroeconomics
Besides labour income, factor incomes earned abroad include (a) profits derived from the
operations of branch plants and offices abroad, and from the ownership of foreign
subsidiaries, (b) dividends from the ownership of foreign stocks, (c) interest on foreign
(government and private) bonds, foreign mortgages and saving accounts, and (d) rents and
royalties from foreign properties and rights.
Summary
1.
NP is basically a measure of goods and services produced and money is used merely
as the unit of account to add them together into a meaningful aggregate,
2.
It is a measure of goods and services accruing to a country only as the result of
production and excludes goods and services received otherwise.
3.
It is a measure only of the final goods and services produced and does not duplicate
the values of the intermediate goods and services used up in their production.
4.
NP, being a measure only of currently produced goods and services, does not include
any element of past production either in the form of old goods or in the form of
capital consumption Thus, NNP is the real measure of the country's current
production. However, because of the conceptual issues and practical difficulties
involved in the measurement of capital consumption, economists prefer to present NP
in gross as well as net terms. Thus, we have two basic concepts: GNP and NNP.
Finally, NP is the measure of goods and services produced by the country's national
resources, irrespective of where they work, at home or abroad. NP, therefore, equals DP plus
net factor income from ROW.
Thus, we have four product aggregates distinguished on the basis of inclusion or
exclusion of (1) net factor income from ROW (National and Domestic Products) and (2)
Capital consumption (Gross and Net Products).
II
3.3 CLASSIFICATION OF THE PRODUCT AGGREGATES ACCORDING TO
BASIS OF VALUATION
3.3.1 Market Prices and Factor Cost Valuation Basis
Goods and services which constitute any national or domestic product aggregate have
necessarily to be valued in terms of market prices in order to add them together into a
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meaningful aggregate. However, market prices of most goods and services include taxes such
as sales fax, excise duties of various types, custom duties, property taxes, etc. Such taxes,
which are collected from or through sellers and which can be shifted to the buyers through
higher prices, are known as indirect taxes. Taxes of this type do not affect the size of incomes
directly. They affect incomes only indirectly through their price-increasing effect-by reducing
the purchasing power of money.
3.3.2 When taxes are levied on the sale or production of goods, their market prices rise. The
tax part of market prices is collected by the government and the rest accrues to the producers
as factor incomes. Thus, NP valued at market prices actually paid by the purchasers in higher
than what accrues to producers as factor incomes by the amount of indirect tax revenue
collected by the government. As a result, we have two alternative valuations of the product
aggregates, one in terms of market prices paid by the purchasers (which include indirect
taxes) and the second, in terms of factor incomes (i.e., market prices excluding indirect
taxes). Any product aggregate NP or DP. valued at market prices, states the value of the
product aggregate in question from the viewpoint of the purchasers while the same product
aggregate valued at factor costs or factor incomes, states its value from the standpoint of the
producers what it costs them in terms of factor incomes.
3.3.3 Government also grants subsidies to enable producers to sell certain goods below their
factor costs. Consequently, market prices of the subsidised goods are lower than their factor
costs. Subsidies thus act like negative indirect taxes. However, the amount of subsidies paid
in any economy is normally much less than the total revenue from indirect taxes. As a result,
indirect tax revenue net of subsidies is always positive. Therefore, all the gross and net
national and domestic product concepts have two alternative valuations, one at market prices
and the other in terms of factor incomes or factor costs. The amount of indirect taxes net of
subsides (-net indirect taxes) is the difference between the two alternative valuations of any
product aggregate. For example, India’s GNP at market prices during 1984-85 was Rs.
2,12,914 crores. During the same year government’s revenue from indirect taxes amounted to
Rs. 30,692 crores and subsidies paid by the government amounted to Rs. 7,195 crores. In
other words, the amount of net indirect taxes (i.e... net of subsidies) came to Rs. 23,497
crores. Accordingly, India’s GNP at factor cost during the year amounted to Rs. 1,89,417
crores (i.e., 21,914 – 23,497 = 1,89,417) Similarly, by deducting the amount of net indirect
taxes from any product aggregate valued at market prices we can derive the corresponding
product aggregate valued at factor cost. Thus, we have four product aggregates valued at
market prices – GNP, NNP, GDP and NDP and their four counterparts valued at factor cost.
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Introductory Macroeconomics
III
3.4 FROM NATIONAL PRODUCT TO NATIONAL INCOME
3.4.1 In out discussion so far we have been using the terms 'product' and 'income'
interchangeably. The reason for this is very simple. In a modern economy instead of
rewarding factors for their contributions in kind they are paid in money. Only in a few cases,
the output produced is itself shares among the participants in production, for example, a part
of the wheat produced on the farm is consumed by the farmer's family or given to farm
labourers in lieu of or in addition to 'money wages. The normal practice, however, is to
reward participants in production in terms of money incomes, rather than in kind. 3.2 In
section 2, we have explained in detail how (1) gross value added by a production unit gets
disbursed into capital consumption allowances, indirect taxes and factor incomes (that is,
wages, rent interest and profits). (2) the sum of the gross values added by all the production
units located in a country equals GDP, and (3) the sum of the factor incomes, the capital
consumption allowances and indirect taxes disbursed by all the production units equal GDI.
Therefore, each of the eight product aggregates has an income counterpart which details the
disbursement of receipts from sale, actual or imputed, into factor incomes, capital
consumption allowances and indirect taxes. Thus
AT MARKET PRICES
AT FACT OR COST
GNI Obverse of GNP
GNI obverse of GNP
NNI Obverse of NNP
NNI obverse of NNP
GDI Obverse of GDP
GDI obverse of GDP
NDI Obverse of NDP
NDI obverse of NDP
IV
3.5 DIFFERENT PRODUCT / INCOME AGGREGATES AND THEIR INTERRELATIONSHIP
3.5.1 Gross and Net National Product / Income Aggregates
GNP is the aggregate value of all final goods and services accrued to a country as the
result of the production efforts of its residents in the course of a year. GNP is a gross measure
of current production of the country because it includes consumption of fixed capital. Capital
consumption is a measure of the part of fixed capital equipment used up in current
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B.A.(Hons.) Economics / B.A.(Programme)
production. In other words, capital consumption is an estimate of the amount of capital goods
that should be replaced in order to keep the country's capital stock intact. NNP is the measure
of the final goods and services produced while keeping the country's capital stock intact.
Thus, NNP = GNP minus capital consumption.
All product aggregates, (national, domestic, gross or net, whether valued at market
prices or at factor cost) have their income counterparts. Gross national income is the income
counterpart of GNP and net national income is the income counterpart of NNP.
Gross And Net National Product / Income Aggregates - At Market Prices and At Factor
Cost
3.5.2 Market prices of most goods include taxes known as indirect taxes. Such taxes raise
market prices. The tax part of sale proceeds accrues to the government and the rest accrues as
factor incomes. As a result, we have two alternative bases of valuation of the product
aggregates, one in terms of market prices including indirect taxes, and the other in terms of
factors incomes. The amount of indirect taxes net of subsidies is the difference between the
two valuations; one includes this amount while the other excludes it. Thus, we can convert
any product/income aggregate valued at market prices into the corresponding product/income
aggregate valued at factor cost simply by deducting the amount of net indirect taxes (that is,
net of subsidies) from the former National Versus Domestic Product/Income Aggregates
3.5.3 As already explained in para 16 above, net factor income from abroad is the
difference between any national and the corresponding domestic product/income aggregate.
By adding net factor income from abroad to any domestic product/income aggregate we can
derive the corresponding national aggregate. Net factor income from abroad may be positive
or negative. Therefore, national product/income may be smaller or larger than domestic
product /income. Summary.
3.5.4. 1.
We distinguish between 'gross' and 'net product and income aggregates,
(whether they are national or domestic aggregates and whether they are valued
in terms of market pries or factor cost) not the basis of capital consumption.
The gross aggregates include capital consumption while net aggregates
exclude it. Thus
NNP = GNP minus Capital Consumption
NNI - GNI minus Capital Consumption
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Introductory Macroeconomics
2.
All product and income aggregates that is, gross or net and national or
domestic) can be valued either in terms of market prices or in terms of factor
cost. The amount of indirect taxes net of subsidies is the difference between
the two valuations. Thus
GNP at factor cost = GNP at market prices minus net indirect taxes
NNP at factor cost = NNP at market prices minus net indirect taxes
Valuation at factor cost is possible only at the level of the economy as a whole. It
cannot be applied to individual goods and services,
3.
Net factor income from abroad is the difference between any national and the
corresponding domestic product or income aggregate, whether gross or net,
and whether valued in terms of market prices or factor costs
Thus
GNP = GDP plus net factor income from abroad
NNP = NDP plus net factor income from abroad.
NNP at factor cost = NDP at factor cost plus net factor income from abroad,
B. Other Income Aggregates
Personal Income
3.5.5 All measures of national or domestic products, net or gross, valued at market prices or
at factor cost, discussed thus far are measures of the current productive achievements of a
country. Personal income and disposable income are not measures of current production.
These are simply the current incomes of persons as direct from factors. Personal income is
simply the spendable income available to individuals before payment of personal taxes. Its
relation to National Income (at factor cost) is as indicated below:
Net national Income (at factor cost),
That is National Income
=
Rs. 1,74,018 crores
Deductions
Additions
(1) Undistributed points of = Rs. 1,200 crores
private corporate sector
(net of retained earnings of
foreign enterprises
(1) National debt = Rs. 4,952 crores
interest
(2) corporation profits tax
(2)
government
transfers
= Rs. 2,556 crores
Other Rs. 5,729 crores
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(3) Entrepreneurship and Rs. 4,391 crores
property income accruing
to govt.
(3)
transfers
ROW
Current = Rs. 1,301 crores
from
(4) Savings of non- = Rs. 2,128 crores
departmental enterprises
Total deductions
= Rs. 10,275 crores
Total additions
= Rs. 13,782 crores
Thus, Personal Income equals Rs. 1,74,018 crores plus Rs. 13,782 crores minus Rs.
10.275 crore = Rs. 1,77,525 crores.
DISPOSABLE INCOME
3.5.6 Disposable Income in simply after-tax personal income. It is known as disposable
(personal) income because all tax liabilities having been met, the balance can be disposed of
according to the preferences of the income owners. Out of the disposable income, the amount
not spent on consumption constitutes saving
During 1984-85 personal income amounted to Rs. 177525 crores. Out of this
government's direct tax revenue from households was Rs. 3238 crores and the government
also realised another Rs. 866 crores as miscellaneous charges. By deducting these two
amounts from personal income we get disposable income equal to Rs. 173421 cores.
PER CAPITA INCOME
3.5.7 Per capita income is the average income which every resident of a country could get if
the total national income was distributed equally among all the inhabitants. For the year
1984-85 per capita GNP at factor cost was Rs. 831.2 and per capita NNP at factor cost was
Rs. 774 6 in terms of 1970-71 prices.
V
3.6 CHANGES IN PRICES: NOMINAL AND REAL NATIONAL INCOME
3.6.1 Goods and services which constitute any national or domestic product aggregate have
necessarily to be valued in terms of market prices in order to add them together into a
meaningful aggregate. But due to changes in the market prices over time valuation in terms of
market prices creates a problem. As a result of changes in market prices, the real magnitudes
of goods and services represented by product aggregates of different years, cannot be
compared unless they are revalued in terms of the prices of the same year. For example, GNP
at current prices (i.e., market prices prevailing during the year in question) was Rs. 39979
crores during 1970-71 and Rs. 212914 crores during 1984-85. Thus, at current market prices,
GNP of 1984-85 was more than five times the GNP of 1970-71. Does this increase of 198448 | P a g e
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85 GNP really represent a corresponding increase in the quantities of goods and services?.
The answer is in the negative because prices of most goods and services during 1984-85 were
more than 3 times the prices of 1970-71. We cannot ascertain the extent of increase in the
quantities of goods and services unless we neutralise the effect of the increase in the general
level of prices. With 1970-71 as the base year (i.e., price index 1970-71 = 100), the price
index during 1984-85 was around 315. In order to make the 1984-85 GNP figure comparable
with that of 1970-71, we deflate the 1984-85 GNP figure of Rs, 212914 crores on the basis of
the price index (by dividing the GNP by 315/100). Thus deflated the 198485 GNP figure
shrinks to Rs. 67582 crores which is only 70% higher than the 1970-71 GNP. In this way, we
can deflate any product aggregate and convert it into its constant prices counterpart
VI
3.7 MEASUREMENT OF NATIONAL INCOME
Economic Basis of Different Methods
3.7.1 The production organisation in the modern world is an extremely complicated affair
Specialisation in production has been carried very far. Today no single producer can claim to
have produced the simplest of things entirely by his own efforts. The production of even an
ordinary things like bread consists of a lengthy process involving the productive contributions
of a large number of production units on its way to the finished state. And within each
production unit the production process is further broken down into several operations and
each operation assigned to a specialist worker and/or a machine. Who produced the bread that
you ate at breakfast? Apparently, the baker but in reality, besides the baker, many other
producers made their productive contributions at different stage of production before the
bread finally emerged at your dining table. The baker must have purchased the flour used for
baking bread from some miller. The miller. in turn, must have purchased the wheat from
some store. The store owner, surely, must not have grown the wheat himself. He must have
purchased it from some farmer and transported it to his store. The farmer too cannot claim to
have produced the wheat entirely by his own efforts, simply because he must have purchased
fertilizers, seeds, insecticides etc from other producers He must have also used some
implements for ploughing. irrigating, harvesting, threshing, etc. Evidently, the end product
(i.e., the final product) of this lengthy and roundabout production process is the bread, and
not the wheat, the flour and a number or other ingredients used up in its production. None of
the production units can claim to have produced the bread entirely by its own efforts. It
incorporates the productive contributions of all the production units involved in the process.
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3.7.2 A simple example will prove helpful in clarifying this point. Suppose a wood supplier
sells wood worth Rs. 1000/- to a bat maker. The bat maker turns the wood into bats and sells
the same for Rs. 2000/- to a wholesaler the wholesaler in turn, sells the same bats for Rs.
2500/- to a retailer. Finally, the retailer sells them for Rs. 3000/- to final users. Evidently, the
end product of the whole process are bats worth Rs. 3000/- and not the wood, the bats made
by the manufacturer and the bats sold by the wholesaler and the retailer Secondly, the final
product-the bats worth Rs. 3000/- sold to the consumers incorporates the productive
contributions of all the production units involved. Assuming that at the very beginning of the
production process the wood supplier purchases nothing from other production units so that
Rs. 1,000/- worth of wood is the result entirely of his own efforts, the following table
presents the productive contributions of the different production units involved in the process.
Production Unit
Value of Gross
Output
Value of goods and
services purchased
from other
production Units
Gross value added
by the Production
unit
Wood Supplier
Rs. 1000
Nil
Rs. 1000
Bat maker
Rs. 2000
Rs. 1000
Rs. 1000
Whole seller
Rs. 2500
Rs. 2000
Rs. 500
Retailer
Rs. 3000
Rs. 2500
Rs. 500
Total
Rs. 8500
Rs. 5500
Rs. 3000
The end product of the whole production process are bats worth Rs 3000/- and this is
the result of the productive contributions of the four producers, the wood-supplier, the batmaker, the wholesaler and the retailer. Thus, value of final product must equal the sum of the
productive contributions of all the production units involved in the production process. Gross
value added by a production unit measures its productive contribution Therefore, the value of
the final product must equal the sum of the gross values added by all the units involved in the
production process.
3.7.3 For carrying out its activities each production unit employs basic factors of production
(natural resources, capital, labour and entrepreneur) and pays them for their productive
contributions in terms of money incomes. The output turned out by a production unit is called
"gross output" It is called "gross" because it also incorporates the value of the "intermediate
products" purchased from other production units. Net output of a production unit equals the
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Introductory Macroeconomics
value of its gross output minus the value of the intermediate products used up in production.
Net output is the production unit's productive contribution. Net output is also known as
"gross product" or "gross value added". It is gross because it includes consumption of capital
equipment caused in the process of producing the output. Gross product or gross value added
of a production unit gets disbursed into factor incomes and some non-factor payments as
shown below in the Income and Product statement of an imaginary production unit for one
year.
Income and Production Account Income
Product 1. Indirect taxes minus
Income
Product
1. Indirect taxes minus
= Rs.
20,000 1. Sales
= 470,000
2. Capital Consumption
= Rs.
25,000 2. Net change in inventories
= + Rs. 30,000
3. Factor Incomes
* Wages & Salaries = Rs.
including social security
contributions
1,50,000 equals
= Rs. 500,000
3. Current production
•
Interest
= Rs.
15,000
•
Rent
= Rs.
7,500 Minus
= Rs. 200,000
4. Intermediate consumption
•
Corporate profits = Rs.
tax
22,500
•
Dividends
= Rs.
22,500
•
Retained profits
= Rs.
20,000
= Rs.
300,000 Net output/gross product = Rs. 300,000
Gross Value added
Gross Income
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3.7.4. Gross Value Added (Or Gross Product), which equals gross output (i.e., sales plus net
change in inventories) minus intermediate consumption, gets disbursed into two broad types
of income, those relating to factors of production and the rest. Wages and salaries (including
social security contributions), interest, rent, profit (which includes dividends, retained profits
and corporate profits tax) and mixed incomes of the self employed relate to factors of
production and represent "income originating" Indirect taxes net of subsidies and business
transfer payments (i.e., bad debts and charities) are non-factor payments not necessary to
enlist the services of factors. These are non-factor costs of production Deprecation is a
provision for merely replacing the worn-out or obsolete capital goods.
Thus:
Gross Product/Gross
Value Added
Indirect taxes
=
Plus
Depreciation
Plus
Factor Incomes
3.7.5 If we prepare income and product statements for all the production units in the
economy and consolidate them into a single statement, we will find that the sum of the gross
values added equals the value of the final product and sales and purchases of intermediate
products between different production units within the country get cancelled.
3.7.6 You are already familiar with an income and product account. An income and product
account are designed to indicate a firm's contribution to current production and its income
payments out of that production. An input-output table can be used to consolidate the income
and product accounts of a number of production units into a single account. The advantage of
an input-output table lies in the fact that the purchases and sales of intermediate products,
which are consolidated in an income and product statement, are presented in it on a 'from
whom to whom' basis. Car purpose is to show that within the country purchases and sales of
intermediate products by different production units necessarily cancel out leaving only final
product.
3.7.7 With the help of an input-output table we can present the income and product
accounts of a number of production units (or industries or sectors) with purchases of inputs
and sales of output in greater details. Each production unit (firm, industry or sector) is
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Introductory Macroeconomics
allotted one column and the corresponding row. The row gives a breakdown of the sales of
output (a) to other production units on current account (as intermediate inputs) and (b) to
final users (households, government, exports or accumulation). The column on the other
hand, gives a breakdown of inputs (a) purchased from other production units and (b) the
primary inputs
3.7.8 Let us suppose that there are only 5 production units, A, B, C, D and E engaged in the
production of five different goods needed for final uses as well as intermediate uses. The
table below presents by hypothetical data to prove the following two points,
(1)
Gross value added by each production unit gets disbursed as factor incomes,
depreciation and indirect taxes
(2)
At the level of the economy as a whole the sum of the gross values added by
all the production units equals the value of the final output, though this
equality may not hold at individual levels
3.7.9 Column 1 and row I provide details of A's sale of output and purchase of inputs
Column 1 shows that A purchased intermediate products worth Rs 27 lacs from other
production units and produced output worth Rs. 60 lacs (1.c., output worth Rs 20 lacs sold as
intermediate inputs to other production units and output worth Rs. 40 lacs sold to final
demand). In other words, gross value added by A amounts to Rs 33 lacs (i e value of gross
output minus intermediate consumption). Similarly, gross values added by B.C D and E are
Rs 84 lacs, Rs 94 lacs, Rs 42 lacs and Rs. 47 lacs respectively. It may be carefully noted that
while gross value added by a production unit and output sold by it to final demand are not
equal the sum of the gross values added by all the production units (i.e., 33 + 84 +94 + 42+
47 = 300) equals the value of the total final output. Sales of intermediate products by all the
units and purchases by them on the same account, being equal, cancel out Secondly, gross
value added by each production unit gets disbursed as factor incomes (i.e. wages, interest,
rent and profits), capital consumption and indirect taxes Thus we can measure aggregate final
output produced either (a) as the sum of the productive contributions (i.e. gross values added
or net outputs) of the production units engaged in production or (b) as the aggregate of the
goods and services made available to final uses or (c) as the sum of the factor incomes,
capital consumption and indirect taxes, etc. Therefore, we have three alternative methods
available for measuring NP, that is, the net output or the production method, the final
expenditures method and the income method.
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3.8 DIFFERENT METHODS OF MEASUREMENT
Net Output Method (The Production Method)
This method is also known is the value-added method or the production" method.
3.8.1 The final output of an economy is the result of the productive contributions of all the
production units that participate in the production process. The productive contribution of a
production unit is the gross value added by it to the raw materials or other goods and services
that it purchased from other production units. Similarly, the "gross value added" by an
industrial division equals the value of its "gross output" minus the cost of the raw materials or
other goods and services (-intermediate consumption-) purchased from other branches and
used up in production during the period. The net output method views GDP as the sum of
"net outputs" (or "gross values added") generated by all the industrial divisions in the
country.
3.8.2 The net output method essentially consists in (1) dividing the economy into broad
industrial divisions, (2) estimating the value of gross output produced by each division; (3)
estimating the costs of capital consumption and intermediate products used up in production
in each division, (4) calculating net product of each division by subtracting the value of
intermediate products used up in production and capital consumption from the value of gross
output; and finally (5) obtaining NDP by aggregating the net products of all the industrial
divisions. Classification of Industrial Divisions
3.8.3 The most prevalent divisions are agriculture, manufacturing industry, transportation,
trade, services of dwellings, professional and other services and government. However, these
divisions are variously combined with smaller divisions such as forestry, fishing, mining,
construction, communications, electricity, finance, real estate, or they may be variously
subdivided for example, for this purpose the Indian economy has been divided into the
following industrial divisions:
A.
The Primary Sector
1.
Agriculture and Allied Activities
2.
Forestry and Logging.
3.
Fishing
4.
Mining and Quarrying
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B.
C.
D.
E.
The Secondary Sector
5.
Manufacturing
6.
Construction
7.
Electricity, gas and water supply
Transport, Communications and Trade.
8.
Transport, Storage and Communications.
9.
Trade, Hotels and Restaurants.
Finance and Real Estate
10.
Banking and Insurance
11.
Real Estate, Ownership of Dwellings and Business Services
Community and Personal Services
12.
Public Administration and Defence
13.
Other Services
3.8.4 As the second step, the value of gross output of each sector is estimated. This can be
done either by computing from the production data the aggregate output of the branch and
then multiplying it by, appropriate prices or by directly collecting from business accounts
their gross sale proceeds and adding to it the value of the net change in their inventories. The
second method is suitable for the organised sectors while the first method has to be used in
unorganised sectors of the economy such as agriculture, cottage and small-scale industries,
mining, forestry, construction in the rural areas.
3.8.5 As the next step, we have to estimate the value of intermediate consumption (i.e.
materials and services used up in production purchased form other branches) and
consumption of fixed capital. The data on these costs are still less comprehensive than the
data on the gross value itself. For estimating intermediate consumption different methods are
used in different countries. In some countries the absolute amount of intermediate
consumption is somehow determined and deducted from the value of gross output to obtain
net output. In some other countries the ratio of intermediate consumption to the gross output
is determined on the basis of samples. This ratio is then applied to the gross output to obtain
net output.
3.8.6 Net output is also known as gross product. It is gross because it includes consumption
of fixed capital caused in the process of producing this output. Therefore, to get net product
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we have to deduct capital consumption from the gross product. For estimating capital
consumption different practices prevail. In USA and Canada rates of capital consumption are
defined by tax laws. The same rates are used in the compilation of national income.
Summation of Net Outputs
3.8.7 Having estimated the net output (gross product) of each branch, all these are
summated to obtain gross domestic product. In order to change GDP into GNP we have to
add net factor income from abroad. As already explained, net factor from abroad equals the
excess of factor incomes receivable from foreign countries over similar factor incomes
payable to foreigners. This may be positive or negative.
Conclusion
Thus, we get GNP by adding together the net outputs contributed by all the branches
of an economy plus net factor income from foreign countries.
3.9 THE INCOME METHOD
3.9.1 As explained above, the net output (or gross value added) of a production unit gets
disbursed into factor incomes and some non-factor costs of production. We have also shown
that the sum of the gross values added (or net outputs) by all the production units located in a
country equals Gross Domestic Product (GDP) and the sum of the factor incomes equals Net
Domestic Product at factor cost or simply as domestic income. The income method views
GDP as the sum of factor incomes plus nonfactor costs of production (i.e. net indirect taxes,
business transfer payments etc.) and depreciation. This method essentially consists in
aggregating all factor incomes generated in the economy during a year and then adding
capital consumption and net indirect taxes to get GDP
3.9.2 The major problem of this method is what to count as income. The key to this
problem is: Is the payment (in money or in kind) a reward for a factor's contribution to
current production? If the answer is in the affirmative, the payment qualifies to be included in
national income and if the answer is negative, the payment disqualifies to be so included.
On this basis the following items are included in NI
1.
Wages and salaries (which include bonuses, commissions, etc.), supplement to wages
(e.g., employer's contributions to various social security funds) and compensation in
kind.
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2.
Interest payments (including interest earned by insurance companies and credited to
insurance policy reserves and net interest paid by banks).
3.
Rent which includes net rents from land, buildings, etc, including imputed rents on
owner-occupied houses and royalties
4.
Profits-dividends, undistributed profits and corporate profits taxes, including profits
of government enterprises
5.
Mixed incomes which include profits of the self-employed (whether taken out or
retained in the enterprise) and their incomes in kind (e.g., farm products consumed by
the farmers, services of farm dwellings).
3.9.3 The following items do not satisfy the criterion of contribution to current
production and are therefore excluded.
1.
Transfer Payments (Government and Personal)
Government transfer payments include government interest, social security payments,
scholarships, unemployment relief, flood relief and a host of similar payments made for
considerations other than contribution to current production. Personal transfer payments
include gifts, inheritances, pocket allowances, etc. These go out of one pocket into another
but not for producing any output.
Business transfer payments (bad debts, charities, gifts, etc.,) along with indirect
taxes, while not factor incomes, are counted in national aggregates at market prices as
non-factor costs of production.
2.
Financial Transactions and Sales of Old Property (including land)
Sale and purchase of financial assets (e.g., stocks, bonds, mortgages, etc.,) are merely
transfer of claims. Changes in the ownership of assets do not produce anything and are
therefore excluded. However, commissions of real estate agents and broker are included in
the category of factor incomes because by bringing together the buyers and the sellers they
contribute to the flow of current services 3. Illegal Activities and Gambling
3.
Illegal Activities and Gambling
Illegal activities are not included in national income. Incomes of illicit distillers are
excluded while those of authorised distillers are included. The decision to do so is completely
arbitrary and not based on economic logic.
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Gains and losses from gambling are the purest example of transfers-out of one pocket
into another without any contribution to current production. The incomes of gambling dens
for providing their services to gamblers are also excluded from national income as illegal 4.
