BBE1002C UNIT 2

MACROECONOMICS

UNIT -2
Keynesian Theory of Income and Employment

The Great Depression and the Keynesian Solution

The "Keynesian State" is a name we give to the regulatory mechanisms of world
capitalism which operated, fairly successfully, from the end of the Great Depression to
the late 1960s. During that period the old mechanisms which had always regulated the
economy --especially the business cycle-- were replaced by new ones. With something
of an adaptive lag, economic theory also changed as classical economics with its
rationalization of laissez-faire (based on the belief that markets will automatically bring
about necessary adjustments) came to be seen as inadequate to the new situation and was
replaced by "Keynesian" economics with its new emphasis on the role of the state in
managing the economy.

Modern interest in income and employment theory was triggered by the severity of
the Great Depression of the 1930s in the United States and Europe. In its failure to
explain the persistent high levels of unemployment and the low levels of business
productivity, the prevailing school of classical economics lacked solutions for the
problems of that era.

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• John Maynard Keynes offered new thinking on income and employment theory
with the publication of General Theory of Employment, Interest and
Money (1936). Building on his theory, Keynesians have stressed the relationship
between income, output, and expenditure.
• Since transactions are two-sided—in that one person’s income is another person’s
expenditure—the relationship could be expressed in the form of a simple
equation:
• Y = O = D,
• where Y is the national income (i.e., purchasing power),
• O is the value of the national output,
• and D is national expenditure.
• What this equation means is that effective demand is equal to income as well as
to output. Since consumers can either spend or save their income,
• Y = C + S, where C is consumption and S is savings.

Keynesianism provided an answer to the question of how to generate growth via surplus
despite rising wages. The classical economists, and the businessmen who had
assimilated their ideas, thought in terms of a Zero-Sum Game. That is to say, if one side
gains, the other side loses (gains and losses sum to zero). Therefore, they felt that if
profits were to rise, wages must be kept down or lowered. In the context of the late
1920s and 1930s, Keynes saw insurmountable obstacles to this approach: both in real
world politics and in theory.

With respect to politics, he was one of the first to perceive the growing power of labor
to resist traditional adjustment through lowered wages. As early as 1925, during the
debate over the post-WWI return to the Gold Standard, Keynes had opposed adjustment
through wage cuts. One of his points of reference was the English coal industry where
attempts by owners to push down wages led to a lock out and the general strike of 1926.
Three years later, in a July 31, 1928 article on "How to Organize a Wave of Prosperity",
he also rejected a "general assault on money wages" in favor of an expansion in public
expenditure.

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• Again in 1930, in his work on the Macmillan Committee and the Economic
Advisory Council (ECA), Keynes rejected arguments for trying to solve the
problems of the economic crisis through a cut in wages. He appealed both to
social justice and to the dangers that workers would not submit to the level of
reductions required.
• With respect to theory, he pointed a way to a solution in which both wages and
profits could rise. Although the political balance of power between labor and
business had shifted in favor of labor, and wages would mainly rise henceforth,
there was still a solution in which surplus or profits could also rise.

Keynesian Theory of Income and Employment

Total Spending and Economic Activity:

Why do changes in spending cause the level of economic activity to change? In

a market economy, buyers, through their spending decisions, choose goods and
services that are produced by sellers. If buyers do not spend their money on
products, sellers will not produce those products for the market. Thus, if total
spending were to decrease, output would decrease; if total spending were to
increase, output would increase; and if total spending remained unchanged,
output would not change.

When the level of spending goes up and sellers increase production, more land,
labour, capital, and entrepreneurship are required. This means that there will be
an increase in the employment of resources, which will, in turn, enlarge
incomes. Thus, increased spending leads to economic expansion, or recovery,
because it stimulates a growth in output, employment, and income.

When spending falls and sellers reduce their outputs, a cutback occurs in the
employment of resources. This cutback in turn leads to a decrease in resource
owners’ incomes. Thus, a reduction in spending leads to a recession, or
contraction in economic activity, because of its dampening effect on output,
employment, and income. The relationship between spending and output,
employment, and income is summarised in Table 18.1.

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Because aggregate spending is composed of expenditures by households,

businesses, the government, and foreign buyers, it is necessary examine the
spending behaviour of each of these sectors, along with how that behaviour
affects the level of economic activity.

Aggregate Effective Demand:

Keynes’ analysis of general unemployment is based on the concept of aggregate

(or total) demand in the economy. To simplify his analysis, Keynes initially left
aside the government sector (and, therefore, the element of government
expenditure in aggregate demand). He also ignored foreign trade (or exports).
(However, for the sake of completeness, we shall incorporate these elements in

In a closed economy (i.e., one having no trading relation with the rest of the
world) with no government sector.