Subsidies
4.
Subsidies
Subsidies are negative indirect business taxes. As previously indicated, subsidies are a
part of factor incomes but not a part of the market value of goods and services. Consequently,
they are included in measures of national income based on factor costs but excluded from
measures based on market prices.
3.10 THE EXPENDITURE (OR FINAL PRODUCTS METHOD)
3.10.1 The net output method or the production method views NP as the sum of the
productive contributions (i.e., net outputs or gross values added) of all the production units
that participate in the production process. The income method measures NP in terms of the
factor incomes (and some non-factor payments) generated in the production process. The
expenditure method (or the final products method) measures NP by tracing the disposition of
the final goods and services (the goods and services not used up in production during the
year) that the economy in the end gets out of all its activity during the year.
3.10.2 As already explained, the output which is not used up in production must necessarily
be disposed of either for consumption during the year or for adding to the nation's capital
stock. Broadly speaking the sum total of consumption and investment equals GNP.
Consumption is generally divided into private consumption and public consumption. Private
consumption consists of all expenditures of households and non-profit institutions (-charities,
labour unions, associations, etc.) on (a) consumer durables excluding land and buildings, (b)
non-durables, (c) services including the value of goods and services received in kind and, (d)
purchase of government services by consumers. Public consumption consists of the current
expenditures of the public authorities on education, health, general administration, law and
order, defence, etc.
3.10.3 Investment is divided into three categories, namely, (a) domestic fixed capital
formation, (b) addition to stocks and, (c) net investment abroad. Fixed capital formation
consists of durable use capital assets (which last longer than a year) such as machines,
buildings, factories, roads, canals, land improvements, growth of live-stock, forests, etc. It
also includes changes in the amount of work in progress in case of heavy equipment or
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Introductory Macroeconomics
construction items. Investment in stocks includes changes in the stocks of raw materials,
semi-finished goods and even finished goods waiting to be sold. Net investment abroad
equals the surplus of exports over imports plus net factor incomes from abroad. The
aggregate value of these final products at market prices equals GNP.
3.10.4 GNP does not have to be equal to the expenditures by the nationals of the given
country simply because a part of the final products of the country may have been exported to
other countries, and conversely, the nationals of the country may have spent a part of their
incomes on foreign goods. Only rarely, when exports equal imports will the expenditure by
the nationals of the country equal its GNP. Thus, the expenditure total to which GNP is equal
is not expenditure by the nationals but the expenditure on NP which will obviously be equal
to expenditure by nationals plus expenditure on NP by foreign nations (i.e., exports) minus
that part of expenditure by nationals incurred on foreign products (imports).
VII
3.11 NATIONAL INCOME AND ECONOMIC WELFARE
The ultimate objective of all our economic efforts is to produce goods and services
needed by the people. NP attempts to provide a single meaningful measure, in monetary
terms, of the volume of goods and services produced by a country during a given year. An
increase in NP, other things remaining constant, implies increased availability of goods and
services to the people of the country. Normally, greater availability of goods and services in a
country is expected to raise the level of well-being of the people. In the present section we try
to answer the question: Is the NP measure a good indicator of economic welfare? Before we
proceed to answer this question, it would be desirable to distinguish between economic and
non-economic welfare.
Economic Welfare and Welfare in General
3.11.1 Human welfare is divided into two parts - (1) economic welfare and (2) non-economic
welfare.
Pigou defined economic welfare as that part of welfare which can be brought directly
or indirectly into relation with the measuring rod of money. Non-economic welfare is that
part of total welfare which is not amenable to monetary measurement.
3.11.2 Economists have always known that NP /NI was not a good measure of welfare in the
wider sense of the word, NP INI cannot be converted into meaningful indicator of total
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human welfare. Any number of things could make a nation better off without raising its
NI/NP, for instance, peace, greater brotherhood among the people, equality of opportunity,
more democracy, elimination of injustice and violence, and so on. It is obvious; therefore,
that NP /NI cannot be a measure of welfare in general.
NP/NI and Economic Welfare
3.11.3 Not to speak of total welfare, economists have many reasons why measured NP /NI
does not even provide a satisfactory indicator of what it is supposed to measure-i.e; economic
welfare. We will discuss these reasons under the following heads:
1.
Size of NP /NI and welfare.
2.
Distribution of NP /NI and welfare
3.
Composition of NP and welfare.
4.
Human costs of production and welfare.
5.
Other unresolved issues
Size of National Income and Economic Welfare
1.
Whenever, we talk of the size of NP /NI and its relationship to welfare, we invariably
have in mind the real NP (the volume of real goods and services) and not nominal (or
money) NP. An increase in the real NP NI would imply increased availability of
goods and services to the country. Larger the availability of goods and services to a
country higher will tend to be the standard of living of the people, other things
remaining constant. A doubling of money national income, without any increase in
the amount of goods and services available to the people, will not add anything to the
welfare of the people. Therefore, in the context of the welfare significance of NP/NI
we always have real NP / NI in mind.
2.
Many items that might be generally agreed to form part of economic welfare, have
been excluded from NP estimates on account of practical difficulties of estimation
Services of housewives, services rendered by members of the family to one another,
and a host of other do-it-yourself activities), current services of consumer durables,
etc., fall into this category. With economic development the task of furnishing them is
taken over by commercial establishments (commercial laundries, tailoring and
cleaning establishments, restaurants, etc.). When this happens, these activities get
included in NP estimates. As a consequence, measured NP increases but obviously
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without any effect on economic welfare. Therefore, exclusion of such services from
NP measure understates economic welfare actually enjoyed by the people,
3.
On the other hand, NP measure includes goods and services which really do not add
to welfare. Expenditure on defence is cited as one such example. Many economists
are of the view that an expansion in this area of spending means a reduction in
national welfare through the diversion of productive resources that could otherwise be
used to produce goods and services to satisfy the wants of the consumers.
4.
The distinction between intermediate and final products is crucial in connection with
the welfare significance of the NP measure. We have already explained that NNP
(i.e., GNP minus capital consumption) represents the true measure of the amount of
goods and services which the people can consume without adversely affecting the
country's capital stock. Therefore, as a measure of sustainable economic welfare we
are interested in NNP and not in GNP. However, the precise concept of 'capital
consumption' is a complex one on which there is no complete agreement and its
measurement in the form of depreciation allowances is not satisfactory.
5.
Apart from the complex problem of "capital consumption" there is far less agreement
on as to whether a considerable part of the goods and services produced are really
"inputs' into the productive system (i.e., intermediate products) or are 'output' of the
system. For example, many economists argue that large parts of public expenditure,
such as general administration, law and order, etc. are really 'intermediate products'
because without them the productive system cannot function the way it does.
Therefore, treating such expenditures as final products is double counting which
exaggerates the NP measure. If such services were supplied by the private enterprise,
these would be treated as intermediate consumption and NP would be
correspondingly reduced, obviously without any adverse effect on the welfare of the
people
There is general agreement that some services of the government are final products
and some are intermediate products. However, because of the practical difficulties of
estimation all government services are treated as final products. As a result of this double
counting the real NP gets exaggerated obviously with its illusory welfare significance
6. (A) The standard of living is indicated by the amount of goods and services available per
head in the economy for consumption. Obviously, for measuring the standard of
living, a simple estimate of the national income would not do. One has also to know
how many persons there would be to share the national output. The larger the number
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of people, the smaller would be the per head availability of output. If national income
data are to indicate the consumption standards, these must be 'corrected' for changes
in population so that we get what is called 'per capita income'. Per capita income is
derived by dividing the total national income by total population Thus, if size of
national income increases but the population of the country increases simultaneously
in a greater proportion, the per capita income will decline, which means lesser
purchasing power and consequently low economic welfare.
(B) Some have suggested that a more meaningful indicator of the well-being of the people
is provided by national income per head of the working population rather than total
population The idea is to relate the total product of the economy to the producers
alone by excluding the nonworking population. Suppose there are two economies with
the same per capita income, but different incomes per head of working population.
The one with higher income per head of the working population would necessarily be
more efficient because it is showing higher labour productivity. Higher productivity
of labour is indicative of higher growth potential and welfare in the economy. In this
sense national income per head of the working population may tell us more about the
growth and welfare prospects of an economy than the simple per capita income.
7.
NP estimate, as a measure of economic welfare, is particularly deficient in as much as
it does not take into account the human cost of producing the output. Reduction in the
amount of effort required to produce a given output, made possible by increases in
labour productivity, afford a larger amount of leisure to the people. NP estimates do
not include leisure as one of the goods. A given quantity of goods produced with little
effort obviously contributes more to the individual's welfare than the same quantity
produced with a greater amount of effort, other things remaining constant.
Mechanisation, improvements in work safety, technological progress and
improvements in production techniques, by raising labour productivity, (that is, by
reducing the human cost of production), afford greater amount of leisure (via
reductions in working hours) as well as other goods. For example, if consequent upon
an increase in labour productivity, a country chooses to produce the same volume of
NP and to enjoy more leisure (by reducing working hours), it would be wrong to say
that constancy of NP in this case means a constancy of economic welfare. To the
constant NP we must also add the extra leisure. It is a well-established fact that
consumers prefer more leisure to more goods when they grow richer. Leisure, like
goods, satisfies human needs but NP estimates do not include it. Therefore, measured
NP understates economic welfare of the people.
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Introductory Macroeconomics
Distribution of NP and Economic Welfare
Per capita national income is a national average income which could be made
available to all members of the society if NP were distributed equally. Per capita income tells
us nothing about the actual distribution of NP in the society.
As a general rule we can assert that the more equitable the distribution of income in a
society, the higher will tend to be the amount of welfare accruing to the society as a whole.
NPs and populations of two countries, A and B, may be the same, but a more equitable
distribution of income in A compared to B, will imply a higher level of welfare in A
compared to country B.
We could look at the distributional aspect from a different angle. Suppose in a
country, as a result of a 10% increase in labour efficiency a factory is able to produce the
same level of output by retrenching 10% of the workforce. Assuming further that the
retrenched employees do not get new jobs. It follows that the reported NP figure remains
unchanged but its distribution becomes more unequal than before, involving a loss of welfare
to the society because of unemployment. Therefore, apart from the magnitude of SP, its
distribution among the people also affects economic welfare. It is the pattern of distribution
which will ultimately determine whether or not the benefits of a larger NP / NI penetrate
down to the neediest sections of the society.
Composition of NP And Economic Welfare
The goods and services included in NP/NI are either meant for current consumption
or for accumulation. The part of NP/NI devoted to current consumption contributes towards
raising the standard of living immediately. The investment component (primarily consisting
of newly created durable-use capital goods) by increasing productive capacity of the country
also leads to increased consumption but with a time lag. It takes some time before the newly
created capital goods become effective in increasing the production of consumption goods. In
other words, while the production of consumption goods raises standard of living
immediately, production of capital goods makes for higher future consumption. Since NP
includes both types of goods, we can take it to be an indicator of the standard of living that
the society may be currently enjoying or heading for it in the future. Therefore, a tilt in the
composition of NP in favour of either has different short term and long-term welfare
implications.
Social Costs of NP and Welfare
There are many features of the market economy that drive a wedge between the
market value of goods and their contribution to welfare, ranging from imperfect competition,
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imperfect knowledge, externalities, to aspects of income distribution that enter into most
people’s notion of welfare. We know that pollution (i.e., environmental pollution including
pollution of the air from smoke, sulphur dioxide, carbon monoxide, water pollution etc.) has
increased sharply as a consequence of industrialisation. Also, crimes of violence and other
manifestations of social disorder in general have accompanied growth of output. As a
consequence, anti-pollution measures result in more resources being diverted from
production of final goods to the prevention of pollution. NP as presently measured, instead of
treating such antidote expenditures as social costs of producing the output, includes them as
expenditure on final goods. Obviously increase in NP due to an increase in such antipollution expenditures only prevents welfare from falling rather than increasing it. Therefore,
NP as measured at present, overstates welfare actually enjoyed by the people when we take
note of this aspect.
VIII
3.12 NATIONAL INCOME ESTIMATION IN INDIA
Pre-Independence Estimates
Though the work on the measurement of national income in a comprehensive manner
developed in this country since the early forties, sporadic studies by individual research
workers for determining the level of national income of the country either at a point of time
or over a period began in the nineteenth century. The first estimate of national income for the
country was prepared by Dadabhai Naoroji for the year 1867-68. Subsequently, a fairly large
number of estimates of very uneven quality were made particularly since 1900. However,
these estimates cannot be used for long period trend studies because of their limitations,
which differ in nature in different cases.
National Income Estimates after Independence
The first official estimate of national income for the Indian Union was prepared by the
Ministry of Commerce, Government of India and related to the year 1948-49. The importance
of this work, however, received official recognition with the setting up of the National
Income Committee in 1949, which published its First and Final Reports in 1951 and 1954
respectively. While the first Report of the National Income Committee included chapters on
basic concepts, the uses of national income and the estimates for 1948-49, the Final Report
dealt with the availability of data, the methods followed for preparation of estimates, and a
detailed chapter on recommendations regarding collection of fresh data for improving the
quality of the estimates of national income and also for extending the coverage of such
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statistics. Since the publication of the Reports of the National Income Committee, the work
on the estimation of national income has continued at the official level on a regular basis and
not only have the estimates been extended to cover a large number of macro-aggregates but
also have improved in quality by using recent basic data as well as by introducing
methodological changes
The National Income Committee presented estimates for three years (1948-49 to
1950-51) both at the current and constant prices of 1948-49. The task of national income
estimation was later on assigned to the Central Statistical Organisation (C.S.O.). The C.S.O.
is producing annual official estimates of national income in India since 1955.
Until 1967, the CSO prepared national income estimates largely on the basis of the
methodology which the National Income Committee has used. This series of estimates, also
known as conventional series, provided national income estimates for the period 1948-49 to
1964-65 both in terms of current and constant prices with 1948-49 as the base year. In 1967,
revised methodology was adopted and the conventional series was terminated. The revised
series began from 1960-61 taking it as the base year. In 1977, the CSO introduced another
series with 1970-71 as the base year. In 1988 a new series was prepared with 1980-81 as the
base year. The base year was later on shifted to 1993-94. A new series with 1993-94 is now
available. The estimates of the new series are not comparable with the estimates of the earlier
series
Methods of Estimating National Income in India
For the purpose of estimation of national income, the Indian economy is broadly
divided into the following broad sectors.
1.
Agriculture including animal husbandry,
2.
Forestry and Logging,
3.
Fishing,
4.
Mining and Quarrying.
5.
Manufacturing (5.1 registered and 5.2 unregistered)
6.
Construction,
7.
Electricity, Gas and water supply,
8.
Transport, Storage and communication,
9.
Trade, hotels and restaurants,
10.
Banking and insurance,
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11.
Real estate, ownership of devellings and business services,
12.
Public administration and defence,
13.
Other services.
Different methods are used to estimate income originating in different sectors. For
making estimates of national income originating from sectors 1 to 5 in the above list, the
production method is used. For sector number 6 i.e., construction, expenditure method is
used. This sector is subdivided into 'pucca' construction and 'kutcha' construction. Pucca
construction includes construction with the help of cement, steel, bricks, timber etc. Kutcha
construction includes construction with the help of freely available materials likes leaves,
mud etc. In Kutcha construction expenditure method is used. In pucca construction
commodity flow method (i.e., net inputs e.g., cement, steel, bricks etc. used multiplied by the
prices paid by the builders in is used. For the remaining sectors 7 to 13 of the above list,
income method is used however, it should be noted that in all these sectors, estimates of
national income are based on sample survey method. Although the data base of estimating
national income has improved over the years, it would be wrong to consider it altogether
satisfactory.
3.13 DIFFICULTIES IN MEASUREMENT OF NATIONAL INCOME IN INDIA
Having obtained a broad idea of the basic data used and the methods used for the
preparation of estimates of national income and related aggregates in India, the question
which arises in one's mind is about the accuracy of the estimates
The principal factors which lead to errors in national income estimates can be
classified into (1) conceptual and (ii) statistical difficulties
Conceptual difficulties are those arising from limitations of the concepts used and the
efforts made by estimators to fit the available statistics to the conceptual framework of the
aggregates. The limitations would arise only when the concepts are still to be standardised.
Since accepted definitions of various aggregates are available and details are known about the
basic data used in India, it is unlikely that such errors appear in the estimates due to
conceptual inadequacies, this is particularly so because the concepts of national income and
related aggregates adopted in the Indian statistical system are the same as the internationally
recommended concepts with modifications to suit the Indian conditions only when necessary.
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Difficulty of double counting
One of the major difficulties as we have already discussed, is that of avoiding double
counting. In order to avoid it, the value of raw materials and half-finished goods produced
and used up in production during the year has to be omitted. Sometimes, the same commodity
is partly used as raw material and partly as a final product. For example, cotton is used both
as raw material in the production of cotton cloth and partly as an article of final consumption
for stuffing quilts and mattresses. The value of cotton which is used as raw material must be
deducted from the total gross product, but not that of the cotton which is used as a final
commodity. To determine how much of cotton produced in one year is used in one way and
how much in the other, is often quite difficult. There are many services, particularly
government services, which are partly rendered to individuals and partly to business. The
services rendered to individuals should be included in national income estimates, while those
rendered to industry should be excluded because these will be included in the value of the
goods produced by business. As the exact distribution of services in the two uses is not
possible, a certain amount of double counting is, therefore, unavoidable.
Existence of a large non-monetary sector in India
The existence of a large non-monetary sector in the Indian economy makes it difficult
to measure the value of a large part of the national product. A considerable volume of output
in this country does not at all enter into the market and is not exchanged for money. It is
either consumed by the producers and their families (as happens in the case of the farm
produce) or bartered for other commodities. The money value of this portion is difficult to
determine. The value in this case has to be imputed, which introduces a large element of
guess work in our estimates.
Statistical Difficulties
a. Absence of proper data on production:
Peculiar to this country. Our statistics of production in agriculture, mining, industry
and services are all of doubtful reliability Businessmen and producers who are the basic
source of this information often do not keep proper and complete records. The smaller
producers often do not have even rough idea of how much they produce, what is its value and
its costs. The statistics are, therefore, based on very unreliable information. According to
National Income Committee "An element of guess work, therefore, inevitably enters into the
assessment of output especially in the large sectors of the economy which are dominated by
small producers or the household enterprise".
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b. Many enterprises in India are engaged in more than one functional industry:
Many enterprises in our country simultaneously perform functions belonging to
different occupational categories. They do not keep separate accounts for those different
categories. Generally household enterprises perform functions falling in various groups of
industries. The agriculturists are often engaged in other occupations in addition to cultivation
of land. Separate records of production and income are not kept by these people for each of
their diverse activities. This presents a problem in the classification as well as the
measurement of national income.
c. non-availability or reliable statistical information:
The primary data used in estimation are either collected through sample surveys or
through routine operations of the official statistical system. In case of data, flowing from the
administrative records, the quality of such statistics depends on the reporters who may not
always be statistically trained
There are, on the other hand, certain parts of the economy, especially in the
unorganised sectors, for which current statistics are either not available on a regular basis or
available only in insufficient detail and the estimates here are prepared with data for benchmark years and indicators. It is, therefore, possible that in trying to fill up gaps in data in such
cases errors are introduced in the estimates
Also, since not all basic data are available on a regular basis, error is introduced in the
national income estimates when different methodologies are adopted for estimating the
missing items with the help of information available from benchmark surveys or from data on
related characteristics. The quality of the estimates in this case depends on the validity of the
assumptions made to compensate for the missing data. Trends in India's National Income
National Income estimates of India are available at 1980-81 prices for the period
1950-51 to 1992-93. Thus, we have comparable data for a fairly long period. From 1993-94
onwards data are available in the new series with 1993-94 as base. The following table
summarizes the trends in India's National Income as well as per capita income
India's National Income and Per Capita Income at Current Prices and Constant Prices
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Net National Product as factor
cost (National Income)
(Rs. Crores)
Year
Per Capital Income
(Rs.)
At Current
Price
At constant
Price
At current
Prices
At constant
Prices
1950-51
8,574
40,454
239
1,127
1960-61
14,242
58,602
328
1,350
1970-71
36,503
82,211
675
1,520
1980-81
1,10,685
1,10,685
1,630
1,630
1990-91
4,18,074
1,86,446
4,983
2,222
1992-93
4,46,023
1,95,602
6,262
2,243
New Series (Base: 1993-94)
1993-94
6,85,912
6,85,912
7,698
7,698
1996-97
10,89,563
8,47,511
11,544
8,987
1998-99
14,31,527
9,49,525
12,729
9,271
According to the old series (Base 1980-81= 109) the net national produce was Rs.
40,454 crores in 1950-51 and it increased to Rs. 1,95,602 crores in 1992-93. The over all rate
of growth comes to 3.8 per cent per annum. However, keeping in view the target laid down in
various five years plans, this performance is not at all encouraging, as shown in the following
table.
Rate of Growth of National Income
Annual Percentage)
Plan
I
II
III
IV
V
VI
VII
VIII
IX (1997-2000)
Target Rate 2.1
4.5
5.6
5.7
4.4
5.2
5.0
5.6
6.5
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Actual
Rate
3.6
4.0
2.4
3.3
5.0
5.4
5.9
6.8
6.0
It is obvious that the rate of increase in national income has always fallen short of the
targets laid down in the various plans, except during the first and the recent plans. Besides,
there have been fluctuations in year-to-year growth rates-in some ears even it declined. In
fact, whatever growth we witness in India was in only half of the years of planning, in the rest
of the years either there has been no growth, or the growth rate was negative. Thus, the
growth rate has not been consistent. In recent years there has been an acceleration in the rate
of economic growth, and it has averaged more than 5 percent per annum. This has been to
some extent due to the rapid growth of the service sector
The performance of the economy can be better assessed if we examine the per capita
national income. The figures of the per capita income given in above table show that between
1950-51 and 1992-93 i.e., over a period of 42 years, the per capita income (at constant prices
i.e., 1980-81 prices) increased from Rs. 1127 to Rs. 2243 which was less than the double. The
increase in the per capita income over the period of planning has been at the rate of 2 percent
per annum. This is by all means highly unsatisfactory. There have been some years in which
it either declined or remained constant. However, during the last five years or so the rate of
increase in per capita income has been about 4.8 percent per annum.
The rate of growth in India has been very low as compared to what is required to raise
the living conditions of the people. It has not made any dent on the poverty in India which,
according to some studies, in fact, has increased. The rate of growth in India has been among
the lowest in the group of the fast-developing countries.
National Product by Industry of Origin
Goods and services are produced in different sectors of a country. In other words,
national income originates from the different sector e.g., agriculture, industry, trade,
transport, services etc. Therefore, it is worthwhile to examine the industry-origin of the
national income and examine whether there have been structural changes in the industry
origin of the national income.
The Indian economy is broadly divided into three sector, namely primary sector,
secondary sector and tertiary sector. The primary sector includes, agriculture animal
husbandry, forestry, fishing, mining etc. The secondary sector comprises manufacturing,
constructions and electricity, gas and power supply. The tertiary sector includes trade,
transport and communication, banking and insurance and services etc. Composition i.e.
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industry-origin of the national income explains the relative significance of the different
producing sectors.
The following tables gives the industry-origin of the national income
Gross Domestic Product by Industry of Origin in India
(Percentage Distribution)
Industry
1950-51
1980-81
1990-91
1998-99
Primary
56
40
33
29
Secondary
15
24
28
24
Tertiary
29
36
39
49
Total
100
100
100
100
Note: The figures given the table for the years 1950-51 to 1990-91 are based on old
series (1.e. 1980-81 prices) and the figures for the year 1998-99 are based on new series (i.e.,
at 1993-94 prices)
It would be seen from the table given above that there has been a considerable change
in the industry-origin of the gross domestic product since 1950-51. The share of the primary
sector (of which the agriculture in the main constituent) which was 56 per cent in 1950-51
has now declined to 29 per cent in 1998-99. However, agriculture sector still remains the
single largest sector in terms of its share in the India's net domestic product. The share of the
secondary sector in India's gross domestic product has increased from 15 per cent in 1950-51
to 24 percent in 199899. The share of the tertiary sector has increased from 29 per cent in
1950-51 to 49 per cent in 1998-99
There is a big increase in the various constituents of the tertiary sectors eg transport,
communications, trade, banking and insurance and services. Though the net domestic product
data by industry-origin are not comparable but some broad conclusions may be drawn from
the trends given in the table above. Firstly, though the share of the agriculture in gross
domestic product has declined over the time, but it still remains the predominant economic
activity. Secondly, the rate of growth of the secondary sector has not been as fast as that of
the tertiary sector, the share of the unregistered manufacturing sector i.e., small and tiny units
has declined. Thirdly, the growing share of the transport, communications, banking and
insurance to the gross domestic product reflects the expansion of economic infrastructure in
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the country to sum up, since 1950-51, the Indian economy has become less geared to the
primary sector and more attuned to the secondary and tertiary sectors.
IX
3.14 NATIONAL CAPITAL: CONCEPT AND MEASUREMENT
The Concept: Real and Financial Capital
1
To the layman capital means anything which yields him an income, by using it
himself or by lending it to others. To him capital can mean money, real goods, or
paper claims against other people or institutions (e.g., shares, bonds, NSCs, bank
deposits, etc.). A man is considered rich if he has a substantial bank balance or
securities. Ownership of large estates or other physical goods, stocks, mortgages and
other debt instruments is treated as a position of wealth. Out of these only producers'
goods which aid production are capital goods in the economic sense. Both money and
securities (paper claims of all kinds) are redundant in that they merely represent
claims of ownership against real capital but are not capital themselves. Counting the
shares held by the shareholders of a cycle factory as well as the real capital of the
factory is double counting.
2
Capital in the economic sense is a factor of production consisting of producers' goods
(1.e., durable-use goods as well as single-use goods, man-made goods and goods
provided free by nature) including such diverse things as proven reserves of natural
resources of all kinds (e.g., oils, minerals, ores, etc.), machines, buildings, structures,
assembly lines, automobiles, factories, radio and television stations, and business
stocks of finished and unfinished goods and materials, which are used in production.
Economists distinguish between durable-use producers' goods made by man and those
provided free by nature. Man-made producers' durable-use goods are called fixed
capital goods while durable-use goods provided free by nature are called land. Land
includes not only agricultural land used for agriculture or land used for building sites
and similar other purpose but also proven reserves of natural resources of all kinds.
Fixed capital includes buildings, machine, tools, transport equipment, and so on.
3
What precisely is the basis of distinction between land and fixed capital? Broadly
speaking we may say that in its economic sense land includes all those durable-use
producers' goods which are provided free by nature. Fixed capital, on the other hand,
includes all durable-use capital goods which are man-made. The supply of fixed
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capital goods can be readily increased with human effort. In contrast, the supply of
land cannot be readily increased with human effort. This is the difference between the
two types of capital goods.
Composition of National Capital
Capital goods are divided into three categories, fixed capital, land and
inventories. Fixed Capital Goods
1
This category consists of all such man-made capital goods which, if properly
maintained and looked after, can aid production for a long period of time. Factories,
buildings, all kinds of machines and implements, transport equipment, powerhouses,
radio and television stations, bridges, roads, canals, etc. are all such capital goods
which can go on being used in production again and again for considerably long
periods. Fixed capital goods form a substantial part of the national capital of advance
economics, Larger the stock of fixed capital in an economy, the higher, other things
remaining constant, will tend to be its capacity to save, invest and grow.
Land-Natural Resources
2
This category consists of durable-use producers' goods which are provided free by
nature and whose supply cannot be readily increased with human effort. This category
includes proven natural resources such as agricultural and urban land, mineral
deposits, oil reserves, rivers, lakes, etc. whose productive lives do not terminate with a
single use but extend over long periods of time. Different countries have widely
different endowments of natural resources. Countries with abundant natural resources
tend to grow faster than the ones poorly endowed with such resources Civilisations
developed first on the banks of rivers where fertile land was easily available. The
development of natural resources into productive capital has been the result of hard
work and use of skill over centuries. Natural resources are an indispensable form of
capital but these can be made more effective by human effort. It is a well-known fact
that South American continent has a richer endowment of natural resources than the
North American continent but due to lack of adequate manpower the former has
remained less developed.
Inventories
3
This category consists of man-made single-use capital goods such as "goods is
process" (i.e., goods actually undergoing production), goods passing from one stage
of production to another, stocks of semi-finished goods, raw materials and stocks of
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finished goods waiting to be sold to the final users. These goods form a kind of buffer
stock to maintain regularity of production.
Measurement of National Capital Introduction
1
It bears repetition to say that capital, in the economic sense, consists of capital goods
(single-use goods, durable-use goods and man-made goods as well as those provided
free by nature) which aid production. It is this stock of real capital goods which we
call national capital. Since this stock includes diverse things, it can be measured only
in terms of its money value
2
During the last two centuries, as a result of various technological changes, inventions
and improvements in production techniques, the advantages of producing on a large
scale have been constantly growing. In order to take advantage of these changes, the
typical size of a firm in most industries has also been growing. Consequently, the
amount of capital goods needed for setting up a firm has grown so much that today it
is neither desirable, nor even feasible to mobilise it even on the basis of partnership
arrangements. Today such a huge amount of capital can be mobilised either through
borrowing (i.e., through the issue of bonds) or by issuing shares. The net result of this
has been that capital equipment of the community, by and large, has ceased to be
owned directly by private persons except for land and houses. They have mostly given
up their direct control over capital goods and have instead acquired titles to
ownership, which are only pieces of paper, without any particular goods being
identifiable to which they correspond. Moreover, shares held by a modern shareholder
are usually spread over a number of companies and as a result his connection with any
particular capital goods has practically disappeared. The capital owned by any
individual capitalist usually includes some actual goods (houses, land, consumer
durables, etc.) but for the most part it is likely to consist of paper titles to ownershipshares, bonds, etc. How do we go about measuring national capital in such a
situation?
Alternative Methods of Measurement
We can look at capital either as (1) a superstructure of titles and rights to ownership
by means of which the real capital goods are attributed to their ultimate owners or as (2) a
factor of production consisting of real goods being used in the production process. From the
standpoint of ownership, national capital is the sum of the net assets (i.e., assets minus
liabilities) of the normal residents of a country (including institutions and the public
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Introductory Macroeconomics
authorities). On the other hand, we may look at capital as the aggregate of producers' goods at
the disposal of the country. In this case we have to bear in mind that while paper titties are
assets for one set of people, the same are the liabilities of others and consequently assets and
liabilities between members of a closed group cancel out. Let us explain these two aspects of
capital with a simple example.
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LESSON-4
BALANCE OF PAYMENTS
STRUCTURE
4.1
Introduction
4.1.1 Current account
4.1.2 Capital accounts
4.1.3 Difference between Balance of Trade and Balance of Payment
4.2
Disequilibrium in Balance of Payments
4.2.1 Causes of disequilibrium in balance of payments for
4.2.2 Measures to remove disequilibrium of balance of payment
4.1 INTRODUCTION
In the modern world each country makes economic transactions with other countries of
the world. As a result of such transactions, it receives payments from and makes payments to
other countries. The record of such transactions is made in the balance of payments accounts.
Thus "the balance of payments is a systematic record of economic transactions of the
residents of a country with the rest of the world during a given period of time." Balance of
payments accounts are divided into two broad parts. The first part which is known as current
account deals with payments for goods and services, income, and transfers. The other part
which is known as the capital and financial account deals with transactions in assets.
These two parts of balance of payments is also known as components of balance of
payments.
4.1.1 Current account
The current account records transactions arising from trade in goods and services, from
income receiving to residents of one country from another, and from transfers by residents of
one country to residents of another. The current account divided into three main sections i.e.,
(a) Goods and services account. It has two components (i) Goods, which is called the
visible account, the trade account or the merchandise account. (ii) Services covers
invisible items.
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Introductory Macroeconomics
(b) Income: The second item is the income account. It again has two parts one is
employee compensation. The second one is investment income.
(c) Current transfers: The third element is the current account in current transfers
divided into central government and other sectors. All components of the current
accounts other than trade is invisibles.
4.1.2 Capital accounts
It is also known as financial accounts, which record transactions related to international
movements of ownership of financial assets. The capital account does not relate to imports
and exports. It relates only to cross border movements in ownership of assets, which involves
financial instruments such as ownership of company shares, bank loans or government
securities. The capital account has two components.
(a) Capital account i.e. (i) capital transfers,
(ii) Acquisition/ disposal of non-produced, nonfinancial assets.
(b) Financial account i.e. (i) direct investment (ii) portfolio investment (iii) financial
derivatives (iv) other investment.
Balance of Payment is a complete Account of all economic transactions of Goods &
Services & it remains always in balance because it is based on double entry system. Each
transaction has two sides one is debit & other is credit. If both sides are equal then it will
remain in balance.
But in practical sense it may be favourable or may not be.
Accommodating items are that items which is called below the line items and not
motivated by economic Profits.
Autonomous items are that item which is called above the line items represents
economic transactions motivated by Profits.
4.1.3 Difference between Balance of Trade and Balance of Payment
Balance of trade and balance of payments are two related terms, but they have different
meaning.
(1) Balance of trade is a narrow concept and Balance of payment is a broader concept.
Balance of trade is a part of balance of payment. (2) Balance of payment includes imports
and exports of goods, services, and capital transfers but on the other hand balance of trade
includes imports and exports of goods i.e., visible items only. (3) Balance of payment of a
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country is always balance but balance of trade can be unfavourable. (4) While formulating
foreign trade policy balance of payment has more significant than balance of trade for a
country.
4.2 DISEQUILIBRIUM IN BALANCE OF PAYMENTS
When total receipts of a country or exports (i.e., visible and invisible) are equal to the
total payments or imports than it is a balance, balance of payment. Disequilibrium occurs
when receipts are greater or less than payments. Disequilibrium has two situations may be
favourable balance of payment or unfavourable balance of payment receipts are greater than
payments and unfavourable balance of payment shows receipts are less than payments.
4.2.1 Causes of disequilibrium in balance of payments for
The major causes of disequilibrium in balance of payments are divided into four parts
they as (i) Natural causes (ii) Economic causes (iii) Political causes. (iv) Social cause.
(i) Natural causes
These include natural calamities such as, floods, earthquakes, famines and droughts etc.
These are quite common factors responsible for disequilibrium in the balance of payments of
developing countries. It creates imbalance in the import and export of a country and
responsible of disequilibrium.
(ii) Economic causes
(a) Large scale development expenditure that cause large imports.
(b) Cyclical fluctuations in general business activities such as recession or depression
that may disturb exports.
(c) When the external value of the domestic currency goes up, imports become cheaper
and exports dearer. Therefore, imports are encouraged and exports are discouraged.
(d) Foreign capital investment flow has adverse impact on balance of payment.
(e) International institutions, practices and policies of foreign countries have a direct
bearing on the balance of payments of a country.
Political Factors
(a) Political disturbances like a frequent change of the government encourage out flows
of capital and discourage inflows of capital.
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Introductory Macroeconomics
(b) International relations of a country may be cordial, hostile or full of tension. These
may have either a favourable or unfavourable effect on the balance of payments of a
country.
Social Factors
Changes in tastes, preferences and fashions may affect imports and exports.
4.2.2 Measures to remove disequilibrium of balance of payment
To remove these causes disequilibrium of balance of payment different methods are used
they are as follows:
(1) Trade Policy Measures
Trade policy measures adopted to promote exports and reduce imports. Exports may be
encouraged by reducing or abolishing export duties and lowering the interest rate on credit
used for financing exports. Besides, on export earnings lower income tax can be levied to
provide incentives to the exporters to produce and export more goods.
On the other hand, imports may be reduced by imposing or raising tariffs on imports of
goods. We also follow the policies of export promotion and import substitution.
(2) Expenditure-Reducing Policies
The important way to reduce imports and reduce deficit in the balance of payment is to
adopt monetary and fiscal policies which help to reduce aggregate expenditure in the
economy. The two important instruments of reducing aggregate expenditure are (i) tight
monetary policy and (ii) Contractionary fiscal policy.
Tight monetary policy is used to check aggregate expenditure or demand by raising the
cost of bank credit and restricting the availability of credit. By raising the cash reserve ratio,
they reduced investment and consumption expenditure. This leads to lower aggregate demand
which helps in reducing imports. Tight monetary policy adversely affects investment increase
in which is necessary for accelerating economic growth. If a country experiencing inflation,
monetary policy is quite effective in curbing inflation by reducing aggregate demand. This
will help in reducing aggregate expenditure and depending on the income propensity to
import.
Contractionary fiscal policy Fiscal policy also helps to reduce aggregate expenditure.
An increase in direct taxes such as income tax will reduce aggregate expenditure. A reduction
in aggregate expenditure may lead to decrease in imports. Similarly, when increase in indirect
taxes such as excise duties and sales tax will also cause reduction in expenditure. The other
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fiscal policy is to reduce, government expenditure. Therefore, both monetary and fiscal
policy help the economy to remove the disequilibrium in the balance of payment.
Expenditure-Switching Policies
Another important method which is used to correct fundamental disequilibrium in
balance of payments in the use of expenditure-switching policies. This policy works through
changes in relative prices. Prices of imports are by making cheaper to domestic produced
goods. This policy may lower the prices of exports which will encourage exports of a
country. In this way by changing relative prices, expenditure-switching policies help in
correcting disequilibrium in balance of payments.
Exchange Control
Exchange rate change is also an important method to correct disequilibrium in balance of
payment. If in the international sphere, rate of exchange is flexible, government need resort to
a policy of devaluation, the demand for and supply of foreign currency that determines the
rate of exchange. If a country's balance of payment is adverse, its rate of exchange tends to go
down owing to limited supply of foreign exchange and its excess demand. As a result, export
will increase and situation of adverse balance of payments will be solved.
Summary
Balance of payment is a systematic record of all economic transactions of goods and
services with rest of the world. Balance of payment has two components-current and capital
account, current account includes all visible and invisible transactions like goods and services
and capital account includes long term and short-term capital transactions like portfolio
investment, borrowings from and lending to abroad, and banking capital etc. Balance of
payment remains always favourable in an accounting sense because it is based on double
entry system but in practical or in operational sense it may be favourable and unfavourable.
When imports are greater than exports then balance of payment becomes unfavourable or
when outflow is more than inflow then it shows disequilibrium and solve this problem
government can take measures.
Self-assessment questions
1.
Define balance of payment and what are its components?
2.
Explain the causes of disequilibrium in balance of payment and give measures to
solve this problem?
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Introductory Macroeconomics
LESSON-5
MONEY
STRUCTURE
5.1
Introduction
5.1.1 Kinds of Money
5.1.2 Definition of Money
5.2
Functions of Money
5.3
Role of Money/Importance / Significance of Money
5.1 INTRODUCTION
Life was very simple in the beginning of human existence. The basic human needs of
food, clothing and shelter were fulfilled by man himself or the group in which he lived.
Whatever simple production was there, was for self-consumption. There was no division of
labour and no scope for exchange. But as time passed, human wants became varied and
innumerable. It was simply not possible for any person to satisfy all his/her wants through
own production. Moreover, man realised the value of division of labour in enhancing
production and making the process more efficient. This led to a complex division of labour
and specialisation in production. Manufacturing of even a single commodity today is divided
into many parts and production has become a joint venture in which large number of people
participates. Every person gets his/her income through performing a very limited economic
activity and spends this income on the commodities of his choice. Therefore, exchange has
become a very important part of the economy. In the initial stages, the form of exchange was
different and goods were exchanged for other goods. This was called barter. But this kind of
exchange was possible in a small society where people had limited wants and knew of each
other's wants. But barter was no longer practical in a big economy composed of innumerable
people with innumerable wants. The necessary condition for barter to take place is double
coincidence of wants, i.e., a person having a surplus of one commodity should be able to find
another person who wants that very commodity and has something acceptable to offer in
exchange at an agreed rate of exchange. But it is difficult to decide the terms of exchange as
there is no common measure of value. Moreover, indivisibility of commodities and difficulty
of storage make the barter system extremely difficult. In a complex economy, people
invariably produce for others and cannot fulfil their wants except through a practical method
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of exchange, i.e., sale and purchase. This need resulted in the invention of money, something
which is generally accepted in the process of exchange. Money may be any commodity
chosen by common consent as a medium of exchange and all other commodities are
expressed and valued in terms of this commodity.
It is not easy to go into the hoary origin of money and spell out precisely how and when
it emerged in the pre-historic period. One theory is that the origin of money is not the result
of man's conscious efforts, but it was discovered accidentally. According to Spalding, due to
difficulties of the barter system (mentioned above), exchange must have become very
difficult and some widely acceptable medium of exchange might have emerged e.g., articles
of necessity or ornaments. The other theory contends that money was the result of man's
rational efforts to find a common measure of value. According to G. Crowther, money
"undoubtedly was an invention, it needed the conscious reasoning power of man to make the
step from simple barter to money accounting." Adam Smith also believed that money resulted
from the rational effort of man, but unlike Crowther, he thought that it was discovered as a
medium of exchange and not as a unit of account. Whatever the origin of money, whether it
emerged accidentally or was invented consciously, it is clear that it existed in societies which
had no contact amongst themselves. Therefore, we can safely assume that it originated in
different societies separately. Also, historically there is a set pattern of the evolution of
money.
Self-Check Exercise
Carefully note that whether money was invented through conscious human effort or
discovered accidently, what is important to know about money is that it removed the
difficulties of barter and by lubricating the wheels of exchange, it facilitated division of
labour and consequent increases in productivity.
5.1.1 Kinds of Money
It is agreed that the earliest form of money used in primitive societies was commodity
money. Things which were commonly demanded (like salt, com, utensils, furs, skins etc.)
were used as money. In some regions, goats, cow or ox were chosen as medium of exchange.
While elephant tusks, plumage of birds or tiger teeth served as money in tropical countries, it
was shells in countries located on the seashore. Money took the form of tea in Tibet, rice in
Japan and cattle in Vedic India. Even today, goats serve as money in some areas of Africa.
Evidently, such commodities cannot perform efficiently as medium of exchange due to being
indivisible, perishable and nonuniform.
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With advancement of knowledge and civilisation, people started using metals as money.
Metals had some merits and did not have the inadequacies of commodity money. To start
with, pieces of brass, copper, iron, silver and gold were used as medium of exchange, but
later on it was realised that iron, brass and copper were not good money materials as these
were not scarce. Therefore, pieces of gold and silver and later on coins of gold and silver
issued by rulers of various countries were used as money. Historical evidence shows that
metal coins were circulating as money in our country around 400 B.C. Even today metal
coins continue to be used as money though the techniques of coinage and quality of coins
have improved tremendously.
Initially, the kings used to issue coins in their own image, certifying the weight and
quality of the metal. Since intrinsic worth of these coins was no less than their face-value,
these were called standard coins or standard money. Under gold standard, the banks and the
government were supposed on demand to pay out gold in exchange for any form of money.
Token money, on the other hand, is different from the full-bodied standard money as the face
value of the token coins is much higher than their metallic worth. It is not of any use to melt
the token coins into metal, today one-, two- and five-rupee coins are an example of token
money. Another important step in the development of money was the emergence of paper
money which was slow and gradual. In the earlier times, goldsmiths used to issue receipts to
people who deposited cash with them for safety reasons. In course of time, these paper
receipts came to be accepted as money due to their credibility. Later on, paper money was
issued by the state or by the central bank. It is believed that the Chinese were the first to use
paper money which had the sanction of the state. Earlier, the currency notes issued were
convertible into precious metals and in fact, represented gold reserves. But when paper
money became widely acceptable, it became inconvertible. Today, the currency notes in
circulation in different countries are not convertible, but they derive their acceptability from
faith in the government.
The latest step in the development of money is bank money or credit money. This money
came into being with the introduction and development of the banking system. Banks all over
the world accept deposits which can be withdrawn or transferred through cheques. Banks
promise to honour all the cheques issued by the depositors for amounts generally not
exceeding the balance in their accounts. The cheque is an instrument through which the bank
deposits become payable on demand and can be transferred from one person or party to
another. Though cheque in itself is not legal tender money (i.e., money which has the
sanction of law), but it can be used to perform the slime functions as money. One can pay for
purchases through cheques and also receive the proceeds of sales through cheques. Bank
money is generally more convenient than money, easier to carry and can be used to make or
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receive big payments. It is widely used in developed countries, but even in underdeveloped
countries like India, it constitutes about 50 per cent of the money supply in the country. Bank
money constitutes cheques, bank drafts and other credit instruments issued by the banks to
transfer deposits.
5.1.2 Definition of Money
As far as the definition of money is concerned, some economists like Withers, Hicks and
Bain define it with reference to its functions. According to these descriptive definitions,
'money is what money does' and what money does is described as working as a medium of
exchange, measure of value, standard of deferred payments and store of value. Other
economists like Hawtrey and Knapp adopt a legalistic view and argue that a commodity
acquires the characteristic of general acceptability only when it is made legal tender by the
state. According to this definition, a commodity cannot function as money unless it has the
necessary backing of the state. This definition is all right in normal conditions, but in a
situation of hyper-inflation (when the general price-level is rising very fast), even legal tender
money loses the characteristic of general acceptability. Moreover, such money does not
include demand deposits of banks. Most economists define money in terms of its general
acceptability. Marshall, Cole and Keynes emphasize this aspect greatly in their writings.
According to this definition, a commodity may or may not be legal tender, but it should
possess general acceptability if it is to be used as money. Money may be classified on the
basis of (1) legality and (2) liquidity. Legal tender money is backed by law and people are
bound to accept it in exchange for goods and services or in discharge of debts. Non-legal
tender money is generally accepted by people as a medium of exchange, but it is upto the
person to accept it or not. Cheques, bank drafts, hundis, bills of exchange etc. are examples of
non-legal tender or optional money. Money in the form of coins and currency notes is highly
liquid and can be exchanged for any type of asset immediately. But there are other forms of
money which are not as liquid as coins and notes, but can be converted into money involving
some inconvenience, time and loss of value. Saving deposits with banks or post offices, time
deposits, bills of exchange, debentures, bonds etc. fall in this category. These claims do not
circulate as medium of exchange and are not actual money, but these can be called quasimoney or near money.
Self-Check Exercise
Note that the most important attribute of money is its general acceptability in exchange
transactions and in settlement of debts. Money loses its utility the moment public loses
confidence in its acceptability in transactions.
5.2 FUNCTIONS OF MONEY
Since the definition of money is also usually in terms of its functions, let us discuss the
functions in some detail. The functions of money have been summed up in a couplet:
Money is a matter of functions four.
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A medium, a measure, a standard, a store.
Medium of Exchange - The most important and primary function of money is that of
acting as a medium of exchange. This is, in fact, the most distinguishing characteristic of
money which separates money from near-money and non-money assets. It also brings out the
importance of the feature of general acceptability since no commodity can act as a medium of
exchange unless it is acceptable to everyone. Money as a medium of exchange breaks up the
act of exchange into two parts: sale and purchase. This removes the major difficulty of barter,
i.e., double coincidence of wants. Hungry weavers who have surplus cloth do not have to
search for naked farmers who have surplus food, but no cloth. This saves a lot of time, energy
and resources. Thus, money brings efficiency into exchange transactions. Moreover, it also
promotes efficiency in allocation of resources by making it possible to exploit gains from
specialisation in production and trade. People can engage in production, get income in the
form of money) from the proceeds of goods sold and spend that income or money on the
goods and services they require. Thus, money which is the general purchasing power, acts
very efficiently as a medium of exchange.
Measure of Value- Money serves as a common unit of account or measure of value in
terms of which the values of all goods and services are expressed. Thus, money measures the
value of economic goods and this value is expressed in terms of their money prices. In a
money economy, it is possible to ascertain the relative exchange values of goods by
comparing their market-prices. According to Crowther, "Money acts as a yardstick or
standard measure of value to which all other things can be compared." There is a close
relationship between the two primary functions of money. The commodity which is used as a
medium of exchange in a society, is also used for measuring the values of various goods and
services. In fact, the function of money as a unit of account is performed first, i.e., we first
measure the value of goods and services to be exchanged and only then exchange various
goods and services at pre-determined rates. Moreover, it is possible to measure the total value
of different kinds of goods and services (measured in different units e.g., metres, kilograms,
litres etc.) in terms of money. There is no other way to measure the national income of a
country except in terms of money. Money as a measure of value is used for making all kinds
of economic calculations. But sometimes there is a dichotomy and medium of exchange
cannot be used as a unit of account. There is the famous case of German mark whose value
declined so much due to hyperinflation after the First World War that it was impossible to use
it as a unit of account. Therefore, American dollar or Swiss franc were used as a measure of
value, but German mark remained in circulation as a medium of exchange. China faced a
similar situation during the Second World War.
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Standard of Deferred Payments-Credit plays a very important role in a modern
capitalist economy. In most of the transactions, instant payments are not made. Debtors
promise to pay on some future date and the debt as well as interest, if any, is settled in terms
of money. This also applies to payments of rents, salaries, pensions, insurance premia etc. In
an underdeveloped economy like India which is based on agriculture, there are instances of
rent and wages being fixed and paid in kind. But in a money-using economy, most of the
deferred payments and future obligations are stipulated in terms of money. This is for the
simple reason that money can be expressed in definite and standardised units and its value in
terms of its purchasing power) remains generally stable over time. But in times of inflation or
deflation, the value of money varies over time and money not only becomes a poor measure
of value, but also a poor standard of deferred payments. All the same, in the absence of
another universally acceptable standard, money continues to perform this function of
settlement of debts. Therefore, just as money facilitates current transactions of goods and
services through its function as a medium of exchange, it also facilitates credit transactions
(i.e., exchange of present goods against future goods) through its function as a standard of
deferred payments.
Store of Value-Another important function of money is serving as a store of value.
People can hold their wealth in the form of money. This function is also derived from the use
of money as a medium of exchange. As stated earlier, money breaks up the exchange
transaction into two separate transactions of sale and purchase. Under barter, the two
transactions are simultaneous, but the use of money separates them in time also. In a moneyusing economy, people get their incomes in the form of wages, salaries, rent interest and
profits at certain points of time. They may decide to spend the same immediately or at a later
point of time. In the latter case, the full or at least a part of the income received is held in the
form of money for varying periods. It is possible to do so because money has the unique
feature of being a generalised purchasing power and is also the most liquid asset. This
ensures that goods and services can be purchased by money at any time in future without
delay or loss of value. Therefore, money can be stored without loss in value (unless a
situation of hyper-inflation prevails in the economy). Since man always felt the need of
holding wealth, under the barter system he did so by storing commodities. But it involved
substantial storage costs and loss in value of perishable commodities due to deterioration.
Other assets can also serve as store of value, but money being the most liquid, is unique in
this respect. According to Keynes, the role played by money as a store of value is no less
important than its role as a medium of exchange. Money, in fact, acts as a bridge between
present and future. But it is equally true that fluctuations in the value of money (due to
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Introductory Macroeconomics
inflation and deflation) affect its function as a store of value just as they affect its functions as
a measure of value and a standard of deferred payments.
There are some other functions too that money performs. It helps us to transfer value
from one person to another, from one place to another and over time due to its general
acceptability. Many a time, such functions are performed by near-money such as cheques and
bank drafts. Money also helps consumers in maximising their utility by equalising the ratio of
marginal utilities to that of respective prices (expressed in terms of money). It also helps
producers to maximise production by equalising the marginal productivities of various factors
of production. Money also facilitates the distribution of national income among the various
factors of production on the basis of their marginal productivities. Banks and firms keep
sufficient money reserves for meeting their liabilities lest they become insolvent and lose
their goodwill. Money, on account of its perfect liquidity, can be converted into any type of
asset according to its profitability at a point of time. Money is also the basis of credit since
circulation of credit instruments is not possible in the absence of sufficient case balances.
Self-Check Exercise
Note that people accept money in exchange and hold it for short or long duration (as a
store of value) in the belief that other people will similarly accept it whenever the need arises.
Money is also used as a standard measure (a yardstick) of value; current and future
(deferred payments).
5.3 ROLE OF MONEY/IMPORTANCE / SIGNIFICANCE OF MONEY
The importance of money in an economy cannot be over-emphasized. Money may not
produce anything, but not much can be produced without the help of money today. Money
renders invaluable services in various economic processes going on in a modern capitalist
economy. According to Dey, "Money is one of the most fundamental of all Man's
inventions.......... in the whole commercial side of Man's social existence, money is the
essential invention on which all the rest is based." The important position of money is largely
due to its two main characteristics. Money being a medium of exchange, is used for making
all transactions and settling most of the debts. Purchases of consumer goods and services,
factors of production and claims such as bonds, bills, payment of taxes, are all made through
money. As a result of this, money is used for distributing national income to workers, traders,
government employees, shareholders and all others. Secondly, since money is general
purchasing power and can be conveniently used to lay claims on goods and services, people
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generally prefer to hold their wealth in the form of money (which includes both currency and
bank deposits).
In a capitalist economy, all the three central problems of what, how and for whom to
produce, are solved through the price-mechanism which consists of prices of all goods and
factors of production expressed in money. This economy is basically unplanned where a large
number of consumers and producers take their decisions individually and it is only money
prices of various goods and factors determined in more or less free markets, that bring order
into the system. Since money splits exchange transaction into purchase and sale, two classes
of buyers and sellers come into existence and their desires find their expression in the form of
demand and supply respectively and influence various prices. Equilibrium between demand
for and supply of a commodity/factor of production determines its price in the market. The
set of goods prices helps consumers in choosing the basket of commodities according to their
preferences and enables them to maximise their utility within the constraint of their income.
The sets of goods and factor prices help the producer in choosing the most profitable line and
technique of production. Profit is nothing but the difference between the price and cost of a
commodity where the latter depends upon the prices and quantities of various factors of
production used in the process of producing this commodity. The share of each person in the
national income also depends upon the quantities of various factors of production supplied by
him and their prices, to what extent that share in income (expressed in money) enables the
person to lay claim on goods and services depends upon the prices of the latter. Thus, all the
three problems of allocation of resources, choice of technique of production and distribution
of income are solved in a capitalist economy through the price mechanism which is nothing
but the value of various commodities and factors of production expressed in terms of money.