The two components of aggregate demand are:

(1) private consumption expenditure and

(2) private investment expenditure.

Table 18.1: Total Spending and the Level of Economic Activity

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The Household Sector:

In the aggregate, the largest spending group in the economy is households.

Households buy far more goods and services than do businesses, government
units, and foreign purchasers combined. Also, over time, household spending
increases at a relatively stable pace. Because individuals do not usually alter
their expenditure patterns from year to year, aggregate household spending on
new goods and services, which is technically termed personal consumption
expenditures, tends to fluctuate very little as it grows over time.

The Consumption Function:

To construct Keynesian macroeconomic models, it is necessary to have a clear

understanding of the consumption function. The concept of propensity to
consume or the so- called consumption function is based on the— “fundamental
psychological law” which states that — “as a rule and on the average” — as
income increases, consumption increases but the rate of the increase in
consumption is less than the rate of increase in income.

Thus, in Keynes’ consumption function, a relationship between functions

has the following characteristics:

(i) Consumption is a function of (disposable) income, i.e., C = f (Y).

(ii) The relationship between consumption and income is a direct one.

(iii) The rate of increase in consumption is less than the rate of increase in
income. In Keynes’ terminology, the value of the marginal propensity to
consume (MPC) is less than one.

The Saving Function:

The portion of income which is not consumed is automatically saved. Thus,

saving is the difference between income and consumption. That is,

Like consumption function, saving also directly depends or income. To have a

clear understanding of the saving function, we must define Keynes’ concepts
like average and marginal propensities to save.

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Four Definitions:

Before we proceed further we have to note four important definitions. These

will come up again and again in our discussion of macroeconomics.

1. The average propensity to consume (APC):

It is the proportion of income which is spent on consumption. It is worked out

by dividing total consumption expenditure (C) by total income (Y) – APC =
C/Y. Thus, if India’s national income is Rs. 10,000 crore and consumption
expenditure is Rs. 7,000 crore, APC = 7/10 or 0.7.

2. The marginal propensity to consume (MPC):

It is the proportion of an addition to income that is spent on consumption. It is

worked out by dividing the (absolute) change in consumption by the (absolute)
change in income that brings it about.

It is expressed as:

MPC = ΔC/ΔY, where C denotes the change in consumption and Y is the

change in income.

[It may be noted that C = f(Y), i.e., consumption is a function of income or,
consumption depends on income. Income changes brings about consumption
change. The converse is not true.]

If for example, income rises by Rs. 10,000 crore and out of this Rs. 9,000 crore
is spent on consumer goods and services, MPC = 9/10 or 0.9.

3. The average propensity to save (APS):

It is the proportion of income that is saved. It is found out by dividing total

savings (S) by total income (Y) or APS = S/Y. Thus, if income is Rs. 10,000
crore and saving is Rs. 3,000 crore, APS = 3/10 or 0.3.

4. The marginal propensity to save (MPS):

It is the proportion of an addition to income that is saved – MPS = ΔS /ΔY,

where S is the change in saving.

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Factors Affecting Consumption:

Various factors affect consumers’ expenditure. Since consumption and saving

are the two sides of the same coin, the determinants of consumption are also the
determinants of saving. These determinants are not separate from each other.
For example, how much people save is determined largely, if not entirely, by
income. People with low income cannot afford to save or cannot save much.

On the other hand, people with very high incomes cannot spend all their income
on goods and services. So they cannot avoid saving a portion of their income. If
we look at different income groups, we observe that as income rises, the average
propensity to consume (APC) falls, or, what comes to the same thing, the
average propensity to save (APS) rises. It is because, as income rises, people
can afford to save more.

Alternatively, Keynes said that, as income rises, the MPS falls. This brings us
on to the consumption function, which lies at the heart of the Keynesian
analysis. The consumption function shows the level of consumer’s expenditure
at each level of income. Fig. 18.1 represents the consumption function
diagrammatically.

We know that even when income is zero, consumption expenditure is positive.

This is known as ‘autonomous consumption’ and can take place because people
draw on past savings to pay for it. Or, some people may depend on others for
survival.

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This is also known as ‘subsistence consumption’. It has no relation to

individual’s (or society’s) income. As income increases above this zero level,
consumption expenditure also increases. In Fig. 18.1, when income rises from
OY1 or OYv2 consumption expenditure increases from OC1 to OC2.

However, the increase in consumption is less than the increase in income —

because part of the increase in income is likely to the saved.

Thus, when income rises from OY1 to OY2 the resulting change in consumption
(MN) is less than the change in income (LM).