Money is essential for the development of an organised credit market. Such a credit
market is not possible in a barter economy. Money also removes all trade barriers at national
as well as international level by making specialisation and exchange of goods and services
possible. Money is also important for the government in the sense that all taxes, fees, fines
and other public revenues are realised in money only. The government also organises its
public expenditure on activities that ensure maximum social advantage. Moreover, money is
not only a technical device serving as a medium of exchange, measure of value, standard of
deferred payments and store of value, but also influences the behaviour of such vital
economic variables as level of output and employment in the economy. In a situation of
unemployment in a modern capitalist economy, monetary adjustments are found useful to
solve this problem. By increasing the supply of money (which we shall study shortly), rate of
interest is sought to be reduced so that investment is encouraged, increasing output and
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employment. Also, by increasing the monetary expenditure on consumption and investment
through reduction in taxes and undertaking government projects, output and employment are
sought to be increased. In a situation of inflation, the opposite kind of monetary policy
(contractionary in nature) is adopted. Therefore, we can say that money is not wanted merely
because it performs some useful functions, but it has become indispensable for the efficient
management of a modern economy.
The role of money is not restricted to the capitalist economy. In a socialist economy also,
where all the economic activities are coordinated by the central planning authority, money
has to be used mainly as a medium of exchange and a unit of account. Resources are
allocated on the basis of shadow prices which are also expressed in money. Wages and
salaries are paid in terms of money. People are free to organise their consumption on the
basis of prevailing prices which may be partly or wholly controlled by the government.
Therefore, even in a socialist society based essentially on economic planning, money and the
price mechanism play a major role in the allocation of resources, distribution of income and
expenditure on consumption. Lenin himself pointed out that a socialist economy could not be
a moneyless economy.
Despite the crucial role that money plays in any modern economy, it cannot be
considered as an unmixed blessing. It does promote employment, economic growth and
welfare if it is properly managed. But if mismanaged, it can cause economic recession or
inflation and result in untold miseries for the common people. As stated before, money acts
as a measure of value, but its performance depends upon the extent of stability in its value in
terms of goods and services or general purchasing power. We are able to measure wheat in
quintals and cloth in metres simply because the weight of a quintal as well as the length of a
metre is fixed. But if the yardstick itself is variable, all measurements lose their precision.
Because of this, there emerges a difference between real values and monetary values of
economic variables like national income, wages and other factor prices, Keynes talked of
money illusion that workers suffer from because they cannot distinguish between money
wages and real wages. But these days workers and their trade unions are aware of the effect
of rising prices on their real wages and try to link their wages to the rate of inflation (through
dearness allowance). But the problem of economic fluctuations caused by imperfections in
various techniques of monetary control is quite real and causes hardships to the people.
To conclude, we can say that money is a tool and a very useful tool at that, but like all
tools, it has to be used properly and efficiently so that it does not cause any harm to the user.
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Self-Check Exercise
In a money economy money does many things. However, its most basic function is its
use in exchange transactions and as a store of value. Imagine what will happen to
productivity if money was not available.
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LESSON-6
MEASURES OF MONEY SUPPLY
STRUCTURE
6.1
Introduction
6.1.1
Supply of money and its various measures Supply of money
6.1.2
Components of Money supply
6.2
Self-Check Exercise
6.3
Summary
6.4
Question for Review
6.1 INTRODUCTION
Having defined money, described its functions and importance in a modern economy, we
now intend to discuss the supply of money and its various measures. But before we talk about
the supply of money, let us say something briefly about the demand for money. It is obvious
that unlike other consumer goods, money is not demanded for its own sake, nor does it
possess any utility to satisfy human wants. It represents general purchasing power and is
demanded because it helps people to gain command over goods and services which possess
utility. It is also true that money is a barren and unproductive asset and does not yield
anything. Other assets like stocks and shares, houses etc. yield returns in terms of dividends
and rent. Money given on loan also yields interest. But even then people (households as well
as firms) do hold their wealth in the form of money for three purposes.
According to classical economists, money is held by people for (1) transaction and (2)
precautionary motives. Derived from the principal function of money as a medium of
exchange is the transaction demand for money. Consumers require money to purchase goods
and services while producers need money to obtain factors of production and intermediate
goods which are required in the process of production. Therefore, the transaction demand for
money depends upon the total volume of transactions in an economy. In addition to the
money required for meeting certain and foreseen expenditures, people also keep money to
cover unexpected expenditures resulting from uncertain and unforeseen circumstances e.g.,
accident, sudden illness, loss of job etc. Thus, the motive to hold money to guard against
future uncertainties is called precautionary motive. The demand for money on this account
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depends upon the level of income and also the access to credit market and the degree of
liquidity of other assets. If there is a developed and organised money market, people can
easily borrow or convert their assets into money to meet their unexpected needs.
Precautionary motive is also a kind of transaction motive where the transactions are
unforeseen and uncertain.
Keynes innovation is the speculative motive for holding money. Both transaction and
precautionary demand for money are derived from its function as a medium of exchange. But
speculative demand for money is totally alien to the classical economics. In Keynesian
theory, however, this demand for money occupies a strategic position. According to Keynes,
speculative demand for money results from people's desire to make capital gains by buying
bonds and other financial assets when their prices are low and selling them when their prices
rise. In other words, people speculate about the future level of prices of various securities. As
rational individuals who try to maximise their gains, they would hold those securities whose
prices they expect to rise and try to dispose off those securities whose prices they anticipate
falling. Keynes defined the speculative motive as "the desire of earning profit by knowing
better than the market what the future will bring forth." Obviously, speculative demand for
money makes use of the function of money as a store of value. People tend to hold money
(which is the most liquid asset) so that they can convert it into securities the moment it
becomes profitable. Keynes related the speculative demand for money to the rate of interest.
Since the total monetary return on bonds is fixed, their prices are inversely related to the rate
of interest. When the bond prices rise, the rate of interest falls and vice-versa. People buy
bonds only when their prices are low and the rate of interest is high. Otherwise, if the bond
prices are high and the rate of interest is low, they prefer to hold money so that they can buy
bonds as soon as their prices fall. Also, if they expect the interest rate to rise, they will
convert their bonds into money and if they expect the rate of interest to fall, they will buy
bonds with the stock of money they have. Thus, the speculative demand for money varies
inversely with the rate of interest and expectations about the rate of interest and bond prices
also play a role.
6.1.1 supply of money and its various measures Supply of money
total volume of money held by the public where public includes the private individuals and
business firms operating in the economy and excludes the producers of money which are
government, central bank and commercial banks. Thus, the money held by the government
and the currency lying with the central bank and commercial banks is not included in the
money supply. Therefore, the money supply of a country at any point of time (this means it is
a stock) is the total amount of money in circulation. This may be held by individuals,
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households, business firms, institutions, local authorities, non-bank financial institutions and
non-departmental public sector undertakings (like Indian Airlines, Hindustan Steel, etc.) and
even foreign banks, governments and International Monetary Fund. The reason for measuring
the stock of money in this way is to separate the producers or suppliers of money from the
holders or demanders of money.
Since money is measurable, we can calculate the total stock of money at a particular
point of time. Measuring money at different points of time, we can construct a whole time
series of money supply which will show the behaviour of money supply over time. This
information can be used to analyse the effects of changes in the money-supply on several
important economic variables like level of income, prices, employment, rate of interest,
investment, balance of payments etc., and to control the supply of money to attain certain
policy goals. We shall discuss this aspect later but let us now concentrate on various
components of the money-supply.
6.1.2 Components of Money supply
The simplest measure of money-supply (denoted by M or M) consists of currency with
the public (notes and coins), demand deposits (DD) at commercial banks and other deposits
of the Reserve Bank of India (RBI).
1.
Currency component -Currency includes coins and notes out of which coins and
one-rupee notes are issued by the government of India while notes of denomination of
rupees two and above are issued by the RBI. All this is legal tender money.
2.
Deposit component -Demand deposits are defined as bank deposits payable on
demand through cheques or otherwise. These deposits can serve as a medium of
exchange if these are acceptable to the other party. If not acceptable, these can be
immediately converted into cash. Thus, demand deposits are as liquid as currency.
Other deposits of the RBI are its deposits other than those held by the government and
banks. They include demand deposits of quasi-govt. institutions (like IDBI), foreign
central banks and governments, IMF and the World Bank, etc. However, these other
deposits (OD) of the RBI constitute a very small proportion (say less than one per
cent) of the total money supply and hence can be ignored.
Till 1967-68 in our country, the RBI used to publish only a single measure of money
supply (M) defined as the sum of currency and demand deposits, both held by the public.
From 1967-68, the RBI started publishing additionally a broader measure of money supply
called 'aggregate monetary resources' (AMR). It was defined as M or M, plus the timedeposits of banks held by the public. From April 1977, another change was introduced and
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since then the RBI has been publishing data on four alternative measurers of money-supply,
M1, M2, M3, and M4.
M1 = C + DD + OD (where C denotes currency, DD denotes demand deposits and OD
denotes other deposits of the RBI).
M2 = M1 + Savings deposits with post office savings banks.
M3 = M1 + net time deposits of banks.
M4 = M3 + total deposits with the Post Office savings organisations (excluding National
Savings Certificates).
We have already explained M1. Currency consists of paper currency as well as coins.
Demand deposits are the net demand deposits of banks and not their total deposits. Total
deposits include both deposits from the public and inter-bank deposits while the latter are
excluded from the definition of money. We have already discussed what other deposits of the
RBI include and also pointed out their quantitative insignificance. M3 is the same as AMR
which, apart from M1, includes time deposits of all banks (net of inter-bank deposits). M2 and
M4 include Post Office deposits in addition to M1 and M3 respectively. It should be
remembered that these deposits are not withdrawable by cheque as are demand deposits of
banks. While M2 includes only savings deposits of post offices, M4 includes all post office
deposits, whether savings or time deposits.
In all the different concepts of money supply described above, currency is the most
liquid asset, followed by demand deposits of banks which can be easily converted into cash if
the need arises. Saving deposits with post offices fall next in terms of liquidity and can be
converted into money at a short notice. Time-deposits, whether of banks or post offices, come
last in terms of liquidity and cannot be redeemed into money before the stipulated maturity
period without loss of time and money. The RBI also views the four measures of moneysupply to represent different degrees of liquidity, M1 being the most liquid and M4 being the
least liquid. When it comes to the choice of the measure of money supply to be used, it all
depends upon the context. It is necessary to know the reasons for which money is demanded
and the sources from which this demand can be met. The most common measure of money
supply is that provided by M1 which is considered appropriate by most of the economists. M3
is another important and broader measure of money supply which encompasses time-deposits
of banks also.
But whatever the measure of money supply used, one thing that stands out clearly is that
the quantity of money in circulation has increased over time and even its rate of growth has
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accelerated over time. For example, the rate of growth of M1 increased from 3.6% during the
fifties to more than 13% during the eighties. You may ask who controls the supply of money?
Basically, it is the central bank, commercial banks and government who can influence or
control the supply of money in the economy. The central bank not only issues currency, but
also influences deposit money through its monetary policy. It can increase the supply of
money by following a cheap money policy and decrease it through a tight money policy.
Commercial banks can create credit in terms of demand deposits on the basis of money
deposited with them by the people. The government can influence the supply of money
through its fiscal policy (relating to revenue and expenditure) and public borrowing, an
expansionary fiscal policy increases the supply of money by reducing taxes and increasing
government expenditure (which may be partly financed by deficit financing). The opposite
happens in case of a contractionary fiscal policy.
6.2 SELF-CHECK EXERCISE
Carefully note that:
1.
Supply of Money in an economy means the stock of money in the hands of the users
of money (i.e., individuals, households, business firms, institutions, local authorities,
non-bank financial institutions etc.) and not the amounts lying in the vaults of
producers of money (i.e., The RBI, Commercial Banks and government)
2.
Various types of money are distinguished on the basis of their liquidity i.e., the case
with which these can be used in exchange transactions. Currency is the most liquid
form of money; it can be used in exchange, as and when needed without loss of time
and value. On the other hand, Savings Bank Deposits are less liquid form of money
since their use involves a cost (loss of interest) and loss of time.
Summary
Measures of money supply are ways of categorizing the amount of money in circulation in an
economy. There are several measures of money supply, including M0, M1, M2, M3, and M4.
Here's a summary of each:
M0: This measure represents the physical currency in circulation and the deposits that
commercial banks hold with the central bank. It is also known as the narrowest
definition of the money supply.
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M1: This measure includes M0 and other types of demand deposits, such as checking
accounts, that are held by households and firms.
M2: This measure includes M1 and other types of deposits that can be easily converted
into cash, such as savings accounts and money market accounts.
M3: This measure includes M2 and other types of large deposits, such as institutional
money market funds.
M4: This measure includes M3 and other types of financial instruments, such as
repurchase agreements, commercial paper, and certificates of deposit.
Central banks typically use these measures of money supply to track the amount of money
in circulation and to make decisions about monetary policy. However, these measures
are not always perfectly accurate, as the definition of "money" can be somewhat
subjective and can change over time.
6.3 SELF-ASSESSMENT QUESTIONS
1.
Define Money supply & what are its components?
2.
What are the measuring methods of money supply & which is the best member of
money supply.
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LESSON-7
MONEY AND PRICES
STRUCTURE
7.1
Introduction
7.2
The Quantity Theory of Money
7.3
Evaluation of The Quantity Theory
7.4
The Income and Expenditure Approach
7.5
Self-Check Exercises
7.1 INTRODUCTION
As you know, money does not have any utility of its own and does not satisfy human
wants directly. However, people exchange goods and services for money and it functions as a
measure of value. As mentioned earlier, this measure of value is not constant itself and its
own value keeps on changing. What is the value of money? Since money helps us to gain
command over goods and services which satisfy our wants, its value is determined by what a
unit of money will buy in terms of a representative assortment of goods and services. In other
words, the value of money is nothing. but its purchasing power which varies inversely with
the general price-level. By general price-level, we mean prices of all the goods and services
as distinct from prices of individual goods relative to those of other goods (which are called
relative prices). Change in relative prices performs the function of allocation of resources in
an economy. For example, a rise in the price of X-good relative to the price of Y-good, raises
profits in the production of X and induces producers to shift resources from the production of
Y to that of X. But when all prices in the economy rise or fall together, relative prices remain
unchanged so that no transfer or reallocation of resources takes place. What happens when
the general price level rises? When that happens, the value of money declines, as a unit of
money now commands a smaller amount of goods and services. On the contrary, a fall in
general price-level raises the value of money since a unit of money can now buy more of
goods and services.
7.2 THE QUANTITY THEORY OF MONEY
We have related the value of money to the general price-level. It will be interesting to go
into the reasons for changes in the general price level/value of money. Why do the variations
in general price level take place? The classical theory in this regard is known as the 'Quantity
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Theory of Money' or 'Fisher's Equation' (since it was formulated by Irving Fisher). According
to this theory, changes in the general price-level are direct result of changes in the quantity of
money in circulation. The equation formulated by Fisher is written as:
MV = PT
Where M stands for the quantity of money in circulation in the economy and V stands for the
velocity of circulation i.e., the number of times a unit of money changes hands on the average
during a given period of time. (If 100 rupees note changes hands 10 times during a month, it
performs the function of 1000 rupees, not 100). Thus, MV stands for the effective supply of
money over a given period of time. On the right-hand side of the equation, P stands for the
average price-level and T for the volume of real transactions. Thus, PT represents the money
value of all transactions in the economy. What does the equation MV=PT really signifies? It
refers to the simple fact, which has to be true under all circumstances, that the stock of money
multiplied by its velocity (i.e., the total supply of money) is always equal to the total value of
all the transactions (i.e., the total transaction demand for money). In other words, this
equation is an identity and conveys only this that all transactions have to be carried out
through money. A change in any of the four variables (M, V, P and T) has to be compensated
by equal change in one or more remaining variables. For example, if the amount of real
transactions (T) increases, but the money supply (M) is fixed, then either each unit of money
will be used a greater number of times to carry out the larger volume of transactions (i.e. V
will increase) or the average price-level P must fall. Suppose T increases from 500 to 1000
and M remains constant at 500, then either V must double or P must fall to one-half of its
previous value. On the other hand, if the product MV on the left side of the equation remains
constant (either because of constant M and V or because of compensating opposite changes in
M and V) and T increases, then P will have to fall proportionately to make the product PT
equal to the constant MV. As an identity, the equation MVPT conveys nothing more than the
simple fact that the total value of all transactions in the economy (PT) must be executed
through the effective money-supply in the system, i.e., MV.
But according to the classical economists, the equation MV = PT was not merely a
definitional identity, it was a theory which relates changes in the general price level (P)
directly to the changes in the quantity of money (M). Their main hypothesis was that changes
in the general price level are directly proportional to changes in the quantity of money in
circulation because volume of real transactions (T) and velocity of circulation of money (V)
are assumed constant. If V and T are assumed constant, it is quite obvious that changes in P
will naturally be proportional to the changes in M. If M doubles, P will also double and if M
decreases, P will also be pulled down proportionately. Thus, so long as we accept the
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assumption of constant T and V, the conclusion of the quantity theory of money that changes
in the quantity of money cause proportionate changes in the general price-level, holds true.
But if a rise in the quantity of money is offset either by a decline in V or an increase in T, it
will not lead to a proportional rise in the general price level.
Self-Check Exercises
1.
Construct examples to show that if V and T are held constant, P will rise and fall
proportionately to rise and fall in the quantity of M.
2.
Construct another example to show that P may change in the opposite direction to
changes in the quantity of M if V and T are allowed to vary.
7.3 EVALUATION OF THE QUANTITY THEORY
This equation was criticised by some economists for ignoring credit money which is a
very important component of money supply in a modern economy. Therefore, Fisher
extended this original equation by incorporating the volume of bank deposits (M1) and its
velocity of circulation (V1). The extended version stands as follows:
MV + M' V' = PT
If M = 200, V = 6, M' = 500, V' = 4 and T = 1600
Then P =
by
MV + M 'V ' 200x6 + 500x4 3200
=
=
= 2 . The value of money can be determined
T
1600
1600
1
T
1
or
. In the above case, value of money is
or 0.5. Now suppose V' V' and
P
MV + M 'V '
2
T remain constant, but M rises from 200 to 400 and M1 rises from 500 to 1000, then P will
rise to
MV + 1 V 400 x 6 + 1000 x 4 6400
1
=
=
= 4 . The value of money will fall to = 0.25
T
1600
1600
4
Let us examine this theory critically. The net effect of a change in the quantity of money
on the general price level will depend upon the following factors:
(a) How the change in the quantity of money affects aggregate demand?
(b) How the change in aggregate demand affects the level of output?
(e) Does velocity of circulation of money remain constant or varies?
Let us examine these questions in some detail. As far as the first question is concerned,
the assumption of the classical economists that an increase in the quantity of money will
result in a proportional increase in aggregate demand, is based on the notion that rational
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individuals have no use for idle cash balances or in other words, there is no speculative
demand for money. Their argument was that if people have more money than they need for
their day-to-day transactions (i.e., if they are able to save), they will lend out the surplus
money to the entrepreneurs at some interest rather than keeping it idle with them. The
entrepreneurs, in turn, will use the borrowed funds by investing them in capital goods
because the funds have a cost in terms of the interest to be paid. Thus, the savings of the
people will automatically generate an equal amount of investment demand in the economy
and aggregate demand will increase exactly in proportion to the increase in the quantity of
money. But in our discussion of the Keynesian theory of the rate of interest, we stated that
rational individuals do hold some idle cash balances for speculative purpose. Therefore, it is
not necessary that an increase in the quantity of money will always be lent out to
entrepreneurs for investment, thus resulting in a proportional increase in aggregate demand. It
is quite possible that it may wholly or mainly be held as idle cash balances, thus not resulting
in any increase in aggregate demand.
The second question whether a change in the level of aggregate demand will or will not
affect the level of output in the economy, will depend on whether the economy is working at
the full employment level or whether there are unemployed resources in the economy. If
there is already full employment of resources in the economy, then an increase in aggregate
demand resulting from a change in the quantity of money cannot lead to an increase in output
and will, therefore, simply raise the general price-level. If, however, there are unemployed
resources available in the economy, the increase in aggregate demand will definitely raise the
level of output rather than general price level. To what extent the increase in aggregate
demand will raise output and to what extent it will raise the price-level, will depend upon the
extent of unemployment in the economy. Thus, when there is considerable unemployment of
resources in the economy, there will be the possibility of increase in aggregate demand
leading to an increase in output rather than a proportional increase in the general price level.
Therefore, we can conclude that the quantity theory of money will not hold if (a) an increase
in the quantity of money does not lead to an increase in aggregate demand, but only results in
a greater amount of idle cash balances and (b) even if an increase in the quantity of money
does raise aggregate demand, but due to unemployed resources in the economy, this increase
in aggregate demand results in higher output, rather than higher price-level.
Finally, the question whether velocity of circulation of money is constant or not, is an
empirical issue. Some economists consider it a fairly stable and predictable variable, while
others think it is quite volatile. Famous economist Kalecki has shown that V is not constant
and over short periods of time, it varies with the rate of interest. If the rate of interest is high,
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holding idle cash becomes costly and people try to manage their transactions with smaller
cash balances by using each unit of money more often (i.e. by increasing V). Therefore, the
higher the rate of interest, the higher tends to be the velocity of circulation, V. If V is not
constant, the conclusion of the quantity theory of money does not hold good.
The classical economists assumed T to be constant because they believed that the
economy would always have full employment and aggregate demand would always equal
aggregate supply. They assumed that rational individuals would have no use for idle cash
balances (i.e. there would be no speculative demand for money) and whatever they save will
generate an equal amount of investment demand in the economy.
Thus we may say that conclusion of the Quantity Theory of Money will hold provided
(a) consequent to a change in the quantity of money, aggregate demand changes
proportionately i.e. no idle cash is held by people for speculative purpose; (b) when the
aggregate demand changes, level of output does not change at all i.e. there is already full
employment in the economy and (c) there is no change in V (velocity of circulation of
money). On the other hand, it is equally possible that changes in the quantity of money may
not affect the price-level at all. This will happen if (1) the whole of the newly pumped money
is held as idle cash for speculative purposes i.e. aggregate demand does not increase at all; (ii)
in case there is some increase in aggregate demand (proportionate or less than proportionate),
this is completely neutralised by increase in output because there are sufficient unemployed
resources available in the economy and (iii) the impact of an increase in the quantity of
money is neutralised by a compensating change in V. However, these two are extreme
possibilities and normally we can expect an increase in the quantity of money leading partly
to an increase in the general price-level and partly to an increase in the level of output.
Therefore, normally the conclusion of the quantity theory of money will hold, but partly.
There are many weaknesses of the Quantity Theory of Money. It takes M, V and T as
independent variables (out of which it assumes V and. T to be constant and this may not be
correct in reality) and considers only P as the dependent variable. In fact, changes in P may
also affect V, T and M. Also, it emphasizes only one function of money i.e., the medium of
exchange function and ignores its function as a store of value. Moreover, the rate of interest is
completely ignored by this theory. Perhaps the biggest weakness of this theory is that it does
not explain how changes in the quantity of money work their way into the economic system
and what the chain of events that follows is.
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Self-Check Exercises
Note the following points:
1.
Because of the speculations motive, aggregate demand may not rise at all consequent
to an increase in the quantity of M.
2.
Even if aggregate demand rises in proportions to a change in the quantity of M, the
price level may remain unchanged if enough unemployed resources are available in
the economy.
3.
The biggest defect of the Quantity Theory of Money is its failure to explain the
channel by which in increase in M bids up the price level.
7.4 THE INCOME AND EXPENDITURE APPROACH
It was Keynes who explained the Income and Expenditure Approach according to which
changes in the quantity of money work their way into the economic system through a certain
process and the net effect of such changes on the price-level depends on a number of 'ifs' and
‘buts'. We can describe the sequence of events roughly as follows. An initial change in the
quantity of money will affect bond-prices (by increasing the demand for bonds) and the rate
of interest since bond-prices and rate of interest are inversely related to each other and are
two sides of the same coin. Normally. an increase in the quantity of money may be expected
to raise bond-prices and thus lower the rate of interest. A production in the quantity of money
may be expected to produce the opposite effects viz. a fall in bond-prices and a rise in the rate
of interest. A lowering of the rate of interest (caused by an increase in the quantity of money)
normally induces producers to make larger investment because the cost of investment (in
terms of the rate of interest) is now lower than before. Here we assume that other factors
affecting producers' profit-expectations remain constant. Now, even if consequent upon an
increase in the quantity of money, the rate of interest does fall and the investment is
stimulated, the extent of rise in aggregate demand will depend upon that in aggregate income
which in turn depends on the value of the multiplier. Finally, the increase in aggregate
demand will raise the general level of prices provided the economy is working at the full
employment level and there are no unemployed resources available in the economy. Thus, we
can see that it is not possible to relate changes in the general price-level directly to changes in
the quantity of money as the Quantity Theory of Money does. In fact, there is many a slip
between the cup and the lip.
First of all, an increase in the quantity of money may be neutralised by an increase in idle
cash balances and may fail to lower the rate of interest. This will happen if the rate of interest
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is already so low that people expect it to rise and hence postpone the purchase of bonds.
Secondly, even if the rate of interest does fall, it may not stimulate investment if the marginal
efficiency of capital also falls due to technological, social, political or economic factors.
Thirdly, even if a fall in the rate of interest does stimulate investment, it may not lead to
much increase in the level of income if the value of the multiplier is low. Finally, even if an
increase in investment does result in a greater increase in income-level via the multiplier and
hence an increase in aggregate demand, it may not affect the general level of prices if the
level of total output increases in proportion to that of aggregate demand due to availability of
unemployed resources in the economy. Therefore, the Keynesian Income and Expenditure
Approach describes all the conditions which should be fulfilled if the changes in the quantity
of money are to result in proportionate changes in the general price level. Increase in the
quantity of money should raise bond-prices and lower the rate of interest. A decline in the
rate of interest should induce more investment which should raise the income-level through
the multiplier. A rise in the income-level should raise aggregate demand, but not the level of
output in the economy so that the general price-level rises proportionately. If any one of these
conditions is not fulfilled, the direct relationship between the quantity of money and general
price-level breaks. Thus, the Income and expenditure Approach explains how changes in the
quantity of money work their way through the economic system step by step and eventually
result in changes in the general price-level.
7.5 SELF-ASSESSMENT QUESTIONS
Carefully note the 'ifs' and 'buts' in the way changes in the quantity of M work their way
through the economic system.
1.
A change in the quantity of M is expected to change the rate of interest. How? When
it may not?
2.
A change in the rate of interest is expected to affect investment. How? When it may
not?
3.
A change in investment is expected to affect the levels of output and employment
through the multiplier process.
4.
It is possible that in one situation the change affects only output and in another
situation in affects only the price level.