The slope of the consumption schedule— denoted by b in the diagram — is

given by MN/LM. Here, LM is the change in income and MN the change in
consumption. Therefore, the slope is given by which is indeed the marginal
propensity to consume (MPC). Thus, the slope of the consumption schedule
gives us the MPC. From the Fig. 18.1, one can establish the relationship
between APC and MPC.

At the zero level of income, APC is infinite. However, as income increases,

APC declines. Its value may be greater than, equal to, or less than one. On the
other hand, the value of MPC is always greater than zero but less than one; i.e.,
0 < MPC < 1. On a straight line consumption function, the value of MPC
remains constant. Thus, APC should exceed MPC.

A More Realistic Consumption Function:

In Fig. 18.2, the marginal propensity to consume is constant. Yet we stated

earlier that as income increases, MPC tends to fall. Therefore, a more realistic
consumption function would be of the type shown in Fig. 18.2. This shows that
as income increases, the slope of the consumption schedule decreases, i.e., as
income increases, MPC gradually falls.

However, for the sake of simplicity, we prefer to work with a linear

consumption function (where MPC is a constant) in the rest of our analysis.

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Saving Function in a Diagrammatic Form:

Like consumption function, saving function can also be represented with the
help of Fig. 18.3. Here SS’ is the saving curve. It starts somewhere from the
vertical axis below the origin (i.e., negative quadrant). This is because, at a very
low level of income, saving may be negative, since consumption is always
positive.

Consumption expenditure takes place during this time by drawing down past
savings. That is why the saving live starts from the negative axis. But, as
income increases, saving increases, so saving curve must be a rising one.

Further, the slope of the saving function is nothing but the MPS. Let us pick up
points/and d on the SS’ curve. As we move from point f to d income increases
(ΔY) by ft and consequently, saving increases (ΔS) by dt.

Thus MPS = ΔS/ΔY = d’t’/f’t’ = slope of the SS’ curve.

Investment as a Multiplier

Meaning:

Investment expenditure is the second component of aggregate effective demand.

Business investment refers to expenditure on capital goods such as plant,
equipment and machinery (fixed capital) as also stocks (working capital), i.e.,
physical or real investment. In economics, the term investment relates

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specifically to physical investment. It creates new assets, thereby adding to

society’s productive capacity.

To be more specific, investment refers to expenditure on the purchase of

physical assets such as plant, machinery and equipment (fixed capital) and
stocks (working capital). Such physical or real investment creates new assets —
thereby adding to the country’s productive capacity, whereas financial invest-
ment only transfers the ownership of existing assets from one person or
institution to another.

Investment requires that an amount of current consumption is sacrificed (i.e., a

portion of income is saved) so as to release the resources to finance it. It is an
injection into the circular flow of national income. Investment expenditure is
normally defined as consisting only of private sector investment spending.

Importance of Investment:

Investment expenditure is of much importance to a modern economy.

Employment depends on aggregate demand. Investment expenditure is a
component of aggregate demand and an addition to the circular flow of income.

If investment increases, aggregate demand also increases and, at the end, we

observe an increase in employment and income. In fact, the level of
employment in a country largely depends on the volume of investment. If more
investment is made more employment can be created.

Gross v. Net Investment:

Investment may be gross or net. Gross investment is the total amount of

investment that is undertaken in an economy in an accounting year. Net
investment is gross investment less depreciation. Depreciation or replacement
investment is necessary to replace that part of society’s existing capital stock
which is used up in producing this year’s output.

The term Investment Multiplier is an important contribution made by Prof. J.M.
Keynes. Keynes felt that an initial rise in investment multiplies overall income by a
large factor. The relationship between an initial increase in investment and the

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subsequent rise in total revenue is expressed by the multiplier. In reality, it has

been seen that when investments are increased by a particular amount, the
change in income does not only reflect the initial investment's value but also
increases by several times. In other words, a multiple of a change in investment
equals a change in income. A multiplier explains how many times an increase in
investment causes an increase in national income.
Hence, Multiplier (k) is the ratio of an increase in national income (ΔY) due to an
increase in investment (ΔI).

k=Increase in National Income (ΔY)