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LESSON-8
CREDIT CREATION
STRUCTURE
8.1
Introduction
8.2
Limits of Credit Creation
8.3
Money Multiplier
8.4
Questions for Review
8.1 INTRODUCTION
It is common knowledge that people deposit money in the banks. This is done keeping in
mind several things. It is not safe to keep large sums of liquid money (currency notes, etc.) at
home because they may be stolen. A safer course would be to keep them in a bank and
withdraw the amount as and when the need arises. People who save would also like to earn
interest on their savings. Cash balances lying idle at home do not yield an income, but if put
in the bank they start earning an interest. The rate to interest depends, however, on the period
for which these balances are left with the bank. If it is for a short period of a few months, the
rate of interest is low and if its for a longer period of a year, two years or five years or even
more, the rate of interest is higher. The longer the period for which a depositor decides to
keep his money with a bank, the higher is the rate of interest. The lending activities of a bank
are planned after determining the requirements of cash to satisfy the demands of customers
who come to withdraw their money. People also save in order to tide over certain
emergencies. Another reason why people save is that a man is able to earn only during the
active part of his life and he must provide for old age. Similarly, there are demands which
require large sums of money that can not be provided out of monthly income. For instance,
the purchase of a TV set or a refrigerator or the construction of a house or the marriage of a
daughter, all these require large sums of money. Wise people foresee their further wants and
save for them over a period of time and keep their savings in a bank.
But generally, all the people who keep their savings in a bank, do not simultaneously
want to withdraw them. At a point of time, only a fraction of people approaches the bank to
withdraw the money in order to meet their needs. Once the bank understands this fact, it can
keep a fraction of the cash as reserve and lend the remaining amount to people who demand
loans for their business and industry. In this way, the bank can convert idle money into
income-yielding assets. Thus, the fact that the people who deposit money in the banks, do not
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all withdraw the whole amount simultaneously, is the basis of credit creation by the banks.
Generally, the amount of credit created is a multiple of the amount deposited with the banks.
In order to understand the process of credit creation, let us take an example. Suppose a
businessman seeks a loan of Rs. 1,00,000 from a bank. The bank would ask him to furnish
security. This security can be in the form of fixed assets like a house, a factory or a machine.
The purpose or this probe is to establish credit worthiness of the borrower. While granting
loans to the farmers or the small entrepreneurs, the banks explore their capacity to repay by
an estimate of the value of crop which is likely to be produced or the estimate of the value of
the prospective output of a small enterprise. In either case, whether the loan is given against
fixed capital or circulating capital, a bank ensures the credit worthiness of the borrower. The
value of the capital or circulating capital kept as a mortgage against the loan advanced is
generally higher by a certain amount (say 30 per cent) called as 'margin'. The purpose of
keeping a margin is that in case a borrower fails to pay back the loan as specified in
agreement with the bank, the latter should be able to recover it by auctioning the assets
mortgaged with the bank. It is in this sense that it may be said that banks create credit not out
of thin air but against the securities furnished by the borrowers. But whenever a bank has to
make a payment, it does not hand over the requisite amount in currency but places the sum in
credit of the payee in its account books and hands over a cheque book to him. The payee
would, of course, draw cheques for discharging his obligations. Now as these cheques are
presented for encashment at the counter, the bank would find itself in difficulty if it had not
kept in reserve cash to the tune of the total amount it placed in this manner at the disposal of
the borrower. And if all the people cash their cheques, bank will never be able to add to the
total supply of money. Some. of course, will do that, but many of the recipients of cheques
would be satisfied by depositing them in their respective accounts in the same bank or what is
more likely, in other banks. What if those other banks demand cash from the first bank? Of
course, they would, but as at the same time they would also be doing similar business, there
would be a fair amount of cancellation of inter-bank obligation, so that the first bank when
placing dep t money at the disposal of borrower must have in hand enough case to put out to
those who cash their cheques and to settle the balance of indebtedness with other banks. This
would generally be a fraction of the total loans given. That is why this type of banking is
called fractional reserve deposit banking and the ratio of the amount of cash held to the total
deposits is called 'safe cash reserve ratio'.
The process of creation of credit can be illustrated with the help of an imaginary balance
sheet of a bank.
First stage– Depositors deposit money in the bank.
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BANK A
Liabilities
Rs.
Assets
Rs.
Deposits
1, 00,000
Cash
1, 00,000
The bank knows that many of their depositors would let their money lie with the bank. If
some withdraw, others will deposit. The law of large numbers would enable the bank to
calculate with a fair degree of accuracy what percentage of the total money deposited will be
lying idle with the bank at any time. Once the banker lows this, he can set about making
profitable use of the idle money. He would, of course, keep a certain percentage as reserve.
This is called safe cash reserve ratio. Let us suppose, the bank keeps 20% as reserve against
advances and the rest it creates deposits.
Second stage– The banker gives loans.
Liabilities
Rs.
Assets
Rs.
Deposits (primary)
1, 00,000
Cash
1, 00,000
Deposits (Secondary)
80,000
Assets against loans
80,000
1, 80,000
Total
1, 80,000
Total
The bank has given loans amounting to Rs.86, 000 keeping Rs.20, 000 reserves against
the primary deposit of Rs. 1, 00,000. Now, suppose all those to whom cheques are paid by the
borrowers deposit their cheques in other banks.
BANK Α
Third Stage
Liabilities
Rs.
Assets
Rs.
Deposits
1, 00,000
Cash
20,000
Assets against loan
80,000
___________
___________
1, 00,000
1, 00,000
Other Banks
(How the other banks are affected)
Increase in liability
Deposits
Rs.
Increase in assets
Rs.
80,000
Cash
80,000
Now, the other banks in tum would start the process of creation of credit by giving loans
all over again and lend what they consider to be excessive cash, keeping with them only a
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fraction, determined as safe cash-reserve ratio, as reserve. The multiplication process will
continue till the whole of Rs. 1, 00,000 is absorbed in what the banks consider necessary
balance of cash reserve against deposits and the deposit money would go on increasing in the
following manner: Rs. 1, 00,000 + Rs. 80,000+ Rs. 64,000 + Rs. 51,200 +.... etc. each
subsequent figure being 20 per cent less than the previous one as each time, 20 per cent is
retained by a bank as necessary cash reserve. In this case, the cash reserve is Rs. 20,000 the
banking system, under normal conditions, can satisfy the demands for withdrawals by
depositors holding credits worth Rs. 1, 00,000. In case, the bank or the banking system keeps
Rs. 1, 00,000 as case reserve, it can lend to the tune of a total of Rs. 5, 00,000 (given 20 per
cent as the safe cash-reserve ratio).
The table below bring out clearly the process of credit creation by the banking system. A
new deposit of Rs. 1, 00,000 created in the 1st series of banks permits after keeping a cash
reserve of Rs. 20,000, h creation of new loans and investment to the extent of Rs. 80,000
which is deposited in the second series of banks as new deposit. After retaining 20 per cent as
cash
reserve,
would
enable
the
second
series
of
banks
to
lend
Rs. 64,000. This creates a new deposit of Rs. 64,000 in the 3rd series of banks which after
retaining Rs.12,800 as cash reserve can create new loans and investment to the tune of
Rs.51,200. Thus, the process moves on and on till the total deposits reach a total of
Rs. 5,00,000 and new loans and investments are Rs. 4,00,000 with a cash reserve balance of
Rs. 1,00,000.
PROCESS OF CREDIT CREATION THROUGH THE BANKING SYSTEM
0
0
0
New Deposits
Rs.
New Loans &
investments
Rs.
Cash Reserve
balance
Rs.
Ist series banks
2nd series banks
3rd series banks
4th series banks
Total
All the remaining
Banks Total for the
Banking system
1, 00,000
80,000
64,000
51,200
2, 95,200
2, 04,800
5, 00.000
80,000
64,000
51,200
40,960
2, 36,160
1, 63,840
4, 00,000
20,000
16,000
12,800
10,240
59,040
40,960
1, 00,000
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8.2 LIMITS OF CREDIT CREATION
There are two limits to the process of credit creation by the banks. They are
(a) quantity of cash deposits with the commercial banks and (b) safe cash deposit ratio.
(a) Quantity of cash deposits with commercial banks– Since the people have to deposit
currency with the banks as the currency deposit, the extent of the cash deposit will depend
upon the total amount of state money, viz., currency issued by the central bank of the country.
In case, the central bank increases the state money supply by issuing more currency, the
quantity of cash deposit can also increase. The second factor that determines the cash deposit
is the banking habits of the people. In underdeveloped countries, banking habits being not
very highly developed people prefer to pay the grocer, the washer man, the milkman and
several other sundry creditors in cash; but in developed countries, even these payments are
made in cheques. Obviously, the quantity of cash required for day-to-day transactions is
much lower in developed countries than in underdeveloped countries. In other words, the
proportion of total currency which is deposited with the commercial banks in developed
countries is higher than in underdeveloped countries and consequently, the limits of credit
creation shall also be higher in the former than in the letter.
(b) Safe Cash Reserve Ratio– Another factor that limits credit creation is the safe cash
reserve ratio. This depends upon the extent to which people are accustomed to the use of
credit instruments in discharge of their business obligations. In other words, the extent of
confidence of the public in the banking system determines the safe cash reserve ratio and the
latter, in turn, sets the limit to the creation of credit. For instance, if the cash reserve ratio is
20 per cent, it would be possible to expand total credit to the tune of Rs. 5, 00,000 with a cash
deposit of Rs. 1, 00,000. But in a developed country where cash reserve ratio is lower, say 10
per cent, it would be possible to expand total credit to tune of Rs.10, 00,000 with a cash
deposit of Rs. 1, 00,000. The capacity of credit creation by the banking system is thus limited
by safe cash reserve ratio.
The discussion makes it clear that banks can lend more than their deposits. Banks also
prescribe for themselves the cash reserve ratios depending upon the experience of the past,
the stage of development in banking reached by a country and the degree of confidence the
people have in a bank.
But there can be a miscalculation on the part of a bank in determining the safe cash
reserve ratio. What happens in the event of miscalculation?
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A look at the balance sheet of any bank will help us in answering this question. The
remarkable fact you will notice will be that most of the liabilities are short period liabilities
i.e.... money liable to be withdrawn without notice. How does the bank manage to meet its
liabilities? The bank conducts its business on the assumption that all the people will not
withdraw money at the same time. As some withdraw, there would be others depositing and
the bank would require cash to meet only the net outflow. If a bank has been giving loans at a
rate far in excess of other banks, it will have to make arrangements to pay cash at the time of
demand. Or if the public demand is against a bank so that depositors are withdrawing their
money and no new deposits are being made, it will have to take exceptional measures to meet
the cash drain. Otherwise, it would not be able to carry on its business by maintaining the
normal cash deposits ratio which is normally ten per cent these days.
If a bank finds itself hard pressed for cash, it will realise some of its assets and slow the
Rate at which it is creating fresh credit. A bank's portfolio of assets should be such that there
are assets falling due simultaneously with claims. There should also be certain percentage of
short period assets which can be called in as and when more cash is needed. The two
considerations which the banker keeps in mind while choosing assets are profitability and
liquidity. Liquidity means the case with which an asset can be exchanged for money at little
loss. The liquidity of an asset is determined by the nature of the market on which it is traded.
Highly liquid assets other than cash and bank deposits are post office savings, treasury bills
and money at call and short notice. A bank is a joint stock company. It has to declare a
dividend to satisfy its owners. The rate of interest which a bank pays to its depositors is lower
than the rate at which it lends money. The rate of interest it charges from borrowers or the
profits it realises on its investments are in direct proportion to the difficulty, delay and risk of
capital depreciation involved. The less liquid the asset, the higher, in general is its yield. A
right balance between the opposites-liquidity and profitability-is the hallmark of successful
banking. The bank can neither afford to be less liquid nor lose an opportunity to cam profits.
But accidents always happen and then the bank has to suspend payments. The bank failures
have been none too rare in the history of banking all the world over. Thus, in the interest of
stability it is necessary to have check on the power of a bank to create credit. But even if
there were no risks of bank failure-as would happen when all the banks are simultaneously
expanding deposits-the aggregate of currency is expanding and banks are carrying on their
business with judicious care, it would still be necessary to safeguard the economic system
against a continuous expansion of bank credit. The need for putting a limit on the expansion
of credit and through it controlling the total supply of money arises due to the fact that an
increase in the supply of money, unaccompanied by an increase in total output may lead to
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inflation, i.e., a rise in the general price level. The adverse effects of inflation on the
distribution of incomes have been hinted at in section 2 above.
8.3 MONEY MULTIPLIER
Money Multiplier is the amount of money which generate by the banking system of
the economy with each amount of reserves.
High Powered Money or Monetary Base
(Money held by the public)
H = C + R reserves of B……. M=C+DD
High Powered Money refers to the money produced by the RBI & govt. of other country &
held by the Public & Banks.
Money Multiplier
M C+D
=
H C+R
If this equation is divided by D by both numerator & denominator
C D
C
+
+1
D D= D
C R C R
+
+
D D D D
If c/d = C
M C +1
=
H C + rd
R/d = rd
M(C + rd) = ( C + 1) x H
M=
 C+I 

xH
 C + rd 
8.4 SELF- ASSESSMENT QUESTIONS
1.
Explain the credit creation process in a single banking system & multiple banking
system.
2.
What are the limitations of credit Creation?
3.
Write a Short Note on:
High Powered Money or Money Multiplier
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LESSON-9
DEMAND FOR MONEY AND ITS DETERMINANTS
STRUCTURE
9.1
Introduction
9.2
Concept of Investment Spending
9.3
Theories of Money Demand
9.3.1
The Keynesian theory of money Demand
9.3.2
Tobin's Portfolio Theory
9.4
Monetary Equilibrium
9.5
Summary
9.6
Self-Assessment Questions
9.7
Suggested Readings
9.1 INTRODUCTION
The equilibrium in macro economics is when aggregate demand and aggregate supply are
equal and aggregate demand in a macro economics consists of consumption by households,
investment by the firms, expenditure by government and net exports. The previous chapters
have talked about consumption, government expenditure and net exports and investment was
assumed to be autonomous in all the previous chapters. This chapter discusses about different
forms of investment and factors on which investment depends. Equilibrium in the money
market is when money demand and money supply are equal. To explain the concept of
money demand it explains various theories that help in determining the demand of money. It
also explains how banks help in creation of money through credit creation process and
various monetary policies of the central bank that have an impact on the money supply.
9.2 CONCEPT OF INVESTMENT SPENDING
Expenditures made by the business sector on final goods and services, or gross domestic
product, especially the purchase of productive capital goods. It can be broadly divided into
three types:
Business Fixed Investment: It is the most common form of investment that includes
expenditure by firms on the fixed investment that is capital goods like machinery,
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equipments, building for factory etc. It is one of the main contributors to economic growth
and one of the most crucial decisions that have to be undertaken. While deciding about
whether to go ahead with a particular investment or not firms use discounted techniques
which is because of the fact that the revenues take place in the future whereas costs are
usually incurred in the present, to calculate the viability the future stream of revenue has to be
discounted to get its present value.
These decisions are very crucial because of the fact the once started it is very difficult to
reverse them without incurring any costs.
Residential Investment: It includes expenditures on houses, buildings, and similar types of
shelter. Residential fixed investment includes structures built, owned, and occupied by
individuals and it also includes residential places developed by businessman whose business
is to sell or give on rent such property. To decide whether to go for this type of investment or
not the benefits and costs associated with it has to be seen. Benefits include the imputed rent
if the house is being used for self accommodation or earned rent if it has been rented out and
the capital gain (or loss) because of change in the value of the investment. Cost includes the
interest payments if investment has been taken on loan and depreciation or annual
expenditure on maintenance. If benefits outweigh the cost the investment should be done
otherwise it should not be.
Inventory Investment: Firms not only invest in fixed assets but also in raw materials, work in
progress and finished goods that are kept in the stock in anticipation of to be sold in the
future. Firms usually keep a ratio of inventory to the sales to ensure they do not lose out any
opportunity in the market. Although inventories are a relatively small portion of the overall
investment sector, inventories are a critical component of changes in GDP over the business
cycle. If the economy is slowing down then inventories and that too unexpected inventory
would pile up and if there is boom in the economy then inventories would come down. Thus,
changes in the inventory determine the production level of the firm whether it needs to
increase the production or reduce it.
9.3 THEORIES OF MONEY DEMAND
Money demand and money supply needs to be understood to establish the money market
equilibrium. Money demand refers to demand for real money that is demand of money for
transactionary purposes. People hold money with them because they need to enter into
transactions and for that liquidity is needed. Demand of money for transactionary purpose is
directly related to income level and inversely related to real rate of interest. This is the
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simplest theory of money demand as was also done in LM or money market equilibrium.
Other motive for holding money is for precautionary motive and speculative motive.
9.3.1 The Keynesian theory of money Demand
According to Keynes, Money is a very liquid form of asset, and everybody wants to keep it in
cash form for specially three purposes:
1.
Transaction Purpose
2.
Precautionary Purpose
3.
Speculative Purpose
1.
Transaction purpose – The first & main purpose for holding money in cash form is
for day-to-day transactions. There is a gap between money income receipt & expenditures.
Money is received by Person at Particular time, but expenditure is continuous in nature. If
there is good synchronization between income receipt & payments, then there will be less
demand for money holding & vice-versa.
It can be denoted by MT – Money demand for Transaction purpose & it is directly
proportionately level of income. Therefore, the nature of curve of MT will be upward sloping
& 450 line.
Fig. 9.1
MT = f(y) means money demand for transaction purpose is the function of income.
2.
Precautionary Purpose – This is the second purpose of demand for money. This
purpose indicates future uncertainties which may occur at any time in future like illness,
unemployment, accident etc. People need to keep money in cash form to protect their own
interest from these uncertainties. Keynes termed it precautionary motive for demand for
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money. It can be denoted by MP and It is also the function of Income and directly or
proportionately related with level of Income.
Fig. 9.2
3.
Speculative Demand – The third and most important motive for holding money in
cash form is speculative motive which is related with rate of interest not by the level of
income. It may be denoted by MSP.
MSP= f(r)
The demand for money for speculation purpose is inversely related with rate of interest when
Speculative demand.
Investors have a relatively fixed conception about ‘normal’ interest rate. When the actual
interest rate is above the normal rate, invertors expect the interest rate to fall. When the actual
interest rate is below the normal rate, they expect it to rise. The relation between the price of
bonds & interest rate changes.
When bond price is low, people will purchase it & at higher price they will sell it, to gain
more profits. At higher rate of interest demand for bonds will fall & vice-versa. Due to this
inverse relationship money demand for speculation purpose curve slope is downward from
left to right.
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Fig. 9.3
At higher rate of interest, MSP will be lower & vice-versa, but rate of interest can never be fall
too much. A situation at a very low interest rate where the speculative demand for money
curve becomes constant or horizontal line that situation is called ‘Liquidity Trap’.
Fig. 9.4
Total demand for money is the sum of money demand for transaction purpose, precautionary
purpose & speculative purpose.
TDM = MT + MP + MSP
r(y) + f(r)
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9.3.2 Tobin's Portfolio Theory
Portfolio refers to a mix or combination of different assets that people hold in with them to
satisfy their requirements. The different proportions of assets that individuals hold depends
on the risk and return of different assets and the total wealth that they have. So the demand
function can be written as:
Md = f(rs, rb, 1re, W)
Where Md refers to real demand of money for transactionary purpose.
rs= Expected real return on stocks
rb = Expected real return on stocks
re = Expected Inflation rate
W = Real Wealth
An increase in real return on stocks or bonds reduces the demand for real money as the
opportunity cost of holding money increases and stocks and bonds become more attractive,
an increase in expected inflation also reduces demand of real money. An increase in wealth
however increases the demand of real money. Thus, this theory emphasize that demand
function of money should include expected returns on other assets too. However, the theory is
applicable only if M2 measure of money is considered and fails if M1 is taken into
consideration. There is another theory by Tobin which takes into consideration behaviour of
individual wealth holder and assumes only two components to be a part of the portfolio money and bonds. The expected proportion of money and bond that an individual would hold
depends on expected gain and expected risk of the portfolio. Earlier theory ignored the
determination of the transactions demand for money and considered only the demand for
money as a store of wealth. Here the focus is on an individual's portfolio allocation between
money-holding and bondholding, subject to the wealth constraint. The theory is based on
certain assumptions like:
1.
Wealth is considered as an economic good and risk is an economic bad
2.
In case of money there is no return or risk.
3.
The expected capital gain on bonds is zero. This is because the individual investor
expects capital gains and losses to be equally likely.
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4.
Bonds pay an expected return of interest, but they are a risky asset. Their actual return
is uncertain due to the fact that the market rate of interest fluctuates even in the short
run.
The theory can be explained using the following figure:
Figure 9.5: Tobin's Portfolio Theory
Here W is the initial wealth that the individual has which has to be divided between money
and bonds. If the individual holds the entire wealth in form of money, then after a year his
wealth would be the same as money earns neither any return nor any risk. However if the
investor invests entire wealth in the bond with an expected real interest rate of r% the wealth
after a year would be w (l +r) and the risk as measured by standard deviation is max shown
by R1. But the portfolio that investor chooses depends upon the point of tangency between
indifference curve and the budget constraint where the highest possible indifference curve is
tangent to the budget constraint it is the equilibrium showing the proportion of wealth
between money and bonds. The shape of the indifference curve is such that because on x axis
there is an economic bad and on y axis there is economic good. If there is change in the
interest rate the budget constraint would change and the portfolio of the investor would also
change depending upon whether the investor is risk adverse, risk neuter or risk lover. It can
be shown as follows:
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Fig. 9.6
Figure 9.6: Tobin's Portfolio Theory: Risk Neuter Investor
A risk neuter is one who is indifferent towards risk and is only concerned about return, so
with increase in the rate of interest the risk neuter brings no change in the proportion as he
gets more return now with the same portfolio because of increase in the rate of interest.
Figure 9.7: Tobin's Portfolio Theory: Risk Lover Investor
A risk lover is one who seeks risk and is willing to take more risk. Thus, with an increase in
the rate of interest on bonds the risk lover increases his holding of bonds such that both the
risk and return increases and the investor is satisfied because of higher risk. Thus, he moves
to a higher indifference curve which is to the right showing greater proportion of bonds as
compared to previous portfolio.
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Figure 9.8: Tobin's Portfolio Theory: Risk Averse Investor
A risk adverse investor is one who prefers less risk and tries to avoid risk. Thus, with an
increase in rate of interest as he can earn the same wealth by investing less in bonds, so a risk
averse investor reduces the proportion of bonds in his portfolio to reduce the overall risk and
to keep the return constant. Thus, there is a leftward shift in the indifference curve. Though
he is on a higher indifference curve because of increased satisfaction due to reduced risk his
return is the same as earlier.
Baumol-Tobin Model of Cash Management: This theory focuses on the transactionary
function of money as people hold money worth them because they need to enter into
transactions and to maintain liquidity cash is needed. The amount of money that people will
hold with them depends on the cost associated with holding money which involves the
interest foregone on the money being held with the individual. The benefit includes the
convenience as there is no need of going to banks to acquire money for entering into
transactions. Thus, taking into consideration the cost and benefit involved the investor has to
decide the optimum sum that he needs to hold with them such that the cost is minimum. Let
us assume that investor requires 'Y' sum of money to enter into transactions for the whole
year and he withdraws this at the beginning of the year and then uses it and by the year end it
becomes zero. Thus, it can be presented diagrammatically as:
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Figure 9.9: One trip to Bank
The figure shows that in the beginning of the year itself individual withdraws 'Y' amount of
money that is needed for the transaction in the whole year. This money is then spent evenly
throughout the year such that by the year end it becomes zero. So, the average holding
throughout the year is 'Y/2' that is opening+ closing balance divided by 2. Now if we assume
that investor makes two trips to bank then the above figure would change as:
Figure 9.10: Two trips to Bank
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The figure shows that in the beginning of the year itself individual withdraws 'Y/2' amount of
money that is half the amount needed for the transaction in the whole year. This money is
then spent evenly throughout the half year such that by the end of six months it becomes zero
and then again he makes a visit to the bank and withdraws Y /2 such that by the year end it
again becomes zero. So, the average holding throughout the year is 'Y/4' that is opening +
closing balance divided by 2.
The above figure can be expanded to show what will happen if he makes 'N' trips to bank.
Figure 9.11: N trips to Bank
The figure shows that in the beginning of the year itself individual withdraws 'YIN' amount
of money that is one by Nth of the amount needed for the transaction in the whole year. This
money is then spent evenly throughout the 1 by Nth of the year such that by the end of it, it
becomes zero and then again he makes a visit to the bank and withdraws YIN such that by the
period end it again becomes zero. This process continues for the whole year such that by the
year end it is again zero and the transactionary need of the whole period has been met by
making 'N' trips to the bank. So, the average holding throughout the year is 'Y/2N' that is
opening+ closing balance divided by 2.
Now to decide how many trips to make to bank we need to use the following derivation:
To minimize cost to the banks we have to do the following derivation:
Total cost = Interest foregone + Costs of trips to bank
TC = iY /2N + FN where i is the rate of interest and F is the cost of per trip to bank.
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dC/dN = -iY/2N2 + F = 0, N = √ iY/2F
Average cash holding is directly related to the income level (Y) and (F) but indirectly related
interest rate (i) If F is greater or Y is the greater or i is lower (where Y is the expenditure),
then the individual holds more money, that is, demand for money depends positively on
expenditure (Y) and negatively on the interest rate.
Figure 9.12: Minimum cost at optimal number of trips
Failure of the Model:
1.
The Model failed because some people have less discretion over their money holdings
than the model assumes
2.
Empirical studies of money demand find that the income elasticity of money demand
is greater than half and the interest elasticity of money demand is less than half. Thus,
the model is not completely correct.
Intext questions: True and False
(1)
Demand of money means demand for transitionary purpose.
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(2)
Risk is measured by standard deviation in Tobin's Portfolio.
(3)
Tobin’s theory is successful in case of M1 measure but not M2.
(4)
Credit creation by banks is dependent on the legal reserve requirement of banks.
(5)
High powered money includes cash and reserves.
9.4 MONETARY EQUILIBRIUM
Monetary equilibrium is a situation where Money demand & money supply curve intersect
each other. Money demand is inversely related with rate of interest. That’s why Md Curve is
downward sloping curve & Money supply is a stock concept and money is supplied by RBI at
Particular Point of time so money supply curve is vertical where both curve intersects
equilibrium can be determined.
Fig. 9.12
Change in Monetary equilibrium can This curve shows the effect of change in
change due to change in Money demand & money demand on equilibrium rate of
Money
interest quantity of money. Due to change
in money demand only rate of interest will
change, quantity will remain same or
constant.
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This curve shows the effect of change in
money supply on equilibrium rate of
interest and quantity of money. Due to
charge in money supply both will change
(R.O.I. and quantity of Money)
supply.
9.5 SUMMARY
In macroeconomics equilibrium is when aggregate demand and aggregate supply are equal.
Aggregate demand consists of expenditure by households in the form of consumption, which
is a function of disposable income, expenditure by private firms in the form of investment, by
government in the form of receipt of taxes, expenditure on transfer payments and government
purchases and external sector's exports and imports. This chapter talks about investment
expenditure which can be broadly divided into residential fixed investment, business fixed
investment and inventory investment. Various theories have been given that explain the
demand and supply of money like Tobin's portfolio theory which determines how an
individual form his portfolio and determine the proportion of different assets to hold.