Increase in Investment (ΔI)
Assume that an extra ₹5,000 crores of investment (ΔI) in an economy result in
extra ₹20,000 crores of income (ΔY). In this scenario, multiplier (k) will have the
value:
k=20,000/5,000
=4
It indicates that a single increase in investment resulted in a 4 times increase in
income.
Multiplier and MPC
MPC and multiplier value are directly related to one another. The value of the
multiplier increases with an increase in MPC, and vice versa. The concept of
multiplier was developed based on the view that the expense of one person is
another person's income. The increase in investment raises the income of the
people, a portion of which is used by people for consumption. The value of MPC;
however, determines how much of the new income is to be spent on consumption.
People will spend a large portion of their increased income on consumption in the
case of higher MPC. The multiplier's value will be higher in such a situation.
However, people will spend a smaller percentage of their increased income on
consumption when the MPC is low. It means that the MPC determines the value of
multiplier.
Algebraic relationship between Multiplier and MPC
The following method can be used to derive the algebraic relationship between
Multiplier and MPC. We already know that:
Y=C+I
This means that any change in income (ΔY) will therefore equal (ΔC+ΔI).
ΔY = ΔC + ΔI
Dividing both sides by ΔY:
ΔY/ΔY=ΔC/ΔY+ΔI/ΔY

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1=MPC+1/k
(∵Δ Y/Δ Y=1, Δ C/Δ Y=MPC, andΔ I/Δ Y=1/k)
OR
k=1/1−MPC
Multiplier (k) in terms of MPS
k=1/1−MPC
Also, 1-MPC = MPS
So,
k=1/MPS
Multiplier is directly related to MPC and inversely related to MPS
The multiplier's value is based on the marginal propensity to consume. In other
words, when MPC is higher, multiplier (k) is higher, and vice versa. On the
contrary, the higher the MPS, the lower will be the multiplier value and vice versa.
It can be clearly understood with the help of the following table:

MPS
MPC (1-MPC) Multiplier(k)=1/MPS

0 1 1=1/1

0.60 0.40 2.5=1/0.40

0.67 0.33 3=1/0.33

0.72 0.28 3.57=1/0.28

1 0 ∞=1/0

The above table clearly shows that the multiplier has a direct relationship with MPC
and an inverse relationship with MPS.

Determinants:

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When considering whether to undertake expenditure an entrepreneur will

compare the cost of the venture (such as setting up of a textile mill) and the
revenue he expects to get from it. The cost refers to the amount to be paid for
the machine, or any other form of capital, and the rate of interest to be paid on
the money borrowed to finance the expenditure. If the rate of interest falls, one
would expect more investment to be undertaken.

The reason is very simple it is now cheaper to borrow the necessary funds,
while, if the rate of interest rises, the amount of investment expenditure may be
cut back. If interest rates have been high for some time, entrepreneurs may be
less inclined (willing) to undertake investment expenditure.

As Keynes put it:

“The amount of current investment will depend, in turn, on what we shall call
the inducement to invest; and the inducement to invest will be found to depend
on the relation between the schedule of marginal efficiency of capital and the
interest rates on comes of various maturities and risks.”

Thus investment decisions are governed by whether the expected rate of return
on the machine is greater than the cost of borrowing the necessary funds, or, if
the funds are already available, the cost of the earnings lost by purchasing the
machine rather than by lending out of funds. In short, the inducement to invest
depends on the marginal efficiency of capital and the rate of interest r. For an
investment to be worthwhile, MEC must never fall below r.

(a) Rate of Interest:

Investment is inversely related to the rate of interest. If the expected return on

investment remains constant at, say, 10%, and the rate of interest increases from
5% to 7%, the net return on investment goes down from 5% to 2%. So an
increase in the rate of interest makes new investment less attractive than before.
Similarly, a fall in the rate of interest, ceterus paribus, will stimulate investment.

(b) Marginal Efficiency of capital:

The other factor affecting investment decisions is the expected rate of return on
investment expenditure—or, what Keynes calls, ‘the marginal efficiency of
capital’. This return (or revenue) will not fully materialise until some years have
passed.

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Moreover, many things may happen in that time to nullify the original
expectations of the entrepreneur, e.g., consumers may reduce their demand for
the commodity being produced (as in the case of black and white T.V. sets due
to the added attraction of colour T.V. sets or simple pocket calculators due to
the emergence of more useful calculating devices such as mini-computers).
Investment is, therefore, a risky matter.

So the desire of on entrepreneur to undertake such risks will depend on their

expectations regarding the future. If their view of future prospects is pessimistic
they will be less willing to spend more on investment. On the other hand,
optimism among entrepreneurs can make them more ready to undertake new
investment projects.

The MEC decreases as the amount of investment increases. This is because

initial investments are made on the most productive or profitable projects later
investments are made on less productive projects, which yield returns.

We have just mentioned that the demand curve for investment goods depends
largely on entrepreneurs’ expectations of the future earnings of these goods.
And since expectations are largely uncertain, the demand for investment goods
is likely to fluctuate overtime. It is not too much to expect that every-thing will
continue in future as at present.

In truth the main factor—which will influence entrepreneurs in making

investment decisions—is the level of consumption. For the demand for
investment goods is a derived demand which depends ultimately on current
expenditure on consumption. If current consumption is high, investment will be
high too, in as much as entrepreneurs will be optimistic. If consumption is low,
then investment will also be low.

MEC represents the demand for new investment goods. MEC is the yield
expected from a new unit of capital. An entrepreneur, who decides to purchase a
new factory or buy a new machine, first of all considers the prospective yield of
the asset in question. He will also have to pay for the asset if it is to be
produced. This price is known as the supply price of the asset or its replacement
cost.

And the MEC of a particular type of asset shows what the entrepreneur expects
to earn from one more asset of that kind compared with what he has to pay to
buy it. Keynes defines MEC as being equal to that rate of discount which would

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make the present value of the series of annuities, given by the returns expected
from the capital asset during its life, just equal to its supply price.

In other words, the MEC of a particular type of capital asset is the rate at which
the prospective yield expected from one additional unit of that particular asset
must be discounted if it is just to equal the (replacement) cost of the asset. It
shows what the rate of discount must be if some entrepreneur is to be just
induced to purchase one more (marginal) unit of that type of asset.

So the investment demand function can be written as:

I = f (r).

On the basis of the two factors affecting investment (i.e., MEC and the rate of
interest) we can draw the MEC schedules in Fig. 18.4.

It is clear that investment will be profitable up to the point where MEC is equal
to the rate of interest (which measures the cost of capital). In Fig. 18.4, at an
interest rate of r0 (which is, say, 20%) only OI0 amount of investment is
worthwhile. A fall in the rate of interest to r1, (say, 15%), increases the amount
of profit investment to OI1.

Investment also depends on expectation of entrepreneurs. If expectations change

and investors expect to receive more return from each investment because of,
say, technological progress, then the MEC schedule will shift from MEC to
MEC1. Consequently, at any given rate of interest (such as 20%) more
investment will be undertaken then before.

This is indicated by point C in Fig. 18.4. A more pessimistic outlook would

cause the MEC curve to shift to the left, e.g., to MEC2 indicating that less

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investment will be undertaken at any given rate of interest. The curve is,
therefore, likely to shift frequently as and when there is a change in the mood
among entrepreneurs.

Equilibrium Level of Income:

In Keynes’ model the equilibrium level of national income is the level at which
aggregate demand is equal to output (aggregate supply).

This is known as the income-expenditure approach. Alternatively, we can say

(following Keynes) that the equilibrium level of income is reached when
planned saving is equal to planned investment. This is known as the saving-
investment (or leakage-injection) approach. We may well start with the income-
expenditure approach.

(a) Income-Expenditure Approach:

In a closed economy with no government the two components of aggregate

demand are consumption and investment. In Fig. 18.5, we have drawn the
consumption schedule. For the sake of simplicity, Keynes assumed that all
investment is autonomous and, hence, independent of income. Thus in Keynes’
model investment is given. It does not change as output (or national income)
changes. Such an investment schedule is drawn in Fig. 18.5.

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Now, by combining the two schedules — the upward sloping consumption

schedule and the horizontal investment schedule — we get the combined C + I
schedule in Fig. 18.5. This is called the aggregate demand schedule. This
schedule (in Fig. 18.5) shows what aggregate demand will be at different levels
of income.

Following Keynes we use the 45°-line as a guideline. Any point on the line is
equidistant from both axes. Thus, for example, the distance OYe represents is
equal to EYe. Here OYe represents national output (or income) and EYe also
represents the level of [Link], it is true if we take any point on the 45°
line, that the distance between that point and the horizontal axis will be a
measure of national output.

The aggregate demand C + I cuts the 45° line at only one point corresponding to
the level of income OY. The distance EY represents output because E lies on the
45° line. But the distance EYe also represents aggregate demand because E lies
on the C + I schedule.

Therefore, at the level of income OYe, aggregate demand is equal to output. It is

only at this level of income that the equality is reached. What is the logic of this
equilibrium? To prove that E is the only point of equilibrium, we have to
disprove that no other point can be a point of equilibrium.

Thus, at any level of income below OYe, aggregate income is greater than
output. The consequent pressure of excess demand will cause prices to rise,
production to expand, and the demand for factors of production to increase.
Since production is profitable, output will increase to meet the extra demand.
Some unemployed resources will now be used. The owners of these resources
will get income and so the economy will move towards the equilibrium point.

Conversely, at any level of income above OYe, aggregate demand is less than
output. There is excess supply. Producers find it difficult to sell their entire
output at current prices. So they will be forced to accumulate inventories (i.e.,
stocks of finished goods and raw materials). So they reduce production.
Consequently, some resources will be unemployed. Their incomes will fall.