Similarly, Baumol explained how much money an investor would hold which depends on the
transitionary need of the investor and a comparison between the holding cost and carrying
cost. Similarly, money supply is determined by the central bank and it takes various policies
that is quantitative and qualitative to alter the money supply as and when required. The most
important function of the banks that leads to money supply in the economy is the process of
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credit creation through which money supply is created in the economy. This process in tum
depends on the legal reserve requirement that is mandatory for the banks to hold and is a
combination of cash reserve ratio and statutory liquidity ratio in our country. Thus, in this
manner equilibrium is attained in the money market when money demand and money supply
become equal.
ANSWER TO INTEXT QUESTIONS
Ans. (1) T, (2)T, (3)F, (4)T, (5)T (6). Transitionary, speculative and precautionary motive
(7). Expected gains and losses are equal (8). Another (10). Qualitative and quantitative
SELF-ASSESSMENT QUESTIONS
1.
Differentiate between Tobin and Baumol's theory
2.
What is the process of credit creation by banks.
3.
Explain the concept of money multiplier.
4.
How does central bank affect money supply in the economy.
5.
Explain qualitative measures of monetary policy.
6.
Explain the concept of floating and fixed rate system
7.
Explain the various components of investment.
8.
Derive aggregate demand curve in a small open economy.
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LESSON-10
TOOL OF MONETARY POLICY
STRUCTURE
10.1
Overview
10.2
The Goal(S) of Monetary Policy
10.3
The Monetary Policy Framework
10.4
Instruments/Tools of Monetary Policy
10.5
Open and Transparent Monetary Policy Making
10.6
Self-Assessment Questions
10.1 OVERVIEW
•
Monetary policy refers to the policy of the central bank with regard to the use of
monetary instruments under its control to achieve the goals specified in the Act.
•
The Reserve Bank of India (RBI) is vested with the responsibility of conducting
monetary policy. This responsibility is explicitly mandated under the Reserve Bank of
India Act, 1934.
10.2 THE GOAL(S) OF MONETARY POLICY
•
The primary objective of monetary policy is to maintain price stability while keeping
in mind the objective of growth. Price stability is a necessary precondition to
sustainable growth.
•
In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a
statutory basis for the implementation of the flexible inflation targeting framework.
•
The amended RBI Act also provides for the inflation target to be set by the
Government of India, in consultation with the Reserve Bank, once in every five years.
Accordingly, the Central Government has notified in the Official Gazette 4 per cent
Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016
to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower tolerance
limit of 2 per cent.
•
The Central Government notified the following as factors that constitute failure to
achieve the inflation target:(a) the average inflation is more than the upper tolerance
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level of the inflation target for any three consecutive quarters; or (b) the average
inflation is less than the lower tolerance level for any three consecutive quarters.
•
Prior to the amendment in the RBI Act in May 2016, the flexible inflation targeting
framework was governed by an Agreement on Monetary Policy Framework between
the Government and the Reserve Bank of India of February 20, 2015.
10.3 THE MONETARY POLICY FRAMEWORK
•
The amended RBI Act explicitly provides the legislative mandate to the Reserve Bank
to operate the monetary policy framework of the country.
•
The framework aims at setting the policy (repo) rate based on an assessment of the
current and evolving macroeconomic situation; and modulation of liquidity conditions
to anchor money market rates at or around the repo rate. Repo rate changes transmit
through the money market to the entire the financial system, which, in turn, influences
aggregate demand – a key determinant of inflation and growth.
•
Once the repo rate is announced, the operating framework designed by the Reserve
Bank envisages liquidity management on a day-to-day basis through appropriate
actions, which aim at anchoring the operating target – the weighted average call rate
(WACR) – around the repo rate.
•
The operating framework is fine-tuned and revised depending on the evolving
financial market and monetary conditions, while ensuring consistency with the
monetary policy stance. The liquidity management framework was last revised
significantly in April 2016.
Before the constitution of the MPC, a Technical Advisory Committee (TAC) on
monetary policy with experts from monetary economics, central banking, financial
markets and public finance advised the Reserve Bank on the stance of monetary
policy. However, its role was only advisory in nature. With the formation of MPC, the
TAC on Monetary Policy ceased to exist.
•
10.4 INSTRUMENTS/TOOLS OF MONETARY POLICY
There are several direct and indirect instruments that are used for implementing
monetary policy.
Repo Rate: The (fixed) interest rate at which the Reserve Bank provides overnight
liquidity to banks against the collateral of government and other approved securities under
the liquidity adjustment facility (LAF).
Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs
liquidity, on an overnight basis, from banks against the collateral of eligible government
securities under the LAF.
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Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as term
repo auctions. Progressively, the Reserve Bank has increased the proportion of liquidity
injected under fine-tuning variable rate repo auctions of range of tenors. The aim of term repo
is to help develop the inter-bank term money market, which in turn can set market-based
benchmarks for pricing of loans and deposits, and hence improve transmission of monetary
policy. The Reserve Bank also conducts variable interest rate reverse repo auctions, as
necessitated under the market conditions.
Marginal Standing Facility (MSF): A facility under which scheduled commercial
banks can borrow additional amount of overnight money from the Reserve Bank by dipping
into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest.
This provides a safety valve against unanticipated liquidity shocks to the banking system.
Corridor: The MSF rate and reverse repo rate determine the corridor for the daily
movement in the weighted average call money rate.
Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills
of exchange or other commercial papers. The Bank Rate is published under Section 49 of the
Reserve Bank of India Act, 1934. This rate has been aligned to the MSF rate and, therefore,
changes automatically as and when the MSF rate changes alongside policy repo rate changes.
Cash Reserve Ratio (CRR): The average daily balance that a bank is required to
maintain with the Reserve Bank as a share of such per cent of its Net demand and time
liabilities (NDTL) that the Reserve Bank may notify from time to time in the Gazette of
India.
Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required to
maintain in safe and liquid assets, such as, unencumbered government securities, cash and
gold. Changes in SLR often influence the availability of resources in the banking system for
lending to the private sector.
Open Market Operations (OMOs): These include both, outright purchase and sale of
government securities, for injection and absorption of durable liquidity, respectively.
Market Stabilisation Scheme (MSS): This instrument for monetary management was
introduced in 2004. Surplus liquidity of a more enduring nature arising from large capital
inflows is absorbed through sale of short-dated government securities and treasury bills. The
cash so mobilised is held in a separate government account with the Reserve Bank.
For current operative policy rates, please see "Current Rates" section on the home
page.
10.5 OPEN AND TRANSPARENT MONETARY POLICY MAKING
•
Under the amended RBI Act, the monetary policy making is as under:
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•
The MPC (Monetary Policy Committee) is required to meet at least four times in a
year.
•
The quorum for the meeting of the MPC is four members.
•
Each member of the MPC has one vote, and in the event of an equality of votes, the
Governor has a second or casting vote.
•
The resolution adopted by the MPC is published after conclusion of every meeting of
the MPC in accordance with the provisions of Chapter III F of the Reserve Bank of
India Act, 1934.
•
On the 14th day, the minutes of the proceedings of the MPC are published which
include:
•
a.
the resolution adopted by the MPC.
b.
the vote of each member on the resolution, ascribed to such member; and
c.
the statement of each member on the resolution adopted.
Once in every six months, the Reserve Bank is required to publish a document called
the Monetary Policy Report to explain:
a.
the sources of inflation; and
b.
the forecast of inflation for 6-18 months ahead.
Source: https://www.rbi.org.in/scripts/FS_Overview.aspx?fn=2752
10.6
SELF ASSESSMENT QUESTIONS
1.
Define Monetary Policy and what are the tools of Monetary Policy.
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LESSON-11
CLASSICAL MACROECONOMICS: EQUILIBRIUM OUTPUT
AND EMPLOYMENT
STRUCTURE
11.1
Introduction - The Starting Point
11.2
The Classical Revolution
11.3
Classical Theory of Income, Output and Employment
11.4
Employment
11.5
Equilibrium Output and Employment
11.6
Aggregate Supply Curve in The Classical Model
11.7
Factors that do not Affect Output
11.8
Key Points
11.9
Reference
11.10 Questions for Review
11.1 INTRODUCTION - THE STARTING POINT
The term Macroeconomics originated in the 1930s. That decade witnessed substantial
progress in the study of aggregative economic questions. After a long period in which
Microeconomic questions dominated the field of economics, the forces that determine
income, employment and prices had been receiving greater attention since the turn of the
century. The products of this research were theories of the “business cycles” and
accompanying policy prescriptions for stabilizing economic activity. The book containing
this theory was “The General Theory of Employment, Interest and Money” by “JOHN
MAYNARD KEYNES” in 1936, and the process of change in economic thinking that
resulted from this work has been called the “Keynesian Revolution”. But revolution against
what? What was the old orthodoxy? Keynes termed it “CLASSICAL ECONOMICS”, as it
was before Keynes General Theory.
The pre-Keynesian era (period before 1936) refers to the period of economic thoughts
of classical; Keynes used the term classical to refer to virtually all economists who had
written on macroeconomic questions before 1936. More conventional modern terminology
distinguishes between two periods in the development of economic theory before 1930.
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The term ‘Classical’ has been used in economic literature to refer to different group of
economists dominated by the work of Adam Smith (Wealth of Nations, 1776), David Ricardo
(Principles of political economy, 1st ed., 1817), and John Stuart Mill (Principles of Political
Economy, 1st ed., 1848). The second, termed the Neo-Classical period, had as its most
prominent English representatives Alfred Marshall (Principles of Economics, 8th ed., 1920)
and A.C Pigou (The Theory of Unemployment, 1933). The theoretical advances
distinguishing the classical and neo-classical periods were related primarily to
microeconomic theory. Keynes felt that the macroeconomic theory of the two periods was
homogeneous enough to be dealt with as a whole. The classical had not produced any unified
macroeconomic theory though some macroeconomic thoughts could be traced into their
writings. Their macroeconomic thoughts were in the form of certain Postulates.
11.2 THE CLASSICAL REVOLUTION
Classical economics emerged as a revolution against an earlier orthodoxy. Classical
economists attached a body of economic doctrines known as ‘Mercantilism’. According to
the Mercantilist’s belief, the wealth and power of a nation were determined by its stock of
precious metals. They believed in the need for state action to direct the development of the
capitalist system. Adherence to this view, under state action countries attempted to secure an
excess of exports over imports in order to earn gold and silver through foreign trade.
11.2.1 The Classical View
The classical economists, in contrast to the mercantilists, emphasized the importance of real
factors as opposed to monetary factors in determining the “Wealth of Nations” (i.e. variables
such as output and employment). Money does not play any significant role in determining
real variables output and employment. Money played a role only in facilitating transactions as
a means of exchange. The classical economists held the view that an economy should based
on "Laissez faire principles". In other words, they stressed the optimizing tendencies of the
free market in the absence of state-control. According to them, the harmony of an individual
and national interest can be had only when the market was free from government rules and
regulations. Thus, two features of the classical analysis, then, arose as part of the attack on
mercantilism:
1. Money has no intrinsic value- Money was held only for the sake of the goods that it
could purchase. It was treated only as a medium of exchange.
2. Classical economist stressed the self-adjusting tendencies of the economy- In other
words, they believed in the efficacy of the free market mechanism.
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11.2.2 Importance of the Classical Theory
The theory of employment and income determination which today constitutes the core of
modern macroeconomics was first developed by John Maynard Keynes in the ‘General
Theory of Employment, Interest and Money’ in 1936. But, to understand that, a pre-requisite
is the knowledge of the classical system that Keynes attacked.
Classical theory plays a more positive role in the later development of
macroeconomics. The classical model also provides the starting point for later challenges that
have been mounted against the Keynesian theory by monetarists, new classical economists,
and real business cycle theorists.
11.3 CLASSICAL THEORY OF INCOME, OUTPUT AND EMPLOYMENT
The equilibrium levels of output and employment are determined in the classical system with:
(1)
(2)
economy's production system from which demand curve for labour is derived.
the supply curve of labour.
According to classical theory, equilibrium of labour market determines the level of
employment and equilibrium level of employment in turn, determines National output. The
classical model presented below displays the determination of the real output and
employment required to produce equilibrium level of national output.
11.3.1 Assumptions
The classical economists held the view that:
1. A capitalist economy due to its built-in system operates at full employment i.e.
absence of involuntary unemployment.
2. Absence of Government control and monopolies restrictive trade policies.
3. Money is used only as a medium of exchange.
4. “Say’s law” is regarded as the core of classical theory which states – “supply
creates its own demand”.
5. The entire system works automatically and free play of demand and supply, forces
the economy in equilibrium whenever there is a deviation from the equilibrium.
6. There is neither over production nor under-production. In other words, all the
resources are utilized to their fullest possible extent.
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11.3.2 Production
An economy's output of goods and services–its GDP depends on:
(1) its quantity of inputs called the Factors of production, and
(2) its ability to turn inputs into output, as represented by the Production function.
The Factors of Production
These are the inputs used to produce goods and services. The two most important factors of
production are capital and labour.
(a) Capital is the set of tools that workers use e.g., accountant's calculator, businessman's
computer used in office etc. We use symbol 'K' to denote the amount of capital.
(b) Labour is working the time people spend. It is calculated in terms of number of working
hours. We use the symbol 'L' to denote the amount of labour. It is assumed that both
factors of production are fully utilized in the Production Function
A central relationship in the classical model is the aggregate production function. The
available technology determines how much output is produced from given amounts of capital
and labour. Therefore,
The production function can be expressed as:
The production function, which is based on the technology of an individual firm, is a
relationship between the level of output and the level of factor inputs
Y = f (K, L) ....... Aggregate Production Function
where,
Y = real output
K = constant stock of capital
L = the quantity of the homogeneous labour input
This equation states that output is a function of the fixed amount of capital and the
amount of labour. For the short run, the stock of capital is assumed to be fixed, as indicated
by the bar over the symbol for capital. The state of technology and the production are also
assumed to be constant over the period considered. For this short period, output varies solely
with change in labour input (L) drawn from the fixed population.
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12.1 (a)
12.1 (b)
Production Function and MP of Labour Curves
In the short run, the production function shows a technological relationship between the level
of the quantity of the homogeneous labour input (L). 12.1 (a) we plot the output that will be
produced by the efficient utilization of each level of labour input. In fig. 12.1 (a)
(i)
At low levels of labour input (before L1), the production function is a straight line, i.e.
having constant slope. This portion of the curve exhibits constant returns to increases
in labour input.
(ii)
To the right of L. (between L1 and L2), as we add more of input, total output increases
but the size of the increments to output declines as more labour is employed. In other
words, beyond L1 till L2, output increases but at a decreasing rate.
(iii)
Beyond L2, the additional units of labour employed produce no increment to output.
Marginal product of labour
In fig. 12.1 (b), we plot the increment to output per increment to the labour input termed the
marginal product of labour
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The marginal product of labour (MPL) is the extra amount of output the firm gets from one
extra unit of labour, holding capital amount fixed.
Using the Production function, the MPL can be written as:
MPL = f (K, L+I) – f (K, L)
MPL =
Y
L
Where,
F (K, L+I) = output produced by using K units of capital and L+I units of labour
F (K, L) = output produced by using K units of capital and I units of labour.
The marginal product of labour is the difference between the amount of output produced by
using L+I units of labour and that produced by using L units of labour. In fig. 12.1 (b)
(i)
As units of labour increases below L1 the curve is flat, representing the constant
marginal product of labour.
(ii)
Beyond L1 till L2, as we add more labour, the marginal product of labour is
positive but decreases and the curve hits the X-axis at L2.
(iii)
Beyond L2 extra unit of labour cannot contribute additional output.
Thus, the marginal product of labour is measured by the slope of the production function and
is a downward sloping curve when plotted against employment (12.1 (b), as slope of the
production function (MPL) is positive but decreases as we move along the curve.
11.4 EMPLOYMENT
Classical economists assumed that the market works well. Firms and individuals’
workers optimize. They all have perfect information about relevant prices. There are no
barriers to the adjustment of money wages, the market clears.
In the classical model, firms are considered to be perfect competitors who choose
their output level so as to maximize profits. As in the short run, output is varied solely by
changing the labour input, so they have to make a decision about quantity of the labour input
which can maximize firm's profits. Classical economists assumed that the quantity of labour
employed would be determined by the forces of demand and supply in the labour market.
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11.4.1 Labour Demand
On the demand side of labour market, purchasers of labour services are firms that
produce commodities. To see how the aggregate demand of labour is determined, we begin
by considering the demand for labour on the part of an individual firm.
The perfectly competitive firm will increase its output until the marginal cost of
producing a unit of output is equal to the marginal revenue received from its sale. i.e.
MC = MR
In other words, in making its decision whether to hire additional labour, a profit
maximizing competitive firm will compare extra revenue from the increased production that
results from added labour to extra cost of hiring that additional unit of labour.
For the perfectly competitive firm, marginal revenue is equal to product price
MR = P
And the marginal cost of each additional unit of output is the marginal labour cost,
being labour is the only variable factor input, therefore,
Marginal cost = Marginal labour cost
Marginal labour cost equals the money wage divided by the number of unit of output
produced by the additional unit of labour. Thus, marginal cost (MC) of the firm is equal to
the money wage (W) divided by the marginal product of labour for that firm (MPL).
MC = W/ MPL
The condition for short run profit maximization is:
MR = MC
P = W/MPL
Alternatively,
MPL = W/P ................................. Profit maximizing condition
Where, W/P is the real wage –the payment to labour measured in units of output i.e. in real
terms, rather than in rupees.
For example, suppose the price P of a bag is Rs. 2 per unit, and a worker earns a wage W of
Rs. O per hour. The real wage W/P is:
W/P = 6/2 =3 bags per hour
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In this example, the firm keeps hiring workers as long as each additional worker
would produce at least 3 bags per hour. When the MPL falls below 3 bags per hour, hiring
additional workers is no longer profitable.
Hence, the condition for profit maximisation shows, to maximize profits the firm will
on hiring labour till the marginal product of labour equals the real wages paid by the firm.
From this profit maximizing condition, the demand for labour schedule for the firm
plotted against the real wages, is the marginal product of labour schedule as shown in figure.
Fig 11.2 Labour Demand Curve for a Firm
Fig. 12.2 shows how the marginal product of labour depends on the amount of labour
employed (holding the firm's capital stock constant). That is, this figure graphs the MPL
schedule. Because the MPL diminishes as the amount of labour increases, this curve slopes
downward.
For any given real wage, the firm hires up to the point at which the MPL equals the
real wage. Hence, MPL schedule is the firm's labour demand schedule.
As shown in fig. 12.2
The condition for profit maximization is met at the point ‘e’ where the real wage
(W/P) is equated with the marginal product of labour (MPL).
W/P = MP
Therefore, the firm maximizes its profits by employing OL* (500) units of labour is
the real wage is 3.
If it employs less than OL* i.e., say OL1 (400) units of labour, the marginal product of
labour (4) exceeds the real wage of 3 i.e.
MPL > W/P
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4>3
And the firm can increase its profits by hiring additional labour.
Alternatively, at a higher labour input than OL * i.e., say OL2 (600) units of labour, the
marginal product of labour (2) falls short of the real wage of 3 i.e.
MPL < W/P
2<3
The payment to labour will exceed the real product of the marginal worker and
marginal cost will exceed product price. Therefore, the firm will reduce the number of labour
inputs employed to increase profits. Thus, the profit maximizing quantity of labour demanded
by a firm at each level of the real wages is given by quantity of labour input that equates the
real wage and marginal product of labour. Hence,
The Marginal product curve (MPL) is the firm's demand curve for labour
This implies that as MPL is downward sloping, so labour demand depends inversely on the
level of real wages, the higher the real wages, lesser is the number of labour input.
The aggregate demand curve for labour is the horizontal summation of the individual
firm's demand curves. For each real wage this curve will give the sum of quantities of labour
input demanded by the firms in the economy.
The Aggregate Demand Function is written as:
Id = f(W/P) ................ Aggregate Labour Demand function
11.4.2 Labour Supply
The next step in determining employment, and hence output in the classical system is the
determination of labour supply. Labour services are supplied by individual workers in the
economy. Classical economists assumed that each individual attempts to maximize their
utility or satisfaction in his life. The level of utility depends positively on “real income"
(which gives command over goods and services), and “leisure” (leisure hours are also a
necessary commodity as they provide satisfaction to the individual).
There is a trade-off between the two goals, income and leisure. Out of 24 hours in a
day, he has to divide his time into working hours and leisure hours. However, income can be
increased only by working and work reduces the available leisure time. So, there is an inverse
relationship between hours worked and leisure hours. The individual, therefore, faces a
choice between income and leisure.
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Labour supply curve is derived from the income-leisure trade-off how individual
allocates one 24-hour period between leisure hours and hour worked. Fig. 12.3(a) illustrates
the choice facing the individual.
(i)
On the horizontal axis, we measure total number of hours (maximum of 24)
which are available to an individual over a given period of time. These hours
can be either used for work or for leisure. We measure leisure hours from left
to right and work hours per day from right to left.
Fig. 11.3 (a) The Income-leisure Trade-off
Fig. 11.3 (b) Individual Labour Supply Decision
(ii)
The vertical axis shows the real income which is equal to the real wages (W/P)
multiplied by the number of hours an individual works.
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(iii)
The curved lines in the graph, IC1. IC2 IC3 are the indifference curves. Each
indifference curve shows the different combinations of income and leisure that
give the same level of satisfaction to the individual so, he is indifferent to
these combinations on same IC. The higher the indifference curve and to the
right, the more is the level of satisfaction associated with it. For example, all
points on IC; represent greater satisfaction than any point on IC2. An
individual tries 10 achieve the highest possible indifference curve in order to
maximize his satisfaction.
The slope of the indifference curve is called Marginal rate of Substitution as it
measures the substitution ratio between the two goods. Here, the slope of the indifference
curve represents the rate at which the individual is willing to trade-off leisure for income, that
is, the increase in income the person would have to receive to be just as well off after giving
up a unit of leisure.
The indifference curve becomes steeper as we move from right to left on the same
curve. For example -for the fifteen hours of work, one would require greater compensation to
maintain same level of satisfaction than the fifth hour of work.
(iv)
The straight lines originating from point Z on the horizontal axis represents
individual's budget line. The slope of the budget line is the real wage, as the
individual can trade-off leisure for income at a rate equal to the hourly real
wage (W/P). The higher is the real wage, the steeper is the budget line,
reflecting the fact that at a higher real wage an individual who increases hours
of work by one unit (i.e., moves one unit to the left along the horizontal axis)
will receive a larger increment to income (will move farther up the vertical
axis along the budget line) than would have been received at the lower real
wage. Three budget lines, corresponding to real wages rules of 2.0, 3.0 and 4.0
are shown in Fig 12.3(a)
For any given real wage rate, in order to maximize utility, the individual will choose
the point where the indifference curve is tangent to the budget line corresponding to that
particular wage rate. At this point, the slope of the indifference curve is equal to the slope of
the budget line. In other words, this implies that the rate at which the individual is willing to
trade-off leisure for income (the slope of the indifference curve) is equal to rate at which he is
able to trade-off the slope of the budget line).
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•
•
•
At a real wage of 2.0, the individual worker attains equilibrium at point A1 working
for AZ hours (6 hours of labour services), earning an income of AA1 (a real income of
12) and spending OA hours on leisure(18 hours of leisure).
When the real wage rises to 3.0, the workers reaches equilibrium at point B1 working
for BZ hours (8 hours of work ) earning an income of BB1 (a real income of 24) and
spending OB hours on leisure (16 hours of leisure).
Similarly, at real wage of 4.0, points like C1 can be derived.
We now can say more labour services are supplied at the higher real wage rates.
Using this fact, we can arrive at the supply curve for labour as shown in fig. 12.3(b).
In fig. 12.3 (b), on the horizontal axis measuring number of hours worked from left to
right and real wage rate on the vertical axis. By plotting the points A, B AND C from fig.
12.3 (a) giving the amount of labour (in terms of working hours) the individual worker will
supply at real wage rate, we obtain the upward-sloping labour supply curve by joining these
points.
11.4.3 The Aggregate Labour Supply Curve is obtained by a horizontal summation of all
the individual labour supply curves and gives the total labour supplied al each level of the
real wage. It can be written as:
L = (W/P) ...............Aggregate Labour Supply function
The classical labour supply theory depicts two features:
(i) the wage variable is the real wage rate that is, the aggregate supply of labour is a
function of real wage.
(ii) the supply curve of labour is positively sloped that is more labour is assumed to be
supplied at higher real wage rates. This is because of the two effects that take
place: income effect and substitution effect.
(a) Income effect: when the real wage increases, the worker earns higher income,
and at higher levels of real income, leisure may become more desirable. This
enables him to indulge in more leisure activities which is only possible if he
works less.
(b) Substitution effect: when the real wages increase, the cost of leisure hours
rise in terms of the income which is given up. So, leisure becomes expensive.
Hence, the worker would choose leisure at this high price of labour.
Here, in the derivation of labour supply curve, the substitution effect is greater
than the income effect, so the supply curve of labour is positively sloped.
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Beyond a certain level of wage rate, the income effect outweighs the substitution
effect. This will the labour supply curve to bend backwards towards the vertical axis and
takes a negative slope.
In our analysis, however it is assumed that every time real wage rises, substitution
effect outweighs the income effect and hence the aggregate supply curve of labour has a
positive slope, throughout.
11.5 EQUILIBRIUM OUTPUT AND EMPLOYMENT
So far the following relationships have been derived:
Y = I'(K/L) - Aggregate Production Function
LD = I'(W/P) - Aggregate Labour Demand Function
LS = I'(W/P) - Aggregate Labour Supply Function
These relationships, together with the equilibrium condition for the labour market, determine
output, employment and the real wage in the classical system.
Classical Output and Employment
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Fig. 12.4 (a) shows the determination of the equilibrium levels of employment (L1) and the
real wages (W/P1) at the point of intersection between the aggregate labour demand and
labour supply curves. From the equilibrium level of employment, the equilibrium level of
output (Y) given by the production function can be determined as shown in fig 12.4(b).
11.5.1 Determinants of Output and Employment
We can classify the variables into two as:
(i) Endogenous Variables: They are determined within or by the model, such as output,
employment and the real wage are designated as the endogenous variables in the
classical model.
(ii) Exogeneous Variables: They are determined outside the model.
In the classical model, it is the exogeneous variables which when changed, causes
changes in output and employment. The factors that determine the output and employment
are those that influence the positions of the labour demand and labour supply curves.
The Demand curve for labour depends on the Production function, as it is the slope
of the production function:
(i)
When the production function shills that is, the productivity of labour changes
because of Technological changes, then the demand curve for labour shifts.
(ii)
The production function also shifts as the capital sock changes over time
which leads to change in the position of labour demand curve.
The Supply curve of labour depends on:
(i)
The size of the labour force. An increase in population will shill the labour
supply curve to the right.
(ii)
Individual tastes and preferences: Individuals express their labour-leisure
trade-off by indifference curves. With changes in individual's preference
functions the labour supply curve also shifts.
A common feature of all the factors that determine output in the classical model is
that they are the variables that affect the supply side of the market for output - the amount
that firms choose to produce. So, we can conclude:
In the Classical model, the levels of output and employment are determined solely by
factors operating at supply side of the market.