The process will continue until and unless the inventories are totally exhausted.
Ultimately, the economy will reach the point E and equilibrium will be restored.
Thus, it is clear that, at the level of income OYe, aggregate demand is equal to

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output and so there is no need for output to change, i.e., there is equilibrium.
OYe is, therefore, the equilibrium level of output (income).

(b) The saving-investment (the leakage- injection) approach:

The alternative approach to income determination is illustrated in Fig. 18.6.

Here the equilibrium condition of national income is found by using the
alternative equilibrium condition—planned saving being equal to planned
investment.

The saving schedule is derived from the consumption schedule in Figs. 18.1 and
18.4. When national income is zero, saving is negative. Such negative saving
(dis-saving) occurs because past savings are being used to pay for autonomous
consumption, as is indicated by the distance Oa in Fig. 18.6. With increases in
income the amount of dis-saving is reduced and a point is reached when saving
is zero, i.e., neither positive nor negative. This point (shown as 5 in Fig. 18.6) is
also called the break-even point in the theory of consumption because at this
point income = consumption and the nation, as a whole, neither saves nor dis-
saves. Beyond this point, saving becomes positive and rises as income rises.

The investment schedule is horizontal (as in Fig. 18.6), because all investment is
autonomous. The equilibrium level of income is given by the point of
intersection of the saving and investment schedules. Since at the level of income
OYe, planned saving = planned investment, there is equilibrium.

Saving and Investment:

Incomes are generated by production and the economic system is said to be in

equilibrium when all the incomes earned are returned to the income flow
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through spending. This simple model system is affected by the existence of two
complicating factors — saving and investment. Saving is that part of income
which is not consumed and, therefore, not passed on in the income flow.
Investment is the process of capital formation plus addition to stocks and,
therefore, is an addition to the income flow.

We know that saving is undertaken by consumers and investment by

entrepreneurs. But, in spite of the fact that saving and investment are undertaken
by different groups, the amount saved and the amount invested will always be
equal in an accounting sense.

The amount spent on consumer goods must equal the sale of consumer goods.
Therefore, that part of national income which is not spent on consumption, i.e.,
saving, must be equal to that part of national income (or national output) which
is not made up of marketed consumer goods, i.e., investment.

The Circular Flow with Saving and Investment:

Income is earned by selling goods and services and the amount received
depends upon the amount spent on them. The circular flow is in complete if
there is no mention of saving. In economics, saving is treated as residue. It is
that part of society’s current income which is not spent on consumption goods.
As savings are not passed on through the purchase of goods and services they
act as leakages from the circular flow.

Saving is treated as leakage (or withdrawal) from the circular flow of income
because it is that portion of income received by households which has not been
spent on consumption goods. To the extent people do not pass a portion of their
income in the form of consumption expenditure, the income of others will fall.
Thus, saving causes the flow of income to become smaller.

On the other hand, there is an injection (addition) into the flow in the form of
investment. When firms undertake investment, capital goods are being
produced. Thus, the producers of those capital goods (such as, textile producing
machines) must be paid, i.e., they receive income. Hence, investment provides
additional income into the flow and this causes the flow to get larger.

From a country’s national income accounting system we know that the actual
amount spent on investment, i.e., adding to the stock of capital will equal actual
savings (Fig. 18.7). Investment is an injection into the circular flow of income

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and if it equals savings, the leakage caused by the latter will be offset and can
be ignored.

The circular flow of income viewed from the expenditure (spending) point
of view can be expressed in the following equation form:

National income = Consumption + Savings = Consumer Goods + Investment =

National Product.

The amount spent on consumption must be the same as the value of consumer
goods produced assuming that savings (the supply of capital goods) equal
investment (the demand for capital goods).

If saving and investment are equal, the flow will remain unchanged because the
amount withdrawn from it is equal to the amount of injected into it. Thus, if
saving and investment are equal, the level of income will not change, i.e.,
national income is equilibrium.

A few numerical examples will help to show why saving and investment must
be equal.

Assumptions of the Multiplier:

The Keynesian concept of multiplier is based on the following assumptions:

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(i) Autonomous Investment:

The Keynesian multiplier comes into operation for any autonomous (income-
independent) change in spending.

(ii) Lump-sum taxes:

The multiplier is derived on the assumption that taxes are lump-sum (once-for-
all) only. If part of economy’s extra income is taxed away by the government,
total leakages (i.e., the withdrawals from the income flow) would rise and the
value of the multiplier would be smaller.

(iii) Closed economy:

It is also assumed that the economy is closed. The multiplier ignores all external
economic transactions that could be significant for a country with foreign
sector.