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11.5.2 Supply Determined Nature of Output and Employment
The supply determined nature of output and employment is a crucial feature of the
classical system. fig. 11.5(a) shows the aggregate labour supply and aggregate labour demand
curves as functions of the real wage, (W/P).
Fig. 11.5(b) plots the labour supply and labour demand curves as functions of the
money wage rate, (W)
Fig. 11.5 The Equilibrium in the Labour Market
In fig.12.5(b): for plotting the labour demand curve against the money wage, we use
the fact that the labour demand is nothing but equivalent to Marginal product of labour which
is a function of real wages, that is;
LD = MPL = W/P
The quantity of labour that will be demanded at any given money wage, depends on
the price level. The firm will choose the level of employment at which
W = MPLP
A rise in the price level (P1, 2P1 , 3P1) will shifts the labour demand curve to the right
(from MPL, P1 to MPL, 2P1 to MPL, 3P1) plotted against the money wage. In other words, for a
given money wage, more labour is demanded at higher price levels because that money wage
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corresponds to a lower real wage rate and the demand for labour varies inversely with real
wage rate.
Similarly, in fig. 12.5(l): for plotting the labour supply curve against the money wage,
we draw a positively sloped curve such as LS (P1) which gives the amount of labour supplied
for each value of the money wage, given that the price level is P1. The curve is upward
sloping because at the given price level a higher money wage is a higher real wage. For a
given money wage each price level will mean a different real wage and hence, a different
amount of labour supplied. A rise in the price level (P1, 2P1, 3P1) shifts the labour supply
curve upward to the left (from LS P1 to LS 2 P1 LS 3P1). In other words, for a given money
wage, less labour is supplied at higher price levels because that money wage corresponds to
lower real wage rule, and the supply of labour varies directly with the real wage rate.
As both, the labour demand and labour supply depend only on the real wage, so an
equi-proportional increase (or decrease) in both the money wage and the price level, leave the
real wage unchanged at (W1/P1) which corresponds to the unchanged quantity of labour
demanded and quantity of labour supplied at level L1.
11.6 AGGREGATE SUPPLY CURVE IN THE CLASSICAL MODEL
The aggregate supply curve in the macroeconomics is same as microeconomic
concept of the firm’s supply curve, in fig 12.6 the classical aggregate supply curve has been
constructed by using the analysis of fig 12.5(b)
(i)
At a price level of P1 and money wage W1, employment is L1 and the resultant
output is Y1 (point e1 in fig 12.5(b)).
(ii)
when the price level rises (from P1 to 2P1), keeping money wage constant, the
real wage rate (W/P) will fall. As a result, the labour demand curve, when
plotted against the money wage rated in fig 12.5(b)) will shift to the right, that
is, firms demand more labour at lower real wage rate. (Point e2), and the
labour supply curve, when plotted against the money wage rate (in fig 12.5(b))
will shift to the left, that is, supply of labour decreases (point e3). As a result
of this, there will be an excess demand of labour (i.e., shortage of labour)
equal to L2L3 units of labour.
(iii)
Now, the firm would try to expand both employment and output. This results
in money wages to rise in order to expand employment and money wages will
continue to rise, as long as there is an excess demand of labour. Equilibrium
will be attained only when money wages have risen to a level where demand
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for labour is equal to supply of labour (that is, the entire excess demand is
wiped out). This position is attained at point e4 where the new money wage
rate is 2W, which has increased proportionately with the price level i.e.,
Increase in money wage = increase in price
As it can be seen in fig 12.5(b), at this point of e4, the initial real wage rate is restored
(2W/2P = W/P)
and employment is restored at its original level of L1 consequently output supplied is
equal to Y1 (same output supplied at P1)
(iv)
Similarly, at still higher price level of 3P1, the money wage rises to 3W1, but
output remain unchanged at Y1. This relationship between price level and
output supplied is shown in fig. 12.6:
Fig 11.6 Classical Aggregate Supply Curve
The aggregate supply curve is vertical, showing that if the higher price levels are
accompanied with proportionate higher levels of the money wage rate in the labour market,
the employment and the output will remain the same (at L1 and Y1, respectively) irrespective
of the price level. This shows that:
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In the Classical model, the vertical supply curve illustrates that the level of
output is determined completely from supply side.
11.7 FACTORS THAT DO NOT AFFECT OUTPUT
As output and employment are supply determined, the level of aggregate demand will
have no effect on output. Factors such as the quantity of money, level of government
spending and the level of demand for investment goods by the business sector are all
demand-side factors that have no role in determining the equilibrium level of output and
employment in the classical model.
11.8 SUMMARY
1.
The period before Keynes General Theory was considered as classical.
2.
According to classical economists, real factors determine the level of output and
employment.
3.
The classical economists believed in the efficacy of free market mechanism.
4.
As per the classical thought, the equilibrium level of income can be only at full
employment level.
5.
The factors of production and the production technology- determines the economy's
output of goods and services.
6.
A perfectly competitive firm will demand labour such that it maximizes its profits. It
will go on hiring labour till the MPL is equal to the real wage. Hence, the MPL curve
is the firm's demand curve for labour.
7.
The supply of labour by an individual worker depends upon his choice between 'work'
and “leisure.
8.
Both aggregate labour demand and aggregate labour supply are functions of real
wage.
9.
The aggregate labour demand curve is a downward sloping curve.
10.
The aggregate labour supply curve is an upward sloping positively sloped curve due
to greater substitution effect than income effect.
11.
Intersection of labour demand and labour supply forces determines equilibrium in
labour market which in turn together with the production function determines the
equilibrium level of output.
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12.
Equilibrium level of output and employment is restored in the economy if the rise in
the price level is accompanied by proportionate rise in the money wage rate. That
results in vertical aggregate supply curve.
13.
The vertical aggregate supply curve in the classical model illustrates the supply
determined nature of output.
14.
The demand side factors will not play any role in determining the equilibrium level of
output and employment in the classical model.
11.10 SELF-ASSESSMENT QUESTIONS
1.
In what respect was the classical attack on mercantilism important in shaping classical
economist's views on macroeconomic questions?
2.
What are the main assumptions in the classical theory?
3.
“The Supply creates its own Demand”. Explain how this law applies to classical
theory?
4.
What determines the amount of output an economy produces?
5.
Explain the concept of an aggregate production function. How would the production
function be affected by an increase in the marginal productivity of labour for a given
output level? How would the shift in the production function affect the level of output
and employment in the classical model?
6.
What factors affect the output and employment in the classical model?
7.
Explain the classical theories of labour demand and labour supply. Why is the labour
demand schedule downward sloping whereas the labour supply schedule is upward
sloping?
8.
What factors are the major determinants of output and employment in the classical
system? What role does aggregate demand play in the determination of output and
employment?
9.
How is the output level determined in the classical model? What will happen to the
output if employment falls because of fall in preference of labour at all wages?
10. The classical aggregate supply curve of the firm is vertical. Why?
11. Explain the supply determined nature of output and employment.
12. What all factors do not affect the level of output and employment?
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LESSON-12
KEYNESIAN MACROECONOMICS : EQUILIBRIUM
DETERMINATION AND MULTIPLIER
STRUCTURE
12.1
Introduction
12.2
Equilibrium in Two Sector and Three Sector Economy
12.3
Concept of Multiplier
12.4
Concept of Automatic Stabilizer
12.5
Summary
12.6
Self-Assessment Questions
12.7
Suggested Readings
12.1 INTRODUCTION
Economics has two diverse fields - Micro and Macro. While Micro is concerned with
analysis of a particular unit, macroeconomics is concerned with the aggregate or the total. In
macroeconomics, the economies can be classified as Open and closed economy, a closed
economy is one where there is no interaction with the external economies having no export
and import. An open economy on the other hand is one where the economies are interlinked
because of export and import of goods and services. Further there can be two sectors, three
sector or four sector economies. In two sector there are Households and Firms. In three
sectors along with the above two there is also Government. Four sector comprises of external
sector too along with export and import in addition to above three sectors.
Household: A sector that makes the expenditure for own consumption. The entire expenditure
by this sector can be clubbed under the consumption function which is explained as follows:
C = C + c Y (Linear Consumption function)
Where C = Autonomous Consumption that is the level of consumption which is fixed
irrespective of the level of income. It is there even at zero level of income. This is the
consumption that households derive out of past savings. It thus determines the intercept of
consumption function.
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c = Slope of consumption function which shows change in consumption because of change in
income. It is shown by MPC (marginal propensity to consume) =
c
. In a linear
y
consumption function MPC is constant that is the slope is same everywhere on the
consumption curve. In non-linear consumption function however the marginal propensity to
consume decreases with increase in income. For simplicity we assume that the consumption
function is linear with constant MPC.
Y = Real Income or total output of the economy.
Linear consumption function can be plotted as:
Figure 12.1: Linear Consumption Curve
Here consumption function is a straight line starting from an intercept shown by C
showing the level of consumption which is there even at zero level of income which is
being supported by past savings. The slope is given by MPC (Marginal Propensity to
consume).
Firm: This is the second component of macroeconomics. It shows all expenditure done by
the private enterprises that spend so that goods or services can be manufactured and sold
further. For simplicity it is assumed that it is constant or fixed. This assumption would be
relaxed in the next chapter when we discuss the concept of IS-LM curves. It is shown by
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I = i that is autonomous investment or fixed investment
Figure 12.2 Investment Curve
Investment by private enterprises is fixed irrespective of the level of income or rate of interest
in the economy. This assumption would however be relaxed later in the IS-LM model.
Government: This is the third component in macroeconomics. Government has mainly three
functions - imposition of tax, granting of subsidy, and government expenditure also called
government purchases.
External Sector: The last component of open economy that includes export and import of
goods and services.
12.2 EQUILIBRIUM IN TWO SECTOR AND THREE SECTOR ECONOMY
Equilibrium is a state of rest where there is no tendency to change. An economy is said to be
in equilibrium when the total output (real disposable income) is equal to the total or aggregate
demand as shown by:
Y = AD where AD= C + I (in 2 sector economy) and C +I+ G (in 3 sector economy).
If Y =ft AD there is disequilibrium and it leads to unplanned inventory which is calculated
as:
IU = Y-AD
If Y > AD, there is accumulation of inventory as total output being produced is more than the
total demand in the economy leading to increase in the unplanned stock and IU > 0 whereas
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If Y < AD, there is depletion of inventory as total output being produced in the economy is
less than the total demand and hence the excess demand is met out of the stock that reduces
the existing stock and IU < 0.
Equilibrium in Two Sector Economy
A two-sector economy is one where there is presence of households and private firms and
there is neither government nor the external sector. It can also be called a closed economy as
there is no interaction with the outside world in the form of exports and imports. A two-sector
economy would be in equilibrium when the total output is equal to aggregate demand by the
households and firms as shown below:
Y=AD, Y=C+ I, Y=C+cY+ i, Y=A+cY
Where A = C + I its autonomous spending
Y -cY = A, Y(l-c) = A, Y = A/(1-c). Thus, the equilibrium condition is
Y = At (1-c)
Equilibrium is thus dependent on autonomous spending and marginal propensity to consume.
If any or both of them changes, there is change in the equilibrium level of output.
Equilibrium can also be attained using an alternative approach as shown below:
Y = C + S (As households can either consume the income or save it). Thus, total income is
spent on either the consumption or saving.
S=Y-C, S=Y-(C+cY),S =-C+(l- c) Y,
In equilibrium Y = AD (C +I). So, from above two equations we get
C+S = C+l, S=I.
Here savings are the leakages from the economy and investment is the injection in the
economy. Thus, according to this approach equilibrium is where leakages and injections are
equal.
Both the above equilibriums can be presented in the following figure:
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Figure 12.3 Equilibrium in 2 sector economy
Equilibrium in two sector economy can be achieved by using two approaches that is Y = AD
approach also called Keynesian cross or Savings and Investment approach which is derived
from the above approach only. In the figure above there is a 45-degree guideline that shows
that any point on this guideline is the equilibrium as the values on X axis and Y axis are
equidistant on the guideline. Thus, equilibrium would always be on this line. Then there is
consumption function that is shown by C which is the linear consumption function with slope
'c' and AD is the aggregate demand curve that is parallel to C. The point where guideline and
consumption function intersect is the break-even point where savings are zero and Y = C. It is
shown by point B at Y 1 level of income. Equilibrium is where guideline and AD intersect
which is at point E in the Keynesian cross and E* in the panel below and equilibrium level of
output is Y 2.
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Intext questions: True and False
(1)
Macro Economics is narrower as compared to Microeconomics
(2)
Both micro and macroeconomics attain equilibrium when demand and supply are
equal.
(3)
A two-sector economy is also called open economy.
(4)
Taxes in a three-sector economy are always assumed to be autonomous.
(5)
Multiplier shows the change in equilibrium level of output because of change in
autonomous spending.
(6)
Equilibrium level of output depends on the slope of Aggregate demand curve
Equilibrium in Three Sector Economy
A three-sector economy is one where there is presence of government in addition to the
households and firms. Households spend on consumption, Firms spend on Investment and
Government performs three functions - Government expenditure called government
purchases which is assumed to be autonomous, collect taxes (it can be fixed or proportionate
tax) and provides transfer payments which is also assumed to be constant. The equilibrium
thus can be attained in two ways:
When there are Fixed Taxes
Equilibrium condition is
Y=AD,
Now here aggregate demand comprises of consumption which is dependent on disposable
income and not only income as was in two sector income as income and disposable income
are different because of presence of taxes and transfer payments in case of three sector
economy whereas in two sector economy the disposable income and income were one and the
same.
Y = C +I+ G, Y = C + cYd + i + G, Y = C + c(Y -TA+ TR)+ i + G
Where TA and TR are assumed to be constant in addition to Investment and government
Y =A+ cY, Y = A /1-c (Equilibrium Condition)
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Figure 12.4 Equilibrium in 3 sector using Fixed Taxes
When there are proportionate taxes
Y = AD, Y = C +I+ G, Y = C + cYd + i + G, Y = C + c(Y - tY +TR)+ i + G
Where TR is assumed to be constant in addition to Investment and government purchases and
tax rate is fixed as a proportion of Y.
Y =A+ c (1-t)Y, Y = A /1-c(l-t) (Equilibrium Condition)
Figure 12.5 Equilibrium in 3 sector using Proportionate Taxes
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Both the cases above consider Yd as compared to Y used in two sector economy. Yd is the
disposable income that is the income available in the income after deduction of taxes and
addition of transfer payments. In fixed tax the slope of aggregate demand function is given by
MPC (c) which is same as that of two sector economy as impact of taxes and transfer
payments is considered in autonomous spending. On the other hand, slope of aggregate
demand function with proportionate taxes is c (1-t). Thus, aggregate demand curve becomes
flatter as slope of AD reduces. The difference between the two equilibrium outputs would be
shown under automatic stabilizers.
12.3 CONCEPT OF MULTIPLIER
The change in equilibrium level of output because of change in autonomous spending by 1
rupee is known as multiplier. As shown above the equilibrium output in a two- sector
economy is given by the following equation
__
Y = A / (1- c)
where A = Autonomous spending that includes fixed consumption by the
households and autonomous investment by private firms.
c = Marginal Propensity to consume (MPC).
From the above equation the value of multiplier can be obtained as:
__
__
Y =  A/1 − C, Y = 1/1 − Cx  A
Thus, the change in equilibrium level of output is more than the change in autonomous
spending because of presence of multiplier shown by the 1 / (1- c).
Example 1- Let Autonomous spending increases by Re 1 and MPC is 0.8 then value of
multiplier would be: 1 / (1- 0.8) = 5 times that is change in equilibrium level of output is
more than change in autonomous spending.
The value of multiplier depends on the value of 'c' and as 'c' varies from 0 to 1 so the value of
multiplier also varies from 1 to infinity as shown below:
Example 2- Calculate value of multiplier in the following cases: a) MPC = 0b) MPC = 1, c)
MPC = 0.2 d) MPC = 0.8
__
Solution: a) l / (1-0) = 1 times so no multiplier effect. Y =  A
b)
l / (1-1) = Infinity
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__
c)
l / (1-0.2) = 1.25 times Y   A
d)
l / (1-0.8) = 5 times, Y   A
__
Thus, it shows that multiplier has a direct relation with MPC, the greater is MPC the higher is
the value of multiplier.
Graphical derivation of Multiplier
Figure 12.6 Multiplier in Two Sector Economy
The figure above shows original Aggregate demand curve with an intercept equal to
autonomous spending and slope equal to MPC. Equilibrium is where the AD intersects the
guideline shown by Y1 level of output. If there is an increase in autonomous spending by M,
the aggregate demand curve shifts parallel up by the same amount as slope is still the same
(c). The new equilibrium is at Y2 level of output. The increase in output from Y1 to Y2 is the
change in equilibrium level of output shown by the horizontal and vertical arrows whereas
the distance between the two aggregate demand curves is M. Thus, graphically also it shows
__
that Y   A because of multiplier.
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To show the impact of MPC on multiplier we can take the following two cases that show that
as MPC increases multiplier also increases:
Figure 12.7 (a): Multiplier and Marginal Propensity to Consume
Figure 12.7(b) Multiplier and Marginal Propensity to Consume
Figure in panel (a) shows aggregate demand curve corresponding to a MPC of 'c' which is
less than MPC (c') exhibited by panel (b). Thus, the slope of aggregate demand curve of
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panel (a) is less than that of panel (b). The intercept in both the cases is shown by
autonomous spending an increase with initial equilibrium at Y1 level of output in panel (a)
and Y1' in panel (b). With an increase in autonomous spending by Min both the cases the
equilibrium is at Y 2 in panel (a) and Y2' in panel (b). the change in output is greater in case
of higher MPC shoeing that there is a direct relation between MPC and multiplier which is
because of the fact that aggregate demand curve is steeper in the second case as compared to
the first one.
Multiplier in case of Three Sector Economy
Figure 12.8 Multiplier in Three Sector Economy
The figure above shows original Aggregate demand curve in case of three sector economy
with proportionate tax with an intercept equal to autonomous spending and slope equal to c(lt). Equilibrium is where the AD intersects the guideline shown by Y1 level of output. If there
is an increase in autonomous spending by Ā, the aggregate demand curve shifts parallel up
by the same amount as slope is still the same c(l- t). The new equilibrium is at Y2 level of
output. The increase in output from Y1 to Y2 is the change in equilibrium level of output
shown by the horizontal and vertical arrows whereas the distance between the two aggregate
demand curves is Ā Thus graphically also it shows that Y > Ā because of multiplier.
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The above discussion thus shows that the economy moves to a new level of equilibrium
output when there is change in the autonomous spending, the quantum of change depends on
the marginal propensity to consume and also on the taxation system being applicable in the
economy (fixed or proportionate tax). However ever economy tries not to deviate too much
from the initial equilibrium and there are certain forces imbibed in the economy itself that
prevents a drastic change which are known as the automatic stabilizers. It is being taken up in
the next heading12.4 CONCEPT OF AUTOMATIC STABILIZER
Automatic stabilizers offset fluctuations in economic activity without direct intervention by
policymakers. When incomes are high, tax liabilities rise and eligibility for government
benefits falls, without any change in the tax code or other legislation. Conversely, when
incomes slip, tax liabilities drop and more families become eligible for government transfer
programs, such as food stamps and unemployment insurance that help buttress their income.
Two examples of Automatic stabilizers areProportionate Tax - The presence of proportionate tax reduces the multiplier effect thereby
bringing a lesser diversion in the equilibrium income as compared to fixed tax. This is
because in case of proportionate taxes whatever is the change in income because of change in
the autonomous spending a part of it goes to the government in form of taxation and hence
disposable income is less as compared to fixed taxes. This can be illustrated using the
following example and figureExample 3- If MPC is 0.8 and tax rate is 0.5 in case of proportionate tax. The effect of
automatic stabilizer can be shown as:
Slope of AD in case of fixed Tax = c = 0.8
Slope of AD in case of Proportionate Tax = c (1- t) = 0.8 (1-0.5) = 0.4
Thus, AD is flatter in case of proportionate tax as compared to fixed tax and change m
equilibrium using above data can be shown as-
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Figure 12.9(a): Change in Equilibrium Output in case of Proportionate Tax
Figure 12.9(b): Change in Equilibrium Output in case of Fixed Tax
Thus, in case of Fixed Tax the change in equilibrium level of output is greater as multiplier
effect is more as can be shown mathematically too
Multiplier Effect in case of Fixed Tax: 1/1-c = 1/1- 0.8 = 5 times
Multiplier Effect in case of Proportionate Tax: 1/1- c (1-t) = 1/1- 0.8(1- 0.5) =1.67 times
Thus, it is visible that multiplier effect weakens in case of proportionate tax because of
reduction in disposable income as with every increase in income a part of it goes towards
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payment of taxes and hence less is available with the households for consumption as
compared to fixed tax where tax is fixed irrespective of the level of income and hence
disposable income is greater that provides greater change in the output.
Unemployment Benefits - The change in equilibrium output reduces if government provides
unemployment benefits to the households thus acting as a stabilizing agent.
Intext Questions: Fill in the Blanks
(7)
A three sector economy has three components namely _________ .
(8)
If MPC is 1 then value of multiplier is _________ .
(9)
The two automatic stabilizers are _________ .and _________ .
(10)
An open economy is one where there is _______ in addition to households, firms and
government purchases.
Impact of Fiscal Policy on the Equilibrium Level of Output
Fiscal policy refers to change in the government policy with respect to change in government
expenditure or taxation policy. There are two types of Fiscal policy - Expansionary fiscal
policy where there is either increase in Government purchases or decrease in taxes and
contractionary fiscal policy where the government reduces the government purchases or
increases the tax. The former brings and upward shift in the aggregate demand curve causing
a change in the equilibrium level of output as shown below:
Figure 12.10 Effect of Fiscal policy on Equilibrium
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The figure above shows that original equilibrium is at Y 1 level of output where AD is
intersecting the guideline. With an increase in government purchases there is an increase in
autonomous spending as government purchases is a part of autonomous spending. This shifts
the AD curve parallel up and new equilibrium is at Y 2. The change in equilibrium level of
output from Y1 to Y2 is because of fiscal policy. This change is more than change in
government purchases because of presence of government multiplier.
12.5 SUMMARY
Microeconomics and macroeconomics are two parts that are studied in Economics. While
microeconomics deals with an individual unit - its equilibrium determination, pricing
decisions and policies. Macroeconomics is wider in sense as it covers all the components of
an economy. The equilibrium condition in both the economics is broadly the same that is
where demand and supply are equal and there is neither excess demand nor excess supply. In
macro we just change the demand to aggregate demand and supply to total output or total
income. Macro Economics can be a two sector economy comprising of only households that
spend on consumption expenditure and private firms that go for investment expenditure, a
three sector economy having Government in addition to the above two sectors that spends on
purchases, collect taxes and provides subsidies and a four sector economy that is also called
open economy as it includes the external sector too in addition to above three, it makes
expenditure on imports and earns though exports. Equilibrium condition is where total output
produced in an economy is exactly equal to the total demand by the different sectors and in
case the two are not equal there are changes in the unplanned inventory and automatic forces
that bring the economy back to equilibrium. Further once equilibrium is attained it may
change over a period of time if any component of autonomous spending changes but the
change in equilibrium level of output is more than the change in autonomous spending and
this is because of the presence of multiplier which is dependent on marginal propensity to
consume and/or proportionate taxes. This change in the equilibrium level of output should not
be very large as that can be destabilizing for the economy so there are some automatic
stabilizers in the economy that prevents the economy from moving too far off from the initial
equilibrium. There are two main stabilizers that is proportionate tax and unemployment
benefits that help in reducing the gap between original and new equilibrium level of output.
Answer to intext questions
Ans. 1. (F), 2. (T), 3. (F), 4. (F), 5. (T), 6. (T) (7). Households, Firms and Government (8).
Infinity (9). Proportional Tax and Unemployment Benefits (10). External Sector.
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SELF-ASSESSMENT QUESTIONS
1. Explain the equilibrium in case of two sector economy.
2. Why the change in equilibrium level of output is greater than change in autonomous
spending.
3. How is equilibrium attained in case of three sector economy with proportionate tax.
4. Explain the concept of automatic stabilizers by giving suitable example.
5. Explain how fixed taxes bring more change in equilibrium as compared to
proportionate tax.
6. Explain the concept of multiplier in a two-sector economy.
7. What is the effect of expansionary fiscal policy on the equilibrium level of output?
8. What is the role of government in a three-sector economy?
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LESSON-13
IS-LM DETERMINATION
STRUCTURE
13.1
Introduction
13.2
Derivation of IS Curve
13.3
Derivation of LM Curve
13.4
Simultaneous Equilibrium
13.5
Impact of Fiscal Policy on The Simultaneous Equilibrium
13.6
Numerical on IS- LM
13.7
Summary
13.8
Self-Assessment Questions
13.9
Suggested Readings
13.1 INTRODUCTION
The previous chapter discussed about how equilibrium is obtained in a two sector and three
sector economy and what IS the change in output because of change in the autonomous
spending. This chapter would discuss about how the goods market and money market are in
equilibrium and how both achieve the simultaneous equilibrium. For explaining the
equilibrium in Goods market is curve would be derived where I stand for investment and S
stands for saving. Equilibrium in Money market would be explained through LM curve (L
stands for demand of real money and M stands for supply of real money). IS-LM analysis
was introduced by Prof. Hicks in 1937 to explain the short run phenomenon. It would further
explain the relationship between price level and equilibrium level of output through the
aggregate demand curve and changes in the aggregate demand curve because of fiscal or
monetary policy multiplier. The fiscal policy explains the change in the government
expenditure or taxation policy to bring a change in the equilibrium level of output whereas
monetary policy shows change in the money supply to bring a change in the level of income.
There are certain assumptions on which the whole IS-LM model is based like constant price
level, firms willing to supply any amount of quantity at the given price and the short run
aggregate supply curve is flat.
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13.2 DERIVATION OF IS CURVE
IS and LM curve analysis is applicable in the short run where the price level is assumed to be
constant.
IS curve shows different combinations of real interest rates and equilibrium level of output
where goods market is in equilibrium. Derivation of IS curve can be established through the
following two steps Derivation of Investment Function: Investment is the total expenditure done by the private
firms. It is an important component of aggregate demand function. Earlier investment was
assumed to be autonomous but now it would be explained as follows__
I = I + ar
__
Where I = Autonomous investment which is not related to rate of interest
a = Sensitivity of Investment to real rate of interest
r = Real rate of interest
There is inverse relation between rate of interest and level of investment as if rate of interest
increases there is decrease in investment because it is expensive for the firms to borrow and
invest whereas a lower interest rate increases the amount of borrowing and investment by the
firms. But how sensitive is the investment to rate of interest depends on 'a' which shows the
sensitivity of investment to interest.
Investment function can be shown graphically as:
13.1 (1) Less Sensitive
13.1 (b) More Sensitive
Figure 1: Investment Function
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Panel (a) shows a steeper investment curve which shows a lesser value of 'a' that is
investment is not that sensitive to rate of interest showing that when rate of interest reduces
investment expands but by a smaller quantum whereas in panel (b) the curve is flatter
because of greater 'a' and higher sensitivity of investment to rate of interest showing that
reduction in rate of interest increases the investment by a greater amount.