Leakages from the Multiplier:

Anything that leads to a fall in national income through the multiplier is to be

considered as a leakage.

There are three such leakages:

(1) Savings,

(2) Taxes, and

(3) Imports.

These are the three deflationary components of national incomes (if

consumption can be regarded as fairly stable in the short run).

Importance of the Multiplier:

The multiplier is one of the most important concepts in the theory of the
national income It offers a means of numerically measuring or quantifying the
impact of changes in aggregate demand and any of its component parts. For
example, surveys of business plans may show that next year business firms
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expect to increase their investment spending above this year’s level by say, Rs.
5 crore.

With a twelvemonth multiplier of 2, this change would bring a Rs. 10 crore rise
in the value of output in the coming year. Business people and government
policymakers can make use of this information to analyse the effects of the
change, forecast its impact on other sectors of the economy, and take necessary
steps to adapt to the new conditions that will prevail. Both corporate and
national planning will be helped.

There is a second way in which the Keynesian multiplier is important. Since the
effect of any change is magnified, it is possible to achieve large results from
relatively small beginnings. For example, suppose the economy is currently
operating well below its full- employment potential by some Rs. 200 crore and
the central government wants to increase aggregate demand so as to move the
GNP upward to the amount.

Additional spending will have to be generated by government directly or by

stimulating consumer spending or business investment. Whatever the path
taken, the amount of new spending required to push the national income upward
by Rs. 200 crore is only half that amount when the twelve-month multiplier is 2.

Government Expenditure Multiplier: G-Multiplier (With Diagram)

Like private investment, an increase in government spending results in an
increase in national income.

Thus, its effect on national income is expansionary. There is a limit to private

investment. Thus, to stimulate income the gap has to be filled up by government
expenditure.

However, the increase in income is greater than the increase in government

spending. The impact of a change in income following a change in government
spending is called government expenditure multiplier, symbolised by kG.

The government expenditure multiplier is, thus, the ratio of change in income
(∆Y) to a change in government spending (∆G). Thus,

KG = ∆Y/∆G and ∆Y = KG. ∆G

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In other words, an autonomous increase in government spending generates a

multiple expansion of income. How much income would expand depends on the
value of MPC or its reciprocal, MPS. The formula for KG is the same as the
simple investment multiplier, represented by KI.

Its formula (i.e., KG) is:

The impact of a change in government spending is illustrated graphically in Fig.

3.19 where C + 1 + G1 is the initial aggregate demand schedule. E1 is the initial
equilibrium point and the corresponding level of income is, thus, OY1If the
government plans to spend more, aggregate demand schedule would then shift
to C + I + g2. As this line cuts the 45° line at E2, the new equilibrium level of
income, thus, rises to OY2— an amount larger than the initial one. It is clear
from Fig. 3.19 that the increase in income (∆Y) is larger than the increase in
government spending (∆G).

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The reason behind this expansionary effect of government spending on income

is that the increase in public expenditure constitutes an increase in income,
thereby triggering successive increases in consumption, which also constitutes
increase in income. However, greater the MPC, greater will be the increase in
income.

Tax Multiplier: T-Multiplier (With Diagram)

We know that a tax increase results in a decline in income. In other words, it is
contractionary in effect. An increase in tax (∆T) leads to a decrease in income
(∆Y). The ratio of ∆Y/∆T, called the tax multiplier, is designated by KT Thus,

KT = ∆Y/∆T, and ∆Y = KT. ∆T

Again, how much national income would decline following an increase in tax
receipt depends on the value of MPC. The formula for KT is

Thus, tax multiplier is negative and, in absolute terms, one less than government
spending multiplier. If MPC = 3/4 then the value of KT = (-3/4)/(1-3/4)= -[Link]
increase in taxes of Rs. 20 crore results in a decline of income of Rs. 60 crore.
That is to

-60 = (-3/4)/(1-3/4)

In contrast, with an MPC = 3/4, the value of KG = 4. Assume an increase in

government expenditure of Rs. 20 crore. Applying the formula for KG, we
obtain

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Thus, KT is negative and its value is one short of K, or KG.

Graphically, tax multiplier has been shown in Fig. 3.18. Pre-tax consumption
line and aggregate demand schedule are represented by C1 and C, + I + G,
respectively. The corresponding equilibrium level of income is OYI. An
increase in taxes shifts the consumption line to C2. Consequently, aggregate
demand schedule also shifts downwards to C, + I + G. Consequently, income
declines to OY2. Thus, the effect of an increase in taxes on income is
contractionary.

The G-multiplier and T-multiplier are also called fiscal multipliers as these
multipliers are associated with the fiscal activities of the government (i.e.,
changes in expenditure and taxation plans).