After getting the investment function the equilibrium in goods market can be attained as
followsEquilibrium is when the economy which is a three-sector economy and in the short run has its
output and aggregate demand in equilibrium
__
Y=AD, Y=C+I+G, Y=C+cYd+ I - ar+G,
__
Y = C + c(Y - tY + TR) + I - ar + G,
Y =A+ (1- t) Y - ar, Y = A-ar/1- c (1- t) (Equilibrium condition)
Thus, here the equilibrium is the same as in case of three sector economy with proportionate
tax with an addition of 'ar'. The IS can be derived graphically as-
Figure 13.2 IS Curve
IS curve is derived from the Keynesian cross in figure above in the upper part. When interest
rate is r1 the investment is I1 where the corresponding aggregate demand curve is AD and
equilibrium level of output is Y1. If rate of interest reduces investment increases and there is a
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parallel upward shift in the AD curve with a new equilibrium level of output Y2. Thus, there
is an inverse relation between real rate of interest and equilibrium level of output as shown in
the figure above. It is because when rate of interest reduces, investment increases and it being
a part of AD the aggregate demand increases. In the equilibrium Y should be equal to AD and
when AD increases Y also has to increase to retain the equilibrium, thus bringing an inverse
relation between rate of interest and equilibrium level of output. Now moving to derivation of
slope and position of IS curve.
Modifying above equation, we getY = A- ar/1- c (1- t), r = A/a - Y/mga where mg = 1/1- c (1- t), (mg-govt. multiplier)
Thus, slope of the IS curve is -1/ mga and position of IS curve depends on autonomous
spending that is A. The negative sign in the slope shows that IS curve is downward sloping.
The slope in turn depends on government multiplier 'mg' which in turn depends on MPC (c)
and sensitivity of investment to rate of interest 'a'. The slope of IS can be shown as followsLet us elaborate taking two different MPC C1 = 0.2 and C2 = 0.8. Assuming proportionate tax
to be 0.5 we calculate government multiplier. In the first case mg1 would be 1/1- 0.2(1-0.5) =
1.11 and in the second case it is mg2 = 1/1- 0.8(1-0.5) = 1.67. Thus, it shows that higher the
MPC higher is the government multiplier and lower would be the slope and flatter would be
the IS. It can be shown graphically as-
Figure 13.3 Slope of IS Curve
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Above figure shows how different Marginal Propensity to Consume have different impact on
the slope of the IS curve the slope of aggregate demand curve in a two sector economy is
given by MPC only but in three sector economy with proportionate tax the slope changes to
MPC (l-tax rate). Taking this further we would show how there can be different slope of IS
because of different government multiplier which in turn depends on MPC. Initially the
aggregate demand curve is AD having an intercept of A-ar1 and as MPC is 0.2 which is lesser
than MPC of 0.8 so this AD is flatter. It gives equilibrium of Y1. Now if interest rate reduces
the AD curve shifts parallel up and provides a new equilibrium at Y2 level of income. Joining
the two combinations we get the IS curve corresponding to c1 level of marginal propensity to
consume. Now similarly if we draw IS curve corresponding to a higher level of MPC (0.8)
we get a flatter IS' curve whose slope is lesser than the previous IS because of the
government multiplier being large and hence slope being less.
Similarly, the component that affects the intercept or position of the IS curve is given by
autonomous spending (A) In case of three sector economy Autonomous spending comprises
of autonomous consumption, autonomous investment by private firms, fixed government
purchases and a part of fixed transfer payments. If any of these components of 'A' changes,
there is a shift in the IS curve as can be shown below-
Figure 13.4 Position of IS Curve
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The above panel shows Keynesian cross that shows equilibrium using a 450degree guideline
and derivation of equilibrium. Initially at 'r' rate of interest and 'A' autonomous spending
equilibrium output is Y1. This shows one combination of IS curve where IS passes through 'r'
and 'Y1'. Now if autonomous spending increases to A' there is a parallel upward shift in the
AD curve as slope is still the same. The new equilibrium is at Y2 level of output. Thus, there
is a parallel shift in the IS curve to the right showing the change in the position or the
intercept of the IS. The figure above shows that it is the change in the autonomous spending
that affects the intercept/position of the IS curve. Thus, fiscal policy by government would
bring a shift in the IS if there is change in autonomous government purchases and if tax rate
changes then there would be change in the slope of IS as change in proportionate tax rate
would change the slope of aggregate demand curve in the Keynesian cross thereby changing
the equilibrium level of output.
13.3 DERIVATION OF LM CURVE
LM curve shows different combinations of real interest rates and equilibrium level of output
where money market is in equilibrium. Derivation of LM curve can be established through
the following two stepsDerivation of Money Demand: Demand for money is demand for transitionary purposes that
is demand for real balances. It is the money that people hold and does not provide any return.
Demand for money can be shown using the following equation:
L=kY-hr
Where L = demand for real money, Y = national income, r = real interest rate, k = sensitivity
of demand to real income and h = sensitivity of money demand to real interest rate of interest.
Demand for money can be plotted as-
Figure 13.5 Demand of Money
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If there is a change in the real rate of interest, then there is a movement up or down on the
demand curve whereas with a change in the income the curve shifts to right or left.
Equilibrium in Money Market: Money market is in equilibrium when money demand is equal
to money supply. It can be shown as:
kY-hr=M/P
Where M = Nominal money supply which is fixed by the central bank and P = Price level in
the economy. For derivation of LM we assume that central bank keeps the nominal money
supply fixed and P the price level is also fixed as IS-LM is a short run phenomenon where
price level is constant. LM thus can be derived as:
Figure 13.6 Derivation of LM Curve
LM curve shows equilibrium in the money market and hence it shows the combinations of
different real interest rates and income. Initially the demand curve is shown by kY1-hn where
money demand and supply are equal, and rate of interest is n and corresponding equilibrium
output is Y1. If rate of interest reduces to r2 then money supply being fixed there is excess
demand of money that leads to disequilibrium and restore the equilibrium level of output has
to be reduced which shifts the demand curve of money to left as income reduces and new
equilibrium is at reduced rate of interest and reduced level of income. Both the combinations
are shown in the right-hand side diagram. Joining the two combinations we get the upward
sloping LM curve which shows direct relation between rate of interest and equilibrium level
of output.
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Now to derive the slope and position of LM, the above equilibrium equation can be modified
as:
r = 1/h (kY-M/P)
Slope of LM is thus k/h that is dependent on sensitivity of demand to real income and rate of
interest and position is dependent on the money supply. The changes in slope and position
can be interpreted as:
Slope of LM curve:
1)
If 'k' is more the slope is more and LM is steeper
2)
If 'k' is less the slope is less and LM is flatter
3)
If 'h' is more the slope is less and LM is flatter
4)
If 'h' is less the slope is more and LM is steeper
Position of LM curve:
The position of LM curve depends on the nominal money supply keeping price level
constant. This is because if money supply changes there is a change in the equilibrium and
shift in the LM. It can be explained with the diagram below:
Figure 13.7 Position of LM Curve
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Initially the equilibrium is at n rate of interest corresponding to a demand curve of money and
real money supply (M as nominal supply and P the price level). The corresponding LM curve
is shown in the right panel. Now if central bank increases the nominal money supply to M1
the new equilibrium rate of interest reduces to r2 at the same level of equilibrium output.
Thus, the LM curve shifts parallel to right to LM1. The shift in LM is thus because of change
in the money supply. If money supply increases LM shifts parallel to right and if money
supply reduces then LM shifts parallel to left.
In-text Questions: True and False
(1)
IS curve shows equilibrium in money market.
(2)
LM curve shows different combinations of rate of interest and equilibrium level of
output where money market is in equilibrium.
(3)
A two-sector economy does not differentiate between Gross income and Disposable
income.
(4)
Fiscal policy refers to change in government expenditure or change in taxes.
(5)
Multiplier shows the change in equilibrium level of output because of change in
autonomous spending.
(6)
Aggregate demand curve shows relation between price level and equilibrium level of
output.
(7)
Proportionate Tax is zero when income is zero.
(8)
If the expenditure of the government is more than the revenue of the government it is
called surplus budget.
13.4 SIMULTANEOUS EQUILIBRIUM
Simultaneous equilibrium is where both the goods market and money market are in
equilibrium. Any point on the IS curve shows that Goods market is in equilibrium and any
point on LM represents equilibrium in money market. The simultaneous equilibrium is shown
in figure below:
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Figure 13.8 Simultaneous Equilibrium
13.5 IMPACT OF FISCAL POLICY ON THE SIMULTANEOUS EQUILIBRIUM
Fiscal policy means change in government expenditure and/or taxes to bring changes in the
equilibrium level of output. If government follows an expansionary fiscal policy and
increases the government expenditure, then the autonomous spending would increase and it
would bring an upward parallel shift in the AD curve that would increase the equilibrium
level of output at the same rate of interest. Thus, new goods market equilibrium would be at
same rate of interest and higher level of output that would bring a rightward shift in the IS
and hence increased level of output and at that point money market would be in
disequilibrium so to bring it to equilibrium rate of interest would finally increase because of
decrease in price level because of increase in income. It can be shown below-
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Figure 13.9 Impact of Fiscal Policy on Equilibrium
Similarly, an expansionary monetary policy would increase the money supply and shift LM
curve to right that too would increase the equilibrium level of output and reduce real rate of
interest. Thereby bringing a new simultaneous equilibrium.
13.6 NUMERICAL ON IS- LM
Question 1. Find out IS and LM equation in the following three sector economy
C = 100 + 0.8 Yd
I= 1000-Si
G=80
T=0.25 Y
L = 0.8Y-0.2i
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M=200
P=2
Solution: Equilibrium in goods market is when Y = AD
Y=C+I+G
Y = 100 + 0.8 (Y-0.25Y) + 1000-Si + 80, 1180 + 0.8*0.75Y-5i, 1180 + 0.6Y-5i 0.4Y = 1180
-Si, Y = 2950 -12.5i …………………………………….IS equation
Equilibrium in Money Market is where Money demand = Money supply
0.8Y-0.2i = 200/2, 0.8Y = 100 + 0.2i, Y = 125-0.25i
…………………
LM equation
Question 2 C = 100 + 0.9 Yd, I= 600 -30r, G = 300, T = 1/3Y, Md= 0.4Y -50r M= 1040, P=2
Full Employment level of equilibrium is 2500.
a)
Derive IS and LM equations and compute equilibrium.
b)
Explain change in slope and position of IS and LM if MPC changes to 0.6.
Solution: a) Equation of IS curve is Y = AD
Y = 100 + 0.9(Y-1/3Y) + 600 -30r + 300, Y = 1000 + 0.6Y -30r, 0.4 Y = 1000-30r
Y =2500-75r
Equation of LM curve is Md = Ms
0.4Y -50r = 1040/2, Y = 1300 + 125r
Solving above IS and LM curve we get the following
2500 -75r = 1300 + 125r, Y = 2050, r = 6%
b) Impact of MPC is only on the slope of IS curve as it is a part of slope of IS curve
Old Slope= 1/mga = l/[1/1-0.9(1-1/3)].30 = 0.0133
New Slope= 1/mga = l/[1/1-0.6(1-1/3)].30 = 0.02
Thus, the slope of IS has increased when MPC changes to 0.6
Question 3 (Practice question) C = 100 + 0.8Y d, I= 150 -6i, G = 100, T = 0.25Y
Md= 0.2Y -2i, Ms= 300, P = 2
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Calculate equilibrium level of output and rate of interest. Also, if government spending is
raised from 100 to 150 find the shift in the IS curve.
13.7 SUMMARY
The previous chapter talked about how equilibrium is attained in case of two sector and three
sector economy using the concept of Keynesian cross. This chapter talked about attainment of
equilibrium in Goods market and Money market using the concept of IS and LM curves.
Where IS curve gave different combinations of real rate of interest and equilibrium output
where goods market is in equilibrium, the LM curve provided different combinations of the
same where money market achieves its equilibrium. Both IS and LM curves are based on
certain assumptions through which they get their downward or upward sloping slopes and
once these assumptions are relaxed there is a change in the slope and/or position of the two
curves. For an economy to be in total equilibrium both goods and money market should be in
equilibrium such that simultaneous equilibrium is when IS and LM intersects. There can be
changes in this simultaneous equilibrium once achieved by a change in the fiscal or monetary
policy as simultaneous equilibrium is based on IS and LM and if either of them changes there
is a new equilibrium. A change in the fiscal policy brings a new IS curve and a change in the
monetary policy changes the LM curve thus changing the final equilibrium of the economy.
While doing IS-LM we assumed that price level is constant as it is a short run phenomenon,
but price level usually changes in the long run. Further IS-LM analysis will be used to derive
relation between Price level and equilibrium level of output known as aggregate demand
curve and it would be taken up in the next chapter. As discussed in the chapter that an
increase the government purchases brings a parallel shift in the IS curve, government
increases the purchases to bring an increase in the equilibrium level of output but while doing
so government does not take into consideration the simultaneous increase in the real rate of
interest which in tum reduces the private investment leading to crowding out and it would be
studied in detail in the next chapter.
Intext Questions: Fill in the Blanks
(9)
Government has three roles to perform in an economy _________
(10)
If MPC is O then value of multiplier is _________
(11)
The slope of IS curve depends on _______ and _______
(12)
Slope of LM is _______ related to 'k' that is sensitivity of demand of money to real
income.
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(13)
Fiscal Policy means changes in ______ or ______
(14)
The shift in the IS curve because of change in government spending can be measured
by __
(15)
Monetary policy includes changes in _______ in the short run.
(16)
The relation between Price level and equilibrium level of output is shown by
________
ANSWER TO INTEXT QUESTIONS
Ans. 1.(F), 2. (T), 3. (T), 4. (T), 5. (T), 6. (T), 7. (T), 8. (F), (9). Government Purchases, Tax
collection and Transfer Payment (10). Unity (11). Government Multiplier and Sensitivity of
Investment to rate of interest. (12). Directly. (13). Government Purchases or taxes. (14).
Government Multiplier. (15). Money Supply (16). Aggregate Demand Curve
13.8 SELF ASSESSMENT QUESTIONS
1. Explain the equilibrium in case of three sector economy.
2. Explain the derivation of IS curve and how is its slope and position derived
3. How is equilibrium attained in case of three sector economy with proportionate tax?
4. Explain the concept of shift in IS and LM curves.
5. Explain how the Aggregate demand curve is derived
6. What is the reason for inverse relation between real rate of interest and equilibrium
level of output in case of IS curve?
7. What is the effect of increase in nominal money supply on the LM curve in the money
market?
8. What is the role of price level in case of money market equilibrium?
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Introductory Macroeconomics
LESSON-14
FISCAL AND MONETARY MULTIPLIES
STRUCTURE
14.1
14.2
14.3
14.4
14.5
14.6
14.7
Introduction
Derivation of Aggregate Demand Curve
Monetary and Fiscal Multiplier
Crowding Out
Summary
Self-Assessment Questions
Suggested Readings
14.1 INTRODUCTION
The previous chapter talked about equilibrium in macro economy that comprises of two
sectors, three sector economy with presence of fixed and proportionate tax. It also showed
how change in the autonomous spending brings a change in the equilibrium level of output.
The present chapter goes ahead and talks about the derivation of aggregate demand curve that
is basically a long run phenomenon as it shows relation between price level and equilibrium
level of output. The shift in the aggregate demand curve can be because of shift in either the
IS or the LM curve and the change in the equilibrium level of output and this is shown by the
fiscal and monetary policy multipliers respectively which would be studied in this chapter.
Another important topic of discussion is the crowding out effect that shows how because of
increase in the government spending the rate of interest increases and leads to decrease in the
private investment that reduces the desired effect expected by government. This too would be
shown using concept of multiplier in the present chapter.
14.2 DERIVATION OF AGGREGATE DEMAND CURVE
The concept of IS- LM curve as given by Hicks was based on short run whereby prices were
assumed to be constant. But here in aggregate demand curve the relation is shown between
price level and equilibrium level of output as it's a long run phenomenon. The AD curve is
derived from simultaneous equilibrium that is IS- LM curve intersections. It is being shown
in figure below:
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Figure 14.1 Derivation of AD curve
Upper panel shows simultaneous equilibrium derived from IS-LM curve. As every LM is
corresponding to a price level. So, the initial price level is P where equilibrium output is Y1
and equilibrium rate of interest is n. This gives a combination for the AD curve drawn in the
panel below. Now if price level reduces to P1 then real money supply increases assuming
nominal money supply to be constant which shifts the LM curve parallel to right providing a
new equilibrium at r2 and Y2 level of income. This provides second combination for the AD
curve which shows that at reduced price level equilibrium level of national income increases
showing inverse relation between price level and equilibrium level of output and thereby
providing a downward sloping AD curve.
14.3 MONETARY AND FISCAL MULTIPLIER
In previous two chapters we discussed about the concept of multiplier that shows change in
the equilibrium level of output because of change in autonomous spending. This can be
applied in case of two sector, three sector economies. The multiplier in three sector economy
with proportionate tax shows what is the desired change in the equilibrium level of output if
government increases its purchases assuming that it has no impact on the interest rates.
However, it shows a shift in the IS curve and hence at the new equilibrium only goods market
is in equilibrium. But this is not the equilibrium of the economy as money market is in
disequilibrium. So, in this entire process there is increase in the interest rates that crowds out
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Introductory Macroeconomics
the private investment and hence actual change in the equilibrium is less than the desired
change. While desired change is shown by the government multiplier, the actual change is
shown by fiscal multiplier. It can be presented diagrammatically as:
Figure 14.2 Fiscal Multiplier and its impact on the AD curve
Panel above shows that initially the Goods equilibrium is shown by IS curve and money
market equilibrium is shown by LM curve which is corresponding to a particular price level
that is P* where simultaneous equilibrium level of output is Y1 and real rate of interest is r1.
The panel below shows that corresponding to Price level P* and Y1 level of output there is an
aggregate demand curve AD. Now if government increases its purchases and expects that the
output would increase to Y2 at the same rate of interest but here the goods market is in
equilibrium as this is a point on the IS curve but money market is not in equilibrium as the
point is not on the LM curve. The new simultaneous equilibrium where both money market
and goods market are in equilibrium is at r2 rate of interest and Y3 level of output which is
less than what is expected by the government. This change from Y1 to Y3 is the fiscal
multiplier. It is shown by a parallel rightward shift in the aggregate demand curve showing
that at the same price level because of increase in government purchases the equilibrium level
of output also increases though not in the same quantum as was expected. The opposite
would hold if there were decrease in the government purchases as aggregate demand curve
would shift parallel to left.
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Similarly, we can show the concept of money multiplier which shows the change in
equilibrium level of output when there is increase in the nominal money supply keeping the
price level constant. When there is increase in the nominal money supply the LM curve shifts
to the right as with increase in money supply there is a reduction in the rate of interest that
increases the money demand to bring the money market to equilibrium again. It can be shown
using the following diagram
Figure 14.3 Monetary Multiplier and its impact on the AD curve
The two panels above show how an increase in the nominal money supply shifts the LM
curve to the right in the above panel that brings a reduction in the real rate of interest and
increase in the equilibrium level of output. This increase in the equilibrium level of output is
shown by the monetary policy multiplier which shows how much is the change in the
equilibrium level of output if nominal money supply changes keeping constant the price level
and other factors impacting the simultaneous equilibrium. An increase in nominal money
supply brings a rightward parallel shift in the aggregate demand curve as shown by the panel
below. The reverse would happen with reduction in the price level.
The concept of Fiscal and Monetary policy multiplier can also be shown mathematically as
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Introductory Macroeconomics
Goods Market is in equilibrium when total output produced is equal to the aggregate demand
of the economy
IS equilibrium Equation is:
Y=C+cYd+I- ar+G,
Y = C + c(Y - tY + TR) + I - ar + G,
Y =A+ (1-t) Y - ar, Y = A-ar/1- c (1-t), Y = mg (A - ar)
(1)
LM equilibrium Equation is:
r = 1/h [ KY - M/P]
(2)
Substituting value of interest rate in equation (1) we get
Y = mg [A- a/h (KY - M/P)], Y = mg [ A- aKY/h + Ma/Ph]
Y = mgA - mgaKY /h + mgMa/Ph, Y = mgAhP/Ph - mgaKYP/Ph + mgMa/Ph
YPh = mgAhP - mgaKYP + mgMa
YPh + mgaKYP = mgAhP + mgMa, Y (Ph + mgaKP) = mgAhP + mgMa
Y = mgAhP/ (Ph+ mgaKP) + mgMa/(Ph + mgaKP)
Y = mgAh/ (h + mgaK) + mgaM/P(h + mgaK)
Substituting  = hmg/h+Kamg we get,
Y =  A + [a/h] [M/P]
Here Fiscal multiplier shows change in equilibrium level of output because of change in
autonomous spending that includes government expenditure and other components but we
assume that the major component here is government purchases and thus fiscal multiplier
shows the impact of changed government expenditure on equilibrium level of output. Thus 'a'
shows how much is the change or shift in the equilibrium when there is a change in
government purchases. Similarly change in the equilibrium level of output because of change
in the money supply is shown by Monetary policy Multiplier that shows by how much there
is change in the equilibrium level of output if nominal money supply changes keeping the
price level constant. Graphically it is shown by a shift in the LM curve as the slope has not
changed and only the position is being changed because of the change in the nominal money
supply. Thus, the two multipliers that shows the impact of two government policies namely
fiscal and monetary policy are the monetary and fiscal multiplier.
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Intext questions: True and False
(1)
AD curve is a short run phenomenon.
(2)
Crowding Out happens because of Monetary Policy.
(3)
A two-sector economy does not differentiate between Gross income and Disposable
income.
(4)
Fiscal policy refers to change in government expenditure or change in taxes.
(5)
Monetizing Fiscal deficit is another name of Monetary Accommodation of Fiscal
Expansion
(6)
Aggregate demand curve shows relation between price level and equilibrium level of
output.
(7)
There is no crowding out when output is at full employment level.
(8)
Fiscal multiplier shows change in simultaneous equilibrium because of change in
government expenditure.
14.4 CROWDING OUT
Gross Domestic Product or national income shows how much production is taking place in
any economy. If the government expects that the production is less than what it should be
then it goes for expansionary fiscal policy where it increases the government purchases
assuming that there would not be any change in the other variables (also the interest rate) and
the output would increase by government multiplier multiplied by change in the government
expenditure. However, this is not true as with an increase in the government purchases the
aggregate demand in an economy increases and money supply being constant the real rate of
interest increases because of which the private investment is bound to decrease as there is
inverse relation between rate of interest and private investment. Thus, the change in output is
less than what is expected by the government. However, whether there can be increase in
output or not depends on whether the economy is operating at full employment that is output
is already at potential output and no further increase in output is possible. Another case can
be when the current output is less than the full employment level and with government policy
it is possible to bring an increase in the actual output. The last case can be when government
does not want any crowding out or decrease in private investment and there by increases the
government expenditure by printing of currency and increasing the money supply
simultaneously. All the three cases are shown using the following diagrams:
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Introductory Macroeconomics
Figure 14.4 (a) Crowding Out - Full Employment
Here IS curve is the original goods market curve and LM is the original Money market curve
where the simultaneous equilibrium is at the intersection of the two. Now if it is already at the
full employment Y* then with an increase in the government spending the IS curve shifts to
the right but because of the full employment output there is a corresponding increase in the
rate of interest that shifts the LM curve to the left. Thus, there is hundred percent crowding
out of private investment as there is no actual change in the output.
Figure 14.4 (b) Crowding Out - Less than Full Employment
In case output is less than the full employment then an increase in the government spending
brings a simultaneous rightward parallel shift in the IS curve. Though government intended
that output would increase from Y1 to Y2 but in this process the real rate of interest increased
and the actual change in output is from Y1 to Y3. The reduction in private investment from Y2
to Y3 because of increase in the real rate of interest is known as partial crowding out.
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Figure 14.4 (c) Crowding Out - Monetary Accommodation of Fiscal Expansion
The third case also known as monetizing fiscal deficits means printing of currency by the
government to finance its increased government expenditure. Thus, there is rightward shift in
the IS as well as LM curve and no corresponding increase in the real rate of interest thus the
intended change in output and the actual change in output are equal with no crowding out.
Intext questions: Fill in the Blanks
(9)
IS-LM is a________ run phenomenon.
(10) Aggregate Demand shows relation between _________ and _______.
(11) AD shows ________equilibrium.
(12) Crowding out shows _______ in private investment.
(13) Monetary Policy means changes in ________.
(14) Monetary Accommodation of Fiscal Expansion means _______ of currency to
________ Government expenditure.
WHY CROWDING OUT IS SO IMPORTANT
Crowding out Effect is so important because it tells us that both the policies monetary &
fiscal are necessary to stabilize the economy.
If IS curve & LM curve both shifts rightward simultaneous by the same ratio then inte4rest
rate will remain same, only national Income will increase multiplier time. In this situation,
there will be no crowding out effect. Thus, both monetary policy and fiscal policy will be
effective. Thus, both play role in regulating the level of economic activity in the country.
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Introductory Macroeconomics
14.5 SUMMARY
The previous chapter discussed about how goods market and money market are
simultaneously in equilibrium which is shown using the concept of Aggregate Demand curve
which shows inverse relation between price level and equilibrium level of output. The chapter
further discussed how changes in fiscal and monetary policy have an impact the real rate of
interest in the economy and hence the simultaneous equilibrium. There are three situations of
crowding out with it ranging from zero percent crowding out to full crowding out depending
on the level of output where the economy is operating that is at full employment, less than
full employment. There is also an extreme situation where government finances its spending
by printing of currency known as monetary accommodation of fiscal expansion.
ANSWER TO INTEXT QUESTIONS
Ans. 1 (F), 2(F), 3(T), 4(T), 5(T), 6(T), 7(F), 8(T), (9). Short, (10) Price Level and
Equilibrium Level of Output, (11). Simultaneous, (12). Decrease, (13). Nominal Money
Supply, (14) Printing of currency, finance.
14.6 SELF ASSESSMENT QUESTIONS
1. Explain the derivation of simultaneous equilibrium.
2. What is Crowding Out.
3. Explain derivation of Aggregate Demand Curve.
4. How do monetary and Fiscal multipliers have an impact on the simultaneous
equilibrium.
5. What happens when there is full employment in the economy and government
increases its purchases.
6. Derive monetary and Fiscal multiplier mathematically.
7. What happens when government increases its money supply to fund its additional
expenditure.
14.7 RECOMMENDED READINGS
Andrew Abel, Ben Bernanke and Dean Croushore (2011). Macroeconomics (7th edition),
Pearson.
Richard T. Froyen (2013). Macroeconomics: Theories and Policies (10th ed.), Pearson.
Blanchard, O. (2006). Macroeconomics (6th edition). Pearson
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B.A.(Hons.) Economics / B.A.(Programme)
Blanchard, O. (2017). Macroeconomics (7th edition). Pearson
Dornbusch, R., S. Fischer and R. Startz. Macroeconomics (6th edition). McGraw- Hill
Dornbusch, R., S. Fischer and R. Startz. Macroeconomics (11th edition). McGraw- Hill
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