Foreign Trade as a Multiplier

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International trade refers to exchange of goods and services between one

country and another (bilateral trade) or between one country and the rest of the
world (multilateral trade).

The basis of international trade, from the supply side, is the Ricardian theory of
comparative cost (advantage).

According to Ricardo the source of comparative advantage is difference in

labour cost between two countries. Modern economists have extended Ricardo’s
theory and identified various other sources of comparative advantage, such as
differences in factor endowments, tastes and preferences, technological gaps
and product cycles. Ricardo’s theory is static in nature.

The same is true of the modern theory of comparative advantage, viz., the
Heckscher-Ohlin theory. Given a nation’s factor endowments, technology and
taste, Heckscher-Ohlin theory proceeded to determine a nation’s comparative
advantage and the gains from trade. However, factor endowments change over
time; technological improvement occurs in the long run; and tastes may also
change. Consequently the nation’s comparative advantage also changes over
time.

Over time a nation’s population grows and with it the size of its labour force.
Similarly, a nation increases its capital stock in the long run. Moreover, natural
resources (such as minerals) can be depleted or new ones found through dis-
coveries or new applications.

All these changes lead to faster economic growth and changing pattern of
comparative advantage over time. Technical change also leads to faster growth
of real per capita income and is thus an important source of growth of nations
and also a determinant of comparative advantage.

The growth of resources (such as land, labour, capital) and technological

progress cause a nation’s production possibilities curve (frontier) to shift
outward.

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There are the two main sources of growth:

1. Increase in the supplies of resources and

2. Technological progress. The effect of growth on the volume of trade depends

on the rates at which the output of the nation’s exportable and importable com-
modities grow and with the consumption pattern of the nation as its real per
capita income increases through growth and trade.

The Effect of Growth on Trade: The Small-Country Case:

If the output of the nation’s exportable goods increases proportionately faster

than that of its importable commodities at constant relative prices (or terms of
trade), then growth tends to led to greater than proportionate expansion of
trade. Economic growth has natural effect of leading to the same rate of
expansion of trade.

On the other hand, if the nation’s consumption of its importable commodity

increases proportionately more than the nation’s consumption of its exportable
commodity, at constant prices, then the consumption effect tends to lead to a
greater than proportionate expansion of trade. What in fact happens to the
volume of trade in the process of growth depends on the net result of these
production and consumption effects. This prediction is relevant for a small
country which cannot influence world prices of tradable goods.

Growth and Trade: The Large-Country Case:

Economic growth is more relevant for one development of LDCs. If economic

growth, what-ever its source may be, expands the nation’s volume of trade at
constant prices, then the nation’s terms of trade (which is the ratio of the price
index of exports to that of imports) tend to deteriorate. On the other hand, if
growth reduces the nation’s volume of trade at constant prices, the nation’s
terms of trade will improve. This is known as the terms-of-trade effect of
growth.

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The effect of economic growth on the nation’s welfare depends on the net result
of terms-of-trade effect and a wealth effect. The wealth effect refers to the
change in output per capita as a result of growth. A favourable wealth effect, by
itself, tends to increase the nation’s welfare.

Otherwise, the nation’s welfare tends to decline or remain unchanged. If the

wealth effect is positive and the nation’s terms of trade improve as a result of
growth and trade, the nation’s welfare will surely improve. If they are both
unfavourable, there is a loss of social welfare. If the wealth effect and the terms-
of-trade effect move in opposite directions, the nation’s welfare may
deteriorate, improve or remain unchanged depending on the relative strength of
these two opposing forces.

Immeserising Growth:

Even if the wealth effect, by itself, tends to increase the nation’s welfare, the
terms of trade may deteriorate so much that there a net loss of social welfare.
This is termed as immeserising growth by Jagdish Bhagwati. The term refers to
a situation in which a developing country’s attempt to increase its growth
potential through exports actually results in a retardation of that potential.

This is very much an exceptional situation confined only in theory to a country

where export speciality (some mineral or agricultural crop) accounts for a major
share of world trade in the product. The country needs to export more to earn
the foreign exchange to finance the capital imports which it requires to
accelerate its rate of economic growth.

If all its export effort is concentrated on its speciality, this could lead to an
‘oversupply’ of its product resulting in a deteriorating of the country’s terms of
trade. As a result, the country’s foreign exchange earnings will now buy fewer
imports and domestic growth potential will be impaired.

So long we briefly explained the effects of economic growth on a country’s

foreign trade but not the other side of the coin, the effects of trade on growth.
Those effects are much more important for developing countries, at least, from
the policy point of view. It is to this issue that we may turn now.

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